What Does The Spike In Rates Mean?

Readers have recently asked for my take on the US Treasury markets. Without a question, that is the hot topic issue of the last few weeks, and inquiring minds are wondering how it "fits" within the larger trend of debt deflation.

I had been a treasury bull for years while many were saying they were worthless trash. In my Themes for 2009 series, I turned cautious:

One area I have my eye on is the US Treasury market. I have been bullish on treasuries for a couple years now. The move over the last few weeks has been stunning. The US Fed has announced that they may start buying these securities as part of their Quantitative Easing programs. Are treasury traders and investors using the same logic as they were for oil in July? Are they using the Fed's intervention threat as justification for believing “prices can't go down?” Just the same as we were hearing “oil can't go down because of peak oil.” Will we all look back at the seemingly bizarre recent occurrence of the US Dollar falling/Treasuries rising as a very obvious hint of irrational exuberance?

I did not have the mettle to short treasuries from those levels, but I am thankful to have recognized the parabolic rise as unsustainable and happily moved out of the way. Now that the market appears to have collapsed despite the Fed's intervention to keep rates low, treasury bears are having their turn in the sun. But most likely not for the reasons they suggest.

It is true that rising interest rates are indicative of increasing inflation expectations. But there are other reasons interest rates rise. They can also rise due to shifting time preferences of investors. If people decide they want higher returns on their capital, they will shift their money to riskier assets in order to try to benefit. In an age where millions of baby boomers and pension funds are realizing they don't have nearly as much as they thought they would, this is a very real potential catalyst. Chasing high returns to make up for previous losses always ends up in tears, but that has never stopped investment managers from doing it over and over again. There is another major reason for interest rates to rise. That is risk of default. And it is a possibility that many have likely not given as much attention to as they should.

With the Fed "printing money" (ie. making credit available) like there is no tomorrow and the treasury spending in kind, inflation seems like a pretty safe bet. But keep in mind that Hoover tried the same thing in '30/'31, and was met with nothing. Ironically, the government's increasing deficits were what had foreign investors so concerned, because they felt the US would not be able to repay their obligations in gold. The Fed subsequently raised interest rates to stem the outflow of redemptions, which eventually killed the economy dead. That increase in interest rates is what Bernanke contends (remember, he is an "expert" on the depression) was the leading cause of the Great Depression.

Foreign concern about a default on gold obligations turned out to be justified. Roosevelt effectively defaulted in '33 when he confiscated all private holdings of gold and devalued it by half. I find it surprising that so many feel such a similar outcome is unlikely to repeat itself. Especially considering that a large percentage of outstanding treasuries are held by foreigners that aren't exactly "friendly." Default could be strategically beneficial. Especially if it were done soon and a majority of it could be blamed on Bush - something Obama has displayed he is fond of doing.

A default would not have to be absolute. Most sovereign defaults are not. They typically just restructure their debt. I can see a situation where the Obama Administration unilaterally decides which holders of which debt are repaid on what terms. He has already demonstrated the will to interfere in contract law in the meddling with Chrysler and GM bankruptcies. If he thinks it fair to stiff the Chinese and other creditors he deems as disposable (hedge funds, for example) in order to free up the funds to provide his dream of socialized medicine, he'll do it. There are no rules in Washington. The messiah will do whatever he wants. And if anyone objects, he can merely defend himself by countering that "Bush did it and the Republicans didn't say anything then."

But the major reason that I do not see the recent drop in treasuries as a signal of future inflation is that there has been little to no follow-through from corporate debt. If the inflation concerns were real, we should be seeing commensurate declines in investment grade corporate bonds and the high yield variety. Investors flee all bond markets when they get a whiff of inflation because they know their purchasing power will be destroyed. There has been no flight from the corporate bond markets.

High Yield Corporate Bond Index


Investment Grade Corporate Bond Index


I don't want to turn this post into another long-winded diatribe on inflation/deflation, but I have heard quite a few suggest that a Treasury default would be hyperinflationary. I suppose it would for holders of the treasuries that were defaulted on. But for anyone else, it would have a deflationary impact. The reason is simple. Less credit in the system means a drop in the existing supply of money and credit.

How does a dollar hold its value if the treasury defaults, when the Fed's main balance sheet component (what gives the dollar value) is treasuries? Simple. The Administration simply orders the Fed's Treasury liabilities to be guaranteed while others are not. After the first 4 months of lawlessness in the Obama administration, does anyone believe he would not do this?

That said, I would not be inclined to bet against the inflation trade as of yet. Interest rates could still rise substantially before Geithner (or his replacement) decides that default is the only real option. Then again, there is a good argument to be made that the current rise in interest rates is simply volatility that has shifted from the stock market to the government and mortgage debt markets. Tyler Durden at Zero Hedge has also been meticulously following the massive short squeeze going on in the junk bond markets comparative to treasuries. Is this all nothing more than the big banks getting money from the taxpayer and using it to bail themselves out by betting against quant hedge funds that had been massively short anything risky? These are questions one needs to ask oneself if they were betting on a looming hyperinflation after the last few weeks of rising rates. Econompic Data has some good illustrations of the above points:

First are the year to date performance of various credit instruments. Anyone long treasuries and short junk has been effectively destroyed.



Next is the year over year spread between treasuries and junk over the last 25 years. "An unprecedented selloff is now an unprecedented rebound," writes Econompic.


I would also point out that with treasury yields spiking, mortgage rates have also risen rapidly. Some brokerages were reporting the costs of fixed rate mortgages rose .75 bps in only two days this week. That is a big difference for someone with a $300,000 mortgage and will certainly not help in preventing foreclosures. The amount of homes entering foreclosure and the number of Americans underwater on their mortgages was already accelerating before the recent events. Surely, if high rates persist, another stunning drop in home prices could result in further economic deleveraging - this time with commercial real estate providing wind at its back. All of this is deflationary and all of this is without mentioning the social and generational trends that suggest deflation is inevitable.

In summary, there seems to be quite a bit of confusion as to what the recent spike in rates means for the overall economic outlook. I don't pretend to know exactly what will transpire. But from what I can see, the risk of a stealth default is being drastically underestimated and its impact is being perceived as more inflationary than a closer look would otherwise suggest.

I anticipate this to be a matter of continuing interest...

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Learn From My Mistakes

Traders and investors are often confronted with information that is counter to their expectations. It is not a matter of if this will happen, it is simply a matter of how one reacts. To be honest, I have reacted extremely poorly to a larger move than I thought possible in the Canadian Dollar and have been punished for that reaction. Perhaps I can blame the fact that I have spent the last two weeks in transition from Germany back to Canada. But far more likely is that I was simply recategorizing the contrary information as it transpired.

If I had asked myself a month ago what my threshold for upside was on the CDN, I would have likely said something like 82.5. At that point I should have had stops set and reevaluated the situation. But I did not. It blew through that level, and I adjusted my threshold to 86, which was a weekly moving average. At the time, I was looking for reasons to justify the move and again watched it blow through that level on it's way to 90 - round number resistance! The Loonie opened higher this morning and I have finally conceded - at a significant loss from what it should have been.

I am surely not alone in experiencing this kind of frustrating behaviour. But the worst part about it is that I am fully aware of the tendency (technically referred to as cognitive dissonance) and have previously caught myself many times from what would otherwise be terrible trades. I've spent a great deal of time reading and researching behavioural finance books, all of which are supposed to teach one how to defeat the natural human inclinations that make 90% of investors and traders lose money. For the most part, I've been very good at rooting it out, but I let myself slip this time.

