News reports are now surfacing that the Germans are open to IMF involvement in the Greece sovereign debt crisis.  This is a 180-degree turn for the German finance minister who has expressed vocal opposition to the IMF’s involvement in ‘internal’ European Union affairs.

Bloomberg reports Germany making the shift to avoid being boxed in by a bailout pledge:

“We have to think about who has the instruments to push for Greece to restore its capital-markets access” if ultimately needed, Michael Meister, a lawmaker with Merkel’s Christian Democratic Union, said today in an interview in Berlin. “Nobody apart from the IMF has these instruments.” Attempting a Greek rescue “without the IMF would be a very daring experiment.”

The German shift underscores Merkel’s attempts to steer clear of any commitment to a Greek bailout and risks scuttling European Union efforts to establish a contingency plan for the debt-strapped nation. Merkel used a budget speech in parliament in Berlin today to caution against “overly hasty” pledges of financial support.

The position the Germans seem to be taking is the one I outlined back in February (see The Germans will not bail out Greece).  However, the situation is still fluid and there is widespread resistance to the IMF’s involvement. My sense is that the Germans do want to move forward with a European Monetary Fund going forward and are now laying the groundwork even if that means involving the IMF.

The plans for the European fund allow for the expulsion of a serial violator of the stability and growth pact. German Chancellor Angela Merkel is now pushing the euro expulsion line because it fits with the Germans’ vision of the EMF.

Greek Prime Minister Papandreou had threatened to go to the IMF over EU objections if he did not receive assistance.  This threat has been nullified.

The next move now falls to Greece.

Related posts:

• Handelsblatt: Bilateral aid and EU aid to Greece off the table
• The Dutch join the Germans in rejecting bailout of Greece
• The Germans will not bail out Greece
• The Germans get tough with the state banks
• Plans for European Monetary Fund well advanced

This is a post from John Lounsbury.

Charles J. Antonucci Sr., the former president and chief executive of the Park Avenue Bank of New York, made a desperate move to try to save his bank with the infusion of TARP funds. TARP refers to the government program to provide up to $780 billion in loans and capital purchases to shore up failing banks. Antonucci’s only problem: He committed fraud in the attempt.

The fraud was committed to mislead regulators into supplying $11 million from TARP. There are also a number of other charges.

What happened is described in a Wall Street Journal article by Lingling Wei and Chad Bray. Here is an excerpt:

"The bank was broken, so, in October and November 2008, [Mr.] Antonucci methodically went about pretending to fix it," said Preet Bharara, the U.S. attorney in Manhattan, at a press conference.

Prosecutors charged Mr. Antonucci with 10 counts of fraud, bribery and other crimes, including accepting free plane rides from a bank customer and stealing $103,000 from pastors of a church in Coral Springs, Fla. He could face up to 30 years in prison for each fraud and embezzlement charge.

Park Avenue Bank was recently taken over by the FDIC (Federal Deposit Insurance Corporation).

The Major Part of the Fraud

According to the WSJ article, the major dollar amount involved was a result of the following sequence of transactions:

1. Antonucci arranged for loans to be made by the bank to entities he controlled. The amounts of these loans have not been made public, but presumably were in excess of $6.5 million.
2. Antonucci then provided $6.5 million "of his own money" to shore up the capital deposited at the bank. The money was in the form of a deposit in his own name.

How this can be used to fraudulently inflate bank assets can be seen in the following simplified hypothetical example.

Simplified Hypothetical Case Study

Bank X has $1 million in deposits. From these it loans $9 million, keeping the required 1/9 reserve. If $500,000 of the loans default, the loan assets and net deposit assets are both reduced by that amount.

The bank’s books now show $0.5 million in net deposits ($1 million gross deposits less $0.5 million default impairment) and $8.5 million in working assets. The reserve is now 1/19 and capital must be added to get back to 1/9.

One way this can be done is to sell enough performing assets to get back to the required reserve ratio. If $400,000 in loans can be sold at par, then loan assets will be reduced to $8.1 million ($9 million – $0.5 million default – $0.4 million increase in deposits from the asset sale). The net deposits are increased by the sale proceeds to $900,000. The 1/9 capital reserve ratio is re-established.

However, if the remaining assets of the bank are considered to be impaired by the market, it may not be possible to ever sell enough assets to recover the required reserve and cover the $1 million in deposit liabilities.

Here is one example: If the remaining loan portfolio can be sold at $0.50 on the dollar, the 1/9 ratio is recovered by selling $4.5 million (par value) for $2.25 million. This produces a $2.25 million write-off and $2.25 million in new deposits, which exactly cancel yielding an end position of $4.5 million in assets and $0.5 million in net deposits. Bank X must still raise $0.5 million to cover deposit liabilities.

If any of the remaining $4.5 million in loan assets can not be valued at par, that creates another debit to net deposits which must be offset with more sales. This is a death spiral because the bank can not remain viable if the end position can end up with the $1 million in original deposits not being covered.

Introducing Bank Fraud 101

So how can Bank X use Bank Fraud 101 to resolve the problem with regulatory requirements? Very simple. The CEO arranges for a loan for $1 million loan to a shell company he sets up and owns. The shell company then loans the money to the an international (preferably third world) intermediary (blindly controlled by the bank CEO) which then makes a personal loan back to the CEO. The CEO now makes a personal deposit of $560,000 in an account at Bank X.

The bank now has $1,060,000 in net deposits with a loan portfolio of $9.5 million, exactly a 1/9 reserve ratio. And the CEO still has $440,000 of the bank’s money for use elsewhere. What in fact has happened is that the bank’s own credit, leveraged at 9/1, has been converted to a deposit asset.

The entire masquerade can be unwound in the future when the bank has restored its books and can withstand a default on $1 million, which would be triggered by a default by the third world entity producing a default by the shell company.

Or the masquerade can be ended when Bank X still goes belly up and regulators start following the money trail.

For Further Study

Another section of Bank Fraud 101 could use as text an article by Karl Denninger at The Market Ticker that discusses the bank fraud at Lehman Brothers.

Prof. William K. Black (University of Missouri – Kansas City), who was a senior regulator in the RTC (Resolution Trust Corporation) that conducted the work-out of the Savings and Loan Crisis, 1989-1996, wrote a book entitled "The Best Way to Rob a Bank is to Own One". That is the book for the more of Fraud 101, as well as 102 and upper class courses.

Note 1: The hypothetical case study here is much oversimplified. It is intended as a tutorial aid and not as a technically correct description in all details. It is a rough sketch and not a fine oil painting.

Note 2: Be careful if you want to be a whistle blower on fraud. Another Wall Street Journal article describes how a Lehman employee who raised questions about the fraud was fired.

Note 3: According to an article in the New York Times by Andrew Ross Sorkin:

"I’m concerned that the revelations about Lehman Brothers are just the tip of the iceberg,” Senator Ted Kaufman wrote in a speech he was preparing to give Tuesday on the Senate floor. “We have no reason to believe that the conduct detailed last week is somehow isolated or unique. Indeed, this sort of behavior is hardly novel.”

Note 4: According to the Sorkin article in note 3, the Lehman fraud was conducted with full knowledge and disclosure to regulators, who did not recognize that it was improper.

Note 5: All indications are that Bank Fraud 101 is merely a prerequisite to the more substantial courses coming, and will soon lead to graduate level study.

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John Lounsbury provides comprehensive financial planning and investment advisory services to a small number of families on a fee only basis. He has a background which includes 34 years with a major international corporation, 25 years in R&D management and corporate staff positions. Since 2002 he has operated his own sole proprietorship business. John is also one of the top ten authors at Seeking Alpha and a featured commentator at TheStreet.com Real Money.

Related posts:

• The FDIC acknowledges it is to run out of money
• Bank by bank breakdown of stress test results
• Citigroup can limit demand deposit withdrawals and money funds can too
• Large bank loses $7.9 billion: CDS involved
• SEC Press Release on Mozilo’s fraud and insider trading

Mortgage fraud was rampant during the housing boom. Regulators were asleep at the wheel during all of this. But now we are getting some indictments as WFAA News 8 in Dallas reports (hat tip Housing Wire). This television station did the dirty work for regulators and uncovered massive amounts of mortgage fraud.

Byron Harris reports:

News 8 started looking into questionable real estate transactions back in 2006 after learning about investors who were "flipping" houses.

Prosecutors say the group used phony buyers, questionable documents and inflated appraisals to sell houses — including properties in the Hills Creek neighborhood of McKinney — for more than what they were worth.

In 2002, one house on Hills Creek Drive was valued at $315,000; by January 2006, it sold for $625,000.

Prosecutors said the value of other modest homes was increased to as much as $715,000. When the properties sold, prosecutors allege that the profits went to the man at the top in the form of "disbursements."…

Appraiser Steve Nichols helped News 8 analyze the paperwork that pinpointed questionable appraisals by Josh Melton, who is now charged in the crime.

"It’s my belief you have to have professionals who are able to identify fraud in their own industry and being willing to report it," Nichols said.

The U.S. Attorney expects suspects to begin turning themselves in to a federal judge next week; trials will follow.

Each suspect faces a maximum sentence of at least 20 years.

The video is embedded below.

Just last month, Bill Black, a former S&L crisis regulator gave a speech on mortgage fraud and its central role in the housing bubble and bust. He asserts that lax regulation was at the very core of this epidemic of fraud. He starts in commenting that the FBI gave a prescient warning in September 2004 that fraud was rampant in the mortgage market. Black says:

[The FBI] didn’t simply warn there was an epidemic of mortgage fraud, they explicitly warned that it would produce an economic crisis if it were not dealt with. So what was done in response to a warning that clear?

Not a whole lot. As I explained in the last post, Black knows that so much fraud goes unpunished because the majority of the fraud involves the lenders. Since lenders control the documentation, none of this gets exposed unless the lenders file criminal referrals — or regulators intervene.

Note, Black says 80% of mortgage fraud losses occur when lender personnel are involved. Other statistics worthy of consideration which Black cites?

• Of roughly 10,000 mortgage lenders, only 900 have ever filed a criminal referral in the relevant five year period.
• Over 700 of those institutions filed fewer than five criminal referrals.
• The twenty-five largest filers of criminal referrals filed over 90% of all referrals.
• There has not been one single enforcement action in five years (I assume 2002-2007) despite regulated institutions failure to file the mandated criminal referrals.

Black concludes that even in the regulated sector of the mortgage complex where criminal referrals are mandated in the case of fraud, no one except these 25 institutions is reporting fraud.  What does that tell you?

It tells me that fraud is rampant and no one is regulating it. Logic would dictate that any regulator which sees evidence of an epidemic of fraud in non-prime lending and non-compliance with regulatory mandates to report fraud would concentrate a disproportionate number of investigators on non-prime lenders. That did not happen. So, clearly there was no regulation.

During the S&L crisis, Black notes that there were over 1000 priority criminal convictions of senior insiders connected to fraud. To date, of the specialty lenders who specialized in subprime, there have been zero convictions.  So you compare 1,000 during the S&L crisis to zero during this one despite the crisis being an order of magnitude larger. In fact, there have been zero indictments, according to Black. There have even been zero arrests he says.

This is the way the system worked under Bush and it is the way it continues to operate under Obama.

Related posts:

• Short sale fraud
• Lawsuit: steering mortgage applicants could mean more writedowns
• 60 Minutes – Pigeon Fever and Ponzi Schemes on Wall Street
• Bill Black and The Federal Reserve’s War Against Effective Regulation
• Bank Fraud 101: How to Rob A Bank

I am going to talk here a little bit about the looming trade war between China and the United States. But I am going to come at it from a side angle via some historical analogies.

Common folklore in the United States says that the Soviet Empire collapsed in large part due to the efforts of American President Ronald Reagan and not due to internal forces. Others downplay Reagan’s role and see internal forces as more significant.

