The Agonist - Economics

Treasury Yield Plunge Sends Warning

Sat, 21 Nov 2009 09:39:05 -0800

By RANDALL W. FORSYTH | MORE ARTICLES BY AUTHOR
Collapse in note yields suggests economic distress will keep Fed on hold well into 2010 or beyond.

IT'S THE CRASH YOU DIDN'T HEAR. Not in the price of any security market, but in short-term U.S. Treasury yields.

Treasury bills once again were trading at negative interest rates Thursday, a mind-boggling state of affairs that hasn't existed since the panic late last year. That followed the collapse of Lehman Brothers and the assorted knock-on effects, notably the run on money-market funds after the Reserve Fund "broke the buck."

More significantly, the yield on the two-year Treasury note -- the most actively traded security on the planet -- fell to 0.669% Thursday, within a hair of the low of 0.657% set in the dark days of last December, according to data on Barrons.com's Market Data Center.

But now, the economy is supposed to be well on the way to recovery, in contrast to late last year when it seemed we stood on the precipice of a second Great Depression. The Dow is back above 10,000 and bulls claim all's right with the world. Why, then, would any rational investor be willing to lock up money for two years for the paltry return of less than two-thirds of 1%?
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Wacky things have happened before in the T-Bill market. Over the turn of the year from 2008 to 2009, investors were so skittish about where they stashed their cash that they effectively paid Uncle Sam to hold it, resulting in negative yields on T-bills. Other times have seen odd happenings in the T-bill market, usually during times of stress when investors wanted only the safest assets.

Unlike T-bills, which have only weeks to run until maturity, the two-year note embodies market expectations for interest rates. Longer-term yields are simply the sum of successive short-terms; all else being equal, you should earn the same from two consecutive one-year notes as a two-year note. Nobody knows what the future holds, of course, so what the second year will yield is just a guess.

Five cities that will rise in the New Economy

Sat, 21 Nov 2009 00:08:52 -0800

Ron Scherer | Fort Collins, CO | Nov 20

CSM - From Seattle to Huntsville, Ala., five cities are poised to prosper in the New Economy because of exports, innovation, clean technology, and healthcare.

In Houston, the Texas Medical Center is expanding so quickly that it will soon become the seventh largest downtown in the US. By itself. The hospital complex brims with restaurants, shops, and hotels, and employs 100,000 people – the population of Billings, Mont.

In Seattle, the erector-set cranes along the waterfront and big forklifts at the airport are loading exports into containers with the constancy of a piston: plywood to Beijing, halibut and crab to Tokyo, Granny Smith apples to Moscow. Last year, Washington was the only state to ship more goods to China than it receives.

In Fort Collins, Colo., town fathers are aggressively transforming the heart of the city into a zone that generates as much electricity as it consumes – making it a showcase for the city’s quest to become the Silicon Valley of clean energy.

As the United States emerges from the worst recession in 80 years, a new economy is taking root that will help create the next tier of powerhouse cities in America. Just as the Industrial Revolution of the late 1800s and the Information Age of the past 40 years helped shift the urban and regional balance of power in the US, forces are now at work that will shape who prospers in the economy of tomorrow.

No one yet knows the exact contours of the New Economy. It is more Monet than Rembrandt. But experts say that certain characteristics are already visible on the canvas that will give cities advantages in attracting new jobs and industries.

UC Berkeley protest ends with 41 arrests

Fri, 20 Nov 2009 20:22:12 -0800

Sandra Gonzales | Berkeley, CA | November 20

San Jose Mercury News - In a striking scene of civil disobedience, dozens of students barricaded themselves inside a UC Berkeley building for more than 11 hours Friday to protest a 32 percent increase in student fees.

The dramatic display ended Friday evening with dozens of arrests, climaxing a week of civil unrest mirrored at other campuses around the state, including Davis and Santa Cruz, where hundreds marched for the third day Friday to decry one of the biggest fee hikes in UC history.

But it seemed unlikely that the protests are having any impact. Repeated budget cuts to the 10-campus system forced UC regents this week to raise the cost of an undergraduate education above $10,000 a year by next fall, triple the cost of a decade ago. The move followed a 10 percent hike earlier this year, employee furloughs and other cuts that UC leaders say are necessary because of a 20 percent drop in state funding.

Still, students continued to try to make their voices heard.

"We have tried going to Sacramento, we've tried less direct and less confrontational ways of getting our voices heard," said UC Davis student Laura Mitchell of Palo Alto, who on Thursday joined a march of hundreds of students to the campus administration building, Mrak Hall. On Wednesday, police arrested 51 protesters there.

Taking back our money

Fri, 20 Nov 2009 13:10:46 -0800

I was trying to think of ways that we could possibly take down as many financial problems as we can while simultaneously bringing the power back to the people. That is, going through our own channels rather than the official process that has proven itself to be ineffective.
I was mulling bank bailouts, "too big to fail" and the notion of money as power when it hit me. What if we just took all of our money out of big banks and put it into local community banks and credit unions? This would greatly strengthen the community, rewarding banks that actually stick to banking, keep money local and even help bolster small business loans, while forcing the large banks to break down. Sure, things would be hairy at first and it wouldn't be pretty, but wouldn't it be a better situation in the long run?
If we could actually organize ourselves to do such a thing, it would be an impressive display of our power to those who sit in their towers. We are the ones who decide who gets our money.
Yes, I know that this also happened in 1929, but if it were a more organized process this time around, there might be a way to make this work in our favor. Anyway, I just wanted to bring the idea up, see what all of you had to say about it, pros? cons? Is it possible to make it work, or would it just ruin everyone simultaneously? All I know is that we have to do something, taking back our control this way might actually be palatable to a great many people.

