A low volume, high quality source from the demand side perspective.The podcast is produced weekly. A transcript is posted on the day of.

Monday, August 2, 2010

Transcript: 398 Are credit default swaps set to blow up in the pockets of European banks?

Listen to this episode

Today on the podcast a market minute with the earnings reports and our question of whether in fact these higher profits for corporations DO contradict the underlying weakness of the economy, as many analysts seem to assume.
Then some data highlights, followed by a heads up on a potential August crisis in European banks triggered by our old friends unregulated credit default swap,

It is amusing to hear analyists puzzled over the contradiction they se between bad economic data and good earnings reports from corporations. In the absence of top line growth, revenue growth, the two go together.

Earnings are fueled by firings, euphamistically called efficiencies or downsizing. Bad economic data is fueled by unemployment. Cancelling out the identities, earnings are fueled by unemployment or earnings without top line growth are bad for the economy.

To add insult to injury, good earnings data in a continuing recession is a sign that nothing has changed about the short-termism of American corporate CEO's. They have no other way of earning their bonuses than cutting labor and other costs, and in concert reducing effective demand.

One of the flaws in the Blinder-Zandi paper we take a look at in next week's podcast is their assumption that improved earnings and profits will generate more hiring and expansion. Increased demand will do that. But although cash flow to corporate bottom lines is available by way of massive government deficits, these profits will do nothing for investment or hiring. Any recovery must start on the demand side. This is one refutation to the invisible hand, where each actor is pursuing single-minded self-interest, to the detriment of the whole, and eventually, to himself.

In the market minute, today, we are not going to offer investment advice. Our observation is that equity other markets may be corrupted to an extent greater than commonly acknowledged by computers trading with each using other zero-cost positions supplied by the Federal Reserve as their stacks of chips.

It is interesting to note on the bottom of your stock charts. In the entire history of the Dow, for example, the volume before 1995 was below 500 million. Between 1995 and 2000, when the Dow went from 4,000 to 10,000, the volume increased to about 1.3 billion. In the period between 2000 and 2005, when the Dow traded flat, the volume increased hardly at all. In late 2006, it hit 2 billion. In late 2007, it hit 4 billion. In the collapse of 2008, it reached 7.6 billion. (Actually at one point 9.3 billion in September 08.) Since then, the level is down to the high fours and low fives.

What a difference a decade makes. Flat prices, multiples of volume.



Demand side strength is not evident in current data. In fact, it is weakening according to two key indicators:

From the American Trucking Association: ATA Truck Tonnage Index Fell 1.4 Percent in June

From the Association of American Railroads: Rail car loadings decreased for the second consecutive month, down 1.3 percent in June.

Manufacturing had been relatively strong. Not so much now.

hat tip Calculated Risk
  • From the Kansas City Fed: Tenth District manufacturing activity rebounded moderately in July. However, plans for future hiring and capital spending were essentially flat. Price indexes were mostly unchanged.
  • From the July 15th Empire State Manufacturing Survey: "[T]he pace of growth in business activity slowed substantially over the month."
  • From the Philly Fed on July 15th: Firms See Slower Growth Rate
  • From the Dallas Fed on July 26th: Texas Manufacturing Activity Remains Sluggish
  • From the Richmond Fed on July 27th: Manufacturing Activity Moderates in July; Expectations Slip
  • From the Chicago Fed: Index shows economic activity declined in June
  • The Commerce Department said durable goods orders fell 1.0 percent after a revised 0.8 percent drop in May. Analysts polled by Reuters had forecast orders increasing 1.0 percent in June from May's previously reported 0.6 percent fall.

