Beware Earnings as F.O.E.

Earnings reports and earnings season every quarter are times when the market responds to impressions rather than researched information.  Too a large extent the public cannot be entirely blamed, because they are relying on news reports and financial information from the companies.  In as much as these do not reflect the underlying tax accounting manipulations, real cash flow, the types of cash, and other legal legerdemain that constitute forward operating earnings (FOE), the information being publicly passed and digested does not give a reliable value of the security or the market as a whole.

John Hussman has written about the problem of forward operating earnings on many occasions in his weekly commentaries.  On July 19, he discussed how dividends are not properly taxed and this leads to companies to report earnings and then waste the "...retained earnings on speculative acquisitions and incentive compensation to insiders...".  He then went on to discuss how he warns investors to be skeptical of valuation metrics built on forward operating earnings as they are estimates of next year earnings but omit a whole range of charges such as bad investments, loan losses, restructuring charges, etc.  This generates statistically distorted and overly optimistic projections as substantiated by historical data.  He then illustrates how Tobin's q ratio, which is based on comparing market value to replacement cost, as advocated by Andrew Smithers and Schiller's CAPE, which is based on the ten year average of actual net (not operating) earnings provide consistently comparable valuations.  "Ultimately, the value of any security is the properly discounted stream of cash flows that the security will deliver into the hands of the investor over time."  Net earnings not operating earnings are the important and more accurate information.  "...net earnings represent the only amounts that investors can hope to obtain, and then only if the net earnings are distributed as dividends or invested in productive activities that don't get written off later."

On August 2, 2010, Hussman continued his concern with the increasingly careless use of operating earnings as a misleading measure of stock valuation.  "The two main failures of standard FOE analysis are that 1) analysts assume a long-term norm for the P/E ratio that properly applies to trailing net, not forward operating earnings, and; 2) analysts fail to model the variation in prospective earnings growth induced by changes in the level of profit margins, and therefore wildly over- or underestimate long-term cash flows that are relevant to proper valuation. By dealing directly with those two issues, we can obtain useful implications about market valuation."  Analysts tend to treat these hypothetical operating earnings to create forecasts "... as if they are distributable cash flows. Unfortunately, operating earnings exclude a whole range of charges that may not occur on an annual basis, but are legitimate costs and losses incurred as part of the ordinary course of business. Meanwhile, operating earnings often include a benefit from those very same "extraordinary" sources - provided they make positive contributions (witness the large boost to the operating earnings of major banks this quarter, resulting from the reduction in reserves for future loan losses)."

On August 9th, Hussman repeated the importance to the investor of being able to properly assess stock valuations.  He then continues with warning investors to not believe that cash on the balance sheet could "... suddenly be used, in aggregate, for new investments and capital spending." Often, this cash is in the form of loans to the government or private companies in the form of T bills and commercial paper.  Consequently, these investment savings are not available to spend.  These marketable securities are someone's liabilities.  Often, cash is the result of the issuance of corporate debt.  You cannot look at cash assets and ignore liabilities in national and global balance sheet of all assets and liabilities; what affects one side of the balance sheet effects the other side of the economic balance sheet of all corporations, individuals, and government.

When you look at market valuation and the value of a security, you need to dig into the actual detailed financial information and historical data and use that data in a rigorous model that yields information and not forecasts.  Too many market pundits will cry earnings and pronounce them as positive or negative based on summaries and estimates of forward operating earnings when they should be focused on net earnings, in what form cash is held, liabilities, and the use of earnings.  Too often market talk about earnings is the shot used to stampede the herd.  Often, market commentators have vested positions in how the market moves or, worse, political motives in forming public opinion.







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Revisionist GDP Numbers

On July 31st we reported the 2010 Q2 GDP numbers of 2.4%, of which 1.05% was from increase or rebuild of inventory and only 1.3% actual demand growth.  Of more concern, Q1 2010 was revised from 2.7% to 3.7%, which included a substantially revised inventory rebuild of 2.64%.  At the same time each quarter of 2007, 2008, and 2009 were also revised indicating the recession was worse then we were led to believe.

What Q2 2010 showed was spending needs to pick up, which is unlikely, and too much consumer and business spending go to imports.  Personal consumption expenditures (PCE) of 1.6% in Q2 slowed from 1.9% in Q1.

Q3 2010 will need to grow 3.4% to get to pre-recession levels.  With the economy slowing, unemployment growing, and housing prices (new existing home sales will be out August 24th) and inventory trending down that is not going to happen.  The July 30 Consumer Metrics Commentary on the GDP numbers shows the problem of the inventory rebuild number in the GDP going forward.  It should be noted that the GDP methodology used in the United States is completely different from that used by any other country, because the United States since 1980 has used a hedonic price index to adjust GDP numbers for a subjective value attempting to determine the economic growth from innovation, such as the economic growth from computers being replaced by more powerful computers.

