Sins of the Fathers

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Linear thought is simple. We all get 2+2 = 4. What is not so simple is to reach the right answer when variables are involved. Hence to solve 2+X =Y requires assumptions, cognizance and eventually recognition.

Nelson’s genius enabled him to measure truly the consequences of any decision. That genius worked on precise practical data...He felt he knew what would happen in a fleet action. Jellicoe did not know. Nobody knew.... Winston Churchill, The World Crisis on the Battle of Jutland

If you are not familiar with the speeches and writings of Sir Winston Churchill, Britain’s war time leader and possibly the greatest Englishman ever, you should be. Even President Obama is conjuring Churchill with his comment that “today marks the beginning of the end”, a quote from Churchill’s famous war time speech made on 10 November 1942 after the Battle of El Alamein which marked a turning point in the Western Desert Campaign fought in North Africa between General Montgomery’s British 8th Army and Field Marshal Rommel’s famed Afrika Corps.

With the perspective of time we can begin to see what has been wrought and what it means for the future. I suspect that endless words and books are still to be written of this great financial crisis but most of the commentary is wrong, because it fails to clearly identify the culprits and the cause, and in the interests of lurid headlines and apologia many have sought to blame failed business plans and inadequate execution on “the crisis.” More importantly, with both the media and our political leaders, wholly committed to spinning every bailout and rescue initiative as good news, the danger is that investors are nor being given a true insight into either the causes, the “where we are” or the “what is to be” of the current drama. Without someone to mark their place in this saga, which has many more chapters to go, most will lose their way. Many more, like petulant children, know not and care less. They just want Daddy to make it all go back the way it was.

death

“Daddy” in this instance started by being the fiscal regulators. You remember Ben Bernanke’s asinine quote “The Subprime problem is contained” and won’t spill over to the wider economy. As more firepower was required when it gradually dawned that first responders, in this case central banks, failed to understand the scope of their problems, “Daddy” changed from the Governor of the Fed, to the Secretary of the Treasury and finally to the President himself. Across the globe, the “go to” Daddy has progressively moved up the ladder until everywhere “Daddy” is now the President, Prime Minister or Head of State, leaving central bank rulers to bring on the drinks at half time and generally pep up the cheer squad.

That is not to say that heads of state are any more clued than the central bankers. Heads of state, being politicians have even less of a grasp on global economies than their advisers, so we are destined to see the same sad circle of mistakes being repeated endlessly.

The failure of Lehman Brothers is continually cited as a mistake in the US policy response. It was, but not for the reasons that are usually claimed. To the contrary, the complete and hopeless insolvency of Lehmans was an opportunity to recognise that other major institutions that had dabbled in the murky pool of  credit derivatives and leveraged, not just the deals, but their own incompetence, were beyond normal commercial redemption. That this has still not happened, speaks volumes of the lack of transparency and accountability in the global fiscal system. But we can’t spook the punters, sport!

The US alone has initiated $700 billion in TARP 1, $850 billion in President Obama’s policy bailout 1 and the Fed’s balance sheet is heading towards $800 billion. Add in UK bank bailouts, plus various EU stimulus/bailout packages and China’s $600 billion stimulus, and a plethora of games in the minor economies like Australia, now North of $56 billion announced, plus undeclared handouts from various Sovereign Wealth funds and we are past $3 trillion that has been promised, mainly by governments and mainly to mop up the hemorrhage from the banks and quasi banks, who were all really acting as unregulated bookmakers. In defense of real bookies, I must say that bookies understand the true odds of an event happening and make sure the punters never get the true odds.

With our fabled institutions, they didn’t know the odds. In fact few even knew what they were betting on. Today’s losers continue to affirm that they didn’t know they were betting at all. Ah! Profit without risk. That’s been the lure of alchemy since time began. And it remains as elusive as ever.

The political dimension now, is to shield the public from the certain knowledge that the great and good on Wall Street, Threadneedle Street and other salutary addresses, hadn’t a clue what was happening. All were players in the greatest Ponzi game of all.

Senior bankers knew they were playing in a bubble. Some, like Citigroup’s Chuck Prince said it publicly. All were confident that they would be off the dance floor when the music stopped. They were wrong.

