Category: politics

War complacency

With investor complacency already high (65% of the sub-10 VIX readings since 1993 took place in the past 3 months), it should be no surprise that the escalation of tensions with North Korea would be met with a yawn.

At 2:21 PM E.T. yesterday (with the S&P 500 down 0.87% on its way to a 1.45% loss), MarketWatch columnist Mark Hulbert published an article advising investors to remain calm:

If war breaks out with North Korea, we’ll have bigger things to worry about than our portfolios.  But that’s OK, because doing nothing is almost always the best investment strategy during a geopolitical crisis.

That is the clear conclusion to emerge from an analysis conducted by Ned Davis Research of the most momentous geopolitical crises of the last century. The firm found that far more often than not, the stock market, as measured by the Dow Jones Industrial Average strongly rebounds from its post-crisis panic low — so much so that within six months it is actually higher than where it stood before that crisis erupted.

The research report covered 51 events from 1900 to 2014, including the bombing of Pearl Harbor and JFK assassination.  Of note: the average stock market drop during each crisis was 17.5%, so the positive returns came after a fair amount of pain.  With stock valuations broadly at record high valuations, it is not difficult to envision a much larger correction if war breaks out with North Korea.

One problem with these sorts of back tests is that economic and market events can’t be replicated in a lab.  History doesn’t repeat, though it often rhymes.  To unravel this complicated puzzle, let’s look at three variables: valuations, sentiment and economics.  From a valuation standpoint, there is no way to compare past crisis lows to today’s twin asset bubbles in both stocks and bonds (at the lowest yields in 5,000 years of recorded history).

As for sentiment, a bit of history:

  • After WWI there was a sharp but brief depression in 1921.
  • After WWII, economists predicted another depression.  Instead we got a two-decades-long boom.
  • Initially, in the early-1960s there was complacency about the Vietnam conflict.  That eventually ushered in the intractable inflation of the ‘70s, which helped trigger (along with Watergate) the worst bear market in stocks since 1929-32, in real terms, from 1972-74.
  • The Gulf War brought back memories of the quagmire in Vietnam and was widely anticipated.  Stocks sold off in late 1990 as a result.  Operation Desert Storm began mid-January of 1991 and was over in a month.  There was no quagmire.
  • In 2003, the Iraq War was widely predicted to be brief, but it turned into quagmire.  Fortunately for stocks, they were 3 years into a burst tech bubble and prepared for bad news.  An aggressive Fed fomented the housing/credit bubble of the mid-2000s.

The lesson of #4 and #5 was that war – brief or quagmire – leads to bull markets.  Investors constantly fight the last war.  The complacency regarding North Korea is a direct reflection of recent past war experience plus an 8-year bull market where buy-the-dip behavior has been constantly reinforced by central bank asset purchases.

Lastly, let’s take a look at economics.  With the onset of war, we can expect the following to occur:

  1. The war economy is engorged while the real economy (or consumer economy) is drained.  GDP growth is highly misleading during wartime.  The consumer is worse off as resources are siphoned off to be destroyed (see chapter 3 of Henry Hazlitt’s Economics in One Lesson, “The Blessings of Destruction“).
  2. The immense costs of war are paid for through government borrowing and inflation.
  3. Government, aka the public sector parasite, is ratcheted up during war, but doesn’t relinquish all of those gains after the war (see Crisis and Leviathan by Robert Higgs).

Imagine these maladies foisted on an economy struggling to grow (the most anemic recovery post-WWII) and wheezing under record debt levels including $20 trillion of government debt (having doubled the past 8 years), $1.2 trillion in auto loan debt, $539 billion in margin debt, etc.  That debt has remained manageable thanks to miniscule interest rates, but a wartime economy would threaten this state of nirvana.

Moral of the story: act before the crisis.  With stocks and bonds priced for perfection, ignore impending danger at your peril.

The race to monetary hell

The Euro dropped to multi year lows as Hungary joined Greece in the global economic sovereign debt crisis. Like the Greeks, Hungary and other Eastern/Central European countries cope with economic contraction while debt servicing on both a private and public level remain insurmountable. Societe Generale (SocGen) rumors started overnight when several sources unveiled derivative impairment charges possibly linked to Hungary economic news which shouldn’t surprise anyone since SocGen has over $28 billion in Eastern/Central European debt exposure. To put things in perspective SocGens Eastern European exposure alone is roughly 60% of equity!

Other French banks remained quiet today as Trichet continues to monetize approximately $2-3 billion per day in Greek sovereign essentially bailing out his countryman’s finance houses while the Germans ask “where is our bailout”. According to latest ’09 filings some of the largest German banks are levered anywhere between 70-80X so a Greek bailout only partially removes some of the toxic waste from their respective balance sheets.

