Author: Daniel Indiviglio

There’s some broad misunderstanding among a number of news outlets about some of the provisions in financial reform. That’s not entirely surprising, because these are huge, complicated bills. But major media outfits should try to get the big issues right. Numerous outlets continue to report that the Senate has a strong provision of the so-called Volcker Rule, which would prevent banks from proprietary trading, while the House bill doesn’t contain any version. This isn’t right.

First, the Senate’s bill (.pdf) only sort of creates a proprietary trading ban. It says (in section 619):

Subject to the recommendations and modifications of the Council under subsection (g), and except as provided in paragraph (2) or (3), the appropriate Federal banking agencies shall, through a rulemaking under subsection (g), jointly prohibit proprietary trading by an insured depository institution, a company that controls, directly or indirectly, an insured depository institution or is treated as a bank holding company for purposes of the Bank Holding Company Act of 1956 (12 U.S.C. 1841 et seq.), and any subsidiary of such institution or company.

So yes, proprietary trading will be banned, subject to subsection (g). And that subsection says that the new Council of regulators will do a study to make sure that institutions are safer without prop trading and the ban doesn’t cause the cost of credit to increase, among other things. So this isn’t a slam dunk. If the Council decides that banning prop trading will harm banks and credit, then it will nullify the provision.

Moreover, despite what new outlets are saying, the House’s bill (.pdf) actually does contain a provision that could do much the same thing. It says (in section 1117):

If the Board determines that propriety trading by a financial holding company subject to stricter standards poses an existing or foreseeable threat to the safety and soundness of such company or to the financial stability of the United States, the Board may prohibit such company from engaging in propriety trading.

Interestingly, the House version preceded the Obama administration championing the proposal and giving it the nickname of the Volcker Rule. It’s different than the Senate’s proposal for two main reasons. First, it doesn’t call for a blanket ban, but allows regulator discretion over which firms should not be allowed to engage in proprietary trading. Second, it gives the power to the Federal Reserve Board to determine which firms to ban from proprietary trading, instead of giving the Council this responsibility.

So which provision is stronger? It could go either way. The Senate’s version calls for a blanket band, which might seem stronger. But the diverse group of regulators sitting on the Council must still consent — after doing an extensive study. The House version, however, gives the Fed more power to forbid whatever large firms it pleases from prop trading, without a study.

Ultimately, it depends on the view of the Fed versus that of the Council. Opponents of the House version who favor the Volcker rule might complain that the Fed won’t ban big banks from prop trading, so the provision is useless. Of course, the same complaint could be made about the Senate version, if you believe the Council will ultimately decide not to enact the ban after its study.

But it should be clear that each bill sort of calls for a ban on prop trading in its own way. They just disagree on how it should be done. That will have to be ironed out during the conference process. Expect to see something in between the House and Senate version, which would specifically exclude insurance companies and allow banks to continue to offer asset management to clients. House Financial Services Committee Chairman Barney Frank (D-MA) has already promised he will fight for these exclusions. The way the House bill is written, these exclusions would already exist.

Americans practically fell over themselves to take advantage of the home buyer credit before its expiration in April. Existing home sales rose to the annualized level of 5.77 million. That’s 7.6% higher than in March, and the largest increase since November — the last consumers were rushing to take advantage of the credit before it was set to expire. Yet, sales didn’t rise enough to decrease the housing inventory. On the contrary, inventory rose by 11.5%. Despite the increase in sales for April, the housing market remains fragile.

So first, the good news. Here’s a chart showing the change in home sales:

April 2010’s existing sales were 22.8% higher than a year earlier. You can see the steep rise created by the home buyer credit this spring. Indeed, the increase in sales due to the mortgage credit was quite predictable. Check out how the rate of existing home sales changed compared to one and two months prior to April compared to November:

You can see how close those rates are in both cases. However, the big difference is that last fall the starting point was higher than it was in early 2010. As a result, fewer existing home sales were recorded this time around.

Home prices also increased in April. The median price was up by 2.1% to $173,100 from $169,600 in March. April’s median was the highest price we’ve seen since September, and 4.0% higher than in April 2009.

So that all sounds great — home sales and prices are rising. If increasing sales were sustainable, then that would be good for the housing market. But the data for new mortgage applications for purchases in May indicates quite the opposite: they fell by a drastic 34% in May.

To make matters worse, housing inventory actually rose in April, despite the additional sales. And it increased a lot:

As you can see, it’s risen steeply since January — up 23.4%. This might look bad, but if sales plummet in May and the months that follow, as predicted by mortgage applications, then inventory will rise even further. At this point, it’s at 4.04 million homes, the highest we’ve seen since July 2009. But a month or two of significant gain could easily put it above record the 4.58 million level hit in July 2008. As foreclosures continue to occur at an elevated rate, a new high for inventory this summer wouldn’t be surprising.

Additional home inventory, along with lackluster buyer demand with the credit gone, should make it hard for prices to continue to rise in the short-term. We can expect some sobering news over the next few months about the housing market recovery.

Note: All data above is seasonally adjusted.

Mortgage – U.S. Housing Market – Business – Foreclosure – Real estate

The health care reform battle was wildly popular among Americans, because every person felt like the issue directly affected their lives. The financial reform battle? Not so popular. Its subject matter is more obscure, and it’s not clearly relevant to the lives of regular people who work outside the financial industry. Yet as we learned through the 2008 crisis, banking and credit can affect everybody. Just as bad health care can create human suffering, so can a toxic financial market.

Each of the foundational sections that will definitely be in the final bill is listed below (see this post for some explanation of the proposals). In each section, you will see how they will affect every American — not just those who work at a bank or hedge fund. But like any regulations, there are potential positive and negative consequences.

Systemic Risk Regulator

The Good: The hope is that this will enhance economic stability by spotting and fixing economic shocks before they hit. That means unemployment rates shouldn’t be a severe during recessions.

The Bad: Of course, we can’t be sure that the crystal ball of this new regulator will be any better than that of previous regulators. It could be a costly waste. The average Americans will face higher prices for products offered by the firms on which it imposes additional regulatory burden. Taxpayers will also be on the hook for its administrative expensive.

