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How globalization changes capitalism, the economy and politics

MBS – then and now, analogy from a small mortgage REIT

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90-day-chart-big

Dynex Capital Inc. is a rather small US based real estate investment trust with its principal investments in securitized residential and commercial mortgage loans and non-agency MBS. The REIT’s portfolio is managed through a combination of short term debt, securitization financing, and equity capital. Dynax provides a glimpse into the current state in short term financing of mortgage backed securities.

This type of financial wizardry in combination with a deterioration in loan underwriting standards has driven the financial industry and the world economy to the brink of disaster. The subprime debacle has forced private capital to flee securitization markets of residential and commercial mortgages.

As of June 30, 2009, Dynex Capital had carrying assets of $245.1 million in non-Agency MBS, that contrasts with $531.5 million in Agency MBS. During the most recent episode of credit contraction, which is still ongoing, impairment of government guaranteed Agency MBS was less severe than of non-Agency MBS.

In the quarter $245.1 million of non-Agency MBS portfolio was associated with $192.5 million securitization financing and short term debt repurchase agreements. Shareholders’ equity amounted to $52.6 million or 21.5% of the total portfolio. In the non-Agency MBS portfolio leverage of equity capital was about 5 times in the end of the second quarter.

Chairman Thomas Akin commented on the quarter, “The story of this quarter is the performance of our Agency MBS investment portfolio. We earned a net interest spread of 3.70% on Agency MBS as our borrowing costs continued to decline (thanks to Bernanke)….Our highly seasoned non-Agency investments continue to generate solid earnings and cashflow for the Company.”  (() emphasize added)

Net interest spread between annualized yield and annualized costs of funds was a record 3.70% in the quarter ended June 30, 2009. In the year earlier quarter the spread was much smaller, only 1.45%. The conditional prepayment rate (CPR) also decreased from 27.3% a year earlier to 19.9% during the last quarter.

Thanks to Fed chair Bernanke’s monetary easing borrowing costs for the financial services industry are almost zero, yet lending rates remain high causing the spreads to widen. According to CEO Akin the joint venture in $6.1 million non-Agency CMBS may be eligible for financial assistance from the government’s TALF program.

There is something suspicious about this joint venture. Could this be a bad bank with potentially impaired investments taken off the REIT owner’s and ultimately its shareholders hands? Akin obviously expects to get help from the government.

In bank land many financial institutions are still getting sicker. At the end of the first quarter the FDIC had still 305 of them (could be less by now) on its problem bank list with about $220 billion in combined assets. Investors in the financial services industry are abandoning their free market principles and line up for a multitude of accommodative government support, yet their commitments to regulation and prudence in compensation are nothing but lip service.

A revealing report by NY Attorney General Cuomo showed that many of the banks which lost billions in 2008 continued to reward its employees with generous bonuses. Financial institutions of all sorts have adopted a motto of ‘heads I win, tails you loose’ . This attitude is rooted in the almost guaranteed government bailouts that have spread all over the Western hemisphere during the last two decades.  

An Icelandic bank lending huge amounts of money mostly to its biggest shareholders shortly before it collapsed, or governors of their states in Germany promising radical changes in compensation policy while asking for public funds to bail out the Landesbanken are just two examples of the prevailing bigotry in the financial services industry. Needless to say top management continued to receive lavish compensations to this day.

This kind of compensation and also lately the marked improvement in earnings for some institutions leave the overall financial health of the industry in doubt. Maybe things aren’t as bad as they seem?! Dynex Capital reported in its press release that delinquencies on securitized mortgage loans increased from April to June of 2009 to $15.0 million from $9.1 million at December 31, 2008, but the company incurred no credit loss during the quarter. That’s payments on about 6.1% of non-Agency MBS loans are 60 to 90 days late.

Finance blogger Calculated Risk has a nice monthly chart with historical data of 90+day delinquency rates for Orange County (CA), one of the hardest hit regions of the U.S. housing bust. The chart above shows 6+% delinquency rate of residential mortgages for June, 2009, and compares with what Dynex reported during the quarter (commercial and single family loans combined).

Interestingly, going back into the archives of financial statements from Dynex, revealed a similar delinquency rate of commercial loans with 5.15% delinquent 90 days and over in the June 2006 quarter. The single family loan portfolio performed much butter, only 2.68% of the loans were delinquent 90 days and over. The commercial loan portfolio is not unlike the non-Agency loan performance during the most recent quarter, although commercial and single family combined.

In general Dynex was substantially less invested in government guaranteed Agency bonds reflecting a more opportunistic environment before hell broke loose in the summer of 2007.  The securitized finance receivables were collateralized with $535.5 million of commercial loans and $136.9 million of single family loans. $487.4 million of commercial loans were financed with non-recourse securitization, and $113.4 million of single family loans were financed with monthly recourse repurchase agreements. The finance strategy was similar then and now, though different in the magnitude of dollar amounts invested.

