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EU-phoria Fades

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The most recent “light at the end of the tunnel” for the European sovereign debt crisis was seen on Friday June 29.  At a summit in Brussels, leaders of the European Union member nations agreed upon yet another “plan for a plan” to recapitalize failing banks – particularly in Spain.  The Summit Statement, which briefly summarized the terms of the plan, explained that an agreement was reached to establish a supervisory entity which would oversee the European banking system and to allow recapitalization of troubled banks without adding to sovereign debt.  By owning shares in the ailing banks, the European Stability Mechanism would no longer have a senior creditor status, in order to prevent investors from being scared away from buying sovereign bonds.

The bond markets were relieved to know that once again, taxpayers would be paying for the losses sustained by bondholders.  The reaction was immediate.  Spanish and Italian bond yields dropped faster than William Shatner’s pants when he passed through airport securitySpain’s ten-year bond yield dropped to 6.51 percent on June 29 from the previous day’s closing level of 6.87 percent.  Italy’s ten-year bond yield sank to 5.79 percent from the previous closing level of 6.24 percent.

Global stock indices went parabolic after the news from Brussels on June 29.  Nevertheless, many commentators expressed their skepticism about the latest plan.  Economist John Hussman of the Hussman Funds discussed the shortcomings of the proposal in his Weekly Market Comment:

The upshot here is that Spain’s banks are undercapitalized and insolvent, but rather than take them over and appropriately restructure them in a way that requires bondholders to take losses instead of the public, Spain hopes to tap European bailout funds so that it can provide capital directly to its banks through the European Stability Mechanism (ESM), and put all of Europe’s citizens on the hook for the losses.Spainhas been trying to get bailout funds without actually having the government borrow the money, because adding new debt to its books would drive the country further toward sovereign default.  Moreover, institutions like the ESM, the ECB, and the IMF generally enjoy senior status on their loans, so that citizens and taxpayers are protected.  Spain’s existing bondholders have objected to this, since a bailout for the banks would make their Spanish debt subordinate to the ESM.

As a side note, the statement suggests that Ireland, which already bailed its banks out the old-fashioned way, will demand whatever deal Spain gets.

So the hope is that Europe will agree to establish a single bank supervisor for all of Europe’s banks.  After that, the ESM – Europe’s bailout fund – would have the “possibility” to provide capital directly to banks.  Of course, since we’re talking about capital – the first buffer against losses – the bailout funds could not simply be lent to the banks, since debt is not capital.  Instead, it would have to be provided by directly purchasing stock (though one can imagine the Orwellian possibility of the ESM lending to bank A to buy shares of bank B, and lending to bank B to buy shares of bank A).  On the question of whether this is a good idea, as opposed to the alternative of properly restructuring banks, ask Spain how the purchase of Bankia stock has been working out for Spanish citizens (Bankia’s bondholders should at least send a thank-you note).  In any event, if this plan for a plan actually goes through, the bailout funds – provided largely by German citizens – would not only lose senior status to Spain’s government debt; the funds would be subordinate even to the unsecured debt held by the bondholders of Spanish banks, since equity is the first thing you wipe out when a bank is insolvent.

It will be interesting to see how long it takes for the German people to figure this out.

The criticism expressed by Charles Hugh Smith is particularly relevant because it addresses the latest move by the European Central Bank to lower its benchmark interest rate by 25 basis points (0.25%) to a record low of 0.75 percent.  Smith’s essay, entitled “Sorry Bucko Europe Is Still in a Death Spiral” consisted of sixteen phases of the death spiral dynamic.  Here are the final seven:

10. Transferring bad debt to central banks does not mean interest will not accrue: interest on the debt still must be paid out of future income, impairing that income.

11. Lowering interest rates does not create collateral where none exists.

12. Lowering interest rates only stretches out the death spiral, it does not halt or reverse it.

13. Centralizing banking and oversight does not create collateral where none exists.

14. Europe will remain in a financial death spiral until the bad debt is renounced/written off and assets are liquidated on the open market.

15. Anything other than this is theater.  Pushing the endgame out a few months is not a solution, nor will it magically create collateral or generate sustainable “growth.”

16. The Martian Central Bank could sell bonds to replace bad debt in Europe, but as long as the MCB collects interest on the debt, then nothing has changed.

The Martians would be extremely bent when they discovered there is no real collateral for their 10 trillion-quatloo loan portfolio in Europe.

Of course, Mr. Smith is forgetting that the Martians could call upon those generous taxpayers from planet Zobion for a bailout   .   .   .


 

Manifesto

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For the past few years, a central mission of this blog has been to focus on Washington’s unending efforts to protect, pamper and bail out the Wall Street megabanks at taxpayer expense.  From Maiden Lane III to TARP and through countless “backdoor bailouts”, the Federal Reserve and the Treasury Department have been pumping money into businesses which should have gone bankrupt in 2008.  Worse yet, President Obama and Attorney General Eric Hold-harmless have expressed no interest in bringing charges against those miscreants responsible for causing the financial crisis.  The Federal Reserve’s latest update to its Survey of Consumer Finances for 2010 revealed that during the period of 2007-2010, the median family net worth declined by a whopping thirty-eight percent.  Despite the massive extent of wealth destruction caused by the financial crisis, our government is doing nothing about it.

I have always been a fan of economist John Hussman of the Hussman Funds, whose Weekly Market Comment essays are frequently referenced on this website.  Professor Hussman’s most recent piece, “The Heart of the Matter” serves as a manifesto of how the financial crisis was caused, why nothing was done about it and why it is happening again both in the United States and in Europe.  Beyond that, Professor Hussman offers some suggestions for remedying this unaddressed and unresolved set of circumstances.  It is difficult to single out a passage to quote because every word of Hussman’s latest Market Comment is precious.  Be sure to read it.  What I present here are some hints as to the significance of this important essay:

The ongoing debate about the economy continues along largely partisan lines, with conservatives arguing that taxes just aren’t low enough, and the economy should be freed of regulations, while liberals argue that the economy needs larger government programs and grand stimulus initiatives.

Lost in this debate is any recognition of the problem that lies at the heart of the matter:  a warped financial system, both in the U.S. and globally, that directs scarce capital to speculative and unproductive uses, and refuses to restructure debt once that debt has gone bad.

Specifically, over the past 15 years, the global financial system – encouraged by misguided policy and short-sighted monetary interventions – has lost its function of directing scarce capital toward projects that enhance the world’s standard of living. Instead, the financial system has been transformed into a self-serving, grotesque casino that misallocates scarce savings, begs for and encourages speculative bubbles, refuses to restructure bad debt, and demands that the most reckless stewards of capital should be rewarded through bailouts that transfer bad debt from private balance sheets to the public balance sheet.

