naked capitalism

Martin Wolf is pessimistic about the whether the financial system can be reformed, but nevertheless offers some toughminded suggestions.

Oddly, he seems to see the big obstacles not as political, but as practical, that markets are too big and interconnected, and sees that as an intractable problem. I agree that it will almost certainly not be solved, but I see the impediments as political. The error is in clamping down on clever intermediaries, Yes, you do try to do that, but what you’d need is international coordination to clamp down on fiduciaries of all sorts too. For instance, one of the big uses of derivatives is to allow insurance companies to evade regulatory restrictions and do stuff they are not supposed to do, like make currency bets. Now if wealthy individuals want to go to the casino, or the markets, fine, but parties in the Other People’s Money business need to be held to a much higher standard.

And that means criminal liability. Right now, the SEC cannot bring a criminal case unless it has the cooperation of the Department of Justice. Not that the SEC has exhibited much will to do so in recent years, mind you, but tougher standards and more serious penalties are needed. The 1990s were rife with all sorts of chicanery that got at more some fines that, relative to the profits earned, were trivial. It’s no wonder that there was sol much pilferage packaged as innovation.

We even have a new term in the wings: bankslaughter, courtesy Paul Collier (hat tip Mark Thoma)

The authorities would also need to be willing to shut down or severely curtain products of limited to no value to the real economy that increase connectedness between markets. Credit default swaps top my list. They affirmatively destroy value. The idea that a market can do a better job than a lender of assessing credit is absurd. A lender is in direct contact with a borrower and can obtain non-public information. The CDS market is not a “market” in the efficient market sense, but is a handful of dealers. And the lack of a cash basis for CDS means the pricing will be inefficient.

Wolf also does not think “too big to fail” institutions can be broken up. Willem Buiter disagrees and provides a road map.

So I do not think the situation cannot be remedies. But it won’t be, at least not yet.

Wolf understands the problem, but only alludes to the implications, It is now abundantly clear, to use that Richard Nixon turn of phrase, that the big banks not only have a license to steal, but the goverment now undermines its risks. That plus the failure to try to engineer controlled deleverging (high leverage is systemically destablizing) guarantees that if we do not sink into Japan-style maliase, we will have an even bigger crisis in pretty short order, five year at the very outside. The failure to implement real reforms will cost us dearly, and sooner than anyone wants to believe.

From the Financial Times:

With one bound the banks are free, or so it seems. Already, the panic of the autumn of 2008 is fading. The period within which lessons can be learnt and changes made is closing. Yet without radical changes, another crisis is certain. It may not even be that long delayed….

Yet what has emerged after the crisis is, as I argued last week , an even worse financial system than the one with which we began. The survivors are an oligopoly of “too-big-and-interconnected-to-fail” financial behemoths. They are the winners not because they are necessarily the best businesses, but because they are the best supported. It takes no imagination to realise what these institutions might now do, given the incentives for risk-taking.

So what is to be done? The characteristic, but futile, response is to move the regulatory deckchairs on the deck of the Titanic…

The starting point has to be with “too big to fail”. We need a credible system for winding up even huge financial institutions. The most attractive proposals are for “good banks”, in which unsecured creditors become shareholders. That would be easier if, as President Barack Obama has proposed, and Mervyn King, governor of the Bank of England, has argued, a regulated institution has to produce a plan for an orderly wind-down of its activities.

Yet bank failures are like buses: you do not see one for hours and then a fleet arrives together. The authorities cannot make a credible promise that they would be prepared to put all affected institutions through bankruptcy in a systemic crisis. This would be a recipe for still-greater panics. “Too big and interconnected to fail” is a reality. It is so, because, as Andrew Haldane of the Bank of England pointed out in a recent speech, the financial system is an increasingly tight network.*

My colleague John Kay has argued that the right response is to create “narrow banks”, which are perfectly safe, leaving the rest of the financial system to go on its merry way, subject to a then-plausible threat of bankruptcy. I find this idea both attractive and unpersuasive. The attraction seems evident. It is unpersuasive in part because it is so hard to agree on what narrow banks should do. It is also unpersuasive because the narrower the banks are made to be, the more vital is the role of the rest of the financial system and so the less plausible it is that governments would let it collapse.

If institutions are too big and interconnected to fail, and no neat structural solution can be identified, alternatives must be found: much higher capital requirements and greater attention to liquidity are the obvious ones. At present, big financial institutions operate with next to no capital: in the US, the median leverage ratio of commercial banks was 35 to 1 in 2007; in Europe, it was 45 to 1 (see chart). As I noted last week, this makes it rational for shareholders to “go for broke”, with the results we have seen. Allowing institutions to be operated in the interests of shareholders, who supply just 3 per cent of their loanable funds, is insane. Trying to align the interests of management with those of shareholders is then even crazier. With their current capital structure, big financial institutions are a licence to gamble taxpayers’ money.

So how much capital makes sense for systemically significant institutions? “Much more than today” is the answer. Moreover, the required capital must also not be risk-weighted on the basis of banks’ models, which are not to be trusted. Shareholders’ funds should make up a minimum of 10 per cent of capital. In the US, it used to be far higher.

Higher capital is, in addition, a good way to internalise the negative “externalities” – more precisely, risks – created by one institution for the entire system. Ideally, therefore, the required capital should be correlated with the systemic significance of institutions, as the excellent new annual report from the Bank for International Settlements argues. Moreover, the requirement should be set against all activities, on the basis of fully consolidated accounts.

Within a far better capitalised financial system, it would also be relatively easy to operate a “macroprudential” regime, with the required capital rising during booms and falling during busts. Again, the bigger the stake of shareholders, the less one would worry if the rewards of managers were aligned with them. Even so, regulators have to have some sort of control on the incentives of management, as long as taxpayers bear residual risk.

Two difficulties remain: the transition; and regulatory arbitrage.

On the former, a demand for much higher capital ratios today would imperil the recovery. The answer is a lengthy transition, perhaps of as much as a decade. On the latter, it is evident that the so-called “shadow banking” system cannot be allowed to operate outside capital constraints if entities within it are likely to be systemically significant, as proved to be the case for money market funds. Moreover, capital ratios would have to be imposed by all significant countries. But the US is powerful enough to force movement in that direction by insisting that any foreign bank operating within it must be appropriately capitalised.

In sum, deleveraging is the right starting point for a healthier financial system. This would work best if we also eliminated today’s huge fiscal incentives for borrowing.

It is cautious incrementalism, not radicalism, that is now the risky option. Where should such radicalism start? The answer is clear: it is the incentives, stupid.

Submitted by Leo Kolivakis, publisher of Pension Pulse.


A follow-up on my last comment where I criticized the Financial Post article, Bonus flap puts Canada Pension’s strategy at risk.

While it is true that paying hefty fees to external managers costs large pension funds hundreds of millions, the article makes it seem as if CPPIB is sourcing their own PE deals and they can compete with the top private equity GPs out there.

That is simply not the case. What typically happens is that they co-invest with some of the top PE funds and stick in a big chunk of change. They use their size to write the big cheques and they then ask for reduced fees.

[Note: Pure direct investments are typically money-losing operations at large pension funds.]

It doesn’t take that much talent to dangle a big fat cheque in front of some hedge fund or private equity manager and then persuade them to reduce their fees. In fact, it is a lot harder to find lesser known PE players in the mid-market who are performing well.

And the example of CalPERS is terrible because they were known to indiscriminately throw money to every Tom, Dick and Harry PE and hedge fund out there. The best performing PE program among the large insitutional pension funds was at CalSTRS. You can read more about their PE portfolio by clicking here.

I would put the CalSTRS PE portfolio against that of any of the large Canadian pension funds and trust me, nobody at CalTRS is getting compensated the way Mark Wiseman and other SVPs are getting compensated at CPPIB.

Paying fees to external managers is fine as long as you are not paying for beta (which happens a lot in hedge funds) or paying for mediocre PE funds.

Enough of “Bonus Gate”. I got nothing against paying out bonuses to those that deserve them and I think Mark Wiseman is a decent guy, but he will have a hard time convincing me that he and his team merit those bonuses, especially after the CPP Fund got clobbered in FY2009.

More importantly, in order to pay someone for alpha, you need to make sure the benchmarks that are being used to evaluate that pension officer accurately reflect the beta, credit risk, leverage and illiquidity of the underlying investments.

I can show you 1,000 ways to scam or fudge your benchmarks. I used to grill hedge fund managers. The more arrogant they were, the harder I grilled them.

I had one guy one time who told me “I come from the George Soros school of risk management”. He was acting like a big swinging dick (BSD) and I had enough of his nonsense. I told him “if you are so great, why did George Soros fire you?”.

The sad fact was in the heyday of hedge funds, this arrogant BSD had no problems impressing or intimidating some unsuspecting public pension officer in the U.S., but if you took a closer look at his performance, you’d see it was all leveraged beta. I ain’t paying any slick hedge fund manager 2 & 20 for leveraged beta!

