naked capitalism

By Andrew Kaplan, a hedge fund manager:

It has become fashionable among equities managers of the bullish persuasion to argue that a strong recovery in GDP will occur in 2010 because the “structural adjustment period” of moving back to a more normal savings rate has been completed. We’ve gone from a savings rate of barely 1% in 2008 up to 4.2% in July (ok, so the argument sounded better when the number was 6.2% in May, but still…).

The story goes something like, “consumers took a little time to recognize that their home equity had disappeared, but now they’ve adjusted their savings rates toward the desired level to reflect the fact that they need to save a larger proportion of income for retirement…so this effect will no longer be a drag on growth in coming quarters.”

This is the kind of conventional wisdom which could only emerge among folks in the 99^th income percentile who spend their time primarily with other folks in the 99^th income percentile. You don’t have to look at the data (mortgage delinquencies, foreclosures, credit card defaults, bankruptcies) all that hard to see a very different picture. In fact, it is almost certainly true that the savings rate for 99% of the US population is negative. These people (a/k/a “all of us”) are drowning. And to the extent that our savings rate is less negative than it was one or two years ago, that simply reflects the reality of reduced home equity and unsecured credit lines rather than any conscious effort to reach a “desired level” of savings.

A little data might help here. Unfortunately, there really IS no good data on PCE (personal consumption expenditure) and savings stratified by income percentile. There are a couple of surveys, the triennial “Survey of Consumer Finances” by the Federal Reserve and the “Consumer Expenditure Survey” by the Bureau of Labor Statistics, but the self-reported data is laughable. For 2007, the Consumer Expenditure Survey showed a personal savings rate of 18.4%. In the same year, the Bureau of Economic Analysis, which calculates the savings rate as a residual from actual income and expenditure data, showed a savings rate of 1.7%. Either the Consumer Expenditure Survey does a poor job of sampling, or people who fill out surveys are really big liars.

Fortunately, there IS some pretty good data on income stratification in the United States, and a few assumptions can help shed some light. Economists Thomas Piketty and Emmanuel Saez have made careers of studying US income inequality using IRS data, which goes back to 1913. The most recent data available (for 2007) showed that the top 14,988 households (0.01% of the population) received 6.04% of income, the highest figure for any year since the data became available. The top 1% of households received 23.5% of income (the second highest on record, after 1928), while the top 10% received 49.7% of income (the highest on record).

The fortunate 14,988 had an average income in 2007 of $35,042,705. They had an average federal tax burden, according to Piketty and Saez, of 34.7%, leaving them after tax income of $22.9 million. If you assume a 50% savings rate among this group, you get total savings of $171.5 billion. This is nearly ONE HALF of the total savings for the entire country implied by a savings rate of 4.2% ($365 bn) reported in this month’s Bureau of Economic Analysis data.

I’ve never actually had an after tax income of $22.9 million, so I couldn’t say for sure whether a 50% savings rate is a reasonable assumption, but I’m going to go out on a limb and say that it is, just based on the pure physics of spending money. Buying cars, clothes, and fancy dinners, even at Masa, won’t get you there…the math doesn’t work. Buying a private jet could get you there, but most people, even rich people, don’t buy one of those every year. The only EASY way to spend more than 50% of $22.9 million on an annual basis is to buy lots of houses…but the definition of “personal consumption expenditure” used by the BEA specifically excludes purchases of real estate. They use an imputed rent calculation instead. So I’m going to stick with my 50% number.

If we expand our survey to the top 1% of all households, we find an average income of $1.36 million for 2007. These folks had an average federal tax burden of just under 33%, so their after tax income averaged $916 thousand. If you assume this group had a savings rate of 33%, you get total savings of $452 billion (remember, $171.5 bn of this comes from the top 0.01%, we’re assuming a savings rate of around 25% of after tax income for the “poorer” 99% of the top 1%) This is more than 100% of the personal savings of the entire population, according to the BEA data. It implies that 99% of the US population still has, on average, a negative savings rate of around 1.3%. If you subtract the next nine percent, which likely still has a positive savings rate, the data for the bottom 90% becomes even more depressing, implying a negative savings rate of close to 5%.

The Republican Death Machine Jacob Weisenberg, Slate (hat tip reader John D)

Marijuana’s new high life Los Angeles Times (hat tip DoctoRx)

Physicists successfully predict stock exchange plunge New Scientist (hat tip reader John D)

Swiss “Black” Accounts – A Trillion Dollar Problem Bruce Krasting

More Foreclosures Than Home Sales, Again Rich Toscano

Flu pandemic’s impact seen as mixed for U.S. stocks Reuters

Anti-speculation push may topple oil prices Reuters hat tip reader Michael)

The Final Days of Merrill Lynch William Cohan, Atlantic

Antidote du jour:

Clearly, the spin is in. As a post earlier today discusses, the Financial Times is running a story that claims that the Fed made money on its rescue programs, then slips in all the tidbits in the body of the article to let discerning readers know that the reporter understands that the analysis is utter rubbish while looking like it is not crossing the Fed.