*   *   *

By our analysis, the U.S. economy is presently entering a recession.  Not next year; not later this year; but now.  We expect this to become increasingly evident in the coming months, but through a constant process of denial in which every deterioration is dismissed as transitory, and every positive outlier is celebrated as a resumption of growth.  To a large extent, this downturn is a “boomerang” from the credit crisis we experienced several years ago.  The chain of events is as follows:

Financial deregulation and monetary negligence -> Housing bubble -> Credit crisis marked by failure to restructure bad debt -> Global recession -> Government deficits in U.S. and globally -> Conflict between single currency and disparate fiscal policies in Europe -> Austerity -> European recession and credit strains -> Global recession.

In effect, we’re going into another recession because we never effectively addressed the problems that produced the first one, leaving us unusually vulnerable to aftershocks.  Our economic malaise is the result of a whole chain of bad decisions that have distorted the financial markets in ways that make recurring crisis inevitable.

*   *   *

Every major bank is funded partially by depositors, but those deposits typically represent only about 60% of the funding.  The rest is debt to the bank’s own bondholders, and equity of its stockholders.  When a country like Spain goes in to save a failing bank like Bankia – and does so by buying stock in the bank – the government is putting its citizens in a “first loss” position that protects the bondholders at public expense.  This has been called “nationalization” because Spain now owns most of the stock, but the rescue has no element of restructuring at all.  All of the bank’s liabilities – even to its own bondholders – are protected at public expense.  So in order to defend bank bondholders, Spain is increasing the public debt burden of its own citizens.  This approach is madness, because Spain’s citizens will ultimately suffer the consequences by eventual budget austerity or risk of government debt default.

The way to restructure a bank is to take it into receivership, write down the bad assets, wipe out the stockholders and much of the subordinated debt, and then recapitalize the remaining entity by selling it back into the private market.  Depositors don’t lose a dime.  While the U.S. appropriately restructured General Motors – wiping out stock, renegotiating contracts, and subjecting bondholders to haircuts – the banking system was largely untouched.

*   *   *

If it seems as if the global economy has learned nothing, it is because evidently the global economy has learned nothing.  The right thing to do, again, is to take receivership of insolvent banks and wipe out the stock and subordinated debt, using the borrowed funds to protect depositors in the event that the losses run deep enough to eat through the intervening layers of liabilities (which is doubtful), and otherwise using the borrowed funds to stimulate the economy after the restructuring occurs.  We’re going to keep having crises until global leaders recognize that short of creating hyperinflation (which also subordinates the public, in this case by destroying the value of currency), there is no substitute for debt restructuring.

For some insight as to why the American megabanks were never taken into temporary receivership, it is useful to look back to February of 2010 when Michael Shedlock (a/k/a“Mish”) provided us with a handy summary of the 224-page Quarterly Report from SIGTARP (the Special Investigator General for TARP — Neil Barofsky).  My favorite comment from Mish appeared near the conclusion of his summary:

Clearly TARP was a complete failure, that is assuming the goals of TARP were as stated.

My belief is the benefits of TARP and the entire alphabet soup of lending facilities was not as stated by Bernanke and Geithner, but rather to shift as much responsibility as quickly as possible on to the backs of taxpayers while trumping up nonsensical benefits of doing so.  This was done to bail out the banks at any and all cost to the taxpayers.

Was this a huge conspiracy by the Fed and Treasury to benefit the banks at taxpayer expense?  Of course it was, and the conspiracy is unraveling as documented in this report and as documented in AIG Coverup Conspiracy Unravels.

On January 29 2010, David Reilly wrote an article for Bloomberg BusinessWeek concerning the previous week’s hearing before the House Committee on Oversight and Government Reform.  After quoting from Reilly’s article, Mish made this observation:

Most know I am not a big believer in conspiracies.  I regularly dismiss them.  However, this one was clear from the beginning and like all massive conspiracies, it is now in the light of day.

David Reilly began the Bloomberg Business Week piece this way:

The idea of secret banking cabals that control the country and global economy are a given among conspiracy theorists who stockpile ammo, bottled water and peanut butter.  After this week’s congressional hearing into the bailout of American International Group Inc., you have to wonder if those folks are crazy after all.

Wednesday’s hearing described a secretive group deploying billions of dollars to favored banks, operating with little oversight by the public or elected officials.

That “secretive group” is The Federal Reserve of New York, whose president at the time of the AIG bailout was “Turbo” Tim Geithner.  David Reilly’s disgust at the hearing’s revelations became apparent from the tone of his article:

By pursuing this line of inquiry, the hearing revealed some of the inner workings of the New York Fed and the outsized role it plays in banking.  This insight is especially valuable given that the New York Fed is a quasi-governmental institution that isn’t subject to citizen intrusions such as freedom of information requests, unlike the Federal Reserve.

At least in the Eurozone there is fear that the taxpayers will never submit to enhanced economic austerity measures, which would force the citizenry into an impoverished existence so that their increased tax burden could pay off the debts incurred by irresponsible bankers.  In the United States there is no such concern.  The public is much more compliant.  Whether that will change is anyone’s guess.


 

When the Music Stops

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Forget about all that talk concerning the Mayan calendar and December 21, 2012.  The date you should be worried about is January 1, 2013.  I’ve been reading so much about it that I decided to try a Google search using “January 1, 2013” to see what results would appear.  Sure enough – the fifth item on the list was an article from Peter Coy at Bloomberg BusinessWeek entitled, “The End Is Coming:  January 1, 2013”.  The theme of that piece is best summarized in the following passage:

With the attention of the political class fixated on the presidential campaign, Washington is in danger of getting caught in a suffocating fiscal bind.  If Congress does nothing between now and January to change the course of policy, a combination of mandatory spending reductions and expiring tax cuts will kick in – depriving the economy of oxygen and imperiling a recovery likely to remain fragile through the end of 2012.  Congress could inadvertently send the U.S. economy hurtling over what Federal Reserve Chairman Ben Bernanke recently called a “massive fiscal cliff of large spending cuts and tax increases.”

Peter Coy’s take on this impending crisis seemed a bit optimistic to me.  My perspective on the New Year’s Meltdown had been previously shaped by a great essay from the folks at Comstock Partners.  The Comstock explanation was particularly convincing because it focused on the effects of the Federal Reserve’s quantitative easing programs, emphasizing what many commentators describe as the Fed’s “Third Mandate”:  keeping the stock market inflated.  Beyond that, Comstock pointed out the absurdity of that cherished belief held by the magical-thinking, rose-colored glasses crowd:  the Fed is about to introduce another round of quantitative easing (QE 3).  Here is Comstock’s dose of common sense:

A growing number of indicators suggest that the market is running out of steam.  Equities have been in a temporary sweet spot where investors have been factoring in a self-sustaining U.S. economic recovery while also anticipating the imminent institution of QE3.  This is a contradiction.  If the economy were indeed as strong as they say, we wouldn’t need QE3.  The fact that market observers eagerly look forward toward the possibility of QE3 is itself an indication that the economy is weaker than they think.  We can have one or the other, but we can’t have both.