This brings me to my latest topic. IPE reports that transparency on pension risks is paramount:

NETHERLANDS – Pension funds must make pension risks more transparent to their participants, the Dutch pensions research organisation Netspar believes. Funds should also focus on real guarantees, which should increase with age.

In addition, they should keep on taking investment risk and stick with the principle of solidarity, according to economists Lans Bovenberg and Theo Nijman of Netspar, an academic centre for pensions, retirement and ageing.

The pension sector must also develop instruments against inflation risks and longevity risk, Bovenberg and Nijman indicated during a debate about the effects of the credit crisis.

For the medium term, the economist called for lower indexation, and argued for an economised pension build-up as well as a rise in the age of the state pension AOW by two years to 67.

The large union FNV Bondgenoten is proposing there should be a flexible AOW age of between 63 and 70 as an alternative, according to Peter Gortzak, its vice-chairman.

However, he claimed the existing automatic retirement at 65 must stop and a stable long-term contribution must be introduced.

Benne van Popta, employers’ chairman of the Association of Industry-wide Pension Funds (VB) and the pension fund for the retail sector, questioned whether solidarity is tenable between the generations, as the contributions instrument is insufficient in tems of keeping pension funds’ finances sound.

“The risk is that different generations will opt for their own [pension] scheme,” he suggested.

Guus Boender, an expert on asset-liability management at Ortec Finance, said there was a need for adjustments to the financial assessment framework FTK, to reflect worldwide efforts to bring interest rates down.

Schemes are making wrong decisions about their real funding ratios, Boender argued, because long-term rates are considerably affecting pension funds’ nominal cover ratios.

In the opinion of Bas Werker of Netspar, pension funds should not exclude the prospect of cutting benefits.

“A 2% cut during 1% inflation is less damaging than refraining from indexation while inflation is at 5%,” he stressed.

As I explained in my comment on pensions apartheid, it’s only a matter of time before benefits are cut in both private and public pension plans. The pension crisis is a long-term issue and let’s be clear on something, it is highly deflationary.

The NYT asks, Has GM overextended its pension plan?:

It had planned — and put money aside — for a steady march of retirees over time. But instead, tens of thousands of blue-collar workers, most in their 40s and 50s, are all becoming eligible for retirement benefits now, as the company rapidly downsizes.

And even as its pension fund faces this giant bulge in payouts, G.M. is not putting any new money in — the company is not required to make any contributions to the fund until 2013.

The longer this goes on, the weaker the fund will be and the more uncertain its long-term viability.

For now, the pension payments to its younger “retirees,” part of a deal G.M. negotiated with the United Automobile Workers union in 2007, allow the company to drastically shrink its work force without having to come up with the cash to pay severance. The payments also relieve some of the burden on social service programs in the countless factory towns and counties around the country with large numbers of G.M.’s newly jobless.

“G.M. basically raided the pension plan, by having a lot of these severance benefits paid through it,” said Douglas J. Elliott, a fellow with the Brookings Institution who specializes in financial institutions and policy.

What G.M. has done is perfectly legal. Nor is this the first time an employer has used a pension fund to pay for pruning its ranks. Well-subsidized early retirements are a time-honored practice in the public sector, where teachers often retire after 30 years and police officers can sometimes claim rich pensions after working as few as 20 years. Many corporations once offered sweetened pensions to people in their 50s and early 60s as well, but they have generally stopped the practice because it locked them into making payments indefinitely.

G.M. never stopped. To the contrary. The question now is whether the plan will run short of money and what effect that might have on the company, its workers and retirees, and the federal government, which insures pensions and is now G.M.’s majority owner.

In the short term, G.M.’s newly minted retirees, those in their 40s and 50s, have the most to lose if the plan is rapidly depleted and fails. But over time, the risk will shift to the government and the dwindling number of active U.A.W. workers still building cars at G.M. For those workers, a secure pension is already becoming an increasingly distant dream.

“They could find that they don’t get their full pensions when they retire, because the plan has had to be terminated because of the payments to current retirees,” Mr. Elliott said. “There are definitely these intergenerational transfer issues with underfunded pensions.”

G.M. declined to discuss the situation, although it has said it intends to keep the plan going when it emerges from bankruptcy.

For decades, G.M.’s blue-collar workers have earned pensions with two components. The first is the “basic benefit,” currently about $1,590 a month, or $19,000 a year, for an auto worker with 30 years’ service. The U.A.W. won this “30-and-out pension” after a strike at G.M. in 1970, and still considers it something close to an inalienable right. In a 30-and-out plan, someone can go to work at 18, work nonstop for 30 years and retire at 48.

The second part is a supplement, worth what each worker’s Social Security benefit will be on the earliest date he or she can start drawing the benefits, currently age 62. (Even then, the workers are joining Social Security three years early, so they qualify for just 80 percent of the full benefits they would get at 65.)

Even in the days when G.M. was healthy, years ago, most of its 30-and-out retirees were too young to qualify for Social Security. The supplements were supposed to make up the difference until the retiree became eligible for Social Security.

The total dollar amounts are not eye-popping. Unlike many pension plans in the public sector, G.M.’s U.A.W. plan cannot be “spiked” by working insane amounts of overtime just before retirement. Nor is it indexed for inflation.

“What we’re getting isn’t enough to live on,” said DeWayne Humphries, a 54-year-old G.M. retiree in Arlington, Tex., who completed his 30 years last year, retired, and is now getting the standard $3,150 a month, or $37,500 a year. Roughly half of the total, $19,000 a year, is the basic benefit. The rest duplicates Social Security.

“It’s tight,” said Mr. Humphries, who was earning $50,000 to $60,000 a year before his retirement. “It takes a different way of living than what you were used to.”

To make ends meet, he helps out with his son’s small business, cleaning swimming pools.

When a G.M. retiree turns 62, he joins Social Security, and the pension fund stops paying him the supplement. So eight years from now, Mr. Humphries will still be getting $37,500 a year, but only about $19,000 will come from the G.M. pension fund. The rest will come from Social Security.

That will greatly lighten the load on the pension fund. But thousands of G.M. workers have taken early retirement in the last few years, and each of those workers’ total benefits come from the fund. So while the benefits may seem inadequate to individual workers like Mr. Humphries, they add up to hundreds of millions of dollars being pulled out of the fund every year.

When a reorganization began to loom at G.M., in 2007, the company faced the choice of offering people cash buyouts or sweetening their pensions, letting them collect their 30-and-out benefits even if they had not yet worked the requisite 30 years.

Mr. Elliott called the decision “a no-brainer,” thanks to the federal rules for funding pensions.

“When you have an increase in benefits in a pension plan, you’re given quite a number of years to fund the increase,” he said. “So by doing it through the pension plan, they could defer paying any cash for this for years.”

How long the fund can sustain this is a mystery. G.M.’s financial reports combine the U.A.W. pension plan with the company’s other big plan, for salaried employees. (It was frozen in 2006 and cannot undergo a sudden increase in benefits.) The U.A.W. plan’s own annual reports, on file with the Labor Department, provide no fresh financial information because they stop at 2006.

At that point, the fund had roughly $67 billion in assets — more than enough to cover the $59 billion in benefits it had promised to pay. The plan was then paying out a little more than $5 billion a year to retirees.

Now the assets are almost sure to be smaller, thanks to the market losses of 2008 and the growing payouts. “My guess is, they can probably go for 20 years before they run out of cash,” Mr. Elliott said. That may sound like a long time, but with so many retirees and spouses still in their 50s, the plan needs resources for at least 50 years.

“If you’re supposed to be paying people for 50 years, it’s actually not that comforting that they have enough cash to pay people for 20,” Mr. Elliott said.

The Pension Benefit Guaranty Corporation declined to comment, but officials there have long worried privately that the collapse of one big automaker pension plan would be the end of the whole federal system of insuring pensions.

Normally, federal law would require G.M. to put fresh money into the pension fund. But G.M. has not had to make any contributions since 2003, when it issued bonds and put the proceeds — $15.2 billion — into the fund. That was more than the required amount, and the pension law allows companies that make bigger-than-required contributions to use the excess to offset the contributions they will owe in subsequent years.

That, and earlier contributions, are allowing G.M. to halt contributions until 2013. By then, the plan may have a significant shortfall. The law gives G.M. seven years to catch up, which could be difficult if the company is not performing well.

Ron Gebhardtsbauer, head of the actuarial science program at Pennsylvania State University, said G.M. and its government stewards could reduce the risk by raising the retirement age in the future.

“They’re a bankrupt company and they shouldn’t be giving overly generous benefits,” he said. “It’s sort of like the banks giving out bonuses when they’re not profitable.”

Or pension funds giving out bonuses after losing billions. It’s ridiculous how the financial aristocrats managed to screw over so many hard-working people.

What’s even more worrisome is that it’s business as usual on Wall Street and at many of the large “sophisticated” pension funds that operate at arms-length and disclose very little information.

Transparency at pension funds is indeed paramount. Too bad we won’t see it before catastrophe strikes again, wreaking more havoc on overextended pension funds.