In a simply remarkable coincidence of timing, the New York Time running a story with the very same message, namely that bailouts are good for taxpayers because the Treasury has made money on the TARP.

If you believe that, I have a bridge in Brooklyn I’d like to sell you. The fact that we have such patent garbage running as a front page New York Times story says either the reporter and his editors lack the ability to think critically (or find sources who could do that for them) or that we have a controlled press. Given that subscriber-driven Bloomberg has even fallen in line, I am inclined to the latter view, but I am still curious as to how this has been achieved. Is this the price of access journalism, or is something more pernicious at work?

Now to the intellectually bankrupt New York Times story. Here is how it determined the TARP was making money:

The profits, collected from eight of the biggest banks that have fully repaid their obligations to the government, come to about $4 billion, or the equivalent of about 15 percent annually, according to calculations compiled for The New York Times.

Help me. Credit 101 is that your best borrowers repay first (unless you gave them overly generous terms, of course, then they might hang on to the proceeds). A quick but not conclusive search suggests that only a small portion of the TARP has been retired, so it is wildly premature to declare victory.

In fact, another source looked at the TARP as of June and estimated that it had lost $148 billion, and had lowered loss total as a result of the repayments. Now bank stocks have rallied since then, but the biggest contributors to the red ink, namely AIG and Citigroup, are not in any better shape fundamentally than they were then. Indeed, the fact that new AIG CEO Robert Benmosche has in a remarkable show of hubris, effectively told the US taxpayer to stuff it, AIG has the dough and is in no particular hurry to return it, nor does it care what the public or Treasury wants, its demands are unreasonable. I wouldn’t hold my breath about having the loans repaid.

Moreover, the piece contains a huge canard:

But the real profit came as banks were permitted to buy back the so-called warrants, whose low fixed price provided a windfall for the government as the shares of the companies soared

Roger Ehrenberg already dispatched this goofy idea with admirable zeal:

The US taxpayer has been systematically looted out of hundreds of billions of dollars….Goldman Sachs is posting record earnings and will invariably be preparing to pay record bonuses, not nine months after the firm was in mortal danger? Whether anyone will admit it or not, without the AIG (read: Wall Street and European bank) bail-out and the FDIC issuance guarantees, neither Goldman nor any other bulge bracket firm lacking stable base of core deposits would be alive and breathing today.

Goldman is a great firm with a stellar culture, and in most circumstances it’s risk management and funding practices have been second to none. Except when the crisis hit. It stood with the rest of Wall Street as a firm with longer-dated, less liquid assets funded with extremely short-dated liabilities….In exchange for giving the firm life (TARP, FDIC guarantees, synthetic bail-out via AIG, etc.), the US Treasury (and the US taxpayer by extension) got some warrants on $10 billion of TARP capital injected into the firm….. Lloyd Blankfein smartly paid the full $1.1 billion requested. He looked like a hero for doing so, a true US patriot repaying the US Government in full for its lifeline, thanking the US taxpayer in the process. $1.1 billion… $1.1 billion…Hmm…something doesn’t seem right. You know why it doesn’t seem right? BECAUSE THE US TREASURY MIS-PRICED THE FREAKING OPTION.

There is not a Wall Street derivatives trader on the planet that would have done the US Government deal on an arms-length basis. Nothing remotely close. Goldman’s equity could have done a digital, dis-continuous move towards zero if it couldn’t finance its balance sheet overnight. Remember Bear Stearns? Lehman Brothers? These things happened. Goldman, though clearly a stronger institution, was facing a crisis of confidence that pervaded the market. Lenders weren’t discriminating back in November 2008. If you didn’t have term credit, you certainly weren’t getting any new lines or getting any rolls, either. So what is the cost of an option to insure a $1 trillion balance sheet and hundreds of billions in off-balance sheet liabilities teetering on the brink? Let’s just say that it is a tad north of $1.1 billion in premium. And the $10 billion TARP figure? It’s a joke. Take into account the AIG payments, the FDIC guarantees and the value of the markets knowing that the US Government won’t let you go down under any circumstances. $1.1 billion in option premium? How about 20x that, perhaps more. But no, this is not the way it went down….

But no, if you subscribe to the world according to the New York Times, you’d think we the long suffering taxpayer got a really good deal. By extension, we should be really happy if financial firms throw themselves off the cliff again en masse, since that will give us all the opportunity to make even more money by rescuing them!

From derivatives expert Satyajit Das of Traders, Guns & Money fame:

In the 1980s, the Japanese were taking over the world. In the 1990s, it was going to be an ‘Asian’ century. These days the pundits are betting on the ‘Chinese Age’. Like all such glib predictions, despite their superficial appeal, they mask complex undercurrents and issues that require careful study.
Michael Schuman, a business journalist, in ‘The Miracle: The Epic Story of Asia’s Quest for Wealth’ tries to describe the transformation that has taken place in Asia over the last 30 years. Schuman covers the post-war reconstruction built on electronics and heavy industry through to the age of outsourcing. The story is personalised and ‘The Miracle’ is at its best when recounting rich anecdotes about the politicians, such as Deng Xiaoping and Park Chung Hee, and business leaders, such as Sony’s Akio Morita and Wipro’ Azim Premji. Schuman’s snappy journalistic style adds colour and insight to the stories.