After two rounds of quantitative easing – followed by “operation twist” – the smart people are warning the rest of us about what is likely to happen when the music finally stops.  Here is Comstock’s admonition:

The economy is also facing the so-called “fiscal cliff” beginning on January 1, 2013.  This includes expiration of the Bush tax cuts, the payroll tax cuts, emergency unemployment benefits and the sequester.  Various estimates placed the hit to GDP as being anywhere between 2% and 3.5%, a number that would probably throw the economy into recession, if it isn’t already in one before then.  At about that time we will also be hitting the debt limit once again.   U.S. economic growth will also be hampered by recession in Europe and decreasing growth and a possible hard landing in China.

Technically, all of the good news seems to have been discounted by the market rally of the last three years and the last few months.  The market is heavily overbought, sentiment is extremely high, daily new highs are falling and volume is both low and declining.  In our view the odds of a significant decline are high.

Charles Biderman is the founder and Chief Executive Officer of TrimTabs Investment Research.  He was recently interviewed by Chris Martenson.  Biderman’s primary theme concerned the Federal Reserve’s “rigging” of the stock market through its quantitative easing programs, which have steered so much money into stocks that stock prices have now become a “function of liquidity” rather than fundamental value.  Biderman estimated that the Fed’s liquidity pump has fed the stock market “$1.8 billion per day since August”.  He does not believe this story will have a happy ending:

In January of ’10, I went on CNBC and on Bloomberg and said that there is no money coming into stocks, and yet the stock market keeps going up.  The law of supply and demand still exists and for stock prices to go up, there has to be more money buying those shares.  There is no other way in aggregate that that could happen.

So I said it has to be coming from the government.  And everybody thought I was a lunatic, conspiracy theorist, whatever.  And then lo and behold, on October of 2011, Mr. Bernanke then says officially, that the purpose of QE1 and QE2 is to raise asset prices.  And if I remember correctly, equities are an asset, and bonds are an asset.

So asset prices have gone up as the Fed has been manipulating the market. At the same time as the economy is not growing (or not growing very fast).

*   *   *

At some point, the world is going to recognize the Emperor is naked. The only question is when.

Will it be this year?  I do not think it will be before the election, I think there is too much vested interest in keeping things rosy and positive.

One of my favorite economists is John Hussman of the Hussman Funds.  In his most recent Weekly Market Comment, Dr. Hussman warned us that the “music” must eventually stop:

What remains then is a fairly simple assertion:  the primary way to boost corporate profits to abnormally high – but unsustainable – levels is for the government and the household sector to both spend beyond their means at the same time.

*   *   *

The conclusion is straightforward.  The hope for continued high profit margins really comes down to the hope that government and the household sector will both continue along unsustainable spending trajectories indefinitely.  Conversely, any deleveraging of presently debt-heavy government and household balance sheets will predictably create a sustained retreat in corporate profit margins.  With the ratio of corporate profits to GDP now about 70% above the historical norm, driven by a federal deficit in excess of 8% of GDP and a deeply depressed household saving rate, we view Wall Street’s embedded assumption of a permanently high plateau in profit margins as myopic.

Will January 1, 2013 be the day when the world realizes that “the Emperor is naked”?  Will the American economy fall off the “massive fiscal cliff of large spending cuts and tax increases” eleven days after the end of the Mayan calendar?  When we wake-up with our annual New Year’s Hangover on January 1 – will we all regret not having followed the example set by those Doomsday Preppers on the National Geographic Channel?

Get your “bug-out bag” ready!  You still have nine months!


 

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No Consensus About the Future

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As the election year progresses, we are exposed to wildly diverging predictions about the future of the American economy.  The Democrats are telling us that in President Obama’s capable hands, the American economy keeps improving every day – despite the constant efforts by Congressional Republicans to derail the Recovery Express.  On the other hand, the Republicans keep warning us that a second Obama term could crush the American economy with unrestrained spending on entitlement programs.  Meanwhile, in (what should be) the more sober arena of serious economics, there is a wide spectrum of expectations, motivated by concerns other than partisan politics.  Underlying all of these debates is a simple question:  How can one predict the future of the economy without an accurate understanding of what is happening in the present?  Before asking about where we are headed, it might be a good idea to get a grip on where we are now.  Nevertheless, exclusive fixation on past and present conditions can allow future developments to sneak up on us, if we are not watching.

Those who anticipate a less resilient economy consistently emphasize that the “rose-colored glasses crowd” has been basing its expectations on a review of lagging and concurrent economic indicators rather than an analysis of leading economic indicators.  One of the most prominent economists to emphasize this distinction is John Hussman of the Hussman Funds.  Hussman’s most recent Weekly Market Comment contains what has become a weekly reminder of the flawed analysis used by the optimists:

On the economy, our broad view is based on dozens of indicators and multiple methods, and the overall picture is much better described as a modest rebound within still-fragile conditions, rather than a recovery or a clear expansion.  The optimism of the economic consensus seems to largely reflect an over-extrapolation of weather-induced boosts to coincident and lagging economic indicators — particularly jobs data.  Recall that seasonal adjustments in the winter months presume significant layoffs in the retail sector and slow hiring elsewhere, and therefore add back “phantom” jobs to compensate.

Hussman’s kindred spirit, Lakshman Achuthan of the Economic Cycle Research Institute (ECRI), has been criticized for the predictiction he made last September that the United States would fall back into recession.  Nevertheless, the ECRI reaffirmed that position on March 15 with a website posting entitled, “Why Our Recession Call Stands”.  Again, note the emphasis on leading economic indicators – rather than concurrent and lagging economic indicators:

How about forward-looking indicators?  We find that year-over-year growth in ECRI’s Weekly Leading Index (WLI) remains in a cyclical downturn . . .  and, as of early March, is near its worst reading since July 2009.  Close observers of this index might be understandably surprised by this persistent weakness, since the WLI’s smoothed annualized growth rate, which is much better known, has turned decidedly less negative in recent months.

Unlike the partisan political rhetoric about the economy, prognostication expressed by economists can be a bit more subtle.  In fact, many of the recent, upbeat commentaries have quite restrained and cautious.  Consider this piece from The Economist:

A year ago total bank loans were shrinking.  Now they are growing.  Loans to consumers have risen by 5% in the past year, which has accompanied healthy gains in car sales (see chart).  Mortgage lending was still contracting as of late 2011 but although house prices are still edging lower both sales and construction are rising.

*   *   *

At present just four states are reporting mid-year budget gaps, according to the National Conference of State Legislatures; this time last year, 15 did; the year before that, 36. State and local employment, which declined by 655,000 between August 2008 and last December – a fall of 3.3% – has actually edged up since.

*   *   *

Manufacturing employment, which declined almost continuously from 1998 through 2009, has since risen by nearly 4%, and the average length of time factories work is as high as at any time since 1945.  Since the end of the recession exports have risen by 39%, much faster than overall GDP.  Neither is as impressive as it sounds:  manufacturing employment remains a smaller share of the private workforce than in 2007, and imports have recently grown even faster than exports as global growth has faltered and the dollar has climbed.  Trade, which was a contributor to economic growth in the first years of recovery, has lately been a drag.

