naked capitalism

We featured reports earlier this year on plant closings in China, and the suffering in manufacturing areas is becoming more acute as the global downturn cuts into Chinese exports.

Reader Michael sent us this report on China’s toymakers, but it also stresses that China may be more vulnerable to a global financial shock than advanced economies. Part of the problem is that many manufacturers were also speculating in currencies or commodities. We also feature a second report from the Guardian, which says that growth in China may fall below 8% due to the drop in manufacturing. While that sounds like a high-class problem, in fact it would be difficult for China, which requires 8% expansion to maintain employment levels. Chinas’ fragile social contract requires more growth to maintain stability. Protests are taking place now, and the worst has yet to arrive.

From China Stakes:

The world financial convulsion is seeping into the Pearl River Delta, base camp of MADE IN CHINA, via Hong Kong. Toy export processing businesses, many owned by HK businesspeople, are closing their doors or going bankrupt because of order reductions from the United States and Europe, or huge losses from inept speculation in financial derivatives…

According to Yu Wenfeng, head of the Assembly Department of Smart Union Group’s Po Shan factory, located in the town of Zhangmutou, Dongguan, orders have actually been pretty good even in early September, and workers have sometimes needed to put in overtime. But insiders disclose that in 2007 Smart Union Group invested and lost 100 million yuan in Fujian Tiancheng Mining, which, along with another HKD 200 million lost in the stock market by some shareholders, brought down the company…

Chuangyi Toys in Shenzhen, a subsidiary of Hong Kong Hua Xing Group, announced its closure on the same day. The boss has absconded, leaving nearly 1,000 employees jobless. The Longgang District Government in Shenzhen had to seal up and sell the property to pay wages to employees who hadn’t received any for a long time.

The spate of closures or bankruptcies of toy companies is not a coincidence. Wang Jun, chairman of the Guangdong Economic Society and vice-president of Lingnan College at Sun Yat-Sen University, points out that the impact of the financial turmoil on China’s tangible economy may be earlier than developed countries. “Economic recession in developed countries triggered by the financial crisis will lead to the reduction of import orders for local enterprises.”

The continuous decline of export growth supports such a judgment. According to customs statistics, during the first three quarters of this year, toy export turnover reached $ 6.31 billion, a growth rate of 3.7%, which is 16.3% below the same period of last year. From January to July, 3507 toy enterprises in China’s showed good export performance, a decrease of 52.7% over the same period of last year.

“Guangdong, whose processing trade accounts for nearly 60% of the whole country’s, will be the first to be affected by the financial crisis,” Wang Jun said. The published data show that from January to July this year, toy export firms in Guangdong dropped by nearly 80 percent. The number of toy exporting businesses in Guangdong now totals only 1404, with 3618 firms having withdrawn from the export market.

Zhao Lei, of Goodbaby Child Products Co., believes that the overwhelming majority of toy businesses in Guangdong are OEM-based with low margins, facing fierce competition, and prone to hiccups in the external environment. That a closures wave is prominent in Guangdong should come as no surprise.

The bankruptcy of toy businesses is only the top of the berg in China. With the spread of financial crisis to the tangible economy, SMEs will go bankrupt one after another when even strong large-scale enterprises are unable to remain unscathed…

As with the last round of closures of a large number of SMEs, many closed companies are OEM businesses with a single product and a high production, generally over-reliant on single market structure. Any substantial reduction in orders makes survival iffy.

Ye Zhongping, on the board of directors of Guangdong Forever Industrial Development Co. and known for his active response to foreign anti-dumping accusations, has extensive experience in foreign trade. In his view, before July, the collapse of a large number of SMEs was due mainly to rising raw material and labor costs, tightening processing trade policy, reductions of the export tax rebate, and continuous RMB appreciation.

“But after July, the collapse of so many large firms is directly related to the financial crisis.” Ye said that along with this, many companies had invested large sums in securities and commodities markets, which have fallen sharply….

With the credit crunch sweeping through western financial institutions, Hong Kong and the Mainland banks are tightening up on credit, which will result in the further tension for many businesses. Henry Tang, the Chief Secretary for Administration in Hong Kong, said a few days ago that the closure and layoff wave among Hong Kong enterprises will have a strong impact on the Pearl River Delta economy.

The Guardian today, in “Chill winds blow through China’s manufacturing heartland,” tells a similar story, abeit with a broader focus than the toy industry:

Two weeks ago, toymaking giant Smart Union was churning out goods for children across the United States and Europe. Now it is in liquidation and 7,000 former employees are in shock.

“One day we went to work as usual, the next it was all closed,” said Wei Sunying, gazing through the barred gate of the factory in Dongguan in southern China where she spent eight years painting plastic components in a fume-filled room…

Few in the west have heard of Dongguan, but the chances are that your shoes, your TV or your children’s toys originated here. Exports have built a city of up to 14 million inhabitants — twice the population of Greater London — almost all migrant workers from the countryside. Its economy has grown 15% annually in recent years.

Now the global financial and economic crisis is proving the final straw for exporters already punished by rising costs and a stronger currency.

In the last year, chill winds have blown through the baking Pearl River Delta. Sixty-seven thousand small and medium-sized businesses in China collapsed in the first half of 2008, many in these manufacturing heartlands, says the national economic planning body. Toy firms have been particularly badly hit, thanks to safety scares and product recalls. Textile firms, with wafer-thin margins, are also reeling.

Next came tighter credit for many foreign-owned firms, such as Hong Kong’s Smart Union. And then, in the last two months, a sharp drop in US and European demand as consumers reined in spending.

A local trade association predicts that by the end of January, Dongguan and its neighbours Shenzhen and Guangzhou will lose 9,000 of their 45,000 factories.

“Many factories are looking at completely empty order books,” warned Stephen Green, head of China research at Standard Chartered, who believes the export sector will be stagnant and could even shrink next year.

Green predicts that China will grow 7.9% next year — well below the double-digit figures enjoyed over the last half decade — while others suggest it could fall closer to 7%.

That sounds enviable to western countries facing recession. But with the working age population still growing, China needs at least 8% growth to maintain the current employment rate. And the fall-out will be highly concentrated in provinces such as Guangdong.

“The social impact of this is going to be huge. The problems are getting bigger and bigger,” said Wooyeal Paik, who is researching Dongguan’s industry and migrant workforce at the University of California at Los Angeles.

“Impromptu protests by disgruntled workers left jobless and without pay are becoming more common; they have resorted to petitioning local officials for backpay because they have few other ways to remonstrate and be compensated.

“They will complain more and they will go to local government offices more… You will see demonstrations and picketing. And probably there’s a risk of violence against bosses — especially foreigners.”…

It’s a sobering end to the dream which lures millions of workers to Dongguan each year, where they struggle and study their way towards the promise of a regular income; perhaps even a place in the burgeoning middle classes. At the city’s night schools, thousands of workers end their long days with classes on everything from car maintenance to law.

Bob Li is one of the area’s success stories. He arrived in 1995 as a casual labourer. “Everyone in my hometown had heard Guangdong was covered in gold,” he said.

