How to bring down the System

There are a lot of angry people out there. I see it every day in my writing. All you have to do is look at the comments at a site like Zero Hedge to realize that fact. To some extent you saw this in the last election. Those who vote (less than half the population) sent a message and as a result there has been a significant change in the political landscape.

But what do the voters get for sending the message? A slap in the face. A few weeks later we get a monster tax break for high end earners, a roll over of the tax treatment for hedge fund mangers (just obscene), another $120 billion “stimulus” that won’t do a damn thing but add to the debt and an extension of unemployment payment for yet another year.

If you pay bills (who doesn’t) you know that all banks, credit card companies, utilities, insurance companies and all the others are just nickel and diming us to death. Every month I am nicked for some damn thing or the other. I think the FinReg rules that were supposed to protect the average Jane or Joe actually just codified what the bastards could charge. As a result we get hit with new fees, charges and higher costs.

The very frustrating part of all this is that there is not a thing you can do about it. Go write your congressperson; you’re lucky to get a form letter response. Get on the phone to your CC provider and bitch over a $25 late charge on a $15 balance? Good luck.

I have been doing something for the past few months that might send a message. If I continued for the next hundred years it would not make a dent. If a hundred thousand did as I am doing it would be noticed but still wouldn’t mean a thing. But if the number got into the millions it would start to make a difference.

I have been sending 1 cent more than what is due on every bill that I get. Citi sends a CC balance of $134.82? I send them $134.83.

I have a small sample of about 30 bills that I have been doing this with. Well more than half get it right. On the next month CC bill you get the Prior Balance as (-0.01). What this means is that a real person actually got the bill and the check (or electronic payment) and made the correct entry and gives you the once cent credit you deserve. This result should not be surprising as people make incorrect payment amounts all the time. What I am trying to do is force more human intervention. That is time and money.

I paid a six-month insurance bill and added a penny to what was owed. So far I have two letters that show the credit. How much does two computer generated letters cost? At least a dollar a pop. There is no better measure of success of my approach than to get a letter like this.

More exciting are the bills that do not pick up the one-cent variance. When this happens your penny is lost. It will show up in an Exception Report. Some computer recognizes that there is a penny that is not properly accounted for. I assume that this happens (accidentally) thousands of times a day. But what would happen if the number of Exceptions all of sudden exploded to 20-50 million a month? Once again, this would force humans to get involved.

The cost of this social protest is very minimal. Say you get 4 bills a month. 48 pennies a year is the maximum cost. Based on my experience the net cost would only be 20 cents or so. But the rewards on the 20 cents just keep on giving. Every month after you can see the results. Either they do it right or wrong. Either way there is an incremental cost. Your penny is gumming up the system.

What if 10mm people did this on a regular basis? That would be a half billion one-penny exceptions a year. If just one in ten resulted in an “exception” it would mean that there would be an incremental cost someplace of at least $50 million. In my dream world 25mm people would do this and get just two letters a year as a result. Cost of that? Who knows? It would imply 1.2 billion exceptions a year. That would be noticed. (It would blow their collective minds if this started to happen)

So if you’re mad at the system and want some revenge send an extra penny to your friends at the gas-company, electric company, insurer, bank, CC company, etc. I highly recommend it. The cost is negligible. Yes, it is true that this form of protest will accomplish very little unless it catches on like a fad. But should you get (as have I) some evidence that your lousy penny is in fact causing someone someplace to spend time and money trying to figure it all out you will beam with happiness at your success. I am.

Dinner up High

Sadly, I’m not on anyone’s A list for a holiday party. I was fortunate enough to get an invite to a swell dinner bash in the City. A nice lady I know (who has no interest in men) needed a date. The thinking was that I would not make a hash of it, so I got the nod.

I was in that enviable/unenviable position of not knowing anyone. There is only a dozen, so I schmooze as best I can. The place is filled with NY types; lawyers, bankers, buy-side types, RE sharpies, art dealers, ad execs, a few (very busy) wives and one degenerate blogger. My kind of crowd. The hostess gives me a quick tour of the place, (30th floor, three bedrooms, view of the park) and drops me with the ‘guys’.

Normal banter from the boys.

“How much money has been lost in the past six weeks betting on NY football teams?”
Answer: Staggering.

“Is Cialis really better than Viagra?”
Answer: It depends. For a quicky Viagra is fine. For something “special” Cialis was a better choice. I was surprised that a cost benefit analysis was part of the discussion. Apparently Cialis is up to $22 a pop and Viagra is still only ten bucks. Of course no one had any first hand knowledge on any of this, it was all “I’ve heard” or “I read”….

“How’s business?”
Answer: Fucking great. This is not a crowd that brags. They don’t really need to. So you had to read into the words; “We were very pleased” or “Best year since 06”. My favorite; “Lots of smiles at bonus time at my shop”.

“What’s 11’ looking like?”
Answer: Fucking great. While this group is a very small subset of the economy they are seeing plenty of opportunities. They are hiring, expanding and acquiring. They all have full plates for the year. This represents a significant change from two years ago.

“What about Obama?”
Answer: Deep disappointment. Keep in mind that it is this crowd who gave Obama hundreds of millions a few years ago. The attitude; “He took his eye off the ball on the economy and wasted his first two years on health care legislation that we will never see” summed up the feelings.

I (of course) pushed my hot buttons.

“What about QE?”
Answer: It’s good for the market. Nothing else matters.

“What about the sorry state of municipal finance?”
Answer: It’s all priced in.

“What about the deficits?”
Answer: They don’t matter. It’s all priced in.

Dinner was a bunch of courses. Something for everyone. This was not family style. I did my best with which fork to use and when. The small talk was over my head.

“Alta or Vail this winter?”
Answer: Vail. Apparently there are no go good restaurants in Utah.

“Was Bloomberg bluffing when he said he was not a presidential candidate?”
Answer: He was bluffing.

“Should one consider full body scans?”
Answer: Absolutely not. Most either had done this or knew someone who had. The conclusion was that if you did the scans the results were 100% certain that they would find something. Interesting state of denial

“Is Sara Palin for real?”
Answer: Yes. While they expressed fear and loathing they also recognized that the level of disappointment in the country with Obama and the Democrats was likely to bring a very different candidate in 2012.


One fellow actually had a very good rep. Been in the investment biz for a long time and damn good at it. Someone asks him, “Is investing overseas still the right strategy?”. He wisely dodges the question with an obvious answer, “If you don’t have some non US exposure you’re not wisely invested.” Another who was looking for some free advice asks the follow on, “Yes, but which country?” He answers, “I focus on the countries that have the highest work ethic.” This last comment prompts a conversation that lasts through coffee.

The talk was about which countries ranked high on that list. This was not about which worker produced more. The answer to that is easy. A worker for VW in Germany produces much more than does a worker in Viet Nam. However, the conclusion at the table was that on the narrow issue of work ethic, Vietnamese workers had a better attitude than German workers.

The general question of East versus West was sort of dismissed. The obvious answer was East. The more interesting debates were on the narrower questions:

France – Germany? Easy for this group.
Italy – Spain? Not so easy.
UK – France? Harder still.

How about China versus India? That’s a tough one. Harder still, Taiwan versus Korea. Israel ranked high. Some Eastern European countries made the final list. Russia was dismissed on the issue of work ethic.

Brazil confounded the group. Everyone recognized the rising tide for this country. But on the work ethic issue Brazil was not high on the list.

The diners did not fall prey to the stereotype of workers from Latin America. Too many of us had worked, lived or done business in that region to make that mistake.

This was all just “dinner talk”. I found it interesting. I’m not going to publish the list we came up with. I think the readers can do that as well as we did. There is a level of arrogance to this type of ranking. Some of the biases we brought to the discussion no doubt tainted our conclusions.

