2008 Was the Third Worst Year for US Stocks Since 1896

1931 was the worst, but notice that 1930 was not far behind.

Ten Things We Might Expect to See in 2009

Madoffed: Dr. Doom of Solly's Heyday

Economist may be latest hurt in Madoff scheme
Wed Dec 31, 2008 6:05am GMT

(Reuters) - A prominent Wall Street economist... the latest people to have lost money on investments connected to accused swindler Bernard Madoff, according to media reports.

Economist Henry Kaufman lost several million dollars, which he had in a brokerage account with Bernard L. Madoff Investment Securities for more than five years, the Wall Street Journal said, citing Kaufman in an interview on Tuesday.

The president of financial consulting firm Henry Kaufman & Co said his Madoff loss was no more than a couple of percent of his entire net worth and immaterial to his financial well-being, the paper said.

Kaufman became known for correctly forecasting higher inflation and interest rates when he was chief economist with Salomon Brothers in the 1970s and 1980s, when he acquired the moniker "Doctor Doom."

Must Have Titles for the Deflation Section of Your Financial Library

Deflation by A. Gary Shilling (Paperback - 2002)

Deflation: How to Survive and Thrive in the Coming Wave of Deflation by A. Gary Shilling (Paperback - 1999)

Deflation: Why It's Coming, Whether It's Good or Bad, and How It Will Affect Your Investments, Business, and Personal Affairs by A. Gary Shilling, 1998

After the Crash : Recession or Depression : Business and Investment Stategies for a Deflationary World by A. Gary Shilling (Paperback - Mar 1988)

The World Has Definitely Changed by A. Gary Shilling ( Hardcover - 1986)

Is Inflation Ending: Are You Ready? A Sober Look At the Prospects for a Decline in Inflation by A. Gary Shilling and Kiril Sokoloff (Hardcover - Mar 1983)
20 Used & new from $0.01

The Fuel for a Speculative Rally but Not a Recovery

At some point we may stop confusing asset bubbles with economic growth.

In the meantime, we might expect the shallow and immature stewardship of the economy to continue, unreformed and unconstrained. We may get quite a bear market rally in the first quarter of 2009. Whether it is the bottom or a bottom will remain to be seen.

Without a sustained increase in the median hourly wage and significant reform in the financial system and a sustainable construct for international currency exchange and trade there can be no sustained recovery in the real economy.

Excess liquidity and a corrupt financial system provides the fuel for a speculative rally, but it is also the fuel for a greater crisis to come, the longer we maintain this monetary charade. The Fed is pouring gasoline on damp wood.

Still, we ought not to underestimate the power of the Fed, having recently witnessed a counter trend reflationary rally after the Crash of 2000-2 that lasted three years and reached new stock market highs, and a housing bubble that almost crashed the world economy. They appear to have a lot of fuel, from a variety of unconventional sources, and Bernanke has the willingness to use it.

Cash at 18-Year High Makes Stocks a Buy at Leuthold
By Eric Martin and Michael Tsang

Dec. 29 (Bloomberg) -- There’s more cash available to buy shares than at any time in almost two decades, a sign to some of the most successful investors that equities will rebound after the worst year for U.S. stocks since the Great Depression.

The $8.85 trillion held in cash, bank deposits and money- market funds is equal to 74 percent of the market value of U.S. companies, the highest ratio since 1990, according to Federal Reserve data compiled by Leuthold Group and Bloomberg.

Leuthold, Invesco Aim Advisors Inc., Hennessy Advisors Inc. and BlackRock Inc., which together oversee almost $1.7 trillion, say that’s a sign the Standard & Poor’s 500 Index will rise after $1 trillion in credit losses sent the benchmark index for American equities to the biggest annual drop since 1931. The eight previous times that cash peaked compared with the market’s capitalization the S&P 500 rose an average 24 percent in six months, data compiled by Bloomberg show.

“There is a store of cash out there that is able to take the market higher,” said Eric Bjorgen, who helps oversee $3.4 billion at Leuthold in Minneapolis. “The same dollar you had last year buys you twice as much S&P 500 as it did a year ago.”

Leuthold Group, whose Grizzly Short Fund returned 83 percent in 2008 thanks to bets against equities, said in its December bulletin to investors that stocks offer “one of the great buying opportunities of your lifetime...”

The ratio of cash on hand to U.S. market capitalization jumped 86 percent in the first 11 months of the year, the biggest increase since the Fed began keeping records in 1959, as the U.S., Europe and Japan fell into the first simultaneous recessions since World War II.

So-called money of zero maturity, the central bank’s measure of U.S. assets available for immediate spending, is mostly held by households, according to Richard G. Anderson, an economist at the Federal Reserve Bank of St. Louis....

Any recovery will depend on a rebound in corporate profits and the economy after $30 trillion was wiped out from world equities this year, according to Frederic Dickson, chief market strategist at D.A. Davidson & Co. in Lake Oswego, Oregon. (At that's the rub, a speculative rally fueled by excess liquidity will fizzle and die if it is not accompanied by a recovery in real corporate profits, and that depends on an increase in consumption that is not dependent on additional consumer debt - Jesse)

Jobless claims reached a 26-year high this month, while economists surveyed by Bloomberg estimate household spending will fall 1 percent next year, the most since the aftermath of the attack on Pearl Harbor. A 13 percent slump in the median home resale price in November from a year earlier was likely the largest since the 1930s, the National Association of Realtors said last week, damping speculation the housing market is close to a bottom.

‘Biggest Cannon’

Analysts estimate profits at S&P 500 companies will shrink 10.3 percent in the first three months of 2009 and 5.8 percent in the second quarter, bringing the stretch of earnings declines to a record eight quarters, Bloomberg data show. Gross domestic product will contract in the first half of the year before growth resumes in the third quarter, according to a Bloomberg survey of economists.

“The fuel supply is there, but people have to have a reason to use it,” said Dickson, who helps oversee about $19 billion. “The Fed fired the shot out of the biggest cannon they know. Now the question is, will it hit the right mark?”

This year’s slump has left S&P 500 companies valued at an average of 12.6 times operating profit, the cheapest since at least 1998, monthly data compiled by Bloomberg show...

The last time cash accounted for a larger proportion of market value was 1990. The ratio peaked at 75 percent in October of that year, after the savings and loan industry collapsed, Drexel Burnham Lambert Inc. was forced into bankruptcy and the U.S. fell into a recession. The S&P 500 rallied 23 percent in six months and almost 30 percent in a year...

Dollar Assets and Liabilities in the International Banking System Update

On 2 October 2008 in The Dollar Rally and Imbalances in the US Dollar Holdings of Overseas Banks we said that:

When a multinational company deposits US dollar receipts from an export business in their domestic banks those deposits are frequently held in dollars... If those dollar assets decline because of a financial event as we are seeing today, the depositors may choose to withdraw their dollar deposit from the bank as they mature. This places the bank in an awkward position since the corresponding assets have deteriorated in value, but the nominal value of the certificate of deposit liability remains the same with the requisite interest accrual. As a result, a demand for dollars can be generated in the foreign country that is artificial but very real in terms of day to day banking operations. This is the 'artificial dollar short'

In the chart below we have updated the data from the BIS report to June of 2008, and the DX dollar index to today. In our October blog entry we forecasted that:

The resulting sharp rally in the US dollar is therefore likely to be an anomaly which will correct, and perhaps quite sharply, once the effect of the short term imbalances dissipates.

