naked capitalism

UCLA gave transplant to Japanese gang boss PhysOrg

Debunking Skill-biased Technical Change Econospeak

Why Is This Legal? Elizabeth Warren, Credit Slips

Greg Mankiw: The Problem With the Corporate Tax Mark Thoma

Hedge Fund Fees and Liquidity – Setting it Straight Roger Ehrenberg

Risk wasn’t dispersed Brad Setser. This paragraph caught my eye:

The authorities in the UK shouldn’t get a free pass either. Their desire to court international business has meant that London has become a data black hole. An enormous amount of money flows through London but the UK’s balance of payments data provides next to no information about the sources of that money. The UK’s attitude may be good for business, but it has resulted in less transparency in the global financial system – and more difficulty tracking who has assumed key financial risks.

The Trouble in Housing Trickles Up New York Times

Antidote du jour. Normally I don’t go for video, but….

Policymakers in Europe have been worried about the appreciation of the euro, which makes local goods less competitive in international markets. Another cost of the currency’s strength is that foreign direct investment has plummeted, as producers shift funds to nations that now have a cost advantage.

From the Telegraph:

Long-term private investors are pulling their money out of the eurozone at the fastest rate since the creation of the single currency, according to a report by the French bank BNP Paribas.

Foreign direct investment (FDI) in plant and factories has turned deeply negative, reaching minus €149bn (£117bn) over the past year. It dropped to minus €19bn in March alone as the soaring euro pushed labour costs in southern Europe to uncompetitive levels.

The annual exodus of private funds from eurozone equities and bonds has reached almost $280bn. Taken together, the total outflows have topped €400bn in 12 months and may spell trouble for Europe’s industry as the economic downturn gathers pace.

Airbus is leading the rush to hollow out production inside the currency bloc, switching operations to the US, Mexico and India. “It really worries me that private accounts are selling assets like this,” said Hans Redeker, BNP’s currency chief.

The euro is being held aloft by central banks in Asia, Russia, and the Middle East seeking an alternative to the dollar as a place to park their mushrooming currency reserves. In effect, the eurozone is now suffering from the reserve currency curse.

While Asian funding has helped ease the credit crisis in Europe, it has also pushed the exchange rate to damaging levels. There is a trade-off effect. The eurozone has gained financial flows, but has lost industrial and investment flows….

The eurozone racked up a record current account deficit of €15.3bn in March, seasonally adjusted. BNP Paribas said the so-called “PIGS” (Portugal, Italy, Greece, and Spain) are dragging down the trade performance of the bloc.

All have suffered a relentless loss of competitiveness since EMU was launched. The deficits have reached 10pc of GDP in Spain and 14pc in Greece. None has begun to narrow the gap in unit labour costs with Germany, ensuring that the inevitable adjustment will be more severe when it comes.

Indeed, Spain’s inflation surged to a record 4.7pc in May. The country now faces the most acute “stagflation crisis” in the developed world. House prices have fallen 15pc nationwide since September, according to the developers’ association (APCE). Madrid University warned this week that Spain’s property slump could throw 1.1m people out of work.

Mr Redeker said the ‘PIGS’ quartet was now facing “collapse”, with mounting signs of stress in France as well after consumer confidence fell to the lowest level in 20 years. French property sales fell 28pc in the first quarter.

“There are a lot of ugly surprises in store as deleveraging finally hits Europe. Investors are going to stop treating the eurozone as if it were Germany, and take very close look at the deficits of the southern countries. We can expect bond spreads to widen significantly,” he said. “We will discover in this downturn whether the eurozone is really an ‘optimal currency area’. This is the test.”

In his final speech as President, Dwight Eisenhower warned against a heretofore unrecognized danger to America, namely the growing influence of what the Commander in Chief called the “military/industrial complex”. This excerpt reminds us that despite our nostalgic view of the 1950s, the struggle against Communist was seen as an epic battle:

Throughout America’s adventure in free government, our basic purposes have been to keep the peace; to foster progress in human achievement, and to enhance liberty, dignity and integrity among people and among nations. To strive for less would be unworthy of a free and religious people. Any failure traceable to arrogance, or our lack of comprehension or readiness to sacrifice would inflict upon us grievous hurt both at home and abroad.

Progress toward these noble goals is persistently threatened by the conflict now engulfing the world. It commands our whole attention, absorbs our very beings. We face a hostile ideology — global in scope, atheistic in character, ruthless in purpose, and insidious in method. Unhappily the danger is poses promises to be of indefinite duration. To meet it successfully, there is called for, not so much the emotional and transitory sacrifices of crisis, but rather those which enable us to carry forward steadily, surely, and without complaint the burdens of a prolonged and complex struggle — with liberty the stake. Only thus shall we remain, despite every provocation, on our charted course toward permanent peace and human betterment.

Crises there will continue to be. In meeting them, whether foreign or domestic, great or small, there is a recurring temptation to feel that some spectacular and costly action could become the miraculous solution to all current difficulties….

But each proposal must be weighed in the light of a broader consideration: the need to maintain balance in and among national programs — balance between the private and the public economy, balance between cost and hoped for advantage — balance between the clearly necessary and the comfortably desirable; balance between our essential requirements as a nation and the duties imposed by the nation upon the individual; balance between actions of the moment and the national welfare of the future. Good judgment seeks balance and progress; lack of it eventually finds imbalance and frustration….

Until the latest of our world conflicts, the United States had no armaments industry. American makers of plowshares could, with time and as required, make swords as well…

This conjunction of an immense military establishment and a large arms industry is new in the American experience. The total influence — economic, political, even spiritual — is felt in every city, every State house, every office of the Federal government. We recognize the imperative need for this development. Yet we must not fail to comprehend its grave implications. Our toil, resources and livelihood are all involved; so is the very structure of our society.

In the councils of government, we must guard against the acquisition of unwarranted influence, whether sought or unsought, by the military/industrial complex. The potential for the disastrous rise of misplaced power exists and will persist.

We must never let the weight of this combination endanger our liberties or democratic processes. We should take nothing for granted. Only an alert and knowledgeable citizenry can compel the proper meshing of the huge industrial and military machinery of defense with our peaceful methods and goals, so that security and liberty may prosper together….

Another factor in maintaining balance involves the element of time. As we peer into society’s future, we — you and I, and our government — must avoid the impulse to live only for today, plundering, for our own ease and convenience, the precious resources of tomorrow. We cannot mortgage the material assets of our grandchildren without risking the loss also of their political and spiritual heritage. We want democracy to survive for all generations to come, not to become the insolvent phantom of tomorrow.

I had to include the last bit, even though it deviates from the thrust of this post; you seldom hear public officials today conjoin the notions of stewardship and fiscal prudence.

Reader Charles directed us to an article in today’s Asia Times on the stunning growth in defense-related spending under the Bush administration. While the costs of the war in Iraq get a good deal of media attention, the overall expansion in military expenditures is given comparatively short shrift. This piece remedies that oversight.

From the Asia Times:

The Pentagon’s massive bulk-up these past seven years will not be easily unbuilt, no matter who dons the presidential mantle on January 19, 2009. “The Pentagon” is now so much more than a five-sided building across the Potomac from Washington or even the seat of the Department of Defense. In many ways, it defies description or labeling….

The Pentagon’s core budget – already a staggering US$300 billion when Bush took the presidency – has almost doubled while he’s been parked behind the big desk in the Oval Office. For fiscal year 2009, the regular Pentagon budget will total roughly $541 billion (including work on nuclear warheads and naval reactors at the Department of Energy).

The Bush administration has presided over one of the largest military buildups in the history of the United States. And that’s before we even count “war spending”. If the direct costs of the wars in Iraq and Afghanistan, as well as the global “war on terror”, are factored in, “defense” spending has essentially tripled.

As of February 2008, according to the Congressional Budget Office, lawmakers have appropriated $752 billion for the Iraq war and occupation, ongoing military operations in Afghanistan, and other activities associated with the “war on terror”. The Pentagon estimates that it will need another $170 billion for fiscal 2009, which means, at $922 billion, that direct war spending since 2001 would be at the edge of the trillion-dollar mark….