House Financial Services Committee Passes Paul-Grayson Amendment to Audit the Fed

Fri, 20 Nov 2009 09:33:48 -0800

Michael Smallberg | Nov 20

POGO - The House Financial Services Committee voted 43-26 yesterday afternoon in favor of an amendment introduced by Reps. Ron Paul (R-TX) and Alan Grayson (D-FL) that would remove restrictions preventing the GAO from auditing the Federal Reserve. The amendment was modeled after Rep. Paul’s long-standing bill to audit the Fed, which was co-sponsored by over 300 Members in the House and supported by POGO and many other groups.

The vote on the final passage of the financial regulatory package to which the Paul-Grayson amendment is attached has been delayed until after Thanksgiving. Nonetheless, yesterday’s vote signals a defeat for Rep. Mel Watt (D-NC), who had introduced an alternative amendment that would have limited the scope of the GAO’s audits.

Kudos to FDL: FDL Statement on the Committee Passage of H.R. 1207, the Paul-Grayson Bill to Audit the Fed

Recession shows shortcomings in U.S. economic data

Fri, 20 Nov 2009 08:49:27 -0800

By Emily Kaiser and Nancy Waitz - Analysis

WASHINGTON (Reuters) - The U.S. government is having a tough time guesstimating how many small businesses failed in this recession, casting doubt on the reliability of vital data on employment and economic growth.

The formula the U.S. Labor Department designed to help it deliver timely, thorough monthly employment reports broke down in the heat of the financial crisis, miscounting the number of jobs by an estimated 824,000 in the year through March.

The most likely culprit is the so-called "birth-death" model, which the Labor Department uses to estimate how many companies were created or destroyed.

That model appears to have misjudged how many companies went out of business during the recession, meaning the labor market was even weaker than initially thought when President Barack Obama took office in January. More recent figures may still be underestimating job losses now, but it will be many months before the Labor Department is certain.

One characteristic of this recession is that it has hit small businesses especially hard, driving down demand and choking off vital sources of credit at the same time.

Obama's administration is scrambling to try to prop up small business -- it hosted a summit on that topic on Wednesday -- because those companies are essential to bringing the jobless rate down from its current 10.2 percent, having accounted for the lion's share of new job growth in recent years.

Government data has difficulty gauging the health of smaller firms because there are simply too many of them, leaving officials to rely on surveys and models that are hit and miss.

Jan Hatzius, an economist at Goldman Sachs in New York, thinks that is distorting not only the employment data, but also figures for retail sales, durable goods and even the biggest economic indicator of all -- gross domestic product.

House Panel Votes to Advance Paul Plan on Fed Audits

Thu, 19 Nov 2009 19:12:10 -0800

Scott Lanman | Washington | November 19

Bloomberg - A U.S. House committee advanced a proposal to remove a three-decade ban on congressional audits of Federal Reserve interest-rate decisions, a measure backed by a lawmaker who has called for the abolition of the central bank.

The House Financial Services Committee today, in a 43-26 vote and a second voice vote, attached the amendment for a broad audit of the Fed to legislation creating a council of regulators to monitor systemic risk. The proposal was offered by Representative Ron Paul, a Republican from Texas, and based on a bill with more than 300 co-sponsors.

Fed Chairman Ben S. Bernanke has opposed the Paul legislation, saying it may result in interference with monetary policy. The panel’s vote increases the possibility that Congress will reverse the ban on audits of interest-rate decisions. The broader bill on financial regulation is subject to a vote by the committee, then must be approved by the House and Senate and signed into law by President Barack Obama.

“It’s going to be seen as weakening the independence of monetary policy with consequent negative implications,” Barney Frank, the Massachusetts Democrat who chairs the committee, told reporters after the vote. “People are going to be worried about the impact on the dollar, on the interest rate.”

Frank, who opposed the Paul measure, said the issue “may be revisited” when the legislation reaches the House floor.

h/t Zero Hedge: Paul-Grayson Amendment To Audit The Fed Passes Overwhelmingly By 43-26
Grayson Remarks On The Passing Of The Paul-Grayson Amendment As Well As A Full List Of Voters

The books cashing in on the crash

Thu, 19 Nov 2009 18:51:10 -0800

Sean O'Grady | Nov 20

The Independent - When the masters of the universe came crashing down to earth last year, the reverberations were felt far beyond Wall Street and the City. Sean O'Grady surveys the best of the books that explode the myth that greed is good

One of the few welcome consequences of the global recession has been a modest upsurge in economic literacy, or at least interest. That's not to be exaggerated; most people still don't know their asset-backed securities from the elbows, but at least we're making some attempt to redress that deficit of understanding.

No previous economic crisis has brought forth such a crop of words – over 3,000 new books, a few more reprints, trillions of column inches of newspaper, magazine and web pieces, official reports, not to mention a Facebook page devoted to "Recession Survivors" and those Twittering and blogging their way to an understanding of seismic changes. OK, it isn't much to throw into the balance when you have mass unemployment, the derangement of national finances and the destruction of the world's banking system on the other side, but at least we are creeping towards some acknowledgement of what went wrong, and why. That's something.