On the ride home I thought of the evening. I had hoped that there would be something interesting to write about. My first thought was that there was not. Just a nice dinner, nothing memorable. But later I reviewed the list we came up with and I was struck by what was missing.

This group of relatively sophisticated, well-traveled and knowledgeable people spent an hour 300 feet above the lights coming up with the country comparisons. America was mentioned and compared on a number of occasions. But the final list did not include the USA. If the elitist don’t think much of our collective work ethic, what does that mean?
Answer: Nothing good.

2011 - What's Coming

Oh boy is 2011 going to be an exciting year! Some things that I think might happen:

-Volatility is going up across the board. If you have the stomach for the swings that are coming across all markets there is a ton of money to be made; balls and timing are all that are necessary. The markets will create dozens of opportunities to make and lose.

-There will be 50 days with a swing in the S&P greater than 1%. There will be 10 days where gold swings $50. There will be two days with a drop greater than 100 bucks. Most of the big moves will be down moves. Bonds will not be spared the volatility.

-Gold will be higher a year from now but off its peak. At some time in the fall, gold will be near 1,800 and the New York Times will do a front-page story that gold is on its way to 2,000. That will be the high point of the year.

-Copper will continue to rise. This metal will benefit as the poor man’s gold. Why buy an ounce of something for $1,600 when you can have a whole pound of something else for only $5? The logic is compelling only because there is no logic. Increasingly, it will become understood that money does not hold value. Copper will do a better job of storing value then a Treasury Bond.

-The US bond market is in for a heck of a year. The 30-year will trade at BOTH 3% and 5%. Higher rates will come early in the year, then the deflation trade will come back into vogue.

-Spain will be the next sovereign debtor that falls prey to the market. This will happen before the end of the 1st Q. The package to bail them out will exceed $500b. This will exhaust the EU resources. There will be very high expectations that contagion will then move to Italy. That will not happen in 2011 (2012?) The European Central Bank will step up to the table (finally) and support the market for Italy. Sometime between March and June Italian bonds will be a great buy.

-The IMF will contribute $125b to the Spanish bailout. The US portion of this will be $25b. Republican Senators and Congressman go nuts. The American people will side with them. The argument, "How can we help Spain but not California?" will be the mantra. In the end the IMF commitment will stand. But that will be the last time the US contributes to a sovereign bailout. This will prove to be very destabilizing at some point after 2011.

-The ECB will be forced to issue bonds that are joint and several debt of the EU members. This development will stabilize the EU temporarily, but it will be hated in Germany. The amount of the new issuance of these bonds will be small. The program will be terminated in 2012.

-The dollar versus the Euro will be all over the lot. The low for EURUSD will be ~1.17. The really big surprise is that toward the end of the year the Euro will be pushing 1.50.

-The CHF will be like copper. It will attract investors as there is no good alternative. Before June EURCHF will trade below 90.

-The market will finally wake up to the fact that the YEN is not a good store of wealth. The continuing argument will be, “Yeah the Yen stinks, but everything is worse so it should be okay”. Wrong. The Yen is a short. The best currency trade of the year will be long Sterling short Yen. There will be better levels to put this trade on then exist today; be patient.

-The US will have a full year deficit of 1.4 trillion dollars. This depressing reality will hang on the US economy/markets. Congress will talk about the problem endlessly, but little will be accomplished. By the end of the year the problem will be so acute that belt tightening is put in place for 2013-15. But it will be too late by then.

-QE2 will be the last QE we see. The program will end (on schedule) on 6/30. Perversely, long-term interest rates will rise as long as QE continues. When the program is finished rates will begin a rapid decline. This will not go unnoticed by academia. The result will be that QE will be a disgraced policy that will not be used again for at least five years.

-The high for the S&P will occur before June. The S&P will fall short of 1,500. The low will be 1,100.

-Oil will rise to $130 in the next six months. It will be above $100 at the end of the year.

-China’s inflation rate will continue to rise. Food will be the primary driver. The central government will respond with monetary tightening and an acceleration of the Yuan appreciation. It will not work. Inflation will push 7%. The domestic economy will continue to grow but at a much smaller pace. 5% GPD will be all that China sees for the year. The trade surplus will fall by a third.

-Brazil will continue to shine as a resource rich country that runs a trade surplus and has low budget deficits. The surprise of the year will be Argentina. Food will be the reason. Argentina’s fortunes will improve with rising wheat and soy prices.

-The US will wind down its presence in Iraq. With every step we take out the door domestic violence will rise. Iran will assume a larger roll in the south (Basra). This will not go over well with the US. Much of the year will be spent debating what should be done. US warships will be off the Iranian coast waiting for a phone call, but no shots will be fired. Russia and Germany will not go along with strong sanctions against Iran. The problem will fester toward a resolution in 2012.

-Kim Jong-Il will die. His son will take over. The heir is a nut, there will be more military exercises that results in shells landing on S. Korea soil. China will make public statements that it is trying to bring order; behind the scenes they will be applauding the chaos.

-Obama’s popularity will continue to fall. The legislative “successes” at the end of 2010 will convert to a series of failures. There will be no new stimulus. Portions of the health care legislation will be dialed back. The mandatory participation feature will be found unconstitutional. Without this feature the legislation makes no economic sense and a great debate will be initiated as to what to do about it. Nothing will be accomplished. Reason? There are no “answers” to this problem.

-Obama will propose a means test for Social Security in his State of the Union Address. Retirees who are living the high-life (Warren Buffet types) are going to have their SS checks cut to the bone. Any senior with income of $200k will be impacted. The great socialization of Social Security will have begun. The popularity of this program will fall of a cliff.

-The 2% reduction on worker contributions to Social Security will be extended and expanded to 3% for 2012. Rates will not go up in future years. Social Security will have to be gutted as a result. This will not happen in 2011. But the seeds will be sown for this to occur in 2014.

-2011 will be a stock pickers market. Index investing will see a bad year. Some of the darlings of 2011 like AAPL and NFLX will not fare so well. While I don’t see big declines in these stocks there are much better places to put money to work. M&A will be a dominant theme. That is where the action will be.

-There will be at least three more 'Flash Crashes'. The SEC will launch another investigation into how this could happen. The conclusion will be that ETF's and how dealers manage them are responsible for the liquidity problems in individual stock names.  There is no solution to this problem. The market will be on edge looking for the next mini crash. A stock will fall prey to this and drop 20% in seconds. Unlike prior examples there will be no recovery in the stock. Holders will protest the losses. There will no restitution. Market confidence will fall as a result.

-Meredith Whitney will be proven wrong in her forecast that 50-100 munis go chapter 9 this year. The process to insolvency takes much longer than she has anticipated. Only 11 munis will make a chapter filing. The rest will be pushed to the brink in 2012.

-The center of attention will move away from California as the most bankrupt state. In his State of the State address in January, New York’s new Governor Andrew Cuomo will fess up to the fact that for the past year of so NY has been burying its problems. Substantial cutbacks in spending will be the result. NY State long -term GOs will trade at 6% at some point in the year.

-Unemployment will not go down. The average for the year will be above 10%. The number of workers who leave the system will rise to 20mm. These workers will find part-time jobs that pay cash. The new day-workers will compete will illegals for employment. Social tensions will be the result.

-The Chevy volt will not sell well. Boeing will be unable to complete a single Dreamliner. GM will trade below $30, Boeing will hit the low $50’s.

-The Singapore dollar will be the strongest currency on the globe in 2011.

-Apple will not come up with a new product this coming year. The rest of the consumer tech manufacturers will gain some market share. The problems with dropped calls with the iphone will be an issue. Apple will respond with alliances with a number of other providers. ATT's stock will suffer as a result.

-Headline inflation will rise a bit. It will push through 2%. Those numbers are meaningless. The price of a pair of jeans will be 50% higher. Food will cost us 15% more. Gas will be at $4. Bernanke’s QE will be blamed for the inflation.