Although it is too early to say with certainty, it does appear that the hypothesis may be valid, and that the correlation is significant. The recent dollar rally was as the result of an artificial short squeeze resulting in an anomalous demand for dollars primarily in Europe.

The actions by the Federal Reserve and the foreign central banks to open their swap lines to relieve the dollar liquidity short squeeze appears to have been successful. We will see in the next series of BIS data how effective that effort has been, and if it will need to be continued as the imbalances are worked out of the system. As the ECB announced on September 13:

In order to facilitate the functioning of financial markets and provide liquidity in dollars, the Federal Reserve and the European Central Bank (ECB) have agreed on a swap arrangement. Under the agreement, the ECB would be eligible to draw up to $50 billion, receiving dollar deposits at the Federal Reserve Bank of New York; in exchange, the Federal Reserve Bank of New York will receive euro deposits of an equivalent amount at the ECB. The ECB will make these dollar deposits available to national central banks of the Eurosystem, which will use them to help meet dollar liquidity needs of European banks, whose operations have been affected by the recent disturbances in the United States.

We assume that at some point the ECB and BIS will take steps to modernize the international currency system to remove its exposure to the fluctuations of a single currency and the need for ad hoc arrangements to facilitate the proper functioning of international trade. Although a crisis has apparently been averted for now, it serves to expose the artificiality of the existing currency regime which may exist but not be as noticeable or measurable under more common conditions.

Madoffed: Kevin Bacon and Kyra Sedgwick

Why do people trust enormous sums of money to a stranger without due diligence, often on the word of another person who they may know only indirectly?

A good part of it is reputation and past performance, and who that person knows.

So Kevin Bacon and Kyra Sedgwick, in a lapse of sound portfolio theory, entrusted a sizable share of their wealth to Bernie Madoff, and are now apparently regretting that decision.

The average person likes to read about celebrity events. It provides an excitement to what might otherwise be a dull period of life. It also makes the ordinary person seem fortunate, smart, to hear of the misfortunes of the rich and famous. Misery loves company, and there is a bit of the voyeur in all of us.

Who would trust their wealth to an opaque and inherently arbitrary store of wealth, based solely on past performance and general reputation?

You would of course.

Don't believe it? Check you wallet and you bank accounts. Where is the majority of your wealth being held, if not in US dollars and dollar related financial assets?

Its not the same thing eh? Let's see how you feel about it at this time next year when Zimbabwe Ben has the monetization machine up to ramming speed.


New York Magazine
Madoff’s Latest Victims: Kevin Bacon and Kyra Sedgwick
12/30/08 at 10:15 AM

...We'd heard that along with Hollywood boldfacers Jeffrey Katzenberg and Steven Spielberg, Bacon and his wife, Kyra Sedgwick, lost money in Madoff's devastating $50 billion Ponzi scheme, and Bacon's rep, Allen Eichorn, confirmed it for us.

"Unfortunately, your report is true," he wrote. He wouldn't elaborate on whether, as we'd heard, they'd lost everything except for their checking accounts and the land they own. "I can confirm that they had investments with Mr. Madoff — no further specifics or comment beyond that," he said, adding: "Please, let's not speculate or rely on hearsay."

But we can't help but speculate! Just think about it: Footloose money: gone. Wild Things residuals: gone. The Singles stash: obliterated. If there's anyone in Hollywood who didn't deserve this, it's Kevin Bacon and Kyra Sedgwick. Those two have worked. It sincerely pains us. At least they have The Closer to fall back on. (For the record I take absolutely no joy in their misfortune. They seem like fine people. I feel genuinely saddened by their misfortune, in the same way I would feel sorry for your misfortune if I knew you. They have a strong cash flow and will recover. You may not be as lucky. Take away a message. Diversify. - Jesse)

The United States of Ennui

Our friend at Some Assembly Required had an interesting reaction to the Wall Street Journal story about the Russian Professor who is predicting the breakup of the US into several independent groups of states:

"Some are predicting the USA will erupt and split in six or seven smaller nations. Nope, there is not enough gumption left in the US citizenry to mount a decent protest, much less massive separatists movements. More likely the US will simply thrash around a bit and then fade into irrelevance. Governments will be overthrown, in more places than you might suspect (think Europe). But the US populace will sit in front of the TV, waiting for someone to reward them with their god-given right to happiness and success."

We doubt that the US will become irrelevant for a long time, but it is hard to disagree with such a frank and insightful analysis of the American public. Our hallmark seems to be a deep and abiding boredom and self-absorption, a walking amnesia with an historical perspective measured in days, if not hours.

At times like these the Almighty will often send His people a wake-up call.

Dancing on a Precipice: The Tenuous Balance in Global Finance

“If you owe the bank $100 that's your problem. If you owe the bank $100 million, that's the bank's problem.” Jean Paul Getty

We imagine J. Paul Getty would probably like to update that quotation to billions if he were still alive. We knew some people who subscribed to this notion that you keep borrowing until you gain a measure of control over your banks, since your default would be so painful to them. It is a tool of financial engineering roughly related to a passive form of extortion, a long con.

Here is an extended quote from a 29 December 2008 essay by Brad Setser titled The collapse of financial globalization...

"Both private capital inflows to the US and private capital outflows from the US have fallen sharply. They have gone from a peak of around 15% of US GDP to around zero in a remarkably short period of time …

Direct investment flows have continued. Other financial flows though have largely gone in reverse, with investors selling what they previously bought. In the third quarter foreign investors sold about $90b of US securities (excluding Treasuries) and Americans sold about $85 billion of foreign securities. And the reversal in bank flows on both sides (as past loans have been called) has been absolutely brutal.

This sharp fall has bearing on the bigger debate over the role global capital, global savings and foreign central banks played in helping to to create the conditions that allowed US households to sustain a large deficit for so long — and whether American and other policy makers should have paid more attention to the risks that came with the surge in foreign demand for US financial assets earlier this decade...

I think we now more or less know that the strong increase in gross capital inflows and outflows after 2004 (gross inflows and outflows basically doubled from late 2004 to mid 2007) was tied to the expansion of the shadow banking system.



It was a largely unregulated system. And it was largely offshore, at least legally. SIVs and the like were set up in London. They borrowed short-term from US banks and money market funds to buyer longer-term assets, generating a lot of cross border flows but little net financing. European banks that had a large dollar book seem to have been doing much the same thing. The growth of the shadow banking system consequently resulted in a big increase in gross private capital outflows and gross private capital inflows... (Hence the subsequent spike in the value of the dollar from the eurodollar short squeeze we have recently seen - Jesse)

Why didn’t the total collapse in private flows lead financing for the US current account deficit to dry up? That, after all, is what happened in places like Iceland — and Ukraine.

My explanation is pretty straightforward.

Central banks were the main source of financing for the US deficit all along. Setting Japan aside, the big current account surplus countries were all building up their official reserves and sovereign funds — and they were the key vector providing financing to the deficit countries."

