Wednesday, December 23, 2009

More capitalism, less regulation

By Derek Scott*
Published: December 22 2009 (Financial Times)

*[Derek Scott is a member of the Investment Advisory Board of Vestra Wealth and was economic adviser to Tony Blair, former UK prime minister, from 1997 to 2003.]


The current crisis reflects not the failure of capitalism, but the failure of the people running capitalism to understand how it works. This is bound to affect how we get out of the mess.

In simple terms, the prevailing consensus is to view the post-2007 crisis as the result of an external shock which could not have been anticipated. The remedy is to deal with the perceived cause (bankers or regulators) embarking on large-scale fiscal and monetary stimuli until the damaged “animal spirits” of households and business are restored. After this, things can get back to normal and stimuli be withdrawn.

In fact, the world’s problems did not come from an external shock but were created within the various economies (in the jargon, they are endogenous not exogenous) and resulted from the failure of policymakers to understand the implications of the re-emergence of genuine capitalism, including large-scale private sector capital flows, which puts a premium on the relationship between the anticipated rates of return and the real rate of interest as the means of combining economic dynamism with overall stability.

A series of monetary policy mistakes in the late 1990s meant that interest rates were too low, creating in several countries what Austrian economists such as Friedrich Hayek, called an “inter-temporal” problem. It is no coincidence that economists who did predict the crisis, notably in Britain the estimable Bernard Connolly, looked at economics in a similar way.

In essence what happens is that inappropriately low rates of interest bring forward investment spending by households and business (adding to demand when it takes place) from “tomorrow” to “today” so that when “tomorrow” arrives, budget constraints reduce spending at precisely the time when “yesterday’s” investment comes on stream, adding to supply. The only way to keep things going is even lower interest rates, bringing forward even more spending, so establishing the international Ponzi game that eventually burst in 2007.

The combination, on the one hand, of newly reinvigorated capitalism and the associated rise in productivity with, on the other, Bundesbank-style inflation targeting, adopted implicitly or explicitly by a number of central banks, proved fatal. The former should have led to a decline in inflation but inflation targeting allowed central banks to achieve “stability” while practically every other indicator was flashing “red”. It was this environment that fostered the “irresponsible” and/or “incompetent” behaviour of banks, regulators, households and the rest.

Once the bubble burst, policymakers adopted what might be termed Keynesian solutions to an Austrian problem though, in the case of Britain, Keynes would certainly not have been starting from here: Gordon Brown’s profligacy as chancellor in the “good years” has certainly left Britain more vulnerable in the bad times.

However, in general, this response was probably correct since the alternative might have led to spiralling debt deflation and even political collapse. Nonetheless, the notion that large deficits and increasing debt can be accepted with equanimity until the private sector starts spending again is too sanguine.

In so far as they do work, virtually all the various fiscal and monetary measures do so only through bringing forward yet more spending from “tomorrow” to “today”, whether this is through low interest rates, rising asset prices or incentives to buy cars. There can be no return to anything approaching “normal”, including normal levels of interest rates, until rates of return increase to enable businesses to be profitable at normal (in other words higher) rates of interest.

Without this, any attempt to normalise interest rates risks pushing economies off the cliff again; and policymakers will either have to tolerate a protracted period of slow growth and high unemployment or run faster to stand still by bringing yet more spending forward from “tomorrow” to “today”.

All the previous periods when high levels of debt in Britain and the US have been brought under control have been associated with either increased innovation and enterprise (Britain after the Napoleonic Wars, the US after the two world wars and later after Reagan’s “supply-side” economics) or have been periods of technological “catch-up” (for Britain and western Continental Europe after the second world war). In both cases rates of return rose.

Today, if rates of return are to rise, it requires not necessarily capitalism “red in tooth and claw” but certainly more capitalism rather than less. The problem is that in most countries policies are moving in the opposite direction: more regulation (it’s called “better” but it means “more”) and, from some quarters, a desire to replace Anglo-Saxon capitalism with European corporatism.

Wednesday, December 16, 2009

U.S. Debt Burden

Only in the minds of court economist and Central Bankers would the idea exist that the U.S. debt level is not a serious problem. Consider the following graph (thanks to Reuters):

Yep, just keep on borrowing yourself to prosperity. Soon enough the entire country will be rich!

Insanity, I tell you. Insanity! The good ol' U.S. of A is broke, folks. If you didn't know that or didn't want to believe, sorry to have burst your bubble.

Thursday, December 10, 2009

Friday, November 27, 2009

Boomtime politicians will not rein in the bankers

By Avinash Persaud**
Published: November 26 2009 (Financial Times)

One of the features that singles out the Warwick Commission on International Financial Reform, which publishes its final report on Friday, is that while other expert groups tiptoe around it, we have been able to point to the true source of the worst financial crisis since the 1930s: regulatory capture and boomtime politics.

Today regulators are working conscientiously to address the issue of banks being too big to fail; the lack of responsibility that can follow securitisation; imperfections in credit ratings; capital requirements which accentuate boom and bust; regulators which were global champions for their local banks; and more. But we should not forget that just a few years ago, regulators, with few exceptions, wanted big banks to have lower capital requirements if they had sophisticated risk models; they were cheerleaders for securitisation and asset sales by banks because, they said, this spread risks; they hard-wired credit ratings into bank risk assessment; they promoted home country regulation over host country control; and they dismissed the idea that regulation was dangerously pro-cyclical.

These and other regulatory mistakes all pushed financial institutions in the same direction. Large international banks compete better on “process” and “models” than credit assessment, and reap economies of scale when rules that segment finance within and between countries are liberalised. As I wrote here in 2002, financial regulation had all the hallmarks of being captured by banks, to the detriment of financial stability.

Separate but related to regulatory capture is the politics of booms. A boom persists because no one wants to stop it. The government of the day wants it to last until the next election. The early phase of a boom brings extra growth, low inflation and falling defaults. Governments tout this as a sign of their superior performance. Bankers argue such alchemy justifies their golden handshakes and excuses their golden handcuffs. Booms spread cheer by providing finance to the previously unbanked. Donations to worthy causes and universities temper traditional channels of criticism. How easily can the underpaid regulator stick his hand up and say it is all an unsustainable boom?

The capture and influence is subtle and there is always a genuine reason, if a wrong one, for why it is different this time. Indeed, one of the key challenges not yet seriously addressed is why the universities and press, falling over themselves to kick bankers today, did not play a more effective counterveiling force to this capture.

One indirect consequence of capture is the mistaken treatment of risk that lies at the heart of regulation. Many politicians and watchdogs think of risk as a single fixed thing inherent in instruments. As a result they put faith in processes that link capital to measures of risk, or in committees charged with determining what is safe and what is risky and banning the risky. But risk is a chameleon: it changes depending on who is holding it. Declaring something safe can make it risky and vice versa. Investment scams are attracted to booms, but booms are in fact built on the belief that some new thing has increased the return or reduced the risk of the world: motor cars, railroads, electricity, the internet or financial innovation. There is often a large element of truth about the original proposition – the world will be different – but the over-investment creates new risks.

In a world in which risk is poorly measured and regulators are vulnerable to political influence, we cannot rely as a defence against a crisis on the regulation of financial instruments, statistical measures of risk, systemic risk committees or the foreign “home country” regulator.

It is not financial instruments but behaviour we need to change. A better defence will come from increasing capital buffers at financial institutions, making these buffers counter-cyclical, and focusing on structural – not statistical – measures of risk capacity. Liquidity risk is best held by institutions that do not require liquidity, such as pension funds, life insurers or private equity. Credit risk is best held by institutions that have plenty of credit risks to diversify, such as banks and hedge funds. No amount of extra capital will save a system that, because measured risks in a boom are low, sends risk where there is no capacity for it.

**The writer is chair of the Warwick Commission, chairman of Intelligence Capital and an emeritus professor of Gresham College

Thursday, November 26, 2009

Game Over?

The following graph demonstrates the percent change from a year ago of the bi-weekly adjusted monetary base.

As can be seen, the change has been dramatic over the recent past. In particular, since August it has been on a longer, sustained decline in comparison to previous periods.

Given the fiat monetary system that underpins our economy, this fall is simply a signal that the economic stability is on its last legs. Unless more money is pumped into the system, thereby reversing the fall we are witnessing in the graph, the so-called stability cannot be sustained.

The excess money printed provided support to strained markets. In other words, the consequence of such policy was to give the impression of low asset risk, thereby inflating their value. No doubt this was achieved. The problem is that when the monetary pump is closed (or the flow of funds decline), values cannot keep up. Policymakers don’t believe this, of course. It is why they are blindsided as to the true risks in our economy.

Saturday, November 14, 2009

Money & Inflation

To gain an understanding of what is happening in the economy, we must carefully review the Federal Reserve actions. The following is a brief overview of the monetary statistics I follow, which I believe give a good summary into the world of price inflation risk.

1. Adjusted Monetary Base (AMB): this is the liabilities of the FED that can be transformed into money in the economy. It includes currency held by the public and bank reserves. The FED affects the fed funds interest rate, which used by domestic banks to price reserve loans to each other, through the monetary base.

Since September 2008, the level of the monetary base on a bi-weekly basis has been expanding like no other time in history. It went from about $900 billion to approximately $2 trillion as of 11/13/2009.

