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    Daily Digest – Jan 29

    by Davos

    Wednesday, January 28, 2009, 10:08 PM

  • The game changer By George Soros
  • The Nation’s Unemployed: Map of States (December)
  • Boeing plans to slash 10,000 jobs as the economy weakens
  • Plan for Banks’ Toxic Debt May Be Unveiled Next Week
  • Seven Suggestions for Dealing with the Banking Crisis (Hat Tip Christopher Peters)
  • Fed Shift Complicates Job for Experts, Central Bank  (Hat Tip Trad)
  • Used Car Value Index (Chart)
  • CBOT Paul Ryan Letter
  • WWII Veteran Freezes To Death In Own Home
  • Flood of foreclosures: It’s worse than you think 
  • Hamptons Prices Fall as Recession Hits Wall Street (Update1)
  • New York City fears return to 1970s 
  • AIG (AIG) To Pass Out Another $450 Million To Keep Workers 
  • Turning Japanese – The audacity of reality
  • History of Home Values (Chart From Quinn Article)
  • Foreign Holders of US Treasury Securities (Chart From Quinn Article) 


The game changer By George Soros 

In the past, whenever the financial system came close to a breakdown, the authorities rode to the rescue and prevented it from going over the brink. That is what I expected in 2008 but that is not what happened. On Monday September 15, Lehman Brothers, the US investment bank, was allowed to go into bankruptcy without proper preparation. It was a game-changing event with catastrophic consequences. 

For a start, the price of credit default swaps, a form of insurance against companies defaulting on debt, went through the roof as investors took cover. AIG, the insurance giant, was carrying a large short position in CDS and faced imminent default. By the next day Hank Paulson, then US Treasury secretary, had to reverse himself and come to the rescue of AIG.

But worse was to come. Lehman was one of the main market-makers in commercial paper and a large issuer of these short-term obligations to boot. Reserve Primary, an independent money market fund, held Lehman paper and, since it had no deep pocket to turn to, it had to "break the buck" – stop redeeming its shares at par. That caused panic among depositors: by Thursday a run on money market funds was in full swing.

The panic then spread to the stock market. The financial system suffered cardiac arrest and had to be put on artificial life support.

How could Lehman have been left to go under? The responsibility lies squarely with the financial authorities, notably the Treasury and the Federal Reserve. The claim that they lacked the necessary legal powers is a lame excuse. In an emergency they could and should have done whatever was necessary to prevent the system from collapsing. That is what they have done on other occasions. The fact is, they allowed it to happen.

On a deeper level, too, credit default swaps played a critical role in Lehman’s demise. My explanation is controversial and all three steps of my argument will take the reader to unfamiliar ground.

First, there is an asymmetry in the risk/reward ratio between being long or short in the stock market. (Being long means owning a stock, being short means selling a stock one does not own.) Being long has unlimited potential on the upside but limited exposure on the downside. Being short is the reverse. The asymmetry manifests itself in the following way: losing on a long position reduces one’s risk exposure while losing on a short position increases it. As a result, one can be more patient being long and wrong than being short and wrong. The asymmetry serves to discourage the short-selling of stocks.

The second step is to understand credit default swaps and to recognise that the CDS market offers a convenient way of shorting bonds. In that market the asymmetry in risk/reward works in the opposite way to stocks. Going short on bonds by buying a CDS contract carries limited risk but unlimited profit potential; by contrast, selling credit default swaps offers limited profits but practically unlimited risks.

The asymmetry encourages speculating on the short side, which in turn exerts a downward pressure on the underlying bonds. When an adverse development is expected, the negative effect can become overwhelming because CDS tend to be priced as warrants, not as options: people buy them not because they expect an eventual default but because they expect the CDS to appreciate during the lifetime of the contract.

No arbitrage can correct the mispricing. That can be clearly seen in US and UK government bonds, whose actual price is much higher than that implied by CDS. These asymmetries are difficult to reconcile with the efficient market hypothesis, the notion that securities prices accurately reflect all known information.

The third step is to recognise reflexivity – that is to say, the mispricing of financial instruments can affect the fundamentals that market prices are supposed to reflect. Nowhere is this phenomenon more pronounced than in the case of financial institutions, whose ability to do business is dependent on confidence and trust. That means that "bear raids" to drive down the share prices of these institutions can be self-validating. That is in direct contradiction to the efficient market hypothesis. 

