What in the name of all that is pure and holy was the ECB thinking? This was a golden opportunity to buy back debt and increase investor confidence. It seems like the ECB has a plan that does not include loading up their balance sheet (like their UK and US counterparts did). As expected the ECB did not alter rates (and maintained the record low 1%). However, the surprise came with the decision to refrain from buying back debt. Though I do not have enough knowledge to deem the move a mistake, a lot more clarity is needed to understand what the ECB plans to do in order to control the crisis. Seeing the behavior of Europe collectively as well as the ECB begs the question: is Europe really a union or just separate countries?

Germany will get to answer this question first hand today when it votes on the aid package for Greece. Unfortunately it is not as simple as giving money and all will be fine and dandy. Even if Greece gets the aid package it seems like it is a small band-aid on a gash that needs multiple stitches. On the other hand, if Greece does not get the package things can get even worse. This would not be good for anyone, especially Germany whose rates are already being affected. Keeping this point in mind I feel Germany will give the package. The question is how much and with what conditions?

Greece has other problems aside from the aid package.  A decline in aggregate demand due to a cut in spending resulting in exports becoming more expensive, 10% unemployment, a stimulus based on borrowed money and the uncertainty related to whether or not the protests are going to continue or if they are going to get worse is making the matter a lot more complicated.

The US had its own drama with the Dow  losing 700 points in 15 minutes and the turning around and gaining 600 points in the next 20 minutes supposedly due to human error. The story right now is that a trader typed B for billion instead of M for million – sounds ludicrous and frankly speaking, I don’t buy it. There has to be more to this story.

The error did not help consumer confidence as the Vix jumped 60% punting it above the 40%  mark for the first time in a year. Even though these trades (e.g.) Accenture for a penny or P & G for thirty five dollars will not stand, its negative impact is going to linger. In the short run traders who made money legitimately will now have their trades scratched, which in turn hurts confidence. In the long term it is going to make price discovery (a process where one determines the price of an asset through supply and demand in the market place for said asset) a heck of a lot harder.

Note: The UK has a lot more to look forward to since its Debt which is 13% of GDP is going to force rating agencies to revisit it’s credit rating – even though the conservatives have promised to raise taxes and aggressively fight the deficit.

The Economy

After a short break I have decided to start writing again. Thanks for the notes of encouragement.

Europe has finally decided to join the ‘economic meltdown party’ the US threw almost 3 years ago. Wow, did she make an entrance. The Euro is at a fourteen month low against the dollar primarily due to the uncertainty regarding sovereign debt in Europe. (Sovereign debt is a debt instrument guaranteed by the government). What started with Greece being unable to honour its sovereign debt soon morphed into, Italy, Spain and now Portugal being, or in the process of being downgraded by the rating agencies. Though the analysts seem to be spilt on the problem of  financial contagion (as defined by Investopedia to be the likelihood of significant economic changes in one country spreading to other countries, in this case referring to economic crises). It is still an issue to be very worried about. The last time we saw severe financial contagion was in 1997 when the Asian economic crisis, started in Thailand and eventually spread to South East Asia and Latin America. In the case of the EU what is even more worrying is that the Euro-Zone is connected not only through geography and low trade barriers but a common currency as well.

Affect on the EU economies:
If the suffering of Greece and Portugal was not bad enough, the Wall Street Journal Blog has an interesting post discussing how Spanish spreads are widening as we speak. This is a serious issue considering that Spain is the 4th largest economy in the EU. Though Spain’s debt problem is not as bad as the one in Greece, it does have problems of its own regarding unemployment. Affected European countries are cutting spending to tackle the crisis which in turn is going to have a negative impact on future growth rates of these countries. The current rioting opposing the austerity measures taken by the governments is not making the situation any better.

Though the UK is not having problems with its sovereign debt, it is still in the news with the looming elections. It will be interesting to see how the UK election will pan out. I am curious to see what kind of government the people want — one that is big on bailouts and intervention or one that takes a more conservative, survival of the fittest approach. Needless to say the election will have a significant impact on how the crisis unfolds.

