Libor: The Largest Insider Trading Scandal Ever

Monday, July 9th, 2012

by George Washington’s Blog

Among other things, the Libor scandal is the largest insider trading scandal of all time.

It also shows that the big banks are literally rotten to the core. And see this.

UC Berkeley economics professor and former Secretary of Labor – Robert Reich – explains today:

What’s the most basic service banks provide? Borrow money and lend it out. You put your savings in a bank to hold in trust, and the bank agrees to pay you interest on it. Or you borrow money from the bank and you agree to pay the bank interest.

How is this interest rate determined? We trust that the banking system is setting today’s rate based on its best guess about the future worth of the money. And we assume that guess is based, in turn, on the cumulative market predictions of countless lenders and borrowers all over the world about the future supply and demand for the dough.

But suppose our assumption is wrong. Suppose the bankers are manipulating the interest rate so they can place bets with the money you lend or repay them – bets that will pay off big for them because they have inside information on what the market is really predicting, which they’re not sharing with you.

That would be a mammoth violation of public trust. And it would amount to a rip-off of almost cosmic proportion – trillions of dollars that you and I and other average people would otherwise have received or saved on our lending and borrowing that have been going instead to the bankers. It would make the other abuses of trust we’ve witnessed look like child’s play by comparison.

Sad to say, there’s reason to believe this has been going on, or something very much like it. This is what the emerging scandal over “Libor” (short for “London interbank offered rate”) is all about.

***

This is insider trading on a gigantic scale. It makes the bankers winners and the rest of us – whose money they’ve used for to make their bets – losers and chumps.

The fact that the big banks have committed insider trading on their core function – setting rates based upon market demand for loans – is particularly damning given that traditional deposits and loans have become such a small part of their business. As we noted last week:

• The big banks no longer do very much traditional banking. Most of their business is from financial speculation. For example, less than 10% of Bank of America’s assets come from traditional banking deposits. Instead, they are mainly engaged in financial speculation and derivatives. (and see this)

• The big banks have slashed lending since they were bailed out by taxpayers … while smaller banks have increased lending. See this, this and this

• A huge portion of the banks’ profits comes from taxpayer bailouts. For example, 77% of JP Morgan’s net income comes from taxpayer subsidies

And Libor isn’t the only way in which the banks trade on inside information. As

Robert D. Auerbach – an economist with the U.S. House of Representatives Financial Services Committee for eleven years, assisting with oversight of the Federal Reserve, and nowy Professor of Public Affairs at the Lyndon B. Johnson School of Public Affairs at the University of Texas at Austin – provided points out:

Billions of dollars can be made from inside information leaks from the Fed’s monetary policy operations. One necessary step to stop leaks is to severely limit inside information on future Fed policy to a few Fed employees.

This has not happened. Congress received information in 1997 that non-Federal Reserve employees attended Federal Reserve meetings where inside information was discussed. Banking Committee Chairman/Ranking Member Henry B. Gonzalez (D, Texas) and Congressmen Maurice Hinchey (D, New York) asked Fed Chairman Alan Greenspan about the apparent leak of discount rate information. Greenspan admitted that non-Fed people including “central bankers from Bulgaria, China, the Czech Republic, Hungary, Poland, Romania and Russia” had attended Federal Reserve meetings where the Fed’s future interest rate policy was discussed. Greenspan’s letter (4/25/1997) contained a 23-page enclosure listing hundreds of employees at the Board of Governors in Washington, D.C. and in the Federal Reserve Banks around the country who have access to at least some inside Fed policy information.

Senator Sanders also noted last October:

A new audit of the Federal Reserve released today detailed widespread conflicts of interest involving directors of its regional banks.

“The most powerful entity in the United States is riddled with conflicts of interest,” Sen. Bernie Sanders (I-Vt.) said after reviewing the Government Accountability Office report. The study required by a Sanders Amendment to last year’s Wall Street reform law examined Fed practices never before subjected to such independent, expert scrutiny.

The GAO detailed instance after instance of top executives of corporations and financial institutions using their influence as Federal Reserve directors to financially benefit their firms, and, in at least one instance, themselves. “Clearly it is unacceptable for so few people to wield so much unchecked power,” Sanders said. “Not only do they run the banks, they run the institutions that regulate the banks.”

***

The corporate affiliations of Fed directors from such banking and industry giants as General Electric, JP Morgan Chase, and Lehman Brothers pose “reputational risks” to the Federal Reserve System, the report said. Giving the banking industry the power to both elect and serve as Fed directors creates “an appearance of a conflict of interest,” the report added.

The 108-page report found that at least 18 specific current and former Fed board members were affiliated with banks and

companies that received emergency loans from the Federal Reserve during the financial crisis.

[T]here are no restrictions in Fed rules on directors communicating concerns about their respective banks to the staff of the Federal Reserve. It also said many directors own stock or work directly for banks that are supervised and regulated by the Federal Reserve. The rules, which the Fed has kept secret, let directors tied to banks participate in decisions involving how much interest to charge financial institutions and how much credit to provide healthy banks and institutions in “hazardous” condition. Even when situations arise that run afoul of Fed’s conflict rules and waivers are granted, the GAO said the waivers are kept hidden from the public.

Whether you want to call it crony capitalism, socialism or fascism, one thing is for sure … this ain’t capitalism.

Postscript: Reich says that the only solution is to break up the big banks and reinstate the laws which separate traditional banking from speculation.

Tags: Bank Interest, Banking System, Best Guess, Borrowers, Chum, Economics Professor, George Washington, Gigantic Scale, Insider Trading, Labor Robert Reich, Libor, London Interbank Offered Rate, Market Predictions, Public Trust, Rotten To The Core, Secretary Of Labor, Service Banks, Supply And Demand, Trillions, Uc Berkeley
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Where’s the Collateral? (Smith)

Tuesday, May 1st, 2012

Submitted by Charles Hugh Smith from Of Two Minds

Where’s the Collateral?

