Second Quarter GDP Contracts 1.0%

GDP contracted by a 1.0% annual rate in April through June 2009. Economists were expecting a 1.5% decline, so this number is better than expected. It follows on the heels of a 6.4% decline in the first quarter and 5.4% in the fourth quarter of last year, indicating that economic conditions are indeed improving. Or, getting worse at a slower pace, for you curmudgeons out there.

Some highlights and lowlights:

• Consumer spending, which is the largest component of GDP (roughly 70% is what they teach you in Macro class) slid by 1.2%, after increasing 0.6% in the first quarter and dropping 3.1% in the fourth quarter. Clearly the rising unemployment rate is hurting consumers causing many to cut back on spending and increase savings (if they can.) I believe that a higher savings rate is healthy for our economy in the long run, not to mention far less stressful for those who are discovering how difficult it is to be up to their eyeballs in debt while facing a very tough job market.
• Trade boosted GDP by 1.38% as exports fell by 7.0% and imports decreased by 15.1%. The shrinking of the trade deficit is also a positive long-term sign of a new, more prudent US, but our trading partners are not too happy about it. Our rabid consumption of overseas goods has allowed our trading partners to grow far more than their domestic consumption would've allowed. The reversal of this trend if proving very painful for them.
• Residential fixed investment, which includes spending on housing plunged by 29.3% on the heels of a whopping 38.2% decline in the first quarter. Housing is still a rather large drag on the economy.
• Government spending rose 10.9%, after declining 4.3% in the first quarter.
• The PCE price gauge, excluding food and energy rose 2.0% after rising 1.1% in the first quarter. You don't need to take an economics class to know that contraction plus inflation is not good.

Senate Investigates Mortgage Fraud at Banks

A Senate panel has subpoenaed several financial institutions, including Goldman Sachs and Deutsche Bank, seeking evidence of fraud in last year's mortgage market meltdown. According to the WSJ, the congressional investigation is focusing on whether internal communications, such as email, show bankers had private doubts about whether MBS they were structuring were as financially sound as advertised to their clients. Unfortunately, the Senate probe is about four years too late to make a difference to the economy, but at least somebody is going to get in trouble, and maybe we'll have some interesting hearings to watch on TV.

Make no mistake, some juicy emails will be uncovered. If there's anything that Wall Streeters do well, it's revel in the idiocy of the investors that purchase their latest financial concoctions. Anyone remember the Enron tapes? Or the musings of a young Henry Blodget who publicly rated internet companies a buy, while privately marveling at their crappy business models? How about Jack Grubman, the "highly respected" telecom analyst who relentlessly told investors to buy Worldcom (in addition to around 10 other stocks that eventually went bankrupt) so he could get his kids into a good private school? As a more recent example, we have the former Bear Stearns internal hedge fund managers, Matthew Tannin and Ralph Cioffi, who await their criminal trial for expressing concerns about their funds' performance a couple of months before the funds imploded.

Something good is bound to turn up. Maybe something like this?

Email exchange between CDO structurer and his boss in late 2006:

CDO guy: Um. Have you looked at the latest batch of mortgages we received? I can't put this in something we plan to have AAA-rated.

Boss: What's the problem? You do this every day.

CDO guy: Every single one of these mortgages is going to default in like four minutes. They've probably already defaulted, we just haven't received word from the servicer yet.

Boss: Look buddy. If you're having moral issues, you better let me know now so I can give you the boot and replace you with some other guy that wants to get paid $2 million this year.

CDO guy: It's just that my grandmother's mortgage is in this pool.

Boss: Yeah so?

CDO guy: Countrywide gave her a $1.4 million cash-out refi with a 1% teaser that resets in 6 months at Libor plus 15%.

Boss: And the problem?

CDO guy: She lives in Florida and collects social security as her only income. Every one of her neighbors on the street is in this mortgage pool. They are a bunch of 80 year olds living in modest houses that sold for $150K two years ago!

Boss: Fine, I'll throw in an extra $500 grand into your bonus. If you wanted a raise, why didn't you just ask?

Has Housing Turned the Corner?

Much has been made of the recent upturn in housing data. All three of the major housing indicators actually rose in June; housing starts were up 3.6%, existing-home sales also up 3.6%, and new-home sales blew the doors off expectations with an 11% rise. Yesterday's Case-Shiller index rose 0.5% for the three month period ended in May, although the seasonally adjusted May number was actually down. However, even Mr. Shiller who had predicted more declines in home prices was surprised at the positive results.

I am including the charts from the WSJ that show housing starts (see end of post), existing-home sales, and new-home sales data going all the way back to 2000 for some historical perspective. What is initially most shocking about the charts is just how far we've fallen and how puny the recent rebounds appear in the context of the past nine years. In particular, new homes, even with the strong rebound in June, are only selling at a very depressed 384,000 annual unit pace. This compares to a pre-bubble rate of roughly 800,000 units in the early 2000's. Existing home-sales have declined much less than new home sales, due to the fact that foreclosures have traded briskly throughout the housing crisis. One positive note is that the number of foreclosure sales as a percentage of existing-home sales in the March-through-May period fell to 33% from 50% earlier in the year. Are we really running out of foreclosed properties? Possibly, but some analysts attribute the decline to foreclosure moratoriums enacted late last year, most of which have recently expired. Foreclosure sales should pick up the pace again later in the year.

One sign that I view as legitimately positive is all of the anecdotal evidence I read about average folks buying their first homes in places where prices have dropped significantly to levels where it makes financial sense to purchase a home versus renting. This is happening in certain parts of the country such as Southern California, but it has yet to happen in certain high priced areas, such as NYC or higher priced parts of the Bay Area. Certainly the ridiculous amount of overbuilding in Las Vegas (where yet another casino, Station, bit the dust and filed for bankruptcy today) are still screwed. According to the WSJ, banks took title to 13,200 properties in June, which is more than the total number of homes listed for sale in Las Vegas that month. Las Vegas has a major inventory problem that won't be resolved for years.

The recent positive housing news is a sign of some stabilization, but not an indication of a return to business as usual. Unemployment induced defaults are bound to continue rising as the unemployment rate hits double digits. Loan modifications have notoriously high re-default rates, and we shall see more foreclosures later in the year as the recent spate of modifications fail to work for a large number of borrowers. Furthermore, the new reality of financing for jumbo mortgages, which requires down-payments of 20-30%, is not going to change anytime soon. Providing cheap financing for buyers of high-priced properties in high-priced areas is not a political priority for this administration. The FHA or Fannie Mae isn't going to start offering 3.5% down loans for those in the market for a $1 million house. Consequently, the pool of potential buyers for higher priced properties has shrunk significantly. While this doesn't affect much of middle America, it is a major issue for places like New York, San Francisco, and their higher priced suburbs. Exotic financing was the norm for several years which helped push prices to unsustainable levels and allowed everyone to trade up. You can't trade up if you don't have equity, and if you've been living the high life and not squirreling away your cash, you can't cough up the 20% required down-payment for a jumbo mortgage.

