Author: Daniel Indiviglio

There’s a cause all politicians claim to love: ending bailouts. A recent amendment by Barbara Boxer (D-CA) made this clear, passing 96-to-1. It sought to end bailouts, no matter what. Of course, as Michael Kinsley pointed out in a recent piece, short of a constitutional amendment, that’s impossible. But should bailouts be avoided at all costs, as Congress appears to be calling for?

Brookings Institution economic policy scholars Martin Neil Baily and Douglas J. Elliott say no. In an article, they assert that “bailouts are necessary to avoid the risk of a depression.” For that reason, they oppose any attempts to tie the government’s hands with inflexible rules that would prevent Washington from saving the economy, if necessary. They go on to say that the tools need to be in place for the government to act quickly when bad things happen.

On one hand, they’re right. Because it’s impossible for us to ever predict precisely what the world will look like in the future, we can never be certain that a bailout won’t be better than the alternative. As ugly as the bailouts of 2008 were, 25% unemployment would surely have been worse. So any move to completely eliminate the government’s ability to perform bailouts is likely ill-advised.

On the other hand, you don’t want to make the prospect of bailouts too easy. Firms need to fear bankruptcy. Just because bailout is possible doesn’t meant that it should be expected. While the financial panic that gripped the markets in 2008 was awful, in a sense, it was also wonderful because it showed their fear of failure. Firms worked very hard to keep the economy afloat, never assuming a bailout would occur. This is made abundantly clear if you read accounts (like former Treasury Secretary Hank Paulson’s “On the Brink”) about the big banks working together to try to figure out a way to save some of the firms that were collapsing during the crisis, including Lehman Brothers and Merrill Lynch.

So the right government reaction is to criticize bailouts and make them very difficult. If they’re too easy, then businesses will take too much risk. Congress should have to approve any major bailout initiative on a case-by-case basis, just like they did in 2008 for the bank bailout. That was a brutal time, and Congress wasn’t thrilled, but ultimately they all put politics aside and did what needed to be done, no matter how bad it stunk. Its action wasn’t lighting-fast, but its speed was sufficient to prevent a depression.

In the meantime, actions should also be taken in an effort to avoid future bailouts. That’s part of what financial reform intends to do. Congress hopes a systemic risk regulator will help. A non-bank resolution authority couldn’t hurt. But they aren’t enough. Higher capital requirements and leverage limits could also bring greater stability, though the Senate’s bill overlooks them.

What all Washington’s reform lacks at this time is some effort to prevent financial panics. It wasn’t really the mortgage-related losses that caused the financial crisis — it was the uncertainty of financial market participants. Financial institutions and investors didn’t know how big the losses of other firms would be, or the amount of capital cushion they had in place. Was there hidden leverage that would magnify losses? The complexity of securities made it even harder to figure out what a firm’s assets were worth.

So many financial institutions were on the verge of failure because they couldn’t turn over their debt. They weren’t only highly leveraged, but much of their debt was short-term — and it was coming due faster than they could secure new funding to roll it over. Why hasn’t anyone talked, not only about leverage limits, but about leverage maturity concentration limits? It might be fine to be leveraged 15-to-1, but not if 90% of that debt has to be refreshed each week.

Transparency is also important, and somewhat taken up by the bills being considered by Congress. But they should be doing more to create an environment where, even in a financial panic, firms have time and disclosure in place to easily present clear and convincing evidence that there’s no reason for financial institutions and investors to fear the worst. The fundamentals at very few big financial firms should have actually caused failure during the 2008 crisis based on losses alone, but all were on the verge of collapse due to widespread uncertainty that caused liquidity to dry up.

If you want to avoid bailouts — and it seems just about everybody does — then you need to reform the cause and prevent panics from becoming severe. Just watching the financial system more closely in the hopes that you can spot a problem before it results in a catastrophic event isn’t enough.

Financial crisis – Lehman Brothers – Congress – Barbara Boxer – Merrill Lynch

Update: Or not! My understanding of this amendment was based on this op-ed on Sen. Udall’s website. Sadly, it looks like the lobbyists got to it before vote. Shortly after posting, I received an e-mail from a Udall spokesperson saying:

I did want to make sure you had the most updated language. The amendment actually gives consumers free access to their credit score if it is used against them in a financial transaction or adverse hiring decision. Although Senator Udall also continues to support language that would give consumers a free credit score with their credit report, that’s not what the amendment would do. However, this updated version actually reaches far more people, so it’s terrific news for consumers!

This is still better than past precedent, but also very disappointing. On some level, every credit decision is more adverse than it could be, since the terms could almost always be more beneficial to the consumer. But this now only applies if credit is denied or results in worse terms than anticipated. In any case, here’s the original post, much of which is now a wish instead of reality:

Soon, you may be able to get your credit scores, for free. Monday evening, an amendment to the Senate’s financial reform bill succeeded which would allow Americans free access to their credit scores along with their free annual credit reports. The measure, sponsored by Sen. Mark Udall (D-CO), passed by a simple voice vote. This move should boost transparency in the consumer credit market.

Up to now, many consumers had no way of knowing how the credit bureaus scored their creditworthiness, unless they paid a fee. This seems a strange notion, given how significant an input credit scores generally are for many lenders. By knowing your score, you may be more easily able to bargain for a better interest rate or loan terms.

Of course, the credit score still remains something of a black box. While some things are known about how various actions affect your score, the detail is unclear to consumers. The bill also doesn’t do much to reform the inequality between a borrower’s word and a lender’s word when it comes to credit scoring. Right now, it’s entirely based on what the lender says, while a borrower complaint is merely noted on the his or her report.