Remember SIVs, financial public enemy number one of late 2007? Henry Paulson spent a lot of time failing around trying to come up with a remedy that involved only the government knocking heads together. That was a resoudnig Then it appeared that everyone shrugged their shoulders and decided this wasn’t such a big deal after all.

I’m left mystified on a couple of points:

1. Why these things existed in the first place (as in why they were deemed preferable to securitization)

2. How much of a role they played in the crisis

To point one, I can come up with some advantages, and they don’t strike me as compelling, so clearly I am missing something important. In a securitization, you can created different risk classes, so the “targeting particular investors” argument does not seem a particular advantage UNLESS SIVs appealed to a particular type of investor who was not keen on normal securitizations of bank assets.

To that issue, SIVs did seem to target shorter-lived asset than other securitizations. Or did they? They were funded largely with commercial paper, so was this simply a yield curve arbitrage strategy with a bit more leverage than a normal commercial bank? SIVs were leveraged typically 10-15x, so this does not appear to be driven primarily by the ability to obtain higher gearing (yes, presumably the leverage was higher since drecky SIV assets presumably not as highly geared on balance sheet).

SIV managers also took ongoing fees, but I am not certain how important this factor was in terms of overall economics. An SIV may have been cheaper to set up than an asset backed security.

It would be helpful if anyone could describe or provide a link to the economics from the bank’s perspective of the economics of an SIV versus an ABS to see why and when SIVs were preferable.

To the point #2, SIVs went in, as far as the media was concerned, from a huge issue to a non-issue. Yet the “we need to get rid of the toxic waste on bank balance sheets” theme reflects in part SIV assets presumably taken back on bank balance sheets (ro at least that was the plan as of early 2008).

This was a $400 billion market at its peak. Citi was the biggest player, and UBS and apparently Merrill were involved in a meaningful way. Does anyone know, ex Citi, if SIV paper caused meaningful indigestion at any big bank?

Thanks! Anyone not set up to comment feel free to ping me at yves@nakedcapitalism.com

Lion prides form to win turf wars BBC

Bottoms up for winning artist The Sun

Sowell: Obama Will Lead to Sharia Matthew Yglesias. This is the political equivalent of a Weekly World News story, but at least the WWN folks were sufficiently in contact with reality to know they were making the stuff up. I imagined they all got high before their editorial meetings. So what’s Sowell’s excuse?

Pedestrians, cyclists among main road traffic crash victims World Health Organization (hat tip reader Michael T)

Japan: 2.3 Applicants for EVERY Job Opening EconomPic Data

FHFA’s Lockhart on CNBC Bruce Krasting

North Korea, the submerging market bet John Dizard, Financial Times

Banks and the financial crisis Linda Beale

Bernanke is a Total Failure Unsuited for Role as Fed Chairman Michael Shedlock

The evolution of the United States’ external balance sheet in the last decade (wonky) Brad Setser

Pushing on a string MarketWatch

Government Bails Out General Electric Jesse

BIS calls for global financial reforms Financial Times. This is a VERY harsh report, has gotten (so far) virtually no traction in the blogosphere or MSM. It’s also sensible and therefore will never get done.

Antidote du jour:

Um, how come this story is in the Sydney Morning Herald (as of about 20 hours ago) and not the US/UK business media? This is a pretty major development. Yes, commodities heavy Australia is most affected, but Oz is hardly alone in seeing the ramifications.

While the US dollar is weakening, the Australian dollar has had an amazing run, and the only justification I could fathom for its outperformance (it normally moves with the euro, albeit with more amplitude) was the commodities/China angle. Australia was the only economy to see its exports increase since the global slump took hold.

From the Sydney Morning Herald (hat tip reader Sean):

A record-breaking run run of commodities exports to China that has sustained the Australian economy may be set to end, with Beijing officials and advisers announcing an end to “strategic” stockpiling, and massive iron ore contracts likely to expire today.

A key state planning official has signalled a halt to government buying of copper, aluminium and other high-value metals because prices have risen too high.

“We don’t anticipate that the country will continue to build its reserves,” said Yu Dongming, the head of the metallurgical department of the National Development and Reform Commission…

Zhang Bin, an economist with the Government’s most influential advisers, the Chinese Academy of Social Sciences, warned that Beijing was leaning against Chinese speculative buying of a range of commodities including Australia’s most lucrative exports, coal and iron ore.

“The commission is acting to reduce pressure on commodities prices and discourage over-production in heavy industry, including guiding steel production and reducing the building of excess capacity,” Dr Zhang told the Herald.

“Too much increase in inventories of commodities is not a good thing because the economy is still not that strong and cannot consume this level of imports of iron ore and coal.”…

“I think the risks are weighted to the downside,” Mr Rennie said. “If China does slow demand for those key commodities, it is not entirely clear there is another obvious buyer out there.”…

“Iron ore imports seem to have started to slow down,” said Paul Bartholomew, the Shanghai editor of Steel Business Briefing. “I can’t see it bettering the 57 million tonnes … in April.”

One way of shaping the news is the framing of stories. Readers are sending articles on a daily basis pointing to a bullish bias in quite a few stories. In most, it not blatant, which is why I don’t parse them, here, in that it would seem like overkill. But in fact the subtle spinning of stories is far more insidious than the obvious sort that might trigger the BS detector of even a casual reader. It used to be the Wall Street Journal which was the prime offender, but Bloomberg has now taken the lead.

Another way to shape opinion is via placement, as in which stories get top billing, and which are put further back or not covered at all. One story that seems important but did not get prominent placement (no first page treatment at the Wall Street Journal or Financial Times, and no mention in the New York Times). The lack of first page positioning is less significant for the FT, since its Web redesign limits it to only a few articles. But by contrast, the Journal’s extensive front page headlines and summaries give the impression that a reader has scanned what is really important if he has looked over the first web page.

Energy use is generally considered a good benchmark of economic activity, so a reduction in the prediction undermines the “green shoots” thesis. A cut in the demand forecast, particularly from the IEAl All official agencies have overestimated both supply and demand growth, but the demand growth overestimates have been larger than for supply. It is also worth noting the IEA has done worse that OPEC, the most conservative. And note the outlook for demand growth for oil through 2014 is surprisingly low, a mere 0.6% per annum.

From the Financial Times:

The worst recession in decades will curtail oil demand for years to come, the International Energy Agency predicted on Monday as it cut sharply its forecasts for world consumption and declared that the threat of a supply crunch had receded.

The consuming countries’ oil watchdog said it expected global demand to grow at an average annual rate of just 0.6 per cent or 540,000 barrels a day from 2008-14, raising consumption from 85.8m b/d to 89m b/d.

This latest forecast is 3.3m b/d lower than the previous forecast for 2013 volumes. If the agency’s most pessimistic economic scenario proves correct, oil demand could contract, with consumption falling to 84.9m b/d by 2014, it said in a report.

The slowdown in demand growth means the crucial cushion of spare supply the Opec oil producers’ cartel holds is now expected to reach 7.78m b/d next year, or 8 per cent of global demand. Last year, the IEA expected surging energy usage to reduce that supply cushion to 1.67m b/d….

The IEA cautioned against putting too much faith in hopes of a swift economic recovery, which have pushed the oil price back up towards $70 a barrel from half that level in February. It said that economic “green shoots” could be accounted for by stock rebuilding across industries after a steep drawdown of inventories….

Total non-Opec supply was projected by the IEA to fall 400,000 b/d from 2008 to 50.2m b/d in 2014, with deferred or cancelled investments in oilfields the main reason for the decline.

Submitted by Leo Kolivakis, publisher of Pension Pulse.

I begin with a message from Diane Urquhart:

You are welcome to put links on your Pension Pulse blog to these letters between Parliamentary Secretary of Finance Ted Menzies and myself. They are about whether preferred status for pension fund deficits and severance would increase the cost and availability of credit. I say it does so on only a nominal basis and so the Federal Government should amend the BIA Act to give preferred status to pension fund deficits and severance.

I have stored the letters to and from Menzies at the following web pages. These links can be added to the LinkedIn Groups’ and NRPC’s website.

ismymoneysafe.org/video/Menzies_from_Urquhart.pdf

ismymoneysafe.org/video/Menzies_to_Urquhart.pdf

I do not have an active website, but you may be interested in the videos on securities corruption and securities crime policing that I have put up at www.ismymoneysafe.org.

I will then turn your attention to Luc Vallée’s latest comment on the tsunami of corporate refinancing:

Did you see this graph in the Wall Street Journal yesterday? It is enough to make you want to read the accompanying article by SerenaNg and Kate Hatwood. I also reproduced it below with all proper credit for those who would have a hard time getting access.

In my blog yesterday (see Chronicles of a Second Wave of Foreclosures based on Ross Mckitrick’s “Green Shoots Reality Check”), I commented on another incoming large wave of home foreclosures that could bring a new series of bank failures and renewed financial distress and, as a result, prolong the current economic recession well beyond 2010.Well, it appears that once we are over this second wave, a tsunami of corporate debt refinancing is going to hit us. It maybe hard to see in the distance, hiding behind two large waves of foreclosures: The first one falling on our head right now and the second one due to hit us with full strength in about 18 months.

