Today's Opinion Picks October 22, 2009

Comment:

Five picks as follows:

1) This article by Ed Harrison, for Seeking Alpha, discusses the deflationary fighting strategies of Japan vs. Bernanke's approach of buying poor quality assets, and Plosser's voice of disapproval.

2) Charles Hugh Smith, for Seeking Alpha, discusses the new pop up real estate and its contribution to the commercial real estate prospects, which are looking dismal.

3) Yves Smith, of Naked Capitalism, builds upon her points from yesterday of "too big to resolve". This subject scares me. Its like saying there are no solutions to this mess. Other than perhaps a very slow controlled reversal and unwinding. But where is the will for that? There is none.

4) This is a paragraph from Fortune's blog about California being too big not to fail.

5) Mohamed El-Erian, for FT, takes on de-risking the banks.


--Kalpa


Qualitative vs. Quantitative Easing: The $1.25 Trillion Question
by Edward Harrison

In January, Ben Bernanke gave a very important speech at the London School of Economics where he laid out the Federal Reserve’s strategy in fighting the forces of deflation and market illiquidity (see post with videos here). His was a strategy that took the Japanese variant of quantitative easing one further – toward what I call qualitative easing.

Earlier this decade the Japanese faced deflation in the wake of the recession after the Tech Bubble. Interest rates were already zero percent (they conducted a never before tried Zero Interest Rate Policy – ZIRP, but this proved inadequate in the face of massive deleveraging). With the recession, outright deflation was sure to follow as interest rates could be cut no more. As a result, the Japanese started quantitative easing, a technobabble term for printing money. The goal was to flood the economy with money which created inflation as the mountains of debt in Japan meant deflation could cause a downward spiral.

Fast forward to 2009 and we see Bernanke embarking on the same path. The twist however is that he has focused on the asset side of things. So while the Fed balance sheet has ballooned in both assets and liabilities, the mix of assets has changed considerably from almost all Treasuries to a bunch of Treasuries and a lot of assets of more dubious quality as well. (This chart, courtesy of Zero Hedge, shows the change). Clearly, this should leave you with a sense of unease as it is the collapse in value of these same assets which was largely responsible for the global panic last year.

One Fed President, Philadelphia’s Charles Plosser, is fed up with this and wants change.

Bloomberg reports:

Federal Reserve Bank of Philadelphia President Charles Plosser said the central bank should limit the securities on its balance sheet to Treasuries and create a policy for serving as lender of last resort.

The Fed’s emergency-credit programs and inconsistency in bailout decisions created confusion and showed the central bank “lacked a well-communicated, systematic approach,” Plosser said yesterday in a panel discussion at Palo Alto, California. Policy rules “would yield better economic outcomes for both monetary policy and financial stability policy,” he said.

Plosser’s comments rank him among the strong internal critics of the Fed’s efforts to stem the worst financial crisis in seven decades. The Fed “strayed into credit allocation” that should be the purview of fiscal authorities, not the central bank, he said at Stanford University.

“Developing such a systematic approach is not easy,” Plosser said at a forum hosted by the Stanford Institute for Economic Policy Research.

“Making a credible commitment to stick to such a lending policy in good times and bad is even more difficult,” he said. “Nevertheless, that is what we must tackle if we are going to achieve better results the next time a crisis arises.”

In effect, Charles Plosser is saying that the Federal Reserve become the handmaiden of the executive branch, conducting fiscal policy on its behalf. This is a clear no-no and the major reason the federal reserve has received so much scrutiny.

In my July post “Is quantitative easing really inflationary,” I said the following:

Because the Federal Reserve has been acting in concert with the executive branch since the credit crisis began, many are beginning to question its quasi-fiscal role in supporting the wider financial system with bailouts, subsidized borrowing, guarantees and liquidity. Add in the QE and a ballooning Fed balance sheet as the central government deficit spends and you have an organization that seems to be acting on behalf of the executive branch.