The implications of this are rather profound. The much touted notion that the US is the preferred destination for private wealth, thus sustaining an out of balance trade deficit through a financial services economy, is rubbish at best, and propaganda at worst. It is rooted in the Dick Cheney nostrum that "Reagan proved that deficits don't matter."

What we have today is a very lopsided vendor financing arrangement, wherein the US is largely supported by China and Japan whose industrial policy currently recommends their support of a US debt that is increasingly unpayable.

If and when China and Japan are no longer able to support the continued growth of US deficit financing, the dollar and the bonds will contract (decrease) in value, and perhaps precipitously, like a house of cards. It is much worse than we had imagined, and more concentrated on these two countries, along with Saudi Arabia, than we had thought.

For now the balance is maintained because of self-interest and fear. But we cannot stress enough the highly artificial nature of the arrangement, and its inherent instability, now that the charade of sustained private investment flow is shown for what it is. There is no economic theory to support this model other than a distorted form of neo-colonial parasitism. Substitute US paper dollars for opium and you get the idea.

Japan and Saudi Arabia are understandable as virtual client states under US military protection, but we struggle with how China was taken into this arrangement which is so potentially destabilizing of their internal political and economic stability.

This is why the world has not developed a sound replacement for the dollar hegemony. It is because if they do, they must navigate around the probability, not possibility, of a collapse of their dollar reserves, and a dislocation of their own export driven economies, much worse than we might have imagined. It is not a matter of economic inventiveness; it has become a matter of will.

Who will be the first to flinch? History shows it is rarely a conscious decision, but rather some incident, an accident, some trigger event, even one so small, that it creates astonishment at the size of the avalanche it unleashes.

To make it clear and simple, this is the first evidence we have seen to suggest that hyperinflation is in fact possible in the US. As you know, we have been strongly adverse to the extremes in outcomes, both in terms of a sustained deflation and a significant hyperinflation.

That has now changed. The dollar is a Ponzi scheme, the waters of debt are overflowing the dam of artificial support, and only a few countries, two of them somewhat unstable, are holding back the deluge.

GMAC: Its Good to Be a Bank

"The bondage of fifteenth century serfdom has become the catalyst for causing the middle-class to grovel for survival. They mistakenly assumed that the business and political leaders would maintain a minimum concern for those whom they serve or lead." Warren B. Eller, 1931

“This country is governed for the richest, for the corporations, the bankers, the land speculators, and for the exploiters of labor.” Helen Keller

Without banking reforms and an equitable median hourly wage, the development of new variations of debt creation for the people to support the corporate status quo is futile, if not cruel.

Bloomberg
Treasury to Buy $5 Billion GMAC Stake, Expand GM Loan
By Rebecca Christie and Hugh Son

Dec. 29 (Bloomberg) -- The U.S. Treasury said it will purchase a $5 billion stake in GMAC LLC, the financing arm of General Motors Corp.

Treasury will also lend an additional $1 billion to GM so the automaker can participate in a rights offering at GMAC to support the lender’s reorganization as a bank holding company, the Treasury announced today. The loan is in addition to $13.4 billion the Treasury agreed earlier this month to lend to GM and Chrysler LLC.

Separately, GMAC said it has accepted all bonds tendered in a debt swap designed to reduce its debt load.

“Once the offers are settled, which we expect to do promptly, results will be disclosed,” said spokeswoman Gina Proia in an e-mail.

“The company intends to act quickly to resume automotive lending to a broader spectrum of customers to support the availability of credit to consumers and businesses for the purchase of automobiles,” GMAC said in statement.

GMAC had limited loans to buyers with the best credit ratings, cutting into GM’s sales.

The credit from the Treasury is under its Troubled Asset Relief Program and comes after the Federal Reserve last week approved GMAC’s application to become a bank holding company.

“This is part of our strategy to position GMAC for long term stability,’’ said Toni Simonetti, a spokeswoman for GMAC. “The reason we’re doing this is so we can provide credit to consumers; we’ll put these funds to use right away.’’

FDIC Guaranty

GMAC will “continue to pursue’’ other ways to boost liquidity, including applying for an Federal Deposit Insurance Corp. guaranty program and attracting retail deposits from consumers, Simonetti said. (We are all banks now - Jesse)

Becoming a bank makes it easier for GMAC to get federal aid and eases the threat of a collapse, which threatened to dry up credit for purchases of GM cars. Dealers depend on GMAC to finance about three-quarters of their inventory. Analysts have said the lender’s survival is a crucial step toward saving GM, which has said it may run out of cash.

GMAC joins more than 190 regional banks, commercial lenders, insurers and credit-card issuers seeking funds from the Treasury’s bailout program for financial firms. American Express Co., the biggest U.S. card company by sales, and CIT Group Inc., the biggest independent commercial lender last year, won capital infusions last week after converting into banks.

Slow Sales

With GM selling cars at the slowest pace in 26 years and the country in its worst housing crisis since the Great Depression, GMAC and its Residential Capital LLC unit have no way to revive their own revenue and have been shut out of credit markets. GMAC has $540 million of bonds due this month and another $11.6 billion that mature in 2009 and previously said it would cancel plans to become a bank if the debt swap failed.

The Fed has since granted approval before the swap was finished....

Japanese Economist Urges Selective Default on US Treasury Debt

Here is an intriguing proposal for a 'selective default' of US Treasury debt to head off a massive devaluation of the dollar, and to promote the US recovery from the ravages of its self-inflicted financial damage.

No matter how one wishes to describe it, the US will have to default on its sovereign debt, most likely on a selective basis, writing down the rest through an inflated dollar. The Japanese recognize this and are volunteering a tentative plan to accomplish it to support their industrial policy.

Although there is a potential for a voluntary debt forgiveness from Japan as a loyal client state, we wonder if the rest of the world will be inclined to accept an unreformed dollar hegemony.

Can the economic world so woefully lack the will, knowledge, and the imagination to develop a more equitable mechanism for international trade?

Financial reforms, although not even on the table yet, are certain to come with any sustained recovery. There has been nothing even seriously proposed yet as Bernanke and Paulson rush to supply fresh capital to prop up the status quo and aid their cronies on Wall Street.

We can surely do better than this.


Bloomberg
Japan Should Scrap U.S. Debt; Dollar May Plummet, Mikuni Says
By Stanley White and Shigeki Nozawa

Dec. 24 (Bloomberg) -- Japan should write-off its holdings of Treasuries because the U.S. government will struggle to finance increasing debt levels needed to dig the economy out of recession, said Akio Mikuni, president of credit ratings agency Mikuni & Co.

The dollar may lose as much as 40 percent of its value to 50 yen or 60 yen from the current spot rate of 90.40 today in Tokyo unless Japan takes “drastic measures” to help bail out the U.S. economy, Mikuni said. Treasury yields, which are near record lows, may fall further without debt relief, making it difficult for the U.S. to borrow elsewhere, Mikuni said. (We struggle a bit with the notion of Treasury yields falling without a substantial debt relief. One would think they would be increasing to uncomfortable levels as the risk of an involuntary default increases, unless the Fed plans to aggressively monetize them to peg the yield curve, trashing the Dollar in the process. - Jesse)

“It’s difficult for the U.S. to borrow its way out of this problem,” Mikuni, 69, said in an interview with Bloomberg Television broadcast today. “Japan can help by extending debt cancellations.” (We seem to have surpassed the Ponzi viability boundary. - Jesse)

The U.S. budget deficit may swell to at least $1 trillion this fiscal year as policy makers flood the country with $8.5 trillion through 23 different programs to combat the worst recession since the Great Depression. Japan is the world’s second-biggest foreign holder of Treasuries after China.

