December 13, 2011

No doubt you've read about the European Union summit meeting in Brussels this past week, which was billed, in advance, as the negotiation that would finally deliver a final solution to Europe's debt crisis. You will probably not be surprised to hear that the outcome fell “short of expectations.”

In all, 23 of the 27 European nations agreed to follow the lead of France and Germany. They drafted a resolution to impose more central control over national budgets, and enforce future spending and budget discipline across the 17 countries that use the euro as their currency. The summit, in other words, focused on preventing the next debt crisis rather than finding ways to meet the current one head-on. 

Even future discipline may be too much to expect. One of the holdouts to the resolution was a major player: Great Britain, whose stiff opposition to mandatory budget guidelines (and giving up control to an outside agency) means that the other governments will have to enforce their agreement as an "understanding" between governments rather than through the full authority of a treaty. (The other non-signatories--Sweden, the Czech Republic and Hungary--want to consult their legislative bodies before signing on for more austerity.) 

In separate analyses, the Economist magazine and economist Cliff Wachtel tell us that there was no progress on addressing the immediate threat of default of Greek, Italian and Spanish bonds, which has become more pressing as their rates soar on the open market. On Thursday, Germany rejected proposals to strengthen the European Central Bank's bailout fund, and the ECB's central banker later announced that he had no plans to lower bond rates or buy government bonds outright. 

The Wall Street Journal reported that currency traders were not impressed by this outcome. They boosted the euro's value a bit on Friday to essentially where it was last week. Credit analysts at Moody's and Standard & Poors were apparently even less impressed. Moody's issued downgrades on the solvency of three major French banks. S&P put several European nations on a downgrade watch; look for France to be the next major nation to suffer the indignity of a ratings drop.

Bond defaults are one worry in Europe; the other is recession. Economists at investment bank UBS announced, during the summit meeting, that they expect the 17-nation Eurozone's aggregate economic growth to fall into negative territory (-0.7%) next year. Without stimulus, with declining economic activity, European nations will have to make do with lower tax revenues, further calling into question their ability to pay the debt they already owe. The threat of default causes investors to demand ever-higher bond rates, raising borrowing costs and making default more likely. 

Interestingly, you find the opposite dynamic in the U.S., where economic growth was a modest but positive 2% for the third quarter, fueled by gains in retail sales, manufacturing and housing. This is good news, an improvement over the 1.3% growth in the second quarter. The U.S. unemployment rate, which topped 10% in 2009, has quietly fallen back to 8.6%. But the U.S. Federal Reserve Board wants better news; on Tuesday, the Fed is expected to announce a strong commitment to keeping the federal funds rate near zero, and may soon undertake a third round of buying U.S. bonds as a way to encourage the housing and labor markets. Europe and the U.S. may be moving in opposite directions, in part because of opposite measures from their respective central banks.

Sincerely,

Edward J. Kohlhepp, CFP^®, ChFC, CLU, CPC, MSPA

Edward J. Kohlhepp, Jr., CFP^®, MBA

Please contact us whenever there are any changes to your financial situation, personal situation or investment objectives.

www.bobveres.com

Wall Street Journal article: http://online.wsj.com/article/SB10001424052970203413304577088752248526164.html

The Economist: http://www.economist.com/blogs/charlemagne/2011/12/britain-and-eu-summit

Wachtel: http://seekingalpha.com/article/313050-prior-week-eu-summit-fails-yet-markets-rally-here-s-why

2% growth: http://www.bloomberg.com/news/2011-11-22/economy-in-u-s-expands-less-than-estimated-as-companies-cut-inventories.html

December 2, 2011

This e-newsletter is a bit long, but I think you will find it interesting.

If you look hard enough, you can find a lot of silliness in the Occupy Wall Street movement. This is unfortunate because, somewhere behind the tents and weird finger communications and alleged drug use, there's a real story to be told. And the story seems to be bigger than the media can get its arms around.