I want to briefly outline this debate and make a parallel to the financial crisis and the near collapse of the American financial system and ask a few questions about anti-Chinese protectionist rhetoric in this context. My basic question will be: How effective is external pressure in precipitating regime change or economic policy moves?

Let’s start off with the collapse of the Soviet Union. When Ronald Reagan died in June 2004, MSNBC ran an article, “Determination to destroy communism was a hallmark of his 8-year presidency” which eulogized the former President with credit for helping to destroy the Soviet Empire.

The article began:

He stunned the Soviet Union with his tough rhetoric, calling it an “evil empire” whose leaders gave themselves the “right to commit any crime.”

His famed “Star Wars” program drew the Soviets into a costly arms race it couldn’t afford. His 1987 declaration to Soviet leader Mikhail Gorbachev at the Berlin Wall — “Mr. Gorbachev, tear down this wall” — was the ultimate challenge of the Cold War.

Ronald Reagan’s determination to destroy communism and the Soviet Union was a hallmark of his eight-year presidency, carried out through a harsh nuclear policy toward Moscow that softened only slightly when Gorbachev came to office.

He is vividly remembered in Russia today as the force that precipitated the Soviet collapse.

“Reagan bolstered the U.S. military might to ruin the Soviet economy, and he achieved his goal,” said Gennady Gerasimov, who served as top spokesman for the Soviet Foreign Ministry during the 1980s.

The article goes on to assert that Reagan’s anti-Soviet stance was a significant departure from Jimmy Carter’s ‘mild detente’ [read: weak on defense], suggesting that this course change brought down the Soviet Union.  The article then provides yet more quotes from influential Russian dissidents to bolster this claim.

But is this really true?

Last November, an online survey demonstrated that Americans are alone in this view that external pressure applied by the Reagan Administration was principally responsible for the Soviet collapse.

The online survey of representative national samples asked respondents to assess the performance of nine political figures of the 1980s, and their effect in the eventual collapse of communism.

For Americans, Reagan is the clear winner with 69 per cent of respondents claiming he deserves a lot of credit or some of the credit for the collapse of communism. More than half of people in the U.S. also commend Gorbachev (56%) and British Prime Minister Margaret Thatcher (57%) for their efforts.

In Britain, only Gorbachev (57%) and Walesa (56%) clear the 50 per cent mark, followed by German chancellor Helmut Kohl (47%), Thatcher (45%) and Reagan (44%).

In Canada, Gorbachev is seen as the most important figure (65%), followed by Reagan (58%), Thatcher (56%) and Walesa (52%). Canadians are more likely to select Reagan and Thatcher as deserving “some of the credit”, and place former Canadian Prime Minister Brian Mulroney at the bottom of the list with 25 per cent.

The survey also shows that a considerable proportion of people in the two North American countries (47% in the U.S. and 44% in Canada) regard Pope John Paul II as an important player in the collapse of communism, while Britons (31%) are decidedly more skeptical.

-People Differ on Who Deserves Credit for the Collapse of Communism, Vision Critical

On some level, it’s irrelevant if the claim that Ronald Reagan ended communism is true because the winners get the spoils. And that means they get to impose their historical narrative on past events whether this narrative is true or not.

If external pressure did bring down the Soviet Union, an analogous claim could be made for the American financial system’s near-collapse because of the focus by regulators post-9/11 on terrorism to the exclusion of financial fraud.

Last month, Bill Black, a former S&L crisis regulator gave a speech on mortgage fraud and its central role in the housing bubble and bust. he asserts that lax regulation was at the core of why this fraud was allowed to occur. What I found interesting about Black’s lecture was the section on the FBI. He starts by commenting that the FBI gave a prescient warning in September 2004 in Congressional testimony that fraud and insider trading were rampant in the mortgage market. Black says:

[The FBI] didn’t simply warn there was an epidemic of mortgage fraud, they explicitly warned that it would produce an economic crisis if it were not dealt with. So what was done in response to a warning that clear?

Not a whole lot. In fact, Black says no one wants to unearth the fraud because the majority of it came from the lenders and not the borrowers. This is a bit like the 9/11 intelligence memo warning of an imminent al Qaeda attack:

RICE: I remember very well that the president was aware that there were issues inside the United States. He talked to people about this. But I don’t remember the al Qaeda cells as being something that we were told we needed to do something about.

BEN-VENISTE: Isn’t it a fact, Dr. Rice, that the August 6 PDB warned against possible attacks in this country? And I ask you whether you recall the title of that PDB?

RICE: I believe the title was, "Bin Laden Determined to Attack Inside the United States."

Now, during the S&L crisis there were 1000 investigators on the case. In 2009 there were 150 FBI agents on the case. And that’s a large part of the problem. After 9/11, more than 500 white-collar investigative specialist FBI agents were transferred from white-collar crime to focus on national security. Had these 500 extra FBI agents been available, perhaps the fraud would have been prosecuted. Similar tales are certainly available at other regulators like the SEC as the U.S. was more interested in connecting charities to terrorist sources than investigating mortgage fraud.

So, in a very real sense, one could make the same argument about 9/11 and al Qaeda causing the collapse of the United States’ financial system  that is made about Reagan causing the collapse of the Soviet economic system. I do not find this line of thinking persuasive. But, the situations are indeed analogous.

So, here’s my question again: How effective is external pressure in precipitating regime change or economic policy moves?

We see that most Americans believe it was very effective in bringing down the Soviets. Most believe it was effective in ending Apartheid in South Africa. It has not been so successful in Cuba or North Korea. But could external pressure work in Iran or even in China?

My general take is no; politicians, especially in command economies, are relatively unconcerned with external pressure. I used to be a foreign policy specialist. And, despite my role, I was keenly aware of the primacy of domestic issues over foreign ones in a politician’s decision-making. What the ruling elite in command economies care about is social unrest that stems from a lack of civil liberties and economic progress. Even in the United States, this is true.  Do you think American politicians will yield to Brazilian threats to retaliate for American cotton subsidies? Of course not.

Threats don’t work. The only thing that can work is inflicting economic pain and creating social unrest. Yes, autarky hasn’t brought the North Koreans or Cubans to heel; nor did it topple Saddam Hussein. However, implicitly, this is the power that some American political historians ascribe to the policies against South Africa and the Soviets. They assert that it was the economic pain that caused those governments to eventually yield.

So, as Americans look to threaten to punish China for China’s protectionist exchange rate policy, we should all understand that these threats will have no effect.  The Chinese will not do anything because of threats. More likely, they will dig in their heels. The Telegraph’s Liam Halligan has it right when he says:

When it comes to China, the West needs to face the truth. The more America calls for China to revalue the longer Beijing will take to do it. Chinese politicians are as unlikely to buckle in the face of Western pressure as their Western counterparts would be given a tongue-lashing from Beijing.

China’s government is petrified of social unrest. Given the importance of the export sector for continued high growth and jobs, this again makes it impossible to Beijing to be seen yielding to pain imposed by the West.

What is more likely to occur is that American politicians, pressured by the upcoming mid-term elections, will create binding legislation to retaliate against China for their undervalued currency. China will not budge – in part out of pride and in part out of need to prevent a hard landing. As a result, the binding legislation will become operative and a trade war will ensue.

For more on how a trade war would affect the global economy read Michael Pettis’ piece How will an RMB revaluation affect China, the US, and the world?. He notes that surplus countries like China have the most to lose and feels that the short-term losses for the U.S. will be less. I agree that surplus nations have the most to lose. But I disagree about the short-term effects on the United States; any economic shock to the United States will tip into a double dip recession, precipitating higher unemployment, a renewed meltdown in the financial sector and the attendant deleveraging. That is very bearish for equities, I should add. Moreover, the Chinese would make their UN Security Council veto work and stymie any efforts the U.S. makes toward controlling Iran. I see a lot more risk in a Chinese trade war for the United States than Pettis.

This is what I have labelled Murder-Suicide in Chimerica. But, I believe this could be where we are headed -  now more than ever.

Related posts:

• China slams U.S. profligacy
• China launches retaliatory investigation into U.S auto subsidies
• Should we expect a protectionist China?
• Will the U.S. allow China to buy more Gulf of Mexico oil assets?
• The U.S. is exporting unemployment with ‘Buy America’

Highlights

The US dollar is softer against most major currencies.  The still expansionary FOMC statement, the BoJ’s extension of Q/E overnight and the conclusion of the EU finance ministers’ meeting yesterday may have helped ease tensions.  However, the dollar was already beginning to soften ahead of these events after failing to extend gains in early March.  That may have disappointed momentum traders who, based on IMM data, hold near record short sterling positions and record short euro positions.  Some speculators may have begun scaling back these short positions as the currencies lost downward momentum.  Sterling, which is the worst performing of the major currencies this year, is helping to lead today’s move higher getting an extra boost from firm UK jobs data and less dovish than expected MPC minutes.  While some pullback is likely given the pound is overextended, momentum traders are likely to re-emerge to buy pounds around $1.5260.  The euro is comparatively stable, briefly extending gains to the highest level since Mar 9^th.  However, the single currency has made a clear break above the downtrend line drawn off the late 2009 highs (comes in today around $1.3700) and is likely to see renewed momentum trader buying above the $1.37 area.  The antipodean currencies are amongst the strongest gainers today, helped by firm commodities. 

Global equity markets are higher in Asia and Europe and commodities firmer after the Fed signaled rates would be left on hold for an extended period and the BoJ extended quantitative easing.  The MSCI Asia Pacific index gained ground for the fourth consecutive session, climbing to a two-month high (up 1.5% on the session) while Japan’s Nikkei rose 1.2% on the session led by oil and gas and basic materials.  S. Korea’s Kospi posted one of the largest gains, rising 2.1% bolstered by export related technology shares.  China’s Shanghai Composite gained 1.9%.  The leading European bourses are up 0.5% to 1.0% while S&P futures are firmer suggesting US markets will open on a firm footing.

Global sovereign bonds are mixed.  US Treasuries are lower, giving up some of yesterday’s post-FOMC gains, with the 10-year yield up 2 bp. In Europe, bonds are flat to slightly firmer.  The Greek/German 10-year spread has narrowed 4 bp to 295 bp after the conclusion of yesterday’s EU finance minister’s meeting and S&P’s removal of Greece from its credit watch list (though the rating was left at negative).  The spread compares with 309 bp a week ago but vs. 252 bp three months ago.  Japanese 10-year JGB yields are up 1 bp while the 2-year is flat after today’s BoJ meeting.  Iceland cut rates 50 bp to 9.0%.

Currency Markets

The Bank of Japan left the key target rate unchanged at 10 bp, but appeared to bow to government pressure and increased the size of the three-month loan facility arranged last December to JPY20 trillion from JPY10 trillion.  Tweaking this facility was widely tipped as a likely compromise formation between the BOJ who has argued that monetary policy was already extraordinarily easy and interest rates were extremely low, while the government wants more efforts to combat deflation.  Nevertheless, the compromise was not satisfactory and two BOJ members (Noda and Suda) dissented.  Japan’s CPI fell for the 11th consecutive month in January and the Q4 GDP deflator was a record -2.8%.   We agree with the BOJ that today’s move will not have much impact, yet the reason we suspect that the BOJ went along was that the JPY10 trillion facility had nearly been exhausted and the banking system faced the imminent withdrawal of liquidity at the end of the month as a separate credit facility (unlimited loans for collateral) was set to expire.  However, it also means that additional measures may require some marked deterioration in conditions.  It suggests that the BOJ is reluctant to extend its rinban operations–under which it buys government bonds–from the current JPY1.8 trillion.  Meanwhile the economic data suggests that the capex–export recovery is having a knock-on effect on other sectors.  The Japanese government appeared to have recognized this early this week, and today it released the Jan tertiary activity report.  The 2.9% increase was more than twice the consensus and follows a 0.9% contraction in December 09.  The dollar remains largely confined to a JPY90-JPY91 trading range.  Contrary to other analysis, we continue to suspect the risk of intervention remains low, as is normally the case.  We note that dollar-yen volatility has fallen to a new multi-year low today below 11.2% and the premium for yen calls over yen puts remains historically speaking (last few years) quite small.  Nor do we place much emphasis on the fact that 3-month yen LIBOR has been fixed in recent sessions below 3-month dollar LIBOR.  The difference is about 1.5 bp annualized and is simply insignificant to change investment strategies.  The Nikkei’s 1.2% advance, led by oil/gas, basic materials and consumer services, brings the month-to-date advance to nearly 7.5%.  Foreign investors were increased their purchases of Japanese equities in January, but slowed considerably in February and appear to be stepping back up this month.

