RBS tells clients to prepare for 'monster' money-printing by the Federal Reserve

As recovery starts to stall in the US and Europe with echoes of mid-1931, bond experts are once again dusting off a speech by Ben Bernanke given eight years ago as a freshman governor at the Federal Reserve.

By Ambrose Evans-Pritchard,
The Daily Telegraph
International Business Section
27 Jun 2010
68 Comments

Entitled "Deflation: Making Sure It Doesn’t Happen Here", it is a warfare manual for defeating economic slumps by use of extreme monetary stimulus once interest rates have dropped to zero, and implicitly once governments have spent themselves to near bankruptcy. The speech is best known for its irreverent one-liner: "The US government has a technology, called a printing press, that allows it to produce as many US dollars as it wishes at essentially no cost."

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Bernanke began putting the script into action after the credit system seized up in 2008, purchasing $1.75 trillion of Treasuries, mortgage securities, and agency bonds to shore up the US credit system. He stopped far short of the $5 trillion balance sheet quietly pencilled in by the Fed Board as the upper limit for quantitative easing (QE). Investors basking in Wall Street's V-shaped rally had assumed that this bizarre episode was over. So did the Fed, which has been shutting liquidity spigots one by one. But the latest batch of data is disturbing. The ECRI leading indicator produced by the Economic Cycle Research Institute plummeted yet again last week to -6.9, pointing to contraction in the US by the end of the year. It is dropping faster that at any time in the post-War era. The latest data from the CPB Netherlands Bureau shows that world trade slid 1.7pc in May, with the biggest fall in Asia. The Baltic Dry Index measuring freight rates on bulk goods has dropped 40pc in a month. This is a volatile index that can be distorted by the supply of new ships, but those who watch it as an early warning signal for China and commodities are nervous. Andrew Roberts, credit chief at RBS, is advising clients to read the Bernanke text very closely because the Fed is soon going to have to the pull the lever on "monster" quantitative easing (QE)". "We cannot stress enough how strongly we believe that a cliff-edge may be around the corner, for the global banking system (particularly in Europe) and for the global economy. Think the unthinkable," he said in a note to investors. Roberts said the Fed will shift tack, resorting to the 1940s strategy of capping bond yields around 2pc by force majeure said this is the option "which I personally prefer". A recent paper by the San Francisco Fed argues that interest rates should now be minus 5pc under the bank's "rule of thumb" measure of capacity use and unemployment. The rate is currently minus 2pc when QE is factored in. You could conclude, very crudely, that the Fed must therefore buy another $2 trillion of bonds, and even more if Europe's EMU debacle goes from bad to worse. I suspect that this hints at the Bernanke view, but it is anathema to hardliners at the Kansas, Richmond, Philadephia, and Dallas Feds. Societe Generale's uber-bear Albert Edwards said the Fed and other central banks will be forced to print more money whatever they now say, given the "stinking fiscal mess" across the developed world. "The response to the coming deflationary maelstrom will be additional money printing that will make the recent QE seem insignificant," he said. Despite the apparent rift with Europe, the US is arguably tightening fiscal policy just as hard. Congress has cut off benefits for those unemployed beyond six months, leaving 1.3m without support. California has to slash $19bn in spending this year, as much as Greece, Portugal, Ireland, Hungary, and Romania combined. The states together must cut $112bn to comply with state laws. The Congressional Budget Office said federal stimulus from the Obama package peaked in the first quarter. The effect will turn sharply negative by next year as tax rises automatically kick in, a net swing of 4pc of GDP. This is happening as the US housing market tips into a double-dip. New homes sales crashed 33pc to a record low of 300,000 in May after subsidies expired. It is sobering that zero rates, QE a l'outrance, and an $800bn fiscal blitz should should have delivered so little. Just as it is sobering that Club Med bond purchases by the European Central Bank and the creation of the EU's €750bn rescue "shield" have failed to stabilize Europe's debt markets. Greek default contracts reached an all-time high of 1,125 on Friday even though the €110bn EU-IMF rescue is up and running. Are investors questioning EU solvency itself, or making a judgment on German willingness to back pledges with real money? Clearly we are nearing the end of the "Phoney War", that phase of the global crisis when it seemed as if governments could conjure away the Great Debt. The trauma has merely been displaced from banks, auto makers, and homeowners onto the taxpayer, lifting public debt in the OECD bloc from 70pc of GDP to 100pc by next year. As the Bank for International Settlements warns, sovereign debt crises are nearing "boiling point" in half the world economy. Fiscal largesse had its place last year. It arrested the downward spiral at a crucial moment, but that moment has passed. There is a time to love and a time to hate, a time for war and a time for peace. The Krugman doctrine of perma-deficits is ruinous - and has in fact ruined Japan. The only plausible escape route for the West is a decade of fiscal austerity offset by helicopter drops of printed money, for as long as it takes. Some say that the Fed's QE policies have failed. I profoundly disagree. The US property market - and therefore the banks - would have imploded if the Fed had not pulled down mortgage rates so aggressively, but you can never prove a counter-factual. The case for fresh QE is not to inflate away the debt or default on Chinese creditors by stealth devaluation. It is to prevent deflation. Bernanke warned in that speech eight years ago that "sustained deflation can be highly destructive to a modern economy" because it leads to slow death from a rising real burden of debt. At the time, the broad money supply war growing at 6pc and the Dallas Fed's `trimmed mean' index of core inflation was 2.2pc. We are much nearer the tipping today. The M3 money supply has contracted by 5.5pc over the last year, and the pace is accelerating: the 'trimmed mean' index is now 0.6pc on a six-month basis, the lowest ever. America is one twist shy of a debt-deflation trap. There is no doubt that the Fed has the tools to stop this. "Sufficient injections of money will ultimately always reverse a deflation," said Bernanke. The question is whether he can muster support for such action in the face of massive popular disgust, a Republican Fronde in Congress, and resistance from the liquidationsists at the Kansas, Philadelphia, and Richmond Feds. If he cannot, we are in grave trouble.

The Third Depression

By PAUL KRUGMAN
The New York Times
June 27, 2010

Recessions are common; depressions are rare. As far as I can tell, there were only two eras in economic history that were widely described as “depressions” at the time: the years of deflation and instability that followed the Panic of 1873 and the years of mass unemployment that followed the financial crisis of 1929-31.
Neither the Long Depression of the 19th century nor the Great Depression of the 20th was an era of nonstop decline — on the contrary, both included periods when the economy grew. But these episodes of improvement were never enough to undo the damage from the initial slump, and were followed by relapses.
We are now, I fear, in the early stages of a third depression. It will probably look more like the Long Depression than the much more severe Great Depression. But the cost — to the world economy and, above all, to the millions of lives blighted by the absence of jobs — will nonetheless be immense.
And this third depression will be primarily a failure of policy. Around the world — most recently at last weekend’s deeply discouraging G-20 meeting — governments are obsessing about inflation when the real threat is deflation, preaching the need for belt-tightening when the real problem is inadequate spending.
In 2008 and 2009, it seemed as if we might have learned from history. Unlike their predecessors, who raised interest rates in the face of financial crisis, the current leaders of the Federal Reserve and the European Central Bank slashed rates and moved to support credit markets. Unlike governments of the past, which tried to balance budgets in the face of a plunging economy, today’s governments allowed deficits to rise. And better policies helped the world avoid complete collapse: the recession brought on by the financial crisis arguably ended last summer.
But future historians will tell us that this wasn’t the end of the third depression, just as the business upturn that began in 1933 wasn’t the end of the Great Depression. After all, unemployment — especially long-term unemployment — remains at levels that would have been considered catastrophic not long ago, and shows no sign of coming down rapidly. And both the United States and Europe are well on their way toward Japan-style deflationary traps.
In the face of this grim picture, you might have expected policy makers to realize that they haven’t yet done enough to promote recovery. But no: over the last few months there has been a stunning resurgence of hard-money and balanced-budget orthodoxy.
As far as rhetoric is concerned, the revival of the old-time religion is most evident in Europe, where officials seem to be getting their talking points from the collected speeches of Herbert Hoover, up to and including the claim that raising taxes and cutting spending will actually expand the economy, by improving business confidence. As a practical matter, however, America isn’t doing much better. The Fed seems aware of the deflationary risks — but what it proposes to do about these risks is, well, nothing. The Obama administration understands the dangers of premature fiscal austerity — but because Republicans and conservative Democrats in Congress won’t authorize additional aid to state governments, that austerity is coming anyway, in the form of budget cuts at the state and local levels.
Why the wrong turn in policy? The hard-liners often invoke the troubles facing Greece and other nations around the edges of Europe to justify their actions. And it’s true that bond investors have turned on governments with intractable deficits. But there is no evidence that short-run fiscal austerity in the face of a depressed economy reassures investors. On the contrary: Greece has agreed to harsh austerity, only to find its risk spreads growing ever wider; Ireland has imposed savage cuts in public spending, only to be treated by the markets as a worse risk than Spain, which has been far more reluctant to take the hard-liners’ medicine.
It’s almost as if the financial markets understand what policy makers seemingly don’t: that while long-term fiscal responsibility is important, slashing spending in the midst of a depression, which deepens that depression and paves the way for deflation, is actually self-defeating.
So I don’t think this is really about Greece, or indeed about any realistic appreciation of the tradeoffs between deficits and jobs. It is, instead, the victory of an orthodoxy that has little to do with rational analysis, whose main tenet is that imposing suffering on other people is how you show leadership in tough times.
And who will pay the price for this triumph of orthodoxy? The answer is, tens of millions of unemployed workers, many of whom will go jobless for years, and some of whom will never work again.

