Quelle Surprise! Unemployment Stats Don't Capture Joblessness

The New York Times has finally deigned to report on the fact that the Bureau of Labor's unemployment rate (aka "headline unemployment") does an incomplete job of capturing the proportion of the population out of work.

The article by Floyd Norris, "Many More Are Jobless Than Are Unemployed," is less than complete. Despite its professed objective of shedding light on how the official unemployment releases understate the extent of inability to find work, the article curiously gives short shrift to explaining how employment data is captured. Nevertheless, it does provide a very useful chart that shows how what the Times calls the jobless rate, which is the proportion of the population without jobs, versus with the published unemployment rate:



In the top chart, it's not hard to see that the gap between the two lines. Not only did has it widened since 1982, but the unemployment rate trends broadly downward while the jobless rate rises. Yet the MSM has chosen to ignore how headline unemployment paints a flattering picture of the labor market until consumer disillusionment with the economy has become acute.

From the New York Times:

The unemployment rate is low. The jobless rate is high....

Men in the prime of their working lives are now less likely to have jobs than they were during all but one recession of the last 60 years. Most of them do not qualify as unemployed, but they are nonetheless without jobs.

The unemployment rate paints a less gloomy picture. Among men ages 25 to 54 — a range that starts after most people finish their education and ends well before most people retire — the unemployment rate is 4.1 percent. That is not especially low, but it is well below the peak rate in all but one post-World War II recession.

Only people without jobs who are actively looking for work qualify as unemployed in the computation of that rate. It does not count people who are not looking for work, whether or not they would like to have a job....

In the latest report, for March, the Labor Department reported the jobless rate — also called the “not employed rate” by some — at 13.1 percent for men in the prime age group. Only once during a post-World War II recession did the rate ever get that high. It hit 13.3 percent in June 1982, the 12th month of the brutal 1981-82 recession, and continued to rise from there...

As can be seen in the accompanying chart, there has been a long-term decline in the proportion of prime-age men with jobs. That decline has been masked by rises in the number of older people with jobs and by a steady rise in the proportion of women working outside the home. But even among women there has been some slippage. The proportion of women ages 25 to 54 without jobs was 27.4 percent in March, a figure that is higher than it was during all but one month of the 2001 recession.

The negative trend can also be seen in the other chart, which shows the annual change in the number of working men in the 25 to 54 age range, using a three-month moving average to smooth the figures.

In the last half-century, that figure has turned negative only after recessions have been going on for at least a few months, although it has often stayed negative well after the recession officially ended. The lags have ranged from four months after the start of the 1960-61 and 2001 recessions, to 15 months after the beginning of the 1973-75 downturn, with an average lag of eight months. This year, the figure turned negative in January.

The Fallen Standing of the US Middle Class

It's no surprise to anyone in America that being middle class isn't what it used to be. Even though we have more gadgets, middle class workers in the 1950s and 1960s could afford to have stay-at-home wives. For mort households, it takes more hours of paid labor, and more borrowing, to support a bourgeois lifestyle.

This article by Christopher Caldwell in the Financial Times, "The lazy, crazy middle class," does a good job of providing an overview of middle class decline, but steers clear of articulating the causes. For that, we can consult Thomas Palley:

America’s economic contradictions are part of a new business cycle that has emerged since 1980...The new cycle rests on financial booms and cheap imports. Financial booms provide collateral that supports debt-financed spending. Borrowing is also supported by an easing of credit standards and new financial products that increase leverage and widen the range of assets that can be borrowed against. Cheap imports ameliorate the effects of wage stagnation.

This structure contrasts with the pre-1980 business cycle, which rested on wage growth tied to productivity growth and full employment. Wage growth, rather than borrowing and financial booms, fuelled demand growth. That encouraged investment spending, which in turn drove productivity gains and output growth.

The differences between the new and old cycle are starkly revealed in attitudes toward the trade deficit. Previously, trade deficits were viewed as a serious problem, being a leakage of demand that undermined employment and output. Since 1980, trade deficits have been dismissed as the outcome of free-market choices....

The new business cycle also embeds a monetary policy that replaces concern with real wages with a focus on asset prices. Whereas pre-1980 monetary policy tacitly aimed at putting a floor under labor markets to preserve employment and wages, it now tacitly puts a floor under asset prices. This is not a matter of the Fed bailing out investors. Rather, the economy has become so vulnerable to declines in asset prices that the Fed is obliged to intervene to prevent them from inflicting broad damage.

All these features have been present in the current economic expansion. Wages have stagnated despite strong productivity growth, while the trade deficit has set new records. Manufacturing has lost 1.8 million jobs. Prior to 1980, manufacturing employment increased during every expansion and always exceeded the previous peak level. Between 1980 and 2000, manufacturing employment continued to grow in expansions, but each time it failed to recover the previous peak. This time, manufacturing employment has actually fallen during the expansion, something unprecedented in American history.

Now to Caldwell on how this is playing out. From the Financial Times:

Two years ago, several prominent economists gathered in Italy to debate the wide gap in annual working hours that separates the workaholic US from leisure-obsessed Europe. The conference was called: “Are Europeans Lazy? Or Americans Crazy?”.... But sometime in the intervening years, ordinary Americans – without stinting on craziness, of course – appear to have made their peace with laziness. On Wednesday, the Pew Research Center, based in Washington, DC, published an eye-opening study on the economic attitudes and prospects of middle-class Americans. Inside the Middle Class: Bad Times Hit the Good Life found that Americans’ number-one priority – named by 68 per cent of respondents and topping children, marriage, career, wealth and religion – was “having enough free time to do the things you want”.

The American middle class is not playing to type these days. The go-getting engine of the global economy is less work-obsessed than it looks and less confident. The percentage of middle-class people who say their life is better than it was five years ago is the lowest in almost half a century, according to Pew. Average Americans feel as though they are barely clinging to their position on the social ladder; 78 per cent say it is harder to maintain a middle-class lifestyle than it was five years ago. A middle-class squeeze (rising healthcare costs, rickety pensions, the collapse of housing prices and so on) has been at the heart of debates in both parties this presidential campaign season.

