Wednesday, August 24, 2011

Today's links



1--The future of the eurozone, Max-Planck Gesellschaft

Excerpt: ...European leaders may first try to implement fiscal sustainability via strengthening supervision and by a modified enforcement mechanism with sanctions for excessive government deficits, together with strict conditionality in case a country has to rely on fiscal aid from the newly installed European Stability Mechanism. We are convinced that this will not work. And once these attempts have failed, this could, directly or indirectly, lead to a dramatic expansion of the system of financial transfers between the member countries inside the eurozone or the EU as a whole: a system in which a constant flow of funds from countries with sound public finances prevents some other countries from bankruptcy. ....

A transfer mechanism that simply equalizes 50 percent of the difference from average, based on 2007 figures, sums up to 445 billion euros per year. For Germany, for instance, this would be a contribution of almost 74 billion euros per year, on the basis of the 2007 figures....

These rough calculations show: a transfer mechanism that achieves little more than half the amount of equalization in governmental revenues would have transfers that are magnitudes larger than the total current EU budget. ...

It is hard to believe that Europe could survive the political antagonisms that would be created by transfers of this magnitude....

A transfer union of the type described here is clearly not a desirable perspective. And the massive volume of transfers is also unlikely to be economically or politically viable. Although such a transfer union could be the logical endpoint of the path which European policy makers are currently pursuing, we consider a transfer union of this type as unlikely. A more likely outcome is a breakdown of the eurozone prior reaching this endpoint. One possible reason for this breakdown is a raise in political tensions among member countries. A second, more likely reason is the bond market’s possible loss of confidence in the sustainability of the whole eurozone.

2--MBA: Mortgage Purchase Activity at Lowest Level Since 1996, Calculated Risk

Excerpt: The MBA reports: Mortgage Applications Decrease with Purchase Index at Lowest Level Since 1996

The Refinance Index decreased 1.7 percent from the previous week. The seasonally adjusted Purchase Index decreased 5.7 percent from one week earlier and is at the lowest level in the survey since December 1996.
...
"Another week of volatile markets and rampant uncertainty regarding the economy kept prospective homebuyers on the sidelines, with purchase applications falling to a 15-year low," said Mike Fratantoni, MBA's Vice President of Research and Economics. "This decline impacted borrowers across the board, with purchase applications for jumbo loans falling by more than 15 percent, and purchase applications for the government housing programs (FHA, VA, and USDA) falling by 8.2 percent. Although mortgage rates remain quite low, they increased over the week, bringing refinance application volumes down slightly."
...

3--Subprime, Shadow Banking and Liquidity Shocks: Lessons of the Great Recession, Obsolete Dogma

Excerpt: Could it happen again? In the short-term, it's difficult to see how another run on cashlike assets could develop given that the securitization machine is still idle. Treasuries are now essentially the only destination for investors to park their piles of cash -- which explains why yields continue to push down to historic lows. Of course, in the long-term, another panic in the shadow banking system is too possible considering that its basic financial architecture remains unchanged.

The rise of the "giant pool of money" has overwhelmed our financial system. Consider that in 1990 these piles of cash held by corporations and asset managers amounted to just $100 billion; today that sum has multiplied to $2-4 trillion. Any story purporting to explain why this has occurred certainly involves a fair amount of hand-waving. Some of the usual suspects include the move towards defined contribution pension plans; globalization and the subsequent decreasing share of revenue going to labor; the liberalization of markets as the Iron Curtain came down; and the centralization of financial institutions (note this does not even include the neo-mercantalist policies of the China bloc recycling their trade surpluses into dollar-assets). These gargantuan sums were simply too big for our insured financial system. Even with the recent move by the FDIC to permanently lift its limit to $250,000, only 33% of this money is held in deposit.

Deregulation and a stance of malign neglect allowed the shadow banking system to develop a seemingly safe place for these vast sums. Now that the illusion of liquidity has been broken, it is clear that right now the government must run mega-deficits to replenish the supply of safe financial assets for the private sector, and that some kind of reform is necessary to make our unregulated financial system safer.

As policymakers responded to the banking crises of the 1930s with deposit insurance, so must we too respond to our shadow banking crisis with some equivalent of the FDIC.

