Thursday, January 27, 2011

Stocks and Butter

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market"(, 2009)

"We are poised for progress. Two years after the worst recession most of us have ever known, the stock market has come roaring back. Corporate profits are up. The economy is growing again."

-President Barack Obama, State of the Union speech, January 25, 2011

Maybe President Obama was at a loss to validate the rousing economy in his State of the Union address. Whatever the reason, this was a strange appeal to the American people. An even stranger validation of Wall Street's prowess was expressed last week by Federal Reserve Chairman Ben S. Bernanke.

On January 20, 2011, the Fed chairman was asked by Steve Liesman if his QE2 chalkboard exercise had failed, given that interest rates have risen rather than fallen. (Bernanke claimed, at the outset, that QE2 would drive interest rates down. The 10-year Treasury yield has risen from 2.62% on November 3, 2010, to 3.43% on January 26, 2011.) Not knowing anything about markets, but pretending to be an expert, Bernanke replied: "The S&P 500 is up about 20%-plus and the Russell 2000, which is about small cap stocks, is up 30%-plus. So I think a stronger economy actually helps small businesses even more than it helps larger businesses."

This is bizarre: The Fed chairman touting small-cap stocks on CNBC. And why is he on a TV talk show that makes a habit of bad advice? The only point to be made here, though, is his belief that a healthy stock market is synonymous with a strong economy. This is always a contestable claim, but particularly now. Americans, that is, retail investors, have largely abandoned the stock market. Studies show that up to 85% of trading is by institutions.

If Bernanke was implying the stock market lifts all boats, that is false. Yacht sales are booming but the withering middle class is lucky to find an abandoned house boat. Richard Fisher, President of the Federal Reserve Bank of Dallas, told the Association for Financial Professionals on November 8, 2010 (five days after Bernanke launched QE2):

"As to the proposition that higher prices of financial assets will liberate those most in need, I wondered aloud if that were indeed true. We are already seeing the beginnings of speculative activity in stocks, bonds, buyouts and commodity markets. The rich and the quick are certainly able to exploit these circumstances to get richer. I have no problem with market operators making money; I did so myself in my previous life as a funds manager (before I took the vow of financial chastity and joined the Fed!). But I take no comfort, and see considerable risk, in conducting monetary policy that has the consequence of transferring income from the poor and the worker and the saver to the rich. Senior citizens and others who saved and played by the rules are earning nothing on their savings, while big debtors and too-big-to-fail oligopoly banks benefit from their subsidy. I know of no presidential administration or Congress, Republican or Democrat, that will tolerate, let alone advocate for, that dynamic for long, and I expressed my worry that this could come back to bite us and possibly threaten our independence." [My italics - FJS]

It is rare for someone inside the central banking cabal to acknowledge how the Federal Reserve subsidizes the rich and makes them richer. Another case was in 1993 when the International Monetary Fund (IMF) published a paper. This was when Fed Chairman Alan Greenspan created the carry trade. (His claim of authorship: "We created the carry trade." See:
"The 2004 Fed Transcripts: A Methodical, Diabolical Destruction of America's "Wealth"). This whirlwind of unnecessary finance, other than to bail out Greenspan's previous mistakes, was a vital stimulant to concentrating money-making into the hands of the few.

The IMF paper (World Economic Outlook, April, 1993) discussed the consequences of "a credit expansion in excess of the expansion of the real economy." "Excess" credit distorts the economy. When credit does not serve a proper function, it is borrowed to speculate. The claims of Obama and Bernanke could not be further from the truth.

The IMF observed: "Financial liberalization, innovation and other structural changes of the 1980s created an environment in which excess liquidity and credit were channeled to specific groups in the markets. These include large institutions, high-income earners and wealthy individuals, who responded to the incentives associated with the changes. These groups borrowed to accumulate assets in global markets - such as real estate, corporate equities, art and commodities such as gold and silver - where the excess credit apparently was recycled several times over." [My italics - FJS]

It is particularly irksome for leaders (the wrong word, but so be it) to root for the stock market when, by doing so, they sink the houseboats of the dispossessed. Wages and salaries in the United States have fallen from $6.6 trillion in the fourth quarter of 2008 to $6.4 trillion in the third quarter of 2010. (This is a much better measure of economic health than GDP, which may be why it is buried in the deluge of government data.) These numbers underestimate the agony since the working-age population has risen.

