Finance
The Myth Of A Good Jobs Number
Look at these headlines!Job growth surges, jobless rate drops to 8.3 percent (reuters)WOW! Things really must be getting better! 243,000 jobs, 8.3% rate.
Unemployment rate falls to 8.3%; fifth straight monthly decline (LA Times)
Obama team trumpets good jobs numbers (USA Today)
US Jobless Rate Falls to 3-Year Low, Report Shows (NY Times)
Snap analysis: Job creation accelerates broadly (Reuters)
Or are they? Hmm.. well that all sounded good right? But what about the data behind those numbers? Things like labor force, participation rate, employment/population ratio... Shh.. those are too complicated for the newspapers and TV news! Besides, you're a good American right? Can't be talking things down in an election year!
Source:BLS.gov
HOUSEHOLD DATA
Summary table A. Household data, seasonally adjusted[Numbers in thousands]Category Jan.
2011Nov.
2011Dec.
2011Jan.
2012Change from:
Dec.
2011-
Jan.
2012
Employment status
Civilian noninstitutional population
238,704 240,441 240,584 242,269 -
Civilian labor force
153,250
153,937 153,887 154,395 - Participation rate
64.2 64.0 64.0 63.7 - Employed
139,330 140,614 140,790 141,637 - Employment-population ratio
58.4 58.5 58.5 58.5 - Unemployed
13,919 13,323 13,097 12,758 - Unemployment rate
9.1 8.7 8.5 8.3 - Not in labor force
85,454 86,503 86,697 87,874 -
So what really has happened in the past year? Well the civilian noninstitutional population rose 3.6 million. The civilian labor force rose 1.1 million. The participation rate FELL 0.5 percentage points. The employment to population ratio rose 0.1 percentage point to an abysmal 58.5%. Finally, those "not in labor force" rose nearly 2.3 million, an astounding 1.1 million in the last month alone.
So for the math challenged, the trick here has been to reduce the size of the labor force at a rate greater than the increase in number of persons employed. Presto chango you get a declining unemployment rate which makes the lede on every news report.
Of course, the reality is far different. What would the top line unemployment rate had been for Jan. 2012 if the participation rate were the same 64.2% as Jan. 2011? Hmm... 8.9%. How about if the participation rate were what it was in Jan. 2009 (65.4%)? 10.6%. Jan 2002 (66.2%)? 11.7% !
And of course, there is the other game that is played - seasonal adjustments. The fudge factor. One can avoid this too by looking at year over year unadjusted figures. For instance, Dec 2010/Dec 2011 and Jan 2011/Jan 2012. Using that method we have Dec'10 9.1%, Jan'11 9.8%, Dec '11 8.3% and Jan'12 8.8%
Splitting the difference, a drop of 0.9%. Wait.. did you say a drop? But...
The partipation rates also dropped - 0.3 pts Dec/Dec and 0.5 pts Jan/Jan. In fact, Jan 2012 is the LOWEST labor force participation rate in the past decade at 63.4%. This is reflected by the 2.6 million increase in 'not in labor force' over that same time frame. In fact, you must go back to pre-1984 to find similar rates. However, the trend at that time was upward from the 57.5 to 58.0% of the late 1940s to late 1960s when women were a smaller part of the work force. the peak at 66.1% in July 1997. On an annual basis 67.1% was the peak rate and ocurred in 1997-2000. From 2004-2008 the rate was 66.0. The other ratio, employment to population peaked at 64.4% in 2000 after spending the late 40s through 1970 either side of 56%. January 2012 saw this figure drop to 57.8%, last seen in 1983 and not far off from those Nifty Fiftie's rates.
Sorry to rain on the parade, but yes, things still really do suck.
Operation Twist?
So Ben Bernanke is running amok again, this time promoting operation twist. Why not call it operation mango? Or better yet, operation FOTS (fuck over the savers)? Because this latest adventure in ruining the empire is going to do nothing to help create jobs, pay down personal debt, create demand or help those on a fixed income.Who does it help? Why, the Federal Govenment of course. Secondarily the banks and non-bank financials. The real issue for the Treasury and the Fed is that the debt held by the public (never mind the fraudulent social security 'trust' fund) is $10 trillion and growing over 10% per year. Every basis point decrease in interest rates directly benefits the budget of the US.
For instance, as of 8/31/11 there were approximately $1.5T in bills outstanding with an average rate of 0.1%, an interest cost of $1.5 billion. A 100 basis point increase (1%) equates to a cost of $15B. At a more normal level of 3% - one which offers a positive real return when compared to even the understated cpi - the US is "saving" $45B per year in interest costs. And that is just on bills which are about 15% of the portfolio (held by the public.) Note that in Oct. 2005, the average on the Treasury's bill portfolio was 3.6%.
It gets more complicated when looking at notes and bonds due to the mix of TIPS as well as where on the curve issuances fall. Again, using 10/2005 as an example of a more 'normal' market, the average rate on notes has dropped from 3.8% to 2.3% and on bonds from 7.9% to 5.8%. So far in 2011, the Treasury has auctioned about $293B in two year notes through August at an average rate of 0.5% and put on a full year basis, about $439B at 0.375%. In 10/2005, the average rate on 2yr notes was 4.27%. Lets be kind and go back to 08/2004: 2.5%, a savings of 2.125% or $9B. A more realistic level would probably be just a touch over bills, maybe 3 3/8% for a $13B savings.
