Wednesday, December 24, 2008
For whatever reason(s), Paulson made a move that led to hyper-deflation this fall and early winter. LEH's collapse wiped out dozens of counterparties - starting with AIG - that has since rippled around the world. The first few cracks were visible and easily contained (AIG and the shorting ban).
BUT, like throwing a stone at a glass window, the cracks spread in a spider web pattern and branched out into dozens, then scores, and now possibly hundreds of smaller branches throughout the global economy. Even those institutions and individuals not directly exposed to LEH's trades became affected. The massive amount of debt destruction was reflected in the record TED spread and impending collapse of the money markets back in October.
Emerging markets were also another victim, then commercial real estate, then commodities, and now retail.
Credit or debt (depending on your viewpoint) is THE lifeblood of the modern economy. Debt allows borrowers to leverage their returns. It grants the small business and average person the ability to achieve in years what took their ancestors generations to achieve - the attainment of wealth (or at least its trappings). Just look at student loans for example. For larger institutions, the returns were phenomenal. Several hundred or even thousand percent returns in months and even weeks were possible (at least on paper).
I am not repeating anything that most readers here already know. I think it's just necessary sometimes to take a step back and analyze the trees from the forest. We get caught up in day-day market movements instead of looking at the bigger picture.
And for the inflation watchers...don't worry, I haven't forgotten you. My next article is called, "Obama: The Road to Hyper-Inflation."
Tuesday, December 23, 2008
They are shoveling all the private sector junk onto the govt's balance sheet and then pushing it onto foreigners. That's why the conversion thesis remains 100% reliant on net foreign creditors like China and Japan continual purchase of Treasuries to keep monetary inflation bottled up behind institutional walls.
Bernanke and Paulson then think they will be able to "dole" or distribute the inflationary money supply through select govt relief programs - aka consumer stimulus, Detroit stimulus, commercial real estate (CRE ) stimulus, etc.
Whether or not their theory succeeds in the longer term is another issue altogether. However at the moment all the central banks in the world are cooperating w/the US.
As for inflation, it will first make its way known through depressed commodity supplies...namely food and energy (mostly oil).
Non-renewable commodities like oil are at depletion levels. If you believe in peak oil (as I do), then you know that when the crunch comes it will be violent and quick. Any type of accord that the US forges w/foreign creditors could collapse in the face of resource wars.
At this point, the US creditors are simply waiting for Bush to expire so they can negotiate w/the Obama team. The US will likely have to surrender some sort of sovereignty rights that it took for granted in the past. Maybe rights for foreigners to own land, invest in "strategic" businesses, etc. Similar to what the US banksters did when they journeyed to Japan in the 1990s to force open their corporate markets.
There will be nationalist backlashes but I believe Obama is a practical man and will compromise w/our foreign creditors. He has to. There is really no other alternative (unless he triggers a Treasury default and no one wants that).
Sunday, December 21, 2008
Which Is Most Likely?
A) Default on Federal Debt (Treasury market)
B) Restructure Debt (Bankruptcy/Bretton Woods 2)
I will go through each option to explore the pros and cons.
A) Default - This is the apocalypse scenario favored by goldbugs.
Under a default scenario, the US federal government will default on its external debt obligations.
While the authorities can wipe out US debt in a single stroke the consequences are catastrophic. Looting and mass riots are the symptoms on the domestic front. Internationally the collapse of the dollar will mean even more widespread chaos in emerging markets and ripple effects among the remaining G7. The largest creditor nations will also face hyperinflation as their contractual debt claims would be wiped out. Nations that depend on US foreign aid in order to function will become suddenly isolated (Israel and Taiwan).
Winners: Agriculture, Energy, Guns, Canned Food, Gold (short term), US Taxpayer
Losers: Everything except the above
B) Debt Restructure (Bankruptcy) - Bretton Woods 2. An international consortium of G7 and powerful emerging market nations will form the parameters of a new world order.
A new currency would replace the dollar. This "New Dollar" would be backed by the full faith and credit of the new world order instead of the US government.
Treasury holders will lose most of their holdings although sovereign (international government) creditors would be given options, warrants, or some form of IOU that places them in a senior position to other debt holders. Institutional holders of Treasuries would be next in line. Finally the retail holders of Treasuries and state government debt would be wiped out. Make no mistake. This is an attempt to preserve the status quo but the price will be high.
Winners: US Govt, emerging markets, large foreign governments, agriculture, energy, corporate (FIXED INTEREST) bonds, non-Western Banking Cartel
Losers: Cash, inflation bugs, retail US govt debt holders (treasuries and munis), corporate CALLABLE (variable) bonds, US Taxpayer, Western Banking Cartel
C) Conversion: All existing US government obligations will be converted into EXTREMELY long term, low, fixed interest loans. Treasuries would be smoothed out to 50 and even 100 year maturities. The Federal Reserve would buy home mortgages outright from the banks and then offer the homeowner rates as low as 1-3%. This is basically a Japanese "Lost Decade" taken to extremes - global slowdown that will last 30-40 years minimally.
Note - This option is ONLY AVAILABLE TO THE US. There can be only one quantitative easing beast in the world and that is the US government. Other nations that try to emulate this model will be only partially successful.
The UK, EU nations, Japan, and maybe even China WILL try to copy the low interest, long term rates and be partially successful in doing so at the institutional level through DOLLAR DENOMINATED credit swaps run by the Fed or a new government agency.
But, they will still have to offer higher interest rates on their debt refinancing because there simply are not enough institutional or retail buyers to soak up all the new bond issuances.
Winners: US Fed govt, Western banking cartel, US State govts, US corporate bonds (fixed interest), agriculture, energy
Losers: Agency Debt holders, Corporate (variable) bonds, foreign govt bonds, commodity dependent emerging markets (Russia, OPEC, Latin American banana republics), smaller manufacturing based emerging markets (Vietnam, Taiwan, S. Korea), US Taxpayer
Conclusion: Out of the 3 options above, I believe US authorities are leaning towards #3 since it is the solution that best preserves the status quo. However, the conversion policy runs a VERY HIGH risk of triggering mass social unrest in less stable, foreign governments - particularly the commodity dependent emerging markets such as Russia, OPEC states, and virtually all of Latin America.
Saturday, December 20, 2008
Callable bonds are like options for the issuer. Issuers have the right - but not the obligation - to redeem the bond before maturity at the call price.
Callable bond holders are compensated for this uncertainty by getting paid a higher coupon (interest rate).
In options terms, the bond buyers are the option sellers. They get paid a premium to assume extra risk.
Callable bond issuers benefit because they bet on interest rates to fall at some time before maturity so they can refinance their debt at a cheaper rate. Similarly the bond holder benefits when interest rates fall and the bond's value rises. When the debt is redeemed it is done so at a premium to benefit the bond buyer. So, the bond buyer benefits 2x:
a) higher coupon and
b) higher premium.
The difference b/t options and bonds is that the bond buyers EXPECT the bond issuers to redeem at some point. There is an implied assumption that the bond seller will try to refinance the debt for the reason I just explained in the prior paragraph. It is expected and priced into the market.
If bond issuers do NOT redeem WHEN interest rates have fallen to new lows, they risk upsetting the bond markets and panicking bond holders (aka institutions).
The automatic assumption among the bond holders is that the bond issuer is at such risk that NO ONE wants to refinance their debt because of...
So which sectors issue the most callable bonds?
Munis, commercial real estate, and European banks.
The parallels are eerie.
Thursday, December 18, 2008
The COMEX theory states that gold is basically being shorted on the commodities exchange by banks in a coordinated effort. I will not bother addressing the merits of such a case except to say that ALL commodity classes have fallen significantly. Oil, agriculture, and industrial metals have declined much more substantially than gold. Gold retains intrinsic value but the possibility of gold $5k/ounce remain remote.