Starting in 2001, but really getting momentum in 2012 and peaking in 2014, hundreds of billions of dollars of debt are due to be renewed. Already the mountain of debt on the horizon is pushing some desperate firms to attempt debt rescheduling exercise to avoid the crowd in 20013 and 2014. For the lucky ones who have already succeeded or who will succeed in the coming months, this means heavy concession to lenders usually under the form of higher interest payments. It may be good management risk practices but it also means reduced profit outlook for the next few years as interest payments immediately jump. Not very bullish for the Stock market.

Read on.

Reuters Loan Pricing Corp reports that U.S. syndicated loan issuance fell 37 percent in the second quarter from a year earlier, plumbing historic lows in the wake of last year’s credit crunch:

Overall issuance fell to $156 billion from $248 billion a year earlier, with investment-grade issuance down by 27 percent to $70 billion and leveraged loan issuance down by 25 percent to $68 billion, according to RLPC.

High-yield bond issuance rose 39 percent in the second quarter to $46 billion.

JPMorgan was lead book-running manager in the second quarter, with $51.6 billion in deals, or 33 percent market share; followed by Bank of America Merrill Lynch, with $30.9 billion, or 20 percent market share; and Citigroup, with $16.7 billion, or 11 percent market share.

Some signs of stability emerged in the second quarter. In the leveraged loan market, prices of the 100 most widely traded loans rose by nearly 15 percentage points to 86 cents on the dollar.

Investors, however, had little opportunity to put cash to work on new deals. Issuance for leveraged buyouts, until recently a key source of new supply, dropped by 95 percent from a year earlier to $590 million in the quarter.

In the investment-grade area, a lack of merger and acquisition financing kept issuance down after the market cleared a number of jumbo deals in the first quarter, such as a $22.5 billion loan for Pfizer Inc.

But things may not be as bad as they seem. The distressed debt ratio is at its lowest point in nine months, dropping to 34% from a high of 85% last December, according to a study released today by Standard & Poor’s.

The amount of affected distressed debt dropped to $177 billion from $232.8 billion in May, according to S&P. The total number of companies with bonds trading at spreads of 1,000 bps ore more is now 268. At the end of May there were 338 such companies.

The speculative-grade corporate bond spread reached 946 bps on June 15, down from 1,136 bps May 15.

The distressed levels in leveraged loans have decreased also. The S&P/LSTA Leveraged Loan Index distressed ratio fell to 47.5% in May from 54.8% in April.

These developments are positive for distressed debt markets and the overall credit markets. In the stock market, growing confidence that the U.S. economy is putting the worst recession in decades behind it has pushed the index known as Wall Street’s fear gauge to its lowest level since just before Lehman Brothers collapsed last September:

The CBOE Volatility Index .VIX, known as the VIX, provides investors with portfolio insurance against fluctuations in the S&P 500 index .SPX. It soared to historic highs in the weeks after Lehman’s rapid failure pushed financial markets to the brink and left an already crippled economy in tatters.

But amid numerous signs the economy is on the edge of a recovery, coupled with the best quarter for stocks in more than 10 years, the VIX has begun to look like its old self again.

“Investors see a lesser need for protection going forward; it looks like they don’t see a revisit to the March lows,” said Andrew Wilkinson, senior market analyst at Interactive Brokers Group in Greenwich, Connecticut.

The VIX, which is calculated from Standard & Poor’s index options, tracks the market’s expectations of volatility over the next 30 days. It often moves inversely to the S&P benchmark and goes up as options premiums are raised.

The S&P 500 .SPX hit a more than 12-year low in early March, down more than 57 percent from the record high it set in October 2007, after the bursting of the housing bubble spiraled into a credit crisis and then into a global recession.

The VIX hit an intraday record high of 89.53 in late October, but on Monday it closed at 25.35, its lowest level since September 11, 2008, before the weekend when Lehman collapsed.

“The path forward appears a less treacherous one according to what the VIX is telling us,” Wilkinson added.

Stabilization of key economic indicators such as payrolls, home prices, bond yields and consumer confidence, as well as the Obama administration’s plan to reactivate the recession-hit economy, have boosted bets on the economy’s outlook. Investors are looking forward to this week’s key housing and job market data on expectations that it will show further signs that the worst is over.

“I think (the VIX) is down primarily because the expectation is the economy is going to recover and we’ve started a bull market,” said Hugh Johnson, chief investment officer of Johnson Illington Advisors in Albany, New York.

The S&P 500 has risen up to 40 percent from its March lows, and is on path to close its best quarter since the fourth quarter of 1998. But even as some market players expect a correction in the near term, the reading of the VIX suggests that that correction may not happen.

“The bears are beginning to throw in the towel on expecting a substantial stock market decline, so investors are beginning to sell implied volatility,” Wilkinson said. “Investors do not perceive there’s going to be another big crash.”

But although the VIX has returned to levels similar to those seen before financial markets imploded, analysts said that does not mean the economy has recovered from the hit it took last year.

“We’ve gone through such a change in the economy that has required such drastic steps from both the Federal Reserve and the government that it is going to create a very different landscape going forward,” added Wilkinson. “We can’t relate (today’s) VIX measures to were we’ve come from.”

In the Australian, Charlie Aitken of Southern Cross Equities writes that investors should get ready for the next leg higher:

OUR market was watching the Dow Futures closely here yesterday, which pointed to a 50-point weaker night on Wall Street.

I have no idea why anyone watches the Dow Futures trading on a Sunday night. Similarly, shorters decided some random comments from some Chinese source about commodity prices was a good enough reason to short commodity stocks in the afternoon session here yesterday.

Both ideas look flawed this morning, with the Dow Jones Industrial Average closing a net 140 points higher than the Dow Futures were predicting, and the commodity complex having a good night led by oil and copper.

While rising oil prices (+$US 2.23 a barrel to $US71.47) aren’t a great thing for the US economy, the market point is that Exxon Mobil (+2.2 per cent) is the largest weighting in the S&P 500, while Chevron and Exxon are both Dow components.

Also, for some reason, oil and financials appear to be closely correlated at the moment (risk?) and every time oil rises, so too do the US financials (KBW Bank Index +1.5 per cent). By the end of a summerish volume session (that is, relatively light), the Dow gained 90 points (+1.1 per cent) to 8529 while the S&P 500 gained 8.3 points (+0.9 per cent) to 927.

The markets seemed to like the fact that Bernie Madoff was sentenced to the maximum penalty of 150 years in jail for his ponzi scheme and it was a nice touch to see his own wife stick the boot into him after the sentencing. In good times and bad, hey, Ruth?

More interestingly, the Chicago Board Options Exchange Volatility Index (VIX) continued to fall (25). A close reading of both the VIX and Dow Jones Industrial Average shows to me that the much larger chance is the Dow plays catch-up to the VIX’s collapse and I think that will be the case in the second half of this year. Last time the VIX was 25 points, the Dow was over 11,000. Food for thought.

The truth is that you can create all sorts of nasty scenarios but if the U.S. economy does surprise to the upside, stocks will keep grinding higher and the only fear that will dominate the big fund managers is the fear of underperforming the major averages.

Finally, Karen Mazurkewich of the Financial Post writes that the bonus flap puts Canada Pension’s strategy at risk:

When the Canada Pension Plan Investment Board disclosed two weeks ago a $24-billion loss for the previous fiscal year, it sparked a political furor in the House of Commons over hefty executive bonuses.

Now, there may be a higher price to pay from the fallout: the fund’s progressive investment strategy could be in jeopardy.

Analysts worry that a parliamentary backlash could put the pension fund’s cost-effective strategy at risk if it loses its ability to attract highly talented managers.

Going “cheap” on talent would save a few million in bonuses, but it would also add 10s of millions of costs to the running of the plan because the fund would be forced to rely more on outside fund managers and consultants who charge high fees to handle alternative assets such as private equity and infrastructure funds.

The financial services industry has a bad rap these days, and bonuses “is a strong political plum to bite into,” said Keith Ambachtsheer, director of the Rotman International Centre for Pension Management at the University of Toronto and the co-founder of CEM Benchmarking Inc. “In general, we pay our [pension managers] better in Canada, but we do it for the right reasons.”

CPPIB and other multi-billion-dollar plans are now boosting performance by direct investing in alternative classes such as private-equity, hedge funds, real estate and infrastructure. Such a strategy requires a high calibre of manager.

“Canadians need to make a choice,” mused Mr. Ambachtsheer. “Do they want top of class or go cheap?”

A better barometer for politicians is how well the plan can streamline fees and reduce operational costs.

CEM Benchmarking, a Toronto-based research firm that collects data on 408 pension funds around the world, has calculated that in 2007 CPPIB’s operational costs were lower than those of its peers. It cost CPPIB 33.2 basis points (pb) to run its pension fund compared with an average of the 36.9 pb to run similar North American funds in comparable asset classes.