But economic recovery doesn’t have to wait for all of America’s imbalances to be corrected.  It only needs the process to advance far enough for the normal cyclical forces of employment, income and spending to take hold.  And though their grip may be tenuous, and a shock might yet dislodge it, it now seems that, at last, they have.

A great deal of enthusiastic commentary was published in reaction to the results from the recent round of bank stress tests, released by the Federal Reserve.  The stress test results revealed that 15 of the 19 banks tested could survive a stress scenario which included a peak unemployment rate of 13 percent, a 50 percent drop in equity prices, and a 21 percent decline in housing prices.  Time magazine published an important article on the Fed’s stress test results.  It was written by a gentleman named Christopher Matthews, who used to write for Forbes and the Financial Times.  (He is a bit younger than the host of Hardball.)  In a surprising departure from traditional, “mainstream media propaganda”, Mr. Matthews demonstrated a unique ability to look “behind the curtain” to give his readers a better idea of where we are now:

Christopher Whalen, a bank analyst and frequent critic of the big banks, penned an article in ZeroHedge questioning the assumptions, both by the Fed and the banks themselves, that went into the tests.  It’s well known that housing remains a thorn in the side of the big banks, and depressed real estate prices are the biggest risk to bank balance sheets.  The banks are making their own assumptions, however, with regards to the value of their real estate holdings, and Whalen is dubious of what the banks are reporting on their balance sheets. The Fed, he says, is happy to go along with this massaging of the data. He writes,

“The Fed does not want to believe that there is a problem with real estate. As my friend Tom Day wrote for PRMIA’s DC chapter yesterday:  ‘It remains hard to believe, on the face of it, that many of the more damaged balance sheets could, in fact, withstand another financial tsunami of the magnitude we have recenlty experienced and, to a large extent, continue to grapple with.’ ”

Even those that are more credulous are taking exception to the Fed’s decision to allow the banks to increase dividends and stock buybacks.  The Bloomberg editorial board wrote an opinion yesterday criticizing this decision:

 “Good as the stress tests were, they don’t mean the U.S. banking system is out of the woods.  Three major banks – Ally Financial Inc., Citigroup Inc. and SunTrust Banks Inc. – didn’t pass, and investors still don’t have much faith in the reported capital levels of many of the rest.  If the Fed wants the positive results of the stress tests to last, it should err on the side of caution in approving banks’ plans to pay dividends and buy back shares – moves that benefit shareholders but also deplete capital.”

So there’s still plenty for skeptics to read into Tuesday’s report.  For those who want to doubt the veracity of the banks’ bookkeeping, you can look to Whalen’s report.  For those who like to question the Fed’s decision making, Bloomberg’s argument is as good as any.  But at the same time, we all know from experience that things could be much worse, and Tuesday’s announcement appears to be another in a string of recent good news that, unfortunately, comes packaged with a few caveats.  When all is said and done, this most recent test may turn out to be another small, “I think I can” from the little recovery that could.

When mainstream publications such as Time and Bloomberg News present reasoned analysis about the economy, it should serve as reminder to political bloviators that the only audience for the partisan rhetoric consists of “low-information voters”.  The old paradigm – based on campaign funding payola from lobbyists combined with support from low-information voters – is being challenged by what Marshall McLuhan called “the electronic information environment”.  Let’s hope that sane economic policy prevails.


 

Rampant Stock Market Pumping

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It has always been one of my pet peeves.  The usual stock market cheerleaders start chanting into the echo chamber.  Do they always believe that their efforts will create a genuine, consensus reality?  A posting at the Daily Beast website by Zachary Karabell caught my attention.  The headline said, “Bells Are Ringing!  Confidence Rises as the Dow –  Finally – Hits 13,000 Again”.  After highlighting all of the exciting news, Mr. Karabell was thoughtful enough to mention the trepidation experienced by a good number of money managers, given all the potential risks out there.  Nevertheless, the piece concluded with this thought:

The crises that have obsessed markets for the past years – debt and defaults, housing markets, Europe and Greece– are winding down.  And markets are gearing up.  Maybe it’s time to focus on that.

As luck would have it, my next stop was at the Pragmatic Capitalism blog, where I came across a clever essay by Lance Roberts, which had been cross-posted from his Streettalklive website.  The title of the piece, “Media Headlines Will Lead You To Ruin”, jumped right out at me.  Here’s how it began:

It’s quite amazing actually.   Two weeks ago Barron’s ran the cover page of “Dow 15,000?.  Over the weekend Alan Abelson ran a column titled “Everyone In The Pool”.  Today, CNBC leads with “Dow 13,000 May Finally Lure Investors Back Into Stocks”.   Unfortunately, for most investors, the headline is probably right.  Investors, on the whole, have a tendency to do exactly the opposite of what they should do when it comes to investing – “Buy High and Sell Low.”  The reality is that the emotions of greed and fear do more to cause investors to lose money in the market than being robbed at the point of a gun.

Take a look at the chart of the data from ICI who tracks flows of money into and out of mutual funds.  When markets are correcting investors panic and sell out of stocks with the majority of the selling occurring near the lows of the market.  As the markets rally investors continue to sell as they disbelieve the rally intially and are just happy to be getting some of their money back.  However, as the rally continues to advance from oversold conditions – investors are “lured” back into the water as memories of the past pain fades and the “greed factor” overtakes their logic.  Unfortunately, this buying always tends to occur at, or near, market peaks.

Lance Roberts provided some great advice which you aren’t likely to hear from the cheerleading perma-bulls – such as, “getting back to even is not an investment strategy.”

As a longtime fan of the Zero Hedge blog, I immediately become cynical at the first sign of irrational exuberance demonstrated by any commentator who downplays economic headwinds while encouraging the public to buy, buy, buy.  Those who feel tempted to respond to that siren song would do well to follow the Weekly Market Comments by economist John Hussman of the Hussman Funds.  In this week’s edition, Dr. Hussman admitted that there may still be an opportunity to make some gains, although the risks weigh heavily toward a more cautious strategy:

The bottom line is that near-term market direction is largely a throw of the dice, though with dice that are modestly biased to the downside.  Indeed, the present overvalued, overbought, overbullish syndrome tends to be associated with a tendency for the market to repeatedly establish slight new highs, with shallow pullbacks giving way to further marginal new highs over a period of weeks.  This instance has been no different.  As we extend the outlook horizon beyond several weeks, however, the risks we observe become far more pointed.  The most severe risk we measure is not the projected return over any particular window such as 4 weeks or 6 months, but is instead the likelihood of a particularly deep drawdown at some point within the coming 18-month period.