A sound system of credit is built on collateral. A doomed system of debt sits precariously on phantom collateral.

The global “recovery” is based not on reducing debt but on increasing it. Nice, but where’s the collateral? The basic idea of debt is that credit is extended based on collateral, i.e. something of enduring, tradable value, or an income stream that isn’t reduced to zero by non-discretionary spending and taxes.

A funny thing happened to collateral like housing equity and financial assets in the past four years–it shrank by trillions of dollars. According to the latest Z1 “Balance Sheet of Households and Non-Profits” from the Federal Reserve, real estate fell by $4.9 trillion since the bubble top in 2007 and owners’ equity lost $4.2 trillion.

Despite the stock market doubling since 2009 and a healthy run-up in the value of bonds, financial assets shrank by $2 trillion as well.

These are non-trivial sums when we consider that collateral is generally leveraged. If a home buyer puts down 20% cash, then that cash collateral is leveraged 4-to-1 in an 80% mortgage. If the buyer puts down 3% (as in an FHA loan), then the leverage is over 30-to-1.

Collateral matters when it comes to assessing the value of the debt. If a bank lists the mortgages in its “assets” column at full value even though the underlying collateral (the houses) has lost much of their value, then the bank is grossly over-estimating the value and security of the mortgage. The bank’s “assets” are based on phantom collateral.

Take away $1 in collateral and you impair $4, $10, $20 or even $30 of debt.

Recall that the vast majority of real estate equity and financial wealth is owned by the top 20%, with the majority of that concentrated in the top 5%. That means the bottom 80% own little collateral to leverage into debt.

How about leveraging income into more debt? Since the top 10% receive almost 50% of the income, and most of the bottom 90%’s income goes to non-discretionary spending and taxes, then only the top 10% have discretionary income that can be leveraged into more debt.

Interestingly, The Wedge between Productivity and Wages by economist Mark Thoma reports that the enormous advances in productivity over the past few decades did not translate into higher wages for the bottom 90%.

I have often addressed income disparity and the evaporation of collateral, for example, Two Americas: The Gap Between the Top 5% and the Bottom 95% Widens (August 18, 2010) and The Housing Bubble Broke the Middle Class (April 27, 2011).

Regardless of the various causal factors, the fact remains that 90% of American households have limited collateral or discretionary income to leverage into more debt. That leaves around 10 million households (the top 10%) with the means to take on more debt–if they want to. Can 10% of the households prop up the entire economy with more debt and consumption? What if the wealthy decline the opportunity to leverage more debt?

We can also ask “where’s the collateral?” of the banking sector. As frequent contributor Harun I. observed about the European banking sector’s phantom collateral:

European banks do not have enough money for deposit redemptions (people withdrawing their cash from the banks) and the only way to get it is to have the European Central Bank (ECB) print money out of thin air thereby devaluing every euro, thereby destroying purchasing power (you get your money but it buys less).

 

And what collateral are the banks providing for these loans? The sovereign debt of countries that are insolvent. Why not sell the bonds to raise the capital that is rightfully owed to depositors so that they could receive their money at par? Why then bond prices would tumble and governments would be forced to borrow at much higher interest rates. But borrow from whom? Insolvent banks that must have money printed to give depositors their money back at a fraction of its worth from when they deposited it. Not due to market forces which indicate their labor is worth less but because everybody just wants what’s rightfully theirs.

 

So to summarize this, the ECB prints money to buy the bonds of insolvent banks which are backed by the bonds of insolvent nations. The result of which is insolvent nations or in reality the people thereof are not only poorer, they are now responsible for paying back money that was their property to begin with… at interest.

Put these two factors together and you get a global economy dependent on debt borrowed against phantom collateral and an American economy in which only the top 10% have credible collateral and income to leverage into more debt. In a sane system, when the collateral vanishes, so too does the debt (writedowns, write-offs, bankruptcy, take your pick). In an insane system, then phantom collateral supports ever greater mountains of debt.

How long do you reckon the insane system we have now will last? The collateral is phantom, but the interest payments are very, very real.

Tags: Balance Sheet, Bubble Top, Cash Collateral, Collateral Recovery, Discretionary Spending, Estate Equity, Federal Reserve, Fha Loan, Financial Assets, Funny Thing, Global Recovery, Home Buyer, Hugh Smith, Income Stream, Leverage, Reducing Debt, Stock Market, Trillion, Trillions, Z1
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Bernanke: Be Humble!

Tuesday, May 1st, 2012

Bernanke: Be Humble

by Axel Merk, Merk Funds

“Humble” is typically not an attribute associated with the Federal Reserve (Fed), especially in light of the trillions of dollars recently printed. Yet, in his latest press conference Fed Chairman Bernanke called for humility: we must be humble in setting monetary policy! The problem is, Bernanke’s definition of the word “humble” appears to be something entirely different from what – in our humble opinion – common sense might expect.

We have previously argued that the only reason the Fed gets away with printing so much money is because that money doesn’t “stick”. Technically, the Fed doesn’t actually print money, but buys fixed income securities with ever-longer maturities (mortgage-backed securities and Treasury securities). To purchase those securities, money is literally created out of thin air; a simple computer entry is all that is required to credit the account of a bank at the Fed in return for the purchase of a security. These purchases are reflected as an increase in assets on the Fed’s balance sheet, with an offsetting increase in liabilities (cash in circulation – Federal Reserve notes – are a liability for the Fed). When proceeds from a maturing security are re-invested, no new money is being created, but the balance stays at an elevated level; as such, when QE1 or QE2 “ended”, the amount of money that had been printed was still in the system. Some economists argue that such policies don’t amount to “money printing” because banks haven’t done much with the money they received (the velocity of money has not shot up). Our response to that argument has been that if you were to give a baby a gun, just because the baby doesn’t shoot anyone, doesn’t mean it isn’t dangerous. So, to us, being humble should focus on being most concerned about the potential side effects of monetary easing.

