But since then, little progress has been made on financial regulatory reform, and many of the large investment banks that received billions of dollars in government bailouts are booking huge profits on the same risky wagers they were making before the financial crisis.

In fact, the five biggest banks in the country – Goldman Sachs Group Inc. (NYSE: GS), JPMorgan Chase & Co. (NYSE: JPM), Citigroup Inc. (NYSE: C), Wells Fargo Corp. (NYSE: WFC), and Bank of America Corp. (NYSE: BAC)  – posted second quarter profits totaling $13 billion.

That’s more than double what they made in the second quarter of 2008 and almost two-thirds as much as the $20.7 billion they earned in the second quarter of 2007, when the economy was still strong, CNBC reported.

Goldman Sachs reported record earnings in the second quarter. As was the case before the financial meltdown, Goldman leaned heavily on its trading desk for revenue. Trading revenue accounted for 50% of the firm’s total revenue. At $6.8 billion, trading revenue was up 186% from the second quarter of 2008.

The bank also saw a massive bump in equity trading where revenue jumped to $2.2 billion – a 110% quarterly increase.

The story was much the same at JPMorgan whose investment-banking operations generated $1.47 billion of profit, almost quadruple the amount earned in last year’s second quarter.

Investment-banking fees – which zoomed 29% from a year ago and 62% from the first quarter – totaled $2.2 billion, and were a “record for any investment bank in any quarter,” according to JPMorgan Chief Financial Officer Michael J. Cavanagh.

Citigroup and Bank of America- which received some $45 billion in government bailout funds – also topped profit estimates in the second quarter.

Of course, it’s not the fact that Wall Street has returned to profitability that’s raised the hackles of analysts, it’s that Wall Street firms are turning huge profits by employing much of the same risky behavior that led to Lehman’s undoing.

“We’re seeing the same kind of behavior from the banks, and that could lead to some huge and scary parallels,” Simon Johnson, former chief economist with the International Monetary Fund, told CNBC.

For instance, banks are still making bets that put far more money at stake than they have on hand to cover potential losses. The five biggest banks average potential losses from a single day of trading topped $1 billion in the second quarter, up 76% from two years ago, according to regulatory filings.

Even more disconcerting is that banks are still packaging risky mortgages into securities and selling them as investments, which is precisely the behavior that helped inflate the real estate bubble and lead to the financial meltdown.

With the full blessings of ratings agencies, banks are repackaging their money-losing securities into higher-rated ones called re-securitization of real estate mortgage investment conduits, or “re-remics,” The New York Times reported. At least $30 billion in residential re-remics have been done this year, according to Morgan Stanley (NYSE: MS).

Wall Street bankers have even set out to create new and exotic financial products, including the securitized life insurance policies.

Indeed, bankers plan to buy so-called “life settlements,” which are life insurance policies that sick and elderly people sell for cash, and package them into bonds for investors. This essentially creates a whole new bond market that lets firms gamble on the lives of thousands of people.

Many analysts fear that insurers will have to raise premiums, because they could end up paying more death claims out to investors than they previously had anticipated. That is, if a policy is purchased and packaged into a security, investors will keep paying the premiums that might have otherwise been abandoned by policyholders. If that’s the case insurance companies will have based their premiums on false assumptions.

“The securitization of life settlements adds another element of possible risk to an industry that is already in need of enhanced regulations, more transparency and consumer safeguards,” U.S. Sen. Herb Kohl, D-Wis., told The Times.

Meanwhile, the regulatory overhaul that U.S. President Barack Obama proposed back in June has been derailed by lobbyists and cast aside by a Congress that is preoccupied with the heated debate over healthcare reform.

Obama’s Overhaul Losing Traction

President Obama on June 17 proposed a sweeping overhaul of the U.S. financial regulatory system.

Under President Obama’s proposal:

• Hedge funds and other private pools of capital would have to register with the U.S. Securities and Exchange Commission (SEC).
• Many financial institutions would be required to increase capital reserves to protect against unexpected losses, and companies would also have to keep part of the credit risk for loans they have packaged into securities.
• The Federal Deposit Insurance Company (FDIC) would have the power to seize and break up large financial companies that are under duress.
• The U.S. Federal Reserve would be granted more powers over payments and settlements systems in U.S. financial markets to prevent a breakdown that officials fear could destabilize the economy.
• The Office of Thrift Supervision would be merged with the Office of the Comptroller of Currency.
• A new consumer protection agency would be created. That agency would write rules related to mortgages, credit cards and other consumer products, taking away powers previously held by the Fed.

However, the proposal has lost much of the momentum it would have had earlier this year. Now that the U.S. economy is seemingly back on track and many banks have paid back their huge government loans, much of the anger over Wall Street’s hand in the financial crisis has dissipated.

