Money for Nothing and Checks for Free

“Those whom the gods wish to destroy they first make mad.”   Anonymous Ancient Greek Proverb

Wow, what a crazy week. About everything that could happen did happen, except for the delivery and signing into law of a credible deficit reduction and debt control plan by the American Legislative and Executive Branches.

In the wake of that failure, investors in the US Dow Jones index rewarded President Obama on the marking of his first half century of walking on this planet by shaving 500 points or almost 5 % off of that stock market gauge. By the end of the week global bourses had shed around $2.5 Trillion of value.

The debt ceiling debacle wasn’t the only motivator behind the gloomy sentiment weighing on markets:  renewed fears that the global economy might be entering a double dip were fanned by weak purchasing reports from Germany, flattish consumption-related and employment numbers in North America, and growing doubts about the fiscal sustainability of the debt-laden laggards in Europe, now to include, most notably, Italy.

On Friday the markets looked set for another big dump following weak employment readings announced early in the  day by the US Labor Department. It is unmistakable that some foreknowledge of the reduction in the S&P US long term debt rating that was announced following the market close was given to the US Government. Therefore it is our surmise that the Plunge Protection Team swung into action to prevent another swingeing setback following on the heels of the 500 point plunge the day previous. Thus,  after a wild intraday ride, the Dow closed on a dead cat bounce, up 61.

These events prompted G-7 and G-20 country governments to convene a set of emergency consultations over the course of the weekend to discuss measures to combat the malaise sweeping global markets and to contain any contagion effect from exacerbating conditions further. The price action on several markets so far today does not engender optimism for a placid trading week ahead.

With the apparent exception of the United States and a few people here in Canada (see below) a growing realization that fiscal stresses in Western economies mean that Government spending needs to be cut back, entitlements need to be cut back, and Government generally needs to right size and reconsider its role. The bottom line is that the social safety net has become too expensive and people need to be made more reliant on their own efforts rather than rely on handouts from Governments.

It is in this context that we read an article last week in the Financial Post entitled “Only More immigrants can save Canada’s Economy” . In this piece, the author, who is associated with the New Frontier Institute, contends that in order to “save” Canada’s pension system that we need to allow immigration to reach a million people per year as an urgent  matter of policy.

What claptrap.

 Nowhere in this article is it mentioned that Canada does not have the capacity to admit that many immigrants into the country. In the last five years the amount of annual jobs growth has been well below 200,000 per annum. Where and how are we going to employ these immigrants? What of the strain on our already overstressed medical, educational and public security infrastructures? No mention. Yet the author makes reference to a recent speech by the Minister of Immigration, Jason Kenney that does clearly spell out all of the constraints and considerations involved in setting immigration policy.

Arctic Circle Cartoons 

What of recent studies that demonstrate that Canada’s immigration policies admitting as they do a few hundred thousand folks per year actually cost the public purse significant money? This is given short shrift. Ivory Tower schemes are suggested to hand over immigration policy to the provinces, magically reduce the cost of admitting immigrants and to assume away the host of logistical and social challenges implicit in this proposal, all in the name of ensuring that Canada can “fund the Baby Boom generation’s retirement obligations.”

And what of the political and social implications of such a policy? Namely that, if implemented, within one generation we effectively would be handing over electoral control of our entire country to a demographic that has no long term  relationship to this place. In exchange for what? A pension bailout that benefits a narrow slice of the population, much of which is quite well off without Government help.

The reality is that the pension deficits are real. Most pension funds are insolvent in Canada, and therefore this is a problem that requires urgent attention. The reasons for these deficits are many. Some reasons include faulty design, poor management, venal politicians agreeing to over-rich settlements with public sector unions, bad luck or bad markets, theft, fraud, perverse incentives, or the fact that some plans ail from all or a subset of the foregoing impairments. None of this however means that they should be bailed out. This makes no sense, particularly in the context of what we already know to be the case of the retirees at Nortel, Enron and numerous other companies that failed to provide safeguards for the pension obligations they had to  their retiring employees. The reality is that in any conceivable context, the prudent, economic, legally and morally correct course of action is to write down benefits in order to meet the resources extant within each of these funds and share them out to the retirees. There can and should not be a bailout unless we intend to become the next Argentina or Venezuela.

