Notable quotes in this 5 minute segment:

• "They don’t want to look in the mirror. America doesn’t have a China problem. It really has a savings problem. America has the biggest shortfall of national savings of any leading country in modern history. And when you don’t have saving you have to run current account deficits to import surplus savings from abroad and run massive trade deficits to attract the capital. Last year America ran trade deficits with over 90 – that’s right  nine zero –countries.
• I think we should take the baseball bat out on Paul Krugman. I think the advice is completely wrong.
• Isn’t it the height of hypocrisy that America can articulate a particular position in its currency but the Chinese are not allowed to do that.
• Senator Schumer’s been bashing China now for about five years. I think he’s probably been to China once during that period. And he always has the view no matter where the Renminbi is, that it’s 27 and a half percent undervalued.

Wow!

Also see Roach Rebuffs Krugman Call to Pressure China on Yuan from Bloomberg News.

Related posts:

• China “serious about the plan to internationalise” Yuan
• Chinese protectionist flashback
• Mea culpa on the need for a new currency
• China launches retaliatory investigation into U.S auto subsidies
• Chinese to start settling trade in Yuan

Here’s how I see things playing out:

• Congress looks at this report and concurs that the key to ending slower global growth is to correct global imbalances via a Chinese currency revaluation. Fair enough.
• However, individual Congressmen, looking to reassure jobless constituents ahead of the midterm elections, will escalate by presenting bills to ‘punish’ China if no actions are taken.
• China will be aghast at this and, in a further escalation, start making noises about ditching the dollar.

At this point, the question is how does this get resolved.  To date, bilateral U.S.-Chinese economic tensions have escalated and led to protectionism. Further escalation will yield unpredictable results and will be destabilizing. Chinese officials cannot be seen by their domestic constituency caving to American pressure.  This would undermine their authority and create problems domestically. Therefore, a public frontal assault on the renminbi peg is likely to backfire.

I wrote this in October of last year. Isn’t this exactly what is happening?  Just wait until April 15th. That’s when the fireworks will begin.

Related posts:

• US angling to get Chinese to revalue renminbi
• China launches retaliatory investigation into U.S auto subsidies
• China “serious about the plan to internationalise” Yuan
• Chinese tariffs of up to 25 percent on Russian and American steel
• Mea culpa on the need for a new currency

In late 2007 the global economy began to stumble, slipping into the abyss of a deep recession and financial panic. We are only now recovering from this stumble, in large part due to an unprecedented level of fiscal and monetary stimulus. Yet, no sooner is daylight within reach, we start attacking each other, tearing each other down.

The two starkest battle lines being drawn are between the Greeks and the Germans and the Chinese and the Americans.

Last month, there was enough clear headedness that I could post a parody of the madness that has overtaken Europe in Video: The Germans take on the Greeks. But, no more. It is clear, the political nerves are frayed. You’ve got ‘Italy’s worse, and the Germans stole our gold’ and German Leader Says Euro Zone Should Consider Expelling Countries That Threaten Regional Stability. That pretty much sums the battle lines up.

On the Chinese – US front, I have been warning for some time that protectionist rhetoric has a slippery way of turning into trade war reality. Some people seem to think the U.S. isn’t risking a trade war, and that ‘the Chinese started this anyway’ or something to that effect. In any event, the feeling is the Chinese will take it on the chin while the US will get off relatively unscathed – if it actually does come to a tit-for-tat trade war.  But is that really true?  A trade war transfers wealth from domestic consumers to the protected producers and decreases consumption demand. Lest we forget, the US banking system is hiding hundreds of billions in toxic assets in loan-to-maturity, level three and off balance sheet asset pools. The US is hardly a bastion of economic strength.

Ryan Avent has it right when he says:

I agree with Paul Krugman and Mr Wolf that actions taken by both Germany and China have been unfortunate. The world would be better off if Germany went ahead and committed to a deal on Greece and if China resumed its RMB appreciation. But I also understand the domestic political constraints those actors face—constraints which suggest that other powers are unlikely to be able to force action. And I believe that both Germany and China recognise what they must eventually do and are prepared to do it.

And I think that the extremely narrow focus on these particular issues, and the increasing willingness to draw a line in the sand over them, is misguided and troubling. Is the RMB peg really the biggest impediment to global recovery? What about economic policy in Japan? What about the conservatism of the ECB? What about the dysfunctional political system in America, where deficit politics is the order of the day while unemployment is near 10%?

There’s nothing wrong with pointing out how Germany and China can do better. But urging leaders to pick a fight over the issue of trade surpluses is not going to be helpful.

There is more than just a whiff of economic nationalism in the air. Is this not exactly the same spectacle we witnessed in the 1930s?

I see all of this as an inevitable consequence of the first truly synchronized global recession since the 1930s. After two plus years of economic stagnation, we’ve reached a point – everywhere it seems – where policy making is increasingly dominated by domestic political concerns. People are fed up with the status quo. They want no more economic pain. And they’re willing to throw the bums out unless this ends.

Politicians respond to this sort of thing. And it’s my feeling that this has led people to crawl back into their ideological positions and hold firm. This is what I see happening in Europe. This is what I see happening in the healthcare debate, on stimulus and on deficits in the U.S. and it is what I see happening in the U.S. – China debate as well.

Ultimately, from a US perspective, this leads us back to the stimulus package and bailouts and their importance. You only get one crack. This is what I said in early 2009. It was what Paul Krugman was saying. And he was right. Obama wasted a golden opportunity; he should have applied a LOT more stimulus, nationalized and liquidated bankrupt financial institutions, and hit the reset button. The Chinese, at least, understood the stimulus part and should be credited with saving the global economy. Now, we are still in an economic malaise and the political battle lines are hardened.

Since some have commented that I am offering criticisms without solutions, below is what I recommend:

1. China – U.S.

I made my case for what the Chinese could do in the last post This is the problem with China’s currency peg. Most of this has to do with spurring domestic demand, something the Chinese are already doing. As Stephen Roach has been saying, adding a lot more oomph to the Chinese social safety net will provide a further boost.

As for the US, an overt act of protectionism is not going to get the job done. On the other hand, coordinating opinion with Europe, India other Asian exporters and multilateral organizations on side behind the scenes is the right approach. The weak renminbi is not just America’s problem. The US or the EU could go to the Chinese and say, ‘look, its in your best interest to revalue. It increases your citizens standard of living, it decreases the value of commodities upon which you’re dependent and it increases your purchasing power of other hard assets. How much are you willing to move your peg per annum? We want 9%.’ I believe this is a reasonable negotiating stance that could work. It also has the hidden threat of retaliation which is credible given the support of multilaterals and the EU.

It is not a softly-softly approach, but rather a speak softly, big stick approach. To me, this is a much more well-thought out approach than simply ‘bleeding China.’

2.  EU- Germany – Greece

As I have been saying all along, the resistance to a Greek bailout in Germany is fierce. Everyone claims the Greeks haven’t even asked for one – and I imagine this is technically true. Nevertheless, there is a clear funding problem in the medium term that must be met.

So, I suggest a two-stage approach. In the short-term, we would need a trust-but-verify approach that only the IMF could institute. Greece would continue as planned with the budget measures they have already enacted. However, the Greeks could, therefore, be assured that – should it face liquidity problems – the IMF would intercede and ensure the Greeks stick to their budgetary plan. From a political perspective this takes the heat off Germany and supports their austerity agenda. For the Greek government, it gets cover domestically: ‘we didn’t create this mess; the former government did.  And we’re not forcing the cuts; the IMF is. The key, of course, is that the IMF funds be available as a loan for temporary fiscal stimulus to support liquidity over the medium-term in exchange for concrete promises on longer-term budget issues. This would attenuate any economic pressure.

Over the long-term, the proposed European Monetary Fund makes sense. However, first and foremost, let’s call it a European Harmonisation Fund because this is the purpose – harmonisation. 

For example, within the United States, I imagine there are substantial interstate capital account imbalances between individual states. Florida might have a substantial capital account surplus because of all of the retirees moving there. While New York could have a capital account deficit because of the financial sector wealth.  (I don’t know if this is true. The example is just illustrative). But you wouldn’t hear New Yorkers screaming bloody murder about the profligacy of Florida. Nor would you hear the Floridians yelling about New York’s enormous current account surplus.

The point is the United States has more well-harmonised internal market because of the free movement of labour and capital, a common language and federal automatic stabilisers. This is what the Eurozone lacks. And this is why we can change the unbelievable EMF – and its inflammatory expulsion clause into the more believable EHF.

I hope this offers some concrete policy solutions and puts more context around the politicization of economic problems we are now witnessing. It makes sense that in 1931, the same general recession weariness began to manifest itself in the very same political way – and that this increased the likelihood of a catastrophic depression as I believe it does today.

Related posts:

• Germans break stability and growth pact terms too
• Stephen Roach sees a W-shaped recovery for China
• And From Berlin Down to Beijing, Can’t You Just Hear Those Factories Hum?
• The Dutch join the Germans in rejecting bailout of Greece
• The Germans will not bail out Greece

In reading Scott Sumner’s take on the China currency peg dilemma, I see that both he and Paul Krugman hit on the fundamental problem in the debate: reserves. Everyone is talking about the peg as if relaxing the peg will be the magic bullet to America’s current account problem. But this is clearly not the case.

If China were to unilaterally revalue it’s currency, the Chinese would start buying fewer dollars incrementally. Part of the benefits of revaluation would accrue to Chinese export competitors in Europe (principally Germany) and in Asia (depending on their currency policy response). As US economic policy would be unchanged, US imports would switch from China to its competitors without any benefit accruing to the US.

If the Chinese revalued, but then also bought euros, selling dollar assets, a Yuan revaluation would effectively be a US dollar depreciation against both the Yuan and the euro (not to mention against other Asian countries again depending on whether they move in concert with the Chinese). In this case, the US would be able to reduce its current account deficit. (**Note: I changed this section to more accurately reflect the mechanics.)

Either way, the policy aim appears to be to force the Chinese to effect a US dollar depreciation – and this is what has the Chinese so outraged.

The Wall Street Journal quotes China’s Premier Wen as saying:

“I can understand that some countries want to increase their share of exports,” Mr. Wen said, in an apparent reference to the Obama administration’s goal. “What I don’t understand is the practice of depreciating one’s own currency and attempting to press other countries to appreciate their own currencies solely for the purpose of increasing one’s own exports,” he added. “This kind of practice I think is a kind of trade protectionism.”

It is not the peg that matters. This is the symptom.  It is China’s accumulation of reserves – it’s capital account surplus – which are at issue. Krugman has it right when he says:

…the right way to think about China’s exchange rate is, initially, not to think about the exchange rate. Instead, you should focus on China’s currency intervention, in which the government buys foreign assets and sells domestic assets, on a massive scale.