It is just one expensive reminder that no matter what the situation, stop losses are an imperative part of investing, even for long term investments. Today's high volatility markets can be seductive, as one knows that in just one day things can turn around. It is tempting to "just wait one more day" before finally giving up on a losing trade. But the volatility makes the necessity for stops more important, not less.

For readers who have followed this blog since inception, it may be surprising to find out that I can be wrong. After calling the deflationary collapse years before any "expert" (there were in fact many others waiting for the same), and experiencing triple digit gains on my account two years in a row, I suppose being wrong was a tough pill to swallow.

I am sure I will learn from this mistake like I have others (I refuse to be one of those pundits who never admits they've ever been wrong). But I write this in hopes that my readers can learn from my mistake instead of making their own.

Perhaps it's time I reread one of my Kahneman and Tversky books...

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Der Nächste Schuh (The Next Shoe)?

The German financial system is teetering on the brink. But you could hear a pin drop amid the silence from Der Spiegel or Frankfurter Allgemeine. The mantra is that Germans were far more responsible in their lending and their borrowing, there were no housing bubbles there, and the regulatory framework was much more stringent than in the US. Therefore, goes the common opinion, Germany will sail through the crisis relatively unscathed.

Instead, the German media (and Germans who listen to it as unquestioningly as Americans do CNN) prefers to focus on the fate of Opel amid GM's impending bankruptcy. This is indeed a problem for the heart of German industry, the Rheinland, where a majority of their auto industry is concentrated. And for Germany, if I remember correctly, the auto industry is a larger percentage of their total GDP than it is for the US. So they have reason to be concerned.

But the size of the problem pales in comparison with the struggling Landesbanks (state owned regional banks). And perhaps this is precisely why the auto problems are garnering so much attention: they are far more manageable. And proving to be able to solve problems is an issue of high importance for the German coalition government, who are hoping to be reelected on Sept 27. It appears they are trying to sweep everything under the rug until after the election. For their sake, one would hope that they do a better job than Paulson/Bush did in '08.

For North Americans, trying to understand the German banking system is a difficult exercise (I'm still working on it). It is tempting to solely focus on the large banks like Deutsche Bank (NYSE: DB) to assess the country's financial health. But that would be misleading due to the large role that state owned banks play.

To get a better handle on what is happening in Germany, I would highly recommend reading the following interview with Hans-Joachim ("Achim") Dübel. Below are some excerpts. The entire interview can be read here.

Dübel: I pursued the housing field as a private consultant economist to agencies such as the World Bank and the EU Commission. My role here in Germany is somewhat that of the critic. Since I have worked outside of Germany and have relative freedom, I decided to use my perspective to provide an independent voice here. The sad fact is that there is virtually no discussion in the policy community in Germany regarding the financial crisis. Most of the professors in the universities in Germany that work in finance have their chairs co-sponsored by banks, so they are effectively gagged in many cases. It is easy to become a critic in Germany because there are so few independent voices. The political parties are deeply involved in finance through the state sector banks, (Landesbanken and Sparkassen) and the private financial community takes its lead from Deutsche Bank (NYSE:DB), which has decided not to make a public issue out of the problems in the state sector institutions.

The IRA: Wait a minute! Was it not DB that sold most of the toxic waste to the Landesbanks? Our recollection is that it was DB, Merrill Lynch and Lehman who were the key perpetrators in stuffing the Landesbanks with toxic waste. No wonder the DB does not want to talk about it! We have the same problem in the US, namely that the larger banks have taken control over the federal government, leaving the real economy and the population at the mercy of Wall Street. Our colleagues who work in the financial world are mostly employees and thus are cowed into silence. The lack of critical debate in the US financial community regarding the crisis is stunning.

Dübel: I am familiar with the problem in the US from colleagues who ran into problems with the GSEs, particularly Fannie Mae. Funnily enough, we have the same problem in Germany with most bank lobby groups, and public banks are not different from private in that respect. They are very aggressive in going after independent economists to attack their reputations if they have the temerity to criticize them. I think both countries have a serious oversupply of bank lobbying groups, which mostly are staffed with aggressive lawyers.

The IRA: We used to get a lot of flak from Fannie and Freddie, but this is not a problem now. In fact, after we published a brief comment about the role of Peer Steinbrück in creating Germany's financial crisis, we started getting calls from the German press before we even ran this interview. One reporter from the German edition of the Financial Times called last week demanding to know the identity of our sources. We gave our usual reply: "Foxtrot Oscar."

Dübel: What Fannie Mae did in her worst days, which I think are behind us, was to put indirect pressure on people who were critical, usually to try to get them fired. German banks play the same games, some as direct as Fannie, but most are more subtle, working behind the scenes to undermine critics. The fact is that everything in Germany is public; all of the data that I use in my work is freely available, yet nobody looks at it or uses it in the public debates. The Brussels declaration of 2001 that allowed the Landesbanken to issue dozens of billions of state-guaranteed bonds without any other purpose than regulatory arbitrage clearly names the German politicians who were the negotiators. Each of these men are also the key figures in creating the problems within the Landesbanks in each state, but still there is virtually no debate in Germany regarding these issues.

...

The IRA: So the German Landesbanks started to issue debt and buy toxic assets from DB, Merrill and Lehman? Great. Was there any legitimate purpose for this debt? How much are we talking about?

Dübel: The direct extra issuance by the banks following the EU transition period decision was already massive and totaled probably €100 billion. However, if you consider guarantees given by Landesbanken you might well end up at €200, perhaps €300 billion in total exposure. Those guarantees were called upon when the banks and investors funding ABCP and SIV called in their capital during 2007. Moreover, there was a considerable balance sheet shift inside Landesbanken in particular from interbank market exposures to securities holdings. All in all, the data leaking out of various sources suggest that Landesbanken today sit on problem assets of €300-500 billion, much of them funded effectively with German government debt. Individual banks, such as WestLB, LBBW, BayernLB, HSH Nordbank sit on high double-digit € billion exposure positions. Compare these pictures to peak outstandings of US high-risk markets in €, e.g. Subprime RMBS of € 575 billion in 2007, and you get an idea about to what extent the Landesbanken funded Wall Street. Take all high-risk securities markets at peak levels together - from leveraged loan CLOs to Alt-A RMBS, and I think we are looking at some 15% of the Buy Side demand.

The IRA: Do you think that the Landesbank management just abused the political system?

Dübel: Politicians were always broadly in the picture regarding strategy; remember that they staff the boards (Verwaltungsrat) of the Landesbanken against good remuneration. They knew that the typical loan portfolio for a Landesbank was only 20-25% of total assets, so the rest of the structure was typically securities. Before 2001, the pressure set by the EU had lead to all types of strategies to spur loan growth. For example, the HSH Nordbank based in Hamburg and Kiel focused on ship finance, WestLB had an aircraft engine finance business. There were also regional expansion strategies, with HSH investing in Scandinavia, WestLB in Britain, BayernLB in South-Eastern Europe. Some have entered retail banking by acquiring other banks (e.g. BayernLB), so the business models were not homogeneous. But these markets were already overcrowded, and nobody in the political system dared to put pressure on the Sparkassen to accept the transfer of retail business to the Landesbanken to stabilize their business models. The Brussels agreement reached by German politicians against a reluctant EU was just the final nail in the coffin: it is like a parent who gets a child to finally focus on studies, only to have a rich uncle show up, give the child $1,000 in cash and says "do what you want" with the money. A political decision completely destroyed market discipline.

