Another Decade of Dependence

I was reading the Wall Street Journal Online Edition today and came across an article Sovereign Impunity (subscription may be required). The article points out that the Abu Dhabi fund that just purchased a stake in Citigroup (a convertible preferred that converts to approximately 4.9% of the company’s shares) is funded with oil dollars. This fund now controls an estimated $875 billion according to this article, which is approximately 25% of all of the $2-3 trillion of assets owned by all of the sovereign wealth funds. This is an entity that obtains its funding through the sale of oil which is controlled by the government, not through free market risk taking. The article concludes by stating that it is US monetary policy that is responsible for the growth of these funds:

These funds owe much of their current size from bad U.S. monetary policy. We were nearly as ‘dependent on foreign oil’ in the 1980s and 1990s as we are today. But with a responsible Federal Reserve and strong dollar, there was no boom in petrodollars.

Only in this decade, amid the Fed's dollar abdication, have we again seen the boom in commodity prices that is enriching Russia, the Arab kingdoms, Venezuela (read a related Review & Outlook) and other dubious corners of the globe. Our own monetary mistakes have made these funds richer than they would be under normal market conditions. The response should not be to restrict their investment, but to start protecting the value of the dollar so that the price of oil falls back down to where it reflects supply and demand, not a cheapening U.S. currency.

Now, I may agree that our monetary policy has contributed to the decline in dollar value, but this completely misses the point. Before even considering the real issue, however, I point out that without a declining dollar we never get to a balance of trade that we can sustain over the long term. That said, what is the real issue?

The real issue is energy independence and it has been energy independence since the very first oil shocks in the 1970s. I knew this even as a teenager waiting on line at the gas station to put gas in my car. When we were originally impacted by the oil shocks we learned that we have an issue that must be dealt with in the long term, and that issue is that we are dependent upon foreign resources for our energy needs. As we have supported globalization through our trade policies, we have also increased competition for these foreign supplies from the emerging economies we support, making us even more vulnerable. This is not the 1980s or even the 1990s, and we now have serious global competition for scarce resources. Finally, we are learning that we cannot continue to poor pollutants into our atmosphere without consequence, and burning more fossil fuel is probably a bad idea.

Just how dependent are we on foreign oil? Well, according to the Energy Information Administration, in 2006 we imported on average 12,390,000 barrels of petroleum products per day. Based on a price of $94 per barrel, that’s about $1,164,660,000 ($1.16 billion). So what is today’s value of 4.9% of Citigroup in terms of petroleum imports? It’s about ($7.5/$1.164) 6.5 days of imports. That’s right, 6.5 days of petroleum imports equals 4.9% of Citigroup in today’s market. (I note that prices of different petroleum products differ, and the price changes regularly.)

Is this a result of poor monetary policy? I argue it is not, and the same forces that have driven up the price of oil have driven monetary policy. These factors are primarily related to globalization and our reaction, as a country, to it. For one thing, we have relentlessly pursued the pools of lowest cost labor we can find. This has driven prices of imported goods down at the same time we have made tremendous productivity gains. These forces have placed downward pressure on prices, and even threatened us with deflation in the early part of this decade. (Unfortunately none of this applies to health care or education that, for now, require the actual presence of professionals.) In response, the Federal Reserve lowered interest rates according to its traditional mandate so as to maintain growth and price stability. In this case, price stability meant avoiding deflation so the reaction was to keep interest rates extremely low for a long period of time. The natural result of this action is an increase in the money supply and a decrease in the value of the dollar (as well as pricing bubbles in, say, real estate). Ultimately, then, our pursuit of cheap labor comes back to us in the form of higher import prices due to a falling US dollar and asset bubbles. A side effect of this policy is that with a declining dollar the dollar value of our raw material imports increase. Add to that scenario the fact that we are now competing with countries such as China for the raw materials to be found around the globe, and we see why the prices of oil and other raw materials are rising. To blame monetary policy for this is to say that we should have left interest rates higher in the early part of this decade and likely suffered a recession with a simultaneous deflation, something that could be devastating to any economy. So is monetary policy responsible or is it the overall trading policies of the United States? I don’t believe the monetary policy argument is the critical issue.

(For additional reading on the impact of higher oil prices on monetary policy and the economy, there is a good article here at the Federal Reserve Bank of San Francisco website.)

