James Saft

It looks just about possible that creditors are going to be paying something like their share of the euro zone debt disaster after all.

This could be a little patch of justice in an unfair world, but like most justice it promises long term benefits but short term pain, both for those dispensing and receiving it.

Firstly, people with money and a choice are going to – indeed already are – voting with their feet, choosing not to lend to the ailing governments on Europe’s periphery.

Secondly some of these creditors to Ireland, Greece and Portugal and their banks will very likely find that their share of the damage exceeds their capital, an inconvenient reality for both the banks involved and the sovereign hosts who will have to pick up the pieces.

The EU summit last week ended with a set of policies that told creditors directly that their heads will be on the block when the European Stability Mechanism (ESM), a bailout conduit, kicks in.

All European government bonds issued from July 2013 will include a provision that makes buyers vulnerable to forced extensions of the bonds, reductions in interest rates and ultimately write downs of principle in the event of a crisis.

On top of that, once the ESM takes effect, garden variety lenders like banks and pension funds will be subordinated, meaning the government bailout fund gets its money back first.

Accessing the fund may require a debt restructuring, a polite term for a partial default.

While this may be just and is definitely politically expedient for the politicians trying to sell the bailout back in Berlin and Paris, it is also the equivalent of ringing a great big fire alarm in a crowded theater – everyone is going to head for the exits.

And they duly have. Ratings agency Standard & Poor’s has downgraded Portugal and Greece, citing the new rules this week. There is every reason to expect that Ireland will not be far behind.

Credit spreads have widened in a self-reinforcing spiral that makes accessing emergency help more likely, which in itself is cause for yet more selling of government bonds.

Don’t get me wrong. People who have lent money in a cynical attempt to cash in on the moral hazard trade deserve their losses, as do earlier lenders who merely failed to do their due diligence.

That said, I can’t help but feel this is going to spin out of the orbit of burden sharing and into something a bit more chaotic. For me, as for many German taxpayers, this is looking like a “be careful what you wish for” moment.

IRISH BANK CREDITORS FACE SHEARS

Shortly after this column is published, Ireland will release the results of its new stress tests on its cratering banking sector. At the same time, if news reports are correct, an indefinite term bailout vehicle for them with ECB and EU support will also be announced.

The stress tests will likely show that Irish banks need an additional 30 billion euros or so of capital, taking Irish state investment to 75 billion or so, a whopping 45 percent of annual gross national product.

This is a staggering amount and given that the policies of austerity will only erode the value of the assets Irish banks have lent against further, there is no guarantee that this is where it ends.

Ireland’s new government appears to be taking a harder line about forcing lenders to Irish banks to take a portion of the losses. Subordinated creditors are sure to have their loans restructured and senior creditors may well face losses too.

To be clear, it is right that the banks that fed the Irish banking beast with easy loans take losses as a means of easing the hardships that are falling on the Irish people.  Ireland’s banking system, like Iceland’s and arguably Britain’s, was way out of proportion to the size of its economy.

This may well be simply a negotiating ploy by the Irish government, as a substantial write down of Irish bank debts will spread losses, and more importantly fear, widely across Europe’s banking system.

A rescheduling by Ireland, Greece or Portugal will be highly disruptive for global markets and you can bet that the ECB and EU are under tremendous pressure to make sure it does not happen.

There is, though, a sense that there is not political will or capacity to bring about a solution that keeps Greece, Ireland and Portugal all on board but can also be sold to the German electorate.

It has been a long first three months of the year. Egypt, Japan and Libya have distracted attention, while the long-running and procedural nature of the euro zone’s problems make them a pleasure to ignore.

Things could, in the next week, move rapidly and perhaps upend widespread expectations of an ECB hike on April 7.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. Email: jamessaft@jamessaft.com)

In a field of endeavor with a long and glorious history of folly, the European Central Bank is preparing to commit an error for the ages: hike interest rates into the face of a crisis of existence for the euro zone.

There is an increasing likelihood that when the ECB meets  on April 7 they will respond to surging energy costs and 2.4 percent annual inflation – the highest since 2008 – by raising interest rates, probably by a quarter of a percent.

“Inflation rates … are now durably above the common definition of price stability in the euro zone,” ECB President Jean-Claude Trichet told an audience in Paris on Monday.

This reinforced expectations of a hike he introduced in early March when he dropped the words “strong vigilance” into remarks following the last interest rate-setting meeting, a phrase that served as a one month warning of rate hikes to come during the 2005-2007 rate hike campaign.

Reports that the ECB is preparing a new bail-out lending vehicle for Irish banks, taken as a precursor to a wider effort at bank relief, are being read in markets as further evidence that the ECB is ready to tighten. The reasoning is that, having squared away the banks, and their mutually dependent sovereign guarantors, nothing will stand in the way of an old fashioned bout of inflation scourging.

