Category: Finance

US incomes

This isn’t just about America, it’s affecting us all!

Yesterday, Learning from Dogs published in full a Stratfor report about China.  The thrust of the report was:

U.S.-Chinese relations have become tenser in recent months, with the United States threatening to impose tariffs unless China agrees to revalue its currency and, ideally, allow it to become convertible like the yen or euro. China now follows Japan and Germany as one of the three major economies after the United States. Unlike the other two, it controls its currency’s value, allowing it to decrease the price of its exports and giving it an advantage not only over other exporters to the United States but also over domestic American manufacturers. The same is true in other regions that receive Chinese exports, such as Europe.

What Washington considered tolerable in a small developing economy is intolerable in one of the top five economies. The demand that Beijing raise the value of the yuan, however, poses dramatic challenges for the Chinese, as the ability to control their currency helps drive their exports. The issue is why China insists on controlling its currency, something embedded in the nature of the Chinese economy. A collision with the United States now seems inevitable. It is therefore important to understand the forces driving China, and it is time for STRATFOR to review its analysis of China.

(My italics)

So the state of US incomes is crucial, not only to Chinese exports to America but for global trade in general.

Karl Denninger

We have often congratulated Karl Denninger of Market Ticker for his commitment in analysing and reporting on the American economic scene and a recent piece on US Incomes was typical of his excellent reporting.  I am taking the liberty of publishing his Post in full because, frankly, this information is of importance to us all, wherever we live.

Where Did The Income Go?

It appears that the Federal Tit Pump is running out of power…

Personal income increased $1.2 billion, or less than 0.1 percent, and disposable personal income (DPI) increased $1.6 billion, or less than 0.1 percent, in February, according to the Bureau of Economic Analysis.  Personal consumption expenditures (PCE) increased $34.7 billion, or 0.3 percent.

Oh boy, now the $1.3 trillion in additional deficit spending is no longer contributing to personal income!  That’s not so positive – indeed, it’s not positive at all.

Private wage and salary disbursements increased $2.0 billion in February, compared with an increase of $16.6 billion in January.  Goods-producing industries’ payrolls decreased $3.5 billion, in contrast to an increase of $5.2 billion; manufacturing payrolls decreased $1.4 billion, in contrast to an increase of $5.0 billion.  Services-producing industries’ payrolls increased $5.5 billion, compared with an increase of $11.4 billion.

Goods down…. uh, where’s our so-called economic recovery?

Proprietors’ income decreased $6.1 billion in February, the same decrease as in January. Farm proprietors’ income decreased $7.1 billion, the same decrease as in January.  Nonfarm proprietors’ income increased $1.0 billion, the same increase as in January.

Very little change in proprietor’s income ex farming, but farmer income is down significantly.

Rental income of persons increased $2.2 billion in February, compared with an increase of $1.9 billion in January.  Personal income receipts on assets (personal interest income plus personal dividend income) decreased $16.5 billion, the same decrease as in January.

Rents up a bit, but dividends are down huge, continuing a trend.  This is not positive at all, and implies that assets are being sold to continue lifestyle choices.  This leads to a question that has begun to gnaw at me: Have we begun to cross into where boomers start pulling funds out of asset classes to live on?

Personal current transfer receipts increased $16.6 billion in February, compared with an increase of $29.8 billion in January.  The January change reflected the Making Work Pay Credit provision of the American Recovery and Reinvestment Act of 2009, which boosted January receipts by $19.8 billion. The Act provides for a refundable tax credit of up to $400 for working individuals and up to $800 for married taxpayers.  When an individual’s tax credit exceeds the taxes owed, the refundable tax credit payment is classified as “other” government social benefits to persons.

Government to the rescue!  $45 billion worth in the last two months, to be specific.  That’s a direct $270 billion in handouts, or 2% of GDP – and that’s only the direct handouts!  So subtract that off GDP and….. (oh, and don’t forget the rest of the $1.3 trillion too.)

Nothing to see here folks, as in “no evidence of sustainability in the recovery.”  We have a government that continues to “prime the pump” but there’s no water at the bottom of the well to generate self-sustaining economic growth.

By Paul Handover

Unwinding $1 trillion in Toxic Assets

Ben S. Bernanke, Chairman of the Federal Reserve

Used toxic assets, anyone?

