A Look at the Case-Schiller, No Good News

The April Case-Schiller report tells us very little. The 3.8% average rise reflects the end of home buyer tax credit. Sales and prices have evaporated since May 1. The CS index will tell us a much different story when the data is released 30/60 days from now. While the April report provides little insight as to where we are today there is some interesting information that is worth noting.

Of the 20 cities the CS index tracks 18 showed price increases. The two that fell were Miami (-.8%) and NY (-.3%). With that in mind consider this chart:

The information is based on April data and is therefore consistent with the CS report. Both New York and Florida are at the top of the list of states with the longest period between initial default and final foreclosure. For the nation as a whole the number of days has nearly doubled over the past few years. NY and Florida are 31% and 21% higher than the national average.

This is not a coincidence. This is cause and affect in action. I live in metro NYC and own property in S.Fl. I see what is going on. There are many middle to upper price homes on the market that have not seen an offer for more than a year. A good number of these are already in default. The borrowers are underwater and there is nothing they can do. A HAMP style ReFi accomplishes nothing. I know people in both areas who have contacted their lender and have been told to come up with an acceptable short sale or deed in lieu transaction. The borrowers have been told by the bank(s) that if they do not cooperate they will have their credit wrecked and be subject to default judgments. So the borrower puts the house on the market and hopes for an offer that is acceptable to the lender. In the mean time they stay in the home for up to two years and pay very little (if anything) on the old mortgage. There is substantial evidence that these people are buying IPhones and going on vacation with the money they are saving by not paying the debt. Some thoughts:

-This “extend and pretend” at its worst.

-The lenders will not let this continue forever. The day of reckoning is coming. It well be felt in all of the states. It will be felt hardest in the states that have the highest days to foreclosure numbers.

-As a former owner is foreclosed they will be forced to rent. Given that few in this category are paying any meaningful amount of their current monthly mortgage it is likely that they will have less disposable income post foreclosure.

-My conclusions:


(A) RE in Fl and NY is going to tank this fall.

(B) Consumer demand for things from clothes, gadgets and leisure is going to suffer an out sized decline.

(C) The extend and pretend policy is catching up with us. This approach was a “buy some time” idea in the hope that things would work out. They have not worked out. We are about to pay the price for that failure.

If we revert to more traditional levels in the ratio of initial default and foreclosure we are going to hit an economic wall. This is just one more thing stacking up against us.

Fed Economist: Bloggers are Stupid

A Richmond Va. Federal Reserve Economist, Kartik Athreya wrote a paper recently that trashes economic bloggers. Mr. Artheya has a PhD from the University of Iowa. I’m not so sure a few years in corn land gives him the right to take cheap shots at the new media. I am absolutely convinced that this type of thinking should not be expressed by Fed officials. It proves to me that the Fed is an elitist organization that is out of touch with America in 2010. The full report from Athreya is here. Some of the more offending comments:

Writers who have not taken a year of PhD coursework in a decent economics department (and passed their PhD qualifying exams), cannot meaningfully advance the discussion on economic policy.

So we have to go to school for two years to be able to write about the issues of the day. That would exclude me and a lot of others. The fact that I worked on Wall Street for 30 years does not qualify me to say a word.

The response of the untrained to the crisis has been even more startling. I listen to Elizabeth Warren on the radio fearlessly speculating about the nature of credit market dysfunction, and so on.

Taking on Elizabeth Warren is a big mistake Mr. Arthreya. You will regret this choice of words.

The real issue is that there is extremely low likelihood that the speculations of the untrained, on a topic almost pathologically riddled by dynamic considerations and feedback effects, will offer anything new. Moreover, there is a substantial likelihood that it will instead offer something incoherent or misleading.

Everything that comes from the Federal Reserve is incoherent and misleading.

The sophomoric musings of auto-didact or non-didact bloggers or writers is instructive. For those who want to really know what the best that economics has to offer is, you must look here.

The only people you should listen to is Federal Reserve economists? I take a different view. The last people you should trust in this matter is FRB economists.

The general public are simply being had by the bulk of the economic blogging crowd.

The general public is being had. But not by the bloggers. They are being had by the folks who make the choices for us at the FRB.

The views expressed are my own, and do not necessarily represent those of the Federal Reserve Bank of Richmond, or Federal Reserve System.

Actually the views expressed are a perfect representation of the mind set at the FRB. Narrow minded, elitist and just plain wrong.


I would suggest that Mr. Arthreya do some additional research. He should look up the word “hubris” (extreme haughtiness or arrogance). After he understands that concept he should write an apology, that or he should resign from the FRB.

Smack Down in Toronto

As anticipated, Obama and Geithner went to the G20 and asked the rest of the world to keep rolling the printing presses for “a little while longer”. They got a resounding “NO”. The head's of state from Germany, France, England and Canada said NO. Ever polite, the Japanese had not thing to say and every smart, the Chinese also had nothing to say. As of tonight there is no engine of growth in any corner of the globe. The US is going to try to go it alone with big fiscal imbalances. Based on this weekend’s lack of support for continued deficit spending outside of America the logical economic conclusion is that the US is going to be running up big trade and current account deficits with the rest of the world. We are also going to look pretty silly in about twelve months.

Our boy Tim G. did a lame effort in defending the US position at a press conference. The full Q&A is here. Some selected thoughts from the guy who has his hands on the tiller:

What we share in the G20 is a recognition that if the world economy is to expand at its potential, if growth is going to be sustainable in the future, then we need to act together to strengthen the recovery and finish the job of repairing the damage of this crisis.

One day Tim tells us that things are recovering very nicely and we have a sustainable economic outlook in front of us. The next day Tim says we are still in “crisis”. Tim talks from both sides of his mouth. He does it on the world stage. No one outside of the border seems to be buying this. After reading tomorrow’s headlines not too many inside the border will believe it either.

I would look to the language the President used in the letter he sent to his counterparts. You can see in that letter, again, the basic strategy we think makes sense, which is to make sure we’re focused on growth now.

Sorry Tim. No sale. You tipped the scales. Now they have to get back.

We do think it’s very important to continue to put in place a targeted set of additional supports to help promote small business lending, give aid to states in the United States to make sure they can keep teachers in the classroom, to provide incentives for business investment to try and make sure we’re helping the long-term unemployed. Those things are good policy now. They make sense for the country.

Tim is referring to a failed effort by the Administration to get Congress to pony up an extra $50b. That was the cost to keep 300k teachers on the books and to extend unemployment until after the election. As of Friday, Congress has said no. As of tomorrow it will be dead on arrival.

There’s another mistake some governments have made over time to, in a sense, step back too quickly in the hope that -- on the hope that it’s over. And we want to do is continue to emphasize that we are going avoid that mistake.

This is the heart of the matter. A growing number of both "leaders" and regular folks have concluded that the really Big Mistake in front of us is if we were to borrow a few more trillion to fend off something for a few more quarters. Tim sees the Big Mistake in exactly the opposite direction.

You’re not going to have growth in the future unless people believe you have the political will to bring these deficits down over time. And that’s our challenge.

Well-said Tim. Without confidence we are dead. And you are doing nothing to instill the confidence we need.

The President has outlined actions to reduce our future deficits

No he hasn’t. He is avoiding the issue like the plague. He set up a deficit commission to look into the matter. What kind of leadership is that? As near as I can tell a cranky octogenarian who has a very fat wallet heads this commission. This commission is not going to tell us anything we don’t already know. This was just a method of delaying the process until after the bi-elections.

We have to make sure that people understand that we’re going to take the steps necessary to bring down our deficits over time. But we also need to make sure we’re growing.

The phrase “over time” could mean anything. It certainly does not mean the next 24-36 months. Tim is completely out of touch on this issue.