With economic data for the last several months being mixed and beginning to show not only a slow down but the possibilities of contraction, analysts from various sources have been pouring over how the Q2 2010 GDP number might be revised on Friday, August 27th, and opining that it will be revised down to 1.9%, 1.4%, or even an extreme 1.0%.  With eyes around the world, particularly Europe, watching the United States for signs of recovery or slowing growth portending a possible near future contraction, the revision could have fear-confidence repercussions globally.  October Q3 GDP reports could begin to show contraction again in some European countries which have been expanding on tax increases, like Spain.  Will the fear-confidence factor grow into a sharp market correction?

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SEC Comment on the Fiduciary Problem

In the United States the financial services industry and the many associations which represent its salespeople, such as the CFP Board, have been pressing for an amorphous financial standard which would apply to all advisors without respect to how many conflicts of interest they have.  An actual discussion of true fiduciary duty is not allowed on the table, because fiduciary duty does not allow any conflicts of interest.  Even with the financial standard smoke screen, the salespeople protest they cannot understand what it is and how it could be applied and the public needs to practice caveat emptor.  Present securities law, rules, and regulations favor salespeople over fiduciary advisors and purposefully confuse the public as to who is who and what they do.

The new financial reform legislation which passed Congress kicked the fiduciary question down the street and required the SEC to study what, if any, fiduciary requirements should be placed on salespeople, advisors who sale, and advisors who do not sale (this later category is not a popular subject on Wall Street or in insurance companies).  Comment on this subject ends August 30 and you can read comments on file here.  The transparency of designations which clearly communicate to the public who is who and the level of fiduciary responsibility or actual fiduciary duty are long overdue.  Even the associations confuse the issue.  For instance, NAPFA holds itself out as an association of fee only advisors, but the majority of its members are salespeople who appear to provide the bulk of the association's revenue.  Besides an initial and annual membership fee, the requirement to become a fee only advisor member includes submitting a fictional financial plan consistent with the example plan sent to prospective members.  How hard can that be?  Yet, many lazy news organizations and writers fail to do the research and think this is the source for fee only advisors, when it actually has a very small percentage of actual fee only advisors as members.  A clear SEC designation would clear this mess up and make a lot of these self-serving associations redundant.

I have previously written on the need for a two years master's degree program for fiduciary advisors and have been working on a curriculum program.

Here is the comment I sent the SEC:

SEC

Comments on File 4-606

In the United Kingdom, Canada, and Australia it is now illegal to give financial advice and sell products and the regulations being phased in, because the two activities are ethically incompatible.

In the United States, the discussion of true fiduciary duty in which there are no conflicts of interest, as above, has not been publicly allowed, as salespeople and the organizations and associations which represent them are committed to the existence of "unavoidable" conflicts of interest and the promotion of a "fiduciary standard" which would put wolves in sheep’s clothing and continue the confusion of the public as to who is who as a commissioned advisor, fee-based, or fee-only. In fact current SEC law and rules and regulations allow financial advisors, with Broker-Dealer relationships, and advisors who accept fees from sources other than clients and/or soft money or services from a Broker-Dealer to legally call themselves fee only advisors. This confusion is purposeful and serves the best interests of salespeople.

I have previously published, prior to the passage of the new financial reform bill, a criticism of the current regulatory process and need for clear designations under the title of "Fiduciary Responsibility vs. Fiduciary Duty" which was published nationally by Advisor Perspectives

and also here.  It is time for public transparency, clearly delineated advisor definitions, and appropriate fiduciary responsibility salesmen and conflicted advisers distinguished from the fiduciary duty of a true fee only advisor with no conflicts of interest.

That article reads as follows:

     

I included the text of the "Fiduciary Responsibility vs Fiduciary Duty" article above as the SEC comments page recognizes no links in my comment.

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Yves Smith Interview

On the 7/31/2010 Radio Show, we had the opportunity to have Yves Smith as a guest.  Yves Smith is the author of ECONNED, which is one of the best books on the financial crisis, because it covers the economic thinking which led up to the financial crisis as well as how Wall Street greed proceeded at high speed towards the crisis and how government failed in its regulatory duties before and after.  Yves Smith is also the creator of the blog naked capitalism.

Here is the link to the RSS feed for The Pursuit of Financial Happiness which you can past into your preferred reader:

http://www.stationcaster.com/stations/wmay/rss/?c=336


 Here is the actual podcast of the Yves Smith guest appearance.

The Pursuit of Financial Happiness radio show podcasts are also available free on iTunes, but you need to go to the Advanced tab at the top of  iTunes and then select Add Subscription and past the above RSS feed in order to get a current list of shows, because iTunes takes its time adding shows from the RSS feed and just subscribing to the show itself in iTunes' Podcasts will not get you a current list of podcasts.

UPDATE: 1 June 2015
The radio station link is no longer any good.  Here is a good link:


http://www.mjscpaplan.com/podcasts/Interview_w_Yves_Smith.mp3



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Does the Media Understand Economic Statistics - Housing?

On Monday, July 26, the media made much of  June New Home Sales going up 23.6% with inventory decreasing from 9.6 months to 7.6 months and it seemingly effected the stock market which went up 100.81 points on the Dow.  Unfortunately, the June sales looked so good, because the May sales were substantially revised down.