“As we get a little more distance from the actual collapse and things begin to stabilize, then people think we don’t need to take as much drastic action,” Michael Bernstein, an expert in political and economic history who is currently serving as provost at Tulane University, told NPR. “That’s a very disappointing reality.”

In fact, a large portion of the anti-business rhetoric that provided the backdrop to the financial crisis has been replaced by public rants against big government and the vehement debate over healthcare reform that has consumed Congress.

“The president has offered a reform proposal that would grant broad new authorities to government bureaucrats while intruding in private markets and restricting personal choice,” Spencer Bachus of Alabama, the senior Republican on the House Financial Services Committee told The Times. “The obvious lesson of the events of September 2008 is that we need smarter regulation, not more regulation, not more government bureaucracy, and not more incentives to engage in harmful business practices.”

Meanwhile, big financial institutions and community banks have unified against several pillars of the proposal, including the creation of a new consumer protection agency, and tighter regulation and more transparency regarding derivatives and credit default swaps – the very instruments that have been blamed for exacerbating the financial crisis. They’ve also lobbied hard against restrictions on executive pay, The Times reported.

On the one-year anniversary of Lehman’s collapse, President Obama again sounded the call for reform, warning that “there are some in the financial industry who are misreading this moment.”

“I want everybody here to hear my words,” Obama said in a speech at Federal Hall in New York. “We will not go back to the days of reckless behavior and unchecked excess at the heart of this crisis, where too many were motivated only by the appetite for quick kills and bloated bonuses. Those on Wall Street cannot resume taking risks without regard for consequences, and expect that next time, American taxpayers will be there to break their fall.”

Still, many in Congress continue to bristle at the prospect of more government oversight.

“President Obama supports changes that push us in the wrong direction,” Rep. Tom Price of Georgia, chairman of the conservative Republican Study Committee, told The Washington Times.

But as Congress continues to substitute rhetoric for action, America’s largest financial institutions are growing more powerful and analysts see a precious opportunity for real reform slipping away.

“The clock is ticking and we’re at a cross roads,” Travis Plunkett, chief lobbyist for the Consumer Federation of America, told CNNMoney. “If we don’t see a substantial move this fall, financial reform may wither on the vine.”

Rep. Barney Frank, D-MA, who leads the House Financial Services Committee and largely supports Obama’s plan, will begin marking up the bill in October and is expected to have legislation to the floor of the House by the end of next month or early November.

Source: Wall Street Back to Business as Obama’s Regulatory Overhaul Loses Momentum

Commercial property values in the U.S. have plummeted 36% since peaking in 2007, and the commercial real estate market is unlikely to recover before 2012, according to the quarterly PricewaterhouseCoopers Korpacz Real Estate Investor Survey, released yesterday (Tuesday).

Office rents in New York and San Francisco may drop 20% through next year, the survey found.

“The biggest problem is that commercial real estate lags what happens in the economy,” Susan Smith, who is the director of PricewaterhouseCoopers’ real estate advisory practice and editor-in-chief of the survey, told Bloomberg News. “Companies are looking for ways to cut costs, many are continuing to reduce workers and are continuing to reduce their space needs.”

That means many of the banks that made commercial real estate have only realized a fraction of their losses. And as those losses continue to mount, we’re likely to see more and more bank failures.

Roughly $530 billion in mortgage-backed securities are due for refinancing between now and 2011, according to property researcher Foresight Analytics LLC. Foresight estimates that the U.S. banking sector could incur as much as $250 billion in commercial real estate losses, enough to cause a as many as 700 banks to fail, in that time.

The FDIC’s “problem list,” or banks that run a higher risk of failure, grew to 416 in the second quarter, up from 305 in the first quarter. That’s the highest number since the second quarter of 1994, when there were 434 banks on the list.

San Francisco-based Wells Fargo & Co. (NYSE: WFC) has the largest share of the $3.1 trillion commercial debt market with 16.5% of its $821 billion loan portfolio invested. JPMorgan Chase & Co. (NYSE: JPM) is a distant second with 5.4% of its portfolio invested in commercial loans, followed by Citigroup Inc. (NYSE: C) with 3.4%.

However, smaller banks – 92 of which have already folded this year compared to 25 last year – are even more at risk because they will likely have a harder time accessing the crucial capital to offset rising defaults, according to the TARP-inspired Congressional Oversight Panel’s August Oversight Report.

“Unlike large banks that can sustain a certain number of defaults, even of large commercial loans, smaller banks may have far more difficulty in absorbing more than a few large loan losses,” the panel said. “The FDIC’s statement that ‘banks have been able to raise capital without having to sell bad assets through the LLP’ may not reflect the reality for these banks.”