The Miracle traces the importance of globalisation of trade and capital flows as well as the role of America in the development of Asia. It perhaps understates the less than benign role played by the state in fostering economic development. The Book also is very forgiving of the political repression, social in-equalities and environmental degradation that underpin Asian development.

The defence would probably be that there are always costs to dragging millions out of poverty. In truth, the average business book reader would not be particularly concerned about those issues.

Paul Midler’s ‘Poorly Made in China’ offers a different perspective that is loquaciously captured in the lengthy sub-title ‘An Insider’s Account of the Tactics Behind China’s Production Game’ (obviously a Twitter marketing ploy!). A businessman who has worked in numerous factories in China, Midler provides interesting and, at times, scarily funny insights into a system that produces products that fail basic safety and manufacturing standards.

Midler identifies the process by which buyer demand for cheap products and the Chinese manufacturers willingness to meet the requirements lead to what he characterises in the chilling anodyne term – ‘quality fade’. This is the process by which manufacturers take increasing liberties with quality to eke out profits from unprofitable contracts. This entails cheaper components, altering chemicals, lower hygiene standards and, in general, lower everything.

Midler describes the process whereby manufacturers compete to gain unprofitable contracts to make sought after products. The sole reason is that access enables Chinese manufacturers to gain access to intellectual property allowing the manufacture of lucrative ‘knock-offs’ in places where patents and trademarks cannot be enforced.

Midler acutely records the tensions between buyer and manufacturers and the entire flawed system where ultimately the only true product control and testing is by the final consumer, sometimes, as in the case of the melamine contaminated milk, with tragic consequences

‘Poorly Made in China’ provides an interesting alternative to the hagiographic view of globalisation and trade much favoured by the Thomas Friedman’s of the world.

Underlying both ‘The Miracle’ and ‘Poorly Made in China’ is a view of the emerging world best captured by the term ‘Orientalism’, associated with Edward Said. A Palestinian academic, Said’s writings on colonialism explored the caricatures, cliches and pre-conceptions that shaped Western perception and therefore relationships with Eastern nations. Said’s argument was that the West’s view of the East was shaped by political power and unequal commercial exchange.

Said’s work built on George Orwell’s criticism of colonialism. Writing in 1939, Orwell provided a vivid and stark view of the developing world that has rarely been equalled: “When you walk through a town like this – two hundred thousand inhabitants, of whom at least twenty thousand own literally nothing except the rags they stand up in – when you see how the people live, and still more, how easily they die, it is always difficult to believe that you are walking among human beings. All colonial empires are in reality founded upon the fact. The people have brown faces – besides they have so many of them. Are they really the same flesh as yourself? Do they even have names? Or are they merely a kind of undifferentiated brown stuff, about as individual as bees as coral insects? They arise out of the earth, they sweat and starve for a few years, and then they sink back into the nameless mounds of the graveyard and nobody notices that they are gone. And the graves themselves soon fade back into the soil.”

The unwritten sub-text is that the East is there as a resource for the West. Developments are read and interpreted through the cultural lens of Western literary and economic tradition. ‘The Miracle’ and ‘Poorly Made in China’ are books in the ‘Orientalist’ tradition, which sees Asia as little more that a vast market, a cheap manufacturing base, (recently) a source of money and an opportunity for developed nations. The books never quite see the world from the point of view of the nations and people that they describe.

‘Prisoner of the State’, the secret journal of former Chinese Premier Zhao Ziyang, provides something of an antidote to a Western view of East Asia.

Remembered now mostly for his disastrous role in the Tiananmen Square student protests and subsequent massacre, Zhao Ziyang was Premier of the People’s Republic of China from 1980-1987, and General Secretary of the Communist Party from 1987-1989. He was involved, with Deng Xiaopeng, in the economic reform of China. Produced from smuggled tapes during his house arrest after being removed from power as a result of his role and handling of the Tiananmen Square protests, Zhao produced a memoir covering details of the crackdown, the intricate manouverings of China’s leadership, and the economic reform program.

While the focus around the book has been on the sensational events around the protests and subsequent crackdown, ‘Prisoner of the State’ provides interesting insights into the rationale behind China’s economic reforms.

Anecdotes of Zhao’ overseas trips, where he begins to gain exposure to the glittering riches of overseas economies, provides a vivid backdrop to the changes in economic policy. The interest in reforms appears driven entirely by pragmatic rather than ideological concerns, such as declining living standards, concern about food security, observed inefficiencies in productivity and fear that economic failure would mean political ruination.

Zhao’s notes were clearly predicated on ‘his’ version of history. His commentary on leadership struggles and the complex interplay of different individuals and camps are difficult to verify to those without a deep understanding of the inner workings of China. His views on the weaknesses of the system, especially the issue of corruption and the sheer difficult of political and economic management of vast complex country, are extremely relevant. They show the difficulties of making simple predictions about the evolution of China.

