The top ninety-one banks that account for roughly two-thirds of the banking assets in Europe passed the stress tests that were conducted later last week. I would have had absolutely no reservations in betting my mortgage on the results of the European stress test being positive. This is not because I have undying faith in the economy, but  because a positive result was expected. Stress tests would not have been announced if a bunch of banks were in the position to fail. The purpose of conducting the stress tests was to instill confidence, not ruin it.

I am not entirely sure if that goal was achieved. The Wall Street Journal has a well thought out article discussing the stress tests conducted by European regulators . The article asserts that the scenarios were not tough enough to give a true picture of whether or not the banks could survive a double dip recession. If you do not like to read (which would be  ironic as you are reading a blog at the moment) the graph at the end of the article says it all – it shows a huge cluster of banks barely making the 6% tier one ratio requirement. Therefore, though only seven banks failed, there are a boat load of banks teetering at the brink of failure. The article covers some good points for both sides of the argument but does not really touch upon the issue that I have with the tests.

All this talk about ‘transparency’ and getting  ‘insight into Europe’s banking’ is fine and dandy, but it seems like a classic case of not looking at the real issue. My beef with the test, aside from the fact that the rules were not stringent enough, is quite simple: the tier one ratio itself can be massaged to a great degree (much like a discounted cash flow valuation). Since the essence of tier one is to measure a variation of a shareholder’s equity to risk adjusted measure of assets, trying to ascertain what the “correct” risk weighting of the assets is open to subjective judgment.

Second, the Sovereign debt issue which is a huge threat to the EU was out of scope of the stress test. Spain is currently plagued with a huge number of over levered banks due to its property crisis. Not taking sovereign debt into account is like focusing on losing 15lbs but ignoring your soaring cholesterol level. Yes it’s a good goal, but it’s not going to lower the risk of a heart attack. I am not advocating that the stress tests should be scrapped, but they should not be considered a harbinger of things being OK at the moment. I do not expect anything drastic to happen in the next year or two since the crisis is still fresh. However, once the IMF and EU tighten their pockets and local governments funds start to dry up, sovereign debt will be a big issue for European banks as well as the Global economy.

P.S. Food for thought: here is an article on Bloomberg discussing how the European debt market, specifically German bonds may take a hit as a result of the the stress tests in Europe. Lets see how the next week pans out.

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.

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.

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.

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.

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.

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.

The current administration is trying its best to mitigate risk in the markets in order to prevent another financial meltdown of this magnitude from ever occurring again. However, I do not think that throwing money at the problem is a viable solution. The premise of a Capitalist economy is based on the survival of the fittest. However, the current president has been the complete opposite. Bailing out companies without requiring them to change their business plans (the initial auto bailout) or the new cash for clunkers deal (in which case if you bought a gas guzzler you get a $4000 rebate) are a few of the governments policies rewarding those who made poor decisions. I can accept (to an extent) giving people second chances, but punishing those who make good decisions makes no sense to me. Why should a person ‘A’ who has a 1998 Nissan Sentra not be allowed to trade in her car (because it is considered fuel efficient) but person ‘B’ be qualify  for the program after buying a 2004 Hummer.

Lets look at the issue from a different perspective. The carrot and stick theory is a simple premise of how a market economy works (rewarded if you do well => Carrot, punished if you do badly => Stick). This theory has been completely violated in the past few months. One cannot reward good work with bonuses or let everyone get a rebate on a car due to government regulation, nor can one fire for inefficiency or incompetence due to Workers Unions. (I am completely in favor of what unions USED to stand for, but I find them a hindrance to business now a days). In short, throwing money at issues, legislating regulation favoring the few and curtailing business and bonuses is not the best way to approach the current situation. I am by no means saying that the bailout was not necessary, but we need to know when to say enough is enough.

It is important to understand that risk management is an evolving science and the current situation is unprecedented, the basic lesson remains the same – the more regulation and complexity that is added to the system, the less likely the risk managers are able to account for risk, making it a lot harder to remedy our current situation.

I am on the fence with this issue. Both scholars make some great arguments, but the decision will come down to what the administration feels is the role of the Fed and whether or not its charter should be expanded. Is the role of the Fed just to control rates and make policy, or is the buying back of debt and bailing out companies going to be added to its charter? In short, Did Bernanke intervene because it was part of his job description (that he was expected to be ready for) or was it an emergency learn-as-you-go type of situation which he tried to make the best of? Depending on the view the government takes the Chairman should be shown either the deepest gratitude or the back door! I am keen to see how this plays out.

Note: Due to switching servers, I lost all my comments and had to reset the counter. Please continue to leave your thoughts, feedback is always appreciated!

As I have mentioned in previous posts, straightening out the balance sheet was not the hard part. GM was such a poorly run corporation, it was inevitable that restructuring both management and financials would lead to cost savings and an increase in efficiency. Furthermore, the decision to reduce the brand offerings was bound to help (only the Chevrolet, GMC, Buick and Cadillac brands remain.) GM will operate 13 fewer American factories and shrink its dealer network from 6,000 to 3,600 by the end of 2010.

General Motors Co. CEO Fritz Henderson revealed a revamped management and is determined to repay loans from the U.S. government “much sooner” than 2015. Henderson expects to cut the workforce from 91,000 (at the end of last year) to 64,000 by the end of 2009. He further proclaimed that GM would launch 10 new products in the U.S. over the next 18 months, as well another 17 overseas. An IPO could be launched as early as the second quarter of 2010 (provided that the market conditions are conducive).

Though GM will be keeping a watchful eye on the condition of its suppliers, the biggest challenge for the ‘new and improved’ GM is going to be to change the perception of the company. The fact that GM has had no marketing for the past six to nine months could be a blessing if they play their cards right. The idea of government motors, overpaid workers and poor quality cars has to be replaced with the thought of an efficiently run organization that makes durable and fuel efficient cars. Furthermore, GM has to ensure that the cars are competitive in the market in order to have a chance to be able to win back the faithful support they once had. It is by no means an easy task and will be a long road ahead…