No words needed

Government Expanded 'Like a Cancer': Marc Faber

Antonia Oprita
CNBC.com
17 Jun 2010
Governments have intervened too much in free markets since the crisis started, to the point that they are affecting the health of the world economy, Marc Faber, the author of "The Gloom, Boom & Doom Report" told CNBC Thursday. Later on Thursday, leaders of the 27 European Union member states will discuss ways of strengthening fiscal discipline in the bloc and tightening financial regulation to prevent another economic crisis. In the US, despite criticism about the way it handled the crisis, the Federal Reserve is set to become the most powerful financial regulator under a financial reform bill being discussed in Congress. "I think that governments have become like a cancer, they have expanded in the financial system," Faber said. "I think the biggest problem is too much intervention. Whatever the government touches is usually done worse than in the private sector," he said. Markets usually give signals when something goes wrong but, if the government is to intervene, as is the case of the European Central Bank, the Federal Reserve and the Bank of England's bond buying, government intervention hides these signals, according to Faber. "I think any government intervention has unintended consequences and is negative," he said. When there is intervention, "eventually the market will break the intervention and things will blow out." Government stimulus packages create volatility in stock markets because they distort economic indicators, said Faber, who predicted that the US will implement another stimulus. Supporters of past government interventions to boost money in the economy have said that without them the world economy would have been in much worse shape now, with unemployment much higher and more companies going bankrupt. "Yes I am familiar with this line of argumentation," Faber said. "The Keynesians will all say … we would be in a depression now. But it's not clear to me that this is correct."

Gold, Stocks Better than Bonds

Some economists raise the spectre of deflation, but Faber pointed out that inflation in the UK is high and that food prices are rising by 20 percent in emerging economies. "People who tell me about the big deflation in Japan, why don't they spend a day in Tokyo? It's still the most expensive city in the world," he added. "At this level I'm not particularly interested in buying anything," he said in response to the deflation argument. "I buy gold, I don't know what else to buy." Faber prefers to be invested in stocks rather than government bonds at this moment, because bonds have had a period in which they out-performed stocks and from now on, he predicted that bond yields will rise. Stocks are "in a correction phase" and got very oversold two weeks ago, he said, adding that 1,170 points was the S&P's resistance level. Indexes are unlikely to hit the lows of March 2009 again in the near future, according to Faber.

- Watch the first part of Marc Faber's interview above and the second part here.

He reiterated his view that another, worse crisis may happen in five to 10 years, "when the whole financial system collapses" because the debt problem has been kicked down the road without actually being sold. "I think US Fed, ECB and other central banks have no other option, they will continue to monetize and buy bad paper, period," Faber said. "The central bankers are precisely the ones that don't know that excessive money creation and excessive debt creation leads to a crisis down the road." Europe's problems are bigger than the ones in the US, because in the US the economy has probably bottomed out, he said. If the S&P drops another 10 or 15 percent from its current level, "you can be sure they'll have another stimulus package," Faber added. "The ECB will talk hawkishly, but act dovish, like the Fed in the US," he predicted.

Price increases fuel fears of food ‘crises’

By Javier Blas in London
June 15 2010

Food commodity prices will increase more than previously expected in the next decade because of rising energy prices and developing countries’ rapid growth, two leading organisations said on Tuesday, worsening the outlook for global food security. “A return to higher global economic growth . . .  together with continuing population gains, are expected to increase demand and trade and underpin prices,” the United Nations’ Food and Agriculture Organisation and the Organisation for Economic Co-operation and Development said in their annual agricultural outlook. Higher crude oil prices would add force to rising agricultural commodities prices, particularly in those regions – including Europe and the US – where energy inputs such as fertilisers were used intensively, said the report. For the next 10 years the FAO and OECD forecast that significant food prices, with the exception of pork, would remain above the 1996-2007 average, in both nominal and real terms – adjusted for inflation. Although prices were unlikely to surge back to the record levels of early 2008, they warned that “if history is any guide, further episodes of strong price fluctuations . . . cannot be ruled out, nor can future short-lived crises”. Angel Gurría, secretary-general of the OECD, said all indications pointed to a “period of high prices”, although these would be below the peaks of the 2007-08 food crisis when prices spiked to record levels, triggering riots in countries from Bangladesh to Haiti. The forecast of high prices is likely to exacerbate concerns about global food security. Since the food crisis, and the number of chronically hungry people surging above the 1bn mark last year, agriculture has drawn more attention from policymakers – particularly in the US. The OECD earlier this year organised its first ministerial meeting on agriculture for 12 years. The prospect of higher prices could prompt those nations dependent on food imports – such as Saudi Arabia and South Korea – to try to secure long-term food supplies by accelerating their investment in overseas agriculture in so-called “farmland grabs”. Mr Gurría said some food-importing nations felt “strategically vulnerable” about their agricultural commodities supplies, but added it was critical to avoid “a race for [food] self-sufficiency”. Developing countries would provide the main source of growth for world agricultural production, consumption and trade, said the report. “As incomes rise, diets are expected to slowly diversify away from staple foods towards increased meats and processed foods,” it said. In turn, with increasing affluence and an expanding middle class, food consumption in developing countries would become less responsive to price and income changes. In real terms, the report projected cereal prices to rise around 15-40 per cent relative to the 1997-2006 average, up from last year’s forecast of 10-20 per cent. Vegetable oils are expected to be more than 40 per cent higher, against last year’s forecast of a 30 per cent increase. Meat and dairy products will also be more expensive in the next decade, reversing last year’s forecast that pointed to lower prices.

