18. These pesky numbers

In the article in post 17 they state, correctly, that Bank of America Acquired Merill Lynch for $50bln. Yet the articles about the recent settlement (including that in post 16) say it was a $20 billion deal. I do not know why.

17. Legal issues in bank settlements

A few of you asked me why nobody went to jail after the Great Recession. Defer this question to your law class. Here is an article that has some information on the legal issues involved.

16. More on the Bank of America-Merill Lynch problem

In post 3 I described the issues around the takeover of Merill Lynch by the Bank of America. Shareholders who approved it were not told in advance about Merill Lynch colossal losses, nor about the promised bonus payments to Merill Lynch executives. The post was about the settlement with the Securities and Exchange Commission (SEC): $150million.
Now Bank of America agreed to pay $2.43billion to settle a class auction lawsuit from investors.
As usual, they deny they did anything wrong.It "said that it agreed to the settlement to get rid of the uncertainties, burden and costs related to the lawsuit." (see the link).
That is some uncertainty.

15. The happiest OECD countries

Today we will talk to an alternative to GDP: measuring happiness. Here is a list of the happiest developed countries in the world. (from OECD).

Note that the article is misleading in what it says about debt of happiest countries. Norway indeed has a huge surplus, but this is unique. Norway gets significant income from North Sea Oil. Most of it is saved to provide funds in the future, when oil ends.

This is an example of  a country trying to maintain constant consumption over time, just as individuals do (we will discuss this in chapter 4).

14. No end in sight to the sovereign debt crisis

A couple of weeks ago the European Central Bank (ECB) announced that it will be buying bonds of Spain and Italy in order to reduce their cost of borrowing. Markets took it as a sign the worst has passed. But the respite did not last. Greeks went on strike, there was violence in Spain over austerity measures and the Bank of Spain predicts difficult time ahead.

As I said at the beginning of the course, the sovereign debt crisis will not go away any time soon.

13. How long will the effects of housing crash last?

Until 2023

This is when, according to a recent prediction, US house prices will reach the pre-crisis level.

12. Tertiary education

OECD has just published a report on tertiary education. Here are 10 most educated countries. Countiries are ranked by the proportion of adult population (25-64) with a tertiary degree.

There is a link in the article to the report. All 560 pages of it. Sorry, 570. The relevant table is on page 34.

Canada is #1.

Canada has by far the largest proportion of people with 2-year college education: 24%. Only in Belgium and Japan the proportion is over 16%. In the US it is 10%.

The countries with the highest proportion of population with university education is Norway (34%) followed by Israel and US (30%). Canada is 8th (26%).

11. Falling off the fiscal cliff

If nothing changes, on January 2 the US will start reducing both civilian and military spending, and taxes will increase.
How did it come to that? In 2011a bipartisan commission was created to reduce the deficit. The commission had equal number of members of both parties. As inducement to come to an agreement, both military and civilian spending were to be cut significantly from 2013 on if no agreement is reached. In the end members voted according to party lines and, indeed, there was no agreement.
The main increase in taxes is due to expiration of the extension of tax cuts introduced by Bush in 2001. They were extended two years ago as the parties could not come to an agreement beyond moving the problem past the presidential election. This is called"kicking the can down the road. Read about it here.There are several other laws that will raise taxes next year.
Bottom line: the US political system became dysfunctional and is unable to make difficult decisions.
So far Canada has not suffered, except for the overvalued Canadian dollar. But if shares in the US fall by 20% as Goldman Sachs predicts, Canadian stocks will fall as well. US economy may fall into a recession if nothing is done; as the Canadian economy is not in great shape, it may follow.

10. QE in Japan

The Japanese economy has been in and out of recession since 1989. Interest rates are among the lowest in the world. So the Bank of Japan followed the FED and announced an increase in its QE : the amount of bond purchases has been increased from 70 to 80 tr yen (by about $125bln).

Do not pay attention to the currency problem mentioned in the article; it is a red herring. Japanese Yen has appreciated in recent years; its depreciation is needed by the Japanese industry and will not surprise anyone, nor will it invite retaliation.

9. Errors

As you may have noticed, I tend to show you various errors so that you do not make them in the future. In a commentary to the Statistics Canada report discussed in the previous post, Canadian Business makes two mistakes that are instructive. They provide the dollar estimates of the underground economy ($18.8 billion in 1992 and $35.7 billion in 2008). These numbers are meaningless, since they are in current, and not in constant dollars.