The Nation’s Unemployed: Map of States (December)

Boeing plans to slash 10,000 jobs as the economy weakens NEW YORK (MarketWatch) — 

Boeing Co. (BA:43.24, +0.02, +0.1%) said Wednesday it plans to slash about 10,000 jobs across its businesses, compared to a prior announcement of 4,500 job cuts from its commercial airplane unit. "The global economy continues to weaken and is adversely affecting air traffic growth and financing," said Chairman and Chief Executive Jim McNerney in a post-earnings call with analysts. "We are also expecting pressure on defense budgets in light of the economic recovery and financial rescue packages." Job reductions will primarily occur in areas that support productivity and infrastructure, driven through a combination of attrition, retirements, cuts in some contracted labor, and layoffs. Shares of Boeing were up 2.4% to $44.25. 

Plan for Banks’ Toxic Debt May Be Unveiled Next Week 

The Obama administration is close to deciding on a plan to purchase bad-or non-performing and illiquid-assets from banks, according to industy sources. The plan could be announced early next week. 

The so-called "bad bank" plan, would address the key problem of how to price the assets by using a model-pricing mechanism.

The model would take account of the government’s ability to hold onto assets, even to maturity, and pay for the them with cheap funding. Result: the government might end up paying more than current market prices for the securities.

On the other hand, if the government paid less than the value at which the asset is carried on the bank’s books, the bank would issue common equity to the government.

In previous Troubled Asset Relief Program deals, banks issued preferred equity to the federal government. But the conclusion is growing within government circles, sources say, that preferred equity is not sufficient to make the banks healthy.

Clearly, the idea of a "bad bank" is gaining momentum. On Capitol Hill today, Senate Banking Chairman Chris Dodd said he was aware the idea is under discussion and "it makes some sense to me." 

The move toward a bad bank concept comes amid growing speculation that banks may need another government bailout.

Goldman Sachs economist Jan Hatzius recently said global credit losses may approach $2.1 trillion. Of that total, banks worldwide have already absorbed about $975 billion in losses, he estimated in a research report, suggesting the worst is far from over.

FBR Capital Markets analysts said eight of the largest U.S. financial institutions need up to $1.2 trillion in new common equity and that "the government is the only entity that can provide bridge capital to get past the current credit crises."

In the developing bad bank plan, it’s unclear how the government would pay for assets. There has been discussion of a "certificate of net worth" in which the government gives the banks a piece of paper that essentially can be applied to capital levels. But sources could not confirm that funding mechanism for the plan or what role existing TARP money or the Fed would play in funding the so-called bad bank.

A Treasury official said nothing will be announced this week and would not comment "on specific policy decisions that have yet to be made." 

Seven Suggestions for Dealing with the Banking Crisis (Hat Tip Christopher Peters) 

The global credit market sickness and the knock-on impact on the broader economy is, I’m afraid, far from over. The world’s largest economies binged on leverage to bid up asset prices and spend beyond their means. Following the sacking of this regime of false confidence, the supply and demand curves for credit have both reset at sharply lower levels. And with each passing day providing ongoing evidence of collateral damage ricocheting around the global economy, I’m increasingly suspicious that a depression-like collapse of asset prices, economic activity, and employment levels might represent the inevitable outcome. The cooperators–especially Asian and Middle Eastern countries with large export surpluses–that provided financing and cheaply priced goods seem no better off as the profligate old ways of their customers rapidly fall away. 

IIgnoring political reality for a second, there are two choices available to the Unites States. The first is to let the system reset without massive government intervention in the financial sector. If the bleak scenario above holds true, then the government shouldn’t be risking the all-in bet it is currently making. By taking massive credit risk based on current cash flows and asset prices, the losses in a collapse scenario are guaranteed to be stupendous and will simply be transferred from the private to the public sector. Government officials instead bear a tremendous responsibility to defend the federal balance sheet in order to act as the (discriminating) provider of credit, spending power, and humanitarian aid of last resort during the tough times ahead. This approach need not mean blindly employing a hard-headed approach of laissez-faire capitalism. It would still make sense to–following the most basic lessons from the Great Depression–continue to insure bank deposits and provide for an orderly wind-down or sale of failed financial institutions in order to prevent panic regarding bank savings and the payment system at large. 

Fed Shift Complicates Job for Experts, Central Bank  (Hat Tip Trad) 

Jan. 28 (Bloomberg) — Investors will have a tougher time assessing Federal Reserve policy when officials today replace interest rates with emergency credit programs as their main tool for steering the economy. 

Without rates as their main policy gauge, Chairman Ben S. Bernanke and the Federal Open Market Committee also will find it more difficult to anticipate the impact of their statements on financial markets during the worst credit crisis in seven decades.

"It’s not only harder for them to predict, but it’s harder for them to get traction" from the Fed’s $1 trillion effort to revive credit, said Keith Hembre, a former Fed researcher who is now chief economist at FAF Advisors Inc. in Minneapolis.

