Pondering the Great Dichotomy While the Fed Meets

The Fed meets today to discuss its next move in the exciting game of "Re-inflate the Bubble." Sure the Fed thinks it's playing whack-a-mole against lousy economic data. Every time a bit of bad news peeps its head out into the supposedly robust economic recovery, the Fed whacks it down with some other ingenious bit of monetary easing. Our monetary authorities are just looking for more and more ways to flood our financial markets with free money, at the behest of Wall Street, so financial assets will rise in value so all of those underwater residential, commercial and other loans can be refinanced or repackaged and sold without another financial catastrophe. You see, it's working really well. Deflation is our worst enemy. Today anyway. That's what Bill Gross says so it must be true. So if we need another $2 trillion in quantitative easing, so be it. Right?

In the economic bad news/deflation corner:

• Fannie and Freddie continue to bleed cash, albeit at slower rates than before. After posting their most recent losses, the mortgage lenders increased their borrowing from the Treasury to a total of $148 billion. Mind you, Fannie and Freddie are 90% of the mortgage market, so regardless of the economic health of the rest of the banking sector, the true state of the mortgage market is reflected by Fannie and Freddie's performance.

• Productivity slowed by a unexpectedly jarring 0.9%. So much for the theory about robust profit growth leading to increased productivity leading to increased hiring.

• Unemployment remains stubbornly high at 9.5% and will likely not decrease unless productivity continues to increase.

In the good news/inflation corner:

• Money is flooding the system and investors have nowhere to go with it, so they are just piling into anything reasonably safe with a yield and forcing rates lower. The WSJ has two articles this morning, one on MLP shares ripping on zero fundamental improvement this year and another on the relentless march lower in corporate bond yields. The FT has commentary on how the bottom line at strong companies is getting stronger while weak companies are floundering. Case in point: IBM can issue debt at 1%. Can you?

I call this the Great Dichotomy. Part of the economy is flashing deflationary signs, the other inflationary signs. What's a good Fed to do?

The Fed Also Forecloses

The WSJ reports on the current state of the Maiden Lane portfolio the Fed acquired in March 2008 when it helped facilitate the sale of Bear Stearns to JP Morgan. You know, that portfolio that was just marked up and showing a "profit" as of the last quarter end? Turns out, not all the assets in the vehicle are performing that well, as it is stuffed to the gills with souring commercial and residential mortgages. The Fed is in the curious position of not wanting to sell problem assets at a discount because it could"disrupt markets and hurt banks." That's funny, because every day I keep reading about how much money banks are making again. Is the Fed suggesting that bank profits are a mirage? In any event, the Fed is going to have to deal with the thorny issue of either foreclosing on delinquent borrowers, or doing workouts. Going ahead with the numerous foreclosures scheduled in coming months on residential properties could raise the hackles of legislators who still believe homeowners need to be protected. Like the real estate investor profiled in the article who is just dying to hand over his investment property because he is obviously upside down on the mortgage. He filed for bankruptcy and the Fed is offering to lower his rate, but he says it's not enough. He needs an extension and a much lower rate to get his investment to workout for him. Apparently, no amount of failed HAMP mods is going to stop politicians from trying more mods!

So far, the Fed has only taken ownership of one commercial property, a mall in Ohio that it is trying to sell. But more commercial foreclosures are on the way. Much less political risk with foreclosing on malls. Malls are as American as apple pie. Why shouldn't the US government own a bunch of them?

Maiden Lane made its first monthly principal repayment in July equal to $30 million. In not entirely unrelated news, Blackrock was paid $35 million in fees last year for its work managing the Maiden Lane portfolio, even though a 22-person team at the Fed is also working on it. I'm guessing the entire Fed team took home roughly $1 million in comp last year? But they probably aren't working as hard as the guy at Blackrock who billed the Fed for $35 million.

Buried in the article is my favorite part: "Maiden Lane now owns a large amount of relatively safe securities guaranteed by GSE's Fannie and Freddie. Many were bought over the past two years with cash Maiden Lane received from interest and principal payments in the portfolio and they have helped make up for some value declines from soured assets." When exactly did Maiden Lane turn into a trading account? Why isn't the money being used just to pay down principal on the loan? Is that because Blackrock's fees are based on the size of the portfolio? So we just want to keep reinvesting so the portfolio maintains its size so we can keep cutting a check to Blackrock? So the Fed, the most leveraged entity on the planet, is buying assets from the other most leveraged entities out there. This is what our government borrows money for, so it can trade with itself and pay money managers in the private sector fees. When will the madness end?

Fed in "Quiet" Discussions Over Economy

According to the WSJ, Fed officials are quietly debating steps to take if the economy falters or inflation falls further. What do you call a debate that is so quiet that it is plastered on the front page of the WSJ? A hint.

