Friday, 24 October 2008

Slowing the pace of the blogs ...

This was supposed to be a way to help me organise my thinking about what was going on, but it started getting a bit too big and lengthy. And also distracting. So I'm still going to write stuff, but not every day.

Friday, 10 October 2008

The illusion of control, shattered

Since Western central banks of problematically high inflation countries, beginning with the Fed and the BoE, wrang the inflation which had built up over the 1970s from their systems in the early 1980s, there has been a belief that they were somehow in control of our economic destiny. There were a certain set of plausible economic scenarios which "would never be allowed to happen." 

After the 1987 stock market crash there were widespread fears of a return to the 1930s style depression. Greenspan slashed interest rates and injected liquidity into the system. It worked like a dream. Not only was the anticipated economic collapse averted, the market closed the year in positive territory. The tone for the next twenty years had been set. 

By the time of the Asian crisis culminating in the collapse of LTCM in 1998, the tried and tested remedy to any economic problem had become simple - slash rates. Again, it worked like a dream as stock markets and economies not only recovered, they bubbled. When those bubbles burst widespread interest rate cuts becan in 2001 cushioned the fallout. The world marvelled at how shallow the recession had been in the face of significant post-tech-bubble headwinds, and birth was give to the housing bubble. 

But this bubble was different. It was the bubble of last resort and the fallout has been larger than anyone foresaw. And now we've had bank bailouts, insurance bail outs, mortgage nationalisations, TARP relief programs ...  even coordinated rate cuts. Yet the desired effect has been missing. Market falls have turned into market freefalls since the coordinated central bank action because it feels that despite having used up our ammo the monster is still stalking us.

A few days ago I wrote:
"It feels that the only thing preventing all out collapse at the moment is the prospect of some sort rate cut. Soon even that prospect will be exhausted and one feels there will then be nothing holding up the market."
Maybe the 1987 crash wouldn't have led to an economic collapse afterall. The stock market rose because it was going to rise not because Greenspan cut rates. And in 1998, when LTCM bust, the economy did OK because the economy was OK, not because Greenspan cut rates. But it didn't matter. The perception was that central banks and policy makers more generally were in control. Risk assets were peceived to be butressed by different versions of the "Greenspan put" and perception is reality. 

But whereas the inflation scare caused by sharp recent rises in food and energy prices hinted at the underlying truth, the finanancial implosion of the last few weeks has made it obvious. The perception has now been terrifyingly altered. Central banks aren't in control afterall.

Wednesday, 8 October 2008

How to thaw the mkts ... Ben signals rate cuts .... Fed tries to unblock the CP market ... who will finance the deficit? ... OPEC to cut

During his speech last night, Ben Bernanke was cystal clear - the Fed are ready to cut rates. The stock market rallied all of thirty seconds before beginning its decline on the way to a 5% down move. Asian stock markets are down a similar magnitude, and I suspect Europe will be down more still. The dollar is flat while commodities are mixed. Energy is lower, metals (especially gold up 1%)  and grains are slightly higher ...

... Bernanke might be criticised for yielding one of his most potent weapons against the market - the element of surprise. But this would be very harsh indeed. The market is going to go where it's going to go. It feels that the only thing preventing all out collapse at the moment is the prospect of some sort rate cut. Soon even that prospect will be exhausted and one feels there will then be nothing holding up the market. 

Every policy responce has so far been sold heavily. Yesterday the Fed announced measures to unblock the CP markets by setting up an SPV with Treasury money to buy 3-month unsecured and asset backed CP directly from issuers.  The Treasury will make a special deposit at the Fed to support the facility, and the Fed will lend to SPV at the Fed Funds rate making it neutral to monetary policy. 

This is a crucial intervention as non-financial and blue chip issuers (like AT&T, Boeing and Deere) and even states like California and Massechusetts had recently been locked out of anything beyond overnight liquidity. After LEH went down and ... forget its name - money market fund ... broke the buck, there has been a collapse in demand for any short term money which isn't issued by the government by the money market funds. These states and companies rely on this liquidity to make payroll and pay suppliers. Moreover, the freeze is hurting financial institutions, not only because financials are the biggest issuers, but because the companies are now drawing on credit lines in the absence of any alternative. These had often been agreed years ago when spreads were in single digit bps and used as a loss leader to get advisory business ... seems  like a long time ago now ... anyway, the effect in the credit markets looked good. GE CP spreads came in around 100bps on the announcement. Yet the stock market, after a sharp 3% move higher, soon fell back and began its long descent lower throughout the day. 

Its kinda funny though ... some commentators, mostly those with a more libertarian leaning have suggested that rate cuts are the last thing develped market economies need right now, as though it's  "like giving a junkie another shot of heroin". Since low interest rates caused the mess we're in why are we looking to low interest rates to get us out of it? I wonder what those people will say now that the Treasury has got the Fed to run a SIV to buy commercial paper?! 

Will it work? Once again, it is a step in the right direction. But what's going to happen if the credit markets are still frozen when longer maturity debt falls due, impairing the ability of the companies to fund themselves at economic rates? 

This is how to unfreeze the credit markets - create a centralised exchange for interbank lending. It looks as though we're moving in that direction in the CDS derivatives market already - why not do the same for interbank lending? If I buy an SPX future on the CME or a copper future on the LME, I don't care who took the other side of my trade. The only counterparty risk I have is with the exchange which effectively insures me against counterparty default by charging me a fee which I pay for with membership of the exchange. There should be a similar mechanism in place initially provided for by the governments, for interbank loans. Effectively, the fear of counterparty default would be removed and banks would once again be in a position to lend to one another. 

On March 6th, 1933 facing the prospect of a run on the banking system and on the country's gold reserves, Roosevelt declared a bank holiday to commence four days. In those days Congress hurriedly passed the Emergency Banking Act (By March 9th Henry B. Steagall, Chairman of the Committee on Banking and Currency, apparently had the only copy of the bill in the House. Waving the copy over his head, he entered the House chamber reportedly shouting, “Here’s the bill. Let’s pass it!" They did so in 40mins and a few hours later the House approved it.) Among other things, the Act allowed the RTC to take equity stakes in private sector banks and set up the FDIC deposit insurance scheme. I say we do the same thing right now - we all get a week to recover, the policy makers get a week to set up a centralised clearing exchange for interbank lending and recapitalise our banks.    

Central banks should also be cutting rates though and at long last it now looks as though they're finally about to. So far, the unconventional measures don't appear to have meaningfully narrowed any risk spreads. Rate cuts won't either but at least they'd lower the ultimate cost of capital for those able to get finance. All this delay has felt like we've been watching the house burn down but are scared to turn the hose because we're worried about the water bill ... better late than never I guess, but there isn't much of a house left ... 

But here's another problem - who the hell is going to finance the US current account deficit? The cash-rich surplus economies currently doing the financing aren't looking to clever at the moment and any sudden withdrawal of capital by them could introduce another black swan in a sky filled with them.

For example, illustration of the confusion over the seriousness of the situation in the Chinese real estate markt was provided by Morgan Stanley. One of their economists - Mr. Wang - predicted that "A substantial improvement in the inflation outlook should help ease the lingering concerns about the inflationary consequences of an expansionary macroeconomic policy,'' and that he " ... expects a decisive policy shift toward boosting growth in the coming weeks and months." All sounds sensible enough. Except that the main risk to his forecast was a "meltdown'' in the property sector across the country which "would lead to a massive collapse in real-estate investment". Wang said the consequences of this could be so serious as too offset any pro-growth policies the authorities might attempt, but put such a probability at a comforting 25%. 

