Next Exit, Bernanke

Oh, how deliciously apropos are these news for a Sunday morning post.. I mean, really, you can't make this stuff up, folks..

It turns out that yesterday the good people of Dillon, S.C. invited their hometown hero Fed Chairman Ben Bernanke to speak at a ceremony naming a highway exit in his honor. Henceforth Exit 195 of Interstate 95 is to be officially known as the Ben Bernanke Exit. How uniquely American can one get? I mean, can anyone imagine the French dedicating anything - say the TGV railroad station in Lyon, where he was born - to Monsieur Jean-Claude Trichet, current president of the ECB? Sacre bleu!

Oh, never mind..

I expect that professional honors of any kind are rather thin on the ground for Mr. Chairman these days, so accepting local transportation-related alternatives may be the only way to satisfy the good professor's needs for ego boosters. Indeed, it takes gumption to "get angry" at the likes of AIG.

Still, it would be perfectly understandable if he had just traveled south for the day, enjoyed a bit of deep-fried chicken, okra and grits with pan gravy, plus the usual small-town shootin' the breeze and backslapping with old-time friends. Charming, even.

But, nooo..

Because Mr. Chairman instead chose this rather declasse event to make a major policy speech. "At the Federal Reserve", he proclaimed, "we will continue to forcefully deploy all the tools at our disposal as long as necessary to support the restoration of financial stability and the resumption of healthy economic growth."

Lock and load, Ben - or is that "start the rotors spinning, cap'n"?

On second thought, "The Bernanke Exit" may be exactly apropos for marking the end of our Permagrowth Era - prophetic, even. What better confluence of rapidly bygone symbolisms than a highway exit for gas-guzzlers named after the chief of a fiat currency?

Yep, you really can't make this up...

Off The Cliff Goes The Coyote

There is no better illustration of the Rise and Fall of The Era of Finance than the chart below (click to enlarge). It compares the market performance of Citigroup stock with GM and the S&P 500 index. Citi is black, GM blue and S&P 500 yellow.

No further comment necessary.

Wile E. Coyote Hills

Market Cap- to-GDP Back At 1990 Levels

Caveat: The following is not meant as prediction, suggestion or inducement to any action. As always in matters of markets and personal finance, I offer no advice and strongly suggest you keep your own counsel.
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US stock markets have taken it on the chin - and everywhere else, for that matter. Year to date the S&P 500 index is down a rather severe 26% - that's in just two months. And that's on top of a 38% drop during 2008, when measured from the high reached in May of that year. The total decline from the all time high reached in October 2007 now stands at -56%, bringing the index to levels last seen in 1996.

This has been repeated a million times already in the financial press and, quite importantly for popular mood followers, also in the regular media (you know, when the financial pages make it to the front page, etc. etc.). Nothing new there.

More interesting, however, is that total US stock market capitalization has plunged to 63% of GDP. That's a level not seen since 1990 (see chart below, click to enlarge).

Data: World Federation of Exchanges, BEA

• You asked for it, so here is the Saturday Morning Addition: A longer-term version of the above chart (click to enlarge). Notice that it only goes to 2004. The current reading is intriguingly sitting right on top of the 85 year average - certainly much more in line with what one would term "reasonable". But markets are almost never characterized by sanity, so...

I am not going to interpret this - I'm keeping my own counsel, too. But feel free to provide comments as you see fit.

Oh, and here's the regular monthly update on the Monster Employment Index released yesterday. It managed to notch up a bit last month.

NOTE: Commenting is now "protected" by squiggly key word verification. Too much comment spam going on... I guess I must be happy to be so "honored".

Thirty Cents On The Dollar

I know I am beating the deflation drum a bit too much, but it's important to record and understand what is happening, as it happens. Because, unlike those who still expect inflation to appear, I see it as being here already.

Unfortunately many people - too many - think deflation is just about consumer prices, i.e. lower prices at supermarkets and malls. They are making a fundamental mistake because they do not understand the direct link between debt, asset prices and our fiat money regime.
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It's springtime in America and the flowers of deflation are blooming everywhere, from real estate and finance to industry. The latest example is yesterday's offer from Ford Motor Company to pay 30 cents on the dollar in order to retire $10 billion of its debt. That's debt destruction, but it is also money destruction since fiat money is nothing but debt.

As longtime readers know, I am an ardent advocate of exactly such actions, which I see as the only way to effectively reduce the pile of debt we have amassed over the past twenty plus years. The trick, however, is to do it without damaging earned income, i.e. wages for working people. With unemployment rising fast during a recession that's not an easy trick.

