Fed decision Wednesday a sideshow to Europe

What to make of last week? The events were certainly tumultuous and the fireworks haven't ended.

Let's start with Europe. First, we saw coordinated central bank intervention by providing USD liquidity to European banks. As Alistair Osborne of the Telegraph points out, central banks do not take this kind of action unless something is up.

Central banks don’t do that sort of thing unless something is up; and something is most certainly up. In the eurozone, an unfolding Greek tragedy is careering towards its final, brutal act. And, in our joined-up, global economy that spells trouble everywhere, with the odds shortening by the day on a return to recession.
 
So, are the central banks signalling Credit Crunch Mk 2 and a rerun of all those hilarious jokes (What’s the difference between an investment banker and a large pizza? A pizza can feed a family of four)? Well, yes and no. They could be signalling something worse.

This is a sign of something very, very bad on the horizon. How bad? A recent poll of economists put the odds of a eurozone breakup at 50%.

An even worse sign is how the stock market shrugged off the effects of this coordinated central bank intervention. The chart below shows the price action of the bank sector against the market. One day after the news of the big intervention, banks stocks underperformed the market. Contrast that to the price action of the sector when Warren Buffett came in and bought into Bank of America.

 
Over to you, sovereigns!
Central bankers appear to recognize that the world is again teetering at the edge of a cliff. They are trying to get ahead of the curve by taking action, but there are constraints on what the Fed, the ECB and other central bankers can do. Central bankers can provide liquidity to the banks, but they cannot provide solvency to the system. (See my discussion here on the difference between banking liquidity and solvency.)
 
 
Can Europe hang together?
The meeting of eurozone finance ministers in Wroclaw, Poland was a sign of how dysfunctional the EU has become and how the EU has lost all political cohesion. Where to start? Consider this summary of the meeting from the BBC.
 
Tim Geithner lectured the EU ministers the importance of political cohesion. "Either you hang together or hang separately", he told them. What was the response? The ministers told him to butt out of European affairs. So, forget about any prospect of Euro-TALF.
 
What about the Greek collateral issue? They can't even say the same thing at the same press conference! Olli Rehn, the EU Commission for Economy Policy stated, "Concerning collateral I refer to what Jean-Claude Juncker said previously. We are in progress and I trust we can soon get this issue out of the agenda."

Evidently Finland's minister Jutta Urpilainen hadn't read the same briefing memo: "Unfortunately I don't see that we can find a solution tonight."
 
German Finance Minister Wolfgang Schäuble went on to put the kibosh on the prospect of Euro-bonds: "It is completely clear that we must solve our problems on the basis of existing treaties. Treaty changes take time."

Olli Rehn was more diplomatic, but is this the European version of the Japanese answer of "we will give the matter the greatest of consideration"?

The first step will be a feasibility study with the Commission in the course of this autumn. In this study we will assess alternatives for euro bonds and we will dig deep into the economic and legal issues connected to the possible introduction of euro bonds.

For me a necessary condition of any possible introduction of euro bonds is a further reinforcement of economic governance in Europe, implying sustainability of public finances and sustainability of economic growth models in Europe.

Otherwise euro bonds will turn into junk bonds and that will not benefit anybody.

The story gets from bad to worse. At about the same time, the news came out that:

• Greece is backsliding on its austerity commitments.
• Portugal has under-reported its debt to the tune of 0.3% of GDP, or more.

So what do the eurozone ministers decide? They agreed to delay the decision to give next round of aid to Greece approved to early October. The aid, if approved, would be for disbursement in mid-October and conditional on Greece meeting its targets. This puts an incredible amount of pressure on the Greek government to comply with even more draconian measures of austerity.

All European politicians are caught in a bind because they need to make highly unpopular decisions. For the Greeks, further austerity can only lead to more political unrest. This study shows that budget cutbacks of more than 5% of GDP greatly heightens the risk of protests, general strikes, assassinations and chaos. At the extreme, it can lead to revolution. The Polish finance minister warned last week that a eurozone collapse could lead to war.
 
On the electoral front, Denmark recently elected a new government that campaigned on a platform of tax increases and increased public spending - which is contrary to the wave of austerity sweeping Europe. The bailout of the Club Med countries is incredibly unpopular in Germany and Angela Merkel must be aware of that as her party recently suffered an electoral defeat in her home state and got crushed in another one in Berlin over the weekend.
 
 
The end game for Europe
These events scream the loss of European political cohesion. Everyone out for themselves. Don't expect the EU to come together with a sensible package that gets them out of this mess without a crisis. That leaves the following possibilities:

1. Greece takes one "for the side" by implementing the austerity package and stays in the euro.
2. Greece defaults and leaves the euro.
3. The EU engineers an orderly default for Greece. On the weekend, eurozone finance ministers agreed that European banks need recapitalization, which is a constructive first step.
4. The EU tries to muddle through with a series of aid packages for Greece in order to kick the can down the road, knowing that it will lead to eventual default (see 2).
5. The EU countries all agree cede power to a greater centralized authority. Such a change will require constitutional change by all member states.

By the way, don't expect China or other BRIC countries to come to the rescue. Patrick Chovanec has a good commentary here on why China is unlikely to be the savior. Don't forget China's mercantilist tendencies. Any Chinese investment into the eurozone may be just their way of stabilizing the EURCNY exchange rate.
 
Peter Boone and Simon Johnson summarized the European dilemma well here. They concluded that there are no good ways out [emphasis added]:

Expect a great deal of shouting behind the scenes at the highest level in Frankfurt (ECB headquarters) and in European capitals. Instability seems unavoidable. Significant inflation may also follow – although first we will see serious recessions in the troubled European periphery, a ratcheting up of bond buying, and repeated political crises.

The US cavalry to the rescue?
Can the United States be the savior of Europe? Earlier in the week, there was some speculation that Tim Geithner might present some ray of hope to the Europeans with funds, instead of just suggestions on how they might fix their problem. Alas, no money is forthcoming. There is simply no appetite on the fiscal side for any stimulus, even for the US economy.
 
The Fed is the wildcard.
 
Doug Short reported that the latest release of the ECRI Weekly Leading Index shows it plunging again and ECRI head Lakshman Achuthan stated on NPR that there is a high risk of another recession. This would give the Bernanke Fed cover to act decisively.
 

