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. 

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.

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

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.

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. 

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 ... 

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.

China cuts but Asian stocks still down 5% ... AIG downgraded ... Iran inches closer to nuclear ... sugar fundamentals looking good

The world has gone ex another inflation fighting central bank after China cut rates by 27bp to 7.20% and also lowered reserve requirements yesterday. The Australians have already cut and everyone else will soon follow as the cycliacal peak in inflation has clearly been seen. As recently as early August, Bernanke suggested the Fed's next move would be up not down. In 2006 the same man - who spends his entire working life observing and analysing the health of the US economy - said under oath that there was no problem in the US housing market. 

AIG were downgraded overnight and this morning their CDSs imply about a 60% chance of bankruptcy. The FT reports they needed to take a $20bn hit on their bond insurance exposure, while a downgrade requires them to post  another $20bn in collatral. But its getting out of control. Yesterday they wanted a $40bn bridging loand from the Fed, presumably adding up those two numbers, but were allowed only to bend the rules so as to give themselves a $20bn bridging loan using otherwise ringfenced holding company assets as collateral. Today, in a Zimbabwesque inflationary leap, they need $75bn.

It seems as though Goldmans and JPM are setting up to lend them that $75bn. Not that either of those banks have anything like that sort of money to lend. But they do have access to the Fed. In March the Fed used JPM as its vehicle to bail out Bear, which at the time as an investment bank had no access to the Fed's lending. It feels like JPM and GS will be used similarly here with AIG.

Will they cut today? I had doubted it. The liquidity response to the panic in the stock market has been comprehensive with the Fed now taking eqities as eligible collateral (wonder if that includes LEH and AIG?) ... more likely was an admission that they're now thinking about it. But BB has shown himself easily paniced by stock market declines so a cut wouldn't surprise me ...in fact, the Fed Fund futures are now pricing in action with greater than 50% probablility from virtually zero a week ago ... the Chinese monetary response hasn't done much in Asia this morning though, where indices are down roughly 5% following on from the US last night. Chinese property prices also rose by 5.3% YoY in August, the lowest gain in 18months.  

As spectacular as the stock drop is that of oil, which is trading down 4% to below $92 this morning. MEND attacked a flow station in a third day of attacks and claim that Alakiri flow has been completely destroyed after what sounds pretty much like all out war, with the military launching air and marine offensives against MEND positions. Shell already announced force majeur on Bonny light deliveries in July and have now extended that. 

Meanwhile, the IAEA said yesterday that Iran had produced 480kg of low enriched uranium and were consistently refusing to answer questions concerning allegations of nuclear weapon making activity. What are the Iranians playing at? Who knows. It seems as though the mullahs are playing a game of brinkmanship with Amadinejad as their pawn-cum-rotweiller. The economy would certainly benefit enormously from a lifting of the sanctions the West is talking about and one would expect that to be the end game. But the Iranians seem to want more than what's on offer.

Rationally, war is in no one's interest. The biggest weapon the Iranian's have (until, crucially, they get nuclear weapons) is to block the Straits of Hormuz.  But that's not actually especially useful as a long term strategy. By preventing the export of their own oil it would harm themselves as much as anyone else. Moreover, their own feeble navy consisting of a couple of dingies and a rowing boat couldn't hope to last more than a few days against the might of the US navy, destroyers and aircraft carriers and all in such an event. And such action would have widespread international support to the extent it lowered world oil prices. And in any battle for public support the Iranian's could only use such a tactic credibly if they could claim to be using it in self-defence defence. That means they need some sort of provocation and that's what the nuclear antagonism is all about. 

The Israelis cannot tolerate a nuclear Iran. They view it as an existential threat (Amadinejad has openly called for Israel to be wiped off the map) and have threatened to take out any Iranian facilites in the same way they did with those in Osirak in Iraq in the early 1980s, and in Syria last year. But an Iranian operation, being much further away and with targets spread out over the country, would be much more complex than either of those operations. It would require Iraqi (US?) permission to use airspace and/or US aircraft carriers. But the US don't want another foreign adventure and would be unlikely to sanction an Israeli attack unless there was no other option. The Israeli noises so far, that they are about to bomb Iran and have conducted training exercises, have largely been bluffs (you don't telegraph to your opponent what your next move is going to be).  But that's not to say they have to be remain bluffs.

