Bailouts for Dummies!

Darwin’s law of Bailouts

Fri, Feb 6, 2009 - 9:34am

Bailouts, stimulus and recovery packages are all sub species of the genus “ Governmentii Handoutus” a well known member of the parasite family. Charles Darwin’s 1859 book “On the Origin of Species by Means of Natural Selection,” has gone on to become an all time best seller and has become the new bible for those of a scientific bent, who have founded and nurtured the “Evolution” religion. Darwin studied medicine at Edinburgh University, also the alma mater of the hapless Gordon Brown, Britain’s Chancellor of the Exchequer (Treasurer) in the years while all the naughty stuff was going on at the banks and now its unelected Prime Minister; and theology at Cambridge. His famous insights into natural science occurred during a five year voyage on HMS Beagle which left Plymouth Sound in December 1831. Darwin was a discerning thinker and among his important observations, which he was accustomed to jotting down on notes, mainly on animal breeding, were his views on marriage. Under the headings “Marry” and “Not Marry,” he noted the advantages as “constant companion and a friend in old age...better than a dog anyhow,” and the against points as “less money for books and a terrible loss of time.” That seems a rational and scientific approach..

Darwin’s basic hypothesis that all life forms evolve or change over vast periods of time is of considerable assistance in the maintenance of this curious religion. You see, the assumed periods of time required to effect Darwin’s changes or evolution, are so vast that science has not yet been able to observe any of these changes. Yes, that’s right. Despite the many millions of fossils and artifacts recovered by generations of researchers, catalogued, compiled and described in museums all over the world, not one trans generation fossil displaying the characteristics of a “changeling” has ever been found.

Not a single one.

Scientists always bridle at this assertion but they shouldn’t. It’s a free world, or our part at least is, and folks are free to believe whatever they want. Some believed that Oil was going to 0 because a prominent broking house said so. Many more believed that sub prime and other noxious securities were a good investment. Even the biggest banks and the Governor of the US Fed thought so; others believed that Bernie Madoff was a good guy as were his spruikers; some believed that Hank Paulson knew what he was doing when they gave him the TARP money to play with; others were delighted to see Timothy Geithner, Paulson’s protégé take over the mantle of the bailout king; still others were seduced by the economists’ “new paradigm” and “goldilocks economy” tales as they entertained the eager children, so there is scope for all sorts of beliefs in this world.

The inability to prove a theory is of course a highly desirable characteristic for those promoting its use. Having an observable and provable series of events that support the hypothesis is a bore that limits the scope of lofty claims and therefore opportunities for profit, to the measurable and mundane. That won’t do at all for the great and lofty ideas of Science. The ability to attract and tap vast amounts of Government and industry funding in support of a theory is the essential element of Scientific life. Inevitably the discoveries made after years of research and experimentation turn out to be hugely expensive and require further buckets of public money to become a viable input to society.

Newer exponents and observers of Darwin’s work hold that it explains all aspects of human behaviour. As this can neither be measured, replicated or proven, it fits right in with modern evolution theory as applied to social behaviour.

Two of my favourite examples on our current radar scan are Ethanol from Corn and wind power. You remember of course that there is considerable interest in the development of alternate forms of energy. What we want is a cleaner form of energy so we can stop transferring wealth from the western world to those dreadful oil producing countries, who by a whim of nature and geopolitics are sitting on 80% of the world’s oil. The economic arguments are that high Oil prices are effectively an indirect tax on consumers and at some stage where the pain threshold is crossed, the notion of a foreign country levying an effective tax on US drivers ignites the populace to revulsion.

Into this crucible comes the scientists and lobbyists who espouse the Ethanol from Corn industry. This is not a new idea. Brazil has become self reliant in motor fuel by converting its sugar cane into Ethanol, but there is a catch. Brazil has not only vast resources including cheap labour, to make this miraculous transformation but the varieties of the Sugar Cane that it grows, predominantly sugar apples rather than the free standing cane familiar to most of us, has a significantly more beneficial energy extraction ratio and less byproduct (biomass) than Corn. In fact it is five times more efficient than Corn as an Ethanol producing stock. So the scientific marvel of US Ethanol from Corn is not only inefficient, it actually costs more to produce than the market (ease of substitution) is prepared to pay for it, but its commercial “viability” is only made possible by Government subsidies from the public purse to growers and processors. Free enterprise and science in action!

