State of the Union
Obama’s State of the Union Address Wednesday night:
Fed exposed
The risk faced by the Fed. Investment banks are being deleveraged; but the Fed got leveraged up:
The Federal Reserve's blowout 2009 profit is no reason to cheer. Rather, it is a reminder of the dangers inherent in the extraordinary policies the central bank has pursued during the credit crunch.
![[FEDHERD]](https://sg.wsj.net/public/resources/images/MI-BA800A_FEDHE_NS_20100112170742.gif)
Last year, the Fed earned $52.1 billion, with most of that income coming from interest-payments on bonds that it bought during the year to shore up the economy and credit markets.
Anyone with access to printing presses could have racked up similar gains. But the Fed's purchases leave it exposed. Its assets are 43 times its capital, compared with 15 times at Goldman Sachs. As a result, its equity could be wiped out by just a 2.8% drop in the value of its Treasurys and securities issued by Fannie Mae and Freddie Mac. True, the Fed could hold on to those securities and ride out any losses, and retain earnings to boost capital, but what self-respecting central bank wants to risk a negative net worth?
Even the fact that the Fed is, as usual, paying most of its profit to the Treasury isn't good news. It means the Treasury is paying almost no interest on a large slug of debt purchased by the Fed. That can only chip away further at fiscal discipline.
Early signs of ‘double dip"
Housing prices turned down again. Be beware of double-dip.
(click to enlarge)
What drives Euro?
Euro outlook from WSJ:
Be careful what you wish for. Six weeks ago, Jean-Claude Juncker, who chairs the group of euro-zone finance ministers known as the Eurogroup, complained that the euro was overvalued. Since then it has fallen 6.6% against the dollar. But Mr. Juncker can't be too happy. Persistent fears about Greece's fiscal situation have turned trade in the euro into a vote on the currency bloc's credibility.
The euro now trades just below $1.41, versus a peak on Nov. 25 last year of $1.51. Even that decline hasn't done much to erase the currency's strength, accumulated over much of the previous decade: in mid-December, at $1.45, the European Commission warned that the euro was overvalued on a real effective basis by 7% to 8%.
![[EUROHEARD]](https://sg.wsj.net/public/resources/images/MI-BA955_EUROHE_NS_20100121211306.gif)
A range of factors are weighing on the euro. Some seem likely to be transitory: Fears about China's moves to rein in credit growth seem more aimed at trying to head off domestic inflation before it gets out of control, and thus should be good for global risk appetite in the long run. But others are more deeply entrenched. The European Central Bank has warned that the recovery in Europe will be gradual, and many expect the bank to increase rates later than the U.S. Federal Reserve or the Bank of England.
The key driver, however, has been the strains within the euro zone that Greece's struggle to rein in its public finances has brought into the spotlight. The euro's fall has come in lockstep with a rise in the cost of insuring Western European sovereign debt against default, as measured by the Markit iTraxx SovX index, which hit a record high of 0.84 percentage point points Wednesday, up from 0.57 at the start of December. Higher yields and a weaker currency might help to lure foreign buyers of bonds, something Greece is desperate to do. But higher yields are being interpreted as a sign of distress, rather than an opportunity. Hawkish ECB rhetoric warning that there will be no fudge on euro-zone rules to aid Greece are intensifying the pressure, even if his should be good for the euro's credibility in the longer term.
Further pressure seems likely as a result—at least in the short-term. Barclays technical analysts warn that a break below $1.4050 could lead to a dip as far as $1.3730; Citigroup said in January the euro could drop as far as $1.35. One worry now is contagion: If investors become concerned about other euro-zone countries such as Portugal, Spain or Ireland, more may decide to dump the single currency.
Existing home sales
Talking about double dip…imagine what it will look like when government’s support is taken away.
Sales/inventory ratio shows we probably still have long way to go (esp. when you compare the current ratio with the average in the past decade):
(graph courtesy of Northern Trust)
Budget gap by state
(click to enlarge; source: CBO)
Smart regulations
More regulation is not the solution; what we need is smart regulation. By this metric, Obama’s proposal fell far short of it. The following piece is by far the most intelligent analysis I have seen.
From WSJ:
President Obama has acquired the sudden appetite for a fight to rein in Big Finance. But he needs something else even more: a coolheaded understanding of where the riskiness really lies in the banking sector.
In an impassioned speech Thursday, the president said he wants financial-overhaul legislation to include measures to stop banks engaging in proprietary trading and investing in hedge funds and private-equity ventures.
On the surface, that makes sense. After the financial trauma of recent years, something decisive had to be done to prevent banks putting the system at risk again through these kinds of activities. Bear Stearns’s hedge funds helped spark the credit crisis. Banks have taken massive hits from real-estate investments made by their principal investment arms, including Goldman Sachs Group, whose losses in this area have totaled nearly $4 billion since the start of 2008. And who can forget the soured mortgage bet that helped trigger Morgan Stanley’s $7 billion trading loss in the fourth quarter of 2007?
But two big questions hang over the president’s push. First, will these moves address other activities that carry as much potential danger? Second, which firms will be affected?
On the first, the real headache lies in deciding how broadly to define proprietary trading. For instance, trading includes the process of amassing and managing inventories of securities and derivatives. Banks say most of that is to serve clients, but they also trade around those positions on their own balance sheets, creating a gray area. A further problem: Banks can take huge losses from asset inventories built up for other reasons. That happened to Merrill Lynch and Citigroup, with subprime mortgages being packaged into structured securities and leveraged loans they intended to sell on. Somewhere in the overhaul there also have to be regulations to protect balance sheets from potential risk-asset buildups that aren’t straight proprietary trading positions.
And with big securities operations, the liability side of the balance sheet can’t be ignored. Losses on assets can make a bank’s creditors skittish, leading to a run. That is why Mr. Obama needs to back stringent changes to make market funding safer. Last week’s bank-liability tax was one avenue, but he also needs to stop the foolhardy taxpayer-backstop for banks’ market funding included in both the House and Senate bills.
On the second question, President Obama seemed to focus his speech on deposit-taking institutions with large securities businesses. Among one of the many areas left very unclear was what would happen to the likes of Goldman Sachs and Morgan Stanley, which could easily unload their small deposit-taking banks. Another big uncertainty is how rules would apply to securities subsidiaries of foreign firms, to avoid giving them an unfair advantage.
There is clearly a reasonable chance the seemingly-rushed-out plans get watered down or held up in Washington. But investors still need to think about who would get hit hardest if they occur. The big deposit-taking banks with large securities arms—Bank of America, J.P. Morgan Chase and Citi—could become far more heavily weighted toward traditional commercial banking. Net income at BofA’s global-markets unit was $7.2 billion, versus $6.3 billion for the whole bank. J.P. Morgan’s investment bank accounted for nearly 60% of overall earnings in 2009.
Meanwhile, it is unlikely that Goldman Sachs or Morgan Stanley call pull off a Houdini-like escape by unloading their deposits. If they do, regulators may choose to push similar restrictions through capital rules and other means instead.
Goldman acknowledges that about 10% of total revenue comes from pure proprietary trading.
As President Obama braces for a fight with the Big Finance, the banks have plenty of reason to take him on.