Institution A -TANGIBLE ASSETS(BILLIONS) B -TANGIBLE EQUITY A/B – LEVERAGE RATIO
DEUTSCHE BANK AG

€1,658

€27.4

60:1

COMMERZBANK AG

€842

€6.8

124:1

DEUTSCHE POSTBANK AG

€237

€3.0

77:1

LANDESBANK BERLIN AG

€143

€1.9

75:1

The Eurozone in general is challenged by rollover risk. Spain, for instance, has to roll over 40% of its external debt, which is about $700 billion to roll over, and because it is running a current-account deficit, it actually has to borrow more than that, which is almost another $80 billion. Just the government has to roll over about 20%, or about $125 billion. Spain will have to borrow more than it has ever borrowed before in the next year at the same time as people’s inclination to lend to Spain is reduced. The government debt of all the peripheral countries in the euro zone that has to be rolled over in the next three years is the equivalent of $1.9 trillion, and that doesn’t include the private-sector debt.

My Comments: The ECB has elected to enter the monetary race to hell so one should ask is Bernanke far behind? Answer: Dollar/Euro swap lines are wide open according to Bernanke thus an increase in the Fed balance sheet from current $2.4 trillion to $3 trillion seems likely.

Bailout nation…

… Not the U.S., but Japan. Japan Airlines, after repeated bailouts, finally succumbed to its $25 billion debt load and filed for bankruptcy today. According to The Wall Street Journal:

The company will be aided by a $10 billion lifeline from the government in the form of capital injections and credit, and by unloading billions of dollars in losses across an already weak Japanese economy. Bureaucrats also strong-armed Japan’s banks into forgiving more than $8 billion in outstanding loans, while retirees and employees accepted more than $11 billion in pension cuts. Shareholders will be formally wiped out when the stock — once considered one of Japan’s bluest of blue chips — is delisted from trading on the Tokyo Stock Exchange on Feb. 20.

For the record, JAL offers a quick primer on how government intervention destroys an economy:

  1. State ownership and control. “Though financial profligacy was one cause of JAL’s demise, its close ties with the government — even after it was privatized in 1987 — effectively crippled the carrier. Pork-barrel aviation policies drawn up by transport bureaucrats caused JAL to fly unprofitable routes for decades.”
  2. Moral hazard of implicit government backing. The 1987 IPO (and others like it, such as Nippon Telephone & Telegraph) were wildly successful in part because investors felt the government wouldn’t allow them to lose money.
  3. Bubble behavior. “When Japan Inc. rose to glory in the late 1980s, gobbling up trophy icons such as New York’s Rockefeller Center, JAL also spread its tentacles around the world by buying the Essex House in New York and setting up resorts in Hawaii.”
  4. Endless government lifelines. According to CNBC, JAL was bailed out four times by the Japanese government over the past decade.

How much capital was squandered on JAL? How much was looted from the real economy? This explains Japan’s “lost decades.” America’s path down the same road can only produce similar results. Repeat after me: “Fannie Mae, General Motors, Citigroup…”

Obama/Bernanke science project now on red alert

Over the past few years we’ve chronicled the build and unwind of the greatest credit bubble in history while most market observers continued to embrace the almighty central planners. Time and time again either the Federal Reserve or the US Treasury appeared on the crime scene with extraordinary measures all fraught with precarious unintendid consequences.

First, the countless interventions involving GSEs, money center banks and AIG all had one common denominator: “save the bondholder.” In all cases the US government stepped into various private sector businesses, took a significant equity ownership interest alongside the prior destroyers of capital, and preserved bondholders, consequently crowding out the future investment capacity of remaining and prospective entrepreneurs. For example, AIG is now 79.9% owned by the US taxpayer thanks to over $180 billion in bailout funds, some of which found their way into the hands of multiple Wall Street beneficiaries, namely Goldman Sachs and Deutsche Bank. Fannie Mae and Freddie Mac are categorized as “works in progress” courtesy of ex-Treasury Secretary Hank Paulson’s “conservatorship” scheme while the Obama administration tinkers with alternative strategies. Meanwhile, these propped-up entities are classified as off balance sheet budget items requiring over $100 billion in bailout funds since last fall with projections of another $300 billion before year end!

Second, the money center banks, specifically Citigroup and Bank of America, are ridiculously insolvent yet the Bush/Obama triage unit remains hell bent on emulating the Japanese model of keeping the zombies alive at any cost. Most of the life support was provided by the $700 billion TARP boondoggle.