Ostensibly, this is the same issue the US should have with Japan since they also have been accumulating an enormous amount of US dollar reserves. But, no one is talking about this because the Japanese have a floating currency. In reality, what is at work here is a high savings rate – a high private sector balance – which is not met by an equivalent government sector deficit. The differential therefore shows up as a capital account deficit aka trade surplus.

Let me illustrate how this works across a number of countries using a chart I showed you when discussing the financial sector balances in Europe last week.

As you can see in the diagram, the Netherlands, Germany, Austria and Finland are the only countries depicted with capital account deficits. In each case, the countries have very large private balance surpluses (Finland to a lesser degree). Also, in each case, the government deficits are smaller than their private surplus. Hence, the capital account deficit.

However, if you look at Ireland, now in a depression, their huge private savings rate is more than offset by the budget deficit. Hence, the capital account surplus (trade deficit).

How do we resolve this problem? On some level, this is a political problem more than anything else.  Take Ireland, for example. Why shouldn’t they have high private sector savings? After all, they accumulated lots of private sector debts during the housing bubble. In their case, they cannot devalue because they are locked into the eurozone. The only way the Irish can run a trade surplus is through an internal devaluation aka an across the board wage and salary cut. This would make Irish exports more attractive, improving their trade balance and cutting their budget deficit.

But, that’s never going to happen in isolation. What will happen is the Irish will cut their budget deficit by cutting expenditure. This will precipitate a decrease in private savings and greater levels of debt distress along with the lower GDP the cuts entail. (**Note: I added ‘in isolation’ to the end of the first sentence to reflect its meaning more clearly.)

So, what about the Chinese (or the Japanese) then? How do we get them to stop accumulating reserves. One way is to revalue their currency. But for fear of the repercussions in the domestic export economy, this is likely to happen slowly. Another way, would be to decrease stimulus, putting the government into a surplus position. In China’s case, this is promising. Signs of overheating are everywhere. The Chinese needs to reduce excess fixed capital investment. I am assuming this policy would reduce government support of export industries giving it a double effect on savings. Since exports are the issue abroad, that would make sense. (**Note: the last paragraph originally erroneously spoke of increasing the Chinese government deficit when it should be decreasing. Apologies.)

The last possibility then is to encourage less saving and more spending. However, this could prove a tough nut to crack as well. For one, Shang-Jin Wei, a Professor of Finance and Economics at Columbia University’s Business School, thinks the high savings rate has much to do with the one-child policy.

He writes:

There are approximately 122 boys born for every 100 girls today, a ratio that translates into cutting about one in five Chinese men out of the marriage market when this generation of children grows up…

“The increased pressure on the marriage market in China might induce men and parents with sons to do things to make themselves more competitive,” Wei says. “Increasing savings is one logical way to do that, to the extent that wealth helps to increase a man’s competitive edge. Parents increase household savings mostly by cutting down their own consumption.”

Wei worked with Xiaobo Zhang of the International Food Policy Research Institute in Washington, D.C., to see if his hypothesis held up, comparing savings data across regions and in households with sons versus those with daughters. “We find not only that households with sons save more than households with daughters in all regions,” Wei says, “but that households with sons tend to raise their savings rate if they also happen to live in a region with a more skewed sex ratio.”

The effect is significant. The household savings rate in China rose from about 16 percent of disposable income in 1990 to over 30 percent today, which is much higher than most countries. About half of the increase in the savings rate of the last 25 years can be attributed to the rise in the sex ratio imbalance. “It’s a very high ratio of savings to income,” Wei says. “The comparable savings rate in the United States would be 2 or 3 percent before the crisis, and about 6 percent since the crisis.”

Even those not competing in the marriage market must compete to buy housing and make other significant purchases, pushing up the savings rate for all households.

“While the conventional explanations for the high savings rate all play a role, they are not as important as people previously thought,” Wei says.

I am not sure what kinds of (gender-based) consumption incentives one could offer to induce more spending. But, the gender skew will be with us for some time. Chinese policy makers need to do anything they can to encourage greater spending. In particular, Chinese policy makers could think about incentives that increase the marginal propensity to spend in families with male children. In concert with a slow revaluation, this will certainly alleviate much of the trade imbalance now causing so much discussion.

Related posts:

• Beijing is not Washington’s banker
• Roach: I think we should take the baseball bat out on Paul Krugman
• China: reflation play spells trouble for rest of the world
• Mea culpa on the need for a new currency
• The Cult of Zero Imbalances

Highlights

The US dollar is firmer against most major currencies. The euro, together with the Swiss franc and Swedish krona are the worst performers.  The euro failed to make a clear break above $1.38 yesterday and news reports suggesting Germany may have shifted its stance on Greece seeking IMF aid saw the euro slip back to around $1.3650 support.  Greek PM Papandreou has subsequently indicated he is seeking EU political support, not aid from the EU or IMF but the euro remains below the $1.3700 area. Sterling is slightly softer after a brief spike above $1.53 on a smaller than expected Feb budget deficit (GBP12.4 bln vs. GBP14 bln exp) as tax revenue rose at the fastest pace in two years.  Still, business lending fell at the fastest pace on record in Jan (down GBP6.5 bln) while mortgage approvals fell for the third consecutive month in Feb (to 48K) damping the rally.

Global equity markets are mostly lower in Asia and Europe.  The MSCI Asia Pacific index closed down -0.3% after reaching a two-month high yesterday as concerns about FOMC tightening and the Greek crisis abated.  The renewed concerns about Greece may have encouraged some profit taking.  In Japan, the Nikkei gave up most of yesterday’s 1.2% gains, slipping -0.9% today led by financials.  The leading European bourses are flat to down -0.5% while the Greek Athex is down -2.6%.

Global sovereign bonds are mixed particularly in Europe.  Greek bonds are lower after the CDU spokesperson called for Greece to seek IMF aid.  The Greek/German 2- and 10-year spreads have widened 31 bp and 12 bp respectively.  The 10-year Italian spread has also widened 4 bp after the EC warned its fiscal position could be worse than expected.  The heavy supply of bonds (15 bln euros or $21 bln) from Spain and France are also in focus with Spanish 10-year yields up 3 bp but comparable French yields flat.  UK 10-year gilt yields are down 4 bp after the better than expected public sector borrowing report.

Currency Markets

The German position vis a vis Greece and the IMF may have shifted according to news reports.  Until now, Germany had seemed to agree with other European officials– including ECB’s Trichet, Eurogroup’s Juncker, France’s Sarkozy–that the IMF can provide technical advice, but this is a problem for the euro zone to resolve.  A financial spokesperson for the ruling CDU party, Michael Meister, is quoted on the news wires suggesting that only the IMF has the credibility and what he calls "instruments" to help Greece get access to the capital markets if it was ultimately needed.  We have long argued that the main obstacle to the IMF’s material involvement was the fear of loss of political face.  And the realist says that in the face of economic necessity, pride is among the first sacrifices. Having Greece go to the IMF, if (when?) needed, would avoid the issue of European treaties and the political backlash that one can only imagine, for example, of the proverbial German worker postponing retirement to finance the earlier retirement of her Greek colleague.  On the other hand, it is not clear yet that this is the new German strategy.  It seems clear the political opposition to material assistance is great.  Yet German Finance Minister Schaeuble was quoted yesterday along the conventional line that IMF involvement would signal the inability of the euro zone to address its own problems.  Bottom line—this could potentially be an important story, though it is difficult to know at this juncture whether it is a trial balloon or something more serious.  As distasteful as a euro zone member going to the IMF may be, it may be the least costly political decision for the euro zone.  Greece is a member of the IMF–(in a way that incidentally, California by contrast can never be).  Until material aid is needed, this is just a theoretical discussion.  The negative implications for the euro stem from the potential disagreement in Europe, the weakening of the Franco-German pillar, and the institutional vacuum.  This is the not stuff that a reserve asset is made.

The Turkish central bank meets today and despite a surprise jump in Feb inflation, we expect rates to be left unchanged at 6.5%. The central bank is aiming to lower inflation to 6.5% y/y by year-end, so the recent spike in inflation would not have gone unnoticed. Expecting an immediate monetary policy response may be premature though. Recent economic indicators have shown some improvement but from a real economy perspective, the case for a rate hike is not compelling at this stage. We expect Turkey to start its tightening cycle by mid-year. The Turkish lira has struggled over the past few weeks and political uncertainty will keep the lira volatile going forward. However, even the end of talks for a new IMF program does not dent our enthusiasm for the lira as underlying economic fundamentals remain solid and higher yields will increasingly play at the lira’s advantage.  In the EM cross play, we still like TRY/HUF, with the recent pull back a good buying opportunity – last year’s high (at 145.497) is a reasonable target

In what we thought was a close call, the central bank of Brazil left its overnight rate steady at 8.75%, a record low.  The decision was made by a 5-3 majority.  The dissenters wanted a 50 bp rate hike.  The closeness of the vote is a strong signal that Brazil’s central bank will hike rates and could very well be the first BRIC country to formally hike rates.  Both China and India have raised reserve requirements, but neither has hiked benchmark rates.  The political future of current central bank governor Meirelles may have been the wild card.  However, if he does resign to enter electoral politics, his successor will have the opportunity to brandish anti-inflation credentials at the very first meeting and deliver a 50 bp rate hike.  Until the next COPOM meeting in late April, key things to monitor would be of course Meirelles’ decision which has to be made by very early April.  In terms of economic data, there may be some seasonal distortion to Brazil’s price pressures.  Watch the inflation reports and the central bank’s survey of expectations.  The relative strength of the currency against the dollar does not appear to be a very salient issue, but if in six week’s time the dollar is testing support in the lower part of the BRL1.60 and volatility has increased, the real could become more important.  That said, currency strength is consistent with monetary tightening in a way it wasn’t when Brazilian officials were trying to fuel a recovery.  A stronger BRL could help dampened imported price pressures.  

Upcoming Economic Releases
US CPI, weekly jobless claims and the Q4 current account are due at 8:30 AM EDT/12:30 GMT.  The consensus is for headline CPI to accelerate 0.1% m/m in Feb after rising 0.2% in Jan and putting the annual pace at 2.3%.  Ex food and energy, CPI is exp up 0.1% m/m (vs. -0.1% in Jan) and 1.4% y/y, vs. 1.6% in Jan.  Weekly claims are exp at 455K.  The current account deficit is expected to widen to -$119.0 bln (from -$108.0 bln.)  At the same time, Canada releases international securities transactions for Jan (exp at C$8 bln in Jan vs $11.2 bln in Dec.  At 10AM/14:00 the Mar Philly Fed index is exp at 18.0, up from 17.6 in Feb.  Leading indicators, due at the same time are exp at 0.1% in Feb vs. 0.3% in Jan.  Turkey is expected to leave rates unchanged at 6.5% (10AM/14:00.)  Speakers include the Fed’s Hoenig, Lacker and Pianalto (9AM/13:00) and the Fed’s Greenlee (10AM/14:00).