Now that we can at least question whether it is monetary policy that is responsible for rising prices or some other factors that resulted in our monetary policy, we can move to the true cause of our problem. Despite decades of advance warning, we have not pursued, together as a nation, alternative sources of energy. Surely this is a goal that almost every American supports, barring those whose livelihood flows from the vertical chain of the oil industry. Lets take a look at some estimated numbers.

If we take the daily barrels we import and convert that to an annual amount, we get 148,320,000 barrels per year. Multiplying that by $94 per barrel gives us an annual cost of about $424 billion. How much is $424 billion? To put it in perspective, it is over two times the projected 2007 fiscal budget deficit of The United States, and on a monthly basis over 60% of the $56.5 billion total US trade deficit in September 2007.

Of course, finding alternative sources of energy is not free, and the alternative energy itself will not be free (although some sources may turn out to be just that). What it would be is liberating for the United States and other oil importing countries around the globe, and possibly very profitable and stimulating to our economy. So, rather than pointing fingers at who or what is responsible for the current situation that leads to 6.5 days of oil imports = 4.9% of Citigroup and proposing ways to make oil cheaper (not that I have a problem with that), I believe we are ready for the national challenge similar to the Kennedy era challenge of reaching the moon. We should have been ready for it decades ago, but we were lulled into complicity by low oil prices. Think of the change in policies that could result from energy independence. Would we fight as many wars? Would the world fight as many wars? Would we be wealthier? Would we save the earth from global warming? Could achieving energy independence balance the budget? Provide for Medicare? Decrease our defense spending? Etc.

I am certainly not the only person advancing this issue these days, but I feel strongly that more people need to advance it and be heard. Certainly a goal of energy independence through alternative and environmentally friendly sources is worth our consideration, our investment, and our short-term sacrifice. Should this be left to the free markets or should we look at this like a system of highways – something we need to build together, combining public finance and the free market system in order to foster the ability of free markets to further our advancement in the annals of human history? I believe the latter, and hope that even if oil prices fall substantially, we have learned our lesson and will make the necessary investments. At this point in our national history I crave a positive issue to unite around. This sounds like a timely one to me. Of course, that’s just my opinion.

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Updates - SIVs, Citi, Social Security, Subprime, and Taxes

First thing to update is the status of this blog. I started it on October 2, not quite two months ago. Since then I have written 26 pieces for publication, but nothing substantial in the past week. The reason is that maintaining the level of publication I started out with has proved difficult as evidenced by the late payment notices I have been receiving (I have forgotten to pay the bills!). So I took some time off to catch up on the other pieces of life not reflected in the blog (bills, family, work, exercise, etc.). I will continue to post so long as I continue to have visitors, although there will be periods of quiet.

There have been some very interesting developments in the interim, and I am writing today to update the issues I have been writing about in November. If you have been following my blog (thank you) then these should be of interest to you. You can click on any of the topics below to go directly to that topic, or just read from the top.

Citigroup Subprime SIVs Social Security and Taxes Short Rant on policy and responsibility

On Citigroup:
It has been interesting watching this unfold. Citi announced today that it will receive a $7.5 billion capital investment from the Abu Dhabi Investment Authority. According to the press release

Each Equity Unit is mandatorily convertible into Citi shares at prices ranging from $31.83 to $37.24 per share. The Equity Units convert to Citi common shares on dates ranging from March 15, 2010, to September 15, 2011, subject to adjustment. Each Equity Unit will pay a fixed annual payment rate of 11%, payable quarterly.

11% seems high to me, about the same as Ford Motor Credit and GMAC high yield bonds give or take a point, and these are convertibles. Abu Dhabi ends up with a 4.9% interest in Citi post conversion.

Now the layoffs are coming in force, and there is a lot of speculation in the media about how many jobs. I heard today on MSNBC anywhere from 15,000 to 45,000. That could be a lot of layoffs and of course it comes just before the holidays.

The investment by Abu Dhabi reinforces the fact that America is currently on sale, as I wrote about in my first piece in November. Interestingly, this purchase is with dollars so the exchange rate is not the issue. Rather it is the price of oil.

