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    Daily Digest – Jan 26

    by Davos

    Monday, January 26, 2009, 12:08 PM

  • Country Default Risk Continues to Rise
  • Nationalization Gets a New, Serious Look
  • Summers Says Economy Entering a ‘Difficult’ Time
  • Office of the Special Inspector General Troubled Asset Relief Program (SIGTARP)/Congressman Bachus (Letter)
  • Lending Less (Table of the biggest recipients of U.S. capital saw loan volumes decline in Q4)
  • Roach: Worst is Ahead for the US (Video)
  • Another Lay-off Shock: Caterpillar (CAT) To Cut 20,000
  • Report: Birth Rates Fall In Tough Economy
  • Six Errors on the Path to the Financial Crisis
  • Gold Bubble Could Be Quite A Bubble, If It Takes Off (Hat Tip Jeff Borsuk)
  • Wasting Time At Davos
  • Governors seek concessions from public workers
  • No New News: Banks Won’t Lend Money 
  • Did Americans think the US economy had bottomed in 1933? 
  • Tax law changes and banking
  • The "Wells Fargo Ruling"
  • (Letter) From FAF (Financial Accounting Foundation) to Barney Frank
  • SEC Altering the Rules
  • (Fast Track) FASB Amends Fair Value Measurements
  • (Fast Track) SEC Begins Mark-to-Market Study
  • (Fast Track) FASB Speeds up Fair Value Advice
  • (Financial
    Opinionators Say) By Relaxing "Mark-to-Market" Rules, Has the U.S.
    Switched Off its Financial Crisis Early Warning System?
  • (Recent News) Does Fair Value Accounting + Credit Default Swaps = Global Deflation?
  • Time to Unravel the Knot of Credit-Default Swaps  


Country Default Risk Continues to Rise 

Below we highlight CDS prices for sovereign debt. These prices measure the cost of protection against default for 38 countries around the world. Specifically, the CDS prices represent the cost per year to insure $10,000 worth of sovereign debt for five years. 

As shown, Argentina and Venezuela have the highest default risk, followed by Iceland, Kazakhstan, Russia, and Egypt. While the UK and US have relatively low default risk compared to most other countries, their CDS prices are getting worrisomely high. At the start of 2008, it cost about $8 to insure $10,000 of UK and US debt. It now costs $135 to insure UK debt and $75 to insure US debt. Japan has the lowest default risk of all of the countries highlighted, followed by Germany and France. (2 Good Charts) 

Nationalization Gets a New, Serious Look 

WASHINGTON – Only five days into the Obama presidency, members of the new administration and Democratic leaders in Congress are already dancing around one of the most politically delicate questions about the financial bailout: Is the president prepared to nationalize a huge swath of the nation’s banking system?

Speaker Nancy Pelosi has alluded to internal debate over whether large banks should be nationalized, while aides to President Obama have avoided the word and are looking into alternatives.

Privately, most members of the Obama economic team concede that the rapid deterioration of the country’s biggest banks, notably Bank of America and Citigroup, is bound to require far larger investments of taxpayer money, atop the more than $300 billion of taxpayer money already poured into those two financial institutions and hundreds of others.

But if hundreds of billions of dollars of new investment is needed to shore up those banks, and perhaps their competitors, what do taxpayers get in return? And how do the risks escalate as government’s role expands from a few bailouts to control over a vast portion of the financial sector of the world’s largest economy?

The Obama administration is making only glancing references to those questions. In an interview Sunday on "This Week" on ABC, the House speaker, Nancy Pelosi, alluded to internal debate when she was asked whether nationalization, or partial nationalization, of the largest banks was a good idea.

Summers Says Economy Entering a ‘Difficult’ Time 

Jan. 25 (Bloomberg) — The U.S. economy faces "very difficult" months ahead, requiring quick passage of a stimulus package and a retooled bank rescue plan aimed at reviving lending, said Lawrence Summers, director of the White House’s National Economic Council. 

"The next few months are, no question, going to be very, very difficult and it may be longer than that," said Summers, appearing on NBC’s "Meet the Press."

Timothy Geithner, the Treasury secretary nominee, will announce Obama’s strategy for stabilizing financial firms soon after the Senate confirms him, Summers said. The administration’s stimulus proposal is "properly sized" at $825 billion, and Obama is "prepared to do what’s necessary" to revive the economy, he said.

