Crunch time?

Possibly the most significant consequence of the EU bailouts last week will be that the “solutions” to the problems in Europe will result in a global credit crunch. To me this outcome is a foregone conclusion. It's already happening.

The agreements give the EU banks till June 2012 to recapitalize. There are only two possible outcomes. (A) Either the banks sell more common and preferred shares to the public, or (B) they improve their capital ratios by de-leveraging.

It’s simply not possible to sell more shares. The costs (in the form of dilution or 10+% Preferred dividends) make this option a dead end. So the banks will have to get smaller.

Some data points on this from Thompson Reuters Loan Pricing Report today:

French banks have been notably absent from high-profile EMEA loans including the US$6bn loan for commodity trader Xstrata and a $4.7 billion loan for Qatar's Barzan project financing.

In Asia, BNP Paribas pulled out of an A$2.075 billion (US$2.14bn) refinancing for Australian media company Seven West after being shortlisted as one of the leads.

In the US, Societe Generale declined to participate in a $15 billion, 364-day bridge loan for United Technologies Corp.

The $6 billion loan for commodities trader Xstrata had no commitments from BNP Paribas, Societe Generale, Intesa and ING.

"Banks structuring deals are mindful of the reduced demand for dollars - you have to factor in a big drop in appetite from French and Germans." a senior banker said.

The syndicated loan market is not falling apart. At least not yet. Other big lenders have stepped into the hole left by the EU banks. Spreads have widened a bit, they will get wider still. The question is whether credit will dry up in the months ahead. I think it will.

I’m convinced that zero interest rates are adding to the problem of liquidity in the US (and therefore globally). Every month money funds get smaller. More and more money is being put on the side. MM loan funds used to buy up big chunks of deals like the 365 day UT deal. Not any longer.

I have no support from economists in my conclusion that ZERO % = ZERO RISK. In fact, the vast majority of deep thinkers (and most importantly Bernanke) believe that ZIRP is the only path to consider.

My conclusion is that the dual forces of the EU bank asset sales and perpetual ZIRP are going to bring us a very nasty credit crunch. It will be global. Given that the clock on the EU bank recaps runs out in 8 months I would expect to see clear evidence of a crunch by year-end. (Does someone have a quote for “turn of the year” LIBOR?)

Food for thought

The folks at the USDA released their projections for 2011/2012-food price inflation. The bad news is that feeding ourselves will cost ~4% more in 2011. The good news is that USDA thinks prices will rise only ~2.5% next year.

I shop (I hate it). My food inflation is closer to 10%. It depends on what you eat. For example, from the report:

Meats, poultry and fish +6%

Seafood +6.5%

Beef +9%

Fresh vegetables +5%

Cooking oils +7.5%

These items are all well above the average set by the USDA. The following kept the index low:

Processed vegetables +1.5%

Beverages +2%

After looking at this I loaded up on canned peas and Coke.

There’s other information at the site I thought was interesting. For example, what’s your guess on the amount spent for food prepared at home and the amount spent on eating out?

Answer: 52% is prepared at home, 48% is purchased and eaten onsite or taken home. Half of what we eat is “out”. I find that to be a surprisingly high number. Behind that 50-50 ratio is, no doubt, the problem with diabetes and obesity.

If you were wondering how the restaurant-bar business did during the depression the USDA has the numbers. My conclusion is that depressions are very bad for eating establishments. It takes a long time for a real recovery in spending habits. It’s also clear that wars are very good for the restaurant biz.

The “eat out” numbers did fall in 2009. But they recovered in 10’ and are headed higher again in 11’. We had recession. A big one. But consumers barely batted an eye. I’m surprised at this result.

The At Home and Away total 2010 food bill came to $1.2T. That makes eating the largest industry in America.

In 1930 19% of all food consumed was Produced at Home. By 1960 that percentage had fallen to 6%. In 2010 it was only 1.6%. While this trend is not surprising, the magnitude of the drop is worth noting. At one time we were a nation of gardeners, today we just do ‘drive through’.

The food we eat makes us sick. The 2010 estimate for food related illnesses came in at a lumpy 76,000,000 people (About ¼ of us get sick every year). These illnesses caused 325,000 hospitalizations and 5,000 deaths. The economic costs of these illnesses came to $152 billion. In other words, the bad food we eat cost us significantly more in 2010 than the combined operations in Iraq and Afghanistan.

