Repost: What Abe wants, Abe gets. Japan's battle on the Yen

Updated from Jan. 2013: 

Aggressive measures by the BoJ and a staunch tone by PM Abe must continue to maintain pressure on the Yen. But is the recent rally enough? Japan's Economy Minister stated on Monday [Jan. 2013] that "the Yen has come to a good level....if it falls to a three-digit level it would boost import prices, weighing on the everyday life of the nation."

The market needs progress, not just rhetoric in order to play its part. PM Shinzo Abe is building up the pressure, and he has a history of speaking out about the Japanese economy, but has done little to actually show for it. Abe was elected as the 90th PM of Japan by a special session in 2006, but only served for less than a year. Perhaps now is his time to shine as he stood on a strong platform of pressuring the BoJ to tackle deflation by means of inflation with aggressive monetary stimulus and greater cooperation with the newly elected government. The monetary-fiscal cooperation interferes with the Bank's legal independence, but talks still continue amid the threat of a constitutional change to the BoJ's independence so long as the Bank abides by Abe's recommended 2% inflation target. 

So called 'Abeconomics' has a direct market effect, causing a bounce off 2012 September lows in USD/JPY to extend to its current rally. The market's reaction is welcomed as a softer Yen helps boost Japanese exports and paves the way for inflation. But will this inflation come with growth? Abe's [2013] $117bn stimulus is projected to boost GDP by about 2% while creating 600,000 jobs. Nomura estimates that the the stimulus will help deliver real annualized GDP growth of 3.5%; and with ongoing disaster recovery from the 2011 tsunami, we could see more government-led growth. Economists worry that this is a big gamble for a sustained recovery. Nikkei Business Daily cites the growing probability of large spending in rural regions and the government's ability to prioritize projects. This is why there is so much pressure on the monetary side. 

In comes Shirakawa, the current BoJ Governor. Shirakawa announced an additional $128bn as part of the Bank's monetary easing programs in the fall [2012]. Japan's total spent on asset-buying programs has now past the $1tn mark, which is quite excessive. Meanwhile, the Japanese economy is stuck in its fourth recession since 2000. Much of this downfall is due to a strong Yen which halts export growth. A sluggish global economy,  and the struggle to recoup from the 2011 tsunami disaster is added pressure on Japan. Nevertheless, the Japanese economy has continued its  constant debt buildup and fiscal woes for about 20 years now. At some point, this cannot be sustained. 

The market implications are clear. Further Yen weakness could continue so long as the BoJ abides by Abe's commands. The market needs to see progress on Abe's strategy in order for the Yen to weaken by theory. The USD/JPY shorts could pave the way for the April appointment of the next BoJ Gov, creating another profit opportunity in the pair. So far, Abe is meeting this week with monetary policy experts to begin the discussion on who will be the next BoJ Gov. Abe stated that he is looking for a "bold leader...someone who shares our views." [in comes Kuroda, current BoJ Gov.]

Challenges for Australia as China reforms point to slower growth

Despite recent signs of modest economic improvement, Australia is likely to remain on a tightrope for quite some time as the country’s mining boom slows down. Recent economic data from China shows strong improvement, but that could change as leaders are set to implement significant reform measures that could slow growth in the near-term. The market is well aware of the challenges ahead for Australia, and several important risk factors suggest that the Australian dollar is likely to remain subdued, especially as it struggles to sustain a rebound off summer lows.

China’s Third Plenum matters

A four-day, closed door meeting between China’s leaders to discuss the economic and political agenda for the next decade just concluded and expectations are high for significant reform. China must pave the way towards a market economy that will redirect credit away from inefficient state-owned-enterprises (SOEs) to much more efficient private enterprises. The new agenda should loosen the state’s control over capital allocation, which starts with reducing the limits on wealth transfers.

Continue reading at Saxo Bank's TradingFloor.com

Asia Focus: AUDUSD up on Australian CPI but pares gains in Asia

Australia's housing sector helped boost Q3 figures. Photo: Shutterstock

Australia’s third-quarter CPI report was impressive despite remaining subdued on the headline print at 2.2 percent on year from 2.4 percent in Q2, which is still at the lower range of the Reserve Bank of Australia’s target of two to three percent for annual inflation.

