I first spoke with Steve in mid-January. Given the pace of developments in Washington, on Wall Street, and at so many other points on our economic and political landscape, I am thrilled to have him back on the show. We will leave no stone unturned in discussing healthcare, financial regulatory reform, the Fed, Lehman Bros., and so much more. I guarantee we will pull no punches in promoting truth, transparency, and integrity in our discussion. Don’t miss it!!

Join us live at the BlogTalkRadio (BTR) website at 8pm ET on Sunday night. You can also mix it up in our always energized chat room, which runs simultaneously with the show at the BTR site. As a reminder, all of my radio shows are archived and previous episodes can be listened to right here at Sense on Cents by clicking on the No Quarter Radio tab located under the page header. (FYI, I keep an audio player of my most recent episode in the right sidebar). In addition, all No Quarter Radio programming is available as a free podcast on iTunes. From the iTunes Store, type “NQR podcasts” in the search window.

LD

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Former Lehman Bros. CEO, Dick Fuld

Reports that Lehman was effectively ‘cooking its books’ prior to its ultimate demise are not a surprise.

Reports that Dick Fuld, then CEO of Lehman, was not aware of the nature of this cooking are both ridiculous and pathetic.

The lifeblood of every financial institution on Wall Street is access to financing for its operations. That financing very often comes in the form of repurchase agreements (repo financing), in which the institution borrows funds while pledging assets. These short term loans, often overnight loans, are unwound at a preset date and preset prices. The rates borrowers have to pay for funds borrowed depend on the credit quality of the borrower itself and the quality of the assets pledged.

Auditors assess the health of the institution on a variety of a measures, but ultimately look at the amount of equity capital the institution holds relative to its assets so it can determine its overall leverage. As defined by Investopedia:

The amount of debt used to finance a firm’s assets. A firm with significantly more debt than equity is considered to be highly leveraged.

A firm such as Lehman would have to pay more to borrow funds to finance its operations if lenders determined it was overleveraged. This increased cost of borrowing would eat right into Lehman’s bottom line and if the lending dried up completely would cause the firm to go belly up.

Was Lehman overleveraged? A report released yesterday is extremely revealing and incriminating of what was truly going on at Lehman, not only in the midst of the crisis but going as far back as 2001.

Welcome to the world of repo financing on Wall Street!!

Bloomberg reports on just how Lehman ‘cooked its books,’ in writing, Fuld ‘Negligent’ as Lehman Hid Leverage:

Lehman Brothers Holdings Inc. used off-balance-sheet transactions to understate its leverage in late 2007 and 2008, deceiving shareholders about its ability to withstand losses, a bankruptcy examiner’s report said.

Then-Chief Executive Officer Richard Fuld was “at least grossly negligent” for letting Lehman file financial reports in which a key gauge of strength was “reverse-engineered” through transactions known as Repo 105s, bankruptcy examiner Anton Valukas said in a report yesterday. Lehman auditor Ernst & Young LLP could be accused of “professional malpractice,” he said.

Lehman moved assets off its balance sheets via Repo 105 transactions (pledging excess collateral in return for funding) and accounted for them as sales, not financings, so that the overall leverage of the firm was disguised.

Bloomberg writes that the independent investigation reveals:

“The balance sheet manipulation was intentional, for deceptive appearances, had a material impact on Lehman’s net leverage ratio” and caused financial reports to be misleading, Valukas wrote of the New York-based company. Higher leverage undermines a firm’s capacity to absorb financial shock.

Was Fuld aware of these transactions? Does a bear dump in the woods? Fuld’s attorney begs otherwise. As Bloomberg reports:

Fuld didn’t know what the Repo 105 transactions were, his lawyer, Patricia Hynes of Allen & Overy LP in New York, said in a statement. He “didn’t structure or negotiate them,” she said. “Nor was he aware of the accounting treatment.”

What does Fuld’s right hand man, Bart McDade, have to say about this financing operation and Fuld’s knowledge?