Toss in the weaker tone of in the Fed's Beige Book, Calculated Risk notes, and this raises the question: Is Fed Chairman Bernanke and the FOMC behind the curve (again)? In his testimony last week, Bernanke said:
My colleagues on the Federal Open Market Committee (FOMC) and I expect continued moderate growth ... Most FOMC participants expect real GDP growth of 3 to 3-1/2 percent in 2010
"That seems pretty optimistic," sez Calculated Risk. Elsewhere The Bureau of Economic Analysis released revisions to its GDP numbers late last week, displaying a slower economy than previously reported since 2006. Changes to real disposable personal income brought that number up, bringing the two measures into closer harmony, but at a 0.2 percent lower rate of GDP. In particular, GDP for the fourth quarter of 2009 was revised down to an annualized increase of 5.0, from 5.6, and in Q1 2010 up from 2.7 to 3.7. President Obama's near six percent growth has faded. The Bureau of Labor Statistics reported initial weekly claims in the 450,000 range for the eighth straight month. The 4-week average of initial weekly claims has been at about the same level since December 2009 at about 452,500. This is above all but the peak months of the 2001-02 recession. In our recovery. Summary: The Demand Side forecast that we are bouncing along a bottom that is sloped downward is intact. Noise from the Recovery Act was not evidence of recovery, Corporate bottom line growth is not evidence of recovery. Without structural changes in debt levels and real investment in private or public goods, there will be no recovery. BREAK THE LOOMING CRISIS IN EUROPE As we noted last week, austerity policy sweeping Europe is threatening to trigger a severe contraction. The perceived need to restructure some sovereign debt has also triggered a full-scale panic. To that in a minute. We begin with words from L. Randall Wray courtesy of the New Economic Perspectives blog.
As part of the EU/IMF plan to resolve Greece's debt crisis and to make its economy more competitive, the government announced a couple of weeks ago plans to revamp labor relations laws and social security entitlements. The minimum monthly wage for new entrants into the labor market will be decreased from 700 euros to 560 euros, and workers will be required to have 40 years of employment to receive a full pension (which has also been subject to significant reductions). And companies would face far fewer restrictions with regard to layoffs and layofff compensations--which have been cut in half. The strategy is obvious: Greece wants to win the race to the bottom in the Eurozone, that is, to win competitive advantage by having the region's lowest and meanest living standards. That, of course, will now be an even tougher race to win, with the recent entry of Estonia into the Eurozone.

The crisis in government budgets trailed the financial sector meltdown by a full two years, yet the IMF and other advocates of the Washington Consensus insist that governments must lead any recovery. They must lead, not by increasing effective demand, but by shrinking their operations and paying off their debts on time.

A footnote here. We delayed presenting this segment to have the benefit of the series running on Calculated Risk describing derivatives and their potential for causing problems. That series minimized the dangers of credit default swaps by concentrating on the net value. Here, however, Carl Weinberg of High Frequency Economics correctly points out that the triggering event may be a very modest rescheduling of payments, but does not necessarily involve a neat netting of values and can create mountains of liabilities among counerparties that have a checkered history of responsibility. This refers not to the governments, but to the banks.

The focus is still on Greece. Credit default swaps on that country's debt have been the chosen weapon of the markets in recent months. Would a restructuring of Greece's debt be cataclysmic? Would allowing lenders to take a hit for their risk premiums be out of line? If not, Why the resistance?

It may not be the governments of Europe that are fragile, nor is the absolute value of their debt that is the sum in question. It may be the banks and their exposure to credit default swaps. Supposedly designed to hedge risk, these unregulated securities may have created a huge risk We heard a note of panic in Weinberg's comments to Bloomberg a couple of weeks ago.


In these comments, we hear that it is apparently not the exposure of Greeks to capital markets that is the great danger. It is the exposure of banks to credit default swaps. What is Weinberg's solution?


Ah, that's it, extend the terms and pass a law in every nation in Europe and presto! And all by the end of August. What could be simpler? How about flying to the moon? If not that, some economists suggest, the lenders could acknowledge that they were paid higher premiums for taking risk and perhaps they need to take their hit. The continued market fundamentalism imposed by the IMF also troubles many, who say that as long as the IMF is calling the tune, the dancers are going to get hurt and perhaps it's time to get a new orchestra.

No comments:

Post a Comment