-Much to my chagrin and surprise Tim Geithner will not be replaced as Treasury Secretary. He will continue to do a very mediocre job for us. He will be replaced in January of 2012.

-Comcast will complete the acquisition of NBC/CNBC. One of the first acts will be to fire Mark Haines. Nothing will help. The ratings will continue to fall. Becky Quick will move to FOX Business. Diana Olick will get her own show. She is being groomed to be the next Suzie Orman. Simon Hobbs will return to London.

-There will be violent weather episodes all over the globe. The La Nina condition that is now dominating global weather is the strongest in 50 years. This will make a dramatic shift to El Nino conditions this summer. This will set the stage for a very big Atlantic hurricane year. There will 12 named storms. Two cat. 4 storms will hit the mainland.

-Fannie and Freddie will be merged. Out of the ashes will come a good bank and a bad bank. The bad bank will hold 2.5 trillion of questionable mortgages. The US will end the year exactly where it started on this critical issue. The federal government will be responsible for more than 95% of all new mortgages issued.

-Washington's other mortgage lender FHA will run into troubles. Their minimum reserve level set by congress will be breached. A bailout will be required.  The true cost is buried. The bailout will be less than $20b. As this is a problem for the Senate, the legislation will passed quickly.

-There will not be a failure of a government bond auction. But the coverage for each issuance will grow smaller. China, Russia and Brazil will reduce their holdings of US reserves. The mysterious "household" sector will show a huge increase in Treasury holdings. This will be confusing as it will not match up with other data. UK reserve holdings will show a decline. These are actually holdings of China that were not included in official reserves. This will bring uncertainty.

-Mortgage Gate will die as a headline story. In fact it will go the other way during the year. Increasingly, the problems in real estate will be focused on the fact that there has been too few foreclosures. That too many people had been living in a home without paying a dime becomes a cost that all have to bear. As a result there will be a much higher level of foreclosures throughout the year. Contrary to expectation, residential real estate for average priced homes will not decline much further. However, prices for high-end homes will continue to fall. Anything with a price tag of greater than $1mm will be worth 20% less by the end of the year.

-The narco violence in Mexico will expand to many more cities. Tourism will be hurt as a result. Some of the violence will pass over our border. Anti immigration attitudes will expand. Because the low-end economy will remain in the dumpster the actual number of illegal aliens will decline by more than 1mm. This will add to the RE woes in some US areas. It will stress the countries that they originated from as $ remittances decline.

-Interest rates will be higher throughout the year for corporate bonds and Munis. This will bring a reversal of the mania to buy dividend stocks. Those who thought that this investment strategy would work for them will be disappointed. The number of hucksters pushing the dividend story will grow in number while the popularity of the strategy declines.

-Jon Hilsenrath will write an article for the Wall Street Journal that is actually critical of the Fed. The unpopularity of the Fed will rise to such a level that Jon will have no choice but to follow suit.

-The Fed will come under attack from all sides. They are truly in a no-win situation. Unemployment will continue to rise while inflation rises and the dollar declines. One side will shout that the Fed did too little (Krugman), others they did too much (the rest of the world). Everyone will hate the Fed as a result. Bernanke will not lose his job, but his term as the boss at the Fed will be forever tainted.

-ZIRP will be with us for yet another year. Bernanke will not let go of this loser policy. Inflationary expectations will respond at some point. By the end of the year a Fed Funds rate increase will be seen as imminent even though the economy will be soft.

-Social unrest will become visible in America in 2011. There will be demonstrations in many major cities. Some will turn violent. Economics will be at the heart of the anger. The frustration that was evident in France in recent years will come to the US.

Have a great year!!

D.C. & Mortgages

Two seemingly unrelated developments in the nations mortgage mess this past week. They both point to how difficult it will be to bring some stability back to the system. I am wondering if they are connected.

The first came as a surprise to me. Mr. Joseph Smith was supposed to be confirmed as the Director of the Federal Housing Finance Authority. Smith was a state banking commissioner from North Carolina. He was a White House pick. Up until last week I thought he was a shoe-in for the job. Kaboom.

Smith is out. Nixed at the last minute by none other than Richard Shelby (R. AL). The ranking member of Banking, Housing and Urban Affairs waved his arms and sent Smith back to North Carolina. Senator Shelby had this to say:

Shelby's main concern was that Smith would be a “lapdog” to outside pressure to use the GSEs, at taxpayer expense, as vehicles for large-scale homeowner assistance programs.

Lapdog? Maybe, I don’t really know. But I doubt that is the reason for canning Mr. Smith. This is politics. Senator Shelby wants his own guy running things over at the FHFA. It is much easier to steer the outcome that way. The early talk is that Mr. Smith is going to be re-nominated. I doubt it. Come Jan. 1 there is a new set of voters on this. If Shelby is saying "no" in December; the majority will say no in January.

We need a very strong hand in this position. 2011 will be the year that Fannie Mae/Freddie Mac get put on the operating table and decisions will be made what role these two dogs will have for the next decade or so. Needless to say this is a critical step if we are to have an outcome that moves us away from socialized mortgage finance. At this point the D.C. lenders are 95+% of the new mortgage market. One way or the other that number is coming down. How our dependency on Washington for the loot that keeps the real estate market alive is resolved will be make or break for the entire economy.

Normally I would say the side show political fight over this appointment was just normal D.C. fun and games. Not the case this time. Keep an eye on this fight, it will provide clues on the direction this is headed.

I have seen again and again where a study by the Congressional Budget Office later becomes the basis for legislation. The CBO put out a report on 12/23 that dealt with Fannie and Freddie. The paper is long and does not contain much new information. The following is the cover page. I thought it sends a terrible message. When I look at it all I can think is, “The Federal Government is lending against every one  of these homes!” Not the image they should be going for.

The CBO tries to layout all sides of the argument on this critical issue. They are quick to point out that an extreme outcome is undesirable. We can’t continue with the government providing nearly 100% of all mortgages, and we can’t expect that the government’s role will fall to a small number anytime soon. The CBO conclusion is that we have to move toward the middle. They call it a Hybrid Market.

I think the CBO is right. While I would love to have Washington’s role in the mortgage market eliminated altogether, that is just a pipe dream. If we shut Fannie and Freddie down on new lending the economy would tailspin into chaos.

The CBO did have one recommendation that I thought could be very useful. They want the government to recognize UP FRONT a mark to market cost of providing a mortgage. This cost would go on the budget as a current expense. The Administration and Congress would fight over all aspects of the budget (as usual) but if they had an agenda for housing (stimulus/support) they would have to appropriate the money and vote on it where all could see the results.

The concept is relatively simple. Assume that the private market for a 30-year mortgage was 6% for a “good” borrower who has 20% equity down payment.

Now assume that in its wisdom Washington wants to provide a stimulus to the housing market. Fannie and Freddie are willing to provide the same 30-year mortgage at 5% and they are will to do it for a lower rated borrower and they are willing to do it at 90% of the purchase price.

Clearly this is a subsidy that will ripple through the system. The suggestion by the CBO is that government would record a charge UP FRONT equal to the difference between the actual terms of the loan and the market terms for the same financing. As the F/F loans have a high advance rate they would get a higher return than the 80/20 deal. If the market rate for the 90/10 deal was 7% then the cost to the government would be the Net Present Value of the 2% over the life of the loan (average 15 years). In this case the government would have to recognize a current cost of ~$15 for every $100 they lend.

My example might be a tad extreme. The point of the mark to market is to force Washington into recognizing that there is a cost to their lending. For years we went by thinking that all that cheap money was in fact without a cost. 2007-10 proved how wrong that was. Fannie and Freddie will cost the taxpayers more than a half trillion before this is all done.

