Friday, November 30, 2007

Further On CDS

Yesterday's post on Credit Default Swaps (CDS) generated considerable discussion. There are a few points that should be expanded.


Despite their name, CDSs are not swaps, but insurance policies.
This is not merely a philosophical argument about names, as the following will make clear.

First, let's look at a real swap - for example, a foreign exchange forward swap.
This is how it works:

On Date X
Bank A sends to Bank B 100 million dollars
Bank B sends to Bank A 67.567 million euro

So far, this looks like a spot USD/EUR foreign exchange transaction taking place at a rate of 1.48 dollars per euro. Notice that actual cash changes hands on both sides: Bank A and Bank B have to send money to each other.

On Date Y, the transaction is reversed:
Bank A returns to Bank B QQ.qqq million euros
Bank B returns to Bank A 100 million dollars.

The exact amount of euros that is returned (QQ.qqq) and the duration of the swap (Date X to Date Y) are agreed and set at the inception of the deal. Again, actual cash payments are exchanged.

These swap transactions are extremely common, with hundreds of billions of dollars, euros, yen and other currencies swapped daily. The crucial point to keep in mind is that they are real swaps, i.e. the parties involved have to send money to one another at the same time.

There are other transactions also termed swaps, e.g. Interest Rate Swaps (IRS). They, too, involve the concurrent exchange of cash flows between the parties involved and are very common. More information on them can be found here.

Unlike the above, a Credit Default Swap transaction swaps nothing. One party buys an insurance policy against default and pays fixed premiums, typically for five years, while the other party sells insurance policies and receives premium income. Like all insurance operations, the seller is exposed to significant event risk and the buyer expects that his insurance company is well enough capitalized to meet its obligations, when it is called to do so.

At this point the difference between a credit insurance scheme and a real swap is obvious. Indeed, when they first started to become popular around 1999-2000, CDSs were not called swaps but, more accurately, Credit Insurance Contracts. Somewhere along the line, for reasons not entirely clear, the terminology was changed to the more familiar and innocuous-sounding "swap".

I leave it to the informed reader to deduce why a name which clearly denoted actuarial risk and the need for substantial reserves, was exchanged for one that falsely implies the concurrent exchange of cash flows.


Who is in the CDS market?

As the above made clear, credit default swaps are insurance contracts, not two-party swaps that exchange cash flows. When an insured event occurs (i.e. a default), CDS sellers have to pay out on the insurance they sold. But CDSs are not underwritten by regulated insurance companies whose operations and reserve requirements are tightly regulated (though some insurance companies are also in the CDS business), but by almost anyone who wishes to participate in the action: investment banks, hedge and private equity funds, family offices, pension funds, special purpose entities like synthetic CDOs and CPDOs, even wealthy individuals. They each buy and sell CDSs for different reasons, including the generation of highly leveraged equity equivalents, but they all have one thing in common: they are not insurance companies.

Credit defaults risk is certainly being spread around this way, but is it adequately reserved against? We won't know until the next credit cycle and, as Warren Buffet says, that's when we will find out who is swimming naked. Knowing how the above participants operate when in party mode, I wouldn't bet on many swimsuits being worn.

But don't take my word for it; look at what is happening right now with mortgage-backed CDOs, SIVs, etc. They, too, were constructed with the extremely optimistic assumptions that defaults would remain at record lows. Now that defaults are rising, even AAA paper is defaulting in one go. This toxic paper was manufactured at the exact same "plants" that also sold credit insurance, by the exact same workforce and under the same assumptions.


Notional CDS amounts matter and should not be immediately dismissed by comparing them to their market value.

The reason, once again, has to do with their insurance policy nature. For as long as defaults are low, anyone can make money writing enormous amounts of credit insurance. Property and casualty insurers are also very profitable, until three Category-5 storms hit in a row. Dismissing notional CDS amounts in favor of market values is similar to a P&C insurer disregarding how much insurance it has underwritten and focusing instead on the present value of its premiums.

The last time defaults rose sharply was in 2001-2002 (see charts below). At that time, the total amount of CDS outstanding was $918 billion, whereas today the amount has reached $45.5 trillion (ISDA). Very little debt was covered by credit insurance in 2001 and thus the effects on the financial system were minimal. We simply cannot compare that experience with today's massive risk exposure. Yes, we had the equivalent experience of three Cat-5's in 2001, but there was very little insurance outstanding back then.

Defaults of Speculative-Grade Bonds (Chart: Altman)

Defaults of Leveraged Loans (Chart: Altman)

Perhaps the CDS market is so spread out that it cancels itself out. Perhaps everything is just perfectly matched between credit assets and liabilities that nobody is holding a risk tail. But with $45 trillion around I wouldn't bet on it.

And you know what? Greenspan was worried about that, too. Last time he spoke on the subject he urged bank operations departments to rapidly clear their CDS paperwork so that open positions can be netted and the real risk profile of each may be assessed. Apparently there is some progress being made on this front.

But the truth be told, netting is not all that it's cracked up to be. All it takes is one nervous risk officer to hold up payment until he receives the other guy's money first and the whole structure goes poof. When push comes to shove everyone holds on to their cash much more tightly, everyone gets much more suspicious. No one wants to be on the no-show side of a "fail".

The full story will be told, like always, after the fat lady sings. For credit default insurance this means during the next high of the default cycle.

Thursday, November 29, 2007

CDS: Phantom Menace

I started writing about Credit Default Swaps (CDS) just a year ago. But, for this market, that's ancient history: within just 12 months notional amounts outstanding have increased from 26 to 46 trillion dollars.

Credit Default swaps allow hedgers and speculators to bet on the likelihood of default (or other "credit events") by borrowers like governments, corporations or pooled-asset Special Purpose Vehicles like CDOs. In addition, a very large portion of CDS contracts are now written against indices tracking debt classes such as investment grade or junk corporate bonds, MBSs, etc. That's the purpose of all those ABX, CDX, iTraxx, LCDX, etc. indices calculated by Markit.

The growth in the CDS business has been nothing short of phenomenal: within just six years amounts outstanding have increased 72-fold. The International Swaps and Derivatives Association (ISDA) in its latest semi-annual survey for the second half of 2007, put the total notional amounts outstanding at $45.5 trillion. In a separate survey, the Bank for International Settlements (BIS) reports a similar amount ($42.6 trillion) and also breaks down the instruments by type: single-name (i.e. against a single borrower like a corporation) and multi-name (i.e. against indices). The growth has been significantly faster in multi-name CDSs, suggesting increased use of CDS by speculators, instead of hedgers (see charts below).