Politicians and central bankers are still wrong. By denying the reality that much, if not most of the world’s financial institutions are insolvent, they are simply passing their failures to the next generation. A very few countries have the dynamic economies to throw off sufficient surpluses to pay down debt, with China and US being the two leaders. The supply/consumption symbiosis between these two mega players means that both will succeed or both will fail with the odds being about even on the likely outcome. But what of the cost even of success, and who will pay? Not us. We likely won’t live, or at best be productive for long enough to see these enormous debt burdens disgorged. Past Aussie Prime Minister John Howard observes that with the onset of the greatest global boom in memory, it still took a surging commodity and mineral giant like Australia, probably positioned by circumstances in the most advantageous state, 10 years to repay the $96 billion of Federal government debt left by the previous Keating government. How long, he asks, with greatly subdued global appetites, will it take to pay off the $200 billion (and still counting) debt, that the present Australian government is underwriting?

Howard adds “One has the distinct impression that the global financial situation has provided members of the Rudd (Labour/Democrat equivalent) Government with the perfect opportunity to do what, deep down, they have always wanted to do, and that is spend large amounts of taxpayers' money.” Unusually for Howard, he is more prescient than he realises and on more than one continent.

Now translate those figures into the $1.5 trillion of US government debt that has materialised in just the past 6 months. Add to that the “whatever it takes” promises of US lawmakers. Graduate that against the UK spendathon with a realisation that UK simply doesn’t have the resources available in the growth countries. The sins of the fathers are rapidly becoming apparent.

The Cause

The cause of the financial meltdown was a flawed funding model for banks called “Securitization”. I have written at length about this multi headed monster, but its essential elements were a grossly inflated credit rating assigned usually by one of the big three US government appointed credit agencies, erroneous assumptions on which those credit ratings were established and the ability of banks to on sell those risks by parceling lots of other securities such as mortgages, credit card loans, auto loans and corporate debt, then finding willing buyers ranging from other banks to municipalities, pension funds and other passive investors.

That’s it in a nutshell. It’s now apparent that many of the buyers had no real idea of what they were buying. Many were classified as “sophisticated” investors which is code for “they have enough money and expertise that they, and their advisers should know what they are doing with their own investments.”

And that’s the game. The purchasers relied on the ratings agencies and their own advisers who in many cases were also the salesmen. I have no sympathy for them and nor should you. If they were wrongfully induced to make the purchase by either the ratings agencies, the salesmen, (which was a large purpose of the shadow banking industry), or others, they can take the appropriate action. The law courts are going to be hearing this litigation for years. That’s just how the system works. If you play the game, the outcomes are that you win or lose. Much of the securitization game worked just fine for years. Assets parceled into the rated bonds were roughly what they were supposed to be and all the players benefitted. Eventually, due diligence disappeared in the ever growing lust for the juicy fees that securitization provided and like Humpty Dumpty, one day it just fell off the wall.

All of the credit sector problems can be laid at the feet of securitization. Whether it was just plain vanilla bonds, sub prime mortgages or the ubiquitous CDOs, the essential features of all these deals are that they had a superior and believable credit rating, they were desirable business for banks because they generated superior fees and they moved the risk on to third parties thus returning the bank’s capital again and again.

Not so long ago, bankers were grey, drab men, along the lines of your local accountant. They had limited capital and took deposits from their customers and they borrowed in the allowable ratios set down by their regulators. But, importantly, there was a finite amount of money to lend, the loans made by the banks stayed on their balance sheets and they were responsible for servicing those loans, managing any problems and living with any losses. In the days of prudent banking, credit worthiness and security values mattered because it was your problem. With the advent of securitization and the technology to rate credit worthiness on credit scores and asset value from a data bank, the simple tether of prudence was loss. Nobody was looking closely at the new loans. Machines and computer models were doing the work. And machines are infinitely fallible. So we can identify the culprits as computer modeled credit ratings and securitization. To which we should add the curse of celebrity.

Celebrity

deathOne of the craziest outcomes of technology in the past 7 years has been the Cult of Celebrity. No one it seems is too stupid, too humble or too frivolous to be accorded the cult of celebrity. In an age when we do less, the ability to admire others, no matter how intrinsically worthless, has become an enduring life style for far too many. When this cult is extended to merely the simple and vaporous, I suppose that it is largely harmless as well as irrelevant. But after years, behaviour patterns become established and gradually morph into social norms. And that’s where the danger has arisen. Strange little men, mainly bankers and economists are made into financial giants, perhaps even people of quality by the adoring spotlight of media.

Nowhere has this process been more concentrated than the lionization of the hapless Alan Greenspan. For decades his words were scrutinised ever more closely. Each public appearance was choreographed and promoted. Markets stood still when Mr Greenspan spoke.