—————————-
Marc Chandler is the global head of Brown Brother Harriman’s top ranked Currency Strategy Team. For more of BBH’s currency views, please visit the BBH FX website here.

This material has been prepared by Brown Brothers Harriman & Co. (“BBH”) and is intended for information purposes only.  This communication should not be relied upon as financial, investment, tax or legal advice.  This communication should not be construed as a recommendation to invest or not to invest in any country or to undertake any specific position or transaction in any currency.  This information may not be suitable for all investors depending on their financial sophistication and investment objectives.  The services of an appropriate professional should be sought in connection with such matters.  The information contained herein has been obtained from sources believed to be reliable, but is not necessarily complete in its accuracy and cannot be guaranteed. Sources used are available upon request. Any opinions expressed are subject to change without notice. Please contact your BBH representative for additional information. BBH’s partners and employees may own currencies in the subject of this communication and/or may make purchases or sales while this communication is in circulation.

Related posts:

• Germany backtracking on IMF involvement in Greece
• Greece sees credit rating cut by S&P
• The Germans will not bail out Greece
• Standard Bank says Greece and Ireland may leave Eurozone
• Why the euro gets weaker when national governments deficit spend

Related posts:

• Links: 2010-03-17 – China, Lehman and more
• Links: 2010-03-15 – Sovereign credit ratings, China and protectionism
• Links: 2010-03-07 – Comparing job losses, China’s workers and more
• China issues bonds to “promote the RMB in neighbouring countries”
• Links: 2010-02-17 – Revaluing China, Goldman and more

News reports are now surfacing that the Germans are open to IMF involvement in the Greece sovereign debt crisis.  This is a 180-degree turn for the German finance minister who has expressed vocal opposition to the IMF’s involvement in ‘internal’ European Union affairs.

Bloomberg reports Germany making the shift to avoid being boxed in by a bailout pledge:

“We have to think about who has the instruments to push for Greece to restore its capital-markets access” if ultimately needed, Michael Meister, a lawmaker with Merkel’s Christian Democratic Union, said today in an interview in Berlin. “Nobody apart from the IMF has these instruments.” Attempting a Greek rescue “without the IMF would be a very daring experiment.”

The German shift underscores Merkel’s attempts to steer clear of any commitment to a Greek bailout and risks scuttling European Union efforts to establish a contingency plan for the debt-strapped nation. Merkel used a budget speech in parliament in Berlin today to caution against “overly hasty” pledges of financial support.

The position the Germans seem to be taking is the one I outlined back in February (see The Germans will not bail out Greece).  However, the situation is still fluid and there is widespread resistance to the IMF’s involvement. My sense is that the Germans do want to move forward with a European Monetary Fund going forward and are now laying the groundwork even if that means involving the IMF.

The plans for the European fund allow for the expulsion of a serial violator of the stability and growth pact. German Chancellor Angela Merkel is now pushing the euro expulsion line because it fits with the Germans’ vision of the EMF.

Greek Prime Minister Papandreou had threatened to go to the IMF over EU objections if he did not receive assistance.  This threat has been nullified.

The next move now falls to Greece.

Related posts:

• The Germans will not bail out Greece
• German responsible for Stability and Growth Pact wants to bail Greece out
• Peer Steinbrueck says Germany might bail out the Austrians
• Irish and Swedish join chorus of countries seeking austerity for the Greeks
• The Dutch join the Germans in rejecting bailout of Greece

This is a post from John Lounsbury.

Charles J. Antonucci Sr., the former president and chief executive of the Park Avenue Bank of New York, made a desperate move to try to save his bank with the infusion of TARP funds. TARP refers to the government program to provide up to $780 billion in loans and capital purchases to shore up failing banks. Antonucci’s only problem: He committed fraud in the attempt.

The fraud was committed to mislead regulators into supplying $11 million from TARP. There are also a number of other charges.

What happened is described in a Wall Street Journal article by Lingling Wei and Chad Bray. Here is an excerpt:

"The bank was broken, so, in October and November 2008, [Mr.] Antonucci methodically went about pretending to fix it," said Preet Bharara, the U.S. attorney in Manhattan, at a press conference.

Prosecutors charged Mr. Antonucci with 10 counts of fraud, bribery and other crimes, including accepting free plane rides from a bank customer and stealing $103,000 from pastors of a church in Coral Springs, Fla. He could face up to 30 years in prison for each fraud and embezzlement charge.

Park Avenue Bank was recently taken over by the FDIC (Federal Deposit Insurance Corporation).

The Major Part of the Fraud

According to the WSJ article, the major dollar amount involved was a result of the following sequence of transactions:

1. Antonucci arranged for loans to be made by the bank to entities he controlled. The amounts of these loans have not been made public, but presumably were in excess of $6.5 million.
2. Antonucci then provided $6.5 million "of his own money" to shore up the capital deposited at the bank. The money was in the form of a deposit in his own name.

How this can be used to fraudulently inflate bank assets can be seen in the following simplified hypothetical example.

Simplified Hypothetical Case Study

Bank X has $1 million in deposits. From these it loans $9 million, keeping the required 1/9 reserve. If $500,000 of the loans default, the loan assets and net deposit assets are both reduced by that amount.

The bank’s books now show $0.5 million in net deposits ($1 million gross deposits less $0.5 million default impairment) and $8.5 million in working assets. The reserve is now 1/19 and capital must be added to get back to 1/9.

One way this can be done is to sell enough performing assets to get back to the required reserve ratio. If $400,000 in loans can be sold at par, then loan assets will be reduced to $8.1 million ($9 million – $0.5 million default – $0.4 million increase in deposits from the asset sale). The net deposits are increased by the sale proceeds to $900,000. The 1/9 capital reserve ratio is re-established.

However, if the remaining assets of the bank are considered to be impaired by the market, it may not be possible to ever sell enough assets to recover the required reserve and cover the $1 million in deposit liabilities.

Here is one example: If the remaining loan portfolio can be sold at $0.50 on the dollar, the 1/9 ratio is recovered by selling $4.5 million (par value) for $2.25 million. This produces a $2.25 million write-off and $2.25 million in new deposits, which exactly cancel yielding an end position of $4.5 million in assets and $0.5 million in net deposits. Bank X must still raise $0.5 million to cover deposit liabilities.

If any of the remaining $4.5 million in loan assets can not be valued at par, that creates another debit to net deposits which must be offset with more sales. This is a death spiral because the bank can not remain viable if the end position can end up with the $1 million in original deposits not being covered.

Introducing Bank Fraud 101

So how can Bank X use Bank Fraud 101 to resolve the problem with regulatory requirements? Very simple. The CEO arranges for a loan for $1 million loan to a shell company he sets up and owns. The shell company then loans the money to the an international (preferably third world) intermediary (blindly controlled by the bank CEO) which then makes a personal loan back to the CEO. The CEO now makes a personal deposit of $560,000 in an account at Bank X.

The bank now has $1,060,000 in net deposits with a loan portfolio of $9.5 million, exactly a 1/9 reserve ratio. And the CEO still has $440,000 of the bank’s money for use elsewhere. What in fact has happened is that the bank’s own credit, leveraged at 9/1, has been converted to a deposit asset.

The entire masquerade can be unwound in the future when the bank has restored its books and can withstand a default on $1 million, which would be triggered by a default by the third world entity producing a default by the shell company.

Or the masquerade can be ended when Bank X still goes belly up and regulators start following the money trail.

For Further Study

Another section of Bank Fraud 101 could use as text an article by Karl Denninger at The Market Ticker that discusses the bank fraud at Lehman Brothers.

Prof. William K. Black (University of Missouri – Kansas City), who was a senior regulator in the RTC (Resolution Trust Corporation) that conducted the work-out of the Savings and Loan Crisis, 1989-1996, wrote a book entitled "The Best Way to Rob a Bank is to Own One". That is the book for the more of Fraud 101, as well as 102 and upper class courses.

Note 1: The hypothetical case study here is much oversimplified. It is intended as a tutorial aid and not as a technically correct description in all details. It is a rough sketch and not a fine oil painting.

Note 2: Be careful if you want to be a whistle blower on fraud. Another Wall Street Journal article describes how a Lehman employee who raised questions about the fraud was fired.

Note 3: According to an article in the New York Times by Andrew Ross Sorkin:

"I’m concerned that the revelations about Lehman Brothers are just the tip of the iceberg,” Senator Ted Kaufman wrote in a speech he was preparing to give Tuesday on the Senate floor. “We have no reason to believe that the conduct detailed last week is somehow isolated or unique. Indeed, this sort of behavior is hardly novel.”

Note 4: According to the Sorkin article in note 3, the Lehman fraud was conducted with full knowledge and disclosure to regulators, who did not recognize that it was improper.

Note 5: All indications are that Bank Fraud 101 is merely a prerequisite to the more substantial courses coming, and will soon lead to graduate level study.

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John Lounsbury provides comprehensive financial planning and investment advisory services to a small number of families on a fee only basis. He has a background which includes 34 years with a major international corporation, 25 years in R&D management and corporate staff positions. Since 2002 he has operated his own sole proprietorship business. John is also one of the top ten authors at Seeking Alpha and a featured commentator at TheStreet.com Real Money.

Related posts:

• The FDIC acknowledges it is to run out of money
• Citigroup can limit demand deposit withdrawals and money funds can too
• Bank by bank breakdown of stress test results
• Large bank loses $7.9 billion: CDS involved
• Short sale fraud

Mortgage fraud was rampant during the housing boom. Regulators were asleep at the wheel during all of this. But now we are getting some indictments as WFAA News 8 in Dallas reports (hat tip Housing Wire). This television station did the dirty work for regulators and uncovered massive amounts of mortgage fraud.

Byron Harris reports:

News 8 started looking into questionable real estate transactions back in 2006 after learning about investors who were "flipping" houses.

Prosecutors say the group used phony buyers, questionable documents and inflated appraisals to sell houses — including properties in the Hills Creek neighborhood of McKinney — for more than what they were worth.

In 2002, one house on Hills Creek Drive was valued at $315,000; by January 2006, it sold for $625,000.

Prosecutors said the value of other modest homes was increased to as much as $715,000. When the properties sold, prosecutors allege that the profits went to the man at the top in the form of "disbursements."…

Appraiser Steve Nichols helped News 8 analyze the paperwork that pinpointed questionable appraisals by Josh Melton, who is now charged in the crime.