Believe it or not, K10 is house hunting. Not because I believe the "bottom is in," but because the family is expanding and it is the right time personally. I live in the Bay Area and have been observing the local markets here like a hawk for over a year, with multiple spreadsheets that compare price-per-square-foot, inventory levels, and other relevant statistics in several neighborhoods in order to find the best deals. I can say with a reasonable amount of certainty that the high-end (i.e. jumbo mortgage land) is due for more of a correction than what we have seen so far. Inventory levels are high, and properties are sitting on the market for very long periods of time. Prices get slashed with still no takers. I am constantly amazed at how many of the homes I look at have been purchased within the past couple of years, and I wonder why they want to sell so soon. There is always a "good" story, but I suspect that in many cases it is simply the fact that the seller is overextended. More on my search later. For now, here is the WSJ chart I mentioned above.

CFTC Points Finger, Traders Balk

The Chairman of the Commodity Futures Trading Commission (CFTC) is talking tough about instituting trading curbs on energy contracts. Gary Gensler, the new CFTC chairman as of May, is pulling an abrupt about-face from the previous administration's stance, which was very hands-off and pro-trader. Mr. Gensler believes that speculation by index investors contributed to massive volatility in the price of oil last year. The CFTC plans to issue a report next month suggesting that speculators played a significant role in driving wild price swings in the price of oil, which is a reversal of the findings of the CFTC last year, which claimed that it was purely supply and demand driving the prices swings. The UK's regulator, the FSA, has also cleared speculators of any responsibility for excessive oil price volatility. Who's right? The truth is probably somewhere in between. What began as a spike in oil prices based on fundamentals, turned into a pile-on of endowments, pensions and other investors looking to get in on the action as a hedge against inflation, or just a bet on something that was going higher. When $300 billion enters a market via new index products, as it did over the course of a few years, it is bound to drive up the price. Whether these folks should be allowed to play in the market is entirely a matter of interpretation. The previous administration believed that everyone was allowed to the party, while the current administration wants to break the party up. The fact that the price of oil is such a major determinant in economic growth is not something that this administration is taking lightly. While the prior administration's laissez-faire attitude may be reflected on wistfully by energy traders, at least the CFTC's tough stance doesn't involve invading any countries. Like I said, it's all a matter of interpretation.

The CFTC is planning to propose new curbs on trading positions in order to limit speculators' ability to drive commodity prices. Currently the CFTC only sets hard limits on speculative trading in certain agricultural markets, leaving the exchanges to set limits on other products. Exchanges only impose hard limits on energy products in the last three days of trading before a contract's expiration. The rest of the time, they impose accountability levels, which trigger additional oversight if exceeded. Mr. Gensler revealed today that in the past 12 months , a total of 70 different parties exceeded those accountability levels in the four major energy contracts. The CEO of the CME, Craig Donohue has apparently agreed to set hard limits on energy contracts, but he doesn't sound happy about it. Mr. Donohue argued that speculators have been wrongly targeted in the debate over energy prices and he believes that any effort to control prices or market volatility by position limits is a "failed strategy."

For some small foreshadowing of what could happen in the oil markets, we go to the New York Mercantile Exchange to check in with the natural gas market. Traders are grumbling about the new limits exchanges have imposed on natural gas trading. In the face of pending restrictions , natural gas prices have swung wildly and trading volume has declined markedly. In June, the New York Mercantile Exchange sent a notice that it would start imposing hard position limits on seven cash-settled natural-gas contracts, limits on the positions traders can hold in the three days before the contracts expire. This is supposed to limit volatility and seems to be working about as well as the price caps imposed on oil in the 70's. Natural gas prices jumped 11% in early June, followed by a 23% dive until July 13 and then rebounded 10% in recent days. Price volatility of three-month contracts shot up in June to the highest levels since the Gulf War, the First Gulf War, when the natural gas contract first started trading. So, you know, so far the restrictions are working really well in terms of curbing volatility.

Lending Slows For Banks, Borrowing Picks Up For Governments

The total amount of loans held by 15 large US banks shrank by 2.8% in the second quarter, according to the WSJ. More than half of the loan volume in April and May came from refinancing mortgages and renewing credit to businesses, not new loans. Government-controlled Fannie and Freddie are propping up the mortgage sector. Without their support, the decline in lending would be far more severe. This news does not bode well for those hoping for a big bounce in the economy in the second half of the year. It points to a weak recovery that is still very heavily subsidized by the government. Furthermore, it reinforces the view that the old trick of offering cheap financing to an economy that was far too leveraged isn't going to work. What good is it to offer businesses or consumers 0% financing when they are already up to their eyeballs in debt?

Nonetheless, the government itself is working very hard to make up for the lack of activity in the private sector. The Treasury plans to flood the market with $200 billion in new debt this week, the busiest weekly schedule since 1985. The auctions include $109 billion in two-year, five-year, and seven-year notes, $90 billion in bills and $6 billion in TIPS. Foreign central banks are expected to be big buyers in order to keep rates nice and low, so the US can continue to borrow and borrow and borrow without any thought as to how we're ever going to pay them back.

Speaking of government borrowing with no regard for repayment, emerging nations are also rushing to issue debt. So if you are unhappy with the super low risk-free rates offered by the US, you can always hop the pond and pick up something with a slightly higher yield. The surge in issuance this year by emerging markets, to its highest point since records began in 1962, "is an encouraging sign for the world economy as activity in emerging market bonds had seized up until a few months ago" says the FT article. Alternatively, it can also be viewed as a bunch of countries with major financial problems realizing they have a small window of opportunity to borrow money while investors are still insane enough to buy emerging market debt, so they'd best take advantage of it. Bond volumes in emerging markets have risen to $352 billion this year, up 45% on the same period in 2007 before the financial crisis. Hungary, which had to receive support from the IMF earlier was able to launch its first bond offering since June 2008. Again, solving a debt crisis with more debt = recipe for disaster. But according to the emerging market strategist at BNP Paribas "From an investor's point of view, it does make sense to buy emerging market bonds because there is a safety net. Since the G20 committed extra money to the IMF in April, it has become clear that governments will not let an emerging market country default." So the notion of "too big to fail" has gone global and investors can now assume that every investment is guaranteed. The problem of risk has been eliminated. You know, just like in 2007, when everyone still believed that risks had been effectively mitigated through derivatives. I'm sure it'll all work out just as well this time too.

Pay Czar Gets Tough Assignment: What to Do About $100 Million?

Kenneth Feinberg, the man with the enviable position of Pay Czar, has his work cut out for him. He is tasked with reviewing and approving the executive compensation packages that were crafted before, and in some cases during, the great banking sector blow-out of 2008. According to the WSJ, Mr. Feinberg is not allowed to rip up previously agreed-to legal agreements. He can reduce salaries to compensate for overly generous bonuses and reduce future earnings. Reducing future earnings will, of course, lead to "top producers" leaving their posts. If your contract says you are owed $10 million and you get paid $10 million today, but are told you'll get a big fat donut next year, why bother coming in to work tomorrow? I wonder, can the Pay Czar cut the salaries enough so that salaries go negative? Isn't that a handy way for the government to defer the cost of supporting these insolvent institutions?