Why this should have been, I never could fathom. Greenspan was purposely obscure to a state of induced catatonia. Not once did I see or hear him say anything of consequence. Yet this elderly, tortured individual was elevated to the status of deity.
Now we see how foolish that all was. Mr Greenspan revealed this week in an incomplete CNBC interview,  what many had suspected. He stated that he had never read (or had read for him) the more complex CDO documents and with hindsight, he averred that he would not have understood them if he had in fact read them.

He said that he had extensive contacts with the senior executives of banks and shadow banks; believed that they at least, fully understood the risks of the new wave of securitization, and were entirely across the risks they encompassed.

We now know that was wrong. Banks and packagers of these bonds, neither knew or understood the risks they posed, which is why so many finished up on their own balance sheets, witness Bear Stearns, Lehman Brothers, AIG, Fannie and Freddie et al. It’s one thing to say that the packagers at least understood the risks and sold them on with caveat emptor being the buyers’ problem; it’s another thing altogether to say, like Churchill, that the Admirals, those in charge of the battle, didn’t understand their own technology.

Bankers themselves became celebrities, far beyond the arcane world of structured securities. Regulators too succumbed to the curse of celebrity to the extent that they had a completely blind spot to the possibility that bankers simply didn’t know what they were doing!

Where we Are

Feb. 23 (Bloomberg) U.S. Secretary of State Hillary Clinton said China should keep buying bonds to help fund President Barack Obama’s economic-stimulus plans. “It would not be in China’s interest” if the U.S. were unable to finance deficit spending to stimulate its economy, Clinton said yesterday in an interview in Beijing with Shanghai-based Dragon Television.

Senate Banking Committee Chairman Christopher Dodd said on Feb. 20 the U.S. may have to take over some lenders for “a short time” to help them survive the recession.

The US, the world’s sole super power, is making it plain to China that it needs its support to fund the new Obama administration’s deficit spending. And the Chair of the powerful Senate Banking Committee is laying the ground work for de facto nationalization of some of the nation’s banks. In fact this may already have happened but the lack of disclosure by the US Treasury means that the government has been able to conceal the true picture of bank support by using funding from different agencies. This is about to end. In a little reported decision on Friday, Judge Richard J Howell of the US District Court ruled that Treasury must comply with a Fox Network request for information on funding to named banks under the Freedom of Information Act. And that may start to unravel the furtive and incestuous Treasury/bank dealings that were sanctioned by both the past and present administrations.

Once the markets and the public gets a whiff of the level of government support that has been extended, nationalization, or Dodds’ “take over for a short time” may start the next reality show.

From Business Spectator in Sydney:

In the banking system most of the sub-prime losses have now been covered by $1 trillion worth of capital raisings (much of it from governments) and it was hoped that a solvent banking system would allow the rescue packages to boost troubled economies. Stock markets are falling again because the world now realizes that there are still at least two more 'sub-primes' yet to be announced by global banks. The first is the complex topic of synthetic CDO losses. The second 'sub-prime' is the lending from the big European banks to Eastern European people in Swiss francs. Their losses may equal sub-prime losses because the customers can’t pay the inflated loan totals thanks to the collapse of Eastern European currencies.

At the same time the bank executives who got us into this mess are using government money to pay bonuses. The public anger with UBS in Switzerland and Merrill Lynch in the US remains white hot. It is becoming increasingly apparent that after struggling to raise $1 trillion to cover sub-prime losses the banks now need a minimum of another $1 trillion and probably more than $2 trillion. We cannot risk another Lehman Brothers so when the global bankers decide to come clean they may need to be nationalized. Wall Street is petrified but there may be no other way.

If most of the big global banks are nationalized then we are looking at a totally different world banking environment. There are already plans in Europe for an increase in regulation, including clamps on hedge funds and salaries which means that banking will no longer be a world of excitement filled with imaginative financial products. But widespread nationalization will take the process even further and it will be back to national or even regional traditional banking. The world capital community will be fundamentally changed and it is highly likely that the nationalized banks will look inward and concentrate on the funding needs of their own countries.

Actually, I think this will be a highly desirable outcome. Robert Gottliebsen’ s view of banking as a “world of excitement filled with imaginative financial products,” is not one I share. You see here the seduction of leading commentators, who too have been caught by the celebrity spin on banks and bankers. My view, which I have consistently espoused to you in these pages, is that bankers are a cancer, yea a vermin that we need to control with 1080 (Aussie Possum poison), so that never again can they pretend to be people of quality, servants of shareholders or community leaders. A pox on them all I say!