Since I wrote that piece, the Fed chairman testified before Congress and released its (now quarterly) report on the economy. The report was pretty much as expected, as was the testimony. Of course some of the dialog during the testimony was simply amazing in that it will likely lead to a proposal by Congress to federally guarantee jumbo mortgages (just what we need – more obfuscation of the “market”). I believe I heard warnings of stagflation in the testimony as well. If you would like more detail on this you can find it here.

While on the subject of the overall economy, I have some anecdotal evidence of a slowdown. Each year my family drives 230 miles to visit relatives for Thanksgiving. Last year the trip took about 6 hours with traffic, each way being a very long drive. This year it took just over four hours each way with almost no traffic. I believe gas prices are beginning to have an impact.

On Subprime:
What is happening there? Well, for one thing the Federal Home Loan Banks have vastly increased their exposure over the past quarter to provide liquidity to the mortgage market. Freddie and Fannie did their part as well, although they have since disclosed problems of their own relating to poorly underwritten mortgages. I wrote abut these increased exposures here. In a pleasant surprise, Senator Schumer is onto this scheme and posted a letter to the Federal Home Loan Bank today. Details here. Other than that there have been increased calls for taxpayer help to bail out homeowners so as to avoid a real economic problem. I don't believe there should be any bailout, and you can read about my reasons for this here and here and here.

On SIVS:
We now know that Citi has taken substantial assets onto its balance sheet relating to the SIVs, and HSBC announced that it is moving approximately $45 billion in SIV assets onto its balance sheet. I believe this is a blow to Citi and the whole MLEC plan because HSBC has taken the matter into its own hands and consolidated the problem. We should ask why Citi does not do the same, but the answer is likely to be one we don’t want to hear. Perhaps Citi does not have the equity to absorb such a move at this point. Whether Citi must consolidate these off-balance sheet entities is the subject of ongoing debate. According to a WSJ Online Edition article there MAY be a requirement to consolidate since Citi has taken over $32 billion in assets onto its balance sheet as of September 30 (as I discussed here). Sounds to me like a lot of intellectual wrangling over a pretty simple issue – if ultimately Citi will be forced to bail out these entities, whether for “reputational” or any other reasons, then they should be on the balance sheet. Of course that’s just my opinion.

The impact of all of this on the money markets is still uncertain. According to this WSJ article:

Efforts by HSBC to protect its SIVs are being watched closely by analysts and managers of money-market mutual funds, some of which have invested in debt issued by the two SIVs, called Cullinan Finance Ltd. and Asscher Finance Ltd. Janus Capital Group Inc. is estimated to have held about $606 million, or 2.7% of its money-market assets, in Cullinan and Asscher through the end of October, which has since been reduced. Federated Investors Inc. holds about $350 million in Asscher in its five largest money funds.

In other words, the mutual funds are still waiting to see whether they will be taking a hit on these. So far it appears they are winding down their exposure, but still have substantial assets tied to SIV structures.

On Social Security and Taxes:
I have been debating with people all week about my stance on Social Security, including the latest proposal by Fred Thompson to address the “crisis” we have. This Fox News Article reports his tax and Social Security plan as follows:

Thompson's proposal, announced on "Fox News Sunday," would allow filers to remain under the current, complex tax code or use the flat tax rates.
Asked whether the plan would cut too deeply into federal revenues, the former Tennessee senator and actor said experts "always overestimate the losses to the government" when taxes are cut.

"We've known for years any time we have lowered taxes and any time we've lowered tax rates, we've seen growth in the economy," Thompson said.

Thompson added that money would be saved by his Social Security reform plan. He proposed that workers younger than 58 receive smaller monthly Social Security checks than they are now promised. Individuals could contribute 2 percent of their paycheck to a personal retirement account, an amount that would be matched by the Social Security trust fund.

The retirement plan "faces up to the fact that Social Security is going bankrupt and we're going to have to do something about it," he said.

Well, first of all Social Security is only going bankrupt if the Federal Government decides not to honor its promise to repay what it borrowed from the Trust Fund (see my article on this topic here). If it does not, then it may be time to sell any treasury securities you have because they would no longer be “risk free”. (The Trust Fund does not own treasury securities, rather special IOUs from the federal government that are backed by the full faith and credit of The United States of America).