The market was expecting slower CPI in Q3, but the trimmed mean figure beat consensus at 2.3 percent on year. The Reserve Bank of Australia (RBA) places more weight on trimmed mean CPI, so the recent rise could sustain the RBA’s more favourable tone on the economy.

Furthermore, the Q3 Aussie CPI report showed a greater contribution from the housing group, which suggests that recent data are starting to reflect the low rate environment. The RBA is now watching the higher AUD. 

Also, top China banks tripled debt-write offs as investors fear default. The seven day repo rate rose 42 basis points in Asia which; lingering fears on banking -- China's weak-spot, was behind the sudden AUDJPY drop during the Asia session. Key China PMI data ahead on Thursday to watch for as well. 

Continue reading at Saxo Bank's TradingFloor.com

Trade Idea: Buy-the-dip opportunity in AUDUSD

US back in business, markets sell the fact

A bipartisan bill to reopen the US federal government and avert default passed in the Senate and House of Representatives and was ultimately signed by President Obama at the eleventh hour on Wednesday. US politicians repeat the same procedure year after year and the market priced in a last minute compromise as US equities advanced ahead of the initial Senate vote. However, USD declined as legislatures approved the bill — a classic “buy the rumour, sell the fact.”

Continue reading at Saxo Bank's TradingFloor.com

Bernanke brings us back to reality as US remains on a tightrope

The Federal Reserve decided to maintain its pace of asset purchases, and the typical kneejerk reaction followed, but the important take-away is that many in the financial media were too optimistic. A lot of the noise leading up to the September Federal Open Market Committee (FOMC) meeting was largely a result of impatience and political speculation, with little regard to the independent structure of the Federal Reserve and its dedication to supporting the economy rather than paving the way for future successors or allowing the market to dictate monetary policy.

Federal Reserve Chairman Ben Bernanke’s press conference allowed everyone a chance to pause, reflect, and return to our trading desks with a more disciplined approach to interpreting information.

Continue reading at Saxo Bank's TradingFloor.com

What Abe wants, Abe gets? Japan's battle on the Yen.

I cringe every time I read a headline from Japan. Rounds of stimulus borrowing and spending is a big gamble for an economy that's not structurally sound, and the well orchestrated softening of the Yen is overstretched and looks ripe for some good profit taking. This means that aggressive measures by the BoJ and a staunch tone by newly elected PM Abe must continue to maintain the pressure on the Yen. But is the recent rally enough? Japan's Economy Minister stated on Monday that "the Yen has come to a good level....if it falls to a three-digit level it would boost import prices, weighing on the everyday life of the nation."

The market needs progress, not just rhetoric in order to play its part; and this could continue to play on with the coming BoJ meeting in about two weeks. PM Shinzo Abe is building up the pressure, and he has a history of speaking out about the Japanese economy, but has done little to actually show for it. Abe was elected as the 90th PM of Japan by a special session in 2006, but only served for less than a year. Perhaps now is his time to shine as he stood on a strong platform of pressuring the BoJ to tackle deflation by means of inflation with aggressive monetary stimulus and greater cooperation with the newly elected government. The monetary-fiscal cooperation interferes with the Bank's legal independence, but talks still continue amid the threat of a constitutional change to the BoJ's independence so long as the Bank abides by Abe's recommended 2% inflation target. 

So called 'Abeconomics' has a direct market effect, causing a bounce off 2012 September lows in USD/JPY to extend to its current rally. The market's reaction is welcomed as a softer Yen helps boost Japanese exports and paves the way for inflation. But will this inflation come with growth? Abe's latest $117bn stimulus is projected to boost GDP by about 2% while creating 600,000 jobs. Nomura estimates that the the stimulus will help deliver real annualized GDP growth of 3.5%; and with ongoing disaster recovery from the 2011 tsunami, we could see more government-led growth. Of course, the way to do this is through private sector growth accompanied by a sound economic structure. More supply growth by way of stimulus could face the consequence of left out demand which would do little to boost prices. Economists worry that this is a big gamble for a sustained recovery. Nikkei Business Daily cites the growing probability of large spending in rural regions and the government's ability to prioritize projects. This is why there is so much pressure on the monetary side. 