Last month, Jerry Lou, one of their strategist said the likelihood of a meltdown was high. Annecdotally, white elephants can be found all over China - empty hotels, shopping malls and sports facilities. And those white elephants are collateral on banks balance sheets somewhere. Also, its nearly always wrong to trust an economist's view, especially if he's a good one. So I'm even more worried that Mr Jerry Lou might be right. If he is, the Chinese will join the Koreans who are already repatriating their dollar holdings to shore up domestic liquidity shortages  ... 

Meanwhile, Russian President Dmitry Medvedev pledged $36 billion of loans to the country's banks for five years to help unfreeze credit markets. That takes the total Russian lending to banks and companies via loans, cash auctions and tax cuts to $190bn in an effort to maintain a decade-long economic boom.  And just in case a quick glance at the stock market didn't tell you how bad things were (down 65% since late May) Russia's big four oil companies have asked the government for loans to refinance debt. Gazprom, Lukoil, Rosneft and TNK-BP are all struggling to raise liquidity at economic rates and so are tapping government reserves ... 

... and in the UAE, the central bank also injected $16bn dollars into their banking system to relieve liquidity shortages there. Nevertheless, Dubai plans to build a 350 billion dirham ($95 billion) development, Jumeirah Gardens, that will be home to up to 60,000 people. It will include offices, retail, residential buildings, two hotels as well as a high-end shopping area andis expected to be complete by the fourth quarter of 2013. Apparently, they think the real estate boom has nothing to do with the recently high but now falling oil price, even though the UAE were shut out of credit markets in 1999 ... if it wasn't so tragic it'd be funny ... 

Speaking of oil ... have the Saudis already pulled back in the 500k bpd they they sold into the mkt after oil hit $147? OPEC members pumped an average 32.19 million barrels a day last month, down 425,000 barrels a day from August, according to the survey of oil companies, producers and analysts. As Goldmans back away from their uber bullish forecast, now saying a rise to $120 was unlikely any time soon, Libya called for OPEC production cuts. The president of OPEC Chakib Khelil said the group would take "appropriate measures" to stabilise markets ... bring back the evil speculators maybe?  

Monday, 6 October 2008

RBA cuts rates by 1% ... events are moving too quickly ... we're watching a policy mistake

A stabilisation of sorts this morning. Asia is still largely softer although there are pockets of green - Korea, Taiwan and Australia are all higher by a percent or so after the RBA surprised the market with a surprise one percent cut, from 7% to 6%. 

There has been the hope of a coordinated cut in recent days ... rate cuts are now the only conventional weapon left in central banks armoury and a globally coordinated move would likely give more bang than individual stand-alones. Who knows if such a move would stave of economic collapse, and God help us if it doesn't - but now is surely the time to try. 

Nevertheless, the BoJ this morning opted to keep rates on hold saying only that economic growth was "sluggish" and likely to persist "for some time given the slowdown in overseas economies is becoming clearer ..." 

You can't help feeling that the world economy is changing more rapidly than its participants can fathom. With his company's stock down 18% yesterday after indicating it stood ready to cut steel production by 15% if needed, Lakshmi Mittal said:
"I believe this situation is short-lived, all of us hope it is short-lived. When this situation is behind us, things will improve.'' 
Only a few months ago the same Lakshmi Mittal said: 
“I can say with considerable certainty that the volatile years of boom and bust are now relegated to the past."  
More serious is that policy makers haven't quite woken up to the problem and the mistakes are compounded an already dire ennvironment as they have every financial crisis in history. In 1930s America it was protectionism, overly tight monetary policy and higher taxes. In Japan in the 1990s it was overly tight monetary policy, bungling financial reform and eventually, higher taxes. 

Today, we have a situation where market interest rates are tightening significantly. Monetary conditions are considerably more restrictive than this time last year, or than this time last quarter, or even at this time last week and the economy is deteriorating lockstep. Yet yesterday, Mr Evans at the Federal Reserve said:
" ... the inflation outlook remains a risk ... energy and commodity prices are notoriously volatile, and could rise again. More importantly, there is the risk that persistently high rates of overall inflation will boost the long-run inflation expectations of businesses and households, and thus become embedded in their actual price and wage setting behavior."
I'm going to put my neck out here, but I think Mr. Evans just might be wrong. The world is already unrecognisable to that which existed two months ago. It is a credit desert and like it or not, economies require the free flowing of credit to function properly. The complete siezure of credit will completly halt economic activity and it is no longer sensationalist to point to the increasingly real risk of depression, especially with central bank attitudes like this. By allowing monetary conditions to tighten so extremely without even trying to lower policy rates we are seeing a policy mistake and history clearly shows policy mistakes make bad situations worse.

Speaking as someone who is structurally bullish of energy, it's difficult to see a doubling of prices while we're looking at a potential debt deflation. This already savage and distressed world-wide financial deleveraging is accelerating and spreading from the US to the rest of the world. Unchecked, the end game is a broken international trading system, an increasingly traumatised world labour force and a radically altered political climate in which international relations will be more strained than they have been since the end of the Cold War. This is the future. Yet policy makers are still looking backwards. 

There is a chance of oil prices doubling in the next twelve months, as there is a chance that a piano falls through the roof of my house, through the office ceiling and lands on my head. There is a much higher chance that this time next year there will be street demonstrations demanding jobs and an increasingly vocal xenophobic nationalism growing in developed and emerging economies alike. Politicians rarely cover themselves in glory in such times.

But few things are as dangerous as a bad idea which is popular. From the Great Deprssion in the 1930s to the lost decade in Japan's 1990s, policy mistakes have been absolutely key ingredients in making bad situations worse. The current obsession with moral hazard and second round price effects echo's, albeit less extremely, the prevailing attitude in the 1930s when Treasury Secretary Andrew Mellon confidently advised Herbert Hoover in 1931:  
"Liquidate labour, liquidate stocks, liquidate the farmers, liquidate real estate. Purge the rottenness out of the system. High costs of living and high living will come down... enterprising people will pick up the wrecks from less competent people."

Friday, 3 October 2008

BRICs need credit too, but less so than the US ... Europeans balk at collective action ... Hypo rescued

As the Latin Americans discovered in the 1980s and the Asians in the late 1990s, being dependent on foreign funding of a deficit position has never been a comfortable place to be. In 1914 the Euroean countries which had invested heavily in the then emerging market of the United States repatriated their investments to pay for what would soon become the First World War. Faced with such an outflow of capital, and of gold which backed the international currency regime of the day, such a panic gripped the stock market that Washington simply closed it for four months. 

A few decades later the roles were reversed. In 1929, it was America which was the distressed debtor nation pulling its money from foreign markets to shore up the liquidity crisis at home caused by the Great Crash. One of the countries most destabilised by this was Weimar Germany whose economic desperation was so utterly complete they voted in Hitler. So as things stand today, we should be rooting for the financers of the US deficit. 

But this morning the Korean Finance Minister Kang Man Soo urged banks to sell overseas assets so that they can use the money to boost domestic lending. The government will provide won-dollar swaps and will use foreign currency reserves to support lenders if necessary. Meanwhile, the Kuwait Investment Authority, that countries sovereign Investment Authority, is considering in vesting $5.6bn into the Kuwait Stock Exchange. And in Brazil, the Treasury is having to inject funds into BNDES - a government sponsored development bank - which has seen applications for loans spike in the absence of market liquidity. The most recent firm to recieve funding from this route was Petrobras ... 

In Europe, the summit of leaders in Paris failed to produce any committment to coordinated action. Merkel said "Each country must take its responsibilities at a national level." The politicians still managed to use the crisis to grandstand to their own voters though. Sarkozy said he wanted a new workd to come out of this, "We want to set up the basis for a capitalism of entrepreneurs, not speculators." 

But what exactly are speculators? Risk-takers? What the difference - entrepreneurs are risk-takers and therefore speculators too, surely. Wasn't it entrepreneurs who ran HBOS, Northern Rock and AIG? I think Sarkozy just doesn't want bad entrepeneurs ...  

