Investors take an opportunistic approach as economy improves

The US economy is expected to strengthen this year, with consensus around 2.6 percent growth. Global business confidence continues to improve with manufacturing in the lead.  With both consumers and businesses more optimistic heading into the new year, the combined strength in shipments could lead to a rise in equipment investment which bodes well for a rebound in global business activity. Consumption growth also rose in November, with core retail sales reflecting better than expected holiday spending despite some concerns about budget priorities in the lower-income group. The general backdrop suggests that investors could continue to seek higher returns in riskier assets that are more economically sensitive as the focus returns to fundamentals.

Allocation still favors equities
Fund managers are increasing weightings in developed market equities: Europe, Japan, and the US being the most favorable markets. There is still the chance for a pull-back in equities this year. The S&P 500 started 2014 in the red, and Asian shares followed lower as the Nikkei moved below 16,000. This could reflect some positioning amid lower volume, but some analysts suggest that this could be another buying opportunity.

For now, there is still room to extend margin debt as traditional bond outflows continue. Historically, investors have been extraordinarily leveraged during market rallies such as the tech bubble in 2000. Times are different now as fundamentals improve and central banks continue to support a stimulative environment. The case is stronger in Europe where valuations are still relatively cheap and in Japan where more easing from the BoJ coupled with large pension funds shifting allocation to equities could prove attractive from a global perspective.

Economic slack remains
Despite the optimistic outlook for 2014, there are still some concerns in the real economy. The lower income group tends to be hit the hardest during budget issues which leads to political dithering. Wage growth has improved, but labor productivity has risen by only 0.3 percent on year, but the rise to 3 percent during the third quarter of 2013 was impressive given the solid GDP report and non-farm payrolls during the same period. Andrew Smithers of Smithers & Co states that bad news on productivity could lead to signs of realism that will continue to make the case for a low rate environment. If the market outlook is premature, higher inflationary expectations without the true fundamental backdrop could be a problem.

An opportunistic approach
After a period of lower interest rates and soft demand for loans, US large cap banks could benefit from an improving economy especially as the yield curve steepens. Profit margins expand as banks borrow at lower short-term rates and lend at higher long-term interest rates. The rebound in housing and auto demand suggests that consumers are more comfortable with taking out loans as the economy improves.

Industrial strength is leading demand for non-residential construction where wages are higher and supply is limited. This will be an important year which will test the true strength of the economy. We are still in a stimulative environment, and even as the Fed reduces its pace of asset purchases, rates could find some comfort around 3.5 percent on the 10-year this year. Financing conditions are still favorable for many sectors which could support expansion. For example, US airlines are posting stronger gains as nominal GDP is upwardly biased, but we will need to see capacity expand as demand picks up to confirm further strength into the next year.

Lessons from Lagarde - St.Gallen Symposium

Christine Lagarde, Managing Director of the IMF, gave a rare 50min long Q&A session at the St.Gallen Symposium. Tough questions regarding the survival of the Eurozone, whether the IMF is in fact the World Government, and others pertaining to global policy decisions were posed. Lagarde is aware that the current system is flawed, especially when she goes silent to the mention of some smaller countries within (or thinking of joining) the Eurozone, and whether or not they should be involved in such a collective group that is clearly not working for the generation of unemployed youth.

The argument is that the Eurozone in its current form, is not sustainable; which is why it must continue to evolve with not just increased oversight, but an improved structure that is quick to realize problems in its critical banking system. With that foundation, according to Lagarde, structural problems should be addressed on an individual basis - no one size fits all approach. The conversation shifted to austerity and whether or not it is acceptable to call it a failure; especially given that it was pushed by the IMF for nearly all constituents in its program last year. 

Austerity was not balanced, and it is true that the results show a prolonged economic dip instead of painting a path to recovery like many officials hoped for. The quick and painful cuts and higher taxes just to receive the next credit tranche was the problem. Now Lagarde suggests a slower pace of austerity in which structural issues are addressed for the long term. This is how it should be done, and frankly the pressure of competing authority with the Troika and IMF rushed a lot of these fiscal snaps. Hopefully with some time granted after the German election, we could see some organizational structure and better thought out policy on the country level. Lagarde says the same stands for the US in its austerity measures, although we still don't have a sensible budget in place to do so. 

Lastly, Lagarde's comments on Japan were interesting. Abe's promise of structural change seems like the best approach, but the monetary side still leaves many in question. Lagarde would like to see better utilization of Japanese talent - particularly women. The demographic imbalance in Japan is very worrying and will definitely skew the dependency structure. 

-- Also, the third prong approach of the IMF caught my attention. Providing technical assistance to emerging countries for better surveillance of their financial markets is a key investment. That sums up a few main points, but the full video is definitely worth watching. 

Facing Austerity. Head-on.

Assuming this isn't outdated by the Mayan calendar, 2013 will be the year of austerity. It's already here, but its impact will be more apparent in the coming year as it dampens the extent of a full recovery as governments continue on with an unbalanced check book. This process is inevitable and in some cases necessary to break out of an economic slump with some sort of fiscal sanity. The problem is not just in the US where this coined term of  a 'fiscal cliff' is actually what has been planned; its just the extent and distribution of the scale-back that's up for debate. As expected, the developed world is set for a stalled recovery with room for only modest improvement that will still lie below full  potential, especially given the new Fed thresholds on employment and inflation. Emerging countries will continue to face some struggles, but they will be busy stimulating during this time.

Some form of the fiscal cliff is inevitable. The fiscal framework of our nation is designed with limits to be  amended as we go to ensure that we are somewhat responsible to continue running the country on a balanced footing. This is why Congress has the power of the purse, but constant partisanship never gets us to that ideal point of leadership. In this case, we see extreme political strategy that surprisingly hasn't seen the kind of backlash that Europe has. The fact of the matter is that each proposal includes spending cuts that target many entitlements that we have grown accustom to but are clearly unsustainable. Our complex tax code deprives us of key revenue while the spending outlook will continue to dig us deeper into deficit. Whatever is agreed upon will still decrease our potential to accelerate economic growth.

We must address the political strategy, because this will determine whether or not we will ever get it right. The White House has cleverly used this 'balance' myth by shying away from real reform and spending cuts. If you really dig into the budget, many of those line items are highly sensitive because so many people rely on entitlements especially during these times. No one is willing to take bold action, and would rather gradually scale down the effects of costly programs that truly have a demographic mishap such as social security and medicare. When Republicans pressure spending cuts and reform, the White House has blamed lack of revenue as the reason for imbalance and then automatically factor in tax hikes and cuts on the middle class to show the 'only' way to balance the books. This type of thinking is a far step-back from reality.

Governments Ready?

