Tuesday, December 30, 2008

Asian Flu

In the past few days we have received confirmation that our thesis regarding Asia is playing out rapidly. The data come from Japan and Korea - both heavily industrialized exporters and relatively open societies. While we have been very bearish on Asian economies here at Financial Jenga, the rapid pace of the implosion even surprises us.

Japan will soon report 4th quarter GDP and the estimates are moving fast - an in a really frightening manner. Bloomberg reports that Barclays now is estimating that Japan's economy contracted at over 12% annualized in Q4. This would be the worst result since the Arab oil embargo of 1974. Korea reported a similarly disastrous result for November industrial production. The YoY decline of 14.1% was the worst on record - with data going back to 1970. Understand that the textbook definition of depression is a 10% fall in GDP - and both Japan and Korea are already on pace to do so in a year or less.

We do not yet have any numbers this bad from China but we should not expect to see them for some time. China's economy possessed tremendous momentum entering the current crisis and that will have to bleed off before the damage becomes apparent on a macro scale. Also, China's government is still rather secretive and probably will attempt to hide the extent of the declines. However, we are getting industrial production numbers showing that December was the fifth straight month of decline.

Once again, Bloomberg reports that industrial output is slowing and the pace of layoff is increasing. The problem is that order also continue to fall so this is not an inventory correction as the head of the People's Bank of China would suggest. This is a collapse of end demand driven by credit. The demand is nearly all external so China has no control over that. Since China's end consumer demand is small and even most of that is tied to export industries in some way, there really isn't any way out for them. The most fascinating quote from that article follows:

China’s economic growth may have slipped to 5.5 percent last quarter, the weakest pace in at least 15 years, according to Shanghai-based Industrial Bank Co.

Once again, numbers that would have seemed shocking a short time ago are now the expected. China will be fortunate indeed if their GDP continues to grow at all in the near future.

Monday, November 3, 2008

Submerging Market Update

note: This post was begun some time ago and the date-time stamp reflects the initial draft. The bulk of the data has been added since then.

China: The Collapse Begins
Chinese exports are collapsing and industrial activity with it.
Recent reports suggest that they are experiencing mass factory shutdowns with owners and manager absconding. According to the BBC, migrant workers from rural areas are returning to their homes in the countryside en masse. Those watching the media would think that an shocking collapse came out of nowhere in the last few weeks. Readers of Financial Jenga have known that this was not just possible but virtually inevitable for many months.

China could spend some of their dollars but they need to keep at least $1 trillion so the Yuan doesn't completely crash and burn. The interesting problem is the currency mismatch and "sterilization" issues. China's money supply growth is going to fall quickly as there will be fewer incoming dollars against which to issue new Yuan. Yes they will also be exporting fewer dollars to pay for raw materials but that doesn't matter to the unemployed citizens.

The mismatch issue is more critical. Everybody likes to talk about China's currency reserves. The problem is they've already been used up. Yes, they still have the dollars at the central bank but they've already issued Yuan against them as part of their "sterilization" operations. I.e. they cannot use the reserves to "stimulate" the domestic economy. They can SPEND them abroad, which will enable China to consume but will add production elsewhere, doing nothing for the production side of the Chinese economy. The mismatch problem is that they need more Yuan but what they have are Dollars. Much of the existing base of Yuan supply only exists because of the Dollar reserves. If they spend down the reserves, they either have to reduce their domestic money supply or simply print more money to make up the difference.

People like to point to China's dollar reserves but they've already had as much stimulative impact on China's economy as they ever will. Note that the Yuan is NOT a convertible currency. There is no large pool of Yuan outside of China that could be exchanged for dollars and spent in the domestic economy. Nor can they be lent out with the understanding that the loan be spent on Chinese goods (vendor financing). They have already done that indirectly by purchasing Treasury and Agency debt. Those looking for such an impact don't understand the structure of China's financial system.

Latin Cognates
Despite a vicious snapback, the trend is quite clearly down. Likely driven in part by the Fed's dollar swaps, these markets found support last week but it looks like a dead cat bounce. During that week a rally in their sovereign bonds of 200 basis points +/- 10 bp, left Mexico and Brazil debt trading 8.55% and 7.58% respectively. What this tell us is that the threat of immediate default has been averted by Fed imprudence but no one is willing to lend at anything less than a huge multiple of the 100 bp spreads we saw only a year and a half ago.

Latin economies are heavily dependent on natural resource extration. Thus they have had and continue to have a symbiotic relationship with the resource-eating black hole known as China. With consumption slowing worldwide and the initial feedback effects on the exporting countries, we are starting to see resource demand falling but the excess capacity created is collapsing commodity prices. The storm of demand destruction is roaring up the supply chain and spawning tornados that tear through individual sectors. The latest example comes from Brazil, where giant mining conglomerate Vale do Rio Doce is desperately cutting spending. The
big news is the cancellation of 12 giant ore carriers - which would have been built in new Chinese shipyards. At the same time, they are cutting ore production as demand falls.

An intersting question is how much demand for their own ore Vale just destroyed by cancelling the ship order. This is a vicious circle as the feedback loop in the symbiotic relationship turns negative. Rising expectations and optimism feed off themselves - until they don't anymore. Then ugliness always ensues. In this case the fall will be long and ugly - like that of Icarus, who flew too close to the sun. We have dubbed it the Universal Debt bubble as virtually every country and every industry was caught up in it. Countries like Brazil and China were some of the biggest beneficiaries of the UDB, yet those who advocated the Decoupling Theory essentially argued that the biggest beneficiaries of a trend would be hurt little if at all when it ended. The silliness of THAT position is now manifest for all to see.

Containment Breach
We've heard many times how the crisis would be "contained" to a specific industry or geographic region. The authorities making these countless claims were either lying, incompetent or both. We see now that it is and was global and across the board - thus UDB is very accurate. While we expect exporters and raw materials producers to suffer worse than most, the damage goes on elsewhere. German factory orders fell 8%. US durable goods spending fell 14.1% in the
3Q GDP report. Japanese auto sales have hit levels not seen since the 1970s, while US sales are Back to the Future of the 1980s. This is global and ugly friends. Please protect yourselves.

Saturday, November 1, 2008

Some Key Questions

The most important question facing us today, both in the US and around the world is just how much of our supposed wealth is real and how much was part of the illusion generated by bubble-mania and the UDB. Most of the actions of various governments and CBs seem aimed at preventing us from answering this question accurately. In The Limits of Optimism we outlined the various elements of the capital structure and it should be immediately apparent why the stock market is the chosen instrument for conjuring chimeras. By coercing a larger and larger percentage of accumulated capital into stocks, Wall Street ensured a large pool of buyers to continue pushing prices higher in complete defiance of fundamentals. By allowing so much of our wealth accumulation to be attached to something so insubstantial, we have collectively ensured the destruction of much of that wealth. Something that falls as soon as anyone wants to sell isn't much of an investment.

Now we see some of the real world impacts of aggressively tying ourselves to the stock market. Once again, the secondary feedback effects may be greater than the primary impact. According to the

At the end of 2007, companies in the S&P 500 had a combined pension-plan surplus of about $60 billion, The market selloff in the nine months to late September turned that into a combined deficit of about $75 billion...

Of course that was before October even started and we all know that things didn't go so well during that month either. Double digit declines were the rule for the month - pretty much across the board. The pension obligation and attempt to meet it by speculating in the stock market are yet another example of companies tying their fortunes directly to stock market whims rather than fundamental performance. It worked well for a while - allowing them to report higher profits than justified by actual results as speculative profits allowed them to pay less into the pension funds than a sensible and stable plan would have required. The reverse is now occurring and it's going to be nasty. This is yet ANOTHER headwind for corporate profits as they are forced to pay cash in to make up for speculative losses.

The lesson that should be learned here is "don't gamble with retirement money" but I fear few will choose to learn it until all other avenues have been exhausted. People can usually be counted on to do the right thing after all else fails.

Confirmed Reservations

Occasionally, I will encounter a supercilious restaurant host who will haughtily ask if we have reservations. When the right mood strikes the answer will sometimes be "yes, but we're planning on eating here anyway." In much the same vein, our prior reservations about the export economies and China in particular have been confirmed with a vengeance recently. Reuters reports that China's PMI hit 44.6 in October - indicating clear and serious contraction in factory output. This now makes three of the last four months down. In addition, recent BBC reports suggest that half of the toy factories in China have shut down since the start of the year.