Total CDS Outstanding (Data: ISDA)

CDS Outstanding by Type (Data: BIS)

This last finding is quite significant: even though financial index trading can and is used for broad-based portfolio hedging, it is most frequently involved in outright speculation, regardless of the instrument involved. Take the example of stock indices: it does not take much argument to ascertain that the dizzying array of broad and narrow derivatives is targeted almost entirely to speculators seeking to increase their leverage.

So why are CDSs a phantom menace, as the title proclaims? There are two major reasons:

Reason #1

At $45 trillion, the notional amount of CDS in existence is now fast approaching the total amount of credit market debt
outstanding in the entire world.

Given that many debt issues are too small and unmarketable for CDS purposes (e.g. small municipal and corporate issues), it is more than likely that CDSs equal or exceed the amount of all readily marketable debt in the world. This is further aggravated by the risk concentration implied in the popularity of index trading: for example, the active CDX Investment Grade index consists of only 125 individual bonds, the CDX High Yield (junk) index of 100 bonds and the iTraxx (Europe) index of 125 bonds. While these three are not the only indices traded, the BIS survey showed there were $18.5 trillion in multi-party CDS outstanding in June 2007, an enormous amount considering the small number of bond issuers involved.

This means that far more CDSs are written relative to the amounts outstanding in individual bonds and thus credit events will infect and destroy much more speculative capital than previous increasing default cycles, when CDSs did not exist. The model is that of a viral infection or a nuclear reaction - thus their description as "financial weapons of mass destruction".

The likelihood of future corporate defaults is rising very sharply, as observed from credit spreads going up almost vertically in recent weeks: for US investment grade bonds the option adjusted spread over Treasurys has reached nearly 200 basis points and for high yield bonds 600 bp (charts below).

Merrill Lynch US Corporate Index (Charts: SIFMA)

Merrill Lynch US High Yield Index

To summarize point #1: There are too many CDSs being written by speculators against relatively few borrowers, just as the probability of default events is increasing sharply. Therefore, the possibility of a generalized financial infection through the CDS medium is substantial and rising.

Reason #2

CDSs are closely correlated to equities because, just like them, they represent business risk. CDSs have created a new way for speculators to generate highly volatile equity exposure with minimal or even zero margin requirements.

By selling a CDS on a corporation's debt, a speculator is betting that its credit will improve or stay the same. In the first case the CDS will become more valuable and result in a capital gain, while in the second the speculator will at least collect the CDS premia, almost like a series of dividends. This is identical to a speculator buying a stock expecting it to appreciate and/or pay dividends.

However, there is a crucial difference between stocks and CDSs: in purchasing a stock outright the speculator has to put up 50% margin, as required by the Fed's Reg T.

[Note: there are currently ways to lower this down to 15% through Contracts For Difference (CFDs). The Federal Reserve, much to its shame, is completely ignoring this blatant evasion. If you are familiar with bucket shop operations from the late 19th-early 20th century, CFDs are practically the same. If you are not, the classic Reminiscences of A Stock Operator is highly recommended. There are many instructive similarities today with what happened 100 years ago, despite our so-called financial innovation.]

But selling a CDS requires zero margin and even produces immediate and regular income from payments received for underwriting the credit insurance. Theoretically the sellers should maintain adequate reserves on their balance sheets to cover their credit risk exposure, but does anyone believe that hedge funds and traders actually do? Not a chance... The result is a highly volatile equity exposure, carried at zero margin in a completely unregulated over the counter market. Recipe for disaster? You bet...

Not only that: CDSs create these infinitely leveraged equity positions out of thin air. Unlike options, single stock futures or other equity derivatives that require the delivery of actual securities at settlement, CDSs do not. They are pure bubble-air and can be created regardless of the amount that is outstanding in the underlying securities.

To summarize point #2: CDSs are equity substitutes carried at zero margin, masquerading as credit instruments. They create a feedback loop mechanism to equity markets that results in reducing volatility when things look good and increasing it when they don't. In other words, they work as risk amplifiers and not as risk attenuators.

Putting the above two points together, we have the potential for a financial viral disease of pandemic proportions. The CDS market is so new that it has never been tested on the downside of the credit/business cycle. We simply have no inkling of how it will behave under real life duress, when major credit events occur with increased frequency and magnitude.

This is why I chose to describe CDS as a "phantom" menace or, as the dictionary defines it: An imaginary embodiment in threatening form of an abstract thing or quality. But in this case, the imagination is embodied in facts and the sure knowledge that the business cycle has not been abolished.

One final observation, also related to the phantom quality of the CDS market: the vast majority of people are simply unaware of its existence, let alone its importance in shaping credit and equity markets. You won't hear about it in the popular media and very little seeps through even in the financial press. This is incredible, given that it is a $45 trillion market, even if this is only the notional amount and not the value of the contracts. By comparison, the capitalization of the entire US stock market is $20 trillion.

P.S. I want to thank "cds trader" for making significant comments on the above. They appear on the comment section and so do my replies.

Something else: The term "swap" as applied to Credit Default Swaps is greatly misleading, at least in the professional meaning of the term. For example, there exist FX swaps and interest rate swaps; very large amounts of such derivatives trade OTC on a daily basis, certainly more than CDSs. Their notional amounts outstanding are even larger than CDS. But they are real swaps, i.e. the counterparties swap payments immediately and in the future. The risk involved is not at all the same as in a CDS, which is in fact an insurance policy. The only thing that is being "swapped" in CDS are regular premium payments in exchange for undertaking the risk of paying off the entire loss in case of default (equal to the notional amount minus recoveries). This is a very close equivalent to the business model of the monoline bond insurers like MBIA, AMBAC and FGIC.

The proper name for CDSs should have been DIPs = Default Insurance Policies. But that name would have certainly attracted the attention of the insurance regulators - anathema for investment banks, traders and speculators. So they called them swaps, just like the more innocent and common derivatives already residing in banks' books (off balance sheet, of course).

Oh what a tangled web...

Wednesday, November 28, 2007

Consumer Confidence and Contrarians

The Consumer Confidence numbers were released yesterday by the Conference Board and they showed that the US consumer is finally losing some faith in the rosier-than-thou view that all will be well despite collapsing real estate prices (down 4.5% in the third quarter), fuel and food inflation running out of control and household debt at an all time high. The headline index dropped to the lowest level in two years (chart below).

Of more significance is that consumers' views about their future declined dramatically. The Expectations Index plunged from 80 to 68.7, closing in to levels last seen during the second Gulf War in 2003 (chart below).

