Thursday, December 31, 2009

More Jobless Claims Confusion

This morning's diminished jobless claims report was celebrated by various CNBC staffers and guests. Later this afternoon, a guest host, Vince Farrell, closed the midday program by carefully lecturing viewers that this news portended a strengthening economy, and all would now be well.

Talking your book, Vince?

Here's another view of the data, with details on Rick Santelli's favorite, "emergency benefits." It's Mark Gongloff's Wall Street Journal piece in this morning's edition, entitled "5.6 Million Reasons to Doubt Jobless Rate."

"The way jobless claims have been receding should signal that U.S. unemployment has finally peaked. That probably isn't the case this time.

The Labor Department releases data on new claims for unemployment benefits on Thursday. Economists estimate claims rose to 455,000 in the Christmas week from 452,000 the prior week.

Holidays make it tricky to seasonally adjust claims. Many economists instead focus on the four-week moving average, which irons out weekly fluctuations.

Fortunately, that average has fallen steadily, from a high in April of 658,750 to 465,250, a 29% drop.

Since the Labor Department started tracking weekly jobless claims in 1967, such declines have signaled an unemployment peak. In fact, by the time this average has fallen by 29%, unemployment already has topped out, typically about six months earlier.

History suggests October's 10.2% unemployment rate was the worst of it, which would do wonders for the sustainability of the economic recovery. It also would mean the Federal Reserve raises rates sooner than investors expect.

So why do most economists still think unemployment has further to rise? Part of the blame goes to the unusually stubborn nature of joblessness in this recession.

The number of workers drawing regular benefits has fallen, from a record 6.9 million in June to just over five million. But instead of finding jobs, most of those people have exhausted regular benefits and joined the rolls of people drawing extended and emergency benefits.

That number has swelled from 2.8 million in late June, when regular continuing claims peaked, to 4.7 million in early December. That extra 1.9 million matches the number of people no longer drawing regular benefits.

Those people already are counted in unemployment. Another 5.6 million aren't: That is the number of people who have given up looking for work and no longer drawing benefits and thus aren't counted in the labor force or in unemployment, which is the jobless percentage of the labor force.

When they start looking again, as they typically do in recoveries, they will rejoin the labor force, competing with the roughly 9.9 million people drawing benefits. That alone will raise the unemployment rate again."

Pretty scary, isn't it? It harks back to my post on this nuance last October.

The 4.7 million additional workers who burned through conventional jobless benefits, and are now drawing "emergency benefits," is what Rick Santelli of CNBC has been noting with alarm recently. This has become a sort of hidden tax in the form of silently extended jobless benefits which you and I fund, with, of course, printed or borrowed, not value-created money.

Santelli's, and Gongloff's points are, this aging of unemployed on extra-long benefits adds some worrisome detail to the otherwise positive-sounding news that overall new claims are down.

Look, nobody in their right mind has ever said 2009 would be a year of extreme US economic decline. After the recession which officially began in December of 2007, eventually, the rate of decline would ease. We may even be at a point of cessation of growing unemployment.

But a healthy economy involves actually adding workers. Despite Vince Farrell's assertions, that's not what today's report indicated. Farrell grossly misinterpreted the data.

Then we come to Gongloff's last point, and mine in the older post. Thanks to carefully-defined terms, the government can avoid including 5.6 million formerly-employed Americans who are no longer "looking for work," and, therefore, able to be uncounted as unemployed.

Another statistical sleight-of-hand which makes things look much better than they really are.

We may have neared a point of maximal unemployment, in terms of newly-idled workers. But it's unlikely, thanks to a number of governmental missteps handling the recent financial crisis and recession, we have seen the last of rising unemployment. And we certainly are very far from actually seeing unemployment decline through new hires.

Gongloff- and Santelli- are correct. We should view these allegedly rosy jobless claim numbers suspiciously.