No wonder though.  There are as many bad entrepreneurs in Europe as the US, it seems. The bailout of Germany's second biggest property lender Hypo Real estate collapsed over the weekend because it turned out, in an echo of Lehmans, the estimated EUR 35bn Hypo had initially said they needed was wide of the mark. The bailout is now back on with a EUR 50bn rescue. The German has govenment moved to fully gurantee personal savings accounts, while in France BNP (entrepreneurs, not speculators) are taking over the Belgian units of Dexia after a govt rescue failed ... 

... Fingers crossed for everyone in Iceland too, where their own lender of last resort just doesn't seem big enough. According to the Telegraph at the weekend, the Icelandic central bank is trying to cut a deal with other Nordic central banks to help them stave of a complete collapse of their financial system.

What was wrong with the Paulson plan ... companies starved of credit, Fed governors see lost of stimulus ... grains should be higher ... S&P value tra

The S&P closed down 4% last night now and now trades close to where it did when the bail out plan was first rejected by the House of Reps ... deflation is the new inflation. Orders data yesterday was weak, as was the weekly employment data and commodity prices took a bath across the board. They are currently heading for their biggest weekly decline in 50 years. Dollar is stronger while Asian equity markets are softer by a couple of percent overnight, although one market notable for its relative strenth this week is Shanghai, which is up by nearly 3% ...  

The House of Reps are due to vote on TARP again today. It looks as though the plan will be passed this time too, after lengthy and tiring discussions seem to have got to the bottom of what was wrong with the first proposal. Some of the new provisions include the "extension and modification of duty suspension on wool products; wool research fund; wool duty refunds", a "7 year cost recovery period for motor sports racing track facility" and "exemption from excise tax for certain wooden arrows designed for use by children." 

So while the bill in its ealier form was a bail out of Wall St, socialism for the rich and an immoral bequest to the country's grandchildren, its now good for America. And there was me thinking the US wouldn't ever be in a position to pass the bank recapitalisation bill it will ultimately require because it was ideologically constrained ... actually its all about wool and wooden arrows. Why didn't anyone tell Paulson and Bernanke? Whoever drafts the next bail out bill should take note and save us all a lot of trouble ... to think that these people are in charge ... of course, the bill hasn't been passed yet ... I dread to think what will happen if it isn't. 

Asian interbank markets are siezing up too now. Bloomberg reports this morning that Hong Kong's interbank rate jumped 41bps to 3.81 even though the HKMA has since Monday been accepting more securities as collateral in its repo transactions. Last week there was a run on Bank of East Asia, this week Hang Seng Bank said it had "exposure" to debt issued by WaMu .... the Fed data meanwhile showed that the CP market had collapsed, the bond market is effectively closed and financial institutions are now using the Fed for nearly all their liquidity needs. Yesterday they borrowed $348.2bn. Needless to say, non financial institutions just have to do without. Caterpillar and GE are struggling to sell commercial paper at economically viable rates, while the state of Massachusetts pulled a sale ... likewise for Fortescue metals yesterday put a mine expansion on hold because it wouldn't be able to raise the funds. 

Not to worry though. St Louis Fed president Bulllard and Kansas City Fed counterpart Hoenig both said yesterday that "there was very strong stimulus in the economy" and that lowering interest rates would be the wrong response because of an "inflation problem" ... to think that these people are in charge ...

The effect of the recession on the commodity markets is intuitively what you'd expect with the commodity shares currently taking the brunt of the pessimism. But there are some anomolies beginning to develop. Yesterday, for example, gold fell by nearly 5% even though there appears to be a widespread shortage of bullion at the retail level. Agricultural commodities too were down by around 5% yesterday. But will a recession cause people to stop eating? I know there's a biofuel link via sugar and corn but does this justify a near 50% correction? 

Yesterday Mosaic fell by an eyewatering 42% (!!) on an earnings miss and a cut in posphate production, the company cited growing posphate inventories and weaker pricing. Monsanto actually raised its guidance but noone seems to have noticed, and all agricultural stocks in all markets fell heavily. Annecdotally, farmers are scaling back on fertilisers because they can't get the credit for the upfront payments required to purchase. Arable land remains uncultivated for the same reason - banks can't lend the necessary upfront capital. All of these factors suggest farmers are spending less on bringing new supply to the market and while that should explain why agricultural companies might struggle, the same logic should also argue for higher grain prices ... 

There is clear value emerging in large parts of the market as evidenced by Buffet's large and high profile recent investments (although the sage is still manageing to buy at levels of cheapness ordinary people won't be able to buy at). Meanwhile, credit spreads are trading at a 12.2% spread over treasuries, the widest since Merrills started calculating the index and the VIX is trading at levels last seen in the aftermath of 9/11. 

It S&P actually trades on 20x the last 12m earnings which sounds rather rich given the sickness of the credit-desert economy we face. Yet high multiples are normal in recessions. In December 2001, for example, the 12 trailing PE ratio rose to 60x as eaernings collapsed according to Bloomberg so there is plenty of scope to go higher.  Nevertheless, for the losers amongst us, forced into playing the timing game, it is worth bearing in mind that as the US economy entered into recession in 2001, the S&P's PE ratio rose to the high 20s just as it is doing now. Then, the S&P was at around 1300. A year and half later it was trading below 800. 

Why anyone follows the collective wisdom of a group of analysts with no investment experience and little apparent understanding of basic financial analysis I'll never know. As if another example of mass incompetence was needed, the consensus earnings estimate for the S&P500 has earnings rising from the current $52.6 in 2008 to $84 in 2009 - a 60% increase, which would be a fair old performance given the credit desert we now live in.  Who was it that said about analysts that in a bull market you don't need them, in a bear market you don't want them? ... to think that these people are in charge  ...  hang on, they're not - hooray!


Thursday, 2 October 2008

We're witnessing a huge policy mistake ...

Last night the Senate sent the amended TARP proposal to the House of Reps who are expected to vote on Friday. It now contains provisions for a temporary increase in the amount of bank deposists insured by the FDIC, a temporary extention of tax breaks and concessions on mark-to-market accounting, which is being blamed for the current mess. 

Mark to market accounting is preferable to any alternative. The Japanese credit crisis lasted for over a decade because they didn't have to value bad loans at realistic prices and so were under less pressure to come clean on the lowered value of the collateral held, or on the solvency of their organisation. So they told everyone that everything was fine because there was no pressure to own up to a failure they could simply deny. The same managers who made the mistakes remained at the helm of the same institutions who were horribly clogging up banking system. And they really did clog up the banking system. Actions spoke far louder than words in revealing how distressed Japanese financial institutions were. They refused to lend any of the liquidity created by the BoJ to anyone other than the government in the form of massive JGB purchases. This cycle led to zero interest rates and, at one point following the tech bust (a staggering 12 years after the banking crisis), 40bp 10y yields! The credit mechanism remained blocked, the velocity of money circulation collapsed as monetary policy became ineffective and the economy slumped into what became known as the lost decade. 

To an extent, therefore, the prolonguation of the Japanese crunch was caused by the absence of the discipline imposed by mark to market accounting. It does help though, if there is a functioning market to mark to which is why the TARP will be a huge step in the direction of ultimate stabilisation and unambiguously, therefore, a good thing. 

But will it provde the banks with adequate capital? In last week's FT Martin Wolf wrote this: 

"The aggregate stock of US debt rose from a mere 163 per cent of gross domestic product in 1980 to 346 per cent in 2007. Just two sectors of the economy were responsible for this massive rise in leverage: households, whose indebtedness jumped from 50 per cent of GDP in 1980 to 71 per cent in 2000 and 100 per cent in 2007; and the financial sector, whose indebtedness jumped from just 21 per cent of GDP in 1980 to 83 per cent in 2000 and 116 per cent in 2007 (see charts). The balance sheets of the financial sector exploded, as did the sector’s notional profitability. But leverage, alas, works both ways.