Still, this is a good first step. Knowing your score can also enhance your motivation for improving it, as you can check its progress each year. You can see how responsible borrower behavior increases your score, or how missing payments or defaulting on loans lowers it. Let’s hope this measure gets through conference and makes it into the final bill.

Just because we own it doesn’t meant we have to recognize it. That was the message of the Senate on Monday evening when it voted down an amendment (.pdf) which would have required the government-sponsored entities Fannie Mae and Freddie Mac be brought on budget. The government promised to stand behind the institutions and put them into conservatorship in 2008. The measure, sponsored by Sen. Mike Crapo (R-ID), failed by a vote of 47-46. Because it was brought up as a motion to waive a budget point of order, it would have required 60 votes.

It’s pretty confusing to understand how Congress can get away with not recognizing in its budget nationalized corporations that have become part of the federal government. At this time any losses these companies incur will be covered by taxpayers. So shouldn’t its “outlays, receipts, deficits or surpluses” be a part of the “Budget of the United States Government”? You would think so.

But then you wouldn’t know much about politics. This amendment failed for two main reasons. First, it would likely require Congress to raise the debt ceiling. That’s something they surely have no desire to do.

Second, Congress really has very little desire to rein in Fannie and Freddie. This has already been seen through the Senate’s financial reform amendment process. Two earlier attempts at GSE reform failed soundly. This one apparently scared Senate Banking Committee Chairman Chris Dodd (D-CT) so much that he used a special motion to require 60 votes, instead of the 50 customary for every other amendment to pass. Indeed, at 47 yea-votes, and seven senators not voting, it might have had a shot at exceeding 50.

The amendment would also have limited the size of Fannie and Freddie’s bailout to $200 billion. So far, it’s cost taxpayers around $148 billion.

The Obama administration’s foreclosure prevention program appears to be running out of steam. Its April progress report (.pdf) shows that it started just 37,021 new trial mortgage modifications — the fewest in a month since at least last June. In fact, its cancelled trials during the month far outweighed those new ones, with 162,467 122,467* failures in April, more than the total 115,173 cancelled through March. The number of permanent modifications rose, though slowly, by 68,291, now sitting at 295,348 active permanent modifications since the program was announced in March 2009. That’s still well short of its goal of helping several million homeowners avoid foreclosure.

New Trials and Permanents

First, here’s a chart showing its progress starting new trial modifications and bringing trials permanent:

It seems pretty clear that the program has run its course in terms of acquiring new applicants. Up to now it has offered about 1.5 million trials, of which about 20% have been made permanent. Considering the report says that only 1.7 million mortgages are eligible, it’s easy to see why new trials are slowing. Unless the program finds a way to widen its net, it won’t have many more borrowers left who can qualify to participate.

The program’s progress bringing these trials permanent continues to be slow. It’s approaching 300,000, but it’s taken over a year to get there.

Cancellations Ramp Up

Perhaps the most shocking results from this report are the number of cancellations for both trial and permanent modifications. This trend was noted last month for March’s data. A whopping 162,467 122,467* trial modifications were cancelled in April. This brought the number of failed trials up to 277,640. That’s nearly as many as have been made permanent. To put these cancellations into context, in the first four months of 2009, only 274,090 trials have been started — fewer than have been cancelled.

Additionally, 865 permanent modifications were cancelled in April. That might not sound like much, but it’s a 30% increase in the number of total cancelled permanents, to 3,663. These modified mortgages shouldn’t be experiencing problems so soon. Remember: they already had to go through a trial period. All of these permanent modifications are less than a year old. Indeed, there were fewer than 5,000 permanent modifications made through September. The fact that these borrowers are already running into problems is very worrying.

Modification Strategy

The April report contains an interesting correction. Servicers appear to be using term extension as a means for modifying mortgages more than we thought. In March, it said 38.9% of mortgages utilized that method, but in April that number jumped to 53.4%. The report notes that this is a correction. That’s a pretty big mistake. The correction also shows than more than half of loans are increasing their terms to lower the payments borrowers face.

Principal reduction is still rarely being used. In April the percentage rose by 1% to 28.6% of mortgage modifications including principal forbearance. Recent efforts by the Treasury indicated that principal reduction would be used more often as a method, but it still appears to be mostly disregarded by servicers.

Report Continues to Evolve

Finally, the program’s report continues to evolve. It now includes a page showing its call center volume and outreach measures — in case you were worried the Treasury and servicers weren’t working hard enough. This is likely an attempt to shift the focus of program evaluation from actual results to effort exerted.

Moreover, the main performance chart continues to change its format, as it has most months. For April it looks like this:

For March, it looked like this:

Perhaps at some point the Treasury will finally settle on a format it likes. Or perhaps not.

*Typo — sorry about that. The analysis remains the same.

Well this is embarrassing. Remember last year when we learned that the investment banks were using their toxic real estate assets to create fancy securitization products called re-remics? Turns out the new bonds aren’t any better than the poisonous ones. Rating agency S&P is downgrading many of them, as some have deteriorated to junk.

In case you forget how re-remics work, here’s a diagram from that post back in October, via the WSJ:

308 classes of re-remics created from 2005 through 2009 were downgraded, according to Bloomberg. Some were issued as recently as last July. You might have thought S&P learned from its mistakes, but apparently not.

This is a pretty awful result for the advocates of real estate securitization. In theory, it should be possible to design a well-performing bond backed by a pool of mortgages that sustains significant losses. It’s just unclear why the rating agencies can’t get it right. It’s one thing to get it wrong during the housing boom. But once they realized their mistakes, how did S&P miss again, so soon? Clearly, its assumptions still aren’t conservative enough.

But this news shouldn’t be taken as a verdict that condemns securitization. Certainly, there’s some amount of credit enhancement — excess cushion for mortgage losses — that could prevent senior bonds from taking a hit. Rating agencies just can’t seem to get the numbers right. As a result, investors should do their own work to determine more reasonable assumptions.

