Saturday, January 31, 2009

The Debts of the Lenders: China Speaks On Davos and the West's Bad Bank Plan

Actions - not words - are the ultimate decider.

Beijing has ultimate authority over any US bailout package - indeed
any Western bailout package. The Chinese could care less about the
Western stock market. All they want is preservation of jobs back at
home and their Treasuries to be worth something.

The Chinese just sent a shot across our bow. The Davos conference is
a collection of Western bankers and politicians who still think they
are in control. Meanwhile, China issued this statement:

"Whether we will continue to buy U.S. Treasuries, how much we will
buy, depends on our own need for maintaining the value of our foreign
reserve investments and keeping them secure."

We also heard from the Chinese on Thursday when the 30 year long bond dropped 4 or 5
points and finally closed on Friday at 3.6%.

To be sure the Chinese did not suggest that they would liquidate treasuries but traders interpreted it that way. Chinese comments also set the tone for the big oversupply of bonds on Thursday's treasury auction on the 5 year note. This encouraged bond shorts to call Bernanke's bluff about monetizing the 30 year long bond and allowed them to ride it 4-5 points lower.

BUT we remain in deflation. This is evidenced by:

1) UUP - strong dollar; AND
2) USD/JPY - (relatively) strong yen; AND
3) General Macro-economic environment

The Debts of the Lenders: The Irony of the West

Irony. Definition - incongruity between the actual result of a sequence of events and the normal or expected result (Merriam-Webster's Online Dictionary).

10-11 years ago the IMF went to the emerging markets (East Asia, Eastern Europe, and Latin America) to demand the following fiscal austerity measures:

1) Don't bailout bad banks
2) Raise Interest rates
3) Cut Government spending

These measures actually worked! And sometime during the intervening decade the emerging markets became net savers/lenders to the net spenders/borrowers of the West. Emerging markets were so successful that the emerging markets largely repaid their IMF debts on time (Argentina being a notable exception).

Today, when the shoe is on the other foot, the West has done the EXACT OPPOSITE.

1) Bailout not just bad banks but ALL sectors of the private sector
2) Lower interest rates to 0
3) Spend vast amounts of money and even resort to inflationary measures like monetizing debt.

In addition, the West is also DEMANDING the emerging markets CONTINUE to lend them more money.

Am I the only one detecting a double standard here? That the Western dominated IMF
is somehow above taking its own medicine? Hypocrisy or a double standard. You decide.

Thursday, January 29, 2009

The Debts of the Spenders: EU Hawkish On Inflation

Can the EU contain inflation? The bond markets don't think so. Since all their attention is focused on the "big boys" (US, UK, Japan, and ARGUABLY Germany) who are engaged in quantitative easing programs of some sort, this naturally leaves the smaller players struggling for the table scraps left behind by bond bulls.

Case in pt: Trichet remains scared of the diverging bond yields in the Eurozone. This is why he has strongly hinted that he will NOT cut rates next week. Then again the EU interest rate decision is made BY COMMITTEE - a 22 member committe that is. Can these fools do anything right?

Not when their self interest conflicts w/others. Interest rate cuts would PENALIZE the peripheral members - those w/the biggest public debt exposure and weakest capital markets (such as Spain, Greece, Portugal, Ireland, and Italy ). At the same time, lower rates would reward those core states w/sufficient access to capital markets and (relatively) lower public deficits (such as France and Germany). I say "relatively" because all of the socialist EU member states have heavy exposure to public debt but the economic "core" of France and Germany are more integrated w/global capital markets.

The Debts of the Spenders: It's the Clearinghouse Stupid!

Consolidation is happening in the OTC derivative markets for CDS products.

WATCH THE EUROPEAN FRONT. Eurex and Clearstream are working on ways to handle the EU crisis (and it is a crisis by any stretch of the imagination).

In America we have the SWIFT standard soon to be integrated w/the Chicago traders - CME/CBOT (they merged) handling the products.

Remember when traders were asking if the LEH and FRE/FNM trades had settled last November? Well, they did successfully.