So, what to read? A bit like the bewildering complexity of "exotic derivatives" that helped to get us into this mess (and which the bankers themselves never understood), the choice seems endless. It really boils down to which of the three prevalent treatments of the crisis you prefer: the anecdotal, the analytical or the apoplectic.

What Really Happened with the AIG Swaps? It's Not What You Think

Thu, 19 Nov 2009 08:01:11 -0800

By now most people who follow Goldman Sachs in the news know that it received $13 billion from the Federal Reserve to liquidate its portfolio of derivatives with AIG. Because the Fed was willing to pay Goldman par value on these derivatives, even though the market valued them at about 48 cents on the dollar, Goldman walked away with no loss whatever from the AIG collapse. This has been described as a great gift for Goldman and all the other banks who dealt with AIG and who were treated the same way. Many others have described this as a colossal rip-off of the taxpayers.

How did this come about? We know a lot more this week about these transactions because of a report that has been issued by Neil Barofsky, the Special Inspector General for the bank bailout programs. The press has described this report as particularly damning of the NY Federal Reserve which negotiated these deals with the banks, and which was led at the time by Timothy Geithner, the current Treasury Secretary. These press reports, however, have mischaracterized what happened and what went wrong. The NY Fed acted properly and entirely as one would expect under the circumstances when they negotiated these contract abrogations. To see what really went wrong, follow along on the details below.

The AIG Transactions

First, a little bit of background on what got AIG into trouble. The insurance giant had a subsidiary in London called AIG Financial Products (AIGFP). This company developed a business that offered customers financial protection on a derivatives contract known as a Collateralized Debt Obligation (CDO). These derivatives packaged together various debt instruments, such as loans, bonds, mortgage-backed securities, even other CDOs, into a single security. When you bought the security, you received a regularly scheduled set of cash flows generated by these debt instruments as interest payments were made. You paid an up-front premium for these cash flows, which usually took place over a three to five year period during the life of the security.

It is interesting to note that the buyer of the security, and for that matter the seller/creator of the security, had no legal interest in the debt instruments. The bonds or loans could be any debt of this nature where public information was known about the interest rate, and whether or not a default had occurred by the debtor. There could be dozens, or even hundreds of different debt instruments bundled into one security.

These CDOs carried a public rating from Moody’s or S&P or Fitch, any of the three big ratings agencies. Also, you could get a daily price on the CDOs from a third party pricing agent located in London. If the price was 100, the security traded at its par value, meaning all payments were highly likely to take place over the life of the security as required by the contract. If the price was 48, on the other hand, it meant the market believed the security was seriously impaired due to defaults occurring on some of the debt instruments in the security.

Big banks loved to create CDOs up until the market crashed in 2007. CDOs were very lucrative. Banks had loan books that gave them a natural portfolio of debt as a start in creating a CDO, but there also was the booming housing market bubble that allowed for the creation of mortgage-backed securities. A huge amount of CDOs were created based on these mortgage instruments. Banks also realized that when they created and sold these securities to earn the profitable premiums involved, they were still on the hook in case any of the debt instruments in a security experienced a default. They wanted to get rid of this risk as much as possible, and pay away a little bit of their lucrative premiums for the privilege.

Here is where AIGFP comes in. AIGFP invented a derivative that acted like an insurance contract. Banks would pay AIGFP a premium, and AIGFP would promise to indemnify the banks in the event they experienced any losses on a specified CDO. The company used a derivative called a Credit Default Swap (CDS, unfortunately easy to confuse with a CDO) to structure this insurance product.

AIGFP was not regulated by any financial oversight agency. It didn’t even have to keep reserves on potential payouts on these CDSs, and even if it did, it has stated that the reserve amount would have been very small because it did not anticipate significant losses on the underlying debt instruments it was insuring. What AIGFP had going for it, and what the banks liked, was that it was a wholly-owned subsidiary of AIG, which carried a Aaa rating in its own name for everything it did. By virtue of this rating, AIG was viewed as one of the highest quality companies in the financial world – almost as safe and sound as a government.

The most common type of CDOs brought to AIGFP were called multi-sector: they had a little bit of everything mixed into them – loans, bonds, mortgage-backed securities on sub-prime mortgages as well as higher-quality instruments like prime mortgages. As long as none of these different types of instruments experienced unusual rates of default, the entire CDO would be traded on the market at a price close to par, and the ratings agencies would have no cause to downgrade the security.

What began to cause AIGFP trouble with its portfolio of credit default swaps backing up about $72 billion of multi-sector CDOs, was not that there were so many defaults on the CDOS that AIGFP had to make large payments under the swaps. The real problem was a series of collateral obligations AIGFP undertook every time it entered into a CDS, and the collateral conditions varied from one swap to the next.

There were three possible triggers for a collateral payment from AIGFP to the banks that bought insurance in the form of CDSs. The first occurred if the underlying CDOs being insured in the swap experienced a drop in price on the market – say from par value to 48 cents. The second occurred if the ratings given by Moody’s or some other agency on the CDOs were downgraded. The third occurred if AIG’s Aaa rating itself was downgraded.

