Finding Shelter From Unrestrained Money Printing

There is an outcry of investors who worry about the consequences of unimpeded printing of dollars, as it increases the danger of hyperinflation. Can our unbacked fiat money system survive the aggressive monetary policies of the central bank? If the history of fiat money is any indication, gold investment is as attractive as ever. For more on this, see the following post from The Prudent Investor.

Neither CNBC, the Bull Street Journal or the Debt Times have covered the latest earth-shaking news reported in the new media concerning gold price suppression by governments and central banks. Let me first send respectful hat tips to Zerohedge, EconomicPolicyJournal.com and GATA who all came out in the last 2 weeks with official documents that prove that especially the USA has a most vital interest to keep the price of gold as low as possible. Please check out all three sources to find links to countless official declassified documents that deal with the hot issue of gold manipulation.

Looking at the 10-year chart shows that all multi-billion operations by central banks in the gold market have led to nothing else than the current near-to-record prices although these institutions can short gold unlimited via futures markets.

The fear of a gold price that would correctly mirror the uncountable money printing excesses which show us that central banks are no more than one-trick-ponies. Take away their privateering privileges of creating money out of thin air and it becomes understandable that tireless Congressman Ron Paul wants nothing less than abolishing the Fed.

While Ron Paul has still many hurdles in front of him he at least nurses a strongly growing community supporting him.

Happy USA - it has at least a few million citizens who understand the biggest ponzi scheme in history, AKA Federal Reserve Notes (FRN) created by the trillions nowadays, and who begin to fight this scheme that led to the impoverishment of every generation in the last 3 centuries.

The Situation in Europe is Sad at Best
The situation in Europe is sad at best. I presume that the number of Europeans understanding the diabolic actions of central banks which always ended in hyperinflation would not fill more than a small town concert hall.

While Fed Chairman Ben Bernanke encounters a more and more aggressive environment on his trips to Congress and Senate, ECB President Jean-Claude Trichet can still get away with such blatant disinformation in the European Parliament (EP) like the following 5 bullet points presented to EU politicians on September 28:

1. First, we have fully accommodated banks’ liquidity needs at fixed interest rates.
2. Second, we have further expanded the list of assets eligible as collateral.
3. Third, we have further lengthened the maturities of our refinancing operations.
4. Fourth, we have provided liquidity in foreign currencies, notably the US dollar, to address the need of euro area banks to fund their dollar assets.
5. Fifth, and finally, we have launched a direct covered bonds purchase programme to support financial markets.

You don't have to be an expert to get angry on the nonsense Trichet tells a generally disinterested EP with no second-guessing of his elaborate speeches that hide the simple process of creating unbacked fiat money by the shipload below a couple of technical terms that work like Quaalude on the EP members.

Trusting that my readership knows about the undeniable fact that so far all experiments with unbacked money ended in hyperinflation I nevertheless want to point out that the abolition of metal standards - gold and/or silver - had at least one positive fact: All kingdoms and empires collapsed, beginning with the revolution in France in 1789 that became the first democratic republic and set a precedent for the rest of the world. Monarchic rulers have only survived on a representative level and they are certainly a proper looking circle for ribbon-cutting ceremonies of all kinds.

Allow me to point you again to the 3 sources in the first paragraph of this post (and save me from uploading PDFs when they can be found there easily) that show us that the real power has moved from policymakers to central banks since the USA abandoned the gold standard in 1971 under a pardoned criminal by the name of Richard Nixon.

The gold standard is most uncomfortable for politicians as it would limit their spending. After almost 4 decades where the public was talked out of gold with the main argument that gold is the relic of a past of un-sophisticated finance, gold is stronger than ever.

Gold has Never Lost its Value in 6,000 Years
Gold has never lost its value as all fiat currencies did and it is the last measure we have to calculate real inflation. If you were told that a bag of potatoes cost 3 guilders or 6 florins or 1 mark some decades ago you would not be able to get down to the real price. But if you are parsing historical price statistics and you find out that one troy ounce bought you 100 bags of potatoes it becomes pretty easy to compare it with current prices.

But this probably the last thing those in charge of the financial world want. Inflation can fool people for a long time as every history of a fiat currency begins with the soothing effect that everybody feels richer.

But there is also another undisputed pattern in the history of unbacked money. The trust about its purchasing power took always only a few months, e.g. Germany's hyperinflation, that collapsed in less than 2 years and set the ground for the rise of Adolf Hitler which then led to the demolition of Europe.

In my opinion it is astonishing that in the presently running ruination of the Western world because of unbacked paper money any discussion dogmatically avoids a return to metal backed money. While China's central bank governor favored a commodity based currency last March in a most interesting article I cannot agree to use a commodity basket as backing for a new international monetary system. All commodities are too volatile and can be manipulated in many ways. Just imagine Russia/China/India announcing that their grain stocks have been erased because of bacterial contamination.

There is only one solution to arrive at a stable monetary system: The paper money must be backed by gold and/or silver as they are a value in itself. This worked well for 5,700 years. It would be better for the world to return to this old fashion instead of wasting more time discussing how to repair the monetary system with the same built in weaknesses that have disowned every generation since 1720.

This post has been republished from Toni Straka's blog The Prudent Investor.

Fed May Be Forced To Release Details Of Bank Bailout

Should the Fed be forced to release details of the $2 trillion bank bailout? That is what may happen if Bloomberg wins their lawsuit against the Fed. The following from The Prudent Investor discusses the implications of this landmark case.

Ben Bernanke did not have time to celebrate his reappointment for another 4 years as Federal Reserve chairman on Tuesday. The day before US president Barack Obama decided to keep Bernanke as Fed head information provider Bloomberg dropped a new bomb shell regarding a lawsuit initiated by the news agency under the Freedom Of Information Act (FOIA) against the Fed.

Bloomberg requires the Fed to publish who got the $2 Trillion in bank aid. Find all the details of the pending lawsuit in this post from November 7, 2008.

The Fed appealed this FOIA request last December, citing concerns that this information would endanger the borrowers of the $2 Trillion.

In a response to Bloomberg it then said,

"The U.S. is facing "an unprecedented crisis" in which "loss in confidence in and between financial institutions can occur with lightning speed and devastating effects."

But on Monday Bloomberg scored a second goal against the Fed:

Manhattan Chief U.S. District Judge Loretta Preska rejected the central bank’s argument that the records aren’t covered by the law because their disclosure would harm borrowers’ competitive positions. The collateral lists "are central to understanding and assessing the government’s response to the most cataclysmic financial crisis in America since the Great Depression," according to the lawsuit that led to yesterday’s (Monday) ruling.

The secretive Fed, a constitutionally questionable institution due to its hybrid public-private status has also come under fire from Republican Congressman Ron Paul who tries to win a majority in Congress and the Senate for an official audit of the Fed.

Bloomberg editor-in-chief Matthew Winkler commented the court`s decision this way:

"When an unprecedented amount of taxpayer dollars were lent to financial institutions in unprecedented ways and the Federal Reserve refused to make public any of the details of its extraordinary lending, Bloomberg News asked the court why U.S. citizens don’t have the right to know," he said "We`re gratified the court is defending the public’s right to know what is being done in the public interest."

David Skidmore, a Fed spokesman, told Bloomberg the Federal Reserve Board’s staff was reviewing the ruling and declined to comment on it at this time.

This ruling is certainly a milestone in the possible end game of the Fed which has come under fire from all sides due to its policy of showering irresponsible institutional lenders with Trillions while the rest of the economy is teetering on the brink of a major depression, induced by more than 2 decades of loose monetary policy.

Astute observers will remember the blunders of the Fed which does not know where $9.55 Trillion in unbacked Federal Reserve Notes went.

I end this post with the most important question of all: Who Owns the Federal Reserve?

Resolving this question may become the most important task in the coming era where the world will see more economic and political turmoil than ever before in history.

After all Bernanke is only the figurehead. His captains are the unknown Fed shareholders and for the time being the world economy`s fate lies in their hands.

His thank you to president Obama is only a PR stunt; I`d prefer to know who else decided to keep the biggest money printer of all times in the pilot`s seat. Get involved in this: Use the multitude of Fed inquiry forms on the Fed`s website here and mail me any answers you get. My former requests did not lead anywhere, but I am not a US citizen who has a constitutional right to be informed about the government`s actions.

This post has been republished from Toni Straka's blog, The Prudent Investor.

Is The Obama Administration Covering Up What Really Happened In Treasury Meeting?

One watchdog group is accusing President Obama's administration of covering up what really went down during the major Treasury meeting that ended with 9 major banks selling equity stakes in their companies to the government for $250 billion. The Treasury originally stated that it had no documentation from the meeting, however, some documents were later obtained. The watchdog group insists some documents — potentially implicating current Treasury secretary Timothy Geitner — are being withheld. Who knows what is true and not in all this, but it will certainly be interesting to see how it all plays out. For more details about the meeting, along with what the watchdog group thinks happened, read the following article from Money Morning.

Despite promises of open government, the Obama administration tried to “cover up the very existence of smoking-gun documents” prepared for a meeting in which former U.S. Treasury Secretary Henry M. Paulson allegedly coerced major banks to allow the government to take equity stakes, according to conservative watchdog group Judicial Watch.

Judicial Watch said the Treasury initially said it had no records about the meeting. It didn’t release a transcript of discussions between government officials and bankers.

However, documents obtained under a Freedom of Information Act request confirm that Paulson and other Treasury officials gave nine major banks no options other than allowing the government to take $250 billion in equity.

Judicial Watch said on its Web site that after it made inquiries, the Treasury insisted on Feb. 4 it had no documents about the historic meeting.

Furthermore, “the cover-up continues, as the Obama administration protects Timothy Geithner by withholding a key document about his role in this infamous bankers meeting,” Judicial Watch president Tom Fitton said in a statement.

The group says suggested edits of the “talking points” for the meeting by Treasury Secretary Tim Geithner, then President of the New York Federal Reserve are being withheld by the Obama administration.

Saying the nine U.S. banks were “central to any solution” of the credit crisis, Paulson told their leaders in the meeting in Washington on October 13, 2008, to take the government aid voluntarily or be forced to by regulators.

“We don’t believe it is tenable to opt out because doing so would leave you vulnerable and exposed,” the document said, citing Paulson talking points. “If a capital infusion is not appealing, you should be aware your regulator will require it in any circumstance.”

Within four hours of the start of the meeting the CEOs wrote by hand the names of their institution and multibillion dollar amounts of “preferred shares” to be issued to the government, the documents show.

“These documents show our government exercising unrestrained power over the private sector,” Fitton said in a statement.

The banks were represented by Vikram Pandit of Citigroup Inc. (NYSE: C), Kenneth Lewis of Bank of America Corp. (NYSE: BAC), John Thain of Merrill Lynch & Co., now part of BofA, Jaime Dimon of JP Morgan & Co. (NYSE: JPM), Richard Kovacevich of Wells Fargo (NYSE: WFC), John Mack of Morgan Stanley (NYSE: MS), Lloyd Blankfein of Goldman Sachs Group Inc. (NYSE: GS), Robert Kelly of Bank of New York Mellon Corp (NYSE: BK), and Ronald Logue of State Street Corp. (NYSE: STT).

A spokesman for the Treasury, Andrew Williams, didn’t return calls seeking comment from Bloomberg News.

The Treasury has invested $199.1 billion in the bank-preferred share program, with $1.2 billion since returned by 12 institutions, according to government data, Bloomberg reported.

Despite his heavy-handed nature, Paulson succeeded at stabilizing the financial services industry, J.P. O’Sullivan, an SNL Financial bank analyst in Charlottesville, Va., told Bloomberg.

“It was a calming mechanism,” O’Sullivan said.

This isn’t the first time Paulson has been accused of strong-arming bankers to bend to his will.

As previously reported in Money Morning, Bank of America CEO Kenneth Lewis said in testimony before New York’s attorney general that Paulson and Federal Reserve Chairman Ben S. Bernanke pressured him not only to move ahead with a merger with Merrill Lynch despite reservations, but also to stay quiet about the mounting losses at the crumbling investment bank.

Lewis went on to testify that he felt Paulson threatened him with losing his job if he didn’t go along with completing the Merrill Lynch deal.

“I can’t recall if he said, ‘We would remove the board and management if you called it [off]‘ or if he said ‘we would do it if you intended to.’ I don’t remember which one it was,” Mr. Lewis said.

This article can also be viewed on moneymorning.com.

Why You Can't Listen To Greenspan Or NAR On Housing Prices

Greenspan opened up his mouth again and told the world that the U.S. is nearing a bottom for the real estate market. Those who remember back to 2006, might remember that Greenspan made another market bottom call, and he turned out to be horribly mistaken. In both accounts his statements were backed by the National Association of Realtors (NAR) who offer up all sorts of real estate data. Investors can't listen to anything that NAR says, for obvious reasons, and history shows us that we should give much more weight to what comes out of the former Fed chief's mouth either. For more on this, read the following blog post from Tim Iacono.

Should anyone be surprised that former Fed chairman Alan Greenspan reaffirmed his "early-2009" housing market bottom call yesterday before the National Association of Realtors?

From Bloomberg:

Former Federal Reserve Chairman Alan Greenspan said that the decline in the U.S. housing market may be bottoming and it’s “very easy to see” financial markets continuing to improve.

“We are finally beginning to see the seeds of a bottoming” in the housing industry, Greenspan said today during a conference of the National Association of Realtors in Washington. The U.S. is “at the edge of a major liquidation” in the stock of unsold properties, which may help to stabilize prices, Greenspan said.

At "the edge of a major liquidation"? What newspapers has he been reading? The headline in my newspaper today says "Foreclosure filings hit record for second month".

Back to the Bloomberg story:

While the housing bottom may not be obvious in prices, it is becoming clear in “significant regional differences,” where some of the hardest-hit areas are starting to show signs of improvement, he said.

While it is certainly true that, in some of the hardest hit areas, home prices just can't go much lower (think Detroit), there are lots of other areas where the descent is ongoing and moving up the socio-economic ladder as Option-ARMs and Alt-A loans sour in record numbers.

Ironically, the realtors' trade group had reported earlier in the day that home prices had just declined by a record amount during the first quarter.

A quick search on housing market predictions during 2008 shows that the former "Maestro" made a few very public calls for a housing market bottom in early-2009, so you'd have to think that, with six weeks left to go, the odds are working against him at the moment.

Despite all the recent cheerleading, it is doubtful that the "seeds" of a bottoming in housing that are now seen will turn into the required "green shoots" in the near-term.

Interestingly, when the NAR joined forces with the former Fed chairman back in November of 2006, this is what they produced:
The advice DON'T DELAY was offered two and a half years ago.Wow! Homebuyers who heeded these words back then would be down about 30 percent today, according to the latest data from the Case-Shiller Home Price Index.

This post can also be viewed on themessthatgreenspanmade.blogspot.com.

So What Is The Fed's Next Move?

With the growing number of positive economic reports coming out, many people are questioning whether the economy has turned a corner. Have we really turned a corner, though, or are we seeing a temporary upswing? The Federal Reserve is playing a difficult game right now. If they leave rates low too long we could be faced with inflation, but if they raise them too quickly it could hamper the recovery. With this in mind, the Fed has some challenging decisions ahead of them. How are they going to respond? Mark Thoma looks at a recent article from Tim Duy that addresses this in his blog post below.

Turning Which Corner, by Tim Duy: Is the economy turning a corner? And, if so, which corner is it turning? In my view, economic activity has been influenced by two separate trends since 2007. One is the structural response to an over-leveraged household sector that pushed the US economy into what was initially a mild recession. The second trend is the sharp cyclical recession that began in earnest in the second half of 2008 as the commodity price shock decimated already weakened households and the deepening credit crunch cut financing for a broad swath of firms. Excess capacity emerged throughout the economy, triggering the familiar phenomenon of rising unemployment. Difficult though they may be, the cyclical dynamics do not last indefinitely - generally speaking, output declines stop well short of zero GDP and unemployment will not rise to 100%. Market participants are rightly anticipating the economy is turning the corner on the cyclical trend. But I suspect we have a long path ahead of us on the structural challenge poised by overleveraged households - suggesting that the green shoots we hear so much about will yield little more than stunted growth. This is why Bernanke and Co. are more likely to fertilize the fields than plan for the next harvest.

If there is one picture that sums up the cyclical story of the past year, it is the path of real consumption:

The sharp deceleration has come to an end, of that there can be little doubt. Nor should there be much surprise. The collapse in commodity prices, lower interest rates to allow mortgage refinancing for those homeowners still above water, and tax cuts all joined to provide powerful support for household budgets allowing consumption to stabilize despite the massive job losses experienced in recent months. The stabilization in consumer demand will eventually slow the pace of job cuts. Indeed, this is already evident in the data - analysts have pointed topeak of initial claims as a key hurdle in the race to recovery. To be sure, it is difficult if not impossible to characterize the data flow as "good." But it is certainly less "bad." The path to Great Depression II has hit something of a speedbump. And seeing that, market participants have priced out some of the most cataclysmic scenarios, supporting equities and commodities while pushing bond yields higher.

There will be more opportunities for euphoria - do not underestimate the power of pent-up demand to trigger bursts of positive data. There is a portion of the population who are not credit constrained, biding their time for the perfect moment to buy a new car or schedule a vacation. Indeed, such bursts of data are more likely than not following a sharp decline in activity (the 2.2% gain in consumption spending in 1Q09 is such an example). I believe, however, that those bursts of data will not be sustainable. Far from it - at a minimum, the ability of households to carry activity forward is at its end, which by itself would leave the economy floundering .

I think it is difficult to ignore the implications of the growth of consumer dominance in defining patterns of economic activity:

The story of the last 25 years has been an increasing role for household spending, rising to perhaps a peak of conspicuous consumption, with the motto "a filet mignon in every stainless steel oven, a RV in every garage." Patterns of economic development - more to the point, capital formation - have favored taking advantage of this trend. Countless business plans are based on the expectation that this trend will continue. The baby boomers have endless wealth (not so anymore, if it ever was), there is a never ending supply of equity rich Californians to support our [insert locality] housing market, etc. Those plans will be stressed, to say the least, if the trend stalls. The implications for a reversal are even more significant. And for those that believe reversal is necessary, note that the reversal has really not even begun. What took 25 years to build may take another 25 years to destroy.

How sure are we that the trend is at an end? My thought is that the factors that supported the trend - a steady march down in the saving rate to zero and a steady march up in household debt, coupled with monetary policy that had room to go from 15% short rates to zero over nearly three decades, are at an end. Even if you believe that savings rates will not rise to 12%, the inability to sustain below zero rates puts a limit on household spending growth (as well as debt accumulation). And with underwriting conditions tightening - a permanent tightening, given the changing regulatory environment - the role of debt financing in the life of the consumer is sure to stagnate.

The challenge then is to transition the economy away from the debt-supported consumption trend that looks no longer viable to a trend more reliant on investment and external spending. This, however, is easier said then done. How quickly can 25 years of growth directed at consumer spending be reversed? And reversed to what, especially if the rest of the world continues to struggle? I see little hope of an "immaculate conception" of a fresh, sustainable pattern of economic activity. Until the transition path reveals itself, fiscal policy will be necessary to fill the economic hole likely to exist if the savings proclivities of households continue to exceed the investment intentions of firms.

Ironically, the "best" road to growth is also the riskiest from a policy perspective - a rapid expansion of emerging market activity. Such an expansion, however, would once again place the US in competition for global resources, and threaten a reversal of the commodity and interest rate trends that have been so important to supporting US consumers. Indeed, just the whiff of recovery has supported oil prices, promising an abrupt end to one of the factors supporting US consumers. In the worst case scenario, a flight of capital away from the Dollar (in response to more promising investments abroad) would generate an inflationary and structural shock that would leave the Fed juggling between renewed recession and higher inflation. In short, the optimal external shock would be one only partially supportive; anything more would push the globe to a revisiting of the commodity price surge of early 2008. Looking for a decoupling story now, however, seems like almost a naïve dream.

What is the Fed's next move? One email crossed my inbox after the April employment report suggested some thinking that the Fed could hike rates as early as November. Such a scenario (absent a stability threatening run on the Dollar) must come from a spectacularly optimistic take on incoming data. Data, I might add, that is a reflection of the massive crutch provided by the Federal Reserve and US Treasury, not necessarily a sea change in the underlying economic environment. Look too how quickly bond rates began to climb after the Fed declined to expand Treasury purchases at the last FOMC meeting. More generally, consider this tidbit on Federal Reserve Chairman Ben Bernanke's thinking back in 2003:

The 2003 FOMC transcripts showed then-Governor Ben Bernanke very tuned into financial markets as he pressed for earlier release of Fed forecasts and a willingness to lower interest rates to zero.
From the June 2003 FOMC meeting, when the Fed lowered the target fed funds rate to 1%:

“I wonder if you might give some thought to whether or not it would make sense tactically to say publicly that we are willing to lower the federal funds rate to zero if necessary…I think it would have a beneficial effect on expectations in that there would no longer be a feeling in the market that we had reached the end of our rope.”

“It’s extremely important that we do what we can to maintain the supportive configuration in financial markets. That means continuing our easy monetary policy and, even more important, using our statement to signal our willingness to keep policy easy so long as there is a risk of further disinflation and continuing economic weakness."

A year and a half after the end of the 2001 recession, Bernanke was looking at the possibility of lowering rates to zero in order to maintain support for financial markets. And comparatively, financial markets were leaps and bounds healthier in 2003 than now. Is a rate hike really feasible this year - or even next - given the current state of dependence of the financial system on government largess? Moreover, consider the disinflation worries in 2003 and fast forward to last week:

Even after a recovery gets under way, the rate of growth of real economic activity is likely to remain below its longer-run potential for a while, implying that the current slack in resource utilization will increase further. We expect that the recovery will only gradually gain momentum and that economic slack will diminish slowly. In particular, businesses are likely to be cautious about hiring, implying that the unemployment rate could remain high for a time, even after economic growth resumes.

In this environment, we anticipate that inflation will remain low. Indeed, given the sizable margin of slack in resource utilization and diminished cost pressures from oil and other commodities, inflation is likely to move down some over the next year relative to its pace in 2008. However, inflation expectations, as measured by various household and business surveys, appear to have remained relatively stable, which should limit further declines in inflation.

Now consider the output gap over the last decade:

The current gap already far exceeds that of the last disinflationary scare, and Bernanke expects it to continue to expand further, and then diminish only gradually. As long as the gap continues to expand, Bernanke's bias will be in favor of additional easing. The only question is whether he remains content to allow TALF funds to slowly trickle into the economy, or speeds the pace of policy with expansions of longer dated Treasury purchases. Given Bernanke's past behavior, expecting patience on his part seems unrealistic. Moreover, the last jobs report provides less room for optimism than observers suggest. Importantly, Jim Hamilton notes the decline in hours worked appears unabated; threat of a currency collapse aside, there will be no policy tightening, only easing, until hours worked moves unquestionably and sustainably in a positive trajectory.

Bottom Line: The economy looks to be turning a corner relative to the downward cyclical force of last year. But this is only a partial victory, as the factors that that started us down this path - namely, a debt-supported consumer spending dynamic - remain in play, and will likely remain in play for years, arguing for a long period of slow growth, punctuated by short-lived bursts of positive data. In such an environment, and considering the importance of government support to sustain financial stability, the odds favor continued policy easing. Those looking for a more positive scenario are pinning their hopes on either an unlikely rapid return to past patterns of consumer behavior, an unlikely rapid evolution in patterns of economic activity that are not consumer dependent, or a decoupling of emerging market economic activity from the US (which could pose a different set of policy challenges).