For example? Financial insiders and those of us in the financial planning profession have watched the brokerage industry (such as Merrill Lynch, JP Morgan, etc.) fight furiously--and successfully--against having to register their brokers with the Securities and Exchange Commission as registered investment advisors. Why? Because that would require the registered brokers to give advice that puts the interests of their customers ahead of their own and also (quel horreur!) ahead of the companies that employ them. 

Perhaps more to the point, those of us in the financial profession have to live with the fact that the major Wall Street firms are rarely held accountable for crimes and other actions that would be severely punished if you or I committed them. 

Such as? Consider the recent settlement of an enforcement case that goes back to the 2008 market meltdown. The Wall Street Journal reported that U.S. District Court Judge Jed S. Rakoff is questioning how diligently the U.S. Securities and Exchange Commission enforced securities law when it investigated Citigroup (parent company of brokerage giant Smith Barney) regarding its sale of some of those infamous toxic mortgage-based debt instruments. Smith Barney brokers were selling the subprime mortgage instruments to their customers as highly-rated, safe bond instruments at the same time that the company's traders were betting heavily that the same packaged bonds would spiral down the toilet. In internal e-mails, one chortling trader described betting against the investments the company was selling, at a commission, to its customers as "The best short ever!!"

This once-in-a-lifetime short bet, combined with selling the dog investments in the first place, resulted in what the SEC estimated to be $160 million in fees and trading profits to Citigroup's bottom line.

The SEC's proposed fine, questioned by the judge: $95 million.

It gets worse. In the SEC's boilerplate language when it settles with major Wall Street firms, Citigroup and Smith Barney were allowed to neither admit nor deny the charges that they would be paying fines to settle. Judge Rakoff questioned whether there wasn't "an overriding public interest in determining whether the SEC's charges are true." Indeed.

Our regulators' very careful, very gentle admonishment of Wall Street's nastiest crimes has become such a routine part of our professional landscape that most of us in the financial services business have lost sight of how outrageous it really is. To put this in perspective, suppose you decided to go out and steal a neighbor's flat-screen TV set. If you were caught, would the justice system require you to pay back a portion of the cost of it, never have to admit guilt, and promise to watch yourself more carefully in the future? 

Might people in all walks of life behave differently if they knew that the routine consequences of their crimes would be so lenient?

While the financial press is reporting on Wall Street crimes gone unpunished, the consumer press is groping to figure out how the rise of enormous, greedy financial gatekeepers is impacting the American economy as a whole. No doubt you've read accounts of how the large investment banks took hundreds of billions of dollars in taxpayer bailout money, and then refused to lend money back into the American economy as it was teetering on the brink.   But Time Magazine recently took a deeper look, in a cover article that concludes that America is no longer the world's leader in upward mobility--the land of opportunity--that it once was.

The magazine rightly calls America the "original meritocracy," where people were never supposed to be prisoners of the circumstances of their birth. Hard work defined the destiny of Americans. Those who were diligent were able to move out of poverty.

But then the magazine cites research by the Pew Charitable Trust's Economic Mobility Project, the Brookings Institute and the Organization for Economic Co-operation and Development, all of whom found that today it is harder for a person in America to move up/out of his/her current economic status than it is in (I hope you're sitting down) Europe. Today, 42% of American men with fathers in the bottom fifth of the earning curve remain there--and you know that at least SOME of them were hard-workers. Only a quarter of comparable men in Denmark and Sweden, and only 30% of men in Great Britain do. France and Germany ranked higher on the opportunity scale than today's America. Sweden and Finland ranked much higher.

How did this happen? The magazine found that the financial sector in America now takes up about 8% of the American economy--a historic high--and this has been correlated with a stall in American entrepreneurship. Meanwhile, the people who run America's companies today earn more than 400 times as much as their lowest-paid worker, while the comparable number in Europe is around 40. Oddly, perhaps coincidentally, Europe's gap between CEO and lowest paid worker is almost exactly where it was in this country, when America was still being called the Land of Opportunity.

To round out the “Occupy Wall Street” picture, some researchers are actually starting to question whether the economy needs the banking sector, and what for? In what may be the most accessible report on this wonkish debate, London School of Economics professor Wouter den Haan notes that when the U.S. economy was emerging as the world's leader, in the decades after World War II, the large investment banks generated about 1.5% of the total profits in the economy. Today, that figure is around 15%--ten times as much. 