Now, there are those that will view this from the contrarian angle and argue that this is an indication of an approaching bottom. I am a dedicated student of contrarian principles myself, but I would be extremely cautious of such interpretation, right now: notice that the main index is still much higher than its 2003 low. The reason is that consumers are still quite confident about the present (chart below). True "panic", that condition so beloved of us contrarians, requires that people are scared about their future and present.

My opinion is that consumers will continue to adjust their current spending lower over the next several months, to reflect their growing negative expectations for the future. For as long as they still have some ready money and credit available they will spend, but increasingly cautiously because their concerns for the future will "color" their decisions and act as a brake, a "spending inhibitor". At some point the two views should merge, producing equally grim public opinion for the present and the future.

Nevertheless, this is clearly not the case right now, so it is still too early to call a "panic". No one is throwing in the towel and least of all the consumer, if we are to judge by the "lunatic" behavior during the midnight shopping madness that gripped the nation a few days ago. People are still rushing to buy the latest doodads, provided they can get them at steep discounts. Their dialectic has definitely not yet shifted to: "save as much as you can because there are hard days ahead". Yours truly, a dedicated contrarian, will await for this to happen at the very least, before starting to look for bottoms.

The main reason for this relatively robust showing of the Present Situation index is that employment, though weakening somewhat, is still quite resilient. The quality of the jobs involved is not excellent and their numbers are inflated by the statistical methods used, but there is no denying that overall unemployment is still low. But.. let me share a thought that popped into my mind as I left the supermarket yesterday.

I noticed that people are increasingly opting for no-name or budget brands; this is a natural trading-down response to price hikes and tighter budgets. I expect that this is going to have significant knock-on effects to the US economy specifically, dominated as it is by the service sector. Switching to no-name products and shopping at lower-tier stores is going to remove swathes of jobs in advertising, marketing and promotion, packaging design, retailing, etc.

Our economy is now dominated by such services and so is employment. The days are gone when a slowdown precipitated immediate layoffs in plants and a rapid plunge into recession - manufacturing has been off-shored. We are now vulnerable to losing "software" jobs more slowly, instead of losing "hardware" jobs faster. Whereas in the past a factory faced with slower orders and high inventories would immediately cancel a shift laying off 5.000 workers at one go, today we will have a grinding, drawn out process as thousands of smaller entities let go of several people here and there. But taken together, these job losses are going to be very significant and, unlike factory jobs, these kinds of jobs won't be fast at coming back, either.

In sum, employment is a lagging indicator, now more than ever. Given that jobs influence consumers' present attitudes more than anything else, I think we have a long way ahead of us before contrarian thinking enters the picture.

Tuesday, November 27, 2007

"Astonishing" vs. "Barbaric"

I started writing this entry before the news broke today about Abu Dhabi's investment in Citi. The purchase of the stake underscores as nothing else the point I wish to make below. Please read on. (There are two posts today).

The difference in diplomatic nuance between the two words in the title is the full a measure of how dependent on imported oil and petrodollars the United States has finally become.

First the details, from a BBC story:

A recently married 19-year old Saudi Arabian woman and a male friend were in a car together when they were abducted, driven to a secluded area and gang raped - both of them - by a number of men. The Saudi court that decided the case found the victims guilty of being in a car together without being relatives and sentenced them to 90 lashes. When their case drew media attention, the appeals court raised the sentence to 200 lashes. The victims were deemed guilty of untoward behavior in publicizing their plight with the media.

The Canadian government issued an official statement describing the sentence as "barbaric". The United States, that beacon of freedom, liberty and a constant champion of human rights everywhere in the world, declined to comment specifically on the sentence, but did call the case "astonishing".

The Saudi "justice" ministry issued a statement that rejected foreign interference, insisted that the ruling was legal and said the sentence would be carried out in accordance to Saudi "law".

Are we "astonished"? And if so, at what?

The Canadians, being net oil exporters and fiscally responsible,
can afford to call the Saudis for what they are: "barbarians". The Americans, who have to scrape and bow to the oil sheiks for their oil and money, are merely "astonished".

I will refrain from drawing parallels to history's other barbarians which the United States fought and subdued at terrible human and material cost. After all, they were enemy barbarians. Bad barbarians. The Saudis are, of course, different: they are our allies. Friendly barbarians. Our barbarians.

Message to the US government and all others concerned: For Heaven's sake, wake up and get rid of our oil dependence. Don't you see that if this horde of barbarians is capable of such atrocity towards its own people, it will not even flinch at using their oil power to dominate and dictate terms to our society?

What are you waiting for? Kristallnacht?

Original post for the day follows below. Please keep reading if you feel like it, and watch the Monty Python clip linked at the end.

Ministers of Silly Walks

Put yourself at Bernanke's shoes; better yet, get Paulson's shoes too and combine them: wear Ben's shoe on the left and Hank's on the right. The goal is to try and walk a straight and narrow a line for the economy, without embarrassing yourself. I submit that this is, in fact, impossible.

On the one foot, the Fed is getting screamed at to lower interest rates by at least another 200-250 basis points: PIMCO, Greenspan, The Conference Board, every bank and broker in town and abroad - they all demand and expect cheaper money for a variety of reasons, all immediately and extremely mercenary. The bond fund managers are salivating at the potential of capital gains from short and medium treasurys, the banks and brokers need the massive cash bailout to stanch the bloodletting from their toxic paper and real estate portfolios, the businessmen need the consumer to keep spending and Greenspan wishes above all to remain relevant - even in retirement.

On the other foot, the Treasury is finally getting pressured about the plunging value of the dollar. Until recently, such strain was easily kicked aside: cheap imports from China and its pegged yuan easily balanced imported inflation, the moribund Japanese economy kept the yen low and rising oil prices and export volumes kept the sheikdoms mostly happy, even if their currencies were pegged to the dollar. The Russians, also highly dependent on dollar-denominated oil and gas exports, were a concern but not nearly as important as 20 years ago. The European manufacturers were taking it on the chin, but no one really cared about them except european politicos - another cast of nobodies, in the US's eyes. But all of these factors are now reversing with a vengeance.

China is finally experiencing domestic consumer inflation as well as a runaway bubble in financial and capital assets. Japan needs to raise the value of its currency to ease the burden of imported oil and gas as the yen gets an additional boost from the unwinding of various carry trades. The oil sheiks are getting worried: not only are a lot of their expenses in euros, $100 oil is finally weakening the global economy and threatening to kill their golden goose. There is a constant murmur about "re-valuing" their currencies, "re-balancing" their financial reserves, etc. Russia is flexing its geopolitical muscles, fed on a rich diet of energy exports. And last, if always least, the Europeans are getting really ticked off at America's cheap dollar: Airbus, that most emblematic of their industrial global champions, is in a mortal battle for its survival.

