The Bank Life: Isn't It Swell

With banks getting preferred treatment by governments across the world, one wonders what life as a bank might be like. Toni Straka from The Prudent Investor dreams of a better life, a life as a bank.

Flirting with the Hindu theory of reincarnation I have decided to do my utmost that may give me a chance to be reborn as a bank.

Just imagine what life must be like. Compare it maybe to a video game where the drunk driver can crash into a wedding party, killing most attendees and wrecking the car. At that point Uncle Sam comes around, saying "no problem boy, never mind all the mangled corpses around you. Here's a bundle of cash so you can get a new car and mess around again."

No. Let's get serious. When being a bank, one does not need to draw on outdated analogies. Reality is already a paradise and this is a true story from cloud nine.

Let's begin with working hours. As the only industry in the world retaining a 5-day workweek, banks have an easy life. In contrast to all other businesses that have to stay open to fill the till banks have an enormous advantage. The money they lend out collects interest for at least 360 and in most cases 365 days. Not bad for working only 250 days. That's as close as one can get to "money for nothing and chicks for free," at least for the first part of this former Dire Straits hit.
Does a bad credit score hike your borrowing costs in real life? Again, better become a bank eligible for central bank refinancing. No matter what crap spoils a bank's asset portfolio, your central bank will be a most reliable buddy, lending you as much money as you want at negative real interest rates and far below what they charge for the risk associated with a client.
As a bank you are basically getting paid for borrowing.

Doesn't that sound like paradise? No, it is not paradise, this the very real world of banks these days, almost entirely free from any consequences for all its acting participants.

Are Banks Except From Common Sense Thinking?
This does not apply to the clerical workers level of course. A bank just needs to fire a couple of hundred secretaries etc. in order to keep its masters of the universe happy with gazillion bonuses. Sssshhhh, nobody wants to be reminded that the suipposed masters of the universe did nothing else than a herd of sheep: Staying together while stampeding in the same direction most times.

While mere mortal humans are told to save up for a nest-egg in case times turn to the worse, banks are again exempted from such profane common sense thinking.

Skimming the profits off shareholder's dividends in order to pay themselves bonuses in the good years banks apparently felt themselves expected from the need to create reserves for loans going bad. OK, they were not the first ones but only followed examples set by companies in many other industries where the aim to create shareholder value led to a short term oriented strategy that was dominated by the desire to raise the share price and not the strength of the company in the long term. Call the game by its true name: CEO compensation roulette.

The years in the casino with freely flowing champagne that came from selling increasingly risky products to clueless customers have created a resistance to change in the banking industry. While other drunks are thrown into the locker cell to sober up, a bank can instead stumble into its concerned parliament and tell a few horror stories about the importance of the credit industry.

Incompetent politicians may feel like heroes when they throw billions after the banks they do not have in the first place. But this recipe for hyper inflation is so old that it has been long forgotten by today's caste of international leaders. They will find out together with revolting populations when Europe and the USA follow the nasty path of monetizing the debt that has reduced Zimbabwe from Africa's bread basket into a lawless impoverished society depending on food aid from abroad.

The common man meanwhile is told that banks deliver an important function to the public by guaranteeing the smooth and efficient flow of funds. What the public is not told is the sour reality that it will be them who will pick up the bailout bill of the banks with its future tax payments.
Declining property prices, the prime driver behind the global debt boom of this millennium, will chip away more of the prosperity the West has become used to in the past 2 decades of surging home values that have financed many luxuries people probably would not have bought had they had to use their savings.

A shrinking business base at least on the consumer level where a sudden change to frugality out of necessity means fewer loans may bring what politicians are so far eager to avoid with their donations to the banking sector: A resizing of the industry to the level needed to service other industries and consumers without dominating them. After all banks profits have seen a higher growth rate in the past 4 decades than all industries.

All attempts to rein banks under stronger regulatory umbrellas were squashed in the past by them. Voicing their commitment to free market ideology it was argued that only self-regulation was sufficient and the state's hands would only hamper business. As the world now finds out that this was not the case, to be polite, banks have turned into super socialists at the same speed they saw their business model of taking on too much risk for lavish profits disappear because we cannot all get rich at the same time.

After all, it may still be most comfortable to be reborn as a bank in the near future. History shows a repeating pattern after bank crises. The bigger the excesses of the banks were the stronger the regulation they were relegated to.

It will not be different this time and for a while banking may become what it was for most of the time: A 3-6-3 business. Borrow at 3%, lend at 6% and be on the golf course at 3 PM. Life could be worse.

This article has been reposted from The Prudent Investor. The full post can also be viewed on The Prudent Investor.

Interest Rate Cut Expectations From Around The World

So which country will be the first to drop interest rates to zero? Japan has a head start, but they are not expected to drop interest rates at their next meeting. The U.S. on the other hand is expected to drop their Fed Funds rate down to 0.5 percent, and could very well win the race to zero, if things don't turn around soon for the economy. Kathy Lien looks closer at interest rates around the world and shares her expectations on how future cuts might pan out.

With the global economic downturn in full swing, one of the burning questions on everyone’s minds is who will be the first central bank to take interest rates to zero and how close will everyone else get?

We are in a global easing cycle and the varying aggressiveness of central banks around the world means that any country could be the first to see zero interest rates.

We expect December to be another active month for the foreign exchange market as central banks around the world take their interest rates to historically significant levels. There are 4 central banks with monetary policy decisions in the first week of December and all 4 are expected to cut interest rates. The closest to zero is the Bank of Japan, but having been there before, they are reluctant to revisit those levels. The US Federal Reserve and the Swiss National Bank have the second lowest interest rates. Both central banks are expected to continue to ease, but the Fed has been far more open about going to zero interest rates than the SNB. Realistically, Japan and the US will probably be the only ones to take rates all the way down to zero. Switzerland should be left with the second lowest interest rate when the dust settles followed by the Bank of England.

What Happens After Zero?
When a central bank runs out of room to cut interest rates, they resort to Quantitative Easing. This term was coined by the Bank of Japan in 2001 when interest rates were already at zero and the central bank stopped targeting the overnight call rate and turned to targeting a current account level. Their goal was to flood the Japanese financial system with liquidity by buying trillions of yen of financial securities including asset-backed instruments and equities.

It can be argued that the US has already engaged in Quantitative Easing as the government has recently announce plans to spend $800 billion to unfreeze the consumer and mortgage market. They have agreed to buy mortgage backed securities backed by government sponsored entities and could accelerate that if interest rates hit zero. Excess reserves have also increased significantly, driving the effective fed funds rate well below 0.5 percent. This would have been one of desired outcomes of quantitative easing. Last week, Fed vice chairman Donald Kohn said quantitative easing measures were under review at the central bank as normal contingency planning. The goal would be to encourage banks to lend more aggressively by coming in as a buyer at specified rates. Even though quantitative easing drove Japan into deflation, it was the key to turning around the economy and this is a risk that the US central bank may have to take.

Here’s where the major central banks stand and what is expected for the next meeting:

Federal Reserve – 50bp Cut Expected on 12/16

On October 29, the Federal Reserve took interest rates to 1 percent, which is near the record low reached in 2003 and 2004. While other countries have just started reacting aggressively to financial conditions, the Fed has been mounting cuts as far back as the middle of 2007. There has been no looking back since, as rates have been cut 425bp since 2007 and 250bp year to date. With interest rates near ultra low levels, the Federal Reserve has already resorted to unorthodox policy tools. More easing is expected with the markets torn between a 50 or 75bp rate cut in December. The FOMC statement will be particularly important this time around because the Fed will have the difficult decision of signaling a move to zero interest rates. In order to deal with this decision, they have expanded their monetary policy meeting from 1 to 2 days. Fed Chairman Ben Bernanke has remained dovish throughout the past few months which mean that another rate cut is practically guaranteed.

European Central Bank – 50bp Cut Expected on 12/04

On November 6, the European Central Bank cut interest rates by 50bp to 3.25 percent. The European Central Bank has abandoned their old monetary policy metric in the previous months, opting for a more growth-concentrated approach to interest rate decisions. Such a change has accompanied a round of rate cuts that has brought the target rate down to 3.25%. ECB President Trichet has made no indication that rate cuts would stop here. However, in relation to neighboring nations, the ECB has not acted as aggressively, dropping rates only by 75bp this year. Compared to a year to date cut of 250bp by the US and 225bp by the UK, the ECB seems to be lagging behind the curve. Now that the region has officially hit a recession, it is possible that they will be more aggressive in easing rates. The ECB has the power to organize a continuous program of such policy implementation since their target rate is one of the highest, outside of Australia and New Zealand. The only factor holding them back is inflation pressures. Although producer and consumer prices have been easing, the central bank is not entirely convinced that the upside risks to prices have alleviated.

