The Credit Problem
By Joseph Y. Calhoun, III
A long wave of credit stimulation has been allowed to obscure the underlying problem of capital accumulation in the United States. We are paying a price, but not solving the problem.
The political class simply cannot be trusted to provide solutions. They are too interested in retaining power for the sake of power. They do not have the guts to say what needs to be said for fear of alienating some group of supporters. They do not have the integrity to stand on principle and advocate unpopular but necessary policies. They are too beholden to special interest groups to do what is right for the country rather than what is right for their campaign contributors. It is high time that politicians were held responsible for the damage done by policies intended to benefit the few at the expense of the many.
In this election year, the greatest concern for most Americans is the economy and there is good reason for that. Unemployment, foreclosures and prices are all rising. The stock market, home prices and the dollar are all falling. Economic growth is still positive but well below potential. Americans are rightly worried.
In a recent market commentary, Bill Gross called credit the mother's milk of capitalism. That sentiment, echoed by our politicians and policy makers, is the source of our problems. It is not credit but capital that is the lifeblood of capitalism and the US doesn't accumulate enough capital to support the growth to which we've become accustomed. The savings rate has ticked somewhat higher over the last few months, but for years we've saved too little and spent too much. The difference to date has been provided by foreigners such as the Chinese who now own over $1 trillion of US debt and Middle Easterners who own even more.
In their efforts to revive the credit markets, the Federal Reserve and their political enablers may have averted an economic crisis in the short term, but the long term implications have yet to be reckoned. Bear Stearns, Fannie Mae and Freddie Mac, deemed too big to fail, were given access to the public purse rather than face the consequences of excessive leverage. The cure for excessive private indebtedness has been deemed to be more public indebtedness. Private actors will reap the benefits if these transactions turn out profitable while the public will pay the price if they don't.
Large financial institutions were encouraged to take on too much leverage and take too many risks by a Federal Reserve that held interest rates at artificially low levels for far too long. Rather than allow these companies to suffer the consequences of their actions our leaders are working overtime to ensure they continue to take imprudent risks in the future. The Fed has allowed overleveraged institutions to borrow funds at attractive rates with dubious collateral. Savers are punished with low interest rates while speculative actors are encouraged to find new avenues for their speculation. Oil prices would seem to indicate they've found a new outlet for their speculative impulses.
Likewise the individuals who borrowed too much to buy homes they couldn't afford. I feel for the people who face foreclosure but why should those of us who were prudent be forced to bail out those who weren't? The recently passed housing bill will allow both lenders and borrowers to forgo the consequences of their actions. And again, if everything works out the lenders and borrowers will benefit while failure is assigned to the taxpayer. It would be better for the foreclosures to proceed and former homeowners to become renters again. The real estate market would face a further increase in inventory but prices could finally fall to market clearing levels. That would make housing affordable for those who have saved and acted prudently.
Over the last 50 years (at least) but especially the last 30, every economic problem has been buried under another layer of credit and government intervention. The Federal Reserve and Congress have worked together to promote an economic environment where failure is deemed a threat to the "system" and all economic ills are "solved" by reducing the cost of credit. The result is plain for all to see. The US has moved from creditor to debtor nation. Debtors are bailed out through the tax code while savers are consigned to a prison of low interest rates. It is no surprise that we must import capital to cover our debts when we encourage debt and discourage saving.
The long term problems facing our economy will not be solved painlessly. Nor will they be solved by providing more of the same policies that got us to this point. While the Federal Reserve sits at the center of our problems the institution itself is not at fault. They have been given an impossible dual mission to maintain economic growth and to limit inflation. Having control only over the money supply, it is beyond the capabilities of the Fed to create growth. Inflation and credit expansion do not add anything to the amount of resources available or the capital stock. The Fed cannot create universal prosperity by creating more money. Inflation consumes precious capital by misdirecting resources into non economic investments. If you have any doubts about that, think of all the empty houses sitting around the country which attracted so much investment over the last decade. The capital devoted to housing was diverted from more productive uses and is now being destroyed as banks are forced to write off the bad loans.
The villains in this story are the inhabitants of our political institutions. They seek to buy our votes with our own money and when they find that is not enough, they turn to the Federal Reserve and the banking system to create more. Rather than raise taxes to pay for the goodies they promise or the wars they deem necessary, they depend on debt and inflation. They do not create jobs, but destroy them. They do not create equality but exacerbate the divide between the haves and have nots and manipulate the divide to accrue more power. They do not create capital but rather destroy it. They are not special but mere mortals susceptible to the same failings as all men. They are self interested actors acting on a stage of their own design in a play written for their own benefit.
It seems evident that the housing bubble that is the source of the current economic malaise was caused by Federal Reserve policy. Does it not seem perverse to turn to the same institution for a remedy? How can they be expected to prescribe a remedy when they obviously don't understand the malady? It would seem more logical to proscribe the manipulation of interest rates for any purpose other than to achieve price stability. While a gold standard or some other real asset backed currency would be preferable and less susceptible to political manipulation, setting a single goal for the Fed is preferable to the current situation. Higher interest rates are obviously needed to reduce the inflation evident to everyone except the government statisticians. Higher interest rates would also encourage saving and discourage further debt accumulation.
It also seems evident that the government budget deficit is a result of excessive spending rather than a lack of taxation. Tax revenue has been remarkably stable as a percentage of GDP for many years, ranging between 18% and 21% regardless of tax rates. Right now it stands at 19%. Furthermore, other countries, such as Hong Kong, are able to collect nearly the exact same percentage of revenue with much lower tax rates. Hong Kong has income tax rates, personal and corporate, of less than 20% and generates a budget surplus while spending over 15% of GDP on government services. Hong Kong also doesn't tax capital gains or dividends. We do not need higher taxes to generate the revenue needed for essential government services. We do need to decide what is essential.
In particular, it is illogical to raise taxes on capital when the basic problem we face is a lack of capital. If anything, taxes on capital should be further reduced to encourage accumulation of the capital needed to fund our growth. As for income taxes, it is time for Americans to assess the wisdom of taxing the very thing we wish to generate. If it is logical to tax cigarettes to discourage smoking, what is the logic for taxing income? A consumption tax coupled with repeal of the income tax would realign incentives toward a more rational economy based on thrift and savings rather than conspicuous consumption.
Because we keep re-electing the same politicians, we have no one to blame but ourselves. It is time to get angry.
http://www.americanthinker.com/2008/07/the..._problem_1.html

The credit squeeze fall-out

How the banks can win back confidence

The world cannot grow its way out of this slowdown

Shrunken Street: Financial groups eye potential predators and prey

False ideology at the heart of the financial crisis

It is time for reflection, not regulation on banking

Act now to stop the markets’ vicious circle

An economy undermined? Experts assess the real costs of a financial crisis

Financial markets need more than a patch-up

Fear fatigue: Financial markets search for signs that the worst is over

A lack of trust spells crisis in every financial language

Job market recession persists
For analysis of today's employment report from the Bureau of Labor Statistics, read EPI's Jobs Picture. Even with boost from stimulus, economy just limps along
Read EPI's GDP Picture for analysis of the lstest Commerce Department report on gross domestic product (GDP).

Pressure grows for action on US economy
Pressure for action to revive the economy grew as a new report showed the unemployment rate rose in July to 5.7 per cent – its highest for four years – and the number of jobs fell for a seventh straight month writeDate( 1217635885000, 'Grey', '01:11', 9999999999999); - 01:11

Pressure grows for action on US economy
Pressure for action to revive the economy grew as a new report showed the unemployment rate rose in July to 5.7 per cent – its highest for four years – and the number of jobs fell for a seventh straight month - Aug 2 2008


Weak US growth adds to gloom
The US economy grew at an annualised rate of 1.9 per cent in the second quarter, faster than earlier in the year but slower than economists were expecting, the commerce department said - Aug 1 2008


Record deficit of $482bn forecast for 2009
Driven by dwindling tax receipts amid the economic slump and the payment of over $100bn in stimulus cheques, the figure was higher than the White House's previous estimate Jul 29 2008


US credit crisis is hitting the wealthy
The US financial crisis is spreading from subprime borrowers to wealthier consumers, with evidence mounting that more affluent people are failing to pay their mortgages and credit card balances - Jul 28 2008


US credit crunch set to last for months
The credit squeeze in the US economy is likely to persist for many months and might even get worse, Gary Stern, president of the Federal Reserve Bank of Minneapolis, has told the Financial Times

The US economy
By the time a US recession is declared official by the National Bureau of Economic Research, it will already be well under way

• Lex: Shrinking US payrolls

America must not act rashly over inflation
Below-capacity output growth and softening oil and commodity prices are likely to push core inflation back towards the comfort zone, writes Mark Gertler


Cherished myths fall victim to economic reality
There is a danger that the macro­economic models now in use in central banks operate like a Maginot line. They have been constructed in the past as part of the war against inflation. They do not provide banks with the right tools to be successful, writes Paul De Grauwe


America braces itself for a second dip
The US economy performed better than expected in the first half of the year but volatile markets suggest the rest of 2008 might bring a W-shaped downturn


Lessons to be learnt from the financial crisis
The aim of this year’s report by the Bank for International Settlements is clear: it is to reduce the frequency and severity of crises. It is not enough to say that we can clear up afterwards. That is too complacent and too one-sided, writes Martin Wolf

Measures to avoid the worst recession in 30 years
America should learn from its mistakes and act pragmatically to regulate markets as they exist in fact, not theory, write Felix Rohatyn and Everett Ehrlich


Guarantees for America’s guarantors
Fannie and Freddie’s doom has been foretold countless times – and yet has been regarded as unthinkable. Now the question is, will they survive, writes Clive Crook


America’s human capital is tested
The educational quality of US workers is in decline. If the country is unable to mend its school system, and unwilling to open its doors wider to skilled immigrants, then the current gloom about its longer-term economic prospects may be justified, writes Clive Crook


Goodbye capitalism
There is a better way to handle the crisis over Freddie Mac and Fannie Mae, without rewarding failure, writes Joshua Rosner

The Real State of the US Economy
Henry Paulson has lost the control over US finance



by William F. Engdahl

Global Research, August 2, 2008

When Henry Paulson agreed to leave his job as chairman of the powerful Wall Street investment bank, Goldman Sachs to go to Washington as Treasury Secretary in 2006 he demanded extraordinary powers as de facto economic czar. He got it. Paulson is also head of the President’s Working Group on Financial Markets -- the secretary of the treasury and the chairmen of the Federal Reserve Board, the Securities and Exchange Commission and the Commodity Futures Trading Commission. The Working Group is the financial world's equivalent of the Pentagon war room. Paulson, not Fed chairman Bernanke, is the person running the Administration’s crisis management. And his recent actions indicate he has lost control as the snowballing problems from the semi-government mortgage companies Freddie Mac and Fannie Mae to the collapse of the multi-trillion dollar market in Asset Backed Securities (ABS) to the real economy are compounding into the worst crisis since the 1930’s Great Depression.