"It’s my belief you have to have professionals who are able to identify fraud in their own industry and being willing to report it," Nichols said.

The U.S. Attorney expects suspects to begin turning themselves in to a federal judge next week; trials will follow.

Each suspect faces a maximum sentence of at least 20 years.

The video is embedded below.

Just last month, Bill Black, a former S&L crisis regulator gave a speech on mortgage fraud and its central role in the housing bubble and bust. He asserts that lax regulation was at the very core of this epidemic of fraud. He starts in commenting that the FBI gave a prescient warning in September 2004 that fraud was rampant in the mortgage market. Black says:

[The FBI] didn’t simply warn there was an epidemic of mortgage fraud, they explicitly warned that it would produce an economic crisis if it were not dealt with. So what was done in response to a warning that clear?

Not a whole lot. As I explained in the last post, Black knows that so much fraud goes unpunished because the majority of the fraud involves the lenders. Since lenders control the documentation, none of this gets exposed unless the lenders file criminal referrals — or regulators intervene.

Note, Black says 80% of mortgage fraud losses occur when lender personnel are involved. Other statistics worthy of consideration which Black cites?

• Of roughly 10,000 mortgage lenders, only 900 have ever filed a criminal referral in the relevant five year period.
• Over 700 of those institutions filed fewer than five criminal referrals.
• The twenty-five largest filers of criminal referrals filed over 90% of all referrals.
• There has not been one single enforcement action in five years (I assume 2002-2007) despite regulated institutions failure to file the mandated criminal referrals.

Black concludes that even in the regulated sector of the mortgage complex where criminal referrals are mandated in the case of fraud, no one except these 25 institutions is reporting fraud.  What does that tell you?

It tells me that fraud is rampant and no one is regulating it. Logic would dictate that any regulator which sees evidence of an epidemic of fraud in non-prime lending and non-compliance with regulatory mandates to report fraud would concentrate a disproportionate number of investigators on non-prime lenders. That did not happen. So, clearly there was no regulation.

During the S&L crisis, Black notes that there were over 1000 priority criminal convictions of senior insiders connected to fraud. To date, of the specialty lenders who specialized in subprime, there have been zero convictions.  So you compare 1,000 during the S&L crisis to zero during this one despite the crisis being an order of magnitude larger. In fact, there have been zero indictments, according to Black. There have even been zero arrests he says.

This is the way the system worked under Bush and it is the way it continues to operate under Obama.

Related posts:

• Short sale fraud
• Bill Black and The Federal Reserve’s War Against Effective Regulation
• 60 Minutes – Pigeon Fever and Ponzi Schemes on Wall Street
• Bank Fraud 101: How to Rob A Bank
• Lawsuit: steering mortgage applicants could mean more writedowns

I am going to talk here a little bit about the looming trade war between China and the United States. But I am going to come at it from a side angle via some historical analogies.

Common folklore in the United States says that the Soviet Empire collapsed in large part due to the efforts of American President Ronald Reagan and not due to internal forces. Others downplay Reagan’s role and see internal forces as more significant.

I want to briefly outline this debate and make a parallel to the financial crisis and the near collapse of the American financial system and ask a few questions about anti-Chinese protectionist rhetoric in this context. My basic question will be: How effective is external pressure in precipitating regime change or economic policy moves?

Let’s start off with the collapse of the Soviet Union. When Ronald Reagan died in June 2004, MSNBC ran an article, “Determination to destroy communism was a hallmark of his 8-year presidency” which eulogized the former President with credit for helping to destroy the Soviet Empire.

The article began:

He stunned the Soviet Union with his tough rhetoric, calling it an “evil empire” whose leaders gave themselves the “right to commit any crime.”

His famed “Star Wars” program drew the Soviets into a costly arms race it couldn’t afford. His 1987 declaration to Soviet leader Mikhail Gorbachev at the Berlin Wall — “Mr. Gorbachev, tear down this wall” — was the ultimate challenge of the Cold War.

Ronald Reagan’s determination to destroy communism and the Soviet Union was a hallmark of his eight-year presidency, carried out through a harsh nuclear policy toward Moscow that softened only slightly when Gorbachev came to office.

He is vividly remembered in Russia today as the force that precipitated the Soviet collapse.

“Reagan bolstered the U.S. military might to ruin the Soviet economy, and he achieved his goal,” said Gennady Gerasimov, who served as top spokesman for the Soviet Foreign Ministry during the 1980s.

The article goes on to assert that Reagan’s anti-Soviet stance was a significant departure from Jimmy Carter’s ‘mild detente’ [read: weak on defense], suggesting that this course change brought down the Soviet Union.  The article then provides yet more quotes from influential Russian dissidents to bolster this claim.

But is this really true?

Last November, an online survey demonstrated that Americans are alone in this view that external pressure applied by the Reagan Administration was principally responsible for the Soviet collapse.

The online survey of representative national samples asked respondents to assess the performance of nine political figures of the 1980s, and their effect in the eventual collapse of communism.

For Americans, Reagan is the clear winner with 69 per cent of respondents claiming he deserves a lot of credit or some of the credit for the collapse of communism. More than half of people in the U.S. also commend Gorbachev (56%) and British Prime Minister Margaret Thatcher (57%) for their efforts.

In Britain, only Gorbachev (57%) and Walesa (56%) clear the 50 per cent mark, followed by German chancellor Helmut Kohl (47%), Thatcher (45%) and Reagan (44%).

In Canada, Gorbachev is seen as the most important figure (65%), followed by Reagan (58%), Thatcher (56%) and Walesa (52%). Canadians are more likely to select Reagan and Thatcher as deserving “some of the credit”, and place former Canadian Prime Minister Brian Mulroney at the bottom of the list with 25 per cent.

The survey also shows that a considerable proportion of people in the two North American countries (47% in the U.S. and 44% in Canada) regard Pope John Paul II as an important player in the collapse of communism, while Britons (31%) are decidedly more skeptical.

-People Differ on Who Deserves Credit for the Collapse of Communism, Vision Critical

On some level, it’s irrelevant if the claim that Ronald Reagan ended communism is true because the winners get the spoils. And that means they get to impose their historical narrative on past events whether this narrative is true or not.

If external pressure did bring down the Soviet Union, an analogous claim could be made for the American financial system’s near-collapse because of the focus by regulators post-9/11 on terrorism to the exclusion of financial fraud.

Last month, Bill Black, a former S&L crisis regulator gave a speech on mortgage fraud and its central role in the housing bubble and bust. he asserts that lax regulation was at the core of why this fraud was allowed to occur. What I found interesting about Black’s lecture was the section on the FBI. He starts by commenting that the FBI gave a prescient warning in September 2004 in Congressional testimony that fraud and insider trading were rampant in the mortgage market. Black says:

[The FBI] didn’t simply warn there was an epidemic of mortgage fraud, they explicitly warned that it would produce an economic crisis if it were not dealt with. So what was done in response to a warning that clear?

Not a whole lot. In fact, Black says no one wants to unearth the fraud because the majority of it came from the lenders and not the borrowers. This is a bit like the 9/11 intelligence memo warning of an imminent al Qaeda attack:

RICE: I remember very well that the president was aware that there were issues inside the United States. He talked to people about this. But I don’t remember the al Qaeda cells as being something that we were told we needed to do something about.

BEN-VENISTE: Isn’t it a fact, Dr. Rice, that the August 6 PDB warned against possible attacks in this country? And I ask you whether you recall the title of that PDB?

RICE: I believe the title was, "Bin Laden Determined to Attack Inside the United States."

Now, during the S&L crisis there were 1000 investigators on the case. In 2009 there were 150 FBI agents on the case. And that’s a large part of the problem. After 9/11, more than 500 white-collar investigative specialist FBI agents were transferred from white-collar crime to focus on national security. Had these 500 extra FBI agents been available, perhaps the fraud would have been prosecuted. Similar tales are certainly available at other regulators like the SEC as the U.S. was more interested in connecting charities to terrorist sources than investigating mortgage fraud.

So, in a very real sense, one could make the same argument about 9/11 and al Qaeda causing the collapse of the United States’ financial system  that is made about Reagan causing the collapse of the Soviet economic system. I do not find this line of thinking persuasive. But, the situations are indeed analogous.

So, here’s my question again: How effective is external pressure in precipitating regime change or economic policy moves?

We see that most Americans believe it was very effective in bringing down the Soviets. Most believe it was effective in ending Apartheid in South Africa. It has not been so successful in Cuba or North Korea. But could external pressure work in Iran or even in China?

My general take is no; politicians, especially in command economies, are relatively unconcerned with external pressure. I used to be a foreign policy specialist. And, despite my role, I was keenly aware of the primacy of domestic issues over foreign ones in a politician’s decision-making. What the ruling elite in command economies care about is social unrest that stems from a lack of civil liberties and economic progress. Even in the United States, this is true.  Do you think American politicians will yield to Brazilian threats to retaliate for American cotton subsidies? Of course not.

Threats don’t work. The only thing that can work is inflicting economic pain and creating social unrest. Yes, autarky hasn’t brought the North Koreans or Cubans to heel; nor did it topple Saddam Hussein. However, implicitly, this is the power that some American political historians ascribe to the policies against South Africa and the Soviets. They assert that it was the economic pain that caused those governments to eventually yield.

So, as Americans look to threaten to punish China for China’s protectionist exchange rate policy, we should all understand that these threats will have no effect.  The Chinese will not do anything because of threats. More likely, they will dig in their heels. The Telegraph’s Liam Halligan has it right when he says:

When it comes to China, the West needs to face the truth. The more America calls for China to revalue the longer Beijing will take to do it. Chinese politicians are as unlikely to buckle in the face of Western pressure as their Western counterparts would be given a tongue-lashing from Beijing.

China’s government is petrified of social unrest. Given the importance of the export sector for continued high growth and jobs, this again makes it impossible to Beijing to be seen yielding to pain imposed by the West.

What is more likely to occur is that American politicians, pressured by the upcoming mid-term elections, will create binding legislation to retaliate against China for their undervalued currency. China will not budge – in part out of pride and in part out of need to prevent a hard landing. As a result, the binding legislation will become operative and a trade war will ensue.

For more on how a trade war would affect the global economy read Michael Pettis’ piece How will an RMB revaluation affect China, the US, and the world?. He notes that surplus countries like China have the most to lose and feels that the short-term losses for the U.S. will be less. I agree that surplus nations have the most to lose. But I disagree about the short-term effects on the United States; any economic shock to the United States will tip into a double dip recession, precipitating higher unemployment, a renewed meltdown in the financial sector and the attendant deleveraging. That is very bearish for equities, I should add. Moreover, the Chinese would make their UN Security Council veto work and stymie any efforts the U.S. makes toward controlling Iran. I see a lot more risk in a Chinese trade war for the United States than Pettis.