Each one of these developments could easily be dismissed, if they occurred in isolation. But all of them together point to a threat so critical to America's interests that they can no longer be ignored: what is at stake here is the role of the dollar as undisputed global reserve currency. I won't explain why this is of vital importance to the United States - I trust readers understand. So, the pressure to restore the value of the dollar must be getting strong within the Treasury Department and the Washington establishment.

The Bernanke - Paulson team is thus experiencing a severe conflict. To take the "shoe" analogy one step further, one bunch of salesmen wants the US economy to wear a size 14 monetary and fiscal policy on its left foot, while another bunch wants to squeeze a size 6 on the right. Given that Ben and Hank do not wish to join Monty Python's Ministry of Silly Walks, they must soon reach a decision about their shoes and stop playing footsie with the economy.

Monday, November 26, 2007

The Great Risk Aversion and The Global Economy

The Great Risk Aversion is unfolding and nowhere is this more obvious than in interest rates and credit spreads.

The 3-month US T-bill is at 3.22%, much lower than the Fed Funds target rate of 4.50%. This is not only a signal that the market expects further Fed rate cuts, but it also shows that participants are getting so risk averse they are willing to accept significantly lower returns from an instrument deemed 100% safe (the government can always print more money), instead of lending to the interbank market. The spread between Fed Funds and 3m T-bills is at a 17-year high (see chart below).

Data: FRB

Longer-term Treasury rates are also moving lower: the 2-year note is at 3.07%, the 5-year at 3.41% and the 10-year at 4.00% - all much below the Fed Funds rate and going down fast (click chart to enlarge).

Chart: FRB St. Louis

There is flight to "certainty" taking place right now, even as commodity prices are soaring. Bond investors are clearly dismissing all current inflation worries: the 20-year inflation indexed Treasurys are now yielding 1.98%.

Chart: FRB St. Louis

Credit spreads
are rising, signifying increased unwillingness to provide credit to those borrowers deemed riskier. Commercial paper spreads are on the rise again (chart below).

Chart: FRB

There are many more indicators of credit spreads widening, in the asset-backed and straight corporate bond and loan sectors. The various CDS indices (ABX, CMBX, CDX, LCDX) are all making new lows in most tranches, pointing to increased worries about upcoming defaults and credit events. The result is that as interest rates drop precipitously for government bonds, other borrowers are not benefiting. Lenders are becoming increasingly worried that they are not going to get their principal back, never mind interest payments. Treasury bond rates are no longer indicative of the general level of borrowing costs in the wider economy.

If this was all that was happening, we would unequivocally expect credit destruction to lead to deflation, or at least disinflation. But the ongoing Chinese boom is lifting the economies of the commodity economies (oil block, Brazil, Canada, Russia, Australia), providing a cushion to the global economy.

The question is this: can China replace the US as the global economic locomotive and prevent a worldwide slowdown? In my estimation, no. Despite its soaring growth rates, China remains a poor country and cannot create nearly as much final demand for goods and services as the US. Replacing export business with domestic consumption may be sustained for a while by the expenditure of accumulated reserves, but after they are gone the pantry will not be restocked with export earnings.

Data show that US imports from China are already slowing down; in September they grew by only 9.5% from a year ago, the slowest in at least five years (see chart below).

US Imports from China, percent change from year-ago level (3m moving avg.) Chart: FRB

Bottom line? The evidence suggests that we are heading for a global economic slowdown, despite the surge in commodity prices. Such price action may be better explained by three factors unrelated to marginal physical demand:

a) The weakness in the dollar as global reserve currency.
b) Late-stage market events (i.e. final speculative blow-off) .
c) Resource extraction maximization (e.g. Peak Oil).

Saturday, November 24, 2007

Lunatic Shopping

From a NY Times article ("Bargains Draw Crowds, but the Thrill Is Gone") describing the "Black Friday" madness - and desperation - that has gripped our nation...

At a Wal-Mart outside Nashville, the doors opened at 5 a.m. yesterday, with customers surrounding a wooden pallet piled high with $50 digital picture frames at the front of the store.

Worried that the frames would sell out, Cindy Chavez, 36, braced herself, yelped and tossed her body on top of the pile, much to her fellow shoppers’ horror. She emerged from the scrum with six frames.

“I just didn’t think I could reach down and bend over and get it,” Ms. Chavez explained.

If this were a movie scene we would scoff at it as "too much Hollywood". And we cannot claim that this was an isolated incident, because many major retailers opened their doors at 4 am or even earlier. We have become, quite literally, lunatic shoppers.

Good luck to us all.

Friday, November 23, 2007

South Seas Turkey

I hope and wish that everyone has had a wonderful Thanksgiving. Stuffed as we all are, this post is going to be light.

In a previous post 6 weeks ago I compared the historic South Seas Bubble (1720) to goings on today and provided a chart that showed the year-to-date relative performance of the South Seas Company stock in 1720 with the stock of a cargo shipping company listed in the US today. I took a bit of heat because I did not reveal the name of the cargo company, but I thought it was not appropriate to single out just one company amongst many. I still won't, but I can add that it is involved in dry bulk cargo. Anyone that wants to do further research can easily do so through the myriad financial sites available.

Here is an update of the chart - the last 6 weeks are shown in red.

The dry cargo business has exploded on the upside with spot charter rates going ballistic. Interestingly, rates for oil tankers are flat to down in the same period (not shown in this chart). The main reasons are China's voracious appetite for iron ore for steel manufacture and the global demand for coal - apparently even the US is starting to export some now.

Spot charter rates for various size bulk carriers

The update on the day after Thanksgiving is to serve as a reminder that the fatter a turkey gets the more likely it is to end up as dinner.

Enjoy the Holiday!

Wednesday, November 21, 2007

Exporting Our Way Out of Trouble?

The latest economic palliative du jour is that the plunging value of the dollar and a vibrant global economy, ex-the US, will boost exports and thus help our economy avoid a recession. This concept does not last long under closer examination. Let's look at some charts...

The first one shows US imports and exports of goods and services as a percentage of GDP. The US ceased being an net exporter long ago; more recently, exports have been rising smartly, but imports have been rising even faster.

Data: FRB St. Louis

The net result has been a massive trade deficit, now at 5% of GDP, slightly improved from the record 6% but still exceedingly high. If we were Argentina or Russia we would have gone bankrupt long ago; but since the dollar is (still) accepted as a reserve currency we are (still) able to issue dollar denominated debt, purchased by foreigners to finance our imports.