The IRA: Well, we know that story. Citigroup (NYSE:C) was doing precisely the same thing in the US during that timeframe under the direction of board members like Robert Rubin. The US banks also expanded their leverage via the issuance of non-guaranteed structures such as SIVs. At the end of this year, assuming that the FASB does not get rolled again a la fair value accounting, all US banks must repatriate hundreds of billions of dollars in off-balance sheet ("OBS") assets, which will drive down capital levels dramatically. The notion of banks repaying their TARP equity this year is ridiculous if you include OBS assets in the analysis. Yet isn't it remarkable that C and the German banks were essentially all doing the same stupid things? The common denominator must the global sales push from the large Sell Side dealers like DB, Merrill and Lehman, among others.

Dübel: The dealers in Germany, DB included, are certainly co-responsible. The dealers always looked at the Landesbanken with their distorted incentives as easy prey. C surely fell into the same trap after Glass-Steagall was repealed; to me the important Citi analogy there is rather the Garn-St.Germain Act of 1982 that allowed the US S&Ls to expand into commercial lending. To me it looks as if C and Landesbanken are not very far apart in their clout on their domestic political system, just the flavors of the favors differ.

The IRA: There are no coincidences on Wall Street. Whatever toxic waste the dealers are feeding to Buy Side firms in the US is also being offered around the world. The Sell Side firms are not clever enough to have a different sell message for each market. We can recall the first adventures of Solomon Brothers in Europe selling CMOs to Belgian dentists in the 1980s. It was a slaughter, but none of the regulators in EU or US ever said a word.

Dübel: In the US and particularly with C, the problems in the asset-backed commercial paper or ABCP market was very similar to what was happening in Germany. This was very typical of the Landesbanken, who basically have no set business model. They saw the yield curve and played the markets. They demanded "AAA" ratings with a juicy spread pickup, which means squaring the circle. If you put together all of the factors, the lack of limits on state guarantees, the lack of controls on the activities of the Landesbanks, and the sales pressure from the global securities dealers, you have a real toxic mix.

The IRA: What we find startling about your tale is the EU here is the more conservative, fiscally responsible party, while the German bankers, who are reputed to be so conservative, seem instead to be completely reckless cowboys. It's as though the entire German financial system was run like Fannie Mae, with the Barney Frank (D-MA) and other American politicians making financial decisions from Capitol Hill and carving out special slush funds for their own personal use. Is this a fair comparison?

Dübel: Yes, absolutely. And it is a complete conflict of interest. The typical German savings or state bank has 25-30 board members. This becomes a harbor for politicians, who are given sinecures on these boards when they retire. The campaign finance system in Germany is under continuous scrutiny, but meanwhile practices like packing the boards of banks with retired politicians continues. But we see some change: there is a big uproar currently as BAFIN has started calling for minimum banking qualifications of supervisory board members, which typically excludes your local mayor.

...

The IRA: So it sounds like the situation in Germany was not about a bubble in the housing market but instead failed financial engineering motivated by the wrong incentives set by politicians.

Dübel: Yes, you must forget the word "mortgage" when you are looking at Germany. I am a housing expert, but this problem comes down to a lack of basic prudential and political controls in German banks. The state banks have entered and exited the mortgage market several times in the past few decades. Most recently, there has been a proliferation of direct banks providing mortgages, ING from the Netherlands and even the Postal Bank is involved. The irony of the Landesbanks is that they did not lose a penny on investments and loans Germany. All of the losses were caused by investments in foreign assets, primarily from the US. The overhang of assets was caused by the failure of the EU Commission to limit debt issuance by the German banks. Thus the question came: where to put the money raised via the issuance of debt? The US was the choice. Had there been a capital markets boom in China, the Germans would have invested there instead. The choice of asset selection was completely opportunistic and engineered by Wall Street. Don't forget that many other nations in Asia and the Middle East were given the same treatment by the American banks.

...

Dübel: Another one of the German stories that connect with the global crisis and nobody here wants to tell is de-facto collapse of local financial centers such as Düsseldorf or Munich. The entire European leg of the crisis is the story of the ambition of smaller banking centers, backed ultimately by local taxpayers. You have Reykjiavik, Dublin, Edinburg with Royal Bank of Scotland (NYSE:RBS), Dusseldorf, Leipzig, Stockholm with Swedbank, Budapest with OTP, you have Lisbon with Millennium Bank losing money in Poland, Belgium with both Fortis and KBC and so on - the axis of the insolvent is longer than most people imagine. So the smaller European banks went on a speculative spree where, the believed, they were becoming regional and even international players. The results are very serious for smaller European jurisdictions, such as Belgium which has 25% of GDP in loan exposure in Central and Eastern Europe. And there was lots of local contagion. Everybody knows the Iceland story, but few know that, for example, basically all of the banks in Düsseldorf went bankrupt in the crisis. My suspicion is that they all talked to the same investment bankers on road shows.

The IRA: Of course.

Dübel: Long story short, the total back of the envelope figure for Germany in terms of rescues so far is already safely in the 10% of GDP range. SoFFin, the federal rescue fund, has provided alone about €190 billion or roughly 7.5% of GDP; add to this the state rescue programs, which are basically SoFFin cofinancing shares, for the Landesbanken. Are some €250-300 billion in protection enough to address a problem calibrated semi-officially in the €800-€900 billion range? Probably not, especially considering the high toxic asset shares at the Landesbanken .

Dübel shows that the rescue programs have already consumed 10% of German GDP, yet the problem assets have hardly even begun to be uncovered. This is going to become increasingly problematic for the world's second largest economy. I find it utterly amazing that Germany's problems have gone almost totally unnoticed in the American press (not to mention Germany's own) and high level politicians are able to get away with statements like the following, which are just simply not consistent with reality:

"The United States is solely to be blamed for the financial crisis. They are the cause for the crisis, and it is not Europe and it is not the Federal Republic of Germany." - Peer Steinbrück, German Finance Minister, September 25, 2008

Sadly, that kind of attitude was very prevalent among Germans during my six month stay there this winter. The Germans are very proud of what they thought was a far more prudent way of living and running business. People did not buy homes they could not afford (down payments of 30% are the norm). There was a trade surplus. The bubble wasn't visible to the average German, so the idea of a collapse sounded absurd. But the bubble was there. Just as big and bloated as elsewhere. It was just buried amid bank balance sheets. Not being used to fund domestic excesses mind you, but as part of an international finance ring that was all caught up equally in funding asset bubbles elsewhere.

So not only are German banks now saddled with garbage, but their export industry is being crippled by falling demand from the same people they were buying debt from. This is the same type of debtor financing that I believe will eventually sink the Chinese economy as well. The major difference being, of course, that the Chinese export surplus was derived from an artificially weak currency. Whereas, the German export surplus appears to be as a result of their willingness to import financial WMD, rather than government treasuries. (Only time will tell who was wiser).

Suffice to say, German purchases of mortgage toxic waste have subsided, and the manufacturing industry is taking a hit. Plant and machinery orders fell at an annualized rate of 58% in April. Exports fell 9.7% in the first quarter. GDP is off 6.9% year on year. Ed Hugh has some nice charts highlighting all of this here.

In summary, there is nothing that leads me to believe that Germany (or Europe in general) are in better shape than the US and will be able to lead the way to recovery. To the contrary. The same cataclysms that hit the US financial system are lurking on the balance sheets of European banks. Should the talk of "green shoots" in the US become a self-fulfilling prophecy (which they won't), there is enough evidence to contend that the crisis baton will be passed to the eurozone.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

More On Social Mood

The markets are ripping this morning on the back of some terrible housing news, and renewed tensions with North Korea. Of course, for those that follow the popular orthodox that "news drives the markets" this is a bit of a head-scratcher. So no doubt, they go searching for something else and come up with consumer confidence numbers that were "surprisingly" higher. Yes, that must be why the markets are 3% higher - and still climbing.

