Shadow Banking

The great trade, capital flow and debt imbalances that were built up over the preceding two decades must reverse themselves. Michael Pettis notes, however, that these imbalances can continue for many years, but at some point they become unsustainable and the world must adjust by reversing those imbalances. One way or the other, in other words, the world will rebalance. But there are worse ways and better ways it can do so. Pettis adds that, any policy that does not clearly result in a reversal of the deep debt, trade and capital imbalances of the past decade is a policy that cannot be sustained. It is likely to be political considerations that determine how quickly the rebalancing processes take place and whether they do so in ways that set the stages for future growth or future stagnation. Pettis' guess is that we have ended the first stage of the global crisis, and most of the deepest problems have been identified. In 2013 we will begin to see how policymakers respond and what the future outlook is likely to be. The following 10 themes are what he will be watching this year in order to figure out where we are likely to end up.

Why has the Fed paid some $6 billion in interest to foreign banks, in the process subsidizing and keeping insolvent European and other foreign banks, in business and explicitly to the detriment of countless US-based banks who have to compete with Fed-funded foreign banks and who have to fire countless workers courtesy of this Fed subsidy to foreign workers? And, perhaps more importantly, why will the Fed pay about $5 billion or much more in interest to foreign banks each year starting in 2014? 

The endless Italian bailout story that keeps on giving, has just given some more. It turns out Italy's insolvent Banca dei Monte Paschi, which has been in the headlines for the past month due to its role as political leverage against the frontrunning Bersani bloc, and which has been bailed out openly so many times in the past 4 years we have lost track, and whose cesspool of a balance sheet disclose one after another previously secret derivative deal on an almost daily basis, can now add a previously unannounced bailout by the Bank of Italy to its list of recent historical escapades.

From Fed's Stein: "The insurance company might approach a broker-dealer and engage in what is effectively a two-way repo transaction, whereby it gives the dealer its junk bonds as collateral, borrows the Treasury securities, and agrees to unwind the transaction at some point in the future. Now the insurance company can go ahead and pledge the borrowed Treasury securities as collateral for its derivatives trade." Thanks to the magic of FAS 140 banks can literally transform worthless garbage into supersafe Treasurys, then use that newly transformed collateral via further repo as cash to fund simple stock purchases, and at the end of the day nobody knows where the exposure came from, who the counterparty is, and what the ultimate liability is!

While Japan's recent attempt to massively reflate and break out of its "liquidity trap" - an artificial construct to explain what happens when an artificial model, created by a flawed and artificial economic theory explodes in a singularity of Econ PhD idiocy leaving billions of impoverished people in its wake, is nothing new, there are those who are rather skeptical this latest attempt to achieve what Japan has not been able to do in over 30 years will work. And while one can come up with complicated, expansive, verbose theories based on Keynesian DSGE models and other such gibberish, why this time will be different for Japan, there is a very quick and simple argument why it won't.

"History is replete with examples of societies whose downfalls were related to or caused by the destruction of money. The end of this phase of global financial history will likely erupt suddenly. It will take almost everyone by surprise, and then it may grind a great deal of capital and societal cohesion into dust and pain. We wish more global leaders understood the value of sound economic policy, the necessity of sound money, and the difference between governmental actions that enable growth and economic stability and those that risk abject ruin. Unfortunately, it appears that few leaders do."

- Paul Singer, Elliott Management

From a valuation perspective, Chinese equities do not, at first glance, look to be a likely candidate for trouble. The PE ratios are either 12 or 15 times on MSCI China, depending on whether you include financials or not, and do not scream 'bubble'. And yet, China has been a source of worry for GMO over the past three years and continues to be one. China scares them because it looks like a bubble economy. Understanding these kinds of bubbles is important because they represent a situation in which standard valuation methodologies may fail. Just as financial stocks gave a false signal of cheapness before the GFC because the credit bubble pushed their earnings well above sustainable levels and masked the risks they were taking, so some valuation models may fail in the face of the credit, real estate, and general fixed asset investment boom in China, since it has gone on long enough to warp the models' estimation of what "normal" is. Of course, every credit bubble involves a widening divergence between perception and reality. China's case is not fundamentally different. In GMO's extensive discussion below, they have documented rapid credit growth against the background of a nationwide property bubble, the worst of Asian crony lending practices, and the appearance of a voracious and unstable shadow banking system. "Bad" credit booms generally end in banking crises and are followed by periods of lackluster economic growth. China appears to be heading in this direction.

A Chinese solar firm which nearly produced the country's first domestic bond default will complete an interest payment on schedule after a local government intervened on its behalf. Investors say the latest instance of a government riding to the rescue of a troubled Chinese firm has led to moral hazard and inefficient credit allocation. In previous near-defaults, local governments had stepped in directly to arrange bailout funding. But as in past cases, the deal flouts legal notions of debt seniority by allowing one group of creditors - bondholders - to get paid in full, even as a pre-existing default remains un-cured. Analysts say the market does not effectively price in risk because investors assume the government will never allow a default.

While it is not news that the GOP has proposed a temporary debt ceiling extension that would suspend the provisions of the debt ceiling target until May 19, as was reported last week, however which would demand that the Senate do something unthinkable, and something it has not done for 4 years, namely pass a budget by April 15, it is news that as The Hill reports, the vote to suspend the debt ceiling in the House will take place "as soon as Wednesday." From The Hill: "While past measures to address the debt limit have simply increased the borrowing cap, the House bill would actually suspend the debt limit for three months. Then, on May 19, the debt limit would be automatically increased from $16.4 trillion to accommodate whatever additional borrowing the Treasury had done during that time frame." As we explained last week, this is merely a plan to shift fiscal (ir)responsibility into the Democrat camp, as it is virtually impossible that America can have a budget now or ever again. After all with $1 trillion deficits as far as the eye can see, the possibility to bluster and claim one is fiscally responsible while demanding $4 trillion in debt until 2016, will hardly fool the majority of the people any more of the time. Sure enough, Pelosi's response has made it quite clear this entire plan is DOA: "the proposed three-month debt- limit increase does not relieve the uncertainty faced by small businesses, the markets and the middle class. This is a gimmick unworthy of the challenges we face.”