THEORETICALLY, these trades cancel each other out so we don't have the LEH problem from last fall. So, if AIG has $50 billion liability and Deutsche Bank has $50 billion trades they are supposed to cancel each other out. Central banks act as the guarantor of risk w/taxpayers as the ultimate guarantors.

The important thing in having a central clearinghouse instead of OTC derivatives is that there will no longer be counter party uncertainty. Therefore I do NOT think ETFs are going away anytime soon. Quite the opposite in fact.

Short ETFs are another story as their future looks uncertain from the relative lack of volatility going forward. Constant leverage will eat into them. On the other hand the bullish ETFs should fare well.The futures casinos (err... I mean exchanges) have been itching for a chance to get the big money. This is a 0 sum game where financiers are poaching each other's business.

After last fall's debacle, politicians and regulators are ready and willing to listen to the CME and Clearstream lobbyists.

Monday, January 26, 2009

The Debts of the Spenders: The Death of Graham Bleach Bliley

Pay close attention to the date this was written and the names in the article. *(Special credit to Temo1051 from for poitning this article out)

Citigroup Statement on Financial Services Modernization Act
Business Wire, Oct 22, 1999

NEW YORK--(BUSINESS WIRE)--Oct. 22, 1999--

Chairmen and Co-Chief Executive Officers Sandy Weill and John Reed said: "We congratulate the leaders of our country for their efforts in hammering out a successful agreement on the last remaining issues surrounding the Financial Services Modernization Act. In particular, we congratulate President Clinton, Treasury Secretary Larry Summers, NEC Chairman Gene Sperling, Under Secretary of the Treasury Gary Gensler, Assistant Treasury Secretaries Linda Robertson and Greg Baer, Senators Gramm, Dodd, Schumer, Johnson, Edwards, and Members of Congress Leach, Bliley, Dingell and La Falce and the Congressional Leadership including Senators Daschle and Lott and Speaker Hastert and Democratic Leader Gephardt."

"By liberating our financial companies from an antiquated regulatory structure, this legislation will unleash the creativity of our industry and ensure our global competitiveness. As a result, all Americans - investors, savers, insureds -- will be better served."

Citigroup (NYSE: C), the most global financial services company, provides some 100 million consumers, corporations, governments and institutions in 100 countries with a broad range of financial products and services, including consumer banking and credit, corporate and investment banking, insurance, securities brokerage and asset management. The 1998 merger of Citicorp and Travelers Group brought together such brand names as Citibank, Travelers, Salomon Smith Barney, Commercial Credit (now named CitiFinancial) and Primerica under Citigroup's trademark red umbrella. Additional information can be found at:

COPYRIGHT 1999 Business Wire
COPYRIGHT 2008 Gale, Cengage Learning

Monday, January 19, 2009

The Debts of the Spenders: Watch the UK and Italy for Signs of Hyper-Inflation

The UK and Italy will be leading indicators of hyper-inflation among the G7.

The UK's Gordon Brown and Mervyn King are idiots. They are trying to imitate Bernanke
and Paulson. Unfortunately for them, they are operating on an accelerated schedule. The FSA's short ban expired on January 16 and this week is going to be all BAD data for the UK.

Also, the fundamental problem with the UK is its smaller population which is roughly 20% of the US. Smaller demographics ensure that there will also be smaller tax revenues. The UK authorities' only other alternative is to raise taxes in the corporate sector. However, this measure will also serve to drive away all the hedgies and banks that made London the "City of Finance" over the past 10 years. Such actions will lead to further job losses in the sector and additions to the ranks of unemployed.

Brown and King could not have picked a WORSE time to nationalize the UK banking system. The system was already bending under the strain of prior banking bailouts. Their actions amount to nothing more than desperate attempts to lift up FTSE share prices. Politicians can "jawbone" lenders all they want but how can you entice people to borrow after the worst credit bubble in history is just beginning to implode?

FTSE 3k w/in 6 months. And then pound-dollar parity w/in a year.

As for Italy, their problems stem not from over exposure to capital markets but in a more perverse way from under exposure. Milan has never been able to match New York, London, or even Frankfurt as a viable economic powerhouse. Capital flows have never been a particularly strong suit in Italian hands.