 No doubt pension reform is a large problem and one fraught with political and economic risks. However throwing away Canada’s entire future to try and paper over mistakes made by the same ”Baby Boomers” that this writing suggests need help is pure madness.

 The New Frontier website lists a number of prominent people as being part of their Advisory Board, among them Ruth Richardson, former Minister of Finance in New Zealand;  and Sir Roger Douglas, the architect of the economic reforms in New Zealand that served as a blueprint for leading the country out of the abyss of subsidies, government interventions and meddling that caused the catastrophic meltdown there in 1984. At the same time, the website is extremely coy about where it receives its funding from, leading us to surmise that it may be acting as a shill for a set of vested interests that want to bias public policy in favor of themselves rather than proposing policies that make long-term sense for Canada as a whole.

I worked under Ruth when I was managing New Zealand’s Sovereign Asset and Liability portfolios in the mid 1990’s and I have met Sir Roger a number of times. The prospect that Ruth or Sir Roger would endorse the policy recommendations as spelled out in the New Frontier article, and in the context of the commentary we provide above and as reflected in Minister Kenney’s recent remarks, is in my opinion a very low probability outcome unless there has been a massive sea change in how they view the role of Government and the constituents of effective policy. If the New Frontier Institute believes that this is not the case, we invite rebuttal, accompanied of course by the math that supports the “million immigrant a year” proposal.

 Who knows what the future might bring? Flush with a majority Government and a five year term in office ahead of him, shamefaced clarion calls for bailouts of their entitlement programs by special interests may be setting up Stephen Harper for his very own “Scargill Moment”.

Posted in Bankruptcy, Canada, Crisis, EU, Fed Policy, Restructuring, Sovereign Debt, Stock Market, USA | No Comments »

The Bernanke Cult

“Insanity: Doing the same thing over and over again and expecting different results.”            Albert Einstein

 The release of the September Fed minutes out yesterday put the final nail in the coffin of those who believe that Ben Bernanke is not a man determined to make financial history. For some time we have been predicting that the Fed’s approach to the crisis will continue and that further doses of expansionary monetary action are in store. As recently as this past Friday Alex Jurshevski reaffirmed Recovery Partners’ view that QE2 was a “done deal” on BNN (see segment 1 and segment 2).

 Indeed, it appears that unless Mr. Bernanke is impeached, suffers a sudden attack of a weird virus or falls under the wheels of a moving bus, that his high wire monetary experiment will continue. Hence our added expectation that there may be additional rounds of QE if this one fails as Round One has. We expect implementation of QE2 and possibly further kicks at the can despite the fact that there is no evidence that these policies have ever worked in a positive fashion to rehabilitate an economy overdosed on credit and suffering from solvency and debt problems on an immense scale.

 David Rosenberg discusses most eloquently the various concerns regarding the present policy course and the confidence we should be placing in Bernanke’s Fed and the Treasury in a recent client communication. We would add the following three points to his most erudite commentary:

 (1)     Donning our trading hats, we note that the concept of “risk limits” is completely absent from the policy course established by Bernanke. The rapid expansion of the Fed’s balance sheet in relation to GDP has no historical comparator save in situations where the central monetary authority lost control of the printing press and hyperinflation was the result.  Moreover the only private sector examples of rapid, massive and intentional balance sheet expansion that we can think of are limited to situations of accounting control fraud and eventual bankruptcy. Where this will all end up one can only guess.

 (2)     Bernanke has demonstrated that he only has a very limited understanding of credit risk and its implications for the cost and risks of his chosen policies. In testimony to Congress he boasts that the Fed “has never lost a penny” in its repo operations. The Fed bailed out banks by repo’ing toxic waste for term and giving back cash which the banks could use to buy risk-free (for the time being) Treasurys and earn a spread in order to re-capitalize their balance sheets. What he does not mention is that this operation could only have been made possible by valuing the repo’ed toxic waste at above-market prices and by the fact that the Fed (a) does not presently have to disclose the detail of these trades; and (b) that it has never been bound by mark-to-market requirements on its portfolio holdings. The hope appears to have been that QE1 would work, asset prices would rise and the trades would be reversed. Since the bulk of the toxic assets are housing-market-related, this seems to have been a “Hail Mary” strategy from the outset.