• With array of challenges, Obama kicks off second term at public inauguration (Reuters)
• Uneasy in the Political Climate, Mickelson Talks Like Someone Ready to Step Away (NYT)
• BOJ Should Slow Easing If Yen Weakens Too Much, Hamada Says (BBG)
• Spain Recession Scars Exposed as Jobless Seen at 6 Mln (BBG)
• Davos Doom Loses to Merkel-Draghi as Euro Defies Roubini (BBG)
• Algeria finds dead Canadian militants as siege toll rises (Reuters)
• Beijing tries to clean up its act (FT)
• Investigators probe Boeing 787 battery maker (Reuters)
• Netanyahu Gets Landslide in Markets Masking No Peace Process (BBG)
• Google aims to replace passwords with ID ring (Telegraph)
• Kim Dotcom launches new upload site (FT)
• Dell Said to Hire Evercore to Seek Higher Bids After Buyout (BBG)
• Hostess Bakers Union Hires Investment Bank Gordian in Asset Sale (BBG)

When one thinks of open-ended, "inflation targeting" one usually thinks of soaring markets, at least in nominal terms, exploding central bank balance sheet, and happy central planners. What one usually does not think of, is, well, inflation targeting. Because while the shadow banking financial system, perfectly devoid of deposits, has for now provided a sufficient buffer from trillions of reserve injections from spreading into the broader economy of the US and Europe, and has primarily impacted stock markets as unsterilized liquidity injections are used by banks to bid stocks, Japan has been far less lucky in this regard. As it turns out, the massive slide in the Japanese Yen in the past 2 months on nothing but ongoing promises of open-ended action, something Europe has perfected, and the US most recently enacted, may have already achieved its goal of pushing inflation. only not to the desired 2% level, but about 50% higher. Luckily, it is for such trivial things that nobody really every needs, such as fuel and consumer products - just ask the BLS.

It is a “fraudulent transfer” to transfer assets with intent to leave the transferor with inadequate capital... Thus every bank “sale” done for the purpose of reducing regulatory capital is, by definition, fraud – a form of bank theft. 

The Chinese economy has been enjoying a cyclical rebound since the beginning of Q4 2012. SocGen's central scenario is that this recovery will last until early Q2 2013 and then gradually lose momentum. In the medium term, they still anticipate a bumpy path of secular deceleration, leading to an average growth rate of 6-7% over the next five to seven years, down from 10% per annum over the last three decades. This piece focuses on what is probably the most popular “what-if” question about the Chinese economy – what if China hard lands (with real GDP growth rate plummets to below 6%)? As China undergoes demographic ageing and growth of the working-age population slows, this minimum stable growth level will decline further. However, if progress in rebalancing and structural reform remains slow, the probability of a hard landing will rise over the medium term. In the tail risk scenario set out below, 2013 will see several quarters with just 3% growth and full year growth would stand at just 4.2%, but what are th triggers, how would it evolve, how would the government respond, and how bad could things get?

Earlier today, Bill Frezza of the Competitive Enterprise Institute and CNBC's Steve Liesman got into a heated exchange over a recent Frezza article, based on some of the key points we made in a prior post "A Record $2 Trillion In Deposits Over Loans - The Fed's Indirect Market Propping Pathway Exposed" in which, as the title implies, we showed how it was that the Fed was indirectly intervening in the stock market by way of banks using excess deposits to chase risky returns and generally push the market higher. We urge readers to spend the few minutes of this clip to familiarize themselves with Frezza's point which is essentially what Zero Hedge suggested, and Liesman's objection that "this is something the banks don't do and can't do." Liesman's naive  view, as is to be expected for anyone who does not understand money creation under a fractional reserve system, was simple: the Fed does not create reserves to boost bank profits, and thus shareholder returns, and certainly is not using the fungible cash, which at the end of the day is what reserves amount to once dispersed among the US banks, to gun risk assets higher.

Alas, Steve is very much wrong.

Overnight, Frank Partnoy and Jesse Eisinger released an epic magnum opus titled "What's Inside America's Banks", in which they use over 9000 words, including spot on references to Wells Fargo, JPM, Andy Haldane, Kevin Warsh, Basel II, Basel III (whose regulatory framework is now 509 pages and includes a ridiculous 78 calculus equations to suggest that banks have to delever by some $3 trillion, which is why it will never pass) to give their answer: "Nobody knows." Of course, while this yeoman's effort may come as news to a broader cross-section of the population, is it well known by anyone who has even a passing interest in the loan-loss reserve release earnings generating black boxes formerly known as banks (which once upon a time made their money using Net Interest margin, and actually lending out money to make a profit), and now simply known as FDIC insured Bank Holding Company hedge funds. This also happens to be the second sentence in the lead paragraph of the story: "Sophisticated investors describe big banks as “black boxes” that may still be concealing enormous risks—the sort that could again take down the economy." So far so good, and again - not truly news. What however may come as news to none other than the author is that the first sentence of the lead-in: 'Some four years after the 2008 financial crisis, public trust in banks is as low as ever" is, sadly, wrong.