I gather Plosser agrees with this assessment given his recent remarks. If the Fed wants to remain independent, or at a minimum resist the legislative branch’s desire for greater oversight, it needs to get rid of these toxic assets and stay out of fiscal policy for good. How the Fed disposes of these junk assets is the $1.25 trillion question.

Commercial Real Estate: The Gathering Storm
by Charles Hugh Smith

Correspondent Thomas H.submitted this fascinating story: 'Pop-up' stores are becoming an overnight sensation. (Los Angeles Times) The basic idea is that retailers are not signing 5-year leases anymore--they're signing 20-day leases for 'pop-up' stores which have the lifespan of an insect and low costs for retailers seeking to unload discounted inventory in a hurry.

The model has been well-established with "holiday theme stores"--retail operations which sell goods aimed at a specific holiday such as Halloween for a few weeks prior to the holiday. (Never mind that the Halloween frippery is massively overpriced--doesn't anyone make their own costumes any more?)

The real surprise is major retailers such as The Gap (GPS) and Toys R Us are using the "pop-up" model:

These quickie retail operations -- known as pop-ups -- are showing up throughout Southern California and around the nation, filling in the gaps at recession-battered shopping centers for a fraction of the regular rents.

Once limited to seasonal shops and dusty liquidation centers, pop-up stores are now being opened by some of the nation's biggest retailers.

It's a trend that could reshape the nation's retail landscape if it continues, diminishing the power of commercial landlords and making it easier for merchants to test new locations and products with little commitment.

Gap Inc. recently opened a pop-up shop on trendy Robertson Boulevard to promote its new premium denim line; celebrities including Halle Berry and Ashlee Simpson-Wentz turned out to the shop's launch party. Toys R Us Inc. is setting up about 80 temporary toy shops nationwide, including several at upscale malls previously unavailable to the chain. J.C. Penney Co. touted its back-to-school offerings through interactive pop-up displays in half a dozen Southern California malls.

The end of the recession, he predicted, would not necessarily bring an end to the model.

Uh, what "end of the recession"? Just in case retailers didn't get the message: Mad as hell, consumers dump credit cards; Balances tumble as fury toward issuers swells.

Credit-card debt dropped the most, falling 13.1%, or $9.91 billion, to $899.41 billion. It was the 11th uninterrupted month of declines, the longest on record. See full story.

With unemployment at a 26-year high of 9.8%, many consumers have no choice but to tighten their belts. But more and more, consumers are closing their own accounts and choosing not to use credit cards because they're just plain angry.

"There's an enormous amount of backlash against the banks," said Dennis Moroney, research director at Tower Group. "It's like in the movie 'Network,' people are saying, 'I'm mad as hell and I'm not going to take it anymore.'"

Credit-card holders are so irritated that 32% of them told Consumer Reports in a recent survey that they have paid off or closed a card in the last 18 months. Half of those who canceled did so because they were peeved by recent actions credit-card issuers took, such as cutting limits, hiking interest rates, jacking up fees or imposing new charges.

At the risk of being tiresome, let's go over the foundation of the U.S. economy once more:

1. Consumer spending is 70% of GDP.
2. Expanding credit and borrowing are the lifeblood of consumer spending.
3. Consumer collateral (housing, income, stock portfolios, etc.) has been gutted, greatly diminishing the foundation of future borrowing.
4. Banks are functionally insolvent and are not lending as they did during the bubble boom.
5. Millions of Baby Boomers have realized that their current assets and savings enable a retirement in:

A. a sturdy cardboard box

B. a camper/20-year old RV on "The Slabs" (or equivalent)

C. Aunt Matilda's house if Auntie has the good grace to croak off fairly soon.

Thus this is no "dip in consumer spending"--it is a generational sea change with no end in sight.

Not only are consumers increasingly unable to borrow or unwilling to do so, but much of the overbuilt retail sector sells items which are superfluous (and that's the polite description).

