First, inventory rebuilds are notorious for distorting GDP growth above & below trend -especially when they’re induced by unsustainable government spending.

Second, you can bet the farm that later this year when the inventory cycle completes, it’s impact on GDP will slam into reverse and then be further pulling down GDP numbers. When that happens the Wall St selling machine will be squawking that GDP growth would be higher if it weren’t for that pesky and spurious impact of inventory rebuilds taking away from GDP. Funny, we haven’t heard much from them over the past year on how the inventory rebuild drove the GDP growth rate up temporarily.

But from our view, it is slightly more interesting to understand how investment prices may be impacted from now until later this year when we see a -3% GDP number posted for 3rd Q and probably 4th Q as well. Since none of this was – or is- baked into current stock prices, you see the disconnect and the opportunity to profit.

We’ve talked about the BEA and their GDP estimates previously, so I’ll be brief. As our economy slows and reverts to recession, the BEA’s method of calculating GDP is apt to produce a steady stream of GDP estimates that are overly rosy on initial estimates, then lowered in later estimates. That’s not intended to sound like conspiracy or cynicism -though it might be justified. It’s just a reflection on their flawed process. The same flawed process will be thrown into reverse when a legitimate economic bottom is put in. Then the BEA’s GDP estimates will be continually revised upwards. I can tell you I genuinely look forward to those days.

With all this talk of GDP lately, it does appear the great Wall St houses are quietly back-peddling from their economic and earnings forecasts. At this point their forecasts remain too optimistic and are slowly being lowered to align with the view espoused by Triangle Wealth Management. But this is how the game is played. This is what the great Wall St selling machine does: perpetually sell a notion that stocks are headed higher. Then when their estimates are wrong and we endure a recession, you’ll notice that stocks fall at a faster rate than they rose. In some cases previously, Wall St insiders expected a stock market correction, invested their money and the firm’s money to profit from a fall, but continued to sell a notion that things are getting better to their clients. This enables them to keep selling product. Someone has to lose when markets decline. They’d prefer it were you.

90 minutes after the BEA released their updated estimate on the US economy in the 2nd quarter, Fed Chairman Bernanke made a statement. The upshot is Ben said the economy has weakened more than they thought it would, but they are ready to “provide additional monetary accommodation through unconventional measures if it proves necessary, especially if the outlook were to deteriorate significantly”. This is fed-speak that they’ll expand Quantitative Easing -otherwise known as the printing press- in order to help the economy. The Fed is committed to spending whatever it takes -hence the phrase – unconventional measures if it proves necessary. But understand, when the Fed tells us it will stand on its proverbial head if necessary, it’s not saying this because happy days are in front of us. This is the Fed gently laying the groundwork to be able to say: Yup, I told you this was going to be ugly.

Ben Bernanke’s statement about continued monetary candy did cause a nearly 200 point upward swing in the Dow over the ensuing 60 minutes. Before Ben’s speech, stock markets were falling at a steep pace as anticipated. There’s a healthy market for you: completely reliant on more monetary candy and steroids. This reminds me of recent comments from several big name Wall St players that have said such ridiculous things like “we’d be OK if the government would stop helping us”. Sure. You’d be OK. That explains why the stock market was tanking from the reality of the GDP report, then rallied within minutes of helicopter Ben stating the Fed would increase the monetary candy if he had to. I truly get a kick out of these guys. They’re delusional.

In Europe, something odd is happening. The recently-weaker Euro currency is allowing Germany to experience a mini economic boom. Last week, Germany announced its fastest quarter of economic growth since 1990. I recall writing in a client newsletter about the potential for this to happen months ago, and how if it happened, it would be short lived. This German economic blip proves my assertion that we’re living in a proverbial “race to the bottom” whereby countries are trying to depreciate their currencies against each other to make their exports cheaper and more competitive. The weaker Euro currency caused by a European banking and sovereign bond collapse this spring is allowing Germany to profit and grow. This -by the way – is exactly what we’re competing against and what we’re going to do in the US: depreciate the dollar so we can compete easier.