Here we see the ECB’s conception of itself – as an institution proudly above the political fray and dedicated single-mindedly to price stability – clouding its ability to treat with reality.

“Sure”, you can almost hear ECB types say to themselves, “we’ve accepted some pretty horrendous collateral, and sure, we’ve kept insolvent banks alive through providing massive liquidity, but at heart we are just honest inflation hating bankers, just like our forebears at the Bundesbank.”

Actually though, as Bank of England Monetary Policy Committee member Adam Posen points out, the Bundesbank, when confronted with the oil shock and global recession of 1979-80 dealt with energy-driven inflation quite differently.

“The Bundesbank made public that it would take several years to bring inflation back to its target long-run inflation level, even though it would partially offset the shock immediately and inflation would rise. In fact, it took six years for German inflation to be brought back to 2.0 percent, and both the Deutsche Mark and the Bundesbank retained their counter-inflationary credibility,” Posen said in a February speech.

Now, when you recall that the Bundesbank was slightly to the right of Atilla the Hun in its attitude towards inflation, the ECB’s current course of action looks even more, to be polite, remarkable.

GREECE,  IRELAND, PORTUGAL

Remarkable, especially, when you consider what is being asked of the peripheral euro zone countries. Greece, for example, last year tightened fiscal policy by 8.0 percent of GDP, a statistic that is more impressive before you learn that its economy, partly as a result, shrank by 5.0 percent. You really cannot do that too many years in a row, either mathematically, or politically.

A semi-revolt against austerity measures in Portugal prompted the resignation of Prime Minister Jose Socrates last week, leaving a European rescue plan in limbo. Portugal is now being pressured to accept a bailout, but there is real doubt as to whether it will sign on for the measures expected, and even more doubt as to whether it can stick with them over time.

Inflation is not the problem in Portugal, it is declining standards of living, exacerbated by rising energy costs, but really the result of a squeeze on labor and consumption that is its only means of regaining competitiveness as it has no currency of its own to devalue.

Or take Ireland, which is fighting for better bailout terms, its latest gambit being to push the idea of burden sharing for bank creditors to its crippled banking system. As burden sharing means banking crisis, you can take this as a negotiating position. Or consider Spain, whose own banking system and economy will not be helped by the ECB fighting inflation.

Meanwhile there is a lack of convincing evidence even in the stronger countries of the euro zone that inflation is hardening into large wage rises.

In the meantime, there is evidence that the European recovery, uneven as it is, is facing headwinds. Measured in real terms, currency in circulation and overnight bank deposits in the euro zone are contracting, a strong leading indicator of a slowdown. While this trend started in the weak periphery, it has spread to the core, and is troubling.

A rate hike will rain down even more pain on struggling Spain and its peers and will on the margins make their task of outgrowing their debts and honoring their European commitments even less feasible and will do exactly nothing about the real cause of inflation – rising energy prices.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

James Saft is a Reuters columnist. The opinions expressed are his own.

If housing is the primary force behind the U.S. economic cycle, then the recession early warning bells just started ringing.

Sales of new single-family homes recorded a shocking fall in February, tumbling by 16.9 percent, to a seasonally adjusted 250,000 annual rate, hitting the lowest such figures since records began in 1963.

New home sales are down 28 percent compared to a year ago and the inventory of unsold new homes is now equal to 8.9 months of sales.

Even more amazingly, in a nation with more than 110 million households, there were just 19,000 single family home sales for the month on a raw unadjusted basis.

Put simply, far from being an engine of growth after several years of contraction, investment in housing looks to be a drag on the economy in 2011.

“We continue to believe that this dip in housing will translate into a double dip on the overall U.S. economy, further rolling forward any stimulus-exit plans set by the Fed, and setting the stage for an announcement of QE3 in July,” said said Douglas Borthwick of Faros Trading. “Jobs and housing remain the focus for the Fed, and both areas continue to face severe difficulties.”

The problems lie not just with new homes. The overall picture is of a housing market slouching its way into a double-dip slump.

Sales of existing homes also fell last month, by a less precipitous 9.6 percent, down 2.8 percent from a year ago.

Prices of existing homes, unsurprisingly, are falling as well, down 0.3 percent in January nationwide, according to the FHFA, the third straight monthly fall.

The number of properties in foreclosure hit a record 2.2 million in January, according to Lender Processing Services, while something on the order of one-in-five homeowners with a mortgage are in negative equity, with mortgage debt exceeding the value of the house. In Florida 20 percent of dwellings stand empty, a statistic implying not just a few quarters of slump in building but several years.