With a military budget more than 30 times that of all State Department operations and non-military foreign aid put together, the Pentagon has marched into State’s two traditional strongholds – diplomacy and development – duplicating or replacing much of its work, often by refocusing Washington’s diplomacy around military-to-military, rather than diplomat-to-diplomat, relations.

Since the late 18th century, the US ambassador in any country has been considered the president’s personal representative, responsible for ensuring that foreign policy goals are met. As one ambassador explained, “The rule is: if you’re in country, you work for the ambassador. If you don’t work for the ambassador, you don’t get country clearance.”

In the Bush era, the Pentagon has overturned this model…

The Pentagon invariably couches its bureaucratic imperialism in terms of “interagency cooperation”. For example, last year US Southern Command (Southcom) released Command Strategy 2016, a document which identified poverty, crime and corruption as key “security” problems in Latin America. It suggested that Southcom, a security command, should, in fact, be the “central actor in addressing … regional problems” previously the concern of civilian agencies. It then touted itself as the future focus of a “joint interagency security command … in support of security, stability and prosperity in the region….

The Pentagon has generally followed this pattern globally since 2001. But what does “cooperation” mean when one entity dwarfs all others in personnel, resources, and access to decision-makers, while increasingly controlling the very definition of the “threats” to be dealt with…..

In the Bush years, the Pentagon has aggressively increased its role as the planet’s foremost arms dealer, pumping up its weapons sales everywhere it can – and so seeding the future with war and conflict.

By 2006 (the last year for which full data is available), the United States alone accounted for more than half the world’s trade in arms with $14 billion in sales…..

In the area of “intelligence”, the Pentagon’s expansion – the commandeering of information and analysis roles – has been swift, clumsy, and catastrophic….. The Pentagon’s takeover of intelligence has meant fewer intelligence analysts who speak Arabic, Farsi or Pashto and more dog-and-pony shows like those four-star generals and three-stripe admirals mouthing administration-approved talking points on cable news and the Sunday morning talk shows…..

the Pentagon now controls more than 80% of US intelligence spending, which he estimated at about $60 billion in 2007. As Mel Goodman, former CIA official and now an analyst at the Center for International Policy, observed, “The Pentagon has been the big bureaucratic winner in all of this…..

When the deciders in Washington start seeing the Pentagon as the world’s problem-solver, strange things happen. In fact, in the Bush years, the Pentagon has become the official first responder of last resort in case of just about any disaster – from tornadoes, hurricanes and floods to civil unrest, potential outbreaks of disease or possible biological or chemical attacks.

In 2002, in a telltale sign of Pentagon mission creep, Bush established the first domestic military command since the civil war, the US Northern Command (Northcom). Its mission: the “preparation for, prevention of, deterrence of, preemption of, defense against, and response to threats and aggression directed towards US territory, sovereignty, domestic population, and infrastructure; as well as crisis management, consequence management, and other domestic civil support.”

If it sounds like a tall order, it is.

In the past six years, Northcom has been remarkably unsuccessful at anything but expanding its theoretical reach….

The US Agency for International Development and the State Department have traditionally been tasked with responding to disaster abroad; but, from Indonesia’s tsunami-ravaged shores to Myanmar after the recent cyclone, natural catastrophe has become another presidential opportunity to “send in the Marines” (so to speak). The Pentagon has increasingly taken up humanitarian planning, gaining an ever larger share of US humanitarian missions abroad…..

In fact, the Pentagon doesn’t do humanitarian work very well. In Afghanistan, for instance, food-packets dropped by US planes were the same color as the cluster munitions also dropped by US planes; while schools and clinics built by US forces often became targets before they could even be put into use. In Iraq, money doled out to the Pentagon’s sectarian-group-of-the-week for wells and generators turned out to be just as easily spent on explosives and AK-47s….

Meanwhile, should the Earth not be enough, there are always the heavens to control. In August 2006, building on earlier documents like the 1998 US Space Command’s Vision for 2020 (which called for a policy of “full spectrum dominance”), the Bush administration unveiled its “national space policy”. It advocated establishing, defending and enlarging US control over space resources and argued for “unhindered” rights in space – unhindered, that is, by international agreements preventing the weaponization of space. The document also asserted that “freedom of action in space is as important to the United States as air power and sea power”…..(The leaders of China, Russia and other major states undoubtedly heard the loud slap of a gauntlet being thrown down.)…

Of all the frontiers of expansion, perhaps none is more striking than the Pentagon’s sorties into the future. Does the Department of Transportation offer a Vision for 2030? Does the Environmental Protection Agency develop plans for the next 50 years? Does the Department of Health and Human Services have a team of power-point professionals working up dynamic graphics for what services for the elderly will look like in 2050?

There’s a good bit more in the article proper.

In addition to the Pentagon’s sizable budget, there appear to be further expenditures not accounted for. This problem was identified by the Comptroller General in 2001:

The Pentagon’s financial statements are in such poor condition that they cannot be audited, Mr. Walker said, and most other agencies do not comply with federal accounting standards. As a result, he said, he cannot certify the accuracy of consolidated financial statements for the government as a whole. Federal auditors have been complaining about this problem for several years.

This hearing in 2006 (listen closely for McKinney’s second question, around one minute into the video) suggests little to no progress had been made:

Look before you leap: New study examines self-control PhysOrg

Outrage as French judge annuls Muslim marriage over bride’s virginity lie Times Online

Gartner Identifies Top Ten Disruptive Technologies for 2008 to 2012 ehomeupgrade

Job Climate for the Class of 2008 Is a Bit Warmer Than Expected New York Times

Derivative thinking Gillian Tett, Financial Times. A history of the evolution of various derivatives.

Moody’s Implied Ratings Show MBIA, Ambac Turn to Junk Bloomberg

$10,000 limit. Can’t fill the tank Angry Bear

Antidote du jour:

Funny how it takes a survey to confirm what any reader of the press ought to know right now: consumers, hit by rising fuel and food prices, expect a higher level of inflation for the next 12 months (5.2%, according to a Reuters/University of Michigan survey):

One of the things that has led the Fed to take signs of rising inflation less seriously than it otherwise might is the lack of worker bargaining power. The 1970s witnesses so-called cost-push inflation, where rising prices led workers to demand and get corresponding wage increases, which then fed more price hikes. That hasn’t happened yet, but a Wall Street Journal story suggests that might be starting to change:

“Parking is going up, gas is going up, food is going up … but the wages aren’t going up,” said Jan Cornell, president of a union that represents 400 workers at the University of Virginia in Charlottesville. The union is seeking a wage increase.

But with unions comparatively scarce, it isn’t clear by what mechanism beleaguered and insecure employees can extract better pay. And note that you don’t need inflation for workers to suffer falling real compensation. Look at the trends in Japan:

Observe also when the change occurred, aroung 1998, when the countries that either suffered in the emerging markets crisis or managed to escape (China) vowed never to be at the mercy of the IMF. Their remedy was currency pegs against the dollar. Japan has managed to have high trade surpluses even post 1998, but at the expense of domestic pay packages.

So far, even though corporate profits have been at a record percentage of GDP (see here and here), some large companies, are trying to contain price increases by sacrificing margins, while others are passing them through:

Some companies, after initially trying to absorb increased energy costs, are passing them along to customers. Wednesday, Dow Chemical Co. said it plans to raise prices on its products as much as 20% to offset “staggering” energy costs. The company joins Kimberly-Clark Corp., which is raising prices on goods including toilet paper, diapers, and paper towels for the second time this year. Others lifting prices include tire maker Michelin North America, Kraft Foods Inc., and several retail jewelers.

While restraint on price increases may for a time reduce the pace at which cost increases move through the economy, at some point businesses will reach the limits of their willingness to absorb expense increases.

Bloomberg reports that the Commodity Futures Trading Commission, which has opened an investigation into whether market manipulation may be influencing oil prices, is taking a hard look at physical delivery and storage.