The U.S. government needs to spend on infrastructure to maintain job creation as it will take a long time for banks to recover from $1 trillion in credit-market losses worldwide, Mikuni said. The U.S. also needs to launch public works projects as the Federal Reserve’s interest rate cut to a range of zero to 0.25 percent on Dec. 16. won’t stimulate consumer spending because households are paying down debt, he said. (One would look for policies to increase the median hourly wage to facilitate this. So far we are seeing nothing, if not the opposite, to support this. - Jesse)

U.S. President-elect Barack Obama wants to create 3 million jobs over the next two years, more than the 2.5 million jobs originally planned, an aide said on Dec. 20. Obama takes office on Jan. 20.

Marshall Plan

Japan should also invest in U.S. roads and bridges to support personal spending and secure demand for its goods as a global recession crimps trade, Mikuni said.

Japan’s exports fell 26.7 percent in November from a year earlier, the Finance Ministry said on Dec. 22. That was the biggest decline on record as shipments of cars and electronics collapsed.

Combining debt waivers with infrastructure spending would be similar to the Marshall Plan that helped Europe rebuild after the destruction of World War II, Mikuni said.

“U.S. households simply won’t have the same access to credit that they’ve enjoyed in the past,” he said. “Their demand for all products, including imports, will suffer unless something is done.”

The plan was named after George Marshall, the U.S. secretary of state at the time, and provided more than $13 billion in grants and loans to European countries to support their import of U.S. goods and the rebuilding of their industries

Currency Reserves

The Japanese government could use a new Marshall Plan as a chance to shrink its $976.9 billion in foreign-exchange reserves, the world’s second-largest after China’s, and help reduce global economic imbalances, Mikuni said.

The amount of foreign assets held by the Japanese government and the private sector total around $7 trillion, Mikuni said.

Japan will also have to accept that a stronger yen is good for the country in order to reduce excessive trade surpluses and deficits, he said. The yen has appreciated 23 percent versus the dollar this year, the most since 1987, as the credit crisis prompted investors to flee riskier assets and repay loans in the Japanese currency.

“Japan’s economic model has been dependent on external demand since the Meiji Period” that began in 1868, Mikuni said. “The model where the U.S. relies on overseas borrowing to fuel its property market is over. A strong yen will spur Japanese domestic spending and reduce import prices, thereby increasing purchasing power.”

Yellow Dawg Howling

Cry havoc, and let slip the dogs of .... ?

Ponzi Nation

America has become more a debt 'junkie' - - than ever before
with total debt of $53 Trillion - - and the highest debt ratio in history.

That's $175,154 per man, woman and child - - or $700,616 per family of 4,
$33,781 more debt per family than last year.

Last year total debt increased $4.3 Trillion, 5.5 times more than GDP.
External debt owed foreign interests increased $2.2 Trillion;
Household, business and financial sector debt soared 7-11%.

80% ($42 trillion) of total debt was created since 1990,
a period primarily driven by debt instead of by productive activity.

And, the above does not include un-funded pensions and medical promises.

America's Total Debt Report - Grandfather's Economic Series

Since a picture is 'worth a 1000 words" here are a few charts for your consideration.

In a simple handwave estimate, one might say that the debt will have to be discounted by at least half. That includes inflation and selective defaults. The seductiveness of this chart is that things have continued on in their frenzied pace for so long, it seems like the norm. That is always a problem with chronic drunks and addicts; they rarely know when to quit, or can't, until they really hit the wall.



Nine out of ten Americans might understand that when the growth of your debt outrageously outstrips your income for so long, that something has got to give. The givers will most likely be all holders of US financial assets, responsible middle class savers, and a disproportionate share of foreign holders of US debt.



While the debtors hold the means of payment in dollars and the power to decide who gets paid, where do you think the most likely impact will be felt?

This is not intended as a rant, a screed in the pejorative sense, or anything else but a reasoned diagnosis based on the data as we find it.

We could be wrong, and we hope we are. Show us better data. The prognosis is not optimistic.

Here is a view of the debt data that is "optimistic" if you are willing to ignore the relative historic context and the huge amount of debts that are off the Federal balance sheet.



A dismissive reaction to this kind of forecast is understandable.

The doctor is always viewed as a 'party pooper' and a gloomy sort when he informs the uber-alpha hard drinking, stress generating, self-medicating, recreational drug=binging forty-something patient that their shortness of breath is emphysema, their blood pressure is soaring as quickly as their self-absorption, and that chest discomfort is a warning sign of a rapidly developing heart problem that could be a deal breaker if they do not change their lifestyle.

But, like most prognostic warnings go, it will be ignored with the dawn of a new day, a successful if awkward commute to work, and the anticipation of another evening's delight and binges yet to come. Until they don't.

It might be a good idea not to be a passenger with a recklessly self-destructive debt junkie at the wheel of your financial assets. Unless you are c0-dependent like Saudi Arabia, China and Japan or are one of the kids in the backseat. Then you have some serious decisions to make.

In the meantime buckle up, because Uncle Sugar-Daddy still has the keys to the car.

The Predator Class

Its interesting to read this essay from early 2006 today in the light of what we have seen in the intervening period. A number of people who might have dismissed this out of hand back then might see a little more truth behind the rhetoric today.

So, how can the political system reform itself? How can we reestablish checks, balances, countervailing power, and a sense of public purpose? How can we get modern economic predation back under control, restoring the possibilities not only for progressive social action but also—just as important—for honest private economic activity? Until we can answer those questions, the predators will run wild.

It is something to think about for the New Year, for all parties involved. FDR was denounced as a 'traitor to his class' at the time, but in reality he was one of the most insightful of leaders. If one views outcomes in other contemporary governments from 1916 to 1940, and considers what a Huey Long administration might have been as an example, the New Deal seems like a wise and appropriate political move for all involved.

