Monday, September 21, 2009

Links to start the week off right

The rise of the financial industrial complex: Despite everything that has happened over the last few years, it turns out that the more things change the more things stay the same. We still face the two most immutable constants of death and taxes but the financial crisis has also provided us with a third blessing. Specifically, the newest inevitability is that banks will be too big to fail and it will be the taxpayer who assumes the corresponding financial burden while the banksters make billions prior to the collapse. Alas, the banks’ right to take any and all risks with the knowledge that the taxpayer will be left holding the flaming bag is becoming such a part of our system that we soon may not even remember a time when this perverse arrangement was not in place:

"Lately the surviving major banks have reported brisk profits, yet in large part this reflects astute politicking and lobbying rather than commercial skill. Much of the competition was cleaned out by bank failures and consolidation, so giants like Goldman Sachs and JPMorgan had an easier time getting back to profits. The Federal Reserve has been lending to banks at near-zero interest rates while paying higher interest on the reserves the banks hold at the Fed. “Too big to fail” policies mean that the large banks can raise money more cheaply because everyone knows they are safe counterparties.

President Dwight D. Eisenhower warned of the birth of a military-industrial complex. Today we have a financial-regulatory complex, and it has meant a consolidation of power and privilege. We’ve created a class of politically protected “too big to fail” institutions, and the current proposals for regulatory reform further cement this notion. Even more worrying, with so many explicit and implicit financial guarantees, we are courting a bigger financial crisis the next time something major goes wrong…

So if we’re looking for a major lesson from our banking mess, it is undoubtedly this: We have made a grave mistake in politicizing the economy so deeply, and should back away now. In health care, the Obama administration should drop its medical sector deals and try to sell a reform plan — in whatever form Mr. Obama chooses — on its own merits. That’s not only good for health care, but also good for the American polity. And in the longer run, that will be good for banking, too. If nothing else, without controlling health care costs, the American government will not stay solvent — and that will be the biggest financial crisis of them all."

Reserve currency status+ fiscal expansion= real recovery? Hat tip to James Kwak from the Baseline Scenario for posting the link to this piece from Ed Harrison on Credit Writedowns. In the piece he makes the very interesting argument that as a result of the dollar’s reserve status the US is in a unique position to create lasting, but low quality growth that produces the illusion of a real recovery.

As Joseph Stiglitz recently wrote, GDP is a very poor measure of growth and economic health. And he is right. There are many questions of statistical accuracy in its measurement. But, more than quantity, I have problems with GDP as a measure because of quality. Robust 4% growth that is underpinned by savings and capital investment is not the same as robust 4% growth underpinned by debt and consumption.

The problem I have with the recent history of growth in the United States, the United Kingdom, Spain and Ireland in particular is that the growth was underpinned by high debt accumulation and low savings. As debt is a mechanism through which we pull demand forward, the debt and consumption has meant we have been growing today at the expense of future growth.

Low quality growth can go on for a long time

This dynamic can continue for a very, very long time. In the United States, by virtue of America’s possession of the world’s reserve currency, an increase in aggregate debt levels has been successfully financed for well over twenty-five years. Mind you, there have been a number of landmines along the way. But, time and again, these pitfalls have been avoided through asymmetric monetary policy and counter-cyclical fiscal expansion.

So, poor quality growth can continue for very long indeed. And it is this fact which allows the narrative of easy money and overconsumption to gain sway.

If you just go by GDP and do not dive into whether the growth is fueled by debt as opposed to investment, then all the liquidity and new debt created by fiscal and monetary policies could obviously produce a recovery. The problem is that spending that comes from new debt issuance just pulls forward demand at the expense of future growth. However, in the short run, this effect can be very powerful and it is always possible that growth begets growth and a strong recovery becomes a self fulfilling prophecy. Maybe those who say don’t fight the Fed or bet against politicians who are desperate to get re-elected are right. The concern of course is about the future. What happens when all of this debt comes due? The bankers will have retired with huge bonuses. Those currently in Congress will be retired. Obama will be deemed a hero based on his perceived ability to fix the economy when he only put his finger in the dam. Call me cynical but somehow creating positive GDP now at the expense of our children’s future just doesn’t seem to make sense.

Whose wages are rising? Not mine: A couple of government surveys have recently suggested that wages have begun to rise again. With all of the job losses still coming online each month this sounds relatively counterintuitive. This article from the NY Times argues that the lack of churn in the jobs market has actually insulated those lucky enough to have a job.

Try thinking of it this way: All of the unemployed people in the country are gathered in a huge gymnasium that’s been turned into a job search center. The fact that this recession is the worst in a generation means that there are many, many people in the gym. The fact that the economy is churning so slowly means that there is not much traffic into and out of the gym.

If you’re inside, you will have a hard time getting out. Yet if you’re lucky enough to be outside the gym, you will probably be able to stay there. The consequences of a job loss are terribly high, but — given that the unemployment rate is almost 10 percent — the odds of job loss are surprisingly low.

The reasons for the slow churn are obviously complex. The baby boomers are moving out of the ages at which people typically start businesses. The economy has shifted away from sectors, like manufacturing, in which temporary layoffs are common. Educational gains have slowed, which affects innovation. And the federal government was not willing, at least until recently, to make the kind of investments that spurred entrepreneurship in the past — building the highway system, supporting scientific research, creating the Pentagon computer network that turned into the Internet.

But whatever the causes, the effects of the slow churn are clear: the pain of this recession has been concentrated. That’s all the more true now that wages may be rising again.