The Tresury rolls over or issues new about $32B in 3's, $35 in 5's, $30 in 7's, $22B in 10's and $13B in 30's every month at total of $132B/month, or $1.6T on a full year basis. Add in the 2's and we are about $2.4T a year. While the front end of the yield curve is near 0%, the curve itself has moved down fairly uniformly and for back of the envelope calculations we can apply a reduction of 200bp across the board to the 2-30 year debt. This is a savings of about $48B per year. In fact, the savings is cummulatively far more than that as older notes with far higher coupons have been replaced the past three years.
This discussion has only focused on a comparison of rates today to what I perceive to be more normal rates of 2004-2005. Of course, one could argue that there may come a point where rates shift dramatically higher (look at 1994 for an example). There is no guarantee that domestic and foreign buyers will continue to suck up the flood of issuance by the Treasury and at some point the Fed's balance sheet will be able to take no more. What would a world of 5% 2 year paper or 8% 10's look like? Not a happy one at all.
August 2011 NonFarm Payrolls
Lots of ink has already been spilled over this dismal number. I thought it might be interesting to take a longer term view of what has been going on. The chart below shows a rolling 12 month average of non-seasonally adjusted employment data from BLS indexed to July 1973=100 and with the actual or estimated US resident population growth for comparison.I was somewhat shocked to see that the Federal government is no larger than it was in 1973! However, the chart clearly shows the big problem is out of control state and local employment growth. There is no reason for state and local employment to grow faster than the actual rate of population growth and in fact we would argue the rate should be far lower than a 1:1 ratio. Bad news indeed - just a question of when the municipal bankruptcies begin. click to enlarge the chart
The shift in population around year 2000 is because the Census bureau did not revise their previous estimates of montly populations between 1990 and 2000 thus there is a discontinuity.
Wa! Waa! Waaa! I Wanted To Play Fed!
Zero Hedge this morning reproduced the entire NYT Op-Ed by Peter Diamond, an Obama nominee for Fed governor - and a Nobel prize winner too (and don't you forget it!) Mr. Diamond used the Op-Ed to announce he is removing himself from consideration because of those mean partisan Republicans in the Senate. Some out takes:The leading opponent to my appointment, Richard C. Shelby of Alabama, the ranking Republican on the committee, has questioned the relevance of my expertise. “Does Dr. Diamond have any experience in conducting monetary policy? No,” he said in March. “His academic work has been on pensions and labor market theory.”
...
In my Nobel acceptance speech in December, I discussed in detail the patterns of hiring in the American economy, and concluded that structural unemployment and issues of mismatch were not important in the slow recovery we have been experiencing, and thus not a reason to stop an accommodative monetary policy — a policy of keeping short-term interest rates exceptionally low and buying Treasury securities to keep long-term rates down. Analysis of the labor market is in fact central to monetary policy.
...
Senator Shelby also questioned my qualifications, asking: “Does Dr. Diamond have any experience in crisis management? No.” In addition to setting monetary policy in light of a proper understanding of unemployment, the Fed is responsible for avoiding banking crises, not just trying to mop up afterward.
Among the issues being debated now is how much we should increase capital requirements for banks. Selecting the proper size of the increase requires a balance between reducing the risk of a future crisis and ensuring the effective functioning of financial firms in ordinary times. My experience analyzing the properties of capital markets and how economic risks are and should be shared is directly relevant for designing policies to reduce the risk of future banking crises.
Rich isn't it? How horrible that the Republicans would question a) the worth of a Nobel prize in the ivoriest of ivory tower academic fields to managing the nation's banking system and unfortunately, monetary policy too and b) the nominee's lack of any real world banking or regulatory experience.
Further - and I'm sure this will fly right over the head of the progressives and others such as Krugman (by far the most dangerous man in the world now that Bin Laden is dead) - it is not partisan for Republicans to decide a nominee is undesirable if his research focus has been on the element of the Fed "dual mandate" they consider to be less important at this time. Is it really out of the mainstream to consider monetary inflation a prime threat to the economic well being of the vast majority of Americans today and down the road? Nor is consideration to the fact the nominee has no substantive experience outside of academia yet seems to feel not only is he qualified to determine "how economic risks are and should be shared" but that the Fed should be making these decisions for the country. There we have not just an issue of competency but one of philosophy too, not partisanship.
Please send Mr. Daimond a nice hand towel to wipe his tears away... and someone please send us one too to wipe away our tears of laughter his Op-Ed brought us.
China and the IMF
Well, well. Shouldn't come as a surprise when the loan shark starts asking for favors after you show up to borrow more and more money each day. So no surprise that China is making it clear that they do not want the next IMF head to be European and definitely notAmerican given the extent to which they backstop not just the US but also the EU."The composition of senior management should better reflect changes in global economic patterns and represent emerging markets," said Zhou Xiaochuan, the head of the People's Bank of China. No Chinese officials figure in the list of possible candidates to lead the IMF, although some analysts and media commentators in China have suggested that Zhu Min, a special adviser at the fund, could take the helm.Source:Reuters
But listen to our political leaders and central
Albany: Still Out of Touch With Reality
This morning there was a wire story reporting on the attempts by the new governor of New York state to reign in spending and the enormous current budget deficit (words defy the out year deficits.) One could say that this is a start:"I was shocked to learn that the state's budget process is a sham that mirrors the deceptive practices I fought to change in the private sector," Cuomo said, referring to Wall Street abuses he challenged in his previous job as New York's attorney general.Source:Reuters
"The budget process is a metaphor of Albany dysfunction: special interests dominate the process with little transparency; programs continue with no accountability and the taxpayers get the exorbitant bills. The greatest challenge --and opportunity -- in this year's difficult budget is to expose this chronic problem and reform it once and for all," he said in the essay.