Shareholder equity was $136.3 million during the quarter, or 20.2% of the $672.4 millions of the commercial and single family loan collateral combined. During the summer of 2006 non-Agency portfolio leverage of equity capital was therefore about 5 times, essentially unchanged to the most recent quarter.

Net interest spread between interest earning assets (average 7.55%) and interest bearing liabilities (average 7.54%) was substantially lower before the crisis, only 0.01% for all investments combined in the portfolio. Thanks to Bernanke, at last something he can be proud of, this margin has improved substantially. For Dynex it was a record 3.7% in the quarter ending June 30, 2009.

The portfolio is certainly more cautious today then it was before the crisis. Government guaranteed mortgage loans have significantly replaced more risky private sector loans. Yet, credit quality benchmarks have not changed that dramatically at all as one would expect.

The following table summarizes the allocation of the Company’s $154.6 million of shareholders’ equity as of June 30, 2009:

REIT-Dynex

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Iran between a pragmatic pseudo-liberal and a theocratic hardliner

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Khamenei-Rafsandjani

Ayatollah Ali Akbar Hashemi Rafsanjani is thought to be a pragmatic conservative, ready to do whatever is necessary to protect mostly his own interests. In a 1999 sermon at the Tehran University he praised the government for using force to suppress student demonstrations. On July 17, 2009 , his highly anticipated speech at the Friday prayer satisfied neither the green opposition movement of the youth in the streets of Tehran nor did it rehabilitate his arch-enemy Ahmadinejad and his role in the most recent elections.

Rafsandjani is walking a tightrope in trying to preserve his influence and keeping pressure on Ahmadinejad and his supporters and at the same time not to alienate the Supreme Leader of Iran, Ayatollah Ali Khamenei. On the one hand he is a supporter of freedom of expression and civil society, and on the other hand he founded the radical Ansar-e-Hezbollah movement in Iran. In 1999 Hezbollah was involved in violent attacks on student protesters at anti-government demonstrations which lasted for about a week and resulted in a number of students being severely injured, some paralyzed and even murdered.

During his Friday prayer Rafsandjani spoke of doubt that has begrudged the people of Iran in this bitter era after the election. He suggested in order to return the trust to the people all, including the system, government, security forces, police and the people should move in line with the law. At this time it is worth mentioning that it was Rafsandjani and other Mousavi supporters who themselves deviated from the rule of law by demanding new elections when there was no legal basis for it. During his sermon Leader Ayatollah Khamenei reminded the opposition of the importance of the rule of law: "By Allah’s favor, the presidential election was accurately held, and the current matters should be pursued legally."

It was Rafsandjani who did not adhere to the law and yet he is now stating the obvious after the fact that protesters have already taken their demands to the streets. That kind of twisting the facts is malicious to say the least. It is the makings of a pragmatic politician who sees his fortunes threatened and is now desperately trying to take advantage of frustration that is settling in among the young generation in Iran. He wants to leave the door to debate open but fails to recognize that there cannot be a reasonable debate with people taking to the streets and chanting death to the dictator from their roof tops. He fails to recognize that protestors want a revolution yet Rafsandjani wants to protect only his own interests.

How did it get to the point that the country of the Iranian revolution is almost going to be torn apart between the forces of a modern, young, moderate Iran and a theocratic, old and conservative leadership? The answer of the theocrats is to suppress freedom in an effort to contain this threat to the system. The answer of the opposition is to revolt against the regime. The losers are most certainly people of Iran, young and old, who are about to be crushed in a vice between this two gigantic millstones.

Rafsandjani who’s role in the current revolt is appalling, nevertheless is most likely the only one who could lead the country out of the current deadlock. If you are going to drown you probably have to grab whatever you get, and Rafsandjani’s pragmatism is maybe just the right thing to pull them out. In the moment the nation of Iran does not really have any alternative.

The United States, Israel and its allies are about to raise the stakes for Iran in its nuclear stand off with the west. The New York Times has floated the prospects of tough sanctions against the nation of Iran from the Obama administration. There is talk about extreme economic sanctions by cutting off Iran’s imports of gasoline and other refined oil products. Iran imports about 40 percent of its gasoline from abroad. The sanctions could be implemented soon after Obama’s deadline to revive talks on Iran’s nuclear program ends in mid-September.

In the meantime the administration is rallying its allies behind a gasoline embargo, which is supposed to change Iran’s cost-benefit analysis according to president Obama. Congress is preparing legislation that would give the president the authority to act on extreme sanction. A bill, the Iran Refined Petroleum Sanctions Act, has already 71 sponsors a majority in the senate and is expected to pass the house as well. US lawmakers consider this bill to arm the president with sanctions authority more appropriate than authorizing the use of military force. They seemed to have learned from the Bush debacle after all.