China's US govt debt holdings hit 2010 high: Treasury

Agence France-Presse, 6/15/2010

China's holdings of US debt climbed to the highest level this year, the US Treasury said Tuesday even as Beijing stepped up attacks on the United States for its burgeoning debt. The cash-rich Chinese government raised its US Treasury bond holdings to 900.2 billion dollars in April, its highest level since November 2009, while posting the second consecutive monthly rise, according to a report on international capital flows. China remained far ahead as the top foreign debt holder, followed by Japan, which held 795.5 billion dollars in April, and third-placed Britain at 239.3 billion dollars, according to the figures. The monthly gain in April and the previous month came after six straight months in which China appeared to reduce its Treasury holdings, or keep them flat. While that triggered concerns Beijing was diversifying away from US bonds, some analysts said Beijing was secretly buying bonds via third countries to mask its importance as a creditor -- a role which had attracted considerable scrutiny. Globally there has been an influx of investments in recent months into US Treasury bonds -- a channel used by the government to borrow from the public to finance its burgeoning deficit -- amid the mounting European debt crisis. The crisis, which sent the euro to four-year lows, also deterred China and several other countries with massive foreign reserves from diversifying away from US bonds and other long-term US securities, analysts said. "Threats of reserve diversification over the last two years by China and Russia have ended since the breakout of the European sovereign debt crisis and the euro's (sharp) decline against the US dollar," said analyst Michael Woolfolk of Bank of New York Mellon. The data Tuesday indicated that China remains "a steadfast buyer" of Treasuries, averaging 10.3 billion dollars per month in 2009 and 8.2 billion dollars per month for the first four months of 2010, he said. China, the world's largest holder of foreign-exchange reserves, has been constantly criticizing Washington for its snowballing debt levels, fearing that Beijing's investment in US government bonds could turn sour if a debt crisis overwhelms America. Analysts cited the latest criticism from the Chinese national pension fund chief last week, saying it had also helped the euro recover against the greenback, including on Tuesday. "The Euro was bought up quite aggressively on comments from the head of the Chinese pension Fund that the euro will survive the crisis and that he was more concerned about their US debt holdings," said Tony Darvall of Easy Forex. The latest Treasury data showed that net foreign purchases of US securities rose in April but at a slower pace than record-setting March levels. Net long-term foreign purchases fell to 83 billion dollars from 140.5 billion dollars in March. "Despite falling from their record-high March level, net long-term capital inflows to the United States remained solid," said Gregory Daco, US economist at IHS Global Insight. "Foreign investors' confidence in the US recovery was illustrated by the increased holdings of all three largest foreign holders of US Treasuries: China, Japan, and the UK," he said.

Nightmare vision for Europe as EU chief warns 'democracy could disappear' in Greece, Spain and Portugal

By Jason Groves
The Daily Mail Online
15th June 2010

+ EU begin emergency billion-pound bailout of Spain
+ Countries in debt may fall to dictators, EC chief warns
+ 'Apocalyptic' vision as some states run out of money.

Democracy could ‘collapse’ in Greece, Spain and Portugal unless urgent action is taken to tackle the debt crisis, the head of the European Commission has warned. In an extraordinary briefing to trade union chiefs last week, Commission President Jose Manuel Barroso set out an ‘apocalyptic’ vision in which crisis-hit countries in southern Europe could fall victim to military coups or popular uprisings as interest rates soar and public services collapse because their governments run out of money. The stark warning came as it emerged that EU chiefs have begun work on an emergency bailout package for Spain which is likely to run into hundreds of billions of pounds.

Crisis point: Demonstrators protest cuts announced by the Government in Malaga last week in an echo of the Greek crisis. A £650 billion bailout for Greece has already been agreed. John Monks, former head of the TUC, said he had been ‘shocked’ by the severity of the warning from Mr Barroso, who is a former prime minister of Portugal. Mr Monks, now head of the European TUC, said: ‘I had a discussion with Barroso last Friday about what can be done for Greece, Spain, Portugal and the rest and his message was blunt: “Look, if they do not carry out these austerity packages, these countries could virtually disappear in the way that we know them as democracies. They've got no choice, this is it.” ‘He's very, very worried. He shocked us with an apocalyptic vision of democracies in Europe collapsing because of the state of indebtedness.’ Greece, Spain and Portugal, which only became democracies in the 1970s, are all facing dire problems with their public finances. All three countries have a history of military coups. Greece has been rocked by a series of national strikes and riots this year following the announcement of swingeing cuts to public spending designed to curb Britain’s deficit. Spain and Portugal have also announced austerity measures in recent weeks amid growing signs that the international markets are increasingly worried they could default on their debts.

Dictatorships: An end to democracy in Europe could see a return of figures ruling dictatorships. General Franco was dictator of Spain until 1975; Georgios Papadopoulos led a military junta until 1973; and Antonio de Oliveira Salazar ruled as Portugese president until 1968
Other EU countries seeing public protests over austerity plans include Hungary, Italy and Romania, where public sector pay is to be slashed by 25 per cent. Deputy Prime Minister Nick Clegg, who visited Madrid last week, said the situation in Spain should serve as a warning to Britain of the perils of failing to tackle the deficit quickly. He said the collapse of confidence in Spain had seen interest rates soar, adding: ‘As the nation with the highest deficit in Europe in 2010, we simply cannot afford to let that happen to us too.’ Mr Barroso’s warning lays bare the concern at the highest level in Brussels that the economic crisis could lead to the collapse of not only the beleaguered euro, but the EU itself, along with a string of fragile democracies.

DICTATORSHIPS
GREECE: Georgios Papadopoulos was dictator from 1967 to 1974.The Colonel led the military coup d'etat in 1967 against King Constantine II amid political instability. He was leader of the junta which ruled until 1974. Papadopoulos was overthrown by Brigadier Dimitrios Ioannidis in 1973. Democracy was restored in 1975.

SPAIN: General Francisco Franco led Spain from 1936 until his death in 1975. At the end of the Spanish Civil War he dissolved the Spanish Parliament and established a right-wing authoritarian regime that lasted until 1978. After his death Spain gradually began its transition to democracy.
PORTUGAL: Antonio de Oliveira Salazar's regime and its secret police ruled the country from 1932 to 1968. He founded and led the Estado Novo, the authoriatan, right-wing government that controlled Portugal from 1932 to 1974. After Salazar's death in 1970, his regime persisted until it eventually fell after the Carnation Revolution. But it risks infuriating governments in southern Europe which are already struggling to contain public anger as they drive through tax rises and spending cuts in a bid to avoid disaster. Mr Monks yesterday warned that the new austerity measures themselves could take the continent ‘back to the 1930s’. In an interview with the Brussels-based magazine EU Observer he said: ‘This is extremely dangerous. 'This is 1931, we're heading back to the 1930s, with the Great Depression and we ended up with militarist dictatorship. ‘I'm not saying we're there yet, but it's potentially very serious, not just economically, but politically as well.’ Mr Monks said union barons across Europe were planning a co-ordinated ‘day of action’ against the cuts on 29 September, involving national strikes and protests.

David Cameron will travel to Brussels on Thursday for his first summit of EU leaders since the election. Leaders are expected to thrash out a rescue package for Spain’s teetering economy. Spain is expected to ask for an initial guarantee of at least £100 billion, although this figure could rise sharply if the crisis deepens. News of the behind-the-scenes scramble in Brussels spells bad news for the British economy as many of our major banks have loaned Spain vast sums of money in recent years. Germany’s authoritative Frankfurter Allgemeine Newspaper reported that Spain is poised to ask for multi-billion pound credits. Mr Barroso and Jean-Claude Trichet of the European Central Bank are united on the need for a rescue plan. The looming bankruptcy of Spain, one of the foremost economies in Europe, poses far more of a threat to European unity and the euro project than Greece. Greece contributes 2.5 percent of GDP to Europe, Spain nearly 12 percent. Yesterday’s report quoted German government sources saying: ‘We will lead discussions this week in Brussels concerning the crisis. It has intensified to the point that the states do not want to wait until the EU summit on Thursday in Brussels.”’ At the end of last month the credit rating agency Fitch downgraded Spain, triggering sharp falls on stock markets. On Friday the administration in Madrid continued to insist no rescue package was necessary. But Greece said the same thing before it came close to disaster. Yesterday the European Commission and the statistics authority Eurostat met to consider Spain‘s plight as many EU countries consider the austerity package proposed by the Madrid administration insufficient to deal with the country‘s problems.

Fannie-Freddie Fix at $160 Billion With $1 Trillion Worst Case

By Lorraine Woellert and John Gittelsohn

June 14 (Bloomberg) -- The cost of fixing Fannie Mae and Freddie Mac, the mortgage companies that last year bought or guaranteed three-quarters of all U.S. home loans, will be at least $160 billion and could grow to as much as $1 trillion after the biggest bailout in American history.
Fannie and Freddie, now 80 percent owned by U.S. taxpayers, already have drawn $145 billion from an unlimited line of government credit granted to ensure that home buyers can get loans while the private housing-finance industry is moribund. That surpasses the amount spent on rescues of American International Group Inc., General Motors Co. or Citigroup Inc., which have begun repaying their debts. “It is the mother of all bailouts,” said Edward Pinto, a former chief credit officer at Fannie Mae, who is now a consultant to the mortgage-finance industry. Fannie, based in Washington, and Freddie in McLean, Virginia, own or guarantee 53 percent of the nation’s $10.7 trillion in residential mortgages, according to a June 10 Federal Reserve report. Millions of bad loans issued during the housing bubble remain on their books, and delinquencies continue to rise. How deep in the hole Fannie and Freddie go depends on unemployment, interest rates and other drivers of home prices, according to the companies and economists who study them.

