Smurfs on Ice

 “For the most part, and with the possible exception of me, I don’t think anybody goes out to try and hurt somebody”           Jeremy Roenick,  former NHL forward

With all of the wailing and howls of protest regarding increased regulation, salary caps and bonus eliminations coming out of certain sectors of the North American economy, it is (perhaps to some) refreshing to see corporate executives in at least one industry marching in total lock step with the US Government’s attempts to fight economic reality. The current debacle in Phoenix regarding the fate of the Coyotes hockey franchise there has opened the window wide on the leadership approach and decision-making style that holds sway in the NHL today.

The mindset appears to be not too dissimilar to the mentality that holds that debt problems can be fixed with more debt, that the Fed can expand credit without limit or ill effect, and the requirement that the consumer sector retrench and shore up its finances can be successfully challenged with “Cash for Clunkers”, outright handouts and other blandishments that will theoretically be paid for not by today’s beneficiaries but by tomorrow’s taxpayers.

Faced with a soft economy, a significant proportion of  NHL clubs (not only Phoenix) are in distress; if it is looking ahead at all, the NHL is probably seeing lower attendance figures, lower corporate marketing spend and lower revenues generally. Some of the owners may be looking “over the next rise” in this fashion. Unfortunately and more to the point, the Phoenix debacle however shows that the current NHL leadership has chosen to divert attention from more pressing commercial concerns, to spurn the injection of fresh outside investment capital into its business, and to effectively act in defense of toxic investment decisions that it itself promoted to itself.

That the NHL leadership has chosen to allow this situation to deterorate to the point where it must participate in a courtroom display centering on the efficacy of its business plans has to be counted as a “first” in business history.

But there are Principles at stake.!!

Yes Petunia, there are principles, and there are principles that you don’t want to risk losing. When they didn’t have to, Mr Bettman and the NHL leadership decided to bet the house on defending the principle that the NHL should have the right to determine where its franchises are located. Instead of principles Mr Bettman should possibly have focused his attention on “cats and how to skin them”. Mr. Balsillie’s support of the NHL is arguably the best thing to potentially have happened to the league since Walter Gretzky decided to flood his backyard in the 1960’s. “How to do a deal” should have been the priority, not “how to stop a deal”. Mr Balsillie is real, he is interested, he is successful, he is connected and he has some good ideas that promise to enrich the game for all the participants – fans, players and owners.

 We do not know of any points of agreement that may have emerged from the recent mediation that was imposed on the Chapter 11 process by Judge Baum last week.

What we do know is that NHL has had negative control of this situation and over the course of the discussions with the Phoenix ownership and latterly with Mr Balsillie for several years now. Given that this process has become very expensive, and given that Mr. Bettman has chosen to lead the League into a fight, which in the context of the negative control position, referred to above is unnecessary, it must be asked of the Commissioner why a solution still hangs up in the air on the cusp of the new Hockey Season? Why has Mr Balsillie’s interest not been turned into the huge positive that it could be for the league?

Mr Bettman has chosen to defend opacity, arbitrariness of decision-making and confused governance in rejecting Mr Balsillie and in not working hard to come to an accommodation with him.

Is the league more profitable since the Southern expansion started? Is the game more popular in the Southwestern US States? Are the endorsement and marketing contracts bigger? Surely by referring to these simple metrics and a few others a normal businessman would be able to determine that a particular expansion strategy was sound and should continue to be pursued.

Clearly, the foregoing considerations dictate that, at a minimum,  the NHL should consider its position on these matters. However, the Phoenix bankruptcy saga is but a symptom of the problem that is afflicting the NHL, it is not the “The Problem”. Whether or not the Bettman – Balsillie fight drags out, the NHL is already encumbered with  reputational and financial challenges. Aside from this aspect, “The Problem” has many dimensions, among them are: 

• Almost one-third of the NHL Clubs are in financial difficulty and/or on the block. The economy and the Coyotes saga are making them less valuable.
• The NHL is Missing Opportunities, for example, the various TV deals, when measured against a team roster show that TV revenues “per player-per game-per team” in the NFL are 26 times higher in that league than in the NHL.
• The NHL does not have a Coherent Marketing Strategy. It has fallen short in embracing internationalization, and the marketing of and investing in opportunities in hockey-mad countries, choosing instead to waste resources on folks that would rather be watching NASCAR and playing golf year-round.
• The NHL Governance Model is out-moded and is exceedingly non-transparent, which provides an open invitation to hucksters of many stripes – Del Biaggio, Samueli and McNall to name a few.
• As evidenced by Mr Moyes’ de facto indenture which has so far cost him almost $300 MM and other situations of this nature, the NHL has continually fallen back on the “somebody else must pay” revenue model.
• Mr Bettman’s tenure has been punctuated by various missteps, gaffes andoutright  mistakes, the like of which any one or two would have been sufficient to cause a normal CEO-type to be led straightaway to the Gibbet. Somehow he has survived all of this value destruction despite also being an obvious impediment to positive change.

At a time when the league is in difficulty, serious questions must be asked of someone who chooses to marshal scarce financial and professional resources to fight this fight and “bid” for the Coyotes when other more pressing items (see above) should precede it on the agenda – especially since Mr Balsillie promises to bring fresh capital to the table.

