Dubai's Shut Up Finance

We have heard of project finance, debt finance, LBO finance, islamic finance... we have even heard talk of Green Finance (self serving smile). But until yesterday, we never had the pleasure of Shut Up Finance.

As with indoor skiing when outside temperatures reach 120 degrees Fahrenheit (50 C), seven star hotels and artificial islands shaped like palms and world maps (see below), the dubious distinction for most uncouth bond salesmanship belongs to none other than Dubai.

Hubris As Seen From Space

The emirate's ruler just said the second half of its $20 billion bond program will be “well received,” and that those who doubt the unity of Dubai and Abu Dhabi (the United Arab Emirates' petro-wealthiest member) should “shut up”. The "unity" in question is, of course, all important since the first $10 billion was bought entirely by the U.A.E.'s central bank and has been used in part to bail out the developers of said artificial islands and other such hubristic extravaganzas.

The bailout money is sorely needed because Dubai is... well... broke. Since it has no hydrocarbons to call its own, the tiny nation first rose to prominence as the playground of other, notionally abstemious, Arabs residing next door. It then went on to blow its own bubble on a sea of easy credit, margin and rollickingly speculative share and real estate markets.

To grasp the magnitude of hubris at the Gulf bubbledom all we need do is compare "before" and "after" pictures from downtown Dubai.

Photos: Dubai Architecture

Dubai In 1990


The Same Place, Last Year

I'm going to shut up now.

Credit Crisis vs. Permagrowth Crisis

Yeah, OK, the Credit Crisis may have abated - at least according to the Sage of Omaha (a.k.a. Warren Buffett, see story here). For example, the spread between BAA and AAA corporate bond interest rates has subsided to a historically reasonable level (see chart below).

Corporate Bond Spread: BAA - AAA

But unless you are amongst the bankers/traders/speculators who survived the bloodbath and is about to see his or her bonus rise once again, you really don't give a damn. Because for you what really matters is the Real Economic Crisis and the chart that really applies is unemployment (see below).

Unemployment Reaches 10.2% - Highest Since 1983

Oh, the pundits will immediately say, but unemployment is a trailing economic indicator and once things are back to normal it will go down fast. Nothing to worry about...

Oh, really? What if this no longer applies? Today's economy is not characterized by fast-reacting manufacturing with short hiring/firing cycles that accommodate domestic production swings. We have exported this dynamic to China, along with much of our manufacturing base, so we are likely to see a very, very slow recovery in job creation.

And if no jobs are to be had, income will suffer and so will consumer spending, which is the foundation of our entire Permagrowth economy. Yes, there is a chance that we will revert to substituting consumer debt for earned income, as we increasingly did during the Bush II era. But if we do, then we will indeed have learned nothing and soon be responsible for our own demise... again.

Therefore, we should immediately start revamping our economy along Sustainable lines. For a model, perhaps we should start looking at Japan from a different perspective, outside the GDP-metric box. I mean, does anyone think that the Japanese are suffering, or are they enjoying a high living standard after well over a decade of so-called "stagnation"?

Let's bottom-line things: Permagrowth/Permadebt is like the high-wire acrobat who must forever keep moving in order to keep his balance and not plunge to the ground. Likewise, our economic model depends on ever more frantic activity to generate more debt and thus more "money" to service this debt. Debt conservation has replaced human development as the self-evident goal of governments.

If this were only a shocking ethical tragedy we could just shrug our shoulders and quote Cicero: O tempora, o mores! Unfortunately, Permagrowth/Permadebt is also completely antithetical to natural law, the simple truth of energy conservation and the constant increase of entropy.

About CIT And Sardines

CIT, one the world's largest finance companies specializing in lending to medium-sized companies and equipment leasing, just filed for bankruptcy. It is highly unlikely that American taxpayers are going to recoup any of the $2.33 billion of bailout money the company was provided with in the form of preferred equity.

In the chart below, let's take a look at CIT's balance sheet assets, its equity and the price of its shares - all at year-end except for the last two quarters of 2009 (click to enlarge), and ask ourselves this simple question: what is the probability these assets (mostly loans and leases) were really worth what the annual and quarterly reports said, particularly after 2006?

Judging from the share price: zero probability, of course.

But, this post is not really about CIT. Rather, it is meant as a general comment on financial company balance sheets. To wit, it is nearly impossible to properly value loans, leases and other more esoteric financial assets (e.g. CDO, CDS, IRS, FRA, etc.) when we are out in 3+ sigma territory in delinquencies, defaults, counterparty risk metrics and volatility. One day a company like CIT is supposed to be "worth" $6 billion according to its books, the next it's hyena food.