Reports over the weekend about a Citi trader's $100 million pay package are bound to put pressure on Mr. Feinberg to make some "tough" decisions about pay. Believe it or not, Citigroup actually has a group that makes money. You've probably never heard of it because it is a "highly secretive" energy trading group named Phibro run out of a barn in Connecticut by a man named Andrew J. Hall. Apparently, Citigroup only likes to publicize its divisions that are bleeding cash. In any event, Mr. Hall is due $100 million in compensation according to his contract and Citi finds itself in a pickle. It's tough to dole out $100 million to one man when the rest of the firm is still losing money and on $45 billion worth of government life support without inciting the pitchforks again from the masses. Sure the guy made hundreds of millions of dollars for Citi and wasn't responsible for the banks losses, but who cares?

Once upon a time, before government intervention in the private sector, there was a very easy way to deal with busting employment contracts at suffering firms. It was called bankruptcy. Nobody got riled up over Enron employees getting fat paychecks after the firm imploded because the employees were screwed along with Enron's investors. So it seems preposterous that a discussion over whether anyone working at Citi should get $100 million is even taking place. If Mr. Hall was such a savvy trader, he should have negotiated his lucrative deal at a bank that would actually remain solvent. Winding up at Citi was just a poor bet from a man who is supposedly good at taking risk. If the group is really that savvy and capable of generating huge risk free profits, then Citi should just spin it off for billions of dollars and pay the government back. But handing over $100 million to one man seems out of the question. Mr. Feinberg should choose wisely.

Rally Peters Out Over Sobering Earnings Data

We're had quite the rally in the past few weeks. I know this because both the front page of the Wall Street Journal and Financial Times trumpet the Dow's return to 9,000. So it was only fitting that three fairly significant companies had to report weak earnings right after the close and spoil the party. Microsoft posted a jarring 17% revenue decline and 29% drop in profits, citing falling global demand for PCs and servers. Furthermore, this fiscal year (the company just reported its fourth quarter) marked the first time that Microsoft faced a revenue decline for the full year. Better earnings released earlier from Apple, IBM, and Intel had sparked hopes for better results from Microsoft and the rest of the tech sector. While Amazon had a 14% increase in sales, its profit fell 10% to $142 million. Since the online retailer has always believed in "providing customers low prices, vast selection, and fast delivery," (a direct quote from Mr. Bezos) the company's shareholders have the stock priced at an earnings multiple of 60, hence the 8% shellacking in the stock price. AmEx's net profits fell 48% on an increase in charge-offs. The company said that consumer spending declined by 16% in the second quarter and charge-offs increased to 10% from 8.5% in the previous quarter. One bright spot was the fact that only 4.4% of customers were one month behind on their payments, which was an improvement from the prior quarter's 5.1%. Perhaps delinquencies have peaked? Maybe, but if the job market gets worse that seems unlikely.

Nevertheless, stocks are only off modestly compared to the recent powerful rally. Maybe we can finish the day with the Dow still above 9,000 and investors can have a nice, restful weekend? That's assuming that the FDIC takes the weekend off and decides not to seize Guaranty Financial or Corus Bank this Friday. But then again, what's another two bank failures, albeit fairly large and expensive ones, when you're already expecting 500?

More on Morgan Stanley

It appears as if I didn't spend enough time heckling Morgan Stanley's earnings yesterday. The earnings themselves were lackluster and not particularly inspiring so I glossed over them. Furthermore, it was not until later in the day that the real juice was reported by Bloomberg; that the company had set aside 72% of its revenue for employee pay. Morgan Stanley's stock sold off in the morning on the earnings release but then bounced back nicely by the end of the day. I'm curious as to why shareholders are interested in owning a part of a company that is always willing to screw them over to pay its employees excessive compensation. I call it excessive because clearly all that "talent" at Morgan Stanley isn't pulling its weight if the bank is just going to continue to post losses. If the talent was worth the money, then employee comp would be roughly 50% of revenues as it has been historically. Of course, compensation experts argue that Morgan must keep up with the spiraling pay at Goldman. But really? Is Goldman going to hire every single finance executive on the planet? In any event, I suspect that Morgan Stanley is just trying to pay everybody out before the investment bank really starts taking it on the chin on its $17 billion portfolio of commercial real estate. That time bomb is ticking and I'd be trying to get paid before it goes off too.

Ford Making Money Again, Sort Of

The pride of the US auto industry demonstrated why it was the only major US automaker to avoid a government-sponsored bankruptcy. Ford posted net income of $2.3 billion or 69 cents a share for the second quarter. This was a huge improvement over the $8.67 billion it punted last year in the same period. The company still managed to burn through $1 billion in cash for the quarter, which was less than analysts' expectations. Of course, Ford's profit came largely from a $3.4 billion gain it received related to its debt-restructuring in April. Excluding the one-time gain, the company would have narrowed its quarterly loss to $424 million. Revenues were also down from $38.6 billion in last year's period to $27.2 billion. It must be painful sitting around and waiting for the economy to turn while you continue to bleed cash. But Ford is betting that it will survive, without the need for a bankruptcy filing or government aid down the road. If the legendary automaker survives, business school case writers will be scribbling furiously to document the story of Ford's survival of the crash of 2008.

WFC, MS Earnings

Morgan Stanley's earnings were subpar, according to the ticker. Second-quarter income plunged 87% to $149 million from $1.14 billion, while revenue declined 11% to $5.41 billion. Although the results beat the average analyst's estimates, the stock is still trading lower before the open. The weakness in earnings came from a large loss related to the company's credit spreads tightening in the quarter, as well as the cost of paying back the $10 billion in TARP funds it owes Uncle Sam. Fixed income and investment banking revenue jumped 44% and 19% respectively, while institutional-securities swung to a loss on a revenue decline of 24%. In any event, compared to Goldman's blowout quarter, it's hard to be impressed.

Wells Fargo's second-quarter earnings soared 81% to $3.17 billion or 57 cents a share, up from $1.75 billion or 53 cents a share in the prior year. Revenue nearly doubled to $22.5 billion from $11.46 billion, with Wachovia making up 39% of the total. Still, the market is not impressed with the earnings report as the company's stock is trading lower before the open. Credit-loss provisions were $5.09 billion, up 69% from a year ago and 11% from the prior quarter. Meanwhile net charge-offs rose to 2.1% of average loans from 1.54% in the prior quarter, while nonperforming assets grew to 2.2% from 1.5%. With the continued deterioration of the economy, particularly in California, investors are perhaps concerned that the credit loss provisions aren't adequate to cover future losses on Wachovia's legacy option arm and commercial real estate portfolio.

Wealth Gap Widens

Once again the nation's wealth gap has widened, much to the chagrin of those who are suffering from the wrecked economy. According to the Wall Street Journal's analysis of Social Security Administration data which excluded stock options, unexercised stock options, unrestricted stock and other benefits, highly paid employees received nearly $2.1 trillion of the $6.4 trillion in total US pay in 2007, the latest figures available. The pay of employees who receive more than the Social Security wage base (now $106,800) increased by 78% or nearly $1 trillion over the past decade. The top-paid represent 33% of the total, up from 28% in 2002. According to the analysis, the growing portion of pay that exceeds the maximum amount subject to payroll taxes has contributed to the weakening of the Social Security trust fund, which is due to be exhausted in 2037, four years earlier than was predicted in 2008.