Since US net international debt was 39 per cent of GDP at the end of 2007, virtually all of this debt is an asset of another domestic entity ... when the gross debt stock is huge and economic conditions difficult, the chances that many entities are bankrupt is high. When people fear mass insolvency, lenders stop lending and the indebted stop spending. "


So probably not. Banks will likely remain undercapitalised. It is possible that the Asian sovereign wealth funds will be able participate in this recapitalisation. But is it likely? They are already heavily underwater with stakes taken too early in the crisis and indeed, in many cases (China) may yet find themselves with domesitic concerns where that capital could be deployed with higher priority before this crisis has run its course. An undercapitalised US banking system will be a vulnerable one, and one which is incapable of lending at anything like the rate the current generations of Americans have been used to. 

And this will be democracy in action. As banking crises have shown in the past, when the problem becomes so great that private-sector recapitalisation is impossible, only the government is left. This is the direction in which Europe is headed. The decisiveness of European govenrments is in stark contrast to the cack-handed and reactive handling of crisis by the US authorities. But Europe has no ideological constraint on state intervention in such matters and can therefore act preemptoraly. As the current mess in Congress is showing the world, America's ideological constraint is very real and very binding. Americans will only sanction the steps the Europeans are now being forced into after they've seen the economic consequences of a disfunctional credit mechanism. The outlook for the US is bleak indeed even with the passing of TARP. Failure by the House of Reps tomorrow will all but guarantee a depression ... 

... the central banking policy mistake we're currently witnessing won't help either. One of the lessons from the Great Depression, and from Japan's experience with its real estate bust is that monetary policy has to be adjusted quickly and decisively lower. Instead we've had the opposite. The BoE and the ECB have been unimaginative at best in recognising the deflationary effects of this crisis and history will show they kept interest rates too high for too long because they were concerned by late cycle inflation. 

But central banks always make this mistake. The larger error has been in allowing monetary conditions to tighten so dramatically. The world is deleveraging. In the US the mortgage market is now largely nationalised. In the UK, where there were ten mortgage lenders last year, there are now seven (and mortgage approvals have fallen 95% YoY). The rest of Europe is catching up and loan books everywhere are being wound down. Reduced credit supply means a higher cost of credit so mortgage rates are significantly higher than last year, as are interest rate costs for business are higher than last year. Central bank cuts would have kept the monetary stance unchanged. Instead, it has been allowed to tighten. This is a policy mistake which will exacerbate the deflationary effects of this crisis. 


Sunday, 28 September 2008

A vote for a Depression ...

The rejection of the TARP by the House is a turning point not only in this financial crisis, or even in the global economic downturn, but in the life of the Aging Empire itself. Ideological dogma has trumped common sense and if this plan isn't sucessfully revived, the calamity will go down in history with the same infamy as the Smoot-Hawley Tariff Act of 1930, which put up international trade barriers and helped turn a US recession into the worldwide Great Depression. 

Following the debate over the last few days had depressed me. Not because I thought they'd actually be brave/stupid enough block it (how embarassingly naive), but because I though Paulson's TARP plan might not be enough. If the bill that wasn't a bank recapitalisation and that would have made the taxpayer money was so difficult to pass, what chance passage of the future one which would be needed to recapitalise the banks and at a very real cost to the taxpayer? Not for the first time during this bailout episode, I was jumping the gun ... 

The House of Reps voted down the bill because their constituents were apoplectic about a bail out of Wall Street, about the prudent saver paying for the reckless speculator, about something worse even than socialism - socialism for the rich. And so this is democracy in action. As the stock market market falls by 9%, oil by 10%, as Gold trades 3% higher and the Ted Spread widens to a never-seen-before and deeply distressed 359bps, a crash followed by an economic depression is now likely. The American taxpayer has just voted for it. 

What happens next? There is still a chance that after realising what they've done, the Republicans fall into line for a revote. Paulson said he was working on a new proposal last night. That's the only hope. That the economy is going into recession is a given. With no second proposal this continued and intensified freezing of credit markets will make it deeper still. As recent events at Fortis, Glitner and Bradford & Bingley have shown, the financial implosion is now global and rates will be cut very aggressively around the world. That will help liquidity, but it won't solve the bank's solvency problem. The Europeans will organise their own financial system bailouts and, unencumbered by ideological qualms that any form of state involvement amounts to socialism, they are likely to come up with something which works, as the Swedes did in the early 1990s.

In the US the problems of failure to deal with the banking crisis will be more acute though, as will the political ramifications. Soon when the economy is on its knees the finger pointing will begin.  Some will blame the Republican's for not voting this bill through. That may be the point at which they pass a proper bailout package. Others will blame the rich bankers, who will be punitively taxed. But if nothing is done, sooner or later they will start blaming foreigners and the Aging Empire will begin a long disengagement from the outside world to a more comfortable place within. 

Friday, 26 September 2008

Ill today ... Congess botch the botch job ... the irony of the Republican Rebellion ...WaMu no more ...

Short blog this moring as I have a horrible cold - stiff neck, sore throat, runny nose and I'm going to moan about it all day ... mkts rallied nicely yesterday on the expectation that the bill was going to be passed but are now lower again because the plan is bumping up against what looks like a fledging Republican rebellion. 

It all looked good when Senator Dodd said last night that they had an agreement in principle and that Congress would act expeditiously ... in fact, the "agreement in principle" is apalling ... it includes the govt taking an equity stake in participating banks, stronger oversight of the Treasury Secretary's use of the funds, modifying govt made mortgages and drip feeding the funds into the scheme rather than making one upfront payment ... in otherwords, is far removed from what Paulson wanted and in all likiehood would massively reduce the already questionable chances of the plan succeeding ... they all sounds reasonable, but the reality is these measure will screw up the plan. 

The whole idea is about creating a transparent market in these illiquid securities. But making equity sacrifice a condition of participation in that market will just act to put banks off participating. It therefore risks preventing the scheme from getting off the ground. Similarly, drip feeding the cash to the plan in installments will prevent the scheme being properly independent from political interference. 

Of course, its not clear Paulson's plan will work. Liquifying the toxic part of their balance sheet is important but it won't be the final chapter in this crisis if the banks remain undercapitalised afterwards, which looks likley. And the assumption that the banking system will go out and recapitalise itself in the private sector flies in the face of historical experience where only the public sector has been able to recapitalise banks. Given the magnitude of the plan and the fuss it has created, Paulson's plan may yet go down as the biggest botch job of all time. But Congress botching the botch job is even less encouraging ...

So since Dodd's optimism equity markets have fallen back again, and Asia is trading softer overnight. Not because market thinks that we have a double botch on our hands, but because a section of the Republican party, increasingly emboldened by public cycnicism - welfare for the rich - appears to be staging some sort of a rebellion ... 

... Senator Shelby has apparently received a letter from "leading economists in America" too, saying the plan is premature and would not help. Banks should be failing before the government gets involved apparently ... Nobel Prize winning Robert Lucas of rational expectations fame is among the strongly libertarian leaning list of economists, game theory guys and behavioralists arguing that the government has no role in interfering in what is a private sector affair. 

Meanwhile the House Republicans, led by Eric Cantor and appalled that any tax payers money is being used at all, have thrown a spanner in the works with an alternative mortgage backed insurance plan which they argue wouldn't put the taxpayer at risk. They want a system put in place to charge premiums to mortgage-backed security holders which would finance insurance on those securities. I haven't seen any details on this yet but although the self-insurance idea along FDIC line is an interesting idea I can't see how it will solve the immediate problem, which is to recapitalise the banking system.  