This post can also be viewed on economistsview.typepad.com.

Fed Delays Release Of Bank Stress Test Results

The Federal Reserve has decided to delay the release of results from its recent stress test on banks. It appears that the Fed is trying to limit damage to the banks who will appear weak based on the results, and allow them more time to figure out how they will raise the necessary funds. It will no doubt be interesting to see how investors react to the information provided by the stress test. For more on this, read the following article from Money Morning.

The results of the bank stress tests are in, but instead of releasing them today (Monday), the U.S. Federal Reserve is holding them close to its chest until after the markets close Thursday.

The amount of information awaiting disclosure seems to have grown, as have the reasons to postpone the potentially damaging data.

Not only will the government unveil which banks require more capital, it will also disclose potential loss estimates for certain loan categories and the banks’ ability to “absorb those losses” assuming economic conditions worsen through 2010, a government official told The Wall Street Journal.

Negative results could deal a huge blow to both the banks and government, as a sub-par grade may be viewed as an indictment not only of the failed management of the banks, but the government’s decision to loan them billions of taxpayer money. The banks also are concerned that anything but a tactful release of the results will cause internal and investor panic.

Government and banking industry officials told Bloomberg that both sides needed the extra time to debate preliminary results, as well as plans regarding how banks can recover capital.

On April 24, the government showed the tests’ preliminary results to the 19 U.S. firms it reviewed – from behemoth banks like Bank of America Corp. (NYSE: BAC) and Citigroup Inc. (NYSE: C) to the smaller GMAC LLC (NYSE: GMA) and MetLife Inc. (NYSE: MET). The banks involved in the stress tests hold more than half the loans in the U.S. banking system and two-thirds of the assets.

“Everybody understands they’ve got a tiger by the tail here,” Mark Tenhundfeld, a senior vice president at the American Bankers’ Association in Washington, told Bloomberg. “If they don’t let him go gently, there will be a lot of mauling going on.”

Already, reports have leaked that two specific banks need more capital, and reaction hasn’t been pleasant.

After showing Bank of America and Citigroup test results, the government told the banks to raise more capital despite receiving a combined total of $95 billion in bailout loans.

At least three more banks need more capital, either from converting common shares to equity and/or receiving more government cash, sources told Bloomberg.

Sensing blowback from Congress, as well as the public, Federal Reserve chairman Ben S. Bernanke said that banks requiring more capital will have to attempt to raise it on their own before receiving another lifeline loan from the government.

Confusion On Evaluation’s Methodology

Debate over the results isn’t the only reason for the postponement. Disputes and confusion over the Fed’s methodology has also erupted.

According to a Fed’s test criterion, common shareholder equity should be the “dominant” portion of Tier 1 capital. Officials favor tangible common equity of about 4% of a bank’s assets and Tier 1 capital worth hovering around 6%.

But The Wall Street Journal reported last week that some bank executives got mixed signals during a meeting with regulators.

The regulators are asking “a million questions” and it’s “very unclear what they’re aiming at,” a senior executive told The Journal. “We can’t discern a pattern.”

Citigroup officials argued that regulators haven’t given the bank enough credit for its efforts to offload large asset chunks, such as Smith Barney and its Japanese brokerage arm Nikko Cordial Securities.

On Friday, Citigroup agreed to sell Nikko Cordial Securities, its Japanese brokerage arm to Sumitomo Mitsui Financial Group (OTC: SMFJY) for about $5.5 billion. The deal, which is to be completed by Oct. 1, also includes a transfer of about $2 billion in excess cash from Nikko Cordial to Citigroup.

The deal will boost the bank’s Tier-1 capital ratio by approximately 27 basis points.

Individual Result Releases

One insider told Reuters that the government is leaning toward releasing individual results for each bank involved in the stress test – a move away from issuing a summary of results.

The source said the plan “is not very far along,” and that regulators also aim to disclose a lot of confidential supervisory information about the banks.

One analyst says that test results could be so specific to a bank’s portfolio that it’s not wise to use them as a litmus test for the overall health of the banking sector.

“Once you try to take that information and extrapolate it, it gets very complicated and it’s dangerous," Kevin Petrasic, who served at the Office of Thrift Supervision from 1989 to 2008 and is now an attorney at law firm Paul Hastings in Washington, told Reuters.

Whatever the results – or how they are disclosed – Money Morning’s Shah Gilani, a former Wall Street hedge fund manager, said the evaluation process has several flaws.

“What’s missing, unfortunately, is an assumption of how much additional capital would be necessary to facilitate credit expansion – which, in turn, would serve to fuel economic growth. That, after all, should be the ultimate stress-test objective,” he wrote.

And the end result is more stress added to an already stressed banking sector, as too much information and/or misinformation only makes a sound assessment more difficult.

Money Morning’s Stress Test

The government’s pushback of stress test results only made the public more hungry for the their release. But you don’t have to wait until Thursday to know which of the 13 biggest U.S. banks are diamonds or duds.

Last week in “Money Morning’s Bank Stress Test,” Martin Hutchinson highlighted the four secrets that will let you separate the winners from the losers in the U.S. banking system

• Banks that made profits in the very difficult fourth quarter of 2008 and first quarter of 2009 are probably in good shape, especially if their loan-loss provisions exceeded their charge-offs (the amount actually lost.)
• Banks that lost money in the fourth quarter and first quarter may or may not be in terminal trouble; it depends on the amount of those losses and whether the red ink is expected to continue to flow going forward.
• With the run-up in bank stocks in recent weeks, there’s been an accompanying rise in the ratio of share price to book value (stock price per share/book value per share). If that ratio is still below 30% - even after the recent price increases - the market lacks confidence in the bank’s ability to solve its own problems. Unfortunately, the market currently appears to be overly optimistic about some of the banks that still have considerable ongoing problems.
• Management’s dividend policy is less of an indicator than it was just a few short months ago; several banks have sharply cut their dividends in order to repay the Troubled Assets Relief Program (TARP) capital they got in late 2008. Reasonably, profitable banks don’t want the government meddling in their business or compensation structures

Hutchinson also gave an individual analysis of each bank, highlighting their strengths and pulling a curtain on their weaknesses.

This article can also be found on moneymorning.com.

Fed Holds Steady...For Now...

Earlier this week the Fed decided to hold steady with their previous policies, however, it is still likely that they will need to provide additional easing in the months ahead. Mark Thoma looks at an article from Tim Duy, in his blog post below, that talks more about the economy and what's likely in store for Fed policy.

Despite Green Shoots, Odds Favor More Easing, by Tim Duy: The Fed took an interesting risk by holding policy steady on Wednesday.With green shoots all the rage, policymakers are ready to step to the sidelines as they monitor the progress of their many programs. And clearly, they must have known that the 3% level on 10-year Treasuries was dependent on the expectation that policymakers would expand the pace of outright purchases of those assets, but are betting that economic conditions will remain sufficiently weak to prevent a crippling increase in rates. Still, given that policymakers still see the economy in decline, albeit at a slower rate, the odds favor additional easing in the months ahead, especially considering expectations of a widening output gap. Recall that labor markets, and the threat of deflation, kept the Fed easing well past the end of the recession in 2001.

Short of an outbreak of inflation, or a unexpected and unlikely surge of growth, there is little reason to think that the Fed is ready to bring policy to a sustained pause. And an imminent rise in inflation remains an outside risk for the Fed; the focus remains consistently on disinflation or, worse yet, outright deflation. A key paragraph is:

In light of increasing economic slack here and abroad, the Committee expects that inflation will remain subdued. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.

Policymakers are counting on a rising output gap (both here and abroad) and lags in the price setting process to keep inflation at bay. Indeed, this must be the case, as some of the current numbers are really not all that comforting. I am not inclined to place too much focus on headline inflation - oil prices appear to have found a bottom around $50 a barrel, and sustained hints of a firming of global economic activity would promise to send prices higher, thus offsetting the strong disinflationary impact of falling energy prices since the middle of 2008. In contrast to low year-over-year headline numbers, the personal income and outlays report for March revealed that core PCE prices gained by 0.2% in each of the past three months, pushing the annualized three month trend back above 2%:

And note that near-term inflation expectations have climbed back up into a normal range:

From this perspective, policymakers have done a good job anchoring inflation expectations against the possibility of deflation. Is this enough, however, to unsettle FOMC members? Despite these inflationary hints, it is simply unlikely that the Fed would ignore the disinflationary implications of the output gap. One way to ignore the gap is to argue that the US will revert to an emerging market inflation dynamic. I think such an argument requires a steady depreciation of the Dollar to hold - which could happen, but a Dollar crisis looks, for the moment, unlikely given relative global weakness. One could also argue that estimates of potential output are optimistic and don't reflect the importance of structural change in the economy. This is the issue that Nick Rowe at the Worthwhile Canadian Initiative attempts to tackle:

Even in the short run a good banking and financial system will be important in re-allocating capital between growing and declining sectors, if there are shifts in relative demand. If people want fewer cars and more restaurant meals, but banks cannot shift loans from car manufacturers to restaurants, the Short Run Aggregate Supply curve may shift left, because the restaurants won't be able to expand to meet demand, and car manufacturers' prices or wages may be sticky downwards.

If you see the financial crisis as causing the recession by shifting the SRAS curve left, then monetary and fiscal policies, which shift the AD curve right, are not the appropriate cure. Even if you see leftward shifts of the SRAS curve as only part of the story, you will see limits on what monetary and fiscal policy can achieve. When expansionary monetary and fiscal policies start to cause excessive inflation, before output and employment have returned fully to normal, you will know that purely AD policies have reached the limit of what can be expected from them.

Nick is slapped down by Brad DeLong:

But if bad banks have shifted the AS curve inward, then right now we should have stagflation: depression and inflation, as output falls and prices rise. We don't. The argument that fiscal and monetary policies won't reduce unemployment to normal levels because we have a supply side problem is completely incoherent in an AS-AD framework.

Brad is correct that in a traditional AS-AD framework, bad banks are demand shocks, not supply shocks. There is still something about Nick's argument that is important - the financial system redirected capital investment into housing and consumption related activities. Presumably, potential output includes the ability to build and sell as many houses the US economy produced at the height of the housing bubble. But what good is that output if we don’t want to build and sell that many houses in the future? How do we redirect capital away from those sectors? And how long does it take? Arguably, the narrowing of the US trade deficit is pushing that adjustment forward, as the US economy can't focus entirely on producing nontradable goods. Recall Brad DeLong from 2005:

There is an alternative scenario, one in which foreigners'--including foreign central banks'--desired holdings of dollar-denominated assets shortly hit the wall, and the asset price shifts that result from desired holdings' hitting the wall reduce, or do not increase, confidence in the dollar.

In this alternative scenario, the U.S. has to move about ten million workers out of currently-favored sectors--construction, home-equity-credit financed consumer expenditures, and so on--into export and import-competing manufactures. How much structural unemployment does such a sectoral shift require, and how long does the structural unemployment last? Other countries have to shift up to forty million workers out of export manufactures into other industries, and to generate demand for the products of those industries (without destabilizing their own monetary systems and asset prices, as Japan appears to have done at the end of the 1980s). The U.S. Federal Reserve would have to cope with whatever inflationary pressures are generated by rising import prices. Foreign central banks would have to cope with whatever stresses on their own asset prices are created by enormous losses of value in the stocks and bonds of their exporting companies.

If structural unemployment is rising - not because banks are currently bad, but engaged in bad behavior in the past - attempts to reduce unemployment back to pre-recession levels will yield higher inflation. This problem is minimized if labor resources can be quickly redirected into other sectors, a process that Nick above is implying is hampered by the existence now of bad banks. But, as Brad suggested in 2005, getting to inflation in the current environment seems to require a Dollar collapse - a story that for now is difficult to tell.

All of which is interesting, but even if you believe that structural unemployment is rising, I don't think anyone believes it is near the 8.5% rate for March (not to mention the underemployment rate of 15.6%). Nor does anyone expect that recent green shoots are sufficient to keep unemployment from rising further. Moreover, note that the Employment Costs Index released today reveals the continued slide in employee compensation costs - consistent with the FOMC's concerns about economic slack. Indeed, the ECI highlights the risks of the Fed's move to hold steady policy: Declining wage growth, coupled with higher interest rates, would play havoc with household efforts to reduce balance sheets and intensify the need to boost saving rates. Hence why the risks still favor additional policy easing - especially if programs such as TALF and PPIP are less successful than imagined.

In short, the shoots are much too green and the output gap much too wide to stimulate much discussion on Constitution Avenue that the end of easing has conclusively been reached. A pause to assess, yes. But Fed officials will be looking for clear and convincing evidence that economic activity is both self sustaining (not likely to fade after the initial burst of federal stimulus moves through the pipeline) and sufficient to substantially reduce the output gap before they sound the all clear signal. An end to the rapid pace of job loss is very different from a return to steady job growth. Again, recall the sustained pattern of easing in the wake of the 2001 recession - we need to go a long way up from -6% GDP growth before the job engine is started. To be sure, there should be some lingering concern that the Fed will act quickly (or at least the markets will act quickly), if there is a perceived need to withdraw monetary accommodation. But the data are well short of what would be necessary to justify such a shift in policy in the near future.

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We Need A Root-And-Branch Reorganization Of The Financial System

Some people are open to the government handing over trillions of dollars to the banks, but no taxpayers want the money handed over without proper controls in place that will ensure it goes to good use. This has been one of the biggest issues the public has had with the bailout efforts thus far. For that reason Steve Waldman is calling for a root-and-branch reorganization of the financial system. For more on this, read the following blog post from Mark Thoma.

Steve Waldman says "we need a root-and-branch reorganization of the financial system":

Value for value, Steve Waldman: Would it have been better if Timothy Geithner had had the power to guarantee all bank debt early on? As James Surowiecki reminds us, that was part of the Swedish solution. Justin Fox plausibly suggests that we might have avoided a lot of pain with a fast, full guarantee.

But that's not the point. The question isn't whether we could have avoided this crisis, if only we had cut a big check. We could have, and that was not lost to any of us debating these issues more than a year ago. (See e.g. me or Mark Thoma.) Had we done so, the near-to-medium term fiscal costs might have been less than they probably will be now. So, with 20/20 hindsight, would it have been a good idea?

How you answer that question depends upon how you view the crisis. Is it an aberration, a shock to a basically sound financial system, or is it a painful symptom of an even more dangerous condition? ...

If you think that our financial system just needs some tweaks, some consolidation of regulators' organizational charts and sterner supervision, then you should prefer that we had just cut a check, passed Sarbanes/Oxley Book II, and moved on. But that is not what I, or most proponents of temporary receivership for insolvent banks, believe.

If you believe, as I do, that we need a root-and-branch reorganization of the financial system, which must necessarily involve the dismemberment and intrusive restraint of deeply entrenched institutions, does that mean pain is the only way forward, "the worse the better" in the old revolutionary cliché? It need not mean that. But it does mean that palliative measures, like giving the banks money, would have to be attached to curative measures, like enacting capital requirements and imposing regulatory burdens that would force financial behemoths to break themselves up or become boring narrow banks. For almost two years, policymakers at the Fed and the Treasury, including Secretary Geithner, have offered bail-out after bail-out and asked for nothing serious in return.

Do I regret that Henry Paulson was not empowered to issue a blanket guarantee of bank assets early on, as the Swedes did? No, I don't regret that at all. Why not? Because I think that "Hank the Tank" was a crappy negotiator... He would have offered the financial system sugar without requiring it to make the medicine go down. He may believe, quite sincerely, that a cure would be worse than the disease. He may believe that, but he is wrong. ...

You may believe that we have learned our lesson, that if we can just get some stability and comfort for a while we are prepared to do what must be done. That's a respectable position. But I don't share it, and neither do the majority of Americans who are unwilling to allow their representatives to sign off on any more expensive aspirin. We want value for value, an ironclad commitment of root and branch reform in exchange for the unimaginable sums of money we are being asked to hand over. ... Congress would, because the public would, support large, explicit transfers, if they were attached to reforms sufficiently radical to prevent a recurrence, and suitably punitive towards the people who managed the system that brought us here. Value for value. ...

I ... would be willing to hold my nose and tolerate a Swedish-style guarantee of bank creditors. I'd acquiesce to that even without formal nationalization. Nationalization is ... a means to an end, and the desired end is a world in which too big to fail is too big to exist for any financial institution that originates or holds credit risk in any form. Secretary Geithner could send a bill to Congress today that would put all banks with a balance sheet of over $50B into run-off mode... I'd fax my Congressman and support a $2T on-budget buyout of bank creditors as part of that bill, as long as it had teeth. ("Teeth" would imply making sure that off-balance-sheet and derivative exposures were included in the size cap, etc.)

It's not that us pitchfork-totin' populists are unwilling to pay the bill. It's that we want to know that in exchange for writing a very, very large check, the people that we are paying will actually deliver the goods. Given the behavior of bankers before the crisis and of shifty policymakers during, we have every reason to watch warily and to insist upon every precaution while we hand over suitcase after suitcase of freshly printed Federal Reserve notes.

This post can also be found on economistsview.typepad.com.

Geithner's New PPIP Plan Looks Too Much Like Failed TALF Program

Hopefully Geithners new PPIP plan that was created to deal with toxic assets works out better than the TALF failure, but unfortunately it looks eerily familiar. For more on this, read the following blog post from Mark Thoma.

The TALF program intended to increase auto loans, student loans, and credit card lending has a lot in common with the Geithner public private investment plan to remove toxic assets from bank balance sheets, including the valuable non-recourse loan feature. The fact that the TALF program is not living up to expectations - not even close - leads to questions about whether the Geithner plan will encounter similar problems:

Federal Program to Boost Private Lending Struggles to Get Money to Consumers, by Neil Irwin, Washington Post: In its first two months, the government's signature initiative to support consumer lending has fallen well short of expectations, deploying only a fraction of the amount officials had hoped to extend to stimulate auto loans, student loans and credit card lending. ...

Under [the Term Asset-Backed Securities Loan Facility, or] TALF, private investors ... put up a relatively small amount of money to be matched with a larger loan from the Federal Reserve. The combined funds are then used to purchase newly created, highly rated securities, which in turn fund a wide range of consumer and business lending.

If the securities become more valuable, the private investors stand to repay their government loans and make a healthy profit; if the securities plummet in value, the investors can lose only what they put up originally...

Officials envisioned TALF supporting tens of billions of dollars a month in new lending, saying it could eventually total $1 trillion. But in March, when it was launched, it backed only $4.7 billion in auto loans and credit cards. For April, it logged only $1.7 billion.

Sources involved in the program said private investors have been reluctant to work with the government, which they view as an unreliable business partner. ... There are restrictions on the business activities of participants in the program. ... But perhaps more significant ... is a fear that the government could retroactively change the terms, exacting new limits on what investors can pay their executives, for example, or trying to claw back profits that firms make in the program. ...

Federal Reserve officials have privately urged President Obama and congressional leaders to publicly state that the government views investors in voluntary programs such as TALF differently than it does companies that need a federal bailout.

Investors are not the only ones who need comforting, though. The Fed relies on primary dealers, or brokerage houses, to play a key role as intermediaries in TALF...

But the primary dealers have been extremely cautious..., hobbling the program's progress... Lawyers at the New York Fed ... have been working to help the brokers and investors work through the issues, and government officials are hopeful about the program's future. ...

The Public-Private Investment Program, designed to buy loans and securities from banks, is structured similarly to TALF. ...

And the differences between the PPIP and TALF programs that I can think of, e.g. that the PPIP has toxic assets as part of the bargain, and some of the banks will need a bailout so the reassurances about executive pay, etc. can't be made in these cases, are additional factors working against the PPIP's success.

This post can also be viewed on economistsview.typepad.com.

Hong Kong Set To Take Off Thanks To Bernanke

Thanks to the chairman of the U.S. Federal Reserve — Ben Bernanke — Hong Kong is about to take off. It might seem a little weird that Bernanke could impact Hong Kong so drastically, but because Hong Kong's currency is so closely linked to the U.S. dollar they are forced to follow the Fed's every move. That — coupled with the fact Hong Kong's stocks are undervalued — is creating a perfect storm for Hong Kong's market. For more on this, read the following article from Dr. Steve Sjuggerud at Daily Wealth.

Ben Bernanke has cut short-term interest rates in the U.S. to essentially zero... the lowest rate we've ever seen.

He's doing this, of course, to "juice" the economy – to give it a jumpstart. He doesn't know (or care, actually) that this action will inadvertently (but undoubtedly) cause one particular stock market to go absolutely nuts.

This stock market I'm talking about is Hong Kong. Today, we have the ultimate recipe for stocks in Hong Kong to skyrocket. The Fed has cut interest rates to essentially zero (causing Hong Kong rates to be next to zero in its unique money system). And yet Hong Kong stocks are incredibly cheap. They bottomed a month ago at a single-digit price-to-earnings (P/E) ratio.

We've seen this before:

• In 1992-1993, the Hang Seng Index shot from 5,500 to 12,000. At that time, the Fed had cut interest rates below the rate of inflation. So "real" interest rates were below zero.
• The Fed did it again from 2003-2005. And in that time, the Hang Seng Index jumped nearly 7,000 points, from a low of 8,600 to 15,500. (It continued to rise... peaking over 30,000 in 2007. That's four times your money from 2003 to 2007.)

And it's happening again, right now... The Fed has cut interest rates to zero, and the uptrend in Hong Kong has arrived. It's time to get in.

While Ben Bernanke is trying to help the U.S., he's unwittingly creating havoc on the other side of the globe...

Hong Kong is quite an incredible place... With no natural resources, the standard of living has gone from subsistence wages to one of the highest in the world in just a few decades.

I believe two things contributed to Hong Kong's boom... 1) Hong Kong has been for decades one of the "freest" markets in the world, allowing entrepreneurs to succeed or fail. And 2) Hong Kong has had a stable currency, thanks to its unique currency system. For the last 25 years, the Hong Kong dollar has been worth about US$7.80, give or take a few pennies.

Hong Kong's unique currency system is called a currency board. A country that has a true currency board has one U.S. dollar in the bank for every dollar of its own currency that it prints. How does it keep the exchange rate equal? Through interest rates...

Interest rates in Hong Kong dollars are always higher than in the U.S. Depositors are willing to "take the risk" on the Hong Kong dollar for the slightly higher yield.

As a result, Bernanke essentially controls interest rates in Hong Kong. Whether Hong Kong is in a boom or a bust, he doesn't care. So Bernanke could be raising or cutting interest rates at precisely the wrong time in Hong Kong's business cycle.

Therefore, Hong Kong's stock market is subject to wild booms and busts, based on what the U.S. Fed is doing with interest rates.

As I said, today we have the ultimate recipe for stocks to skyrocket in Hong Kong. Interest rates are next to zero. And Hong Kong stocks are cheap, hitting single-digit P/E ratios a month ago.

I have two nearly guaranteed "rules" for making money in Hong Kong...