Nothing will move Washington out of the lending business faster than if they have to pay for it. Recent history shows beyond doubt that there are real costs to subsidized mortgage lending. For the current budget to take a hit that approximates the fair value of mortgages would be the smartest thing we could do. The reserves created would go a long way toward assuring that there would never be a blowup and conservatorship again. If the reserves prove unnecessary after a period of time they could be returned to the taxpayers as a bonus. From the CBO report:

CBO believes that treating Fannie Mae and Freddie Mac as governmental entities for the purposes of the federal budget, and accounting for them on a fair- value basis, accurately reflects their current status. That treatment also provides more timely and relevant information to policymakers considering options for the future of the GSEs.

For instance, if legislation required Fannie Mae and Freddie Mac to increase subsidies on guarantees to first-time home buyers through a new program, the program would show an immediate cost under CBO’s budgetary treatment.

If you’re a conservative and you want to see a smaller role for government the CBO proposal on mortgages is the ticket for you. I can’t help but connect the dots between Shelby’s "no" vote on Thursday and the CBO report from the same day.

Something along the lines described by the CBO is coming. Barney Frank does not have the influence or the votes to stop it. Strong hands like Shelby will get their way. While the actual outcome is cloudy there is one conclusion you can take to the bank. Mortgages are going to be more difficult to get and they will cost more in twelve months. That will hurt, but it is a good thing.

Note: Edward DeMarco is the acting director at the FHFA. He has had this ‘temporary’ position for two years. Ed has done a good job. I believe that his policies and actions have consistently taken the side of the taxpayer. Exactly how it should be. DeMarco deserves a shot at the job. I doubt he will get it. Another mistake.

Head-Fake

A friend sent me the following chart. The arrows, shading etc. are his. Note that he has a few questions. If you can answer the second question you could make some money.

 

The green shaded area was clearly a head-fake by the market. This was (in part) a reaction to the Greenspan comment that the economy had “hit an invisible wall”. Alan was right. Many indicators and a fair number of soothsayers (myself included) saw the signals and concluded that a double dip (or at least a significant slowdown) was in the cards. As far as the markets go that call was dead wrong. The view was that employment would continue to worsen. That of course was spot on. Wrong for the right reason. Yuck.

The yellow line covers the time that QE2 first became official. It took the Fed another two months to actually implement the policy after the September comments by Ben. But there was very little doubt on the outcome right from the get-go. Yes there were speeches and planted news stories that suggested there was some debate. That was all show pony, there was never any doubt about the outcome.

Stocks have loved it. Why not? The Greenspan Put worked great for a while. QE is even better. The Bernanke Put is ‘In the Money’. The thinking is you can’t lose. A very dangerous state of mind. The bond reaction was: buy on the rumor and sell (hard) on the news.

Looking at the chart since September you have to ask the question; “Is this real or is this another head-fake?” It’s hard to fight the lines that point up since September and not conclude that the market is telling you a sustainable recovery is being formed. I read a fair bit and can say that an awful lot of pundits are looking at this and concluding that the worst is behind us and that reasonably solid growth is on tap for 2011. The next read on the Leading Indicators will no doubt show an uptick, the principal reason being that the yield curve has steepened.

I am going to stick my neck out and say it is a head-fake. It is not clear sailing in front of us. Some things that I think “fight” the conclusion that stocks, bonds and pundits are drawing:



-Sustaining the Bush tax cuts is not a stimulus. No one’s check is going to be bigger as a result. This is more of an absence of a negative versus a positive.

-The $115b, 2% reduction in Social Security taxes is a stimulus. But not much of one. It comes to $15 a week for the average worker. Helpful, but I don’t see it changing things too much. The reduced deductions are largely offset by the elimination of the Make Work Pay program. Net net no big deal.

-The dollar is too strong to think that our economy is going to grow much. 2011 will bring us higher trade and current account deficits. 

-2011 will be a year of non-stop muni “crisis” talk. What this really means is that the states, counties, cities, towns and villages will all be cutting expenses. They have to. They (for the most part) have to balance their budgets. Big cut backs in muni spending will drag on GDP.

-BABs is dead. This is going to make a difference in how big ticket projects are financed. Large construction projects of hospitals, schools, roads and the like are going to have to be scaled back.

-Energy prices are rising. In 2011 we will see this in both electricity and gas. That $15 a week savings from SS is going right out the window and into a gas tank.

-The cost of food and insurance is about at least 10% YoY. Don’t look at those CPI numbers. Look at your bills. Real disposable income is going down, not up.

-We will spend most of 2011 with unemployment NORTH of 10%. Give me a break, how can we expect much growth with that as a backdrop? Sure the checks are still going out. But this is the third year that we have been at post depression highs on UE. We also know that the UE numbers are bogus. The number of people who are out of the system altogether or are working part time just keeps getting bigger.

-ARRA, the 09 stimulus, is essentially finished. Another absence of a positive.

-We will have ZIRP. A plus. But how much of one? Loan demand is not responding to ZIRP. Most large companies are sitting on bundles of cash. ZIRP actually hurts them.

-Mortgage rates are not getting cheaper. Long-term bonds for corporates have backed up a bunch. 

-We have six months of QE2 left. The last month will see only small amounts bought by the Fed. Therefore in approximately 75 days we will be sliding downhill on this program. I’m not sure what it means or what will be the outcome. I know it will add to a sense of instability as something very significant will be passing into uncertainty. Put differently, we have 53 trading days left to half-life. Not much time at all.

-Don’t’ count on the EU lifting US GDP in 11. Not going to happen. China is a question mark. I say that they cool in the coming year by more than the current thinking.

-Wild Card. There are always surprises. Rarely are they good.

What are the odds that we see a head-fake? A surprise outcome where numbers and events force a significant rethink of the now prevailing 3+ % growth in 2011 story? I would say those odds are not too high. Does 30% probability for a hard landing sound right? It’s very hard to handicap. One thing about this; if we do see the head-fake it is going to put a big dent in markets that are now trading very rich.

If the first few weeks in January give us another run up in equities and yet cheaper bonds it might be worth buying some out of the money puts/calls. The money spent may be a throwaway. But if in fact what we are seeing is a big misread on the economy and a distortion by QE2 then we are going to see the bottom levels on the chart again. Something like that happens and there are big multiples on the money spent on the bet.

Census and Social Security

The census numbers were a surprise to me. Our population is growing at a much smaller rate than I had thought. Less than 1% per annum, the lowest since the 30s. My first thought was that this was probably not anticipated 10 years ago. So I looked up one credible source for population forecasts. The Social Security Trust Fund lives and breathes this stuff. I looked at the 2000 base case (intermediate) assumptions for population in 2010. I was very surprised to see that they hit the nail on the head. Good for them.

Just for the heck of it I looked up the 2010 SSTF report to see if the new forecasts were on track with the old ones. Then I got confused.

While the SSA correctly forecast what our population would be a decade ago, they are currently overstating the population by 7,500,000 people. That comes to a 2.4% overstatement as to just how many of us there are walking around. I found that interesting.

There is a direct correlation to total economic activity and population. The more people, the more GDP. The more mouths to feed, clothes to wear, transportation, shelter, healthcare the greater the output will be. The number varies from country to country so there is no definitive relationship between populations and GDP. For example, China has a population of ~1.3b and a GDP of ~5T, therefore the GDP per person is $3,557. This number is much higher in the USA. Based on the census number and current GDP the US has a ratio of $47,300 of GDP per person. Germany has a population/GDP ratio of $41,000.

I don’t want to suggest that that if there were one additional person in the US that GDP would grow by $47K. It doesn’t work like that. But it is absolutely correct to say that if population were higher, GDP would be higher as well. Population drives demand.