Keep in mind that we expect a crash and burn in China's economy even if exports stagnate, much less roll over. Government action can partially ameliorate this but only to a small extent. We laid out the full case four months ago in China Syndrome. All of the elements preliminary requirements have now been met for this scenario to play out. The US is desperately trying to prevent a meltdown across the submerging markets with swap lines to exchange valuable dollars for garbage currencies like the Mexican Peso and the Brazilian Real. The temporary availability of dollars in those imploding economies has relieved the pressure from capital flight for the moment and perhaps even caused a small short squeeze for those who were looking for reality to catch up to those nations' financial system. But the banking systems overseas cannot sustain their credit expansion in the face of falling external demand and especially the collapse of primary commodity prices on which their economies rely heavily.

Monday, October 27, 2008

A Little Credit

That really is all that is available in the debt markets today and the consequences are obvious. At the same time, we'd like to claim a little credit for calling the direction and - to some extent the magnitude of this crisis. We felt that these (then pending) consequences were obvious 18-24 months ago. In fact, one of the first posts on this blog in August 2007 noted:

Today's actions by the European Central Bank and the Federal Reserve confirm that the real threat is DEFLATION - not inflation. Central Banks don't pump $150 billion dollars into the banking system because they are afraid of creating too much money.

Again this June:

That is where we are now. The Fed has failed. The Great Oz has been exposed a just a man behind the curtain. Prepare for severe credit deflation and falling asset prices in markets that traditionally use leverage to purchase or hold positions.

For years massive credit inflation raged unchecked and asset prices soared as the pool of buying power increased far faster than the assets available to absorb it. As the debt machine began to break down and collapse under its own weight, credit creation proved insufficient to continue propping up all asset prices. At this point the Universal Debt Bubble (UDB) began to falter selectively. First housing, then junk bonds, asset-backed securities, commercial real estate, equities, corporate bonds and sovereign debt all fell off the wagon in turn. By early 2008, the one asset class that had not yet been hammered was commodities - though in reality, that was also a fragmented market with the highest profile stuff still going up while nearly everything else was down.

Selected commodities proved to be the final bastion of credit-driven asset inflation - leading many analysts to mistakenly call for inflation when the exact opposite was looming. Credit creation has now fallen to such a low level that asset inflation is now dead virtually everywhere. Grains, metals and oil were the last holdouts of the UDB and they are now being hammered into the ground. The WSJ provides us with evidence and a salutary example of how demand destruction works in Metals Meltdown Burns Scrap Dealers:

Now demand and price are in a freefall. Does the Miami businessman sell his now high-priced inventory at basement prices, or wait for the market to recover?


But in the last six weeks, scrap steel prices have fallen nearly 60% to about $400 a ton. Prices for aluminum scrap has dropped 33%, copper 25% and nickel about 15%. Peter Marcus, metals analyst for World Steel Dynamics, says, "We aren't near the bottom yet."

For a while, the trend in price seemed to be in favor of commodity inflation. The reality was that the huge amount of "money" (really credit) created during the UDB has been running around looking for someplace, anyplace to hide and commodities were the last asset bubble it ran towards. But the economic function of bubbles is draw in such phantom "capital" and destroy it as if it had never been. The trend-followers and and performance chasers will never understand this as they are always late by definition. One has to take a systems analysis approach to understand how pulling a lever over here can impact things that have no obvious connection to the original stimulus.

The last bubble is over. Oil has collapsed from nearly $150 to less than half that. Grains are down 60% or more. Industrial metals are in worse shape than that. Deflation is now the order of the day. Governments will try to stop it but will fail repeatedly. They do possess the power to stop it before deflation runs its full, natural course but the price will be self-destruction and national suicide via devaluation and hyper-inflation. In this case the cure is much, much worse than the disease.

Thursday, October 2, 2008


The commercial paper market certainly appears to be critically wounded. The seasonally-adjusted amount of CP has fallen dramatically since mid-September. Per the Federal Reserve the declines over the last three weeks:

September 17: -$52.1 billion
September 24: - $61.0 billion
October 1: -$94.9 billion

Headlines emphasizing funding cutoffs to companies in the real economy, like Caterpillar and A&T are highly misleading. Non-financial CP took a single hit of $18 billion ($217 billion to $199 billion) two weeks ago and has hardly budged since. The REAL story is the collapse of CP issued by banks and other financial companies. Domestic financial paper is down by $93 billion ($590 billion to $497 billion); foreign financial paper fell $40 billion ($225 billion to $185 billion, down 20%!); asset-backed paper is off $55 billion ($780 billion to $725 billion).

We have seen record withdrawals from money market recently, which has led to falling demand for commercial paper - which is usually purchased by these funds. In order to stem the flight from MM funds and hide the losses in asset-backed CP, the Fed recently extended their alphabet soup yet again. The "Asset-backed commercial paper money market mutual fund liquidity facility" or ABCPM3FLC for short was instituted just two weeks ago. It's gone from zero to $152 billion in just days - $22 billion average last week, to $122 billion average this week, to $152 billion by 10/2/08. All data are from the
Fed's H.4.1 release.

Panic Lending

Actions of this magnitude clearly indicate that a major crisis is unfolding behind the scenes. The freeze in interbank lending, the explosion of LIBOR loan rates, the collapse of financial commercial paper and counter-measures taken by CBs around the world indicate that the final act of the Universal Debt Bubble may be upon us. The UDB rested entirely on confidence - and badly misplaced confidence at that. It allowed credit to be extended to those who were manifestly NOT credit-worthy and the temporarily elevated economic activity created the illusion of prosperity.

All of that is going in reverse now and the politicos don't like it. Well, unfortunately this is all necessary to return to a stable economic structure after the bankers deliberately destabilized it. One of our first blog entries was Legions of the Damned - wherein we pointed out:

Over the last several weeks, there has been a collective recognition of the inherent riskiness of using illiquid, volatile and hard to value paper as collateral for lending. The lenders are requiring either much more (paper) or better (cash) collateral to secure the loans. The result is the global "Dash for Cash" that we've seen recently. Cash is King again and the scramble to come up with it resulted in huge spikes in overnight lending rates. The injection of $150 billion into the system was designed to bring the rates back down to the ECB and Fed targets of 5.25% and 4.0% respectively.

Had the CBs not acted, there would have been massive forced selling of the illiquid paper, demonstrating it to be nearly worthless. Now that would only formally recognize a situation that already exists in reality but as long as the banks can pretend that it's worth face value, they can continue to make loans and prop up consumption. This is a classic example of Gresham's Law - to oversimplify "Bad money drives out good money." When dodgy paper assets are treated nearly the same as cash, nobody is going to put up cash.

As we surmised well over a year ago, the repricing of risk is ongoing and the current crisis is simply the big brother of the one we experienced last summer. The clearest indication of risk recognition is the explosion of spreads. Once again, according to the Fed's Commercial Paper Report, yield differentials between high-quality (AA) and lower-quality (A2/P2) commercial paper have blown out enormously - from 80 basis points (0.80%) just a few weeks ago to over 400 bp today. Then there is the spread due to implied higher risk just for being a financial company. The spread on financial vs non-financial paper has widened from 30 bp to 160 bp in just weeks. A risk that Financial Jenga readers have known about for a long time is now confirmed by the market.

Inability to borrow in the US money markets helps to explain the severe dollar starvation overseas. It is this problem that the Fed is trying to fix with the their massive dollar loans (mischaracterized as "swaps") to foreign CBs. Less than a week ago, the Fed announced a
$330 billion expansion of these loans.

The results of the dollar starvation are manifest across Europe. Huge institutions like Dexia, Fortis and Bradford & Bingley have been fully or partially nationalized within the last few days. It does not help that the leverage ratios of European commercial banks are typically much higher than their American counterparts. Not only are the commercial paper markets closing to such banks but elevated LIBOR rates cut those same banks off from cheap dollar loans from other banks. The squeeze to dress up balance sheets to make them look good for the quarter-end reports undoubtedly contributed to it but the fact that pressures have not abated much yesterday and today indicates that much more than a seasonal problem is at work here.