I'm not going to go off on some ranting tirade about the growing wealth gap. Obviously poor people just need to work harder to keep up with all those folks who were busy getting $500,000 paychecks structuring CDOs for the banks back in 2007. The data presented here is stale and represents the peak of a bull market where bank employees and company executives were being showered with lavish pay. Since then, the economy has shed roughly 6 million jobs, many high paying ones in finance, and I suspect that the gap has returned back to a more recessionary 2002 level.

A very quick and easy fix for the fact that the pay of employees has exceeded the wage base is to simply raise the wage base. Democrats are already trying to cram through a 5.4% tax on employees making over $1 million to fund their ambitious health care plan, so really what's another 12% on another $50k or so in pay? Although rumor has it that the 5.4% tax is not sitting too well with some of the Democrats' wealthiest constituents. The real solution to resolving the problem of our underfunded Social Security system is the one proposed by former Fed Chairman Alan Greenspan: Simply raise the retirement age. To perhaps a nice round number like 90? That would plug up the Social Security gap in a jiffy.

Investors in Citi's Alternatives Search For Alternatives

If you ignore the issues with subprime mortgages, SIVs, auction-rate securities, leveraged lending and commercial real estate (just to name a few), the rest of Citi's businesses are doing well, right? Right?? Well, not exactly. The WSJ has an article this morning detailing the problems surrounding Citi's alternatives business. One only has to look at assets under management, which have shrunk from $54 billion to $14 billion in the past year to know that something isn't really sitting right with investors. The article doesn't detail how much of the shrinkage was from investor withdrawals and how much was from investment losses but one can assume it was a healthy a combination of the two.

Citi plans to scale back its approach to alternative investments by pulling back from peddling the investments to retail clients and instead focusing on private-banking and institutional customers. As if the rich and institutions are more interested in poorly managed alternative investments with terrible returns than retail clients. Nevertheless, this is Citi's new strategy and I wish them luck. However, it seems like clients are perhaps not going to go for it. I offer exhibit A as evidence: clients of a private-equity fund that amassed $3.4 billion in airport, road, and other infrastructure projects last month voted to bar it from making new investments after its co-head quit and several high-profile deals collapsed. A second, smaller fund geared towards sustainable development failed to attract clients and was shelved. It's not a very high vote of confidence when your clients tell you to stop making investments and no longer wish to invest in your brilliant new fund ideas. The funds were the brainchild of Michael Froman, former operations chief of Citigroup Alternative Investments, who was apparently so bullish on the alternatives group's prospects that he left to go work for the Obama administration in January. Another co-head of the group has also recently left. But, no hard feelings from those who remain at Citi slugging it out. After all, with the government taking a stake in Citi, they too are working for the Obama administration. Citigroup's Vice Chairman praised Mr. Froman for doing "an outstanding job" at Citigroup. Other executives agree that he assembled a strong team of managers and that his funds "were hurt by market forces beyond his control." You know, market forces such as deciding to invest in leveraged illiquid infrastructure projects at the peak of a credit bubble. Because really, you can't control market forces like that.

CIT Saved...For Now

CIT, the lender to small businesses, managed to a squeeze a few nickels out of its own lenders in order to stave off bankruptcy late Sunday night. The beleaguered lender secured $3 billion from its bondholders at a steep price, roughly 10% over LIBOR, and will secure the funds with its highest-quality loans. The new loan will essentially provide the company with a bridge so that CIT can complete a series of debt-for-equity swaps in order to restructure the company's finances. Six of CIT's largest bondholders agreed to the proposal, including PIMCO, Oaktree Capital, Silver Point Capital, Centerbridge Partners, Capital Research and Baupost.

CIT's CEO Jeffrey Peek will remain in his current role but perhaps that is only because bondholders had a mere 48 hours to craft a deal to save the company and didn't get around to discuss attempting to overthrow the CEO. The WSJ had a great article about Mr. Peek recently which described him as a former Wall Street "pro" who came to CIT in 2004 from former posts at Merrill and CS First Boston. He worked hard to change CIT's culture, which at the time was a stodgy risk-averse lender to small businesses. Mr Peek eschewed the company's historical base near a shopping mall in Livingston, N.J. and installed the top brass in a glitzy office building on Fifth Avenue where he brought CIT into the high-society orbit by sponsoring the New York City Opera and other high profile New York non-profits. He threw lavish parties from his office and his home. Mr. Peek expanded CIT's presence in subprime lending, repackaging and selling loans just like the Wall Street banks were doing at the time. He bought a student-loan company and a small mergers and acquisition team. He even led CIT into the glamorous business of "leveraged lending", which has worked out so well for everyone in 2009. CIT's debt rose from $33 billion in 2003 to $55 billion in 2007. Everything was going swimmingly, well, until the credit ponzi scheme collapsed on itself. Now CIT's goose is cooked, and it appears to be the result of a series of very bad decisions made by its CEO. Something tells me Mr. Peek's days may be numbered.

B of A, Citi, GE Earnings

Let's go in alphabetical order, shall we? Bank of America posted income of $3.22 billion or 33 cents a share, down from $3.41 billion , or 72 cents a share. Notice how earnings were down slightly, yet earnings per share were cut in half? That's dilution working for you. It's what happens when you have 64% more shares outstanding due to a capital-raising frenzy. Revenue jumped 61% to $32.77 billion. No indication yet where the increase in revenues is coming from. Actual growth? Merrill Lynch? Countrywide? I presume we'll get a few more details later, but the company did say that results were driven by strong revenues in the wholesale capital markets business and home loans, with most of the activity in mortgages coming from refinance activity. Revenues are up, which I'll take at face value as much better than being down. However, credit-loss provisions more than doubled from a year earlier, while the net charge-off rate surged to 3.64% from 1.67% a year ago and 2.85% in the first quarter. Credit-card managed losses increased to a whopping 11.7% from 5.96% a year ago, and total nonperforming assets rose to 3.31% from 1.13% in the prior year and 2.64% last quarter. Bank of America is pedaling hard against the rising heap of losses in its poorly performing loan portfolio. The question is: Can robust capital markets activity continue to counteract the losses in its loan portfolio until the economy turns?

Moving right along, Citigroup posted a record $4.28 billion in profits! Who needs government help with profits like that? Well, the results were distorted with a little help from a $6.7 billion gain related to the combination of its Smith Barney brokerage operations with those of Morgan Stanley. Conveniently, Citigroup didn't provide results excluding the gain, so I'll have to do my own math. By my calculations $4.28 billion minus $6.7 billions equals a loss of around $2.4 billion. Now this is probably not the right way to do the calculation, but you know, I don't think it would be inappropriate for the damn company to break out its operating results so that analysts and investors can see what the real story is. Particularly when you're on government life support and everyone and their mother is trying to figure out if you're going to survive another quarter.

