Margin Debt Plunges - The Age of De-Leverage

No matter how you interpret it, the recent plunge in margin debt in the US is thought provoking (see chart below).

Latest data from NYSE show a vertical drop: from a high of $381 billion in mid-2007 to $186 billion in December 2008, with most of the decline occurring in just the last three months. Margin debt has likely declined even further in January and February. De-leveraging writ very large, indeed.

For a more instructive longer-term perspective it is better to look at a log-scale chart (see below).


One (fundamental) interpretation is that The Great Pump-Up, which lasted over thirty years, is finished and the Age of De-Leverage is fast upon us. Though I don't expect the latter to last as long as the former (economic declines being swifter than expansions), I nevertheless think that the de-leveraging process will last more than most people believe. And this, despite the (un)heroic efforts by Fed and Treasury to rapidly pump trillions of fresh debt into the system. All they are achieving so far is to replace a portion of the debt going terribly bad (eg sub-prime mortgages and speculative trading leverage) with government debt. Unfortunately, private debt is rotting away much faster than the feds can replace it.

I wonder.. When will the people of the new Obama administration cotton on to the simple fact that the whole debt-fuelled Permagrowth structure is rotten, not just one small portion of it? When will they wake up and realize that Bernanke, Paulson & Co. (and now Geithner) are not providing fresh solutions, but simply making the old problems even worse?

C'mon folks, PLEASE! Step out of the box and look at things from another angle. Whatever you think, dare to think the opposite. For one, stop comparing today with the Great Depression - that's a ridiculous, fear-mongering scare tactic used by the finance community to convince the public to supply bail-outs by the trillion.

Today's US economy bears no resemblance whatsoever to the 1930's. Capital and labor intensive industries like manufacturing and farming account for a far smaller portion of GDP and the social safety net is much bigger (deposit and pension insurance, Social Security, Medicare, food stamps, etc). It's the debt-laden asset-based FIRE economy which is in deep trouble today and it should be allowed to shrink back to a relative insignificance.

Unintended Consequences

I was going to post about "Green" today but this came up yesterday and is highly topical to what is going on right now.
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Deflation is being writ larger and larger, and it is showing up beyond the narrow confines of the credit crunch in banking, finance and real estate.

Spain's Santander Bank - one of the world's largest - needs to raise fresh cash to shore up its balance sheet after suffering huge losses in mortgage lending. It is, therefore, offering to sell its 31.6% stake in CEPSA, Spain's second largest oil company. Nothing odd, so far.

But the (shocking) news is that it is offering to do so at a huge markdown: a range of 30-35 euros per share, versus a closing price of 67 euros just three days ago. That Santander has to provide a monstrous 50%+ discount for a crown jewel unrelated to finance is most assuredly a rude wake-up call. At least for those who still view generalized deflation as unlikely.

Ring, Ring - Deflation Calling

Well, ring-a-ding-ding..

Long-time readers may remember this post from March 2007 about the Spanish developing vacation real estate in even the most unlikely places (excerpt follows).

"I was in ... (south Spain)... a few months ago and I can confirm that the whole Costa del Sol, from Gibraltar to Almeria (about 500+ km), is one giant vacation construction site, with El Cheapest attached condominium projects machine-gunned from the water's edge up to the hills. We are talking, up one hill and down the other. I saw the saddest excess at Carboneras, at the far end of Almeria province, a grungy but laid-back factory town still undeveloped by comparison to, say, Estepona. Just around the corner (and down-wind?) from the huge, smoke-belching cement factory they are building this enormous "luxury" vacation-condo complex, having hollowed out an entire hill."

Here is a picture from another monstrous complex, under construction just north of the same factory, which I just found in Google Earth. The word "rape" - environmental and financial - does not do justice to what went on there.

Building Prosperity in Spain - a posteriori

I believe the sound of toppling deflation dominoes can now be heard clearly by everyone. Can anything be done to stop them from smashing into each other? The US and EU are trying, furiously creating new money (i.e. government debt) to replace the "liquidity" being drained away by the swift and merciless process of debt destruction. In this way they hope to shore up prices of all manner of assets, from homes in California to factories in Dalian and charter-less bulk carriers riding their anchors.