Fed Chairman Ben Bernanke has made several comments voicing his optimism about the economic recovery and down-played the risks of a double dip. Yet the signs of a double dip are growing more evident by the day as domestic economic numbers fail to impress and turmoil overseas threatens our recovery further. So it's time for the Fed to hedge its bets and leak a story to the press and say something like:

"I know we said we were going to end our asset purchases, but we might reverse course, even though rates are already preposterously low and monetary stimulus at this point may have a muted effect on demand. We have to do something, but frankly, we're all out of ideas that don't involve a helicopter. Let's hope we're wrong and our next move is a tightening. But just in case we're wrong, or wrong about being wrong, be forewarned. We have no idea what we're doing. Got that bond market?"

Crystal clear.

What Happened to Financial Armageddon?

Amidst the somewhat decent economic headlines (excluding unemployment) and a number of relatively robust earnings reports (because it's much easier to make a bunch of money when you fire all those people,) we seem to have forgotten about the economic crisis of two years ago. Certainly the market has bounced back to a level much more tolerable to most investor's stomachs. Sure, Obama is going to "Castigate Wall Street" today and our legislators are going to pass some watered down version of a financial reform bill. Even the SEC is going after Goldman in an extremely complicated case involving CDOs, after failing to go after two obvious monstrous ponzi schemes that they were repeatedly warned about. But really, what happened to the financial armageddon that everyone was talking about? I'm talking about gold-hoarding-living-in-caves style financial armageddon. Has it really been averted?

A few worthy souls are still carrying the armageddon torch. For instance, Marc Faber thinks that our governments will bankrupt and expropriate us and that the whole system will collapse. He believes the crisis has merely been postponed by all the government intervention. Who does this Marc Faber guy think he is? He's the editor of the Gloom, Boom & Doom Report and he's just a savvy investor, that has been shockingly right about alot of stuff. Then there is Louis Bacon, head of Moore Capital that is joining George Soros in his expectation of a breakdown of the European Monetary Union. Also, the FT's chief economics commentator, Martin Wolf, in yesterday's paper discussed the "Challenge of halting the financial doomsday machine," which was accompanied by some fairly sobering graphs showing the explosion in financial sector assets in the UK and US, as well as displaying how much the fate of the financial industry was now concentrated in a few hands.

So which is it? Global economic V-shaped recovery? Or government reinflation by money printing leading to a much bigger bubble which is bound to burst later? I'm currently reading "Lords of Finance", the pulitzer prize winning account of the central bankers whose actions supposedly caused the Great Depression. It should offer some insight into our current situation. The problem is, I keep falling asleep, can't make it past page 237 and not much has happened yet. The good news is that Mr. Bernanke is a student of the Great Depression, and he's supposedly put us on a course to avoid it. The bad news is that his, as well as the other central bankers' actions around the world are unprecedented, and we still have no idea how this story is going to end.

Inflation VS. Deflation Inside the Fed

The WSJ has a somewhat troubling front page piece on the current debate raging inside the Fed over what poses the biggest threat to the US economy. It seems as if our fearful economists who control the US money supply can't agree over what to fear most: inflation or deflation. Here I thought the fed was busy genially discussing the nuances of a zero percent vs. .25% fed funds target. It turns out, they can't even diagnose the underlying economic issues that need to be targeted. It's as if our leading economists have turned into an episode of "House" where Dr. Foreman is arguing over some treatment that will kill the liver to save the heart, while Thirteen thinks it's a brain tumor. Yet every episode of "House" neatly resolves itself when the brilliant Dr. House has some sort of epiphany that leads him to discover that the patient was just pregnant. And then Dr. Cuddy adopts the unwanted child.

If only economics were so cut and dried. Markets seem to have concluded that the Fed has figured out how to extricate itself from the massive experimental quantitative easing and zero percent fed funds policies of the past couple of years without doing any harm. Interest rates are still relatively low, volatility is sagging at pre-crisis levels, bond spreads have tightened and equities have rebounded sharply. Commentators have resurrected the "goldilocks economy" phrase from the mid-oughts that served us so well right before the economy crumbled and went to Hell.

Whether the inflationists or deflationists are right won't likely be determined for some time, particularly since Fed policy has so much to do with the outcome. Yet Janet Yellen, widely rumored to be the next Fed Chairman is siding with the deflationists. That, my friends, is why I'm siding with the inflationists. No disrespect to Ms. Yellen, but there is one thing I know for certain: the Fed will not perform its duties perfectly. It always has and always will overshoot in one direction or another. If the person leading the charge is leaning towards a more accommodative monetary policy then we're headed towards much higher inflation down the road.