But what sticks out is that most people, including the politicians, don't understand what the plan is. They think it's some sort of $700bn net injection into the financial system when it's actually a $700bn swap of liquid assets on the governments balance sheet for a bunch of illiquid assets on the private sector balance sheet at a price close to, but probably below those assets' economic value.  

The irony is that the $700bn net injection plan - which this isn't - would recapitalise the banks and would therefore probably work, while the $700bn market creation plan - which Paulson's plan is - doesn't recapitalise the banks and so probably won't. So the rebel Republicans are trying to vote down the one that won't work because they think its the one that will ... 

Washington Mutual went down last night with JPM taking over their deposits and their branch network. They now become the biggest US bank by deposits as well as by exposure to the unregulated $60tr CDS market ...

Lots of the talking heads on CNBC were asking how the stock market could be rallying yesterday while the credit markets remained frozen - the TED spread was unchanged on the day, but spiked as high as 337bps early on. As anyone who is actually involved in markets, rather than just being a clever sounding pundit knows, one market is usually a view on another. Gold stocks, for example, are a view on the gold price. But it doesn't work the other way - gold doesn't care about what gold stocks are doing. So at turning points you often see the two behaving differently, with gold stocks rallying even as gold continues to fall because the equity market is in effect making a judgement that gold is going to rally. That doesn't always mean it's right, but it's what you're seeing right now. The stock market is a currently a view on the credit markets, and the view of the stock market right now is that if the Paulson plan is passed the credit markets will unfreeze ... that may or may not be the correct view and I'm still not sure that this plan will work because it doesn't address the issue of capital inadequacy, but that's why the stock market isn't waiting for the credit markets for permission to rally at the moment.

Thursday, 25 September 2008

Do congress get it? ... TED spread above 3 as Chinese banks favour domestic counterparties ... more oil in Brazil ... buy beef

Market's fell yesterday on McCain's offer to suspend the campaign, including tomorrow's scheduled debate with Obama, until the TARP is passed. McCain, who is now nine points behind Obama in the capmpaign and presumably desperate said for any kind of favorable attention said:

"It’s become clear that no consensus has developed to support the administration’s proposal. I do not believe that the plan on the table will pass as it currently stands and we are running out of time.”

Most other members of the house, including majority leader in the Senate Nanci Pelosi appeared to indicate a narrowing of differences, citing agreement on increased oversight, executive compennsation and taxpayer protection. John Kerry said there was now a consensus on equity participation in those banks using the scheme. So notwithstanding McCain's attentions seeking it still looks to me as though a bill will be passed. 

However, some of these details look far removed indeed from the recommendations put forward by Paulson and Bernanke. Bernanke's testimony yesterday was interesting. His view was that the $700bn was only being used to kick start a market where there isn't one. By shining some light into the darkest corners of banks' balance sheets uncertaintity would be removed as to exactly what capital posisions were. This would help in delevering, and to the extent that mismarked capital could marked up, in the recapitalisation process too. But the real intention would be to provide the transparency needed by the banks and potential investors to attract the fresh capital they needed to become economically viable once more. The key, then, is that the plan is primarily about creating a market.

The real risk in my mind is not that Congress don't pass something, but that they pass something stupid. The plan to create a market, rather than directly "bailing out the financial industry" seems too subtle a distinction for Congress to understand. Curbs on executive pay are fine if they are retrospective clawbacks of some of the most egregiosly golden parachutes (Stan O'Neil's $100m+ for leaving Merrill in a state which ultimately killed it as an independently viable institution springs to mind). But an incomes policy is crazy. Similarly, there appears to be mounting interest in drip feeding funding for the proposal rather than stump up the $700bn in one go. All this will do is politicise a process which will only work if it is run independently. Worst of all is the punishing of participating banks by taking equity stakes in their businesses which risks, I think, no banks actually participating and defeating the whole purpose of the bill. I watched Bernanke's pained attempts at trying to be understood by the point-scoring politicians yesterday and actually felt sorry for him ... like a guy herding cats with his life depending on it ... 

The TED spread spiked back above 3 yesterday, to where it was at the height of last week's panic, and higher than it was going into the 1987 crash ... Chinese banks, meanwhile, have stoped entering into interest rate swaps with internation finance companies favouring only domestic counterparties. The Chinese regulator has denied reports that it has been leaning on the countries banks ...

Amid the fixation with developments in the US, the HBOS Lloyds deal has attracted little attention. But it's surely another disaster for the reeling UK housing market? NRK was doing 20% of the volume of new mortgages in the first half of 2007. When it hit the skids last year and was ultimately nationalised it ceased new lending. What happens to any market when you take out 20% of the supply? Mortgage rates rose, certainly helped and possibly even triggered the increasingly vicious housing slump and have been higher ever since ... fast forward to now and note that while Lloyds’ Cheltenham & Gloucester offshoot is renowned in the industry for its aversion to lending to buy-to-let, and buyers purchasing new-build houses, HBOS has traditionally given generous valuations and therefore bigger mortgages to new home customers. They also have a much higher proportion of first-time buyers than everyone else. Already tight conditions in the UK mortgage market are set to become tighter still.

Hong Kong, meanwhile, saw its first bank run since the Asian crisis as depositiors lined up at the Bank of East Asia. The HKMA stepped in with emergency funding while Li Ka-shing and the bank's CEO made a show of buying stock ... an investigation is now underway as to how the, er ... "malicious rumours" that the bank was in trouble were spread ... 

On the bright side, Buffet clearly sees value in the market. Not only has spent $24bn in the past nine months but he's now taken this stake in Goldmans ... in an interview with CNBC he said he was approached by Lehman's in April's capital raising but wasn't comfortable with their marks. He is very happy with the Goldman Sachs marks. He is probably also very happy with the Goldman deal he just got. The $5bn paying 10% a year is senior to the other prefs. Not only that, but he gets a five year option on another $5bn of stock with a strike at $115 (current price $130). A large part of an options value is its time value, so a five year option is worth quite a lot. Plugging in the numbers to BBG's Black Scholes model gives those options a value of around $2.5bn. So the net outlay on the prefs is actually only $2.5bn, giving an effective yield of 20% ... nice work ...  

Petrobras, trading on a PE of 8x (energy bubble??!) confirmed that there are "large" deposits of natural gas in the Jupiter (which GALP have a stake in) well and will give more details upon further analysis. Brazilian offshore looks as though it may contain as many as 50bn barrels of oil, and most of that will go to Petrobras. Already, they are one of the few integrated oil companies to show any production growth, yet they trade on a PE of only 8x ... 

The Australian Agricultural Co said the market conditions for cattle were now improving. High feed prices have seen high slaughtering of herds as current prices aren't economic, but that process may now be over. Flat or declining beef output in China, Russua and the US were cited, along with evidence that Brazilian exports have peaked

Wednesday, 24 September 2008

Bernanke doesn't know if the "bailout" will work ... Buffet takes stake in GS

Well it looks like I jumped the gun - Paulson's master plan is no RTC. In fact, I'm not sure what it is ... what is clear after yesterday's hearing is that the main problem with this crisis is the unprecedented and excessive complexity of the securities at the heart of the problem which precludes a simple solution. Understand that as presented, this is not a "deal" as such but an abstract concept. No one knows how much it will cost in the end, no one yet knows the mechanism for valuing illiquid assets and, unsurprisingly I guess in light of that no one even knows if it will work. Wheather or not Bernanke was afraid of putting his neck out and making a prediction, in the way that doctors are highly unwilling to offer proabilities on the success of an operation, I don't know. But I could have sworn he outright refused to vouch for its chances, saying only that it was the best they could come up with ... 