June existing home sales and June housing starts were also down in reports from the prior week.

On July 28th, the Fed Beige Report came out and indicated sluggish housing sales, a decline in housing starts, and a struggling commercial real estate market.

When reading news articles, you need to dig for as complete information as possible in order to understand what the data really means.

The home ownership rate fell to 66.9% which is the lowest level since 1999.  While the Case-Schiller Housing Price Index showed a May increase in prices, the data is actually indicating that prices are probably starting to decline, although those results may not show up in the Case-Schiller for months.

Negative home equity is still at 4.1 million homeowners with more than 50% negative and 5 million with 20-50% negative equity, although the number has declined from its 2009 peak.  Banks are holding foreclosed and repossessed properties on their books rather than try to sell them in this market and to procrastinate in writing down the value of the repossessed homes on their books.

On Monday, July 26, did the stock market react rationally to housing data or did it just hear what it wanted to hear?


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What Have I Been Doing

I have been very deficient in making posts and I wish to apologize.  It is my intent to always attempt to make regular and hopefully daily posts.  However, many of my posts require significant research and organization and then hours to actually write.  The "Leftovers" posts from the Radio Show take 2-3 hours minimum. 

Since April I have been heavily involved in research on the European Credit Crisis looking at not just the countries but the banks in the countries, the ECB, the EU, the eurozone, account imbalances within the eurozone, the monetary and fiscal structure of the eurozone, interbank lending, country and bank exposure to deficit countries encountering credit confidence problems, interbank lending, liquidity issues, and trying to identify trends and the reasons effective solutions were or were not emerging. 

The European Credit Crisis is now at a lull, but credit and liquidity issues remain and they present potentially global ramifications, particularly as China and India attempt to control inflation internally, China attempts to control its real estate bubble, and political internal pressures build within France, Germany, the UK, Greece, not to mention India, China (a major competitor with Germany for the export market), and other countries.  In the meantime, Russia has been exerting its energy muscle to build relationships within the EU and eurozone to benefit its own economic interests which could eventually put enormous pressure on NATO.

Professionally, I have had to get Quarterly investment management reports out and otherwise earn a living.

I have almost 20 articles outlined and/or researched and waiting for the hours to write them.  Although I have not been posting, I still spend significant hours during normal sleeping hours working and doing research.  One article on Germany and how its history is consistent with the current Credit Crisis has been ready to write for over three weeks and will undoubtedly be relatively long while still concise.  I have another I want to do as soon as possible on Spain and its importance in how the European Credit Crisis winds down or proceeds.  I have at least two more planned and researched on the Pan-European Credit Crisis.  I have another on The Great Moderation as the Great Enabler.  I have one planned on China and its currency.  I have another on rethinking macro policy; another on wages, aggregate demand, and unemployment.

I intend to post all Leftovers from the Radio Show even though I am a half box behind in getting it done, because I think it is important to see how the data and facts have evolved.  When I get commentaries on the market from various sources, I like to read them and then hold them for at least a month and then read them again.  It can be very insightful.

I intend to make it worthwhile to check this Blog on a regular and, hopefully, a daily basis.

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Leftovers -- Radio Show 5/22/2010

Bank analyst, Meredith Whitney, said investors should avoid bank stocks at all costs.  In the second half of 2010, she expects job losses and a housing double dip.  The drop in reported credit card delinquencies was actually the result of new credit card rules which took effect earlier this year.  She thinks the financial reform bill will "be very bad" for banks".

When it comes to credit cards, the banks are gaming the payments, because, under the new laws which were designed to appear to protect consumers from self-serving billing practices, only the amount of the payment in excess of the minimum must be applied to higher rate balances.  The minimum payment is applied by the banks to lower interest rate balances first.

Elizabeth Warren continues to argue that the loopholes in financial reform which allow the big interstate banks to escape tougher state laws and rules on banks and credit unions create unfair competition, a destruction of a level playing field, and subjects consumers to higher interest rates if not usury.  Senator Whitehouse's amendment would close these loopholes and make big banks subject to stronger state laws if they want to do business in those states.

Another financial reform amendment by Senator Durbin would require credit card companies to cease charging transaction fees if the business also accepts debit cards.  This will help businesses, but it is expected the credit card companies will pass the lost transaction fees in higher card fees to credit card holders.

April CPI went down one-tenth just as it went up one-tenth in March for an annual inflation rate of 2.2%.  Core inflation was unchanged at .9%.  Using the 1980's calculation for inflation, inflation would be approximately 9.5-9.6%.  Using the 1990's calculation for inflation, inflation would be approximately 5.5%.