The "dash for cash" is on. Despite the Fed lending as fast as it can, commercial credit is being drained from risky financial institutions faster than the Fed and other CBs can pump it in. Having seen Wachovia, WaMu and a half-dozen European banks fail in the last week, we see no near-term end to the pressures or the bank failures.

Tuesday, September 30, 2008

The Limits of Optimism

The absurd actions of our financial authorities continue to impress with the sheer hubris and vast scale of their proposals - with today's bailout attempt being the latest and greatest of many attempts. Some of the government's contortions would be impressive even for Cirque du Soleil were they not such a blatant effort to distort the market. Our nation and the world at large seem to be living out the economic equivalent of a Kafka novel today. Yet even here we see the boundaries of government interference and the limits of (unjustified) optimism. As advocates of the free market and rule of law, we have been constantly appalled. A nominally Republican administration continually interferes with market forces and changes investment rules in the middle of the game. How did we come to such a sad pass?

Like many children, yours truly had a favorite word for much of his childhood - "Why?" Eventually, I stopped bothering Mother but never stopped asking the question. It is particularly pertinent now. How did we put ourselves in a position where using tax money to subsidize Wall Street's losses could even be considered? Well, the stock market is now considered key to the retirement of many Americans.

Er, most Americans now have a substantial part of their pension or 401(k) invested in stocks.

Well, the higher average rate of return on stocks allows us to say that retirement is fully funded with less up-front investment. This is especially important for corporate and government pension plans. For individuals it allows hope of the big score and a cushy retirement.

Did the pension managers decide that was a good idea, themselves?
Umm, not really. Remember, stocks are not bought - they are sold. Some smart salesmen on Wall Street started to push this in the late 1980s, just as the last people who lived through the Great Depression were retiring.

But what about the higher risk?
The salesmen could point to the superior long-term returns from equity, while glossing over the risk and the folks who remembered the risk in very visceral ways were gone. Even so, many pension managers objected but were overruled by their bosses who wanted to lay out less money for pensions so they could spend it elsewhere (government) or report higher earnings (corporate).

What about 401(k) plans?
The long bull market convinced many individuals that there was little risk in stocks. They certainly had produced high returns. Many people hitched their wagon the Wall Street.

Perpetual Motion Machine
With so much money from average Americans pouring in, stocks could hardly do anything else but rise. Eventually it became a self-fulfilling prophecy as money chased performance, while pushing the price up in turn. That reached its peak with the Tech Bubble, when completely worthless companies were valued in the billions. When that broke down, the Fed stepped in and created a new bubble - actually several bubbles, led by housing. The same self-reinforcing dynamic - as old as markets themselves played out again.

With so much money from the masses committed to the stock and housing markets, there is considerable support for ANY measure to bail out these markets and prop up asset prices. This is the end result of individuals and pension funds refusing to settle for the smaller but steady gains from lower-risk investments. Keep in mind that not long ago, most pension and endowment type funds invested almost exclusively in bonds. For the economic importance of this, let's examine the characteristics of each class of capital:

- Senior Debt (bonds or bank loans):
first in line for assets and cash
must be paid or the creditor can liquidate the borrower
reliant on total company cash reserves

- Junior Debt:
next in line but otherwise similar to Senior Debt

- Preferred Stock:
3rd in line for assets and cash
dividend can be suspended as stockholders CANNOT force liquidation
reliant on company cash flow

- Common Stock:
last in line for assets and cash
dividend has the least protection of any security
reliant on company profits
potential for speculative gains

Slouching towards Insolvency
Over time, asset allocations at all levels have become riskier, including pension funds. From an economic standpoint, investment results became more reliant on marginal financial activities. For example, bonds are tied to current and future corporate cash (reserves + cash flow), which tends to have a linear relationship with revenue. Preferred is reliant largely on cash flow. Common is tied to marginal profit and even to the growth rate of profit - the second and third derivatives of revenue. Investment results went from relying on the soundness of the companies, to their profitability and then to the growth rate of that profitability. Under these circumstances, it is no surprise that the emphasis shifted away from ensuring that companies remained sound and certain to survive and towards showing growth or even accelerating growth (a fourth derivative!) at almost any price.

The eventual price was to lever up companies far beyond what was prudent in the quest for "growth." It didn't matter if the growth was real or not, it just had to look real for the shareholders. Companies undermined their own capital base with stock buybacks that juiced EPS growth while consuming cash flow and in some cases requiring additional indebtedness. We pointed to this problem nearly a year ago in Tactical Nukes. The paradoxical result was a slew of companies that were "growing" rapidly but could not survive a downturn. By placing so much reliance on marginal outcomes, the system became easy to game as small movements in revenue could drive huge changes in "growth" rates. Eventually, growth became THE foundation of many investment strategies, making those folks dependent on them willing to support increasing distortions of free markets for financial gain.

Those distortions have been a large part of the discussion here at Financial Jenga since the very beginning. The collapse of the illusion of growth and the economic distortions that supported it have revealed the true state of the underlying economy for all to see and it's not a pretty sight. Such are the ironic outcomes of the Universal Debt Bubble.

Saturday, September 27, 2008

Shadow Banks, Shadow Government

Here at Financial Jenga, we don't often comment directly on politics - being much more inclined towards economics. We are also equally skeptical of both groupthink and conspiracy theories - which tend to be opposite sides of the same psychological coin. However, the sheer scale of the current crisis and many of the proposed solutions make this problem inherently political. It would also appear that many of the "fixes" being bandied about won't actually fix anything but WILL benefit certain politically-connected parties.

There is considerable evidence that the proposed $700 billion bailout of Wall Street will do little to fix the credit problems. One of the key arguements used by supporters is that banks don't have enough money to keep lending. This is simply a lie. The latest
Fed H.3 report shows that excess reserves in the banking system were $68.8 billion as of 9/24/08. This is 1400% above any other datapoint for the past year and more than 2000% higher than the average for that time. In other words, the Fed has FLOODED the banking system with borrowed money (the excess reserves) and the banks STILL won't lend.

In the real world, you cannot conduct fully-controlled experiments to validate an economic theory. But to the extent that it can be, we have already tested the thesis that giving banks more money will cause them to lend more and found it to be flawed. The most likely outcome of the bailout appears to be many banks saved at taxpayer expense but we get a credit crash and recession-depression anyway and Main Street has even less money to struggle through it since it will have been given away to Wall Street. Basically, it redistributes the losses for past transgressions from the guilty to the innocent and does little to help the future. We therefore oppose the bailout on both economic and moral grounds.

Hitting the Panic Button
According to various media reports, the supposed experts threatened Congress with all sorts of terrible repercussions if the bailout was not passed immediately and without strings. From their public statements, our representatives have been told that failure to do so would result in an immediate end of credit, a stock market crash, massive layoffs and likely a new Great Depression. As regular readers here know, many of these consequences ARE likely but they do NOT stem from the lack of a bailout for Wall Street. They are the DIRECT result of the orgy of foolish lending that preceeded the bailout request. Paulson and Bernanke are using their control of information and the ignorance of the politicians to run a bluff. We are being threatened with consequences that are likely to come in any event and the bailout won't change that.

In many ways, the financial authorities are taking active measures to make the crisis worse. The Fed has been withdrawing liquidity from the financial system for over a week. According to
the Slosh Report, system liquidity topped at $190 billion on 9/18 and fell to $110, $110, $90, $65, $63 and $59 billion on subsequent days. With the Fed deliberately cutting prior support, it's no wonder the short-term stress has become overwhelming. One result has been the largest bank failure in history (Washington Mutual) followed within days by a shotgun marriage to prevent an even larger one (Wachovia). The WaMu failure itself is quite interesting. The FDIC ALWAYS buries failed banks on a Friday, in order to give themselves time to sort the mess out over the weekend. We've gone back and checked and it's been true for many years. Yet the WaMu failure was announced on a Thursday, the day after the President unveiled the bailout proposal. The FDIC's timing on WaMu looks suspiciously like an attempt to rachet up the pressure on Congress - as does the Fed's withdrawal of liqidity support from the system.