Considering the continuous compounded rate of change, it is currently expanding at a rate close to 100% annually.

2. M1 (money supply): monetary aggregate made up primarily of currency and checking account balances.

Mathematically = [{(currency/deposits)+1)}/{(currency/deposits)+(reserves/deposits)}]*AMB

The level of the (weekly) money supply has been elevated during the most recent recession and unlike any other time since data have been compiled.

Focusing on the last five years, we note the extent of the monetary expansion.

3. Money Multiplier: the number of dollars that can be created out of thin air from each dollar in the adjusted monetary base.

Mathematically = [{(currency/deposits)+1)}/{(currency/deposits)+(reserves/deposits)}]

The money multiplier decreases when the currency/deposit ratio or the reserve/deposit ratio increases.

As can be noted from the graph, the multiplier (computed on a bi-weekly basis) has declined significantly during the recent financial crisis.

4. Excess Reserves: Reserves are deposits of depository (i.e. banks) institutions. After accounting for the FED imposed requirement, excess reserves are loaned out.

Excess reserves have ballooned during the crisis. Bank are not lending as a result of decreased loan demand and an abundance of unworthy borrowers. As a result, financial firms have decided to lend the money to the FED. Reserves stand close to $1 trillion.

Wednesday, November 11, 2009

Powerful interests are trying to control the market

By John Kay (Financial Times, Published: November 10 2009)

You can become wealthy by creating wealth or by appropriating wealth created by other people. When the appropriation of the wealth of others is illegal it is called theft or fraud. When it is legal, economists call it rent-seeking.

Rent-seeking takes many forms. On Europe’s oldest highway, the Rhine river, the castles on rocky outcrops date from the time when bandits with aristocratic titles extracted tolls from passing traffic. In poor countries the focus of political and business life is often rent-seeking rather than wealth creation. That helps explain why some countries are rich and others poor.

Rent-seeking drives the paradoxical resource curse. Oil or mineral wealth mostly reduces the population’s standard of living because it diverts effort and talent from wealth creation to rent-seeking. Sadly, foreign aid often has a similar effect.

Rent-seeking can be effected through rake-offs on government contracts, or the appropriation of state assets by oligarchs and the relatives of politicians.

But in more advanced economies, rent-seeking takes more sophisticated forms. Instead of 10 per cent on arms sales, we have 7 per cent on new issues. Rents are often extracted indirectly from consumers rather than directly from government: as in protection from competition from foreign goods and new entrants, and the clamour for the extension of intellectual property rights. Rents can also be secured through overpaid employment in overmanned government activities.

Rent-seeking is found whenever economic power is concentrated – in the state, in large private business, in groups of co-operating and colluding firms. Private concentrations of economic power tend to be self-reinforcing. This problem was widely recognised in America’s gilded age. The well-founded fear was that the new mega-rich – the Rockefellers, Carnegies, Vanderbilts – would use their wealth to enhance their political influence and grow their economic power, subverting both the market and democracy. Today it is Russia that exemplifies this problem.

But America has a new generation of rent-seekers. The modern equivalents of castles on the Rhine are first-class lounges and corporate jets. Their occupants are investment bankers and corporate executives.

Control of rent-seeking requires decentralisation of economic power. These policies involve limits on the economic role of the state; constraints on the concentration of economic power in large business; constant vigilance at the boundaries between government and industry; and a mixture of external supervision and internal norms to limit the capacity of greedy individuals in large organisations to grab corporate rents for themselves. Vigorous pursuit of these is the difference between a competitive market economy and a laisser-faire regime, and it is a large difference.

Privatisation and the breaking up of statutory monopolies has reduced rent-seeking by organised groups of public employees. But the scale of corporate rent-seeking activities by business and personal rent-seeking by senior individuals in business and finance has increased sharply.

The outcomes can be seen in the growth of Capitol Hill lobbying and the crowded restaurants of Brussels; in the structure of industries such as pharmaceuticals, media, defence equipment and, of course, financial services; and in the explosion of executive remuneration.

Because innovation is dependent on new entry it is essential to resist concentration of economic power. A stance which is pro-business must be distinguished from a stance which is pro-market. In the two decades since the fall of the Berlin Wall, that distinction has not been appreciated well enough.

The story is told of the Russian policymaker, visiting the US after the Soviet Union collapsed, who asked: “Who is in charge of the supply of bread to New York?” The bureaucrat had not learnt how markets work, and we are in danger of forgetting it. The essence of a free market economy is not that the government does not control it. It is that nobody does.

Tuesday, November 10, 2009

Not All Bubble Present a Risk To The Economy (And I have a Bridge for Sale)

With respect to our current economic woes, we have long passed the point of no return. The sad part of it is not the loss wealth, which could be recuperated, but the loss of intellectual rigor and economic wisdom. This is quite evident in a recent Op-Ed (“Not all bubbles present a risk to the economy”…FT, 11/9/2009) by Frederic Mishkin, former FED governor and current Professor of finance & economics at Columbia University. Some of the stuff he writes is absolute silliness, which only a bureaucrat, politician, and most professional economists would believe.

Let’s digest a little bit of what he says. My comments are in bold

There is increasing concern that we may be experiencing another round of asset-price bubbles that could pose great danger to the economy. Does this danger provide a case for the US Federal Reserve to exit from its zero-interest-rate policy sooner rather than later, as many commentators have suggested? The answer is no.

The introduction is just setting the stage of his argument: happy days do not have to end.

Are potential asset-price bubbles always dangerous? Asset-price bubbles can be separated into two categories. The first and dangerous category is one I call “a credit boom bubble”, in which exuberant expectations about economic prospects or structural changes in financial markets lead to a credit boom. The resulting increased demand for some assets raises their price and, in turn, encourages further lending against these assets, increasing demand, and hence their prices, even more, creating a positive feedback loop. This feedback loop involves increasing leverage, further easing of credit standards, then even higher leverage, and the cycle continues.

Prof. Mishkin omits important variables necessary to answer the following questions: who creates money? How is money created? The omitted variables are Federal Open Market Committee and fractional reserve banking. Leverage, without concomitant increase in the supply of money, cannot by itself cause the effects Prof. Mishkin outlines.

Eventually, the bubble bursts and asset prices collapse, leading to a reversal of the feedback loop. Loans go sour, the deleveraging begins, demand for the assets declines further and prices drop even more. The resulting loan losses and declines in asset prices erode the balance sheets at financial institutions, further diminishing credit and investment across a broad range of assets. The resulting deleveraging depresses business and household spending, which weakens economic activity and increases macroeconomic risk in credit markets. Indeed, this is what the recent crisis has been all about.

This is malinvestment repriced to reflect the true (subjective and imputed) value by the market. In this environment, prices decline.

The second category of bubble, what I call the “pure irrational exuberance bubble”, is far less dangerous because it does not involve the cycle of leveraging against higher asset values. Without a credit boom, the bursting of the bubble does not cause the financial system to seize up and so does much less damage. For example, the bubble in technology stocks in the late 1990s was not fuelled by a feedback loop between bank lending and rising equity values; indeed, the bursting of the tech-stock bubble was not accompanied by a marked deterioration in bank balance sheets. This is one of the key reasons that the bursting of the bubble was followed by a relatively mild recession. Similarly, the bubble that burst in the stock market in 1987 did not put the financial system under great stress and the economy fared well in its aftermath.

Mr. Mishkin is a trademark politician. Notice the terms he throws out there: “does much less damage” or “not accompanied by a marked deterioration in bank balance sheet.” He fails to mention his standard of comparison. But, why would he? Doing so might expose his dillusion.

The reason prior bubbles did not have the level of impact as the current one has to do where the printed money by the FED made its way through the economy. Money enters through the financial system. Financial firms dealt with each other in the form of opaque instruments, which had little genuine economic value. When the implosion occurred, there was a high level of expected risk that financial firms would go belly-up. As a result, credit in essence stopped flowing. Since other non-financial (as well as financial) companies rely on a smooth flow of credit to finance their day-to-day operations, the result was catastrophic. Prior bubbles did not have this dimension magnified to the extent we recently experienced.

Because the second category of bubble does not present the same dangers to the economy as a credit boom bubble, the case for tightening monetary policy to restrain a pure irrational exuberance bubble is much weaker. Asset-price bubbles of this type are hard to identify: after the fact is easy, but beforehand is not. (If policymakers were that smart, why aren’t they rich?) Tightening monetary policy to restrain a bubble that does not materialise will lead to much weaker economic growth than is warranted. Monetary policymakers, just like doctors, need to take a Hippocratic Oath to “do no harm”.

Mr. Mishkin states that if policymakers were clairvoyant and “smart, why aren’t they rich?” In fact, they are rich in comparison to median household income. More egregious is the fact that monetary policymakers are the culprits of the economic crisis we are enduring presently. Summers, Geithner, Bernanke, et. al. are jus a few names who were around in policymaking circles while the current bubble was being inflated. Of course, let us not omit Mr. Mishkin. They never saw it coming. But, somehow today we are led to believe that they see “green shoots” and that everything is and will be just fine. If this is not a contradiction, then I don’t know what is.

Nonetheless, if a bubble poses a sufficient danger to the economy as credit boom bubbles do, there might be a case for monetary policy to step in. However, there are also strong arguments against doing so, which is why there are active debates in academia and central banks about whether monetary policy should be used to restrain asset-price bubbles.