Regarding Goldman's Questionable Deals

Long ago, in the time of John Whitehead's tenure as CEO of Goldman Sachs, the firm had a policy of not competing with its customers, nor, in effect, acting in its own interests apart from them.

How the world has changed, as described in this article, sent to me by a friend, which appeared yesterday in McClatchy's online edition.

Entitled, "Investors could only lose in Goldman's Caymans deals," it would seem to mark a new low in the ease with which Goldman will saddle its clients with losses as it knowingly takes the other side of the deal, if only indirectly through side bets via swaps with third parties.

Perhaps not since the audio tapes of Bankers Trusts' derivatives salesmen detailed their wanton of customers whom they considered to be stupid, and said so, has such explicit evidence of an investment or commercial bank's callous attitude toward its customers come to light.

According to the article,

"McClatchy has obtained previously undisclosed documents that provide a closer look at the shadowy $1.3 trillion market since 2002 for complex offshore deals, which Chicago financial consultant and frequent Goldman critic Janet Tavakoli said at times met "every definition of a Ponzi scheme."

The documents include the offering circulars for 40 of Goldman's estimated 148 deals in the Cayman Islands over a seven-year period, including a dozen of its more exotic transactions tied to mortgages and consumer loans that it marketed in 2006 and 2007, at the crest of the booming market for subprime mortgages to marginally qualified borrowers.

In some of these transactions, investors not only bought shaky securities backed by residential mortgages, but also took on the role of insurers by agreeing to pay Goldman and others massive sums if risky home loans nose-dived in value — as Goldman was effectively betting they would."

That last part, alone, is pretty tough to understand. How could sophisticated institutional investors, including, evidently, many pension funds, buy a position in risky engineered securities, then be induced to also sell Goldman, the originator, insurance on the performance of those same bonds?

The article continues,

"While Goldman wasn't alone in the offshore deal making, it was the only big Wall Street investment bank to exit the subprime mortgage market safely, and it played a pivotal role, hedging its bets earlier and with more parties than any of its rivals did.

McClatchy reported on Nov. 1 that in 2006 and 2007, Goldman peddled more than $40 billion in U.S.-registered securities backed by at least 200,000 risky home mortgages, but never told the buyers it was secretly betting that a sharp drop in U.S. housing prices would send the value of those securities plummeting. Many of those bets were made in the Caymans deals.

At the time, Goldman's chief spokesman, Lucas van Praag, dismissed as "untrue" any suggestion that the firm had misled the pension funds, insurers, foreign banks and other investors that bought those bonds. Two weeks later, however, Chairman and Chief Executive Lloyd Blankfein publicly apologized — without elaborating — for Goldman's role in the subprime debacle.

Goldman's wagers against mortgage securities similar to those it was selling to its clients are now the subject of an inquiry by the Securities and Exchange Commission, according to two people familiar with the matter who declined to be identified because of its sensitivity. Spokesmen for Goldman and the SEC declined to comment on the inquiry.

Goldman's defenders argue that the legendary firm's relatively unscathed escape from the housing collapse is further evidence that it's smarter and quicker than its competitors. Its critics, however, say that the firm's behavior in recent years shows that it's slipped its ethical moorings; that Wall Street has degenerated into a casino in which the house constantly invents new games to ensure that its profits keep growing; and that it's high time for tougher federal regulations.

Tavakoli, an expert in these types of securities, said it's time to start discussing "massive fraud in the financial markets" that she said stemmed from these offshore deals.

"I'm talking about hundreds of billions of dollars in securitizations," she said, without singling out Goldman or any other dealer. " . . . We nearly destroyed the global financial markets.""

It looks like Goldman may finally have gone too far in actively selling clients on one market view, then investing the other way for itself. This piece is far more explicit and, in my opinion, damaging to Goldman than anything I've read in the Wall Street Journal.