Please readers you misunderstand me. I am not an enemy of gold or precious metals.
I have no position in gold. I am not shorting gold. Nor do I have a long position.
Gold rallies on 2 things: 1) FEAR and 2) INFLATION.
1) There remains a lot of fear in the market. Who knows where the next time bomb is?
2) Global govts continue to cut interest rates. Highly inflationary (for them).
I prefer to remain neutral and just watch gold. I believe that there are better inflation/fear plays out there - like agriculture. People need to eat food. They do not need to eat gold bars.
Because of the Treasury ponzi scheme. EVERY single US financial print media - WSJ, Financial Times, Investor's Business Daily, Barron's, etc. - is against an auto bailout. At least in the UAW's, Michigan politicians', and auto corporations' proposed form of TARP funding.
A bailout will undermine the shadow banking system of Treasury swaps and TARP re-capitalization of the financials. The money would be going into the real economy - UAW, creditors, Detroit councilmens' districts, etc. - as opposed to staying w/in the digital boundaries of the Fed's playland.
Wednesday, December 17, 2008
1) Excess money creation led to this problem
2) Money creation is not just limited to govt actors
3) Pvt actors can create money too (no not counterfeiting) through loan syndications and tranche bundling.
4) These pvt debts were created on leverage and fantasy accounting
5) When loans and tranches become marked to 0 money is destroyed.
Since all this private supply of money is basically 0 or in limbo land then the mkt reacts accordingly. Hence deflation.
This is my biggest disagreement w/gold bugs who keep calling for hyperinflation. They say money creation is only possible from govt actors. NOT TRUE. The pvt sector was minting money at the ratios of over 90:1 (Lehman and Bear Sterns).
Who knows how much imaginary money and leverage there still out of there?
Why are the banks now leveraged 20:1? Why even 10:1?
Friday, December 12, 2008
Their actions result in de facto shorting.
Alternately, another way of looking at it is to see that these primary broker dealers are the same charity cases that accepted TARP money in the form of Treasuries. And those Treasuries are the ONLY thing holding up their balance sheets (which should be uniformly negative by now). Given such a situation, the primary dealers have a powerful incentive to hoard the Treasuries they have in order to meet investor scrutiny.
Imagine an auctioneer being assisted by helpful agents (The Fed) in the room bidding up the price amid a crowd of frantic rubes. The way the secondary market works is that the primary dealers get to buy govt paper at a discount and then sell it on the secondary (repo) market w/a slight markup for their services. That's the way it works in normal times.
The majority of the traders in this market are institutions but remember that not all institutions are built equally. We have the primary dealers (This is the same group that I write about in my earlier article, "The Libor Cartel") and then everybody else (wealthy individuals, regional banks, credit unions, pension funds, foreign governments, state governments, charities, endowments, etc.).
Pay special attention to the regional banks. These banks are the same entities that are also feeding from the TARP trough but are STILL hemoraghing cash from: sour commercial real estate loans, sour residential mortgage loans, sour trade loans, sour CDS bets, etc. They also have an incentive to meet analyst expectations by stuffing their balance sheets w/Treasuries to offset the horrendous fiscal reality of their finances.
The best example was the fierce bidding in the 4 week paper where there was NEGATIVE interest rates earlier this week in intra-day trading.
So, why is this allowed to happen?
This arbitrage is allowed to happen because of the antiquated method of settlement.
The value and quantity of bonds traded and the value and quantity settled are not the
same because of the process known as “netting.” In netting trade obligations, the Fixed Income Clearing Corporation, or FICC, uses bonds due to a participant to offset bonds due from the same participant in the same security. In many cases, there is NO ACTUAL DELIVERY of the treasuries because in their infinite wisdom our regulators believe that this process simplifies final settlement.
The markets say otherwise. Instead it allows a group of greedy, well connected profiteers to plunder billions from institutions and accelerate the cash flow problems for the broader financial sector. It is impossible to know just how badly the secondary buyers have been cheated because propietary data identifying specific parties is hard to come by.
HOWEVER, the parlous status of state and local finances in the muni bond market reflects just how badly governments have been violated by the chosen few of Wall Street.
The promise to deliver in the secondary market is backed by very lax penalties. This is actually a gray legal area that some academics have drawn attention to in the past. The problems have only accelerated exponentially since that time.
Apparently, the Treasury and Fed believe this to be a small price to pay in their in their broader policy of quantitative easing and - gasp - dare I say it, re-capitalizing the banks at the expense of the taxpayers (again).
You have to look at failures to deliver since they are the root of the problem. Until the Treasury implements a real "penalty" for treasury holders (aka primary dealers) that refuse to surrender their bonds in a timely manner then there will be no fix.
Paulson won't investigate the problem b/c he knows that the banks have been playing an arbitrage game against the slight fees and penalties they incur. In fact he and Bernanke are ENCOURAGING it as part of their quantitative easing policy.
To see why we must examine repos. A repo is essentially an unsecured "loan" or promise backed by nothing more than the primary dealer's "full faith and credit" to deliver the asset in a timely manner. (Sounds suspiciously like Uncle Sam? Where else did you think the big boys learned such irresponsible behavior from?)
To understand why the repo market is malfunctioning we have to examine the "I know it when I see it" test made famous by Justice Potter Stewart of the Supreme Court when he tried to explain "hard-core" pornography, or what is obscene, by saying, "I shall not today attempt further to define the kinds of material I understand to be embraced . . . [b]ut I know it when I see it . . . Jacobellis v. Ohio, 378 U.S. 184, 197 (1964).
In other words something funny is going on in Wall Street. But then again something funny is ALWAYS going on in Wall Street. The question we have to ask ourselves is "Exactly how does Wall St benefit from delayed deliveries of Treasuries?"
The repo market is suffering from a liquidity crunch w/all kinds of maturities - not just bills. In fact I am going so far as to say that many of the primary dealers would become de facto insolvent if they were to honor their obligations RIGHT NOW.
Even the new treasury auction schedules won't help for 3 and 7 year notes. It's the REPO market that matters and repo buyers want the paper that they are familiar and comfortable with - not something that has unknown liquidity.
The result is that most treasury funds have simply stopped accepting new clients. W/interest rates so low the fund managers are squeezed for fees and can't legally justify dipping into the investors' principal to pay themselves.
Wednesday, December 10, 2008
The government is refinancing. They sell the bonds at 0% and then can pay off longer term bonds at higher percents.
The gold and inflation bugs got it all wrong because they are effectively shorting the dollar, shorting Treasuries, and betting on inflation.
Deflation is here to stay for a bit longer.
The best time to short Treasuries is when interest rates approach 0% or go negative (depending on the term we are talking about) because there is literally no further room to go.
But in this kind of environment all you can do w/that trade is short term scalping. The longer term trade will be after the Fed cuts to .5%
I say after instead of before because we remain in a deflationary spiral for the short - medium term. Normally the rates would go back up. Especially w/all the money printing going on.
BUT, just look at the case of Japan for an ex of what didn't happen according to plan.
A lot of yen bond shorts got destroyed or made only marginal returns in the mid-90s to first part of the 21st century because the BOJ continues to keep rates below 1%.
Monday, December 8, 2008
The companies are de facto shifting the burden of retirement and healthcare costs onto the balance sheet of first the state and then federal governments.
State governments will have to contend w/lost business tax revenues, lost tax credits offered to these businesses, Medicaid contributions. These drawbacks are IN ADDITION to the plunging property tax revenues that local governments traditionally base the bulk of their budgets on.
The Federal government will have to contend w/unemployment benefits costs, food stamp costs, Medicaid contributions, lost income tax revenues, and possibly pension benefit guarantee costs (through the Pension Benefit Guaranty Corporation or PBGC that extends coverage to defined benefit plans) at the very least.
