That Great Sucking Sound

Data for global CDO issuance (Collateralized Debt Obligations) were recently released by SIFMA. Astonishingly grim, as one can see in the chart below: amounts have collapsed from nearly $180 billion in the second quarter of 2007 to a paltry $5 billion in the fourth quarter of 2008.

The great sucking sound created by the sudden vacuum has been heard from mortgage originators, private equity funds and chop shops (aka securitizers), all the way to simple families desperately trying to borrow for a new house and car, or just to send junior to college.

Will the market for securitized loans ever come back? Best not hold your breath.

Here's An Alternative

A trillion dollars (or two) for the banking industry, a trillion for consumers... pretty soon we'll be talking about serious money. Oh, but I forgot - it's just dollars. Never mind..

Seriously, though: since we are shelling out all this federal bailout and stimulus money, shouldn't we also be making sure it's going to get us the most bang for the buck? Predictably, the Republicans want it to go towards tax cuts. I won't even bother to debate this; tax cuts for the rich have been as effective as the Berlin Wall was in preserving homo Sovieticus. On the other hand, and just as predictably, the Democrats want extended unemployment benefits and job programs.

Both are thinking inside the boxes they built decades ago. Such thinking is singularly unfit for overcoming today's challenges, which include such game-changers as resource depletion and environmental destruction - not to mention an already monstrous mountain of debt. The policy knee-jerks are plainly dusting off and doffing their respective Friedmanite and Keynesian hats, believing that the future is a linear continuation of the past. Unfortunately, it isn't.

Today, we are sitting atop an epochal inflection point in the History of Man, at the crossroads of very different and mutually conflicting future possibilities. Which road we choose to go down is crucial. We cannot willy-nilly assume that the tools of our past will fix the problems of our future.

Here's just one alternative suggestion on how to best invest our trillions, one of literally hundreds we can all think of, once we abandon our beaten-path thought processes.

Have the federal government directly build a few dozen alternative, renewable energy power plants all over the US and then immediately sell them one by one to the highest qualified bidder(s). It's the TVA and Hoover Dam model, but with a twist: the government would not operate them or even own them. Instead, it would be up to new or existing utilities to take advantage of such opportunities, since it is certain the selling price would be below cost.

But here's another twist: the federal government could "boost" the price it would get for the new power plants by legislating strict carbon-emission standards on existing utility companies, perhaps in the form of a carbon tax. This will increase the present value of the new "green" plants.

Yes, it is almost certain that the government would lose money on the deal, at least by conventional accounting rules. But the added gains in R&D, manufacturing and construction employment and the intangible geo-strategic and environmental benefits will definitely outweigh the "loss".

It's a thought..

Revisiting The Spanish Inquisition

I am reading a rather excellent book right now, Niall Ferguson's The Ascent of Money: A Financial History of the World. (See "FEATURED RECOMMENDATIONS" on the right.) Following is a brief excerpt relevant to today's post, about the connection between precious metals and money in the Victorian era.

"Precious metals alone are money," declared one City grandee, Baron Overstone. "Paper notes are money because they are representative of Metallic Money. Unless so, they are false and spurious pretenders. One depositor can get metal, but all cannot, therefore deposits are not money." Had that principle been adhered to, and had the money supply of the British economy genuinely hinged on the quantity of gold coin and bullion in the Bank of England's reserve, the growth of the UK economy would have been altogether choked off, even allowing for the expansionary effects of new gold discoveries in the nineteenth century.

The above passage is not intended as music for the ears of monetary goldbugs, also known as moldbugs. Rather, it highlights the direct connection between money supply and economic "growth": the two are directly and proportionately related. (I am using quotation marks to highlight the difference between quantitative and qualitative aspects of economic activity.)

It is, therefore, a given that in order to rapidly establish a Sustainable Economy we have to radically transform our present monetary system which is geared exclusively towards the ever-expansionary Permagrowth Economy. This is crucial: no matter how many wind turbines we install and how much organic food we eat, we must also design and install the proper monetary apparatus if sustainability is to work.

Let's begin with what is going on right now in response to the credit crisis. Monetary authorities and politicians are working up a lather, pumping as much fresh state-sponsored liquidity into a rapidly draining cesspool of private debt gone horribly bad. They are doing so because they cannot for a moment imagine a non-inflationary world of falling and ultimately stable prices caused by a zero growth economy. To them, schooled as they are in "modern" academic economics, such a development would be an abomination; and even talking about it would be equivalent to heresy punishable by burning at the stake.

Their actions are entirely wrong and counter to our best interests - at least the "other" 99.9% of us that do not qualify as yacht-haves. Just like the Spanish Inquisition, they are unlikely to go down in history as enlightened financial progressives, despite the thin veil of populist Keynesianism with which they are attempting to cover the absence of originality in their thinking.