My guess (hope) is that the smack down in Toronto makes a big splash in the MSM. Both public and market sentiment could be negative. Should that happen, who might be the lighten rod? None other than Tim G. This could set up as an opportunity for a new Treasury Secretary that has a different perspective. If confidence is something you wanted, then a change is necessary.

We’ll see what the Market says.

The G20 and the Dollar

It was a terrible week in Euro land. Greek bond spreads broke 10%. A restructuring can’t be too far away. They are performing a bank stress test that appears to be a joke. The results will exclude sovereign risk. Exactly where the risk lies. With this as a backdrop the Euro should have been slammed. It would have been in the market we had just a month ago. But not this week. Some charts of the larger reserve currencies versus the dollar.

The dollar has backed up in a significant way since the first week in June. Some would say that the Buck is just suffering some indigestion after a big move up in a short period of time. A very good case can be made for the Euro to be 10-15% lower than it is today purely on fundamentals. But that is not what the tape is telling us.

Currencies have two roles. They are a medium of exchange for settlement of cross boarder trade and finance. All the reserve currencies do a good job in that function. The other role of a currency is as a store of wealth. It is not clear to me if any of the major currencies are doing well in that capacity.

In the long run things like trade imbalances and current account deficits are determinants in setting exchange rates. In the course of any given month those influences have almost nothing to do with how rates are set. In the short term it is all about sentiment.

I see the US losing the sentiment battle. With all the problems in the UK and the EU at least the governments are attempting to address the fundamental problem of fiscal imbalances. Even Germany is taking up the issue. This is probably going to prove to be the kiss of death for Greece. But a failure of Greece is not by itself the kiss of death for the Euro.

This weekend’s G20 meeting may give us some clues on the sentiment issue. We are going to see some battle lines drawn. Both Obama and Geithner will be pushing for a growth package. It is likely that some of the other countries are going to give the US a thumbs down on that. America is going to be the only major country left that is continuing down the path of fiscal insanity.

The final communiqué will have some nice talk about global coordination and a big “thank you” to China for stepping up to the plate and adjusting its FX policy. Behind the scenes it will be less friendly. A number of countries will attempt to chastise the US for its profligate ways. No one at the meeting will really be satisfied that China adjusted its FX rate against the dollar by a measly ½% as a ticket to the show.

Should the US be held up as “the way not to do it” or if we getting some snotty comments from a finance minister or two then we will see this in the FX markets on Sunday night. The one thing that no one is thinking about in the summer of 2010 is a dollar problem. That is probably the best reason why one might pop up.

Fannie Talks Tough

On Wednesday Fannie Mae issued a statement regarding its policy toward strategic defaulters. The new policy is a (weak) carrot and stick approach for dealing with those homeowners who are underwater and have little (or no) hope of getting out of the water. Several measures were announced to achieve the goal of getting trouble borrowers to come forward and speak with their loan servicer versus to just stop paying and wait to see what happens. No new credit and a risk of default judgments were the sticks. As near as I can tell there was no carrot.

There are several aspects to the announcement that has me puzzled.  Fannie appears to be doing this in a vacuum. Freddie Mac has not established any similar policies. The quote from Freddie was:

“Freddie Mac is closely following Fannie’s moves but had not yet adopted them.”

The FHFA (the regulator for Fannie and Freddie) commented:

“We support Fannie Mae taking a policy position that discourages borrowers who can afford to pay their mortgage from walking away.”

A significant comment on this comes from the Treasury Department:

“Fannie Mae’s plan does not represent official Obama administration policy.”

Fannie and Freddie have been in conservatorship for nearly two years. Treasury has already plunked $120b into the rat hole. Even the CBO is estimating the ultimate cost at nearly $400b. There are private estimates that take the number as high as $1 Trillion. A meaningless, but still “optically” significant step has been taken to de-list F/F. This horrible mess is today a 100% government problem.

Given that as a background I find it very difficult to believe that Fannie did this without the full involvement of the FHFA. This means that Chris DeMarco, the acting Director, had to have signed off on it. If DeMarco approved it for Fannie, why was Freddie not included? There is no way that he considers these two beasts as separate entities at this point.

I don't believe that DeMarco let this happen without the express prior approval of Treasury. That is not how things work in D.C.  When a Treasury “spokesman” says that the moves by Fannie, “Do not represent Obama administration policy” there is some form of cover up. In my opinion this important step had to have the sign-off of Treasury Secretary Tim Geithner. Geithner would not have approved this without specific WH approval. This probably means he called Rahm. This conversation could have gone like:

TG: We are getting killed on the strategic defaults. It could cost us a half trillion if we don’t do something about it. Fannie has a plan to scare its lenders. Should the government take a heavy hand in this?

RE: We talked about it and the decision is that we can’t afford more losses so go forward and threaten the lenders. But the WH wants to distance itself from this. So make it look like a “one off” policy by Fannie and Treasury and WH will give it a no comment. Okay?

TG: Got it. This is going to put DeMarco in a tight spot. What should I tell him?

RE: Tell him if he plays ball with this and keeps us out of the “hardball” strategy we might consider removing that “Acting” title. We need a lightening rod. He’s it.

For me there are only two possibilities. Both are troubling. The “get tough” approach by Fannie was either:

(A) Just a one off thing that happened based on an internal decision at Fannie and given the nod by FHFA.

or;

(B) This plan was vetted by many levels within the Government including Treasury and the White House. A decision was made to go forward. It had the approval of Obama.

If it is (A) it would suggest that there very little coordination/discussions of critical policy choices being made on what is clearly the “Big Risk” to the broad economy. It would imply that there's no one running this big ship. If that should prove to be the case, then heads (Geithner’s) should roll. I would call that Benign Neglect.

If it is (B) and the WH approved this plan, then I think this should be understood by all. I have no problem if the WH plays tough with the likes of Iran, N. Korea or Venezuela. It is quit another matter to turn on the citizens.

The policy changes at Fannie should have been handled differently. This is a difficult problem. Our economic health will be impacted for many years by the choices we make. I think an announcement as significant as the Fannie move should have come from the President. He should have made these points:

-It is a mistake of history that the US government has become the dominant provider of mortgages.

-We must accept that mistake and the consequences of what has come with it.

-As the government has been part of the problem, we must be part of the solution.

-A policy is being established that will impact all of the Federal mortgage lenders including Fannie, Freddie and FHA.

-Borrowers who are underwater today as a result of the unprecedented decline in RE values will be eligible for principal debt relief. Borrowers who get lowered principal will be obligated to pay a tax of (50%?) on any gains that are realized on the sale of a home that is in excess of the new mortgage balance.

-Borrowers who do not come forward over the next 180 days and seek assistance (strategic defaulters) will be treated harshly. Those that do not come forward and are delinquent on loans to Federal lenders will be subject to rapid foreclosure leading to eviction. Judgments (where permitted) will be aggressively pursued. IRS tax liens will be used to enforce judgments.

-Private sector lenders will be encouraged to follow the decisions made at the Federal level. If private lenders fail to cooperate they will be subject to draconian regulatory scrutiny. If they don’t play ball we will make their lives miserable. We will shut them down if necessary. We will publish a list of those who are not contributing to the resolution of the problem on a monthly basis. Those who do not cooperate will be run out of town. Their depositors and customers will desert them. Their bondholders will lose money; their equity will be wiped out.

Something along these lines would be a real carrot and stick approach. The one from Fannie is just a pretend one.

What's Ben Gonna Do?

Every day the deflation story gets stronger. Almost all of the numbers in the US are pointing in that direction. A slowdown in the EU is a sure thing. Japan is going nowhere. China is a question mark, but even if they do continue growing it will not result in enough Eco. Juice to offset the global deflationary forces.