Of course by some stretch of imagination this energy embargo scenario could also be viewed as an act of aggression not unlike war and its use of military force. Such a draconic measure is therefore not without risk. it could further destabilize an already weakened regime in Iran and change a rather benign and contained situation into uncontrollable violence and bloodshed. This will not be enough to deter the U.S. and its allies as long as the violence remains within Iran. The U.S. has certainly a long history in such ruthless endeavors.

There is also the possibility that Iran’s president Mahmoud Ahmadinejad will capitalize on tough sanctions and rally his fellow countrymen behind him. Enemy number one for most Iranians is still the U.S. and sanctions will only help to reinforce anti-American sentiment in the region. After his defeat in the first Persian Gulf War Saddam Hussein was hugely unpopular, but a decade lasting of crippling sanctions transformed him into Iraqi’s favorite leader once again.

In Iran’s nuclear standoff with the west the door is slam shut, neither the U.S. nor the theocratic leadership seem ready to compromise. The only hope to open a window of negotiations is through the pragmatic conservative Ayatollah Rafsandjani. His support for a free market domestically and his moderate position internationally brings him closer to the U.S. than any of the other Iranian clerics and in stark contrast to president Ahmadinejad. It can be assumed with absolute certainty that Rafsandjani is the main force behind the opposition movement and the current mini-revolt against Ahamdinejad and the Islamic revolution itself.

The fronts in this historic struggle for dominance are clear. Leader Khamenei and Ahmadinejad stand for the integrity of the Islamic revolution and are pitted against more moderate reformers around clerical businessman Rafsandschani and Mousavi. Initially everything seemed to fall in line with the Supreme Leader almost hastily anointing his candidate Ahmadinejad as the winner of the current election. Nobody expected the president to alienate his conservative friends by promoting Rahim Mashaie to the post of vice-president.

After Khamenei signaled his anger with this choice Ahmadinejad decided to ignore the Supreme Leader’s wish for almost a week before he finally gave in and demoted Mashaie to the post of his new chief of staff. Over the course of this row with the hard line, conservative leadership in Iran several of his ministers resigned from their posts causing a major stir among the theocratic system. His opponents immediately seized the opportunity to sense unease amongst conservatives over the disputed elections, and saw there claims of election fraud confirmed.

Some have even argued that Ahmadinejad was preparing for a coup d’état to install a military dictatorship in Iran. I think this is wrong. We have no credible evidence that the president is planning such radical action against Leader Khamenei. In his defense Ahmadinejad himself characterized his relationship with Khamenei like that of a father and son, going beyond politics and administration.

Still uncertainty remains about why would Mr. Ahamdinejad provoke his closest allies at a time when his opponents are already fiercely attacking him. The most likely explanation is, he lost his nerves. In an attempt to reach out, he wanted to include more moderate forces in his new cabinet. That did not ring through with ultraconservative, hard line members in the government. Unsure about how to resolve the current dispute with the opposition and end the threat that street protests pose to the system he charged ahead and fired some of his conservative members in the government.

Though we cannot be sure about the motives, friction between Leader Khamenei and his protégé Mr. Ahmadinejad  became apparent yesterday during the official endorsement ceremony for his second term as president.  A video shot during the procedure clearly showed how awkward the two men approached each other. In another sign of turmoil major critics of the recent election, including Mr. Rafsandjani, did not participate in the endorsement. In the meantime another influential ultraconservative cleric instructed the president to consult with parliament before naming his new ministry. Indeed Ahmadinejad seems to be marginalized in his power over the influential theocrats.

Among all the accusations and problems that have befallen the nation of Iran, Rafsandjani’s influence has gained importance but is still up against the ultraconservative Supreme Leader of Iran. We can only speculate about the outcome of this confrontation but can be fairly certain about the main actors in this drama. Although his motives are questionable moral objections have to be abandoned in favor of an end that justifies the means of ending a nuclear standoff with the west. But here is the problem. Rafsandjani who can help to end this international dispute can only do so by committing treason on the Iranian revolution and risking civil war in Iran. Today’s protestors in the streets of Tehran should be fearful to get what they wished for.

Bernanke in a town-hall meeting, shopping for popularity

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bernankeintownhallmeeting

Last Sunday Ben Bernanke, chairman of the Federal Reserve responded to questions from the public in a town-hall style meeting. For the first time in history an acting Federal Reserve chair stepped into the arena that is usually the prerogative of obligations among elected officials. We truly live in interesting times.

What could have provoked this extraordinary move by the chairman given the daunting unpopularity of cumulative actions taken by the Fed in the last twenty four months? The answer is already given in the question. Ben Bernanke is shopping for popularity in order to better his approval ratings. His term as chairman ends in January 31, 2010, when he is up for reappointment by president Obama.

