Bruce Krasting

IRS Cuts Deals

2012-05-24T04:28:00.000-07:00

The other day the IRS announced new rules for settling tax liabilities for individuals. It’s a sweet deal. I thought that was interesting. Then yesterday we get an announcement from Altria (MO) that they too have cut a deal with the boys at the IRS. Coincidence? Leading indicator? Some details:

Individuals - The IRS spells out the new terms for individuals who are delinquent here.

Summary:

When the IRS calculates a taxpayer’s reasonable collection potential, it will now look at only one year of future income for offers paid in five or fewer months, down from four years, and two years of future income for offers paid in six to 24 months, down from five years. In addition, equity in income producing assets generally will not be included in the calculation of reasonable collection potential for on-going businesses.

The basis of settlement is now 25 cents on the dollar. (a percentage of 1 year of income vs. 4) if payment is made in less than five months. The IRS has provided a big incentive to settle fast.

Altria

If you look at the headline you would think that poor old MO took it in the ear on this one. $500m is big bucks for anyone, especially if it is paid to the IRS. But actually this is “good news” for the company.

Altria got nailed by the IRS as a result of aggressive tax accounting on leveraged leases it owned. The potential loss could have been $1b. Last year MO took a charge of $627m to cover the cost of a settlement. The deal it cut with the IRS is well under budget.

MO will end up with a gain of 3 cents ($61m) a share as a result of the settlement. The difference between last year's charge and the amount paid to the IRS is $127m. The net gain to the shareholders of only $61m means that the litigation expense was a cool $66 mil.

I’m thinking that the lawyers and the MO top brass are drinking expensive champagne and smoking Luckies with this result.

I have a few questions:

- The IRS is Treasury and Treasury is the White House. The change in policy on cutting deals comes from the WH. Why? The fact that the new rules are geared to cash settlements in less than five months is curious. The election is in five and a half months. Are these guys trying to rig numbers to show some improvement on the tax receipt line? I wouldn’t put it past them.

- What’s the message here? Don’t pay your taxes and later cut a deal for 25 cents on the dollar? I’m no fan of taxes, but I, and most other folks, pay 100%. I wonder if the precedent being set by the IRS won’t undermine its ability to collect that 100%.

A thought:

If you believe that this WH is willing to cut tax deals to raise much needed cash, then you're apt to believe that there is plan for a tax holiday on corporate foreign income. There is a about $1 trillion of untaxed earnings sitting outside the US currently. The tax on this would come to about $200 billion. Look for a proposal from the WH to give US multinationals corporations another tax break. They would pay $100b and keep the other $100b.

More champagne and smokes…
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Trust in America – Not

2012-05-20T05:59:00.000-07:00

I wish I could have been a fly on the wall at the G8 summit at Camp David this weekend. The final communiqué from the global big shots talks about keeping Greece in the Euro and a shift away from austerity and a move towards growth oriented policies. Forget the Happy Talk, I want to know what they were really saying.

Obama must be praying for a miracle with the other members of the G8. If we get a “Grexit”, there will be months of turmoil in the global capital markets before the dust settles. The last thing the Big O wants to have is a recession in Europe that infects the USA with lower growth and higher unemployment when Americans are going to the polls in six months. For the same reason, Obama needs Japan to keep QEing and spending money it does not have.

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Obama may be a slave to what happens outside of our borders during the period prior to the election, but those same foreign leaders are completely at the mercy of the USA and the next President after the election. It won’t matter what the UK, Germany, France or Japan does with stimulus in their countries; what’s on the table in the USA will overwhelm any of those efforts.

The USA is months (220 days) away from initiating fiscal policies that will trigger a recession in the US that will be at least as severe as that experienced in 2008. With the rest of the world already teetering on recession, America is set to push the global economy right into the tank. The non-US members of the G8 are well aware of these facts. They must be crapping in their pants at the prospects.

I think those concerns are completely justified. Any foreign leader who is banking on the hopes that America will end its political stalemate and put forward a credible economic plan that puts the US and global economies on a better footing is a fool. If you want proof of just how far away viable compromises are, consider some legislation put forward by Republican leaders this week.

House Representative “Buck” McKeon (R.Ca) runs the powerful Armed Services Committee. He has come up with a fiscal 2013 spending plan for the military. The CBO looked at H.R. 4310, so did the White House. It’s a joke.

$637 billion! That’s a lot of loot for a country that’s tapped out. This is not a compromise. This is an insult. The following chart shows that the 2013-spending plan proposed by Republicans has no reduction from the historic highs of the past few years.

What does the White House have to say about H.R. 4310?

When it comes to military spending, the Republicans want to bust the law that led to the increase in the debt limit. They propose legislation that would renege on the deal that they fought for last summer. The fight over the debt limit brought the economy and the markets to its knees. It cost the USA its AAA. And now the Republicans propose to kiss it away.

Obama had lunch with House Speaker Boehner last week to discuss the political impasse and the critical issues the country faces. To make it look like B&O are just a couple of regular guys they went for a bite to a local sandwich shop. I’m thinking there must have been 300 Secret Service types outside. There is nothing regular about these guys.

Did the “deciders” at the hoagie shop agree on anything? Not a chance.

There is a near zero chance for America to address the fiscal cliff that is coming on Jan 1 before the election. I think there is also a zero chance that it will get resolved in the six-weeks following the vote. Those G8 leaders have every reason to be worried. So should the markets.

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On FX and Worst Fears

2012-05-17T13:11:00.001-07:00

Two market developments are worthy of note today (so far). Gold is up 2.5% (off a very cheap low) and USDYEN and EURYEN have made very significant 1.3% moves down.

Stuff like this scares me. It looks like acceleration in the flight to quality. The news backdrop is terrible and supports a panicky market outcome. My ability to look into the future has gone to zero.

For those that follow this blog for my read on FX, I cut out my short on the Euro and the long on USDYEN today. The outcome was (sort of) what I anticipated. I collected a few dimes on net. This was always a trading position, having lost my rudder on what might happen next, I’m just taking oars out of the water.

It’s been my experience that my “Worst Fears” on matters of global macro economic developments never come true. Some of my worst fears at the moment:

- A full-blown bank run in Europe. This is already happening. It is happening in cash by the billions at the bank teller windows and cash machines, it is happening by the hundreds of billion in electronic transfers. It can’t go on much longer.

There is a story/rumor going around that Euro denominated bills will soon be stamped with a single letter of country origin. This is what may happen in Greece. To stop the cash drain from the local banks, bills taken from a bank/ATM would have a red G on them. Any money transfers out of the country would similarly be flagged G (or temporarily blocked). Functionally a two tiered Euro will have been created.

If (when) this happens the bank run will explode in Spain, Portugal and Ireland. The precedent will have been set with Greece. The response by authorities will be more stamped money, this time with red S’s, P’s and I’s. Basically the whole ball of wax melts down.

In that scenario, what would the value of a EURUSD marked with a D for Germany or an F for France be? My answer is that it would be far higher than the 1.2700 it is at the moment.

My point is that it is not entirely clear what it means to be short the Euro against another currency, currently. I want to be short the Euro that will be marked with the dreaded S, P, or I (or maybe one with red IT?), but I don’t want to be short the one with a D.

Exchange controls of some form or another are not far away. If there is a two tiered Euro being formed by events in Greece, then contracts, including FX contracts, will be settled with the Euros that are the strongest legs of the two tiered system. While there are long odds for this outcome, they are odds I do not want to play.

- If things keep up as they are in the financial markets, there will be another problem someplace that is not now on the radar. It could be in Eastern Europe, or even Russia. My bet is it comes from Asia, possibly China. There will be liquidity issues someplace.

This story by Izabella Kaminska talks about the potential for a problem (link).

- There are other things on my radar that could be trouble. One that could be a kick in the pants is a “failed” IPO for Facebook.

Nevertheless, I think this deal will be a huge success. It will be a monster IPO that raises record amounts of capital. More shares will be sold to the public than has been assumed. There is a big ‘Green Shoe” of additional shares that the underwriters have to offer if there is post issue market demand.

I expect that the stock will open at a big premium to the IPO price, and then rise some more. What I’m afraid of is the print at 3:30.

There is an aspect to this deal that is a bit troubling. Mark Zuckerberg has made it clear to the underwriters that he wants a good portion of the stock sold in the IPO to go retail investors who believe in Facebook. Those investors would not stand a chance of getting any stock in a normal IPO. Good for Marky.

But that is not how IPOs work. Deals get “hot” because retail investors want to own shares, and those investors typically have been excluded from getting shares at the IPO price. Retail is normally the force that gets an IPO a 10%+ pop at the opening.

But what if a fair chunk of the retail demand that is needed for the stock to catch a bid has already been filled?

This is a very big deal with some unusual features. It will be priced rich with lots of shares sold. If there is a pop tomorrow morning that results in the green shoe getting filled, and the flippers (like me) get out, it could lead to a disappointing day.

Who knows? We might have a $100b lead weight on our hands.

Note: The results for FB may get tainted by news from Europe or elsewhere. What’s the chance for bad news from Europe tomorrow? A Friday? High, is the answer.
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A Surprising Conversation With Athens

2012-05-15T10:54:00.000-07:00

If you read me on a regular basis you know that I speak with a fellow in Athens who is connected to the shipping industry and the government. I provide links below to some of those articles to establish this person’s credibility. He’s been pretty much right on things that have happened in his hometown.

I called him today to discuss the (now definitive) fact that there is no new government and elections will take place on June 16. What he said completely blew my mind.

He started with the well-documented fact that 70-80% of Greeks do not want to give up the Euro. They are afraid for their future, and their ability to survive if that link is broken. The following are his words, not mine:

Athens - The results of the May election are in conflict with the people's desire to stay with the Euro.

The people voted in anger. They voted against those they had voted for in the past. Now they see whom they have elected.

Every day on TV the extreme right is interviewed. They are Nazi’s. People are frightened by this.

On the left you have Alexis Tsipras (Syriza). This man is an uneducated thug. The people understand that. They don’t want this man to be their leader.

When the next election comes, Greeks will not vote in anger and they will not vote for the idiots on the fringes. The centrist parties will rebound. A National Salvation Government will be formed.

BK - There are polls in the US press that say that Syriza will win a majority. (link)

Athens - I don’t think those polls are accurate. To me, things look much brighter today than a few weeks ago.

BK - But does it matter who wins? Can Greece be saved?

