While the campaign to establish a "fiduciary standard" is commendable in that it could establish fiduciary responsibility for at least advisers, it is not professional fiduciary duty. Fiduciary responsibility assumes "unavoidable" conflicts of interest, while professional fiduciary duty does not tolerate conflicts of interest.
Already there has been movement to remove registered representatives and insurance agents from any fiduciary responsibility, because they have a contractual duty to their broker/dealer and/or insurance company. It is assumed that entitles them to only an issue of "suitability". When a salesman offers a product as suitable, how is that not advice in the mind of the consumer, however well informed? With "disclosure", the well informed consumer is dumped into the caveat emptor barrel and pickled. Purposeful confusion about who is commission or fee-based and commission or fee-only but a broker-dealer representative or truly fee-only has been the historical and current result of the SEC and FINRA both seeing their constituency reason for being as salesmen and the investment industry rather than the American public.
This purposeful confusion cannot be abated by transparency alone. There have to be clear labels with no confusing terms. A salesman is a salesman who should have a fiduciary responsibility to do no harm to the customer; suitability is not enough. We have already seen in the current financial crisis what can happen when salesmen are allowed to sale toxic garbage as "investments".
An adviser who receives commissions and so called fee-only representatives of a broker/dealer advisory service are conflicted salesmen who give advice and, as such, are "advisory salesmen" who have a fiduciary responsibility to act in the best interest of the customer despite inherent, not unavoidable, conflicts of interest. Such adviser salesmen cannot have the same regulatory title as a true fee-only advisor who has the fiduciary duty to act in the best interests of the client without any conflicts of interest. While an "advisory salesman" will require a documented "process" and a minimal standards based training consistent with current certificant programs to substantiate "advice" culminating in sales, a true fee-only advisor will require education consistent with a rigorous Masters in Finance which includes finance courses, CFA courses, CMT courses, macro-economic courses, tax courses, and retirement and estate planning concepts/case study courses. A true fee-only advisor would save the client at least 80% or more in total costs. The salesmen and "advisory salesmen" depend on the current regulatory deception which blurs who is who and what the real cost is to their customers. There needs to be a true financial advisory profession based on substantive education.
In the United Kingdom, the Financial Services Authority has proposed and is implementing that a financial advisor must be fee only. This may result in many leaving the advisory trade, because they prefer the money from sales. That is as it should be. The choice should be salesman or advisor with no confusing alternatives. Until the general public can have a clear and transparent knowledge of who is who and the costs involved, they will continue to be fodder for salesmen and "advisory salesmen" who hide behind the current regulatory curtains of deception. Simply disclosing a conflict of interest does not go far enough. Simply disclosing one receives commissions without providing a total cost to the customer does not go far enough. The current "profitable" business model grew out of the purposeful SEC regulatory confusion which panders to salesmen and investment companies. We have seen time and again this business model is inherently and intrinsically corrupting, if not corrupt. Regulation of financial advisors needs to be in the best interests of the American public. This means fee only with no conflicts of interest, no product sales, and no special relationships with proprietary product providers or fund companies or investment management companies or broker/dealer advisory firms.
All of the debate about harmonization and the impracticality of applying one fiduciary "standard" on all investment sales and advice is a smokescreen for those who want to do both and be perceived as something other than a salesman while letting the broker/dealers and insurance agents go merrily on their way. Mary Schapiro of the SEC said in a December 3, 2009 speech, "I believe all securities professionals should be subject to the same fiduciary duty --- and that all investors receiving advice should rest assured that the advice they get is being given with their best interest at heart. But to be effective, the fiduciary duty needs to be meaningful and uniform across all securities professionals; it cannot be weakened or diluted just so that it can be applied broadly." Salesmen and "advisory salesmen" can only have limited fiduciary responsibility and that should be required. While some current financial advisers go to commendable lengths to address fiduciary responsibility, fiduciary duty without any conflict of interest is possible only in the context of true fee only professional advice. One standard cannot be applied without diluting required professional fiduciary duty to a sale person's limited fiduciary responsibility in order to elevate sales people from suitability. It only continues the confusion of who is who doing what.
The Committee for a Fiduciary Standard has allowed the CFP Board to use the fiduciary standard effort as a means to seek recognition as the regulatory organization. The CFP Board is well known for its dependence on salesmen as members. The Committee has attempted to get a six step process defining the financial advice "process" included in the financial reform bill which is so basic and minimal that it would include any person who provides any two of the steps, which means it would be extended to include estate attorneys, tax accountants, brokers, insurance agents, trust officers. pension advisers, and potentially many more. Knut Rostad has laid out the application of six principles for the Committee for a Fiduciary Standard and the CFP Board has long maintained a basic minimal "process" approach to financial planning consistent with its minimal standards of competence.
It appears that any final financial reform bill may exclude this "two out of six" definition of a financial advisor in the Senate version, while it remains in the House version, with respect to a fiduciary standard and replace it with a study on the obligations of brokers, dealers, and investment advisers. The "two out of six" approach was too broad and aimed at making the CFP Board a choice for a regulatory organization. It would have been more appropriate to keep the salesmen and "advisory salesmen" under the SEC and FINRA and to have put the true fee only financial professional advisor under the Consumer Financial Protection Agency as an independent agency, but the banksters wanted no possibility of an independent consumer agency and have managed to get it placed under the authority of the Federal Reserve whose consumers are bankers.
The investment sales people have won and the American public has lost. Fiduciary duty has no home in investment sales. Sales people want no part of responsibility. The CFP Board's power grab and the attempt to make diluted fiduciary duty in the form of fiduciary responsibility, as enunciated by the financial standard coalition, palatable to the sales people, upon whom the CFP board is dependent and so actively solicits, has seemingly doomed consumer financial protection on the advisory level and the advancement of financial planning to a professional level. Given all the confusing business models allowed under SEC rules, a consumer cannot transparently ascertain if a financial planner/investment advisor is a true fee only advisor with a fiduciary duty to act in their best interests only without any conflicts of interest. It is not in the best interests of investment sales people for consumers to have clear, transparent choices. The regulatory curtain of deception remains.
The 2008 Rand study clearly delineated the confusion in consumer minds as to who is who and what different financial adviser and financial salesmen do and that current SEC regulations do not help. It is time to clearly delineate who is who and have salesmen and "advisory salesmen" regulated by the SEC and FINRA, whose constituency is primarily sales people just as the is true for the CFP Board and have true fee only professional advisors regulated by a truly independent Consumer Financial Protection Agency.
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Wednesday, April 28, 2010
Saturday, April 24, 2010
Leftovers -- Radio Show 4/10/2010
We talked about how banks appear to be masking risk levels as major US banks have lowered debt levels before reporting earnings in the last five quarters. 18 banks, including Goldman Sachs, J. P. Morgan Chase, Bank of America, and Citigroup, understated debt levels used to fund securities trades by lowering them an average 42% at the end of each period and increasing the debt levels in the middle of each successive quarter. The question is what are they doing which is producing a similar result just as Lehman used the Repo 105.
We discussed how oil production is up in all oil producing countries despite an oversupply glut. While it may be based on speculation of impending growth, it could potentially hamper any recovery as unemployment remains at 9.7% officially and will remain high for a very long time and gasoline prices have a tendency to strangle growth as every one cent increase in the price of gasoline takes out $1.5 billion from consumer pockets annually.
We noted that three banks in Puerto Rico holding almost 25% of the assets of the island are in trouble and the remaining healthy banks do not have the ability to acquire these banks, Since mainland banks have abandoned Puerto Rico, the FDIC may not be taking action, because it cannot find buyers and it cannot absorb losses from the resolution of these banks.
For over twenty years, investors have been told that over 90% of portfolio returns is from diversification. This is a common myth as the actual study only wrote about variation of returns and not returns based on performance. A new study published in March/April 2010 shows about 75% of a typical fund's variation comes from general market movement and the rest from specific asset allocation and active management. The old study incorrectly ascribed all 100% of return variation to asset allocation, when the variation actually comes from stock selection and general market movements. This just another example of the common investing myths that permeate financial planning and investment advice, such as 4% withdrawals, 60/40 to 40/60 equity/bond portfolios, and "market efficiency" in Modern Portfolio Theory and Capital Asset Pricing Model -- all of which do not work. Even William Sharpe is now attempting to develop asset allocation based on market movements.
John Hussman continues to see the market as over bought and overvalued as well as over bullish with hostile yield conditions. Historically, this means a continued tendency of the market to achieve successive but slight marginal new highs. Unfortunately, this skew in the market also has a remaining probability of vertical drops well over 10%. He believes one should be in a defensive stance. He notes that mortgage delinquency rates remain at record highs while foreclosures have lagged creating a shadow inventory. He finds the implied return for the S&P 500 over the next ten years to be 5.7%. He think any credit hiccup could cause a market reversal.
While the Federal Home Loan Banks financial statements are showing $1.9 billion profits, but $8.8 billion in mortgage portfolio paper losses which are not expected to recover in the foreseeable future are not included, because the FASB changed the accounting rules over a year ago. All 12 banks reported $42.8 billion total capital or 4.2% of assets while the government gave them credit for $60.2 billion in regulatory (primarily imaginary) capital.
Pragmatic Capitalist posted on "The Enron Banking System" in which he attributed the financial crisis to profitable excess risk taking and called for drawing the line between banks and risk taking firms. He said banks should be more like utilities and less like hedge funds, banks should not exact onerous fees on the public or engage in a business model which drives customers into debt, and banks should be true lending institutions devoid of non-banking activities such as hedge funds, CDS, off balance sheet financing, and trading. Banks should be oriented towards productive economic growth.
Rick Bookstaber posted on the current dangers in the municipal bond market. He sees leverage and complexity problems with unreliable credit ratings, general obligation bonds actually being residual claims as revenue streams have been sold off, and the potential for default which could cascade.