Low economic morale is a problem even when it is illusory. In this case it is not, US census data show. A majority of Americans of all races and regions tend to identify themselves as middle class (the figure is 53 per cent today). There are not enough perches in the middle class to accommodate all of them. A standard measure defines “middle-income” households as those earning between 75 and 150 per cent of median family income, now about $60,000. Where 40 per cent of American households met that definition in 1970, only 35 per cent do today. (Using “income” as a synonym for “class” is crude, but that is how US social scientists do it.)

This “hollowing out” of the middle class is an old story. It has been going on for three decades. But there are a couple of new twists. Rising inequality was always accompanied by rising prosperity. Certainly gains were unevenly apportioned: the rich, black people and single women gained disproportionately while high-school drop-outs and single men suffered disproportionately. But the system was thriving and so was the ordinary US worker, even if the meaning of “ordinary” was changing. The system was not managed to egalitarians’ liking – but it retained the resources to set more egalitarian priorities if politicians chose. Now, even the resources are in doubt. For the first time since statistics have been gathered, the adjusted median family income actually declined from one economic boom to the next, from $61,227 in 1999 to $59,493 in 2006.

A transitional economy is sometimes hard to measure. Americans have trusted that the hard-to-measure bits concealed strengths, not flaws. True, they reasoned, the incomes of the poorest have fallen since 1970, but that included many of the 35m immigrants the country has added since then and the US offered them a way up. True, houses were growing more expensive, but the average new house is bigger, fancier and more efficient than the places the poor lived in decades ago.

Today, though, a large swath of Americans is being priced out of what the Pew authors call the “anchors of a middle-class lifestyle”, starting with housing, medical care and education. And one of the economy’s hard-to-measure phenomena (the housing boom) has become an easy-to-measure one (debt). The debt-to-income ratio for the middle class has risen from 0.45 in 1983 to 1.19 now. Some of this shift is due to the rise in house prices: the percentage of middle-class income spent on housing rose from 26.8 per cent in 1981 to 33.7 per cent in 2006. In 1970, people tended to pay twice their family income for a home; now they pay five times. That money did not seem to be lost because it could be spent – you just had to borrow against your home to get it. Americans borrowed too much. In a world of “ownership” without equity, the difference between ownership and rental is not obvious.

The US middle classes have always had an empathy with the rich that is anomalous in a world context. They oppose milking high earners, thinking that they themselves might be rich someday. But that empathy is eroding. Only 42 per cent of the middle class think that “rich people achieve their wealth through hard work and ambition”; 47 per cent chalk up wealthy people’s fortunes to “connections and family ties”.

Who is to blame for this debacle? The answers will tell you a lot about the politics of this presidential election. The Pew analysts find a certain ambiguity. The middle class is more conservative than the very rich and the very poor, but it is tending towards the Democrats. Its sympathies are split – to borrow the terminology of that Italian economic conference – between a Lazy party and a Crazy party. Republicans, the Crazy party, are twice as likely (by 17 per cent to 8) to blame “the people themselves”, who thought they could use their home-equity loans to live like the rich. Democrats, the Lazy party, are twice as likely (by 35 per cent to 16) to blame the government. At least they blame the Republicans who thought the government, too, could somehow borrow without incurring debt. For now, the smart money is on the Lazy, rather than the Crazy, party. But, of course, they could both be right.

With all due respect to Pew, survey research has to be taken with a handful of salt. The fact that 68% of the respondents said having enough free time to do the things you want” was their top priority is probably aspirational and a symptom of ever-worsening time stress. I doubt that many of the participants would accept a job with lower pay and better hours.

Links 4/12/08

For sale: the video archive Wal-Mart should have erased Independent

Lehman CFO Says Market Recovery May Take Until 2009 Bloomberg. That's quite a concession....

Windows is 'collapsing,' Gartner analysts warn ComputerWorld

ECB hawks defiant as storm gathers Ambrose Evans-Pritchard, Telegraph

Australian girl, 6, in case against miner PhysOrg

Financial Leaders Try To Repair Damage From Failed Policies Dean Baker

Fed Is Not King Midas Michael Shedlock

Frontier Airlines, The Latest Credit Card Victim Felix Salmon

Volcer's Speech at the Economic Club of New York (hat tip Calculated Risk). In five parts at You Tube. One, two. three, four, five.

Antidote du jour:

More on the Jump in China's Reserves

We commented the other day on the surprisingly large jump in China's foreign currency reserves, noting that the monthly gain wa the biggest on record, when an appreciating yuan ought to put the growth in reverse (although one must note that the yuan hasn't gained much if any ground relative to non-dollar currencies).

I'm following up because my instinct is that this development will prove to be important, even if the causal chain isn't yet clear.

Brad Setser (who follows this beat more closely than I do) was kind enough to weigh in in comments:

The pick up in US export growth from 2003 on is clearly tied to the fall in the dollar, so I am a bit more optimstic than you are. Moreover, without a fall in the dollar, there is little incentive to reindustrialize the US. German auto makers are investing in the US now; they weren't in 2001 and 2002. The rise in the RMB also seems to have slowed the increase in Chinese exports to the US (compare uS imports from China to Europe's imports from China), so I am more optimistic there as well. I would tho caution that the us slump explains most of the slowdown in us imports from china.

The deindustrialization reflected at least in part the strong $ of the 90s and the artifically weak RMB of this decade; reversing course requires painful adjustments -- and a weak dollar is part of the pain.

The problem is that reindustrialization is not a fast process. and the pain is likely to be attenuated, The US isn't particularly good at taking setbacks.