Now he manages a factory for Richall, which supplies durable bags to companies such as Walmart, Carlsberg and Disney. Twenty-five thousand totes for Tesco are stacked up awaiting delivery.

But he is unnerved by the economic downturn.

“These days it is getting more and more difficult for factories like us,” he said, citing the cost of wages and materials.

“The exchange rate is already a huge issue here; people are losing interest. The price of our materials has risen because they’re made from oil… Taken together, costs have risen by 30%-40%.”

To some extent, Dongguan has become a victim of its own success. The rising prosperity of the region has created inflationary pressures. Workers want higher wages; new labour laws are designed to wipe out sweatshops but bring higher costs, which squeeze many companies.

Manufacturers have already fled inland to cheaper provinces, in many cases encouraged by Guangdong authorities, who hoped to move the province up the value chain — condensing 200 years of western industrial history into fewer than 15.

“We have a policy to empty the cage for the new birds,” Guangdong’s vice-governor, Wan Qingliang, told reporters this month.

“The ultimate target is to build the Pearl River Delta into the core region of modern manufacturing.”

Others are unsure of the wisdom of the policy in the face of a worldwide downturn.

“Places like Guangdong miscalculated the development of the economy. They actually tried to push those labour intensive and small and medium sized enterprises out of the [established industrial] area because they wanted hi-tech industries there. But when something bad happens, like the economic downturn, what are they going to do?” said Paik.

He acknowledges that numerous East Asian economies, such as Japan, have moved up the value chain in just the same way; and that the Chinese government deserves to be confident, given its economic record.

“But they haven’t experienced a serious economic downturn except right after 1989 and have been overconfident in their policy of the quick transformation of industrial structure toward hi-tech in Guangdong,” he cautioned.

The risk is that officials push the city off the economic ladder rather than up it. Whether new subsidies, export tax rebates and other support for small businesses can save them remains to be seen.

Yet China’s rising living standards in the 30 years since economic reforms were launched has left most people optimistic about its long-term prospects. Migrant workers returning home think they may come back in a few years.

One of the widely criticized features of Japan’s approach to its post-bubble crisis was that its regulators tried for some time to avoid the recognition of bank losses. In a deflationary environment, it was not clear how this would lead to a better ending, since with a flagging economy and no inflation to reduce the real (as opposed to nominal) value of the debt, there was no reason to expect the borrowers’ ability to pay to improve. Thus, these dud assets would remain dud assets until some banks (occasionally) made large writeoffs, forcing others to at least whittle away at their dud loans, and a worsening of the downturn in the late 1990s and some financial firm failures finally forced the government to recapitalize banks.

The latest proposal from Bernanke has Japan written all over it. Rather than let the housing market fall to its sustainable price level (in the long run, housing cannot trade far out of line to incomes) and address the damage to bank balance sheets directly, through consolidation and recapitalization, the Fed chair is instead suggesting to not merely continue to support the de facto guarantees to Freddie and Fannie debt, but to continue to provide some sort of prop to the MBS market.

Note that this runs counter (philosophically, at least) to what Paulson said in the conservatorship announcement. that Freddie and Fannie would expand their balance sheets in 2009 but start shrinking them in 2010. We said at the time we doubted that would happen and indeed, the script is already being revised.

The US over time needs to reduce its subsidies to the housing market. It may be quite a while until that can be done, and for political and practical reasons probably has to wait until we are past the downturn we are entering. But it is appalling that the authorities are already renouncing the few commitments to that goal that they have made.

And this of course misses another issue. The Fed, and ultimately the US taxpayer, cannot serve as the guarantor of the entire financial system, which appears to be the posture it is taking. The Fed has already moved to take on considerable risk not only through its alphabet soup of domestic programs, but now has considerable foreign exposure through dollar swap lines.

From Bloomberg:

Federal Reserve Chairman Ben S. Bernanke said the market for mortgage-backed bonds will require some form of government support through either guarantees or insurance programs to weather times of heightened stress.

The Fed chief also said Fannie Mae and Freddie Mac, the largest sources of money for U.S. home loans, should retain some form of government support and oversight even if the companies are transformed from their current federal conservatorship to become private companies…. Bernanke said the current crisis shows there wouldn’t be a mortgage securities market without some government backing.

“The U.S. government’s strong and effective guarantee of the obligations issued under the current government-sponsored enterprise structure must be maintained,” Bernanke said today in remarks to a conference in Berkeley, California. “If the GSEs were privatized, it would seem advisable to retain some means of providing government support to the mortgage securitization process during times of turmoil.”

The vagueness in this statement is deeply troubling. Bernanke wants the GSEs privatized, yet still wants government support to the MBS market. How is that supposed to work, exactly? A new Federal guarantee program, the son of Freddie and Fannie, to compete with the privatized Freddie and Fannie?

In fact, he considers that to be a completely reasonable idea:

One approach would be to create a government bond insurer which would allow issuers to obtain a government guarantee for their bonds for a fee, the Fed chief said.

“This new agency would offer, for a premium, government- backed insurance for any form of bond financing used to provide funding to mortgage markets,” Bernanke said. Mortgage securities “issued by the privatized GSEs as well as mortgage- backed bonds issued by banks would be eligible.”…

Bernanke also discussed the option of covered bonds, while noting that they might be less competitive with existing finance options. Covered bonds offer banks a way to raise money for new mortgages without either selling the loans or packaging them into securities. Instead, a bank issues bonds that are backed by a dedicated and regularly updated pool of loans, which stay on the bank’s balance sheet.

Another alternative for Fannie Mae and Freddie Mac would be a public-utility model, where the two remain as shareholder- owned corporations and are overseen by public boards, Bernanke said.

“Beyond simply monitoring safety and soundness, the regulator would also establish pricing and other rules consistent with a promised rate of return to shareholders,” he said.

The reason Freddie and Fannie were privatized, and were NOT fully taken over by the government (roughly 20% of the shares remain outstanding) is that the powers that be do NOT want to consolidate Freddie and Fannie debt on the Federal balance sheet. The same problem would occur with any new entity once it had been in operation a few years.

The efforts to get a covered bond market started here have produced underwhelming results. And the “utility model” sounds like largely reverting to status quo ante. We tried that before and it didn’t work, remember? If the GSEs are properly capitalized as private companies without Federal support, they would have to have balance sheets a great deal smaller than what they are now. Bernanke simply refused to acknowledge the elephant in the room.

But more troubling than the particulars is the philosophy:

….it would seem advisable to retain some means of providing government support to the mortgage securitization process during times of turmoil.

That goes WAY beyond merely continuing government support for mortgages already issued or guarnateed by the GSEs. This implies an ongoing commitment. How do you provide support during times of turmoil and not other times? This is either appallingly naive or patently dishonest. Take your pick.

Investment banks? What investment banks, says the alert reader. They are all gone, either bought by big banks, dead, or forced to become them so as to be able to pull funds from the Federal Reserve more readily.