Of course, it's not like such deflationary events have not happened before; most recently we were threatened with one during the dotcom bubble burst in 2000-01. Followed by the 9/11 events, it caused serious panic in policy circles and precipitated the Late Great Real Estate Heave-Ho. Instead of grasping the opportunity to put the US economy in a sound footing Bush, Greenspan and Co. decided to just pump up another debt/asset bubble and prayed (literally) to Heaven.

We got Hell, instead. (Yes, yes, pun intended).

It is imperative that we do not repeat the same mistake. We are still trying to keep the clinically dead debt/asset economy alive by massive injections of new government debt, i.e. providing bailouts for banks and insurance companies. That's just replacing the private debt with public debt; but, in the end, it's the same old US economy that will have to bear it and service it. Can't be done, dammit!

Let's say it once more: let the debt die and focus instead on increasing earned income.

And that's precisely why we need a radically new fiscal/industrial policy, instead of more and more of the old monetary "fixes". We have to create new good, high-paying jobs to counterbalance the withering of the FIRE economy and to minimize - as much as possible - the pain from debt destruction.

Add to this mixture the negative factors of geopolitical dependency on crude oil and gas, plus resource depletion and environmental/climate degradation and the route forward is strikingly, even incredibly clear. Changing our energy regime from black to green in a massive and concerted way will quickly generate millions of new jobs and absorb trillions in new investment.

Net-net we may stand still or even retrench in classical GDP arithmetic - but that's old hat economics, isn't it? Here's just one way our current accounting is providing the wrong picture: where is the cost, the negative growth which results from massive habitat degradation? Economists hide behind the term "external cost", but that's plainly nonsense in a world of 7 billion souls ultimately aspiring to American-style living standards.

What if instead we subtracted from each nation's annual GDP growth $50 per metric ton of CO2 it emitted to the atmosphere? This is actually not a price I picked out of the hat. It is close to the top market price for European CO2 emission permits last year. Prices have since come down with lower economic activity but, if anything, I believe $50/ton underestimates the total negative impact (just think of health effects).

Here's a list for the top ten CO2 emitters, unfortunately dated back to 2004 (latest data available). It has changed significantly since then, mostly because of the growth in Asia.


That's a trillion dollars per year, right here.

So... where should our trillion dollar bailout money go, instead, eh?

What Is Deflation?

An extremely short entry today, prompted by the following comment from an anonymous reader:

Hell... stop the stupid hysteria about deflation. Thus far we're talking asset deflation. You can wax eloquent about deflation when we can fill a cart with groceries at the supermarket for $50, or when crude goes back to $10...

In a fiat currency monetary system asset deflation is actually all the deflation that matters and is the direct consequence of debt destruction (aka money destruction). Consumer price deflation, i.e. lower prices for goods produced by utilizing said assets, may or may not follow depending on the balance between lower costs for capital assets reducing production costs and the actual production of goods, i.e. how many units of goods are produced by the assets.

Asset deflation is the worst nightmare of modern-day central banks and governments, inured as they are to Permagrowth. In this light, it is quite easy to understand why we are currently witnessing a constant barrage of trillion-dollar bailouts for banks and other financial firms. They are simply at the nexus of the asset-debt-money structure.

More De-Leverage

The following data on CDS (Credit Default Swaps) amounts outstanding is not exactly fresh (latest available are from June 2008), but it is relevant to what was just announced by AIG - and apparently precipitated yesterday's steep drop in global equity markets.

Data: ISDA

The world's erstwhile largest insurance company lost a record-setting $61.7 billion in the last quarter. It comes as no surprise to yours truly that most of the losses were attributed to CDS contracts. Readers will recall that I have long been beating the drum on the terrible consequences of unchecked issuance of credit insurance. In a nutshell, I had pointed out that enormous CDS exposure would act as an accelerant to a financial meltdown, despite the frequent and voluble objections that "these are just notional amounts and the real exposure is much smaller."

Well... size does matter, ladies and gentlemen. Because the proviso, that little asterisk attached to or implied in all the objections to my warnings, was always the same: assuming counterparty risk is not increased. That's a bit like saying that cigarettes are completely harmless as long as you don't smoke them. Or, they are almost OK if you don't inhale.. As I am fond of saying, good luck with that (nonsense).