A particular focus is the role of Cushing in the trading of West Texas Intermediate Crude, one of the two most important contracts in oil pricing. As we noted in an earlier post, citing an article by John Dizard in the Financial Times:

You don’t have to buy the evil-specs-caused-all-this argument to believe there are problems with the way parts of the commodities markets work. As Mr [Eugen] Weinberg [at Commerzbank] points out: “The West Texas Intermediate oil contract, based on delivery in Cushing, Oklahoma, is good for 300,000-400,000 barrels per day. The storage capacity in Cushing is about 20.5m barrels. The trading volume on which that is based is between 500m and 600m barrels per day. If you are going to manipulate the price, you would think about doing that in Cushing.”

Reader mxq also pointed out a revealing quote from this morning’s Wall Street Journal story on the CFTC investigation from a Paul Pantano, a Washington lawyer who advises energy companies:

Commercial parties and speculators are operating in a market where the rules about what is considered manipulative conduct versus legitimate trading activity are not very clear.

Now of course, this statement raises several interesting questions: first, that traders may have engaged in behavior that would be deemed manipulative in other markets, but the CFTC cannot call it such due to the difference in rules. The second, of course, is that traders knowingly exploited these ambiguities (litigation would enable one to get into e-mails to probe intent; I suspect that level of discovery is not a normal feature of a CFTC investigation. (I’ve been in the room when counsel has advised trading operations on what to say if the SEC were to come calling, so I’ve seen first-hand that ambiguities are exploited with intent).

Reader wprestong pointed out that NYMEX is increasing margins on oil futures as well as additional contracts. Not clear yet what impact this will have.

From Bloomberg:

The oil investigation is far enough along that the commission could announce it publicly without hindering its ability to gather information, he said. “I hope we have something more to say about this sooner rather than later,” [Commissioner Bart] Chilton said.

Chilton didn’t elaborate on the December incidents that drew the CFTC’s interest. The benchmark tanker rate from the Middle East to the U.S. Gulf Coast surged that month.

In terms of oil storage, regulators will likely focus on Cushing, Oklahoma, the delivery point for crude oil sold on the New York futures market, said Kyle Cooper, director of research at IAF Advisors in Houston. Stockpiles at Cushing amounted to 21.3 million barrels of oil as of last week, 6.8 percent of the nation’s total, according to the Energy Department.

“Cushing has always been a bone of contention because of the relatively small size and the influence it has on a market as big as crude oil,” Cooper said. “If you have a few players who have a significant influence over the market, then they have the ability to influence prices.”….

There had to have been something that “caught the attention” of the commission to launch the oil-trading investigation, said Michael Haigh, head of U.S commodities research at Societe Generale SA in New York and a former CFTC economist.

“However, they may be under pressure from Congress to look at this market, given the high prices,” Haigh said. “The CFTC doesn’t want to be perceived as being asleep.”

The CFTC also said yesterday it was taking steps to improve transparency in energy markets, including more monitoring of U.S. oil trading on Intercontinental’s ICE Futures Europe exchange in London.

“That’s definitely an issue, and it’s been a burr in the side of the CFTC for a long time,” said Walter Zimmermann, vice president at United Energy Inc. “You whack it on the Nymex and it pops up on the ICE.”…

“Obviously, more accountability, more transparency is a good thing, but all this stuff about checking delivery routes — I just don’t subscribe to this whole conspiracy thing,” said Guy Gleichmann, president of United Strategic Investors Group in Hollywood, Florida. “The speculative buying would not have come this far if they did not have a story. The supply-and-demand scenario is very tight.”

Nymex Chief Executive Officer James Newsome and his counterpart at ICE, Jeff Sprecher, said they don’t see data to indicate speculators are driving up oil prices. Sprecher said ICE has had a rapid influx of commercial users trading to hedge against fluctuations in prices.

Michael Greenberger, a former head of the CFTC’s Division of Trading and Markets, said the agency is likely to find that some investment banks, hedge funds and wealthy individuals manipulated futures prices. Traders may face prosecution if they reported false prices or made offsetting trades designed to manipulate the market, he said.

“There will be a lot of administrative and criminal litigation before the sun sets on this,” said Greenberger, who teaches law at the University of Maryland.

Greenberger said that in addition to the pressure caused by consumer furor over record motor-fuel prices, the CFTC may be trying to protect its regulatory turf from the Federal Trade Commission, which has new authority to investigate energy-market manipulation.

“I think everyone is going to be watching to see how serious the CFTC is about this,” Greenberger said. “Yesterday’s take was that this is very serious.”

It’s a bit premature to say that the price correction in oil and commodities generally is a harbinger of a reversion of much of the runup of this year; they were so overbought that some profit-taking was inevitable. But now that the bulls have finally met some strong headwinds, cautionary views are suddenly getting more respect.

John Dizard of the Financial Times has wryly noted:

The political reaction to high prices is most likely to lead to legislated changes in commodities markets regulation in the US and elsewhere. I am fairly certain that the changes will take effect after the coming decline in commodities prices.

I say decline because there always is one, and the late-stage political reaction suggests it is coming soon.

Indeed, although all may indeed not be well in commodities trading land, where insider information is legal and a so-called swaps loophole allows financial buyers to be classified as commercials, the investigation announced by the CFTC into possible speculation has the smell of a hunt for a few scalps to show to the public. From the Wall Street Journal:

The move Thursday by the Commodity Futures Trading Commission, including its unusual announcement of an investigation in progress, comes after crude-oil prices topped $130 a barrel last week and tested all-time highs….

“It’s important that people who are paying high gas prices understand the CFTC is on the case and that we’re closely monitoring and in this instance deeply investigating any potential abuse in this important energy market,” said Bart Chilton, a CFTC commissioner…..

Mr. Chilton, the CFTC commissioner, said regulators are looking at cases where traders have made simultaneous bets on unregulated and regulated markets, in particular in West Texas Intermediate crude-oil contracts. He said he wants to know “whether there’s any possibility for attempted manipulations as a result.”

Apart from its investigations into specific allegations, the CFTC said Thursday it will require more information in general from large traders. It wants to know about their bets in commodity-linked index investments as well as speculative trades that they are able to place via Wall Street dealers, often in large quantities.

Nevertheless, it does appear the CFTC has been less than forthcoming. An alert reader Juan pointed out that in reports on agricultural commodities trading, the CFTC published a supplemental report, the CIT, which broke out index speculators and showed their positions were severely imbalanced. A CFTC into oil trading (which predictably declared there was no speculation, using the superficial parsing of commercial versus non-commercial contract buyers) failed to provide the more detailed breakout. Looks a bit sus, no?

Note that one of the options under consideration is increasing margins to drive out speculative long buyers. The problem is while some of the recent entrants may be levered investors from other markets (anetodatal evidence suggests that some hedge funds, who are finding it difficult to get as much gearing as they once did from their prime broker, have moved into commodities because futures exchanges offer plenty of leverage), a large group, commodities index investors, seldom use leverage. Thus Mack Frankfurter says that an increase in margin requirements might produce perverse outcomes:

But as our analysis reveals using Dr. Spurgin’s model, the oil market currently indicates that there is a net hedging response where long hedgers are willing to pay short speculators excess premia to enter into a contract. As Michael Masters posited, the predominant long hedgers may very well be the commodity index funds. Yet it should also be noted that these same index funds will not be materially impacted by an increase in margin because they are fully-funded.

Hence, while the hedging response function may or may not be causing the market to steadily rise, it is prudent to err on the side of caution. If our thesis is correct, then raising margin requirements will result in a disastrous short covering rally.

At $135 a barrel per oil, we are beginning to see indications of demand destruction. It may in fact be the case that threats from Congress are already having a detrimental impact on the oil markets.

Note that Michael Masters, who contended in his Congressional testimony that committed long-only buyers like pension funds were contributing to rising commodity prices, did NOT recommend margin increases.

With some evidence in the US that gas use is declining even before the recent spike has worked its way through to the pump, more observers are coming to the point of view that high prices may be the cure for high prices. As John Authers writes in the Financial Times:

When will the oil price start to cause true macroeconomic pain? Once it does, it could create stagflation – something that is still not with us, given enduring strength in US manufacturing and growth in the emerging world. It will also, probably, reduce demand for oil and hence start to push the price down.