The new focus on changes in the size and composition of the central bank’s assets makes it harder for policy makers to revive confidence in bond and stock markets, Fed watchers said. Such confidence is needed after financial shares tumbled 29 percent and unemployment hit a 16-year high since the Fed cut the main rate to a record-low 0.25 percent or less on Dec. 16.

The central bank, while pursuing its policy of easing credit, probably won’t alter borrowing costs today and for the remainder of 2009, according to the median forecast of analysts surveyed by Bloomberg News.

That means analysts can’t base their predictions for Fed decisions on a simple interest rate benchmark for the first time since the FOMC began releasing policy statements in 1994.

"It’s not multiple-choice anymore," said RBS Greenwich Capital chief economist Stephen Stanley, a former Richmond Fed researcher. "It’s essay questions."

Meeting Resumes

The FOMC will release a statement at about 2:15 p.m. in Washington at the conclusion of a two-day meeting, which resumed today at about 9 a.m.

Policy makers lost one reliable measure of market sentiment in September when futures ceased to be an indicator of investor expectations for interest rate decisions.

The Fed had failed to align its policy target rate with the rate banks charge each other for overnight loans. Traders had looked at the so-called federal funds rate when determining their bets on what the policy makers will do.

Central bankers have yet to dispel investor uncertainty by announcing targets for the size or composition of its balance sheet beyond current programs, such as plans to purchase mortgage bonds and housing-finance totaling $600 billion. Assets held by the Fed have more than doubled to $2.04 trillion over the past year.

‘Communications Challenge’

Bernanke highlighted the Fed’s difficulty of transmitting its intentions in a Jan. 13 speech, saying "the lack of a simple summary measure or policy target poses an important communications challenge."

"To minimize market uncertainty and achieve the maximum effect of its policies, the Federal Reserve is committed to providing the public as much information as possible about the uses of its balance sheet, plans regarding future uses of its balance sheet and the criteria on which the relevant decisions are based," he said at the London School of Economics.

The FOMC statement in recent years has followed a clear structure: After a decision on the main interest rate came a paragraph on the economy, one on inflation and another one on the policy stance. The release usually ran about 100 words, fitting on a single page.

Emergency Lending 

Used Car Value Index (Chart)

CBOT Paul Ryan Letter

WWII Veteran Freezes To Death In Own Home 

BAY CITY, Mich. — Officials in Mid-Michigan said the 93-year-old man who owed more than $1,000 in unpaid electric bills froze to death inside his home — where the municipal power company had restricted his use of electricity. 

Neighbors and friends of Schur want answers as to how this could happen.

"Now that we do know it was hypothermia, there’s a whole bunch of feelings that I’ve got going through me," said Jim Herndon, a neighbor of Schur’s. "There’s anger, for the city and the electrical company."

Bay City officials said changes are on the way in an attempt to not let another instance like this happen again.

An autopsy determined Schur died from hypothermia in the home he lived in for years.

A medical examiner who conducted the autopsy on Schur told TV5 and WNEM.com that Schur died a painful death due to the hypothermia.

Dr. Kanu Varani said he’d never seen a person die of hypothermia indoors.

A neighbor who lives across the street from Schur is angered that the city didn’t personally notify the elderly man about his utility situation.

Schur’s neighbor, Herndon, said Schur had a utility bill on his kitchen table with a large amount of money clipped to it, with the intention of paying that bill.

Right now the city said the situation is still under investigation.

A memorial service for him will take place Wednesday at 11:00 a.m. at the Gephart Funeral Home in Bay City.

Meanwhile, Bay City Electric Light and Power is raising rates. The move was approved Monday night and the retro-active rate hike will cost the average homeowner an extra $21 per year.

The change will take effect this spring. The 3 percent increase comes on top of a 9 percent hike approved last summer. 

Flood of foreclosures: It’s worse than you think 

Banks are moving slowly to list repossessed homes for sale, which could mean that housing inventory is even more bloated than current statistics indicate. 

NEW YORK (CNNMoney.com) — Housing might be in worse shape than we think.

There is probably even more excess housing inventory gumming up the market than current statistics indicate, thanks to a wave of foreclosures that has yet to hit the market.

The problem: Many foreclosed homes and other distressed properties that are now owned by banks have yet to be listed for sale. The volume of this so-called ‘ghost inventory’ could be substantial enough to depress already steeply falling prices when it does go on the market.

"That’s not good news," said Pat Newport, an analyst with IHS Global Insight. "[Excess] inventory is the biggest problem in housing these days, and it leads to lower housing prices, which leads to more foreclosures."

RealtyTrac, the online marketer of foreclosed properties, recently discovered that it has far more foreclosed properties listed in its database, which the company compiles using courthouse records, than there are listed in the multiple listing services (MLS) maintained by real estate agents.