‘Worst-Case Scenario’

The Congressional Budget Office calculated in August 2009 that the companies would need $389 billion in federal subsidies through 2019, based on assumptions about delinquency rates of loans in their securities pools. The White House’s Office of Management and Budget estimated in February that aid could total as little as $160 billion if the economy strengthens. If housing prices drop further, the companies may need more. Barclays Capital Inc. analysts put the price tag as high as $500 billion in a December report on mortgage-backed securities, assuming home prices decline another 20 percent and default rates triple. Sean Egan, president of Egan-Jones Ratings Co. in Haverford, Pennsylvania, said that a 20 percent loss on the companies’ loans and guarantees, along the lines of other large market players such as Countrywide Financial Corp., now owned by Bank of America Corp., could cause even more damage. “One trillion dollars is a reasonable worst-case scenario for the companies,” said Egan, whose firm warned customers away from municipal bond insurers in 2002 and downgraded Enron Corp. a month before its 2001 collapse.

Unfinished Business

A 20 percent decline in housing prices is possible, said David Rosenberg, chief economist for Gluskin Sheff & Associates Inc. in Toronto. Rosenberg, whose forecasts are more pessimistic than those of other economists, predicts a 15 percent drop. “Worst case is probably 25 percent,” he said. The median price of a home in the U.S. was $173,100 in April, down 25 percent from the July 2006 peak, according to the National Association of Realtors. Fannie and Freddie are deeply wired into the U.S. and global financial systems. Figuring out how to stanch the losses and turn them into sustainable businesses is the biggest piece of unfinished business as Congress negotiates a Wall Street overhaul that could reach President Barack Obama’s desk by July. Neither political party wants to risk damaging the mortgage market, said Douglas Holtz-Eakin, a former director of the Congressional Budget Office and White House economic adviser under President George W. Bush. “Republicans and Democrats love putting Americans in houses, and there’s no getting around that,” Holtz-Eakin said.

‘Safest Place’

With no solution in sight, the companies may need billions of dollars from the Treasury Department each quarter. The alternative -- cutting the federal lifeline and letting the companies default on their debts -- would produce global economic tremors akin to the U.S. decision to go off the gold standard in the 1930s, said Robert J. Shiller, a professor of economics at Yale University in New Haven, Connecticut, who helped create the S&P/Case-Shiller indexes of property values. “People all over the world think, ‘Where is the safest place I could possibly put my money?’ and that’s the U.S.,” Shiller said in an interview. “We can’t let Fannie and Freddie go. We have to stand up for them.” Congress created the Federal National Mortgage Association, known as Fannie Mae, in 1938 to expand home ownership by buying mortgages from banks and other lenders and bundling them into bonds for investors. It set up the Federal Home Loan Mortgage Corp., Freddie Mac, in 1970 to compete with Fannie.

Lower Standards

The companies’ liabilities stem in large part from loans and mortgage-backed securities issued between 2005 and 2007. Directed by Congress to encourage lending to minorities and low- income borrowers at the same time private companies were gaining market share by pushing into subprime loans, Fannie and Freddie lowered their standards to take on high-risk mortgages. Many of those went to borrowers with poor credit or little equity in their homes, according to company filings. By early 2008, more than $500 billion of loans guaranteed or held by Fannie and Freddie, about 10 percent of the total, were in subprime mortgages, according to Fed reports. Fannie and Freddie also raised billions of dollars by selling their own corporate debt to investors around the world. The bonds are seen as safe because of an implicit government guarantee against default. Foreign governments, including China’s and Japan’s, hold $908 billion of such bonds, according to Fed data.

‘Debt Trap’

“Do we really want to go to the central bank of China and say, ‘Tough luck, boys’? That’s part of the problem,” said Karen Petrou, managing partner of Federal Financial Analytics Inc., a Washington-based research firm. The terms of the 2008 Treasury bailout create further complications. Fannie and Freddie are required to pay a 10 percent annual dividend on the shares owned by taxpayers. So far, they owe $14.5 billion, more than the companies reported in income in their most profitable years. “It’s like a debt trap,” said Qumber Hassan, a mortgage strategist at Credit Suisse Group AG in New York. “The more they draw, the more they have to pay.” Fannie and Freddie also benefited by selling $1.4 trillion in mortgage-backed securities to the Fed and the Treasury since September 2008, bonds that otherwise would have weighed on their balance sheets. While the government bought only the lowest-risk securities, it could incur additional losses.

‘Hard to Judge’

Treasury Secretary Timothy F. Geithner has vowed to keep Fannie and Freddie operating.
“It’s very hard to judge what the scale of losses is,” Geithner told Congress in March.
One idea being weighed by the Obama administration involves reconstituting Fannie and Freddie into a “good bank” with performing loans and a “bad bank” to absorb the rest. That could cost taxpayers as much as $290 billion because of all the bad loans, according to a May estimate by Credit Suisse analysts. At the end of March, borrowers were late making payments on $338.4 billion worth of Fannie and Freddie loans, up from $206.1 billion a year earlier, according to the companies’ first- quarter filings at the Securities and Exchange Commission. The number of loans more than three months past due has risen every quarter for more than a year, hitting 5.5 percent at Fannie as of the end of March and 4.1 percent at Freddie, according to the filings.

Surge in Delinquencies

The composition of the $5.5 trillion of loans guaranteed by Fannie and Freddie suggests that the surge in delinquencies may continue. About $1.98 trillion of the loans were made in states with the nation’s highest foreclosure rates -- California, Florida, Nevada and Arizona -- and $1.13 trillion were issued in 2006 and 2007, when real estate values peaked. Mortgages on which borrowers owe more than 90 percent of a property’s value total $402 billion. Fannie and Freddie may suffer additional losses as a result of the Treasury’s effort to prevent foreclosures. Under the program, banks with mortgages owned or guaranteed by the companies must rewrite loan terms to make them easier for borrowers to pay. The Treasury program is budgeted to cost Fannie and Freddie $20 billion. The companies have already modified about 600,000 delinquent loans and refinanced almost 300,000 more, in some cases for an amount greater than the houses are worth. The government is using Fannie and Freddie “for a public-policy purpose that may well increase the ultimate cost of the taxpayer rescue,” said Petrou of Federal Financial Analytics. “Treasury is rolling the dice.”

Republican Phase-Out

If the plan works and foreclosures fall, that could help stabilize Fannie’s and Freddie’s balance sheets and ultimately protect taxpayers. “Avoiding foreclosures can be a route to reducing loss severity,” said Sarah Rosen Wartell, executive vice president of the Center for American Progress, a Washington research group with ties to the Obama administration. Loans issued since 2008, when the companies raised standards for borrowers, should be profitable and help offset prior losses, Wartell said. Republicans attempted to include a phase-out of the mortgage companies in the financial reform bill. Democratic lawmakers and the Obama administration opted for further study, and the Treasury began soliciting ideas in April. Representative Scott Garrett, a New Jersey Republican and co-sponsor of the phase-out amendment, said eliminating Fannie and Freddie would force the government and the housing market to confront the issue. “It’s somewhat impossible to predict the magnitude of their impact if they continue to be the primary source of lending,” Garrett said in an interview.

Caught in ‘Quandary’

Democrats dismissed the phase-out idea as simplistic. “We need to have a housing-financing system in place,” Senate Banking Committee Chairman Christopher Dodd said last month. “If you pull that rug out at this particular juncture, I don’t know what the particular result would be. We’re caught in this quandary.” By delaying action, the Obama administration keeps losses off the government’s books while building a floor under housing prices during a congressional election year. Keeping Fannie and Freddie functioning could also support an overall economic recovery. Residential real estate -- the money spent on rent, mortgage payments, construction, remodeling, utilities and brokers’ fees -- accounted for about 17 percent of gross domestic product in 2009, according to the National Association of Home Builders.

