Archive - Jul 2012 - Story

The market's hopes and dreams for the next LSAP remain high. As gold inches higher, tail-risks priced out (expectations for extreme FX moves are considerably lower than sentiment would suggest), and US equity vol expectations (and put skews) are crushed; the equity market clearly remains 'at a premium' in its notional indices given what is sheer lunacy in earnings expectations going forward. The question every investor should be asking is not when QE or even if QE, but so-what-QE? As Credit Suisse notes, given the deterioration in US economic activity (and the extension of Operation Twist) the FOMC will probably wait until its September meeting (and remember the trigger for further pure QE is a long way off for now). The most critical question remains, will additional QE work? After all, few would argue that US interest rates are too high or that banks in the US need still more excess reserves. Two things stand out in their analysis of how QE is supposed to work (transmission mechanisms) and its results to date: QE1 was more effective than QE2, and it's easier to find QE's effect on Treasury yields than on real economic performance. Perhaps more concerning is that the potential negative effects of such unconventional monetary policy has received little attention (aside from at fringe blogs here and here).

Something interesting happened on the way to the detail-free bailout of Spain's insolvent banking system (which may or may not see senior bond impairments depending on just how big of a capitalization hole the ECB, not some fringe blog, sees). We got details. To wit, from Dow Jones:

The European Union loan to Spain will have a 30-year maturity, an interest rate of 2.5% and a 10-year grace period, reports ABC in its Monday Internet edition, without citing any sources.

Now here's the thing: anyone who has ever looked at a balance sheet, and actually happens to be familiar with terms such as priority, seniority, guarantee, and subordination, will notice something rather peculiar. Namely that only idiots of the n^th degree will claim that a 30 year 2.5% bond is pari passu, or equal in right of subordination - precisely what those unelected technocrats in Europe have been repeating day after day since various European summits - with a 10 year at 7%, which is where the Spanish debt actually clears the market. In other words, sorry - there is something here which gives the bailout debt implied seniority.  And here is the punchline: if the Spanish bailout debt does not trade like a pari passu piece of debt, it means that it is... i) not pari passu, and that it is ii) priming, no matter what any so-called pundit with a newsletter to peddle, may claim otherwise. Period. End of Story.

Even though the policy mix is extraordinarily stimulating, developed-world economies just cannot embark on a virtuous circle of recovery. Worse still, as Pictet points out in this excellent brief, governments, whose finances have been bled dry, are powerless to boost demand. This all suggests, they note, that Keynesian policies have failed. With no credit to dispense, State-administered Keynesianism is, in effect, bankrupt as government spending levers can no longer be activated. The implications are plain for all to see: once governments apply a brake to public spending, growth slows considerably. Economies of the developed world have become addicts, ‘hooked’ on government spending. A fresh approach to economic policy is needed. But policymakers will need to be both bold and brave as excess lending will always and inevitably lead to artificially-driven economic growth as it breaks the link between the cycles of innovation and economic growth. At a time when capitalism is being accused of the most reprehensible wrongdoings, policymakers will need to display great courage to promote the virtues of entrepreneurship and business.

In a landmark shift in its bank "impairment" stance, the WSJ reports that "in a sharp turnaround" the ECB has advocated the imposition of losses on senior bondholders at the most "damaged" Spanish savings banks, "though finance ministers have for now rejected the approach, according to people familiar with discussions." The WSJ continues: "The ECB's new position was made clear by its president, Mario Draghi, to a meeting of euro-zone finance ministers discussing a euro-zone rescue for Spain's struggling local lenders in Brussels the evening of July 9. It marks a contrast from the position the central bank adopted during the 2010 bailout of Irish banks--which, like Spain's, were victims of a property meltdown--when it prevailed in its insistence that senior bondholders in bailed-out banks shouldn't suffer losses." Needless to say, if indeed the fulcrum impairment security is no longer the Sub debt, but Senior debt, as the ECB suggests, it is only a matter of time before wholesale European bank liquidations commence as the ECB would only encourage this shift if it knew the level of asset impairment is far too great to be papered over by mere pooling of liabilities (think shared deposits, the creation of TBTF banks, and all those other gimmicks tried in 2010 when as a result of Caja failure we got such sterling example of financial viability as Bankia, which lasted all of 18 months). It also means the European crisis is likely about to take a big turn for the worse as suddenly bank failures become all too real. Why? Senior debt impairment means deposits are now at full risk of loss as even the main European bank admits there is no way banks will have enough assets to grow into their balance sheet.

The wishful thinking dominant today is that "with a little more growth, a little more energy, a little more technology -- a little more magic -- we'll somehow sail past our current tribulations without having to change our behavior." Such self-delusion is particularly dangerous because it is preventing us from taking intelligent, constructive action at the national level when the clock is fast ticking out of our favor. In fact, we are past the state where solutions are possible - instead, we need a response plan to help us best brace for the impact of the coming consequences. And we need it fast. One of the lessons that used to be at the center of a liberal education, and no longer is, is that life is tragic. And by that we do not mean that happy endings are impossible or that bad outcomes are guaranteed. What we mean is that there are consequences to the things that you do and that everything has a beginning and a middle and an end. And we have to get real with those. We are discovering more and more is that the world is comprehensively broke in every sphere, and in every dimension and in every way. The governments in every level are all broke, the households are going broke, the banks are insolvent, the money really is not there. And the pretense that the money is there has been kept going simply with accounting fraud.