It all boils down to one objective, one fervent desire: Let's keep the Permagrowth Party going.

I will say it once more: Before it's too late, before untold trillions are wasted on supporting yesterday's corrupted and corroded "borrow-spend-inflate" economic structure, let's instead invest heavily in our (and our children's) Sustainable future.

The Trouble With Harry, or CCC

You are a large global bank. What is your business model, right now? I discussed this with a friend at a bank today and we came up with this: cross my fingers and hope to survive.

In other words, current banking strategy is based on the fervent hope that things are not as bad as they seem, that the global economy will improve faster than feared, that credit and equity markets have overshot on the downside because they are panic stricken instead of discounting a terrible future.

That, above all else, The Trouble With Harry is not that he is stone-cold dead from repeated overdoses of deleterious debt, but that he is suffering from a temporary confidence coma.

A Banker Hard At Work Implementing
His Current Business Model

Well, good luck with that.

Hope may be a fine personal trait but it does not make for good banking business models. When bankers have to rely on sentiment instead of hard-nosed greed you know they are in deep trouble. And what is the nature of their problem? It's in the title of today's post: the Capital Conservation Conundrum, or CCC for short.

Let me explain.

Banks are very simple businesses: borrow - lend - repeat. The crucial word being repeat, because if the cycle stops banks almost immediately start losing money. When principal is repaid (or defaulted) and is not re-lent net interest margins (NIM) decline and high fixed costs hit the bottom line hard. Therefore, as banks go into capital conservation mode and shut lending down they create a negative boomerang effect for their own earnings. In more ways than one, banks are like sharks: they have to keep swimming in order not to sink.

Banks striving to preserve capital (i.e. to maintain capital adequacy ratios) are in effect winding down their core business. This is another reason - beyond loan defaults and trading losses- that banking stocks have been pummelled into the dust. The KBW banking index is down a whopping 80% in two years (see chart below).

KBW Banking Index (US)

As a confirmed contrarian investor/speculator I look at the above chart with interest. But when I try to attach a fundamental story - where is the next seminal earnings upswing going to come from - I cannot find one.

Perhaps it is my own lack of imagination, but I cannot see the next big thing for banking revenue and earnings. (For example, after 2001 it was clear that mortgage and consumer lending was going to boom as the Fed slashed rates). So, in my own mind at least, the banking sector is not worthy of a long-term investment commitment - even as a dead-cat rebound may be imminent. (I would be very interested if readers could supply alternative perspectives).

In my opinion "Green" is the sector - many sectors, actually - providing future multi-year opportunities. More on that in the next post, based on my recent trip.

Poorhouse For FIREmen

Just about every civilian (i.e. a non-finance professional) thinks that a Crash is the way to send financiers to the poorhouse en masse. Wrong - just as it is completely wrong to think that casinos go bust because too many people win. The truth is, of course, completely different.

The FIRE Casino (finance, insurance, real estate) feeds on the Two Vees: Volume and Volatility. Thus, it goes bust only when no one wants to play, when the market is flat and volumes shrink. This hasn't happened in a long, long time. The last time, when brokers became cabbies, was the 1970's. The Dow literally yawned its way through that entire decade, fluctuating a mere 100 points around the 900 mark (with one exception - see chart below).

When Brokers Became Cab Drivers

You see, the house doesn't really care about "How The Dow" (though it does prefer it to go up because it then captures the hoi polloi's imagination and induces more participation by the marks - remember dotcom daytraders?).

As I said, market makers feed on volume and volatility, not direction. And there's the rub: so far volatility has been immense and volumes quite strong - at least in equity markets. The prediction, therefore, is that this whole crisis thing won't be over until ... you guessed it... volatility drops sharply and volumes tank - and cab companies get job requests from unusually well educated applicants.
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Note: I'm off on business for a week (green business, by the way) and will try to post ad hoc.