Gross domestic product probably contracted at a 5.5 percent annual rate from October through December, the biggest drop since 1982, according to the median estimate in a Bloomberg News survey ahead of Commerce Department figures due Jan. 30.

Summers said Obama plans to overhaul the $700 billion Troubled Asset Relief Program enacted in October. Obama’s bank rescue plan, using the remaining $350 billion in TARP, will be "very different" than it was under George W. Bush’s administration, Summers said.

Under Bush, TARP focused on providing fresh capital to financial institutions.

"The priority is to get credit flowing again," Summers said. "It’s going to emphasize transparency, it’s going to emphasize accountability."

Office of the Special Inspector General Troubled Asset Relief Program (SIGTARP)/Congressman Bachus (Letter)

Lending Less (Table of the biggest recipients of U.S. capital saw loan volumes decline in Q4)

Roach: Worst is Ahead for the US (Video)

Another Lay-off Shock: Caterpillar (CAT) To Cut 20,000 

Caterpillar (CAT) said it had a good year in 2008 and even a reasonable fourth quarter. But, its prospects for this year are so bad that it will dump 20,000 people, an astonishing number. 

CAT admitted that it could not even call the depth of the recession. The company said "Global economic conditions and key commodity prices have continued to decline significantly. Financial markets remain under stress, and our expectations for 2009 have deteriorated. Uncertainty around the depth and duration of this recession makes it very difficult to forecast sales and revenues."

If lay-offs of this magnitude continue, unemployment will be 9% going into the second quarter. 

Report: Birth Rates Fall In Tough Economy 

The recession is leaving some doctor’s offices empty. More women are putting motherhood on hold and recent reports show contraceptive sales are through the roof. 

Many prospective parents are changing their plans when it comes to pregnancy. Planned Parenthood has seen an increase in patients, but they say economic effect is more because of lost jobs and health care.. 

Six Errors on the Path to the Financial Crisis 

What’s a nice economy like ours doing in a place like this? As the country descends into what is likely to be its worst postwar recession, Americans are distressed, bewildered and asking serious questions: Didn’t we learn how to avoid such catastrophes decades ago? Has American-style capitalism failed us so badly that it needs a radical overhaul? 

The answers, I believe, are yes and no. Our capitalist system did not condemn us to this fate. Instead, it was largely a series of avoidable – yes, avoidable – human errors. Recognizing and understanding these errors will help us fix the system so that it doesn’t malfunction so badly again. And we can do so without ending capitalism as we know it.

My list of errors has six whoppers, in chronologically order. I omit mistakes that became clear only in hindsight, limiting myself to those where prominent voices advocated a different course at the time. Had these six choices been different, I believe the inevitable bursting of the housing bubble would have caused far less harm.

WILD DERIVATIVES In 1998, when Brooksley E. Born, then chairwoman of the Commodity Futures Trading Commission, sought to extend its regulatory reach into the derivatives world, top officials of the Treasury Department, the Federal Reserve and the Securities and Exchange Commission squelched the idea. While her specific plan may not have been ideal, does anyone doubt that the financial turmoil would have been less severe if derivatives trading had acquired a zookeeper a decade ago?

SKY-HIGH LEVERAGE The second error came in 2004, when the S.E.C. let securities firms raise their leverage sharply. Before then, leverage of 12 to 1 was typical; afterward, it shot up to more like 33 to 1. What were the S.E.C. and the heads of the firms thinking? Remember, under 33-to-1 leverage, a mere 3 percent decline in asset values wipes out a company. Had leverage stayed at 12 to 1, these firms wouldn’t have grown as big or been as fragile.

A SUBPRIME SURGE The next error came in stages, from 2004 to 2007, as subprime lending grew from a small corner of the mortgage market into a large, dangerous one. Lending standards fell disgracefully, and dubious transactions became common.

Why wasn’t this insanity stopped? There are two answers, and each holds a lesson. One is that bank regulators were asleep at the switch. Entranced by laissez faire-y tales, they ignored warnings from those like Edward M. Gramlich, then a Fed governor, who saw the problem brewing years before the fall.

The other answer is that many of the worst subprime mortgages originated outside the banking system, beyond the reach of any federal regulator. That regulatory hole needs to be plugged.