So “Where we are,” may be summarised as follows:

  • Many, perhaps most, banks and financial pretenders (monolines, insurers, mortgage originators etc) are insolvent.
  • The commercial mortgage collapse is being covered by government funding
  • The CDO losses and who owns what are still to be revealed. All we know is that it will be the next generation that pays for the global government largess.
  • The loan interplay to Eastern European countries is a big deal that is under reported and under the radar for the US. Most of that lending has been done in strong currencies that have appreciated massively against Eastern European State currencies. There is no chance of the borrowers making repayments, and those losses are going to be much greater than currently assumed. With no central authority, (the EU is, under stress, just a loose confederation of trading interests) those losses are going to fall on the IMF, the lender of last resort at the behest of European powers. And that wouldn’t matter unless you were to ask who funds the IMF? The answer is largely “you guys,” so add the support of a bankrupt Easter Europe to the legacy that you are leaving your children. Factually, the US is by far the largest shareholder in both the World Bank and the IMF and together with France, Germany, UK and Japan, controls about 40% of both those august institutions.
  • What markets keep thinking is good news, ie bailouts and government support for insolvent businesses is in fact bad news. These actions are simply transferring the losses that companies, their shareholders, bondholders and creditors incurred, to you. And your children. It’s no fun when you have to pay for that party, to which you were never invited. Not even a free drink or bonus or booze up in Vegas. Nada.
  • Australian banks are faring better than global peers, boosted by the government guarantee to deposits and to wholesale funding. Of the 11 banks in the world to still have a AA rating, four are Australian (the Four Pillars). The nation's biggest banks have sold more than $US45 billion of state-guaranteed debt since Nov. 28, when the AAA-rated government first backed their funding in a bid to thaw credit markets frozen by Lehman Brothers Holdings Inc.'s bankruptcy, according to data compiled by Bloomberg. Australian banks are being held up by their regulators as models of prudence. It’s not so. They survive only by the complicity of government in the old game of privatize the profits and socialise the losses and the risk.

What is to be

NY Times: Credit cards, home equity lines, student loans, car financing: none come cheaply or easily in these credit-tight times. The banks, the refrain goes, just will not lend money.
But it is not simply the banks that are the problem. It is also what lies behind them.
Largely hidden from view is a vast financial system that serves as the banker to the banks. And, like many lenders, this system is in deep trouble. The question is how to fix it. Most banks no longer hold the loans they make. Instead, the loans are bundled into securities that are sold to investors, a process known as securitization. But the securitization markets broke down last summer after investors suffered steep losses on these investments. So banks and other finance companies can no longer shift loans off their books easily, throttling their ability to lend.

The result has been a drastic contraction of the amount of credit available throughout the economy. By one estimate, as much as $1.9 trillion of lending capacity, the rough equivalent of half of all the money borrowed by businesses and consumers in 2007, before the recession struck,  has been sucked out of the system.

The Obama administration hopes to jump-start this crucial machinery by effectively subsidizing the profits of big private investment firms in the bond markets. The Treasury Department and the Federal Reserve plan to spend as much as $1 trillion to provide low-cost loans and guarantees to hedge funds and private equity firms that buy securities backed by consumer and business loans.
The Fed is expected to start the first phase of the program, which will provide $200 billion in loans to investors, in early March. Some worry it may benefit only select investors at taxpayer expense.

The program also does not try to change securitization practices that, many investors say, spread risks throughout the world and destroyed financial institutions. Policy makers acknowledge that for now, fixing credit ratings, reducing conflicts of interest and improving disclosure can wait.

deathUnder the program, the Fed will lend to investors who acquire new securities backed by auto loans, credit card balances, student loans and small-business loans at rates ranging from roughly 1.5 percent to 3 percent. Investors will be able to borrow 84 percent to 95 percent of the face value of the bonds. Investors would not be liable for any losses beyond the 5 percent to 16 percent equity that they retain in the investment. In the initial phase, the Treasury will provide $20 billion and the Fed will provide $180 billion. Treasury Secretary Timothy F. Geithner said last week that the Treasury could increase its commitment to $100 billion to allow the Fed to lend up to $1 trillion.

The market for new securities backed by mortgages and other types of loans has collapsed. Last year, investors bought $313.9 billion of these securities, down from $1.6 trillion in 2007 and $2.1 trillion in 2006, according to Dealogic. Last month, banks issued just $1.6 billion worth of such deals. Banks and finance companies are holding more loans on their books, but their ability to do so has been eroding as losses rise on their existing assets.