This news could further delay the return of the mortgage securitization market. Now that the Federal Reserve is done buying mortgage securities, it needs private investors to re-enter the market. Although there were some rumblings last month that the private mortgage-backed-securities were coming back, S&P’s continued bumbling could keep investors away. Without their funding, however, mortgage availability will suffer and mortgage interest rates will rise.

(h/t: Felix Salmon)

You don’t have to look far to find someone on TV talking about how gold is a great investment. It seems like at least once a week, CNBC has someone on-air that says gold is going to hit $1,500 or $2,000 an ounce (currently, it’s around $1,240). So how do you know if gold is a good investment? By figuring out whether or not other people believe it is.

Why They Love It

For starters, gold is a commodity, so it isn’t a traditional investment. A prudent long-term investor buys a stock or bond with the intention that it will provide dividends or coupon payments that would provide a nice return. Investing in gold is purely speculative: you only make money if its price goes up — it pays no dividends or interest.

And that price will only increase insofar as investors buy more of it, because they believe their other options will do comparably poorly. One driver for gold investing is inflation. Since currency values decline when deep inflation grips a nation, gold might seem like a good place to put your money, since its value can’t be debased.

But that doesn’t mean gold is the only option here. Platinum should also retain its value fairly well. So should most other commodities that are little affected by other economic shocks. What makes gold so attractive? The fact that it’s the first thing people think about investing in when inflation is feared. It’s popular, so its price may increase even more than other commodities.

Even stocks can be a good investment as a hedge on inflation. Companies that produce goods and services will raise their prices if inflation becomes a problem. As a result, their stock’s nominal values will also increase as their nominal — not real — revenues climb with the price level. Your return on those stocks will include an inflation adjustment. The only thing that would make stocks a bad investment during this time is stagflation: when that inflation is accompanied by a recession. Under that circumstance gold is a better investment, since its value likely won’t decline as much as stocks or currency.

Is Now the Time?

If you follow the markets, then you know gold has been doing quite well over the past several years. Here’s a chart from goldprice.org:

As you can see, gold has increased by almost 200% in just five years. That averages out to 40% per year. This sort of return isn’t sustainable, unless inflation has gotten completely out of control. It hasn’t, as it’s been only a few percent per year over this time period. But gold’s continued rise shows that many investors are still scared of currency and other investment options.

But its future success depends on this mindset growing even stronger. Will investors continue to prefer gold forever? It’s hard to see how. As the recovery takes hold, businesses will begin growing again, and investors won’t be as scared of stocks. For gold to keep rising, you would need even more investors to flock to gold and sell off their current portfolio of stocks, bonds, currencies, or other commodities. Surely, there’s some limit to how many investors can move their money to gold. Nothing can sustain 40% annual returns for too long.

(Nav Image Credit: tao_zhyn/flickr)

Investment – Business – Investing – CNBC – Inflation

How important is college? As most high schoolers graduate this spring, they won’t even bother asking this question: getting a degree after college is a no-brainer. So any young adult who gets in generally goes. But a college education isn’t all that necessary for many jobs. That leaves some shelling out — or more often getting loans for — tens or hundreds of thousands of dollars on an education that might not ultimately help them do their job better. After all, they can’t simply not go to college, right?

The Problem

The question of the necessity of college was brought up this weekend in a thought-provoking article in the New York Times. Here’s one of the most important points in the piece:

College degrees are simply not necessary for many jobs. Of the 30 jobs projected to grow at the fastest rate over the next decade in the United States, only seven typically require a bachelor’s degree, according to the Bureau of Labor Statistics.

Among the top 10 growing job categories, two require college degrees: accounting (a bachelor’s) and postsecondary teachers (a doctorate). But this growth is expected to be dwarfed by the need for registered nurses, home health aides, customer service representatives and store clerks. None of those jobs require a bachelor’s degree.

Of course, whether or not a job actually requires a degree isn’t really asking the right question. Employer demand matters. In a blog post today, David Leonhardt focuses on relative pay, which sheds some light on what a college degree can get you. He concludes that, since those with college degrees have better compensation prospects, college must be worth it. Here’s a chart he uses to prove his point:

From this, college definitely looks like the right choice. But what does this chart actually show? Not that a college degree was necessary — just that employers prefer them. The value of a degree has become something of a self-fulfilling prophecy: it’s become worth so much because people assume it should be.

Let’s do a quick thought experiment. In the example above, it’s not unrealistic to assume at least 10% of the jobs of “college graduates” didn’t actually need the degree for the skills their job requires. Imagine if those 10% of individuals hadn’t gone to college. There would still have been demand for the jobs that they took, so who would have got them? Easy — people without college degrees, possibly even the same ones. Just because college graduates earn more doesn’t mean that their degree provides them any additional knowledge necessary to succeed in their jobs; it just means that employers found them more attractive because of the degree.

These days, four-year colleges have all sorts of majors that didn’t used to be necessary for jobs. For example, at some colleges, you can major in “criminal justice” and get a job as a police officer after graduating, even though being a cop didn’t traditionally require a degree. Other college students major in subjects with little practical use in the job market — like anthropology or Russian literature. Those graduates often end up in careers that have little or nothing to do with their education, but their college degree still gives them an edge over someone with just a high school diploma. Employers would rather you have studied something irrelevant to the job in college than nothing at all.

Why It’s A Problem

Is over-education really a problem? What’s so bad about a population with more knowledge than it needs? The problem is the expense and opportunity costs. By plowing more money into an education, many students incur incredible amounts of debt before they ever get their first paycheck, or maybe their parents spend savings that would have helped their retirement. That adds to the nation’s debt problems. These young adults would have saved more, and maybe even invested a little in the economy. Instead, any extra money young adults earn often goes towards paying off loans.