Attempting to salvage a corrupted, unsustainable financial edifice by issuing trillions of dollars in newly minted IOUs carrying the blessing of the state reminds me of the infamous Catholic indulgences, the written pardons marketed in the thousands by some Popes to raise money for the Vatican. They even had a jingle: "As soon as a coin in the coffer rings, a soul from purgatory springs". Well, we know how all that ended..

Absolution from sins, circa 1521

Carrying the theological parallel a bit further, I should point out that our present monetary system is based solely on faith. After all, the word "credit" derives from credo, i.e. faith. When those responsible for acting in the most moral and responsible manner possible, instead debase our trust (fides, and thus fidelity) why do they expect us to believe?

I will not be surprised at all to see a modern-day Martin Luther posting his Theses on some central bank's doors one of these days.

In the meantime, vade in pace (go in peace) - at least for the weekend...

Welcome And Good Luck

Dear President Obama,

Welcome and good luck - success being the result of placing yourself in a position of getting lucky.

No other US President has ever been inaugurated with such high hopes from the entire world riding on his shoulders. It's an incredible weight, to be sure, but it is also a tremendous honour and a huge opportunity.

This is your historical moment, Mr. President; to re-establish the image of America as a force for good and to re-define its role as an agent for change. Change not only for Americans but also for the billions on this world that may not necessarily share in the wealth of our nation but are affected daily by its reach, for better or worse.

Grasp the moment and go. Go. Go.

The Future of Banking

I thought of today's post as I remembered a stockbroker's question from almost a year ago: "Are you really concerned about having money at the bank?" I answered that his question was irrelevant, for investment/speculation purposes: the government would always bail out big deposit-taking banks. It was their business model that was entirely bankrupt. Ditto for earnings (losses actually), for as long as the eye could see.

You see, I was fully expecting the collapse of the "asset inflation-margin-trading" model of banking, particularly when derivatives boosted leverage and risk sky-high.

So, what now? What's the future of banking?

I know that while monster bailouts are flying fast and furious it may be a tad premature to talk about the future. But that's just me, always trying to be ahead of the curve... thus, bravely onwards.

Many readers may have come to the conclusion that banking has no future - particularly after observing recent price action for bank stocks (see chart below) and pondering the effect of ongoing nationalizations by governments all over the world (a.k.a. "bailouts").

S&P Bank Index

I am inclined to agree, at least for those institutions that still believe their future will resemble anything like the 2000-06 period. To them, I would point out that a 75% collapse in their share prices is a powerful signal that they should radically transform themselves. And that's only to survive, never mind thrive.

The question is, transform themselves into what? To answer, let's start with a few premises:

1. Permagrowth is over. Sustainable is the new socio-economic model.
   
2. Lending for consumption is over. Lending for transformation is the new strategy.
3. Lending against financial assets (i.e. margin) is over. Lending against productive assets is the way forward.
4. Ditto for real estate.
5. Significant dealing room gains are over. Trading will once again be a facilitator of banking operations,not a mainstay.

The conclusion is that from now on banks will have to concentrate on making loans to smart and industrious enterprises that look to the future. Forget consumer loans, credit cards, auto loans and, yes, even forget mortgages - at least the kind made popular in the last 10 years. Also, forget the chop-shop model of packaging and selling loans as securities to clueless "investors". Credit risk will simply have to stay inside the bank.

The banking business is going to be MUCH smaller. Only the smartest and fittest will survive, those that think before they lend and scrupulously follow up regularly once they make the loans. Bankers will once again need to be hard-working business analysts with sharp pencils and heavily used "LOAN DENIED" stamps.

Corollary: The politicians' current calls for banks to once again open up the lending spigots are entirely wrong and highly dangerous. Such an occurrence will perpetuate the failed business model that got us into trouble in the first place and pile on even more problems for the future.
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Post Script: On this, the last day of the Bush presidency, I have only one thing to say.

So long and thanks for all the fish.

Not In My Name

The following two stories appeared today:

Jan. 16 (Bloomberg) -- The U.S. government agreed to invest $20 billion more in Bank of America Corp. and backstop a $118 billion asset pool to help the lender absorb Merrill Lynch & Co. and prevent the financial crisis from deepening. The government agreed to the rescue “as part of its commitment to support financial market stability,” the Treasury Department, Federal Reserve and Federal Deposit Insurance Corp. said today in a e-mailed joint statement.