 I was anticipating a slowdown in the 4th Q. It is now looking more likely that we will fall of a cliff starting July 1st. Extended benefits will be ending. Most states start a new fiscal year and they are all dead dead dead on revenue. Any benefit we got from the census will be in reverse gear. By August 1st approximately 1mm temporary workers will again be out of a job. Housing is falling off a cliff.

The market sees this. The ten-year is at an incredible 3.1%. The last few days of trading in gold has a smell of deflation as well.

Bernanke must be beside himself. He bet the farm to save the economy in 2009. He has done things that no other Fed head as ever contemplated. As betting goes, he is “all in” on this one. He bet the economy, our future solvency and his reputation. In my opinion there is no way he is going to throw in the towel and accept that deflation is inevitable.

Ben spelled out what he would do in the “unlikely” event that deflation became a real threat in his famous 2002 “Helicopter” speech. The full speech is here. This speech has been hashed many times before. Given the news of late it is worth relooking at what Ben had to say. Some excerpts:

Under a fiat money system, a government should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero.

Well Ben, we have had ZIRP for two years now. It has made a difference. But zero interest rates have just bought time, not a recovery.

The U.S. government has a technology, called a printing press that allows it to produce as many U.S. dollars as it wishes at essentially no cost. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

Ben has been running that printing press. QE created $1.75t. It has not had a lasting benefit.

The Fed could stimulate spending by lowering rates further out along the Treasury term structure. There are at least two ways of bringing down longer-term rates:

(I) Fed could commit to holding the overnight rate at zero for some specified period.

(II) A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt. The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities.

Ben has done (I). As of yet we have not seen (II). For me it is scary that this is his “favorite” approach. That makes this one a sure thing if evidence mounts that we are rolling over. But this does not accomplish much in today’s markets. The 2-year is at 75bp. What is Bernanke going to do? Push that to zero also? He might.

The Fed could also attempt to cap yields of Treasury securities at still longer maturities, say three to six years.

Why stop at 6 years Ben? To make a dent he would have to have the 10-year at 1%. Is that what he has in mind? I think it is a real possibility.

An option would be for the Fed to use its existing authority to operate in the markets for agency debt.

We have done that already in a biblical manner. $1.25 trillion. Three months after the program ended the housing market is falling off a cliff. I would not be surprised if Ben re-established this program. Buying another $1 trillion would not accomplish anything but make the primary dealers rich. But a desperate Ben would do this again in a NY minute.

The Fed might next consider attempting to influence directly the yields on privately issued securities.

Oh boy, this is the beginning of the end. Ben would buy corporate debt. GE would be high on the list; the rest of corporate America would follow. Ben could buy BP bonds. That would solve our problems, wouldn’t it?

The Fed might make 90-day or 180-day zero-interest loans to banks.

Lights out when this happens. Ben will stop at nothing. This option is not far from reality. That said, if this happens the public backlash is going to be vicious.

The Fed has the authority to buy foreign government debt. Potentially, this class of assets offers huge scope for Fed operations, as the quantity of foreign assets eligible for purchase by the Fed is several times the stock of U.S. government debt.

The “nuclear option” is to buy up the sovereign debts of other countries. This would extend QE globally. In a way we just did this with the opening of $100b in swaps lines to the European central banks. This gives them the wherewithal to buy their debt. The ultimate is when the Fed starts doing it for their own account. I doubt this option is realistic. It would require the approval of the other CB’s. That said, should you see this headline buy lots of canned food and rice. If this step is implemented bread lines will follow.

It's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation.

In this case the Fed would attempt to devalue the dollar in order achieve its goals. This of course would just destabilize everything else in the world and would insure a downward spiral in economic activity.

Most of the things Ben spoke of back in 2002 have already been tried (or are now in place) and have not worked. The remaining options do not appear to have much chance of working either. But that does not mean that we will not see these steps.

Ben has already destroyed savers. This is the consequence of his steps. It was not his goal, but he understood fully that savings would have to be penalized. He is in so deep at this point that I believe he will consider anything to protect his reputation in history. The one thing that he did not bring up in the 2002 speech was negative interest rates. While this option sounds ridiculous it can’t be excluded as a possibility. The SF Fed had a paper on this recently. A graph of the “proper” Fed funds rate:

John Hilsenrath at the WSJ also put the idea of negative interest rates on the table in a recent piece. I think the article was from Ben’s lips, into John’s ear and then onto the front page of the Journal.  If Ben has something to say on this matter he should address us all. He should not use a beard to influence public/market thinking.

How could something as crazy as negative interest rates work? Consider this from none other that Harvard economist Greg Mankiw. He had this to say on the subject back in March of 2009:

I can now state the proposed solution: Reduce the return to holding money below zero. Imagine that the Fed were to announce that it would pick a digit from 0 to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent.

This bit of lunacy comes from one of our best and brightest economists. Should this (or any other negative % plan) be implemented it would mean that a depression is just a few months away. The last desperate acts would insure that we would fall into a very big hole. We will hear more on these “emergency” measures in the coming months. Should any of them come to pass, be guided accordingly. These steps will only agonize what must come.

Black Hole, NASA photo

Good Time to Re-Short the EUR/DLR?

The EUR/CHF is opening in Asia at few pips under 1.36 while the EUR/USD is at 1.2275. It is not surprising that the Swiss is strong against the Euro. The SNB has let the cross go. They were last seen at 1.40 where they made a big stand. But to me it is surprising to see this sharp appreciation of the Franc while the dollar lost 3% to the Euro. Proving once again that the business of forecasting FX markets is tricky stuff.

The Euro was (is?) oversold. The open short interest has been cut sharply in the past 10 days. There has not been any “Really-really bad” news out of the EU either. In fact some of the austerity talk seems to have traction. Austerity is a popular theme. So the back up in the Euro is justified.

It’s easy to predict that there will be more bad news from the EU in the next few months. With that as a backdrop the current market level looks attractive to shorten up on the EUR/DLR. But I am smelling a rat on that trade.

It was not that long ago that the short dollar trade was popular. The reasons were obvious. The US fiscal issues were overwhelming. Growth prospects (I think that relative growth drives FX) in the States was questionable. That was six months ago. What can you say about those issues today? Nothing is being accomplished on the fiscal side. Bernanke intends to continue ZIRP forever. Everyday we see new evidence that a slowdown is likely in the months ahead.

The fact that the US will not even raise the issue of an austerity budget until 2011 is going to become a drag. With all of Europe’s problems there is evidence that they are coming to terms with their budgets. In the US it is still full steam ahead. This week we may get another $50b to extend unemployment and keep the states alive for another four months. As many have recently pointed out, the municipal finance problems in the US could overwhelm the bad news from the EU. That story is going to explode as of July 1.

We are at an interesting juncture in FX. Either the trend to a weaker Euro comes back into line soon or we may have a surprise ending. The appreciation of the CHF against all currencies is a sign to me that this is a market against the dollar, not just the Euro crosses. While it may look tempting to re-short the Euro it could also be a trap. Keep your eyes on the other crosses. If the Yen/DLR weakens or we see a decisive breakout in gold to the upside look up. The weak dollar carry trade could come back into vogue.

SNB Loses 8b on Euro Intervention. Folds.

The Euro/CHF cross closed in NY at 1.3732 Friday. I believe that is an all time low close. I am still scratching my head how this could happen during a week where the Euro did a five big figure move to the upside.

The Swiss National Bank has been actively intervening in the FX market to slow/stop the appreciation of the CHF against the Euro for the past six months. This week they threw in the towel and will let the Franc float higher. It cost them a bundle.