Sterling was already leading the foreign currencies higher against the US dollar in early European trading and the less dovish MPC minutes and firm employment figures have given the pound an extra boost.  The March 4^th meeting minutes showed the MPC voted unanimously to keep policy unchanged. Importantly for those looking for bullish sterling news, the case for fresh QE was not really debated as the MPC thought that there was ‘little evidence to suggest’ a change in the UK economic outlook since the prior meeting. Policy makers confirmed they stand ready to expand purchases of gilts or tighten monetary policy if needed, with a ‘bumpy’ path ahead for the economy. On the inflation front, some members considered that the upside risks to inflation had increased slightly over the month, while others felt that the balance of risks had not changed materially (January inflation has reached a 14-month high of 3.5% y/y as the VAT effect fed through).  Meanwhile, UK unemployment fell by 32.3k in Feb (vs a 6k rise exp and vs a 5.3k Jan gain.) Jobless claims fell at their fastest pace since 1997, which is a very encouraging sign for growth prospects. Jan average earnings were up by just 0.9% y/y (from 0.7% and versus 1.7% expected) but the ex-bonus y/y rate firmed to 1.4% y/y from 1.2%. This remains a very soft labour market so wage inflation risk is contained.  Sterling has now gained four big figures from yesterday’s low around $1.4978 and is overextended on an hourly basis. Still, technicals are supportive of the pound with the 5- and 20-day moving averages about to cross to the upside and longer term momentum indicators pointing up suggesting short term traders may trim some of their short sterling positions on pullbacks toward $1.5260.  

Upcoming Economic Releases

US PPI is due at 8:30 AM EDT/12:30 GMT.  The consensus is for headline PPI to slip -0.2% m/m in Feb after rising 1.4% in Jan and putting the annual pace at 4.9%.  Ex food and energy, PPI is exp up 0.1% m/m (vs. 0.3% in Jan) and 1.0% y/y, unchanged from Jan.  Canadian wholesale sales (exp up 0.5% m/m in Jan) are due at the same time.  Fed Chairman Bernanke and ex-Fed Chairman Volcker testify at the House hearing on bank supervision (2PM/18:00) while the Fed’s Fisher speaks at 4:30PM/20:30.

—————————-
Marc Chandler is the global head of Brown Brother Harriman’s top ranked Currency Strategy Team. For more of BBH’s currency views, please visit the BBH FX website here.

This material has been prepared by Brown Brothers Harriman & Co. (“BBH”) and is intended for information purposes only.  This communication should not be relied upon as financial, investment, tax or legal advice.  This communication should not be construed as a recommendation to invest or not to invest in any country or to undertake any specific position or transaction in any currency.  This information may not be suitable for all investors depending on their financial sophistication and investment objectives.  The services of an appropriate professional should be sought in connection with such matters.  The information contained herein has been obtained from sources believed to be reliable, but is not necessarily complete in its accuracy and cannot be guaranteed. Sources used are available upon request. Any opinions expressed are subject to change without notice. Please contact your BBH representative for additional information. BBH’s partners and employees may own currencies in the subject of this communication and/or may make purchases or sales while this communication is in circulation.

Related posts:

• When will Sterling hit Euro parity?
• The Long Run Dollar Outlook
• Big Mac Index: Europe overvalued, Asia undervalued
• Japanese defend dollar’s status while China tears it down
• Swine Flu Tempature Rises, Dollar and Yen Remain Firm

Lehman Brothers

Related posts:

• Links: 2010-03-07 – Comparing job losses, China’s workers and more
• Links: 2010-03-13 – Fed’s Lehman Repos, States may hold onto tax refunds
• Links: 2010-03-15 – Sovereign credit ratings, China and protectionism
• Links: 2010-02-17 – Revaluing China, Goldman and more
• Links: 2010-03-09 – AIB’s loan book and China, Japan and the U.S.

Last week the federal Reserve released its quarterly flow of funds data. I have been unusually slow to parse the numbers. But I did do a very comprehensive sweep of the historical data in an October 2009 post called A brief look at the Asset-Based Economy at economic turns.

The overall conclusion of this analysis was that the consumer was not deleveraging significantly yet, but that the financial sector was deleveraging for the first time since 1982 when the so-called Great Moderation began. The government was filling in the difference and keeping the economy afloat with an unprecedented increase in debt.

Ultimately, however, the financial sector data were the key to the entire analysis:

Financial Services Debt

This is probably the key damning piece of data confirming the asset-based economy thesis.  The data are much worse than I expected.  Not only do Financial Sector debt levels rise from negligible to percentages well over 100% of GDP, but the entire post-1982 period sees zero decline compared to nominal GDP until last quarter.

What conclusions can one draw here?

1. The financial services sector is six times more important than in 1982 when its debt is measured as a percentage of GDP.
2. The financial sector protected the American economy since 1982 by increasing its debt burden relative to nominal GDP even during recession.
3. The financial services sector contracted in Q2 relative to GDP for the first time since 1982.  If this is a rear-view mirror view, that means recovery could continue. However, if this is a canary in the coalmine, that is negative for the U.S. economy. This number bears watching.

I said watch these numbers to see if Q2 2009 was a rear-view or a front-view mirror. So, what are the numbers saying now? Annaly Salvos has the chart.

The data are not good.

First of all, what this chart shows you is that the consumer is not deleveraging significantly (see Consumer credit down, but does it show deleveraging? and Why is everyone saying consumer credit is falling? It’s not). Sure revolving debt (read: credit card debt) has fallen. But mortgage debt is still sky high. And on a debt to GDP basis, there really isn’t a huge come down. Sorry, but that’s what the data are saying. For an indebted household sector, this is bad news.

But, then you look at the other sectors and you see that the financial sector is deleveraging in a massive way. When I last looked the data, I concluded that the U.S. economy was wholly dependent on leverage in the financial sector to continue growing. So, the decreased financial sector leverage spells a lower growth future.

Finally, the government sector debt load continues to surge upward. Keynesians will tell you that the deficit spending that is the source of this increasing debt load is needed to increase savings in the private sector. However, it appears that most of the savings is being done in the financial sector and not in the household sector where it should be.

I see the data as an indication the private-sector deleveraging is only in its beginning stages and has much farther to go.

Related posts:

• Chart of the day: household debt vs. savings
• A brief look at the Asset-Based Economy at economic turns
• Consumer credit falls 4.4% from year ago levels
• Chart of the day: Total US Debt
• Chart of the day: consumer credit growth

I see Diana Olick’s recent comments about government mortgage modification programs as proof that these props will not work.

She says:

Despite extraordinary loss mitigation efforts that have resulted in the execution of approximately two million loan modifications – including the federal government’s Home Affordable Modification Program (HAMP) trial periods – the number of new delinquencies since January 1, 2009, still exceeds this number by 25 percent.

What does that tell you?

Note, that right now only 16% of borrowers eligible for the HAMP received permanent modifications. I am not a big fan of all of the government programs designed to prop up house prices because they only put off the inevitable – and usually at higher cost to the mortgagee and economy. They are only good for banks who want to get as much money out of a mortgagee desperate to hold onto their property as they can.

But, the government has turned to a new fix: short sales. Olick writes in another recent post:

The government’s short sale program is designed specifically to lower the number of foreclosures by getting these homes sold quickly to financially able buyers.

The problem here is that no one wants to do a short sale. As a first lien holder, why would you write down your mortgage and do a short sale when you could just as easily extend and pretend?

Delinquencies are rising at a rapid rate.

But foreclosures are not rising anywhere near this fast (see my second chart from Strategic default: In come the waves again). That’s called extending and pretending.

Paul Jackson of Housing Wire, who provided the chart above says:

What the above chart should call attention to is the aging of loans in the default pipeline. Again using LPS data, for all loans more than 90 days in arrears, the average days delinquent is now at 272 days—up from 204 days in early 2008. For loans in foreclosure, the aging numbers are even more staggering: loans in this bucket average 410 days delinquent, up from 260 days delinquent in early 2008.

Ponder those numbers for just a second. On average, severely delinquent borrowers have gone more than 9 months without making a mortgage payment—and yet foreclosure has not yet started for them. For those borrowers who are in the foreclosure process, it’s been an average of 13.6 months—more than one full year—since they last made any payment on their mortgage.

Jackson goes on to say that short sales are not going to save the day and provides a very good analysis as to why, citing second liens and the size of the problem as the biggest stumbling blocks. Read the full account at his post Housing Recovery is Spelled R-E-O.

Also see The fake stress tests and the coming wave of second mortgage writedowns for more on second liens because this gives another take on why second lien holders don’t want to do short sales either.

Let’s go back to Diana Olick for a second, because she makes another point that is a particular stumbling block: taxes. Borrowers don’t want to do short sales as well.

Unfortunately any loan forgiveness [from a short sale] would be counted as taxable income.

That would cost beleaguered borrowers thousands of dollars after losing their homes! But no worries, Congress to the rescue; it quickly passed the Mortgage Forgiveness Debt Relief Act of 2007, which keeps homeowners from being liable for the canceled debt.

That law is in effect through 2012.

California did the same thing, except that its law expired at the end of 2008, so any Californian who got mortgage debt forgiveness in 2009 is potentially on the hook for a big bad state tax bill.

Translation: California borrowers, where the most people are the most underwater, are not going to like this new HAFA short-sale program at all because they will receive a massive tax bill.

Olick makes her case in the video below.

Bottom line: These programs are not going to get it done. The only thing that will is market-clearing prices, and prices won’t be a low enough to clear for a long time.

Source

Loans Going Bad Faster Than the Fixes – Diana Olick, CNBC

California Could Tank Short Sale Stimulus – Diana Olick, CNBC

Home Affordable Foreclosure Alternative program – Treasury Department

Related posts:

• Short sale fraud
• Extend and pretend and the growing divide between delinquencies and foreclosures
• The coming wave of second mortgage writedowns
• Wow, judges now nixing lenders’ foreclosure claims entirely in court
• Ivy Zelman: “Home prices are going back down”

Meredith Whitney was on CNBC in London this morning. She concentrates her comments on mortgages and banking. She sees the winter lull as a harbinger of renewed softness in the housing market.

Note: the FOMC statement today reiterated the ending dates for MBS purchases. Let’s see how this plays out for mortgage rates in April and beyond.

Whitney is bullish on some financials, namely Visa (V) and Mastercard (MC). However, in the video below she talks a lot about the coming supply of houses which are now receiving modifications. Whitney believes these modifications will fail, forcing those houses onto the market and upsetting the supply-demand balance. She notes that banks are under-reserved for another leg down in the housing market, meaning the credit writedowns from a second wave will impair lending capital. The money quote comes right at the end of the second clip. Look for it.

Related posts:

• Meredith Whitney: more bearish than ever, but…
• Links: 2010-02-18 – fallacies of composition, housing bubbles, taxes and more
• Meredith Whitney: The government is "out of bullets"
• Swedish Risks
• Connecting Fed cuts with credit writedowns and quantitative easing

This is a post from John Lounsbury which will cover ground on the official designation of recessions and his own designation of depressions about which he has written in the past. Previous articles in this series have discussed:

• The NBER process for dating recessions;
• Redefining the business cycle;
• Normalization of GDP to population; and
• Normalization of employment to population.