Ben Bernanke, Chairman of the U.S. Federal Reserve, announced that the Fed was likely to begin to sell some of the $1 trillion in mortgages, the so-called “toxic assets,” that it purchased over the last fifteen months to help stave off a total credit market meltdown. Those purchases essentially doubled the U.S. money supply, igniting fears of potential inflation should the underlying real economy recover before the money supply could be drawn back down. See earlier post.

Well, the process of tightening the money supply may be just around the corner. And increases in interest rates and the cost of everything purchased on credit – homes, cars, durable goods, and business capital expenditures – are not far behind. Increases in interest rates dampen economic activity, an unfortunate development given the current lethargic state of the U.S. economy. But it has to be done sometime – we cannot sustain such a huge increase in the money supply without paying an even higher price in terms of inflation and a weak dollar.

It will be interesting to see who buys the toxic assets and how much they will pay. Regardless, the sale will reduce the money supply which, if done in a slow, orderly manner, is a good thing for the economy. Getting the Fed out of the business of buying and selling private market securities will be an even better thing for the U.S. economy. Now more than ever we need a monetary authority that is focused on the best policies for our economy, not those that help Fannie Mae, the White House, or the Treasury Secretary save face.

By Sherry Jarrell

The GPS and the AAAs

Welcome Per Kurowski Egerström

On the 22nd March, Learning from Dogs had the pleasure of a Post from our first Guest Author, Elliot Engstrom.  We are doubly delighted to have Per Kurowski join us as our second Guest Author.

Per Kurowski

Per is a prolific blogger.  He has had a full career including serving as an Executive Director of the World Bank from 2002 until 2004 for Costa Rica, El Salvador, Guatemala, Honduras, Mexico, Nicaragua, Spain and Venezuela.  More about Per’s life experiences can be found here.

Here is Per’s first Guest Post for Learning from Dogs.

——————-

The GPS and the AAAs

Not so long ago I asked my daughter to key in an address in the GPS and then even while I continuously heard a little voice inside me telling me I was heading in the wrong direction I ended up where I did not want to go.

Whither we are led?

Something similar caused the current financial crisis.

First the financial regulators in Basel decided that the only thing they would care about was the risk of individual financial defaults and not one iota about any other risks.

Second then, though they must have known these were humanly fallible they still empowered some few credit rating agencies to be their GPS on default risks.

Finally, by means of the minimum capital requirements for banks, they set up all the incentives possible to force them to heed what the GPS said and to ignore any internal warning voices.

Of course, almost like if planned on purpose, it all ended up in a crisis. In just a couple of years, over two trillion dollars followed some AAA signs over the precipice of badly awarded mortgages to the subprime sector. Today, we are still using the same financial risk GPS with the same keyed in instructions… and not a word about it in all recent Financial Regulatory Reform proposals

I hate the GPS type guidance of any system since I am convinced that any kid brought up with it will have no clue of what north, south, east or west means; just as the banker not knowing his client’s business or how to look into his client’s eyes or how to feel the firmness of his client’s handshake, can only end up stupidly following someone else’s opinion about his client on a stupid monitor.

I hate the GPS type guidance system because, on the margin, it is making our society more stupid as exemplified by how society, day by day, seems to be giving more importance to some opaque credit scores than to the school grades of their children. I wait in horror for some DNA health rating scores to appear and cause a total breakdown of civilization as we know it.

Yes, we are buried under massive loads of information and these systems are a tempting way of trying to make some sense out of it all, but, if we used them, at least we owe it to ourselves to concentrate all our efforts in developing our capacity to question and to respond adequately when our instincts tell us we’re heading in the wrong way.

Not all is lost though. I often order the GPS in my car to instruct me in different tongues so as to learn new languages, it gives a totally new meaning to “lost in translation”, and I eagerly await a GPS system that can describe the surroundings in more extensive terms than right or left, AAA or BBB-, since that way not only would I get more out of it but, more importantly, I would also be more inclined to talk-back.

By Per Kurowski

The Fed’s Exit Strategy

The Federal Reserve finally addresses how it plans to unwind trillions in toxic assets

Finally, we hear from the Federal Reserve about how they plan to unwind the billions of dollars of toxic assets they purchased over the last 18 months or so without creating further distortions in the U.S. and world financial markets (Fed lays out exit detail). This after the Fed barely acknowledged one of the most dramatic runups in the money supply in U.S. history.