You can now begin to see the sequence of liquidity disasters that befell AIGFP, and soon engulfed its parent AIG, starting in the summer of 2007 and extending until September 16, 2008 when AIG was near death. First, as the market realized that the US sub-prime mortgage business was experiencing very high and unexpected defaults, everyone looked at multi-sector CDOs that carried a significant percentage of these debt instruments in the security. These CDOs began to trade at lower and lower levels in the market as no one was sure just how impaired they would become.

Second, the ratings agencies began to downgrade dozens of CDOs because of the heightened default risk, and the lower prices in the market.

Third, the ratings agencies realized by 2008 that AIG stood behind the CDO market as insurer for the tune of $72 billion. At first, the long term rating of AIG was lowered, and this began a series of collateral calls from AIGFP’s swap customers. Then, by the summer of 2008, the ratings agencies were looking at downgrading AIG’s short term ratings, and doing so by several notches, which brought into question whether AIG could meet all of its obligations under these swaps. This accelerated the demands for collateral on AIG, which was experiencing a very unexpected triple whammy of collateral calls. By September, 2008, AIG had already coughed up an astounding $30 billion in collateral, and was really only half way through what ultimately it would need to satisfy contractual demands for collateral from the market. It simply ran out of resources to raise any more liquidity, and it faced inevitable default under its swap contracts, which would have led to bankruptcy.

This was the situation facing the Fed by the second week of September, 2008.

The Fed Steps In

The Fed already had its hands full in the summer and fall of 2008. First, Bear Stearns collapsed and was thrown into the arms of JP Morgan Chase, but only after the Fed agreed to take over the Bear Stearns real estate portfolio worth $30 billion in dodgy real estate assets. The quasi-government giants Fannie Mae and Freddie Mac had to be taken over by the government, then Countrywide Financial collapsed and also was pushed into a forced sale to a bank.

There was so much criticism directed at the government for the way in which these rescues were being done, and the amount of taxpayer money spent in the process, that when it came time to deal with the collapse of Lehman Brothers, the Treasury and the Fed threw this firm to the wolves on September 15, 2008. It received no help from the government and was thrown into the bankruptcy courts. This precipitated a global market meltdown.

The trigger for this meltdown occurred at the oldest mutual fund in the US, American Reserve Fund, which took a writedown of $785 million on Lehman Bros. bonds it held in its money market fund. This was announced on the afternoon of September 15, and by the close of business that day massive amounts of withdrawals were taking place at American Reserve since no money market fund had ever experienced such a loss (money market funds were supposed to be as safe as checking accounts).

When the market opened the next morning, mutual funds everywhere couldn’t cope with the withdrawals. The commercial paper market ground to a halt, as did the Eurodollar market for short term loans in London. Stock markets around the globe tanked. The global financial system was nearly paralyzed.

The US government stepped in and guaranteed the safety of all money market funds. It allowed Goldman Sachs and Morgan Stanley, the last two surviving old-line investment banks, to become commercial banks and enjoy the benefits of Fed liquidity. The Fed had been working since the previous week on the dire liquidity situation at AIG, and it had asked JP Morgan Chase and Goldman Sachs to form a bank syndicate to provide AIG with a massive $75 billion loan to solve its liquidity problem.

JP Morgan Chase came up with a package that charged AIG an onerous 11.3% on the $75 billion loan – a full $9 billion a year in interest alone. The banks would take an 80% ownership interest in AIG’s assets. This loan package was also intended to stop the ratings agencies from yet again lowering AIG’s ratings, which would have cost the company yet another round of collateral calls from the market.

There was one big problem, though. When the banks looked at AIGFP’s portfolio of swaps, and the potential collateral demands that could still occur, they realized that AIG, if it could sell all of its assets at decent market prices, still wouldn’t be able to meet the liquidity demands. In other words, the way the market was developing, AIG was headed straight towards default and the bankruptcy courts. Making this situation even worse was the global market collapse occurring at the same time as the result of the Lehman bankruptcy. The banks told the Fed that the loan package had collapsed. The banks effectively threw the AIG problem on to the laps of the regulators, none of whom by the way had any legal responsibility, regulatory oversight, or historical familiarity with AIG. It was an insurance company that had somehow become bigger and more important than even the biggest banks.

In deciding what to do, the Fed had about 24 hours from September 15 to 16 to analyze with the Treasury the AIG situation. They discovered that AIG would default on $103 billion in loans from state and local governments, $50 billion in bank loans and derivatives, $20 billion in commercial paper, and $40 billion in insurance covering 401k retirement packages across the US. The problems ranged from the horrendous to the horrific. The municipal bond market stood to be devastated by state and municipal loan losses. The Lehman bankruptcy involved $8 billion in commercial paper losses, which led to the Reserve Primary Fund disaster, but AIG’s commercial paper losses were much bigger at $20 billion. The 401k losses would affect tens of millions of Americans. AIG’s loan losses spread to banks all around the world.

The Fed and Treasury, standing in the middle of a global financial collapse the day after the Lehman Brothers bankruptcy, felt they had no choice but to save AIG, a much bigger player with far greater reach and implications for economic and financial disaster. The Treasury authorized an $85 billion line of credit at the Federal Reserve NY for the purpose of lending to AIG the amounts needed to post collateral behind its swaps at AIGFP. The Fed had no plan in place on how to do this, so it simply lifted the term sheet conditions from the JP Morgan failed loan package, and used those terms to lend to AIG.