But the good news is not uniformly spread across Europe. The PIIGS countries (Portugal, Italy, Ireland, Greece, and Spain) are seeing continued economic weakness despite the weaker Euro, and the cost of insuring their debt is rising again. Mind you, things aren’t as bad as they were back in May. Europe is not in a panic again. Yet. But I want to point out that this week saw a spike in overnight lending from the European Central Bank -the ECB- to banks, and that the level of lending is the highest since the panic this spring. Also, the cost to insure Ireland’s debt rose 45% in the past few weeks. The rest of the PIIGS -even Italy – have seen the cost to insure their debt rise noticeably in the past few weeks. That’s the bond market telling European governments -and the ECB- it has less confidence in their economic recovery, that the bank stress tests were a sham, and that they are noticeably more concerned that bond investors will be paid back. Case in point: the cost of insuring Greek debt is discounting a 40% chance of default in the next 5 years. Personally, I’m forecasting more like a 70-80% chance, and that it will happen in the next 2 years when the great chase to issue $ Trillions in sovereign bonds in the US & Europe will peak. This intense competition for buyers will cause someone to be left out in the cold with no one buying their bonds. Greece looks weak enough.

I give some weight to the argument that that the PIIGS countries are seeing their bonds come under pressure largely because their economies have not shown much in the way of recovery whereas Germany’s has. So by comparison, they look weak. If the PIIGS country’s economic recovery looks weak enough, there will be rising fear among investors. When this happens, they’ll pile into historically safe-havens like US Treasury bonds, German bunds, and British gilts. This in turn causes those safe haven bond prices to rise (a la supply & demand), and the yield (or interest rate) falls. So as German bond yields fall and German bond prices rise, this makes bonds from the PIIGS countries look ugly by comparison. Either way, Europe, you get what you get. The Euro currency project has Germany at its core and includes the PIIGS countries that are financial basket-cases. All countries in the Euro have to compete with Germany since they can’t depreciate their own national currency anymore. That’s the deal they struck when they signed up for the Euro. Based on the strength of the German economy, the PIIGS countries got an unjustifiably cheap ride from bond markets for many years. They gorged themselves on cheap bonds rather than use that money -and time – to implement structural economic reform to position themselves to compete. Now its time to shut off the cheap money spigot and see who can raise money without relying on the German balance sheet. Don’t be surprised when it’s obvious that none of the PIIGS can compete without leaving the Euro project, defaulting, and re-issuing their own currency.

Now the self trash-talking Japanese: The Japanese currency is a safe-haven not unlike the US dollar. So if Germany had a fantastic Q2 largely because the Euro currency depreciated suddenly, then what would you guess happened in Japan during this same time ? Answer: since investors fled Euros, they ran to the Japanese Yen. That pushed the Yen up and was the reverse process seen in Germany. With that in mind, it should not surprise you that the Japanese economy suddenly slowed in Q2 to a 0.1% growth rate — a measly 0.4% annualized pace. Basically a flatline. This comes after a 1Q which saw the Japanese economy grow at a 4.4% annualized pace. Another result of the sudden surge in demand for Yen is demand for Japanese sovereign bonds rose, causing yields to fall. 10 year Japanese gov’t bond interest rates dropped under 1%. There’s some perspective for you: earning 0.9%/year interest to lock up your money for 10 years. For comparison, US 10 year Treasury Bond yields have fallen to the 2.6% range. Based on this argument, 10 year Treasury bond yields could head lower. That means the 10 year Treasury note price could go higher.

To be fair, a large part of Japan’s 1Q big economic growth was the tail end of a sugar-rush impact of stimulus packages around the globe. This situation also speaks to how rapidly a large economy can slow when magical monetary and fiscal steroids are stopped. Naturally the rising Yen is making Japanese exports more expensive and thus harder for the Japanese to compete internationally. So you can guess what Japanese politicians are doing: they’re busy trash-talking their economy in an effort to convince international currency speculators and bond buyers to stop buying their currency and thereby driving the value up. They should be careful what they wish for because before too long (probably next year or the year after), the Japanese government will be forced to do an about-face and attract international bond buyers in a larger way to help fund their budget deficits. Currently only about 5% of Japanese Bond buyers are from outside Japan. That will change radically in the coming years because Japanese demographics are terrible: there aren’t enough young people to drive the economy forward, and there are too many pensioners that will begin redeeming their Japanese bonds instead of buying more.

The Fed is responsible for setting short term interest rates. Normally, that’s the main tool the Fed uses for having the economy speed up or slow down. But what do you do if short term interest rates have been lowered pretty much to zero, and when you repeatedly say you’re going to leave them there for a while ?  