The previous discussion of GDP might be called the “Wall Street business cycle”. The discussion of employment could be called The “Main Street business cycle”.

Of course, there are more factors involved in the business cycle than just GDP and employment. These two have been selected because they are “broad brush” representations of economic activity.

A recent article by Ben, at the Department of Numbers, suggested that recessions should be timed separately for GDP and employment. That is the direction my work has been pointing.

NBER Recessions

The NBER (National Bureau of Economic Research) defines the start and end dates of economic recessions, both after the fact. Some dates are determined as much as a year after the event actually occurs, such as the December 2008 announcement that a recession had started in December 2007. The dates of recessions all the way back to 1854 are listed here.

The NBER does not measure depressions.

Wall Street Recessions and Depressions

The following three graphs show the NBER recessions (in gray) and the GDP recessions and depressions (in green) for the three 21 year intervals between 1947 and 2009.

Eight of the ten recessions are single recessions within a defined depression. The recessions of 1980 and 1981-82 are both within the same depression. However, this is just barely so. The recovery of normalized GDP to the level of 1Q/1980 occurred in 1Q/1981; the same quarter was the point from which the next normalized GDP decline began.

It could be argued that one depression ended and another began at the same time. I reject that interpretation as illogical: It is nonsense to say that one depression ends at the same time another begins. They are a single double dip depression.

Main Street Recessions and Depressions

We will use the normalized employment data in the preceding article to represent recessions and depressions on Main Street. In the section after this one, the recessions and depressions on Wall Street (represented by normalized GDP) will be compared to the Main Street business cycle.

The following graph shows the employment recessions and depressions over the past 60 years. There were seven depressions and eleven recessions. Four depressions (1948-51, 1969-73, 1974-79 and 1990-96) each contained one recession. Two depressions (1979-83 and 2000-?) each contain two recessions. The depression of 1953-69 contained three recessions.

Of course, the current depression has not concluded, so additional recessions are possible before it ends.

The growth in normalized employment (normalized to adult civilian population) from the mid 1960s to 2000 can be attributed to shrinkage of the military population (the smaller contributor) and the increasing participation of women in the labor force. There was a small counter factor due to the gradual increase in the percentage of retirees over the 35 years. Now the initial wave of baby boomers is reaching normal retirement age and the rate of people entering retirement would normally be expected to increase.

However, there are survey reports that the number of people in their 60s that are delaying retirement for economic reasons is increasing. A recent analysis suggests that the number of people working past normal retirement age has been increasing for at least a decade and the trend may continue. See here.

To make the above curve more meaningful, the normalized employment ratio should be adjusted for demographics going forward. The perfectly corrected curve would most likely show depressions in employment between periods of full employment, possibly in the range 64% of the adjusted adult population.

The question of how to properly adjust the normalized employment curve for demographics is being put off to a future time. For now, we will just recognize that factor is introducing a bias (downward with advancing time) that may or may not become more significant in the coming decades.

Comparing Wall Street and Main Street Business Cycles

The following graphic shows the NBER recessions, the normalized GDP recessions and the normalized employment recessions superimposed on the same timeline.

The first eight recessions show similar durations for all three measurements of recession, with the exception of (1) the recession in 1980 which had a longer employment recession than either NBER or GDP metrics and (2) the recession of 1981-82 which had a longer GDP recession than either NBER or employment metrics.

The three most recent recessions had much longer duration employment recessions than either NBER of GDP metrics.

The following graph shows GDP and employment depressions on the same timeline. The NBER does not determine dates for depressions.

Employment depressions last longer or much longer than GDP depressions. One employment depression, 1953-1969 covers the time span of two separate GDP depressions. The current employment depression is the other on this timeline that covers more than one GDP depression.

Summary

Using employment as a metric for recessions and depressions on Main Street and either the NBER or GDP as indicators of recessions and depressions on Wall Street, we can draw the following conclusions:

1. It should be no surprise that the business cycles experienced by Wall Street and Main Street are correlated in time.
2. The duration of the recessions on Wall Street and Main Street were quite similar from 1947 through 1982.
3. The durations of recessions starting in 1990 have been significantly longer on Main Street than on Wall Street.
4. Depressions on Main Street have been far longer than those on Wall Street. Since 1947, 34% of the time has been spent in GDP depressions while 78% of the time has been spent in employment depressions.
5. I have a fundamental question: Why is the longest Main Street depression (1953-69) associated with a time generally considered to be one of growing prosperity. In fact, within this time frame, we had the longest time period (1962-69) without a Wall Street depression? This question deserves more research.

There has been no attempt to adjust the adult civilian population for the increasing percentage of people in retirement which is likely to have occurred over the 62 years of this study. That has introduced an unknown negative bias to the determination of employment recessions and depressions. Further refinement of this analysis should lead to a reduction of the duration of the employment timelines, especially for depressions. This affect will be analyzed in further work.

Other work to be completed includes:

1. Measurement of the relative economic impact of different recessions and depressions. My proposed term for these impacts is “burden”, introduced here.
2. Comparison of the business cycles of the first half of the twentieth century with those covered here.
3. Application of this analysis to other business cycle variables including industrial production, aggregate personal income less transfer payments, stock market returns, etc.

—————————————-

John Lounsbury provides comprehensive financial planning and investment advisory services to a small number of families on a fee only basis. He has a background which includes 34 years with a major international corporation, 25 years in R&D management and corporate staff positions. Since 2002 he has operated his own sole proprietorship business. John is also one of the top ten authors at Seeking Alpha and a featured commentator at TheStreet.com Real Money.

Related posts:

• Personal income and recessions since 1929
• Is the recession dating committee preparing for a double dip?
• Data on past consumer deleveraging during recessions
• Economic recovery and the perverse math of GDP reporting
• Unemployment claims falling faster than in half of past recessions

With US midterm elections up ahead, we are already seeing political posturing by US politicians regarding China’s currency.  Democratic lawmakers are reportedly drawing up legislation that sets criteria on whether a country has a misaligned currency.  It would modify the current US Treasury semi-annual report to misalignment instead of manipulation.  The House Ways and Means Committee plans a March 24 hearing on the yuan, and so we expect the rhetoric to ratchet up in the coming weeks.  It doesn’t help that the US economy is still facing uncertainty, and so politicians are looking for scapegoats.  China has not been receptive, with Premier Wen saying this month that countries shouldn’t point fingers and try to force a country to appreciate its currency. 

We think a confrontational approach is not helpful, as China has never reacted well to outside pressures or criticism.  And it’s not like the US is in a great position to be dispensing economic advice to the largest holder of USTs (we note that benchmark revisions last month allowed China to retake that position from Japan). There is a clear risk that the US pushes this matter too far given the political landscape.  If both sides were to take a hardline approach, then the risks would be for a weaker dollar and lower UST prices, as China’s ultimate scorched earth response would clearly be to stop (or threaten to stop) purchases of USTs and dollars.  We hope cooler heads will prevail all around.  As it is, China’s trade surplus has fallen sharply even as the US deficit has narrowed, so the imbalances are already improving.

Press is reporting that the draft legislation calls for action if Treasury determines misalignment of a currency.  The US would be forced to take some sort of action with the IMF and, after 60 days, would have to bar federal procurement from that country. After 360 days of inaction, the US Trade Representative’s office would bring a complaint at the World Trade Organization.  We have a hard time believing that the IMF would be drawn into this dispute.  UNCTAD is reportedly on the wires today saying criticism of China’s currency policies are unfounded, so this may really be seen as a bilateral dispute. The biggest problem with changing the language to that of misalignment is that currencies are more often misaligned than not.  Right now, AUD is about 25% overvalued.  Would the US try to punish Australia even though it is not trying to manipulate its currency?  Or does it only work only in one direction with regards to undervaluation?  And how does one measure misalignment?  We note that even the simplest measure PPP is fraught with difficulties, as choice of price index or basket of goods can shift PPP values greatly.  

Source:  Bloomberg
Win Thin
Senior Currency Strategist
Brown Brothers Harriman & Co.

Win Thin is part of Brown Brother Harriman’s top ranked Currency Strategy Team. For more of BBH’s currency views, please visit the BBH FX website here.

This material has been prepared by Brown Brothers Harriman & Co. (“BBH”) and is intended for information purposes only.  This communication should not be relied upon as financial, investment, tax or legal advice.  This communication should not be construed as a recommendation to invest or not to invest in any country or to undertake any specific position or transaction in any currency.  This information may not be suitable for all investors depending on their financial sophistication and investment objectives.  The services of an appropriate professional should be sought in connection with such matters.  The information contained herein has been obtained from sources believed to be reliable, but is not necessarily complete in its accuracy and cannot be guaranteed. Sources used are available upon request. Any opinions expressed are subject to change without notice. Please contact your BBH representative for additional information. BBH’s partners and employees may own currencies in the subject of this communication and/or may make purchases or sales while this communication is in circulation.

Related posts:

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As Irwin Stelzer argued in a recent opinion article in the Wall Street Journal, Spain’s Prime Minister José Luis Rodríguez Zapatero seems to be an admirer of Charles Dickens’s character Mr. Micawber. When asked what he plans to do about Spain’s 11.4% fiscal deficit, first he promises to extend the retirement age, only to later tell us the measure may not be necessary. Then he promises a public-sector wage freeze, only to have his Economy Minister, Elena Salgado, say he really doesn’t mean exactly what he seems to say. And in any event, we shouldn’t worry too much, since given that Spain is a serious country, somehow or other the fiscal deficit will be cut to 3% by 2013, even though most serious analysts consider the economic growth numbers on which the budget plans are based to have their origins more in the dreams of an Alice long lost in Wonderland than in any kind of sober analysis of real possibilities. "We do have a plan," deputy prime minister, Maria Teresa Fernandez de la Vega assures us, but to many that plan now seems to be little better than hoping, like the proverbial Mr. Micawber, that "something will turn up."

The latest to draw attention, to the problematic nature of this "wait and see" approach – and to the gaping hole which is now yawning in Spain’s national balance sheet – is the credit ratings agency Fitch, who only last week warned that many Western governments now face unsustainable debt dynamics following measures taken to address the financial crisis.

The agency singled out Britain, France and Spain as being in special and urgent need of outlining plans to strengthen their public finances if they don’t want to risk losing their current highly prized AAA ranking.

This strong and direct warning was issued by Brian Coulton, Head of Global Economics at Fitch, who said "High-grade sovereign governments need to articulate more credible and stronger fiscal consolidation plans during the course of 2010 to underpin confidence in the sustainability of public finances over the medium-term and their commitment to low and stable inflation. The UK, Spain and France in particular must outline more credible fiscal consolidation programmes over the coming year given the pace of fiscal deterioration and the budgetary challenges they face in stabilising public debt."

Yet, while criticising Portugal’s gradual approach to fiscal consolidation as a matter of "concern" Fitch senior director Paul Rawkins also argued that the Spanish government had acted swiftly in announcing plans to consolidate public finances. Nonetheless he did still warn that the economic risks facing Spain remain very high, especially since the pace of decline in tax revenues is dramatic enough to be preoccupying, while continuing “labour market inflexibilities could well prolong the economic adjustment”.

The current problem facing Spain (and other similarly affected countries) has its roots in two quite distinct sources. In the first place measures taken to counteract the impact of the financial crisis have been inadequate and have simply produced large short term deficits. However to this short term liquidity and adjustment problem must now be added the further dimension of longer term impacts on public finances which have their origins lie in ageing populations, and the effect on economic growth of having older and smaller working-age populations.