A key reason why all the money that has been printed hasn’t made it to the real economy is because major deflationary forces are present, as a result of the financial crisis. In our assessment, in the run-up to the financial crisis, the Fed had lost control over the credit creation process. That is, consumers used their homes as ATMs, creating their own money. Similarly, financial institutions found ways to create their own money, e.g. increasing leverage by creating special investment vehicles (SIVs). In the goldilocks economy of much of the last decade, it was only rational for investors to take on more risk, to increase leverage. After all, house prices could never fall. However, starting in 2007, risk came back to the markets. As a result, it became similarly rational for investors to reduce leverage. Unfortunately for investment banks Bear Stearns and Lehman Brothers, they didn’t have sufficient liquid collateral to downsize. Similarly, many consumers buried in debt have been unable to downsize, causing elevated numbers of defaults on their obligations (mortgages, auto payments, credit cards…) It’s because policy makers initially lost control on the credit creation side that we are now witnessing a gargantuan effort to stem against deleveraging, deflationary forces. We believe this is a key reason why, with all the money spent and printed, the U.S. can only generate lackluster economic growth.

In this environment, it’s likely that the Fed can get away with just about anything in terms of monetary expansion. But should these policies work, should all the money that has been printed make it through to the real economy, the Fed may find itself in a tricky situation. Bernanke argues that he can raise interest rates in as little as 15 minutes to contain any inflationary fallout that might occur. In the early 1980s, former Fed Chair Paul Volcker raised rates to 20% to beat inflationary pressures. In those days, people complained, but because there was so much less leverage in the economy, it was bearable. In today’s environment, 6% appears to be the threshold for countries such as Spain before commentators believe the International Monetary Fund (IMF) has to come to the aid of the government. Wait. Paying 6% interest is considered unsustainable? What type of world are we now living in? More importantly, will the Fed have the will to potentially crush the economy in order to contain inflationary pressures? Anyone reading this and even considering that the Fed may hesitate proves that the Fed has lost credibility. Credibility requires the perception that the Fed will not hesitate to beat inflation.

Tags: Amount Of Money, Computer Entry, Fed Chairman, Fed Doesn, Federal Reserve, Federal Reserve Notes, Humility, Income Securities, Maturities, Monetary Policy, Money Printing, Mortgage Backed Securities, New Money, Qe1, Qe2, Simple Computer, Thin Air, Treasury Securities, Trillions, Velocity Of Money
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Is William Cohan Right That Wall Street “Regulation” Has To First And Foremost Curb Greed?

Tuesday, April 10th, 2012

Now that the world is covered in at least $707 trillion in assorted unregulated Over the Counter derivatives (as of June 30, the most recent number is easily tens of trillions greater) and with at least one JPMorgan prop|non-prop trader exposed to having a ~$100 billion notional position in some IG-related index trade, pundits, always eager to score political brownie points, are starting to ruminate over ways to put the half alive/half dead derivative cat back into the box. Unfortunately they are about 20 years too late: with the world literally covered in various levered bets all of which demand hundreds of billions in variation margin on a daily basis, the second the one bank at the nexus of the derivative bubble (ahem $70 trillion JPMorgan) starts keeling over, it will once again be “the end of the world as we know it” unless said bank is immediately bailed out. Again.

As a result William Cohan, in a half-right narrative, suggests that instead of trying to curb derivatives this late in the game, which is a lost cause by definition as the JPMs of the world will simply change the rules to abuse the regulatory loopholes, says that regulation should be geared toward capping the potential of infinite greed to generate next to infinite losses. His suggestion is not to curb financial innovation, but to make “traders and bankers once again financially liable for what they are selling. If that were the case — as it was when Wall Street was a series of private partnerships — financial innovation would once again be revered and help to restore the luster of America’s capital markets.” So far so good. The problem is that even in a private arrangement, those who become TBTF, whether with clawbacks or not, would still abuse the system? Anyone remember all too private LTCM, and how its legal team was frantically begging the Fed and Wall Street to bail them out, in essence launching the modern equivalent of TBTF? The truth is that modern Wall Street does have too much innovation, whose only purpose is to extract as much cash flow from increasingly worthless assets. And once the assets are completely depleted, to create synthetic assets which generate all too real cash flows out of parties close to the Fed.

From Cowan:

Ah, I can hear you scream, didn’t Milken’s junk-bond monsters bring about the stock market crash of 1987, when the Dow Jones Industrial Average lost 22.6 percent in one day, leading to the credit crunch that engulfed the economy from 1989 to 1993? And didn’t Ranieri’s little devils lead to the current financial crisis when one mortgage-backed security after another went into a tailspin? Wouldn’t an FDA-type agency, like the “pre-cogs” in the 2002 movie “Minority Report,” have seen these two train wrecks coming and prevented them?

 

This is beyond ridiculous, for the simple reason that there is no way to deconstruct a financial product before it goes to market to determine whether it will end up doing more harm than good. Yes, the excesses in Milken’s junk-bond market helped cause the speculation in the stock market that led to the Crash of 1987. But both before the crash and most certainly for the last 25 years the junk-bond market has been robust and vital, allowing thousands of companies access to capital while also providing investors with the sorts of risk-adjusted yields they most certainly cannot find in the overinflated Treasury market.

 

Much the same can be said for the securitization market, which worked brilliantly for more than 20 years before credit standards deteriorated miserably in the middle part of the last decade, sending the mortgages tied to them and the entire housing market spiraling downward. Chances are good that as we emerge from the downturn, securitization of mortgages will again be a viable and important market.