It’s not surprising that the US pays less for food as a percentage of income than any other country. But the comparisons are still interesting. The US spends 6.5% of disposable income for food. Poorer countries like Nigeria, Kenya and Cameroon are forced to pay ~45% of incomes to put food on the table. The high population countries are as follows:

Vietnam = 38%

Indonesia = 32%

India = 28%

China = 22%

I find these numbers troubling. There is only one direction for them to go. The developing countries with big populations will see greater gains in income, with that will lead to increased food consumption. Approximately 30% of income goes to food in these areas.  It’s hard not to see that this is going to push up the prices the globe pays for everything we eat.

For example, the USDA put the per person food cost in China at $129 in 2000. Today that number is $360 (280% increase). Over the same period the USA consumption increased only 42%.

It’s old news that China and the other big/fast growing populations are consuming an ever-increasing amount of the world's supply. But these numbers are scary big. If the underlying trends continue (why would they not?) then we are headed into supply problems that can only mean rapidly rising prices.

This conclusion gets back to the beginning. Food inflation in America is running today at 5+%. The USDA says the inflation will moderate next year. This is more government hopium. I’ll take the “over” on their numbers. In my view rapid increases over the next decade are baked in the cake.

The most regressive economic consequence is for food inflation to take place. We have 45mm Americans on food stamps and tens of millions of others on the edge. I find it ironic that the Federal Reserve excludes food inflation when setting monetary policy. While the Fed can’t be blamed for rising food cost, they are most certainly stoking the fires.

Bernanke has said he wants to contain inflation (excluding food and energy) at less than 2%. Food inflation is running at double his target. Possibly Ben needs a new Mandate.

Dis and Dat

On Cocktail Party Stocks

A chart of NFLX and some thoughts.

There are good and valid reasons for this 75% drop in 4 months. The stock deserved to have gotten crushed. But this is more than just bad company news. There are a bunch of other “names” that have been slammed to the ground of late (FSLR/MCP etc). Those who listened to the TV hosts, stockbrokers and “smart guy” talk over drinks deserve everything they get. But I have to ask,

“How much of the ‘air’ in NFLX was just a phony push caused by Ben Bernanke’s Fed?”

The answer is that Ben’s contribution to this stockholder debacle is not zero. All the Fed talkers have said again and again they want to force people to buy risk assets. They succeeded. And along the way those that listened to Ben got stepped on.

For sure this will happen again and again. When money has no intrinsic value due to ZIRP it will create froth in prices of stocks, commodities and bonds. I can’t think of a dumber policy than that. I hope that Bernanke followed his own advice and loaded up on NFLX.

On Flat Taxes

So Perry is out with his flat tax. The joke is that under his proposal one could either pay a flat rate or go back to the 1040 and do it the old way. This achieves a worst-case outcome. Less revenue and more paperwork.

I’m in favor of ripping up the tax code. I’m also in favor of a progressive tax code where those with high incomes pay more. The arguments from liberals are that with a flat-tax (or a 999) those in the lower brackets would pay more than they do today.

I don’t think that has to be the case. The critical question when considering an alternative tax plan is what happens to FICA (payroll) taxes. The combined FICA is now 15.3%. In a flat tax world, that would be eliminated. Half would go to the worker via lower taxes. The other half would be retained by the employer. The employer could rebate that amount to the worker with a 7.65% salary increase. There would be no pre or post tax consequence for employers to do that. Their revenues/profits would not be impacted at all.

For a worker who makes $40k who today is subject to FICA AND pays 10% federal tax the numbers are:

Current treatment:

Pre tax = $40,000
Federal Tax = 10%
Take home including FICA (7.65%) = $33,000

With a 20% flat tax:

Old salary = $40,000
New Salary (7.65% increase) = 43,060
Take home = $34,448

A flat tax approach could be structured to achieve a neutral/positive tax result for the average worker. Liberals are fools not to embrace this. It is the most progressive tax approach out there. It would put money in the pockets of those making less than $100k.