Instead, the Italian economy has relied on the seeming "allure" of its Old World craft industries to sell overpriced fashion and home furnishings to gullible consumers in status climbing, luxury obsessed Japan and the US. These social climbers were the same fools who lived beyond their means - flipping multiple McMansions w/marble kitchen countertops and buying the latest Gucci fashion to compete for status among their peers. The market for such luxurious indulgences has waned signficantly in recent months even as the ECB stubbornly refuses to cut rates to match the competitive devaluation favored by other world governments.

Moreover, the Italian government has never been able to reign in state spending and is chronically over budget in its wasteful public works programs. The problem is compounded by its rapidly aging demographic and relative dearth of younger workers. Put bluntly, Italians are simply not having enough babies and are also racking up extreme numbers of elderly. This problem has been growing for years but recent developments are showing just how widespread the cracks in the system have grown (and will continue to grow). Whereas the UK and US at least have the hope of increasing immigration to offset the decline in birthrates common to all developed nations, the Italians (for reasons of ethnic, cultural, or political pride) have stubbornly resisted the integration of foreigners into the social and economic fabric of their nation.

Are the Chinese, Japanese, and Arabs as willing to buy gilts as they are Treasuries? Will there be any more oil left in the North Sea w/in the next 10 years? The sun set on the British Empire a long time ago but the UK is still in denial.

Are the Chinese, Japanese, and Arabs as willing to buy Italian bonds as they are gilts or treasuries? Do they even have a strategic economic stake in Italy that can match the scale of their investments in America or the UK?

The bond markets have already spoken. But they will really roar in the latter parts of 2009-2010.

Sunday, January 18, 2009

The Debts of the Spenders: The Bad Bank Idea

US government officials are now considering a "bad bank" to hold the bad assets of bank balance sheets. UK officials are also reportedly researching similar proposals.

This new credit that world governments are pumping into the banking system can THEORETICALLY offset the deflation in the private sector without triggering long as it is contained w/in the banking matrix.

This is accomplished through electronic swaps and transfers between governments and large institutions (corporations, ngos, quasi-govt bodies, etc.). In the past, bodies like the Resolution Trust Corporation, or RTC were established to handle credit failures. But now the problem is complicated by the existence of derivatives whose notional value FAR outstrips any real
economic value by orders of staggering magnitude:

40x-50x the ENTIRE GDP of the world by common measures.

We can enter a discussion about the different kinds of derivative packaged instruments - CDOs, CDS, CMBS, etc. - and how much value is retained within these "assets" (and I use that label very loosely). But the talking points will always return to the focal point of marketability - if private buyers are unwilling to buy then just how much value is really there? I don't have a specific answer because the books have been sealed by the Treasury and authorities by judicial order.

These derivative pools are a ponzi scheme where the banks relied upon new borrowers to pay interest to existing holders. The banks even had mathematicians who ran complex equations to manage the money pools and decided who gets what payment. Once the last sucker was in, there is no more new money to payout the previous investors their interest.

Madoff, the hedge fund con artist, is a minor blip on the radar screen compared to the utter levels of fraud being concealed by the authorities.

Governments can backstop existing debt obligations ...but can central banks print more money than has ever existed in the world?

Remember, the modern financial system is built on trust in the government, trust in social order, and trust in debt.

And what happens when there is a need for REAL currency to circulate throughout the economy? Case in point - America's auto bailout which I have discussed previously. Workers, sub-contractors, suppliers, small businesses, and other economic actors that had NOTHING to do with Wall Street gamblers are going to have to take money out of the system eventually.

The results will not be pretty.

Saturday, January 17, 2009

The Debts of the Spenders: The Euro - Diverging Bond Yields Show Systemic Cracks

How can a monetary union coordinate economic policy when member states cannot even acquire a common interest rate spread? Granted, complete convergence of yields is not possible given the breadth of diversity within the union but a NARROWER trading band should be possible.

But, instead the bond markets are telling European governments that they are pricing in HIGHER risks (either interest rate risk or the previously unthinkable default risk) for peripheral member states than the core industrial and economic powerhouses of Germany and France.