Here is one that is almost never considered, let alone even think: abolish the Federal Reserve.

But if bubbles are a possibility now, does it look like they are of the dangerous, credit boom variety? At least in the US and Europe, the answer is clearly no. Our problem is not a credit boom, but that the deleveraging process has not fully ended. Credit markets are still tight and are presenting a serious drag on the economy.

Mr. Mishkin, who is providing credit right now? The Federal Reserve System. Simply look at the size of its balance sheet. Yes, I know, it is technically part of the money supply in the form of the monetary base. But the effects are the same as credit. The bubble that is being inflated is in Treasury debt.

Tightening monetary policy in the US or Europe to restrain a possible bubble makes no sense at the current juncture. The Fed decision to retain the language that the funds rate will be kept “exceptionally low” for an “extended period” makes sense given the tentativeness of the recovery, the enormous slack in the economy, current low inflation rates and stable inflation expectations. At this critical juncture, the Fed must not take its eye off the ball by focusing on possible asset-price bubbles that are not of the dangerous, credit boom variety.

La! La! La! I am selling the George Washington Bridge…any takers? Mr. Mishkin?

Tuesday, November 3, 2009

US GDP Growth: A Myth

Pundits and market cheerleaders hailed the reported third quarter GDP figures. Strong growth, said some! We have turned the corner, said others. But amidst this nonsense, there is perspective. As a Financial Times Editorial put it:

Americans rediscovered their taste for consumption: personal expenditures
grew by an annualised 3.4 per cent after falling in four of the previous six
quarters. Durable goods were swept up, with sales higher by an annualised 22 per
cent, but services and nondurables as well grew at respectable if modest speeds.
Businesses and households also started investing again: although non-residential
construction fell for the fifth quarter in a row, equipment spending rose for
the first time since 2007, and residential investment jumped by an annualised 23
per cent.

But this spending spree is brittler than one would like. The durable goods
spurt – even as disposable incomes fell – was powered by a car scrappage scheme
that borrowed GDP from the future more than anything else. With motor vehicles
excluded, output grew by only 1.9 per cent. Up to half of that in turn consisted
of businesses rebuilding depleted inventories – a sign of optimism, but also,
like cash-for-clunkers, a one-off boost to output that will not persist.

There you have it folks. Suddenly the numbers are not so stellar, as first reported. Those who have ears, let them hear.

Wednesday, October 21, 2009

How to Fix Our Economic Mess

It is not as hard as it seems. You don’t have to go to Harvard or Columbia to figure it out. You don’t have to spend hours and days campaigning for your candidate to create a change you can believe in. No, you don’t have to do any of those things. In fact, the answer is so obvious even the average Cuban businessman can tell you what to do. I am not kidding. This is really the case. To prove my point, let me introduce you to Evelio and Carlos, businessmen living in the island of Cuba—notorious for its economic follies. They were interviewed as part of a report by the Financial Times on said country.

What does Evelio think about Cuba’s central economic planning? Let’s see.
"Farmers have never wanted the state to give them anything,” one farmer,
Evelio, aged 60-plus, said in a telephone interview from the provinces. “What we
want is that they sell us what we need to produce and then not waste it through
poor planning, transport and other problems.”

What about Carlos, who is an industrial worker? Maybe he can enlighten us. What did he say?
“Our work does not depend on us but on orientations from the ministry. I can’t
plan anything because they decide the factory’s work and supplies and that’s
where the problems are and continue.”

See, this is the problem with government intervention: it ends up causing a bigger mess than what it intended to solve. It hurts the very people the system is claiming to help. It is as if you are going to cure your headache by banging your head in a wall. You will reach a point when the headache will be gone. In fact, if you continue doing this you will reach a point that you’ll have no more headaches, but at a high cost: your life. It is the same with central economic planning.

It is rather amazing that policies of state intervention are being hailed as the next best thing since sliced bread in the Western world these days. Always and everywhere government intrusion in the free-market economy fails and causes poverty. The recent state guarantees in various sectors of the U.S. economy contradict this logic. A large majority of our leaders truly believe they have done a great deed by promoting de facto communism/socialism. Politicians can put a different spin and/or play on words, but the essence in the same. Don’t listen to what is said, look at the action. You don’t take my word for it, simply listen to Evelio and Carlos. They know more than I do, and as well as most tenured economists, political leaders, and Wall St. CEOs.

Thursday, October 15, 2009

Why The U.S. Dollar Will Loose Its Eminence

Professional economists are a funny bunch. Most resemble a person who looks himself in the mirror and after walking away from it immediately forgets his appearance. Similarly, economists inspect their economic trade tool with diligence, but seem to forget them when it is of utmost important; that is, when abandoning them may lead to tenured positions or a high profiled political job. The issue of the U.S. Dollar’s eminence in international markets is no different. There are elaborate theories and abstruse statistical methods supporting this or that view of how the currency is supposed to behave. But there is an even simpler approach, a model which a scientist would say has parsimonious characteristics: it is called logic.

Since 1945 the U.S. Dollar has reigned supreme in world affairs. Many international prices and other market mechanisms are set in terms of the value of the greenback. Yet, this distinction comes with a (hidden) string attached. Simply, the Dollar status maintains a unique advantage vis-à-vis other currencies because, as long as foreigners allow it, the currency does not have to follow the standards which others are held to. In other words, the fact that the U.S. Treasury can merely print Dollars to pay its foreign claims, unlike other nations, provide America with special privileges. This is referred to as asymmetrical position. The reserve-emitting country (i.e. U.S.A) can fund many of its activities, and as long as the majority of foreign do not economically rebel, it will not suffer the consequences that another country would.

For example, a country with non-reserve currency can fund its day-to-day operations above it collects in taxes, but at a high cost: inflation and subsequent political upheaval. Inflation because the excess money printed exceeds currency demand. These excess funds chase a fixed amount of goods, or at least it is far more than the level of production. Prices will rise in this environment. High price inflation distorts prices and business decision plans.

On the contrary, the reserve currency country is not readily prone to such immediate consequences. Because of it’s prestige, traders and international investors have granted the greenback a tremendous standing. When economic worries sip into various countries, immediately you will see a sell-off in the said country. These investors pursue capital preservation. The U.S. Dollar has that perception. U.S. dollar assets are purchased, consequently providing support for the currency and the economy too. Over this decade, however, the growth in money printing has exceeded the growth in currency accumulation of foreigners. Said differently, had the U.S. dollar not have its unique status, it would have depreciated below what it is now a long time ago. An overvalue currency without due adjustment through the foreign exchange market would be price inflationary. However, in the case of the U.S., demand for dollars by foreigners has increased faster during the time the currency has had eminence, thereby transferring price inflation and other economic costs to foreign markets.

This arrangement cannot continue indefinitely. At some point it will come to an end. As to how it will unravel? I leave that thought to seers and soothsayers.

Saturday, October 10, 2009

Why Will the Next Economic Crisis Be Worse

The spate of economic data revealing the supposed economic recovery is merely covering the massive capital misalignment that still plagues the U.S. Bad debt and toxic assets continue to clog the balance sheets of financial firms, many of which would have gone under had it not been for the massive intervention provided by the government. Many economists and armchair pundits hailed the apparent success of the interventionists, I suppose, like the admirers who hailed the survival miracle of Annie Taylor’s daredevil stunt at the Niagara Falls.

Government intervention and its failure to prevent the dissolution of insolvent firms have magnified the problem of asymmetric information. The reasoning of their intervention, of course, ran along the logic that these firms are “too big to fail.” In other words, these companies are deeply embedded in the economic landscape that one bankruptcy would have triggered a cascade of other failures, causing the economy to come to a grinding halt and ultimately a collapse. Of course, politicians and government bureaucrats never let a crisis of this magnitude go to waste for their own purposes. There are always votes to win for the next election.

That being said, the problem of “saving” these so-called “too big to fail” firms is that it helps foster and promote moral hazard. Moral hazard is the idea that individuals will act different than they otherwise would in the presence of insurance. For example, a person might drive more recklessly, which increases the likelihood of an accident, if he knew he has full-cover car insurance. Similarly, for many years financial firms and investors understood that should a major crisis occur, the government would bail them out. And bailed out they indeed were. Let’s take a brief look into the annals of recent bailout history: In the early 1980s, banks received help from the government which curtailed looses stemming from the emerging market debt crisis. In the late 1980s, the government stepped in to help the financial industry from the saving and loans debacle. In the late 1990s, the Federal Reserve orchestrated a bailout of a prominent hedge fund. From 2005-2009, the government has become a shareholder in industries where constitutionally they have no business to be in. Of course, this has been spun in such a manner that glorifies the behavior of the market interventionists.

Moral hazard is a hidden action in the sense that it cannot be seen publicly: that is, only those holder of toxic assets—to use an example—know with almost full assurance the type and quality of assets they hold in their balance sheets. The government and other outsiders do not. Since the firms know the government will intervene in the case of a crisis, companies will be more conducive to take on higher riskier. Given the massive amounts of unprecedented money printed during the most recent crisis, government is laying the foundation for further capital misallocation. The “money” (which really is just paper printed with green tint) is being spent on things that are not productive. The risky behavior feeds on itself to the point of speculation. When we reach this transition, it is just a matter of time before the economy collapses again.