 (3)     Every first year economics student understands that in economics there “is no free lunch”.  Hiowever, Mr. Bernanke’s entire bag of policy tricks is based entirely on the premise that it is possible to have a free lunch – by paying for it with scrip. Conversely, the US population are beginning to rapidly see through the subterfuge and understand that the intended re-capitalization of the banks was and is intended to be largely taxpayer and scrip funded. Moreover the public backlash against additional pump priming has already been noted in Washington, thankfully reducing the propensity of the Obama Administration to further jack up deficits and the need for Bernanke to issue even more scrip. Even the MSM is now finally beginning to understand this reality and  that the second order effects of the Fed’s policy stance include, in part,  fomenting a full blown currency war. Although this latter realization is only now making headlines, the currency war has been in progress in earnest since QE1 was first announced.

 The bottom line is that while there may have been some basic understanding of the risks of policy failure at the Fed and Treasury there appears to have been, and there continues to be, no appreciation of the consequences of these risks beyond their potential impact on one-dimensional economic variables.

This is because Bernanke seems a technocrat of the highest order who has forgotten that the study of economics is more formally known as “Political Economy”. The potential consequences of Bernanke’s policies include: the utter debasement of the US dollar; an economy that remains mired in slowdown through an extremely protracted adjustment period; widespread bankruptcy, social unrest, the bankrupting of smaller countries and populations, geo-political trade and military friction and the erosion and possible destruction of the Postwar Pax Americana from which the entire World has benefited enormously for over a half century.

 Believing that these policies will work is rapidly becoming an article of faith.

 Welcome to the Bernanke Cult.

Posted in Bankruptcy, Bond Market, Fed Policy, Loan Losses, Stock Market | No Comments »

Fed Says “Don’t Worry, Be Happy”

 

 ”The last duty of a central banker is to tell the public the truth.”   Alan Blinder, Fed Vice Chairman

 We are sure that if Professor Blinder had known what was coming down the tracks, that he would never have made the foregoing comment on the national airwaves in 1994.

 Last Friday the Fed finally released a document describing the methodology behind it’s the long awaited stress tests (called Supervisory Capital Assessment Program (SCAP)). As you know we have been calling for this triage to be imposed even before the September meltdown of Lehman and AIG (see our previous posts) According to the Fed document the process began in February and focused on banks with assets over $100 billion dollars. According to the Fed there are 19 firms in this group that collectively holds two-thirds of the assets and more than one-half of the loans in the U.S. banking system. Taken together this group supports a very significant portion of the credit intermediation done by the US banking sector.

Full results of how each bank fared are expected to be released by the Fed on Monday, May 4. The SCAP report can be found at:

http://www.federalreserve.gov/newsevents/press/bcreg/20090424a.htm

 However the initial pages of the report make ominous reading for anyone who is hoping for transparency, and more importantly, solutions, to come out of this process. The first sentence of the report states “Most U.S. banking organizations currently have capital levels well in excess of the amounts required to be well capitalized.” In reading further it did not get any better or more objective, thus significantly heightening our concerns that this exercise is designed to be a whitewash rather than a fact-finding process aimed at measuring the scale and depth of the problem such that appropriate remedies might be devised and implemented.

 The SCAP document goes on to state:  “The SCAP is a forward-looking exercise designed to estimate losses, revenues, and reserve needs for Bank Holding Companies (BHCs) in 2009 and 2010 under two macroeconomic scenarios, including one that is more adverse than expected. Should the assessment indicate the need for a BHC to raise capital or improve the quality of its capital to better withstand losses that could occur under more stressful-than-expected conditions, supervisors will expect that firm to augment its capital to create a buffer.”

Tested firms were asked to estimate potential losses on loans, securities trading positions, off-balance sheet commitments and contingent liabilities over a two-year time horizon. Firms trading over $100 billion in assets were also asked to estimate additional possible trading-related market losses and counterparty credit losses under the adverse scenario based on the market shocks experienced in late 2008. These submissions were then analyzed by supervisors from the Federal Reserve Board, the 12 regional Federal Reserve Banks, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency.