You could lower the interest rate you pay banks for parking their cash with you. That would encourage them to make loans, rather than just sitting on the money. Normally, that would help get the economy going. But the problem banks face now is they’re more concerned with not losing money than with making money. US consumers have managed to pay down their debt from 133% of income to 120% in the past 3 years, but banks know that a 120% debt level is still a basket case and not someone you want to lend to. Plus, a large portion of consumers with solid balance sheets – the only ones banks will lend to — don’t want to borrow more. All consumers want to do is pay down debt and re-finance their mortgage if interest rates are lower.  There’s no economic growth from that. So having the Fed lower the interest rate it pays banks for parked cash won’t stimulate the economy.   

What else can the Fed do in order to stimulate the economy?  They can do something I’ve mentioned previously: quantitative easing. Quantitative easing is when the Fed buys Treasury bonds or mortgage backed bonds from Fanny, Freddie and GNMA. The Fed did this last year in order to lower mortgage rates and put a floor under house prices. $1.2T later, the plan was for the Fed to stop buying mortgage backed bonds and let them gradually disappear over the course of years as the underlying mortgages are paid off.  

There seems to be a change of plan in the works. Two Fed governors — so far – have been recently quoted supporting the Fed in buying Treasuries because they’re concerned about deflation.  Unlike the previous example, this Fed action might actually stimulate the economy.  But it comes with a steep price. Quantitative Easing is the proverbial printing press. It means the government is printing more money with one hand, and then borrowing it with the other.  

This de-values the currency.  If you’re one of the roughly 50% of buyers of US Treasury Bonds, you live outside the US. If you see the US government openly de-valuing it’s dollar, you’re going to be upset and concerned that they keep printing money because it means you’re going to be paid back in dollars that are worth less. Sooner or later, you may reach the conclusion that you’re throwing good money after bad when you keep buying US Treasury Bonds in the weekly Treasury auctions we have. Sooner or later you will start looking for something else to put your ongoing savings in, and you may even begin selling your existing US Treasury Bonds if you’re worried they’ll lose enough value. They’ve always worked out in the past. Could now be different? 

Back to being a US consumer and investor.  Now ask yourself:  is this (quantitative easing / printing press) something the Fed would do if it were confident the economy was growing on its own and in a normal recovery?  Or maybe does quantitative easing sound like a desperate move with a real risk of de-valuing the US dollar and therein cause interest rates to rise from a weak or failed Treasury auction because foreign buyers stop showing up?

While you ponder that question, also think about this: we need to dramatically increase our exports to help drive the economy. Any ideas on how to do that? OK, you could spend more on R&D and innovate more than everyone else. The US is very good at that.  But that’s time consuming and difficult.  Why not just de-value your currency?  That’s the fastest way to make your exports more competitive and is what all our trade partners have been doing for years. That’s how the German economy improved so much in the past few months. Remember the European Banking crisis earlier this year? It caused the Euro currency to drop and thereby caused German exports to be cheaper and more competitive.  Maybe that’s what we’re just about to do here in the US. That’s what quantitative easing will do.   

This week the Commerce Department released a report for June’s Consumer spending and saving. Apparently, it comes as a surprise that consumer spending stopped expanding in June.  Also in the report, the savings rate went up – to 6.4%. It needs to rise to the 8-9% level and stay there for several years in order for the consumer to reduce their debt load to a manageable level and have any hope at being able to get a bank loan with reasonable terms. Banks aren’t making a lot of loans these days because many consumers are still the worst credit risk that banks have seen in decades. Despite being demonized -admittedly sometimes by me — banks are a business and won’t make loans unless they’re pretty sure they’ll be paid back. I don’t blame them. 

This week also saw reports updating the state of US manufacturing. One of the key reports is from the Institute for Supply Management -the ISM.  The ISM report for July showed that new orders fell to their lowest level in 14 months. It also showed a pronounced slowing in the rate of growth of the manufacturing sector to a near flatline — certainly not what any economic recovery since the second world war looks like.  Echoing the same pattern, the Commerce Department report for July showed factory orders continued to drop as they did in June.  The data from both sources indicates the sudden growth in manufacturing that began last summer ended in May this year. If so, that’s the end to the famous inventory rebuild we hear so much about in economic circles.
Most if not all of the economic growth we’ve seen in the US over the past year has been driven by federal government incentive programs of historically large proportion that spurred consumers to spend. This increased demand for goods and services which in turn caused manufacturing to ramp up and inventories to be rebuilt. In a normal recovery, this kick starts the economy and it then takes off on its own.