If one is still not convinced that social mood determines the interpretation of news, rather than reacting to the news, all one has to do is watch the early market hours and how headlines change among the mass media outlets. This morning's headlines were along the lines of "futures point lower on Case-Shiller home price data." A half hour after market open, they had reversed course and turned positive with no additional information. The Nasdaq alone rallied 2.3% from 9:30 to 10. At 10 o'clock the consumer confidence numbers were released and the markets rallied further. Now the headlines read "stocks jump as consumer confidence surges higher."

It doesn't pass the sniff test.

If stocks opened lower because of falling home prices, then why did they rally strongly in the first half hour of trading? Why are the worse than expected home price declines less important than the better than expected consumer confidence increases? If the markets were lower now, what do you think the headlines would focus on? Home prices or consumer confidence? Home prices obviously. So what determines the news? Is it whatever "most" people think is "most" important? Or does the market's reaction determine how we interpret the news?

The market has its own preferences based on the underlying social mood which determines how news is interpreted. Social mood is in the process of correcting the collapse in optimism we saw last autumn. So while mood is improving, nearly any piece of news will be greeted with a positive slant. Even terrible news can be construed to be positive if one focuses on a certain component or a "second derivative."

Socionomic Theory contends that social mood in humans patterns itself much the same as countless other creatures pattern their behaviour, and the stock market is the best barometer of social mood we have. What this morning's trading tells us is that the wave of optimism is still rolling. The decline we saw over the past few weeks was not met with a corresponding drop in optimism.

If I were looking for a lasting top to this market (which I am), I would be looking for a change in character in social mood. I would be looking for a certain datapoint or comment from a highly respected person that would normally be considered bullish to be completely ignored and for headlines like "stocks drop substantially despite optimistic comments from Buffett."

Until something like that occurs, expect the markets to wind higher and squeeze the shorts into oblivion.


Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

William Black on Fraud

Criminal fraud was endemic over the last 30 years. That is not a widely debatable statement. Even people that would disagree with me ideologically or would typically have opposing economic views would have a hard time denying that the backdating of stock options, mortgage fraud, accounting fraud, appraisal fraud, and many other types of fraud have gone on without notice from law enforcement, regulators or journalists - the people typically charged with exposing such crime.

Even though such a consensus can be reached on the prevalence of fraud, it hardly garners a mention in the media or in congressional hearings. Typically, the focus will be laid on easier subjects like greed or underfunded regulators who could not keep up with the innovations of "the rabid free-market." The targets are very vague. And therefore the solutions prescribed to address the problems are also very vague and typically avoid the real issues or even endorse them by providing support.

Why is this the case? Well, it should be obvious. The people we have put in charge of tackling the crisis are the same people that would eventually be implicated if the charges of fraud were investigated. Scapegoats and strawmen are sought that will deflect attention away from the true culprits that encouraged the fraud toward their minions that went ahead and carried it out. Nowhere is this more apparent than in the handling of the crisis by the mainstream media, all of whom were cheerleaders of "the great moderation" and the "cinderella economy" that masked such blatantly obvious shenanigans.

However, there are a number of individuals (not to mention entire schools of thought) that have a clean history and are able to speak out without implicating themselves in the process. Among those people is William Black. He is a former regulator of the S&L crisis and subsequently went on to specialize in white collar crime. Two weeks ago he gave a presentation in Iceland on how prevalent fraud was in the bubble economy that has now burst. (Why he needed to go to Iceland in order to gain an audience is supportive of the media's muzzling attempt toward those that would implicate the media itself as accessories to fraud.)

Black is not considered an Austrian, nor does it sound like he has roots in the Minsky-Shumpeterian school. But I was constantly struck by the wisdom (and valiance) of a man who was a former government bureaucrat in telling it like it is. In the presentation he makes references to:

- failures of the neoclassical Efficient Market Hypothesis (EMH)
- how hierarchal power structures perpetuate fraud (what he refers to as "control fraud")
- the benefits of "mutually beneficial exchange" in a truly capitalistic society
- how the implicit endorsement of fraud creates "moral hazard" and a "misallocation of resources"
- that we are and have continued to follow the same regulatory and economic policies which have continually resulted in widespread fraud over decades

The complete presentation can be viewed in two parts: Part 1 and Part 2. The intro is in Icelandic and takes a few minutes to get going. It is well worth the time.

From what I have heard previously, Black's solution appears similar to most in that he argues for "better regulation." But he seems to have a far better grasp than others in that he understands if existing criminal laws were enforced for white collar fraud, the need for excessive regulation would be minimized. For that, Black's common sense is a message worth rallying around.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Technical Update 19.09

The S&P 500 was again turned back from the 920-930 level and finished the week near its lows, but marginally positive on the week. Market internals continued to deteriorate from their extreme overbought levels. Volume continued to be weak, although heading into a holiday weekend probably had a hand in that.

My continued interpretation is that this is a pullback amid a longer bear market rally. The character of the decline thus far has not given the signals one would expect if it were intending to breach the March lows. However, as we are in a protracted bear market of secular nature, surprises can come to the downside. The resurgence of positive sentiment could be abruptly halted at any time as a result of any of the numerous catalysts this blog often focuses on.

I am watching support levels bunched in the 860s and 830s. If I can see a low risk entry at those levels, I may consider exchanging the small short position I am currently carrying for some select longs. Otherwise, I will continue with the basic theme I have employed for a few months now, which is "hands off." Any long positions taken will be with very tight defined risk.

Ideally, the current rally would last 6 months or longer and do its best job of convincing as many people that the worst is over. Even thought it may sound like that has already occurred, judging by the cheerleading in the MSM, the prevailing opinion is that the recovery, when it arrives later this year, will be weak. I expect a vast majority of the media darlings like Roubini, Krugman, Greenspan and Bernanke to give official claims of an "all clear" as a signal that the bear market is set to resume. Call me a cynic.



If we do see a decline in the major averages over the next few days or weeks, I will be watching a few indicators to give me hints that could provide some buy signals. One of those indicators is the VIX (Volatility Index). Volatility collapsed early this week, before recovering over the last few days. A continuation up to the 38-40 area would tell me that a little bit of fear had returned to the marketplace.



I will also be watching the Advance/Decline Ratio. If it manages to work its way down to the lower bound of the range, a buying opportunity could be at hand.



Crude oil is chugging along on its way to the $65-75 area I mentioned previously. However, the daily chart couldn't be a more perfect example of an Elliott Wave "5", which has also brought it in contact with its 200day EMA. This could be a top for crude.



I've been dead wrong over the last month regarding the "inflation trade." The Dollar has broken below levels I though it would hold, and the precious metals have refused to provide the kind of buying opportunity I was hoping this summer would yield. That said, the seasonal lull for the precious metals has only just begun. The charts look fantastic, and the fundamentals for the yellow metal have never been better. But consider this: Amid all the events of the last year. All of the major bankruptcies and "money printing" by the Fed. The stock market crashing. The Chinese making threats. Nearly everything a gold bug could conceive of as bullish for gold has happened in the last year. Yet gold has gone nowhere in 16 months. It is flat. Of course, that is better than nearly anything else. But the perfect storm for gold has still not been enough to satisfy the claims for gold prices in the many thousands of dollars.

I'm maintaining an open mind. If it were to push new highs, I won't be too proud to jump aboard. But I still believe the PMs have a washout low ahead of them in the next year before continuing a multi-decade bull market.

Priced in Euros, gold does not appear to be looking as sexy as it does in dollars. That is, gold's rise is underperforming the Euro's rise over the past few weeks.





Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Early Week Reading List

After spending much of the day yesterday walking around London until my toes were nearly bleeding, I've taken a few hours off from sightseeing to catch up on a little reading. Below are some of the better articles I thought worth passing along:

Chasing the Shadow of Money - Tyler Durden of Zero Hedge

I've got to say that Zero Hedge has taken the unequivocal top spot on my reading list. Typically his posts are shorter and more pointed, but in this one he takes to task a topic I've been dancing around for the last year. He starts with Frederich Hayek's reference to "shadow money" and goes on to explain in detail, how it so massively outstrips any other conventional measure of our money supply. He concludes that even though the government attempts to replace the contraction in this "private shadow money" with "public shadow money" are having some effect, it does not come close to making up the difference. He also concludes that the need to hold higher cash reserves (and the drop in velocity that is its inverse) will eventually doom any attempts at reflation.

Coincidentally, Prices and Production by Hayek is one of about 15 major titles on my summer reading list awaiting my arrival in Vancouver.

Asia Will Author Its Own Destruction if it Triggers a Crisis Over US Bonds - Ambrose Evans-Pritchard of the Daily Telegraph

I normally find myself in agreement with AEP, who is asking the relevant question in the Asian savings of US treasuries fiasco, "Who ultimately holds a gun to the head of whom?" It would seem rational that China and Japan, with trillions in US Treasuries, hold the advantage here. But I don't think it is quite that simple. Both countries have maintained illegitimate export economies based on suppressed currencies. If either or both were to tactically sell all their holdings, an obvious outcome would be the total destruction of their export economy and the productive capacity that has been built to support it. As Evans-Pritchard points out, the resultant unemployment, already a problem, would turn into a political nightmare for the characteristically paranoid Asian governments.

"If you owe your banker a few thousand pounds, you have a problem. If you owe your banker a few million pounds, your banker has a problem." - Keynes paraphrase

A Populist Interpretation of the Latest Boom/Bust Cycle - Ed Harrison of Credit Writedowns via Naked Capitalism

This post is primarily a rerun of a March 2008 article. In it, Harrison attempts to find the line between free-markets and political populist interventionism. Like many commentators, Harrison seems to do a fine job in finding the problems and injustices of our current social construct. But he fails in the same area as many others seem to. That is, he glosses over the effect that populist interventionism has played in bringing about the adverse qualities we have experienced from "capitalism." He falls into the trap that socialists and other big government proponents have laid out in response to this crisis. They claim that everything is the fault of poor regulation and a greedy cabal of sociopathic bankers.

I don't deny that there are sociopathic bankers and poor regulation at the center of this crisis. But I see them as symptoms of far different diseases than are commonly put forth. I'll touch on a few before I head out for tea with the Queen:

1. Regulation. It is not a lack of regulation that was the problem. It was the current construct of regulation that created implicit government guarantees behind anything that was under the watchful eye of regulators. With such impossible guarantees in hand, bankers took this as a license to print money (literally) without regard to the risks that it would normally have. Bankers knew that regulators (like the FDIC, OTS, OCC and Fed) would not let any large institution fail. So they went balls to the wall. They did whatever possible to ensure they were big enough to be considered "too big to fail." Absent regulation? Banks would have been smaller and would have taken less risks knowing that their institution could collapse if they were irresponsible. There would have been failures. But they would have been smaller and more manageable.

2. Manipulation by the Central Banks It should go without saying that interest rates, held too low for too long, will cause asset prices to rise unnaturally. Even this is acknowledged by most now - that the Fed does not know or cannot know what the real rate of interest should be. But it is not just the wrong interest rate that is the problem. It is a mandated positive rate of inflation that central banks target that breeds problems. This guaranteed positive rate of inflation encourages people to speculate wildly on the next bubble and to avoid saving money for risk of losing their purchasing power. This is what is really behind the "greedy" characteristic of people that are being persecuted. There can be no satisfaction with one's wealth knowing that over 25 years one will lose a minimum of half their purchasing power solely via inflation. To summarize, central banks cause a society of degraded values via its inflationary policies.

3. Legal Tender Laws. Another patently anti free-market characteristic of the previous boom/bust cycle has been the government's forceful insistence on using their currency, and nothing else, as a medium of exchange. By forcing regular people to use one currency, while (as Tyler Durden pointed out above) allowing the banks to, at a whim, create their own forms of "just as good as cash" fiduciary media, the government essentially does the job of widening the rich/poor gap all by themselves. Those who are able to put themselves first in line at the trough of newly minted "money" get rich to absurd degrees. Those that get it further down the line become increasingly dependent on the rising asset prices it creates, rather than increases in productivity and rising wages which result. And those that get it even further down the line, see everything they need rising in price, while their wages are perpetually stuck in the last decade. Poverty inevitably results.

There are many more, but Harrison, like many others before him, lacks the ability to see the relationship between cause and effect.

Cheerio.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Technical update 18.09

Note: Coming to you from London today. Posts over the next week will be few and far between. I apologize to readers who may not get prompt responses to comments or e-mails.

The divergences I have been following have proven legitimate and a meaningful decline has resulted. This decline is thus far, and should continue to be, the most meaningful decline we have experienced since the early March lows. The question remains whether the decline will be the start of a new wave lower past the March lows, or whether it will correct the previous advance on way to achieving either a test of last weeks highs (930 S&P) or a push to previously discussed resistance levels of a higher degree.

The character of the decline should give some clues to how this is resolved. Thus far, one will notice the significantly lower volume of the past week despite falling on option expiry. The approximate 5.5% decline in the S&P/NDX from their highs has not seen an acceleration in trading volume. This will be something to watch as we move into the typically quieter summer months.

However, it bears mentioning that a large number of key indices have made significant reversals from their 200 day EMA. This is classic behavior one would expect to see before the prevailing trend reasserts itself. Among the indices making near perfect contact with this line are:

- KBW Bank Index
- Dow Transports
- Russell 2000
- German DAX
- Japan Nikkei
- London FTSE
- XLE (energy ETF)
- XME (mining & metals ETF)

KBW Bank Index


Dow Transports


Of course there are a number of key indices that exceeded their 200 day EMA:

- Nasdaq
- Emerging Markets
- XLY (Retail ETF)
- TSX

Emerging Markets


And a number which failed to even reach the area, perhaps giving clues to relative underperformance in the days and weeks to come:

- S&P 500
- Dow Industrials
- Dow Utilities
- XLV (health care ETF)
- XLP (consumer staples ETF)
- TSX Venture
- CRB Commodities

S&P 500


Those lists are not complete. However, the overwhelming number of indices to meet or fall short of this moving average, followed by the strong reaction, serves as confirmation to my belief that equities remain in a secular bear market. Of course, this does not disqualify the major averages to push higher from lower or even current levels. In fact, I expect nothing less than a test of the YTD highs at some point before the end of the summer. For the sake of "seeing both sides," I have taken some short exposure via LEAP puts of the S&P. It is only what I would consider to be a 1/3 position of what I would hope to take before the markets ultimately roll over - roughly equalling the odds I give the recent highs to mark the peaks for 2009, and likely many years thereafter. Just sharing my process in hopes it adds to yours...

That's all for now.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

European Squabbling Intensifies

Around the 'bearish' minded websites and blogs, dollar bullishness is blasphemy. Those who could even conceive of an outcome other than a hyperinflationary collapse of the US Dollar are commonly referred to as traitors to the ursine religion.