Over There, Then And Now

Just in case anyone thinks the grass is greener over yonder, i.e. across the Atlantic Pond (globalization having shrunk everything in size), here is an article by The Telegraph's eminent Ambrose Evans-Pritchard to remind us that "sudden debt" was how the world bubbled its economy to the bursting point. And the consequences.

Scary read to be found here: Failure to save East Europe will lead to worldwide meltdown.

We see that "in Poland, 60pc of mortgages are in Swiss francs. The zloty has just halved against the franc." How about that? By comparison, US sub-prime loans appear almost benign and boring.

And.. "Austria's finance minister Josef Pröll made frantic efforts last week to put together a €150bn rescue for the ex-Soviet bloc. Well he might. His banks have lent €230bn to the region, equal to 70pc of Austria's GDP."

I should remind everyone that after the 1929 stock market crash the global economy seemed to hold together - for a while. It was not until 1931 and the collapse of an international bank that the entire world spun into the Great Depression. Location of said bank? Yes, Austria*.

From today's stock market perspective, however, it is troubling that we have not yet seen any significant rebound from November's lows. The market is just going sideways, in a rather tight range.


By comparison, the Dow managed a near 50% jump in 1930.

DJIA 1929-1933

Which begs the question: is today's market action discounting the past (i.e. being scared of a repeat Great Depression) or is it discounting the future (i.e. hoping for a rather swift economic rebound)? I think it is doing both, which is why it is range-bound for nearly four months. Simply put, even professionals have no idea whatever which way the market will "break" (up or down) and are thus sitting on their hands.

Think deer, headlights, truck. But will the truck hit the long-horns or the short-horns? Beats me. But there IS an alternative possibility, derived from the maxim that "the market strives to make fools of the largest number of participants possible": the truck is stopped, albeit with the lights on. Oh dear...

In that case we will just have to scrape a living by selling volatility to both long- and short- horns.

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* The Creditanstalt Bank failed in May 1931. It was closely linked to the global Rothchild network.

Short Sunday Musings: Words v. Pictures

It's Sunday and global financial markets are closed. In the absence of bid-offer gyrations the mind spins a little slower and has the chance to see things somewhat differently, perhaps more clearly. Even the qualities of light and colour are richer, more saturated somehow. Time stretches to its potential, striving to claim the full extent of space.

Ahh, perception is everything. So, here goes something about that.

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A picture is worth a thousand words, they say. How true.

The headline of the BBC story immediately caught my attention: "Global warming underestimated", it proclaimed and warned that "the severity of global warming over the next century will be much worse than previously believed."

The story continued:

"Speaking at the American Science conference in Chicago, Prof. Field said fresh data showed greenhouse gas emissions between 2000 and 2007 increased far more rapidly than expected.

"We are basically looking now at a future climate that is beyond anything that we've considered seriously in climate policy," he said.

Prof Field said the 2007 report, which predicted temperature rises between 1.1C and 6.4C over the next century, seriously underestimated the scale of the problem. He said the increases in carbon dioxide have been caused, principally, by the burning of coal for electric power in India and China."

The whole story is quite short; you should read it here.

But my point is about the picture that accompanied it..

This Is Not About Us

A polar bear... for heavens' sake, a cuddly polar bear - and in a pristine frozen landscape, at that. The less than subtle message: this whole global warming schtick is all about a couple of bears in some godforsaken frozen place a million miles away. "Move on, this is none of our concern", screams the photo, despite the dire warnings of the text.

How about this photo, instead?

Not A Drop To Drink

Or this one?

Global Warming Is A Burning Issue

And this one..

Global Warming Hits Home

Finally..

Global Warming Is All About Us

And if you think all of the above have nothing to do with debt, money or the price of beef in Iowa.. well.. perhaps you should look into emigrating to Mars.

Carbon Tax or Carbon Trading?

In discussing "green" energy the following question inevitably arises: should we tax "black" energy (coal, petroleum, gas, etc.) or should we instead install a cap-and-trade regime whereby emissions are capped at a given level and entities can trade pollution permits?