Monday, October 5, 2009

The Deminse of The Dollar - by Robert Fisk



In the most profound financial change in recent Middle East history, Gulf Arabs are planning – along with China, Russia, Japan and France – to end dollar dealings for oil, moving instead to a basket of currencies including the Japanese yen and Chinese yuan, the euro, gold and a new, unified currency planned for nations in the Gulf Co-operation Council, including Saudi Arabia, Abu Dhabi, Kuwait and Qatar.

Secret meetings have already been held by finance ministers and central bank governors in Russia, China, Japan and Brazil to work on the scheme, which will mean that oil will no longer be priced in dollars.

The plans, confirmed to The Independent by both Gulf Arab and Chinese banking sources in Hong Kong, may help to explain the sudden rise in gold prices, but it also augurs an extraordinary transition from dollar markets within nine years.

The Americans, who are aware the meetings have taken place – although they have not discovered the details – are sure to fight this international cabal which will include hitherto loyal allies Japan and the Gulf Arabs. Against the background to these currency meetings, Sun Bigan, China's former special envoy to the Middle East, has warned there is a risk of deepening divisions between China and the US over influence and oil in the Middle East. "Bilateral quarrels and clashes are unavoidable," he told the Asia and Africa Review. "We cannot lower vigilance against hostility in the Middle East over energy interests and security."

This sounds like a dangerous prediction of a future economic war between the US and China over Middle East oil – yet again turning the region's conflicts into a battle for great power supremacy. China uses more oil incrementally than the US because its growth is less energy efficient. The transitional currency in the move away from dollars, according to Chinese banking sources, may well be gold. An indication of the huge amounts involved can be gained from the wealth of Abu Dhabi, Saudi Arabia, Kuwait and Qatar who together hold an estimated $2.1 trillion in dollar reserves.

The decline of American economic power linked to the current global recession was implicitly acknowledged by the World Bank president Robert Zoellick. "One of the legacies of this crisis may be a recognition of changed economic power relations," he said in Istanbul ahead of meetings this week of the IMF and World Bank. But it is China's extraordinary new financial power – along with past anger among oil-producing and oil-consuming nations at America's power to interfere in the international financial system – which has prompted the latest discussions involving the Gulf states.

Brazil has shown interest in collaborating in non-dollar oil payments, along with India. Indeed, China appears to be the most enthusiastic of all the financial powers involved, not least because of its enormous trade with the Middle East.

China imports 60 per cent of its oil, much of it from the Middle East and Russia. The Chinese have oil production concessions in Iraq – blocked by the US until this year – and since 2008 have held an $8bn agreement with Iran to develop refining capacity and gas resources. China has oil deals in Sudan (where it has substituted for US interests) and has been negotiating for oil concessions with Libya, where all such contracts are joint ventures.

Furthermore, Chinese exports to the region now account for no fewer than 10 per cent of the imports of every country in the Middle East, including a huge range of products from cars to weapon systems, food, clothes, even dolls. In a clear sign of China's growing financial muscle, the president of the European Central Bank, Jean-Claude Trichet, yesterday pleaded with Beijing to let the yuan appreciate against a sliding dollar and, by extension, loosen China's reliance on US monetary policy, to help rebalance the world economy and ease upward pressure on the euro.

Ever since the Bretton Woods agreements – the accords after the Second World War which bequeathed the architecture for the modern international financial system – America's trading partners have been left to cope with the impact of Washington's control and, in more recent years, the hegemony of the dollar as the dominant global reserve currency.

The Chinese believe, for example, that the Americans persuaded Britain to stay out of the euro in order to prevent an earlier move away from the dollar. But Chinese banking sources say their discussions have gone too far to be blocked now. "The Russians will eventually bring in the rouble to the basket of currencies," a prominent Hong Kong broker told The Independent. "The Brits are stuck in the middle and will come into the euro. They have no choice because they won't be able to use the US dollar."

Chinese financial sources believe President Barack Obama is too busy fixing the US economy to concentrate on the extraordinary implications of the transition from the dollar in nine years' time. The current deadline for the currency transition is 2018.

The US discussed the trend briefly at the G20 summit in Pittsburgh; the Chinese Central Bank governor and other officials have been worrying aloud about the dollar for years. Their problem is that much of their national wealth is tied up in dollar assets.

"These plans will change the face of international financial transactions," one Chinese banker said. "America and Britain must be very worried. You will know how worried by the thunder of denials this news will generate."

Iran announced late last month that its foreign currency reserves would henceforth be held in euros rather than dollars. Bankers remember, of course, what happened to the last Middle East oil producer to sell its oil in euros rather than dollars. A few months after Saddam Hussein trumpeted his decision, the Americans and British invaded Iraq.

S&P 500...Insanity???

S&P 500 Statistics As of September 30, 2009

Total Market Value ($ Billion) 9,337
Mean Market Value ($ Million) 18,673
Median Market Value ($ Million) 7,978
Weighted Ave. Market Value ($ Million) 74,455
Largest Cos. Market Value ($ Million) 329,725
Smallest Cos. Market Value ($ Million) 814
Median Share Price ($) 32.850
P/E Ratio* 140.76
Indicated Dividend Yield (%) 2.05NM

*Based on As Reported Earnings.

Tuesday, September 29, 2009

Credt Default Swaps and Counterparty Risk

This is a summary of a recent publication by the European Central Bank on the topic of credit default swaps and counterparty risk. It is a worthwhile reading. Given that the length of the paper is somewhat extensive, I have provided a brief report of its content. The full version of the paper can be read here.


· Credit default swaps (CDS) are bilateral contracts that work similar to insurance policies. A purchaser of a CDS agrees to pay a periodic fee (i.e. premium) and/or an upfront payment in exchange for a payment by the CDS seller in case of a credit event (e.g. bankruptcy, credit downgrade, etc.) in the underlying reference.

· In terms of notional amounts outstanding, CDS comprises about 7% ($42 trillion) of total OTC derivatives as of year-end 2008. Interest rate swaps are the lion’s share of OTC contracts.

· In terms of gross market value, which considers the cost of replacement, CDS grew from $133 billion in December 2004 to approximately $5.7 trillion in December 2008.
Several key observations:

· High concentration of CDS dealers. The top 5 firms comprised approximately 50% of the total outstanding notional amount according to DTCC data. Four are ANC firms: JP Morgan (#1), Goldman Sachs (#2), Morgan Stanley (#3), Barclays Group (#5).

· CDS market has come to demonstrate a high level of interdependence (i.e. connection), which manifests itself in various ways:
(1) Market values of financial firms tend to fluctuate together.
(2) There is an increasing correlation between counterparty and reference entities (e.g. a bank that received government assistance and at the same time sold CDS on the sovereign credit risk of the country that is domiciled—this is known also as “wrong-way risk”).
(3) It was noted that less important CDS players in fact turned out to be critical for the market, as their failure would have severely impacted the “too big to fail” firms (e.g. AIG and its counterparties).

· Circularity of risk. This term relates to when national governments provide economic support to financial institutions. This results in the latter firms being stabilized, however the national government’s additional burden increases sovereign risk; thereby increasing the risk for bank.

· A CDS has a call-type option for the defaulting counterparty. That is, the increase in the contract’s market value is a benefit for the defaulting counterparty. The party suffering the loss typically uses 3 approaches to minimize this risk:
(1) Price the CDS to consider counterparty risk. This may entail different price for each counterparty.
(2) Hedge in such a way to consider the counterparty defaulting during the life of the CDS. (3) Require collateral to cover replacement cost. · Collateral is the primary way for firms to manage this risk. In a CDS framework, CDS buyers receive collateral when spreads are widening and vice-versa when spreads are declining.

· Unlike other OTC derivatives, CDS contain both credit and counterparty risk.

· What makes CDS particularly risky vis-à-vis other derivatives is the credit risk distribution of the underlying reference entity is skewed (i.e. non-symmetric). As a result exposure levels during market turbulence for the CDS buyer from the CDS seller could increase significantly. This could cause potentially enormous payouts from the latter to the former. In such instances not only counterparty risk is an issue but also liquidity risk.

· CDS markets are used as price indicators for other markets, including loan, credit, and equity markets.

· CDS spreads tend to lead changes in bond spreads in the short run.

· In theory, CDS spreads should provide a pure measure of default risk.

· A rough approximation of CDS spreads = (PD)*(1 - recovery rate) = PD*LGD.
PD = Probability of Default
LGD = Loss Given Default

Research demonstrates that PD and LGD may be cyclically positive correlated, implying that during economic downturns recovery rates suffer disproportionally in relation to PD, which will ultimately increase CDS spreads. Systemic risk can also negatively affect spreads.

· In abnormal market conditions, there is a breakdown in the interrelationship between CDS market and the underlying cash bond market as a means of reference pricing. Cash market reflect credit risk and funding risk, whereas the CDS market focuses on credit risk and counterparty risk. This mismatch has been attributed to periods of reduced liquidity.

Thursday, September 17, 2009

Some fires are best left to burn out

By William White
Published: September 16 2009 19:01 (Financial Times)

[Note: The writer is former economic adviser, head of the monetary and economic department at the Bank for International Settlements.]