In a Washington's Blog post on rental prices, he noted that it may take until 2014 for unemployment to decline to 5% and unemployment is a primary cause of foreclosures. He also noted that the rich have become richer as the middle class continues to disappear into the poor. The rich tend not to rent. The foreclosed tend to seek shelter with family or friends.
Greek citizens and companies have started moving money from Greek banks to foreign banks with more the 3 billion euro leaving the country in February. There are also pressures from increasing bond spreads. These are symptomatic of a lack of participant confidence.
Hoenig, Kansas City Fed President, that a long period of low rates builds bubbles and the Fed could, in his opinion, raise interest rates to 1%, leaving them at historically low levels but sending a signal that easy money policies are pulling back. This caused a noticeable negative market reaction on the 7th. Bernanke said it is too early to raise rates with weak housing, low loans to small business, and unemployment. Lacker, Richmond Fed President, said he is becoming less comfortable with low interest rates and sees the recovery as sustainable and unlikely to double dip.
The Obama Administration is calling for limitations on GRATs, by not allowing zero value for estate purposes, and calling for a ten year term on GRATs. This could make them far less beneficial. A GRAT is a trust to which an individual has transferred assets in return for an annuity in order for the assets to pass to a beneficiary free of gift taxes after the term of the trust ends which is normally two to three years. If the grantor dies before the term is up, the entire asset is put back into the estate. If the value has to be at least 10%, this could cause the potential losses to the donor to outweigh the benefits.
A recent Transamerica Retirement Study found 71% of workers surveyed had access to company 401(k) retirement plans and 77% of those contribute to the plan with 41% saving more than $50,000 and 29% more than $100,000. 30% of those surveyed were not offered a plan at work and only 22% had saved more than $50,000 and 18% had saved more than $100,000.
The EU agreed on an unspecified rescue plan for Greece in the form of loans, perhaps at approximately 5%. Fitch downgraded Greece's credit rating two notches. Trichet, ECB chairman, said Greece is not at the point where it needs a financial bailout and default is not an issue. However, the ECB did extend looser collateral rules and will continue to accept lesser rated debt, as low as BBB-, as security in lending operations but will apply new risk buffers on riskier assets in the form of risk margins known as haircuts. Government bonds ar not affected. Here are some key political risks to watch in Greece with respect to deficit cuts, public opposition, social unrest, and bond and CDS markets.
There is growing expectation the Chinese yuan will be allowed to appreciate, but the Chinese government, while it is exploring just such options, is resistant to external pressures to do what they may have to do in order to control inflation and a potential real estate bubble internally. Western commentators keep calling for appreciation of the yuan and some think it is imminent, but I have been maintaining it will be done slowly and in steps to allow appreciation of perhaps 2-4% after other monetary policies have been engaged. Contrary to some commentators, the appreciation of the yuan will not have many benefits to the United States and could cause prices, including oil, to rise with jobs going to other Asian countries.
In 2008, US births were down 2%.
Of privately held financial wealth in the US, as of 2007, the top 1% of the population hold 42.7%, the next 19% of the population hold 50.3%, and the remaining 80% hold 7%. Only 31.6% of the population own more than $10,000 in stock. 70% of white families wealth is in their principal residence compared to 95% of blacks and 96% of Hispanics ("Wealth, Income, and Power" by William Dormhoff -- University of California - Santa Cruz).
Kocherlakota, Minneapolis Fed President, said Fed should start selling small (non-trivial) amounts of MBS each month to normalize the Fed B/S. He also said there cannot be a sustainable recovery until housing starts pickup dramatically. Paul Volcker said the US may need a VAT (national sales tax) on energy or carbon to control the deficit.
It is a tax fact that 47% of all US households will pay no income taxes for 2009.
A senior vice-president of Bank of America at a building industry conference in Irvine, California said Bank of America will increase its foreclosures from 7500/month to 45.000/month by December. That is a 600% increase.
Not counting 2009, 1.2 million households have been lost in this financial crisis through 2008.
Office vacancy rate is at a 16 year high.
Pending home sales were up 8.2% in February.
ISM non-manufacturing index is up to 55.4 in March from 53.0.
US wholesale inventory is up .6% in February; sales up .8%; inventory sales ratio still 1.2 months. January sales were revised down to .9% from 1.2%.
Treasury will sale $142 billion in bills this coming week plus $8 billion in TIPS, $40 billion in 3 year, $21 billion in 10 years, and $13 billion in 30 year.
Brazil's inflation is projected at 5.18% for 2010.
Chile's February economic activity index was up 2.7% vs year ago, but it may contract ifor March post earthquake and then pick up with construction.
Australia raised interest rates 25 basis points for the 5th time in 7 months to 4,25%.
US consumer credit fell $11.5 billion in February.
Germany's trade surplus jumped 39% to $16.3 billion as exports rose 5.1% to $94.9 billion and imports rose .2%.
Bulgaria delayed plans to adopt the euro with a budget deficit higher than EU target 3% of GDP.
GM lost $4.3 billion in the 2nd half of 2009, but says it will pay off government loans by June of this year.
Poland's central bank sold zlotys to curb a rise in its currency and to bolster exports and the economy.
Despite the EU imposed austerity program, Spain is attempting government programs to create jobs (over 20% unemployed) and to offer loans to small businesses.
Bank of England held their interest rate at .5 % for the 13th monthand made no increase in asset buying.
The ECB kept their interest rate at 1%. Trichet said recovery will be no better than moderate or uneven this year with no inflationary pressures medium term.
US Treasury Auctions:
9 year 9 months TIPS, $8 Billion. yield 1.709%, bid to cover 3.469, foreign 37.5%, direct 7.51% (small direct).
3 year Treasury, $40 billion, yield 1.776%, bid to cover 3.10, foreign 52,25%, direct 10,75%.
10 year Treasury, $21 billion, yield 3.9%, bid to cover 3.73, foreign 43.11%, Direct 16.32% (strong demand, biog direct).
30 year Treasury, $13 billion, yield 4.770%, bid to cover2.73, foreign 36.85%, direct 24.48% (better than expected, huge direct).
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We discussed how oil production is up in all oil producing countries despite an oversupply glut. While it may be based on speculation of impending growth, it could potentially hamper any recovery as unemployment remains at 9.7% officially and will remain high for a very long time and gasoline prices have a tendency to strangle growth as every one cent increase in the price of gasoline takes out $1.5 billion from consumer pockets annually.
We noted that three banks in Puerto Rico holding almost 25% of the assets of the island are in trouble and the remaining healthy banks do not have the ability to acquire these banks, Since mainland banks have abandoned Puerto Rico, the FDIC may not be taking action, because it cannot find buyers and it cannot absorb losses from the resolution of these banks.
For over twenty years, investors have been told that over 90% of portfolio returns is from diversification. This is a common myth as the actual study only wrote about variation of returns and not returns based on performance. A new study published in March/April 2010 shows about 75% of a typical fund's variation comes from general market movement and the rest from specific asset allocation and active management. The old study incorrectly ascribed all 100% of return variation to asset allocation, when the variation actually comes from stock selection and general market movements. This just another example of the common investing myths that permeate financial planning and investment advice, such as 4% withdrawals, 60/40 to 40/60 equity/bond portfolios, and "market efficiency" in Modern Portfolio Theory and Capital Asset Pricing Model -- all of which do not work. Even William Sharpe is now attempting to develop asset allocation based on market movements.
John Hussman continues to see the market as over bought and overvalued as well as over bullish with hostile yield conditions. Historically, this means a continued tendency of the market to achieve successive but slight marginal new highs. Unfortunately, this skew in the market also has a remaining probability of vertical drops well over 10%. He believes one should be in a defensive stance. He notes that mortgage delinquency rates remain at record highs while foreclosures have lagged creating a shadow inventory. He finds the implied return for the S&P 500 over the next ten years to be 5.7%. He think any credit hiccup could cause a market reversal.
While the Federal Home Loan Banks financial statements are showing $1.9 billion profits, but $8.8 billion in mortgage portfolio paper losses which are not expected to recover in the foreseeable future are not included, because the FASB changed the accounting rules over a year ago. All 12 banks reported $42.8 billion total capital or 4.2% of assets while the government gave them credit for $60.2 billion in regulatory (primarily imaginary) capital.
Pragmatic Capitalist posted on "The Enron Banking System" in which he attributed the financial crisis to profitable excess risk taking and called for drawing the line between banks and risk taking firms. He said banks should be more like utilities and less like hedge funds, banks should not exact onerous fees on the public or engage in a business model which drives customers into debt, and banks should be true lending institutions devoid of non-banking activities such as hedge funds, CDS, off balance sheet financing, and trading. Banks should be oriented towards productive economic growth.
Rick Bookstaber posted on the current dangers in the municipal bond market. He sees leverage and complexity problems with unreliable credit ratings, general obligation bonds actually being residual claims as revenue streams have been sold off, and the potential for default which could cascade.
In a Washington's Blog post on rental prices, he noted that it may take until 2014 for unemployment to decline to 5% and unemployment is a primary cause of foreclosures. He also noted that the rich have become richer as the middle class continues to disappear into the poor. The rich tend not to rent. The foreclosed tend to seek shelter with family or friends.
Greek citizens and companies have started moving money from Greek banks to foreign banks with more the 3 billion euro leaving the country in February. There are also pressures from increasing bond spreads. These are symptomatic of a lack of participant confidence.
Hoenig, Kansas City Fed President, that a long period of low rates builds bubbles and the Fed could, in his opinion, raise interest rates to 1%, leaving them at historically low levels but sending a signal that easy money policies are pulling back. This caused a noticeable negative market reaction on the 7th. Bernanke said it is too early to raise rates with weak housing, low loans to small business, and unemployment. Lacker, Richmond Fed President, said he is becoming less comfortable with low interest rates and sees the recovery as sustainable and unlikely to double dip.