Athens - This up to Germany. Most of the debt is now with Germany and France. France’s Hollande would agree in one minute to reset the interest on the debt to zero for the next five years. If Germany agrees to do the same, there is a chance. The IMF would support Greece under these conditions. The restructured bank debt would get paid interest.

BK - Do you really believe that Greece can achieve a long-term recovery with this?

Athens - Not a chance. Everything will blow up again in less than one year.

The thrust of this conversation runs counter to what I believed likely to happen next in Greece. There is a six-week period before the election. Anything can happen. The scenario my friend outlined is not out of the question.

If this fellow is right that the Greek elections are going to produce a surprise result, one that will create another “Kick the can down the road” opportunity, then it's not in the market today. The exact opposite is.

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Other articles based on conversations with "Athens".

http://brucekrasting.blogspot.com/2012/04/three-conversations.html

http://brucekrasting.blogspot.com/2012/01/greece-china-and-usa.html

http://brucekrasting.blogspot.com/2011/11/thoughts-from-athens.html

http://brucekrasting.blogspot.com/2011/09/whats-up-in-cyprus-war.html

http://brucekrasting.blogspot.com/2011/04/shipping-news-pirate-update-thoughts-on.html

A Defense of the Morg

2012-05-13T05:43:00.000-07:00

Man-o man did the Morg screw up! Let me count some of the ways:

- It announced a $2B loss, but everyone in the market knows its trading book, so the losses have nowhere to go but up.

- Investors took JPM’s stock behind the woodshed and beat it with a stick. The one-day damage resulted in a $14.5B (9.5%) drop in the market cap for the company.

- The SEC, the Fed, and the UK's FSA have all initiated investigations into what went wrong. This insures that this story is going to remain on the front pages for at least another month.

- The timing of this debacle could not have been worse. Any chance that the big banks had of creating some wiggle room on the Volker Rule has been lost. Over time, the tighter regulations that will certainly follow will cost JPM multiples of the loss the have incurred so far. The other big banks have the same problem. The CEOs (and the shareholders) of the big banks must hate Jamie Dimon.

- Dimon will lose one of his best friends, Obama. There is no way the White House can look the other way on regulating the banks anymore. This is an election year, so red meat is needed to get votes. JPM/Dimon has served itself up as a roast beef and is just waiting for folks to start slicing it up.

- By far and away the worst aspect of the story is that the big brass at JPM did not have a clue as to how risky their “hedges” were. The big shots thought that the bank was reducing risk, actually it added (substantially) to the risk it was facing.

It’s possible that I’m the only person in the world (other than Dimon and the JPM Board) who has any sympathy for poor old Morg.

As of today, I’m operating under the assumption that the losses at JPM are the result of hedges that went bad. The original intent was to minimize risk, the result was exactly the opposite. This was not about some rogue trader that hid the risk that was being taken, senior management was (sort of) aware of the “hedging” trades that were put on by the bad folks in London.

Hedging risk is a very complicated business these days. There are two ways of reducing risk, (1) sell everything and go out of business, or (2) do what you can to manage risk, and at the same time recognize that there really are no effective hedges.

It is very difficult to reduce risk without taking on derivative exposure. That is the way of of our financial system. To make this point I’ll describe what I did on Friday.

Two weeks ago I reported in this blog that I had bought a one-month put option on the EURUSD. The option is at a strike price of 1.3210 (spot price at the time of execution). As of this past Friday night I’m three big figures into the money on this position. For me, this is the equivalent of a double in baseball. I’ve not hit many doubles of late, so the thought crossed my mind that I ought to take some chips off of the table.

To be honest, I was troubled with the price action of the EURUSD in the latter part of the week. Yes, the Euro cross closed on the lows, but to me the price action looks sticky. I’ve only got two weeks left on this option, I know from past experience that under 1.30 the damn Euro has found demand in the past.

It’s my best guess that the news flow out of Europe is going to get worse over the next fortnight. There is a reasonable chance that things go wrong and we see another big price adjustment in the EURUSD. To my eyes it looks like there is a good possibility for a move to 1.2500. If that happens my “double” will turn into a home run. I could use a home run (who couldn’t).

I pondered this on Friday. What to do? How does one reduce risk, and at the same time stay in the game? I chose a hedging strategy that is not unlike what the Morg did to protect its book. I took a derivative position against my short EURUSD position; I bought USDYEN.

What??

I’ll take all the criticism that readers can dish out on this trade idea. I can understand if someone were to say, "It was the ‘wrong’ thing to do".

In a number of ways I added to the risks that I was taking. There is no certainty that my new Yen position will act as a hedge against the existing EURUSD short. I have substantially increased my market exposure overall. I now have two long dollar positions. If some event happens and the result is a new market mood that translates into a “Sell the dollar across the board” mentality I will get my head handed to me.

The flip side is that there is empirical evidence from the market that when EURUSD goes lower, USDYEN also moves lower. That’s just the way it is. So if the Euro does find some stability in the next few weeks that results in a higher EURUSD I will give back some (all?) of the gains that I have in the option position, but it's damn near a sure thing that if that happens, USDYEN will move significantly higher. So I do have a hedge on.

Part of my thinking here is that at 79.90 the USDYEN is a buy. Yes, the position should be a hedge against the EURUSD short, but it also could end up a win-win for me. The EURUSD could weaken and I get fatter while the USDYEN could be flat. So I’m speculating with my hedges. I know that. This is exactly what JPM did with its hedging activity. It chose to put on a derivative short, against a book long. Call this “aggressive hedging”.

A big question for me was how much do I short the Yen to offset the short EURUSD exposure? There is no answer to this. There is no formula to look to. I’m “hedging” in two different markets; there is no certainty that there is a correlation between the two. If I have $1 short EURUSD, how long USDYEN should I be to create an effective hedge? Is it 1 – 1? 0.5 – 1? 2 – 1? This is not science, it’s guess work.

I think that JPM screwed up this critical calculation. They bought some protection in a market that they thought was correlated. It turns out the were right, but they bought too much protection so the hedge losses ended up being greater than the gains from the underlying portfolio.

If JPM had hedged with a much smaller exposure to CDX.NA.IG.9 (the derivative contract that done JPM in) the headlines would have been different. We might have gotten these instead:

Much to Jamie Dimon's chagrin, we will never see those headlines.

I wouldn’t be surprised if most readers thought I was nuts. Hedging one exposure with a derivative position in a different market is not de-risking, it is adding to risk. But in the complex world we live in there really are no hedges that work. Everything is connected, every price is a derivative of something else. Everything is negatively or positively correlated. Right?

I watched Senator Carl Levin on TV Friday. He crapped all over JPM/Dimon. He wants the Morg out of the spec side of the banking equation. If the good Senator reads this blog, he would think I’m nuts, he would also make me the poster boy of why guys like me should be shut down. (I’ll be sure to send him a link)

It might just be that this ends up with Levin getting his way. More regulations, a transaction tax, or a very high tax rate on short-term capital gains seem likely as a consequence. Maybe that is how this should resolve itself. Kill the beast.

The risks are out there folks. Chasing small fry like me, and “Whales” like JPM into the bushes does not take the risks away. It magnifies them. For example:

- Since the start of May we’ve had a minor correcting in the stock markets. Hardly a ripple. But the Wilshire 5000 is down by $600 billion. Apple’s stock value has risen by $47B and then fallen by the same $47B in the last thirteen trading days.

- The market value of US government bonds has soared the past two weeks. At this point every high-grade bond in existence is trading at a premium. The funny thing is that every cent of that market premium has to go to zero.

- The Euro is down by a lousy 2.5%, but a different way to look at it is that the value of Euro denominated assets fell by more than a Trillion dollars on a relative basis. I doubt that one in a thousand even noticed the change.

I don’t think that anyone who lives on the grid is free of macro, derivative or tail risk. They might think they are, but they are not. The upcoming effort to curtail the risk takers may make many “feel” good. I think those same folks will regret it when the specs get put in a pen.
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Unscrambling the Euro Eggs

2012-05-10T05:26:00.001-07:00

On April 17 I wrote about a conversation (link) with an individual who lives in Athens. He had this to say about the coming Greek elections:

“The other parties are communists, radicals and crazies. If they have a hand in the new government, then on May 7 Greece will be forced to take dramatic steps. The whole idea that the country should suffer, so the bankers can get paid will have to change.”

He also said this:

“The attitude in Brussels and Bonn towards Athens will change after the election as well!”

He had that right, so I called him back to get an post-election update.

BK: Is it true that you will soon spending Drachmas?

Athens: This seems to be the only possible outcome. Germany will no longer support Greece, neither will the IMF.

BK: What would the new Drachma be worth in Euros?

Athens: Far less than the rate that was used to convert Drachma to Euros in 2001. At least 50% less. For Greece, the exchange rate for the Euro will be the key, but you can’t forget that the Drachma will also have a new exchange rate for the dollar.

Greece joined the Euro in 2001 at a fixed conversion of 341Greek Drachmas to the Euro (EURGDR). In the period preceding the link, the USDGDR was 328.

Assume the Drachma floats freely and promptly loses half of its value versus the Euro. The market rate would be EURGDR 682. If the EURUSD was trading at 1.3000 it would mean that the USDGDR would be 568. The GDR would lose half its value against the Euro but it would only lose on 37% versus the dollar. I asked the fellow from Athens about this:

Athens: There is the proof. The Euro is too high against the dollar.

I thought that was an interesting comment. I went back and looked at the original conversion rates to the Euro for France, Italy and Spain and compared them to what the USD exchange rates would be today:

The +11% results for these countries versus the USA looks wrong to me. I considered what the local currency rates would be if the Euro were lower in value versus the dollar. A rate of EURUSD 1.20 still doesn’t get it done for me. It starts to “look right” with the EURUSD at 1.10

If the Euro were to be broken back into its original pieces, the old legacy currencies would trade around the Deutche Mark (DM). It is a very safe bet that if there was a free float of the currencies, the DM would increase in value versus all of the other EU members. It’s an equally safe bet that the USDDM of ~1.67 that was posted on 12/31/98 (last day of the DM) is going to also be much weaker (DM strength).