Anyone remotely familiar with the various contortions banks in the US have been going through in order to continue to project a “patina of solvency” to the market, knows that the banking system in the US is insolvent at a macro level. This is why Fed Borrowings have remained at historically unprecedented levels since the latter part of calendar 2007. The relaxation in the FASB 157 rule; a lax attitude by FDIC inspectors and it seems a continued unwillingness on the part of the Fed and the Treasury to admit to the true scale of the problems, add up to the reality that a Giant Bamboozle is Underway.

 Furthermore, with the Federal Government borrowing all the dough on God’s green earth, thus effectively “crowding out” all but the most creditworthy borrowers, it is not clear how Zombie Banks might be expected to raise capital on economic terms and in sufficient quantities from skittish investors.

 The answer to this is found in the nature of the stress tests themselves. The following table compares the “Stress Test” data to the worst recorded previous down cycles:

 

 On the surface, although the process looks legitimate and thorough, the reality is that the “Stress Tests” are anything but. In comparing the stress data to previous down-cycles one finds that the scenarios tested were not stress scenarios at all. In fact, the recently released GDP numbers show that the US economy is already contracting faster on an annualized basis than in the “More Adverse” scenario. Similarly the Bureau of Labor Statistics has already published unemployment numbers that exceed 13%. The SCAP does not even explicitly incorporate issuer default forecasts in its analysis. This seems strange in the context of a comprehensive risk assessment of lending institutions. We could go on with further criticisms of the process but it would belabor the point.

 What this means is that the magnitude of the continued vulnerability of the banking system to economic weakness will not be revealed; the deposit-making and investing public will not know which banks are in real trouble and no transparent and credible plan to find and apply a solution will ever be found as a consequence of this exercise.

 The whole point of the SCAP it seems has been to obscure the problem and prevent anyone from finding out how bad things really are. Most likely this is because there is significant confusion and debate within the Fed and Treasury and the Administration on the best way forward. These institutions appear to be making things up as they go along.

 Despite our assessment, it is not clear that come Monday the SCAP report will announce a clean bill of health for all 19 Banks. That may have been determined to be too much for the market to swallow. More likely is that some of them will be shown to be at risk, but that on balance the system will be given a “Pass”.

 This amounts to a very risky bet that the economy will improve sufficiently and within a short enough timespan in order to re-float the many sunken US banks that so far no one is admitting to the existence of.

 What this means for investors is that traditional areas of activity – stocks , bonds and real estate – will remain danger zones despite the recent stabilization and/or uptick in prices. The apparent manipulation of this process also suggests that the current positive price action very likely constitutes a Bear Market Rally that should be avoided unless one intends to trade from the long side with tight protective sell orders and the intention of bailing before the music stops yet again.

 In coming months we would not be surprised to see forward thinking investors contemplate entry into markets that are un-correlated with stocks, bonds, and real estate, and to diversify out of US Dollars – buying up commodities, precious metals and other instruments. Despite what US Representative Barney Frank has recently said about America’s largest foreign investor (”They are bluffing!!”), China is already leading the charge away from the Greenback.

  ”The Fed was forced to improvise in the Bear Stearns, Lehman and AIG episodes. These improvised actions have had mixed success”   St. Louis Fed President James Bullard

Posted in Bank Loans, Bond Market, Crisis, Economy, Stock Market, USA | No Comments »

The Politics of Denial meet the Economics of Hypocrisy

 

 “When the Blind lead the Blind, both will fall into the water”            Old  Chinese Proverb

Several months ago we referred to market psychology as being in a State of Denial as regards the Death of the Bull Market. This diagnosis can now usefully be extended to the New Administration and Congress. At every turn this Administration, similar to the last, is making decisions believing that somehow everything will turn out alright in the end – that the massive deficits will be financed overseas, that we in the West are not vulnerable to further financial disruption, that missteps now could never produce social dislocation, not to mention risk heightening geopolitical stress and the probability of conflict. In short, the intent of their public communications has been to assure the US electorate and those beyond its shores that life will go an as before.

Don’t Worry; Be Happy

 The actions and public pronouncements of the American Leadership however belie this unfounded optimism. Throughout the current crisis, and at each critical stage, US policy-making authorities have taken steps that are in violation of a basic rule of decision-making under uncertainty.