The Obama Administration is calling for limitations on GRATs, by not allowing zero value for estate purposes, and calling for a ten year term on GRATs. This could make them far less beneficial. A GRAT is a trust to which an individual has transferred assets in return for an annuity in order for the assets to pass to a beneficiary free of gift taxes after the term of the trust ends which is normally two to three years. If the grantor dies before the term is up, the entire asset is put back into the estate. If the value has to be at least 10%, this could cause the potential losses to the donor to outweigh the benefits.
A recent Transamerica Retirement Study found 71% of workers surveyed had access to company 401(k) retirement plans and 77% of those contribute to the plan with 41% saving more than $50,000 and 29% more than $100,000. 30% of those surveyed were not offered a plan at work and only 22% had saved more than $50,000 and 18% had saved more than $100,000.
The EU agreed on an unspecified rescue plan for Greece in the form of loans, perhaps at approximately 5%. Fitch downgraded Greece's credit rating two notches. Trichet, ECB chairman, said Greece is not at the point where it needs a financial bailout and default is not an issue. However, the ECB did extend looser collateral rules and will continue to accept lesser rated debt, as low as BBB-, as security in lending operations but will apply new risk buffers on riskier assets in the form of risk margins known as haircuts. Government bonds ar not affected. Here are some key political risks to watch in Greece with respect to deficit cuts, public opposition, social unrest, and bond and CDS markets.
There is growing expectation the Chinese yuan will be allowed to appreciate, but the Chinese government, while it is exploring just such options, is resistant to external pressures to do what they may have to do in order to control inflation and a potential real estate bubble internally. Western commentators keep calling for appreciation of the yuan and some think it is imminent, but I have been maintaining it will be done slowly and in steps to allow appreciation of perhaps 2-4% after other monetary policies have been engaged. Contrary to some commentators, the appreciation of the yuan will not have many benefits to the United States and could cause prices, including oil, to rise with jobs going to other Asian countries.
In 2008, US births were down 2%.
Of privately held financial wealth in the US, as of 2007, the top 1% of the population hold 42.7%, the next 19% of the population hold 50.3%, and the remaining 80% hold 7%. Only 31.6% of the population own more than $10,000 in stock. 70% of white families wealth is in their principal residence compared to 95% of blacks and 96% of Hispanics ("Wealth, Income, and Power" by William Dormhoff -- University of California - Santa Cruz).
Kocherlakota, Minneapolis Fed President, said Fed should start selling small (non-trivial) amounts of MBS each month to normalize the Fed B/S. He also said there cannot be a sustainable recovery until housing starts pickup dramatically. Paul Volcker said the US may need a VAT (national sales tax) on energy or carbon to control the deficit.
It is a tax fact that 47% of all US households will pay no income taxes for 2009.
A senior vice-president of Bank of America at a building industry conference in Irvine, California said Bank of America will increase its foreclosures from 7500/month to 45.000/month by December. That is a 600% increase.
Not counting 2009, 1.2 million households have been lost in this financial crisis through 2008.
Office vacancy rate is at a 16 year high.
Pending home sales were up 8.2% in February.
ISM non-manufacturing index is up to 55.4 in March from 53.0.
US wholesale inventory is up .6% in February; sales up .8%; inventory sales ratio still 1.2 months. January sales were revised down to .9% from 1.2%.
Treasury will sale $142 billion in bills this coming week plus $8 billion in TIPS, $40 billion in 3 year, $21 billion in 10 years, and $13 billion in 30 year.
Brazil's inflation is projected at 5.18% for 2010.
Chile's February economic activity index was up 2.7% vs year ago, but it may contract ifor March post earthquake and then pick up with construction.
Australia raised interest rates 25 basis points for the 5th time in 7 months to 4,25%.
US consumer credit fell $11.5 billion in February.
Germany's trade surplus jumped 39% to $16.3 billion as exports rose 5.1% to $94.9 billion and imports rose .2%.
Bulgaria delayed plans to adopt the euro with a budget deficit higher than EU target 3% of GDP.
GM lost $4.3 billion in the 2nd half of 2009, but says it will pay off government loans by June of this year.
Poland's central bank sold zlotys to curb a rise in its currency and to bolster exports and the economy.
Despite the EU imposed austerity program, Spain is attempting government programs to create jobs (over 20% unemployed) and to offer loans to small businesses.
Bank of England held their interest rate at .5 % for the 13th monthand made no increase in asset buying.
The ECB kept their interest rate at 1%. Trichet said recovery will be no better than moderate or uneven this year with no inflationary pressures medium term.
US Treasury Auctions:
9 year 9 months TIPS, $8 Billion. yield 1.709%, bid to cover 3.469, foreign 37.5%, direct 7.51% (small direct).
3 year Treasury, $40 billion, yield 1.776%, bid to cover 3.10, foreign 52,25%, direct 10,75%.
10 year Treasury, $21 billion, yield 3.9%, bid to cover 3.73, foreign 43.11%, Direct 16.32% (strong demand, biog direct).
30 year Treasury, $13 billion, yield 4.770%, bid to cover2.73, foreign 36.85%, direct 24.48% (better than expected, huge direct).
Print Page
Tuesday, April 20, 2010
What Economic Indicators?
On Monday, 4/19/2010, the Conference Board Leading Indicators Index came out reporting a new high of monthly one year improvement. On the 12th of April, the NBER committee of economists announced it could not yet determine an end to the current recession citing government revision of statistics since they were initially released and the duration and severity of the downturn combined with continuing unemployment. While no committee member would discuss specifics, it is generally reported many felt the recovery had begun but there was significant concern that risk remained in the economy running out of steam in late 2010.
The Leading Indicators Index like the Consumer Sentiment Index and other media followed soft indicators, whether leading or lagging, are not well liked by me. They are to soft and prone to psychological misuse and interpretation. I do pay some attention to coincident indicators, but I do not consider them primary indicators. The coincident indicators are more informational of the economic trend. The Chicago Fed National Activity Index is a coincident indicator. Also, coincident indicators have direct impact on sales tax revenue. The Philadelphia Fed has a coincident index for the fifty states.
Karl Denninger had a good post on indicators back in January in which he identified what he considered the most important macro level indicators as sales tax receipts, consumer credit, and civilian employment ratio.
Sales tax receipts directly reflect the importance of personal consumption accounting for 70% of the US economy and are crucial for local government and states, unlike national governments with their own currency, which are constrained in their spending. While there is some slow improvement in sales tax revenue from Q3 2009 to Q4 2009, it is not very encouraging. This is one of the reasons a national VAT (value added tax or national sales tax) is being discussed, although many think it would help with the national deficit, it's real purpose would be to provide more spending power by the national government to local and state governments. The VAT issue as opposed to a progressive consumption tax is one which should be addressed in a separate post. Denninger makes the accurate mathematical observation that a sales tax is proportional and not progressive, but I disagree with his claim it is not regressive, because it is not entirely based on discretionary spending. The spending constraints for shelter, clothing, food, medical care, education, and work expenses are not equal or proportional to income and disposable income. While he lives in a state which does not tax food purchases, I live in one of the 18-19 states which either do and/or allow local government to do so. He is correct in sales tax receipts being a accurate picture of consumer spending. I find it a very useful indicator.
Consumer credit, as Denninger notes, is additive to GDP when it expands and subtractive when it contracts. In fact, there are some economists who consider credit more important than money. In my opinion, it is important to look at total leverage and its sources as it gives a better indicator of economic bubbles, such as housing, and as an indicator requiring monetary and/or fiscal policy action.
The civilian employment ratio, of all working age (16-65) people determine by a household survey, because it provides a smoothing contrast to other employment/unemployment figures, not because it is predictive of government revenue as Denninger maintains, and impacts GDP and is a function of aggregate demand.
I have not commented on Denninger's good post since reading it in January, because he makes the deficit hawk erroneous statement that the US deficit would have to be cut in half to bring employment back into balance. Federal spending to target unemployment and get the economy growing is essential. The debatable question is are the programs designed for this purpose efficient and strong enough. Secondly, he also asserts the need to establish benevolent (not his word but my assumption) detention facilities to provide emergency food, clothing, and shelter to the unemployed at formerly closed military facilities ("work is good" camps?), because "... a hungry and homeless population is a dangerous population, and "discontent" when married to an empty belly can easily turn to armed rebellion, especially if and when the "rabble" discern (and they eventually will) that they have been systematically robbed for decades by Wall Street, K Street and 1600 Pennsylvania Avenue." I could find no facetiousness in his comments, which may actually be based on a concern for the unemployed, but they are not appropriate phrased if benevolently meant as I would hope they were meant.
With the civilian employment ratio I also like to look at the weekly jobless claims, monthly unemployment figures, and monthly inflation figures, which are subject to substantive revisions and methodological changes. The change in how shelter has been defined and applied with respect to inflation calculations has had a noticeable effect in deflating core inflation. Consequently, I also like to look at alternative unemployment and inflation figures based on prior period calculations. For how inflation and discouraged unemployed (as opposed to the official U6) where calculated in the middle 1990's, I go to Shadow Government. I also look at how inflation would look if it were still calculated as it was in the 1980's.
I like to see the weekly EIA oil, gas, and distillate supply figures and compare with current gasoline prices. While these will show disjunctions more than trend, they have to be viewed in relation to vehicle miles driven.
These can by no means be all inclusive, but I do wish to distinguish from the many "indicators" which the media and the market seize upon in almost desperate attempts to find hope. Even the above can become prey to the need by the media and the market to depict hope if phrases are taken out of context or misinterpreted. It is necessary to dig down into the figures of the inflation and employment reports and compare all f this inflation together. And it is always changing and leading and lagging. Nothing is perfect or in equilibrium.
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The Leading Indicators Index like the Consumer Sentiment Index and other media followed soft indicators, whether leading or lagging, are not well liked by me. They are to soft and prone to psychological misuse and interpretation. I do pay some attention to coincident indicators, but I do not consider them primary indicators. The coincident indicators are more informational of the economic trend. The Chicago Fed National Activity Index is a coincident indicator. Also, coincident indicators have direct impact on sales tax revenue. The Philadelphia Fed has a coincident index for the fifty states.
