The Lords of Hedgistan

The top 50 hedge fund managers in 2007 made a combined personal income of $29 billion and now plan to incorporate themselves as a country. They are looking at Antarctica, which is getting balmier all the time. Despite record high crude oil prices ($115/bbl) that may restrict consumption and cause fewer greenhouse gases, they are nevertheless going ahead with plans to eventually grow cotton in the vast lands of the South Pole. Apparently, the Founding Lords of Hedgistan - for that is to be the name of their new nation - are betting heavily that burning coal will more than compensate.

Antarctica will be obtained from its current owners/claimants in exchange for immunity from speculative attacks on their currencies and domestic financial markets. America's McMurdo Station is widely expected to be renamed the Dead Buck Station as a warning to other countries that may resist surrender.

The new nation will have a tiny population (50 plus household members and serfs), but based on the earnings of its residents its GDP will exceed that of 100 out of 180 countries tracked by the IMF. Next on the list is Kenya (pop. 32 million, 2007 GDP $29.3 billion). One of the Lords suggested its outright purchase, but he was voted down. "Why waste equity when we have leverage?" was the sensible objection from the other 49.

The fifty Founders are to award themselves hereditary titles of aristocracy proclaiming their exalted station. Heraldic work is already under way for Order of Quantum, Lord of The Citadel, Harbinger of Perpetual Good News and Rex of Renaissance. The new nation's highest recognition for financial bravery has already been established, and is called Pour Les Cochons Volants. The medal of solid gold depicts two winged piglets encircled in a wreath of cocktail sausages.

And since (exploding) penguins come from the Antarctic...

I bid you all a fine weekend with the above Monty Python skit. The penguin bit comes near the end.

Crunch Metrics

Probably the best measure of the seriousness of the credit crunch is the ratio of rates for 3-month bank CDs to those for 3-month Treasury bills (see chart below, click to enlarge).

Data: FRB St. Louis

After decades of banks paying just a tad over T-bills for CD funds (ratio slightly over 1.00), their deposit costs exploded upwards reaching 3.20 times more than bills in the week of March 21. This was a somewhat misleading reading, however: with CD rates at 2.62% it was a low 0.81% T-bill rate that caused the ratio to shoot up so much, coming as it did amidst the Bear Stearns panic.

Last week the ratio eased back to 2.10 as bill rates moved up (CDs at 2.75%, Bills at 1.31%), but it is still high by historical standards and a continuing sign of severe risk aversion. Should it persist for much longer it will restrict lending practices even further and wreak havoc to bank profitability.

In a related topic, ISDA today announced that notional amounts outstanding for CDS rose to $62.2 trillion at the end of 2007, up 75% from 2006. The credit crisis is surely prompting many to seek default protection, but I think outright speculation is an even bigger factor. I have often said that CDS can be used as phantom equity equivalents and this comment supports my view: "Trading volume has gone up dramatically,'' said David Vershoor, a default swap trader at BNP Paribas SA in Hong Kong. "People are punting it harder than they punt equities.''

ISDA estimated CDS gross and net market values at at $9.8 and $2.3 trillion respectively which, though lower than notional, have now climbed to be significant on their own. By comparison, global stock market capitalization in February 2008 stood at $56 trillion. And if the Bear Stearns snafu taught us anything it is this: we can't ignore counterparty risk, i.e. we can't ignore gross market values for derivatives. Which ultimately means that notional amounts also matter a great deal and can't be dismissed out of hand as "unimportant".

Data: ISDA

Commenting

I have taken the patently unfair step of deleting every comment made in the previous post in order to make a point. I will not allow the comment section to become uncivil. Electronic schoolyard bullies will not be allowed to "play".

I thank those who make constructive and often pointed remarks; they add value to the discussion. From now on I shall excise only those comments that do not follow common sense rules of decency.

Thank you once again.

Crude Facts

With crude oil hitting new all-time highs over $114 per barrel, everyone is concerned - to put it mildly. Some of the appreciation is surely attributed to misbegotten monetary policy factors, as the Saudis claim. The US dollar is the benchmark currency for oil pricing and Mr. Bernanke's Fed is throwing good dollars after bad in his attempts to bail out Wall Street, leading to the debasement of the dollar. Another factor is commodity speculation, with risk capital betting on even higher prices. Finally, and most important of all in my view, is the depletion of easily accessible high quality crude oil, i.e. the forerunner of geologic Peak Oil.

There have been millions of pages written about Peak Oil, both pro and con, and I don't claim to be an expert. But I do want to add just one fact based on common sense. Exxon is the world's largest non-state oil company and the largest publicly traded corporation by market capitalization ($478 billion). If anyone has both the incentive and the resources to find and sell more oil, it is them. But they can't. In the last five years, as the average price of oil more than tripled, their production has been flat (see chart below, click to enlarge).