Regarding the first, as Willem Buiter, now chief economist at Citi has pointed out, more than 40 per cent of global GDP is currently being produced in countries (overwhelmingly advanced economies) running fiscal deficits of 10 per cent of GDP or more. Over most of the last 30 years, this level fluctuated in the 0-5 per cent range and was dominated by debt form emerging economies. So the crisis marks a watershed, from which there will likely be no turning back, and in many ways could not have come at a worse moment for those countries who still have to undertake substantial pension reform to put their nation finances on a solid footing when faced with the unprecedented ageing which lies ahead.

Indeed, to take the Greek case, while the short term fiscal deficit has been the focus of most of the press attention, the longer term problem associated with the funding of Greek pensions far outweighs issues associated with the falsifying of national accounts in the early years of this century. A recent report by the European Commission found that Greek spending on pensions and health care for its ageing population, if left unchecked, would soar from just over 20 percent of GDP today to around 37 percent of G.D.P. by 2060. And Greece is simply an early warning indicator of troubles to yet to come, in larger countries like Germany, France, Spain and Italy who have all relied for decades on pay as you go type state-financed pension schemes. Now, governments across Europe are being pressed to re-examine their commitments to providing generous pensions over extended retirements because fiscal issues associated with the downturn have suddenly pushed at least part of these previously hidden costs up to the surface.

In fact, unfunded pension liabilities far outweigh the high levels of official sovereign debt. According to research by Jagadeesh Gokhale, an economist at the Cato Institute in Washington, bringing Greece’s pension obligations onto its balance sheet would show that the government’s debt is in reality equal to something like 875 percent of its gross domestic product. That would be the highest debt level in the 16-nation euro zone, and far above Greece’s official debt level of 113 percent. Other countries have obscured their total obligations as well. In France, where the official debt level is 76 percent of economic output, total debt rises to 549 percent once all of its current pension promises are taken into account. Similarly, in Germany, the current debt level of 69 percent would soar to 418 percent. Of course, these numbers are arguable, and may well be in the excessively high range, but the fact still remains: outstanding and unfunded liabilities are huge, and would have been difficult to honour even without the present crisis. As it is, we are now in danger of spending the seedcorn which could have been harvested later on down the road.

Public opinion has yet to assimilate the seriousness of the issues involved here. As Pimco Chief Executive Mohamed El-Erian said in a recent FT Opinion article, the importance of the shock to public finances in advanced economies is not yet sufficiently appreciated and understood. With time, this issue will prove to be highly consequential. The latest Fitch report is simply another warning shot. The sooner we all recognise this, the greater the probability of our being able to stay ahead of the disruptions this adjustment to reality will cause. It is time to stop simply waiting around to see what is going to turn up, since if we do continue like this we won’t like what we eventually find.

Related posts:

• Pension disaster makes states and cities into financial basket cases
• Video: Fitch downgrades Greece to BBB+ as violence erupts
• New Citigroup maven Buiter warns of sovereign debt delusion
• Spain’s debt woes and Germany’s intransigence lead to double dip
• The roots of the European sovereign debt crisis go back thirty years

It’s curious how one and the same message is emanating from both Beijing and Berlin at the moment: “don’t blame us, it’s not our fault”. And it isn’t.

According to the Financial Times, the Chinese Authorities spent their morning pushing back against the mounting US criticism of their currency policy, arguing that their huge trade surplus is not the result of their undervalued exchange rate and warning the US not to “politicise” the issue.

“The trade imbalance is not something that the exchange rate can resolve and politicising exchange-rate issues is counterproductive to global efforts in tackling the financial crisis,” said Yao Jian, spokesman for the Chinese commerce ministry at a briefing.

The Chinese rebuttal came a day after the US Congress signed a letter calling on the Obama administration to label China as a currency manipulator, an indication of the rising pressure in the US to take a tougher line with China. “The impact of China’s currency manipulation on the US economy cannot be overstated. Maintaining its currency at a devalued exchange rate provides a subsidy to Chinese companies and unfairly disadvantages foreign competitors,” the letter said.

Curiously the Chinese statements come just a day after similar reactions have come from Germany following Christine Legarde’s attempts to mediate in the growing conflict between Europe’s centre and its periphery about how to restore growth to the Eurogroup. Responding to suggestions that Germany should do something to reduce its trade surplus, Werner Schnappauf, general-secretary of the BDI trade association, said Germany’s success at exporting was not the result of “some planned model”, but reflected “the competitiveness of German companies on global markets”.

As Eurointelligence point out, the German establishment feel threatened, and are closing ranks. This comment from Rainer Bruderle, the German economics minister, is very typical for the way Germans are reacting. According to Bruderle, the German surplus is not a problem for anybody, since it is simply a sign of success, and the foundation on which growth, employment and well-being are based.

In the words of Eurointelligence, “the whole interview shows that the minister, in line with every other German politician who is publically commenting on this issue, has no understanding of what imbalances in a monetary union imply. It also shows a misunderstanding since what Germans consider as their success is primarily the result of real revaluations elsewhere in the eurozone, which makes Germany’s good relatively cheaper. A first pre-requisite for the solution of any problem, let alone any problem as complex as imbalances, is the recognition that this is a problem in the first place.”

Of course, the fact that in the peripheral countries that very same “real revaluation” was primarily the result of having an interest rate policy over at the ECB more geared to the deflationary worries of a German society in the throes of a major restructuring than to the inflation needs of those who are now being criticised for having become totally uncompetitive (see chart below for the Spanish case).

Now it may seem platitudinous at the point, but I can’t help endorsing Gideon Rachman’s plea that what we all need to do here is calm down a bit. We are talking at each other, not talking to each other. Correcting the large current account surpluses in both the Chinese and the German case is not as easy as some would make it out to be, since in part the issue is one of demographic imbalances which may need decades to correct, and there is no point in putting people who are already in difficulty even more on the defensive. At the same time, simply to talk about fiscal irresponsibility on Europe’s periphery (which again is a gross oversimplification of the issues involved) is only going to raise the temperature without producing any useful result. If the people on the periphery feel under threat then this will make it harder, and not easier, to get those much needed changes.

My feeling is that we have really all congratulated ourselves here far too soon. The OECD economies, by and large, have been stabilised. There is no “V” shaped rebound. Prompt action by the central banks stopped a meltdown in the banking system, but they did this at the price of massively inflating sovereign debt. Now we need to find the road back to growth, and this is not going to be as easy as it first seemed. The old imbalances don’t work anymore, and we need to learn something from why they don’t. We also need to leave behind us stereotypical discourses which were always of doubtful validity, and now seem downright dangerous. People have talked for years about the dangers of a return to protectionism, what we are currently hearing isn’t quite that, but it is damn near to being the next best thing.

This post first appeared at A Fistful of Euros, where Edward Hugh also blogs.

Edward Hugh has a lively and enjoyable Facebook community where he publishes frequent breaking news, economics links and short updates. If you would like to receive these updates on a regular basis and join the debate please invite Edward as a friend by clicking this Facebook link.

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Lehman

• Lehman Whistle-Blower’s Fate: Fired – WSJ.com
• Blogs Beat the Press on the Lehman Brothers Scandal : CJR
• ABN Amro hielp Lehman bij manipulatie – Het Financieele Dagblad
• Dealbook Column – At Lehman, Watchdogs Saw It All – NYTimes.com
• Lehman’s Repo 105: More Than You Ever Wanted to Know – MarketBeat – WSJ

Financial News

• Mish’s Global Economic Trend Analysis: Misconceptions about Money and Velocity
• China’s currency: How is this supposed to work? | The Economist
• Our Next Economic Plague: Japan Disease – Andy Xie – English_Caixin
• Memo to Moody’s: It’s Accounting 101, Not Economics » Marshall Auerback
• Brazil to Break Patents on U.S. Films, Books, Drugs – Bloomberg.com
• Lawmakers press for action on China currency | Reuters
• Netanyahu defies U.S. over Jerusalem settlement
• More than 23,000 layoff notices issued to teachers statewide – San Jose Mercury News
• Final destination Iran? – Herald Scotland | News | World News
• Driving retirement for seniors – Science News
• Confidence is key to gauging impressions we make – Science News
• Payback Time – Avalanche of Maturing Junk Bonds Looms for Markets – NYTimes.com
• Senator Graham’s Inexplicable National ID Support | Cato @ Liberty
• China’s currency: The return of the "get tough" approach to China | The Economist
• Only seven percent of Americans would pay for online news

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• Links: 2010-03-17 – China, Lehman and more
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John Hussman notes that the very large non-subprime Alt-A and Option ARM cohort interest-rate resets lie ahead of us and not behind us in his latest weekly market commentary. In my view, this is a very big problem for the US banking sector and economy because of the credit writedowns these resets will generate.

For his part, Hussman says:

I should note parenthetically that as you read reports about the mortgage and credit markets during the next few months, it will be extremely important to pay attention to the time period being discussed. For example, we are seeing articles with very recent datelines that are drawing conclusions based on relatively pleasant data from the fourth quarter of last year, which reflects the end of the reset lull that was completed with the low in September.

To reiterate what the reset curve looks like here, the 2010 peak doesn’t really get going until July-Sep (with delinquencies likely to peak about 3 months later, and foreclosures about 3 months after that). A larger peak will occur the second half of 2011. I remain concerned that we could quickly accumulate hundreds of billions of dollars of loan resets in the coming months, and in that case, would expect to see about 40% of those go delinquent based on the sub-prime curve and the delinquency rate on earlier Alt-A loans. Notably, by 2005, the credit score allowed on Alt-A loans fell to about 620, which is consistent with sub-prime. And not surprisingly, the later in the housing bubble the loan was made, the higher the delinquency rate has been right out of the gate.

The earliest data we will observe in terms of Alt-A and Option-ARM loans will be driven by the relatively small initial round of resets that began in November of last year. That implies that any data prior to February is relatively clean of these effects. What we are interested in is the extent to which we observe a spike in 30-day delinquencies in data beginning about the February-March time frame. The size of the delinquency effects is likely to increase through the year, back off in the first half of 2011, and then reach their final peak in late 2011.

Emphatically, we do not need to work through the whole reset cycle in order to accept market risk. But significant damage in the stock market is often taken in the "recognition phase" where troubling reality departs from optimistic expectations. On that front, I am doubly concerned here because on the basis of an ensemble of fundamental measures (normalized earnings, revenues, book values, dividends), the only points between the pre-Depression period and the late-1990’s when the market has been so richly valued were November-December 1972 (before a 2-year market loss of about 50%), and August-September 1987. The hostile yield trends I noted last week (The Rubber Hits the Road) only amplify that concern.

This is something I am on to and have mentioned a few times in the past few months. As I wrote last month in The coming wave of second mortgage writedowns:

When the crisis first developed, in February of 2007, it was subprime where the worries were, with the lion’s share of writedowns coming from mark-to-market losses in the securitisation market.  However, subprime was a relatively small part of the overall market, making up 14% of loans outstanding at that time. Alt-A loans were 27% and prime loans were 57% respectively of loans outstanding according to a Banc of America Securities report.

As the 2004-2007 cohorts of Alt-A option ARM mortgages have started to reset and prime borrowers have come under stress, we have started to see defaults in markets which are an order of magnitude larger than subprime.

The same dynamics will be at play here that were at play during the meltdown in subprime, except this time we are talking mainly about prime borrowers. Remember, this is and has always been a credit crisis, not a subprime mortgage crisis. It is the result of lax regulation, easy money and lending recklessness on a mammoth scale that goes far beyond subprime. Hussman makes the same point when he quips:

it should be evident that the recent credit crisis did not emerge as some unpredictable surprise, but was instead the very ordinary outcome of extraordinary recklessness. Though the mounting problems in 2005 were utterly ignored by the stock market for more than two years after this analysis was published, the fact is that even with the recent rebound, the S&P 500 remains below where it was in mid-2005. Overvaluation and reckless lending do not always translate into near-term market weakness, but they invariably haunt investors in the form of poor long-term returns.