 

The problem on Wall Street is not financial innovation per se or the risks tied to untested products. Rather, it is a terribly outmoded incentive system that rewards — with big bonuses — the Wall Street armies who generate revenue by selling the array of new products without any accountability.

 

The key to Wall Street reform is to make Wall Street executives, traders and bankers once again financially liable for what they are selling. If that were the case — as it was when Wall Street was a series of private partnerships — financial innovation would once again be revered and help to restore the luster of America’s capital markets.

Alas, while superficially correct, this merely a case of revisionist history of a story that has ended well. For now. Yes: it took $20 trillion in backstops, cash infusions and guarantees from the central planners to stabilizie the system, but what happens next? What happens when the central bankers themselves need bailing out. After all none other than that modern day champion for all things right, Austan Goolsbee himself was a strong advocate of, get this, subprime back in March 2007. Just read the following sheer idiocy from a man who was Obama’s economic advisor:

When Senator Christopher J. Dodd, Democrat of Connecticut, gave his opening statement last week at the hearings lambasting the rise of “risky exotic and subprime mortgages,” he was actually tapping into a very old vein of suspicion against innovations in the mortgage market.

 

Almost every new form of mortgage lending — from adjustable-rate mortgages to home equity lines of credit to no-money-down mortgages — has tended to expand the pool of people who qualify but has also been greeted by a large number of people saying that it harms consumers and will fool people into thinking they can afford homes that they cannot.

 

A study conducted by Kristopher Gerardi and Paul S. Willen from the Federal Reserve Bank of Boston and Harvey S. Rosen of Princeton, Do Households Benefit from Financial Deregulation and Innovation? The Case of the Mortgage Market (National Bureau of Economic Research Working Paper 12967), shows that the three decades from 1970 to 2000 witnessed an incredible flowering of new types of home loans. These innovations mainly served to give people power to make their own decisions about housing, and they ended up being quite sensible with their newfound access to capital.

 

These economists followed thousands of people over their lives and examined the evidence for whether mortgage markets have become more efficient over time. Lost in the current discussion about borrowers’ income levels in the subprime market is the fact that someone with a low income now but who stands to earn much more in the future would, in a perfect market, be able to borrow from a bank to buy a house. That is how economists view the efficiency of a capital market: people’s decisions unrestricted by the amount of money they have right now.

 

And this study shows that measured this way, the mortgage market has become more perfect, not more irresponsible. People tend to make good decisions about their own economic prospects. As Professor Rosen said in an interview, “Our findings suggest that people make sensible housing decisions in that the size of house they buy today relates to their future income, not just their current income and that the innovations in mortgages over 30 years gave many people the opportunity to own a home that they would not have otherwise had, just because they didn’t have enough assets in the bank at the moment they needed the house.”

And this man shaped US policy two years later? Is it any wonder America’s is progressively collapsing into the worst Depression in history despite optical gimmicks that fool increasingly less of the people, all of the time?

While we agree with Cowan on one part of his analysis, we disagree that financial innovation is reasonable going forward, as all it does is take flawed exit assumptions (yes, the securitization market did work for 20 years but only because it was a hyper-levered bet on one very wrong assumption: that markets and home prices can only go up, and that the cost of money will always go down). And yet it is precisely the flaw embedded in Goolsbee’s simpletonian argument that has also fooled Cowan, and all those other sophisticates on Wall Street: the ability to predict cash flow. Alas, that is now impossible, because the very cash flows depend on the level of future innovation! Yes, there may be a greater fool if even more greater fools pay Facebook $10 billion to buy companies with 13 employees which make photo filters, at a valuation that is about 50 times greater than reasonable. But one day the greater fools run out of money, courtesy of their own capital misallocation decisions. And as shown here before (read How The Fed’s Visible Hand Is Forcing Corporate Cash Mismanagement), it is none other than the Fed which is now the ultimate driver of capital misallocation across the US corporate sector. When predicting the future depends entirely on reading the mind of the central planners at every given moment, what can possibly go wrong?

Well, everything…. as history teaches us over and over. And which lessons humanity, in the pursuit of its own selfish infinite greed interests, always ignores.

Tags: Brownie Points, Capital Markets, Cohan, Daily Basis, Derivatives, Financial Innovation, Greed, Index Trade, Jpmorgan, Jpms, Loopholes, Ltcm, Luster, Nexus, Private Arrangement, Private Partnerships, Pundits, Trillion, Trillions, Variation Margin
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Biderman: Where Are We Headed as a Global Economy?

Tuesday, March 20th, 2012

“Where are we headed as a global economy?” is a question most of us worry about. My best guess is that over time – in years not months – governments will wither away and the underlying global economy will grow and prosper.

How I get there starts with where we are right now. And right now, there are enormous headwinds facing us. The headwinds all have a common theme however.

The governments of the United States, Europe and Japan currently owe trillions of dollars that it will not be able to pay. Part of the un-payable debt is due to the printing of close to $10 trillion of paper the central banks hope and pray will be considered money by their publics. The rest of the un-payable debt is due to promises about future benefits made by these governments to placate their citizens.

That rotten mess sits on top of a global expansion of the ability to produce goods and services wanted and needed by the emerging world. The truly amazing fundamental reality not understood by most is that more people as a percentage of this planets population have achieved calorie sufficiency in the past decade than ever before. That is worth repeating, more people as a percentage of this planets population are no longer calorie insufficient than ever before. Calorie insufficient is a nice way of saying starving to death.

Look at Asia. Broadband has created the possibility of a global economy. With broadband Asian factories can be the low cost producer for the world. Yes, the loss of manufacturing jobs to Asia costs the developed world jobs, but consider how many people have stopped starving as a result.