Karl Denninger had a good post on indicators back in January in which he identified what he considered the most important macro level indicators as sales tax receipts, consumer credit, and civilian employment ratio.
Sales tax receipts directly reflect the importance of personal consumption accounting for 70% of the US economy and are crucial for local government and states, unlike national governments with their own currency, which are constrained in their spending. While there is some slow improvement in sales tax revenue from Q3 2009 to Q4 2009, it is not very encouraging. This is one of the reasons a national VAT (value added tax or national sales tax) is being discussed, although many think it would help with the national deficit, it's real purpose would be to provide more spending power by the national government to local and state governments. The VAT issue as opposed to a progressive consumption tax is one which should be addressed in a separate post. Denninger makes the accurate mathematical observation that a sales tax is proportional and not progressive, but I disagree with his claim it is not regressive, because it is not entirely based on discretionary spending. The spending constraints for shelter, clothing, food, medical care, education, and work expenses are not equal or proportional to income and disposable income. While he lives in a state which does not tax food purchases, I live in one of the 18-19 states which either do and/or allow local government to do so. He is correct in sales tax receipts being a accurate picture of consumer spending. I find it a very useful indicator.
Consumer credit, as Denninger notes, is additive to GDP when it expands and subtractive when it contracts. In fact, there are some economists who consider credit more important than money. In my opinion, it is important to look at total leverage and its sources as it gives a better indicator of economic bubbles, such as housing, and as an indicator requiring monetary and/or fiscal policy action.
The civilian employment ratio, of all working age (16-65) people determine by a household survey, because it provides a smoothing contrast to other employment/unemployment figures, not because it is predictive of government revenue as Denninger maintains, and impacts GDP and is a function of aggregate demand.
I have not commented on Denninger's good post since reading it in January, because he makes the deficit hawk erroneous statement that the US deficit would have to be cut in half to bring employment back into balance. Federal spending to target unemployment and get the economy growing is essential. The debatable question is are the programs designed for this purpose efficient and strong enough. Secondly, he also asserts the need to establish benevolent (not his word but my assumption) detention facilities to provide emergency food, clothing, and shelter to the unemployed at formerly closed military facilities ("work is good" camps?), because "... a hungry and homeless population is a dangerous population, and "discontent" when married to an empty belly can easily turn to armed rebellion, especially if and when the "rabble" discern (and they eventually will) that they have been systematically robbed for decades by Wall Street, K Street and 1600 Pennsylvania Avenue." I could find no facetiousness in his comments, which may actually be based on a concern for the unemployed, but they are not appropriate phrased if benevolently meant as I would hope they were meant.
With the civilian employment ratio I also like to look at the weekly jobless claims, monthly unemployment figures, and monthly inflation figures, which are subject to substantive revisions and methodological changes. The change in how shelter has been defined and applied with respect to inflation calculations has had a noticeable effect in deflating core inflation. Consequently, I also like to look at alternative unemployment and inflation figures based on prior period calculations. For how inflation and discouraged unemployed (as opposed to the official U6) where calculated in the middle 1990's, I go to Shadow Government. I also look at how inflation would look if it were still calculated as it was in the 1980's.
I like to see the weekly EIA oil, gas, and distillate supply figures and compare with current gasoline prices. While these will show disjunctions more than trend, they have to be viewed in relation to vehicle miles driven.
These can by no means be all inclusive, but I do wish to distinguish from the many "indicators" which the media and the market seize upon in almost desperate attempts to find hope. Even the above can become prey to the need by the media and the market to depict hope if phrases are taken out of context or misinterpreted. It is necessary to dig down into the figures of the inflation and employment reports and compare all f this inflation together. And it is always changing and leading and lagging. Nothing is perfect or in equilibrium.
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Saturday, April 10, 2010
Leftovers -- Radio Show 4/3/2010
We continued the discussion on the new Health Reform Bill and confirm that children's pre-existing conditions coverage has been questioned by the insurance industry as not being covered in the language of the legislation, but supposedly the insurance industry group AHIP has compromised with the Administration, who threatened to cover the issue in rules and regulations, to allow pre-existing coverage for children, starting September 23, if their families already have an existing policy. We also discussed that existing group plans are exempt from this legislation and there is conflicting information from the different experts analyzing this legislation as to whether the exemption ends with a new plan as some iterate and others do not mention.
We covered the unemployment numbers and what they really mean. We emphasized the tax facts, contrary to popular myth, that the average American with $50,000 in income does not pay 20-25% of gross income in federal taxes, that the actual amount is less than 7% in federal income taxes and less than 15% in federal income taxes and social security taxes, and taxation revenues are not equal to about 40% of GDP but are in fact less than 10%. While many people believe taxes increased under the current Administration, taxes, as a whole, actually went down as the result of the economic stimulus package.
We also commented on the fact that, although the Illinois General Assembly, suddenly passed the Illinois pension reform bill, as we have pushed for over a year, in order to prevent a credit rating downgrade, the credit rating was still downgraded one notch to A- by Fitch because Illinois has failed to make any credible effort to to address the operating deficit which is at least $13 billion. We found it interesting that there had been no known Illinois or Springfield media coverage of the credit downgrade.
At the very end of the show we tried to cover research on asset allocation. In the past we have extensively covered the myths of Modern Portfolio Theory, specifically with respect to allocation and efficient market theory and how it is taught improperly and misapplied, and Capital Asset Pricing Model. These myths are deeply entrenched and resilient to factual education. For over twenty years people have been told that asset allocation is responsible for over 90% of investment returns. This is wrong and new research has shown that the returns are not from asset allocation but from the actual market movement of the different asset classes without respect to "proper" allocation for a given period. This is very similar to recent attempts by William Sharpe, who won the Nobel Prize for MPT and CAPM contributions, to devise an investment methodology based on re-balancing as asset classes move in the market.
We got through all of the economic data during the show.
While some mysterious, unspecified agreement between the EU and the IMF has supposedly been agreed upon, no apparent help has been forthcoming to Greece. Roubini joined the deficit chorus insisting the budget deficit be slashed further to avoid a refinancing crisis. The credibility of the Southern euozone countries to pay debt has been under attack by the financial markets and economic commentators without respect actual ability to pay as opposed to the draconian negative effects of the imposed EU austerity programs on the potential for economic growth in those countries, which they could solve if they had their own national currencies. Any analysis of the eurozone current trade balances show that it is in the best interest of Germany to assist in the formation of an effective EU assistance program. Germany needs to urgently foster internal consumer consumption and German banks have large exposure to Spanish mortgage and public debt. If Greece is thrown to the deficit wolves and forced to restructure or default on debt, Spain will be next. Not to be forgotten, Italy's debt is 25% of all EU debt. Greece has no reason to default, although some argue otherwise, on debt unless it is imprudently and politically forced to do so rather than exit the euro.
Paul Krugman does not believe breaking up big banks will solve any problems, because a financial crisis can still emanate from a run on smaller institutions. He wants to update and extend old fashion bank regulation and include "shadow banking" in the regulated. While I continue to have concerns about size, I have consistently asserted that the real question is not size but whether the financial entity, of whatever size, is systemically dangerous. Regulation, as it has existed in the United States, is not enough without effective risk management policies in place and rigorously enforced.
Paul Volcker said that proprietary trading was not central to the financial crisis, but a ban is necessary because it could distract banks from their fiduciary responsibilities. He finds no need for commercial banks to be involved in proprietary trading and arguments that liquidity requires proprietary trading are over blown.
The Baseline Scenario argued that capital requirements are not enough to regulate big banks and that they must be broken up. They argue for asset caps on financial institutions and, if they want to take on risk, they need to be smaller. Again, the need for proper risk management is essentially ignored.
The Aleph Blog wants banks reformed by encouraging liquid assets, limiting derivative transactions, fixing the accounting to become transparent, raise capital requirements disproportionately to the rise in assets, and fix the risk-based capital formula to emulate the risk management policies of insurance companies.
China is expected to report a trade deficit in march for the first time in recent memory. We have previously published articles on China's spending bubble and China's real estate bubble and growing leverage problem. We have also published an article on Chinese and United States publications on the practice and use of economic warfare. Pressure continues to mount on China to allow the yuan to appreciate against the US dollar. This international pressure will only delay the 2-4% appreciation China needs to allow slowly in order to respond to internal wage and inflationary pressures requiring monetary policy action. New analysis reports are detailing China's debt bubble and internal needs from different perspectives, but coming to similar conclusions that China will not address its internal needs soon enough to avoid a hard economic landing. If this were to occur, it would have massive global repercussions as even a soft landing will cause global contraction.
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We covered the unemployment numbers and what they really mean. We emphasized the tax facts, contrary to popular myth, that the average American with $50,000 in income does not pay 20-25% of gross income in federal taxes, that the actual amount is less than 7% in federal income taxes and less than 15% in federal income taxes and social security taxes, and taxation revenues are not equal to about 40% of GDP but are in fact less than 10%. While many people believe taxes increased under the current Administration, taxes, as a whole, actually went down as the result of the economic stimulus package.
We also commented on the fact that, although the Illinois General Assembly, suddenly passed the Illinois pension reform bill, as we have pushed for over a year, in order to prevent a credit rating downgrade, the credit rating was still downgraded one notch to A- by Fitch because Illinois has failed to make any credible effort to to address the operating deficit which is at least $13 billion. We found it interesting that there had been no known Illinois or Springfield media coverage of the credit downgrade.
At the very end of the show we tried to cover research on asset allocation. In the past we have extensively covered the myths of Modern Portfolio Theory, specifically with respect to allocation and efficient market theory and how it is taught improperly and misapplied, and Capital Asset Pricing Model. These myths are deeply entrenched and resilient to factual education. For over twenty years people have been told that asset allocation is responsible for over 90% of investment returns. This is wrong and new research has shown that the returns are not from asset allocation but from the actual market movement of the different asset classes without respect to "proper" allocation for a given period. This is very similar to recent attempts by William Sharpe, who won the Nobel Prize for MPT and CAPM contributions, to devise an investment methodology based on re-balancing as asset classes move in the market.