This matters to the economy in two important ways. Firstly, housing activity, from building to buying to outfitting, is one of the prime drivers of the economic cycle. Secondly, if a slump is deep and protracted the bad debts it will produce will once again threaten to capsize the banking system.

NINE OUT OF ELEVEN IS NOT BAD

At a paper delivered at the central banking conference in Jackson Hole, Wyoming, in 2007 entitled “Housing IS the business cycle”, UCLA professor Edward Leamer argued that residential investment plays a key role in US recessions. He demonstrated that 8 out of 10 postwar recessions were foreshadowed by serious and sustained problems with housing, at least as of 2007.

Counting the most recent recession we can now call that 9 out of 11, with a good shot shortly at 10 out of 12.

“Of the components of GDP, residential investment offers by far the best early warning sign of an oncoming recession,” Leamer wrote.

“After a surge of building there has to be a time-out… before building can get back to normal, and before this channel through which monetary policy affects the real economy is operative again. The Fed can stimulate now, or later, but not both.”

Of course the Fed, as has been its way since the Greenspan era, has tried to eat the same cake repeatedly, but the recent run of data shows that the housing market is not responding.

Efforts at foreclosure mitigation have been a failure as well, with a small success rate and a high probability of re-default.

You could argue that efforts to prop up the housing market, from loan modification to tax incentives, have only served to lengthen the time that the fall of house prices takes, prolonging at the same time the “time-out” in construction and allied activity.

It will also be interesting to see just how well the banking system weathers a second fall in house prices. Much of their portfolios of loans and loan-derived securities are being carried on bank books at what may turn out to be optimistic levels.

If another wave of defaults comes, the truth of cash flows may well expose those marks for the fantasies they are. In this light the U.S. Treasury Department’s decision this week to allow many large banks to raise or recommence dividends may prove to be a mistake.

To be sure, U.S. manufacturing is doing well, and demand from emerging markets, particularly for natural resources and other commodities, will help to counteract the drag that housing will have on the economy.

Perhaps the scariest aspect is this: another housing bailout is probably politically impossible. This time the chips really will fall where they may.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

James Saft is a Reuters columnist. The opinions expressed are his own.

HUNTSVILLE, Ala. — We finally have an answer for what kind of financial service only a too-big-to-fail bank can provide: a record-setting loan to fund a takeover that will hugely reduce competition in U.S. wireless communications.

AT&T on Monday said it would pay $39 billion for Deutsche Telekom AG’s T-Mobile U.S. wireless unit, backed by $20 billion of financing from JPMorgan Chase & Co.

The deal, which is subject to regulatory approval, will leave AT&T and Verizon Wireless in control of 80 percent of the U.S. market for contract customers, according to rival Sprint Nextel Corp.

The one-year unsecured bridge loan has an 18-month commitment period, meaning it can be drawn any time during that time when AT&T is ready, and is the largest ever such loan made by JP Morgan Chase, a bank with more than 200 years of institutional history.

While there have been M&A loans this big before, the vast majority would have been syndicated among a consortium of banks to reduce risk.

This is the kind of bridge deal that earned the sobriquet “bridge to nowhere” when so many banks were stuck with them during the last crisis. It is also yet another example of how too-big-to-fail (TBTF) subsidizes banks and encourages risk taking.

Could other banks have made the loan? Perhaps, but they didn’t and it is unimaginable that a bank that was not in receipt of a government guarantee could compete with one that was.

Full disclosure: I am doubly on the wrong side of this deal, both as a customer of T-Mobile who was hoping for some negotiating leverage and as an owner of shares in American Tower, a company which operates towers that carry wireless communications and which will see its negotiating position similarly diminished.

During the long debate about whether the largest U.S. banks, including JP Morgan, should be broken up to make them small enough to fail, the main counter argument was that the U.S. needed huge banks to serve their global clients’ global needs. Well the needs of AT&T were met, but arguably at a cost to consumers and with additional risk being borne by taxpayers.

Of course, if you believe that there is a real subsidy from TBTF status, as I do, then everything a bank does will to some extent be an attempt to leverage that advantage and will therefore leave the taxpayer and economy bearing more risk than they otherwise would if this were a community bank lending to a copy shop.

UNLUCKY CONSUMERS

An un-syndicated deal is much superior from the point of view of AT&T, being quicker, quieter and an expression of confidence on the part of the bank. From JP Morgan’s point of view, it is allowing it to use its balance sheet power to gain access to lucrative investment banking fee business. There is nothing wrong with these activities as such, but there is a grave problem with doing them while being the beneficiary of the special risk status granted by immense size.