The book is illuminated by the hidden tragic sub-text that this is ultimately the story of a man who finds himself a victim of a system that he entirely understands and helped create. In the end, Zhao does not quite understand this irony.

Unlike other books on Asia, ‘Prisoner of the State’, despite its flaws, provides insights not found in traditional perspectives on emerging nations grounded in the simplistic world of ‘El-dollardo Economics’.

I know it may be hard for most readers to believe this, but once upon a time, the New York Times really was a very good paper. I trace its demise to its decision to become a national newspaper, which took place in the later 1990s, instead of a New York city newspaper that set national standards.

That is not to say the Times was perfect, Lord knows it wasn’t, but the average quality was high and there was not too much deviation in the caliber of its stories. Now, while the good stories are still fine indeed, the quality is inconsistent, and there are too many articles that look to be PR plants or are otherwise too obviously hewing to some sort of party line.

Like the New York Times, the Financial Times has decided to become important paper in the US, and the caliber of the paper as a whole has deteriorated. Yes, it still has some excellent reporters and columnists, but it like the Times has taken to writing up tidbits from influential sources with a notable lack of critical thought. I wish I could have my FT circa 2006 back.

Today’s object lesson is a story now on the front page of the Web edition that reports that the Federal Reserve “earned” $14 billion on its special facilities, according to an unpublished estimate by the central bank. That calculation is based on the interest it earned in excess of what it would have made on T-bills. The article then says,

The Fed assessment underlines the possibility that other central banks could make a profit on their crisis-fighting measures – at least before adjusting for the risk they assumed.

And a few paragraphs later, we get another caution:

The figure is not a complete picture of Fed finances as it excludes its company-specific bail-outs and purchases of long-term assets.

Ahem, that means it excludes some elephants in the room, such as the AIG and Bear rescue facilities. The Fed was ‘fessing up to combined losses of nearly $8.6 billion on them as of July. Willem Buiter and anyone else of a reasonable skeptical persuasion thought those losses were understated. And then we have the untallied losses on the Fed’s $1.050 trillion program of purchases of mortgage-backed securities and Treasuries. Unless the US winds up in Japan-style long-term mild deflation, those purchases are very likely to be worth less than what the Fed paid for them.

While the FT offers the right caveats. the “let’s not look at this palaver too deeply” posture means it sidesteps the real story. If anyone at the Fed treated this bogus analysis seriously, it says the Fed is not competent to oversee anything more complicated than a dog pound. pricing in the option to renew it or adjust the balance size periodically is missing a very big part of the real value here. The Fed is not going to deny renewal of these loans. Similarly, judging performance by comparison to a risk free asset is obviously bogus. Any student in a basic finance course who did a simple spread comparison, failed to assign a risk premium appropriate to the borrower, and ignored the option value of these facilities would get an F.

Since we assume that someone at the Fed does understand these issues, we are left with a second line of thinking which is actually not much more favorable to the central bank, namely, that it holds the financial press and the public in contempt and figures they will buy any and every superficial and misleading explanation, so long as it has a few numbers attached. The fact that the Financial Times dignified this rubbish will only reinforce the Fed’s imperial tendencies.

And the public is not as dumb as the Fed assumes it is. The Financial Times notes:

A recent Gallup Poll found the Fed had the worst public approval rating of nine government agencies, even lower than the tax authorities.

Senate Hearing On Brain Cancer Risks From Cell Phone Use Nears As New Study Is Released News Junkie Post (hat tip reader John D)

42.90 Euros Per Arm Der Spiegel (hat tip Tim Coldwell)

London’s Luxury Homes Sell at the Fastest Pace Since July 2007 Bloomberg

US Equity Markets Look Dangerously Wobbly As Insiders Sell In Record Numbers Jesse

The Grapes of Wrath revisited: The plight of Native Americans Guardian

U.S. Farm Profit Plunging on Lower Crop, Dairy Prices Bloomberg

Thanks to the Deficit, the Buck Stops Here Joseph Stiglitz, Washington Post

Antidote du jour:

Barney Frank is joining the “rein in the Fed” party, with a key distinction: he wants to steer clear of messing with the central bank’s independence in monetary affairs. Thus, the call for a Fed audit ex that activity is not surprising.

However, a possible new front is that Frank also wants to place some curbs on the Fed’s authority to lend to anyone it wants to in “unusual and exigent circumstances.” This is another blow against the idea of Fed as systemic risk regulator, a role it lists on its website as part of its mission, but was never authorized by Congress.

The Fed (and no doubt many bankers) will howl that these powers are necessary for the Fed to safeguard banks, now that markets and exposures are so enmeshed. And Frank may not be serious about winning on this issue, but may regard it as tactically useful to take a particularly aggressive stance here to make sure the Fed does not become the One Regulator to Rule Them All.