Data: Exxon Annual Reports, NYMEX

And it's not as if they haven't been trying: their capital and exploration expenses for upstream operations have nearly doubled in recent years.

Data: Exxon Annual Reports

These are not comforting facts.

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P.S. Senator McCain, he who wants to be President, today called on Congress to suspend the federal gasoline tax. Sure thing, Senator... and while you're at it, why not re-instate the draft? After all, we're going to need every boot possible on the ground to safeguard America's energy future. The hard way.

Bear Market-Less Recession?

A regular reader (eh) wondered if we are throwing a recession, but all the market bears are refusing to come to the party. My thinking is as follows:

1. Unlike the 1999-2001 period when everyone got hit with stocks-on-the-brain, stocks today are mostly owned by the super-rich, many through a variety of hedge and private equity funds that won't sell until they have to (fees, you see..), plus by corporations through buybacks and LBOs of an unprecedented scale. Those types of well-heeled and (supposedly) sophisticated stockholders can hold on to positions longer, even if they show losses.
2. There is definitely a lot of contrarian double-think going on amongst those players. Their theory is that, if we are already in a recession, then we will come out of it in another 6-8 months because of the Fed's largesse* and thus the time to buy is now. Also, there is admittedly way too much negative sentiment on the economy and markets (this blog included), usually a sign of a bottom. Putting those two together, "sophisticated" investors and speculators are betting on a bottom.
   

This is a parallel to the 1999-2001 bubble, when it was mostly the small fry retail investors who got nailed, thinking they could quit their regular job and become millionaires by day-trading stocks. Today it is the nouveau-riche Asians, Russians and Arabs (plus the usual assortment of Westerners) who believe they can be set for several lifetimes with portfolio income, if they can just make a big killing right now with as much leverage as possible. The phenomenon has even permeated the official sector, with sovereign wealth funds investing in highly leveraged hedge and private equity funds. Let me put it this way: in this bear market it will be the super-rich that will lose big.

Before anyone chimes in with accusations of pinko-bolshism, forget it. The Cold War is over and we won, so move on. What I am observing is plain old hubris. In 2000 it struck the hoi polloi, today it is striking the princely class. It's their turn to get struck down, that's all...

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(*) Here is an example from today's news: Lehman repackaged a bunch of risky LBO loans into an entity called Freedom (make your own snide remarks about the name) which then issued bonds of its own, conveniently rated A by the usual suspects. Lehman then took those new bonds to the bend-over-backwards-to-oblige Fed as collateral and...presto: cash. Feel free to bulge your eyes in incredulity and scream, if it helps.

a + b = \

As even optimistic analysts now believe that a recession is upon us, the debate has shifted to its "lettering": will it be a quickie in-and-out (V), a more prolonged (U), a double-dip (W), or a Japanese version (L) ? My opinion is somewhat different and is not described by a letter, but the - aptly named - slash (\). To wit, I believe we are in for many years of painfully slow contraction, akin to a maddening Chinese drip-drip-drip torture.

The reasons for this view are:

(a) The elements dragging down the economy are deeply-rooted and fundamental. Huge debt, low earned income, zero saving rate, resource depletion and climate change cannot be reversed by a "mild purgative" recession. If left completely unattended, the economy would go into a tailspin (|).

But, at the same time:

(b) Monetary, fiscal and political authorities, steeped as they are in decades of Keynesian and central banking traditions, will be confident of their abilities to cure the economic cycle's weakness. They will keep applying their customary medicines to stop the decline, with some temporary success. If that was all, the economy would go into a flat-line ( _ ) or a slight uptrend (/).

But because of (a), this slowdown virus will prove far too resilient against the usual treatments designed to combat the common economic flu, and the decline will resume until a completely different set of doctors take over and prescribe the necessary radical treatment.

Symbolically, then: a + b = \

or, if you remember your vector physics: | + --- = \

P.S. Crude oil hit $111 per bbl today. One hunnerd an' eleven... them's a lot of castles in the sand for all the khalifs (with banners flying from their "Peaks"?).

The Fed's Dowry Fund Is Running Low

If you assume that the Fed has nearly unlimited capacity to bail out the US financial system, you better think again. A look at the size and makeup of its balance sheet versus the "shadow banking system" is enough to send shivers down your spine. To wit, look at the chart below (click to enlarge):

Data: FRB

After providing a very generous dowry to JP Morgan for marrying Bear Stearns plus beauty salon money for the bridesmaids, the quality of the Fed's own balance sheet has deteriorated rapidly. Holdings of Treasury securities plunged from 90% to 65% of assets and will drop further as more ugly spinsters come asking for makeovers.