Non-Bank Resolution Authority

The Good: Again, economic stability is the goal here by quickly and painlessly winding down big firms.

The Bad: The way Congress structured it, the taxpayers will have to loan the FDIC the money to cover costs for winding down big institutions that fail. So if that includes paying creditors that the failed firm owes $10 billion to, for example, then that money will come in part from your tax return. Those firms are required to pay back the FDIC in full, but if they also go bankrupt before they can, then taxpayers could still end up with a loss.

Consumer Financial Protection Agency/Bureau

The Good: This one is easiest to relate to the average American. If it works as intentioned, it will protect consumers from dangerous financial products. Think: option adjustable-rate mortgages. Such toxic loans could be forbidden. It also seeks to ban abusive credit practices. Additionally, the agency will impose new requirements on borrowers — like proving your income before being provided a loan.

The Bad: This will limit the options available to consumers, as it will probably eliminate some products from the marketplace that it deems dangerous. You can also expect credit to cost more. As we saw with the credit card regulation last year, when banks are ordered to change their practices, consumers get stuck with a higher bill.

Regulation of the Derivatives Market

The Good: These new rules could produce a more stable economy, if advocates for this regulation are right.

The Bad: It’s easy, however, to see how these new requirements could make consumers worse off. It will likely be quite expensive for small banks and real estate shops with a weak capital base to utilize derivatives if they must be cleared (longer explanation here). That means more expensive loans for consumers.

New Rules for Securitization

The Good: Again, the hope is better economic stability if better underwriting produces safer asset-backed securities.

The Bad: By forcing banks to retain some of their securitizations, however, they will be forced to originate fewer loans. That will lead to less credit availability, which will raise the price of credit for consumers. Those people without spotless credit will also have more trouble getting loans going forward.

If all works as Congress anticipates, the result will be a more stable economy and additional protection for consumers in their financial transactions. But as you can see, those potential benefits also come with a great many costs.

Financial services – Federal Deposit Insurance Corporation – Credit card – Congress – Bank

Toyota is interested in the electric car market too. The company announced a new partnership with and sizable equity investment in the young American electric car company Tesla. Although Toyota has had great success with its hybrid vehicles, it had not shown much intention of entering the electric car space — until now. The move is a good one for both automakers.

The two companies “intend to cooperate on the development of electric vehicles, parts, and production system and engineering support,” according to the press release. Toyota will also purchase $50 million in Tesla equity. Additionally, Tesla will purchase an old factory in California that had been formerly used as apart of the now defunct Toyota-GM partnership.

Smart for Toyota

Puts Automaker Immediately into the EV Race

Two of Toyota’s chief competitors — GM and Nissan — are on the verge of releasing mass market plug-in electric vehicles. Toyota’s ability to leverage Tesla’s electric car expertise should significantly condense the time it would have taken Toyota to produce a vehicle of its own. Even though the company still won’t get a new electric car out as quickly as GM and Nissan, there’s little doubt that Toyota will now produce a high-volume electric car before too long.

Cheap Foray into the EV Market

Not only does Toyota now have Tesla’s expertise at its fingertips, but it came relatively cheap. If it were to attempt to develop an electric vehicle platform on its own from scratch, the investment would have been far more significant than the $50 million piece of Tesla it purchased. This also hedges Toyota’s risk: if the electric vehicle market turns out to be a dud with consumers, the company would have wasted a huge investment developing its own expertise and infrastructure.

Helps Public Image

After the accelerator fiasco, Toyota could use a strong dose of good public relations. Since electric cars are associated with environmental protection and green aspirations, it will likely give Toyota’s public image a little boost.

Smart for Tesla

Toyota Is a Partner You Want

In fact, this deal is arguably even better for Tesla than Toyota. The company was created in 2003, and is still a relatively small operation. By trading some of its engineering expertise for some of Toyota’s production and distribution knowledge, its business model should strongly benefit. No auto company has been as successful as Toyota over the past few decades.

Boosts Its Brand

The majority of Americans have probably never heard of Tesla, but almost everyone has heard of Toyota. Tesla should be able to leverage Toyota’s popularity to create greater awareness of its own brand. Although Tesla has focused on luxury electric vehicles up to now, its aspirations to make mass market vehicles will be more easily achieved through better brand recognition.

Helps Sustain Its Growth

This deal should allow Tesla to continue to grow quickly. First, there’s the investment. $50 million might not sound like a huge amount of money for a big automaker, but for a small one, that can go a long way. Moreover, for Tesla this deal is all about expansion. Tesla plans to build its Model S as a higher volume family car than its Roadster. Toyota’s knowledge will help this effort succeed, as the Japanese automaker knows all about manufacturing cheaper vehicles with widespread consumer appeal. But this is just the beginning for Tesla. The Model S will only occupy a small part of the factory — leaving lots of room for additional new models, according to the New York Times.

Partnerships like this aren’t always easy. It’s fairly likely the culture of each firm is quite different. Toyota is an established Japanese automaker, while Tesla is a young American start-up. But if Toyota and Tesla manage to work well together, then they should both reap huge dividends through their cooperation.

Toyota – ModelS – ElectricVehicle – Tesla Motors – Electric car

Thursday night the Senate passed the most robust financial regulation bill since the Great Depression. The legislation, authored by Banking Committee Chairman Christopher Dodd (D-CT), passed mostly along party-lines, 59 to 39. Four Republicans voted in favor; two Democrats voted in opposition; and two Democrats abstained. The bill will now have to be reconciled through the conference process with the mostly less aggressive House’s bill passed in December.

The Republicans could have delayed the final vote for 30 hours after the cloture motion passed on Thursday afternoon, but declined to do so. Without any hope of derailing the bill, there really would have been no point in a delay.

There were a few amendments that were supposed to be voted on before the final vote, however. The first was sponsored by Sen. Brownback (R-KS) and would have excluded auto dealers from the consumer financial protection bureau’s jurisdiction. But Republicans declined to bring up the amendment, as not forcing a vote automatically killed another amendment that they were against — one sponsored by Senators Merkely (D-OR) and Levin (D-MI) that would have banned banks from proprietary trading. Republicans are likely hoping that they get their amendment through the conference process, however, since the House bill excludes auto dealers from the new consumer protection regulator.