Affect on the Euro:
The current crisis can have an effect on the future of the Euro as well. Stuart Burns makes a great case for how Greece, (along with most of the Mediterranean countries) have enjoyed the fixed borrowing rates by being a member of the European Union. Greece with little or no organic growth and double digit unemployment and inflation was allowed to borrow money at the same rate as France or Germany. As a result the Greek economy grew rapidly (mostly through financing by the public sector) but did not have the means to support herself. With the current bailout and fear of contagion, responsible countries like Germany or France are being tested, and are not taking kindly to the increase in the  borrowing costs and taxes in order to bail out other EU member countries.

Affect on US Markets
The dow lost around 200 points yesterday and 95% of S&P stocks were down while the Vix was moving up. Though these movements could be attributed to the Oil spill on the Gulf of Mexico and the foiled terrorist plot in NYC, it would be naive to think that the state of Europe is not causing a significant burden on the US or even global markets. The unemployment numbers to be released in the next few days will have a significant impact on how the US economy will react to the current declines.

If the US should learn any lesson from this European crisis, it should be that the inability to repay sovereign debt is a real concern, especially after accumulating a large deficit. Is it time for the US to start taking care of its own debt? Jim Owens, CEO of Caterpillar Inc. writes a phenomenal article in which he goes over major areas of the economy that the government should be focusing on in order to tackle the current deficit problem in order to heal the ailing economy.

Note- The ECB (European Central Bank) general meeting tomorrow morning is going to have a significant impact on the direction of the Euro. Hopefully, the ECB will restructure the debt of the struggling countries and cut interest rates. Such cuts will devalue the Euro, but it is a necessary step at this point.

Finance, The Economy

Unfortunately Hollywood was wrong about 2010, we are no where near to having flying cars, jet packs or robots as butlers. However, here’s what we can expect:

1) Policy:
The past year it was easy to make policy to counter the global economic meltdown because of coordination amongst the leading economies.  There was no special reason for the coordination and cooperation except that it was painfully obvious that it was the only move that could be made. The real test is going to come now when the countries will have to start planning exit strategies from the current stimulus driven global economy (since governments can’t fund their recovery efforts for ever). Developed economies like the US and Britain have to be careful not to make the mistake of withdrawing the stimulus too quickly like in the case of the US in 1937 and Japan in 1997, where the ill timed change in policy (in this case a tax increase) sent these already fragile economies back into recession. In short, withdrawing the stimulus too soon= recession and deflation!

With the large US current account deficit I feel fiscal policy should remain the same  for most of 2010 (with modest tightening)  since a tightening of fiscal policy will happen when the tax cuts susnset in 2011. This could prove to be tricky, as this is right around the time the stimulus programs will begin to start tapering down. As mentioned earlier, if not handled with care the US can fall back into the deep dark gallows of the recension. Therefore, after a very busy crisis management 2009, 2010 should be quiet for policy makers as governments will be focusing on taking charge of their over inflated budget deficits.

2) Shape of the recovery: will it be in the shape of a  V, U  or a reverse square root?
The recovery of the US economy should be interesting. The recovery after a recession is traditionally strong whereas after a financial crisis it is obviously weak. Since the US was caught in the perfect storm between both, it is difficult to determine which route the recovery will take. A a lot will depend on how fiscal and monetary policy pan out.

I think it is safe to assume that the a V or U shape recovery of out of the question. The excess spending and borrowing of the past few years will take a lot more to recover than a few months of good economic news and data. I have to agree with the economists that believe that that the  recovery will be in the shape of a reverse square root. This basically means that the economy will expand briskly and then taper down to an extended period of weak growth.

3) Interest rates:
In the past high interest rates were caused by inflation and their lowering ended recessions (well it was not that simple but it was pretty darn close). This time is an exception (we’ve all heard that before). At the time of entering the recession the US had a modest interest rate of 5.25%. The Fed effectively cut it to zero and aggressively bought bonds, mortgage backed securities and anything else it could to get the economy going again. However, bank loans to both businesses and individuals still continue to decline with only government backed Fannie and Ginnie Mae along with Freddie Mac are the only one to really give out credit.