Financial Headlines 4/1/2010

• CEOs watched in horror as their pay declined for a second year in a row, according to the WSJ. Average comp for the 200 CEOs in the analysis declined by 0.9% to $6.95 million. Really, I have no idea how anyone can expect to get by on so little coin.
• The Federal Reserve has released the details of the crap, I mean securities/other stuff, it purchased from Bear and AIG in its attempts to keep financial markets from imploding in 2008. I scrolled through the cusips and lack of cusips contained in Maiden Lane I (i.e. former Bear Stearns garbage barge) and wondered if it was as worthless as it looked (i.e. reams of unsecuritized loans on hotels and other commercial properties.) But I'm pretty sure I knew it was worthless back in March 2008 when Jamie Dimon said "We'll take that and that but, um, we're not gonna take any of THAT."
• Speaking of Jamie Dimon, he regrets ever using the FDIC to guarantee $40 billion of JP Morgan's debt during the crisis. "We didn't need it" Dimon claims, although he goes on to say that it did "save us money." Curiously, he doesn't regret the zero interest financing that JP Morgan probably also didn't need. Also unloading Bear's $30 billion in crap collateral onto the Fed? I'm pretty sure none of us needed that.
• Most importantly, everybody gets the long Easter weekend to think about the non-farm payroll number which is set to be released on Good Friday.

Fed MBS Purchase Program Ends Today

Today marks the end of the Fed's $1.25 trillion agency MBS buying spree. The program contributed to reviving the mostly dead housing market by keeping mortgage interest rates low so home buyers could afford their mortgage payments. A zero fed funds target didn't hurt either. It's like the Fed acted as the anesthesiologist, while Drs. Fannie, Freddie and FHA argued over how to correctly perform the quadruple bypass, with the Treasury occasionally running in with a crash cart, shouting "Clear!" and introducing another homeowner tax credit.

The Fed's attempts to boost the housing market had other side affects as well. Today's WSJ has a front page story on the monster rally in bonds since October 2008. Junk bonds, in particular, have outperformed nearly every asset class since the lows in the market. By buying over one trillion in MBS and another $250 billion in Treasuries, the Fed gobbled up a significant amount of supply from bond market investors who had nowhere else to go with the $375 billion in inflows that their funds received in 2009.

So now what? Pundits far and wide are arguing over what will happen to interest rates once the Fed is out of the picture. My two cents is that the long end absolutely has to go higher. It's just simple economics. A huge portion of the demand has been removed and who will replace it? Bulls keep arguing that zero interest rates for an "extended period of time" will continue to stoke demand for higher-yielding assets. But does anyone really know the Fed's exact definition of "extended period"? Sometimes my three-month-old spends nearly 30 minutes in her swing, a time period which she refers to as "an extended period." The Fed can turn on a dime if it needs to. Particularly if the FT's front page stories go from today's "Steel Prices Set To Soar" to "Holy Cow! Steel Prices are Surging" tomorrow.

Financial Headlines 3/26/2010

• The headline reads "Europeans Agree on Bailout For Greece". Although leaders of the euro zone backed a deal where they and the IMF would jointly bail out Greece "should the country's debt troubles intensify," (yeah, because that hasn't already happened) details remain somewhat scant. "The agreement won't immediately trigger a Greek rescue, but it lays the groundwork." Sounds like if things get really bad, everybody's promised to have another meeting.
• More than a dozen banks are accused of conspiring to rip off muni bond issuers in a criminal probe begun by the Justice Department's Antitrust Division. Financial are ripping on the fabulous news.
• The White House has entered the mortgage principal forgiveness fray by extending its foreclosure prevention program. The new efforts will give unemployed borrowers forbearance for a few months as well as require banks to consider writing down loan balances as part of a formula for lowering monthly balances. The FHA is going to be used to put this initiative in place, which aims to help borrowers who are current on their mortgages, but are just unhappy about being upside down on their mortgage. For awhile there, I was leaning towards Fannie and Freddie ultimately costing the government the most in the long run, but now I'm rooting for FHA.
• Meanwhile, at the Fed, Bernanke and Plosser have been running off at the mouth about what to do about all the crap they purchased in the quantitative easy frenzy of the past year. "I anticipate that at some point we will, in fact, have a gradual sales process." quoth Bernanke, in his typical calm and measured way. Because unloading a couple of trillion in securities when the world is watching your every move will be really easy, calm and measured. Right. I'm sure bond traders aren't going to be running around with their hair on fire trying to front run while screaming "Just find me a freakin bid and hit it!!"