* * * * * * * * * *
Jan. 16 (Bloomberg) -- Russian Prime Minister Vladimir Putin's standoff with Ukraine over supplies of natural gas may have angered European Union leaders and denied heat to millions; at home, it’s winning him plaudits. .... “His message to the people is that nobody should mess with Russia when he is around.”

* * * * * * * * * *

Anyone who cannot see the connection between them probably also thinks that Joe the plumber provided a significant contribution to the pre-election political discourse. Yes, ladies and gentlemen, our economy is literally screaming out that we should get our priorities straight.

Let's look at the first story. An ADDITIONAL 138 billion dollars - nearly $1,000 from each and every American household - for just ONE bank. If there is better on-the-ground proof of the debt madness that gripped the nation in recent years, I haven't seen it.

The amount of money provided and guaranteed by We The People to this august banking institution dwarfs its entire market capitalization by 2.6 times. What are we getting in return for this extremely generous bailout, I wonder? A logical person would presume we are getting 100% of the equity, every seat on the board plus every single asset that current and past managers and board members possess. Somehow, I'm pretty sure that's not happening, eh?

Let me also point out this: when We The People have to provide this kind of capital to just ONE bank, what "financial market stability" are we talking about? It's just keeping the clinically dead on life support, using precious resources that could be much more properly utilized to revive the real economy and to provide a decent future for our children.

Where should we invest The People's $138 billion? Look no further than the second story and its tremendous implications for geopolitical energy blackmail. Are we blind, stupid or both?

Here are just two alternatives for this kind of money:

• We could build at least 28,000 monster-sized 5 MW wind turbines.
• We could provide every household in America with smart two-way electricity meters, the kind necessary to establish the Energy Internet.
  

But ooooh, noooo - we need to "save" the financial system, instead. Well, NOT IN MY NAME, ok?

I'm mad as hell (pun intended) and I sincerely hope Mr. Obama will swiftly put an end to this incredible nonsense, starting next week. But with Wall Alley insiders Geithner and Summers calling the econ-shots, I highly doubt it. These guys' thinking is as dead and "inside the box" as Schrodinger's cat after the lid is opened. What we really, really, really need is people that get it.

I will once again recommend two books that I consider ESSENTIAL READING for anyone who is even remotely concerned about our future.

• Tom Friedman's "Hot, Flat, and Crowded". I consider it the most important and timely book in print right now.
• Michael Klare's "Resource Wars". The man really understands who has the big stick - and where it's pointed at.

Those two guys really get it, separately. Put their thoughts together and you have an economic and geopolitical policy for decades to come.

End of An Era

Retail sales for the month of December were announced yesterday. The number was much worse than expected, creating a rather severe reaction in Wall Street.

Or is it Wall Alley, these days? Merrill's thundering herd has been reduced to a wimpering clutch and Smith Barney's owner (Citigroup) doesn't seem able to earn it "the old fashioned way" and must sell it to raise cold hard cash. Sic transit gloria mundi, indeed... I point those two investment banks in particular, with not a little sadness, because they were my employers for a considerable number of years, way back when...

Anyway, back to retail sales. They certainly do look sick (see chart below).


Nevertheless, we must take into account the fact that gasoline prices have tumbled sharply in recent months and thus influence gross numbers more than usual. Here is a chart that compares total retail sales (red line) with sales excluding gasoline stations (blue line). Still pretty bad, but not as horrible as the headline number.

Nevertheless, the break in the trend is significant - unprecedented, even, in our modern-era consumer society. It remains to be seen if it marks a tectonic shift away from the vicious debt-induced Permagrowth cycle (borrow-consume-borrow), towards a more benign Sustainable paradigm. I believe it does - mostly because I hope so, but also because I can recognize from history certain signs common to all "end-of-an-era" periods.

Yes, most people may wish the party to go on, but deep down they know it's over. And this knowledge affects their behavior very significantly. When it's over, it's over.

The Middle East is ABC

Note: Relevant addendum added further below.
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As the tragic events in Gaza continue to unfold, mirroring countless similar ones over the previous decades, I have a suggestion: make the entire Middle East geopolitically irrelevant and let's the rest of us stop stirring this hornet's nest. How? Reduce and ultimately stop using crude oil and natural gas as prime energy sources.

No one who has even a smattering of historical knowledge about the area would dispute that the Middle East is ABC: All 'Bout Crude. A truly excellent source is Daniel Yergin's classic book "The Prize", for which he won the Pulitzer Prize.

I am not going to even attempt to apportion blame for the essentially internecine slaughter that has been going on between Jews and Arabs - both are Semites - since at least 1947, when the modern State of Israel was founded. All I am saying is that the region's importance as a source of hydrocarbons intensifies and gives singular importance to their conflict. Our insatiable thirst for oil generates resource wars, by proxy in the past and with our direct involvement more recently.