The bank, which had been using the repos since 2001, ramped them up in mid-2007, breaching internal limits, the report shows. Lehman’s former president, Herbert “Bart” McDade, commented on them in an April 2008 e-mail exchange, after he was asked whether he knew about their effect on the balance sheet, Valukas said. “I am very aware,” McDade wrote back. “It is another drug we r on.”

Fuld, 63, received a presentation referencing Repo 105s in March 2008, and McDade, 50, recalled discussing the transactions with the CEO in June of that year, according to the report.

“Fuld knew about the accounting of Repo 105,” McDade said in an interview with Valukas on Jan. 28 this year.

What regulatory authority was charged with overseeing Lehman during this period? The NASD, which then became FINRA in 2007. Recall that FINRA’s oversight (or lack thereof) of Lehman and others is addressed in the Amerivet Securities v FINRA complaint.

In regard to Dick Fuld, his career on Wall Street started as a commercial paper trader (another form of short term borrowing). To think he was not fully cognizant of the Repo 105 transactions is beyond absurd.

Where should this Lehman situation go now? Let’s start with the following, in the appropriate halls of justice: ”Mr. Fuld, raise your right hand and repeat after me…..”

LD

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What can we learn about Ms. Yellen? Let’s read Larry Kudlow, a highly regarded economist and market practitioner with extensive experience on Wall Street, in Washington, and on the airwaves. Kudlow and Yellen look at the economy from a decidedly different perspective. Kudlow recently wrote of Ms. Yellen’s nomination and what it says about the Obama administration in his Kudlow’s Commentary:

The new Obama Fed is going to be very dovish when it comes to fighting future inflation and defending the value of the dollar.

The president has nominated Janet Yellen to be vice chair of the Federal Reserve. Ms. Yellen is a distinguished economist who unfortunately subscribes to the Phillips-curve model that trades off unemployment and inflation. In other words, rather than excess money creation as the cause of rising prices, she focuses on the unemployment rate, the volume of new jobs being created, and the growth of the overall economy. For Ms. Yellen, inflation is caused by too many people working and too much economic prosperity.

And since we have the opposite problem today — high unemployment and too few people working — she will be the last Fed governor to turn out the lights on the central bank’s zero interest rate.

There is no evidence in Ms. Yellen’s public opinions or speeches that she might use a market-price rule — targeting commodities, gold, bond rates, or the dollar — as a forward-looking inflation (or deflation) signal. So the absence of a commodity- or dollar-price rule will continue at the Fed. Bernanke doesn’t use a market-price rule, and Obama’s additional Fed appointees — whoever they are — will undoubtedly come from the same Phillips-curve camp.

Supply-siders like myself who believe that only market prices can provide accurate signals of the supply and demand for money are going to be very disappointed. If the Fed supplies more cash than markets want, the inflation rate can go up whether unemployment is high or low. We learned this painfully in the 1970s, when high unemployment was accompanied by high inflation.

And this is a crucial juncture. The Fed is going to encounter excruciatingly difficult problems as it deals with the magnitude and timing of its decisions to start withdrawing excess cash and raising the fed funds target rate. Markets should be the guideposts for these decisions, not the unemployment rate.

Janet Yellen, who served as a top economic advisor to Pres. Bill Clinton and was a Clinton appointee to the Federal Reserve Board, has for the past six years been the president of the San Francisco Fed. She is a very able economist. But if you work from the wrong money model, you are likely to get the wrong money results.

The likely Yellen appointment is not a surprise. Obama’s economic team has paid mere lip service to defending the value of the dollar.

Will Kudlow’s reference to the economic malaise of the 1970s during the Carter administration be prescient? Time will tell, but we need to know who our trail guides are as we navigate the economic landscape. With Ms. Yellen marking the trail, the chances for stagflation just increased.

LD

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Timely access to information as to who is buying/selling what, how much they are buying/selling, and why they are buying/selling is absolutely invaluable. The Wall Street banks fight tooth and nail to protect their information franchises.

That said, there are supposed to be rules as to how information is handled and processed so that trading complies with the rules of the road. Banks are not supposed to front run clients. Banks are not supposed to give up client names. Do the banks practice what the regulators preach?  