So where does that leave us? A nuclear Iran is such a game changer in Iran's favour that they want far more compensation than what's on offer for forgoing it. More posturing by both sidesis therefore likely until some sort of diplomatic solution is reached. Losing Russia over Georgia has probably upped the price the West will now have to pay. But this is a dangerous game indeed because there are euphemistic "hawks" on all sides - Iranian, Israeli and US - who want conflict.

The grain markets are also being swamped by the panic in stocks right now and the associated strength in the dollar, but the Australians said this morning that they expected to haverst 5% less wheat than they'd forecast because of dry weather. That puts the current forecast at 22.5m tons, still materially higher than last year's measly 13m tonnes ... but we're still early in the season down there ... 

... meanwhile, the fundamentals in the sugar market are looking better than they have done in a while with various factors coming into play. As sugar prices have been flat comparered to those of othe crops the Indians have switched production leading to an output drop of 16% according to the ISO. This would lead to a drop in exports of 86%, basically removing India from the export market. Meanwhile in Europe, the WTo ruling on EU dumping of excess sugar supply on world export markets comes into effect on Oct 1st. This outrageous and pernicious EU legislation currently subsidised EU farmers in the production of sugar, causing them to over produce for their domestic market, but allows them to dump that excess production on world markets. That game is now up and there will be a consequent decline in world sugar supplies to the tune of 14m tonnes according to  F.O. Licht in Germany. Allowing ethanol importation from Brazil into the US is increasingly gaining traction with McCain on record as saying he would remove the current prohibitive tarrif which corn based ethanol relies on to compete. Any move in that direction would see a huge diversion of the Brazilian crop towards ethanol and away from sugar ... interesting ... need to check on the inventory position before I get frothily bullish

 

LEH no more ... MER no more ... AIG no more? ... what's the marginal cost of oil? ...Chinese copper stocks fall

Its the markets' turn to blink this morning. This will do down as a defining weekend on Wall St history with Lehman being allowed to fail and ML being taken out by BoA. LEH being allowed to go to the wall has spoooked markets (SPX futures off 3.5% this morning) but there can only be one conclusion: the Fed and the Treasury believe LEH are neither too big nor too entwined to fail. Barclays seem to have been pushing for a deal which would have protected them from lossed caused by the toxic mortgage book, as JPM were when they took out Bear. But neither the Fed nor the Treasury went for it. 

We'll know very shortly if this was the correct decision. Futures, Dollar and most Asian stock markets weak. Europe will open down more since it rallied heavily on Friday in anticipation of a deal. The Fed have braced themselved for this storm by loosened the criteria on the eligible collateral for lending to include equities and all investment grade debt instruments.

Jim Rogers investor, author and world citizen said a few days ago:

"Bernanke is a very-narrow-gauged guy.  He’s spent his whole intellectual career studying the printing of money and we have now given him the keys to the printing presses. All he knows how to do is run them. Bernanke was [on the record as saying] that there is no problem with housing in America.  There’s no problem in housing finance.  I mean this was like in 2006 or 2005."

That sort of criticism must smart. So as arch-capitalist leaders of the free and democratic world it must be a great relief to be able to talk so tough, and finally be able to take the medicine they've prescribed so often to others in the past, to allow failing institutions to die. It's time for a futile gesture, and LEH is it.

The warning signs were there. "Bank of America said to lead list of potential Lehman buyers" flashed Bloomberg on Friday as the equity mkt rose ... while also "Paulson adamant that no govt money available for LEH" ... there is another conclusion which seems to have slipped off the radar screen in the fixation with the LEH stock price though. Maybe the US govt. didn't want to get involved in any backing LEH because it's keeping its' powder dry for AIG? Which surely is too big and entwined to fail? ... the FT reports this morning that the firm asked the Fed for a $40bn bridging loan to tide it over while it disposed of assets. Failure to do so would trigger a ratings downgrade which exiecs are worried would set off a fatal chain reaction. More on that today I suspect. 

Mer are off the Fed's list of things to worry about thanks to Bank of America who have bid $29 per share, which Mer have agreed to apparently. This is surely a massive relief to stock holders as the MER price resembled  that of LEH several weeks ago ...   