Philipp Hildebrand took over as the head of the SNB on January 1, 2010. He inherited a policy of defending the strong Franc. He continued the policy from the day he took office. He will suffer the biggest loss in FX history. Hildebrand publicly defended his actions on numerous occasions. He always hid behind the threat of deflation in Switzerland as the justification for his massive purchases of Euro’s. A chronology of this. Note the dates:

Reuters:

Swiss Central bank repeats will fight franc appreciation

Sun Jan 17, 2010 9:08am EST

* SNB will fight excessive franc appreciation resolutely

* Deflation continues to pose risk to Swiss recovery

Reuters:

SNB says FX intervention a success, sticking to policy

Tue Mar 23, 2010 8:15am EDT

* SNB chairman repeats cbank's intervention threat

* Says will not allow deflation risks from franc rise

This is from an important annual presentation. There is no equivocation here regarding the threat of deflation in Switzerland.

Speech by Mr Philipp M Hildebrand,

30 April 2010.

Any threat to this currency stability would, by definition, have a negative impact on Switzerland, above all if the Swiss franc were to appreciate sharply due to its role as a safe haven currency. The SNB will not, however, allow such a development to turn into a new deflation hazard for Switzerland. For this reason, it is acting decisively to prevent anexcessive appreciation of the Swiss franc.

HILDEBRAND, MAY 11
"We will not allow any excessive appreciation that might generate deflation risks".

Okay, we got that message. Deflation was to be avoided at all costs. But actually those cost got too high. The SNB has foreign reserves of CHF230 billion. Nearly half of total GDP. It comes to CHF 30,000 for every citizen. The policy got out of control.

The SNB has reported a CHF 3b loss from Euro holdings in March. Based on the close today and an estimated Euro 50b intervention in the past 75 days and you have a mark to market loss of CHF 8.4b. That may not sound like a big number but you have to consider this in the context of Switzerland's GDP which is small. The 8.4b loss for the SNB would be equivalent to a $200 billion loss for the Fed. So actually this is a very big deal.

What does Mr. Hildebrand do? He does a u-turn on the fight against deflation. His words from Thursday:

“The deflationary risk in Switzerland has largely disappeared.”

What? In the past 60 days the risk of global deflation and particularly deflation in Switzerland have increased. With the Euro/Franc at 1.37 and now obviously headed lower deflation is a very real risk for the Swiss. The decision to discontinue the policy of holding down the franc had nothing to do with a risk analysis of deflation. It was about the money. The losses were too big. The impact on the money supply was undesirable.

So Hildebrand went to the big casino on his first day on the job and lost a bundled and continued to double up until he had no chips. The FX market ate his lunch for the biggest ever FX loss that I am aware of.

It is true that some Swiss exporters, farmers and the tourist industry got some benefit from Mr. Hildebrand's efforts. My guess however, is that 80% of his losses went into speculative hands. A nice win for some folks.

Sheila Talks Tough

Sheila Bair spoke at the Wharton School today. She laid it on the line regarding what she thinks should be done to reform the nation's mortgage market and the role that the government plays. Everyone should read this speech. Especially the current crop of “deciders” in Congress and the Administration. I agree with Ms. Bair on almost all of her points. Her speech confirms to me that she has a vision of what must be done. She is the only one in Washington who has the guts to spell it out for us. I have said in the past and will say again now that Sheila Bair should be our Treasury Secretary. We need leadership. We have none.

I am convinced that what Sheila describes will happen in one form or the other. It is not a question of “if” the government’s role in the mortgage market will change. It is a question of by how much and how fast it will change. We can do this over the next 10 years and suffer a lost decade or we can accelerate the process. Ms Bair is in the sooner versus later camp.

As you read through the speech (or the few snippets below) consider what she is saying in the broader context of the US housing market. It is clear to me that the changes to come will have a long-term deflationary impact on the housing market and the related industries. Should that be what’s in store, I am left wondering where the economic growth will come from.

A critical task lies before us: rebuilding U.S. mortgage finance on a sounder footing, not only to restore the confidence of homeowners, investors and lenders, but more fundamentally to restore balance to our broader economy.

If we are willing to take bold steps, and return to the fundamentals we can get back to a more rational world.

We must recognize that the financial crisis was triggered by a reckless departure from tried and true, common-sense loan underwriting practices.

Traditional mortgage lending worked so well in the past because lenders required sizeable down payments, solid borrower credit histories, proper income documentation, and sufficient income to make regular payments.

All told, over $2.1 trillion in private securities backed by risky subprime and Alt-A mortgages were issued between 2004 and 2006.

Market discipline was tossed to the wind. It explains why trillions of dollars in faulty mortgage paper was issued before the home price bubble finally collapsed.

We need to have some basic underwriting guidelines that apply to all mortgages. Basic limits on loan-to-value and debt-to-income ratios, and consistent documentation requirements should be set for any loans held by a depository institution or sold to a securitization trust.

In 2009, the FHA and the GSEs accounted for 95 percent of total U.S. mortgage originations.

Does it make sense for the federal government to subsidize homeownership in an amount three times greater than the subsidy to rental housing? In the end, these subsidies have helped to promote homeownership, but have failed to deliver long-term prosperity.

Homeownership was once regarded as a tool for building household wealth, in the crisis it has instead consumed the wealth of many households.

The financial crisis and the Great Recession it spawned threw 8 million people out of work, reduced our GDP by about 3 percent, caused a huge increase in federal debt, and virtually wiped out the entire net income of FDIC-insured institutions for at least a two-year period.

We need to get back to a world where our financial sector supports the functioning of our economy, and not the other way around.

Correlating the S&P

I love correlation trades. They are like women. There is always logic to them. They are seductive. But you can never really trust them completely. When you finally fall in love with them they turn on you. Here’s an example a friend sent to me. This one matched up tight for a while. Now it is straying.

Consider the correlation between movements in the ten-year and the S%P during the May 1 – June 8 period. It comes to a .96 R squared. Very tight indeed.

From June 9 through today’s close the correlation has fallen apart. It may have been just a short romance. Memorable, but not lasting. Or it may come back and the good times can continue. Time will tell.  One or the other of the legs in this correlation is “wrong”.

The current level of the ten-year of 3.19% translates into an S%P of 1050. To get back into the tight correlation it would mean a 58-point drop in the S&P, a tad over 5%.

In order to justify the current level of 1108 on S&P the ten-year would have to back up in yield all the way to 3.35%.

I think the bond market is looking as if it smells deflation. That stink is rising. There are plenty of domestic economic numbers that point in that direction. There is no growth story outside of our border either. The risk in this trade is that the 10-year moves toward 3%. That would put the S%P down around 10%.

BP Inverts, Spain Next?

Zero Hedge had a piece today (BP Curve Goes Nuts) on the inversion (blowout) of BP’s 1 year/10 year spread. At one point the short date paper was yielding 10% while the long dated stuff was at 7%. You don’t see this too often. When you do, it is always a giant red flag waving “Risky”.

What is the price of a 5% AA 10 year if market forces bring it to an 8% yield? 80% of par. As a result, there is a 20% upside to this bond. What is the upside on a one-year investment at 10%? 10%. Therefore short date paper has half the return potential. Who would want that? Short-term yields explode as a result.

It works on the downside as well. If there were a default that led to a payout of 60% of par the guy who buys at 80% loses a quarter of his money. The holder of the short-term stuff pays 90% and loses a third of their money.

The BP inversion is a function of the uncertainty the company faces. I doubt there was much liquidity. That said, the market was making a prediction of a default. When the dust settles in a few days it will be interesting to see if the inversion is sustained.

There is another case of an inversion in the making that is worth watching. Rather than a one-day explosion like BP this one has been on a slow burn. It is every bit a red flag.