In the April meeting minutes of the Federal Open Market Committee meeting of the Federal Reserve, it was observed that business conditions are improving but most anticipated the pick up in output would be slower relative to past recoveries.  It is unlikely that consumer spending will be driving economic recovery and the savings rate has dropped.  The housing market appeared to have stalled.  Commercial real estate activity continued to to fall on deteriorating fundamentals.  Small businesses continue to have continuing difficulty in obtaining bank loans.  Small and regional banks are vulnerable to commercial real estate loans.  If European countries expand fiscal consolidation (cut deficits), the result would likely be slower growth in in Europe and a weaker global economy.  As I have noted on several occasions, and as one participant in the FOMC commented, core inflation appears to have been held down in recent quarters by unusually slow increases in the price index for shelter (its composition was changed)  and the recent behavior of core inflation might be a misleading indicator of the underlying inflation trend.  While inflation remains low to flat, expectations of inflation are increasing among market participants.  Again Mr. Hoenig was the sole dissenting vote on "exceptionally low levels of the federal funds rate  for an extended period", because he fears it will lead to a build up of future financial imbalances increasing the risks of longer run macroeconomic and financial stability and limit the FOMC's flexibility in when and how it begins to raise rates.

David Beckworth has concluded that a current high unemployment is not cyclical but structural, which means there are thousands of jobs which are permanently gone and will never be refilled.  In my opinion, this also means those unemployed over 55 years old will particularly have a hard time find comparable work or comparable pay to their former jobs.

The SEC suspects ETFs fueled the May 6th drop.  ETFs accounted for 70% of the securities that fell 60% or more from their price at 2:40 P.M.  Bond ETFs did not see sharp drops.  Many of the trades involved stub quotes or place holders (one cent) as the result of computer programs.

John Hussman in his weekly commentary is concerned that the ECB's pledge to buy sovereign bonds from European banks will place weak assets on their balance sheet just as the Fed did with toxic mortgage backed assets.  I personally do not think they are comparable assets.  Hussman sees monetary policy as being only as good as fiscal policy.  Unfortunately, the eurozone has removed monetary policy from its member nations control and the Stability and Growth Pact has significantly crippled member nations' fiscal policy applications consistent with internal economic needs.  Hussman is also ignoring the current account imbalances within the eurozone.  He believes that without a central taxing authority, the eurozone lacks the ability to control deficits.  Consequently, he thinks Greece will have to restructure debt, but he is ignoring that the IMF/EU bailout forbids restructuring.  He actually thinks Greece and other countries will pull out of the euro, but he is not acknowledging that that would require withdrawal from the European Union in totality, which is very unlikely and difficult to happen.  He sees tepid wage growth for the next several years and inflation not being a factor until the last half of this decade.

Congress will be considering a mish-mash conglomerative bill which includes several diverse issues: a 30 day extension of jobless benefits, retroactive reinstatement of expired tax cuts, summer jobs, police and teacher jobs, and increased taxes on investment fund managers from 15% capital gains to 35% as well as other oil barrel tax, a three year delay in Medicare payment cuts to doctors, etc.  These bills are designed to have a little something for each party and often end up either mired in controversy.or whisked by the wind.

Hundreds of cases have been referred to the Justice Department over several years involving bid rigging of municipal bond sales by financial advisors and traders, including banks.  This also involved the sell of interest rate swaps to local governments that backfired.  The process was pervasive and may have involved many, if not most, of the largest banks.

Pinalto, Cleveland Fed President, sees a gradual recovery and low inflation.  She sees high unemployment and overwhelming cautiousness by consumers and businesses as a major impediment ("headwind") to recovery.  Kohn, Fed vice-chairman, sees keeping future price expectations intact as vital with interest rates are very low.  Unanchored expectation would be risky and far too costly.  He addressed the uncertainty of determining proper price stability, asset bubbles, asset purchases and sells, and balancing financial stability.  Dudley, New York Fed President, said the recovery will not be robust, household deleveraging started last year, and the transitory inventory boost to GDP is over.  Tarullo, Fed Board Governor, in Congressional testimony said the European credit crisis could spill over and cause U.S. bank losses on credit exposures.

The passage of the Senate financial reform bill has a variety of winners and losers, but it is going to Conference Committee with the vastly different House version and in conference committee anything can happen and a bill could emerge which is vastly different from the two which went into Conference Committee.  You can expect many amendments which were not debated publicly and the bank and financial services lobbyists will have their knives out and counter attacks washing across the Conference Committee like the waves of the ocean.

Economic information we did not get to on the show:

The IMF said the European Union fiscal tightening will slow recovery.

The new UK government will cut $8.75 billion in spending.

Japanese core machinery orders were up 5.4% in March.

EU plans hedge fund crack down with rules to control pay and borrowing as well as force disclosure of investing information.  Some think this will discriminate against U.S. hedge funds and other none EU funds.

Germany unilaterally and without consultation with other EU countries banned short selling of equities and sovereign debt swaps.  It had negative effect on the markets, but it is essentially meaningless without action by other countries as the trades will just be executed in other foreign markets.

Eurozone CPI was up .5% in April on rising energy prices.  CPI was up 1.5% vs year ago.

UK CPI was up 3.7% April vs year ago with higher food and tobacco/alcohol taxes.

Chinese CPI is expected by the government to rise 3% vs year ago in May and June.

Dubai World reached a tentative agreement with creditors to restructure $28.5 billion in liabilities.

Japan's economy grew 4.5% (expected 5.4%).

Spain's lar4gest union may call for a general strike.