So who else is left? Of the big boys, only those who walk on water and Morgan Stanley ... we've had Bear, LEH and Mer, and we've had the GSE's ... AIG are next on the block and then what? a silver lining of falling interest rates now that inflation has cyclically peaked ... who knows? ... what follows today will likely be the low point of this financial crisis, certainly in terms of the financial panic surrounding it. 

Some of the smart money appears to be turning too. Paulson said last week he was looking at buying opportunities in the financial sector, Jim Rogers has started closing out his financial shorts while Jim Chanos believes the worst is over for the financials. And while a less noteable an investor, Jeremy Grantham is an undisputably brilliant intellect and he too now appears to be turning bullish. He believes large cap US equities will return >5% real return in the next seven years ... sounds like the product of analysis way too clever for me, but he is a very smart and thoughtful guy ... he does have a reputation for being a "perma-bear" butI think that's harsh. During the time he has been constantly bearish, developed market equities have gone nowhere ... but most of the talking heads think anyone to the bearish side of Jim Cramer is a "perma bear" ... 

Too late for Bill Miller though, who successfully masqueraded as a sagacious value investor, outperforming the SPX consistently for fifteen years or so. That cumulative outperformance has now been completely unwound now though by his bet on financials in general and the GSEs in particular, where his fund was the second biggest holder. His bitter take on the GSE bailout?

"Most troubling to the market is having private companies seized when they're in compliance with all published capital requirements."

He must be looking at a different market from me ...   

... nothing else seems newsworthy after this, but in pondering the marginal cost of oil, which I thought about $75, Total's chief exec's comments are interesting.  He said in Friday's FT that at prices below $100 planned projects would no longer be profitable.  http://www.ft.com/cms/s/0/dc3b9c66-8053-11dd-99a9-000077b07658.html

Oil prices are off a couple of percent this morning, below that $100 level, as hurricane Ike failed to materiallt damage the refining infrastructure in Texas and the EIA released around 300k barrels from the SPR. 

And despite the Chinese property meltdown MS are talking about, Shanghai copper stocks fell to their lowest since January 2003 according to the Shanghai futures exchange. Seperately, metal production data showed a decline in Chinese copper output, while BHP's Kloppers said last week that although demand was weakening, so to was supply as existing mines hit lower grade ores. Escondida, which represents 10% of world output was expected to see a 15% decline. 

Credit markets sieze up ... who's the next casualty? ... when to buy Russia? ...Chavez expels US ambassador

Yesterday wasn't a very fun day as the credit markets appeared to completly sieze up. Reportedly, there were only cash sellers yesterday with no bids at all, one broker saying it was as dry as he'dever seen it, including in the run up to the Bear bankruptcy. Moreover, the iTraxx indices don't hint at the stress under the hood because almost no one is trading CDSs right now because of the huge up front payments now required for the index constituents. Everyone knows there is another casualty - Lehman today, who the hell know who tomorrow? - and feels it's only a matter of time before that casualt starts dumping its market making inventory on the market. It felt like something very bad was about to happen all day, although it didn't ... in fact it turned into a modest rally which has carried through into Asia this morning ... 

No doubt the fastest retail sales growth since 1999 in China this morning helped. Might the consumer now "decouple" from the the slowing export driven sector of the economy? Well, if "decouple" is the latest euphemism for "lag" then yes, it probably will. Property prices are now falling now in major cities (e.g. Shanghai down 25%) making a meltdown look increasingly in the cards according to Morgan Stanley. So maybe we should temper our relief. Anhu Conch Cement - China's biggest construction materials maker - fell 10% this morning on just such concern. 

In recent months the authorities raised downpayment requirement for potential purchasers, and reserve requirements at banks ... look for those to be reversed in coming months. Can you refinlate bubbles once they've burst though? No you can't. But maybe it wasn't a bubble - maybe it was a miracle? I guess we'll just have to wait ... also out this morning was industrial production growth which was reported as the softests it's been in six years ...