As for AT&T, it is selling the deal as a means to serve a growing customer need for wireless data, gaming, video and telephone capacity. That is true, but so is the fact that the U.S. is going to drop from four to just three national carriers. Most local markets have local competitors, but for many people they are not seen as an option.

And if you are someone who wants a national carrier and insists on GSM technology, which works far better internationally, then you will be left with a choice: AT&T or AT&T.

I know that when my contract with T-Mobile runs out in July my negotiating position will be much worse than if it had expired in February, and it is also clear that some of the features I enjoyed may not survive the merger.

“I think it could reach some level of controversy,” said an antitrust expert quoted by Reuters who asked not to be named. “There’s going to be spectrum issues. This is going to be a complex deal and I don’t think it’s a foregone conclusion that it will be approved.”

The deal must be approved by the Federal Communications Committee and the Justice Department, which will examine whether the deal meets antitrust laws.

In the end, the deal may well go through, and perhaps marks a turning point for the M&A market. If you own a lot of assets or work in financial services this is a good deal.

If you are more of a taxpayer and a consumer, not so much.

(Other than those disclosed above, at the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

James Saft is a Reuters columnist. The opinions expressed are his own.

If rebuilding after tragedies is actually good for the global economy, someone clearly forgot to tell investors.

In the days after Japan’s earthquake and tsunami and its still unfolding nuclear disaster, global stock markets have fallen sharply, as have bond yields and even energy prices, all indicators that someone, presumably someone with quite a bit of money, thinks this all will not end well.

While replacing broken windows will flatter GDP, it does not do a whole heck of a lot to increase productive capacity. The contrary argument, of course, is that Japan is suffering from a surfeit of savings and that these funds will finally be given something worthwhile to do in rebuilding.

Perhaps demand from Japan will do someone some good, but the idea that we can all grow rich by rebuilding our ruined houses seems little better than the old canard that we’ll all get rich buying each other’s houses. Both theories rest on employing more debt and both, therefore, present considerable risks.

Even beyond the idea that Japan’s plight will somehow provoke a bond crisis, of which there is no evidence yet, two factors may explain why markets are so scared; the nuclear risk and the spreading unrest in oil-producing nations in the Middle East and North Africa.

First, the events at the Fukushima nuclear plant are as unpredictable as they are frightening. Reports are confused and attempts to control the situation, such as a failed bid to dump water by helicopter, evoke images of the kind of movie happy endings we all view as far fetched.

This brings fear and that kryptonite of risk markets, uncertainty.

This cuts a much wider swath than just Japan, where nuclear power represents 29 percent of electrical generating capacity.

The truth is that nuclear power, one of the most important sources of electricity in many markets around the world, now has a very uncertain long-term and immediate future. That could have a nasty impact on energy prices, and in turn on growth and inflation.

The impact is spreading quickly; European Union energy officials agreed Tuesday to apply new stress tests on plants across the 27-nation bloc and Germany moved to switch off seven older reactors. China’s cabinet on Wednesday said it will suspend approvals for nuclear power stations to allow for a revision in safety standards, while Switzerland put on hold renewal of three of its atomic stations.

This is significant; nuclear power represents a third of Japanese electrical generating capacity, 20 percent in the U.S. and 75 percent in France.

OIL ON TROUBLED WATERS

Oil prices initially fell after the earthquake, operating on the assumption that immediate demand in Japan will fall. Prices rose on Wednesday, as fears of nuclear power rose and people worked through the implications.

This is all made even harder to predict by the unfolding path of revolts and protests in the Middle East. Libyan forces supporting Muammar Gaddafi were predicting on Wednesday the fall of rebel stronghold Benghazi within 48 hours, a development that, while ghastly, would actually help to suppress oil prices if it came to pass. That, ladies and gentlemen, is your global economy, 2011 edition, left hoping for the restitution of a vicious dictator.

Developments in the gulf state of Bahrain, which used tanks and helicopters to drive protesters from the streets on Wednesday, added to uncertainty. Bahrain has brought in troops from fellow Sunni-ruled Saudi Arabia, Qatar, Kuwait and the United Arab Emirates as it seeks to put down a largely Shi’ite-led protest movement, risking retaliation from Shi’ite-dominated Iran.

There is simply no way to know how this will work out, but financial markets look to be pricing in elevated energy prices for an extended period.

It is possible, of course, that protest is stifled, that nuclear doubts are damped and that the price of oil sinks rapidly, in which case you can expect a massive rally of risk assets and for the Federal Reserve to resume making noises about the transition away from quantitative easing.

If not, and if energy prices remain high or rise, they will be a tax on growth and consumption, all the while fanning the flames of inflation in food and energy.

It is worth noting that U.S. producer prices spiked last month, with finished foods rising 3.9 percent, the highest rate since November 1974, when President Gerald Ford was attempting to lead a “Whip Inflation Now” movement.