 

Specifically, at each of the recent major decision points the US Leadership has opted for alternatives and commitments that cannot be changed very easily, They have done so in place of pursuing more flexible, better advised policy options that are consistent with the substantial uncertainties that still swirl around our current predicament. In so doing they have constrained possible future courses of action, increased the risk of even worse problems occurring in the near future and made the World a more dangerous, as opposed to, a safer place.

 

Let us examine this hypothesis in somewhat more detail:

 

Son of TARP

 

Pity poor Secretary Geithner. His plan got panned. The reason for this is that it fell far short of the Scale and Detail needed to adequately combat the current problems.

 

The reality of the present situation is that we are in a Global Solvency Crisis. We are not in a Liquidity Crisis. There is ample liquidity, there just isn’t a whole lot of capital left. In the United States there is on the order of $3.0 to $3.5 Trillion of losses still unannounced and sitting in the financial system. This dwarfs the remaining $400 billion or so of financial institution equity that remains on balance sheets following the debacles of the last year. To be sure much of what is bring counted as equity would make even Andy Fastow blush. Take for example the $44 Billion of “deferred-tax assets”  that Citigroup is claiming as Tier 1 equity. This is an amount that represents accumulated losses that the bank hopes to use later to cut its tax bills. The number accounts for over half of Citigroup’s reported Tier I Capital, is more than three times what it was a year ago, and more than double the company’s $19 billion stock-market value.

 

Citigroup is not alone in this situation. The entire banking system in the US is effectively insolvent. This is why it makes more sense to conduct a comprehensive Stabilization and Triage operation as soon as possible instead of trying to ram piecemeal pieces of legislation through Congress that address in part but not in totality or in scale the various issues that need to be addressed and the way in which this must occur. The steps taken so far – borrowing vast amounts of money to prop up zombies; being unduly concerned about micro issues like executive pay and perks and making various pronouncements to the markets regarding the size and scale of the problems without disclosing the “how” of the bailout only serves to sap market confidence. Most importantly the recent announcement reflects a fundamental failure to understand that banks aren’t going to lend (and neither is anyone else except the Fed) as long as collateral values are falling and/or are still unknown.

 

Parenthetically, the Congressional Oversight Panel recently disclosed that assets bought by TARP are now worth $78 billion less than they paid for them. Not bad for a three month turn!!

 

The Stimulus Package

 

President Obama is on record as saying he will not run in 2012 if the package fails to deliver the intended benefits. His Staff better tell him to stop making these type of promises. Such rants are in fact best confined to election campaigns and later forgotten.

 

The Stimulus Package is anything but, but you would not know it, listening to the Obama-ites and the One himself. This past week ahead of his first Press Conference, President Obama lobbied hard for the Stimulus Bill. In fact, the numbers show he spent about 3½ minutes out of his 7 minute address talking about all of the roads and bridges that were going to be built.  From that one would have thought that about $350-400 Bn of the total package would be devoted to infrastructure renewal and other shovel-ready projects. No such luck.  The infrastructure spending total is around $30 Billion or less than 5% of the total vote contained in the Bill. The remaining monies are being largely spent on items that the Democrats hope will allow them to tighten their grip on power in the next mid term elections and some other initiatives that will not kick in for years.

 

However this only begs the question of why they are engaging in this spending in the first place. Every available shred of evidence from Weimar to Hoover to Latin America to Japan’s Lost Decade to Gideon Gono in Zimbabwe shows that you cannot spend your way out of this type of a predicament. Add to this the fact that the severity of this Depression is being made even worse by the Fed’s policy of holding interest rates at artificially low levels, which discourages savings – the exact opposite of what we have for some time being saying is needed.

 

One Trick Pony?

 

The scant weeks since the Inauguration have not been kind to the new President. The Stimulus Bill passed without any real bipartisan support. Several of his high ranking cabinet nominees have had to abandon their candidacy. President Obama has been given a rough ride in the foreign press, and received a public bollocking from President Ahmadinejad of Iran. And, although he still enjoys a high degree of public support, the President is down 20 points in the opinion polls,

 

Candidate Obama promised Change. President Obama gives is the same old spin in a different package.