Indeed, the number of smaller banks expected to seized by the FDIC (Federal Deposit Insurance Corporation) is forecast to accelerate by economists. More than 150 publicly traded U.S. banks have nonperforming loans that account for 5% of their assets, according to the report.

The panel said rising commercial real estate loan defaults may prompt the need for $12 billion to $14 billion more in TARP funds as well as well as stress tests for smaller banks.

The early 1990s saw a devastating crash of the real estate market, but this coming time around the result could be far worse. The $3.1 trillion that makes up the commercial real estate debt market is three times the size it was during the early 1990s – meaning the potential for losses is steeper than ever before.

In 1993, less than 2% of U.S. banks and thrifts had an exposure to commercial real estate that was more than five times their Tier I capital. By the end of last year, that ratio had spiked to 12%, involving about 800 banks and thrifts.

And this time around – compared to the early 1990s – banks left themselves no margin of safety in the form of “Tier I Capital” – a measure of how well a lender can navigate serious levels of losses. The higher the ratio, the less likely a lender will be able to work its way through a stretch when loans start going bad.

Source: Bank Failures Could Surge as Commercial Real Estate Losses Continue to Mount

In June, financial advisor and CNBC contributor Dennis Gartman even called Buffett “an idiot.”

But now that Berkshire has rallied more than 35% from its March lows, the only idiots to be found are those that ever doubted the world’s second-richest man’s business savvy. Indeed, many of the moves Buffett made during last year’s market melee are paying off in a big way.

Take, for instance, his $5 billion investment in Goldman Sachs Group Inc. (NYSE: GS). Berkshire last September agreed to buy $5 billion in perpetual preferred Goldman shares that pay 10% interest.  In addition, Berkshire received warrants giving it the right to buy $5 billion worth of Goldman’s common shares at any time over the next five years at a price of $115 per share.

Critics lampooned that deal when shares of Goldman Sachs fell to a 52-week low of $47.41 in November. Since then, however, Goldman’s stock has rocketed more than 240% to close yesterday (Tuesday) at $160.25.

If Berkshire cashed in it’s warrants today, it would make a 40% profit or about $2 billion. But Warren Buffett has always been a long-term investor, which makes that highly unlikely.

“We will hold the warrants,” Buffett said on Fox Business Network. “Every instinct in my body tells me that we will want to hold those warrants until they’re very close to their expiration date. The preferred pays us the dividend and the warrants are going to make us the money.”

While Berkshire waits, the $5 billion in preferred Goldman shares pay an annual interest of $800 million in dividends.

Berkshire’s total stake in Goldman is now worth more than $9 billion – $4 billion more than the company paid for it – according to University of Louisiana finance professor Linus Wilson.

Berkshire’s investment in BYD Co. Ltd., a Chinese producer of both cars and specialized batteries, has also paid off.  Berkshire’s MidAmerican Energy Holdings Co. agreed last Sept. 26 – just three days after the Goldman deal was announced – pay roughly $230 million for a 9.89% stake in BYD. MidAmerican bought 225 million shares of BYD at a HK$8 a piece. Those shares have since risen 430% to close yesterday at HK$42.40, handing Buffett a paper profit of about $1 billion.

Berkshire reported second-quarter profit of $3.3 billion, up from $2.88 billion a year earlier. The boost was largely attributable to derivative gains, which soared to $2.36 billion from $689 million the year prior.

Berkshire’s book value rose 11.4% in the second quarter, to $73,806 a share, and Barron’s estimates that it already could have increased since to around $79,000 now.

What Buffett’s Buying

So if Buffett’s supposedly cold hand has suddenly turned hot, how can investors benefit? Simple: By following the leader.

A 2007 study by two university professors titled “Imitation is the Sincerest Form of Flattery” showed that buying what Buffett has bought – even a month after his purchases – is a pathway to superior returns.

“The market … appears to under-react to the news of a Berkshire stock investment since a hypothetical portfolio that mimics Berkshire’s investments created the month after they are publicly disclosed earns positive abnormal returns of 14.26% per year,” the study said.

And according to a regulatory filing disclosed Aug. 14, Berkshire is reading the tealeaves on healthcare reform. As of June 30, the company had loaded up 1.2 million shares of Becton Dickinson & Co. (NYSE: BDX), a maker of such medical equipment as scalpels, catheters and syringes, while winding down its positions in healthcare insurers. Berkshire cut its holdings in WellPoint Inc. (NYSE: WLP) by 27% to 3.5 million shares and sold 3.4 million shares, or 24%, of its UnitedHealth Group Inc. (NYSE: UNH) stock.