Other commodities have gone off the boil, with the S&P GSCI non-energy commodity index falling 13.5 per cent since mid-March while the energy index has gained 22.6 per cent. So attention now focuses on oil.

Even when adjusted for inflation, crude oil at $135 a barrel is more expensive than at the peak of the oil spike in 1980. That is an alarming statistic.

But Véronique Riches-Flores of Société Générale adjusts this by measuring the “oil burden” – the volume of oil consumed, multiplied by the average price and divided by nominal gross domestic product. This gives the proportion of the world economy devoted to oil and accounts for the way the world has reduced its reliance on oil since 1980.

The oil burden so measured has risen about 75 per cent during the past year, to its highest level in almost 25 years. This must soon have an economic impact if prices do not quickly reverse. But prices would need to reach about $190 before the burden regained its peak of 1980…..

Another area of doubt is the role of subsidies in the developing world….Most notably, Chinese consumers are only paying about 10 per cent more for oil than they were 12 months ago, while JPMorgan research suggests consumers in Egypt, Indonesia, Malaysia, Mexico and Vietnam are buying petrol at an even bigger discount than in China.

Demand for oil, and therefore oil prices, could now depend on the future of those subsidies.

Ambrose Evans-Pritchard in the Telegraph argues that the days of many of those subsidies are numbered:

One by one, countries across Asia and the Middle East are being forced to abandon price controls on fuel and energy, bringing hundreds of millions of consumers face to face with the true market cost of oil. The effect has already begun to chip away at world demand and may ultimately trigger a slide in crude prices.

Egypt – the most populous Arab state – has raised petrol prices by 40pc, despite protests in Cairo. Sri Lanka lifted diesel and petrol prices by 25pc over the weekend. India may have to follow soon to prevent its trade and budget deficits climbing to dangerous levels. “The situation is alarming. We need to stem the rot,” said India’s energy secretary, MS Srinivasan.

Indonesia has raised petrol prices by 33pc in order to restore fiscal discipline (subsidies are 3pc of GDP). Taiwan has mooted a 20pc rise, and Malaysia is to peel back controls. While China has so far resisted calls for price freedom, the policy is becoming unsustainable. Analysts predict a change in tack after the finish of the Beijing Olympics at the end of August….

The number of miles driven by Americans fell in March at the steepest rate ever recorded. Oil use in the OECD club of rich states has been falling for more than two years.

Stephen Jen, currency chief at Morgan Stanley, says half the world’s population now enjoys fuel subsidies of one sort or another. Petrol costs 5 cents a litre in Venezuela, 12c in Saudi Arabia, 64c in China, $1 in the US, and $2.16 (£1.10) in Britain. It is heavily subsidised in Mexico, Iran, central Asia and the Gulf states.

The result has been to encourage promiscuous use of fuel. It has masked the underlying rate of inflation in emerging markets, and flattered the economic growth rate.

Mr Jen says the game is largely over. “The subsidies will need to be rolled back, especially for governments with fragile fiscal positions. They face a stagflationary shock,” he said.

Michael Waldron, an oil analyst at Lehman Brothers, said the bullish case for oil over the next year or so rests on an ever narrower group of countries – essentially China and the Gulf states.

“Are they really enough to support oil prices at this level? Inventories are building up at 600,000 barrels per day [bpd] across the world,” he said.

Lehman Brothers estimates that supply will average 86.2m bpd in the second quarter, while demand slips to 85.6m. The surplus will widen to 1m bpd later in the year as new oil comes on stream from Brazil, Azerbaijan, Kazakhstan and the Sudan. The US Energy Information Agency expects US output to rise by 400,000 bpd by the winter.

A cyclical correction as the global economy slows would not necessarily invalidate the Peak Oil theory. There can be powerful ups and down with an upward “supercycle”, even if the world is gradually running out of fossil fuels.

Reader Michael provided us with more detail on the crunch in India with the story, “Oil firms are weeks away from bankruptcy“:

There was no diesel for a day at a gas station in north India recently. The public sector oil companies are slowing down the issue of new gas connections to households. The private sector oil companies are closing down petrol pumps and exporting petrol and diesel. Kerosene is not easily available in the public distribution system; the open market rate is around Rs 30 a litre when the official rate is under Rs 10.

If you think these are isolated events, think again. A fuel shortage looms ahead of the nation as the oil companies rapidly head towards bankruptcy.

With international crude oil prices hovering around $129 a barrel, the country’s three oil marketing companies – IndianOil, Bharat Petroleum, and Hindustan Petroleum – are collectively looking at losses of Rs 200,000 crore this year. These losses belong to the budget, but finance minister P Chidambaram doesn’t want his own copybook ruined. If these numbers were added to this year’s Union budget, Chidambaram’s fiscal deficit – the borrowings needed to finance government expenditure – would bloat from a fictitious 2.5% of gross domestic product (GDP) to more than twice that figure.

Under the subsidy sharing formula designed by the government, the Oil & Natural Gas Corporation (ONGC), the country’s main oil producer, along with gas pipeline company GAIL is supposed to share one-third of the oil marketing companies’ losses. But ONGC’s turnover for 2007-08 will be around Rs 65,000 crore – one-third of the projected losses. Loss-sharing can thus wipe out ONGC as well.

In less than two months from now, some oil companies will be plain and simple broke as they exhaust their borrowing limits of Rs 90,000 crore. They have already notched up borrowings of around Rs 70,000 crore when their combined net worth is just over Rs 54,000 crore. The only reason they are still able to borrow is because they are owned by the government, and governments are not expected to default.

By early July, they will simply have no cash to run their business and some of them will find it difficult to pay staff salaries. “It is like a time bomb ticking away. If the prices of petro-products are not increased immediately, they will just sink without a trace,” top industry sources said.

What is worse, global suppliers of crude and petro-products are not going to honour contracts unless money is paid upfront, which means the country could be looking at a frightening scenario of a fuel shortage.

Losses on the sale of diesel, petrol, liquefied petroleum gas (cooking gas) and kerosene are already Rs 550 crore a day. What has been especially worrying is the alarming rise in the consumption of diesel. Sources say that diesel consumption has grown 25% since January this year. With world prices of the fuel closer to $160 per barrel, imports will soon have to be reduced.

Private sector refiners like Reliance and Essar are exporting diesel because it is not viable to sell in the local market. Reliance Petroleum has closed down all its 1,432 gas stations.

A spokesman for Essar Oil said the company continued to operate its 1,000-and-odd outlets, but at a reduced scale. According to him, both petrol and diesel are retailed at roughly Rs 9 more than the public sector companies. Clearly, few people will buy fuel when the state oil companies are giving them the same stuff cheaper.

However, the public sector oil companies cannot continue to bleed indefinitely. If they are unable to buy any more diesel abroad due to a shortage of cash, user industries like power, shipping, transport (rail and road) and telecommunications could face a crunch. There could be havoc if the crisis extends to petrol, LPG and even a fuel like kerosene, which is used in the aviation sector.

A good comment by Philip Stephens in the Financial Times, “Uncomfortable truths for a new world of them and us,” is a polite and understated wake-up call to the fading former imperialist of the West. He notes that the countries currently dominant in major international organizations assume that life will continue more or less as now, except the rising powers will have a few more votes. Stephens argues that the advanced economies are psychologically ill prepared for the shift in power and economic might that is in motion and are too often assigning responsibility to third world countries for phenomena where the West is far from blameless.

As uncomfortable as this message is, there is an even grimmer way to cast Stephens’ data. For the first time since the Great Depression, a major financial crisis is centered in first world countries. And the irony, mentioned here before, is that the US’s status is very much like that of Indonesia or Thailand circa 1997, except we have the reserve currency and nukes.

But the ugly fact is that the US (and the UK) has the potential to go from first world to third world on a relative basis. We’ve already have one developing economy trait: the emergence of a super-rich cohort that lives in splendid isolation, often with considerable security.

If you think that’s impossible, remember that Argentina had a spectacularly rapid fall. Bad leadership can destroy an economy in a surprisingly short period of time. Again, the US will hopefully escape that fate, but no matter what happens, our economic strength is ebbing as others are moving forward. A severe crisis in the advanced economies could lead to a bad outcomes even in emerging economies, but that scenario has perils of its own.