Let’s look at a brief comparison of what our current economy is showing versus a normal recovery. By the 4th quarter into a normal recovery, the economy is expanding at a 6% clip, not 2.4% –which I also point out is apparently subject to be lowered by the government at some point in the future when no one is looking.  This is what the government did in the GDP report 2 weeks ago by revising down 2007, 2008, and 2009 economic growth.  In fact cutting it in half.  

In a normal recovery at this point the economy is 8% larger than when we entered recession.   How about now?   The US economy is still 1% smaller than it was in late 2007 when the recession began. As for employment, an average recovery would have generated enough jobs to gain back all the jobs lost in the recession and added over 700,000 new ones. Any guess as to how that metric looks now?   Try this.  Not only have we not gained back all the lost jobs like other recoveries, we’re still down over 7M jobs compared to when the recession began.    So we’re down 10X the number of jobs that a normal recession would have gained.    
 
Clearly this recovery doesn’t resemble any other recovery since the second world war.  Government fiscal steroids are being turned off and we’re seeing the consumer and manufacturing clam up over the past couple months. The bond market has figured this out, but the stock market hasn’t.  This is the reason 2-year Treasury’s are paying less than half a % interest, and 10-year Treasury’s are paying 2.8%.   When 10 year Treasury pays less than money market did four years ago, you know you’re in a different world. The Fed’s remaining ammo is less effective when interest rates are already this low.

• 71,000 new private payroll jobs created  
• 143,000 census jobs lost 
• 59,000 federal, state & local govt jobs lost
• TOTAL  131,000 jobs lost . Considerably more than 65,000 expected.

Here is what you need to keep in mind in considering these numbers -and in particular, the private payrolls number of 71,000. Normally, in a recovery, our economy is generating 200,000 – 300,000 new private payroll jobs per month, and a small number of government jobs. And since the last recession was particularly bad, we would expect a stronger recovery – if this were like every other recovery we’ve had in the past half century.  But it’s not.      Our economy needs to generate 125,000 new private payroll jobs a month to keep up with population growth and stop the increase in the number of people out of work.

The July employment report showed the initial claims unemployment rate remaining at 9.5%. At first blush that sounds like things are staying the same / not getting worse.  But that’s 14.6M unemployed Americans. If that were the end of the employment report, we’d just call it very poor and be done with it.  But here’s the part that doesn’t make the headlines – and this is probably the reason that markets did what they did on Friday. In addition to those 14.6M Americans on initial claims unemployment insurance benefits, there are:

• 6.6M people on long term unemployment insurance benefits
• 8.5M working part time but need full time work 
• 2.6M want work but have used up their extended unemployment insurance.    

This adds up to 17.7M Americans that need and want full time work but can’t find it.  But that doesn’t show up in the headline 9.5% unemployment figure. 

Now add this 17.7M to the headline figure of 14.6M and you end up with over 32M Americans that want full time work but can’t find it. That’s over 20% the size of the labor force.   No recession since the 1930s has come anywhere close to this figure. In the Great Depression it was around 25%.
I don’t know why the mainstream financial press doesn’t discuss this figure of 32M Americans in need of work.  It paints the most complete picture.  Instead, they continue to present an incomplete and misleading picture. Let me illustrate via this simple example: say the unemployment rate drops. That suggests our economy is improving. But unless you have the rest of the information, you wouldn’t know the employment rate dropped because more people fell out of the unemployment insurance benefits system because their benefits have been used up, or if they found a job. There’s a big difference in those two reasons, but they both show the same headline statistic.  

 
In housing, this week’s June report on pending home sales fell to yet another record low. This despite record low interest rates and prices close to 30% below where they were 3 years ago. So it will be a while yet before we work through the housing inventory at this rate. This slow-down in house sales will put further downward pressure on prices.      
 