Wind power and the electric car are variants of the same theme. Wind power is not economic without Government largess usually hidden in the form of R and D grants and the electric car too, has the problem that costs exceed present utility. For electric cars to sell at prices way above conventional fossil fueled machines, either the cost of gas has to be increased very significantly by a gasoline sales tax or Government has to redress the cost benefit equation by subsidising this new technology. To put that in perspective, Europe and the lands Down Under have been paying the equivalent of per gallon for gas for many years and the barrier of marginal utility has not been breached at those prices, so think of a number somewhat North of per gallon before demand for electric cars becomes real. Think also that the bulk of electricity, the new fuel for these vehicles is produced by coal burning plants and you can start to see the limits of this technology. Mere substitution of one dirty fossil fuel for another may have appeal as it transfers resources to dirty coal miners rather than dirty Oil pumpers, and for US and Australia that means a transfer to home grown polluters rather than those of the Arab kind, but this is still Government subsidy for polluters!

Those espousing these new technologies argue with some justification that the technology has first to be invented and then refined and made more efficient over time, until it becomes a viable stand alone product. This too is an essential part of the scientific argument. In the same way that we don’t know how long we will have to wait to observe the first proof of Darwin’s evolution of species, we also don’t know the timeline for electric cars to reach commercial maturity. And that’s the joy for those of the evolutionary mindset. Funding for the theory can be maintained indefinitely so long as the proof is not apparent.

That’s the whole idea guys!

A simpler demonstration of the Theory of Evolution, which should be better named “An unquantified observation of structural changes over an indeterminate period” is being afforded us by the plethora of bailout, stimulus or restructuring packages being espoused and delivered globally. Some of the easiest bailouts for us to observe are those immediately past and soon to be renewed under a different brand, taking place in US, UK and Australia.

The US version consists of TARP I and II and the new, much debated Obama stimulus package, shortly to be followed by the mooted “Bad Bank”. For those that have followed my columns over the past year, you will know that I am firmly of the view that all banks are bad and are to be avoided at all times as a wealth hazard. That the US administration should be now coming to the belief that a “Bad Bank” is required, is only slightly more amusing than its corollary, ie the rest are presumably “Good Banks”.

So we can summarise the essential elements of bailouts:

  • They are always initiated in times of crisis which by definition means they are impulsive and ill considered.
  • They are always in response to some events that might actually threaten politicians’ jobs. You think that they are acting to save your jobs but they only truly get excited when enough of your job losses may imperil their job.
  • The more misdirection that can be given to justify the bailout, the better. There is always misdirection (known in the real world as lies). Paulson lied when he convinced Congress that the only way to avert a banking meltdown was to buy toxic assets from the banks’ balance sheets. The more immediate problem was that most were insolvent and just like ordinary punters, needed money to pay their bills or they were going to go belly up. Be grateful that at least you were told. Even if it was a fairy story. Down Under the government does its banking tricks by regulation and secrecy, which is allowed only through the mind numbing political and fiscal apathy of its voters.
  • There are always underlying issues of crony capitalism. The party donations must be preserved or pretty soon there will be no party.
  • It’s best if the problematic areas are nebulous. That way there are more opportunities to insert policy objectives. These economic gifts, called transfers are just another version of pork. Best of all with a big enough stimulus package, incumbents can strike a lofty moral tone against ear marks and pork while loading the equivalent of the Gadarene Swine herd into the new Bill (there were about 2000 porkers in the great swine herd feeding nigh unto the mountains in the land of the Gadarenes. Mark 5:1-13).

At the present levels of concern, nay hysteria, in some quarters, the problem ceases to be one of economics which is a cause for optimism, since economists were the boys espousing the joys of globalisation and securitisation, and becomes one of politics, which is a science we can all understand. As Darwin so presciently observed, nature is ruled by the doctrine of “survival of the fittest”. All creatures in nature including homo sapiens must adapt or die. Politicians are the most adaptable group of humans, so it is no coincidence that they are changing their spots so regularly.