Elsewhere in the developed world, governments have realized the problem and are cutting their forecasts. Canada, which relies on a US comeback in order to fully push on with full potential, has pushed its expectations back by one year to around 2015 when the country should return to surplus. The country also decreased its revenue projections over five years, and will essentially rely on decreased government spending in order to balance the books. In the UK, the Autumn Statement called for a decrease in welfare entitlement spending which caused quite a stir among its dependents. The ECB decreased its growth forecasts for the eurozone, and Germany is set to feel a pinch with declining industrial production. Lastly, Australia's Finance Minister Swan admitted during an unscheduled press conference on Thursday that the country is unlikely to achieve a budget surplus this year, breaking the major platform in the Labor Party's election pledge. Meanwhile, Australia's Prime Minister Gillard is on vacation; once again shying away from addressing fundamental issues.

Greece is a special case. Yes, we all know this. But it has essentially become the hallmark of austerity, and could set precedent on how its done (whether the country is proceeding in the right or wrong direction is a separate discussion). The fact is that Prime Minister Samaras is quick to work on structural reforms and grow the economy as part of the strict terms of its long awaited aid tranche of short term rescue loans. Closing in on its  sixth year of recession and +20% unemployment, Greece's real problem is demographic. Greek youth are fleeing the country, choosing school over work, or are busy protesting austerity in the streets of Athens. The country is one of the worst in the world for setting up a businesses given the impending legal costs, and the businesses that do come to fruition are short lived. Most of the people are employed by the government; and working for a broke employer disrupts the dependent system to begin with. Austerity at its finest. Or maybe just pure socialism.

Central Banks Prepared?

Central banks are ahead of the game, but it still won't provide a full cover-up of the underlying fiscal set-back. The Fed removed its 2015 guidance and agreed on additional asset purchases which suggests that the US economy is still under performing. The RBA cut rates and hinted at a mining peak which should help prepare for some fiscal tightening down the road for Australia to eventually reach a budget surplus.

The bottom line is that fiscal tightening is ahead, and this will force us to struggle along the recovery stage, performing below our full potential. Banks may have access to easy capital thanks to the easing mechanisms of central banks, but that money will remain stashed on the balance sheet until the political storm passes. Businesses will not invest unless there is some certainty on corporate taxes and the consumer's ability to be productive. We will all be a bit shaken with a change in the status-quo.

Check out: Rising stars of the fiscal cliff - Maya MacGuineas of Fix the Debt

Soft Landing Ahead for Housing Markets in Canada and Australia

Global housing prices rose steadily from 2001 to about 2008 when the bubble eventually burst in the US. The problems in the US were a special case as a growing system of over-leveraged banks fueled by government subsidized guarantees led to a hard landing. During this time, resource driven economies such as Australia and Canada experienced a minor correction. With prices continuing to rally despite global deleveraging, China's major trading partners will bear the brunt of a soft landing. However, China's desperate need for resources will stabilize the imbalance.

The chart above clearly shows Australia, Canada, and Hong Kong being stubborn to the US correction post-08. Hong Kong's prices have risen sharply due to artificial demand as part of China's economic plans. Expect a major correction soon; stabilized afterward as China undergoes more "laissez-faire" economic reform.
** Click here for full interactive chart. Look at Sweden and South Africa! Poised to pop soon. **

Canada's Banks are Well Positioned, But Worries Remain

Concerning LIBOR

via Dantes Outlook Facebook Page

Once again the issue of accountability is questioned in the banking system. In finance, the line between accountability and responsibility becomes fuzzy as the system grows more complex. The real question is whether or not Barclays and other major banks are to be held accountable for manipulating LIBOR to their advantage, or if they are in fact responsible to be fair and honest in reporting. 

Explaining the Euro Deal

The Euro Group delighted us all late last week with hints of progress. The plan expands the scope of the European Financial Stability Fund (EFSF), European Central Bank (ECB), and International Monetary Fund (IMF). It also includes strict measures to enforce fiscal stability, but is gridlocked at the will of member country politics. The proposal places more hope in the ECB and Central Banks to liquidate our way out of the mess, but does nothing to solve structural issues, and places a heavy burden on the IMF. It is essentially a transfer of responsibility (the bad bank(s) method). It could work, but it involves a lot of risk. Let's step back and understand how the system works.

The two videos  accurately explain the European capital markets. 

The ECB strategy is to become a lender of last resorts. There is clearly an imbalance between surplus central banks like Germany and deficit central banks like Ireland and Greece. Too many Euro-zone countries riddled in financial misery have a high dependency on stronger countries to provide liquidity. The strong national central banks loan money to the ECB, which in turn loans to the deficit central banks in greater amounts than received. The new strategy is to tap the inter-bank market and borrow just enough funds from private banks in strong countries like Germany. These borrowed funds are then loaned to the private banks in deficit countries. The hope is to sure up the private banks, while reducing exposure to the deficit national central bank.

Solving the Collateral Crunch comes in when surplus national central banks loan to the IMF. The IMF then buys sovereign debt from the private banks in deficit countries. Euro group system lending by the surplus national central banks is also acquired by the IMF. Again, the hope is that the private banks, with cleaner balance sheets, will sure up the system. The trash held in the IMF and ECB will then regain value, and the IMF will now be equipped with collateral that was purchased by the surplus national bank sellers.

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Now, structural issues still remain. Public trust is not evident in Europe as savers deposit less money into banks. These banks have less cash on hand to make loans; the hope is that the IMF and ECB can offset this. With new cash on hand, will private banks lend? Not quite. Just like int he US with QE, banks know that there is greater risk of default among borrowers. Austerity and further slowdown is a big factor, and growth is still nowhere in the agenda.

In the UK, Prime Minister Cameron chose to veto the decision to join in the Euro Group proposal. The plan calls for tougher fiscal surveillance and high standards; if the UK does not perform up to par it faces the risk of financial sanctions. London is all it's got at this point, with finance being its economic life-support.

Bottom line - we still have major work to do. But, the plan makes sense. It just lacks the structural gut to make sure that it is executed as planned, and that the private banks realize the economic uptick to actually perform. That economic uptick is unfortunately political.

The US markets turned soar on Monday as the Dow dropped 162 points. The Euro declined as well, as the dollar strengthened giving rise to Gold and Crude Oil. Gains from last week Friday were virtually lost. Moody's warned that the EU Summit does not decrease the chances of a downgrade - citing political and structural constraints as the big factor (the European culture). S&P raised a red flag again as it now looks to review Germany and France.

Central Banks Prepare for Greater Risk

A hell week full of European bond sales, bank downgrades, and government response indicates that greater risk is ahead. All participants in the global capital markets from governments to investors are taking necessary steps to protect themselves against further downturns.