From Stephens:

Globalisation belonged to us; financial crises happened to them.

The world has been turned on its head. Consumers in the wealthiest nations are struggling with the consequences of the credit crunch and with the soaring cost of energy and food. In China, retail sales have been rising at an annual 15 per cent. I cannot think of a better description of the emerging global order.

The trouble is that the politics of globalisation lags ever further behind the economics… the west still wants to imagine things as they used to be. In this world of them and us, “they” are accused by Democratic contenders in the US presidential contest of stealing “our” jobs. Now, you hear Europeans say, “they” are driving up international commodity prices by burning “our” fuel and eating “our” food.

The other day I listened to an eminent central banker offer a lucid explanation of the collapse of confidence that last summer paralysed international credit markets…

The crisis, this banker told a conference hosted by the Weidenfeld Institute for Strategic Dialogue, flowed from the coincidence of a global savings glut with the explosion in financial innovation made possible by ever more sophisticated information technology. This had engendered among all those highly paid investment bankers and traders an insouciant indifference to risk. It was always going to end in tears.

The savings had come largely from the fast-growing Asian economies and from the burgeoning incomes of oil and gas producers, though some could be traced to a disinclination to investment in developed nations after the bursting of the dotcom bubble. As risk premiums had fallen and spreads narrowed, central bankers and regulators had warned of the dangers. What they had not foreseen was that the explosion in subprime mortgage lending in the US would be the catalyst for such a sudden bust.

None of the above, I suppose, is any great revelation to those in the banking business now counting the bonuses lost to irrational exuberance. What struck me, though, was how this crisis (no one is sure it is over) provides a perfect metaphor for the new geopolitical landscape.

Think back to the financial shocks of the 1980s and 1990s. For those of us in the west, these were unfortunate events in faraway places: Latin America, Russia, Asia, Latin America again. There was a risk of contagion, but in so far as rich nations paid a price, it lay largely in the cost of bailing out their own feckless banks. The really unpleasant medicine, prescribed by the International Monetary Fund, had to be taken by the far less fortunate borrowers.

The parameters of globalisation were set by the west. Liberalisation of trade and capital flows was a project owned largely by the US. It was not quite an imperialist enterprise, but, while everyone was supposed to gain from economic integration, the unspoken assumption was that the biggest benefits would flow to the richest. The rules were set out in something called, unsurprisingly, the Washington Consensus.

Against that background, the west’s present discomfort is replete with irony. A sizeable chunk of the excess savings that inflated the credit bubble were a product of the Washington Consensus. Never again, the victims of the 1997 east Asian crisis said to themselves after being forced to take the IMF’s medicine in 1997. This would be the last time they were held hostage to western bailouts. Instead they amassed their own huge foreign currency reserves.

So the boot is now on the other foot. The IMF is forecasting that the advanced economies will just about keep their heads above water. With luck, growth this year and next will come in at a touch above 1 per cent. If they do avoid recession – and most of my American friends think it unlikely as far as the US is concerned – they will have to thank robust growth rates in Asia and Latin America. The forecast for China is growth of about 9 per cent in both years, for India 8 per cent and for emerging and developing economies as a whole something more than 6 per cent.

The old powers have not grasped this new reality….. More seats, maybe, at the World Bank, the United Nations and, yes, on the board of the IMF. But the assumption is that the rising powers will simply be accommodated within the existing system….Missing is a willingness to see that this is a transformational moment that demands we look at the world entirely afresh.

One of the reasons for such reticence has been the emergence of another “them and us” – this time within western societies. The “us” in this case are the well educated and well positioned who have been able to extract sizeable rents from the process of global economic integration. The “them” are the under-educated and less fortunate who have seen their jobs lost or their incomes depressed by big shifts in comparative advantage flowing from technological innovation and open economies.

The response of governments thus far has lain somewhere between despair and denial: there is nothing to be done in the face of global market forces; or the benefits of globalisation will eventually trickle down. The active education and welfare policies necessary to ease the adjustment have been conspicuous by their absence. How do you tell your electorates that all the old assumptions about welfare capitalism must be rethought?

Difficult. But these two sets of pressures – between nations and within them – cannot indefinitely be ignored. That way lies an inexorable slide into the beggar-thy-neighbour protectionism that would make the recent financial storm seem like a summer squall. However it is handled, the adjustment process to the new world order will be wrenching. The US and Europe, after all, have between them have enjoyed the best part of two centuries of effortless political and economic hegemony.

There is no reason they should not continue to prosper in a world where power is more evenly spread. Globalisation need not be a zero-sum game. But if the west is going to adapt, it must recognise that it can no longer expect to write the rules.

Satyajit Das has a very useful post, “The Credit Default Swap (“CDS”) Market – Will It Unravel?,” in which he describes some of the ways that CDS may fail to perform as expected in real world situations, ie, when companies start getting in trouble. While this work isn’t quite at the Tanta Uber-Nerd level of detail, it does get more granular than most discussions, which I thought was useful.

Two aspects of Das’ article merit mention. First, he goes through what most may find a surprisingly long list of various ways CDS might not fully cover the risks they are supposed to guarantee even before getting to the big bugaboo of counterparty failure. One case that Das has mentioned elsewhere is that in the one big test of the CDS market to date, Delphi. CDS protection buyers got 37 cents on the dollar when the recovery value on the senior bonds was set by Fitch at 1-10%, meaning the fall in the value of the credit was 90+ cents per dollar, yet the CDS holder got only about 40% of that. That’s a considerable shortfall.

Second, he alludes to rather than spells out the coming-to-a-courtroom-near-you battles over defaulting LBO debt. In this world of covenant lite deals, creditors lack the big stick they had to force either bankruptcy or a restructuring of the debt, namely, if you breached the covenants, the lender could accelerate (demand payment of) the debt. Now if borrowers don’t pay, creditors don’t seem to have much (any?) leverage.

How does this affect CDS? Per Das, for many CDS, non-payment is NOT an event of default. So what good is insurance if it doesn’t cover the most likely outcome for the debt in question? This will make for some interesting theater.

This post also provides some third party estimates of possible losses from CDS counterparty failures. From Das:

The CDS contract and the entire Structured Credit Market originally was predicated on hedging of credit risk. Over time the market changed focus – in Mae West’s words: “I used to be Snow White, but I drifted.” The ability to short credit, leverage positions and trade credit unrestricted by the size of the underlying debt market have become the dominant drivers of growth in the market for these instruments…

Banks have used CDS contracts extensively to hedge credit risk on bonds and loans. The key issue is will the contracts protect the banks from the underlying credit risk being hedged. As Mae West noted: “An ounce of performance is worth pounds of promises.” Documentation and counterparty risk means that the market may not function as participants and regulators hope if actual defaults occur.

CDS documentation is highly standardised to facilitate trading. It generally does not exactly match the terms of the underlying risk being hedged. CDS contracts are technically complex in relation to the identity of the entity being hedged, the events that are covered and how the CDS contract is to be settled. This means that the hedge may not provide the protection sought. In fairness, all financial hedges display some degree of mismatch or “basis” risk.

The CDS contract is triggered by a “credit event”, broadly default by the reference entity. The buyer of protection is not protected against “all” defaults. They are only protected against defaults on a specified set of obligations in certain currencies. It is possible that there is a loan default but technical difficulties may make it difficult to trigger the CDS hedging that loan. Some credit events like “restructuring” are complex. There are different versions – R (restructuring); NR (no restructuring); MR (modified restructuring); MMR (modified modified restructuring). Different contracts use different versions.

“PAI” (publicly available information) must generally be used to trigger the CDS contract. Recent credit events have been straightforward Chapter 11 filings and bankruptcy. For other credit events (failure to pay or restructuring), there may be problems in establishing that the credit event took place.

This has a systemic dimension. A CDS protection buyer may have to put the reference entity into bankruptcy or Chapter 11 in order to be able to settle the contract. A study by academics Henry Hu and Bernard Black (from the University of Texas) concludes that CDS contracts may create incentives for creditors to push troubled companies into bankruptcy. This may exacerbate losses in case of defaults.