Gordon Brown. the hapless history major currently acting as Prime Minister of UK is having trouble reinventing himself as the champion of global free trade with a ridiculous assertion that UK would double its exports to China in 18 months. Not to leave anything so important to the free market in which he sometimes professes to believe, all of the projects and the lucky UK beneficiaries will be chosen by China and UK’s governments respectively.

In US, President Obama is floating the idea of a “Bad Bank” to acquire all those toxic loans that keep destroying the banks’ balance sheets. You remember that the original purpose of the TARP was to do exactly this. Then having stampeded the steers and cows up at Congress (I hesitate to use the term “Bulls), with a horror story of standing on the abyss etc, young Hank decided that he couldn’t continue down that track because i) most of the banks were, and still are insolvent; ii) the banks themselves didn’t know what they actually owned; iii) to disclose what the impaired securities were really worth would have spread the panic to the US and global population and iv) 0 billion wasn’t going to be enough to get the job done as the toxic loans alone are likely twice that amount.

Faced with these daunting problems and realising that he, George and the rest of the boys were going on an enforced sabbatical in a few months, Hank did what any prudent Wall Street banker would have done in the circumstances. Stick his fingers (in this case your fingers) in the dyke, keep the sinking ships afloat for the requisite 4-5 months and let someone else solve the problem. Hank learned this technique from the securitisation boys on Wall Street. Their solution, like Hank’s was to flog the toxic bonds to others, pocket their fees and let others deal with the fallout. That’s the Wall Street way sport and so far its proven a neat solution with no real consequences for the players!

The Australian solution has been even neater. Faced with a capital drought for this most rapacious borrower of foreign funds, Prime Minister Kevin Rudd, a Mandarin speaking China expert and career diplomat before his transfer to the Prime Minister’s Lodge (Australia’s version of the White House), jumped straight from “there won’t be a recession here” and “China will save us” to Chicken Little and “the sky is falling,” apparently all in the space of a few weeks. In the process he has had the Federal Government guarantee everything from bank deposits to securitisation of every kind and has released not one but two stimulus packages onto the Australian people, on a GDP basis, roughly of the same size as the US efforts, and replete, like US with favoured Labor (Democrat) social policy initiatives:

Feb. 3 (Bloomberg) -- Australian banks may have saved at least 0 million in the two months since Prime Minister Kevin Rudd’s government started guaranteeing their bonds, freeing up money to help restore finances battered by the credit crunch.

Macquarie Group Ltd., Australia’s largest investment bank, and six other lenders sold more than .4 billion of state- backed notes since Nov. 28, when the AAA rated government first backed their funding in a bid to thaw global credit markets frozen by Lehman Brothers Holdings Inc.’s bankruptcy. Australian banks cut at least 2 percentage points off their dollar bond yields and about 1 percentage point from local currency and yen debt since the guarantee began, according to data compiled by Bloomberg. Lenders including National Australia Bank Ltd. were forced to pay as much as 8.5 percent for five-year bonds last year, the data show. Macquarie raised about billion since November from bonds yielding as much as 5.8 percentage points less than dollar- denominated notes it sold without government backing. After paying a fee for the guarantee, the Sydney-based bank saved about 8 million in interest payments on its .8 billion of fixed- rate dollar notes, Bloomberg data show. The executive director in Macquarie’s treasury department, declined to comment State Aid

Rudd announced A.7 billion (.9 billion) in aid for families, bond markets and home buyers as well as extra spending on schools and roads since Oct. 14 to ensure the A trillion economy avoids its first recession in 17 years.

Australia’s government may establish a fund to lend directly to companies should foreign banks fail to roll over as much as A billion of maturing debt, Finance Minister Lindsay Tanner said on Jan. 22. The fund would be used if foreign banks withdraw from the Australian market and domestic banks can’t meet the shortfall, he said.

Local banks may need to sell A billion more bonds this year to cope with an estimated A0 billion of maturing debt. Westpac Banking Corp., Australia’s biggest lender by market value, sold 245 billion yen (.7 billion) of bonds yesterday including the first samurai bonds since Lehman’s collapse, Bloomberg data show. The “big surprise” was that the guarantee helped Westpac achieve the fifth-biggest samurai sale on record in a time of economic crisis, said Tetsuo Ishihara, a senior credit analyst with Mizuho Securities Co. in Tokyo. Samurai bonds are yen-denominated notes sold in Japan by non-Japanese borrowers.