As for the final tally, the four Republicans Senators voting in favor included Olympia Snow (ME), Susan Collins (ME), Scott Brown (MA), and Charles Grassley (IA). The only surprise there was Grassley, who did not side with Democrats on the cloture vote. The two Democratic Senators who voted against the bill were Russ Feingold (WI) and Maria Cantwell (WA). Their vote reflected their disapproval that additional more aggressive amendments were not given a vote before final passage. Senators Arlen Specter (D-PA) and Robert Byrd (D-WV) did not vote.

The House and Senate bills have many similarities; in fact, it’s probably not a stretch to say that they are both built on the same foundational ideas. They each create a new systemic risk regulator, non-bank resolution authority, consumer watchdog, and a more aggressive regulatory framework for derivatives and securitization. But there are also some very important differences between the two bills, as the Senate bill is more aggressive in some ways, like on rating agencies and derivatives. But the House’s bill contains tougher language in other sections, such as setting leverage limits and creating a truly independent consumer financial protection agency.

In the weeks to come, the two chambers will have to compromise on a final version of the bill. Then it will make its way to President Obama’s desk, who will eagerly sign it into law. Given the sense of urgency among Democrats to wrap the bill up, we should see the President sign it this summer.

Maria Cantwell – Russ Feingold – Susan Collins – Arlen Specter – Robert Byrd

Probably not, but her jewelry may be. Miley Cyrus’s entire line of necklaces and bracelets has been pulled from the shelves of Wal-mart after tests determined that they contain high levels of the toxic metal cadmium. This is an awful scandal for both Cyrus and Wal-mart.

First, how did this oversight occur? According to the Associated Press, which broke the story, the jewelry was imported from China. The article explains that Wal-mart began a policy last month to require suppliers to prove their products contain little or no cadmium, but this jewelry must have slipped through the cracks.

According to Wal-mart, the jewelry is probably not a threat. Cadmium is only known to be toxic of ingested. But the retail giant tells AP that the jewelry was not intended for children. That claim, however, borders on preposterous, considering that virtually all of the teen star’s fans are kids. But Wal-mart probably means that very young children, who are more likely to bite or suck on a product, wouldn’t generally wear the jewelry.

Still, the damage is done. Events like these can cause some customers to lose trust in large retailers like Wal-mart. Product safety is generally something of a base-motivation for consumer purchases. Just ask Toyota. Even if no lawsuits come from of this incident, it could result in a pretty bad tarnish on the firm’s reputation — especially given parents’ likely reaction since the product has a hugely popular child star’s name attached.

This incident should also serve as a lesson for entertainers turned retailers. What’s a great way to anger your fans? Sell them harmful products. You shouldn’t put your name on a product without doing significant due diligence first. In the case of Cyrus, it’s hard to imagine that at 17-years-old, she should have been expected to ask her distributor if the products contained cadmium. But celebrities need to keep in mind these kinds of concerns when pedaling products bearing their name. In the case of Cyrus, she should be concerned about losing the trust of parents, in particular. They, after all, are the ones who pay for her movies, music, and now retail products that are making her rich.

It’s somewhat understandable that Democrats are having trouble convincing Republicans to vote for their aggressive financial reform bill. They are, after all, political opponents. But why can’t Democrats get all of their own Senators on board? Yesterday’s cloture vote included two Republicans, plenty to get the 60 needed if all 59 Democrats had voted in favor. But two — Sen. Maria Cantwell (D-WA) and Sen. Russ Feingold (D-WI) — voted against the motion. Each wanted at least a few more amendments heard. Why is that too much to ask?

A few of the prominent progressive amendments that haven’t been voted on include Cantwell’s proposal and one by Senators Merkley (D-OR) and Levin (D-MI). Cantwell’s amendment would reinstate the investment and commercial banking separation that Glass-Steagall required, and the Merkley-Levin amendment would put in place the Volcker Rule’s proprietary trading ban for banks.

There are two possibilities to consider here. One is that, despite Democratic leadership aggressively working to bring additional progressive amendments to vote, their attempts are blocked by Republicans. If that happens, would Cantwell and Feingold continue to vote against the bill? Maybe, but do they really believe that no financial reform would be better than a more moderate bill? That might be a hard sell politically.

The other possibility, however, is that the Democratic leadership fears that some of the amendments will actually will pass. The Cantwell amendment, in particular, is co-sponsored by Sen. John McCain (R-AZ). If it really has bipartisan support, then it could succeed. That prospect might frighten moderate Democrats, who think breaking up the banks would take things too far.

Frankly, that latter possibility is the only thing that makes sense. It shouldn’t be difficult or overly time consuming for the Democratic leadership to push for a few more amendments to be heard. In fact, you would think that they would be falling all over themselves to make that happen if it means getting the last two votes they need. But with another vote scheduled for 2:30pm this afternoon, no amendment votes have been held yet this morning before lunchtime.

Is the recovery running out of steam? You might think so, considering that the Conference Board’s Leading Economic Indicators Index fell in April. Last month it decreased for the first time in more than a year. The drop was slight — just 0.1%, but it contrasts with the 0.2% increase expected by economists. What happened?

The index is made up of ten indicators that can help to predict how the U.S. business cycle is trending. They are aggregated at certain weights depending on their relevance to the economy. Here’s a chart from the Conference Board showing some history:

The red line, titled LEI, is the Leading Economic Indicator Index. That’s where there was a decline for April. The blue line is the Coincident Economic Indicator Index, which shows how the economy is doing currently. It continued to rise, as expected.

According to the report, the decline in building permits and supplier deliveries (vendor performance) played a huge part in index’s April small fall. Other components that had a negative effect included real money supply, average weekly initial unemployment claims, consumer expectations, and manufacturers’ new orders for consumer goods. The positive indicators included the interest rate spread, stock prices, average weekly manufacturing hours, and manufacturers’ new orders for nondefense capital goods.

This is not particularly good news. The index had been growing significantly for the past year. Even if it doesn’t continue to trend negative, hitting a plateau would imply a weak recovery going forward. Of course April’s decline was small and could just be a blip. If the index continues to move downward, however, then there is definitely reason to worry.

