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

Thursday, May 5, 2011

Transcript: 437 German banks in worse condition than the Greek state?

Listen to this episode



That was George Magnus of UBS speaking to Bloomberg, admitting, more or less under his breath, that the hysteria around sovereign debt in Europe has not been about the sovereigns, but about the banks. If you have been following Demand Side for long, you are aware that we pegged this early on. Further, it is not the bonds that are restructured that is the problem, but the derivative credit default swaps that will reallocate all this paper according to wagers made in other times. After all, when you buy a bond, you are getting paid for taking a risk, so the eventuality of restructuring is in the picture from the beginning. The absurdity is that many times the value of the actual bonds have been “insured” by credit default swaps, so the financial players are looking at a far more significant event than the state of Greece. And the fact of restructuring is almost assured, at least for Greece, by the change in the language. It is now “restructuring” instead of “default.”
Why now? The new Greek budget deficit came in worse than forecast. Quelle Surprise. Austerity failed to produce prosperity. According to the Wall Street Journal
Greece's budget deficit in 2010 was 10.5% of gross domestic product, significantly larger than forecast ... Lower-than-expected government revenue was the main culprit behind the higher deficit number. ...

The missed target was "mainly the result of the deeper-than-anticipated recession of the Greek economy that affected tax revenue and social security contributions," the Greek government said in a statement.

As Calculated Risk said trenchantly, “More austerity coming - the beatings will continue until morale improves!”

Also on today’s podcast, Robert Kuttner with more on the nonsense economics of austerity, Robert Reich pointing out that not everyone is suffering under high oil – witness Exxon-Mobil, Econ Intersect’s Rick Davis on the suddenly slowing GDP numbers, Steven Hansen and Doug Short, also of Econ Intersect, on how price is inflating seemingly solid PCE numbers, Keith Jurow on the high end strategic defaults that could spell serious trouble for any housing recovery, Elliot Morss on the Gini measurements of income inequality which put the U.S. in the wrong neighborhood, the melting GDP projections from Ben Bernanke and the Fed, the silliness of the Conference Board’s leading economic indicators LEI – which point to the sky as the economy trips on the ground, Calculated Risk on the outlook for residential and nonresidential investment, and Dennis Altig of the Atlanta Fed on the latest plan to unwind the Fed’s trillion dollar plus purchase of mortgage back securities – it’s a bad bank! I kid you not. Following on from Allan Meltzer, it is to spin off the garbage purchased from the financial sector into a bad bank. The Fed as a bad bank. What a concept.

Let’s get going.

Robert Kuttner, of Demos and American Prospect, pointed out correctly last week that austerity will only slow down the recovery. “The idea that a steeper path to deficit reduction will somehow restore business confidence and thus more than offset the hit to purchasing power is just blarney. And with both parties committed to some version of austerity, we could easily have the worst of both worlds -- increasing inflation coupled with persistent stagnation.”


“Can the president shift to a rhetoric and policy that emphasizes the need for more jobs and a stronger recovery, and soon? Let's hope so. There is nothing like an election hanging to concentrate a politician's mind.”

Robert Reich, the former labor secretary, wants us to remember that Exxon-Mobil’s first quarter earnings of $10.7 billion are up 69 percent from last year. That’s the most profit the company has earned since the third quarter of 2008 — perhaps not coincidentally, around the time when gas prices last reached the lofty $4 a gallon.
This gusher is an embarrassment for an industry seeking to keep its $4 billion annual tax subsidy from the U.S. government, at a time when we’re cutting social programs to reduce the budget deficit.

Demand Side notes that 2008 is the year of the great financial crash, and asks you to remember our call on the oil and commodity bubble in November of last year, when we predicted it would trigger – not cause, but trigger – a new leg down.

Rick Davis at Econ Intersect dissected the disappointing GDP number for Q1 2011. The BEA’s advance estimate put it at 1.75% down significantly from the 3.11% growth rate reported for the fourth quarter of 2010. Davis unpacks the lower growth into: somewhat weaker consumption of durable goods, weaker fixed investments, substantially weaker overall trade numbers, and increased contraction in governmental expenditures. The only improving factor was stronger inventory growth, which reverted to form after an anomalous fourth quarter reduction (most likely driven by a noisy, if not aberrant, price “deflater”).
The BEA’s “Advance” GDP growth estimate differs on average about 1.2% from their eventual third (i.e., “Final”) growth estimate. In July they will restate previously reported growth rates dating back to the first quarter of 2003. “Those restated growth rates are not necessarily minor,” says Davis. “Last July we learned that the “Great Recession” was worse (by as much as a percent in nearly every quarter) than previously reported, and that the bottom of the recession occurred a quarter earlier than we had been previously been told.”
Doug Short and Steven Hansen of Econ Intersect point out that March 2011 Personal Income and Consumption Expenditures from the BEA look good until cost increases are considered. Most of the increases are due to rising prices.
At Minyanville – and this is one of the few links we have online for today’s podcast –