Seen from another viewpoint, if peoples in the region did not have all this petro-wealth to "divide" between them as oil owners and/or "watchdogs" respectively, the fight would be pretty meaningless from a global perspective and would quickly devolve into a regional spat over water rights.

Obviously, both Jews and Arabs would hate such a development. I am convinced that one of the reasons they keep fighting each other is to keep the rest of us involved, one way or another. This may have been understandable in the past, when resource depletion and climate change were irrelevant as factors driving geopolitical priorities, but this is clearly no longer the case. We cannot afford to keep on with the present carbon-as-usual economy and MUST move on to the Green, Renewable and Sustainable model.

Determining The Fate of Hydrocarbon Baby

We are all familiar with King Solomon's wise judgement to order a baby cut in two so as to determine who its true mother was. I suggest a variation: let's in fact "kill" the hydrocarbon baby so the two mothers have nothing to fight over.
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Addendum: Someone is getting this exact message. And guess who it is? The Arab oil exporters who wish to maintain their relevancy. Here is an article from the NY Times: Gulf Oil States Seeking a Lead in Clean Energy.

A relevant excerpt (bold added for emphasis)...

The crown prince of Abu Dhabi, the wealthiest of the seven emirates that make up the United Arab Emirates, announced last January that he would invest $15 billion in renewable energy. That is the same amount that President-elect Obama has proposed investing — in the entire United States — “to catalyze private sector efforts to build a clean energy future.”

Linked: Bonds and FX

A friend from the broker community called me a couple of days ago and asked me what I thought about the dollar, i.e. its value against foreign exchange (in this case the euro). I replied that I was pretty much a euro/dollar agnostic these days, but that my gut told me the dollar would appreciate against most major currencies. My view surprised her because her first take was that the US needs to keep the dollar low to boost exports and thus help revive the economy .

I don't disagree on the need for exports, but my analysis is based on another, much more pressing need. With $1 trillion plus budget deficits projected for several years, the US must sell a record amount of bonds to cover the gaps. Who will buy them?

Domestic investors cannot raise the money. If the personal saving rate was to rise to 5% of disposable personal income (see chart below) - and stayed there - the amounts involved would be less than one half of what is required to finance the deficits. And even this assumes that all savings would go to US Treasurys - a completely unrealistic expectation.

So, a very large amount of bonds will have to be purchased by foreigners, many of whom have fiscal problems of their own, right now. How to make US bonds attractive to them? For a foreign investor, total return on dollar-denominated bonds comes from three sources:

(a) Interest payments,
(b) Capital gains (or losses) and,
(c) Foreign exchange gains (or losses).

Let's look at each one..

• Interest rates are near record lows: right now the 5-year note yields 1.6% and the 10-year bond 2.4%. Not exactly designed to attract precious capital, they currently reflect fear instead of a sensible rate of return on long-term investment.
• The prospect for capital gains/losses is a corollary of the above: bond yields can't really fall below 0%, at least not for long. And since we are already close to 0%, capital gains will be hard to come by in the future.
• This leaves (c), gains on foreign exchange. Given the poor prospects for (a) and (b), an appreciating dollar is key to attracting foreign investors, in my opinion.

Now, I'm not talking about a "zooming" dollar, you understand. But even a 5% "steady" appreciation against, say, the euro would make US bonds quite a good proposition for a foreigner in this environment of limited investment choices.

Are You Listening, Neo?

"Were you listening to me Neo, or were you looking at the woman in the red dress?"

You may recall this line from the movie "The Matrix", when Morpheus points out to Neo that all is not what it seems. Red herrings have always been used to snatch attention away from what is truly important.

Here's one bright red herring everyone is focusing on right now:

Effective Fed Funds Rate

Fed Funds are set in a range of 0%-0.25%, the lowest ever if I am not mistaken. A pretty darn exciting red herring, eh?

And how about this one?

Ten Year Treasury Bond Yield

Ten year treasury bonds are yielding a measly 2.50%, the lowest in (at least) 45 years.

But what's the importance of the fish above, compared to reality? Take the red pill Neo, because... Reality is the rates at which everyone else gets to borrow. For example, the vast majority of US businesses, as exemplified by Moody's seasoned Baa-rated corporate bond yield, currently at a rather forbidding 8.10%.

BAA Corporate Bond Yield

And if the spread between corporates and treasuries remains as atrociously high as it is now (see chart below)...

... pretty much, this is the way things are going to go: the Treasury will borrow at near zero rates (assuming it can) to recycle the money into tax cuts, social benefits and make-work (a.k.a. Keynes-work). Revenge of the socialist nerds, big time.

What's next, the Five Year Plan?