In case of default, the protection buyer in CDS must deliver a defaulted bond or loan – the deliverable obligation – to the protection seller in return for receiving the face value of the delivered item (known as physical settlement). When Delphi defaulted, the volume of CDS outstanding was estimated at US$28 billion against US$5.2 billion of bonds and loans (not all of qualified for delivery). On actively traded names CDS volumes are substantially greater than outstanding debt making it difficult to settle contracts.

Shortage of deliverable items and practical restrictions on settling CDS contracts has forced the use of “protocols” – where any two counterparties, by mutual consent, substitute cash settlement for physical delivery. In cash settlement, the seller of protection makes a payment to the buyer of protection. The payment is intended to cover the loss suffered by the protection buyer based on the market price of defaulted bonds established through a so-called “auction system”. The auction is designed to be robust and free of the risk of manipulation.

In Delphi, the protocol resulted in a settlement price of 63.38% (the market estimate of recovery by the lender). The protection buyer received 36.62% (100% – 63.38%) or US$3.662 million per US$10 million CDS contract. Fitch Ratings assigned a R6 recovery rating to Delphi’s senior unsecured obligation equating to a 0-10% recovery band ….

The settlement mechanics may cause problems even where there is no default. One company refinanced its debt using commercial mortgage backed securities (“CMBS”). The company was downgraded by rating agencies. A shortage of deliverable obligations (the company used the funds from the CMBS to repay its bond and loans) meant that the CDS fee for the company fell sharply (indicative of an improvement in credit quality). This resulted in mark-to-market losses for bemused hedgers. This is known in the trade as an “orphaned CDS”.

In the case of actual defaults the CDS market may provide significant employment to a whole galaxy of lawyers trying to figure out whether and how the contract should work…

CDS contracts substitute the risk of the protection seller for the risk of the loan or bond being hedged. If the seller of protection is unable to perform then the buyer obtains no protection.

Currently, a significant proportion of protection sellers is financial guarantors (monoline insurers) and hedge funds. Concerns about the credit standing of monolines are well documented….

For hedge funds, the CDS is marked-to-market daily and any gain or loss is covered by collateral (cash or high quality securities) to minimise performance risk. If there is a failure to meet a margin call then the position must be closed out and the collateral applied against the loss. In practice, banks may not be willing or able to close out positions where collateral isn’t posted.

ACA Financial Guaranty sold protection totaling US$69 billion while having capital resources of around US$425 million. When ACA was downgraded below “A” credit rating, it was required to post collateral of around US$ 1.7 billion. ACA was unable to meet this requirement. The banks have agreed to a “forbearance agreement” whereby the buyer of protection waived the right to collateral temporarily. ACA subsequently has been downgraded to “CCC” reducing the value of the CDS contract and the protection offered. The problems at ACA are not unique.

A critical element is the level of over-collateralisation. The buyer of protection will want an initial margin to cover the risk of a change in the value of the contract and the failure by the seller of protection to meet a margin call. The seller of protection wants to increase leverage by reducing the amount of cash it must post as initial margin. It is possible that the level of initial collateral may prove be too low. Collateral models use historical volatility and correlation that may underestimate the risk. The entire process also assumes liquidity in the underlying CDS market that may be absent in a crisis.

CDS contracts entail significant operational risks. Delays in documenting CDS contracts forced regulators to step in requiring banks to confirm trades more promptly. Where collateral is used, there are additional challenges of the accuracy of mark-to-market of CDS and monitoring of collateral.

If the CDS contracts fail then “hedged” banks are exposed to losses on the underlying credit risk. Recently, one analyst suggested that losses from failure of CDS protection sellers to perform could total between US$33 billion and US$158 billion [Andrea Cicione “Counterparty Risk: A Growing Cause of Concern” (25 January 2008) Credit Portfolio Strategy - BNP Paribas Corporate & Investment Banking]. This compares to the around US$110 billion that banks have written off to date. While it may be unlikely that the CDS market will fail entirely it is possible that losses on the hedges will add to the losses that the banks have already incurred.

The CDS market entails complex chains of risk. This is similar to the re-insurance chains that proved so problematic in the case of Lloyds. The CDS markets have certain similarities with the reinsurance markets. The CDS fees like the reinsurance premiums are received up front. In both cases the risks are both potentially significant and “long tail” – they do not emerge immediately and may take some time to be fully quantified. As in the re-insurance market, the long chain of CDS contracts may create unknown concentration risks. Defaults may quickly cause the financial system to become gridlocked as uncertainty about counterparty risks restricts normal trading.

The impact of a bankruptcy filing by Bear Stearns on the OTC Derivatives market, including the CDS, was probably one of the factors that influenced the Federal Reserve and US Treasury’s decision to support the rescue of the investment bank. Barclays Capital recently estimated that the failure of a dealer with $2 trillion in CDS contracts outstanding could potentially lead to losses of between $36 billion and $47 billion for counterparties. This underlines the potential concentration risks that are present.

Over the last year, securitisation and the CDO (collateralised debt obligation) market have become dysfunctional. As the credit crisis deepens, the risk of actual defaults becomes real. Analysts expect the level of defaults to increase. The CDS market is about to be tested.

Note: this post has been shortened from its original version due to an error pointed out by alert readers. Apologies!

The Term Auction Facility is considered within the Fed and by the Street to be a success, even though academic studies have found that the TAF did not achieve its intended goal of reducing risk premia in the money markets (high spreads are a Bad Thing, a sign banks aren’t willing to lend to each other). And there remains the looming, unanswered question of how to wean the financial services industry off such a substantial support.

Of course, now that the Fed is stuck with rolling these loans until the banking industry is healthy enough to remove this prop, the monetary authority has tried to put a good face on the situation, rebranding the TAF as a tool and hinting it might be ongoing. As Vice Chairman Donald Kohn said in a speech Thursday:

I start from the premise that central banks should not allocate credit or be market makers on a permanent basis. That should be left to the market–or if externalities or other market failures are important, to other governmental programs. The Federal Reserve should return to adjusting reserves mainly through purchases and sales of the safest and most liquid assets as soon as that would be consistent with stable, well-functioning markets…

However, the Federal Reserve’s auction facilities have been an important innovation that we should not lose…. The new auction facilities required planning and changes in existing systems, and we should consider retaining the new facilities for the purposes of bank discount window borrowing and securities lending against OMO-eligible paper, either on a standby basis or operating at a very low level when markets are functioning well in order to keep the new facilities in good working order.

That’s nice in theory, but in practice, it’s going to be very hard to wean banks off the TAF. The central bank certainly can’t do it when either the banking system or the economy look weak, and you can be sure banks will howl about possible damage and risk even in better times. As the comic said, when the bank loans you $10,000, it owns you, but if it lends you $100,000,000 in this case, add a few more zeros), you own it.

So why is the Fed looking at broadening the types of collateral it is willing to accept? Perhaps it sees or worries about new problem areas, which in some sense suggests that the TAF hasn’t yet achieved the hoped-for results (indeed, there are signs of continuing money market stress). But persisting in a course of action that is not succeeding is not intelligent. As we noted earlier:

Yet again, the Fed is acting out the cliche, “if all you have is a hammer, every problem looks like a nail.” Central banks know how to deal with liquidity crises; the TAF and its other facilities are well suited for that sort of problem. But fundamentally, the financial services industry is suffering from a solvency problem. Too many of the assets on its balance sheets contain loans to borrowers who lack the ability (and in some cases the desire) to make good on their debts. Forcing interest rates into negative real interest rate territory will only help a portion of the underwater borrowers. In addition, a distortion this severe is almost guaranteed to produce more misallocation of capital, which is not good for the US in the long term. And if the Fed miraculously manages to keep asset values from falling further, it is merely delaying the day of reckoning, and Japan is the poster child of the results of such a Phyrric victory.