From September 16 through October, the Fed lent $61 billion to AIG, over half of which found its way into the market as collateral to support its swaps. At the same time, AIG was instructed to begin reducing its swap book. This required AIG to turn to all the big banks with which it had a swap portfolio, and ask to close out, or abrogate the swap contracts. The banks would consider doing this, but would not want to be then left with the CDO risk that caused it to enter into the swaps in the first place. There was some talk of AIG therefore taking over the CDOs as well, which had sunk substantially in value because of the default risk, but it was very difficult to agree with each bank on what these CDOs were worth. In fact, the banks weren’t willing to sell these CDOs at any discount whatsoever, despite what the market said they were worth, so AIG turned to the Fed for help, and authorized the Fed to negotiate on their behalf.

Here is where we come to the gist of the Barofsky report and the criticisms of the Fed. But let us recap two critical facts up to this point. As of September 15, AIG was certainly heading for bankruptcy, within a manner of days. The banks stood to lose billions on their swaps with AIG, because they would be under-collateralized if the CDOs fell further in value, and because they could not easily all at once get replacement CDS coverage for their CDOs.

Second, shortly after September 16, the banks began receiving collateral from AIG, courtesy of the Fed via the $85 billion loan authorization. For the next two months, the banks were made whole as necessary whenever their CDOs fell in value. The banks could look at their portfolio with AIGFP and consider it safe and secure because of the collateral, and as important, because of the guaranty of more collateral to come as necessary, courtesy of the federal government.

The Fed Tries Its Hand at Negotiating

In early November the Fed assigned a team of managers to begin negotiating for the abrogation of the CDSs. They chose the eight largest bank counterparties to talk to, including Goldman Sachs, BOA, JP Morgan Chase, Deutsche Bank, UBS, and top of the list was Societe Generale in Paris. The plan was to ask the banks to tear up the CDS contracts through a legal abrogation agreement. It was common for banks to do this in the derivatives market from time to time, though never before on a large scale. The banks always required the customer to pay them for any potential real market losses they may incur in abrogating the contract, plus interest and a bit of a fee for all the trouble. Abrogations have never been cheap, especially if the customer was desperate to get out of a deal.

What would the banks want? Collectively, they held CDOs worth a face value of $62.1 billion, and these were the underlying CDOs behind the swaps bought from AIGFP. The banks wanted to give these over to the Fed and get $62.1 billion back, because otherwise the banks would be stuck with CDOs that were unhedged for further default problems.

The market price for this collective group of CDOs was in early November $29.6 billion, which tells you just how badly the market had trashed these instruments. But the banks held cash collateral of $35.0 billion to protect against just this contingency, and if you add the two numbers up, you come to a bit over the $62.1 billion in face value. In other words, the banks were sitting pretty. They were 100% covered for the existing market losses on these CDOs, and the market pricing was beginning to stabilize.

Remember that all this collateral came from the Fed on behalf of the now moribund AIG. The banks wanted to do a simple deal. They would give the Fed all the CDOs in exchange for $29.6 billion in cash – their current market value. They would keep all the existing cash collateral, so they would be perfectly whole. They would then abrogate the CDSs and have no further claim on AIGFP, as if the whole mess never occurred. The Fed, meaning the taxpayers, would be out $62.1 billion in cash to clean this mess up.

In preparing talking points for the negotiations, the Fed reminded each bank that it would be appropriate to give back some of the collateral to the Fed rather than keep it all. The Fed, by stepping in a month earlier, had saved the banks from billions of losses had AIG gone into bankruptcy, and these losses might have included a systemic crisis in which a few other banks went under and couldn’t pay their obligations as well. “”Be nice to us, given all that we have done for you,” was the Fed motto.

The Fed then tied the hands of their negotiators in several ways. First, the Fed would not threaten to throw AIG into bankruptcy if they didn’t get a “haircut” on the $35 billion in collateral. This would be unethical because the Fed had no plan to put AIG into bankruptcy and everybody knew it. Second, the Fed negotiators would have to do the same haircut deal with everybody. If Goldman Sachs agreed to return 30% of the collateral, JP Morgan Chase would have to agree to the same thing. Third, the banks were told up front that their participation in the negotiations was entirely “voluntary”; nobody was going to be forced to do anything or accept any haircut.

You should not be surprised that seven of the eight banks refused to take any haircut on the collateral and would therefore return none of it. They argued the cash was theirs, not the Fed’s, and they owned it by the sanctity of a legal contract that the Fed was proposing to violate. Second, AIGFP was not in default and there was no bankruptcy, and there wouldn’t be any, so giving back collateral when there was no legal requirement would constitute a breach of fiduciary duty that the banks had to their shareholders. Unstated in all this was the fact that the Fed wasn’t threatening any consequences if the banks refused to give back any of the collateral.

The kicker that destroyed any possibility of the Fed getting some of the collateral back occurred with the French bank. They told the Fed that it was not simply a fiduciary responsibility they had to follow in keeping cash that was rightfully theirs – it was decidedly against French law to give back the collateral because there was no bankruptcy. The French regulators confirmed this in no uncertain terms to the Fed, with the implication that if the Fed pushed on this point relationships with the French government would be damaged. Remember that all the banks had to agree to the same deal, so each bank had a veto power over any deal, and the French bank had the ultimate veto – it was illegal for them to give back the collateral.