If the DM is going to make a comeback it will create a very nice new reserve currency. Money will migrate from both Switzerland and Japan to a different “safe” place. It will end up in Frankfurt. These are my estimate for what may happen:

USDYEN = +10%

USDCHF = +10%

DMYEN = +30% (1999 to date)

USDDM = -40% (1999 to date)

USDDM = Parity

DMCHF = Parity

DMFF = +15% (1999 to date)

DMLIRE = +20% (1999 to date)

DMPESETA = + 40% (1999 to date)

DMDRACHMA = +60% (2001 to date)

DMESCUDO = +50% (1999 to date)

DMGUILDER = +10% (1999 to date)

Of course these are just estimates, but I think the directional moves I describe will take place. The issue is how long it will it take and how violent the markets will be. On that score, I would estimate that it would take at least a year for these adjustments to take effect, the process of making these adjustments will be very violent indeed.

One thing is clear to me, Germany is going to take the brunt of the adjustments that must follow. The Germans are going to get hit from all sides. Its currency will rise against all the EU countries, it will rise against the Dollar and the Yen. This reality is the reason that Germany has done what they have to avoid a breakup of the Euro. I don't think they can avoid the consequences much longer. Germany is now stuck between a rock and a hard place.

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On the Odds of an Ease

2012-05-06T17:32:00.000-07:00

A friend sends me the following chart to support his conclusion that another round of QE is coming from the Fed sometime in June. The chart tracks the ten-year bond and the performance of the S&P since 2009.

Some thoughts on the info provided in this graph:

+While both QE1 & 2 were ending, the S&P fell.

+Operation Twist appears to have successfully restrained any increase in long-term interest rates.

+The European Long Term Financing Operation (LTRO) liquidity operations had a significant positive impact on US equity prices.

+As of today, the spread between LT interest rates and the S&P is the widest it has been in three and a half years.

+ The current level of the ten-year bond is the same as it was during the height of the recession/depression during the 1Q of 2009.

My observations:

- Tyler Durden at Zero Hedge (among others) has been pounding the table with the thesis that what drives markets today is not the size of the Central Bank balance sheets, it is the daily/weekly flow of additional monetary easing that matters. I think the chart confirms this.

- Twist and LTRO are finished for the time being. Bond yields are reacting to the economic slowdown that comes with the ending of these monetary jolts. Stock markets around the world have flattened out; there is good evidence that an equity market correction is underway.

- The huge gap in the current spread between bonds and stocks is scary. Notice that the orange and white lines have crossed numerous times in the past. If the lines were to cross again, it would imply that either interest rates have to shoot up, or the stock market is looking at a very sizable adjustment. I see little chance for interest rates to move higher in the current environment. This sets up the possibility for an out-sized down move in stocks.

- Everyone (most importantly Bernanke) is aware of the information that is contained in this chart. Bernanke is also aware of Durden’s point: you have to feed the beast every week, and you have to commit to weekly feedings far into the future, or markets will get grumpy.

- The expectation from all directions is that the Fed and the ECB will (once again) rise to the occasion (June is the popular time frame), and when they act, stocks will go “green” again.

- That the market is so convinced that the Fed will bail it out (or prevent any significant decline) allows for the very high spread between stock prices and interest rates that exists today. There is a high degree of complacency in the market. It believes the Fed is the backstop, and it will always be there when markets flutter.

The arguments and logic for additional Fed accommodation are compelling. The assumption is that the Fed will do the “logical” thing and repeat its past actions . I disagree.

The next opportunity for the Fed to act is June 21. That is 133 days before the election. Any new Fed program (sterilized QE) would take time to become operational. To be effective, it would have to have a time frame of at least six months. This leads to the conclusions that (1) the earliest the Fed could act is late August, and (2) if it were a six-month program, it would be in full gear for the first week of November.

The Fed can’t do that. It would (appropriately) be accused of supporting Obama and interfering with the political process in the US. An independent Fed can’t throw elections. If it tried, the result would be a lose of its independence.

The Fed's only support comes from the political right. I think this is because the Political Right = Money, and Money "believes" it is better off with an independent Fed. If the Fed takes action to support a liberal president in a key election, it will lose what support it has.

The folks at the Fed ain’t dumb. If they cared about their role in society and wanted to maintain their power, prestige and independence, the last thing they would do is start another round of QE in the 3rd quarter of 2012.

The situation is quite the opposite in Europe. I think the outcome will be the same. Europe has had its critical elections this weekend. Now we know that a Socialist will lead France. The message from this election is very clear. The French people do not want austerity. Neither do the Dutch, Italians or Spaniards. The only country left that is pushing for austerity is Germany.

I think that there is a near zero chance that the German people will permit their leaders to write a check that supports growth programs in the EU. If France says, “To hell with austerity”, the politics in Germany will turn away from those that support pan European bailouts. Merkel will be D.O.A. if she tries to have Germany foot the bill for a French expansion program.

I will add that if France does turn its back on austerity, (almost certain that they will) the German Bundesbank will just say, “Nein, danke”. Without "Bubba", no deals will happen.

The markets are going to hit a wall on Monday. There will be a cry from the pundits,

"Don't worry, QE is coming for sure! Buy the dip! The Fed is going to come to the rescue and bailout the global markets!"

I’m going to go against the consensus opinion.

The Fed is on hold until December.

We will not see another LTRO operation this year.

If I'm right, what does it mean for those lines on that chart? Nothing good.
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Treasury Fudges Numbers??

2012-05-05T09:03:00.003-07:00

NOTE

In this blog I question the accuracy of information regarding expectations for future inflation that was contained in a report from the Treasury Department.

The Treasury Department has contacted me. It has provided the source of information it used for the report I referred to. This is the link:

http://www.clevelandfed.org/research/data/inflation_expectations/

I'm not changing the article based on this information, but please read it with this information in mind.

Before publishing the blog I communicated with two individuals active in financial markets. Their responses confirmed what I consider to be the case. When the topic of "Inflation Expectations" is raised, those who follow markets think of the TIPS/Coupons spread.

It's all well and good for some academics to come up with a formula for what Implied Inflation is. But the Treasury Department is ignoring what a trillion dollar market is telling us. I find that interesting, given that Treasury is the one who's selling those trillions of bonds.

Un-edited and with a few warts:

The Treasury Department’s Dr. Janice "Jan" Eberly put together a deck of slides describing the state of the US economy. (Link) This is an impressive presentation with charts on many key economic variables. You can’t blame the good Doctor for putting a spin on her presentation. After all, this is an election year, so putting lipstick on a pig is to be expected.

There was one slide that caught my eye. It was in a section labeled:

As “evidence” that the US is on the right fiscal footing, the Treasury provided this chart on inflation expectations:

Short and long term inflation expectations are just 1.5% according to this impressive presentation. I think the chart is wrong.

The Treasury Department does not tell us where it got the information supporting the claim that inflation expectations are so low. The only place I know to look for a market-based forecast on future inflation is the TIPs versus coupon spread. Possibly the Treasury has some other source.

Bloomberg tracks the implied inflation outlook that is derived from market data. This is the Bloomberg methodology:

This is pretty simple stuff. Take one number, the prevailing yield on ten-year Treasury bonds, and subtract the yield on the TIPS and presto, we have a future inflation forecast.

10-year minus Tips = Inflation Expectation (IE)

The yields on the respective bonds were as follows as of the close on Friday:

Ten-Year Bond = 1.88%

Ten-Year TIP = -.34%

So the arithmetic is 1.88% minus .34% to produce a forecast of 1.54% for future inflation, right?

WRONG!

The correct calculation is:

1.88 – (-.34) = IE

1.88 + .34 = 2.22%

(Subtracting a negative number is the same adding a positive.)

This is the Bloomberg chart for inflation expectations based on the TIPS/Coupon spread. Note that the spread closed at 2.22 on Friday:

The next chart overlays the Treasury IE calculation with that provided by Bloomberg. The Treasury chart consistently understates the actual market results for the entire period.

I contacted the Treasury and asked for a clarification. I think the nice folks at Treasury are pretty busy coming up with happy charts, so they didn’t bother to respond to my request.

There are few possible explanations for the discrepancy in the information provided by Dr. Eberly and her crew:

-Treasury has some unknown (and undisclosed) source of information that yields a significantly different view on inflation expectations than the market. (I doubt it).

-Treasury made a mistake in the calculation for Implied Inflation. They did the math wrong. (A distinct possibility.)

-Treasury is making stuff up.

The report by Treasury was widely read. It was favorably referenced in a number of E-Mags. This article at Business Insider includes the words “the True State of the Economy” in its title:
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BI reviewed the information from the Treasury and concluded:

"All in all, it's a very useful presentation."

Maybe the folks at BI assumed that the information from the Treasury, had to be right. But it wasn’t. My guess is that a few million people looked at the data from Treasury, and a good chunk of them were left with the conclusion, “Things are getting better, all the signs look good”. That would be the conclusion that the Treasury was trying to elicit.

I’m left wondering. Either Treasury bungled the calculation for Inflation Expectations, or they fudged it. That being the case, what credibility is there for the rest of the information?

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Military Winning War Over Pensions

2012-05-02T12:52:00.000-07:00

America has two classes of debt: Debt Owed to the Public (DP) and Intergovernmental Debt (IG).

The two components of debt as of April 30, 201:

The IG accounts consist of the Trust Funds (TF). The three largest funds are Social Security (SS), the Federal Employee Retirement Fund (FERS) and the Military Retirement Fund (MRF).

The Congressional Budget Office (CBO) provided projections for these retirement programs in its January 31, 2012 report, "The Budget and Economic Outlook" (Link). The numbers that CBO uses are consistent with the projections provided by SS, FERS and MRF individually in their annual reports. The following discussion relies on the CBO's numbers.

The basic TF arithmetic is as follows:

The sum of (a) Tax receipts (cash in) plus (b) Interest (non cash), minus (c) Benefit Payments (cash out), minus (d) Overhead (cash out) equals Net Surplus/Benefit.

This slide looks at the CBO's projected growth of the retirement funds:

The chart above shows that the MRF is expected to grow while SS and FERS remain relatively flat. The following looks at the projected percent change in these funds.

The MRF’s 300% increase jumps out at me, and I ask, “What’s that about”?

The answer is interesting.

MRF uniquely benefits from a special law that obligates the Treasury Department to pay MRF an annual amount equal to a portion of the unfunded obligations of MRF. The law requires the Treasury to make the payment in “Warrants” (decidedly non-cash). The annual amount is calculated using a complex actuarial formula that is designed to eliminate 100% of the unfunded portion at MRS by 2026.

Over the past few years the actuarial assumptions used in the calculation have deteriorated. As a result, the annual cost of making the MRF whole is rising (up 6.5% YoY). In 2010 and 2011 "we" paid MRF $120B, but the amount of future payments we still owe fell by only $100B. The unpaid tab now sits at $1.3 Trillion.