Tension in the Middle East, oil spikes, inflation and nuclear fears; It is all looking a bit 1970s now, and that is not something to be nostalgic about.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

Photos, top to bottom: A red umbrella is seen among the ruins as survivors walk past in Kamaishi, Iwate Prefecture, days after the area was devastated by a magnitude 9.0 earthquake and tsunami March 16, 2011. REUTERS/Damir Sagolj; A Japan Self Defense Forces helicopter fights a mountain fire after a magnitude 8.9 earthquake and tsunami hit near Kamai City, Iwate Prefecture in Northern Japan March 13, 2011. REUTERS/Kyodo

James Saft is a Reuters columnist. The opinions expressed are his own.

As the people of the great state of California are finding out, very small changes in our assumptions about the world can have very large consequences.

The $230 billion California Public Employees’ Retirement System (CalPERS) will likely cut its expectation this week about how much the pension fund will earn in future years, reducing its “discount rate assumption” to 7.5 percent from 7.75 percent.

That is going to land the State and other employers with workers in the fund with a bill to make up the shortfall that could total upwards of $200 million.

And let’s not just pick on California; this is, or should be, happening all over the U.S. as government and private pension plans come to terms with the reality of a low-growth, low-return world. The median discount rate for leading U.S. public pension plans is 8 percent, according to the National Association of State Retirement Administrators, while consultants Milliman say the largest defined benefit corporate pension plans are banking on 8.1 percent.

Those figures are not only far higher than recent returns, they are very likely far higher than what it is reasonable to expect going forward.

As those assumptions fall, there will be intense pressure for higher contributions, lower benefits and — and here is where it could get really ugly — higher risk investments.

Here is what to expect as a result:

• More Wisconsin-style political conflict, as workers and employers clash over who will pay what to whom.
• More corporate earnings hits, as the recognition dawns that too many companies are hedge funds with businesses attached (Does anyone remember General Motors?).
• More risk-taking by pension funds as the intense pressure from the first two prompts pension funds to swing for the fences to avoid having to make painful choices. If you manage a hedge, private equity or emerging markets fund this will be very good news for you.
• This will not be a sudden process, it will be slow and grinding and will be made worse (or better if you like) as life expectancy assumptions improve.

“GREAT MODERATION” FALLOUT

While it is true that the current level of pension underfunding is caused in part by the atrocious returns on equities over the past decade, it may well be that this is not simply a cyclical problem which will come right as returns improve, but a structural one driven by much larger assumptions.

Returns over the past 30 to 40 years were driven by a number of factors that may prove to be either one-time benefits, pendulum swings that are in the process of coming back the wrong way, or illusions.

The conquering of inflation that began in the early 1980s allowed for higher prices of financial assets, particularly stocks. Having come all the way down, there is no more expansion of multiples possible from that source.

Secondly, deregulation and globalization allowed the percentage of GDP that flowed to profits to rise and rise. That flattered returns on stocks and corporate bonds. If that trend reverses, as well it might, and wages rise relative to profits, stock valuations will have to fall.

Thirdly, and this is crucial, the illusion otherwise known as the “Great Moderation,” a theory of ever shorter and milder recessions due to clever central banking, has been burst. Part of what the Great Moderation did was to lull investors, regulators and policy members alike into a false sense of security about how volatile growth and conditions may be.

That illusion of moderation encouraged risk taking, borrowing and speculation, all of which drove up the price of financial assets, notably stocks. Risk premia are being artificially suppressed now by easy monetary policy and willful blindness by regulators but that will unravel sooner or later, either via a spike in inflation or some other unexpected force. When it does, we face a few years of very poor returns in most of the things pension funds invest in.

As all of this unfolds, governments, corporations and individuals will face painful and divisive fights involving promises, taxes and expectations. Here is where we can expect the financial services industry to step in with its magic beans. After all, it is far more pleasant to earn a higher rate of return through “shrewd” investment than it is to save more, work longer and pay more in taxes.

This is already happening in New Jersey, which faces a huge pension fund problem and is in the midst of a political dogfight over who will bear the costs. The New Jersey Division of Investment, for example, recently hiked its upper limits on alternative investments such as hedge funds to 38 percent from 28 percent and for private equity to 12 percent from 7 percent.

Wish New Jersey, and California, luck. They are going to need it.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

Patience, particularly in investing, is one of those virtues everyone praises but for which no one seems willing to pay.

An investment manager given money to manage is going to do the same thing with it pretty much every time: put the money to work.

This is true almost always and almost without reference to how attractive the alternatives are. Partly this is because the fund manager reasons that you would not have given him money if you wanted him to keep it sitting idle in a liquidity account, but also because most fund managers spend most of their time managing a specific kind of risk: career risk.