Brian Sack, EVP Markets Group, Federal Reserve
The announcement came in a speech by Brian P. Sack, the executive Vice President of the Markets Group at the Fed.  I am impressed by this guy. He seems to know what he’s talking about and seems to understand how markets and fed policy interact.

In earlier posts I wondered aloud how the Fed might accomplish this tricky task. It is a very delicate balance between reducing the money supply too quickly, which would spike short term rates, and too slowly, which would increase long-term rates due to worries about inflation (which occurs when money growth is higher than the economy’s real growth, even if money growth is falling).

The Fed, the article explains, apparently intends to let $200 billion of the estimated $1.25 trillion in new money supply simply “mature” by the end of 2011 without replacing it. This represents largely toxic assets. The Fed might let another $140 billion of Treasuries it purchased during normal open market operations mature at the end of 2011, but they aren’t committing to that.  So that’s about $340/$1,250 or about 35% of the historic increase in money supply that may be vaporized over the next 21 months. What about the rest?  It would be nice to know but….

The Fed is doing the right thing by explaining its policy intentions — ANY of its policy intentions — to the markets.  Markets want, need, and deserve information from our officials, something that has been sorely lacking of late. With information, lenders and borrowers can plan, they can optimize. Without information, guessing, withdrawing from the market, and fear rule the day. Not a good environment for economic recovery.

by Sherry Jarrell

Should you invest in U.S. bonds? Part 2

Sources and types of risk in U.S. and other bonds.

This is part 2 of a multipart [Part One is here, Ed.] series on the factors that drive U.S. and foreign bond prices and yields.

Recall that a bond’s price is the present value of its coupons (if any) and face value (or principal or par value).  Let’s keep things simple for now and assume a zero-coupon or “discount” bond.

One thing of interest to note first: As we move forward in time from the issue date toward the maturity date, and the number of periods between now and the maturity date falls, the price of a discount bond rises toward the face value of the bond, even with no changes in the interest rate.  At maturity, the price of the bond equals the face value. Only unexpected changes in the effective return on a bond can change the natural upward progression of its price toward face value between the issue and maturity dates.

This example makes clear that the (annual) yield on a bond, simply put, is driven by the difference between the price paid for the bond and the cash flows it generates, that is, the difference between “dollars out” today and “dollars in” later.

The “dollars out” are known because we pay a given price for the bond today.  The “dollars in,” consisting of coupons (if any) and the face value of the bond, are also “known” in that they are specified in a contract at the time the bond is issued.  The realized value of these dollar returns is, however, subject to many different sources of uncertainty or risk. A short list includes:

Interest rate risk: how sensitive the price of the bond is to changes in interest rates over the life of the bond.  Interest rate risk is higher for bonds with a longer maturity (more time for the unexpected to happen), a lower coupon (more of the value of the bond is tied up in the principal), and a lower initial yield (a 1 percentage point change in interest rates represents a higher relative change in low yields).  Floating-rate notes and bonds have much lower, though not zero, interest rate risk.

Reinvestment rate risk.  Bondholders may reinvest their coupons at the then-prevailing rate of interest. As those market rates of interest change, the return on reinvested coupons becomes more uncertain. The higher the coupons, the more frequently they are paid, and the longer the maturity of the bond, the higher reinvestment rate risk.

Bankruptcy Court: Destination for issuers in default

Credit or default risk:  the risk that the issuer will default on the payments of the bond, which reduces the amount and value of “dollars in” relative to price paid, lowering the earned yield on the bond.   Credit risk is frequently measured as the credit spread over like Treasuries, which are assumed to have zero credit risk.  Credit risk includes downgrade risk, where a credit rating agency lowers the rating on an issuer as their ability to repay the debt is brought into question.

Call risk:  the risk that a callable bond will be called by the issuer. Since a bond is typically called only when it’s in the best interest of the issuer, the call feature is systematically harmful to the bondholder.  Prepayment risk reverses these risks:  prepayment is good for the bondholder, and bad for the issuer.

Exchange rate risk (that the value of the repaid currency will be lower), inflation risk (that the value of the repaid dollar will be lower), and event risk (natural disasters, corporate restructurings, regulatory changes, sovereign or political changes) round out the list of broad types of risks that drive bond yields.

