Monday, November 30, 2009

Insolvency Vs. Illiquidity

Is Dubai going through a temporary liquidity crisis, or is it facing a serious insolvency problem? Does it need a couple of billion to tide it over a rough spot, or is the income produced by the assets it built by the dozen insufficient to cover their debt load?

The answer is, obviously, the latter: Dubai has a serious solvency problem, as can be seen from the see-through buildings dotting its shore and spiking its skies.

Does it matter? Of course it does; the ONLY remedy for insolvency is debt liquidation and a commensurate drop in the price of the associated assets. That's how asset prices may once again come into line with the income said assets can produce. Corollary to this basic truth is that monetary bailouts of the type envisaged by the central bank in Abu Dhabi do nothing in such cases - except possibly avert panicky bank runs. That's a laudable and necessary step, of course, but what must come next is, perforce, the painful liquidation phase.

And why does it matter to the rest of the world what is going on in Dubai? Because it is the world's most glaring, most spectacularly obvious case of what is wrong in the real economy, all over the world. The quantities and prices of all kinds of assets rode high on a sea of easy credit with no regard to their end use. Assets were built and financed with an eye only to their immediate sale, to flipping them for an instant capital gain instead of operating them for real economic gain, like rents or dividends. That's the economic principle known as "the greater fool" or "the trading sardine". It works for a while and then always fails, quite often most spectacularly.

In my opinion, Dubai is the warning bell that the global economy has entered Phase B. The greater part of the liquidity crisis is over; but now starts the real pain of dealing with insolvency. Central banks and financial ministers did a creditable job of subduing illiquidity. They even fostered the view that the global Great Recession was over. That's a mistake.

Dealing with insolvency will require far greater political resolve and much different skills than merely lowering rates and opening credit facilities to all comers.

Thursday, November 26, 2009

The Value Of Money (Plus Bye-Bye, Dubai)

First, this item about Dubai:

Nov. 25 (Bloomberg) Dubai World, the government-owned holding company struggling with $59 billion of liabilities, is seeking to delay repayment on all of its debt, even after Abu Dhabi banks provided $5 billion for Dubai’s support fund.

It didn't take long, did it, for the "pearl" to turn into a turkey?


On with the value of money (Debra's comment on the last post made me do it, honest....).

There I was two days ago sitting in my attorney's office, when a couple of guys walked in; a father and son pair, as it later turned out. They had come to receive compensation as settlement of a securities fraud case. Apparently, they had invested in a fund that went under several years ago; after a prolonged legal battle they were finally to get forty cents on the dollar. Despite the buzz-saw cut they suffered they were very happy - grateful even - to get something back.

They didn't look all that prosperous and I felt kind of sorry for them, when I noticed that what they were about to receive implied an original investment of over $1 million. Not exactly a pair of hoi polloi. But, anyhow...

We started talking while the lawyer was drafting a receipt and our discussion inevitably turned to money. I climbed onto my usual monetary affairs soap-box and started the dime speech on what constitutes money and banking in a fiat currency regime. Back I went into monetary history, watching their faces all the time... The link between dollars and gold (yes, yes of course we know this, signalled their nods), Bretton Woods (eh?), Nixon's final revocation of the gold standard in 1971 (whaaa..?), how money is created today (the government prints it, no?), the power of banks to create money out of thin air via credit demand (no, no, that's not possible!).

In this exchange, as in many before it, I once again witnessed the widespread ignorance about money and banking that permeates our society. Father and son, like 99% of all people, still hung on to a super-outdated notion that gold and money were - somehow - still connected. That money is still attached to (and thus reflects) some tangible "value", and that its creation is strictly regulated by a higher authority permanently answerable to society.

So, I explained to them that our money is like a ship: centuries ago it was firmly anchored (gold and silver coin), but that as time passed more and more cable was let out so the ship swung wider around its anchorage (gold standard). Finally, in 1971 Nixon let go the anchor altogether by shutting down the gold "window", so the ship is now completely untethered; it floats and rides the waves freely, counting solely on its captain's seamanship to stop it from running aground.

Though father and son listened attentively and even respectfully (probably a reflection of our legal surroundings and the fact they were about to receive a bunch of money they considered forever lost), I could see that they didn't really believe me.

I was not surprised; this is almost always the case: people find it extremely difficult to come to grips with the idea that today's money embodies nothing more than pure confidence, fides, credo.. That fiat money is a belief system; an organized, state-sponsored religion complete with high priests, acolytes and genuflecting flock.