The following is a “Before and After” look at Spanish and Greek bonds. First consider Greece on 5/2 (white) and 6/16 (blue). You can see how the yield curve inverted from 2yr -10. Today it has “normalized” at very high rates. The market perception is that the risk of default is less. This is backed up in Greek CDS pricing.

Now consider Spain on 6/15 (yellow) and six weeks ago (red). The disorderly market that Greece suffered is not evident, yet. I see a steepening curve, higher rates across all maturities and a sharp flatting around the 2-5 year. This is where the inversion will take place.

The following is a different look of the 2s/5s for Spain. The spread is still positive (65bp) but we just broke levels not seen since the world was ending in 2008.

This deterioration is happening during a ‘risk on’ period for the markets. When the sentiment pendulum swings the other way in a few weeks Spain will face an inverted curve. This will shut them out of the long-term debt market. Call that a crisis. The only thing preventing it from happening is the ECB. They are buying sovereign paper to the tune of E40-50b per week of late. I don’t believe they can keep up that level of buying for another month.

On GoM, BP and the Jones Act

According to a NY Times story the President is about to move on BP. No details on what is to be forthcoming as yet. A White House spokesman told the Times an “escrow” account would be required to insure that BP met all of its obligations.

“The president will use his legal authority to compel them." Robert Gibbs, White House spokesman.

This is the kiss of death for the dividend. This may mean that BP’s US assets are encumbered in some way. Should it work out that there is a form of conservatorship in the works it would be without precedent.

Like everyone else I am freaking out over the Gulf BP spill. The short and long term environmental impacts are frightening. The consequences to the country’s energy base are also frightening. While I am not concerned with the fate of BP or its dividend, this too is going to have a horrendous cost. It is clear that the gutting of this company is going to have far reaching impacts to investors and pensioners.

It looks like the Coast Guard is going to take over operations this week. That will be the beginning of the “big blank check “for BP.

A curious announcement comes this weekend from Dredging News. This site has had several articles bringing attention to the fact that foreign flag oil cleanup resources are not being employed in the Gulf. They blame it on the Jones Act.

Flanders Today reports that Belgian dredging companies DEME and Jan De Nul are "struggling to understand" why BP and the US authorities have not called on them in the wake of the Deepwater Horizon oil spill in the Gulf of Mexico.

The companies say that the fact that the Americans have not accepted their proposed assistance is down to two reasons - that the US authorities are reluctant to admit that somebody else has better equipment and the protection of the American market through the protectionist 1920 Jones Act, prohibiting foreign dredging companies from operating in US waters.

The Jones Act (1920) protects union jobs in the US. It was waved after Katrina. It looks like it is going to waived again soon. From the same source: (Dredging News. Go figure?)

“The American maritime industry (MCTF) has not and will not stand in the way of the use of these well-established waiver procedures to address this crisis."

I read this statement as being a public acceptance (in advance) that foreign vessels will soon be in the Gulf. A welcome development should it happen. One has to ask why the suspension of the Jones Act was not done sooner. We can only hope that pressure from (or fear of) unions was not part of the reason.

Thad Allen, the Coast Guard Admiral who seems to be running things, had this to say regarding the Jones Act during a Q and A on Friday:

"If it gets—if it gets to the point where there's a Jones Act required, we're willing to do that, too. Nobody's come to me with a request for a Jones Act waiver, but any skimming capability we can bring in, we're looking for."

Nobody’s come to you Thad? What have you been waiting for? It's well past the ‘point’.

We don’t know how much is leaking into the Gulf. Assume an estimate of 40,000 barrels a day. Hopefully it is smaller than that. The following is a picture of the reservoir in Central Park NYC. The leak is pumping crude into the Gulf sufficient to fill this lake every ten days. If you run around it you know it's pretty big.

The amount of oil spilled in the last 55 days is equal to about 8 hours of average US consumption. It is equal to .06% of our annual usage. We simply use too much. How quickly can we change this? A generation if we’re lucky.

White House Saturday Night Special – Another $50 billion of Debt

Last night the White House sent a letter to lawmakers asking them for legislation to (primarily) assist states. The plan is to distribute the states money so that they can defer job cuts of teachers, police and fireman.

-I hate it when these things get snuck onto the table in the dark hours of a weekend. Doing it this way is a measure of just how unpopular the “spend more” economic policies are both in D.C. and in the country.

-This request is about politics. The President wants to spend an extra $50b between now and the November elections. The thinking is that that the 300,000 state workers who will keep their jobs for another half year will all vote for Democrats. That might be the case. My guess is another million or so voters will pull a non-Democrat lever as a result.

-This additional spending bill will happen. The votes are there. It will probably end up as a technical adjustment of the 2009 ARRA stimulus legislation. The result will be a future year budget impact but nothing new on the books in 2010.

The letter from the President strikes me odd. Last week the head of the Fed, Ben Bernanke, went out of his way to tell us that things were on the mend. The MSM pushed this thinking broadly. Many suggested that the better tone to the markets recently was a product of the “soothing” words from the Fed maestro. The President’s Treasury Secretary, Tim Geithner has been on the airwaves as well, touting the recovery that he and the Administration has created. Others like Christine Romer and Larry Summers have been talking the same line. With that in mind a few lines from the Presidents letter:

“We are at a critical juncture on our nation’s path to economic recovery.”

“Given the urgency of the continued economic challenges we face…”

“address the devastating economic impact of budget cuts at the state and local levels that are leading to massive layoffs of teachers, police and firefighters.”

“if additional action is not taken hundreds of thousands of additional jobs could be lost.”

“Because the urgency is high these provisions must be passed as quickly as possible”.

“We must take these emergency measures.”

“ I know you share my sense of urgency as we continue our efforts to jumpstart job creation and restore fiscal discipline in Washington”.

The pundits (and political leaders) out there who are selling the story that we are in a sustainable V shaped recovery are wrong. The economy struggles to create 40,000 jobs a month. But budget cuts are about to lay off 300,000 high paid workers. The President’s proposal will pass the buck forward a few months on these layoffs. But by January they will be back on the table. We are less than six months away from another significant slowdown. The President no longer has the money to avoid that reality.

H.R. 5072 Accomplishes Little

On June 10, the House passed H.R. 5072 by a landslide vote of 406-4. This bill is called the FHA Reform Act. The legislation was sponsored by Maxine Waters (D-Cal.).

The White House pushed it:

The boss over at HUD, Shaun Donovan loved it:

"I am grateful to the members of Congress who worked diligently on this bill - specifically, Housing and Community Opportunity Subcommittee Chair Maxine Waters, Financial Services Committee Chair Barney Frank and Subcommittee Ranking Member Shelley Moore Capito. We look forward to quick action by the Senate on this proposal to encourage responsible home ownership while further reducing risk to the American taxpayer."

We know the FHA is having problems. The director, David Stevens made these remarks a month ago:

On the mortgage market in general:

“This is a market purely on life support, sustained by the federal government.”

On FHA’s exploding balance sheet:

“Having FHA do this much volume is a sign of a very sick system.”

On the status of FHA’s “book”:

"FHA has been taking steps to shore up its program after being left with “terrible portfolios” from 2007 and 2008."

It is high time that Congress started addressing the problems with the D.C. Mortgage lenders. I think they missed a chance. But given that Barney Frank was involved it is not surprising.

There is nothing in this legislation that restricts the FHA from insuring up to 96.5% of a mortgage. The window to buy a home with government financing with less than 5% down is still open.

While there may be social implications to this that some consider to be beneficial, it has nothing to do with the soundness of FHA and the financial risk to the taxpayers. We are the only country in the world that has a program like this.Why is is the US government continuing to be the only provider of junk mortgages?