Third, FDIC debt guarantees enabled additional dead men walking, such as Morgan Stanley, Goldman Sachs, JP Morgan and countless others, the opportunity to sell debt at below-market interest rates in the hope of recapitalizing the murky lenders during the recovery process.

Finally, the Federal Reserve – under fearless leader Ben Bernanke – has assured the American people that his science project, a.k.a. Shadow Banking II, will revitalize the private sector credit machine since over 60% of all US lending the past decade took place in the toxic off balance sheet world (Shadow Banking I). Predictably, his reliance on the same incompetent rating agencies and questionable collateral never comes up when presenting his plan. One simple question comes to mind regarding the Fed’s current balance sheet vs. several years ago: “How will the Fed remove all of this temporary liquidity when the balance sheet two years ago was primarily short term T-bills vs. longer-term structured finance instruments today?” Of course the answer is they won’t be able to remove any of it without creating hyperinflation.

In summary, the US government, in cahoots with the privately-owned Federal Reserve, intervened in an unprecedented fashion in order to preserve the US dollar fiat monetary system. It took conservatorship of Fannie and Freddie, the Bear Stearns bailout, TARP, FDIC guaranteed debt, and a plethora of “temporary” Federal Reserve credit facilities as well as permanent government credit backstops totaling $12.7 trillion to prevent the mother of all bank runs.

Until now the economic and investment minyans have applauded the work of Alan Greenspan’s worthy successor, but what lies ahead should make any supporter of central planning awfully concerned. Ladies and gentlemen, the dollar reserve currency system is now teetering on the edge thanks to the latest decisions by the Obama/Bernanke administration. Instead of allowing bank receivership or worthy bankruptcy law to remove the misallocated private sector debt in our lopsided system, team Obama has created additional bailouts resulting in a projected record budget deficit of $2.2 trillion for 2009 (an unprecedented 20% of GDP). This year alone sends over $1 trillion to the Wall Street dealers who created the fiasco with no mention whatsoever of the epic fraud from various participants, some now on the Obama team roster (Rubin, Geithner, et al.). The $1 trillion happens to be roughly 8 years of productivity in this country so expect government handouts to crowd out potentially thousands of new businesses and related jobs. (Despite the current government-created economic drought, the public sector parasite must be well-fed.) On cue, team Obama – literally televised daily – continues to tell the American people not to worry since his recent stimulus plan will create thousands of new government jobs similar to FDR’s New Deal.

By 2011 some economists project another several trillion in borrowing needs, taking the national debt above $15 trillion with an economy contracting by another 10%. This begs the question: “Who will lend us money to operate the USS of A?” Clearly scientist-in-chief Bernanke is now in the final phase of his lab experiment since earlier test results have all been negative. Showing signs of desperation, beginning in December of last year Bernanke discussed the possibility of extraordinary measures by the Fed, specifically buying mortgage-backed securities and longer-term Treasuries in hopes of controlling the long end of the yield curve. Germany tried this in the ’20s and we all know how that ended up. Since Bernanke’s trial balloon in December, the 10-year Treasury yield has climbed from 2.28% to over 3.45% as of Friday’s close. Subsequent to the December speech Bernanke has implemented his quantitative easing experiment as the Fed announced in March it would buy $750 billion in mortgage-backed securities and $300 billion in Treasury notes and bonds. $113 billion has been committed to buying Treasuries year-to-date. Not only has the yield spiked on the 10-year, but the US dollar index has declined by approximately 11%! Note to Bernanke: your experiment is an unmitigated disaster; please refrain from any more of this economic insanity! (Fortunately, Dr. Ron Paul has now garnered momentum in his quest to strip Mr. Bernanke of these insidious actions.)

It is said the road to hell is paved with good intentions. In this case, the perpetrators of the crime of the century are simply motivated by saving their own bacon.

AIG: America’s Insolvent Guarantor

Since the Fall of 2008 the US government has committed over $11 trillion in new credit and or credit backstops to prevent the collapse of our modern day banking system. Closer examination of various TARP and other bailout recipients reveal the extraordinary demands of American International Group (AIG) which after Monday surpassed the $173 billion level. Hard to imagine when AIG had assured shareholders just one year ago that “excess capital was $14.5-19.5 billion”. At the same time we were commenting on how credit default swaps would follow sub prime lending as disaster du jour with AIG leading the charge. Of course as a taxpayer and reluctant current shareholder of AIG I have to ask how did we get here and how high does this bailout number get over the next several years?

If we rewind the tape back to the Summer of 2007 most market participants envied AIG, the world’s largest insurance company. How could you not after hearing statements like this from one of their top brass:

“It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions.”