Cuomo called for replacing automatic increases in the budget on various items with a more reasonable formula, contending that if education and Medicaid rose only at the rate of inflation, there would be only a $1 billion deficit.
But lets be honest here - this barely moves the needle. In total, the budget will be 2.7% lower. Ironically, a NY Daily News story headlines it as a '10% cut'. How? Because Cuomo apparently reduced the rate of increase of some programs by 10%, i.e. from +13% to +3%.
What is really disheartening is that this is Cuomo's greatest chance to effect real change. He complains that many programs, education in particular, have built in increases of up to 13% per year(1) yet can only see fit to reduce the rate of their increase. If those increases have been in the cake for years, if not decades, and they are wrong today were they not also wrong yesterday? If education did not deserve a 13% increase last year, why not cut the education budget by 13% (or more) this year?
Cuomo should instead lay out a two year budget that will cut spending by at least 25% and bring it to the people of the state - on TV, radio and in person and vow to veto any budget in excess of that amount. Instead, Cuomo has just put a compress on the wound - the patient is still going to bleed to death, just a little slower.
Quantitative Easing For Dummies
This little video by Malekanoms pretty much says all you need to know about QE I and II:QE2: What Is A Dollar Really Worth?
There has been a lot of talk the past few weeks (mostly negative) regarding the Federal Reserves latest disaster, QE2 (Quantitative Easing 2) whereby the Fed will buy US Treasury obligations (and who knows what else) and print money to pay for them. The theory goes that money will then eventually be lent by banks to corporations and consumers rather than hording the balances. Of course, this disregards the fact that the Fed now pays interest on bank reserves.Left unsaid of course is why interest rates at near zero on the short end and only a few percent on the very long end are not sufficient to spur economic growth on their own. This would appear to be inconsistent with conventional economic thought but maybe what is needed is a Francisco D'anconia on the Federal Reserve Board:
"Check your premises. There are no such things as inconsistencies"The reader should consult Ayn Rand's Atlas Shrugged if they are not familiar with the phrase.
The premise the Fed is using is that our economic woes are largely due to the lack of money in the banking system. We would argue that instead a better premise is 'Low interest rates are largely to blame for our economic problems."
On area where a negative effect of low interest rates, slow (if any) growth and large debt shows itself is in the value of the US dollar. It has again slumped on the international exchange markets and in fact the average person bears witness to its continued decline every time they go to the supermarket, gas pump, department store or pay for their child's education. The Fed and the US government live in a fantasy world where prices are stable or declining, not the everyday reality seen by over 300 million consumers.
A small but growing segment of the population, including some economists and legislators, have begun to push for the return to the constitutionally mandated monetary system: gold and silver. For a very long time all our currency was backed by gold or silver which could be requested on demand by presenting the paper note to the proper bank/authorities. For all intents we left this system under Roosevelt in the 30s (only silver backed dollars) and any last vestiges were eliminated in the early 70s when the US dollar was allowed to float freely and not officially backed by anything - hard money was replaced by fiat money.
But what if we returned to that system today? What would the dollar be worth? This is a difficult question as one must decided what shall be the base (gold? silver? some combination or some other metal?) and then how many dollars are we applying that too? (total debt? public debt? money in physical circulation?). For the sake of argument we elect to use gold as the monetary base and the public debt outstanding as the quantity of dollars that monetary base must support.
At this time the US has 261.5 million troy ounces of gold in reserve (we assume for argument sake that they do in fact exist) and a public debt of $9.14 trillion. At a market rate of $1,200 per troy ounce the US gold reserves are 'worth' only $313.8 billion. Dividing this by the public debt outstanding gives 0.034, or looked another way, each ounce of US gold reserves must support 29.1 times its worth. Looked at this way, each dollar in your wallet is only really worth a little over 3 cents.
Are We Back?
It has been a very long time since the last post on this blog, for any number of reasons. Today there is a new post. Whether that means there will be many more, I do not know. Does it mean the posts will be on a regular schedule? Again, I do not know. We'll see how it goes. Same goes for the topics. Stay tuned. The RSS feed might be the easiest way to check up on things.Are we there yet?
Everyone wants to know.... have we found a bottom yet in the stock market? Last October we wrote that a break of the 7400-7500 on DJIA would be critical and should see a move towards 5800. The past few sessions have seen the market bouncing around the 6500/6600 level so we are certainly close, if not quite at 5800. On the economic front, it seems to us that there really isn't a lot more to shock to the downside - the market expects unemployment to continue to rise and sees no immediate turnaround in GDP either in the US or abroad. The failure to see another dramatic sell off after the payroll report last Friday shows the market has reached some degree of equilibrium.But there are still other events which can drag the averages down. There is some justified fear of another round of credit crunch, perhaps from problems in the commercial real estate market, perhaps from insurance companies selling bonds which have been downgraded. Perhaps both. However, what we see as the big cloud over the stock market and corporate earnings is pension plans. The market went through a scare not too many years ago about underfunded pension plans and the effect they would have on corporate earnings. For awhile the market suffered but an improved economy brought sunnier thoughts. Should the market once again focus on the need for many companies to add funds to their pension plans at a time when capital is scarce it would not be at all surprising to see the DJIA on a 5,000 handle, if not testing 5,000. This go around there does not seem to be an economic corner to be quickly turned to allow the accountants to say 'never mind!'