It's not just retail that is doomed, of course; the hotel/hospitality sector is massively overbuilt and overleveraged. Everyone, it seemed, was chasing the "luxury" and business traveler. Now that the cold wind of reality is rising, owners are discovering that the hotel they bought for $250 million with a $230 million mortgage is worth about half that amount--at best: Hawaii Hotels Face Fewer Visitors, More Debt.

As for commercial office space--ponder this data point. It was recently announced that Internet darling Twitter leased more space in San Francisco as it was expanding its 30-person staff to maybe as high as--gasp!--100.

Let's follow that to its conclusion: the "hot headline" tech companies have vanishingly few employees, and a significant majority of them can work partly from home or from some other remote location. They don't need a cubicle or a conference room or an office at all.

Even mighty Google (GOOG) employs about 16,000 people globally--perhaps a tenth of a major industrial company like GE and not much more than the student populace of a moderate-sized state university.

And many of these people can work remotely as well. The truth is you don't need huge office towers for the new economy.

As for smaller space--please see End of Work, End of Affluence III: The Rise of Informal Businesses (December 10, 2008) and Trends for 2009: The Rise of Informal Work (December 30, 2008). Thousands of small businesses can be operated out of home offices and garages, and the work done at clients/customers' homes.

The Problem is Not TBTF, but TDTR
by Yves Smith

....I expressed concerns about dealing with the difficulties of Too Big Too Fail institutions yesterday, saying (in effect) that many of the appealing-sounding ideas (including some I had favored, like putting credit default swaps on an exchange) were not workable or would not solve the problem (for instance, as Satyajit Das explained at some length, the amount of initial margin it would take to deal with “jump to default” risk would make credit default swaps uneconomic. No one is willing to kill CDS, which would be the effect of such measures. An undercapitalized exchange creates a concentrated point of failure, an AIG waiting to happen. And even though we would love to shut that casino down overnight, having looked into it is some depth, the cure would probably be at least as bad, if not worse than the disease. The best of the bad choices on offer is to regulate them like insurance, ideally more intrusively, and take affirmative measures to contain the market, particularly restricting the writing of “naked” short exposures).

From Johnson:

It would not be too strong to say that the architecture of derivatives regulation and market structure is the heart of Too Big to Fail policy.

Absent a drastic simplification of derivative exposures and a transparent and comprehensive improvement in the monitoring of those positions when imbedded in large firms, complex derivatives render these behemoth institutions Too Difficult to Resolve (TDTR). I say that because, the policies of resolving troubled financial institutions, so- called enhanced resolution powers, cannot be invoked unless government authorities have the capacity to assess and understand the entanglements of derivatives exposures throughout the financial sector and the economy at large. Resolution powers themselves can be quite useful and should be passed into law as a part of the financial reform you are considering. The ability to undertake “prompt corrective action” vis a vis bank holding companies and financial services holding companies, as the FDIC can now do vis a vis failing banks, would diminish the probabilities of a cascading bankruptcy or other disruptive panic.

Yet opaque, complex entangled derivatives exposures would serve to deter the authorities from invoking those powers and taking over a failing institution for fear of setting off a system wide calamity of magnitudes that policy officials can dread but not understand or estimate. Complex entanglements through derivatives exposures discourage government officials who are the risk managers on behalf of the citizens of our nation from invoking and using those powers. The spider web of complex opaque derivatives renders enhanced resolution powers impotent.

It is in this respect that complex and opaque derivatives exposures at large financial institutions contributed mightily to a policy of induced forbearance, as we witnessed in the first quarter of 2009. That experience, as we have seen, was very demoralizing to our citizens who have put their faith in philosophies that emphasize the use of markets as a mechanism for achieving social goals. The inhibitions that authorities experience in applying market discipline to large financial institutions and their managements tend to undermine belief in the use of markets.