‘Already Lost’

Allowing the companies to go under and hoping that private financing will fill the gap isn’t realistic, analysts say. It would require at least two years of rising property values for private companies to return to the mortgage-securitization market, said Robert Van Order, Freddie’s former chief international economist and a professor of finance at George Washington University in Washington. The price tag of supporting Fannie and Freddie “needs to be evaluated against the cost of not having a mortgage market,” said Phyllis Caldwell, chief of the Treasury’s Homeownership Preservation Office. Whatever the fix, the money spent will not be recovered, said Alex Pollock, a former president of the Federal Home Loan Bank of Chicago who is now a fellow at the Washington-based American Enterprise Institute. “It doesn’t matter what you do or don’t do, Fannie and Freddie will cost a lot of money,” Pollock said. “The money is already lost. There’s an attempt to try to avert your eyes.”
To contact the reporter on this story: Lorraine Woellert in Washington at lwoellert@bloomberg.net; John Gittelsohn in New York at johngitt@bloomberg.net. Last Updated: June 13, 2010 19:00 EDT

Uncertainty Restores Glitter to an Old Refuge, Gold

By NELSON D. SCHWARTZ
The New York Times
June 13, 2010

It is the resurgent passion of the doomsday crowd, a bet that everything will go wrong. No matter what has you worried, they say, the answer is gold. Inflation, deflation, government borrowing or the plunging euro — you name it — the specter of these concerns has set off a dash to gold, driving the precious metal to new highs and illustrating how fears of economic turmoil have moved from the fringe to the mainstream. And gold bugs, often dismissed as crackpots who hoard gold bars in the basement, are finally having their day. “I just think you’re in a world where a lot of chickens are coming home to roost,” said John Hathaway, manager of the Tocqueville Gold fund. “Gold is an escape hatch.” The most visible new gold enthusiasts range from the Fox News commentator Glenn Beck on the right to the financier George Soros on the left, with even some sober-minded Wall Street types developing a case of gold fever. While their language may differ, they share a fundamental view that the age-old refuge of gold is relevant again, especially as other assets like stocks and national currencies show signs of weakness. Now, individual investors are following their example around the world. The United States Mint is running short of gold coins, and the South African mint increased Krugerrand production by 50 percent late last month, to its highest level in 25 years, on brisk European demand. The debt crisis in Europe and the ensuing drop in the value of the euro are the most recent catalysts for gold’s spike last week to $1,254 an ounce, a record before adjusting for inflation, but the deeper concern is that even in the United States, government borrowing is unsustainable and the day of reckoning is at hand. Sales of American Eagle one-ounce gold coins tripled in May from the month before. If governments print more money to pay off their debts, the logic goes, inflation will destroy the value of the dollar, the euro and other paper currencies — thus enhancing the value of gold. What is more, with tax increases unlikely and with Europe on the brink, the unthinkable — a sovereign debt default or the collapse of the credit system — has suddenly become thinkable. To be sure, gold buyers have always been motivated by fear. What has changed is that some of the most respected investors on Wall Street are now among the fearful. “In recent years, we have gone from one bubble and bailout to the next,” David Einhorn, a New York money manager who was among the first to foretell the failure of Lehman Brothers, said in a speech last month. “Our gold position reflects our concern that our fiscal and monetary policies are not sufficiently geared toward heading off a possible crisis.”

Since ancient times, gold has been deemed intrinsically valuable, holding its worth even as governments fell and currencies collapsed, while seemingly casting a spell on its owners. Still, gold can go down — sometimes sharply. After peaking in 1980 at more than $800 an ounce, gold sank over the next two decades, bottoming out at just over $250 an ounce in 1999. But unlike paper assets that can become worthless, gold always retains at least some value. These days, gold is also something of a political Rorschach test. On conservative talk radio, opposition to the Obama administration’s economic policies and warnings that huge budget deficits will set off runaway inflation have made gold a hot topic of on-air discussion — and lured gold companies as advertisers. Tongue only half in cheek, Glenn Beck advised his audience to consider “Gold, God and Guns,” while laying out three possible scenarios for the economy: recession, depression or collapse. One major advertiser on Mr. Beck’s show is Goldline, a huge California marketer of gold coins and bars that is also a sponsor of programs hosted by other prominent conservative commentators like Laura Ingraham and Mike Huckabee. Mr. Beck has said he “was a client of Goldline long before they were a client of mine,” adding: “I personally don’t buy gold as an investment. I buy it for protection.” Of course, the right hardly has a monopoly on gold. Mr. Soros, a prominent donor to liberal causes and candidates, holds more than $600 million in bullion and gold mining shares. Even as worries about the global economy have intensified, gold has become easier to buy. Although some people still regard bars of gold in a vault as the ultimate insurance policy, exchange-traded funds, or E.T.F.’s, that hold gold have exploded in popularity in recent years. Gold E.T.F.’s, which trade like stocks but track the price of physical gold, account for 1,856 tons of gold, up from less than 500 tons in 2005, according to Credit Suisse. Besides luring individual investors, these funds have also made gold more appealing to hedge funds and other institutions, allowing them to own vast amounts of gold without the burden of having to store it. John A. Paulson, a top New York hedge fund manager who earned billions betting against subprime mortgages, holds $3 billion worth of gold E.T.F.’s, making gold the largest single position in his $35 billion portfolio. Daniel J. Arbess, who manages more than $2 billion in Perella Weinberg’s Xerion fund, is another new gold lover. A few years ago, he said, he would not have taken a second look at gold as an investment. But now Mr. Arbess, a Harvard Law graduate and a generally conservative investor, is very serious about gold. Spiraling deficits in the United States, Japan and Britain are unsustainable, he said, and could eventually hurt confidence in what are called “fiat currencies” — paper money not backed by gold, including the United States dollar. “Indebted countries may soon be forced to choose among three politically difficult alternatives: sharp cuts in expenditures, debt default or printing money to pay off debt,” he said, with the last option the most likely outcome. Gold, he said, is a logical hedge against this risk, because firing up the printing presses ignites inflation. True believers note that gold has risen in each of the last nine years, and that while the Standard & Poor’s 500-stock index is down 13 percent since 2001, gold is now worth nearly five times what it was then. For all its newfound respectability, gold still manages to bring out the inner survivalist in its adherents. Gold bugs like Peter Schiff of the investment firm Euro Pacific Capital in Westport, Conn., envision a black market arising in the United States, with merchants refusing paper money and insisting on gold instead, while Mr. Hathaway, the gold fund manager, says the credit system has entered “the end game.” “People probably still think I’m nuts,” Mr. Hathaway said. “But I’m not talking to myself in an isolation chamber anymore. We’ve got company now.”

Obama pleads for $50 billion in state, local aid

By Lori Montgomery
Washington Post
Sunday, June 13, 2010; A01

President Obama urged reluctant lawmakers Saturday to quickly approve nearly $50 billion in emergency aid to state and local governments, saying the money is needed to avoid "massive layoffs of teachers, police and firefighters" and to support the still-fragile economic recovery. In a letter to congressional leaders, Obama defended last year's huge economic stimulus package, saying it helped break the economy's free fall, but argued that more spending is urgent and unavoidable. "We must take these emergency measures," he wrote in an appeal aimed primarily at members of his own party. The letter comes as rising concern about the national debt is undermining congressional support for additional spending to bolster the economy. Many economists say more spending could help bring down persistently high unemployment, but with Republicans making an issue of the record deficits run up during the recession, many Democratic lawmakers are eager to turn off the stimulus tap. "I think there is spending fatigue," House Majority Leader Steny H. Hoyer (D-Md.) said recently. "It's tough in both houses to get votes."
Democrats, particularly in the House, have voted for politically costly initiatives at Obama's insistence, most notably health-care and climate change legislation. But faced with an electorate widely viewed as angry and hostile to incumbents, many are increasingly reluctant to take politically unpopular positions.

The House last month stripped Obama's request for $24 billion in state aid from a bill that would extend emergency benefits for jobless workers. Senate Majority Leader Harry M. Reid (D-Nev.) hopes to restore that funding but with debate in that chamber set to resume this week, he acknowledges that he has yet to assemble the votes for final passage. Obama's request for $23 billion to avert the layoffs of as many as 300,000 public school teachers has not won support in either chamber.