Thursday, December 4, 2008
Condo flippers walking away are the first sign of trouble. The worst part (for them) is that there is a HUGE glut of inventory just about to come online in the market. This reminds me of Florida in early 2007.
Unfortunately, the UAE government is likely to repeat the mistakes of global governments
elsewhere. All of their fancy economics and finance degrees only boil down to one thing: print more money. Or in this case, slash interest rates . . . for now anyway.
Dubai's property bubble is financed on the expectation of $100+/oil and built by the toil of horriblly paid and treated workers from Muslim South Asia (overwhelmingly Pakistan and Bangladesh). These foreigners are a prime recruiting target for Al Qaeda and other Muslim extremist groups.
After all, what further proof do the imams need to demonstrate of the way mainstream Muslim leaders have isolated themselves from the common man? These workers know firsthand the kind of world they are forever barred from entering b/c they were building it w/their own hands.
Of course the UAE elite will respond by cutting interest rates and taking other means of printing money to protect the wealthy speculators. For all their fancy econ and finance degrees that's the only thing govt ministers know how to do. This will invite food and energy inflation - 2 areas which disproportionately affect the poor. And when that happens Dubai will be sitting on a powder keg.
At best ratings agencies are pressured by politicians to give local governments higher grades so that they may qualify for cheaper refinancing. At worst there is blatant lying or obfuscation of the off balance sheet fiscal weakness of these governments. Why?
Because state governments are run on politically necessary but fiscally unviable promises to select voter groups. The same situation exists at the federal level but Treasuries remain protected by large global actors such as the entire Far East, Middle East, and even the US' own Treasury purchases.
In 1929, more than 98 percent of the largest U.S. cities were rated Aa or better, according to Ciccarone’s research, which cites a study of municipal bonds showing that 3,252 issues went into default at the peak of the economic contraction in 1935. Almost half the bonds in default were rated Aaa in 1929.
“We may be facing the same conditions today that we did in the 1930s, but they could be worse because of pension and other liabilities,” Ciccarone said. “We have some huge liabilities at the same time that real estate values are falling.”http://www.bloomberg.com/apps/
Wednesday, December 3, 2008
You might hear the term "quantitative easing" being thrown around by media pundits (as if they have a clue what it really means). So, what does it mean?
Quantitative easing is a term used to describe the fiscal and monetary policies of central banks in a zero or near zero short term interest rate environment. It was first applied by Japan during the 1990s. After Japan's equity markets imploded in the late 1980s, the BOJ repeatedly cut interest rates to nearly 0 percent. When these actions failed to stop the tide of poor economic data from affecting the markets, the authorities started buying its own longer term debt and then the debt of its banks. Their intent was to encourage less spending and more consumption by the consumer sector. The results were disappointing to say the least.
The overall effect was to keep Japan's banks on life support. Critics derided Japan's financial sector as "zombie banks". Notable critics included Greenspan, Bernanke, and other luminaries from the US who flew to Japan and lectured their authorities on what bad boys they had been.
Well. Fast forward 8 or 9 years to the present. The hypocrisy is astounding.
We now have the Fed buying Treasuries from the Treasury. But the Fed has scaled operations up significantly. Instead of just buying government debt, they have also taken on mortgage backed loans, credit cards, student loans, auto financing, and other commercial paper junk that will never see the light of full (model) valuation again.
When will it stop? No one knows exactly but the government looks prepared to bail out the Detroit 3 automakers and their staggering legacy costs.
Moreover, the situation is worse than any comparisons to 1990s era Japan. The Japanese economy is overwhelmingly geared towards exports while the US economy is geared towards consumer consumption. A staggering 65-70% of US GDP derives from consumer spending...the vast majority of which was built on the credit bubble.
The Japanese consumer is also more responsible than his or her US counterpart. Nowhere else in history have people been able to buy 5 or 6 houses w/no money down and w/no job. Nowhere else in the world are people able to buy cars and then trade them 2 or 3 years later for a newer model. And nowhere else in the world are people able to buy tvs, computers, and furniture w/zero percent financing for 18 months and no payments for 2 years. The worst part is that this culture of profligacy is still continuing during the holiday season.
So, can the US borrow its way out of a deficit?
I don't know but there is over 3% left on 30 year Treasuries left to go! After that the government might get the bright idea of issuing 100 year notes or even perpetuals. Don't laugh. The UK is still paying off World War I war bonds or perpetual gilts. But who would be dumb enough to buy government paper that has 0 inflationary protection, is callable, and is thinly traded?
Even China can't be that dumb. . .
Monday, December 1, 2008
The effect of Bernanke being the main buyer at recent auctions has been a record push of T-bills and T-notes to nearly zero percent interest rates. The government's aim is to force people to look for alternative investment channels that can offer higher returns, e.g., equities and corporate bonds.
This strategy will work. . . at least in theory. Investors remain wary of equities for a good reason. The fundamentals have not changed and have in fact gotten a lot worse. Corporate bond markets are a little better but the yields in some areas are priced for armageddon - commercial real estate and property funds are offering (forward) dividends in the triple digits (percentage wise)! More conservative bonds are pushing the low double digits. So, does this mean that corporate bonds are now the next green pasture to attract the Treasury bulls?
Institutions have to be convinced first. Since bonds are denominated in increments of roughly $10k or more the debt markets remain the domain of the big boys. Unfortunately for the government, many institutions have conservative mandates that require them to invest in less risky asset classes. And that has meant US government paper. For now anyway. I would not be surprised to see fund managers with links to dubious (aka troubled) firms lobbying the SEC and other regulators to allow them to change their investing mandates in the near future.
Tuesday, November 25, 2008
But what happens if the mark to market rules are changed? Banks have been lobbying regulators for the past few months to change the accounting rules to reflect financial modeling valuations. Numerous banks and industry analysts are writing non-performing assets down to zero and this is reflected in their share price.
The asset writedowns are also angering government regulators because it allows the banks to qualify for free taxpayer money from the TARP and various other federal assistance programs.
IF the government waives the rule changes this could spark a large bear rally in financials and the greater market. Savvy traders would merely fade the rally though. When market valuations are completely abandoned opacity increases and confidence decreases.
Sunday, November 23, 2008
They are structured in such a way that when a certain exchange rate level is breached, for example Y95 in dollar/yen, the coupon disappears but the note is still valid. Unfortunately for the Japanese market makers, these instruments amount to DE FACTO SHORT POSITIONS on the yen. The money managers are now faced w/the prospect of either buying yen on the spot market (hideously expensive) or buying yen calls. In either case the Japanese bond desks are being forced to contribute to the further unwinding of the carry trade. This in turn will result in only more bearishness for global equities markets.
Potentially, the Japanese government COULD step in to buy all those bad bonds. But the cost would be astronomical, time consuming (months to plan and weeks to implement), and extremely complicated to oversee. And that is just speaking from the domestic angle. Foreign traders would also have to be consulted or else the ripple effects of policy decisions in Tokyo would quickly make their way felt in global markets. Don't believe me? Just look at how well the US government's TARP program has been implemented.
bullish treasuries = bearish equities
and vice versa: bearish treasuries = bullish equities.
When yield starts to get negative or close to 0 then you have a turning point (13 week or 3 month note). After all traders can't give the govt more money than they're already lending out for very long. The same thing happened one month ago in October when TED was above 4.0.
This time the catalyst is not TED but rather the fear of collapsing CRE (commercial real estate) and the rapid decline in Citicorp's share price. I'm seeing dividends on commercial REITs at nearly 100%! That is ridiculous. And completely oversold. Citicorp however is anothe story.
Wednesday, November 19, 2008
The perception of value in US commercial real estate has completely evaporated in November as this chart from CMBX illustrates. The chart maps the staggering jump in CDS insurance or the cost of using credit swaps to protect corporate bonds and loans from default.