Interest rates, as mentioned earlier, will have to be treated with great care. If growth is good the Fed will resist the temptation to increase rates.  However, as of right now I feel that a very modest increase will be witnessed by mid 2010 and go through 2011. Depending on how interest rates will move, stocks will be impacted as well. When interest rates move up people move from ‘offensive stocks’, semi conductors, tech etc. to ‘defensive’ ones like pharma and food.

4) Housing market:
This is going to be a tough one to call. Some analysts are seeing a bottom while others are expecting it to go down further. The facts are quite depressing: new home construction is at its lowest point of GDP since the 1960′s and inventory of  unsold new homes is the lowest its been in nearly 2 decades.  Ive already mentioned (in a previous post) that commercial real-estate is a ticking time bomb, ready to wreak havoc. I feel that with unemployment still in double digits, housing stats will not be improving any time soon.

5) Unemployment:
Though double digit unemployment is concerning, in terms of employment numbers improving your guess is as good as mine. I expect it to peak at around 10.4% and then be in check after Q2 in 2010.

6) Inflation:
Inflation is something to be worried about in the long term. Currently there is not a high probability of any run away inflation. Basic economics states that inflation is caused when there is excess aggregate demand. However, currently the economy is dealing with excess capacity (firms are not producing to their optimal capacity) rather than excess aggregate demand.

7) Company earnings:
Pundits have been quite happy with earnings from companies and with the economy in general. Without sounding like a pessimist, though the end of 2009 did seem encouraging it is important to note that the numbers may be a little skewed as the economy went through a serious tightening followed by a widening of credit spreads. Furthermore, a lot of companies feeling the pinch were able to strip out a lot of the bad results while conveniently leaving in the non-recurring (one time) positive results.

2010 will not see the economy soar. It will consist more of policy makers trying to tackle weak demand for borrowing, fixing their balance sheets and developing strategies to ween the economy off the stimulus. It is going to be a year that needs to be handled with intense care, finesse and economic prowess.

It has been a tough year for a lot of people. Lets work hard not only to improve our lives but the lives of those around us. I hope people realize that they have a lot to be grateful for and that though things may be tough, we have it better than a lot of those less fortunate around us… On that note, I would like to both wish all my readers a very happy and prosperous new year and thank you for reading and supporting my blog.

Finance, The Economy

I recently heard an interesting argument as to why the economy was doing well and the recession for all intents and purposes was over. The argument justifying the health of the economy was that the S&P is up by 23% since 2009. Furthermore, since the credit spread is close to the pre-Lehman levels, the economy should have followed suit. I have a few concerns with this statement both in regard to the logical fallacy and because I believe there are some other issues that we must be cognizant of before prematurely celebrating the revival of the economy.  However it is important to note that while I disagree with this statement I do think that the economy has taken a turn for the better and is on the path to recovery. However, I feel the road to recovery is going to be a lot longer.

My rebuttal to the statement is as follows: though the credit spreads are a good indicator of the health of the economy, it is naive to ignore the other aspects of the pre-Lehman economy that are being overlooked by the above statement. The unemployment rate in the pre-Lehman days was a relatively high 7.2%. Currently the unemployment is projected to reach a whopping 11%. Unless unemployment is curbed, it is impossible to posit that the economy is out of a recession.

Furthermore the effect of the withdrawal of stimulus funds like TARP (which is due to expire in December) and the first time homeowner tax break (which will essentially expired at the end of November) are just some of the stimulus withdrawals that should have an interesting (and possibly negative) effect on the economy. Although the S&P did reach highs for the year in mid November, many experts believe that equities are disconnected from fundamentals and a correction is expected in the coming weeks. It is also important to keep in mind that 48% of companies on the S&P have foreign sales. Thus, the increase in the stock prices may not solely reflect the condition of the domestic economy. Finally, until the people sitting on the sidelines decide to move back into the market and trading volume increases, the market is going to continue to trade on low.

While on the topic of things to be worried about with regard to the economy, I was discussing the condition of the economy with my mentor and was surprised at the numbers when looking at the projected default rates for speculative-grade corporate debt. According to Moodys research, the global speculative-grade default rate was up to 11.5% in August; to put this in perspective, the default rate a year ago stood at only 2.5%. Thus, it is awfully bold to proclaim that the recession is over.