Given the fact that Wall Street banks run both customer operations and proprietary desks, there are supposed to be Chinese walls in place to make sure that information is handled properly between desks. At the firms where I worked, the proprietary desks were either on a different floor from the customer desk or in an entirely different building.

Thank you to a friend of Sense on Cents for sharing a recently released report which would seem to indicate that the Chinese walls at Goldman Sachs would appear to be neither tall nor long (said in jest), but virtually non-existent.

Asset-Backed Alert, a Wall Street trade publication, reports:

Data-Sharing Worries Grip Goldman Clients
Investors are accusing Goldman Sachs of violating Wall Street code by permitting information-sharing between two types of collateralized debt obligation traders:those who work on behalf of clients and those who handle proprietary capital.

Goldman currently has the two desks situated next to each other in its Lower Manhattan headquarters. They also have a common supervisor, managing director Jerry Ouderkirk. Such a lack of separation is frowned upon by market players,and buysiders say the bank has committed an even graver transgression by allowing the traders to exchange information about CDO prices and dealflows.

Legally, investment banks don’t have to separate their proprietary and “client” traders. Most do anyway, as they don’t want to create the impression that they might be using insights into customers’ trades to their own benefits.

Virtually all banks have “firewall” policies in place between the two types of traders, and a majority of them also create physical barriers. Barclays, for example, keeps a CDO prop trader in Philadelphia and its client traders in New York. And J.P. Morgan has shuttered its CDO prop desk.

Goldman itself used to isolate its proprietary and client traders. But the bank united those personnel under Ouderkirk last year, perhaps to maximize the efficiency of efforts to unwind many of its on-balance-sheet positions in collateralized debt and loan obligations.

In the sector’s heyday, Goldman’s prop desk was among the
biggest buyers of subordinate CLO paper. It continued holding those positions through the 2007 creditmarket freeze, and began selling opportunistically late last year. The bank’s holdings appear to have fluctuated downward since then, from more than $1 billion.

With its proprietary traders mainly in selling mode, Goldman
might argue that it isn’t in a position to front-run customers who
are on both sides of similar trades.

A bank spokesman would say only that “Goldman Sachs has a strict framework in place to prevent the sharing of client information between our customers and proprietary dealers.”
Some investors, however, claim the close relationship between the bank’s proprietary and client traders creates an unlevel playing field. That’s mainly because the prop desk, regardless of whether it is buying or selling, could tap client traders for information about bond prices and the identities of others who want to do deals — privileged facts that aren’t available to the general buyside population. A few said they have cut off business with the bank, which is still doing some buying.

Separately, the fate of proprietary trading in general has been cloudy since President Obama said in January he would seek to implement a recommendation from former Federal Reserve chairman Paul Volcker that would push banks out of the business. Now industry players are waiting to see what parts of the so-called Volcker Rule make it into a financial-reform bill that Sen. Chris Dodd (D-Conn.) plans to introduce March 15. The issue, as one source put it, is an increasing lack of differentiation
between making markets and taking profits. “The line has been
more and more blurred over the years,” he said.

The proximity of these two desks is a clear indication that Goldman Sachs more highly prioritizes the benefits from timely information than the reputational risks associated with this questionable management decision.

I addressed this exact point of reputational risk and whether clients will want to do business with Goldman on my appearance on CNBC last week.

LD

How does Hintz define Lehman’s accounting? In a word, “shenanigans.”

Take a look at a brief Bloomberg video clip to get an insider’s view of the Lehman kitchen:

In the spirit of full disclosure, while looking for background material on Mr. Hintz himself, I unearthed the fact that Mr.Hintz was sanctioned by the NASD (now FINRA) for selling his own personal positions in stocks (Lehman and Morgan Stanley) while continuing to recommend them. An NASD release highlights:

NASD announced today that it has imposed a fine of $350,000 against Sanford C. Bernstein & Co. LLC of New York and a fine of $200,000 against Charles B. (“Brad”) Hintz, one of the firm’s research analysts, for violations of NASD’s research analyst conflict of interest rules.