The savings of 3.7 bp translated to $44-million savings – meaning that CPPIB managers negotiated better fees or managed their funds more efficiently in-house.

Those savings are even greater when CPPIB is compared with a pension plan that farms out all its alternative assets to outside fund managers. According to CEM, a North American fund of similar size to CPPIB paid 54 bp in 2007 for the management of their fund. Not only were a large majority of its assets managed externally, but 20% was invested in expensive asset classes: real estate, hedge funds and private equity. That means CPPIB saved 20.8 bp, or $248-million by comparison.

Giving Canadian pension executives hefty incentive packages to run multi-billion funds was a trend that began 19 years ago, when Claude Lamoureux was recruited to run the Ontario Teachers’ Pension Plan (OTPP). Mr. Lamoureux, who retired from OTPP in December 2007, remains a defender of that policy:

“When [former executive vice-president investments and chief investment officer] Bob Bertram and I started [at OTPP], we wanted to run money internally because we felt we could do as well as external [managers]. If you look at the economics, it’s a fairly compelling case to manage internally.”

Mr. Lamoureux said that he faced off with critics who challenged OTPP’s salaries, which are some of the highest in their field. In 2006, for example, Mr. Bertram made $6.17-million in compensation – although his total package was shaved to $2.49-million for 2008 after the fund lost $21.1-billion in assets. But his reduced salary in bad times is still many times higher than the average salary for a top manager at California Public Employees’ Retirement System (CalPERS), which ranges between US$400,000 and US$600,000.

Mr. Lamoureux argued that when funds reach a certain size, it makes more economic sense to reward top managers internally, while paying less to external funds whose fees in certain asset classes are becoming “prohibitive.”

Not only do companies such as Kohlberg Kravis Roberts & Co. (KKR) and The Blackstone Group charge 2% management fees plus 20% of the profits, “they’ve found new ways to charge fees for practically getting out of bed in the morning,” he added. Their real fees are more in the 5% range.

So while CalPERS executives receive less compensation, the real cost of running alternative assets through third-party funds is kept hidden. “In the case of private-equity, these fees never show up in the [operation] expense column of the pension funds because they are deducted from the earnings,” said Mr. Lamoureux. He has argued for years that the cost of those fees should be transparent. As a result, “when parliament criticizes the [bonuses] they don’t know what the alternatives are,” he added.

Mark Wiseman has been in the eye of the political storm. As senior vice-president, private investments, with the CPPIB he was one of a handful of top executives singled out for a compensation package that totalled more than $2.4-million this year. However, Mr. Wiseman argues that his team is saving many more millions that would otherwise be paid out to external fund managers.

Take CPPIB’s private-equity arm alone. Over the past three years, CPPIB did $3.5-billion worth of direct investments. If Mr. Wiseman’s team had paid 2% in management fees on that sum, it would have cost the fund $70-million annually. That doesn’t even include what CPPIB would have to pay their external manager when the investment was realized. If its $3.5-billion investment doubled over time, the pension plan would have to pay $700-million – 20% of its profit – to its outside manager. By contrast, it costs CPPIB about $20-million annually in compensation, office allocation and travel, to run its in-house direct private equity team.

These savings are just a small part of the picture. CPPIB is also beefing up its internal capabilities in all other classes including infrastructure, real estate and private-debt – in hopes of saving hundreds of millions of dollars. By contrast, CalPERS “pays hundreds and hundreds of millions of dollars in fees to external managers,” Mr. Wiseman points out.

Success for CPPIB’s direct investment teams means earning returns at least as good as those achieved by third-party funds. “And that requires a highly qualified team,” said Mr. Wiseman.

That’s why the political firestorm over the bonuses has him worried: “I think it would be a shame if these issues forced us to take a different path as an institution, because at the end of the day I think it would be Canadian pensions that would lose.”

I can’t stand reading this nonsense. What progressive investment strategy? What are the bloody benchmarks for private equity and do they accurately reflect the leverage, liquidity and credit risk of the underlying investments?

And by the way, those “direct investments” in private equity were probably co-investments so don’t be so impressed with the headline performance figure. If they are that great, let them start a PE fund of their own (good luck).

The bottom line is CPPIB lost $24 billion and they have the audacity to claim that they deserve bonuses?

As for Mr. Lamoureux, the guy who told me to “shut up” after I testified on Parliament Hill and exposed all these bonus shenanigans based on bogus benchmarks, he is obviously going to defend current compensation practices because he made millions while he was at the helm of Ontario Teachers.

And Mr. Ambachtsheer should come clean and state who pays his salary. Is it the big funds or the pensioners they invest on behalf of?

Should we really fear that the “top talent” will leave Canadian pension funds to join hedge funds and private equity funds?

Give me a break. I say this to all the pension “all-stars” who lost billions in 2008: stay where you are because unlike most pensioners, you obviously have no fear of underperforming these markets. You get all the upside in good years and in terrible years, you can hide behind a four-year rolling return.

These pension fund managers have the best gigs in town and the only fear we should have is that they continue pulling the wool over their stakeholders’ eyes and get away with huge bonuses for delivering mediocre performances.

Americans on average are more liberal than sterotypes about US attitudes would suggest.

So why do most Americans, and more important their representatives, act as if the country is conservative-leaning? The cynical take is the most persuasive: while the numbers may be skewed to the left, the money is weighted to the right. With TV advertising both costly and crucial to getting political messages out, conservatives have been able to punch above their weight thanks to their well-heeled donors. And these efforts to shape opinion go beyond the airways to trying also to reach opinion leaders, such as economists. However, there also appears to be a shift to the left due to the economic crisis plus left-leaning groups showing more demographic growth.

There were a couple of interesting tidbits in this story. The first is how the media continues to depict popular attitudes as more right wing than they are. Second is that individuals may be labeling themselves as conservative (thanks to “liberal” having been made a dirty word) when their attitudes on issues may in fact put them in the progressive camp.

From Voltairenet (hat tip reader Michael T):

The media still calls America a “center-right” nation, but “center-left” is closer to the truth. On issues ranging from health care to energy, the public is more progressive than people think. Demographic groups from youth to Hispanics are voting farther left and in larger numbers than ever before. The new report the Campaign for America’s Future is publishing with Media Matters for America— “America: A Center-Left Nation” —documents the trends and challenges the mainstream media to recognize reality….

In issue after substantive issue, significant majorities of Americans favor progressive solutions to the nation’s problems and reject the right’s worldview. That’s true whether the issue at hand is taxes, war and peace, the role of government in the economy, health care, and on and on.

Yet the idea that America is a “center-right” nation persists; Republican and conservative activists repeat the assertion ad nauseum — as it’s in their interest to do — and most of the political press corps swallows it whole.

The idea is like a zombie — you can bludgeon it, burn it or get Dick Cheney to shoot it in the face, but it keeps coming — it will not die.

The persistence of the center-right narrative, even in the face of piles of evidence suggesting it’s little more than a myth, has very real consequences on our political discourse….

This week [end of May], a new report [1] released by the Campaign for America’s Future and the media watchdog group MediaMatters attempts to finally bury the idea that the U.S. leans rightward. It takes a comprehensive look at the political landscape in which we live and a look forward at America’s shifting demographic profile — all of which reveal a citizenry that is anything but center-right and will only continue to trend in a more progressive direction, leaving modern conservatism increasingly isolated in its ideas.

The study gathered public-opinion data from a number of respected, nonpartisan polling outfits, findings from the (huge) National Election Study series and official statistics on ethnicity and gender to make the case. Among the findings:

On what may be the key difference between liberals and conservatives today — the role of government — more than twice as many people agree with the statement, “there are more things government should be doing” than believe the Reaganite adage, “the less government, the better.”

In 1994, more than half of Americans said, “government regulation of business usually does more harm than good” and fewer than 4 out of 10 thought “government regulation of business is necessary to protect the public interest.” That’s been flipped on its head during the 15 years since — today, fewer than 4 in 10 believe regulation causes more harm than good.

A majority (55-70 percent, depending on how the question is worded) believes it’s the government’s responsibility to provide health care to all Americans; fewer than a third of those responding to a CBS/New York Times poll thought health insurance should be “left only to private enterprise.”

Almost 2 out of 3 Americans believe the taxes they pay are fair, and that the very wealthy pay too little in taxes; almost 7 in 10 believe corporations don’t pay their fair share of taxes.

During a conference call with reporters, Robert Borosage, co-director of Campaign for America’s future, acknowledged that until 15 to 20 years ago, a center-right coalition of conservatives and political moderates did represent a majority of the electorate, but noted that the views of moderates and independents have grown much more closely aligned with those of more progressive voters, and the result is a center-left mandate for the new administration and Democratic-controlled Congress.