Merrill Tattled on Lehman

The FT reports that Merrill officials warned the SEC and the Fed in early 2008 that Lehman was "incorrectly calculating a key measure of its financial health" (or, "cooking the books" as you or I might call it.) The former Merrill officials' intentions were far from humanitarian. They alerted regulators because Lehman was touting its reported liquidity position to investors and counterparties as proof that it was sounder than Merrill. Merrill officials probably said to themselves, "Hey wait a minute. I know we're insolvent, but Lehman is DEFINITELY more insolvent than we are. " We're talking about Wall Street guys here. They're so damn competitive.

The Merrill guys didn't believe Lehman's claims. In fact, they thought that Lehman was including regulatory capital in its liquidity calculations. Big no no. So, they picked up the phone and called the SEC and the New York Fed, both of whom did, well, absolutely nothing about it. But we already knew that because we know how this story ended. The SEC declined to comment beyond saying that the folks who fell asleep at the switch at that particular unit are no longer there. The NY Fed claims it was unable to verify that the conversation with Merrill ever took place.

The Fed's Move: Expected and Unexpected All At the Same Time

Yesterday's Fed statement following the FOMC meeting offered little in the way of surprising news. Sort of. Traders and investors were focused on two things:

1. Would the Fed remove the statement about keeping interest rates low for an extended period of time? (It left it in.)
2. Would the Fed end its purchases of mortgages as scheduled by the end of the month or extend its quantitative easing further? (It chose to end the program.)

It seems somewhat contradictory that the Fed would both end the purchase program AND plan to keep interest rates at zero, yet this is exactly what it did. The Fed justified its moves by stating that "Economic activity has continued to strengthen. The labor market is stabilizing." And "Inflation is likely to be subdued for some time." Now that economic activity has picked up, the Fed thinks it can end its quantitative easing program, yet leave interest rates at zero all without causing inflation. You see, it's a "Goldilocks Economy." Growth is not too high, not too low, it's just right. Besides, if inflation does pick up, the Fed will know exactly what to do to stop it in its tracks without causing another meltdown in the markets. The Fed is really good at this type of thing, right? Remember the last time we had a Goldilocks economy from 2004-2007, and how well the Fed handled "easing" us into a recovery after asset price inflation got a wee bit overheated? It'll probably go something like that.

Fed Shocks Market With Largely Symbolic Discount Rate Hike

Yesterday afternoon, the Federal Reserve announced a hike in the discount rate from 0.50% to 0.75%. Everybody panicked, sold equity futures and bought dollars. While the Fed had already made clear that a hike in the discount rate would likely be the first move towards reversing the extraordinary monetary easing of the past two years, the market was positively flummoxed. Despite accompanying comments from the Fed stating the "modifications are not expected to lead to tighter financial conditions for households and businesses and do not signal any change in the outlook for the economy or for monetary policy," market participants were scrambling to interpret the move. Traders of all products were seen running around in circles after the close yesterday grabbing each other by the collar and screaming "I know they said it doesn't mean anything, but WHAT DOES IT MEAN???!"

After all, if the move was completely meaningless, why do anything at all? And why announce it at a weird time on a day when nobody was looking for the Fed to make an announcement? In its effort to keep from roiling the market, at least the folks at the Fed made the announcement after the close. But still, has Mr. Bernanke not heard of after-hours trading?

The discount rate, for those who are still unclear on the difference between the Fed's money market rates and various facilities, is the rate that banks can borrow from the Fed's emergency discount window. Up until the most recent credit crisis, NOBODY borrowed from the discount window, EVER unless they were minutes away from bankruptcy. In fact, rumors of a bank needing to borrow from the discount window could cause a run on the bank. Until the Fed relaxed the rigid rules of borrowing from the discount window during the height of the panic, investment banks on the brink would go knocking, begging to the Fed's discount window (i.e Drexel, Bear etc.) only to be turned away. Even though the Fed tried to encourage banks to borrow during the height of the crisis and ignore the stigma, it still refuses to hand over the names of the banks who were borrowing from the discount window. The stigma still exists even though nobody wants to admit that there is still a stigma.

So why, for the love of God, would the Fed raise the discount rate? Why make an announcement when nobody is expecting an announcement from the Fed? What purpose can it possibly serve? If it's largely symbolic, why accompany the move with a statement that says don't read anything into this? I believe that this is a big hint to the credit markets. The easy money party is nearly over. Be prepared for the Fed to turn on a dime and start making moves that aren't largely symbolic. Take heed. You have been warned.

What the Future Holds After Fed MBS Purchases End

Other than how to deal with the AIG backlash, the largest conundrum facing the Fed is how and when to pull back on its massively expansive monetary stimulus. Certainly Bernanke maintains that he will know what to do and when to do it. You know, just like he saw the housing bubble from a mile away and prevented the whole thing from happening. Right. Moving along, the Fed made it relatively clear in its announcement on interest rate policy yesterday, that it would be ending its massive Agency and MBS purchases as originally scheduled. So that's been settled. Hope everybody's ready.