Back to SSA. What are they going to do with their population estimates? The answer is they have to take them down. When they do, they will have to adjust ALL of their numbers. The have to adjust both short and long term estimates. Given that we now know that our population is smaller than SSA had assumed and is growing at a smaller rate, there are significant implications to the retirement system. All of those implications are negative.

From the census data alone SSA will be forced to conclude A) the date that the system goes negative is not 2037 and B) the date that SSA goes permanently cash flow negative is not 2015. Just from the census data I am now forecasting that the date that the SSA goes permanently cash negative was 2008. We will never see a return to a cash surplus. The 2037 drop-dead date will be shortened by a minimum of 5 years. I say they system explodes in 2030. These are very material changes.

Is the population data a game changer on the debate that is now raging on the fate of SSA? I think it is. If you were worried about the long-term solvency of the system and its impact on the broad economy before, you should be much more worried about those things after the census report.

In 2000 SSA correctly forecast the population for 2010. In the same 2000 report SSA forecast a CASH surplus at SS for 2010 of $93 billion. The actual result of 2010 will be a deficit of $45 billion. The $140b miss is largely a function of the lasting impact of the 08 recession and the continuing high unemployment. That big miss is also function of our population growing at a smaller rate than what had been assumed.

At so many levels we are fooling ourselves as to how wealthy our country is and how quickly we should be growing. The estimates we use are out of whack with reality and therefore we have this false belief that we can and should be able to just grow our way out of trouble. This fundamental belief is part of the budgetary policy driven to stimulate higher growth. It is part of the Feds thinking in their effort to push against the string with policies like QE. Those policies will not achieve the desired effects. The reason is that there is less of us around then has been believed. Slow population growth will trump any stimulus Congress or the Fed throw at it.

If we did in fact have an extra 7.5mm people in the country and they contributed to economic activity by the $47k multiplier it would translate into additional GDP of ~$353 billion. A very big number. That is approximately equal to the GDPs of Austria, Norway, Taiwan or Saudi Arabia. It is double that of Chile. The states of Virginia, Washington and Massachusetts have similar populations. On a pure population comparison the 7.5mm is equal to the entire population of countries like Israel, Switzerland and Hong Kong.

It will be interesting to see if D.C. recognizes the slow population growth in the US and ignores the implications. My guess is that that they will. But they will do so at our collective peril. There is an assumption in Washington that we can simply grow our way out of our problems. The census report says we can’t.

Too Much Alcohol

My very expensive Stihl “climbers” chainsaw won’t start. I yanked on it till my arm hurt and then threw it in the back of the truck. I toss in (the also expensive) back-pack blower that won’t start either. I go to the repair place. The guy in the back, behind the grease-stained counter has a grizzled look to him. He’s about 5’2”, 200 pounds, no hair to speak of and chewing an old, unlit cigar. He looks at me and my handful of machines and says, “What’s the matter, you can’t start em?”

I take this the wrong way and respond, “I’ve been starting these things for years. It ain’t me. It’s the damn machines!”

He eyes me and says, “Your problem is alcohol”.

Being pissed to begin with as a result of the sore arm, busted machines and wasted time this took me over the top and I snapped back, “My drinking has nothing do with the fucking machines!”

He takes a second, grins, and comes back with, “No, I meant the alcohol in the gas. That’s why the motors won’t start. I see a dozen just like em every week”.

So I shuffle and back-peddle a bit and listen while this guy explains to me that when alcohol exceeds 10% of regular gas it dissolves plastic engine parts. Things like fuel-lines or float gaskets in the carburetor. When the mixture is too rich the engine burns hot and wears out the rings. He explains that the legal limit is 10% but that all the fuel distributors cheat and mix in some extra alcohol so they can make a buck. When the mix gets to 15% it’s toxic for two cycle engines. And that is what killed my machines. He pulls off the gas line and shows me that it has deteriorated to the point where it has fused shut.

Armed with this new found underground information I go online to see if anyone else knows about this. Sure enough, it is all over the web. But what gave me a laugh was this article today: (Bloomberg link)

Carmakers, Engine Makers Challenge Rule Allowing 15% Ethanol in Gas

The premature introduction of mid-level ethanol blends (as a general purpose fuel) could result in unintended adverse impacts on the 250 million Americans who own and operate over 400 million motor vehicles, motorcycles, lawnmowers, chainsaws, recreational boats, ATVs, etc.

The EPA granted a request from ethanol producers, including Decatur, Illinois-based Archer Daniels Midland Co., to increase concentrations of the corn-based fuel additive in gasoline

This bit spells out the problem with alcohol and gas. The EPA has now proposed that all gas contain 15%. They want the subsidies for ethanol to be expanded. Along the way they are going to shorten the life of all the engines we use. Progress? Stupidity??

I’m thinking to myself that if the guy behind the greasy counter knows this, why don’t the bright folks in D.C.? Or do they know it and understand it, but they are doing it anyway because they have an axe to grind? Either way, it’s a sorry state of affairs.

By the way, the repairs cost me 175 bucks.

Trade Against the SNB

The Swiss National Bank has made two significant reserve management moves over the past decade that have blown up spectacularly. Now they have put on another big position. Given the past track record, a spec position against their book might be a winner. First, a bit about the past.

Starting in 2001 and ending in 2005 the SNB sold off half of their big holdings of gold. They sold a total 1,300 tonnes. Phillip Hildebrand, the current chairman of the SNB gave a speech in 2005 to the Institute for International Economics. He crowed about the success of the program. (PDF Link). This chart from that speech tells it all. The SNB sold at the dead bottom of the market. The four-year program netted them an average selling price around $350. What a disaster. The 42 million ounces of gold is now worth $44 billion more than what it was sold for.

The next blunder occurred early this year when the SNB made the terrible choice of defending the weak Euro against the strong Swiss Franc. They absorbed an additional CHF 120b in reserves in this losing battle. After spending a fortune they folded their cards and just watched the CHF appreciate even more. Today the EURCHF is at the lowest level in history. How much did this cost? In the first nine months of the year the tab came to CHF 21b ($22b). Things have gotten worse since 9/30.

My criticism with the SNB is not that they lost money. I don’t think they should have taken these steps. I doubt they would have if they had not fallen sway to political pressure. The farmers, exporters and tourist industry pushed the SNB into a corner. They reacted in a dumb way at the wrong time and now are paying a big price. I think that in an effort to gloss over their past mistakes they have now made yet another mistake.

The most recent move by the SNB was to convert a portion of their unwanted (and losing) Euro holdings into Japanese Yen. In the 3rd Q they made a number of reserve shifts to mask their exposure to the Euro. They reduced their Euro holdings from CHF 120b to 90B. A good chunk of that reserve diversification went into the Yen. This chart looks at the quarterly changes in holdings. You can see that the Yen assets increase by 150% and now total 10% of all reserves.

The SNB bought 1 trillion Yen and sold Euros during the third quarter. So the result is that the SNB is short EURYEN. But actually they got long the Euro by shorting the CHF so the real currency exposure is short CHFYEN.


This is a chart of Q3 for CHFYEN. The SNB short CHFYEN position was put on (functionally) at a level around 82.5.

What has happened since? The CHFYEN has strengthened. A more recent chart:

The one-year chart suggests that the SNB got into this position at a low level but not so far from the average for the year.

But now consider the five-year chart:

The big gap down in 2008 was somewhat of a fluke as during that time the dollar got excessively strong and money was leaving all of Europe. But now it is 2011 and Japan is not the darling it once was. My bet is we see a move in the CHFYEN cross back to the 95+ level. A tradable move.

The FX markets bounce around quite a bit in the short term. Should we get some gyrations that create a good entry point for a long CHFYEN trade it might be worth a punt. You will be trading against a big guy. But that big player has had a losing hand.

Disclosure: Long CHFYEN

What’s Going on with Credit Unions?

