As expected, the Bank of England left rates unchanged at 0.5% and the European Central Bank left rates unchanged at 1.0%. The BOE also signaled that they would not be expanding their QE program, but left open the option to buy more down the road should conditions change. We’re awaiting ECB’s Trichet to comment on Greece and the rest of the PIIGS to see if more will be done to assist them. Two of Greece’s largest unions are setting strike dates for February 10th and February 24th to protest the austerity proposals proposed by the government.

Of course, Greece is not the only country with major fiscal problems. Portugal, Spain, Italy, and Ireland are all seeing their sovereign CDS prices shift out significantly with Portugal now at the level Greece was at during December. This is the first true test of the Maastricht marriage for all of the Euro zone members and highlights the major problem with the construct: it’s not a true union.

Case in point, it seems the IMF is the only body that may have the legal capability to assist these countries in their time of need. This reminds me of something, what is it?

I’m thinking of what happened between the shotgun marriage of Bear Stearns to JPM and the failure of Lehman. Nothing. Nothing happened for 6 months even though US authorities knew they could potentially see another major problem. This is what I think could be happening in the Euro Zone and with the European Union. The ECB and EU know they have a problem with some of their members not meeting the 3% debt to GDP metric and yet there doesn’t seem to be any action to legally assist these countries or have the legal authority to create something like a TARP.

This is the test many have predicted that would eventually come for this quasi-union. Given the sloth-like movement of the EU parliament, it may take a true crisis for them to create what is needed to avoid this in the future. The clock is ticking on the EU/ECB and they’re wasting time.

Today, President Obama holds a press conference to discuss the details of his 2011 budget. According to the press release, here are the key facts:
Overall 2011 Spending: $3.834 trillion.
2011 Discretionary Spending: $1.415 trillion.
2011 Projected Deficit: $1.267 trillion or 8.3 percent of GDP (down from $1.556 trillion or 10.6 percent of GDP in 2010).
10-year Deficit Reduction: $1.2 trillion, excluding war savings.
Tax Cuts: More than $300 billion in the next 10 years for individuals, families, and businesses.
The White House fact sheet also contains these highlights: “The Budget includes $100 billion for immediate job-creating investments in small business tax cuts, infrastructure, and clean energy. This includes a new Small Business Jobs and Wages Tax Cut to spur small business hiring and wage increases; this will cost $33 billion. Extend for another year the Making Work Pay Tax Credit for 110 million American families. Increase the child care tax break for middle-class families. Eliminate the tax on capital gains from new investments in small business. Extend through 2010 the Recovery Act provision that allows small businesses immediately to expense up to $250,000 of qualified investment.”

They are proposing a 3 years spending freeze on non-security discretionary spending to save $250 billion over 10 years; cost cutting of $20 billion, bank tax fee of $90 billion over 10 years, elimination of tax preferences for oil, gas, and coal companies for $40 billion over 10 years; and allow the 2001 and 2003 tax cuts to expire for households making more than $250,000 raising $678 billion over 10 years. This 2011 budget will be the third year in a row of trillion dollar deficits.

The simple figures to understand are these: receipts versus outlays. In trillions, 2009: 2.105 receipts, 3.518 spending; 2010 2.165 receipts, 3.721 spending; 2011 2.567 receipts, 3.834 spending. Spending increases every year. Today, there are no surpluses and the spending remains high: 5.8% increase in 2010 and 2.9% increase in 2010. Note, the anticipated increase in receipts for 2011: a massive 18.5% increase from taxes.

The longer run projections are for $8.5 trillion in deficits over the next ten years. The public debt will reach $10.5 trillion in FY11, an astounding 68.7 percent of GDP. Even with today’s low rates, interest costs would more than quadruple by the end of the decade, reaching $840 billion in 2020, and overall spending will remain well above the historical average at 23.7 percent of GDP by 2020.

When I think of this structure, several phrases come to mind: This isn’t rocket surgery. It’s rare, but not unusual. We have to run it up the flagpole to see if it floats. It’s a classic mixed metaphor.