Most folks are anticipating an increase in mortgage interest rates when the Fed's purchase program is over. With the Fed purchasing roughly 80% of all GSE issuance from last year, it seems the most logical conclusion. However, the WSJ did manage to find that the ranks of "mortgage bulls" are growing. These folks argue that investors who are "reaching for yield" in this great new bull market of ours will step in to purchase MBS because it is a lower risk investment than other corporates that are not explicitly backed by the US government. We saw how well that "reaching for yield" argument worked in early 2007 too, when bubble investors were trying to convince themselves to continue to purchase all sorts of crap at ridiculous prices.

So who are these fools that are about to dive into the market when the largest and currently only buyer is about to step out? Sadly, it might be your pension fund. A very interesting, yet widely ignored, article in the WSJ yesterday mentioned that pension funds were considering leveraged fixed income investments as a way to make up for all the money they have lost in the credit crisis. The pension managers were really unhappy about the fact that they had piled into stocks in the late 90's, only to get smoked. Then they followed that shrewd move by piling into private equity and hedge funds in the '00's, then got smoked. So now they are going to make up for all of it by using that low-risk strategy of purchasing high- rated fixed income products and levering up to juice returns. Because leveraged fixed income investing never blows up in your face, particularly when you dive in when rates are at historical lows and the Fed is considering pulling back on its easy monetary policy. I mean look at how well Orange County did with this strategy in 1994, and Long Term Capital in 1998. It's bound to be a big winner.

Naturally, this idea is the brainchild of pension consultants who are just looking for more and better ways to blow-out pensions so they continue to lose money so they need to hire more consultants. Because frankly, I can't think of a single reason why anyone would advise this strategy right now. Furthermore, if you wanted to give a pension fund some good advice on how to meet its 8% a year earnings target, you could've told them to pile into fixed income, without any leverage, in 2008-2009 when high quality corporates were yielding double digits. But most consultants were probably too busy cowering in the corner while their customers were yelling at them because they couldn't get their money out of that hedge fund the consultant had recommended. Not to mention the private equity fund. Or the money market fund. Oh yeah, and why the hell were their stocks all trading back at 1997 levels?

The AIG Soap Opera Continues

Tune in today for some fairly dramatic daytime television programming: the House Oversight and Government Reform Committee's hearing on AIG. The interrogations are unlikely to reveal any new information that points to a conspiracy among bankers and the Fed to siphon money out of taxpayer pockets into fat cat bankers' wallets. The truth is likely closer to the WSJ's description of emails between Fed officials in late 2008: "the emails paint a picture of confusion, uncertainty and fatigue among a small army of Fed staffers, lawyers and bankers on the rescue." So the bad news is, rather than finding a real villain in the AIG mess, the House is likely to be met with revelations of incompetence instead. I'm sure those Fed staffers were doing their best to stop the financial meltdown that was a "certainty" if the banks weren't paid 100 cents on the dollar on their CDS contracts. The real question remains: why on earth did nobody at the Fed see this coming until that fateful week in September 2008? It was widely known that AIG had a huge short CDS position, much of it tied to subprime. This became abundantly clear when its own auditor found accounting irregularities at the firm in early 2008, and the stock began its nosedive.

In any event, if we're really looking for a good conspiracy, perhaps Larry Fink from BlackRock should testify before the House and explain why his firm put out a 44-page analysis in November 2008 to the Fed that stated that the banks had significant bargaining power with AIG and had little incentive to cancel the contracts unless they received par, or 100 cents, on the dollar. But then again, if you are depending on a fund manager with very strong ties to Wall Street to tell you how much bargaining power you have with Wall Street, then you're bound to be in the noodle in negotiations.

V is for Volcker, and Also Vendetta

In what is being coined "The Volcker Rule," President Obama introduced a sweeping agenda yesterday aimed at limiting the size and scope of activities of the nation's largest banks. With former Federal Reserve Chairman Paul Volcker at his side, the President railed against the banks and promised the American taxpayer that we would no longer be held hostage by banks that are too big to fail. Although the specifics of the plan have yet to be outlined, the basic premise is that that banks would no longer be able to own hedge funds and private equity funds nor engage in prop trading. As many analysts have already pointed out, it will be extremely difficult to differentiate between customer-driven trading and proprietary trading. Take Goldman Sachs for example. The investment bank claims that only 10% of its trading profits come from prop trading. But then take a look at its balance sheet, which carries $882 billion in assets. If Goldman was strictly buying on the bid and selling on the offer, then it would carry no inventory. Clearly that is not the case, as the bank carries a tremendous inventory of financial assets. How much of it is related to customer trading? Is it hedged? (Obviously not all of it, as it wouldn't be making so much money) What about all the carry it is making holding that inventory while lending it out at zero percent? That is considered taking interest rate risk, so does that count as prop trading or customer trading? Making a distinction will be extremely difficult and banks will figure out ways to get around it.