Conference Board – Money supply – Economic – Economic indicator – Leading Economic Indicator Index

In the wake of a lawsuit by the SEC and a day-long grilling by the Senate, Goldman Sachs is feeling pretty battered. The New York Times piled it on yesterday, with a sprawling front page article that claims Goldman’s clients are questioning whether to continue doing business with the bank. There’s little doubt that Goldman’s bankers and traders have thick enough skin to handle some criticism from Washington, but if they start losing business, then that’s a real problem. A bank is only as strong as its relationships. Does Goldman really have reason to fear? Probably not.

The Times article uses nearly 3,500 words to argue that Goldman’s clients have lost trust. But it really boils down to four criticisms of the firm. Let’s consider each, then the broader claim that Goldman’s business might be hurt due to its actions over the past few years.

Washington Mutual and New Jersey

Two of the article’s sections make essentially the same argument. First, Goldman underwrote securities for failed bank Washington Mutual and the state of New Jersey. Ultimately, however, Goldman bet against Washington Mutual once it realized the retail bank’s problems. Goldman also advised clients to buy protection against New Jersey’s potential default as the state’s fiscal problems became clearer. Should we be outraged at Goldman treating its clients this way?

There are two points here. First, of course these clients were angry at Goldman: the bank exposed their problems. But wouldn’t it have been worse to recognize their issues and ignore them? Then Goldman would have done a disservice to its hundreds of other clients who it advises, as well as its shareholders.

Second, the division of the firm that underwrites securities is completely separate from its proprietary trading desk and municipal research team. Some years ago, banks were required to put “Chinese walls” up to prevent these groups from colluding. It’s irrelevant to the prop traders and muni researchers who the firm underwrites for — that’s not supposed to affect their actions or opinions.

Auction Rate Securities

Next, the article faults Goldman for its involvement with auction rate securities. Yes, Goldman was wrong to think that these securities would be okay. But then, so was every other investment bank. Virtually all were advising clients to sell auction-rate securities, and all got out as quickly as possible when they realized how poorly the securities would perform as liquidity was drying up.

But the article also blames Goldman for not breaking a contract so to treat one client more favorably regarding its auction rate securities. So the bank should have ignored a contract in order to voluntarily endure losses due to the risk a client agreed to take on? How do you think Goldman shareholders would feel about that decision? Goldman has a fiduciary duty to maximize their profit, which arguably outweighs any desire it has to protect clients form themselves.

Collateral Calls

Is Goldman responsible for the fall of AIG? The article appears to make that utterly wild implication. It criticizes Goldman for requesting collateral to cover mortgage-related losses on assets backing loans it provided to AIG and other firms. Goldman — rightly — recognized the deterioration of these assets. So what exactly was the bank guilty of? Again, it was just hedging its own risk, so to protect its shareholders and profits. Ignoring a bad loan when you can guard against its losses isn’t good customer service: it’s stupid business.

Its Unwritten Principle

This point sort of relates to the last one. The article complains that Goldman has an unwritten 15th principle:

any business in any industry, has potential conflicts and we all have an obligation to manage them effectively

In other words, even though your clients are important, you should not lose sight of the big picture. This isn’t just good business sense; it’s basic common sense. Let’s say you loan your brother your car from time to time. He’s family, arguably the strongest relationship bond possible. But if he develops an alcohol problem and wants to borrow your car to drive to a bar one night, would you let him? Of course not. Similarly, if Goldman realizes a client could cause its shareholders a grave loss, then it must do what it can to prevent that, despite the relationship.

Are Customers Really Growing Weary of Goldman?

The Times piece manages to find five or so past clients of Goldman that no longer wish to work with the bank. But what about the other thousand or so? Is it plausible that all of the bad press will lead the others to question doing business with the firm? Warren Buffett doesn’t think so. He argues that Goldman’s clients understand the bank wears many hats, and that could sometimes conflict with a client’s interest.

The industry sources I spoke with also agreed. One equity analyst at a fund that deals with Goldman in its market-making capacity said his firm has no intention of changing its relationship with the bank due to recent allegations. He doesn’t believe many other firms the bank trades with will either.

The analyst has also observed little impact to Goldman’s underwriting so far. Goldman continues to play a prominent role in recent new issue equity offerings that hit the market, he says. He imagined a worst-case scenario being that Goldman goes from lead manager to co-manager on some deals until Washington turns its microscope off.

Sophisticated clients know what they’re getting when they do business with Goldman: a highly skilled market maker that always keeps its own interest in mind. And that’s okay — every bank that hopes to remain in business is ultimately out for its own interest. But the fact that it cares about its own well being doesn’t mean it can’t also provide excellent service to its clients.

Goldman Sachs – Washington Mutual – New Jersey – Warren Buffett – Business

The financial reform debate will go on. A motion to limit debate and consider the Senate’s regulation bill as is failed this afternoon, by a vote of 57 to 42. It needed 60 votes to pass. What went wrong? Two Democrats broke with their party.

In fact, two Republicans voted for the motion — the Senators from Maine Susan Collins and Olympia Snowe. All other republicans voted against it. But with 59 seats, Democrats only actually needed one Republican to defect, so those two should have been plenty. That means Democrats have their own party to blame for preventing the bill from moving forward.

Two Democrats were responsible for the bill failing: Sen. Maria Cantwell (WA) and Sen. Russ Feingold (WI). Majority Leader Harry Reid (D-NV) also voted against the motion, but did so for the procedural purpose of being able to call it back up later. Arlen Specter (D-PA) did not vote.

So why did Cantwell vote ‘no’? She had actually already threatened to do so if her amendment was not heard. It wasn’t. Her proposal would reinstate Glass-Steagall, which forbid retail banks from certain investment banking activities. She made good on her promise. After the vote, she began speaking in favor of her amendment on the Senate floor.

Feingold released the following statement regarding his no-vote:

After thirty years of giving in to the wishes of Wall Street lobbyists, Congress needs to finally enact tough reforms to prevent Wall Street from driving our economy into the ditch again. We need to eliminate the risk posed to our economy by ‘too big to fail’ financial firms and to reinstate the protective firewalls between Main Street banks and Wall Street firms. Unfortunately, these key reforms are not included in the bill. The test for this legislation is a simple one – whether it will prevent another financial crisis. As the bill stands, it fails that test. Ending debate on the bill is finishing before the job is done.