Spain, Portugal, Greece, and Italy (Ireland will soon be added to the list) are some of the most debt ridden states w/in the Eurozone. Capital markets were always lacking to begin with but the global economic freeze has placed additional strain on governments to increase social spending. Everyone wants a bailout in tough times . . . but who can fund it?

Certainly not the corporate taxpayer - business was never a strong pillar to begin with in the bureaucratic and openly hostile morass of Western European regulation. Tourism, the other main source of revenue, for these musuem states (for that is what they are - capitalizing on the grandeur of the past instead of moving forward into the future) is also in decline given the reluctance of travellers to embark much farther from their native shores.

That leaves only the bondholders. And their message is quite clear:

The Debts of the Spenders: The Euro - An Inherently Flawed Currency

Commentators calling for the demise of the dollar as an "inherently flawed currency" should be looking at another currency across the Atlantic instead.

The Euro is a fundamentally flawed currency. The Eurozone is in even worse shape than the US due to a combination of inherent structural and banking flaws.

Structurally, the EU is a union of disjointed states that lack common fiscal and monetary policy. Indeed, the Euro's biggest flaw is the requirement that individual member states surrender their sovereignty over key economic policy decisions to a distant council in Brussels.

The weakest links in the chain are in the periphery - Greece, Spain, Italy, Ireland, and Portugal. These are spendthrift happy states perpetually in big deficit that are dragging the rest of the Eurozone down w/them. All states have common taxes and public services throughout their territories. BUT on average, poorer areas and regions pay lower taxes and receive more public services than their richer ones. This is a thinly disguised wealth transfer scheme that has caused animosity among the EU members even during the best of times. Brussels was not even able to get the EU Constitution ratified DURING the credit bubble in 2004! The prospects for economic integration and common ground have diminished dramatically since then.

As for the banking system, European banks are even MORE leveraged than their American counterparts. Fractional reserve ratios of 30-40% LOWER than American banks are common among European banks. The most egregious culprits are the British banks but since this is a piece on the Eurozone, we should focus on the German, Belgian, and French banks instead.

The Europeans are trying their hand at native quantitative easing experiments. But these measures will inevitably fail. There is simply not enough demand in the world to soak up all the supply being issued by G7 govts (emerging market govts are a different story as they will continue to attract yield chasers and other risky money).

Conclusion: There can be only one quantitative easing beast in the world and that is the United States.

Saturday, January 10, 2009

The Debts of the Spenders: Has the Bond Bubble Burst?

I think Treasuries have one more leg up before the inevitable rise in interest rates.
But that being said, the long bond (30 year) has definitely weakened considerably since early December. The re-introduction of 3 year paper has also sparked some uncertainty among bond traders who are (rightly) concerned about wider bid ask spreads and other signs of deeper liquidity.

We are in a period of early thaw right now.

Capital flows have slowly moved into more risky assets such as private debt and muni bonds during December and early January. The relative dearth of equity buyers means that institutions remain wary of that sector and for good reason.

In the long run, inflation will return as the velocity of money begins to accelerate. Thus, long-term Treasuries should NOT be approaching Japanese-like levels of near 0% yield for decades on end. Please note that accelerating velocity does not necessarily equal economic growth. The gold bugs might yet have their day and see the US hit Weimar Germany hyper-inflation.

There is a limit to what the Fed can backstop. Exogenous factors like rising ag prices and simultaneous quantitative easing by VIRTUALLY EVERY SINGLE COUNTRY in the world will ruin Bernanke's plan. Remember that the BOJ's Q.E. experiment was conducted in a period where they were the only Q.E. beast.

That is not the case this time. What we are beginning to see is weakness in the G7 bond markets as supply begins to outstrip demand.

The "brave" money is flowing into emerging market govt debt because they have the highest interest rates (a relic of 2005-2008 inflation) and therefore the biggest room to run in terms of capital appreciation.

Friday, January 9, 2009

The Debts of the Spenders: Duration Of Bernanke's Fixed Income Rally

The Fed will continue fighting its war on deflation until housing prices begin recovering.
At least, that's what Bernanke would like to accomplish.