On Rage

I got an email from a regular reader. This one is a full professor at a top Ivy League school. He had this to say:

One of my usually staid colleagues said to me the other day, "I am hoping for some violence." How odd.

How odd indeed. It would be a huge mistake to underestimate the level of anger in our society. Could this go from a relatively peaceful OWS to something far more ugly? You bet it could. All that would be required is some more bad economic news and an increase in gas prices……

 

On FX

I’m hearing that many big players have stepped back from the FX market. The devaluation of the CHF a few months ago hurt some of the interbank hitters. Hedge funds have been whacked every which way and have also cut positions. The UBS rogue trader story scared a bunch of the prop traders at the big banks. They’ve scaled back too.

So without the usual dancers adding liquidity the FX market is reverting to good old supply and demand to set prices. As Zero Hedge has been reporting for some time, there has been liquidation of dollar based assets by EU banks. Some of the liquidity is being repatriated back into Euros in an effort to prop up weak balance sheets.

As a result, there has been demand for EURUSD. The strong Euro flies in the face of the crumbling and bumbling of what is actually happening. That does not matter. As long as there is Euro repatriation, the EURUSD will remain overvalued. It’s about day-to-day demand, not the backdrop of the news.

I can’t predict how long this will take to wash out. My guess is under a month. I think the Euro is a big short.

There is also a very big question growing for the Yen crosses. I’m betting we see some action by the BOJ before month end.

This is, net - net, a strong dollar story, the worst news for Obama, Geithner and Bernanke. It's also a strong gold story. I can see EURUSD = 1.3000, Gold = 1900, USDX = 82 by year end


Seatbelts on.

On the (not so) Mega ReFi

Finally some details on a plan that has been whispered about for six weeks now. Actually, the information available begs some questions. Some thoughts on what was released from the FHFA yesterday:


- I’ve said from the start that the fatal flaw in the Refi program is that it only includes those who happen to have their mortgage held by Fannie and Freddie. About 40% of the mortgages that would otherwise qualify for a new deal are getting nothing.

This is the telephone number to determine if you are eligible: 800-7FANNIE. Four out of ten who call will be told to buzz off. The reason is that they got a mortgage from a Community Bank.

Obama is going to take credit for the refi program (he already has). But he’s also going to take a ton of flack from those who get left out in the rain.



- On the topic of fairness, there is one condition for eligibility that got me a laugh:

The current loan-to-value (LTV) ratio must be greater than 80%.

In other words, all “good” borrowers (LTV<80%) need not apply. To qualify for a new mortgage today one would have to put down a minimum of 20%. How does one characterize the refi? Subsidy comes to mind.


- In order to have a chance at a refi one must also:

*Have a clean payment history. (One late payment in the past 12 months is okay). There will be a waiver on any LTV (no need for appraisal).

*Have entered into the mortgage prior to May, 2009.

So there are a lot of hoops to jump through to take advantage of what has been offered.


- FHFA is very vague on their estimates of how many mortgages will be eligible. The guess is that it might be as high as 900,000 by the end of 2013. The program does not start until January 1, 2012. Thereafter the number would be about 37,000 a month.

What does that mean for the economy? The answer is not much; at least not for 2012 (Beyond that is anyone’s guess).

The average mortgage is $200,000. Assume that the savings from the refi is 1.5% and the closings commence in March of 2012. The result is that there is a monthly reduction in the mortgage payment of $333. By the end of 2012 there should be about 370,000 refi’s completed. That would put the full year total interest reduction at $680mm. ($540mm adjusted for taxes)

While this is clearly good news for those lucky enough to get the Refi, the $540mm is not a big number in our $15T economy. Obama’s (busted) Jobs Program was supposed to provide a stimulus of $435B. The economists who looked at it thought it might add 1.5% to total GDP. If the same logic is applied to the Refi program the benefit would have a stimulative effect of only 1/8% of GDP. Yawn.


- There is a question of how much interest savings can be achieved. As of today, the cheapest Refi for a new 30 yr mortgage would be ~4.25%. To achieve a net 1.5% savings, the old mortgages have to be 5.75% on average. This rings wrong to me. I think the average for those who are otherwise eligible is meaningfully lower than 5.75%. This suggests (to me) that the benefits will be muted.