Last week saw a flurry of activity relating the nations credit unions. I’m not sure what it adds up to, but it is curious. For example, Congress passed a law on the subject:

111TH CONGRESS 2D SESSION

S. 4036

AN ACT To clarify the National Credit Union Administration authority to make stabilization fund expenditures without borrowing from the Treasury.

Just the heading of this scares guys like me. The purpose of the law is to avoid Treasury from forking out money to the NCUA? That would be a bailout. Everyone hates bailouts. But there is a large hole in the NCUA system that should be filled. If that bucket is not filled by Treasury then who will fill it?

I believe the plan for the empty bucket is to assess the individual credit unions for several years worth of insurance premiums. This is exactly what NCUA’s big sister, the FDIC, did last summer. The FDIC collected four years of premiums upfront to bolster their underwater insurance fund. In the case of banks, the prepayment shows up as an asset on the books, the expense is recognized over the four years, so there is no economic penalty for the banks to front the losses. The question then becomes, can the individual credit unions pay the premiums? That was addressed in the new law:

Any insured credit union that fails to make timely payment of the assessment or special premium is subject to the procedures and penalties described under 21 subsections (d), (e), and (f) of section 202.’’

Basically this means if they don’t/can’t pay, they are toast. How big is this issue? Consider the following:

As of November month end, 372 federally insured credit unions, with assets of $43.4 billion were designated as CAMEL code 4 or 5. In addition, there were 1,792 CAMEL 3 credit unions with assets of $158.2. Overall, 22.3 percent of all credit union assets are in CAMEL code 3, 4 or 5 credit unions.

What does CAMEL 4-5 mean? Answer: Dreck.

 

What does CAMEL 3 mean?

There are of course losses embedded in this $200b of assets. How much? I would estimate $20-40b. That may sound like a big number, but it is not. There are about $900b of total assets in CUs so the problems are in the 5% range. They are also concentrated in a few large corporate CUs. Four-years of prepaid insurance covers the nut. The question becomes; “Who is going to step in to fill the roll of those that are in the process of failure?”

The answer to that (I think) lies in the minutes of a board meeting by the National Credit Union Administration. The meeting took place on December 16th. The exact same day that Congress was voting to approve S.4036. (If you believe in coincidences, stop reading) The language:

New subpart C of Part 708a establishes procedural and substantive requirements for converting a credit union to a bank through merger.

They change the rules so that the commercial banks can play in this space? This change to the charter is also interesting:

The new requirements apply to direct mergers as well as transactions where the credit union first converts to a mutual savings bank (MSB) and then merges with another bank without operating as a stand-alone MSB.

This suggests that a CU can become a MSB in the morning, and in the afternoon it can merge or sell itself to a commercial bank. What do they need to get all of this done? SECRECY, of course. From the NCUA 12/16 minutes:

Finally, the proposed amendments to Parts 708a and 708b revise existing rules to enhance the secrecy and integrity of the voting process in MSB and insurance conversions.

Given that this can now be accomplished with the desired level of secrecy I would anticipate that the process will commence sometime in 2011. I anticipate that some of the big banks will step in and buy up the shells of a number of the corporate CUs.

Should this happen many will call it a success. The alternative was a federal bailout that would have cost taxpayer dollars. This outcome is the objective of S.4036. But here is my rub; the CUs provide important banking services to millions of people. Were it not for the legacy assets of 2006-08 the CU’s would be muddling along just fine today. They provide an important alternative to the big commercial banks. But now some key players who provide important services to the smaller CUs are going to get gobbled up by fat cat bankers from Wall Street.

There is big money to be made in this consolidation. Big players will no doubt be involved. At the end of the day the big banks will make another bundle. The cost, over time, from less competition and higher fees to consumers will be more than the $30b that is being avoided.

This is another of those examples where if you are big and have muscle you can bend the outcome and come out ahead. Guess who brought you S.4036? Dodd/Frank of course (surprised? I hope not). These two guys have been the best friends the big banks ever had.

IRS – Heck of a Job!

If you were thinking about cheating on your taxes this year I would suggest that you read the latest report from the IRS. The catchy title says it all: (PDF Link)

INTERNAL REVENUE SERVICE
FISCAL YEAR 2010 ENFORCEMENT RESULTS

It seems that the good folks at the IRS are burning the mid-night oil. Their results are up across the board, with only one exception. Audited returns for companies with assets greater than $250 million fell by nearly 50% between 2005-2010 (2010:23.44%, 2005:44.1%). This, no doubt, reflects the fact that our large corporations are so honest these days.

Some bits from the report. Note that there are two ways of looking at this. The results are presented in both percent and raw data. The percent numbers may lead you to conclude that you might not get caught if you fudge some numbers. But the raw data will scare you in a different direction.

-Only 1% of taxpayers with incomes under $200,000 are audited. So you have a 1 in 99 chance of getting hit. However, in 2010 1,428,000 people got “the letter”. There are only six cities in America that have a population greater than 1.4mm.

-If you make more than 200k, but less than a mil you have more to worry about. 153,000 (3%) in this group got nailed.

-If you are lucky enough to make more than a mil you have the IRS looking over your shoulder. The odds are 1 in 12 for an audit. 32,500 rich folks got porked in 2010.

-Speaking of high incomes these graphs blow me away. We hear again and again about how terrible it was during the deep recession of 2007-2009. Nonsense. The number of people filing big-ticket returns never dipped. It steadily rose.

 

-If I was wearing an IRS hat the first place I would look is at partnerships. The opportunities for abuses jump out at you in these set ups. The IRS would not hire me. They think quite differently of partnerships in general. Of the 3.4mm partnership and 4.4mm Sub-S returns (7.8mm total) only 28,700 were looked at. A scant 0.37%. Go figure.

-There are 22,700 IRS agents looking for trouble. They find it. In 2010 they filed 1.64mm cases and as a result collected an extra $57 billion (100% ten year increase). That aint hay. It comes to more than $2.5mm per agent. These nice people are not bounty hunters working commission. They are civil servants. But don’t for a second believe that there is no connection to what they collect, and what is their pay grade.

-If you did slip up, you get a letter that goes like this:

Dear Taxpayer,

We have audited your return……..

It ends with:

……..So please stop by next Tuesday at 2. Bring your papers and a lawyer might be nice. Don’t be late, we will just lean on you harder.

Should you get the black letter; just bend over. The IRS wins 90+% of the cases it pursues.

-The final thing to consider when contemplating stiffing Uncle Sam is, "What's the downside?" In 2001 the average tax cheat spent 18 months in the slammer. If you get banged in 2011 you're looking at 27 months.

Debt Factoids - CBO

If you’re interested in the subject of our national debt there is a new must read report from the CBO on the topic. Some odds and ends I found interesting:

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We know that there is a law called the debt ceiling. We also know that we will (again) hit that limit early in 2011. Many think that this will be a line in the sand fight with the new Congress. Phooey. This from the CBO report:

Options for the Treasury When Debt Approaches the Limit

Suspending Issuance of Maturing Cash Management Bills in the Supplementary Financing Program.

$200b

Suspending Flows and Redeeming Securities in Government Accounts.

A) $124B (The TSP is a retirement program for federal employees similar to a private-sector 401(k) plan; the G Fund is one component of the TSP and is solely invested in Treasury securities.) NOTE: Federal workers 401Ks to be raided. An interesting precedent)

B) At least $200b from Civil Service Retirement Fund (there is ~$800b in total, but there are some restrictions on usage.

C) $20b Exchange Stabilization Fund

Swapping Debt with the Federal Financing Bank.

$15b

Total $560 billion.

Conclusion: If there is to be a fight over the debt limit, it could be a long one.