Dick Fuld has brought Lehman back from the brink on four seperate occassions in recent times. On Wednesday's conference call he said “We’ve been through adversity before, and we always come out a lot stronger.” So much stronger that they continue getting into these ridiculous near-death experiences every time there's a downturn ... looks like they've finally managed to kill themselves this time though. The stock was down about 40% yesterday and is now trading around its 1994 IPO price! One of the few guys who's done well out of LEH is Mr. Dick Fuld himself, who was paid $40m last year. I'd have blown LEH up for half that ... 

Things are looking very ugly now. Merrill looks like the next target, trading below $20 (from $80 last year and $100 eighteen months ago) as does AIG (also trading well below $20). When the tech bubble burst earlier in the decade most of its darlings either went bankrupt or fell by the wayside. The strong, the ones still standing prospered when the weak had been eliminated. I wonder who amongst AIG, Merrills and Goldman will be World Com, who will be Amazon and who will be Google?    

The Russian index was down another 4.1% after a late swoon yesterday. It had actually been trading in slightly positive territory most of the day ... so how bad can it get? Well let's see ... the banking system relies on the capital markets for 75% of its funding; capital is fleeing the country by around $1bn a day; the banking system has leant heavily to oligarchs who've levered up holdings in Russian stocks; those stocks are now cratering because the "industrialists" who levered into them are now forced sellers of them; power, not the rule of law, holds sway; and that power is concentrated in this man's hands:

However, there is still $1bn coming into the country every day from the oil and gas revenues, and despite having spent $20bn defending the rouble in the past two weeks, reserves stand at $570bn, the third largest in the world. This is the key chapter missing from the usual emerging market blow up story. The entire market cap of the Russian equity market is around $500bn, so they probably have enough ammo to weather the storm (although I don't know what foreign holdings of domestic bonds are ... trying to find that out). 

Meanwhile, the CB is also providing as much liquidity as it physically can to the banking system. This isn't having an obvious effect right now since interbank rates continue to spike. Moreover, transferring dodgy collateral from the banking system's balance sheet to the central bank's rarely ends in anything but tears. But that's a problem for tomorrow. Everything has a price and its beginning to feel like it's time to buy Russia. It has the potential to get uglier first, as these things always do, but if there's one thing I know about emerging market investing its that these sorts of collapses are as inevitable as their timing is completely unpredictable. The only way to make decent money as an investor is to hold your nose and buy when things look ugliest ... difficult to do as a short term trader so we have to wait for the trigger ... just not sure what that might be yet ... 

Maybe it will be a turn in commodities? The historical volatility of of the CRB hit a thirty year high this week according to Bloomberg, although its not clear to me why an indicator which works well for equities should work for commodities, which have very different statistical properties ... oil is stronger this morning though, as are the other commodities, as Ike heads towards Texas and Venezuela expels its US ambassador while threatening to stop supplying the US market ... Ken Livingston's mate Hugo Chavez, eh?

Rally fizzles ... so do Russia's oligarchs ... demand destruction a euphemism for income elasticity ... more oil in Brazil

Well England, and Theo Walcott in particular's slick performance in Croatia last night hasn't sparked the world wide euphoria you'd think is meritted by the excitement in the tabloids this morning (we're going to the "Wald Cup" says the Sun ...) The SPX gave back ten points of what had been shaping up as a decent rally led by energy and materials to end up six points at 1232 after Moodies downgraded LEH and WaMu (hello??). Decent figs from Fed Ex after hours don't seem to have done much and the futures right now are already pricing out most of those gains ... Asia is soft by a percent or two across the board while the dollar continues its staggering rise and is now trading comfortably through 1.40 against the euro (if you annualise the recent rate of appreciation it will cost only $0.12 to buy a euro this time next year) The precious metals are soft following the dollar, while the grains and energy are pretty much flat.

The Russian RTX index with a 4.4% decline yesterday, following on from a 7.5% decline the day before posted its biggest two day decline since 2000. Foreigners have realised that its actually quite risky to invest in Russia ... doubt yesterday's comments by the Resources Minister that BP would have to sell a stake in its Kovotka gas field to Gazprom or the govt would "be forced to intervene again" helped ... just as it looked as though BP and TNK were friends again ... 