I am not saying that starvation is no longer an issue, I still contribute monthly to the Global Hunger Project, but what I am saying is that broadband is the communication technology breakthrough that is the best tool ever developed to fight starvation.

To summarize where we are right now is we have a vibrant global economy being stifled by bad governments in the US, Europe and Japan. Maybe the solution is simply removing all those governments and letting the rest of the global economy alone?

Do you know who would be most opposed to such a solution? My guess is the governments and those who are being paid by the government whether in salaries and benefits; as well as all the special interest group parasites.

Let me be emphatic that I am not advocating any sort of physical or even non-physical violence.

A buddy who read this in draft form suggested we need government to act as a monitor and referee to keep the bad guys under control. Maybe we do. But does it have to be called government or could social media take on being the referee and monitor for the globe?

By the way, Happy Anniversary my darling Virginia.

Charles Biderman
President & CEO TrimTabs Investment Research
Portfolio Manager, TrimTabs Float Shrink ETF (TTFS)

Tags: Asian Factories, Best Guess, Central Banks, Communication Technology, Fundamental Reality, Global Economy, Global Expansion, Global Hunger, Governmen, Governments, Headwinds, Hunger Project, Manufacturing Jobs, Planets, Promises, Starvation, Starving To Death, Sufficiency, Technology Breakthrough, Trillion, Trillions
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“This Time It’s Different?” – David Rosenberg Explains The Melt Up And The Latent Risks

Monday, March 19th, 2012

The market is ripping. That much is obvious. What some may have forgotten however, is that it ripped in the beginning of 2011… and in the beginning of 2010: in other words, what we are getting is not just deja vu (all on the back of massive central bank intervention time after time), but double deja vu. The end results, however, by year end in both those cases was less than spectacular. In fact, in an attempt to convince readers that this time it is different, Reuters came out yesterday with an article titled, you guessed it, “This Time It’s Different” which contains the following verbiage: “bursts of optimism have sown false hope before… Today there is a cautious hope that perhaps this time it’s different.” (this article was penned by the inhouse spin master, Stella Dawson, who had a rather prominent appearance here.) So the trillions in excess electronic liquidity provided by everyone but the Fed (constrained in an election year) is different than the liquidity provided by the Fed? Got it. Of course, there are those who will bite, and buy the propaganda, and stocks. For everyone else, here is a rundown from David Rosenberg explaining why stocks continue to move near-vertically higher, and what the latent risks continue to be.

UP, UP AND AWAY!

It has been quite a move up in the U.S. equity markets. The S&P 500 just completed its fifth straight week of gains, the longest streak of the year. From the closing low of last October 3rd, the index has rallied a breathtaking 28%. So far in 2012, the Dow is up 8%, the S&P 500 is up 12% and the Nasdaq is up 17%. Breathtaking to say the least.

What accounts for all this optimism:

• The European LTRO program has obliterated financial tail risks in the region.
• The successful second bailout of Greece.
• Chinese inflation down to 3.2% has fuelled hopes of monetary ease.
• Perceptions that that the U.S. economy is reaccelerating — all the Fed had to do was change “modest” to “moderate” (plus the ECRI leading index has improved to a seven-month high).
• Tentative signs that the secular headwinds are subsiding — housing, credit, employment, local government fiscal restraint.
• Oil prices stabilizing with a calm emerging with respect to Iran.
• Technically, the market is making higher highs and higher lows — a confirmed uptrend.
• Global earnings estimates are no longer going down.
• Financial conditions are easing with corporate bond spreads narrowing sharply.
• The success evident in the Fed’s latest banking sector stress tests — bank
• stocks advanced 9% last week.
• The snapback after the early-March triple-digit decline in the Dow — the first of the year has emboldened the ‘buy the dip’ psychology.

What are the risks?

That we wake up some time in the second quarter and discover that the economy may well have contracted if not for the extremely warm weather we had in the opening months of the year, which provided a huge, if not unprecedented, skew to the data (see Weather Alert: Why the Sun Could Be Bad for Risky Assets on page 14 of the weekend FT).

Remember —January and February were both 5 degrees warmer than usual. For months usually beset by winter weather, the seasonal factors attempt to correct for this by boosting the raw data, which at that time of year are about the lowest given that many folks are snowbound. If not for the seasonal adjustment process, we would only be able to compare the data on a year-to-year basis because there is no apples-to-apples comparison between economic activity in January and what you would typically see in May. So in January and February in particular, the raw nonseasonally adjusted basis get a “bell curve” like we would in school in a tough mid-term exam. The problem this time is that January and February were downright balmy. This wreaked havoc on all the data, especially housing, employment and spending.

We estimate that over 40% of the job gains were weather-related, taking both months into account. We also know that productivity is contracting and 100% of the time in the past decade, companies responded by curbing their hiring. So taking the weather effect into account and the reversal this will have in coming months with respect to the data impact, combined with the likely cooling-off in hiring plans already evident in many surveys, and we could well see the nonfarm payroll numbers get cut in half and come in closer to 100k than 200k as we move into the spring and summer months.

This is not a disaster story at all, but recall that it was this sort of sluggish backdrop that brought at least a temporary end to the equity market rally last year and forced the Fed into more intervention in support of the bond market. Don’t write off QE3 just yet. On top of all that, we do expect to see the trade deficit continue to widen as the European recession and Asian slowdown hit the U.S. shores, and contraction in net exports is going to very likely emerge as a big headwind for the GDP data in the next few quarters. In fact, it is only now starting.

And by the time it subsides later this year, households and businesses will be preparing for next year’s massive tax grab. If logic prevails, this preparation is probably going to include a move to boost savings and raise liquidity (ostensibly at the expense of spending growth — expect the retailers to head into the 2012 holiday season lean and mean).