Mr Balsillie’s expression of confidence in the NHL should not be undervalued in any way, shape or form since the current financial debacle has dried up sources of capital for numerous industries. Banks are stingy with lending cash. This is not a credit-friendly environment.

Enema Now…Rah ….. Enema Now… Rah Rah!!!

If the NHL continues on this path, our prediction is that within a short period of time, within say twelve to twenty four months, it could find itself in serious financial difficulty – maybe even Chapter 11. It does not to us seem sensible that in this economy, any enterprise could withstand the various incompetencies and goofs that are piling up in increasing amounts on the NHL’s doorstep. Therefore our message to the Fans, Governors and the Players Association is that the NHL needs a “Corporate Enema” now. Consider the following:

• Your business is valuable, but it is a long, long distance from being as valuable as it could be. Your revenue model is in fact now under threat.
• Your Leadership must change. Mr Bettman seems to have surrounded himself with like-minded individuals who are not commercially orientated and who view matters through a narrow, legalistic lens. The League Front Office has ossified, yet seems to have the Board of Governors in its back pocket. The NHL needs Vision, Ingenuity and Execution; not Cronyism, Legalism and Confrontation. Investigating the processes for removing the Commissioner must proceed without delay. (Is he a Stalin or an Italian Prime Minister?) The findings here will determine in large measure how high the Mountain is that needs to be scaled. However, if Judge Baum makes a ruling detrimental to the League, even modestly so, this could simplify matters greatly in this area.
• Your Opaque Governance Structures must change. The recent vote, for example, by 26 NHL Governors against Mr Balsillie, accompanied by some abstentions (most notably from the Leafs) AND the contemporaneous NHL bid proposal for the Coyotes, smacks of thinly-veiled self-dealing and does not pass the smell test.
• You must understand that these changes are not going to be palatable to everyone. Some Clubs will need to be put down or reorganized. Players might lose jobs.
• You must seek Trusted Advisors Now to help you make those changes

The Puck Stops Here

For his part Mr Balsillie must answer for his confrontational behavior. He has chosen to crash the net repeatedly and this has raised the ire of the NHL leadership. This behavior has clearly risked having him lose the “prize”. We will all have to wait and see on that one. However, if he is to claim the prize, a prerequisite step will likely be that he rapidly and personally repair bruised relationships and  establish sufficiently collegial relations with the ownership groups and at the Board of Governors level. An accommodation must obviously be reached with affected Clubs if he is to move the team.

As for the Glendale City Leadership and their Jobing.com albatross – Too Bad!! This is a bankruptcy and you need to carry the can for your lousy decisions. Under any conceivable outcome to this process, their $500 MM claim will be shredded by what is, by definition, a bankruptcy estate limited to far below that fantasy number and accompanied by a defined waterfall as relates to the distribution of valid outgoings. Sorry, but you might not get re-elected.

Whatever Mr Bettman, Mr Melnyk or the other owners might think of Mr Balsillie, in our opinion he has  done a great service to Professional Hockey. He is knowledgeable and passionate about the Game, and seems to have an instinct as to where this league needs to go in order to maximize the experience for the Fans, Players and Owners. His quest has cost him significant sums of money and his personal reputation to a degree, but assuming that the NHL’s problems meet solutions as discussed above, we all stand to benefit from the sacrifice he has made in exposing the serious weaknesses in the current stewardship of the Game.

For his efforts and perseverance,  Jim Balsillie merits appreciation and high regard whatever the outcome of the Coyotes saga. Here at Recovery Partners we wish him all good fortune in his quest to turn around the Coyotes and exert a positive influence in the NHL.

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The March of the Kakistocracy*

 “You don’t have to pass an IQ test to be in the Senate”       Sen. Mark Pryor (D – AR)

 The dog days of August are here, the markets are largely quiet, news of strife in far off places is light and even Somalian pirates seem to have dropped off of the radar (literally). In fact, aside for some unusual tornado activity north of here, we are not even in receipt of the customary tidings  of hurricane and other weather related devastation that one normally one hears of at this time of year.

 Therefore it was with some degree of expectation that we opened a box that arrived in our office last week. In it were a couple of new books from Bill Bonner and Addison Wiggin . The new arrival that we chose to read first was “The New Empire of Debt” (John Wiley and Sons, 2009, 356 pages) available at Amazon and other booksellers . These are the folks that also brought you I.O.U.S.A.

 The book begins with a rollercoaster ride through history, examining the rise and fall of civilizations and empires of yore. The Mongols, the Greeks, the Persians, the Romans all had a kick at the imperial can. Sometimes the book is serious, and sometimes it is falling off the chair funny – completely at odds with most treatments of economic history.

 Much in the tradition of “Collapse” by Jared Diamond, Bonner and Wiggin examine in detail the process of empire building and the taxonomy of decay. Corruption, Hubris, Military Over-extension, Financial Mismanagement and the Emergence of Rival Powers are all typical hallmarks of the slide. The narrative leads us up to the present day and details the ascendance of the United States through the latter part of the 19^th century and the first half of the 20^th century to unrivalled political and military power.

