Kaffee: I want the truth!
Jessep: You can’t handle the truth! Son, we live in a world that has walls. And those walls have to be guarded by men with guns. Who’s gonna do it? You? You, Lieutenant Weinberg? I have a greater responsibility than you can possibly fathom. You weep for Santiago and you curse the Marines. You have that luxury. You have the luxury of not knowing what I know: that Santiago’s death, while tragic, probably saved lives. And my existence, while grotesque and incomprehensible to you, saves lives … You don’t want the truth. Because deep down, in places you don’t talk about at parties, you want me on that wall. You need me on that wall. We use words like honor, code, loyalty … we use these words as the backbone to a life spent defending something. You use ’em as a punchline. I have neither the time nor the inclination to explain myself to a man who rises and sleeps under the blanket of the very freedom I provide, then questions the manner in which I provide it!
From A Few Good Men, Columbia Pictures, 1992.
In an article that will discuss the world of finance and the apparent illogic of the current market rally, the longwinded quote from one of my favorite films of Jack Nicholson isn’t as misplaced here as it initially seems.
The role played by the actor, of a smarmy self-justifying army general who condones human rights abuses in the guise of defending America’s freedoms, is the same role that has been undertaken by various members of G8 governments in recent weeks: be it US Treasury Secretary Tim Geithner and Federal Reserve chairman Ben Bernanke in the US, President Nicholas Sarkozy of France, Prime Minister Gordon Brown of the United Kingdom or any of their support staff speckled around the establishment.
In another manner of discussing this, we could say that all of the Keynesian initiatives are already being given the all-clear by world asset markets, egged on by the “Jessep” in everyone.
Jesseps around the world will have you believe in the following:
1) There are green shoots of economic recovery to be seen everywhere in the world;
2) The banking system has been rescued globally;
3) Corporate earnings will rise by the end of this year;
4) There is no danger of a new pandemic (see Swine flu over cuckoo markets, April 29, 2009, Asia Times Online, );
5) Palestinian assassins will bump off North Korea leader Kim Jong-Il to prove their seriousness to create a lasting peace with Israel.
Okay, I may have made the last one up, but one never knows these days when propaganda machines are in full scream night and day. In any event, it perhaps behoves me to comment on the other items that now appear consensus for stock and bond market investors.
About those green shoots: I have been hearing the term “green shoots” so often for the past few weeks that it almost appears curmudgeonly for anyone to question the notion of an incipient economic recovery. The most recent example came on Friday when the US economy was reported to have lost “only” 539,000 jobs in April, as against the estimates of around 575,000 jobs by economists employed at the major Wall Street banks.
Now this was supposed to be great news in and of itself because it offers proof that the US economy is shedding jobs at a slower rate than previously. That notion is of course complete nonsense, but more importantly, the point to note that continuing declines in employment cannot be treated as good news in any market; seeing as the linkage between people curtailing consumption after losing their jobs is rather straightforward. So the first question to ask yourself after Friday’s US jobless report is whether an economy that loses half a million jobs every month is a good place to spot economic growth.
Then comes the heavy hand of “Jessep”, as a good 72,000 jobs were added on a temporary basis by the government as it commissioned a new national census. Take that into account and suddenly the numbers look worse than the consensus estimate.
After that we come to the issue of serious underemployment that is now building up in all the major economies. Much like the French sleep over nine hours a day because very few of them are gainfully employed in the first place, there is a lot of similar momentum being built into the other economies as governments provide sustenance support through jobs. In effect, everyone gets to show up at an office for wages slightly higher than the minimum, which money is used for maintaining their standstill payments to banks and other creditors; whatever remains probably goes to Burger King.
Nothing wrong with any of that in theory; but none of these folks on pseudo-employment support will be any good in actually pushing up asset values through their actions, that is, improving the quality of assets; nor will they provide much support for consumption in quarters to come. These are people who used to feel rich, with their US$1 million Mac-mansions paid with $1.2 million mortgages and $200,000 in credit card limits that were provided on their $50,000 per year jobs. With homes either repossessed or in arbitration with the banks, such folks have been reduced to an existence long on savings and short on disposable income.
The bad news continues on another end. Banks have been cutting credit card limits with gay abandon as they have to demonstrate new prudence to the regulators; so that $200,000 credit card limit is probably around $5,000 now.
I am hardly picking on just the US economy here. News out of eurozone and Asian economies is worse; with both consumption and industrial production falling off a cliff in places such as Germany, Japan and so on. While some countries such as China are showing a bounce in their purchasing manager surveys (PMIs), this is almost entirely due to the benefits of heavy-handed government intervention in certain sectors of the economy (see China’s unreal estate, Asia Times Online, April 10, 2009 ).