In some of my earlier posts I said that the Fed would push quantitative easing to the limit - beyond the event horizons reached by the BOJ in earlier attempts to dig itself out of the speculative credit hole. Bernanke's grand plan involves "fixing" housing loans. Consumer credit (auto/credit card/student loans/etc.) are also on the list but housing remains the priority.

This can be accomplished through either

a)Lengthening loan maturities to 50 years or more; and/or

b)Rewriting loan terms through Bankruptcy Code revisions.

I originally covered only Option A).

B) is something that is currently being attempted in Congress but will result in further loan writedowns from the banking sector and an increased reluctance to initiate new lending.

The immediate effects of such a Bankruptcy provision being rammed through Congress will be the blatant re-writing of debt covenants that will punish bond holders. This is not a desirable effect either. Bernanke WANTS to push investors back into more risky asset classets. And if he punishes fixed income, the more conservative asset class, you can imagine the kind of message he will be sending to equities.

Solution? The Fed will step in to backstop or guarantee the debt. This should ensure the fixed income rally will last for a while since housing has virtually no hope of recovery this year.

So, will this plan actually work? It might.

EXCEPT...for the exogenous factors

The Fed's plan relies on an inherently flawed assumption - that the US continues to live in a unipolar world.

Here are some factors that can, either independetly or together, re-ignite the inflationary wildfires:

a) Foreign Creditors - their reluctance to buy Treasuries continues to grow. EVERY single one of America's creditors has their own economic problems and is ALSO running a quantitative easing plan of its own. The 800 lb gorilla here is of course China which has its own unique problems (to say the least).

b) Commodity Supply Bottlenecks - Commodities crashed hard in the latter half of 2008 and continue to fall as of this writing. However, supply bottlenecks are already being formed. Industrial metals and energy are selling below cost for many producers. Farmers lack access to credit (there are also fewer farmers b/c of demographic trends). Weather conditions in the Pacific for La Nina are also developing.

c) Trade Wars - Competitive devaluation will take on a whole new meaning in 2009 as export dependent nations desperately debase their own currencies to attract the attention of jaded 1st world consumers. Protectionist sentiments will also continue to grow in 2009. Backlashes against foreign imports will become increasingly common.

d) Demographics - America's ranks of aged continues to grow. Their numbers are putting a strain on government benefit mandates. Already Social Security and Medicare comprise nearly 40% of the US budget.

e) Actual Wars -Political volatility remains very high. As energy prices continue to crater, the probability of energy exporters initiating actual or proxy conflicts escalates. This is particularly true of the Middle East and Russia.

f) Terrorist/Cyber Attack - See above but not exclusively limited to energy prices. America's foreign policy remains . . . . controversial in many parts of the world.


Basically inflation will not pick up until we begin to see a recovery in housing prices OR one of the exogenous events I write about above occurs. The deflationary momentum remains strongly skewed by housing prices and are dictating the Fed's actions.

Thursday, January 8, 2009

The Debts of the Lenders: Forex And Risk Appetite

Forex will tell the story. Look at the yen/aussie and yen/real pairs. These are both carry trade instruments.

The aussie and real are not really falling. It is the yen that is selling off against them. So it SEEMS like they are gaining in value. In fact, the macro-economics are quite the opposite.

The more the emerging markets cut their interest rates, the faster they debase their own currency. This hurts their native consumers (like govt ministers care about their own people) but attracts foreign money to invest in their countries.

That has been the emerging market growth formula for the past 20 years. In 2007 and 2008, emerging markets had kept interest rates high to stave off inflation (see high oil). But now they are cutting in a desperate attempt to re-attract foreign investors. And its working...for now anyway. Remember - the classic correlation between interest rates and bonds are INVERSE movements. When yields fall, bonds rise.

This situation won't last forever. (Sovereign default among the emerging markets remains a very real possibility). But it might last a good deal longer. There are trillions parked in Treasuries waiting to be unleashed.

So where will the money flow?