- Many have written to me that the Refi is a plot to eliminate any prior flaws in the loan documentation. I don’t think so. But I’m not a lawyer. It’s best to check with your own counsel. The FHFA is actually waiving prior Representations and Warranties made by the borrower and the originator of the loan. From the FHFA:

Reps and warrants protect the Enterprises from losses on defective loans. FHFA has concluded that eliminating the reps and warrants will be good for borrowers, housing markets, and the Enterprises and taxpayers.

- There is no discussion of fees/expenses in the FHFA news release. That’s interesting. The proposal is for ~1mm refi’s over 24 months. How much is the re-documentation cost for one of these? $2,000? Who pays for that? Is the cost added onto the principal of the new mortgage? Do the Feds pay for all/part of it from the Hope Now money that Treasury is sitting on?

The expenses come to about $2b over the first 24 months of the program. That money will go to lawyers, banks and loan servicers. I, for one, am very happy that the bloodsuckers get another 2 large. It’s interesting to note that the fees eat into the benefits of the refi such that the first two years of interest savings are lost to the costs.


- The lower the refi interest rate, the better the economic results. This raises the question of, “What’s the Fed’s role in this?"

Bernanke has already pulled out all of the stops to assist refi’s. We have perpetual ZIRP, QE1&2, the Twist and a change in Fed policy to reinvest principal payments back into new MBS. As a result, we have 10-year Treasuries at 2.25%. The refi works much better if the 10-year is at 1.50%. My conclusion is that the Fed will announce a new LSAP (QE-3) in the not too distant future. While I see this coming pretty clearly, I still want to vomit.

Bernanke – “I’ve abandoned the dual mandate!”

I find myself this morning hoping for the failure of the Federal Reserve. This implies that I’m also hoping for a collapse in the equity markets and a severe recession. Coupled with that, I want to see that the massive increase in money supply and the endless interventions of the Fed bring us a round of much higher inflation. I want the Fed to fail so miserably that they are marginalized for the next twenty years. I want Bernanke fired. I want the Fed disgraced.

I’m not rooting for this to happen because I’m short assets. I’m not hoping for more pain for Americans. I don’t want to see a collapse in the economy. And I certainly do not want to see more inflation. But I’m convinced that the only hope for the country is to shut this Fed down. For that to happen there must first be a collapse.

This morning we once again we have the mouthpiece of Bernanke, Jon Hilsenrath at the WSJ, telling us what is coming next from the Fed. This is disgusting in so many ways.

Hilsenrath got a call from Benny yesterday. This time Ben Boy tipped his hand. A new LSAP plan is in the works. This time it will be directed at the Agency MBS market (a la QE #1).

What killed me is this quote from the WSJ:

Fed officials believe their past purchase programs helped to lift stock markets, by driving investors from low-risk investments toward riskier investments.

So we’re back to that old argument. Ben wants the S&P higher. He wants savers to do the heavy lifting by taking more and more equity risk. We have seen this plan again and again the past three years. It hasn’t worked. It won’t work this time either.

I’ll get what I want (chaos), but it will take some time. The new LSAP can’t happen till at least December. But sometime in the 1st Q it will be coming. In the past, articles like the one today in the WSJ lead to expectations of new Fed actions. This put a bid under equities. But as soon as the new monetary stimulus is announced the markets sell on the news. This time will be no different.

Core inflation is running at 2%. This is a level that Bernanke has repeatedly said he would respect when it come to more monetary gas. That he has initiated operation twist in the face of this inflation was the first evidence that he was abandoning his promise. In my book, Bernanke has flat out loud lied to the public on this. He should be fired for that.

CPI-U is a closer measure of actual inflation. That number is steaming along at 3.9%. We now have a situation where basic inflation is running at 8Xs the rate of short-term inflation. That ratio has never existed before in history.

Money supply is exploding over the past half year. Up over 30% (See Zero Hedge story). Inflation is the only possible outcome.


I’m not insensitive to the plight of the unemployed in America. There are some 20mm people who are either out of work or underemployed. I wish that something could be pulled out a hat and make that problem go away. But there is no magic solution. It’s time that Bernanke start to look at the other 280 million citizens that are paying the price for his actions. Ben is robbing savers. He is killing seniors who need predictable income (and should not be investing in risky equities). He is stealing from all of us with his push for more and more inflation as a cure to our problems.