The excesses that followed as a result of the availability of 100% financing were contributing factors to the blow up of 2008-09. It would appear that we have learned very little from that experience. That’s too bad. It cost us $2 trillion so far.

Some of the language in the bill:

Sec. 2)
Amends the National Housing Act to authorize the Secretary of Housing and Urban Development (HUD) to increase the maximum annual premium payments for mortgage insurance, and make the charging of them discretionary instead of mandatory.

Increasing fees would make a difference. It would be a step in the direction of getting the private sector back involved. But they make the fees “discretionary”. Read this to mean that we will not see these higher fees for at least two more years. What a cheap way out. Pass the buck.

(Sec. 3)
Authorizes the Secretary to require specified mortgagees to indemnify HUD for payment of a mortgage insurance claim if the mortgage was not originated or underwritten in accordance with HUD requirements. Authorizes the Secretary to require a mortgagee to indemnify HUD for loss regardless of when an insurance claim is paid if fraud or misrepresentation was involved in connection with the mortgage origination or underwriting.

(Sec. 4)
Authorizes the Secretary to terminate approval of a mortgagee to originate or underwrite single-family mortgages if the mortgagee's rate of early defaults and claims is excessive.

This is nice. Just a question. What did they have before? They had no ability to go after someone who was generating bad paper? That is not correct. Go to the press releases. They have been filing enforcement actions against mortgage lenders for years.

(Sec. 6)
Establishes within the Federal Housing Administration (FHA) a Deputy Assistant Secretary for Risk Management and Regulatory Affairs responsible for all matters relating to managing and mitigating the risk to HUD mortgage insurance funds and for ensuring the performance of HUD-insured mortgages. Abolishes the position of the FHA chief risk officer.

It’s like a joke. They get rid of one risk officer and replace him with a new one. Someone will get a nice new office. FHA does not need a new risk officer. It needs a lower risk profile. It is not hard: Charge a market rate, do not exceed 80% LTV and only insure borrowers who have the ability to pay. Why should the government take so much risk that we need new and important risk managers? Just get rid of the risk.

(Sec. 7)
Authorizes the Secretary to use outside sources to:
(1) analyze credit risk models and practices employed by HUD in connection with mortgages;
(2) evaluate underwriting standards; and
(3) analyze lender compliance with, and HUD enforcement of, underwriting standards.

Oh boy. I don’t like this one. This means that private vendors will get fat. But who? This is just an opportunity for “leakage”. We have Fannie, Freddie, FHLB and FHA with $7 trillion of mortgages that they “own”. They have 70% of the outstanding mortgages. And we have to buy outside databases to evaluate it? What are they doing down there?

(Sec. 12)
Prescribes conditions compelling the Secretary to review and reduce certain cash investment requirements (down payment requirements) binding upon mortgages or mortgagors.

Reduce down payment requirements? I thought this was about protecting the taxpayers?


Following the expiration of the housing tax credit last month home sales in many regions fell by 20-30%. Mortgage rates are at record lows, yet applications are way off. The housing market has a wall of worries. We are not out of the woods. A second leg downward is possible. Should that happen the FHA would need a bailout. It could happen as early as 2011. H.R. 5072 does little to minimize that risk. If anything, it just kicks the can down the road a bit longer.

Social Security At Mid-Year

There is enough published information from the SSTF to make some observations for the first six months of 2010. The data on FICA/SECA tax receipts and benefit payments: (all amounts in $billions)

The numbers are going in the wrong direction. Receipts are down across the board while expenses keep rising. This chart looks at the Jan.-June results for 2008-2010.

These lines were not expected to cross for at least another five years. This is the cost of the protracted recession and the failure of the economy to generate new jobs. The 2008-2009 increase in benefits was at a nosebleed level of 9.5%. That level has collapsed to 3.9% in the 2009-2010 period. This is the result of a “0%” COLA increase for 2010. The flip side is that those receiving checks are getting squeezed as their costs rise and income is stable. In the real world COLA is a joke. As this evolves it will just be a drag on consumption and extend the weak economy.

Most analysts, the CBO and the SSTF look at the Fund’s results in the context of a 75-year time horizon. Some point to a date in 2037 as a point where SS “may have problems”. I leave that discussion to others. It has been well proven that we can’t look two years into the future with any degree of accuracy. I prefer to look at the here and now and focus on cash flow. Consider the changes in the 2009-2010 semi annual period:

Cash flow has fallen from $63b to $7b from 2008 to 2010. One might take heart that the number for 2010 is still in the black. But that will not last long. The seasonality of the Fund produces big cash flow losses in the second half of a calendar year. For the full year 2009 the net cash flow was $3.4B. In other words the cash flow fell by $32 billion in the July-December in 2009. It is certain that cash will evaporate in 2010 as well. My number for the net cash flow drain in the second half of 2010 is $55b. This translates to a~$50b deficit for the full year.

My thoughts on the SSTF year to date results:

-I am stunned by the continued drop in FICA/SECA tax receipts. There are many metrics on the overall economy that have shown YoY improvement. The SS revenue numbers are telling us something different. They measure the incomes of 160 million workers. This is the broadest definition of employment we have. My read on the numbers is that we have very fundamental weakness in employment. The problem is bigger than the headline numbers from the BLS suggest.

-The payroll tax revenues versus the benefits paid number lines have crossed. Some, including the CBO, see this as a temporary phenomenon. I disagree. For there to be a return to a positive result of (payroll tax revenue – benefits) the economy would have to grow on a sustained basis at 5% and inflation would have to remain near zero. Those conditions are unlikely to be met.

-The estimated $50 billion of negative cash flow to be realized in the second half of the year is just more money that Treasury has to borrow. It does not, by itself, increase our total indebtedness. It is a shift between the Intergovernmental and Debt to Public accounts. Does an extra 50 Bil matter when the total the public holds is already 8.6 Tril? No, not really. Not as of today at least. But when the tables turn and the markets focus on the US bond/bill calendar it will make a difference.

-All heavily indebted borrowers, whether they be individuals, corporations or sovereigns are highly dependent on cash flow to service debt. When cash flow goes negative individuals and corporations go bankrupt. Most sovereigns do too. The US is in the enviable position of being able to ignore cash flow. We can simply print our way out of this problem. At least some people think we can.

-SS is $2.5T of the $4.5T Intergovernmental account. I believe that this entire group is going cash flow negative. The IG account cost us ~$160 billion in interest last year, but some out there are pretending the IG account does not exist. An example of this is in the following link.

Sorry, U.S. Federal Debt Is NOT Approaching 100% Of GDP Anytime Soon

This kind of thinking is not only lunacy; it is dangerous.

What's Ben Selling?

Fed Chairman: Recovery on Track (CNBC)

That was the take of the MSM of Ben Bernanke’s words over the past few days. To some extent Ben’s soft talk has had a beneficial impact. “Soothing” was how Paul Mccully from PIMCO described it. But the market overall does not seem to be listening. The NY close stank. Currencies, bonds and stocks moved to risk off mode again.

I heard different words from Bernanke. I heard him say:

“Now is not the time to change monetary policy or raise taxes.”

We have been in an environment of crisis/emergency monetary and fiscal policy for two years. We have ZIRP, QE, stimulus, 10% deficits and total debt exploding.

Bernanke said again today that these emergency responses must be continued far into the future. This high-octane life support is essential to keep the patient alive. Never before in history has so much gas been thrown on a financial fire. And if you believe Ben, we have to continue doing that or we die.

The reason the markets are punky in spite of the all pro MSM cheer leading and those "soothing" words from the Chairman is that the markets are not buying Ben’s words. They shouldn’t. Ben should take note of the reaction. At least he would better understand what he is up against.

My read and apparently the market’s is:

If the patient needs life support, then the patient is by definition not well.