Forest fires are judged to be nasty, especially when one’s own house or life is threatened, or when grave harm is being done to tourist attractions. The popular conviction that fires are an unqualified evil reached its zenith after a third of Yellowstone Park in the US was destroyed by fire in 1988. Nevertheless, conventional wisdom among forest managers remains that it is best to let natural forest fires burn themselves out, unless particularly dangerous conditions apply. Burning appears to be part of a natural process of forest rejuvenation. Moreover, intermittent fires burn away the undergrowth that might accumulate and make any eventual fire uncontrollable.

Perhaps modern macroeconomists could learn from the forest managers. For decades, successive economic downturns and even threats of downturns (“pre-emptive easing”) have been met with massive monetary and often fiscal stimuli. This was the case when the global stock market crashed in 1987, and it was repeated when the property boom in many countries collapsed in the early 1990s. Interest rate rises were put on hold during the Asian crisis of 1997, even though traditional indicators said some industrial countries were overheating. Rates were then sharply reduced in 1998, after the collapse of the hedge fund Long-Term Capital Management, and were lowered again when the stock market collapsed in 2001. Today, policy rates in most industrial countries are close to zero, in response to the financial crisis.

What needs reflection, against this backdrop, is whether the policy reaction to each successive set of difficulties laid the foundations for the next one. Worse, the encouragement by lower interest rates of debt accumulation and spending imbalances was the equivalent of undergrowth accumulating in the forest. This undergrowth not only made subsequent downturns more dangerous; it also made the available policy instruments less reliable in response. Looking back over successive cycles, interest rates have had to be reduced with ever more vigour to get the same (and sometimes reduced) response from spending. Most recently, new and untried policies such as quantitative and credit easing have had to be introduced. Logically, the end point of such a dynamic process would seem to be the mother of all fires and few if any means of resistance.

The current Keynesian mindset rightly observes that we have a shortage of aggregate demand. It then concludes that demand stimulus, from whatever quarter, is to be welcomed. However, in addition to the undergrowth problem on the demand side, we can also have an undergrowth problem on the supply side. This was the core of Friedrich Hayek’s position when he debated Keynes in the early 1930s. In response to demand stimulus over recent decades, with investors implicitly assuming that the future would be like the recent past, there has been a massive increase in supply potential in many industries. The upshot is that many of them are now too big and must be wound down. This applies to automobile production, banking services, construction, many parts of the transport and wholesale distribution industries, and often retail distribution as well. Similarly, many countries that relied heavily on exports as a growth strategy are now geared up to provide goods and services to heavily indebted countries that no longer have the will or the means to buy them.

In this supply side context, policies such as “cash for clunkers” and value added tax cuts in countries with very low household saving rates and massive trade deficits are clearly suboptimal. So too, in countries with large trade surpluses, is resistance to exchange rate appreciation along with a continuing reliance on export demand. Such policies are equivalent to trying to resuscitate a patient long since dead. Not only will time prove that such attempts are futile, but they also impede the desirable adjustment from declining industries to those that should be expanding. In effect, relying solely on macroeconomic stimulus may well head off a more violent downturn, but only at the expense of a more protracted recession. Maybe this is the principal lesson to be drawn from Japan’s almost two decades of sub-par performance. Indeed, resisting structural adjustment could also imply a decline in the level of “potential growth” in the years ahead. This would bring with it the threat of a stagflationary outcome, if the demand stimulus from Keynesian policies were not to be adjusted downwards in consequence.

Where to go from here? In terms of future crisis management, governments should give more weight to the longer-term implications of their policies. Those that threaten to make future crises more costly, or that impede required structural adjustments, should be moderated. Such inter-temporal trade-offs imply, from time to time, accepting a temporary economic downturn to avoid even bigger future costs. In this sense, good crisis management also contributes to crisis prevention.

But still more might be done with crisis prevention. Just as good forest management implies cutting away underbrush and selective tree-felling, we need to resist the ­credit-driven expansions that fuel asset bubbles and unsustainable spending patterns. Recent reports from a number of jurisdictions with well-developed financial markets seem to agree that regulatory instruments play an important role in leaning against such phenomena. What is less clear is that central bankers recognise that they might have an even more important role to play. In light of the recent surge in asset prices worldwide, this issue needs urgent attention. Yet another boom-bust cycle could have negative implications, social and political, stretching beyond the sphere of economics.

Tuesday, September 8, 2009

Why some economists could see the crisis coming

By Dirk Bezemer
Published: September 7 2009 (Financial Times)

(Note: The writer is a fellow at the economics and business department of the University of Groningen in the Netherlands).

From the beginning of the credit crisis and ensuing recession, it has become conventional wisdom that “no one saw this coming”. Anatole Kaletsky wrote in The Times of “those who failed to foresee the gravity of this crisis” – a group that included “almost every leading economist and financier in the world”. Glenn Stevens, governor of the Reserve Bank of Australia, said: “I do not know anyone who predicted this course of events. But it has occurred, it has implications, and so we must reflect on it.” We must indeed.

Because, in fact, many had seen it coming for years. They were ignored by an establishment that, as the former Federal Reserve chairman Alan Greenspan professed in his October 2008 testimony to Congress, watched with “shocked disbelief” as its “whole intellectual edifice collapsed in the summer [of 2007]”. Official models missed the crisis not because the conditions were so unusual, as we are often told. They missed it by design. It is impossible to warn against a debt deflation recession in a model world where debt does not exist. This is the world our policymakers have been living in. They urgently need to change habitat.

I undertook a study of the models used by those who did see it coming.* They include Kurt Richebächer, an investment newsletter writer, who wrote in 2001 that “the new housing bubble – together with the bond and stock bubbles – will [inevitably] implode in the foreseeable future, plunging the US economy into a protracted, deep recession”; and in 2006, when the housing market turned, that “all remaining questions pertain solely to [the] speed, depth and duration of the economy’s downturn”. Wynne Godley of the Levy Economics Institute wrote in 2006 that “the small slowdown in the rate at which US household debt levels are rising resulting from the house price decline, will immediately lead to a sustained growth recession before 2010”. Michael Hudson of the University of Missouri wrote in 2006 that “debt deflation will shrink the ‘real’ economy, drive down real wages, and push our debt-ridden economy into Japan-style stagnation or worse”. Importantly, these and other analysts not only foresaw and timed the end of the credit boom, but also perceived this would inevitably produce recession in the US. How did they do it?

Central to the contrarians’ thinking is an accounting of financial flows (of credit, interest, profit and wages) and stocks (debt and wealth) in the economy, as well as a sharp distinction between the real economy and the financial sector (including property). In these “flow-of-funds” models, liquidity generated in the financial sector flows to companies, households and the government as they borrow. This may facilitate fixed-capital investment, production and consumption, but also asset-price inflation and debt growth. Liquidity returns to the financial sector as investment or in debt service and fees.

It follows that there is a trade-off in the use of credit, so that financial investment may crowd out the financing of production. A second key insight is that, since the economy’s assets and liabilities must balance, growing financial asset markets find their counterpart in a growing debt burden. They also swell payment flows of debt service and financial fees. Flow-of-funds models quantify the sustainability of the debt burden and the financial sector’s drain on the real economy. This allows their users to foresee when finance’s relation to the real economy turns from supportive to extractive, and when a breaking point will be reached.

Such calculations are conspicuous by their absence in official forecasters’ models in the US, the UK and the Organisation for Economic Co-operation and Development. In line with mainstream economic theory, balance sheet variables are assumed to adapt automatically to changes in the real economy, and can thus be safely omitted. This practice ignores the fact that in most advanced economies, financial sector turnover is many times larger than total gross domestic product; or that growth in the US and UK has been finance-driven since the turn of the millennium.

Perhaps because of this omission, the OECD commented in August 2007 that “the current economic situation is in many ways better than what we have experienced in years . . . Our central forecast remains indeed quite benign: a soft landing in the United States [and] a strong and sustained recovery in Europe.” Official US forecasters could tell Reuters as late as September 2007 that the recession in the US was “not a dominant risk”. This was well after the Levy Economics Institute, for example, predicted in April of that year that output growth would slow “almost to zero sometime between now and 2008”.

Policymakers have resisted inclusion of balance sheets and the flow of funds in their models by arguing that bubbles cannot be easily identified, nor their effects reliably anticipated. The above analysts have shown that this is, in fact, feasible, and indeed essential if we are to “see it coming” next time. The financial sector is just as real as the real economy. Our policymakers, and the analysts they rely on, ignore balance sheets and the flow of funds at their peril – and ours.


*‘No One Saw This Coming’: Understanding Financial Crisis Through Accounting Models, MPRA

Saturday, September 5, 2009

S&P 500: Welcome To Fantansy Island

S&P 500 Statistics (As of August 31, 2009)

Total Market Value ($ Billion) 8,981

Mean Market Value ($ Million) 17,961

Median Market Value ($ Million) 7,494

Weighted Ave. Market Value ($ Million) 72,830

Largest Cos. Market Value ($ Million) 337,432

Smallest Cos. Market Value ($ Million) 700

Median Share Price ($) 31.200

P/E Ratio* 129.19

Indicated Dividend Yield (%) 2.10

*Based on As Reported Earnings.