Michael Pettis addressed the question short-form in his blog today (promising to do more digging):

As I noted in yesterday’s entry, the trade surplus accounted for $41.6 billion of that total while FDI accounted for another $27.4 billion. That sums to $69 billion. Roughly 30% of PBoC reserves are presumed to be held in currencies other than the US dollar, so the weakness in the dollar added to headline reserve growth – I am only guessing but my quick-and-dirty calculation suggests perhaps $30 billion or so. Add another $15 billion to account for interest received on the securities held. That takes us all the way up to $115 billion. There is still nearly $40 billion that needs to be accounted for. I am sure it is not all hot money, but it seems pretty obvious that the FDI numbers, and perhaps even part of the trade numbers, include speculative inflows. There is a lot of money coming into China and even a global slowdown is not going to make the country’s monetary policy easier to manage.

.....Needless to say this is a huge number, but I guess I am becoming a little numb to big numbers. Of course this makes me all the more convinced that inflation is not going to peak as soon as most people in the market seem to believe – everyone I have been reading recently is arguing that inflation will peak in the next three months, and then drop in the second half of the year. I not very confident that will happen.

Setser combed through the data today, stressing that the yuan has not risen against most currencies ex the dollar, and in agreement with Pettis on the amount of surplus increases that it unexplained and therefore could be hot money inflows (not a good thing):

Neither the fact that China added $154b to its reserves in the first quarter ($153.9b) nor the fact that the RMB (briefly) broke through 7 was exactly a surprise. China’s reserves were heading up quite nicely in January and February, and the RMB was steadily marching up (at least against the dollar) as well....

The US treasury has gone out of its way to praise the increase in China’s pace of appreciation against the dollar. I think that is a mistake. The G-7 recently has called for broad-based RMB appreciation not just appreciation v the dollar. That broad-based appreciation has yet to happen....

The $154b in reserve growth in q1 is both a little less and a little more than meets the eye....

However, there is also good reason to think that China’s reported reserve growth understates the overall increase in China’s foreign assets. After adjusting for valuation, China added $53.9b to its reserves in January (when the trade surplus was large), $47.7b in February (when the trade surplus was small) and $15.8b in March (when the trade surplus was moderate). The $15.8b increase in March (a level that implies large hot money outflows) is suspiciously small.

The increase in January if not all that large relative to the underlying flows (FDI of $11b, a trade surplus of close to $20b and $5-6b of interest income), while the increase in February is quite substantial.

The key question is what might be left out of the reserve data, or more precisely who else inside China might be adding to their foreign portfolio to take pressure off the central bank....

My personal view is that hot money inflows were at least as strong in the first quarter of 2008 as in the first quarter of 2007 — and that the overall increase in China’s foreign assets in q1 was over $150b, and perhaps substantially more than $150b...

I find it hard to believe that China’s export sector has really been squeezed by the RMB’s appreciation. The RMB hasn’t appreciated against China’s largest trade partner. And the increase in China’s exports – measured in dollar billion – remains very very strong.

Maryland Greatly Lengthens Foreclosure Process

Housing Wire provides this report:

Maryland governor Martin O’Malley joined with local elected officials and consumer advocates last week to sign emergency legislation that targets troubled borrowers in the state.

Perhaps the most immediate industry impact will be felt by just one of the three bills passed last week — the obscenely-long-named Real Property–Recordation of Instruments Securing Mortgage Loans and Foreclosure of Mortgages and Deeds of Trust on Residential Property bill. (Yes, that’s the actual name).

The legislation significantly lengthens the foreclosure process from 15 days to approximately 150 days, by requiring a lender to wait 90 days after default before filing the foreclosure action and to send a uniform Notice of Intent to Foreclose to the homeowner 45 days prior to filing an action.

It also requires personal service to notify a homeowner of impending foreclosure action, and requires that a sale may not occur for 45 days after service. A lender must also produce “proof of ownership” when filing a foreclosure action, according to a press statement put out by the governor’s office.

“Proof of ownership” has been a hotly contested issue in many courts as the number of borrower defaults have surged. Many judges are now requiring the actual mortgage note to be produced, when such requirements did not exist in the past and when such requirements may actually be contrary to existing law.

Nonetheless, it’s unclear what Maryland’s definition of “proof of ownership” is; calls to a few industry sources in the state were not returned by the time this story was published.

Programs like this, intended to help homeowners, have the potential to wind up in the Land of Unintended Consequences. Consider: there's ample evidence that lenders are already dragging their feet on foreclosing, choosing to defer the costs of getting the owner out and managing the property. So the problem of servicers eagerly petitioning courts to seize property is a tad overstated.

But more important, what is eventually going to restore local real estate markets to some semblance of health is when investors start to put a floor on housing by either buying property or mortgages. Having the state push out the timetable for when foreclosed inventory will hit the market discourages real estate bottom fishers; having it reduce lenders rights in foreclosure (and increase costs, per the personal service requirement) will deter potential buyers of Maryland mortgages (and in other states) by raising the specter that the creditor's standing will be weakened even further down the road.

Goldman Recommends Shorting Wamu

We were not at all keen about the TPG-led $7 billion investment in Wamu, and we appear to have company. Note that it's one thing for an analyst to downgrade a stock, quite another to recommend selling it short. From Bloomberg:

Washington Mutual Inc.'s full-year loss will be wider than first estimated, according to Goldman Sachs Group Inc. analysts, who recommended selling the shares short. The lender declined as much as 6 percent.

Washington Mutual, the biggest U.S. savings and loan, may lose $3.30 a share this year, said Goldman Sachs analysts including New York-based James Fotheringham in a note to investors today. Goldman previously forecast a 2008 loss of $1 a share for the Seattle-based company....Washington Mutual may have $23 billion in mortgage-related losses, Goldman said today. The firm cut its 12-month price target on shares of Washington Mutual, also known as WaMu, by 17 percent to $10.

``Given WaMu's disproportionate exposure to states'' where home prices are forecast to decline, Goldman expects losses between $17 billion and $23 billion, the analysts wrote. Washington Mutual may have a $14 billion provision charge in 2008, the analysts said.....