In its investigation, NASD found that Sanford Bernstein, a subsidiary of
Alliance Capital Management L.P., had favorable ratings on Morgan Stanley and Lehman Brothers securities that remained in effect while its research analyst, Hintz, was selling his own shares in the two companies, a violation of NASD Rules prohibiting trading contrary to an analyst’s recommendation. Hintz also engaged in transactions in six securities held in a discretionary personal account that were contrary to his then-current recommendations.

The fines represent the largest NASD has imposed to date for violations of its new research analyst conflict of interest rules, which were first approved by the SEC on May 10, 2002 and went into effect beginning July 9, 2002.

“NASD’s research analyst conflict of interest rules are designed to give
customers confidence that analysts’ stock recommendations are not biased due to any financial self-interest of the analyst,” said James S. Shorris, Acting head of Enforcement. “Inconvenience or expense does not excuse non-compliance with NASD’s rules against analysts trading contrary to their research recommendations.”

NASD found that Hintz, a high profile analyst covering financial services
companies, held a substantial amount of stock in Lehman Brothers and options to purchase stock in Morgan Stanley that he received as compensation when he served as the Chief Financial Officer and Treasurer, respectively, at those firms. Hintz’s Morgan Stanley options were set to expire in January 2005. NASD found that Hintz wanted to sell his holdings in both companies to realize the substantial gain in the value of the securities and to diversify his portfolio.

NASD rules, however, prohibit an analyst from effecting stock
transactions contrary to the analyst’s current recommendations; Hintz had favorable ratings on both companies at the time.

In 2004, Sanford Bernstein — at Hintz’s request — unsuccessfully sought an exemption from the rule prohibiting the sales, arguing that Hintz’s circumstances constituted a “hardship” and that he should be allowed to sell his holdings. Thereafter, Sanford Bernstein developed a plan — approved by the firm’s legal and compliance department and senior management — that it believed would allow Hintz to sell his holdings in Morgan Stanley and Lehman Brothers without violating NASD rules. Under this plan, Hintz issued what were purported to be his “final” reports on Morgan Stanley and Lehman on Dec.23, 2004. Those reports rated the two companies “outperform” (the firm’s highest rating) and “market-perform,” respectively, and purportedly “terminated” coverage, while indicating that Hintz intended to resume coverage in February 2005 after selling all of his holdings in both companies.

The reports further stated that the only “alternative” open to Hintz to allow him to sell his stock was to “terminate” coverage. One of the reports emphasized Hintz’s purported dilemma by quoting Joseph Heller’s Catch-22: “That’s some catch, that Catch-22.” To the contrary, Hintz did not have to sell his holdings and could have continued to hold his Morgan Stanley and Lehman Brothers securities, using other funds to pay for the costs of exercising his Morgan Stanley options.

Sanford Bernstein’s plan did not comply with NASD rules. There was no
bona fide termination of coverage because the firm intended to resume coverage of both stocks shortly after Hintz’s stock sales were complete. The investment recommendations on both companies therefore remained in force, despite the purported “termination,” and the stock sales in January 2005 violated NASD rules.

NASD also found that Hintz violated NASD rules as a result of numerous
stock transactions in a discretionary brokerage account maintained at a
domestic trust company. Sanford Bernstein, which received copies of the account statements, failed to supervise the activity in the discretionary account with a view towards preventing the violations. The account held securities in six companies that Hintz covered. Between August 2002 and January 2004, Hintz’s discretionary account engaged in 27 transactions in those securities that were contrary to his ratings. Also, 39 transactions were executed in the account either 30 days before or five days after Hintz published a research report on the company, thus violating NASD rules prohibiting transactions during a proscribed blackout period.

In addition, between August 2002 and December 2003, Sanford Bernstein and Hintz did not disclose his holdings in these six securities in 60 research reports, as required by NASD rules.

In connection with these settlements, Sanford Bernstein and Hintz neither admitted nor denied the charges, but consented to the entry of NASD’s findings.

What is the real lesson to be learned in both the Lehman case and also with this news about Brad Hintz as well? Once again, investors need to take the mantle of CAVEAT EMPTOR.

What a world.