The events of this week displayed the true colors of market participants. Finally, for better or worse, governments have come to the realization that fiscal policy will accomplish very little. Efforts to correct this fiscal grid-lock places pressure on central banks to perform. With monetary stimulus essentially exhausted (certainly in the US), central banks seized this opportunity to protect themselves against foreseeable risks.

This report is lengthy, but feel free to skip sections. If you care less about the reasoning behind the downgrades, you might want to just skim straight to the Central Bank response section.

Ratings Agencies Draw their Red Flags
S&P presented a string of bank downgrades which included Bank of America, Citigroup, Morgan Stanley, Wells Fargo, and other major players. At face value, people were quick to either panic or brush this off. The panic came from those who saw this as confirmation of a deepening crisis. Others viewed the downgrades as useless; the problems are obvious, and we saw this coming. However, both groups share the same belief that the global capital markets are entering further misery. We cannot be arrogant and place the downgrades aside without looking deeper into the reasoning behind it.

The math explains the underlying worries about further risk. Once we understand this, everything else begins to fall in place.

The ratings result from a calculation comprised of a weighted average of significant variables. These variables measure the strength/weakness of a banks' financial structure.

The Stand Alone Credit Profile (SACP) is comprised of preferred stock evaluations, combined debt ratings, and basic levels of government support. This portion of the formula is all about the bank's ability to pay back debt to stock and bond holders based on its balance sheet of deposits, returns on lending, government guarantees, etc. Bottom line - this is the overall health of the bank.

Extraordinary Support is the next variable. Simply put, this measures the bank's access to government support on extraordinary levels such as capital injections and other sorts of "bailout-style" measures. This also includes support by a group - if a bank is part of a major bank, it will receive support from greater levels.

SACP + Extraordinary Support = ICR 

Issuer Credit Rating (ICR) is the result of this calculation. This is what we see as investors; the combined rating of the bank. It is important to note that the ICR takes into consideration of potential for additional direct support from the parent bank or sovereign government. 

All math aside, this all shows that government support is a major component in the model used to rate banks. With the current turmoil, there is intense pressure on governments to perform. If there is uncertainty, it is reflected in the rating. 

Patterns of boom/bust indicate likely government support. However, history shows that government support never solves the underlying problems. Banking crises will happen again, and these rating will continue to take this fact into account. 

The recent S&P report is revised for modern times. The truth is that government support is uncertain. Governments are less able to support a range of banks because of its own balance sheet constraints. However, we are given more certainty for groups of banks with shared problems, as systemic risk on the entire system is more important for Central Banks to perform their role of  ensuring price stability in the economy. 

Supporting the system is one thing, but direct support will make less impact. Liquidity and capital injections are unlikely to raise SACP because of the underlying internal cash difficulties of that specific bank. There is execution risk of utilizing government funds effectively, and managing the flight back to independence is very difficult.

History shows that banks almost never reach back to a level of independence. Government support is a drug that never leaves the system. It causes market distortions that raises false expectations, creating an environment in which a completely independent bank will not be equipped to operate in (hence the fall of regional banks in the US). Depositors are propped up with artificial fiscal and monetary measures such as stimulus and low interest rates. The most striking part of government support is that banks are pressured into providing loans to industries and companies that support the growth mission of that nation. These are usually high risk loans (a repeat of the housing crisis), but the certainty of government support is priced in to these models, so it does not look as bad. 

We are operating in a world of powerful zombie banks (a fancy way of saying Government Related Enterprises - GRE) that are in desperate need to become independent and correct these market distortions - thereby saving the public from underlying misery.  

Central Banks to the Rescue

Market distortions aside, the Central Banks (well, the US only) seem to be saving themselves as they work to calm the financial crisis. 

Eurogroup ministers held a press conference to discuss their progress in expanding the capacity of the European Financial Stability Fund (EFSF). The ministers appeared exhausted and less hopeful; but there might be good reason behind this attitude. The thought is that even if the member countries do not cooperate in getting its fiscal house in order to pay back debt, the ECB and partners would have hedged against this. 

The frustration is certainly directed towards the politicians in the member countries. As Megan Greene (Economist Meg) strongly advocates in her blog, Central Banks need to protect themselves against losses on these relief funds. The use of Special Drawing Rights (SDR's - a combination of currencies), or implementing  her 'Big Bazooka' plan is a way for these Central Banks to play defense amidst the political bickering. This is business!

Notice the large amounts of swaps used during the '08 crisis

Fortunately, the US Federal Reserve understands this. Calling for global cooperation to increase access to US Dollars through currency swaps will strengthen the safety net of global banks in seek of liquidity. The idea is that a foreign bank or firm will pay their currency in exchange for borrowed dollars from the US Federal Reserve. At the end of the contract, the foreign firm or bank is obligated to repurchase their currency from the Fed at the same exchange rate. The foreign firm also pays a market based interest rate to the Federal Reserve for the liquidity swap protection. The US stands to gain from this move.

The interest rate paid to the Fed after the swap agreement (usually ranging from overnight to 3 months at most) is determined by the market, on average. The US Fed sets the Federal Funds Rate, but swap rates are left for the market to decide upon agreement between banks and firms. To influence a lower rate with the liquidity swap program, all the US Federal Reserve has to do is simply announce that their swap window is open for more business. Banks run back to price in a lower interest rate in their models, and by doing so, future liquidity increases in the entire market. Rates are expected to decrease to 0.645% from 0.805% as of Tuesday. Now, rates are hovering around 0.523%.  

The Federal Reserve is artificially increasing the demand for dollars at its swap window, which will eventually send the dollar exchange rate higher. As foreign firms and banks extract greater value from our dollar, the Fed moves closer to inflating our way out of debt (paying back interest to our debt holders with a higher valued dollar is more affordable). The inflation is seen in the value of commodities such as corn, with future prices rising consistently. 

Bank of America, Buffet, and Army of Analysts Shut Down Crooked Henry Blodget Sell-Off

Warren Buffett's Berkshire Hathaway will invest $5 billion in Bank of America 

News broke out this morning, pushing BofA higher after this blog post was published yesterday afternoon, encouraging investors to hold on despite what the pundits say. 

Henry Blodget is the CEO and Editor-In Chief of Business Insider and a familiar pundit on Wall Street who loud mouths for or against tech companies depending on his investment objectives. Now banned for securities trading following some questionable predictions during his internet and e-commerce analyst positions at Prudential and Merril Lynch. Gaining popularity, Blodget offered good calls particularly on Amazon.com hitting his price target of $400 per share, and bad calls in which he labeled eToys as a good long term buy back in 1999 - which eventually tanked two years later and had assets acquired by KB-Toys; perhaps a move to prop up share prices to leverage a sell through indirect trading accounts pointing back to his personal stake. Now ousted from the industry, Blodget remains active - with a new target on Bank of America.