First is the "Hong Kong Can't Help It Rule." That's when the U.S. Fed cuts interest rates below the "market" rate. This means "real" interest rates are below zero. When this happens, buy Hong Kong... It can't help it. It soars.

The second rule is the "20/10 Rule." In short, you want to be a buyer of stocks in Hong Kong when the P/E ratio falls below 10. And you want to be a seller when the ratio rises above 20.

Hong Kong stocks often soar by hundreds of percent after they fall below a P/E of 10. And often they lose half their value soon after they rise above a P/E of 20.

Right now is an extraordinary moment... both rules are in play... AND we have an uptrend in Hong Kong stocks that started last month.

You should consider buying Hong Kong shares now... Triple-digit gains are possible... and you can limit your downside risk by using a trailing stop. Those are my kind of odds!

Dailywealth.com offers a free daily investment newsletter which focuses on contrarian investment opportunities.

Depression Looms Without More Stimulus

Do we really need more economic stimulus? We have already spent trillions of dollars attacking this financial crisis, and unfortunately we also have seen billions apparently wasted by poor policy decisions and implementation. All that aside, according to famed economist Robert Shiller, we need more economic stimulus or else we are likely facing another depression. For more on this, read the following blog post from Mark Thoma.

Robert Shiller says we need to continue with the monetary and fiscal policies we are pursuing, but both efforts need to be larger:

Depression Lurks Unless There’s More Stimulus, by Robert Shiller, Commentary, Bloomberg: In the Great Depression ... the U.S. government had a great deal of trouble maintaining its commitment to economic stimulus. “Pump- priming” was talked about and tried, but not consistently. The Depression could have been mostly prevented, but wasn’t. ...

In the face of a similar Depression-era psychology today, we are in need of massive pump-priming again. We appear to be in a much better situation due to the stronger efforts to date. Still, there is a danger that, because of a combination of faulty economic theory and inadequate appreciation of human psychology, as well as deep public anger, we will not continue with such stimulus on a high enough level. ...

In our analysis of the current economic crisis, we conclude that the government should have two targets. One would be a joint fiscal-monetary policy target. The same kind of expansionary policies embodied in the government expenditure stimulus and tax cuts that are already being tried have to be done on a big enough scale and for a long enough time in the future. ...

The government should also have a credit target. Once again, we are calling for more of the same kinds of existing policies... Achieving this requires new approaches, like those announced by the Bernanke Fed and the Obama administration, but on a continuing and even larger scale. ...

In this crisis, acceptance of these measures is being replaced with outrage. It is increasing the blood pressure of the public, and that can’t continue without damage to our system. ... It is time to face up to what needs to be done. The sticker shock involved will be large, but the costs in terms of lost output of not meeting either the credit target or the aggregate demand target will be yet larger.

It would be a shame if we are so overwhelmed by anger at the unfairness of it all that we do not take the positive measures needed to restore us to full employment. That would not just be unfair to the U.S. taxpayer. That would be unfair to those who are living in Hoovervilles...; it would be unfair to those who are being evicted from their homes, and can’t find new ones because they can’t find jobs. That would be unfair to those who have to drop out of school because they, or their parents, can’t find jobs.

It is now time to keep our eye on the ball and set clear targets to fix a system that broke when our animal spirits got out of bounds.

This post can also be viewed on economistsview.typepad.com.

The Fed Is Running A "Laboratory Experiment" On What Drives Inflation

A former Fed governor says the Fed is basically running a laboratory experiment on what drives inflation. Of course that terminology probably doesn't sit well with most Americans, who are looking to the government to fix our economy, it is close to the truth. Beyond the laboratory experiment, though, there is a potentially bigger problem with the Fed. It is looking more and more like the Fed's independence is being squandered...again. There is a reason why the Fed was made independent, and it wasn't to succumb to every whim of the Federal government. For more on this, read the following article from Tim Iacono.

With growing optimism that the worst may now be behind it for the U.S. economy, a growing number of observers are starting to look at what sort of an economic landscape might take shape should the optimists be right, given all the money creation over the last year or so to bailout financial firms and effectively nationalize the mortgage lending industry.

According to Allan Meltzer, one of the world's foremost experts on U.S. monetary policy, the outlook is not good and it has much to do with the historical role of the Federal Reserve as an independent organization as described in this report at Bloomberg.

Meltzer says political pressure will prevent Bernanke, 55, and fellow policy makers from withdrawing liquidity quickly enough as the economy recovers. That’s similar to the pattern that occurred back in the 1970s, he says. Then-Chairman Arthur Burns allowed excessive money-supply growth because he was unable or unwilling to resist pressure from President Richard Nixon’s White House to hold down unemployment, leading to the “great inflation” of that era, he says.

Now, Bernanke and fellow policy makers have “squandered their independence” by becoming involved in bailouts of financial firms and by taking long-term and illiquid assets onto their balance sheet, Meltzer says. “They don’t have the political ability to control inflation.”

It really is too bad for the central bankers of the world that the labor market is a lagging indicator. During the latter stages of a recession, when other economic statistics begin pointing unambiguously upward, job losses generally continue at a healthy pace and this can make reining in easy money an exceedingly difficult task.

That's one of the most important reasons why the Federal Reserve was created as an independent organization - to do what's best for the economy in the long-term regardless of the political whims and wishes in Washington.

[Note: Yes, the most important reason for the Fed's independence is its unholy relationship with big New York banks, but that's an entirely different discussion.]

Anyway, with many now seeing "green shoots" all over the landscape, the inflation/deflation debate looks set to heat up once again, and Fed policy is right in the thick of things.

“All that money is going to find a home,” says Ken Mayland, president of ClearView Economics LLC in Pepper Pike, Ohio. He sees oil prices increasing to “$80, $90, $100 before the end of next year” from $52 a barrel now.

Commodity prices may be more prone to rise as the world economy recovers because tight credit and volatile pricing will discourage investment in new supplies, says Mark Zandi, chief economist at Moody’s Economy.com, in West Chester, Pennsylvania.
...
Some Fed policy makers seem more worried about deflation than they do about inflation. A sustained fall in prices can debilitate the economy by causing consumers and businesses to postpone purchases.

“For some time to come, disinflation, and even deflation, will represent greater risks than inflation,” San Francisco Fed President Janet Yellen said in a speech on March 25.

At the root of that concern is substantial and growing slack in the economy, which, according to White House chief economist Christina Romer, is operating 5 percent to 10 percent below potential. That means the economy will have to grow a percentage point above trend -- reckoned by the administration to be about 2.5 percent annually -- for five or more years before the slack is used up.

The Phillips curve -- developed by economist A.W. Phillips using Keynesian concepts -- posits that such excess will reduce inflation as firms stuck with idle capacity cut prices and workers facing layoffs accept smaller wage hikes.

Not everyone at the Fed buys into that argument. Noting that some economists forecast substantial slack will keep inflation low for several years, Richmond Fed President Jeffrey Lacker said in a March 26 speech that he would be “cautious about relying on this correlation.”

The Fed is “running a laboratory experiment” on what drives inflation: the money supply or the output gap, says Laurence Meyer, a former Fed governor and now vice chairman of St. Louis-based Macroeconomic Advisers

“How it turns out will do a lot to influence the economic debate,” he says, adding that his money is on Bernanke.

How it turns out will also do a lot to influence whether the Federal Reserve continues to exist in its current form and whether there are major revisions to current economic theory.

If the amount of inflation bears any resemblance to the size of recent asset bubbles or the volume of money printing deemed necessary to combat their bursting, there may be a wholesale rethinking of what a central bank is and what economists do.

This post can also be viewed on themessthatgreenspanmade.blogspot.com.

Do You Believe Alan Greenspan?

Former Federal Reserve chief, Alan Greenspan, is towards the top of most people's lists for who had the biggest part in the creation of the current financial crisis. Ask Greenspan, though, and he'll tell you that he had nothing to do with it. Tim Iacono calls Greenspan out on this claim, and takes a deeper look into the origin of the financial crisis in his blog post below.

On the same day that his successor signaled dramatic policy changes that would see the Federal Reserve "take away the punchbowl" before inflating yet another asset bubble, radically altering the way financial market regulators operate in the process, former Fed chairman Alan Greenspan was readying yet another in a long series of op-ed pieces aimed at defending his legacy.

He didn't cause the housing bubble, or so he says.

After yesterday's commentary by David Leonhardt at the New York Times about how the central bank had been played like a fiddle by big financial firms who took on "excessive risk" knowing that the government would be there to bail them out, you'd have thought that maybe there would be some reluctance to go forward with the editorial.

Apparently not.

Still seemingly unfamiliar with the concept of "moral hazard" where, in the words of Mr. Leonhardt, big firms can "act as if their future losses are indeed somebody else’s problem", and having only confessed to being "shocked" last year after finding a flaw in his ideological framework about how "self-interest" works in the real world, the opinion piece made it into the Wall Street Journal this morning.

Alan Greenspan still hasn't got a clue.

After a long period of relative silence since the wheels fell off the global economy last fall and as his critics grew in number, his name often cited in public opinion polls as "the one individual" most responsible for the current mess (this term, admittedly, now failing to adequately describe the extent of the problems the world now faces), his defense has become defiant, if not desperate, the most recent example being provided today:

The Fed Didn't Cause the Housing Bubble
Any new regulations should help direct savings toward productive investments.
By ALAN GREENSPAN

We are in the midst of a global crisis that will unquestionably rank as the most virulent since the 1930s. It will eventually subside and pass into history. But how the interacting and reinforcing causes and effects of this severe contraction are interpreted will shape the reconfiguration of our currently disabled global financial system.
There are at least two broad and competing explanations of the origins of this crisis. The first is that the "easy money" policies of the Federal Reserve produced the U.S. housing bubble that is at the core of today's financial mess.

The second, and far more credible, explanation agrees that it was indeed lower interest rates that spawned the speculative euphoria. However, the interest rate that mattered was not the federal-funds rate, but the rate on long-term, fixed-rate mortgages.

Not surprisingly, the "easy money" thesis is dismissed out of hand - there is nothing further about fostering a culture of debt or being overly accommodating to the slightest of financial market stumbles over a period of almost two decades, all of which surely contributed to the prevailing attitudes and conventional wisdom of just a few years ago.

Having dispensed with that, it is on to the now-familiar, "I was powerless to do anything about long-term rates" retort, as if long-term rates really played a key role in the housing bubble during its bubbliest years.

With prices having risen to nosebleed levels during the middle of the decade, who could afford to buy a house with a 30-year fixed loan?

It was the tsunami of "innovation" in financial products - Pay Option ARMs, "liar loans", MBSs, CDOs, and CDSs - all of which were blessed by the central bank, that caused nearly all the damage, not 30-year fixed mortgages.

Next comes the "savings glut" rationale for why long-term rates were such a conundrum followed by the now-familiar, "our housing bubble was just average" angle:

That ex ante excess of savings propelled global long-term interest rates progressively lower between early 2000 and 2005.

That decline in long-term interest rates across a wide spectrum of countries statistically explains, and is the most likely major cause of, real-estate capitalization rates that declined and converged across the globe, resulting in the global housing price bubble. (The U.S. price bubble was at, or below, the median according to the International Monetary Fund.)

What follows is a rebuke of Stanford University Professor John Taylor' revisionist history (apparently, it takes one to know one) in which short-term interest rates were cited as the proximal cause for the current meltdown.

And after that, it's always handy to cite glowing criticism from someone who died back in 2006, before it became widely known just how bad things would get.

Given the decoupling of monetary policy from long-term mortgage rates, accelerating the path of monetary tightening that the Fed pursued in 2004-2005 could not have "prevented" the housing bubble. All things considered, I personally prefer Milton Friedman's performance appraisal of the Federal Reserve. In evaluating the period of 1987 to 2005, he wrote on this page in early 2006: "There is no other period of comparable length in which the Federal Reserve System has performed so well. It is more than a difference of degree; it approaches a difference of kind."

That's just pathetic when you think about it...

Even after the recent admonishment from the late Milton Friedman's long-time partner Anna Schwartz as documented in "A 92-year old finger pointed squarely at the Fed", he has the chutzpah to cite favorable words from 2006.

Lastly, the question of regulation and the lack of sophistication.

It is now very clear that the levels of complexity to which market practitioners at the height of their euphoria tried to push risk-management techniques and products were too much for even the most sophisticated market players to handle properly and prudently.

However, the appropriate policy response is not to bridle financial intermediation with heavy regulation. That would stifle important advances in finance that enhance standards of living.

Before getting to the big finale, it's worth noting that the book has not yet been written on these "enhanced standards of living". It seems that standards of living in most of the world, particularly in the U.S., are one big moving target right now, a target that is generally moving in the downward direction.

Come to think of it, "enhanced" is clearly not the right word choice here - it is premature at best and, at worst, it is a sad, almost mocking commentary on the rapidly changing lives of the vast majority of people in the world.

And, in conclusion...

If we are to retain a dynamic world economy capable of producing prosperity and future sustainable growth, we cannot rely on governments to intermediate saving and investment flows. Our challenge in the months ahead will be to install a regulatory regime that will ensure responsible risk management on the part of financial institutions, while encouraging them to continue taking the risks necessary and inherent in any successful market economy.

Maybe what the smartest economists in the world thought was "sustainable growth" wasn't sustainable at all and all that "risk taking" was just a way for bankers to enrich themselves.

People are beginning to sour on the whole idea of "prosperity", that is, if the current economic and financial market tumult is part of the package.

This post can also be viewed on themessthatgreenspanmade.blogspot.com.

Currency Market Update: Look To The Australian Dollar

Yesterday's market rally got a lot of investors excited, but the rally was short lived. Currency expert Kathy Lien points out 3 reasons why investors should have been suspicious of the rally in her blog post below. In addition Lien offers some insight into the future of currencies, and suggests that the Australian Dollar might be a great investment opportunity right now.

The currency and equity markets are turning lower after a strong rally on Tuesday. In my Daily Currency Focus, I talked about the 3 reasons why the currency market rally was suspicious. None of the reasons for Tuesday’s jump delivered real solutions. The market only rallied because Bernanke delivered no surprises. President Obama’s attempt at reassuring Americans also failed to comfort investors.

Instead we are faced with a weakening economy that is only confirmed by this morning’s plunge in existing home sales. Sales of existing homes plunged 5.3 percent to a 12 year low in the month of January. The housing market remains the Achilles heel of the US economy as prices fall and demand wanes. The median price of a home sold dropped 14.8 percent compared to the year prior. Such disappointing numbers are not much of a surprise given the big decline in housing starts and building permits. With banks and mortgage lenders reluctant to lend, even potential homeowners with sufficient capital have found difficulty attaining loans.

The British pound has been hit the most because Bank of England member Barker said that the weak sterling is helpful. UK officials have taken every opportunity to talk down the currency.

USD/JPY on the other hand remains an animal. Despite weak economic data and a turn in equities, the currency pair continues to rise.

My favorite is still the Australian dollar because of strong M&A flow, higher gold prices and the prospect of the country remaining recession free. The AUD/USD is also prime for a breakout.

This post can also be viewed on kathylien.com.

Should We Create Government Sponsored Shadow Banks?

According to Paul McCulley from Pimco, to revive the economy the government simply needs to create government sponsored shadow banks. Naturally this idea is a little controversial, especially considering the recent demise of this type of system. Tim Iacono from The Mess That Greenspan Made looks at an article written by McCulley in his blog post below:

Paul McCulley of Pimco thinks the new kind of shadow banking system is just swell:

The United States government now has both the tools and the will to save the private banking system, and more importantly, the real economy, from its own debt-deflationary pathologies. Not that it will be easy. But it can be done, notwithstanding the catcalls that greeted Secretary Geithner last week.

And the essential game plan is clear: use the power of the Fed, the FDIC and the Treasury to create government-sponsored shadow banks, such as the Term Asset-Backed Securities Lending Facility (the TALF) and the Public-Private Investment Fund (the P-PIF).

The formula? Take a small dollop of the Treasury’s free-to-spend taxpayer money (there is still $350 billion left) to serve as the equity in a government sponsored shadow bank, and then lever the daylights out of it with loans from the Federal Reserve, funded with the printing press.
...
Yes, there will be subsidies involved, sometimes huge ones. And yes, the process will seem arbitrary and capricious at times, reeking of inequities. Such is the nature of government rescue schemes for broken banking systems, while maintaining them as privately owned.

You might not like it. I don’t like it, because regulators should never have let bankers, both conventional bankers and shadow bankers, run amok. But they did.

So it’s now time to hold the nose and do what must be done, however stinky it smells, not because it’s pleasant but because it is necessary.

Pragmatism takes on a whole new meaning at Pimco.

This post can also be viewed on themessthatgreenspanmade.blogspot.com.

Total Financial Crisis Commitment Nearing $10 Trillion

Bloomberg has been fighting with the government in an attempt to gain visibility into the Federal Reserve's recent lending practices, however, to this point they have been unsuccessful. Of course the fact that the government is denying the request has only brought ramped speculation about what they are hiding. One thing that we do know is that the price tag for this financial crisis keeps growing and growing, with no end in sight. Most people are only aware of the $700 TARP package, and the new $800+ billion stimulus package nearing completion as we speak. The truth of the matter is that the real price tag is much more than that. Tim Iacono looks at the Bloomberg report in his blog post below that shows us the real price tag is close to $10 trillion (that is not a typo).

It looks like Bloomberg v. Board of Governors of the Federal Reserve System is moving along nicely with arguments to be heard as soon as this month.

Recall that Bloomberg sued the central bank after their Freedom of Information Act request about Fed lending to distressed banks was denied. They simply wanted to know what kind of assets they were getting in exchange for their pristine Treasuries, how much and from whom.

The Fed wouldn't tell 'em. The Treasury Department isn't talking either.

In the meantime, the staff at Bloomberg is taking an increasingly skeptical look at both the sums of money involved and how it is being authorized and spent, as seen in this report:

The stimulus package the U.S. Congress is completing would raise the government’s commitment to solving the financial crisis to $9.7 trillion, enough to pay off more than 90 percent of the nation’s home mortgages.
...
Only the stimulus bill to be approved this week, the $700 billion Troubled Asset Relief Program passed four months ago and $168 billion in tax cuts and rebates enacted in 2008 have been voted on by lawmakers. The remaining $8 trillion is in lending programs and guarantees, almost all under the Fed and FDIC. Recipients’ names have not been disclosed.

“We’ve seen money go out the back door of this government unlike any time in the history of our country,” Senator Byron Dorgan, a North Dakota Democrat, said on the Senate floor Feb. 3. “Nobody knows what went out of the Federal Reserve Board, to whom and for what purpose. How much from the FDIC? How much from TARP? When? Why?”

You have to wonder why Congress even bothers going through the arduous task of passing legislation for a measly trillion or two when so much money can be made available without the approval of elected officials - about four times as much by my math.

And the best part about doing it that way is that you don't have to tell anybody where it went.

Of course, Congress might want to know and you might get sued.

The Bloomber report goes on to put the total amount of money in perspective just like when Senate Republicans were talking about the stimulus package the other day with images of hundred dollar bills stacked 600+ miles high and/or laid end to end, circling the earth 40 times.

That was for just $800 billion.

Somehow, for $10 trillion, this doesn't sound nearly as impressive.

The $9.7 trillion in pledges would be enough to send a $1,430 check to every man, woman and child alive in the world. It’s 13 times what the U.S. has spent so far on wars in Iraq and Afghanistan, according to Congressional Budget Office data, and is almost enough to pay off every home mortgage loan in the U.S., calculated at $10.5 trillion by the Federal Reserve.

Maybe it is impressive, but $1,430 doesn't really sound like a lot of money.

Remember when they talked about $30 or $50 billion for Iraq and then it turned into hundreds of billions of dollars and that was such a big deal?

Now, even a hundred billion dollars doesn't sound like much anymore.

Soon, one trillion might not sound like a lot either.

This post can also be viewed on themessthatgreenspanmade.blogspot.com.

Should The Fed Be Abolished? Ron Paul Thinks So...

This isn't the first time that Ron Paul has brought this measure to abolish the Federal Reserve before Congress, and it probably won't be the last. While most politicians, and Americans for that matter, write Paul off as crazy because of proposals just like this, is he really that offbeat? His arguments seem a lot more powerful now that the economy is struggling so mightily, however, there is still no chance that his legislation will be accepted, at least in his life time. Tim Iacano from The Mess That Greenspan Made talks more about Paul, and his new legislation, in his blog post below.

Earlier this week, Rep. Ron Paul (R-Texas) reintroduced legislation to abolish the Federal Reserve. While it's not likely to go any further than it did last time, efforts like this are an important first step toward making substantive changes in the future:

Madame Speaker, I rise to introduce legislation to restore financial stability to America's economy by abolishing the Federal Reserve. Since the creation of the Federal Reserve, middle and working-class Americans have been victimized by a boom-and-bust monetary policy. In addition, most Americans have suffered a steadily eroding purchasing power because of the Federal Reserve's inflationary policies. This represents a real, if hidden, tax imposed on the American people.

From the Great Depression, to the stagflation of the seventies, to the current economic crisis caused by the housing bubble, every economic downturn suffered by this country over the past century can be traced to Federal Reserve policy. The Fed has followed a consistent policy of flooding the economy with easy money, leading to a misallocation of resources and an artificial "boom" followed by a recession or depression when the Fed-created bubble bursts.

How can you argue with any of this?

While the "lender of last resort" function of the Fed makes a good deal of sense, the "master of the economy" and "master of the money" roles do not.

They never did (unless you're a banker or a politician).

With a stable currency, American exporters will no longer be held hostage to an erratic monetary policy. Stabilizing the currency will also give Americans new incentives to save as they will no longer have to fear inflation eroding their savings. Those members concerned about increasing America's exports or the low rate of savings should be enthusiastic supporters of this legislation.

Though the Federal Reserve policy harms the average American, it benefits those in a position to take advantage of the cycles in monetary policy. The main beneficiaries are those who receive access to artificially inflated money and/or credit before the inflationary effects of the policy impact the entire economy. Federal Reserve policies also benefit big spending politicians who use the inflated currency created by the Fed to hide the true costs of the welfare-warfare state. It is time for Congress to put the interests of the American people ahead of special interests and their own appetite for big government.

Abolishing the Federal Reserve will allow Congress to reassert its constitutional authority over monetary policy. The United States Constitution grants to Congress the authority to coin money and regulate the value of the currency. The Constitution does not give Congress the authority to delegate control over monetary policy to a central bank. Furthermore, the Constitution certainly does not empower the federal government to erode the American standard of living via an inflationary monetary policy.

In fact, Congress' constitutional mandate regarding monetary policy should only permit currency backed by stable commodities such as silver and gold to be used as legal tender. Therefore, abolishing the Federal Reserve and returning to a constitutional system will enable America to return to the type of monetary system envisioned by our nation's founders: one where the value of money is consistent because it is tied to a commodity such as gold. Such a monetary system is the basis of a true freemarket economy.

In conclusion, Mr. Speaker, I urge my colleagues to stand up for working Americans by putting an end to the manipulation of the money supply which erodes Americans' standard of living, enlarges big government, and enriches well-connected elites, by cosponsoring my legislation to abolish the Federal Reserve.

This post can also be viewed on themessthatgreenspanmade.blogspot.com.