These are the projected total payments to “cure” the unfunded portion from the prior reports produced by MRF:

It gets worse. The folks at MRF are understating the future liability.

MRF invests its interest from Treasury securities. It needs a high return to offset costs. But it can’t get a high return today, thanks to the Fed. The Board at MRF has set a ridiculous projected interest rate on its holdings of Treasury IOUs:

Consider the dog meat portfolio that MRF is sitting on:

There is no way in hell that MRF will get 5.75% in any year over the next five. I doubt it will realize that hurdle rate anytime over the next decade. This means that every year the unfunded portion grows and the annual warrant payment keeps getting larger. It could easily exceed $2 trillion over the next thirteen years.

The 5.75% hurdle rate is a significant flaw in the MRF's assumptions. They don’t agree:

Some observations regarding the projected growth of the MRF and the asymmetrical treatment of the MRF versus FERS and SS:

+This is unfair. Those dependent on SS or FERS do not have the legal protection that MRS has. How can this be? As the annual cost of protecting military pensions skyrockets over the next few years, there will have to be political fallout. This will be an interesting war: the Retired American People versus the US Military. Who will win?

+Turn this around. What if SS and FERS had the same deal that MRS has? The 2012 SS report to Congress established that the unfunded amount over the next 75 years is $8.6 trillion.

Assuming that FERS was in similar financial shape (it is), this would bring the combined unfunded amount to $10 trillion. If this number were resolved according to the MRF deal, the Treasury would need to issue $700B more warrants annually for the next fourteen years (not remotely possible). Total debt would race ahead faster then its current nosebleed trajectory. The USA would pass 150% Debt to GDP before 2020.

+Warrants are easy for Treasury to issue. It doesn't have to find a new bond holder to make these payments. It just writes scrip IOUs. But the scrip comes due just the same as regular Treasury bonds. The IOUs owing to the TFs must be paid in cash. So the back end of the process hurts.

+The Disability Fund is cashing in its IOUs like mad. The Old Age Fund started the process a few years ago, but an more modest rate. The retirment fund will have very big redemptions for the next twenty years. FERS will be hocking its IOUs at the same pace as SS. In about ten years, FERS and SS will be forcing the Treasury to issue mountains of extra Debt to the Public to meet the redemptions. At about that time, MRF will be sticking its hand out for another few trillion that the Treasury will have to borrow.

This is not about something that might happen in the distant future. It is written in stone, and coming in less than eight years.

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Got an Edge?

2012-05-02T04:16:00.000-07:00

The 1st Q reserve numbers for the Swiss National Bank tell an interesting story. For a second quarter in a row, the foreign reserves have declined.

There is only one way that this could have happened; the SNB offloaded a portion of the EURCHF position it took on back in September of 2011 when it was forced to intervene.

A significant portion of the CHF 60B ($67B) "reverse intervention" was the result of the unwinding of large speculative short EURCHF positions by market players. (This demonstrates how big the speculative capital flows were.)

Some additional EURCHF sales by the SNB were, no doubt, accomplished when the market was betting that the SNB would raise the Peg from 1.20 to 1.30 or higher.

Officials at the SNB did everything they could to encourage speculation that the Peg might be raised. I find it amusing that while those officials were talking the EURCHF higher, they were actually selling on the side. Basically they lied. For an interesting perspective on this: Link

Just a few weeks ago a big shot at Goldman was selling the idea that the SNB would raise the Peg to 1.35. Maybe some of the SNB's“chatter” rubbed off on O’Neill.

At this point the EURCHF is truly pegged. If it goes higher, the SNB will take the opportunity to offload more of its unwanted Euros. The flip-side is also true, having reduced its reserves by 20% over six months, the SNB has tons of ammunition to fight off a speculative attack. It’s as if the Swiss have joined the Euro at a fixed exchange rate.

If the political issue of actually getting married to the EU/Euro were on the ballot, the Swiss would vote 10 to 1 against it. But when it comes to creating a currency advantage, the Swiss look the other way.

If the discussion ever came up about what exchange rate the EURCHF should be permanently fixed at, it would be at a rate much closer to 1.00 then 1.20. The Swiss politicians understand that; so do the folks at the SNB. Most of the population understands it as well. In the meantime they reap the benefits.

What do you get if you have a currency whose value is manipulated? These two headlines answer that question:
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On Student Loans, Accounting Gimmicks, Electric Cars, FX and a note on SS

2012-04-29T05:01:00.001-07:00

Student Loan Battle

There was a big fight in D.C. this past week over student loans.

The issue is a scheduled increase in interest on new student loans from 3.4% to 6.4% set for July 1. Clearly this is a dumb plan. I don’t see any political opposition to the idea that the summer of 2012 is a horrible time to double the cost of student loans. It will shock no one that the ‘solutions’ being put forward by the politicos are the same ones they propose for every other problem.

The House Republicans have put forward a Bill to extend the 3.4% rate for a year. The cost (increased deficit) of the twelve month extension is $6B. The Republicans want to offset the $6B with (surprise) $12B in reduced spending for the Affordable Care-Act. The Republicans love to trade marbles for reduced Obamacare. They want a 2-1 reduction in medical spending versus education costs. Maybe the “Reds” have the chips to push this outcome. They might settle for a 1-1 deal, but the White House will hate this outcome.

The Senate Democrats want to raise taxes on those making over $250K to offset the cost of the one-year deferral. Their argument is similar to the Buffett tax plan they tried a few weeks ago. Lacking support, it was so clear it wouldn't pass that it was never voted on. I would give the Senate legislation on student loans a zero chance in the House. It is D.O.A.

There will be the same ideological pissing match and the same result. We will get a one-year extension “paid” for with “promised” reductions in expenses starting in 2017. Another kick of the can, and another big problem in 2013.

This is what happens over a crummy $6B. On January 1, 2013, there are cutbacks and higher taxes totaling $500B scheduled. The coming “Tax Armageddon” is supposed to be resolved in a lame duck session of Congress after the November election. There is a “zero” chance of that working out.

One in a Hundred

I have been following the evolution of new global lease accounting standards. At the heart of this issue is the recognition that a lease is just another form of debt, and that the debt should be put on the balance sheet of the lessor.

The big hitters in the US leasing business (and their accountants) have opposed the new standards. At this point 100 countries have signed on to the new accounting rules, but the adoption has been delayed by the good old USA.

At the G-20 meeting last week, finance ministers extended the deadline for the our rule makers to adopt the new rules till June, 2013. That date is already 30 months late. My guess is that there will be another delay, and the source of the delay will be the powerful companies, (think GE) that have a lot to lose if a lease is treated as debt (as it should be).

The Foxes are the cops in this hen house. When it comes to accounting and full disclosure, nothing has changed.

On Electric Cars

GE has dug itself deeper into the electric car business:

It’s all well and good if GE wants to put its shareholders at risk on the future of electric cars. My concerns are that a great deal of money is being spent by D.C. on this effort, and that GE's, Jeff Immelt, is the President’s policy adviser. Jeff blows smoke in Obama’s face and the government doles out billions to support GE, Ford, Fisker, Tesla and others.

If I were running the show, I would have invested in the infrastructure for delivering natural gas as a fuel for vehicles. The US has an abundance of cheap natural gas. A fair bit of that energy is just being flared into the air these days.

It’s not as if Natgas cars are some untested concept. Brazil has been using them for thirty years. Globally, there are about 15m Natgas powered vehicles. Of that amount only 300,000 (2%) are in the US.

So why is the government, the car manufactures and the energy companies avoiding this opportunity? The answer is that it is much more profitable to sell expensive gasoline to consumers than it is to sell cheap Natgas.

Note:
Honda makes a Natgas powered car. This vehicle was named Green Car of the year in 2011 as it gets 31 miles to the gallon with much lower emissions than gas powered cars. If there were a distribution system available, these cars would be more popular than electric cars. The cost of running cars on Natgas is about half of the cost of a gas car.

Why is the government supporting one technology over another? Why is it supporting the expensive alternative versus the cheaper one? Another example of the foxes being the cops.

On FX

There was very little net movement in the major currencies last week. I was surprised that the Euro did not weaken. The news is terrible. There is a very good chance that the French and Greek elections on May 6 will bring about political changes that will undermine the stability of the EU. If the French kick out Sarkozy (I think they will) then the chances of Spain getting a desperately needed rescue package will fall to zero. Without France standing shoulder to shoulder with Germany in support of the Euro, the whole experiment may fall into the crapper. Yet the Euro managed to eek out a small weekly gain against the buck.

Some are attributing the relative strength of the Euro to ongoing capital repatriation by the EU banks as they reduce their non-Euro assets. (Zero Hedge) Others are suggesting that large existing EURUSD short positions are the problem.

Maybe, but I’m catching a whiff of dollar weakness. I don’t pay that much attention to the hourly trading action in FX, but I do watch how the USD trades when news comes out. When there has been “good news” the dollar has not traded higher. When there is “bad news” (the weak GDP report) the dollar has traded lower.

I believe that the US is currently in 3rd place in the race to the bottom. The EU and Japan are leading this race. So this makes me (reluctantly) a dollar bull. I’m not getting fat on this position, I’m not even getting fed, so I cut some positions on Friday. I took a small loss on some recently acquired USDYEN and took a nice profit on an older (smaller) position on USDYEN that I picked up under 79.00. I took the net gains and bought one month puts on the EURUSD.

Note:
The EURCHF has been trading at less than 1/8th percent away from the intervention level of 1.2000 for over a month. This is an accident waiting to happen. It looks very quiet on the charts, but there is a steam kettle with a hot fire underneath this chart. If the French election goes against Sarkozy, I have to believe the kettle is going to blow a few rivets.

I have no exposure in the CHF crosses, but I’m watching the action. If the Swiss National Bank is forced to support its peg over the next few weeks, it will send a bunch of other lighting bolts flying.

On Social Security

I’ve been trying to stir the pot on Social Security this week after the release of the annual report (Link). I thought the report was ample evidence to stimulate a discussion of what changes are needed at SS, and by when. I was wrong. The terrible report and its terrible conclusions have been ignored.

The typical response I get from the Defenders of SS is,

“The Trust Fund behind SS was always scheduled to run out some day; that it's happening ahead of schedule does not matter at all.”

