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The next bubble: bonds.  This week, investors parked their money in an investment with absolutely no return. They poured $30 billion into four week T-bills at zero percent.  (At this rate, the government will have plenty of cheap cash to build all the bridges, roads, tunnels, highways and roads it wants—too bad fewer Americas will be able to afford cars to take advantage of all the new infrastructure). Now back to the original point: the demand for bonds has also ballooned in the secondary market, which has pushed yields down to 1929 lows.

The gaping trade deficit and prospects for a protracted and painful recession don’t seem to faze bond-buyers because the market considers U.S. government debt the safest investment in the world. If it turns out not to be, the thinking goes, we’ll all have much bigger problems.

Sound familiar? That’s because it is. At the peak of the buying spree for then-Triple A rated subprime mortgage securities, a common response to skeptical investors was that the majority of homeowners wouldn’t default, and if they did, we’d have bigger problems. Then came the bigger problems: the collapse of Lehman, a worldwide panic in the financial markets, historic level of unemployment, skyrocketing foreclosure rates and the possibility of another depression.

There are signs, however, that some investors are questioning the U.S. government’s ability to make good on all its debt. “The cost of buying protection against deteriorating creditworthiness is surging for every nation; five-year swaps on the U.S., for example, trade at about 66 basis points, a six-fold increase in six months,” according to Bloomberg.

There are countless differences between the sub-prime lending frenzy and the surge in demand for U.S. debt. For one, the U.S. dollar is the world’s reserve currency, which ensures a ready market for U.S. dollars. Additionally, the government has signaled that it will print as much money as it needs to get through the financial crisis. None of this means that the U.S.’s triple-A credit rating is safe. The prevailing view in the market is that the rating won’t change. If that assumption changes, the Treasury bond market will crash.

Then we’ll all have bigger problems. Again.

The government rescue of an entire industry felled by greed and poor leadership, however, becomes an expensive quagmire, which is what TARP is proving to be.

After LTCM’s rescue, the Cleveland Fed reviewed the Federal Reserve’s action.  The number one lesson learned:  Context matters.  Large losses at a financial firm do not by themselves create a need for Federal Reserve action; the losses must have a systemic component.

While one could argue that the failure of the big three would worsen the unemployment significantly and cause a spate of follow-on bankruptcies, the orderly unwinding of the auto manufacturers still does not pose the same kind of systemic risk that failure of the major U.S. commercial banks would have.

A bailout for the Big Three also would not force the kind of changes that domestic auto manufactures need but which a pre-packaged bankruptcy plan created outside a courtroom might.  More importantly, it would prevent the obvious scenario a few months from now when the auto industry comes back for an even bigger handout.

The financial services bailout is exhorbitant, messy and rife with moral hazard.   It was also necessary to avoid a meltdown of world financial markets.  Unpalatable as a bailout for financial services is for the country, replicating it for the automakers makes no sense.

Source: Bloomberg

Barney Frank speaks to reporters

The outrage over Wall Street pay has erupted too late to prevent the ravages of the corrupt financial system.  Few workers earning average salaries, and ever fewer politicians, raised objections to spiraling Wall Street salaries when the financial services industry fueled the boom in New York’s and the nation’s economy.

Now that tens of thousands of workers who benefited from the largesse are on the dole or losing their homes, politicians are demanding changes in Wall Street pay.  Where were these concerns when times were good?  Aside from being disingenuous now, these calls are also moot, because most bonuses this year will be dramatically lower than they have been in the last several years.  They are likely to stay that way for some time as capital flows elsewhere.

Henry Waxman could have called hearings years ago when the crisis was festering; to do so now reeks of political opportunism.  Even worse, Waxman’s witch hunt is a cowardly sideshow that ignores the fact that he bears responsibility for the crisis as well.

Putting all that aside, investment bankers make tons of money.  Perhaps they earn more than they deserve.  But how much is too much, and who gets to decide that?

It would be easy if we could ascribe value to the amount of good each profession produced for society.  If so, good public school teachers might make a half million dollars a year.  But what of the bad ones—how much should they make?  Should we dock their pay for poor results in the classroom?   This country faces a lot of irresponsibility and not just on the trading floor or the boardroom.

America should get serious about accountability, but let’s not stop at Wall Street.  Focusing solely on the financial services industry will only hurt New York, (and maybe Charlotte) which relies disproportionately on this sector to drive its economy and pay its bills.

It’s been a bad month for hedge funds and private equity may soon share some of the pain. Faced with a swelling budget deficit and public anger over financial market excesses, Congress may reconsider the generous tax treatment private equity firms now enjoy.