As a detailed example of what the McClatchy piece contends, consider these next passages,

"However, one billion-dollar transaction that Goldman assembled in early 2006 is illustrative. It called for the firm to receive as much as $720 million from Merrill Lynch and other investors if defaults surged in a pool of dicey U.S. residential mortgages, according to documents in a court dispute among the parties.

Securities experts said that deal is headed for a crash that's likely to cause serious losses for Merrill Lynch, which Bank of America acquired a year ago in a $50 billion government-arranged rescue.

Taxpayers got hit for tens of billions of dollars in the Caymans deals because Goldman and others bought up to $80 billion in insurance from American International Group on the risky home mortgage securities underlying the deals.

AIG, rescued in September 2008 with $182 billion from U.S. taxpayers, later paid $62 billion to settle those credit-default swap contracts. The special inspector general who's tracking the use of federal bailout money has reported that beginning in 2004, Goldman itself bought $22 billion in insurance from AIG for dozens of pools of unregistered securities backed by dicey types of home loans.

When the federal government saved nearly bankrupt AIG, Goldman got $13.9 billion of the bailout money, and it still holds more than $8 billion in protection from AIG.

Tavakoli said that Goldman's subprime dealings burned taxpayers a second way. She said that three foreign banks — France's Calyon and Societe Generale and the Bank of Montreal — bought protection against securities they purchased in Goldman's Caymans deals, using AIG as a backstop.

Those banks got a total of $22.6 billion from AIG (Societe Generale $16.9 billion, Calyon $4.3 billion and Bank of Montreal $1.4 billion), though not all of the money was related to investments in deals underwritten by Goldman.

Each of the 12 Goldman deals in 2006 and 2007 traced by McClatchy included credit-default swaps that reserved a chance for the firm to lay down modest wagers that could bring thousand-fold returns if a bundle of securities, in several cases risky home mortgages, cratered.

The investors wouldn't buy the securities, but would agree that the insurance would hinge on their performance. Goldman said that it or an affiliate would hold those bets, at least initially.
"This might look stupid in hindsight, but at the time the investors thought they were lucky to get a piece of low-risk (AAA-rated) bonds created by Goldman Sachs with above-market returns," said Kopff, the securities expert."

This may, of course, all get swept under the proverbial rug again. But something tells me that the fact that Goldman made so much money on deals which US taxpayers ultimately paid for might cause this to be tossed to the Department of Justice as a possible fraud case. I'm no lawyer, so I don't know if there's actually a basis for that. But, sadly, when has that stopped Justice from attempting to coerce companies or citizens in the past?

On that note, the article states,

"The documents obtained by McClatchy also reveal that:

_ Goldman's Caymans deals were riddled with potential conflicts of interest, which Goldman disclosed deep in prospectuses that typically ran 200 pages or more. Goldman created the companies that oversaw the deals, selected many of the securities to be peddled, including mortgages it had securitized, and in several instances placed huge bets against similar loans.
_ Despite Goldman's assertion that its top executives didn't decide to exit the risky mortgage securities market until December 2006, the documents indicate that Goldman secretly bet on a sharp housing downturn much earlier than that.

_ Goldman pegged at least 11 of its Caymans deals in 2006 and 2007 on swaps tied in some cases to the performance of a bundle of securities that it neither owned nor sold, but used as markers to coax investors into covering its bets on a housing downturn.

_ If Goldman opted to buy the maximum swap protection cited in the 12 deals in which McClatchy found that it sold both swaps and mortgage-backed securities, and if the securities underlying the swaps defaulted, its clients would owe the firm $4.1 billion. If all 31 deals were similarly structured, investors could be on the hook to Goldman for as much as $10.6 billion, according to Kopff, who assisted McClatchy in analyzing the documents.

From 2005 to 2007, Goldman says it invited only sophisticated investors to act as its insurers. In those CDOs, Kopff said, Goldman appears to have created "mini-AIGs in the Caymans," arranging for investors to post the money that would cover the bets up front.

Kopff charged that Goldman inserted the credit-default swaps into CDO deals "like a Trojan Horse — secret bets that the same types of bonds that they were selling to their clients would in fact fail."