Washington Mutual is at risk of further losses on credit- card lending, the Goldman analysts said. ``WaMu leads its peers with respect to recent growth in credit-card delinquencies,'' they said.

Fotheringham advised Goldman's clients to sell short, which is the sale of stock borrowed from shareholders. People who sell short hope to profit by repurchasing the securities later at a lower price and returning them to the holder.

Goldman reiterated its ``outperform'' rating on Washington Mutual bonds and credit-default swaps....

The lender on April 8 reported a $1.1 billion first-quarter loss and said it will stop making loans through mortgage brokers and close 186 home-lending offices.

Investment Bank Demand for Fed Liquidity Falls

The Financial Times reports a rare bit of encouraging news on the credit crisis front, namely, that investment banks have been making less use of the Fed's liquidity facilities of late:

Direct borrowing from its new primary dealer credit facility fell $8bn from $34bn (£17bn) to $26bn in the week to April 9, the Fed said. Meanwhile, the central bank also said that its latest swap auction of Treasury securities was undersubscribed.

But should we then conclude that investment banks are in improved health? After all, Goldman CEO Lloyd Blankfein asserted that the industry is more than half way through the debt contraction.

This optimistic assessment seems at odds with facts on the ground. Yes, we in a period of relative calm, but each time this has happened of late, a new eruption of problems has led to panic, worries of systemic collapse, and new moves by the Fed, And even more worrisome, each time the intensity of the outbreak has increased.

Let's consider some less than pretty realities. Some investment banks have been classifying more and more assets as Level 3. That gives them lots of freedom in how they value them. The markets appear to be tolerating this expedient, even though the sources who speak to me about the industry view the firms as being considerable weakened and at risk. For instance, it seems to be a commonly held view that Lehman is in every bit as bad shape as Bear was, but Lehman is a better citizen than the soon-to-be-history trading firm and the Fed wasn't going to let two firms go under (in other words, the industry participants I've been in contact with are not of the view that Bear was solvent. That admittedly may be sample bias, since this blog no doubt appeals to cynics).

Moreover, there are plenty of shoes yet to drop. Interbank cash hoarding is on the rise despite the Fed's heroic efforts; a bottom of the housing market is nowhere in sight (and we won't know how low it will go in the mortgage market until we know the end game for residential real estate); commercial real estate losses have only started. But scariest by far is the credit default swaps market.

I happened to meet with a hedge fund yesterday (unlevered, BTW) and it comments in passing were telling. They are seeing very large volumes of mortgage paper even though, this fund has not bought a single mortgage and expect that there is even more that would be offered if buyers were stepping forward. In addition, credit default swaps traders tell them that that market is in perilous shape. A great deal of the protection was written by hedge funds, who were typically levered. When they get into trouble, their problems will redound to the investment banks, both through their exposure as CDS counterparties and as lenders to failed hedge funds.

The fact that CDS traders are discussing such a grim viewpoint with people outside their firms (let's fact it, most businesspeople don't go around saying their product is about to implode) suggests that it is a common knowledge in the dealer community. I wonder if this topic is getting short shrift for a reason. The media has been known to overlook the foibles and failings of public figures until they are on the ropes. There may be similar self-censorship operating here, since the press probably does not want to be accused of fomenting panic.

Links 4/11/08

Brazil makes 'rainforest' condoms BBC

Health Care Horror Stories Paul Krugman

IMF rejects criticism over global turmoil Financial Times. The IMF says the US credit crisis isn't its fault, pointing out that America was among the minority of countries that refused to participate in the Financial Sector Assessment Programme, a joint IMF-World Bank program to alert countries to weaknesses in their financial systems

Politics and trade: evidence from the age of imperialism Kris James Mitchener Vox EU

Mortgage Insurers (Quietly) Downgraded: CDS Spreads Scream Trouble The Financial Ninja

As pets live longer too, hospice care helps owners say goodbye MarketWatch

Same Store Sales Boosted by Inflation, Retail Slumming The Big Picture

Beekeepers call for pesticide ban PhysOrg

Antidote du jour:

China's Foreign Reserve Increases Accelerate Despite Yuan Appreciation

In a very bad bit of news for the US, the Los Angeles Times (hat tip Lune) reports that the Chinese policy of letting the yuan appreciate has not succeeded in reducing the country's massive increases in foreign reserves. In fact, the situation is getting worse rather than better.

Normally, when a country's currency appreciates, its current account surplus drops, as does foreign direct investment (the notion being it will be a less competitive exporter). But in China's case, the usual pattern isn't operating. From the Los Angeles Times:

In 2006, the yuan rose just 3.24% against the dollar. But since the second half of last year, the appreciation has accelerated amid a sharply falling dollar and surging inflation in China. Chinese policymakers figured a stronger yuan would boost imports and curb excess exports, thus slowing the growth of China's trade surplus and the flood of dollars into China that has pushed up inflation.

So far, though, the yuan's sharp rise hasn't staunched the massive inflows of cash. In fact, China's foreign reserves, the largest in the world, have ballooned to $1.65 trillion this year, with about $60 billion added in January and in February -- up from a monthly average of about $40 billion in 2007.

With the yuan appreciating quickly, speculators are continuing to pour money into China, says Michael Pettis, who teaches finance at Peking University. Nor is there clear evidence, he says, that the stronger yuan is reducing China's trade surplus, even though lower demand for goods from the U.S. appears to have slowed China's export growth recently...

Although the stronger yuan makes U.S.-made goods cheaper for customers in China, Zhang Renren, manager of a U.S.-based wood exporter, said that hadn't translated into a noticeable pickup in orders from China.

The article does report that Chinese firms are looking at moving operations into lower-cost Vietnam and also observes:

Wessco [a US company that has its products made in China] also hopes to move up the value chain and take advantage of China's growing pool of skilled and creative talent -- still cheap by Western standards. Two months ago, Sakkis said Wessco opened a design office in Shanghai with a staff of 10.

With the yuan and other costs rising, he said, China as a production base for low-value goods is yesterday's news. "We're shifting how we look at China," he said.