Keith Jurow posted under the title “Strategic Defaults Revisited: It Could Get Very Ugly.”
According to Wikipedia, a strategic default is “the decision by a borrower to stop making payments (i.e., default) on a debt despite having the financial ability to make the payments.”
Jurow defines a strategic defaulter to be “any borrower who goes from never having missed a payment directly into a 90-day default.”

When home prices were rising rapidly during the bubble years of 2003-2006, it was almost inconceivable that a homeowner would voluntarily stop making payments on the mortgage and lapse into default while having the financial means to remain current on the loan.

Things have changed, particularly in those major metros where prices soared the most during the housing bubble. Homeowners who have strategically defaulted share three essential assumptions:

• The value of their home will not recover to the original purchase price for years.
• They can rent a house similar to theirs for considerably less than what their mortgage payments.
• They could sock away tens of thousands of dollars by stopping mortgage payments before the lender finally got around to foreclosing.

A last point on Jurow’s article. The high end underwater homeowner is more likely to choose strategic default. That is, although by far most defaults occur at the lower end, if you are in a high end home, you are less likely and willing, though presumably more able, to stick it out if you are under water.
Demand Side has from the very beginning, actually following the lead of Robert Kuttner, advocated use of the Home Owner’s Loan Corporation model and writing down the principle on loans to avoid the mess we are now witnessing. Since the big banks and others would have had to take a hit, to realize risk was not just a cherry on top of their returns, that idea has so far been quashed. Some form of mortgage bankruptcy is necessary for recovery.

Elliott Morss looked at the the Gini coefficient across countries. A measure of income inequality developed by Italian Corrado Gini a century ago, a coefficient of 0 means everyone earns the same income; a Coefficient of 1 denotes total income inequality. The range of better to worse among nations begins in Sweden and runs roughly from Northern Europe, through Central Europe, Southern Europe, Canada, Australia, India, Japan, and China before finally arriving in the United States. The US at 45 is in a cohort with China and Singapore in the 40s. No other developed nation is above 34. Full list online

Baffled Ben Bernanke held a news conference. Seemed to go well. People bought what he is selling. Things are sadly slow, but stable. Yes, we have zero percent interest rates, and we’ve actually been forcing money into the financial sector. But look, the stock market is up. And better to pay attention to our predictions and projections than the way things actually turn out. You’ll feel better.

But GDP is melting already for 2011. The Fed’s ideas for unemployment are holding up well. They are helped by the continuing weakness in the denominator – participation – as well as by the fact that the 2011 number is defined as the average in the fourth quarter, and we aren’t quite there yet.

April 2011 Economic projections of Federal Reserve Governors and Reserve Bank presidents
2011 2012 2013
Change in Real GDP 3.1 to 3.3 3.5 to 4.2 3.5 to 4.3
Previous Projection (Jan 2011) 3.4 to 3.9 3.5 to 4.4 3.7 to 4.6
Unemployment Rate 8.4 to 8.7 7.6 to 7.9 6.8 to 7.2
Previous Projection (Jan 2011) 8.8 to 9.0 7.6 to 8.1 6.8 to 7.2
PCE Inflaton 2.1 to 2.8 1.2 to 2.0 1.4 to 2.0
Previous Projection (Jan 2011) 1.3 to 1.7 1.0 to 1.9 1.2 to 2.0
Core PCE Inflation 1.3 to 1.6 1.3 to 1.8 1.4 to 2.0
Previous Projection (Jan 2011) 1.0 to 1.3 1.0 to 1.5 1.2 to 2.0

FOMC definitions:
1 Projections of change in real GDP and in inflation are from the fourth quarter of the previous year to the fourth quarter of the year indicated.
2 Projections for the unemployment rate are for the average civilian unemployment rate in the fourth quarter of the year indicated.

Calculated Risk picks up a report showing that in a March survey almost half of the housing market is now distressed properties.