Data: FRB St. Louis

Under normal conditions, the drop of the dollar against other currencies would have made foreign goods more expensive, crimped imports and restored balance. However, these are not normal times: there are two major issues that prevent this from happening.

Firstly, China's exports rely heavily on its pegged currency. The yuan is only very slightly firmer vs. the dollar in the past two years. This mercantilistic approach to currency valuation heavily promotes China's exports and restrains their imports. In the past, such policies were known as "beggar thy neighbor". In today's trade-dependent world we use slightly more diplomatic terms, but the end result is the same: we are running close to $300 billion per year in the red in our China trade balance, or 2.1% of GDP.

The deficit with China was already growing between 1990 and 2001, but thereafter it accelerated at a much faster pace. This can't be accidental - it was as if a switch was thrown and Chinese imports were suddenly allowed to flood into the US.

Data: FRB St. Louis

We can also observe this sudden shift in the number of manufacturing jobs in the US. The sector lost 3 million jobs within just 18 months and has never recovered.

Employment in the US manufacturing sector (chart: BLS)

These events point to a conscious plan, a policy choice to remove manufacturing from the US and replace it with cheap Chinese imports. I don't know if it was supposed to go so far as it has, but it has clearly gone too far.

Secondly, the rise in oil prices currently penalizes the US trade balance to the tune of at least $350 billion per year, or 2.5% of GDP; that's how much we have to pay each year at current market prices to import crude oil. In 2001 we paid less than 0.9% of GDP; within just 6 years oil import bills have increased by 1.6% of GDP.

Our trade deficit, as it stands today, is structural: it is caused by our decision to import from China instead of manufacturing at home (deficit: 2.1% of GDP) and relying on oil imports (increased deficit: 1.6% of GDP). Adding together the two effects (3.7% of GDP) we see that they account for 75% of our current trade deficit. Unless we do something about those two structural factors first, we cannot possibly hope to export our way out of domestic economic troubles.

Monday, November 19, 2007

Washington (Not Constantinople)

The title is a parody of Istanbul (Not Constantinople), the fun 1953 song by The Four Lads. The tune, which is very similar to Irving Berlin's 1929 Puttin' on the Ritz, has since been covered by many bands, including They Might Be Giants in 1990.

For a hilarious Daffy Duck/Porky Pig cartoon with their version, click here.

I have on occasion remarked that the current situation, with the US as the largest debtor in the world while still maintaining a huge military machine with ongoing commitments in at least two "hot" wars, has parallels in the waning years of the Ottoman Empire.

Two similarities stand out:

High Debt and Corrupt Financiers

"The Sick Man of Europe" was massively indebted, had a thin and ineffective domestic tax base and relied on foreign loans arranged by London and Continental bankers, who demanded several pounds of flesh. The stories of quick 12-18% gains (in hard currency, no less) from one or two year Ottoman Treasury bills are legion, particularly during the latter part of the 19th century. Many a "respectable" European house made killings in such operations, always in co-operation with local bankers in Istanbul (Constantinople). Look at this review of Gold for the Sultan, a specialist book I do not dare put on the Amazon sidebar: they want almost $100 for it! For those interested, I am certain it can be had for less elsewhere - or you can try the local library.

The instruments and details are different today, of course, but the machinations of mortgage and structured-finance bankers to create and extract embedded fees are identical. Only collusion, malfeasance and determined obscurantism can transform a basket of 100% CCC loans into 85% AAA bonds and produce huge fees paid to all involved. Just look at the food chain: mortgage brokers and supervisors, their shareholders, loan warehousers, loan servicers, the packagers, rating companies, salespeople and managers at investment banks, their shareholders...they all gorged on the spread between what the hapless (and sometimes illicit) borrowers paid and what the ultimate "investors" received.

How large were the spreads? In a word, huge - particularly when compared to regular corporate AAA bond issuance fees. I have heard of spreads of 10 points and in some cases even more. Before anyone objects, these are not basis points but bond price points, i.e. "investors" (in quotation marks because they were either complete fools or corrupt) bought bonds that were worth 85-90% of what they paid, right out of the box. This is money that will never be recouped, under any circumstances. It has been transformed into, and readily consumed as, bottles of Cristal, Porsches, Hamptons homes and vacations in Mustique. I am not surprised that no one is making a big stink about the role of such fees in the creation and propagation of the MBS crisis: It's called Omerta.

Look at who owns the largest heaps of such stinking waste: funds, funds, funds - whose managers bought them because they were such good investments? No: some did it after considerable research and analysis contained within sealed brown envelopes and others just got plied with the business-as-usual extra-curricular goodies (boobs and booze). Like the befuddled innocent said long ago: But...where are the customers' yachts? (see the last book in the sidebar).

An over-indebted state populated by apathetic citizens and feasted upon by legions of perennially corrupt financiers and corruptible politicians: That was what the once mighty Ottoman Empire had become by the 1850's. I leave it to everyone's common sense to determine if there are any Sultans, Grand Viziers, Pashas and Constantinople Bankers around today.

Political and Cultural Paternalism

The political system of the late Ottoman Empire centered around a succession of Sultans who based their power on primogeniture and ruthless elimination of other candidates (usually by strangulation or "accidental" drowning) . If any of you have been to the Topkapi Palace and taken the tour of the private quarters, you know what I'm talking about (reader contest: why were all harem eunuchs negroes?). The ablest candidates rarely made it to the throne: the palace intrigues were constant and the cliques favored those weakest and easiest to manipulate, in order to maintain their privileges and status quo.

In the past quarter century the political scene in the US can only be described as "same old, same old". There are no candidates with fresh ideas out there - or if they have them, they do no dare voice them in public. Yes, there are are credible and attractive non-mainstream candidates, but the idea is to change the mainstream, not to have to reach out to the fringe. Broad-based political innovation is a sign of social, economic and cultural vibrancy, a dynamism necessary to maintain a top spot in the world. Paternalism, repetition and "playing-safe" is a sure sign of society's dissipation.

This decadence can even be identified in popular culture: a steady stream of "safe" movies (remakes, I/II/III/IV series), music stuck for years in an amorphous rut, TV programs that reach for the basest human emotions of violence and lust, incessant shopping for needless trifles as a passtime. How much precious brainpower is applied daily to the production of blast-em' video and computer games? Why are stores now crowing about being first to open their doors after (or even before) Thanksgiving?