Brits Blame Greenspan For Global Financial Crisis

Everyone is looking for the person responsible for the economic mess the world is in, or at least a fall guy we can blame everything on. According to a recent web poll, Brits believe that former Fed chief, Alan Greenspan, is the man. Truth is no one person is solely responsible for all our economic problems, however, it is still interesting to see who people think the biggest culprits are. Tim Iacono from The Mess That Greenspan Made looks closer at this poll and adds some thoughts of his own, in the blog post below.

It is not at all clear what, if any, significance the survey results attached to this story in the U.K.'s Times Online hold but, when asked which of ten individuals to blame for the current financial mess, fingers were pointed squarely across the Atlantic Ocean at the guy who ran the Federal Reserve for almost two decades.

Are the British that attuned to monetary policy in the U.S. or are they, perhaps, more willing to look overseas for a culprit rather than on their own soil?

(BTW - that little radio button thingy is my vote, just in case anyone was wondering.)

The much better known local boy, Gordon Brown, comes in a distant second (for very good reason, actually) and George W. Bush is even further back in third place.

Interestingly, the three individuals who were probably more responsible than any politician in the world - Fuld, Paulson, and Mozilo - filled the next three spots.

As for the other four, the British are probably about as familiar with the name Hank Greenberg as Americans are with Sants, Goodwin, and Corbert, though, after reading the descriptions provided, these three clearly deserved more votes than they received.

Here's what they had to say about former Fed Chairman Alan Greenspan:

Alan Greenspan was feted for his management of the US economy while he stood in charge of the US Treasury, but has since been put under the spotlight. He was responsible for cutting interest rates to near zero in the US in the aftermath of September 11, flooding the world with cheap and easily available money. Did this pave the way for a “once-in-a-century credit tsunami"? In October last year he said: “I made a mistake in presuming that the self-interest of organisations, specifically banks and others, was such that they were best capable of protecting their own shareholders.”

Allan Meltzer is a professor of political economy at the Carnegie Mellon University in Pittsburgh, said: “Alan Greenspan was much too afraid of a slowdown or other recession…he allowed the credit to expand too rapidly."

The confusion about the Fed chairman heading up the U.S. Treasury Department may be understandable as we Americans are often confused by the British position of Chancellor of the Exchequer which we'd be just as likely to say headed up the Bank of England.

This post can also be viewed on themessthatgreenspanmade.blogspot.com.

How To Prevent Another Depression

We are no where near a depression yet, but many people are worrying that we are heading for one. So what can the government do to prevent another depression? According to Brad DeLong we have 4 options. Mark Thoma from The Economist's View looks at DeLong's 4 options in his blog post below.

What can governments do to try to keep the economy out of a depression?:

Depression economics: Four options, by J. Bradford DeLong, Commentary, Project Syndicate: When an economy falls into a depression, governments can try four things... Call them fiscal policy, credit policy, monetary policy, and inflation.

Inflation is the most straightforward to explain: The government prints lots of banknotes and spends them. The extra cash in the economy raises prices. As prices rise, people don't want to hold cash... - its value is melting away every day - so they step up the pace at which they spend... This spending pulls people out of unemployment..., and pushes ... production up to 'potential' levels.

But sane people would rather avoid inflation. It is a very dangerous expedient, one that undermines standards of value, renders economic calculation virtually impossible, and redistributes wealth at random. ... But governments will resort to inflation before they will allow another Great Depression. We just would very much rather not go there, if there is any alternative...

The standard way to fight incipient depressions is through monetary policy. ... The problem with monetary policy is that ... the ... nominal interest rate on government securities is zero. ... And this is too bad, for if we could prevent a depression with monetary policy alone, we would do so, as it is the policy tool for ... stabilisation that we know best and that carries the least risk of disruptive side effects.

The third tool is credit policy. We would like to boost spending immediately by getting businesses to invest... Risky projects are at a steep discount today... No one is willing to buy assets and take on additional uncertainty... Although the world's central banks and finance ministries have been devising many ingenious and innovative policies to stimulate credit, so far they have not had much success.

This brings us to the fourth tool: fiscal policy. Have the government borrow and spend, thereby pulling people out of unemployment and pushing up capacity utilisation to normal levels. There are drawbacks: the subsequent dead-weight loss of financing all the extra government debt..., and the fear that too rapid a run-up in debt may discourage private investors from building physical assets...

But when you have only two tools left, neither of which is perfect for the job - credit policy and fiscal policy - the rational thing is to try both, at the same time. That is what the Obama administration ... and other governments are attempting to do right now.

This post can also be viewed on economistsview.typepad.com.

What Will The Fed Do To Stimulate The Economy Now?

Bernanke and the Fed already played their last interest rate card, so if they can't lower rates what else can they do to get the economy back on track? There is a lot of speculation going around right now about what they might do, but we shall find out for ourselves later today. James Picerno from The Capital Spectator talks about the Fed meeting and the economy in general, adding some valuable input in his blog post below.

The press release that follows the Fed's FOMC meeting today may offer clues about how the central bank will proceed now that it's out of conventional monetary policy ammunition. Then again, maybe not. We're all trapped in gray zone of trial and error about what to do next and the Federal Reserve is also now faced with grasping at straws.

Typically, an afternoon FOMC press release attracts interest for an update on where short-term interest rates are headed. Today, and probably for some time to come, everyone already knows the answer. The Fed controls short rates, starting with the all-powerful Fed funds, but with the effective Fed funds at roughly 0.16%, the mystery about what comes next is, like the price of money, virtually nil.

Yet Bernanke and company may yet surprise us by dropping fresh clues about how the Fed plans to practice unconventional monetary policy from here on out—quantitative easing, to use the phrase of the dismal science. The details are a work in progress, although the immediate goal is still clear: stabilize general price levels.

We won't belabor the issue of deflation today, in part because we've discussed it often in recent months, including here and here. Let's just say that the D risk is still very much with us, and so the Fed has a fair amount of work to do in the months ahead.

The market appears to understand this, at least by way of monitoring Fed funds futures. For the year ahead, all the contracts are expecting Fed funds to remain under 60 basis points, and quite a bit lower for the immediate future.

Long rates remain in a holding pattern as well. The yield on the benchmark 10-year Treasury Note is in the 2.5% range and it may go lower yet, depending on what the next round of inflation reports reveal, although those won't arrive for several weeks.

Meantime, there's plenty of guesswork about what the Fed's next move. "With rates going nowhere for some time, the market's focus will be on whether the Fed will be looking to buy government (or corporate) securities in the near future," Sacha Tihanyi, an analyst at Scotia Capital, opines via AFP.

John Authers in today's FT argues that the critical variable is housing prices. What can the central bank do on that front? "The Fed can give details on quantitative easing— the ugly phrase for the art of buying bonds so as to push down the yields they pay, and stimulate the economy with lower rates, especially for mortgages," he writes. "If there is a single key variable to determine when the crisis in the US banking system can be brought under control, it is house prices. The further they fall, the higher the likely default rate on the mortgage-backed securities that banks now hold on their balance sheets."

Unfortunately, the news on housing prices is still discouraging, even after several years of a falling market. One of the latest bits of housing data shows that prices fell again last month even as sales perked up. Existing home sales rose 6.5% in December, albeit driven by distressed sales at bargain prices, the National Association of Realtors reports. Nonetheless, the median national price of existing homes in the U.S. still dropped by a hefty 15.3% last month.

Even if the Fed is successful in fending off deflation, which we expect it will be, that by itself isn't a cure for what ails the economy. "Ben Bernanke is rightly concerned about deflation right now," Desmond Lachman of the American Enterprise Institute explains in The Christian Science Monitor. But that's merely step one in a multi-step recovery program. "Getting inflation back into the system … is not going to be sufficient," Lachman notes.

Convincing banks to lend and consumers and businesses to borrow is arguably the next big step beyond containing the deflation risk. Solving the latter will be easy by comparison. The real challenge will come later this year in trying to promote growth. But first things first, and so we await today's Fed commentary.

This post can also be viewed on capitalspectator.com.

Division Mounts Among Fed Officials

The swelling balance sheet at the Federal Reserve is causing problems in more ways than one. One Fed official, Philadelphia Fed bank president Charles Plosser, recently went public with his objections against current Fed policies. Plosser’s main objections concern the ballooning balance sheet and the apparent endlessness to the madness. Fed chief Ben Bernanke doesn’t think that the balance sheet is a problem, but Plosser does, and he is ready to take his argument to whoever will listen. The following are excerpts from a MarketWatch article that detail some of Plosser’s concerns:

“Plosser said that the growth of the Fed's balance sheet was a key metric. ‘It is not appropriate to ignore quantitative metrics in this new policy environment,’ Plosser said.”

“Fed officials who pay attention to the money supply believe that the Fed's current policy of printing money never ends well and the danger of inflation is very high. They believe the Fed must withdraw the stimulus before there is any sign of inflation or it is too late.”

“Plosser also argued that the Fed has put its independence at risk by buying long-term assets. He worried that some "interest groups" will try to use political persuasion to stop the Fed from selling these longer-term assets even if the central bank has decided it makes sense.”

“‘We will need to have the political fortitude to make some difficult decisions about when our policies must be reversed or unwound,’ Plosser said. Bernanke said that he would watch this situation closely but didn't expect it to be a ‘significant problem.’"

Plosser isn’t the only one expressing concerns. William Poole, who recently left his position as president of the St. Louis Fed, has also been outspoken about issues with current Fed policies. The following are experts from a MarketWatch article:

“Poole said the expansion of the Fed's balance sheet is unprecedented and research suggests that a surge of inflation is sure to follow. ‘I would say if the policy is not reversed, there is a high probability that the unpleasant risk (of inflation) materializes,’ Poole said in an interview.”

“‘I believe that the Fed should set a hard number—a target that they take seriously for the overall size of the balance sheet,’ he said.”

“Poole said he was very concerned that the Fed could simply lend money to anyone, without constraint.”

“In the Soviet Union and Eastern Europe during the Cold War era, economies were inefficient because they had a soft-budget constraint. If a firm got into trouble, the banking system would give them more money, Poole said. The current situation at the Fed seems eerily similar, he said.”

"’What is discipline—where are the hard choices—when does Fed say our resources are exhausted?’ Poole asked.”

Bernanke seems content to continue on the current path, but it should at least be a little concerning that the opposition inside the Fed is becoming more vocal. I would venture to guess that there are others that oppose Bernanke, but they do not have the guts to stand up publicly against him. If things continue to worsen, it will be at least interesting to see how much the opposition ranks swell.

U.S. Exports Continue Their Downward Trend

Last year, while the U.S. dollar was down, manufacturers were joyfully experiencing one of the the loan bright spots in the U.S. economy, increased exports. Oh, how things can rapidly change for the worse. The latest trade report showed that U.S. exports were down again, for the fourth consecutive time. Is there any bright spots left in the economy? If so they are hiding pretty well. James Picerno from The Capital Spectator looks closer at the latest trade report in his blog post below.

The trade boom is fading. That's no great surprise, given the weakening state of the global economy. But the slippage in export-related activity comes at an especially challenging moment for the U.S.

Exports remained a bright spot for the U.S. economy last year. As other areas weakened in 2008, the American export machine bucked the trend. It was a timely boost, offering some hope that the approaching recession might be mitigated and perhaps even sidestepped altogether.

The high point came in last year's second quarter, when real (inflation-adjusted) export activity soared 12.3% on an annualized basis while GDP advanced 2.8%. That took some of the sting out of the drop in durable goods spending and a growing sense of unease otherwise in the GDP trend. In the third quarter, the export boom slowed but remained robust, rising 3.0%, in sharp contrast to the 0.5% decline in GDP.

The long-suffering dollar was no small advantage for juicing exports. As the greenback declined, the price cuts on American goods and services became increasingly attractive to foreign countries. Then in July 2008, the dollar began to rally. Although the U.S. Dollar Index has been trading in a range recently, it's still up sharply from its summer lows.

It was a tempting notion to think that exports would save us, although we warned last summer about expecting too much from the trend. "There's a limit to how much economic gain any nation can enjoy through a weakening of its currency," CS wrote in July. "Devaluation may offer short-term benefits, but the U.S. can't devalue its way to prosperity for very long."

The dollar's recent strength at the moment surely isn't helping U.S. exporting activity, nor is the credit crisis or the general economic turmoil blowing through economies around the world. Few analysts expected the fourth quarter GDP report to deliver anything other than a negative number. Today's trade update for November only strengthens that forecast. Exports dropped nearly 5.8% last month, the fourth consecutive montly decline.

No one will be shocked by the trend, although it's a humbling reminder that the economy has nowhere to hide. Employment, consumer spending, and so on have each fallen victim to the ill winds of recession. Exports are no exception. As we discussed on Friday, this is the eye of the economic hurricane and, as a result, all news from the dismal science is likely to be discouraging news for the time being. Not forever, but for a few quarters at least. Time moves slowly when you're waiting for a bottom.

This post can also be viewed on capitalspectator.com.

How Will Deflation Worries Affect Gold?

Gold has historically been an asset that people turned to when they are worried about inflation. Today, though, we are in a very unique situation. Governments around the world still don't have inflation under control, but there is a lot of worry right now of deflation. Because inflation is tracking down and deflation is on the horizon nuemours measures are being taken that could have dramatic impact on inflation, and the price of gold, in the future. Deflation may or may not ultimately come, but if it does what impact will it have on Gold prices? What about if deflation doesn't come, and inflation spikes, what then? Tim Iacono from The Mess That Greenspan Made looks closer at that question in his blog post below.

This morning's Ahead of the Tape column($) in the Wall Street Journal neatly summarizes conventional wisdom regarding gold, beginning with the 'ol "inflation hedge" saw.

As the quintessential hard asset, one that traditionally hedges against rising consumer prices, gold's trajectory these days should be downward. After all, prices for just about every other commodity, from oil to nickel to cotton, have plunged as inflation risks have seemingly abated and as investors increasingly fear deflation.

Yet, gold has largely traded between $750 and $850 an ounce for the last few months, and is up about 8% since the Fed cut interest rates to between 0% and 0.25% last week.

It hasn't been an entirely smooth ride. Gold sank amid panic this fall as investors crowded into the U.S. dollar. And it remains well under its $1,002 close back in March. But the metal hasn't stumbled nearly to the degree many other commodities have. Clearly, deflation worries aren't tugging at gold.

It's probably fair to say that, with what the central banks around the world have been doing over the last year or so, gold owners who are now worried about the recent downward trend in the consumer price index are few and far between.

It continues...

And while inflation isn't apparent today, stimulus packages and bailouts mean much more money in the system. That is classically inflationary. Moreover, despite efforts to sop up this liquidity later, the effects of unintended consequences might mean some portion of the trillions added to the Fed's balance sheet are likely to "stick around" to fuel inflation, says Axel Merk, who recently increased gold exposure in his Merk Hard Asset Fund and personal portfolio.

Says Malcolm Southwood, commodities analyst at Goldman Sachs JBWere in Australia, "I'm telling clients that the environment over the next five years is extremely constructive because of the inflationary risks further out."

Near-term gold could still demonstrate some weakness as the last of the panic trade peters out. And if the European Union cuts interest rates, as some expect, that could boost the dollar's value, which could undermine gold. And U.S. and European Central banks could sell gold to raise cash to pay for bailouts, which would be bearish for gold prices. But Mr. Southwood suspects Asian central bankers looking to diversify reserves would grab that supply, seeing the sales as "an alarm signal about the dollar."

And what if deflation does hit? Even that doesn't necessarily spell doom for gold, as some think. During the deflationary Great Depression, "gold preserved its value," says Matt McLennan, a lead manager at First Eagle funds, which runs a gold fund. "It preserved its purchasing power."

Yes, some of this new money is likely to "stick around" as Axel Merk says - maybe a lot of it.

This post can also be viewed on themessthatgreenspanmade.blogspot.com.

Understanding The Federal Reserve System

Are you completely confused by the whole Federal Reserve system? If so you are not alone, but you really should at least attempt to understand it. The Federal Reserve plays a huge part in how our economy runs, and every American should be concerned with that right now. While most explanations I've read about the Federal Reserve would probably be confusing for most non-economists to read, a recent one published by James Hamilton on Econbrowser does a fabulous job explaining how the Federal Reserve works.

As a bonus Hamilton also explains all the new and creative things the Fed is doing to help get us out of the financial mess we are in, as well as the present state of the Fed's balance sheet. If you are at all interested in how the Federal Reserve works, and what is going on there today, I strongly recommend that you read his article.

Click here to read the full article.

Flurry Of Fed Moves Could Lead To Hyper Inflation

In what was a surprising move yesterday, the Fed dropped the Fed funds rate basically to zero, surpassing market expectations. Everyone fears deflation, and the Fed is willing to do whatever it takes to avoid it. But as Toni Straka from The Prudent Investor points out, these drastic moves could soon lead us to hyper inflation.

Share and bond markets rallied on Tuesday after the Federal Reserve announced that it will give away new money for almost free, lowering the Fed Funds target range to a historical low of 0% to 0.25%. The Fed had cut the Fed Funds rate in late October by 50 basis points. The new record low rate is a reaction to to the de facto status quo in treasury securities where short maturities of up to 6 months trade at yields below the upper end of the target range.

In a most unusual move the Fed provided publishable background on its decision, writes the WSJ blog, detailing it all here. The Fed has not held press briefings until now.

While markets welcomed the bold move, gold, the canary in the mine of inflation, advanced as well, piercing the important resistance at $850. Investors are obviously pricing in that all Treasuries yield less than the inflation rate of currently 3.7% YOY.

But the move to a zero interest rate policy will come at the cost of higher inflation in 2009 and 2010, it can be safely predicted. Chairman Ben Bernanke and his fellow Federal Open Market Committee (FOMC) members pulled out all stops in order to jumpstart the economy and assured market participants that the Fed would continue to engage in the dubious game of printing fresh money for collateral it does not want to talk about.

Once more proving their image of inflationistas par excellence the FOMC said the Fed can be expected to hold on to its free money policy for quite some time and use all tools to promote a return to growth.

The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.

But money for nothing alone will not help, the Fed reasoned, preparing markets for more growth in the Fed's balance sheet after it has exploded from $800 billion to $2.2 trillion since last summer. Expect the Fed to continue to buy more worthless MBS (mortgage backed securities) while substituting the banking sector in the commercial paper market.

The focus of the Committee's policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level. As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities. Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.

I translate this into "we will throw (fiat) money (that costs us next to nothing) on every problem as we did in the past 2 decades." See more worthless money created that will be exchanged for more MBS that are valued on a theoretical basis, i.e. not the market price which may be only a tiny fraction of the initial face value.

The announcement that the Fed is looking into buying longer term US Tresuries raises immediate fears that the Fed will be monetizing the federal debt again after a portfolio shift towards MBS in the recent past. Any talk about deflation misses the point of unprecedented monetary inflation that will show up in the real economy 2009/10.

Eric de Carbonnel argues at DollarDaze that monetary inflation does not even have to pump up money supply - my favorite theory - but that it is a loss of confidence that increases the velocity of money, resulting in the dange of hyper inflation.

The record low official Fed Funds rate may be elusive though. Jake at EconomPicData sees a disconnect between municipal bonds and Treasuries, reflecting the horrendous outlook for cash strapped communities which had invested heavily in property debt. Now they are broke.

GRAPH: The yield spread between Munis and 5-year Treasuries soared to a record high of 325 basis points. Graph courtesy of EconomPicData.

DollarDaze draws a historical comparison that shows deflation can be a hazy illusion.

As an example of deflation leading to hyperinflation, consider the case of the Weimar Republic. In 1920, Germany experienced a deflationary collapse, with the average citizen finding it harder and harder to get enough money for necessities. Banks, short of money, could not honor checks, and businesses were strapped for cash to buy materials and meet payroll. Fearing a collapse that would throw millions of workers out on the street, the German government desperately printed money in an attempt to re-inflate the economy. During this period, despite the government's money printing, the mark actually gained in value against foreign currencies, so that prices of imported goods fell by some 50%.

Eventually, as a result of the money supply's rapid expansion, the nation's massive foreign debt, and the shrinking economy, German citizens lost all confidence in their currency, and the Weimar Republic experienced one of the worst cases of hyperinflation in modern economic history.

Check out the time series of the Weimar hyper inflation - with the interim "correction" before it went parabolic - here.

The new policy to lend money to banks for free shows that the Fed is obviously willing to monetize all debt problems that come along. With its seven new financing tools introduced since the beginning of the crisis in August 2007 the Fed is already intervening in MBS markets and tries to keep the commercial paper market afloat.

But after all these attempts are nothing more than new fiat money with a different ribbon. The road to hyper inflation is clearly visible as were most problems already more than 3 years ago.
Time will show whether the Fed has been correct in its view of current conditions. Taking it from the past 15 months the Fed has been behind the curve despite its fast moves. It is to be doubted that the increasing readiness to prop up all markets with new money will mitigate the crisis. It will rather delay it but the point of no return comes closer with every day. Central banks have a bad record of containing inflation once they set the process into motion willingly.

But these facilities have not brought the liquefying effect the Fed had hoped for. So far all attempts to revive credit markets have failed, observes not only Bloomberg, which has all the details on Tuesday's rate decision.

This post can also be viewed on prudentinvestor.blogspot.com.

Fed Drops Fed Funds Rate To Zero

Well, it looks like the Fed wasn't going to take any chances, they played all their interest rate cards as they dropped the target federal funds rate down to the 0 to 0.25 percent range. They obviously were trying to send a powerful message since most investors and economists only predicted a 0.5 percent reduction. It will be interesting to see how this plays out, but the U.S. has officially won the race to zero. Economics professor Mark Thoma from The Economist's View looks closer at this new development, and brings in some additional outside thoughts and opinions, in his blog post below.

The Fed announced it will move the target federal funds rate into the zero to .25% range, an that it plans to keep it there for some time.

Here's the Fed's statement:

Press Release: The Federal Open Market Committee decided today to establish a target range for the federal funds rate of 0 to 1/4 percent.

Since the Committee's last meeting, labor market conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production have declined. Financial markets remain quite strained and credit conditions tight. Overall, the outlook for economic activity has weakened further.

Meanwhile, inflationary pressures have diminished appreciably. In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate further in coming quarters.

The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.

The focus of the Committee's policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level. As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities. Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Christine M. Cumming; Elizabeth A. Duke; Richard W. Fisher; Donald L. Kohn; Randall S. Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh.

In a related action, the Board of Governors unanimously approved a 75-basis-point decrease in the discount rate to 1/2 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of New York, Cleveland, Richmond, Atlanta, Minneapolis, and San Francisco. The Board also established interest rates on required and excess reserve balances of 1/4 percent.

Well, that's it, we're at zero now. Any further monetary policy action will have to come through other means, e.g. quantitative easing and the purchase of financial assets.

Brad DeLong adds:

Hale "Bonddad" Stewart Is Scared: The Federal Reserve reacts to the fact that the economy train has arrived in Depression City.

Stewart writes:

Hale "Bonddad" Stewart: The Fed's Kitchen Sink Interest Rate Policy: The Fed announced their policy of establishing "a target range for the federal funds rate of 0 to 1/4 percent." This brings two points to mind:

1. The Fed has no interest rate moves left. This is it.
2. The Fed is terrified about the economy. And they have good reason:

Since the Committee's last meeting, labor market conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production have declined. Financial markets remain quite strained and credit conditions tight. Overall, the outlook for economic activity has weakened further....