Then, there’s the opportunity cost of the time spent studying instead of working. At this time, the labor market clearly doesn’t need more workers. But in a good economy, these individuals might have been able to add to the gross domestic product sooner and spun their career track forward a few years.

Saying college is valuable for many young adults is an indisputable claim. But saying it’s valuable for all — or even most — young adults isn’t as clear.

United States – Bachelor’s degree – Higher education – High school – Education

Anyone who hoped manufacturing would be the key to the jobs recovery won’t be pleased with today’s news. The New York Federal Reserve’s Empire State Index of manufacturing for May was 19.1. That’s a significant decline in activity from April, when it stood at 31.9. But this isn’t as bad as it looks: any measure above zero means additional gains in manufacturing for the New York area. Still, that’s a pretty steep drop.

First, here’s a chart from the Fed showing the index since 2003:

Even though this index only measures manufacturing in one region it’s generally believed to serve as an early indicator for broader U.S. manufacturing. As you can see, during the recession the manufacturing industry got battered. But it also recovered far more steeply than it fell. It has remained above zero for 10 consecutive months.

There’s no doubt that more manufacturing is helping the labor market. The report’s index for employees rose for the fifth straight month, to the highest mark since 2004. But May’s big drop comes as a disappointment. Economists expected it to barely fall, to 30.

At this point, the index is not that far from its average since 2001 of 10.6. As it nears that mark, job growth in manufacturing will slow to normal levels, instead of the steep job growth that could help make a more significant dent in unemployment, which remains near 10%. If the index’s downward trend continues, then manufacturing isn’t likely the answer to the labor market problems.

New York – United States – Federal Reserve System – Manufacturing – Employment

The Department of Justice is reportedly considering whether to bring criminal charges against investment bank Goldman Sachs, based on the Securities and Exchange Commission complaint. Speculation is swirling that Wall Street haters could finally get their wish and see some bankers behind bars. Here are the answers to some key question about a potential criminal investigation:

Could a Criminal Case Succeed?

The fraud statute that the SEC is using for its civil suit could also be used to prosecute Goldman criminally. So in theory, it is possible that criminal charges could stick — if the SEC’s civil case succeeds. Yet, the standard for a criminal case is much higher. The DOJ must present very compelling evidence that a jury would be able to understand well enough to find that, beyond doubt, Goldman and/or some of its bankers are guilty of fraud. Given that there are many people questioning whether even the civil case can succeed under a weaker standard of guilt, it’s relatively doubtful that the criminal charges would stick. Yet, the public doesn’t have all of the information, so it’s too soon to know the fate of a criminal case for sure.

Who Could Be Prosecuted?

The civil case was brought against the firm and a single named banker — Fabrice Tourre. Who might the DOJ choose to prosecute? According to Chicago Law School Professor and securities law expert M. Todd Henderson, the sky is the limit. If the DOJ feels particularly ambitious, they could try to allege a conspiracy and prosecute the heads of the mortgage unit, he says. But he also finds it unfathomable that the DOJ could show that such a conspiracy existed. He further thinks it’s extremely unlikely that the government could indict the firm itself, as this would essentially condemn Goldman as a criminal organization. As a result, it’s more likely prosecutors focus on a few bankers, like Tourre, if they have enough evidence to bring a case.

Where does Settlement Fit In?

Yesterday, reports indicated that Goldman might be considering settling the civil case. If they do, how would that affect a potential criminal case? Henderson thinks that it would likely preempt one. “It’s hard to imagine that they wouldn’t strike some deal that would get rid of all these actions simultaneously,” he says. In fact, he notes that there have been many cases where the U.S. attorney’s office was used to add additional leverage to civil cases. So the threat of a criminal investigation could merely serve to pressure Goldman to settle. He speculates that what looks like an escalation could just be an attempt by SEC officials to ensure a quick settlement to get the case behind them.

Consequences for Wall Street on a Whole?

In the eyes of Wall Street haters, the SEC-Goldman case probably looks a little analogous to indicting Al Capone for tax evasion. Government officials are largely displeased with the actions of Goldman and Wall Street, but have trouble identifying any tangible wrongdoing. Many accusations of Goldman breaching its fiduciary duty were thrown around at this week’s marathon Senate committee hearing. So if officials figure out some way to go after the banks connected to the government’s belief that Goldman breached its fiduciary duty to clients, then there could be broader consequences for Wall Street. Otherwise, the government will have to rely on fraud. In the context of sophisticated investing, such one-off cases won’t be easy to win.

The Federal Reserve Board announced today that it approved a new Term Deposit Facility program, which would allow member banks to receive interest on certain deposits held at the central bank. Think of the program as Certificates of Deposits (CDs) for banks. Term Deposits (TDs) would act as a way for the Fed to begin draining some reserves from the banking system and reining in money supply, without much disruption to the broader economy.

The program will start small, but could ramp up as the Fed tries to slowly remove excess credit from the financial system. This is one of the tools that it will use as a part of its exit strategy. It’s a clever program, because it will result in temporary reductions in monetary supply — so they should provide the Fed with flexibility if the recovery stutters. They would discourage banks from letting another credit bubble form between now and when the economy is healthy enough to begin more permanent monetary tightening.

Funds held as TDs will not be a part of the required reserves that members are already obligated to hold at the Fed. They would act as another way for a bank to invest some of its capital. They would curb credit, because banks would be putting cash into TDs instead of funding more loans. Like CDs, TDs will pay interest for a certain time period while the deposits will remain at the Fed. TD maturities will likely be six months or less.