That is sufficiently vague, but it sounds like he essentially didn’t think that the Senate’s work was done, as there were still issues that needed to be considered with further amendments.

As mentioned, Reid reserved the right to call the cloture vote again. Another vote will almost certainly be held before the Memorial Day recess, though it’s unclear precisely when. You can probably expect Democratic leadership will do whatever it can to satisfy Cantwell and Feingold, however, since those are the only votes they need get the bill through. And that also probably sheds some light on when the vote will take place — once those two Senators are on board. Given the Republicans from Maine voting for cloture, the bill will almost certainly pass in the days to come.

Update: Just heard from Reid’s office. They hope to hold another vote to end debate on Thursday.

The Federal Reserve Open Market Committee (FOMC) discussed how it might begin shrinking its balance sheet through asset sales during its April meeting, the minutes reveal. In the statement it released at that time, there was no mention of how or when the Fed would sell assets, but we now know that the topic was discussed at length. It looks like sales won’t begin anytime soon, and they will be very gradual.

During the financial crisis, the Fed swelled its balance sheet to accommodate asset purchases for a variety of programs meant to increase credit and liquidity in the market. Here’s a chart from the Wall Street Journal that shows the change:

As you can see, its balance sheet nearly tripled in size. Once it gets rid of all of the assets it purchased backed by mortgages, the agencies, consumer credit, etc., however, its balance sheet’s size will be pretty close to what it was before the intervention.

So when will the sales begin? The minutes say:

A majority preferred beginning asset sales some time after the first increase in the Federal Open Market Committee’s (FOMC) target for short-term interest rates. Such an approach would postpone any asset sales until the economic recovery was well established and would maintain short-term interest rates as the Committee’s key monetary policy tool. Other participants favored a strategy in which the Committee would soon announce a general schedule for future asset sales, with a date for the initiation of sales that would not necessarily be linked to the increase in the Committee’s interest rate target. A few preferred to begin sales relatively soon.

It doesn’t look like asset sales will begin soon. In fact, the majority doesn’t want to sell anything until the Fed begins raising rates. And as we know, it intends to keep rates at approximately zero for “an extended period.”

How might those sales occur? The minutes explain that too:

Most preferred that the agency debt and MBS held in the portfolio be sold at a gradual pace that would complete the sales about five years after they began. One possibility would be for the pace to be relatively slow initially but to increase over time, allowing markets to adjust gradually. A couple of participants thought faster sales, conducted over about three years, would be appropriate and felt that such a pace would not put undue strain on financial markets. In their view, a relatively brisk pace of sales would reduce the chance that the elevated size of the Federal Reserve’s balance sheet and the associated high level of reserve balances could raise inflation expectations and inflation beyond levels consistent with price stability or could generate excessive growth of credit when the economy and banking system recover more fully.

There’s a difficult task here. The Fed must sell assets quickly enough to prevent inflation, but slowly enough that it doesn’t shock the market. It doesn’t want to crowd out the new issue markets by selling too much agency debt and mortgage-backed securities. In a perfect world, inflation won’t be a threat, and the Fed can conduct sales gradually. But by the time it begins selling these assets, once the economy is close to full strength, inflation might become more of a real concern.

On that note, the minutes also provided a little more detail on maverick committee member Kansas City Fed President Thomas Hoenig’s usual dissent. This time, they said what he was specifically calling for:

Mr. Hoenig believed that the target for the federal funds rate should be increased toward 1 percent this summer, and that the Committee could then pause to further assess the economic outlook.

Of course, Hoenig is the only one advocating raising rates in the near-term. That’s good, because if the Fed raised rates this summer, the market would probably have a heart attack. Considering that inflation is not a threat in the short-term, but unemployment remains near 10%, it’s not very likely other committee members will adopt his view by the June meeting.

With a vote on the financial reform bill in the Senate set to occur in less than an hour, sources indicate that Banking Committee Chairman Chris Dodd (D-CT) has decided not to compromise on derivatives. Yesterday, he introduced a last-minute amendment which would have given a council of regulators and the Treasury Secretary the option to kill a controversial provision that would have forbid banks from dealing derivatives. But now, Bloomberg is reporting that a Senate aide says that he won’t offer the amendment after all. What changed his mind? Here are a few theories.

He Doesn’t Have the Votes With the Compromise

It’s possible that Republicans have decided to band together and vote against the bill, despite the amendment. If that’s the case, then there would be no point in him keeping it. To be sure, the entire purpose of revising the derivatives language was to get Republican votes. If it didn’t accomplish that, then why bother? The vote will fail either way.

He Has the Votes Without the Compromise

On the other hand, he may have determined enough Republicans were on board even without the amendment. If he doesn’t need to compromise for the bill to pass, then why would he? If Republicans were satisfied with the bill as is, then he wouldn’t need this revision.

He’s Protecting Sen. Lincoln

The last-minute introduction of an amendment to water down the derivatives section of the bill was predicted, since it was believed that Democrats were protecting the legislation’s author, Sen. Blanche Lincoln (D-AR), who was enduring a brutal primary battle. She wanted to appear tough on Wall Street to appeal liberal voters. But she didn’t win on Tuesday. Instead, a run-off was forced. That means she still needs protection. If she convinced Democrats that they can’t alter her provision, then Dodd’s compromise might have been put aside.

That final option seems a little unlikely, mostly because passing financial reform is probably a more important priority than protecting one senator, who could instead just argue that she tried to keep the provision but the Democratic leadership overruled her. If the bill does pass without this amendment — and the derivatives spin-off provision is left intact — then it could still be eliminated during the conference process. Perhaps Senate Democrats find that a politically preferable alternative to killing it now? That is, if they have the votes to pass the bill without the compromise. If they don’t, the decision is baffling.

Anyone who thought the housing market might be able to continue its positive trend without the home buyer credit got a swift dose of reality today. The Mortgage Bankers Association reported that mortgage applications for home purchases fell off a cliff, declining by 27% last week to a level not seen since May 1997. Clearly, the housing market is already missing the home buyer credit.