Tech guy turned bank guy, Blodget had great power leveraging his platform at Business Insider and connections with big heads on Wall Street to spread fears about Bank of America being under capitalized with great risk exposure. The fears rippled throughout the blogosphere and investors began shorting heavily. A rumor was sparked about JP Morgan preparing to purchase Bank of America with government cash support. Especially at a time when everyone is worrying about economic slowdown leading to a double-dip, negative attention towards US banks is sure to spark big fear -- another 2008-type crisis? No. Take a breather.

The fundamentals are worrying, but not as scary as Blodget and friends make it seem. On July 19th of this year, Bank of America reported a net loss of $8.8 billion ($0.90 per share), largely due to charges resulting form a recent agreement to resolve Country-wide liens on Residential Mortgage-Backed Securities (RMBS) involving a line of $900,000 worth of loan modifications, repurchase exposures, and other related costs. The bank's core business performance this past quarter was held back from higher costs as management absorbed more mortgage issues. With losses canceling out gains and draining cash, investors have good reason to be cautious.

However, Bank of America continues to experience a good inflow of deposits and revenues gained from those holdings. The bank reported $147 billion of new extended credit in the second quarter, an increase in consumer deposit balances by $44 billion (4% from previous year), and more small business accounts equipped with the support of new branch locations and local loan specialists. An increase in Global Wealth clients contributed to $1.6 billion in investment banking fees, the bank's highest since the Merril Lynch acquisition.

Tangible Book Value (TVB) essentially measuring the net-worth, has decreased by about $1 to $12.65 per share from the first quarter of this year. Since the bank is balance sheet driven, investors can use TVB as a rough estimate of its liquidation value - apparently being low. This is a problem; consistently lower TVBs shows that too much of the banks' interest earning assets are covering interest bearing liabilities. Again, the costs on the liabilities side coming from mortgage loan problems.

The financial short-fall is a natural consequence of addressing the mortgage problems head-on, an organic approach taken on by the new CEO. Brian Moynihan is doing a good job with cleaning up the mess from former CEO Ken Lewis who grew a troubled bank. The fact that this is going on internally is great news for the long term investor. Given no immediate disaster in the economy, Bank of America is preparing a sustainable path for itself.

The big worry among investors is that Bank of America may dilute its shares for immediate cash. Not quite. The internal operating overhaul will provide sufficient liquidity for Bank of America to remain solvent. Moynihan is looking at what works, and what doesn't work. More clients, depositors, fees, liquid interest-earning assets, and sales are working well. A sell-off should not be shunned upon; so far 20 assets have been sold under Moynihan's leadership including the Canadian card unit, plans to exit UK and Irish card units, and write downs of credit cards and mortgage units. The power of a write down - reducing the book value because the asset is deemed overvalued - will help Bank of America adjust to reality and manage its operations better. As with most banks, Bank of America is overstaffed with toxic paper pushers, not value creators. The 3,000 layoffs recently marked a significant move to restructuring operations. Shifting labor from what doesn't work, to what works (hence more local loan officers to monitor small business credit lines during economic uncertainty) is a result of good management.

Trusting Moynihan is tricky, but moving forward will hurt in the short term. The rumors will continue, but those who stick to the fundamentals will gain.  The JP Morgan merger is unlikely as Bank of America already has $62 billion in market cap with enough on its plate. External moves will hurt the company, and it knows this -- investors are voicing their opinion that the company should continue internal restructuring, or else risk a sell-off (with a stock price so low, there's not much room to risk such a blow in equity value).

The risk of being undercapitalized is important, but debatable. Basel III capital requirements will force Bank of America to raise $25 billion, according to JP Morgan (not $200 billion according to Blodget). Here's what the army of analysts say:

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Bank of America (BAC) got a new supporter on Wednesday, as analyst Meredith Whitney told Bloomberg Radio that the hemming and hawing over the bank’s need to raise billions in new capital is overdone. “I don’t think that there’s a mad dash to raise capital immediately,” she said. --Barron's

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"There is no impact whatsoever on Bank of America's balance sheet, based upon the price of its stock in the open market. If the price of the stock goes to a penny a share, it has no impact on the balance sheet of Bank of America. Bank of America sells the stock to the public, it takes in the money, and that is the end of the transaction as far as Bank of America is concerned. If you're going to break a bank, you're going to have a run on its deposits. That's not happening. Exactly the opposite is happening…Deposits are pouring into Bank of America."

"Or, as in the case of the fourth quarter of 2008, you've got to bust a bank by making it repay all of its short-term debt immediately. Bank of America has so much cash on its balance sheet that it can pay back all of its short- term debt, it could pay back a big chunk of its long-term debt and still have excess cash on the balance sheet. You can't break the bank by driving the price of the stock lower, particularly if the bank is as cash-rich as this one is with deposits pouring in as fast as they are." --Bank Analyst Dick Bove

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Core Portfolio - Prime mortgages 30 days or more past due increased to 1.98% from 1.67%.

Legacy Asset Servicing Portfolio - Subprime mortgages 30 days or more past due increased to 46.7% from 46.6%.

Commercial – Commercial loans 30 days or more past due decreased to 2.01% from 2.55%.

Credit and Consumer – Loans 30 days or more past due decreased to 3.38% from 3.93%.

Also, 90% of the loan portfolio is paying in a timely fashion.

And 8.5% of the loan portfolio is 90 days or more past due or was purchased credit impaired.

If all of these loans default with no recovery rate, BAC would be looking at $75 billion in future write-downs. With $37 billion already allotted to loan loss reserves, the bank would be looking at a decrease of $38 billion from tangible book value, which held steady near $130 billion. That would still leave the bank with over $90 billion in tangible book value and selling for just 75% of tangible book value. Currently, the bank only sells for half of tangible book value, an unprecedented valuation.

For Bank of America to become insolvent, 14% of its loan portfolio would have to default with no recovery rate. With only 8.5% of loans currently 90 days or more past due and/or purchased credit impaired and almost assured to have some recovery rate, this would mean defaults would have to at least triple for the bank to become insolvent, a level much worse than the depths of the recession in 2009. -- Matt Blecker 

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This is nothing like 2008, says CEO Brian Moynihan. "Simply put, we have twice the capital we did back then," he said on a recent conference call. B of A currently has twice as much capital as regulators require. New international banking standards called Basel III require large banks to hold 9.5% Tier 1 common equity, phased in between 2013 and 2019. B of A says it will already exceed 8% next year. Seven years to raise less than two percentage points of capital is hardly onerous, particularly since B of A isn't paying dividends to shareholders. As for aneverending stream of lawsuits caking the bank in uncertainty, Moynihan said he isn't going down without a fight. --Motley Fool

Historic US Downgrade Adds Pressure to Liquidity Trap, Markets Signal Trouble

This past week, the markets have provided useful indication that trouble is brewing. The private sector has gone rogue, and the message is clear that enough is enough. The economy has been poisoned by political dithering and government crowd out, and now it is time to fess up with the consequences. In the midst of a liquidity trap, safe haven depletion, structural problems, fiscal insanity, and now a historic downgrade of the used up global superman (that is the US), the world sits to drown in worry about what will happen next.