And that in 6 paragraphs is the problem. The miracle (or curse) of securitization has expanded the global banking system beyond recognition. Absent securitization, global banking and hence international trade is going to have to contract by at least 40%. The estimated 30 million Chinese peasants who have made the trip to urban industry will have no source of income. Already we are seeing that a little belt tightening in supposedly conservative EU countries is setting off waves of strikes and protests. Only governments know how fragile is the working man’s grip on a survivable income. But after a decade of indulgence and excess, many are already stretched to the breaking point.

That is the real abyss that the world looked into in October. Failure of major financial institutions is what makes the papers. Civil insurrection is what gives the leaders of much of the world nightmares. Globalization has linked the world inextricably. Financial innovation and creativity was, as some of us always knew, just code for more markets to plunder. Greed has surmounted prudence, responsibility and common sense. And now the politicians at the highest level must manage the fallout. Central banks are now deep in apologia. The people were right. The Emperor was naked. But those who played the game had the rulers’ ear.

Faced with the alternatives, government guarantees to financial intermediaries and large employers is to their minds, not only the path of least resistance, but the only course they can contemplate for survival. The wholesale support of risk takers by government balance sheets is an incidental part of the plan. But they are the sins of the fathers.

Markets

The black line number at 462.11 is the last level of Danielcode support for the major swing from 2003. By using this consistent measurement tool we can get a quick and effective picture of how badly impaired various markets are. The International Market Index is rapidly approaching its date with destiny.

ADR

The Dow is more advanced in its retreat, and having studiously avoided giving a monthly close below the DC black line, it is certainly threatening to do so now.

DJIA

Germany’s DAX index is considerably stronger than the Dow:

DAX

While UK’s FTSE index made its October low just a handful of points from the Danielcode number and is heading that way again.

FTSE

India’s NIFTY 50 index is considerably stronger than major US indices which gives Aussie RBA chief Glenn Stevens, hope that India and China will continue their growth story and save Australia from recession. It won’t happen, but Asian growth may be an ameliorating effect for the economies Down Under.

NFTY

China’s Shanghai Composit Index, the source of much distain by commentators in the first half of 2008, has actually bounced from its DC target and has avoided the dreaded DC black line. For all the bad jokes about China’s market, it is relatively stronger than the Dow.

Perhaps RBA will have something to hang their hat on after all!

SSE

And this is Japan’s Nikkei index. This is the quarterly chart which shows at least what markets think of ZIRP and quantitative easing. I guess that “buy and hold” argument from brokers has some difficulties in the face of this evidence. Despite the body blows sustained by this market since 1990, Japan’s economy remains huge and strong. This highlights Mr Market’s view of an apparently successful economy.

Nikkei

The US Dollar Index is still clawing its way towards the 90.22 target that is the last level of Danielcode resistance for the November 2005 swing and the likely target that I wrote about back in December as DX had its 11c nerve attack. Is it plausible that US has not given some understanding or comfort to China and other mega debt holders over the level of the US Dollar?

I think not. But it’s a battle in the face of the obvious fundamentals.

DX

Crude Oil has two DC targets at 31.44 and then 25.68 depending on which swing is being corrected. The 31.44 number has been published in these pages, and for DC members since shortly after the July high made at its DC target, so DC members are among the few not to be surprised by Oil’s collapse. That target certainly looked extreme at the time but not so silly now. In fact, the January contract traded to 32.40 in December. Oil maintains a strong contango against reports of huge storage programs. That outcome should be fun.

Crude

Gold continues its show of strength as it only corrected its June 2006 swing and is now threatening the last level of DC resistance for the March 2008 swing at 995.1. A monthly close above this number will have Gold bulls breaking out yet another bottle of Champagne. Perhaps even a case or two!

COMEX

Silver has not yet caught the full enthusiasm of its partner. Silver made a much deeper correction from its March high, dropping to the penultimate DC support for its 2001 swing, and is now approaching the 50% retracement of its selloff. Much is being made of this obvious divergence, but for traders, it doesn’t matter until it matters. That is the way of markets.

COMEX

I invite you to visit the Danielcode website where we chronicle the adventures of these and other markets on a much smaller time frame.

Psalm 25:4  Show me thy ways, O LORD; teach me thy paths.

 

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Copyright © 2009 John Needham

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