“If the government is going to open health care to more people, demand for health care supplies would increase,” Gerald Martin, a finance professor at American University’s Kogod School of Business told Bloomberg. “The plan that’s going through Congress could be a real negative to the health insurers, but the people who provide the supplies could really benefit.”

Berkshire also increased its holdings in Johnson & Johnson (NYSE: JNJ), the world’s largest maker of health-care products, by 14% to 36.9 million shares. The purchase of J&J shares marks the second straight increase in the size of Berkshire’s stake, according to Bloomberg.

All of the biggest holdings listed in Berkshire’s filing gained in value in the second quarter. American Express Co. (NYSE: AXP) rose 71% in the period, Wells Fargo & Co. (NYSE: WFC) rose 70%, and Burlington Northern Santa Fe Corp. (NYSE: BNI) jumped 22%. Berkshire’s single largest holding, The Coca-Cola Co. (NYSE: KO), rose 9.2% in the three months ended June 30.

Source: Berkshire’s Back, So What’s Warren Buffett Buying Now?

More consumers are turning to their checking accounts for purchases, and this could make for a significant boost in overdraft fees. Charges related to overdrawn accounts this year may add up to $38.5 billion following last year’s $36.7 billion, according to data from research firm Moebs Services Inc.

The shift from credit to debit cards means banks still have another avenue to collect lucrative fees despite legislation signed in May by U.S. President Barack Obama that protects consumers from excessive fees and last-minute contract changes such as interest rate hikes.

“Fee abuse hasn’t disappeared in banking with the credit- card legislation,” Tony Plath, a finance professor at the University of North Carolina Charlotte told Bloomberg News. “It’s just migrated to checking accounts.”

If President Obama gets his way, a new consumer protection agency would be formed and have the power to ban “unfair, deceptive and abusive practices.” This puts the Obama administration at odds with the U.S. Federal Reserve, the agency that is currently tasked with regulating such practices.

Overdraft fees, which account for more than 75% of all bank fees, could make or break some banks. Without the fees, 45% of the banks and credit unions would have been unprofitable, according to Moebs.

“Banks are returning to a fee-driven model and overdraft fees are the mother lode,” Mike Moebs, founder of Moebs Services, said in an interview with the Financial Times.

The largest banks charged the largest overdraft fees: The median fee among banks worth $50 billion or more, including Citigroup Inc. (NYSE: C), Bank of America Corp. (NYSE: BAC), JPMorgan Chase (NYSE: JPM) and Wells Fargo & Co. (NYSE: WFC), is set at $33.  The median fee among all banks is $25 to $26.

Fees for overdrawing an account can be astonishingly high when calculated as an annual interest rate. For example, a consumer who overdraws an account by $20, repays the bank in two weeks and pays a $27 fee, would be charge the equivalent of a 3,520% annual interest rate according to a study conducted last year by the Federal Deposit Insurance Corp.

Higher fees at bigger banks are appropriate because they do not know their customers as well as smaller local banks, and need to be compensated for the higher risk, Nessa Feddis, general counsel at the American Bankers’ Association told The FT. Consumer advocacy groups reject this, saying that overdrafts are the least risky form of credit, and the most expensive for consumers.

“The banks own your paycheck before you do, so the only way you can default on your overdraft is if you choose to open another account and deposit your income elsewhere,” said Eric Halperin, director of the Center for Responsible Lending.

Source: Hefty Overdraft Fees Raise Banks’ Profits and Consumers’ Eyebrows

But there are some overlooked problems with this belief. The first is that while monthly sales of existing homes have improved, on a seasonally-adjusted basis, we are still worse off than we were last year in all regions but the west. Here’s some data from the National Association of Realtors:

The next problem we face is that inventory levels are still quite high. We are down from the peak of 11 months of backed up inventory, during parts of 2008. But today’s inventory level of 9.4 months is about to get a lot worse. Here’s why: Banks are sitting on their REOs (real estate owned a.k.a foreclosures) and are not re-listing many of these properties. Banks may be doing this for a number of reasons. Foremost is that they do not want to flood the market and drive down prices even further. But how long they will hold on to this “shadow inventory” before slowly releasing them on the market? That is anyone’s guess, but there is no doubt that there is a significant backlog of properties that will eventually hit the market.

The final blow to any hopes of a housing recovery are mounting foreclosures. The Obama administration’s “Making Homes Affordable” program has had abysmal results. Bank of America (NYSE:BAC) has modified 4 percent of its eligible loans. Wells Fargo (NYSE:WFC) has modified 6 percent. There is mounting evidence that lenders are simply unwilling to modify most loans since most modified loans end up right back in foreclosure after a few months. According to Renae Merle at the Washington Post, “The problem is that modifying mortgages is profitable to banks for only one set of distressed borrowers, while lenders are actually dealing with three very different types. Modification makes economic sense for a bank or other lender only if the borrower can’t sustain payments without it yet will be able to keep up with new, more modest terms.”