 
ZeroHedge reported that even uber-bear David Rosenberg is expecting Fed action on Wednesday beyond Operation Twist. In last Friday's edition of Breakfast with Dave, he wrote that Bernanke watches stock prices as a measure of the effectiveness of Fed policy:

Even the casual observer can have no doubt, then, that FOMC decisions move asset prices, including equity prices. Estimating the size and duration of these effects, however, is not so straightforward. Because traders in equity markets, as in most other financial markets, are generally highly informed and sophisticated. any policy decision that is largely anticipated will already be factored into stock prices and will elicit little reaction when announced. To measure the effects of monetary policy changes on the stock market, then, we need to have a measure of the portion of a given change in monetary policy that the market had not already anticipated before the FOMC's formal announcement [emphasis added].

Rosenberg believes that Bernanke is more likely to act now rather than later, because "the more he does now means the less he has to do later during the election campaign" and "he has the support from enough FOMC votes, including regional bank chiefs like Evans from Chicago, to be aggressive". He concluded that Bernanke needs to give the stock market a positive surprise on Wednesday:

[I]f Bernanke wants to juice the stock market, then he must do something to surprise the market. 'Operation Twist' is already baked in, which means he has to do that and a lot more to generate the positive surprise he clearly desires (this is exactly what he did on August 9th with the mid-2013 on- hold commitment). It seems that Bernanke, if he wants the market to rally, is going to have to come out with a surprise next Wednesday. If he doesn't, then expect a big selloff.

What kind of surprise? On Thursday, Rosenberg speculated about extreme measures available to the Fed by pointing to Bernanke's famous helicopter speech of November 21, 2002 [emphasis added]:

The Fed can inject money into the economy in still other ways. For example, the Fed has the authority to buy foreign government debt, as well as domestic government debt. Potentially, this class of assets offers huge scope for Fed operations, as the quantity of foreign assets eligible for purchase by the Fed is several times the stock of U.S. government debt.

I need to tread carefully here. Because the economy is a complex and interconnected system, Fed purchases of the liabilities of foreign governments have the potential to affect a number of financial markets, including the market for foreign exchange. In the United States, the Department of the Treasury, not the Federal Reserve, is the lead agency for making international economic policy, including policy toward the dollar; and the Secretary of the Treasury has expressed the view that the determination of the value of the U.S. dollar should be left to free market forces. Moreover, since the United States is a large, relatively closed economy, manipulating the exchange value of the dollar would not be a particularly desirable way to fight domestic deflation, particularly given the range of other options available. Thus, I want to be absolutely clear that I am today neither forecasting nor recommending any attempt by U.S. policymakers to target the international value of the dollar.

Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly.

Given that the Fed participated in coordinated intervention last week, Bernanke must be worried. Indeed, the WSJ reported that the US financial system is highly exposed to Europe [emphasis added]:

If there is any doubt on this score, all one need do is consider the U.S. financial system's massive exposure to the European banks. In a recent survey, Fitch found that, as of the end of July, the U.S. money-market industry still had direct exposure to European banks of over a trillion dollars—or roughly 45% of money markets' overall assets. The Bank for International Settlement reports that American banks have loan exposure to German and French banks of more than $1.2 trillion.

Of course, all this moves are highly speculative. Even if any announced measure is likely to have limited effect, equity markets are likely to rally on the news of a positive surprise.
 

The week ahead
Here's what I am watching for for the week to come:
 
Monday: The Budget Committee in Germany's Lower House of Parliament will debate the EFSF expansion and Greek bailout. Watch for what comes out of those discussions.

As well, Greece updates the Troika (EU, ECB and IMF) on the progress of the implementation of the austerity package by conference call. The Troika has decided on not going to Athens. If the aid is not forthcoming, then the Greeks will run out of money around October 10. As I write this, the Greek cabinet is reportedly holding weekend emergency meetings in order to ensure that its budget in compliance with the Troika criteria. The EURUSD exchange rate is down about a penny and ES futures are deeply in the red.
 
Tuesday: Greece has bond payments totaling €769 million due.

Wednesday: The FOMC will announce its decision after an extended two-day meeting.

Get ready for the fireworks. My inner trader is wincing at the prospect of volatility of more up and down 2% days. My inner investor tells me that anything that the Fed does is likely to be a sideshow. If the Fed were to announce an unexpected round of stimulus, the markets may rally, but the final resolution will depend on how the European sovereign crisis is resolved.




Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Banking liquidity vs. solvency

In the past few weeks I have had a number of discussions with investors. Virtually everyone knows that there is a banking crisis brewing in Europe but some have only a vague understanding of the mechanics of the crisis of its resolution. For the benefit of everyone, here is a primer on banking.

Here is an idealized model of a bank. Bank ABC takes in $100 in deposits (so it owes the depositors $100). To make money, it lends out its deposits. To be prudent (because loans can go sour), it lends out $93. It has $5 in common equity and an additional $3 in preferred share equity and bonds.

Supposing that Bank ABC makes 1% on the spread between its deposits and loans. Since the ratio of deposits to common equity is 20 to 1 ($100 to $5), that equates to a 20% return, before paying expenses, such as salaries, rent, etc.


What happens in a liquidity crisis
Let's assume the economy is doing fine, but there are whispers on the street that Bank ABC is unstable. Depositors rush to the bank and withdraw their money. What happens then?

The bank has an obligation to give the depositors their money (it is their money, after all). The bank has a health porfolio of loans. That's called a liquidity crisis.

In order to have the funds on hand to pay out its depositors it borrows from other banks, or to the central bank as a lender of last resort. It may be required to put up collateral to fund those loans.


Solvency crisis: What if the loans aren't any good?
Supposing the rumors were right. A part of the $93 in loans that the bank lent out have largely gone sour. The loan portfolio is now worth $90 (and $3 in loan losses).

In that case, the shareholders take the first hit. Their $5 in equity is now $2. If there are further loan losses, then shareholders get hit further, then the preferred shareholders are next, followed by bondholders.

Supposing that Bank ABC were to get hit with $10 in loan losses instead of $3. They now have negative equity. This is called insolvency - and no amount of liquidity injection from the central bank can save Bank ABC.


European fears
Yesterday, we had news of coordinated USD liquidity injection into the European banking system, largely on the basis that European banks had trouble finding USD deposits.

Will that be enough or is that just a band-aid?

Investors' worst fear about European banks is that they are insolvent, not merely illiquid. Supposing that Greece were to default - and their loans are suddenly worth, say, 30c on the dollar. Other peripheral European countries follow: Portugal, Ireland and possibly Spain and Italy.

The European banking system would become insolvent.