We got through all of the economic data during the show.
While some mysterious, unspecified agreement between the EU and the IMF has supposedly been agreed upon, no apparent help has been forthcoming to Greece. Roubini joined the deficit chorus insisting the budget deficit be slashed further to avoid a refinancing crisis. The credibility of the Southern euozone countries to pay debt has been under attack by the financial markets and economic commentators without respect actual ability to pay as opposed to the draconian negative effects of the imposed EU austerity programs on the potential for economic growth in those countries, which they could solve if they had their own national currencies. Any analysis of the eurozone current trade balances show that it is in the best interest of Germany to assist in the formation of an effective EU assistance program. Germany needs to urgently foster internal consumer consumption and German banks have large exposure to Spanish mortgage and public debt. If Greece is thrown to the deficit wolves and forced to restructure or default on debt, Spain will be next. Not to be forgotten, Italy's debt is 25% of all EU debt. Greece has no reason to default, although some argue otherwise, on debt unless it is imprudently and politically forced to do so rather than exit the euro.
Paul Krugman does not believe breaking up big banks will solve any problems, because a financial crisis can still emanate from a run on smaller institutions. He wants to update and extend old fashion bank regulation and include "shadow banking" in the regulated. While I continue to have concerns about size, I have consistently asserted that the real question is not size but whether the financial entity, of whatever size, is systemically dangerous. Regulation, as it has existed in the United States, is not enough without effective risk management policies in place and rigorously enforced.
Paul Volcker said that proprietary trading was not central to the financial crisis, but a ban is necessary because it could distract banks from their fiduciary responsibilities. He finds no need for commercial banks to be involved in proprietary trading and arguments that liquidity requires proprietary trading are over blown.
The Baseline Scenario argued that capital requirements are not enough to regulate big banks and that they must be broken up. They argue for asset caps on financial institutions and, if they want to take on risk, they need to be smaller. Again, the need for proper risk management is essentially ignored.
The Aleph Blog wants banks reformed by encouraging liquid assets, limiting derivative transactions, fixing the accounting to become transparent, raise capital requirements disproportionately to the rise in assets, and fix the risk-based capital formula to emulate the risk management policies of insurance companies.
China is expected to report a trade deficit in march for the first time in recent memory. We have previously published articles on China's spending bubble and China's real estate bubble and growing leverage problem. We have also published an article on Chinese and United States publications on the practice and use of economic warfare. Pressure continues to mount on China to allow the yuan to appreciate against the US dollar. This international pressure will only delay the 2-4% appreciation China needs to allow slowly in order to respond to internal wage and inflationary pressures requiring monetary policy action. New analysis reports are detailing China's debt bubble and internal needs from different perspectives, but coming to similar conclusions that China will not address its internal needs soon enough to avoid a hard economic landing. If this were to occur, it would have massive global repercussions as even a soft landing will cause global contraction.
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Friday, April 9, 2010
Ireland's Bad Bank
Ireland has received praise for its draconian austerity program and the creation of the National Asset Management Agency, a "bad bank" formed to purchase toxic assets from Irish banks. The EU, the IMF, and Moody's have all praised the formation of this bad bank, but is it a good "bad bank" or a bad " bad bank"?
The Baseline Scenario did a good analysis of the Irish financial crisis: "Ireland’s difficulties arose because of a massive property boom financed by cheap credit from Irish banks. Irelands’ three main banks built up 2.5 times the GDP in loans and investments by 2008; these are big banks (relative to the economy) that pushed the frontier in terms of reckless lending. The banks got the upside and then came the global crash in fall 2008: property prices fell over 50%, construction and development stopped, and people started defaulting on loans. Today roughly 1/3 of the loans on the balance sheets of banks are non-performing or “under surveillance”; that’s an astonishing 80 percent of GDP, in terms of potentially bad debts."
Much to the original consternation of the EU, Ireland responded by guaranteeing all liabilities of Irish banks, rather than a capped amount like other EU members, and injected capital into the banks purchasing 25% of the Allied Irish Bank and 16% of the Bank of Ireland while nationalizing the Anglo Irish Bank, whose CEO had hidden 122 billion euro in loans and has just been recently arrested for fraud. In the last two years, approximately 40 billion euro in loans in the eleven Irish banks and building societies have been written down.
Now they are planning to buy toxic assets from the banks and give them government bonds; in essence, the government will be issuing 1/3 of GDP in government debt for these distressed assets.
Rather than forcing the creditors of these banks to share the burden, a strong lobby of real estate developers, bond investors, and politicians linked to the developers and bankers prevailed in pushing a "corporate socialist" solution in which the profits were privatized and the losses shoved on the public by making the taxpayers responsible rather than have the creditors pay for their risk taking. A bad bank formed for the public good would have restructured those debts and the creditors would have taken the hit.
On March 30th, the National Asset Management Agency said it would be taking on $22 billion in loans at an average 47% discount amounting to a 32 billion euro writedown for the banks: 3.29 billion euro from Allied Irish Bank at a 43% haircut, 1.93 billion euro from the bank of Ireland at a 35% haircut, 10 billion euro from the already nationalized Anglo Irish Bank, and smaller amounts from the Irish Nationwide Building Society and the EBS Building Society. Eventually, NAMA will buy 81 million euro of loans in four tranches of which this first tranche contains 5.5 billion euro of investment property loans, 1.3 billion euro in land, and 800 million euro in hotels. It will also require the banks to have 8% in private core equity capital, which has caused considerable confusion as to how much each bank will have to raise. It also means the government will own 70% of Allied Irish Bank and 40% of the Bank of Ireland, but actual ownership statistics are hard to reconcile with respect to ownership statistics before and after discounts and capital levels.
The future tranches may show significantly higher discounts as more land rather than investment gets moved.
The debt burden of this bailout of creditors will force the debt/GDP burden of Ireland to over 100% by the end of 2011. All of the harsh austerity deficit cuts are still going to leave a 2010 deficit of 12.5%. While these discounts constitute a restructuring, the use of government debt to finance the purchases rather than shares in NAMA places the burden on the public which faces continue long-term unemployment. On the other hand, NAMA and the Irish government recognized the necessity to strip the toxic purchases out in parallel from all of the banks and building societies at the same time rather than in a cascading chaos of individual institutions as is so prominently discussed in the United States.
In April, the Allied Irish Bank sold assets for 4.6 billion euro to raise capital and the Anglo Irish Bank raised 2.25 billion euro in two bonds covered by the government guarantee.
A good "bad bank" places the burden on the creditors where is belongs in a capitalist society. A bad "bad bank" places the burden of future losses on the shoulders of common taxpayers.
Ireland is an excellent case study, but it is not a good example. Its parallel action in toxic asset purchases is highly commendable and it appears they have actually got, with EU insistence, some value with the discounts in the first tranche. The use of full government guarantee of all liabilities and government bonds to purchase the toxic assets shoves the losses off to the public and away from the risk takers who caused the problems.
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The Baseline Scenario did a good analysis of the Irish financial crisis: "Ireland’s difficulties arose because of a massive property boom financed by cheap credit from Irish banks. Irelands’ three main banks built up 2.5 times the GDP in loans and investments by 2008; these are big banks (relative to the economy) that pushed the frontier in terms of reckless lending. The banks got the upside and then came the global crash in fall 2008: property prices fell over 50%, construction and development stopped, and people started defaulting on loans. Today roughly 1/3 of the loans on the balance sheets of banks are non-performing or “under surveillance”; that’s an astonishing 80 percent of GDP, in terms of potentially bad debts."
Much to the original consternation of the EU, Ireland responded by guaranteeing all liabilities of Irish banks, rather than a capped amount like other EU members, and injected capital into the banks purchasing 25% of the Allied Irish Bank and 16% of the Bank of Ireland while nationalizing the Anglo Irish Bank, whose CEO had hidden 122 billion euro in loans and has just been recently arrested for fraud. In the last two years, approximately 40 billion euro in loans in the eleven Irish banks and building societies have been written down.
Now they are planning to buy toxic assets from the banks and give them government bonds; in essence, the government will be issuing 1/3 of GDP in government debt for these distressed assets.
Rather than forcing the creditors of these banks to share the burden, a strong lobby of real estate developers, bond investors, and politicians linked to the developers and bankers prevailed in pushing a "corporate socialist" solution in which the profits were privatized and the losses shoved on the public by making the taxpayers responsible rather than have the creditors pay for their risk taking. A bad bank formed for the public good would have restructured those debts and the creditors would have taken the hit.
On March 30th, the National Asset Management Agency said it would be taking on $22 billion in loans at an average 47% discount amounting to a 32 billion euro writedown for the banks: 3.29 billion euro from Allied Irish Bank at a 43% haircut, 1.93 billion euro from the bank of Ireland at a 35% haircut, 10 billion euro from the already nationalized Anglo Irish Bank, and smaller amounts from the Irish Nationwide Building Society and the EBS Building Society. Eventually, NAMA will buy 81 million euro of loans in four tranches of which this first tranche contains 5.5 billion euro of investment property loans, 1.3 billion euro in land, and 800 million euro in hotels. It will also require the banks to have 8% in private core equity capital, which has caused considerable confusion as to how much each bank will have to raise. It also means the government will own 70% of Allied Irish Bank and 40% of the Bank of Ireland, but actual ownership statistics are hard to reconcile with respect to ownership statistics before and after discounts and capital levels.
The future tranches may show significantly higher discounts as more land rather than investment gets moved.
The debt burden of this bailout of creditors will force the debt/GDP burden of Ireland to over 100% by the end of 2011. All of the harsh austerity deficit cuts are still going to leave a 2010 deficit of 12.5%. While these discounts constitute a restructuring, the use of government debt to finance the purchases rather than shares in NAMA places the burden on the public which faces continue long-term unemployment. On the other hand, NAMA and the Irish government recognized the necessity to strip the toxic purchases out in parallel from all of the banks and building societies at the same time rather than in a cascading chaos of individual institutions as is so prominently discussed in the United States.