Goldman's chief financial officer, David Viniar, has said that the firm purchased the AIG swaps only as an "intermediary" on behalf of its clients, first writing protection on their securities, and then buying its own protection to eliminate those risks.

If that were true of all of the swaps contracts, however, Goldman would have earned only the lucrative investment fees on the deals and any gains from selling protection to its clients.
In a Dec. 24 letter to McClatchy, Goldman said it sold those products only to sophisticated investors and fully informed them of which securities would be the basis of any swap bets. The investors, it said, "could simply decide not to participate if they did not like some or all the securities.""

On the subject of why none of this has come to light, the article contends,

"Whether Goldman deceived investors with its secret bets depends partly on whether the courts or investigators conclude that disclosing the swaps would have dissuaded potential buyers from purchasing its registered mortgage securities, the experts said. Separate questions of disclosure could apply to clients who invested in the Caymans deals.

The Wall Street figure who insisted upon anonymity said that despite all the hoopla, there were few private investors in CDOs, and that banks have suffered most of the losses, one reason "why you haven't seen a lot of complaining."

However, other experts said that many of Wall Street's victims have chosen to remain silent. Douglas Elliott, a former investment banker at J.P. Morgan Chase who's a fellow at The Brookings Institution, a center-left policy organization in Washington, said that pension funds are loath to discuss investments that "blow up" because "it could potentially lead to lawsuits against them."

Christopher Whelan, a senior vice president and managing director of California-based Institutional Risk Analysis, said that foreign banks "got stuffed" in the Caymans deals, but that Wall Street dealers typically averted litigation by buying back failed securities at a discount to avoid court fights. Any investors who sued would face the threat of being "blackballed" — shunned by Wall Street firms, he said."

Which is why it's so important to get rid of any notion that any commercial or investment bank (the latter of which there are no longer any large ones) has any sort of implicit guarantees of rescue from the federal government.

Remember, Goldman did these things when it was completely on its own. Now, it's apparently viewed as one of the "too big to fail" institutions.

Any guess on how that new designation will affect their appetite for risk, and likelihood of repeating this sort of financial sleight of hand?

Wednesday, December 30, 2009

Treasury's Midnight Removal of Fannie & Freddie Rescue Caps

Last weekend, while most of America was still celebrating Christmas, Tim Geithner's Treasury department quietly announced that it is removing the ceilings on government funding which will be provided to Fannie Mae and Freddie Mac.

Prior to this, there was some sense of winding down the two failed GSEs. Not anymore.

Now, these badly-managed quasi-government financial utilities have new leases on life to blunder into even larger messes.

This is the very antithesis of Schumpeterian dynamics. Rather than let failure be punished with death, our government is now doubling down on financial stupidity and bad risk management.

Happy New Year!

More Fannie Maes & Freddie Macs To Come

Jonathan Koppell, an associate professor at the Yale School of Management, wrote a rather comprehensive piece in Monday's Wall Street Journal concerning the dangers of our current path to creating a group of "too large to fail" private sector, publicly-held financial institutions.

Citing the implosion of politically-protected and government-guaranteed Fannie Mae and Freddie Mac, Koppell argues that, in exchange for governmental backing, these banks will slowly, inexorably be drawn into political capital allocation. For example, he contends.

"Financial institutions will inevitably be beset by requests from members of Congress to "take another look" at rejected loan applications from favored constituents."

Further in his editorial, Koppell observes,

"The question is whether the marginal benefit of maintaining large integrated financial groups justifies the hazards that they introduce. There is scant evidence that financial giants make working capital more affordable or allocate credit more efficiently than smaller institutions. In fact, they may siphon capital away from lending activities that more directly expand the economy."

Amen to that.

I was a senior planning executive at Chase Manhattan Bank when it employed about 45,000 people. Now, the bloated financial utility has over 220,000 people.