In addition, the Politburo (Bernanke and the Bureau of Labor Statistics) claim there is no inflation. Yesterday, January 26, 2011, the Federal Reserve released the minutes of its December, 2010, FOMC meeting, at which the Federal Reserve Open Market Committee apparently decided that "measures of underlying inflation have been trending downward." At the same time: "Among the broad budget categories, employee benefits was expected show the steepest price increase; respondents foresaw a 10.1 percent rise in the cost of benefits, up from 8.9 percent in 2010." - The Federal Reserve Bank of New York, December, 2010. One can only hope that someday the gang of swindlers will be held to account.

Most domestic prices are inflating, with the exception of income and houses: "[B]ank-owned properties (REO's) and short sales, where the home is sold for less than the value of the mortgage, made up 47 percent of all home sales in December. That's up from 44.5 percent in November." - Diana Olick, CNBC, January 24, 2011. "Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance." - Simple Ben (Bernanke), November 4, 2010. All readers are enjoined to buy anti-Bernankes: gold, silver, and premium scotch.

Instances of inflation, over the past few days: "World Moves closer to Food Price Shock" - Headline, top of front page, Financial Times, January 12, 2011. At Supervalu and Safeway [supermarkets], "profits had already been declining because of rising food prices..." - The King Report, January 18, 2011. Rising Gasoline Prices Sour American Mood" - Reuters, January 18, 2011. At the semi-annual Canton [China] Fair, prices of apparel, shoes, and luggage rose 20% between fairs held in the spring and autumn of 2010. - The King Report, January 24, 2011. "As market prices go up, Roswell-area growers report increase in pecan thefts" - The King Report, January 24, 2011. "McDonald's said...that it may have to raise prices at its restaurants this year as it braces for rising costs of commodities." - Financial Times, January 24, 2011. "The price of the BK Whopper Junior has risen from $1.00 to $1.49 over the past year or so." -Frederick J. Sheehan, upon deciding to skip lunch, January 24, 2011. "Starbucks Sees Higher 2011 Coffee Costs" - The King Report, January 27, 2011. A pound of butter rose from $1.53 a pound on December 1, 2010 to $2.10 a pound on January 25, 2011 - Chicago Mercantile Exchange.

President Lyndon Johnson waged a big war on Vietnam and on poverty (guns and butter) at the same time. Almost everyone lost. President Obama is inflating Wall Street, a strategy that is, in turn, inflating the cost of butter. This will end badly.

Wednesday, January 19, 2011

Greenspan Confirms the Fed's Highly Leveraged Fix

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market"(, 2009)

On January 7, 2011, Kelly Evans of the Wall Street Journal interviewed former Federal Reserve Chairman Alan Greenspan. He rooted for the stock market.

Greenspan's circular logic was unenlightening: "Stocks are cheap if earnings are to continue higher." Taken as a whole, this does not mean much, akin to prophesizing: "The Red Sox will win if they score more runs than the Tigers." Greenspan's successful impoverishment of the American people often hinged on the suppression of his dependent clauses: "Stocks are cheap," was all we needed to know.

Greenspan also revealed the (purported) economic recovery is hostage to a bigger and better stock market bubble. He did not put it that way. Interviewer Evans pestered the deaccessioned relic into a defense of the current Fed's market-rigging policy. The former central banker denied any such collusion, but did claim: "The stock market overall is the only type of stimulus that you can get into the economy that doesn't have any debt associated with it." There may never have been greater debt associated with the stock market than in 2011. That, after all, is how it stays up.

Gluskin, Sheff economist David Rosenberg celebrated the new year by publishing some unnerving charts. Margin debt at U.S. broker/dealers has risen 24% over the past year. The hand wringing about atrophied bank lending is a narrow view. A broader investigation shows that commercial banks' trading assets surged $64 billion in December, 2010. UBS Prime Brokerage Services reported on January 12, 2011, that hedge funds have increased their leverage to within 10% of the peak in 2008. Since the bottom (when Lehman Brothers surrendered), gross leverage at hedge funds is up 43%.

A favorite destination for releveraging is stock mutual funds and ETFs - they received $24 billion in net flows in December, 2010. This does not even account for the far greater leverage during buying sprees of S&P 500 futures contracts, the domain of the banks and hedge funds. The institutions have plenty at stake. They took the Fed at its word. ("[H]igher stock prices will boost consumer wealth and help increase confidence..." - Fed Chairman Ben S. Bernanke, November 4, 2010)

The Fed is doing its best to fulfill institutional confidence with its current money-pumping program (QE2). The bulge-bracket brokers compensate for Federal Reserve lapses by raising S&P 500 futures prices when the market flags.