The Obama budget is doing something now that will incent people to hire workers that in the long run is going to cost them their jobs. It’s ironic that the plans are to provide a tax cut to hire workers (Small Business Jobs and Wages) and then a tax hike (2001-2003 Bush cut roll off) to discourage it. Remember, many small businesses are subchapter S and the profits roll straight through to individual tax returns. So when you tax earners over $250k, you hurt small business. Cheap loans (any loans) will help, but incenting people by letting them keep them own money is better for the economy and for job creation.

While the President met and debated Republicans over the weekend, we’ll have to wait and see for any breakthroughs for cooperation on the budget. So far, I don’t see any carrot at the end of the tunnel.

As part of his small business focus, President Obama wants to offer tax credits to companies that hire new workers. According to CNBC, Obama’s proposal would give companies a $5,000 tax credit for each net new worker they hire in 2010. “Businesses that increase wages or hours for their existing workers in 2010 would be reimbursed for the extra Social Security payroll taxes they would pay. No company could reap more than $500,000 from the combined benefits, one of several features meant to tailor the program more to small businesses than to large corporations. Startup companies could receive half that amount. Existing companies could not close down and then reopen under a new name and receive any benefits, White House officials said.” A similar proposal was floated to Congress last month and was shot down. Why? Even Congress knows, this program is difficult to enforce and likely to be abused. Translation: these funds would be better spent elsewhere.

President Obama’s state of the union address had something in it for everyone last night. The loudest bipartisan cheer occurred when President Obama said, “And tonight, I’d like to talk about how together, we can deliver on that promise. It begins with our economy.” For the markets, the most critical component came next.

“So I supported the last administration’s efforts to create the financial rescue program. And when we took the program over, we made it more transparent and accountable. As a result, the markets are now stabilized, and we have recovered most of the money we spent on the banks…..To recover the rest, I have proposed a fee on the biggest banks. I know Wall Street isn’t keen on this idea, but if these firms can afford to hand out big bonuses again, they can afford a modest fee to pay back the taxpayers who rescued them in their time of need.”

This was it as far as beating up on the banks. The speech (coupled with the Federal Reserve statement) had the salubrious effect on the markets and helped stabilize the “Risk Off” theme that Obama had driven hard since last week. Stocks rallied, the US dollar dropped, and bond yields increased.

Other positives from the speech were a mention of fiscal reform (freeze some spending), elimination of all capital gains taxes on small business investment, and “a tax incentive (bonus depreciation extension?) for all businesses, large and small, to invest in new plants and equipment,” and an extension of the Bush tax cuts for middle income earners.

The negatives are formally announcing that the Bush tax cuts for wage earners over 250k will roll-off, a small business tax credit for hiring workers or raise wages (proven to be not effective), and the creation of a potential new entitlement program surrounding student loans.

For the US dollar, the President made this important statement: “Third, we need to export more of our goods. Because the more products we make and sell to other countries, the more jobs we support right here in America. So tonight, we set a new goal: We will double our exports over the next five years, an increase that will support two million jobs in America. To help meet this goal, we’re launching a National Export Initiative that will help farmers and small businesses increase their exports, and reform export controls consistent with national security.” While anything to eliminate barriers to trade and reform export controls are a good thing, it’s tough to export more from this point forward if the US dollar strengthens. So, the read-between-the-lines interpretation is that the US needs a weaker US dollar to help accomplish this goal.

SOTU speeches are renowned for being long on strategy and short on details. Last night, President Obama followed this tradition by asking for bi-partisan support, but not offering any compromises with the Republicans to achieve his goal. While I think the President’s offer to meet with them on a regular basis is a great idea, I would hope that he does more than just meet and agrees to use their suggestions for policy.

We’ll receive more of the President’s specific policy measures next week when he presents his 2011 budget. With the CBO estimating that the 2010 fiscal deficit will be $1.35 trillion, Obama will need to walk the fine line of dually reassuring the markets that he is doing something to in the short run to keep the economy going while addressing the long run problem of red ink.

Today, we have the financial odd couple of current US Treasury Secretary Tim Geithner and former US Treasury Secretary Hank Paulson testifying in front of Congress on the AIG bailout. At 10:00 am, they will testify before the House Committee on Oversight and Government Reform and discuss in detail the steps the government took to rescue AIG and how the consequences of AIG failing at that time, in those circumstances, would have been catastrophic for our economy and for American families and businesses” according to the US Treasury.