It is important to realize that some of the major factors that are considered the origins of the crisis still remain unresolved: the US still has over extended consumers and the banking system remains significantly reliant on debt formation and asset prices (an example of the latter would be housing). Commercial real estate has been on a thin life line due to extensions on  credit by banks and is sure to have a nasty decline in the coming year. Currently the US is more of a stimulus based economy than the service or manufacturing based economy of old. The strength of the economy will be tested when the Fed eventually stops buying mortgage backed securities and normalizes monitory policy by increasing short term interest rates. The dollar is weak and cannot strengthen unless the Fed takes some positive steps. The Fed needs to either raise interest rates,  announce some plans to re-lever its balance sheet or have some sort of positive commentary regarding the future of the dollar.

This leads me to my next point: there is no debate on if there will be strong inflation, the debate is in regards to the timing of when inflation will occur. It is safe to say that we can expect significant inflation in the next 24-36 months, and depending on how the markets react, this will play a big part in the complete exit from the current recession. Things are getting better but we are certainly not back!

Note: Greg Curl the chief risk officer of the Bank Of America has brokered a deal to pay 45B in TARP money back to the government. Could this be a preliminary move before he takes over the job as CEO, or will the B of A opt for new blood to lead the organization? Only time will tell.

The Economy

With lending still being anemic and the unwillingness of people to borrow or spend money, banks are continuing to grow their cash reserves at a rapid rate. The blog post of  Frank Shostak of The Ludwig von Mises Institute discuses an interesting dilemma that the liquidity trap is causing for some economists (it also has a good explanation of Kayne’s Liquidity trap). The Liquidity trap which according to investopedia is ‘a situation in which prevailing interest rates are low and savings rates are high, making monetary policy ineffective’. In the case of the US, since interest rates are not expected to fall below 0 it essentially renders monitory policy to be impotent.

Like Mr. Shostak,  I do not think that the liquidity trap should be something one should be overly concerned with, However  current government and monitory policy does  need to be readdressed. With the euphoria surrounding health-care legislation and the bonus structure at investment banks, people are not focusing as much on serious red flags that are being raised in regards to the economic future of this country that will have ramifications felt the world over.

The Economy

I thought I would share something on a lighter note with you all… Here in Illinois (IL), the sales tax is a whopping 10.25%, however, necessities such as food items are exempt and are taxed at a lower 2.5%.  In prior years, candy was taxed at 2.5%. However, under the new regulation (set to increase revenue for the state) Candy is now being classified as a non-food item and thus moving up to the 10.25% bracket. How does one differentiate food from candy? Simple, anything with flour is considered food. Therefore, according to this law Twix and Kit Kat are food items and jolly ranchers are candy. Since it is only a state law, I do not think there is going to be much of a reaction from candy manufacturers, unless this becomes a trend with other states.

I do not really have an opinion either way except for the fact that the new regulation disagrees with everything my mother ever told me (Chocolate is NOT food).  If only this law had been in place when I was younger…

On a side note, my heart goes out to all the super market staffers that are going to have to re-program the scanners to reflect the new tax as well as move out the ‘food’ from the candy section.

Politics, The Economy

The VIX is no where as high as it was towards the end of last year and the markets have been doing significantly better since then as well. However, that does not mean that the market and public are still not afraid of an over involved government. In these trying times everyone is tuning into the news and following every word coming out of Tim Geithner’s mouth. With such high scrutiny on every word uttered, I was astounded to hear about Tim Geithner’s simpleminded and pointless decison to regulate both Venture Capital and hedge funds. What surprised me more is the tepid response this issue has received both from the press and public. Secretary Geithner went onto justify his statement by mentioning the high risk and instability caused by these firms due to the high levels of leverage that they take on. Though I understand his concern regarding Hedge funds, Venture Capital (VC) by their very nature do not take on high amounts of leverage.

There is a significant difference between venture investment funds (what Berni Madoff ran) and venture capital (the kind of investing that started Amazon.com, Google, Microsoft and Apple to mention a few).