 Their thesis is that the economic underpinnings of the current US hegemonic set-up are unstable. Instead of having the periphery support the center through the payment of tribute, the US has inadvertently subsidized the emergence of competitors and bankrupted itself. This entropy began to occur in earnest when Nixon abandoned the Gold Standard, it accelerated under Reagan and is reaching a blow-off stage now with Obama in charge. When the blow-off actually happens is not ventured, but on present course the authors say that it is inevitable. By way of comment here, we have discussed the structure of the Pax Americana in previous blogs and the treatment of it in this book is largely in agreement with our views.

 The authors state further that an “Entente Cordiale” of deluded bankers, economists and politicians is preventing the needed policies from being implemented and is hastening the onset of Financial Armageddon: 

• The policies being applied to support a resurgence of growth in the US and elsewhere won’t work. The book details previous attempts at applying similar policies in similar circumstances. (We agree with this in spades as our previous blogs will attest) 
• The monetary authorities have created an “Inflation Bomb” that they will not be able to defuse. This is a key observation to us. In our humble opinion if the United States Dollar had not been the main Reserve Currency, the steps taken so far would have already blown up the US Economy. Quantitative Easing does not lead to an immediate blow-up only if you can convince other central banks to go along with you, and keep up with you in running the printing presses. Even then, this policy can have only fleeting benefits as it does not solve the underlying problems; 
• The recent policy moves have led to the inflation of a Great Bond Bubble that will burst as the weight of upcoming Bond Supply proves overwhelming relative to the supply of Global Savings. ‘Nuff said, see our blogs from last January on this point;  
• Due to these factors the decline of the US dollar is inevitable. “When” is the question, not “If”; 
• Buy Gold to protect yourself. Natch.

 Whilst we do not agree with everything that the book has to say, we agree the majority of the arguments and we find the context and perspective that it brings to these issues refreshing, well researched and well-written. Unlike many of the writers in this space, the prose is not verbose, bombastic or shrill. This is a thoughtful and cogent treatment of the most important issue the World is facing today.

 You are in good company reading this book. Among those endorsing it are Pete Petersen, Warren Buffett, David Walker, Paul O’Neill, Jim Rogers and others. We recommend that all elected officials and concerned citizens everywhere consider this book required reading.

 * Kakistocracy: Government populated by the most corrupt and inept members of a society.

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The Phony War

(The Phony War is a phrase coined to describe the months following the German invasion of Poland in September 1939 and preceding the Battle of France in May 1940. The Great Powers of Europe had declared war on one another, yet neither side had committed to launching a significant attack, and there was relatively little fighting on the ground.)

 Every so often it is important to reflect on one’s earlier expectations for the market and the quality of the predictions that one has made to support and guide one’s business judgments. Here at Recovery Partners, we have been consistently bearish on events for the past three years – and we have been largely correct.

 The meltdown in the sub-prime area came as no surprise because, in addition to other factors, we had been flagging the weakened condition of the GSE’s for some time, while Paulson and Bernanke were hailing them as possible saviors of the US housing market.

During a TV interview in October of 2007 we projected that US Speculative Grade Default Rate would reach or exceed 5% before the end of 2008. At the time of the TV spot, it stood just a shade above 2%. It ended 2008 just below 8% and it is now over 10%.

In July of 2008 we published our “Zombie List” of the top “walking dead” banks. Of the 14 institutions on the list, fully 10 have either been bankrupted or forcibly merged. The others have all accepted TARP funds.

We have repeatedly warned that the stock market was vulnerable and that defensive-minded investors should avoid it altogether. We first provided a warning in January 2007 and repeated the warning before the avalanche in September 2008. The market is over 25% lower today than when we first piped up on this topic.

In January of this year we warned that the configuration of Bond Yields in the US was unsustainable and that rate rises should be expected in the immediate and medium term ahead. At the time of our call the US Ten Year Treasury Note was trading at a yield of 2.25%. Since then it has risen to yields approaching 4% before settling back somewhat. We continue to be very bearish on US term interest rates in the medium term.

We have for some time also said that the US stimulus package was unlikely to have the intended effect. The general view now is that additional stimulus is likely required and that US unemployment  will most probably rise yet further, contrary to the jawboning and promises made by various officials prior to the passage of the monster spending program.

With all of the foregoing under our belt, you would think that we would be feeling pretty good. Unfortunately this is not the case. We are disappointed because while making all of the earlier calls, our “sidecar” expectation was that there would be ample opportunities for Recovery Partners and firms like ours to provide advisory services to financial sponsors who were backing now-failing companies; and that this would be accompanied by a large flow of distressed loans into the market, thereby creating additional opportunities for us, our competitors, and our service providers.

Unfortunately, so far the bankruptcy statistics are not telling a tale of undue financial stress, and activity in the distressed M&A market remains at a low ebb. True, in the US the number of business failures is up about 190% from the trough in 2006. However the annualized run rate is only tracking on a par with the experience of the relatively mild recession in the early 1990’s. That said, the number of personal bankruptcies has escalated rapidly in the US, consistent with the scale of job losses. The weakness of consumer finances promises to restrain consumption activity and will further stress the corporate sector.

In Canada we have also seen rapid increases in personal bankruptcies that mirror the weakness in the jobs picture and the cost-cutting efforts of many firms desperate to remain in business. However, on the business side of the coin, the situation in Canada is positively perverse. In the latest twelve months of data, which arguably spans the most severe economic crisis of the Postwar period, the incidence of corporate failures in Canada has actually gone down! The data show that there were 5.7% fewer bankruptcies coast-to-coast in the year to April 2009 than in the twelve month period to April 2008.