FIDDLING ON FORECLOSURES The government’s continuing failure to do anything large and serious to limit foreclosures is tragic. The broad contours of the foreclosure tsunami were clear more than a year ago – and people like Representative Barney Frank, Democrat of Massachusetts, and Sheila C. Bair, chairwoman of the Federal Deposit Insurance Corporation, were sounding alarms.

Yet the Treasury and Congress fiddled while homes burned. Why? Free-market ideology, denial and an unwillingness to commit taxpayer funds all played roles. Sadly, the problem should now be much smaller than it is. 

Gold Bubble Could Be Quite A Bubble, If It Takes Off (Hat Tip Jeff Borsuk) 

The thought in this post may be obvious (I wrote something similar about a year ago when I was a complete gold newbie), but it struck me as fresh and relevant today. 

Here’s a quote from LeMetropoleCafe: "If Gold can continue this week’s outperformance of all other asset classes, investment demand for Gold should continue to accelerate."

What happened when there was an Internet bubble? It was ultimately extinguished by the supply of Internet Stocks (in the form of IPOs) exceeding the demand for stock. Then the bubble popped.

What happened when there was a real-estate bubble? Home builders ramped up home building and the bubble was ultimately extinguished by the supply of houses exceeding the demand for houses.

Now, let’s consider gold as a potential bubble. Suppose "investment demand for gold continues to accelerate". There is a limited amount of gold in the world. Wikipedia reports that there has been roughly 158,000 tonnes of gold over all history. At $1000 / oz and 33.1 grams / troy oz that is 4.8 billion oz and 4.8 trillion dollars.

By comparison, Global GDP is around 48 trillion dollar / year. US household financial assets (as of a year ago) were roughly the same size.

The supply of gold (mine production) is increasing at the rate of around 110 million oz / year or 2.3% of all gold ever mined per year. Again at $1000 /oz that is 110 billion dollars / year or roughly .2% of global GDP.

Wasting Time At Davos 

David Paterson, the governor of New York State, will be attending the World Economic Forum in Davos this week, along with aides and several state troopers, sparking rumors that Switzerland is a hot bed of extremists who might cause Paterson physical harm. The press is unhappy that he will be there, instead of staying home, where he could be working to find solutions to the severe economic crisis in New York State. 

It is noteworthy that so many CEOs of failing companies and heads of faltering governments are showing up in Davos to exchange pleasantries and listen to lectures which are unlikely to offer even modest clues about how the recession might be halted or reversed. Why should a group of economists or business titans travel to Davos to hear commentary about why the economy is broken when there are so many intelligent and conflicting opinions in their home countries?

So, it is alarming that Michael Dell, the founder and CEO of Dell (DELL) will be at Davos. He cannot lay off people fast enough back in his hometown of Austin. The chairman of Lloyd’s will be there. Lord Levene can say he was away from London when the UK nationalized his company due to massive losses. John Thain, who was the head of Merrill Lynch and was fired from its parent, Bank of America (BAC), is scheduled to attend. After Merrill reported a $15 billion loss no one expected, he may decide to cancel. BAC will certainly not cover the cost of his travel..

A very large number of government officials will also attend. This list includes the heads of Germany, Japan, and the premier of The People’s Republic of China.

Governors seek concessions from public workers 

COLUMBUS, Ohio (AP) – Governors across the nation are seeking significant concessions from public employee unions in hopes of helping to balance their teetering budgets during the economic downturn. 

From Maryland to California, Ohio to Hawaii, governors have asked or ordered state workers to accept furloughs, salary reductions, truncated workweeks or benefit cuts. They say the concessions are a better alternative to further job losses in the face of record-breaking unemployment.

Unions argue their members shouldn’t be singled out and are even more vital in hard times – securing neighborhoods and prisons, educating children and providing social services to growing numbers of citizens.

In hard-hit Ohio, Democratic Gov. Ted Strickland has been a friend of the unions. But as the state’s budget woes have intensified, he is asking unionized state employees to consider a 5 percent pay cut, a 35-hour workweek and the elimination of paid personal days and holidays, to save the state hundreds of millions of dollars.

No New News: Banks Won’t Lend Money 

Despite getting cash from the government, banks aren’t lending more money. It makes a good headline, but it does not have any shock value. Why would anyone be surprised? 