Bruce Krasting took apart SocGen boss Frederic Oudea's discussion of his bank and concluded that SocGen is in a very precarious position:

The market cap of SOGN as of the close was E12b. That is the bottom of a pile of assets that total E1.3T. The market cap to assets is only 1.0%. Compare that to Wells Fargo @ 10.0% and you see the problem. Even stinky old BAC has a 3.30% of market cap to its balance sheet.

Krasting went on to diss the prospect of SocGen shoring up its equity through a rights offering or preferred shares, as well as its efforts to de-lever and shrink its balance sheet through asset sales:

This is both accurate and scary. The clear suggestion is that many of the banks in Europe face much steeper problems than SocGen. I thank the CEO for this important clarification.

Don't confuse a solvency problem with a liquidity problem. If SocGen is the tip of the European banking iceberg, then we do have much to worry about.


Judging the effectiveness intervention
If a problem were to appear, watch how the authorities intervene. The cleanest approach is the Swedish solution that I wrote about before. Let's go back to the previous example where Bank ABC suffers a $10 loan loss and becomes insolvent. Under the Swedish solution, the government comes in and injects new equity to make the depositors whole. The shareholders get wiped out. The preferred shareholders and bondholders either take haircuts or get wiped out.

On the other hand, we have the US approach in 2008, or what I call the TARP solution. In effect, the authorities said, "I know that these loans are not worth face value, but we'll pretend that that they are and we'll make you whole on the loans." In effect, they bought those loans for roughly face value on the fear that if they didn't, the entire banking system would go down.

Notwithstanding the inequity of the arrangement, let's consider the relative cost of the Swedish solution compared to the TARP solution. If you were to spend $1 to recapitalize a bank that is levered 20 to 1 under the Swedish solution, you would have to spend $20 (20 to 1 leverage) under the TARP solution.

Reuters reported that Tim Geithner is proposing to lever EFSF 10 to 1 and implement a TALF program to the Europeans at their meeting in Poland today. Initial reactions have been negative. Felix Salmon writes:

The point here is that the EFSF was specifically designed as a fiscal alternative to the ECB; if the ECB wasn’t happy putting up $440 billion of its own money for such schemes, it’s unlikely to put up $2 trillion.

FT Alphaville went on to point out the shortcomings of TALF:

Talf, you’ll remember — and as wonderfully explained and pilloried by Tracy Alloway — involved the US Treasury offering credit protection to the NY Fed, which then loaned out money to investors with the explicit intent of using the loans to buy asset-backed securities.

But the design was deeply flawed — not least because the loans were non-recourse, meaning that borrowers could simply default, surrender the crap ABS collateral, and walk off into the sunset with nary a remedy for the Fed to pursue.

Watch this space. Once you understand the mechanics of banking you will begin to understand the problem and the likely effectiveness of any intervention.





Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

A Rorschbach test for traders

The Rorschbach inkblot test was supposedly an interesting psychological test. You looked at an inkblot and what you saw said more about the you than the inkblot.

Here is an interesting test for both bulls and bears. On Monday, US equities rallied in the last hour on reports from various media outlets that the Italians were in serious discussions with the Chinese about buying Italian debt. Here is the original report from the FT and another from the WSJ.

For the bulls who are ready to jump in on the long side on this news, consider the following trade as a test of your resolve.

The SNB has indicated its willingness to defend the CHFEUR exchange rate to prevent the Swiss Franc from rising any further against the euro. In effect, the SNB has become the liquidity provider of last resort to the eurozone. Given the combination of Swiss resolve and the news of a possible Chinese rescue of Italy, why not put on the long Italy/short Switzerland carry trade? Two-year Italian paper is yielding roughly 4.5%:

Italian Bonds - 2 year gross yield

...while Swiss two-year paper is yielding a measly 6 basis points - effectively zero:

Swiss Government Bond generic 2-year Note bid yield

Imagine you're a hedge fund. Buy Italy and short Switzerland. Lever the trade up 10x or 20x. Think of your return!

If you're truly bullish and believe that this represents the turning point, then would you put on that trade? Underlying that assumption is that, even if Greece defaults, any contagion would be contained before it reaches Italy.

Of course, there is the contention from ZeroHedge (which has always a bearish bias) that Asians are reluctant to buy Italian bonds because if the ECB won't buy it, why should they?

On one hand we have FT "reporting" about Chinese Italian bond purchasing ambitions citing "unidentified Italian officials" one day ahead of a major Italian bond auction (wink wink nudge nudge). On the other hand, we have Reuters, citing a real live Italian Finance Minister (though not for long) Giulio Tremonti, who tells us a slightly different story, which, gasp, cites real live people: "Italian Economy Minister Giulio Tremonti said on Thursday that Asian investors are reluctant to buy Italian bonds because it sees they are not being bought by the European Central Bank."

For the bulls, the answer is, "It doesn't matter what the ECB does. The SNB stands ready to provide oodles of euro liquidity to the market."

For the bears, there is that minor item in the WSJ article stating that CIC has $200 billion in reserves. Assuming that only a small fraction of the $200 billion goes into Italian bonds, will it be enough?

Where do you stand?


Disclaimer: I am not advocating that you take any position in the long Italy/short Swiss trade. It's just a way of getting you to think through the implications of these latest developments.



Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Should Greek bondholders tender?

FT Alphaville posted an analysis from BarCap on whether Greek bondholders should tender to the "voluntary" exchange offer. BarCap concluded that on a probability weighted basis, bondholders should tender to the offer because the probability-weighted payoff is higher if you tender than if you don't.

I beg to differ. It's a little bit more complicated than that. Look closely at BarCap's analysis of the payoffs if a bondholder tender decision under the two scenarios of successful and unsuccessful exchange.

This looks like a case of the Prisoner's Dilemma, which is described by Wikipedia in the following way:

Two men are arrested, but the police do not possess enough information for an arrest. Following the separation of the two men, the police offer both a similar deal- if one testifies against his partner (defects), and the other stays quiet (cooperates), the betrayer goes free and the cooperator receives the full one-year sentence. If both remain silent, both are sentenced to only one month in jail for a minor charge. If each 'rats out' the other, each receives a three-month sentence. Each prisoner must choose to either betray or remain silent; the decision of each is kept quiet. What should they do?

If the exchange is unsuccessful, then the forecast payoff is 40%, regardless of what the bondholder does. If the exchange is successful, then the bondholder gets a higher payoff if he doesn't tender - the higher payoff is the result of being a "free rider".