The Financial Times report that the changes to the bankruptcy law in 2005 may have played a role in the undoing of these firms. The danger for an investment bank, as the Bear Stearns case illustrated, is that counterparties can become nervous about having credit exposure and can start curtailing certain types of activities and close accounts that would be frozen in bankruptcy. Worse, if a firm is downgraded beyond a certain point, counterparties will stop trading with the troubled firm because exposure to that firm would get them downgraded. And an inability to trade is a death knell for a securities firm.

The irony is that carveouts in the 2005 bankruptcy reform bill intended to help investment banks appear to have worked in the opposite fashion. From the Financial Times:

Wall Street unwittingly created one of the catalysts for the collapse of Bear Stearns, Lehman Brothers and American International Group by backing new bankruptcy rules that were aimed at insulating banks from the failure of a big client, lawyers and bankers say.

The 2005 changes made clear that certain derivatives and financial transactions were exempt from provisions in the bankruptcy code that freeze a failed company’s assets until a court decides how to apportion them among creditors.

The new rules were intended to insulate financial companies from the collapse of a large counterparty, such as a hedge fund, by making it easier for them to unwind trades and retrieve collateral.

However, experts say the new rules might have accelerated the demise of Bear, Lehman and AIG by removing legal obstacles for banks and hedge funds that wanted to close positions and demand extra collateral from the three companies.

“The changes were introduced to promote the orderly unwinding of transactions but they ended up speeding up the bankruptcy process,” said William Goldman, a partner at DLA Piper, the law firm. “They wanted to protect the likes of Lehman and Bear Stearns from the domino effect that would have ensued had a counterparty gone under. They never thought the ones to go under would have been Lehman and Bear.”…

The changes in the code expanded the scope and definition of financial transactions not covered by bankruptcy rules to include credit default swaps and mortgage repurchase agreements – products used widely by Lehman, Bear and AIG.

Lawyers said under the old rules, creditors of companies facing financial difficulties were wary of settling trades or seeking extra collateral because they knew such demands could precipitate a bankruptcy filing and potentially freeze their claims.

However, when the financial health of Bear, Lehman and AIG took a sharp turn for the worse this year, their trading counterparties – mainly hedge funds and other banks – were not deterred from seeking to settle their trades or forcing the three companies to put up more collateral.

Such pressure exacerbated the liquidity squeeze that ultimately forced the three companies to hoist the white flag. Bear was sold to JPMorgan in a cut-price deal in March, while Lehman filed for bankruptcy last month and AIG was rescued by a $120bn government loan.

Lawyers said the 2005 exemptions also could apply to non-financial companies, potentially complicating the bankruptcy process of any company that uses derivatives. Stephen Lubben, professor at Seton Hall University School of Law, said: “These provisions affect a non-financial firm, such as a car company or an airline, because they also engage in derivatives trading.”

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Polar warming ’caused by humans’ BBC

Calif. to cut water deliveries to cities, farms AP

Drinking alcohol occasionally when pregnant ‘does no harm’ Times Online.

Euro wines carry dangerous amounts of heavy metals Wine Economics

Sherlock of rock Dalhousie University News

Blame the party, not the campaign James Carville, Financial Times. Comes perilously close to being a post mortem, but worthwhile nevertheless.

Closing the Gates of Hedge Hell Pension Pulse

DC Metro, Other Transit Agencies Could Soon Find Themselves in Default Tax Foundation

Fed Watch: More Easing Expected Tim Duy

Major Tax Incentive For Bank Purchases: IRS Eliminates the Limitation on Banks’ Built-In Losses Post-Purchase Jones Day (hat tip reader Richard). Estimates cost of this little change at $140 billion. Oh, and Treasury doesn’t have the authority to change the tax code, not that that is stopping them.

Wikipedia founder Jimmy Wales expects internet downturn but no ‘bloodbath’ Telegraph

Some Additional Observations on the 2008Q3 Advance GDP Release Menzie Chinn, Econbrowser. Takes a hard look at the GDP release and does not like what he sees.

And look at where we are in Technorati! I am surprised and pleased. Thanks to all of you who link to our articles!

Antidote du jour:

Five-Foot Bat, African Delicacy, Is Out in Force for Halloween Bloomberg

Let’s see, AIG had to ask to be included in the Fed’s new commercial paper program. AIG was reported to have said it needed a wee bit more money, but no more than $10 billion. No reasons were given in any news stories.

Now we find out the intended use. From Reuters (hat tip reader Steve A):

American International Group Inc (AIG.N: Quote, Profile, Research, Stock Buzz) reduced the amount it owes under a U.S. Federal Reserve credit line by $6.8 billion, but only by borrowing from a different government lending program.

AIG currently owes $83.5 billion under two emergency facilities from the Fed, which were necessary to prevent the company from filing for bankruptcy. That figure was $90.3 billion a week ago.

An AIG spokesman said neither the company nor the Fed plan to disclose the exact amount the Fed was repaid.

The company was able to repay part of the amount already borrowed by voluntarily participating in a program that the Fed started on Monday to buy short-term debt known as commercial paper from companies.

Surprisingly, a Bloomberg story on the same snookering gamesmanship was entirely approving and indicates the amount borrowed through the CP program to repay the other credit lines was even larger:

American International Group Inc., the insurer bailed out by the U.S., reduced its debt under two credit lines to $83.5 billion by using cash from the Federal Reserve’s commercial paper program.

The insurer got as much as $20.9 billion from the program, which swaps commercial paper for cash, AIG spokesman Nicholas Ashooh said yesterday in an interview. The terms of the commercial paper funding are better than the U.S. loan made last month to save New York-based AIG from collapse, he said.

“They’re paying off a Fed loan with another kind of government subsidy — it’s like using one credit card to pay off another credit card,” said Robert Haines, an analyst at CreditSights Inc. “If they make progress paying off debts over time, I don’t think it’ll be viewed as necessarily a bad thing.”

The interest on the $85 billion Fed facility is 8.5% over Libor, which (assuming it was 3 month Libor) is 3.19$, for a total of 11.69%. The commercial paper rate was 1.74% today plus an additional 1% for firms that did not post collateral. Thus the most AIG would be paying for the CP is 2.74%, almost 9% lower than the initial rescue package.

The terms of that were designed to be punitive but the Fed let AIG slip its supposedly short leash.

As the economy weakens, a predictable result is an increase in corporate defaults. In the early 1990s, the default rate on high-yield bonds peaked at 12+% (note some define the universe differently and come up with somewhat lower figures)

The most recent Standard & Poor’s forecast, while noting a marked deterioration in the economy and revising up its expected level of defaults accordingly, still forecasts that defaults over the next year will be considerably lower than the worst periods in the early 1990s recession and the dot-bomb era. However, in part that is because they are forecasting only as far out as full year 2009. From Research Recap:

Standard & Poor’s expects the rate of default in the U.S. speculative-grade segment to increase materially in the next 12 months, reaching 7.6% by September 2009, the highest level in nearly six years. Under a “pessimistic scenario,” the rate could go as high as 9.6%….

The pessimistic scenario yields a mean default rate of 9.6%, more than double the long-term average of 4.4% but still below the peaks of 10.8% in the 2001-2002 recession and 12.5% in the 1991-1992 recession. The optimistic scenario yields an average default rate of 6.1%. In the next 12 months.