The United States debt ceiling debacle completely missed the golden opportunity to introduce a complete overhaul to reverse the years of folly that got us into this mess. Lawmakers failed to realize the underlying problem - the US has been abused, and it is time to heal it for good. A while back, this blog reported that talks were in progress to craft SDRs (a basket of currencies) to replace the US Dollar as the world's reserve currency. My analysis of this was that the US was beholden to the world's demand in spite of its domestic issues. Issues that included fiscal woes following the decision to leave the gold standard and accumulate an unsustainable supply of dollars to fuel world demand for more US debt. The cycle continued as the world progressed (case in point: the emerging economies off the back of US pain -- China, the biggest holder of our debt). Congress, given the constitutional power of the purse, has yet to realize that we are being played continuously. Recently, Russia's Putin stated that the US is a parasite to the world. China continues to lecture us on how to reverse our addiction to pleasing the world with debt, because it is no longer sustainable for their country as it moves past our problems. And now, our own private markets have raised the alarm. Standard & Poors steps into the debate.

The downgrade from AAA to AA+ is primarily because of the deficit deal reached by lawmakers one day before the debt ceiling deadline. It was merely a band-aid approach to calm markets, and shifts responsibility to a committee that must use politics to decide what government program will receive a cut. With something so nonsensical, a downgrade is inevitable, no need to be shocked. The structural problems have yet to be addressed. 

Lower GDP, and what seems to be better jobs numbers at face value, sent lawmakers reassuring the American people that this is just a short term thing, and the economy will get better...in their hands. Almost laughable to watch this play out. A deeper look into the data shows that the labor market has continued to decline, and because of our messy approach to employment statistics, a drop in the labor market means that the troubled Americans in search of work have left the pool, and the active few (some of whom successful in finding employment) provide a boost to the data. This is correlated to a structural problem, in which the supply of labor is due to an unskilled workforce. Businesses need skilled thinkers to cut through the problems created by the government, and pave the way to recovery. Instead, we have many Americans who are the result of failed government programs with no where to go. And now lawmakers must accommodate for this weird skew with budget shifts. 

The structural problem is not entirely American. The European Union continues to struggle with a way to balance the needs of constituents and bond holders. EU's Rehn recently urged everyone to stay calm and breathe deeply as officials try to craft a plan for Greece to continue borrowing at low costs, with less fiscal burdens due to austerity measures, all while making sure that current bond holders receive their fair share. It's a complex mess that will take time to correct. The markets are not impressed.

Italy rushed through an entire austerity package in one week, under pressure by the EU to make sure that the country is in good shape in case of contagion disaster. Italy is a major route for European debt, so there is big internal worry that they remain solvent. Yields on Italian debt surged as investors panicked and withdrew money from its bonds. The backroom deals sent a message that there are more problems to come. There is hope in Spain as yields decreased with an improving stock market. But, these spreads between Italian, Spanish, and German yields show that the movement of cash within Europe is due to uncertainty. 

US markets experienced a significant decline this week, as the Dow Average moved into the red for this year. Safe havens are now at risk of a price drop too. Margin calls were a major factor in the drop in Gold and Silver prices as investors needed to exit positions in commodities for liquid cash to cover riskier investments in stocks, all to maintain a balanced portfolio. The intense movement of cash to Switzerland caused the Swiss Franc to rally. However, the Swiss Government saw this as too cumbersome a risk to foreign banking demand; thus in an effort to remain stabilized, its Central Bank cut rates to calm the markets. 

US Treasury bills are still in hot demand, and this is somewhat problematic. Investors have no where to go, and Treasuries will continue to be a safer alternative. However, with the US now on "negative outlook" by S&P, the supply and demand of Treasury Bills at auction is uncertain. States have already started buckling up with less debt accumulation. The lower supply of municipal bonds are good for the state's sustainable budget goals, but leaves investors hoarding more cash. 

The Financial Times accurately calls this a liquidity trap - the 2011 deposit crisis. Banks like BNY Mellon are charging more for services that are costing them. The service of hoarding depositor cash in savings is not feasible. Banks have the duty to utilize your savings to provide interest returns. However, with no utilization of cash because of global uncertainty, they rather avoid having to be pressured into risk. 

So, what can be done? The government should shift from spending to investment. As much as there is a spending problem, governments are in desperate need of revenue to please bondholders. Taxes should not be the only source of revenue. Government services need to be measured by its affect on producing a good supply of labor, which will in turn utilize the assets created by government (infrastructure, education, etc) to enhance their well-being. Every project must have ROI in mind. States are in a better position to do this well by making sure that each municipal bond issued must have a plan of repayment with ROI instead of new debt.   We desperately need to send a signal to the markets that the US is back in business. 

Investors Finding Safety in the Swiss Franc and US Debt

Out of all the general safe haven investments during US troubles, the Swiss Franc has performed the best this year. Whether it be the threat of Mid East oil supply disruptions during the Arab Spring, or the continuing worries of a messy budget situation in the US, investors have shifted to the franc as their safe haven currency. As we see further in the post of charts; investors may not want our currency, but they still like our debt.

The first chart on top shows the US Dollar's 3 month decline against the Franc.The bottom chart shows  a fast increase in volatility in the EUR/CHF (euro to swiss franc) pair, against the decline in volatility in Gold. This is quite interesting. Investors seem to be demanding more franc than Gold during the US deficit mess. 

FT Alphaville has a nice feature today on this topic. The article states that mortgage borrowers in Poland and Hungary held Swiss Franc denominated debt taken out prior to the 2008 financial crisis, as an extra hedge. Even Central Bank policies have centered around the Franc. 

In a world of uncertainty, investors are realizing that during times of crisis, you must reserve your spot in the haven where the frantic crowd heads. At that point, you'll be prepared to collect what essentially is a rent-seeking cost. The funds from this strategy can eventually offset the losses from bad exposure. 