What’s more, the country’s changing demographics suggest that America will continue to be a center-left country in the coming decades. The most progressive (or at least solidly Democratic-leaning) constituencies in the country — single women, African Americans and other minority groups, young people — are growing as a share of the electorate, while the “Reagan Democrats” — older, working-class whites — who were the backbone of the conservative movement are declining as a share of the population.

Page Gardner, founder of Women’s Voices/Women Vote, said of the new coalition, “if you look at their views across the board, they’re incredibly progressive.”

More Americans are also living in high-density urban environments than ever before, which political scientists have long held creates more tolerance for diversity and in general a more receptive attitude toward the role of government in one’s daily life…

And it’s not just returns from the election — the report notes:

“Conservative commentators, particularly those on Fox News, have portrayed Obama as so liberal that his activist agenda bordered on socialist or even Marxist. Yet according to Gallup polling, Obama’s approval ratings for this first 100 days in office were higher than those of any president since Ronald Reagan and higher than seven of the last eight presidents at the 100-day mark. It doesn’t seem likely that an entrenched center-right nation would reward such a liberal president with historically high job approval.”

But as MediaMatters Director Eric Burns outlined, by and large, the media have not only failed to fully acknowledge the ideological outlook of the American electorate, the months since the election has been marked by the “mainstreaming of incredibly conservative views” within America’s pundit class, with “sometimes violent” rhetoric being debated as if it were comfortably within the mainstream.

Burns suggested that part of the reason the center-right meme persists is that many political reporters today cut their teeth in the era of the “Reagan Revolution” and during the “Clinton wars” of the 1990s — an era in which conservatives were ascendant.

Another factor is that there hasn’t been a significant shift in Americans’ self-described ideology, as a much-discussed Pew poll taken just after the election found.

Pew’s research showed, “Only about 1 in 5 Americans currently call themselves liberal (21 percent), while 38 percent say they are conservative and 36 percent describe themselves as moderate. This is virtually unchanged from recent years; when George W. Bush was first elected president, 18 percent of Americans said they were liberal, 36 percent were conservative and 38 percent considered themselves moderate.”

The problem with self-identification, however, is that it hinges on how one defines those labels — an individual may say he or she is conservative for a variety of reasons, but that same person may favor the progressive position on every issue down the line. According to the most recent (1997) Household Survey of Adult Civic Participation, only around half of Americans could say “which party is more conservative at the national level.”

It’s ultimately issues that get decided in Washington, and the report issued this week adds to an already-large body of data suggesting that Americans are highly receptive to progressive arguments on issue after issue, regardless of with which label they may identify themselves.

‘Oldest musical instrument’ found BBC

Sex feels the credit squeeze in Nevada Independent

How To Save The Newspapers, Vol. XII: Outlaw Linking TechCrunch

Obama is choosing to be weak Clive Crook, Financial Times. Crook is measured but the substance of the article is damning.

Pecora Whirling Robert Knutter, Huffington Post

A Tangled Policy Web Tim Duy

Translators Wanted at LinkedIn. The Pay? $0 an Hour New York Times

Wary Banks Hobble Toxic-Asset Plan Wall Street Journal. Readers may recall we were skeptical that this would get done.

China’s Dependency Ratio: As Good As It Gets Paul Kedrosky

Japanese Industrial Production Jumps, But Still Down 30% YoY EconomiPic Data

Antidote du jour. Do not try this at home, although I must admit Duma made cheetahs seem like great pets. Hat tip reader Eric: :

Sharing a bed with your furry friend has taken on a whole new meaning for Riana Van Nieuwenhuizen.

The sanctuary worker shares her South African home with not one but FOUR orphaned cheetahs, five lions and two tigers.

Forty-six-year-old Riana said: ‘I love them all. But they’re a handful.’

More pictures and text here.

Readers may recall that it wasn’t all that long ago that China’s banks were sitting on big losses and the analysts debated how bad the mess was. In 2003, for instance, the damage was pegged at $500 billion, a stunning figure given the size of the economy, and meant the banking system was insolvent.

Even though the Western press has gotten excited about Chinese loan growth, seeing it as a sign of imminent recovery, appearances are deceiving. First, the government set targets, so loans had to be made, whether they made sense or not. Michael Pettis has reported some transactions were shams to meet the mandated goals. About 1/3 of the proceeds were estimated to go to the stock market, hardly a productive use. And the banking aurhorities themselves were recently reported to be trying to curtail loan growth, a confusing signal.

Ambrose Evans-Pritchard is even more dour, thanks to the reading a less than cheery reports from Fitch:

China’s banks are veering out of control. The half-reformed economy of the People’s Republic cannot absorb the $1,000bn (£600bn) blitz of new lending issued since December.

Money is leaking instead into Shanghai’s stock casino, or being used to keep bankrupt builders on life support. It is doing very little to help lift the world economy out of slump.

Fitch Ratings has been warning for some time that China’s lenders are wading into dangerous waters, but its latest report is even grimmer than bears had suspected….

“Future losses on stimulus could turn out to be larger than expected, and it is unclear what share the central and/or local governments ultimately will be willing or able to bear.”

Note the phrase “able to bear”. Fitch’s “macro-prudential risk” indicator for China threatens to jump from category 1 (safe) to category 3 (Iceland, et al). This is a surprise to me but Michael Pettis from Beijing University says China’s public debt may be as high as 50pc-70pc of GDP when “correctly counted”.

The regime is so hellbent on meeting its growth target of 8pc that it has given banks an implicit guarantee for what Fitch calls a “massive lending spree”.

Bank exposure to corporate debt has reached $4,200bn. It is rising at a 30pc rate, even as profits contract at a 35pc rate…Roll-over risk is rocketing. China’s monetary stimulus since November is arguably more extreme than the post-Lehman printing of the US Federal Reserve, though less obvious to the untrained eye….

China’s Banking Regulatory Commission fired a warning shot last week. “The top priority at the moment is to stop explosive lending. Banks should carefully monitor the process of credit approval and allocation, and make sure that loans flow into the real economy,” it said….

World trade may be stabilizing at last after contracting at faster rate than during the early Great Depression. But it will not rebound fast in a world where the US savings rate has risen to a 15-year high of 6.9pc. A trade policy based on the assumption that debtors in the Anglosphere and Europe’s Club Med can ruin themselves for ever is absurd.

Andy Xie, a Sino-bear and commentator for Caijing, said Western analysts are in for a rude shock if they think that China’s surging demand for raw materials implies genuine recovery.

Commodity speculators have been using cheap credit to play the arbitrage spread between futures and spot on the oil markets. They have even found ways to trade lumber to iron ore by sheer scale of leverage. “They’ve made everything open to speculation,” he said.

Mr Xie thinks the spring recovery is an inventory spike, to be followed a double-dip downturn into next year as stimulus wears off.

Reformers know what must be done to boost consumption. China needs a welfare revolution. But creating a social security net takes time, and right now Beijing is facing a social crisis as 20m jobless workers retreat to the rural hinterland.

So the regime is resorting to hazardous methods to keep excess factories humming: issuing a “Buy China” decree: using a plethora of export subsidies; holding down the price of coke, bauxite, zinc and other resources to lower production costs (prompting a complaint from America and Europe); and suppressing the yuan, again.

Protectionism is a risky game for a country that lives off global trade and runs a surplus near 10pc of GDP. Mr Pettis said he fears China is nearing its “Smoot-Hawley moment”, repeating the US tariff blunder of 1930 that brought the world crashing down on Washington’s head.

Two facts stand out about China’s green shoots. While the Shanghai composite index is up 70pc since November, Chinese imports are down 25pc from a year ago. China is still draining real stimulus from the global economy.

If the world’s biggest surplus state ($400bn) is too structurally deformed to help offset the demand shock as Western debtors retrench, we are trapped in a long deflation slump.

The Bank of International Settlements, mindful of the importance of its role, would never say anything as crass as the translation I offered in the headline. But that is nevertheless a message in its newly-released annual report. From the Guardian (hat tip reader DoctoRx):

Taxpayers around the world still face potentially large losses because governments have failed to act quickly enough to remove toxic assets from the balance sheets of key banks, the world’s leading central bankers warn today.

Despite months of co-ordinated action around the globe to stabilise the banking system, hidden perils still lurk in the world’s financial institutions according to the Basle-based Bank of International Settlements.

“Overall, governments may not have acted quickly enough to remove problem assets from the balance sheets of key banks,” the BIS says in its annual report. “At the same time, government guarantees and asset insurance have exposed taxpayers to potentially large losses.”…

As one of the few bodies consistently sounding the alarm about the build-up of risky financial assets and under-capitalised banks in the run-up to the credit crisis, the BIS’s assessment will carry weight with governments. It says: “The lack of progress threatens to prolong the crisis and delay the recovery because a dysfunctional financial system reduces the ability of monetary and fiscal actions to stimulate the economy.”

It also expresses concern about the dilemma facing policymakers on when to start reining in the recovery. “Tightening too early could thwart the recovery, whereas tightening too late may result in inflationary pressures from the stimulus in place, or contribute to yet another cycle of increasing leverage and bubbling asset prices. Identifying when to tighten is difficult even at the best of times, but even more so at the current stage,” it says.