This is not to say the accountants still can't play around with the numbers. They most certainly can as the pension rules are convoluted - firms can take averages over many years, have 'contribution holidays' and muck about with discount rates. This may buy time in the short run but if the stock markets do not make a dramatic turnaround the clock will run out and those firms with underfunded plans will be in quite a bit of trouble. Merril has been on top of pension obligations and they are estimating over $35B in pension expenses for 2009 - figured when the averages were considerably higher. What is worse is that if there is a shift out of stocks and into bonds, the capital shift could be in excess of $200B. More frightening still is most of these plans have assumed returns in excess of 8% a year yet government bonds are at record low yields (for now), well below that 8% bogey. And a certain portion of their equity assets are not just paper loses but instead are never to return - AIG, GM, BS, LEH, etc.
But that is just a small tidbit of the pension nightmare. This time, Wall Street may actually pay attention to the underfunded plans of states and local municipalities. Now we are talking some real dough! As an example - the principal retirement funds for New York State have fallen over 50% (no surprise) - $60 billion. While a decade of stock market 'growth' has been erased, has a decade of pension obligations? What of California, a third world basket case of a state which can't seem to keep its regular budget short falls from exceeding the GDP of many small nations. How will it meet its generous public employee pension obligations?
The good news? Well the total capitalization of the US stock market is roughly $7.9 trillion per the Wilshire 5000 index. So there is still money to be found by selling stocks for those who need to raise cash. The bad news? The market cap has dropped by over $10 trillion since the fall of 2007. No wonder everyone is feeling so poor!
Are You Stimulated Yet?
We left the below comment on another blog in response to a post on the stimulation our government plans for us:Well if they count everything we will be approaching a 4, yes FOUR, trillion dollar federal budget. The first $1T budget was in 1987. $2T came in 2002. $3T came in, your choice 2006,07,08 as much of the war spending was not 'on budget'. Tack on $900 B and we are at $4T. Note that 30 years ago, in 1979 the budget was about $500B.
This year federal spending will be close to 28% of GDP. The prior, non-WWII peak was 23.5% in 1983. And to put these in perspective, in 1930, Federal spending was 3.4% of GDP, in 1950 15.6%. Is the problem really that the government is now spending too little?
There are two problems at the moment. Unsustainable spending on entitlements and the prevailing need "to do something". We all know about the first. The second though is left in the dustbowl of history - FDR (and Hoover before him). Contrary to popular belief, the massive post 1929 crash / depression time spending did little to change the picture. They were also suffering from the 'we have to do something' problem. While there was an initial rebound in the economy in 1934-36, things tanked again in 37 and 38 with unemployment going back to 1934 levels. Spending however increased 6% in 1930, 8% in 31, 20% in 32, 42% in 34 and 28% in 1936. There is no clear link between the massive increases in spending and resultant changes in gdp and employment.
[UPDATE 2/4/09:From the wires this morning, the Treasury Dept. said it will need to borrow $493 billion during the current January-March quarter, a record amount for this period, following actual borrowing of $569 billion in the October-December period, the all-time record.]
A bit rough and dirty, but the basic points are there. Very large spending programs by the government in dire economic times have historically not had the effect their proponents claim they would have. At best the New Deal spending is a mixed bag and some might argue the 1937 tank was in part a result of knock on effects from the massive stimuli. The current economy has already seen a huge stimulus - a few hundred billion directly to taxpayers under Bush and about $500B in aid to the financial industry. Interest rates are near 0, though that may apply more to the return investors are getting rather than the rate borrowers pay, assuming they are able to secure the financing they desire. We have long maintained that the ZIR policy followed by Japan in the 1990s through today has hurt and prolonged their economic slowdown and we feel the same will be true of the Fed version. We also believe that the end effects of the government running the printing presses at full speed will be inflation (not deflation) and eventually new bubbles. Are there any doctors in high places in our government? Primum non nocere!
We do not, however, summarily dismiss all government spending nor all the new spending proposed by the new Administration. Our highways require significant maintenance as do our many state controlled roadways and bridges. If well monitored, spending in this area will be worthwhile, but is not likely to provide any short term stimulation to the economy. Increased funding to our national labs, in particular to the physical sciences and technologies, will ultimately pay significant dividends both to the economy and our knowledge... just down the road a bit. But these are things which should be addressed in normal, continuing resolutions and not emergency spending bills. These are investments, not stimulus.
Our current spending is unsustainable. At some point our creditors will pull the plug and/or our currency will devalue significantly. The government is on track to become an ever larger percentage of the economy and we all know that the government does very little well. The entitlement bogey man must be addressed, the sooner the better. However, if our politicians feel they absolutely must, must do something now! we recommend significant tax credits for the formation of new (not realigned) businesses. Giving people an incentive to start a business and hire employees is a far better way to go.
Retail Sales & Payrolls: Don't Panic!