In comes Shirakawa, the current BoJ Governor. Shirakawa announced an additional $128bn as part of the Bank's monetary easing programs in the fall. Japan's total spent on asset-buying programs has now past the $1tn mark, which is quite excessive. Meanwhile, the Japanese economy is stuck in its fourth recession since 2000. Much of this downfall is due to a strong Yen which halts export growth, the sluggish global economy,  and the struggle to recoup from the 2011 tsunami disaster. Even still, the Japanese economy has continued its  constant debt buildup and fiscal woes for about 20 years now. At some point, this cannot be sustained. 

The market implications are tricky. USD/JPY has soared enough, but not yet touching that 90 mark. Abe would like to see more JPY weakness to aid in his aggressive growth strategy. However, with USD/JPY shorts back in the game, we could see some profit taking. Over the past two weeks, the USD/JPY breather has extended for longer time-frames, but has always returned with a rise to continue the the upward trend. This could indicate some positioning as traders decrease exposure to the pair ahead of a correction or just pure uncertainty. Further Yen weakness could continue so long as the BoJ abides by Abe's commands in its coming meeting. The market needs to see progress on Abe's strategy in order for the Yen to weaken by theory. Remember that Shirakawa's term as BoJ Gov is up in April, so there is the possibility for this to continue, albeit at a softer tone (assuming no sharp correction). The USD/JPY shorts could pave the way for the April appointment of the next BoJ Gov, creating another profit opportunity in the pair. So far, Abe is meeting this week with monetary policy experts to begin the discussion on who will be the next BoJ Gov. Abe stated that he is looking for a "bold leader...someone who shares our views." 

US following in Japan's footsteps? Further reading:

Charts: US debt following Japan's trajectory

Japan's debt ceiling showdown

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

The US must seize the economic opportunity

 

This past election was about who will be in charge of the nation's long road to recovery from the 2008 downfall. In the month leading up to election day, the US reported encouraging figures which at first glance seemed to indicate that we are on a path to a sustained recovery. The disappearance of housing inventory and a low rate environment inspired some support for a sector that was at the heart of the recession. Unemployment continued its decline to 7.9%, but still the overall trend remains weak with a lot of Americans simply settling for lower wages to make ends meet. Let's not forget about the long term unemployed facing declining skill levels and personal discouragement. It's clear that a recovery is in sight, but many challenges are ahead that will disrupt the progression.

Despite the debatable policies of the last four years and failed attempts to try to get the economy going (ie QE and fiscal stimulus), the private sector surely has struggled, but it carried along to continue doing business. Individuals and businesses don't rely on government wholeheartedly to keep moving; it is in our nature to keep the economy going. Surely, the pace at which we do this can be fine tuned by government forces. We know that businesses have high amounts of cash, but are cautious to invest and hire because of the high level of uncertainty. The private sector needs proof of a sustained recovery in order to take that risk to naturally stimulate a return through growth. So far, the government has discounted many of these potential decisions, and the political dithering is causing the economy to under perform.

Two examples that support this claim are seen in the recent earnings season and our domestic energy sector. Earnings came out relatively good at face value, but the slew of negative profit outlooks is very troubling. The fact of the matter is that consumers are spending because the cost of living is higher. This does not necessarily mean the price of goods are higher; lower wages decreases our purchasing power and uncertainty about what's to come forces us to spend rather than save. This fuels revenue growth in key sectors such as consumer cyclical. Companies that deal with trade and logistics such as UPS and FedEx have expressed some concern about future demand despite having the capabilities to continue running smoothly.

In energy, we have a clear distribution problem that cuts directly into the business of drilling. Despite the opening of some federal lands during the last four years, the pipeline network to actually fuel demand is severely lacking and the decision to block Keystone until after the election only adds to the problem. Drillers know the economics don't work just by having access to a glut of supply; a concrete energy plan is needed and will get us on a solid track to recovery. This could truly be America's new innovation moment, but again it has been discounted. A lame duck session is unlikely to get this rolling.

Furthermore, the market has responded to the electorate decision, and it clearly supports my stance. Despite an immediate rise in equity futures following the election results, equities came to terms and reversed direction to the downside. Treasuries saw a significant rise as yields declined. Gold and silver soared with gains at 1.91% and 2.76% respectfully. This indicates a level of risk-aversion due to both the near term uncertainty and the longer term assurance of monetary easing.

