Leftovers -- Radio Show 3/20/2010

Edward Harrison of Credit Writedowns observed there has been no credible reform of the financial system while monetary and fiscal normalization is taking place.  He remains concerned that several pitfalls remain in the global economy with respect to protectionism, unemployment in the United States, sovereign debt crisis, and commercial real estate.  In his opinion, any renewed economic weakness could be viewed as a double dip and he gives the probability at even odds.  Last week Roubini gave the odds at 20%, Roach at 40%, and three months ago Hussman gave the odds at 60% but now sees the market as irrationally sustained despite its overvaluation.  The banking analyst Meredith Whitney said the housing market in the United States will go through another double dip while mortgage backed securities and Treasuries will surely retreat.

In his weekly commentary, John Hussman observed that the financial crisis was not an unpredictable surprise but an ordinary outcome of extraordinary recklessness as observed by problems in the market beginning in 2005.  Adjustable rate mortgages are just now hitting their 5 year reset dates and this will require payments of interest plus principal replacing payments less than interest on loans well above current market values of the homes.  Any analysis which alludes to data prior to now are reflective of a reset lull and the real time frame to watch is the three months following July-September 2010 which may start showing delinquency increases which will peak in the second half of 2011,  With hundreds of billions of dollars in resets in the coming months, it would be reasonable to expect 40% to become delinquent.  He believes it will be interesting to observe to what extent 30 day delinquencies spike in February-March 2010 as the result of the small number of resets in November 2009 and expects the delinquencies to increase through 2010, back off in the first half of 2011, and reach a final peak in late 2011.  He is doubly concerned, because "...the only points between the pre-Depression period and the late-1990's when the market has been so richly valued were November-December 1972 (before a 2-year market loss of about 50%), and August-September 1987."

The Federal Reserve will close the Term Asset-backed Securities Loan Facility on June 30 for loans backed by new issue commercial mortgage-backed securities and on March 31 close loans backed by other types of collateral.  They reaffirmed with one dissent that interest rates will remain zero to 25 basis points for an extended period of time.  This has some economic observers questioning what effect these actions will have on liquidity in the market.

The Baseline Scenario commented on the Irish economy as an example of why the United States should limit the size of risk taking banks and force them to hold more capital.  Exports are down 9%.  Its GDP was down 7.3% through Q3 2009.  Housing prices continue to fall.  Its euro currency exchange rate cannot move relative to its major trading partners and, therefore, cannot improve competitiveness without drastic wage cuts.  It is perceived by some to be a success story for its EU imposed austerity program with draconian fiscal cuts with lower wages and higher taxes, because its bond yields imply just a 1% chance of default greater than Germany.  The whole fiscal austerity program is a gamble that GDP will recover to over 4% in 2012, while planning further cuts through 2013.  Its budget deficit will still be 12.5% of GDP in 2010.

According to The Baseline Scenario, the difficulties in Ireland began with a massive property boom financed by cheap credit from Irish banks with the three largest banks building up loan and investment portfolios 2 1/2 times GDP.  With the financial crisis, housing prices fell 50% and today approximately 1/3 of loans on the banks balance sheets are essentially non-performing which means potential bad debts are 80% of GDP.  As the result of strong lobby by real estate developers, bond investors, and politicians with links to developers and the banks, the Irish government guaranteed all of the liabilities of the banks and injected funds into the banks.  It is now planning to buy the most worthless assets in exchange for government bonds.  In doing so, they have converted private liabilities into public (sovereign) debt, while creditors remain free and clear of the results of their reckless behavior.

Deutsche Bank, J.P. Morgan Chase, UBS, and Hypo Real estate were charged with fraud in the sale of derivatives to the City of Milan.

Ernst & Young ignored a whistleblower on the Lehman Repo 105 transactions, which materially misstated Lehman's balance sheet, ignored questions from audit staff, and became "comfortable" with the Lehman's use of the Repo 105 transactions.

Tyler Durden ventured the opinion that the decline in purchases of US Treasury securities by China and Japan have been offset by increased purchases by the UK, as a proxy of China, oil exporting countries, and Caribbean banking centers, as a proxy for hedge funds.