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 The CBO is speaking with forked tongue in this report. A critical issue is; “How do we define what is debt at the federal level?” There are so many components to the puzzle. I give the CBO an A+ for this position:

CBO believes it is appropriate and useful to policymakers to include Fannie Mae’s and Freddie Mac’s financial transactions with other federal activities in the budget. The two entities do not represent a net asset to the government but a net liability—that is, their impact on the government’s financial position is a negative one.

So how does CBO actually account for F/F? They get a D- for this:

Neither CBO nor the Administration currently incorporates debt or MBSs issued by Fannie Mae and Freddie Mac.

That’s interesting. They say they “should” do it, but they don’t. Who makes that decision?

The Administration’s Office of Management and Budget (OMB) makes the ultimate decision about whether the activities of Fannie Mae and Freddie Mac will be included in the federal budget.

The White House decides which categories of debt are included when determining what constitutes debt? That is convenient. When did that happen? We are not talking chicken scratch here. The good folks over at the Fannie and Freddie have piled up $6 Trillion in debt. We would blow out the debt ceiling set by congress by over 40% if that came on the books. So it stays off the books. But the debt is staring us in the face. Funny system.

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This caught my eye:

Interest from the Federal Financing Bank.

Payments of interest from the FFB to the Treasury have been less than $1 billion annually in recent years but are projected to increase (to as much as $6 billion) because of higher loan activity (particularly by the Department of Energy’s Advanced Technology Vehicles Manufacturing program and the Rural Utilities Service). As of September 30, 2010, the FFB portfolio totaled $60 billion.

Hello, what is this? For interest to rise at the FFB from 1 to 6b it would have to imply that there is at least a 4-5 fold increase in the balance sheet. This means that there is a plan to grow the FFB by $250b. Who is going to be the beneficiary of that? That is a hell of a lot of money. Is the FFB going to fund a solar build-out? The existing portfolio of DoE loans:

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Another (minor) data point of interest.

The federal government has a number of Trust Funds that are used as accounting vehicles to store up IOUs from the government. The principal accounts and current holdings:

Social Security Trust Fund…….2.6t
Civil Service Retirement Fund...0.8t
Military Retirement Fund……...0.3t
Medicare……………………….0.3t
All others…….………………...0.6t

Total:…………………………..4.6 Trillion

These funds are all anticipated to grow over the next decade. One has a growth rate that is way out of whack with the others:

The Military Retirement Fund is growing at three times the rate of the others. The raw numbers are, 2010=282b and 2020=1,012b. A ten-year increase of $730 BILLION. (a 350% increase) What is that about? Are we planning on a new war, or have we just not accounted for the retirement costs of the military properly over the past decade or two? I suspect (hope) it is the latter.

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We have all seen a form of this chart elsewhere. It is nothing to be proud of. Yes, there are a few countries in worse shape than us. But Italy, Greece and Belgium are now making front-page news with their debt. And the USA will have a different outcome than Japan.

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 This chart of Trust Fund Assets is central to our problem. Notice that these funds are scheduled to grow by more than 2 trillion. It sounds nice that the nation has Trust Funds where money is squirreled away someplace safe. Money that can be used to pay bills (Social Security) when they come due over they next 20 years.

But there is no money in the Trust Funds. They have IOU’s that obligate future taxpayers to come up with the cash when needed. The Trust Funds have nothing to do with “savings” in the traditional sense.

This has been going on since 1983 when Greenspan created the accounting gimmick and the huge surpluses that followed. The fact is we do have future liabilities, and there has been some savings set aside for that. But the money has been spent on funding past deficits. So really there are no savings. I am not sure there is a fix to this problem. I do know that the bills on this are coming due in the next five years or so. I don’t think we will make it another ten-years without having to confront this problem.

Ben Takes Out the SNB?

There are a dozen different barometers for economic stress in the EU. They are all pointing higher. CDS and bond spreads are going through the roof. There are riots again. While it is not a new story, the fact that Belgium is now going center stage in the EU mess is a very interesting elevation of risk. Geographically speaking, we have reached the core.

For me, the best measure of stress has always been the EURCHF. That pair is sending off alarms. We are just a tad above the all time low of 1.2770. I see no reason why a new low should not be set by the NY open.

The strong Swissie, weak Euro story has been with us for quite a while now. This graph shows how far we have travelled on this cross.

It is easy to blame all of the weakness in the EURCHF on the ongoing circus in Disney Euro Land. But I think there is more to the story. The recent meltdown in the cross started on 11/3/2010, the day that QE-2 became a reality (surprised?). I never have believed in coincidences, this time is no exception.

As of the end of the third quarter the Swiss National Bank reported reserves in Euros totaling 90.9b. If the year-end rate is the same as today it translates into a three-month loss of CHF 5.5b (USD 5.6b). On a population-adjusted basis this would be the equivalent of a $214b loss in the US. On a GDP comparison this is equal to $160b. Can you imagine if the Federal Reserve had a loss in three months of that magnitude? Ron Paul would shut them down. This is a big deal for little Switzerland.

The problem that the market faces is that the year is not over. Liquidity between now and year-end is going to get thinner and thinner. Big risk taking and big FX books are not in the cards this holiday. That being the case, some unanticipated things might occur.

Watch out for gaps in currency trading for a bit. If that starts to happen and volatility jumps up it will spread to other markets. I think markets have been “thin” across the board for some time. Equities are just robots moving paper for the most part. The big jump in global bond yields of late stinks a bit of liquidity issues. FX volume has been heavy, but are there folks who are willing to take on big new risk if money starts moving? I wouldn’t think so. If money decides it does have to make a move over the next few weeks, then it’s likely to have an out-sized impact. 

Many Questions - No Answers

Another absolute pasting in the bond market today. I have been anticipating something along these lines, but this is happening much faster than I expected. I suspect we are near a tipping point . Either the run on the long end abates and we find a new trading range or the 30-year is going non-stop to 5%.

There is an interesting little sideshow developing. QE-Lite is getting smaller by the day. This program is the balance sheet top off of the original QE where the Fed bought MBS. Mortgages prepay when interest rates fall. But the rate of prepays declines sharply when rates go back up. In addition, the mortgage gate problem has gummed up the process and we are now in the holiday period where, by recent tradition, the bankers prove they are nice guys and suspend all foreclosures.

How much are prepays declining? How much does it knock off the estimates for QE-Lite related Treasury POMO buys? Good questions. You can be sure that there are a bunch of deep thinkers in the bond market who are trying to figure this out. There were estimates that this would total as much as $300b through 6/30/11. Whatever your estimates were, you have to cut them today, by a third to a half. Does it matter if the sum of QE-2 and QE-Lite is reduced by 100/150b (10-15%)? I’m not sure. But it’s a new wrinkle in the puzzle.

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I keep an eye on the relationship of the 10-year bond and the S&P. From time to time this pair shouts out about stress. That the lines crossed today may not be significant. But it is an interesting milestone.

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Last summer there was a period of time where the bond’s performance lined up perfectly with the S&P. Strong bonds = Weak stocks. Then the correlation went away. But now it has come back. It is the exact opposite today than when it was warm. Now we have Weak bonds = Strong stocks. Does this mirror image repeat performances mean anything? We shall see. In the past, the correlation breaks (hard). The question is, which leg moves where?

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Cap&Trade - A Train Wreck

What to do with carbon based emissions? I have no clue. I’m not sure Congress does either. They will be more confused than ever after reading a recent CBO report on the topic.

In theory, the Cap&Trade approach is simple. A market will be formed. There are two classes of participants. Those that produce carbon based emissions, and those that don’t. The government will intervene and provide a floor price (a cost to produce carbon based energy). The government will also provide a ceiling (to insure that the cost of this is not too expensive). Finally, the government will provide “allowances” to certain green participants. Those allowances can be sold for cash in the ‘market’.