The FT says that Republicans on the House oversight committee are accusing the New York Fed of a “cover-up” after reviewing thousands of pages of e-mail traffic between officials discussing the decision to pay $27.1bn, equivalent to par value, to banks led by Société Générale and Goldman Sachs that had bought credit default swaps from AIG.

The markets should anticipate a vigorous defense of their actions during today’s political theatre. What-did-they-know-and-when-did-they-know-it will be the over-arching theme of the questions. According to the US Treasury Department, Geithner was recused from “working on issues involving specific companies,” including AIG after he was nominated on Nov. 24th, 2008, for the US Treasury Secretary. This was the point I made yesterday with Larry Kudlow on CNBC.

However, this will boil down to decisions made during the height of the financial panic and what was the best path to stabilizing the markets.

Geithner has decided to release his testimony early to allow for all to see and review. In it, he denies any cover-up allegations: “I had no role in making decisions regarding what to disclose about the specific financial terms of Maiden Lane II and Maiden Lane III and payments to AIG counterparties,” Geithner said, referring to Fed investment vehicles that bought securities from the banks according to Reuters.

I think Paulson will also be on the hot seat not only for his role, but also because of his connection to Goldman Sachs. Again, this will be great theatre with the requisite red faces of disgust and disdain for Geithner and Paulson from members of Congress.

The most important element of the testimony for the American public will be the acknowledgement from Geithner that “Taxpayers are unlikely to get back all money pumped into AIG.” As Gomer would say, “Surprise, surprise, surprise.”

After all the smoke has cleared, this will be the one fact that will be indisputable.

Tonight at 7:30 PM ET, I’ll be appearing on CNBC’s Kudlow Report discussing the Federal Reserve meeting and monetary policy changes.

After LK called me a squishy liberal on government spending, I can’t wait to be back on tonight!

Today at 11:10 AM ET, I’ll be appearing on CNBC’s The Call discussing the negative impact on the markets due to the political uncertainty in the United States.

Last night, the White House leaked out a portion of their State of the Union platform and it was a good start. Actually at this point with spending, the markets want any start, hope, action on reigning in government spending that doesn’t contribute to job growth. Why is Obama shifting/morphing in this direction?

The NYT writes, “With his poll numbers down and Democrats fearing disaster in this year’s midterm elections, Mr. Obama is at a particularly rocky point in his presidency and has been shifting his rhetoric lately to adopt a more populist tone. He heads into his first formal State of the Union speech in a radically reshaped political climate from even one week ago.” Call it the Brown effect, call it the race to the middle, call it Clintonism, or whatever you want. This is what occurs when a new president doesn’t get what he wants on his agenda.

Although I’m not a huge fan of Thomas Friedman (I liked his first book, not the rest), he did have some interesting advice for the president. “Well, here’s my free advice to Obama, post-Massachusetts. If you think that the right response is to unleash a populist backlash against bankers, you’re wrong. Please, please re-regulate the banks in a smart way. But remember: in the long run, Americans don’t rally to angry politicians. They do not bring out the best in us. We rally to inspirational, hopeful ones. They bring out the best in us. And right now we need to be at our best.”

Granted, it’s a bit trite on the inspirational message, but I think Friedman has a point. It’s about doing what is best for the country in trying to solve problems and not solve declines in opinion polls. At one point in the Simpsons movie, President Schwarzenegger is faced with a difficult decision on what policy to follow. He has 5 choices and all will cause varying degrees of misery. Before his adviser can tell him about the details, he shouts out, “I pick Number Three!” When asked if he wants to review them first, he says, “I was elected to *lead* not to *read*.”

This is what ultimately Obama has to choose to do: not read the opinion polls and go with what may be currently unpopular to his party. The spending freeze is the start of the process.

US existing home sales (EHS) fell a disappointing 16.7% as the rush from the first time home buyers credit earlier in the fall depleted sales in December. However, sales had rebounded significantly from the lows last Jan-Mar and have reduced inventories significantly as well. It’s the inventory component that holds the key for prices as they move down from a catastrophic 11.2 months worth of homes down to 6.5 months of supply. Just put up a graph on EHS (as they decrease inventories) with S&P CS home prices and you will the relationship.