The plan seems to be to conduct a series of reverse auctions for the problematic illiquid securities. These auctions will be designed by egg-headed game theoriticians to establish fair prices where currently there are none. At the moment, there is no proper market for these securities so they are only sold at distressed levels. Once the sale has been done though, the seller and any other banks holding similar securities are forced to mark their capital to those distressed prices. In this way, I think the argument is, banks' capital is mismarked to give the appearance of being dangerously low when in fact it isn't. And if the scheme can establish a fair price and pay the banks slightly below that fair price but still considerably above the distressed price, then everyone is a winner. The bank wins because they get to mark up the value of their holdings and therefore their capital from the current deeply distressed level to one which is meaningfully higher.  Meanwhile the taxpayer benefits too because they will pay less than than fair value for the assets.

But will it work? What if the banks are still too levered even with a liquid market for assets which can be marked at fair value? Loads of the really toxic stuff is held as level 3 anyway and so not marked to market at all. Indeed, last I read Goldman Sachs - to take an example - had $96bn in Level 3 assets, three times its capital ... and what about commercial banks who don't trade as heavily as brokers and so aren't under the same pressure to mark to market? Don't they hold that stuff at model values anyway? Paulson said the heart of the problem was the real estate market. I actually think the heart of the problem is concern that the banking system is under capitalised and in a poor position to withstand the problems in the real estate market. And I'm not sure if the remarking of capital which will result from the greater liquidity and fairer pricing in the toxic areas of concern the scheme will provide will be enough to address that issue. 

Markets fell as the hearing progressed. The one month bill yield collapsed from 70 to 10bps ... according to the commentators it was because the bail out looked less likely to be approved ... I have no idea why this stress reapeared in the market, but my heart sank as I realised that any light at the end of the tunnel is distant indeed ... aside from concerns that the plan might not work, it's also clear that it's no quick fix. There will be an auction for each type of security and it will take months to work through each asset, starting with the simplest first according to Paulson. That means the money markets remain frozen for months. Which means no liquidity for the real economy for months. Which means continued deflationary pressure. 

I have no doubt that this bill will be passed. The posturing by senators yesterday with the world's gaze firmly on them would have been too good an opportunity to pass up on. It was clear that each one of them understood that the costs of doing nothing would enormous. You don't need to be a student of financial history to understand that the precedent for "letting it burn" was established in 1929/30 and led to the Great Depression and all that societal stresses which followed, including the rise to power of an Austrian oddball with a funny moustache. Which ones will be brave/stupid enough to take that risk? No, the bill will be passed and I'd expect some short term relief in the markets in response. But will it work? Hmmm ... still need to think.

Where does that leave us on the markets? ... Rogers, Chanos and Paulson have all recently restrained their bearishness on the financials. Now Buffet has added even more glitz to the already dazzling list ... futures are higher this morning on Buffet buying a $5bn stake in 30x levered with chunky Level3 assets Goldman Sachs ... hope its a better judgement than his one in Salomon Brothers ... it's being done on distressed terms to be fair, as you'd expect. Munger once said Berkeshire like to insure bridges against fire risk only if they're made of concrete and covered in water. Here, they get $5bn in preferred stock with a 10% dividend abd warrants to buy common stock at $115 at any time in the next five years. GS will also sell $2.5 in a public offering.

Monday, 22 September 2008

I, Paulson

GoldEnron Sachs and Morgan Stanley applied to become bank holding companies regulated by the Fed at the weekend, giving them access to wider sources of funding including direct loans. William Isaac, former chairman of the FDIC said, "The decision marks the end of Wall Street as we have known.  It's really too bad, as our country has benefited greatly from the entrepreneurial risk takers on Wall Street." ... interesting perspective ... wonder what planet he's been on this last six months? There's no doubt some people did very well indeed out of Wall Street's "risk taking" ... not sure it's been the country as a whole though.  

Paulson's master plan is now taking shape and looks as though it will involve a request for around $700bn to buy "troubled assets" (not just mortgages) from any bank with US operations (not just US banks). Interesting, Paulson gets unparalleled dictatorial powers to decide what assets to buy and from whom with no provision for subsequent judicial review ... wow ... but add to that the $85bn bail out of AIG and the estimated eventual cost of bailing out the GSEs of $250bn. Then add in the $500bn writedowns already taken by the private sector, and we get to a cost of the crisis so far of about $1.5tr ... as well as a new financial dictator ...  

Greenspan used to say a problem delayed is a problem solved. The Paulson plan will mark the end of this financial crisis by drawing a line under the root cause of the problem - bad system-wide collateral. There is still a recession to come. There is still the possibility that China's real estate bust might make the banking bust we've just seen in the West look like a picnic. And there remains a looming energy crisis.

But there has also been a very sharp increase in US government debt, by around $5-6tr depending on how you measure it. That will take total US govt. debt to around 100% of GDP, not including the "off-balance sheet" committments on health and social security which would likely take it to around a staggering 600% of GDP. Guess who said this:

"The budget should be balanced, public debt should be reduced, the treasury should be rebuilt, the arrogance of officialdom should be tempered and controlled, and assistance to foreign hands should be curtailed."

That's right - Cicero, the famed Roman consul and orator. 

The long-term over-committment of resorces won't trigger the sort of sudden financial crisis we've just been through. It will be a much slower moving decline, like the one currently killing the Detroit auto industry. Although Marcus Tillio Cicero's comment was attributed to around 44AD, for example, the inflation didn't really kick in in the Roman empire until the time of Marcus Aurelius over one hundred years later. Moreover, the Western Roman Empire's power didn't really peak for another hundred years after him, even though history books quote its ultimate demise as happening in 472 (although even this is probably a meaninless date because the real Roman Empire simply moved east to Constantinople and lasted through medieval times only coming to a definitive end when it was sacked by the Turks in 1453) .

The point is that while such massive debt issuance ultimately pressures the integrity of the empire and its currency it is something else to worry about in the future. Right now, the crisis is over. The Japanese, for example, went through a similar episode in the early 1990s and saw their debt load increase significantly as they tried and failed to fiscally revive their economy without fixing their banks. The economic pressures since have been deflationary, not inflationary ... so far ...  

Nevertheless, and regardless of the ultimate time horizon, the process is very clearly underway today. We are seeing a peaking of US imperial influence and historically such peaks have historically been disastrous for the imperial currency ...  gold and silver will serve role as the store of value as they have historically always done in such times. 

Thursday, 18 September 2008

HBOS no more ... Goldenron Sachs? ... will this be another Great Depression? ... let the printing press roll ... gold spikes ... infrastructure bill

Plenty of blood on the streets now ... another ugly close in the US last night (S&P down 4.7%, Nasdaq down 5%) has driven an equally horid session in Asia where markets are down 5-6% as I write. Morgan Stanley came under attack yesterday, its shares falling as far as 44% at one point, before closing around 20% lower. The criticism following the Bear rescue, and then that of the GSEs clearly hurt the US authorities and allowing LEH to go to the wall, and helping out AIG only on stringent and distressed terms was a very deliberate attempt to draw a line under the moral hazard problem. Unfortunately, it now appears as though the whole structure is build on moral hazard. It feels like we just had the rug pulled from under the financial industry ... 

... of course, the authorities presumably knew this would happen and the situation may yet stabilise without any intervention. They will feel they've done a good thing and they'll be right. But we don't know yet if this gamble will pay off. The reality is the wholesale credit markets are closed and there is no liquidity. Without that the entire financial sector, and eventually the real economy, is paralysed. 

Of the five bulge bracket firms last year only two are left, but how long will Morgan Stanley and Goldman Sachs last? This morning the talk is of Wachovia hooking up with Morgan Stanley, along the lines of BoA and Merrill ... the structural problem built into the broker-dealer model is that these guys rely on wholesale markets for the funding of long-term assets and those markets have dried up. There is a basic flaw in the model which is being painfully exposed. 