Interest rates on U.S. commercial paper also rose to the highest in almost two weeks, according to yields offered by companies and compiled by Bloomberg. This is reflected in the yield (aka borrowing costs) in terms of basis point increases. Traders are pricing in higher yields as paranoia now rules the day.
To be fair, a contrarian viewpoint is that these elevated levels are not based on reality but rather pure fear. A short term turnaround - if not capitulation - could be around the corner.
Wednesday, November 12, 2008
"To say Russia has quickly been humbled would be an understatement.
After a brief period of complete shock, expect a sudden outburst of
absolute rage from the Russian people and Russian politicians as they
squarely lay the blame for their instant fall from grace on 'the
West'. Unfortunately Russia's regional neighours are likely to bear
the brunt of that blind rage."
Tuesday, November 11, 2008
Higher interest rates on future bond issuances will lower the value of existing treasury holdings. This is unlikely to be a problem w/shorter term issuances such as the 3 year or lower maturities. However, it spells big trouble for bonds that have longer dated maturities.
10 year Treasuries still offer yields below 4% (roughly 3.75-3.8% the last time I checked). Throw in several more trillion dollar bailouts of the financial, auto, insurance, and other industries currently begging at Washington's doorstep and you have the formula for a meteoric rise well north of 4-5%.
Rising inflation is also a problem in the future as the US government continues to run their printing presses 24/7.
Ironically, a steep yield curve has been beneficial to banks as it reduces their borrowing costs while raising the return on their loans. This is yet another example of Paulson and Bernanke's unintended consequence of unlimited bailouts: robbing Peter to pay Paul.
Thursday, November 6, 2008
First, a lot of them bet on $200 oil and $9 corn. Second, they betted on each others' demise through CDS. Third, they betted on a strong euro. And finally, they're betting on a strong yen.
Ironically the yen is at the heart of all the prior bets since a cheap yen fueled easy borrowing. Now, you have the currency trading desks bidding up a strong yen while the arb and prop desks frantically try to unload their losing trades. And this is going on in the same house!
``An intervention to change the yen's rising trend would be like trying to stop a tsunami with one hand tied behind your back,'' Toru Umemoto, chief currency analyst in Tokyo at Barclays Capital, said in an interview on Oct. 28. The unit of London-based Barclays Plc is the third-largest foreign-exchange trader.
Wednesday, November 5, 2008
WASHINGTON (MarketWatch) -- The Federal Reserve on Wednesday said it has raised the interest rate paid to banks on reserves that banks keep with it. The Fed said the latest formula for excess reserves sets the interest rate at the lowest FOMC target rate in effect during the reserve maintenance period. The previous formula set it at the target rate minus 35 basis points. The rate on required balances will be set at the average target fed funds rate over the reserve maintenance period. The previous formula set it at minus 10 basis points. The Fed said these changes would help foster trading in the funds market at rates closer to the FOMC's target federal funds rate. In recent weeks, trading has been below the Fed's target. The Fed said the new formula for paying interest on reserves -- an authority the Fed received as part of the Congressionally approved $700-billion bailout program for financial firms -- will be effective from Thursday, November 6.
Saturday, November 1, 2008
Medium term government paper is another canary in the coal mine. Traditionally, 10 year notes occupy the middle ground between the extremes of short term (13 week - 2 year) and long term (30 year) paper. The fact that they are veering towards bearish sentiment is troubling for the US government.
The short term paper has seen yields driven down to below 0 at several points in October because of a flight to safety. Meanwhile, the longer term paper continues to maintain an upwardedly biased yield curve (despite some minor down movements also based on a flight to safety). This is no surprise as interest rate risk rises to match uncertainty when the time horizon expands.
Some commentators believed that medium term paper yields were supposed to fall. Instead the opposite happened. Rates rose.
I believe this is an ominous sign. EVERY SINGLE world government is flooding the bond markets w/paper. EVERYONE. Foreign Treasuries are doing this to finance the gigantic budget deficits arising from new bailouts and existing social spending programs.
The US government has to compete w/these new issuers for bond buyers' attention. While rates here are relatively low, they are sure to rise in the future.
Short term paper is continuing to offer low yields because they are the extension of central bankers' wills. However, central bankers are powerless to determine longer term interest rates. No. Long term rates remain under the domain of the markets.
Treasury Auction Schedule:
Friday, October 31, 2008
Government bond buyers rejoice! This is becoming a buyer's market.
While central bankers control short term interest rates - the infamous rate cuts so widely discussed in the media - the market controls longer term issues. Interest rates on 20 and 30 year notes are expected to soar in the future as governments continue to flood the markets with paper and provide aid to everyone except the taxpayer. Government battles against deflationary demons of their own design are even now rousing the inflationary bears from their slumber.
The US lacks a sufficient number of primary dealers to act as intermediaries in bond distribution even as Treasury auction schedules have increased. 4 have already passed on out of 20 - Washington Mutual, Bear Sterns, Countrywide, and Lehman Brothers have all either declared bankruptcy or been absorbed by more politically connected rivals. Moreover, the remaining bond and fixed income desks have been decimated by round after round of layoffs that have also affected the greater financial sector
Western Europe is in even worse shape. While the ECB, the fiscal body of the EU, can set interest rates, it is powerless to affect greater flows of monetary capital. Why?
Because there is no such thing as a "Euro bond". Individual member states continue to issue more and more bonds. Individual states such as France, Germany, and Holland have been the largest instigators of bailouts. Other nations such as Spain and Greece have not followed suit because their banks were too small to attract much investor notice to begin with.
This lack of coherent fiscal and monetary policy is straining the delicate balance upholding the union. Under the Maastricht Treaty, members are supposed to maintain fiscal deficits at no more than 3% of GDP. Even if Brussels were to tinker w/the figures, the structural cracks will eventually overwhelm a fundamentally flawed system.
I find it unlikely that the EU will survive in its present form within 5 years.
Thursday, October 30, 2008
Tuesday, October 28, 2008
But eventually the G7 will get what they want: a single OECD currency (not to be confused w/a single world currency). They will be able to use this control to influence events in emerging market nations - or at least try to. Recent events have already shown that complete isolation from negative market effects are impossible to prevent.
All those crazy programs Paulson and Bernanke invented to keep the banks on life support are costing a lot of money to say nothing of the daily breadline that forms outside the discount window every day.
Foreigners are only too happy to lend us the money as evidenced by the capital flows from Asia and the Middle East. Just watch the action in the govt bond and spot fx markets if you don't believe me. Take special note of the Treasury auctions that form up every so often.
Unfortunately for the dynamic duo, they don't realize the ultimate cost of their spending. Corporate earnings among exporters are going to get slammed in Q1 because of a stronger dollar.
Additionally, foreign investors are fleeing to US govt debt which includes both federal (treasuries) and local (munis). Traditionally wealthy individuals also preferred munis because of their tax free status.
Some of the upwards yield pressure will be mitigated by this demand. States will also continue to petition the Federal government for more handouts. However, the near bankrupt state of many local budgets WILL see increased capital flows into the US.
So, what does all this mean? More dollar strength. At the moment, most of the world's money is all pouring into either the USA or Japan.
This is one sneaky way for the Japanese to sell yen w/o cutting interest rates. By sending yen to hard hit commodity currency countries (like Australia and S. Africa), the central bankers of these nations are able to buy back their own currencies on the spot markets.
So, watch the JPY/AUD, JPY/Kiwi, and JPY/Rand as they will be the first pairs to reverse.
However, upward pressure remains on the yen from domestic Japanese fund redemptions as well as hedgies unwinding their carry trades. We won't see those dramatic 10% appreciations overnight but a steady appreciation of the yen looks to be in the cards.