Wikipedia went on to describe the optimal solution in the Prisoner's Dilemma:

Here, regardless of what the other decides, each prisoner gets a higher pay-off by betraying the other. For example, Prisoner A can, with close certainty, state that no matter what prisoner B chooses, prisoner A is better off 'ratting him out' than staying silent. As a result, solely for his own benefit, prisoner A should logically betray him. On the other hand, if prisoner B, acts the same way, then they both have acted the same way, and both receive a lower reward than if both were to stay quiet. Seemingly logical decisions result in both players being worse off than if each chose to lessen the sentence of the accomplice at the cost of himself spending more time in jail.

How should a bondholder think about the tendering problem? I believe if tender rates are relatively low, then the probabilistic approach is the correct framework as the unsuccessful tender scenario is dominant. However, as tender rates rise and approach threshold levels for a successful exchange, bondholders should start to think about this in game theory terms as there is a higher payoff by being the "free rider".
 
The bottom line: The probability of an unsuccessful tender than the market might think it is. If you were to assume that the 90% threshold acceptance rate specified by Greece is a bluff, then at current acceptance rates there is little incentive for bondholders to tender. If the 90% threshold isn't a bluff, then it's unlikely that we are going to get there and the tender will be unsuccessful in any case.

 
Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.
 
None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Where's the bottom?

As stocks cratered Friday on renewed concerns over a Greek default, investors are undoubtedly asking, "Where's the bottom?"

I believe that investor sentiment is by no means at bearish extremes for a meaningful bottom to be put in at current levels. Bespoke recently conducted an (unscientific) poll that showed an excess of bulls.

The VIX Index, which is a measure of fear, has spiked. Readings are elevated but nowhere near either recent highs or Lehman Crisis extremes.

In addition, the Sep 7, 2011 reading on DAX investor sentiment shows an astounding level of 64% bulls and 20% bears. No capitulation here.

What's more, the violation of a significant technical support level for the euro is a signal that this decline is nowhere near an end.

Where's the technical support?
Given the current technical and sentiment backdrop, the S+P 500 is likely to violate its recent support level at 1100. The next logical support level is the 50% retracement at about 1020. The big question is, "Should Greece default, which would cause a banking crisis in Europe, would the 1020 level hold?"

Similarly, when I look at the Canadian market, the TSX is in a well-defined downtrend. Will the market hold at the 38% Fibonacci retracement level of 11650, the 50% retracement level of 10900, the 62% level of 10700, or does the market have to test the 2009 low?

Watching Europe
Rather than guessing, you have to go to the source and the source of any financial contagion comes from Europe. The key, then, is to watch the technical condition of European stocks.

The chart below of the STOXX 50 shows the index to be testing support at about the 2070 level. Should that not hold (and it likely won't in the event of a Greek default or banking crisis), the next logical stopping point is the 2009 lows at 1600 - which represents a decline of 24% from current levels.

A look at the point and figure chart of the STOXX 50 shows a downside projection of 1540 (circled in purple), a level that is close to the low seen in 2009.

In addition, this analysis from Brockhouse Cooper shows that European equities have less valuation support on a free cash flow or dividiend yield basis compared to other regional markets.

Moving from denial towards acceptance
The EU has been undergoing the classic stages of grief, which begins at denial and ends at acceptance. Last week, the finance minister of Estonia, a minor EU country, said that it was illogical to exclude the possibility of Greek bankruptcy (h/t Mish):

The economy minister of Estonia, member of the euro area since January, said it was “illogical” to exclude the possibility of bankruptcy, in an interview published Friday.

“I still do not understand how a failure to pay (heavily indebted countries) can be avoided,” said Juhan Parts in German daily Financial Times Deutschland. “In a market economy, this should be an option. It is illogical to want to avoid this issue,” he added.

More importantly, Bloomberg reported Friday that Germany was putting together contingency plans to insulate German banks and financials from the worse effects of a Greek default.

Chancellor Angela Merkel’s government is preparing plans to shore up German banks in the event that Greece fails to meet the terms of its aid package and defaults, three coalition officials said.

The emergency plan involves measures to help banks and insurers that face a possible 50 percent loss on their Greek bonds if the next tranche of Greece’s bailout is withheld, said the people, who spoke on condition of anonymity because the deliberations are being held in private. The successor to the German government’s bank-rescue fund introduced in 2008 might be enrolled to help recapitalize the banks, one of the people said.

It seems that a Greek default is virtually a done deal. A senior IMF economist was quoted as expecting a Greek default by March at the latest. Add to the equation the kind of finger pointing that happened at the G-7 meeting on the weekend: Eurozone blamed by US for world's economic plight. It is clear that the likelihood of coordinated intervention is off the table:

[I]nstead of the predicted economic debate, it emerged on Saturday that the bad-tempered meeting was dominated by American and British warnings that political failures and broken promises in the euro zone were in danger of triggering a wider crisis.

"Seventy-five per cent of the dark things happening in the world economy are because of the euro zone," said a senior US official after a round of talks ended in the early hours of yesterday morning.

Why do we want prolong this agony? Why not just rip off the band-aid and be done with it?
 
 
What to watch for
In the meantime, here is I am watching for as signs of a significant equity market bottom:

• The behavior of European stocks. Will STOXX  hold at its 2009 lows or will it drop further?
• Wait for the panic to show up in gold and gold stocks. During a panic liquidation, everything gets sold and the USD rallies. Will gold get liquidated in a "margin clerk" market? If not, I would expect at the very least the de-coupling of gold and gold stock prices - gold may rise, but gold stocks decline in sympathy with the broader equity indices.
• Watch commodity prices and commodity currencies for signs of fear. In 2008, commodity prices cratered on the expectation that a global recession would result in lower commodity demand. This time around, commodity prices have been relatively firm. I would monitor the CRB Index, as well as commodity sennsitive currencies such as the Australian and Canadian Dollar for signs of panic.
• Watch for credit spreads to blow out and bond index prices to turn negative. During the Lehman Crisis of 2008, bond indices, which included all bonds, turned negative while Treasuries rallied. Watch for a similar event by monitoring the relative performance of AGG against IEF. Right now, AGG (iShare Bond Index ETF) is underperforming IEF (7-10 year Treasury ETF) but levels are nowhere near the lows seen in 2008. Also watch the price of AGG to dip - but that ETF remains in rally mode and upward sloping for now.

Fasten your seatbelts. One day, you'll be able to tell your grandchildren, "I was there.".



Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Some financial innovations that aren't going to end well

Most of the time, innovation can be good. Other times, they have unintended side effects. This is especially true of financial innovations. Paul Volcker famously said that the banking's greatest innovation was the ATM.