In April, the Allied Irish Bank sold assets for 4.6 billion euro to raise capital and the Anglo Irish Bank raised 2.25 billion euro in two bonds covered by the government guarantee.
A good "bad bank" places the burden on the creditors where is belongs in a capitalist society. A bad "bad bank" places the burden of future losses on the shoulders of common taxpayers.
Ireland is an excellent case study, but it is not a good example. Its parallel action in toxic asset purchases is highly commendable and it appears they have actually got, with EU insistence, some value with the discounts in the first tranche. The use of full government guarantee of all liabilities and government bonds to purchase the toxic assets shoves the losses off to the public and away from the risk takers who caused the problems.
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Monday, April 5, 2010
Leftovers --- Radio Show 3/27/2010
We went through a list of what is in the new Health Reform Bill, detailed that what some business are reporting as an immediate expense to income is actually the repeal of a deduction for employee medical benefits for which they have also been receiving a subsidy, and we discussed that children with pre-existing conditions may not be covered until 2014 as the result of the actual language in the legislation. This bill is still being analyzed by experts and the analyses are not all in agreement. We did not get around to Marshall Auerback's article explaining how this health reform is actually a status quo entrenchment of the private insurers, who will profit immensely. He also maintains that deficit hysteria also drove the legislation to put revenue before expenses, which is backwards, and left the insurance companies uncontrolled. Cutting costs would not be as profitable. These are positions I have long maintained and voiced time and again.
Just as Bill Gross of PIMCO was saying bonds have seen their bet days, we saw the 10-year US swap spread turn negative for the first time on record. This means the Treasury yield is higher than the swap rate, which is typically greater given the floating payment are based on interest rates that contain credit risk. The 30-year swap spread turned negative for the first time in August 2008. There is rising demand for higher-yielding assets such as corporate and emerging market securities. Debt issued by financial firms is swapped from fixed-rate into floating-rate payments, which trigger receiving in swaps, which causes the spread to narrow.
John Hussman in his weekly commentary railed against the FASB continuing to allow banks too much discretion in valuing assets and this risks creating zombie banks as the gap between stated assets and actual probability of cash flow from those assets grows. He indicated "... the ability to obscure valuations appears to be a primary reason for the growing gap between delinquencies and foreclosures ...". This is consistent with my repeated observations and warnings that the bank balance sheets are fraudulent and cannot be relied upon. Hussman elaborates that we should not be relying upon any foreclosure data, because the minor resets in the later part of 2009 will not be appearing until March-April at which time we should be looking for any spike in 30-day delinquencies. If one seeks to accept greater risk than there needs to be better clarity and better valuation upon there can be reliance.
We talked again about the proposed rules to require investment advice to retirement plan participants to be conflict free, which means that most of the financial services current players would not be able to provide that advice, leaving only impartial fee-only, conflict free financial advisers like myself. Unfortunately, employers have shown no concern or interest in these new proposed rules and the mandatory consequences.
J. P. Morgan, Lehman, UBS, Bank of America, Bear Stearns, Societe Generale, two of General Electric's financial companies, and Salomon Smith Barney, which was a part of Citigroup, have all been charged by the US Justice Department for being involved in a conspiracy to pay below market interest rates to US state and local governments on investments.
The Federal Home Loan Bank of San Francisco has filed suit in the Superior Court of California against nine securities dealers in order to rescind its purchases of 134 securities in 113 securitization trusts amounting to more than $19.1 billion alleging the dealers made untrue and misleading statements about the characteristics of the mortgage loans underlying the securities.
Retiring Fed Vice Chairman Kohn said that US policy makers were complacent about complex financial instruments and they did not know as much as they thought they did. In separate comments he outlined four homework assignments for monetary policymakers: 1) evaluate implications of changing character of financial markets in designing liquidity tools to be used when panic-driven runs threatened financial stability; 2) improve our understanding of the effects of the large-scale purchases of various types of securities and the massive increase in bank reserves; 3) should central banks use adjusting level of short-term interest rates in order to rein in asset prices that appear to moving away from sustainable values (asset bubbles) while maintaining objectives of full employment and price stability; and 4) should central banks adjust their inflation targets to reduce the probability of reaching zero interest rates.
Yellen, San Francisco Fed president, said the housing market seems to have stalled, unemployment will be 9.25% at the end of this year and 8% by the end of 2011, and interest rates will need to remain low.
The Economics of Contempt blog argued that clearinghouses for derivatives will not work , because it is too burdensome to provide the documentation of collateral behind the securities and would disrupt the liquidity of the market. In my opinion transparent markets where transactions are recorded and tracked are necessary if we are to determine risk management concerns and I question why any security should be sold if it cannot document collateral.
Germany continued a hard line against developing a plan to assist Greece within the European Union and keeps insisting the Stability and Growth Pact be rigidly interpreted even if this means the debt crisis inflames Spain, Portugal, and Ireland. Germany risks damaging the European Union, which provided it with favorable current trade balance exchanges in the euro, in its pursuit of its own national interests at the expense of other EU member states. In Spain, the problems exposed by the bursting of the housing bubble are piling up and the government appears to not have the determination to accept the political consequences of EU austerity imposed plans, which means the more serious financial condition of Spain's regional banks and their heavy exposure to construction and housing loans is not getting the crucial attention it needs.
Speculation that the US Treasury will classify China as a currency manipulator in its semi-annual report on April 15th appears to be political jockeying and China warned against such a sanction and said it will probably report a trade deficit in March. Fan Gang, the only academic member of the People's Bank of China, contended that a rise in the yuan is not a solution for the problems of the United States and a stronger yuan could actually push up inflation in the US. China will weigh all of the external and internal possibilities and sees a primary concern as the need to reduce income inequality between rural and urban workers.
China and Germany have become the two surplus trade countries driving the global economy and both may have to come to the realization that helping their trading partners may be in their best interests.
We have talked and published at length on the spending and real estate bubbles in China. If those bubbles exist and they burst, the effect will be felt around the world and will have severe economic consequences for every nation.
While many have called for the appreciation of the yuan, including Paul Krugman who sees no danger in a trade war, others disagree and think a revaluation of the Chinese currency would actually cut global economic growth by 1.5%. Exports are an essential 1/3 of China's economy and if it well to revalue the yuan and continue exporting to the US at higher prices and lower profits than inflation in the US could be pushed up. All countries need to export, but not all countries can compete and the marketplace is not a level playing field. Attempts to create global reforms effecting current trade balances could end up creating the same problems in the European Union.
One of the reasons the current financial crisis spread so far so fast, besides the proliferation of derivatives, may have been the increasing worldwide reliance on wholesale funding to supplement demand deposits.. When those sources dry up, the banks become even more vulnerable. Wholesale funding includes Federal funds, public funds (sate and local), Federal Home Loan Bank advances, Fed primary credit program, foreign deposits, and brokered deposits obtained through the internet or CD listing services. This only emphasizes the need to assess the safety of the sources of bank funds as part of prudent risk management.
Fitch downgraded Portugal's sovereign debt one notch to AA- and cited budget underperformance, although Portugal is taking positive steps. The downgrade wasmuch anticipated is not considered significant with Fitch already in the middle of S&P and Moody's. In fact, the premium Portugal pays on bonds actually fell compared to the German bund.
US Treasury auctions:
2 year treasury, $43.5 billion, yield 1.0%, bid-to-cover 3.025%, foreign 34.78%, direct 13.8%.
5 year treasury, $42 billion, yield 2.605% (10 bops higher), bid-to-cover 2.55, foreign 39.6%, direct 27.1%. This was a weak auction which drove US CDS wider (more risky) than Europe CDS.
7 year Treasury, $32 billion, yield 3.374%, bid-to-cover 2.61, foreign 41.9%, direct 8.1%. This was a weak auction also.
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Just as Bill Gross of PIMCO was saying bonds have seen their bet days, we saw the 10-year US swap spread turn negative for the first time on record. This means the Treasury yield is higher than the swap rate, which is typically greater given the floating payment are based on interest rates that contain credit risk. The 30-year swap spread turned negative for the first time in August 2008. There is rising demand for higher-yielding assets such as corporate and emerging market securities. Debt issued by financial firms is swapped from fixed-rate into floating-rate payments, which trigger receiving in swaps, which causes the spread to narrow.
John Hussman in his weekly commentary railed against the FASB continuing to allow banks too much discretion in valuing assets and this risks creating zombie banks as the gap between stated assets and actual probability of cash flow from those assets grows. He indicated "... the ability to obscure valuations appears to be a primary reason for the growing gap between delinquencies and foreclosures ...". This is consistent with my repeated observations and warnings that the bank balance sheets are fraudulent and cannot be relied upon. Hussman elaborates that we should not be relying upon any foreclosure data, because the minor resets in the later part of 2009 will not be appearing until March-April at which time we should be looking for any spike in 30-day delinquencies. If one seeks to accept greater risk than there needs to be better clarity and better valuation upon there can be reliance.
We talked again about the proposed rules to require investment advice to retirement plan participants to be conflict free, which means that most of the financial services current players would not be able to provide that advice, leaving only impartial fee-only, conflict free financial advisers like myself. Unfortunately, employers have shown no concern or interest in these new proposed rules and the mandatory consequences.
J. P. Morgan, Lehman, UBS, Bank of America, Bear Stearns, Societe Generale, two of General Electric's financial companies, and Salomon Smith Barney, which was a part of Citigroup, have all been charged by the US Justice Department for being involved in a conspiracy to pay below market interest rates to US state and local governments on investments.
The Federal Home Loan Bank of San Francisco has filed suit in the Superior Court of California against nine securities dealers in order to rescind its purchases of 134 securities in 113 securitization trusts amounting to more than $19.1 billion alleging the dealers made untrue and misleading statements about the characteristics of the mortgage loans underlying the securities.