While the Fed had announced its intention to create these TDs several months ago, it’s interesting that the FOMC failed to mention the new program in the statement from its meeting earlier this week. It almost begs the question of whether the Fed avoided saying anything about its exit strategy due to fear of spooking the market. It’s pretty hard to believe TDs wouldn’t have come up in the committee’s discussion, considering their formal approval would be announced later in the week.

In the continuing news trend that consumers are feeling more confident about the U.S. economy, the Reuters/University of Michigan consumer sentiment index rose in late April. It increased from 69.5 mid-month to 72.2 at the end of April. That beat expectations of a smaller rise to 71.0. This data point is an important revelation, because the index fell earlier this month. While the reversal appears to confirm other economic data points indicating better consumer spending, it remains something of an outlier.

Earlier this week, we learned that the Conference Board’s consumer confidence reading jumped this month, so it was strange that the Reuters/U Michigan index was down in early April. Although it was positive in the month’s second half, overall, the index was ultimately lower over the entire month, moving from 73.6 in late March to 72.2 in late April. It also remains well below its long-term average in the high 80s.

The Reuters/U Michigan index appears to contradict all of the other positive news about increasing consumer sentiment and spending. Yet as first quarter GDP clearly shows, consumers are definitely spending more, so their sentiment must be improving. But mixed measures can still be useful to consider. The disparity between this index and other readings likely indicates that the recovery isn’t likely to be a steep one. A clear, rapid recovery wouldn’t allow for any doubt. Certainly, some consumers are feeling more confident, but many remain pessimistic as they continue to struggle.

The survey’s chief economist, Richard Curtin, explains this point:

Consumers think the recovery is well underway, although most think it will be distressingly slow and have little immediate impact on their finances.

Sentiment and spending increases face the prospect of a worrying plateau if the labor market recovery is too slow. If that happens, economic growth will be stagnant.

The U.S. economy continued to strengthen in the first quarter of 2010, growing at an annualized pace of 3.2%, according to the Bureau of Economic Analysis. This matched economists’ expectations for real gross domestic product (GDP) growth. The data continues to indicate that the U.S. is in recovery. In particular, the changes in the various contributions to growth make clear that the U.S. economy appears to be on the right track.

First, here’s how GDP growth has looked for the last 16 quarters:

The American Consumer is Back

3.2% isn’t as aggressive growth as we saw in the fourth quarter of 2010, when the economy grew at a 5.6% pace. But at that time, economic activity was mostly driven by companies ramping up their inventories — rather than the American consumer picking up the slack. That changed in the first part of 2010. In Q4, consumer spending only made up 1.2% of the 5.6% growth rate. In Q1, it made up 2.6% of the 3.2%. To put that in perspective, in the final quarter of 2009 consumer spending accounted for only 21% of GDP growth, but in the first quarter of 2010 it accounted for 80%. Since consumers are traditionally responsible for around 70% of GDP, this is an important shift.

The kind of consumer spending that drove the rise in GDP is also encouraging. Some purchases that get cut back on during hard times saw stronger sales, like clothing. In particular, services made up a much larger portion of GDP growth last quarter than in the previous, adding 1.2% compared to just 0.5%. That was due to factors including more restaurant dining and recreation.

Business is Good

Since ramping up inventories played such a major role in growth for Q4, it’s only natural that they would play a less significant role in Q1. But businesses did continue adding to inventories to respond to renewed consumer demand — just not as aggressively. They accounted for 1.6% of GDP growth, compared to a 3.8% contribution the quarter prior.

Interestingly, business investment actually decreased for structures, which may imply that commercial real estate inventory has caused a decline in business expansion-driven construction. All other metrics for business investment rose, however. Equipment and computer software investment continued to be a standout, adding 0.8% to GDP growth.

Net Exports Worsen

The import-export news was mixed. Although the U.S. economy benefitted from additional goods and services being sold overseas, more imports overshadowed the increase. As a result, a net exports actually brought down GDP growth by 0.6%. This contrasts with Q4, when net exports resulted in a 0.3% positive contribution. U.S. consumer and business demand is benefiting global businesses as well as those at home.

Less Government

Finally, government spending had a smaller contribution to economic growth in the first quarter. This is also a good sign, as private enterprise overshadowing government is exactly the kind of trend that indicates real recovery. Government spending actually brought down GDP growth by 0.4%, since there was less of it. That was driven mostly by states spending 4% less. Federal government spending, however, actually increased by a little.

Overall, today’s report is very encouraging. It’s clear that American consumers are opening their wallets again, and even spending on non-necessity items. Business also continued to flourish last quarter, adding to equipment and inventory. Finally, government is generally pulling back its influence, with private growth vastly taking up the slack. The most significant discouraging news from this report is net exports, which isn’t particularly surprising, since American consumers have long exhibited a strong demand for goods and services from overseas. Of course, we should bear in mind that this is just a first estimate and will be revised twice. Last quarter, however, the revisions turned out to be insignificant.

While today’s news provides reason for optimism, challenges still remain for this recovery, particularly in the labor market. For this growth rate to be sustainable, underemployment needs to come down significantly and income growth needs to improve. As businesses growth healthier, those changes should follow — it’s just a question of how quickly.

Note: All statistics are seasonally adjusted.

(Nav Image Credit: tinkerbrad/flickr)

If you thought that the worst housing market collapse in 80 years would make Americans much less comfortable with buying a home as an investment, then you would be wrong. A new Rasmussen poll shows that most Americans still view a house as a great investment. This sort of news must really upset those who believe a house isn’t an investment to begin with.

In fact, a whopping 59% of Americans think buying a home is the “best investment a family can make.” 21% disagreed, while another 21% were unsure. Even if a home is an investment, there’s no guarantee that it will be a very good one. House appreciation doesn’t always occur, even in good economic times.