Although it might seem unreasonable that the flow of defaulted loans has remained relatively light in the US and that it has actually decreased in Canada, there are some very good reasons why this is occurring and Recovery Partners is confident that the avalanche of activity that we along with other market participants have been expecting, is as a consequence, simply late in arriving:

• Recovery rates for both bondholders and leveraged-loan investors are hitting historical lows. According to Fitch, loan recovery rates for the first five months of 2009 came in at 57.5%, a full 10 percentage points lower than the 67.5% experienced during the last recession trough in 2002. This weakness in real asset markets has caused bankers to shy away from pulling the plug on weak customers in the hopes of better markets and prices ahead. 

• There were a number of structural issues associated with the boom in loan issuance in the four years that just preceded the recent Crash. Corporate balance sheets had become heavily tilted toward senior bank debt, but protective covenants that were normally embedded in loans were systematically relaxed or removed by market-share hungry bankers as the boom in loan issuance ran its course. This means that the early warning systems that signaled borrower problems in previous cycles do not in many cases exist in the current cycle and it is therefore now more time-consuming and laborious for banks to triage the Zombies in their portfolios.

• A reduction in market liquidity has not only impacted banks’ recovery prospects, it has also eliminated exit alternatives. In the years preceding the crash there were numerous leveraged loan funds, who, usually oblivious to credit quality, would eagerly pay up for whatever assets the banks happened to be selling. These participants are either out of business or have sharply reduced their activities.

•  Banks have been protective of their loan portfolios because they have wanted to appear as financially strong as possible in order to attract much-needed infusions of private sector capital. These issues were aimed at shoring up balance sheets that had been ravaged by sub-prime and related losses. Announcing large provisions on their loan portfolios would have done little to reassure investors who were being asked to put more money into these firms. This behaviour has to a greater or lesser extent been condoned by regulators and authorities in North America who have winked and looked the other way. Witness for example, the recent relaxation of mark-to-market rules in the US.

• Banks have extended forbearance terms to Zombie borrowers, jacking up spreads and adding on fees and restrictive covenants in the hopes of buying time until the economy improves. Then, one of two hoped for outcomes would allow the Banks to skate away from these problems: either (1) another lender would step in to take the Bank out of their position; or (2) the Borrower’s business would re-float in line with an improving economy generally. This strategy only buys time, it does not solve any problems.

 Unfortunately for the banks, time is running short. Further cracks are appearing in the banking system and the economy and the authorities cannot stop them from spreading. In fact our views on the Stress Tests reflect the opinion that the problems in the banking system are far from having been properly resolved and that in aggregate, US banks remain significantly undercapitalized. Moreover, numerous US Banks that have earlier qualified for TARP funds now have more toxic (Level 3) assets on their books than before the financial crisis began. Other areas of concern include credit cards, commercial mortgages, and of course the fact that anecdotal and other evidence continues to reflect an anemic US economy whose consumers are tapped out and who are either falling into unemployment or under-employment in vast numbers, where a substantial portion of the housing stock is under water, and whose Government is in a deepening fiscal hole.

Some of the stronger banks have therefore recently begun to aggressively set aside money for future loan losses. Last month Moody’s warned that over $400 billion in charge-offs the U.S. banking industry are expected to occur in 2010. While this number may be vastly understated, as have all of Moody’s and S&P’s recent similar forecasts, it should be expected that whatever the size of the number, a good chunk of the losses are expected to occur in commercial and industrial loans portfolios.

The situation is broadly similar in Canada with the exception that the amounts are rather smaller. Based on the differences in market size, and a reversion to normal default rate relationships between the Canadian and US markets, Recovery Partners expects a flow of at least $20 to $30 billion of loan-related charge offs to occur in Canada in the next 12 to 18 months.

In both countries we forecast that the affected sectors will be Manufacturing (particularly automotive-related), Travel and Hospitality, Forestry and related, Construction, Commercial Real Estate, Media and Newspapers, and Transportation. In terms of timing we anticipate that Canadian banks will begin to actively weed out the weaker credits in third and fourth quarters of this year and that this process will run through 2010 and into 2011.

 It took a good bit of time for the really serious shooting to start in WWII, and we reckon that we are now in the midst of a broadly similar lull (see last months post entitled “The New Normal”) that is seducing shell-shocked market participants with an array of false hopes as to the future economic picture. The World Economy is not out of the woods, additional, significant, credit-related carnage lies immediately ahead, as does therefore the bulk of the distressed investing and advisory opportunities that this cycle will eventually bring forth. In short:

“You Ain’t Seen Nothing Yet!!”

Randy Bachman,  Bachman-Turner Overdrive, 1974

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The “New Normal”

“The crisis did not come about because we issued too little money but because we created economic growth with too much money, and it was not sustainable,”

 Angela Merkel, German Chancellor

Last week your correspondent participated in a World Pensions Conference in Toronto. The event was well-attended by investors, hedge fund advisors, industry representatives and regulators from North America, Europe and the Middle East. I had the pleasure of speaking on a panel together with Cynthia Steer, Chief Research Strategist at Rogers Casey, a well known US Pension Fund Advisor. Our general remit was to answer the question “Has the US turned the corner and are we now seeing the green shoots of recovery?”