Monday, October 27, 2008
Unfortunately, the economic turmoil that started in the West is driving many Japanese to repatriate their funds. That's right - they are going through the same kind of fund redemption as the US. Ironically, their spending power is increasing as their equities markets tank - just like ours.
BUT, the story takes a darker turn. Unlike the US, Japan's fundamentals aren't as impaired. The Japanese do NOT have a network of 700 odd foreign military bases, massive foreign aid promises to other countries, and a sea of corrupt bankers to bail out (they already took care of most that back in the 90s).
Translation? Speculators - including US funds - are piling onto the Japanese yen. This possibly includes US pension funds which are MANDATED to seek safe harbor investments.
Finally, the Japanese are also in a demographic crunch - a substantial portion of their population are pensioners. Japan now is the USA 15 years in the future demographically; many seniors with declining birthrates. These seniors are going to have to start dipping into their retirement accounts more steadily.
Nothing goes up or down in a straight line. But the overall trend for the yen is up. And the trend for the Nikkei is down. The spillover effect on the US market is unmistakable - forced unwinding. In the long term, the more damaging effect is the aversion to US financials and most forms of structured finance.
Sunday, October 26, 2008
Simple. In any deal, lenders usually impose some sort of restrictions or parameters on the terms of the loan. Lenders impose these restrictions to increase the chances of their loans being repaid in a timely and efficient manner.
During the 1997-1998 financial crises, the IMF (a cabal of G7 nations) was able to successfully bailout emerging markets...but at a steep price. IMF aid was "conditional" on certain covenants. Social spending was slashed to the bone and public infrastructure privatized to raise the money needed to repay the loans. Rapacious Wall Street bankers and private hedge funds profited from the plundering of public treasuries. S. America, E. Europe, and E. Asia underwent political and economic turmoil. Entire governments collapsed. Riots, food shortages, and poverty spread like wildfire.
Fast forward to 2008. The emerging markets recovered on the backs of export engines: typically high commodity prices (agriculture, energy, or metals depending on the nation in question) and cheap manufactured goods. Now in the space of less than 2 weeks their recovery looks like it is about to reverse.
Leaders in emerging markets are loathe to turn to the IMF for help. They remember the chaos that engulfed their countries in the wake of similar help in the past and would rather remain loyal to their domestic constituency. Remember, most emerging markets are politically fragile to begin with.
Instead of going to the IMF, private, bilateral contracts have been struck between China, Russia, and the Gulf States (lenders with deep pockets). Unfortunately, such help does not seem enough. Besides, China, Russia, and the Arabs have their own problems.
Nor can the IMF afford to holdout for profitable deals that benefit their corporate constituency. The IMF may be forced to offer unconditional aid regardless of any existing ties of loyalty. In other words: No more one sided deals that profit their banking and private side friends. Globabilization itself is at stake.
Friday, October 24, 2008
If I gave you a credit card w/ .5% interest on it and guaranteed that rate for 12-14 years...what would you do? I think you know the answer already.
Now instead of being a credit card company, replace the issuer with the Bank of Japan. Japan has had low interest rates for a long time now. These low rates were the result of repeated "fiscal stimulus" attempts to re-invigorate a moribund economy. However, the interest rate cuts did not have the desired effects and instead turned Japan's banking system into a series of zombie banks kept artificially alive through government largess.
Hedge funds took advantage of this situation and went on a global buying spree. I can't tell you exactly what they bought since hedgies are privately owned for the most part and have no disclosure requirements...BUT they evidently bought into emerging markets big time. Why?
Emerging markets were a pot of gold for the last 10 years. After the Asian, Latin American, and Russian markets collapsed in 1997-1998, the IMF forced these guys to raise interest rates to 2x digit levels to pay off their debt. The amazing thing is that the foreign governments were actually successful in servicing their debt on the backs of high commodity prices and cheap labor intensive exports.
BUT... along come the hedgies. Smelling a good profit, they used dollars to borrow yen. Then they used that money to buy high interest bearing debt in places like Turkey, Mexico, and Indonesia. The profits were amazing as long as they rolled in. Turkey for example was offering 17-20% interest rates earlier this year. Imagine getting 20% and only having to repay .5%. Even after inflation costs, these guys were raking in several hundred percent profit every quarter.
Currency traders have been talking about the currency trade implosion for YEARS and speculating on just such an event. Look at the Yen/USD and Yen/Aussie. These are the 2 top floating major currency pairs.
From here arb desks will "flip" the money into more illiquid but higher yielding projects (most developing countries have illiquid trading volume at best so bid/ask spreads are poor). In many cases hedgies did private side deals. Infrastructure projects (aka project finance) were really popular - they financed power plants, roads, ports, sewage plants, and similar projects. High yields at the time. Unfortunately the illiquidity of the self-same projects mean that it's hard to find a buyer in times of crisis.
Fast forward to the Fall. The Fed bans shorting (another hedgie favorite). The sell-off builds and they're unable to profit so they're forced to sell existing long positions. Redemptions increase. Several emerging markets teeter on the brink of default. The sell-off began in earnest.
Thursday, October 23, 2008
A strong dollar is DESTROYING the carry trade, the practice of borrowing low interest bearing currencies and using it to "flip" into higher interest bearing instruments....such as emerging market debt.
There is a chain reaction going on as hedgies and other institutions cascade from the highest bearing junk rated debt to cheaper, lower interest bearing debt. And what can have lower interest rates than the USD?
Answer: Nothing. This is why the dollar is rallying in spite of all the massive debt Uncle Sam is accumulating. The cycle perpetuates itself by encouraging Bernanke and Paulson to keep printing more money. In the end, they are really executing their own friends on the Street.
Wednesday, October 22, 2008
So, what does that mean now? They have to spend dollars to defend against a run on their own domestic currencies! Countries like China, Russia, and the Gulf states w/big dollar hoards and strict capital controls don't have to worry that much.
BUT countries w/o dollar reserves and loose controls are on a Treasury spending spree. Countries like Argentina, Turkey, Hungary, ...actually all of Eastern Europe are some of the big culprits behind the dollar's strength.
Chiefly, emerging markets remain EXTREMELY vulnerable to political risk. Most emerging markets are built on fragile politics. The majority either retain authoritarian governments or infant democracies. The social fabric, thin at the best of times, is becoming stretched to the breaking point. Extremely wide gulfs between poor and rich, rising inflation, and rising unemployment (tied to collapsing commodity prices) lead to increased potential for violent riots. This is the stuff of revolutions.
Additionally, companies in emerging markets are facing margin calls from wrong sided bets on $200/barrel oil, $9/corn, and other stratospherically priced commodities. It seemed like a smart idea back in June when inflation and a weak dollar were the impetus behind commodities' rally. However, in the current deflationary spiral they spell doom.
Finally, emerging markets are burning their foreign exchange reserves of dollars and euros to defend a run on their own currencies. While the wealthiest nations such as Russia and the Muslim petro states have acquired an impressive hoard, others are not so fortunate. Nigeria, Indonesia (no longer an OPEC member), and all of Eastern Europe and South America face a severe cash crunch.
Tuesday, October 21, 2008
Sure, he will bring down the TED and OIS-LIBOR spread by flooding the system with even more liquidity.
The unintended consequence? A flight out of equity to money market funds by baby boomers. Once retirees see that money market funds - NOT ACCOUNTS (which are FDIC insured) - are now de facto guaranteed, they will dump their mutual fund stocks in favor of money markets.
Monday, October 20, 2008
For ex: California's revenue shortfall has increased by $3 billion in 2 WEEKS since their budget bill was passed!
Translation: State income taxes will skyrocket in order to cover for a massive shortfall in property tax revenues. Moreover, municipal bonds have started to look attractive to investors again as governments are being forced to hike interest rates. Whether or not they will retain their tax free investment status remains to be seen as cash starved governments continue to look for ways to stretch their budgetary needs.