Connecting employment & housing:  Among many other things, what is different about this recession – I mean recovery — is the high unemployment rate combined with falling house prices. These 2 processes are in a bit of a feedback loop. By that I mean when 1 worsens, it worsens the other as well and increases the downward spiral. Case in point: an unemployed person won’t easily be able to sell their house and move to where a job may be. This is a phenomenon we didn’t have in previous recessions – I mean recoveries — and is particularly corrosive to the economy.

• Thing 1:  that you can sleep better knowing the Fed will spend whatever it takes to stop deflation. (tongue firmly in cheek)
• Thing 2: that the economy is so weak and the prospects so dark, the Fed is about to use-up one of their last policy bullets in a desperate move. 

Many of the stock market players will focus on the Fed bailing out the economy and spending whatever it takes. If you can only see slightly further than your nose, that conclusion is going to be the one you reach. Though at some point, even the stock market players will wake up and smell the coffee.    Contrary to this, the bond market players will see an action by the Fed to begin printing money and buying Treasuries as a sign our economy is desperately weak. One of these two markets will get it right.  
 
One of these markets can be described this way:

• It always predicts next year’s profits will be higher and therefore current prices are cheap. 
• It focuses on company income statements, not balance sheets. I point this out because income statements are easier to manipulate. 

The other market can be described this way:

• It focuses on company balance sheets and whether you’re likely to get your money back. 
• It pays attention to economic information.
• It tends to be less volatile than the other market.

That should help you understand which market will get it right.   For those still struggling with the answer, the Bond Market – the second one in this example — is the right answer.   At least it is in my view.

 The slide from the April peak has not been a gentle one. It has resembled a roller coaster with this important distinction: each major high has been lower than the previous high, and each major low has also been lower then the previous low. Granted, the drop to each of the lows can be a little hair-raising. Hence the roller-coaster analogy. The last rise was generated by a 3-week long European bank stress test boondoggle that few give credibility to.  

 Have a look at this chart of the S&P500 index year to date…

The right half of the chart shows the roller coaster ride. From a market technician’s point of view, when we see a pattern of lower highs & lower lows, it is a time to expect another leg down.

 The highs and lows (S&P500 value and date) are as follows:

• high 1217 April 23rd
  • low 1110 May 7th
• high 1171 May 12th
  • low 1050 June 7th
• high 1117 June 18th
  • low 1022 July 2nd
• high 1115 July 26th   

There have been large swings on this ride, but it has managed to lose 1.2% year to date (and 30% below where it was in 2007, and 28% below where it was in 2000). This market is acting like it did in the summer of 2000, 2007, and 2008 in terms of its volatility. That is a good segue… With respect to the S&P500 stock market index, guess which quarter had these 2 attributes:

• earnings was the highest ever recorded — before or since.
• Wall St analysts were forecasting continued growth and higher still record earnings.

I’ll give you a hint. It was the worst possible time to go long on US stocks in the past 70 years.  The answer: summer 2007. 2Q earnings were announced as now – in July & August.  If you heeded the Wall St cheerleading machine in the summer of 2007, you increased your stock positions right before the stock market peaked in October 2007. Exactly the wrong time.    The second most obvious example:  remember the historic stock market collapse in 2000?  The US stock market hit an all time high up to that point in time. Not surprisingly that corresponded to the previous peak in earnings. The Wall St machine was saying the same thing in the summer of 2000, the summer of 2007, and right now.  That is:  an all-time peak in earnings is next year.  

The big news this week was Friday’s report on 2Q GDP growth.  Stock markets continue to price-in $82 of earnings on the S&P500 index this year, $90+ next year, and 2.5-3% GDP growth for this year and next year. A lot of people going to be surprised when we end up seeing total GDP growth this calendar year at close to zero, and a similarly weak economy next year – with these years joined and punctuated by another recession in the second half of 2010 that carriers into 2011.  
 
Back to Friday’s GDP report. What was expected was 2.5% growth. What was announced was 2.4 % growth. If that headline sounds insignificant to you, you may be forgiven. But a deeper read of the report tells you a very troubling story:

• The report quietly but substantially increased the government’s estimate on the size of the 2008 recession.  Such a major revision does not happen every day. It tells you the so-called Great Recession may have been more damaging than the government initially thought.  
• the report revised the previous quarter’s (1Q 2010) growth from 2..7% to 3.7%. But but almost 2.7 of the 3.7% came from a spike in inventory rebuilding. Since we know that is a sporadic event -albeit it may last a few quarters – the government’s data show inventory contribution to economic growth peaking in late Q1 and coming to an abrupt end. It showed the inventory contribution to the economy dropping from roughly 2.7% in the 1st Quarter, to 1% in the 2nd quarter.   At that rate of decline, the inventory rebuild contribution to economic growth will not only be done in the 3Q, it will be subtracting from GDP —further slowing the economy.