This trend is likely to continue as a backlog of foreclosures and mortgage defaults make their way through the housing pipeline.
Survey respondents reported mixed opinions on traffic for the winter and spring housing market. “January, February and March sales were characterized by a wait and see attitude of buyers.
[S]hort sales boomed in the month of March and the proportion of damaged REO fell. REO is property owned by banks. Damaged is damaged, by situation or condition.

Calculated Risk also points out that residential investment and non-residential investment in structures are at record lows as a percentage of GDP. Residential Investment (RI) decreased in Q1, and as a percent of GDP, RI is at a post-war record low at 2.21%.

Non-residential investment in structures is at a record low of 2.48% of GDP, and will probably stay depressed for some time.

Residential investment (RI) is the best leading indicator for the economy. This isn't perfect - nothing is - but RI is usually a strong leading indicator for the business cycle.

In 2011, CR says, residential investment will make a positive contribution to the economy for the first time since 2005. The five years of drag on GDP from RI (2006 through 2010) is the longest period on record, breaking the previous record of four years from 1930 to 1933 (yeah, the Great Depression). The positive contribution this year will mostly be due to a pickup in multifamily construction (apartments) and in home improvement. However single family housing starts will continue to struggle.

And still CR is positive on the economic prospects. Demand Side is not. We note that most states are within striking distance of their high marks for the current recession in terms of unemployment rate.

On the darker side of reality, we find the The Conference Board Leading Economic Index® (LEI) for the U.S. LEI increased 0.4 percent in March to 114.1 (2004 = 100), following a 1.0 percent increase in February, and a 0.2 percent increase in January.
Says Ataman Ozyildirim, economist at The Conference Board: “The U.S. LE’s continued increase in March points to strengthening business conditions in the near term. The March increase was led by the interest rate spread and housing permits components, while consumer expectations dropped. The U.S. CEI, ® a monthly measure of current economic conditions, also continued to rise, led by gains in industrial production and employment.
Yes, indeed, we have liftoff at the Conference Board, but as EconIntersect points out,
“It is confusing—“ EconIntersect’s word – “confusing why The Conference Board does not comment on the historically unprecedented monetary measures (the monetary measures set by the Fed) which are creating a forward looking index which has questionable forward looking ability.”

“Confusing” and “Questionable”, nice neutral words. Particularly since in other news, the NFIB’S Small Business Optimism Index fell again, Consumer Metrics says flatly “consumer weakness continues,” and current data is being revised downward.

Now to the Bad Bank solution

Posted by Dennis Altig at macroblog, but referring to star idiot of the week Allan Meltzer’s op-ed in the Wall Street Journal, which says, among other things:

"One of the Fed's recent errors was increasing the money supply by buying more than $1 trillion of mortgage-backed securities as part of its 'quantitative easing' policy. Its hefty balance sheet now threatens to finance further inflationary increases in the money supply. How can it be unwound in an orderly way?"

"One idea is for the Fed to create its own version of a 'bad bank.' The Fed should promptly put the $180 billion of its long-term government debt and more than $1 trillion of its mortgage-backed securities into a separate entity. The long-term government debt and mortgage-backed securities would be the new bank’s assets. (The $1 trillion in Fed-created 'excess' bank reserves as a result of quantitative easing would become the liabilities of the bad bank.)

"The Fed would make a commitment not to sell any of the bad bank's mortgage-backed securities and Treasurys until they mature. Almost half of the Fed's currently held assets, more than $1 trillion, have 10 or more years until maturity, so all of them would be off the table as far as financing inflation during the gradual economic recovery. As the mortgages mature and are paid off, the bad bank's assets decline.

The reduction in the bad bank's assets means that its liabilities, the excess reserves, would also decline—though that would be years away. Letting the market know precisely when the mortgage-backed securities would be sold makes the adjustment to the future elimination of excess reserves manageable."

Altig says it sounds okay. Demand Side says, I dunno. Let’s see, we bought these things to push money into the economy and force interest rates down. Why don’t we sell them if we are worried about inflation. If inflation rears its ugly head, just sell the stuff, take that money right out of the economy like that.

Oh, Right, nine-tenths of it is garbage. You can’t sell it. There is no market for it. That’s what it means when Altig says, “ winding down of the mortgage-backed securities (MBS) and long-term Treasury securities on the Fed's balance sheet should be conducted in a way that avoids market disruption and distortion as much as possible.” Code for junk. When we can’t sell it, that means, let’s get the right coded language here, “the excess reserves held in the banking system—the liability side of the Federal Reserve’s balance sheet—have to be removed or "locked up" as needed to avoid an inflationary expansion of broad money and credit.”