But Accrued Interest, in “20% high-yield defaults? Don’t underestimate the power of the autos!” argues that Motown defauls could swamp forecasts:

On Monday the yield on the Merrill Lynch High Yield Master index reached a shocking 19.6%….. In short, if we’re getting 20% yield, could we wind up suffering 20% losses in defaults?

According to Moody’s, the largest default rate in history was 15% in 1933. In the post Depression era, there have been three years which produced double-digit default rates: 1990 (10.1%), 1991 (10.4%) and 2001 (10.6%). The average recovery rate (i.e., the amount the bond is worth immediately after default) is 32% for the three peak default years. So if a portfolio suffers 10% in defaults with 30% in recovery, it has actually suffered 7% in total credit losses.

That history would seem to favor high-yield….But risks remain. First, the proximate cause of most corporate bankruptcies is either an inability to roll over debts or a demand by creditors for collateral which the company cannot obtain.

Right now roll-over risk in high-yield is higher than any time since at least the early 90′s. Junk-rated companies can obtain funding through one of two routes, either bank loans or the public bond market. But neither of those are open to lower-quality borrowers right now. There have not been any new high-yield issues for the entire month of October. And banks remain highly unwilling to lend to anyone, much less to high-credit risk firms.

Should the credit markets thaw somewhat in the near term, new deals may be possible. But even if that happens, how many companies will be able to operate where the cost of debt is 20%?…

Then there is the 900-pound gorilla in the junk bond market: the autos. Ford and General Motors alone make up about 7% of the high-yield index. Recent stories in the media suggest that GM will need a loan from the government to complete a merger with Chrysler, and even then there are no assurances that the companies significant problems can be solved….

If high-yield defaults follow the “normal” recessionary pattern of about 10% defaults, but GM and Ford default as well, that would bring total defaults to about 17%, disturbingly close to the 19.6% yield on the index currently.

Hauling executives from the private sector before Congress and lambasting them about pay has had zero impact on top level compensation. However, now that the banking industry is a ward of the state and the Democrats might not just win the Presidency but also could get a filibuster-proof majority in the Senate, the banking industry appears to realize it might behoove them to make stronger efforts to curtail hard-to-defend pay levels before restrictions are imposed on them.

The Journal has two related pieces, one on how Wall Street is taking the idea of curbing its practices seriously, the second on how most of the complaints about pay have overlooked a big source of future outgo: pension and deferred comp programs for ex-execs.

Before you contend that these moves are unreasonable, consider the criticism from a former Wall Street co-CEO, John Whitehead, from a post last year:

John Whitehead, former co-chairman of Goldman, who with John Weinberg, presided over the firm when it went from being a commercial paper dealer and institutional equity broker to a top investment bank, decried Wall Street compensation levels in a Bloomberg interview:

“I’m appalled at the salaries,” the retired co-chairman of the securities industry’s most profitable firm said in an interview this week. At Goldman, which paid Chairman and Chief Executive Officer Lloyd Blankfein $54 million last year, compensation levels are “shocking,” Whitehead said. “They’re the leaders in this outrageous increase.”

Whitehead went even further, recommending the unthinkable, that Goldman cut pay:

Whitehead, who left the firm in 1984 and now chairs its charitable foundation, said Goldman should be courageous enough to curb bonuses, even if the effort to return a sense of restraint to Wall Street costs it some valued employees. No securities firm can match the pay available in a good year at the top hedge funds.

“I would take the chance of losing a lot of them and let them see what happens when the hedge fund bubble, as I see it, ends,” Whitehead, 85, said….

Goldman during its rise to preeminence had a very different compensation formula. The joke at the firm was that partners lived poor and died rich. That wasn’t precisely true, but new partners actually had lower cash earnings than senior vice presidents (their interest on the debt borrowed to buy their partnership interest left them with modest pay packages in their early years as partner, a brilliant formula to keep them working hard). Consider that Bob Rubin, who was co-chairman of the firm after the Whitehead/Weinberg era, had an estimated net worth when he left the firm of $100 million. Not shabby, but the point is that Blankfein in one year earned half of what Rubin made in this career at Goldman.

From the Wall Street Journal:

In a sign that Wall Street is waking up to the political tempest over billions of dollars in year-end bonuses likely to be paid out at securities firms lining up for government infusions, top executives are in discussions to possibly cap their own compensation,…

At least one major firm has looked at former PepsiCo Inc. Chairman and Chief Executive Roger Enrico’s move in 1998 to give up his $900,000 salary. Instead, Mr. Enrico asked PepsiCo directors to fund scholarships for children of “frontline employees.” Mr. Enrico still got a $1.8 million bonus that year.

And as Wall Street firms examine their pay and bonuses, distinctions are being made between the highest-ranking executives and lower-level traders and investment bankers who aren’t widely known beyond Wall Street but could get plucked away by rival firms if compensation practices are significantly altered…..

Yves here. I’d like to know by whom, with the hedge fund industry contracting and the whole industry presumably under pay pressure. Back to the Journal:

Since the start of 2002, Goldman Sachs Group Inc., Morgan Stanley, Merrill Lynch & Co., Lehman Brothers Holdings Inc. and Bear Stearns Cos. have paid a total of $312 billion in compensation and benefits. Bonuses generally account for about 60% of total Wall Street compensation, meaning that the five firms paid out an estimated $187 billion in bonuses…

Part of the problem for Wall Street is that some politicians contend that executives and employees responsible for fueling the credit crisis should now pay a steep penalty, especially since huge profits during the housing boom are being swept away by losses and write-downs. Since the start of 2007, for example, Merrill has had net losses of nearly $20 billion — or nearly all of the profits made by the company from 2003 to 2006…

Overall, top Wall Street executives who might have earned $30 million last year could see their pay plummet to $8 million this year, predicts Mr. Johnson, the compensation consultant. Most of that is likely to come in the form of restricted stock with little or no cash. Other pay experts predict Wall Street bonuses will decline an average of 40% to 45% from last year, reflecting sharply lower revenue and profits.

Yves here. The pay cuts are being depicted as due to pressure, which is clever, when it typically drops like a stone in down times. In the dot-bomb era, managing directors in M&A who had made $2-4 million in the boom years saw it drop to $400,000-500,000, assuming they still had a job.

To the second Journal story, “Banks Owe Billions to Executives,”on the magnitude of deferred pay:

Financial giants getting injections of federal cash owed their executives more than $40 billion for past years’ pay and pensions as of the end of 2007, a Wall Street Journal analysis shows.

The government is seeking to rein in executive pay at banks getting federal money…But overlooked in these efforts is the total size of debts that financial firms receiving taxpayer assistance previously incurred to their executives, which at some firms exceed what they owe in pensions to their entire work forces.

The sums are mostly for special executive pensions and deferred compensation, including bonuses, for prior years. Because the liabilities include stock, they are subject to market fluctuation. Given the stock-market decline of this year, some may have fallen substantially…

Few firms report the size of these debts to their executives. (Goldman is an exception.) In most cases, the Journal calculated them by extrapolating from figures that the firms do have to disclose.