Meanwhile, GE, that finance company that calls itself an industrial bellwether, reported a 47% drop in second-quarter earnings Friday. GE posted income of $2.67 billion or 24 cents a share, down from $5.07 billion or 51 cents a share a year earlier. Revenue fell 17% to $39.08 billion amid a 29% drop at GE Capital. Analysts expected earnings of 23 cents on revenue of $42.16 billion so I'll call these results worse than expected. GE Capital's profits plummeted 80%, but really the only reason GE Capital is even posting profits is that it isn't required to mark its assets to market. More details on the performance of its loan portfolio will be extremely enlightening. Although the energy-infrastructure business only had a 1% drop in revenue, the consumer and industrial operations saw revenues and profits drop 20%.

GE's stock is down around 4% and seems to be the biggest disappointment to investors. Yesterday's lackluster results from Google, 5% revenue growth for a company that is used to 30% or more, is also weighing on the market. IBM's respectable quarter, a 12% jump in second-quarter profit on a 13% decline in revenues coupled with raised guidance for the forthcoming year, hasn't done much to propel the market higher. If you were hoping for an exciting expiration Friday, you will likely be sorely disappointed.

Financial Headlines 7/16/2009

• JP Morgan's profits rose 36% from a year earlier to $2.7 billion. The bank posted $26 billion in revenues, up 39% from a year earlier. The strong revenues were offset by an $8 billion provision for loan losses. Loan losses continue to rise but the bank believes that the $30 billion it has set aside to cover uncollectible loans should be sufficient.
• CIT was denied government assistance and is scrambling to line up at least $2 billion in rescue funds from existing debtholders. Debtholders have 24 hours to decide if they will come up with new cash. A bankruptcy of CIT could potentially wreak havoc on many small retailers and clothing manufacturers and suppliers that rely on the finance concern to provide cash advances to operate their businesses. Apparently California may be particularly hard hit because of the state's large apparel-import business. Also, the FT reported yesterday that a CIT bankruptcy could trigger widespread losses for investors in the $600 billion market for synthetic CDOs. The company is the second most widely referenced company in CDOs after Volkwagen, with almost two-thirds of those rated by S&P in Europe including it in their portfolios of credit default swaps. Synthetic CDOs are debt products that pool CDS against a range of companies. Shame on you for not knowing that. A credit event could trigger further downgrades of synthetic CDO debt, which would lead to more writedowns. The clock is ticking. Now we wait.
• Unemployment claims declined by 47,000 to 522,000 while continuing claims declined by 642,000 to 6.273 million. Calculated Risk notes that the seasonally adjusted weekly claims are being impacted by the layoffs in the automobile industry and other manufacturing sectors. Usually companies cut back production in the summer and the numbers are adjusted for that pattern, but this year the companies cut back much earlier. The distortion is expected to last another week or two.
• The Philly Fed index fell to negative 7.5% from a nine-month high of negative 2.2% in June. Manufacturing activity has declined for 19 out of the past 20 months. This was a weak report. Not much else to say about that.

Citi , B of A and Secret Deals With Regulators

The FT reports that Citigroup is close to a secret agreement with one of its main regulators that will increase scrutiny of the US bank and force it to fix financial (like those involving losing buckets of money), managerial (such as the fact that management caused and now can't stop the firm from losing buckets of money) and governance (such as those concerning directors that did nothing other than rubber stamp everything that management did causing the firm to lose buckets of money) issues. The agreement is apparently so secret that both the WSJ and FT got the story, but the WSJ figured it was old news and merely relegated it to the bottom of story about Bank of America's secret deal with regulators (keep reading, I'll get to it.)

The FDIC has been tightening the screws on Citi and wants the bank to strengthen its board and governance, improve asset quality, better manage its expenses and provide more information to regulators on its capital and liquidity. This supposed "agreement" between Citi and the FDIC would strengthen the FDIC's position in its dealings and its demands for detailed financial information as it deliberates over whether to include Citi on its list of "problem banks." Huh? Why does the FDIC need to strengthen its position in dealings? It regulates the bank and is guaranteeing a bunch of Citi's debt. If Sheila Bair asks for detailed financial information, Vikram Pandit better drop his sandwich and hand it right over. Furthermore, does the list of problem banks even mean anything? If Citi wasn't already on it after three government bailouts, then the list is completely meaningless. Adding to the hilarity of this article is the following line: "Agreements between regulators and bank's management and board- known as "informal actions" are not made public to avoid stoking investors' fears." You know, so secret that they somehow wind up on the front page of the FT. But then again, we're talking about Citi, and it's no secret that the bank is in deep doodoo.

Meanwhile, the headline banking secret being revealed at the WSJ concerns B of A. Supposedly Bank of America is operating under a secret regulatory sanction that requires it to overhaul its board and address perceived problems with risk and liquidity management. According to the article Bank of America is operating under a "memorandum of understanding" which gives the bank a chance to work out its problems without the glare of outside attention. But don't tell anyone, because nobody knows that there are problems at B of A. The order was imposed in May, you know after about three government bailouts, and the bank faces a series of deadlines, some at the end of July and others in August, say the story leakers.

What's wrong with this picture? Retroactive regulation doesn't solve problems. It would've helped a tremendous amount if these banks were actually regulated when they were making the serious mistakes that cost shareholders and our economy hundreds of billions of dollars. But go ahead, sign those memorandums of understanding if it makes regulators feel like they are actually accomplishing something.

Financial Headlines 7/15/2009

• Industrial production decreased 0.4% in June on the heels of a 1.2% decline in May. For the second quarter as a whole, output fell at an annual rate of 11.6%. If you like your data delivered with a bullish bent, click on the Bloomberg link which claims that the continued decline, albeit at a slower pace, is a sure sign that the economy is on the mend. Alternatively, you can visit the realists at Calculated Risk, who point out that capacity utilization for total industry declined in June to 68%, a level 12.9% below its average for 1972-2008. Prior to the current recession, the low over the history of the series which began in 1967 was 70.9% in December 1982. Little reason for new investment in production facilities until capacity utilization recovers.
• CPI rose 0.7%, but if you strip out that pesky food and energy component that nobody really purchases anyway, the core rose 0.2%.
• The MBA index increased 4.3% to 514.4 from the prior week. The increase was mostly due to a surge in refi activity, as the purchase index actually declined 9.4%. The average interest rate for 30-year fixed rate mortgages declined to 5.05% from 5.34%. Good news again for those cash strapped home owners who have yet to refinance. Unless, of course, they can't get a decent appraisal, which is a whole other story.
• Intel reported a loss, due mostly to a $1.45 billion anti-trust fine. However, quarterly revenues were sequentially higher by 13% to $8.02 billion, although still 15% below year earlier levels. The tech giant forecast a surprisingly strong third quarter, calling for revenues to hit $8.9 billion. The positive guidance has sparked a rally in tech stocks.
• The folks over at Calpers are steaming mad and plan to take action. The California pension fund manager has filed a lawsuit against the three biggest rating agencies accusing them of "wildly inaccurate and unreasonably high" ratings. It's funny that the pension holders of California haven't filed a lawsuit against Calpers for "being too lazy to do any of its own investment analysis and depending on a rating from a firm that derives its revenues from the sellers of the securities." I find these lawsuits to be really annoying. If you're a professional investor tasked with managing money, take your job seriously and know what you're investing in. Did somebody put a gun to Calpers head and ask them to invest $1.3 billion in three separate SIVs with AAA ratings that happened to own buckets of collateral probably secured by subprime mortgages? No. They did it because it offered higher returns. Higher returns = higher risk. Sack up and face the consequences of your stupid investment decisions.