The interesting bit for me is he leads into this via a quote from a five-year old piece from the Economist which way back in 2005 predicted calamity for the global housing bubble that had already formed. This is the very same article I referenced in June 2008 when I wrote Naysayers, the housing bubble was obvious as the housing bubble was beginning to unravel in the U.S.

The Economist said presciently:

Interest-only mortgages are all the rage, along with so-called ‘negative-amortisation loans’ (the buyer pays less than the interest due and the unpaid principal and interest is added on to the loan). After an initial period, payments surge as principal repayment kicks in. In California, over 60% of all new mortgages this year are interest-only or negative-amortisation, up from 8% in 2002. The national figure is one-third. The new loans are essentially a gamble that prices will continue to rise rapidly, allowing the borrower to sell the home at a profit or refinance before any principal has to be repaid.

And when prices stopped rising, homeowners defaulted on a massive scale. The carnage spread in the financial sector most quickly via huge losses in marked-to-market mortgage backed-securities (MBS) and collateralised debt obligations (CDOs). However, when the mark-to-market rules allowed for greater ‘discretion’ in designating these derivatives as hold-to-maturity assets, financial institutions got a free pass and are now hiding hundreds of billions in writedowns this way. This was a huge boon for financial shares, which have increased markedly ever since. See Wells profit forecast is a clear bullish sign.

The difference going forward has to do with strategic defaults. When a delinquent mortgagee runs into problems, a bank servicer has a lot of discretion in the way it can deal with this situation. Inevitably, this leads mortgage lenders to extending and pretending the delinquency is temporary. However there is a growing divide between delinquencies and foreclosures, which suggests that foreclosure data understate the mortgage distress and delinquencies now building in the U.S. residential housing market.

When Option-ARM and Alt-A interest rates re-set higher, payments will increase dramatically for many borrowers who are hopelessly underwater on their mortgages. This will be a significant driver of defaults in 2010 and 2011.

Moreover, a recent article in the New York Times demonstrates that borrowers with high FICO scores are still at risk of default, opting to pay credit cards off instead of mortgages.

This is all pointing to a coming wave of strategic defaults. Borrowers whose homes are significantly underwater could be looking at losses at sale for up to 6 years. Therefore, many are opting to default strategically. When a borrower defaults and walks away, the loss becomes unrecoverable and the value of the asset must be written down. So while holding MBS paper to maturity has  cushioned banks to date, a large wave of strategic defaults would pressure lenders who are under-provisioning for future losses.

Expect this to play out over 2010 and 2011.

Sources

Ordinary Outcomes of Extraordinary Recklessness – John Hussman

In come the waves ($) – Economist, 16 Jun 2005

Related posts:

• Prime Foreclosures greater than subprime
• Prime looks terrible
• Alt-A: defaults lie ahead of us, not behind us
• New Writedown Risk: Alt-A
• Extend and pretend and the growing divide between delinquencies and foreclosures

Popular myth and, allegedly, the laws of aerodynamics have it that the bumblebee should not be able to take flight. Yet still, our good bumblebee refuses to be pulled down by such details and year after year it takes flight as if nothing has happened. This allegory applies, with some imagination, to Japans economy too. Year after year it consequently appears able to simply ramp up domestic debt to cover the shortfall of domestic demand at the same time as low investment demand, a savvy export sector, and a strong net foreign asset position mean that Japan does not have to rely on foreign investors to finance government debt outlays. Together with a central bank stuck in perpetual QE mode due to persistent deflation this has so far constituted the core of Japan’s bumblebee moment.

Recent comments and analysis however suggest that while the bumblebee should certainly continue to enjoy the ability to defy gravity, Japan’s time just may be up. In particular two pieces of research authored by Societe Generale’s Dylan Grice (see here and here) as well as a recent piece by Kenneth Rogoff have added to the concerns that Japan may be headed for a Greek party of their own. In reality of course, the sudden focus on Japan is a direct function of the change in market discourse since end 2009 and the focus on government debt sustainability and how to rein in fiscal policy (if at all). Thus it is only logical to expect the great eye of the market to also turn to the biggest sovereign debtor in the world which just happens to be the oldest (demographically speaking) too.

In order not get confused here is Grice himself;

To recap, the thesis I outlined back in January 1 was that since Japanese households – the biggest effective drivers of JGB demand – are set to dis-save in coming years as they retire (left-hand chart below) there will soon be no one left to finance the government’s nosebleed deficits at current yields. Indeed, the chart below suggests households are already running down assets. And because the interest rates which might attract international investors will inevitably blow up the budget (debt service is already 35% of government revenues at existing yields) there is a very clear and present danger that the government reverts to the well- established historical precedent for cash-strapped governments of currency debasement.

As you can see, the issues here are complex but intellectually they are hugely important since what happens in Japan may tell us a lot about what will happen in other ageing economies such as, most notably, Germany but essentially a whole host of OECD economies (and China) who are set to move in the same direction as Japan. In this sense, I should immediately admit that on an intellectual level I agree with almost everything Grice says and especially his focus on Japan and the nature and extent of dis-saving.

But, and in order not to make this into a fan letter, I am going to quibble a little bit with Grice in what follows.

Firstly, and on a very specific point, the chart (in Grice’ last note) which shows how Japanese households are actually running down their assets does not fit with the picture I get from my data (BOJ).

Now, I certainly don’t want to start the chart wars II here and obviously, there are many ways to define the stock of savings which might prove me as wrong as Grice is right (and vice versa). What is certain is that the incremental flow from household saving (if any) will not be enough to offset the incremental flow of bonds issued by the ministry of finance. This leaves the crucial role of corporate savings which is quite high in Japan and which also seems to be responsible for the Japan’s external surplus (on the trade balance at least).

Yet, in order not depart down the path of reinventing the wheel I will immediately refer to my most recent notes on Japan and this in particular in which I butt heads with the FT’s Martin Wolf on exactly the issue of (dis)saving in Japan and the distinction between corporate and private savings. Essentially then, this is a question of perspective and timing since I agree with all parties involved here on, at least, two accounts. Firstly, Japan government finances in an extraordinarily bad shape and the future ability of Japan to ever hone up to its liabilities is very, very slim. Secondly, dis-saving is very likely to become a binding constraint in Japan at some point which would epitomized by how Japan would need to borrow from foreigners in order to finance an external deficit. In this case, and I agree with Grice here, it is game over.

But how we get from here to there may be just as important as what happens when we get there. In fact, yours truly have just defended his master’s thesis on exactly this topic and the overall conclusion, which fits quite well in the present discussion, is as follows;

Ageing societies are not, in the main characterised by aggregate dissaving but rather by the fight against it.

While my thesis councillor did indeed like the entire ouevre he was none to happy about this one. And can can you blame him? Isn’t it almost tautology? As I did on my day of graduation I will stand my ground and argue that it isn’t.

The crucial issue in my opinion is the change in perspective from waiting for the inevitable pop in Japan, Germany etc to a look at the main characteristics of an ageing economy such as Japan, Germany [1] and soon others. In a nutshell, these sum up to a deeply export dependent economy which exactly manages to keep the boat afloat because of higher domestic savings than merited by domestic investment demand and thus an external surplus. Naturally, and as a very important aside, Japan also has its own central bank who has been in QE for the better part of two decades and thus serves to allow government debt to grow without Japan needing foreign money.

This perspective provides us with two very important pieces of insight I think. One is that a rapidly ageing economy will not be able to revert to a growth path characterised by external borrowing and thus a net contribution to the unwinding of global imbalances. The second is that the global process of ageing becomes an externality to the whole global macroeconomic system because it puts more and more economies in a situation where they need to maintain external surpluses in order to prevent the forces of dis-saving or, more accurately, the slump in internal demand as ageing pushes up the dependency ratio.

Now, think about the discourse we are having exactly at this point in time. It is a perfect mirror on the two points above with the added spice, in the context of the Eurozone, of how economies embarking on internal devaluation are also forced to find growth based on external demand because whatever growth they were able to generate from domestic activities in the first place are now being effectively choked off.

Moving back into the real world, Grice believes that Japan’s time may just be up and he specifically points to the fact that Japan needs to roll over 213 trillion while at the same time, the biggest holder of Japanese government bonds has openly announced that it has no inflows with which to suck up extra JGB supply.

I honestly don’t know whether he is right. He may be and if so, Japan will stand as a poster example of just how an ageing economy can take it before it folds in on itself in the sense of trying to maintain a modern market economy that is. However, I am inclined to call him on his bet and in this sense I am much closer to Buttonwood’s take on the situation;

(…) the huge amount of Japanese debt rolling over this year need not be a problem. Investors will simply recycle their existing holdings. Takahira Ogawa, a sovereign analyst at Standard & Poor’s, thinks there is more scope for the Bank of Japan to buy government debt, as central banks have done elsewhere.

Of course, such measures just postpone the evil day. The crisis will surely arise when Japan becomes dependent on foreigners for finance, or if a sharp rise in inflation or a sudden slump in the currency causes domestic private investors to take fright. But since the country is still running a current-account surplus, the yen is trading at 90 to the dollar (compared with 124 in June 2007) and deflation is forecast for the rest of the year, the apocalypse seems unlikely to occur in 2010.

Thus I would point to the continuing surplus in the corporate sector, the fact that households are not yet drawing down their deposit base, and most importantly; the fact that the BOJ has every right and reason to continue keeping the QE taps open as long as deflation is running at +2% on an annual basis. In fact, here is one of the other feedback loops from ageing right here; namely that as domestic demand simply spirals downwards, the economy gets caught in a deflationary trap (the liquidity trap in monetary policy circles) which only serves to push up domestic government debt thus forcing the central bank’s hand on QE and making it even a larger imperative to maintain an external surplus.

However, before I myself try to emulate the bumblebee by defying gravity with another complex argument, I think I will hold off with this one for another day.

—

[1] – See this excellent piece by Edward which exactly touches on a similar issue in the context of Germany.

————–

This was a post by Claus Vistesen, who also blogs at his own site Alpha.Sources.

Related posts:

• Japan does not demonstrate the failure of stimulus
• Revisiting the sectoral balances model in Japan
• The new Japan, domestic consumption, and the neo-liberal thought machine
• Japan’s growth embarrassingly revised down by 3.5%
• We need humility

Gallup shows President Obama’s approval rating tied for a low of 48% in the most recent polling.  But if you look at the data split by party, it’s like we’re living in three separate worlds.

Obama’s personal numbers have fallen mostly amongst Republicans – directly contradicting some of the recent evidence we saw last week on economic satisfaction.

But, leaving aside why the numbers are falling, what should be striking is how wide the gulf is between the three partisan groups in how they view our President. 83% of democrats approve of Obama’s job versus only 12% of Republicans who do. It doesn’t get much wider than that. When it comes to Obama, Republicans and Democrats are living in two wholly separate worlds.

Source

Obama Weekly Job Approval Average at 48%, Tied for Lowest – Gallup

Related posts:

• 2010 elections: “Completely out of control” for Democrats
• Patrick Buchanan throws in the towel
• The Democratic Party meltdown of 2010
• President Obama, are you listening?
• Arlen Specter to switch parties

I was talking to a friend of mine who does emerging market investing for a living and I asked him what he made of recent China-bullish comments by Stephen Roach. 

The Morgan Stanley Asia head was in Germany speaking to German business daily Handelsblatt last week. The guys from Handelsblatt wrote up a piece called “In China bildet sich keine Blase an den Märkten” which translates “China is not creating a market bubble.” Unfortunately, the story is behind a pay wall (and it’s in German anyway). But Gwen Robinson of the FT got the inside scoop and posted “Roach: Pooh-pooh to Chinese bubbles” at FT Alphaville. She writes:

As Roach notes, the Shanghai A-share composite index soared 3.5 times in the year ending October 2007 before plunging more than 70 per cent in the ensuing 12 months.