Next time: why the types and level of risks are so difficult to measure and predict.

by Sherry Jarrell

In praise of Yves Smith

Helping thousands better understand this crisis

Yves’ Blog Naked Capitalism has been mentioned many times on Learning from Dogs.  Indeed, she was one of the Blog authors highlighted recently in this Post.

Yves Smith

I fail to understand how she finds the hours in the day to write in such detail – but those of us interested in getting under the skin of our present economic situation are all the better for it.  Here’s a great example that was published on the 23rd February.  I quote the opening paragraphs and then link to the rest of her post. From here on is her piece:

———————–

Martin Wolf, the Financial Times’ highly respected chief economics editor, weighs in with a pretty pessimistic piece tonight. This makes for a companion to Peter Boone and Simon Johnson’s Doomsday cycle post from yesterday.

Let us cut to the chase of Wolf’s argument:

Now, after the implosion, we witness the extraordinary rescue efforts. So what happens next? We can identify two alternatives: success and failure.

By “success”, I mean reignition of the credit engine in high-income deficit countries. So private sector spending surges anew, fiscal deficits shrink and the economy appears to being going back to normal, at last. By “failure” I mean that the deleveraging continues, private spending fails to pick up with any real vigour and fiscal deficits remain far bigger, for far longer, than almost anybody now dares to imagine. This would be post-bubble Japan on a far wider scale.

Yves here. Notice he associates success and failure with polar options. But how can you “reignite the credit engine” when the financial system is undercapitalized even before allowing for the need to take further writedowns? The IMF has found the converse in its study of 124 banking crises, that purging bad debt is a painful but necessary precursor to growth. So I fail to understand how Wolf envisages that “skip Go, collect $200″ of releveraging quickly comes about. And in fact, it turns out that Wolf’s “success” is a straw man:

[to read the rest click here, Ed]

By Paul Handover

Now this IS smart!

A very good idea from the Canadians

Read this quote:

“Time and again we see behaviour by people – we are talking highly educated, high income people – who are making less than ideal financial decisions for themselves and their families,” said one source. “Other countries that have developed a strategy have focused on education in high schools. This task force has come to the early conclusion that, while enhanced financial education is vital over the long term, it is insufficient.”

The first sentence is so important, to my mind, that it is worth repeating, “Time and again we see behaviour by people – we are talking highly educated, high income people – who are making less than ideal financial decisions for themselves and their families,”

This comes from a piece published by the Canadian newspaper, The Globe and Mail, about a Canadian taskforce that is

Group will be headed by Sun Life's Don Stewart

looking into ways of making Canadians “more savvy” about their personal finances.

The financial industry is very adept at producing complex financial products that are almost beyond the limits of the understanding of good common people.  We, the people, need to be much smarter and that’s why this initiative from the Canadians seems, on the surface, to be such an excellent idea.

By Paul Handover

Fed Funds Rate and Consumer/Business Costs

Looking more closely at the implications of changes in the Fed rate

Fed funds rate chart_img
Fed Funds rate influences consumer and business interest costs

Does the Fed Funds Rate, the rate charged by the Federal Reserve to make short-term loans to banks, directly influence the interest rate consumers and businesses pay on credit cards, mortgages, and consumer and business loans?  If you took the word of the average business news commentator, you would think not.  But the answer, of course, is yes.

One way to view the market rate of interest, although certainly not the only correct or useful way, is to think of it as a base rate that represents the risk-free rate, a rate that compensates the population for its impatience to consume the goods it would have consumed had it not lent the funds out in the first place. This risk-free rate is also influenced by the efficiency and functioning of the capital markets that bring borrowers and lenders together.

A risk premium is then added to this base rate of risk-free interest, one that varies depending on the degree of uncertainty of the lender getting repaid.  The risk of default, the risk of prepayment, the risk of political uprising, exchange rate risk, and many other sources of uncertainty — including the risk of inflation — raise the level of the risk premium commanded by lenders in the market.  As an example, over the last 100 years or so, the average annual risk-free rate in the U.S. has been about 4%, and the average annual risk premium for equity securities has been about 8%, bringing the average annual observed interest rate or rate of return to about 12% on these securities.