This is what I have labelled Murder-Suicide in Chimerica. But, I believe this could be where we are headed -  now more than ever.

Related posts:

• China slams U.S. profligacy
• China launches retaliatory investigation into U.S auto subsidies
• Should we expect a protectionist China?
• Will the U.S. allow China to buy more Gulf of Mexico oil assets?
• The U.S. is exporting unemployment with ‘Buy America’

Highlights

The US dollar is softer against most major currencies.  The still expansionary FOMC statement, the BoJ’s extension of Q/E overnight and the conclusion of the EU finance ministers’ meeting yesterday may have helped ease tensions.  However, the dollar was already beginning to soften ahead of these events after failing to extend gains in early March.  That may have disappointed momentum traders who, based on IMM data, hold near record short sterling positions and record short euro positions.  Some speculators may have begun scaling back these short positions as the currencies lost downward momentum.  Sterling, which is the worst performing of the major currencies this year, is helping to lead today’s move higher getting an extra boost from firm UK jobs data and less dovish than expected MPC minutes.  While some pullback is likely given the pound is overextended, momentum traders are likely to re-emerge to buy pounds around $1.5260.  The euro is comparatively stable, briefly extending gains to the highest level since Mar 9^th.  However, the single currency has made a clear break above the downtrend line drawn off the late 2009 highs (comes in today around $1.3700) and is likely to see renewed momentum trader buying above the $1.37 area.  The antipodean currencies are amongst the strongest gainers today, helped by firm commodities. 

Global equity markets are higher in Asia and Europe and commodities firmer after the Fed signaled rates would be left on hold for an extended period and the BoJ extended quantitative easing.  The MSCI Asia Pacific index gained ground for the fourth consecutive session, climbing to a two-month high (up 1.5% on the session) while Japan’s Nikkei rose 1.2% on the session led by oil and gas and basic materials.  S. Korea’s Kospi posted one of the largest gains, rising 2.1% bolstered by export related technology shares.  China’s Shanghai Composite gained 1.9%.  The leading European bourses are up 0.5% to 1.0% while S&P futures are firmer suggesting US markets will open on a firm footing.

Global sovereign bonds are mixed.  US Treasuries are lower, giving up some of yesterday’s post-FOMC gains, with the 10-year yield up 2 bp. In Europe, bonds are flat to slightly firmer.  The Greek/German 10-year spread has narrowed 4 bp to 295 bp after the conclusion of yesterday’s EU finance minister’s meeting and S&P’s removal of Greece from its credit watch list (though the rating was left at negative).  The spread compares with 309 bp a week ago but vs. 252 bp three months ago.  Japanese 10-year JGB yields are up 1 bp while the 2-year is flat after today’s BoJ meeting.  Iceland cut rates 50 bp to 9.0%.

Currency Markets

The Bank of Japan left the key target rate unchanged at 10 bp, but appeared to bow to government pressure and increased the size of the three-month loan facility arranged last December to JPY20 trillion from JPY10 trillion.  Tweaking this facility was widely tipped as a likely compromise formation between the BOJ who has argued that monetary policy was already extraordinarily easy and interest rates were extremely low, while the government wants more efforts to combat deflation.  Nevertheless, the compromise was not satisfactory and two BOJ members (Noda and Suda) dissented.  Japan’s CPI fell for the 11th consecutive month in January and the Q4 GDP deflator was a record -2.8%.   We agree with the BOJ that today’s move will not have much impact, yet the reason we suspect that the BOJ went along was that the JPY10 trillion facility had nearly been exhausted and the banking system faced the imminent withdrawal of liquidity at the end of the month as a separate credit facility (unlimited loans for collateral) was set to expire.  However, it also means that additional measures may require some marked deterioration in conditions.  It suggests that the BOJ is reluctant to extend its rinban operations–under which it buys government bonds–from the current JPY1.8 trillion.  Meanwhile the economic data suggests that the capex–export recovery is having a knock-on effect on other sectors.  The Japanese government appeared to have recognized this early this week, and today it released the Jan tertiary activity report.  The 2.9% increase was more than twice the consensus and follows a 0.9% contraction in December 09.  The dollar remains largely confined to a JPY90-JPY91 trading range.  Contrary to other analysis, we continue to suspect the risk of intervention remains low, as is normally the case.  We note that dollar-yen volatility has fallen to a new multi-year low today below 11.2% and the premium for yen calls over yen puts remains historically speaking (last few years) quite small.  Nor do we place much emphasis on the fact that 3-month yen LIBOR has been fixed in recent sessions below 3-month dollar LIBOR.  The difference is about 1.5 bp annualized and is simply insignificant to change investment strategies.  The Nikkei’s 1.2% advance, led by oil/gas, basic materials and consumer services, brings the month-to-date advance to nearly 7.5%.  Foreign investors were increased their purchases of Japanese equities in January, but slowed considerably in February and appear to be stepping back up this month.

Sterling was already leading the foreign currencies higher against the US dollar in early European trading and the less dovish MPC minutes and firm employment figures have given the pound an extra boost.  The March 4^th meeting minutes showed the MPC voted unanimously to keep policy unchanged. Importantly for those looking for bullish sterling news, the case for fresh QE was not really debated as the MPC thought that there was ‘little evidence to suggest’ a change in the UK economic outlook since the prior meeting. Policy makers confirmed they stand ready to expand purchases of gilts or tighten monetary policy if needed, with a ‘bumpy’ path ahead for the economy. On the inflation front, some members considered that the upside risks to inflation had increased slightly over the month, while others felt that the balance of risks had not changed materially (January inflation has reached a 14-month high of 3.5% y/y as the VAT effect fed through).  Meanwhile, UK unemployment fell by 32.3k in Feb (vs a 6k rise exp and vs a 5.3k Jan gain.) Jobless claims fell at their fastest pace since 1997, which is a very encouraging sign for growth prospects. Jan average earnings were up by just 0.9% y/y (from 0.7% and versus 1.7% expected) but the ex-bonus y/y rate firmed to 1.4% y/y from 1.2%. This remains a very soft labour market so wage inflation risk is contained.  Sterling has now gained four big figures from yesterday’s low around $1.4978 and is overextended on an hourly basis. Still, technicals are supportive of the pound with the 5- and 20-day moving averages about to cross to the upside and longer term momentum indicators pointing up suggesting short term traders may trim some of their short sterling positions on pullbacks toward $1.5260.  

Upcoming Economic Releases

US PPI is due at 8:30 AM EDT/12:30 GMT.  The consensus is for headline PPI to slip -0.2% m/m in Feb after rising 1.4% in Jan and putting the annual pace at 4.9%.  Ex food and energy, PPI is exp up 0.1% m/m (vs. 0.3% in Jan) and 1.0% y/y, unchanged from Jan.  Canadian wholesale sales (exp up 0.5% m/m in Jan) are due at the same time.  Fed Chairman Bernanke and ex-Fed Chairman Volcker testify at the House hearing on bank supervision (2PM/18:00) while the Fed’s Fisher speaks at 4:30PM/20:30.

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Marc Chandler is the global head of Brown Brother Harriman’s top ranked Currency Strategy Team. For more of BBH’s currency views, please visit the BBH FX website here.

This material has been prepared by Brown Brothers Harriman & Co. (“BBH”) and is intended for information purposes only.  This communication should not be relied upon as financial, investment, tax or legal advice.  This communication should not be construed as a recommendation to invest or not to invest in any country or to undertake any specific position or transaction in any currency.  This information may not be suitable for all investors depending on their financial sophistication and investment objectives.  The services of an appropriate professional should be sought in connection with such matters.  The information contained herein has been obtained from sources believed to be reliable, but is not necessarily complete in its accuracy and cannot be guaranteed. Sources used are available upon request. Any opinions expressed are subject to change without notice. Please contact your BBH representative for additional information. BBH’s partners and employees may own currencies in the subject of this communication and/or may make purchases or sales while this communication is in circulation.

Related posts:

• When will Sterling hit Euro parity?
• The Long Run Dollar Outlook
• Japanese defend dollar’s status while China tears it down
• Big Mac Index: Europe overvalued, Asia undervalued
• Swine Flu Tempature Rises, Dollar and Yen Remain Firm

Lehman Brothers

Related posts:

• Links: 2010-03-07 – Comparing job losses, China’s workers and more
• Links: 2010-03-13 – Fed’s Lehman Repos, States may hold onto tax refunds
• Links: 2010-03-15 – Sovereign credit ratings, China and protectionism
• Links: 2010-02-17 – Revaluing China, Goldman and more
• Links: 2010-03-09 – AIB’s loan book and China, Japan and the U.S.

Last week the federal Reserve released its quarterly flow of funds data. I have been unusually slow to parse the numbers. But I did do a very comprehensive sweep of the historical data in an October 2009 post called A brief look at the Asset-Based Economy at economic turns.

The overall conclusion of this analysis was that the consumer was not deleveraging significantly yet, but that the financial sector was deleveraging for the first time since 1982 when the so-called Great Moderation began. The government was filling in the difference and keeping the economy afloat with an unprecedented increase in debt.

Ultimately, however, the financial sector data were the key to the entire analysis:

Financial Services Debt

This is probably the key damning piece of data confirming the asset-based economy thesis.  The data are much worse than I expected.  Not only do Financial Sector debt levels rise from negligible to percentages well over 100% of GDP, but the entire post-1982 period sees zero decline compared to nominal GDP until last quarter.

What conclusions can one draw here?

1. The financial services sector is six times more important than in 1982 when its debt is measured as a percentage of GDP.
2. The financial sector protected the American economy since 1982 by increasing its debt burden relative to nominal GDP even during recession.
3. The financial services sector contracted in Q2 relative to GDP for the first time since 1982.  If this is a rear-view mirror view, that means recovery could continue. However, if this is a canary in the coalmine, that is negative for the U.S. economy. This number bears watching.

I said watch these numbers to see if Q2 2009 was a rear-view or a front-view mirror. So, what are the numbers saying now? Annaly Salvos has the chart.

The data are not good.

First of all, what this chart shows you is that the consumer is not deleveraging significantly (see Consumer credit down, but does it show deleveraging? and Why is everyone saying consumer credit is falling? It’s not). Sure revolving debt (read: credit card debt) has fallen. But mortgage debt is still sky high. And on a debt to GDP basis, there really isn’t a huge come down. Sorry, but that’s what the data are saying. For an indebted household sector, this is bad news.

But, then you look at the other sectors and you see that the financial sector is deleveraging in a massive way. When I last looked the data, I concluded that the U.S. economy was wholly dependent on leverage in the financial sector to continue growing. So, the decreased financial sector leverage spells a lower growth future.

