Deflation Returns to Britain for First Time Since 1960

Deflation returned to Britain for the first time in nearly five decades last month as prices measured by the retail price index (RPI) were lower than the same time a year ago.

That will add to the chancellor, Alistair Darling's problems as he prepares to deliver his latest budget tomorrow. Figures out tomorrow morning are likely to show another big jump in unemployment to the highest level in over a decade.

David Kern, chief economist at the British Chambers of Commerce (BCC), said: "The RPI is in negative territory and fell by more than expected. Deflationary pressures could make the recession worse in the short-term, despite quantitative easing and the huge budget deficit posing inflationary pressures over the medium-term.

"The chancellor must address both these conflicting risks in his budget. He must support business and administer targeted fiscal stimulus for the year ahead. But, he also has to present a credible medium-term plan for restoring the public finances back to health."

Shadow chief secretary to the Treasury, Philip Hammond, said: "The return of deflation to Britain for the first time in nearly 50 years adds to the woes of the British economy.

"With unemployment rising at the fastest rate on record, our public sector deficit the highest in the G20, and our recession looking likely to be the longest since the war, this is another nail in the coffin of Gordon Brown's economic reputation."

The Office for National Statistics said the RPI was 0.4% lower in March than it had been in March 2008. That was the first negative reading since March 1960, when Harold Macmillan was prime minister and John F Kennedy was running for the US presidency.

On the government's preferred consumer price index measure, which excludes housing and mortgage costs, inflation was still comfortably in positive territory, at 2.9%. CPI is much higher here than the 0.6% figure for the eurozone and economists say the falling pound has pushed up some import prices, delaying the drop in the CPI.

A short period of falling prices should help consumers because it will make their increasingly squeezed income go further. However, if prices continue falling for a long period and deflation becomes entrenched, that can have an adverse effect on the economy as consumers continually hold off making purchases in the expectation of lower prices. This in turn forces firms to cut wages and sets off a damaging spiral.

Committed to quantitative easing

Figures from the Bank of England show that a third of firms have agreed pay freezes in recent months and some have cut pay. Workers at Honda's car plant in Swindon were recently told they will have to take a 10% pay cut this year, after a similar announcement by Toyota to its workers in Derby.

Japan suffered a prolonged period of deflation in its "lost decade" of the 1990s and policy makers in Britain have thrown a huge stimulus at the British economy in the shape of tax and interest rate cuts in a bid to prevent deflation taking hold.

Colin Ellis, economist at Daiwa Securities, said: "With deflation now having arrived, the overwhelming priority is to ensure that this period of falling prices is short-lived."

Speaking to the Treasury select committee today, new Bank of England monetary policy committee member Paul Fisher said he was concerned that the Bank could miss its 2% CPI target "on the downside" as the big oil price rises of spring 2008 drop out of the figures in the coming months. Fisher stressed that the MPC remained committed to its policy of "quantitative easing", by which it is seeking to pump £75bn of new money into the economy to breathe life into it.

Fuel and vegetables

The ONS said the largest downward effect on inflation came from falling gas and heating oil bills. Food and non-alcoholic drinks also pushed inflation down with the largest effect coming from vegetables, where prices fell by more than a year ago across a range of products.

Transport costs also pushed the figure down. This was mainly because of lower air fares on European routes. There was also an effect from fuel, which is rising less this year than it was at the same time last year.

The average price of petrol rose by 0.9p a litre between February and March to 90.4p but this compares with a rise of 2.3p a litre last year.

"The inflation data do little to dispel expectations that interest rates are set to stay at 0.5% for an extended period and that the Bank of England could eventually extend its quantitative easing programme," said Howard Archer, economist at IHS Global Insight. "The danger of an extended, deep recession still outweighs inflation risks.

Banks Reject U.S. Terms for Cutting Chrysler Debt

A group of big banks and other lenders rebuffed a Treasury Department request that they slash 85% of Chrysler LLC's secured debt, proposing instead to eliminate about 35% in exchange for a minority stake in the restructured car maker and a seat on its board.