So what happens to the interest rate charged to consumers and businesses when the Fed raises the fed funds rate?  Basically, the level of the risk-free rate in the economy rises and, as debt contracts expire or new lending takes place, this higher base rate gets factored into the market rate of interest charged.

Overall, the demand for loanable funds falls, the aggregate demand curve for the economy falls, and equilibrium output and employment fall, RELATIVE to where they would have been without the rate increase. The bright side is that a reduction in the money supply that accompanies an increase in the fed funds rate is absolutely essential to curtailing inflation, which drives the risk premium, and represents a much greater cost to the economy.

By Sherry Jarrell

Oh, Irony! The Markets and Obama’s Policies

Where are capital markets heading?

In a recent article, Moody’s announced that it may have to reduce the AAA rating of U.S bonds because of excess spending and historic debt levels of the U.S. government under President Obama.

Moody’s Investors Service Inc. said the U.S. government’s AAA bond rating will come under pressure in the future unless additional measures are taken to reduce budget deficits projected for the next decade.

The U.S. retains its top rating for now because of a “high degree of economic and institutional strength,” the New York- based rating company said in a statement today. The ratios of government debt to the U.S. gross domestic product and revenue have increased “sharply” during the credit crisis and recession. Moody’s expects the ratios to remain higher compared with other AAA-rated countries after the crisis.

What this means in practical terms is that the cost of borrowing by the U.S. government will rise, which will increase spending via more borrowing or higher taxes or more money creation to pay for the higher interest costs.  Sound like a vicious cycle to you?

Has anyone noticed the absolute irony of the world capital market having a seat at the table that assesses the viability of Obama’s policies? Obama, who has spent the last year denigrating free markets and capitalism, and has laid the blame for the credit crisis squarely at the feet of those greedy capitalists, now has to deal with a rating agency, which plays a pivotal role in the functioning of those very capital markets, evaluating the creditworthiness of his policies and those of his budget director, Peter Orszag, pictured here.

Peter Orszag, Obama's Budget Director

How wonderfully ironic!

The U.S. would not be the first.   Ireland was recently downgraded, and Japan lost its AAA rating from Moodys in November of 1998; both faced higher borrowing costs as a result.

By Sherry Jarrell

Tax, Law, Crime and Morality in Banking

More holes than in a Swiss Cheese!

There is currently a merry old ding-dong spat going on between the German and Swiss governments. Basically, someone has got hold of information about German citizens with bank accounts in Switzerland where they are hiding large sums on which they should pay German taxes.

This or these enterprising whistleblower(s) are offering to sell this data to the German government for a hefty fee. The German government is on the point of accepting to buy this “illegally-obtained” information from the (from the Swiss point of view) criminals who have stolen their secret bank data.

This story raises a large number of fascinating questions. It has long been common knowledge that Switzerland offers banking facilities with few questions asked. Any self-respecting criminal or tax evader has or had a secret, numbered Swiss account.

What has always amazed me is how they have got away with this for so long, stuck as they are in the centre of Europe. How is it possible that other countries have allowed Switzerland to become a haven for money obtained illegally in other countries?

For it is clearly immoral to profit from the illegal activities of foreign nationals, isn’t it? What exactly is the difference between this behaviour and “receiving stolen goods”? Worse, we have to remember that the largest sums come from drugs. Anyone willing to look after (or launder) drug  money is complicit in the misery and deaths of millions of drug addicts worldwide. Yet the Swiss have pulled off this trick for decades. The Swiss banking (and government) fraternity has never shied away from shady dealings, being until the end of WWII covert supporters of the Nazis.

Well, Angela Merkel is going to do a deal with presumably Swiss “criminals” (according to the Swiss government) in order to recoup money it is owed by German criminals (according to Germany). What a merry old moral maze we have here. But in truth, the world is now too small and inter-connected to allow either tax evasion on a vast scale  or the safeguarding of criminal funds.

Switzerland has to decide whether to remain as a supporter of tax evaders and gangsters (including of course African Presidents who have ripped their countries off in a big way) OR to join the real, civil, honest and inter-connected world.

The rest of us should stop tolerating this connivance with crime. “Client secrecy” is no excuse for condoning and profiting from crime.

More on the whole  Nazi gold in Switzerland story is here.

By Chris Snuggs