In one sense the agenda was timely because it comes on the heels of the recent trumpeting by the news media of the arrival of “green shoots” everywhere in the US and the expectation that a speedy economic recovery is a foregone conclusion.  Some of this recent chatter has included views to the effect that:

• The US Federal Government deficit blowout is actually a good thing because it will encourage politicians there to reduce it. (Our view: It is a testament to the skill of the DC PR mavens hired to work on this, that this argument actually made onto the airwaves.)
• The stress tests showed the banks to be in relatively good health so don’t worry. (Our view: the whole SPAC exercise is a cause for worry because it was heavily manipulated in order to achieve the announced results. We can all well imagine that the various news leaks surrounding this process would have been vigorously investigated unless they were officially sanctioned.)
• The stock market is signaling a recovery so stop worrying (Our view: It is a Bear Trap. Don’t buy into it!)

For now US banks are again standing tall in the elevator boots afforded them by the machinations surrounding the SCAP exercise. The spin machines in Washington have been working in overdrive to ensure that the message received by the markets and the public in relation to the stability of US banks is quite simple: “Nothing to see here…please move along…nothing to see here”. (For greater insight into how news and the media are regularly manipulated you would do well to read our good friend George Pitcher’s book “The Death of Spin”.)

Of far more interest to us was the turn of phrase coined by Cynthia, into the face of this bullishness when she asked: “What is the ‘New Normal’ that we seem to be moving towards?”. “Sure”, she commented, “we may have turned a corner, but what are we converging toward and what do we need to do from an investment management standpoint in order to take advantage of what is coming down the track?”

Are we going back to the “spend and borrow” culture that has dominated most of economic activity in the Western World for the last twenty five years? Or are we converging towards a James Howard Kunstler, post-peak-oil severe shrinkage of living standards and lifestyles kind of place? Will it be something in-between? It is hard to profile this Brave New World definitively given the many uncertainties swirling around.

However, in our view a return to the way things were a few years ago seems highly unlikely:

• There is still an overhang of housing inventory in the US;
• Private sector balance sheets are illiquid and must be restructured;
• The Income share of debt servicing is still too high and must come down; For example  The  Economist recently estimated that US consumers need to pay off $3 trillion worth of excess mortgage debt, alone, in order to get back to year-2000 levels. If all US savings were put to the task, even that would take 4 or 5 years at the present rate.
• Private Sector savings behavior needs to revert back to what it was in the 60’s and 70’s in order to finance a pay-down of debt;
• Manufacturing needs to work off excess inventories and mothball excess productive capacity. Until demand is restored then businesses have no need to invest in more plant and equipment.
• The US Budget and Trade Deficits need to come back into balance.

Add to this mix the fact that the US is no longer a financial superpower. Far from it. Last year the US borrowed 65% of the available savings on the Face of the Planet. On the basis of current projections it is expected to borrow the same ratio or more going forward. Is this sustainable? Is it righteous? Will the surplus nations call a halt to this profligacy or at least seek to change the terms of the arrangements?

Is the “New Normal” expected to feature a bond market where yields seem impervious to rising inflationary expectations, and massive increases in US note and bond supply amid fears of a Sovereign Ratings downgrade? We think not. In fact we warned last January that the configuration of currency values and bond yields was not at all consistent with the underlying fundamentals.  Since bottoming in January 10 Yr Treasury Yields have popped by over 130 basis points. our fears have thus proven out to some extent already, but we caution that we have yet to see the full force of the selling fury will impact the US bond market in the near future. Nothing would derail a recovery faster than a serious increase in term interest rates.  

So Wrong; So Soon

In January President Obama promised that his Recovery Plan would create millions of new jobs. Take a look at the foregoing chart to see how right anyone was to have believed him then (The March and April actual Unemployment numbers are superimposed on the chart he presented in early February). So far the authorities appear to have have succeeded in doing only one thing: They seem to have slowed the downward spiral of the economy. They have not stopped it. Things are only getting worse at a slower rate. They have not yet begun to improve despite the rhetoric and jawboning that has been inflicted on the markets to date. “When will the US authorities run out of credibility?” is in our opinion a more relevant question than whether there are “green shoots” springing up.

This is because to expect that we will return to the type of world that existed before the Sub-Prime Crash is to bet on very long odds indeed. To illustate this in part, one would need to hope that:

• The US Housing correction will shortly have run its course;
• US Employment trends will reverse imminently;
• US Consumption spending will snap back;
• The US Bond Market yields will stay around current levels or move back down;
• The Fed will be able to sterilize the injections of high powered money that they have put into the system;
• The Fed will be able to reverse its purchases of un-fundable toxic waste from various market participants;
• Foreign Investors’ appetite for US Government debt will hold steady and not wane;
• Commodity prices (especially oil) will remain in check.
• The US regains its status as the World’s sole superpower and economic Pole Star
• Solving a Debt Crisis by creating more Debt is the way to go;

Yet, this spread of outcomes appears to be exactly what the US authorities are betting on. They are making the bet that the “New Normal” is in fact the “Old Normal” and that that is where we are all heading.