Most firms haven’t set aside cash or stock for these IOUs. They are a drag on current earnings and when the executives depart, employers have to pay them out of corporate coffers…

The liabilities are an essentially hidden obligation. Even when the debts to their executives total in the billions, most companies lump them into “other liabilities”; only a few then identify amounts attributable to deferred pay.

The Journal was able to approximate companies’ IOUs, in some cases, by looking at an amount they report as deferred tax assets for “deferred compensation” or “employee benefits and compensation.” This figure shows how much a company expects to reap in tax benefits when it ultimately pays the executives what it owes them.

J.P. Morgan, for instance, reported a $3.4 billion deferred tax asset for employee benefits in 2007. Assuming a 40% combined federal and state tax rate — and backing out obligations for retiree health and other items — implies the bank owed about $8.2 billion to its own executives. A person familiar with the matter confirmed the estimate.

Applying the same technique to Citigroup Inc. yields roughly a $5 billion IOU, primarily for restricted stock of executives and eligible employees. Someone familiar with the matter confirmed the estimate.

The Treasury is… imposing some restrictions on how they pay top executives in the future, such as curtailing new “golden parachutes” and barring a tax deduction for any one person’s pay above $500,000. But the rules won’t affect what the banks already owe their executives or make these opaque debts more transparent…

Bear Stearns Cos., the first financial firm the U.S. backstopped, owed its executives $1.7 billion for accrued employee compensation and benefits at the start of the year, according to regulatory filings. When Bear Stearns ran into trouble after investing heavily in risky mortgage-backed securities, the government stepped in, arranging a sale of the firm and taking responsibility for up to $29 billion of its losses.

The buyer, J.P. Morgan, says it will honor the debt to Bear Stearns executives, which it said is shrunken because much of it was in stock that sank in value.

J.P. Morgan will also honor deferred-pay accounts at another institution it took over, Washington Mutual Inc. It couldn’t be determined how big this IOU is. J.P. Morgan’s move will leave the WaMu executives better off than holders of that ailing thrift’s debt and preferred stock, who are expected to see little recovery. J.P. Morgan’s share of the federal capital injection is $25 billion.

Obligations for executive pay are large for a number of reasons. Even as companies have complained about the cost of retiree benefits, they have been awarding larger pay and pensions to executives. At Goldman, for example, the $11.8 billion obligation primarily for deferred executive compensation dwarfed the liability for its broad-based pension plan for all employees. That was just $399 million, and fully funded with set-aside assets.

The deferred-compensation programs for executives are like 401(k) plans on steroids. They create hypothetical “accounts” into which executives can defer salaries, bonuses and restricted stock awards. For top officers, employers often enhance the deferred pay with matching contributions, and even assign an interest rate at which the hypothetical account grows.

Often, it is a generous rate. At Freddie Mac, executives earned 9.25% on their deferred-pay accounts in 2007, regulatory filings show — a better deal than regular employees of the mortgage buyer could get in a 401(k). Since all this money is tax-deferred, the Treasury, and by extension the U.S. taxpayer, subsidizes the accounts.

In addition, because assets are rarely set aside for executive IOUs, they have a greater impact on firms’ earnings than rank-and-file pension plans, which by law must be funded…

While disclosing its liability for executive pensions, the bank doesn’t disclose its IOU executives’ deferred compensation, and it couldn’t be calculated. The bank’s share of the federal capital injection is $25 billion…

To be sure, deferred-compensation accounts can shrink. Those of lower-level executives usually track a mutual fund, and decline if it does. Often the accounts include restricted shares, which also may lose value, especially this year. To the extent financial-firm executives were being paid in restricted stock, many have lost huge amounts of wealth in this year’s stock-market plunge.

The value of Morgan Stanley Chief Executive John Mack’s deferred-compensation account declined by $1.3 million in fiscal 2007, to $19.9 million; much of it was in company shares. Mr. Mack didn’t accept a bonus in 2007.

Executives can even lose their deferred pay altogether if their employer ends up in bankruptcy court. When Lehman Brothers Holdings Inc. filed for bankruptcy last month, most executives became unsecured creditors. The government didn’t come to Lehman’s aid.

Before we debate the merits (more accurately, the lack thereof) of the latest trial balloon of a plan being floated to rescue overextended mortgage borrowers, we need to consider a few not sufficiently discussed facts:

1. The problem is that banks are not making loan modifications as they did in the past. That is turn is due to securitization In the old days, including in the nasty (in the Southwest and Texas) housing bear market of the early 1990s, it was standard practice for banks to modify mortgages. That was not charity on the part of the bank but a cold-blooded economic calculation, that in the majority of cases, it would take a lower loss by changing mortgage terms than by foreclosing.

80% of mortgages are now securitized, however, and the servicers do not do mods in the vast majority of cases, despite over a year of tough talk, pressure, and various half-baked programs (Hope Now Alliance as the poster child).Why? Our belief is the big reason is the most obvious: servicers get pretty well compensated for foreclosing, but cannot charge (much if any) for the work of doing a mod. Servicers are also set up like factories, with highly standardized procedures. They are not set up to do anything on a one-to-one basis, lack knowledge of the borrower (no doc and low doc mortgages mean the initial files are skimpy, and I am told they are often a mess) and have no experience in assessing borrower ability to pay (ie, they never were in the credit-extension business). To top that off, many servicers have lousy relationships with their borrowers, and so borrowers would probably not be as forthcoming as they would need to be to work out a fair and viable deal (the borrower would assume anything could and would be used against them).

2. A foreclosure lowers the value of all other homes in the neighborhood. Readers have said that recent studies have found 5% is a typical level; anyone with better data or links is encouraged to speak up.

3. I am amazed that the banking industry is and remains opposed to the idea of letting bankruptcy judges modify mortgages. This is not a radical new idea; in fact, it is standard practice in commercial bankruptcies. And bankruptcy judges are not pinkos; most come from the creditor side of private practice and so would understand the banks’ viewpoint, but they are also pretty savvy about lender games-playing. Moreover, filing for bankruptcy has high personal costs; it is not something people do casually (anyone who thinks so I would hazard does not know anyone personally who has gone through bankruptcy, It is demeaning and isolating). So while any program of borrower relief has the potential for abuse, this one is a pretty unlikely candidate.

Moreover, it does NOT demand that servicers do something that they are not set up to do and are pretty likely to be bad at doing, And existing servicing agreements DO have provisions for how servicers get paid when the borrower declares bankruptcy, so servicers would not suffer under this approach.

But instead of admitting and addressing the securitization problem in a more direct fashion, the latest remedy has all the trappings of a costly workaround that does little to solve the real problem. In fact, it appears most likely merely to push the problem down the road a few years.

The proposed arrangement, at least as presented in the New York Times, is to offer borrowers lower payments for a few years (three seems to be the magic number) and only in very exceptional cases reduce the principal balance. What does that accomplish? It does nothing to improve the borrowers’ ability to repay, and with real wages stagnant since the 1970s, there is no reason to think most borrowers will be magically earning more in 2012. It is just about certain NOT to reduce the ultimate amount of foreclosures, just push off some until the relief expires.

