Archive - Jul 2010 - Story

The Cleveland Fed has spent another boatload of taxpayer money analyzing a topic so simplistic even a 5 year old would know the answer in advance, to wit: "Is debt overhang causing firms to underinvest?" Let's see here... Uh yeah. And you can keep the $1,000,000 "research" cost. While the paper is sufficiently entertaining courtesy of a few graphs, flow charts and general widgets, the conclusion is startlingly absurd. In essence the authors conclude (in less than definitive terms) that debt forgiveness may be the best outcome for highly leveraged companies: "The debt-overhang problem may be so severe that creditors can actually benefit from forgiving a portion of the debt. With excessively high levels of debt, the risk of default is large and the market value of debt is well below its face value. If the creditors forgive part of the debt in this situation, the lower debt burden helps realign the interests of the equity holders and the creditors. The firm’s effort and investment will rise, increasing the total value of the firm and the market value of the remaining debt. If this effect is strong enough, the market value of the remaining debt may be even higher than the market value of the total debt in the absence of debt forgiveness, in which case debt relief will ultimately benefit the creditors themselves." Well, now we know the reason for the financial cram up, in which stockholders were spared while preferred and sub debt was being raped back in 2008. Yet if this thinking is indicative of prevailing Fed ideology, the move for a wide-reaching, Federally-mandated debt repudiation may be just steps away. And just in case you note that the Chapter 11 process, in which existing underwater debt is converted into post reorg equity, is a perfectly logical, viable and working alternative, the authors will have none of such dogma: "A creditor takeover of the firm after it defaults is another potential solution to the debt-overhang problem. Creditors would have an incentive to undertake all profitable investment
opportunities. However, this solution is not satisfactory either, since
most investment opportunities depend on business continuity and
disappear or lose substantial value when default occurs and the equity
holders lose control of the firm." Because creditors obviously have no idea how to preserve business continuity if they end up being the equityholders....And in case you were wondering, author Filippo Occhino does have a Ph.D from a (semi) respectable institution.

Whereas Alphaville presents several statutory observations by David Rosenberg as to a variety of reasons over which one "could" be bullishly inclined based on a goal seeked read of the data (if one so chose), his daily letter is once again capped with yet another bearish summation: the bad news more than drowns out all the positivity, even if that means that another double dip is practically priced in.

A lot of talk about what the “New Normal” means. Here’s a contribution.
There are three essential ingredients to the one we have.

1. Higher, less stable volatility
2. Lower returns
3. Unstable inflation expectations

All three of these contribute to the risk?on/risk?off mentality markets exhibit. The focus here is inflation expectations. Not only is it the fuel for the inflation?deflation debate, it is a leading indicator for the shape of the next normal coming up. The next step is a settling down of expectations.

If in addition to 85% of the economic data releases in the past month coming below expectations was not enough, the ECRI leading indicator has just came below the critical threshold of -10%, which according to Rosenberg has virtually assured recessions based on data from the past 50 or so years, hitting an annualized rate of -10.5%. And since even the index creators (and Ivy League tenured professors) are openly refuting the adverse implications of their own index (when they, and everyone were praising it when it topped out at 27.80 a year ago), one can be sure this is a rather dramatic data point.

I’m sorry to be the bearer of bad news. There are no easy solutions. There are only painful, more painful, and really really painful solutions. Both mainstream corrupted political parties have had the chance to put the country back on a prudent fiscal path. They have both failed miserably. One party will spend the country into oblivion and the other country will try to democratize the world with their military machine. There are no fresh ideas from either party. There are the same old stale ideas and rhetoric. - Jim Quinn

Leaks that 5 Spanish Cajas will fail (ooohhhh) including CajaSur, Caixa Catalunya, and Caja-Duero. The denoument is that no Spanish commerical bank will fail (aaahhhh). We will be back to the very dramatic conclusion of this season's finale of Who Wants To Invest In A Bankrupt Continent after 20 minutes of advertisements from our sponsor, the US taxpayer.

The news rocked the global gold market when an almost obscure line item in the back of a 216 page document released by an equally obscure organization was recently unearthed. Thrust into the unwanted glare of the spotlight, the little publicized Bank of International Settlements (BIS) is discovered to have accepted 349 metric tons of gold in a $14B swap. Why? With whom? For what duration? How long has this been going on? This raises many questions and as usual with all $617T of murky unregulated swaps, we are given zero answers. It is none of our business! Since President Richard Nixon took the US off the Gold standard in 1971, transparency regarding anything to do with gold sales, leasing, storage or swaps is as tightly guarded by governments as the unaudited gold holdings of Fort Knox. Before we delve into answering what this swap may be all about and what it possibly means to gold investors, we need to start with the most obvious question and one that few seem to ask. Who is this Bank of International Settlements and who controls it?

And now, for today's real news: "Chinese banks may struggle to recoup about 23 percent of the 7.7 trillion yuan ($1.1 trillion) they’ve lent to finance local government infrastructure projects, according to a person with knowledge of data collected by the nation’s regulator. Only 27 percent of the loans to the financing vehicles can be repaid in full by cash generated by the projects they funded, the person said. The China Banking Regulatory Commission has told banks to write off non-performing project loans by the end of this year." Got China CDS? Because this is the point where one follows Hugh Hendry's advice about that whole panic thing.