The weather also had a direct impact on spending by releasing more than $30 billion in recent months in terms of household cash flow from a radically lower utility bill. Absent that de facto tax cut’, and retail sales would have stagnated over the past three months as opposed to rising at what appears to be a healthy 8% annual rate. This will subside now and we have not yet seen the full brunt of $4 gasoline either — many a commentator has stated that the consumer sector is less vulnerable now and there is less of a “shock factor” this time around. We shall see about that.

As it stands, nominal spending at the pumps is at its lowest level since last June — we have not seen the draining impact on household cash flows yet. But we did see the impact on University of Michigan consumer sentiment, which surprised to the downside in a month that saw the Nasdaq head to 12-year highs and employment rip by more than 200k — going from 75.3 on sentiment to 74.3 is largely explained from the rise in gasoline prices.

The IBD/TIPP economic optimism index also slumped to 47.5 in March from the one-year high of 49.4 in February. The components of the recently released March survey data from NY Fed Empire and Philly Fed looked on the soft side, especially order books and production plans. This has also shown up in a recent reversal in President Obama’s approval ratings — so the gasoline impact, with a lag, is only now starting to rear its ugly head.

Keep in mind that even with WTI consolidating, the prices that consumers pay at the pump are on a steady march higher — up 31 cents in the past month to an average of $3.82 a gallon (nationwide) — but already nearly one-third of Americans are paying $4 or higher. What does this then do to the GDP price deflator and hence to real growth — well, just have a look and see what happened in the first quarter of 2011. It’s called stall speed, not escape velocity.

It is unclear just how stable things are in Europe. The ECB has papered over the problems for now but has jeopardized the sanctity of its balance sheet at the same time. The U.K. is seemingly on the precipice of losing its AAA rating status. Then we have Asia. India in a full-blown economic downturn and its banking system is in disarray. And the Chinese economy is now slowing down at a pace we have not seen since the 2009 hard landing. As the U.S. market has been surging, the MSCI China index sagged 2.7% in March —not a constructive signpost for the commodity complex. While this has caused the TSX index to lag the S&P 500, the Canadian dollar has managed to stay above par, in part because the rate-hike that is now being priced into the local bond market (Canadian 2-year note yields now offer a hefty 90 basis point premium to the U.S. comparable).

Back to China for a minute — the country’s A shares are down 3.3% in the past month while the H shares have gained 18%. The Chinese stock market now trades at a 9.9x forward multiple, versus a 15-year average of 12x. So the market there is well valued and the A shares (those listed in China; the H shares trade in Hong Kong) may well be poised to play some catch-up here. Something we have noticed and are definitely keying on.

As for the overall market, our CIO, Bill Webb, likes what he sees in the form of the lingering wide gap between the prevailing return on capital and the cost of capital. Screening for GARP (Growth at a Reasonable Price) and yield remains in vogue. While we are involved in those slices of the market, the major averages have managed to rally to levels above the year-end targets the consensus established at the start of 2012 (of 1,355 on the S&P 500), as was the case this time last year. The S&P 500 has actually risen as much in 2012 so far as it did at this stage in 1998 and when you consider how benevolent 1998 was in terms of fiscal, monetary and economic stability just three years after the advent of the Internet, how can anyone really compare the two years?

What we are seeing unfold really is a liquidity-induced rally that is built on a lot of hope. Neither were required in 1998 — the Fed kept a neutral policy in place for most of that year and there was no need for hope; the growth in the economy was organic and self-sustaining without unprecedented government assistance. Even then, we had a near-20% correction that summer. Nothing moves in a straight line indefinitely and while Bill and the investment team have been tactically bullish for most of this year, we are feeling the need to dial back the risk somewhat near-term given the high levels of complacency and the fact that valuation is less compelling than it was four-six months ago.

For example, the FT cites research showing that the S&P 500 is now two standard deviations above its 50-day moving average, which is far beyond the norm of even an overbought market and in the past this has proven to be a pretty good ‘chill for now indicator. Breadth has also deteriorated of late as the market has scaled new highs, which is often a technical sign that an intermediate top is at hand.

In the name of being ‘tactical’ and ‘nimble’, which is critical in today’s rapid-fire volatile backdrop, getting a little more defensive here is not a bad idea at all. We also remain long-term bulls on gold and commodities, but with the U.S. dollar breaking out and the Chinese data coming in softer than expected for the most part, we have taken on a less ebullient posture for the time being and plan to get more involved at better pricing levels once this corrective phase runs its course. The mining stocks have broken below key support levels here and over the near-term, the chart points are to be respected.

Also keep an eye on the bond market, which has become a bit unglued in recent weeks. Of course, this happens at least four times a year so hiccups like this are really par for the course. And as usual, we are hearing once again how we should all be prepared for the end of the secular bull market in Treasuries. These Wall Street reports come out at least once per year, the latest coming from UBS strategists. When will these people ever learn? In any event, it has been a rocky road as the 10-year note yield spiked 27 basis points last week to a five-month high of 2.3%. This is all part of the global risk-on trade because German bunds sold off just as much, and other assets that tend to do better in risk-off environments, such as gold, also suffered setbacks (the yellow metal lost S50/oz over the week).

Bond yields are not yet at a level to upset the equity market apple cart, especially with the yield on the banks improving so much in one fell swoop. But if we approach 3% on the 10-year note then we could start to see the stock market pay some attention — it’s not so much the level, as the change, and at a time when gasoline prices start to really pinch the consumer (driving season is right around the corner), rising borrowing costs are not going to provide a very constructive backdrop.