4--Treasury 2-Year Notes Sell at Record Low Yield; 30-Year Bond Yield Rises, Bloomberg

Excerpt: The Treasury sold $35 billion of two-year notes at a record low yield of 0.22 percent as investors continue to seek the world’s safest securities as a refuge from financial market turmoil and a slowing economy.

U.S. 30-year bonds dropped as stocks rose. Yields on Treasuries were at almost record lows amid speculation Federal Reserve Chairman Ben S. Bernanke may signal on Aug. 26 that policy makers are willing to take further measures to prevent the U.S. economy from returning to recession. The note auction was the first of the maturity to be sold after Standard & Poor’s on Aug. 5 downgraded the U.S. AAA long-term sovereign rating.

“Obviously, there’s still a bid for fixed-income securities,” said Paul Horrmann, a broker in New York at Tradition Asiel Securities Inc., an interdealer broker. “The ramifications of this rating doesn’t do much. We have plenty of money. There’s lots of cash on the sidelines.”

Yields on benchmark 10-year notes rose five basis points to 2.15 percent at 5:01 p.m. in New York, according to Bloomberg Bond Trader prices. The yield reached as high as 2.16 percent. The 2.125 percent securities maturing in August 2021 fell 13/32, or $4.06 per $1,000 face amount, to 99 3/4.

The current two-year note yield rose one basis point to 0.22 percent. The yield on the 30-year bond rose to 3.49 percent, touching the highest since Aug. 18....

Record Low

The two-year note auction yield was less than the previous record low of 0.395 percent on June 27 and compared with the average forecast of 0.221 percent in a Bloomberg News survey of eight of the Fed’s primary dealers.

5--Big Banks: Under-Capitalized, Overexposed, Opaque, The Big Picture

Excerpt: The US banking sector is not healthy.

There is a fundamental misunderstanding about the Wall Street bailouts amongst the public, and quite a few policy makers at Treasury and the Federal Reserve: Somehow, they “fixed” the banking system. All it took was few trillion dollars in liquidity and a few $100 billion dollars in recapitalization, and all is now fine (I suspect some people at the Fed know the Truth).

In fact, they did nothing of the sort. The banking system was not saved; The massive injection of liquidity temporarily salved the day-to-day operations of banks, but they did not repair what ailed our financial institutions. Indeed, pouring billions into nearly identical management teams that mismanaged the risk, over-leveraged exposure, and drove banks off the cliff in the first place was an invitation for another crisis.

And that crisis now appears to be arriving. And, its our own fault.

Consider what was actually done in 2008-09, and you will understand why none of the underlying problems have been repaired:

• Bank holdings: Remain stuffed with declining assets, primarily in Housing and Derivative holdings. Another leg down in Housing could be nearly fatal.

• Transparency: Balance sheets are unnecessarily Opaque; Eliminating Fair value accounting via FASB 157 did not fix balance sheet problems, but instead allowed banks to hide them.

• Capitalization: Remains too thin; leverage should be mandated back to the pre-2005 rule change of no more than 12 to 1; As we have learned, management does not keep adequate capital unless mandated to do so (sufficient capital reserves cuts into profits);

• Misaligned Incentives: Compensation and bonus schemes were not significantly changed after bailouts, except during loan repayments. Thus, management and traders still have the same upside to roll the dice, but do not have the downside risks, which remains on shareholders and taxpayers;

Let’s use a counter-factual, a simple thought experiment of what would have been had we gone Swedish on banks like Citi and B of A, placing them into a prepackaged reorganization (that’s a polite phrase for “bankruptcy”).

The easy stuff: Senior management all gets fired. More than just the CEO — nearly the entire top floor at the bank, including the Board of Directors, gets canned. Equity shareholders get wiped out. Whatever is left over after all is said and done goes to the bondholders, typically, at about 25-50 cents on the dollar. (Note that in Sweden, bondholders got 100 cents on the Kroner, but that currency was significantly devalued — so the bondholders were not made whole, they lost between 50-75%).

Temporary nationalization is the play: Uncle Sam provides debtor-in-possession financing to keep operating. All of the bad holdings, mortgages, derivatives and other liabilities are pulled out, and auctioned off. This includes the REOs, the CDS/CDO book, defaulted mortgage obligations. Remember, there is no such thing as toxic assets, only toxic prices. At some valuation, these are worthwhile investments — just not 100 cents on the dollar. Let healthy buyers pay 15-30 cents.And anything that is worthless is written down to zero.