I’m not happy with my position. I wish that I did not feel so strongly about this. But I’m convinced that the only thing that can actually help us out economically is that the Fed is completely marginalized. To have that happen there must be some big pain. Pain is exactly what we are going to get with Bernanke’s insane policies.

Visas 4 Sale - Two years late

Two and a half years ago I wrote a proposal that would have addressed a portion of the overhang of residential real estate in the USA. Pretty simple idea. Swap a US visa for a foreign national's purchase of a property in the US.

Today we have Chucky Schumer, Senator, NY on the airways and in print with exactly the same proposal as I made back in 09. From the WSJ (Link):

Way back then I sent my proposal to all sorts of folks in government. Given that Schumer is my Senator I sent a copy to him and never heard a word.

I don’t think that this concept is really going to change the direction of RE values, but it would have made some difference these past few years. There would have been fewer defaults, smaller losses on housing values and significantly less red ink at Fannie and Freddie (now$140b and counting). If the proposal had been adopted, economic activity would have been somewhat higher over the past 30 months.

I’m left wondering what Chucky did with my letters to him. I’d like to ask him why he waited so long to come forward with this plan. Maybe he does not read his constituent mail. I hope that he does not try to sell this as an original thought. It’s been in his in box for years.

The original article can be found here (link). I cut and past a copy below.

A Proposal to Stimulate the US Housing Market

In order to stimulate demand for residential housing the United States expands the existing EB-5 visa program to include immigrant investors who purchase a home in the US with a value of not less than $250,000.

The demand for this type of visa from non-residents could be substantial. It could exceed 100,000 per year. The current volume of unsold homes is in the range of 2,000,000. Therefore this proposal will address 5% of the problem per year. This by itself would be a significant source of stability for housing prices. Stability must come before recovery.

The following is a description of the existing EB-5 visa program.

Congress created the EB-5 immigrant investor visa category in the Immigration Act of 1990 in the hopes of attracting foreign capital to the US and creating jobs for American workers in the process.

There are three basic requirements as follows:

• First, the alien must establish a business or invest in an existing business that was created or restructured after November 19,1990
• Second, the alien must have invested $1 million ($500,000 in some cases) in the business
• Third, the business must create full-time employment for at least 10 US workers

This language could easily be amended/expanded to create demand for housing. The framework is there. This proposal re-directs the objectives but not the intent of Congress.

The devil will be in the details. If there was a will in Congress it could be done in a week. These laws already exist. We do not need a new Bill to do this. This proposal only addresses legal immigration.

There is another advantage to this approach. This proposal will not cost us a cent. That would be a first.

Pricing the EU WI bonds

It appears we are getting a Monoline to solve the problems in the EU. For the life of me I can’t figure how this will work, but we are about to find out. There are no details on this as yet, just planted rumors.

The talk is that EU sovereign debt to be issued in the future would have the benefit of an insurance guaranty that covers the first 20% in the event of default. This guaranty would be backstopped by the EFSF.

The thinking is that a new bonds issued by Spain, Portugal, Ireland, Italy (and presumably Belgium but not Greece) with the guaranty would be widely perceived as a money good investment. As a result, huge amounts of capital could be raised in the global bond markets under very attractive terms (total = Euro 2+ trillion). Funding costs for the PIIBS would plummet as a result. With the debt market stabilized, economic prosperity would soon follow. I say "rubbish".

The enhanced bonds would be “Story” bonds. In my experience story bonds have a very limited investor interest. I have no doubt that ten of billions of these bonds could be sold, but Trillions? The USA Treasury market is the most liquid in the world. The total public float (excludes Fed and Intergovernmental) is about 9 trillion. The proposal is that an amount equal to 1/3 of the US public float of new EU enhanced bonds are issued in just a few years. IMHO that will never happen.

The global bond markets will have to figure out how to price this new debt. I’ve been pondering this for days. I can’t come up with a pricing structure that works.

Consider a newly issued ten-year Italian sovereign bond that has a 20% first loss guaranty by the EFSF. Assume that the German ten-year was 2% and Italian at 5% (about where we are today). You tell me, how is that new bond going to trade based on this?