Note that Wessco is hardly alone in looking to China for higher-value added manufacture; this repositioning was frequently mentioned at a recent presentation at Asia Society.

Where does this leave the US? Not in a pretty position at all. Having become a service economy and sent so much manufacturing overseas, a cheap dollar may not produce the benefits the US hoped to achieve. Indeed, the US trade deficit widened in February, contrary to expectations. Even though economists argued that this month was a one-off due to unexpectedly high import demand, the confidence that this pattern will change soon may be misplaced. The main contributors to the blip up were purchases of foreign cars, computers, and oil. The oil part of the equation won't change, computer manufacture is offshore and thus not likely to shift soon either. The buys or non-US cars and computers reflect consumer preferences that may prove stubborn as well.

With a limited manufacturing base, it remains an open question how much improvement we will see in the balance of payments even with continued debasement of the currency.

Ban "No One Could Have Foreseen the Crisis"

Floyd Norris of the New York Times, in an otherwise fine piece, "It’s a Crisis, And Ideas Are Scarce" has a paragraph that set my teeth on edge. But let's deal with the parts that have merit first, and hold the rant in abeyance.

Norris uses the Paul Volcker's speech at the Economic Club of New York this week as a point of departure, covering it in more detail than other commentators:

Paul Volcker, the former Federal Reserve chairman whose legacy has not crumbled since he left office, was right this week when he said the financial engineers had created “a demonstrably fragile financial system that has produced unimaginable wealth for some, while repeatedly risking a cascading breakdown of the system as a whole.”....

“Any return to heavily regulated, bank-dominated, nationally insulated markets is pure nostalgia, not possible in this world of sophisticated financial techniques made possible by the wonders of electronic technology,” he said.

In any case, the banks are not all that healthy anyway, thanks to their losses from the strange securities created under the new system.....

Regulation needs to be strengthened, particularly for investment banks. Providing a safety net brings, in Mr. Volcker’s words, “a direct responsibility for oversight and regulation.” He forecast that “investment banks are going to end up with a leverage ratio imposed upon them.” And one lesson of this disaster is that having parallel financial institutions — one regulated and one not — simply drives activity to the unregulated area, at least until something blows up....

It is also clear that the efforts being made to cut back American regulation, in the name of making our markets more competitive, are attempts to deal with the wrong issue. To quote Mr. Volcker again, “For financial regulation in general, competition in regulatory laxity cannot be a tolerable approach.”....

Mr. Volcker, who knows how inflation can get out of hand, said the current situation reminds him of the early 1970’s, when inflation began to accelerate. The Fed’s moves to slash short-term interest rates and bail out Wall Street, however necessary they may be, could easily raise inflation and cause more damage to the weak dollar.

Volcker puts his finger on the central problem, the the securitization model, aka "originate and distribute," has broken down. New issuance volumes are off dramatically in all product areas. But what is more troubling is that many types of securitized products depended on credit enhancement, and that does not appear to be coming back anytime soon, if ever (at least in anywhere near the same volumes). Note how many "rescue the housing market" plans rely on federal guarantees (Fannie, Freddie, FHA), an indirect acknowledgment of the problem.

Yet the consensus view, which increasingly appears to be wishful thinking, is securitization will come back once the credit crisis is past the acute phase. Yet look at the elements that appear irretrievably damaged: monolines, key providers of credit touch-ups, have renounced the structured finance business. Credit default swaps, another important source of credit improvement, are suffering from a shortage of protection-writers (among them the bond guarantors) and other former sources of credit enhancement (hedge funds and investment banks) are now correctly regarded as less secure. That leaves overcollateralization as the only readily available means for creating the desirable AAA tranches out of pools of less than stellar assets. It isn't yet clear what that means for the structured credit business going forward,

In addition, with rating agency reputations in tatters and many investors burned by buying pseudo AAA paper, it may be a very long time before investor confidence is restored. It may not occur in the absence of reforms that have teeth.

Yet even the astute Volcker does not appear to have considered the possibility that the securitization process will remain largely non-operative until root-and-branch re-regulation is in place to entice investors back into the pool (no pun intended). That implies that in the meantime, on-balance-sheet credit intermediation will assume a large role. But that requires far more financial firm capital (the resulting bigger balance sheets dictate larger equity bases) precisely at a time when losses are shrinking bank capital and new equity is costly and hard to procure.

Now to the offending part. From Norris:

At the same time, there is a limit to the usefulness of finger-pointing. Most of the critics — myself included — did not anticipate the severity of the credit collapse, and we should not act as if the executives and regulators who failed to prevent it were blind or stupid. Rather than go into self-defensive crouches, those people need to use hindsight to ameliorate the mess.

I can't fathom where Norris' concern about an excess of "finger pointing" (except perhaps at Greenspan) comes from. If anything, there has been too little, rather than too much, investigation of how we got where we are.

Consider the contrast. In 1987, after the stock market crash, the so-called Brady Commission (formally, the Presidential Task Force on Market Mechanisms) was established a bit more than two weeks after the crisis. Admittedly, the stock market meltdown was a discrete event, while our credit crisis has been an slow-moving train wreck. Nevertheless, the Brady Commission working oars were not part of the regulatory apparatus; its executive director was a Harvard Business School finance professor, Robert Glauber; the staffers came heavily from the private sector. This gave them the freedom to look at deficient practices without incurring the ill will of people in their field.

By contrast, consider Bernanke's in a speech yesterday, "Addressing Weaknesses in the Global Financial Markets," of the measures taken to understand the roots of our current financial mess:

In the United States, policymakers' efforts to identify the sources of the financial turmoil and the appropriate public- and private-sector responses have been coordinated through the President's Working Group on Financial Markets (PWG), chaired by the Secretary of the Treasury. The group's other principals include the heads of the Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission, and the Board of Governors of the Federal Reserve System. With the support of the staff of the respective agencies, the PWG began to address these issues last fall, as the severity of the financial turmoil became increasingly apparent; in mid-March, we issued a brief statement outlining our tentative conclusions and policy recommendations.1 At the international level, the Financial Stability Forum (FSF), whose membership consists of central bankers, regulators, and finance ministers from many countries, including the United States, will also soon release a report on the causes of and potential responses to the turmoil.