Friday, October 17, 2008
1) The short ban really hurt the hedgies. They were unable to "hedge" against long bets. So, many liquidated their positions and went to cash. This started the sell-off.
2) Hedgie short term financing was destroyed in the past 3 weeks as Fed guarantees of money market accounts led to record hoarding by banks (as reflected in TED spread). Fund redemptions didn't help as investors dumped their positions to favor the now guaranteed money markets. This accelerated the sell-off.
3) CME/CBOT/NYMEX all raised margin requirements. Hedgies now have less leverage and are more liable to sell to cover any positions (long or short). This led to record volatility as hedgies swung from short to long to short again.
4) Conclusion: Hedgies are REALLY hoping for their lottery tickets on CDS contracts to pay off. Otherwise, they will go bankrupt.
Will Paulson bail them out? It depends on how much leverage (pun intended) hedgies have over the markets. I don't know since its all very opaque. I don't think even the hedgies or govt knows the true extent of the damage.
Thursday, October 16, 2008
Brazil, Russia, Mexico, India, Indonesia, and S. Korea have suffered heavily in the past 3 weeks. I am not sure what their CDS costs are but they should be pretty high. In any event, there is more solid evidence of their instability - daily circuit breakers being applied (mkts temporarily shut down), short selling bans, strict capital controls, and other signs of panic.
Although insulated from the worst excesses of the credit bubble storm that has wracked the developed world, developing nations are now facing sharply falling demand for their goods as consumers tighten their belts. Many- if not most - emerging markets are one trick ponies; good only for a particular export or raw material sector.
For ex: Brazil's Bovespa is dominated by agriculture and mining, Russia's by oil and natural gas; and the East Asian economies by cheap manufactured goods. Moreover, credit problems in the West are exacerbating importers' problems in securing short term credit...even in the face of slumping freight costs.
Mutual fund redemptions are hurting the emerging market indices as the flow of funds from account holders reverts back to the US. Fund managers are liquidating the higher priced foreign stocks and triggering further sell-offs in lower trading stocks.
Finally, emerging market economies remain vulnerable due to their debt exposure to foreign currencies. Unlike the EU and the USA, most emerging markets do NOT have the luxury of having their debt denominated in their native currencies. They are unable to adopt the
sweeping corporate welfare programs that the US and EU have adopted due to fears of higher inflation. Government ministers imported inflation through monetary and fiscal ties such as currency pegs to grow their export engines. While inflation was a necessary evil during the expansionary boom times, it has the potential to become a greater demon within the borders of emerging markets. Countries such as Russia, Iran, and Venezuela already have to contend with double digit rates of inflation (15-40% according to which source you believe).
The cost of shipping bulk commodities such as iron ore, coal or grains on Thursday tumbled to its lowest level in more than six years as recession fears intensified and the difficulty of obtaining trade finance left many ships without any cargo.
The Baltic Dry Index, a benchmark for shipping costs and seen as an indicator of global economic activity, fell 6.75 per cent to 1,506 points, its lowest level since November 2002. The index has plunged 53.2 per cent since the end of September.
The average daily cost for the largest dry bulk vessels – known as Capesize and used mostly to ship iron ore from Brazil and Australia to China – on Thursday sunk 11.4 per cent to just $11,580 a day.
The Capesize rate has collapsed 95.1 per cent since it hit an all-time high of $233,988 a day in early June.
Steve Rodley, director of the London-based shipping hedge fund Global Maritime Investments, said some vessels were anchoring, waiting for better times, while some shipping companies were thinking about scrapping their older vessels.
“The whole shipping market has crashed,” Mr Rodley said. “But the biggest ships are suffering particularly,” he added.
The slowdown in Chinese commodities demand was confirmed yesterday by Tom Albanese, Rio Tinto’s chief executive.
“In the near term, the Chinese economy is pausing for breath. China is not completely insulated from an OECD recession and we will see an impact on Chinese exports,” he said.
The index’s latest fall follows several weeks when the short-term spot market on which the index is based has seen very little activity because of the current difficulty in arranging letters of credit, a key trade finance instrument.
Peter Norfolk, director of research and consultancy at London-based Simpson, Spence and Young shipbrokers, said: “You face continued freezing of activity because of the problems with credit in particular.”
Although it is traditionally regarded as one of the safest forms of financial activity, rates for trade credit have risen sharply in recent months as banks have withdrawn facilities to bolster their own liquidity.
Shipowners are suffering from banks’ reluctance to issue letters of credit, normally straightforward instruments used to assure a shipper of payment for a cargo after it is loaded on to a ship, but before the buyer receives it.
There was also a continued stand-off between Brazilian iron ore producers seeking to raise prices and Chinese steel mills now cutting production and using up stockpiles in retaliation.
“All of this means that, in a very short space of time, we have very little chartering activity,” Mr Norfolk said. “There’s even talk of owners laying up tonnage because the market is so weak.”
London-based brokers added that some charterers where defaulting on their contracts and returning the vessels to their owners due to lack of demand.
The Baltic Dry Index has fallen 86 per cent from May’s all-time high of 11,893 points.
The tanker market for crude oil shipment has also been hit by lower prices
The current crisis has effectively erased all the rate cuts Bernanke has made this cycle and even added another 75 basis points.
Wednesday, October 15, 2008
Thursday, October 9, 2008
First, a quick review. The cost of credit is determined by factors such as trust and solvency. Trust and solvency lie at the heart of the TED spread, which is the gap between 3 month Treasuries and 3 Month Eurodollars. I already addressed the 3 month Eurodollar so now I turn our attention on 3 month Treasuries.
Treasury rates are set by regularly scheduled government auctions in the CBOT or Chicago Board of Trade. These are reverse auctions where traders compete against each other by offering HIGHER interest rate bids. Traditionally, the 3 Month treasury rates were at or near the fed funds rate.
The yield on the 3-month Treasury bill, seen by many as the safest place to put money in the short term, slipped to 0.63% from 0.69% late Tuesday, indicating investors are willing to take a very small return on their money. In the past 2 weeks, the 3-month bill skidded to a 68-year low around 0% as panicked investors fled stocks.
However, all that has changed.
The factor in TED now is T bills being very near 0.
Now, in the United States the Fed says it will buy commercial paper; that is, it will buy up loans made to U.S. companies...or even loan the money directly to troubled firms. And not just financial firms. Any companies can apply -industrials, tech, retailers, etc. - just as long as they meet the criteria of "too big to fail". Whatever that means.
In the EU, government ministers have pledged to lend UNLIMITED amounts of money to banks after yesterday's coordinated rate cut failed to have any meaningful effects. Really, they should not be using words like "lend". Those are taxpayer donations to help ailing banks that will in all likelihood disappear down the drain.
In the UK, the government has had a long history of socialist intervention. British taxpayers barely protested when the authorities nationalized Northern Rock and HBOS. Now, they are being forced to subsidize the losses of Icelandic bank depositors after the entire country failed.
And the natural result of all these government interventions? Massive inflation.
Wednesday, October 8, 2008
What is the cost of money? Or, to put it another way, what is the cost of debt? There are 2 answers to this question.
1) On the private side -LIBOR is an important interbank lending rate set by the private sector. It is rougly comparable to the US Fed Funds rate.
$USD LIBOR is set by the BBA, or British Banker's Association, a cartel of commercial banks every day. While the BBA has over 200 members and scores of associates, the inner circle which determines the private cost of short term US debt is composed of only the 16 largest members.
JPM, C, and BAC sit on this panel (GS and MS may sit here too since they are now retail banks. Their real status is still up in the air). The average of the middle 8 banks quotes is the daily rate reported by Reuters.
For years, LIBOR tracked the Fed Fund rate....until this year.
Starting in January LIBOR started diverging big time.