The fiscal cliff poses a large threat to the economy, and House Speaker Boehner said it best - we have to build a house on rock instead of a house on sand. No doubt there will be some bickering, but this is our chance (once again) to reverse years of economic folly that is already deeply rooted in the US. The spending limit is a mandate that has been abused year after year to continue along an unsustainable path. Recoveries come and go, but we need to make sure that we have a country that has its books in order to limit the downfall. Boehner is calling for a new growth/reform model that is open to greater revenue, but it will require lots of work. That's what these next four years should be about. We must continue the fight outside of the ballot box and vote with our dollars. Trust in ourselves to make it through, and be prepared for any outcome. Four years should not be the end all. Make it a legacy.

Europe MUST Make Critical Decisions by Year End. ECB Disappoints.

A busy week so far brought along some disappointment as the US Fed Bank and Europe's ECB chose not to take immediate action. The decision was contrary to Draghi's pledge to do 'whatever it takes' to preserve the currency.  In the US, the Fed made no bold promises prior to the FOMC meeting, but continued to state the obvious and remain cautionary in its assessment of the US economy.

The problems in the US are relatively stable to comprehend compared to the ticking time bomb in the Eurozone. As expected, the FOMC left rates unchanged at 0.25% and will remain near zero until late 2014. US savings continued to increase, consumer spending is flat, and income is slightly up. Consumer confidence came out higher than expected, which produced a mixed view of structural conditions. ISM came out lower than expected at 49.8 from 49.7, when expectations were higher. There seems to be a slight slow-down in spending and productivity, while consumers and businesses are holding onto cash, indicating higher levels of uncertainty.

Rising Debt Levels in Private Equity

The private equity market is becoming more hostile as investors demand greater return through calculated risk. With a general decrease in buyout returns, aside from the star outliers like Bain, private equity firms are demanding more from their portfolio companies. According to CNN Money, the activist shareholder is pushing for companies to explore alternatives that will provide higher yields.

Starboard Value, Paulson & Co recently pushed AOL to sell off a large portion of its assets. The sell off provided immediate cash amidst declining ad revenue for the online media conglomerate. This just following the acquisition of the Huffington Post, a major milestone for AOL, which seemed to be on a path of organic growth as the company hired more journalists and segmented its online brands. The demand for quick cash by Starboard forced AOL to reduce overhead by laying off nearly all of its in house writers, and instead opting for the purchase of TechCrunch and Huffington Post. The sudden pick up in corporate activity at AOL highlights the inherent demand for cash during the risky PE shuffle.

Rewind to 2007 when the Economist warned against trouble in the PE market. The magazine cited the risk of rising interest rates causing an uptick in borrowing costs leading to more hostile activity to cover this additional credit expense. This hostile PE market will thereby take on more risk. The difference now is that we have record low interest rates, but low buyout returns. The latter problem is enough to revert us back to the same warning of 2007. Investors are demanding more cash by being hostile in their PE activities.

PE firms are in the business of selling assets, and then flipping companies for huge gains. In some cases, this might involve dismantling a conglomerate, purchasing undervalued companies, executing a turnaround, and then finally an exit through sale. The model involves time and risk, two factors that cause investors to be anxious.

Continue reading on the Dantes Outlook Facebook Page

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.

******************
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. 

Markets Prepare for an Italian Size Problem

Italy was tested this week as bondholders sent yields rising near 7%, increasing the cost of borrowing for the country. The timing was perfect as the markets realized the growing risk of an Italian size problem for the Euro zone. We realized that the European Central Bank (ECB) is not capable of artificially buying enough Italian debt to push yields down, thus decreasing Italy's borrowing costs despite market based movements. We also saw a win situation for investors as they were able to use their selling power to force the incompetent Prime Minister of Italy, Silvio Berlusconi, to pledge his resignation after a budget bill is passed, paving the way for structural reform and cooperation with the ECB over debt issues.