“Overall market activity in the guaranteed funding space has been very encouraging,” the group treasurer for ANZ, Australia’s fourth-biggest bank, said in a phone interview from Melbourne. “We are now ahead of the run rate for our annual term-funding target, having already raised slightly over 50 percent of the annual target for the year ending September.”

A new survey from the 5th Annual Demographia International Housing Affordability Survey, released just 10 days ago supports what I have been writing about for the past year. This version is from the NZ Herald so puts the Kiwi slant on its content, but the report actually made it into the mainstream media, albeit on about page 22 which is no mean feat for a country stubbornly opposed to publishing anything that might impact on the streams of gold flowing to the print media on ads for jobs, autos and real estate. I have omitted part of the story that claims these exorbitant prices are caused by stringent resource approval (planning) regulations. I wouldn’t insult your intelligence by burdening you with such rubbish.

The real reasons why the Australian and New Zealand property booms have soared to such dizzying heights are because that was government policy as it was in UK, US, Spain and others. “First buyers” (including new migrants) got a home loan grants of ,000, now ,000 from the Federal government; off balance sheet securitisation and tax bias by favoured treatment on interest deductibility including negative gearing allowance (the interest and depreciation is greater than the income so you can offset the losses against other income, a favourite of high earning airline pilots, overpaid executives and sportsmen), and no capital gains tax on principal residences in Australia and an even more favourable regime in NZ, together with habitual funding of 100% LTV and more, are the well known culprits.

NZ Herald -Buying a home in New Zealand is prohibitively expensive due largely to planners. The reality, however, is far more complex. In this instance, coming second to Australia is not so bad. The Aussies are the undisputed world champions in unaffordable housing - a home in the lucky country costs 6.3 times the average annual household income. But New Zealand is not far behind. Buying a house in Godzone is prohibitively expensive too - 5.7 times average household earnings. Crikey. That's almost double the rule of thumb for affordable homes - that they should cost no more than three times annual household income. In Canada the "median multiple" is just 3.5. And in the United States, it's 3.2. How the hell did things get so out of whack Downunder?
Interest.co.nz shows that it now takes 59.6 per cent of one median after-tax income to pay the mortgage on a median priced house purchased in December, down from November's 63.8 per cent. The index was a whopping 81.1 per cent a year ago and 52.3 per cent five years ago. It reached its highest point - 82.9 per cent - in November 2007. While prospects are improving, housing is still out of reach for most.

For household incomes the picture looks better. "Median-priced housing is now affordable for families in New Zealand when both adults work," says the website. On this measure it now takes 38.9 per cent of a median household take-home pay to service a mortgage of a median home purchased in December. That's down from 41.6 per cent in the previous month and a year ago, when it was 52.8 per cent. But just when the trend towards affordability is improving, a new barrier has emerged - the banks' increased deposit requirements. Whereas in the past, banks regularly lent 95 per cent and sometimes 100 per cent of the mortgage, they now require a 20 per cent deposit. "Based on current income and house prices it will take an individual 8.2 years to save the 20 per cent deposit as now required by most banks," A first-time buyer wanting a lower quartile priced house will struggle too - taking 6.6 years to save the 20 per cent deposit as now required by most banks.

In past economic cycles, the lands Down Under have lagged US cycles by about 6 months. This time the lag time seems more like 14 months. Australia is not yet in recession and its Prime Minister is vowing it won’t happen whilst the IMF says recession for Australia is inevitable as the greatest mining and commodity boom in history normalises. In New Zealand, the country has been in recession for three quarters but like Australia, there are no signs of it in the real economy. Home prices in both Australia and NZ are down about 5% but it’s patchy. Some suburbs continue to see price rises. Unemployment is creeping up but just. At 4.6% unemployment is not much above the norm.

For Australia, the resilience can be attributed to the lag effects of big mining contracts, and in NZ, the agricultural sector has been a star performer with the first effects of the normalisation of extreme dairy prices only now making the financial pages. Much is still to be played out. How and when governments intend to extricate themselves from the blanket guarantees of bank’s funding has not been considered yet. As with all political masterpieces, it is a matter of act now, and think (and pay) later.