When the profits were at 1.5%, bankers circulated money efficiently around the business landscape in the form of loans that were carefully researched. That, clearly, provided an enormous net value to society. But the professor wonders whether it is equally valuable when those firms began to extract "huge fees from the rest of the economy to construct opaque securities that were so complex that only a few understood how risky they were." If the prices had accurately reflected the true value of the products, he says, then those fees would have been negative, "since many such products were not beneficial to the buyer or to society as a whole."

The article doesn't consider the economic value that is created for society when a brokerage firm makes its profits betting against the toxic securities it created and sold to its customers.

Very little of these various issues are understood specifically by the people who are squabbling with police over whether they can pitch their tents in parks near the largest financial offices. The “Occupy Wall Street” crowd is acting on nothing more than a strong instinct that something is terribly wrong in America, and that the large banks are somehow at the center of the problem. The press can only seem to get its arms around little individual pieces of a very big picture. 

But that picture, if we can see it clearly, is troubling. The American Dream is at stake. So, too, is the fairness of our legal system. What Wall Street fears more than anything else is a debate that asks whether much of what goes on in the largest investment banks--perhaps as much as 90% of it, based on current statistics--is doing our country and our economy more harm than good. Even more, it fears the idea that its hired representatives (the brokers) should have to give advice that primarily benefits their customers--which would immediately put an end to both the lucrative sales of creative new toxic securities and the revenue streams that would come from betting against them. 

If we can start that debate in earnest, maybe the tents can come down. Or, at least, the people living in them could tell the reporters who cover them exactly what it is they're protesting.

Sincerely,

Edward J. Kohlhepp, CFP^®, ChFC, CLU, CPC, MSPA

Edward J. Kohlhepp, Jr., CFP^®, MBA

Please contact us whenever there are any changes to your financial situation, personal situation or investment objectives.

Sources:

www.bobveres.com

Rakoff and the SEC: http://blogs.wsj.com/law/2011/10/28/sec-may-have-to-get-admissions/

http://www.cbsnews.com/8301-501369_162-20126566/ny-judge-challenges-$285m-citigroup-settlement/?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+CBSNewsTravelGuru+%28Travel+Guru%3A+CBSNews.com%29

Time magazine article: http://www.time.com/time/magazine/article/0,9171,2098586,00.html

Wouter den Haan blog: http://pragcap.com/why-do-we-need-a-financial-sector

What might this mean for the economy & the markets?

November 28, 2011

Congress punts on third down. Unable to reach consensus, the Congressional super committee of 12 offered America a disappointing result Monday. Panel co-chairs Rep. Jeb Hensarling (R-TX) and Sen. Patty Murray (D-WA) announced that “it will not be possible to make any bipartisan agreement available to the public before the committee's deadline" on November 23, throwing in the towel with two days to go.¹

The big divide was over the Bush-era tax cuts. While Sen. John Kerry (D-MA) reminded the public and his fellow legislators that “we are not a tax-cutting committee, we’re a deficit-reduction committee,” there was stiff opposition to rolling back the EGTRRA and JGTRRA cuts of the 2000s. The super committee paired some strange bedfellows among Capitol Hill legislators, so this head-butting was not unexpected.²

What happens now? As the super committee failed to create a plan to trim $1.2 trillion or more from the federal deficit, that sets things up for an automatic $1.2 trillion in cuts effective over a 10-year stretch beginning January 2, 2013.(Notice that this is after the November 2012 elections). According to the Budget Control Act passed in summer 2011, that $1.2 trillion will be slashed almost 50/50 from the defense budget and government services programs. Social Security and Medicaid payments, military pay and veteran’s benefits will be exempt from cuts; current Medicare recipients will not be directly affected. This default deficit reduction could mean as much as a 9.3% cut to some federal programs, by the estimate of the Center for Budget and Policy Priorities.^3,4

This is what the super committee’s apparent failure means politically. Economically, it could result in pain for American investors given the probable impact on our credit rating, stock market, tax laws and economic growth.