Greek demonstrations were mild after last week's violence,


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Financial Reform is a Dirty, Corrupt Process

While many, including myself, labor and desire financial regulatory reform in the United States which will protect the American public, defuse systemically risky financial companies, provide a practical liquidating process of multiple financial companies during a financial crisis, and enter the 21st Century with respect to the need for fiduciary duty and how that is distinct from a watered down wolf in sheep's clothing fiduciary standard.

What can be said of a country that will not even debate the need for fiduciary duty and the ethically incompatible functions of selling financial products?  In the United Kingdom, Canada, and Australia is illegal to provide financial advice and sell financial products.  Period.  Are they more civilized or more democratic or just more pro consumer protection oriented than regulators and congressmen in the United States?  Are their regulatory agencies more conflict free and less corrupt than the United States?  In the United States not even the main line bloggers think fiduciary duty is worth discussing.  I have made my position very clearly and I have not minced words.

It is more popular to talk about "too big to fail" when the topic should actually be the "systemically dangerous".  Obviously, a Volcker Rule which addresses financial companies of any size which are systemically dangerous is necessary.  The fight for an independent consumer financial protection agency is lost with its imprisonment in the Federal Reserve.  Stripping commercial banks of derivatives, private equity, and hedge fund trading and product development is fundamentally necessary.  Taxing financial companies for excessively risky behavior is perceived as too much to ask; after all, it might actually curtail excessive risky behavior and limit the compensation of investment bankers/traders who live to devour the competition much less the unsophisticated.  If, during a financial crisis multiple financial companies need to liquidated or restructured simultaneously, we are doomed, because the resolution process proposed in the United States addresses single companies and will not work if initiated. 

Stiglitz has recently listed what financial reform should do and what it is not doing in a recent article.  He shows that the House and Senate versions are both inadequate, the pressures of the financial lobbyists, and the need for a resolution process, and reforms to prevent another financial crisis like one we continue to experience.  He falls into the "too big to fail" myth while he has written about systemically dangerous as the proper term, because it is not about size; it is about excessive risk and being a systemic threat.  But, then, he also falls into the fiduciary standard trap.  Perhaps he is just trying to be inclusive in an attempt to promote reason.  His article covers a lot of territory with little substantive argument in an attempt to show the problem and the need for solution.

Exemplifying the extreme focus on what many consider "the" important issues, Rortybomb compared the House and Senate versions of resolution authority, bank capitalization, derivatives, and auditing the Fed only.  He does mention he is also concerned at the loss of the ratings companies being subject to an independent agency which assigns raters to debt issuances and auto dealers exempt from consumer protection disclosures.  What he does not mention is fiduciary duty, the consumer financial protection agency, the exemption of many small banks, and the provisions which make the largest banks more powerful than before the current crisis. 

The inadequacy of the Orderly Liquidation Fund is well discussed in this article by Jennifer Taub on The Baseline Scenario.  The proponents of the financial elite want no part of any law which would actually make the financial elite pay for their mistakes, when the losses can be so conveniently dumped on the American public in a pious contrition towards the unspoken state of corporate socialism.  The Baseline Scenario has many other posts on financial reform.

The attack upon any type of Volcker Rule which addresses the issue of systemically dangerous financial behavior is unrelenting.  Rortybomb, which is an excellent source on financial reform, recently wrote about how any form of the Volcker Rule is not being taken seriously in the Conference process.  Some congressmen are concerned that stripping private equity, derivatives, and hedge fund activities from banks will put them in unregulated entities.  Are they being obstructionist?  Without divorcing commercial banks from trading excesses, we will be primed for the next financial crisis and nothing will stop it.

Do we live in a corrupt society?  Do we desire a society feudalistically dominated by financial corporations?  Is the general welfare of the people a dominant concern or just a phrase which money from financial lobbyists allow congressmen to ignore?  Do we need to go back to the Constitutional mandate of a U. S. Representative for every 30,000 citizens and have a larger lower House like other developed democracies, like the United Kingdom?

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Leftovers --- Radio Show 5/15/2010

We discussed the use of stop loss orders and stop loss limit orders.  In liquid markets, stop loss orders are usually sufficient, but on May 6th we saw how stop loss orders would have been more appropriate given high frequency and computer program trading gone awry.  A stop loss order is a market order after the stop loss is reached.  A normal stop loss is 8% from either the original basis or a higher gained level after purchase.  In a stop loss limit, you might have a stop of 4% with no execution below an 8% loss.  This would save you from a precipitous drop from which the market then recovers; if the market does not recover your loss is even greater, because there was no execution.  Those people, who followed my consistent advice, would have been completely out of stocks and stand alone ETF positions by May 5th, because the market went into correction on the 4th and they would have sold any positions in which there stop loss orders had not yet executed.  You do not stay in stocks and stand alone ETF positions in a correcting market.

The major securities exchanges agreed to create a uniform system of circuit breakers to slow trading during intense market volatility.  Part of the problem on the 6th of May was a slow down on the NYSE and trades routed to electronic exchanges.