‘The US banking system is sound…’

In an eerie echo of President Herbert Hoover in 1930, during a Presidential campaign against Roosevelt, following the stock market crash and collapse of numerous smaller banks, Paulson recently appeared on national TV to declare "our banking system is a safe and sound one." He added that the list of "troubled" banks "is a very manageable situation." In fact what he did not say was that the US bank deposit insurance fund, the Federal Deposit Insurance Corporation (FDIC) has a list of problem banks that numbers 90. Not included on that list are banks such as Citigroup, until recently the largest bank in the world.

The statement is hardly reassuring. The California savings bank, IndyMac Bank which was declared insolvent a month ago was not on the FDIC list a week before it collapsed. The reality is the crisis created by "securitizing" millions of home mortgages into new financial instruments and selling the packages to pension funds and investors is unfolding like a snowball rolling down the Swiss Alps.

Indication of the lack of control is the statement just weeks ago by Paulson that "financial institutions must be allowed to fail." That was two weeks before Paulson went to Congress to ask for "Congressional authority to buy unlimited stakes in and lend to Fannie Mae and Freddie Mac." As I noted in my recent piece, Financial Tsunami: The Next Big Wave is Breaking: Fannie Mae Freddie Mac and US Mortgage Debt , those two private companies insured some $6 trillion worth of home mortgages, half the entire US mortgage debt. Paulson defended the request by calling Freddie Mac and Fannie Mae "the only functioning part of the home loan market."

That comes back to the statement about a "sound banking system". Can we have a sound banking system where the only functioning part is literally insolvent—its debts greater than its assets?

It is well known on Wall Street that some of the largest financial institutions have huge undeclared problems with Asset Backed Securities they have valued far above their worth to make their books look better than they are. The names Citigroup, Lehman Bros., Morgan Stanley, even Paulson’s old firm, Goldman Sachs and of course the inventor of sub-prime mortgage securitization, Merrill Lynch, all hold a huge percentage of what are called Level Three assets, these being assets where no one is willing to buy but the bank declares their worth based on "fantasy." In short the value of those core financial institutions of the US financial system is massively overvalued compared with their value were they forced to sell into the open market today. In a sobering aside, readers should not expect any serious economic remedies for the crisis from a President Barack Obama. Obama’s National Campaign Finance Chairman is Chicago real estate billionaire, Penny Pritzker, who is heir to among other things the Hyatt Hotels. It was Pritzker together with Merrill Lynch ten years ago who first developed the model for securitizing "sub-prime" real estate, the trigger for the current Financial Tsunami crisis.

Already Citigroup has been forced to go to Dubai hat in hand and ask for billions in cash. After it announced it would not need more capital. Now Citigroup just announced plans to sell some $500 billion more assets to raise funds. Is Citigroup really solvent is the question sober investors are asking. Similarly Merrill Lynch raised $6.6 billion from Kuwait Mizuho, stated it was fine and weeks later had to raise still more capital. Morgan Stanley sold a 10% share of the company to China International Corp.

The real economy contracting rapidly

Behind the reassuring statements from Paulson and others that the "worst is over" the reality of the credit collapse since August 2007 is a deepening economic contraction which I have said several times in this space will surpass the Great Depression of the 1929-1938 period. A goof friend who is an unemployed homebuilder in a prosperous part of Arizona just sent me the following list of US department retail store closures. It is worth noting that over 70% of the US GDP is consumer spending and that the entire Federal Reserve strategy of Alan Greenspan after the March 2000 collapse of the stock market bubble, was to bring US interest rates to their lowest levels since the 1930’s in order to stimulate consumer spending on credit, i.e. debt, to avoid "recession." Note the scale of the following store closings across America in recent weeks:

Ann Taylor closing 117 stores nationwide.

Eddie Bauer to close more stores after closing 27 stores in the first quarter.

Cache, a women’s retailer is closing 20 to 23 stores this year.

Lane Bryant, Fashion Bug, Catherines closing 150 stores nationwide

Talbots, J. Jill closing stores. Talbots will close all 78 of its kids and men's stores plus another 22 underperforming stores. The 22 stores will be a mix of Talbots women's and J. Jill.

Gap Inc. closing 85 stores

Foot Locker to close 140 stores

Wickes Furniture is going out of business and closing all of its stores. The 37-year-old retailer that targets middle-income customers, filed for bankruptcy protection last month.

Levitz - the furniture retailer, announced it was going out of business and closing all 76 of its stores in December. The retailer dates back to 1910.

Zales, Piercing Pagoda plans to close 82 stores by July 31 followed by closing another 23 underperforming stores.

Disney Store owner has the right to close 98 stores.

Home Depot store closings 15 of them amid a slumping US economy and housing market. The move will affect 1,300 employees. It is the first time the world's largest home improvement store chain has ever closed a flagship store.

CompUSA (CLOSED).

Macy's - 9 stores closed

Movie Gallery – video rental company plans to close 400 of 3,500 Movie Gallery

and Hollywood Video stores in addition to the 520 locations the video rental

chain closed last fall as part of bankruptcy.

Pacific Sunwear - 153 Demo stores closing

Pep Boys - 33 stores of auto parts supplier closing

Sprint Nextel - 125 retail locations to close with 4,000 employees following 5,000 layoffs last year.

J. C. Penney, Lowe's and Office Depot are all scaling back

Ethan Allen Interiors: plans to close 12 of 300 stores to cut costs.

Wilsons the Leather Experts – closing 158 stores

Bombay Company: to close all 384 U.S.-based Bombay Company stores.

KB Toys closing 356 stores around the United States as part of its bankruptcy reorganization.

Dillard's Inc. will close another six stores this year.

For anyone familiar with American shopping malls and retailing, this represents a staggering part of the daily economic life of the nation, from furniture stores to clothing to video rentals to leather. The process has only begun and neither major party Presidential candidate has dared to mention this on the ground economic reality, because they evidently have no solutions to offer that would not jeopardize their campaign finances. Obama is tied to not only Pritzker but also to Omaha billionaire, Warren Buffett and George Soros. McCain depends on the traditional money contributions of the Republican Party which demand permanent tax reform for highest income earners and a pro-bank laissez faire treatment of millions of homeowners facing home foreclosure and asset seizure by banks.

Banks across the country have severely cut back on loans, fearful of bad debts. That has aggravated the consumer collapse documented above. Hundreds of thousands of real estate brokers, small and large bankers, furniture workers and salespeople, and construction workers are unable to find work. Jobs are being cut wholesale and those working are often on reduced hours. Car sales in June plunged by 28% for Ford, 18% for General Motors and even 21% for Toyota which will mean more layoffs in coming weeks. This will be the next wave of unemployment.

The economic reality is not reflected in official US Commerce Department or Labor Department statistics. There the data is constantly being "revised" to hide the grim reality in an election year.

My good friend, economist John Williams of California, has meticulously tracked such "data revisions" for more than 25 years and found the manipulation of reality so alarming that he founded an independent subscriber service titled "Shadow Government Statistics" (http://www.shadowstats.com/ ), where he makes best estimate calculations of the reality not the official mythology.

By Williams’ calculations the US economy first entered recession, defined as two consecutive quarters of negative GDP growth, at the end of 2006. Ever since, the recession has deepened, dramatically so in the past 12 months. Little known is the fact that the Labor Department also publishes six different unemployment statistics from U1, U2 through to U6 being the most comprehensive. The reported "official unemployment" is the very narrowly defined U3 which stands at 5.5%. However, as Williams notes, U6 is the real measure and that officially shows 9.7% unemployed. His calculations put the figure at 13.7% actually unemployed and seeking work.

A personal account

The unemployed homebuilder from Arizona I mentioned above recently sent me the following personal note on the situation:

"Here is how it looks to people like me: Real estate dealings fuelled the economy in most areas of the country for the past decade or more. We’ve been in a market downturn for three years. We have seen the cost of doing business increase for builders, along with a big drop in buyers as everyone tightens their belts, or can’t sell existing homes. Many employers have gone under ending thousands of jobs. If they have a job people are worried about losing it. Driving long distances to work is not possible with gasoline costs double that of 2006. There has been a 40% drop in most peoples’ home equity worth. Many people are "underwater" on their homes, meaning they owe more than the market price is worth today. So many under-employed don’t show up in government unemployed statistics. Self employed like me never get counted."

The Arizona homebuilder continued, "Today nobody is building. Unsold home inventories are triple that of 2003. Banks no longer give easy credit for home buyers. Many realtors I know have gone two years without selling a home. Empty storefronts are becoming common. In many areas unemployment among construction trades people is 50% or more. Tens of thousands of illegal Mexicans who did most of the manual labor have returned to Mexico to find work. What now? Well, I do handyman projects of all sorts, big or small and make about 70-90% of what it takes to survive with a family of a wife and three young children. My savings make up the rest. That can’t go on for too much longer. We went from affluent and comfortable to nervous and broke with diminished opportunities in just three years. We used to be the middle class."