I've never been an investment banker, but I was a research analyst once upon a time. (Yes, Virginia - Chinese walls do exist.) I do know enough about investment banking to know that it can be a very creative job. You spend a lot of time thinking of creative and innovative ways to get around regulations in order to get the deal done. That's how financial innovations get engineered.


Disintermediation in China
Here are a couple of examples of financial innovations that are not likely to end well. The Chinese authorities have been taking active steps to rein in bank lending by raising reserve ratios and interest rates. Recently, we have seen examples of disintermediation in China as a way of getting around restrictions on banking regulation. Patrick Chovanec explains:

According to Caixin, Chinese banks — limited in their ability to lend by China’s efforts to rein in inflation — have introduced a dizzying array of “private wealth management” (PWM) products aimed at higher-income investors.

These products are a way of getting around banking regulation by matching lenders with borrowers:

Why are Chinese banks suddenly so active in selling these products? One possibility is that they are simply an end-run around high reserve requirements. Instead of struggling to gather deposits (at less and less attractive interest rates) and then setting aside 21.5% as cash reserves before lending the rest out, banks can promise high interest rates and channel the whole amount directly into lending, collecting a fee instead of a spread.
The other possibility is that PWM funds provide a way for banks to shift growing lending risks onto customers. Rather than underwriting loans, they’re playing matchmaker. In some cases, critics fear, banks may have a conflict of interest, and may actually be shifting not just risk but known losses onto naive investors. For instance, if bank helps a local government sell bonds in order to repay its troubled bank debt, it can offload its problem debts onto its clients.

Tracy Alloway at FT Alphaville wrote that Chinese companies are also getting into the act. She quotes a Standard Chartered research report:

In City X, something slightly different is happening, which we suspect is being repeated in cities across the country. We found that a couple of large local state-owned firms whose main business was not finance are now expanding into operating guarantee companies, pawnshops, trusts, etc. We surmise that they are doing so with the support of large surplus cash earned by the group’s (often monopoly) activities, or with funds easily borrowed by the parent group from friendly banks. It appeared that at least some of their business was based on their ability to borrow funds at 7-8%, and then on-lend at rates of 20-30%, arbitraging the dual-interest rate environment. They would also in theory be free to funnel funds borrowed for one purpose into, say, real estate.

We find this disturbing for a number of reasons:

• The state already dominates much of the financial sector, but areas like GCs and small loan companies open a window to private-sector activity. Local SOEs now look set to dominate these new parts of the financial sector too.

• Such platforms combine industrial and financial functions within the same group. This introduces new risks, since it facilitates fund flows that fall outside of regulators’ monitoring. It also adds a new transmission mechanism for bad credit problems to spread through the economy.

• These platforms also broaden the scope for corruption at firms with low levels of government oversight.

There are times when government regulation inhibits economic activity. At other times, they are meant to minimize systemic risk by avoiding the moral hazard problem. This is one of the instances of the latter. Chovanec commented that disintermediation can makes the system more opaque. If this unravels, then how do you unscramble an omelette?

The most alarming part of the story, however, is how banks have been rolling over and pooling short-term, high-return funds in a way that makes it very difficult to trace how, exactly, investors are being paid off.

If this blows up, some people are going to get bullets in the backs of their heads.

The collateral swap
Another example of financial innovation is the collateral swap. Izabella Kaminska of FT Alphaville explains the mechanics [emphasis added]:

A collateral swap is essentially a form of secured lending whereby one counterparty transfers relatively liquid assets to another in exchange for a pledge of less liquid collateral. In a typical collateral swap, a bank holding a portfolio of ABS or other securitizations will transfer these assets to a pension fund or insurance company which, in exchange for a periodic fee, will deliver a portfolio of more liquid collateral such as high-grade government or corporate bonds.

The pension fund or insurer thereby receives a higher yield on its (ostensibly) safe investments, while the bank obtains access to a portfolio of liquid assets which it can then re-pledge to obtain funding from central banks and other sources which, in the wake of the GFC, have been less willing to accept ABS and other securitizations as eligible collateral. The development of collateral swaps is thus, in effect, an innovative response to both the post-crisis funding constraints on banks and the need to satisfy new liquidity requirements soon to be imposed under Basel III.

The immediate benefit to the investor (pension fund, insurer, etc.) is a higher yield on its investments. It's fully collateralized, right??? The bank gets higher quality paper to satisfy Basel III requirements and, in the event of a liquidity squeeze, to pledge to a central bank such as the ECB or BoE.

Everybody wins! Right?

The Ray DeVoe quip still applies today, "More money has been lost reaching for yield than at the point of a gun." Here are the risks:

Collateral swaps contribute to the complexity of modern financial markets in at least three ways. First, the collateral swap market is extremely opaque. Nobody knows with any certainty, for example, how big this market is, who the major players are, or the size of the aggregate exposures. As a result, it is exceedingly difficult to ascertain the nature and extent of the attendant risks. Second, given the identity of the counterparties, collateral swaps seem destined to strengthen the interconnections between (1) banking markets and (2) insurance and pension markets. Finally, as described above, collateral swaps are a reflexive response to changes in the post-crisis market and regulatory environment.

 

An accident waiting to happen
Given the heightened level of systemic risk in the financial system, these developments can only be viewed as disturbing. In my first example of disintermediation in China, it suggests that a shadow banking system is forming in China and control of the banking system is slipping away from the Chinese authorities.

In the second case, it suggests that a number of institutions could get hurt should a banking crisis erupt in Europe. They will have to read the legal language of those swap agreements very, very carefully in order to limit their exposure.

Something tells me that this isn't going to end well. This is one of those times when the markets really needs some adult supervision and we can't all walk around with the attitude that risk management is for pu**ies.


Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Super-Twist: Ben's secret weapon?

At the Jackson Hole meeting, Fed Chairman Ben Bernanke said, in effect, that he has some secret weapon(s) that they FOMC would discuss at its September meeting [emphasis added]:

In addition to refining our forward guidance, the Federal Reserve has a range of tools that could be used to provide additional monetary stimulus. We discussed the relative merits and costs of such tools at our August meeting. We will continue to consider those and other pertinent issues, including of course economic and financial developments, at our meeting in September, which has been scheduled for two days (the 20th and the 21st) instead of one to allow a fuller discussion. The Committee will continue to assess the economic outlook in light of incoming information and is prepared to employ its tools as appropriate to promote a stronger economic recovery in a context of price stability.

Since he didn't specify what the "range of tools" were, they might be "secret weapons" of monetary stimulus. What could they be?