Mixed signals

Senior Democratic congressional aides said those initiatives have not gained traction in part because the White House has not made additional spending on the economy a clear priority.
In recent weeks, for instance, the White House has appeared more intent on cutting spending -- threatening to veto a defense bill over a jet engine project that the Pentagon views as unnecessary and urging every agency to come up with a list of low-priority programs for elimination. Obama has also proposed a three-year freeze in discretionary spending unrelated to national security, an idea endorsed by leaders of both parties at a meeting at the White House last week, according to Obama's letter. With the letter, however, Obama makes a direct and unequivocal case for additional "targeted investments," including state aid and several less-expensive initiatives aimed at assisting small businesses. He specifically calls for passage of the measure that is before the Senate, which would extend unemployment benefits and offer states additional aid, increasing deficits by nearly $80 billion over the next decade. Obama asks lawmakers to be patient on the deficit, noting that a special commission is at work on a comprehensive deficit-reduction plan. "It is essential that we continue to explore additional measures to spur job creation and build momentum toward recovery, even as we establish a path to long-term fiscal discipline," Obama wrote. "At this critical moment, we cannot afford to slide backwards just as our recovery is taking hold." In an interview, White House Chief of Staff Rahm Emanuel said the letter is intended to settle the growing debate over the opposing priorities of job creation and deficit reduction and "where you put your thumb on the scale." "While some people say you have to spend and some people say you have to cut, the president wants to talk about both cuts and investing," Emanuel said. GOP alternative
Don Stewart, a spokesman for Senate Minority Leader Mitch McConnell (R-Ky.), called the letter full of "contradictions."
"He's calling on Congress to pass a [jobless] bill that will add about $80 billion to the deficit, but then calls for fiscal discipline; he says these measures need to be targeted and temporary, but then calls for extending programs passed in the stimulus more than a year ago," Stewart said in an e-mail.
Republicans have offered an alternative package that proposes to cover the cost of additional jobless benefits -- but not aid to state governments -- by cutting federal spending elsewhere. In contrast to the Democratic bill, the GOP measure would reduce deficits by nearly $55 billion over the next decade, according to the nonpartisan Congressional Budget Office.
The politics of the Democratic bill before the Senate are further complicated because it has become a grab bag of must-pass provisions. In addition to state aid and more money for jobless benefits, it includes a plan to extend $32 billion in expired tax breaks for individuals and businesses and a separate provision, known as the "doc fix," that would postpone until 2012 a scheduled pay cut for doctors who see Medicare patients. When it was first unveiled last month, the total cost of the package approached $200 billion, with only about $50 billion paid for through higher taxes on multinational corporations, hedge fund managers and certain small businesses. Conservative Democrats in the House balked, forcing House leaders to scale back the doc fix and strip out the state aid, as well as $6 billion in health insurance subsidies for jobless workers. In the letter, Obama asks Congress to reconsider that decision. The House narrowly approved the trimmed-down bill.

Now the Senate is struggling to assemble a 60-vote coalition for the measure. Reid moved last week to restore the state aid, but the CBO said the resulting measure would add nearly $80 billion to budget deficits over the next decade. Moderates objected, saying they could not support such a big increase in borrowing at a time when the total national debt has topped $13 trillion, nearly 90 percent of the gross domestic product.
On Saturday, as Obama called for urgent action, senior Senate aides said the scramble for votes would delay final action on the bill for at least another week.

Retail sales fall unexpectedly, but consumer sentiment strong

By Lucia Mutikani

WASHINGTON (Reuters) - Sales at retailers unexpectedly fell in May for the first time in eight months, but a jump in consumer sentiment to a near 2-1/2 year high in early June eased fears of a slowdown in the economic recovery. The drop in sales reported by the Commerce Department on Friday followed last week's data showing a step back in private hiring in May, but analysts still saw little risk of the economy slipping back into recession. "The report is not evidence that the economy is getting ready for a double-dip or that consumers, facing headwinds of double-digit unemployment and bank credit restriction, are taking their ball and going home," said Chris Rupkey, chief financial economist at Bank of Tokyo/Mitsubishi in New York. Total retail sales dropped 1.2 percent in May, weighed down by a record decline in receipts at building materials suppliers, after rising 0.6 percent in April. Financial markets participants had forecast retail sales increasing 0.2 percent last month. Retail sales, which had risen for seven straight months, were up 6.9 percent compared to May last year. In a separate report, the consumer sentiment index rose to 75.5 from 73.6 at the end of May, according to the Thomson Reuters/University of Michigan's Surveys of Consumers. That was above market expectations for an increase to 74.5. The data offered some reassurance on the economic recovery after the surprise drop in retail sales. "This reinforces the view that what moved sales in May was the unwinding of incentives to buy energy-efficient appliances, and other issues like weather, the price of gas, and so forth," said Nigel Gault, chief U.S. economist at IHS Global Insight in Lexington, Massachusetts. "If consumers were getting panicked, you'd have expected to see more worry showing up here." U.S. stock indices pared losses Friday morning after the sentiment data, while prices for government debt held gains. The U.S. dollar edged higher against the yen and the euro.

HIGH UNEMPLOYMENT

In data published last Friday private businesses unexpectedly held back on hiring in May after expanding payrolls for two months, a trend which could undermine recovery from the worst recession since the 1930s. Restoring the economy to health is a key priority for President Barack Obama and voter anguish over the slow pace of the recovery could inflict heavy losses on the Democratic Party in November's Congressional elections. Consumer spending accounts for about 70 percent of U.S. economic activity, but with the unemployment rate near 10 percent, households' spending habits have become more cautious than during previous recoveries. Retail sales last month were dragged downed by a record 9.3 percent drop in receipts from building materials and garden equipment suppliers, which could reflect a drop in construction following the end of a popular homebuyer tax credit. Motor vehicle and parts receipts also fell 1.7 percent, although dealers reported a rise in sales. Excluding autos, sales fell 1.1 percent in May, the largest decline in 14 months, after rising 0.6 percent in April. Markets had expected sales excluding autos to gain 0.1 percent. However, core retail sales -- which exclude autos, gasoline and building materials -- rose 0.1 percent after falling 0.2 percent in April. Core sales correspond most closely with the consumer spending component of the government's gross domestic product report. Clothing and clothing accessories sales dropped 1.3 percent, while gasoline receipts fell 3.3 percent, the largest decline since March 2009. There were a few bright spots in the report, with sales at sporting goods, hobby and book stores rising 0.4 percent in May after falling 1.3 percent in April. Receipts at electronics and appliance stores increased 0.6 percent, reversing the prior month's fall. In another report, the Commerce Department said U.S. business inventories hit a 10-month high in April, while sales were at their highest level since October 2008. Inventories are a key component of gross domestic product changes over the business cycle and the rebuilding of merchandise stock from record low levels is one of the key drivers of the economy's recovery.

(Additional reporting by Ellen Freilich and Richard Leong, Editing by Chizu Nomiyama)

Nassim Taleb: What is a "Black Swan"?

Obama Administration is sedating the sick, ignoring the cure

Debt Spreading 'Like a Cancer': Black Swan Author

The economic situation today is drastically worse than a couple years ago, and
the euro is doomed as a concept, Nassim Taleb, professor and author of the
bestselling book "The Black Swan," told CNBC on Thursday.

Nassim Taleb

"We had less debt cumulatively (two years ago), and more people employed. Today, we have more risk in the system, and a smaller tax base," Taleb said. "Banks balance sheets are just as bad as they were" two years ago when the crisis began and "the quality of the risks hasn't improved," he added. The root of the crisis over the past couple of years wasn't recession, but debt, which has spread "like a cancer," according to Taleb, who is now relived that public attention has shifted to debt, instead of growth. The world needs to prepare itself for austerity, he warned. "We need to slash debt. Unfortunately, that's the only solution," Taleb said. Other analysts warned about austerity programs spreading from the euro zone to the US where the growth in debt will become unsustainable over the longer term. Obama administration's efforts to pull the US out of recession haven't succeeded, according to Taleb. "It's not that they make mistakes, it's that they almost get nothing right." Moreover, a second major stimulus package may be futile, he warned. "Obama promised us 8 percent unemployment through stimulus. It hasn't worked." There are significantly more liabilities in the US than in other countries around the world, he said. "Don't give a junkie more drugs, don't give a debt junkie more debt." Investors should avoid Treasurys and other bonds and place their money in instruments that will hedge them against looming inflation. Commodities are one place where a bull market may form over the coming years, as people try to protect their cash from price rises, famous investor Jim Rogers told CNBC earlier Thursday.