Might it be even worse than that though? Stansberry and Associates wrote a few months ago that over the last three years, Goldman Sachs reported net income totaling $19.6 billion but produced a cash flow of negative $93.6 billion - a $113.2 billion disparity. Even when factoring in the returns from its investments (which produce negative operation cash flow), they end up with a net negative number of –$800 million. They concluded "I've got no doubt that Goldman has the world's smartest accountants. In fact, I wonder how many of them used to work at Enron ... "

Back home it looks as though Lloyds have agreed to take out HBOS for 2.32 with regulatory competition restrictions waived. Once in a lifetime market share opportunity for Lloyds, but can't see anything yet on ring fencing HBOS's toxic "assets."

Russia suspended trading on its exchanges for a second day yesterday as the ruble denominated Micex fell by 10% in less than an hour, despite the CB injecting $20bn into the money marketsand the Finance ministry offering $44bn to fund the country's three top banks. KIT Finance, a brokerage, went the way of the Lehman and banks are now no longer lending to one another.  What a familiar sounding mess. 

This is serious on a number of levels though. It has become common to benchmark current situation against the 1930s depression. Everything is the worst, the toughest, the most serious  ... fill in the blank ... since the 1930s. And its true that there were many similarities between what's happened now and what happened then - the availability of cheap credit, the dangerous dependence on that credit to fund the purchase of consumer goods, stocks and fixed investment ... but there are many differences too. 

Firstly, the policy response was different. The Fed believed that allowing bankrupties was the right economically and even morally as it had been warning on the dangers of reckless lending in the preceding years. As the banking system was engulfed in panic and the money supply contracted by one third the Fed sat idly by. Milton Friedman believed that this alone was the difference between what should have been an ordinary recession and the depression which ensued. The rest of the US government was similarly inactive, failing to respond with any sort of fiscal stimulus until Roosevelt's new deal in 1933. Indeed, in the meantime, the government enacted the Smoot-Hawley Act which put up trade barriers and set off a chain reaction of similar responses around the world causing a collapse in world trade. 

Compare that to the central bank liquidity provision, the monetary and the fiscal stimulus we've already seen so far and the current downturn shouldn't be anywhere near what was seen in the 30s. There is no legislating for the utter stupidity of politicians of course, and there are increasingly autarkic noises emanating from the US (autarky as a policy of economic independence and non-trade was born in the 1930s incidentally) but with such a strong trading ethos throughout Europe and Asia it is difficult to imagine the world lurching back into the isolationism of the early 1930s.   

But there is one more aspect to the 1930s crash which is less widely discussed - the US was then the world's biggest creditor nation. When its domestic economy hit the skids it pulled that foreign capital home, badly destabilising the countries it had invested in (most notably Weimar Germany). This time round we have seen the opposite. The creditor nations of the world in Asia and the Middle East have stepped up their investment in the US and played a pivotal role in the recapitalisation of the financial system.

Russia hasn't been a big player in that respect, but neither is Russia the only EM to be in meltdown. The Chinese stock mkt is now down 60% from its peak and its real estate market is looking dangerous indeed with home prices as much as 25% lower in major cities and annecdotal evidence of white elephants all over the country. In other words, the collateral backing of China's banks' balance sheets may not be as robust as it appeared during the upturn. Any fix will likely include their massive foreign reserves which would require a repatriation of the capital currently invested in the US. You could come to a similar conclusion looking at the Gulf states, where authorities appear to be trying their best to prop up domestic share markets while the suddenly softer oil price is reducing inflows of dollars by the day ...

Yesterday the US treasury announced it would give the Fed another $100bn to restore its balance sheet following the AIG loan. Where does the Fed get the money for all those treasuries? The printing press. The ultimate solution to this mess will be the monetisation of dodgy collateral, which may or may not lead to another sort of mess further down the line. Interestingly, gold started its staggering 10% intraday rise almost immediately following that announcement breaking its hitherto tight correlation with the dollar. The dollar this morning though, is weak ...

A study by National Bank Financial says an oil sands mine, including upgrader needs a price of $85 to be economic. Meanwhile, the financial bust is going to make it harder for firms to raise the $179bn the industry expects to need for investment over the next ten years. That's worth bearing in mind as commodity prices sink. The EIA estimated that in the next 25 years the world would need to invest $30tr to satisfy its energy needs. Estimates of the required infrastructure in clean water provision over the same period take that number up to $40tr, or $1.6tr per year. That's more than the annual run rate of the current global financial crisis, for twenty five years ... 

Wednesday, 17 September 2008

Will this be another great depression? ... let the printing presses roll

Plenty of blood on the streets now ... another ugly close in the US last night (S&P down 4.7%, Nasdaq down 5%) has driven an equally horid session in Asia where markets are down 5-6% as I write. Morgan Stanley came under attack yesterday, its shares falling as far as 44% at one point, before closing around 20% lower. The criticism following the Bear rescue, and then that of the GSEs clearly hurt the US authorities and allowing LEH to go to the wall, and helping out AIG only on stringent and distressed terms was a very deliberate attempt to draw a line under the moral hazard problem. Unfortunately, it now appears as though the whole structure is build on moral hazard. It feels like we just had the rug pulled from under the financial industry ... 

... of course, the authorities presumably knew this would happen and the situation may yet stabilise without any intervention. They will feel they've done a good thing and they'll be right. But we don't know yet if this gamble will pay off. The reality is the wholesale credit markets are closed and there is no liquidity. Without that the entire financial sector, and eventually the real economy, is paralysed. 

Of the five bulge bracket firms last year only two are left, but how long will Morgan Stanley and Goldman Sachs last? This morning the talk is of Wachovia hooking up with Morgan Stanley, along the lines of BoA and Merrill ... the structural problem built into the broker-dealer model is that these guys rely on wholesale markets for the funding of long-term assets and those markets have dried up. There is a basic flaw in the model which is being painfully exposed. 

Might it be even worse than that though? Stansberry and Associates wrote a few months ago that over the last three years, Goldman Sachs reported net income totaling $19.6 billion but produced a cash flow of negative $93.6 billion - a $113.2 billion disparity. Even when factoring in the returns from its investments (which produce negative operation cash flow), they end up with a net negative number of –$800 million. They concluded "I've got no doubt that Goldman has the world's smartest accountants. In fact, I wonder how many of them used to work at Enron ... "

Back home it looks as though Lloyds have agreed to take out HBOS for 2.32 with regulatory competition restrictions waived. Once in a lifetime market share opportunity for Lloyds, but can't see anything yet on ring fencing HBOS's toxic "assets."

Russia suspended trading on its exchanges for a second day yesterday as the ruble denominated Micex fell by 10% in less than an hour, despite the CB injecting $20bn into the money marketsand the Finance ministry offering $44bn to fund the country's three top banks. KIT Finance, a brokerage, went the way of the Lehman and banks are now no longer lending to one another.  What a familiar sounding mess. 

This is serious on a number of levels though. It has become common to benchmark current situation against the 1930s depression. Everything is the worst, the toughest, the most serious  ... fill in the blank ... since the 1930s. And its true that there were many similarities between what's happened now and what happened then - the availability of cheap credit, the dangerous dependence on that credit to fund the purchase of consumer goods, stocks and fixed investment ... but there are many differences too. 

Firstly, the policy response was different. The Fed believed that allowing bankrupties was the right economically and even morally as it had been warning on the dangers of reckless lending in the preceding years. As the banking system was engulfed in panic and the money supply contracted by one third the Fed sat idly by. Milton Friedman believed that this alone was the difference between what should have been an ordinary recession and the depression which ensued. The rest of the US government was similarly inactive, failing to respond with any sort of fiscal stimulus until Roosevelt's new deal in 1933. Indeed, in the meantime, the government enacted the Smoot-Hawley Act which put up trade barriers and set off a chain reaction of similar responses around the world causing a collapse in world trade. 