To those who do not see the fire burning here I point to the following slides from the 2008 and 2012 reports to Congress:

The base case assumption on the timing of the peak in the TF balance has changed dramatically over the past four years:

Social Security is going to eat our lunch much faster than the public thinks. Those who think that this does not matter and that nothing should be done are dead wrong.

Note:
I get a lot of flack about my focus on the Trust Fund (TF). I agree with those who say, “There is no Trust Fund”. The accounting on this is just a sham. But TF accounting is the reality in D.C., and that is not going to change. So I push on the deteriorating status of the Trust Fund (that doesn’t exist) in an effort to raise a red flag.

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On the Social Security 2012 Report to Congress

2012-04-24T03:52:00.000-07:00

The Social Security Trust Fund (SSTF) 2012 report to Congress is now out (link). It’s 242 pages and contains a great deal of information. I have reviewed a number of sections in the report that I consider to be key measures of SS’s health. Not one of those variables showed any improvement. Some highlights:

-The Net Present Value of the unfunded liabilities at SS is now a staggering $20.5 Trillion. One year ago this was $17.9T ($2.6T increase - 15% YoY). This yardstick grew at more than double the rate of the entire national debt 12/31/10 = $14T, 12/31/11 = $15.2T, total increase = $1.2T).

This deterioration is staring policy makers in the face. The burden that SS will put on future generations is growing exponentially.

-The “Drop Dead Date” where the SSTF is exhausted has been moved up three years to 2033. This is a number that the MSM will focus on. It is a bogus deadline. The SSTF must maintain at least one year’s worth of benefits. The year that TF assets will equal one year of payments will be ~2026. This means that anyone who is age 53 today can expect to get 75% of the value that a baby boomer will get. (Under current law, when the TF is exhausted, benefit payments must be cut.)

Fourteen years is not a very long time for people to plan and adjust for what's coming. The Politicians will have to address this reality sooner versus later. It is already passed the time where it is unfair to those who will be affected.

-The Drop Dead Date for the Disability Fund has been changed from 2017 to 2016. This is important as the TF has confirmed that the next President will HAVE to bailout one component of SS. It is crucial to ask the candidates what they will do if elected. They better have an answer. When the debate on the future of Disability Insurance (DI) gets going, it will be marked with a sharp divide of opinions. It could easily be a factor in the election.

-The SSTF creates Best, Base and Worst case scenarios for 2012 through 2021. The Base-case is for SS to run an $800B cash deficit for the period. The Worst-case analysis is for a $1.8 Trillion cash shortfall. I’m firmly convinced that the Worst-case is most likely.

-The critical assumptions used to develop SSTF’s assessment of the future include:

i) CPI will average only 2% in years 2012 – 2015. From 2015 – 2021 inflation will average 2.5%. Utter hogwash.

ii) Real GDP will average 3% a year for the next decade. There will be no recessions according to the TF. More hogwash.

iii) The TF uses these estimates for Real GDP:

2012 – 2.6%

2013 – 2.9%

2014 – 3.5%

2015 – 4.0%

2016 – 3.8%

These results simply will not happen. Is the SSTF not aware that the USA will face the biggest cut backs in spending, and the largest increases in taxes in the country’s history, eight months from today?

iv) The TF uses the following estimates of ten-year interest rates:

2012 – 2.4%

2013 – 3.4%

2014 – 4.4%

2015 – 5.0%

2016 – 5.1%

These are important as the TF is sitting on $2.6T of IOU’s. The interest it earns on this surplus is critical to the short-term results. Possibly the TF is unaware that the Fed has promised to keep ZIRP in place until 2014. This interest rate outlook is based on the assumption that the economy will be zooming along without any interruptions. Nothing could be farther from the truth.

I stick with my prior forecast for SS. The TF will “Top Out” in 2017 and will have a maximum surplus of $2.75T. That’s five-years earlier than the TF forecast in its report today. It is $1T light of what the TF says the Maximum TF balance will be. I’m please to report that the SSTF’s High Cost (Worst-case) scenario is now ahead of my own forecast. They have the TF topping out in just two years. The TF will not exceed $2.75T.

If anyone in D.C. wakes up to this reality, they would have to yell, “Fire.” Given that it’s an election year we probably won’t hear a peep.
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Is Exim going to flop?

2012-04-21T10:38:00.001-07:00

America’s Export-Import Bank (Exim) is tapped out. Its authority runs out on May 31 and Congress has to agree to some form of extension. Exim has $100 billion of borrowing authority, none of which shows up on the federal balance sheet. It may have already reached its $100 billion limit; there are billions of additional requests for financing that may not get fulfilled if its charter is not extended and its debt limit is not increased.

The Administration has requested a 40% increase in Exim’s borrowing authority. This would keep Exim afloat until 2015. The Republicans, led by Eric Cantor, have made a counter proposal to increase the debt limit by only $13 Billion. Cantor’s plan would have Exim run out of money in less than one year.

So there is a fight brewing on this issue. It is the same fight that has been going on over every economic issue. Conservatives want to cut back on big programs, liberals want to expand them as fast as possible.

Some on the Pro side include the Administration, big exporters like Boeing, liberals and their press:

There are many voices on the Con side:

Central to the issues at Exim is Boeing. From 2005 to 2010 Exim financed 634 Boeing aircraft. In 2011 it lent foreign airlines another $11.4B. This lending has surely helped Boeing, but it’s killing the domestic air carriers which have to compete on overseas routes.

Delta Airlines has sued Exim over its lending to Air India. The lawsuit has to be resolved as part of the extension of the debt limit. Liberal guys, like Chuck Schumer have been talking to Delta. The proposal is to offset the competitive disadvantage that Exim creates, with new subsidies for the airlines.

Subsidies that create inequities that are fixed with more subsidies is bad government. I can’t see the Delta Airlines “fix” getting inked without a large price tag. That cost will be the Republicans insisting that any subsidies be “paid” for with other cuts. A pissing match appears to be in the offing.

When S&P downgraded the USA, it pointed at political gridlock and the inability of D.C. to agree to confront issues as the principal reason for the downgrade. The fight over Exim is a good example of that gridlock.

I’m 70% confident that an Exim "patch" will be in place within the next few weeks. That leaves a 30% chance for this to go wrong. If it gets nasty, it will highlight all that is wrong with the country.

The following video is an edited version of one that is making the rounds on YouTube. This has no ads and runs 64 seconds. Obama’s Exim flip-flop is worth noting.

On the Swiss, the IMF and the G-20

2012-04-19T11:45:00.000-07:00

There will be some drama, and few splashy headlines out of the G-20 meeting in D.C. this weekend. Europe is cracking up (again), and the IMF and big guns of the G-20 will spout about “expanded firewalls” and “global co-ordination” in the final communique Sunday evening. If we don’t get a big dose of “happy talk” then the markets will crap out.

A big agenda item for the weekend is the $400b capital raise for the IMF. There will be plenty of corridor conversations and side deals regarding which country puts up what, and what deals it gets for the money.

There are two sideshows of interest in the IMF's new money raise. The first is the USA; the second is Switzerland.

The USA is not going to be a player in the IMF deal. That blows my mind. The USA is the biggest stakeholder in the IMF, but when push comes to shove, and there is a Rights Offering of the common shares, the USA says, “No thank you”.

The USA "no-show" at this critical juncture is due to election year politics. Tim Geithner knows that he could not sell Congress (much less the American people) on a plan where US funds are used to bailout the EU, while there is so much pain at home.

The “We’ll take a pass on this one” attitude by the US speaks volumes about the credibility of the happy talk we will hear on Sunday. Without the US involvement in backstopping the Euro Zone, there is no backstop. This reality will undoubtedly be a topic of those corridor chats.

It will be an important weekend for Switzerland and its citizens. Every indication is that the Swiss will be big players in the IMF deal. As of this writing, the amount the Swiss are in for has not been revealed. The head of the IMF, Christine Lagarde, hinted at what the Swiss were willing to pony up when asked about the size. She responded:

"a considerable amount"

What does that mean? The following countries have made commitments to the IMF:

Switzerland has a GDP of $0.6T. Based on the above information, it might be expected to commit about 2% of GDP, or approximately $12B. I suspect the amount will be much higher. The reason is that Switzerland has a mountain of reserves that it has accumulated on the backs of the EU countries. The Swiss have built up these reserves through years of currency intervention. Now it will pay the price that comes with an undervalued currency.

All of the big hitters from Switzerland will be in attendance this weekend. The President, Eveline Widmer-Schlumpf, the Minister of Economics Johann Schneider-Ammann, and the new boss at the Swiss National Bank (SNB), Thomas Jordan, will all be at the party. The big shots should be there, after all, they are about to give a large chunk of the country’s money away.

The side deals on the Swiss IMF participation should be interesting. What would the Swiss get in exchange for a giant check? One thing that will be up for discussion is the SNB’s currency peg. A month ago, the IMF blasted the SNB over the peg. My guess is that the criticism goes away if the Swiss write a check for $25 large. What a system…

Note:

China is expected to play in the IMF deal for $50B. And the USA can’t come up with a dime. Just who is the economic super power these days?

What did China get for playing big in the IMF bailout deal? Happy talk, of course:

Down to a Trickle

2012-04-18T12:45:00.000-07:00

Some much needed rain is headed to the East Coast for the weekend. The question is, "Will it be enough to end the drought"?

I look after a five-acre pond that’s thirty miles north of NYC. There's not much to it. I keep the sluice clean, maintain the concrete and earth dam, and once every year or so I struggle to get a permit for to a few irradiated (sterilized) carp to keep the weeds down (see note below). I’ve been doing this for twenty-five years.

In dry years the water level has fallen below the sluice a few times, but this has only happened in late summer. So far, 2012 is setting up as an extremely dry year. The overflow of this pond is down to a trickle. The water level will fall below the sluice in a matter of days.

The dry conditions extend past my little pond to most of the East coast. These slides from NOAA show the rainfall over the past 90 and 30 days. Many areas of the country have had 25% (or less) of average rainfall.

It’s not just the USA that is looking at a drought. The UK is dry as a bone:

A contributing factor to the change in rainfall pattern over the past three-months is that the two year long La Nina cycle is ending. ENSO neutral conditions in the Pacific Ocean have been re-established. From the April 16 report from NOAA:

The timing of the sharp reversal of water temperatures in two of the regions of the Pacific where the transition is taking place match the onset of the dry conditions:

The computer models forecast a shift from ENSO neutral conditions to a full El Nino over the next six months:

The record spring heat, the explosion of tornadoes and the below average rainfall have prompted a variety of reports blaming climate change for these occurrences. Maybe, maybe not. If the observable weather patterns are attributable to the change from La Nina to El Nino conditions, then there would be nothing unusual about it at all.