According to The Wall Street Journal, "Ten of the 13 big beneficiaries of the Treasury Department’s Troubled Asset Relief Program, or TARP, saw their outstanding loan balances decline by a total of about $46 billion, or 1.4%, between the third and fourth quarters of 2008."

The banks put forward the compelling argument that in a recession there is too much credit risk. What they do not admit so readily is that they may need the cash to offset more losses from the pools of toxic assets, consumer credit, and LBO loans that they hold.

The federal government has three courses it can take to rectify the problem: 1) to force banks which get federal funding to loan out a portion of the money and risk defaults on those loans, 2) allow financial firms to hoard the cash because they will need it to stay in business, or 3) a combination of the two which would substantially increase bank aid from the government giving the largest institutions in the industry such huge injections of capital that they could afford to take loan risks and protect their balance sheets.

It is beginning to look like the $350 billion balance of TARP funds will not be nearly enough.  

Did Americans think the US economy had bottomed in 1933? 

Marshall Auerback here. Now that Barack Obama has been inaugurated, we should actually look back to 1933 to get a sense of perspective. How did Americans see the economy at the Inauguration of Franklin Roosevelt? The short answer is that Americans were actually anticipating worse to come in 1933, but Roosevelt delivered on his promises? I do not expect the same from Obama. 

On Inauguration Day, 1933 (then March 4), there were machine-gun nests at the corners of the great government buildings in Washington, for the only time since the Civil War. All banks in 32 states had been closed sine die. Six other states had closed almost all their banks. In the other 10 states and D.C., withdrawals were limited to 5 per cent of deposits, and in Texas to $10 a day. The New York Stock Exchange and Chicago commodity exchanges had also been closed indefinitely. The financial system had effectively collapsed, and was threatening to take the life savings of millions of people and what was left of the world’s financial system with it.

In a fever of activity, Roosevelt guaranteed bank deposits, made the federal government a temporary non-voting preferred shareholder in thousands of suddenly undercapitalised banks – more than half the banks in the country – refinanced millions of residential and farm mortgages, tolerated cartels and collective bargaining to raise prices and wages, increased the money supply, effectively departed the gold standard, repealed Prohibition of alcoholic beverages (wrenching one of America’s largest industries out of the hands of the underworld), and legislated reduced working hours and improved working conditions for the whole work force. In the next two years, in what became known as the Second New Deal, he set up the Securities and Exchange Commission, created the Social Security system, and broadened the powers of the Federal Reserve to equal those of other national central banks.

What FDR did, however, was inculcate hope and I don’t think the same can be said for Obama. In fact, I would go further. I don’t think that Obama has the moral strength to institute the equivalent of the SEC that FDR did and then use the act to hit hard where it is deserved. His limpwristed reaction to Thain’s thievery (yes, that is what it is, no matter how "legal") and his appointment of Wall Street’s friend, Timothy Geithner, tells me otherwise.

Obama spent too much time between Nov 8th and Jan 20th pretending that he was going to be like Lincoln and FDR when indeed he was far different. He actually fooled me at the beginning.

We will get the equity rally (led, in my opinion by commodities) (take a look at crude after having been lower on the day) but the smash up in the Treasury market and more Thain-type problems that are not dealt with forcefully will render his time in office to look much like the late 1970’s sooner than later.

As for China, I disagree with Albert Edwards at SocGen. You can’t rely on a strategy of export led growth in this kind of environment. This is in fact what China did in 1992-94 and it destroyed the Southeast Asian economies in the process (making them vastly uncompetitive and running large current account deficits which went as high as 9% of GDP). What he is in fact suggesting is a return to Bretton Woods II and I think we all agree that this is the last thing required. You want to get rid of these imbalances.

And I still believe that one has to distinguish between a coastal export driven economy, which comprises about 140m people, and what is happening in the interior, which is very different. It will ultimately be self-defeating (which is probably Susan’s point, when she argues that surplus nations, such as the US in the 1930s, get really screwed in this kind of environment. I think China has to turn massively toward infrastructure projects. 

The "Wells Fargo Ruling" 

The financial world was fixated on Capitol Hill as Congress battled over the Bush administration’s request for a $700 billion bailout of the banking industry. In the midst of this late-September drama, the Treasury Department issued a five-sentence notice that attracted almost no public attention. 