Canadian business estimates what would have happened if all the underground activities had been taxed and all extra proceeds were used to reduce the deficit. This is naive: government spending does depend on its revenue. So the assumption that all the extra revenue would have been saved by the government is incorrect.

This type of reasoning is quite common. Something changes and the writer assumes all the effects fall on one thing only. But the economy is an interconnected system; if one thing changes, a lot of others do as well.

8. Underground economy

In this and the next lecture we will be discussing GDP. One of the things not included in GDP is the underground economy. Globe and Mail reported on 19/9/2012 that most Canadians have paid under the table to avoid taxes. No surprise there. The article references a Statistics Canada report (the link in the paper is bad; to find the report Google: Estimating the Underground Economy in  Canada, 1992-2008, click on the www.carpenters.org link - it is from the United Brotherhood of Carpenters - now, that is funny: why would carpenters read a report on paying under the table?). Big surprise here: the underground economy in Canada is only 2.2% of GDP. The estimates I have seen are much higher. An IMF article, provides estimates for 1990 using several methods; for Canada the size of the underground economy is between 10% and 13.5%, depending on the method. The difference may be due to the fact that the Statistics Canada report does not include illegal activities.

4.The effect of iphone5 on US GDP

I repeat here for your convenience the posting from mylearningspace. We talked about it last Thursday; I have updated it by what I have learned since then.

The calculation was not a journalistic mistake, as I thought. It was made by the chief economist of JP Morgan, the largest US bank. Here it is. I wrote to him and got an answer that is cited below.

1. Here is the calculation. Mr. Feroli, the chief economist, expects that 8 million of iphones 5 will be sold in the US in the 4th quarter. He thinks the price will be $600, of which $200 will be imported (they call it "imported cost component" , a typical gibberish of financial analysts). In economics we say that,in the production of iphone, $200 is produced outside of the US (and so does  not count as US GDP) and $400 is produced in the US (and so counts in US GDP). The value of the portion of iphones produced in the US is 8 million times $400 = $3.2billion in a quarter, or $12.8bln in a year. Somehow this becomes 0.33% of US GDP. This is not correct. The US GDP is around $15 trillion so iphone5 contribution to US GDP is a bit less than 0.1%.

2. Should the analyst subtract the number of iphones 4 sold in the 4th quarter of 2011? Of course he should. The contribution to growth is not the level of production, but the change in the level of production.

What is going on? Hard to say. I actually have not seen anything like it before. Everyone made the same mistake, including a Nobel Prize winner Paul Krugman (it is clear from what he writes that he did not check the calculations).

It is a good example of the need to check what you read.
As business students you should be numerate.

*********************

Here is more on this topic. I wrote to Mr. Feroli that I have difficulty replicating his calculations. By my calculations, to increase growth by 0.33% of GDP, i.e. $12 450bln = 0.33% * $3 773bln (US GDP per quarter was, according to IMF, 15 090bln/4=3 773bln), the sales of iphones must be higher by 31 million =$12 450bln/$400 in Q4 2012 than in Q4 2011.

His reply: "Our apple analyst is of the belief that price-cutting on the 4 and 4s will actually lead to some increase in sales of previous generations"

That cannot explain the effect.

Writing this I realized what went wrong. I suspect the following:

JP Morgan took the value of GDP in 2011 ($15 090bln or $3 773bln a quarter),
added 3% for growth of nominal GDP and obtained, for Q4 2012, $3 885bln,
for some reason they divided this by 4 again, obtaining $971bln,
they calculated the value of the iphones produced in the quarter: $400*8 mln =$3.2bln,
dividing $3.2bln by $971bln they got 0.33%.

So there were two mistakes:

1. they got confused by quarters and years

2. they forgot that growth means the difference between this year and last, and calculated not extra growth, but extra GDP.

Well, do not laugh at them. As I wrote, every news organization, plus a Nobel laureate, copied it without noticing the error. Let us call it the Apple Awe

Two definitions of the word awe:

• From Wikipedia: Awe is an emotion comparable to wonder but less joyous, and more fearful or respectful.
• From dictionary.reference.com: an overwhelming feeling of reverence, admiration, fear, etc., produced by that which is grand, sublime, extremely powerful, or the like: in awe of God; in awe of ...

Oh, and one more thing. I found that the number of iphones sold in the US in Q$ 2011 was 11.6mln was 11.6mln.

I am not sure where the 8 million estimate for Q4 2012 came from.