U.S. Senate voted to force credit card companies to cut transaction fees to businesses that accept debit card transactions.  This will help businesses more than the public as the cost of the cuts is passed on by the credit card companies to the card holders.  The Senate also stripped the right of banks to directly engage ratings agencies to rate bonds.  The Senate wants the SEC to set up an independent board to decide which ratings agency provides ratings for a bond issue.  The New York Attorney General has subpoenaed eight banks for information on their dealings with ratings agencies: Goldman Sachs, Morgan Stanley, Deutsche Bank, Merrill Lynch, UBS, Citigroup, Credit Suisse, and Credit Agricole.  Moody's received a Wells notice from the SEC, because there is concern Moody's 2007 initial application to become a nationally Recognized Statistical Ratings Organization (NRSRO) was misleading.  Morgan Stanley is being investigated by the Justice Department to determine if they misled investors on mortgage derivatives it helped create, market, and sometimes bet against.  The New York Attorney General is suing a unit, Ivy Assets, of NY Mellon alleging they kept clients in the dark about problems with Bernie Madoff of which they had knowledge.

The U. S. Senate approved an audit of the Fed, but only of the emergency actions since December 2007.  It is not a full audit.

FHA commissioner David Stevens urges private mortgage insurers to not ease standards.  They have seen a massive drop in business, but prices are falling and the mortgage insurers want to do more business and the bailout of Fannie and Freddie, with their higher costs, is pushing private mortgage insurers out.  The FHA intends to maintain lending volume until capital comes back.

The ECB is committed to the survival of the euro and is buying sovereign bonds in the secondary market with a $1 trillion fund.  While this is portrayed as necessary steps to strengthen the eurozone, the bond purchases will primarily help European banks by taking the sovereign bonds off their balance sheets while increasing their liquidity.  The ECB pledged to keep the bonds for their full maturity.

There is a fake SEC being operated by con artists under the name of "U.S. Securities and Equities Administration", "U.S. Securities Administration", and the U.S. Securities Bureau enticing investors with offers to remove supposed restrictions on stocks they own or release funds being held by the government for a fee.  They had a global counterpart, an address shared with Deutsche Bank and Standard and Poor's in Boston.  They even set up a website with detailed investor alerts and warnings.

Parallel criminal and civil probes have been launched by DOJ and CFTC into whether JPMorgan through its trading activities actively suppressed the price of silver.  There has also been some speculation that big bullion dealers and ETFs do not have the physical bullion they claim to possess.

According to a study from the Center for Retirement Research at Boston College, if a couple turned 65 last year and at least one spouse suffered from a chronic disease, they would face lifetime health cost of $220,000.  A healthy couple without any chronic diseases would have lifetime health care costs of $260,000.  For 5% of the unhealthy couples, the cost can be as high as $465,000 compared to $570,000 for 5% of healthy couples, because a healthier couple will live significantly longer lives.

In the past we have said several times that a sustainable recovery is usually preceded by a strengthening dollar.  Since 2008, commentators have been extolling the export benefits of a weak dollar as the road to recovery.  The increase in exports and a significantly declining trade deficit has not been happening.  A strong dollar encourages foreign investors to invest in the U.S., bring money into the United States.  A stronger dollar makes imports cheaper and helps control inflation.  Services and production outsourced to other countries may find economic reason to return to the United States.  The strength or weakness of the dollar is always a double edged sword.

Lacker, Richmond Fed President, again said the Fed must not wait too long to raise rates given public inflation expectations despite low inflation.  Economy is slowly improving but it will take some time to make substantive progress in high unemployment, although he sees progress.

Kohn, Fed vice-chairman, said economic rebalancing prevents turmoil. in addressing the problem of global financial imbalances in the emergence of global financial crises.  In my opinion this is exactly the problem within the eurozone.  It is unfortunate that Germany and China are not interested in global rebalancing.

Hoenig, Kansas City Fed President, who also wants the Fed to raise interest rates and to move back to a more neutral policy, was profiled with a explanation of his monetary beliefs by The Wall Street Journal online.

Elizabeth Warren of the Congressional TARP Oversight Panel said she remains infuriated that TARP has failed to funnel some of the $700 billion to small businesses.  Big bank lending to small businesses actually dropped 9% from 2008 to 2009.  Small banks still remain constrained by exposure to commercial real estate.  In my opinion the banks which have profited the most from the government bailout are lending the least to promote economic recovery.  A study by the Panel found that several TARP initiatives were ineffective in getting money for small business.

The National Federation of Independent Business monthly economic trends survey showed more optimism but still weak economy with spending at record low levels.

FINRA is focusing its enforcement priorities on selling-away cases, municipal disclosures, structured products, and leveraged exchange-traded funds.

John Hussman in his weekly commentary is of the opinion that no repetition of game theory will produce a result that will keep Greece from needing to restructure its debt despite the EU/IMF bailout, which was designed to last three years.  In his opinion it might give Greece only 18 months relief from seeking capital in the open market.  Unfortunately, he appears to be to focused on deficits and not enough on the current account imbalances among the eurozone countries.