With Alt-A and Option ARM resets kicking in at high levels in 2010 and 2011, all this program looks likely to do is delay the housing recovery further by giving temporary relief that will expire on the heels of resets petering out. Unless we have high inflation in the intervening years that erodes the real value of the mortgage and monthly payments, there is no reason to think with a deep recession just starting that most borrowers will be in markedly better shape in three years.

I am also bothered by the slant of the story, focusing on the resentment of those who might not get assistance, rather than on the practical shortcomings of the program. although it admittedly seems to be in the high concept stage and may not come to fruition.

In the Great Depression, one of my relatives ran the general store of a large island off the Maine coast. When people could not pay for food, he would take their deed. He wound up with all the deeds for the entire island.

He gave them all back when the local economy recovered.

From the New York Times:

As the Treasury Department prepares a $40 billion program to help delinquent homeowners avoid foreclosure, it confronts a difficult challenge: not making the plan too tempting to people like Todd Lawrence.

An airline pilot who lives outside Norwich, Conn., Mr. Lawrence has a traditional 30-year mortgage that he has no trouble paying every month. But, thanks to the plunging real estate market, he owes more on his house than it is worth, like millions of other people.

If the banks, which frequently lent irresponsibly, and many homeowners, who often borrowed irresponsibly, are getting government assistance, Mr. Lawrence says he believes sober souls like himself are also due a break.

“Why am I being punished for having bought a house I could afford?” he asked. “I am beginning to think I would have rocks in my head if I keep paying my mortgage.”…

“If the lunch truly is free, the demand for free lunches will be large,” said Paul McCulley, a managing director with the investment firm Pimco….

Government officials say that homeowner bailouts are not a gift. For one thing, they assert, most mortgages will simply be revamped so the monthly payments become affordable for the next few years. Reductions in loan balances, which are drawing the most attention, will generally be a last resort.

“This is not about trying to create fairness,” said Michael H. Krimminger, special adviser for policy at the Federal Deposit Insurance Corporation, which is working with Treasury on the latest plan. “The goal is to keep people in their houses.”

Still, he acknowledged, “a lot of people are angry because they feel some people are getting something they don’t deserve.”…

Though hard numbers are scarce, estimates are that foreclosures will surpass one million this year. Losses on home loans are piling up faster than banks can deal with them. First Federal Bank of California said this week that as of June 30 it owned 380 foreclosed houses. It managed to sell 329 of them during the third quarter but acquired another 450.

This sense of rapidly losing ground underlies the urgency behind the Treasury’s new plan, which is being developed even as various homeowner bailouts that were announced earlier are just getting under way.

A White House spokeswoman, Dana M. Perino, said on Thursday that the plan was not “imminent” and that several different proposals were being considered.

“If we find one that we think strikes the right notes and could meet all of those standards that we want to protect taxpayers, make sure that it’s also fair and that it would actually have an impact, then we would move forward and we would announce it,” Ms. Perino said.

San Francisco Fed president Janet Yellen is concerned about recent economic data and recommends more action to save homeowners from foreclosure. From Bloomberg (hat tip reader Dwight):

Federal Reserve Bank of San Francisco President Janet Yellen said recent data on the U.S. economy is “deeply worrisome” and the government should consider new ways to help homeowners and stem foreclosures.

“Clearly, we have a long way to go before the credit crunch shows significant healing,” Yellen, 62, said today in the text of a speech in Berkeley, California. “We are in the grip of an adverse feedback loop,” in which tighter credit conditions are exacerbating economic weakness…..

“Recent data on the economy has been deeply worrisome,” Yellen, who doesn’t vote on interest rates this year, said during a symposium held at the University of California, Berkeley. In the current quarter, “it appears likely that the economy is contracting significantly” and “inflation risks have diminished greatly,” she said…

The Fed’s actions to lower rates and boost liquidity “have been helpful,” Yellen said. “But the enormity of this crisis required more,” she said, adding that she supports increased aid to homeowners.

“The effects of the growing credit crunch have outpaced the easing of policy, and, indeed, every major sector in the economy has been adversely affected by it,” Yellen said…

Home prices in 20 U.S. cities fell 16.6 percent in August from a year earlier, and have dropped every month since January 2007, the S&P/Case-Shiller home-price index also showed this week.

“Unfortunately, this is another case where the bottom is not yet in sight,” Yellen said of home prices, adding that “direct assistance to homeowners and the housing market are worthy of serious consideration.”

With the dollar appreciating against other currencies, “exports will not provide as much of an impetus to growth as they did earlier in the year,” the bank president said.

The text of the speech is here.

Sabretooth tigers hunted in packs BBC

Harvard’s Charlie Neeson raises Constitutional questions in RIAA litigation ZDNet

Disgruntled call centre worker ‘froze customer’s bank account in revenge prank’ Telegraph

I have had my victories. Just not tonight … Christopher Buckley, Financial Times

‘We’re not going to win this war’ Asia Times

A.I.G. Has Used Billions From the Fed but Hasn’t Said for What New York Times. I am glad someone has taken interest in that question.

Mizuho $7 Billion Loss Turned on Toxic Aardvark Made in America Bloomberg.

U.S. airfares hit record high Los Angeles Times

Investors shun Greek debt as shipping crisis deepens Ambrose Evans-Pritchard, Telegraph

Deflation risk Jim Hamilton, Econbrowser

Pay Up, Or Else! Independent Accountant

Liquidity Then and Now Paul Kedrosky

Antidote du jour:

Banks have proven to be remarkably immune to condemnation over senior level pay. CEOs and top level producers seem to have an undimmed sense of entitlement, even though the nine banks receiving the first Treasury handouts equity purchases earned a collective $305 billion from 2004 to mid 2007, followed by $323 billion in writedowns.

But the powers that be are keeping up scrutiny and pressure. The latest salvo comes from New York attorney general Andrew Cuomo. At this stage, Cuomo appears merely to have made a request to the nine recipients of Federal largess to cough up fairly extensive information about bonuses. If the firms fail to respond, he may try to force them to comply. The New York AG would then resort to a legal theory that is a bit of a stretch. Even if Cuomo is unlikely to win a case based on this theory, it may have enough substance to survive a motion for summary judgment from the opponents. If it does, Cuomo can then proceed to discovery, which means he can gather a great deal of potentially embarrassing information.

From the New York Times:

Under pressure from members of Congress to curtail compensation, banks now face a new threat from Andrew M. Cuomo, the New York attorney general, who sent a letter on Wednesday to nine big financial institutions receiving government aid.

Mr. Cuomo gave the companies a week to provide a “detailed accounting regarding your expected payments to top management in the upcoming bonus season.”

That could prove difficult for the banks, which typically do not complete bonus pools until later this month at the earliest.

Mr. Cuomo’s letter also warned that payments worth more than the services provided by executives might violate New York law.