CIT Hanging on By Thread; US Considers Bailout

CIT has not given up its quest for government assistance. Although somehow FDIC Chairman Sheila Bair had no trouble guaranteeing the debt of the likes of Citi and Bank of America, she refused to risk draining the FDIC's deposit insurance fund by guaranteeing the debt of the ailing CIT. The Treasury and Fed, however, are more amenable to the idea of coming to the lender's aid, according to the WSJ. US government officials are in advanced talks with the lender to keep the lender afloat. Although CIT is not viewed as a systemic risk to the market, CIT has loans to nearly one million small businesses. According to the story, government officials believe that CIT's failure could have "many unforeseen consequences."

Why would the government be interested in bailing out a lender that is not a systemic risk to the economy? Certainly there are always unforeseen circumstances when a company collapses but why CIT? I'm not one to start conspiracy theories, but since this one is already out in the open, I might as well come right out and say it: Goldman Sachs extended CIT a $3 billion loan. Sure, in today's earnings announcement the investment bank claims it has no exposure. It is hedged. Blah blah blah. Please refer to transcript related to AIG government bailout. But it would certainly be very convenient if the government bailed out yet another company that owed GS billions of dollars. Wouldn't it?

Goldman Earnings Better Than Expected

Goldman Sachs posted net income of $3.44 billion or $4.93 a share, up from $2.09 billion, or $4.58 a share. Net revenue leapt 46% to $13.76 billion thus proving that it really is possible to make buckets of money when the government keeps throwing it at you. Nobody is really all that surprised by the news of Goldman's great quarter. Rumors have been circulating in the financial press claiming that the company was teeing up record bonuses for its employees and making gobs of cash trading. Indeed Goldman has set aside $6.65 billion during the second quarter to compensate its 29,400 employees and $11.36 billion for the first six months, up 33% from the comparable period in 2008. I know I've hammered on this point far too much in the recent past, but I'll say it again: There is something very wrong with the way that our government has chosen to boost the economy, when the method boosts the ability for many who were responsible for an economic catastrophe to have record profits, while the rest of the economy remains in the dirt. Sure Goldman might have survived anyway, but it wouldn't be making record profits without massive help of the Fed, Treasury, and FDIC.

Option ARM Defaults Now Worse Than Subprime

Buried on page two of the Money and Investing section of the WSJ is a very interesting article that highlights one of the few reasons why I believe a true recovery in the US economy is far off. Option ARM (or "pick-a-pay") default rates are now surpassing those of subprime. As a quick review, option ARMs were mortgages issued to borrowers with solid credit ratings that allowed them to choose from a variety of payment options. The minimum payment option was a partial interest-rate payment, where the unpaid interest portion was merely added to the loan's balance. A few years into the life of the loan, the loan would recast and require that the borrower begin to pay principal causing the monthly payment to balloon. The loans were most popular in high-priced real estate areas such as California and Florida, where they were used to aid in the purchase of houses that consumers couldn't afford with a traditional fully amortizing mortgage. As of April, 36.9% of option ARMs were at least 60 days past due, while 19% were in foreclosure, according to First American CoreLogic. This compares to 33.9% of subprime loan delinquencies and 14.5% of foreclosures. Many of my posts last year focused on the looming option ARM debacle, as it seemed very clear to me that these loans were being used as a mechanism for homeowners to "get in" on the great housing market ponzi scheme with the intention of just refinancing or selling before their payments recast and they were required to actually pay down the principal on the mortgage. The largest option arm lenders, Wachovia and Washington Mutual were predictably torpedoed by option ARMs but their toxic portfolios live on inside of their acquirers, Wells Fargo and JP Morgan. Certainly both banks took large writedowns on the option arm portfolios when they required the now-defunct lenders at distressed prices, but only time will tell how these mortgages end up performing. According to the WSJ article, Wells Fargo holds $115 billion, which it had marked at $93.2 billion, giving the bank room to absorb future losses. According to a securities filing in May, borrowers making the minimum payments accounted for 51% of its outstanding Pick-A-Pay balances as of March 31. JP Morgan holds $40.2 billion in option ARMS that it acquired from Wa Mu and another $46.5 billion sitting in complex off-balance sheet entities. Furthermore, our friends at the FDIC are picking up the tab on potential future losses on a $5 billion portfolio from BankUnited, the Florida-based bank that the FDIC seized and sold to private investors with a loss guarantee.

What is disconcerting about the option ARM debacle is that I don't believe we are near the peak in loan defaults. Most subprime lenders went bust in early 2007, and only now are we working our way through the worst period of subprime lending, which data shows was the mid-to late 2006 period of subprime lending. I wrote a post recently about the extraordinarily high default rates coming out of this period of lending from now-defunct subprime lenders. But option ARM and alt-A lending continued through 2007 and 2008, until it became clear that the credit crisis was not just contained to subprime. So, many of these loans have yet to recast and cause problems for borrowers. We have that to look forward to, which is nice.

Financial Headlines 7/10/2009

• GM has emerged from bankruptcy, as the recently bankrupt automaker completed the sale of its best assets to the new government and union-owned company. The asset sale to the new company allows GM to shed half its US brands, cut more than 6,000 salaried jobs and idle or close 16 factories. Now if they could just get consumers to buy some cars...
• The FDIC is unwilling to guarantee CIT's debt through the TLGP due to the credit risk associated with the struggling lender's portfolio. If you happen to have some FDIC-backed bank deposits, you should send a thank you note to Sheila Bair for having the sense to draw the line on this one. As I've said many times before, I want my FDIC to guarantee my bank deposits and only my bank deposits, not some crappy commercial lender's bad lending decisions (or some investment bank's trading operations, but it's too late to stop her on that one...)
• The trade deficit unexpectedly narrowed in May to $26 billion down from $28.8 billion in April. May exports were up slightly to $123.3 billion, while imports were lower at $149.3 billion. The decline in imports was due primarily to decreases in crude oil and auto parts imports. Hmmm, wonder why we're not importing that many auto parts anymore. At any rate, a shrinking deficit is positive for GDP, so I'll label this "unexpectedly good news."
• AIG is once again risking a public flogging by seeking permission to pay previously agreed-to retention bonuses to its employees. This time they have to clear it with the new Comp Czar, Kenneth Feinberg. The last time the folks at AIG were paid bonuses was in March, which led to quite the public outcry. And it is now July, and unemployment has ticked higher, so I guess we're due for more public protests. I know that everything was contractually guaranteed and agreed to before the company punted $100 billion and required a government bailout, but bonuses every three months? No wonder they went bankrupt.
• JP Morgan has decided not to repurchase the warrants that the government acquired during the apex of the crisis when former Treasury Secretary Hank Paulson forced government money down the bank's throat. CEO Jamie Dimon disagrees with the valuation methods that the government is using to value the warrants and refuses to pay the price the government is requiring for the repurchase. Mr. Dimon is instead choosing to opt out and allow the government to hold a public auction. The results of the auction should be very interesting as most other banks also believe that the government is placing too high of a value on the TARP warrants and don't appear to want to repurchase the warrants at those prices. So, if I were a competing bank that also didn't want to overpay, I'd probably sit out the auction for the JP Morgan warrants, so as not to push the price too high and support the pricing on JP Morgan's warrants. I'm not sure who, outside of the large banks' derivatives desks, would be buyers of the warrants, but certainly the results will be enlightening.