Rob Parenteau of the Levy Economics Institute, for whom I have been doing economic research on the eurozone crisis and European and U.S. bank exposure as well as hedge fund investment opportunities, wrote that the Greek bailout will fail for three reasons: 1) higher taxes and lower public worker wages create discontent, 2) Greeks have borrowed from French, German, and Swiss banks not just Greek banks compounding the problem, and 3) Greeks will have less money to spend and countries and businesses with business ties to Greece, like Germany and the Netherlands, will also suffer.  He also indicated the euro will fall at least 20-30% this year.


The IRS has issued average premiums by state for the new small group tax credit.
Chinese prices were up 2.8% for the year to April; industrial output was down 17.8% vs year ago; bank lending is still pumping despite monetary tightening at $113.4 billion in April.

French economy may see a .4% growth in Q1 and .5% in Q2 according to the Bank of France (the forecast is 1.4% and is now in doubt).

China April trade surplus is $1.7 billion after a March trade deficit of <$7.2 billion>.

Keeping children until age 26 on parent's insurance will raise employer premium costs by 1%.

UK production was up 2% in March; output was up 2% vs year ago.

US retail sales, ex autos, were down 2% in April with all sales up .4% in April; all sales were up 8.8% vs year ago.  March was revised up to 2.1% from 1.9%.  US trade deficit was up to 19% in March.  It grew by 2.5%, $40.4 billion, in March.  Imports were up 3.1% led by oil.

US industrial output was up .8% in April with capacity utilization up to 73.7%, which is still 6.9 below the average.

China April producer prices were up 6.8% and property prices were up 12.8%.

Hong Kong GDP Q1 was 8.2%.

U.S. Treasury auctions:

3 year Treasury, $38 billion, yield 1.414%, bid-to-cover 3.28, foreign 51%, direct 16.5%.

10 year Treasury, $24 billion, yield 3.548%, bid-to-cover 2.97, foreign 59.6%, direct 24.96.

30 year Treasury, $16 billion, yield 4.49% (higher than current market which means this yield is "tail"), bid-to-cover 2.60, foreign 32.5%, direct 17.5%.  This was a weak 30 year auction.


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Illinois Has No Political Will; Fiscally and Ethically Bankrupt

Moody's downgraded the State of Illinois credit rating for its General Obligation bonds from AA3 to A1 citing the State's continued inability over years to confront mounting debt with a balanced budget as required by Illinois Constitution.  This is one in a series of debt downgrades which will undoubtedly continue.  Moody's observed that Illinois is making only stop gap steps by borrowing against the tobacco settlement funds, an economically questionable tax amnesty program, and dependence on Federal stimulus funds which are running out.  Moody's also stated the economic recovery in Illinois will lag the Nation.  The Illinois political leadership in the House, Senate, and Executive has failed to solve large unfunded pension liabilities, exceptional retiree health benefits, and a chronic disparity between revenue and spending.  Moody's commented that the larger the deferral of action lasts the harder implementation of a solution will become.  Conservatively, the FY 2010 budget deficit will be approximately $13 billion, although I have long maintained it may be closer to $15 billion after all non-recurring funds are considered.  Illinois is fiscally bankrupt.

The primary response of the State of Illinois to the budget problems has been to not pay its bills to vendors, universities, local government, private social service agencies, and school systems.  Some have not been paid for over a year.  In fact, there are at least $5 billion in unpaid bills, which is twice the amount one year ago and almost ten (10) times the amount of unpaid bills in 2008 ($512 million).

The primary and absolute cause of this fiasco is the failure of the Democrat and Republican elected representatives and senators to work together and perform their governmental duties in the best interest of the people rather than political posturing and partisan combativeness aimed at no results.  Results, decisive political leadership, would require acceptance of votes.

The Governor submitted a budget which attempted to show the value of a 1% income tax increase for education with significant education cuts if not passed, examples of what 10% agency cuts might mean, and more borrowing to make pension fund payments as well as massive fund sweeps of dedicated funds.  All of this was artfully constructed for political effect, but in no way adequate in resolving the debt problems of Illinois government.  A prior proposal for a 2% income tax increase to a flat 5% was never seriously considered in 2009.  The Republican party has been adamant that operational cuts must be made but have failed to provide concrete cuts for consideration.  The opposing candidate for Governor has proposed, in the past, across the board 10% cuts but has equivocated recently as it is widely acknowledged such cuts would not be enough to solve the debt problem and could be destructive of the services government is expected to provide its citizens.  The current Governor has spoken of making cuts and cost savings but they have yet to materialize beyond words.

One bill passed in 2010 would raise judicial retirement ages from 55 to 67 after January 1 and reduce annual pensions from 85% of ending salary to 60% of social security wage base.  This is a significant cut, yet, the General Assembly was unable to make other pension reforms or increase retiree health premiums to levels still below the private sector.  The president of the Illinois Judges Association objected to the pension changes for judges appointed after January 1, 2011 and said judges need to provide for their families and educate their children.  Does this logically mean other, average, people do not need to provide for their families and educate their children?  The annual pension of a current associate judge making $165,588 would be $140,750.  If appointed after January 1, 2011 the annual pension at current salaries would drop to $64,080.  The average State employee (the regular joe --- not the special, politically connected elite) pension is approximately $20,000 according to AFSCME. 