The main argument for taxation is simplicity, whereas for cap-and trade is the certainty of a pre-determined volume of emissions. The EU already operates an active emissions market, quite successfully at that. See below for a chart of futures prices for CO2 emissions (click to enlarge).

Source: European Climate Exchange

We can immediately see the Achilles heel of a market-based cap-and-trade system: as prices for CO2 permits drop - recently from 30 euro/ton to 8.85 euro/ton - industry can simply put off becoming greener until economic conditions improve. This regime, therefore, does not drive continuous greening but does so only on a marginal basis: pressure to change varies with economic activity, since most activity is still "black".

The answer to the tax or trade question is quite simple: both. Taxation, ideally steadily rising on a pre-determined basis, will constitute the constant pressure towards "greening", whereas the permit trading system will provide variable impetus for marginal profits. Think of polluting, in broad terms, as running a business that has both fixed and variable costs.

Now, couple the above with one more "missing link", the appropriate monetary system (see my recommendation for The Greenback), and we're off to the Green Races.

Remember Decoupling?

A bit over a year ago (post of January 21, 2008) I posed the following question:

If the global economy has become highly integrated, as so many say ("globalization"), isn't it illogical that parts of it will decouple by a wide margin and just keep going strong, despite weakness in the US, EU and Japan (70% of global nominal GDP)?

The reason for the question was the hyping of "decoupling" by a bunch of talking-head econo-analysts as the way forward for the global economy.

The answer finally came - in spades - today:

Chinese exports contracted by 17.5% in January, the steepest in 13 years, and the third month of contraction. Imports contracted even more (43.1%, the worst since data begun being collected in 1995). Full details here.

Instead of decoupling some of its newer cars, the global economy train has derailed in toto. And it really doesn't look very good going forward, either; inventory-to-sales ratios in the US are zooming higher. Remember that the US and Europe account for 50% of Chinese exports.

From AAA To Zero

The government is preparing yet another bank rescue plan, this time hoping that private investors will be willing to buy "toxic" assets at a greatly reduced price. The government would provide a put option to the buyers, i.e. a guaranteed floor price.

Here, then, is my suggestion for the floor price: zero.

I know this won't promote the sale of a whole lot of radioactive CDO's, CPDO's, etc, and thus won't lead to a clean-up of bank balance sheets. But zero is, in fact, a very realistic price - at least for a great deal of those so-called assets. Why?

Because...

• The cascade structure means that most of the tranches (i.e. all except the super-senior) are worth zero once the underying assets (mortgages) default at a rate beyond a certain benchmark. This benchmark, based on highly optimistic historic assumptions, was overtaken a long time ago.

• The fees involved in structuring such products "sucked away" a large portion of the stated face value and probably the entire residual value. Consider the whole cycle involving the purchase of a newly-built home: the builder's profit, the realtor's/saleman's commission, closing costs, the mortgage originator's commissions, the loan packager's fees, the investment banker's fees, the broker's commissions. Add it all up and it easily comes to 20-25%.

• Home prices have plunged fast and furious, wiping out the security deposit of the original borrower - if there was a deposit in the first place. Look at this example from Florida:
  

Put everything together and you come up with this disturbing conclusion: even the super-senior tranches are highly suspect of being worth exactly nothing. In fact, given local ordinances on property upkeep, back real estate taxes, etc., there is a good possibility that whoever gets title to homes after prolonged foreclosure proceedings may end up owing more money than the property is worth.

In such cases even zero is too much to pay for "toxic assets" and that's why the government should provide no better floor price than that.

Bankers In Paradise

It was decades ago, I was young and I was on vacation in Honolulu, Hawaii. Jimmy Buffet was appearing live at an outdoor stage someplace in Waikiki Beach, singing "Cheeseburger in Paradise".