In many ways this power-grab resembles the cynical use of religion in primitive societies. It is well documented that the priesthood in many cases studied the heavens with great care. One benefit would be the ability to predict solar eclipses - one of the most terrifying astronomical events to our ancestors. In some cases, the religious leaders used that terror to wring offerings, greater control and even political power from a frightened populace. The events in Washington today are quite similar but even worse. The crisis is already pre-determined. But the current financial leaders helped to create the disaster and now demand power to end it. In contrast the shamans and witch doctors were merely opportunists. The crisis centered in the Shadow Banks is now being used to create a Shadow Government.

Friday, September 19, 2008

Frederick the Great vs. Hank Paulson

This is total panic time. They're now firing off everything that they have after the first several attempts at an options expiration week stick save failed badly. Basically, the Treasury is guaranteeing virtually everything now with backstops for money market mutual funds and a new super SIV for bad assets. But as Fredrick the Great said: "He who defends everything, defends nothing!" This was a simple acknowledgement of military reality - concentrate on protecting the most important assets. Spreading yourself too thin invites defeat in detail and the destruction of your forces. Then the enemy can loot at leisure.

The government seemingly doesn't understand this but they will. There simply isn't the money to do everything and in their arrogance the Fed and Treasury have over-reached badly. By trying to save all of the bankrupt financial companies, they are weakening the defenses of the strategic key - Treasury debt. The bond market is already demanding 50 basis points more in interest than just days ago. Another way to look at it is that 10-year government bonds have lost 3.5% of their value in that time. The Treasury is the logistics depot from which the army defending every other target is being supplied. If it falls, the war is over and our enemies win.

One shot wonder, long-term consequences
The SEC, erstwhile market watchdog is barking up the wrong tree again. They sat on their hands and did nothing while the disaster built all around them and now they are attacking the group pointing out the problem, not the ones who caused it. In banning short-selling, they also increase the probability that there will be no bounce when the next decline occurs since short-covering is the one thing that has kept our stock market from collapsing like much of the rest of the world's.

The fact that they feel the need to use this one-time guaranteed short-squeeze now ought to tell you everything you need to know when the cost is so high for so little gain in terms of time. This tells me that election politics are paramount here since there is at least a chance (maybe 50/50) to delay the crash by 6 weeks. There is little prospect that we make it 6 months. With so little difference, I'd prefer it occur before the election to guarantee an Obama presidency. Whichever party holds power over the next 4 years will be discredited for a generation (after Hoover and GD 1.0, the Republicans were unable to build sustainable majorities for two generations). Though I'm disgusted with both political parties, there is at least some chance that the Republicans will return to their Reaganite roots after a time in the wilderness. I have no hope at all where the Democrats are concerned. The fundamentals are positively horrific and much depends on sustaining the illusion of control. Short-sellers overwhelmingly profit from disparities between perception and reality - as such, they are always among the first to point out that the emperor has no clothes. Given the stakes, anyone who sees through the deception must be punished and silenced.

There isn't even enough tax money to cover the normal operations of our bloated government, much less this madness. But the bond market was willing to make up the difference as long as there was a high probability of repayment. But the checks that Paulson is writing with his mouth right now are guaranteed to bounce and some bond buyers are noticing. From a low beneath 3.30% this week, the yield on the 10-year Treasury bond has skyrocketed by 50 basis points. The fact that the bailout silliness has more than doubled that deficit doesn't help at all. Like any fool who continues to spend far beyond his means, the creditors will charge us more and more to borrow until insolvency.

The only solution is immediate cuts in government spending and the repudiation of all the backstops that have been proposed. Getting within shouting distance of a balanced budget is the only thing that can prevent an imminent spike in Treasury rates. The entire game depends on the willingness of foreign savers to fund the now gaping chasm of the Federal Deficit. If they balk, the whole structure is endangered. By taking on the toxic waste of the financial industry, all the US government has done is place itself at risk in the inevitable implosion. This is too large for any government or even all of them together to solve. Remember how Congress sent the GSEs out to save a drowning housing market and the "lifeguards" not only failed the rescue but also got pulled to the bottom right along with everybody else? That is precisely what is going to happen to the US government if they don't extricate themselves now. A blowout in borrowing costs was a precursor to the demise of Fannie and Freddie; we appear to be seeing a super slow-mo, reverse-angle replay with the Treasury right now.

One reason the US survived GD 1.0 without the political damage in the rest of the world (think Hitler, generals in Japan, Peron and petty dictators from Pilsudski to Metaxas) was the fact that the our government's finances never reached a state of existential crisis. The deficit (what there was of it) and government bonds were always sure to be paid back. That assurance is not present today and the government's actions are making ultimate repayment ever less likely. The Argentine example is particularly poignant. In the early 20th century, that country had a higher per capita income than the USA. After decades of socialist and corporatist policies under the Perons, they became the ongoing basket case and borderline Third World country they are today.

I hate to paraphrase anything from the Star Wars series but it is too apropos: This is how freedom dies - to thunderous applause.

Wednesday, September 17, 2008

The Fed is Broke

Three months ago we published Why Bennie Can't Lend, detailing the Fed's balance sheet and the limitations they were up against. We contended that they were out of cash and unable to sell their bond holdings without serious consequences. That is why their incremental actions have been limited to the TSLF, where they loan out the actual bonds rather than cash. Today, the Fed admitted that we were right all along by arranging for the US Treasury to raise more money for them so they can keep lending via the alphabet soup of liquidity facilities.

The Federal Reserve has announced a series of lending and liquidity initiatives during the past several quarters intended to address heightened liquidity pressures in the financial market, including enhancing its liquidity facilities this week. To manage the balance sheet impact of (ed. - ie. pay for) these efforts, the Federal Reserve has taken a number of actions, including redeeming and selling securities from the System Open Market Account portfolio.

The Treasury Department announced today the initiation of a temporary Supplementary Financing Program at the request of the Federal Reserve. The program will consist of a series of Treasury bills, apart from Treasury's current borrowing program,
which will provide cash for use in the Federal Reserve initiatives.

Basically, this is simply another holding action by the Fed to prevent the "fire sale" (actual price discovery) of assets held across many financial institutions. Yet the implications are profound. This would have been a perfect opportunity for the Fed to print money if it had any intention of actually doing so. Yet they did not, even under the extreme pressure of Lehman failing and AIG bailing. Instead they chose to stay within the framework of fractional-reserve banking and they BORROWED instead. If they were going to conjure money out of thin air, this would have been the time to do it and they demurred.

We believe that this is a shock to the market in a number of ways. It clearly demonstrates the limitations of the Fed's power when many market participants believe that power to be virtually unlimited. It shows that the Fed is no different than any commercial bank in this regard - they have to be able to borrow and lend to expand the money supply. They have the advantage of being able to turn to the Treasury in a pinch but they are trying to support asset prices (promoting asset inflation) and they need cash to do it. The Fed either won't or can't create that cash by decree.

Ironically, just as the weaknesses of the Fed's inflationary program are being made clear, the herd is stampeding back
into the inflation trades. This appears to be based on the assumption that today's Fed action is inflationary (true on a very small scale) and demonstrates some new power on their part (not true at all). What has been demonstrated is the INABILITY of the Fed to inflate asset prices without the willing cooperation of the market. With sentiment having turned, the best they can hope for at this point is to slow the crash in prices of risky debt used to fund credit expansion. This is a desperate rear-guard action by the Fed

Wednesday, August 27, 2008

MBS Deep Freeze

According to various sources, the GSEs Fannie Mae and Freddie Mac have been buying somewhere between eighty and ninety percent of all mortgages recently. This has led to very rapid growth of their mortgage portfolios. Just a few weeks ago, this report appeared in Newsday:
Fannie Mae, the largest provider of funding for U.S. residential mortgages, on Wednesday said it grew its investment portfolio in June at the fastest annualized rate in nearly five years.

Fannie Mae's mortgage portfolio increased at a
22.8 percent annualized rate to $749.6 billion in June, from $736.9 billion in May, the Washington-based company said in a statement.