LD

There are a handful of financial journalists who pull no punches in telling the absolute truth and in providing real transparency. Bloomberg’s Jonathan Weil holds a special spot in the Sense on Cents Hall of Fame for his determination in calling people and institutions on the carpet. From Wall Street to Washington to around the global financial landscape, Weil leaves no stone unturned in promoting integrity. His commentary today is superb. Please share it with friends. Weil writes, Greece Lifts a Page From Citigroup’s Playbook:

Is it too much to ask for the world’s titans of government and finance to speak credibly when they open their mouths?

Some of them sure seem to think so, judging by the latest news from the financial-crisis front.

To hear Vikram Pandit tell it, Citigroup Inc. was a healthy institution when it got bailed out by the U.S. government. The problem back in November 2008, Citigroup’s chief executive officer told a congressional oversight panel last week, was that short sellers were driving down its stock price in spite of the bank’s fundamental strength.

At the same hearing, Herb Allison, the assistant Treasury secretary for financial stability, said “there is no too-big- to-fail” guarantee by the U.S. government for Citigroup or any other financial company. He dodged other questions about Citigroup by noting, with no apparent sense of irony, that the Treasury is now its largest shareholder.

Not to be outdone, Greek Prime Minister George Papandreou traveled to Washington this week to complain how unfair it was that “unprincipled speculators” were tearing down his country’s markets. Sure, Greece had lied for years about the size of its budget deficit. But what needs to be fixed urgently, he said, is the scourge of credit-default swaps that let investors bet on whether Greece will default on its debt, while European nations mull a possible bailout.

This all has a certain mid-2008 ring to it. Back then, in the months between the U.S. rescues of Bear Stearns Cos. and the government-backed mortgage financiers Fannie Mae and Freddie Mac, the talk from Wall Street kingpins and regulators was much the same.

In April 2008, Lehman Brothers Holdings Inc. CEO Dick Fuld declared the “worst is behind us,” while blaming short sellers for his bank’s faltering share price. (In a short sale, an investor sells borrowed shares in hopes of buying them back at a lower price later and pocketing the difference.)

By July, the Securities and Exchange Commission had unveiled the first in a series of emergency short-selling rules that made it harder for investors to bet against the stocks of Lehman and 18 other “substantial financial firms.” Instead of helping the companies, the move wound up highlighting which financial-services companies the government was worried about the most, including Fannie and Freddie.

That same month, Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke testified in Congress that Fannie and Freddie were adequately capitalized. Two months later, Paulson directed the government to seize both companies because they were insolvent.

Neither short sellers nor rumors spread by speculators were to blame for any of these companies’ collapses. Bogus balance sheets and incompetent regulators were, along with the panic that ensued once investors decided they couldn’t deny the reality any longer.

One lesson government officials and CEOs alike should have learned is that they only undermine market confidence when they try to deflect attention from their own organizations’ failings by making preposterous claims or blaming trumped-up bogeymen. That some of them keep reaching for the same tired playbook speaks to their capacity for deluding themselves into thinking that others will believe them when they say ridiculous things.

Meantime, the financial system has seen little substantive regulatory change since its near-meltdown in late 2008. In Europe, the one significant effort underfoot in response to Greece’s fiscal crisis is to possibly ban traders from selling credit-default swaps on some countries’ sovereign debt. It’s an idea that also may be gaining momentum in the U.S.

There has been no evidence such trading has had any effect on Greece’s borrowing costs. Greece’s swaps aren’t even all that expensive, at about 284 basis points yesterday, meaning it would cost about $284,000 a year to insure $10 million of Greek debt for five years.

While high by sovereign-debt standards, that’s paltry compared with the price to protect against a default by, say, Ambac Financial Group Inc. Its swaps were trading yesterday at 4,679 basis points. That tells you the market believes a default by the New York-based bond insurer is many times more likely than one by Greece.

Likewise, in the U.S., the only financial-regulatory change of note has been a new round of SEC restrictions on short selling. In Congress, reform legislation has gone nowhere.

The U.S. government has done nothing to address too-big-to- fail, except to dispatch underlings like Allison to deny its existence. The way the government measures banks’ regulatory capital remains broken. (Citigroup, which reported a $27.7 billion net loss for 2008, was deemed “well capitalized” when it got bailed out.) Credit-rating merchants such as Moody’s and Standard & Poor’s are as entrenched and conflicted as ever.