Is another downgrade ahead? Standard and Poor’s cut the U.S. credit rating a notch to ‘AA+’ on July 14, and it warned that another cut to ‘AA’ was possible by mid-2013 without decisive federal action on the issue. After the super committee conceded defeat on November 21, S&P, Fitch’s and Moody’s stood pat regarding a possible downgrade.^5,6

What might be in store for the market? In a November 21 note to investors, Goldman Sachs equity strategist David Kostin warned that the S&P 500 could potentially correct to 1100 as a result of this gaffe. Other analysts are less gloomy; some feel that the market may have priced this one in and will at least maintain some momentum barring a second downgrade (last Monday’s selloff certainly could have been worse).⁷

What does this mean tax-wise? The Bush-era tax cuts are set to expire at the end of 2012 as part of the involuntary deficit reduction now set to occur. There could be other possible tax consequences as a result of the super committee’s failure. Unless Congress unexpectedly passes the President’s American Jobs Act, the payroll tax holiday will go away in 2012 (worth about $935 to the average worker, which some legislators wanted to make permanent). RBC Capital Markets analysts warn that taking the payroll tax back to 6.2% could shave 1% off U.S. GDP next year. For businesses, the current “bonus” depreciation write-offs for new capital equipment and the R&E tax credit could also become casualties. Additionally, when you do a broad cut to federal programs, you are impacting payments from Washington to state programs; state taxes could rise to compensate for that lost money.^4,8

How about Medicare, the SSA & jobless benefits? While Medicare recipients won’t be bitten by the default deficit reduction, payments to Medicare providers could be shrunk by 2%. Long-term unemployment insurance would also dry up for 2.1 million Americans by February, according to the Department of Labor’s forecast; JPMorgan Chase economists think that development alone might hurt U.S. GDP by 0.75%.^4,8

The Social Security Administration is in line for budget cuts as a result of the super committee’s indecision, along with Head Start and federal job training programs. A Congressional Budget Office analysis shows that the Pentagon would face the largest cut in 2013 (10%). Federal agriculture, environmental and education programs would face cuts of approximately 8% starting in that year.^4,9

Could congress “undo” this? President Obama is emphatic that there will be no rewind on this one. While there could be a move in Congress to try and nullify or alter the automatic budget cuts, the President has said he will not support such a bill.

There had to be deficit reduction at some point, and the legislators of the super committee faced a Herculean task to come up with a plan that satisfied their many constituencies. However, it will be difficult to convince economists and investors that doing nothing is better than doing something; this unpalatable easy out may leave many in the lurch.

Sincerely,

Edward J. Kohlhepp, CFP^®, ChFC, CLU, CPC, MSPA

Edward J. Kohlhepp, Jr., CFP^®, MBA

Please contact us whenever there are any changes to your financial situation, personal situation or investment objectives.

Citations

1 –www.cnbc.com/id/45391077 [11/21/11]

2 - www.foxnews.com/politics/2011/11/20/blame-game-erupts-as-hope-for-deficit-deal-fades/ [10/20/11]

3 - blogs.abcnews.com/politicalpunch/2011/07/debt-ceiling-framework-where-they-landed.html [7/31/11]             

4 - www.usnews.com/news/articles/2011/11/21/so-the-super-committee-failed-how-will-that-affect-you [11/21/11]

5 - bloomberg.com/news/2011-08-06/u-s-credit-rating-cut-by-s-p-for-first-time-on-deficit-reduction-accord.html [8/5/11] 

6 - blogs.wsj.com/marketbeat/2011/11/21/sp-super-failure-wont-affect-us-credit-rating/?mod=google_news_blog [11/21/11]

7 - www.cnbc.com/id/45355898 [11/21/11]

8 - www.csmonitor.com/Business/Latest-News-Wires/2011/11/21/Super-committee-fails [11/21/11]

9 – www.foxnews.com/politics/2011/11/21/clock-ticks-down-to-super-committee-failure/ [11/21/11]

Bond yields climb dangerously high. It looks like the EU may forego a bailout.