What makes this statistic surprising is that it’s changed very little since the financial crisis. Back in September 2008, it was only 7% higher, according to Rasmussen. Since then, houses in the U.S. have broadly experienced price declines. Many homeowners faced foreclosure. Yet, Americans still largely believe buying a home the best investment they can make.

In that context, however, Rasmussen also found that just 15% of Americans think it’s a good time for someone in their area to sell a house. 68% disagreed, and 17% were undecided. Of course, they’re right: the housing market continues to have a huge amount of inventory, as foreclosure hit a new record high in March. As long as inventory grows, it will be a buyer’s market.

This may appear to fly in the face of February’s seemingly good news that home prices experienced their first year-over-year increase since December 2006, according to the S&P/Case-Shiller Index (.pdf). Yet, that increase wasn’t particularly impressive, considering it was due more to prices decreasing by more from January 2009 to February 2009 (-1.5%), than from January 2010 to February 2010 (-0.1%). It’s hard to celebrate a year-over-year price increase, when it’s in the context of month-over-month a price decline. As the home buyer credit ends this month, and demand evaporates, prices could suffer further. If interest rates go up, that will make matters worse for sale prices as well.

Now that Senate Republicans have allowed the financial reform debate to begin, what demands will they have for a bipartisan compromise? Until this week, there were only several vague notions of changes they wanted. Reports included concern with the resolution fund, a push for less aggressive rules for derivatives, and a desire for the prudential regulator to overrule the consumer protection agency. But through the leak of the summary of their financial reform alternative, we can gather a little more specificity of the kinds of changes Republicans might call for.

No Resolution Fund

The Republicans intend to eliminate the $50 billion resolution fund which would be paid for proactively by large financial institutions to cover costs in winding down big firms that fail. But until the Republican alternative was leaked, we didn’t know how Republicans wanted the resolution authority to cover resolution costs without the fund. Now we know that they want to do this through loans to creditors to be paid back through after bankruptcy proceedings end.

As mentioned yesterday, this is a strange idea, as it could result in a taxpayer bailout if creditors end up not being able to pay back those loans. You can certainly imagine a situation where Lehman got a loan due to the Bear Sterns failure, for example, and defaulted on it. Alternatively, the Republicans might settle for after-the-fact assessments on financial firms to pay for any shortfall. This also seems a poor alternative, however, since the financial firms who didn’t fail would be forced to pay for the poor performance of their competitors.

Mandatory Liquidation

Republicans worry that the Senate bill allows a little too much wiggle room to regulators to bail out firms. That’s why it takes great care in its alternative bill to forbid the Federal Reserve or FDIC to keep alive failing firms. It orders liquidation if any government involvement — other than temporarily liquidity for firms that can prove their solvency — is required.

It’s a little unclear how well this would have worked during the financial crisis. When there’s a great deal of uncertainty in the market around asset values, how can a firm prove its solvency? At first, AIG was thought to be a mere liquidity problem. With this standard, the government likely would have found itself winding down several other major firms, possibly including Citigroup and Bank of America. It’s hard to see how the economy could have handled that, even with a resolution mechanism in place.

GSE Reform

There’s a gaping hole in both the House and Senate reform bills when it comes to Fannie Mae and Freddie Mac. Neither addresses the problem. Republicans, however, have made clear that they believe that the GSEs were a chief cause of the financial crisis and need major supervision and new limits.

This will be a hard sell to Democrats, who likely want no part in dealing with a mess of this size at this time. The Treasury has also said that it has no intention of approaching GSE reform until 2011. Republicans could be more willing to let this point drop, however, as Democrat’s refusal to address the GSE problem could make for a nice political talking point come midterms.

Federal Reserve Reform

The Republicans want to more aggressively rein in the freedom of the Federal Reserve. They would create a Presidential appointee to supervise the central bank. They would also prefer if it had less flexibility in deciding how to run its credit programs and how to conduct its emergency lending operations.

While the Republicans’ distaste in bailouts is understandable, jeopardizing Fed independence and tying the central bank’s hands in stabilizing credit market is inadvisable. At most, Senate Democrats could revise their bill to include some of the enhanced Fed oversight found in the House bill’s amendments.

Consumer Financial Protection Agency Changes

Interestingly, there was nothing explicit in the Republican plan that would significantly water-down a consumer financial protection agency. In fact, what Republicans want here looks sort of like what the House version calls for. Unlike Senate bill author Chris Dodd’s surprising decision to have a sort of all-powerful consumer protection czar, the House would have a council of regulators decide how to protect consumers.

The Republicans want something similar. But more specifically, they appear to have many of the same figures sitting on the CFPA council as would sit on the prudential regulation council. That would presumably eliminate the worry of regulatory conflict, since the power would be condensed to mostly the same group. It might not be too likely that you see this approach fully adopted, but Senate Democrats would meet Republicans in the middle and have a committee head the CFPA like in the House bill.

Less Agressive Derivatives Regulation

The Republican and Democrat plans don’t actually differ that much on derivatives. They both seek to better utilize clearing and exchanges. They would both allow regulators to exempt some derivatives from clearing. They also both provide for special consideration of so-called end-users — firms with businesses that have a natural exposure a derivative could help hedge.

The main difference, of course, comes in the more controversial measures Democrats want to take, the most extreme of which includes forcing banks to spin off their derivatives desks. Republicans will likely fight this. But some Democrats might find this provision goes too far as well. Also look for a regulation exemption for existing derivative contracts, which will make Warren Buffet happy, and could get Senator Ben Nelson (D-NE) on board.

It remains unclear how many of these demands Republicans can get Democrats to agree to, but they’ll likely get at least a few. Other of their priorities, where the House and Treasury concur, could be ironed out through conference after a bill passes the Senate.