7. Why the US economy is weak

A typical recession lasts about a year and its followed by rapid expansion as firms rebuild inventories and consumers make up for delayed purchases. But not in the Great Recession. The rapid expansion never came, unemployment is still significantly higher than before the recession and the US economy is weak. Why? Because it is a financial recession brought about by housing and spending boom. US households are saving to reduce their debts (they are deleveraging and  consumer spending is weak. Since consumer spending is about 2/3 of US economy, without growing consumption the economy is sluggish.

6. Non-recourse loans

Today we will be talking about one reason so many US households defaulted on their loans: in the US, the loans are non-recourse. The loan is secured by property only and the lender cannot take over other assets of a defaulting household. The only penalty then is a bad credit rating. In Wednesday's New York Times there is an article that provides details. Some defaulting households can get another mortgage after as little as 2 years.

In contrast, in other countries the borrower is responsible with the rest of her assets. I once read a sad story of a Peruvian immigrant inn Spain. He bought a house near the peak of the boom which, in Spain, was much bigger than in the US. He could not pay the mortgage so he defaulted. The bank took over the house and sold it very cheaply. He ended up without a house but with a huge debt:  he was responsible for the different between what he owed minus the (low) price the bank got. He was thinking of giving up and going back to Peru but, as I recall, he could not escape the debt because of an agreement between Peru and Spain. He lost everything he had and could not afford to go home.

The different treatment of loans is the reason that, while US households default often, European households do not.

5. To QE3

The FED on Thursday announced two things:

1. QE3: they will be buying mortgage based securities to raise their price and reduce long term interest rates. Unlike the two previous round, there is no fixed amount of purchases set; the FED will do it for as long as it takes to get economy growing.
2. They also announced that they will not stop when the economy starts growing, but will continue for a "considerable time" to make sure that, when the monetary stimulus ends, the economy will continue to grow.

3. The good judge did it before

when he rejected a $33 million settlement between SEC and the Bank of America. (in the end he approved a $150million settlement).

A bit of background. On the crucial weekend of Sep 13-14 2008, Bank of America agreed to acquire Merill Lynch, the third largest investment bank in the world. The acquisition had to be approved by shareholders. The Bank was sued since it did  not disclose, prior to the vote, that it agreed to bonus payments at Merill Lynch of $5.8bln (in the end $3.6bln was paid). Another issue was that the bank did not disclose expected Merill Lynch losses ($15bln) prior to the vote (the details are here).

Judge Rakoff complained that any fines paid by the bank hurt shareholders, who had nothing to do with the lack of disclosure.

Guess what: "Bank of America said it was pleased with today’s decision.[...] Bank of America rose 40 cents to $16.28 as of 2:38 p.m. in composite trading on the New York Stock Exchange." (source: see above).

Sum up: by Geto Boys Geto Boys; just replace "gangsta" with  "banksta" (the term bankster was coined, as far as I know, by the Economist).

2. More on Citigroup legal issues

Here is the answer on why Citi did not admit any wrongdoing

Apparently there is not enough resources to pursue financial fraud cases. So as long as regulators extract a substantial fine, they do not want to waste precious resources on finding out if there was any wrongdoing, and if there was, who was doing the wrongdoing.

1. Bank fines

As I mentioned in class last Thursday, there was a lot of unsavoury activity during the Great Recession. One example is in this article: Citibank pays $590 million fine

The skinny: accounting rules required "mark-to-market" pricing of securities. This means the bank has to adjust the value of securities it holds as assets continuously as the price of such securities changes. This is a legal issue so I will quote:

"The allegations date back before the 2008 financial crisis erupted. Plaintiffs allege that Citi, the nation’s third largest bank behind JPMorgan Chase and Bank of America, lied to its own shareholders regarding tens of  billions of dollars in toxic mortgage-backed securities on its books. The bank did not writedown the positions down even though executives there knew the assets were worth less than what the books reflected, shareholders claim."  (the quote is from Forbes)

Another quote from the same article in Forbes: "The settlement of $590 million, which has yet to be approved by a New York judge, is a hefty sum for Citi but it helps clear some of its ongoing litigation related to the financial crisis. The bank, which denied wrongdoing, saw shares pop up almost 2% and led financial stocks today."

This means that:

- nobody is guilty, as long as  they can pay the fine;

- according to markets, the fine was not too high (in fairness, the increase in the price of the stock could reflect the elimination of uncertainty".