Democrats control both houses of the General Assembly but refuse to take action by their majority only.  Republicans demand cuts but refuse to be associated with cuts affecting public services.  There have been demands for a forensic audit despite the estimate of a cost in excess of $60 million and the existence of State Auditor reports on all State agencies, departments, and boards.

Illinois pension systems are the most under funded state pensions in the United States in excess of 50% (almost 60%)  under funded.

Over 3000 State employees are exempt from the civil service and there has been an absolute refusal to assure these employees positions are evaluated for cost effectiveness and individual performance as any competent organization would do annually.

The sad fact is that, after so many years of incompetent and corrupt political administration have transpired, the debt problem cannot be resolved by cost savings, efficiencies, and spending cuts alone but also require tax increases.  This creates a situation which is unpalatable to both political parties as well as unions, local governments, public employees, retirees, and diverse public interest groups of all political spectrums.


Some civic organizations have proposed radically differing proposals.  The Center for Tax and Budget Accountability traditionally proposed a wide adoption of service taxes, because Illinois is a State which taxes few services, despite the disposable income regressive nature of sales and service taxes, but this year embraced a variety of income and sales taxes combined with some tax relief for lower income groups proposals.  The Illinois Policy Institute saw the solution in significant public sector labor and wage cuts and freezing spending for coming years.  The Civic Federation has consistently advocated the need for an income tax and significant pension system reform as well as full funding as well as detailing other budget proposals.
During the Democrat primary there was a good debate on flat rate income tax and a progressive income tax, but unfortunately most of it revolved around exemptions and taxing the "rich".  However, a progressive income tax would require a Constitutional amendment, which would mean a new Constitutional convention which would open up a wide variety of political controversies.  The flat rate increase was hobbled by high personal exemptions, an assumption of a four person family size, and no consideration of the regressive nature of sales taxes on disposable income.  Neither proposal would have generated enough money to solve pension funding or cover current spending.  When it comes to actual per capita taxation, Illinois is relatively low ranked compared to other states.

Illinois tax revenue is decreasing at serious levels during this period of financial crisis and fragile economic recovery.  Sales tax revenue alone is down $494 million for the year and all revenue is down $1.456 billion through May.

The budget as passed by the General Assembly is acknowledged to not be in balance.  Consequently, it is unconstitutional.  It does give the Governor authority to transfer funds, not restricted by Federal or State mandates, within the budget. 

And all of the politicians and the candidates want to wait until after the election.  Whoever wins will still face the same bureaucracy and fiscal problems.  How do you get qualified veterans hired with their legal preferences much less other qualified management personnel if all state job opening descriptions contain a requirement for specific knowledge and experience in specific department and program rules and regulations and statutes?  This limits hires to current state employees or the politically connected who get to bypass the process.  How can needed cuts be done if every special interest group with enough political campaign contribution clout and/or voting voices dissuade what needs to be professionally and reasonably done?

What needs to be done is obvious to any trained professional.  1) Make cuts based on top down evaluation of program spending and revenue efficiencies provided by an intergovernmental team which is independent of any department working out of the Governor's Office.  2) Make efficiency cuts based on cost savings and target possibilities to increase current revenue programs, such as uncollected or unenforced fines.  3) Professionally evaluate all exempt personnel and positions for competence, organizational necessity, and cost effectiveness.  4) Implement all State Auditor report recommendations and findings in past department, board, and agency audits and terminate those people who cannot get it done.  5)  Make a choice as to what programs are economically and socially safety net and growth necessary and which are not and prioritize each category and the programs within each category.  6) Increase the flat rate individual income tax to 5.5% from 3% with 1/2 percent directly deposited in the pension funds for an increase of $5.7 billion in general revenue and $1.425 billion for pensions; leave the personal exemptions unchanged but provide a sales tax credit for the 40 % lowest taxpayers.  7) Increase the corporate flat tax rate from 7.3% to 8.5% (same as Indiana) with 1/2% directly deposited in the pension funds.  8) Reform pension and retiree health benefits and ages consistent with actuarial needs and private sector costs; create a two tier system for current participants and new hires after reforms.  9) Create the necessary changes and review process to properly terminated or demote and reassign any civil service or union employee for documented inadequate job performance in an expeditious time frame.  10)  Reform legislative and elected official pensions to eliminate double dipping and limit pension amounts to no more than 60% of final social security wage base with service years prorated to state employee vesting period (if full vesting is 30 years for state employee and elected official has ten years in any state government elected office that would equal 1/3 of the 60 of final social security wage base as a pension).  11) Create a luxury sales/service tax which applies to luxury items starting at specified dollar amounts for each type of item adjusted for CPI (inflation) but not declining.

No wonder politicians prefer handpicked "experts" to professionals.  The ethical pursuit of serving the best interests of the people is obviously not as rewarding as not getting things done right or not done at all.

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