I don't demand of our society to reach for a modern-day Sophocles as popular amusement for the masses, as it once was in ancient Athens. Not even Mozart and Bach as creators of everyday music, as they were two centuries ago. But how about a current version of America's own Irving Berlin or George Gershwin? They were wildly popular in their time. Heck, I'll gladly settle for mainstream music with more than a throbbing beat and lyrics containing words exceeding four letters.

Quality for the average American has been thrown away, replaced by the cheapest possible denominator. Cheap thinking, cheaper goods, cheapest culture; and above them all a dissolute political machine that has become so self-indulgent that in the face of adversity it demands nothing more of us but to borrow and shop. We deserve much better than this madness. Contrary to many I don't think average Americans have become thoughtless slobs: but the average "Sultans" have, because we have allowed them to. We do not demand more of them.

We are guilty of neglect towards our democratic institutions. We have too easily fallen prey to a corrosive rhetoric that debases our individual and collective responsibility to our society, to our polis. True democracy is a fragile and precious construct; neglect brings about naive populism, itself one precarious step away from fascism and dictatorship. We the people need to get involved again. It matters little what party, candidate or principles we espouse, so long as we are willing to debate and challenge them and one another.

Or we might as well all go shopping. But we should not then complain if USA comes to stand for United Sultanate of America.

Friday, November 16, 2007

Send Hank Home

Under the law, the foreign exchange value of the US dollar is the responsibility of the Treasury Department. In the Clinton years a succession of Treasury Secretaries from Lloyd Bentsen to Bob Rubin and Larry Summers maintained a strong dollar policy, ultimately taking the dollar as high as 0.82 cents per euro.

The "industrial heartland" disagreed violently with this policy because it lowered the international pricing advantage of US industries such as steel, aluminum, autos and chemicals that faced stiff international competition. But the Clinton administration had a post-industrial view of the US economy, one that was based on the "software" produced by Hollywood, Silicon Valley and Wall Street, rather than the "hardware" coming out of the industrial Midwest.

There was another reason for the strong US dollar policy: the inception of the euro posed a very real threat to the dollar's global reserve status and had to be defended against, right from the start. Some US economists even went so far as to suggest that the euro would precipitate severe global tensions, ultimately leading to war! Marty Feldstein wrote a highly biased polemic article in the November/December 1997 issue of Foreign Affairs titled "EMU and International Conflict". The summary is below:

Jean Monnet's dream that European integration would eliminate conflict may have been a delusion. France and other countries do not share Germany's fixation on sound money -- or its hegemonic vision. A European central bank would be unresponsive to local unemployment, while political union would remove competitive pressures within Europe for structural reform, prompting protectionism and conflict with the United States. A Europe of 300 million people and an independent military might be a force for world peace, but war is also a distinct possibility.

I clearly recall the howls of protest coming out of the EU at that time and later, that the US was trashing the euro just as it was starting out - and they weren't without justification. For a while, Bob Rubin and Larry Summers included "a strong dollar is in the best interest of the United States" to each and every speech and comment they made.

When George W. Bush took over all of this was changed in the blink of an eye. The new administration appointed Paul O'Neill as Secretary of the Treasury and we all looked at each other across our screens and asked.."Paul Who?" Clearly, he was not "one of us", i.e. not a member of the global finance "club". As soon as we found out he was the CEO of Alcoa we knew the strong dollar game was up. The euro immediately rallied from 0.82 to 0.95, went back to 0.85 to test its lows a couple of times in 2001 and then embarked on the massive rally that has brought it to its current 1.46-1.48.

I won't go into why the Bush administration decided to trash the dollar; I have my theories, but suffice it to say that, as with several other major policy moves, it was astonishingly short-sighted and stubbornly defended even in failure.

This brings us to the present: in the past few days Hank Paulson has been attempting to verbally shore up the dollar in various comments, in a clear shift from previous remarks. The sharp rise of commodity prices and the real, or threatened, actions of various dollar-block countries (UAE, Qatar, Kuwait, China, KSA, et. al.) to move their reserves away from the dollar, is finally starting to raise red flags even for the otherwise color-blind Bush administration. But it is way too late for mere talk; if the US is really determined to halt the slide of the dollar it has to send some serious and tangible messages to the global financial community. All talk, no action simply won't cut it.

The very first thing to do is "Thank Hank for his excellent work done at the Treasury"... and send him home (unfortunately - or fortunately, depending on your viewpoint - this is how things are done). All other things equal, it doesn't much matter who replaces him so long as he is known to the "club" and the very first thing he says publicly after "I thank the President for the honor.." is "The United States Government is fully committed to a strong dollar as a store of value and global purchasing power...". Bang, that's good for 10 cents against the euro right there.

Naturally, such a statement will have to be followed by tangible policy shifts to restore balance to the global standing of the US economy, but this is a subject for another post. Suffice it to say that Empires with debased currencies do not last long.

Thursday, November 15, 2007

Retail Sales

The numbers for retail sales were released yesterday, in line with (rather anemic) expectations. Such activity directly accounts for approx. 35% of GDP, and much more when all other effects are factored in. Let's take a look at a few charts.

First, the year-over-year change in real retail sales, i.e. adjusted for official CPI inflation. The blue line is the monthly data and the red tracks the six month moving average.

Data: St. Louis Fed

The downtrend is quite apparent, even when using the low, official CPI figures produced by the government. Furthermore, with the price of gasoline and other fuels spiking sharply in the past few years, the impact of fuel sales to the overall numbers is becoming increasingly important. The next chart shows sales at gasoline stations as a percentage of total retail sales. Unquestionably, energy is becoming a more important part of the family budget.

On the other hand, food and beverage expenses at the supermarket have eased off very considerably over the years, as the next chart shows. Until very recently, real prices for food had been coming down for years and this allowed even less affluent consumers to spend more on other, non-essential items that carried higher profit margins (e.g. iPods, flat-screen TVs and Chinese imports). In addition, some food purchases were perhaps getting counted in other sectors of the retail "pie", i.e. as part of purchases at big discount stores that have added food sections (WalMart is an example). In any case, this trend appears to be bottoming out now; if recent food price increases stick, people will have less money to spend on the non-essentials.

The combination of gasoline and food purchases (i.e. adding the last two charts together) is shown in the next chart. After bottoming out during 2002-04, expenses for essentials is now on the rise once again.

How likely is this trend to continue on the upside? In my opinion, the chances are very high; food and fuel price pressures at the retail level are becoming apparent everywhere, China and Europe included. They are not caused by one-time events like droughts or pests, but by more fundamental supply/demand factors and questionable monetary policies in both the US and China.