Reality has now hit us on the face like a baseball coming off a bat - and it has "Mfg. by CDS Industries, Inc." written all over it. Make no mistake: such derivatives, plus the second- and third- order artificial products manufactured from them, are the proximate cause for the seizure suffered by the FIRE economy. Simpy put, everyone is scared witless not only of their own but, most crucially, of everyone else's exposure to this stuff. That's counterparty risk, big time.

There's one silver lining, however: such derivatives are typically structured to last five years and we are already well into the second year of the crisis. Meaning, amounts outstanding - and the dangers associated with them - are coming down fast. There were nearly $8 trillion less CDS outstanding in mid-2008 than at the end of 2007, a 12% drop in six months. I am certain this process has accelerated sharply in the last nine months, as risk and leverage appetite has quite obviously turned into revulsion.

So, just like plunging margin debt (data in the previous post), the drop in CDS is a sure sign of rapid de-leveraging happening as we speak. I think its a very good sign, all things considered..

Now, if we could just get through the next year without any huge implosions... (note: I think we will).

Margin Debt Plunges - The Age of De-Leverage

No matter how you interpret it, the recent plunge in margin debt in the US is thought provoking (see chart below).

Latest data from NYSE show a vertical drop: from a high of $381 billion in mid-2007 to $186 billion in December 2008, with most of the decline occurring in just the last three months. Margin debt has likely declined even further in January and February. De-leveraging writ very large, indeed.

For a more instructive longer-term perspective it is better to look at a log-scale chart (see below).


One (fundamental) interpretation is that The Great Pump-Up, which lasted over thirty years, is finished and the Age of De-Leverage is fast upon us. Though I don't expect the latter to last as long as the former (economic declines being swifter than expansions), I nevertheless think that the de-leveraging process will last more than most people believe. And this, despite the (un)heroic efforts by Fed and Treasury to rapidly pump trillions of fresh debt into the system. All they are achieving so far is to replace a portion of the debt going terribly bad (eg sub-prime mortgages and speculative trading leverage) with government debt. Unfortunately, private debt is rotting away much faster than the feds can replace it.

I wonder.. When will the people of the new Obama administration cotton on to the simple fact that the whole debt-fuelled Permagrowth structure is rotten, not just one small portion of it? When will they wake up and realize that Bernanke, Paulson & Co. (and now Geithner) are not providing fresh solutions, but simply making the old problems even worse?

C'mon folks, PLEASE! Step out of the box and look at things from another angle. Whatever you think, dare to think the opposite. For one, stop comparing today with the Great Depression - that's a ridiculous, fear-mongering scare tactic used by the finance community to convince the public to supply bail-outs by the trillion.

Today's US economy bears no resemblance whatsoever to the 1930's. Capital and labor intensive industries like manufacturing and farming account for a far smaller portion of GDP and the social safety net is much bigger (deposit and pension insurance, Social Security, Medicare, food stamps, etc). It's the debt-laden asset-based FIRE economy which is in deep trouble today and it should be allowed to shrink back to a relative insignificance.

Unintended Consequences

I was going to post about "Green" today but this came up yesterday and is highly topical to what is going on right now.
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Deflation is being writ larger and larger, and it is showing up beyond the narrow confines of the credit crunch in banking, finance and real estate.

Spain's Santander Bank - one of the world's largest - needs to raise fresh cash to shore up its balance sheet after suffering huge losses in mortgage lending. It is, therefore, offering to sell its 31.6% stake in CEPSA, Spain's second largest oil company. Nothing odd, so far.

But the (shocking) news is that it is offering to do so at a huge markdown: a range of 30-35 euros per share, versus a closing price of 67 euros just three days ago. That Santander has to provide a monstrous 50%+ discount for a crown jewel unrelated to finance is most assuredly a rude wake-up call. At least for those who still view generalized deflation as unlikely.

Ring, Ring - Deflation Calling

Well, ring-a-ding-ding..

Long-time readers may remember this post from March 2007 about the Spanish developing vacation real estate in even the most unlikely places (excerpt follows).

"I was in ... (south Spain)... a few months ago and I can confirm that the whole Costa del Sol, from Gibraltar to Almeria (about 500+ km), is one giant vacation construction site, with El Cheapest attached condominium projects machine-gunned from the water's edge up to the hills. We are talking, up one hill and down the other. I saw the saddest excess at Carboneras, at the far end of Almeria province, a grungy but laid-back factory town still undeveloped by comparison to, say, Estepona. Just around the corner (and down-wind?) from the huge, smoke-belching cement factory they are building this enormous "luxury" vacation-condo complex, having hollowed out an entire hill."