But it now looks as though a classic emerging market panic is brewing. The Russian banking system has exploded in size in recent years, to the extent that deposits only account for around a quarter of its assets, it relying on capital markets for the rest of its funding. These numbers are similar to where Northern Rock was sitting before the music stopped ... has the music stopped in Russia? Well, I'm no Russian expert but I see interbank rates have spiked to last summer's levels ...

Russia is a worry indeed. For all its culture and rich history, it represents and is dominated by the darker side of Europe's contribution to philosophical thought - xenophobic nationalism - and has a tendency to authoritarian rule which is built into its societal DNA. Annecdotally, foreign exchange students who are non-white (e.g. African Americans) report of no-go areas in Moscow and St. Petersburgh (never mind out in the sticks). Sergei Rebrov's advice to his Russian friend Roman Pavliuchenko who has just signed for Spurs, whom Rebrov played for many years ago was:

"I wouldn't go for a walk on my own around White Hart Lane. A lot of dark-skinned people live there. So naturally the crime rate is higher than anywhere else. It's not nice to be a robbery victim. So I suggest that Roman doesn't walk but drives around that area."

Nice. Russia's strained relationship with the West has very deep roots indeed. Of course, none of this matters so much when everything is going up, what worries me is how nasty this nuclear power will get when things aren't ... the FT report today that margin pressure was behind the liquidiation with some of Russia's richest (now ex-richest?) industrialists mentioned ... and the first shall be last ... wonder if that means Chelsea will be relegated next season?

The Russian president believes its all a storm in a teacup. The FT quotes him as saying 

“If the right decisions are made, the situation will straighten out ... We will return to the levels that we saw at the start of the year. In any case, I believe this is in the power of the government.”

So there you have it. The Russian govt. intend to show the market who's boss. Interesting idea ... it would be the first time in history, certainly that I'm aware of, a policy maker (or even a private ring) will have been successful at sustainably rigging a market ... 

China's Minster of Commerce has pledge state aid for exporters suffering from falling demand. No specifics are given but one assumes he's talking about aid over and above the yuan's recent weakness. Although we don't really know what's really going on in China the government certainly appear concerned enough that the slowdown is real to want to do something about it. China has built up a very strong fiscal position in recent years and it looks as though they're about to start using it.

As the oil price continues to fall, partly on the basis of these Chinese fears, the latest forecasts from the IEA yesterday were noteworthy. Yes, they lowered their forecast for oil demand for 2008 and 2009. Yes they cited OECD demand as particularly weak. But all this "demand destruction" the market is so excited by, which seems like good old fashioned income elasticity to me, is only a small piece of the jigsaw. The expectation is for demand to continue rising by 700k barrels this year and 800k next. That's certainly a slowdown from the boom years, but a more modest rate of growth should not be confused with a decline. Echoing comments from what Petrobras were seeing a few months ago, non-OECD demand weakness is likely to offset that in the OECD, and rise by around 1.4mb this year and next. Let's just hope the Saudi's get following capacity additions planned by the Saudis come on stream, and are not overwhelmed by the delpetion of existing fields. Those capacity additions are as follows:

Field kbp year

AFK 500 2008

Nuayyim 100 2008

Shaybah II 250 2009

Khurais 1200 2009

Manifa 800 2012

The great hope long term is Brazil, and Petrobras last night announced that its Iara field (co-owned with GALP and BG) is likely to contain 3-4bn barrels of oil. Tupi was estimated last year to contain 8bn. The discovery probably doubles Brazil's reserves, but Iara is a smaller sized field than Tupi and proportionately, Iara looks higher than might otherwise have been expected. This find is encouraging indeed and bodes well for the reserves in the Santos pre-salt regions hitting the 30bn barrel preliminary estimates.

Where from here ... the next shoe ... peak copper ... is oil cheap at $100 ... Korean unification

Carnage in the US last night as LEH, the oil price and probably hedge fund redemptions dragged down nearly everything, the SPX closing down 3.4%. On the bright side, although Asia is generally lower - the Nikkei, Hang Seng and ASX all down - Shanghai, Taiwan and Korea are all higher an better inflation numbers (arithmetically its very difficult to see anything other than a cyclical inflation peak from here). Dollar is flat overnight after ralling into equity weakness, US yields around 5bps higher with most commods down except energy which is up.