Economist Nouriel Roubini (a/k/a Dr. Doom) provided a sobering counterpoint to the recent stock market enthusiasm in a piece he wrote for the Project Syndicate website entitled, “The Uptick’s Downside”.  Dr. Roubini focused on the fact that “at least four downside risks are likely to materialize this year”.  These include:  “fiscal austerity pushing the eurozone periphery into economic free-fall” as well as “evidence of weakening performance in China and the rest of Asia”.  The third and fourth risks were explained in the following terms:

Third, while US data have been surprisingly encouraging, America’s growth momentum appears to be peaking.  Fiscal tightening will escalate in 2012 and 2013, contributing to a slowdown, as will the expiration of tax benefits that boosted capital spending in 2011.  Moreover, given continuing malaise in credit and housing markets, private consumption will remain subdued; indeed, two percentage points of the 2.8% expansion in the last quarter of 2011 reflected rising inventories rather than final sales.  And, as for external demand, the generally strong dollar, together with the global and eurozone slowdown, will weaken US exports, while still-elevated oil prices will increase the energy import bill, further impeding growth.

Finally, geopolitical risks in the Middle East are rising, owing to the possibility of an Israeli military response to Iran’s nuclear ambitions.  While the risk of armed conflict remains low, the current war of words is escalating, as is the covert war in which Israel and the US are engaged with Iran; and now Iran is lashing back with terrorist attacks against Israeli diplomats.

Any latecomers to the recent festival of bullishness should be mindful of the fact that their fellow investors could suddenly feel inspired to head for the exits in response to one of these risks.  Lance Roberts said it best in the concluding paragraph of his February 21 commentary:

With corporate earnings now slowing sharply, the economy growing at a sub-par rate, the Eurozone headed towards a prolonged recession and the American consumer facing higher gas prices and reduced incomes, a continued bull market rally from here is highly suspect.   Add to those economic facts the technical aspects of a very extended market with overbought internals – the reality is that this is a better place to be selling investments versus buying them.  Or – go to Vegas and bet on black.


 

Government Should Listen To These Wealth Managers

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A good deal of Mitt Romney’s appeal as a Presidential candidate is based on his experience as a private equity fund manager – despite the “vulture capitalist” moniker, favored by some of his critics.  Many voters believe that America needs someone with more “business sense” in the White House.  Listening to Mitt Romney would lead one to believe that America’s economic and unemployment problems will not be solved until “government gets out of the way”, allowing those sanctified “job creators” to bring salvation to the unemployed masses.  Those who complained about how the system has been rigged against the American middle class during the past few decades have found themselves accused of waging “class warfare”.  We are supposed to believe that Romney speaks on behalf of “business” when he lashes out against “troublesome” government regulations which hurt the corporate bottom line and therefore – all of America.

Nevertheless, the real world happens to be the home of many wealth managers – entrusted with enormous amounts of money by a good number of rich people and institutional investors – who envision quite a different role of government than the mere nuisance described by Romney and like-minded individuals.  If only our elected officials – and more of the voting public – would pay close attention to the sage advice offered by these wealth managers, we might be able to solve our nation’s economic and unemployment problems.

Last summer, bond guru Bill Gross of PIMCO  lamented the Obama administration’s obliviousness to the need for government involvement in short-term job creation:

Additionally and immediately, however, government must take a leading role in job creation.  Conservative or even liberal agendas that cede responsibility for job creation to the private sector over the next few years are simply dazed or perhaps crazed.  The private sector is the source of long-term job creation but in the short term, no rational observer can believe that global or even small businesses will invest here when the labor over there is so much cheaper.  That is why trillions of dollars of corporate cash rest impotently on balance sheets awaiting global – non-U.S. – investment opportunities.  Our labor force is too expensive and poorly educated for today’s marketplace.

*   *   *

In the near term, then, we should not rely solely on job or corporate-directed payroll tax credits because corporations may not take enough of that bait, and they’re sitting pretty as it is.  Government must step up to the plate, as it should have in early 2009.

In my last posting, I discussed a February 2 Washington Post commentary by Mohamed El-Erian (co-CEO of PIMCO).  El-Erian emphasized that – despite the slight progress achieved in reducing unemployment – the situation remains at a crisis level, demanding immediate efforts toward resolution:

Have no doubt, this is a complex, multiyear effort that involves several government agencies acting in a delicate, coordinated effort.  It will not happen unless our political leaders come together to address what constitutes America’s biggest national challenge. And sustained implementation will not be possible nor effective without much clearer personal accountability.

One would think that, given all this, it has become more than paramount for Washington to elevate – not just in rhetoric but, critically, through sustained actions – the urgency of today’s unemployment crisis to the same level that it placed the financial crisis three years ago.  But watching the actions in the nation’s capital, I and many others are worried that our politicians will wait at least until the November elections before dealing more seriously with the unemployment crisis.

On October 31, I focused on the propaganda war waged against the Occupy Wall Street movement, concluding the piece with my expectation that Jeremy Grantham’s upcoming third quarter newsletter would provide some sorely-needed, astute commentary on the situation.  Jeremy Grantham, rated by Bloomberg BusinessWeek as one of the Fifty Most Influential Money Managers, released an abbreviated edition of that newsletter one month later than usual, due to a busy schedule.  In addition to expressing some supportive comments about the OWS movement, Grantham noted that he would provide a special supplement, based specifically on that subject.  Finally, on February 5, Mr. Grantham made good on his promise with an opinion piece in the Financial Times entitled, “People now see it as a system for the rich only”:

For the time being, in the US our corporate and governmental system backed surprisingly by the Supreme Court has become a plutocracy, designed to prolong, protect and intensify the wealth and influence of those who already have the wealth and influence.  What the Occupy movement indicates is that a growing number of people have begun to recognise this in spite of the efficiency of capital’s propaganda machines.  Forty years of no pay increase in the US after inflation for the average hour worked should, after all, have that effect.  The propaganda is good but not that good.

*   *   *

In 50 years economic mobility in the US has gone from the best to one of the worst.  The benefits of the past 40 years of quite normal productivity have been abnormally divided between the very rich (and corporations) and the workers.

Indeed “divide” is not the right word, for, remarkably, the workers received no benefit at all, while the top 0.1 per cent has increased its share nearly fourfold in 35 years to a record equal to 1929 and the gilded age.

But the best propaganda of all is that the richest 400 people now have assets equal to the poorest 140m.  If that doesn’t disturb you, you have a wallet for a heart.  The Occupiers’ theme should be simple:  “More sensible assistance for the working poor, more taxes for the rich.”

I’ve complained many times about President Obama’s decision to scoff at using the so-called “Swedish solution” of putting the zombie banks through temporary receivership.  Back in November of 2010, economist John Hussman of the Hussman Funds discussed the consequences of the administration’s failure to do what was necessary:

If our policy makers had made proper decisions over the past two years to clean up banks, restructure debt, and allow irresponsible lenders to take losses on bad loans, there is no doubt in my mind that we would be quickly on the course to a sustained recovery, regardless of the extent of the downturn we have experienced.  Unfortunately, we have built our house on a ledge of ice.