When Ben can stand before the cameras and put his policies where his mouth is by ending the emergency monetary steps and work with other leaders toward a more balanced fiscal approach the markets will listen and respond. In the meantime he is not going to fool the audience that really matters. That audience is the capital markets, they are not buying what Bernanke’s selling.

FX Comments

One important development two important articles.

The Swiss National Bank came into the FX market again today after the E/CHF broke another critical milestone of 1.38

Tyler Durden did a piece and discussed how quickly the benefits of the intervention evaporated. He pointed to the fact that in less than two hours the E/CHF was below the intervention levels.

JPM wrote a report that summed up the critical issues. Their report was very bearish for the E/CHF. Their argument is that the Swiss have now spent 1/3 of GDP in currency intervention and they have accomplished nothing. The conclusion is that the Swiss will be forced to stop and let the Euro to float to a much lower level.

Some thoughts on this.

-I wrote recently that I thought we were near to “the edge” of what might be a major hiccup. We are there now. The status quo has to change. We can’t have the SNB be the only force that is holding a market together. They simply can’t absorb the daily supply. Either other Central Banks step into the market in a visible and committed fashion or there is going to be an FX explosion.

-The Swiss have failed miserably. The long-standing rules of this road say you do not fight when you cannot win. They spent their chips defending levels that proved unsustainable. Now they have too small a pile of chips left. They simply can’t double up any longer. The implications on money supply are already troubling.

-As T. Durden points out the sharks smell blood. What is the smartest way to make money lately? Sell the E/CHF when the SNB comes in and bids the cross up 1%. This trade has proved to be a money machine for those that play. That will not stop. It will bring in more money every time the trade succeeds.

The measure of successful currency intervention is whether the intervention results in the re-establishment of two-way risk. Speculators must be made fearful. They must feel some pain. The Swiss have accomplished precisely the opposite. Hot FX money is now emboldened. They have been making a killing at the expense of the SNB. They have a pile of chips in front of them and are looking to ‘make the year’.

-Possibly SNB head Hildebrand is in over his head. He is very popular in Switzerland. He was an Olympic swimmer. An alpine Mike Phelps type of hero. Here’s his bio. I’m sure he is a great guy, but a few years of experience would be helpful if you wanted to take on the entire global FX market.

In his youth Hildebrand worked as a bellhop at a hotel in Davos, Switzerland, where he met many leading European bankers. He attended the University of Toronto, Oxford University, and the Graduate Institute of International Studies in Geneva. Hildebrand was a member of the Swiss national swimming team and reportedly almost qualified for the 1984 Olympic Games. According to bloomberg.com, Hildebrand was the "youngest ever governing board member when he joined the SNB in 2003.


With effect from 1 January 2010, the Federal Council appointed him to the positions of Chairman of the Governing Board and Head of Department I of the Swiss National Bank.

Source: Wikipedia

-I have done a fair bit of wondering of late if the ECB is not using the SNB as an intervention beard. CB’s intervene on behalf of other CB’s on a regular basis. So it would not be without precedent. But it would be bizarre if true. The magnitude is too large. There would have to be public disclosure if the SNB had an E50 billion sneaky Pete side deal. What causes me to consider this is that I find it incredulous that the SNB is single handedly trying to stabilize/save the financial system.

-I estimate that the SNB had a book loss of CHF2b in just the past few days. That would bring their losses year to date to around CHF8b. About 1,000 Francs per person. This “stealth tax” will not go unnoticed.

-I agree with the SNB when they say that a 1.35 exchange rate would be deflationary. Deflation is being imported to Switzerland via the FX market. That same deflationary force is in the US dollar exchange rate versus the Euro. Question: What does a 10% adjustment in the Euro/$ mean to US GDP? It is not a small number.

-The dollar versus the CHF has been fairly steady at around 1.15. When JPM says the E/CHF is going to 1.25 what they are really saying is that the Euro/Dollar rate is going to ~1.02. A level that many have been calling for. Another of those questions: What does a 14% move in the E/$ do to S&P top and bottom line? It is not a small number.

-JPM suggests a put on one-year E/CHF at current levels with a target of 1.25. If you like that bet consider saving some premium expense and forget the one-year horizon. This thing is moving faster than that. Anyway, in a year from now we will be in a dollar crisis and everything will look different.

Hungarian Bond Story

I was rummaging through some old stuff and found this:

Here is a close up of the legend:

As you can see this is a $500 Hungarian bearer bond issued in 1924. It is worn, but still pretty. This is how they printed money back then. They issued bonds. Sound familiar?

A bit of history. My father bought these and hundreds of others like it after WWII in Zurich, Switzerland. Czech, Polish, Yugoslav and Hungarian bonds. The pile was six inches high. They stayed in a closet until I got them in 1980. Years later, with the help of the Foreign Bondholders Protection Agency I was able to peddle the pile for a few pennies on the dollar. I kept this bond as a reminder.

There is a stamped legend on the front of the bond that says it was restructured in 1937. At that time the principal was rolled over to 1979. The interest rate was reduced to 4.5% from 7.5%. A forty-year extension of the principal, the yield was cut in half. A lousy deal for the bondholders.

Attached to a bearer bond are coupons which one clipped and sent to a bank for collection. The following is a picture of the remaining coupons. Presumably the August 1941 payment was made. But no effort was made to collect on the February 1942 coupon. Not hard to imagine why.

Fifty years later the $500 of principal and the $1,250 of accrued interest were worth $40.

In 1924 Hungary was a prosperous nation and could issue debt because people believed it would be paid back on a timely basis and in the meantime it was a “store of wealth”. Banks were suspect, but a sovereign credit was as good as gold. And this store of wealth could be transported across borders.

Things changed in the first 13 years in ways that could not be anticipated. An effort was made to formally restructure what were un-payable debts. The evidence is that partial interest continued for another five years and then it was worth nothing.

There are very few similarities to the Hungary of 1924/37/42 and Hungary/PIIGS/etc. of today. First and foremost there are no attractive looking, negotiable bearer bonds. But electronics has made the debts more mobile then ever. There is no war in Europe to destroy the value of a debt. Today there is just too much debt. That alone will destroy its value.

The observation is that many countries defaulted over the years. Every country south of Texas went bust in the 80’s. Each time the bondholders got whacked. Some debts just got rescheduled at a lower rate. Some paid nothing at all. The difference between 1945 in Europe and the problem countries in the EU today is that the numbers are so crazily large. The deflationary implications of restructuring a few trillion in debt are difficult to fathom. But history does have a way of repeating itself.

Another takeaway from a review of this bond is that it was backed by gold. Of course there was no gold. Only ink that said there was. And today we are still talking about this very same subject. Ink is not gold. Amazing how little things change.

On FX – Who to Trust?

French President Sarkozy on May 7, 2010:

“We will confront speculators mercilessly. They will know once and for all what lies in store for them.”

But it has not worked out the way Sarkozy planned:

Sarkozy changed his tune on June 4th:

“I see good news from the current euro-dollar rate.”

This is a good example how things can go wrong when an elected official (who has no understanding of markets) speaks and acts rashly. Basically Sarkozy said, “Bring on the wolves!” And wolves came and ate him alive. Angela Merkel is no different. She initiated a freeze on shorts and restrictions on CDS. The German markets have been southbound ever since.

So the heads of state of the two critical countries in the Euro drama have made things worse not better. At this point the Wolves have a nice wad of cash in their pouches and they are still very hungry. They are more dangerous than ever.

On the other side of the Euro ledger is the ECB. They have bought a modest amount of troubled sovereign bonds so far. More importantly the have borrowed in the public markets to finance it. This is not QE by any means.