Why are people so reluctant to believe that sociopaths and narcissists can use the power of the pen to prey on people? Because they are well spoken and organized? We would contend that these are the most dangerous of the emotionally warped with a need to acquire, dominate and control, because they are smarter and more calculating than the impulse murderers, burglars, rapists, thieves, and pedophiles.
There is a need for economic law and enforcement as there is a need for the less cerebral, hairy knuckled criminal law and enforcement. The notion that people become naturally good, rational and well-adjusted because they are wearing a suit is ludicrous, especially to anyone who has worked with many of those who move in the upper echelons of money and power.
Some of the scariest people we have ever met were articulate and pathologically driven borderline psychopaths with a need to acquire political and economic power. It is the focus of their illness that makes them powerful. They are not distracted by the diffusion of emotional responses that color most people's actions. They have a need, and the will to satisfy it, no matter what it takes.
As an aside, we have met many kind and gentle and thoughtful people in all walks of life, rich and poor. It is not the office that makes the person; it is their character. Class prejudice is mistaken and unjust, and there is always someone less fortunate than you who might view you as the object of their anger, no matter who you might be. The hypocrisy and injustice of prejudice and 'class warfare' knows few limits.
There will always be those at the extremes who need to 'take it to the limit,' with a well stocked foreign retreat in case things get ugly. But for most of us, restoring a sense of justice and order and putting the nation back into some kind of working balance will be high on the priority list, if not for ourselves, then for our families. Violence does not work, ever. The Constitution is a restraint that works both ways, against the predations of the powerful, but also as a shield against would-be Robespierres with their dark reigns of terror.
It is going to take a lot of hard work, and time. Its been a long time coming, it will be a long time gone. But it has been done before by those who created this nation, and it can be done to restore it again.
We are not doomed. Our situation is not hopeless. But the system is badly out of balance, and will have to be restored by meaningful reform. There will be inflation and selective defaults, real justice and show trials, innovation and false starts, disproportionate suffering, uncertainty and even some level of conflict. But eventually the accounts will be squared and we will gather ourselves together an move forward. The sooner we start, the sooner it will be over.

Mother Jones
The Predator State
By James K. Galbraith
May/June 2006 Issue


WHAT IS THE REAL NATURE of American capitalism today? Is it a grand national adventure, as politicians and textbooks aver, in which markets provide the framework for benign competition, from which emerges the greatest good for the greatest number? Or is it the domain of class struggle, even a “global class war,” as the title of Jeff Faux’s new book would have it, in which the “party of Davos” outmaneuvers the remnants of the organized working class?

The doctrines of the “law and economics” movement, now ascendant in our courts, hold that if people are rational, if markets can be “contested,” if memory is good and information adequate, then firms will adhere on their own to norms of honorable conduct. Any public presence in the economy undermines this. Even insurance—whether deposit insurance or Social Security—is perverse, for it encourages irresponsible risktaking. Banks will lend to bad clients, workers will “live for today,” companies will speculate with their pension funds; the movement has even argued that seat belts foster reckless driving. Insurance, in other words, creates a “moral hazard” for which “market discipline” is the cure; all works for the best when thought and planning do not interfere. It’s a strange vision, and if we weren’t governed by people like John Roberts and Sam Alito, who pretend to believe it, it would scarcely be worth our attention.

The idea of class struggle goes back a long way; perhaps it really is “the history of all hitherto existing society,” as Marx and Engels famously declared. But if the world is ruled by a monied elite, then to what extent do middle-class working Americans compose part of the global proletariat? The honest answer can only be: not much. The political decline of the left surely flows in part from rhetoric that no longer matches experience; for the most part, American voters do not live on the Malthusian margin. Dollars command the world’s goods, rupees do not; membership in the dollar economy makes every working American, to some degree, complicit in the capitalist class.

In the mixed-economy America I grew up in, there existed a post-capitalist, post-Marxian vision of middle-class identity. It consisted of shared assets and entitlements, of which the bedrock was public education, access to college, good housing, full employment at living wages, Medicare, and Social Security. These programs, publicly provided, financed, or guaranteed, had softened the rough edges of Great Depression capitalism, rewarding the sacrifices that won the Second World War. They also showcased America, demonstrating to those behind the Iron Curtain that regulated capitalism could yield prosperity far beyond the capacities of state planning. (This, and not the arms race, ultimately brought down the Soviet empire.) These middle-class institutions survive in America today, but they are frayed and tattered from constant attack. And the division between those included and those excluded is large and obvious to all.

Today, the signature of modern American capitalism is neither benign competition, nor class struggle, nor an inclusive middle-class utopia. Instead, predation has become the dominant feature—a system wherein the rich have come to feast on decaying systems built for the middle class. The predatory class is not the whole of the wealthy; it may be opposed by many others of similar wealth. But it is the defining feature, the leading force. And its agents are in full control of the government under which we live.

Our rulers deliver favors to their clients. These range from Native American casino operators, to Appalachian coal companies, to Saipan sweatshop operators, to the would-be oil field operators of Iraq. They include the misanthropes who led the campaign to abolish the estate tax; Charles Schwab, who suggested the dividend tax cut of 2003; the “Benedict Arnold” companies who move their taxable income offshore; and the financial institutions behind last year’s bankruptcy bill. Everywhere you look, public decisions yield gains to specific private entities.

For in a predatory regime, nothing is done for public reasons. Indeed, the men in charge do not recognize that “public purposes” exist. They have friends, and enemies, and as for the rest—we’re the prey. Hurricane Katrina illustrated this perfectly, as Halliburton scooped up contracts and Bush hamstrung Kathleen Blanco, the Democratic governor of Louisiana. The population of New Orleans was, at best, an afterthought; once dispersed, it was quickly forgotten.

The predator-prey model explains some things that other models cannot: in particular, cycles of prosperity and depression. Growth among the prey stimulates predation. The two populations grow together at first, but when the balance of power shifts toward the predators (through rising interest rates, utility rates, oil prices, or embezzlement), both can crash abruptly. When they do, it takes a long time for either to recover.

The predatory model can also help us understand why many rich people have come to hate the Bush administration. For predation is the enemy of honest business. In a world where the winners are all connected, it’s not only the prey who lose out. It’s everyone who hasn’t licked the appropriate boots. Predatory regimes are like protection rackets: powerful and feared, but neither loved nor respected. They do not enjoy a broad political base.

In a predatory economy, the rules imagined by the law and economics crowd don’t apply. There’s no market discipline. Predators compete not by following the rules but by breaking them. They take the business-school view of law: Rules are not designed to guide behavior but laid down to define the limits of unpunished conduct. Once one gets close to the line, stepping over it is easy. A predatory economy is criminogenic: It fosters and rewards criminal behavior.

Why don’t markets provide the discipline? Why don’t “reputation effects” secure good behavior? Economists have been slow to answer these questions, but now we have a full-blown theory in a book by my colleague William K. Black, The Best Way to Rob a Bank Is to Own One. Black was the lawyer/whistle-blower in the Savings and Loan and Keating Five scandals; he later took a degree in criminology. His theory of “control fraud” addresses the situation in which the leader of an organization uses his company as a “weapon” of fraud and a “shield” against prosecution—a situation with which law and economics cannot cope.

For instance, law and economics argues that top accounting firms will protect their own reputations by ferreting out fraud in their clients. But, as with Enron, Tyco, and WorldCom, at every major S&L control fraud was protected by clean audits from top accountants: You hire the top firm to get the clean opinion. Moral hazard theory shifts the blame for financial collapse to the incentives implicit in insurance, but Black shows that the large frauds were nearly all committed in institutions taken over for that purpose by criminal networks, often by big players like Charles Keating, Michael Milken, and Don Dixon. And there’s another thing about predatory institutions. They invariably fail in the end. They fail because they are meant to fail. Predators suck the life from the businesses they command, concealing the fact for as long as possible behind fraudulent accounting and hugely complex transactions; that’s the looter’s point.