Super-Twist?
One of the much anticipated tools is a repeat of "Operation Twist", a Kennedy Administration plan to flatten the yield curve by buying longer maturity bonds in order to push down long term yields. The San Franciso Fed explains:

The Kennedy Administration’s proposed solution to this dilemma was to try to lower longer-term interest rates while keeping short-term interest rates unchanged—an initiative now known as “Operation Twist” in homage to the dance craze then sweeping the nation. The idea was that business investment and housing demand were primarily determined by longer-term interest rates, while cross-currency arbitrage was primarily determined by short-term interest rate differentials across countries. Policymakers reasoned that, if longer-term interest rates could be lowered without affecting short-term yields, the weak U.S. economy could be stimulated without worsening the outflow of gold.

This move has been so well telegraphed that Bill Gross announced that Pimco was extending the maturity of its portfolio.

What if there's more? Bruce Krasting provided a clue in this recent post. He speculated that Obama Administration is going to propose a gigantic refi program. If homeowners pay off their mortgages and refinance, that will create tremendous cash flows to MBS holders. The Fed happens to hold about $1T in MBS and all these pre-payments will give the Fed money to do an Operation Twist and buy in the long end of the curve without expanding their balance sheet. If they hold $1T in MBS and pre-pays are sufficiently high, then the program will be QE2 sized.

My first reaction was, "Wow! This is a form of Operation Twist on steroids - a sort of Super-Twist. Another QE2 sized purchase of Treasury bonds in the long end of the curve!" This would spark a QE2-style rally in risky assets.
 
Upon some more sober reflection, I realized that there are major drawbacks to this scheme inasmuch it is unlikely to have a significant effect on asset prices. First of all, major MBS holders are Fannie, Freddie and the Fed (3F). Most mortgage backed securities are priced at a premium and this re-fi program will pay investors off at par. Thus, 3F will be taking a substantial loss on their holdings.
 
There is another problem. Suppose that this re-fi program generates $X billion in pre-payments which get re-financed. Then $X billion of MBS supply will come back into the market. One of the ways that QE2 pushed up asset prices was because it ballooned the Fed balance sheet by pushing a wall of liquidity out into the market. This program is more of a variation of Operation Twist, which extends the Fed balance sheet out to the longer end of the yield curve, but at a cost. Depending on how it's implemented, I could see substantial movement in credit spreads but don't expect QE2-like effects.

Moreover, it isn't clear to me what the sustainable benefits there to flattening the yield curve. The last FOMC meeting statement indicating that rates would stay low for another two years encouraged financial institutions to get long the carry trade of borrowing short and lending long. An Operation Twist, or Super-Twist, that flattens the yield curve undoes some of those benefits - though it does provide an immediate boost to investors who are already positioned in the longer end of the Treasury curve.
 
I suppose that the market could focus on the fact that $X billion is available to the Fed to re-deploy on its balance sheet, which would be bullish. On the other hand, it could also decide that this program is net neutral to negative because of the costs involved.
 
If Super-Twist is indeed the major weapons in Bernanke's stash of "secret weapons", I am unimpressed and I bet that the bulls will be unimpressed as well.


Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Why Germany should leave the eurozone (in pictures)

Everyone knows that Italian yield spreads against Bunds have been blowing out:

10-Year Italian bond yields vs. 10-year Bunds.

I thought that I would look at the long-term performance of the other major eurozone stock markets against the DAX. Here is Italy, which is a bellwether for stress within the eurozone. It's been in a relative downtrend since 2005 and there are no indications that there is any bottom. The downtrend has been steady, well-defined and not oversold on RSI.

What about the other major partner, France? Oh, never mind...

How about other "hard" currency countries, like the Netherlands?

The one "silver lining" in this analysis has been the performance of Spain's IBEX 35 against the DAX, which has appeared to have rallied out of its relative downtrend.

How much longer can Germany carry the rest of the eurozone?



Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

One-eyed men (who would be kings)

As events turned south in Greece on Friday, the WSJ reported that a senior IMF economist expected a Greek default before March:

"I expect a hard default definitely before March, maybe this year, and it could come with this program review," said a senior IMF economist who is keeping close tabs on the situation. "The chances for a second program are slim."

Furthermore, the Greek bailout was dealt a blow as Angela Merkel's CDU was soundly defeated in local elections over the weekend.

As investors look for safe havens in a potential market panic, I am reminded of the adage, "In the land of the blind, the one-eyed man is king."

Today, I see several metaphorical one-eyed men in this land of the blind that could serve as safe havens were there to be a market panic. All of them have significant flaws. In this post I would like to discuss them one by one.


US Treasury bonds
US Treasuries remain my favorite safe haven play and they have significant upside potential in the event of a market meltdown. The long Treasury ETF staged an upside breakout to all-time highs on Friday, surpassing the levels seen during the Lehman Crisis - a bullish sign.

My reservation about Treasury bonds is that the US has long-term fiscal problems. In such a case, can bonds be really a safe haven?


Gold
The price of gold has been on a tear since the market bottomed in March 2009.

Gold stocks staged an upside breakout to all-time highs on Friday, which I interpret as being bullish for bullion. Longer term, I still favor holding gold over gold stocks.

My principal reservation about gold is that it generally hasn't held up well in a market panic. It didn't during the Lehman Crisis of 2008. It sold off during the mini-panic earlier this year after the Japanese earthquake.

Despite what the gold-bugs say, gold and commodities have traditionally been part of the "risk-on" trade. In a "risk-off" market panic, risk managers and margin clerks control the market. They demand that traders and investors liquidate positions in order to meet their risk criteria and meet margin calls on all of their positions. That's why correlations converge to 1 during these market selloff episodes. One sign that I would watch for as a "tell" of a "margin clerk market" might be that gold stocks will de-couple from the price of gold. While gold may go up as a safe haven during such an episode, gold stocks may sell off because the risk managers regard them as stocks first and gold the alternative currency second.

In the current environment, I am inclined to give gold the benefit of the as a safe haven given its recent history of rising during this period of fear. I would not be inclined, however, to give the same benefit of doubt to other hard asset commodities. If there were to be a market selloff because of the fear of a recession or a banking crisis which would plunge the world into a global recession, don't you think that global demand for copper, oil and other economically sensitive commodities would fall as well?


Swiss Franc
The Swissie has been rising in the current environment of fear. As the chart below shows, CHF has been in a well-defined uptrend.