There must be a fair bit of pressure on J.C. Trichet to open the floodgate and print money. Tim Geithner has been breathing down his neck with the, “Do it Big and Do it Fast” plan for more than a week. That J.C.  has resisted this step is one reason to be optimistic. At some point the resolve of the ECB on the anti QE issue will translate into confidence. Heaven help the Euro zone should they waiver and open the printing presses. That mistake would take many years to fix.

If you follow FX you should ignore what the elected officials are saying. If anything, trade against them. Focus on the ECB and what they are doing. In this case they are doing nothing for the Euro. There have been rumors and suspicious market moves that make it possible that the ECB has been involved with sub rosa currency intervention. It is my belief that they have not been in the market. Based on that I conclude that the ECB wants the Euro lower. It would provide a big boost to the entire region. It is very beneficial to the German economy. At the end of the day that is all that matters.

It should be an interesting week. Another five days of losses for the Euro without a visible response from the ECB would confirm the policy of ‘orderly retreat’. That could set up a summer of weakness for the Euro and across all markets.

Tim's Gotta Go

The following are portions of Treasury Secretary Tim Geithner’s final communiqué to the G20 and my comments. The full communiqué can be found Here.

Last year, the G-20 acted to restore growth to a world in crisis. The IMF expects global growth to exceed 4 percent in 2010 and 2011.

Tim, that is not what the IMF said. From Reuters:

"An IMF report presented at the G20 meeting earlier estimates that coherent adoption of the adjustment policies could increase global growth by as much as 2.5 percent annually over a medium-term five year period."

The head of the IMF Strauss-Kahn had this to say on growth prospects:

"I am totally comfortable" with a final communique calling for troubled euro zone countries to accelerate fiscal consolidation. They have to consolidate strongly even if it has some bad effect on growth."

So Tim, the IMF does not share your rosy views on global growth. In fact they are worried that the necessary fiscal consolidation will result in slower growth. Geithner’s statement was read by every finance minister at the meeting and around the world. They will read Tim’s words and just conclude that he is selling a story to the newspapers and has no substance to offer. So much for financial statesmanship.

The US is in its 4th quarter of solid growth.

Solid growth Tim? This is just a lie and he and the other heads of state know it. The recovery to-date has been tepid by any comparison to any recent US post recession cycle. We have unemployment at 9.7%, a 50 year high and we can’t create 50,000 jobs a month without massive fiscal and monetary stimulus. We are growing because of a very big inventory cycle and the continued stimulus measures. Were it not for those factors we would be looking at negative real organic growth. Tim is selling a bag of crap to an audience who knows better.

European authorities gave us an update on their reforms and financial programs. Our discussions were focused on our two core priorities: growth and financial reform.

On growth, we reaffirmed our strong interest in making sure we reinforce the ongoing recovery in private demand across the G-20. As we do so, we agreed on the need to undertake and credible commitments to restore fiscal sustainability over the medium term.

This stupid sentence did not go unnoticed. The focus was on the words, “medium term”. In this case what Tim was really saying was:

“We all know what we are doing is not sustainable and it may kill us if we continue, but we have to keep kicking the can down the road for at least two more years. That way my boss has at least a chance of being re-elected and I might keep my nice job”.

Tim wants the world to do what he is doing at home. Deficits in excess of 10% of GDP. Debt levels that are approaching annual GDP. Debt levels that far exceed GDP when the D.C. mortgage debts are included. He wants ZIRP to last forever, even though he knows it is killing savers. He wants an unending stimulus program for housing, cars, agriculture and every other segment of the economy. And he wants to do this when our country is in a protracted and expensive war. There is no leadership.

In the United States, we’re moving forward with important reforms of health care, education, and our financial system—together with substantial investments in innovation, basic science and research and development, and infrastructure. All these initiatives are designed to provide a stronger foundation for future economic growth.

More lies. The health care reform was a joke that was rushed through in the dark of night. The assumptions used were bogus. The whole thing is going to have to come back on the table in less than one-year it is so badly flawed. About those investment in science and research, is that why the administration gutted NASA?

What Tim and his cohorts did in the past 18 months is wrack up an additional $2 trillion in debt to keep things going. The have not done one thing that I can think of to, “provide a stronger foundation for future economic growth”. There is a great deal of empirical evidence that economies have a difficult time of sustaining any growth when debt to GDP exceeds 100%. We are functionally there today. Tim has done nothing to help us long term. If anything, his plans will mute growth for decades.

Within the G-20, we discussed how the ongoing shift toward higher saving in the United States would need to be complemented by stronger domestic demand growth in Japan and in the European surplus countries, and sustained growth in private demand, together with a more flexible exchange rate policy, in China.

Tim is begging the rest of world to help him out. He wants Japan, China and Germany to help him out? Those folks are not listening and Tim knows it. He was just in China and the issue of exchange rates was not addressed. There is little prospect for “flexibility” by China anytime in the near future. He failed miserably on this issue. Japan has 200% debt to GDP and Tim thinks they are going to be the source of global growth? This country has 1/3 our population and 1/3 of our GDP. They will not assume the role that the Treasury Secretary wants.

For me, the most significant response to Timmy’s plea for more deficit spending came from the head of the ECB, J.C. Trichet:

“The impact of narrower budget gaps on growth could not be considered negative because it would improve confidence. The need for such action is clear in old industrialized economies.”

Trichet has said he will not play in Tim’s sandbox. I love that he stresses the point that confidence is now a central issue in global economies. He is admitting that without sane policies confidence will be lost and when confidence is lost the mother of all depressions will follow.

When Trichet says, “old industrial economies” he is talking about the USA. These folks choose their words carefully. They are diplomatic. When Trichet said this it was equivalent to a punch in the nose in the real world. While Tim shed no blood, this comment hurt. It was a strong rebuke. Damn near an insult. Do not look for the ECB to bailout the US or Europe for that matter. Consider also the comment from the head of the German Central Bank, Wolfgang Schaeuble:

"I made no bones about the fact that I share the IMF's underlying philosophy only in a very limited way,"

The ECB and the Bundesbank have spoken as one. They both have said “no” to Tim. This exchange should not be ignored. It has significant implications as to how far the Germans are prepared to go in support of the EU. My read on this is that the answer to the question, “How far should we go?” is “Not far at all”.

Fiscal consolidation should be “growth friendly”—as the IMF puts it—with the pace and composition of adjustment varying across countries.

“Growth friendly” = big deficits = Death. Tim relies on words from the IMF. He is using this as a way to defend what he wants. He is hiding behind the skirts of the IMF technocrats? A very weak place to hide.

The United States is moving aggressively to fix things we got wrong and to strengthen our economic fundamentals.

Moving aggressively? What is he talking about? Fin Reg? That is also a joke. Timmy G has gone out of way to avoid addressing the problem the country faces with the mortgage agencies. These beasts now represent an off balance sheet commitment in excess of $7 trillion. They continue to write 97% LTV loans and suffer double digit defaults. They are 90% of the current mortgage market. The GSEs represent a far greater systemic risk than any other component of our economy. Yet the Treasury Secretary thinks these problems are too difficult to confront. The result will be over $400b in losses born by the public.

Tim is going to get hit in the face with a two by four on December 1st when the Fiscal Commission comes public with its recommendations on how the US can return to fiscal prudence. On that day everything that Tim has been calling for will be trashed. The Fiscal Commission was made necessary to some extent because the Treasury Secretary was too weak to lead a proper response. But the job of selling and implementing the spending cuts and tax increases that will be recommended will fall to the Treasury Secretary. There is not one chance in a hundred that he will succeed in that role. He is wedded to big debt and big government spending. He is the wrong guy to lead us in the right direction. If we are going to make it to 2015 without a major financial collapse we need some leadership.

Time's up Tim. You gotta go.