First, for a little perspective, here’s mortgage applications for new purchases since 1990:

The red line is the index, and the bright green line shows its level during the week ending May 14th. The chart shows how incredibly high applications were in 2005, and how low they dropped last week, after rising significantly, with consumers anticipating the credit’s expiration. The index fell 34% from the week ending April 30th through the week ending May 14th — in just two weeks.

How can we be sure that the home buyer credit caused this huge drop? No other variable appears to be responsible.

On the supply side, little has changed. There’s still plenty of housing inventory. Even though existing home sales were likely relatively strong in April given the credit, foreclosures are still occurring in high numbers. As a result, the housing inventory probably declined only a little. Prices haven’t moved much either.

On the demand side, the other factors that might encourage buyers haven’t changed much either. Interest rates still remain relatively low: in fact, they decreased to 4.93% this week from 5.21% a month earlier, according to Freddie Mac. The economy hasn’t suddenly worsened in the past few weeks, as jobless claims have been declining over the past few weeks. Banks also haven’t experienced any shocks that would have caused a drastic decline in credit.

That basically just leaves the home buyer credit as the chief cause. And history supports this theory. In November, when the credit was extended, new purchase mortgage applications also plummeted, then to a 10-year low. At that time, potential buyers realized they no longer had to rush, so they put off their buying until the spring. This time around, the drop was even more significant, because even more demand was pulled forward while the credit was in effect.

There’s little doubt that last week’s drop in mortgage applications for home purchases foreshadows what we can expect over the next few months. The home buyer credit likely soaked up most of the home buying demand out there. At this point, the American consumer might be experiencing home buying fatigue. If sales decline to very low levels — and this data indicates that they probably will — then that will result in foreclosures increasing housing inventory further. That could cause a decline in home prices, which had just begun finally rising again.

Instead of inflation, April’s Consumer Price Index (CPI) indicates slight deflation. Prices fell by 0.1% compared to March, according to the Bureau of Labor Statistics. April’s change met expectations and was the first decline in prices since March 2009. As long as prices are flat to falling, it’s hard to take short-term inflation concerns seriously.

The following chart emphasizes just how low inflation has been over the past year:

April’s decline was led by energy prices, which were down 1.4% for the month. Food prices rose slightly, by 0.2%. This resulted in ever-important core inflation — the measure that excludes food and energy — remaining unchanged for the month. That was slightly below the 0.1% rise economists predicted. Here’s another chart that smooths core CPI with a trailing 3-month average:

Remember, the vertical axis above only maxes out at 0.3%, which stresses just how low core inflation has been since the recession began. Considering this chart, in conjunction with the earlier one, it looks like full and core CPI are both experiencing a downward price trend since last June.

Combining today’s CPI news and yesterday’s report indicating producer prices were also slightly deflationary, it’s crystal clear that inflation is currently under control. In fact, there may be reason to worry more about deflation, if the trend noted above continues through summer.

Although we will also learn May’s inflation reading before the next Federal Reserve Open Market Committee meeting in late June, April’s price data indicates there’s little chance its economists will feel any new urgency to soak up monetary supply sooner than planned. Unemployment — which rose to 9.9% in April — remains the bigger immediate threat to the U.S. economy.

Note: All data above is seasonally adjusted.

(Nav Image Credit: [sic]/flickr)

Inflation – Consumer Price Index – Bureau of Labor Statistics – Federal Reserve System – Recession

The Securities and Exchange Commission may be doing its best to enhance up its public image these days, but a new report (.pdf) criticizes its past performance. The Republican wing of the House Committee on Oversight and Government Reform, lead by Sen. Darrell Issa (R-CA), released the scathing document this week criticizing the regulator. It provides 10 findings of inadequacy and provides five recommendations for improvement. The report explains that the SEC’s problems are fundamental in nature, so deep reform is necessary.

So where did the SEC go wrong? If you haven’t seen anything screwed up in the financial markets over the past few years, then you really haven’t been paying attention. They missed a few big Ponzi schemes, including those run by Bernard Madoff and R. Allen Stanford. They didn’t do their job to adequately oversee investment banks, which partially led to the collapse of a few and the near-demise of them all. They also missed the opportunity to eliminate gray areas or wrongdoing that existed in the financial markets that helped create the financial crisis.

As you might guess, some of the findings had to do with precisely these failings. Here are all 10 (summarized):

• The SEC missed Madoff because investigators didn’t understand his business and failed to coordinate to identify the fraud.
• The Consolidated Supervised Entity (CSE) program to supervise investment banks didn’t address systemic problems that led to the financial crisis, so the SEC cancelled it.
• The disclosure process for new securities is archaic (think paper and pencils) and is run like an amateur shop, with SEC staff using services like Yahoo Finance to analyze filings.
• Virtually all major fraud since Enron has been found by outsiders, not the SEC staff.
• The SEC was investigating fraudster Allen Stanford for seven years, and concluded four times that he was guilty of fraud, but never brought suit.
• Despite the claim that funding is to blame for failures, its budget has nearly tripled in the past decade. The problems result from its culture and structure.
• One structural issue is a “silo problem” that prevents adequate collaboration among divisions, which leads to poor performance.
• It has a lawyer-heavy approach to regulation, which prevents it from developing better expertise in financial products and industries.
• Due to the SEC’s unionization in the 1990s, it’s hard to fire employees who perform poorly.
• Overly burdensome procedures and rules impose excessive cost on financial firms and ultimately harm transparency for investors.

How does the report say these problems should be remedied? It recommends Congress requires the SEC to do the following (also summarized):

• Simply its structure
• Insist its Chairman appoint a Chief Operating Officer with the power to bring lasting change
• Reform its hiring, firing, and review practices, as well as staff culture and incentives
• Overhaul, update and simplify its securities disclosure rules and forms
• Be subject to an independent study of its mission, organization, and work force

Considering the regulator’s massive failures over the past decade, these requirements sound pretty reasonable. The SEC serves a vital function in the financial markets. If it cannot perform its job adequately, then something needs to change. In particular, its staff must possess the understanding, collaboration, culture, and drive to uncover fraud and identify activities that can lead to problems in the market.