And every China watcher knows about the surge in nonperforming bank loans that required a major recapitalization of a nascent Chinese banking system less than 10 years ago.

But these problems were mere bumps in the road, in retrospect. Roach explains (our emphasis):

That’s because Beijing was vigilant in preventing asset and credit bubbles from spilling over into the real side of the Chinese economy. This was very different from the Japan endgame of the late 1980s, where the confluence of equity and property bubbles led to a massive overhang of excess capacity.

What’s more, he adds, it stands in sharp contrast to the more recent US experience, where property and credit bubbles pushed up homebuilding and personal consumption to nearly 80 per cent of US GDP prior to the bursting of the subprime bubble.

Of course, China is “hardly the poster child of macro stability” – with exports and fixed investment surging to nearly 75 per cent of Chinese GDP and private consumption at 35 per cent and still falling, China’s macro imbalances are in a league of their own.

But in Roach’s view, these distortions are less of an outgrowth of asset and credit bubbles and more a by-product of a conscious strategy of externally-oriented economic development.

While China can hardly avoid bubbles, he notes, it has been successful in preventing them from destabilising the real economy.

Because of the spate of China currency manipulation/protectionism stories hitting the wires (see my links post), I had been thinking about 1931 a lot recently – more on that later. But when I asked my friend what he thought of Roach’s comments, he said: “I think China is indeed Japan in 89/90, but potentially magnified.”

Let me explain. Contrary to current folklore, the reign of Paul Volcker was not one of extreme inflation hawkishness and anti-bubble moral suasion. In fact, there were serious animal spirits building in the U.S. in part due to a September 1985 Plaza Accord, in which the major countries all agreed to depreciate the US dollar. The exchange rate plunged a fantastic 51% before the carnage was done. And as anyone will tell you, currency depreciation is inflationary – either for consumer prices or asset prices or both.

By February 1987, the U.S. Government was alarmed at the speed of the U.S. dollar’s depreciation and looked to reverse it at the Louvre Accord. The problem, however, was that the U.S. wanted Japan to continue a stimulative monetary policy. Here’s what the accord actually said:

The Government of Japan will follow monetary and fiscal policies which will help to expand domestic demand and thereby contribute to reducing the external surplus. The comprehensive tax reform, now before the Diet, will give additional stimulus to the vitality of the Japanese economy. Every effort will be made to get the 1987 budget approved by the Diet so that its early implementation be ensured. A comprehensive economic program will be prepared after the approval of the 1987 budget by the Diet, so as to stimulate domestic demand, with the prevailing economic situation duly taken into account. The Bank of Japan announced that it will reduce its discount rate by one half percent on February 23.

The Plaza Accord may have helped correct imbalances, but it also put the Japanese economy into a blow off bubble top that sent the Nikkei into the stratosphere above 38,000. The result was a spectacular bust from which Japan has still not recovered.

So, now that we see the Chinese, with their $600 billion stimulus package and massive increase in credit, causing serious malinvestment, one wonders whether we are seeing a repeat of the 1989/90 excess in Japan.

I have repeatedly pointed to enormous levels of malinvestment in China. Here are a few posts of that ilk.

• Hugh Hendry: China – The Emperor has no clothes Jul 2009
• China’s empty city: the emperor really has no clothes Nov 2009
• The Chinese bubble economy Jan 2010
• Construction in China’s Ghost Towns Jan 2010
• Jim Chanos still bearish on China, talks malinvestment Feb 2010

Yet, we see Stephen Roach’s cogent defence of what is going on in China. He is not known as a perma-bull – - quite the contrary.

So what gives? Is China experiencing a massive bubble or not? If so, will the bubble’s inevitable pop spill over into the real economy in a nasty way as it has done in the U.S. and elsewhere?

These are important questions given the central role China plays in the world economy. My own point of reference has been the 1920s and the 1930s more than the 1980s and 1990s. In the 1920s, Great Britain played the role now played by the United States: military power, declining economic power, anchor global currency, and largest debtor nation. The United States played the role now played by China: rising economic and military power and alpha creditor.

So, the section in Charles Kindelberger’s seminal book, “The World in Depression 1929-1939 on French accumulation of sterling bears noting. Sterling was weak and the French had been accumulating huge amounts of British pound foreign reserves in 1926. This created a problem for the British because the French could threaten to redeem those pounds for gold under the gold standard then in operation. Kindelberger says:

this accumulation put [French central banker] Moreau in a strong position and [British central banker] Norman in a weak one. As an opening gambit, the bank of France began to convert sterling into gold…

There were threats of further conversions of sterling into gold.

Eventually, the French and British reached a compromise which involved the Federal Reserve Bank of New York lowering interest rates to help the British (and the Germans who had just had their travails with hyperinflation).  The result of this easy money was a blow-off top to the U.S. stock market and credit bubble that had almost collapsed after the Florida real estate boom went off the rails.

Clearly, the U.S. role of easy money global saviour in the late 1920’s was played by Japan in the late 1980’s and by China in the late 2000’s. Each time, the speculative mania the easy money fuelled ended in disaster. 

Eventually, the whole system broke down in the 1930s, with the U.S. playing the protectionist card and precipitating collapse.

I have trouble believing this time is any different. If any of you have a different take on these events, I’m all ears?

Sources

Statement of the G6 Finance Ministers and Central Bank Governors (Louvre Accord) – University of Toronto G8 Information Centre

Charles Kindelberger – The World in Depression

Related posts:

• China is now on the same bubble path as Japan post-1987 crash
• Chinese officials warn banks about reckless lending
• More from Chanos on the Chinese property bubble
• The Chinese bubble economy
• Stephen Roach is talking double dip again

The US Financial Conditions Index (BFCIUS) is a composite measure of the condition of U.S. financial markets, using yield spreads, indices from bond, equity and money markets. Right now, it is at a 32-month high.

But, while this is supposed to measure market strength, it really seems to measure market bullishness. I see the US Financial Conditions Index (BFCIUS) as somewhat of a contrarian indicator.  As you can see from the chart above, the index tanked in September 2008 when Lehman Brothers went bankrupt. But immediately, it resumed an upward path due to the huge numbers of government backstops and liquidity measures, plateauing in March 2009 right when equities bottomed.

From April 2009 onward it was off to the races.

Source

US Financial Conditions Index – Bloomberg.com

Related posts:

• Irish equities suffer largest losses in 215 years
• Market risk is high
• High yield is back in business in Europe
• China sovereign wealth fund diversifies into a massive loss
• Bill Gross: Fed on hold through 2010

China

Distraction of the Day: March Madness 1973 Edition

Related posts:

• China slams U.S. profligacy
• Australian Professor in Japan makes case for protectionism against China
• Protectionism: China and chickens versus Canada and Buy American
• Links: 2010-03-09 – AIB’s loan book and China, Japan and the U.S.
• Links: 2010-03-17 – China, Lehman and more

Well, I for one can’t help thinking that it’s now well time we all stopped getting carried away with the use of so many acronyms. Not only may one man’s meat easily prove to be another’s poison, it may even be that for some the entire meal will be so distasteful as to prove totally indigestible. And so it is with the latest set of proposals to appear on the table hastily erected to find the “cure all” for the eurozone’s many ills.

Daniel Gros, in a well meaning, but I feel fatally flawed, move to get us all away from talking about some of the members of our own community as PIGS, has decided to tell us, that they are not pigs at all, they are merely GIPSYs. Of course, depending on which way you look at it, such forms of reference could be taken as a compliment (”you sure do eat like a pig”), or not, but with due regard with the kind of controversy which has been provoked by the arrival of large numbers of Roma in Italy, perhaps it may not be the best move to get debate going to start by telling the countries which lie of Europe’s periphery that the best way to conceptualise them is as a bunch of “gitanos”. Nor is it the nest way to tell the members of core Europe that they way things stand they are essentially F-UK-DE. But there it is. That’s just how things are these days.

Now, to take us back a bit nearer to reality, in fact Daniel, in his ill-named Working Paper “Adjustment Difficulties in the GIPSY Club“, actually does get to the heart of some very important matters, and really I thoroughly recommend everyone to read it from start to finish. The core of Daniel’s argument is, I feel, the extraordinarily obvious point that the kind of fiscal adjustment being proposed for some of the peripheral countries is going to have one, and only one immediate consequence: these countries are going to be sent off to the outer darkness of very, very (see his numbers) sharp GDP contractions, and these contractions run the risk of precipitating pre-Argentina 2000 type situations in the countries involved, whereby the contractions in nominal GDP are so large that they effectively take away with the one hand what was given (in the form of sacrifice) with the other, and lead to a seemingly endless spiral of increases in the debt to GDP ratios, which lead to ever deeper short term fiscal cuts, and ever stronger contractions, etc, etc.

As Daniel argues, the only way to restore competitiveness, and avoid the dreaded Argentine spiral is to carry out some form of internal devaluation:

“What can Greece do to escape the ‘Argentine’ vicious circle of higher risk premia and a worsening economic outlook? The only way to minimise the cost of the external and fiscal adjustments that are required to… make the situation sustainable is to make Greece more competitive and thus stimulate exports.”

“This can be achieved only by an across-the-board reduction of wages (or rather labour costs) in the private sector of between 10 and 20%. Cuts in wages of this order of magnitude will encounter fierce popular resistance. They could come about either at the end of an extremely painful process when unemployment has reached peaks never seen before or they could come much earlier as the result of an overarching national agreement in which the government, opposition parties and the social partners agree on what is needed in the light of present circumstances. Greece thus needs a concerted effort at the national level not just a government that pushes austerity measures through Parliament.”

So Why Are The Other F-UK-De?

The problem is, conceptualising this situation as one group of fiscally derelict countries having to be controlled by another group of upright and competitive ones does not give us a complete picture of the mess we are all in, as Gideon Rachman eloquently argues in his Dr Schäuble’s Torture Chamber post:

Behind the careful bureaucratic language, Schauble makes some amazing claims and proposals. Here are just a few.

“All eurozone members must return to adherence to the stability and growth pact as rapidly as possible.” This is just hypocrisy. I was living in Brussels when the pact was gutted the first time – because Germany and France were unable to keep within the 3% deficit limit.

Schauble also seems keen to resurrect the main feature that made the stability and growth pact lack credibility in the first place: the notion that countries that are running out of money need to be shocked back onto the path of virtue and prudence by being fined – a move that would obviously worsen their financial plight.

Basically, as Rachman argues, we all need to calm down a bit here, and get things rather more in perspective. In the first place the Eurozone’s economies – as I keep arguing day in and day out – are all roped together via the system of current account deficits and surpluses.

This is a point France’s finance minister Christine Lagarde draws attention to in an interview in this morning’s Financial Times. As M. Lagarde says:

“[Could] those with surpluses do a little something? It takes two to tango,” she said in an interview with the Financial Times. “It cannot just be about enforcing deficit principles.”

“Clearly Germany has done an awfully good job in the last 10 years or so, improving competitiveness, putting very high pressure on its labour costs. When you look at unit labour costs to Germany, they have done a tremendous job in that respect. I’m not sure it is a sustainable model for the long term and for the whole of the group. Clearly we need better convergence.”

Well, let’s leave aside today the issue of whether or not convergence is a realistic (or even a possible) objective for Europe’s economies given the large demographic mismatches between countries, but still, Lagarde is on to something. What we don’t have is a situation where on the one hand we have everything for the best in the best of all possible worlds, while on the other we have a group of slouchers and forgers. This kind of thing makes for nice headlines, but it is far from corresponding to reality.

Another reason the F-UK-De group are in trouble if the GIPSYs wander off to the outer darkness, is that they will have issues to resolve in their banking systems, as the chart below reveals. German banks may have little exposure to Greek debt, but their exposure to Spain and Ireland is enormous.