~ Joseph J. Cassano, a former A.I.G. executive, August 2007

Just 12 months later the shadow banking system was imploding and former Treasury secretary Hank Paulson called Goldman CEO Lloyd Blankfein and several other counterparties to discuss implications of AIG’s swap exposure. Unbeknown to many at the time was Goldman’s counterparty importance to AIG, specifically both credit default and interest rate swap exposure. Unfortunately 70% of the derivative market trades under-the-counter so specifics on CDS and interest rate swaps is difficult to decipher, until now. After reporting a quarterly loss of $61 billion last week, the largest quarterly loss in U.S. history, AIG’s largest shareholders demanded details on where the bailout money was dispersed. The list of culprits comes as no surprise.

Goldman Sachs Group Inc and a parade of European banks were the major beneficiaries of $93 billion in payments from AIG — more than half of the U.S. taxpayer money spent to rescue the massive insurer. Revelations that billions of U.S. taxpayer dollars were funneled through AIG to Goldman Sachs — one of Wall Street’s most politically connected firms — and to European banks including Deutsche Bank, France’s Societe Generale and the UK’s Barclays could stoke further outrage at the entire U.S. bank bailout.

It doesn’t to me seem fair that the American taxpayer has got to bear the 100 percent of the downside,” said Campbell Harvey, a finance professor at Duke University. “A hedge is not a hedge if you did not factor in the counterparty risk. And the U.S. taxpayer should not be obligated to make people whole for hedges that were not properly executed.”

My Comments: In a little over 12 months the largest insurer in the world has now become part of the zombie gang joining other former leveraged high fliers such as Citigroup, Fannie Mae and Freddie Mac. Latest disclosure documents from AIG put potential CDS exposure north of $500 billion. When adding interest rate swap exposure to the mix the total derivative book exceeded $1.5 trillion! Are derivatives becoming a problem now that the asset inflation game has come to a grinding halt? Citibank, Bank of America , HSBC Bank USA , Wells Fargo Bank and J.P. Morgan Chase reported that their “current” net loss risks from derivatives — insurance-like bets tied to a loan or other underlying asset — surged to $587 billion as of Dec. 31, 2008 . Buried in end-of-the-year regulatory reports that McClatchy has reviewed, the figures reflect a jump of 49 percent in just 90 days.

As the shell game continues we get closer to the real players in this collapsing fraud, primarily the insolvent TARP recipients who require yet another open ended capital conduit. Is it any surprise that the AIG bailout money flows through to politically connected zombies such as Goldman, Merrill (now Bank of America) and Deutsche Bank? Or that Bernanke makes a 60 Minutes infomercial Sunday night assuring the American people that money center banks will not fail based on his “new”reflation experiment?

Finally, we look at the Obama administration where Turbo Tax Timmy Geithner is assigned to the AIG bonus scandal hoping the distraction preoccupies most of main street. Unfortunately this too shall backfire since many of these potential bonus recipients know where all of the counterparty skeletons reside in this open ended bailout sham. Note to the administration: Be careful what you wish for.

Bailout winners and losers

On Thursday, September 18, the financial establishment was coming unhinged. By early afternoon the combined market values of Citigroup, Bank of America, JPMorgan Chase, Goldman Sachs, and Morgan Stanley had shrivelled to $360 billion.

That night DC’s power brokers – Paulson, Bernanke, Cox, Pelosi, Frank, et al. – concocted a scheme to rescue the “chosen ones,” with the initial installment set at $700 billion. Result? As of yesterday’s close, the Elite 5 tacked on $192 billion in market value, or 51%. The rest of the market, as measured by the Dow Jones Wilshire 5000 Index, lost $509 billion, or 4.5%.

Mr. Market is not always rational, but in this case he figures a blank check for a former CEO of Goldman Sachs will benefit the political economy at the expense of the real economy. Our sense is that both are in trouble; transferring more blood from the productive host to the parasite can not possibly help.

Paired trade of the decade?

Long gold ($869.00/oz.), short the S&P 500 (1255.08). The gold/S&P ratio is currently 0.69 and going much, much higher (see above).

The catalyst? The federal government is planning to cut a check for $900 billion to bail out Fannie/Freddie and now purchase mortgage-backed securities at above-market prices. The final tab is going significantly higher, the lion’s share of which will be paid for with printed dollars. From these delusional levels, a 1930s-style collapse in real terms is all but guaranteed.

Addendum: As the graph shows, U.S. equities have been in a relentless bear market versus gold since their tech bubble highs of 1999-2000. In fact, a unit of the S&P 500 that purchased 5.23 ounces of gold 9 years ago buys just 1.45 ounces today. The S&P has lost 72% of its gold value during that time.