The headlines sure are shocking this morning! Retail sales plunge again in November! Down 1.8% from October and 7.4% from November 2007 !!! The sky is falling, details at 11pm! Unemployment claims surge again!Well stop and take a deep breath. Now we are not going to tell you things are peachy for the economy but we will try to bring some sanity to the headline numbers. Lets start with the retail sales figure as here we use the figures from the release. On a seasonaly adjusted basis (we aren't fond of these but its the only way to compare month on month):
US Retail Sales as Reported 12/12/08
| ItemNov 08 | Oct 08 | Nov 07 | |
|---|---|---|---|
| Total Sales | $355,655 | $362,035 | 384,099 |
| less Gas Stations | $32,653 | $38,274 | $41,875 |
| Net | $323,002 | $323,761 | $342,224 |
| Change | -0.23% | -5.62% | |
| less Autos | $51,637 | $53,736 | $71,461 |
| Net | $271,365 | $270,025 | $270,763 |
| Change | +0.50% | +0.22% |
Wait! You mean.. taking out gas station sales leaves November nearly flat compared to October? Who would have thought plunging gas prices might overstate the decline? And.. oh no.. this can't possibly be! Ex-gas stations and Ex-Autos... retail sales were actually up not just on the month but the year? Shocking! Of course lost sales in the auto industry is not good either, but by excluding them we see the rest of the economy is flat but not off a cliff. (This should be a lesson too on the upside - things were never quite as great as made out.)
As to the non-farm payroll and weekly claims reports - two points come to mind. First, there had been a large disconnect between the job losses over the past year as reported by the household survey (used for the unemployment rate) and the non-farm, corporate supplied data - roughly 2 million jobs. We suspect much of the recent drops (including revisions) to the more official non-farms data reflect a catching up and ties in with the recent increases in claims, our second point. Its our opinion that much of the recent jump in claims and the non-farm are because both (former) employees and employers were not yet able to file for unemployment insurance or report jobs as lost until severance payments had run out. Thus we think much of this large bump relates to the many cuts announced last spring and summer and is not necessarily an acceleration in the present time frame. Others announced layoff plans this fall and those may still be in the data pipeline, so the headline numbers are likely to grow but we may be closer to the end than the beginning of the major layoffs.
Its Official: Stocks Worse than 73-74
This was quite a day in the financial markets. US Treasury bond yields hitting record lows and prices rising at a record pace. First time claims at a 16 year high. Another late day swoon in the equity markets. And swoon they have. It can now be said officially: The bear market of 2007-2008 is worse than that seen in 1973-1974. During that very unmemorable period, the S&P 500 index declined from a peak of 121.74 in January, 1973 to a low of 60.96 in late September, 1974 - a decline of 49.93% over 21 months. It then rose about 50% off the lows during the following 9 months and by early 1976 was trading only about 15% below its 1973 peak ... for the next 18 months. All told, the index traded over 4 years in a range of -25% to 0 compared to its peak before finally making a new high in July 1980. The chart below shows that period.
The bear market of 2007-2008 (lets hope it doesn't continue into 2009!) has now seen a drop of 51.9% in the S&P 500 index over a 13 month period - greater and faster than 73-74 and rivaled only by the 1929 crash (in the US). Graphically:
Finally, the view from 1965 thru late 2008:
As a bonus for those of you into BDSM, here is a view of the DJIA from 1928 until 1965. It took over 25 years to regain the 1929 high with over 15 years spent at under 50%.
CDS Insanity
Lest you be lulled to sleep by the daily 400+ point swings in the DJIA, word comes yesterday of new insanity in the capital markets. Bloomberg is reporting that Credit Suisse and Citi are now using credit default swap rates to determine rates on corporate loans. Yes, there were reports of unidentified pigs flying over NYC last night. So now future loan agreements will have rates decided not as a spread to LIBOR based on a firms credit rating and a thorough analysis of its balance sheet by bank loan officers but on the whims of an illiquid derivative market which is prone to bouts of extreme panic.How does this all work? Cited in the Bloomberg report is the case of FirstEnergy:
FirstEnergy, with utilities in Ohio, Pennsylvania and New Jersey, agreed this month to link interest rates on a $300 million credit line to the cost of Libor as well as the sum of the spread on its default swaps and those of Credit Suisse, according to a regulatory filing. Loans from the Zurich-based bank would require total interest payments of about 6 percentage points over Libor if the power company draws on the bank line, according to regulatory filings and Bloomberg data. That's almost 14 times the spread on a $2.75 billion credit line the company negotiated in 2006.So not only is the rate dependent upon their own 'rating' in the CDS market, it is also dependent upon how the market views the default risk of Credit Suisse. What kind of nonsense is this? The borrower should pay more because the market thinks the lender more likely to default?
The utility would pay Libor plus 3 percentage points to draw on the line, according to company filings. Based on yesterday's levels, FirstEnergy would be charged an additional 1.70 percentage points, reflecting the levels of its credit- default swaps, and another 1.35 percent to account for the bank's own spread, according to Scilla. Pricing on the loan will change as Libor and the swap spreads on Credit Suisse or FirstEnergy move. Source: Bloomberg.com
The game here seems to be the banks wanting to appear to provide a credit facility, while in fact, offering nothing. As the only time most firms need these lines are in times of economic or market turmoil, CDS spreads are likely to have increased dramatically for both the borrower and lender. As an example of the former, consider what happened to many insurance companies at the beginning of October. Not only did the CDS rates for Hartford, Metlife and Lincoln National blow up to 500 bp, they went to trading on an upfront basis requiring prepayment of from 500 to 1100 bp. Those rates are now down dramatically, though still at elevated levels of 300-400 bp. "Normal" might be measured in the 10s of basis points. Would any of these companies have been able to draw on these lines at the start of October? This realization has led a number of companies, such as Nestle, to demand caps be in place in exchange for accepting these new terms.