Tags: Bailout, Canadian, Canadian Market, Cautious Hope, Central Bank Intervention, David Rosenberg, Dawson, Deja Vu, Election Year, False Hope, Latent Risks, liquidity, Nasdaq, Optimism, Perceptions, Reuters, Rundown, Spin Master, Time After Time, Trillions, Verbiage, Year End
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Ten-Year Treasury Yield Breaks Above 200-DMA

Thursday, March 15th, 2012

by Bespoke Investment Group

Following a pretty sizable move in interest rates, the yield on the 10-Year US Treasury (2.22%) is now above its 200-day moving average for the first time since last July.  Granted, 2.22% is still low by historical standards, but it still doesn’t negate the fact that the US government has seen its borrowing costs increase by 12% in a week.  When your borrowing amounts are measured in trillions, every little basis point counts.  For every trillion the government borrows, a one basis point increase in interest rates translates to an extra $100,000,000 in annual borrowing costs.

Copyright © Bespoke Investment Group

Tags: Basis Point Increase, Bespoke Investment Group, Dma, interest rates, Moving Average, Nbsp, Trillion, Trillions, Us Government, Us Treasury
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LTRO 2: Goldman’s Take

Wednesday, February 29th, 2012

Goldman waited exactly 20 minutes to try to comfort the market, especially the EURUSD which is getting increasingly jittery, that €1 trillion in Discount Window borrowings is a “positive.” We beg to differ that trillions in more debt collateralized by candy bar boxes and condoms will cure an excess debt problem, especially with all the good collateral now gone, and we are confident that ongoing deleveraging needs will put a major cog in the system, especially since the only liquidity expansion move now is “fade”, at least until the next major crisis.

Banks take out ECB “funding insurance”

The ECB has today – through its long-term refinancing operation (LTRO) – fully allotted €529 bn of 3-year funds to 800 banks. Together with the first auction, the ECB has now injected €1 trn of 3-year funds into the system. This is an extremely high amount and equals, for example, 131% of total (249% unsecured) European bank bond maturities in 2012 and 72% (130% unsecured) for 2012 and 2013 combined. European banks are now effectively pre-funded through to 2014.

Funding stabilized, revenues supported

Large take-up is an important positive. Key reasons are: (1) banks are now largely insulated from shocks in the funding market, having prefunded through 2014; (2) consequently, the costs of bank and sovereign funding have now been detached; (3) pressures for forced deleveraging should reduce (first evidence of this is visible in the recent ECB loan data); (4) deposit pricing pressures should fall (this too is already taking place), resulting in a positive revenue effect.

Country aggregates in coming weeks

While the focus is on the aggregate take-up, we see country aggregates as arguably more important. Over the course of the next weeks, we will get disclosure of country aggregates where we expect the Spanish and Italian take-up figures to be high.

ECB’s actions expand the investable group

We derive our group of ‘investable’ banks by: (1) incorporating P&L effects of ECB action; and (2) overlaying these estimates with ‘extreme’ credit losses (as per the EBA stress test). Within this group, our Eurozone top picks are Erste Bank, BBVA, BNP Paribas (all Conviction Buy), and Intesa Sanpaolo (Buy).

We identify banks likely to be “disproportionate beneficiaries” of the ECB LTRO including: Banesto (Buy), Banco Popular Espanol (Not Rated), BancoPopolare, Banca Monte dei Paschi di Siena and UBI Banca (all Neutral).

Tags: Aggregates, Bn, Borrowings, Candy Bar, Cog, Condoms, Debt Problem, ECB, European Banks, Eurusd, Excess Debt, First Evidence, Goldman, Key Reasons, liquidity, Loan Data, Maturities, Shocks, Trillions, Trn
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European Nash Equilibrium Collapses – Bank Bailout Stigma Is Back At The Worst Possible Time

Tuesday, February 7th, 2012

In all the excitement over the December 21 LTRO, Europe forgot one small thing: since it is the functional equivalent of banks using the Discount Window (and at 3 years at that, not overnight), it implies that a recipient bank is in a near-death condition. As such, the incentive for good banks to dump on bad ones is huge, which means that everyone must agree to be stigmatized equally, or else a split occurs whereby the market praises the “good banks” and punishes the “bad ones” (think Lehman). As a reminder, this is what Hank Paulson did back in 2008 when he forced all recently converted Bank Holding Companies to accept bail outs, whether they needed them or not, something that Jamie Dimon takes every opportunity to remind us of nowadays saying he never needed the money but that it was shoved down his throat. Be that as it may, the reason why there has been no borrowings on the Fed’s discount window in years, in addition to the $1.6 trillion in excess fungible reserves floating in the system, is that banks know that even the faintest hint they are resorting to Fed largesse is equivalent to signing one’s death sentence, and in many ways is the reason why the Fed keeps pumping cash into the system via QE instead of overnight borrowings. Yet what happened in Europe, when a few hundred banks borrowed just shy of €500 billion is in no way different than a mass bailout via a discount window. Still, over the past month, Europe which was on the edge equally and ratably, and in which every bank was known to be insolvent, has managed to stage a modest recovery, and now we are back to that most precarious of states – where there is explicit stigma associated with bailout fund usage. And unfortunately, it could not have come at a worse time for the struggling continent: with a new “firewall” LTRO on deck in three weeks, one which may be trillions of euros in size, ostensibly merely to shore up bank capital ahead of a Greek default, suddenly the question of who is solvent and who is insolvent is back with a vengeance, as the precarious Nash equilibrium of the past month collapses, and suddenly a two-tier banking system forms – the banks which the market will not short, and those which it will go after with a vengeance.

The WSJ has more on this very subtle but so very critical shift in the European bailout game theory equilibrium:

A group of top European banks is disclosing that they didn’t borrow money under the European Central Bank’s bank-lending program, fearful of being perceived as bailout recipients.

The broad participation in the program, known as the Long-Term Refinancing Operation, fueled a sense of euphoria among many bank executives and investors that the worst of the Continent’s two-year banking crisis was over. In a second batch of loans in late February, analysts expect the ECB to distribute as much as €1 trillion in additional funds, partly because the central bank is making it easier for banks to borrow.