*   *   *

As I’ve frequently noted, even if a bank “fails,” it doesn’t mean that depositors lose money.  It means that the stockholders and bondholders do.  So if it turns out, after all is said and done, that the bank is insolvent, the government should get its money back and the remaining entity should be taken into receivership, cut away from the stockholder liabilities, restructured as to bondholder liabilities, recapitalized, and reissued.  We did this with GM, and we can do it with banks.  I suspect that these issues will again become relevant within the next few years.

The plutocratic tools in control of our government would never allow the stockholders and bondholders of those “too-big-to-fail” banks to suffer losses as do normal people after making bad investments.  It’s hard to imagine that Mitt Romney would take a tougher stance against those zombie banks than what we have seen from the Obama administration.

Our government officials – from across the political spectrum – would be wise to follow the advice offered by these fund managers.  A political hack whose livelihood is based entirely on passive income has little to offer in the way of “business sense” when compared to a handful of fund managers, entrusted to use their business and financial acumen to preserve so many billions of dollars.  Who speaks for business?  It should be those business leaders who demonstrate concern for the welfare of all human beings in America.


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Recession Watch

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A recession relapse is the last thing Team Obama wants to see during this election year.  The President’s State of the Union address featured plenty of “happy talk” about how the economy is improving.  Nevertheless, more than a few wise people have expressed their concerns that we might be headed back into another period of at least six months of economic contraction.

Last fall, the Economic Cycle Research Institute (ECRI) predicted that the United States would fall back into recession.  More recently, the ECRI’s weekly leading index has been showing small increments of improvement, although not enough to dispel the possibility of a relapse.  Take a look at the chart which accompanied the January 27 article by Mark Gongloff of The Wall Street Journal.  Here are some of Mr. Gongloff’s observations:

The index itself actually ticked down a bit, to 122.8 from 123.3 the week before, but that’s still among the highest readings since this summer.

*   *   *

That’s still not great, still in negative territory where it has been since the late summer.  But it is the best growth rate since September 2.

Whatever that means.  It’s hard to say this index is telling us whether a recession is coming or not, because the ECRI’s recession call is based on top-secret longer leading indexes.

Economist John Hussman of the Hussman Funds has been in full agreement with the ECRI’s recession call since it was first published.  In his most recent Weekly Market Comment, Dr. Hussman discussed the impact of an increasingly probable recession on deteriorating stock market conditions:

Once again, we now have a set of market conditions that is associated almost exclusively with steeply negative outcomes.  In this case, we’re observing an “exhaustion” syndrome that has typically been followed by market losses on the order of 25% over the following 6-7 month period (not a typo).  Worse, this is coupled with evidence from leading economic measures that continue to be associated with a very high risk of oncoming recession in the U.S. – despite a modest firming in various lagging and coincident economic indicators, at still-tepid levels.  Compound this with unresolved credit strains and an effectively insolvent banking system in Europe, and we face a likely outcome aptly described as a Goat Rodeo.

My concern is that an improbably large number of things will have to go right in order to avoid a major decline in stock market value in the months ahead.

Another fund manager expressing similar concern is bond guru Jeffrey Gundlach of DoubleLine Capital. Daniel Fisher of Forbes recently interviewed Gundlach, who explained that he is more afraid of recession than of higher interest rates.

Many commentators have discussed a new, global recession, sparked by a recession across Europe.  Mike Shedlock (a/k/a Mish), recently emphasized that “without a doubt Europe is already in recession.”  It is feared that the recession in Europe – where America exports most of its products – could cause another recession in the United States, as a result of decreased demand for the products we manufacture.  The January 24 World Economic Outlook Update issued by the IMF offered this insight:

The euro area economy is now expected to go into a mild recession in 2012 – consistent with what was presented as a downside scenario in the January 2011 WEO Update.

*   *   *

For the United States, the growth impact of such spillovers is broadly offset by stronger underlying domestic demand dynamics in 2012.  Nonetheless, activity slows from the pace reached during the second half of 2011, as higher risk aversion tightens financial conditions and fiscal policy turns more contractionary.

On January 28, Steve Odland of Forbes suggested that the Great Recession, which began in the fourth quarter of 2007, never really ended.  Odland emphasized that the continuing drag of the housing market, the lack of liquidity for small businesses to create jobs, despite trillions of dollars in cash on the sidelines, has resulted in an “invisible recovery”.

Jennifer Smith of The Wall Street Journal explained how this situation has played out at law firms:

Conditions at law firms have stabilized since 2009, when the legal industry shed 41,900 positions, according to the Labor Department.  Cuts were more moderate last year, with some 2,700 positions eliminated, and recruiters report more opportunities for experienced midlevel associates.

But many elite firms have shrunk their ranks of entry-level lawyers by as much as half from 2008, when market turmoil was at its peak.

Regardless of whether the economic recovery may have been “invisible”, economist Nouriel Roubini (a/k/a Dr. Doom) has consistently described the recovery as “U-shaped” rather than the usual “V-shaped” graph pattern we have seen depicting previous recessions.  Today Online reported on a discussion Dr. Roubini held concerning this matter at the World Economic Forum’s meeting in Davos:

Slow growth in advanced economies will likely lead to “a U-shaped recovery rather than a typical V”, and could last up to 10 years if there is too much debt in the public and private sector, he said.

At a panel discussion yesterday, Dr Roubini also said Greece will probably leave Europe’s single currency within 12 months and could soon be followed by Portugal.

“The euro zone is a slow-motion train wreck,” he said.  “Not only Greece, other countries as well are insolvent.”

In a December 8 interview conducted by Tom Keene on Bloomberg Television’s “Surveillance Midday”, Lakshman Achuthan, chief operations officer of the Economic Cycle Research Institute, explained his position:

“The downturn we have now is very different than the downturn in 2010, which did not persist.  This one is persisting.”

*  *  *

“If there’s no recession in Q4 or in the first half I’d say of 2012, then we’re wrong.  …   You’re not going to know whether or not we’re wrong until a year from now.”

I’m afraid that we might know the answer before then.


 

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Scary Economic News

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The information which I’m passing along to you today might come as a shock to those listening to the usual stock market cheerleaders, who predict good times ahead.  Let’s start with economist John Hussman of the Hussman Funds.  For quite a while, Dr. Hussman has been warning us to avoid drinking the Kool-Aid served by the perma-bulls.  In his latest Weekly Market Comment, Hussman offers yet more sound advice to those under the spell of brokerage propagandists:

I want to emphasize again that I am neither a cheerleader for recession, nor a table-pounder for recession.  It’s just that given the data that we presently observe, an oncoming recession remains the most probable outcome.  When unseen states of the world have to be inferred from imperfect and noisy observable data, there are a few choices when the evidence isn’t 100%.  You can either choose a side and pound the table, or you can become comfortable dwelling in uncertainty, and take a position in proportion to the evidence, and the extent to which each possible outcome would affect you.