I can only imagine it must have been scary and embarrassing for the chief to step in front of the very same audience he led down over the course of the last ten years. He certainly did not mean to inflict any harm upon his fellow countrymen, but together with his predecessor Greenspan he helped lay the foundations of a shaky economy based on bubble economics.

Sure he gave birth to many millionaires and even some billionaires, but for most people Greenspan’s and Bernanke’s policies were rather harmful. Certainly one cannot expect any sensational outcome of such meetings with both a preselected audience and preselected questions. Organizers won’t let that happen though the chairman won’t suffer any lasting damages. It would have been nice though to read Bernanke’s mind.

To his defense the chairman admitted that he was disgusted from bailing out giant Wall Street firms like AIG, Bear Stearns or Merrill Lynch and rescuing them from going bankrupt. Though we certainly respect his wish not to reside over a second Great Depression, of course we have to believe him that there were no other options at the time. I might also add we are not yet with absolute certainty out of the woods with regard to another Great one.

Asked about his too-big-to-fail policy he seemed to indicate sympathy for the public’s frustration and promised to make it better in the future. Though his credibility was called into question by reiterating his opposition to an independent outside audit of the Fed. Why no audit if he has nothing to hide? Yes there is the issue of independence of the Fed, but just how much independence was there say in the last ten years?!

The Federal bank closest to Wall Street, and therefore in a special position with regard to the nation’s largest financial institutions, is the Federal Reserve Bank of New York. During the financial crisis Federal Reserve and Treasury Department officials made all major decisions, but the New York Fed executed them.

In the meantime the New York Fed has been criticized as too close to Wall Street. William Poole, a former Fed president, missed a longer-run perspective among the Fed’s staff. They adopted a trader mentality instead and did not pay enough attention to a system skewed towards too much risk taking by numerous bailouts of large Wall Street firms.

The Fed’s board of directors is composed of powerful bankers and corporate titans like Jamie Dimon, the head of JPMorgan Chase, and Jeffrey Immelt, General Electric’s chief. Richard Fuld had to resign after Lehman’s bankruptcy and Stephen Friedman called it quits over a conflict of interest with the other board he served, of investment power house Goldman Sachs. The corporate-federal officials network seems too tight to ever disintegrate.

It is not only the Federal Reserve that has to fear for its independence. The lobbying departments of large financial institutions have expelled their tentacles even into the Financial accounting Standards Board (FASB) of the United States and the International Accounting Standards Board (IASB) of Europe.

According to a recent report by an international team of former regulators and corporate officials, the Financial crisis Advisory Group deplored efforts by politicians to prescribe changes on accounting standards. The integrity of valued assets on the books of financial institutions should not be called into question in an effort to save those institutions from potentially harmful bets gone awry. In April, 2009, FASB already caved in to heavy financial lobbying and paused fair-value accounting rules for illiquid assets.

Beside all the regulatory and statutory powers bestowed on elected or appointed officials their most potent tool still remains the integrity of the person and organization in question. It is by no means sufficient for Fed chair Bernanke to communicate his objection to the bailouts on Wall Street even if it is within such an elaborate setting of a town-hall meeting. There is not enough meet on the bone to undo what has already happened.

A Gallop poll, conducted in mid-July, found that only 30% rated the Fed as doing an excellent/good job. The bank had the lowest score out of nine government agencies and it was down sharply from the 53% who still approved of the Fed’s job in 2003. This time even the CIA and the Internal Revenue Service scored better than the Fed. Bernanke will have to do better. It will most certainly be like walking a tightrope.

Hearing on Speculative Position Limits in Energy Futures Markets, July 29, 2009

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CLU9Sep09WTIcontract-andFFtarget

Donald Casturo, Managing Director, Goldman, Sachs & Co, in his opening testimony during the second day of hearings at the CFTC, blew into a familiar horn with respect to speculative actions in trading energy future contracts. Maybe so because of his position as head of trading and managing the commodity index business at Goldman or maybe it was just something that comes with the job as a trader.

In his defense Casturo referred to convergence at settlement of a future’s contract price with the spot price in a physically deliverable commodity like oil, as vital to well-functioning futures markets.Therefore prices in the future’s market are determined only by supply and demand fundamentals the same way spot prices are.

This makes a lot of sense under normal circumstances but we surely don’t live in normal times. The convergence argument does not take into account that fundamentals are not really that important considering the accommodative stance of the Federal Reserve. Who is going to take the other side when everybody and his cousin are assuming that the Fed will trash the dollar in order to revive an ailing financial industry? By doing so the Fed will increase commodity prices and inflation over the long run. After all that’s what they have done for the last thirty years.

From this it clearly follows that future prices can influence spot prices in such a way detached from market fundamentals. Excessive speculation therefore will drive the spot price in the direction of the shape of the futures curve. To pinpoint such a shift away from fundamentals is of course extremely difficult. Speculators seem to say we are innocent until proven guilty, and see their business in trading energy as legal.