Meanwhile, Marxist policies are pushing the UK into its sharpest economic downturn, which threatens to accelerate rather than decelerate due to the policy actions (see G8’s first bankruptcy, Asia Times Online, April 25, 2009). With the financial sector threatening to quit the City of London over the government’s punitive tax regime and crumbling physical infrastructure, there is no hope for the UK showing any semblance of economic growth until at least 2011 and even that looks iffy with every passing day.
About the only bit of really positive economic news that I could discern in recent days is that Zimbabwe has hit its economic bottom and no longer appears to be contracting. Even the International Monetary Fund has noticed this, despite being preoccupied with all the supposedly rich countries queuing up at it doors, and announced a possible resumption of economic aid over the next few months. That might actually hurt the poor folks of Zimbabwe over the longer-term, which seems rather cruel after all the evils endured with Mugabe regime, but such is the natural course of justice.
Rescuing the financial system
One of the proximate causes of the current rally in financial markets is the idea that the worst is over for the world’s financial institutions. This notion is so hilariously discordant with reality that I struggle to even begin responding without collapsing to the ground clutching my stomach laughing uproariously.
Painful as all that is, I still need to go on. Firstly, let’s look at these wonderful stress tests that were promulgated on the US banks and serially leaked to the markets over the course of last week. Look at the ones that the US government decided didn’t need any new capital: these include the likes of Goldman Sachs, American Express and Capital One. Then let’s examine the ones that the government said did need new capital, such as Bank of America and Wells Fargo.
The first one is Goldman Sachs. The bank holding company (previously an investment bank) announced outsize profits for its first quarter, but only by the sleight of hand of avoiding to report the rather thumping loss suffered in December 2008 because it changed the financial reporting period from a December-February (financial year ending November) to the more conventional January-March (financial year ending December). That change alone meant a neat $1.85bn addition to profits; a trifling figure that meant the difference between a loss and a profit for the quarter.
Then there is the wonderful bit of news on the company’s credit default swap contracts (CDS) with the defunct American International Group (AIG). Thanks to the September rescue of AIG, the government was able to pay Goldman Sachs in full to the tune of some $12 billion, give or take a few hundred million. This is in sharp contrast to what happened with brokers such as Merrill Lynch, who had bought their insurance from other insurers like XL (that were not rescued by the US government), that returned less than a fifth of what was owed to those firms: in effect pushing those firms into significant loss positions.
Call it corruption or happy coincidence, what the AIG-disguised rescue of Goldman Sachs does reveal though is that the firm itself is not very good at either picking its investments or covering its possible losses. No word from the US government whether it evaluated these two aspects: the company’s actual ability to make money and its ability to hedge the large proprietary exposures when the “all clear” was given for the bank.
Then there are the two large credit card issuers, American Express and Capital One, which have been given the all-clear as well. I find their assessments ridiculously overoptimistic for exactly the reasons laid out in the previous part of this article – namely the apparent catch-22 situation prevailing between cutting credit card limits (leading to lower earnings in future quarters) or retaining those limits (leading to losses from credit card defaults).
Capital One recently revealed that their credit card losses were now in excess of the amounts expected for the given level of US unemployment, this is that the straightforward link that is a cornerstone of pricing credit card asset-backed security transactions has now fallen on the wayside. This is a classic response to the underemployment that I described: as people are barely employed, there is no chance of repaying existing loans and credit card debt on those salaries.
Effectively, anyone lending money to the American consumer will have to think long and hard about how to get that money back faster than the economy crumbles from under their feet.
Then there are the banks that failed the test. Bank of America was deemed to have a need for $35 billion in new capital, which led the company’s stock prices 18% higher on the day. This raises an obvious question: if the government had revealed that the bank needed over $50 billion in new capital (as the initial estimate was before the bank reportedly haggled the figure down by $15 billion), would stock prices have jumped 30%?
Wells Fargo was another bank that failed the test, which is even more interesting when you remember that the bank’s pre-announcement of its first-quarter earnings was the proximate cause of the market rally that ended up doubling the price of financial stocks in following weeks. In its 8K filings, the bank showed the following “interesting” aberrations:
a) Increased commercial mortgages as well as “other” mortgages to the tune of almost double the same period last year (due to the acquisition of Wachovia meanwhile);
b) The bank showed a big jump in second-lien mortgages: these are the worst performing of all categories of lending;
c) Trading assets have risen by 600% from the same period last year: so here is a bank that is actually increasing its leverage rather than reducing it during a period of financial distress;
d) Then there is the matter of some $20 billion in goodwill that the bank holds on its books: given that these pertain to purchases like Wachovia that haven’t quite panned out (now there is understatement), don’t equity investors and the government not have to worry about possible write-offs?