It is this symbiotic relationship that lies beneath Greenspan's confident stock market forecast, an inevitable conclusion after listening to his other reasons to buy stocks, all of which are often associated with an impending crash:

GREENSPAN: "We've had an extraordinary rise in profit margins. This is coming to an end." That may seem to contradict the rationale for his "stocks are cheap" analysis, and it does. Greenspan was never a model of cogency.

The following exchange was of the same quality:

GREENSPAN: "[W]e are going on the assumption that long-term interest rates will stay down. We don't know that...We are in the position we were in 1979....There were no inflation fears, then, within three to four months, we went up 400 basis points [i.e., 4 percent].

EVANS: "Do you think something like that could happen again?"

GREENSPAN: "I think it's a danger."

Inflation had been 12% in 1974 and 9% in 1978, so the leap to 13% inflation in 1979 was not difficult to imagine, except, apparently, to the man who had led the President's Counsel of Economic Advisers from September, 1974 to January, 1977.

My own view is in accord with Greenspan's. Interest rates could very well jump 4%, but, this time it could take 15 seconds. The government-sanctioned machinery that now operates the stock, bond, commodity, futures, foreign exchange, and executive-pay markets is even more susceptible to a miscue than was true when the Greenspan Put assured investors the Nasdaq would never fall below 5,000. (That great unwinding receives its due in
Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession.) Should interest rates revert to a proper level, it may take an additional 15 seconds for the stock market to follow.

It is no wonder that after the interview, Business Insider choose as its headline: "Alan Greenspan Sees a Huge Chance of a Bond Collapse, While Lashing Out at His Critics." As to the second half of Business Insider's headline, the incoherent scolding of his critics was pathetic. The less said about it the better.

Friday, January 14, 2011

Liquidate the Fed

“I would also like to note that the same research paper [produced by the Federal Reserve staff] analyzed the macroeconomic effects of the FOMC's full program of securities purchases [“Quantitative Easing,” usually called, by non-economists, “printing money”], including the first round of purchases that was initiated in late 2008 and early 2009, the modification of the reinvestment policy that was announced last August, and the second round of purchases that was initiated in November. Those simulation results indicate that by 2012, the full program of securities purchases will have raised private payroll employment by about 3 million jobs. Moreover, the simulations suggest that inflation is currently a percentage point higher than would have been the case if the FOMC had never initiated a securities purchases, implying that, in the absence of such purchases, the economy would now be close to deflation.”
-Federal Reserve Vice-Chair Janet L. Yellen; Denver, Colorado; January 8, 2011

“This is a great job, if you like to travel around the country and read speeches written by the staff”

-Federal Reserve Governor Janet L. Yellen, 1997

“Recent data show consumer price inflation continuing to trend downward. For the 12 months ending in November, prices for personal consumption expenditures rose 1.0 percent, and inflation excluding the relatively volatile food and energy components--which tends to be a better gauge of underlying inflation trends--was only 0.8 percent…”

“[I]nflation is likely to be subdued for some time…”

“Very low rates of inflation raise several concerns: First, very low inflation increases the risk that new adverse shocks could push the economy into deflation, that is, a situation involving ongoing declines in prices. [Sic]”

-Chairman Ben S. Bernanke, Testimony before the Committee on the Budget, U.S. Senate, Washington, D.C., January 7, 2011
“From the moment that art ceases to be the nourishment of the best brains, the artist can use all the tricks of the intellectual charlatan. The refined people, the rich ones and the professional layabouts, only want what is sensational or scandalous in modern art. And since the days of cubism I have fed these boys what they wanted and pacified the critics with all the idiotic ideas that went through my head. Whilst I amused myself with all these pranks, I became famous and very rich. I am just a public clown, a fairground barker.”
-Pablo Picasso, 1951, attributed. I doubt he said this; but the description fits academic economists, who, unlike the time at which Picasso (may have) spoken, are of another generation, a generation of professional layabouts that is no longer in on the joke. The clowns and barkers spout idiotic ideas because they only think idiotic ideas.

Thursday, January 13, 2011

Illinois is No Peter Pan

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market"(, 2009)

"I'll never grow up, never grow up, never grow up, Not me!"

-Peter Pan, Lyrics from play

"I knew Peter Pan and you're no Peter Pan."