Indeed, how could such a worthless piece of paper backed by the promises of an even more worthless set of bureaucrats possibly hold its value any longer? One answer to that question could be that England succeeded in using split pieces of wood known as "Tally Sticks" as a currency for over 700 years. Another answer could be "for lack of better options." The aforementioned will immediately point to gold as a better option, and I would agree. And I would take that one step further and say that the best option for an alternative to the dollar is whatever people damn well please. That is, we should have a competitive currency system. But until legal tender laws are repealed, that is not going to happen. And legal tender laws will not be repealed until the streets run with the blood of central bankers and the militaries which they command (let's be honest here) who will defend them to the death.

As disturbingly pleasing as that visual image may be, it is not going to happen in the near term. Therefore, we can conclude that the only options to worthless US paper are worthless paper issued by someone else. Exhibit A is the Euro, which coincidently accounts for 57.6% of the Dollar Index. If the Euro rises, the Dollar falls and vice versa. In my opinion, there is no reason to believe that the Euro has any intrinsic characteristics to make it more valuable than the Dollar. And unfortunately for Dollar bears, the Euro has a web of bureaucracy behind it that I believe will eventually lead to its collapse. An article by Bloomberg this morning sums this picture up nicely.

ECB Policy Makers Clash After Trichet Engineers Truce

May 14 (Bloomberg) -- European Central Bank policy makers clashed over the bank’s asset-buying program less than a week after President Jean-Claude Trichet engineered a truce.

Slovenia’s Marko Kranjec said yesterday the ECB is likely to spend more than the 60 billion euros ($82 billion) it has earmarked for covered-bond purchases and hasn’t ruled out acquiring corporate bonds and commercial paper. Hours later Germany’s Axel Weber, who had already said there’s no need to buy other assets, insisted 60 billion euros is the “maximum.” Slovakia’s Ivan Sramko said today nothing can be excluded.

“The ECB Governing Council looks like a battlefield,” said Laurent Bilke, an economist at Nomura International in London. “It would be simply ridiculous if we weren’t already in the middle of the worst recession in postwar history. But now it has more dramatic consequences. Trichet will have to restore some order.”

The diverging views suggest the ECB is still split over the best way to tackle Europe’s worst recession since World War II, even after Trichet said the decisions taken last week by the 22- member Governing Council were “unanimous.” Weber has always opposed asset purchases and warned yesterday against stimulating the economy too much. Other policy makers have argued the bank may need to do more to counter the risk of deflation.

Euro Falls

Currency traders said the prospect of the ECB expanding its asset purchases was weighing on the euro, which fell to $1.3526 today from as high as $1.3721 yesterday.

“The markets have begun to think there’s a possibility the ECB may commit to non-traditional steps,” said Hideki Amikura, deputy general manager of foreign exchange in Tokyo at Nomura Trust and Banking Co. “The euro is likely to be top-heavy.”

Trichet declined to comment on the bank’s plans today after a meeting with French President Nicolas Sarkozy in Paris.

On May 7 Trichet cut the benchmark interest rate to a record-low 1 percent and said that’s not necessarily its lowest level. He also announced the ECB will buy 60 billion euros of covered bonds, securities backed by mortgages and public-sector loans which have suffered a slump in demand during the financial crisis. Details of the plan are to be unveiled next month.

“The 60 billion euros they announced is peanuts for an economy the size of the euro zone,” economics professor and former Bank of England policy maker Willem Buiter said at a conference in Dublin yesterday. “I expect they will announce more or that the recession in the euro zone will be longer and deeper than would otherwise be necessary.”

Quantitative Easing

The Federal Reserve, Bank of England and Bank of Japan have lowered their key rates to close to zero and are buying government and corporate debt, effectively pumping new money into their economies to prevent the development of a deflationary spiral.

The economy of the 16 euro nations will contract 4.2 percent this year, according to the International Monetary Fund. Recent reports suggest the recession may be bottoming out.

Trichet was forced to compromise on the ECB’s asset- purchase program in order to get Weber on board. Weber argues Europe isn’t at risk of deflation and the ECB should avoid taking additional risk onto its balance sheet. He also wants the ECB to signal an end to rate cuts.

Other council members say the ECB can do more. Athanasios Orphanides, the former Fed economist who now heads the Cypriot central bank, has said the ECB may have to continue easing policy if deflation risks increase.

Final Amount?

Kranjec, who heads the Bank of Slovenia, said in an interview in Ljubljana yesterday that the ECB can lower rates further if needed and 60 billion euros is “not the final amount” for the asset-purchase program. The bank has not ruled out buying corporate bonds or commercial paper, he said.

Sramko said at a conference in Vienna today that the ECB “can exclude nothing” on non-standard measures. “I’m sure the council will also discuss other possibilities,” he said.

Still, Marc Chandler, head of global currency strategy at Brown Brothers Harriman in New York, said that as president of Germany’s Bundesbank Weber has considerable influence.

His views “probably reflect the attitude of most of the other participants,” he said. “Who’s going to agree with the guy from Slovenia against Weber?”

Austria’s Ewald Nowotny said today the ECB has decided to buy covered bonds and “that’s it. No further options are of relevance now.”

‘Powerful Comeback’

Weber said in a speech in London last night that inflation may make a “rapid and powerful comeback” if the economy recovers faster than expected and policy isn’t tightened as quickly as it was loosened.

ECB Vice President Lucas Papademos agreed, saying there are signs the economy is stabilizing and “the recovery may start sooner than previously envisaged.”

“Once financial conditions and the macroeconomic environment improve, the non-standard monetary policy measures taken should be quickly unwound,” Papademos said in Vienna.

At the same conference, Dutch council member Nout Wellink contradicted Papademos on the economy, saying it’s best not to “become too optimistic when you see a few swallows flying around or green shoots.”

Turning to asset purchases, Wellink said: “The council has made it’s decision and that’s it for the time being. There is a need under the present circumstance, with so much uncertainty around, to be clear. There is a need for a precise clear-cut message. We have given such a message.”

Wellink insists that the ECB has given a clear message. The message I got was that these folks probably couldn't agree on what to order for breakfast let alone monetary policy.


Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Consumers Throw in the Towel

Amid talk of green shoots and second half recoveries, the average American, Canadian and European is being squeezed without respite.

Last week, we got the monthly report on consumer credit. This week, we learned of the previous month's retail sales. Both reports were abysmal. This is, of course, intuitively logical. The savings rate is rising, wages are falling, unemployment is still climbing, tax receipts are plummeting and the social aversion toward conspicuous consumption often mentioned in these pages continues to grow.

Here are some updated charts showing all of the above in pictures. Considering that consumption accounts for approximately 70% of the US economy, I have a hard time believing a month over month increase in housing starts (residential investment is 3% of economy) can be a legitimate "signal" for much of anything. But I supposed some are more inclined to drinking kool-aid than others...

The first chart is of this morning's retail sales numbers. (via Calculated Risk)



Note that household expenditures were one of Bernanke's "green shoots" that he has been talking about for the last few months. So much for that idea. The little blip on the chart will likely fade into the distance as retail sales continue to weaken throughout the year.

Next are two charts of Consumer Credit. The first is revolving and non-revolving separated. They are both below the zero line for the first time since numbers were collected. (courtesy of Econompic Data) The second shows consumer credit back to the early 40's (from Zero Hedge). We are in unchartered territory.





It is painfully obvious that the growing unemployment is taking its toll on personal consumption expenditures. Unfortunately, unemployment is still rising at a frightening pace. Analysts and pundits have been trying to use the fact that because the April nonfarm payrolls (-538,000 jobs) wasn't as bad as the previous month's (revised to -699,000 jobs), we should look to that as signs of a pending recovery. Hardly. To start, the BLS continues to add jobs (226,000 this month) via their mysterious birth/death model. The model assumes that because one business has closed, another one must open in order to satisfy demand. It doesn't matter if there is no longer demand for a certain good or service. That is impossible according to the model. The model is the ultimate microcosm of the neoclassical "General Theory of Equilibrium," which is bunk.