That a government run by people rooted in this culture should also be predatory isn’t surprising—and the link between George H.W. Bush, who led the deregulation of the S&Ls, his son Neil, who ran a corrupt S&L, and Neil’s brother George, for whom Ken Lay sent thugs to Florida in 2000 on the Enron plane, could hardly be any closer. But aside from occasional references to “kleptocracy” in other countries, economic opinion has been slow to recognize this. Thinking wistfully, we assume that government wants to do good, and its failure to do so is a matter of incompetence.

But if the government is a predator, then it will fail: not merely politically, but in every substantial way. Government will not cope with global warming, or Hurricane Katrina, or Iraq—not because it is incompetent but because it is willfully indifferent to the problem of competence. The questions are, in what ways will the failure hit the population? And what mechanisms survive for calling the predators to account? Unfortunately, at the highest levels, one cannot rely on the justice system, thanks to the power of the pardon. It’s politics or nothing, recognizing that in a world of predators, all established parties are corrupted in part.

So, how can the political system reform itself? How can we reestablish checks, balances, countervailing power, and a sense of public purpose? How can we get modern economic predation back under control, restoring the possibilities not only for progressive social action but also—just as important—for honest private economic activity? Until we can answer those questions, the predators will run wild.

James K. Galbraith teaches economics at the Lyndon B. Johnson School of Public Affairs at the University of Texas-Austin. He previously served in several positions on the staff of the U.S. Congress, including executive director of the Joint Economic Committee.

A Question Worth Considering for the New Year...

What is at the heart of the US financial crisis?

Is it that the US has been precipitously cut off from some foreign source of funding? Has there been an oil embargo, a supply shock imposed such as the one that triggered the financial crisis of the 1970's? Are the problems caused by some external change, some actor outside the system?

I think most will say the answer is 'no.' The problems are internal to the US, to its financial system.

So, how would you fix a system that has broken from an internal flaw in this way? Try more of the same, business as usual, apply fresh debt to a failed system based on a growing pyramid of debt without making any substantial changes?

The US financial system, the housing, equity and Treasury markets, are all Ponzi schemes, with the need for a constantly increasing source of fresh money to keep going. That funding is new debt, new dollars based on nothing produced, just the trust and confidence of the participants.

Would you fix the Madoff Ponzi scheme by giving Bernie more money, public money, to keep his payments flowing to his 'investors?'

I think most of us would say, no, no more money.

But what is the difference between that and what Paulson and Bernanke are doing today? Is there a graceful exit strategy? Have any serious reforms or changes been made or even proposed? Has there even been a frank disclosure and discussion of exactly what happened, and what is continuing to happen, beyond blaming the victims, or cynically hiding behind 'well that's how things are?'

No. The key participants in the Ponzi scheme are continuing to take their gains out, in dividends and bonuses, front running the final collapse and admission that "its all gone; we're bankrupt."

Think about it.

What would you do if it is a Ponzi scheme, teetering on the edge?

The CFTC Is Failing to Regulate Commodity Market Ponzi Schemes

Christopher Cox recently admitted that the SEC has willfully overlooked significant abuses in the equity markets. One thing on which we agreed with John McCain was that his tenure at the SEC is a national disgrace and he should have been dismissed. Given the US stock market bubbles over the past eight years one can hardly disagree.

It is becoming obvious that there is significant price manipulation in the commodity markets, to the point where they have become nothing more than Ponzi schemes in which the object of the investment will never be delivered, and a market roiling default will occur.

Below is one example in the oil markets. Silver is an even better example. Ted Butler has documented the abuse on numerous occasions, and has been ignored in the same way those exposing the Madoff Ponzi scheme to the SEC were also willfully and repeatedly ignored.

The problem with commodities price manipulation is even worse than the manipulation of stock prices since it involves the capital formation of the means of production with significant lead times. Not only does this manipulation cheat investors and small speculators, but it causes significant, damaging misalignments in supply and demand in the real economy. The example of the electricity markets in California and the Enron fraud was the wake up call that was ignored.

It is beyond simple fraud. This has disproportionate and severely damaging effects on other countries in the global economy.

The perfect solution, the complete market restructuring is complex, and is detailed below. Expect the market manipulators to wallow in the complexity and create loopholes for future exploitation.

However, there is an 80% effective solution that is simple. Transparency of positions is a first step. The second step is to impose strict position limits for those who are not hedging actual and verifiable inventory and production.

The position limits for the 'naked shorting' is appropriate for those who believe that the market price is incorrect. But there comes a time when the naked shorting becomes so large that it IS the market, and the consequences of such outrageous manipulation are real and significant.

Constantly tinkering with regulations and making them more complex is not the answer. The root of the problem has been the lack of enforcement and the bad actions of a handful of banks that have become serial market manipuators since the overturn of Glass-Steagall. There really are no new financial products or frauds. There are just variations on familiar themes.

It is not clear that the solution can come from within the US. Violence never works, and writing our Congress and voting for a reform candidate have now been done, although we should continue this.

A practical solution may be ultimately imposed on the US by the rest of the world, and that is a less attractive prospect than an internal solution.



Reuters
NYMEX oil benchmark again in question
By John Kemp
December 23rd, 2008

The record differential between the front-month and more liquid second-month contracts at expiry last week once again raised pointed questions about whether the NYMEX light sweet contract is serving as a good benchmark for the global oil market, or sending misleading signals about the state of supply and demand.

The expiring January 2009 contract ended down $2.35 on Friday at $33.87, while the more liquid February contract actually rose 69 cents to settle at $42.36 - an unprecedented contango from one month to the next of $8.49.

Criticism of the contract is not new, and past calls for reform have been successfully sidelined. But with policymakers taking a keener interest as a result of wild gyrations in oil prices this year, and a continued focus on regulatory changes to improve market functioning in future, there is at least a chance changes will be adopted as part of a wider package of futures market adjustments.

AN UNREPRESENTATIVE PRICE

During the surge to $147 per barrel earlier this year, OPEC repeatedly criticized the NYMEX reference price for overstating the real degree of tightness in the physical market and causing prices to overshoot on the upside. (That was the point, see Enron for details - Jesse)

While rallying NYMEX prices seemed to point to an acute physical shortage and need for more oil, Saudi Arabia could not find buyers for the 200,000 barrels per day (bpd) of extra oil promised to U.N. Secretary-General Ban Ki-moon or the 300,000 bpd promised to U.S. President George Bush in June.

Bizarrely, rather than acknowledge there was something wrong with the reference price, some market participants suggested Saudi Arabia should increase the already large discounts for its physical crude to achieve sales in a market that clearly did not need the oil, and was not paying enough contango to make storing it economic (contango is where the futures price is above the spot market). (There is nothing bizarre about it. That is standard disinformation by the frauds and their mouthpieces - Jesse)

The NYMEX WTI price may have achieved unprecedented media fame as a result of the “super-spike”, but a futures price to which producers and consumers were paying ever larger discounts for actual barrels was clearly not a good indication of where the market as a whole was trading. (It was a fraud. Lots of people lost lots of money in it. It was a great excuse to build a Ponzi scheme in a market price, raise the price of gasoline to $4 gallon, and then take the market down. This is the 1929 model of market manipulation pure and simple - Jesse)

Now the market risks overshooting in the other direction. Intense pressure on the front month in recent weeks has more to do with the contract’s peculiarities (in particular storage restrictions at the delivery point) than a further deterioration in oil demand or a market vote of no-confidence in the 2.2 million barrels per day further cut in oil production announced by OPEC at the end of last week. (The beauty about price manipulation is that it works in both directions. Different damage, but the same jokers get to pocket their fraudulent gains - Jesse)

The collapse in NYMEX prices nearby risks exaggerating the real degree of oversupply and demand destruction, sending the wrong signal to producers and consumers about the wider availability of crude in the petroleum economy. (It may take a few countries along with it. But that may be by intent. Chavez and Putin are not on the Friends of W list - Jesse)

DOMESTIC PRICE, GLOBAL BENCHMARK

The NYMEX contract is for a very special type of crude oil (light sweet) delivered at a very special location (Cushing, Oklahoma) in the interior of the United States. It is not representative of the majority of crude oil traded internationally (most of which is heavier and sourer) and delivered by ocean-going tankers.