Bank of England – 100bp Cut Expected on 12/04

The Bank of England has been the most aggressive and proactive of the G-10 central banks in their attempts to ease monetary policy. The most recent cut of 150bp was a huge surprise to all traders and represents the largest single meeting cut to occur for any of the major central banks during the financial crisis. However what was even more shocking was the fact that the minutes from the most recent monetary policy meeting in early November suggested that they considered an even larger interest rate cut. Going into the December monetary policy decision, the market expects the BoE to ease by another 100bp. With the economy in a recession according to UK officials, interest rates could fall as low as 1% if the crisis continues well into the New Year. The BoE’s ability to cut by such a sizable amount was also reflected in the fact that inflation, once the primary concern, has eased considerably in the last few months. In addition to monetary stimulus, the UK government has been at the forefront of bank bailouts and fiscal stimulus.

Bank of Japan – No Rate Cut Expected on 12/19

After cutting interest rates by 20bp last month’s meeting, the Bank of Japan left interest rates unchanged in November. It is unlikely that we will see much more easing as officials have expressed a certain sense of reluctance in bringing rates back to zero. The Japanese are all too familiar with the implications of such rates and will be forced to look for new methods to ease the financial strain on the country. Masaaki Shirakawa, the BoJ Chairman, informed the Bank’s staff to, “swiftly examine and report possible changes in the treatment of corporate debt as collateral, as well as possible ways to enhance flexibility in funds-supplying operations collateralized by corporate debt.” Such statement seem to indicate that, while we will unlikely see much in the way of new rate cuts, we will see new initiatives that focus on shoring up lending and improving liquidity.

Bank of Canada – 50bp Cut Expected on 12/09

On October 21, the Bank of Canada cut interest rates by 25bp to 2.25 percent, the lowest level since October 2004. Although the size of the rate cut was smaller than the market had anticipated, the BoC had already cut interest rates by 50bp on October 8th. Mark Carney, the Governor of the Bank of Canada, has been very vocal in explaining his thoughts on the health of the Canadian economy. Carney comments can be summed up in this statement, “the risks to growth and inflation in Canada appear to have shifted to the downside…some further monetary stimulus will likely be required to achieve the inflation target over the medium term.” We can rarely expect such a “cut and dry” statement from a central bank official. He leaves little to question. However, he does note that the economy does have some strong areas, specifically domestic demand (retail sales rose 1.1 percent in the month of September). The BoC governor also noted that the weakness in the Canadian dollar has picked up some slack from the declines in international demand. The market expects the central bank to ease interest rates by another 50bp at the next meeting, which would take rates down to 1.75 percent. Canadian interest rates have not been below 2 percent since the 1960.

Reserve Bank of Australia -100bp Cut Expected on 12/02

The Reserve Bank of Australia has definitely not sat idly by watching its economy deteriorate. Along with 175bp of easing this year, the central bank has also resorted to intervening in the currency markets to support its currency. Intervention has been a very controversial monetary tactic because it simply does not have a good record. However, such desperation does indicate that the bank is having a tough time dealing with the consequences of rate cuts. A target rate of 5.25 percent leaves the RBA with plenty of opportunity for additional easing in the future. However, the RBA minutes explain that the 75bp cut made at the last meeting would be necessary in that “there was an advantage in moving the setting of monetary policy quickly to a neutral position.” Regardless of such a statement, the market still believes that the RBA will cut interest rates by 100 to 125bp at the December meeting.

Reserve Bank of New Zealand – 150bp Cut Expected on 12/03

The Reserve Bank of New Zealand cut interest rates rates by a full percentage point in October, citing “ongoing financial market turmoil and a deteriorating outlook for global growth. In a statement published in an article released by the RBNZ, the bank notes that “global developments have proven extremely disruptive and it will likely be some time before financial market conditions normalize. The Bank will continue to adopt measures as needed to maintain the stability of our financial system as far as possible in these difficult times.”Once again we see some very dovish statements made explicitly from central banks. The recession embattled country has plenty of ammunition as rates are at the very high level of 6.50%. While zero percent interest rates may not be a possibility, it is possible that we will be surprised by some extremely aggressive cuts. The market currently expects the RBNZ to cut as much as 1.5 percentage points in December and eventually take interest rates down to 5 percent. It is also important to note that rates have not fallen below 4.50% in the last ten years.

Swiss National Bank – 50bp Cut Expected on 12/11

The Swiss National Bank surprised the market by delivering a full percentage point intermeeting rate cut. Citing the obvious fact that international economic conditions have worsened, the central bank made its largest one day rate change in eight years. The economy has weakened substantially due to the fact they have a large exposure to the banking sector. The Swiss National Bank hopes that the move will provide the market with a generous and flexible supply of liquidity. The bank’s continuous issuance of surprise rate decisions leads us to believe that more can be expected. Many economists expect the SNB to continue cutting interest rates to 0.5 percent.

This article has been reposted from Kathy Lien. The full post can also be viewed on KathyLien.com.

Loan Loses Continue To Mount: A Look At FDIC Graphs

You're probably not surprised to hear that loan losses are continuing to mount at financial institutions, but just how bad are things getting? Anthony Freed from Your Mortgage or Your Life looks a little closer at some FDIC graphs and helps paint the grim picture in his blog post below.

More Institutions Report Declining Earnings, Quarterly Losses:

Troubled assets continued to mount at insured commercial banks and savings institutions in the third quarter of 2008, placing a growing burden on industry earnings. Expenses for credit losses topped $50 billion for a second consecutive quarter, absorbing one-third of the industry’s net operating revenue (net interest income plus total noninterest income). Third quarter net income totaled $1.7 billion, a decline of $27.0 billion (94.0 percent) from the third quarter of 2007. The industry’s quarterly return on assets (ROA) fell to 0.05 percent, compared to 0.92 percent a year earlier. This is the second-lowest quarterly ROA reported by the industry in the past 18 years. Evidence of a deteriorating operating environment was widespread. A majority of institutions (58.4 percent) reported year-over-year declines in quarterly net income, and an even larger proportion (64.0 percent) had lower quarterly ROAs. The erosion in profitability has thus far been greater for larger institutions. The median ROA at institutions with assets greater than $1 billion has fallen from 1.03 percent to 0.56 percent since the third quarter of 2007, while at community banks (institutions with assets less than $1 billion) the median ROA has declined from 0.97 percent to 0.72 percent. Almost one in every four institutions (24.1 percent) reported a net loss for the quarter, the highest percentage in any quarter since the fourth quarter of 1990, and the highest percentage in a third quarter in the 24 years that all insured institutions have reported quarterly earnings.

Lower Asset Values Add to the Downward Pressure on Earnings:

Loan-loss provisions totaled $50.5 billion in the quarter, more than three times the $16.8 billion of a year earlier. Total noninterest income was $905 million (1.5 percent) lower than in the third quarter of 2007. Securitization income declined by $1.9 billion (33.0 percent), as reduced demand in secondary markets limited new securitization activity. Gains on sales of assets other than loans declined by $1.0 billion (78.7 percent) year-over-year, and losses on sales of real estate acquired through foreclosure rose by $518 million (588 percent). Among the few categories of noninterest income that showed improvement, loan sales produced net gains of $166 million in the third quarter, compared to $1.2 billion in net losses a year earlier, and trading revenue was up by $2.8 billion (129.2 percent). Sales of securities and other assets yielded net losses of $7.6 billion in the third quarter, compared to gains of $77 million in the third quarter of 2007. Expenses for impairment of goodwill and other intangible asset expenses were $1.8 billion (58.6 percent) higher than a year ago.

Loan Losses Continue to Mount:

The industry reported year-over-year growth in net charge-offs for the seventh consecutive quarter. Net charge-offs totaled $27.9 billion in the quarter, an increase of $17.0 billion (156.4 percent) from a year earlier. Two-thirds of the increase in charge-offs consisted of loans secured by real estate. Charge-offs of closed-end first and second lien mortgage loans were $4.6 billion (423 percent) higher than in the third quarter of 2007, while charged-off real estate construction and development (C&D) loans were up by $3.9 billion (744 percent). Charge-offs of home equity lines of credit were $2.1 billion (306 percent) higher. Charge-offs of loans to commercial and industrial (C&I) borrowers increased by $2.3 billion (139 percent), credit card loan charge-offs rose by $1.5 billion (37.4 percent), and charge-offs of other loans to individuals were $1.7 billion (76.4 percent) higher. The quarterly net charge-off rate in the third quarter was 1.42 percent, up from 1.32 percent in the second quarter and 0.57 percent in the third quarter of 2007. This is the highest quarterly net charge-off rate for the industry since 1991. The failure of Washington Mutual on September 25 meant that a significant amount of charge-off activity was not reflected in the reported industry totals for the quarter1.