“They might be next on the list,” said hedge fund specialist Andrew Wright of law firm Kirkland & Ellis in a telephone interview last week.

A move to raise taxes on private equity couldn’t come at a worse time for the firms.  Many have suffered as investments soured. Cerberus Capital’s private equity arm has been hurt by its stake in Chrysler and GMAC. The major pullback in bank lending will also diminish private equity’s ability to fund future deals that could be more lucrative. Meanwhile, investors who funded these venture in the past and took big losses might not have the same appetite for these risky investments.

That trend has already hit the hedge fund industry.  As capital flocked to safer investments in September, investors withdrew a record $43 billion from hedge funds, the most since the market began tracking outflows in 2000. As redemptions continue, Credit Suisse estimates 30% of the roughly 8,000 hedge funds will close in the next few years. Recent tax code reform, which closed a tax loophole that saved hedge fund managers $2 billion a year, will certainly accelerate closures as fund managers lose another incentive for keeping funds afloat.

Meanwhile, Congress has left tax perks for private equity intact. Victor Fleischer, associate professor at the University of Illinois who testified at Congressional hearings on this issue last year, said it was easy to reform the hedge fund taxation because the issue was already on the Senate Finance Committee’s agenda.

Changes in private equity taxation, he said, remain controversial.

Private equity firm managers usually receive a hefty 20 percent of the profits the firm generates. Their investors agree to this arrangement because management is supposed to be talented enough to produce outsized returns on their money.

“Ordinarily when this happens under the current tax code, the fee you get in exchange for the services you provide would be taxed as income,” said Fleischer in an interview today.

The tax code currently allows these private equity profits to be treated as capital gains because they represent profits on long-term investments. This is called “carried interest” and it is taxed at the capital gains rate of 15 percent, instead of the ordinary income tax rate that ranges from 28 to 35 percent.

Changing the treatment of these profits for private equity partnerships “will be under consideration again next year,” said Fleischer. “But changes depend on who is elected president. If it’s Obama, it is not only possible but likely” that the tax code will be changed to tax private equity managers’ income at a higher rate.

Either way, it could be a case of too little too late for the American taxpayer. With private equity set to have its worst year ever, there will be fewer profits to tax anyway.

“SOVEREIGN is a fundamentally sound financial institution,” CEO Joseph P. Campanelli said, noting: “Importantly, our capital exceeds the levels defined as ‘well capitalized’ by our regulators.”

New York’s smaller, non-money center banks could soon be hit by a wave of defaults on loans for commercial real estate. Many of these regional banks have so far endured the crisis that toppled larger rivals such as Wachovia, IndyMac and Washington Mutual, but that may be about to change.

A sputtering economy may force other regional banks to face the same decision Sovereign Bancorp did this week: sell themselves to larger banks or fail. (hear the bank’s earning call below) With comparatively few toxic credit derivatives on their balance sheets, many of New York’s community-based banks, have relied on a conservative asset mix of mortgages, business and commercial real estate loans for revenue. Like Sovereign, which held half of its $57.8 billion loan portfolio in commercial real estate loans of as December 2007, many smaller banks assumed these loans would generate steady income until their maturity dates. Now that some economists are predicting a prolonged recession that would force businesses to go belly up, some of these loans may not be repaid. Banks will then have to tap their reserves to stay afloat but many of them may not have enough to cover their potential losses.

Last week, a UBS analyst cut his earnings estimate for U.S. banks by 26 percent because of the impending losses related to commercial loans, according to a Bloomberg article.  A number of regional lenders made the list of banks whose bottom lines would suffer: Sovereign Bancorp Inc., which agreed to sell itself to Santander, First Horizon National and Zions Bancorporation.

All banks are supposed to set aside money to cover future losses.  But the FDIC doesn’t specifically mandate that banks add to their reserves each time credit conditions worsen. The regulator leaves it up to individual banks to decide their adequate reserve levels.

And decide they do. In 2005, some regional banks cut their loan loss reserves to boost their bottom lines and little evidence suggests banks have reversed this trend.  Once the credit crisis began last August, many of these institutions should have begun strengthening their reserves to protect against a surge in commercial loan defaults.

In the aggregate, U.S. banks have set aside 1.80 percent of their total loans as a cushion in the event loans go bad, according to data provided by SNL Financial. The total amount of loans that all U.S. banks held as of the end of June stood at $8 trillion, according to SNL Financial.  Nonperforming and loans past due accounted for $197 billion, up nearly 40 percent from the same time a year earlier. After the nine largest banks get their share of the Federal Reserve’s capital injection, only $125 billion will be left for smaller institutions.  Without enough emergency funding to meet the need, some banks will fail—but it won’t be the J.P. Morgans of the world.