The negotiating team reported all this back to Timothy Geithner, and recommended that the Fed settle all the swap abrogations by allowing the banks to keep all the collateral and thereby effectively receive par value on contracts that in the market were worth less than half that. Geithner agreed and the deal was done. The Fed then promptly kept all these details secret, including the names of the banks involved, and even went to court to maintain this secrecy under the financial equivalent of a “state secret” argument. They recently lost this argument on appeal to a higher court, and the Barofsky report severely berated the Fed for this because no terrible consequences have occurred now that the details are known.

What Went Wrong Here?

The Barofsky report lays a pretty heavy blanket of criticism on the Fed for not just the secrecy of their actions, but the actions themselves. The Fed didn’t have to treat everyone all the same. It could have accepted different levels of haircuts. It didn’t have to put so much faith in the sanctity of contracts when AIG was in virtual suspended animation – bankruptcy in all but name.

These criticisms do not show an understanding of how the Fed works. Like any large American organization, it pays considerable attention to the law. Timothy Geithner had a high powered, high-priced General Counsel sitting as his right side all the way. Geithner was told clearly that as long as AIG was not in bankruptcy, the Fed might damage its reputation by violating the terms of perfectly sound legal contracts and insisting on repayment of collateral when it was not legally required. He was also told the Fed had no ethical right to threaten bankruptcy when the threat could not be backed up later in court with proof it was real. He was probably told – though there is no proof of this in the report – that giving any bank preferential treatment on haircuts exposed the Fed later to lawsuits of unfair treatment.

Timothy Geithner is like most American executives – he is a technocrat. He respects technical advice, especially of the legal kind, and he abides by it. Past presidents of the NY Fed might be different – Gerald Corrigan comes to mind during the Drexel Burnham bankruptcy. He would bang some heads together to get an outcome that satisfied the political pressure on the Fed, even if it meant overriding legal advice. Gerald Corrigan, by the way, now works for Goldman Sachs. He might have in this situation taken Goldman Sachs and JP Morgan Chase aside and said, “I want you guys to get your consortium of banks to agree on a haircut – something like 30% would be nice – and I want all of you to come back and voluntarily request that the CDS collateral provisions be waived in favor of paying back to the Fed some amount of the collateral. I don’t care how you do this, and it is not going to be the Fed asking for it – it is going to be voluntarily offered to us.” The banks would not need to be told that there was a steel hand underneath the Fed’s velvet glove.

Maybe Timothy Geithner would have done this, technocrat though he is, if there were enough political pressure on him to save the taxpayers billions of dollars, but there wasn’t. No one in the Bush administration – certainly not Henry Paulson at Treasury – was demanding fairness for the taxpayers. There was public disgust over the whole bailout process, but this disgust got bottled up in a Congress paid for by the financial industry. Barofsky might have mentioned that lack of political pressure, and the consequent insensitivity to taxpayer needs that the Fed and the Treasury displayed, but he didn’t, maybe because his current paymaster, the Obama administration, isn’t showing any such sensitivity either.

Which brings us to the crux of the problem, only hinted at in the Barofsky report. The real problem for the taxpayers didn’t occur when the NY Fed failed to negotiate the return of some of the collateral in November, 2008. The problem occurred on September 16, when the Fed and the Treasury were suddenly faced with a collapsing AIG. Had there been any forethought and planning for such an event, the reaction could have been very different and far less panicky.

The first response should have been: ”Financial markets worldwide are frozen, and they are going to stay frozen for a long time no matter what we do with AIG." In hindsight, this is exactly what happened. The commercial paper market has taken nearly a year to recover a fraction of its previous activity, and this was only after the Fed had to guarantee transactions. Credit spreads took nine months to begin coming down to normal levels. Banks are lending to each other only because governments around the world now guarantee their bank activity, but banks are still not lending to corporations, small businesses, or individuals. The housing market in the US exists entirely on the generosity of Federally-managed firms like Fannie Mae, Freddie Mac, and FHA. In other words, the disaster that the Fed faced on September 16 rolled on despite the rescue of AIG.

If AIG had been allowed to fail, the market would have learned a serious lesson about dealing with companies that act like banks but really have no controls or regulatory oversight like banks. The pain would have been greatest at the banks themselves. Some banks like Citigroup and Bank of America would have been even more crippled than they are now, but their current status as zombie banks would not be any different. The damage done to 401ks could have been mitigated by additional federal government guaranties, but even here the cost while enormous would have been less than what was spent paying off AIGFP’s credit default swaps at par.

Suppose you say that it is impossible to expect government bureaucrats to react on September 16 in any different manner. You can argue that any normal person would have panicked too, and that tough-nosed regulators like Gerald Corrigan don’t come around all that often – in fact these days they are all working for Goldman Sachs. Fine. Where, then, was the prudential planning for this catastrophe. All it would have taken is someone in advance of the crisis – a clever lawyer for example – inserting one clause in the agreements with banks before any collateral was posted with them. It would have said “The Federal Reserve Bank of New York reserves the right at any time to demand immediate repayment of any or all amounts of collateral posted with Bank X, with no compensation required to be paid to Bank X in any form by the Federal Reserve Bank of New York, and Bank X hereby waives all rights to petition for a legal stay of said repayment.” If the banks didn’t like this clause, they wouldn’t get their collateral. They could go ahead and sue the government for breach of contract, but in the meantime they would be experiencing real pain with their CDO portfolio and the pressure would be on them to settle. Once the collateral was out the door, the Fed lost all leverage with the banks, and this is why the November negotiations were a foregone conclusion and a waste of time.