Where as venture investment funds, invest your money in the market and generate returns using their savvy investing skills (or Ponzy schemes). Venture capital invests money in small business without using much leverage (debt). Start ups traditionally don’t take on debt because they don’t have steady or at all predictable cash flows, they also make it clear from the outset that you may loose 100% of your investment if things don’t go as planned. Thus, it is not the average Joe that invests his life savings but wealthy institutions and investors that are looking to make high returns by ‘gambling’/investing a few hundred thousand.

Mr. James Freeman the author of the Op-Ed peace, makes a compelling case and there is little I can add to what he wrote.What I will try to do in this piece is try and understand what Secretary Geithner was trying to accomplish by making such statements.

I will give the treasury secretary the benefit of the doubt and assume that his intention behind the policy recommendation was not to regulate venture capital per se but to try and make it harder for hedge funds to pose as venture capital funds to avoid the vast umbrella of SEC regulation. We saw an example of such shenanigans at work with TARP 1.0, when insurance companies started to buy small and mid size banks in order to be eligible for TARP funds. However, what I don’t understand is why Mr. Geithner would explicitly go after VC funds, instead he could have made more caveats regarding hedge funds rather then explicitly talking about VC funds. The fact of the matter is that the NASDAQ has by far been the best functioning exchange this year. Small and medium sized industries suffered already due to the high expense incurred due to compliance with Sarbanes Oxley. Regulating VC funds is going to create more road blocks for start ups and make it harder for these companies to come up. By trying to mollycoddle the investor the administration is not encouraging risk (something the treasury secretary insisted he wanted to see more of) but instead is scaring people away from the mere thought of taking risk. This Results in the suffocation of yet another growth artery of the currently (growth) anemic economy.

I hate to quote fictional charecters such as Spider man’s grandad but the guy had a point when he told his grandson Peter Parker, “with great power comes great responsibility’. Think about it Timmy G!

Politics, The Economy

Re-Cap
Monday the 23rd of March was the best day for the market since October 2008 and consequently the best day of 2009. The S&P was up 7% (12% in March) making March 2009 the best month since March of 2000. While the Dow was up 6.8%  (10% for March) it has managed to be the best monthly percentage gain since October 2002. Technology continued to lead the charge with the NASDAQ up 6.76% (it has only been down 1% the entire year, and March has been the best month for the index since November ‘02)

Unlike the rallies of the past six months that were hard to explain, the reason for this rally can be primarily attributed to an Op-ED that Tim Geithner wrote (a couple of weeks ago) along with some other news that we will discuss further in this post. In short, Mr. Geithner stated that the treasury will vow to use $100 billion in funds from TARP (through its toxic asset plan) to buy distressed debt and pool these assets together. In return, the treasury secretary wants both individuals and banks to take more risk.

In spite of the S&P going south 3.5% on the news of the administration cracking down on the auto industry and FASB ditching mark to market accounting in favor of mark to model, I could not be happier. I think someone in the administration finally read my blog.

In regards to the auto industry I am ecstatic that the government has started taking some initiative and given Chrysler thirty days to make a deal with FIAT or else resort to bankruptcy. In principle I do not support a large amount of government intervention, nor can I be happy when someone loses his or her job. However, I whole-heartedly support the president’s decision to ask the GM CEO to step down. The fact of the matter is that unless the companies change their business plans drastically they do not deserve any money as they will continue to be non-competitive and be a recurring expense on the government’s already over leveraged balance sheet. The pressure on the auto manufacturers is not unpatriotic by any means. All it is doing is requiring that auto manufacturers take some serious initiative to try and right many years of inefficacy. To illustrate my point, the Ford Model T was more fuel efficient than a Ford Taurus.

In reference to the accounting standards, changing to mark to model will by no means solve the financial crisis. Mark to model accounting rates assets valued purely by mathematical models. This should be able to help value assets that do not have a market available. Contrary to popular belief this will not increase the big banks’ stock prices either because the market will ‘price in’ the fact that mark to market accounting is not being used. What mark to model accounting will do is boost the banks’ capital ratios (the ratio gives an idea of a company’s financial structure and some insight into the companies financial strength). In essence, the higher the capital the ratio, the less money will be required by the banks. It is important to note that this will not be retroactive (for past years) and will only be valid starting the first quarter.