Additionally, April saw the addition of 60,000 government workers to carry out the census - which itself doesn't add anything to the economy. Regardless of what you heard, the employment picture is not getting any better. The chart below shows the contraction as a percentage of the workforce in comparison with other recent recessions. There is no end in sight. (hat tip Denninger for the chart)



As one would expect when jobs are being lost at the most rapid pace in 80 years, wages are falling as desperate workers accept lower pay or fewer days of work in order to save their jobs. (chart via Econompic Data)



You don't have to be a bean-counter extraordinaire in order to figure out that with the above combination, government tax receipts are going to fall off a cliff. Perhaps it would have been wise then for government budget officials to take this into consideration when making their budget projections for at least the near-term. But I suppose that gives too much credit to the ability of bureaucrats to see any potential outcome other than their own wishful thinking.



California, which by itself makes up 13% of the US economy, revealed in it's latest budget update that its sales tax receipts are down 50.8% year over year. Income tax receipts were down by 43.6%. This for a state that is already in dire straits with its budget. Following the release of the report, governor Schwarzenegger suggested he would be required to close schools, release prisoners and limit basic services in order to keep the state running. Swell. Somehow I don't think we've heard the end of this story.

One positive signal that I have referred to previously is the rising savings rate. It is rising now at the steepest rate since WWII. Neoclassical economists will disagree that this is a good sign because they believe in the twisted logic of a "paradox of thrift." They see a rising savings rate as the ultimate evil, and will go to absurd lengths to discourage this behavior. Those who practice common sense economics, on the other hand, see a rising savings rate as a positive sign because it signals the necessary accumulation of capital that is required prior to any legitimate investment in productive capacity.



It comes as no surprise to anyone looking at the above data that the consumer is retrenching. In order to conclude otherwise, one would have to selectively be looking for disconfirming data and subsequently using the stock market's meteoric rise as further confirmation. Textbook cognitive dissonance and circular-logic thinking.

From an anecdotal perspective, there is evidence abound that people are changing their consumption preferences and delaying purchases until big-ticket prices move more inline with their perceived future incomes. My weekly google search for "frugality" yielded this following article among many others:

Tulsa Couple Is Happy Being Frugal

TULSA, OK -- What a turn-around it's been. From lusting after the latest gadgets to wondering whether we'll have jobs tomorrow. The recession has changed a lot of assumptions, including the one that says we should live our lives in debt and never go without. A young Tulsa couple embraced a different outlook on life when they were living on one income with a baby on-the-way.

The baby's now here and they say their old way of spending money, money they didn't have, is gone forever.

A recession's no walk in the park for any of us. But, for Natasha and Aaron Ball, a walk in the park is part of their strategy for beating an economic bust. They've embraced bad times as a chance to get ahead. And, turned their backs on a way of life that collectively sent us off-the-tracks.

"I think the first fight we had about it was I told her we're only gonna eat out once a month and she refused. ‘No, no, no, I have to eat out once a week or twice a week,' whatever," said Aaron Ball.

"When I married my husband he was very in to frugal living and wanted me to come on-board with that and that was difficult at first, yes, very hard," said Natasha Ball.

But, not anymore. Natasha's fully on-board. In fact, she's the engineer driving the family frugality train now.

Summary:

- Contracting Retail Sales
- Contracting Consumer Credit
- Falling Wages
- Rising Unemployment
- Plummeting Tax Receipts
- Rising Savings Rate
- Social Embracement of a new "Culture of Frugality"

As I said from the outset of this crisis. Bernanke and his banking buddies can make as much credit available as they want. But if there is not the desire nor the ability for consumers to borrow it, it will have no effect. He is pushing on a string. How exactly does any of this lead to inflation?


Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Worse Than Useless

Question: What do you call a regulator that doesn't regulate or an inspector that doesn't inspect?

Answer: Worse than useless.

Worse, because their presence in the first place gives a false sense of security to market participants that everything is being looked after. Participants are misled about risks in certain areas of the economy because they are advertised as "well regulated" when in fact, regulators are either asleep at the switch or have fallen prey to the phenomenon of "regulatory capture."

Regulatory capture is what happens when the goals of the regulators and the goals of the industry they are supposed to be regulating become so closely interconnected that rules get changed, bent or ignored altogether. If there is a phrase that summarizes the effectiveness of regulation over the last two decades, "regulatory capture" does a better job than any other. Administration after administration (Democrat and Republican equally - Conservative and Liberal equally) have fallen prey to the fallacious logic promoted by industry lobbyists that former industry insiders are the only ones qualified to regulate. The cozy relationships they have with big industry are sold as a plus factor by the lobbying groups that spend literally billions of dollars per year ($3.27 Billion in '08) to affect favorable legislation and regulation. If they weren't getting some serious bang for their buck, they wouldn't be spending that kind of money, would they?

But regulatory capture is only one half of the story. There appears to be other regulators who don't even pay attention.

Below is a video of a congressman Alan Grayson questioning New York Fed Inspector General last week. Sorry for the terrible audio. If you have headphones it comes across much clearer. Otherwise, a transcript is available to read.



The total cluelessness of this high level official is appalling. She seems totally oblivious to the fact that the Fed has taken on obligations off balance sheet. She does not even appear to have knowledge of any of the multiple Fed lending programs other than TALF. Nor does she even really acknowledge her role as an "inspector." A few exchanges:

Alan Grayson: Well, I understand that, but we’re talking about events that started unfolding eight months ago. Have you reached any conclusions about the Fed expanding its balance sheet by over a trillion dollars since last September?

Elizabeth A. Coleman: We have not yet reached any conclusions.

Alan Grayson: Do you know who received that money?

Elizabeth A. Coleman: For the… we are in the process right now of doing our review and…

Alan Grayson: Right, but you’re the Inspector General. My question specifically is do you know who received that $1 trillion-plus that the Fed extended and put on its balance sheet since last September. Do you know the identity of the recipients?

Elizabeth A. Coleman: I do not know. We have not looked at that specific area at this particular point on those reviews.

...

Alan Grayson: So I’m asking you if your agency has in fact, according to Bloomberg, extended $9 trillion in credit, which by the way works out to $30,000 for every single men, women, and child in this country. I’d like to know if you’re not responsible for investigating that, who is?

Elizabeth A. Coleman: We, actually… we have responsibility for the Federal Reserve’s programs and operations, to conduct audits and investigations in that area. In terms of who is responsible for investigating… would you mind repeating the question one more time?

Alan Grayson: What have you done to investigate the off-balance sheet transactions conducted by the Federal Reserve, which according to Bloomberg now?

Elizabeth A. Coleman: I’ll have to look specifically at that Bloomberg article. I’m not… I don’t know if I have actually seen that particular one.

Alan Grayson: That’s not the point. The question is have you done any investigation or auditing of off-balance sheet transactions conducted by the Federal Reserve?

Elizabeth A. Coleman: At this point, we’re conducting our lending facility project at a fairly high level and have not gotten to a specific level of detail to really be in a position to respond to your question.

Alan Grayson: Have you conducted any investigation or auditing of the losses that the Federal Reserve has experienced on its lending since last September?

Elizabeth A. Coleman: We are still in the process of conducting that review. Until we actually, you know, go out and gather the information, I’m not in a position to really respond to this specific question.

Alan Grayson: So are you telling me that nobody at the Federal Reserve is keeping track on a regular basis of the losses that it incurs on what is now a $2 trillion portfolio?