Then there’s the fiscal health of the U.S. itself. Absent policy changes, “the federal government faces an unsustainable growth in debt,” the Government Accountability Office said in a January report. Within 10 years, the national debt held by the public, as a share of gross domestic product, could exceed the peak it reached in the aftermath of World War II, the GAO said.

Someday, should the rest of the world ever begin to question the U.S. government’s creditworthiness, don’t be surprised if the geniuses running our financial system find a way to blame short sellers and speculators for that, too.

I could not have said it better myself. Not that Jonathan Weil could have further positively distinguished himself, but with this commentary he just did.

LD

When those implicated in ‘pay to play’ schemes on Wall Street are not dealt with in truly appropriate fashion, everybody loses. Why? We end up with a loss of confidence not only in the markets, but even moreso a loss of confidence in our judicial system. I am not so naive as to think that our fields of justice are level, but that doesn’t mean we should not pursue that goal and highlight inequities when and where we see them.

Those engaged in financial crimes or schemes including ‘pay to play’ should never be able to buy their own justice by writing a check. That system of justice will never truly dissuade those engaged in or attracted to ‘pay to play.’

I see a strong sign of just such a potential inequity this morning. It smells.

The Wall Street Journal highlights that former Obama car czar, Steven Rattner, is in the midst of settlement talks with New York Attorney General Andrew Cuomo over his role in a ‘pay to play’ scheme. The WSJ writes, Rattner in Talks to Settle a Probe:

Wall Street financier and former auto czar Steven Rattner is in settlement talks to resolve his role in the “pay to play” investigation at the New York state pension fund, according to people familiar with the matter.

A guilty plea on Wednesday by David Loglisci, the former chief investment officer of the $129 billion fund, turned a spotlight on Mr. Rattner, a well-known Wall Street player who last year spearheaded the Obama administration’s auto overhaul.

On a call with reporters, New York Attorney General Andrew Cuomo said the 57-year-old Mr. Rattner remained under investigation but declined to provide more details.

A spokesman for Mr. Rattner declined to comment.

For months, Mr. Rattner’s lawyers have been engaged in protracted settlement discussions with both the New York attorney general and the Securities and Exchange Commission over his conduct in the case, said the people familiar with the matter. Defense lawyers Jamie Gorelick and William McLucas of Wilmer Hale in Washington are representing him in the talks, these people added.

Mr. Cuomo’s investigation of Mr. Rattner focuses on his activities at Quadrangle Group, the private-equity firm he co-founded a decade ago. The New York-based firm obtained a $100 million investment from the New York pension fund three weeks after a DVD company owned by Quadrangle agreed to distribute “Chooch,” a low-budget movie co-produced by Mr. Loglisci and his brother, according to court papers.

Quadrangle also paid a $1.1 million finder’s fee to Hank Morris in exchange for securing the investment from the New York fund. Mr. Loglisici said Wednesday he had “effectively ceded” his authority over the fund’s private-equity investment decisions to Mr. Morris, a former top New York political adviser.

How tough is Steve Rattner? By reputation, Rattner is viewed as one of the meanest SOBs to run between Wall Street and Washington. In fact, Rattner is believed to be the individual implicated in directly threatening Chrysler creditors in the midst of the Chrysler bailout a year ago. (Read my piece, “Is Barack Obama Going Tony Soprano?”)

White collar crime of this nature needs to be adjudicated in terms of hard time — not by writing a check.

Rattner is obviously entitled to due process, but if, in fact, Rattner is implicated in this ‘pay to play’ scheme (the fact that he is in protracted settlement talks seems fairly incriminating), then the courts should throw the book at him and everybody else involved.

Rattner may not be all that tough sitting in the can being eyeballed by his new ‘friends.’

Unless and until that happens, this cesspool of activity and those swimming in it will continue to smell and pollute all of us.

What do you think?

LD

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China’s economy is only one-fifth the size of the U.S. economy while China’s population is more than four times that of the United States. In fact, China’s population is approximately one-fifth of the entire world’s population. Clearly, the People’s Republic of China represents a huge growth opportunity in this century.