To be continued…

F. William Engdahl is author of A Century of War: Anglo-American Oil Politics and the New World Order (Pluto Press) and Seeds of Destruction: The Hidden Agenda of Genetic Manipulation (www.globalresearch.ca). He is at work on a new book, from which this has been adapted, Power of Money: The Rise and Decline of the American Century. He may be reached through his website, www.engdahl.oilgeopoitics.net.

William F. Engdahl is a frequent contributor to Global Research. Global Research Articles by William F. Engdahl

http://globalresearch.ca/index.php?context=va&aid=9728

U.S. Vehicle Sales Fall 13.2% Amid High Gas Prices and Tight Credit - NY Times (08/02/2008 05:58 AM)
After the Bubble, Ghost Towns Across America - WSJ ($) (08/02/2008 06:03 AM)
Finance Has Become the Business of America - Barron's $ , Forsyth (08/02/2008 06:44 AM)
ISM shows no factory growth in July - Market Watch from Dow Jones (08/01/2008 09:30 AM) More Arrows Seen Pointing to a Recession - NY Times (08/01/2008 05:24 AM)
Paterson Looks to Washington on Budget - NY Times (08/01/2008 08:30 AM)
Hank Paulson's Fannie Gamble - WSJ ($) , Lindsey (08/01/2008 05:51 AM)
More Sectors Look Ripe For Job Losses - WSJ ($) (08/01/2008 05:53 AM)
U.S. Employers Cut 51,000 Jobs, Fewer Than Forecast; Jobless Rate at 5.7% - Bloomberg (08/01/2008 07:44 AM)
Head scratching and the budget - N.Y. Post (08/01/2008 09:49 AM)
Let's make America thrifty again - CNN/Money (08/01/2008 09:53 AM)
Stressed banks borrow record amount from Fed - Reuters (08/01/2008 05:27 AM)
World factories gearing down but raising prices - Reuters (08/01/2008 06:10 AM) Construction spending falls in June - CNN/Money (08/01/2008 09:56 AM)

New York to File Charges Against Citigroup Over Securities - NY Times (08/02/2008 06:00 AM) Small Florida bank is 8th U.S. failure this year - Reuters (08/02/2008 06:01 AM)
Highland to Pay in Stages - WSJ ($) (08/02/2008 06:05 AM)
Profit Data May Explain U.S. Gloom - NY Times , Norris (08/01/2008 05:26 AM)
Merrill `Co-Opted' Analysts Backed Auction-Rate Debt to the End - Bloomberg (08/01/2008 05:20 AM)
Lehman in talks to sell $30 bln mortgage assets: report - Reuters (08/01/2008 05:32 AM)
The New Chemistry of Speculation - WSJ ($) (08/01/2008 05:47 AM)
MGM, Dubai Fall Behind on $3.5 Billion Loan for Las Vegas Plan - Bloomberg (08/01/2008 08:52 AM)

Quotable
"The amount U.S. commercial banks have at risk in derivatives markets jumped 50% during the first quarter as the credit crisis triggered an increase in the value of contracts that protect against borrower defaults and changes in interest rates. The amount of money banks would be owed if all derivatives contracts were liquidated, known as 'net current credit exposure,' rose $156 billion in the first quarter to $465 billion..." Bloomberg, July 2, 2008

Recession fears as America sheds jobs - UK Telegraph , Evans-Pritchard (08/01/2008 07:52 AM)

Manufacturing gloom deepens - FT ($) (08/01/2008 06:36 AM)

Corporate insolvencies jump 15% - FT (08/01/2008 06:03 AM)

BA plunges amid 'worst trading ever' - FT (08/01/2008 05:23 AM)

Another Bad Employment Report: Brad DeLong Calls Recession Aug 1, 2008 If I were on the NBER Business Cycle Dating Committee, I would call this a recession:



The U-6 measure of unemployment--reported unemployed plus part-time for economic reasons plus marginally-attached workers all divided by the labor force plus marginally-attached workers--has risen by 1.1 percentage points in the past three months to its current level of 10.3 percent. It now stands 2.2 percentage points above its mid-2000s low, and is just a hair below the maximum reached in the 2001-2003 episode. As you all know, I have been unhappy with the conventional unemployment rate this decade--it has not been telling the same story as the other labor market indicators. U-6 seems to be a better fit to the overall state of the economy.

And by my book, U-6 is now telling us that we are in a recession.

But I am not on the NBER Business Cycle Dating Committee. There's no reason for them not to wait a couple more months before deciding thumbs-up or thumbs-down. And they may not, by their definition, call it a recession.

On the other hand, when I write my history--Macroeconomic Policy in the Age of Central Bankers (Princeton: Princeton University Press, 2025)--this will count as a recession starting in the last quarter of 2007.

The BLS this morning:

Employment Situation Summary: The unemployment rate rose to 5.7 percent, and nonfarm payroll employment continued to trend down in July (-51,000).... Over the past 12 months, the number of unemployed persons has increased by 1.6 million, and the unemployment rate has risen by 1.0 percentage point.... In July, the number of persons who worked part time for economic reasons rose by 308,000 to 5.7 million and has risen by 1.4 million over the past 12 months. This category includes persons who indicated that they would like to work full time but were working part time because their hours had been cut back or they were unable to find full-time jobs.... About 1.6 million persons (not seasonally adjusted) were marginally attached to the labor force in July, an increase of 197,000 over the past 12 months. These individuals wanted and were available for work and had looked for a job sometime in the prior 12 months. They were not counted as unemployed because they had not searched for work in the 4 weeks preceding the survey. Among the marginally attached, there were 461,000 discouraged workers in July, 94,000 more than a year earlier. Discouraged workers were not currently looking for work specifically because they believed no jobs were available for them....

Total nonfarm payroll employment continued to trend down (-51,000) in July. Thus far in 2008, payroll employment has fallen by 463,000. Over the month, employment continued to decline in manufacturing, construction, employment services, wholesale trade, and the information industry. Health care and mining continued to add jobs over the month...

Originally published at Brad DeLong website and reproduced here with the author's permission.

Permalink

Another Quasi-Governmental Agency that's Lending Hundreds of Billions to Troubled Banks Aug 1, 2008 Daniel Gross on another GSE we haven't heard much about:

Freddie and Fannie's Healthy Cousin, by Daniel Gross: The Federal Reserve's extraordinary efforts to help investment banks have effectively put the taxpayer on the hook for enormous potential losses..., we could end up paying tens or hundreds of billions...

But the actual amount of credit extended so far through these public-rescue efforts pales in comparison with the credit that has quietly been extended to banks in the past year—another lifeline that taxpayers could end up paying dearly for. ... For the past 12 months, an obscure agency created by President Herbert Hoover during the Great Depression has come to the rescue of the banking industry. It is called the Federal Home Loan Banks.

Like Fannie Mae and Freddie Mac, the FHLB (here's ... a brief history, and an overview) is a government-sponsored enterprise. But it differs from the wounded giants in some significant ways. Instead of being owned by public shareholders, as Fannie and Freddie are, the 12 independent regional FHLBs are owned by their 8,100 members. Banks large and small, representing about 80 percent of the nation's financial institutions, own shares in the FHLB and share in the profits.

The FHLB has a simple business model.... Basically, it funnels cash from Wall Street to banks on Main Street. Member banks present mortgages they've issued—high-quality ones, not junky subprime ones—as collateral to the FHLB and borrow money so they can have more cash to lend. To finance its activity, the FHLB sells debt to big investors in the capital markets. As with Fannie and Freddie, the FHLB benefits from a unique status. ... While the FHLB takes pains to note that "Federal Home Loan Bank debt is not guaranteed by, nor is it the obligation of, the U.S. government," there's an assumption afoot in the marketplace that were the FHLB to encounter serious trouble, the government would step in. In return for this special treatment, the FHLB provides some vital public services. Twenty percent of its net earnings are used to help cover interest on debt issued by the Resolution Funding Corp., which paid for the Savings & Loan bailout. The FHLB also channels one-tenth of its profits to affordable-housing loans and grants.

During the mortgage boom, FHLB quietly did its job and avoided many of Fannie and Freddie's excesses. ... Subprime holdings were minimal. And since commercial banks were able to raise capital from Wall Street to make any kinds of loans they wanted, they didn't have all that much need for the FHLB's services. As the chart ... shows, the number of loans extended to member banks rose modestly in the boom years, up 7 percent in 2005 and only 3 percent in 2006. ...

But last year the mortgage house of cards began to collapse. And as Wall Street's securitization machine, which had enabled banks to raise cash with alacrity, broke down, banks staged their own run on the FHLB. .... Since ... the broken-down Wall Street mortgage securitization machine was sold for scrap, FHLB loans to member banks ...[rose] to $914 billion at the end of this June. In the past 12 months, FHLB loans to its members have risen by 43 percent, representing an additional $274 billion in real credit provided by the system to its member banks. That sum dwarfs the actual amount of credit extended to investment banks by the Fed—or by the government to Fannie and Freddie.

Does the increase in FHLB's balance sheet mean taxpayers may be on the hook for another trillion dollars in mortgage debt? It's unlikely. FHLB has a much better track record than Fannie and Freddie. Because it maintains high standards, it has never suffered a credit loss on a loan extended to a member. It doesn't spend hundreds of millions of dollars each year on executive compensation or lobbying, as Fannie and Freddie did. And it didn't lower standards ... as a way of increasing market share.... Seventy-six years after it was created by a president whose administration was hostile to government intervention in markets, the FHLB stands as an enduring and (so far) effective example of socialism among capitalists.