Growth in Reported Noncurrent Loans Remains High:

The amount of loans and leases that were noncurrent (90 days or more past due or in nonaccrual status) increased to $184.3 billion at the end of September. This is $21.4 billion (13.1 percent) more than insured institutions reported as of June 30 and is up by $101.2 billion (122 percent) over the past 12 months. The percentage of total loans and leases that were noncurrent rose from 2.04 percent to 2.31 percent during the quarter and is now at the highest level since the third quarter of 1993. The growth in noncurrent loans during the quarter was led by closed-end first and second lien mortgage loans, where noncurrents rose by $9.6 billion (14.3 percent). Noncurrent real estate C&D loans increased by $6.9 billion (18.1 percent), while noncurrent loans secured by nonfarm nonresidential properties rose by $2.2 billion (18.1 percent). Noncurrent C&I loans were up by $1.8 billion (13.7 percent) during the quarter.

Nine Failures in Third Quarter Include Washington Mutual Bank:

The number of insured commercial banks and savings institutions fell to 8,384 in the third quarter, down from 8,451 at midyear. During the quarter, 73 institutions were absorbed in mergers, and 9 institutions failed. This is the largest number of failures in a quarter since the third quarter of 1993, when 16 insured institutions failed. Among the failures was Washington Mutual Bank, an insured savings institution with $307 billion in assets and the largest insured institution to fail in the FDIC’s 75-year history. There were 21 new institutions chartered in the third quarter, the smallest number of new charters in a quarter since 17 new charters were added in the first quarter of 2002. Four insured savings institutions, with combined assets of $1.0 billion, converted from mutual ownership to stock ownership in the third quarter. The number of insured institutions on the FDIC’s “Problem List” increased from 117 to 171, and the assets of “problem” institutions rose from $78.3 billion to $115.6 billion during the quarter. This is the first time since the middle of 1994 that assets of “problem” institutions have exceeded $100 billion.

Failure-Related Restructuring Contributes to a Decline in Reported Capital:

Total equity capital fell by $44.2 billion (3.3 percent) during the third quarter. A $14.6-billion decline in other comprehensive income, driven primarily by unrealized losses on securities held for sale, was a significant factor in the reduction in equity, but most of the decline stemmed from the accounting effect of the failure of Washington Mutual Bank (WaMu)2. The WaMu failure had a similar effect on the reported industry totals for tier 1 capital and total risk-based capital, which declined by $33.6 billion and $35.3 billion, respectively. Unlike equity capital, these regulatory capital amounts are not affected by changes in unrealized gains or losses on available-for-sale securities. Almost half of all institutions (48.5 percent) reported declines in their leverage capital ratios during the quarter, and slightly more than half (51.2 percent) reported declines in their total risk-based capital ratios. Many institutions reduced their dividends to preserve capital; of the 3,761 institutions that paid dividends in the third quarter of 2007, more than half (57.4 percent) paid lower dividends in the third quarter of 2008, including 20.7 percent that paid no dividends. Third quarter dividends totaled $11.0 billion, a $16.9-billion (60.7-percent) decline from a year ago.

Source FDIC: http://www2.fdic.gov/qbp/index.asp

For more on what the graphs are telling you, read What are CAMELS ratings? Is My Bank Okay?

Graphs From Q2-2008: Graphs - Not Laughs - From the FDIC Report

More: Graphs show Gaffes - More from the FDIC Report

This article has been reposted from Your Mortgage or Your Life. The full post can also be viewed on yourmortgageoryourlife.wordpress.com.

President-elect Barack Obama Asks Americans For Patience

During his presidential campaign Barack Obama made many promises to the American people, and there will be a lot of pressure to deliver when he takes office. Americans are losing their jobs, and to say that the economy is struggling is an understatement. The voters who showed up in record numbers to select Obama as our next president expect results, and fast. Knowing that he is going to be on the hot seat, Obama has done the smart thing by reminding people that fixing these problems isn’t going to happen overnight. "The economy's likely to get worse before it gets better. Full recovery will not happen immediately," Obama said Monday, according to CNN.

In a society that wants and demands immediate results, this is a hard pill to swallow, but Obama is right. If we want to fix the economy—and by fix I don’t mean slap a band aid on—it is going to take time and things will get worse before they get better. Americans need to understand this and give Obama a little slack. We need to look at the big picture, not at what will just get us through the next year.

However, though Obama is saying the right things right now, whether he will actually do the right things is an entirely different matter. I don’t agree with many of Obama’s plans to correct the financial crisis, but no one on this planet knows for certain how to fix this thing. There are various and potentially valid opinions on the best course of action, and I don’t intend to sit here and say that I have the perfect plan. I also don’t envy the position Obama is in. He will listen to plan after plan from top economic experts, and then choose the one that will either save us or sink us, and forever bear the weight of that decision on his legacy. Not a pleasant task. I think Obama is a very smart man, and I think that it is important that we give him a chance. This is the man that America selected to get us out of the current crisis and we need to accept that. It is scary to think that one man will have such a huge role in deciding our future, but Obama is the man chosen for the job.

So, President-elect Obama: Even though I might not agree with all of your decisions, this blogger promises to give you the time that you’ve requested. Just do your best to make the right decisions, because my daughter’s future is in your hands.

Las Vegas And Phoenix Battle For Real Estate Infamy

So which city was hit harder by the real estate collapse, Las Vegas or Phoenix? To be sure they both have taken serious hits, but only one will go down as the winner. Tim Iacono from The Mess That Greenspan Made looks at the latest reports and gives the latest update on the markets. If your city is not in the top spot, don't fret because there is still lots of time to play catch up.

The September report(.pdf) for the S&P Case-Shiller Home Price Indices shows the 10-City and 20-City Composite Home Price Indices at new record annual declines of 18.6 percent and 17.4 percent, respectively. Price indices for all 20 cities are shown below.
To aid in viewing this graphic, the order of the legend (upper left) reflects the top-to-bottom position of all 20 cities for the current month (far right). As such, the legend order indicates which cities have managed to hold onto the largest real estate price gains since 2000.

Congratulations New York!

You've just surpassed Washington D.C. as the metro area that has held onto home price gains the best in this decade. The bad news is that, with all the recent troubles on Wall Street, this may not last that long.

Not surprisingly, Phoenix and Las Vegas continue to lead the way down, year-over-year home price declines in both areas pushing past 31 percent in September as indicated in red in the table below - the death match continues.

A few other areas are also threatening to crack the 30+ percent annual decline threshold as indicated in blue, notably, San Francisco, an area where the annual price decline worsened to 29.5 percent.
Two areas showed month-to-month improvement - Cleveland and Boston - while home prices in Dallas were unchanged from August. Cleveland was the only region where the annual home price decline improved from a year ago, from -6.6 percent in August to -6.4 percent in September.

David M. Blitzer, Chairman of the Index Committee at Standard & Poor's, noted:

The turmoil in the financial markets is placing further downward pressure on a housing market already weakened by its own fundamentals.

All three aggregate indices and 13 of the 20 metro areas are reporting new record rates of decline. Looking at the returns of the U.S. National Index, prices are back to where they were in early 2004. As of September 2008, the 10-City Composite is down 23.4% from its peak, the 20-City Composite is down 21.8% and the National Composite is down 21.0%

You'd think that things couldn't get any worse for home prices, but they probably will.

This article has been reposted from The Mess That Greenspan Made. The full post can also be viewed on The Mess That Greenspan Made.

Another $800 Billion Committed: Crisis Tally Tops $8 Trillion

Yesterday on Bloomberg, I saw a disturbing article that disclosed that the government had already committed $7.76 trillion to fix the credit crisis. This number was staggering to me. I write about this stuff every day and yet even I didn’t realize the tally had gotten that high. The $7.76 trillion number includes the over $300 billion committed to Citigroup, but another $800 billion to free up the credit markets was announced this morning. So far this week—which isn’t even two days old yet—the tally has already surpassed a trillion dollars. This is absolutely insane, and you can bet that there will be more where that came from once the new administration takes over.

I don’t know about you, but these numbers are freaking me out. Sure a lot of these commitments have an investment component, but I don’t believe claims that we will make a bunch of money from these deals. I would consider us lucky if we are able to recover the principal. Things have only gotten worse of late, and we seem prepared to throw as much money at the problem as needed, so what will the final tab be? When will this spending spree stop?