Look at how the Pacific Ocean has flip flopped from La to El conditions over the years:

Notes

My pond is designated as a class B watershed area for NYC’s water supply. As a result, there are many restrictions. (Basically it must stay as it is). No chemicals are permitted, so algae are an issue. Carp eat the green stuff, but if they multiply, they can devour all the vegetation. This would starve the water for oxygen. Hence the need for a permit to get the carp, and the requirement that the fish must be sterilized.

In mid-April the average overflow into the reservoir system is 2m gallons per day (I keep track), enough for 10,000+ people. As of today, that is down to zero. If the dry spell is extended much longer, water restrictions will be imposed on a wide section of the country.

To those NYers who do get some water from this pond, I’m doing my best to keep it clean for you. As far as I can tell, the whole system is pretty good.

There was one time that two deer fell through the ice and drowned. They bloated up and floated for a month. Stank like hell before they sank. That’s part of the mix too…

Drink up!

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A Different Buffett Rule - One That Would Work

2012-04-17T18:32:00.000-07:00

The Senate torpedoed the Administration’s Buffet Rule.

This was a dumb piece of legislation. The joke was that it would have only raised $5b a year. That’s chump change. It never had a chance of passing. It was a show pony for the November election. Shame on Obama for making a circus out of what is (was) a necessary debate.

If I were running the show, I would have proposed a tax that socked the top 5% for some additional money. I would have earmarked that extra tax money to pay a portion of the country’s annual Disability Insurance Fund (DI) benefit payments.

The Social Security Administration (SSA) started a program in 2008 called the Compassionate Allowance initiative. Severely disabled people who qualified for the program - by being diagnosed with one of the listed diseases - could get expedited benefits, sometimes within weeks.

The list of severely disabling conditions covered by Compassionate Allowances (CAL) has been growing. It started with 50 conditions. In 2010, the SSA added another 38, and another 52 conditions will be added on August 13, 2012. (Link to all conditions)

Total DI benefits in 2011 were $130B. The number of beneficiaries increased by about 500,000 during the year. Of those, 60,000 were Compassionate Allowance cases. This data suggests that the CAL cost is approximately $20B a year. I want the top 5% to pay for this cost.

In 2009 the top 5% of income earners had income of $2.5 Trillion. There were seven million individuals in this income group. They paid a total of $507 billion in taxes. The average tax rate was 20.3%. The extra $20B for the CAL would raise their effective tax rate by a lousy 0.7%. In good years, where capital gains can be had, like 2010 and 2011, the cost to the rich folks would be an extra ½%.

I would like to hear one of those fat cats standup and oppose this plan. What would they say?

“It’s not fair! Just cause I made a Mil+ last year doesn’t mean I should pay more! I don’t care about those kids who get Neuroblastoma (#25) or Non-Hodgkin Lymphoma (#26). I shouldn’t have to pay for the fifty-year old who gets Gall Bladder Cancer (#49) and I don’t give a damn about those who have suffered Heart Transplant Graft Failure (#56)”

Same for the politicians. On what basis would they argue against this? I would love to see one of them try. They would get creamed in the next election if they did.

Folks with big incomes know that higher taxes are coming. If you asked this group if they favored a Buffett Rule that put more money in the government’s general coffers or a tax that was earmarked to pay for people with disabilities, they would point in the direction of my plan. It would make them “feel” better.

Yellen Vs. Geithner - Two Views

2012-04-16T04:44:00.000-07:00

Janet Yellen, Bernanke's soul mate (and mouthpiece) spoke last week. She argued that the Federal Reserve's Zero Interest Rate Policy (ZIRP) should be maintained for another three years.

Tim Geither, Obama's side kick, had a completely different take on the economy on the Sunday talk shows.

And all this time I though it was only stockbrokers who talked their book....

One minute/no ads:

Three Conversations

2012-04-12T14:14:00.000-07:00

I’ve had some interesting conversations in the past few days with folks whose opinions I consider important. I'm passing them on:

I spoke with my Greek shipper friend from Athens about the upcoming May 6 election. This is an event that should be feared by the markets according to this person.

There are two large political groups that have been the basis of coalition governments in Greece. On the right is the New Democracy party; on the left is the Pan Hellenic Socialist Movement. Both of these parties are out of favor today. The most recent polls show that the two parties together would get less than 40% of the popular vote. If this is the result, it will be very difficult to put a new governing coalition together.

There are many other smaller political parties that will get the dissenting votes. At this point it is unclear who will end up with the bargaining chips post-election. The fear is that some of the smaller parties will have a big say in the outcome. My friend had this to say:

“The other parties are communists, radicals and crazies. If they have a hand in the new government, then on May 7 Greece will be forced to take dramatic steps. The whole idea that the country should suffer, so the bankers can get paid would have to change.”

“Remember the history. After WWII there were years of fighting in the streets of Athens with the Communists. British troops were forced to come in to end the fighting.” If the Communists make a comeback in this election, then instability will follow.

“Also on May 7, the attitude in Brussels and Bonn towards Athens will change as well!”

May 7th is sixteen trading days from today….
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British troops on the

 streets of Athens in 1948.

I spoke with a guy I’ve know for a long time who lives in Paris. He is an ex-banker, turned technocrat.

Paris:
The bond market has been forcing every decision by Paris, Bonn and Brussels. Every step taken has been done to make peace with bondholders. There are many who are tired of this process. The most recent effort to bring stability and support to this market has been the LTRO. As of today, this program has not succeeded. It is unlikely that it will be repeated.

BK:
Yes, the LTRO worked for less than two months. But absent a stabilization program like the LTRO or direct market purchase of bonds by the ECB, what is plan B?

Paris:
There are no good answers to this. One option would be for the ECB/IMF to make a guarantee that the annual working capital requirements of Spain, Ireland Portugal and, if necessary, Italy are met. The promise of financing would include trade deficits and interest payments. It would not cover maturing debt obligations. As debt came due, holders would be offered new three-year notes at an attractive yield. They would be forced to keep their feet in the fire.

BK:
Something like this would destroy the EU bond markets!

Paris:
They are already destroyed. They only exist because the Northern countries have provided so much support. It is a mirage that there is a true market any longer.

BK:
But what you describe would be a default. Existing bonds would collapse in price.

Paris:
Yes, but why does this matter? In some ways it would be a good thing. If Spanish bonds trade at 50 cents on the Euro, then the market is doing the job for us. The strong countries and the IMF can buy up the debt, with that comes a restructuring with lower principal. This happened to some extent in Greece.

BK:
But wouldn’t this wreck the banks?

Paris:
Why? The banks would accept new bonds in exchange for maturing ones. They would be forced to. If they did not, they would suffer an immediate loss. So the banks and their accountants would voluntarily extend the maturities without loss. The countries involved would have the necessary access to fresh debt to cover all interest. There would be no default on interest payments. No one ever expected the debt to be paid off. It never will be. But the countries can afford to pay reasonable interest.

BK:
But what about holdouts and lawsuits?

Paris:
Yes this is an issue. And yes this would be messy. But what are the options? Continuing as we have been is not acceptable. The bond markets have reacted with hostility toward the EU countries, it is not surprising to see the countries becoming hostile to the bond markets. Either there is peace, or there is war. The status quo is unacceptable. We have tried to make peace. That has not worked. Other options must be considered.

BK:
What you describe would be a dramatic shift in policy. Do you really think that what you suggest could actually happen?

Paris:

The answer to this question lies with France. As of today the French/German efforts at saving Europe have failed. The French people are tired of the process. You will see this emotion in the coming national election. Even if Sarkozy wins the election, his ability to push for additional risk sharing with the South will be lost.

Without France’s active participation in the bailouts, the process will have to end. Again, many of us are sick and tired of doing what the bond market tells us we must do. There is a limit. Many think that the limit has already been exceeded. This is especially true in France. The bailouts and special lending efforts will not last for one more year.

Note:
I don’t buy into this line of thinking (at least for the time being). What is described is something that could only happen in a worst-case scenario.

His mindset is very interesting. He’s pissed at the bond market, and he’s tired of it. He left me with the impression that he was not alone in being pissed.

This is perfectly understandable. For years the poor politicians, bureaucrats and technocrats have been scrambling to appease the fucking bond market. They’ve paid a big price so far. And it hasn’t paid off. The bond market is still their primary problem.

At some point someone will say (sort of) “Fuck the fucking bond market”. We’re getting closer by the day.
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III

My friend who has been running hedge fund money for years had this to say:

“Nat Gas could go to zero. Gas is a byproduct of drilling for oil. With US oil still worth $100+ a barrel, the drilling will continue, and more gas will be the result.”

“There are many things that are changing due to the cheap Nat. gas. Companies that are running short haul truck routes out of central locations are converting to gas. Chemical companies that use natural gas as a feedstock are seeing new opportunities. The first new ethylene plant (plastic from natural gas) in many years will be built in Oklahoma. This plant was going to be built in Mexico, but cheap gas has brought it back home.”

“The near zero cost of natural gas will transform energy use in America over the next five years.”

I’m not sure I believe in this “miracle” story just yet. But coming from this guy, the conversation has me wondering.
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Houston - We have a problem, in Switzerland

2012-04-10T11:18:00.000-07:00

The ‘risk off’ trade is commanding the markets. A subtle, but interesting example is the EURCHF.

For four days the EURCHF has held to 1/8th percent away from the official 1.2000 peg. It sits at 1.2016 as I write.

Wherever you look, from China to Japan, to the USA, and the EU, trouble is brewing. As currencies go, there is no safe haven left. The Yen has benefited (as I anticipated, Link). There may be more Yen strength ahead as the market turmoil escalates, but I think that the Yen is no longer a safe place to hide.

On the other hand, Switzerland’s economy is doing very well, thank you. Its economy is growing and it has low unemployment. Thanks to an artificial exchange rate, (The Peg), it is still maintaining a trade surplus with its poorer neighbors.

There is evidence that money continues to poor into Switzerland. Six month T-bills are now trading at -25%. That the short end of the curve is trading at negative levels is not all that surprising, but the Swiss two-year went negative earlier today:

There is only one thing that can make the 2-year go negative. Demand. Hot money is getting converted into Francs, and then it is pushed forward in the swaps market.