Like any cartel, the members inevitably resorted to undercutting and hiding information from each other to gain an advantage. Chief among these problems were members hiding the true extent of their Level 3 Assets.
The reason why LIBOR is so important is because it is the benchmark used as an index for most OTC derivatives....such as the $600 or $800 Trillion in CDS.
Libor members sit on a panel that determines interest rate swaps...while also being the same counterparties to such swaps.
LIBOR "supposedly" averages the rate by taking the middle 8 and tossing out the top and bottom 4 quotes. However, there is still room for abuse ESPECIALLY when all the cartel members have been hiding Level 3 assets from each other.
2) On the government side - Coming soon.
Saturday, September 27, 2008
Well, we finally got our wish. Just not in the way we expected.
In the past 4 weeks, the USA has gone from being a nation on credit to a nation of savers. BUT the impetus of this change is based on fear of the banking system collapsing.
This change is not just limited to individual depositors but has spread to institutions. Banks and companies are now hoarding cash, reluctant to lend it out except at the most exorbitant rates (see my prior article on the credit markets).
The impetus of this fear is the federal government's misguided actions at attempting to "solve" the financial crisis. Companies that fail are normally supposed to enter receivership or conservatorship. Their creditors are entitled to a fair hearing before a bankruptcy court to determine the allocation of assets. Different "tranches" or levels of creditors were relatively insulated from losses by the underlying common and preferred stock shareholders who would bear the brunt of the losses.
All of that has changed.
Now, the feds are literally making it up as they go along. Financial institutions are collapsing left and right with only the chosen few allowed to survive.
We now live in an environment of uncertainty.
Institutions were the first to withdraw funds. Now Main Street is panicking and extracting their 401k money from mutual funds. Even foreign investors have caught on and are cautiously taking their capital out of the US.
Thursday, September 25, 2008
Unlike regulated futures markets such as the CBOT or NYMEX where financial instruments are traded openly, CDS are traded in the OTC (Over the Counter) market. This means that there is no way to transparently view pricing mechanisms. It is difficult - but not impossible - to find the bid and ask price spreads.
In the NORMAL futures market, brokers act quickly to shut down losing trades. They do this by requiring customers to post more margin or liquidate existing accounts. There is a clear chain of responsibility in the futures exchanges - in the unlikely event customers are unable to meet their trading losses, their brokerage firms are responsible for meeting the losses. In the even more distant possibility of default by the wirehouses, the exchange itself is obligated to make the counterparties whole. Finally, both the brokers and exchanges possess billions of dollars worth of individual insurance.
There is NO such mechanism in the CDS market. In fact, until a few days ago the CDS market was not even regulated! Traders played in a gray realm of insurance, futures, and options compliance where the market was deemed "too big to fail".
Trading losses were bundled into mortgage packaged loans (CDOs or collateralized debt obligations) and sold to unwitting suckers like the NY Teachers Pension Fund or some village in Japan. When this private casino finally collapsed, Wall Street approached Main Street to ask taxpayers to pay for their gambling debts.
Monday, September 22, 2008
Less well known however are the credit markets. Credit markets are the realm of the big players - the place where commercial paper and other short term loans - are traded between banks, insurance companies, and industrial giants. This is the "shadow banking system" where companies obtain financing for short term financing - w/terms as short as overnight. The bid and ask spreads in this lending system are opaque and are called "dark pools of liquidity" since there is little if any government oversight. And taking place front and center in the credit markets is the TED spread.
The TED spread is a measure of liquidity and shows the degree to which banks are willing to lend money to one another. The name comes from a combination of "T-Bill" (3 month US debt) and "Ed" (the ticker symbol for 3 month Eurodollar futures). The T-bill part is set by US bond markets while the Ed part is set by British bond markets. The British bond market is set by the LIBOR or London Inter Bank Offered Rate.
It is also an indicator of market perception of credit risk, as T-bills are considered risk free while the LIBOR rate reflects counterparty credit risk in lending between commercial banks. As the TED spread increases, the risk of default (also known as counterparty risk) is considered to be increasing, and investors will develop a preference for safer investments.
Spread sizes are denominated in basis points or percentage points. For ex: when the T-Bills are trading at 3.1% and Ed trading at 3.8%, the TED is said to be trading at .5% or 50 basis points.
During the past week, the TED spread rose dramatically as T-bill interest rates declined substantially while LIBOR rose. This huge gap was at one point close to 9%. It may not sound like a lot but consider that the TED spread is usually less than 1%.
The high spread was potentially lethal to banks and other financial institutions raised in an environment of cheap debt and poor capital w/lending ratios as high as 30:1. Case in point - Lehman Bros. had a 30:1 leveraged debt ratio and had to file bankruptcy last Monday.
Saturday, September 20, 2008
They are called credit because they are speculating on the price of credit (bond payments). They are called default because they are speculating on whether that company will default. And finally they are called swaps because ANY 3rd party (that is major US/UK bank or insurance company) can participate. Thus a company like AIG could sell CDS to Ford to protect Ford in the case of a default. But AIG could also sell CDS to ANYONE else. Only the big boys played this game since the premium payments were so high.
In a typical CDS, the “protection buyer” gets a large payoff from the “protection seller” if the company defaults within a certain period of time, while the “protection seller” collects periodic payments from the “protection buyer” for assuming the risk of default. Just like normal insurance companies, CDS sellers collected premiums or insurance payments on a regular basis - usually every 3 months.
Unlike normal insurance, "protection buyers" were not just limited to the underlying company. Noooo. Protection sellers were willing and able to sell CDS to ANYONE with the money as long as they met regulatory standards and had the cash.
A seller like AIG could sit back and collect $320,000 a year ($80k/every 3 months) in premiums just for selling “protection” on a risky BBB junk bond from a crap company like Ford. The premiums are “free” money – free until the bond actually goes into default, when AIG could be on the hook for $100 million in claims. Remember, just like insurance the seller only charges a miniscule percentage of the total insured amount. However, they are insuring astoundingly large amounts of money here - $100 million and up. This means that only big guys can play - who else can afford to pay $80k every 3 months w/no guarantee of payment? And to do so on a scale of dozens of different CDS contracts? Not even private millionaires have the cash to participate.
And there’s the catch: what if AIG doesn’t have the $100 million? What if 10 "protection buyers" had bought CDS from AIG and now demand a total of $1 billion? AIG is screwed and goes into bankruptcy; but both parties are claiming the derivative as an asset on their books, which they now have to write down.
Players who have “hedged their bets” by betting both ways cannot collect on their winning bets; and that means they cannot afford to pay their losing bets, causing other players to also default on their bets. The result is a chain reaction that kills every major bank/insurance company in the US/UK (CDS ONLY exist in the US/UK due to "free market" principles).
Oh here's the best part - CDS aren't available to the public. They are only traded between the big boys on their own private computer networks. That means, no one - except them - knows the true price until the whole house of cards collapses.
The Federal Reserve is literally owned by a cartel of 19 banks. These are the guys who get cheap interest loans from the Fed (this is called the Fed Funds rate) and then sell it to smaller banks at higher interest. This is the ONLY reason why the Fed/Treasury acted together. They had to protect their oligopoly over dollars.
Eventually buyers would migrate out of the country towards more attractive foreign locales.
Thursday, September 18, 2008
Under FASB terminology, Level 1 means mark-to-market, where an asset's worth is based on a real price. Level 2 is mark-to- model, an estimate based on observable inputs and used when there aren't any quoted prices available. Level 3 values are based on “unobservable” inputs reflecting companies' “own assumptions” about the way assets would be priced.
Wednesday, September 17, 2008
I admit I was wrong about gold and continued dollar strength this week. All of the classic history cases have gold rising solely due to hyper-inflation. Most of the gold bug web sites and other subscription channels repeat the hyperinflationary environments astheir textbook cases to go long gold.