My reservations about the Swiss one-eyed man is twofold. Firstly, it didn't serve well as a safe haven during the crisis in 2008. Second, were Europe to blow up because of a banking crisis, does anyone really think that the Swiss banks won't escape collateral damage? Just look at this chart of Swiss bank asset to home country GDP exposure.

We want a vehicle that will hold up well in a market meltdown. The CHF strikes out in my book.

Incidentally, the Japanese Yen has also rallied during these turbulent periods and some investors have regarded JPY as a possible safe haven in a crisis. But I have observed how the BoJ (cough) "manages" JPY levels and there is too high a risk of intervention. JPY levels is overly "managed" in my book to qualify as a true safe haven in a crisis.


The winners are...
In summary, I would look at the following two vehicles as safe havens in a crisis (in order of preference):

1. US Treasury bonds (long Treasuries if you want to be aggressive);
2. Gold, but avoid gold stocks.

I would avoid currencies such as CHF and JPY because of specific problems connected with those countries or currencies.



Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

No help from the banks for the bulls

I have been writing about the relative performance of the KBW Bank Index (BKX) relative to the market since May. I indicated that a relative breakdown of the BKX against the market was an indication of rising systemic risk, consistent with a Russia Crisis or Lehman Crisis. Since then, the relative breakdown did take place and things have gotten worse, a lot worse.

Despite a half-hearted rally from the Berkshire/BAC deal, the banks remain in a relative downtrend against the market.

Up until recently, the performance of the Regional Banks have been relatively well behaved. While the BKX, which is heavily weighted with Too-Big-To-Fail (TBTF) banks, had broken down on a relative basis, the Regional Bank Index had held steady. Now the Regionals have broken down and they are having trouble rallying above relative resistance.

FT Alphaville has been writing extensively about the short-term funding problems of European banks because of the withdrawal of money market funds from the eurozone banking market (example here), now it appears that the French banks are having trouble because of their heavy reliance on wholesale funding.

Look at this chart of the ratio of the Euro STOXX Banks vs. the EURO STOXX Index. The Europeans banks are in a relative downtrend and they have broken a major relative support line. The relative ratio is now at all time lows - a sign of trouble.

Signs of systemic risk are rising. Take a look at this chart of funding costs of various banks. Eeek!

How many bullets can you dodge?
Putting all this together, I interpret these conditions as:

• Systemic risk in the US banking system: The US TBTF banks are signaling rising systemic risk.
• High risk of a US recession: The relative weakness of the US Regional Banks is signaling a high risk of a US recession.
• Lehman/Russia Crisis warning in Europe: The combination of continuing stories of short-term funding problems at eurozone banks and the relative breakdown of that sector in Europe are signaling a very serious problem. No wonder IMF Managing Director Christine Lagarde warned at Jackson Hole that European "banks need urgent recapitalization."

Maybe the combination of the Fed, ECB, the Obama Administration, Congress and the EU can get together and kick the can down the road yet one more time.

Realistically though, how many bullets can you really dodge? With risks like these on the horizon and technical indications that the bulls are losing control, I would be inclined to stay long the US long bond.


Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Seeds of a revolution

I have written extensively about the widening income gap between the rich and poor in America. For examples, see:

1. Which is more elitist? France or America?
2. It's a Class War, Stupid!
3. The Fed's (inadvertent) role in the class war

A number of mainstream figures have jumped on that bandwagon. Consider this article from the Washington Post from June that decried the filthy rich:

It was the 1970s, and the chief executive of a leading U.S. dairy company, Kenneth J. Douglas, lived the good life. He earned the equivalent of about $1 million today. He and his family moved from a three-bedroom home to a four-bedroom home, about a half-mile away, in River Forest, Ill., an upscale Chicago suburb. He joined a country club. The company gave him a Cadillac. The money was good enough, in fact, that he sometimes turned down raises. He said making too much was bad for morale.

Forty years later, the trappings at the top of Dean Foods, as at most U.S. big companies, are more lavish. The current chief executive, Gregg L. Engles, averages 10 times as much in compensation as Douglas did, or about $10 million in a typical year. He owns a $6 million home in an elite suburb of Dallas and 64 acres near Vail, Colo., an area he frequently visits. He belongs to as many as four golf clubs at a time — two in Texas and two in Colorado. While Douglas’s office sat on the second floor of a milk distribution center, Engles’s stylish new headquarters occupies the top nine floors of a 41-story Dallas office tower. When Engles leaves town, he takes the company’s $10 million Challenger 604 jet, which is largely dedicated to his needs, both business and personal.

Henry Blodgett recently wrote Remember "The American Dream?" What A Bunch Of Crap where he decried the lack of opportunity in America by pointing to the correlation of intergenerational earnings, which is a point that I made some time ago by referencing an OECD study that came to the same conclusion.

Now Bill Gross, who can hardly be characterized as a pinko commie, lamented the death of the American Dream in his latest missive [emphasis added]:

This impending divorce in America is not about sex or sleeping around, but more about romancing the now stone-cold notion that anyone could be a millionaire in the good old U.S. of A. if only they worked hard enough. Our Statue of Liberty proclaimed “give us your tired, your poor…” and sent many of them West to build a little house on the prairie or strike it rich in the goldfields of Sacramento, California or Skagway, Alaska. Many of them did and a century later, the option-laden fields of Silicon Valley provided modern-day examples of rags to riches fairytales come true. But this odd couple marriage of rich (and poor hoping to be rich), now seems on rather shaky ground. Instead of boundless opportunity, the nursery rhyme describing Jack Sprat – who could eat no fat – and his wife – who could eat no lean – appears to be the starker of the two realities. There are the poor and there are the very rich, with the shrinking middle class resembling Mr. Sprat rather than his wife.

How Wall Street owns America
The truth is that the top 0.1% really controls most of the wealth in American and even the merely affluent are just making do. Consider this commentary from an experienced wealth management professional. Here is his characterization of the bottom of the top 1% in America today - these are your Horatio Alger stories:

The 99th to 99.5th percentiles largely include physicians, attorneys, upper middle management, and small business people who have done well.

Those in the bottom half of the top 1% are actually rather insecure and not exactly living the life of the rich and famous [emphasis added]:

I’ve had many discussions in the last few years with clients with “only” $5M or under in assets, those in the 99th to 99.9th percentiles, as to whether they have enough money to retire or stay retired. That may sound strange to the 99% not in this group but generally accepted “safe” retirement distribution rates for a 30 year period are in the 3-5% range with 4% as the current industry standard. Assuming that the lower end of the top 1% has, say, $1.2M in investment assets, their retirement income will be about $50k per year plus maybe $30k-$40k from Social Security, so let’s say $90k per year pre-tax and $75-$80k post-tax if they wish to plan for 30 years of withdrawals. For those with $1.8M in retirement assets, that rises to around $120-150k pretax per year and around $100k after tax. If someone retires with $5M today, roughly the beginning rung for entry into the top 0.1%, they can reasonably expect an income of $240k pretax and around $190k post tax, including Social Security.