The government-sponsored enterprise (GSE) has been boosting growth in its investments since its regulator earlier this year began easing requirements on capital it must hold against the assets. Lawmakers consider such purchases by Fannie Mae and rival Freddie Mac as playing a key role in supporting the U.S. housing market that is going through a wrenching downturn.
What a difference a month makes. Buried deep inside a Bloomberg article today, we find this:

Freddie's portfolio expanded at a 9.8 percent annualized rate to $798.2 billion in July, the slowest since March. The holdings may shrink this month based on forward commitments, according to the company's monthly volume summary today. Fannie expanded to $758 billion, an annual rate of 14.4 percent, the smallest increase since April.

The declining demand from the federally chartered companies, the biggest buyers of home loan securities, is sending mortgage prices lower and causing home loan rates to increase.

``It's become pretty obvious that they're not going to be able to grow going forward,'' said Walt Schmidt, a mortgage-bond strategist at FTN Financial Capital Markets in Chicago. ``Without a capital raise, you're not going to see a major recovery in'' mortgage securities.

Growth went from north of 20%, to low double or high single digits, then possibly to NEGATIVE in just a few months. It is a tribute to the speed with which leveraged pyramid schemes fail once the confidence is gone. Since the massive growth of the GSE portfolios was unable to arrest the rapid fall in bloated housing prices, the removal of this prop and sidelining the buyer of last resort is likely to result in another down leg in prices and unit sales.

Although Treasury Secretary Paulson pushed the GSE bailout bill through Congress by saying he needed a bazooka so he wouldn't have to use it, the market appears to have called his bluff. The problem is that many commercial banks hold Fannie and Freddie preferred stock as part of their capital. Simply guaranteeing the debt does nothing for the preferred it would be wiped out in the re-organization - adding another hit to capital and more failed banks. Government purchases of preferred stock would be less bad for the banks but they would still be diluted and have less capital. Only purchasing common stock would leave the preferred (and bank capital) intact. But that would bail out the management and prevent a much, needed re-organization of the companies. More to the point, it would also be seen as a pure bailout and politically very damaging heading into a national election.

There has been very little reason for the credit inflation crowd to cheer lately and the rapid growth of the GSE portfolios was one of the few bright spots for them. This growth appears to be done as well. The Shadow Banks are now shattered banks as off balance sheet vehicles are unwound and hedge funds shut their doors. We should expect to see even more of the later in the near future. The WSJ reports that July was the worst month ever for the Morningstar 1000 hedge fund index at negative 3.07%.

Monday, August 25, 2008


We turn to Europe in this commentary as important events are occurring there behind the scenes and Asia has gotten the lion's share of the attention recently. The mariner's distress call actually comes from French, where "m'aidez" simply means "help me." We thought that would be a particularly appropriate title as Europe's financial system is starting to show signs of severe distress. From the actions of the CBs over there, we can infer that the problems there may be significantly worse than here in the US. Current open market operations show that the ECB has 451 billion Euros (about $640 billion) outstanding. This dwarfs the Fed total of just over $300 billion - including all liquidity facilities. It's pretty clear that there are many European banks in deep, deep trouble.

Starving for Dollars
It is also becoming increasingly clear that the European financial system has a desperate shortage of dollars. Since much of the debt outstanding is denominated in dollars and many European banks have taken in dollar deposits as well, there is a need for them to transact in our currency that is not reciprocated. When the Fed and foreign CBs set up the currency swaps, there was some suggestion that the purpose was to give the Fed enough Euros to intervene in the currency markets. That really didn't make much sense as the Treasury and the Fed have conducted a sub rosa weak-dollar policy for years. The logical and obvious explanation is now coming to the fore - Europe is seriously short of dollars and if they were forced to go out into the market and buy dollars, our currency would strengthen too much for the planners at the Fed who have been attempting to devalue it.

The bid to cover ratios from recent auctions make the point quite forcefully. The last set of TAF auctions in the US produced ratios of 1.51 and 2.19 (for the initial 84-day facility). The comparable ECB auctions in Euros had a bid to cover of 1.58. But ECB dollar auctions were bid at 4.56 and 3.85. US banks' demand for dollars appears to be roughly equal to Eurozone banks' demand for Euros. But Eurozone demand for dollars is twice as great as either one. This trend is confirmed by the result of the Swiss dollar auctions. Those had bid to cover ratios of 2.90 and 4.90. Finally, note that the Fed is not auctioning off Euros or Swiss Francs to anxious American bankers.

In addition, the high-yield bond market in Europe is completely frozen. Not one junk issue of any size has come out of Europe this year or for quite a few months of 2007. Retail sales there are falling farther and faster than in the US and the housing bust there has barely begun. Granted that theoretically the ECB had more room to cut rates than the Fed but the strength of unions and the social program costs make a wage-price spiral much more likely in the Eurozone, which seems to be constraining the actions of the ECB.

Friday, August 1, 2008

UDB meltdown

We have often spoken of the UDB (Universal Debt Bubble) and how it had permeated nearly every asset class and geography. It's existence is the reason that we have often chided believers in economic "decoupling" as fantasists. We wrote about the structural weaknesses of the Asian economies in China Syndrome and Silent Scream. The trend has been quite clear lately as India teeters on the edge of recession and Japan's trade surplus collapses. Today we receive additional confirmation (as if any were needed).

The last bastion of the "decoupling" fantasy is China. Yes OPEC and Russia can remain strong as long as oil prices stay high but that scenario rests on the further assumption of nearly unlimited demand growth out of Asia (especially China). Chinese growth had continued to be high even as it trended down for 5 consecutive quarters. Now we see a report that the industrial sector is SHRINKING outright over there. Bloomberg reports that Chinese PMI fell to 48.4 in July (anything below 50 indicates contraction). Naturally, there will be apologists who will blame the entire decline on the Olympics and the shutdown of industry in the Beijing area. I present for their edification import orders:
The output index fell to 47.4 in July from 54.2 in June, while the index of new orders dropped to 46.2 from 52.6. The index of export orders declined to 46.7 from 50.2.
Clearly, there is no correlation between demand for exports and the Olympics. While that is likely and aggravating factor, it's a long way from the heart of the problem. Exports are the be-all and end-all for China's economy and they are going down in no uncertain terms. This should be no surprise as the end demand in their trade partners is clearly weakening. This is horrible news for China, as their entire economy is a pyramid leveraged to exports. What we wrote in China Syndrome less than a month ago has particular resonance given this report:
Essentially, everything will be fine as long as everyone there believes the economy will continue to expand at a breakneck pace and invests accordingly. This is virtually the definition of a pyramid scheme.

The most likely trigger for a fall in China's capex is weakening exports. They don't even have to stagnate to trigger real problems, much less fall. When the current investment pattern is predicated on rapid and continuous growth, material decline in the growth rate should be sufficient to kick off lower capital spending. An event the magnitude of 1980 would cause a direct hit of 12% of GDP in China in addition to any multiplier effects and that is hardly unthinkable. Keep in mind that exports themselves account for 33% of Chinese GDP so any outright decline there would be a real problem for them - likely triggering a minimum 20% fall of GDP. Frankly it will be difficult for them to avoid it given the economic and political climate in their trading partners.
China is simply following the same pattern that we have already seen in India. In China's case, the slowing of demand may have been masked by the massive construction projects and inventory building prior to the Olympics. In many ways, this event is similar to the Y2K phenomenon that marked the top of the tech bubble. It is a date-certain occurrence which inspired massive spending and investment as well as hoarding and stockpiling (for different reasons). That date also marks the absolute cutoff of all related investment and spending as well as a potential inventory draw down. In this instance, the cycle is exacerbated by the reduction or cessation of industrial activity in and around Beijing. So instead of a gradual reduction in industrial production growth like India, China looks to be set for a sudden end to growth.

We see problems globally, not just in the US and Asia. Deflating housing bubbles in Spain, the UK, Italy and Australia. Retail sales falling across the developed world, with their supplier nations beginning to follow suit. This is no ordinary credit crisis. It is the beginning of the end for the largest and most extensive credit bubble in all of human history - the Universal Debt Bubble. No nation, no asset class will escape the effect of the bubble bursting. Preserve your wealth, reduce risk and get ready to buy assets on the cheap on the other side of this mess.