The other two types of distressed borrowers are those that will inevitable become delinquent again or those that can find a way to become current on their loan with a little coaxing. Banks have little incentive or desire to assist these two types of borrowers.

The housing market still has some serious challenges ahead. Sure, we may see a small increase in prices here or there, but long term, the fundamentals are still garbage. I am not saying that you shouldn’t buy a home right now, either as an investment or as a primary residence. There are screaming buys out there right now, and long term, real estate is still a great buy. Just don’t expect to be able to buy a property today and flip it for a huge profit in the next twelve months. You may see a small decline in your property value, but the huge drops seem to be behind us. We will still face a very long recovery period. But as Samuel Clemens said, “Buy land, they’ve stopped making it.”

Respectfully,

Christian Hill

Source: Don’t Believe What You Hear About a Housing Recovery

In my column, I used the example of Yamana Gold (NYSE: AUY), showing you how to reduce your cost when buying stocks – and thereby increasing your upside potential if the shares move higher.

Today, we’re going to kick things up a notch and explain how you can cleverly take the same covered call strategy and add a twist, by using deep-in-the-money covered calls. When you do so, you can achieve more consistent returns over time, while also protecting your capital.

Simply put, I’m going to focus on mitigating risk…

Getting Deep-In-The-Money… Even When Your Stocks Fall

With a conventional covered call strategy, you buy regular shares of a stock and then sell a call option against them, whose strike price is higher than the current share price. Your aim is that the shares will move higher and will get called away at expiration for a profit.

While this does happen, it doesn’t occur as often as you might think. Plus, it usually only happens during an upward moving market.

However, with the deep-in-the-money (DITM) covered call strategy I’m focusing on today, we’re not expecting the shares to move higher. In fact, we don’t even need the stock to trade higher in order for us to make money. It can actually go lower (sometimes much lower) and we’ll still make money.

Pretty compelling, right?

In short, what we’re seeking is safety. And to get it, we need to employ a strategy that protects us much more often than not.

Deep-In-The-Money Calls: A 75% Win Rate Over 13 Years

So how about a win/loss ratio of 75%? That’s the performance the deep-in-the-money strategy recorded over the past 13 years that I’ve used it. That means we’ve only lost money or broken even 2.5 times out of 10. At all other times, we’ve made money, usually notching up market-beating returns.

Just yesterday, in fact, in my Strategic Income service, we closed out two winning positions – 13% on Wells Fargo (NYSE: WFC) and 33% on Goldcorp (NYSE: GG) – positions we initiated before the market’s collapse.

Here’s how it works, using the Yamana Gold example again. Recall that in last week’s example, we bought Yamana under $9 and sold the $10 (out-of-the-money) calls against our position.

Using Deep-In-The-Money Covered Calls On Yamana

This time, we’re going to buy the same Yamana shares. But instead of selling the $10 calls, we go deep-in-the-money instead.

• Buy 1,000 shares of Yamana at $9.50 – a total outlay of $9,500.

• Sell 10 contracts of the January 2010 $9 calls (AUY-AL). Trading at $1.75 per contract, you receive proceeds of $1,750 (remember that each contract contains 100 shares, so it’s $1.75 multiplied by 100 = $175. Then $175 multiplied by 10 = $1,750).

• Your cost for Yamana shares is now $7.75 ($9.50 minus $1.75) – a full 18% below the current price. This is the crucial number. If Yamana closes above $7.75, you’ll be profitable.

• If Yamana closes above $9 at expiration, you’ll make 16%. You arrive at this number in this way…$9 (strike price) minus $7.75 (cost) = $1.25 (profit).
  $1.25 divided by $7.75 = 16%.

  If the stock moves higher, your returns are capped at 16%, regardless of where it goes.

• Even if Yamana shares stay at today’s level, you’ll still make 16%. So you have an additional chance of profiting from the trade, versus just one with a straight long strategy, which requires the shares to move higher.

Additionally, you reduce your cost of ownership in Yamana to $7.75.

Basically, you’re saying that you’re willing to own Yamana at $7.75 – 18% below current prices. But if you don’t get the shares at that price, then you want to be paid for trying – something that happens nearly 80% of the time.

Key Points to Remember When Using DITM Covered Calls

Here are a few things to remember whenever using deep-in-the-money covered calls:

• You can execute a deep-in-the-money covered call strategy in any trading account.
• If you do end up with the shares, you can sell additional calls against your position to reduce your cost even further. The goal is to own the shares for zero dollars or even a negative cost over time.
• Always make sure you employ position sizing – i.e. never put too much in a single investment.
• At expiration, if the shares are trading above your strike price, they’ll be automatically taken from your account.