Banks’ Balance Sheets: Getting Worse

Following up on my previous report (, banks’ balance sheets show no signs of improvements during the Second Quarter of 2009. In fact, key ratios demonstrating bank weaknesses have increased—in some instances they have surpassed all-time highs. All the charts demonstrate an uninterrupted upward trend since 2007. The caveat of my analysis is that the data are backward-looking; that is, we can only extrapolate from the past to give us an adequate assessment of the future. In addition, it takes the St. Louis FED about 6 weeks after the closing of the quarter to publish these figures (this time it took them close to 8). Considering the present condition of commercial real estate, along with the upcoming ARM and Alt-A mortgage resets, there is no light at the end of the tunnel for bankers. Given the information I will present, it is inconceivable that the FED will pull the plug on its intervention in the market any time soon. At the very least, until these figures reverse, all talk about “green shoots” and “economic recovery just around the corner” must be taken with exceeding caution.

Net Loan Charge Offs-to-Total Loans at commercial banks increased to an all-time high of 2.06%, up from 1.76% as of 3/31/09 and up from .96 reported during 4th Quarter 2008. The ratio has more than tripled year-over-year from .64 in 3/31/08. The most recent recorded figure supersedes the prior peak of 1.81% reached in 12/31/91 [see Note 1].

Loan Loss Reserves-to-Total Loans ratio increased to 2.94 from 2.65% reported on 3/31/2009. Year-over-year the recent ratio is up from 1.79% [see Note 2]. In particular to banks whose assets fall between $1 billion to $15 billion, the increase was from 2.10% to the current figure of 2.28% [see Note 3]. For the biggest banks, that is those with assets in excess of $15 billion, the current figure stands at 3.32%, up from 2.96% reported the previous quarter [see Note 4]. Reserves act as a buffer to capital losses resulting from asset deterioration. From a historical perspective, however, reserves at these institutions are low. For example, for the largest banks (assets > $15 billion), reserves reached a high of approximately 4.65% in terms of total loans during the late 1980s. The fact the current trend is up is good news. The bad news is that it’s not growing fast enough.

Considering Net Loan Losses-to-Average Total Loans, there is no evidence of a turnaround in business condition. The most recent figure broke the previous all-time high of 2.03% reported in 1Q2009. Currently, the ratio stands at 2.36%, which is more than doubled on a year-over-year basis [see Note 5]. For banks with average assets of $1 billion to $15 billion, the ratio currently stands at 2.08%, up from 1.63% in the previous quarter. The recent figure is an all-time high, surpassing the mark of about 1.8% in 1991 [see Note 6]. For institutions exceeding the $15 billion average assets threshold, the figures continue to be abysmal: The ratio currently stands at 2.68%, up from 2.35% in the previous quarter. During the last twelve months, this ratio has more than doubled, which indicates a worsening banking condition [see Note 7].

The next key statistic to consider is Non-Performing Loans-to-Total Loans. You may recall that Non-performing loans constitute past-due principal and interest in excess of 90 days. These are bank assets that will most likely turn toxic. The current figure stands at 2.78%, up from 2.20% reported the previous quarter and up from 1.71% reported on 12/31/08 [see Note 8]. At its peak for all commercial banks, the ratio stood at 4.88%, so the trend is evidence that the figures will continue to deteriorate. The same ominous gap is present for all banks exceeding $1 billion in average assets [see Note 9]

As I stated previously, banks’ balance sheets have deteriorated and will continue to get worse. The trend demonstrates that non-performing loans will continue to increase. Many of these loans will be charged-off. Loan loss reserves, which buffer against defaults, are not sufficient to cover the potential losses:

* * * * * * * * * * * * * * * * * * * * * *

(Note 1)

(Note 2)

(Note 3)

(Note 4)

(Note 5)

(Note 6)

(Note 7)

(Note 8)

(Note 9)

Wednesday, August 26, 2009

Insight: Beware the bubble’s distorted allure

By Tim Price
Published: August 25 2009 (Financial Times)

What kind of a financial crisis are you having? If you are a graduating student, good luck with the job hunt. If you are a banker or an economist still in employment, you are probably keeping your head down while you count the bonus that your fellow taxpayers have so generously if involuntarily gifted you. If an otherwise blameless investor, you are probably wondering why you are being penalised with such derisory deposit rates and whether you should be jumping on to the equity market rally instead.

That might be dangerous. Headline equity index returns, year to date, are desperately misleading. There is, in fact, a two-tier market in operation: speculative (or, more politely, “growth”) stocks, which have done fantastically, and everything else. Industrial metals and mining stocks are one of the best-performing sectors internationally – not a little surprising, given that the global recovery has yet to be sustainably confirmed; energy and utilities sector stocks, along with plenty of other classic defensives, have largely been a washout. (They may yet have their day.)

And an analysis of the Altman Z Score, which assesses the likelihood of corporate insolvency by comparing various balance sheet measures, shows that the frankly flakiest companies have seen their shares hugely outperform the rest of the market even as their capital strength deteriorates. In short, this has been a rally driven by junk.

But then what should we expect, when governments and their nominally independent central bank associates have conspired to manipulate prices throughout the capital asset structure, primarily to bail out banks that are conspicuously unfit for purpose? We are now trapped within a global parody of free markets.

Within this parody, governments redirect a waterfall of capital towards the banks. The banks then “invest” this in effect free money in what looks suspiciously like securities speculation and property lending. Meet the new bank: same as the old bank. And while the sums “borrowed” from future taxpayers as economic stimulus have been extraordinary in the west, they are not even the largest. Relative to gross domestic product, as fund managers Eric Sprott and David Franklin point out, China has been busily stimulating its economy more than anyone – injecting the equivalent of fully 64 per cent of its first half 2008 GDP during the first half of 2009. That is the equivalent of buying 122 Ford Class aircraft carriers costing $8.1bn each.

Some questions now deserve to be answered. With credit provision in full-scale withdrawal, does it really make sense to be contemplating bank stocks as investments, not least given the messy governmental scrutiny at work in the sector? And if private sector credit availability is set for broad retreat throughout the Anglo-Saxon economies, how on earth can our nascent economic recovery be described as anything other than pale, sickly and fragile? Equity markets have rallied nicely from their lows, but a degree of realism is surely in order.

The banking sector profits of recent years were never sustainable, inasmuch as they were built on the sandy foundations of leverage. Corporations and households around the world are now urgently paying down debt and rebuilding their balance sheets. They are, in short, battening down the hatches in preparation for a nuclear winter. There is little credit to spare for that diminished crowd with the appetite to take it on. Those are not conditions conducive to a robust recovery, far less to a new boom.

So for those chasing the rally: what, precisely, is your endgame? Perhaps you see extraordinary levels of government indebtedness miraculously evaporating amid new economic expansion, even as taxes rise. Perhaps you see ailing, cash-hoarding banks mysteriously opening the lending taps for the next wave of entrepreneurs. Or perhaps you are looking at the future through the hugely distorting prism of the recent credit bubble. Years of massive misallocation of capital cannot be followed by effortless recovery.

Thursday, August 13, 2009

Alternative yardsticks for US earnings tell different stories

Paul Marson is chief investment officer of Lombard Odier. He wrote the following article in today's Financial Times (8/13/2009). It is worth the read because it explains the irrationality behind the financial markets these days. Make no mistake, the upward turn in the market since early March has been propelled by factious perceptions. "Green shoots" are nothing more than code words by politicians and other central economic planners to replace the reality of our situation. The "green shoots" they talk about are merely the consequence of massive fiscal and monetary inflation; they are temporary. In this environment, of course firms are going to report "earnings." Yet, few recognize that these numbers have been massaged and twisted in such a way that value estimates are difficult to ascertain. Against this backdrop, Mr. Marson provides some insigthful comments. Here it is...enjoy.


The US second-quarter earnings season is now ending, apparently on a good note as nearly three-quarters of US companies have beaten consensus expectations. But a closer look at these earnings shows there is cause to be more cautious about the health of corporate America than the headline numbers would suggest. The cloud of euphoria that followed recent results had more to do with extraordinarily low expectations than to any meaningful and lasting improvement in prospects, which still require a rapid recovery in economic activity. This suggests the recent equity rally off the back of these results is overdone.

Every quarter, US companies publish their results under the defined US GAAP accounting rules. These results are labelled "reported earnings". However, the most commonly looked at form of earnings are adjusted "operating earnings" on which companies prefer to focus as they consider these better capture the underlying trend in activity. Adjusted operating earnings exclude non-recurring expenses such as restructuring charges, asset sales gains, major litigation charges, goodwill right downs and other write-offs. While reported earnings are based on strict accounting rules, adjusted operating earnings are at the discretion of companies because there is no defined set of exclusions. Neither measure is perfect but with adjusted operating earnings, exclusions are currently so large that information about the true state of companies (and therefore the market as a whole) is being excluded.

These exclusions have reached the level where the gap between adjusted operating earnings and reported earnings is so wide that they deliver different messages on the state of US corporates.

There is plenty of evidence to show that the exclusions in adjusted operating earnings are not one-off or non-recurring items. Often they contain useful information pointing to weaker cash flows ahead. Messrs Doyle, Lundholm, Soliman, in their "Predictive value of expenses excluded from pro forma earnings" 2003 study found that the three-year return for companies in the top decile of "other exclusions" is 23 per cent lower than for those in the bottom decile for exclusions. One dollar of exclusions in a quarter predicts $4.17 less of cash from operations over the next three years.