The lenders' counteroffer marks a significant act of brinksmanship as the banks and the Obama administration's auto task force duel over concessions to avoid liquidating the country's third-largest car company.

Chrysler faces an April 30 Treasury deadline to seal an alliance with Italy's Fiat SpA that also requires concessions from lenders, as well as from the United Auto Workers union.

Chrysler owes the lenders, which include Citigroup Inc. and J.P. Morgan Chase & Co., about $6.9 billion. But President Barack Obama and his auto team had requested that the banks cut that to $1 billion, while gaining no equity stake in a restructured Chrysler.

In their five-page counteroffer, which was sent to the Treasury late Monday, the lenders said they are prepared to cut Chrysler's first-lien debt by $2.4 billion, or down to about $4.5 billion, in exchange for a 40% equity stake and a Chrysler board seat, according to a copy of the proposal provided by individuals outside the lenders' group.

The lenders also are demanding that Fiat pour $1 billion in capital into Chrysler in exchange for whatever equity stake it would gain. That could be a source of conflict with the Italian auto maker, which has said it instead wants to give Chrysler only technology.

The Treasury shot back, making it clear that the government didn't plan to accept the lenders' proposed terms.

"It is neither in the interest of Chrysler's senior lenders nor the country for them to advance a proposal that would yield them an unjustified return as Chrysler, its employees and other stakeholders are working tirelessly to help this company restructure," the Treasury said in a statement.

"Our hope and expectation is that these lenders take a more constructive position in the coming days that reflects the actual situation that they and the company face," the statement continued.

In making their case for a significantly smaller sacrifice than what the government wants, the lenders have argued that their fiduciary duty to their own shareholders and investors requires them to recoup as much as possible from the car maker. The lenders have told Treasury officials they believe they could recover at least 65% of their loans if Chrysler is liquidated in bankruptcy.

In their counteroffer, the lenders blasted the government's proposal as unfair. They said it is "in no way a shared sacrifice."

The lenders also questioned the logic of having Chrysler pair up with Fiat. The Italian company, they said, would bring "negative synergies for the first 3 years" and would enter the alliance with "limited downside for a deal of this size." Moreover, they said it could result in a "wealth transfer from the U.S. taxpayer to a foreign company of potentially $10 billion or more."

The steering committee of banks that made the counterproposal holds more than 66% of the $6.9 billion owed Chrysler's lenders, said people familiar with the matter, giving the committee the requisite amount of debt to control the votes of lenders if Chrysler files for bankruptcy.

Under U.S. bankruptcy code, holders of at least two-thirds of the amount owed a group of creditors must approve concessions. There also must be approval from a majority of total debt holders in a group.

The committee has eight members. The largest bank-debt holders are J.P. Morgan, Citigroup, Goldman Sachs Group Inc. and Morgan Stanley. The four hold about $4.3 billion of the debt, said people familiar with the matter.

Also on the committee are hedge fund Elliott Management, distressed-asset investor Stairway Capital Management, fund manager OppenheimerFunds and advisory and asset-management firm Perella Weinberg Partners. In all, an estimated 45 lenders and funds hold the Chrysler bank debt.

The dispute is heating up as Steven Rattner, who is leading President Obama's auto-industry bailout, and his team haggle in Washington with the heads of Chrysler, Fiat and the UAW over details of a Fiat alliance.

The counteroffer also came about a week after the government presented Chrysler lenders with more than 60 pages of financial assumptions for a combined, restructured Chrysler. The government projects that Fiat-Chrysler wouldn't be able to start making payments on its debt until 2012, said several people familiar with the report.

The government also assumes that the $4 billion it lent Chrysler largely will be wiped out, as will a combined $2 billion Chrysler owes Cerberus Capital Management LP and Daimler AG, Chrysler's last two owners. The government would then put in an additional $6 billion to fund the operations of Fiat-Chrysler.

One assumption that upset some lenders was that Chrysler would pay about $3 billion total to a UAW retiree health-care fund in 2009 and 2010, said these people. The fund, which had been owed about $10 billion, would also get an unknown amount of equity in the new Chrysler.