Wait a second. Hold on. There is nothing close to being ‘simple’ about this. The government is going to be on the buy-side and on the sell-side at the same time and they are going to be handing out allowances that are worth money? What the hell kind of plan is that? It gets better. Consider the following slide from the CBO on the theoretical size of the Cap and Trade market:

Note that the estimate for the buy side of Cap and Trade is between 70-80b. A very big number. It is 6Xs the wheat market. It is a bit smaller than Nat Gas. It is equal to the combined soybean and corn turnover. It is 60% of the action in the 30-year bond.

Wheat, corn, gas and the long bond are MONSTER markets. There are 100rds of thousands of participants. There is billions of equity money behind these markets. Under most conditions they are highly efficient. They allow for a high degree of price discovery. Most importantly, the efficiency of these markets is dependent on an extremely high usage of derivatives. Note that the corn/soy primary market of $80b produces a combined exchange traded and OTC derivatives total of $10 Trillion. Based on the CBO data the ratio of primary to derivatives is 125 to 1.

The CBO looks at this and correctly concludes that a market this big has it’s own systemic risks:

For example, a rapid increase in allowance prices could raise electricity prices, which would harm U.S. businesses that rely on electricity. The risk of cascading disruptions from the market for a single asset, such as allowances, to other markets and possibly the entire U.S. economy is called systemic risk.

So to address the systemic risks what are the suggestions?

Prohibition on Traders
BK: Dumb idea. Without traders there is no liquidity and then it becomes a government bucket shop. The worry is that there will be some sharpies in Chicago who make a killing off of this. But without the sharpies there is no market.


Circuit Breakers
BK: That there is a perceived need for this when the government is going to be on both sides of the market to begin with just shows how worried these folks are.


Prohibition on Derivatives
BK: Dumb idea. There will be no market without derivatives. Can’t and won’t happen.

Reliance on Centralized Clearing
BK: Anything that can be traded on an exchange can also be traded “upstairs” or “on the curb”. It merely requires a buyer and a seller and a willingness to settle up based on a future date price. Markets don’t work the way the CBO thinks.

Increased Regulation of Over-the-Counter Trading
BK: Accepting that Centralized Clearing is not possible; they propose new regulations. That has never worked.

Position Limits
BK: What limits? Who sets them? Does EXXON have a bigger limit than Goldman Sachs? Limits don’t work. Want an example? Just look at JPM and silver.

I am quite certain that the CBO believes that A) Cap and Trade is coming and B) that it will result in a very big market in a relatively short period of time. I draw that conclusion in part from the cover page of their report. They actually believe that the guys in the yellow coats are trading futures on “Allowances”.

The CBO provides a description of who might play in this sandbox:

Energy producers and other covered entities that would have to comply with the cap on emissions;

Great! Another profit opportunity for Exxon.

Entities that would receive allowances from the government but would not be subject to the cap;

Just who would get these allowances?

Businesses and individuals—mainly banks and investors, as well as companies that use emissions-intensive goods and services—that would trade allowances and related financial products with the first two types of participants and with each other.

Just one big happy family of traders and crooks.

Washington has no idea how markets work. They have some Utopian notion that markets can work efficiently without the bad apples like speculators and ugly things like derivatives. That they don’t understand this makes it a certainty that C&T will end badly.

-The government will lose money supporting a bastard market.


-The probability of a Goldilocks outcome is small. The extremes of either, (i) nothing is accomplished with emissions (supports too low) or (ii) too high a cost is established and the economy tanks, are just as probable as a favorable outcome.


-The only winners will be the banks, hedge funds, exchanges, specs, arbs and the derivative players. (AKA “Greater Wall Street”)

I don’t think there was ever much support for cap and trade. The last election probably killed it. But anyone still standing that thinks this is a good idea should read the CBO report. The table of contents tells it all:

Note: I have a number of articles of late based on reports from the CBO. Now another. Sorry if I am beating this horse to death. They just keeping dishing up stuff that I think is worth noticing.

CBO Recommendation to Munis – Default!

You hear a lot about the states that are facing a financial wall. California, NY and Il are on top of the list. But that is a 2010 story. The 2011 story will shift toward the nations municipalities. There are 36,000 cities, towns, villages and boroughs across the land. They all are facing problems. This chart from the CBO (pdf LINK) describes the problem:

As you can see the local munis get the lions share of their revenue from three sources; direct payments from the State (30%), local property taxes (26%) and other revenues (22%). A total of nearly 80% of the muni revenue stream is now suspect.

If you are living in a hard up municipal area (who isn’t?) you know that the fees you pay for everything has increased in the last year or so. Building permits, licensing fees, transportation fees, library cards, speeding and parking tickets, you name it have all doubled. There is a limit to this. I think it has already passed. Nickel and diming residents and having the cops turned into a revenue source is just not going to fly much longer. We are at the point where if some town wants to raise the price for garbage collection they are going to run into a wall. Don’t look for this source of revenue to bail out the munis in 2011.

Property tax revenue is also a risk. At the end of the day there is a relationship between the value of a property and the taxes that the property pays. With housing in the dumps now for two years (and with no prospect for any improvement) the tax base is falling apart. Where I live price are down about 40% from the 06 levels. One after another neighbors are petitioning the local authorities for relief based on lower values. RE agents who represent sellers tell their customers to go forward with the process before the house is listed. If the listing price is less than the value on the books, tax relief is granted. This process will accelerate. This is what the CBO had to say on the prospects of property taxes actually falling:

The decline in house prices implies that (tax) collections will probably fall in the coming years as local governments gradually update property tax assessments to reflect lower market values. On average, collections of property tax revenues lag behind changes in house prices by three years. Even small declines in collections could cause fiscal stress when the cost of providing public services is growing.

The largest contributor to Muni budgets is the states themselves. We know that the states are broke and have to cut costs, so this source of revenue has to be reduced.

Here is a (surprising to me) chart of both state and municipal revenue for the past few years. Of no surprise is the sharp drop off of revenue at the state level. But the municipal revenue has continued to increase. Given the foregoing discussion on the sources of muni revenue it would seem certain that their income is going to decline in 2011.

A few factoids on local munis tells the importance they play in our economic picture.

-90% of all cities have cut backs in spending scheduled for 2011.

-Approximately 14 million people are employed by local munis (not state workers). That is 11% of the entire work force. Do the math. A 15% drop in employment translates to 2.2mm jobs. That would come to 175,000 per month. By itself this would add 1.7% to the unemployment rate. We would be pushing 12% UE as a result.

-Muni spending is 9% of total GDP. A 10% cutback translates into a drag on top line GDP by 1%. The estimates for growth range from 2-3%. If local governments are forced into cuts (they will) a better estimate for GDP is 1-2%.

-When looking for places to cut, munis always go to capital projects first. Roads, sewer, water hospitals, schools are not going to get built. What does this do for the private sector construction industry?

What are the options for a cash strapped muni? Unlike state borrowers, munis can go bankrupt. (more than half have laws on the books permitting a chapter filing - including key ones). The CBO report provided an excellent set of reasons for munis to default:

Benefits of Bankruptcy

-One key advantage of bankruptcy is the “automatic stay,” which is issued by a court and prevents creditors from taking action against the municipality and its officials without approval from the court.

-Another important advantage of bankruptcy is that courts can implement a restructuring plan without the consent of every creditor.

-The bankruptcy process may also allow a municipal government to reduce its labor costs by facilitating the con- sent of employee unions to changes in labor contracts.

-While a stay is in place, bondholders cannot force municipal officials to raise taxes in order to make debt-service payments.

Over the past 30 years of the 18,400 muni borrowers only 54 have defaulted on their debt. An admirable track record. One that is unlikely to be continued over the next few years. Not a pretty picture for a muni investor. To top it off BABs (the last pillar of support for munis) is gone. I wouldn’t be at all surprised if some big Muni became the Greece of America in the near future.

Disclosure: Very “underweight” in long term munis.