“What I was looking at was a tussle between two groups of mass-men, one large and poor, the other small and rich. As judged by the standards of a civilised society, neither of them any more meritorious or promising than the other. The object of the tussle was the material gains accruing from control of the State’s machinery. It is easier to seize wealth than to produce it; and as long as the State makes the seizure of wealth a matter of legalised privilege, so long will the squabble for that privilege go on.”

Alfred Jay Nock - Memoirs Of A Superfluous Man - 1943

Despite assurances that "we always get the majority we need" by Frau Merkel, the FT reports that the Bundestag's vote this Thursday (expected to come down in favor of the bailout) will not gain the so-called 'Chancellor's majority'. While she retains an overall majority of 19 (from the ranks of her own Christian Democratic Union, its Bavarian sister party, the Christian Social Union, and the liberal Free Democratic party in her coalition), the recent ESM vote saw 26 of her  supporters rebel (voting 'Nein' or abstaining) - though ended up being passed thanks to support from SPD and The Greens. While a 'Chancellor's majority' is not required to approve the EUR100 billion Spanish bailout, "Anything other than a chancellor’s majority is a defeat, and a sign of the erosion of the power of the chancellor," which leads us down the path we have noted previously of the inevitability of a referendum-like vote next year (which may just be the leave-the-Euro-coz-that's-what-the-people-want 'out' Germany has been looking for). Certainly, the vote is no panacea (politically or economically) as Jens Weidmann notes that the bailout would be more effective 'conditions' were applied across Spain, adding that "It would have a positive effect on the bond market if investors saw that the conditions... went beyond the banking sector".

"There are a lot of wealthy, successful Americans who agree with me -- because they want to give something back.  They know they didn’t -- look, if you’ve been successful, you didn’t get there on your own.  You didn’t get there on your own.  I’m always struck by people who think, well, it must be because I was just so smart.  There are a lot of smart people out there.  It must be because I worked harder than everybody else.  Let me tell you something -- there are a whole bunch of hardworking people out there.  (Applause.)... If you were successful, somebody along the line gave you some help.  There was a great teacher somewhere in your life.  Somebody helped to create this unbelievable American system that we have that allowed you to thrive.  Somebody invested in roads and bridges.  If you’ve got a business -- you didn’t build that.  Somebody else made that happen.  The Internet didn’t get invented on its own.  Government research created the Internet so that all the companies could make money off the Internet."

By now it really, really should be obvious. While the insolvent "developed world" is furiously fighting over who gets to pay the bill for 30 years of unsustainable debt accumulation and how to pretend that the modern 'crony capitalist for some and communist for others' system isn't one flap of a butterfly's wings away from full on collapse mode, China is slowly taking over the world's real assets. As a reminder: here is a smattering of our headlines on the topic from the last year: ""World's Second (China) And Third Largest (Japan) Economies To Bypass Dollar, Engage In Direct Currency Trade", "China, Russia Drop Dollar In Bilateral Trade", "China And Iran To Bypass Dollar, Plan Oil Barter System", "India and Japan sign new $15bn currency swap agreement", "Iran, Russia Replace Dollar With Rial, Ruble in Trade, Fars Says", "India Joins Asian Dollar Exclusion Zone, Will Transact With Iran In Rupees", 'The USD Trap Is Closing: Dollar Exclusion Zone Crosses The Pacific As Brazil Signs China Currency Swap", and finally, "Chile Is Latest Country To Launch Renminbi Swaps And Settlement", we now get the inevitable: "Central bank pledges financial push in Africa." To summarize: first Asia, next Latin America, and now Africa.

Escalation. The inevitable collapse of the Prisoner's Dilemma that kept the LIBOR contributors together is occurring rapidly. After Barclays' forced admission and initial fine, the 'he-who-defects-first-wins' strategy has been trumped by Deutsche Bank as they turn all 'Donnie Brasco' on their oligopolistic peers. As Reuters reports this morning "The bank last year obtained the status of being a witness for the prosecution in the EU and in Switzerland," and "as a result of that, the bank could get a lighter penalty if a punishment is imposed," though of course this does not mean they are admitting guilt (sigh). Under the leniency programs of the EU, companies may get total immunity from fines or a reduction of fines which the anti-trust authorities would have otherwise imposed on them if they hand over evidence on anti-competitive agreements or those involved in a concerted practice. How quickly the worm turns when trust leaves the system - the warning the rest of the Liebor contributors - be afraid, be very afraid.