CFTC and others might not be able to refute it but might recognize their illegitimate actions on the basis of common sense. I hope that the CFTC hearings will help them and the public to acknowledge today’s peculiar situation in energy markets and commodity trading in general and act accordingly as outlined in section 4a of the CEA  (Section 4(a) of the Commodity Exchange Act) to protect the public interest.

In order to illustrate this point I charted the monthly price of the front month WTI crude oil futures contract (CLU9) including FOMC decisions on the Fed Funds rate since 2006. The last of a series of restrictive steps was implemented in June 2006, FOMC raised interest rates by 25 basis points to 5.25 percent in that month. After that rates were kept steady at that level for more than a year. Over that time period the price of WTI oil was range bound between $60 and $80.

In September 2007, two months after two Bear Stearns hedge funds had defaulted, FOMC changed course and lowered their target rate by 50 basis points. During September for the first time ever the price of WTI cut through $80 threshold like a knife through butter. Unprecedented cumulative cuts of 125 basis points in January and 95 basis points in March and April the following year saw similar price jumps in WTI crude oil future contracts.

The price of oil kept increasing from about $85 at the end of 2007 to almost $150 in June of 2008 even though the economy was already in a severe recession as determined by NBER since the end of 2007. As one might argue that this was not recognized until many months later, unprecedented actions taken by the Federal Reserve should have proven otherwise. Speculators kept pouring money into commodities and were driving up prices to unsustainable levels.

During the CFTC hearing commissioner Bart Chilton was chastising the industry for their go slow attitude and reiterated CFTC’s commitment to swift action. He was particularly concerned with the London loophole and look-alike contracts traded on London futures markets. In the connection with hedge exemptions traders can buy and sell these OTC contracts on unregulated electronic exchanges with almost no position limits attached to them. These contracts were traded outside of the commissions oversight.

The policy debate according to Chilton is to find the right balance between the amount of commercial hedging and speculation. Within the CFTC he seems to be the driving force behind stronger regulation. In his statement he acknowledged the commission did not perform its due diligence function with as much zeal as it should have last year. No such words coming from chairman Gensler.

In fact there seems to be a rift between Gensler and Chilton on the role speculators played during the commodity bubble of 2008. In last years report CFTC blamed supply and demand fundamentals rather than speculators for the run up in oil prices. Chilton seemed to suggest that this year’s report would deviate from that view, but chairman Gensler merely talked about updating but not necessarily reversing the 2008 findings. CFTC will release the new report next month.

Tyson Slocum is Director of Public Citizen’s Energy Program, an organization that supports the public in helping to ensure households have access to competitive priced energy markets. In doing so they are vitally interested in functioning energy markets and fair prices. Public Citizen is neither funded by the government nor by the corporate sector.

Slocum’s independence represented the true public view on the issue of energy prices, which should be determined only by supply and demand fundamentals. He suggested to the CFTC to implement: 1) aggregate position limits across all energy products and markets for all index traders, swaps dealers and proprietary traders. 2) increased transparency of OTC contracts and clearing them through a CFTC controlled exchange. 3) investigation of potential market integrity concerns.

The Intercontinental Exchange (ICE) according to Slocum operates OTC and Exempt Commercial markets (ECM), both are not effectively regulated by CFTC, yet their overall market penetration has exploded in the last couple of years. ICE’s electronic exchange volume increased 567% from 2004 to 2008 (from 35 million contracts to 237 million) and the company’s OTC platform has seen volume grow 700%, from 31 million contracts in 2004 to 247 million in 2008.

Major investment firms like Goldman Sachs, JP Morgan Chase/Bear Stearns, Morgan Stanley, Citigroup and Bank of America/Merrill Lynch invest in commodity index funds by buying huge amounts of energy and other commodities future contracts in OTC markets. The same firms hedge their exposure to these markets in offsetting portfolios of future contracts on regulated exchanges. These hedges are very often exempt from position limits. Since many firms operate index funds and at the same time function as swap dealers they manage to evade CFTC regulation not once but twice through OTC markets and hedge exemptions.

GS operates the long only GSCI index fund, with 65% of its 24 commodities being in the energy space and only 25% in agricultural commodities. The CME has a 20000 contracts hedge exemption on the GSCI index fund. When GS radically changed the weighting of the index in the summer of 2006, selling about $6 billion worth of gasoline futures contracts, future prices fell by nearly 10 percent.

To gain inside into physical movements of energy products large energy traders like Goldman Sachs are acquiring energy infrastructure assets like pipelines and storing facilities or in some cases even outright oil and gas fields. Highbridge Capital Management, a hedge fund controlled by JP Morgan Chase, bought a stake in oil and natural gas trader Louis Dreyfus Group. As of November 2008  Morgan Stanley paid $452 million to lease storage facilities for 2009. In January 2009, investment banks like Morgan Stanley and Citigroup stored about 80 million barrels of oil in takers at sea. According to a Wall Street Journal report financial speculators were snapping up leasing rights in Cushing, the most important delivery point of physical crude in North America.