2009 was a terrible year for housing on many fronts, but was especially onerous from a foreclosure standpoint. Approximately 2.9 million home went into foreclosure and the outlook for 2010 is similar. As most know, a foreclosed home on average loses 15-25% of its value and also drags down other homes in the area due to comparables. I would posit that the current foreclosure environment is due to a combination of over-priced homes, over-levered borrowers, and the jump in the unemployment rate.

As part of the State of the Union address, the Obama administration is expected to announce changes to the Making Home Affordable program to assist more middle class borrowers. So far, the loan modification program has assisted over 65,000 borrowers with possibly another 45,000 in the works. This is a tiny percentage of what the US Treasury was hoping to assist and is not likely to make a major impact on foreclosures. It’s estimated that millions of US homeowners are upside down on their mortgages meaning that they owe more than they home is worth. This negative equity situation has not been addressed due to banks not incented to reduce the principal owed especially if the homeowner is keeping up on the mortgage.

Behavioral scientists are having a field day with this behavior and one professor states these borrowers are suffering from “norm asymmetry. According to a paper by University of Arizona professor Brent White, “Despite reports that homeowners are increasingly “walking away” from their mortgages, most homeowners continue to make their payments even when they are significantly underwater. This (article) suggests that most homeowners choose not to strategically default as a result of two emotional forces: 1) the desire to avoid the shame and guilt of foreclosure; and 2) exaggerated anxiety over foreclosure’s perceived consequences.”

“Moreover, these emotional constraints are actively cultivated by the government and other social control agents in order to encourage homeowners to follow social and moral norms related to the honoring of financial obligations - and to ignore market and legal norms under which strategic default might be both viable and the wisest financial decision. Norms governing homeowner behavior stand in sharp contrast to norms governing lenders, who seek to maximize profits or minimize losses irrespective of concerns of morality or social responsibility. This norm asymmetry leads to distributional inequalities in which individual homeowners shoulder a disproportionate burden from the housing collapse.”

Writing in the NYT, Richard Thaler provides the disturbing potential conclusion on homeowners changing their viewpoint and strategically defaulting: “An important implication is that we could be facing another wave of foreclosures, spurred less by spells of unemployment and more by strategic thinking. Research shows that bankruptcies and foreclosures are “contagious.” People are less likely to think it’s immoral to walk away from their home if they know others who have done so. And if enough people do it, the stigma begins to erode.” If enough people do it, the housing market collapses.

Fortunately if the US residential market continues to recover and prices continue to improve, the desire to walk away will decrease further as the potential recovery will keep borrowers paying. The key is to keep the market recovering. Job growth, low rates, and better access to liquidity will be all needed to keep the housing market recovering. If not, the scenario described by Thaler becomes more likely. And truly disturbing.

After a stunning loss in the Massachusetts Senate race and loss of the critical 60-40 split in the US Senate, President Barack Obama did not wait long to change tactics and go on the offensive. Yesterday’s bank plan announcement is a fascinating turn in the political discussion. While the details are still a bit sketchy, the rhetoric is not. The speech had a direct negative impact on the equity markets as the S&P 500 dropped 1.89% and the financial sector dropped 2.93%.

While I (and others) believe the agenda of the White House will be pulled more mainstream due to the loss, Reuters John Kemp advocates otherwise. He writes, “In the next few weeks, the administration will disappoint many of its supporters on the left by abandoning ambitious elements of its healthcare and climate programme, as well as card-check.
But the president cannot afford to seem weak or be “triangulating” towards the centre.”

Kemp says, “The unabashed populism of the bank plan enables him to shift attention from healthcare, dominate the political conversation for a while, and provides useful cover for dropping other parts of his domestic agenda. It puts the opposition Republicans in an exquisite dilemma. With their 41st vote, Senate Republicans now have the power to block the proposals. But if they do, Obama and his Democratic allies will campaign against them as friends of Wall Street and its unpopular bailouts. If Republicans agree to go along with the curbs, Obama wins a significant and popular victory.”

According to Reuters, President Obama’s own Treasury Secretary voiced concerns about using the Volcker rule for reducing the size of banks. “Geithner is concerned that the proposed limits on big banks’ trading and size could impact U.S. firms’ global competitiveness, the sources said, speaking anonymously because Geithner has not spoken publicly about his reservations. He also has concerns that the limits do not necessarily get at the root of the problems and excesses that fueled the recent financial meltdown, the sources said.”