The really big question is the following: What was the true significance of Paul Volcker's presence behind Mr. Obama as the President delivered his speech? Sure Mr. Volcker has been wandering the press circuit, calling for the repeal of Glass Steagall. But that might not be the whole story. For those who aren't familiar with Mr. Volcker, he served as Fed Chairman from 1979 to 1987. He is widely credited with stamping out the runaway inflation of the late 70's and early 80's by hiking short term interest rates to a peak of 20%. Politically, this was an extremely unpopular move, and he reportedly received death threats while in office. So you've got to hand it to the guy, he sticks to his guns, and isn't afraid to piss people off and ruin presidencies if it means doing the right thing with monetary policy.

Meanwhile, Bernanke's confirmation hearing in the Senate has been postponed and the Senate Democrats are not sure they can get enough votes to reconfirm him. Who would be a likely nominee in the event that Mr. Bernanke is not reconfirmed? Paul Volcker. Having proven himself to be perhaps one of the greatest inflation hawks of all time who doesn't bow to political influence, Mr. Volcker's possible nomination could tank the bond market. And if the bond market tanks, the stock market will follow, particularly financials. All of this is pure rampant speculation and probably unlikely, but worth considering. Next week could get interesting...

Financial Headlines 12/17/2009

• Yesterday's Fed decision yielded little unexpected news. Chairman Bernanke and his cronies basically said that the economy was a bit better, but not enough for them to actually do anything to stop the potential for a massive bubble reflation. The fed funds target will remain stuck between zero and .25%, so please, won't you please, keep buying the long bond cause we're going to need to sell ALOT more of those. But don't worry about agencies and MBS, we plan to buy another $150 billion or so of those. Oh, and by the by, you should expect some volatility in Feb after we let most of the artificial liquidity supports expire.
• Citi completed its $20 billion offering. The sale was considered a bit of a bummer, as the shares wound up being priced at around a 20% discount. Furthermore, the government backed out of its plans to sell up to $5 billion in Citi's shares that was intended to lower its stake from 34% to 30%. According to the FT, the government backed out because it would have suffered a loss on its investment. Frankly, that's a fairly stupid reason to back out of selling stock. I know the government wants to keep crowing about what a great money manager it turned out to be and how much money it has made on the TARP so far. You know, because Paulson and Geithner were smart enough to buy preferred stock in GS with a 5% dividend when Buffett got his with a 10% dividend? While the rest of the market was pricing in insolvency and the government could've and should've received a 25% dividend? Yeah, they're a bunch of geniuses. In any event, they're probably going to wait until the stock hits $2 and then try to offer it out at $3.
• In the cheery world of commercial real estate, Morgan Stanley handed over 5 more office buildings in downtown San Francisco to lenders. In yet another example of why we don't want these "savvy" investors, who don't lend to small businesses or consumers, playing with money that carries an implied government guarantee, the buildings have lost around 50% of their value since the purchase. The buildings were part of a $2.5 billion deal where MS purchased 10 buildings from Blackstone Group in May 2007. Blackstone had just purchased the buildings in its $39 billion buyout of Equity Office Properties and then flipped them for a nice profit. It's still hard to fathom how nobody recognized a bubble back in 2007 when office building flipping was a major financial activity.
• Bank of America finally found a new CEO. The job went to Brian T. Moynihan, a longtime B of A employee. In a sign that big transformative changes will be afoot as a result of hiring an insider, Mr. Moynihan said that he doesn't foresee any "big changes," nor does he plan to exit any of the companies current businesses. So yeah, his hiring will make a really big difference.

Nonfarm Payrolls Boost Stocks

Did you ever think the phrase "unemployment falls to 10% would elicit such enthusiasm?" Relatively speaking, the employment report was not too shabby, with the Labor Department reporting that nonfarm payrolls fell by only 11,000. That's practically an increase. Last month's number was also revised to an 111,000 drop. The unemployment rate edged slightly lower to 10% from 10.2% the prior month. See? Obama's jobs summit, begun just yesterday, is already working.