Though I will be the first to admit that I am excited about the progress being made, I caution you not to ignore the past and to ensure that you put the recent gains of the market in perspective. Though things are looking much improved, the gains may be misleading as the market has taken such a beating the past six to eight months that 100 point days may lead you to believe the recession is long gone… Unfortunately, the truth is we still have a long road ahead.

The Economy

Don’t worry, I am not asking you to remember the day, date and location of your first date with your significant other…

Recap:
On March 5th the Dow closed below 6600, the S&P closed at its lowest since Dec 1996 and Citi managed to drop below a dollar. If this news was not depressing enough, an economics professor at Harvard says there is a 20% chance of a depression (and further elaborated that the 1/5 estimation is on the optimistic side.)

Back to the stress test:

The government stress test is expected to be carried out later this month. The goal of the stress test is to see how much capital the banks need to remain solvent and how much money the government will need to invest in order to absorb losses and ensure that the banks are able to sustain lending. Though the final details of the stress test have not been released (or decided), three major scenarios are being looked into during the initial discussions. Will the banks be able to remain solvent if:
i) Unemployment hits a whopping 8.9% in ’09 and 10.3% in 2010.
ii) The Case-Shiller (housing) index declines 22% in ’09 and 7% in 2010.
iii) The GDP contracts 3.3% in ’09 and 0.5% in 2010.
It is important to note that the stress test guidelines are a good indicator of how the government is expecting 2009 and 2010 to pan out. The stress test is set to give banks an idea of what they did right in the past, where they are currently weak and what they should expect in the future (keeping in mind current geo-political stresses and trends).

Now that I have explained what the government is hoping to achieve by using a stress test, I will now show you why this is all a huge waste of time. First, crises don’t occur at the drop of a hat. Unemployment will not instantly hit 10.3% and cause havoc. Most serious problems occur as a series of events. For example, sub-prime loans were only 14% of the US financial market. The problems arose when banks started to package and tank up on AAA rated mortgages as if they were AAA utilities. It is only then that sub-prime became an issue. In short, one ”bad” piece of news will not cause the economy to go down in a tail spin.

Second, can the test be objective? Scenario one: the same test is administered to all banks. The problem with this is that all banks are not the same. For instance Citi Bank and Goldman Sachs are in very different positions. Thus, giving all banks the same test inadequately models the situation and will fail to generate useful information. Scenario two: each bank gets a customized stress test. The problem with this strategy is that there is a chance that the test givers bias (how’s that for a technical term?) may come into play. However, I will be magnanimous for a moment and assume that the test will be extremely fair. In this case, how will the banks be compared on a level playing field if they are been given different tests?

Third, all banks were forced to take TARP 1.0 because the government did not want to single out the banks that needed the money. What is going to happen when a bank fails the stress test and needs more capital? Is it OK for the market to punish the stock now?

Furthermore, there is no guidance on whether the government is going to use tier one capital (common stock, preferred stock and hybrid debt and equity) or tangible equity capital (focus on shareholders equity) to gauge the health of the banks.

How do further capital injections in the absence of altering business models solve anything? AIG just required another $30 billion, after all the money they have already received. Much to GM’s chagrin, their auditors and accountants have said that the company can not function in its current state and will need to file chapter 11 and restructure to remain viable (a fact that GM continues to vehemently deny). Nationalization (or pre-privatization) could be a temporary solution. However, the issue of Moral Hazzard still remains.

The Economy

We have two items of good news. First, the administration has finally addressed what I consider one of the most important issues regarding the economic meltdown… Housing! I am happy that the issue is being addressed, but not how it is being addressed because of the possibility of a moral hazard – individuals that will be insulated from risk may behave differently after receiving the stimulus than they would if they were fully exposed to the risk.  Second, irrespective of where you stand on the issue politically or socially, I feel that it was a good move to lift the ban on stem cell research as it will further strengthen the (thus far) ‘recession proof’ bio tech industry.

Politics, The Economy