The authorities there are hoping that economic conditions will improve enough and in a short enough period of time to re-float the many failed businesses and banks that need to be re-liquified and recapitalized. They are hoping that foreign investors don’t find another home for their surplus savings. They are hoping against all available evidence showing that the current policy moves have never succeeded in restarting activity in other economies and at other times does not, and will not, apply in this instance. They are hoping that the goal of returning to the relationships and old ways of doing things is not only a desirable objective, that it is in store.

We are not alone in registering these fears. Several Federal Reserve Bank Presidents including Thomas Hoenig of the Kansas City Fed, Jeffrey Lacker President 0f the Richmond Fed and Gary Stern President of the Minneapolis Fed  have all publicly criticized the line taken by the Fed and Treasury in managing the banking crisis, saying essentially that the moves have increased, not decreased, systemic risks.

 The Financial Lifeboat for the “New Normal”

Getting back to Cynthia on the investor panel: Her contention was that a risk-neutral portfolio for the “New Normal” environment might well be one that is sitting in a mix of cash denominated in different currencies accompanied by a 5-10% precious metals allocation and an allocation to some alternative strategies (Distressed Debt and Distressed Bank Deals) . No Stocks. No Bonds.

In our humble view, and looking ahead over the next several quarters and years, we completely agree with her prescription. This is because we expect the “New Normal” to feature severe bouts of market volatility and economic uncertainty accompanied by political instability intermittently punctuated by periods of apparent calm. The “New Normal” is therefore going to be a relatively inhospitable place for investment managers following strategies that rely on friendly markets and a ready supply of gullible clients. Added to the mix will be the additional financial pressures in the US that are associated with the shortfalls in the Health Care and Social Security spending envelopes. With the passing of the Baby Boomer generation into retirement these excesses will figure strongly in the investment environment and the financial flexibility (or lack thereof) that the US will be able to wield in relation to its fiscal challenges.

Together with recent geo-political concerns (Al Quaeda, War on Terror, War on Drugs, the loss of US hegemony etc) we are concerned that the ongoing global transition into a multi-polar political paradigm is fraught with a paucity of leadership and beset by conflicting policy prescriptions emanating from countries with new found influence on the world stage. The process is further encumbered by a veritable witches’ brew of unprecedented monetary stimulus and fiscal excesses. It will not be a smooth ride nor one that will likely end with a soft landing.

Brace for Impact – the “New Normal” is on the way!!

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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

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Eyes Only!!! – President’s Report ahead of the G20 – IMF Financial Sector Stability Assessment

1^st April 2011

His Excellency
Mr. Xie Xuren
Managing Director
International Monetary Fund
700 19th Street, N.W.
Washington, DC 20431

Dear Mr. Xie;

Using this opportunity I would like to express my gratitude to the International Monetary Fund (IMF) for its continued support of the United States’ economic reforms, including the ongoing IMF-sponsored Staff Monitored Program (SMP). We are currently taking the necessary measures to address the problems associated with the episode of misreporting and risk management failure that was exposed in 2007, and to remove the institutional weaknesses that led to it. The field work for the special audit of the Federal Reserve Board has been completed and the draft report was made available to Dr Gideon Gono, the Special Advisor to the Federal Reserve Board System, in late December. We also made three repayments to the IMF, and expect to make the remaining sixty-nine payments as scheduled.

It is heartening that macroeconomic developments through end-September of last year were positive, despite recent difficulties which include the domestic civil disobedience and disorder that occurred in the aftermath of the recent re-basing of the US Dollar to the US Peseta standard; the unfortunate nuclear incident in the Middle East and the subsequent repatriation of US military personnel and forfeiture of materiel from every offshore base and operational area outside of the Continental USA (see below for revisions to National boundaries), and the significant escalation in the prices of imported electricity and fossil fuels imposed by Hydro Quebec, Ontario Power Generation and certain other energy companies in Canada.

Economic growth was stronger than envisaged under the SMP. This was partly driven by a surge in overseas remittances from US migrant workers, which allowed the Treasury to accumulate net international reserves faster than programmed. We were able to achieve an overall fiscal deficit (excluding the externally financed Public Private Investment Program, PPIP), of 7.0 % of GDP, slightly lower than targeted, largely because of buoyant revenues. At the same time, concessional loan disbursements under the PPIP at end-year were faster than anticipated, though all disbursements were made under existing loan agreements and do not constitute additional borrowing under the definitions agreed with Fund Staff. As a result of these disbursements, we now project a higher amount of concessional external borrowing at end-December than programmed. In this context, the Congress, on October 28, 2010, approved a three year debt management strategy that sets a debt ceiling of 180 percent of GDP. We also tendered the audit of the state-owned car company GM/Chrysler and the state-owned electricity company AIG/Con Edison, and issued legislation establishing a supervision unit in the Department of the Treasury for regular monitoring of the financial operations of the 500 largest state-owned enterprises.

We are confident that we will achieve our SMP policy objectives for end-December 2012. In this context, we remain committed to the policies and targets I set out in my letter to you dated June 15, 2010.

It is of note that the external environment will continue to weigh on the United States’ macroeconomic outlook in 2011. The ongoing global slowdown, in particular in China, Europe and Japan will continue to dampen demand for US export goods and weigh on consumer sentiment. However, given significantly reduced direct linkages to global financial markets, we do not foresee any meaningful direct impact on The United States’ financial sector. All in all, we still aim to sustain the same growth level as in 2010, around 0.0% (measured gross of land and natural endowment sales and certain adjustments to our national borders – see below).