RealtyTrac looked at listings in four states, California, Maryland, Florida and Wisconsin, and found that they contained only a third of the foreclosures it has in its database.

The scope of the problem isn’t clear, but it could be huge considering that RealtyTrac has a total of 1.5 million bank-owned properties on its site.

"Many properties that should be listed on the MLS are not listed on the MLS," said Lawrence Yun, chief economist for the National Association of Realtors (NAR).

Underestimating inventory
The National Association of Realtors calculates official housing inventory statistics using data from the multiple listing services. By that measure, there were 4.2 million existing homes for sale in November, an 11.2-month supply at the current sales pace, up from a 10.3-month supply in October.

But now it seems quite possible that these figures, which are already at record highs, are underestimating the situation. And if that’s the case, it could take much longer for the housing market recovery than analysts currently expect.

Until supply can be brought down to a more normalized level of six to seven months, home prices will continue to come under pressure, according to Yun.

"It could be a worse problem than we think," he said.

L.J. Jennings, a real estate broker with Pyramid Real Estate and Investments in Oakland, Calif., sees plenty of evidence that it is.

"There are a number of properties in my area that have actually been taken back by the banks, but have not hit the market yet," he said. "Once a bank repossesses a property, in some cases, it can take more than six months to hit the market."

He cites a handful of examples offhand, including a single-family home in Richmond seized in early October, a condo in San Ramon taken back the same month and a four-family building in Oakland that was repossessed in July.

"Either lenders are overwhelmed and can’t get these properties back on sale quickly" said RealtyTrac spokesman Rick Sharga, "or they’re deliberately slowing down."

Hamptons Prices Fall as Recession Hits Wall Street (Update1) 

Jan. 27 (Bloomberg) — Home prices in the Hamptons, New York’s oceanside resort favored by financiers and celebrities, fell 14 percent in the fourth quarter as Wall Street cut jobs and the U.S. recession spurred sales to plunge. 

The median price in Long Island’s Hamptons and the North Fork slid to $690,000 from $800,000 a year earlier, appraiser Miller Samuel Inc. and broker Prudential Douglas Elliman Real Estate said in a report today. The number of sales dropped 41 percent and the inventory of properties rose 19 percent.

"The market is in stagnation," said Paul Brennan, regional director for the Hamptons at Elliman. "If you sell in this market, it’s usually one of the three D’s: death, divorce or debt."


New York City fears return to 1970s 

NEW YORK (Reuters) – While many U.S. cities worry that their economies are deteriorating to the level of the 1930s Great Depression, New York City fears reliving a more recent decade that features strongly in city lore. 

The 1970s were a low point in city history as a fiscal crisis almost pushed it into bankruptcy, crime rates soared, and homeless people crowded sidewalks as public services crumbled.

Almost a million people fled New York’s Mean Streets during the decade for the safer, more stable suburbs, a population decline that took more than 20 years to reverse.

When discussing the current crisis, Mayor Michael Bloomberg, now seeking a third term, promises that he will not allow the city to return to the darkness of those days, although he stresses that it faces "giant financial problems."

"I know some are concerned that city services will erode," he recently told reporters. "Let me remind you that the city went down that road in the 1970s … I can just tell you that we are not going to make that mistake again."

But behind the rhetoric, there are signs of a city under growing stress, including a rise in homelessness that’s driving more families to shelters and last year’s 57 percent spike in bank robberies.

AIG (AIG) To Pass Out Another $450 Million To Keep Workers 

AIG (AIG) will make $450 million in payments to workers at it derivatives unit to make sure that they don’t leave. 

"I was extremely disappointed — but not surprised — to learn that AIG will be awarding bonuses to the very division that drove the company into the ground," said Elijah Cummings, a member of the House Committee on Oversight and Government Reform, according to Bloomberg.

AIG loses so much money, it would be better off if it paid all of its employees to leave. 


Every day seems worse than the previous day. Five hundred thousand people are getting laid off every month. Our banking system is on life support. Retailers are going bankrupt in record numbers. The stock market keeps descending. Home prices continue to plummet. Home foreclosures keep mounting. Consumer confidence is at record lows. You would like to close your eyes and make it go away. Not only is the news not going away, it is going to get worse and last longer than most people can comprehend. The Great Depression lasted 11 years, but the more pertinent comparison is Japan from 1990 until today. A two decade long downturn has a high likelihood of occurring in the United States. There are many similarities between the U.S. and Japan, but in many areas the U.S. has a much dire situation. If the next decade resembles the Japanese experience, there will be significant angst and social unrest. 

History of Home Values (Chart From Quinn Article)

Foreign Holders of US Treasury Securities (Chart From Quinn Article)

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