There has been no independent investigation by people who had access to the key actors and relevant documents. No matter how well intended the regulators and government officials looking into the credit crunch might be, it simply isn't human nature to point fingers at oneself.

Similarly, I don't place much stock in Norris' "I didn't think it would get this bad, therefore no one should be held accountable for missing it." With all due respect, Norris may be well connected, but that is not the same as being an insider (see Daniel Ellsberg's book Secrets for long-form treatment of this topic). And there were few Cassandras with far less access than Norris who did see this coming. We shouldn't shy away from understanding why those who should have known better chose instead the convenient path of wishful thinking and willful denial.

Buyout CLOs Used for Fed Loans

Just when you think you've heard everything about how low the Fed has stooped to rescue an industry that really ought to be left to twist in the wind a bit, another squirmy critter crawls out from under a rock.

Investor Scott directed us to a Bloomberg story that cites a Morgan Stanley report which argues that investment banks are taking their hung leveraged buyout loans and bundling them into collatearlized loan obligations so they can use them as collateral for loans fromt the Fed.

Now admittedly, AAA-rated CLOs are permitted collateral at the discount window, valued at 93% to 98% of par depending on their duration. However, the discount window used to be an overnight, in extreis facility for banks under duress, while the alphabet soup of new central bank enabled loans to Wall Street increasingly look like a subsidy.

The article winks as hard as it can, but carefully avoids saying that Lehman assembled a CLO to put to the Fed.

Scott also passes along the following:

1. A rumor is circulating that Lehman sold $2.5 billion in CLOs, but the buyer insisted Lehman retain 25% of the worst tranches. Oh, and that buyer was the Fed.

2. The quality of Lehman's first quarter earnings was terrible. It recorded a gain on widening debt spreads. That means the marker value of its debt fell because the market thought Lehman was less creditworthy. That reduction in market value of debt was a gain that flowed though its income statement.

In addition, "LEH recorded a gain of $695 million in the category of level 3 Corporate equities. That’s ten times the levels recorded in the last 2 quarters of 2007, and it’s not some first quarter of the year aberration either—the year-ago quarter yielded a gain of $13 million. This during a quarter when the major equity indexes took significant hits."

Aren't unaudited financial statements just wonderful?

From Bloomberg:

Wall Street firms may be bundling high-yield, high-risk corporate loans into securities to use as collateral to borrow from the U.S. government, according to a report by Morgan Stanley analysts.

Securities firms can borrow against collateralized loan obligations at the Federal Reserve's Primary Dealer Credit Facility, the analysts said. The Fed set up the facility last month, its first extension of credit to non-banks since the Great Depression.

The creation last month of CLOs comprised of loans for private-equity buyouts or other leveraged loans to larger companies totaling $11.4 billion ended ``the deep freeze'' in the market, and many arose from unusual motives, today's report said. ``At least one'' recent CLO was probably done to take advantage of the Fed's new facility, it said.

``It's not cheap to finance loans today in the market,'' Vishwanath Tirupattur, a Morgan Stanley analyst in New York, said in a telephone interview.

Lehman Brothers Holdings Inc., the fourth-largest U.S. securities firm, last month created the $2.8 billion Freedom CLO, the largest this year, out of loans that couldn't be readily sold to investors, such as for buyouts of payment processor First Data Corp. and power producer TXU Corp. JPMorgan Chase & Co., Deutsche Bank AG and Barclays Plc also underwrote CLOs in March, according to data complied by Bloomberg.

Issuance of collateralized debt obligations, a subset of which repackage company loans into new securities with varying risks, totaled $16.7 billion last quarter, tumbling from $165 billion a year earlier, according to the report. CLOs created last month -- including $2 billion comprised of high-yield loans to ``middle market'' companies -- represented 80 percent of all the CDOs created in the first quarter.

Only about a third of the CLOs issued this year have been created for the traditional reason, the analysts including Tirupattur and Sivan Mahadevan wrote in the report. The typical model is for a CLO ``equity'' investor to profit by selling off its safest classes, keeping the difference between the coupons on those securities and on the underlying loans.

The pipeline of unsold debt from leveraged buyouts has shrunk to $118 billion from more than $230 billion in July, Bank of America Corp. analysts said in a report yesterday. High-yield loan prices climbed 1.3 cents in the past week to 90.14 cents on the dollar yesterday, according to Standard & Poor's. Prices are still 4.67 cents below the beginning of the year, according to S&P, which tracks loan prices.

Recent CLO deals have been ``eating into the massive overhang of leveraged bank loans and alleviating some of the stress in the capital markets,'' said Peter Plaut, an analyst at hedge fund Sanno Point Capital Management in New York.

They're also ``an easy way for banks to reduce balance sheet risk, which indirectly helps reduce capital requirements, by funding the AAA through the Fed and selling the equity, which provides high yield to investors,'' Plaut said.

Morgan Stanley's Tirupattur declined to say which firm he believed recently repackaged buyout loans into CLOs with investment-grade rated classes to enable Fed borrowing. Randy Whitestone, a spokesman for New York-based Lehman Brothers, declined to comment.

Borrowing through the Fed facility rose 16 percent to $38.1 billion in the week ended April 2. The Fed accepts ``all investment-grade corporate securities, municipal securities, mortgage-backed securities, and asset-backed securities for which a price is available,'' along with safer debt, according to the Federal Reserve Bank of New York's Web site.

Andrew Williams, a Fed spokesman, declined to comment.....

U.S. lawmakers such as Senator Charles Grassley, a Republican from Iowa, and investors such as First Pacific Advisors LLC Chief Executive Officer Robert Rodriguez in Los Angeles have said the central bank has been taking unusual risks that may cost taxpayers.