Today reported earnings per share for the S&P 500 companies gathered by Standard & Poor's is $7.2 per share, down 91 per cent from the 2007 peak. On an adjusted operating basis, earnings are $61.2, down 34 per cent from the 2007 peak. This $54 gap is a record.

How has this come about? Much of the difference between adjusted operating earnings and reported earnings is caused by massive writedowns in the financial sector. However, outside the financial sectors write-offs are also at record highs as corporates are eager to toss out impaired assets during periods of stress.

Furthermore, when looking at adjusted operating earnings, it seems that most US corporates managed to beat their analyst estimates thanks to production and job cuts.

There is no doubt that strong earnings numbers several years ago reflected extraordinarily high, debt-fuelled margins that are difficult to imagine again, particularly in a deleveraging and deflating economy. Investors should not expect a rebound in earnings or profitability and certainly not to previous elevated levels. Why? Because earnings growth must entail some combination of increased profit margins, rising turnover or greater leverage. Increased leverage is currently unacceptable to managements and investors alike. Wider profit margins and higher turnover may be achievable in the short term, but are much less attainable in a deleveraging cycle.

Those assessing the health of corporate America seem to be assuming a substantial, and above normal, recovery in reported earnings, alongside a return to above-trend GDP growth over the next 12 months. They are in danger of looking at the prospects for economic recovery, revising earnings expectations higher, but without considering how this might happen. In the meantime, the elephantine gap between adjusted operating earnings and reported earnings sits quietly in the room.

Monday, August 3, 2009

Read between the lines and know the real facts, or risk being deceived

By Marty Chenard

It is now August. Many are guessing that the 4th. Quarter will see a positive GDP number this year. The market appears to be factoring in that possibility. Will it really be possible to generate a positive GDP?

Second Quarter earnings results can now be given some thought. Here is what happened on the S&P 500:- Almost 61% of the S&P 500 beat their estimates. - 35.5% did better than last year's earnings per share.- Almost 25% had sales ahead of last year's.- 75% reported lower sales.

It is hard to find fault with the improvement in earnings per share ... but the fine print says: "75% had lower sales, but 61% beat their estimates."

So ... 60 out of every 100 companies beat their estimates ... but 75 out of every 100 had lower sales? How does one have lower sales but beat estimates?

You could do it by under estimating future expectations. In this way, what would normally be a bad result, looks good because you did better than the worse result that you reported "could happen".

Okay, so how could you have lower sales, but better earnings? You would have to cut costs ... cut inventories, layoff, reduce expenses, etc. That works the first time around ... the second time around is very difficult to cut as much on a percentage basis. So, the salvation will have to be an increase in sales during the current and future quarters.

That's the rub. The economy needs an increase in spending by consumer and business end users. We are getting some increases due to government stimulus programs. That can't go on forever without the consumer taking back the spending reins ... or our government will go bankrupt, the Dollar will fall, and interest rates will go up.

So, now we need the real thing ... increased spending by the consumer. We need an increase in demand because people can afford it, not because the government gave a consumer a $4,500 credit so he could buy a car. Christmas is not that far away, and the government will not be giving any consumer subsidies out for buying clothes, appliances, pots & pans.

So, as an investor, that's what you want to be watching for: Reports that indicate consumers and businesses are increasing their spending levels. Recent earning estimates are turning up slightly ... that's a good thing. It would be nice if "lots of increased spending" could happen without big increases in debt levels, because all of the excess debt and leverage has not been wrung out of the system yet.

If all goes well, and positive expectations bear fruit, then we will see forward economic progress. But, if GDP remains negative in Q4 along with weak consumer spending appears during the holidays, then the market will have a confidence retraction bringing things back to where the true balance is.

Although some earning estimates have turned slightly up, sales have not moved from declining to "increasing". The progress we are making is one of "getting less worse", and granted ... that has to happen first before we get to where things are "good". For now, don't mix the two ... getting less worse is different than getting better, and less worse is economically a lot different than getting better.

Be open minded and consider the real "comparative conditions" relative to time ... sometimes the media tries to "headline" the news to make things look better than they really are.

Take Financials for example. Some media sources have excitedly reported that " Financials are up 273% from the Second Quarter of 2008". Well, the 2nd. quarter of 2008 was negative, so what did the media really mean? Did that 273% improvement mean that things were in the positive ... or almost positive, or in the negative?

Here is what they could have said, if the media had wanted to use a different time-frame for the same result: They could have said that, "Financials were down 83% from the 2nd. quarter of 2007".

Was it misleading to make things appear as if they were wonderful? Or, was it a good thing to show the optimistic side? Our thinking is that "enough of the numbers should be reported so that someone really understands what is going on". If a person gains 30 pounds, is that good or bad? To answer the question you need to know what their ideal weight should be and how much they weighted before losing 30 pounds. Depending on the answer, they could be grossly over weight, underweight, or just right.

Tuesday, July 21, 2009

America is for now still blowing bubbles

By Richard Bernstein
Published: July 20 2009 19:30 (Financial Times)

Although many market and economic observers quarrel over whether the Obama administration’s involvement in the private sector upholds the American principals of contract law, private investment and capitalism, this discussion misses the most important point for investors. The question is not whether there is a battle between socialism and capitalism, but whether the US economy is on a path to mimic Japan’s.

Financial history shows that bubbles create capacity, which is no longer needed once they deflate. An inevitable and intense period of consolidation follows. For example, the internet bubble gave rise to hundreds of publicly traded dot-com companies, many of which either merged with other technology companies or went out of business once the bubble deflated. Similarly, the gold rush of the 1800s led to construction of outposts that subsequently became ghost towns after that bubble subsided.

The global economy has experienced during this decade the biggest credit bubble in our lifetimes, and virtually every industry in every country benefited. In fact, all the growth stories of the past decade (such as China, emerging market infrastructure, residential housing, hedge funds, private equity and commodities) are capital intensive investments that benefited from easy access to cheap capital. The global credit bubble seems to have created a global economic bubble.

History would suggest, therefore, that there should now be massive overcapacity in the global economy. That is indeed the case. Global capacity utilisation was recently at generational lows.

Ignoring this history, the goal of Washington’s policies has been to stymie the inevitable consolidation, keeping companies operating – and employing voters – rather than managing the consolidation to maximise the economic benefit. History says that Washington’s is an unwise and ultimately fruitless strategy. Certainly, there may be short-term gains in an economy by keeping a bubble’s unnecessary capacity alive (this may explain the recent improvement in economic statistics), but the continued misallocation of capital significantly hinders longer-term growth.

Washington’s tact has not been unusual. Politicians everywhere are naturally fearful of post-bubble consolidation because it always means higher unemployment and voter distress. As a result, policies in post-bubble environments tend to sustain an economy’s unneeded capacity, with the hope that economic growth will rebound so the economy can eventually grow into and soak up those excesses.

Japan’s post-bubble strategy during the 1990s supported excess capacity and stymied the post-bubble consolidation forces. Companies were deemed “too big to fail”, and excess capacity (particularly in the financial sector) was kept alive. Basic economics states that significant overcapacity leads to lower product prices, and Japan’s policies accordingly resulted in an extended period of deflation. Japan did have some inflation during its “lost decade”, courtesy of China’s boom, which soaked up Japan’s excesses. However, deflation returned to Japan and overcapacity grew once the Chinese economy cooled.

US policymakers made a clear choice to follow a Japanese-like route when they declared that a select group of financial institutions were too big to fail, and devised the troubled asset relief programme (Tarp), term asset-backed securities loan facility, and public-private investment programme. The bankruptcies of General Motors and Chrysler may seem to run counter to this contention, because the government took swift action to reduce unnecessary productive capacity, but it will be interesting to see how the government deals with the resulting consolidation within the industries that supply carmakers.

Recent private sector support for CIT Group – which saved the lender from failure – may be a good deal for investors who bought CIT’s debt at a discount, but it is clear that lending capacity will not be reduced as much as it would under a full CIT bankruptcy. If CIT had failed, some rightly feared that lending to smaller companies might have been constrained. However, the government could have encouraged other Tarp-funded institutions to lend to small businesses rather than continuing to allow bailed-out institutions to make outsized trading profits. If public policies insist on maintaining excess financial sector capacity, then at least utilise that excess capacity productively for the economy.

Many observers claim that comparisons between the US and Japanese economies are inaccurate because the US economy is more “dynamic” and less “rigid”. There are, of course, differences between the two economies, but it seems increasingly clear that both the US public sector and, with CIT, now the private sector too are working against post-bubble consolidation, slowing the economy’s dynamism and increasing rigidity.

A California roll is an American version of a maki, a type of sushi. It is based on Japanese tradition, but has a decided American flavour. Similarly, the actions of the US’s public and private sectors seem to mimic Japan’s. Although the markets’ short-term reactions might correctly be positive, investors should be wary that the US will be an American version of Japan’s moribund economy.

The writer is CEO of Richard Bernstein Capital Management and a former chief investment strategist at Merrill Lynch

Monday, July 13, 2009

“The Invisible Hand, Trumped by Darwin?” - My Critique

This is my response to an article written by Robert H. Frank, an economist at Cornell University, titled “The Invisible Hand, Trumped by Darwin?”