The end of October will see the government’s first report on the economy in the 3rd quarter (July-Sept).  By then, the inventory rebuild will have run its course. So I’m expecting to see an overall red GDP number in the -3% range. By that, I mean confirmation that we are now back in a recession and the economy is fairly rapidly shrinking. Recall that any GDP growth rate slower than +2% means unemployment is growing. Imagine what -3% will do. Long before the end of October, we’ll see a steady stream of weakening consumer spending and broad economic data. We’re seeing it now, and it is picking up in pace.  

I expected a +1.8% GDP growth figure (+/-) to be announced this week. What was announced was +2.4%. The combined impact of the housing credit, cash for appliance clunkers, and larger (stimulus) tax refunds, drove 1Q GDP up 1% higher than previous estimates, and it drove up the growth rate on the front end of the 2nd quarter as well (April). The BEA is the branch of the government that produces the GDP reports. Their process is antiquated and inefficient. Right now, their first of three estimates on Q2 has just been reported.  They have the most data on the front part of the quarter (more time for businesses to respond). In the case of Q2, that part -April - saw very strong economic growth. But May’s economy weakened, and June’s weakened even more (according to my independent data sources AND the Federal Reserve). So we should anticipate that the next 2 GDP reports in late August and late September (revisions to 2Q’s report) will show more data on the later portion of Q2, and that the +2.4% will end up being lowered. 

I began this article with comments from the Fed this week. I’ll finish it with other Fed governor comments this week…..

The Federal Reserve Beige Book was released this week. The Fed’s Beige Book is a report on economic and business conditions from each of the 12 Fed District central banks, and happens 8X a year. The latest report was for the period for June and early July and was the weakest report this year. Within the report, the Dallas Fed showed an economy that was the weakest since July last year.   The Chicago Fed report showed the worst economic data since October last year. In fact, according to the Chicago Fed data, we never actually came out of a recession.     From the point of view of several Fed districts, the report showed the economy is seeing deflationary pressures, orders falling, and profit margins coming under pressure. That means earnings are going to be under pressure next earnings season  —3 months from now.

The results are that 91 banks across 20 countries were tested. 7 banks failed: 1 in Germany, 1 in Greece, 1 in Slovenia, and 4 in Spain. Failure of the test means that tier 1 capital falls below 6% under either of 2 scenarios. Tier 1 capital is common stock plus retained earnings (for those that are interested).Tier 1 capital is the money that a bank can very quickly get its hands on if it had to (in theory).  
 
Scenario 1: An economy showing these attributes:
·        A 3% contraction in GDP over this year & next.
·        A 6% increase in unemployment
·        A 6% increase in interest rates
·        Large currency swings (I could not get more details than that)
·        Bank book value dropping 36% over this year and next
·        A debt downgrade of 4 notches
Scenario 2: A Sovereign bond issue.  NOTE:  NOT a sovereign default:
·        Several haircuts to bond values were applied that range from a 4% loss on 5 year German bunds to a 15% loss on Portuguese 5 years bonds, to a 42% loss on 10 year Greek bonds.
 
One German bank failed: Hypo Real Estate. This was expected since it is in the process of being recapitalized by the German government. The rest of the banks that flunked have already secured the additional capital they need.  
  