Even if they may be personally convinced that the markets they follow do not represent good value, the decision to stay in cash is personally risky for them. People don’t get fired for trailing the index by a point or two, but they do often if they miss a big rally.

That leaves most money managers with a perverse incentive; look like everyone else, take a few small bets away from the index you track and live to pay off your mortgage and fully fund your kids’ educations.

It is also, I would argue, psychologically hard for primates like us to refrain from activity; big cats do well out of waiting for their moment but monkeys usually make a living through ceaseless activity.

“Patience is also required when investors are faced with an unappealing opportunity set,” James Montier of fund manager GMO writes in a letter to clients that argues that no major asset class currently offers fair value, much less a margin of safety.

“Many investors seem to suffer from an “action bias” — a desire to do something. However, when there is nothing to do, the best plan is usually to do nothing. Stand at the plate and wait for the fat pitch.”

The baseball metaphor is apt; nothing gets less respect, historically, from the people who decide who gets to play baseball for a living than the walk. Batters who are willing to take pitches used to actually be thought of as lazy, even though recent statistical evidence indicates that the ability to get on base is highly correlated, amazingly enough, with scoring runs.

So it is with investors; deciding not to act, not to participate when value is not there is both freeing and likely to lead to better returns over the long haul. That said, there is absolutely no doubt that sitting out overvalued markets is a career killer for investment professionals and the kind of tactic best discussed with one’s spouse well in advance.

BILL GROSS’ BIG BET
This brings us to the astounding bet currently being made by bond king Bill Gross and PIMCO, whose flagship Total Return Fund, the world’s biggest bond fund, has dumped all U.S. government-related securities, including Treasuries and agency debt. Gross took cash to 23 percent of the fund, up from just 5 percent a month ago. In the Unconstrained Bond Fund, which is given more latitude, cash is an unbelievable 92 percent (CORRECTION: cash not pledged as collateral is 18 percent).

In part perhaps this reflects that Gross — rich, a brand unto himself and well along in years — is past the point of managing career risk.

It also, though, reflects the extraordinary state of markets today. Quantitative easing has effectively rigged the markets by buying up huge amounts of Treasuries. This has prompted a rally in riskier assets and raised legitimate questions over who will be there to buy U.S. government debt when the QE program comes to an end on June 30.

Gross argues that this will come as a shock to risk markets and Treasuries alike.

If it does and PIMCO keeps its portfolio looking like it does now, Gross will have quite a fat pitch to hit with his bundle of cash. If not, well then …

It all puts me in mind of Tony Dye, a legendary British fund manager who earned the nickname “Dr Doom” with his correct analysis of the stock market bubble that popped in 2000.

Dye, who was the dominant manager in a highly concentrated pension fund industry, was so convinced of the bubble that at one point he took his main fund to a zero weighting in U.S. stocks. Hilariously, Dye’s funds were so large that they distorted the index used to judge fund manager performance and many of his less convinced peers duly turned bearish too, managing their own careers.

Dye, I hate to tell you, was bearish right until he was forced into early retirement in March of 2000, less than a month from the top of the market.

(CORRECTION: Replaces “… which is given more latitude, cash is an unbelievable 92 percent”  with “cash not pledged as collateral is 18 percent” to reflect that the original higher figure included cash being used as collateral and was therefore not an accurate gauge of risk appetite)

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.  Email: jamessaft@jamessaft.com)

James Saft is a Reuters columnist. The opinions expressed are his own.

HUNTSVILLE, Ala. — Technology is limiting U.S. employers’ appetite for both lawyers and big box stores, two excellent reasons to expect monetary policy to remain loose for a long time to come.

In fact the underlying theme, an economy that uses technology to efficiently dispense with labor, raising productivity but forcing many into difficult transitions to new work, may well help to explain why rates were allowed to stay so loose for so long before the crisis broke.

While the U.S. employment report released last Friday was passably strong, the overall picture is of an economy that is going to take a long, long time to return to anything approaching full employment. The drop in the unemployment rate to 8.9 percent looks good at first glance, but the rate is flattered by a drop in labor force participation that is probably itself a marker of weak employment conditions. If the same percentage of the population were in the labor force as before the financial crisis, unemployment would be 12 percent.

To be sure, technology is not the principal reason for the jobs mess — that lies at the feet of the bursting bubble — but there are interesting reasons to think job losses tied to newer technology may be making the recovery that much more difficult.

Of course technology has been destroying old ways of making a living for a very long time — think of blacksmiths and the automobile — and the huge mass of evidence indicates that technological efficiencies are associated with both economic growth and rising demand for labor.