Obama is prepared to open up the taxpayer checkbook when he takes office, recently announcing plans to roll out a new stimulus package estimated to cost $500 billion to $700 billion according to CNN. In addition, his selection for Treasury Secretary, Geithner, has had a huge part in the economic decisions made by Treasury Secretary Paulson, and it seems unlikely that he will stray far from the current path. With these combined factors, we could face countless trillions more before all is said and done. Where is this going to leave our children?

The answer to that question of course is that our children will be unfairly burdened by an absolutely enormous debt. Their financial prospects will be dim as they are forced to deal with higher taxes and other restrictive policies. Personally I find this completely unacceptable, and I hope beyond hope that it doesn’t come to that. I’ve mentioned this before in some of my posts, but to knowingly leave a burden such as this on the future generation is immoral to the fullest extent. We need to pay for our own mistakes, and our own excessive lifestyles. Our children have enough to worry about, and paying for the previous generation’s debt shouldn’t be one of them.

Homebuilders Next In Line To Beg For Bailout Funds

Detroit automakers recently received the cold shoulder from Congress on their quest for a piece of the $700 billion bailout pie; next in line are the homebuilders. Hopefully they will learn from the automakers and won’t fly to Washington in private jets to beg for these funds, although at this point it appears doubtful that their wishes will be answered anyway. The homebuilders are prepared to request an aid package estimated at $250 billion and aptly called “Fix Housing First”, according to the Wall Street Journal. The homebuilders are trying to convince Congress that the rest of the financial system will continue to deteriorate until home prices stabilize.

The “Fix Housing First” plan calls for two parts, a large tax credit for homebuyers and a government subsidy of mortgage rates. The tax credit that the homebuilders are proposing would equal 10 percent of the home’s purchase or $22,000, whichever is less according to the Wall Street Journal. The mortgage subsidy requested by the homebuilders would aim to bring interest rates on government backed 30 year fix loans down to 3 percent for loans made in the first half of 2009, and 4 percent for loans made in the second half of the year, according to the Wall Street Journal. The Wall Street Journal also notes that Realtors are pushing a 4.5 percent interest rate buy down for new mortgage loans. It is their estimation that for each 1 percent that rates fall, 500,000 to 800,000 additional homes could be sold.

It seems very unlikely that any variation of the “Fix Housing First” plan will get passed before Obama takes office, but once he does all bets are off. I seriously doubt that the plan would remain intact as is, but some variation of the proposal could be possible. There is a lot of support for the idea that the housing crisis is the underlying cause of the greater financial crisis, and most Americans are more likely to approve of measures that will aid the housing and mortgage markets before aiding banks and other financial institutions. We have been trying to prop up the financial industry for a long time, without much avail. Why not give housing a try?

Of course the problem is that this will simply artificially inflate housing prices yet again. We did that before and look where that has left us. If we are able to inflate housing prices, that will alleviate many of the problems plaguing the financial industry and homeowners alike, but it is not sustainable. Housing simply became too expensive, and it will become too expensive again if we inflate it, and the next time it will cost us even more to fix the fallout. Housing prices need to rise in correlation with a rise in income, which is the only sustainable way. I hope that Congress and the next administration know better than to rely on biased research when looking to spend hundreds of billions in taxpayer money.

Citigroup Bailout, Deflation And The Worldwide Financial Epidemic

The news of Citigroup's $300 billion bailout seems like déjà vu, and the scary word "deflation" that is being thrown around seems distant compared to everything else we are dealing with. The U.S. is not the only country with problems either, this is without a doubt a global financial epidemic. James Picerno from The Capital Spectator wonders, though, if the cure might be worse than the disease.

Have we seen this movie before? It certainly sounds familiar.

Once again, the government steps in to bail out a financial institution and Mr. Market takes kindly to the idea. Initially. But then reality sets in and the process starts anew. Perhaps it'll be a true sign of a bottom when the Feds engineer a bailout and the market tanks on the news.

But not yet. The latest installment of rescue revolves around the once mighty Citigroup. A giant among giants, this behemoth of financial behemoths surely fits the bill as too big to fail. If such a thing exists as a financial institution that must be saved at any cost, Citigroup looks like the poster boy for this idea.

Total assets for Citigroup were a bit more than $2 trillion in September. For those who like to keep score, that's roughly 14% of the annualized value of U.S. GDP for this year's third quarter.

The days of pulling another Lehman and letting a big bank fail are history. Better to bailout more rather than less and deal with the consequences later. The grand strategy here is that if the government bails out enough banks (and perhaps an auto company or two) while spitting out stimulus in various forms as far as the eye can see, the system will correct itself, or at least stop bleeding. At a time when deflationary risks are rising, this plan is considered prudent and timely by a growing swath of economists and voices from the peanut gallery, including yours truly. The risk of an even deeper implosion of prices and confidence must be avoided lest the vortex of deflation pull everything down the rat hole. Preventing deflation is the last battle in this horror film because once the big "D" takes hold, in sentiment and prices, the challenge becomes much, much tougher.

The problem is that no one's really quite sure if deflation with a big "D" is on our doorstep. Quite possibly it is, or so one could reason after witnessing consumer and wholesale prices fall last month on a scale unmatched since the government began keeping tabs on such things in the late-1940s. Waiting for definitive signs risks letting the monster out of the cage. Decisions, decisions. Nonetheless, there's a strong case for assuming deflation is coming. If we're wrong, we'll have more inflation on our hands than we otherwise would. But the world knows how to fight inflation, even if the political will is sometimes lacking. Attacking deflation, on the other, is another story.

Any way you slice it, there's bound to be more than a little disappointment and finger pointing in the months and years ahead. Indeed, no one should think that the necessary but risky strategy of preventing deflation is destined to end in triumph, or quick results. The stakes are high, in part because the government's moving quickly toward betting the house on a fiscal/monetary solution. On the opposing shore is the unwinding of excess, some of which has been decades in the making. When an immovable force meets government printing presses, the outcome isn't entirely clear.

All the more so if the world is looking for signs, one way or the other, by next Wednesday. It's difficult to gauge expectations as we run from one crisis to another. But this much is clear: the financial and economic problems will take time--years--to solve, and to the extent that the crowd thinks otherwise, the seeds of disenchantment have been planted.

The U.S. economy is sick, and getting sicker. Europe has the disease and Asia is at risk of contracting the same, albeit in a milder form. Looking back on the past five decades offers no clue for what may be coming. Growth has been a constant, according to GDP numbers from economist Angus Maddison, emeritus professor, University of Groningen (Netherlands). As the chart below shows, outright contraction is unknown in the postwar era.

Fifty years is a long time, virtually an eternity for mere mortals studying the past in search of clues about the future. It's all too easy to look at this track record and conclude that real declines in global GDP aren't possible, or are so unlikely as to be unworthy of considering. The IMF forecast, for one, still imagines more of the same with next year's estimate for real global GDP rising by a respectable if not impressive 2.4%.

Of course, the crowd used to think in persistent-growth terms for housing prices, and how they never fall on a year-over-year basis. Oh, sure, that happened in the Great Depression, but such episodes were dismissed as a thing from the past.

Perhaps it's time to consider the unthinkable. We've all received a crash course in just that over the last few months. But has the education so far been sufficient? Or do we still need to spend more time studying?

There are many dangers stalking the global economy, and at the top of the list is the assumption that the governments of the world can spend their way out of the slump on our collective doorstep. In the U.S. alone, the government now stands at the ready to spend $7 trillion--yes trillion with a "t"--to bring financial salvation to the system, according to Bloomberg News. That's the equivalent of three-and-a-half Citigroups, or half the U.S. economy. Scale no longer looks to be a stumbling block.

By spending enough money, governments are likely to keep inflation-adjusted global GDP floating somewhere above zero, if only slightly. That would still bring a fair amount of pain and repricing, but embedded in the expectation is the notion that a floor can be built under the crisis.

Perhaps, although at some point one might wonder if the cure will be worse than the disease. There are some awkward questions that will accompany the mother of all spending sprees now underway. First up: Is there some point at which additional government spending becomes counterproductive because a) it encourages future inflation on a scale that will be excessively burdensome; and/or b) the prospect of the government owning ever-larger chunks of the economy risks institutionalizing mediocrity or worse in the economy?

There are two great episodes of deflation in modern history, and each continues to raise questions about the associated lessons. Yes, spending is the only hope of sidestepping the beast, and if that means artificially engineered demand from the government, so be it. But it's not clear that the strategy leads to happy results all around. Meantime, there's more than one way to fight deflation.

That's not to say we shouldn't try to spend our way out of a deflationary trap. We should. We must. And we will. The risk is real this time, unlike the previous worries over deflation in 2001-2003. But the details of how we engage our anti-deflationary war may matter as much, if not more, as the decision to wage the war in the first place.