Finally, the government sector debt load continues to surge upward. Keynesians will tell you that the deficit spending that is the source of this increasing debt load is needed to increase savings in the private sector. However, it appears that most of the savings is being done in the financial sector and not in the household sector where it should be.

I see the data as an indication the private-sector deleveraging is only in its beginning stages and has much farther to go.

Related posts:

• Chart of the day: household debt vs. savings
• Consumer credit falls 4.4% from year ago levels
• Chart of the day: Total US Debt
• A brief look at the Asset-Based Economy at economic turns
• Chart of the day: consumer credit growth

I see Diana Olick’s recent comments about government mortgage modification programs as proof that these props will not work.

She says:

Despite extraordinary loss mitigation efforts that have resulted in the execution of approximately two million loan modifications – including the federal government’s Home Affordable Modification Program (HAMP) trial periods – the number of new delinquencies since January 1, 2009, still exceeds this number by 25 percent.

What does that tell you?

Note, that right now only 16% of borrowers eligible for the HAMP received permanent modifications. I am not a big fan of all of the government programs designed to prop up house prices because they only put off the inevitable – and usually at higher cost to the mortgagee and economy. They are only good for banks who want to get as much money out of a mortgagee desperate to hold onto their property as they can.

But, the government has turned to a new fix: short sales. Olick writes in another recent post:

The government’s short sale program is designed specifically to lower the number of foreclosures by getting these homes sold quickly to financially able buyers.

The problem here is that no one wants to do a short sale. As a first lien holder, why would you write down your mortgage and do a short sale when you could just as easily extend and pretend?

Delinquencies are rising at a rapid rate.

But foreclosures are not rising anywhere near this fast (see my second chart from Strategic default: In come the waves again). That’s called extending and pretending.

Paul Jackson of Housing Wire, who provided the chart above says:

What the above chart should call attention to is the aging of loans in the default pipeline. Again using LPS data, for all loans more than 90 days in arrears, the average days delinquent is now at 272 days—up from 204 days in early 2008. For loans in foreclosure, the aging numbers are even more staggering: loans in this bucket average 410 days delinquent, up from 260 days delinquent in early 2008.

Ponder those numbers for just a second. On average, severely delinquent borrowers have gone more than 9 months without making a mortgage payment—and yet foreclosure has not yet started for them. For those borrowers who are in the foreclosure process, it’s been an average of 13.6 months—more than one full year—since they last made any payment on their mortgage.

Jackson goes on to say that short sales are not going to save the day and provides a very good analysis as to why, citing second liens and the size of the problem as the biggest stumbling blocks. Read the full account at his post Housing Recovery is Spelled R-E-O.

Also see The fake stress tests and the coming wave of second mortgage writedowns for more on second liens because this gives another take on why second lien holders don’t want to do short sales either.

Let’s go back to Diana Olick for a second, because she makes another point that is a particular stumbling block: taxes. Borrowers don’t want to do short sales as well.

Unfortunately any loan forgiveness [from a short sale] would be counted as taxable income.

That would cost beleaguered borrowers thousands of dollars after losing their homes! But no worries, Congress to the rescue; it quickly passed the Mortgage Forgiveness Debt Relief Act of 2007, which keeps homeowners from being liable for the canceled debt.

That law is in effect through 2012.

California did the same thing, except that its law expired at the end of 2008, so any Californian who got mortgage debt forgiveness in 2009 is potentially on the hook for a big bad state tax bill.

Translation: California borrowers, where the most people are the most underwater, are not going to like this new HAFA short-sale program at all because they will receive a massive tax bill.

Olick makes her case in the video below.

Bottom line: These programs are not going to get it done. The only thing that will is market-clearing prices, and prices won’t be a low enough to clear for a long time.

Source

Loans Going Bad Faster Than the Fixes – Diana Olick, CNBC

California Could Tank Short Sale Stimulus – Diana Olick, CNBC

Home Affordable Foreclosure Alternative program – Treasury Department

Related posts:

• Short sale fraud
• Extend and pretend and the growing divide between delinquencies and foreclosures
• Ivy Zelman: “Home prices are going back down”
• The coming wave of second mortgage writedowns
• Wow, judges now nixing lenders’ foreclosure claims entirely in court

Meredith Whitney was on CNBC in London this morning. She concentrates her comments on mortgages and banking. She sees the winter lull as a harbinger of renewed softness in the housing market.

Note: the FOMC statement today reiterated the ending dates for MBS purchases. Let’s see how this plays out for mortgage rates in April and beyond.

Whitney is bullish on some financials, namely Visa (V) and Mastercard (MC). However, in the video below she talks a lot about the coming supply of houses which are now receiving modifications. Whitney believes these modifications will fail, forcing those houses onto the market and upsetting the supply-demand balance. She notes that banks are under-reserved for another leg down in the housing market, meaning the credit writedowns from a second wave will impair lending capital. The money quote comes right at the end of the second clip. Look for it.

Related posts:

• Chart of the day: household debt vs. savings
• Meredith Whitney: more bearish than ever, but…
• Consumer credit falls 4.4% from year ago levels
• Chart of the day: consumer credit growth
• Swedish Risks

This is a post from John Lounsbury which will cover ground on the official designation of recessions and his own designation of depressions about which he has written in the past. Previous articles in this series have discussed:

• The NBER process for dating recessions;
• Redefining the business cycle;
• Normalization of GDP to population; and
• Normalization of employment to population.

The previous discussion of GDP might be called the “Wall Street business cycle”. The discussion of employment could be called The “Main Street business cycle”.

Of course, there are more factors involved in the business cycle than just GDP and employment. These two have been selected because they are “broad brush” representations of economic activity.

A recent article by Ben, at the Department of Numbers, suggested that recessions should be timed separately for GDP and employment. That is the direction my work has been pointing.

NBER Recessions

The NBER (National Bureau of Economic Research) defines the start and end dates of economic recessions, both after the fact. Some dates are determined as much as a year after the event actually occurs, such as the December 2008 announcement that a recession had started in December 2007. The dates of recessions all the way back to 1854 are listed here.

The NBER does not measure depressions.

Wall Street Recessions and Depressions

The following three graphs show the NBER recessions (in gray) and the GDP recessions and depressions (in green) for the three 21 year intervals between 1947 and 2009.

Eight of the ten recessions are single recessions within a defined depression. The recessions of 1980 and 1981-82 are both within the same depression. However, this is just barely so. The recovery of normalized GDP to the level of 1Q/1980 occurred in 1Q/1981; the same quarter was the point from which the next normalized GDP decline began.

It could be argued that one depression ended and another began at the same time. I reject that interpretation as illogical: It is nonsense to say that one depression ends at the same time another begins. They are a single double dip depression.

Main Street Recessions and Depressions

We will use the normalized employment data in the preceding article to represent recessions and depressions on Main Street. In the section after this one, the recessions and depressions on Wall Street (represented by normalized GDP) will be compared to the Main Street business cycle.

The following graph shows the employment recessions and depressions over the past 60 years. There were seven depressions and eleven recessions. Four depressions (1948-51, 1969-73, 1974-79 and 1990-96) each contained one recession. Two depressions (1979-83 and 2000-?) each contain two recessions. The depression of 1953-69 contained three recessions.

Of course, the current depression has not concluded, so additional recessions are possible before it ends.

The growth in normalized employment (normalized to adult civilian population) from the mid 1960s to 2000 can be attributed to shrinkage of the military population (the smaller contributor) and the increasing participation of women in the labor force. There was a small counter factor due to the gradual increase in the percentage of retirees over the 35 years. Now the initial wave of baby boomers is reaching normal retirement age and the rate of people entering retirement would normally be expected to increase.

However, there are survey reports that the number of people in their 60s that are delaying retirement for economic reasons is increasing. A recent analysis suggests that the number of people working past normal retirement age has been increasing for at least a decade and the trend may continue. See here.

To make the above curve more meaningful, the normalized employment ratio should be adjusted for demographics going forward. The perfectly corrected curve would most likely show depressions in employment between periods of full employment, possibly in the range 64% of the adjusted adult population.

The question of how to properly adjust the normalized employment curve for demographics is being put off to a future time. For now, we will just recognize that factor is introducing a bias (downward with advancing time) that may or may not become more significant in the coming decades.

Comparing Wall Street and Main Street Business Cycles

The following graphic shows the NBER recessions, the normalized GDP recessions and the normalized employment recessions superimposed on the same timeline.

The first eight recessions show similar durations for all three measurements of recession, with the exception of (1) the recession in 1980 which had a longer employment recession than either NBER or GDP metrics and (2) the recession of 1981-82 which had a longer GDP recession than either NBER or employment metrics.

The three most recent recessions had much longer duration employment recessions than either NBER of GDP metrics.

The following graph shows GDP and employment depressions on the same timeline. The NBER does not determine dates for depressions.

Employment depressions last longer or much longer than GDP depressions. One employment depression, 1953-1969 covers the time span of two separate GDP depressions. The current employment depression is the other on this timeline that covers more than one GDP depression.

Summary

Using employment as a metric for recessions and depressions on Main Street and either the NBER or GDP as indicators of recessions and depressions on Wall Street, we can draw the following conclusions:

1. It should be no surprise that the business cycles experienced by Wall Street and Main Street are correlated in time.
2. The duration of the recessions on Wall Street and Main Street were quite similar from 1947 through 1982.
3. The durations of recessions starting in 1990 have been significantly longer on Main Street than on Wall Street.
4. Depressions on Main Street have been far longer than those on Wall Street. Since 1947, 34% of the time has been spent in GDP depressions while 78% of the time has been spent in employment depressions.
5. I have a fundamental question: Why is the longest Main Street depression (1953-69) associated with a time generally considered to be one of growing prosperity. In fact, within this time frame, we had the longest time period (1962-69) without a Wall Street depression? This question deserves more research.

There has been no attempt to adjust the adult civilian population for the increasing percentage of people in retirement which is likely to have occurred over the 62 years of this study. That has introduced an unknown negative bias to the determination of employment recessions and depressions. Further refinement of this analysis should lead to a reduction of the duration of the employment timelines, especially for depressions. This affect will be analyzed in further work.

Other work to be completed includes:

1. Measurement of the relative economic impact of different recessions and depressions. My proposed term for these impacts is “burden”, introduced here.
2. Comparison of the business cycles of the first half of the twentieth century with those covered here.
3. Application of this analysis to other business cycle variables including industrial production, aggregate personal income less transfer payments, stock market returns, etc.