Competence and Mandate

For the world’s great democracies, there is a disconnect between what the voters want and what the executive enacts. 68% of voters polled in US were opposed to TARP, and the revelations of how those funds have been used will only have strengthened public opposition. Downunder, such considerations are only addressed every 4 years when the government is reluctantly forced to stand for re-election, so we don’t really know what my countrymen think. As Australians’ overwhelming preoccupation is with sport and leisure, it is likely that we don’t think about it at all, until such time as it threatens the hip pocket nerve. That is a common default setting.

How all of this works out, can be drawn from an examination of past performance. Traders and issuers of securities usually have a statutory disclaimer that past performance is no guarantee of future performance. In the bailout world, whether this adage holds true or not is a function of the state of the patient when terminal care is administered. When the Resolution Trust bailout was applied to the Savings and Loan crisis in the 1980s, the recipients were total wrecks. The RTC bought in new partners to control the asset sale and distribution. This time the model is different. The overwhelming sense of governments globally, is a steely determination not to let the normal consequences flow and hence the bailouts now, are being administered to live breathing bodies where the bad players are not only alive and well, and still in control of the infected enterprises, but in many cases enjoy tenure in the most senior government positions as in the case of Messrs Bernanke and Geithner.

The normal consequence of insolvency is bankruptcy. This allows a restructuring of the enterprise substantially free of legacy costs and the management that got it into the jam initially. While there surely is a stigma to bankruptcy and the argument is validly made that consumer confidence in the product takes a hit, at least investors can make a proper assessment of the balance sheets, something that is not possible now as banks and big business have failed to convince investors that they have come clean on their bad loans and other assets. What is the difference now? Consumers know GM and Chrysler are functionally bankrupt.

Given that the “to be bailed out” entities, by avoiding bankruptcy, maintain their fatally flawed management and culture, we can have faith that past performance for these worthies will exactly and precisely match future performance, a strategy that traders can only hope for!

Let’s just take two quick examples of how this works. These are my favourites because they were so predictable. First we have the Bank of America-Merrill Lynch disaster. In 2008, BOA saw the opportunity to buy Merrills, apparently on the cheap as it was heading down the Bear Stearns/Lehman Brothers track. Months later as the deal was due to close, BOA discovered a billion loss in Merrills loan portfolio, that it is alleged John Thain, he of the .2 million office makeover and ,000 office commode, had failed to disclose during the hectic two day due diligence that BOA was afforded. BOA blinked and according to third party news reports, the Fed under that dour expert on depression history Ben Bernanke, forced the consummation with threats that future Fed and government largess would never again appear for BOA if the deal was not closed. After all sorts of Fed support including guarantees against further portfolio losses, the deal was done. Thain walked off with $ millions as did some of his mates, one of whom scored a startling million for little more than one month’s work, and the shareholders saw their stock fall from the mid s to . Admittedly that is more than they should have, as Merrill at least was insolvent absent the government sponsored rescue, but it’s a good idea of what happens when you try to repair the chicken coop with the fox still inside!

Let’s stop saying these are the “smartest guys in the room.” They are not smart, other than in their own self interest. Then they are exceedingly smart. Often at your expense.

The next example is even more obvious. Auto part suppliers are in talks with US Treasury for a billion bailout. Having succumbed to the GM and Chrysler calls for bailouts on the basis that the loss of jobs from their bankruptcy would impact not only the car companies’ workers, but those in the wider parts making community, the same argument is now being trotted out to support a bailout of the suppliers. Wasn’t that part of the rationale of the initial bailout? Bailouts beget more bailouts. That too is part of bailouts for dummies.

Gold

All of the bailouts are a direct consequence of a failure by economists and analysts to understand and flag the problems within the securitisation universe and its associated madness of excess leverage. I guess in their defense it should be said that if auditors and regulators won’t force disclosure, particularly of off balance sheet shenanigans, then analysts can hardly be expected to uncover the trash. Generally, however, analysts have known and said too little too late. The latest example which I can think of, was yesterday’s breathless announcement that the biggest name on the Street had raised their price target for Gold from 0 to 00. This Delphic like pronouncement was greeted with the same deference and awe, that got punters into this mess with their 401(k)s. Listening to Wall Street analysts is a major health hazard!