The letter follows one sent earlier this week to the same banks by Henry A. Waxman, the California Democrat who is chairman of the House Committee on Oversight and Government Reform, urging them not to use any government money for bonuses or other payments and asking for data on pay going back to 2006…

Any lawsuit based on the law cited by Mr. Cuomo would take some creative legal footwork, said Edward R. Morrison, a law professor at Columbia University. The law permits creditors to try to recover or block payments. “You have to find a way for the attorney general, for Cuomo, to shoehorn himself into the position of a creditor,” Professor Morrison said. “It’s not implausible.” The attorney general could act under the law, Professor Morrison said, if New York state pension funds hold bonds issued by the nine companies. Mr. Cuomo might also claim jurisdiction over any of the companies that might owe taxes to New York.

The attention raised questions on Wall Street, because bonus payments are already expected to be as much as 50 percent smaller than last year and perhaps even far smaller at banks that posted big losses. The New York State comptroller estimated that Wall Street paid $33.2 billion in bonuses for 2007, compared with $33.9 billion the year before…

Lloyd C. Blankfein, the chief executive of Goldman Sachs, received bonus and stock awards worth about $68.5 million last year, while Goldman’s co-presidents got just slightly less. Those numbers will not be repeated. John J. Mack, Morgan Stanley’s chief executive, declined to take a bonus last year…

In his letter, Mr. Cuomo asked specifically for a description of bonus pools for this year, a description of how money in those pools would be allocated, an explanation of how that allocation might have changed since each company received money under the federal Troubled Asset Relief Program and a description of bonuses paid to executives earning more than $250,000 in 2006 and 2007….

Citigroup said it would “cooperate with federal and state inquiries about our global expenditures for wages, health insurance and other benefits, which we believe reflect compensation best practices. In addition, we will of course adhere to applicable legal and regulatory requirements, including those in the federal government investment program, such as restrictions on executive compensation.”…

Other financial institutions did not return calls.

This Times Online story is frustratingly vague about the exact nature of these complicated and risky foreign exchange products sold to Japanese retail investors. While the size of the problem ($90 billion) may seem not all that bad in comparison, say, to subprime exposures, recall that these trades are likely to be unwound in a compressed period of time when currency markets are already volatile, thus increasing the potential for havoc.

The irony is that Japanese regulators were once hugely protective of retail investors and placed tough restrictions on what products could be sold to them. That attitude clearly went out the window.

From the Times Online:

Traders in Tokyo have given warning that about $90 billion (£55billion) of complex foreign exchange products, sold mainly to Japanese households and institutions, are on the brink of falling “like a house of cards”.

A rescue effort by the product issuers – large Japanese, European and American investment banks – is expected to involve extensive hedging measures that will throw global currency markets into even deeper turmoil.

The products, which are known as power reverse dual currency notes (PRDC), were sold to Japanese households as simple products offering higher yields than regular savings but the bonds were in reality hugely complex structures “with 15 moving parts and multiple points of pain”, derivatives experts at RBS in Tokyo said.

The products combine exposure to foreign exchange, interest rate differentials and domestic inflation and have formed a small but potent part of the so-called yen carry trade – the borrowing of yen to invest in currencies offering higher interest rates – a gambit thought to have financed huge amounts of global risk-taking in recent years.

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The PRDC’s complexity disguised from the buyers the fact that they were taking on the same big foreign exchange risks as the regular carry trade but with additional exposure to global interest rate volatility.

The warning on PRDCs coincides with a phase of unprecedented volatility for the yen, which this week soared to levels against the dollar and euro that are likely to hurt the country’s exporters. The yen traded at 97.65 to the dollar yesterday, close to levels not seen since 1995. Two months ago, the yen stood at 110 per dollar.

Foreign exchange traders have blamed the unwinding of the yen- carry trade for much of the upward pressure on the Japanese currency.

Also fuelling yen volatility has been speculation that the Bank of Japan (BOJ) may be preparing to cut interest rates this week – rumours that provoked a sharp reversal for the yen over the past two days. The speculation suggests that the BOJ could be about to trim 25 basis points from rates and bring them down to only 0.25percent.

At the same time, Japan’s “Big Three” banks – Mitsubishi UFJ, Sumitomo and Mizuho – are tallying mounting losses from Tokyo’s plunging stock market. Japanese banks have vast share portfolios that are bleeding red-ink.

When the Nikkei share index hit a 26-year low of 7,000 points this week, combined paper losses on the stocks held by the Big Three since March 2007 amounted to about $100billion.

Industry figures said that if the savaging of the Japanese banks’ huge stock portfolios continues, it could trigger a capital crisis among institutions recently viewed as among the safest and best capitalised in the world.

The stock losses suffered by Mitsubishi UFJ alone – $41 billion – are greater than the total sub-prime writedowns of HSBC, JPMorgan or Bank of America.

Commodities had a nice day Wednesday, with oil in particular spiking up. Although the trigger appeared to be the Fed rate cut, one has to wonder at the seemingly disproportionate price reaction, particularly given deteriorating fundamentals and hence falling demand.

One reason for the sudden enthusiasm for commodities is that, as in the frenzied days of last spring and early summer, hard assets can serve as an anti-dollar trade. And the dollar is looking pretty richly valued right now.

From the Financial Times:

Commodities prices rose sharply on Wednesday, with oil trading above $69 a barrel, as the dollar retreated after the Federal Reserve lowered US interest rates half a percentage point to 1 per cent.

The Reuters-Jefferies CRB index, a global benchmark for commodities, rose almost 6 per cent propelled by a surge in energy, metals and agricultural raw materials.

The price of several commodities, ranging from wheat to oil and from nickel to sugar, rose 10 per cent on the day. But traders warned that sentiment was weak and the gains could be shortlived amid worries about a global economic slowdown.

“Demand for physical commodities is tanking in many parts of the world, with US oil consumption contracting at the sharpest rate since 1980,” said Francisco Blanch, commodities strategist at Merrill Lynch in London.

In the oil market, Nymex December West Texas Intermediate jumped $4.77 to $67.50 a barrel after hitting a session high of $69.24, while ICE December Brent rose $5.18 to $65.47 a barrel after reaching a high of $67.12.

Dollar weakness and gains for equity markets outweighed the impact of the latest US weekly inventories data which painted a mixed picture. US crude stocks rose by 0.5m barrels, below the consensus forecast for a 1.4m barrel increase. But total US demand averaged 18.88m barrels a day over the past four weeks, down 7.8 per cent compared with the same period a year ago.

US petrol stocks fell 1.5m barrels, confounding the consensus forecast for an increase of 1.2m barrels. However, petrol demand remains weak, averaging 8.93m barrels a day over the past four weeks, down 3.4 per cent compared with the same period a year ago.

Nymex November RBOB unleaded gasoline rose 10.8 cents to $1.5628 a gallon.

US refinery utilisation rose 0.5 percentage points to 85.3 per cent, recovering towards the 88.8 per cent reached in late August just before the arrival of hurricane Gustav.

The market was also bolstered by further signs that the world will struggle to build enough oil production capacity over the next 20 years to compensate for steep declines in output in mature oil fields such as those in the North Sea, Mexico or Alaska…

James Steel of HSBC cautioned that next week’s US elections could weigh on gold prices if the new president was granted a “honeymoon” period by investors or if the dollar rallied after a new administration entered the White House.