The circus in Europe can't come to an end soon enough. As Zero Hedge posted and speculated previously, according to a draft document, it has now been confirmed that banks will only be tested for sovereign debt exposure just on trading books, not on debt held to maturity. Guess what: about a month ago, all banks almost certainly decided to quietly reclassify their hundreds of billions of sovereign exposure from "trading" to "held to maturity," thus taking advantage of the same FASB 157 accounting abortion that America has gripped tightly on to for almost two years now, as accounting fraud follows the Bernanke Put in going global. If this is supposed to inspire confidence, then the market has truly lost it. As we explained last week, "the haircut will only pertain to
trading books. In other words this is Europe's equivalent of FASB 157:
everything that banks hold "to maturity" will not see a major haircut,
and very likely not see any haircut at all. Which simply means that all
European banks that hold such debt will merely reclassify their Greek
exposure from trading to a "held to bankruptcy at par" category. The
surreality of European banking assets (which as we pointed out
previously is a $100 trillion circle jerk where one bank's assets are another bank's liabilities) has now passed well into the twilight zone." In other completely irrelevant news, the micro trading books will see the following haircuts, as presented by Bloomberg.

On one hand, there is speculation that the Stress tests [May|May Not] be relevant, [May|May Not] push equities to fresh [highs|lows] and will prove just how [strong|broke] Europe is - that's fine: it is all part of the expectation and the show that the Stress Test theater was from the beginning. On the other, 3 Month EUR Libor is as the highest it has been since August 23, 2009, as the market continues to lock up, and while it is still materially tighter than all time highs, when Libor was surging in the 4-5% range two years ago, banks did not have the explicit backing of every currency printer in the known Keynesian world. The fact that this indicator has been on a straight up path since April is the only thing European regulators need to explain. But for those who just can't get enough of the [lack of] backstabbing in this year's season of the Stress-ful soap opera, here is Goldman's grade sheet. We, on the other hand, grade the excitement level surrounding the season finale of the second season of the Stress Test soap opera at C+: enough to make people forget for a few hours that the world is bankrupt, but not enough for them to throw their life savings into the market with giddy fervor and reckless abandon.

Yesterdays’ activity was befuddling to say the least. Personally, I thought the 1200 strike would act as a magnet going into options expiration, but Wednesdays’ activity said the 1180 strike was going to be an issue. Yesterday turned out to be a total head fake. The market may in fact be beginning to price QE2 as every other market moved in tandem higher. Maybe Gold just got the message late. We are still sticking to our guns that the market is one that shows no reason to buy strength, but are aware that there may be some bigger picture buying beneath the market once again.

• More "fantastic beats" out of Europe: UK GDP for Q2 1.1% q/q 1.6% y/y –
  higher than expected, Germany IFO - Expectations for July 105.5 – 
  higher than expected; flip Risk On switch after bankrupt Cajas rumored to fall off clownmobile
• Jean Claude Trichet: Stimulate no more – it is now time for all to tighten (FT) - funny, because even as Europe tightens fiscally, it lets rip monetarily
• Bernanke offers no silver bullets, which means depressed yields and P/Es amid more dreary, deflation (Barrons)
• For those who care about the circus happening in Europe today, here is Reuters on Europe's "banking credibility" (Reuters)
• Bank Stress Test Success Hinges on Data, Not Failure Count (Bloomberg)
• Several Spanish savings banks fail stress test-El Pais (Reuters)
• Swiss aim to steal EU stress test thunder (FT)
• Beijing Considers Plan To Move Its Currency Further From Dollar (WSJ)
• North Korea threatens "physical response" to U.S. moves (Reuters)
• Japan Says Yen Climb May Hurt Economy, Increasing Policy-Intervention Risk (Bloomberg)
• Australian mining tax is far from settled (SMH)

From S&P: "Discussions with the IMF reportedly concluded July 17, 2010, without a subsequent donor package having been agreed. We understand that the IMF will return to reactivate discussions with the authorities in September 2010. In our view, the likelihood of a new program with the EU and IMF being agreed could be contingent on some amendments by the government of some aspects of specific policy measures such as the temporary financial institutions tax. We believe that without an EU/IMF program to anchor policy, Hungary is likely to face higher and more volatile funding costs, which in our view could weigh on financial sector balance sheets, the public finances, and economic growth."

• Euro weakens versus Dollar, Yen on speculation tests to reveal loan losses.
• 3M net income climbs 43%; raises 2010 EPS view to $5.65-5.80 (prev $5.40-5.60).
• Adidas posts 2Q results 'significantly above' market expectations.
• Akzo Nobel says net profit rose 76% in 2Q thanks to sales growth.
• Amazon's Q2 earnings rose 45% to $207M on a 41% increase in sales of $6.57B.
• AmEx's Q2 profit rose to more than $1B from $337M, and Capital One's increased to $608M from $223M.
• AT&T's Q2 net income jumps 25% to $4.0B; adds 1.6 million wireless accounts.

A New Normal world is likely to
be one with frequent flips between “risk on” and “risk off” days. With
so much profit and loss riding on tail events and so little profit and
loss tied to the cluster of outcomes near ex ante means,
repositioning will likely be more frequent. This is because many
investors lack conviction in their understanding of the true
distribution, so that each passing day provides an opportunity to learn
or unlearn how likely the relevant tail events are. Positioning
for mean reversion will be a less compelling investment theme in a world
where realized returns cluster nearer the tails and away from the
mean. James Carville said twenty years ago that he
wanted to be reincarnated as the bond market because the vigilantes had
so much clout over policymakers. But in the New Normal world, he might
wish to be reincarnated as the Asian equity markets because they are
where traders in Europe and the U.S. look to see if it is a “risk on” or
“risk off” day. With so much money chasing fewer assets with known
return distributions, and with reliable investment rules of thumb
scarce, frequent flips between “risk on” and “risk off” days will likely
be a continuing symptom of the Knightian uncertainty that still, to
some extent, hangs over global financial markets.

- Richard Clarida, Pimco