This move to using CDS as the basis for loan terms will also open another Pandora's box of speculation in CDS contracts. There is already a perception that CDS have been misused by speculators who were short equity to help force bankruptcies by driving up the cost of funding for a company to impossible levels. Having revolving loan agreements also tied to CDS will remove the last fire wall against this type of activity, perhaps even opening the door for another company to push a competitor under. It really is shocking that after the near meltdown of the capital markets this fall that we should move deeper into the unknown while the original fires are not yet out.
How Low Can It Go?
The sigh of relief which the world equity markets breathed earlier this week just became a gale force wind pushing prices back near last week's lows. Most technicians look at variants of bar charts or candle charts of various durations for guidance on market direction. Less so the point and figure chart and even rarer the percentage change point and figure chart. The beauty of pf charts are the clarity they bring by consolidating market movements. Below are a few charts we made at StockCharts.com tonight of both the Dow Jones Industrial Average as well as the S&P 500 index. Each box represents a move of 3 ⅓% and reversals occur when direction changes by three boxes (10%). The first two charts include the daily high and low to determine how many up (X) and down (O) boxes to draw. The latter charts use only the daily closing price and the change from day to day to calculate which, if any, boxes to draw.It looks to us that a break of DJIA 8100 again should see a test of 7500-7500 area (these days perhaps within hours). Looking at a longer dated chart, this is a very key level and provided support in 1997 and 1998. A break would open up significant more downside, with 5700-5800 looking to be the objective. Eeek! The serious break level in the S&P is about 790.
A Solution To The Credit Crisis
No matter which way you turn, somebody has serious problems with the Paulson 'bailout' plan as proposed and amended by the house and senate. Our own view is that the situation is too far gone to just let the chips fall where they may. But we also agree that the Paulson proposal has serious flaws and may not work at all. We would like to propose a far simpler plan which addresses the immediate problem while also attempting to protect the taxpayers.The Financial Gedanken Experiment
- Immediate elimination of mark to market accounting for those assets which were originally booked as 'hold to maturity'.
- Immediate formation of a Mortgage Trust to purchase, at historical cost, up to $1.5 trillion of mortgage securities and associated securitizations such as CDOs
- If purchases by the trust fund are oversubscribed, it shall fill orders uniformly based on the largest percentage of total assets which absorbs the fund and no single firm placing more than $100B until all others have had their entire request fulfilled.
- The Mortgage Trust will hold to maturity for the benefit of each institution the securities tendered.
- Each institution shall be responsible for any net loss, accounting for recoveries, on securities sold to the Mortgage Trust.
- Each institution will pay back any net loss amortized over a period of 20 years, payable in full at any time.
- Each institution participating in the program agrees they will not pay any dividend on common stock or new preferred shares until such a time as their account with the Mortgage Trust is cleared and any losses are repaid.
- Each institution agrees no top managers will be paid more than $500,000 in salary per year and any bonus shall be in equity with a value of no more than $1 million at the date of the award with 50% of any shares restricted until the account with the Mortgage Trust is cleared and fully settled.
- Each institution shall pledge its remaining assets against its obligation to the Mortgage Trust.
So what does this plan accomplish? First off, it recapitalizes the financial institutions by allowing them to book their non-impaired hold to maturity securities at historic cost as was done pre-Enron. Second, it allows them to remove from their books impaired securities or those which are not yet impaired but likely to be in the near future. But it is not a free ride. Unlike the Paulson plan(s), the taxpayer is not on the hook for the losses. Instead, each firm participating will be required to make good on the net losses over a 20 year period. By allowing a lengthy period, the government enables the firms to continue their normal operations without a gun to their head of a single large payment due in a short time. However, to accelerate the process, no dividends will be paid to shareholders thus preserving cash which can be used to pay off these debts. Likewise, the mega bonuses of the past will be eliminated. It would be in the institutions best interest to clear these obligations as soon as they are financially able so as to once again pay their shareholders dividends as well as have more flexibility with executive compensation. As a backstop, the government will have first claim on the assets of any firm unable to meet its obligation to pay the ultimate losses on the securities sold to the Mortgage Trust.
This, to our thinking, is a far better way to proceed. It frees up significant capital immediately, allows firms flexibility in whch assets to sell, allows firms to spread potential losses out over a long period of time if need be, allows the government to receive any income paid on the securities, puts the firms on the hook for any future losses, and places some constraints on the institutions to prevent 'rewarding' bad management. All these combined will allow firms to go back to normal operations (lending) and eliminate much of the counter party fear gripping the credit markets.
Beyond this initial proposal, which we see as the most pressing, we would enact a follow on which looks to some of the other problems. We wouldn't dally too long here either:
- Restore the uptick rule.
- Complete ban of naked shorting except by a market maker providing liquidity to facilitate an investor purchase.
- Institutions selling total return swaps are not exempt from the uptick or naked shorting restrictions.
- No shorting of any stock with a price under $15.
- A complete investigation and review of the credit ratings agencies.