Goldman may try to settle the SEC case it faces rather than endure an embarrassing court battle, a new report from the New York Post indicates. Earlier this week past and present Goldman executives endured an 11-hour witch trial-like hearing before a Senate committee where there was broad bi-partisan anger at the bank’s actions leading up to the financial crisis. Goldman may feel that it’s worth paying up instead of going through that sort of thing for weeks at trial. Still, given the bank’s unwavering claim of innocence, a settlement would be a little surprising.

The New York Post reports:

“It’s almost a certainty that there will be a settlement,” said a source.

As another person put it, the SEC has an “unlimited supply of ammunition” in the form of e-mails and records that it could release, and Goldman officials would like to avoid having those documents fired back at them the way they were on Tuesday.

The problem with settling, of course, is that it means a defendant is implicitly admitting guilt. If there was anything clear through Goldman’s marathon testimony on Tuesday, it was the bank’s unflinching belief in its innocence. The only banker named in the suit, Fabrice Tourre, “categorically” denied that he did anything wrong. All the others testifying, including Goldman CEO Lloyd Blankfein, swore innocence as well. If they were planning on settling anyway, you might have expected at least a slightly more apologetic tone. Instead, they were brazen throughout the questioning.

Considering the defense it intends to take, they also might have a pretty good chance at winning. Whether they misled collateral manager ACA comes down to a dispute of fact, which should be easily shown in Goldman’s favor if its executives are telling the truth.

The harder question is whether they should have disclosed hedge fund manager John Paulson’s involvement in the portfolio selection to the investor IKB. Goldman has a pretty strong argument that it was immaterial for two reasons. First, ACA ultimately had the authority to decide which bonds to pick, and in fact threw out many of those Paulson suggested. So the disclosure was accurate and complete. Second, pool selection influences aren’t relevant to an investor’s analysis. If the investor is given all available statistical information to analyze the collateral, then it should be indifferent to how the portfolio happened to be chosen.

Goldman must be asking itself: will there be more reputational harm done to settling a suit and implicitly admitting guilt, or by enduring a grueling trial but possibly winning. Neither is a particularly good alternative, but this question should be considered in the context of how it might affect the firm’s client relationships.

Goldman’s customers are almost exclusively other financial firms or giant corporations. Most people at such companies understand the nature of derivatives and a broker-dealer’s fiduciary duty. As a result, it’s likely they most of its clients considered this week’s hearing a performance for Senators to score political points, rather than a just censure of Goldman. This week’s hearing surely brought more applause from average Americans outside big business and high finance — those who are not clients of Goldman Sachs. So its actual past and future customers might find admission of fraud more troubling than a messy trial.

However, those average Americans might be the ones sitting on the jury, and that’s a problem for Goldman. The argument for taking the case to court, hinges on the likelihood that Goldman can win. Since this case is intended for a jury, that might be tough. The subject matter is complicated, and few people outside of Wall Street have a positive opinion of Goldman. So there’s also a possibility that even though Goldman believes in its innocence, it’s smart enough to question the likelihood that a jury will accept its version of the truth.

(h/t: Felix Salmon)

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President Obama has chosen his three nominees to fill vacant slots at the Federal Reserve, reports indicate. We’ve already heard that he will choose San Francisco Fed President Janet Yellen to take over for Vice Chairman Donald Kohn. But the two new names — MIT Professor Peter Diamond and Maryland financial regulation commissioner Sarah Bloom Raskin — are interesting choices to round out the group. Each of these nominees appears to satisfy a specific political objective.

Janet Yellen

As an expert on unemployment Yellen can help with the present problem the U.S. economy faces. Some have complained that the Federal Reserve is too worried about the financial industry and not concerned enough with Main Street’s problems. As vice chair, Yellen would provide greater focus on the unemployment problem. Since so many economists believe the labor market recovery will be a slow one, that expertise will be needed for some time.

Peter Diamond

Diamond also makes perfect sense in the context of the deficit problem. He has studied and written extensively on pensions and Social Security. He even co-authored a book on saving Social Security with Obama’s Office of Management and Budget Director Peter Orszag back in 2005. To the extent that the Fed can help with the deficit and entitlements problems, the President must want someone with strong expertise on the team.

Sarah Bloom Raskin

At this point, there’s almost no doubt that the Federal Reserve will obtain additional regulatory oversight of the financial system through whatever financial reform bill is passed by Congress. It’s just a question of how much. Raskin would presumably be Obama’s choice to make sure that new regulation is effectively executed. She’s a lawyer with extensive experience in financial regulation. By perusing her recent speeches, it’s pretty clear that she’s a strong advocate for consumer protection — a specific aspect of financial reform that the Obama administration is particularly interested in.

Maybe they should call it Foreclosure City instead of Sin City. Las Vegas was again the source of the highest foreclosures density in the U.S. during the first quarter, according to a new RealtyTrac report documenting foreclosure rates in the 209 largest metropolitan statistical areas. It had an incredible one foreclosure for every 28 properties. That’s even worse than Nevada’s overall 1-in-33 foreclosure rate for the quarter. The city’s foreclosure density was also nearly 5x the national average.

Most of the other worst cities were from states who are the usual suspects for housing market problems. In fact, you have to look all the way to the #22nd worst — Boise City-Nampa, Idaho — to find a city outside California, Florida, Nevada, or Arizona. Here are the 10 worst:

The good news is that all but two of the 10 worst saw fewer foreclosures than in the first quarter of 2009. The bad news is that only four of those ten have seen declines since the fourth quarter of 2009. Las Vegas is a prototypical example of this phenomenon. It has 19% fewer foreclosure than a year earlier, but 13% more than a quarter earlier.

These changes suggest a lack of stability in foreclosures. Earlier this month, we learned that March set a new high for total U.S. foreclosures. That was partially due to modification programs and banks releasing more shadow inventory into the market.The short-term increases but long-term declines in some of the worst cities make sense in this context.

