Thursday, April 10, 2014 - Mr. Toad’s Wild Ride

Financial Review with Sinclair Noe

DOW – 266 = 16,170
SPX – 39 = 1833 (-2.1%)
NAS – 129 = 4054 (- 3.1%)
10 YR YLD - .06 = 2.62%
OIL - .20 = 103.40
GOLD + 5.80 = 1319.10
SILV + .19 = 20.13

If you want to know why the stock market is up one day and down the next, and not just little moves but triple digit swings – I don’t know. If anybody says they know, they probably don’t. Maybe it’s the Fed, maybe it is earnings reporting season, maybe it’s a strong economy or a weak economy, or maybe the markets are just trying to imitate Mr. Toad’s Wild Ride. The one thing we know is that stock prices fluctuate, and over time a pattern or trend develops; right now things are wobbly.

In economic news, the Labor Department said that the number of people applying for unemployment benefits dropped to 300,000, the lowest level in nearly seven years.

The Treasury Department says the federal budget deficit for the first half of the 2014 fiscal year totaled $413 billion, down $187 billion from where it stood at this point last year, as tax revenue surged and spending sank.  In March, the Treasury collected $216 billion in taxes, up 16% from a year ago, helping reduce the deficit for March to $37 billion from $107 billion last year. 

Meanwhile, spending sank by 14%, or $40 billion; military spending has been cut, federal government jobs have been cut, and Fannie Mae and Freddie Mac are no longer a drain but rather a contributor to the Federal coffers. Tax receipts have been increasing as the stock market improved (not necessarily today but remember last year was strong). Also, the economy has been better, not great but better. 

The budget gap last month was the smallest deficit recorded for the month of March since 2000. Over all, the deficit is expected to equal 4.1% of gross domestic product in 2014, down from nearly 10% in 2009, during the depths of the recession. It is the fastest four-year reduction in deficits since the demobilization after World War II.

California is sinking. Scientists estimate that the Central Valley accounts for about 20% of the groundwater that is pumped in the nation. It's the lifeblood of the flourishing agriculture industry, producing crops from almonds to plums, nectarines and cotton. And the water to irrigate is pumped from aquifers that are not being replenished by rainfall.

The US Geological Survey published a study that found that 1,200 square miles of the Central Valley were sinking half-an-inch per year, but the rate is not consistent everywhere. The town of El Nido, just south of Merced sank almost a foot a year between 2008 and 2010. A foot a year is not sustainable. You can’t really mitigate against a foot a year.

Farmers are digging deeper wells, and as the water is pumped out of clay aquifers, the earth above falls to fill the void, and the clay compresses. It’s called subsidence. The land sinks and the compressed clay cannot hold as much water as it once did. Once subsidence happens there is no way to undo it.

About 30% of California’s water supply comes from underground supplies, more during droughts, and about 80% of state residents rely to some degree on groundwater. Some towns, cities and farming operations depend entirely on it. And it has been a problem for a long time. Three generations ago, so much groundwater was pumped from aquifers that half the valley sank like a giant pie crust, sagging 28 feet near Mendota and inflicting damage to irrigation canals, pipelines, bridges, roads and other infrastructure.

The sinking only stopped because of 2 massive government funded irrigation projects, the federal Central Valley project and the California State Water project, which flooded the region with water from distant mountains and relieved pressure on the natural underground water supply. Now, the drought and climate change have opened up a new era of groundwater pumping. The result is the ground is sinking and the land subsidence is perhaps the worst ever seen in California.

This causes multiple problems for infrastructure. Dams and irrigation canals rely on gravity to move water, but when the ground sinks, the water doesn’t always flow as expected.  Flood safety is another concern; flood control channels might not perform as expected as levees sink. Bridges sag; well casings fail; and then there is the issue of the state’s multi-billion dollar high-speed rail line plotted to run through an area that is sinking by about a foot a year.