The Fed will step up their other activities...

To the point: the Fed is scared right now. I mean really scared. And they will do anything even remotely possible right now.

Paul Krugman:

ZIRP!: That’s zero interest rate policy. And it has arrived. America has turned Japanese.

This is the thing I’ve been afraid of ever since I realized that Japan really was in the dreaded, possibly mythical liquidity trap. You can read my 1998 Brookings Paper on the issue here.

Incidentally, there were a bunch of us at Princeton worrying about the Japan problem in the early years of this decade. I was one; Lars Svensson, currently at Sweden’s Riksbank, was another; a third was a guy named Ben Bernanke. I wonder whatever happened to him?

Seriously, we are in very deep trouble. Getting out of this will require a lot of Show allcreativity, and maybe some luck too.

This post can also be viewed on economistsview.typepad.com.

Consumer Prices Show Record Fall: Fight Against Deflation Heats Up

Consumer prices are continuing to fall, even setting new records. This is of course heating up discussion about deflation, which is a horror no one wishes to see. Bernanke and the Fed are going to do everything they can to prevent deflation from coming, but with this crazy economy who knows if they will have the wherewithal to do so. James Picerno from The Capital Spectator dives deeper into the issue in his blog post below.

For the second month running, consumer prices fell. And by more than a little, invoking the specter of deflation once again.

CPI slumped by a hefty 1.7% in November on a seasonally adjusted basis, the government reports today. That follows October's 1.0% fall. More dramatically, last month's tumble is the deepest monthly decline in CPI since the Labor Department began keeping records on this series in 1947. Meanwhile, MarketWatch.com reports that the 1.9% non-seasonally adjusted fall in CPI is the steepest monthly rate since January 1932—the height of the Great Depression.

Meanwhile, core CPI (which strips out food and energy) is unchanged, following a slight decline in October. As this is the Fed's preferred measure of inflation, even a central banker can't deny that inflationary pressures have evaporated, at least for the time being.

Looking at the more familiar year-over-year calculation of headline CPI, consumer inflation is still positive, running at 1.0% for the 12 months through November. Even so, that's down sharply from October's annual rate of 3.7%. At this rate, CPI will soon be falling on an annual basis too.

As striking as the news is, a decline of some magnitude in CPI was expected, partly based on the earlier report of the ongoing decline in producers prices. Nonetheless, the sight of broad price indices sinking month after month in both the consumer and wholesale markets raises the question of whether this is merely a temporary state or something with more endurance?

We've been writing about rising deflation risk for some months now, and it's clear that the beast is here. It's still unclear how long it lasts, and so for the moment one can be optimistic that an unhealthy downward spiral in prices isn't fate.

Keep in mind that the massive monetary stimulus engineered by the Fed has only partly filtered into the economy. Monetary policy has a fair amount of lag time, perhaps a year or more. With each passing month, the aggressive liquidity injections will work deeper into the consumer and business sectors. Few expect a sudden rebound in spending and lending, but at this point simply keeping prices steady would be no small accomplishment.

Another reason to think that prices may soon stabilize comes from the fact that heavy drops in energy prices are currently leading CPI's descent. The energy component of consumer price inflation has lost ground for four months straight, with November's whopping 17% fall the biggest so far. But energy prices can't keep falling off a cliff month after month. Yes, the world economy is headed for tough times, which is paring demand for oil, gasoline and other fuels. But the lion's share of the price cutting relative to the highs of last summer is behind us.

There may yet be more declines in energy coming. In fact, we expect as much. But the magnitude of future declines, if any, will almost surely be smaller. Nor is it unreasonable to expect that energy prices generally will soon tread water, albeit at substantially lower levels compared with recent history.

As for the other components of CPI, well, that's another story. The transportation slice of consumer prices retreated by nearly 10% last month—the fourth month in a row of red ink. Housing prices are weakened last month, although just barely. But not every is posting price discounts. Prices for food, apparel, education/communication and medical care all managed to rise last month. Deflation hasn't yet infected everything, and therein lies more reason for hope.

Still, no one will wonder why Fed funds futures are pricing in a 50-basis-point cut at the Fed's FOMC meeting later today. If accurate, that would bring the target Fed funds down to 0.5%. As extraordinary as a 0.5% will be in historical terms, at this point it's something of a formality to reflect reality since the effective Fed funds (which is based on actual banking activity) is already at a scant 0.14%.

In sum, the war to head off inflation is in full swing. The Fed can't afford to fail in this battle. Allowing deflation to build a head of steam at this point is tantamount to economic suicide. It must be stopped, even at the risk of letting inflation out of the bag down the road. Controlling inflation, after all, is well understood, even if the political will isn't always there. Fighting deflation, by contrast, is far tougher and so preemptive medicine is preferred.

The challenge before us is defeating deflation with unconventional monetary policies, supported by aggressive fiscal stimulus. Since there's not a lot of precedent for the former, one might reason that the fiscal side of the ledger will have to do the heavy lifting, which necessarily depends on the political process. 'Nuff said.

Yet the task is not insurmountable. Indeed, monetary and fiscal policies will be that much more effective if consumer prices merely stabilize in the coming months, or at least stop dropping so rapidly. But that, as they say, is a big "if." Stay tuned.

The full post can also be viewed on capitalspectator.com.

The Next Big Bubble To Burst: U.S. Treasuries

Everyone in the world knows that the U.S. has a huge debt, and that the U.S. economy is performing poorly. Yet, people are flocking to U.S. treasuries like never before driving yields down to record lows. The U.S. has no plans of stopping the debt train, though, so who knows how high it will go. We are on uncharted ground right now, and all it would take to push this train off the tracks is one major debt holder to start selling. Lots of other bubbles have burst recently, so why not possibly the biggest one of all? Needless to say if this happens there will be serious ramifications for the U.S. and the rest of the world, which is probably why it hasn't happened already. Toni Straka from The Prudent Investor looks closer at this looming problem in his blog post below.

Having seen most of the bubbles bursting I had listed in this post from 2005 the world may soon be in for the mother of all bubbles. With a size of $10 trillion the US government debt market has remained the world's #1, now that MBS have shed the better part of their initial values.

US treasuries have long been hailed as a safe haven for money fleeing from other overheated markets. Massive losses in more or less all other asset classes in the past 15 months have shown that investors followed Pavlov's reflexes, driving the 10-year yield to a record low of 2.55% last week.

CHART: The yield for 10-year US Treasury debt fell to a record low of 2.55% last week. This chart may see a sudden reversal based on the fundamentals.

It may be questioned whether this trust into the Federal Reserve's ability to contain long term inflation is justified, given the fact that chairman Ben Bernanke will enter history as the fastest money printer of all times.

While the Fed has reduced its federal debt holdings by $290 billion to $484 billion (buying doubtful MBS instead) in the last 12 months it was foreign investors TIC data and Treasury statistics show.

This has driven yields across the curve to record lows, leaving investors with a negative real yield when discounting inflation. US Inflation was 3.7% YOY as of October.

Institutional investors have been allocating more money into US treasuries recently, citing the safe haven status of American government bonds. But this era may be coming to an end as so many things do nowadays.

There appears to be a split of opinion. While European and American investors follow the old rule of buying US debt with a questionnable AAA rating their Asian counterparts see themselves trapped with US debt holdings they cannot sell in order to avoid a panicky stampede out of the biggest market of all.

The deficit outlook justifies a skeptical approach. Barack Obama will have to finance a budget deficit of an estimated $1 trillion in 2009, the biggest in American history. If Mr. Obama will not manage a U-turn in foreign policy which was mainly based on ignorance and arrogance under Bush, he could run into financing problems. China has urged other countries to replace Federal Reserve Notes with their own currencies in bilateral trade and voiced its concern about US fiscal policy repeatedly.

The global downturn may bring a different borrowing climate too. Losses in all asset classes across the board and record low yields will result in lower reinvestment amounts overall, it can be safely projected.
The borrowing needs will skyrocket as both the federal government and bankrupt local communities will scramble for funds to replace sudden drops in tax revenues.

Bets On A US Default Become More Expensive
While still being a mainstay for investors from all around the world, not everybody is confident about the future of a USA in the grip from the biggest financial crisis ever. Some wary souls are increasingly buying insurance against a default of the US government. According to a Reuters report from November 26, credit default swaps involving Treasuries reached a record high.

Ten-year U.S. Treasury CDS widened to 54.7 basis points from Tuesday's close of 50.0 basis points, credit data company CMA DataVision said.
Five-year Treasury CDS jumped to a record 52.0 basis points from Tuesday's close of 47.50 basis points, it said.

In plain language this means investors were willing to pay $54,700 to insure a portfolio of $10 million 10-year debt paper.

Summarizing the fundamentals such as no end to new debts, tax shortfalls, higher social and military expenditures, a central bank willing to monetize the debt and flooding the world with fresh Federal Reserve Notes, it can be safely bet that this bubble will end like all bubbles: In a gigantic burst that will unsettle everything we have learned about investing in the past.

A hat tip to Econbrowser who undug this paper by Stanford economics professor John Taylor on the failures of the Fed in the current crisis and why it all became worse this autumn.

I stand by my opinion that monetary inflation is in the early stages worldwide and will have seeped through into the real economy in 2009/10.

This article has been reposted from The Prudent Investor. The full post can also be viewed on The Prudent Investor.

U.S. Debt Offerings: The Biggest Ponzi Scheme In History?

The U.S. Treasury has not been able to keep up with the monetary demands from the Fed which lead them to request the authority to print their own debt. In what has to be considered a ridiculous run up in the national debt of late, this move just compounds the potential problems. This is leading some people to question the validity of U.S. sovereign debt. Is the U.S. government running the biggest ponzi scheme in history? It sure seems like it. Toni Straka from The Prudent Investor looks closer at this in his blog post below.

Ladies and gentleman, fasten your seat belts in anticipation of more monetary madness. In its drive to keep the helicopters above Wall Street (and certain privileged corporate headquarters) filled with colourful stacks of fiat money that can be showered onto everybody that is deemed too big to fail the Federal Reserve blueprints a new layer of debt, writes the Wall Street Journal on Wednesday.

According to the story based on sources "familiar with the matter" the Fed considers to issue its own debt. This would allow the Fed to circumvent banks as intermediaries, possibly leading to a recovery of capital markets. But it could also lead to a situation where the Fed would be a direct competitor to the US Treasury in debt issuance.

While the privately owned Fed's right to print unbacked fiat money is already constitutionally doubtful (see my sidebar) even the Federal Reserve Act does not explicitly permit the Fed to issue debt either.

As chairman Ben Bernanke religiously follows a policy of the easiest money ever in order to combat what will become a bigger depression than the 1930s Ben is looking into new ways to drop Federal Reserve Notes all over the world.


Always remember that chairman Ben Bernanke has become the biggest and fastest money printer in the history of mankind by now, doubling the monetary base within a week. It took 95 years for the first 750 billion. Ben added the same amount last November.

The WSJ reasons that the Fed has to make a move because of the explosive growth of its balance sheet and the questionnable quality of its collateral.

What the WSJ does not ask is whether the continuation of the game of unlimited funny money is another desperate attempt to keep the biggest Ponzi scheme of all times running a little longer. Without ever expanding credit the whole FRN scheme is destined to fail as did ALL other unbacked fiat currencies before.

From the WSJ:

The Federal Reserve is considering issuing its own debt for the first time, a move that would give the central bank additional flexibility as it tries to stabilize rocky financial markets.

...Fed officials have approached Congress about the concept, which could include issuing bills or some other form of debt, according to people familiar with the matter.
It isn't known whether these preliminary discussions will result in a formal proposal or Fed action. One hurdle: The Federal Reserve Act doesn't explicitly permit the Fed to issue notes beyond currency.

Just exploring the idea underscores many challenges the ongoing problems are creating for the Fed, as well as the lengths to which the central bank is going to come up with new ideas.

At the core of the deliberations is the Fed's balance sheet, which has grown from less than $900 billion to more than $2 trillion since August as it backstops new markets like commercial paper, money-market funds, mortgage-backed securities and ailing companies such as American International Group Inc.

The ballooning balance sheet is presenting complications for the Fed. In the early stages of the crisis, officials funded their programs by drawing down on holdings of Treasury bonds, using the proceeds to finance new programs. Officials don't want that stockpile to get too low. It now is about $476 billion, with some of that amount already tied up in other programs.

The Fed also has turned to the Treasury Department for cash. Treasury has issued debt, leaving the proceeds on deposit with the Fed for the central bank to use as it chose. But the Treasury said in November it was scaling back that effort. The Treasury is undertaking its own massive borrowing program and faces legal limits on how much it can borrow.

More recently, the Fed has funded programs by flooding the financial system with money it created itself -- known in central-banking circles as bank reserves -- and has used the money to make loans and purchase assets.

Some economists worry about the consequences of this approach. Fed officials could find it challenging to remove the cash from the system once markets stabilize and the economy improves. It's not a problem now, but if they're too slow to act later it can cause inflation.
Moreover, the flood of additional cash makes it harder for Fed officials to maintain interest rates at their desired level. The fed-funds rate, an overnight borrowing rate between banks, has fallen consistently below the Fed's 1% target. It is expected to reduce that target next week.

...There are also questions about the Fed's authority.

"I had always worked under the assumption that the Federal Reserve couldn't issue debt," said Vincent Reinhart, a former senior Fed staffer who is now an economist at the American Enterprise Institute. He says it is an action better suited to the Treasury Department, which has clear congressional authority to borrow on behalf of the government.

I conclude the Fed is looking for ways to fuel future monetary hyper inflation in truly creative ways. This move comes only 2 months after the Fed had announced unlimited FRN refinancing in collaboration with other major central banks.

Bernanke is of the stubborn opinion that the last depression was a result of too tight monetary policy. While this may be true to a certain extent we have no reality based example that a zero interest rate policy has helped averting an economic downturn that stemmed from too much easy money in the first place. It was the Fed that refused to recognize the unsustainable property bubble. It appears this was not their first mistake and it will not be their last one.

This article has been reposted from The Prudent Investor. The full post can also be viewed on The Prudent Investor.

The Fed Seeks Ability To Issue Own Debt

The Fed can't get enough money from the Treasury to fund all their ventures, so what do they do? Simple, they request the authority to issue their own debt. If Congress approves this measure it would give the Fed even more power, an idea that should be at least a little scary to taxpayers. Tim Iacono from The Mess That Greenspan Made looks closer at this new development in his blog post below.

One of the great mysteries of our debt-fueled financial system in general and central banking in particular is exactly when it is that "money is printed", a phrase that is thrown around quite casually by far too many people when maybe it shouldn't be.

Our fractional reserve banking system effectively "prints money" each time a new loan is made. That much should be clear. With a ten percent bank reserve ratio, each new $1,000 in deposits can generate $10,000 in loans. Where does this extra money come from? It is created "out of thin air". That's the way banks work.

Up until late-2007, Wall Street's "shadow banking system" did something similar, however, it apparently had what amounted to a zero percent reserve ratio which is one of the major reasons that we have the crisis that we have today.

As for the U.S. government, "printing money" is performed by the Federal Reserve when it buys Treasury bills (or any other assets of questionable quality) and in return provides money that it creates "out of thin air".

This is generally frowned upon for obvious reasons.

Largely as a result of the willingness of our Asian trading partners to do so, the Fed has not needed to buy much U.S. debt in recent years, its balance sheet remaining fairly constant at around $800-$900 billion up until a few months ago when Lehman Brothers was allowed to fail and the downward spiral commenced.

As most everybody knows, the Fed's balance sheet is now almost $1.5 trillion bigger, prompting the question of where exactly this $1.5 trillion came from.

Well, some of it came from the Treasury Department but, as discussed last week, a good portion of this was simply "created out of thin air" and then exchanged with companies like AIG for one toxic asset or another.

It is all adding up very quickly and, with no end in sight for the current crisis, it should come as no surprise that the central bank is looking for ways to get even more money into the system without people all around the world wondering about where all the money is coming from.

According to this report in today's Wall Street Journal, it seems the Fed is now looking at issuing its own debt in order to bypass that cumbersome Congressional approval process for issuing Treasuries.

The Federal Reserve is considering issuing its own debt for the first time, a move that would give the central bank additional flexibility as it tries to stabilize rocky financial markets.

Government debt issuance is largely the province of the Treasury Department, and the Fed already can print as much money as it wants. But as the credit crisis drags on and the economy suffers from recession, Fed officials are looking broadly for new financial tools.

Fed officials have approached Congress about the concept, which could include issuing bills or some other form of debt, according to people familiar with the matter.

It isn't known whether these preliminary discussions will result in a formal proposal or Fed action. One hurdle: The Federal Reserve Act doesn't explicitly permit the Fed to issue notes beyond currency.

Just exploring the idea underscores many challenges the ongoing problems are creating for the Fed, as well as the lengths to which the central bank is going to come up with new ideas.

As Andre Agassi used to say, "Image is everything".

Why look bad when the rest of the world remains scared to death of global financial markets, more than willing to continue gobbling up U.S. debt at ridiculously low yields, and your only real problem is that your government can't authorize enough spending fast enough?

This article has been reposted from The Mess That Greenspan Made. The full post can also be viewed on The Mess That Greenspan Made.

Here Come More Interest Rate Cuts

Central banks from around the world are cutting interest rates in dramatic fashion in an attempt to curtail the financial crisis. If these record interest rate cuts will help remains to be seen, but it seems that the world's central bankers feel it is their best hope. Tim Iacono from The Mess That Greenspan made talks more about these rate cuts in his blog post below.

Now's not the time to be timid if you're a central banker or an elected official. Day after day they watch a once vibrant world economy sink deeper into an abyss caused by a massive credit contraction following the collapse of multiple asset bubbles.

Central banks all around the world were busy today slashing interest rates with abandon:

• Bank of England -------------- cut 100 basis points to 2.0 percent
• European Central Bank -- cut 75 basis points to 2.5 percent
• Sweden's Riksbank ---------- cut 175 basis points to 2.0 percent
• Bank of New Zealand ------- cut 150 basis points to 5.0 percent
• Bank of Indonesia ------------ cut 25 basis points to 9.25 percent
  

Earlier in the week, Australia's central bank cut short-term interest rates by 100 basis points to 4.0 percent and Thailand slashed by a full percentage point.

Tumbling home prices and a rapidly weakening economy have created a near state of panic in the U.K. that makes the situation in the U.S. somehow look tame by comparison. Short term rates have fallen by 300 basis points in less than two months and they now sit at their lowest level since 1951.

On the continent, the fifteen countries that use the euro got their biggest interest rate cut in the common currency's 10-year history as the central bank attempts to mop up after collapsing housing bubbles in Spain and Ireland while also dealing with major economic slowdowns in Germany and Italy. The French just announced a $33 billion stimulus package.

Herding cats has never been more difficult.

The Swedish central bank couldn't wait for their regularly scheduled mid-December meeting and hastily made their biggest rate cut in 16 years in an attempt to combat a recession that officially began two months ago. The government also announced a $4 billion stimulus plan.

In New Zealand, rates were slashed by a record 1.5 percentage points and Reserve Bank Governor Alan Bollard indicated there are more, smaller cuts to come. The kiwis entered a recession back in the first quarter of the year and short-term rates have been slashed from 8.25 percent over the summer to just 5.0 percent.

In Indonesia, both interest rates and inflation (~12%) are still quite high and the central bank has received some criticism for making its first rate cut in over a year. They were no doubt influenced by the full-point rate cut in Thailand a few days ago.

The day is still young - there may be more rate cuts to come.

This article has been reposted from The Mess That Greenspan Made. The full post can also be viewed on The Mess That Greenspan Made.

Homebuilders Next In Line To Beg For Bailout Funds

Detroit automakers recently received the cold shoulder from Congress on their quest for a piece of the $700 billion bailout pie; next in line are the homebuilders. Hopefully they will learn from the automakers and won’t fly to Washington in private jets to beg for these funds, although at this point it appears doubtful that their wishes will be answered anyway. The homebuilders are prepared to request an aid package estimated at $250 billion and aptly called “Fix Housing First”, according to the Wall Street Journal. The homebuilders are trying to convince Congress that the rest of the financial system will continue to deteriorate until home prices stabilize.

The “Fix Housing First” plan calls for two parts, a large tax credit for homebuyers and a government subsidy of mortgage rates. The tax credit that the homebuilders are proposing would equal 10 percent of the home’s purchase or $22,000, whichever is less according to the Wall Street Journal. The mortgage subsidy requested by the homebuilders would aim to bring interest rates on government backed 30 year fix loans down to 3 percent for loans made in the first half of 2009, and 4 percent for loans made in the second half of the year, according to the Wall Street Journal. The Wall Street Journal also notes that Realtors are pushing a 4.5 percent interest rate buy down for new mortgage loans. It is their estimation that for each 1 percent that rates fall, 500,000 to 800,000 additional homes could be sold.

It seems very unlikely that any variation of the “Fix Housing First” plan will get passed before Obama takes office, but once he does all bets are off. I seriously doubt that the plan would remain intact as is, but some variation of the proposal could be possible. There is a lot of support for the idea that the housing crisis is the underlying cause of the greater financial crisis, and most Americans are more likely to approve of measures that will aid the housing and mortgage markets before aiding banks and other financial institutions. We have been trying to prop up the financial industry for a long time, without much avail. Why not give housing a try?

Of course the problem is that this will simply artificially inflate housing prices yet again. We did that before and look where that has left us. If we are able to inflate housing prices, that will alleviate many of the problems plaguing the financial industry and homeowners alike, but it is not sustainable. Housing simply became too expensive, and it will become too expensive again if we inflate it, and the next time it will cost us even more to fix the fallout. Housing prices need to rise in correlation with a rise in income, which is the only sustainable way. I hope that Congress and the next administration know better than to rely on biased research when looking to spend hundreds of billions in taxpayer money.

Citigroup Bailout, Deflation And The Worldwide Financial Epidemic

The news of Citigroup's $300 billion bailout seems like déjà vu, and the scary word "deflation" that is being thrown around seems distant compared to everything else we are dealing with. The U.S. is not the only country with problems either, this is without a doubt a global financial epidemic. James Picerno from The Capital Spectator wonders, though, if the cure might be worse than the disease.

Have we seen this movie before? It certainly sounds familiar.

Once again, the government steps in to bail out a financial institution and Mr. Market takes kindly to the idea. Initially. But then reality sets in and the process starts anew. Perhaps it'll be a true sign of a bottom when the Feds engineer a bailout and the market tanks on the news.

But not yet. The latest installment of rescue revolves around the once mighty Citigroup. A giant among giants, this behemoth of financial behemoths surely fits the bill as too big to fail. If such a thing exists as a financial institution that must be saved at any cost, Citigroup looks like the poster boy for this idea.

Total assets for Citigroup were a bit more than $2 trillion in September. For those who like to keep score, that's roughly 14% of the annualized value of U.S. GDP for this year's third quarter.

The days of pulling another Lehman and letting a big bank fail are history. Better to bailout more rather than less and deal with the consequences later. The grand strategy here is that if the government bails out enough banks (and perhaps an auto company or two) while spitting out stimulus in various forms as far as the eye can see, the system will correct itself, or at least stop bleeding. At a time when deflationary risks are rising, this plan is considered prudent and timely by a growing swath of economists and voices from the peanut gallery, including yours truly. The risk of an even deeper implosion of prices and confidence must be avoided lest the vortex of deflation pull everything down the rat hole. Preventing deflation is the last battle in this horror film because once the big "D" takes hold, in sentiment and prices, the challenge becomes much, much tougher.