The following is a slide of the EURCHF three and six months swaps.

Note that they are trading at a discount (left side larger than right). To determine the market price for six-month EURCHF, take the bid side (.0026) and subtract it from the current spot rate (1.2016) - that yields 1.1990. This means that the outright six month forward EURCHF is trading below the 1.2000 Central Bank peg.

This slide looks at the one and two-year swap spreads. The implied outright forward EURCHF for one and two years are 1.1957 and 1.1792, respectively.

The swaps and bond market are showing that that money is coming into the Franc in a significant way. But the EURCHF has not touched on the magical 1.2000 level and there has been no reported Swiss National Bank (SNB) intervention. This does not add up. Two possibilities:

1) Some very big (and ballsy) prop desk/ hedge fund is shorting the CHF to the market and using the negative cost of money as a carry trade to fund other investments. This is a beautiful trade as one is “guaranteed” not to lose money on the short CHF position because the SNB has “guaranteed” that the Franc will not exceed 1.2000.

While this is possible, I consider it unlikely. The negative cost of money may look attractive on paper, but there is no real guarantee from the SNB that the peg will last for the next two years. Money is cheap and available in other currencies all over the globe right now; there is no need to gamble the house to save another ½ percent on funding costs. If the peg were to break, that ½ percent savings would turn into a 20% loss. The risks and rewards of shorting the Swissie just aren't justified.

2) The SNB is involved with “sub rosa” intervention in the currency market. It may be using one or more banks (to make it look like commercial buying interest) to bid for Euros above the 1.2000 peg rate. Alternatively, the SNB may be offering EURCHF FX options to market makers.

I think #2 is happening. The SNB is quietly doing its best to avoid a visible and splashy round of intervention. If true, the SNB will have to back off in the near future and allow the Franc to trade at the 1.2000 peg. At that point it can be as aggressive as needed.

The EURCHF may be the tipping point for a new round of financial instability. I see this tipping into the dark side. I see this happening before week’s end.

ht/ms

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Betting on the race to the bottom

2012-04-08T18:42:00.000-07:00

On Monday and Tuesday the market’s attention will be on the USA and the negative economic implications of the Nonfarm payroll (NFP) miss. Market eyes will also be focused on the bond markets in Italy and Spain. As of last Thursday, Europe seemed to be on the verge of another “accident.” The EURCHF closed the week a fraction above the 1.20 peg to the Euro. The Swiss National Bank will likely be forced to show its muscle. While the peg will not break, news of the attack will rile the FX markets.

If this scenario plays out, the Yen should benefit against the dollar and the Euro. If the Yen crosses get cheap, I think it will be a good opportunity to short the Yen. As bad as Euroland appears, and as shaky as the USA looks, Japan looks like it might end up winning the race to the bottom.

There are two very big issues that Japan is confronting; energy and taxes. Both of these issues will come to a head over the next sixty days. I don’t see a soft landing.

Fourteen months ago Japan had 54 operating nukes. Today it has one. By the end of May, it will have none.
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The Japanese press is discussing options such restarting the nukes, but many people want to shut them all down:

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There are two significant consequences of the shutdowns: (A) soaring imports of expensive hydrocarbons (LNG, oil and coal), and (B) this summer, there will be as much as a 12% shortfall in electricity to to cool homes and run factories.

The shutdown of the nukes has already led to a major turnaround of Japan’s external trade position. In 2011 Japan reported its first annual trade deficit in over 30 years. The shortfall came to Y2.5T ($32B). In 2012 that number could be as large as $100B.

The shortage of “juice” this summer will cause cut backs in supply to big industry. As a result, industrial production will fall. Depending on the severity of the summer slump, Japan could face negative GDP growth for the full year. This will translate into more red ink in the national budget (already 10+% of GDP). More debt will have to be issued to cover the gap. Japan’s already insane Debt to GDP (230%) has nowhere to go but up.

Japan is leading the world into trouble as far as demographics go. The Social Security and medical costs of its aging population are exploding. Unlike in the USA, most of the Japanese leaders have acknowledged that the country's position is un-sustainable. Not a day goes by without it being the subject of an article in the press. On March 31, the Noda government formally proposed doubling the consumption tax from 5% to 10% in a desperate effort to shore up the government’s empty coffers. The proposal for new taxes will be debated in the Japanese Diet in April. A final vote is anticipated in June.

I doubt this critical legislation will pass. The proposal has opposition from many political directions. It has fierce opponents within Mr. Noda's own party, the Democratic Party of Japan, but the real opposition will come from the Liberal Democratic Party (LDP).

Japan’s politics are not unlike that of the USA. The opposition parties will do anything to undermine the efforts of those in power. My reading is that the LDP would support a tax increase as a philosophical matter, but it will oppose Noda’s legislation with the objective of bringing down the government.

It’s a good bet that the LDP will succeed, and the Noda government will be forced to call for new national elections. That would be a "worst case” outcome. As of today, polls show that there is substantial opposition to the new tax. Failure to pass new taxes would put Japan on a debt trajectory pointing to infinity.

Political instability in Japan is becoming a real issue. The country has had six Prime Ministers in six years. Another recession may kick in this summer. The trade deficit will be at levels never seen before. ($500m USDYEN must be bought every trading day to fund the deficit.) The failure of the country to pass new taxes will force downgrades of the public sector debt. Japan will be on track to exceed 300% Debt to GDP.

I like USDYEN on the long side at 81 and under. EURYEN is hard to call, and for the time being is a “stay-away”. If the EURYEN cross would somehow get down to around 100, I think it would be“safe” to get long.

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A Laugh

2012-04-07T06:17:00.000-07:00

I got a chuckle from this article in the Economist: (Link)

For several years I have been pushing against all of the voices saying that it was essential that financial derivatives be banned or that their use be dramatically curtailed.

It isn’t that I think that derivatives are such a great thing. I do believe they contributed to the 2008 blowup. The problem is that they are so much a part of the system that to change their role and function would, undoubtedly, cause a bunch of bad things to happen.

Most derivative contracts are related to credit and debt. The reason there is so many derivative contracts is that there is so much debt. The CIA put total world cross border debt at $69 Trillion for 2011:

The Economist puts total derivatives outstanding at $700 Trillion, so for every $1 of global GDP there is $10 of derivatives. This sounds crazy, but is not inconsistent with other markets. Global forex trading is running at 50 times global trade and the turnover in stocks is 20 times asset values. That derivatives are 10 to 1 versus global debt should not be much of a surprise.

That the capital markets must churn multiples of actual underlying values is understandable. An individual transaction causes a transfer of risk from one party to another. The subsequent transactions are the market mechanism in which risk is transferred through the system and ultimately absorbed. Why it takes so many knock on transactions to achieve the necessary transfer of risk is a mystery to me. It just does.

In the back of their minds, the regulators know that putting constraints on markets will result in something breaking down someplace else. The deciders know that the most likely place for a breakdown to occur is the global market for sovereign debt. Without a relatively smooth running market for the massive amount of sovereign debt, the economies would come to a violent halt. The deciders and their regulators may understand this, but they also want red meat when it comes to derivatives.

With the critical importance of derivatives in mind, the regulators and other deciders have taken the path of least resistance. They want to “fix” the problems with derivatives by forcing these evil contracts to settle through central clearinghouses. And that is exactly what is being done.

One of the big pushers of the Central Clearinghouse ‘resolution’ to derivatives was none other than our pal Tim Geithner. He had this to say on June 11, 2011:

Without international consensus, the broader cause of central clearing will be undermined.

Tim and the other deciders got their way (mandatory central clearing is required under Dodd-Frank). But a new systemic risk is the consequence of their efforts. The Clearing Houses have now become ground zero for risk. Some thoughts from the Economist on the Clearing Houses that Geithner etal. have been pushing for:

It THEY failed, there would be “mayhem”.
Paul Tucker of the Bank of England.

“If you put all your eggs in one basket, you better watch that basket.”

Ben Bernanke (quoting Pudd’nhead, a Mark Twain character).

“Too big to fail, on steroids”

Un-named “regulator”.

Regulators and deciders need to “do things”. When they do things, they can stand up to a big audience and say:

“We did something to fix a big problem. Now re-elect us to do more good work!”

Actually, what the regulators have done is concentrate risk. Exactly the opposite of what the markets are attempting to do. The regulators are trying to unscramble the eggs and put the diversified risks back into the original shell.

I understand why people are uneasy with financial derivatives. A lot of folks think of derivatives in the same way they think of necrophilia; despicable and obscene. I can’t offer a truly valid explanation of why it takes $600 Trillion of them to spread the risks of a $70 Trillion economy. And yes, I’m afraid of them.

But I’m also afraid of what happens when the use of them is constrained. This is not a free lunch. Derivatives are an essential component of the capital markets, like it or not. The “solution” patched together by the regulators has not made the world safer, it has just magnified the risk in one or two places. It would not take a failure of one of the Clearing Houses to bring about a catastrophic end. Merely the whisper of a problem would do it.

To the regulators who are cheering their success, I would respond with:

You just magnified the risk!

On FX

2012-04-05T13:53:00.000-07:00

There was a mini flash crash in the EURCHF cross this morning. Two charts on the price move:
(Link and Link)

I was watching markets on a screen. When I saw the EURCHF price break I called a lady I know on an FX desk. She picked up the phone after a few seconds and yelled at me:

“We’re 16 bid. It’s a piece of shit!”

and then hung up...

Translation:

“FX Bank is prepared to buy Euros and sell Swiss Francs at 1.2016 currently. There is no breach of the CHF peg at this time. It was just some computers gunning stop losses.  Nothing to worry about. Please excuse me, as I have to take another call. Have a nice day!"

The price break took place in under a minute; it might have been for just a few seconds. There are some reports that the Swiss National Bank (SNB) actual bought some Euros during the fray. I’m not sure that is true. If it did happen, then the SNB bought them from a computer, and the computer lost money.

What happened this A.M. shows that the EURCHF market is wound tight. It could uncoil quickly. I have no doubt that the SNB has resting orders in the capital markets for buying up to 10 billion EURCHF. I also don’t doubt their resolve to do more. But nine hours after the mini crash the EURCHF is sitting at 1.2021, a measly 0.17% away from the SNB wall. That’s too close for comfort. Something has to give. Another bad day in the Spanish bond market might do it.

If we see a headline in the next few days that the SNB was forced to actively defend the peg, and in the process absorbed tens of billions of Euros, it will be very unsettling across all markets. It would be a sign of financial desperation; the ultimate “risk off” move.