In fact, the massive exposure of German and French banks to Portugal, Ireland, Greece and Spain offers part of the explanation as to why Europe’s biggest economies have been steadily moving to rescue their southern neighbors in recent days, according to a recent report from Societe General entitled “Shotgun Greek Wedding.” According to the report banks in Germany and France alone have a combined exposure of $119 billion to Greece and $909 billion to the four countries, according to data from the Bank for International Settlements. Overall, European banks have $253 billion in Greece and $2.1 trillion in the four countries collectively referred to as the “PIGS”.

“The exposure is enormous,” said Klaus Baader, co-chief European economist at Societe Generale in London. “The crisis in Greece isn’t Greece’s problem alone but a concrete problem for Europe’s whole banking sector. That explains the interest of finance ministers in stabilizing the situation.”

Defining Moment?

Gideon Rachman admitted that this one felt like a significant moment to him, and I am inclined to agree. We have two proposals on the table, and neither of them will work. In the first place simply treating the problem on Europe’s periphery as an essentially fiscal one will not return these countries to competitiveness, and will simply precipitate GDP contractions, and deflationary spirals, that will lead inexorably towards failure, default, and possibly exit from the Eurozone (which, in fact, Herr Schäuble seems to feel would be an acceptable outcome to all this).

On the other hand, A Germany (or a Japan) which is not able to maintain a substantial external surplus (which is the only way a country with their kind of demographic profile can attain headline GDP growth, since internal demand is long gone as a “driver”) since without a surplus and without GDP growth the implicit liabilities of ageing populations (via health and pension commitments) will become unpayable, leading to default (or a huge slashing of public welfare commitments) in these countries too.

Wolfgang Munchau also seems to think it is decision time. As he argues in his Op-Ed in today’s FT, “Shrink the eurozone, or create a fiscal union“. I know which side I am on. As Joaquín Almunia once argued, people would need to be crazy to leave the Eurozone. So let’s get on with it, and go climb that hill which lies out there in front of us.

Edward Hugh also blogs at A Fistful of Euros.

Related posts:

• Plans for European Monetary Fund well advanced
• Portugal Update
• The Germans guarantee all savings deposits
• Fiscal Follies
• Greek bailout news

Michael Lewis is out with a new book “The Big Short: Inside the Doomsday Machine” which discusses how the big hitters on Wall Street destroyed $1.75 trillion of capital. His phrase ‘Doomsday Machine’ is reminiscent of former IMF chief economist Simon Johnson’s ‘Doom Loop’ phraseology which I reviewed two weeks ago.

Below, Lewis discusses his take on events with 60 Minutes. He focuses a lot less on criminality and looting and a lot more on a mass delusion caused by skewed short-term incentives.

Update: Lewis is also on Bloomberg talking about the same issues. Here he adds in a different spin on Greece and the currency default swaps debacle. Video below.

Related posts:

• Ken Lewis defends Bank of America’s stress test results
• Doubling down at AIG
• WSJ Video: The End of Wall Street – Part Two
• Bloomberg is coming down hard on Goldman
• 60 Minutes – Pigeon Fever and Ponzi Schemes on Wall Street

Highlights

The US dollar is firmer against most currencies. The euro failed to extend Friday’s break up out of the $1.3436-$1.3788 range in which it has been trading since Mar 17th while against the Swiss franc, the euro is trading at its lowest level in 17 months.  The single currency is consolidating above $1.3685 support area vs. the dollar ahead of the Greek progress report (due at the EU Finance Ministers meeting that began today) and tomorrow’s FOMC meeting.  Poor results from Sarkozy’s UMP at this weekend’s regional elections had little impact.  Cable is the worst performing currency amidst a slew of poor news –Moody’s warned that the UK and the US have moved substantially closer to losing their AAA credit ratings over the past few years as the cost of servicing debt continues to rise, a weekend YouGov poll highlighted the risk of a hung parliament with the Tories lead over Labour at just 4bp, the BoE’s Barker warned of another quarter of negative growth and there is talk of M&A related selling. The yen is relatively steady after the Japan upgraded its assessment of the economy was expected.  The focus is on the BoJ where there is speculation MoF pressure to address deflation could see an extension of Q/E at the Wed meeting. 

Global equity markets are generally softer in Asia and Europe with early indications suggesting US markets will open lower.  In Asia, concerns about Chinese tightening weighed on equities after China’s Premier Wen refuted claims that the yuan is undervalued.  The one-year yuan NDF had continued to rise in recent days as US and other officials put pressure on the country helping to boost speculation of a revalution.  Today’s comments saw NDFs come in with the market now pricing in a 2.65% revaluation in the next 12-months, down from 2.97% Friday.  While the PBOC Gov downplayed the risk of an imminent rate hike after last week’s stronger than expected Feb CPI, Wen’s comments boosted talk China could hike instead of allowing the currency to appreciate.  The MSCI Asia-Pacific index closed down -0.5% while China’s Shanghai Composite closed down -1.2%.  Japan’s Nikkei was flat on the day.  In Europe, bourses are down 0.2% to 0.8%. 

Global sovereign bonds are firmer.  In Europe German 10-year bonds are off three-week lows with the yield down 1 bp as the EU Finance Minister talks get underway with Greece expected to meet its initial targets.  Greek yields are lower with the 2- and 10-year down 12 bp and 3 bp respectively.  S&P warned the markets they had exaggerated the risk of a Greek default given the country’s fundamentals and noting the country is still rated investment grade. 

Currency Markets

The FOMC meets this week.  While slower perhaps than desirable, the Fed officials should be generally pleased with the trajectory of developments since they met last in late January.  On the real economy side, Q4 09 turned out to be quite strong at 5.9% and Q1 10 appears to be tracking something closer to 3%.  Of course, Q4 was flattered by a large shift in the inventory component which no one expects to be sustained.  Consumption and hourly earnings are rising.  The Fed has cited three metrics they are watching to help determine the appropriateness of current rates:  resource utilization, inflation expectations and inflation.  In terms of resource utilization, the unemployment rate appears to have steadied for the moment, but it will likely be too early for officials to have much confidence.   On the industrial side, plenty of capacity still exists and manufacturing employment rose in both Jan and Feb.  The poor weather may have seen the trend improvement in utilization rates stall (to be reported today March 15), but should be expected to resume as the winter thaws.  There are various measures of inflation expectations Fed policy makers will access, but for a general view we would note that the yield curve (2-10 yr) has flattened over the past month and the 5-yr/5-yr forward fell from 2.75% around the time of the last FOMC meeting to 2.36% before recovering to trade around 2.55%, the middle of the lower range seen since.  Inflation itself has been largely steady.  The core rate of CPI was negative in January for the first time in more than a quarter of a century.  The key drag here appears to be coming from the owner equivalent rents.  Rather than a reflection of the general price level, the pressure on the core rate is a function of the housing market.  Since the Fed met last, the data from the housing market appears weak, even if some allowance is made for the weather.  The Fed could mention this in its statement.  Also the last FOMC statement expressed concern about the decline in bank credit for the first time.  It appears that bank credit has continued to contract and the statement will likely reflect this.  While consumer credit did increase in January for the first time in a year, the increase was a reflection of the Federal government’s student loan program.  There is some speculation that Fed officials are looking for some way to change the language to help modify expectations about its extraordinary policy stance.  The key phrase that many are focusing on is "extended period".  Previously–Dec 08-Jan 09–the Fed used the phrase "for some time."   While it is possible, and we suspect it is coming, this week’s meeting may be too soon.  At this juncture, nothing is lost by waiting another month.  More Fed-speak–verbally preparing the market may be deemed necessary.  There are a number of Fed officials who are scheduled to speak in the second half of the week.  

In Greece this week as the government is due to present a progress report on the deficit -cutting plan at the EU finance ministers meeting, starting in Brussels today. There is fresh speculation that a Eur25bn package to help Greece may be introduced, but we remain of the view that as market jitters have eased (see narrowing in spreads) and as the Greek refinancing schedules have gone quite well so far, euro members may not need to go for the package solution. Germany comes across strongly against this idea, still.  In Japan, the government upgraded its assessment of the economy for the first time since last July, noting that ‘The economy has been picking up steadily’, but also acknowledging that the rebound has been weak. However, MoF officials have been stressing the importance of fighting deflationary forces over the past few weeks, raising speculation that the BoJ could decide to introduce fresh QE measures (via more JGBs purchases) at this week’s meeting.

Upcoming Economic Releases

The Fed’s March Empire survey is due at 8:30AM EDT/13:30 GMT.  The consensus expects 22.0, down slightly from Feb when the highest reading since Oct07 was recorded at 24.9.  At the same time, Canadian new vehicle sales are exp flat in Jan.  US Treasury International Capital (TIC) flow data for Jan are due at 9AM/14:00 and the consensus expects net long-term TIC inflows of $47.5 bln, down from $63.3 bln in Dec.  At 9:15AM/14:15 Feb industrial production is exp flat (vs. 0.9% in Jan) with vehicle production limiting gains.  Capacity utilization is exp at 72.5% vs. 72.6% in Jan.  There are no scheduled Fed speakers ahead of tomorrow’s FOMC decision.  Mexico is closed today.

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Marc Chandler is the global head of Brown Brother Harriman’s top ranked Currency Strategy Team. For more of BBH’s currency views, please visit the BBH FX website here.

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The video below from the Wall Street Journal gets at the heart of why the bailouts have been so toxic for the economy. Banks, still laden with existing bad loans to small businesses, are unwilling to make new ones. Businesses, unable to receive credit, cannot expand or must downsize. This in turn puts a squeeze on consumers who underpin 70% of economic output.

If the bad loans were written down right now and the debts recognized, even more banks would be declared insolvent, further weakening credit conditions. However, a Swedish-style solution could avoid this outcome.

This sobering portrait comes from Michigan, one of the hardest hit areas of the American economy. Listen to stories by real business managers and bankers there.

The Wall Street Journal has an accompanying front page story on the Michigan video called “Loan Squeeze Thwarts Small-Business Revival.”

Also see "Bank failures in Georgia crushing small business and home owners," which is a more mortgage-related take on the same theme in Georgia, the state in the U.S. with the highest number of banking insolvencies in this crisis.

Update: Barry Ritholtz disagrees that it is credit availability that is at issue. He points to the demand for credit. Fair enough – demand for credit is the critical factor nationwide. However, supply side issues are also there. Availability of credit is key for those smaller businesses that actually do want to expand because they are being denied in a way that they were not as reported by the Fed’s survey of credit officers.

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This past week’s posts marked a turn for me on a few levels. It is apparent that most market reform efforts are mere tweaks of the existing system. I am being to conclude that no meaningful financial reform can occur absent an absolute collapse in the global economy and the financial system. This is quite troubling in the context of policy normalization which is occurring on the fiscal and monetary fronts across the developed world.

On the whole, I believe the U.S. has been in a technical recovery since August and the strength of GDP growth will force the recession dating committee at the NBER to recognize this. However, I continue to be concerned about a number of pitfalls for the global economy including protectionism, the sovereign debt crisis, unemployment in the U.S., strategic default and commercial real estate. Therefore, any renewed economic weakness will be viewed as a separate episode – a double-dip.

I give a double dip about even odds, which is generally more bearish than even Stephen Roach (40%) and Nouriel Roubini (20%). My baseline had been a multi-year recovery because the cyclical agents of recovery (inventory builds, employment, consumer confidence, retail sales growth, etc) are self-reinforcing. My main reason for seeing a double dip has to do with anticipated policy responses which will be less accommodative, as it is driven now by the rising debate over fiscal probity given the sovereign debt crisis.

Debt levels in the developed world would mean any renewed economic weakness risks a debt deflationary scenario. In my view, the underlying economic fundamentals across the developed world are considerably weaker than many believe – and this will be made apparent if policy is normalized too quickly.

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