But corporate tax lawyers quickly realized the enormous implications of the document: Administration officials had just given American banks a windfall of as much as $140 billion.

The sweeping change to two decades of tax policy escaped the notice of lawmakers for several days, as they remained consumed with the controversial bailout bill. When they found out, some legislators were furious. Some congressional staff members have privately concluded that the notice was illegal. But they have worried that saying so publicly could unravel several recent bank mergers made possible by the change and send the economy into an even deeper tailspin. 

"Did the Treasury Department have the authority to do this? I think almost every tax expert would agree that the answer is no," said George K. Yin, the former chief of staff of the Joint Committee on Taxation, the nonpartisan congressional authority on taxes. "They basically repealed a 22-year-old law that Congress passed as a backdoor way of providing aid to banks."

The story of the obscure provision underscores what critics in Congress, academia and the legal profession warn are the dangers of the broad authority being exercised by Treasury Secretary Henry M. Paulson Jr. in addressing the financial crisis. Lawmakers are now looking at whether the new notice was introduced to benefit specific banks, as well as whether it inappropriately accelerated bank takeovers.

The change to Section 382 of the tax code — a provision that limited a kind of tax shelter arising in corporate mergers — came after a two-decade effort by conservative economists and Republican administration officials to eliminate or overhaul the law, which is so little-known that even influential tax experts sometimes draw a blank at its mention. Until the financial meltdown, its opponents thought it would be nearly impossible to revamp the section because this would look like a corporate giveaway, according to lobbyists.

Andrew C. DeSouza, a Treasury spokesman, said the administration had the legal authority to issue the notice as part of its power to interpret the tax code and provide legal guidance to companies. He described the Sept. 30 notice, which allows some banks to keep more money by lowering their taxes, as a way to help financial institutions during a time of economic crisis. "This is part of our overall effort to provide relief," he said.

The Treasury itself did not estimate how much the tax change would cost, DeSouza said.

A Tax Law ‘Shock’

The guidance issued from the IRS caught even some of the closest followers of tax law off guard because it seemed to come out of the blue when Treasury’s work seemed focused almost exclusively on the bailout. 

(Letter) From FAF (Financial Accounting Foundation) to Barney Frank

SEC Altering the Rules

(Fast Track) FASB Amends Fair Value Measurements 

The Financial Accounting Standards Board has provided new flexibility to allow banks and other financial institutions to re-price their assets during the credit crisis by amending its standard on fair value measurements. 

The FASB Staff Position clarifies the application of FASB Statement No. 157 in an inactive market and provides an illustrative example to demonstrate how the fair value of a financial asset is determined when the market for that financial asset is inactive.

At a meeting on Friday, FASB considered the proposed amendment, which it had put out for comment on Oct. 2 on an accelerated schedule (see FASB Speeds up Fair Value Advice). FASB received over 100 comment letters in just a week’s time and on Friday the board made some modifications to the proposed staff position and planned to quickly issue it.

"The staff analyzed all the comment letters and the recommendations of the board," said spokesperson Christine Klimek. "The board was in favor of the staff’s recommendations and the FSP will reflect that."

Among the suggestions received by the board, the staff had recommended ways to make the illustrative model clearer, she noted.

(Fast Track) SEC Begins Mark-to-Market Study 

The Securities and Exchange Commission said it has started work on a study of mark-to-market accounting authorized by the financial rescue bill that was approved last week.

The study is to be completed by Jan. 2, 2009, within the 90-day limit mandated by the bill, and will focus on the effects of mark-to-market accounting standards on a financial institution’s balance sheet; the impacts of such accounting on bank failures in 2008 and on the quality of financial information available to investors; the process used by the Financial Accounting Standards Board in developing accounting standards; the advisability and feasibility of modifications to such standards; and alternative accounting standards to those provided in FASB Statement Number 157 on fair value measurement.

(Fast Track) FASB Speeds up Fair Value Advice 

The Financial Accounting Standards Board has decided to shorten the comment period on its proposed guidance for determining the fair value of assets in inactive markets, even as Congress may allow banks to temporarily suspend mark-to-market accounting. 