The dismal science has precious little experience with fighting deflation and so we must recognize that we may soon be caught up in an economic experiment on a scale that has little or no precedent. By all means, let's fight this war ferociously. But it also needs to be fought intelligently. What exactly do we mean by "intelligently"? We can't say for sure. No one can, and therein lies the greatest risk.

This article has been reposted from The Capital Spectator. The full post can also be viewed on The Capital Spectator.

16,000 Homeowners Get Early Christmas Present From Freddie and Fannie

In an attempt to stop the flow of foreclosures that is ravaging the companies, Freddie Mac and Fannie Mae have decided to put a temporary hold on new foreclosures and evictions. This hold will last till early 2009 and is meant to give homeowners the chance to work out loan modifications, hopefully allowing them to stay in their homes. Between the two companies this move is expected to affect around 16,000 homeowners facing foreclosure, according to the Wall Street Journal. So it seems that these 16,000 homeowners are getting a nice little Christmas present from Freddie and Fannie, as well as from taxpayers I presume.

If nothing else, it will be interesting to see how this idea works. I was skeptical at best when the foreclosure moratorium was discussed during the presidential debates, and I still don’t think this will work as well as they are hoping. Nevertheless, this shall give us an opportunity to test the program on a smaller scale, which it could open up the door for similar action by other lenders if it works.

My problem with this strategy: I predict that ultimately the homeowners will still be foreclosed on, but they will enjoy some free time in their homes. If the homeowner doesn’t stay in the home, or somehow sell it, then the delay will just put the lender in even worse shape than before. Because in the case of Freddie and Fannie this equates to taxpayers taking on the burden, I’m not too fond of the idea. It will work out better if the companies are selective about who qualifies for a foreclosure delay, but if they offer it to all owner occupants it is doomed to failure. The problem is most people are in foreclosure for a serious reason: Some people lost their jobs, some can’t afford the payment (with or without loan modification) and some people are choosing to enter into foreclosure because they are so far underwater on the house. The last reason is becoming a huge problem, and really should be the one most feared in this scenario. At least I can feel bad for the people who lost their jobs, or possibly even the poor sucker who got an interest only ARM sold to them that they couldn’t afford, but it is hard to feel bad for someone who can afford the payment and just wants out of their contract. Why on earth would we want to give these people another month, two or three of free housing? If they aren’t going to pay their mortgage and just plan on working the system, why should taxpayers be stuck with the bill? We already have to deal with the fact that we are going to lose money on the foreclosure, so why add anything else?

It will be interesting to see how this all plays out. I have my doubts, and I hope that I’m proven wrong and that this plan saves taxpayers a bunch of money. But unless we are able to create a method to accurately identify the homeowners who want help and can be helped, this is doomed to fail.

How Much Damage Can Be Done Before Obama Takes Office?

The economic prospects of this country are getting worse everyday, and the current administration seems content to sit back and do nothing. This transition period, before the new administration officially takes power, has caused problems before, way back in 1932, and we all saw how that turned out. It makes you wonder, just how much can the current administration further mess things up before Obama takes power? Economics professor Mark Thoma looks at an opinion piece from Paul Krugman on the topic in his blog post from Economist's View.

The outlook for the economy is deteriorating, yet economic policy "seems to have gone on vacation":

The Lame-Duck Economy, by Paul Krugman, Commentary, NY Times: Everyone’s talking about a new New Deal, for obvious reasons. In 2008, as in 1932, a long era of Republican political dominance came to an end in the face of an economic and financial crisis that, in voters’ minds, both discredited the G.O.P.’s free-market ideology and undermined its claims of competence. And for those on the progressive side of the political spectrum, these are hopeful times.

There is, however, another and more disturbing parallel between 2008 and 1932 — namely, the emergence of a power vacuum at the height of the crisis. The interregnum of 1932-1933, the long stretch between the election and the actual transfer of power, was disastrous for the U.S. economy, at least in part because the outgoing administration had no credibility, the incoming administration had no authority and the ideological chasm between the two sides was too great to allow concerted action. And the same thing is happening now. ...

How much can go wrong in the two months before Mr. Obama takes the oath of office? The answer, unfortunately, is: a lot. ... The prospects for the economy look much grimmer now than they did as little as a week or two ago.

Yet economic policy, rather than responding to the threat, seems to have gone on vacation. In particular, panic has returned to the credit markets, yet ... Henry Paulson ... has announced that he won’t even go back to Congress for the second half of the $700 billion already approved for financial bailouts. And financial aid for the beleaguered auto industry is being stalled by a political standoff. ...

What’s really troubling ... is the possibility that some of the damage being done right now will be irreversible. I’m concerned, in particular, about the two D’s: deflation and Detroit.

About deflation: Japan’s “lost decade” in the 1990s taught economists that it’s very hard to get the economy moving once expectations of inflation get too low (it doesn’t matter whether people literally expect prices to fall). Yet there’s clear deflationary pressure on the U.S. economy right now, and every month that passes without signs of recovery increases the odds that we’ll find ourselves stuck in a Japan-type trap for years.

About Detroit: There’s now a real risk that, in the absence of quick federal aid, the Big Three automakers and their network of suppliers will be forced ... to shut down, lay off all their workers and sell off their assets. And if that happens, it will be very hard to bring them back.

Now, maybe letting the auto companies die is the right decision, even though an auto industry collapse would be a huge blow to an already slumping economy. But it’s a decision that should be taken carefully, with full consideration of the costs and benefits — not a decision taken by default, because of a political standoff between Democrats who want Mr. Paulson to use some of that $700 billion and a lame-duck administration that’s trying to force Congress to divert funds from a fuel-efficiency program instead.

Is economic policy completely paralyzed between now and Jan. 20? No, not completely. Some useful actions are being taken. For example, Fannie Mae and Freddie Mac ... have taken the helpful step of declaring a temporary halt to foreclosures, while Congress has passed a badly needed extension of unemployment benefits now that the White House has dropped its opposition.

But nothing is happening on the policy front that is remotely commensurate with the scale of the economic crisis. And it’s scary to think how much more can go wrong before Inauguration Day.

This article has been reposted from Economist's View. The full post can also be viewed on Economist's View.

Does Anyone Know How To Fix This Financial Crisis?

I read a couple interesting articles this morning that I thought I’d share. One article talks about how no one, including President-elect Obama, knows how to fix the financial crisis. The other offers a potential solution that will cost more than $1 trillion. I’ll summarize the two articles below:

The first article was written by Russell Roberts, economics professor at George Mason University, and published in Forbes. In his article, Roberts equates this financial crisis to raising children, saying that each one is different and there is no official manual on how to raise the perfect child. He goes through the measures that have already been enacted, saying how each one thus far has failed miserably. Many people have this belief that Obama will miraculously save the day, but Roberts points out that the only solution Obama has really posed thus far is to offer another stimulus package, and idea that has already been tried and failed. Paulson is lost at this point, and he doubts Obama will be the answer either. He ends his article saying:

“What if doing whatever it takes means doing less, rather than more?

That is the conundrum for Obama and the successor to Paulson. The more options there are, the harder it is to know which one is the right one. The more options you try, the more uncertainty is injected into the economy, and the more cautious are investors and employers and consumers.

Nobody knows what it takes to move the economy forward right now.”

The second article was written by Neha Singh and published by Reuters. This article is about the findings of Paul Miller, an analyst for Friedman Billings Ramsey. Miller has come up with a plan to save the U.S. financial system, and it will cost only $1 trillion to $1.2 trillion in additional capital. Basically, he says that in order to restore confidence and improve liquidity in the credit market, this injection needs to happen. In addition, rather than the investments being made via preferred shares or long term debt mechanisms, Miller thinks that in order for the plan to work the investments need to be common equity injections. The following is a quote from Miller: “Debt or TARP capital is not true capital. Long-term debt financing is not the solution. Only injections of true tangible common equity will solve the current crisis.” Miller says that even his plan will take a few years to fix things.

Obviously these two articles have very different views, but one thing they have in common is that they agree that the solutions proposed or enacted thus far have failed.

Of the two views, I tend to side with Roberts, author of the first article. I think that pretty much we are lost in the forest and going around in circles trying to get out, and as they teach you in Boy Scouts, when you get lost sometimes it is best to wait it out.