The problem is that no one's really quite sure if deflation with a big "D" is on our doorstep. Quite possibly it is, or so one could reason after witnessing consumer and wholesale prices fall last month on a scale unmatched since the government began keeping tabs on such things in the late-1940s. Waiting for definitive signs risks letting the monster out of the cage. Decisions, decisions. Nonetheless, there's a strong case for assuming deflation is coming. If we're wrong, we'll have more inflation on our hands than we otherwise would. But the world knows how to fight inflation, even if the political will is sometimes lacking. Attacking deflation, on the other, is another story.

Any way you slice it, there's bound to be more than a little disappointment and finger pointing in the months and years ahead. Indeed, no one should think that the necessary but risky strategy of preventing deflation is destined to end in triumph, or quick results. The stakes are high, in part because the government's moving quickly toward betting the house on a fiscal/monetary solution. On the opposing shore is the unwinding of excess, some of which has been decades in the making. When an immovable force meets government printing presses, the outcome isn't entirely clear.

All the more so if the world is looking for signs, one way or the other, by next Wednesday. It's difficult to gauge expectations as we run from one crisis to another. But this much is clear: the financial and economic problems will take time--years--to solve, and to the extent that the crowd thinks otherwise, the seeds of disenchantment have been planted.

The U.S. economy is sick, and getting sicker. Europe has the disease and Asia is at risk of contracting the same, albeit in a milder form. Looking back on the past five decades offers no clue for what may be coming. Growth has been a constant, according to GDP numbers from economist Angus Maddison, emeritus professor, University of Groningen (Netherlands). As the chart below shows, outright contraction is unknown in the postwar era.

Fifty years is a long time, virtually an eternity for mere mortals studying the past in search of clues about the future. It's all too easy to look at this track record and conclude that real declines in global GDP aren't possible, or are so unlikely as to be unworthy of considering. The IMF forecast, for one, still imagines more of the same with next year's estimate for real global GDP rising by a respectable if not impressive 2.4%.

Of course, the crowd used to think in persistent-growth terms for housing prices, and how they never fall on a year-over-year basis. Oh, sure, that happened in the Great Depression, but such episodes were dismissed as a thing from the past.

Perhaps it's time to consider the unthinkable. We've all received a crash course in just that over the last few months. But has the education so far been sufficient? Or do we still need to spend more time studying?

There are many dangers stalking the global economy, and at the top of the list is the assumption that the governments of the world can spend their way out of the slump on our collective doorstep. In the U.S. alone, the government now stands at the ready to spend $7 trillion--yes trillion with a "t"--to bring financial salvation to the system, according to Bloomberg News. That's the equivalent of three-and-a-half Citigroups, or half the U.S. economy. Scale no longer looks to be a stumbling block.

By spending enough money, governments are likely to keep inflation-adjusted global GDP floating somewhere above zero, if only slightly. That would still bring a fair amount of pain and repricing, but embedded in the expectation is the notion that a floor can be built under the crisis.

Perhaps, although at some point one might wonder if the cure will be worse than the disease. There are some awkward questions that will accompany the mother of all spending sprees now underway. First up: Is there some point at which additional government spending becomes counterproductive because a) it encourages future inflation on a scale that will be excessively burdensome; and/or b) the prospect of the government owning ever-larger chunks of the economy risks institutionalizing mediocrity or worse in the economy?

There are two great episodes of deflation in modern history, and each continues to raise questions about the associated lessons. Yes, spending is the only hope of sidestepping the beast, and if that means artificially engineered demand from the government, so be it. But it's not clear that the strategy leads to happy results all around. Meantime, there's more than one way to fight deflation.

That's not to say we shouldn't try to spend our way out of a deflationary trap. We should. We must. And we will. The risk is real this time, unlike the previous worries over deflation in 2001-2003. But the details of how we engage our anti-deflationary war may matter as much, if not more, as the decision to wage the war in the first place.

The dismal science has precious little experience with fighting deflation and so we must recognize that we may soon be caught up in an economic experiment on a scale that has little or no precedent. By all means, let's fight this war ferociously. But it also needs to be fought intelligently. What exactly do we mean by "intelligently"? We can't say for sure. No one can, and therein lies the greatest risk.

This article has been reposted from The Capital Spectator. The full post can also be viewed on The Capital Spectator.

Fed Preparing For Another Interest Rate Cut

With inflation concerns now being trumped by the fear of deflation, and the economy still struggling, the Federal Reserve is expected to cut the Fed Funds rate again during their next meeting in December. Kathy Lien examines this closer and shares her expectations in her blog post below.

US consumer prices dropped 1 percent last month, taking the annualized pace of growth to 3.7 percent, which is the lowest level since October 2007. Falling oil prices takes the credit for lower inflationary pressures with gasoline prices tracking the 50 percent decline in crude. Gas station receipts fell a whopping 14 percent and commodity prices have fallen in general, which has helped to push down transportation costs.

Although the core PPI numbers accelerated, core CPI dropped 0.1 percent and we expect it to head even lower. Less price pressure will give the Federal Reserve more room to cut interest rates. We expect the Fed to cut by another 50bp in December, but it is important to note that Fed Fund futures are pricing in a tiny chance of a 75bp rate cut next month.

The housing market continues to be one of the weakest links in the US economy. Housing starts fell to a record low while building permits dropped to the lowest level in close to 50 years. When you have an environment where foreclosures are rising at a very rapid pace, there is no desire by builders to break new ground.

This afternoon, we have the minutes from the latest FOMC meeting at which the Fed cut interest rates by 50bp to 1 percent. Given the continued concern reflected in Bernanke’s testimony to the House Financial Services Committee on Tuesday, the Fed is likely to support further easing.

All of the major currency pairs have been consolidating since the middle of last week and the FOMC minutes could be the trigger for a major breakout.

This article has been reposted from Kathy Lien. The full post can also be viewed on KathyLien.com.

Why Have Homeowners Been Forgotten?

As part of the latest directional shift in the allocation of the bailout funds being managed by Hank Paulson, it seems homeowners have once again been overlooked. The bailout funds which were originally intended to boost the lending markets have now been earmarked to boost bank balance sheets. Paulson and Bernanke seem much more concerned with propping up failing banks than homeowners at this point. Anthony Freed from Your Mortgage or Your Life even goes so far as to call them liars. You can read more about this in his blog post below.

Two months ago, in late September, I penned a piece titled Liars, and the Lying Lies They Are Telling You, which examined just one single publicly available FDIC document from 2002 which shows beyond any doubt that the Feds were not only aware of the problems in the finance industry that have led to near economic collapse today, they were already convinced that there would soon be dire repercussions.

Yet, today we have Treasury Secretary Hank Paulson and his mini-me Neel Kashkari, as well as a host of other top Federal officials, testifying under oath that the threats to our economic security were not immediately apparent until just months ago - hence the gun-to-the-head threats that produced the biggest bailout of private industry in history, while prescribing less governance on the application of those funds than is required to redeem a typical twenty-cent manufacturers coupon for kitty-litter.

Now we will see Barney Frank and others on the Hill posture and shuffle, as they feign attempts to look like they are in control of anything whatsoever, and they will act surprised that they had handed Paulson and his boy a blank check, and they is spending it as they sees fit.

Well, there should be no surprise there if they actually took the time to read the legislation they passed.

Paulson, who is overseeing the bailout program for the Bush administration, changed course and announced last week that the government would not use any of the money to buy rotten mortgages and other bad assets from banks. That had been the centerpiece of the plan when Paulson and Bernanke originally pitched it to lawmakers.

“Our assessment … is that this is not the most effective way” to use the bailout money, Paulson said at that time.

Instead, Paulson said the department would focus on rolling out a capital injection program to pour $250 billion into banks in return for partial ownership stakes in them.

The idea behind the capital injection program is for banks to use the money to rebuild reserves and lend more freely to customers. However, banks do have the leeway to use the money for other things, such as buying other banks or paying dividends to investors. That has touched a nerve with some lawmakers. Locked-up lending is a prime reason why the U.S. is suffering through the worst financial crisis since the 1930s. All the fallout from the housing, credit and financial crises have badly hurt the economy, which is almost certainly in recession, analysts say.

FDIC chief Sheila Bair continues to be the loan voice - I mean lone voice - advocating that some of the crumbs of the Bailout Cake be scattered in the direction of distressed borrowers who are, or will soon be, facing foreclosure.

In a break with the administration stance, Sheila Bair, chairman of the Federal Deposit Insurance Corp., who also will testify Tuesday, recently proposed using $24 billion of the bailout money to help some American households avoid foreclosure. So far, the Treasury Department has pledged $250 billion for banks and has agreed to devote $40 billion to troubled insurer American International Group(AIG Quote - Cramer on AIG - Stock Picks) — its first slice of funds going to a company other than a bank. That leaves just $60 billion available from Congress’ first bailout installment of $350 billion.

As much as I appreciate that there is at least one person in the Federal Government’s ivory tower who has some sense of the pain and heartache that the American Homeowner is facing, even if her advocacy basically ends with the gavel and the conclusion of the hearings.

The hearings may address a lot of things today, but the most important thing they will not address is who is responsible for letting us get into this terrible position in the first place? Are we and the now completely vegetative national press, really expected to believe that no one saw this entire catastrophe heading our way, when a simple Google search will produce hundreds of documents that show that version of the truth is ridiculously false?

In the article Liars, and the Lying Lies They Are Telling You, I featured testimony by Karen Shaw Petrou and others who were sounding the alarm repeatedly, exposing the vulnerabilities to the system posed by the nearly industry-wide use of risk-abatement models that only work in a market that never contracts.

That was a fatal strategy on the part of the financial industry. The notion that Federal Regulatory agencies were not aware of the risks is patently false. From 2002:

“The next panelist, Karen Shaw Petrou, Managing Partner of Federal Financial Analytics, had a considerably different take on the appropriateness of the Basel initiative. Ms. Petrou said that she has significant concern with Basel II, not because the individual pieces of it are necessarily wrong but because “nobody understands how it all works together.”

Ms. Petroustressed that reliance on models on which the Basel rules are based must be evaluated with tremendous caution and a careful look at the bottom line. She also highlighted problems with the operational risk rule. Reputation risk is not included in the Basel definition of operational risk for purposes of determining a capital requirement. As another weakness of the Basel II proposal, Ms. Petrou stressed the difficulty with relying on models.

She suggested that the Basel Committee move forward only with the provisions of the rule on which there is widespread agreement and considerable evidence of immediate need.”

In the article, I half-jokingly asked if any readers happened to know where Karen Shaw Petrou was today, and wheter or not she was available to take either Paulson’s or Bernake’s jobs. Well, a friend from OpenSalon.com - Tom Cordle - was curious enough to follow through, and what he found is gold: More proof that the Federal Regulatory Agencies charged with protecting the economy, the nation, and the American taxpayer from the reckless profiteering that is the nature of capitalism were at best asleep on the job - at worst they were completely complicit in the manufacturing of this crisis.

The long and short of it is - WE ARE BEING LIED TO REPEATEDLY, AND THE PROOF IS AVAILABLE TO EVERYONE - CONGRESS, THE PRESS, AND ALL OF US…

Trillions of dollars of our tax money to bailout foreign investors, and nothing for distressed homeowners but failed programs and broken promises. The bailout money is now being directed to the Credit Card companies and foreign investors, and the icing is that they want us to believe that they never imagined this could happen.

That is a bald-faced lie. The following is subsequent Congressional testimony from Karen Shaw Petrou, this time the pudding is from 2006:

Testimony Of Karen Shaw Petrou

Managing Partner

Federal Financial Analytics, Inc.

Before the Subcommittee on Financial Institutions and Consumer Credit

Committee on Financial Services

U.S. House of Representatives

September 14, 2006

This panel has led the way in recognizing the critical importance of the Basel risk-based capital rules, starting the policy debate in early 2002 with the first Congressional hearings on the rules long before many in the industry realized their critical importance. I was honored to testify then to offer views on the rules at that early stage and am grateful again now to outline ways to modernize the regulatory-capital requirements governing U.S. financial-services firms.

Sad to say, much of what I will say today is what I said in 2002 and at several later hearings on the proposal in the House and Senate. For example, in 2002, I urged the regulators carefully to consider the competitive implications of their rules. The House Financial Services Committee has pressed hard on this point and the agencies are now paying heed to it, but I fear that many aspects of the most recent proposal still do not address ongoing problems raised by the unique nature of the U.S. industry. It is different in many key respects from other national financial-services regimes, and U.S. rules must thus be carefully tailored to reflect U.S. reality.

There is, though, one key difference between 2002 and now: the Basel risk-based capital rules - for better or worse - are final everywhere else but here. Thus, we no longer have the luxury of pushing for a better international Accord. That is now final, and banks around the world will start to operate under it in January of 2007. This means not only that internationally-active U.S. banks will operate under anachronistic capital rules that place them at a disadvantage and that put the banking system at risk - that would be bad enough. However, it also means that foreign firms may have an undue capital advantage with which to enter the U.S. and acquire banks and other financial-services firms. As I said before this panel in May of 2005, M&A by global firms here is fine if it’s a fair fight. It isn’t fine, though, if our domestic institutions are gobbled up by foreign competitors able to engage in “regulatory arbitrage” solely because we can’t make up our minds on our capital standards.

What are the key U.S. financial-system realities that must be kept carefully in mind as new capital rules are finalized? Put very simply, they are:

• We are facing emerging financial risks, most notably in housing and mortgage markets. We can debate all day long if the housing “bubble” will burst or fizzle, but we know for sure that U.S. consumers are highly leveraged and are making use in unparalleled fashion of high-risk mortgage products. The current Basel I rules applicable to all U.S. institutions woefully under-capitalize high-risk assets, creating a regulatory incentive for banks to hold them. Getting the risk right in risk-based capital is not just an issue for model builders. It’s a critical challenge to protect the FDIC and the economy more generally.
• In the U.S. bank regulatory capital rules cover only insured depositories and a subset of parent holding companies. We have a wide range of charter options, the consolidated supervised entity (CSE) importantly among them, that permit astute companies to pick and choose among the charters. Outside the U.S., almost all firms fall under the Basel rules, eliminating much of the competitiveness concerns critical in the U.S. The Basel rules as now finalized may be good, bad or indifferent, but they will apply with few distinctions outside the U.S., ensuring the proverbial “level playing field.” We will have a most uneven one - with dangerous systemic-risk ramifications - if the final U.S. bank capital rules do not reflect our charter and supervisory diversity. The proposed operational risk capital standard is particularly problematic in our competitive and legal reality.
• We have a unique capital requirement, the “leverage” standard proposed now to continue under the Basel IA and II regimes. Advocates of leverage argue that it will counteract possibly risky drops in regulatory capital. However, the leverage standard, while providing false comfort, exacerbates the charter disparities noted above because it applies only to some financial-services players, not to all of them. It is, further, no panacea for the problems in Basel. This panel will well remember the thousands of banks and S&Ls that failed in the 1980s and early 1990s even as the leverage standard applied to each and every one of them.
• We have thousands of banks, savings associations and credit unions - not just the four or five big players that dominate most other markets. Initial plans simply to ignore all but the biggest U.S. banks in the Basel rules have rightly been shelved, but the current proposal still has unnecessary restraints on what size institution may choose which capital regime. Each insured depository and, when applicable, holding company should choose the rules it thinks are right for it, not have that choice defined by its regulators. Supervisors have full powers - actually expanded under the Basel proposals - to intervene and add more capital if they think an institution’s choice is risky.

With these thoughts in mind, I offer and urge the following recommendations related to the Basel rules in the U.S.:

• First, we need to get our rules in place as fast as possible. If we can’t make up our minds on the more complex issues, leave them aside and finalize at least the simpler, “standardized” sections of the rules (revised for U.S. mortgage and other issues as necessary) and the Basel IA requirements. As noted, the current Basel I rules encourage risk-taking because there is no regulatory capital penalty for it. A simple rewrite that better equates risk-based capital to risk is urgently needed, and debate over the fine points of these highly-complex rules should not deter action on their key points on which there is, in fact, broad general agreement.
• Second, we should not cling to the leverage standard in hopes that it will protect us from “undue” capital drops. I very much doubt that risk-based capital under Basel II would drop here in anywhere near the amounts suggested by the fourth quantitative impact study, which was based on top-of-the-cycle numbers and back-of-the-envelope estimates. Putting banks and their holding companies through all of the hoops and all the added expense of the Basel rules and then slapping the leverage standard atop them undermines the entire point and purpose of the Basel standards and - importantly - is far from the guarantee of safety and soundness hoped by those now pushing for retaining the leverage standard. It should be discarded - especially for holding companies - and regulators should rely on their own powers and market discipline to press banks that might consider unwise capital reductions to think again.
• Third, the U.S. rules should not include an operational risk-based capital (ORBC) standard. The Basel IA proposal rightly does not include this and it should similarly be omitted from the Basel II rules. While this will put the U.S. Basel II rules at still more variance with the international Accord, it is necessary because of the lack of any agreed-upon methodology or measurement systems for operational risk. Worse still, a focus on ORBC will distract both banks and supervisors from urgently-needed disaster preparedness and contingency planning - capital is no substitute for back-up systems and advance planning as was made all too clear after September 11 and Hurricane Katrina.
• Finally, we must make up our mind and move forward. All of the benchmarks, caveats, limits and questions in the Basel II rules create wholesale uncertainty about what capital rules will apply when to whom. As noted, U.S. banks operate in the real world of aggressive competitors at home and abroad. We have proposed imposing not only new risk-based capital standards, but also new powers for regulators to buttress these - Pillar 2 - and new disclosure standards - Pillar 3 - to enhance market discipline. Far too little attention has been paid in the current debate to these critical elements of the overall Basel framework - indeed, they are almost unmentioned in the current notice of proposed rulemaking. Rightly structured, however, these two additional pillars will give U.S. regulators all the tools they need to ensure that capital is right for each bank under their purview without forcing institutions into the one-size-fits-all leverage standard, benchmarks, and other constraints on Basel now under consideration.

In conclusion, Basel critics might wish none of this had started and the U.S. could just get back to Basel I as is. This is understandable given all the flaws in the initial proposal and all the problems to which regulators turned a deaf ear for so long. However, it is critical to remember that Basel I as is rewards risk-taking and the leverage standard as is will do nothing to constrain this. It is also vital to remember that major competitors at home and abroad are now or will soon come under a more risk-sensitive capital regime with no leverage standard. Each and every one of these firms is a major force to be reckoned with in the U.S. whether or not it chooses to become a bank under the Federal Reserve’s domain or headquarter itself here.

Thus, Basel II is here like it or not. Charters will be selected and deals done based on it, like it or not. The longer U.S. banks are kept under Basel wraps, the fewer of them there will be under our traditional regulatory framework. The longer Basel I is in place, the riskier our banking system will be - leverage standards now have no meaningful impact on risk other than to encourage taking it. Unless Congress is prepared to rewrite our rules and force all banks - big and small - and all competitors under the same capital regime - a major challenge that would keep Congresses busy for years to come - U.S. banks cannot be the last ones allowed to come under modern, risk-sensitive regulatory capital standards.

This article has been reposted from Your Mortgage or Your Life. The full post can also be viewed on yourmortgageoryourlife.wordpress.com.

Bailout Plan Changes Again

All the hype about Treasury Secretary Henry Paulson’s wonderful plan to save Wall Street and the financial system by purchasing troubled assets is now officially over; the plan has changed. Officials have apparently come to the conclusion that buying these assets will not help in the immediate future, and they need results now. Instead, they plan to continue buying stakes in the financial institutions and encourage them to resume lending, according to the Associated Press. I don’t know about you, but I think this is just a way for the administration to save face while admitting they were wrong in the first place.

I don’t think too many people were thrilled about Paulson’s original plan to buy up the toxic assets from banks--well, other than the bank executives and shareholders. That plan was severely flawed because it offered little upside to taxpayers and required too little accountability on the part of banks. Many people have speculated that Paulson cares more about the banks then taxpayers. I’m not going to make an argument for that one way or another, but I think the current plan of buying bank shares is much better. At least this offers taxpayers some level of upside and allows us to have a say in things such as executive bonuses and so on.

It will be interesting to see how the bailout continues to morph. They have been holding out on offering aid to the auto makers and financiers thus far, but how much longer can they hold out? What about other companies? American Express was allowed to become a bank and is now seeking $3.5 billion in government assistance (everyone should have seen that one coming). Where will they finally draw the line? Many companies and industries are going to be hit hard during this recession and they will all want a piece of the government handouts. I would imagine that this won’t be the last time we are talking about a change in strategy for the bailout, especially considering that we will be looking at a new administration soon.

Fed Concealing Information On $1.5 Trillion In Loans; Bloomberg Files Lawsuit

Bloomberg is filing a lawsuit, under the Freedom of Information Act, in an attempt to acquire information from the Federal Reserve on approximately $1.5 trillion in loans that the Fed has issued to banks. Specifically they want to know what type of collateral the Fed has been taking on these loans. The Fed does not want to disclose this information, though, and is prepared to fight to keep the information private. This should be very alarming to taxpayers. Toni Straka from The Prudent Investor dives deeper into the issue in his blog post below.

Information provider Bloomberg has started a fight with the Federal Reserve that may turn some stones in the secretive private organization that has never been audited.

Bloomberg had asked the Fed to see documents concerning the collateral the Fed accepts in exchange for freshly digitized credit in its bailouts. The Federal Reserve first insisted a Freedom Of Information Act (FOIA) request and then said the data required is from the Fed New York which does not fall under the FOIA.

A 9-shot salute goes to nakedcapitalism which was the first blog to break this important story. In a sarcastic lead Yves Smith (or Ed Wright) write up the most important points:

In case you somehow managed to miss it, our friendly pawnbroker of last resort (central bank) has been taking lots of crap (collateral) in return for loans under its alphabet soup of facilities. As we are learaning in our housing meltdown, collateral may not prove to be worth as much as it was said to be at the time the loan was made. Inquiring minds are curious as to what, exactly the Fed has taken, particularly as the numbers are becoming stratospheric.

Bloomberg has asked nicely for some of this information, and is now being forced to sue under to the Freedom of Information Act, and the Fed intends to fight! This ought to be a scandal, but after the TARP, the electorate is seems resigned to taxpayer money being thrown at floundering financial enterprises with little in the way of checks or prudence. If the Fed indeed was taking conservatively valued collateral as it has always claimed it was, there would be no reason for it to attempt to squash this request. The Fed's argument, as I infer, is the loans were made by the Federal Reserve Bank of New York, which isn't a federal agency and thus not subject to the FOIA.

David Merkel's Aleph Blog was quick to come up with five reasons for the Fed's secrecy, all of them most alarming for believers in a free market system. Headlining "What Do You Have To Hide" he lists the following:

1. The Fed is breaking its own rules, and lending on collateral that it publicly said that it wouldn’t lend against.
   
2. They are playing favorites with institutions, and don’t want that to be revealed.
   
3. The assets in question are technically in compliance with the rules of the Fed, but are worth far less than the amount loaned against them.
   