While the San Joaquin Valley faces the worst problems of land subsidence, other regions of California are dealing with similar problems on a smaller scale. The USGS has been studying sinking ground in the Coachella Valley for years in conjunction with the local water district. In a 2007 USGS study, researchers determined that the ground had subsided up to 4 inches in parts of La Quinta, with smaller effects in parts of Palm Desert and Indian Wells, during a year-and-a-half period from 2003 to 2005.In the Coachella Valley, the ground has sunk in some places where groundwater levels have fallen. Uneven settling has cracked the foundations of houses and fractured walls, swimming pools and roads.

After years of drought, water tables are dropping fast. Well-drilling costs are soaring. The biggest problem is the gradual, irreversible compaction of the earth that occurs when aquifers are pumped to historic lows. It doesn’t make the aquifer unusable. It just reduces the amount of water that can be stored in it, now and in the future.

The Basel Committee on Banking Supervision released its final ruling on just how much derivatives traders have to hold in reserve to pay off on defaults. International regulators are trying to safeguard trades and bring more openness to a $700 trillion market, known for its secrecy.

Swaps are what investors use to help guard against risk (at least theoretically). They’re bought by pension plans and retirement funds to protect against fluctuations in interest rates, meaning they affect most people who own annuities. They’re used by the US government to limit exposure in the mortgage market and cut home-loan costs. Investors can also hedge an investment in a company by buying a swap that will pay them if a borrower stops paying its debts. They’re called swaps because investors and banks exchange, or swap, payments over time based on how interest rates move or how the creditworthiness of companies changes.

Think of it as a form of insurance, with a few major exceptions; swaps do not require an insurable interest. For example, you can buy life insurance for your spouse and your spouse can buy life insurance on you because you have an insurable interest in each other. Your doctor can’t buy a life insurance policy on your life because your doctor does not have an insurable interest. And when you think about it that is a good way to approach insurance. Otherwise, your doctor might buy an insurance policy on your life and then bet against you; which is essentially what many people did with swaps in the financial crisis; they bought insurance on mortgage debts betting mortgages would default.

More frequently, swaps dealers sold swaps to people or entities who didn’t need the swaps or didn’t understand the swaps; for example the city of Detroit or the nation of Greece; they bet interest rates would go one way, and then they took on more debt than was prudent and when rates turned, they lost everything. Swaps made bankers billions of dollars before helping to blow up the global economy in 2008.

The other significant difference between swaps and insurance is that insurance companies must have reserves to pay claims. Swaps dealers, not so much; and so when defaults happen, the swaps contracts have a nasty history of not covering the risks they are supposed to cover. In other words, they never paid their claims.

After the crash, regulators set to work to make them less dangerous, through changes that in the process would make them less profitable. Where swaps had been one-on-one deals before, now they would be backstopped by third parties in clearinghouses that ensure everyone can pay, with the aim of avoiding emergency bailouts and panic. And the new Basel Rules now applies a minimum 20% risk weighting to money deposited at clearinghouses, which are third parties that guarantee the transactions. Note that is not a 20% in actual reserves, just a 20% risk weighting on money deposited at clearinghouses; big difference.

Today’s edition of “Banks Behaving Badly” features a hedge fund, SAC Capital Advisors, run by Steven A. Cohen. A judge has accepted a guilty plea from the hedge fund firm as part of a $1.2 billion criminal settlement for insider trading. In total, SAC Capital has agreed to pay $1.8 billion to resolve criminal and civil probes into insider trading. The Department of Justice said that payout is the largest insider trading settlement in history. The judge said: "These crimes clearly were motivated by greed, and these breaches of the public trust require serious penalties."

Now here is the peculiar part; if these breaches of the public trust require serious penalties why would they not include prison time? The answer is that you can avoid prison if you can pay enough money. SAC Capital has lots of money. Manhattan U.S. Attorney Preet Bharara said: "Today marks the day of reckoning for a fund that was riddled with criminal conduct." Not exactly. Today marks the day SAC Capital writes a check and continues on; that does not constitute a day of reckoning.