Source: Deep In The Money Covered Calls: Lower Cost, Risk & Win 75% Of The Time

Source: Investment News Briefs Wednesday, July 15, 2009

Source: Investment News Briefs Tuesday, July 14, 2009

And state governments are feeling the pinch. According to the National Conference of State Legislators, there are only three states (Arkansas, Wyoming, and North Dakota) that do not face budget shortfalls for fiscal years 2009 or 2010. In other words, 47 states are currently projected to run short on cash in the near future.

And California – the world’s eighth largest economy – is in the worst shape of all. Currently, the state has committed to spend $26.3 billion beyond what it takes in. Controller John Chiang estimates that the state has enough cash to last through July. To avoid defaulting on debt payments, California will issue more than $3 billion of IOUs this month.

But while the plan may buy some time, it will only make the situation worse. The big banks (Bank of America -NYSE:BAC-, Citi -NYSE:C-, Wells Fargo -NYSE:WFC-, JP MorganChase -NYSE:JPM- and others) have stated that they will not cash the IOUs after July 10th. On a side note, this likely means that the banks are either so short on liquidity that they can’t afford to do so, or they are not confident that the state will honor its commitments when the IOUs mature in October.

That means that the state’s contractors and vendors must either hold these IOUs until they mature, sell them at a discount in the secondary market (listings are already popping up on Ebay and Craigslist) or, for smaller denominations, take the hit at a check cashing store.

Many of these contractors are already strapped for funds to pay their employees and subcontractors and can ill afford the disruption in cash flow. Undoubtedly, this will cause a cascading domino effect of layoffs, defaults and business closures. This will depress tax revenues even more, while increasing the demands for government services.

And it is not just contractors and vendors taking a hit. Local governments are also receiving IOUs for the state’s financial obligations. That could force some local governments to default on their municipal bond payments.

But this is not what constitutes the greatest threat to municipal bondholders nationwide. That threat comes from the federal government.

You see, state governments are not permitted to run budget deficits. Unlike the federal government, state governments are required by law to balance their budgets each year. And they can’t just print money like the federal government does (California’s quasi-legal IOUs notwithstanding).

That means the states must either cut services, raise taxes, or both. Neither alternative is easy to get through the legislature. In the case of California, Schwarzenegger recently declared that tax increases are “politically impossible.” And yet the alternatives include slashing spending on health care and education and releasing inmates from prison.

Political difficulties aside, California and just about every other state will be cutting services. And you can guarantee that just about every tax you pay will be going up in the future. But the states will also be putting increasing pressure on Washington for handouts. If there was money for the banks and the car companies, certainly there must be something for the states, right?

So far, Washington has rebuffed California’s calls for bailout money. The aid they have issued has come in the form of stimulus, such as increases in Medicaid and education funding. But the stimulus is obviously not working, and it’s not just California that is in trouble.

Corina Eckl, Director of National Conference of State Legislators, recently wrote, “The state fiscal situation is rapidly deteriorating and the figures for fiscal year 2009 and fiscal year 2010 have moved from sobering to distressing”. She compares the situation to a bad horror movie, where the “details get more gruesome, and the story never seems to end.”

As the cries for help become more urgent, the possibility grows that Washington will come to the aid of California and other states facing serious shortfalls. But don’t think for a moment that this assistance will come without strings. And one of these “strings” could well be the elimination of the tax exemption on interest payments from municipal bonds. In fact, the Obama administration has already pushed us over that slippery slope.

The interest payments on state and local bonds for public projects have always been exempt from federal taxes. But since the FDR administration, various presidents and legislators have tried to remove this exemption.

Given the “tax the rich” mentality in government, and the fact that nearly 50% of tax-exempt bond income is claimed by households earning over $500,000, it’s no wonder that efforts to roll back the exemption have grown stronger. And the “extenuating circumstances” of the current financial crisis have provided just the cover that was needed.

As part of the “American Recovery and Reinvestment Act of 2009” state and local governments are now authorized to issue taxable “Build America Bonds” to finance projects for which they could otherwise issue tax-exempt government bonds.

State and local governments that issue these bonds would “receive a federal subsidy payment for a portion of their borrowing costs on Build America Bonds equal to 35% of the total coupon interest paid to investors.”

And because there was no hearing on these bonds, there was no opposition. Investment manager, Richard Shaw of QMV Group, calls this the proverbial “camel’s nose under the tent.” Before long, the entire beast is sleeping right beside you. It was enough for Bloomberg to state that, “Barack Obama may be the worst thing that ever happened to tax-exempt bonds…”

Now, you might be saying that issuing new taxable municipal bonds is a far cry from re-writing the rules on existing bonds. And I would say the same thing, if it were not for what happened recently to bondholders of Chrysler and General Motors.