Finally, what is fundamentally missing at the Fed and the Treasury, and certainly now with two successive administrations and almost all 535 public servants in Congress, is the sense that the big financial institutions which have created this monstrous mess are dispensible. The problems that have arisen due to their avarice and misjudgments are only going to be solved over time, and are best solved in bankruptcy courts or through FDIC closure processes, not by making these institutions wards of the state until 10 or so years later they are nursed back to health. The public can and has been protected through deposit insurance, but the collapse of lending and credit in general has not been mitigated one whit by anything done so far to rescue these institutions. Let them die a merciful, quick death if death is their fate anyway. We will all of us individually benefit from such mercy as well.

The downside of a weak dollar

Thu, 19 Nov 2009 06:52:34 -0800

MarketWatch First Take

Nov. 13, 2009, 2:03 p.m. EST
The downside of a weak dollar
Commentary: Inadvertently driving a bigger trade defici

By MarketWatch

SAN FRANCISCO (MarketWatch) -- The latest international trade numbers border on blasphemy.

For the generations of college kids who learned the ABCs of global economics from Paul Samuelson, a weak dollar is supposed to tip the balance of trade in favor of the nation's exporters. So why is the trade deficit exploding?

The dollar has lost 16% of its value against six other major currencies since March. In one quarterly report after another, companies doing business abroad showed they padded their profits every time they converted sales in local currencies back into U.S. dollars -- effectively enjoying the equivalent of a price hike without actually hiking prices.

The weaker greenback also gives American companies a competitive edge over the foreign rivals when bidding on big projects.

So why in the world did the U.S. trade deficit widen in September? Not just a little, either.

The Commerce Department reported Friday the deficit surged 18% to $36.5 billion from $30.8 billion in August, its biggest one-month jump since 1999. Read about the September trade gap.

What gives?

The answer is pretty easy, really: Oil. Despite the nation's manic obsession with bank bailouts and unemployment, crude oil remains its Achilles heel.

Senate Democrats introduce $849 billion healthcare reform bill

Thu, 19 Nov 2009 06:11:56 -0800

Brad Knickerbocker | Washington | November 18

CSM - Though the congressional debate and legislative sausage-making are far from over, the Senate took a major step Wednesday in putting forth a $849 billion healthcare reform bill.

The bill, launched by Senate majority leader Harry Reid – and vigorously opposed by Republicans – aims to provide health insurance for 94 percent of all Americans, including 31 million people now uninsured.

The measure reportedly would require most Americans to carry health insurance, require large companies to provide coverage for their employees, and prohibit insurance companies from denying coverage because of preexisting medical conditions.

A senior Democratic leadership aide told the Associated Press that Congressional Budget Office analysis showed the bill would reduce federal deficits by a total of $127 billion over 10 years.

[...]

A key subject of debate – in addition to a public option and the impact on the federal deficit – is abortion. The House-passed bill includes the so-called “Stupak amendment” offered by Rep. Bart Stupak (D) of Michigan, which tightens current restrictions on the use of federal funds for abortion services.

Newsweek reports that abortion language in the Reid bill is less restrictive than Stupak. But it could well reappear as House-Senate negotiators try to work out their differences in conference committee.

[...]

Reuters reports that the debate is expected to begin on Nov. 30, after the Thanksgiving holiday next week, and last for at least three weeks.

Capital flows to US surge despite dollar weakness

Tue, 17 Nov 2009 13:19:47 -0800

Bangkok | November 18

Bangkok Post -

Foreign investment for US bonds and other long term investments, including from China, rose beyond expectations despite concerns over the weakness of the dollar, official data showed Tuesday.

Net long-term capital flows to the United States climbed to 40.7 billion dollars in September from a revised 34.2 billion dollars the prior month, according to the Treasury International Capital Data (TIC) monthly report.

Most economists had expected flows to reach 30.0 billion dollars.

On the whole, foreigners bought 133.5 billion dollars of US securities in September, the most since October 2008, from a revised inflow of 25.3 billion dollars in the previous month.

"This is the fourth consecutive month of positive net TIC flows and good news for the greenback," said Tu Packard, a senior economist at Moody's Economy.com.

She said the Treasury data showed financial markets were on the road to recovery from the worst crisis in decades that arose from a home mortgage meltdown.

Although investors are pursuing more risky investments in line with recovery, there remains foreign appetite for US financial assets, Packard said.

Investors usually flock to the US dollar during financial and other troubles but the greenback took a hit in recent months on rising risk appetite and concerns over a ballooning US government budget deficit.

China, in the forefront of criticism on dollar's weakness, also raised its Treasury bond holdings in September to 798.9 billion dollars from 797.1 billion in August, the Treasury report said.

China, top holder of US debt, has consistently raised concerns about the mushrooming US debt, for fear it could erode the value of the dollar and its Treasury holdings.

Audit Faults New York Fed in A.I.G. Bailout

Tue, 17 Nov 2009 05:26:08 -0800

Mary Williams Walsh | Washington | November 16

NYT -
The Federal Reserve Bank of New York gave up much of its power in high-pressure negotiations with the American International Group’s trading partners last year, according to a government report made public on Monday.