In more scientific terms, the pair's aversion to the truth is similar to believing in a Newtonian/Einsteinian unitary "reality", as quantum uncertainty and multiplicity are swirling all around us.

So, what is the Value Of Money? Just like the quantum universe(s), simply what we think it is.

Happy Thanksgiving to all.

Friday, November 20, 2009

2012: Dollar At The End Of The World

I am a devoted and frequently bemused student of aberrant market behaviour as expressed in the popular media, i.e. "lifestyle" TV programs, films, radio, magazines, etc. I'm always on the lookout for such market signals emanating from unlikely, non-professional sources because I see them as excellent signs of excess. In other words, I'm an inveterate watcher of unusual bubble clues.

A few days ago I saw 2012, the latest "end of the world" movie. Apart from the spectacular end-of-days visions (California slipping into the Pacific, mile-high tsunamis crashing on Mt. Everest), what really caught my attention was the mention of the dollar's low value against the euro; I believe it was highlighted three times. (Oh well.. my obsession with all things monetary is obviously well beyond redemption.)

An Unusual Clue For The Dollar?

The one I remember best is when an Arab sheik is asked to pay "a billion" per person to be saved; he responds that "he has a big family" and that "a billion dollars is a lot of money" - only to be told that the price is "a billion euro".

There are two possible interpretations :

a) The dollar's demise is now irreversible and will proceed as a natural catastrophe.


b) The dollar's drop has gone so far that it permeates even the most popular global mass media. Therefore, it has nowhere else to go but up.

Being mostly a contrarian I favor choice (b), but not yet with any real conviction, i.e. I have not put my money where my bemused observations logically lead me.

However, I am also increasingly vigilant for other, more fundamental signs of trouble brewing in euroland, where several peripheral economies are in real danger of falling apart under the triple stress of a weak uncompetitive economy, huge debts and an overvalued currency.

Thursday, November 12, 2009

Calling Archimedes

Within 6 hours deserts receive more energy from the sun
than humankind consumes within a year

Prompted from the previous post about Dubai, today's post is about a quiet revolution planned for the deserts of North Africa. It's called DESERTEC and it's a pretty simple concept: harvest the massive amounts of solar energy in that region, turn it into electricity and send it across to Europe via cable.

The basic technology is quite old and proven: Concentrated Solar Thermal Power (CSP), i.e. using mirrors to concentrate sunlight, generate steam and thus drive turbines and electrical generators. The crucial difference between this and direct conversion of sunlight into electricity via photovoltaic panels, is that heat can be stored in media exhibiting high heat capacity (e.g. salts) and used to generate electricity 24/7, even when there is no sunlight. In addition, waste heat (i.e. lower enthalpy steam) can be used to desalinate water or drive cooling systems.

If you think that this sounds a bit like "pie from the sky" (sic), think again: a few days ago twelve of the world's largest companies signed on to the project, including the likes of Siemens, ABB, RWE, E.ON, MAN, Munich Re, Deutsche Bank and ABENGOA, bringing the project one step closer to becoming reality. The thumb-prints of Germany are all over this consortium, as one would expect from the largest EU member that is also forward-looking and firmly committed to alternative energy and infrastructure transformation.

This type of massive, game-changing project rings a huge wake-up bell: the days of debt-fuelled consumer spending growth are over. The economic paradigm for the next hundred years will be based on huge infrastructure spending, to radically transform energy sourcing, generation, transmission, storage and utilization.

Please keep this simple maxim in mind:
  • Energy is the biggest business of them all, by a long shot.
(If you have any doubts, I strongly urge you to read The Prize , Daniel Yergin's Pulitzer Prize winner about how oil companies and producers came to dominate our world.)

I am hopeful that after wasting resources* on financial bailouts (perhaps a necessary evil), our societies will see the light and now shift to productive and responsible courses of action.

* (Well.. it's only fiat money, actually, so the damage is mostly limited to the public's perception of policy priorities, i.e. propaganda. But such perception makes a big difference to the success or failure of necessary initiatives.)

What does this mean for investors with longer-term horizons?
  1. Avoid the consumer non-essential sectors. By definition, societies will have to save more in order to finance these projects and will thus have less to spend on non-essentials.
  2. Avoid the consumer finance sector, for the same reason.
  3. Interest rates will have to rise from near zero, to induce savings.
  4. Grid-related technologies will become increasingly important.
  5. Let Gaddafi pitch his tent where he wants (smile).

Tuesday, November 10, 2009

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.

Dubai In 1990

The Same Place, Last Year

I'm going to shut up now.

Monday, November 9, 2009

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.

Monday, November 2, 2009

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..
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!"