Once again, it isn’t only the US financials that fail my basic evaluation of system integrity. In the UK, we have RBS announcing losses of around 850 million pounds for the first quarter of this year, as bad loan charges of over 2 billion pounds more than wiped out any organic increase in revenues from its corporate banking department. Similarly, the French bank Societe Generale posted losses of 414 million euros against a profit of 140 million euros last year, once again due to rising provisions for bad debts.
Financial markets have been misled by the rise in profits of banks with strong fixed income dealing desks, which pertains to trading rather than organic interest income. Even with all the help being given by the government, there is no reason to believe that banks can sustain this trading performance.
Corporate earnings recovery
By far the most ridiculous of all the market assumptions is the one about a recovery in corporate earnings. Non-bank earnings of the sort shown by multinationals (MNCs), technology companies, aircraft companies and so on depend more than any other on the progress of the consumer. This is highly doubtful around the world.
The main reason for that would be the effects of balance sheet recession on the average consumer around the developed world. Take the example of the US economy: some $10 trillion of asset values have been wiped out in the housing bust; compared to debt write-offs of “only” $1 trillion. Remaining debt will have to be serviced by borrowers (see above paragraphs on how difficult that would be); inevitably that process entails significant cuts in consumption. That is the core problem confronting the corporate landscape globally: when people no longer buy new cars, washing machines and whatever else have you, where would new earnings come from?
Japan’s experience since the beginning of the 1990s highlights the impact of balance sheet recessions on corporate earnings. While Japan itself benefited from growing demand for its exports in the US and other economies, the same cannot be true this time around as economic decline is broad-based and global.
Then there are the new moves to tax the MNCs being initiated by the Obama administration but very likely to be followed up by others including the UK and France. These taxes will mean that the benefits of overseas growth no longer accrue to the companies, but rather to the heavy hand of government yet again.
Costs are being held in check, but the problems associated with supply chain disruptions aren’t minimal. As companies teeter on the edge of bankruptcy, their typical buyers will have to stock higher amounts of inventory to hedge such disruptions; that is even worse than the impact of falling demand as such higher working capital spend inevitably cuts into capital expenditure. To complete the cycle, cuts in capital expenditure then eat into future economic growth further undercutting the first argument about the nascent economic recovery.
European companies have it worse; their export dependence has caused first-round losses in output that soon translate to second-round consumption effects (as workers are laid off or made temporarily redundant), which further depress the output of other companies that sell to these consumers. With government taxes already excessive in these countries, there isn’t the prospect of US or Chinese-style infrastructure binges; which removes important circuit breakers to the downturn.
All this isn’t even the most bearish bit. If there are still some bullish readers at this point, perhaps now would be a good time to highlight that none of the above constitutes the most bearish of my arguments. Rather, some other details could make the bearish argument more foolproof in coming months:
1) It isn’t clear to me, or apparently anyone else in debt markets, how and where the $6 trillion of new debt being issued by governments will be absorbed in an era where organic surpluses of countries such as China and those in the Middle East have been declining. Indeed, by most measures the stock of foreign assets of these countries will likely begin declining by the end of this year; in effect adding rather to the supply against market expectations of rising demand. Supply of debt without adequate demand is a recipe for higher interest rates: imagine the carnage to my scenarios above from rising interest rates;
2) Destroying the rule of law has always been a pastime of the left but in wiping out the rights of secured lenders of Chrysler Corporation, the US government has created unprecedented doubts about the entire loan market in the country. Similar gaps in the rights of creditors in countries such as Germany (witness the shenanigans around Hypo Real Estate) make credit markets far too risky for ordinary (and even well-connected) investors. Needless to say, a lack of private capital flowing back into credit inevitably causes damage to prospects of new bouts of risk taking that will be needed to advance economic recovery;
3 Higher rates of homeowner defaults in the US, UK, Spain and Ireland could further imperil banks operating in these countries. Changes to bankruptcy laws have made such defaults easier, not to mention more acceptable socially;
4) The rising chances of global pandemics such as the H1N1 I wrote about two weeks ago also highlight potential risks to economic growth in coming weeks and months.
Health warning: Commenting on financial indices I am not acting as your adviser per se; readers must always perform their own research and never believe everything they read or see on television for that matter. In any event, unlike my colleagues on Asia Times Online such as David Goldman and Julian Delasantellis, I remain a pseudonymous contributor to these pages, thereby making the act of following my advice in this article all the more treacherous for the average reader.