The negative effects for corporate profitability in the services and non-essential goods sectors (i.e. just about the entire US economy) are going to be very significant and likely won't go away in one or two quarters.

Wednesday, November 14, 2007

Then and Now...

Very short post today.

Who was the motoring enthusiast who proclaimed...?

"If one formerly attempted to measure the standard of living of a population by the number of kilometres of railway line, in future one will apply the kilometres of roads suitable for motor traffic".

For a clue, he was the boss of the man who demanded....

"I want to hear nothing, I want to see nothing, I want to know nothing...I know what is going on, but you don't need to tell me about it. Don't ruin my nerves. I need my confidence to be able to work."

The car fanatic was Adolf Hitler and the see no evil, hear no evil advocate was Joseph Goebbels. As soon as they got into power in 1932 they pushed hard for the Volkswagen (the people's car) and the Volksempfaenger (the people's radio set), respectively. The Nazis actually instituted a whole program of cheap Volksprodukte, from sewing machines and refrigerators, to gramophones, bikes and even tractors and apartments.

The idea was to provide an artificial boost to the living standards of the vast majority of Germans who had to accept low wages in order for the German economy to be able to service WW I reparations debt. With the exception of the huge success of the "people's radio" necessary for propaganda, the rest of the Volksprodukte were ultimately failures because the Nazis were busy investing in a more direct instrument for raising living standards: the Wehrmacht.

Any similarity with current events and conditions is purely coincidental.

Tuesday, November 13, 2007

Opium Wars

When Richard Nixon visited Communist China in 1972 there was a great frisson of hope in the hearts of American corporate managers and shareholders: ... just imagine all those hundreds of millions each buying just one of our products... oh, the sales...oh, the profits. Thirty-five years later, the promise of immense Chinese trade has been realized, but in a way that no one could foresee back then. Instead of America exporting to China, it is China's torrent of cheap manufactures that flood US markets and, adding insult to injury, it is Chinese savings that provide the vendor financing necessary to sustain the hand-to-mouth existence of American consumers.

This situation is eerily reminiscent of Anglo-Chinese trade during the 18th and 19th centuries: China exported valuable silk, porcelain and tea, but had no need or desire to import much from England in return. Large trade deficits ensued and had to be paid for by British gold and silver - a situation not at all to the liking of the City's capitalists and bankers. So, Perfidious Albion came up with a novel, if entirely unscrupulous, trade-balancing product: opium from the Empire's poppy fields in India. Dope for the masses quickly caught on in China, the trade deficit evaporated and then even shifted to England's favor. The rest, as they say, is history (the Opium Wars and Boxer Rebellion).

In today's fiat currency world there is no need to make payments in gold and silver specie, but there is an implied promise that the dollar IOU's will be readily exchangeable at reasonable rates for essential commodities like oil, iron ore, copper and food, procured from around the globe. Today's Chinese trust, expect, or ultimately hallucinate that their massive holdings of book-entry blips are equivalent to gold. In oh, so many ways they are smoking dope once again, aren't they?

One look at market prices reveals that waking up from the stupor induced by dollar-debt dope is becoming very painful. American consumers are already curtailing their spending and thus growth in Chinese imports and vendor financing is coming to an end. The Chinese are finding out that their accumulated dollars now buy much less wheat or oil: fifty to seventy percent less, depending on the commodity.

The Chinese are certainly not naive. They saw this coming some time ago and tried to directly purchase long-term hard goods and assets with their dollars, e.g. oil and gas reserves in Africa and Iran, US and EU companies, etc. Their success was limited, so they piled into private equity funds, along with their petro-dollar brethren from the Gulf and Russia, as a way to circumvent direct-purchase obstacles. Naturally, they got thoroughly skinned in the "standard 2/20" way, with some funds even charging more. But the alternative - holding rapidly depreciating cash dollars - was even less appealing. Shaking a dope addiction has always been a terrible and costly experience, after all.

But these back-door investments have been drops in the bucket - large drops to be sure, but drops nevertheless. The Chinese Treasury still holds the majority of its reserves as "dollar debt dope" and its officials must be getting increasingly frustrated as they watch purchasing power eroding daily. The foreign "dope" dealers are not dumb, either: their ability to service US debt gets easier with every tick up in international commodity and transportation costs, priced as they are in dollars.

Inflation rose once again in China during October (6.5%), mostly due to sharp rises in food and fuel prices which hit the poor particularly hard. Three days ago in Chongqing three people died in a stampede as they rushed to buy cooking oil on sale at a supermarket. Attempts by the central bank to stem inflation center on raising mandatory reserves (up to 13.5% now, the highest ever) and interest rates (one year depo at 7.29%), but they are hobbled by the dollar-yuan peg which devalues the Chinese currency in international markets as the dollar drops.

Can China free itself from its present day opium addiction and America from the easy vendor financing terms? No one really knows; the situation has been allowed to get out of hand and the blame is shared equally by US and Chinese policy makers. They act like junkies who earnestly promise ...this will be the last hit, really man... as they feverishly light up another pipe, supposedly their last.

Monday, November 12, 2007

Corporate CDS Indices

Because of the rapidly widening crisis in real estate, there has been a lot of attention in the ABX and CMBX indices tracking credit default swaps (CDS) for sub-prime and commercial mortgage-backed securities. They started showing signs of weakness as early as a year ago, well before the real estate situation became critical (see post from January 9, 2007 - "Some Rather Unpleasant Charts"). Thus, the CDS market was acting as an early warning signal, a canary in the mine.

Likewise, corporate bond and leveraged loan CDSs (CDX and LCDX respectively) are weakening significantly again, after their initial swoon and bounce in August.

LCDX spreads have jumped from 210 to 340 basis points in just one month; buyouts and other leveraged M&A transactions are facing strong headwinds. Banks will also have to further mark down their inventory of approx. $300 billion in such loans still sitting in their books, as they are unable to securitize and sell them to investors as CDOs. The golden age of LBOs is over and this has obvious consequences for share valuations in all stock markets.

The spread for investment grade corporate bonds (CDX IG, click to enlarge) has also rapidly moved towards its all time high, going from 45 to 78 bp in a manner of days.

Both of the indices are warning us that there is trouble ahead for the corporate sector. The canary may not be dead yet, but it has certainly stopped chirping happily and is looking rather distraught.

Friday, November 9, 2007

Innovation v. Entropy

Energy consumption and economic growth are very highly correlated. This may be common sense, but you will be surprised how many people (professionals included) take energy for granted, dealing with it as just another input factor. The chart below starts in 1980, but the correlation goes back centuries.