Most of major cities less affected by foreclosures are those in relatively rural areas. Of the 10 best, three are in upstate New York, while the others are scattered around states like North Carolina, Alabama, Nebraska, Vermont, and West Virginia.

When it comes to major cities, it’s not hard to figure out which ones are at the top — Phoenix, Miami, Detroit, Los Angeles, and San Francisco. Interestingly, the foreclosure problem in New York City metropolitan statistical area remains relatively benign, showing that its economy probably won’t be much affected by defaulted homeowners going forward. Its foreclosure density is only about a third of the national average. Here’s a list of some major cities:

Computer maker Hewlett-Packard announced today that it will acquire smartphone maker Palm for $1.2 billion in cash. The reason for the acquisition is clear: HP wants to be a bigger player in the lucrative smartphone market. Currently, it has a rather poor showing with its iPaq model. Yet, Palm also has a pretty weak market share. It’s a little hard to see how this acquisition will be a boon for HP.

First, Palm’s operating system accounts for just 0.7% of the market, according to IT research firm Gartner. Bloomberg says that HP’s is even smaller. So HP will instantly go from virtually no presence in smartphones to a very, very tiny presence in the market. That’s not exactly a major foothold.

To make matters worse, Palm has been a disastrous company for some time. Bloomberg also notes:

While Palm has a bigger presence in the phone market than Hewlett-Packard, it too has struggled to match the appeal of Apple’s iPhone, RIM’s BlackBerry and phones using Google Inc.’s Android software. The company’s Pre and Pixi phones, released last year in a comeback bid, didn’t sell as well as expected. The company has reported 11 straight quarterly losses.

This is hardly an acquisition where HP can sit back and let the synergies work their magic. HP will have to invest heavily in Palm to make it a major player. Chiseling away at the market share of the smartphone titans listed in the block quote above won’t be easy. It will take some major innovation to attract new customers to an HP/Palm device. Unfortunately, HP has not been one of the foremost names in technological innovation for some time, with Apple, Google, Samsung and others leading the way.

And yet, HP will purchase Palm for a 23% premium over its share price. That’s sort of like if a home buyer purchased a house for that needed a lot of work for more than its market value. The premium shows the clear winner in this transaction: the Palm shareholder. It’s hard to complain about a 23% premium on a stock that has scored 11 straight quarterly losses. Whether HP shareholders will be better off with this acquisition, however, will take some years to determine. HP must see some potential for Palm to perform significantly better under its watch.

The Federal Open Market Committee (FOMC) released its statement this afternoon for its April meeting. The market is looking for it to answer questions such as: Will anyone join the dissents of maverick committee member Thomas Hoenig? Will the FOMC retain its “extended period” language regarding how long rates will remain exceptionally low? Will the Fed indicate it intends to soon begin selling some of the securities on its balance sheet? Its short April statement probably won’t satisfy the market’s hunger for all of this knowledge, but some answers are provided.

First and foremost, Kansas City Fed President Hoenig remained the lone dissenter. The reason he voted agains the policy action was the same as for the past few months: the Fed continues to use the “extended period” language to explain how long it will keep rates very low, much to Hoenig’s dismay. He remains concerned that the Fed won’t have as much flexibility to raise rates if inflation suddenly ramps up. He’s still the only committee member worried enough about this possibility to dissent, however.

To be sure, the Fed thinks the economy has continued to improve since March and sees a moderate recovery for a time. It notes that spending by business on equipment and software, and by households, has continued to improve. But it still sees consumers restraining themselves, due to high unemployment, low income growth, reduced wealth, and low credit. It also noted that businesses remain reluctant to add payrolls.

Since the Fed continues to get more and more optimistic about the economy with each statement this year, its decision to remain so dovish on rates is a little surprising. Even though no one expects the Fed to raise rates anytime soon, with each month that passes, Hoenig’s argument grows stronger and stronger. With strong first-quarter corporate earnings across-the-board and job growth starting in March, it’s curious that the Fed hasn’t eased its dedication to indefinite near-zero rates.

The FOMC statement revealed little else, however. It contains no mention of when or how the Fed intends to begin selling some of the many billions of dollars in assets it has accumulated on its balance sheet since the financial crisis. In fact, the statement doesn’t mention any plans or timeline to begin reining in the money supply. But given that inflation remains extremely low, perhaps this shouldn’t be a shock. Still, with such an enormous balance sheet, some might have expected the Fed to remind the market that some preparations have been made to soak up excess credit when the time comes. Perhaps the more detailed meeting minutes will provide greater insight when released in a few weeks.

In case you missed it, General Motors has a new commercial out bragging about the company paying back all of its government debt. Last week, the company paid back the last $4.7 billion of its $6.7 billion loan. Does that make its commercial accurate? Technically, but if you consider the bigger picture, then this repayment looks much less significant than GM wants Americans to believe.

Here’s the commercial:

The key quote comes from GM Chairman and CEO Ed Whitacre towards the beginning:

We have repaid our government loan in full, with interest, five years ahead of the original schedule.

Again, this is technically true. The entire $6.7 billion loan has been repaid. But as pointed out last week, that was a small fraction of its $50 billion bailout. The U.S. government still retains 60.8% ownership in the firm, even though the tiny bit of debt has been repaid. So to act like GM is in the clear in regard to its obligation to the government is misleading at best and disingenuous at worst.

In fact, it shouldn’t have been very hard for GM to repay this loan — even without any profit. That’s because it used the equity injection from its bailout to repay the loan, according to Special Inspector General for TARP, Neil Barofsky. So even implying that GM was able to repay the government loans due to its improved performance is misleading. In reality, it just took money from Uncle Sam’s right hand and put it into his left.

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