Furthermore, its Treasurys now account for a low 3.5% of the debt issued by the US financial sector, down from 8.5% in 1996. In gross terms, the Fed's capacity to provide bailouts to the financial system without resorting to the printing presses is 60% less than twelve years ago. And this is before we account for the considerably higher risk being carried by the financial system as a whole versus a decade or more ago.

I leave the conclusions, once again, to the informed reader.

Jobs, Again: Double Trouble

I continue on the employment subject because I believe it is of great importance in evaluating the economy's prospects, shorter and longer-term. First, a chart (click to enlarge) that compares the annual growth rate of the civilian labor force (those that want to work - red line) to growth in the payrolls of the private sector (those that are currently working in businesses - blue line).

The initial observation is that we are likely already in a recession, if we judge by the history of past drops in the growth rate of payrolls below that of the labor force. The economy is now creating jobs slower than people need them.

Also important is the simultaneous decline of both growth rates to near zero. The drop in payrolls means that the economy is losing jobs right now, whereas the drop in labor force means the economy is unlikely to create many jobs in the future. This has only happened twice in the previous 50 years, in 1991 and 2001. Interestingly, the recoveries following both recessions were called "jobless".

But in 1991 and 2002 household debt as a percentage of disposable personal income was 85% and 108% respectively, whereas today it is at 136%. Since debt must be serviced from future earned income, the current combination of record-high debt and zero (soon, negative?) job growth is very dangerous, both from a short and long-term perspective.

Therefore, I believe that the current credit crunch is not merely a cyclical event but a fundamental problem that will be with us for a long time to come.

It's The Jobs, Stupid

As jobs go, so does the economy - and financial markets. This was always true but even more so today because of Americans' hand-to-mouth existence (saving rate down to zero) and record-high debt (household debt is 134% of disposable income vs. 92% just ten years ago). More than ever, the lifestyle of spend-borrow-spend is teetering at the edge of the employment precipice. And with personal consumption making up 70% of GDP, job losses now have a disproportionately negative effect on the economy.

So, how are jobs doing? Putting aside the poor performance of qualitative indicators like part-time jobs and people dropping out of the labor pool statistics because they cannot find a job, even headline numbers are starting to look decidedly unhealthy. Weekly initial jobless claims spiked to 407.000 yesterday and continued claims to 2.937 million (see charts below, click to enlarge). After initially modest damage, the employment picture is now deteriorating at an accelerated pace.



And how about financial markets? Looking at stocks in particular, I sense a heightened willingness by leveraged speculators to go bottom fishing. They interpret the bad employment data as lagging indicators that will soon peak, and at lower levels than previous recessions. Their optimistic reasoning is that Fed and Treasury initiatives have the power to provide the economy with enough fuel to keep demand going, even under current conditions.

I disagree, precisely because these conditions are so fundamentally problematic and cannot be soon turned around by using a lot of monetary policy and a bit of fiscal stimulus. Furthermore, I do not subscribe to the "sheeple" concept, which I find derogatory in the extreme. I am certain Americans are well aware they are being crushed in the vise of low earned income and high debt, and that their ability to borrow ad infinitum to maintain spending has ended. Therefore, a long period of family balance sheet repair is ahead of us, with reduced consumer spending a given.

I believe I do not have to spell out what this means for the economy and, furthermore, what it means for politicians who send out "tax rebate" checks (i.e. more money borrowed from abroad), urging Americans to go shopping. Little wonder the current administration has such abysmal approval ratings, a fact that is further damaging consumer confidence.

One of these days there may come a politician with a sound, independent understanding of the relationship between peoples' income statements and their balance sheets, one that won't rely on voodoo economics and Street advisers. He/she may even get elected... I can dream, can't I?

Terms of Endearment

The fourth largest US investment bank raised $4 billion in new capital (we used to call them brokers, but that moniker is considered demeaning nowadays). Markets cheered, but should they have? Let's look at the terms of the transaction...

Preferred shares paying 7.25%, convertible at any time into 20.05 shares of common stock, i.e. at a conversion price of approx. $50 (the stock closed at $44 yesterday, up 18%). That's 80 million potential new shares vs. 550 million common outstanding, or 14.5% potential dilution. By comparison, the common pays a 1.5% dividend at current prices and - lest we forget - Fed funds are at 2.25%.

Measured by any yardstick you wouldn't describe these terms as "favorable" to the seller. And they claim that they really didn't need the money, but raised the capital essentially to prove that the market still loves them (press release).

Terms of endearment, indeed...