In both cases, once the government got involved the contractual rights of capital were superseded by the “greater good of society” – a blatant violation of contractual law and more than a thousand years of common law. Chrysler bondholders were denied first priority in liquidation. And GM bondholders were shafted in favor of the union.

I am not saying the rules will be re-written for municipals. But I wouldn’t rule it out either. If the federal government intervenes in state finances, you can be sure there will be strings attached. And one of them could involve an assault on tax-exempt income.

Quoting Richard Shaw again: “If the federal government steps in to provide ‘exceptional assistance’ to California or any other state, it would be imprudent to deny the possibility of the rights of bondholders being subordinated to the ‘greater good.’”

Considering the tenuous state of state and local finances, the risk of default on municipal bonds is almost certain to increase. Add to that the outside potential for a change in tax status and caution is advised. If you own municipal bonds, diversification is paramount. And stick to general obligation bonds, which are backed by the full taxing power of the issuing jurisdiction.

And don’t forget, banks and Property & Casualty insurance companies own about 25% of all municipal bonds. So, if the municipal bond market takes a hit, these sectors will suffer the consequences. Invest accordingly.

P.S. My colleague, Steve McDonald, runs an exceptional service called, The Bond Trader. His focus is on high quality, investment grade corporate bonds. According to Moody’s the long-term default rates on these bonds are less than 1%. And because Steve only recommends bonds trading at a discount, he has led his subscribers to capital gains as high as 84%, combined with super-safe income.

Since September, 59 out of 62 of Steve’s recommendations have increased in value… two are breakeven and only one is down. Compare that to the stock market and you might wonder why you’re taking such a big risk in stocks. Learn more about The Bond Trader here.

Source: Will the Feds Use the California Crisis to Change the Rules on Munis?

Traders have grown increasingly fearful in recent weeks that the powerful surge in the three major U.S. stock indices – one of the strongest in history – may not have been justified because of an ongoing economic recovery that’s not as strong as originally believed.

“There’s no question in my mind that the economy is improving,” Phil Orlando, chief equity market strategist at Federated Investors, told The Associated Press on Friday. “But investors are betting on some sideways consolidation rather than a continuation of a sharp spike in share prices.”

All the major indexes closed the week down for the first time since the week of May 11. The Dow Jones Industrial Average lost 3%, theStandard & Poor’s 500 Index fell 2.6%, and the Nasdaq Composite Index 1.7%.

Stocks returned to the whipsaw trading pattern investors had grown wearily accustomed to in the months before the rally got under way.

Stocks fell early in the week as a handful of weak economic reports – including news that industrial production had fallen for the seventh straight month – contradicted other reports that seemed to depict a gradual improvement in the American economy.

But some modestly upbeat economic reports sent U.S. share prices up a bit on Thursday; one report demonstrated that the overall number of people drawing unemployment benefits fell last week for the first time since the start of January.

But it wasn’t until stocks finished the day mixed on Friday – with financial, retail and tech shares gaining, while energy and utility shares dropped – that the three major indices finished with their first weekly loss since the start of May.

Last week was a loss. And the week before the three key indices each rose less than 1%.

“It’s not going to be a one-way ride,” Keith Walter, portfolio manager of Artio Global Equity Fund, told reporters.

Since periods of powerful market overperformance are usually followed by a period of sharp underperformance, institutional players have been looking for a down week.  Usually, a 40% surge like the one seen in the S&P 500 index takes years to develop, not months.

But here’s the question: Does last week’s market pullback have more to go, or can it still move higher after two consecutive weeks of sideways trading?
The conventional wisdom is calling for a stretch of choppy trading that will last through the summer, a period during which there’s low volume, until July when Corporate America begins announcing second-quarter earnings.

Market Matters

As the Dow finished the week in the “red,” it also turns out that its push into positive territory for the year was relatively short-lived.  Just one trading session beyond the index’s surge into the “black,” traders surveyed the economic landscape, evaluated the new regulatory environment, reconsidered the ballooning deficit (not even including health care) and chose to book some profits.  While the other major indexes remain profitable year-to-date, many investors believe the markets stand at a crossroad as they attempt to determine whether the recent move has been:

• A mere blip on the radar screen, amid a much-longer bear market.
• A much-too-fast run-up for a rebounding economy that that still faces a plethora of challenges.
• The start of a new bull market that simply is taking a week off to digest all the “euphoric” news.

The analysts, TV pundits, and bloggers maintain no shortages of views about the markets’ future direction.  Only time will tell.

As expected, major financial institutions rushed to pay back $68 billion in Troubled Assets Relief Program (TARP) money and get out from under the strong arm of the government.

