BondSquawk

by Natalie Cohen – The Public Purse

June 1, 2010

See this post on Reuters for discussion about Antioch, latest city in California to talk bankruptcy.  There is a bill, sponsored by state senator Mendoza, AB155, that would require cities to go through the state (via the California Debt and Investment Advisory Commission, CDIAC).  The bill was referred last week by the Senate appropriations committee — but now appears there will be some further review.  The pros and cons line up as follows;  cities strongly against state involvement in order to preserve local autonomy; unions and bondholders in favor in order to prevent reduction of obligations, whether they are union contracts or debt obligations.  Interesting line-up.  Many states have had oversight programs for their distressed communities for years.  Distressed designation may trigger  grants or aid to distressed municipalities that would not be present in a federal bankruptcy.  Some states map out a “receivership” process that gives the state certain intervention rights to reorganize the municipal government and bring finances back into balance.  Cities oppose any additional intervention by the state that encroaches on their powers.  Pro-union forces in the legislature want to prevent the cities from filing bankruptcy since it may result in reduction of  contract provisions (which was determined to be possible in the Vallejo case).  So far the pension albatross has yet to be tested.  According to Antioch’s 2009 audit the city is obligor on about $27 million certificates of participation, paid through lease agreements, current underlying ratings are Standard and Poor’s “A” and there is MBIA insurance on at least some (maybe all, we didn’t check each series) of the certificates.

Natalie Cohen is principal author and has deep experience in the municipal bond market, credit research, bond insurance, risk management, rating agency and government. She previously published the Fiscal Stress Monitor, a monthly independent trend letter. She has also written articles for the Bond Buyer, Municipal Finance Journal, American City and County Magazine, Government Finance Review and the Brookings Institution. A victim of the financial services meltdown herself, she recently founded National Municipal Research, Inc. a New York City-based consulting company and producer of The Public Purse.

by Marc Chandler – Marc to Market

May 29, 2010

Increasingly policy makers and investors are thinking about the consequences of the European financial crisis. The following focuses on two such consequences that are unlikely to appear on other lists. The attempt here is to be additive not exhaustive.

Europe: Re-writing the Social Contract

This year was supposed to be about the US and UK exiting quantitative easing programs at the end of the first quarter and for the global economy to continue the recovery begun, albeit slowly, in 2009.

While this did indeed take place, it was obviously overshadowed by the European debt crisis and the strengthening of the deflationary grip in Japan. This resulted in both the European Central Bank and the Bank of Japan extending, and in the former’s case, devising new emergency facilities.

The European debt crisis will have far-reaching political and economic consequences. The politics contemplated here is not about partisanship but rather the balance of power between the state, business and labor.

Over the years, European citizens have increased the basket of goods and services they receive from the state. These concessions mean that the state was subsidizing the true cost of labor and this generally bought social peace.

The financial crisis is bringing to an end that which was unsustainable in the first place. Given slow growth even in the best of times and demographic considerations, that basket of goods and services is no longer affordable. The basket of goods that citizens will get going forward from the European states will be less. How much less will be a function of the distribution of power within each country.

If the state is not going to be subsidizing labor as much, the distribution of productivity gains may be more fiercely fought over. The divergence between the return to capital in the form of profits and rentson one hand, and the returns to labor in the form – of wages and benefits on the other, may re-emerge as a powerful political and social force. And this will likely take place at the same time as businesses realign themselves with new regulations and slower economic growth (see new normal).

United States: More and Less than Meets the Eye

As economists and investors consider the impact on the US from the European crisis there is an understandable emphasis on the disruption to the US financial system. This includes not only the rise in LIBOR, the TED spread (T-bills minus Eurodollars) and swaps curve, but also some disturbance to the US commercial paper market and, of course, the negative wealth effect of the sharp drop in equity prices.

The erosion of household net worth from the fall in the stock market however is mitigated by two other considerations. The first is that American households have increased their holdings of fixed income products. They have lengthened maturities by shifting savings from money market funds to bond funds and Treasuries.

The second mitigating factor is the improvement in the labor market. More Americans are working a slightly longer work week and earning a little bit more. Look at the three-month moving average to smooth out this volatile series. In Q3 09, the US lost an average of 233k private sector jobs a month. In Q4, the loss slowed to 90k. In Q1 10 it was a positive 84k and here in Q2, it is likely to be closer to 200k.