But some bankers and observers are starting to warn about unexpected fallout from the ECB’s loan program. A top concern among banks is that the receipt of central-bank lifelines could subject them to potential political or regulatory interference and sully their ability to declare themselves free of any outside help. That sentiment has the potential to damp demand for future ECB loans, at least among the Continent’s strongest banks.

In other words, the market is finally waking up that the LTRO, more than merely carrying the upside of a mechanism preserving the status quo for a brief period of time, also has the downside of implicit stigma associated with any and every bank that is found to use it. And the punchline here is that the second a European “Jamie Dimon” emerges and starts touting their lack of need to use LTRO cash, the whole plan collapses. It appears that Deutsche Bank, the bank whose assets are 80% of German GDP, is just that equilibrium collapse factor.

It isn’t yet clear how many banks declined to borrow but the list includes Deutsche Bank AG and Barclays PLC. While the ECB doesn’t divulge which banks borrowed, most companies are expected to disclose the information as they release annual results this month.

“The fact that we have never taken any money from the government has made us, from a reputation point of view, so attractive with so many clients in the world that we would be very reluctant to give that up,” said Josef Ackermann, Deutsche Bank’s chief executive, explaining to analysts last week why the German lender didn’t borrow from the ECB.

Mr. Ackermann said Deutsche Bank still is scarred from its experience borrowing from the Federal Reserve in the first phase of the financial crisis in 2008. U.S. regulators encouraged banks to borrow under the cloak of promised confidentiality, but when the banks’ identities were subsequently disclosed by the Fed, the recipients were dubbed bailout recipients. “We learned a lesson,” Mr. Ackermann said.

Other bank executives privately have voiced similar opinions. Some of that sentiment is likely to surface publicly in coming weeks as banks report annual results and executives face questions from investors about whether they borrowed from the ECB.

English banks are also suddenly scrambling to portray themselves as healthy:

In the U.K., the Financial Services Authority informally encouraged the banks to tap the ECB loan program, although the regulator also made clear that the decision was up to the individual banks, according to executives with several British banks. The goal of the FSA, shared by other European regulators, was to promote broad use of the facility and reduce any stigma associated with borrowing, said people familiar with the matter.

A number of top British banks, including Barclays, Standard Chartered PLC and Lloyds Banking Group PLC, opted not to borrow from the ECB, according to people familiar with the matter.

Beyond the implicit, there are explicit risks associated with being bailed out:

“Those heavily reliant on ECB funding run risks of interference as a price for continued support. This may come to be seen as a form of nationalization,” said Simon Samuels, a European banking analyst at Barclays Capital. He said bank executives are likely to worry that regulators will view their dependence on ECB funds as a sign of a broken business model and will pressure them to restructure operations.

Such concerns are peripheral for banks that potentially were going to have trouble refinancing maturing debt at nonpunitive prices. Virtually every major French, Spanish and Italian bank borrowed billions of euros from the ECB, according to bank disclosures and people familiar with the matter. Among those was Banco Bilbao Vizcaya Argentaria SA, Spain’s second-largest lender by assets, which borrowed €11 billion, the bank’s president told analysts last week.

Some healthy banks also pounced on the opportunity for inexpensive three-year funding. HSBC Holdings PLC was among those that borrowed even though it didn’t need the money, according to people familiar with the matter. Any profits the British bank reaps from investing the borrowed funds will be segregated from HSBC’s bonus pool, one person said.

Yet all these considerations pale before the reality that any banks that borrows even €1 on February 29 will suddenly be perceived as a lower-tier performer, when faced with banks that parade with their “fortress balance sheet.” And as everyone knows, bail outs only work when everyone agrees to be bailed out. Otherwise, it is a shortcut to collapse. Because the last thing Intesa and UniCredit and STD and a whole lot of not so healthy banks will want on March 1 and onward is to be put in the “bailout recipient” category when so many others clearly no longer need the cash…

It appears that European banks, in their vain attempts for short-term capital gains, may have just sealed the fate of the entire financial sector.

Tags: 3 Years, Bank Bailout, Bank Holding Companies, Banks, Borrowings, Capita, Continent, Death Sentence, Excitement, Functional Equivalent, Hank Paulson, Jamie Dimon, Largesse, Lehman, Nash Equilibrium, Qe, Reminder, Stigma, Trillion, Trillions
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R.I.P. Fed Dollar Swap Intervention: Central Bank Liquidity Injection Half Life Two Weeks

Wednesday, December 14th, 2011

As noted two weeks ago when predicting the efficiency and duration of the latest global coordinated USD liquidity injection, we had a sinking feeling the Fed action would have a very brief time span. Sure enough, judging by the action in two critical FX liquidity indicators – the 3M and 1 Y basis swap indicators, the dollar shortage is baaaaack… only this time, very paradoxically, with implied infinite backstopping from the Fed: if even that factor no longer has an influence on the market’s perception of liquidity risk we are in very deep trouble. Which of course is to be expected: the gross synthetic dollar short back in 2007 was $6.5 trillion. Add a few years of ZIRP to this, where the USD is also the funding currency of the world, and one can see why the global USD short position currently is in the double digit trillions. So just how will the Fed backstop $10+ trillion in explicit USD shorts? We can’t wait to find out.

3 Month Euro Basis Swap now almost back to pre November 30 global bailout levels:

… but the real action now is in the 1 Year Basis Swap which is back down to December 2008 levels.

Tags: 3m, Backstop, Bailout, Bank Liquidity, Basis Swap, Currency, Deep Trouble, Dollar Bank, Duration, Efficiency, Euro, Gross, Half Life, Liquidity Risk, Perception, Short Position, Time Span, Trillion, Trillions, Zirp
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