Thursday, July 10, 2008

The FDIC and You

Well friends it's time to talk about bank failures and wealth preservation. We have talked about insolvent banks on multiple occasions before but the threat of large banks failing is now imminent. Countrywide was saved from such a fate by Bank of America. Now IndyMac is right on the edge. They're not officially dead yet - only mostly dead but there's no Miracle Max in sight.

Their recent letter to stakeholders reads like a death certificate:
  • regulators involved
  • prohibited from getting brokered deposits
  • can't sell stock (no buyers)
  • asset sales would deplete capital (tacit admission of mis-valuation)
  • ===> must stop making loans
The FDIC has been bulking up for months now, anticipating a wave of bank failures. So far it's been a few small banks but now it's the big boy's turn. So how secure are bank deposits and and how much can the insurance fund really cover? For now, it looks like the answers are pretty safe (as long as you're under the $100,000 limit) and a pretty good amount as they have $54.5 billion in the fund as of the March 31 report.

The report contains further indications that they see the problem as serious and imminent. For instance, last March the fund held $3.7 billion in cash, going to $4.0 billion in December and $8.0 billion this March. Clearly they are raising cash in anticipation of something. There is a similar pattern to the provision for losses from negative last March to $95 million in December and $525 million the March. Interestingly, that last number is about 2.5x the estimated losses on ALL failed banks YTD.

$5.6 million - Douglass National
$214 million - ANB Financial
$2.3 million - First Integrity

ANB is almost the entire amount but was not shut down until
May. The FDIC was already anticipating a lot more at the end of March. It will be fascinating to see what kind of provisions they made at the end of June. We should have that report in approximately 2 weeks. The banks that have failed so far have cost the FDIC about 10% of deposits to make the depositors whole. This suggests that the regulators were planning on banks with another $3 billion in deposits going bad as of 4 months ago but IndyMac alone is much larger than that.

So what kind of impact should we expect if the FDIC has to liquidate a large part of their portfolio to make good on their guarantees? Personally, we're expecting a bear steepening of the yield curve but have a look at the composition for yourself:

There is a big slug of bonds maturing in 2009 so if FDIC is forced to liquidate, the pressure should be strongest on the 2-year and shorter Treasury market. Given the amount of cash, it would take a significant failure to force them to liquidate much before the maturity dates but we want to start thinking about the possibility and the implications of such an event.

Saturday, July 5, 2008

China Syndrome

Today we turn our attention to China - certainly the most celebrated economy in the world today and possibly the most celebrated ever. Yet China's contemporary economy may be the most unbalanced in the history of the planet.

The Problem
Though it is hard to find reliable numbers, most sources agree that capital investment in China accounts for
over 40% of GDP. Frankly, this is a terrifying and unprecedented number. For reference, Japan during their boom years was typically around 30% of GDP and never exceeded 35% for long. During the Roaring Twenties, fixed investment in the US economy averaged less than 20%. Looked at a bit differently, about 42% of China's economy is based on ------ the expansion of the economy. This creates tremendous momentum but also huge potential for disaster. Essentially, everything will be fine as long as everyone there believes the economy will continue to expand at a breakneck pace and invests accordingly. This is virtually the definition of a pyramid scheme. Does anybody see anything wrong with this picture? Does this perhaps sound familiar? It should since the psychology is the same as every bubble in history.

So what could go wrong and how would it likely play out? I'm going to use post-war US recessions since that is an example most readers can relate to and gauge the seriousness. In reality, the US economy is relatively stable and mature so I would expect volatility to be much higher in China, not to mention the bubble nature of current investment levels. During its post-war recessions, US capital spending declined between 10% and 30% - with the extreme value being achieved in the 1980-82 period. This is simply the impact of over-investment during the preceding boom and the sudden realization of that fact and the resulting over-capacity during the recession.

The most likely trigger for a fall in China's capex is weakening exports. They don't even have to stagnate to trigger real problems, much less fall. When the current investment pattern is predicated on rapid and continuous growth, material decline in the growth rate should be sufficient to kick off lower capital spending. An event the magnitude of 1980 would cause a direct hit of 12% of GDP in China in addition to any multiplier effects and that is hardly unthinkable. Keep in mind that exports themselves account for 33% of Chinese GDP so any outright decline there would be a real problem for them - likely triggering a minimum 20% fall of GDP. Frankly it will be difficult for them to avoid it given the economic and political climate in their trading partners.

This would be just the result of inflated current investment combined with a typical cyclical decline in demand overseas. We don't need a replay of the Great Depression for China's economy to suffer horribly. From 1929 to 1932, capital investment in the US economy fell by over 90%. Given the much higher weighting of such spending in China today, the result of such an event would be literally unthinkable.

You might ask why China's currency is doing so well if their economy is so vulnerable? And that would be a fair question, though we would point out that the Shanghai exchange is down over 50% in less than a year, so some markets are reflecting probable severe damage to the economy. But the answer to the currency issue is the one that we often give - perception lags reality.

It's usually a pretty good bet that the locals will know their market better than those who are far away. This is just common sense. In China, only local buyers can participate on domestic stock exchanges and they have obviously gotten a lot more cautious since the Fall. However, the currency market is subject to outside forces despite the nation's currency controls. Essentially, the locals have started to sell China while the foreigners are still buying. We have long believed that there is a hot money problem in China since their currency reserves have been growing a lot faster than their trade surplus would suggest. In addition, the reported surplus itself looks pretty squirrelly.

The hot money problem has recently been recognized by the government and some of the financial press. Here's an example from the Financial Times:
Given that the inflows far outstrip trade and direct foreign investment, China appears to be receiving vast amounts of speculative "hot money".
The FT article goes on to cite an estimate of $150-$170 billion of hot money flowing into China in the first 5 months of 2008. This money is coming in despite the collapsing stock market and despite the fact that the Yuan is losing domestic purchasing power at a rapid pace - far faster than the currencies the money is coming out of certainly. This is the virtual definition of speculative money flow. The FT continues:
China has two big attractions for foreign investors - interest rates are higher than in the US and the currency is expected to appreciate.
Of course real interest rates in China are hugely negative - 400 basis points or more due to high and rising CPI. This is a far worse situation than in the US or Eurozone. And why is the currency expected to appreciate? Why because everyone THINKS so. Kind of reminds of the tongue-in-cheek description of a celebrity as "some who's famous for being well-known." What it boils down to is herd-animal behavior. The herd is going over there, they must know something. Let's follow them, the grass must be better over there. Mooooooo.

One final clip from the Financial Times:
But government officials also believe that illegal transfers are taking place - through foreign companies declaring that funds are for direct investment and then putting the money in the bank and exporters exaggerating the value of overseas revenues in order to bring in extra funds. (As an aside, economists point out that if fraudulent export receipts really are widely used to bring in hot money, China's politically troublesome trade surplus would actually be much lower than thought.)
Prior to 2005, China's trade surplus never exceeded $50 billion on an annual basis. It hit $100 billion that year and roughly $250 billion in 2007. The dollar peg was dropped in mid-2005 and the surplus began to grow explosively at the same time, soaring through the period of the stock bubble. The monthly surplus peaked in October 2007, the same month as the stock markets did worldwide - including China's. Since the suspected route of the hot money is fraudulent trade or investment deals, we cannot know with certainty but the timing of the flows is highly suspicious.

Here at Financial Jenga, we are automatically suspicious of consensus, orthodoxy or any widely-held belief unless there is strong evidence to support it. The meme of unstoppable growth in China does not meet that test. While that country has many strengths, they appear to already be discounted and then some. The massive imbalances create vulnerabilities and the economy appears to be just as much a bubble as anything in the West - perhaps more so. In this case, the bubble is in factory investment, not housing but tremendous over-supply is already present, with more being created. The Wall Street Journal recently published a front-page article about factories closing down as overseas demand falls and China's manufacturers become uncompetitive due to rising costs. We've already discussed the implications of that scenario. We have long believed that China today is very comparable to Japan 20 years ago and we see nothing to make us change that hypothesis.

Tuesday, July 1, 2008

Silent Scream

(editor's note - This blog entry was completed and posted on July 4. The entry date is showing as July 1, as the software uses the date on which the first draft was saved.)

Marc Faber was on Bloomberg TV today and he mentioned that the higher reported consumer inflation rates in Asia were a function of lower per capita GDP and a higher proportion of income spent on food and fuel - which are nearly the only prices that are rising aggressively. Common sense right? But of course that really made me start thinking - always a dangerous prospect.