From Reuters:

Rep. Barney Frank, the chairman of the U.S. House of Representatives Financial Services Committee, said he plans legislation to restrict the Federal Reserve’s emergency lending powers and subject the central bank to a “complete audit.”

At a recent town hall meeting, Frank said the House would pass a bill to use an audit to crack open the central bank’s books more widely, but in a way that will not encroach on the central bank’s monetary policy independence.

In addition, he said the House would move to rein in the authority that allows the Fed to lend to a wide range of non-bank firms in “unusual and exigent circumstances.”….

Frank said the audit and emergency lending provisions would be incorporated in broader legislation to revamp U.S. financial regulation that would likely pass the House in October. By seeking a compromise with [Ron] Paul, Frank could strengthen the broader legislation’s chance at passage…

Frank said the House legislation would pave the way for an audit to look into what the central bank “buys and sells,” but he said the data would be released after a period of several months to avoid impacting financial markets.

We will be transitioning this site from Blogger to WordPress (and a new hosting service) this evening. The ability to leave comments will be disabled for approximately an hour until the transfer is complete. There may be up to a 20 minute service outage when the actual switch happens.

For readers there should be no changes required to continue reading us via the website, email or newsfeed. However anyone posting comments or articles (i.e. guest bloggers) will notice a few changes to the editor interface.

There will be another notice posted here once the transition is complete.

Even if you don’t get a thrill from looking at spectacular car wrecks, one reason to take interest in the Lehman bankruptcy is that it may get at issues that regulators seem remarkable loath to address, namely, how did a company that reported positive net worth and not a single big firm equity analyst ever dreamed was insolvent wind up showing $130 billion of losses? The US administrator, which aspires to coordinate the entire international BK, has blamed the size of the black hole (on a $640 billlionish balance sheet) on the disorderly bankruptcy.

I’m sorry, losses of that magnitude are simply not plausible, particularly when you have to add back the $20 plus billion of book equity prior to the collapse. Yes, much of it may indeed have been the result of a sudden implosion, but the fact set strongly suggests accounting fraud was also a factor (for instance, Lehman had some notoriously aggressive marks on some high profile Inland Empire white elephants, namely Archstone and SunCal. If they had to put valuations like that on deals that were certain to raise eyebrows, what must one assume about positions that would be impenetrable?

But the bankruptcy jousting does have its perverse charms. The move by Alvarez & Marsal to expand its role in an unprecedented fashion by coming up with a “global plan” seems more than a bit peculiar, given the fact that bankruptcies are subject to governing law in the relevant jurisdictions, and is not well suited to coordination. In fact, one hat to wonder whether this move is simply an attempt to co-opt counsel in other countries.

The UK liquidator, PriceWaterhouseCoopers, took a dim view of this notion from the outset, perhaps in part because it was clear that the UK units would be seeking redress from the US operation. Lehman raided the UK brokerage operation of $8 billion in its waning days, something that would be impermissible under US regulations.

The latest update comes via the Times Online:

Administrators of the London arm of Lehman Brothers…are preparing a $100 billion (£61.5 billion) claim against its former parent company in America…. It will mark an acrimonious new stage in the international battles by creditors to recover billions still tied up in the largest corporate collapse in history….

John Suckow, president of Lehman Brothers Holdings — the remains of the US parent company — and a managing director at liquidator Alvarez & Marsal, is braced for a deluge of claims. The one from the London arm, which was the largest operation outside America, is likely to be the biggest.

Tony Lomas, one of the partners at PWC leading the case, said he will file on behalf of “more than 100” Lehman units that fall under the London umbrella. “On the face of it guaranteed most of the obligations of other subsidiaries so we’re going to be filing claims in the many tens of billions. It will be close to $100 billion,” he said.

The London claim will add to tensions between American and British administrators. Earlier this month, Alvarez & Marsal brokered an agreement with 13 other Lehman liquidators around the world.

The deal sets a protocol to share information on claims and assets with the hope of speeding up the reconciliation process and avoiding litigation. PWC declined to participate.

“Why you’d enter into an agreement with a bunch of other parties that you’ll probably end up litigating against is beyond conception,” said Steve Pearson, another PWC partner working on the case.

“We’re talking about billions of dollars. To sit in a room and say, ‘we’re all going to be nice to each other’, is almost certainly the wrong thing to do.”…

As the ultimate guarantor of the deals they did, including billions on inter-company loans and share trades, the former Lehman businesses will argue that the US parent should pay.

At the time of its collapse, Lehman had $639 billion in assets on its books. These included everything from real estate to office equipment. The most tangled element is the more than 1.7m “hung trades” to which Lehman was a party — transactions in shares or instruments such as derivatives that were frozen when the company collapsed.

Deer ‘fakes death’ to escape cheetah and a hyena: video Telegraph

Police baffled as dozens of ‘suicidal’ cows throw themselves off cliff in the Alps Daily Mail (hat tip reader Jim C)

‘Stress’ is shrinking polar bears BBC (hat tip reader John M)

Scientists: Tick saliva may hold cure for numerous cancers Raw Story

Elders Leading the Charge, Frugality-Wise Michael Panzner

Pensioners ‘stay in bed’ to cut fuel bills Telegraph

Corporate Sleuth Plans to Start Credit Rating Firm New York Times. This is a simply brilliant brand extension. Whether they are any good at it remains to be seen.