Comic Relief: Citigroup Posits AIG Equity Worthless

A Citigroup analyst wrote a research report claiming that there is a 70% chance that AIG's equity is worthless. Investors may be shocked that such a bold and decisive investment proclamation could emerge that is such a deviation from the usual "neutral" and "hold"-type crap emanating from most Wall Street analysts. What could've possessed this analyst to finally put his foot down and proclaim now, a year after the company has lost 99% of its market value, not to mention puked over $100 billion in actual earnings, and received a massive government infusion, that the final $2 billion in market cap is in danger? What type of secret insight can this analyst possibly have that the AIG stock-buying diehards are missing? Well, he does work at Citigroup. Really, does anyone know worthless equity better than Citigroup?

A few weeks ago, I looked up at my stock screen and was astonished to discover that AIG was a $20 stock again. After rubbing my eyes a few times and conducting a small amount of due diligence, I discovered the company has executed a 20-1 reverse split. The move was done presumably to keep the company's stock listed and to entice investors into buying the stock again? I'm not entirely sure. What it means to me is that I get yet another opportunity to short this stock into the dust. I don't consider this move to be un-American, merely a hedge against all of my taxpayer dollars that are being wasted keeping this unwieldy beast of a company afloat.

East Coast Vs. West Coast Commercial Real Estate Blowouts

The WSJ reports that Deutsche Bank has finally found a buyer willing to shell out $600 million for the Worldwide Plaza in Manhattan. Duetsche, for those who are fuzzy on the details, was one of the bankers who thought it was a great idea to lend to Harry Macklowe back in early 2007 so he could pay the all-time record high in commercial real estate prices. Mr. Macklowe was the first high profile developer to default on his loans and start handing over the keys to his lenders during this real estate bust, although he certainly has plenty of experience doing it in the last real estate bust of the early 90's. Maybe the next time around, bankers will think twice before lending to him? But really, who am I kidding? Next time around, we'll have a whole new set of fresh-faced bankers throwing money at anyone with a pulse and a grand idea for why this time, things really are different and fundamentals don't matter.

The Worldwide Plaza is a lovely building on the fringes of better neighborhoods, but it obviously wasn't worth the $1.75 billion that Mr. Macklowe shelled out for it. The new owner, George Comfort & Sons., should do much better on his investment than Mr. Macklowe given that he paid 65% less, but he still has some work to do. The building is 50% vacant, which is nothing that a good slashing in asking rents can't remedy, much to other midtown Manhattan's office property owners' chagrins. But I'm fairly certain that this is how markets work. Prices adjust until we reach equilibrium. Unfortunately, an equilibrium price that reflects a 65% drop in Manhattan office property values should everyone involved in a deal during the boom years browning themselves.

Meanwhile, over on the West Coast, New York developer Millenium Partners, owner of the Four Seasons, didn't make payments in May and June on the hotel's $90 million securitized mortgage in a bid to compel the loan's special servicer to rework its terms. The developer claims that withholding the debt was a strategic decision, but I'm guessing it had something to do with the property not generating enough money to meet the debt service. You see, Millenium wants to restructure its debt and it's hoping to get conversations started. Funny thing is, when you or I "strategically withhold payments on our mortgages", the bank takes the damn house away. I guess that's not the way it works when you are a hoity toity NYC developer. We'll see how the lenders feel about this one.

In May, Barclay's put the Stanford Court Hotel into receivership because of a default on the hotel's $90 million mortgage. I'm fairly certain there was nothing "strategic" about that default. The WSJ journal points out that hotels aren't generating enough cash to make interest payments on their mortgages, which has caused the delinquency rate on securities with hotels pledged as collateral to jump to 4.3% in June up from 0.5% in a year earlier (data from Trepp LLC.)

The Four Seasons and the Marriott (owner of the Stanford) can blame their lack of cash flow on AIG of course, and that stupid junket that the company refused to cancel, which has put the kibosh on most luxury business travel. 2008 was the death of the boondoggle as we knew it. Oh, and also the depressed economy, which AIG is sort of also responsible for. In any event, the slow motion train wreck that is the commercial real estate market is playing out all over the country and is likely to pick up steam as a wave of defaults lead to foreclosures and bank liquidations. I happen to think this will be equivalent and possibly worse than the subprime problem. But then again, subprime was "contained" so we have nothing to worry about.

On Record HELOC Delinquencies and Near-Record Office Vacancies

The American Bankers Association reports that late payments on home-equity loans rose to a record in the first quarter to 3.52% of all accounts from 3.03% in the fourth quarter of last year. Late payments on home-equity lines of credit climbed to a record 1.89%. Delinquent bank-card accounts jumped to a record 6.6% of outstanding card debt in the first quarter from 5.52% in the previous period. Delinquencies and late payments are, of course closely correlated with unemployment, which continues to rise unabated. In the recent past (for example the 2002 recession), when the Fed lowered interest rates, banks would shower consumers with 0% credit card offers and HELOCs, thus cushioning the blow for many of the unemployed until they found work again. What seems to be markedly different this time is that banks are yanking credit card offerers and cutting off lines of lines of credit. According to data compiled by Equifax, US banks issued 9.8 million credit cards from January through April, a 38% decline from the year earlier period. Now that is what I call a credit contraction.

Meanwhile, in commercial real estate land, the US office vacancy rate hit 15.9% in the second quarter. Calculated Risk has a illuminating graph that shows office vacancies going all the way back to the early 90's. It clearly depicts how office vacancies tend to follow the business cycle and really makes you wonder what the hell all of those real estate developer clowns thought they were doing when they were striking deals at ridiculously inflated prices more than five years into an economic upturn that was growing long in the tooth. The peak in office vacancy rates in the previous recession was 17% and it seems we are well on the way to surpassing that record. According to real estate research firm Reis, effective rents fell 2.7% in the quarter. The firm is calling for the vacancy rate to top out at 18.2% in 2010 and for rent to fall through 2011.

I know, it doesn't really seem fair to cram HELOC delinquency rates and office vacancies into one post. But I think both are highly crucial economic data points that focus on what I believe are the two biggest headwinds for our economy:

1. The consumer is finally tapped out, in debt up to his eye-balls, can't borrow more, can't afford his current debt burden, and is watching his assets deflate.
2. The commercial real estate market is just beginning to unravel, which will have a devastating impact on banks, insurance companies, not to mention those developers and investors that borrowed way more than the current or future cash flows from their projects can hope to generate.

Goldman: Manipulator or Victim?