Why does the FHLB exist at all?:

The Housing Giants in Plain View, by William R. Emmons, Mark D. Vaughan and Timothy J. Yeager , FRB St. Louis, July 2004: ...The Federal Home Loan Bank System was the first housing GSE. The FHLBanks were established by Congress in 1932 to advance funds against mortgage collateral. At the time, the country was in the midst of an unprecedented wave of depositor runs. Depository institutions faced the risk that loans would have to be liquidated at fire-sale prices to pay off anxious depositors. The FHLBanks enabled their members, primarily savings and loan associations and savings banks, to obtain cash quickly should depositors come calling. This access to ready cash reduced the liquidity risk of mortgage lending, thereby freeing FHLB members to originate more home loans.

The FHLBanks also allowed the thrifts to offer better terms on mortgage loans. At the time, there was no secondary market for mortgages; so, thrift institutions were forced to hold loans until maturity. Consequently, they made only very short-term loans—three to five years at most. Moreover, these loans were nonamortizing "balloons"—upon maturity, the borrower either repaid the loan in full or paid a fee to renew the loan. Few families had the incomes necessary to get funding under these terms; so, few families owned their own homes. The FHLBanks stepped in and provided a source of long-term stable funding, thereby allowing member institutions to separate the credit risk and the liquidity risk of mortgage lending. ...

Many of the conditions that were present when the FHLB was created have now eased or been eliminated (e.g. by the FDIC which resolves the depositor run problem, at least for small depositors, financial innovation, etc.). So why does the FHLB still exist?:

Although advances against mortgage collateral remain the focus of FHLBank activities, the justification for this focus has widened beyond support for home ownership. Now, the system sees its mission as including support for community banking. Community banks are relatively small institutions that specialize in making loans to and taking deposits from small towns or city suburbs. Community bankers find FHLB membership and services attractive... FHLB advances are dependable and convenient... Indeed, the FHLBanks offer a wide variety of maturities, from overnight to over 20 years.

The FHLB web site adds:

In a time when cash deposits in community banks are dwindling, the funds provided by the Federal Home Loan Banks guarantee a stable source of funds for mortgages and community lending. Without the Federal Home Loan Banks, most depository institutions would not have access to medium- and long-term sources of funding.

By supporting community-based financial institutions, the Federal Home Loan Bank System helps to strengthen communities.

What are the costs of the FHLB? Going back to the St. Louis Fed article:

Many economists believe that the implicit subsidization of the housing GSEs distorts the allocation of scarce funds in the capital markets. Left alone, these markets would allocate funds to the business and household borrowers capable of putting them to the best use. Cheaper funding for the housing GSEs means more new homes, more larger homes and higher rates of home ownership. On the other hand, this distortion might lead to fewer funds being available for business investment, possibly resulting in slower economic growth. ...

Three problems are clearly associated with housing GSEs...: moral-hazard problems related to risk-taking, incomplete pass-through of subsidies intended for mortgage borrowers, and risk-shifting to the Federal Deposit Insurance Corp.

Moral Hazard

When a firm can take risks, enjoy the full benefits and avoid the full costs, economists say a moral hazard is present. The hazard is that the firm will respond to these incentives by increasing risk to imprudent levels. Moral hazard is a problem for the housing GSEs. Because the capital markets view their debt as virtually free of default risk, Freddie, Fannie and the FHLBanks can enjoy all the upside of risk-taking and little of the downside. ... The burden of the extra risk does not, of course, go away just because the housing GSEs do not bear it. Indeed, taxpayers ultimately would bear the extra risk if the federal government were to stand behind a failing GSE.

Taxpayer exposure to risk-taking by housing GSEs is not limited to potential losses from default. Risk-taking by housing GSEs could undermine the stability of the financial system because so many banks depend on them for liquidity. Commercial banks hold more than one-half of their securities portfolios—a key source of emergency liquidity—in the form of mortgage-backed securities and GSE debt. Moreover, the portion of commercial bank loans backed by real estate is at an all-time high. Banks are comfortable holding mortgage-related securities because these securities can be sold quickly with minimal transaction costs, and banks are comfortable holding real-estate-backed loans because these loans can be pledged against advances from the FHLBanks or sold to Freddie or Fannie. A severe shock to one or more of the housing GSEs could lead to a market lockup, in which investors become reluctant to hold GSEs' direct or indirect obligations. This could, in turn, lead to a temporary suspension of mortgage purchasing, mortgage securitizing or mortgage "advancing," thereby forcing the Federal Reserve to intervene to re-liquefy the mortgage markets.

Incomplete Pass-Through of Subsidies

Who actually benefits from the subsidy—homeowners or the employees and shareholders of GSEs? As noted, the implicit guarantee against default lowers housing-GSE funding costs. Lower funding costs can be used to reduce mortgage rates for homeowners or to raise employee salaries or dividends for housing-GSE shareholders. Estimates vary about the division of the subsidy; one recent study estimated that the subsidy to Freddie and Fannie lowered mortgage interest rates by about 7 basis points (0.07 percent), yielding a savings to homeowners of about $44 billion. At the same time, the gain to Freddie's and Fannie's shareholders was estimated at $72 billion. ...

Shifting Risk to the FDIC

Of the three housing GSEs, the FHLBanks are the least likely to increase their own risk. The shareholders of the 12 regional FHLBanks are also the customers. Therefore, the cost of excessive risk-taking by an FHLBank would fall on the same parties that enjoy the benefits. Still, the FHLB System may create moral hazard through another channel by implicitly encouraging its members to ramp up risk.

Advances from the FHLBanks may encourage risk-taking at member institutions because the FHLBanks have little incentive to demand higher interest rates when the credit risk of a borrowing bank increases. Advances are heavily collateralized—the market value of mortgage collateral typically covers 125 to 170 percent of the advance. This protection explains why the FHLB System has never lost a penny on an advance. Because advances carry no credit risk, the individual Home Loan banks can set terms that are largely independent of the failure risk of the borrower. Put another way, borrowing from the FHLB enables a bank to avoid any market-imposed penalty for failure risk. Moreover, the FDIC, which covers losses to insured depositors in the event of a bank failure, cannot make up the difference by hiking deposit-insurance premiums. Many observers believe that the current cap—27 cents a year per $100 of deposits—is too low to deter risk-taking. In short, greater risk-taking by FHLB members implies a higher failure rate over time. A higher failure rate, in turn, implies greater losses to the deposit-insurance fund. Taxpayers ultimately stand behind this fund.

Unless someone can identify the substantial government failure that this program solves, show that the FHLB provides liquidity insurance banks cannot get from the discount window or through other means, or make the case that the private sector, even with all of the recent financial innovation, would not make the necessary array of financial services available to smaller communities without the implicit government guarantee standing behind the FHLB, and further make the case that financial services, like telephone service or electricity, are essential services that all communities should have, then we should follow the recommendations we've heard for Fannie and Freddie and slowly eliminate the implicit government support of this institution.

Originally published at Economist's View and reproduced here with the author's permission.

• Related RGE Content:
• The Costs and Benefits of the GSEs FannieMae and FreddieMac
• Congress Agrees On Liquidity Access, Equity Stake, And Credit Line for GSEs: Plan May Cost Taxpayer $25bn Until 2010
• U.S. Congress and White House Agree on the Housing Bailout Bill: Will It Be Effective in Containing the Housing Downturn?

10 Things to Understand About the Housing Bubble and the Debt Crisis Daniel Alpert | Jul 30, 2008 Highlights

• In time, history will provide a fulsome overview of the twin housing and debt crises, perhaps the most challenging debacle since the Great Depression. At this early stage, however, Westwood tallies a "top 10" list of underlying causes and considers what can be done to reverse the situation.

• Ranging from an unprecedeted level of debt creation that fueled massive asset inflation, to insane lending practices and, ultimately, exploring the last 20 years of the American debt-culture, this report outlines just how the economy arrived at this juncture, and how our business and government leaders mistook debt-driven liquidity for real wealth.

• In order to avoid the dismal results experienced by Japan after its bubble burst in 1989-1990, we must rapidly resolve loans, re-capitalize and rehabilitate our financial institutions, and end our dependence on easy money (negative real rates of interest).

• Moreover, Wall Street, the banking sector and government must cooperate to recognize the magnitude of the crisis, to enable a swift recovery and to minimize the chances of its reoccurrence.

Overview

The current state of affairs in our housing and mortgage capital markets should not have come as a shock to regulators, lenders, investment bankers or homeowners. All were, evidently, willing participants in a classic bout of speculative asset inflation, the likes of which have been seen before but have, unfortunately, become a more frequent occurrence in the US-led, global economic system. The hallmarks of asset bubbles and resulting financial crises over the past quarter century have been substantially similar: (a) a failure to observe basic economic and financial fundamentals regarding value, capital and the markets; combined with ( a uniquely American tendency to believe that almost any new economic phenomenon ushers in a new era to be governed by a completely new set of measures of value and economic performance. The results of bubble behavior are invariably the same, and it is certainly debatable as to whether the absolute defense of unfettered and undisciplined markets, that leads to such bubbles, is in our nation's, and our economy's, medium or long-terms interests. The clean-up required in the current case, and in prior bubbles, results in the elimination of huge amounts of wealth and is accordingly destabilizing to our country's interests.
The "Top 10" List

In Westwood's view, the following ten factors most significantly contributed to the housing bubble and mortgage crisis:

1. Residential mortgage and consumer credit more than doubled in the first six years of this decade. From the founding of the nation through 1999, our citizens amassed some $5.1 trillion of home mortgage debt and $1.4 trillion of installment and credit card debt. By the end of 2006, these numbers stood at outstanding amounts of $11.0 trillion and $2.4 trillion, respectively. In total, American individuals became indebted by an additional $6.9 trillion in six short years (the bulk of which was in the three-year period from 2004 through 2006) more than doubling the debt outstanding at the beginning of the decade. Apologists often cite increases in wealth and in home equity value as offsetting this unprecedented and crippling increase in our citizens' indebtedness. But the truth is we live in a nation with one of the lowest savings rates in the world (it was actually negative in 2005 and was likely negative in the year just ended) and, as detailed below, a significant portion of the perceived growth in home values has been specious at best.
2. Cheap mortgage loans offered on lax lending terms were responsible for much of the ballooning of home prices. Let's say that in 2000, you had $100,000 to put down on the purchase of a home. In the same year, with residential mortgage rates at 6% for adjustable rate mortgages, you were offered a mortgage for 80% of the purchase price of the home you were seeking to buy. The $100,000 you had available meant that you could afford a $500,000 home (80% of $500,000 = $400,000 in mortgage) and, interest only, your monthly payment would have been approximately $2,000 per month. Now, zoom ahead to 2006. With the same $100,000 in your pocket, and an adjustable teaser interest rate of 3%, mortgage companies nationwide were knocking down your door offering you mortgages at 90% of your purchase price (and more – often over 95% in some cases). With your same $100,000 and for the same $2,000 per month interest payment – voila – you could now afford to pay $1,000,000 for the same house for which you would have been able to pay $500,000 six years before. And of course, that is pretty close to what happened during this period – residential home prices increased by over 74% from 2000 through 2006. Does that mean the homes themselves were actually worth more? Of course not.
3. The growth in home prices during the first six years of this decade has been unprecedented and should have had our mortgage bankers, investment bankers, regulators and the Fed raising at least an eyebrow or two. As prices more than doubled in some markets and increased over 74% nationwide from 2000 through their peak in 2006, the stewards of our banking sector and their overseers in government apparently neglected to consider why. Pointing to "global reserves of excess savings" and "more efficient capital markets" as the new paradigms rendering previous market fundamentals obsolete, the best and the brightest ignored the fact that debt driven home prices had totally disconnected from median household income which has increased by a mere 15% during the same period, before adjusting for inflation (median income actually decreased after adjusting for inflation). If there had been a global glut of savings, we would have experienced a boom in the production of all capital goods – not just limited to housing – which would be fully sustainable by those real savings (in contrast to what was actually a debt driven spate of asset inflation in housing). More importantly, the purchase price of homes actually rendered it more expensive, even on an after-tax basis, to own rather than rent a residence – in some markets by more than 30%. This phenomenon is not only historically unprecedented, but any student of finance and economics can tell you that it is as unsustainable as any market that is based on pure speculation. And pure speculation is what ultimately developed in residential real estate market – the notion of ever rising value, so similar to the dot com boom.
4. Mortgage lenders, seeking to maximize lending, relied on aggressive appraisals to justify outsized loans – and appraisers cooperated by ignoring their own established methodologies. The Chicago-based Appraisal Institute, the gold standard in real estate appraisals with 22,000 members, maintains guidelines known as the Uniform Standards of Professional Appraisal Practice (USPAP). Among other requirements, the USPAP directs, generally, that appraisers consider multiple indicia of the value of any form of property being appraised, with value defined as the most probable price at which a willing buyer and a willing seller would agree to transact a fair sale, assuming (among other things) that "both parties are well informed, or well advised" and "the price [is] unaffected by special or creative financing…..granted by anyone associated with the sale." In addition to considering recent sales of real estate, generally, Appraisers are regularly required to consider the value of properties based on the income they would produce if rented and based on the cost of replacing any improvements (buildings) to the property. They are then required to reconcile any differences among these three classic valuation methods. As it turns out, however, during the housing bubble, home prices completely disconnected from both rental values and from replacement costs. From 1960 through 1996, the ratio of average home rents to average home prices hovered in a band of 5% to 6% per annum. From 1996 to 2000, it declined to 4.6% and then, in a stunning drop this decade, the ratio fell to 3.5% by the end of 2006. Although common wisdom may have it otherwise, the fact is that construction costs barely moved at all during this decade, on an inflation adjusted basis, while home prices increased by 74%. If construction costs were constant and home prices ballooned, the only explanation – according to established valuation methodologies – could be that land was very suddenly worth dramatically more. But that much more, and that quickly? Appraisers couldn't possibly reconcile these dramatically divergent indications of fair market value, so what did they do? Well, as it turns out – Fannie Mae, Freddie Mac, and pretty much all other mortgage originators, guarantors and investors, don't consider income value as relevant to the appraisal of non-rental, residential real estate. Instead, appraisers merely conclude that recent sales are, for all intents and purposes, the only valid indication of fair market value. In doing so they enabled the entire market to ignore the impact of comparisons to rental properties and "special and creative" financing that – although it didn't come from sellers – was demonstrably, and has now proven to be, uneconomic.
5. Incremental home sales are not always a reliable indicator of fair value – a market almost tailor-made for a bubble. While homes are the largest repository of individuals' wealth in the United States and certainly the largest asset of most homeowners, they are extraordinarily inefficient to buy and sell and the number of all homes that change hands in a given year is tiny, in comparison with the stock market, for example. By nature of their unique locations and characteristics, homes are very difficult to trade, relative to other assets of such substantial financial significance to their owners. Sellers typically pay sales costs of 5% to 6%, incur repair and improvement costs to make homes more saleable and, ultimately, have to suffer the cost and inconvenience of moving all their possessions. Contrast that with the pennies it costs to effectuate a stock trade, and the differences become apparent. Consequently, people are not constantly pricing and re-trading their residential real estate and, when they do, the value of their property is very much in the eye of the buyer as no two residences (as opposed to shares of stock) are exactly the same. Depending on where we end up as a result of the present crisis, the value of all homes in America will likely level off somewhere in the range of $15 to $20 trillion (a big chunk of our national assets). At current valuations, some 7.6% of existing homes change hands each year. In comparison, the total current market capitalization of all the stocks listed on the New York Stock Exchange is $18.26 trillion, and the recent annual volume of all trades on the NYSE is $17.14 trillion – a full 94% of the total market value. The old saw on Wall St. that "the tape never lies" may not always be true, but share pricing on the big board is certainly a better indicator of fair value than what Joe down the block sold his house for to some rube at the peak of the bubble. And when what the rube paid causes someone to pay as much or more for a roughly similar house a mile away, that's how bubbles are born – marginal sales volume, relative to the size of the overall market capitalization, translating into false assumptions of value for the entire market.
6. The game of musical mortgages undervalued risk and spread the resulting pain across vast sectors of the global capital markets and market participants. It is not reasonable to believe that the housing bubble and the mortgage crisis issues discussed here eluded everyone in the financial community. A vigilant few (Robert Shiller comes to mind) long predicted the current outcome. Many more, in order to profit from the enormous volume of new debt being created, chose to ignore or didn't fully appreciate the situation – and didn't care much either as they were playing a game of musical chairs with limited capital at risk (insufficient capital, as has been demonstrated recently). Mortgage originators (primary lenders) were able to sell off mortgages – often at a profit – to banks, investment banks, Fannie Mae and Freddie Mac, retaining little more than the risk that they might lose ongoing mortgage servicing revenue. Investment banks, Fannie and Freddie, labored mightily to turn mortgages into, and sold to investors, residential mortgage backed securities (RMBS), with the blessing of the rating agencies which assumed that sub-prime, Alt-A and other high loan-to-value mortgages would perform pretty much like more conventional mortgages of yore and, like the appraisers, ignored the real world implications of the housing bubble being created by precisely the same debt they were rating. Buyers of the more risky portions (known as tranches) of the RMBS, swiftly aggregated those tranches into more highly rated collateralized debt obligations (CDOs) which were sold to even more investors. Investors in CDOs then often packaged multiple CDOs they held into what became known as CDO-squared securities in order to wring out more fees and profit. Finally, investors holding the most risky pieces of these securities variants then sought to hedge their risk by trading nifty hedging securities known as credit default swaps, the magnitude of which were virtually unlimited as they amounted to nothing more than bets for or against the performance of a particular security or pool of loans (and, as any bookmaker knows, you can take as much action on one side of a bet as you have on the other). At each stage of this game, there were enormous fees generated – and the more lax lending standards became, the more loan volume there was to generate fees. Until, of course, the music stopped. When it did – losses were scattered all over – vast amounts of investor capital vanished, and continue to disappear. Vast numbers of homeowners will either lose their homes or be "under water" on their mortgage debt. But – as has become customary in the boom and bust cycles of the financial markets, the fees, bonuses and capital gains will be retained by the owners and employees of the lenders and bankers orchestrating the music.
7. The amount of mortgage debt outstanding versus the value of homes securing that debt is a risk that is concentrated in middle class income earners. Many professionals, who saw mortgage loan balances ballooning to $11 trillion by the end of 2006, took comfort in the fact that home values had ostensibly ballooned to roughly $20 trillion at the same time. At first glance, that would indicate that – on average – about 55% of the value of all homes was owed to lenders, not a particularly uncomfortable percentage. Looking more closely at these numbers, however, raises some uncomfortable questions. First off, US Census data estimates that 33% of all homes have no mortgage debt on them at all. Homes belonging to our older or retired citizens generally have little or no debt outstanding against them, if only by virtue of the period of time such people have owned their homes. In reality, therefore, the $11 trillion of mortgage debt outstanding may be secured by homes worth only about $14 trillion to $15 trillion when the market peaked in 2006. This would indicate that the average loan-to-value ratio was actually north of 75%. Accordingly, if the value of homes falls 25%, on average, from 2006 values, as some very respectable economists and analysts believe may be the case, such a reduction would set the value of all homes in the US at around $15 trillion and the value of all homes with mortgages at about $11 trillion – a 100% average loan-to-value ratio. If that is not bad enough, consider the fact that mortgage debt is not spread evenly over all mortgaged homes, some homes are mortgaged for well below the average loan-to-value ratio. The unfortunate corollary is that a similar number of other homes, after such a reduction in value, would be mortgaged for amounts in excess of 100% of their value. A large number of these homeowners will find their homes worth far less then the mortgage debt outstanding thereon. Unfortunately, older and retired individuals with low or not mortgage debt do not comprise the heart of our consumer economy. Thus the impact of over-leveraged or "under water" housing will fall squarely on the shoulders of middle class homeowners, those raising families, working and, in better times, the core earners and consumers on which our economy depends.
8. Selling homes to 20 year-olds – how the homebuilding industry killed off years of future demand. With inventories of existing homes for sale honing in on nearly a 12-month supply (the highest since the early 1980's) at current absorption rates, and new home sales inventories at roughly nine month's supply, reaching price equilibrium may be a long process. One of the reasons that price firming, to say nothing of recovery, may not occur until at least 2009 is that so many people who would have remained as renters during the first half of this decade were instead encouraged to buy homes with little money down. Sub-prime/Alt-A mortgage lending not only targeted people with bad credit, but also young people – many of them in their early 20's – with no bad credit history, but with nowhere near the equity down-payment required to qualify for a conventional mortgage. In earlier times, this portion of the population would have rented until they saved up enough to acquire a home. Not in this decade. As a result, a significant number of families that would have normally entered the home buying market over the next 5 or more years are already homeowners (albeit burdened by mortgage debt they may not be able to afford). Essentially, the extraordinary demand created by this decade's "special and creative financing" will not reappear until an entirely new cadre of young people can save up enough to truly afford a home.
9. The current crisis can be traced back to the advent of home equity and sub-prime lending in the 90's, and in part to the Tax Reform Act of 1986. There are few financial crises in this country that aren't traceable to events occurring long before the crisis. For generations, people in this country have borrowed to afford a home and grew equity in their home through slowly paying off their mortgage loan and being the beneficiaries of normal economic inflation. The vast majority of people had the vast majority of their net worth represented by their home equity, and paying off mortgage debt contributed significantly to the nation's savings rate. The federal and many state governments promoted what is generally regarded as the social good of home ownership by providing a tax deduction for interest paid on mortgage loans. Prior to the Tax Reform Act of 1986, however, governments also permitted taxpayers to deduct almost any other kind of interest they incurred as well and the credit card companies and other consumer lenders naturally benefited, as their "product" (unsecured credit, auto loans, student loans, etc.) was this made cheaper to the consumer. After the non-mortgage interest deduction was phased out in the early 1990's, a new financial product came over the horizon – the Home Equity Line of Credit, or HELOC. At first, the HELOC was designed to solve the problem created by the elimination of interest deductions on consumer loans. Simply grant a lender a second mortgage on your home and suddenly, as long as you had less than $1 million in total home loans, you could deduct all of the interest on what really was a personal line of credit. Better yet, because it was secured, the interest charges were typically lower than on credit card debt. A great solution to the problem from lenders' and consumers' points of view, HELOCs became very popular and – by the end of the 90's – ubiquitous. Homeowners soon realized, however, especially as home values began to rise more rapidly beginning in 1996, that they could qualify for HELOCs far exceeding the amount of credit card lines and other consumer debt they used to have. And why was that? Because they were now borrowing against their home equity – their largest concentration of savings. Suddenly, consumers realized there were all sorts of things that they needed to acquire – available liquidity tends to produce that reaction in the United States – beginning with things like home improvements (a good investment) and better education for their children (also a good idea). But before long, and as the wealth effect of persistently rising home values entered the national psyche, American consumers needed other things too – that great vacation, the newest electronics and technology, or perhaps a nice boat. The mortgage lending industry made such spending almost irresistible, even providing special check books to pay for the things you thought you needed or deserved. It didn't feel as though people were dipping into savings – but they most assuredly were. And all along the government was subsidizing the interest on the debt being created. And if you used a lot of availability under your HELOC, the industry was all too happy to take some fees to refinance your entire mortgage. And when borrowers got in a little over their heads in the 90's, something called a "sub-prime" mortgage loan was created by the lending industry – at a little higher interest cost – to help them still qualify for refinancing, When interest rates started to drop precipitously earlier in this decade, it saved borrowers money to refinance and they could borrow even more against home equity without seeing payments increase.
10. The levels of consumer spending over the past several years are being re-evaluated and consumer spending is in jeopardy as the culture of debt is dis-assembled. As noted, from 2000 to 2006, residential real estate and consumer debt more than doubled by a factor of some $6.9 trillion. That money found its way into the pockets of homebuilders (in small part, about $1.3 trillion) on the one hand and, on the other hand, to homeowners, sellers of land and existing homes and others (through home sales at inflated prices, refinancings, home equity lines of credit and credit card/installment sales credit). Other than the portion going towards the creation of new homes, where did all that money go? Depending on the proclivities of the homeowner or home seller, the money went to one of three places:

• Savings and investments in stocks and bonds, causing massive rallies in both markets;
• Consumer spending – all those plasma TVs, boats, home improvements, and Asian imports that have been the life blood of our economy; or
• Inter-generational wealth transfer – spurring consumption and or investment by the lucky recipients.

At first, that sounds OK, saving and investing are good, consumer spending is generally good, and we all love our children – so what's wrong with all that? The problem is that somebody in the equation needs to pay back a lot of money – it was a debt driven cycle, not production driven, after all. The extent to which all of this liquidity impacted consumer spending over the past several years is difficult to assess. It is a fair assumption that a good portion of this wall of money found its way into investments of a number of types, but it is equally reasonable to be concerned that a very sizable amount fueled a significant portion of consumer spending (of particular concern is that credit card companies, attempting to lend where mortgage lenders no longer can, are continuing to put out money to the already strapped consumer – the most recent data showed unsecured consumer credit ballooning 7.5% in November to a new high of $2.5 trillion – credit card defaults are the inevitable next shoe to drop). What is truly alarming is that the 2000 through 2006 bubble debt is equal to about 25% of all consumer spending during the 6-year period of the debt's creation, and an even higher percentage if one looks at the three years from 2004 through 2006 (this is just math, not necessarily a direct correlation). Certainly, not all of the bubble debt was attributable to overvaluation of housing. Some of it can be accounted for by the increases to home prices consistent with inflation in the rest of the economy. But it is apparent that a good chunk of it found its way into consumer spending and represented a significant enough portion thereof that the elimination of that consumer liquidity would significantly impact consumer spending, and thereby, corporate profits. If the country descends into a recessionary environment, the foregoing will be the cause of that recession. And a pullback in jobs and consumer spending of the magnitude indicated by the size of the debt bill that was driving jobs and spending, could be quite severe.

What Can be Done to Put this Behind Us

So that's what happened and why. Now the question is what to do about it, both to recover from the present situation and to prevent its possible reoccurrence (the financial markets have very short memories). The catastrophic debt driven bubbles in Japan and the US in the period of 1989 – 1990 provide good direction in this regard. In Japan, assets re-priced just as assets must at the end of any bubble (with real estate falling by an unimaginable 75% from peak to trough). Financial and commercial real estate assets also fell dramatically (although not nearly as much) in the US. The difference between the two cases is that Japan allowed their financial institutions and investors to continue in business without recognizing the massive losses they had incurred. This delayed the re-capitalization of their institutions and continued their post-bubble recession for some 13 years. In the US, however, the Fed, banking regulators and ultimately the then-newly formed Resolution Trust Corporation moved relatively swiftly to force assets and investments to be marked to market, disposed of and recapitalized, which saw the US back on track by the mid-90's. This must happen again, and without waiting for a change in administration.

The recent pressure on the Federal Reserve Bank to lower its Fed Funds target is counter productive in the above context. Encouraging more lending, the creation of more indebtedness and dis-saving, is precisely what got us into trouble in the first place. And in any event, more lax lending is fundamentally impossible in the current situation. Lenders and investors have finally woken up to the fact that more of the same will merely result in their not getting their money back. And the marginal reduction in floating rate mortgage loan interest rates will not prevent the eventual revaluation of homes, and may in fact delay it, resulting in a more sustained recession.

Conclusion

In past debt debacles, and other market crises, the affected assets have been things like commercial real estate, farmland, tech stocks and bank shares. This time around, along with the stock market, it is people's homes, the re-pricing of which literally hits us where we live. The potential for massive social and economic destabilization needs to be taken into account in considering solutions. Every effort must be made to restore lost jobs, production and eventually savings – and that will be nearly impossible by increasing the number of bankrupt and/or homeless citizens. At the same time, we are a nation of laws and contracts and the government should not be stepping in to advocate the abrogation of loan documents and other legally-engaged-in business dealings (consumer fraud is another matter).

It is often said that economic bubbles don't burst, they deflate. We are watching the air gradually leak out of a bubble of our own creation – the underpinnings of which were the massive increase in the indebtedness, and the reduction in savings and net worth, of our fellow citizens. Wall Street, the banking sector and government must cooperate to recognize the magnitude of the crisis, to enable a swift recovery therefrom and to minimize the chances of its reoccurrence.

http://www.rgemonitor.com/us-monitor

U.S. July Payrolls Indicate the Worst of Labor Market is Yet to Come Aug 1, 2008

Today's employment report showing large job losses and a spike in the unemployment rate indicate things are only getting worse for the U.S. consumer, especially when he is dealing with high cost of living, mortgage and credit card debt and tighter credit conditions. Given the jobless recovery and slow wage growth since the last recession, households used their homes and credit borrowing to finance consumption and drive the economy. But the housing and financial sectors took a hit and now with even the labor market flashing a 'no-entry/only exit signal' at them, it seems like a perfect storm for the U.S. households. What are the Indicators Showing?

Several leading labor market indicators are now showing trends that in the past have been observed only when the economy was in the initial stages of a recession. After total job losses of 412,000 in H1 2008, July witnessed job loss of 51,000 in July. Payrolls often called lagging indicators 'usually' start softening as the economy slows and turn negative when the economy enters a recession, moving back to the positive territory only after the recession ends and recovering slowly thereafter. Job creation started slowing since mid-2007 but has turned negative since Jan 2008. Job growth has in fact turned negative on a 3-month moving-average and quarterly basis since Feb 2008. Job growth on a 12-month moving-average and yearly basis has also slowed starting Jan 2008.