The "Black Swan" metaphor is used to describe those rare, unexpected but consequential events that people cannot predict because they view the world through a sort of tunnel vision - as something structured, ordinary, and comprehensible. "I want to live in a society that is robust to adverse events. We don't live in that world," Taleb said. "A bridge that's very poorly constructed will eventually break. A white swan for the butcher is a black swan for the turkey," he added. The "Black Swan" reference has become ubiquitous within popular and business culture over the past couple of years.

As recently as Wednesday, a top authority on oil reservoir management and upstream technology called the BP [BP-LN 365.50 -26.05 (-6.65%)] oil spill in the Gulf of Mexico a "Black Swan" event that, however catastrophic, has the potential to improve drilling practices in particular and the industry in general. Taleb expressed reservations about the future of BP, given the catastrophic fall in its market capitalization since the oil spill on April 20th. He suggested that incentives in corporate culture are inherently flawed. "Size is bad for companies," he said. "We shouldn't give a manager of a nuclear plant an incentive bonus. People are given bonuses to hide risk, to cut corners. The same thing happens with every large corporation. It permeates the entire economic system."

Capitalist Fools: The Impending Commercial Real Estate Bust

Commercial real estate is dominated by financial professionals, not hustlers looking for a quick flip. So why is the market about to melt down?

By Megan McArdle
The Atlantic Monthly, January/February 2010

Few places in New York are less likely to inspire grand dreams than Stuyvesant Town and Peter Cooper Village, the twin housing projects that sprawl across 80 acres of the Lower East Side. Built by MetLife in the 1940s, the project encompasses block after block of boxy brick apartment buildings and stolid public spaces, entirely barren of inviting corners or eye-catching detail. The critic Lewis Mumford dubbed it “the architecture of the Police State”; a slightly kinder motto might have been “What do you expect for $68.50 a month?” Yet when MetLife spruced up the complex and put it on the market in 2006, real-estate moguls jetted in for the sale. A joint venture put together by Tishman Speyer and BlackRock carried the day through its willingness to, as The New York Times noted, “pay up—way up—to unlock future profits in the sprawling Manhattan properties.” At $5.4billion, their winning bid made the sale the most expensive real-estate deal of all time. Three years later, however, those profits were still securely locked inside the property’s 11,232 apartments—many of which remained rent-controlled, despite strenuous efforts to convert them to upscale market-rate rentals. With net income well under projections, the partnership started spending down its reserves. Then, in October 2009, a court ruled that the partnership had improperly decontrolled the rent for thousands of apartments, and would have to return them to their original status. As of this writing, analysts are predicting default in a matter of months unless the partnership’s debt of $4.4billion can be restructured—a shaky prospect, given that the owners may owe tenants of formerly rent-stabilized apartments as much as $200million in rent overcharges and damages. Stuyvesant Town might soon set another record: the biggest real-estate default in history.
That default would be one of the first tremors of an earthquake about to roil financial markets: a commercial real-estate crisis mirroring the catastrophe in the residential market. October brought both the Stuy Town deal’s first death rattle and the bankruptcy of the real-estate financier Capmark. As annual bank failures topped 100 for the first time in almost two decades, Federal Deposit Insurance Corporation Chair Sheila Bair fretted over the threat posed to lenders by losses linked to hotels, malls, and condominiums. But even as this new impending crisis unsettles commercial lenders and borrowers, the story of its origins can shed new light on how we got into this larger financial mess in the first place.
Commercial mortgage lenders basically have to worry about two kinds of default risk: cash-flow risk, and asset-price risk. Cash-flow risk is what happens to homeowners when the primary breadwinner becomes unemployed, and to landlords or hotel owners when rental prices plummet. Since commercial tenants typically sign relatively long leases, this problem tends to grow slowly except in hotels—and, apparently, in rent-controlled properties with litigious tenants. But the risk posed by falling asset prices is a big problem for commercial landlords, and for their bankers. The value of much commercial real estate is tightly linked to employment—if employers don’t have bodies to put at desks, they don’t need more rooms to put the desks in. With unemployment north of 10percent, and retail suffering, the nation’s stock of commercial real estate is suddenly less valuable than it used to be. In some ways, price declines are a bigger problem for landlords than for homeowners. Unless forced to move, homeowners with long-term mortgages who make enough to cover their payments can sit tight and hope the market recovers. Landlords, however, typically take out commercial loans for shorter terms of three to 10 years. In normal times, landlords coming to the end of a mortgage simply roll the debt over into a new loan. But collapsing asset values have wreaked havoc on this process. Now, as loans come up for renewal, lenders have to reassess how much credit they’re willing to extend. Take a property that was worth $100million in 2007, when it was financed with a four-year, $70million mortgage. That’s a reasonably conservative 70percent loan-to-value (LTV) ratio. But if the building is worth only $70million when it’s time to roll the loan over, keeping the LTV at 70percent means that the owners can now borrow only $49million, and have to come up with tens of millions to pay off the original loan. Worse, as the markets tighten, lenders tend to want to see a lower LTV in the deals they finance. That suggests that a lot of commercial loans are going to go bad. According to Joseph Gyourko, a Wharton real-estate professor, at least $250billion worth of commercial loans are going to roll over in each of the next few years. When they do, many landlords will probably be caught short—and so will their bankers. Although most U.S. residential mortgages were bundled into mortgage-backed securities, only a fraction of commercial mortgages were securitized. Some bank or finance company still carries the rest on its books and will have to write them down if they can’t be rolled over; some of those banks will ultimately have to be taken over by the FDIC. As the banks’ loan portfolios are sold off, the write-downs of the underlying collateral will give bank examiners a new, lower reference price for the collateral held by other banks, possibly tipping those banks into insolvency as well. You get the picture. That said, the repercussions from the commercial collapse will not be as great as those from the housing sector. The commercial market is considerably smaller than the residential market. The existing FDIC system can handle the decline, which will likely hit smaller banks harder than those in the “too big to fail” bracket. Moreover, fraud was probably much more prevalent in the residential than the commercial market, where even the newbie investors tend to be financial professionals or established businesspeople, not hustlers looking for a quick flip. But given how experienced those investors were, why are our problems now as bad as they are? Fraud aside, Gyourko notes that at the height of its bubble, the commercial real-estate market displayed most of the pathologies that characterized the residential side. Only 50percent of the increase in prices between 2003 and 2008 resulted from rising rents, he says; the rest was just inflated optimism about the rents landlords would be able to charge sometime in the future. And just as in housing, banks joined the folly, increasing the LTVs and requiring less amortization over the life of the loan. Take the Stuyvesant Town deal. The investors aren’t shady subprime lenders or naive kids. Tishman Speyer has been in the real-estate business for decades, and the investors who trusted the firm with their money are sober institutions like the Hartford Financial Services Group and the California Public Employees’ Retirement System. Yet according to TheWall Street Journal, when Stuyvesant Town was sold, lenders were projecting that the Tishman Speyer–BlackRock partnership would be able to triple its net income in five years through building upgrades and decontrol. That’s why the principals paid a premium for the property, and financed the purchase with loans totaling more than 80percent of the price.
Even before the financial crisis sapped demand in the rental market, this plan was questionable. The buildings simply weren’t built as deluxe rentals—the mosaic tile in the public areas has been replaced by marble, but in the cramped vestibules and narrow hallways, the effect isn’t luxurious; the buildings just look like they’re dressed up for Halloween. With mostly tiny kitchens, and no room in the lobbies for a doorman, these apartments were never going to command the kind of rents that would justify the partnership’s bid. Even though many of the apartments have been decontrolled, net income has barely risen. Besides, anyone who’s been in New York long enough to find Zabar’s without a map knows that rent-controlled tenants like to sue, and New York’s housing law is notoriously tenant-friendly. Even if the new owners had found tenants willing to pay top dollar, there was a good chance they would never have been allowed to charge it. Game theorists often speak of the “winner’s curse”: the tendency of auctions to be won by the people who are the most delusionally overoptimistic. It’s an apt description of what seems to have happened. Not just to the Tishman group, but to America.
One of the most persistent narratives of the recent crisis portrays a nation of unsophisticated home buyers led astray by greedy bankers. Supposedly those bankers were willing to write risky loans because they intended to pass them on to some unwary investor. But this explanation falters in the face of a legion of failing commercial deals. Prospective landlords had all the expertise they should have needed to put a fair price on properties—and the majority of lenders who were originating loans for their own portfolios had ample incentive to perform careful due diligence.
The best explanation for the calamity that has overtaken us may simply be that cheap money makes us all stupid. The massive inflows of international capital, which Ben Bernanke has called the “global savings glut,” poured into our loan markets, driving interest rates lower—and, since most real estate is purchased with borrowed funds, pushing up the price of property in both the commercial and residential sectors. Rising prices, in turn, disguised any potential problems with the borrowers, because if they ran into cash-flow problems, they could always refinance, or sell. Everyone was getting bad signals from the market, and outlandish purchases looked almost rational. That answer isn’t quite satisfying, especially in the face of another financial meltdown. We don’t want ambiguity and complex systems; we want heroes, villains, and a happy ending. But by now we should all know that real-estate markets are rarely the stuff of fairy tales.