What remains is the issue of credit default swaps. This is a bit more tricky. The most significant problem with CDS are counter party capitalization and pure speculation. As CDS are at their heart insurance, institutions selling these contracts should be regulated in a manner similar to existing insurance operations. This would prevent a holding company taking excessive risk underwriting CDS contracts without commensurate capital in place. Likewise, it would also prevent hedge funds from being a writer of CDS as few, if any, have sufficient capital to make good on any contract which is exercised.
Speculation in CDS must also be addressed. The current notional outstanding far exceeds the debt they are written against. Simply put, too many people have an economic interest in seeing companies fail and thus default on their debt obligations. Going forward, restrictions can be put in place which required the buyer of CDS to own the underlying security and in the same amount. That, however, does not eliminate the looming present day problem. With no better solution at hand, we are inclined to suggest the nullification of all contracts where the purchaser does not own the underlying. Contracts would be settled at original cost with all periodic and up front payments returned to the buyers, with interest. This is preferable to allowing the sellers of the CDS contracts the opportunity to cherry pick those contracts they wish to negate. It is hardly a beautiful solution but we see no other practical way of eliminating this very large ticking time bomb.
Paulson's Fantasy
Those in the world of finance have seen things happen in the past 10 days which they never could have imagined. The Fed/Treasury pulling the plug on Lehman Brothers, before the market did so, an extortionist 'bail out' of AIG, money funds breaking a buck, 20-50% moves in some financial stocks (over $10), and now to top it off, comes Paulson with his 'plan'.A few choice items from the Pauly Plan:
Authority to Purchase.--The Secretary is authorized to purchase, and to make and fund commitments to purchase, on such terms and conditions as determined by the Secretary, mortgage-related assets from any financial institution having its headquarters in the United StatesSo lets take a look at this. Paulson is going to 'designate' certain financial institutions - who were probably either a holder or seller of the various bad debts and derivatives - to act as his agent. We assume this shall be to buy, hold auctions and value these securities. And of course, pocket what will likely be some substantial fees.
Necessary Actions.--The Secretary is authorized to take such actions as the Secretary deems necessary to carry out the authorities in this Act, including, without limitation:
(3) designating financial institutions as financial agents of the Government, and they shall perform all such reasonable duties related to this Act as financial agents of the Government as may be required of them;
Sec. 5. Rights; Management; Sale of Mortgage-Related Assets:
(b) Management of Mortgage-Related Assets.--The Secretary shall have authority to manage mortgage-related assets purchased under this Act, including revenues and portfolio risks therefrom.
The Secretary’s authority to purchase mortgage-related assets under this Act shall be limited to $700,000,000,000 outstanding at any one time
Sec. 8. Review:
Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.
For purposes of this section, the following definitions shall apply:
(1) Mortgage-Related Assets.--The term “mortgage-related assets” means residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages, that in each case was originated or issued on or before September 17, 2008.
Paulson will also manage the portfolio of assets the Treasury buys. We wonder though, where will the expertise come? Does the Treasury Dept. have on hand staff who are versed in RMBS, CMBS, CMOs, CDOs, CDO2, CPDOs? Or will Paulson fall back at his agents at Goldman Sachs or JP Morgan to value these assets? And wasn't that the root of the problem? And by the definition above, Paulson can buy all of those and probably a few other things nobody has heard of yet.
The press keeps bleating about this being a $700B bailout but in fact, it can be much larger. Paulson will be allowed to keep $700B at any one time on his books. So as some paper matures or is sold, he will be able to buy more distressed assets.
Perhaps the most offensive portion of the Paulson proposal is his coronation as Financial Emperor of the World. Nobody, not even the Spanish Inquisition, may ever challenge any decision he makes going forward with this plan.
But the most glaring error in this whole plan - what makes it a complete fantasy - is that he has no authority to force anyone to sell things they do not wish to sell. Will Paulson show bids sufficiently high to attract selling interest? After all, if a bank or other investor has been holding a CDO tranche they believe will be worth at least 40 cents (or perhaps much more), why would they hit Paulson's 10 cent bid when they chose not to hit the same already? And why, if a firm has already written down as unrealized loss or impaired 70,80 or 90% of an asset, would they sell it to Paulson and then lose any upside while turning an unrealized loss into a realized one?
The Paulson plan, just like all prior actions by the Fed, SEC and Treasury Department, is too little, too late, ill conceived and reactionary. As it stands now, it will have limited, if any, positive effect.
AIG - Q3 Expectations and Capital Needs
We've spent the past few days trying evaluate AIG's 2nd quarter report and use it as a basis for a guesstimate of what may be on tap for Q3. From our perspective there are four primary issues:(1)CDS portfolio valuationWe note up front that our modelling methods are very crude and at best ballpark approximations as we relied heavily on the Markit ABX-HE indices as well as AIG's conference call and 10-Q presentations. The ABX-HE indices are synthetic CDS based on a pool of 20 underlying CDOs of the same credit grade issued in the prior six months. In the case of the AAA ABX-HE tranche, it is well known to be one of, if not the lowest rated AAA (it is longest in duration of the AAA's). To address this short coming, Markit has added PENAAA tranches which are one step higher up.