Fast forward to today. Speaking in the 128th Assembly for Bank Directors Janet Yellen, president of the San Francisco Fed, said that many of the economy's current dynamics are similar to the Great Depression, requiring "urgent, aggressive action". Furthermore, "the economy is in the midst of a downward spiral, and that calls for strong policy responses".

Given the current reduced state of banks all over the nation and massive bailouts in the trillions, one would expect the meeting to be held at the Chicago airport Ramada Inn. Cookies and weak coffee free, anything else you have to pay out of your pocket.

Instead...

Welcome to the Kohala Coast on the Big Island of Hawaii...


The Fairmont Orchid is the site of the 128th Assembly for Bank Directors, February 5-8, 2009. The Fairmont is set on 32 acres with a white sandy lagoon and aquamarine waters, five restaurants, and the largest petroglyph field in the Pacific.

Ocean view rooms start at $424/nite. But, hey! They can afford it - they have a really rich Uncle.

Those guys are incredible...

The Economics of Stagnation

From the Always Uncertain Predictions Dept. comes today's exhortation to all economists: dust off your (very) old textbooks and learn to live with (and perhaps love) an economy in stagnation - at least for a few years.

To wit, our Cloudy Ball predicts that, unlike previous economic cycles, the US will not see a rapid rebound after the current recession hits bottom and will instead scrape along at a -1% to +1% rate. Let's look at what the Ball is seeing..

Exhibit En (I'm counting in Danish today): Population growth has been declining from 1.4% annually in the early 1990's to 0.8% now. Population is (always) destiny; in recent years its growth came mostly from foreign immigration and that's going to slow down further as the recession bites and creates fewer opportunities for migrants.

Annual Population Growth (%)

Exhibit To: Layoffs are at the highest level in 27 years. More importantly, continued claims for unemployment insurance are at 4.8 million - the highest ever - meaning that laid-off workers cannot find a job quickly. And most importantly, prospects of a quick rebound in job creation are dim because of the nature of the economy: low-end service jobs, part-time jobs and underemployment are widespread.

Continued Claims for Unemployment Insurance (thousands)

Exhibit Tre: Pre-consumption. The explosion of debt meant that in previous years people consumed much more than they needed to, or could afford, versus their income. Household debt soared from 60% of disposable income to 102% in a mere eight years. Remember home equity loans, the house-as-credit-card scheme? People satisfied their consumption needs far into the future and won't be back spending with abandon any time soon. Putting it another way: don't overestimate the American consumer.

Soaring Debt for Households

Exhibit Fire: Saving is the new ethos. For an economy that's 75+% consumption the result is obvious, at least until we replace the borrow-spend-inflate assets model with a work-save-invest model. As they say in the fashion business, black is the new red.

Save For A Stormy Day

Exhibit Fem: Interest rates for long term Treasury bonds are at lows not seen in multiple decades (10-year bonds touched 2.1% before rebounding to 2.9%), even with quantitative easing and fiscal stimuli in unprecedented amounts. The bond market, at least, is betting heavily on a long, drawn out period of economic weakness, most probably out-and-out-deflation.

Gentlemen Prefer Bonds

Pricing Green Energy

I have been reading an interesting paper about alternative energy investing. It was authored by the World Economic Forum, that supra-national, self-congratulatory establishment pow-wow held annually at Davos, Switzerland. It's called Green Investing: Towards a Clean Energy Infrastructure and can be accessed here in PDF form. When this most exclusive Club of Clubs for the PTB crowd takes Green to heart - as it apparently has - it is time for everyone to realize that it's no longer an activist issue but has gone 100% mainstream.

Within the paper appears this sentence: "It should be noted that any comparison of levelized costs of different energy sources is a minefield". Never one to be easily dissuaded by risk of explosion (or is it exposure?), I put forward a simple formula for calculating the cost of "green" energy when comparing it against "black" energy.

Here it is:

P= Pb - Of - Oc

where,

• P is the price of green energy.
• Pb is the "basic price" of green energy, without subsidies, as normally calculated for any project including cost amortization, financing, operating expenses, etc. For example, right now onshore wind energy costs 9-13 US cents per kWh .
  