Assuming Mr. Bernanke gets to keep his job for another four years, an improvement in employment conditions should convince the Fed Chairman that it might be time to pull in the reigns on the quantitative easing. But then again, wouldn't it be nice to let the banks have yet another year of blockbuster profits so everyone on Wall Street can party like it's 2007 again? Certainly, that would be the easy thing to do. After all, easy has been the road that the Fed has chosen time and time again over the past few decades. Easy first, then worry about the mess from the blow-out later. Certainly, Chairman Bernanke had to take quite the beating yesterday from angry Senators who berated him for allowing the financial crisis to occur and then bailing out Wall Street, without taking any blame themselves for not enacting any regulation that might have enforced some discipline on a banking sector run-amok. And certainly his easy money predecessor Alan Greenspan never had to listen to this kind of garbage when he was in office. But it's a small price to pay to hold on to the coveted position of the man who controls the money supply in the US. No doubt Mr. Bernanke will be reconfirmed, but soon enough we are likely to learn that who we really need right now is Paul Volcker.

Fed Lousy Negotiator During AIG Crisis

So why did the Fed pay off AIG's couterparties at 100 cents on the dollar during AIG's meltdown late last year? Many of us critical of the Fed's drastic and opaque actions with respect to AIG, which it didn't even regulate or have authority to lend to, lie awake at night pondering this question. According to a government audit by the special inspector general for the TARP, the answer is that the folks at the Fed are terrible negotiators. Apparently the Fed called up AIG's counterparties late last year, asked them to cancel the swaps and take a haircut on the securities, the counterparties refused and demanded they be paid 100 cents on the dollar. The Fed said "Ok. Fine." That's your government working hard for you, as it shoveled multiple billions of dollars to Goldman Sachs, Merrill Lynch, Soc Gen, Calyon and others. Just keep that in mind next time you ever wonder who the Fed is really working for. Clearly, its allegiances lie with the big banks.

I've never actually taken a negotiations class, but common sense tells me that when you have even the tinniest bit of leverage, you use it to get a better deal. When you hold all the cards, you squeeze the living daylights out of the counterparties. Of course, when you have none, you cave. A fine example of someone who did a terrible job of negotiating was former CEO of Lehman Brothers, Dick Fuld. Mr. Fuld kept pretending that he had leverage, insisting on a ridiculous price for Lehman during its final days. Yet everyone knew he had no leverage, but Mr. Fuld refused to cave, costing him his firm. That's lousy negotiating taken to the opposite extreme. In the Fed's case with AIG's counterparties, the Fed held all the cards. Or rather, all the money. At the time, the Fed was the only game in town. Had it let AIG collapse, AIG's counterparties would've lost multiple billions of dollars. Why the Fed didn't use its leverage remains a complete mystery to me, despite its lame explanations in the inspector general's report.

In a letter accompanying the inspector general's report, the Fed claims it "acted appropriately" in its dealings with AIG's counterparties. It said its intervention in the insurer was designed to prevent a system-wide collapse. Curiously, it couldn't use its leverage as a regulator because it was acting on behalf of AIG. So instead of protecting the interests of taxpayers, whose money the Fed seems to have no trouble risking at every turn, it was protecting the interests of the bankrupt insurer that blew itself up through sheer greed and stupidity.

According to the WSJ's account of the inspector general's report, AIG's counterparties played hardball with the Fed because the Fed had already made it clear it wouldn't allow AIG to go bankrupt. They claimed they were contractually due the full value of the securities and that they had a fiduciary duty to their shareholders. Lucky for them, the Fed fell for it. The article goes on to say that the Fed's lack of leverage was rooted in decisions it made earlier in the fall, in September 2008, when the Fed felt confident that the banking industry would solve AIG's problems. After Lehman's failure, it tried to get the banks to pony up $75 billion for a loan to AIG, during which time AIG tried unsuccessfully to get the banks to accept less than full payment to cancel the swaps it had written. When those negotiations fell apart, the Fed itself lent the insurer $85 billion and then took over negotiations in early November to try to get the banks to accept haircuts. With the exception of UBS, who agreed to a 2% haircut, the banks refused. The Fed then decided that the only way to stop the cash bleed was to buy out the securities at par and cancel the swaps. There was another way, of course. It could've just given the banks the finger and let AIG fail. But then that's what a good negotiator would've done.