-Vice-Presidential candidate Lloyd Bentsen, (sort of), 1988

"Top Illinois Democrats have agreed to push a plan that would temporarily boost income taxes by 75 percent and double cigarette taxes," harked CBS Chicago on January 6, 2011. The proposed plan would increase Illinois' personal income tax rate from 3 percent to 5.75 percent for the next three years. After that, it would drop back to 3.25%. So they say.

is a state in which the legislators have so betrayed the taxpayers that a lifetime on Devil's Island would be too good for them. For instance, the liability of the four state pension plans is calculated at $151 billion or $280 billion, depending on the assumptions used. The $280 billion figure is analytically controversial but deductively compelling given the efforts to deny and confuse bondholders and the public alike respecting the coming collapse of the municipal bond market.

, the capital of Illinois, is a nice town. As state capitals go, it is strikingly uninhabited with a population of 110,000 (and falling, but not as fast as its benefit obligations are rising). Farm country starts about three blocks from the state house. Illinois has more representation in its capital than any other state.

The politicians raised pension benefits faster than poker bids in Macau. Presumably, they have boosted their own benefits faster the state's public servants, who, once they retire, no longer pay one cent for health insurance.

Clay ducks would have done better at funding promises than the elected representatives. There are $70 billion of assets to support the $280 of pension obligations (See The Liabilities and Risks of State-Sponsored Pension Plans, in which Professors Novy-Marx and Rauh lay forth their provocative and engaging argument).

borrows from the bond market each year to pay benefits, a total of $16 billion since 2007. Bondholders have been paid $550 million (on the first $10 billion) for funding this pyramid scheme. In other words: Illinois taxpayers have paid a $550 million late-fee that, if there were justice in this world, would be paid by the Illinois legislators.

These legislators - and this is true across the country, not just Illinois - cannot conceive of a time when there will be no buyers of bonds to pay benefits that the politicians failed to fund. By borrowing to meet current payments, the "top Illinois Democrats" have fostered the national charade of limitless taxing authority. State General Obligation (G.O.) bonds are backed by the "full faith and credit" phrase, stamped on their offerings. Wall Street research would have it that a G.O. bondholder can take that phrase to the bank. It is from this precipice that bondholders hang by their fingernails.

Goldman Sachs research chips in: "[G]eneral obligation debt is backed by a state or local government's pledge to raise taxes to service that debt if necessary." Barclay's wrote to its California-averse clients that the state is obligated "in good faith to use its taxing power as may be required for the full and prompt payment of debt service."

There are four problems here.

First, the State of Illinois had accumulated over $5 billion of unpaid bills by the end of 2010. Electricity to the governor's mansion will be cut off if the politicians don't grow up.

Second, the authority to raise taxes to meet bond payments often does not work. The most recent instance is the State of Oregon. In early 2010, voters increased tax rates on high earners and businesses to fill a $700 million deficit. Civil servants danced in the streets: "We're absolutely ecstatic," said Hanna Vandering, a physical education teacher from Beaverton and vice president of the statewide teachers union. "What Oregonians said today is they believe in public education and vital services." (The Oregonian, January 26, 2010) On December 16, 2010, the state of Oregon had received one-third less than was expected from windfall tax receipts. Those Oregonians who weren't talking while Hanna Vandering was spouting decided they would rather leave town than contribute to this scandalous love-in between legislators and public unions.

Third, the authority and inclination of courts to issue a writ of mandamus (ordering state officials to raise taxes) is not a topic discussed in brokerage firm research. It is hereby suggested to municipal bondholders who are recipients of such reports to ask why this is so. There have been many decisions in which the court concluded it did not have the authority (or inclination: because efforts, such as in Oregon, are generally unsuccessful) to demand tax increases. The decisions are too varied to discuss here. (See, as a start, Tax Increases in Municipal Bankruptcies, Kevin A. Kordana, Virginia Law Review, volume 83, No. 6, pp. 1035-1107.) Readers may recall that states cannot file for bankruptcy. This is true, but an insolvent body that reneges on its obligations to bondholders will sit in the dock. Municipal decisions are the obvious precedents for the courts.

Fourth, a Sword of Damocles hovers over all transactions and contracts in the United States today: who still trusts the "full faith" of any government body? And, this is the worst situation of all: politicians who think they can fly.

Tuesday, January 4, 2011

Markets Vanish - "In a Flash"

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market"(, 2009)

Following is a short excerpt from "War of the Nerds," which I wrote for the December, 2006, edition of the Gloom, Boom & Doom Report. I discussed the crises an investor ("Our Serious Investor") navigated from the 1960s to the present. Doomsday had been predicted since the dollar crises of the 1960s, yet risk had been transient. By the fall of 2006, it was obvious the U.S. mortgage market and banking system were in collapse, but securities markets were deemed riskless, as measured by bond and credit-default spreads. It is timely to resurrect the vanishing bond markets of 1914 and 2007 after the failed or distressed auctions since December 27, 2010, of euro zone, Chinese, and U.S Treasury bonds with 5-year and 7-year maturities.