—————————————-

John Lounsbury provides comprehensive financial planning and investment advisory services to a small number of families on a fee only basis. He has a background which includes 34 years with a major international corporation, 25 years in R&D management and corporate staff positions. Since 2002 he has operated his own sole proprietorship business. John is also one of the top ten authors at Seeking Alpha and a featured commentator at TheStreet.com Real Money.

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• Is the recession dating committee preparing for a double dip?
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With US midterm elections up ahead, we are already seeing political posturing by US politicians regarding China’s currency.  Democratic lawmakers are reportedly drawing up legislation that sets criteria on whether a country has a misaligned currency.  It would modify the current US Treasury semi-annual report to misalignment instead of manipulation.  The House Ways and Means Committee plans a March 24 hearing on the yuan, and so we expect the rhetoric to ratchet up in the coming weeks.  It doesn’t help that the US economy is still facing uncertainty, and so politicians are looking for scapegoats.  China has not been receptive, with Premier Wen saying this month that countries shouldn’t point fingers and try to force a country to appreciate its currency. 

We think a confrontational approach is not helpful, as China has never reacted well to outside pressures or criticism.  And it’s not like the US is in a great position to be dispensing economic advice to the largest holder of USTs (we note that benchmark revisions last month allowed China to retake that position from Japan). There is a clear risk that the US pushes this matter too far given the political landscape.  If both sides were to take a hardline approach, then the risks would be for a weaker dollar and lower UST prices, as China’s ultimate scorched earth response would clearly be to stop (or threaten to stop) purchases of USTs and dollars.  We hope cooler heads will prevail all around.  As it is, China’s trade surplus has fallen sharply even as the US deficit has narrowed, so the imbalances are already improving.

Press is reporting that the draft legislation calls for action if Treasury determines misalignment of a currency.  The US would be forced to take some sort of action with the IMF and, after 60 days, would have to bar federal procurement from that country. After 360 days of inaction, the US Trade Representative’s office would bring a complaint at the World Trade Organization.  We have a hard time believing that the IMF would be drawn into this dispute.  UNCTAD is reportedly on the wires today saying criticism of China’s currency policies are unfounded, so this may really be seen as a bilateral dispute. The biggest problem with changing the language to that of misalignment is that currencies are more often misaligned than not.  Right now, AUD is about 25% overvalued.  Would the US try to punish Australia even though it is not trying to manipulate its currency?  Or does it only work only in one direction with regards to undervaluation?  And how does one measure misalignment?  We note that even the simplest measure PPP is fraught with difficulties, as choice of price index or basket of goods can shift PPP values greatly.  

Source:  Bloomberg
Win Thin
Senior Currency Strategist
Brown Brothers Harriman & Co.

Win Thin is part of Brown Brother Harriman’s top ranked Currency Strategy Team. For more of BBH’s currency views, please visit the BBH FX website here.

This material has been prepared by Brown Brothers Harriman & Co. (“BBH”) and is intended for information purposes only.  This communication should not be relied upon as financial, investment, tax or legal advice.  This communication should not be construed as a recommendation to invest or not to invest in any country or to undertake any specific position or transaction in any currency.  This information may not be suitable for all investors depending on their financial sophistication and investment objectives.  The services of an appropriate professional should be sought in connection with such matters.  The information contained herein has been obtained from sources believed to be reliable, but is not necessarily complete in its accuracy and cannot be guaranteed. Sources used are available upon request. Any opinions expressed are subject to change without notice. Please contact your BBH representative for additional information. BBH’s partners and employees may own currencies in the subject of this communication and/or may make purchases or sales while this communication is in circulation.

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As Irwin Stelzer argued in a recent opinion article in the Wall Street Journal, Spain’s Prime Minister José Luis Rodríguez Zapatero seems to be an admirer of Charles Dickens’s character Mr. Micawber. When asked what he plans to do about Spain’s 11.4% fiscal deficit, first he promises to extend the retirement age, only to later tell us the measure may not be necessary. Then he promises a public-sector wage freeze, only to have his Economy Minister, Elena Salgado, say he really doesn’t mean exactly what he seems to say. And in any event, we shouldn’t worry too much, since given that Spain is a serious country, somehow or other the fiscal deficit will be cut to 3% by 2013, even though most serious analysts consider the economic growth numbers on which the budget plans are based to have their origins more in the dreams of an Alice long lost in Wonderland than in any kind of sober analysis of real possibilities. "We do have a plan," deputy prime minister, Maria Teresa Fernandez de la Vega assures us, but to many that plan now seems to be little better than hoping, like the proverbial Mr. Micawber, that "something will turn up."

The latest to draw attention, to the problematic nature of this "wait and see" approach – and to the gaping hole which is now yawning in Spain’s national balance sheet – is the credit ratings agency Fitch, who only last week warned that many Western governments now face unsustainable debt dynamics following measures taken to address the financial crisis.

The agency singled out Britain, France and Spain as being in special and urgent need of outlining plans to strengthen their public finances if they don’t want to risk losing their current highly prized AAA ranking.

This strong and direct warning was issued by Brian Coulton, Head of Global Economics at Fitch, who said "High-grade sovereign governments need to articulate more credible and stronger fiscal consolidation plans during the course of 2010 to underpin confidence in the sustainability of public finances over the medium-term and their commitment to low and stable inflation. The UK, Spain and France in particular must outline more credible fiscal consolidation programmes over the coming year given the pace of fiscal deterioration and the budgetary challenges they face in stabilising public debt."

Yet, while criticising Portugal’s gradual approach to fiscal consolidation as a matter of "concern" Fitch senior director Paul Rawkins also argued that the Spanish government had acted swiftly in announcing plans to consolidate public finances. Nonetheless he did still warn that the economic risks facing Spain remain very high, especially since the pace of decline in tax revenues is dramatic enough to be preoccupying, while continuing “labour market inflexibilities could well prolong the economic adjustment”.

The current problem facing Spain (and other similarly affected countries) has its roots in two quite distinct sources. In the first place measures taken to counteract the impact of the financial crisis have been inadequate and have simply produced large short term deficits. However to this short term liquidity and adjustment problem must now be added the further dimension of longer term impacts on public finances which have their origins lie in ageing populations, and the effect on economic growth of having older and smaller working-age populations.

Regarding the first, as Willem Buiter, now chief economist at Citi has pointed out, more than 40 per cent of global GDP is currently being produced in countries (overwhelmingly advanced economies) running fiscal deficits of 10 per cent of GDP or more. Over most of the last 30 years, this level fluctuated in the 0-5 per cent range and was dominated by debt form emerging economies. So the crisis marks a watershed, from which there will likely be no turning back, and in many ways could not have come at a worse moment for those countries who still have to undertake substantial pension reform to put their nation finances on a solid footing when faced with the unprecedented ageing which lies ahead.

Indeed, to take the Greek case, while the short term fiscal deficit has been the focus of most of the press attention, the longer term problem associated with the funding of Greek pensions far outweighs issues associated with the falsifying of national accounts in the early years of this century. A recent report by the European Commission found that Greek spending on pensions and health care for its ageing population, if left unchecked, would soar from just over 20 percent of GDP today to around 37 percent of G.D.P. by 2060. And Greece is simply an early warning indicator of troubles to yet to come, in larger countries like Germany, France, Spain and Italy who have all relied for decades on pay as you go type state-financed pension schemes. Now, governments across Europe are being pressed to re-examine their commitments to providing generous pensions over extended retirements because fiscal issues associated with the downturn have suddenly pushed at least part of these previously hidden costs up to the surface.

In fact, unfunded pension liabilities far outweigh the high levels of official sovereign debt. According to research by Jagadeesh Gokhale, an economist at the Cato Institute in Washington, bringing Greece’s pension obligations onto its balance sheet would show that the government’s debt is in reality equal to something like 875 percent of its gross domestic product. That would be the highest debt level in the 16-nation euro zone, and far above Greece’s official debt level of 113 percent. Other countries have obscured their total obligations as well. In France, where the official debt level is 76 percent of economic output, total debt rises to 549 percent once all of its current pension promises are taken into account. Similarly, in Germany, the current debt level of 69 percent would soar to 418 percent. Of course, these numbers are arguable, and may well be in the excessively high range, but the fact still remains: outstanding and unfunded liabilities are huge, and would have been difficult to honour even without the present crisis. As it is, we are now in danger of spending the seedcorn which could have been harvested later on down the road.

Public opinion has yet to assimilate the seriousness of the issues involved here. As Pimco Chief Executive Mohamed El-Erian said in a recent FT Opinion article, the importance of the shock to public finances in advanced economies is not yet sufficiently appreciated and understood. With time, this issue will prove to be highly consequential. The latest Fitch report is simply another warning shot. The sooner we all recognise this, the greater the probability of our being able to stay ahead of the disruptions this adjustment to reality will cause. It is time to stop simply waiting around to see what is going to turn up, since if we do continue like this we won’t like what we eventually find.

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• Video: Fitch downgrades Greece to BBB+ as violence erupts
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It’s curious how one and the same message is emanating from both Beijing and Berlin at the moment: “don’t blame us, it’s not our fault”. And it isn’t.

According to the Financial Times, the Chinese Authorities spent their morning pushing back against the mounting US criticism of their currency policy, arguing that their huge trade surplus is not the result of their undervalued exchange rate and warning the US not to “politicise” the issue.

“The trade imbalance is not something that the exchange rate can resolve and politicising exchange-rate issues is counterproductive to global efforts in tackling the financial crisis,” said Yao Jian, spokesman for the Chinese commerce ministry at a briefing.

The Chinese rebuttal came a day after the US Congress signed a letter calling on the Obama administration to label China as a currency manipulator, an indication of the rising pressure in the US to take a tougher line with China. “The impact of China’s currency manipulation on the US economy cannot be overstated. Maintaining its currency at a devalued exchange rate provides a subsidy to Chinese companies and unfairly disadvantages foreign competitors,” the letter said.

Curiously the Chinese statements come just a day after similar reactions have come from Germany following Christine Legarde’s attempts to mediate in the growing conflict between Europe’s centre and its periphery about how to restore growth to the Eurogroup. Responding to suggestions that Germany should do something to reduce its trade surplus, Werner Schnappauf, general-secretary of the BDI trade association, said Germany’s success at exporting was not the result of “some planned model”, but reflected “the competitiveness of German companies on global markets”.

As Eurointelligence point out, the German establishment feel threatened, and are closing ranks. This comment from Rainer Bruderle, the German economics minister, is very typical for the way Germans are reacting. According to Bruderle, the German surplus is not a problem for anybody, since it is simply a sign of success, and the foundation on which growth, employment and well-being are based.

In the words of Eurointelligence, “the whole interview shows that the minister, in line with every other German politician who is publically commenting on this issue, has no understanding of what imbalances in a monetary union imply. It also shows a misunderstanding since what Germans consider as their success is primarily the result of real revaluations elsewhere in the eurozone, which makes Germany’s good relatively cheaper. A first pre-requisite for the solution of any problem, let alone any problem as complex as imbalances, is the recognition that this is a problem in the first place.”