Data Source: Bureau of Labor Statistics

The unemployment rate started inching up since Dec 2007 and hit a four-year high of 5.7% in July. Theunemployment rateusually tends to rise steadily as the recession deepens, peaking nearly two years later and recovering very slowly, often reaching the pre-recession level only after four years. The number of unemployed as a share of total population and the unemployment rate among laid-off workers claiming for jobless benefits has also shown an upward trend in recent months. The latter called the jobless rate rose to a high of 2.5%. The increase in unemployment rate is especially large (like during most recessions) for teens, blacks and Hispanics. Looking at the state level trend, it is not surprising that states hit hard by the housing crisis have shown a significant increase in the unemployment rate (as of June-08): California (6.9%), Nevada (6.4%) and Florida (5.5%); so have states affected by auto sector woes: Ohio (6.6%), Michigan (8.5%). However, booming exports and energy prices may have helped keep the unemployment rate down in states like Texas (4.4%), Louisiana (3.8%) and Oklahoma (3.9%).



However, due to underlying trends in the labor market, the unemployment rate may be hiding or understating the extent of labor market deterioration. This is because usually, the hiring rate turns flat as the economy enters a recession and continues to remain subdued or declines for almost two years before recovering (Several studies have in fact highlighted the importance of slowdown in hiring relative to the pick-up in lay-offs during a recession). This time too, it is the significant slowdown in hiring (of both unemployed workers and new labor force entrants) that is contributing to the labor market weakness. Hiring started slowing since Q3 2007 and declined to 3.2% in May as firms facing uncertain economic prospects and rising production costs off late have been less eager to hire workers. This has deeply affected job prospects for fresh graduates and summer-job seekers, including school/college students and teens. Similarly, job opening has slowed down since Q4 2007 and was at 2.6% in May. So owing to sharp slowdown in hiring, several new and laid-off workers unable to find jobs are backing out of the labor force (called discouraged and marginally attached workers) or working part-time (as firms prefer them over full-time workers during economic slowdown). In fact, the labor participation rate has been flat or somewhat weak since early-200, thus keeping a lid on the unemployment rate. Also given the very modest job creation since the last recession, firms may actually have less excess labor to shed, preventing employment from declining severely and thereby holding down the unemployment rate. So instead, calculating the unemployment rate including these workers (long-term unemployment rate) shows a continuous upward trend since Dec 2007, hitting a double-digit figure of 10.3% in July.

One of the most important indicators of the labor market strength are the initial and continued unemployment insurance claims (UI) since they usually start rising even before the economy enters a recession. While both started spiking since Mar-Apr 2008 and the latter hit recessionary levels of over three million in mid-April while the former started jumping into the +400k level only since June-end, which implies that slower hiring/rehiring of workers were initially driving the labor market weakness. As lay-offs are gaining pace, initial claims are expected to rise further in the coming weeks. Moreover, continued claims may be underestimated as workers who are unemployed for over 26 weeks (amid weak hiring prospects) and exhaust their benefits are not counted in the data Those eligible for extended jobless claims under the Congress Bill are accounted for in a different dataset. Also, self-employed workers whose share in affected sectors like real estate, rental and leasing and construction has risen in recent years are also not eligible for jobless claims. Moreover, many of the lay-offs are occurring in the high-paying financial sector and the illegal immigrants-laden construction sector where workers may not file for claims. Others may also delay or decide not to claim benefits in the hope of finding a new job soon even as different states have varied eligibility requirements to file for claims.





Apart from jobless claims, other 'leading indicators' have been weakening since H2 2007. The Index for newspaper and online job ads for Help-Wanted has been declining since Q4 2007 with the former hitting a record low in July and the latter down 7.9% y/y. The Monster Website online job availability Index is also down 14% y/y. The Manpower Index also indicates that firms planning to increase hiring in Q3 2008 is at a five-year low. The Conference Board Employment Index in June continued to reflect the fact that households are finding jobs hard to get and see fewer jobs available in the next six months. The weak demand for temporary workers escalated after Jan 2008, declining further by 29,000 in July. Also, weekly hours of labor started flattening since Jan 2008 and hit a record low and a recession level in July. In addition, part-time workers have increased since Q3 2007 and while full-time workers started to decline since Dec 2007.

Apart from the fact that the BLS data is subject to large revisions, there has been much criticism of the BLS methodology and its inaccuracy in predicting business cycles due to which employment numbers would indicate a recession only after it has begun. For firms not covered under the survey, BLS estimates how many firms (jobs) come into business and go out of business each month (called the birth/death model). But this model often overestimates the former and underestimates the latter during an economic slowdown, thus missing the turning point in business cycles. In fact, in the recent months, BLS has been overestimating job creation in the weakening sectors like construction, leisure and hospitality, finance and thus underestimating the extent of job losses.

Sector-Wise Job Losses:

Private sector employment started slowing in 2007 and turned negative in Dec 2007 losing 665,000 jobs including a loss of 76,000 jobs in July. As expected, job losses first showed up in real estate, construction, manufacturing, financial services and related activities. The manufacturing sector being highly cyclical, starts shedding jobs when the economy enters a recession lost 35,000 jobs in July (271,000 ytd) led by goods-producing sector (46,000 in July and 522,000 ytd). While the ISM manufacturing employment Index began showing weakness since end of 2007, the ISM Non-Manufacturing Index also started softening since Jan 2008 and both contracted in June.

Automobile, airlines, shipping sector woes (on slowing consumer demand) have been exacerbated by rising fuel costs; technology sector also expects lower demand from consumers as well as firms (as firms cut IT spending as one of the first steps to cut costs). While many firms have been bullish about the booming global economy and therefore manufacturing exports offsetting lower demand in the U.S, it may just be a matter of months before the U.S. slowdown and subdued demand spreads to the rest of the world and hits export-oriented manufacturing industries. Correction in oil and commodity prices will also impact employment in these sectors. Self-employment which boomed during 2004-07 has also shown a decline since July 2007 but by being counted only in the household survey, the payroll numbers ignore job loss among this group

Construction employed after boom during 2004-06, particularly in the residential and specialty trade contractor sectors) has witnessed large job losses in the recent months even without taking illegal immigrants into account. In July it lost 22,000 jobs taking the Jan-Jul figure to 290,000. Residential construction employment after peaking in 2006 started deteriorating in H2 2007 (especially in residential specialty trade) and shed 14,000 jobs in July. It was expected that the non-residential sector (where job creation was going strong in 2006 and early-2007 even when residential employment had started slowing) would provide some cushion by absorbing labor from the residential sector but here too employment has been falling since Q3-07 albeit at a slower pace. Given the pending correction in home prices and inventories, construction and housing-related employment will continue to trend down in the near future. Recent trends in commercial real estate show that jobs there too might be at risk. There has been some evidence of slowing remittances to Mexico as immigrants lose jobs and also slowing inflow of new immigrants into the country (and even outflow of some immigrants) on weakening job prospects. However, booming agriculture prices may help absorb some immigrants laid-off in the construction sector into the farm sector.

Services have been a bright-spot in terms of job creation in the recent decades. They tend to shed jobs later in the recession (due to the lag effect in consumers feeling the pinch and cutting down on spending). As a result, job creation in services has been weakening since Jan 2008 and we saw job loss of 5,000 in July. This may be a matter of concern given its high share in GDP and employment. Retail and business and professional service employment have also shown an upward trend over the years and have tended to lose more jobs in the last two recessions compared to the previous ones (due to increasing significance of consumers in the economy). Retail employment started slowing in mid-2007 and showed continued job loss of -17,000 in July, while employment in business and professional services (which started declining from Jan 2008) showed a decline of 24,000 in July (-189,000 ytd).

Government, and health care & education jobs have been resilient since the last two recessions showing little weakness. In fact, these sectors have been significant sources of job creation in the recent years (especially in govt sector compared to the private sector) and continued to add 25,000 and 39,000 jobs in July respectively. However, it will be interesting to see how long government jobs can hold up especially the state and local government ones given that several state governments and municipalities are facing huge deficits and are planning to cut down on services like health, education and infrastructure spending (even as falling individual and corporate income, property prices and consumer spending is eroding their tax revenues, and higher interest cost on muni bonds is raising their debt for health care, transportation and schools).

Financial sector jobs were unchanged in July from June. Given that this sector has taken a major hit from the credit meltdown one would have expected much larger lay-offs (especially at Wall Street) than what the numbers are showing. But this may be because only a small sub-sector of the financial sector has been affected by the credit crisis (like credit intermediation, fixed income, investment banking, asset management, real estate brokerage and mortgage division) and is shedding jobs while other sub-sectors like equities, currencies and commodities have been holding up (so far). Moreover, the affected sectors represent a small share of the total financial sector jobs and total Wall Street jobs. Wall Street represents a small share of the total financial sector jobs and many workers offered severance packages continue to be counted in the payroll survey. Credit intermediation (-3,800 in July), finance and insurance, real estate (-2,400 in July), rental and leasing services have also shown large decline in employment since early-2007 (especially during Aug-Oct 2007). Commercial banking also witnessed weak to negative job growth during this period. Over 100,000 finance jobs have been lost since Aug 2007 with over 21,000 of them since Jan 2008. While Wall Street has lost only over 10,000 jobs so far, close to 35,000 lay-offs are expected in the coming quarters but these estimates have been raised up recently following continued bank writedowns and job cut announcements. As the credit crisis spreads to the other sub-sectors of the financial sector (as liquidity crunch reduces capital flowing into asset management, hedge funds, private equity, consumer/auto loans, and banks and fund managers suffer credit losses and begin cutting operating costs), job losses are also bound to spread. Moreover, as the global economy slows and oil and commodity boom end, the presently booming sub-sectors will also feel the pain. In fact, job creation in securities, commodities, investment firms started slowing since late-2007 though is still positive.

Not many sectors have added excess labor since the last recession (or at least at the same pace as in previous recoveries) to now shed workers. This is particularly true for the manufacturing sector (and partly service sector) where several jobs have moved offshore since 2001. However, some sub-sectors especially in construction and finance sectors have seen strong hiring in recent years, making it obvious for them to shed jobs once the bubble bursts.