These specifications made sense when the contract was introduced as a benchmark for the U.S. domestic market.

U.S. refiners have a strong preference for light oils, for which they were prepared to pay a premium, because of their much higher yield to gasoline. The inland delivery location, centrally located and near the main Texas oilfields, rather than one on the coast, made sense for a contract that tried to capture the “typical” base price for crude oil paid by refiners across the continental United States.

But these specifications make much less sense now the NYMEX price is increasingly used a benchmark for the global petroleum economy, in which light sweet crudes are only a small fraction of total output. Just as NYMEX prices sent the wrong signals about physical oil availability on the way up, distorting the market and triggering more demand destruction than was really necessary, they now risk sending the wrong ones on the way down.

Earlier this year, the problem was a relative shortage of light sweet crude oils at Cushing, while all the extra barrels being offered to the market by Saudi Arabia were heavier, sourer crudes that could not be delivered against the contract. Moreover, extra Saudi crudes would have arrived by ship, and the pipeline and storage configurations around Cushing would have made it difficult to deliver them quickly against the contract.

Financial speculators were able to push NYMEX higher safe in the knowledge Saudi Arabia could not take the other side and overwhelm them by delivering physical barrels to bring prices down. The resulting spike exhibited all the characteristics of a technical squeeze: tight contract specifications ensured there could be shortage of NYMEX light sweet inland oils even while the global market was oversupplied by heavier, sourer seaborne ones.

Now the opposite problem is occurring. Crude stocks at Cushing have doubled from 14.3 million barrels to 27.5 million since mid-October. Stocks around the delivery point are at a near-record levels and approaching the maximum capacity of local tank and pipeline facilities (https://customers.reuters.com/d/graphics/CUSHING.pdf).

As a result, the market has been forced into a huge contango as storage becomes increasingly expensive and difficult to obtain, ensuring the expiring futures trade at a substantial discount.

But Cushing inventories are not typical of the rest of the U.S. Midwest (https://customers.reuters.com/d/graphics/PADD2_EX_CUSHING.pdf) or along the U.S. Gulf Coast (https://customers.reuters.com/d/graphics/PADD3.pdf), where stock levels are high relative to demand but nowhere near as overfull as in Oklahoma.

Once again the problem is geography. Coastal refiners have responded to the downturn by cutting imports of seaborne crude, limiting the stock build. But the inland market is the destination for some Canadian crudes that have nowhere else to go, and the pipeline configuration means they cannot be trans-shipped to other locations readily.

Light sweet crude has been piling up in the region, with refiners choosing to deliver the unwanted excess to the market by delivering it into Cushing.

NEW GRADES, NEW DELIVERY POINTS

The easiest way to make NYMEX more representative would be to widen the number of crude grades that can be delivered, and open a new delivery point along the U.S. Gulf Coast. Both reforms would link the contract more tightly into the global petroleum economy. (The easiest way would be to do exactly as I suggested above. It can be done with the stroke of a pen and the kick of a few asses - Jesse)

NYMEX already permits some flexibility in delivery grades. Sellers can deliver UK Brent and Norwegian Oseberg at small fixed discounts to the settlement price, and Nigerian Bonny Light and Qua Iboe, as well as Colombia’s Cusiana at small premiums.

In principle, there is no reason the contract cannot be modified further to allow a wider range of foreign oils to be delivered at larger discounts to the settlement price.

More importantly, NYMEX could open a second delivery location along the Gulf Coast, increasing the amount of storage capacity available, and linking it more closely into the tanker market.

If prices spiked again, a coastal delivery location would make it much easier for Saudi Arabia to short the market and deliver its own barrels into the rally. By widening the physical basis, it would also make it easier to support the market by cutting international production and avert a glut trapped around the delivery location.

So far, the market has continued to resist change. But there are signs policymakers might enforce one. (No one likes to give up a successful fraud voluntarily until the clock runs out - Jesse)

Earlier in the year, Saudi Arabia strongly hinted western governments should look at reforming their own futures markets rather than call for production of even more barrels of oil that could not be sold at the prevailing (unrealistic) price. (Saudi Arabia is the US's creature so any criticism is coming from a loyal source and credible - Jesse)

Naturally, some of the reform impetus has ebbed along with prices and demand. But policymakers continue to show interest in structural reforms, as was evident at last week’s London Energy Meeting, and there is an increased willingness to challenge unfettered market dynamics.

It is still possible the incoming Obama administration might force contract changes as part of a wider package of reforms designed to improve the functioning of commodity markets, reduce volatility and send clearer, more consistent price signals to the industry and consumers.

US Monetary Deflation

There isn't any monetary deflation visible in the data, at least so far.

This is despite the drop in the Consumer Price Index which appears to be driven by quickly weakening aggregate demand, as reflected in the National GDP numbers, in conjunction with a powerful short squeeze in the eurodollar which we have documented earlier that had a dampening effect on key import prices, in particular oil.

Whether a true monetary deflation develops later is another matter. We are still early in this economic downsizing of the financial sector and a massive credit bubble created by lax banking regulation and an over-accommodative Federal Reserve.

Granted there is credit creation outside of the banking system that was and still is significant, particularly with regard to feeding asset bubbles. But the role of the banks has been underplayed in this. The banks, in conjunction with the Fed, were key enablers of this series of credit and asset bubbles we have seen. Fannie and Freddie were bagmen, to borrow an analogy, but the banks were the capos with Greenspan as consigliere.

The growth of credit (indebtedness) is not money supply. It is potential money that feeds into inflationary expectations, most obviously in asset prices and consumption based on debt taken on against inflated assets. Whether my house if valued at $690,000 or $500,000 means little unless one is a speculator, or financing their daily consumption through HELOCs rather than productive growth in the median wage.

Along the same line of thought, the liquidity being added by the Treasury and the Fed to the banking system, reflected in the spike in the Adjusted Monetary base, is not feeding a monetary inflation yet either, but rather a parabolic bubble in Treasuries, and perhaps the Dollar although this is not yet demonstrable given the many degrees of freedom in the calculation.

There is an even more sophisticated linkage, with the expected lags, which we will be exploring in future charts and discussions. But if one considers the percentage growth in money supply and credit shown below against the growth in GDP which is now negative the hand of the Fed and Treasury in the economy is pronounced.

As a warning however, there are lags, and we still will expect a contraction in money supply to show up next year, probably coindicent with a trough in financial asset prices as occurred in 2002.