Retiring Fed Vice Chairman Kohn said that US policy makers were complacent about complex financial instruments and they did not know as much as they thought they did. In separate comments he outlined four homework assignments for monetary policymakers: 1) evaluate implications of changing character of financial markets in designing liquidity tools to be used when panic-driven runs threatened financial stability; 2) improve our understanding of the effects of the large-scale purchases of various types of securities and the massive increase in bank reserves; 3) should central banks use adjusting level of short-term interest rates in order to rein in asset prices that appear to moving away from sustainable values (asset bubbles) while maintaining objectives of full employment and price stability; and 4) should central banks adjust their inflation targets to reduce the probability of reaching zero interest rates.
Yellen, San Francisco Fed president, said the housing market seems to have stalled, unemployment will be 9.25% at the end of this year and 8% by the end of 2011, and interest rates will need to remain low.
The Economics of Contempt blog argued that clearinghouses for derivatives will not work , because it is too burdensome to provide the documentation of collateral behind the securities and would disrupt the liquidity of the market. In my opinion transparent markets where transactions are recorded and tracked are necessary if we are to determine risk management concerns and I question why any security should be sold if it cannot document collateral.
Germany continued a hard line against developing a plan to assist Greece within the European Union and keeps insisting the Stability and Growth Pact be rigidly interpreted even if this means the debt crisis inflames Spain, Portugal, and Ireland. Germany risks damaging the European Union, which provided it with favorable current trade balance exchanges in the euro, in its pursuit of its own national interests at the expense of other EU member states. In Spain, the problems exposed by the bursting of the housing bubble are piling up and the government appears to not have the determination to accept the political consequences of EU austerity imposed plans, which means the more serious financial condition of Spain's regional banks and their heavy exposure to construction and housing loans is not getting the crucial attention it needs.
Speculation that the US Treasury will classify China as a currency manipulator in its semi-annual report on April 15th appears to be political jockeying and China warned against such a sanction and said it will probably report a trade deficit in March. Fan Gang, the only academic member of the People's Bank of China, contended that a rise in the yuan is not a solution for the problems of the United States and a stronger yuan could actually push up inflation in the US. China will weigh all of the external and internal possibilities and sees a primary concern as the need to reduce income inequality between rural and urban workers.
China and Germany have become the two surplus trade countries driving the global economy and both may have to come to the realization that helping their trading partners may be in their best interests.
We have talked and published at length on the spending and real estate bubbles in China. If those bubbles exist and they burst, the effect will be felt around the world and will have severe economic consequences for every nation.
While many have called for the appreciation of the yuan, including Paul Krugman who sees no danger in a trade war, others disagree and think a revaluation of the Chinese currency would actually cut global economic growth by 1.5%. Exports are an essential 1/3 of China's economy and if it well to revalue the yuan and continue exporting to the US at higher prices and lower profits than inflation in the US could be pushed up. All countries need to export, but not all countries can compete and the marketplace is not a level playing field. Attempts to create global reforms effecting current trade balances could end up creating the same problems in the European Union.
One of the reasons the current financial crisis spread so far so fast, besides the proliferation of derivatives, may have been the increasing worldwide reliance on wholesale funding to supplement demand deposits.. When those sources dry up, the banks become even more vulnerable. Wholesale funding includes Federal funds, public funds (sate and local), Federal Home Loan Bank advances, Fed primary credit program, foreign deposits, and brokered deposits obtained through the internet or CD listing services. This only emphasizes the need to assess the safety of the sources of bank funds as part of prudent risk management.
Fitch downgraded Portugal's sovereign debt one notch to AA- and cited budget underperformance, although Portugal is taking positive steps. The downgrade wasmuch anticipated is not considered significant with Fitch already in the middle of S&P and Moody's. In fact, the premium Portugal pays on bonds actually fell compared to the German bund.
US Treasury auctions:
2 year treasury, $43.5 billion, yield 1.0%, bid-to-cover 3.025%, foreign 34.78%, direct 13.8%.
5 year treasury, $42 billion, yield 2.605% (10 bops higher), bid-to-cover 2.55, foreign 39.6%, direct 27.1%. This was a weak auction which drove US CDS wider (more risky) than Europe CDS.
7 year Treasury, $32 billion, yield 3.374%, bid-to-cover 2.61, foreign 41.9%, direct 8.1%. This was a weak auction also.
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Friday, April 2, 2010
Is Canada Better Regulated?
As the United States struggles with achieving any substantive financial system regulatory reform against the well financed opposition of bank lobbyists intent on preserving the profitability of systemic risk, there has been a weak and poorly focused debate on whether Canada, which was relatively unaffected by the current financial crisis, has a better regulated financial system or not and, if so, why.
In May 2009, The Wall Street Journal argued that the Canadian financial system is not exportable to the United States, because Canada does not promote affordable home ownership through government subsidized programs with down payments as low as 3%. In Canada you need a down payment of at least 20% or you are required to purchase mortgage insurance. Mortgage interest is not deductible in Canada. While a homeowner in the United States can walk away from a loan if the balance on the mortgage exceeds the value of the home, in Canada mortgage holders are strictly responsible for the their home loans and the lender can file claims against other assets. While the purchase and sale of asset backed securities is permissible in Canada, only 27% (as compared to 67% in the United States) of mortgages have been securitized with the rest remaining on the books of the banks. Canadian banks were profitable in Q4 2008 and the Canadian government bought 55 billion Canadian dollars of insured loans from the banks in the first half of 2009 as the global financial crisis intensified to assure liquidity. While much has been made of Canadian banks having a lower average leverage ratio (18:1) than the US commercial banks (26:1) and US investment banks (40:1), the balance sheets are not comparable, because the US banks are allowed to carry toxic debts at inflated values not consistent with fair market value. What good are higher leverage ratios if the balance sheets are essentially fraudulent? When Canada's Office of the Superintendent of Financial Institutions (OSFI) was formed more than twenty years ago, to regulate banks, insurance companies, and pension funds, it has concentrated on risk management. Rather than housing, bank regulation, less securitization, or monetary policy, did Canadian banks just practice more prudent risk management?
In January 2010, the Financial Times concentrated on the "cultural" differences between Canada and the United States. Mark Carney, a governor of the Bank of Canada, said "Canadian bankers are still bankers. They ... are proficient at managing credit risk and market risk ... they have retained a banking culture through(out) the organization." The head of OSFI, Julie Dickson, stresses the principle based approached as opposed to legalistic rules in assuring three specific restrictions are followed: capital requirement of a Tier 1 of at least 7%, quality of capital in which 75% of Tier 1 must be in common shares, and a leverage ratio no higher than 20:1. The OSFI wants to be told everything that is going on. "Having lawyers looking at this line or that clause and debating with you about whether something is do-able or not is not the right conversation to have. The right conversation is the principle. You have to know the risks you are undertaking."
Canada has an uncomplicated and well coordinated regulatory framework involving the central bank responsible for stability of the overall system, the superintendent responsible for the stability of the financial system, a consumer protection agency responsible for protecting individuals, and a finance ministry responsible for setting the broad rules on ownership of financial institutions and the design of financial products. In the early 1990's, after a period of failed trust companies, the government set out to create a risk aware financial system. While the Financial Times article also caters to a "robust" mortgage market with only a 1% default rate while having approximately the same home ownership rate as the United States, David Dodge, a former governor of the Bank of Canada, maintains the structure of the banking business allows the banks to make healthy profits without taking extreme risks. "You had a set of banks that had essentially very profitable domestic commercial banking franchises. They had to be pretty bad in their other business to lose money overall."
Some commentators have been attempting to posit a growing Canadian housing bubble by looking at housing prices in Vancouver, which has caused Worthwhile Canadian Initiative to ask for a data documented proof of how falling prices in Vancouver can be expanded into a made-in-Canada recession? In actuality, Canada has not had an over investment in housing. It has been recovering from under investment in the 1990's, following the housing bubble of the 1980's, and what one is seeing now is typical price reaction to supply and demand as lower prices have reduced extra supply and prices are no going back up to prior levels.
Macro and Other Market Musings has shown, in an analysis of a commentary on Canadian housing published by the Cleveland Federal Reserve written by James MacGee, David Beckworth shows the monetary policy of the Fed and the Bank of Canada were not the same and that the Canadian authorities got it right while the Fed was too accommodating with monetary policy being an important component in the US housing boom-bust cycle in which there was weak underwriting with collateral-based lending and the "... interest rates charged to non-conventional mortgages were closely tied to the federal funds rate ...".
In March 2010, Beckworth asked how Simon Johnson and James Kwak would reconcile the success of the Canadian banking system, which benefited from nation-wide branch banking allowing better geographical diversification of assets and quicker access to reserves, in this financial crisis since the nation-wide branch banking led to a very high concentration of Canadian banking in the 5 largest banks. Later in March in a piece in Economix and an expanded version in The Baseline Scenario, Peter Boone and Simon Johnson responded that the Canadian banking system is a fallacy and not the answer, because over half of Canadian mortgages are "effectively" guaranteed by the Canadian government. Despite home owners with less than 20% down payment being required to purchase mortgage insurance, Boone and Johnson insist that the Canadian Mortgage and Housing Corporation directly or indirectly guarantee these riskiest mortgages. Boone ande Johnson also maintain the well coordinated Canadian regulatory system is actually an oligarchic camaraderie between regulators and banks, which is dependent on easy access to taxpayer bailouts. Boone and Johnson assert this would mean the United States would have to shrink its banks into even larger mega banks and re-inflate Fannie Mae and Freddie Mac. It is not just capital ratios, it is not regulation, it is size that matters for Boone and Johnson: "... smaller banks with a lot more capital --- and able to fail when they act stupid ...".