Implications:

So far, firms had perceived the crisis to be sector-specific and a short-lived one therefore making it inefficient and costly to fire and later re-hire workers and were instead hiring fewer workers, reducing overt-time, full-time and temporary workers and relying more on part-time workers. They have also been making the existing workers work for fewer hours or adjusting their wages, perks and bonuses. However, now the firms realize that weakness in consumer spending is going to get worse in H2 2008 as consumers face increasing financial headwinds and the impact of tax rebates fade. And add to this the spike in fuel and raw material prices and its impact on production costs. Indicators for industrial production, manufacturing activity, capex, factory and durable goods orders also show that producers plan to scale back on production As a result, of slowing economy and rising costs, firms have lowered their earnings forecast and plan to cut operating costs and lay-off thousands of workers in the coming months. Hence, lay-offs are bound to escalate ahead and add to the pool of unemployed workers so far dominated by slow hiring trends. Also after spending the rebates, consumers will continue to face job loss, slowing asset and wage income, high debt, credit constraints, and inflation (food, fuel prices and prices of other goods as well since most firms plan to pass on higher costs to consumers). So consumer spending on goods and services will only deteriorate ahead, so that job losses will spill-over to other sectors (with a lag) creating a vicious circle. Impact on consumption may especially be true when job cuts occur in the high-paying service sector and some high-skilled sub-sectors like financial and business and professional services. Also during a recession, workers (particularly in less-skilled and manufacturing sectors) find new jobs where wages are relatively less compared to their previous job. Job losses in retail (consumer durables, luxury goods, home-related goods, apparel, textile, electrical sectors), leisure and hospitality, business and professional services are bound to intensify as consumers opt for discounted and low-ticketed items. The diffusion index also shows that job losses started spreading to other sectors of the economy starting Nov 2007 and this trend continued even in July as economic weakness slowly spread from residential to commercial real estate, financial to non-financial corporate sector. A consumer-centered recession may exacerbate this and pose further downside risks to a prolonged economic slowdown and recovery.

However, there doesn't seem to be any significant risk of wage pressures that might toughen Fed's job of price stability by creating a wage-price spiral. Average hourly and weekly wages have stabilized in recent months (the former rose only 0.3% in July while the latter was unchanged). Unit labor costs and compensation have also weakened since Q4 2007. The employment cost index in Q2 2008 rose slowest in two years at 0.6% while slowing wages and benefits led to a weaker compensation growth of 3.1% y/y. But more importantly, productivity growth has rebounded since H2 2007 (which may be because firms started using fewer labor or labor hours as the economy began slowing). Anyways, compensation growth (which in recent years has mainly been driven by bonuses, perks and stock options) is bound to decline as firms cut costs. Moreover, the Fed's past worries of shortage of skilled labor in certain states and sectors (say finance) is fading as demand and even compensation of skilled labor is softening while productivity growth continues to be buoyant. Also, as producers increasingly pass on higher prices to consumers, real wages may remain subdued and prevent the risk of a wage-inflation spiral. However, this also implies that labor is taking home less in real wages. In fact, real hourly compensation was negative in Q1 2008 and real wages have been negative since Oct 2007. Labor and individual income tax receipts as well as withholding taxes have also shown weakness recently. So while somewhat good from the monetary policy perspective, but as long as inflation erodes the purchasing power of workers, it may tend to delay the recovery in consumer spending and hence economic growth. And firms recognizing weak consumer demand may reduce production activity and workforce, thus re-enforcing the labor market weakness.

It is argued that given the structural changes in the economy and the 'great moderation' and also the demographic and compositional changes in the labor market in recent decades (including rising employment share from manufacturing to services, declining labor participation rate and labor force), the extent to which the unemployment rate and job losses rise during a recession may be contained. Also, like the last recovery, many manufacturing and service jobs may again move overseas (as a part of re-structuring and cost-cutting by firms). Labor participation for teens and women may decline further if labor market weakness prolongs. Older workers depending on their skill level may or may not return to the labor force. But a prolonged recession and/or a slow recovery might lead to significant job losses, pushing up the unemployment rate to higher than forecast (which itself was revised up by the Fed in June) up to 6.5-6.7% levels by 2009. Taking cues from past recessions, the unemployment rate may start declining by 2010 but may recover to pre-recession level only by 2012.

http://www.rgemonitor.com/blog/economonitor

<sub>from BNP Paribas



from BNP Paribas</sub>

It is no surprise that consumer confidence indexes are at the lowest level in almost two decades. Consumer spending most likely got a boost as a result of the tax rebates - and a break from $140+ oil and $4 gasoline is a welcome development. But is oil at the breakpoint? Should the U.S. consumer really cheer oil at $120? Wait for those winter heating bills! And is there need for more fiscal stimulus?





The financial crisis is far from over and it is rapidly moving from subprime borrowers to prime borrowers prompting banks to tighten credit across the board to both consumer and businesses. Clamping down on consumer credit will pose further strains on the U.S. consumer. Moreover, while probably only a small fraction of the credit related losses has been disclosed, new surprises could be in the pipeline including for institutions that are less exposed to subprime paper. So far this year seven banks have failed – more than in the past four years combined and ninety banks are currently on the FDIC's undisclosed problem bank list.

My wife manages a large super store and she had to fire someone yesterday for being too nice.
From what I gather he is like what I called (under my breath) an, "emotional scab picker," when I let myself get too tired and depressed. Anyway, this guy likes listening to their stories so well that everyone seeks him out and interrupts his restocking of shelves. It got so disruptive she moved him to the night stock crew. He's been running all kind of scams trying to get back to his adoring public
and has received some support from key places. So when he confronted my wife yesterday demanding to go back to days and she said No, not at this time and he got nasty with her and she fired him. Even though her major goal for the quarter is to shave 2 points off the turn-over rate.
She already has one of the lowest turn-over rates in the division. Life's a Beach!

Who's Going to Bail Out the Banks?
Rachel Ziemba | Jul 21, 2008 Nouriel Roubini and I have an op-ed out in the latest issue of Time International on the role of sovereign wealth funds in providing capital to the U.S. and European banks (see link here). We suggest that as the crisis deepens, so too does the challenge of finding financing for the troubled banks. Either directly or indirectly, financing from foreign governments (central banks and sovereign wealth funds) is becoming more and more significant source of capital, a trend which was driven home by last week's events with Fannie and Freddie. Foreign central banks, especially in Asia, have significant exposure to U.S. agency bonds including those issued by and those guaranteed by Fannie Mae and Freddie Mac. China alone holds well over $300 billion of U.S. Agency bonds (for more detail on these holdings see related RGE content, a series of posts by Brad Setser or a piece in today's new york times by Heather Timmons). The bailout of Fannie and Freddie shows that these investors may have been right to trust in the implicit guarantee from the U.S. government.

While the over $40 billion invested by sovereign wealth funds in late 2007/early 2008 got a lot of attention, over the last few months, assets managed by central banks of countries like China, Russia and Saudi Arabia have grown at even faster paces. Their asset allocation choices (including any shifts of currency composition) will affect prices and yields of different assets. Some of the biggest financers of the U.S. are now publicly worrying about their USD assets and the effect that their heavily managed currencies are having on their domestic economies. Will they be willing to keep investing in the U.S. and if they do, will they start to demand better terms?
Here's the full text.
Investing: That Sinking Feeling

Time International

Thursday, Jul. 17, 2008 By Nouriel Roubini and Rachel Ziemba

Early last Winter, when the west was suffering the first casualties of the credit crisis, sovereign wealth funds (SWFs) rode to the rescue, providing over $40 billion in capital to some of the largest of the faltering U.S. and European banks. The U.S. government — reluctant to bail out banks directly — welcomed this infusion, even though SWFs are investment arms of foreign governments and American politicians are often suspicious of outsiders acquiring stakes in key domestic assets. So instead of a bailout of financial institutions by American taxpayers, we saw a foreign-funded bailout.

As mortgage losses continued to mount and the credit-crisis snowball rolled on, private equity, with some SWF support, took on the role of recapitalizing regional banks. Yet there's still no end to the crisis in sight. On July 11, U.S. regulators shut down IndyMac Bank, the second-largest largest financial institution to close in U.S. history. If current estimates are right and more losses are coming — Goldman Sachs says U.S. and European banks may need another $200 billion — where's the money going to come from to keep the financial system functioning?

One nonobvious answer is: the central banks of emerging economies. To keep their currencies from appreciating too much against the dollar, emerging nations continue to buy increasingly large amounts of U.S. debt. This provides the U.S. with an indirect funding source to prop up its banks and brokerages, but it's a compromised solution. After all, the willingness of central banks to lend almost without limit to America helped create this mess. Cheap money from abroad suppressed U.S. long-term interest rates, helping to set the stage for the housing bubble and its catastrophic collapse. Continuing such inappropriate monetary and exchange-rate policies feeds more asset bubbles in emerging economies as well as global inflation.

SWFs, on the other hand, control more than $3 trillion, an amount that is growing rapidly. That money needs a home, and the weak U.S. dollar presents foreign investors with opportunities to put it to work by snapping up "bargains" like the Chrysler Building and Citigroup stock. But after turning to SWFs in their hour of need last winter, will U.S. and European officials be willing to do so again?

Possibly — but SWFs may want better deals. In the first round of recapitalization, SWFs took small (less than 10%) stakes in financial giants including UBS and Citigroup by purchasing preferred or convertible shares without voting rights. In return, the funds got fairly high interest payments and the chance to buy into institutions at what they thought were cheap prices. They've since suffered losses on the order of 30-50%. SWFs might be wary of coming back for more unless they get more control, along with greater opportunities for synergies between Western banks and their own domestic financial systems.

It remains to be seen whether U.S. authorities will be comfortable with SWFs taking larger stakes. Consider that while the U.S. is aggressively pushing China to open up its banking system and