This is not over till the fat lady sings.

If Alan Greenspan were serious about rehabilitating himself, he could hire himself out to central banks and instruct their officials in the art of Looking Serous and Appearing to Say Important Things While Actually Communicating Nothing. This is a crucial skill for anyone in an important bureaucratic position. The Chinese could use a few lessons.

In a bit more than 48 hours, the Chinese taketh away and giveth back again. On Friday, the central bank released a review that called, in no uncertain terms, for the IMF to play a larger role in managing member’s foreign exchange reserves, and called for a greater role for special drawing rights. This statement was seen as a reiteration of views expressed by Governor Zhou back in March. The dollar fell on the news.

Today we get this, via Bloomberg:

People’s Bank of China Governor Zhou Xiaochuan said the nation won’t change its currency reserve policy suddenly, helping the dollar to snap a two-day decline.

“Our foreign-exchange reserve policy is always quite stable,” Zhou told reporters at a central bankers’ meeting yesterday in Basel, Switzerland. “There are not any sudden changes.”

The dollar slumped on June 26 after the central bank renewed its call for a new global currency, fueling speculation it will diversify its reserves, the world’s largest at more than $1.95 trillion. U.S. President Barack Obama needs the support of China as his government tries to spend its way out of a recession.

“I don’t see any practical alternative as a key reserve currency when I look around,” said David Woo, London-based global head of foreign-exchange strategy at Barclays Capital. China’s proposal to expand the use of special drawing rights, the unit of account used by the International Monetary Fund, isn’t a “practical solution” because they aren’t liquid, he said.

This certainly looks like a retreat, although Zhou may simply be clarifying the difference between long term policies and immediate plans. But that still begs the question of when and how the transition between the two comes into play.

The tension may also reflect the need to posture aggressively before a domestic audience without unduly rattling markets. But it may also result from the need to appease certain interests within the government. A New York Times article last year explained that as the central bank took foreign exchange losses as the RMB rose, it may have to go hat in hand to the finance ministry, which opposes many of the central bank’s policies, particularly on the dollar:

The central bank has been the main advocate within China for a stronger yuan. But it now finds itself increasingly beholden to the finance ministry, which has tended to oppose a stronger yuan. As the yuan slips in value, China’s exports gain an edge over the goods of other countries.

The two bureaucracies have been ferocious rivals. Accepting an injection of capital from the finance ministry could reduce the independence of the central bank, said Eswar S. Prasad, the International Monetary Fund’s former division chief for China.

“Central banks hate doing that because it puts them more under the thumb of the finance ministry,” he said.

Mr. Prasad said that during his trips to Beijing on behalf of the I.M.F., he had repeatedly cautioned China over the enormous scale of its holdings of American bonds, emphasizing that it left China vulnerable to losses from either a strengthening of the yuan or from a rise in American interest rates. When interest rates rise, the prices of bonds fall….

The finance ministry, however, has pushed for investments in overseas stocks. Last year, it wrested control of the $200 billion China Investment Corporation, which had been bankrolled by the central bank. That corporation’s most publicized move, a $3 billion investment in the Blackstone Group in May of last year, has lost more than 43 percent of its value….

Victor Shih, a specialist in Chinese central banking at Northwestern University, said that when he visited the People’s Bank of China for a series of meetings this summer, he was surprised by how many officials resented the institution’s losses.

He said the officials blamed the United States and believed the controversial assertions set forth in the book “Currency War,” a Chinese best seller published a year ago. The book suggests that the United States deliberately lured China into buying its securities knowing that they would later plunge in value.

“A lot of policy makers in China, at least midlevel policy makers, believe this,” Mr. Shih said.

Despite the seemingly confused state of play, all the dollar and Treasury bulls seem to be back in the pool. Related stories on Bloomberg are positively exuberant. We have, count ‘em, three “trend is changing” story. You’d think this was the fashion industry telling the middle class what colors were in this year. Or maybe more like Pravda, where the public is told what to think:
Treasury Bond Dealers Say Worst Over as Demand Soars at Sales

Commodity Rally May End as Supply Rises, Speculators Sell Bets

Dollar to Rise Most Since 1981, Best Predictor Says

Submitted by Leo Kolivakis, publisher of Pension Pulse.

In my last comment on the ‘Golden Cross‘, I warned people not to be overly reliant on technical signals. Someone on Naked Capitalism commented that it is better to use the exponential 50 and 200 day moving averages, which lends more weight to more recent data.

While it is true that the 50 and 200 day EMA are not showing a Golden Cross yet (you can verify this for free on Yahoo Finance, for example, on the S&P 500), there is a danger when you just look at technical signals and ignore other things like fundamentals and liquidity.

On his blog, Luc Vallée discusses the chronicles of a second wave of foreclosures and notes the following:

Another incoming large wave of home foreclosures could bring a new series of bank failures and renewed financial distress and, as a result, prolong the current economic recession well beyond 2010. This is because, according to Mckitrick, resets on Option-ARM mortgages, currently averaging $2 billion a month, will rise to $25 billion per month by late 2011; mostly in California and neighboring states. This means we could relive the nightmare of the last two last years when we went through a big wave of resets.

I have already alluded to how Alt-A resets will slam alternative investments and I think it is wise for people to understand the difference between bottoming out and a full fledged recovery.

Importantly, given the economic destruction and spare capacity in the economies of industrialized nations, it increasingly looks like the next recovery will be the weakest recovery in post-war history and expect interest rates to stay low longer than what the market is currently pricing in.

But this does not mean that the world will come to an end. Any student of economics who has studied Schumpeter’s creative destruction knows that dynamic changes are constantly occurring in the economy and that innovation will displace older mainstream industries.

Today, I want to focus on one of the new industries in alternative energy, the solar industry. I am personally invested in this industry, both long-term and short-term (trading), and I think it will be the next “new thing”.

Greentechmedia notes that the U.S. House of Representatives cleared a big hurdle late Friday by passing a bill that set goals for reducing the United States’ greenhouse gas emissions, a first in Congressional history.

The Associated Press reports that the solar industry to see faster than expected growth:

The solar energy industry will grow faster than expected during the next few years as American utilities invest heavily in large-scale solar farms, analysts with Barclays Capital said Tuesday in a research note.

Barclays analyst Vishal Shah noted that demand for utility-scale solar projects could eventually make up half of the U.S. market. Major utilities could install about 5 gigawatts of solar photovoltaic projects during the next three years, the analyst said.

Solar power is still a tiny player on the American electrical grid, however.

The utility-scale projects currently in operation in the U.S. provide 444 megawatts of energy to the grid according to the Solar Energy Industries Association. That’s enough to power 2.8 million homes, and it’s only a fraction of the power generated by another alternative energy source, the Palo Verde Nuclear Generating Station near Phoenix.

That amount is expected to jump more than 12-fold in the next few years, however, with dozens of new solar plants under development in California, Arizona, Florida and Hawaii.

Shah said SunPower Corporation, First Solar Inc., Suntech Power Holdings Co. and Yingli Green Energy will be the primary players in utility-scale projects in coming years.

Because of the banking meltdown, the expansion depends heavily on the promise of billions of federal stimulus dollars that Congress earmarked for solar in the past year.

Power companies have had trouble raising money for major projects, and they still don’t yet know how they can access federal grants and loan guarantees.

SEIA spokeswoman Monique Hanis said the Treasury Department and the Department of Energy are expected provide more information this summer.

“The sooner we can get some guidance, the sooner we can get moving on these projects,” Hanis said.

While some are skeptical of government intervention, there is no doubt that the solar industry will need strong government incentive programs to continue expanding. In California, for example, the legislature must act to keep solar glowing.

If the U.S. does not get its act together, it risks losing ground from other countries which are actively promoting the solar industry. Europe’s solar power seen competitive in 2010. Japan is relighting its solar PV industry.Beijing’s bid to boost the solar energy sector could draw more than $10 billion in private funding for projects and put China on track to become a leading market for solar equipment in the next three years.

Not everyone is convinced solar is the way to go for clean tech. Some feel a more realistic energy option to be invested in for the next 5-20 years is nuclear energy.

But all these naysayers forget that advances in photovoltaics could make solar cost competitive:

Building-integrated photovoltaics (BIPV) is poised to change the face of construction, energy and urban planning in the coming decade.

The Department of Energy has estimated that BIPV technology could potentially generate 50% of the electrical needs of the U.S. and other developed countries, and the DOE’s Solar America Initiative has set the goal of making solar cost-competitive with grid electricity by 2015.

In this continuing effort the Department of Energy just announced the selection of 24 new solar projects to advance photovoltaic technology research, development, and design, ultimately lowering the cost of photovoltaic generation. The competitively-selected projects will be eligible for up to $22 million from the President’s American Recovery and Reinvestment Act and will be matched by more than $50 million in cost shared funding from private partners.