I've said it before and I'll say it again: a company that bases its valuation, indeed its entire business, on the Trading Sardine principle (see below) should be judged not by analysts but by fishmongers. Better yet, by their wives..
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The Trading Sardine

Andy convinces Billy to buy a can of sardines at a high price by telling him how wonderful they taste. Billy, being greedy, decides to resell them to Charlie for a profit at an even higher price by convincing him, too, about how great these sardines are. The process is repeated several times until the last buyer, let’s call him Zebediah, pays a million bucks to Yorick for a can of the “world’s absolute best sardines – EVER”.

Well, Zebediah decides to open the can and eat the sardines, only to discover they are ordinary, plain sardines. Furious at being swindled, he yells at Yorick: “You crook! You liar! I paid you a million bucks for plain ordinary sardines. They were not the greatest tasting sardines - EVER”, yells Zeb.

Yorick shrugs and replies…

“Hey Zebediah, you are such a schmuck. Those were not eating sardines – them were trading sardines!"

A More "Personal" Look At Debt

It is common enough to look at debt as a percentage of GDP, DPI, etc. but that's so... impersonal. So here are a couple of (very scary) charts that look at things from a dollars per person perspective (click on charts to enlarge).

• Debt per person and GDP per person.
  

• Debt per person and Disposable Personal Income per person.

Note: the Total Debt used to construct these chart does NOT include debt of the financial sector so as to avoid any double counting (e.g. a mortgage inside a CDO), even at the cost of somewhat understating the crush of debt. It's bad enough, anyway..

Boundary Conditions

A reader asked if I think the yield curve will flatten. The answer is yes, I do.

A steeply positive yield curve - as it is now - is the bond market's way of discounting a sharp rebound in the economy; I believe this optimism is unfounded and will soon be proven wrong, leading to a reversal. Sketching the picture in very broad lines, declining consumer spending (70% of GDP) will be the most serious drag on the US economy, due to persistently high and rising unemployment.

Let's look at the curve itself (see chart below).

US Treasury Yield Curve

The next chart shows the spread, or difference, between interest rates for 10-year Treasury bonds and 3-month bills since 1953. Currently the rates are 3.47% and 0.07% respectively, resulting in a spread of 3.40%, or 340 basis points (a basis point is 0.01%). That's very high by historical standards (see chart below, click to enlarge).

Data: FRB St. Louis

Next, I perform a frequency analysis for this spread and produce the following histogram (click to enlarge).

In the last 45 years the spread averaged 139 bp with a standard deviation of 119 bp. Quite obviously, the vast majority of the values are positive (above zero), since inverted yield curves are rare.

The charts above, however, do not tell the whole story because they track the difference in rates without taking into consideration their absolute levels. Because nominal interest rates cannot go below zero, it makes a whole lot of difference if a spread of 340 b.p. is the result of 6.40% minus 3.00% or 3.50% minus 0.10%. These two situations describe completely different economic and financial market conditions, even if the spread is exactly the same. So, we need to look at the spread from another perspective.

• Let's chart the spread as a ratio of the 10-year bond rate, i.e. take the spread and divide by the 10-year rate at any point in time. This provides a better sense of how wide the spread is in relation to the absolute level of interest rates.
  

The spread is now 96.5% of the 10-year yield (3.40/3.47= 0.965), i.e. a person by putting his/her money in 3-month bills is giving up almost the entire return possible from a longer-term bond. That's quite extreme and unprecedented in the last 45 years (see chart below, click to enlarge). The average over the same period is 25% and the standard deviation is 22%, i.e. the current ratio is in +3σ plus territory.

In a previous post (Bills And Swaps Indicate Great Optimism) I said that such low rates for Treasury bills (plus other indicators such as forward rate swaps) are the result of the Street's optimism. Speculators think the economy is bouncing back, bringing inflation, higher interest rates and lower bond prices with it. Therefore, they are piling into the shortest possible investments in order to shorten portfolio duration and avoid market value losses.

But, we have now demonstrably approached boundary conditions: T-bill rates are essentially zero, meaning that most speculators are 100% certain of the optimistic scenario. The only thing certain being that there are no certainties, I am more comfortable taking the opposite view, i.e. that the economy will weaken again and that the curve will flatten.
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Addition by special request (Greenie): The 10y-3m spread for 1931-1952.

The spread between 1931 and 1952

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GDP Addendum
Third quarter GDP came in at +3.5% (real, seasonally adjusted, annualized), as usual "higher than expected". Crunching through the full set of numbers we can immediately distill the whole report to the following:

• Cash for clunkers accounted for 1.7%, i.e. half of the increase.
• Inventory adjustments (lower liquidation of goods in stock) accounted for another 1%.

In other words, 80% of this "growth": (a) came from a temporary government boost that is already gone (see chart below), or (b) was essentially technical in nature.