Miller’s suggestion, on the other hand, I find completely ludicrous. So instead of the government (i.e., taxpayers) getting preferred treatment for their extremely risky investments into struggling companies, they should settle for common equity investments that would surely lose a ton of taxpayer money? Sorry, but that sounds pretty dumb to me. And I’m certainly not willing to lose $1 to $1.2 trillion of taxpayer money to find out that this crazy idea isn’t going to work. There are a lot of ways that we can help the economy with that kind of money that would have a bigger impact. Besides, there is no way that plan would ever get approved without people rioting in the streets and threatening rebellion. People are already outraged at the current investments we are making into these companies, and if we were to take even lesser terms in exchange, look out. The only people who would support this plan would be shareholders in these institutions, and I don’t think anyone feels bad for them at this point.

Fed Preparing For Another Interest Rate Cut

With inflation concerns now being trumped by the fear of deflation, and the economy still struggling, the Federal Reserve is expected to cut the Fed Funds rate again during their next meeting in December. Kathy Lien examines this closer and shares her expectations in her blog post below.

US consumer prices dropped 1 percent last month, taking the annualized pace of growth to 3.7 percent, which is the lowest level since October 2007. Falling oil prices takes the credit for lower inflationary pressures with gasoline prices tracking the 50 percent decline in crude. Gas station receipts fell a whopping 14 percent and commodity prices have fallen in general, which has helped to push down transportation costs.

Although the core PPI numbers accelerated, core CPI dropped 0.1 percent and we expect it to head even lower. Less price pressure will give the Federal Reserve more room to cut interest rates. We expect the Fed to cut by another 50bp in December, but it is important to note that Fed Fund futures are pricing in a tiny chance of a 75bp rate cut next month.

The housing market continues to be one of the weakest links in the US economy. Housing starts fell to a record low while building permits dropped to the lowest level in close to 50 years. When you have an environment where foreclosures are rising at a very rapid pace, there is no desire by builders to break new ground.

This afternoon, we have the minutes from the latest FOMC meeting at which the Fed cut interest rates by 50bp to 1 percent. Given the continued concern reflected in Bernanke’s testimony to the House Financial Services Committee on Tuesday, the Fed is likely to support further easing.

All of the major currency pairs have been consolidating since the middle of last week and the FOMC minutes could be the trigger for a major breakout.

This article has been reposted from Kathy Lien. The full post can also be viewed on KathyLien.com.

Why Have Homeowners Been Forgotten?

As part of the latest directional shift in the allocation of the bailout funds being managed by Hank Paulson, it seems homeowners have once again been overlooked. The bailout funds which were originally intended to boost the lending markets have now been earmarked to boost bank balance sheets. Paulson and Bernanke seem much more concerned with propping up failing banks than homeowners at this point. Anthony Freed from Your Mortgage or Your Life even goes so far as to call them liars. You can read more about this in his blog post below.

Two months ago, in late September, I penned a piece titled Liars, and the Lying Lies They Are Telling You, which examined just one single publicly available FDIC document from 2002 which shows beyond any doubt that the Feds were not only aware of the problems in the finance industry that have led to near economic collapse today, they were already convinced that there would soon be dire repercussions.

Yet, today we have Treasury Secretary Hank Paulson and his mini-me Neel Kashkari, as well as a host of other top Federal officials, testifying under oath that the threats to our economic security were not immediately apparent until just months ago - hence the gun-to-the-head threats that produced the biggest bailout of private industry in history, while prescribing less governance on the application of those funds than is required to redeem a typical twenty-cent manufacturers coupon for kitty-litter.

Now we will see Barney Frank and others on the Hill posture and shuffle, as they feign attempts to look like they are in control of anything whatsoever, and they will act surprised that they had handed Paulson and his boy a blank check, and they is spending it as they sees fit.

Well, there should be no surprise there if they actually took the time to read the legislation they passed.

Paulson, who is overseeing the bailout program for the Bush administration, changed course and announced last week that the government would not use any of the money to buy rotten mortgages and other bad assets from banks. That had been the centerpiece of the plan when Paulson and Bernanke originally pitched it to lawmakers.

“Our assessment … is that this is not the most effective way” to use the bailout money, Paulson said at that time.

Instead, Paulson said the department would focus on rolling out a capital injection program to pour $250 billion into banks in return for partial ownership stakes in them.

The idea behind the capital injection program is for banks to use the money to rebuild reserves and lend more freely to customers. However, banks do have the leeway to use the money for other things, such as buying other banks or paying dividends to investors. That has touched a nerve with some lawmakers. Locked-up lending is a prime reason why the U.S. is suffering through the worst financial crisis since the 1930s. All the fallout from the housing, credit and financial crises have badly hurt the economy, which is almost certainly in recession, analysts say.

FDIC chief Sheila Bair continues to be the loan voice - I mean lone voice - advocating that some of the crumbs of the Bailout Cake be scattered in the direction of distressed borrowers who are, or will soon be, facing foreclosure.

In a break with the administration stance, Sheila Bair, chairman of the Federal Deposit Insurance Corp., who also will testify Tuesday, recently proposed using $24 billion of the bailout money to help some American households avoid foreclosure. So far, the Treasury Department has pledged $250 billion for banks and has agreed to devote $40 billion to troubled insurer American International Group(AIG Quote - Cramer on AIG - Stock Picks) — its first slice of funds going to a company other than a bank. That leaves just $60 billion available from Congress’ first bailout installment of $350 billion.

As much as I appreciate that there is at least one person in the Federal Government’s ivory tower who has some sense of the pain and heartache that the American Homeowner is facing, even if her advocacy basically ends with the gavel and the conclusion of the hearings.

The hearings may address a lot of things today, but the most important thing they will not address is who is responsible for letting us get into this terrible position in the first place? Are we and the now completely vegetative national press, really expected to believe that no one saw this entire catastrophe heading our way, when a simple Google search will produce hundreds of documents that show that version of the truth is ridiculously false?

In the article Liars, and the Lying Lies They Are Telling You, I featured testimony by Karen Shaw Petrou and others who were sounding the alarm repeatedly, exposing the vulnerabilities to the system posed by the nearly industry-wide use of risk-abatement models that only work in a market that never contracts.

That was a fatal strategy on the part of the financial industry. The notion that Federal Regulatory agencies were not aware of the risks is patently false. From 2002:

“The next panelist, Karen Shaw Petrou, Managing Partner of Federal Financial Analytics, had a considerably different take on the appropriateness of the Basel initiative. Ms. Petrou said that she has significant concern with Basel II, not because the individual pieces of it are necessarily wrong but because “nobody understands how it all works together.”

Ms. Petroustressed that reliance on models on which the Basel rules are based must be evaluated with tremendous caution and a careful look at the bottom line. She also highlighted problems with the operational risk rule. Reputation risk is not included in the Basel definition of operational risk for purposes of determining a capital requirement. As another weakness of the Basel II proposal, Ms. Petrou stressed the difficulty with relying on models.

She suggested that the Basel Committee move forward only with the provisions of the rule on which there is widespread agreement and considerable evidence of immediate need.”

In the article, I half-jokingly asked if any readers happened to know where Karen Shaw Petrou was today, and wheter or not she was available to take either Paulson’s or Bernake’s jobs. Well, a friend from OpenSalon.com - Tom Cordle - was curious enough to follow through, and what he found is gold: More proof that the Federal Regulatory Agencies charged with protecting the economy, the nation, and the American taxpayer from the reckless profiteering that is the nature of capitalism were at best asleep on the job - at worst they were completely complicit in the manufacturing of this crisis.

The long and short of it is - WE ARE BEING LIED TO REPEATEDLY, AND THE PROOF IS AVAILABLE TO EVERYONE - CONGRESS, THE PRESS, AND ALL OF US…

Trillions of dollars of our tax money to bailout foreign investors, and nothing for distressed homeowners but failed programs and broken promises. The bailout money is now being directed to the Credit Card companies and foreign investors, and the icing is that they want us to believe that they never imagined this could happen.

That is a bald-faced lie. The following is subsequent Congressional testimony from Karen Shaw Petrou, this time the pudding is from 2006:

Testimony Of Karen Shaw Petrou

Managing Partner

Federal Financial Analytics, Inc.

Before the Subcommittee on Financial Institutions and Consumer Credit

Committee on Financial Services

U.S. House of Representatives

September 14, 2006

This panel has led the way in recognizing the critical importance of the Basel risk-based capital rules, starting the policy debate in early 2002 with the first Congressional hearings on the rules long before many in the industry realized their critical importance. I was honored to testify then to offer views on the rules at that early stage and am grateful again now to outline ways to modernize the regulatory-capital requirements governing U.S. financial-services firms.

Sad to say, much of what I will say today is what I said in 2002 and at several later hearings on the proposal in the House and Senate. For example, in 2002, I urged the regulators carefully to consider the competitive implications of their rules. The House Financial Services Committee has pressed hard on this point and the agencies are now paying heed to it, but I fear that many aspects of the most recent proposal still do not address ongoing problems raised by the unique nature of the U.S. industry. It is different in many key respects from other national financial-services regimes, and U.S. rules must thus be carefully tailored to reflect U.S. reality.