Asia, Inc.

So Asia's consumer "basket" looks a lot different than that of the average American or Western European. But there are other differences as well. Many Asian nations are resource-poor, major importers of either food, raw materials or both and they depend upon exports of manufactured goods to pay for those imports. Now, let's look at the situation from a slightly different perspective. The industrial sectors of Asian economies look much like any diversified manufacturing enterprise.

Similar to our notional enterprise, these nations' factory sectors buy raw materials and energy. They employ people, paying wages in the process and sell a finished product to a customer. Substitute "import" for buy and "export" for sell and it's actually a pretty good analogy. A few differences, instead of profits, these entities collectively produce a surplus for the nation and they are also responsible for feeding and housing their workforce like an old-fashioned company town to the extent that the workforce doesn't grow its own food.So how do current conditions affect our metaphorical manufacturer? Inputs costs are rising fairly fast overall, with oil being a spectacular example though most increases are far more sedate and a fair number of industrial inputs are falling in price. Just as important, labor costs are rising. This is an obvious corollary to rising living standards and wage costs have been rising by double digits across much of Asia for years. At the same time, demand for many of their products has been weakening as their key markets (US, Europe, Japan) drop into a coordinated recession. So raising prices significantly isn't a solution as they would quickly suffer loss of market share. These factory economies are backed into a corner as surely as domestic manufacturers, with rising costs and falling demand. The Asian suppliers have the additional burden of rising labors costs on top of that. They can choose either lower revenues, lower profit margins (surplus) or some of both.

Now let's look at factors that introduce some added complexity to the model. Instead of cutting wages, nations also have the option to devalue their currency. This effectively reduces labor costs though not other inputs if they are imported. Lower "profits" can take the form of actual margin compression at the individual companies or smaller surpluses in the trade account. The factory sectors of Asia have an additional burden of the industrial surplus having to subsidize food imports - which of course are rising in price fairly quickly also.

What we see then are economies that likely will have to accept either smaller surpluses, lower corporate profits, lower wages, weaker currencies or some combination of the above.

Theory meets fact

Normally, high inflation rates tend to be associated with weakness against other currencies. Rapid declines in domestic purchasing power usually are accompanied by lower international purchasing power - again common sense. This is doubly true if the high-inflation economy does not raise interest rates to restrain demand. CPI equivalents have been high and rising across Asia for some time now, yet the currencies - like most others have been gaining vs. the dollar. To make matters worse, real interest rates in those countries are negative as well and have been for some time. Consumer prices are going up faster in most Asian economies than even the worst-case numbers here in the US - for instance John Williams at Shadow Government Statistics.

It has been odd to see such currencies rising against the dollar but there are several factors that have contributed. First was the differential in growth rates. Second was the perception of deep trouble in the US financial system combined with the impression of unstoppable rise for Asia. Third was the systemic imbalance of trade. Well, now we see that the extenuating factors are all at least beginning to falter. Growth rates are falling across Asia and we believe this is only the beginning of a very deep retrenchment there. The perception has shifted and the false impression that Asia would be immune to the problems of the US has been broken. The terms of trade are also starting to shift as fewer goods are sold to the US and other export markets. US trade deficit remains relatively flat with less of a gap with Asia being offset by higher oil prices.

In light of these factors, we are seeing high CPI and deeply negative real interest rates catching up with many Asian nations. Significant, and in some cases quite large currency reversals have taken place. One of the worst is India, where double-digit CPI, twin structural deficits and a severe slowdown are the story. With CPI pushing 12% and policy rates between 6.0% and 8.5% it's no wonder the Rupee recently reversed - down over 10% vs the dollar this year. Similar situations are brewing in Korea, the Philippines, Thailand, Malaysia and China, not to mention Vietnam. With the exception of still-hyped China, these currencies have lost 5-14% against the dollar from their recent highs. It's taken a while but normal economic relationships seem to be asserting themselves.

As we mentioned above, these economies are in the midst of a squeeze that will push down revenues and profits as well as the currency. Despite significant drops in many regional exchanges, fundamental deterioration can drive this process much further. The potential for a currency kicker on the downside simply makes these markets even more attractive as shorts. Loss of confidence could inspire capital flight, which would devastate both the local stock markets and the currencies. Again, with the exception of China, these nations probably won't have to worry about their currencies being too strong for much longer.

The stock markets and currencies of Asia's industrializing nations are screaming but few people seem to be listening. They were key beneficiaries of the UDB and it's demise will hurt them in direct as well as indirect ways. But that is a subject for another post.

Tea Leaves
So, why does the dollar index still look so weak? The index really isn't a good indicator of the strength of the dollar against the world since it is a trade-weighted index. Note that the Euro accounts for 57.6% of the weight, with both the Pound and the Yen also in double digits. The policies of the Fed have done nothing to help the dollar but at this point, the weakness is just as much a tribute to the ambitions of the EU and Germany's near-pathological fear of inflation as they are the result of incompetence at the Fed (though there is plenty of that). I have almost nothing good to say about the Federal Reserve but they only deserve half of the credit for the decline of the dollar index.

Sunday, June 29, 2008

Why Bennie Can't Lend

Those of us from a certain age will recall a book about the failings of the education system called Why Johnnie Can't Read. Well, we're about to see the failings of the financial system exposed in similar fashion. The Fed has gone from "savior" that will "bail out the market" to talking tough on inflation and pointedly refusing to promise further rate cuts.

So when did this happen and why? The first thing to note about the Fed is they don't actually determine interest rates. They have the ability to set the Fed Funds target rate but then they have to go out and defend it in the marketplace - just like any other private entity seeking to set an arbitrary price. The strongest tool they have in this price-fixing scheme is the aura of omnipotence that they have acquired over the years so few other players are willing to take them on. A wise Fed chairman knows this and sets the target close to the market rate to avoid a test of wills that he might lose - along with his credibility in the process.

So let's look at the resources they have available to defend their chosen target rate. The Fed began 2007 with $277 billion in Treasury bills. As of the August 23 report, that number was unchanged but things began to move quickly thereafter. From the late summer of last year the Fed reduced its T-bill holdings by $76.7 billion by the March 6, 2008 report, which works out to about $12 billion per month. This was accomplished by bills maturing and not being rolled over as they usually would, which was sufficient to fund the TAF and discount window lending. Then things changed.

Storm Warning
In March, something really bad was brewing. We would later find out that Bear Stearns, a major investment bank was in the process of going under. Demand for Fed loans picked up dramatically and maturing T-bills no longer provided enough cash to fund the demand. So, for the first time since the crisis began, the Fed began to sell outstanding Treasury debt from their own inventory in order to supply the funds for the Primary Dealer Credit Facility (PDCF) which was introduced in early March:

3/7 - $10 billion sold
3/12 - $15 billion
3/17 - $18 billon
3/19 - $15 billion
3/25 - $12 billion
3/26 - $9 billion
total - $79 billion sold in 3 weeks

Of course, that is in addition to the normal process of runoff as bills mature. The numbers can be easily confirmed with a search of the NY Fed's permanent market operations. These actions pushed the 3-month bill's yield from under 1.0% to 1.4% in a short period. In addition, the Fed also began to sell off its longer-term Treasury obligations - $35 billion worth in 7 auctions through April 3rd. This pushed the yield on the 10-year (TNX) from 3.3% to 3.6% over that time. They sold another $30 billion in May, helping to push the yield on the TNX north of 4.0%. These actions account for the entire 12-month decline in longer-term treasuries. I'm virtually certain that the initial upward push in Treasury rates was welcomed as an "end to fear" and "return to normalcy" - also helping to push down risk spread by the simple expedient of increasing the base rate. I doubt that the second surge above 4% was quite so welcome and a repeat of that right now would be quite a major problem for the Fed.

The Box
We have now seen that the Fed can move longer-term interest rates if it has the resources and is willing to suffer the consequences of those actions - just like any other private bank or bond market player. We also note that there have been no open market sales of Treasuries since late May and the accompanying spike in the 10-year rate - critical since standard fixed rate mortgages are priced off of that rate. Even without selling pressure from the Fed, the TNX is still hanging out right around 4.0%. The rise above 4.3% must have scared the Fed to death since they reversed their rhetoric and even obliquely threatened to raise the Fed Funds target. Another half-point rise in mortgage rates would be likely to finish off a housing market already on life support and Bernanke doesn't want that on his record.