It is hard enough to determine what, when and how to invest even with solid data. We live in an unpredictable and chaotic world, and the last thing that investors need is misinformation and distortions. That is why the LIBOR manipulation scandal is so infuriating; as banks skewed the figures, they skewed entire marketplaces. The level of economic distortion is incalculable — as LIBOR is used to price hundreds of trillions of assets, the effects cascaded across the entire financial system and the wider world. An unquantifiable number of good trades were made bad, and vice verse. Yet in truth we should not expect anything else from a self-reported system like LIBOR. Without real checks and balances to make sure that the data is sturdy, data should be treated as completely unreliable.

Unsurprisingly, it is emerging that many more self-reported figures may have been skewed by self-reporting bullshittery.

On Friday morning, Jamie Dimon as head of the bank many (well, some: Zero Hedge) expect will be the first casualty when the Liebor scandal finally breaks on US soil, which it will within 2-3 weeks, faced several questions on his Q2 conference call trying to extract more information from the bank as to where it may stand in the Liebor scandal. Jamie was not only not very talkative, but refused to answer questions why by default should have had an answer - i.e., internal controls, which after the discovery 10 minutes prior to the earnigs release that the bank had found a material internal controls weakness vis-a-vis CDS marks, is probably rather critical. Of course, the market being as headline drive as it is, took the lack of further Libor clarity as an "all clear" and send the stock up 6%. That may well have been rather premature. Because as the NYT reports, criminal charges are coming, which may explain JPM's reticence to say much if anything while it is the subject of a multi-year long criminal investigation which is about to break.

And now a little something for everyone who consistently has a nagging feeling that at any second the world is one short flap of a butterfly's wings away from complete systemic disintegration: according to David Korowicz of FEASTA, and his most recent paper: 'Trade-Off: Financial System Supply-Chain Cross-Contagion: a study in global systemic collapse." that just may be the case. Think of the attached 78-page paper as Nassim Taleb meets Edward Lorenz meets Malcom Gladwell meets Arthur Tansley meets Herman Muller meets Werner Heisenberg meets Hyman Minsky meets William Butler Yeats, and the resultant group spends all night drinking absinthe and smoking opium, while engaging in illegal debauchery in the 5th sub-basement of the Moulin Rouge circa 1890.  To wit: "Something sets off an interrelated Eurozone crisis and banking crisis, a Spanish default say, which spreads panic and fear across other vulnerable Eurozone countries. This sets off a Minsky moment when overleveraged speculators in the banking and shadow banking system are forced to unwind positions into a one-sided (sellers only) market. The financial system contagion passes a tipping point where governments and central banks start to lose control and panic drives a (positive feedback) deepening and widening of the impact globally. In our tropic model of the globalised economy, the banking and monetary system keystone hub comes out of its equilibrium range, crosses a tipping point, and is driven away by positive feedbacks to some new state.... it is very clear that we have learned almost nothing general about risk management as a societal practice arising from the financial crisis. We have merely adopted a new consensus, with a questionable acknowledgement that we will not let this type of crisis happen again. However, the argument in this following report is that we are facing growing real-time, severe, civilisation transforming risks without any risk management."

In an interview on Bloomberg TV, RDM Financial's Ron Weiner summarizes the thing that keeps him up at night as in over thirty years he has never seen "The fate of the world economy rests so much on politicians." Pointing to the sad reality that since WWII the US has always spent more than it earns, he warns that if the politicians don't make it right, then "the markets will!" The heuristic bias to accept the spending status quo, as for most young-to-middle-aged people 'it has always been this way' - just like rising home prices (whose 'new normal recovery' Bloomberg's Joe Brusuelas admirably destroys with a single-chart of shadow inventory and opacity of bank balance sheets), is so entrenched, thanks to the last sixty years or so of 'growth', that when asked 'if it is possible to cut spending', he replies "you have to!" and if it's not politically possible then once again "the market will take care of it". This brief three minute clip reminds us of the disbelief and head-in-the-sand mean-reverting bias so widespread in developed nations (citizens and politicians) and summarily dismisses it with a reminder that 'it just has to be reasonable men that we elect to do it" - and better that than let the market force their hand.

In a few moments we will post a critical analysis by David Korowicz, titled Trade-Off: Financial System Supply-Chain Cross- Contagion: a study in global systemic collapse, arguably one of the best big picture overviews of the New Normal in systemic complexity, which considers the "relationship between a global systemic banking, monetary and solvency crisis and its implications for the real-time flow of goods and services in the globalised economy" and specifically looks at how various "what if" scenarios can propagate through a Just In Time world in which virtually everything is connected, and in which even a modest breakdown in one daisy-chain can lead to uncontrolled systemic collapse via the trade pathways more than ever reliant on solvency, sound money and bank intermediation.To wit: "For example, when the Federal Reserve Bank of New York commissioned a study of the structure of the inter-bank payment flows within the US Fedwire system they found remarkable levels of concentration. Looking at 7,000 transfers between 5,000 banks on an average day, they found 75% of payment flows involved less than 0.1% of the banks and 0.3% of linkages."