Bloomberg highlights this inflation news this morning in writing, China Inflation Quickens as Industrial Output Climbs:

China’s inflation reached a 16- month high, industrial output climbed and new loans exceeded forecasts, adding to the case for the government to pare back stimulus measures.

Consumer prices rose 2.7 percent in February from a year earlier, the National Bureau of Statistics said in Beijing today, compared with the 2.5 percent median estimate of 29 economists surveyed by Bloomberg News. Seasonal factors stemming from a weeklong holiday may have boosted prices. Production rose 20.7 percent in the first two months of 2010, the most in more than five years.

Premier Wen Jiabao aims to hold full-year inflation around 3 percent after banks flooded the financial system with money to drive a rebound from the global recession. Gross domestic product grew 10.7 percent last quarter and central bank Governor Zhou Xiaochuan said March 6 that anti-crisis policies, including the yuan’s peg to the dollar, must end “sooner or later.”

What does this increase in Chinese inflation mean for the global economy? Is it accurate to project that the boom in China’s economy is a precursor to a global boom? Is it accurate to project that inflation in China will lead to inflation elsewhere?

As with most everything in economics, in my opinion, these questions have no clear cut and simple answers but we would be remiss not to assess the developments in China in the context of the global economy.

First and foremost, be aware that within the inflation in China, food inflation is in runaway mode running at an 18% annual clip according to Bloomberg. How will Chinese officials react to this inflation news? In order to ease what are clear signs of asset bubbles, especially within the property sector, China will have to raise interest rates and allow its currency (Chinese yuan) to appreciate while loosening its tie to our U.S. greenback.

Bloomberg’s report adds fuel to this fire in reporting:

“Inflation may top the 3 percent policy target by April, which is bound to trigger further monetary tightening,” said Dariusz Kowalczyk, chief investment strategist at SJS Markets Ltd. in Hong Kong. He sees benchmark interest rates increasing as early as this month.

Additionally,

“More decisive policy tightening measures than those implemented so far are needed to prevent the economy from overheating,” said Song Yu and Helen Qiao, Hong Kong-based economists with Goldman Sachs Group Inc. The government may increase interest rates and bank reserve requirements and control investment approvals and funding, they said.

While China will have to raise rates to stave off inflation, what is happening to its closest global economic engine, that being Japan? Deflation is gaining a stronger foothold as Bloomberg highlights in writing, Japan Yield May Reach December Low on Deflation:

Japan’s bonds may gain, pushing 10-year yields to the lowest level since December, as the economic recovery slows, deflation lingers and interest rates stay near zero, Citigroup Global Markets Japan Inc. said.

Deflationary pressures are most widely highlighted in Japan, but are also building in the Euro-zone as well.

Meanwhile here in the U.S., we have a mixed bag of inflationary pressures within selected segments of our economy (food, fuel) while little pricing pressure, if not outright deflation, within other segments (wages, housing, commercial real estate).

Add it all up and what does it mean?

China’s raising rates will not only slow the strongest economic engine in the world today, but it will also attract more capital to that nation.  I do not see how Japan or the EU can raise rates given their economic weakness and deflationary pressures. I see the U.S. as stuck in the middle currently, but with the likelihood that the U.S. will have to indicate a moderate tightening sooner rather than later.

LD

Regrettably, America deals with this pandering and posturing from our political leaders and regulators all too often. While Americans are being told one thing, what are the regulators telling the banks? Hold cash.

I am not shocked, but certainly disappointed, that American financial periodicals failed to run this story detailing these recommendations from our bank regulators. The London based Financial Times highlights this bombshell in writing, Regulators Tell U.S. Banks to Hold Funds: >>>>

US regulators have told banks not to increase dividends or buy back shares until political and economic uncertainty surrounding the industry dissipates, in a move that will delay by months the return of capital to shareholders.

Some investors in financial stocks argue that winners of the credit crisis, such as JPMorgan Chase and Goldman Sachs, have profitable businesses and strong balance sheets and should consider raising dividends or buying back stocks.