The economy grew 231k private sector jobs in April and likely grew another 200k here in May. The work week increased by 0.3% in the first four months of the year. This is the equivalent of more than 900k jobs, not in terms of the unemployment rate, of course, but in terms of income and output. And those jobs were paying a little more. Average hourly earnings rose 0.4% in both Q4 09 and Q1 10, though this pace is unlikely to be sustained this quarter.

The Direct Investment Strategy

Outside of the financial impact, economists see US exports as another channel for contagion. The European Union receives roughly 20% of US exports. The fiscal austerity that many European countries are adopting will likely weaken aggregate domestic demand, which was not all that strong to begin with.

Jeffrey Lacker, the President of the Richmond Federal Reserve suggested that the knock-on the US economy from the European crisis could shave this year’s growth by 0.1-0.2%– roughly $140-$280 bln dollars. Lacker, like other prudent observers recognizes that the crisis also raises some downside risks.

One of those downside risks may arise from a fact that few people seem to really appreciate. Although the US is among the world’s largest exporters, exports are not the primary way US companies service foreign demand.

While US exports account for more than 1 trillion dollars a year in recent years, sales by US majority owned foreign affiliates eclipse that number dramatically. Over 4 trillion dollars of goods a year are sold by majority owned foreign affiliates using a ‘build locally, sell locally” strategy.

This strategy often not only reduces labor and transportation costs, it also insulates US companies from the effects of foreign exchange fluctuations. Exports will be impacted by both the dollar-euro exchange rate and the strength of the euro zone economy. The price of money adjusts much quicker than the price of goods. This helps explain the phenomenon that economists call the J-curve effect.

Initially after a currency depreciates, the trade account may deteriorate as goods that were previously ordered work their way through the system. It might not show up in corporate earnings immediately. However, the sales by majority owned affiliates are hit immediately by the economic slowdown, resulting in a much quicker impact on corporate earnings.

There are other implications that arise from the direct investment strategy. The majority-owned non-bank foreign affiliates are not just selling goods abroad, t they are also producing them. The most recent data is for 2007. That year the value-added of these affiliates of US multinationals was about $1.12 trillion. The affiliates in Europe accounted for a little more than half of this.

The affiliates in Europe are a significant part of the direct investment strategy. The assets of these affiliates account for almost two-thirds of all US affiliate assets, and a little more than 50% of all affiliate sales and income. The affiliates based in Europe account for 40% of all the foreign employment by US multinationals (suggesting that low wages are not the main driver of the direct investment strategy, but rather being closer to one’s customers may be a better explanatory variable).

To look at it from a slightly different angle, consider the value-added that these affiliates create contributes to the Europe’s GDP in a more profound way than many suspect. For example, the majority-owned non-bank foreign affiliates of US multinationals account for more than a fifth of Ireland’s GDP, more than 6% of the UK’s GDP, more than 5% of Belgium’s output and 4% of the Netherlands’s output. They account for 3% of Germany and Sweden’s GDP and 2.2% of France’s and Portugal’s GDP. They account for about 1.5% of the output in Austria, Italy, Spain, Finland and Greece. Slower growth in Europe and the dollar’s appreciation may curb on the margins US exports to Europe. However, the deeper penetration through the production and sales of the affiliates of US multinationals warn of the risk of a greater potential negative impact. Over the medium term, as the euro, which is still modestly over-valued according to the OECD’s measure of purchasing power parity, moves below fair value, these affiliates of US multinational companies may find that rather than simply service local demand, its exports from Europe may become more attractive.

Marc Chandler has been covering the global capital markets in one fashion or another for nearly 20 years, working at economic consulting firms and global investment banks. A prolific writer and speaker he appears regularly on CNBC and has spoken for the Foreign Policy Association. In addition to being quoted in the financial press daily, Chandler has been published in the Financial Times, Foreign Affairs, and the Washington Post. In 2009 Chandler was named a Business Visionary by Forbes. Chandler’s first book, Making Sense of the Dollar was published by Bloomberg Press in August of 2009. Currently, Chandler is the chief foreign exchange strategist at Brown Brothers Harriman.