Halting Recovery Divides America in Two Wall Street Journal

Rakoff Pokes Further at Attorney-Client Privilege in Bonus Case American Law Daily (hat tip reader Stuart L)

The Debts of the Spenders: The Dollar Carry Trade – Cheaper to Borrow than Yen The Debts of a Nation

America’s deepening inferiority complex begins to bite Russia Russia Today (hat tip reader John D)

Antidote du jour:

It must be lonely being a China bear….particularly for those dubious about its longer term prospects, as opposed to those who might simply think its stock market is a bit ahead of itself even after its recent correction.

Vitaliy Katsenelson, in an article at MorningStar, beings almost sounding a tad persecuted before he warms up to his theme. that there is more in common between Japan in the late 1980s, when it seemed poised to continue its inexorable rise and China today. And the differences for the most part favor Japan. Katsenelson first quotes Jim Grant at length, then offers his own comments.

From Morningstar (hat tip reader Michael):

China today is where Japan was in the late ’80s, except with the greater political instability that comes with a semi-controlled economy and the lack of a social safety net (read: jobless, hungry people don’t write angry letters, they riot)…Today China projects to the world a similar image as Japan did in the 1980s…

Lately, the Chinese economy has been impressing us with its growth…But Chinese economic structure is not is not superior to the West’s; the Chinese can just cook GDP numbers better and control their economy more effectively through forced lending and spending.

However, these short-term advantages come with long-term consequences – there will be a steep price to pay for them; there always is. I’ve written a lot about this (here and here). Instead I’ll quote James Grant, the publisher of Grant’s Interest Rate Observer. Jim is providing the latest issue of his newsletter free…Here are a few quotes …:

“A superb primer on the risks of China’s go-for-broke lending drive was published by Fitch Ratings on May 20. Is it not passing strange, the agency asks, that Chinese lending is accelerating even as Chinese corporate profits are shrinking? ‘Ordinarily, falling corporate earnings are met with tightened lending, but in China, precisely the reverse is evident. . . .’ You would expect—and Fitch does anticipate—that the borrowers of these trillions of renminbi are not so profitable as they were in the boom, and some will therefore struggle to service their debts.”

I think this chart, also excerpted from Grant’s Interest Rate Observer, tells the full story of the quality of China’s latest growth…

“Examining, first, the track of Chinese bank lending and, second, the trend in Chinese nonperforming loans, the seasoned reader will remember … Drexel Burnham Lambert. In the mid-to-late 1980s, the American junk bond market combined breakneck growth with muted default rates. The secret, fully revealed during the subsequent bear market, was that the default rates were a direct product of the issuance rates. Borrowers didn’t default because of—to adapt the Fitch formulation to that earlier time—the ‘pervasive rolling over and maturity extension of bonds as they fell due.’ Drexel failed when the junk market did.

Yves here. Hyman Minsky fans will recognize this as his Ponzi unit paradigm. Back to Grant via Morningstar:

“Since 2005, China has generated 73% of the global growth in oil consumption and 77% of the global growth in coal consumption.” [emphasis is mine]

Yves here, I know extended quotes in blog posts can be a bit confusing. We are now done with Jim Grant and are back to Katsenelson in a second of two linked articles:

Today, Chinese economic growth is the force pushing the global economy. The quality of this growth, however, is low as it is predicated on massive (forced) lending and thus unsustainable. As Chinese growth slows, China will turn from a wind into sails of global economy to its anchor. The impact will be felt in many, often unsuspected places.

It will tank the commodity markets, commodity producers and commodity exporting nations. Let’s take oil, for instance. As incremental demand from China collapses, oil prices will follow, taking the Russian economy with it, as Russia is for the most part a one-trick-petrochemical-pony. According to GavKal Research China accounts for 15% of Brazil’s exports (up from 1.5% a decade ago), significantly impacting the economy of that South American nation..

Demand for industrial goods will fall off the cliff. China consumed a lot of those goods – $550 billion worth annually (also according to GaveKal Research). So if Caterpillar expects to sell more of its yellow earthmovers to China, it will have put that thought on hold for awhile…..

Finally, Chinese appetite for our fine currency will diminish, driving the dollar lower against the renminbi and boosting our interest rates higher. No more 5% mortgages and 6% car loans.

Identifying bubbles is a lot easier than timing them. An astute observer could have seen the Japanese bubble developing in 1986, 1987 and 1988, but he would have been “wrong” until 1989….

Yves again. The other reason to take this gloomy appraisal seriously is that in the Great Depression, it was the big exporter (the US) that faced the most difficult adjustment. Overconsuming indebted countries in Europe simply defaulted.

Conspiracy theorists will have to wait until the article described in Inside Science is published to determine whether it delivers on its claims. It purports to analyze stock holding across 48 countries and alleges they are held in very few hands. But the work was done by physicists, which means they may not have understood the limits of the data they were working with.