Now this is where it gets interesting. Treasury yields (which basically signal the inverse movement to and from T-Bills, as T-prices rise with demand, yields fall) have risen throughout the latter part of 2010 as investors got out of treasury bills. Now, so far this year, yields have been on a decline as investors are buying back more T-Bills. Is this confidence? Or are investors busy fleeing riskier investments and settling for the somewhat safer US debt? More so of the latter. There's no risk free rate here, but given the intense measures taken (hence the high publicity and frantic government), this shows that the US is concerned about bondholders, and will probably continue issuing more debt which is apparently in demand. No talk about how we pay for it until the next debt ceiling date (see the cycle?) Sad, but true. US debt will always be in the mix of a safe haven portfolio, until that time comes -- when someone with a stiff spine paves a correct path towards fiscal sanity at home, in which bondholders are paid back with ROI instead of debt, and spending is on a sustainable level. 

Another Chance to Get it Right - The US Debt Ceiling

A deficit deal must be reached before the August 2nd deadline. In a press conference this morning, President Obama stated that he will meet with his budget team, Vice President Biden, and House Speaker Boehner. The US is in desperate need of a strict budget overhaul, and this could be its chance to do so. In an ideal, somehow unrealistic situation, the debt ceiling will remain and the US will agree to make the necessary cash adjustments to remain solvent in both the current and long term. The US needs a strict force to whip it into shape; the debt ceiling is that force.

White House officials, economists, and pundits in the media use scare words like catastrophic consequences, disaster, the end of the US - if the debt ceiling is not raised. President Obama even lashed out against those that disagreed with him on the debt ceiling issue as irresponsible. Laughable that the ones who were irresponsible are now clinging for political and economic survival. The blame game, and further dithering is not the heart of the matter, as some in the media cleverly make apparent. As daunting as it might be, the numbers deserve more light.

Keeping the debt ceiling at its current level will force us to make serious sacrifices, and operate within our limits, for once. Now is our chance to reverse the status-quo and allow the nation to freely grow without the strangles of debt and bad budgetary practice. Let's delve deeper into what's at stake.

US default is not as scary as the media makes it out to be. It's nowhere close to what Argentina experienced, or what we see now in Greece. The US simply does not have enough cash to cover its debt payments, which fuels the government machine behind the economy. There have been 16 consecutive occasions since 1993 in which the debt ceiling was raised. The decision to open up allow a little more debt to keep up with unsustainable government services adds up, and now we find ourselves at what should be the debt peak. The argument rests in the decision of whether or not to default on bond interest or the principle. We seldom hear of the debate to stay within the set limit and introduce a budget overhaul to correct the mistakes we clearly made after budget plan that came out of the previous debt ceiling lift. Now that's irresponsible.

Here's an option on the table. The not so scary default could be tamed if the Treasury department rolls over maturing issues, so long as the overall stock of outstanding debt does not rise. The term rollover means that the Treasury uses money from the sale of new T-Bills to fund the rollover of maturing debt. It's essentially replacing debt due with new debt, instead of paying for it in cash (which we don't have). The treasury already does this every Monday -- $30 billion worth of T-Bill due for payment are rolled over with the issuance of new debt. See the cycle? It's all virtual faith. The safe haven is made more of an idea every Monday, when the  underlying asset is clouded. The continuing pattern after the gold standard (in which every dollar was backed by gold).

According to ICAP data made public by The Economist, interest payments can be covered. In August of 2011 (the debt ceiling deadline), the US will have an estimated $185 billion in cash receipts, $37 billion in interest due, and $340 billion in other outlays, equating to a ($192 billion) deficit. If the government fixes its budget so that these outlays (which fund government services, bank transfers, bond payments, etc) decreases to allow cash to cover interest, we can avoid less harm. The Prompt Payment Act enforces penalties on late interest payments - yet another expense to worry about. This is a clearly unbalanced position, and the ICAP estimates see a continuing deficit problem with outlays becoming an increasing burden. The problem is obvious - the US is not using its cash receipts in a responsible manner. Giving out more than we have, while creating more of what we don't have is just nonsensical, and it must stop.

If we are forced to default, Treasury will use less scare rhetoric and will explain what we are defaulting on exactly. T-Bills come in periods, so we still have some room to get our act together, broken up by each issuance and disbursement of debt. But a grand overhaul to orchestrate each minuscule (billions are actually big) payment is essential. The US will be forced to create a strategic game play in which the Treasury is held responsible for a balanced budget of inflows to outflows, which means that the government must act with what's given. If the requester of Treasury funds needs more, then they should create more through revenue generation. That will help the budget of each municipality, state, and in a broader sense, the federal government. Creating $3 with $1 requires innovation, and better use of the private sector. Allowing people to do what they do best (create value), will increase cash receipts. It's up to the local politicians to get this right.

The government must be forced to balance its budget. Austerity is painful, but it's clear that the economy needs a step back to leap forward; the US recession needed that J-Curve. If the debt limit does not provide this force, the economy will naturally seek responsible action. And this is exactly what bond investors are thinking. Let's tap into the thought process of the investor.

Are the bond markets really worried about default? So far, there is no demand for higher interest rates to compensate for default. Yields are lower, while treasury prices rise, signaling increased demand for T-bills as a safe haven. Investors are not fleeing the bond markets, because the general picture is still sluggish growth (again, the economy will naturally push for responsible leadership). The safe haven is still viewed as a risk-free asset.

However, the number of Credit Default Swap (CDS) contracts are up from 600-1,000 so far this year. The one year to 15 year spread has tightened, as it is now more expensive to insure a one year bond compared to a fifteen year bond against US government default. Even though investors are buying more Treasuries, they are insuring against default by relying on CDS. Playing it safe. China is also diversifying its reserves outside of US Treasuries.

The Economist interviewed a bond strategist about the patterns she sees in the markets:

Priya Misra, head of US rates strategy at Bank of America Merrill Lynch, says anyone who thinks America might default for several weeks this summer should sell a bond with interest due on August 15th and buy one with interest due on November 15th, which would result in the price of the first bond falling relative to the second. But, she says, neither market pricing nor the chatter of clients shows such a trend.

The debate should focus more on a budget overhaul, and the debt ceiling issue will follow these standards.

What to do about Greece

Greece isn't so much of a headache as it an opportunity for traders. It allows us to step back and think like an economist; evaluating the what ifs of contagion and speculating the fate of the Euro. The task list is complex.

Last week, the Prime Minister successfully passed a confidence vote, but voters outside his elite backing remained angry. Protesting outside government buildings continued, spreads on Greek/Spanish yields widened, and traders sold off on the Euro sending the currency on a decline. The markets are one step ahead, as the value of the Euro rises ahead of key meetings and votes just to show that expectations are rising, only to increase fears about the next step.

The fact is that Greece is and will continue to be a burden on the Euro zone - lower GDP per person coupled with higher government debt as a percent of national GDP. The country is in desperate need of a 12 billion euro life-line loan by mid-July. This, along with a plan for further austerity measures will be the next task for Greece. The Prime Minister and his cabinet must balance the interest of pleasing bond holders and pleasing voters. This battle is essentially the same, as voters, who want to continue life as it once was (living beyond their means) are the major holders of Greek debt.