The Perry article, published by the conservative American Enterprise Institute, cited by Beckworth listed features of the Canadian banking system which helped explain the resilience of Canadian banks compared to American banks:
1. Full recourse Mortgages in Canada in which the borrower remains fully responsible for the mortgage;
2. Shorter-Term Fixed Rates in Canada where mortgages carry a fixed interest rate for a maximum of
five years at which time the rates are re-negotiated for another five years, allowing banks to achieve a
better maturity match between assets and interest income and bank liabilities and interest expense;
3. Mortgage insurance is more common in Canada than the United States with approximately half of
Canadian mortgages carrying insurance compared to about 30% in the United States. Private
insurance companies in Canada have the authority to approve or reject a property appraisal giving
them a strong financial incentive to approve realistic appraisals;
4. No tax deductibility of mortgage interest in Canada which means there is no tax advantage to home
ownership and no tax benefit to converting home equity into household debt;
5. Higher prepayment penalties in Canada (three months of mortgage interest) which discourages the
type of refinancing that took place in the United States;
6. Public policy differences with respect to low income housing, because Canada provides public
funding of low income rental housing rather than encourage low income home ownership (I find this
problematic since a mortgage payment should be less than a rental payment for a comparable piece
of property and wonder if the US problem not a combination of easy securitization of high risk
mortgages and lobbyists getting credit standards lowered, i.e., improper risk management);
7. Canada's larger bank concentration allowed more geographical diversification for deposits and loan
portfolios (I have to ask if this was not the result of nation-wide branch banking in a country whose
GDP is 1/10th that of the United States and the "geographical diversification" would be meaningless
without proper risk management?);
8. Other differences contributing to bank safety in which only 35% of Canadian mortgages are
originated by mortgage brokers and there is a much smaller sub-prime mortgage market resulting in
approximately 63-68% of mortgages staying on the books of originating lenders which encourage
prudent lending with banks putting more of their own capital at risk; additionally, all mortgage
payments in Canada are made electronically limiting late payments.
While size is a consideration when commercial and investment banking are mixed together, the real measure is not size but whether the financial entity (bank, pension fund, hedge fund, insurance company) is systemically dangerous in its operation. A simple, uncomplicated and well coordinated regulatory system which includes independent consumer protection is highly desirable. Such a regulatory system without a strong emphasis on proper risk management would be ineffective. It is all about the principle of proper risk management and the active enforcement of the principles of risk management. That is the difference between the Canadian regulatory system and the Untied States, which actively promotes risk taking. We should be looking for financial regulatory reform which stresses the principles of risk management.
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In May 2009, The Wall Street Journal argued that the Canadian financial system is not exportable to the United States, because Canada does not promote affordable home ownership through government subsidized programs with down payments as low as 3%. In Canada you need a down payment of at least 20% or you are required to purchase mortgage insurance. Mortgage interest is not deductible in Canada. While a homeowner in the United States can walk away from a loan if the balance on the mortgage exceeds the value of the home, in Canada mortgage holders are strictly responsible for the their home loans and the lender can file claims against other assets. While the purchase and sale of asset backed securities is permissible in Canada, only 27% (as compared to 67% in the United States) of mortgages have been securitized with the rest remaining on the books of the banks. Canadian banks were profitable in Q4 2008 and the Canadian government bought 55 billion Canadian dollars of insured loans from the banks in the first half of 2009 as the global financial crisis intensified to assure liquidity. While much has been made of Canadian banks having a lower average leverage ratio (18:1) than the US commercial banks (26:1) and US investment banks (40:1), the balance sheets are not comparable, because the US banks are allowed to carry toxic debts at inflated values not consistent with fair market value. What good are higher leverage ratios if the balance sheets are essentially fraudulent? When Canada's Office of the Superintendent of Financial Institutions (OSFI) was formed more than twenty years ago, to regulate banks, insurance companies, and pension funds, it has concentrated on risk management. Rather than housing, bank regulation, less securitization, or monetary policy, did Canadian banks just practice more prudent risk management?
In January 2010, the Financial Times concentrated on the "cultural" differences between Canada and the United States. Mark Carney, a governor of the Bank of Canada, said "Canadian bankers are still bankers. They ... are proficient at managing credit risk and market risk ... they have retained a banking culture through(out) the organization." The head of OSFI, Julie Dickson, stresses the principle based approached as opposed to legalistic rules in assuring three specific restrictions are followed: capital requirement of a Tier 1 of at least 7%, quality of capital in which 75% of Tier 1 must be in common shares, and a leverage ratio no higher than 20:1. The OSFI wants to be told everything that is going on. "Having lawyers looking at this line or that clause and debating with you about whether something is do-able or not is not the right conversation to have. The right conversation is the principle. You have to know the risks you are undertaking."
Canada has an uncomplicated and well coordinated regulatory framework involving the central bank responsible for stability of the overall system, the superintendent responsible for the stability of the financial system, a consumer protection agency responsible for protecting individuals, and a finance ministry responsible for setting the broad rules on ownership of financial institutions and the design of financial products. In the early 1990's, after a period of failed trust companies, the government set out to create a risk aware financial system. While the Financial Times article also caters to a "robust" mortgage market with only a 1% default rate while having approximately the same home ownership rate as the United States, David Dodge, a former governor of the Bank of Canada, maintains the structure of the banking business allows the banks to make healthy profits without taking extreme risks. "You had a set of banks that had essentially very profitable domestic commercial banking franchises. They had to be pretty bad in their other business to lose money overall."
Some commentators have been attempting to posit a growing Canadian housing bubble by looking at housing prices in Vancouver, which has caused Worthwhile Canadian Initiative to ask for a data documented proof of how falling prices in Vancouver can be expanded into a made-in-Canada recession? In actuality, Canada has not had an over investment in housing. It has been recovering from under investment in the 1990's, following the housing bubble of the 1980's, and what one is seeing now is typical price reaction to supply and demand as lower prices have reduced extra supply and prices are no going back up to prior levels.
Macro and Other Market Musings has shown, in an analysis of a commentary on Canadian housing published by the Cleveland Federal Reserve written by James MacGee, David Beckworth shows the monetary policy of the Fed and the Bank of Canada were not the same and that the Canadian authorities got it right while the Fed was too accommodating with monetary policy being an important component in the US housing boom-bust cycle in which there was weak underwriting with collateral-based lending and the "... interest rates charged to non-conventional mortgages were closely tied to the federal funds rate ...".
In March 2010, Beckworth asked how Simon Johnson and James Kwak would reconcile the success of the Canadian banking system, which benefited from nation-wide branch banking allowing better geographical diversification of assets and quicker access to reserves, in this financial crisis since the nation-wide branch banking led to a very high concentration of Canadian banking in the 5 largest banks. Later in March in a piece in Economix and an expanded version in The Baseline Scenario, Peter Boone and Simon Johnson responded that the Canadian banking system is a fallacy and not the answer, because over half of Canadian mortgages are "effectively" guaranteed by the Canadian government. Despite home owners with less than 20% down payment being required to purchase mortgage insurance, Boone and Johnson insist that the Canadian Mortgage and Housing Corporation directly or indirectly guarantee these riskiest mortgages. Boone ande Johnson also maintain the well coordinated Canadian regulatory system is actually an oligarchic camaraderie between regulators and banks, which is dependent on easy access to taxpayer bailouts. Boone and Johnson assert this would mean the United States would have to shrink its banks into even larger mega banks and re-inflate Fannie Mae and Freddie Mac. It is not just capital ratios, it is not regulation, it is size that matters for Boone and Johnson: "... smaller banks with a lot more capital --- and able to fail when they act stupid ...".
The Perry article, published by the conservative American Enterprise Institute, cited by Beckworth listed features of the Canadian banking system which helped explain the resilience of Canadian banks compared to American banks:
1. Full recourse Mortgages in Canada in which the borrower remains fully responsible for the mortgage;
2. Shorter-Term Fixed Rates in Canada where mortgages carry a fixed interest rate for a maximum of
five years at which time the rates are re-negotiated for another five years, allowing banks to achieve a
better maturity match between assets and interest income and bank liabilities and interest expense;
3. Mortgage insurance is more common in Canada than the United States with approximately half of
Canadian mortgages carrying insurance compared to about 30% in the United States. Private
insurance companies in Canada have the authority to approve or reject a property appraisal giving
them a strong financial incentive to approve realistic appraisals;
4. No tax deductibility of mortgage interest in Canada which means there is no tax advantage to home
ownership and no tax benefit to converting home equity into household debt;
5. Higher prepayment penalties in Canada (three months of mortgage interest) which discourages the
type of refinancing that took place in the United States;
6. Public policy differences with respect to low income housing, because Canada provides public
funding of low income rental housing rather than encourage low income home ownership (I find this
problematic since a mortgage payment should be less than a rental payment for a comparable piece
of property and wonder if the US problem not a combination of easy securitization of high risk
mortgages and lobbyists getting credit standards lowered, i.e., improper risk management);
7. Canada's larger bank concentration allowed more geographical diversification for deposits and loan
portfolios (I have to ask if this was not the result of nation-wide branch banking in a country whose
GDP is 1/10th that of the United States and the "geographical diversification" would be meaningless
without proper risk management?);
8. Other differences contributing to bank safety in which only 35% of Canadian mortgages are
originated by mortgage brokers and there is a much smaller sub-prime mortgage market resulting in
approximately 63-68% of mortgages staying on the books of originating lenders which encourage
prudent lending with banks putting more of their own capital at risk; additionally, all mortgage
payments in Canada are made electronically limiting late payments.
While size is a consideration when commercial and investment banking are mixed together, the real measure is not size but whether the financial entity (bank, pension fund, hedge fund, insurance company) is systemically dangerous in its operation. A simple, uncomplicated and well coordinated regulatory system which includes independent consumer protection is highly desirable. Such a regulatory system without a strong emphasis on proper risk management would be ineffective. It is all about the principle of proper risk management and the active enforcement of the principles of risk management. That is the difference between the Canadian regulatory system and the Untied States, which actively promotes risk taking. We should be looking for financial regulatory reform which stresses the principles of risk management.
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