With most analysts dismissing the likelihood of recession, I have been vocal about ongoing recession concerns not because I want to align myself with one side, but because the investment implications are very asymmetric.  A slow but steady stream of modestly good economic news is largely priced in by investors, but a recession and the accompanying earnings disappointments would destroy some critical pillars of hope that investors are relying on to support already rich valuations.

Yale Professor Robert Shiller is the guy who invented the term “irrational exuberance”, which was title of his bestselling book – published in May of 1996.  Although the widely-despised, former Federal Reserve Chairman, Alan Greenspan is often credited with creating the term, Greenspan didn’t use it until December of that year, in a speech before the American Enterprise Institute.  Shiller is most famous for his role as co-creator of the Case-Shiller Home Price Indices, which he developed with his fellow economists Karl Case and Allan Weiss.  While many commentators decried the idiotic economic austerity programs which have been inflicted across Europe, Professor Shiller investigated whether austerity is at all effective in spurring economic growth, seeking a better understanding of austerity’s consequences.  In a recent essay on the subject, Dr. Shiller cited the work by Jaime Guajardo, Daniel Leigh, and Andrea Pescatori of the International Monetary Fund, who recently studied austerity plans implemented by governments in 17 countries in the last 30 years.  The conclusion reached by Professor Shiller should sober-up the “rose-colored glasses” crowd, as well as those aspiring to implement similar measures in the United States:

The austerity plans being adopted by governments in much of Europe and elsewhere around the world, and the curtailment of consumption expenditure by individuals as well, threaten to produce a global recession.

*   *   *

There is no abstract theory that can predict how people will react to an austerity program.  We have no alternative but to look at the historical evidence.  And the evidence of Guajardo and his co-authors does show that deliberate government decisions to adopt austerity programs have tended to be followed by hard times.

Policymakers cannot afford to wait decades for economists to figure out a definitive answer, which may never be found at all.  But, judging by the evidence that we have, austerity programs in Europe and elsewhere appear likely to yield disappointing results.

The really scary news concerning the state of the global economy came in the form of a report published by the World Bank, entitled Global Economic Prospects (Uncertainties and vulnerabilities).  The 157-page treatise was written by Andrew Burns and Theo Janse van Rensburg.  It contains more than enough information to induce a serious case of insomnia.  Here are some examples:

The world economy has entered a very difficult phase characterized by significant downside risks and fragility.

*   *   *

The downturn in Europe and weaker growth in developing countries raises the risk that the two developments reinforce one another, resulting in an even weaker outcome.  At the same time, the slow growth in Europe complicates efforts to restore market confidence in the sustainability of the region’s finances, and could exacerbate tensions.

*   *   *

While contained for the moment, the risk of a much broader freezing up of capital markets and a global crisis similar in magnitude to the Lehman crisis remains.  In particular, the willingness of markets to finance the deficits and maturing debt of high-income countries cannot be assured.  Should more countries find themselves denied such financing, a much wider financial crisis that could engulf private banks and other financial institutions on both sides of the Atlantic cannot be ruled out.  The world could be thrown into a recession as large or even larger than that of 2008/09.

*   *   *

In the event of a major crisis, activity is unlikely to bounce back as quickly as it did in 2008/09, in part because high-income countries will not have the fiscal resources to launch as strong a countercyclical policy response as in 2008/09 or to offer the same level of support to troubled financial institutions.

*   *   *

Developing countries need to prepare for the worst

In this highly uncertain environment, developing countries should evaluate their vulnerabilities and prepare contingencies to deal with both the immediate and longer-term effects of a downturn.

If global financial markets freeze up, governments and firms may not be able to finance growing deficits.

*   *   *

One major uncertainty concerns the interaction of the policy-driven slowing of growth in middle-income countries, and the financial turmoil driven slowing in Europe.  While desirable from a domestic policy point of view, this slower growth could interact with the slowing in Europe resulting in a downward overshooting of activity and a more serious global slowdown than otherwise would have been the case.

In other words, Europe’s economic austerity programs could turn another round of economic contraction into a global catastrophe (as if we needed another).

This is what happens when economic policymaking is left to the plutocrats and their tools.  “Those who fail to learn from the past are doomed to repeat it.”  It appears as though we are well on our way to a second financial crisis – with more severe consequences than those experienced as a result of the 2008 episode.


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Trouble Ahead

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I find it very amusing that we are being bombarded with so many absurd election year “talking points” and none of them concern the risk of a 2012 economic recession.  The entire world seems in denial about a global problem which is about to hit everyone over the head.  I’m reminded of the odd brainstorming session in September of 2008, when Presidential candidates Obama and McCain were seated at the same table with a number of econ-honchos, all of whom were scratching their heads in confusion about the financial crisis.  Something similar is about to happen again.  You might expect our leaders to be smart enough to avoid being blindsided by an adverse economic situation – again – but this is not a perfect world.  It’s not even a mediocre world.

After two rounds of quantitative easing, the Kool-Aid drinkers are sipping away, in anticipation of the “2012 bull market”.  Even the usually-bearish Doug Kass recently enumerated ten reasons why he expects the stock market to rally “in the near term”.  I was more impressed by the reaction posted by a commenter – identified as “Skateman” at the Pragmatic Capitalism blog.  Kass’ reason #4 is particularly questionable:

Mispaced preoccupation with Europe:  The European situation has improved.   .  .  .

Skateman’s reaction to Kass’ reason #4 makes more sense:

The Europe situation has not improved.  There is no escape from ultimate disaster here no matter how the deck chairs are rearranged.  Market’s just whistling past the graveyard.

Of particular importance was this recent posting by Mike Shedlock (a/k/a Mish), wherein he emphasized that “without a doubt Europe is already in recession.”  After presenting his readers with the most recent data supporting his claim, Mish concluded with these thoughts:

Telling banks to lend in the midst of a deepening recession with numerous austerity measures yet to kick in is simply absurd.  If banks did increase loans, it would add to bank losses.  The smart thing for banks to do is exactly what they are doing, parking cash at the ECB.

Austerity measures in Italy, Spain, Portugal, Greece, and France combined with escalating trade wars ensures the recession will be long and nasty.

*   *   *

Don’t expect the US to be immune from a Eurozone recession and a Chinese slowdown.  Unlike 2011, it will not happen again.

Back on October 8, Jeff Sommer wrote an article for The New York Times, discussing the Economic Cycle Research Institute’s forecast of another recession:

“If the United States isn’t already in a recession now it’s about to enter one,” says Lakshman Achuthan, the institute’s chief operations officer.  It’s just a forecast.  But if it’s borne out, the timing will be brutal, and not just for portfolio managers and incumbent politicians.  Millions of people who lost their jobs in the 2008-9 recession are still out of work.  And the unemployment rate in the United States remained at 9.1 percent in September.  More pain is coming, says Mr. Achuthan.  He thinks the unemployment rate will certainly go higher.  “I wouldn’t be surprised if it goes back up into double digits,” he says.