Contagion is based mainly on fear rather than the actual. Although the euro zone is becoming entangled in the mess of Greece through its Central Bank (a bad bank of debt) and the flows of bail out cash extending a line of dependency, the risks are greater at home. Greek banks will ultimately feel the pain in the event of a default. The National Bank of Greece, Piraeus Bank, and Eurobank EFG, all have 6-8% of capital tied up in Greek government bonds. However, outside banks such as BNP Paribas and Dexia group, have 2-5% of capital in Italian and Spanish bonds. This is a big problem.

Banks within the euro zone and around the world don't have to be tied up in Greek debt specifically. If the balance sheet has Italian, Irish, and Spanish bonds, it is indirectly affected by Greek default or other types of restructuring. Yields will fluctuate in response, as investors display emotion with their dollars. Banks around the world that have holdings in funds that are exposed to European debt face risk. Similar to the financial crisis, in which investment banks struggled to determine counter-party risk -- who the heck owns the stuff? Eventually, the knot becomes too tight to untangle, and we end up with a Lehman style collapse. Not so much the case here. Transparency is much greater with government debt, but still, exposure and contagion fears remain.

Investors are already evaluating exposure. Shares of Dexia Group, a Belgian bank with major holdings of euro zone debt, have declined significantly (down 24% YTD). However, banks like Dexia are insured through credit default swaps. Back in June, Dexia joined other banks to rollover a combined 30 billion euros of Greek debt for an emergency package. On the other hand, taxpayers and public workers have savings in Greece, and they should worry. The people of Greece can begin with tightening their belts so that the government can get on with tackling its fiscal woes.

So, what are the options.

A second bail out will continue the spiral of dependency and will only succeed if its backed by strict austerity measures. Voters even see a second bail out as a continuing problem. Investors will see this as some certainty, but only short term.

In the long run, the euro zone will continue to funnel money through a stabilization fund (essentially a little IMF of their own). Countries need to get away from this. The money just stalls time.

Default will ripple the markets, but will force people to get serious. If this happens, Greece should think about a gradual exit from the euro zone to focus on creating an organic model that will be more sustainable.

Restructuring is the best bet. First, greater privatization should be considered. Already, Greece is selling shares of its ports and an immediate sale of state assets. Second, a private 'bail-out' focused on restructuring debt should occur. Give Germany and the rest of the euro zone a break, and consider this:

SWFs [Sovereign Wealth Funds] have the might and the risk appetite, but do they have the interest? China has repeatedly pledged support to Europe’s periphery, motivated by the prospect of currying favour with Europe in order for its domestic firms to gain greater access to the European markets.

Norway’s sovereign fund—the world’s second largest—also has an interest in the euro area’s speedy recovery, given its home country’s proximity and links to the euro zone. Although the fund largely tracks public equity and bond indexes, it leaves some room for active management. Recent statements from government and fund officials suggest that the fund may use its discretion to buy more euro area peripheral debt. As of the third quarter last year, Norway’s SWF held US$3.9bn in Spanish sovereign debt, its seventh-largest individual bond position. -- Economist Meg, SWFs: the euro zone's white horse? (May 2011)

For now, we wait. Honestly, I enjoy the buzz among my Twitter and Facebook friends as we frantically try to make sense of this mess. Traders will continue to monitor these events, taking pulse of the Euro. In the meantime, the US should prepare for a shift of interest and get its budget deficit under control to show investors that the country is serious about becoming solvent.

The Future of Toxic Assets

Once again, a Facebook discussion inspired me to think further. The banking idustry will face many challenges ahead, as outlined in last week's Special Report in The Economist. The culprint behind it all are "toxic assets". It's not as toxic when viewed in the long run, but for now bankers and regulators are still trying to find a place for it. The US went through this, and is slowly recovering with cleaner balance sheets. Europe is starting to experience similar troubles, especially Spain with its housing bubble. The question remains, what's next for these troubled assets (troubled is a better term than toxic).
In general, it is still too early to forecast the future of the banking system. The US, the source of the financial crisis, is still in the idea phase. The Dodd-Frank Bill is essentially a long list of proposals on what regulators intend to accomplish. Once a specific action plan full of regulations is introduced, analysts will surely weigh the pros and cons. We are starting to see the plans leak out, begining with consumer protection, and regulations on small things such as debit card transaction fees. The industry as a whole will be tightened, with higher capital and reserve requirements, cutting into profits. This might also force banks to venture into new exotic investments, and spill over risk from the shadow banking system - financial dealings with investment banks and other non-deposit institutions.

The initial plan, and what remains to be the first resort, is to set up a bad bank. The government purchases troubled assets and places them in a 'bad bank' where they sit and wait to be bought at a higher value. The government also collects payments in the form of a core capital ratio from the banks. The tricky part is valuing these assets and figuring out book values. The market for troubled derivatives is essentially dead, and there is little transparency, no source of ownership, and no demand pressure to set an actual price. The government has actuaries who assume the price, and we have some faith in this value. I think that the cost of the lump sum of purchases should equal to the amount of cash desperately needed to free up the bank's balance sheet.

The underlying asset that sets the value of these derivatives such as credit default swaps and mortgage baked securities are mainly consumer debt and homes, respectively. Currently, the US housing market is sluggish, as many homes remain vacant, foreclosed, and on a tightrope amidst mortgage loan restructuring. Some banks are desperately extending loan terms to help buyers by decreasing mortgage payments, in hopes to hold on to income producing properties. Other banks have lost hope and started a wave of short-sales, accepting small losses, but still face low demand from buyers. An empty home is...an empty home, and the derivatives that are fueled through the payments of borrowers are empty too, dead, or as some like to call it - toxic.

Fast forward a decade into the future. By this time, these troubled assets will be worth something. Governments can sell them off for profit, but I feel like there is a better way for banks to deal with this on their own. Consider this:

Banks establish a bad bank of their own and bear the costs involved in doing so (no initial sale, no cash). The government is artifically valuing the assets, when given some time, these instruments can arrive at a fair market value. These bank owned 'bad banks' will be managed by a team in charge of re-structuring the assets for a gradual launch throughout the recovery years. The assets are already structured for a good economy with cash flows from income generating properties and debt accumulation. The problem that caused systemic collapse was when the economy went sour, these instruments became toxic because they were not created to yield positive results during default. No matter how many parties insured the risk of default, the process of capital payment to borrowers and faulty ratings trumped all other pre-cautionary measures. Also, the web of insurers grew to large, that a collapse was inevitable, because no one could pinpoint the source of risk.