I suspect this will wind up resembling a paper a friend studied in his graduate level statistical methods course over two decades ago (he has since gone on to a successful career in academia). Everyone in the seminar was assigned a single paper and told to analyze the techniques used and to present their findings to the class. This was the sole basis for the grade.

The paper my buddy got had already created a bit of a stir, although it had not yet been published. The author had looked at the prices at which the Fed did its daily operations (then the famed “noon buying rate”) and compared it to the results of Treasury auctions. The paper concluded the Treasury was doing a terrible job, as demonstrated in all sorts of analyses.

When my friend’s day to present came, he stood up and said, “I have only one comment to make. The Fed conducts its daily operations in transaction sizes ranging in the millions. Treasury auctions are in the billions. The Fed data is irrelevant to the Treasury analysis,” and sat down.

He received an A.

In this case, an obvious fly in ointment is many (most?) stocks are held in street name, meaning in the name of the brokerage firm or fund, not the ultimate owner. I presume it is impossible to segregate accounts where the broker has discretion to trade versus those where the clients simply trades through the securities firm.

But even if the analysis is flawed, it might stir up some interesting discussion.

From Inside Science (hat tip reader John D):

A recent analysis of the 2007 financial markets of 48 countries has revealed that the world’s finances are in the hands of just a few mutual funds, banks, and corporations. This is the first clear picture of the global concentration of financial power, and point out the worldwide financial system’s vulnerability as it stood on the brink of the current economic crisis.

A pair of physicists at the Swiss Federal Institute of Technology in Zurich did a physics-based analysis of the world economy as it looked in early 2007. Stefano Battiston and James Glattfelder extracted the information from the tangled yarn that links 24,877 stocks and 106,141 shareholding entities in 48 countries, revealing what they called the “backbone” of each country’s financial market. These backbones represented the owners of 80 percent of a country’s market capital, yet consisted of remarkably few shareholders.

“You start off with these huge national networks that are really big, quite dense,” Glattfelder said. “From that you’re able to … unveil the important structure in this original big network. You then realize most of the network isn’t at all important.”

The most pared-down backbones exist in Anglo-Saxon countries, including the U.S., Australia, and the U.K. Paradoxically; these same countries are considered by economists to have the most widely-held stocks in the world, with ownership of companies tending to be spread out among many investors. But while each American company may link to many owners, Glattfelder and Battiston’s analysis found that the owners varied little from stock to stock, meaning that comparatively few hands are holding the reins of the entire market.

“If you would look at this locally, it’s always distributed,” Glattfelder said. “If you then look at who is at the end of these links, you find that it’s the same guys, [which] is not something you’d expect from the local view.”

Matthew Jackson, an economist from Stanford University in Calif. who studies social and economic networks, said that Glattfelder and Battiston’s approach could be used to answer more pointed questions about corporate control and how companies interact….

Based on their analysis, Glattfelder and Battiston identified the ten investment entities who are “big fish” in the most countries. The biggest fish was the Capital Group Companies, with major stakes in 36 of the 48 countries studied. In identifying these major players, the physicists accounted for secondary ownership — owning stock in companies who then owned stock in another company — in an attempt to quantify the potential control a given agent might have in a market….

Glattfelder added that the internationalism of these powerful companies makes it difficult to gauge their economic influence. “[With] new company structures which are so big and spanning the globe, it’s hard to see what they’re up to and what they’re doing,” he said. Large, sparse networks dominated by a few major companies could also be more vulnerable, he said. “In network speak, if those nodes fail, that has a big effect on the network.”

The results will be published in an upcoming issue of the journal Physical Review E.

Bloomberg reports that Wall Street is back to its free-wheeling, high-levered ways. This is a classic example of moral hazard in action. Why worry about blowing up the bank when you know the taxpayer will bail you out?

From Bloomberg (hat tip DoctoRx):

Banks are increasing lending to buyers of high-yield company loans and mortgage bonds at what may be the fastest pace since the credit-market debacle began in 2007.

Credit Suisse Group AG and Scotia Capital, a unit of Canada’s third-largest bank, said they’re offering credit to investors who want to purchase loans. SunTrust Banks Inc., which left the business last year, is “reaching out to clients” to provide financing, said Michael McCoy, a spokesman for the Atlanta-based bank. JPMorgan Chase & Co. and Citigroup Inc. are doing the same for loans and mortgage-backed securities, said people familiar with the situation.

“I am surprised by how quickly the market has become receptive to leverage again,” said Bob Franz, the co-head of syndicated loans in New York at Credit Suisse. The Swiss bank has seen increasing investor demand for financing to buy loans in the past two months, he said.

Federal Reserve data show the 18 primary dealers required to bid at Treasury auctions held $27.6 billion of securities as collateral for financings lasting more than one day as of Aug. 12, up 75 percent from May 6.