At its Oct. 1 board meeting, FASB Chairman Robert Herz (pictured) announced that the rules of procedure governing the length of comment periods have been temporarily modified to allow a window of time within which FASB can act to provide needed guidance in the interest of investors and the capital markets.

(Financial Opinionators Say) By Relaxing "Mark-to-Market" Rules, Has the U.S. Switched Off its Financial Crisis Early Warning System? 

By relaxing the U.S. financial system’s mark-to-market accounting standards, the U.S. government is effectively deactivating the financial "early warning system" that let investors know that a global credit crisis was brewing – and kept it from turning into a total global meltdown, professional investors warn. 

As part of the just-passed U.S. bailout bill, the government has reiterated the Securities and Exchange Commission’s authority to relax the mark-to-market standards. If the SEC actually follows through on that directive, many professional investors worry that we won’t catch on to the next leg of the ongoing credit crisis until it’s way too late.

While politicians point to mark-to-market rules as the cause of the billions in write-downs and losses suffered by financial firms in recent quarters, in fact, it was mark-to-market accounting that first exposed the underlying problems in the complex markets for mortgage-backed securities (MBS) and credit-default swaps (CDS).

"Mark-to-market is reality-based accounting," said Money Morning Contributing Editor Shah Gilani in a phone interview yesterday (Tuesday). "Anything else requires a looking glass and a ticket to Wonderland."

"To me, mark-to-market accounting is the clarion sound of beagles barking, letting transparency hunters know down which dark hole the fox is hiding," said Gilani, a former hedge-fund manager who recently penned a five-part investigative series on the U.S. credit crisis – including an alternate bailout plan that he says would’ve cost taxpayers very little.

What FASB 157 did introduce was an asset hierarchy based on the market available for the assets. Assets are assigned to one of three categories based upon how liquid the assets actually are and, in turn, how easy they are to value, or price:

Level 1 assets are fully liquid, and easy to price.
Level 2 assets can be priced with the benefit of "comparable assets."
And Level 3 assets are completely illiquid and nearly impossible to price. 

(Financial Opiniators Say) "Mark-to-market" accounting fight goes down to the wire 

With the House vote looming on the financial-system bailout plan, proponents of "mark-to-market" accounting rules are trying to beat back efforts in Congress to suspend the rules as part of the bailout. 

The head of the Financial Accounting Foundation, which oversees the Financial Accounting Standards Board, on Thursday warned against "political interference" with accounting rules — although it’s clear this issue already has become seriously politicized.

"We believe that once Congress starts setting accounting standards through its political process, the integrity of U.S. accounting standard-setting and the credibility of U.S. financial reporting will be dangerously compromised," wrote Robert Denham in a letter to House Financial Services Committee Chairman Barney Frank (D-Mass.) 

(Recent News) Does Fair Value Accounting + Credit Default Swaps = Global Deflation? 

Over the past several weeks we have been engaged in the debate over the nomination of Tim Geithner as Treasury Secretary. See our friend John Crudele’s comment in the NY Post in that regard, "The Other Job Geithner Gets May be Troubling." 

We can’t decide in whom we are more disappointed, Geithner for clearly trying to evade his duties as a citizens and pay his paltry amount of taxes, or the members of the United States Senate who seem to be a completely confused and ill-informed rabble. We’ll be coming back to the issue of national governance soon.

But today we wanted to return to the issue of fair value accounting and whether this last remnant of bubble-think is not driving us into the proverbial Thresher (SSN-593) scenario, straight down into the deepest trench of an economic correction that is well-beyond crush depth. Over the past several months, we have come to the conclusion that we must make a correction in the FVA rule. We see two issues:

Time to Unravel the Knot of Credit-Default Swaps   

WITH a new administration in Washington, let us hope that there will be an interest in defining the origins of the financial crisis, its abettors and, most important, its resolution.

Any honest assessment must include the role that credit-default swaps have played in this mess: it’s the elephant in the room, the $30 trillion market that people do not want to talk about.

Credit-default swaps are insurancelike contracts that Wall Street created in the early 1990s. They allow bondholders to protect themselves against losses if a company or a debt issuer defaults.

There is a viable and legitimate use for C.D.S.’s, especially when they allow bondholders and corporations to limit their risks. But in recent years, these contracts became a haven for speculators who were doing nothing more than betting on whether a debt issuer would survive.

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