When these assets are structured, they need boundries. These derivatives should perform similar to options. It must come with a start date, and most important, maturity. The maturity period should arrive when the economy gives signals of exhaustion. Next, the assets should be split into groups of investors so that transparancy can flow easily. This is a better alternative because it is re-structured to be sustainable. Sitting on the government's books does nothing, and will only leave the new investors in more pain.



Possible Effects of Basel III

Central Bank leaders from around the world came to a consensus on September 13, 2010 about new banking requirements. Basel III calls for an increase in common equity, which banks use to absorb losses. In addition to that safety net, internationally active banks must hold levels of common equity equal to at least 7% of their assets. The current international standard is 2%, with the US at 4%, Basel III will be a significant increase.

The WSJ reports:

"Some changes will go into effect as soon as 2013, but others won't be in place until the beginning of 2019. Technical changes to the definitions of capital won't be fully in place until 2023.

Banks will be allowed to phase in these new standards over a period of years, so they will have more time to comply. By 2015, banks will have to begin building a 2.5% "buffer" of capital that must be fully in place by Jan. 1, 2019. 

If banks fall below the buffer, regulators could force them to hold onto more of their earnings to augment their capital, which means the companies will have less money on hand to pay dividends or offer large compensation packages. Some analysts believe the new standards could essentially force banks to shrink their loan portfolios or shed other assets in order to improve their capital positions."

Despite the gradual implementation of the conservative requirements, banks claim that the costs will be transferred over to borrowers and employees. This will mean higher lending standards causing a decrease in loans, and higher fees. Employee bonuses, under intense media and shareholder scrutiny will likely decrease; although several analysts expect this to remain steady. Academics argue that according to past data, increased reserve requirements have little to no effect on lending productivity.

Although this is very much needed, there is still the risk of moral hazard. Knowing that there is a safety net, despite it being their own cash, banks might continue risky investments. Surely, if they grow large enough, the state will provide additional funds lacking in common equity reserves - that being the mentality of the crisis. Whatever the case, banks will find themselves scrambling for cash. Inter-bank short term lending might pick up and banks will flock to more liquid investments; those that seem attractive in yield but also pose risk. Banks will find a way to get the cash they need. Government will find it difficult to tackle a new system that grants liquidity, if it poses systemic risk that is.

Another risk is that banks might gradually decrease their stake in government debt. In the US, banks are utilizing bail out cash to purchase Treasuries and other forms of hedging. Since then, the Fed has been active in quantitative easing to try to crowd out the treasury market and encourage banks to transfer their cash to borrowers.

Update: The Fed's latest QE3 program will  provide liquidity to mortgage providers through MBS purchases. However, the underlying disappointment in Wells Fargo's recent earnings report due to lower than expected revenue is concerning. With Basell III approaching, Wells Fargo is in a good position with mortgage banking non-interest income up 53% due to fees associated with the productive mortgage market. However, with low rates providing an incentive to borrower's choosing to refinance, banks like Wells Fargo are seeing interest income plunge. Again, the hope is that QE3 MBS purchases will help compensate for the decreasing returns stemmed from a low rate environment. Currently, Wells Fargo sits on $127bn of MBS, up from $106bn reported in the previous year. There's more to be sold, thus more liquidity to be provided.

In sum, for the US this still means we have more work to do. Basel III is an international standard meant to secure the banking system, but domestic responsibilities of each country still remains. Now that in the long run banks will have to reserve more cash, we need to figure out a way to encourage lending. That starts with a healthy economy of both borrowers and lenders.

Janet Yellen Tapped to Lead Trio of Nominees for Fed Board

President Obama acted quickly to nominate a team of three to fill the open seats of the Federal Reserve Board. He saw it as a chance to gather a strong team of experts to revamp the economy using their influence on monetary policy. Each nominee has expertise in specific areas such as the labor market, federal budget, and financial regulation. Being that these are the three current concerns in economic policy, it makes sense to nominate these three experts.

The first to be tapped for Vice Chairman of the Federal Reserve is Janet Yellen. She is the current president of the Federal Reserve Bank of San Francisco, which oversees the economy of the 12th district. Yellen is a voting member of the Federal Open Market Committee (FOMC) and Professor Emeritus at the UC Berkeley Haas School of Business. She is originally from Brooklyn, NY and received her degree in Economics from Brown in 1967, and later graduated from Yale 1971 with her PhD. In July of 2009, Dr. Yellen was a potential successor to Bernanke before he was renominated by President Obama for another term as Fed Chairman. Dr. Yellen also served as the Chairwoman of the White House Council of Economic Advisors for President Clinton from 1997 to 1999. This vast experience makes her well respected within the Federal Reserve system and academia.

As expressed in the Fed Board's latest statement, the economy is slowly coming back with better housing numbers and consumer spending, however unemployment and lower income levels remain troubling. Therefore, Dr. Yellen, an expert in macro and labor economics, will be a great addition to the Board. She voiced concerns about how downward prices may lead to deflation and further increase unemployment and decrease incomes as businesses struggle to spur demand. She admits this is unlikely as the Fed and policymakers work hard to stimulate a recovery. Dr. Yellen also understands that the Fed is an independent body, and in her speeches, she keeps the focus of discussion on monetary policy. However, if there are issues that deserve attention such as employment, she is not hesitant to voice concern and pressure DC politicians to act in accordance with the Fed.

President Obama also nominated Peter Diamond to fill an open Board seat. Diamond is a professor of Economics at MIT and has written about the federal budget deficit. He co authored a book with Peter Orzag, Chairman of the Congressional Budget Office (CBO). Diamond understands that Social Security and Pensions are unsustainable, and if they are not reformed, the budget deficit will deepen. But are these problems for the Fed to address? This is the responsibility of the CBO, and it seems that Diamond's expertise lies beyond the Fed's core duties.

Sarah Bloom Rasken was also tapped to join the Federal Reserve Board. She is currently a lawyer and consumer advocate. She is a strong fighter for financial reform and regulation. If confirmed, Rasken will be the main liaison between DC and the Fed. She will help determine the Fed's role in further financial reform. I hope that she will help with Bernanke's fight to keep the Fed independent and reserve one of their main roles of preceding over banks through regulation, handling reserves, and ensuring consumer protection. This allows the Fed to be in tune with banking conditions around the country to make major monetary policy at the national level. The board members must be in the know, and Rasken will serve as that connection of information.

Overall, I support Janet Yellen for the Vice Chairman position, however Diamond and Rasken has expertise that mixes too well with DC responsibilities. That mix is not helpful to the Fed's independent approach to policy making, and these two nominations present some concern. The final decision is up to the Senate, and there are no apparent oppositions as of yet.