The state of the bond market leaves the Fed unable to sell any of its longer-dated Treasuries without severely damaging consequences. Yet long-dated securities are essentially all they have left - Treasury notes (2-10 years) and bonds (30 years) equal $412.4 billion. That compares to only $21.7 billion of the original $277 billion worth of T-bills. This is all that the Fed can really use without inflicting damage on the bond market that will be somewhere between severe and completely counter-productive.

June 19 H.4.1 report

This is the box that Bernanke is in. He can declare a cut in the target rate but he has no ammo to defend it. $21 billion is nothing and trying to defend a lower target and failing would be the worst possible outcome. The market may eventually give the Fed room to cut another quarter point but economic conditions will have to deteriorate further before that happens. Worse yet, the market appears to know that. The one tool that can still be used is the Term Securities Lending Facility (TSLF) but the Fed is growing more reluctant to lend out its remaining hoard of high-quality Treasuries in return for toxic waste from the banks and brokers.

As we have pointed out before, the Fed has always had the ability to hide problems temporarily by papering over the cracks. In this case, they lent a lot of money to the commercial and investment banks so they would be able to hold assets instead of selling and recognizing the losses. If confidence and credit growth return quickly, this can reduce the pain. However, they do not have the ability to actually solve problems in the credit market and papering things over only makes things worse if the problem does not go away on its own. That is happening now as banks that should have sold before are now going to be forced to sell at lower prices and bigger losses. By trying to avoid a "fire sale" the Fed merely created a bigger one with a bit of a delay.

That is where we are now. The Fed has failed. The Great Oz has been exposed a just a man behind the curtain. Prepare for severe credit deflation and falling asset prices in markets that traditionally use leverage to purchase or hold positions.

Saturday, June 28, 2008

More Credit Deflation

It is critically important to understand the decline in overall credit levels in order see just how powerful the emerging deflationary trend is. One of my favorite analysts is Doug Noland of Prudent Bear. His Credit Bubble Bulletin is an indispensable tool for anyone hoping to fully understand what is happening. From his latest edition:
Total Commercial Paper increased $1.1bn to $1.753 TN. CP has declined $471bn over the past 46 weeks. Asset-backed CP fell another $5.0bn last week (46-wk drop of $447bn) to $748bn. Over the past year, total CP has contracted $390bn, or 18.2%, with ABCP down $412bn, or 35.5%.
So there is a hole roughly $400 billion wide of destroyed credit in the shadow banking system of SIVs and other off-balance sheet entities. That would be pretty tough to fill. And in the immortal words of Ronco "But wait, there's more!" Bloomberg reported yesterday that CDO defaults since October now total 200, with a face value of $220 billion. Given the performance of the ABX and CMBX indexes, it seems safe to value the defaulted CDOs at 50% of face value or less. So add at least $110 billion to that already deep hole of vanishing commercial paper. This is all on top of whatever enormous losses emerge in the official banking sector.

So what new credit is being created to counteract all of this credit destruction? No help from the official banking sector, including the Fed. Back to our friend Doug Noland:

Bank Credit dropped $24.8bn to $9.339 TN (week of 6/18). Bank Credit has now expanded only $126bn y-t-d, or 2.9% annualized.
Fed Credit has increased $1.1bn y-t-d and $27bn y-o-y (3.2%).
There is very little ability to create new shadow credit now that the inherent riskiness of these absurdly complex vehicles has been exposed. A lot of investors are learning the hard way that if you can't understand it, you shouldn't buy it - a lesson that goes all the way back to the Mississippi Company and South Sea Bubbles of the early 18th century. The entire panoply of complex derivative securities is being revealed for the severely under capitalized pyramid scheme that it always was: SIVs, conduits, auction-rate securities, CDOs, CDS, asset-backed commercial paper and more.

The Universal Debt Bubble was a massive confidence scheme but the marks are now wise to the game. A whole new generation of "investors" with no memory of the current scandals will have to grow up before such a thing can be attempted again. We are witnessing the slow-motion collapse of the multi-trillion dollar shadow banking sector. With (commercial) bank credit also beginning to drop and Fed credit nearly stagnant, the supply of credit to support asset inflation is shrinking outright.

Expect more pain across all major asset classes that are typically purchased in highly leveraged transactions.

Sunday, June 22, 2008

No Credit for You!

As the Universal Debt Bubble has begun to collapse under its own weight, various portions of the shadow banking sector have come under enormous pressure. These are the non-bank lenders that have magnified a credit bubble into the UDB. Starting last summer, the initial push shattered the most egregiously complex and levered structures - the CDOs. In the Fall of 2007, the conduits and SIVs joined the tankage - along with asset-backed commercial paper, their primary funding mechanism. The worst of the hedge funds have been closing their doors at an increasing rate.

Now we are beginning to see simpler securitized products being shunned as well. From Prudent Bear's Doug Noland:

Asset-Backed Securities (ABS) issuance slowed this week to $3.3bn. Year-to-date total US ABS issuance of $104bn (tallied by JPMorgan's Christopher Flanagan) is running at 27% of the comparable level from 2007. Home Equity ABS issuance of $303 million compares with 2007's $191bn. Year-to-date CDO issuance of $14bn compares to the year ago $217bn.

Over the past year, total CP has contracted $381bn, or 17.9%, with ABCP down $402bn, or 34.8%.

Credit Bubble Bulletin

As I read it, ABS (mostly credit card and auto loans) are down 73% from last year. Securitized home equity is down 99.8%. CDOs have fallen 93%. These were key shadow banking sectors that provided trillion during the last leg as the credit bubble mutated into the UDB. Because the structures were kept off the banks' balance sheets, they almost never had proper reserve structures. With leverage ratios of 30, 50 or even 100:1, the inherent risk was high. At 30:1, your valuation assumptions only have to be wrong by 3% for the whole thing to blow up - as they are now duly exploding.

Any hope that the Fed and other central banks had of keeping the asset bubble intact is fading along with the excess credit that has supported absurd asset prices for so long. The disappearance of the shadow banks is critical to the process of deflating the bubbles. At the same time as this illegitimate source of funding is drying up, the commercial banks are being forced to recognize large losses. Now the banks must lend within the restrictions of their required reserves and capital. At the same time, that capital is being wiped away by losses far faster than it can be replaced.

The math virtually guarantees that there will be a lot less credit available for the foreseeable future. Assets and goods that are dependent on the availability of credit are likely to see sharp further price declines.

Friday, May 23, 2008

A Child's Perspective

The UDB grew until it encompassed virtually all asset classes and nearly every nation around the world. Many markets and countries have now fallen off the former trend but the consequences are just starting. In covering something this large and complex, we tend to use a lot of statistical analysis here at Financial Jenga. But occasionally, a simpler perspective can be really helpful.

I occasionally play babysitter for my young nieces on weekdays and they sometimes overhear my phone conversations with friends and colleagues. Yesterday, they were here and overheard me ranting about the bankers' attempt to get even looser accounting treatment. Right afterwards, the 5 year old said: "Those must be really bad people if they lie so much."

She made me think a bit. We've always known that the only way to offset a bubble bursting is to inflate an even bigger bubble somewhere else. And most of us learned from our parents that if you lie, you'll just have to make up bigger lies to cover it up too. I'd just never made the connection before but a child did.

At the heart of every bubble is a lie, often multiple lies. At a minimum, there is extraordinary mis-valuation and mal-investment. But usually, it is much worse than that - deliberate fraud and orchestrated deception on a large scale. One of the earliest was the South Seas Bubble, which rested on visions of wealth from commerce with exotic countries when in fact there was little basis and certainly no profit from such activities. In much the same way, the tech bubble produced fantasies of fabulous profits from commerce using exotic technologies. Both visions were fed to credulous "investors" by a whole host of con men and by the belief that the herd must be stampeding to rich pastures.

Every bubble has its (many) victims and its villains. The best way to avoid them is to remember something else your parents probably told you: "If it sounds too good to be true, it probably is."