(2)Investment portfolio valuation
(3)Liquidity Needs
(4)Dividend
AIG's CDS portfolio is (notionally) concentrated in the regulatory capital relief area which for all intents has been and should remain nearly risk free. The problems have been in the multi-sector area, particularly those swaps on CDOs with subprime or alt-a collateral. AIG stopped writing these multisector CDS in the first half of 2005 and much of the portfolio was written on 2004 and earlier collateral. Thus, using the ABX-HE-2006-H1 index is, at best, only a very rough approximation. There is also the question of subprime vs alt-a collateral, though that seems to be a matter more of degree of correlation. In addition, we have made assumptions that those credits which are on watch for downgrade will only be moved down one notch this quarter.
As a test, we modelled AIG's CDS losses from Q1 and found our estimate to be about 15% too high - again, not surprising as we are using an index weighted for 2005 H2 collateral against a portfolio written against 2004/2005H1 CDOs. Adjusting for this overshoot, we come up with these figures for Q3:
We estimate the current marks as of 8/18 are $1,300B
If current price trends continue but no collateral is downgraded, we estimate unrealized losses of $2,100B
If current price levels hold and all collateral currently on watch is downgraded, losses of $6,500B
If current price trends continue and all collateral currently on watch is downgraded, losses of $7,100B
For purposes of the CDS estimates, we assumed that the downgrades were distributed by grade as in the Conf Call Supplemental pg 10.
By 9/30, assuming the collateral on watch is all downgraded, fully 60% of AIG's CDS portfolio will have been marked to A credit or lower. From a valuation perspective, the underlying collateral has been written down to near nil. At this stage it becomes pointless to try to estimate Q4 marks as there will be little 2005 exposure left and we will be guessing what, if any, of the 2003/2004 swaps remain to be hit with no easy reference valuations.
Keep in mind, the above figures are all unrealized losses, or as AIG likes to call them, economic losses. AIG does modelling for this very complex task and have estimated ultimate realized losses of $5B to $8B. Their model and assumptions have come along way since 2007 and appear to be very conservative. For example, in coming to the $5-8B figure, they assume virtually all mortgages that become delinquent will be foreclosed.
Our best guess is that the CDS will suffer on the order of $5B in marks this quarter, similar to Q2 and less than our $6.5-7.1B worst case scenarios, primarily as we expect most, but not all, of the collateral on watch to be downgraded.
The investment portfolio is a similar beast but with most of the risk in 2006 and 2007H1 RMBS. Ironically, while one half of AIG was selling protection the other was going without. We have applied a similar methodology to the RMBS portion of the investment portfolio as we used for the CDS - the various ABX-HE indices. Again, at best those indices are ball park proxies for reality.
Based on downgrades through 7/31 and assuming 2/3 of the $6.1B on watch negative are downgraded one step with 90% AAA and 10% AA:The problem for both the investment portfolio and the CDS portfolio is not so much that the market values for any particular credit grade deteriorate but that collateral be downgarded. The drop from AAA to AA is a cliff, as is from AA to A on the older 2005 collateral. Once again though, these are only unrealized losses at this stage. In fact through July, only two tranches of the Markit indices have suffered any writedowns - 2006-BBB-H2 and 2007-BBB-H1 of about 5% in each. Realistically this will go up as homes go through the foreclosure process but considering the level of subordination in the RMBS portfolio we would only expect very small, if any losses in the Alt-A and subprime paper. The area we see as more likely to have a loss (though not large in absolute terms) would be the prime loan RMBS where subordination is only 2-3%.
Based on CMBS portfolio also showing same level of marks as Q2 of $400M
Based on Jumbo/Foreign MBS showing slightly worse than estimated Q2 marks of $1B
Based on HELOC and 2nd Lien already reflecting significant downgrades
We estimate (whether reflected as OTTI or unrealized loss) marks of $5,305B +/- 15% ($4,500-$6,100B)
But what of AIG's liquidity needs? This is currently the subject of much chatter in the market and it seems most of it from shorts. Since Q1, AIG has raised a total of $23.5B in new capital. But what have the used and what looms ahead?
AIG has posted collateral of $16.5B thru Q2 against CDS, up from $9.7B in Q1.
We expect this to rise in line with expected losses in the portfolio. Taking our 2nd worst case of $6.5B marks, expect collateral posted to climb to $23B. This would be a use of $13.3B
2a-7 puts. They have issued a total of $11.3B notional including $7.5B from a commitment made in 2005. Of this, they purchased $917M in Q2 and have taken loss reserves of $810M. The buyers of the puts have agreed to provide liquidity for up to $8.5B of which $3.2 is in use. No effect except the balance sheet enlargement.
CDS with over collateralization provisions resulting in accelerated payment: Roughly $8B notional in total of which $1.5 (6 securities) have had such defaults and $103M has been purchased at par (1 security). The majority of the $8B notional is not multisector w/subprime. Additional needs: $1.4B
Ratings Agency Downgrades. Would result in $14.5B additional collateral demands against the GIA's for a 2 notch downgrade ($13.3 for one notch, $10.5 if only by one agency). Prepayment risk of $4.6B - $5.4B on contracts subject to early termination but unlikely due to the forfeit of large economic benefits. Additional needs: $14.5B
Income from operations: $2.9B per quarter or $5.8B total which reduces need for capital.
AIG had cash from operations of $16.6B for 2008 H1
AIG has revolving credit lines, some with one year add-ons which total $9.2B
Adding that all up, AIG has already used or is expected to use about $23.4B of capital through Q3, including the potential of a ratings agency downgrade.This would leave them in the same position as the end of Q1. However, unlike Q1, the swap book has for all intents been kicked to the scrap heap. It -more-