Next problem with this statement is the same old crap about the Laffer curve and taxes – if we can decrease taxes to grow the economy it will raise tax revenue. If this is true then why worry about Social Security? We can just cut taxes to pay for it! Ridiculous indeed. Now, to be fair, the article does not actually say that he believes a tax cut will result in higher tax revenue, but this is the argument we consistently hear from Republicans on this issue. I have yet to see any actual proof that the Bush tax cuts CAUSED tax revenues to increase. I have seen plenty of evidence that tax revenues have increased, but never any cause and effect proof. In other words, we do not know if it is the Bush tax cuts, fiscal stimulus from excessive borrowing, or normal economic growth from population growth and global growth that has caused tax revenues to increase. What we do know is that since the Bush tax cuts we are in a lot more debt and that is becoming a problem, especially when no one wants a tax increase to pay it down.

Finally, a flat tax has the potential to be regressive and could be another gift to the high-income population. In any event, a reduction in tax revenue is a problem at a time when we are at war (two wars, actually), and facing the need to begin repaying what has been borrowed from Social Security (not to mention the health care issues). At the end of the day, this boils down to paying for the Bush tax cuts and maybe even more tax cuts by reducing promised Social Security benefits relied on and paid for by lower- and middle-income retirees. It is a transfer of wealth from those with less to those with more. It is a sham. Again, that is just my (somewhat informed) opinion.

A short rant on policy and responsibility.
I think it’s about time we begin taxing to pay for our wars. Until now, we have fought this war in Iraq by borrowing the money and paying civilian warriors so as to avoid a draft and any tax increase. I wonder how long we would be in Iraq if we instituted a draft to get the soldiers we need and raised taxes to pay for it. I see uprisings on college campuses. I hear the cries of the high-income earners writing checks to the Treasury. My guess is we would already be gone. Isn’t this irresponsible? What happened to the party of personal responsibility? Isn’t keeping promises to taxpayers such as Social Security an act of personal responsibility? Isn’t managing the country in a fiscally sound manner an act of personal responsibility? How is it we get lectured on the values of personal responsibility by those who seem to ignore theirs? I shall continue to object.

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Open Questions for Citi

I took a few minutes to review the Citi third quarter 10Q that was released today to much fanfare. I have four basic issues/questions, and I invite anyone to provide answers for them. Here goes:

1. An issue. I searched the document for “SIVs” and came up with 33 hits. I then searched the second quarter 10Q for “SIVs” and guess how many hits I got? Zero. Nada. Zilch. So I guess this wasn’t anything important, that is until it became something important. (I also searched for “structured investment vehicle” and got the same result.)

I looked at some of the footnotes and I have a headache and three questions. Here they are numbered my points 2-4:

2. “Citigroup has no contractual obligation to provide liquidity facilities or guarantees to any of the Citi-advised SIVs and does not own any equity positions in the SIVs. The SIVs have no direct exposure to U.S. sub-prime assets and have approximately $70 million of indirect exposure to subprime assets through CDOs which are AAA rated and carry credit enhancements. Approximately 98% of the SIVs’ assets are fully funded through the end of 2007. Beginning in July 2007, the SIVs which Citigroup advises sold more than $19 billion of SIV assets, bringing the combined assets of the Citigroup-advised SIVs to approximately $83 billion at September 30, 2007. See additional discussion on page 46.

“The current lack of liquidity in the Asset-Backed Commercial Paper (ABCP) market and the resulting slowdown of the CP market for SIV-issued CP have put significant pressure on the ability of all SIVs, including the Citi-advised SIVs, to refinance maturing CP.

“While Citigroup does not consolidate the assets of the SIVs, the Company has provided liquidity to the SIVs at arm’s-length commercial terms totaling $10 billion of committed liquidity, $7.6 billion of which has been drawn as of October 31, 2007. Citigroup will not take actions that will require the Company to consolidate the SIVs.” From Citi's third quarter 2007 10Q pg. 7.