In August 2006, Goldman Sachs, AIG and Carlyle/Riverstone took over pipeline operator Kinder Morgan for $22 billion, thereby controlling 43,000 miles of crude oil, refined products and natural gas pipelines, in addition to 150 storage terminals. In 2005, Goldman Sachs and private equity firm Kelso & Co. bought a 112,000 barrels/day oil refinery in Kansas operated by CVR Energy. In May 2004, Goldman spent $413 million to acquire royalty rights to more than 1,600 natural gas wells in Pennsylvania, West Virginia, Texas, Oklahoma and offshore Louisiana from Dominion Resources.

Goldman Sachs owns a six percent stake in the 375-mile Iroquois natural gas pipeline, which runs from Northern New York through Connecticut to Long Island. In December 2005, Goldman and Carlyle/Riverstone together invested $500 million in Cobalt International Energy, an oil exploration firm.

During yesterday’s hearings senator Sanders characterized the situation in the financial industry as heads, bankers win; tails, everyone else loses. Looking at the vast increase in scope of energy specs, their many loopholes in electronic exchanges where thousands of contracts are evading CFTC regulation with the speed of light, or the explosion of hedge exemptions to those very same traders that are fleeing into the dark pools of OTC markets, makes me think he is on to something.

The goal has to be to avoid extreme volatility in energy and other commodity prices for the sake of the common good. To achieve this we must implement Tyson Slocum’s suggestions and constitute strict aggregate position limits, close all possible loopholes and absolutely assure market integrity. In the nearby future big investment firms like GS and Morgan Stanley have to make a decision, whether they want to continue their lucrative trading venues or switch to the physical part of the commodity business. Either commercial or non-commercial, we should not allow this huge firms to be both at the same time.

Hearing on Speculative Position Limits in Energy Futures Markets, July 28, 2009

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CushingWTIspotprce1985-09

British Petroleum reported second quarter results with earnings off 53 percent compared to the same period last year. The company still earned $4.39 billion compared to $9.3 billion a year ago, but during the quarter the price of oil had averaged $59.13 a barrel compared to a stunning $121.18 in the second quarter of 2008.

Several industry insiders and analysts have stated time and again that based on fundamentals of supply and demand the price of oil should not exceed $60 per barrel and yet in the last 12 months we have seen prices spike to $150, to fall back to about $30 and to rise again to about $70 in the first half of 2009. Even the staunchest free market defendants will have a hard time to explain these prices swings.

While the oil industry is still coping well with the current situation others are more unfortunate. In a recent CFTC testimony Ben Hirst on behalf of the Air Transport Association of America outlined that airlines consumed 5 percent fewer fuel in 2008 yet their fuel costs went up by $16 billion. According to Hirst who is also senior vice president of Delta Airlines fuel expenses consumed 40 percent of Delta’s total revenue in 2008, forcing the company to lay off about 10000 employees. A price swing of $1 had an annual impact of $100 million to Delta’s bottom line.

This reminiscent of beg-thy-neighbor policy where some are profiting handsomely at the expense of others has now become the subject of a series of hearings by the Commodity Futures Trading Commission (CFTC). The hearings are scheduled to be held between 9:00 a.m. EDT and 1:00 p.m. EDT on Tuesday, July 28, Wednesday, July 29, and Wednesday, August 5, 2009. In the spirit of transparency all hearings will be live webcast and testimony and statements as well as supplementary material will be available till August 12, 2009.

The subject of the hearings concerns the recent price volatility in energy futures trading and their impact on the spot price for this diverse class of commodities. Chairman of the CFTC Gary Gensler laid out the primary objective to gather information from a wide-range of industry participants and academics in several points. The most important are 1) how to apply aggregate position limits consistently across all markets and participants and 2) how to deal with exemptions from position limits by bona fide hedgers and others.

As chair Gensler pointed out in his statement 37 exemptions were granted to NYMEX spot month speculative position limits for crude oil as of July 21, 2009. The average size was 5.639 contracts, almost 2 times the size of the 3000 contracts set as position limit. A survey conducted by the CFTC from July 1, 2008 to June 30, 2009, found that in the nearby NYMEX futures contract for WTI crude oil 2 traders exceeded 10% or more of open interest in all futures and options combined. The largest trader’s position held 14% of OI total. In the first deferred month 5 traders exceeded 10% of OI with a maximum of 18% OI, and in the second deferred month 6 traders held more than 10% with a maximum of 19% OI. This of course does not include bilateral swap trades because CFTC does not have regulatory oversight within the dark pool of OTC markets.