Elizabeth A. Coleman: I don’t know if… you’re telling me that there’s… you’re… missing… that there are losses. I’m just saying that we’re not… until we actually look at the program and have the information, we are not in a position to say whether there are losses or to respond in any other way to that question.

Alan Grayson: Mr. Chairman, my time is up, but I have to tell you honestly, I am shocked to find out that nobody at the Federal Reserve including the Inspector General is keeping track of this.

Grayson is "shocked." I'm not. This is par for the course for an organization that views itself as "above the law." Note the uneasiness of the Fed's team of lawyers in the background of this video. They are literally terrified of anyone saying too much. Unfortunately for them, saying nothing, like Ms. Coleman did in this questioning, is starting to have a negative effect. People are outraged at the blatant deception techniques being used by the Fed.

Thankfully, one member of congress who has been speaking out against the Fed's unlawful and damaging interventions for decades has introduced a bill to forcibly audit the books of the Federal Reserve and all its member banks. Ron Paul's HR 1207 now has bipartisan support of at least 147 cosponsors (growing daily).

President Obama campaigned on a platform of honesty, transparency and integrity in contrast with the abomination that were the Bush years. A full audit of the Fed would be a step in the right direction. More than likely, the details that would emerge from such an audit would enrage the American people so much that an outright repeal of the Federal Reserve Act would be demanded. Ideally, that would serve as a template for a full review of the Bank of Canada's mandate as well.

The damage that arises from implied but not applied regulation, the moral hazard that their interventions create, the degrading nature mandated positive inflation has on social preferences, and the distortions their manipulation of interest rates causes are all major factors in explaining the credit crisis we are in the midst of.

I urge my readers south of the border to call their representative (regardless of their party) and ask them to cosponsor HR 1207. It needs to be made obvious that non-participation in this bill would be political suicide.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Stress Tests an Exercise in Calculated Deception

I'm simply awestruck by the insanity. In order to cater to my audience, I try to be as cynical as possible in these pages. I work hard at it, I really do. But ever since I started writing, the ridiculousness of our current economic situation has consistently surpassed even my Orwell-inspired perpetual skepticism.

The recent debacle with the bank "stress tests" is yet another manifestation of this phenomenon. From the outset I dismissed the tests and their legitimacy. But I never dreamed that the Obama Administration, the banking industry and big media would go to such lengths to blatantly deceive investors. Now that the results of the tests are being used to justify further potential interventions, I suppose I need to summarize why the whole exercise is a fraud.

From the outset, there were so many problems with the structure of this plan that it should not have been given any attention as a legitimate exercise in the first place by the major media. By completely ignoring the contradictions that were plain as day in the process of the tests, the media tipped its hand that it would simply regurgitate whatever the administration and banking lobby told them to say. Here is a quick summary of why the tests were not even a worthwhile exercise in the first place:

1) The tests focused only on the loan books of the banks. It made no mention of derivative exposures, which are what really put the "entire financial system at risk." If the credit crisis were as simple as too many loans to people without jobs, this would be sufficient. But it is not.

2) The Treasury hired under 200 people to inspect the balance sheets of 19 banks over the course of approximately 6 weeks. A similar team of lawyers and securities experts spent years trying to untie the knot of Fannie Mae's loan book. They never really finished when Fannie went in to receivership. To think that 200 people could analyze 19 banks in such a short period of time is preposterous.

3) The Treasury officials relied on information given to them by the banks. There was nothing to stop the banks from picking and choosing what information to give. The models and assumptions that went into valuing the assets were not disclosed.

4) The goal of the test was to "restore confidence in the financial system." It was not to discover the truthful health of these institutions. So it was implicit in the very intent that banks should lie and obfuscate in order to achieve the "higher ideal" of confidence.

5) The test's "baseline" and "more adverse" scenarios were laughably optimistic. In some metrics, the baseline scenario's assumptions were already surpassed. Additionally, the scenarios did not factor in any acceleration of the Commercial Real Estate collapse, nor did it account for further deterioration in "Alt-A" loans or "Jumbo Prime" loans that are only now starting to approach their peak reset periods. The "stressful" scenarios flat-out assumed that no new problems would arise.

6) Immediately preceding the tests was the rejection of FASB 157, which allowed the banks to continue to mark their books to whatever they wanted, rather than what they were actually worth. Coincidence? Highly unlikely.

7) The repeal of FASB 157, along with inflated Q1 trading profits and other accounting shenanigans allowed the banks to post record profits for the first quarter. Those profits were used as the basis for future assumed profits in determining the capital ratios banks would require.

8) The banks were permitted to negotiate the results of the tests with the Treasury prior to their release. This alone should be enough to conclude that the whole exercise is a travesty of regulation. If the capital requirements were interpretive enough to be negotiable, they are effectively meaningless. The interpretive nature of such simple guidelines like, "what constitutes capital" makes it blatantly obvious that the results should not be trusted. In one such situation, Citigroup was able to negotiate their capital requirements down to $5 Billion from $50 Billion by claiming that assets that they have "pending for sale" should be considered as tangible equity. I tried to buy groceries this morning with a craigslist ad of furniture that I have for sale. They nearly called the police before I caved and paid cash.

9) Banks were permitted to use "Tier 1 Capital" as opposed to "Tangible Common Equity" as a measurement of their capital. The former massively overstates this capital. An analyst from RBC suggested that using the former would have resulted in an additional $68 Billion shortfall to the $70 Billion that was released. Below is a table from Rolfe Winkler that highlights this clearly:



The tests as they were originally crafted were supposed to be using TCE. But the banks didn't like this so they bitched and moaned until Treasury finally agreed to the less aggressive metric. Just another example of who was really calling the shots.

10) Now that the results are in, the banks have been reassured that the capital requirements may not actually be required if bank earnings continue to improve over the next two quarters. Essentially the Treasury said, "look guys, don't worry about the capital requirements we make public. We will give you ample opportunity to make up the difference by booking profits over the next two quarters. And we'll even turn a blind eye to any accounting tricks you need to make those numbers."

I could probably go on with another ten reasons why this whole process was a charade, but I will spare you the details. It is plain to the bare eye that what we have witnessed is a coordinated attempt by government and the financial industry to do anything possible in order to "restore confidence." If that means falsifying information, so be it. If that means tinkering with definitions, so be it. If that means trampling over decades-long regulatory procedures in order to obfuscate the truth, so be it.

As usual, what I find to be the most appalling factor in this is the mainstream media's total ignorance of the above and outright cheerleading of the results as an "all clear" signal.

Conclusion:

Together with the media's compliance, the Obama Administration and the Financial Services industry have staged a massive confidence building charade, which to anybody not in direct benefit comes across as precisely the opposite. The fact that the Administration would go to such lengths to hide the truth behind the bank's insolvency issues, is anything but confidence inspiring.

All of the policy actions of the government over the last 6 months seem to be directed toward giving the "appearance" that the system is still solvent. The powder-puff regulatory treatment. The constant wink-wink, nudge-nudge relationship between regulators and boards of directors. The FASB 157 decision. Q1 earnings. The carefully crafted "scenarios" of the stress tests. The list goes on. It is all a carefully coordinated game of chicken being played with the minds of investors.

I'm not buying it. And I am fairly certain that some nasty details will be revealed of this whole situation as the economy deteriorates beyond the "more adverse" parameters, banks require continued capital infusions from Treasury or from FDIC via the Treasury. There was undoubtably collusion between the regulators and the regulated.

Which of course is one of the most identifiable characteristics of regulation in the first place. Heads are going to roll over this. Perhaps "Regulatory Capture" will become the catch phrase of 2010?

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.