Data: IMF, BP

Humanity exploded in numbers and achievement after the Steam Age. Was it because we suddenly became smarter? Of course not - all that happened was coal. A bit later the rate accelerated further because of crude oil. Dense energy subsidies freed us from the drudgery of localized subsistence farming and improved hygeine. Free time and longer lifespans allowed humanity to innovate at a record pace: means and need came together in a virtuous cycle. Boom. That's all; the rest is commentary.

The corollary: We need to find more oil and gas plus the ability to neutralize the greenhouse gas emissions. If we don't, we need to come up with other dense forms of energy. If we don't, we will necessarily slow down our activity (i.e. economy) to the rate at which we can transform dilute solar energy into useful work. The limits of this process are bound by the Second Law of Thermodynamics, a law that is so universal and basic in nature that it even defines the arrow of time. Without dense energy, we can't innovate our way out of entropy.

They should teach Thermodynamics to all economists. Actually, they should make Thermodynamics mandatory for all college degrees. Too bad Adam Smith died a century before Clausius and Carnot discovered entropy. He was a brilliant man and would have sharply constrained the Invisible Hand in his writings.

Thursday, November 8, 2007

The AAA Trap

Things are snowballing in the (nominally) AAA residential mortgage-backed securities land. As I pointed out two weeks ago and then again just a week ago, the weakness in those tranches is more a matter of structure and time delay, than anything else.

Lo and behold, the AAAs are now getting some serious selling attention, as investors and speculators alike wake up to the ultimate effects of cascaded tranches. (I should point out that ABX indeces are NOT direct bond prices, as some think. They follow credit default swap prices for CDOs; the lower the index, the more expensive the CDS and thus the higher the presumed risk of default.)

Here is the set of all AAA ABX tranches...

Real money investors (e.g. pension funds) who bought into this AAA sub-prime trap are now in a bind. They thought they were buying gold-plated bonds but are now stuck with securities whose value is melting away with no bid underneath. Turns out, you can't make silk purses out of sows' ears, after all.

Where does this leave the Fed? After yesterday's plunge in stocks the air is full once more with calls for them to cut, cut, cut. Two decades of regular pilgrimages to the temple of Fed The Saviour has resulted in financial invalids, rogues, mountebacks, conjurers and snake oil merchants expecting that their Lourdes is located at 33 Liberty Street in Manhattan.

But what if the Fed's own juju majik, even if supplied in copious quantity, fails to miraculously grow new limbs for the credit amputees? Will they pitifully gather outside the massive faux Renaissance palazzo, begging for miracles and alms? Some have already been unceremoniously defenestrated (e.g. Merrill and Citi CEOs), though their golden parachutes made the decent rather comfy.

The trip down will not be as painless for plain shareholders and creditors.

P.S. The ABX/CMBX situation is now quite well understood - if not by the populace at large, at least by the more informed. But the CDX, iTraxx and LCDX indeces tracking corporate bonds and high-yield loans are not yet discussed as much. I believe the market is still underestimating the extent of the trouble in the corporate sector.

Wednesday, November 7, 2007

The MRE Economy

MRE: Meal, Ready to Eat. It is a self-contained, individual field ration for the US military.

It is becoming quite obvious that our global economy is reaching its own MRE nexus: Maximum Resource Extraction. Be it in energy, metals, foodstuffs, clean water, habitable and arable land or climate change, man is stressing the Earth as never before. All comparisons with the past are now inapplicable, because the scale at which we are stripping our planet of resources is orders of magnitude greater and more intense than in the past.

To those that have been studying this now permanent crisis, it's not news. The very first time I came upon the term "global warming" was in 1982, in a Foreign Affairs article titled "Society, Science and Climate Change". I will never forget it because I was just out of engineering school and on vacation in Hawaii, right before starting my first job. I read the article while laying on a pristine beach in Kauai. I remember thinking ...this has nothing to do with me; it is so far in the future that I will be long dead before anything really important happens. Wrong is a five letter word, but it might as well have been eleven: wrong plus stupid... But at least it made an impression, because I still remember it after a quarter century.

Much later (2001), as oil prices were starting their upward move, I read John McNeill's Something New Under The Sun (see the books sidebar) and it changed the way I saw things. It dawned on me that mankind is now a much more significant force than Nature and that its actions are affecting our environment, economy and society in profound and time-critical ways.

Putting the two MRE's together, our global economy is only able to function and "grow" in its present form because it is extracting and consuming scarce "ready" resources at maximum capacity. For example, oil is a form of solar energy that was concentrated and "cooked" for us hundreds of millions of years ago. We are consuming it at maximum right now. If you don't believe it (I don't mean Peak Oil, that's another matter), just think of this: the only reason that Alberta's tar sands are a profitable operation is because we are burning natural gas to produce steam for the separation process. From an energy balance perspective, it's a losing proposition. Yet, under MRE conditions, dollars and BTUs have become so unbalanced that people are still willing to accept paper (i.e. debt) instead of equivalent goods, because they think they will be able to exchange it for other goods in the future. Obviously, the negative energy balance says otherwise.

Another example of MRE imbalances is China: hundreds of millions of people are willing to work for a relative pittance - and save a large percentage of it. They do not realize that they are essentially performing an energy arbitrage for the benefit of foreign consumers. They are being paid the equivalent of two bowls of rice daily and provide wealthy Westerners the ability to consume the energy difference contained in their products, as cheap sneakers and t-shirts. But what if the value of their paper savings measured in energy and food terms diminishes rapidly, as is happening right now? Or, worse still, what if the their current wages no longer buy two bowls of rice? Multiply this by 1.3 billion souls and you can bet we are in for upheavals.

And how about stock prices? "Investors" are still willing to believe that there will be enough readily available resources (and steady climate) around for decades on end - otherwise why would they pay P/E multiples in the 40s and 50s? Is this a good bet? Because looking around I see that some other "investors" are betting heavily against them: oil reached $98 today. The two are mutually exclusive, except during that tiny fraction of historical time when holders of paper believe themselves wealthy.

Do a simple calculation: add up all the ready energy reserves in the world (oil, gas and coal) at today's prices and subtract 20% as cost (average EROEI of 5). Then compare to the value of all the shares, debt and fiat money floating around. You will find that there aren't nearly enough energy resources around to cover all those claims on future economic activity. And if we want to be even remotely realistic, we need to subtract from our energy resource balance the rapidly rising environmental costs, lowering our ultimate EROEI to perhaps 3, or even less.

Simply put, our Meals, Ready to Eat are not enough to cover all those meal tickets we have issued.