The entire 33-page report contains a lot of fascinating detail regarding specific findings. You can find it here (.pdf).

Allen Stanford – Bernard Madoff – U.S. Securities and Exchange Commission – SEC – Business

As anticipated, Senate Banking Committee Chairman Chris Dodd (D-CT) offered a compromise for the derivatives section of the financial reform bill on Tuesday. He did so almost literally at the last-minute — offered just three minutes before the noon deadline for new amendments. This should result in the few Republican votes the bill needs to pass tomorrow.

The Washington Post reports on how the amendment will affect the controversial provision that would have forced banks to spin-off their derivatives desks, or place them in a separate affiliate:

Under the compromise, the Senate would keep the sweeping provision, but delay its implementation for two years while it’s studied and quite likely kill it at the end.

Dodd’s plan calls for submitting the derivatives rules, which were initially proposed by Sen. Blanche Lincoln (D-Ark.), for study by a federal council of regulators. Several key members of the council and Treasury Secretary Timothy F. Geithner, who could have final say under the compromise, have serious reservations about forcing banks to get out of the derivatives business altogether.

So he didn’t kill the provision, just sent it to its death. As noted here, virtually every significant Washington policymaker is against the proposal. They will likely be the ones sitting on that council. According to the Post, Geithner, in particular, would decide if the provision will survive. Considering that the Obama administration is against the rule, it’s as good as dead.

Of course, this is a politically savvy move. Democrats can now blame the council for the death of the proposal. Sen. Blanche Lincoln (D-AR) can continue to say that she advocated for it and made it a part of the bill. It was theorized that Dodd might wait until after her Tuesday primary to offer this amendment, and he did wait precisely as long as possible. It should have little effect on voter’s decisions, given the timing. And even if a run-off is required for her seat, she can still claim she took a strong stance against Wall Street.

This last-minute move by Dodd should help guarantee a few Republican votes from Senators who were very concerned about this piece of the legislation. Notwithstanding any highly controversial amendments passing before the big vote tomorrow, the bill should easily pass.

Android mobile phone user-bookworms might be thrilled to hear that Amazon plans to release a Kindle e-reader app that they can download for free this summer. The only thing surprising about this announcement is that it took so long. What was Amazon waiting for? Here are three reasons why it should have fallen over itself to get this app out as quickly as possible.

Other Devices Have Had It for a While

For starters, other mobile devices have had the free Kindle app for quite some time. The iPhone got it way back in March 2009. Blackberries got free Kindle in February. While there are surely other devices that still lack the app, Android is one of the fastest growing platforms. If Amazon has determined that it’s a smart strategy to provide its free Kindle reader for mobile devices (and it is, see reason #3 below), then it should roll this app out as quickly as possible to maximize market penetration.

Apple Is No Longer an Ally

Amazon should have also begun providing this app to other mobile devices with a renewed sense of urgency after learning that Apple was releasing its own tablet device. Yet, the iPhone remained the only mobile platform with the free Kindle app for nearly a year. The iPad is a direct competitor with the Kindle, even though Apple’s device has superior capabilities. Few people who own an iPad will think they also need to purchase a Kindle. Moreover, most Kindle users will just rely on Apple’s iBook store, rather than download the Kindle app for iPad — what’s the point?

Competition from Apple further accentuates the need for Amazon to push the app out to Android users. Think about the segment of the population who owns an Android phone. They’re almost certainly not Apple fanboys/girls. If they were, they’d have an iPhone. So that means they’re less inclined to buy an iPad than an iPhone owner. But they’re also more technologically savvy than consumers who might opt for a simpler mobile phone with fewer capabilities. Amazon should get their Kindle app in these consumers’ hands quickly, in an attempt to fend off any urges they may have to purchase an iPad instead of their device. Getting them hooked in Kindle first will lower the likelihood that they buy another e-reader or tablet instead.

There’s Really No Downside

From a strategic point of view, there’s really no reason why Amazon shouldn’t provide the free Kindle app to as many mobile devices as possible. Won’t that cut into Kindle sales? Probably not much, particularly not in regard to mobile phone app downloads. Anyone who really wants a richer e-reading experience won’t settle for reading books on their little phone screen: they’ll still spring for the full Kindle (or an iPad, tablet, or e-reader).

Meanwhile, those who can stomach reading books though the mobile app on their phone may choose to pay for books through Amazon’s Kindle store. Some may even like the Kindle experience on their mobile phone so much that they decide to buy the device from Amazon after all. Surely, Amazon would want to capitalize on the book purchases and potential new sales thanks to providing the Kindle app for the growing population of Android users.

All of these reasons likely had something to do with Amazon finely wising up and pushing out the Kindle app to Android users. It’s a smart move, long overdue.

Monday night Senate Majority Leader Harry Reid (D-NV) filed a cloture motion on the financial reform bill. That means a final vote could be held as soon as Wednesday. Until then, the Senate will continue to hear amendments to the bill. But even if they aren’t all in, the leadership could push to vote without them. If they do, will it pass?

Speaking more broadly about the bill’s chances, Michael Grunwald of Time doesn’t think they look good:

It’s mostly an Occam’s razor thing. Every House Republican voted against the bill the House passed last year. Every Senate Republican signed a letter opposing the bill the Senate is debating now. Big Finance is spending $1.4 million a day to fight reform, with a lobbying army that includes 70 former Congressmen and just about everyone who ever staffed a congressional banking committee. It’s certainly possible that Congress would resist all that pressure, and the same Republicans who marched in lockstep against health reform would stop blasting President Obama’s socialism long enough to hand him another huge victory before the 2010 elections.

It just doesn’t seem all that likely.

The Republicans

It’s easy to see where he’s coming from. After all, Senate Republicans were even blocking debate at first, until finally consenting to at least hear the bill. Has that much changed so they now will support it? Not yet, but some necessary changes could be incorporated before the final vote.

Republicans did get a little of what they want — but only a little. Most of the complaints about the original bill providing bailouts have been silenced by a few amendments. They got a weak Federal Reserve audit as well. But they didn’t make any significant leeway on the consumer financial protection bureau, Fannie and Freddie, or derivatives.