Here is a picture from another monstrous complex, under construction just north of the same factory, which I just found in Google Earth. The word "rape" - environmental and financial - does not do justice to what went on there.

Building Prosperity in Spain - a posteriori

I believe the sound of toppling deflation dominoes can now be heard clearly by everyone. Can anything be done to stop them from smashing into each other? The US and EU are trying, furiously creating new money (i.e. government debt) to replace the "liquidity" being drained away by the swift and merciless process of debt destruction. In this way they hope to shore up prices of all manner of assets, from homes in California to factories in Dalian and charter-less bulk carriers riding their anchors.

It all boils down to one objective, one fervent desire: Let's keep the Permagrowth Party going.

I will say it once more: Before it's too late, before untold trillions are wasted on supporting yesterday's corrupted and corroded "borrow-spend-inflate" economic structure, let's instead invest heavily in our (and our children's) Sustainable future.

The Trouble With Harry, or CCC

You are a large global bank. What is your business model, right now? I discussed this with a friend at a bank today and we came up with this: cross my fingers and hope to survive.

In other words, current banking strategy is based on the fervent hope that things are not as bad as they seem, that the global economy will improve faster than feared, that credit and equity markets have overshot on the downside because they are panic stricken instead of discounting a terrible future.

That, above all else, The Trouble With Harry is not that he is stone-cold dead from repeated overdoses of deleterious debt, but that he is suffering from a temporary confidence coma.

A Banker Hard At Work Implementing
His Current Business Model

Well, good luck with that.

Hope may be a fine personal trait but it does not make for good banking business models. When bankers have to rely on sentiment instead of hard-nosed greed you know they are in deep trouble. And what is the nature of their problem? It's in the title of today's post: the Capital Conservation Conundrum, or CCC for short.

Let me explain.

Banks are very simple businesses: borrow - lend - repeat. The crucial word being repeat, because if the cycle stops banks almost immediately start losing money. When principal is repaid (or defaulted) and is not re-lent net interest margins (NIM) decline and high fixed costs hit the bottom line hard. Therefore, as banks go into capital conservation mode and shut lending down they create a negative boomerang effect for their own earnings. In more ways than one, banks are like sharks: they have to keep swimming in order not to sink.

Banks striving to preserve capital (i.e. to maintain capital adequacy ratios) are in effect winding down their core business. This is another reason - beyond loan defaults and trading losses- that banking stocks have been pummelled into the dust. The KBW banking index is down a whopping 80% in two years (see chart below).

KBW Banking Index (US)

As a confirmed contrarian investor/speculator I look at the above chart with interest. But when I try to attach a fundamental story - where is the next seminal earnings upswing going to come from - I cannot find one.

Perhaps it is my own lack of imagination, but I cannot see the next big thing for banking revenue and earnings. (For example, after 2001 it was clear that mortgage and consumer lending was going to boom as the Fed slashed rates). So, in my own mind at least, the banking sector is not worthy of a long-term investment commitment - even as a dead-cat rebound may be imminent. (I would be very interested if readers could supply alternative perspectives).

In my opinion "Green" is the sector - many sectors, actually - providing future multi-year opportunities. More on that in the next post, based on my recent trip.

Poorhouse For FIREmen

Just about every civilian (i.e. a non-finance professional) thinks that a Crash is the way to send financiers to the poorhouse en masse. Wrong - just as it is completely wrong to think that casinos go bust because too many people win. The truth is, of course, completely different.

The FIRE Casino (finance, insurance, real estate) feeds on the Two Vees: Volume and Volatility. Thus, it goes bust only when no one wants to play, when the market is flat and volumes shrink. This hasn't happened in a long, long time. The last time, when brokers became cabbies, was the 1970's. The Dow literally yawned its way through that entire decade, fluctuating a mere 100 points around the 900 mark (with one exception - see chart below).

When Brokers Became Cab Drivers

You see, the house doesn't really care about "How The Dow" (though it does prefer it to go up because it then captures the hoi polloi's imagination and induces more participation by the marks - remember dotcom daytraders?).

As I said, market makers feed on volume and volatility, not direction. And there's the rub: so far volatility has been immense and volumes quite strong - at least in equity markets. The prediction, therefore, is that this whole crisis thing won't be over until ... you guessed it... volatility drops sharply and volumes tank - and cab companies get job requests from unusually well educated applicants.
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Note: I'm off on business for a week (green business, by the way) and will try to post ad hoc.