Executives at the two companies have talked in public and with regulators about the possibility of returning cash to investors after taking action to conserve resources during the turmoil. But they say they are not in a rush to go ahead, especially if their watchdogs oppose such moves. “Regulators are gun-shy at this stage, partly because they fear that giving the green light to healthier banks to return cash to investors would prompt demands from more troubled institutions to do the same,” one senior Wall Street executive said.

People close to the situation said government agencies, led by the New York Federal Reserve and the Treasury, told banks they would have to wait until the economic and legislative picture became clearer before returning funds to investors.

In a letter sent in December, officials reminded financial groups they would have to meet criteria, such as “stress-testing” their balance sheets and achieving sustainable profitability, before releasing funds to shareholders. The New York Fed and Treasury declined to comment.

Mike Mayo, an analyst at CLSA, said: “The word banks have used the most … is ‘fragile’.

Economic growth is predicated on the flow of money, otherwise known as the velocity of money. With news like this, we should expect that velocity to remain at a trickle.

The burden will remain on the Fed to keep its Fed Funds rate low so these banks can continue to recover. The burden should also remain on the regulators and bank executives to not allow the Fed liquidity to walk right out the front door of these banks in the form of big fat bonuses.

LD

In late January, we witnessed a massive lawsuit filed on behalf of the Federal Home Loan Bank of Seattle against a large number of Wall Street banks. To reference that suit, read here. Today, The Wall Street Journal highlights Connecticut Attorney General Richard Blumenthal to Sue Moody’s, S&P, the pillars of the Wall Street ratings game:

Connecticut Attorney General Richard Blumenthal will announce a lawsuit Wednesday against rating firms Moody’s Investors Service and Standard & Poor’s alleging that they knowingly assigned “tainted ratings” for “risky investments” backed by subprime loans.

In a press advisory, Mr. Blumenthal’s office said the attorney general will discuss the lawsuit at a press conference in Hartford at 11:30 a.m. EST.

The practices outlined in the lawsuit enabled the worst economic downturn in the nation since the Great Depression, Mr. Blumenthal said.

Mr. Blumenthal told Dow Jones Newswires in November that he was planning to sue the major credit raters over ratings that he alleges enabled the “structured finance debacle” in recent years.

At the time, Mr. Blumenthal said he may pursue a lawsuit on behalf of state pension funds or as an extension of investigative actions by his office.

In 2008, Mr. Blumenthal’s office separately sued Moody’s Corp., the parent of Moody’s Investors Service; McGraw-Hill Cos., the parent of Standard & Poor’s; and Fimalac SA’s Fitch in state court in Connecticut.

In those lawsuits, Mr. Blumenthal alleged that the major rating firms “systematically and intentionally” gave lower ratings to states, municipalities and other public entities than corporate and other forms of debt with similar or worse default rates. Those suits are pending.

While Blumenthal is filing suit, what have financial regulators and our leaders in Washington done to address the inherent conflicts in the ratings game? De nada.

In fact, the ratings game is nothing short of the great enabler and facilitator for Wall Street. I highlighted as much last June in writing, “Wall Street’s Great Enabler Dodges a Bullet”:

Did Barack Obama and team give a sly and subtle wink to Wall Street that ‘the game goes on’ and the ‘fix is still in?’ I believe they did.

Many analysts, myself included, view Obama’s proposed regulatory reforms as a combination of ‘reshuffling the deck chairs’ and ‘cosmetic surgery.’ In the process of those maneuvers, the rating agencies – Wall Street’s Great Enabler – went largely untouched.

The rating agencies business model presents massive conflicts of interest for all involved. The greatest conflict centers on the fact that the rating agencies’ stream of revenue remains beholden to the Wall Street banks. Without addressing that issue, any dialogue on this topic holds no water.

While I respect Blumenthal for bringing this suit to address issues within the ratings agencies, I am not optimistic this action will bring real change. Why? How have the courts and regulators handled issues regarding investor protection? To a very large extent the message to investors is a resounding “CAVEAT EMPTOR”, that is “BUYER BEWARE”. You had better be looking out for yourself.

Sense on Cents will try to help you along the way!!

LD