Sergey Aleynikov, an ex-Goldman Sachs computer programmer, was arrested July 3rd and charged with a criminal complaint with stealing trading software. Teza Techonologies, the Chicago-based firm co-founded by a former Citadel Investment Group trader, said it suspended Aleynikov, who started work there the day before his arrest. The folks over at Zerohedge have spent an inordinate amount of time speculating and outright accusing GS of manipulating markets. I've maintained my usual level of skepticism, despite the fact that I love a good conspiracy theory, particularly when it pertains to an investment bank that seems to always get a bone from the government when it needs a boost. But I must admit, I'm seriously considering jumping on the Goldman-market-manipulator bandwagon. The Assistant US Attorney told a federal judge that Aleynikov's alleged theft poses a risk to US markets. He goes on to say that the code, which is worth millions (more likely billions if it really can manipulate markets), was transferred to a server in Germany and others may have access to it. "The bank has raised the possibility that there is a danger that somebody who knew how to use this program could use it to manipulate markets in unfair ways." the attorney asserted. Theoretically speaking, the folks over at GS know how to use this magical code better than anyone. They're admitting it is so potent that it can manipulate markets. But don't worry, they would never use it to that end. GS only uses its power for good, not evil. Furthermore, I'm sure that the totally innocent guys at Teza had no idea that their employee was trying to steal a top secret code from GS that holds the market's fate in its hands. No doubt this trial will be an interesting one.

In what is bound to be more disheartening news for the folks at Goldman, the CFTC is proposing sweeping trading limits on oil, natural gas, and possibly other commodities. The agency is in the process of altering how it presents information to the public by incorporating data from swap dealers, foreign contracts tied to US futures, and professionally managed market positions such as hedge funds. Commodities swaps are all done OTC and the market is huge, so a bit more clarity on the size of the market should be a real eye-opener and possibly eye-popper. Goldman is a huge player in the commodities markets and likes to do things like put out research papers declaring that the price of crude will spike to $200 right before commodities prices take off. The investment bank cleverly lumps its equities, commodities and fixed income p&l together when it reports earnings, which for some reason seems to only annoy me and not the bone-headed analysts who cover the stock, because it does disguise the true volatility of the company's trading profits. Nevertheless, stricter trading limits on commodities is bound to cut into the firm's trading profits, as well as the other dealers that trade in commodities.

Banks "Reinvent" Securitization to Reduce Capital Costs

According to the FT, the day that libertarians fear, one where government intervention squelches innovation on Wall Street, is still far away. The FT has a front page article detailing how investment banks are attempting to rejigger securitization in order to reduce the capital cost of risky assets on banks' balance sheets. The schemes, referred to as "insurance" at GS and "smart securitization" at BarCap, involve pooling assets from several clients into a secured financial product that can be sold to investors and rated by a credit agency in order to reduce capital costs by 10-50%. Something about this sounds very familiar, hmmm, scratching head...oh yeah! I've got it! It's exactly what they were doing before (presumably we can now safely refer to its predecessors as "dumb securitization" or "AIG-style insurance") which virtually caused our financial system to collapse on itself. "But wait!" bankers argue. "This time it's completely different! This time we'll be using existing assets, instead of new lending and the products do not disguise the transfer of risk!" They cry in unison. "Because last time we were trying to deceive everyone by pretending there was no risk and we succeeded! Ha! Ha! Fooled all of you suckers! Oh, wait a minute, don't print that last part. Turn the microphone off!"

Now, I have no problem with securitization, particularly on new lending. In fact, I'm fairly certain, with the exception of all the FHA-condo lending and the 125% LTV loan refis recently introduced by the risk averse folks over at HUD, that recent lending has probably been extremely well-underwritten. In fact, I'm confident that any underlying collateral in a securitization underwritten during a period of time when bankers were dropping loads in their pants on a daily basis because they were terrified the world was coming to an end is going to perform very well. What I don't approve of is the shoveling of old refuse from banks' balance sheets into newly concocted garbage which is then sold to some endowment or pension fund that's desperate to make up for the 50% losses they've suffered in the past year just so that banks can lever up again. The PPIP was created so that banks could get a price for their toxic waste and unload it. The banks chose not to participate because they didn't like the prices their assets would command even with government-sponsored leverage, and preferred to raise equity into a short squeeze and hoped to ride out the economic storm. So now they are concocting schemes to game the system. Let's hope that this time our regulators are awake and paying attention.

Nonfarm Payrolls Disappoint

Nonfarm payrolls declined 467,000 in June, which was worse than the 350,000 job losses economists were expecting. The unemployment rate ticked higher to 9.5%, the highest level since August 1983. Curiously, 1983 was the year of Michael Jackson, who had three number one songs that spent 15 weeks at the top of the charts. So I'd like to dedicate this month's employment report to the one-gloved wonder who just passed away. While emulating the economic environment of the early 80's is nothing we should aspire to, at least Michael Jackson was on his game, moonwalking and cranking out the pop hits, before he ruined my childhood memories by creeping into the weird and controversial figure he would later become.

Not much silver lining in this employment report, for those still clinging to the story of our great recovery in the second half. The rate of unemployed or underemployed workers hit 16.5%, up from May and the average workweek was down 0.1 hour at 33 hours, a record low. An informed friend of the blog points out that every .1 hour decline is equal to roughly 350-500k jobs lost, so the continuing decline in the average workweek bodes ill for the recovery in the labor force.

The equity markets are not taking this news well after shrugging off a fairly significant amount of weak data this week. Auto sales remained below 10 million units annually for June, and construction spending declined in May. The MBA refi index showed that refinance applications were down 30%, which is not surprising given that interest rates have shot up recently. But the green shootists were all about the ISM, which showed further contraction in manufacturing, albeit at a slower pace.

After all of this sobering economic data, I propose that everyone go out and enjoy a few drinks and a barbecue this Fourth of July weekend. We can all start looking for jobs on Monday.

Merkin Forced To Sell Art

One of the many many leeches who fed off of the Madoff Ponzi scheme, J. Ezra Merkin, was forced to sell $310 million of Mark Rathko and Alberto Giacometti sculptures, potentially offering some payback to his defrauded investors. The sale was announced, curiously, by New York Attorney General Andrew Cuomo, who has sued Mr. Merkin and secured a freeze on his assets. Only in America can someone become rich enough to acquire over $300 million in art by charging fees to funnel money into a fraudulent investment scheme, all while helping to run a finance firm into the ground (Mr. Merkin was also Non-executive Chairman of GMAC.) The Merkins have agreed to place the proceeds of the sale, which only amount to around $192 million after liens and fees have been paid, in escrow while the litigation continues. Even if you aren't a criminal or an art lover, this is a fine example of why it is important to own a boatload of art if you are too lazy to actually manage the money you are entrusted with and simply hand it over to some other guy without performing any due diligence. If it weren't for the art that the Merkins can easily dispense with, maybe they'd have to give up one of their houses, or God forbid, Mrs. Merkins jewels or furs.

The best part of this article in my opinion, is the following quote by the reporters: " The deal shows how the credit boom, the Madoff fraud, returns on Wall Street and soaring art prices all fed off each other during the bull market-and collapsed at the same time." In other words, the stunning correlation between all asset classes, which rose smartly together during the boom, made alot of folk very rich, even though it was all a mirage. Unfortunately, everyone has to pay the price for the cleanup.