Bad Bank!

The best idea is, of course, to make the sellers take it back because it is not at all what it was presented to be.

Oh, yeah, that’s the other bad banks.


  1. The austerity imposed on Greece was always doomed to fail. It slashes government income yet does not invigorate the economy. I always thought that what was likely to happen was that governments would fall for imposing austerity. That has been the case in Ireland and Portugal.

    As for US real estate strategic defaults will return as the market has entered a double dip. The fundamentals for real estate have not significantly improved for many people so any weakness will force people to default. They are only renting until they clear that mortgage. The side effects of QE in commodity prices is taking a further toll on low and middle income earners around the world. This reduces their ability to maintain the mortgage repayments. Once an area starts getting hit by foreclosures or strategic defaults it lowers the value of the rest of the area making further strategic defaults still more likely.

    As for the Fed bad bank scenario the real problem is that it still has implicit government backing. What is needed is the removal of that backing while it is mismanaging its own balance sheet. Force the Fed to return the toxic debts back to the banks and let the banks deal with them. This might actually force the banks to deal with their bad debts. The Fed should only buy treasuries as part of QE. As for creating a bad bank with all the MBS held to maturity the problem is that many will never make it that far with employment prospects so poor. As you say making the banks take it bank might weaken them again but it might actually put some of them out of business which will probably be a good thing in terms of restoring moral hazard.

    As for longer term prospects the problem is that many people are still struggling and trapped in negative equity are unable to move to find work. As for Residential Investment that might be low but that will be a consequence of the long boom. Once that has worked itself out then RI can increase but efforts should be made to stop a repeat of past mistakes.

  2. As for the state of german banks, I agree they may be in a worse state than anyone expects. I doubt that the stress tests considered significant defaults, and much of the process has been to kick the can down the road in the expectation that the banks will be in a better state to deal with any eventual defaults. I think that process might be very misguided. If you know that big losses are likely, then the most rational solution for the bankers is to pay out big sums to top bankers so that they can effectively retire or ramp up risk still futher to force governments to bail them out.

  3. Hi Alan
    Banking has become a huge question, every thing from cleaning up the mess (not!), punishing the wrongdoers (we may be so lucky!), legislating to prevent the same happening again (where?) and regulating practices where appropriate (capture). I saw this and wondered if the three proposals have a role to play http://www.huffingtonpost.com/stephen-zarlenga/reducing-us-debt-and-crea_b_857230.html

  4. I've copied the the three measures from the post Jim refers:

    The three essential measures include:

    1. Moving the mostly private Federal Reserve System under the US Treasury Department. The Fed would no longer be a virtual fourth branch of government, unaccountable to the public. Their important financial research functions would continue. But the Fed would no longer make unilateral monetary policy decisions beyond the reach of We the People.

    2. Making the power to issue money a public function -- bypassing the current system which invited the careless and risky lending that led to the global economic crisis. The U.S. government would be authorized to issue dollars debt free. This power would replace the current undemocratic and unstable "fractional reserve" system in which money is created as debt through loans by financial corporations who lend many more times what they possess. Banks would no longer have this privilege to create our money supply!

    3. Enabling the U.S. government to use its money power -- creating and spending money into circulation -- to address pressing infrastructure needs such as repairing our crumbling roads, bridges, rails and highways. The government also would be enabled to invest in health care and education. These projects would provide a huge numbers of jobs without going into debt and having to repay interest on debt to financial institutions. Economist Kaoru Yamaguchi's computer model has shown that a public-based money system and spending government money on jobs fixing our infrastructure is the best form of economic growth.

    I happen to agree with all three points, though I have not studied the organization or the author, Mr. Zarlenga. Not so much that this scheme is a template for all times and places, but we need investment in public goods desperately, so #2 (which is the biggest stretch of the three) is within reason. Practically speaking, the nation and the world have to get radical about our future.

    That said, #1 must be done sooner or later. As I've said before, the Fed is not independent, it is owned literally and de facto by its constituent banks.

    #3 ought to be allowed, but it is not clear to me that public works could not be financed by borrowing. There are plenty of pension funds and others who need a safe, secure return on their investments that is above zero. An inflation-indexed investment program could work.

    Thanks for this link.