November 22, 2011

The Eurozone has another mess on its hands. On November 9, the yield on Italy’s 10-year bond soared to 7.46% - an interest rate clearly unthinkable in the long run, a danger signal EU leaders had to address immediately.¹

Bond yields above 7% have served as a kind of litmus test for the European Union. When 10-year yields topped 7% in Portugal and Ireland, those countries got bailouts, but a bailout for Italy is unlikely. Quite simply, Italy is too big to be rescued; it appears the nation will just have to save itself.

“Financial assistance is not in the cards.” So said one Eurozone official (who preferred to remain anonymous) to Reuters; that official said that Italy would not even get a preventive credit line from the EU.¹

Italy dwarfs Greece in economic magnitude. The Dallas-Fort Worth metroplex contributes about as much to the world economy as Greece does. In contrast, Italy is the third-largest economy in the Eurozone and the eighth-largest economy in the world. It is now carrying somewhere between $2.2-2.6 trillion in debt, making its debt ratio 110-130% of its 2010 GDP.^1,2,3

Here’s why a bailout seems off the table. Italy’s sovereign debt is about €1.7 trillion; three times that of Spain, and almost six times that of Greece. Across the next three years, it will have to come up with roughly €650-700 billion to avoid default (so estimates a forecast from Capital Economics). Even with its future increase, the European Financial Stability Fund would be drawn down alarmingly by a bailout of that size. Since Italy is hardly the only EU nation still in trouble, the EFSF would probably be loath to commit to such a mammoth rescue. The three major players funding the EFSF are Germany, France and Italy.^2,4

Guess what EU nation is one of the world’s key government bond markets. That’s right: Italy. Its 10-year note rates rose above 7% on fear that it won’t be able to repay what it owes on government debt. Are the higher yields going to be attractive to foreign investors? Hardly, given that Moody’s and other credit rating agencies have given Italy downgrades.²

Name the EU member economy to which U.S. banks are most exposed. Again, the answer is Italy. According to Barclays Capital, that exposure amounted to about $269 billion in total claims as of July. European banks are six times as exposed to Italy ($998.7 billion) as they are to Greece ($162.4 billion).⁵

A call for a core Eurozone. Not surprisingly, French president Nicolas Sarkozy and German chancellor Angela Merkel have visions of an altered EU. On November 8, Sarkozy spoke of a two-tier Europe. It would feature a smaller and more financially integrated core Eurozone comprised of the most economically influential nations on the continent, with the bulk of the EU as a confederation of less economically influential countries with less say in policymaking.⁶

The weeks ahead are crucial. With the debt issues in Italy escalating, the European (and global) economy is looking at another major challenge. Can the European Central Bank buy up a whole bunch of Italian paper? If so, what concessions will Italy have to make? How contagious will this crisis prove, and how will it impact America?

Pronounced volatility may be the norm for the next few weeks or months on Wall Street.  In the meantime, let’s all remember to be thankful for our blessings. We wish you all a wonderful, safe, happy Thanksgiving! 

Sincerely,

Edward J. Kohlhepp, CFP^®, ChFC, CLU, CPC, MSPA

Edward J. Kohlhepp, Jr., CFP^®, MBA

Please contact us whenever there are any changes to your financial situation, personal situation or investment objectives.

Citations.

1 – www.cnbc.com/id/45225893 [11/9/11]        

2 – www.guardian.co.uk/business/2011/nov/09/italys-debt-crisis-ten-reasons-to-be-fearful [11/9/11]   

2 – www.guardian.co.uk/business/2011/nov/09/italys-debt-crisis-ten-reasons-to-be-fearful [11/9/11]   

3 – www.npr.org/templates/story/story.php?storyId=142158007 [11/9/11] 

4 – www.npr.org/blogs/money/2011/11/09/142169733/why-italy-is-so-scary [11/9/11]            

5 – www.nytimes.com/2011/07/12/business/global/italy-evolves-into-eus-next-weak-link.html [7/11/11]

6 –www.reuters.com/article/2011/11/09/us-eurozone-future-sarkozy-idUSTRE7A85VV20111109 [11/9/11]