There is, though, one key difference between 2002 and now: the Basel risk-based capital rules - for better or worse - are final everywhere else but here. Thus, we no longer have the luxury of pushing for a better international Accord. That is now final, and banks around the world will start to operate under it in January of 2007. This means not only that internationally-active U.S. banks will operate under anachronistic capital rules that place them at a disadvantage and that put the banking system at risk - that would be bad enough. However, it also means that foreign firms may have an undue capital advantage with which to enter the U.S. and acquire banks and other financial-services firms. As I said before this panel in May of 2005, M&A by global firms here is fine if it’s a fair fight. It isn’t fine, though, if our domestic institutions are gobbled up by foreign competitors able to engage in “regulatory arbitrage” solely because we can’t make up our minds on our capital standards.

What are the key U.S. financial-system realities that must be kept carefully in mind as new capital rules are finalized? Put very simply, they are:

• We are facing emerging financial risks, most notably in housing and mortgage markets. We can debate all day long if the housing “bubble” will burst or fizzle, but we know for sure that U.S. consumers are highly leveraged and are making use in unparalleled fashion of high-risk mortgage products. The current Basel I rules applicable to all U.S. institutions woefully under-capitalize high-risk assets, creating a regulatory incentive for banks to hold them. Getting the risk right in risk-based capital is not just an issue for model builders. It’s a critical challenge to protect the FDIC and the economy more generally.
• In the U.S. bank regulatory capital rules cover only insured depositories and a subset of parent holding companies. We have a wide range of charter options, the consolidated supervised entity (CSE) importantly among them, that permit astute companies to pick and choose among the charters. Outside the U.S., almost all firms fall under the Basel rules, eliminating much of the competitiveness concerns critical in the U.S. The Basel rules as now finalized may be good, bad or indifferent, but they will apply with few distinctions outside the U.S., ensuring the proverbial “level playing field.” We will have a most uneven one - with dangerous systemic-risk ramifications - if the final U.S. bank capital rules do not reflect our charter and supervisory diversity. The proposed operational risk capital standard is particularly problematic in our competitive and legal reality.
• We have a unique capital requirement, the “leverage” standard proposed now to continue under the Basel IA and II regimes. Advocates of leverage argue that it will counteract possibly risky drops in regulatory capital. However, the leverage standard, while providing false comfort, exacerbates the charter disparities noted above because it applies only to some financial-services players, not to all of them. It is, further, no panacea for the problems in Basel. This panel will well remember the thousands of banks and S&Ls that failed in the 1980s and early 1990s even as the leverage standard applied to each and every one of them.
• We have thousands of banks, savings associations and credit unions - not just the four or five big players that dominate most other markets. Initial plans simply to ignore all but the biggest U.S. banks in the Basel rules have rightly been shelved, but the current proposal still has unnecessary restraints on what size institution may choose which capital regime. Each insured depository and, when applicable, holding company should choose the rules it thinks are right for it, not have that choice defined by its regulators. Supervisors have full powers - actually expanded under the Basel proposals - to intervene and add more capital if they think an institution’s choice is risky.

With these thoughts in mind, I offer and urge the following recommendations related to the Basel rules in the U.S.:

• First, we need to get our rules in place as fast as possible. If we can’t make up our minds on the more complex issues, leave them aside and finalize at least the simpler, “standardized” sections of the rules (revised for U.S. mortgage and other issues as necessary) and the Basel IA requirements. As noted, the current Basel I rules encourage risk-taking because there is no regulatory capital penalty for it. A simple rewrite that better equates risk-based capital to risk is urgently needed, and debate over the fine points of these highly-complex rules should not deter action on their key points on which there is, in fact, broad general agreement.
• Second, we should not cling to the leverage standard in hopes that it will protect us from “undue” capital drops. I very much doubt that risk-based capital under Basel II would drop here in anywhere near the amounts suggested by the fourth quantitative impact study, which was based on top-of-the-cycle numbers and back-of-the-envelope estimates. Putting banks and their holding companies through all of the hoops and all the added expense of the Basel rules and then slapping the leverage standard atop them undermines the entire point and purpose of the Basel standards and - importantly - is far from the guarantee of safety and soundness hoped by those now pushing for retaining the leverage standard. It should be discarded - especially for holding companies - and regulators should rely on their own powers and market discipline to press banks that might consider unwise capital reductions to think again.
• Third, the U.S. rules should not include an operational risk-based capital (ORBC) standard. The Basel IA proposal rightly does not include this and it should similarly be omitted from the Basel II rules. While this will put the U.S. Basel II rules at still more variance with the international Accord, it is necessary because of the lack of any agreed-upon methodology or measurement systems for operational risk. Worse still, a focus on ORBC will distract both banks and supervisors from urgently-needed disaster preparedness and contingency planning - capital is no substitute for back-up systems and advance planning as was made all too clear after September 11 and Hurricane Katrina.
• Finally, we must make up our mind and move forward. All of the benchmarks, caveats, limits and questions in the Basel II rules create wholesale uncertainty about what capital rules will apply when to whom. As noted, U.S. banks operate in the real world of aggressive competitors at home and abroad. We have proposed imposing not only new risk-based capital standards, but also new powers for regulators to buttress these - Pillar 2 - and new disclosure standards - Pillar 3 - to enhance market discipline. Far too little attention has been paid in the current debate to these critical elements of the overall Basel framework - indeed, they are almost unmentioned in the current notice of proposed rulemaking. Rightly structured, however, these two additional pillars will give U.S. regulators all the tools they need to ensure that capital is right for each bank under their purview without forcing institutions into the one-size-fits-all leverage standard, benchmarks, and other constraints on Basel now under consideration.

In conclusion, Basel critics might wish none of this had started and the U.S. could just get back to Basel I as is. This is understandable given all the flaws in the initial proposal and all the problems to which regulators turned a deaf ear for so long. However, it is critical to remember that Basel I as is rewards risk-taking and the leverage standard as is will do nothing to constrain this. It is also vital to remember that major competitors at home and abroad are now or will soon come under a more risk-sensitive capital regime with no leverage standard. Each and every one of these firms is a major force to be reckoned with in the U.S. whether or not it chooses to become a bank under the Federal Reserve’s domain or headquarter itself here.

Thus, Basel II is here like it or not. Charters will be selected and deals done based on it, like it or not. The longer U.S. banks are kept under Basel wraps, the fewer of them there will be under our traditional regulatory framework. The longer Basel I is in place, the riskier our banking system will be - leverage standards now have no meaningful impact on risk other than to encourage taking it. Unless Congress is prepared to rewrite our rules and force all banks - big and small - and all competitors under the same capital regime - a major challenge that would keep Congresses busy for years to come - U.S. banks cannot be the last ones allowed to come under modern, risk-sensitive regulatory capital standards.

This article has been reposted from Your Mortgage or Your Life. The full post can also be viewed on yourmortgageoryourlife.wordpress.com.

Housing Starts And Permits Fall To Record Lows

October brought us, among other things, record lows for housing starts and permits, according to a U.S. Census Bureau news release. Housing starts reached an annual rate of 791,000 in October, the lowest level since the department began tracking starts in 1959, according to a CNNMoney article. Building permits also fell 12 percent to an annual rate of 708,000 in October, breaking the previous low of 709,000 in March 1975, according to the same article. While this is certainly bad news for homebuilders and the economy, it is just what the real estate market needs to eventually recover.

Most people are stuck on how these numbers are horrible things, unable to see past the initial job losses and financial stresses on homebuilders. The truth is that this is 100 percent necessary right now, and the market is doing exactly what it needs to do. There are way too many homes for sale right now and the last thing we need at this time is more homes to add to that bloated tally. We need to cut the amount of new homes being brought onto the market and allow the existing inventory to move. Once the existing inventory gets back to normal ratios, then we might actually begin to see a recovery in the real estate market.

The bad part is that homebuilders are always behind the curve. They stop building too late and they start building too late. This means that, in all likelihood, homebuilders are going to be slow to respond once the need for new housing is already upon us. When that time comes, we are likely to see a run-up in prices on existing housing as buyers are forced into competition for available housing. There is no need to panic, though, if you are in the market for housing, because we aren’t going to hit that point for a long time.

Prices Are On Their Way Down--That’s Good News, Right?