4. Certain banks would be embarrassed by revealing what they own.
   
5. It’s just a power game, and the Fed thinks it is above the law, particularly during a crisis (that it helped to cause).
   

The reporters committee for freedom of the press has some technical details on the lawsuit Bloomberg has filed.

Bloomberg News filed a Freedom of Information Act lawsuit against the Federal Reserve system Friday, seeking documents related to the financial services crisis, the news service reported.

The suit, filed in federal court in New York, asks for documents the government says are held by the Federal Reserve Bank of New York. The bank, one of a dozen in the Federal Reserve system, has not complied with FOIA because it has not been considered a government agency.

In contrast, the Federal Reserve Board of Governors in Washington is subject to FOIA. However, the bulk of the documents Bloomberg wants are housed at the New York bank, the Fed told Bloomberg.

According to Bloomberg, the Fed has made loans totalling $1.5 trillion to banks, not including the $700 billion bailout package. Bloomberg is seeking information on the collateral the banks posted for the loans. The news service’s FOIA requests have gone unanswered.

Creditwritedowns joins the team of Fed bashers, publishing the Bloomberg story on the topic and peppering it with criticism on the Fed's overly secretive style that should be a thing of the past.

For those of you concerned about the Fed's risky behavior, its ballooning balance sheet, and its acceptance of dodgy collateral, well you may be about to see whether the American democracy can allow this unchecked power to continue without oversight. Bloomberg News has sued the Federal Reserve to force them to reveal what kind of collateral they are accepting in loaning out trillions of dollars to U.S. banks.

The Federal Reserve, a quasi-government body (which strictly speaking is a private corporation in that it is owned by member banks), has been accepting assets of ever more dubious quality in a bid to liquify the U.S. banking system. Moreover, their efforts should be considered highly inflationary and a long-term threat to the value of the U.S. dollar and to the American economy.

The Fed balance sheet is expected to balloon to $3 trillion by the end of the year, up from $900 billion in August -- a rise in the Fed’s balance sheet from 6% of GDP to more than 20% of GDP in four months. In Japan, which was known for quantitative easing during its own deflationary crisis, the central bank’s balance sheet rose progressively from 9% of GDP to 29% of GDP. But this was over ten years from 1994 to 2004. At the current pace, the Fed might do in six months what it took ten years to do in Japan. Amazing.

Bloomberg had published this story last Friday (sorry, can't find a link:)

Bloomberg News asked a U.S. court today to force the Federal Reserve to disclose securities the central bank is accepting on behalf of American taxpayers as collateral for $1.5 trillion of loans to banks.

The lawsuit is based on the U.S. Freedom of Information Act, which requires federal agencies to make government documents available to the press and the public, according to the complaint. The suit, filed in New York, doesn't seek money damages.
"The American taxpayer is entitled to know the risks, costs and methodology associated with the unprecedented government bailout of the U.S. financial industry,'' said Matthew Winkler, the editor-in-chief of Bloomberg News, a unit of New York-based Bloomberg LP, in an e-mail.

The Fed has lent $1.5 trillion to banks, including Citigroup Inc. and Goldman Sachs Group Inc., through programs such as its discount window, the Primary Dealer Credit Facility and the Term Securities Lending Facility. Collateral is an asset pledged to a lender in the event that a loan payment isn't made.

The Fed made the loans under 11 programs in response to the biggest financial crisis since the Great Depression. The total doesn't include an additional $700 billion approved by Congress in a bailout package.

Fed's Position
Bloomberg News on May 21 asked the Fed to provide data on the collateral posted between April 4 and May 20. The central bank said on June 19 that it needed until July 3 to search out the documents and determine whether it would make them public.

Bloomberg never received a formal response that would enable it to file an appeal. On Oct. 25, Bloomberg filed another request and has yet to receive a reply.

The Fed staff planned to recommend that Bloomberg's request be denied under an exemption protecting "confidential commercial information,'' according to Alison Thro, the Fed's FOIA Service Center senior counsel. The Fed in Washington has about 30 pages pertaining to the request, Thro said today before the filing of the suit. The bulk of the documents Bloomberg sought are at the Federal Reserve Bank of New York, which she said isn't subject to the freedom of information law. "This type of information is considered highly sensitive, and it would remain so for some time in the future,'' Thro said.

The Fed didn't give Bloomberg a formal response because "it got caught in the vortex of the things going on here,'' said Michael O'Rourke, another member of the Fed's FOIA staff.

The case is Bloomberg LP v. Federal Reserve, U.S. District Court, Southern District of New York (Manhattan).

While this story is in itself highly interesting as it contradicts chairman Ben Bernanke's earlier vows to lead a more transparent Fed it could be the beginning of the dismantling of the Fed's untouchable aura.

In his book "Secrets of the Temple" - the most extensive work about the Fed - William H. Greider highlights the opaque legal status of the Federal Reserve that is neither federal nor has any reserves (besides unlimited fiat currency) but takes the best from both worlds to keep ist doors closed to the public. Being the biggest fiat money creator in the world the Fed has never been audited, controls itself and does not even publish a balance sheet that would fulfill the expected norms.

Republican congressman Ron Paul has repeatedly called for an audit of the Fed and the abolition of the USA's third central bank. As the Fed's most important tool is to set the price of money via interest rates and recalling all its blunders it is most interesting that the constituionality of the Fed has never been challenged in court although the constitution says in Article 1, section 10:

No State shall ... coin Money; emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts....

Story developing...

This article has been reposted from The Prudent Investor. The full post can also be viewed on The Prudent Investor.

Haven’t We Already Bailed Out AIG Twice? Well, Here We Go Again…

This morning the federal government announced that it is was going to inject additional capital into AIG and restructure the existing debt as part of a new bailout to save the troubled insurance giant AIG. For those not familiar with the situation, the government had originally offered AIG a lifeline loan of $85 billion, only to later pony up an additional loan of $37.5 billion when it became clear that the company needed more. Now the government is giving them another loan, this one nearly $30 billion. In addition, as part of the deal, the government is lowering the interest on the previous loans and extending the repayment term from two years to five years, according to the Associated Press. What it boils down to is that AIG didn’t want to have to fire sell their assets in order to pay back the government loan, so instead of forcing them to do so, the government offered up even more money and agreed to ease the terms on the previous loans. Is your head spinning on this one, too?

This would essentially be the equivalent of me going to the bank and saying I’m not going to be able to pay my mortgage anymore, so can I get a loan to stay afloat for awhile till things get better? They say yes, but then a little while later, I go back for more and they again say yes. But that still isn’t enough, so I go back a third time and when they ask me about other assets, I tell them sure, I have a 2008 Escalade fully paid for, but I wouldn’t dare sell it right now because the SUV resale market just isn’t good. Because the bank didn’t want to force me to make this sacrifice, they decided to give me yet another loan and make the terms easier on my previous ones. Does this scenario sound a little farfetched? I certainly don’t know any banks that would ever agree to terms on the first loan, let alone more down the road; that would be bad business. Now obviously in the real world, the AIG scenario isn’t quite as simple, considering how huge the company is and the fact that the government now has ownership interest in it, but the decision to inject the business with additional taxpayer capital when there are alternative ways the company could have raised the money is concerning to me.

I was just reminded of a Saturday Night Live clip from a while back, after AIG was infused with the second loan of $37.5 billion. In the segment “Oh Really” on Weekend Update, which skewers the news, they drill AIG about the executive retreat and then transition into the “Oh My God Are You Serious?” segment, where they are completely dumbfounded at why the government would give AIG more money. The clip is funny and definitely applicable to the situation at hand. The clip below is for the entire Weekend Update segment, but if you skip to about 2/3 of the way in--when there are around 2 minutes remaining--that is where the “Oh Really” portion starts.

Central Banks Around The World Continue With Rate Cuts

Last week the U.S. cut their Fed Funds rate by 0.5, and now the rest of the world is following right behind issuing rate cuts of their own. Tim Iacono from The Mess That Greenspan Made looks closer at these interest rate cuts and evaluates what that mean for Gold.

Quarter-point interest rate cuts seem so passé in the new world financial order. It seems that, if you're going to cut interest rates, you need to cut by at least a half-point, otherwise your central banker friends are going to laugh at you.

In the ongoing game of competitive currency debasement, the Bank of England made a bold move this morning in pushing lending rates to their lowest level since 1955, shocking world markets with a cut of 1.5 percentage points - from 4.5 percent to 3.0 percent.
That made the half-point cuts by the European Central Bank and Switzerland's central bank look downright wimpy by comparison.

The BOE leapt past the euro-zone where interest rates are now 3.25 percent and looks intent on catching up to the Swiss in short order where the key lending rate now stands at 2.0 percent. Then it's on to the Americans where the Fed funds rate is 1.0 percent and perhaps even Japan, where interest rates have not exceeded one percent for many years.

As has been the case for months now, all of this slashing of rates in Europe has made the U.S. dollar stronger by comparison and, on one of those rare days when the dollar and precious metals move together, gold and silver have posted even bigger gains.

The much lamented, negative correlation between the U.S. dollar and gold looks like it will be put to the test in the period ahead - and for good reason.

A rising U.S. dollar - a currency that only looks less bad than all of the world's other paper money at this time - provides no fundamental reason why the gold price should move lower.

On days like today, the real fundamental relationship is once again on display - gold is rising against all of the world's currencies, as it should.

While there are many factors that contribute to the dollar-gold relationship, it is sometimes maddening to watch central banks around the world make money cheaper and cheaper in an effort to pull the global economy up out of its nosedive, while nature's money just sits there and goes along for the ride.

Gold deserves better than that.

After all, the nosedive of the global economy was rooted in the reckless expansion of money, credit, and its various Wall Street offshoots which can be collectively termed "cheap money", and as it becomes increasingly clear that the cause and the cure can not be one-and-the-same, gold should continue to shine.

With the world's bankers and economists having failed so badly in stewarding paper money into the new century, there is increasing talk of a Bretton Woods II or some other "improved" monetary system where precious metals and/or other commodities may play a role.

Yes, they'll go kicking and screaming back onto a "commodity-backed" currency, but one look around the world today should make clear that we are not yet ready for a global system of pure fiat money - we may never be ready.

This article has been reposted from The Mess That Greenspan Made. The full post can also be viewed on The Mess That Greenspan Made.

Former Bear Stearns Chief Risk Officer Hired By Fed

In a bit of a surprising twist the New York Fed hired the former chief risk officer at Bear Sterns. This has obviously caused a bit of an uproar among the public. University of Oregon economics professor Mark Thoma discusses the move in more depth below in his blog post from the Economist's View.

This doesn't inspire much confidence:

You may make a mess, but please don't try to clean it up by Barbara Kiviat: It's hard to believe, but people are starting to express outrage over the New York Fed hiring the former chief risk officer of Bear Stearns to help supervise banks. To be fair, I feel like I should acknowledge that it would be practically impossible to clean up this mess without employing some of the people who created it. ...

To be fair again, I feel like I should go back and see what, exactly, Michael Alix has been saying these past few years. Just because he was running risk management at Bear Stearns when the company collapsed from a lack of sound risk management doesn't necessarily mean he was sitting idly by. ...

So I did a little rooting around, and found this June 2006 BusinessWeek story about Wall Street's "culture of risk" for which Alix was interviewed. An excerpt:

Yet for all the risks they're taking on, banks insist they're safer than ever. They've hired many of the greatest mathematical minds in the world to create impossibly complex risk models... "Right now everything on my screen is flashing red," said Michael Alix... But "that doesn't make me nervous"... The bank has built such powerful computing systems that Alix can reevaluate every day the risks of thousands of positions across the firm's trading businesses under various stressful scenarios to be sure the firm doesn't hold too much of any risky investment at any one time. That type of analysis used to take a week to complete. "The machine works," he says.

This, we now know, didn't work so well.

It seems that as chairman of the Securities Industry Association's risk management committee, Alix was also an important part of the effort to convince regulators that investment banks didn't need to hold nearly as much capital as their commercial bank brethren. Here's a letter he wrote to the Federal Reserve's board of governors in August 2003...

This, we now know, didn't work so well, either.

But my favorite thing I found in my rooting around was Alix's June 2004 House testimony on the topic of Basel II. One of the reasons investment banks should be allowed to use more leverage, he said, was because of the protective qualities of mark-to-market accounting...

This, we now know, not only didn't work so well, but is also, we're told, causing a lot of the problems we're having.

Look, I don't envy the position the New York Fed is in. I have the luxury of not having to go out and hire people who 1) deeply understand the operations of finance firms, and 2) are willing to take a job in the public sector. At the same time, I'm guessing I'm not the only person a little squinty-eyed over this one...

This article has been reposted from the Economist's View. The full post can also be viewed on the Economist's View.

What Can The Fed Do Now About The Housing Crisis?

The housing crisis that is plaguing the United States seems only to be getting worse. Does Bernanke, or any other government official for that matter, have the answer? Toni Straka at The Prudent Investor looks more closely at the situation in his post below.

Halloween started early this year with a televised speech by the Fed's bearded chairmen Ben Bernanke. Recognizing that the problems in the biggest debt bubble of all times are far from over, Bernanke appeared helpless when offering several options for the future of the government sponsored entities (GSE) Fannie Mae and Freddie Mac.

The reorganization of the two mortgage giants, saddled with so many debts in default that no one can quantify reliably due to a lack of proper accounting, can take several ways.

Obviously addressing US policymakers, Bernanke presented four possibilities for the future role and organization of Frannie. The first one is rather wishful thinking: Returning the two GSEs to their pre-conservatorship status quo.

According to a Reuters dispatch from Friday, one in five homeowners sits on negative equity and it is going to get worse:

Nearly one in five U.S. mortgage borrowers owe more to lenders than their homes are worth, and the rate may soon approach one in four as housing prices fall and the economy weakens, a report on Friday shows.

About 7.63 million properties, or 18 percent, had negative equity in September, and another 2.1 million will follow if home prices fall another 5 percent, according to a report by First American CoreLogic.

The data, covering 43 states and Washington, D.C., includes borrowers nationwide, even those who took out mortgages before housing prices began to soar early this decade.

Seven hard-hit states -- Arizona, California, Florida, Georgia, Michigan, Nevada and Ohio -- had 64 percent of all "underwater" borrowers, but just 41 percent of U.S. mortgages.

As if this was not enough, Marketwatch raised concerns that nothing influences people's investments more than the change of value of their house.

Consumers react more to changes in their home values than changes in their investment portfolios, according to a recent study.

In fact, real estate economists at UCLA and the University of Southern California found that a 10% decline in housing wealth from the 2005 highs would result in a $105 billion, or 1.2%, drop in personal consumption expenditures. That 10% decline in home values translates to roughly a 1 percentage-point reduction in real GDP growth, researchers said. Read the report.

One of Bernanke's other options looks DOA when checking the state of markets. A true privatization is simply not in the cards after a 99% decline in the share price of Fannie and Freddie.

Elaborations about copycatting the European system of covered mortgage bonds may bring its problems too at a time when trust between lenders has reached an all-time low as it is demonstrated by the essential seize-up of interbank markets for more than a year by now.

This leaves Bernanke's last option: Bringing the GSEs under Uncle Sams rule, with or without additional shareholders. Taking it from the recent past where the former champion of free market ideology has made a bizarre U-turn with several acts of Fedization I would not wonder if this will also be the future of Frannie.

Seeing that Bernanke offers options without favoring one of them I am afraid that it is not Bernanke who will solve the mess that Greenspan made. Thinking about Treasury secretary Hank Paulson's recent moves that cost the taxpayers basically another $70 billion in bonuses for his friends on Wall Street and had them pay almost double the price for some bank shares it is most likely we will see another round of more government in everything.

Somehow the American economy reminds me of the twists in the life of Joseph A. Schumpeter, an economist who coined the term "creative destruction" 90 years ago, favoring a laissez-faire capitalism over any government intervention. Schumpeter did not fail to recognize the signs of his times. In a speech held in Tokyo in 1932 Schumpeter had already shifted his perception towards permissible protectionism.

10 years later, in 1942, Schumpeter had morphed into a socialist. In his late work "Capitalism, Socialism and Democracy" Schumpeter declared that capitalism had no chance of survival, praising Karl Marx' theory on socialism which offered a more flexible approach to the headwinds any system will encounter. Will the same happen to the USA?

This article has been reposted from The Prudent Investor. The full post can also be viewed on The Prudent Investor.

Federal Reserve Invoking Serious Monetary Inflation

The U.S. Federal Reserve is trying everything right now to fix the financial crisis. The latest plan, as outlined below by Toni Straka at The Prudent Investor, involves sending billions of dollars to foreign countries around the world. The end result of all this is going to be severe monetary inflation, read on...

Only 75 minutes after the Federal Open Market Committee (FOMC) slashed Fed Funds half a point to the lowest recorded level of 1%, chairman Ben Bernanke started his money dropping helicopter fleet in order to shower the world with another $120 billion. This time it is the central banks of Brazil, Mexico, Singapore and South Korea that will receive up to $30 billion each in newly established swaplines.

A Fed press release states that each country will enter into $30 billion swaplines with the Fed,

in order to help improve liquidity conditions in global financial markets and to mitigate the spread of difficulties in obtaining U.S. dollar funding in fundamentally sound and well managed economies.

In response to the heightened stress associated with the global financial turmoil, which has broadened to emerging market economies, the Federal Reserve has authorized the establishment of temporary liquidity swap facilities with the central banks of these four large and systemically important economies. These new facilities will support the provision of U.S. dollar liquidity in amounts of up to $30 billion each by the Banco Central do Brasil, the Banco de Mexico, the Bank of Korea, and the Monetary Authority of Singapore.

The Fed has now established swaplines with 14 central banks responsible for 28 countries in order to market its only product: Federal Reserve Notes (FRNs) that are backed by nothing than the belief that today's FRN will buy you the same amount of goods and services in the future.

The other central banks helping to fly the FRN helicopters are the Reserve Bank of Australia, the Bank of Canada, Danmarks Nationalbank, the Bank of England, the European Central Bank, the Bank of Japan, the Reserve Bank of New Zealand, the Norges Bank, the Sveriges Riksbank, and the Swiss National Bank.

IMF Will Dish Out Still More FRNs
In its efforts to flood the whole world with FRNs the Fed

welcomes the announcement today by the International Monetary Fund of the establishment of the Short-Term Liquidity Facility, which is designed to help member countries that are facing temporary liquidity problems in the global capital markets. The Federal Reserve is supportive of the IMF's role in helping countries address and resolve their ongoing economic and financial difficulties.

Jumping to the IMF website one finds more details how the IMF will dish out more FRN loans all over the world with the newly established Short-Term Liquidity Facility (SLF). This comes one day after the IMF warned that Latin America would not escape the global turmoil.
According to the release members can borrow up to 500 percent of their quota.

Quoting IMF head Dominique Strauss-Kahn the new facility is a better design than usual standby agreements. He said the IMF would use its full financial force to stem the crisis.
Here are the details of the SLF:

• Purpose. Provide large, upfront, quick-disbursing, short-term financing to help countries with strong policies and a good track record address temporary liquidity problems in capital markets.
  
• Eligibility. Countries with a good track record of sound policies, access to capital markets and sustainable debt burdens may qualify (the IMF's standard debt sustainability analysis should indicate a high probability that both public and private debt will remain sustainable). Policies should have been assessed very positively by the IMF's most recent country assessment.
  
• Conditions. Financing is made available without the standard phasing and loan conditions of more traditional IMF arrangements. However, borrowers are expected to certify that they are committed to maintaining strong macroeconomic policies.
  
• Size of loan. Disbursement of IMF resources can be up to 500 percent of quota, with a three month maturity. Eligible countries are allowed to draw up to three times during a 12-month period.

Altogether it appears as the global banking machine requires more and more grease with every week but the engine is sputtering worse than at the beginning of the credit crisis.

We have entered the stage where even hundreds of billion of freshly created money will not be enough to deflate the biggest credit bubble in an orderly way.

Stocks reacted to the news of the rate cut in a classical "buy the rumour, sell the news" fashion. Early gains fizzled away as soon as the widely expected rate cut was announced as was the case after a second late bounce.

The near 10% advance in crude oil signals that commodities are again bought as as an inflation hedge.

Make no mistake: Only because recent inflation figures looked better than in summer does not mean that all this poisonous "liquidity" will not result in monetary inflation. What we see here is monetary inflation by the textbook and it will be felt dearly within the next 12 months. Central banks have gone wild since they found themselves behind the curve, rather following the wishes of Wall Street than insulating the inflation virus and absorbing all the liqudity that allowed the leverage excesses of this millennium.

Oh, and by the way; IMHO gold as the oldest inflation hedge has seen its low of the year with a very high probability based on the fundamentally bad outlook.

This article has been reposted from The Prudent Investor. The full post can also be viewed on The Prudent Investor.

Fed Cuts Interest Rates By 0.5 Percent

The Federal Reserve followed through today on expectations once again, cutting interest rates by 0.5 percent. Tim Iacono from The Mess That Greenspan Made looks closer at the latest interest rate cut, and compares it to past cuts.

With today's half-point cut to short-term interest rates, the Federal Reserve is once again back out "in front of the curve"... well, at least in front of the curve from a few years ago.
This morning's announcement that the Fed has once again lowered short-term interest rates to the freakishly low level of 1.0 percent was widely expected, particularly since the effective Fed funds rate has been below that level for weeks now, averaging just 0.82 percent since October 10th.

here were some major changes to the policy statement as shown below. In fact, Compare It!, the software program used to detect subtle changes to the wording was stymied, finding many, many more differences (in red) than similarities (in blue).

It's good to know that certain passages have remained unchanged - that "the Committee expects inflation to moderate" and they "will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability".

As for what has changed, there is a rather sobering assessment of the current state of the rapidly deteriorating economy with special emphasis given to the slowdown in consumer spending and business spending.

They really do "monitor economic and financial developments" and "act as needed".

This article has been reposted from The Mess That Greenspan Made. The full post can also be viewed on The Mess That Greenspan Made.

Fed Funds Rate Cut Expectations

Tomorrow the Fed will announce whether or not it decided to lower interest rates, and if so, by how much. Pretty much everyone is expecting a cut to the Fed Funds rate, but they are split on how much it will be. Currency expert Kathy Lien looks more closely at tomorrow's big announcement and adds some well found advice for investors in her post from KathyLien.com.

The biggest event risk this week is undoubtedly the Federal Reserve’s monetary policy decision on Wednesday. Now more than ever, the Fed’s decision could turnaround the currency and equity markets. Since the last interest rate cut by the central bank on October 8th, the dollar has rallied more than 8 percent and the Dow Jones Industrial Average has fallen by more than 10 percent. The Fed’s half point rate cut at the time was a part of a coordinated effort with central banks from around the world including the ECB, the Bank of Canada, the Bank of England and the Swiss National Bank. With US interest rates now at 1.50 percent, the Fed will need to start rationing rate cuts going forward unless they want to take interest rates to zero.

Going into the FOMC meeting, economists can’t seem to agree on how much the Federal Reserve will cut interest rates. Of the 64 economists surveyed by Bloomberg:

53 percent expect a 50bp rate cut
26.5 percent expect a 25bp cut
19 percent expect interest rates to remain unchanged
1 lone economist or 1.5 percent of the people polled expect a 75bp rate cut.