Given the times we are living, I am not surprise that such nonsense by Mr. Frank is camouflaged as scholarly. First, Adam Smith never attached “greed” to his “invisible hand” statement. This was done by free-market haters to further their flawed economics. They, like Mr. Frank, conveniently disregard Smith’s Theory of Moral Sentiments written in 1759, which buttresses any legitimacy of equating “invisible hand” with “greed.

Second, the basic premise of Darwin’s theory provides the foundation to socialism/communism/totalitarianism. This is why Karl Marx said it was the “most important and suits my purpose in that it provides a basis in natural science for the historical class struggle.”

Third, although never explicitly stated by economic Darwinist but certainly inferred, implementing their theory means a few (e.g. a committee or an elite group) coordinate the most efficient allocation of capital in a society. In other words, a few control the many. Any which way one looks at it, Mr. Frank’s philosophy is anti-free market to the core.

Monday, July 6, 2009

Why hopes of a fast recovery have been much exaggerated

By Eric Uhlfelder
Published: June 28 2009 (Financial Times)

When he was made chief economist at the International Monetary Fund in March 2007, Simon Johnson was deeply concerned about the state of finance across the world’s major developed markets.

But under secretaries of Treasuries, deputy ministers and deputy central bank governors of G7 nations reassured the IMF that in spite of some rumblings all was well.

While he was amazed by how unprepared these leaders were for dealing with the worst economic meltdown seen since the depression, Mr Johnson acknowledges that everyone, including himself, “bought too much into the idea that the financial industry, particularly big banks, had a complete grip on what we thought was risk and how it was being managed”.

But a year after the initial market hit in August 2007, Mr Johnson felt much of the developed world was still in denial about what needed to be done to address the crisis. So he left the IMF and became an academic at Massachusetts Institute of Technology. He is now professor of entrepreneurship, global economics and management at the MIT Sloan School of Management.

“I was trying to speak out while I was at the IMF,” he recalls, “but certain constraints come with position, and I found it was time to speak more bluntly than I could as an official.”

And blunt he was in a recent article in The Atlantic entitled, The Quiet Coup, in which he noted a disturbing similarity between emerging market failures and the US. “Elite business interests – financiers in the case of the US – have played a central role in creating the crisis,” wrote Mr Johnson, “making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse.”

What he finds even more unnerving is that these special interests “are now using their influence to prevent precisely the sorts of reforms that are needed, and fast, to pull the economy out of its nosedive. The government seems helpless, or unwilling, to act against them.”

This is not to say Mr Johnson thinks administration policy is way off mark. He likes the mixed-bag approach. “It makes sense that if you’re not sure what will work, you try a bit of everything: fiscal stimulus, housing support, and recapitalising the banks.”

While he thinks Barack Obama has been a little overweight on the fiscal stimulus, he says the president “bent over backwards not to really annoy the banks or to do anything harmful to their interests”. And to Mr Johnson, this could be Mr Obama’s Achilles heel. He thinks the so-called bank stress tests underestimated the worst-case scenarios by as much as a factor of two.

So, then, is the market rally for real?

Mr Johnson thinks it is mostly a response to the end of the panic phase of the crisis and calm returning to financial markets.

But he does not think those two features alone can carry stocks very far. “We’ll need to see a turnaround in the real economy before investors believe the current rally is sustainable.”

He fears that hopes of an immediate recovery have been greatly exaggerated, and thinks there is still a lot of nastiness that has to work its way through the system.

Asked about a model portfolio, Mr Johnson thinks in terms of US securities as he believes America has the greatest capacity to regenerate through the creation of new technologies and innovation.

Seeing a lack of creative policy response across the eurozone, he is sceptical about western European prospects. He anticipates anaemic growth for some time to come due to the European Central Bank’s refusal to sufficiently lower interest rates and embrace quantitative easing [where Treasuries purchase securities to pump capital into markets].

He is much more keen about certain emerging markets that have already weathered their own crises over the past 10 to 15 years. “I like Brazil, Mexico, India, and South Korea,” says Mr Johnson, “countries that have made systemic changes, which have helped them to hold up much better than most people anticipated.” With an eye on good management, he would have between 20 to 30 per cent of a model portfolio in such places.

However, he would be underweight equities in general. “I can’t imagine a return to the kind of equity growth we had seen over the past two decades, but I can imagine a 10-15 year period where stocks go nowhere.”

He admits his own retirement account is too equity heavy and should include more bonds. He also feels this crisis has taught many investors they have been holding too much stock, and that lots more volatility comes with such exposure. He thinks the recent market collapse proves the need for investment horizons of at least 20 years when investing in stock.

Since he believes quantitative tightening will be no easy feat to ensure impending inflation is contained, Mr Johnson agrees with many financial advisers that commodities will likely prove an effective hedge to future rising prices. But he cautions investors about the likely reinflating of commodity bubbles.

For the same reason, he also likes inflation-linked government bonds.

Overall, he thinks we are still in very uncertain times and believes the average investor would be well served by sticking with safe investments, such as US government debt. But he cautions “that even ostensibly safe sovereigns may not be for the faint of heart”.

Friday, July 3, 2009

Causes of Recessions

There is a perception that the current economic crisis stemmed from appropriate regulatory oversight, compounded by the creation of opaque financial instruments. None of these issues by themselves adequately explain the dire circumstance we are presently experiencing. In fact, considering the first part of the alleged reason leaves a lot to be desired. The fault lies in Central Bank policy.

The creation of money out of thin air by Central Bankers all over the world gave financial institutions perverse incentives to undertake unprofitable business. The financial instruments created during the bubble period could not have happened if money were not so easily available. Indeed, any financial firm (just like any other business) that desires to expand needs capital, which comes from saving not by resorting to the printing press. Printing money is not capital. Ask yourself this question, why is that a large number of businesses, which its owners are risking their capital in this endeavor and receive profits by adequately forecasting future demand, suddenly and in unison fail in their function? In other words, why business owners experience a “cluster of errors”? The answer lies in that Central Bank policy (i.e. printing money) fools them.

The severity of an economic crisis is directly related to the level of interference preceding it. The U.S. Central Bank, for example, lowered interest rates to historically low levels in 2003-2004 (1%). The easy money fed through the financial system and to the housing market. When the Central Bank reversed the easy money policy in 2006, the bust phase was inevitable. The economy began to crack in mid-2007 and busted in 2008. “Austrian” Theory says that we are not out of the woods yet; but rather a bigger bust is ahead, given the unprecedented level of market interference that has occurred thus far.

Monday, June 29, 2009

Tales From A Republic Gone (Once Again) Bananas

In any political crisis the first victim is truth. There are few exceptions. The case of my native country of Honduras is not one them. To briefly summarize what has happened, the President of Honduras, Mel Zelaya, was removed in a coup and forced to leave the country to Costa Rica. Subsequently, the Congress voted to officially oust Mr. Zelaya and affirmed the new presidency to Roberto Micheletti, formerly President of the Congress.

Here are the facts. First, Mel Zelaya wanted to amend the Constitution to abolish the one-term limits of Presidents. To that end, Mr. Zelaya called a referendum, which was to have taken place on Sunday (6/28). The Supreme Court had determined that such referendum was unconstitutional and therefore illegal. In Honduras the National Army hold the responsibility to distribute all ballots in elections. The head of the Army, Romeo Vasquez refused to follow orders. Consequently, Mr. Zelaya ordered the removal of Mr. Vasquez and place one of his allies in charge. As a result, the ballots were ultimately distributed.

Second, irrespective of what anyone calls it, the presidency of Mel Zelaya experienced a coup d’état. This action was unconstitutional and therefore illegal. Zelaya’s opposition (in the Congress) could have begun a process of impeaching the President, but they refused to follow an orderly process. Instead, the powers-that-be resorted to illegitimate activities to depose Mr. Zelaya.

In between these facts, there are suppositions, presuppositions, surmise, guesswork, and speculation. None of which is credible at the moment. Everyone has the right to personal opinions, but they are just that, opinions. I don’t agree with Mel Zelaya. In fact, if he is reinstated as President and wins reelection, it would be disastrous for my native country. He wants to follow the footsteps of Hugo Chavez and Daniel Ortega, among other like-minded socialist proponents. Socialism causes poverty. I know this is not in vogue these days, but it is the truth. If socialism would work, the USSR would be in existence and have eminence today. This is not the case. Moreover, China’s economic growth, which has been spectacular over the last several decades, is largely the result of market reforms (i.e. abandoning socialist economic policies going back to the silly adventure call “The Great Leap Forward”) started under Deng Xiaoping in 1979.

Having said that, what is irrefutable in Honduras today is that the now-deposed President Zelaya broke the law. The administration that has replaced Mr. Zelaya equally broke the law. Both sides erred. As I just shared, I have a strong opinion against Mr. Zelaya; however, my opinion and feelings are not worth much outside the framework of constitutional law. Such framework tells me both Mr. Zelaya and current President Roberto Micheletti violated the law. Therefore their administrations, after appropriate impeachment proceeding, must be removed.

Against this backdrop, what we need to ask is the following: why did the Congress not follow constitutional process of impeaching Mr. Zelaya? My opinion is that such process would have shown how the majority of present and former politicians are thieves, liars, and usurpers of the very Constitutions they have claimed to protect. This is why I believe it never happened in the first place.

As unfortunate as the consequences are in my native country, none is unexpected for those of us who value the rule of law, liberty, and free markets—something which has never taken root not only in Honduras but in Latin America in general.