We recapitalize the parent bank, and spin off each division: IPO Merrill Lynch for $20 billion, spin out a clean Countrywide at $8 billion, sell of all of the non depository bank pieces. What you have left over is a well capitalized bank, owned by Taxpayers, with well capitalized former divisions as stand-alone companies. All of the above have transparent balance sheets (No FASB 157 required to hide the garbage investments). Eventually, everything is spun out back to the public markets. Uncle Sam is repaid, and what is left over goes to the bondholders.

This would have created a transparent, unleveraged, adequately capitalized banking system that would be contributing to, rather than detracting from, the US economy.

But all that was a missed opportunity — for W and O alike. What we have today instead is an over concentrated set of banking behemoths, barely off life support. Many of these remain mortally wounded by the holdings — holdings that they would have to shed through a healthy reorg.

The recent downturn in the banking sector? I suspect it amounts to nothing more than a credible bet that these banks are not in any condition to withstand the next recession. (No, it was not Henry Blodget’s Fault). A rise in unemployment and another next leg down in Housing could very well be fatal.

If the banks come crawling back to Uncle Sam for another bailout, it will be proof that “rescuing” failing financial institutions that blow themselves up is the exact wrong strategy.

Real Capitalists know failure is part of the process. I suspect we may have another chance at a banking reorg. Let’s hope we do it correctly this time . . .

6--Can an Obama Jobs Bill Be Taken seriously?, Huffington Post

Excerpt: President Obama is preparing to propose a jobs bill which will seek to address the chronic unemployment in the US, likely through a combination of payroll tax cuts, extending unemployment benefits and some public spending. To describe this proposal by the president as a day late and a dollar short would be extremely generous. Obama is already two years late and several billion dollars short in his efforts to generate employment.

For Obama to begin talk of legislation to create more jobs following signing off on a Republican debt ceiling deal which has had the predictable, and predicted, result of causing the country to move ever closer to another recession seems almost surreal, as if the President seems almost unaware of the damage his failure to stand up to the right wing extremists who now constitute the Republican Party has done.

This bill almost certainly has its origins both in Obama's need to address the problem of widespread unemployment as well as for the President to regain the political upper hand in the jobs debate. While it is good that the President is concerned about unemployment and preparing to try to address this problem, albeit through proposals that will inevitably end up being too modest to make a significant difference, it is troubling that this far into his term, Obama is still searching for a way to both help develop jobs and to demonstrate that he is genuinely concerned with the widespread unemployment that has existed since he took office.

7--Bank of America CDS Spread Nears Record As Credit Market Misses Rally Memo, Wall Street Journal

Excerpt: Stocks are bouncing this morning, like they do, because Chinese economic data were not soul-meltingly awful and because stocks have sold off so hard for so long. But the credit market is still moving in the other direction.

In the credit-default swap market, spreads are wider across the board, meaning people are paying up for protection. The Markit investment-grade corporate debt index is 3 basis points wider. The index of European sovereign debt is 10 basis points wider. The index of European financials is also 10 basis points wider.

Bank of America’s five-year CDS spread, meanwhile, is pushing toward 390 basis points, a record high. In other words, higher than the levels it hit during the financial crisis. At last check, the five-year spread was up 8% to 388 bp. The one-year spread is even higher, up 8% to 424 bp, meaning the CDS curve is inverted, usually a sign of trouble.

Peter Tchir at TF Market Advisors is baffled that stocks are trying to push higher even as credit gets worse:

It is not only the CDS market that is struggling. The cash bond market is at a virtual standstill. Bids for bonds have dropped and so far, sellers haven’t yet given up hope and hit the much lowered bids, but it doesn’t feel like it would take much for that to happen as the market is teetering.

It is interesting how many investors talk about credit leading the markets, but choose to ignore it when they see it.

At least Bank of America stock investors are getting the message from the CDS market — its stock price is now down to $6.33, lower than its close of $6.42 yesterday. A key mark for the stock, now that $6.50 has been breached, is $6.31. Keep an eye on this today.

“In the very near term, we’re watching what the credit bears are doing, as we don’t feel any bounce in stocks is convincing as long as the bears are upping the pressure,” writes Brian Reynolds, chief market strategist at WJB Macro Strategy.

Update: BofA 5-year CDS spread is now 17% wider at 419 bp. That’s more than its crisis-era close.

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