Kohn also suggested that not only might the US central bank accept foreign securities as collateral for loans, but that central bankers might set up a joint facility for global financial institutions. While this on one level sounds practical, a creation of such a vehicle represents a serious erosion of national sovereignty:

Globally active banks manage their positions on an integrated basis around the world, and pressures originating in one market are quickly transmitted elsewhere. Central banks should consider how to adapt their facilities to help these institutions mobilize their global liquidity in stressed market conditions and apply it to where it is most needed. That approach will require the consideration of arrangements with sound institutions in which central banks would accept foreign collateral denominated in foreign currencies. Those arrangements are under active study and a number of issues need to be resolved. It is possible that over time, major central banks could perhaps agree to accept a common pool of very safe collateral, facilitating the liquidity management of global banks. The stipulation that the institutions be sound is important: Decisions about lending to troubled banks should be made by home country authorities with knowledge and responsibility.

Dani Rodrik positied that countries cannot simultaneously have democracy, national sovereignty and global economic integration. I wonder which two of those three the US will choose.

White House issues climate report 4 years late PhysOrg

McCain’s health terrible Diane Francis. How come it takes a Canadian to point out the obvious?

The Costanza Energy Policy: 25 Ways to Drive Oil to $150 Barry Ritholtz

Another perspective on liquidity Willem Buiter

Gold Newsletters Remain Too Bullish Mark Hulbert, Marketwatch

Charges of Insider Trading for a Wall Street Luminary New York Times

Antidote du jour:

The dollar rose today, and gold has fallen below $900 as f this writing due to revisions in the first quarter GDP release that increased growth from “anemic” to “slightly less anemic”.

Note that there was considerable skepticism about the initial 0.6% GDP growth figure (the revised level is 0.9%) because the total was entirely due to inventory increases, which some cynics regarded as a fudge. The current version of the figure attributes more to improved exports, less to inventory gains.

The continued rally in the dollar is due to a perception that the Fed might start raising interest rates sooner rather than later. As much as I think that would be the better course of action (see here for why), those views seem overdone.

The big reason is the Fed is very concerned about the housing market. Low short rates will reduce ARM reset shock. ARM resets peak in August and continue at high levels through 2008:

The second is that 0.9% nominal reported growth, likely a contraction in real terms (the deflator used was 3.5%; many argue that closer to 5% is more accurate), hardly indicates that the economy is out of the woods. As long as the economy looks to be at risk of falling into a recession, it will take more courage than the Fed has shown thus far to increase interest rates. As Jeff Frankel noted:

It is hard to say that we entered a recession in the first quarter, without a single negative growth quarter, let alone two of them. Even so, three minor qualifications to that 0.9% remain:
1) The number will be revised again, and could move in either direction.
2) A bit of the measured growth consisted of an increased rate of inventory investment, which was almost certainly not desired by firms and is likely to reverse in the 2nd quarter
3) As Martin Feldstein has pointed out, the QI growth number is defined as the change for the quarter as a whole relative to QIV of 2007; within QI, the information currently available suggests that GDP fell from January to February to March.

The reason why many suspected a QI turning point in the first place is employment, which is virtually as important an indicator to the NBER BCDC as is GDP. Jobs have been lost each month since January. Total hours worked is my personal favorite, because in addition to employment it captures the length of the workweek, which firms tend to cut before they lay off workers. This indicator too has been falling.

And of course there are the longer run indicators that have been very worrisome for almost a year: depressed household balance sheets, mortgage defaults, high oil prices, low consumer confidence, etc.

The economy is a four-engine airplane flying at stall speed, skimming along the top of the waves without yet going down. Real gross domestic purchases increased only 0.1 percent in the first quarter. But exports provided an important source of demand for US products, and are likely to remain a positive engine of growth in the future. The same is true of the fiscal policy engine, as consumers receive and spend their tax cuts in the 2nd and 3rd quarters. On the other wing, the investment engine has been knocked out; inventory investment is likely to fall and residential construction will remain negative for sometime. The big question mark is the consumption engine. Is the long-spending American household taking a hard look at its diminished net worth and taking steps to raise its saving rate above the very low levels of recent years?

We are already clearly in a “growth recession.” All in all, I put the odds of an outright recession sometime this year at greater than 50%. That number is meant to add together:
(1) the odds that it will turn out that we have already entered reached the turning point and
(2) the odds that the sharp recent expansions in monetary and fiscal policy will succeed in postponing the recession, but only until later in the year.
Come the fall, if demand starts to slow, I can’t see either the Fed delivering a second big dose of interest rate cuts (as they were able to in the 2001 recession, when the dollar was strong and inflation under control), nor the government delivering a second big dose of tax cuts (as they could in the 2001 recession, when the budget outlook was strong and debt under control).

Note two things in Frankel’s commentary: he sees the only possible of engine of growth as consumption, yet as we have discussed elsewhere, the current US level of consumption, with zero to negative consumer savings, is simply unsustainable. The longer the powers that be try to hold off an inevitable slowdown, the worse the collateral damage is likely to be.

Second, note that Frankel doesn’t even consider the possibility of a Fed rate increase given the weak fundamentals; he simply sees the ability to cut further as constrained by inflation and the dollar.

Two UK columnists looked at the credit markets, and neither liked what he saw. And they wrote it up more colorfully than most of their American counterparts would have.

The first, Nils Pratley of the Guardian, tells us that that the idea that the credit crisis is on the wane is more than a tad optimistic:

Some say the credit crisis is over. Not Tom Attwood, managing director of Intermediate Capital Group (ICG), a firm which makes few waves outside financial circles. Its business is mezzanine finance, specialist high-risk lending to private equity firms. That puts it at the frontline of the financial turmoil and Attwood’s bleak assessment of conditions yesterday is worth quoting.

Sub-prime, he says, was merely a catalyst to the bursting of the credit bubble. It was going to happen anyway. “Credit disciplines across almost all markets were bypassed in favour of loan book growth at almost any cost.”

So far, so uncontroversial, and Attwood has been singing a similar tune for a while. The key point is that he can’t spot the break in the clouds that many bankers claim to see. “What was a liquidity crisis is likely to lead to a credit crisis,” he says. “Buy-outs structured in the benign credit climate prior to August 2007 were often over-geared with no margin for safety. This is likely to lead to an increase in default rates over the next year or two.”

A year or two? Well, yes. ICG assumes there will be a recession in the US, the UK, Spain – the markets most pumped up with credit – and a slowdown elsewhere.

His bottom line is: “There is no sign of a return to liquidity in debt markets as a whole. Raising new funds will become increasingly difficult across the board.”…

But the implication is that an awful lot of duff loans are still to surface. Attwood’s killer fact is that in 1999 ICG was one of three funds in Europe in the mezzanine and leveraged loan business; by 2007, there were 112. Some of the inexperienced losers are known already, but there’s surely more pain to be revealed.

Ambrose Evans-Pritchard of the Telegraph looks at the rise of credit default swaps prices on investment banks and increasing interbank spreads, both indicators of heightened concern about counterparty and systemic risk.

No wonder Mishkin resigned. He probably doesn’t want to go though another month like March. But his end-of-August departure date may not be soon enough to save him from more crisis management.

From the Telegraph:

The debt markets in the US and Europe have begun to flash warning signals yet again, raising fears that the global credit crisis could be entering another turbulent phase.

The cost of insuring against default on the bonds of Lehman Brothers, Merrill Lynch and other big banks and brokerages has surged over the last two weeks, threatening to reach the stress levels seen before the Bear Stearns debacle. Spreads on inter-bank Libor and Euribor rates in Europe are back near record levels.

Credit default swaps (CDS) on Lehman debt have risen from around 130 in late April to 247, while Merrill debt has spiked to 196. Most analysts had thought the coast was clear for such broker dealers after the US Federal Reserve invoked an emergency clause in March to let them borrow directly from its lending window.

But there are now concerns that the Fed itself may be exhausting its $800bn (£399bn) stock of assets. It has swapped almost $300bn of 10-year Treasuries for questionable mortgage debt, and provided Term Auction Credit of $130bn.

“The steep rise in swap spreads this week is ominous,” said John Hussman, head of the Hussman Funds. “The deterioration is in stark contrast to what investors have come to hope since March.”

Lehman Brothers took writedowns of just $200m on its $6.5bn portfolio of sub-prime debt in the first quarter even though a quarter of the securities had “junk” ratings, typically worth a fraction of face value.