I don’t think it’s possible for the EURCHF to trade so close to the peg without some accident happening that could start the hot money rolling. Either we drift back up to the "safer" mid 1.20’s, or we're going to have an Intervention Party. This might sort itself out by the weekend. One thing is certain, the US VIX is not priced for a hard landing of the EURCHF.

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Bernanke - I'm Slowing Down the Ship

2012-04-04T16:10:00.003-07:00

A full trading day after the release of the Fed minutes has brought us some reasonably significant changes in market levels. S&P –1.5%, Gold – 3.5%, Crude –1.5%. Apparently, the confirmation that it is on hold surprised the market. (link)

I’m not surprised. Bernanke understands that upping the anti with more QE would send the price of crude through the roof. The deflationary effect on the consumer economy of another dollar increase for gas would far outweigh any positive consequences that another LSAP would have produced.

Some random thoughts: (Warning, I stray from side to side on this.)

-I see that the Fed has been put in check by the global price of crude. While this is not checkmate, it forces the Fed to move to the defense. The language from the Fed meeting confirms it. For the past four years, the Fed has been on the offense. It has had no opposition from the markets. The subtle change in the Fed’s position is a major change in its strategic advantage. To me, this represents a significant change of events.

-While this represents an important strategic change, the reality is that the short-term monetary consequences are negligible. ZIRP will linger on for at least another year. As as a monetary stimulus, ZIRP has much greater consequences to the global economy than do QEs, TWISTS etc. It's as if the Fed has shifted from fifth gear down to fourth. It's still speeding ahead. The shift to fourth is more about gaining some additional traction over a rough spot, not about a change in velocity.

-Bernanke has said that if there were to be a new TWIST, the operation would be “sterilized” by reducing very short-term cash liquidity (2-14 days). The Fed would have to do that because they have no more medium term paper to swap against long-dated paper. It is faced with an operational constraint to extending TWIST. The result is the necessity to drain short-term liquidity to complete the swap.

I think the sterilized swap is a ~~stupid~~ terrible idea. Yes there is a lot of cash around. But if Ben thinks he can suck up $800b of cash and not have a consequence, he is mistaken.

The financial markets have been running on dirt cheap money (0.1%) the past few years. I wonder if some folks with white spats haven’t whispered to Bernanke, “If you quit on QE we will be okay. But whatever you do, don't give up on the high-octane liquidity!”

-IMHO if the US economy is buying up 15m cars (annually) it is not in crisis, and does not need emergency monetary measures. I’m not ignoring high unemployment. I’m saying the problem is structural. Hot money can't fix this problem and hot money is causing other problems. The question is, “Is the Fed thinking like this too?”

The Fed has a dual mandate: Price Stability (PS) and Maximum Employment (ME). If Bernanke had been asked the question at any time over the past three years,

“Between the two mandates, how are you allocating your efforts?”

Bernanke would have answered:

“99% to ME and 1% to PS.”

What would Bernanke’s answer to this question be today? Would he say:

“95% to ME and 5% to PS.”

Or would he say:

“We’re back to 60 - 40”.

Answer: It isn’t 99 - 1 any longer, and we’re still a long way from 50 – 50. But the needle has moved on this measure. This too is very subtle, but not insignificant.

-As Bernanke withdrew one card from the deck, he has inserted two jokers. These jokers can be played by Ben anytime he likes it. He just needs an excuse. I wholeheartedly agree with the sentiment that all it would take was a 20% correction in the S&P and we would have QE3 in a NY minute.

Think about that. It’s insane, but it’s also true. The economy can’t expand unless the S&P steadily rises. What was once cause and effect is now effect and cause.

-Bernanke has a bad sense of timing. He iniated QE2 in response to an “invisible wall”. He launched Operation Twist in response to a slowdown he (and others) thought was coming last summer. Neither of those “slowdowns” actually happened. It was just the New Normal ebb and flow of the economy. Bernanke missed the signs.

I wonder if Ben is suffering another bout of bad timing. He is sailing a big ship and it is on fast forward. He is sending out signals that he going to slow the ship down. Definitive evidence that the ship is slowing will come when/if the Fed announces that it will not extend Operation Twist. (The White Spats folks are insisting it’s coming in June).

If the Fed does not renew TWIST, then the history books will say that this was the turning point of a move away from monetary accommodation. Those books may compare the timing of the Fed's transition to the fateful tightening steps the Fed made in 1936 that precipitated the second leg of the Great Depression. Funny thing about those history books.

-Absent a blow up in the stock market, I don’t think that Operation Twist will be renewed. That will be a big surprise to the folks with the spats. The likes of Morgan Stanley and PIMCO are loaded up for a new MBS TWIST.

I believe that the deep thinkers on Wall Street are missing the political angle on this. Bernanke’s hands are tied by the election. If he comes forward in May with a New Twist program that will last through November 15th, the Republicans will (rightly) call foul. Bernanke does not want to take the resulting flack. It would tarnish his and the Fed’s image.

-There will be no more QEing or TWISTING until after Christmas. By then, the fiscal time bombs that are set to go off on Jan. 1 will make any steps the Fed takes irrelevant.

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Social Security – Good News, Bad News

2012-04-02T03:40:00.000-07:00

The Good News

Social Security (SS) has released estimates for both payroll tax revenues and benefits paid for April. The results are adjusted for the 2% payroll tax reduction. (The Treasury pays SS monthly for the shortfall.) The numbers tell an interesting story.

Revenues from FICA and SECA taxes are up significantly in the first four months of 2012.

A look at the actual income and the percentage change:

I’m surprised by the extent of this improvement. These numbers appear to be too good. The Jan. – Apr. results suggest that total employment has now exceeded the levels that prevailed in 2008. But that is not the case based on other information.

According to the BLS data, the number of people who are employed rose from 139.6m to 142.1m from Feb. 2011 – Feb. 2012. The increase of 2.5m workers translates into $5B of additional revenues at SS for the Jan. – Apr. 2012 period. (This assumes average annual income of $50,000) The $19B YoY improvement at SS suggests that there are many more people now working then the reported BLS data. There are some reasons why this discrepancy is so large:

-Annual adjustments to SS’s reported income.

-Quarterly adjustments to SS’s reported income.

-Many workers received bonus payments in Jan. and Feb. 2012. Therefore they have already maxed out their annual SS contributions. (The max = $110,500 of income.)

-SS data covers all workers; BLS data only covers Non Farm workers. It’s possible that more people are finding employment outside of the areas that the BLS covers.

I think that taken together these factors can only account for half of the increase in payroll tax revenue. The other half is a function of more people working. The data suggests there are 1-2 million more people working than the BLS is reporting.

Is this possible? “Yes”, is the answer. The BLS puts the work force at 142m. Could its numbers be wrong by 1%? Sure they could. The BLS conducts its surveys by land-line phone. It does not attempt to contact households that exclusively use cell phones. In 2010, 27% of all households exclusively used cell phones. The exclusion of a quarter of all households makes the BLS numbers very suspect.

Note: The observation that there may be 1-2 million more people working (including part time) runs counter to other information that I look at, so I’m a bit confused by the result. The data can be found here. I’d be interested in any alternative theories as to why the numbers appear so strong.
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The Bad News

The double whammy of inflation and 10,000 new people a day getting SS checks is causing costs to soar at SS. The payout has been averaging $4B a month higher than a year ago:

A basic metric for measuring SS is payroll tax income minus benefit payments. This chart looks at the results for the Jan. – Apr. periods:

The first four months of the year is a period of high seasonal tax income for SS. Most of the months for the rest of the year will end with cash flow shortages. Based on Jan. - Apr. results for 2012, I forecast a full year cash deficit of $40B (vs. $45.5B of red ink in 2011.)

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Bernanke - 'The Fed never makes mistakes'

2012-03-31T07:17:00.002-07:00

Everyone makes mistakes. The best thing one can do is face up to the facts and acknowledge the error; fix the problem to the extent possible and do what is necessary to avoid repeating the mistake. Ben Bernanke's inability to admit his (and his predecessor's) mistakes condemns the Fed to repeat the sins of the past.

In this week's lecture tour at George Washington U, Bernanke spoke to the students about the causes of the economic collapse of 2008. In his presentation, he identified most of the bad actors and the mistakes that those institutions made. He pointed his finger at:

-Fannie Mae and Freddie Mac
-The big banks and Wall Street wire houses
-Mortgage brokers
-AIG

He blamed:

-Sub Prime mortgages
-Excessive leverage
-Banks’ failure to adequately monitor and manage risks
-Excessive reliance on short‐term funding
-Increased use of exotic financial instruments that concentrated risk

Bernanke never acknowledged that the Fed contributed to the mess of 2008. If Ben wasn't flat out lying, his head is buried very deeply in the sand.

In response to the recession of 2001 the Fed allowed money supply to increase by 30% in 4 years:

The Fed also manipulated interest rates. It drove short-tem rates (Federal Funds) to 1% in 2004.

When Greenspan tried to normalize interest rates in 2005 he was forced to raise the Fed Funds rate 13 times. This sharp increase was a significant factor in blowing the top off of the real estate market. Greenspan’s Fed contributed to the housing bubble. The Fed's tightening brought on the bust that it helped create.

So where are we today on the critical issues that brought about the collapse of 2008?

Money supply is zooming:

Inflation is chugging along:

Interest rates are pegged at zero:

The Fed’s balance sheet is bloated

The government is still making junk mortgages; FHFA is guaranteeing loans at 97.5% of value.

Consumers are borrowing more. Debt has grown 6% in the past year, three times the rate of growth in the economy.

Student loan balances have been exploding. They passed the Trillion mark this week:

The savings rate is the lowest it’s been since the crisis. Who would want to save money when the return on savings is negative?

Junk bonds (and other forms of exotic debt) are back in style, and investors are lapping up the swill up.

Funny money credit is back. This outfit is lending money to all comers. I love it when the lady says, “Yes it is expensive”. (11 second video)

It’s not just expensive money, It’s crazy. Consider this chart of pricing:

If you want $10,000, the cost will be $52,343 in interest. If you only need a quick $500, these nice folks will give to you, but the cost will be $1800 or 340%%.

For the Chairman of the Fed to stand before all those GWU students and avoid accepting a share of the responsibility for what happened in 2008 is a gross re-write of history. That he does not see that he is making the same mistakes that the Fed made in every prior economic cycle is sad. The audience should have booed him. I am.