It all started when two major European clearinghouses raised collateral amounts for investors wanting to borrow Italian bonds. By doing so, the clearinghouses sent a message that Italian debt is deemed too risky, and therefore requires more money up front to protect against losses while dealing with Italy. Not wanting to take on the extra costs while anticipating a sell-off, more banks began reducing exposure to Italy. This lead to the sell-off that sent yields rising near 7%, the dreadful levels reached by Greece, Ireland, and Portugal during the height of their debt panic. The Financial Select Sector SPDR Fund dropped 5.4% on Wednesday - further proof of the sell-off by banks with exposure to Italian debt.

The worry is whether or not Italy can sustain the high cost of borrowing. If not, will the country be on a path to default? Not quite.

Again, the timing is perfect. Italy has time to make the necessary reforms. If it does not, it will certainly be a major blow to the region, causing an eventual break-up or break-down of the Euro zone. With Greek troubles, Spanish structural issues, and Germany becoming financially exhausted, economic leaders are not prepared to tackle another problem. Not to mention that nothing has been solved for the current mess that's becoming worse, except mere agreements among leaders to meet.

The scariest part of this situation is that the ECB does not have enough market power to artificially decrease yields. The Central Bank desperately tried to purchase Italian debt to decrease the burden on the country's borrowing, but this hardly placed a dent in the sell-off.

Italy can get this right, and Berlusconi made the right decision to resign as the markets pressured him out of his role as Prime Minister. Now the hope is that the Italian Senate approves the budget deal (which it did) so that Berlusconi will officially resign, and the new government under Mario Monti, the man touted as the next Prime Minister, will move forward with reforms.

The Italian government will need to implement the budget plans which includes spending cuts and tax increases, but must also focus on growth.

In a world of high growth or high inflation, those interest costs would be manageable. Either income covers the outlay or inflation erodes the debt burden.
But Italy has neither to look forward to. The International Monetary Fund forecasts Italy to grow by less than 1% a year over the coming three years and for Italian prices to rise by little more than 1% over the same period. -WSJ

This will result from incentives for investments and productivity; the economy needs to produce enough revenue to pay the increasing costs of debt accumulation. Investors particularly find Italian debt  attractive because it is very liquid. Italy is the world's fourth largest borrower, and is a magnet for European bondholders. This is why Italian leaders must present a plan that focuses on growth in order to calm the markets and eventually send yields lower to comfortable levels. Even if the plan is not implemented properly, at least borrowing costs will be lowered so that the expectations for economic growth are reasonable.

The political shake-up in Greece and Italy are good first steps to calming the markets. Getting rid of incompetent leaders is always reassuring. It is not a complete reset though - this will only come in the form of default and a completely new government. Realistically speaking, new politics and budget plans have already proven to calm markets in the short term. The Euro currency and US stock markets gained some ground after Berlusconi made his pledge to resign, and the Italian Senate approved the budget bill on Friday.

Don't think Europe is off the hook yet. There still needs to be drastic changes. Getting rid of incompetent leaders is only the start.

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.



The Coming Health Care Collapse: Balancing the Costs of Supply and Demand

The health care industry is the fastest growing employer in the United States. According to the Bureau of Labor Statistics, the industry is estimated to contribute 3 million additional jobs between 2008 and 2018, adding to the 14.3 million wage and salary workers as of 2008. The labor growth in health care is a result of increasing demand. The pace of hiring is greater than the pace of lay-offs, which makes me wonder if this is sustainable. During the recession, the health care industry maintained its standing as a major employer, despite short term lay-offs. A high skilled medical professional at a struggling hospital is able to relocate to another hospital that is busy expanding to fulfill increasing demand. However, patient demand places a strain on capacity and costs. The short-term layoffs, weaker job growth, and increasing costs expose the reasoning behind the coming health care collapse.

Hospitals are struggling to break even, and the results are painful. In April 2010, St.Vincent's Medical Center, a major hospital in downtown NYC, closed its doors. With approximately $750 million in debt, and no way of controlling increasing costs, St.Vincent's reached its shut down point. A major blow to NYC, as the last Catholic General hospital after 160 years in operation left the entire lower West Side of Manhattan without a hospital. St.Vincent's had a 6 month struggle with a budget deficit, and suffered an earlier bankruptcy prior to its closing. The bankruptcy apparently did nothing to restructure the financial model of the hospital. The State of New York issued $9 million in emergency loans to cover payroll, but this too was not enough. The community fought tirelessly to keep the hospital open, and a glimmer of hope arrived as Continuum Health Partners and Mount Sinai Hospital came on board to bid on a buy-out. However, a team of accountants deemed St.Vincent's an unsustainable investment. Also, there is word that state government chose to shy away from helping to structure a bidding process. Previous employees in the billing department have spoken up, stating that the St.Vincent's was very generous in providing care to poor patients. There was a lot of missing reimbursements for Medicare and Medicaid, and accounts receivables grew too cumbersome to manage. Sadly, this is true with other hospitals across the country.