The historian Niall Ferguson (The Cash Nexus, War of the World) has written a paper on the risk imbedded in sovereign bond spreads between 1848 and 1914: "Political Risk and the International Bond Market Between the 1848 Revolution and the Outbreak of the First World War." Published in the Economic History Review earlier this year, his exhaustive study of weekly great-power bond prices (United Kingdom, France, Germany, Austria-Hungary and Russia) comes to a surprising conclusion - the closer Europe edged towards war, the less the financial markets cared. Ferguson sees two distinct periods: from 1848 through 1880, the markets were anxious. Sovereign bonds were sold at the slightest scent of war. After 1880, the response to international tensions grew less and less pronounced.

....It is 2006. Our Serious Investor has grown calloused to once-in-the-history-of-the-universe events. Our Investor survived the dollar crises, the stock market collapse and deep recession of 1973-1974, the Business Week "Death of Equities" front cover, the $250 billion federal budget deficits of the 1980s, the frequent financial and derivative crises of the past twenty years (far more prevalent than between 1950 and 1970), the current $500 billion federal budget deficits, and the (prospective) $1 trillion trade deficit. Our Serious Investor has prospered. He gradually learned to shrug off the deteriorating macro world. He grew accustomed to the "Greenspan put" (that is, central banks will bail out any-and-all financial meltdowns), the risky adventures of hedge funds, the abandonment of debt covenants by bond issuers, the private-equity moon shot; he has, by now, grown so accustomed to the warnings that he keeps his head down, plugs away....

Ferguson's narrative of the countdown to war is a splendid chronology of how quickly the world can change: "It was not until 22 July [1914] - more than three weeks [after Archduke Franz Ferdinand of Austria was assassinated, on June 28, 1914] - that the possibility of a European political crisis was first mentioned as a potential source of financial instability in the financial pages of The [London] Times....

The 2-1/2% British consols rose from a 3.30% yield on July 7 to 3.31% on July 22 - a single basis point of fear.... Tensions rose on the exchanges and grew acute on July 27 when the Vienna and Budapest exchanges closed. The Sarajevo incident could still be interpreted as a local affair, but trading slowed on the other European exchanges. Now [British] consols rose to 3.45%. The St. Petersburg exchange closed on July 29 and the Economist considered the "Berlin and Paris bourses closed in all but name."

....A wholly unanticipated domino effect now engulfed London. The bond market did not seem to acknowledge this vaporization of liquidity: "....The Economist was especially struck by the widening of the bid-ask spread for consols (the gap between buyers' offers and sellers' asking prices) to a full percentage point, compared with a historic average of one-eighth of 1 per cent... "

The London market started to close on July 29. London clearing banks concentrated on funding their stock-exchange clients, eight of which failed by the end of the day. On July 30, the Bank of England raised its discount rate from 3% to 5%. On July 31, the Stock Exchange was closed and the Bank of England raised its discount rate from 5% to 8%.

As to how much we can trust the Greenspan "put": "[T]he British and Continental financial authorities pulled every trick." [Ferguson] furnishes a list of clever, arbitrary and confiscatory maneuvers, but, "systematic central bank interventions to maintain bond prices" only worked for a time. Government assistance "could only disguise the crisis that had been unleashed in the bond market; it could not prevent it." [My bold- FJS]

Ferguson scrapes up the debris: "For all save the holders of British consols, who could reasonably hope that their government would restore the value of their investments when the war was over, these outcomes [for French, German, Austrian, and Russian sovereign bond holders] were even worse than the most pessimistic pre-war commentators had foreseen. The fact that investors do not seem to have considered such a scenario until the last week of July 1914 surely tells us something important about the origins of the First World War. It seems as if, in the words of The Economist, the City only saw 'the meaning of war' on July 31-'in a flash'."

Aside from the origins of World War I, the last week of July 1914 surely tells us something important about investors today.

"The sense of security more frequently springs from habit than from conviction, and for this reason it often subsists after such a change in the conditions as might have been expected to suggest alarm. The lapse of time during which a given event has not happened, is, in this logic of habit, constantly alleged as a reason why the event should never happen, even when the lapse of time is precisely the added condition which makes the event imminent."

-George Eliot, Silas Marner