The Financial Accounting Standards Board may be preparing to propose banks expand the use of market values for financial assets, such as loans.  The banks have been exempted from mark-to-market rules, which means their financial statements and income statements are not accurate and cannot be relied upon.  40% of the total assets ($2.8 trillion of loans) of the four largest banks (J. P. Morgan Chase, Bank of America, Citigroup, and Wells Fargo) could be affected.  The impact could be even larger on smaller banks.  While the banks will fight any proposal, the FASB proposals are actually fairly limited to balance sheet and income statement disclosure of historical cost and loan-loss reserves and market values, of financial holdings divided between those they trade and those they hold with trading assets affecting profit and non-trading assets being marked-to-market as a portion of shareholder equity called other comprehensive income, and income statements would show more than just net profit by adding an "other comprehensive income" category reflecting market value changes of loans and securities.  The "other comprehensive income" would be added to net income for a new bottom-line figure called comprehensive income, while earnings per share would still be based on net profit.  Whatever happened to the concept of fair market value?

While markets are becoming slightly more bullish on Greek debt, the resolute desire by member nations against any "stronger" political union to resolve the structural problem of the euro means the EU must consider a European Monetary Fund funded by member countries with excessive deficits and debt levels, as proposed by Gros and Mayer, and the creation of Euro Bonds with the interest rate of each participating country dependent on the interest rate it pays when it issues its own bonds.  In my opinion, if the competitiveness gap refelct in current account balances resulting from the structural problems of the euro are to be addressed sufficiently, any EMF would have to be funded by countries with excessive deficits and excessive surpluses.

Germany insists that every country eliminate its excess fiscal deficit quickly, but that can only happen is current account balances improve or private balances deteriorate,  If private balances are to deteriorate, then private debt financed spending must surge.  If current account balances must improve, then they must deteriorate elsewhere in the Eurozone resulting in a move to smaller private surpluses in countries like Germany or the Eurozone must shift towards surplus.  The most likely outcome of a fiscal retrenchment would be a continued, long lasting economic slump in those countries forced to implement austerity programs.  Why should their populations endure and accept this imposition?  Martin Wolf has said "Germany's structural private sector and current account surpluses make it virtually impossible for its neighbors to eliminate their deficits, unless the latter are willing to live with lengthy slumps.  The problem could be resolved by a eurozone move into external surpluses." Germany wants its neighbors to be like itself, but they do not have Germany's deficient internal demand.  What is required is for Germany to become less German and increase internal demand.

In Spain the central government is hobbled by 17 regional governments which control 17% of the public spending as well as regulate the banks within their regions.  The political problem is the regions have been given control over spending, such as health and education, without the need to go to the taxpayer and ask for the money.  The only real control the central government has is that it must sign off on region's debt issuance.  Yet, it is dependent on these regions for political support in maintaining parliamentary control.  The Spanish banks regulated by the regions have significant mortgage loans which have never been marked to market and may pose a systemic risk to Europe and, perhaps, globally.

While it is obvious that China uses trade and currency rules to boost exports, any attempts to take protectionist actions against the Chinese currency rate would be self-defeating. China's use of the WTO to file more complaints than any other country on other country's trade practices is an example of how China would react.  It is entirely possible they view any pressure to appreciate the yuan as economic warfare just as their pegging the yuan to the dollar may be a form of economic warfare.  Yet, Paul Krugman has indicated that the Treasury Department should declare China a currency manipulator in its April 15 semi-annual report.  Krugman asserts we have nothing to fear from China with respect to selling US assets and we must act forcefully with a large 25% surcharge on imports.  This would be trade war on a truly global scale, not just nation against nation.  Krugman has also maintained that the US does not need China to continue buying US debt for the US to keep interest rates down, because they would be selling US dollars which would be expansionary for the US.  Krugman totally dismisses the consequences of a global trade war asserting the US and Europe can get what they want elsewhere and the real issues are Chinese currency intervention which increases their exports, elastic pessimism which would support foreign exchange controls do not apply because China is in the process of rapid economic transformation and a real exchange rate has to change to reflect the significant changes in the economy internally, and China's outlandish mercantilist policies must be stopped if the acute damage from their currency policy is to be abated. The Chinese premier strongly argued that the Chinese currency  policy needs to be maintained to control Chinese inflation and social stability and that its exit policies need to be deliberate in order to avoid a global double dip.  Wen Jiabao warned against protectionism and strongly defended free trade, while expressing concern about the US dollar.  The Chinese central bank recently did some stress testing of the effect of appreciating the yuan on selected exporting industries and found that every 1% appreciation would likely result in a 1% drop in profit margin.