The fund is behind the banks, Cerberus, Daimler and the U.S. in the order to be paid. Another contentious point with lenders was that Fiat was not putting in any money. The Italian automaker's most valuable contribution would be new fuel-efficiency technology and small-car platforms, said these people.

"Fiat seemed to be getting a lot for not much," said one of these people.

Lenders on the Chrysler bank-steering committee had originally hoped to make their counteroffer late last week, but differences of opinion between larger lenders like J.P. Morgan and Citi and the smaller bank-debt holders delayed the offer, said people familiar with the matter.

The larger lenders were pushing for a counteroffer that was closer to the original government proposal than smaller lenders, such as hedge funds, were willing to agree to, said these people.

This conflicting view is likely due to several things, such as the fact the larger banks bought or paid full price for billionsof Chrysler bank debt, while smaller holders bought theirs at a steep discount and would likely make a tidy profit even in a quick liquidation of Chrysler, said people involved in the talks.

"Not everyone was on the same page. The big bank view was 'hey guys, the offer back can't be outrageous. This is the government,"' said one of these people. "There were others, smaller lenders, who wanted to be a lot more aggressive."

In the end, the big banks "came closer to the smaller lender view," said another person familiar with the talks.

Bank Profits Appear Out of Thin Air

Another day, another attempt by a Wall Street bank to pull a bunny out of the hat, showing off an earnings report that it hopes will elicit oohs and aahs from the market. Goldman Sachs, JPMorgan Chase, Citigroup and, on Monday, Bank of America all tried to wow their audiences with what appeared to be — presto! — better-than-expected numbers.

But in each case, investors spotted the attempts at sleight of hand, and didn’t buy it for a second.

With Goldman Sachs, the disappearing month of December didn’t quite disappear (it changed its reporting calendar, effectively erasing the impact of a $1.5 billion loss that month); JPMorgan Chase reported a dazzling profit partly because the price of its bonds dropped (theoretically, they could retire them and buy them back at a cheaper price; that’s sort of like saying you’re richer because the value of your home has dropped); Citigroup pulled the same trick.

Bank of America sold its shares in China Construction Bank to book a big one-time profit, but Ken Lewis heralded the results as “a testament to the value and breadth of the franchise.”

Sydney Finkelstein, the Steven Roth professor of management at the Tuck School of Business at Dartmouth College, also pointed out that Bank of America booked a $2.2 billion gain by increasing the value of Merrill Lynch’s assets it acquired last quarter to prices that were higher than Merrill kept them.

“Although perfectly legal, this move is also perfectly delusional, because some day soon these assets will be written down to their fair value, and it won’t be pretty,” he said.

Investors reacted by throwing tomatoes. Bank of America’s stock plunged 24 percent, as did other bank stocks. They’ve had enough.

Why can’t anybody read the room here? After all the financial wizardry that got the country — actually, the world — into trouble, why don’t these bankers give their audience what it seems to crave? Perhaps a bit of simple math that could fit on the back of an envelope, with no asterisks and no fine print, might win cheers instead of jeers from the market.

What’s particularly puzzling is why the banks don’t just try to make some money the old-fashioned way. After all, earning it, if you could call it that, has never been easier with a business model sponsored by the federal government. That’s the one in which Uncle Sam and we taxpayers are offering the banks dirt-cheap money, which they can turn around and lend at much higher rates.

“If the federal government let me borrow money at zero percent interest, and then lend it out at 4 to 12 percent interest, even I could make a profit,” said Professor Finkelstein of the Tuck School. “And if a college professor can make money in banking in 2009, what should we expect from the highly paid C.E.O.’s that populate corner offices?”

But maybe now the banks are simply following the lead of Washington, which keeps trotting out the latest idea for shoring up the financial system.

The latest big idea is the so-called stress test that is being applied to the banks, with results expected at the end of this month.

This is playing to a tough crowd that long ago decided to stop suspending disbelief. If the stress test is done honestly, it is impossible to believe that some banks won’t fail. If no bank fails, then what’s the value of the stress test? To tell us everything is fine, when people know it’s not?