Considering all the bad news in the headlines now, the fact that prices are falling is probably making most people ecstatic. The biggest excitement of course is likely surrounding gas prices, which fell nearly 25 percent last month, according to a Bureau of Labor Statistics (BLS) press release. And while prices of goods other than food and energy actually rose 0.4 percent last month, according to the same report, as the cheaper commodity prices come into play for manufacturers, we are surely going to see these prices fall soon enough. Since Americans, along with the rest of the world, are in penny-pinching mode right now, these new lower prices are a godsend. This good news, though, could quickly turn bad if it gets too out of control.

Of course we like to see prices fall; that means we can now buy more stuff than we could before, and for the most part falling prices are a good thing, especially when they had been inflated so much in recent years. What we have to watch out for is deflation. Deflation can be a horrible thing, and even though you might think it is good, it most certainly is not. Deflation leads to lower company profits, layoffs, business closures, falling wages, loan defaults (deflation increases the real interest rate on loans) and so on. People lose the incentive to spend, and borrowing becomes nearly extinct as borrowers don’t want to borrow and banks don’t want to lend. Deflation can even be the catalyst that pushes a country into a depression, and we know we don’t want to go there again.

Deflation is an extremely scary thing to think about in reality, and the only scarier thing to think about is the fact that we might not be able to prevent it from happening. Typically, preventing deflation has been as easy as lowering interest rates and adding to the monetary supply. Interest rates are already at 1.0 percent, meaning there really isn’t much more room to maneuver. Japan had to deal with their own bout of deflation during their so-called lost decade, and they weren’t able to dig out of it even with interest rates at 0 percent. Sure, there are a few other things that the government can pull out of its sleeve, but again, there is no guarantee that anything is going to work this time around.

If the government is able to help us prevent deflation, it is also possible that they could end up creating another boom and bust cycle. The following is an excerpt from an opinion piece by Gerald P. Driscoll, the former vice president of the Federal Reserve Bank of Dallas, published in the Wall Street Journal:

“The economy now confronts deflationary forces. If past is prologue the Fed will concentrate on those deflationary forces for too long and rekindle an asset boom of some kind. The fiscal "stimulus" being contemplated by Congress could be another economic accelerant. If both the fiscal and money stimulus efforts kick in just as market forces also kick in, we're likely to see another unsustainable boom that will be followed by a bust.”

Either way it seems that we are likely headed for an undesirable outcome. This reminds me of the game Operation I used to play when I was a kid. The smallest mistake in any direction is going to cause all heck to break loose. I don’t know about you, but I sure hope Obama and his new staff have amazingly steady hands.

Bush And Paulson Tell Obama To Clean Up Their Mess

It appears that Bush and Paulson are content to leave their mess for Obama to clean up. Rather than push forward with new initiatives that can help relieve pressure on the financial system, they would rather wash their hands of the situation. Considering the magnitude of our problems, though, the economy might not be able to wait for Obama to take command. Kathy Lien investigates this issue in more depth in her blog post below.

There are increasing signs that the Bush Administration wants to leave the clean up job to Barack Obama.

According to Treasury Secretary Paulson, even though the first half of the $700 billion bailout package is being used up quickly, the Bush Administration will not be asking Congress for the remaining $350 billion.

With 8 weeks to go before Bush leaves office, the current Administration is more focused on wrapping things up than starting new initiatives.

Paulson said it best:

“I’m going to do what we need to do to keep the system strong but I’m not going to be looking to start up new things unless they’re necessary, unless they make great sense” and “I want to preserve the firepower, the flexibility we have now and those that come after us will have.”

This was the same spirit that Bush took at this weekend’s emergency meeting of G20 nations that I talked about this morning. The meeting was a big disappointment as the Group failed to deliver any specific solutions. Instead, they set an action plan for March 31 and another meeting for April 30th. The G20 is clearly waiting for the new Administration to take charge before putting the pedal to the medal. The only question is, will the global economy be able to wait that long.

This article has been reposted from Kathy Lien. The full post can also be viewed on KathyLien.com.

The OECD Employment Projections Look Very Optimistic

The Organization for Economic Co-Operation and Development (OECD) released updated economic projections on several countries late last week, and while some are calling the projections grim, they look extremely optimistic to me. The report projects different economic variables through 2010, but the one I want to specifically focus on is employment. In their report they see the U.S. capping out with an unemployment rate of 7.6 percent in the first quarter of 2010. Considering that we are already at 6.5 percent, and news of mass layoffs keep coming with no end in sight, it is hard to believe that we won’t easily surpass 7.6 percent next year.

The big headline in the papers this morning is the 50,000+ people that are getting laid off by Citigroup, on top of previous layoffs the company has already announced this year. Things certainly are not getting better in the financial industry, and really the outlook is not the great anywhere else, either. If the automakers don’t get a big bailout we will soon see tens--if not hundreds--of thousands more people laid off there, not to mention all the vendors and suppliers who would also be forced to lay off workers. Nearly every industry you can think off, short of medical and a few others, is in belt tightening mode right now, and more layoffs are all but imminent.

The OECD projected the unemployment rate to be 6.5 in Quarter 4 of this year; considering that we are already at 6.5 after October’s announcement, we are sure to beat that number. In addition, we must also remember that the Labor Department has been drastically underreporting jobless claims in initial reports. I blogged about this recently, but if they keep the underreporting ratio intact from the past couple months, we could see up to 200,000 more jobs lost than was originally announced for October. That would be scary, considering that the numbers for November look like they are going to be bad, too. We could very well end up with an unemployment rate over 7 percent by the end of the year, a number the OECD is not projecting us to top until Quarter 2 of 2009. By then we might be over 7.6 percent--who knows?

Really, I don’t see how we won’t top 7.6 percent unemployment before 2010, short of an amazing government intervention orchestrated by President-elect Obama. However, that of course would have its own set of ramifications for us to deal with. This problem isn’t going to get better any time soon, and this recession will be deep and hard felt. We can hope for the best, but just make sure to prepare for the worst. The way people have been talking about this OECD report as being overly grim, I just don’t think enough people truly see the big picture.

How Long Will Labor Markets Continue To Struggle?

The biggest worry most people have during a recession is that they may lose their job. With major layoff announcements happening daily now, the labor market is certainly struggling. But how long will labor markets continue to struggle? Economics professor Mark Thoma looks closer at this dynamic, and offers valuable insight, in his blog post from Economist's View.

How long will the recession last? I don't know for sure, but we may be able to say something about how long labor markets will continue to struggle even after output growth begins to increase. The next two graphs show the unemployment rate and the employment to population ratio since 1948:

Notice that in the last two recessions, unlike those that came before, these measures of labor market performance continue to deteriorate even after the official end of the recession (as dated by the NBER). The delayed recovery can be seen more clearly in a graph of the two series since 1985:

This means that once the trough of the recession in output growth is reached - and we are not there yet - then there will be a considerable period of time before the labor market recovers if this downturn is like the last two. How long of a time period?

Output growth troughs very near the NBER assigned date for the end of recessions:

Focusing on the last two downturns, the trough of the 1990-91 recession was in March 1991. However, the peak unemployment rate wasn't until June, 1992, 15 months later. The employment to population trough was a bit earlier, December, 1991, but it was still 9 months later (and there is a second, slightly higher trough a few months later - see the red line in the second graph above).

The 2001 recession has a trough in November, 2001, but unemployment doesn't peak until 20 months later in July, 2003. The employment to population trough is 22 months later in September, 2003. Summarizing:

Recession	Trough	Unemp Peak	Emp to Pop Trough
1990-91	Mar., 1991	June, 1992 (15)	Dec., 1991 (9)
2001	Nov., 2001	July, 2003 (20)	Sept., 2003 (22)

Thus, once the recession has officially ended, the average number of months until unemployment peaks is 17.5, and the average time until the employment to population ratio troughs is 15.5 months.

So, if the past two recessions are a reliable guide, expect around five quarters or so of additional labor market problems even after output growth turns around.

Is the past a reliable guide? I wish I could answer, but as far as I know the exact reason for the increased time until the labor market recovers observed in the last two recessions is unknown (there has always been some delay, but lately it has increased considerably). One reason could be that labor hoarding has increased due to higher training costs or some other reason. With firms retaining more labor through the downturn and hence more excess capacity than in the past, they can expand output once the recovery starts for a longer period of time without increasing the labor force, or at least not increasing it by much. With employment growing slower than population, and also growing slower than the number of people looking for jobs, the measures above would increase for awhile even after the economy turns around. If firms also install labor saving equipment at a greater rate than in the past as the recovery begins, or if the equipment is installed at the same rate but it is even less labor intensive than in the past, the growth in employment could be even slower. But as I said, even though there has been lots of research into this question, the exact reason for the change in labor market behavior is not known with certainty.

This article has been reposted from Economist's View. The full post can also be viewed on Economist's View.