JPMorgan Chase & Co. (NYSE:JPM), Goldman Sachs Group Inc. (NYSE: GS), and Morgan Stanley(NYSE: MS) highlighted the list, while Citigroup Inc. (NYSE: C), Wells Fargo & Co. (NYSE: WFC), and Bank of America Corp. (NYSE: BAC)are among those still seeking Uncle Sam’ approval for every action.
Meanwhile, Standard & Poor’s downgraded 18 related institutions, including a few that paid back the bailout money - BB&T Corp. (NYSE:BBT) and U.S. Bancorp (NYSE: USB) – and warned about the industry’s future

The Obama administration revealed plans for the most significant financial regulatory overhaul since the Great Depression.  The proposal expands the oversight role of the U.S. Federal Reserve, and includes higher capital and liquidity requirements, stricter reviews over hedge funds and certain derivative products, and the creation of a new consumer protection agency.  U.S. Treasury Secretary Geithner detailed the plan before the Senate and was met with mixed (but predictable) reactions…Republicans thought it was excessive, while Dems felt it didn’t go far enough.

If both sides dislike it equally, perhaps it’s a good plan?

Volatility returns to the markets as the VIX (Chicago Board Option Exchange Volatility Index) surged past the critical 30 mark early in the week, a sign generally associated with stock-market pessimism.  Bonds continued their ongoing roller-coaster ride as some fixed-income investors remained concerned about the global demand for U.S. debt, while others turned to the asset class as a flight-to-quality from riskier securities.

The worries continued as both China and Japan reportedly cut back their treasury holdings in April, a worrisome development considering the upcoming Treasury auctions will add a record $104 billion of government securities to the Street.

Oil hovered around the $70 a barrel level and gas prices increased for 52 straight days as consumers began to feel the pinch just in time for the summer holiday travel season.  Options expiration from “quadruple-witching Friday” brought additional volatility as each major equity index gave back some ground for the week on less-than-favorable reports from the likes of Best Buy Co. (NYSE: BBY) and FedEx Corp. (NYSE:FDX).

Market/ Index	Year Close (2008)	Qtr Close (03/31/09)	Previous Week (06/12/09)	Current Week (06/19/09)	YTD Change
Dow Jones Industrial	8,776.39	7,608.92	8,799.26	8,539.73	-2.70%
NASDAQ	1,577.03	1,528.59	1,858.80	1,827.47	+15.88%
S&P 500	903.25	797.87	946.21	921.23	+1.99%
Russell 2000	499.45	422.75	526.84	512.72	+2.66%
Global Dow	1526.21	1347.38	1,694.76	1,633.70	+7.04%
Fed Funds	0.25%	0.25%	0.25%	0.25%	0 bps
10 yr Treasury (Yield)	2.24%	2.68%	3.79%	3.79%	+155 bps

Economically Speaking

While U.S. Federal Reserve Chairman Ben S. Bernanke will be gaining enhanced powers under the federal financial system makeover, he must be wondering whether he will be around to experience them.  Despite the unprecedented challenges he has faced over the past few years, U.S. President Barack Obama has been tightlipped about whether he will reappoint Bernanke for another term when the central bank chairman’s current stint expires in January.

“Ben Bernanke has handled his position extraordinarily well under extraordinary circumstances…but I’m not going to make news on that right now,” President Obama said.

Some Fed watchers believe that President Obama has Lawrence Summers, the former U.S. Treasury secretary and present National Economic Council chairman, in mind for the position.

On the economic front, inflation data highlighted the week’s releases as both producer price index (PPI) and the consumer price index (CPI) for May were reported as below expectations.  While certain naysayers pressed forward on the scary “deflation” argument, other naysayers point to the rapid rise in energy prices as proof that the dreaded “I” word is merely lurking on the horizon.

For now, however, inflation is not considered “Public Enemy No. 1″ and economists will focus on housing, labor, and manufacturing for more signs of economic stability.

Turning to housing, new construction climbed by its largest amount in three months and even building permits jumped in May as prospects for the future look more promising.  Bear in mind, however, homebuilding activity still remains more than 45% below last year’s levels.

Industrial production fell more than 1% in May as automakers Chrysler Group LLC and General Motors Corp. (OTC: GMGMQ) continued shutting down plants and limiting production as they initiated their restructuring plans.  While initial jobless claims actually increased slightly in its most recent weekly release, total insurance claims actually fell for the first time in five months.  Still, the labor market remains the primary concern as the economy begins to show some signs of improvement.

On that note, the leading economic indicators (LEI), an index thought to forecast economic activity for the next three to six months, experienced its best showing since March 2004.

Weekly Economic Calendar

Source:  Market Stumble Heightens Worries That Economic Rebound May Not Be That Strong