This article available online at:
http://www.theatlantic.com/magazine/archive/2010/01/capitalist-fools/7824/

Bernanke Puzzled by Gold Rally

The Wall Street Journal
June 9, 2010
Federal Reserve Chairman Ben Bernanke says he’s a bit puzzled by surging gold prices. The 30% rally from a year ago, on top of gains in previous years, might be interpreted as a loud signal from markets that big inflation pressures are building in the U.S. Gold is seen by many investors as a hedge against inflation risk. In this case, it might instead be a risk against risk broadly. Mr. Bernanke notes that the inflation signal isn’t confirmed by movements in other asset classes. Yields on Treasury bonds tend to rise when investors worry about inflation, but those yields have been falling recently. Inflation expectations as measured in Treasury Inflation Protected Securities (TIPS) markets remain low. And other commodity prices are falling. Gold is breaking records, but copper prices are down 17% so far this year. “I don’t fully understand movements in the gold price,” Mr. Bernanke admitted. But he suggested it might be another example of investors fleeing risky assets and flocking to assets that are perceived as less risky, not only Treasury bonds, but also ones like gold.

Bernanke Warns of ‘Unsustainable’ Debt

New York Times, June 9, 2010

WASHINGTON — When it comes to the deficit, Ben S. Bernanke has a story, and he’s sticking to it. Mr. Bernanke, the Federal Reserve chairman, warned on Wednesday that “the federal budget appears to be on an unsustainable path,” but also recognized that an “exceptional increase” in the deficit had been necessary to ease the pain of recession. In nearly two hours of questioning by the House Budget Committee, however, Mr. Bernanke gave potential succor to members of both parties, while refusing to side with either of them. To Republicans, he offered warnings about the fiscal perils of an aging population and the potential threat of soaring long-term interest rates. To Democrats, he made it clear that persistently high unemployment was a drag on growth and said that additional short-term stimulus spending might be needed. All the while, Mr. Bernanke refused to endorse any particular spending cuts or tax increases, or even specify the balance between the two. And he was not subtle about his strategy. “I’m trying to avoid taking sides on this because it’s really up to Congress to make those decisions,” he told Representative Michael K. Simpson, Republican of Idaho. “But we need your expertise on it,” Mr. Simpson pressed. “Well, no,” Mr. Bernanke replied. “Plenty of people have that kind of expertise, including the Congressional Budget Office and others.” With inflation well below the Fed’s unofficial target of about 2 percent, attention has turned to the other side of the central bank’s mandate: maximizing employment. At the same time, the debt crisis roiling Europe has made deficit-cutting a potent topic. Mr. Bernanke suggested that the United States had a while longer — but not much — before it would have to pull in the reins. “This very moment is not the time to radically reduce our spending or raise our taxes, because the economy is still in a recovery mode and needs that support,” Mr. Bernanke told Representative Bob Etheridge, Democrat of North Carolina. In the next breath, however, he added that continuing deficits risked a “potential loss of confidence in the markets.” Representative Paul Ryan of Wisconsin, the top Republican on the committee, focused his opening statement on Europe. “What we are watching in real time is the rough justice of the marketplace and the severe economic turmoil that can be inflicted on profligate countries mired in debt,” he said. But if Mr. Ryan had hoped for similarly dire pronouncements from Mr. Bernanke, he was disappointed. “If markets continue to stabilize, then the effects of the crisis on economic growth in the United States seem likely to be modest,” Mr. Bernanke testified. “Although the recent fall in equity prices and weaker economic prospects in Europe will leave some imprint on the U.S. economy, offsetting factors include declines in interest rates on Treasury bonds and home mortgages, as well as lower prices for oil and some other globally traded commodities.” Representative Jeb Hensarling, Republican of Texas, cited the research of the economist Carmen M. Reinhart, who has found that growth tends to stall in countries where the national debt reaches 90 percent of gross domestic product. The United States is at just about that threshold. “I don’t think there’s anything magic about 90 percent,” Mr. Bernanke said, while noting that in the worst-case projections by the Congressional Budget Office, “debt and interest payments are going to get explosive in 10 or 15 years.” When Representative Jim Jordan, Republican of Ohio, asked Mr. Bernanke to “talk to me about those tax increases that we know are going to happen,” Mr. Bernanke replied: “We have a recovery under way now. So in the very near term, increased taxes, cuts in spending, that are too large would be a negative, would be a drag on the recovery.” But he reiterated that “I’m not going to try to adjudicate for Congress” between tax and spending measures. Mr. Bernanke’s nimbleness in navigating deficit politics reflects his position as the most visible bridge between two administrations, having been appointed by President George W. Bush in 2006 and then reappointed by Mr. Obama to a second four-year term.
Mr. Bernanke has seemed more optimistic, or at least confident, since the crisis peaked in 2008. “As long as we have the confidence of the markets that we will be able to exit from this situation with a sustainable fiscal program, then I think we’ll be O.K.,” he told Mr. Simpson of Idaho.
How long that confidence will last, Mr. Bernanke did not say. Only after several rounds of back-and-forth did he agree with Representative Chet Edwards, Democrat of Texas, that tax cuts do not entirely pay for themselves. And he danced around with Representative Gerald E. Connolly, a Virginia Democrat, on whether the Obama administration’s $787 billion stimulus package last year was “necessary.” Mr. Bernanke would only say it was “useful.” “It must be nice to be an economist,” Mr. Connolly replied.

U.S.’s $13 Trillion Debt Poised to Overtake GDP

By Garfield Reynolds and Wes Goodman

June 4 (Bloomberg) -- President Barack Obama is poised to increase the U.S. debt to a level that exceeds the value of the nation’s annual economic output, a step toward what Bill Gross called a “debt super cycle.” The CHART OF THE DAY tracks U.S. gross domestic product and the government’s total debt, which rose past $13 trillion for the first time this month. The amount owed will surpass GDP in 2012, based on forecasts by the International Monetary Fund. The lower panel shows U.S. annual GDP growth as tracked by the IMF, which projects the world’s largest economy to expand at a slower pace than the 3.2 percent average during the past five decades. “Over the long term, interest rates on government debt will likely have to rise to attract investors,” said Hiroki Shimazu, a market economist in Tokyo at Nikko Cordial Securities Inc., a unit of Japan’s third-largest publicly traded bank. “That will be a big burden on the government and the people.” Gross, who runs the world’s largest mutual fund at Pacific Investment Management Co. in Newport Beach, California, said in his June outlook report that “the debt super cycle trend” suggests U.S. economic growth won’t be enough to support the borrowings “if real interest rates were ever to go up instead of down.” Dan Fuss, who manages the Loomis Sayles Bond Fund, which beat 94 percent of competitors the past year, said last week that he sold all of his Treasury bonds because of prospects interest rates will rise as the U.S. borrows unprecedented amounts. Obama is borrowing record amounts to fund spending programs to help the economy recover from its longest recession since the 1930s. “The incremental borrower of funds in the U.S. capital markets is rapidly becoming the U.S. Treasury,” Boston-based Fuss said. “Do you really want to buy the debt of the biggest issuer?”

To contact the reporters on this story: Garfield Reynolds in Sydney at greynolds1@bloomberg.net; Wes Goodman in Singapore at wgoodman@bloomberg.net.