The increase suggests money is being used for riskier home- loan, corporate and asset-backed securities because it excludes Treasuries, agency debt and mortgage bonds guaranteed by Washington-based Fannie Mae and Freddie Mac of McLean, Virginia or Ginnie Mae in Washington. Broader data on loans for investments isn’t available.

Yves here. That is a big increase in repo lending. Greenspan used to look at repos as a proxy for hedge fund leverage. And when repo lending contracts, as it did in the crisis, it tends to do so across a wide range of collateral as banks increase haircuts, leading to synchronized downturns.

And we get these tidbits:

The increase over that 14-week stretch is the biggest since the period that ended April 2007, three months before two Bear Stearns Cos. hedge funds failed because of leveraged investments….

Yields on top-ranked debt backed by auto loans and credit cards have fallen by as much as 2 percentage points relative to benchmark rates. The yield premium has shrunk to less than 1 percentage point since TALF began in March, according to Charlotte, North Carolina-based Bank of America Corp. data. The average interest rate on loans for new cars declined to 3.88 percent in June, from 8.23 percent in January, Fed data show.

Yves again. Note how auto lenders, who are mainly out to subsidize sales, are passing on the improvement in terms, while banks are instead using the fatter margins on credit cards to boost profits.

We clearly have not learned the lessons of the crisis, that leverage increases risk and fragility, period. We’ve thrown massive backstops against the financial system with no checks on risk-taking, and we are getting precisely the sort of behavior you’d expect. Worse, everyone assumes any problems would arise gradually, when shifts tend to be suddenly, more like phase changes. As an op-e, “This Economy Does Not Compute,” by Mark Buchanan in the New York Times last year noted:

For example, an agent model being developed by the Yale economist John Geanakoplos, along with two physicists, Doyne Farmer and Stephan Thurner, looks at how the level of credit in a market can influence its overall stability.

Obviously, credit can be a good thing as it aids all kinds of creative economic activity, from building houses to starting businesses. But too much easy credit can be dangerous.

In the model, market participants, especially hedge funds, do what they do in real life — seeking profits by aiming for ever higher leverage, borrowing money to amplify the potential gains from their investments. More leverage tends to tie market actors into tight chains of financial interdependence, and the simulations show how this effect can push the market toward instability by making it more likely that trouble in one place — the failure of one investor to cover a position — will spread more easily elsewhere.

That’s not really surprising, of course. But the model also shows something that is not at all obvious. The instability doesn’t grow in the market gradually, but arrives suddenly. Beyond a certain threshold the virtual market abruptly loses its stability in a “phase transition” akin to the way ice abruptly melts into liquid water. Beyond this point, collective financial meltdown becomes effectively certain. This is the kind of possibility that equilibrium thinking cannot even entertain.

Now this is admittedly just a model, but it seems far more descriptive of what we’ve just been through than anything the Fed appears to be using. And if it proves valid, relevering will proceed until we hit a trigger point again.

This was too good to pass up. The key section of an offering at The Reformed Broker (hat tip reader Gonzalo):

The Five Stages of Panic Buying!

1. Denial (Late March/ Early April)

“Ha, another Bear Market rally…wait til the foreclosure/ new home sales/ confidence data comes in! Right back to 6500, maybe lower…bagholders”

“Dude, the stress tests are coming out next month. B of A may be done-ski. Sell the May 10 calls, you’ll never have to cover.”

2. Anger (Mid-April)

“What the f@&% do you mean the goddamn banks are cheap based on normalized earnings? They will never ever earn anything again, ever! Idiot!”

“You gotta be kidding me with these retailers running now. RETAILERS? Are you nuts? They’re FINISHED!”

“If one more consumer discretionary name rallies on a less-than-expected loss, I’m gonna kick this Bloomberg down a flight of stairs.”

3. Bargaining (May-June)

“Okay, I can stomach picking up some large cap tech and I’ll nibble – NIBBLE! – at discount retailers, but I will absolutely NOT buy Goldman Sachs at 130.”

If China would just pull back 5 to 7% I’d get in, but I can’t chase it here…except Sohu, and I guess a little Baidu and I’ll just take a quarter position in China Mobile just in case. But I’m not chasing here.”

“(whispered) Dear market god, please stop the tape. Just give me one crack at the Nazz and some banks and I will never doubt the solvency of the US balance sheet or the wisdom of the Troubled Asset Relief Program ever again.”

4. Depression (July)

“I can’t believe I missed it. Those D-bags next to me are high-fiving after every earnings report. Hate those f@&%ing guys.”

“How could Las Vegas Sands do this to me? I’ve been watching this stock go up for 900% now. Couldn’t just give me one chance to get in. I suck.”

5. Acceptance (Early August)

“That’s it! I don’t give a damn anymore, GET ME IN NOW! Forget the big ones, they’re already up too much, are there any $5 stocks left that haven’t done anything yet?

“I gotta blow out this stupid GLD, it does nothing, sick of it and sick of hearing about inflation. Even Paulson blew it out. Get me some $2 biotechs and some midwest regional bank stocks, I gotta get poppin’ over here! We’re going to 10,000 baby!”