“I can’t think of a single, positive thing to say about the stress test concept — the process by which it will be carried out, or outcome it will produce, no matter what the outcome is,” Thomas K. Brown, an analyst at Bankstocks.com, wrote. “Nothing good can come of this and, under certain, non-far-fetched scenarios, it might end up making the banking system’s problems worse.”

The results of the stress test could lead to calls for capital for some of the banks. Citi is mentioned most often as a candidate for more help, but there could be others.

The expectation, before Monday at least, was that the government would pump new money into the banks that needed it most.

But that was before the government reached into its bag of tricks again. Now Treasury, instead of putting up new money, is considering swapping its preferred shares in these banks for common shares.

The benefit to the bank is that it will have more capital to meet its ratio requirements, and therefore won’t have to pay a 5 percent dividend to the government. In the case of Citi, that would save the bank hundreds of millions of dollars a year.

The Real Crime in the Bailout -- Naked CDS Deals

The size of our national economy this year is roughly $15 trillion. The size of the Credit Default Swaps (CDS) market is $64 trillion. The whole world GDP is about $56 trillion. How could the CDS market be larger than the world GDP combined? That doesn't make any sense.

The minute I read that many months ago, I realized that there was something unreal going on in the CDS market. By "unreal" I mean something that is given value even though it is not attached to real assets. And the more I researched, the more I realized that was true.

CDS are basically supposed to be insurance on a group of assets. So, if you have a collection of mortgages, loans and other assets, and you would like to insure their value, you get a CDS. This makes sense since some of these underlying assets turned out to be quite risky.

What doesn't make sense is for the insurance market to be many times larger than the value of all of the underlying assets combined. Well, it turns out there is a reason for that. It's called the "naked" CDS. These deals are not attached to any underlying asset. They are not collateralized. They are not attached to anything of real value. They are simply bets. As in wagers. As in gambling.

For example, one bank will bet another bank that a group of mortgages will go under, and the other one will say they won't. Neither one owns the mortgage; they're just "insuring" it in theory. The reality is they are gambling -- pure and simple. Now, the numbers make sense. The CDS market got to be so large because people were making bets in ways that were not attached to the value of the underlying assets at all. So, they were free to bet as much as they liked.

And, of course, the more money they bet, the more money they made. And if they ever lost those bets, they knew didn't have the money to pay it anyway. So, they had all the incentive in the world to keep multiplying their bets.

So far, this is crazy enough, but here comes the really crazy part -- the American taxpayer is now paying off these bets. The people who bet that the housing bubble wouldn't burst or that the assets would retain their value, well, they lost -- but they don't have the money to pay off all of these theoretical bets since they never put any collateral down on them. So, they're turning to the government and saying they're out of money. And we're paying them. That's insane.

It's one thing to pay off mortgages that went bad. It's another to pay off insurance for a collection of bad debts. But it's another thing all together just to pay off gambling debts that otherwise have nothing to do with the economy. We, as the taxpayers, would have to be utter fools to provide the money for these inane bets. And, of course, that's exactly what we're doing now.

AIG was the epicenter for the naked CDS. If you care about this topic at all and want to understand how everything went down, you must read this excellent article by Matt Taibbi in Rolling Stone. As he explains, AIG started this madness and never had the money to back up their bets.

But what really drives me crazy is that I never hear anyone in government talk about this. I've never heard Tim Geithner or Ben Bernanke or any congressman or senator talk about what we should do with the naked CDS. They talk about all of the assets and obligations as if they are all the same. But some of the debts are based on underlying assets and some are not. Is that not an enormous distinction?

The only person who used to be in government who has raised this issue recently is Eliot Spitzer. He said what I have been wondering for a long time now - do we even have to pay these things? Since they are simply gambling wins, if the counterparties who won the bets don't get paid, nothing really happens. They didn't really actually have anything on the line, so it's not like they are going to suffer heavy losses. They are only going to suffer theoretical losses on money that never existed.