The issues I have with the European bank stress tests are the following:
1.   The worst case scenario tested is nowhere near a worst case scenario. There’s no point in having a test if it is rigged to let everyone pass except those that didn’t have the best lobbyists or that were already known to be under reconstruction by their federal government.
2.   Not all the systemically important banks were included in the test.
3.   I don’t trust that bank executives won’t massage their test results before they hand them in to the ECB. Where’s the independent auditor on this process?  We’ve seen how US bankers have played with their balance sheets. But we’re supposed to assume European bankers will be more trustworthy?
4.   There’s no equivalent to the Fed in Europe. So in the event of a sovereign default -and I’m saying we’ll see Greece default inside the next 2 years — a coordinated and cohesive strategy on monetary policy will be nearly impossible. There are 25 separate EU member states. They each set their own capital and accounting rules.
5.   The measure of creditworthiness a European bank is how a given bank is likely to be supported by its federal government, and how that government is in turn able to borrow from the ECB & the IMF — not the banks own balance sheet.
6.   The eurobank stress test has been a great PR exercise.  But!!!!  Let’s see whether European banks start lending to each other next week. And let’s see if Deutsche Bank stops shorting Spanish banks. 

When we held our bank stress tests in May of 2009, equity markets ran up before the announcement, then sold off afterwards. I’m looking for something similar to happen this time as well.
Here’ what it all means. Europe remains the largest economy on the planet, and has seen its economic growth constrained by high debtload, and graying population for years.  The solution is broad-based austerity measures that will further slow an already anemic economy for years to come. Incidentally, if this sounds like what we’re facing here in the US, you’re right.   But I’ll rely on the Greeks to do what they’ve done half the time for the past 200 years: default. Apparently we won’t see an economic meltdown that starts in Europe this summer because of the success of this PR exercise. We won’t know for sure for a few more weeks. I’m still not interested in owning equity or debt in Europe until reality sets in and there’s a reconciliation. Vegas looks safer.

 
Elsewhere in FINREG, there are new and improved underwriting standards for home mortgages that look a great deal like what we used to see before the housing bubble. Naturally a higher lending standard that reduces risk is a good thing for the bank system. But it won’t help the economy in the near term since there’s a shortage of qualified buyers because the personal balance sheet of Americans has taken a beating in the past 3 years.
 
FINREG also has a provision for a panel to be set up to manage orderly wind-downs of large banks. This is designed to preclude situations like the AIG bailout, or a Lehman bankruptcy.  In theory, this should be a good idea, but I have doubts about how this will work in practice.  
 
The bill has a Consumer Protection Agency provision. Again, in theory I think an agency that’s focused on protecting consumers -and by extension individual investors  - is a good thing. That said, I’d like to see cutting from other Federal organizations to fund the new agency, so we don’t see an expansion of government and costs. Apparently auto manufacturers have the best lobbyists because they got an exemption from the agency. So I predict that later this year, large banks will give up their bank status and become auto companies.     (my attempt at humor)    
 
FINREG also has the famous Volker Rule. This rule is intended to stop proprietary trading by Wall St banks and is named after a previous Fed Chairman — Paul Volker. Proprietary trading is where a bank makes trades for their own account. Bank ownership in hedge funds is included in proprietary trading. We ended up with a 3% cap on capital for proprietary trading as opposed to an outright ban. It’s true that 3% of a bank’s capital is not a lot, but again if a hedge fund is heavily leveraged, the losses can mount very quickly. In the end, this rule won’t change much. The big banks already have less than 3% of their capital in hedge funds. Goldman is an exception. It may have to spin-off some of its business. Then again, it could avoid the restriction if it walked away from being a bank holding company and therein the implicit support of the Federal Government. Banks have 2 years to transition their business to be compliant.
 
FINREG touches the $600T derivatives business as well. Wall St Banks will be forced to spin off their derivatives business to separate companies. In addition, derivatives trades will eventually happen on exchanges where there will be better oversight, and improved transparency. This will offer some level of protection for taxpayers since these new separate companies will not be back-stopped or bailed out if they make bets that go bad.  Wall St banks will be allowed to keep some derivatives business in-house in order to hedge their own risk. On the whole, the new provision helps reduce systemic risk, but it does not eliminate it.  It also removes a previous profit center for Wall St banks. Of course, I’m very comfortable with this since all I want from big banks is transparency and boringness. I don’t want exciting banks that are highly leveraged and use clever and deceptive accounting tricks. We tried that already and it ended badly.  
 
Wrapping up the FINREG discussion, let me also point out that fixing Fanny & Freddie was conspicuously absent. I doubt these new financial regs will stop another financial crisis, but they’ll probably make one less likely. On balance, FINREG is good for investors and the public in general. It reduces some of the financial system’s risk. But there are a pile of issues still left unchecked. So we’ll see another financial system crisis at some point. We always have and apparently always will.