Last year, President Obama, while promoting his health care plan, praised Cleveland Clinic and Mayo Clinic as the model hospitals that work to reduce costs. Weeks later, Cleveland and Mayo refused to serve Medicare patients in its Arizona locations; citing many missed reimbursements - and even the payments that were received did not cover the full cost of care. This coming from hospitals that are a model for cost reduction is a huge blow to the government who can not keep its promise. What about the many hospitals that are in worse shape, that didn't get the pleasure of being hailed as the model clinic? Government continues to make promises that it cannot keep.

The Pennsylvania Health Care Cost Containment Council has kept record of its growing list of hospitals that have closed or merged. University Medical Center, the hospital that treated Congresswoman Giffords after her gunshot wound to the head in an attempted assassination, decided to use this opportunity sue the US Department of Health and Human Services over Medicare reimbursements. Also, Congresswoman Giffords worked hard to keep the trauma center open amidst budget constraints; the one which saved her life. In my area, Our Lady of Mercy Hospital in the Bronx faced bankruptcy and was on the brink of shutdown. Fortunately, weeks before the birth of my little sister, the hospital was rescued by Montefiore, a huge conglomerate of failed medical centers in the North Bronx. Hospital mergers have formed a strong pact to pressure government to pay its fair share of promised reimbursements. Benefiting from economies of scale, these large hospital conglomerates are closely tied with politics, funneling campaign cash, and doing whatever is necessary to cover costs. The US health care industry is in a desperate situation.

The cost of serving the poor is an issue. Media tends to be biased in exposing the faults in Medicare (government health care for the elderly) opposed to Medicaid (government health care for the poor). My mother worked as a medical biller throughout the 1990's, and she recalls many situations in which Medicaid patients were not reimbursed. After several attempts, the billing department is then instructed to contact the patient for payments, with the excuse that Medicaid is not able to cover the visit. Patients have the choice to enroll in a payment plan, or pay all up front and deal with the local Medicaid office themselves; thereby transferring the reimbursement burden on the patient rather than the hospital. Also, a lot of government programs have strings attached. For all of the blame that private insurers receive, it's almost laughable that government fails to realize that Medicare and Medicaid operate the same way. They all cover certain services, while refusing to cover others. The only difference with government plans is that the insurance pool receives a large percentage of its funding from the government via taxpayers. Increasing demand through government funding does nothing to bend the cost curve from the supply side.

Hospitals need to improve their responsibility based cost measurement systems. Overhead is the continued expense to operate the hospital, and the costs are either direct (equipment) or indirect (administrative and miscellaneous). The hospitals budget these expenses based on the past and future expectations of demand. The goal going forward should increase under applied overhead - spending less than budgeted in order to cover funding gaps such as missed reimbursements. Next, hospitals must do a better job at tracing indirect costs and match it up with specific procedures. Capacity is strained with increasing patient demands; more occupied space comes with additional costs such as paperwork, additional staff responsibilities, food, etc. Operating leverage will be the make or break portion in this game-plan. Fixed costs that go directly into any service is usually uncontrollable; the procedure equipment, softwares, building services etc are there to stay. The variable costs are controllable - often indirect that naturally come about with an increase in patient demand. Operating leverage is made up of the ratio of fixed costs to total costs -- if this number is high, it means that the hospital is at high risk. We're trying to avoid shutdown when costs are greater than revenue. The problem is that indirect costs are often brought about when the hospital places extra effort in recovering reimbursements, which in turn don't cover variable costs, cancelling out the overall funding of the increasing demand from patients who think they are being covered. This is the danger in the health care system.

Solutions to this problem are open for discussion. Leave a comment.