Michael Kleist, who lives in Shanghai, has written that China's real estate bubble is overrated, because the Chinese government has the power to exert any fiscal control it needs whenever it needs and it needs to maintain a strong housing market which does not appear to be credit driven.  He, however, is not addressing the significant speculation in vacant real estate and vacant buildings and the use of leverage in that speculation.  While the Chinese government has taken some small monetary tightening policies to control this bank lending and speculation, the question is can it control the credit bubble from bursting and prices falling as defaults mount.

James Rickards has joined Chanos, Faber, and Rogoff in warning of a potential crash in the China's economy.  He said the Chinese central bank's balance sheet resembles a hedge fund buying US dollars and selling the yuan and characterizes the economy as a giant bubble with a massive misallocation of wealth.  He also asserted that China would incur massive losses if it tried to dump US debt.

There has been a recent paper by Rogoff and Reinhart citing evidence that bad things happen when debt goes above 90% of GDP, but as Krugman observes it is really "...that bad things happen to debt when growth is low."  William Mitchell has criticized the paper for mixing data from countries which had debt issued in foreign currencies and with faulty research with respect to sovereign defaults and that no nation with non-convertible currencies and flexible exchange rates has ever defaulted.

Former Goldman Sachs traders reacted to the Lehman Repo 105 transactions, as reported by Felix Salmon, disclosed in the Valukas report to the Lehman Bankruptcy court as if it was no big deal; it was just business and no big deal with one saying, "like, whatever."  If people do not go to jail, why should they care what the peons think?

Bank of japan doubled to $221 billion funds available to Japanese banks for 3 month loans on a split 5-2 vote.

The US "jobs" bill is basically providing tax credits to small businesses for new hires through December, if they have been unemployed for at least 60 days, by forgiving 6.2% sales tax payments through December and a $1000 tax credit if new hire on job one year and approximately $20 billion for highway funds.  This will have little effect.

IMF says Chinese yuan is undervalued.

I have consistently warned about financial reporting in China and Fuqi International (Jeweller) fell 37% on March 17th when they disclosed accounting errors will cause the last 9 months of 2009 to be restated.

Chicago Fed Midwest Manufacturing Index was up 1.9% in January with automobiles up 4.5%.

Eurozone trade deficit is down 26% to $12.2 billion in January; exports were up 5% vs year ago and imports were up 1%.

US home prices were down .7% in January vs year ago and down 1.9% from December.

US trade current account deficit was up 12.9% to $115.6 billion in Q4.  The 2009 deficit was down 40.5% to $419.9 billion (8 year low) and only 2.9% of GDP (smallest in 11 years).

Indias's central bank raised its interest rate to banks to 5%.  They are experiencing wholesale price inflation which rose to 9.9% annualized in February primarily on food.

The EU is drawing up a plan for banks to pay into a fund to unwind failed banks.

The Federal Reserve reported industrial output was up one-tenth percent in February (was up .9 in January); capacity utilization was up to 72.7 from 72.5 and is still 7.9 points below the average.

NY Fed manufacturing was up to 18.9 from 17.6.

Producer Price Index (PPI) was down .6% in February with energy down 2.9%; core prices were up .1% and up 1% for last 12 months.

US wholesale prices were down .6% in February (biggest drop since July) and, excluding food and fuel, it was up .1%.

Capital One credit card defaults fell to 10.19% in February; Bnak of America's were up to 13.51% from 13.25%.

Geithner, Orzag, and Romer all said they do not expect further declines in unemployment this years.

AIG will withhold $21 million in bonuses --- retention bonuses for former and current employees and is paying out $46 million to 70 people mostly former employees.  This will help AIG to meet its $45 million give back target to the US Treasury.  It was due to pay $195 million in bonuses on 3/15, but many, including almost all current employees, took $20 million cut for early payment.

After bankruptcy proceedings, Lehman will re-emerge as LAMCO.

Banks failing to make TARP dividend payments was up to 82.

US Appeals Court said Fed must release loan information as public information.  The Fed is expected to appeal.

The ECB's Trichet said he will "push" for more transparency on CDS trades by establishing a central counter party facilities.

IMF's Strauss-Kahn said he was against the Tobin Tax concept, which would tax risky financial transactions in order to discourage them.

Greece tells EU help us  or we are going to the IMF for help.  Sarkozy (France) opposes the IMF alternative despite Germany's turnaround (from Chancellor Merkel) in support of the IMF possibility although internal dissension (Finance Minister Schaeuble) remains.  Sarkozy sees Strauss-Kahn pf the IMF as a potential political opponent in the next election.

Latvia's coalition government collapsed in a dispute over how to handle the economic crisis with the largest of the five coalition parties --- People's Party --- wanting a more "populist" action plan.

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