I based most of my analysis on the Japanese deflation of the 1990s inthe wake of their market crash. During the 90s gold sold off a little and didn't rise much. This is because in Japan, the process was moreor less orderly and well managed by the government and big banks.
The USA is different. I assumed the Fed and Treasury would be able to manage things in much the same way as the Japanese and hold things off until after the election is finished. Instead, the debt monster has grown so huge that the efforts of the government and banks to gently unwind the beast have failed repeatedly. They know the trend is down and are trying to calm things in an orderly fashion but are losing power. Each time they intervene there is less and less effect. This is the law of diminishing returns.
The catalyst for gold's super rise today was the bailout of AIG latelast night. People got scared that the markets will fall faster and harder down the road. Also, treasuries have reached capitulation.Foreigners are beginning to exit the dollar and focus on protectingtheir own countries' economies.
Conclusion - We are in an environment of both hyperinflation and hyperdeflation. This is normally an impossible thing to achieve. However the USA's unique position as the biggest debtor in worldhistory living well beyond its means is responsible for the current market environment.
Wednesday, September 10, 2008
Countries worldwide are experiencing the bursting of bubbles.
There are 3 types of international economies undergoing asset deflation - commodity based exporters, manufacturing based exporters, and mature economies. Commodity based exporters - United Arab Emirates, Iran, Venezuela, Russia, Brazil, Australia, Kuwait, Saudi Arabia.
Manufacturing based exporters - China, Vietnam, Taiwan, S. Korea, Mexico.
Mature economies - UK, Ireland, Japan
ALL of these countries have one thing in common - BIG real estate bubbles and in many cases big stock market bubbles too.
Many of these countries built too much too fast. Just look at China or the Middle East.
Who else builds 20 skyscrapers a month? A 7 star hotel in the desert?
China has even worse problems than we do - their stock market is ALSO deflating. The Shanghai index has been down for the past 3-4 months (look at FXP - Ultrashort China ETF for ex.).
I repeat, gold will NOT rise in value until the asset deflating is done. Until then, all these foreign countries are piling into Treasuries and buying more time for the US to do more bailouts. The full effects of hyperinflation will begin sometime next year.
Tuesday, September 9, 2008
Well, here they are:
1) Deflation in housing (lower prices),
2) deflation in credit (stricter lending standards),
3) deflation in commodities (oil, gold, and corn were the most egregious offenders),
4) and now deflation in equities (DOW and S+P ran up to ridiculous levels).
Yes, the money supply is increasing, including M3.
This is going to lead to inflation...but we won't fully feel its effects for a while. Normally, gold should shoot up like a rocket.
However, the gold bugs forget one little detail - the unique position of the USA as the world's biggest economic engine.
Foreigners HAVE to keep buying dollars - either directly on the fx markets or through Treasuries and/or agency debt. They NEED our consumers fat and happy to run their factories and prime the oil pumps. They NEED to keep their currencies competitive for their exporters to be strong.
We WILL fully feel inflation's effect...in time; perhaps as early as late November. Until then, the Fed/Treasury is re-loading for another round of bailouts.
Now the consumer is tapped out...exhausted from an inexhaustable supply of layoffs, rising fuel costs, and other cost of living adjustments. Now, they can't even make it to the malls in time for X-mas. Expect a brutal holiday earnings season for the REITs and their tenants.
While there's a kernel of truth to that, the real story is in deflation.
I'm watching the BOND markets - not precious metals -for the realstory. There was a HUGE rush to Treasuries today because of the Lehman implosion.
Poor economies in the OECD are leading to a rush to cash - and no currency is more "safe" than the dollar. The retail investor is not used to thinking of debt as money...but it is the de facto currency of the institutions. All Treasuries and government paper is merely the present value of future payments. This leads to deflation buying more time for the government agencies to bail out their friends on Wall Street.
Effectively, when deflation is strong it gives the Treasury more ammo
for another round of bailouts. The ultimate, long term effects will beVERY bad for the US economy...but Paulson and Bernanke will be long gone by then or on the other side.
Just look at Greenspan - he now works for the Paulson hedge fund (no relation to Hank Paulson), which actively shorts sub-prime debt.
Chalk it up to institutional inertia by central banks and long standing tradition by formerly poor developing nations. Gold will keep on going down until the next President pulls an FDR.
Until then, we might see another short term rise if there is another banking bailout -possiblyas early as this weekend (the traditional time to bail out banks).
Saturday, September 6, 2008
Thursday, September 4, 2008
Tuesday, September 2, 2008
What has changed are geo-politics and economic weakness in Europe. Inmany respects, we are in a "Race to the Bottom" w/the Europeans to seewhose economy does worse. Wall St led the pack for the past fewmonths. Now, it is the Europeans' turn. In this perverse game,"victory" is measured by how much better one's economy is inincremental comparisons to its peers.
Interestingly enough, the recent Russian-Georgian war has created ashort term boost to the dollar. The recent strength in the USD is notUSD strength per se, but Euro weakness. The fear is that Europe willbe involved in a war with Russia, and energy will be involved. Russiasupplies 25% of the EU's energy needs and over 50% to many EasternEuropean states. The EU is Russia's largest trading partner.
Sunday, August 31, 2008
Friday, August 29, 2008
Monday, August 25, 2008
Problem: No one knows who the ultimate guarantor of these contracts is.
Saturday, August 23, 2008
Option ARMs - you know, those exotic loan payment schedules that enticed so many Americans into borrowing? Yup - a lot of them come due in 2010 and 2011. Conveniently, that is also when many Baby Boomers become eligible for Social Security...
Friday, August 22, 2008
2008's toll so far: 9 and counting.
Now, executives from the 3 companies are taking a page from the banking sector in seeking federal government assistance in the form of low interest loans. They claim that their bankruptcy would result in a chain reaction of closures in auto parts suppliers as well as downwind effects in the credit markets. Why? The $45T credit default swap market would take a severe beating if GM or FORD went bankrupt.
This however is unlikely. While the banks are deemed "too big" to fail, the automakers aren't. Foreign competition in the form of Toyota, Honda, and Nissan have bit deeply into Detroit's market share. And while the CDS market might take a hit, it will continue to trudge along.
More cynically, none of the Big 3 are represented at the helm of any regulatory agencies. In contrast, Wall Street can count on the likes of such star studded alumni as Rubin (Clinton's Treasury Secretary), Paulson (current Treasury Secretary), and Fuld (current NY FRB director).
"We are desperately in need of radical new thinking among the financial elite. We may not simply be at the end of an era, we may be on the verge of a reformulation of capitalism itself. However, the signs are that there are few iconoclasts among the policy elite. Central bankers in particular seem hopelessly stuck in their world views, starting with their conception of their role."
Thursday, August 21, 2008
Most equity investors don't know much about the debt markets, so they aren't paying attention to this. However, debt spreads, or the difference between corporate bonds and treasuries continues to widen. In fact, these spreads are worse than they were in March following the Bear Stearns collapse. This indicates reduced risk appetite resulting in credit drying up. Every time this has happened in the past, the equity markets have corrected and caught up to what the debt markets were telling them.
Why the temporary divergence? Simple, the market is ignoring this for the time being, but it won't last for much longer. Additionally, the government cannot intervene nearly as easily in the debt markets as they can within equity markets. After all, there are only 30 stocks in the DOW Jones Index, it's very easy to buy up some big names on very bad days to even out the supply/demand imbalances.
Where were these guys when I started making my predictions a few months ago?
"Targets Fannie Mae, Freddie Mac as among possible casualties...""
“We’re not just going to see mid-sized banks go under in the next few months, we’re going to see a whopper, we’re going to see a big one, one of the big investment banks or big banks,” said Mr. Rogoff, who is an economics professor at Harvard University and was the International Monetary Fund's chief economist from 2001 to 2004.
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