 

Candidate Obama promised fiscal probity. America saw its debts double under George Bush. Under President Obama they are going up at a faster rate.

 

Candidate Obama promised bipartisanship. America gets to see partisan politics at their worst with President Obama leading the charge.

 

Candidate Obama promised fairness and transparency. America gets a President Obama who recently appeared to want the White House to have a say in the use of Census data and the redistricting of electoral boundaries.

 

We could go on. Suffice it to say that no one (except the Obama-ites) in the US is still in Campaign mode and we are hoping the President Obama is soon going to snap out of it too. Let us further hope that the new President is a fast learner, and that the first thing he now starts learning and doing is to get some substantive and workable policies in place. The World is waiting.

 

The Bottom Line

 

We are not the only pessimists. Many prominent politicians, economists and thinkers are joining the ranks of those that perceive the West to be in the midst of an unfolding crisis of vast proportions that is being fed by a sequence of serious policy failures.

 

Recently in Malaysia, IMF Managing Director Dominique Strauss-Kahn said the world’s advanced economies — the US, Western Europe and Japan — are already in depression, and that the IMF would slash its global growth forecasts further.

 

Jacques Attalli, the former inaugural Head of the EBRD stated recently “The major powers think that the crisis is only fleeting, and that we’ll soon return to the old order. No one really wants to undertake the profound changes necessary to resolve it. Although the world’s public debt should be cut, now it is only being increased.”

 

The result is that Foreign Investors who are being asked to foot the bill for all of these shenanigans in the United States are becoming increasingly impatient with the leadership there. We have revised our earlier expectation that the US might be able to run this game for a few years and now beleive that they are going to be tested much earlier. In the absence of immediate, substantive and effective policymaking it is highly questionable, due to the speed of the unfolding crisis and competition for limited investment funds, that  the US can play at this for much longer before foreign sources of capital dry up and it is forced to decide whether to bite the bullet and to then implement a set of appropriate policies or to keep rolling the dice.

 

Posted in Bank Loans, Bankruptcy, Banks, Bond Market, Fed Policy, Stock Market, USA | No Comments »

Oppenheimer Redux

 “We don’t know what to do. It’s really a throw-the-kitchen-sink-at-the-problem strategy”

 Kenneth Rogoff
former Chief Economist at the International Monetary Fund

We have been trawling through the usual year-end smorgasbord of predictions, prognostications and punditry. We have reviewed the usual plethora of numerical price targets, the sectors to watch out for and the hot stocks and so on but have come away from the table feeling a little empty.

Therefore we have to say “Thank You” to Professor Rogoff for his frank admission that the authorities have been fumbling in the dark for answers to the problems they ignored until it was too late.

In our view what most of these commentators are missing, (with the exception of Ken Rogoff and a few others) is the fact that the markets are still in fundamental disequilibrium. Nothing has been solved. The size, scale and prioritization of the financial policy issues that need to be dealt with is still far from being clearly reflected in the policy responses we have witnessed to date.

Significant, unprecedented risks to the system remain and we observe that whether the Western economies will emerge from this debacle relatively intact and soon; or, whether additional painful and extenuated maulings are in store is a Big Picture question that hinges on expectations regarding the level of US Treasury yields, the debt calendar, the dollar exchange rate and their combined effect on saving and spending decisions the world over. These critical factors will overwhelmingly drive investor expectations and activity in the months and quarters immediately ahead in all markets.

Buy Bonds for Paulson

Yields on US Treasuries have plummeted to historic lows. The 10 year Note currently pays a scant 2.25 %, a level that is below the rate of inflation, placing real investor returns in negative territory. Yields on T-bills are zero, meaning that Investors in those instruments are in effect financing the US Government at no cost to it and costing investors even greater negative returns in the process.

In September Hank Paulson announced the TARP aimed at averting catastrophe in the financial markets – price tag: USD 800 billion (USD 700 billion plus the add-ons and the pork). This, in combination with slowing tax revenues and new stimulus initiatives already in the works by the incoming Administration, will boost the US national debt by as much as USD 2.0 trillion in fiscal 2009 – an unprecedented increase in Treasury supply.