US Dollar Weekly Chart with Commitments of Traders

The 'small speculators' are doing a remarkably good job of moving with the market in the dollar which is unusual.

The funds long positions and the Open Interest dropped precipitously as of the market close on Tuesday December 16. They do however remain net long, so we will have to see if the selling continues on.

Notice how neatly the dollar came down and tagged key support. We suspect strongly that unless there is significant official intervention, probably from Japan, that we will go back down and retest that low.

The Problems Which Banks Face in a Post Credit Bubble World

Fear and Loathing in Financial Products
Banks – The “V”, “U” or “L” Recovery
By Satyajit Das
December 21, 2008

In 2007, equity markets fell out of love with financial institutions, especially those with large investment banking operations. 2008 saw something of reconciliation - the bigger the write-off, the bigger the dividend cut, the bigger the capital raising, perversely the greater the investor buying interest. By the end of 2008, there seems to have been an irreconciliable breakdown in relationships that no counsellor could fix.

The outlook for banks remains grim.

The asset quality of major banks remains uncertain. Svein Andresen, secretary general of the Financial Stability Forum, which is made up of global regulators and central bankers, recently told a conference of bankers in Cannes: “We are now 10 months through this crisis and some of the major banks have yet to make disclosure in [crucial] areas.”

Despite significant writedowns, sub-prime assets remain vulnerable. Other assets - consumer credit, SME loans, corporate lending and high yield leverage loans to private equity transactions- all look vulnerable as the real economy slows. Banks have increased provisions but it is not clear whether they will be adequate.

Bank balance sheets have changed significantly. Traditional commercial bank assets consisted primarily of loans and high quality securities. Traditional investment bank assets consisted of government securities and the inventory of trading securities.

In recent years, asset credit quality has deteriorated. High quality borrowers have dis-intermediated the banks financing directly from investors. Banks also hold lower quality assets to boost returns.

Bank balance sheets also now hold investments – private equity stakes, principal investments, hedge fund equity, different slices of risk in structured finance transaction and derivatives (of varying degrees of complexity). Sometimes, the assets don’t appear on balance sheet being held in complex off-balance sheet structures with various components of risk being retained by the bank. Further write-downs in asset values cannot be discounted.

Banks require re-capitalisation. The capital is required to cover losses. Capital is also needed for assets returning onto their balance sheet (as the vehicles of the “shadow banking system” are unwound). This capital is required to restore bank balance sheets. Additional capital will be needed to support future growth. Availability of capital, high cost of new capital and dilution of earnings will impinge upon future performance.

Earning growth in recent years has been driven by a rapid expansion of lending – both traditional and disguised forms such as securitisation and derivatives activity. Bank balance sheets have expanded at rates well above GDP expansion. Lower volumes in the future will mean lower earnings. (The desire for banks to grow profits faster than GDP becomes a drag on the real economy when the financial sector is outsized - Jesse)

Lack of lending capacity may also affect other activities. Corporate finance and advisory fees are driven by the capacity to finance transactions and also co-investing in risk positions. Lower origination of lending driven deals may reduce this income significantly. Banking fees for leveraged finance deals are down 90%.

Structured finance has contributed strongly to earnings in recent years. Securitisation, including CDO activity, has been a major growth area. Volumes have collapsed. The slowdown in structured finance has complex effects. Banks generated large earnings from off balance sheet vehicles in the shadow banking system. The vehicles provided banks with the ability to “park” assets and reduce capital. They also provided significant revenue – management fees; debt issuance fees and trading revenues. Recovery in these earnings is unlikely any time soon.

Trading revenue has been a bright spot. Increased volatility and much wider bid-offer spread have generated increases in both client driven and proprietary trading earnings. Volatility and the need to adjust trading positions created strong trading flows and earnings. As the markets stabilise, trading flows and earnings decline.

Several factors may limit trading income. Derivatives and structured investments, especially complex products, generated significant earnings. Problems in structured finance highlighted concerns about complexity, transparency and valuation. Market volatility has resulted in significant losses in some structured investments. Revenues may diminish as investors and borrowers curtail their use of such instruments preferring simpler products that are less profitable to the bank.

Trading revenues relied heavily on hedge funds and financial sponsors. Hedge fund activity is likely to slow through consolidation, investor redemptions and reduced leverage. Derivatives and hedging activity from private equity transactions and structured finance has been significant. Hedging revenues typically contribute 50% or more of bank earnings from a private equity transaction. Reduction in financial sponsor activity will limit revenue from this source.

Banks have increasingly relied on proprietary trading to supplement earnings. This increases risk and depends on the availability of capital. It relies on availability of counterparties and liquidity. Concern about counterparty risk and reduction in market liquidity in some products increases the risk of this activity and reduces its earning potential.

Future earnings will be affected by the availability of risk capital. The banks may not be able to access capital to the extent needed. The demise of the shadow banking system will mean that purchased capital will not be available. Regulators may also increase capital levels for some transactions exacerbating the capital problem.

Risk models in banks are a function of market volatility. The low volatility regime of recent years reduced the amount of capital needed. Increased market volatility will increase the amount of capital needed. This may restrict the level of risk taking and therefore earnings potential.

Higher costs will also increase limiting earning recovery. Bank funding costs have increased. Most firms have been forced to issue substantial amounts of term debt to fund assets returning to balance sheet and protect against liquidity risk. To the extent, that these costs cannot be passed through to borrowers, the higher funding costs will affect future funding.

Banks have issued high cost equity to re-capitalise their balance sheets. Hybrid capital issues paying between 7.00% and 14.00 % pa will be drag on future earnings. Highly dilutionary equity issues (often at a discount to a share price that had fallen significantly) will impede earnings per share growth and return on capital.

Accounting factors may also affect any earnings recovery. FAS157 allows the entity's own credit risk to be used in establishing the value of its liabilities. Changes in the entity's credit standing are therefore reflected as changes in fair value. This results in gains for credit downgrades and losses for credit upgrades.

As credit spreads increased, banks have taken substantial profits to earnings from revaluing their own liabilities. If markets stabilise and the credit spreads for banks improves then banks will have to reverse these gains. There may be significant mark-to-market losses especially on new debt issues by banks at high credit spreads since mid-2007. Investors are looking for a rapid recovery in bank earnings. Earnings may recover but the “gilded age” of bank profits may be difficult to recapture.

Glamorous banks reliant on “voodoo banking” may find it difficult to achieve the high performance of the “go-go” years. (Goldman Sachs is the poster child - Jesse)

Banks with sound traditional franchises that have avoided the worst excesses of the last 10-15 years will do well in the changed market environment. Such old fashioned banking may ironically do well in the “new” environment. Interest rates that they charge customers have increased. Bank deposits have become far more attractive than other investments. Stronger banks have also benefited from a “flight to quality”.

Will the recovery in bank stocks take the form of “V” or “U”? It may be a “L”. With the Northern Rock and Bear Stearns bailouts, central banks and governments have signaled that major banks are “too big to fail”. This is a necessary but not sufficient condition for recovery of bank earnings and stock prices. The recovery might take the form of a “L” (Kirsten ITC font) – note the small upturn at the far right of the flat bottom.