While income and lifestyle are all relative, an after-tax income between $6.6k and $8.3k per month today will hardly buy the fantasy lifestyles that Americans see on TV and would consider “rich”. In many areas in California or the East Coast, this positions one squarely in the hard working upper-middle class, and strict budgeting will be essential. An income of $190k post tax or $15.8k per month will certainly buy a nice lifestyle but is far from rich. And, for those folks who made enough to accumulate this much wealth during their working years, the reduction in income and lifestyle during retirement can be stressful. Plus, watching retirement accounts deplete over time isn’t fun, not to mention the ever-fluctuating value of these accounts and the desire of many to leave a substantial inheritance. Our poor lower half of the top 1% lives well but has some financial worries.

People who are in the top 0.1% or 0.5% generally got their wealth from finance [emphasis added]:

Folks in the top 0.1% come from many backgrounds but it’s infrequent to meet one whose wealth wasn’t acquired through direct or indirect participation in the financial and banking industries. One of our clients, net worth in the $60M range, built a small company and was acquired with stock from a multi-national. Stock is often called a “paper” asset. Another client, CEO of a medium-cap tech company, retired with a net worth in the $70M range. The bulk of any CEO’s wealth comes from stock, not income, and incomes are also very high. Last year, the average S&P 500 CEO made $9M in all forms of compensation. One client runs a division of a major international investment bank, net worth in the $30M range and most of the profits from his division flow directly or indirectly from the public sector, the taxpayer. Another client with a net worth in the $10M range is the ex-wife of a managing director of a major investment bank, while another was able to amass $12M after taxes by her early thirties from stock options as a high level programmer in a successful IT company. The picture is clear; entry into the top 0.5% and, particularly, the top 0.1% is usually the result of some association with the financial industry and its creations. I find it questionable as to whether the majority in this group actually adds value or simply diverts value from the US economy and business into its pockets and the pockets of the uber-wealthy who hire them. They are, of course, doing nothing illegal.

You need intellectuals and leaders for a revolution
History is filled with peasant revolutions that fizzled and never went anywhere. The ones that are really dangerous to the Ruling Powers are the movements that have 1) leadership; 2) followers; and 3) an intellectual foundation. It may be easy to dismiss the likes of left leaning DailyKos account of Iceland's ongoing revolution, which is the modern equivalent of peasants gathering with pitchforks. It's more difficult when establishment figures like Bill Gross and Warren Buffett stands up for the cause.
 
In addition, we also have George Magnus, of UBS, who has writing an editorial in that pinko website Bloomberg entitled Give Karl Marx a chance to save the world economy. The likes of Gross, Buffett, Magnus et al represent the leadership in this movement to save capitalism from itself. If they aren't careful, they may spark a revolution that goes in an unintended direction. (For example, remember Gorbachev? Where is he now?)
 
What about the intellectual foundation for a revolution? I found an intriguing and disturbing interview with David Graeber, a social anthropologist, who has a new theory of money - that the use of debt and credit is a way to creating a class of debt slaves. He explains that credit came first before currency as a medium of exchange:

So really, rather than the standard story – first there’s barter, then money, then finally credit comes out of that – if anything its precisely the other way around. Credit and debt comes first, then coinage emerges thousands of years later and then, when you do find “I’ll give you twenty chickens for that cow” type of barter systems, it’s usually when there used to be cash markets, but for some reason – as in Russia, for example, in 1998 – the currency collapses or disappears.

Even in ancient Mesopotamia, there were debt slaves [emphasis added]:

This was the great social evil of antiquity – families would have to start pawning off their flocks, fields and before long, their wives and children would be taken off into debt peonage. Often people would start abandoning the cities entirely, joining semi-nomadic bands, threatening to come back in force and overturn the existing order entirely. Rulers would regularly conclude the only way to prevent complete social breakdown was to declare a clean slate or ‘washing of the tablets,’ they’d cancel all consumer debt and just start over. In fact, the first recorded word for ‘freedom’ in any human language is the Sumerian amargi, a word for debt-freedom, and by extension freedom more generally, which literally means ‘return to mother,’ since when they declared a clean slate, all the debt peons would get to go home.

Graeber said that the idea of debt is deeply embedded in the language of ancient cultures and religions:

In Sanskrit, Hebrew, Aramaic, ‘debt,’ ‘guilt,’ and ‘sin’ are actually the same word. Much of the language of the great religious movements – reckoning, redemption, karmic accounting and the like – are drawn from the language of ancient finance.

Throughout history, we have seen shifts between a credit based economy and commodity/barter based economies, but those shifts are highly disruptive and can cause the fall of civilizations:

Since antiquity the worst-case scenario that everyone felt would lead to total social breakdown was a major debt crisis; ordinary people would become so indebted to the top one or two percent of the population that they would start selling family members into slavery, or eventually, even themselves.

Top one or two percent? Sound familiar? He went on to talk about how the financial institutions are now perpetuating the status quo [emphasis added]:

Well, what happened this time around? Instead of creating some sort of overarching institution to protect debtors, they create these grandiose, world-scale institutions like the IMF or S&P to protect creditors. They essentially declare (in defiance of all traditional economic logic) that no debtor should ever be allowed to default. Needless to say the result is catastrophic. We are experiencing something that to me, at least, looks exactly like what the ancients were most afraid of: a population of debtors skating at the edge of disaster.

And, I might add, if Aristotle were around today, I very much doubt he would think that the distinction between renting yourself or members of your family out to work and selling yourself or members of your family to work was more than a legal nicety. He’d probably conclude that most Americans were, for all intents and purposes, slaves.

Remember that quote, "[Aristotle] would probably conclude that most Americans were, for all intents and purposes, slaves."

The American Revolution was sparked by the theory of natural rights, as espoused by thinkers such as John Locke. Today, Graeber may fill the role of Locke. We have all the ingredients for a revolutions: the intellectual foundation (a new theory of money that concludes that Americans are debt slaves), a leadership cadre (Buffett, Gross, Magnus et al) and dissatisfied peasants with pitchforks.

America needs to be careful. Down that road is Robespierre, Hitler and the disintegration of a civilization.




Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.



None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.