Mr. Achuthan’s outlook was echoed by economist John Hussman of the Hussman Funds, who pointed out in his latest Weekly Market Comment that investors have been too easily influenced by recent positive economic data such as payroll reports and Purchasing Managers Indices:

I can understand this view in the sense that the data points are correct – economic data has come in above expectations for several weeks, the Chinese, European and U.S. PMI’s have all ticked higher in the latest reports, new unemployment claims have declined, and December payrolls grew by 200,000.

Unfortunately, in all of these cases, the inference being drawn from these data points is not supported by the data set of economic evidence that is presently available, which is instead historically associated with a much more difficult outcome.  Specifically, the data set continues to imply a nearly immediate global economic downturn.  Lakshman Achuthan of the Economic Cycle Research Institute (ECRI) has noted if the U.S. gets through the second quarter of this year without falling into recession, “then, we’re wrong.”  Frankly, I’ll be surprised if the U.S. gets through the first quarter without a downturn.

At the annual strategy seminar held by Société Générale, their head of strategy – Albert Edwards – attracted quite a bit of attention with his grim prognostications.  The Economist summarized his remarks this way:

The surprise message for investors is that he feels the US is on the brink of another recession, despite the recent signs of optimism in the data (the non-farm payrolls, for example).  The recent temporary boost to consumption is down to a fall in the household savings ratio, which he thinks is not sustainable.

Larry Elliott of The Guardian focused on what Albert Edwards had to say about China and he provided more detail concerning Edwards’ remarks about the United States:

“There is a likelihood of a China hard landing this year.  It is hard to think 2013 and onwards will be any worse than this year if China hard-lands.”

*   *   *

He added that despite the recent run of more upbeat economic news from the United States, the risk of another recession in the world’s biggest economy was “very high”.  Growth had slowed to an annual rate of 1.5% in the second and third quarters of 2011, below the “stall speed” that historically led to recession.  It was unlikely that the economy would muddle through, Edwards said.

So there you have it.  The handwriting is on the wall.  Ignore it at your peril.


 

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European Sovereign Debt Crisis Gets Scary

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The simplest explanation of the European sovereign debt crisis came from Joe Weisenthal at the Business Insider website.  He compared the yield on the 5-year bond for Sweden with that of Finland, illustrated by charts, which tracked those yields for the past year:

Basically they look identical all through the year up until November and then BAM.  Finnish yields are exploding higher, right as Swedish yields are blasting lower.

The only obvious difference between the two:   Finland is part of the Eurozone, meaning it can’t print its own money. Sweden has no such risk.

While everyone’s attention was focused on the inability of Greece to pay the skyrocketing interest rates on its bonds, Italy snuck up on us.  The Italian debt crisis has become so huge that many commentators are voicing concern that “sovereign debt contagion” across the Eurozone is spreading faster than we could ever imagine.  The Los Angeles Times is now reporting that Moody’s Investors Service is ready to hit the panic button:

Throwing more logs on the Eurozone fire, Moody’s Investors Service said early Monday that the continent’s debt crisis now is “threatening the credit standing of all European sovereigns.”

That’s a not-so-subtle warning that even Moody’s top-rung Aaa ratings of countries including Germany, France, Austria and the Netherlands could be in jeopardy.

Meanwhile, every pundit seems to have a different opinion about how the crisis will unfold and what should be done about it.  The latest buzz concerns a widely-published rumor that the IMF is preparing a 600 billion euro ($794 billion) loan for Italy.  The problem with that scenario is that most of those billions would have to come from the United States – meaning that Congress would have to approve it.  Don’t count on it.  Former hedge fund manager, Bruce Krasting provided a good explanation of the Italian crisis and its consequences:

I think the Italian story is make or break.  Either this gets fixed or Italy defaults in less than six months.  The default option is not really an option that policy makers would consider.  If Italy can’t make it, then there will be a very big crashing sound.  It would end up taking out most of the global lenders, a fair number of countries would follow into Italy’s vortex.  In my opinion a default by Italy is certain to bring a global depression; one that would take many years to crawl out of.  The policy makers are aware of this too.

So I say something is brewing.  And yes, if there is a plan in the works it must involve the IMF.  And yes, it’s going to be big.

Please do not read this and conclude that some headline is coming that will make us all feel happy again.  I think headlines are coming.  But those headlines are likely to scare the crap out of the markets once the implications are understood.

In the real world of global finance the reality is that any country that is forced to accept an IMF bailout is also blocked from issuing debt in the public markets.  IMF (or other supranational debt) is ALWAYS senior to other indebtedness of the country. That’s just the way it works.  When Italy borrows money from the IMF it automatically subordinates the existing creditors. Lenders hate this.  They will vote with their feet and take a pass at Italian new debt issuance for a long time to come.  Once the process starts, it will not end.  There will be a snow ball of other creditors.  That’s exactly what happened in the 80’s when Mexico failed; within a year two dozen other countries were forced to their debt knees.  (I had a front row seat.)

I don’t see a way out of this box.  The liquidity crisis in Italy is scaring us to death, the solution will almost certainly kill us.

Forcing taxpayers to indemnify banks which made risky bets on European sovereign debt is popular with K Street lobbyists and their Congressional puppets.  This has led most people to assume that we will be handed the bill.  Fortunately, there are some smart people around, who are devising better ways to get “out of this box”.  Economist John Hussman of the Hussman Funds, proposed this idea to facilitate significant writedowns on Greek bonds while helping banks cope the impact of accepting 25 percent of the face value of those bonds, rather than the hoped-for 50 percent:

Given the extremely high leverage ratios of European banks, it appears doubtful that it will be possible to obtain adequate capital through new share issuance, as they would essentially have to duplicate the existing float.  For that reason, I suspect that before this is all over, much of the European banking system will be nationalized, much of the existing debt of the European banking system will be restructured, and those banks will gradually be recapitalized, post-restructuring and at much smaller leverage ratios, through new IPOs to the market.  That’s how to properly manage a restructuring – you keep what is essential to the economy, but you don’t reward the existing stock and bondholders – it’s essentially what we did with General Motors.  That outcome is not something to be feared (unless you’re a bank stockholder or bondholder), but is actually something that we should hope for if the global economy is to be unchained from the bad debts that were enabled by financial institutions that took on imponderably high levels of leverage.

Notably, credit default swaps are blowing out even in the U.S., despite leverage ratios that are substantially lower (in the 10-12 range, versus 30-40 in Europe).  As of last week, CDS spreads on U.S. financials were approaching and in some cases exceeding 2009 levels.  Bank stocks are also plumbing their 2009 depths, but with a striking degree of calm about it, and a definite tendency for scorching rallies on short-covering and “buy-the-dip” sentiment.  There is a strong mood on Wall Street that we should take these developments in stride.  I’m not convinced.  Our own measures remain defensive about the prospective return/risk tradeoff in the stock market.

The impact this crisis will have on the stock market explains why mainstream news media coverage has consistently understated the magnitude of the situation.  It will be interesting to observe how the “happy talk” gets amped-up as the situation deteriorates.


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