Do you think smarter people are running Chase now? Don't bet on it. It's just an amalgamation of four old-fashioned money center banks which once did the same things in four different organizations scattered across Manhattan and the world: Chemical Bank, Manufacturers Hanover, JP Morgan and Chase Manhattan.

What you see now is simply the compressed remains of the four money center banks which weren't Citi, and didn't fail, like Bankers Trust.

I can vouch for Koppell's suspicions. Even in its smaller days, Chase Manhattan's scope and scale resulted in inefficient capital allocations among its businesses, "play it safe" lending and operating decisions by business managers, and far too much political maneuvering for career advancement.

I'm quite sure it's only worse now.

Add government guarantees, and you are looking at even worse problems. Think of Merrill's runaway mortgage finance unit of a few years ago, on steroids.

This time, any mess that some fairly innocuous business buried in the bowels of Chase gets into will be paid for by- you and me. As taxpayers.

Think this will result in more effective risk management at Chase? Not on your life.

Koppell finishes his piece by noting,

"To the leaders of financial powerhouses, the siren song of government backing will be nearly irresistible, particularly when irritants like federal pay czar Kenneth Feinberg can be tuned out. Unlike Ulysses, however, these captains of finance will never bind themselves to the mast. If we don't do it for them, we'll all end up on the rocks."

There's only one silver lining which I can see in all of this.

That is, my friend B's prediction from 1996 will come true among the ashes of exploded, government-seized banks whose activities were guaranteed. After the next blowup, they will probably be restricted from risky activities like underwriting and proprietary trading, as Paul Volcker has suggested.

In their absence, dozens of private equity firms and boutique lenders, traders and underwriters will flourish.

Nature and markets abhor vacuums where services need to exist to service demand. When the inept, gigantic financial utilities have been "guaranteed" out of the riskier financial businesses, new, more skilled ones will replace them.

Tuesday, December 29, 2009

Where Is The Derivatives Exchange?

The weekend edition of the Wall Street Journal contained an article discussing the failure of Congress, over a year after Lehman's bankruptcy, AIG's seizure and nearly two years after Bear Stearns' collapse, to create a derivative exchange.

Recall, if you will, that government interventions were based, at the time, on the unknown size of risks to the financial markets and, presumably, the economy, from allowing derivatives contracts to fail.

Yet, here we are, on the brink of 2010, with no new derivatives exchange in place.

Why not?

The article recounts the various actions of derivatives customers, brokers, and sellers. But buried in the piece is the one really simple fact that explains it all,

"For Wall Street, switching to exchanges would have cut their profits in a lucrative business. "Exchanges are anathema to the dealers," because the resulting price disclosure "would lower the profits on each trade they handle, and they would handle many fewer trades," said Darrell Duffie, a finance professor at Stanford business school."

That's it in a nutshell. After taking government handouts and the benefits of zero-rate fed funds, a number of financial service firms blocked Congressional attempts to replace the risky current practice of largely unsupervised, party-to-party credit derivatives trading with an exchange.

The direct benefits of exchange-based trading, of course, is that counterparty risks are assumed by the exchange, which monitors and demands adequate collateral, plus clears and settles each day's trades.

This allows risks to be more easily known, margins to be set and enforced, and the prospect of endless daisy chains of loss from one failed contract to be eliminated.

But the price of this systemic safety, of course, is always the profits of an inefficient market.

No financial product which has moved to exchanges has ever gotten more profitable. In fact, Wall Street firms dream up innovative products primarily to escape the low profit margins of widely-traded products. This is essentially what Paul Volcker was suggesting in his recent remarks about financial innovation at a Wall Street Journal conference.

As a recent Journal piece on which I wrote this post was correct, we were originally told that AIG had to be saved due to derivatives exposure for the entire financial sector.

If the administration has changed its mind, then an explicit accounting of just what was the risk would be in order.