Caroline Baum of Bloomberg throws cold water on the oil bull thesis:

Three months ago, the world was running out of oil…

Now there’s too much oil, prodding OPEC to cut production targets for the first time in two years…

World markets greeted the news of reduced oil supply by pushing prices down further. Crude oil fell $3.69 a barrel Friday to $64.15. Yesterday, oil dropped another 93 cents to $63.22, a 17-month low.

How quickly things change. Or do they?

All speculative bubbles have a kernel of truth behind them to justify their existence. This time around it was China and India. These emerging Asian giants were gobbling up all the commodities the world could produce to fuel their rapid industrialization.

It wasn’t that the story was untrue; it was old. Growing global demand probably was the reason for the gradual rise in oil prices from $20 a barrel to $40 earlier in the decade, and even to $60 by mid-2005.

It was the moon shot to $147 that took on a life, and a litany, of its own. Emerging nations didn’t start gobbling up crude, coal and copper all of a sudden in the middle of 2007.

Yet analysts on TV and in print told us with a straight face that the doubling in oil prices from July 2007 to July 2008 was a result of fundamental demand, not speculative buying or investors, including pension funds, “diversifying” into “alternative investments” in search of “uncorrelated returns.” (It sounds a lot better than admitting you got suckered into buying what was going up and are now stuck with a pile of stuff that no one wants.)

“It happens in every market,” says Michael Aronstein, president of Marketfield Asset Management in New York. “Once it goes up an enormous amount, creating unfathomable wealth for the fortunate participants, someone makes an ex-post case as to why we are only at a beginning and it’s not too late to get in.”

This advice is “generally formulated by someone who has a vested interest in selling the stuff,” he says…

The silliness that accompanies speculative bubbles isn’t to be outdone by what passes for economic analysis. It’s just over three months since commodities began their sharp, swift descent, and already the nonsense is starting: Lower oil prices are going to boost consumer demand.

Whoa! The price of oil (and other raw materials) is falling because of a cutback in demand, both actual and expected. Expressed as a graph, the demand curve for oil has shifted back, to the left. Consumers demand less energy (gasoline, heating oil) at any given price than they did before.

To say that lower prices will stimulate demand, a widely held misconception, confuses a movement along the demand curve (lower price, higher quantity) with a shift back in the curve (lower price, lower quantity).

Why this is such a hard concept to understand, I’m not sure. People imbue oil prices with all kinds of mystical powers. They see a falling price and treat it as a cause, not an effect.

That oil prices are falling in the face of OPEC’s announced production cuts — a reduction in supply would tend to raise the price, not lower it — suggests that demand is falling even faster than OPEC can reduce supply.

That won’t boost demand, but who knows? Maybe it will help recapitalize the banks!

Reader Michael also passed this thought along:

I almost forgot about nat gas…its bounced back with oil, but that’s got $4 written all over it…we can’t export the stuff yet we increased drilling to a level not seen since 83. These producers saw $20+nat gas overseas, and figured that’s where we were headed…but the demand picture is obviously different here…That’s why tboone and mcclendon were spending money on commercials, pleaing for people to create some sort of demand that would soak up this massive supply that will hit the mkt over the next few months.

The agonies of Jefferson County, Alabama, which got itself into a too-clever-by-half funding arrangement that put the county on the verge of bankruptcy, have faded from the public eye. However, the type of transaction that caused so much woe, a swaption to supposedly lower financing costs, has been the subject of SEC and Justice Department investigations for some time. The focus has moved to JP Morgan based on its role n the ill-fated Jefferson County deal and other municipal transactions.

The Bloomberg story provides some detail on the swaption itself, and if the reporting is accurate, this looks like an a deal almost certain to have turned out badly for the county. This is not at all uncommon for OTC derivatives, where even if the transaction in theory has merit, the fees charged are so high as to make the deal uneconomical to the client. But clients almost universally lack the skills to properly model the deal to figure this out. Most deals don’t blow up as spectacularly as this one did, so most clients never figure out they were had.

From Bloomberg:

The U.S. Justice Department is investigating a derivative trade between the state of Alabama and JPMorgan Chase & Co. as part of a nationwide criminal probe.

The Justice Department subpoenaed documents about a so- called swaption, or an option on an interest-rate swap, between JPMorgan and the state’s school construction authority, according to a federal lawsuit filed by the state, which is trying to void the 2002 deal. The agency is investigating whether banks and advisers conspired to overcharge governments on the contracts.

“Although the authority does not seek by this action to avoid payment of any legitimate obligation, the pendency of at least two separate governmental inquiries implicating the validity of the transaction heightens the necessity for a judicial determination of the parties’ rights,” the complaint, filed yesterday in federal court in Montgomery, Alabama, said.

U.S. prosecutors and the Securities and Exchange Commission have searched for almost two years for evidence of rigged bidding and price fixing by banks in the $2.7 trillion municipal bond market. They have focused on derivatives, such as interest-rate swaps tied to bonds, and contracts to invest bond-sale proceeds.

The SEC has also sought information from the Bethlehem Area School District in Pennsylvania about its swap transactions with JPMorgan, while two other school districts in that state have sued the bank for allegedly conspiring to shortchange them on swaption deals like the one in Alabama.

Prosecutors have informed at least five former JPMorgan derivative bankers that they’re targets of a grand jury investigation, according to the Financial Industry Regulatory Authority. Finra is the largest self-regulator for securities firms doing business in the U.S…

Alabama’s Public School and College Authority, which sells bonds for public schools, colleges and universities, alleges the deal doesn’t comply with state law because it wasn’t a “legitimate hedging transaction.”

In March 2002, the agency received $12.6 million upfront from JPMorgan in return for selling the swaption. That gave the bank the right to force the state into $710.2 million of interest-rate swaps on four series of bonds between 2008 and 2011. The swaps called for the state to pay a fixed rate and receive a percentage of the London interbank offered rate.

JPMorgan pitched the deal as a way to protect against the risk of rising interest rates and refinance old debt at a lower cost, the complaint said.

In June, JPMorgan told the state it would exercise its option on Nov. 1 on a series of bonds issued in 1998.

That would have required the state to issue floating-rate bonds, a type of security whose interest rates have jumped more than 10 percent because of the U.S. credit crisis. The state also could have terminated the deal at a cost that wasn’t disclosed in the complaint.

Alabama alleges the swaption wasn’t documented in accordance with state law, which requires a governmental body to certify the swap was entered into for the purpose of hedging.

State law also says governments can issue refunding debt only at a lower cost than the old debt. The cost of issuing variable-rate bonds, including a fixed-rate payment to JPMorgan, would exceed the amount payable under the 1998 bonds, the complaint said.

The $2.2 million Alabama received for the swaption on the 1998 bonds was less than 1 percent of the amount outstanding, the complaint said.

The deal was also structured so that JPMorgan would receive more than $66 million, 50 percent of the fixed-rate payments due from the state, within two years after the swaption was exercised.

“By structuring APSCA’s fixed-rate payments in this manner, JPMorgan’s exercise of the swaption was for all intents and purposes a certainty, since by doing so it would receive what amounts to a $66 million loan from APSCA with effectively no rate of return or implied interest rate,” the complaint said.