That being said, two forces associated with recent spikes in productivity, the Internet and very cheap and very powerful computer processing power, are of recent advent and may be doing a lot to encourage the Federal Reserve to keep conditions easy.

These forces are neatly illustrated by two recent stories in the financial press.

Large retailers are increasingly turning away from so called big-box stores, according to the Wall Street Journal, in part because of competition from the Internet. Home Depot, Wal-Mart and Best Buy are all shifting in different ways towards smaller stores. This is bad for employment in a number of ways; directly it means fewer staff for smaller stores and indirectly for the construction and real estate industries.

This also ties in with a trend evident in the last holiday season of ‘pop-up’ stores, short-term retail outlets set up by major brands to build awareness but without a commitment to staff or to maintain the store long term.

LUCKLESS LAWYERS

It is not just shop assistants and construction workers who are finding themselves on the wrong side of the cutting edge of technology. A fascinating New York Times article from Friday detailed the ways in which software is being used to do work that used to fall to lawyers. This is the formerly time-consuming and tedious business of sifting through documents as part of the process of “discovery,” the part of a lawsuit when both sides must make available to the other documents which may contain pertinent facts.

What used to add up to hundreds of billable hours now can be done much more quickly and cheaply by software programs which search documents for terms, concepts and specific information. Who knows, rather than cutting back employment for lawyers perhaps this will cut the cost of litigation to the point where more people engage in it, but somehow I doubt we will all end up suing each other for a living.

If high-end workers like lawyers find themselves hurt by the forces of technology, perhaps even more of the benefits of economic growth will be channeled towards the very top of the economic tree. I don’t think that would be a good thing, but perhaps more to the point, I don’t think it is something a central bank in a democracy like the U.S. can stand by and watch. The pressure, more indirect than direct, to keep rates easy to keep the machine of consumption trundling along will be strong.

Arguing that current historical conditions are exceptional is almost always foolish. That being said, it is very striking that the past 20 years or so have seen huge leaps in technology and a much more globally integrated economy. At the same time the benefits of economic growth, at least in the U.S., have largely gone to the best paid and the most wealthy.

Those forces don’t look to be weakening, in fact they may be accelerating. This will make it harder for the Federal Reserve to tighten, despite signs of strength in the economy.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

While Treasury Secretary Tim Geithner prepares for a “financial deepening” he hopes will be a boon to U.S. banks, we may be steering instead for broader, shallower waters which will drive down margins in financial services and favor simplicity.

Geithner told The New Republic that he sees a coming boom for demand for financial services from emerging markets as a newly affluent middle class seeks new and more sophisticated financial products.

“I don’t have any enthusiasm for … trying to shrink the relative importance of the financial system in our economy as a test of reform, because we have to think about the fact that we operate in the broader world,” Geithner said.

The vision, perhaps unspoken, is for a recapitalized U.S. banking system with strong enough titans at the top to compete globally to sell complex financial services to Indian corporations as well as Chinese households.

On this reading, the decision to not take effective action to whittle down the too-big-to-fail banks makes sense; the new world will need Citigroups, not community banks.

Besides the false underlying assumption that regulation can mitigate the risks of TBTF banks, the financial deepening thesis is likely wrong on at least two additional counts. First, it assumes that the newly middle class of the world will want the kinds of products that only a huge bank can provide, and second, it assumes that the financial landscape of the future is like that of today, only bigger.

Now, to be sure, if you subsidize something it will grow. So, TBTF banks, enjoying a U.S. backstop and the funding advantage that goes along with it, will have some success in devising products to sell in emerging markets that arbitrage that subsidy. There is doubtless an unmet need for these products in India just as there was an unmet need for liar loans in California’s Central Valley. Look at some of the horrific experience with micro-credit in India, where the poor borrow to simply finance current consumption.

What is not clear is what complex financial services this new world will need, and why only a large global bank enjoying an implied government guarantee will be able to provide it. Certainly there will be capital markets services needed in emerging markets, such as share listings and bond financing, but it is unlikely that the advantage that a TBTF bank will get based on its size alone compared to the cost, to taxpayers and to the economy, is justified. Surely a smaller Goldman Sachs could compete in this arena without an implied guarantee.

A WIDENING
The real action will be not in fancy products devised by math PhDs, though devise them they will, but in simple utility-like functions like transfers and simple risk sharing such as life or property insurance.
Economist Barry Eichengreen, writing in the Wall Street Journal, argues compellingly that the dollar will lose its role as the main global reserve currency over the next decade.

One of the forces he cites is technology, which will make it easy for trade to happen outside of the dollar, for example between Korea and Chile, where before trade had to be routed through the dollar as an intermediary step.