How much ammo do we have left? Bear is no longer with us, the GSEs have been nationalised and LEH is a dead man walking because it can't raise capital at economic rates ... you just can't help but wonder how many others are in the same boat?

Bill Bonner was interesting yesterday ... he said that he spoke at a conference in 2004 on the dangers posed by the GSEs. He didn't have a crystal ball, he couldn't see the future and he didn't have any great insight at all, other than at 30-40x, depending on how you measured it, they were overly levered. At that level you have no margin of error should something, er, "unexpected" arise ... which got me thinking ... if I was a financial company with a return on assets of 1.2% but a return on common equity of 32% ... leaving me levered 27x ... I'd be sitting with fingers and toes crossed right now hoping that I'd thought of absolutely EVERYTHING, right? Well, let's hope all those clever guys at Goldman Sachs are cleverer than the clever guys at LTCM, Enron ...

But, where do we go from here - cen bank cuts? They can't be far off given the improving inflation picture, but its difficult to see anything other than a short term bounce. The first discount rate cut by the Fed occurred last August with the SPX at just over 1400. Then, in January and between meetings the Fed cut again, this time with the SPX at about 1310 ... but that didn't prevent the need for Bear to be bailed out at 1280 ... after the GSE nationalisation the SPX currently sits at 1224 ... you get the picture ...

BHP chief exec Kloppers said that copper output from Chile's Escondida (which accounts for 10% of world output) would fall by 15% over the next couple of years. In a few years time, output would rise again as the current investments payoff but in the meantime, lower grade ores were hurting output. Although he can see demand falling, he thinks prices will remain resilient. As a broker was complaining yesterday though, no one is listening to the bull case, and no one wants to buy ... is that a signal?

It seems that the commodity boom has now been revealed for what it was - a bubble, which is now bursting. Except that BP is trading on 5x earnings, BG which is has grown its revenues by 35% per year is trading on 10x, Yara the Norwegian fertiliser company is trading on 7x ... silver has fallen by one half, and trades at 70% below its all time high, zinc mines are closing because prices are not economic at these levels, so too are nickel mines ... what kind of bubble is this?!!

Or are hedgies just dumping stuff to pay redemptions? Yesterday Goldman's wrote about their index of popular hedge fund trades and how they'd been underperforming ... that happened spectacularly yesterday with bread and butter equity hedge fund bets like LonMin - £33 bid but down 5.65% on no news - and Yara - down 12.5% on no news whatsoever, except that a few brokers had upgraded them to buy (being on the same side as jumped up pundit research would certainly make me question whether I should be in a trade but -12% is excessive) ... these were hammered despite an initially positive market ... redemptions, distress ... who the hell knows? But it felt very panicky to me, and those situations don't usually last long ...

OPEC's lack of enthusiasm for production cuts pummelled oil and the rest of the commodities ... and then the commodity stocks ... and then came the news that Ike looks set to miss the oil installations. So we're approaching $100 on oil and I think that will be decent support.

Why? Well, fear of what the Chinese economy is about do do is definitely seeping into the commodity market now. The problem is that anyone who says they understand what's going on there is LYING. In a plausible slowdown scenario copper and aluminium could easily go the way of zinc, nickel and lead. Chinese real estate, both commercial and residential, is now falling and banks rarely escape such stress. Banks lend to the rest of the economy, which means that real estate busts tend to be painful all round. Just ask the Japs, who suffered 15 years of stagnant growth after their real estate bubble popped, crippling their banks, or over the pond at the USA where the leader of the free world now has a nationalised and very public sector mortgage market. The French will be calling them commies now!!

That the Chinese economy will hit a large bump at sompoint is inevitable. Which economy has industrialised without several? But when? ... when will it roll over? I don't know. Goldman Sachs doesn't know. No one does. So best not get involved in anything that is vulnerable to that event ... what does that leave? ... not much when you think about it. But the Chinese haven't been as instrumental in driving oil demand growth as is generally assumed. They have accounted for about 20% of demand growth over the past five years, compared to nearly 100% in copper or aluminium. The same is true of soybeans, while net net, they still export corn ... oil at $100 is worth a nibble.