Many of the projects selected focus on improving the effectiveness of the materials used to capture the sun’s rays.

There are some interesting things one learns in putting together a book. Blogging is a lot like working in watercolors, speed and confidence in execution are key, versus the oil-painting medium of a book. And you learn how many times you wind up scraping the canvas and reworking. I’m up to the sixth revision of one chapter, and I guarantee it isn’t the last for that one either.

Another thing is dealing with comments. Input from informed sources is critical. Better to have friendly people tell you where you are full of it when you can do something about it than learn of glaring omissions or errors after it’s in print.

But the flip side is that comments also reflect people’s personal perspectives, which means you need to watch whether your are rejecting an argument because you think it reflects a reader’s idee fixe, or whether, even if that is true, they still have a point.

The object lesson today is a chapter that discusses liquidity and leverage. I will say it’s well written, which at this stage is dangerous; I may be unduly taken with the fact that the the sentences, on the whole, are good and it moves forward. That is a far cry short of it necessarily being persuasive to someone how knows the terrain.

I’m getting pushback from one reader, an economist, who is of the view that interest rate policy played a role in the crisis (a role, mind you; it certainly was not the sole factor). His argument is a full employmemt; anything less than full employment, the US has labor slack which means rates should be lower.

I am taken with the view of Richard Alford (Tim Duy and Axel Leijonhufvud, who argue that interest rate policy was too loose since the mid-late 1990s because the Fed didn’t allow for the role of imports:

One of the interesting aspects of economic policy in the US is a belief that we exist independent of the rest of the world. In the minds of many policy makers, the US is the focus and the rest of world economy is just a stable background. To open the model up to external factors, market imperfections, and quasi-floating exchange rates would increase the complexity of the model and limit the number of policy prescriptions that could be made, so most US economists pretend that the rest of the world does not exist, is stable, or that the dollar will quickly adjust so as to maintain US external balances. It has only been in the past few years that the trade deficit has moved to a level that is clearly unsustainable….

If you look at the difference between gross domestic purchases and potential output, by US consumers, businesses, and government — all are above potential output. The only time in recent memory when the difference between these two measures started to narrow was in 2001 when we were in a recession. One of the things we need to consider is that that US may need to see consumption drop significantly before we can achieve a sustainable position, for example vis a vis the dollar…

[T]he demand side is fine. Remember, US domestic purchases are still running around 105-106% of potential domestic output. The problem is not the level of demand but rather the composition of demand. Americans are buying too many imported goods and the world is not buying enough of our exports. So we have a growing wedge growing between gross domestic purchases, which is what the Fed really controls, and net aggregate demand, which is defined as gross domestic purchases less the trade deficit. Given the inability or unwillingness of the US to correct the trade imbalance, the Fed has run expansionary monetary policy almost continuously, generating higher levels of domestic purchases so as to keep net aggregate demand near potential output. The Fed did this using low interest rates, which generated asset bubbles, large increases in consumer debt and sharp declines in savings, and also a larger trade deficit. What has been totally missing is any policy aimed correcting the external imbalance. We are relying on the tools of counter-cyclical domestic demand management to address problems caused by a structural external supply shift..

A second bone of contention is the argument that Greenspan kept rates too low too long 2002-2004. The Fed was clearly worried about deflation; recall the famous Helicopter Ben speech of 2002. But this strikes me as a mistake analogy to Japan post-bubble. The Japanese had undergone a real estate bubble of catastrophic proportions (remember the stories how a parcel of land in central Tokyo was worth more than all of California?) Banks would lend 100% against land in central Tokyo, Osaka, and Nagoya. This was a classic case of debt feeding an asset bubble, and the financial system piling on lots of loans that turned out to be bad,

By contrast, margin lending even at the peak of the tech mania was not large relative to total market cap. And unlike real estate loans, when equity values decline, either the borrower puts up more margin or the position is liquidation. The potential for losses is limited. Yes, you could have a crash, and the gap down might lead to losses, but I don’t have the impression that losses on broker loans was a major issue in the dot-com bust.

So the big effect on falling stock prices was wealth effect, and that would (did) produce a downturn. Yes, the recession might have been moderate rather than mild in the absence of (overly) aggressive Fed policy, but I don’t buy the defenses of the Fed on this one.

One bit that I think gets missed, but is hard to prove, is that we had a big structural change in the 1990s. Workers had nada bargaining power. bargaining power unless you had gambled correctly and developed very narrow skills in high demand. But lose your perch, and next best, if you don’t have a buddy who will give you a chief administrative officer job at a private company (hopefully not too small) is Home Depot or “consulting”. And if people high in the food chain don’t, imagine what it is like at the bottom. The version there was ridiculously overspecified hiring requirements.

This was due to opening of markets, and companies going hog wild (well beyond what was economically defensible) for offshoring and outsourcing. The successful outsourcing was with foreign co’s. The research is pretty unambiguous here. But companies continued to outsource and offshore even in the face of mediocre to bad success rates. Why? Wall Street expected it. It was something analysts liked hearing. And if you didn’t do it, you were a Luddite. But this was the most visible symptom of an ongoing fixation with cost reduction to boost bottom lines. I heard about this across the board, particularly companies “dis investing” as in cutting spending on stuff necessary to maintain the viability of their business long term, like advertising. And this was when the economy was good. Even though everyone is familiar with short-termism, we’ve become desensitized to what exactly it means and how it operates.

Big companies were in savage cost cutting mode from at least 1995 through now. I’m not certain I can prove what happened at medium sized companies. Suppliers were clearly squeezed, and one might assume at least ones that competed with public companies would be under pressure to match their cost-cutting efforts to stay competitive.

The proof is in the complete failure in the post 2002 expansion for workers to get ANYTHING. Prior expansions had them getting in the low 60% of GDP gains. They got only 29% this time. Prior low was 55%.

So we had the great sucking sound of jobs going to China, India, Korea, Mexico, you name it, but a fair bit of it was in excess of what was necessary to maintain competitiveness due to companies’ obsession with short term profits and cutting costs. Interest rate policy is not a great way to beat that (although we went a long way that way anyhow). Using interest rates v. unemployment as a metric against a fundamental shift like that is going to lead to bad decisions. But there are no economic models that can deal with a change like that in progress (or are there?).

The only job engine in the post 2002 period was small companies, or at least that’s conventional wisdom and I’ve seen some data releases supporting that. I need to do some checking here as to how solid that factoid is and when that pattern took hold, But assuming it is accurate, what are lower rates going to do much for them? Given big co job shedding, and medium co’s being squeezed (some as suppliers to Big Cos and subject to more cost pressures due to intense focus on cost reduction) an economy-wide interest rate cut is a VERY inefficient way to get the only type of company predisposed to create jobs to make them. Reductions in borrowing costs don’t help them directly; the vast majority have access only to credit cards, which are not too sensitive to short term rate reductions. And other loans to small business are based on prime, again a pretty sticky rate. So in the new world of anorexic companies, you have to stimulate the entire economy to get job creation by small establishments, which by the way are not stable employers.

Now I’d need to look at the right data series to see when the pattern took hold (do either of you know which series breaks out job gain/losses by establishment size//type? There is one that has only three sizes, that’s the one I have in mind), but when you start seeing job creation in a period of say 2% or greater GDP growth ONLY in the small establishment cohort, that is when interest rate policy as a way to create employment is likely to have been blunted by structural factors.

Another issue is that I think some culprits in the crisis have been overdone. My current hunch is that the reason for the explosion in debt was the use of leverage on leverage: hedge fund of funds adding another layer of borrowing to often levered hedge funds, credit market investment strategies that used leverage to meet target returns, and vehicles that were highly geared (CDOs in particular, perhaps also CMOs and CLOs).

I’m not sure one commonly-cited culprit, the SEC liberalizing capital requirements for the big five broker dealers in 2004 is as big a deal as many make it out to be. Yes, it most certainly did mean that when things got bad, they were fragile. So in the unwind their leverage played a role as a point of breakdown, But I am not certain their gearing played much of a role in creating the mess. The bigger impact no doubt was their assets were drecky and thus were more sensitive to the repricing that started when credit spreads started to blow out.

This chart shows leverage ratios, and there is no obvious smoking gun (click to enlarge). The issue seems to have been composition of the balance sheet, and (for some banks) off balance sheet commitments.

I am also not certain that SIVs played a major role. They were geared 14x. That’s higher than a bank would gear, but not hugely so. The unwind was more orderly than many expected. My impression is that the big issue here was that Citi was heavily exposed (they were far and away the biggest SIV player). But the losses on SIVs weren’t all that large relative to other culprits. This was a $400 billion product at its peak. Last data I saw was NAVs just below 70%, which means losses of under 3% ish. Even if you got to 5% losses, that’s $20 billion on the product. Am I missing something here? Now having said that, Cheyne did liquidate for 44 cents on the dollar, but I didn’t see any other reports of that ilk.

Reader comments encouraged, Pointers to relevant data and research particularly appreciated. Feel free to write me at yves@nakedcapitalism.com

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