Another atypical motivation for the creation of CLOs in recent months has been to restructure ``market-value'' CLOs, a type that can be forced to liquidate when their collateral's prices fall by a certain amount, according to Morgan Stanley.

``A few other CLOs that priced during the past few weeks are hung warehouses from mid-to-late 2007,'' or loans sitting on the lines of credit granted by banks and securities firms to CLO arrangers, the analysts wrote.

The ten U.S. commercial banks with the most mortgage-backed bonds boosted holdings of securities that lack guarantees from government-linked entities such as Fannie Mae by $48 billion in the fourth quarter, partly because they were making the loans for consumer customers anyway, Barclays Plc analysts Ajay Rajadhyaksha and Derek Chen wrote in February.

The 12 Federal Home Loan Banks, the government-chartered cooperatives that lend to U.S. banks, thrifts, insurers and credit unions, generally extend more against AAA bonds than loans. The Fed also last month began to temporarily swap U.S. Treasuries for non-guaranteed mortgage bonds, a form of lending meant to restore liquidity to financial companies.

Stress Returns to Interbank Lending (It Isn't Over Till the Fat Lady Sings Edition)

Just when market participants were patting themselves on the back, focusing on indicators that suggested the credit crunch was easing, even making forecasts that it would be behind us before year end, troubles creep back on little cat feet.

The proximate cause for Fed intervention wasn't the subprime crisis or rise in agency spreads, but a seize-up in the money markets as banks exhibited a decided distaste for lending to each other in August and September. That led to (among other things) emergency rate cuts and Paulson launching his stillborn "save the SIVs" initiative. That worked only till November, when the difference between Libor and risk-free rates again rose, leading the Fed to launch the Term Auction Facility in December. Then trouble emerged on a new front, as agency spreads rose to attention-getting levels in late January. This appeared to be a vote of no confidence by the markets in various plans to use Fannie and Freddie as major actors in the rescue of underwater American homeowners. That resurgence of the debt crisis culminated in the sale of Bear Stearns, which many hoped was a watershed event and signaled that the worst was over.

We didn't think so, and we appear to have company. Banks are still hoarding cash, which means the Fed's heroic and ever-larger efforts have still not resolved the initial problem, namely, high interbank spreads. Its persistence suggests it may not be amenable to Fed action.

Update 2:30 PM Paul Krugman is not happy:

All of this involves fear of defaults by banks — despite what look from here (central New Jersey) like utterly clear signals from the Fed that bank debts will be socialized if necessary. I’m puzzled, and worried.

From the Financial Times:

Money markets in the US and Europe are signalling renewed fears about the financial strength of banks, with key confidence barometers almost returning to the levels that preceded the collapse of Bear Stearns.

The concerns are being highlighted by the difference between overnight lending rates set by central banks and three-month Libor, the rate at which banks lend to each other. This spread, known as the overnight index swap rate, has been rising in the US and remains elevated in Europe, indicating that banks are reluctant to lend to each other.

“Libor is still dysfunctional and, for whatever reason, banks still appear unwilling to lend funds,” said Dominic Konstam, head of interest rate strategy at Credit Suisse.

The difference between the overnight central bank rates and three-month Libor was typically about 12 basis points before global credit turmoil grew worse last summer.

In the US on Wednesday, that spread rose rose 2bp to 77.5bp. The difference had climbed above 80bp on concerns about Bear, then fell back to 60bp in mid-March after the investment bank was sold to JPMorgan Chase.

In the UK, the swap rate gained 2.45bp to 95.45bp on Wednesday. In Europe, the swap rate was up 1.29bp at 74.68bp. It had been 67bp after the Bear sale.

Investors also sought the safety of government debt on Wednesday, pushing the yield on the two-year Treasury down 12bp to 1.75 per cent.

Tensions are rising in the money markets in spite of the injection of huge amounts of liquidity into the banking system by central banks. Traders say market conditions suggest the Bear rescue has not completely alleviated worries about counterparty risks. Until confidence is restored, the availability of credit to investors and companies will be restricted, potentially hurting the broader economy.

Soros: Things Will Get Worse Before They Improve

Storied investor George Soros believes that the credit crisis is far from over, and sees regulatory failure as a major cause. From Bloomberg:

Billionaire George Soros said the global credit crisis will get worse before it gets better.

Soros, who said lack of oversight is partly responsible for problems in the financial markets, criticized regulators and the U.S. administration for not ``responding fully enough.'' He was speaking on a teleconference call with reporters today....

``Authorities have not accepted the responsibilities to try to control asset bubbles from going too far,'' Soros said. Recently established markets, including for credit-default swaps, are ``totally unregulated, that's the cause of the troubles.''...

Total losses for banks, hedge funds, pension funds, insurance companies, and sovereign wealth funds may swell to $945 billion, the International Monetary Fund said in a report on April 8.

``I think it's a pretty accurate estimate of the loan losses,'' Soros said. ``But we have not yet seen the full effect of possible recession.''

Uncertainty about the ability of investors and traders to meet contract obligations is creating ``mistrust'' in the markets that ``will not be fully cleared up until you have a regulated delivery mechanism and oversight over this market,'' he said.

Morgan Stanley Chief Executive Officer John Mack said on April 8 that the credit crisis will last a couple of quarters longer and that the markets are facing the most difficult conditions he's seen in 40 years.

Soros said the crisis will last longer than authorities predict.

``They claim that there will be a pickup in the second half of the year,'' he said. ``I cannot believe that. I don't see any reason to believe it because it will take much longer for the full effect of the decline in the housing market to be felt.''

``This is a man-made crisis and it's made by this false belief that markets correct their own excesses,'' Soros said. ``That's the job of the regulators. And the regulators failed to perform their job.''

Separately, Soros said China was not immune to worldwide market conditions. China's inflation has peaked and may be abating, he said.