This kind of round tripping into and out of the dollar is one of the main drivers for foreign exchange market volume and for hedging. If it goes away we will not see a deepening, but a shallowing. We would see just as much global trade as before, but a heck of a lot less foreign exchange trading and dollar hedging. The same thing may also be possible in the oil market, which is denominated in dollars and which drives a huge market in foreign exchange and hedging as a result.

It does seem likely that many hundreds of millions of additional people will become consumers of financial services, but like telephony this growing demand will likely come with falling margins.

Think, for example, of the agricultural middlemen in India who have lost their advantage now that farmers can easily access prices via mobile phones. Banks may find themselves in the same position, because of the same forces.

The payments and transfers business will grow tremendously, but this is a utility function and, likely as not, competition from outside of financial services, from technology or communication companies, will drive margins down.

My guess would be that, if the market were left to itself, the financial deepening will belong to Google Bank rather than Citigroup or J.P. Morgan. The too-big-to-fail subsidy may slow or distort that, and that is bad policy.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.  Email: jamessaft@jamessaft.com)

James Saft is a Reuters columnist. The opinions expressed are his own.

By some measures the bank loan market is partying like it’s 2007, a remarkable turn of events considering three intervening years of recession, crisis and volatility.

This time the market is enjoying a rush of money from small investors, Bernanke’s children if you like, who have decided to take on risk in a world of zero interest rates and quantitative easing.

As a result 25.2 percent of all syndicated bank loans made in the U.S. so far this year have been “covenant-light” credits, according to Standard & Poor’s LCD, more than at the peak of the credit market frenzy year of 2007.

Covenant-light loans are credits in which the lenders have agreed to give up many of the protections that they have traditionally used to safeguard their investment, such as requirements that borrowers maintain a certain amount of earnings compared to debt.

Covenant light loans were widely derided in the aftermath of the credit crisis, and for a time all but disappeared, shrinking to just 4 percent of the market in 2008.

Remember 2007 was an eerie time in loan markets. Supposedly sophisticated hedge funds were not even downloading the documents on the loans they were being offered, essentially taking the arranging bank and the ratings agencies’ word. Really they were reaching for yield, searching for anything that paid enough to allow them to make the return they had promised their investors.

The hedge funds and structured investors of 2007 have been replaced by retail money in 2011; issuance of Prime Funds, mutual funds which buy bank loans, hit $5.9 billion in January, a pace which if maintained would make it not just the biggest year on record for Prime Funds, but five times bigger than the second biggest. Meanwhile huge numbers of borrowers are coming back to market and demanding, and getting, easier and cheaper terms.

While it is impossible to track exactly where the Prime Fund money is coming from, or its motivation, the typical investor is an individual who, seeing good returns last year in the market, is moving money out of lower risk funds,  such as ones which often invest in short-term debt.

In other words, it is a great example of the way in which money has been crow-barred out of safety by monetary policy.

“At this point we are in the Goldilocks period of the cycle. Sans QE II we might still be wearing sweaters,” said Steve Miller of S&P LCD, which tracks loan market activity and trends.

The story is complex, according to Miller, and the market has also gotten a lift from better overall economic conditions, a shortage of supply and low and declining rates of default.

THE DOG THAT DIDN’T BARK

There are two strongly contrasting explanations for the resurgence of covenant-light loans. One argument says that the  loans proved their mettle in the crisis; among loans made in 2007 covenant light issues defaulted far less often. Looking at the market over the past five years covenant-light loans have made a higher return for their investors.

That is really a remarkable performance given the seriousness of the crisis and the downturn, and quite different from most predictions.

The second less reassuring take is that the loan market reflects what happens when monetary and government policy bails out risk takers. On this reading, the cov-light loans of 2007 did well partly because they were the stronger credits which could command easy terms, but largely for the same reason the whole market did well; easy money and extend and pretend.

The heroic measures taken by the Federal Reserve and government in 2008 and 2009, combined with a policy by banks to string borrowers along in hopes they would eventually recover, meant that the weak did not get washed out and go bust in the way they normally would.

That shows not that abandoning old-fashioned banking practices is wise, but rather that if you do it be sure you have a flexible and friendly central bank ready to help out.

This is a great example of how the Federal Reserve’s asymmetric response to crises, bailing out but not pricking bubbles, pollutes the process of asset allocation in the economy. Lenders have learned the lesson of moral hazard from the Fed’s actions and are plunging back into the market, sleeping well at night because their conditioning has deadened them to risk.

This does not mean that today’s loans will go bad; perhaps we are early in a recovery and perhaps investors will be rewarded for riding with the momentum.

Whether this ends in a leveraged buy out boom or a bust, risk has risen and the signals that denote risk are being scrambled.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)