My question is, if “Citigroup has no contractual obligation to provide liquidity facilities or guarantees to any of the Citi advised SIVs…” then why does it provide “liquidity to the SIVs at arm’s-length commercial terms totaling $10 billion of committed liquidity, $7.6 billion of which has been drawn as of October 31, 2007.”? And, why wasn’t this $10 billion in liquidity facilities mentioned earlier? Sounds to me like Citi is not contractually obligated to provide the facility, and that means it can keep the SIV off of its balance sheet. But, in order to make the SIV work, someone has to backstop the liquidity, and guess who did that? Yup – Citi. Accounting hanky panky if you ask me. Of course this could all be perfectly legitimate according to the accounting rules, I guess. This could be a new facility, although why would Citi expose $10 billion into this market if it did not have to? If it isn’t new, then the question is why did “SIVs” not show up on the previous 10K? Is $10 billion in liquidity facilities to a managed entity immaterial? Was it lumped into that total “notional” exposure disclosure about VIEs (see below)?

3. Next up, the commercial paper question. From pg. 9 of the third quarter 10Q:

“ABS CDO Super Senior Exposures
Citi’s $43 billion in ABS CDO super senior exposures as of September 30, 2007 is backed primarily by sub-prime RMBS collateral. These exposures include approximately $25 billion in commercial paper principally secured by super senior tranches of high grade ABS CDOs …. Although the principal collateral underlying these super senior tranches is U.S. sub-prime RMBS, as noted above, these exposures represent the most senior tranches of the capital structure of the ABS CDOs.”

I want to point out the part that says “These exposures include approximately $25 billion in commercial paper principally secured by super senior tranches …….the principal collateral underlying these super senior tranches is U.S. sub-prime RMBS…” Looks like they had to purchase some of the commercial paper issued by those conduits. $25 billion of it, in fact. They don’t specifically tell us that’s where the commercial paper comes from. Guy Moszkowski - Merrill Lynch – Analyst asked the question on the conference call today. The answer he received from Gary Crittenden - Citigroup – CFO made no mention of conduits, only liquidity backstops for CDOs. I would like to know whether these were purchases of commercial paper from ABCP Conduits managed by Citi or not.

4. Finally, there is one other tidbit I would like to point out. Here is the disclosure I would like to know more about, from pg. 73 of the third quarter 10Q:

“As mentioned above, the Company may, along with other financial institutions, provide liquidity facilities, such as commercial paper backstop lines of credit to the VIEs. The Company may be a party to derivative contracts with VIEs, may provide loss enhancement in the form of letters of credit and other guarantees to VIEs, may be the investment manager, and may also have an ownership interest in certain VIEs. The Company’s maximum exposure to loss as a result of its involvement with VIEs that are not consolidated was $141 billion and $109 billion at September 30, 2007 and December 31, 2006, respectively. For this purpose, maximum exposure is considered to be the notional amounts of credit lines, guarantees, other credit support, and liquidity facilities, the notional amounts of credit default swaps and certain total return swaps, and the amount invested where Citigroup has an ownership interest in the VIEs. This maximum amount of exposure bears no relationship to the anticipated losses on these exposures.”

On its face this looks like a plain vanilla $141 billion no prob. But this amount was $91 billion at December 05, growing 19.8% in the ensuing twelve months to $109 billion at December 06. Since last September when this number was $93 billion, it has grown by 51.6% to $141 billion this September. In fact, in the three months since June 07 alone this number has grown by 29.4%, from $109 billion to $141 billion. I would like to know more about that number.

I hope these questions are eventually answered. Meanwhile, I remain cynical. My opinion, of course.

PS:
If you read my October post, Hocus Poke-us, then you know that banks are marking some liabilities to market. That maneuver resulted in a pre-tax gain to Citi of $466 million in the third quarter. Here is the note from pg. 6:

“Market Value Gains Due to the Change in Citigroup Credit Spreads
SFAS 159 provides companies the ability to elect fair value accounting for many financial assets and liabilities. As part of Citigroup's adoption of this standard in the first quarter of 2007, the Company elected the fair value option on debt instruments that are provided to customers so that this debt and the associated assets the Company purchased to meet this liability are on the same fair value basis in earnings. At the end of the third quarter, $28.6 billion of debt related to customer products was classified as either short- or long-term debt on the Consolidated Balance Sheet. Under fair value accounting, we are required to use Citigroup credit spreads in determining the market value of any Citigroup liabilities for which the fair value option was elected, as well as for Citigroup trading liabilities such as derivatives. The inclusion of Citigroup credit spreads in valuing Citigroup’s liabilities gave rise to a pretax gain of $466 million in the third quarter of 2007 and is reflected in the Securities and Banking business.”

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