Social Benefit and National Security spending will be helped by the secession of Alaska, Oregon, Washington, Montana, North Dakota, and Upper New York State to join the Dominion of Canada and the re-districting of the southernmost 200 miles of each of California (to include all of Baja), Arizona, New Mexico, and Texas, into a buffer zone aimed at the containment of the drug cartels. At the same time, with global food, fuel and commodity prices soaring, we see inflation performance deteriorating throughout the year and the US Peseta depreciating in line with inflation differentials. As you know domestic CPI inflation in the United States remains stuck in the region of 12-15% while the inflation performance of our trading partners, most notably Canada and Europe remains anchored below 3%.

During the remainder of 2011, we expect to strengthen our net international reserves position somewhat faster than previously projected, and intend to save any revenue over-performance while maintaining strict expenditure control. This will be helped greatly by the anticipated revenues attached to the sale of the State of Hawaii to a consortium led by Club-Link Japan, Nike, and Tiger Woods Inc. Against that, it will take more time than initially thought to finalize the amendments to the new Federal Reserve Board Law and the new Commercial Banking Law. We have prepared a first draft of these amendments which go beyond the scope of the program, incorporating additional recommendations from the Financial Sector Stability Assessment (FSSA) report, and which we will now discuss with Fund Staff. We plan to submit these amendments to Congress by March 2012.

In this difficult global context, macroeconomic policies will be geared toward maintaining stability, while structural reforms will aim at raising the United States’ medium-term growth potential. The 2011 budget targets a modest overall fiscal deficit (excluding the PPIP) of 8.0 percent of GDP, allowing us to raise social spending by over 25 percent and undertake important investments in entitlements, roads, hospitals and other infrastructure. We do not see any scope for any reduction in the growth of net-debt in 2011 due to these important initiatives.

Negotiations with foreign creditors over Instruments and Guarantees issued by the Federal Reserve Board and Treasury are currently ongoing, and we are committed to settling all valid claims promptly while maximizing recoveries from domestic borrowers including the Federal Government. Our structural reform agenda for the remainder of 2011 will focus, inter alia, on: improving the deteriorated financial position and governance of the Federal Reserve Board, enhancing transparency and management at key state-owned enterprises, strengthening tax administration and public financial management, and creating an environment for financial sector re-development.

In line with our commitment to transparency of economic policies, we will continue publishing all SMP-related documents on the IMF’s website as well as the recent FSSA report. In addition, we will publish all key findings of the special audit of the Federal Reserve Board on the Federal Reserve Board’s website. Given the good progress we have made so far under the SMP and our firm commitment to successfully completing our 2011 program, we hope to begin discussions on a new program that could be supported by the Fund under the Poverty Reduction and Growth Facility in early 2012.

Your Excellency, please accept my assurances of my greatest attention to these matters of utmost importance,

Barack Hussein Obama

President of the United States

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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.

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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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Sell Everything !! (…or “Bernanke’s Blunder”)

First some figures.

This morning Bloomberg reported that the total amount of assistance provided by the US Federal Government has reached more than $7.4 Tn., or half the value of everything produced in the United States last year, to rescue the financial system since the credit markets seized up in the late summer of 2007.

According to data compiled by the Bloomberg news organisation, the unprecedented pledge of funds includes $2.8 Tn. already tapped by financial institutions in the biggest response to an economic emergency since the New Deal of the 1930s, This financial commitment dwarfs the only plan approved by lawmakers, the Treasury Department’s $700 Bn. Troubled Asset Relief Program. So far the Treasury has committed some $300 Bn. under the TARP,  and has indicated that it would hold off until the new Administration is sworn in. Recall that the TARP was sold a a panacea for the nation’s financial ills back in September. You know our views on this topic.

Last week Morgan Stanley reported that global losses from the sell-off of equities has now reached more than $30 trillion – or more than twice the size of US GDP. This number only encompasses losses on traded equities and does not include other various write-downs, write-offs and value adjustments. For example the estimated hit to value of the US housing stock adds another $5.0 Tn. to the blood running in the streets.

Despite the toll to date, financial and economic conditions continue to deteriorate further. The World Trade Organization warned last Wednesday that the financing of global commerce is “deteriorating” amid the financial crisis and the situation is likely to worsen over the coming months. “The market for trade finance has severely deteriorated over the last six months, and particularly since September,” WTO Director-General Pascal Lamy told ambassadors of the organisation’s 153 members following a meeting with trade experts and bankers. “The view expressed this morning by the trade finance practitioners is that the situation is likely to deteriorate further in the months to come,” Lamy said.

Citibank, one of the behemoths on our “Zombie” watch-list, has predictably gone to ground after months of denial, and over this past weekend, agreed to a Government bailout.

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Saddle Up and Ride!! We’re Headin’ fer Armageddon

Dateline Washington, DC, Columbus Day Weekend, IBRD/IMF Meetings

The markets were up sharply overnight and today on news that 15 European countries are taking moves to shore up stresses in their banking systems. However, volume was thin as it was a holiday Monday in parts of Asia and all of North America. This impressive relief rally belies significant unease in the investment markets and does nothing to dispel fears of the now generally acknowledged wider recession that is on the way and the fears that yet more stresses are in store.