For senator Bernard Sanders Rome is burning, using his words to characterize the current situation in the energy markets. As the first one to testify in this most recent hearing he demanded that the CFTC takes urgent action and puts an end to heads, bankers win; tails, everyone else loses.

Last year Sanders introduced S.1225, the Energy Markets Manipulation Prevention Act, to address rampant speculation. Last July the House of Representatives overwhelmingly passed similar legislation by a strong bipartisan vote, yet S.1225 did not become law. Congressman Bart Stupak also introduced legislation included in the American Clean Energy and Security Act (ACESA), which recently passed the U.S. House of Representatives and is now pending in the Senate.

In his testimony Stupak emphasized the influence index investors have on price developments. From January 2008 till the end of June 2008 index investors were responsible for $55 billion of hot money inflows driving the price of oil from $99 to $140 per barrel. A massive financial crisis caused investors to withdraw $73 billion over the next six months, and the price collapsed to about $30 per barrel. Since the end of 2008 index investors have again increased their holdings of future positions by 30 percent to the equivalent of more than 600 million barrels of crude oil.

During his testimony he also addressed the issue of non-commercial traders, namely those banks, hedge funds and large institutional investors who qualify as speculative traders and yet are able to operate under almost unlimited conditions. As of June 30, 2008, at the height of the commodities bubble, non-commercial traders held about 60 percent of the open interest in natural gas markets, and 75 percent of the West Texas Intermediate crude oil market. At the same time commercial traders, who actually take delivery of physical oil because they need it to operate their businesses, held only about one third of the long positions in OTC markets.

LongpositionsinOTCmarkets

The CFTC is an independent agency of the United States government and operates under the regulatory powers of the Commodity Exchange Act (CEA) enacted June 15, 1936. In 1974, congress amended the Act in an attempt to provide more comprehensive regulatory oversight for the trading of future contracts, and created the Commodity Futures Trading Commission. Since then the commission has fine tuned its regulatory framework but many including Sanders and Stupak urge CFTC to take more decisive steps towards regulation of future markets.

For any additional regulation to be successful it will be necessary to close loopholes many energy traders are using today to circumvent existing regulation. Most importantly 1) swap exemptions included in the CEA, 2) Foreign Board of Trade no Action letters, and 3) general swap loopholes which allow swap dealers to circumvent position limits. Hopefully the hearings will help to deal with these very issues, since they are crucial to any successful attempt to reign in rampant specs in energy markets.

The Intercontinental Exchange (ICE) is under the supervision of authorities in the UK although it is based in Atlanta, U.S.A. ICE is the largest internet market place to trade futures and OTC energy and commodity contracts in the world and as such detrimental to price developments in energy markets. The exchange cooperates with the CFTC though a no-action letter prevents the commission to impose tough regulation on foreign markets. This loophole has to be closed.

Similar to ICE the Dubai Mercantile Exchange (DME) is a fully electronic exchange with its contracts listed on CME Globex and primarily offers energy futures contracts. The DME is regulated by the Dubai Financial Services Authority and can serve as another loophole for trigger happy energy traders. In August 2008 the CME has acquired a 32.5% stake in the DME from NYMEX. In addition about 20% belong to Goldman Sachs, Morgan Stanley, Shell and JP Morgan.

In 1991, CFTC authorized the first bona fide hedging exemption to a swap dealer, since then 15 different investment banks have taken advantage of this exemption. Since 2006, NYMEX has granted 117 hedging exemptions for West Texas Intermediate crude contracts, many of which are for swap dealers without physical hedging positions. These exemptions have to end and swap dealers need to come under the umbrella of conventional regulation by the CFTC.

Craig Donohue, Chief Executive Officer of CME, admitted that future exchanges took disciplinary actions in 1,334 cases, levying fines and restitutions of $10.3 million, suspending traders for a total of 3,414 days and barring 22 traders from trading at the exchange for at least a year in some cases. According to his testimony he is ready to adopt a hard limit regime to regulate energy future contracts that will include all-months combined limits and tailored hedge exemptions for swap dealers and index funds.

But that’s about as far as Donohue goes. During his testimony he defied any involvement of speculation in the recent volatility in energy prices. As much as he condoned this unfortunate development supply and demand remained as the sole culprit. To support his thesis he cited research that used quantitative evaluations rather than qualitative ones from his opponents. In January this year a GAO report did not grant conclusive evidence to some of those qualitative studies which designate speculators as being responsible for the price swings in energy markets. A Wall Street Journal survey of 53 economists agreed and found that market fundamentals were driving prices of food and energy.

Donohue confronted the issue of causation by citing evidence that net long exposure of futures-equivalent swap positions declined by 11% in the first half of 2009, refuting the fact that speculators were behind the run up in energy prices during this time period. This somehow neglects the issue of absolute positions in a sense that even less of something can still be a lot, and I do not think it can be used as an effective argument against a casual relationship between speculators and excessive price movements in energy futures and spot prices.