Currently US Federal Government funded debt stands at a shade under USD 11.0 trillion or a little over 70 percent of gross domestic product. Approximately 40 percent of this total is short term, meaning that it will mature in under one year. (Note that the short term debt includes not only current “on-the-run” Bills and cash management instruments but also significant quantities of seasoned Treasury Notes and Bonds which had original maturities of up to 30 years)

This means that in the next year the Federal Government will have to roll over about USD 4.3 Trillion of Debt on top of the estimated USD 2.0 Trillion of new financing.

Assuming that there are no more financial shocks, tax cuts or new spending initiatives, the debt managers at the Treasury have been tasked by their Fearless Leaders to find buyers for around USD 6,300,000,000,000 of US paper within the next twelve months. This is unparalleled by an extremely wide margin (and extremely inopportune for reasons discussed immediately below).
 
 
Care and Feeding of the Golden Goose

For years the US has typically enjoyed lower debt financing costs than other nations at every point on the yield curve. In addition, despite running high trade deficits the US was able to fund its fiscal and trade requirements effortlessly due to an “Entente Cordiale” between it and the countries with which it runs a trade deficit. The basic deal has been: We (the US) will buy your goods and in some cases provide a security guarantee and other multinational goodies (support for WTO membership and so on), and you (the surplus country) will buy our Treasury debt securities (and do us other favors). The ability of the US to cut these deals has relied not only on the fact that since 1971 the US Dollar has functioned as the World’s reserve currency, it is also because the US exercised (mostly) sober political leadership, has the World’s largest, most liquid and most (arguably) transparent capital markets, effective control of key multinational institutions and an overwhelming military capability.

Historically, the US could therefore borrow what it wanted at prices set by it regardless of the wisdom or efficacy of the economic policies it was following. In economic terms this meant that the supply schedule for imported funds into the US had zero slope, i.e. it is invariant with respect to the level of the USD, US interest rates or US funding demand.

As with any mechanism, this will work fine until it stops working.

This Postwar status quo ante has led most commentators and analysts to assume that this time around it will also be business as usual. These pundits maintain that because Japan ran large deficits in the 1990’s at negative real interest rates with no problem and no impact on the currency that it will be relatively simple for the US to achieve this feat. We beg to differ. Japan was able to do this because:

• Japan has a very large, persistent Trade Surplus. The US Trade Deficit is running at over 5% of GDP;
• Japan has a very large supply of domestic savings which soaked up all of the government debt supply through captive issuance channels (Kampo, Yucho and the domestic financial institutions). Short of printing money, the US is dependant on foreign investors to finance ongoing activity; and
• In terms of timing, Japan was alone in experiencing its own bubble and bust. The US is at the center of a Global Maelstrom which is laying claim to a chunk of everyone’s pot of savings.

To this we add that the recently rising USD and coincident low Treasury yields are a consequence of some very temporary factors in the marketplace.

•  The $700 Billion Lehman bankruptcy. Lehman had operations in dozens of countries. US Bankruptcy law requires that the bankruptcy trustees must consolidate the assets in the US or US controlled jurisdiction and in USD. Naturally this has boosted demand for USD in the short term;
• Repatriation of overseas assets by US private investors and institutions reacting to price declines and volatility in the US markets. (The flip side of this was the massive sell-off in many emerging and overseas markets in sympathy with the US.) This has also ramped spot demand for USD;
• The flight to quality by investors dumping toxic MBS and other structured paper;
• The parking of all of this cash in US Treasury Bills, Notes and Bonds sending their yields to historic lows;
• Parenthetically, the forced deleveraging has also hit other asset markets that were being propped up by large speculative positions held by banks, hedge funds and others that are now in liquidation because of the credit squeeze: Energy, Hard and Soft Commodities, Life Settlements, Corporate bonds, Municipal Bonds (You name it!)

What the current configuration of US Interest rates and currency values essentially means is that we are in a bubble which has arisen in part because of policy actions taken to combat the deflating sub-prime bubble. It is an aftershock, not an equilibrium state of affairs.

Pax Americana under Threat

In a fiat currency world it all comes down to confidence. And in a world where you are running a deficit profile of staggering proportions it all comes down to the confidence of foreign investors.