Bear, AIG and Other Headlines

• Ralph Cioffi and Matthew Tannin, the two former Bear Stearns hedge fund managers were found not guilty of securities fraud and insider trading. Ever since these two bozos were arrested, I've marveled that somehow they wound up as the only ones prosecuted for securities fraud from the credit crisis. After all the obvious mortgage fraud, horrendous underwriting, bogus creation of securities, stupid AAA ratings granted by the rating agencies, not to mention major conflicts of interest from certain regulators with crucial decision making powers, somehow all prosecutors could come up with were these two clowns. Two former salesman who had dreams of hedge fund greatness, who discovered in a few short years that they were really really lousy money managers. In any event, the jury didn't buy the prosecution's case, which is amazing considering how much average Americans are dying to see Wall Streeters burned at the stake.
• AIG's CEO Robert Benmosche, who has spent a whopping three months at the helm of the beleaguered insurer, told the board that he is considering stepping down. Apparently, he is really mad that the government is interfering with his ability to run the company like he wants. Pretty unbelievable that the government, which owns 80% of AIG, due to a massive $125 billion or so infusion into the otherwise bankrupt insurer would have the nerve to interfere with how the company is run. I'm not quite sure why anyone would actually care if Mr. Benmosche stays or goes. So far his biggest accomplishments have been taking a two week vacation in Croatia during the first two weeks on the job, threatening to quit when his $10.5 million pay package wasn't yet approved, and then publicly insulting various regulators with outlandish comments that no sane CEO would ever make. Here's hoping that when Mr. Benmosche does retire, he goes back on his meds.
• US Treasury Secretary Tim Geithner said Wednesday that maintaining a strong dollar is "very important" for our country's economy. Then he was caught winking at Ben Bernanke. Meanwhile, the dollar fell through 15-month lows and gold hit new highs.
• Chris Dodd, chairman of the Senate banking committee, introduced a new bill that would strip the Fed of its powers and create a single banking regulator. Naturally, neither the Fed nor the FDIC are happy about losing some of their powers, but when you've spent years asleep at the switch while the banking industry created a massive bubble, maybe you shouldn't be the one in charge next time. The bill does include a new Consumer Financial Protection Agency, which the Republicans (i.e. the banking industry) adamantly oppose, but it does not call for the break-up of large banking institutions.

Productivity, Jobs and the Fed

• Jobless claims declined by 20,000 to 512,000 for the week ended Oct 31, the lowest level since Jan 3. Continuing claims fell by 68,000 to 5,749,000. Some improvement in the employment picture, but still pretty high numbers overall. Tomorrow's employment report should be more enlightening.
• Productivity rose at a 9.5% annual rate last quarter. Naturally, companies are more efficient as they are shedding employees left and right and those left behind are forced to pick up the slack. The hope is that companies will eventually return to hiring once they've squeezed the lifeblood out of their remaining employees.
• Yesterday's decision from the Fed wasn't terribly surprising. The central bank left rates unchanged and promised The Street not to raise them for an "extended period of time" unless they sense inflationary pressures brewing. Although many (World Bank, IMF Nouriel Roubini, just to name a few) are worried about brewing bubbles popping up in asset classes around the world, the Fed has made it clear that it doesn't care about such silly things. After all, the Fed didn't care about the mother of all credit bubbles that inflated between 2005-2007, so why should it start caring now? We have all the rescue vehicles we need in place. We'll just bail everybody out again when we have to, right?
• When I said that the Fed promised The Street it wouldn't raise rates for an extended period of time, I was being very specific. It is a promise to the Street, because Wall Street is benefitting the most from the zero interest rate, quantitative easing, free money bonanza. That is why we keep seeing articles with headlines such as "Goldman Benefits From Trading Bonanza" in the FT today, as well as "Big Bonuses Are Back For Many on Street" from the WSJ.

Blackstone Hoping to Renegotiate Hilton Debt

I give Blackstone bonus points for attempting to fix its pesky $20 billion Hilton debt problem before the crud actually hits the fan. Apparently, the private equity group is hoping to convince holders of the debt to make some minor adjustments, like swapping their crappy debt for crappier equity, or extending maturities out even further, maybe until 2050 when the commercial real estate market starts booming again. Blackstone is even offering to contribute $800 million in additional equity to buy back debt at a discount. So many fancy accounting and financing tricks, so little time. The problem is it is hard to escape a turkey of a deal like the Hilton LBO, that was struck during the fairy tale days of the credit bubble. Unfortunately, it is hard for us to escape the Hilton LBO as well, for the Fed owns $4 billion in Hilton bonds, courtesy of Bear Stearns, via that awesome $29 billion risk-free loan the Fed gave to JP Morgan so it could purchase the more solvent portions of Bear. The only good news is that the terms of the debt limit Blackstone's ability to repurchase Hilton debt.

Blackstone is hoping to cut the debt load by $5 billion, as I'm sure that will make its equity portion worth more. After already writing off the investment by two-thirds, Blackstone needs all the help it can get to make its investors whole. I wish them luck with their negotiations. Personally, as a senior debt holder, I'd tell them to take a hike. Maybe cough up another $5 billion in equity? Then we can talk.

Mr. Bernanke is probably just getting a phone call right now from Steve Schwarzman asking him to take a haircut on the Fed's Hilton debt. Mr. Bernanke wonders out loud "How'd we wind up owning Hilton bonds?" An assistant whispers something in his ear. He sighs, then picks up the phone to call Blackrock, to find out what to do...