What makes induced forbearance of TDTR institutions even more troubling is that their potential creditors would understand that they will not have their debts restructured when government officials are deterred by complex derivative exposures from taking a TDTR institution into receivership and restructuring the entity. This would create the perverse impact of reducing the risk premium on the unsecured debt of these institutions, lowering their funding costs, and giving them incentive to take more risk. It would also create a competitive advantage for TDTR firms that encourages an increase in their market share relative to those firms who had to pay more for funding because their creditors would fear that their bonds could be restructured in the event of solvency problems. TDTR financial institutions are enabled to get larger and larger by wrapping themselves in a spider web of complex derivatives and thereby inducing authorities to make ever-larger scale gambles on forbearance. Forbearance is a two-sided coin. Firms can continue to lose money rather than return to health. This is not a tolerable state of affairs for taxpayers who are held hostage by the fear of resolving complex intertwined institutions.

California: Too Big Not to Fail?

...Name almost any serious malady and the state of California has it: the nation’s highest marginal tax rate coupled with an abysmal public education system; the most home foreclosures; a free-falling commercial real estate sector; lame-duck governor with no legislative support and a disdain for an annual budget process that he refers to as kabuki theater; unemployment somewhere between the official number of 12% and the whisper number of 18%; a 20% drop in year-over-year revenue; municipalities that have either declared bankruptcy (Vallejo) or are on the verge (Los Angeles); and a black-box permitting process that scares away business investment even while every week, 3,000 more taxpayers migrate to greener pastures.....

The two-stage de-risking of banks
By Mohamed El-Erian

.....The massive policy reaction succeeded in stabilising the banking system. And while the banks are still not lending in any meaningful manner to the real economy – an issue that will become politically even more problematic as unemployment continues to rise in the industrial countries (particularly, in the US and UK) – most have used the extraordinary policy support to strengthen their balance sheets and, also, take on risk.

The question is whether this is the end of the story. It is not.

There is another stage of de-risking in banks’ future. This second stage will be driven by the regulatory authorities, rather than the markets. Ironically, the success of some banks in restoring huge profitability will make this phase come earlier and be more consequential for banks.

What will this de-risking look like? Widespread consensus is forming around five issues.

First, banks must be subject to higher capital requirements, with capital being defined more robustly.

Second, they should be induced to think of capital counter-cyclically, increasing it in good times so that they have a meaningful cushion for the bad times.

Third, the prudential regulation of banks should be supplemented by better consumer protection.

Fourth, ”large” institutions should be subject to an additional layer of prudential regulations given their potential to contaminate the economy as a whole.

Fifth, better resolution mechanisms are needed for those firms that stumble badly.

There is a sixth issue, which is much more controversial. Should regulatory authorities reverse the multi-year trend towards combining commercial and investment banking activities in single institutions? At the heart of this issue is whether to restrict the ability of banks to use government-guaranteed deposits to fund investment banking activities.

Mervyn King, the governor of the Bank of England, is pushing for such a reversal. In doing so, he is reacting to the view that, to use his colourful language adapted from Churchill, ”Never in the field of financial endeavour has so much money been owed by so few to so many. And, one might add, so far with little real reform.”......

Regardless of what happens on this sixth issue, it is clear that the banking system will soon be taking an important step towards the ”utility” end of the institutional spectrum – a likelihood that is yet to be internalised, both in market valuations and in consensus expectations regarding the medium-term prospectus for growth in the US and UK, in particular.....

Similarly, consensus growth projections for the US, which have been heading steadily towards 4 per cent for 2010, underestimate the extent to which the economy’s credit factories are undergoing a long-lasting contraction.....

All this speaks to a critical issue that should remain front and centre on the radar screens of both policymakers and markets. The panic engendered by the crisis may be behind us, but its longer-term consequences are yet to play out fully. These – be they economic, political or institutional – will become apparent in the period ahead....

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