They probably won’t get anywhere regarding the first two of those priorities. Democrats aren’t willing to compromise much further on consumer protection and have no intention of touching Fannie and Freddie. But derivatives could be a different story. There’s some talk that after today’s primary elections, Blanche Lincoln’s (D-AR) aggressive derivatives regulation could be relaxed a little. Some controversial provisions may have been left in place only temporarily to help secure votes of her constituents angry at Wall Street.

If the derivatives section is made more favorable to Republicans, then you may see a few come over to support the bill. And that’s all Democrats need. Remember, Republicans would prefer not to appear soft on Wall Street, but they also don’t want to support regulation that could debilitate the financial market. A little compromise with derivatives could be all it takes.

Yet, one of the big players on the Republican side of the aisle, Sen. Bob Corker (R-TN), said in an interview with CNBC today that he thinks the bill will pass this week (video at end of the post):

Look we’ve got about four or five Republicans that I think are going to vote for this. I think we’ve always known that a financial regulation bill is going to pass. And it is. I’m not going to vote for it, unless there’s something miraculous that occurs here in Washington over the next 36 to 48 hours, which I know is not going to be the case. Ya know, I’m just being honest with you. We’re going to have a financial reg bill. I don’t support it, but I’m only one of 100 Senators.

He also said that there are around five Republicans who have consistently voted in such a way that would indicate their support of the bill. It’s surprising to hear Corker so confident that several Republicans will vote in favor of the legislation, as that would be a change from a few weeks ago when all Republicans at first blocked debate.

The Democrats

Republicans votes might be tough, but getting Democrats on board should be the easy part, right? Not necessarily. Some may not vote for the bill unless their amendments are heard. Politico reports:

Sen. Byron Dorgan (D-N.D.) has said he will filibuster the bill unless the Senate votes on his amendment banning a speculative financial instrument known as a “naked” credit default swap. Sen. Maria Cantwell (D-Wash.) has done the same, saying she needs a vote on her amendment separating commercial and investment banking operations.

Still, it shouldn’t be that hard for Reid to provide his fellow Democrats a little extra time to get their amendments in. Even if that delays things by a day or two, obviously it would be worth having a few more votes.

So will financial reform pass? Probably. Will it pass this week? If all Democrats are satisfied that their amendments were heard and the derivatives section is revised to appease Republicans, then it likely will. If one or both of those criteria aren’t satisfied, however, it might take a little more time.

Home builders had a good month in April. Construction of new homes improved again last month, as housing starts rose by 5.8% to an annualized rate of 672,000 from March’s revised level of 635,000, according to the Census Bureau (.pdf). That beat expectations of 650,000 and also marked a huge 40.9% rise compared to April 2009.

While the new construction data sounds great, new permits declined last month. They fell by 11.5% to an annualized rate of 606,000. There were still 15.9% additional new permits than in April 2009, however. Fewer new permits might indicate that new construction is slowing back down, with the home buyer credit now expired.

First, let’s look at some charts to give these numbers some perspective. Here’s one showing housing starts:

As you can see, there’s been a fairly steady rise for the past year. But this chart also shows just how far new home construction has fallen from its peak in 2006. Permits tell a similar story:

The fairly steep fall in April for permits marks a big difference compared to another rise for starts.

It’s plausible that the end of the home buyer credit has something to do with this disparity. It applied to any contracts signed through April 30th. As a result, much of the new construction that broke ground might have continued to benefit from the credit, if some of those homes were already spoken for. New permits occur at an earlier stage in home building, however. Consequently, fewer of those contracts might have been signed by April 30th, so the credit didn’t benefit them as much. Builders are also likely just anticipating a decline in demand for new homes now that the credit has expired. The drop in permits likely foreshadows what we’ll see in home building and sales numbers in May and beyond, without the government credit.

This report should be considered along with yesterday’s news that homebuilders are more optimistic. The National Association of Home Builders said its confidence index rose to its highest level since August 2007. The index reading indicates that builders are still generally negative about the market, however. The report also says, although the market picked up with the home buyer credit in place, the builders expect demand to decline now that it has expired.

Fewer new homes being built isn’t necessarily a bad thing. While it’s obviously not great for the construction industry, it’s arguably better for the housing market. There’s still a big inventory of existing homes for sale. Moreover, there are still very high numbers of foreclosures hitting the market. Buyers should work on drawing down the current inventory before building new houses.

The big problem with building fewer homes, of course, is fewer construction jobs. It has been one of the worst industries hit due to the housing collapse-induced recession. As home building slows, the hope would be that more construction workers might find work renovating newly purchased existing homes or foreclosures. But as the charts above show, even additional renovation isn’t likely to put the number of construction jobs anywhere near what was seen in 2006.

Note: All numbers above are seasonally adjusted.

(Nav Image Credit: Concrete Forms/flickr)

National Association of Home Builders – Construction – Housing starts – Real estate economics – Business

Inflation remains subdued, at least at the producer level. Although the consumer price level for April doesn’t come out until tomorrow, Producer Price Index (PPI) indicates that inflation is still quite low, even slightly deflationary. PPI for finished goods changed by -0.1% last month compared to March, according to the Bureau of Labor Statistics. That was lower than March’s PPI growth of 0.7%, and right around expectations of -0.2%. Today’s news supports the assertion that inflation still isn’t a problem.

Here’s the PPI chart from BLS:

This statistic tends to jump around a little, but since February it’s been vacillating right around zero.

The relatively volatile prices of food and energy are most of the reason for PPI’s big swings. Stripping those out, you get so-called core PPI. Many economists view this measure as more important than the overall reading. It was also low in April, growing by 0.2% from March. As you might guess, food and energy brought the overall PPI negative for April, as their individual index levels changed -0.2% and -0.8%, respectively.

Core PPI has remained very stable over the past year. Here’s its chart:

BLS also reports PPI for intermediate and crude goods, which changed by 0.8% and -1.2% versus March, respectively. These readings remain mostly in-line with the levels seen over the past year. So they don’t indicate any reason to worry about inflation at this time.

Tomorrow we’ll know more about overall inflation when CPI data is released, but PPI indicates that prices are still quite flat.

Note: All statistics above are seasonally adjusted.

Producer Price Index – Price index – Inflation – Bureau of Labor Statistics – Economic