Fed Funds traders appear to be more optimistic as they have already priced in 50bp of easing for Wednesday with a 32 percent chance of a 75bp rate cut.

The recent strength of the US dollar will add pressure on the Federal Reserve to make a larger interest rate cut but everyone needs to realize that the rate cut by the Fed this week will not be their last. Even though the national average of gasoline prices has fallen 35 percent, layoffs continue to rise. If GM and Chrysler are forced to cut back or worse, pushed into bankruptcy, unemployment will continue to grow. The US economy is expected to get worse before it gets better and the Federal Reserve will not want to back themselves into a corner quite yet; a larger rate cut on Wednesday would give them less room to cut interest rates in December.

Here are the 3 most likely outcomes for Wednesday’s monetary policy decision:

Coordinated Rate Cut by the Fed, ECB and BoE (Dollar Bearish)

The best and most effective option for the Federal Reserve would be to coordinate a rate cut with the European Central Bank and the Bank of England. All 3 central banks would get the most bang for their buck by working together. Given Monday’s comments by ECB President Trichet about cutting interest rates again in November, he may not be opposed to making the rate cut one week earlier. The Times of London has also indicated that the BoE is under pressure to cut rates as well. This measure of solidarity would send a strong message to investors and at the same time not require the Federal Reserve to take interest rates below 1.00 percent, leaving them little room to cut interest rates later. A coordinated rate cut to should be bullish for the global equity markets and bearish for the US dollar.

Independent 50bp Rate Cut from the Fed (Dollar Neutral)

Although a coordinated rate cut is the most effective option for the currency market, it may not be the most likely option because for whatever reasons, the ECB and the BoE may be opposed to coordinated intervention. Since an independent rate cut by the Federal Reserve is exactly what the market expects, the impact on the US dollar should be limited. The key will be the tone of the FOMC statement.

25bp Rate Cut (Dollar Bullish)

A 25bp rate cut will be a big disappointment to both the currency and equity markets. Given the degree of risk aversion and fear, we do not believe that Bernanke will risk the consequences of a disappointment since it could trigger another round of selling for stocks and high yielding currencies. In this type of market environment where investors are becoming immune to new measures taken by the US Treasury and the Federal Reserve, it pays to over deliver.

75bp Not a Viable Option - Too Close to ZIRP

Even though Fed Funds traders are pricing in a respectable chance of a 75bp rate cut, we do not believe that this will happen because it is too close to zero. Zero interest rates come with a host of problems. If the economy worsens substantially despite zero interest rates, we will be experiencing a world of problems in rejuvenating growth. This situation can best be exhibited by the Japanese recession that ensued during much of the nineties. With interest rates at nearly zero levels, the BoJ found itself unable to stimulate growth with no policy tools available at its disposal. During this time the BoJ was forced to implement newly devised policy measures that had little if any effect on promoting growth. At the same time, a zero interest rate is also inflationary.

Although we believe that a coordinated rate cut would be the best option for the Federal Reserve if they want a good chance at stabilizing the markets, the fact that Trichet talked about cutting interest rates on November 6th specifically suggests that it may not be an option that he is seriously considering. If the central banks can work together, Wednesday’s rate decision could turn around the currency markets, but if they choose to respond with fractured rate cuts, risk aversion could remain a problem.

This article has been reposted from Kathy Lien. The full post can also be viewed on KathyLien.com.

Fed Interest Rates Due To Fall Again

In what is likely to be another feeble attempt to stimulate the economy the Fed is expected to lower the Fed funds rate again at the conclusion of their next meeting on October 29. The Fed last lowered the funds rate in an emergency session on October 8, but as we can see, it accomplished very little. Right now the Fed funds rate sits at 1.5 percent, and the lowest it has ever been is 1 percent. It was last at that level in 2003 and 2004, and many believed that is what fueled the housing bubble. Investors everywhere are calling for the Fed to cut rates in dramatic fashion. In fact, the Fed funds futures are pricing in a 26 percent chance of the interest rate being cut by 0.75 percent, down to a record low of 0.75 percent according in CNNMoney. Will even a record cut really make a difference, though? Not likely.

The problem is not that rates are too high, the problem is that banks are unwilling to lend money. If banks feel that they have to hoard money in order to avoid disaster, than lowering interest rates will be nothing more than a practice in futility. "It's window dressing, only a psychological weapon," said Sung Won Sohn, economics professor at Cal State University Channel Islands, in a CNNMoney article. "Right now, the problem isn't the cost of the Fed's money, it's that the existing money supply is not circulating. The pipelines are clogged." The Bank of Japan tried this back in the '90s and it didn’t work for them, either. They lowered interest rates all the way down to 0 percent, and to this day their rates are still near that level.

Typically, when the Fed lowers interest rates, people worry about inflation, but with all the pressure on the economy right now inflation is the least of everyone’s worries. The real risk in this action is that when it doesn’t work, people will see that the government has few, if any, options left to fix the crisis. This could potentially send a shockwave through the financial system. "There's a hesitation to do it because it looks like desperation. But they're getting desperate," said, David Wyss chief economist with Standard & Poor's, in a CNNMoney article in response to the proposed Fed funds rate cut.

At this point I think it is a safe bet that we will see some sort of cut to the Fed funds rate by the end of the month--the question is how large it will be. If I had to guess, I would say 0.5 percent. I would be surprised if they went to 0.75 percent, but stranger things have happened. As Wyss, said they are getting desperate.

Fed Funds Rate Cut By 0.5 Percent, Along With Several Other World Central Banks

In what shouldn’t have come as a surprise, the Federal Reserve slashed its Fed funds rate by 0.5 percent. What was a tad unexpected by some was that the rate cut was done in unison with several other central banks from across the world. Also cutting their interest rates were the European Central Bank, the Bank of England, the Bank of Canada, the Swiss National Bank and the Swedish Riksbank, according to MarketWatch. Chances are this won’t be the last of the rate cuts, either.

Ian Shepherdson, chief U.S. economist at High Frequency Economics in Valhalla, N.Y., said in a MarketWatch article, "The playbook to avoid depressions says rates need to be as close to zero as possible, banks have to be rescued, public spending has to rise and free trade must be maintained." The Fed is not worried about inflation right now; what is on their mind is growth. How are they going to get the economy rolling again and avoid a long, drawn-out recession, or even a depression? Right now, the Fed funds rate sits at 1.5 percent, so there is still some room for it to fall, and I expect it to keep coming down.

What does this all mean? The answer really depends on the banks. The Fed is taking these actions in hopes that it will help convince banks to resume lending, but thus far, their actions have done little to change the mindset of the banks. Some estimates are saying the bailout package will begin making an impact in the markets in about a month, so it is possible that a resurgence in bank lending could occur around that same time, but that is just a guess. It all boils down to trust, and right now no one trusts anyone. Will the prospect of making some extra cash give banks the push they need to take some risk? No one knows for sure. One thing can be certain, though: If this situation doesn’t get better in the next month, watch out.

Are You Ready For Higher Mortgage Rates?

Mortgage rates have been low for many years, but if things continue at their current pace, that isn’t going to last much longer. The biggest factor controlling the rates charged for standard 30-year mortgages is the price of bonds (called mortgage-backed securities) sold by Fannie Mae and Freddie Mac. Over the past few years, these bonds have been selling with an interest rate just a little higher than U.S. treasuries. Now, with all the problems being talked about surrounding Fannie and Freddie, investors are becoming more cautious. In case you need help connecting the dots, that means investors are requiring a higher spread on these notes. The more Fannie and Freddie have to pay to secure funds, the more they are going to have to charge to their borrowers; it’s that simple. The bigger question to think about is how these higher mortgage rates will affect an already suffering real estate market.

Probably the biggest single factor behind the housing bubble was the abundant access to cheap credit. More people than ever were buying homes because more people than ever could qualify for loans. This was in part because of law borrower credit standards required by lenders, but it was also in part because of the low interest rates offered. Homebuyers tend to focus more on the monthly payment than the actual purchase price of a home. If they know they can afford $2,000 a month, then they are willing to buy a home for up to that payment, whether it costs $250,000 or $400,000. With all these new buyers entering the market, and people now able to afford more home than ever before, this scenario created the perfect atmosphere for a run-up in housing prices. Now let’s look at present circumstances.

On a historical scale interest rates are still low, but compared to the interest rates during the height of the bubble, they are substantially higher. While interest rates are low compared to historical averages, housing prices are high compared to historical averages. With mortgage rates rising, along with the credit standards of lenders, we are getting the opposite effect of what we had during the bubble run-up. This means that we are decreasing the number of people who can buy homes in addition to decreasing the amount of home for which people can qualify. Obviously this is going to negatively affect the housing market. While we certainly have seen a sharp contraction in the housing market compared to what existed during the bubble’s peak, if mortgage rates continue to rise, you can bet that the contraction will continue and become even sharper.

Keep an eye on the investor confidence in Fannie Mae and Freddie Mac. If somehow the companies can regain this confidence, then mortgage rates could stabilize, but at this point that doesn’t appear likely to happen anytime soon.

New Mortgage Regulations Come Just A Tad Late

The Fed approved some new measures Monday meant to crack down on what they deem to be deceptive lending practices. Because most of these problems have already worked themselves out, thanks to the whole credit crisis thing going on, these measures likely will have little impact. But just for fun, let’s take a look at what the changes are.

The following summary was collected from the San Francisco Chronicle:

Rules for all mortgages

- Prohibit creditors and mortgage brokers from coercing appraisers into misstating a home's value.

- Require additional information about rates, monthly payments and other loan features in all advertising.

- Ban seven deceptive or misleading advertising practices, including calling a rate or payment "fixed" when it can change.

New lending rules

- Force lenders to consider a borrower's ability to repay loans from income and assets other than the home's value.

- Require lenders to document a borrower's income and assets.

- Ban penalties for borrowers who pay off loans early if the payment can change in the first four years. In certain cases, a prepayment penalty period can't exceed two years.

- Mandate that creditors ensure certain borrowers set aside money to pay for property taxes and insurance by establishing escrow accounts.

The “new” rules for all mortgages are welcome additions, I guess, and really should be no brainers. I’m pretty sure coercing appraisers into misstating home value was already a no-no, but now it is “official,” for whatever that’s worth.

The new subprime lending rules are, for the most part, already being followed. At this point in time a borrower is going to be hard-pressed to get a loan if they can’t document their income (unless they are putting down a large down payment). Also, on almost all loans now--and in recent memory--lenders have required escrow accounts to pay for taxes and insurance. Since this was the norm even during the subprime heyday, I’m not sure exactly what they were trying to accomplish, but I guess we can now use that “official” word again. The biggest change that I can see is with the pre-payment penalties. In the past, having a two year pre-payment penalty was pretty much the norm, and borrowers who wanted to get that waived had to buy it off. From the lender's perspective it made complete sense: They wanted to ensure that they were able to make at least X dollars on the loan even if the borrower sold the house the next day. This is one that I think could backfire for borrowers. Now that lenders are not going to be able to add a pre-payment penalty, they are going to make the loan more expensive because they have to ensure that they are able to make their profit no matter what the borrowing time frame. So we can expect that buy-down pricing will now be included in every loan--whether the borrower wants it or not. The borrower who knows that they are going to be in the property for at least two years will now have to pay a little more on their loan. I think a better solution might have been to make the pre-payment penalty opt in rather than opt out--that way people who do want it can still have it.

All in all, I think these new regulations were more for show than for function. The government needed to appear like they were trying to do something about the problem, so they put together a list of things that look good on paper, but in practice are pretty much useless.

Fed Rate Cut History And Future

Can the Fed rate cut history show us the future for Fed rate cuts? I always knew that for the most part we have been able to fairly closely determine whether or not the Fed was going to cut the funds rate--and if so even by how much--but this morning I learned something new that I wanted to share. Before, I always looked at Fed fund futures to weigh the chances of a rate cut or increase, and while these future contracts tend to give us a pretty solid estimate, they have historically overestimated the Fed rate cuts, according to Ed Nosal, economic advisor at the Federal Reserve Bank of Cleveland. So how else can you accurately determine whether a rate cut is coming or not?

Elliot Wave International is one of the largest forecasting firms in the world, and they think they can predict to a T when a Fed funds interest rate change is coming and how much it will be for. They don’t look at the Fed fund futures, though; they look at the 3-month T-Bill yield. They put together a chart that you can see below, which shows just how accurate this method is:



"And forecasting fed rate cuts isn’t all it's cracked up to be, or at least it doesn’t appear to warrant the countless hours of discussion devoted to it on financial television. As we’ve discussed numerous times in our newsletters, the Fed follows the market, not leads it. This quasi-government entity simply validates what the freely traded Treasury market has already done. The above picture should be familiar to long-time subscribers and illustrates our point about the juxtaposition between the Fed and the freely traded T-bill market. With the current gap between the U.S. 90-day T-bill rate and Fed Funds at a wide 112 basis points, the Fed’s rate cutting is not over," Steve Hochberg, Elliot Wave International's chief analyst, wrote Jan. 22 in Elliot Wave’s Short Term Update.

So if you are trying to figure out what the Fed is going to do about interest rates at their next meeting, now you have a new crystal ball to look at. As for what is going to happen at the next Fed meeting, almost everyone believes the Fed will stand pat on the fed funds interest rates, including Donald Kohn, vice chairman of the Fed.

Odds Of Recession At 45 Percent, Down From 90 Percent Last Month

Identifying a recession is a tricky thing, and that was never more apparent than in the flip-flopping of many economists’ opinions on the state of the economy and its odds for a recession. It wasn’t too long ago that 71 percent of economists believed we were already in a recession, and even more thought a recession inevitable. Wachovia, which last month put the odds of recession at 90 percent, just downgraded those odds to 45 percent, according to The Wall Street Journal. Is the economy really turning around, and can we begin to be a little optimistic about the future?

Recent data released by the government has been a little better than expected, but I think we are missing some things. Perhaps we are clinging to any last ray of hope we can find, but the bottom line is we should look at the facts for what they are, not coat them in sugar. One example is that yesterday everyone was elated that the CPI came in at only a 0.2 percent increase, compared to the expected 0.3 percent. This surely is good news--I don’t want to discount that--yet at the same time we can’t take this to mean that our inflation fears are over and that everything is peachy. First off, I have my concerns that the numbers being reported by the government aren’t all that accurate to begin with. In addition, while inflation might be taking a little break, so to speak, I don’t think it is gone.

Another piece of irrational exuberance in my book was how the market treated the recent earnings reports from Freddie Mac and Fannie Mae. Fannie Mae reported a loss of more than $2 billion, much more than was anticipated, yet their stock skyrocketed that same day. Something just doesn’t seem right about that. Then this week, Freddie Mac actually beat estimates and reported a loss of only around $150 million. That seems great compared to the $2 billion loss over at Fannie, but in order to cut their losses to only $150 million, Freddie Mac had to alter their accounting methods. I’m no accounting expert, but any time I hear of companies altering their accounting practices, and voila, their books suddenly look better, I get suspicious (if anyone has more knowledge about this, I’d love to hear your take). As we saw in the foreclosure numbers reported this week, the housing problems are far from gone. More and more people are losing their homes, and to me that doesn’t spell good news for Fannie and Freddie, or the housing market in general.

We also saw reports this week that more companies are laying workers off--typically not a positive sign at all--yet for the most part the markets shrugged off this news in favor of celebrating the fact that inflation was only at 0.2 percent last month. While it certainly is good news to see the economy rebounding somewhat, and for the economic news to come back better than we expect, I urge investors not to get their hopes up too much at this point. It is possible that the interest rate cuts and the economic stimulus package will come together to bring our economy out of the rut it’s been in, but I certainly wouldn’t put those chances as high as 55 percent. I still think a recession is coming, and whether it is officially here now, or whether we are able to delay it, it will surely come. Our economy has too many serious problems to fix with a few Band-Aids.

If Bernanke discovered the magic recession avoidance elixir, that is just fabulous, and we all should be ecstatic.

At the same time it has always been my belief that you plan for the worst, so that’s what I’m doing. Jump on the U.S. economy is great wagon if you will, but be careful, because I’m pretty sure the axel is loose.

Federal Reserve Meeting Today: BYOB, Pizza Will Be Served

The Fed is meeting again today and tomorrow. To mark this diminishingly historic occasion, I have composed the following ditty. Ahem...

There once was a man named Bernanke:

For the banks, an immaculate flunky.

When their assets all failed

with our money he bailed

them all out like a good little monkey

Thank you. Thank you.

As the Fed disappears behind the curtain yet again, ‘O we of little faith’ are bracing for yet another quarter percent drop in interest rates. Soon it will be official: You will likely see more appreciation on kitsch from the Franklin Mint than anything that comes out of the U.S. Mint. My friends all laughed when I plunked down 100 smackers for my Mystical Dreamcatcher Pocketwatch, but who’s laughing now?!

For those of you who didn’t have foresight enough to invest in chilling likenesses of dead royalty and zirconium encrusted daggers, allow me to predict what the Fed is planning to do. Just let me look into my Dragon of Lore Crystal Ball (a steal at 5 payments of only $39.99!)...

Abra-cadabra!

~~Ah yes...I scry a rather stoned-looking Bernanke telling the table that he knows exactly what needs to be done. Well! That’s good news!~~

~~Oh. He wasn’t talking about the economy. He was suggesting that they order pizza.

But still...based on his track record, that’s one of his more reasonable suggestions.~~

~~Now someone else at the table is telling him that no one there can afford to have a pizza delivered

because food and gas prices have soared again.~~

~~Bernanke insists that “Referendum Deepdish” be passed as they can just print more money

in the office next door. The motion is passed.~~

~~Someone raises a new motion: Will the Reserve lower interest rates again despite the fact that it has done nothing to mitigate the housing crisis or prevent a recession? They ask the chairman directly.~~

~~Bernanke teeters in his seat for a moment, opens his mouth...and then passes out on the floor.

The attendees concur with the chairman’s motion to drop the interest rate again. Motion is passed.~~

~~The pizza arrives. The delivery fellow receives a lousy tip.~~

As we can see, it’s all business as usual at the Federal Reserve. But before I go off to polish my collection of Elvis Head Silver Dollars, I leave the Fed with three bits of advice:

1. These are tough, confusing times, and I do in fact sympathize with anyone tasked with sorting this out, but your methods have proven to be the financial equivalent of bloodletting for the ailing economy. Try something new for once, PLEEEEEEEASE!
2. We know the banks own you (literally), but at least pretend that you have the interest of the American people in mind. You know, we love a good circus act. And if you piss us off, then...
3. Don’t stiff the pizza boy: He knows where you live.

Do We Really Want Increased Government Oversight Of The Mortgage Industry?

The Bush administration is calling for a major overhaul of how we monitor the financial industry in what would be the largest financial regulatory makeover since the Great Depression. It isn’t as much oversight as many Democrats are demanding, but it is fairly substantial.

I am generally against added government regulation, so this doesn’t sit well with me. The government has a way of making things more complicated and costly than they need to be, and it is taxpayers who bear the burden. Increased regulations in the financial and mortgage industries will only make lending tougher. It seems that people want the government to protect them from themselves and from lenders who might take advantage of them. If the government gets involved, some people may be protected, but fewer people will receive mortgages. In an already struggling market in which it is increasingly difficult to find funding, the last thing we need to do is to make it even more difficult.

I expect that the regulatory agency will, at a minimum, call for increased documentation and transparency on the part of the lenders. I’m all for transparency, but the documentation is already overdone. When I signed the docs for the last house I bought, my hand started to cramp halfway through signing all the paperwork. If increased paperwork is all they do, and they do not become too restrictive, then the legislation shouldn’t have much negative impact, though it will mean more work for the loan officers, processors, lenders and escrow agents. If they start modifying loan qualifications and guidelines, or imposing penalties on lenders, it might scare many lenders out of even remotely related programs. If lenders become even more hesitant and restrictive, this only spells more bad news for the housing market.

Fed Cuts Interest Rates By 0.75 Points: U.S. Dollar Now Second Lowest Yielding Major Currency

Yesterday, the Fed did what everyone expected by cutting interest rates. The 0.75 point interest rate cut was lower than the full 1 point rate cut that futures traders were expecting, but within the range most people expected. It is doubtful that this interest rate cut will revive the economy for more than a brief showing on the stock market, and most people expect further interest rate cuts in the future. President Bush also mentioned yesterday that he is willing to take further measures to revive the economy, but first he wants to see how his economic stimulus package pans out.

Rather than discussing future cuts and policies, let’s talk about the present: The U.S. dollar is now the second lowest yielding major currency. The lowest yielding currency is the Japanese yen, which has pretty much maintained that title since Japan’s financial meltdown in the '90s (see previous post: Could The U.S. Be Headed For A Recession Similar To Japan's In The '90s?), which was eerily similar to the one the U.S. is experiencing. The U.S. dollar yields 2.25 percent, while Japanese yen yields 0.5 percent. The dollar still has some room to fall before it gets that low, but it is well on its way.

Why is the yield of a currency important?

Investors want to see return on their money, so if they aren’t getting the returns they seek at home, they will start to look elsewhere. For a good example of this, we can look to Japan. The Japanese don’t want to keep their savings in yen because they earn almost nothing on it, and with inflation is higher than interest rates, they are actually losing money. Because of this, people take their savings elsewhere. As more people sell off their yen, the currency goes lower.

There are also the carry traders who borrow money at low interest rates and invest that money in higher yielding currencies hoping to profit from the yield difference. Again, these traders are selling the low-yielding currency (lowering its value further) and buying higher yielding currencies (raising their value). Carry trading has become popular of late, and its power to move currencies should not be overlooked.

For the reasons mentioned above and others, as currencies decrease their yield their value goes down, and as the yields get raised the currency value goes up. The fact that the U.S. keeps lowering the dollar yield is further reason to believe that the dollar will continue its slide.

Bear Stearns, Carlyle Capital And The Fed

For those who haven’t already seen the headlines in the local paper, Bear Stearns agreed this weekend to be acquired by JP Morgan for $236 million or about $2 a share, a sharp contrast to its 52 week high of $159. In addition, on Sunday the mortgage-bond fund Carlyle Capital decided to close up shop. Many people believe that this is only the beginning of the financial melt down. How will the Fed respond to these recent events at their meeting today?

The Fed will likely lower the key interest rates yet again, anywhere between .5 to a full point. Most traders will welcome as large a rate drop as Bernanke will give after the hammering the markets took this past week, but people who have their savings held in dollars might have other thoughts.

I know that I’ve been pounding this point home a lot lately, but the Fed is destroying the value of the dollar. I can’t imagine that it will be much longer before any foreign countries buying up U.S. treasuries start to think twice. What will happen then? The U.S. is funding its enormous debt by issuing more debt, and if that option gets reduced or eliminated there will be serious consequences. The options come down to printing more money (and further deflating the dollar) or default, and neither scenario would end well.

I’ve said it over and over again, but if you aren’t already diversifying out of the dollar, do it now. It is ok to keep some savings in dollars, but people really need to start looking at a basket of currencies. EverBank offers a product called a foreign currency CD which will pay interest on your money and also allow you to easily diversify into other currencies. They even offer various baskets of currencies to aid with diversification. EverBank also offers silver and gold CD’s, which is a simple way to diversify into the precious metals market.