The equity front remains in miserable condition with news of corporate defaults, job layoffs, and other bearish news. However, the debt side should attract the bulk of investor sentiment because the sector is considered safer. This remains equally true among the emerging markets and developed nations.

The Debts of the Spenders: G7 Floods Bond Markets w/Massive Supply

VROOM! You hear that sound? That is the noise the US Treasury makes as it sucks up the world's liquidity in the global bond and fixed income markets. As I said before in earlier articles, there can be only one quantitative easing beast in the world - and that is the USA. Other issuers, no matter how "safe" their secured status, are forced to raise yields in order to entice borrowers to pick up the slack. Let alone even try native QE programs.

The following article covers the German bond market (THE perceived bastion of Eurozone stability). If Germany is having trouble raising funds then what does that bode for less stable countries such as the Mediterranean belt of Greece, Italy, and Spain? More bearishness is in the cards.

Wednesday, January 7, 2009

The Debts of the Spenders: Commercial Real Estate To Get Its Own Bailout

Commercial real estate companies, the U.S. Chamber of Commerce and other business groups are pushing Congress for a temporary tax break on forgiven debt similar to relief given in 2007 to homeowners facing foreclosure.

The provision would let solvent businesses negotiate new terms with lenders, lowering the amounts they owe, without being required to pay taxes on the forgiven portions of the loans. The proposal may emerge as a priority among Republicans for inclusion in a stimulus package that President-elect Barack Obama seeks to pass with bipartisan support.

About $270 billion of mortgages on shopping malls, apartment complexes and office buildings must be refinanced in 2009, according to Barclays Plc estimates. Commercial loan defaults will accelerate as banks and insurance companies rein in lending to manage their balance sheets and as the market for commercial mortgage-backed securities stays shut, Fitch Ratings Ltd. said in a Nov. 17 report.

Friday, January 2, 2009

The Debts of a Nation: Looking Forward Into 2009

Markets were already pricing in a mild recession in late August 2008. This was a KNOWN certainty. BUT, they were not pricing in UNKNOWN certainties, e.g. the collapse of the credit markets caused by Lehman's bankruptcy.

Earlier this fall trading systems were (and to my knowledge still are) based on quantitative risk modeling and other bs economic theories invented by ivory tower academics.

That complacency was shattered when Paulson and Bernanke allowed LEH to fail. Their theoreticians had assured them that the damage could be contained. But they were wrong.

Their parameters contained a genteel, orderly world that its participants had navigated successfully for generations. The foundations were established in the virile youth of early 20th century America when the Federal Reserve was founded as America's 3rd Central Bank. It was a system that many assumed was fundamentally sound.

But nothing lasts forever. Successive crises since the Federal Reserve's founding (World War II, Bretton Woods I, Bretton Woods II, Soviet collapse, Asian Flu, and Dot Com implosion) were merely band-aids applied to the festering rot at the core of the world's largest nation.

America had transformed from a net creditor into a net debtor. And in that transformation, America also turned from an idealistic capitalist into a machine continually searching for new ways to refinance its debt. . . .at any cost.

US policymakers rely on the assumption that foreigners in developing nations will continue to lend funds despite lower returns. This assumption is a monetary fiction that severely distorts risk premiums and encourages exchange rate anamolies. The excess liquidity present in the US only accelerates economic problems.

More than a decade ago, when financial crisis spread from Thailand to South Korea to Russia and Brazil, the unifying thread was that these emerging markets had borrowed heavily in dollars. Declines in their own currencies increased the burden of repaying these debts. Severe austerity measures were imposed by their creditors, a cabal of Western bankers that syndicated loan repayments through transnational organizations such as the IMF and World Bank. Developing nations suffered bankruptcies, high taxes, and massive civil unrest. Under the repayment terms, debtor governments were forced to ruthlessly cut essential social entitlement programs and privatize state owned industries (which often employed large segments of the population) at deep discounts to international creditors.

Might we see the tables turned? Perhaps.

2009 will be the year of unknown risks surfacing. The majority of market pundits continue to operate under the assumption that all known risks have been contained. They still believe that the system's parameters can sufficiently contain the world's credit problems. They still continue to believe in the debts of a nation.