The “by-the-book” policy prescription for banking crises is for the Central Bank to raise rates, not to lower them. Higher interest rates are needed to ensure that foreign investors continue to supply credit to the debtor country. This policy move is typically supplemented by measures to shore up system liquidity using Central Bank support. Weak institutions are allowed to fail or are forcibly merged thus cleansing the system of the detritus and excess which led to the crisis in the first place.

The Fed and other Central Banks globally have done pretty much the exact opposite of this – they have cut rates and propped up most of the zombies. Foreign investors (Governments and Institutions) are now being asked to continue financing yawning US deficits at zero or negative real yields.

We submit that this state of affairs is fundamentally unstable, unsustainable and financially very risky.

Therefore, look for the following to occur in the coming months and quarters :

•  The US will be unable to achieve issuance levels of its debt in sufficient quantities along the yield curve to keep its Fixed/Floating exposure ratios within acceptable bounds. (The usually acceptable range of a Fixed/Floating mix is between 60/40 Fixed/Floating and 80/20 Fixed/Floating. The US is already at the outer bound of this range at 60/40. A higher proportion of floating issuance will mean even greater sensitivity of debt servicing costs to short term rates. For a wider discussion of Sovereign debt management go here on the Recovery Partners website)
• There will be failed Treasury Auctions. (Can’t believe it can happen in the US ? It already has, in the mid-90’s when I was a sovereign debt manager myself in an OECD country.)
• Interest Rates will rise along the Yield curve except where the Fed has most influence: one month and under. The yield curve will steepen considerably;
• The USD will sell off against the currencies of other countries whose financial policies are deemed to be more sensible or stable than those of the US; and, importantly, it will also depreciate in commodity terms; 
•  The US may decide to print money to “buy” its way out of the situation. Bernanke has already indicated that he will not hesitate to do this;
•  In the extreme the US may have to fund itself in currencies other than the USD because foreign investors go on “strike” until it cleans up its problems or provides them with a new “deal”. The key overseas debtholders here are China (25%), Japan (20%) and the UK (5%) who together own around 50% of US foreign held debt. (This latter development would be very serious and likely only occur after a period of significant geopolitical stress. If it did occur, the second order outcomes would likely include more geopolitical stress and unpredictability, probable domestic unrest and significantly increased incidences of adventurism by the usual cast of rogue states.)

“The ice age is coming, the sun is zooming in
Engines stop running, meltdown expected and the wheat is growing thin
A nuclear error, but I have no fear
London is calling – and I live by the river”

The Clash “London Calling” (emphasis added by Recovery Partners)

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Whistling past the graveyard

The markets continue to whistle past the graveyard. Most commentators are in fact suggesting that the worst is behind us and that the Fed’s rescue actions have saved the day yet again.

We couldn’t disagree more.

In her seminal work “On Death and Dying” Swiss Doctor Elizabeth Kübler Ross postulated that there were seven stages of coming to terms with reaity upon being told that one has a terminal illness. Denial is but the second stage following Shock. There are four more stages before Acceptance is reached and the stricken individual can again find his or her forward. We are obviously past the Shock stage. We suggest that markets are now experiencing Denial.

Anger and Depression lie ahead for investors who do not yet understand that the Bull is DYING and will soon be DEAD.

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Half way there

In 2007 Recovery Partners became engaged in a $500 million bad loan remediation in Asia. Working for certain Multilateral Financial Institutions, in part our activities determined early on that the Central Bank of this particular country had attempted to shore up financial problems in the agricultural sector by using its balance sheet to support unprofitable borrowings by private sector entities. The game had gone on for a few years but was doomed to crash. Unsurprisingly, the finances of this country and the private sector entities involved are in a now in a shambles.

This morning we heard that the Fed is attempting to shore up liquidity problems in the shadow banking system (i.e. bankruptcy-remote private sector asset backed funding vehicles) by extending its balance sheet further. It has now encumbered more than half of it’s almost $1 TRN in financial resources, by supporting re-purchases of assets that  are either non-financeable or non-priceable in the open market – in short, assets that are unsellable, unprofitable and illiquid.

Time to batten the hatches. This is going to get worse before it gets better.

Posted in Crisis, Economy, Restructuring, Stock Market, Sub-Prime | No Comments »