Real Estate Porn

In a departure from our usual programming, I thought I would introduce a real estate opportunity (yes this is an ad of sorts). But as you can see, it is particularly attractive and also presents an interesting case example of the issues involving the marketing of unique and illiquid assets.

The asset in question is a private lake roughly an hour and forty-five minute drive from Manhattan. The property is 47 acres, and the lake itself is 9 acres.

Broker hype aside, this is an exceptional property. It's gorgeous. It's also unusual topographically, a mini Mohonk. The teardrop shaped lake is situated below schist and granite cliffs that rise on almost all sides to an elevation of 100-150 feet, surrounding nearly the entire property. Visitors have called it a "pocket universe." You'd need to considerably more land to get the same degree of privacy.




The lake is stream and spring fed, and has a strong enough current that it once operated the most reliable mill in the area and fed George Washington's troops. If you know anything about lakes, this is a big deal. Many so called lakes are glorified ponds. This one is active, with seven varieties of fish.



The property currently has two houses, both in impeccible shape, one the Lake House, with two decks cantilevered over the water, the other the Admiral's Cabin, a guest house recently built in fine materials (example: mahogany beadboard). It also has an Airstream trailer (top of the line). There are at least two possible locations for the construction of a very large house, one the site of a former hotel, the other a meadow at lake level.

The owner has also gone to considerable lengths to improve the land. He has put in a mile long road around the lake, cleared underbrush, removed dead trees. These are all things that require more time and expense than one might expect.



Many buyers would treat this as a turnkey situation. Everything has been maintained at a very high level and as many as eight people can stay in high style. Alternatively, a very wealthy buyer might choose to use the existing buildings on an interim basis while building a grand estate, and the current buildings would then become guest houses.

The region (the west side of the Hudson) is oddly underpriced. It's probably the lowest cost area that is an easy drive to Manhattan and yet has good services. It's attracting people who want a lower-key, less hassled alternative to the Hamptons. Robert De Niro, Brad Pitt, and Meryl Streep all have vacation homes within a half hour drive of the lake. Steve Case's company Canopy Development recently bought lakefront property on a different lake in the same town and is building a high end resort and gated community. Case vacation developments are high-end time shares and sell for an average value of $3 million.

Now the marketing issues. Local brokers make their money selling low end houses to locals. Although people like De Niro and Pitt parachute in from the blue, they don't know how to access them. Conversely, brokers in Mahnattan who have the right clientele can't be bothered to dabble in vacation homes (except perhaps in the Hamptons). Therefore the owner is showing it himself.

The owner had started a program to get the lake in front of wealthy Wall Street types, but with the credit crunch, it's harder to find who has been on the winning side of trades (it's easier to identify the cohort that has been losing out, like private equity types and quants). But there is clearly a subset in the financial community that is still prospering.

Other prospects are wealthy individuals who are either not affected by the turmoil in the markets, such as top athletes and entertainers and foreign ibuyers. Managers for those individuals might also take an interest.

You can find further information about the property here, which includes photos of the buildings and more detail about the surrounding area, and there is also a print brochure available. If you have any questions, ideas. or best of all, suggestions for people who might be interested, please e-mail the manager for the owner.

The owner may also be willing to consider renting the property during the spring and summer.

Thanks again. And no, this isn't my property. I'm a die hard city person.

Links 4/10/08

Experts hack power grid in no time NetworkWorld

Britain could be hardest hit by financial crisis,says IMF Telegraph

US mortgages action given backing Financial Times. Perhaps I should be taking this more seriously (and providing more commentary), but given the Bush Administration's disapproval, I am not convinced this will get done before the election. Plus fisking Shiela Bair is usually painful and time consuming.

Another Flavor of Bonds Threatens to Turn Sour Mark Gilbert, Bloomberg. Hat tip reader Tim, who noted, "Another shoe drops, pretty sure a lot of this stuff went East,"

Abortion and crime Leo Kahane, David Paton, and Rob Simmons, VoxEU

Is There Really Disagreement on Trade? Dean Baker

Ponzi Financing At Citigroup Michael Shedlock

Goldman Sachs Level 3 Assets Jump, Exceeding Rivals' Bloomberg. I'd really like to know why assets Goldman could formerly value on a Level 2 basis, particularly derivative contracts, are now Level 3.

Antidote du jour:

Goldman Had More Loss-Making Trading Days Than Rivals

As Bloomberg reports. Goldman lost money on more trading days in the first quarter than Lehman or Morgan Stanley, although its winning days outnumbered its losers by more than four times. Thus, the fact that Goldman outdid its rivals on this peculiar metric is a sign of undue caution on the part of its competitors, consistent with a preoccupation with minimizing losses.

From Bloomberg:

Goldman Sachs Group Inc., the biggest U.S. securities firm by market value, lost money on more trading days during the first quarter than rivals Morgan Stanley or Lehman Brothers Holdings Inc., according to regulatory filings.

In the three months through Feb. 29, Goldman lost money on 17 days, compared with eight days at Morgan Stanley and seven at Lehman Brothers, the filings show. Goldman's trading department also had more big wins, raking in $100 million or more on 28 occasions, compared with 20 days at Morgan Stanley. Lehman reported it made more than $90 million on 13 days.

``Goldman Sachs takes a more aggressive posture on trading and feels confident doing so because they have some of the most talented people,'' said David Killian, a portfolio manager at Stoneridge Investment Partners....``They're in the business of trading and taking on risk, and they've shown that they're better than peers over the cycle.''

Goldman, under Chief Executive Officer Lloyd Blankfein, depends on trading for 68 percent of the New York-based firm's revenue, more than either Morgan Stanley or Lehman. While Goldman's first-quarter trading revenue slumped 27 percent to $5.66 billion from a year ago, it remained higher than Morgan Stanley's $5.13 billion or Lehman's $1.67 billion.

The filings also show that Goldman lost $100 million or more on five trading days during the quarter. Morgan Stanley lost more than $100 million on one day, while Lehman reported that it lost more than $60 million on three separate occasions.