How Times Change

In years past the IBRD/IMF meetings represented the “Gotta be There” Schmoozefest for A-List Investment Bankers, Lawyers, Fund Mangers and a variety of other hangers-on in the game of international finance. To say that this year’s affair was subdued would be a vast understatement. In fact at times it appeared that the host institutions and the various politicians in attendance would have welcomed news of a massive asteroid on a collision course with Earth or an outbreak of a new virulent flu bug as a welcome diversion from what is turning into a quagmire of thorny and seemingly intractable issues.

The non-party got going late last week when the Treasury announced that it was going to substantially rework the TARP Plan as it did not meet the requirements of the situation (See our last month’s post on this topic). The G20 communiqué then announced that officials endorsed the idea of a coordinated response to the financial crisis, but offered no specifics on what this coordination might entail. The proceedings really started to fall apart when the Managing Director of the IMF, former French Finance Minister Dominique Strauss-Kahn declared that, rapidly growing “…… solvency concerns about a number of the largest U.S.-based and European financial institutions have pushed the global financial system to the brink of systemic meltdown.” Our readers might well imagine how pumped up the audience was after that pronouncement.

As an interesting counterpoint, an ANIME (Japanese Cartoon) conference was being held in the hotel adjacent to mine coincident with the IBRD / IMF meetings. Wild wigs, brassy makeup and other getups were the order of the day. Taking a cue from this event, I was given to wonder whether any of the IBRD/IMF delegates were tempted to join the cartoon celebrations in place of the sombre proceedings taking place within the Perimeter.

And the Second Angel Blew his Trumpet

Sunday afternoon we learned that the lip service given to a coordinated a response among the G-7 and G-20 has resulted in European countries announcing plans to inject “billions of dollars into their banks.” This needs to be viewed in the context of UK Prime Minister Gordon Brown declaring that he plans to sue Iceland over the failure of its banking system and consequent impact on British depositors; while Russia is being looked to as a saviour by the Icelanders – ahead of the IMF – as it is bearing a possible EUR 4.0 Bn rescue loan package.

Rather than reinforcing confidence, the general lack of coordination up until last night’s announcement, the paucity of answers and surplus of buck-passing that appear to be the hallmarks of this year’s set of meetings, will likely significantly worsen the already very gloomy market sentiment, despite today’s uptick.

The bottom line is World Leaders, with the US at the forefront, seem to have squandered a major opportunity at these meetings to draw a line in the sand and calm market fears about the spread of the liquidity crisis and the seeming resistance of this credit virus to the policy tonics that have so far been applied .

As the realization that this crisis is far from over watch for the fear and loathing to spread:

• Banks have already tightened lending conditions significantly. Expect further credit rationing as opposed to price-driven activity. This means that some well-capitalized borrowers will likely fail. No one is immune. (Note to the Unbelievers: When Lehman went to ground its leverage ratio was 10.5:1 , Hugely conservative for an I-bank and much less than Goldman’s contemporaneous 22:1);
• Consequently, there will be a significant spike in corporate bankruptcies both as a result of the credit squeeze but also intimately related to the vast volumes of sub-investment grade debt issuance in the last 5 years.
• Global Stock Markets will remain weak and IPO activity will continue at a low ebb, sapping banks of fee and spread income and foreclosing deal entry and exit points for private equity funds and corporations.
• Expect a further strain on Government resources in the affected countries, with consequent implications for employment, profits, inflation and growth. In this connection it is worth noting that, on our count, the Fed has already blown its wad and exhausted its Balance Sheet. Thankfully, cooler heads are tempering the Treasury’s initial planned reliance on fixed income financings as a way out of the mortgage quagmire. In part this strategy would have caused a predictable spike in bond yields (no doubt a reason why the TARP is being reconsidered along the lines we first suggested). So watch for additional money creation…..and a more immediate reaction on global markets once they realize that the wheels were never even on the TARP or any other plan in the first place;
• The witch hunt is only starting. This week we saw Dick Fuld, the former CEO of Lehman Brothers, being grilled by the House Oversight and Government Reform Committee. At the close of the sessions, Committee Chairman Henry Waxman ominously stated “Mr. Fuld, You say you will be haunted by the collapse of your firm until the end of your days, but you don’t seem to think that you did anything wrong. And that is troubling to me! (sic)” Will they call Fuld back to the Hill and then on to a courtroom for a slow “perp roast”, to be aired on C-SPAN? Maybe, maybe not. But you should expect a slew of corporate executives in a number of countries, but particularly the US, to be indicted, tried, convicted and led to the gibbet before the dust settles on this debacle.

The larger questions about this crisis still remain. The IMF’s resources at around USD 200 billion are woefully short of the amounts needed to make a dent in the problem. In fact the IMF appears to be holding its resources in reserve for a kind of “reverse triage” in case any of the emerging economies run into trouble. The G7 and G20 do not appear to be equipped or inclined to solve these problems. Therefore, questions must legitimately be asked as to whether the IBRD, the IMF and other global institutions are effective or even relevant any more, and moreover, whether the economic policy-making machinery and risk management systems in all of the major economies, should be in line for a major overhaul.

Don’t get sucked into today’s rally. It is primarily a technical bounce that will fade once the markets realize the scale and number all of the risks and obstacles that lie ahead.

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