Just two days before the New York Fed paid A.I.G.’s partners 100 cents on the dollar to tear up their contracts with the insurance giant, one bank volunteered to take a modest haircut — but it never got the chance.

UBS, of Switzerland, alone offered to give a break to the New York Fed in the negotiations last November over how to keep A.I.G. from toppling and taking other banks down with it. It would have accepted 98 cents on the dollar.

But UBS’s good-faith gesture was quickly drowned out by Goldman Sachs and the top French bank regulator. They argued, with others, that it would be improper and perhaps even criminal to force A.I.G.’s trading partners to bear losses outside of bankruptcy court.

The banks and the regulator were confident that the New York Fed was not willing to push A.I.G. into bankruptcy, because earlier in the fall the New York Fed had stepped in with $85 billion to prop up the insurer.

The New York Fed, led then by Timothy F. Geithner, who is now the Treasury secretary, therefore had little leverage in the negotiations, according to a post-mortem of what has emerged as the most inflammatory episode in the rescue of A.I.G.

The Fed “refused to use its considerable leverage,” Neil M. Barofsky, the special inspector general for the Troubled Asset Relief Program, wrote in a report to be officially released on Tuesday, examining the much-criticized decision to make A.I.G.’s trading partners whole when people and businesses were taking painful losses in the financial markets.

Recession causes more families to go without food

Tue, 17 Nov 2009 02:51:15 -0800

Tony Pugh | Washington | Nov 17

McClatchy - The number of U.S. households that are struggling to feed their members jumped by 4 million to 17 million last year, as recession-fueled job losses and increased poverty and unemployment fueled a surge in hunger, a government survey reported Monday.

These "food-insecure" households represent about 49 million people and make up 14.6 percent, or more than one in seven, of all U.S. households. That's the highest rate since the U.S. Department of Agriculture began monitoring the issue in 1995.

Additionally, more than one-third of these struggling families — some 6.7 million households, or 17.2 million people last year — had "very low food security," in which food intake was reduced and eating patterns were disrupted for some family members because of a lack of food.

In phone interviews, more than two-thirds of people with very low food security said they went hungry from time to time, and 27 percent of these adults said they didn't eat at all some days.

These families make up 5.7 percent of U.S. households, again the highest rate since 1995, up from 4.1 percent and 4.7 million households in 2007.

Benefactors or Piranha ? Our Foreign Friends

Mon, 16 Nov 2009 11:50:46 -0800

Like Blanche DuBois, the United States is "down on its uppers." We rely on the kindness of foreigners to finance our government.

A Whole Lot of Kindness

U.S. Department of the Treasury, Oct. 16, 2009

These customers must be extending kindness. How else do you explain the massive purchase of Treasuries Securities? They're ignoring wars that we can't afford and defense expenditures equaling 50% of the world's total spending. They're also ignoring the giveaways to failed Wall Street firms and others plus the forgiveness of the executives in charge by assuring their ongoing positions and bonuses.

It would be easy for an investor to look at the United States and say forget about it. But they don't. As a result, we're able to function, at least for a while, as though we're not totally upside down. Of course, there's self interest involved. If we hit the skids, they're likely to feel the back draft. But their self interest serves us well right now.

But there's another take on our benefactors. A "new kid" on the advocacy new block is sounding the alarm. Economy in Crisis is the new media group and their publication is America's Economic Report Daily.

"The American sellout is happening faster than ever as our companies are being taken over in a buying frenzy by foreign investors – like piranha fish consuming its weakened prey. Many of these companies have taken one hundred or more years to develop and were the source of our wealth, strength, and living standards; now overnight, gone. We should be concerned and even outraged that our government let this happen." About Economy in Crisis

Economic Emergency has some well known political figures signed up. These include Senator Byron Dorgan (D-ND), Pat Buchanan, Paul Craig Roberts, and former Sen. Fritz Hollings (D-SD) are the headliners. There also Democrats listed including Danny Schechter, Dan Mercia, and independent commentator Thom Hartmann.

There is a good deal of finger pointing in the group's mission statement. Foreign investors are like a school of piranha rippling the flesh off this country by devouring our businesses. And it's the "government" that let it happen. This is curious. Is the government some sort of discrete entity operating on its own rather than an arm of the financial interests that buy and control those who make up the three branches?

The people are left out in favor of offering, "solutions to return America's former economic glory" by becoming a key information source showing how the "US economy is being drained by foreign competitors and how our standard of living is being diminished."

Where were these people in the 1980's when Ronald Reagan systematically destroyed the union movement? Where were they over the past three decades when wages have been essentially flat? Where were they when money polluted election after election giving us a bought and sold Congress and White House? Did they notice that we've been spending half of our budget on war and fighting a few lately that have nothing to do with defense? We've had a tech bubble and a housing bubble. The former ended poorly. The latter triggered the current disaster. What glory? When would that have been?

It looks like our benefactors are losing faith based on these percentage changes from Dec 08 through Jul 09. Is this a good time to start calling the foreign governments that keep us afloat nasty names?

You can tell a lot about a political advocacy group by what they leave out. This organization has some good points on trade agreements etc. but there is hardly any mention of people, other than in reference to "our living standards." Who knows? That might mean the living standards of the membership.

Even if the foreign investors are piranha, the feeding frenzy wasn't arranged by the fish. It was home grown; Made in the USA by the very people screaming for protection right now.

END

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