Here is the Comex Gold chart which last night put the futures price of Gold at 5, less than from their new target. The last time Gold traded at 0 was in the second week of November 2008 which I have marked in the red rectangle! This earth shattering insight was hardly timely, prescient or helpful for Gold traders or investors. What exactly is the benefit of this sort of advice?

It’s 3 months out of date and the market has already moved 5 of the claimed 0 that these worthies think will happen. Much more compelling would have been definitive Buy signals so that you could have bought Gold futures or bullion at strategic points.

Of course you couldn’t get the buy signals in Gold from Wall Street. They don’t know, and most are too busy wining and dining clients to extract the next buck or decorating their offices, or planning the next taxpayer funded shindig at a luxury resort.

But you can get it from the T.03 signals, supplied by the Danielcode. Here is every T.03 buy signal since the October lows in Comex Gold. Of the 5 important buying points for Gold in this rally, the T.03 signals got them all either with a direct buy signal or one of the alternate correlated and anti trades that I have written of often in Financial Sense. One of the six signals gave an unprofitable countertrend. We also had every sell signal for traders who like to trade both ways. That’s what I call prescient and timely! Did you know that these were the major buying points for Gold bulls? Danielcode members knew.

Offer for Financial Sense Readers

This week I want to extend a special offer to Financial Sense readers. From Monday 02/09 you will be able to have a 10 day free trial of the Danielcode T.03 signals in all the markets I cover, as my guest. These include Gold, Silver and HUI Index; S&P, Dow, DAX, Russell, QQQQ, the Australian SPI and India’s NIFTY 50; Crude Oil, Corn, Wheat and Soybeans, Currency futures, 16 forex pairs, DX the US Dollar Index and US T Bonds. The T.03 signals are simple to trade and are explained in the T.03 tutorial video at the Danielcode website. If you are already registered with Danielcode Online, just use your existing username and password. If not you can register at the DC website any time by clicking the “register” button on the landing page at https://www.thedanielcode.com/ and providing a username, password and valid email address.

Once you are registered, you can log in every day while the trial lasts, to access the T.03 signals. New T.03 signals are posted at the website about 3 hours after US markets close, valid for the next two trading sessions.

You don’t have to look at the DC price levels or chart indicators. Signals are just “Buy” or “Sell” and I do all the hard work for you. But to be valid, the T.03 signals must have the requisite price action for them to be “elected,” although more experienced traders will choose to anticipate them on shorter term charts. It’s all explained in the videos and the T.03 doc for those who prefer to read.

This is the only leading indicator I have ever seen. I hope you enjoy seeing it work in real time and get an insight into how your trading could be improved with these trade signals. The signals are a fusion of the DC number sequences for price, and “time.” They are not a complete solution; to achieve that we need to generate trade signals off several dominant short term time cycles and that is unnecessarily complicating the process for most traders. Properly applied, the T.03 signals will generate returns on all markets approximately in line with the T.03 forex model account which we ran in real time as a demonstration of the results of trading just one consistent output of the Danielcode programs. The results of this exercise are available at the “Forex” tab at the DC website.

I trust you find the DC T.03 signals both interesting and profitable. I ask that you ensure that you have seen the free tutorial video, and understand that price action to elect the signal is required to validate it. Try to observe as many markets as possible. A trader’s greatest limitation is to become fixated on one or a few markets. All markets trade the same with the Danielcode; the more you scan, the more opportunities you will have, so this is your chance to see a wider horizon in your trading stance.

Other than that, make money, be happy and have fun. For traders the world is always a joyous place. Markets pay just the same going down as going up and the T.03s and their protocols (move your stops to protect profits; once you have got your stops to break even, I call it a winning trade) will keep you on the right side of the vast majority of trades.

Buy and hold strategies are being paid what they deserve. Traders are joyous in the fountain of unprecedented volatility, the markets’ gift to traders. You should welcome volatility, not fear it. Suck it all up while it’s on offer!

Mat 13:15 for this people's heart has become gross, and their ears are dull of hearing, and they have closed their eyes, lest at any time they should see with their eyes and hear with their ears and should understand with their heart, and should be converted, and I should heal them.

Copyright © 2009 John Needham

About the Author

Lawyer and Financial Consultant
jneedham [at] thedanielcode [dot] com ()
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