Compare that to the central bank liquidity provision, the monetary and the fiscal stimulus we've already seen so far and the current downturn shouldn't be anywhere near what was seen in the 30s. There is no legislating for the utter stupidity of politicians of course, and there are increasingly autarkic noises emanating from the US (autarky as a policy of economic independence and non-trade was born in the 1930s incidentally) but with such a strong trading ethos throughout Europe and Asia it is difficult to imagine the world lurching back into the isolationism of the early 1930s.   

But there is one more aspect to the 1930s crash which is less widely discussed - the US was then the world's biggest creditor nation. When its domestic economy hit the skids it pulled that foreign capital home, badly destabilising the countries it had invested in (most notably Weimar Germany). This time round we have seen the opposite. The creditor nations of the world in Asia and the Middle East have stepped up their investment in the US and played a pivotal role in the recapitalisation of the financial system.

Russia hasn't been a big player in that respect, but neither is Russia the only EM to be in meltdown. The Chinese stock mkt is now down 60% from its peak and its real estate market is looking dangerous indeed with home prices as much as 25% lower in major cities and annecdotal evidence of white elephants all over the country. In other words, the collateral backing of China's banks' balance sheets may not be as robust as it appeared during the upturn. Any fix will likely include their massive foreign reserves which would require a repatriation of the capital currently invested in the US. You could come to a similar conclusion looking at the Gulf states, where authorities appear to be trying their best to prop up domestic share markets while the suddenly softer oil price is reducing inflows of dollars by the day ...

Yesterday the US treasury announced it would give the Fed another $100bn to restore its balance sheet following the AIG loan. Where does the Fed get the money for all those treasuries? The printing press. The ultimate solution to this mess will be the monetisation of dodgy collateral, which may or may not lead to another sort of mess further down the line. Interestingly, gold started its staggering 10% intraday rise almost immediately following that announcement breaking its hitherto tight correlation with the dollar. The dollar this morning though, is weak ...

A study by National Bank Financial says an oil sands mine, including upgrader needs a price of $85 to be economic. Meanwhile, the financial bust is going to make it harder for firms to raise the $179bn the industry expects to need for investment over the next ten years. That's worth bearing in mind as commodity prices sink. The EIA estimated that in the next 25 years the world would need to invest $30tr to satisfy its energy needs. Estimates of the required infrastructure in clean water provision over the same period take that number up to $40tr, or $1.6tr per year. That's more than the annual run rate of the current global financial crisis, for twenty five years ... 

The Fed branch out ... GS made up numbers beat expected ones ... spare some change for an ex-oligarch ... Asian reaction to AIG muted

Wild and hitherto unimaginable events are now happening daily ... overnight AIG was bailed out by the US banking regulator, the Federal Reserve, after what appears to have been a couple of days squabbling between the private sector and the Treasury over just who's responsibility AIG was. What had been sold as a liquidity issue didn't convince the likes of Goldman Sachs, JPM, Allianz JC Flowers who had been party to the negotiations. So it was decided that although the Fed had no real insurance expertise they were better pladed than the Treasury to lend the money. Afterall, they're the ones with the printing presses. 

To be fair, if AIG is merely illiquid as opposed to insolvent, the Fed is doing what it's supposed to as a lender of last resort. The $85bn 24m facility is at a distressed 3m LIBOR + 850bp in return for the option to take a 79.9% stake in the company. The board remain but senior management are replaced and will be charged with selling off assets to repay the loan. Amid all the hooting about tax payers money being used to bail out the Maserati-driving AIG guys that's likely to follow, the tax payer could end up making a decent return on the loan ... if AIG is solvent ...  but what if it's not? The private sector's involvement apparently stalled because the parties couldn't agree on the value of the collateral suggesting it was more than just a liqiuidity issue ...

But who cares - cue the rally!! ... sort of ... Asian markets rose sharply at the open, as the dollar weakened, only to drift back. As I write, they are now largely in negative territory, as the dollar is where it started ... I'd expect this episode to mark a near term bottom in the equity markets, but credit markets have been far better predictors of the future than  their equity cousins throughout this whole crisis and they're still frozen. Maybe the markets have been so utterly spooked by the last few weeks it's going to take a little longer for people to feel safe going back in. Maybe they're wondering how many of their counterparties will be around this time next week ... 

...  speaking of which ... WaMu was downgraded to junk status yesterday too. GS were rumoured to be looking at them for their deposits but that was subsequently denied. Meanwhile, Those Who Walk On Water announced their earnings yesterday and - who'd a thunk it - managed to BEAT net income estimates. I sure am relieved they have all those clever guys working there ... net income was down 70%, trading revenue was down 67%, advisory was down 56%  and Investment Banking was down 40% but they still made money and what's more, more money than all those clever analysts expected. One slight problem - there was no cash flow statement ... still - great numbers eh?

Maybe having branched out into insurance the Fed didn't have time to think through the demand implications of the removal of half of the financial system in the space of a couple of weeks. They kept rates unchanged at 2%, arguing that it is already pumping as much liquidity into the banking system as it can. Maybe, but all the interest rates I look at are higher than they were a few months ago, or even last year and only rate cuts would get them down. But they're scared of zero aren't they? I'd be scared of a heart transplant, but if it was the only think that might save me ...

Barclays look as though they've bought Lehman's US assets for $1.7bn . Apparently some of the LEH guys were complaining that this was a terrible option because the cultures were so different, Barclays being an English bank! Amazing. Surely there's more of a culture overlap for those guys with Barclays than there is at the local dole office?? 

HBOS fell 40% yesterday too, while UBS was down 20% ... I'm becoming numb to these big numbers, but the crisis has been a bit US centric so far. Isn't it about time some non-US banks went down?

 ... and as if this wasn't enough excitement for one day, the Russian market yesterday fell a mind-bending 17% ... and that came after a 50% fall in three months leaving the RTS down 58% from its May high. Now that's what I call a crash ... none of this 4% in day, 20% from the highs amature stuff we've been fretting about ... falling oil prices were cited as the cause but the FT reported yesterday that there are "few oligarchs who do not have $500m to $1bn in loans backed by shares." Those loans came from the banks, but the banking system relies on the wholesale market for 75% of its funding and that market is now closed. While Russian Standard banks struggles to raise a relatively paltry $200m from the market, Standard and Poors estimate that $45bn of loans need to be financed before the end of the year. But no one knows how many loans are collateralised by shares! Estimates range from $40bn to $140bn. Oleg Deripaska and Vladimir Potanin, the two guys fighting for control over Norilsk have a combined $4bn in margin loans outstanding ...

Medvedev said in yesterday's FT before the 17% decline:

"Despite all the global economic problems there are today, the situation in our economy is on the whole completely stable. We definitely have no crisis or pre-crisis situation.”

Does this now qualify? The Russians' sovereign wealth fund has $570bn. Wonder how much will be left after they've bailed out the banks so they can bail out the billionaires so they can bail out the Premiership and the high-end London housing market? More interestingly, Putin has the oligarchs right where he wants them ... what pound of flesh does he extract in return? 

The Minerals Management Service said yesterday that while guys like Transocean and BP go looking for their lost rigs, 97% of oil production and 84% of nat-gas output in the GoM (worth about 26% of US oil production) was idled after Ike. Oil prices rebounded last night on the AIG deal (??) but Libya and Iran have both said they have no plans yet to call an emergency OPEC meeting.

Monsanto said it's full fiscal year profit likely rose more than it had earlier forecast, with ongoing profit running at $3.58-$3.60 compared to $3.37 previously. Can farmers afford these record GM prices, or record potash prices, or record ammonia prices? I'd have thought not, which will surely lower yields over the next few years until more supply can come on stream ... Dell also warned that it was now seeing a widespread slowdown in its business. Not to worry though, HP said the opposite. Cue Nasdaq rally.