• Of is the current value of options to lock in the price of a conventional fuel (e.g. coal or natural gas) at today's prices over the entire expected lifetime of the green energy plant (e.g. 30-50 years).
• Oc is the current value of options to lock in the cost of carbon taxes/permits at today's prices of an equivalent-sized conventional power plant - again over the expected lifetime of the green plant.

Obviously, option prices should be calculated on a per kWh basis.

In this way green energy prices will reflect two crucial adjustments:

a) Stripping out the risk (i.e. cost) of fuel price volatility. Most green energy alternatives, such as wind, solar, tidal and geothermal, use no fuel and thus are not subject to "black" fuel price adjustments.

b) Stripping out the risk (i.e. cost) of carbon permit price volatility. Green energy is obviously not subject to carbon emission costs.

Comments invited.

About Protectionism (and Salary Deflation)

As the new $800 billion stimulus bill is being put together, a clause about "Buy American" contained within it is stirring fears of protectionism. The clause would require all projects funded through the bill to use American-made steel, etc.

Sounds very reasonable, but lots of (interested?) parties are against it claiming it would result in a wave of countermeasures against the US. In particular, they resurrect the old bugaboo of the Smoot-Hawley Tariff Act, often blamed for exacerbating the Great Depression.

This analysis is just another example of knee-jerk thinking from "inside the box". In addition to objecting to the above clause, this line of post hoc thought is also responsible for other misguided and inappropriate actions, such as massive bank bailouts, zero interest rates and quantitative Fed easing.

Why? Because what really happened was not globalization of trade but an abrupt and massive relocation of manufacturing capacity, mostly to China. The US alone has "exported" an incredible 4.5 million manufacturing jobs in just seven years, an unprecedented economic event of historic proportions. Other western nations have done the same.

Gone to China: 4.5 million manufacturing jobs

What did we exchange these jobs for? Loans of Chinese labourers' savings in the form of US Treasury and other bonds, i.e. debt. This insane policy of national emasculation will surely go down as one of the worst mistakes in the history of all empires.

OK, so why is "Buy American" a good idea? Because, first of all, it is most definitely NOT protectionism - just look at the above chart. And also because...

a) It will work towards slightly rebuilding manufacturing capacity and well-paid jobs.
b) It will encourage localization of production and distribution, sorely needed in a world of diminishing resources and environmental degradation.
c) It more fully recognizes real production costs, as stricter US environmental and social protection regulations must be adhered to, as opposed to the anything-goes regime in China.

...and...

President Obama (annual salary $400,000) has recommended that compensation for bailed-out executives be capped at $500,000 annually. Oh ho, ho! That's not even enough to pay for pool maintenance, never mind food and drink. But it is a most definite sign of deflation - even if it is highly populist and very popular with the hoi polloi.

Compare the measly 500K with compensation at Citi during 2007, to pick just one example. Click to enlarge for legibility.

From Citi Annual Report 2008

I am aware of the restricted stock provisions of Mr. Obama's proposal, but even so I bet a ca. 97% reduction in lucre as loot is most definitely deflation.

It's a SNAP

SNAP is the brand-new acronym for the old US Food Stamp program; it stands for Supplemental Nutrition Assistance Program. I guess "food stamps" was too old fashioned and, well, kinda depressing - as in "the greatest economic crisis since the Great Depression".

Call it what you may, as of November 2008 (latest data available), the number of Americans needing help with the most basic requirement of life, to wit eating, jumped 14% from the same month last year.

Data: USDA

If you look at the data going back to 1969 you will see a definite correlation between food assistance and the economy: recessions result in higher participation and booms in less. For example, the 1991-93 period saw 30% more people receiving benefits, while during 1994-2000 participation dropped back sharply as the economy expanded.

What is most interesting, then, is that despite the supposed economic expansion after 2003 more and more people needed to go on food stamps. As of November 2008 their number was at an all time record 31.1 million - a number that has since certainly gone higher with increased unemployment.