Martin Van Buren on government bailouts

Those who look to the action of this government for specific aid to the citizen to relieve embarrassments arising from losses by revulsions in commerce and credit, lose sight of the ends for which it was created, and the powers with which it is clothed. It was established to give security to us all. … It was not intended to confer special favors on individuals. The less government interferes with private pursuits, the better for the general prosperity.
~ Martin Van Buren, 8th President of the United States, 1837

My comment: Mr. Paulson, you’re no Martin Van Buren.

Paulson’s gift to the bears

It’s official: The U.S. economy is headed for its worst recession in three decades. Henry Paulson’s scheme to keep Fannie Mae and Freddie Mac on government life support and bail out its creditors (i.e. Wall Street, Big Banks, and Bill Gross at PIMCO) removes any doubt. The only question remaining: Will this downturn rival the Big Kahuna of the 1930s?

Paulson was interviewed today on Bloomberg. Here is the money quote:

“No one likes to put the taxpayer into situations like this. No one does; I certainly don’t. Government intervention is not something I came down here wanting to espouse, but it sure is better than the alternative.”

The alternative, of course, is that Paulson’s friends are actually forced to take huge losses on their reckless, ill-fated loans to Fannie and Freddie. Unthinkable! Paulson assures the naïve interviewer that the taxpayer will come before the shareholder, forgetting to mention the shareholder has already been wiped out, putting the taxpayer last in line behind the creditors. Under Hanky Pank’s scheme, the taxpayer is simply the bagholder of last resort. Paulson was obviously a quick study under former Goldman Sachs CEO and Treasury Secretary, “Mr. Bailout” himself, Robert Rubin.

The initial reaction of the stock market was to celebrate with a 300 point rally in the DJIA. Our guess is the euphoria will fade quickly as investors realize bailout money does not grow on trees, and the cash will either be taxed, borrowed or printed. The only question: How much will the final tab run?

The more pressing concern, however, is the economy. This economy needs to break its addiction to cheap credit, remove the waste of the previous credit binge, shed its political parasites (e.g., friends of Hank), and rebuild on a solid foundation. Every intervention prolongs the process and deepens the malaise. A wholesale government takeover of the mortgage market virtually guarantees the economy will be mired in deep recession for years.

The only winners (besides whiners like Bill Gross)? Those who are short the market.

Note to self: Move those inflation hedges from the attic to the front hall closet.

GSE bailout bill may cost taxpayer over $1 trillion

When President Bush named Hank Paulson treasury secretary several years ago the media welcomed the free market supporter with open arms. Today we see the man’s true colors as both he and Bush have now capitulated by endorsing the most recent GSE bailout bill potentially costing you and I over $1 trillion!

The reversal upends admonitions Bush made starting almost a year ago. “A federal bailout of lenders would only encourage a recurrence of the problem,” Bush said Aug. 31, 2007. No way, he said May 6, would he allow “a costly bailout for lenders and speculators.” The warning was repeated several times this month.

Enactment constitutes “a very important message that we are sending to investors around the world” that would play a key role in “turning the corner” on the housing crisis, Paulson told reporters. “This is about not only our housing markets, but it’s about our capital markets more broadly,” Paulson, 62, said today in a Bloomberg Television interview. “This goes well beyond the two institutions — Fannie and Freddie — it has to do with investors in the United States and investors all over the world.”

In detail the bill added over 700 pages in the past 24 hours, which included several shocking inclusions:

– Fannie Mae and Freddie Mac already own $6.9 billion of foreclosed homes. Almost as much property as the entire rest of the other 8,500 commercial banks – combined.

– Assuming the default rate stops rising immediately, it’s likely that around 10% of Fannie and Freddie’s owned and guaranteed mortgages will end up in foreclosure. Assuming a 50% recovery rate, that’s a $250 billion loss.

– $2.5B line of credit to the Treasury (Fannie & Freddie) is “open-ended”

– Unlimited– Treasury now allowed to buy all ‘F & F’ housing securities

– Congress no longer involved in appropriating funds (Treasury now does)

– New housing trust fund totalling $500-700 billion which resembles a similar proposal submitted by Bank of America months ago.

– No changes in existing GSE model

– Ultimate cost to US taxpayer $1.1 trillion according to S&P

My Comments: The ongoing intervention comes as no surprise yet this bill all but guarantees a nationalization in residential lending. Equity holders and taxpayers will bear the cost while Wall Street benefits. Have the US citizens learned anything from government intervention?

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