Willem Sels, a credit analyst at Dresdner Kleinwort, said the banks are beginning to face waves of defaults on credit cards, car loans, and now corporate loans. “We believe we’re entering Phase II. The liquidity crisis has eased a little, but the real credit losses are accelerating. The worst is yet to come,” he said.

The jump in corporate bankruptcies has not yet been picked up by the usual indicators, which tend to lag the market, lulling investors into a false sense of security. The true losses are already known to specialists in the business, said Mr Sels.

Note the Fed does have ways to surmount its balance sheet constraints other than selling liabilities (which would be inflationary), but it is possible that the markets will react badly to any such move. The pushback would probably come in the form of higher interest rates on ten year and longer maturity Treasuries. Oh, wait, we’re seeing that already:

Treasurys were tripped up for a second day Wednesday, due to a poor auction and better-than-expected durable-goods data.

The selling pushed yields on the two and 10-year notes above the upper end of the trading range that has been in place since late April.

The 10-year note’s yield rose above 4% for the first time since early January, while yields on the two and five-year notes hit their strongest levels in four months on an intraday basis.

The benchmark 10-year note dropped 23/32 point, or $7.1875 for every $1,000 invested, to yield 4.009%. That is up from 3.923% Tuesday as yields rise when bond prices fall. The two-year note lost 7/32 point to 2.611%.

The government’s durable-goods report in April set off the selling, as it alleviated worries of a protracted recession. That bolstered speculation in interest-rate futures markets that the Federal Reserve may start tightening monetary policy by year end amid continued inflation concerns.

Note one bit of cheery news: this Journal piece did say the TED spread, another indictor of perceptions of interbank risk, was tightening.

The housing contraction in England, not surprisingly, is following a similar trajectory to that in the US, and as here, tighter credit is the main culprit. However, since England’s overall consumer debt levels were even higher than those in the US, it’s an open question as to how deep the downside will be.

One factor that may cushion the fall is that London, always a favorite spot for foreign buyers, is a far greater proportion of the value of the UK market than Manhattan is of the US. But would expats venture much further than the preferred haunts, such as Mayfair, Belgravia, Chelsea, and Kensington?

From Bloomberg:

U.K. house prices fell in May by the most in at least 17 years as the shortage of credit starved the property market of buyers, Nationwide Building Society said.

The price of an average home dropped 2.5 percent from April to 173,583 pounds ($344,000), Britain’s fourth-biggest mortgage lender said today in a statement. That’s the biggest drop since the index started in January 1991. From a year earlier, prices fell 4.4 percent.

Bank of England Governor Mervyn King predicted this month that property values are “likely to fall further” and said there is a risk that the U.K. economy may contract. Mortgage approvals fell in April by 39 percent from a year earlier, the British Bankers’ Association said this week.

“Tighter credit conditions in the market at present are making it more difficult for borrowers to obtain loans,” said Nationwide Chief Economist Fionnuala Earley in a statement. “More weak economic news added to the gathering momentum of negative sentiment about the housing market.”

Property values have now declined for seven months, the longest streak of drops since 1992…

U.K. banks increased the cost of home loans with a 5 percent down payment to the highest in more than eight years in April, failing to pass on the Bank of England’s three interest-rate cuts since December.

As the mortgage mess grinds on, just as with body counts in war, we are getting to the point, as matters get worse, that the numbers don’t have the impact they used to or ought to. The forecast that housing prices may fall 30%, which would put over 40% of the US mortgages underwater, is now a possible outcome, not a scene from a financial horrowshow.

And even though many of the stories of the crisis have now assumed a ritual quality, with various archetypes forming (Hapless Borrower, Optimistic Bottom Fisher, Heinous Mortgage Lender), there are some accounts that are, well, unusual enough to merit attention.

This tale doesn’t score high in the schadenfreude or pity category, but it does serve to reinforce stereotypes about financial institution bad behavior, particularly if you place stock in old-fashioned ideas like contracts and legal procedures.

From Nathalie Martin at Credit Slips:

This site has had some fabulous posts about mortgage fees in Chapter 13 and mortgage services fraud. This is a short story about mortgage fees or funky interest rates, or perhaps just plain old fraud, in the context of the stripdown of a mobile home. Many of us know about negative amortization mortgages, ARMs that adjust up when the rate goes up, ARMs that adjust up no matter what happens, 2/28s, and a host of other exotics. I think, however, I have discovered a new type, one that has the same principal balance no matter how much money the borrower pays on the loan. I call it the magical mystery mortgage.

A client in our Southwest Indian Law Clinic had previously filed a Chapter 13, stripped down the mortgage on his mobile home from $28,570 to $12,000, paid $9,000 in principal toward the $12,000, then defaulted. The case was ultimately dismissed and the mortgage company (we’ll call it “Voldemort Mortgage,” just for fun) came back with a vengeance, threatening repossession or foreclosure, etc. We entered the case and were acknowledged by the mortgage company as the attorneys for the borrower. We then attempted to get Voldemort to take what was left on the bankruptcy payments, rather than insisting on the full pre-bankruptcy loan amount. They agreed, so we thought. In exchange for an extension, the client agreed to pay $1,400 up front and the remaining $1,600 over a period of roughly five months.

Before the terms were memorialized, however, Voldemort sent a loan extension agreement directly to the client for his signature, without first providing it to us for review. I go into all this just so you can see what goes on. It is not pretty. The loan extension agreement did not reflect the terms of the agreement as verbally explained to the client. Instead it set the balance of the loan due at $28,570, not the $3,000 we had negotiated. We only discovered that the new agreement did not reflect the oral agreement, after Voldemort presented it to our client for his signature. Oddly the balance due, the $28,570, supposedly took into account the bankruptcy payments and a $1400 payment made by the client at the time of execution of this agreement. The client then made yet another payment of $800. The new balance? You guessed it…..$28,570.

We called Voldemort, and the student and I and finally reached someone in the bankruptcy department. The conversation went something like this.

Student attorney: We do not appreciate that you scared our client into signing something without our consent when you knew we represented him. You should never contact him directly. You know that right?

Silence.

Student attorney: We are really calling to find out how all the various payments have been applied. Starting out with the $9,000 paid during the bankruptcy….how was that applied? The principal seems not to have moved a penny (literally).

Voldemort: We bought these loans from Chase and they are so tricky. The borrowers have to make the payments in 30 day increments and if they don’t, say they pay on the first and a month is 31 days, the interest rate just skyrockets. Yeah…these are designed to trip people up and they do. It is hard to get ahead with these.

Student attorney: But how was the $9,000 applied?

Voldemort: To the interest. See…the trustee in the bankruptcy did not comply with the 30 day rule and the interest rate just went crazy during the bankruptcy.

Student attorney: Is this the bankruptcy department?

[my sentiments exactly. Since this is a stripdown or cramdown, the trustee clearly need not pay under this funky system…surely we had reached the Chinese culture department instead, right?]

Voldemort: Yes, this department processes all bankruptcies, why?

[explanation of the chapter 13 rules for stripping down loans, which were clearly as much as a mystery to this person as the principal calculations].

Student Attorney: We just want to know why the principal balance does not ever change. Please forward us all the loan documents and the payment history so we can see how this works.

Voldemort: Ok, but seriously, I told you why. Interest. Super-high interest. The rate is just so high, so high it is amazing, isn’t it?

Student Attorney: Amazing.

Niceties are exchanged and the conversation ends. So far, no papers explaining all this. I will keep you posted. This just confirms what you already know, namely that there are some very odd things going on in the mortgage world. Only a tiny fraction of them end up in bankruptcy. The rest are hidden from view. Call this high interest, or whatever you want. I am tempted to just call it not applying the payments to the loan. Is this legal? I assume no, but given the absolute lack of regulation of these things, it is possible that it is. Consumers can’t fight this kind of thing, at least without an attorney, something few in this boat can afford.

I don’t know if you fully appreciate what happened in that last paragraph. Here you have a card carrying, “defend the rights of the little guy” attorney reduced to saying that maybe, just maybe, the financial wizards had succeeded in creating a product in which, if you fell into the right trap, you never could pay down the principal. That’s a form of thralldom.