Last night on PBS’s NewsHour, Geithner said that the proposed measures were in the works for weeks and were not driven by political considerations. “”What it does is try to ensure that we limit risk-taking, the kind of risks that could threaten the stability of the system in the future.” This question of how to resolve “To-Big-To-Fail” is critical for the financial system and was a critical factor in how the financial panic erupted in 2008.

In a word, uncertainty. In February of 2008, Bear Stearns was married to JP Morgan. In September, Lehman was allowed to fail. Markets hate uncertainty and rush for the exits until they can regain confidence. Yesterday was a great example of this. However, business leaders also struggle with uncertainty. They react by delaying projects, delaying financing for those projects, and delaying hiring for those projects.

With the announced plan on banks, the President is shifting the focus again of the Congress and the tax writing committees away from some critical areas. Think of the estate tax, tax extenders, and most importantly what to do about the Bush tax cuts. This further fuels uncertainty for business and now for individuals. It’s extremely difficult for a company to decide whether to buy a piece of equipment if the don’t know what the depreciation schedule will be. It’s extremely difficult for an individual to decide whether to buy a new washer&dryer or a new car if they don’t know what their taxes will be…..or if they will have a job.

On January 27th, the President will deliver his state of the union address. On February 1st, he’ll deliver his priorities for the budget for the coming year. The markets, business, and individuals will be looking for clarity and certainty in policy for the new year. If Obama can’t deliver, then he runs the risk of stalling the recovery and putting additional downward pressure on the equity markets.

The victory in Massachusetts for Republican Scott Brown over Democrat Martha Coakley is seen by political strategists as a repudiation of the current health care legislation and the policies of the Obama administration. The Washington Post writes, “Republican Scott Brown’s win in a liberal state will do more than vastly complicate Obama’s bid to overhaul the U.S. health care system. It will send his party into a painful re-examination of voters’ anger and desires ahead of the November elections for Congress, governorships and state legislatures.”

Yesterday, I wrote about the ways that Democrats could still pass the bill if Brown won. Today at least one Democrat is already stating that a vote should be delayed. “In many ways the campaign in Massachusetts became a referendum not only on health care reform but also on the openness and integrity of our government process,” said Sen. James Webb, D-Va. He urged that “we suspend further votes on health care legislation until Sen.-elect Brown is seated.” (WaPo)

Clearly, this is a game changer from many aspects and should confirm my prediction that in 2010 President Barrack Obama will morph into President Bill Clinton. On foreign policy, this is already occurring as the 30,000 troops to Afghanistan attests. Also, the shift on homeland security and the focus back on terrorism due to the Xmas day bombing attempt, the Fort Hood attack, and the suicide bombing of the CIA operatives. Lastly, the demonstrations in Iran. All have pulled the President towards a more hawkish position.

The election last night will also bring about further change. The trial balloons on the budget are already filling the air. There has been one last week about extending the Bush tax cuts from 2010 to 2012. There has been one this week on freezing government spending budgets. OMB has asked agencies to plan for three different spending plans and one has a 5% reduction across the board. Finally today, there is a deal to create a fiscal commission and a pay-as-you-go budget enforcement bill. This deal would allow Congress to pass an increase in the debt ceiling while addressing the long term deficit problems.

Unfortunately, there is great consternation over what a commission would ultimately recommend. Cato and others warn that the likely outcome would be mainly higher taxes and not lower spending. This is not a Republican nor a Democrat issue alone as both parties have dramatically increased spending when they have been in charge of Congress and the White House. As Laffer, Moore, and Tanous wrote in “The End of Prosperity”, “If Congress had just held spending to the level of inflation and even taking into account the extra $200 billion annual cost for the war in Iraq, there would have been a $100 billion surplus in 2007 rather than a $162 billion deficit.” Funny how small those numbers look now in an era of $1.4 trillion budget deficits.

The point is that Brown’s victory is a game changer for the Senate’s 60-40 split, but there are more important changes coming. Expect a centrist Obama to focus on the deficit and creating jobs during his January 27th State of the Union address and his upcoming budget.