According to Donohue an exchange and not the CFTC is best suited to police activities in its markets. This is very reminiscent of what Siebel Harris, then vice-president of Chicago Board of Trade, said to senator Capper in a 1936 hearing about the establishment of the CFTC. Capper responded: “I take it that your position all hangs on this point, that you want the board of trade to make all the rules and regulations governing the grain trade rather than an impartial agency of the Government that will function in the interest of all parties interested?”

The most compelling argument of those who support speculation has historically been to provide liquidity to the market and in doing so helping to find the real price for the underlying commodity. For them the logic followed the more speculation in the markets the better for transparency and price discovery. Granted the mediators in this process were the regulators but markets worked best with the least amount of regulation possible.

Senator Saunders begged to differ and saw Rome burning with respect to modern day players in the field of energy speculation. He therefore suggested three swift and unmitigated actions. 1) Immediately classify all bank holding companies and hedge funds engaged in energy futures trading as noncommercial participants and impose strict positions limits on them. 2) Eliminate the conflicts of interest between Wall street’s trading desks and their internal research departments. 3) Revoke all staff no-action letters for foreign boards of trade that have established trading terminals in the United States.

Were CFTC to follow these three simple rules excessive volatility in energy prices would almost certainly be a relict of the past. The question is not will it be effective but rather will regulators have what it takes to pierce the zone of influence of powerful financial institutions. Since the necessity to act is so urgent, by no means is it trivial anymore to be complacent and ignore the call for action, there is a good chance we might get tougher regulation this time, even though traders will explore all possible venues to avoid it.

Is CRE the next accident to happen?

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Commercial real estate is shaping up to become another causality of the financial crisis and CRE mortgage delinquencies and loan defaults are now starting to pile up on the balance sheets of US financial institutions. That is of course on top of losses from residential real estate, consumer credit and the securitization markets that sort of connect all the sore spots on Wall Street.

$817 billion of total CRE-loans are still outstanding in June, 2009, and about 29 billion have run into trouble. In the month of June loan delinquencies soared by $10 billion heating up the debate about future CRE losses by financial institutions.

But that’s not all. About $105 billion worth of troubled loans have been worked out. A majority of those loans experienced an averaged loss of almost 64 percent. Delinquency rates on CRE are up to 4.5 percent in the second quarter from 3.6 percent in the first quarter, 2009.

Similar to residential real estate CRE property prices have also collapsed. Moodys/REAL Commercial Property Price Index (CPPI) has not bottomed as of April 2009:

CREallPropertynationalindex

In CRE much like with residential real estate many loans have been securitized and actual losses to financial institutions and investors will therefore depend largely on two conditions. First, the total amount of loan defaults will be substantial given the collapse in prices. Second, FASB statements 166 and 167 will determine how big the losses are or if they can be deferred onto some future time horizon.

FASB statements 166 and 167 refer to securitized loans in special purpose entities, and require banks to consolidate insufficiently capitalized SPEs onto their balance sheets. Although this should foster more disclosure for investors its impaired with whims of possible rule-bending.

FASB determination to implement these rules is another uncertainty factor. In April, 2009 FASB halted fair value accounting to stop the hemorrhaging of impaired financial assets. Statements 166 and 167 are supposed to take effect in the first fiscal quarter beginning after November 15, 2009.

Some are already preparing for the worst. Bank of America now expects to bring about $150 billion back onto its balance sheet under the new FASB rules. This 150 billion off-balance-sheet assets comprise of $12 billion home equity conduits, $85 billion card securitizations, and other variable interest entities make up the remaining $53 billion. Maybe BofA is just lucky.

Neil Diamond at The Greek Theatre in Los Angeles in 1972

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About 2 years later president Nixon resigned over the Watergate scandal. Ford while in office pardoned Nixon and inflation and economic depression plagued the nation. In 1977 Jimmy Carter moved into the White House. The 39th president of the United Sates was uncharacteristically farsighted and introduced a national energy policy asking his countrymen to conserve. They did not like it and along came Ronald Reagan. Together with Margaret Thatcher he helped orchestrate men’s biggest heist – a corporate takeover of democratic societies. Sure we got 1989, the internet, a digital revolution but we also got Friends, Spice Girls and worst of all we got soft.

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“He sounds just like Eric Burdon playing Elmer Gantry, the melodrama is irresistible, and the only thing he could do to top this would be to collaborate with James Michener and Frank Capra on a Cinerama rock opera about the second coming of Thomas Jefferson as a wandering Jesus Freak minstrel who sews this wicked land up at the seams and brings the children home and their parents into the street to dance. Starring none other.”                   The Rolling Stone

Written by Alfred

26. July 2009 at 11:03 am

Posted in Music

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