If not, and we need a derivatives exchange, then one should have been in place by now. We certainly have enough existing models to quickly develop one for credit default swaps and related derivatives.

It is no longer a partisan issue. One of the functions of government is to handle issues like this. That a functioning derivatives exchange has not yet been made operational is shameful.

We pay taxes for a government to provide basic services. Instead, last year, we witnesses billions of taxpayer dollars paid to avoid, we were told, financial sector disaster due to failed derivatives contracts.

It's about a derivatives exchange was in place. The systemic costs of our federal government fumbling with the consequences of not having such an exchange are too great too allow remaining investment banks and brokers to retain high profit margins on derivatives.

Monday, December 28, 2009

More On the Coming Inflation

This past weekend's Wall Street Journal published a prominent article on the front page of the Money & Investing section regarding Stephens' Bill Tedford's bet on inflation.

Tedford has an enviable record over the past 20 years, as described by the Journal, as a fixed-income fund manager with Stephens. I found these passages describing part of his model to be extremely compelling,

"The key data point in Mr. Tedford's model: the monetary base, basically money circulating through the public or reserve banks on deposit with the Federal Reserve. Over long sweeps of time, he says, inflation closely tracks increases in the monetary base that exceed economic growth.

For instance, he notes, in the 40 years to 2007 the U.S. monetary base grew at 7.08% a year. Gross domestic product, meanwhile, grew at 3.04%. The resulting surplus monetary-base growth of 4.04% closely matches CPI and the personal-consumption-expenditures price index, another measure of overall inflation."

The piece goes on to note that the U.S. monetary ballooned from less than $850 billion (the Journal stated "million," but I'm fairly sure that is a typo) in August, 2008, to more than $2T at the end of last month. Tedford explained that, even if you subtract $1T still held as reserves, the resulting growth in monetary base is "one of the highest changes I've ever measured."

For evidence, Tedford observed that as of October, the year-over-year CPI had sunk .02%, while the year-to-date change is 2.3%.

This article struck me as one of those pieces that crystallizes common sense.

I've been following the thinking of several prominent economists in the Wall Street Journal this year. Two themes have made a lot of sense to me.

One is that whatever growth the US economy seems to exhibit will be the result of federal printing or borrowing money, not real, lasting, reliable private sector growth.

The other is the incredible growth in the monetary base. Alan Reynolds and Art Laffer have both mentioned this as a reason to worry about coming hyper-inflation. Now Tedford, with a proven track record in fixed income, is taking action along those lines.

You don't have to be really smart or have a PhD in economics to understand the following question.

If the US monetary base, valued to reflect the worth of the US economy, was under $1T at mid-2008, and it now is more than double that, does this represent a true increase in value in the US economy? Especially just after, or still during, an economic recession?

Of course it doesn't. It cannot.

What it represents can then only be one of, or a mixture of, two things- the present value of suddenly-monetized growth, or a simple depreciation of the currency, leading to subsequent inflation.

I can't see how the world's investors have magically granted the US double the prior present value of future economic growth. So it makes more sense that we have about double the amount of dollars in existence to value the same amount of economic worth in our economy.

Any way you slice it, that's depreciation of the dollar that will lead to inflation.

Only this morning, a guest on CNBC expressed doubt that the Fed will raise rates at any time before next November, thus leaving us open to an inflation-tinged bout of 'growth.' He doubted that any equity market gains would be "real," either in the deflated or reliably-sourced sense.

I think he was correct. It's not clear exactly when the effect of the huge monetary base increase will hit, but history strongly suggests it won't be correctly or effectively handled by a Fed reduction in the base in a timely fashion. Second, federal spending will hit the economy in such a manner as to exacerbate inflation and, then, when expended, lead to a fall in equity values as private sector growth fails to immediately pick up for borrowed-money growth.

For anyone else who, like me, remembers the rise of inflation in the 1970s, it is very discomforting to see these economic indicators coinciding- federal spending, higher deficits, much higher monetary base, amid a recession.