I have to be honest. I don’t buy the government’s data that says wages are rising. With substantial job losses each month a logical person would assume that in aggregate wages are falling. I am certainly not an expert on the plethora of government reports so maybe there is something unique or skewed about this data. However, I do think the author has an interesting point regarding job security. If you work for a company that is somewhat stable and despite certain headwinds will survive the crisis (and maybe even come out of the other side even stronger) then maybe you are as safe as you have ever been. If the company has become as lean as possible and will not hire new people for a long time then new competition for a specific job never arises. People are also much less likely to leave their jobs voluntarily to search for a new one or move into a less certain position. The problem of course is that for those people who cannot find a job it may take months if not years to find meaningful employment as a result of the reduced churn.

Tick, tick tick. That’s the sound of the Wachovia bomb inside Wells Fargo: Hat tip to The King Report for posting the link to this piece on Wells Fargo. When WFC decided to take on Wachovia just about everyone who follows bank stocks knew that WB’s Pick a Pay loan portfolio would be an albatross for a long time. However, what never got much mention was the equally as large commercial portfolio. However, we are now starting to see some signs of stress in that book:

In order to sort through the disaster that is Wells Fargo’s commercial loan portfolio, the bank has hired help from outside experts to pour over the books… and they are shocked with what they are seeing. Not only do the bank’s outstanding commercial loans collectively exceed the property values to which they are attached, but derivative trades leftover from its acquisition of Wachovia are creating another set of problems for the already beleaguered San Francisco-based megabank.

Wachovia, which Wells purchased last fall as it teetered on the brink of collapse, was so desperate to increase revenue in the last few years of its existence that it underwrote loans with extremely shoddy standards and paid traders to take them off their books…

According to data from which tracks financial numbers that Wells files with its regulators, the bank’s Construction and Development portfolio, with $38.2 billion in loans, is defaulting at a level eight times greater than the rest of the nation’s banks, as of June 30th. Alarming, right?

When Wachovia was trading around $16 I looked at its loan portfolio and concluded that this was a home run short. The Pick a Pay book alone was enough to justify that call. As a result, WFC is now dealing with that book, its own mortgage book, its toxic home equity book, and now WB’s legacy commercial book. CEO John Stumpf and even Warren Buffett continue to tell us how much earnings potential WFC has and the implication is that with rates at just about 0% the company can earn enough to outrun all of these losses. But from the beginning I worried that despite the opportunity to expand its footprint, WFC made a mistake trying to swallow WB and its cancerous loan portfolio. Now is when the real test begins…

Albert Edwards refuses to surrender: Hat tip to Zero Hedge for posting these comments from my favorite Soc Gen analyst (now that Montier has left for GMO). Albert continues to pound the table and shoot signal flares warning about impending deflation. He argues that we have not seen the last of the unwind of a multi-decade debt bubble and that no amount of money printing can offset or stall this process. He shares my feeling that in just a few short months you don’t recover from a near economic collapse that came about because people and companies were no longer able to service their debt. The necessary de-leveraging just logically should take some time as people realize that the world has changed. On that same topic Edwards contradicts those who believe that banks health is what we should focus on. Instead, he believes that de-leveraging is a much larger concern, as evidenced by the lost decades in Japan:

The reasoning behind the acceleration of the credit crunch is simple and needs to be re-emphasised. The unwinding of the grotesque debt excesses of the last decade have only just begun (see chart below)! Rapid expansion of government debt and QE will not and cannot prevent the revulsion that is now underway (the Fed publishes the Q2 update of the debt data today, Thursday)…

In addition, banks are retrenching their loan books as policy makers force higher capital requirements. In all probability this process would occur irrespective of government involvement as banks inevitably act pro-cyclically, exacerbating both boom and bust. But as we repeatedly highlight, one of the lessons from Japan is not to mistakenly believe that banks are the problem. Similarly a healthy, recapitalised banking sector is not the solution. As Japan experienced before, it is de-leveraging that is the problem and retrenchment takes many years, rendering the economy extremely vulnerable to rapid relapses back into recession when any reverse or pause in extreme stimulus occurs. The Great Moderation relied on the debt super-cycle which is dead and buried.

The ramification of the growing dollar carry trade: In this piece, William Pesek of Bloomberg discusses the emerging dollar carry trade in which people and institutions borrow dollars at very low rates and invest the proceeds in higher yielding assets. Thus, many people are essentially short the US dollar and anything that caused the trade to unwind could lead to panicked short covering of the dollar. The impact of this may be meaningful and probably would be exacerbated by the fact that the dollar is still the world’s reserve currency (at least for now).

The perils of the carry trade were seen in October 1998. Russia’s debt default and the implosion of Long-Term Capital Management LP devastated global markets. It was a decidedly panicky and messy period culminating in the yen, which had been weakening for years, surging 20 percent in less than two months.

Now imagine what might happen if the world’s reserve currency became its most shorted. Carry trades are, after all, bets that the funding currency will weaken further or stay down for an extended period of time. It’s also a wager that a central bank is trapped into keeping borrowing costs low indefinitely.

What if, for example, a U.S. recovery comes faster than expected, sparking a massive reversal of the carry trade? Its implications would be felt far more widely than shifts in yen bets. Increased dollar volatility could even bring down a few hedge funds and the odd investment bank.

The dollar-carry trade says nothing good about confidence in the U.S. economy. It’s also a reminder that the side effects of this crisis may be setting us up for a bigger one.

(Picture of Einsehower courtesy of