Of course, the fact that in the peripheral countries that very same “real revaluation” was primarily the result of having an interest rate policy over at the ECB more geared to the deflationary worries of a German society in the throes of a major restructuring than to the inflation needs of those who are now being criticised for having become totally uncompetitive (see chart below for the Spanish case).

Now it may seem platitudinous at the point, but I can’t help endorsing Gideon Rachman’s plea that what we all need to do here is calm down a bit. We are talking at each other, not talking to each other. Correcting the large current account surpluses in both the Chinese and the German case is not as easy as some would make it out to be, since in part the issue is one of demographic imbalances which may need decades to correct, and there is no point in putting people who are already in difficulty even more on the defensive. At the same time, simply to talk about fiscal irresponsibility on Europe’s periphery (which again is a gross oversimplification of the issues involved) is only going to raise the temperature without producing any useful result. If the people on the periphery feel under threat then this will make it harder, and not easier, to get those much needed changes.

My feeling is that we have really all congratulated ourselves here far too soon. The OECD economies, by and large, have been stabilised. There is no “V” shaped rebound. Prompt action by the central banks stopped a meltdown in the banking system, but they did this at the price of massively inflating sovereign debt. Now we need to find the road back to growth, and this is not going to be as easy as it first seemed. The old imbalances don’t work anymore, and we need to learn something from why they don’t. We also need to leave behind us stereotypical discourses which were always of doubtful validity, and now seem downright dangerous. People have talked for years about the dangers of a return to protectionism, what we are currently hearing isn’t quite that, but it is damn near to being the next best thing.

This post first appeared at A Fistful of Euros, where Edward Hugh also blogs.

Edward Hugh has a lively and enjoyable Facebook community where he publishes frequent breaking news, economics links and short updates. If you would like to receive these updates on a regular basis and join the debate please invite Edward as a friend by clicking this Facebook link.

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Lehman

• Lehman Whistle-Blower’s Fate: Fired – WSJ.com
• Blogs Beat the Press on the Lehman Brothers Scandal : CJR
• ABN Amro hielp Lehman bij manipulatie – Het Financieele Dagblad
• Dealbook Column – At Lehman, Watchdogs Saw It All – NYTimes.com
• Lehman’s Repo 105: More Than You Ever Wanted to Know – MarketBeat – WSJ

Financial News

• Mish’s Global Economic Trend Analysis: Misconceptions about Money and Velocity
• China’s currency: How is this supposed to work? | The Economist
• Our Next Economic Plague: Japan Disease – Andy Xie – English_Caixin
• Memo to Moody’s: It’s Accounting 101, Not Economics » Marshall Auerback
• Brazil to Break Patents on U.S. Films, Books, Drugs – Bloomberg.com
• Lawmakers press for action on China currency | Reuters
• Netanyahu defies U.S. over Jerusalem settlement
• More than 23,000 layoff notices issued to teachers statewide – San Jose Mercury News
• Final destination Iran? – Herald Scotland | News | World News
• Driving retirement for seniors – Science News
• Confidence is key to gauging impressions we make – Science News
• Payback Time – Avalanche of Maturing Junk Bonds Looms for Markets – NYTimes.com
• Senator Graham’s Inexplicable National ID Support | Cato @ Liberty
• China’s currency: The return of the "get tough" approach to China | The Economist
• Only seven percent of Americans would pay for online news

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John Hussman notes that the very large non-subprime Alt-A and Option ARM cohort interest-rate resets lie ahead of us and not behind us in his latest weekly market commentary. In my view, this is a very big problem for the US banking sector and economy because of the credit writedowns these resets will generate.

For his part, Hussman says:

I should note parenthetically that as you read reports about the mortgage and credit markets during the next few months, it will be extremely important to pay attention to the time period being discussed. For example, we are seeing articles with very recent datelines that are drawing conclusions based on relatively pleasant data from the fourth quarter of last year, which reflects the end of the reset lull that was completed with the low in September.

To reiterate what the reset curve looks like here, the 2010 peak doesn’t really get going until July-Sep (with delinquencies likely to peak about 3 months later, and foreclosures about 3 months after that). A larger peak will occur the second half of 2011. I remain concerned that we could quickly accumulate hundreds of billions of dollars of loan resets in the coming months, and in that case, would expect to see about 40% of those go delinquent based on the sub-prime curve and the delinquency rate on earlier Alt-A loans. Notably, by 2005, the credit score allowed on Alt-A loans fell to about 620, which is consistent with sub-prime. And not surprisingly, the later in the housing bubble the loan was made, the higher the delinquency rate has been right out of the gate.

The earliest data we will observe in terms of Alt-A and Option-ARM loans will be driven by the relatively small initial round of resets that began in November of last year. That implies that any data prior to February is relatively clean of these effects. What we are interested in is the extent to which we observe a spike in 30-day delinquencies in data beginning about the February-March time frame. The size of the delinquency effects is likely to increase through the year, back off in the first half of 2011, and then reach their final peak in late 2011.

Emphatically, we do not need to work through the whole reset cycle in order to accept market risk. But significant damage in the stock market is often taken in the "recognition phase" where troubling reality departs from optimistic expectations. On that front, I am doubly concerned here because on the basis of an ensemble of fundamental measures (normalized earnings, revenues, book values, dividends), the only points between the pre-Depression period and the late-1990’s when the market has been so richly valued were November-December 1972 (before a 2-year market loss of about 50%), and August-September 1987. The hostile yield trends I noted last week (The Rubber Hits the Road) only amplify that concern.

This is something I am on to and have mentioned a few times in the past few months. As I wrote last month in The coming wave of second mortgage writedowns:

When the crisis first developed, in February of 2007, it was subprime where the worries were, with the lion’s share of writedowns coming from mark-to-market losses in the securitisation market.  However, subprime was a relatively small part of the overall market, making up 14% of loans outstanding at that time. Alt-A loans were 27% and prime loans were 57% respectively of loans outstanding according to a Banc of America Securities report.

As the 2004-2007 cohorts of Alt-A option ARM mortgages have started to reset and prime borrowers have come under stress, we have started to see defaults in markets which are an order of magnitude larger than subprime.

The same dynamics will be at play here that were at play during the meltdown in subprime, except this time we are talking mainly about prime borrowers. Remember, this is and has always been a credit crisis, not a subprime mortgage crisis. It is the result of lax regulation, easy money and lending recklessness on a mammoth scale that goes far beyond subprime. Hussman makes the same point when he quips:

it should be evident that the recent credit crisis did not emerge as some unpredictable surprise, but was instead the very ordinary outcome of extraordinary recklessness. Though the mounting problems in 2005 were utterly ignored by the stock market for more than two years after this analysis was published, the fact is that even with the recent rebound, the S&P 500 remains below where it was in mid-2005. Overvaluation and reckless lending do not always translate into near-term market weakness, but they invariably haunt investors in the form of poor long-term returns.

The interesting bit for me is he leads into this via a quote from a five-year old piece from the Economist which way back in 2005 predicted calamity for the global housing bubble that had already formed. This is the very same article I referenced in June 2008 when I wrote Naysayers, the housing bubble was obvious as the housing bubble was beginning to unravel in the U.S.

The Economist said presciently:

Interest-only mortgages are all the rage, along with so-called ‘negative-amortisation loans’ (the buyer pays less than the interest due and the unpaid principal and interest is added on to the loan). After an initial period, payments surge as principal repayment kicks in. In California, over 60% of all new mortgages this year are interest-only or negative-amortisation, up from 8% in 2002. The national figure is one-third. The new loans are essentially a gamble that prices will continue to rise rapidly, allowing the borrower to sell the home at a profit or refinance before any principal has to be repaid.

And when prices stopped rising, homeowners defaulted on a massive scale. The carnage spread in the financial sector most quickly via huge losses in marked-to-market mortgage backed-securities (MBS) and collateralised debt obligations (CDOs). However, when the mark-to-market rules allowed for greater ‘discretion’ in designating these derivatives as hold-to-maturity assets, financial institutions got a free pass and are now hiding hundreds of billions in writedowns this way. This was a huge boon for financial shares, which have increased markedly ever since. See Wells profit forecast is a clear bullish sign.

The difference going forward has to do with strategic defaults. When a delinquent mortgagee runs into problems, a bank servicer has a lot of discretion in the way it can deal with this situation. Inevitably, this leads mortgage lenders to extending and pretending the delinquency is temporary. However there is a growing divide between delinquencies and foreclosures, which suggests that foreclosure data understate the mortgage distress and delinquencies now building in the U.S. residential housing market.

When Option-ARM and Alt-A interest rates re-set higher, payments will increase dramatically for many borrowers who are hopelessly underwater on their mortgages. This will be a significant driver of defaults in 2010 and 2011.

Moreover, a recent article in the New York Times demonstrates that borrowers with high FICO scores are still at risk of default, opting to pay credit cards off instead of mortgages.

This is all pointing to a coming wave of strategic defaults. Borrowers whose homes are significantly underwater could be looking at losses at sale for up to 6 years. Therefore, many are opting to default strategically. When a borrower defaults and walks away, the loss becomes unrecoverable and the value of the asset must be written down. So while holding MBS paper to maturity has  cushioned banks to date, a large wave of strategic defaults would pressure lenders who are under-provisioning for future losses.

Expect this to play out over 2010 and 2011.

Sources

Ordinary Outcomes of Extraordinary Recklessness – John Hussman

In come the waves ($) – Economist, 16 Jun 2005

Related posts:

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• New Writedown Risk: Alt-A
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Popular myth and, allegedly, the laws of aerodynamics have it that the bumblebee should not be able to take flight. Yet still, our good bumblebee refuses to be pulled down by such details and year after year it takes flight as if nothing has happened. This allegory applies, with some imagination, to Japans economy too. Year after year it consequently appears able to simply ramp up domestic debt to cover the shortfall of domestic demand at the same time as low investment demand, a savvy export sector, and a strong net foreign asset position mean that Japan does not have to rely on foreign investors to finance government debt outlays. Together with a central bank stuck in perpetual QE mode due to persistent deflation this has so far constituted the core of Japan’s bumblebee moment.

Recent comments and analysis however suggest that while the bumblebee should certainly continue to enjoy the ability to defy gravity, Japan’s time just may be up. In particular two pieces of research authored by Societe Generale’s Dylan Grice (see here and here) as well as a recent piece by Kenneth Rogoff have added to the concerns that Japan may be headed for a Greek party of their own. In reality of course, the sudden focus on Japan is a direct function of the change in market disc