Why is Tim Geithner still paying off these debts? If he doesn't understand this phenomenon, he should be fired immediately. If he does understand it, and he thinks it is the obligation of the US taxpayer to pay off the gambling binges of the large financial institutions in the country, then I would seriously question his judgment, to say the least.

The argument they trot out every time is that we must have these financial institutions survive. I don't think that's true, but even if I did believe that, it would be important to shore up the real assets. But under no scenario is it important to pay off debts on imagined assets.

At the very least, can we please have this conversation? I would love for Tim Geithner or anyone else in the administration or Congress to explain why they think these naked CDS must be paid off. Can someone please ask them the question already, before more of our money is funneled over to the "counterparties" who won these bets?

Let Big Banks Fail, Bailout Skeptics Say

NEW YORK (Fortune) -- The Obama administration must break up the biggest financial firms if the nation is to return to economic health, three prominent bailout skeptics told a congressional panel Tuesday.

Columbia University professor Joseph Stiglitz and MIT professor Simon Johnson warned the Joint Economic Committee of Congress that the current government policy of propping up troubled financial giants could impede an economic recovery.

They each said spending taxpayer dollars freely on behalf of struggling big banks risks drowning U.S. productive capacity in debt -- while handing what amounts to an enormously costly subsidy to politically powerful financial sector insiders.

If the Obama administration fails to hold troubled banks accountable for their problems, the U.S. could face a lost decade of economic growth like Japan's in the 1990s, they said.

The third skeptic, Federal Reserve Bank of Kansas City President Thomas Hoenig, said policymakers must allow troubled firms to fail rather than propping them up, a la AIG (AIG, Fortune 500). He said banks must be treated consistently, regardless of their size or connections, for the sake of restoring confidence to markets and normal function to the economy.

"Rather than letting the market system objectively discipline the firms through failure and stockholder loss," Hoenig said of the current approach to bailouts, "we tend to micromanage the institutions and punish those within reach."

The hearing comes as Congress prepares to consider an Obama administration proposal to give regulators the authority to take over systemically important institutions. Treasury Secretary Tim Geithner has said such a plan is crucial if the U.S. is to avoid a recurrence of the current crisis.

Meanwhile, regulators led by the Treasury and the Federal Reserve are conducting so-called stress tests on 19 big banks, in an effort to demonstrate that the banks are well capitalized.

Big bank stocks have risen sharply over the past month, amid hope that government-subsidized lending and toxic-loan disposal programs will help restore the vitality of struggling financial institutions.

Shares of the most troubled banks -- Citigroup (C, Fortune 500) and Bank of America (BAC, Fortune 500), which together have received hundreds of billions of dollars of federal capital and asset-guarantee aid -- were among the biggest winners in that rally.

All three panelists said they believe the Bush and Obama administrations have misspent taxpayer funds in their zeal to stabilize the financial system -- and they warned that taxpayer money will continue to circle the drain if the Obama administration doesn't change course soon.

Along those lines, the International Monetary Fund estimated Tuesday that financial institution writedowns tied to toxic assets could reach $4 trillion globally.

Hoenig said authorities must set up a procedure that would allow big nonbank financial firms to be temporarily taken over by the government. Regulators would then replace management, wipe out shareholders and seek to sell the cleansed institution back into private ownership.

Stiglitz, formerly an aide in the Clinton administration, said the process of briefly taking over banks then selling them back to investors would be much less costly for taxpayers.

Both he and Johnson, a former IMF chief economist, added that the structure Hoenig sketched out would be good to have now - though it would have been better before last year's implosions at Bear Stearns and Lehman Brothers.

Instead, the government rescued Bear and let Lehman collapse - then got $700 billion from Congress that many argue was distributed willy-nilly to good and bad banks alike, as well as automakers and others.

The Lehman decision also froze credit markets and pushed AIG to the brink of insolvency. In response, the government extended an $85 billion emergency loan to the insurer. The cost of that rescue has since more than doubled.

The short-sighted responses to crises last year highlight the need to take bold steps now, Stiglitz said. "We really now ought to draw the line and say where we want to go from here," he said.

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