Finally, South Korea's Unification Ministry is on "high alert" after a tip off from US intelligence that Kim Jong Il may have siffered a stroke in the last month. Kim is clearly ill as he didn't attend his country's 60yr birthday party (must have been a blast) This could be quite a negative for the Korean stock market - there's a good chance that whoever follows Kim will want to either nuke South Korea or re-unify with it.

Shanghai is Chinese for Florida ... hedgy plays hurting ... why is gold so strong? ... mobiles killing the bees ... Algeria joins OPEC squealers

Despite a strong finish going into the last hour of US trading last night Asian equities are soft as I write as I write this morning. Particularly weak throughout are the commodity plays although financials and real estate equities are soft too. But worth special note is the Chinese market, which was the sole and notable absentee from yesterdays GSE-inspired stock market rally.

When the Chinese mkt started to decline last yearI didn't take it as necessarily telling us anything other than it had been trading on a multiple of 50x, which would have made peak Nasdaq blush. Ownership was far too low for a stock market bust to make any difference to demand. But what happens if you add a property burst onto that too?

It's certainly looking more ominous. China Vanke, China's biggest property company, became the latest company to warn on the health of the domestic economy reporting last night that property sales were down 35% (I'm assuming YoY) in August and that Shanghai new home prices were down 24% ... annecdotally it's not hard to find examples of reckless overbuild of both residential and non-residential property. And all those empty houses and offices are collateral on some banks somewhere's books. It would also be a mistake to add the commodity demand generated from that overbuild as something you could count on until the excesses are unwound ...

BBG reports that Goldman's index of equities which are particular popular with hedge fund managers (Google, Petrobras and Potash Corp being the some of the most loved) have been battered the most ... all the more puzzling that gold has been holding up relatively well these past few days. Why? Buggered if I know. The dollar is doing a very good impression of a phoenix, while the entire commodity complex has gone in the other direction. Yet gold - the classic inverse dollar play - remains at $800. That's still 25% below the peak reached in March, but compare that to Nat Gas, Silver or Wheat, each down around 45% from their respective highs, and Golds move doesn't seem so bad. Moreover, during this most recent bout of dollar strength coinciding as it has with financials' strength in the equity market, Gold, which is the diametric opposite of those credit dependent "alchemy" shares has hardly budged ... Is gold about to catch up with rest of the commodities? Or is it a signal that all is not well with this new confidence that the worst is over on the inflation and/or financial distress front? I've no idea. It's not difficult to see the bull case for gold implied by the nationalisation of half of the US mortgage industry. It's just hard to see why the same logic isn't sending the dollar lower. I suspect gold has further to fall nearer term before it is clean again, and ready to make new all time highs.

OPEC's Minesterial Monitoring Committee appears to have made no recommendation on oil output despite the Algerians joining in with the Iranians and Venezuelans making noises that they wanted less supply. I have no idea what these guys' marginal cost of production is but it costs XOM and COP around $25 to extract a barrel of their oil, with another $25 to invest in further production. In other words, the industry leading and cheapest producers on the planet have a marginal cost of around $50pb. Would state run clowns like those from Mexico, Iran and Venezuela have a higher or lower cost? I suspect the latter, which probably explains their squealing ... they need revenues well in excess of those marginal costs to finance their stupidly populist and military expansionary policies. The only ones who count though, are the Saudis since they're the only ones who appear to have any spare capacity (though I'm still skeptical just how much is actually there). They have signalled that they view current production as adequate. I suppose we should be grateful that the Saudis remain one of the last few bad guys in the world who's interests seem aligned with ours.

Finally, the Independent reported at the weekend the findings of an Ulrik Warnke that the growing "electronic smog" caused by Wi-Fi systems, mobile phone systems, etc is disorientating forager bees to the extent they are losing their bearings and failing to make it back home with the pollen. This can lower the number of bees in the hive to below critical mass, preventing the chances of the hive surving the winter in a fit state. In the last few years there has been a collapse in the honey bee populations of the USA, the UK, Germany, France, China and Taiwan to name just a few (in the US the decline has been in the order of around 35% this year and last). Bees pollinate 70% of the agricultural produce which either we or the meat we eat ultimately rely on, including oranges, soybeans and cotton for the speculatively minded. The declines are worrying indeed, but more concerning is the apparent inability of scientists to reach a consensus on what is causing them.