This is not equivalent to 20% German risk and 80% Italian. That would be far too easy. But if the market were to trade it as an 80/20 it would imply that the new Italian Enhanced Bond (“IEB”) would yield about 4.4%. This would mean that the IEB/German spread would be 240bp while older Italian debt had a spread of 300bp. If that were the result, it would be a disaster. While 60bp is a big deal, it would do nothing to stabilize Italy’s long-term debt cost. For a new program to work, it would have to drive the IIB/German spread to 100bp.

In order to evaluate the 80% Italian risk and price it properly one must first make an assumption as to the probability of an Italian default over the next ten years. One must also make some assumptions regarding what losses might be incurred should there be a default.

Folks, those are very complex questions to answer. I’ll give it a shot.

Probability of Italian default over ten years = 20%


Probability for loss > 20% in the event of default =100%.

While I think that Italian default risk is relatively low, I believe that should it happen, the net haircut would be substantially above the 20% first loss protection. A country like Italy would not go through the pain of a default to achieve a 19% debt reduction. If push comes to shove and Italy decides it is best to default, the haircut would be in the 50% range (a la Greece).

Any investor who looks at the new bonds and concludes that they’re money good is just nuts. That will not happen.

My conclusion is that the new enhanced debt has to trade cheap. There is a massive amount of this story paper coming our way. That mountain of supply has to mean the bonds have to have a high yield. If one wanted a litmus test for this I would ask the Swiss National Bank. They have E200b in reserves. I bet they would not put a dime into these new securities. Neither would Singapore, Venezuela, Kuwait, Hong Kong or Saudi Arabia.

It’s quite possible that the new paper does very little for Italy. If that were the result for Italy (a relatively strong borrower) it would be the kiss of death for the weaker ones like Spain and Ireland.

What I find fascinating about this is that the deep thinkers in the EU are relying on the global bond market to price the new securities in a way that would produce the desired results. The deciders are going to trust Goldie, Citi and good old JP to price this swill on the rich side? Not a chance in the world.

After four agonizing years the inescapable conclusion is that complex derivative securities were at the heart of our problem (they hide risk). The response by the EU is to give us the largest derivative transaction that has ever been created. Talk about a sign of weakness.

The most amazing thing is that the global markets are lapping this up. Any confirmation (the silly Guardian story) that the Mega Monoline is in our future is a cause for celebration.

Wait and see how these new bonds trade. I think they will trade on the cheap. If I’m right, then you can kiss off the possibility of an EU soft landing. If the markets give the new bonds a thumbs down it will be the final act in the story. There’s an ‘event risk” to look forward to.

Note: The only way the new enhanced bonds can trade rich is if the ECB stands ready to buy them such that the spreads are very narrow to German paper. I see a very small chance that this would happen. But if they did step up, the markets would see through the charade in a NY minute. The lights would start to go out shortly after they started buying.

On MMT and Munis

If you have any interest in the topic of Modern Monetary Theory (“MMT”) there is a good discussion in this article at the Harvard International Review. (Link) Bill Mitchell, the Research Professor of Economics at the University of Newcastle, Australia, is interviewed. He provides his take on what is going on.

MMT is not a theory about what should be done. It’s a road map of how the global fiat money system works. From the article:

MMT just describes the system that most countries in the world live under and have lived under since 1971.

There’s a whole bunch of things in this that I don’t agree with. But who am I to question an eminent economist. The final conclusion by Mitchell is a case in point. His words:

Budget deficits, independent of any monetary operations, drive interest rates down, not up. This is the complete opposite of what orthodox economists claim is the case, and it’s confirmed by the present combination of record low interest rates and very large budget deficits.

I think this is completely wrong. Yes we have low interest rates and huge deficits. But the reason for this is that the Fed is controlling interest rates at artificial levels.

Does Mitchell really believe that .25% Federal Funds rate is a fair market rate given that CPI-W is over 3.5% for the past year? Do MMT’ers believe that 5 year T-Notes at 1.1% are reasonably priced looking at Core Inflation north of 2%? Do these deep thinkers not understand that the Fed bought $2 trillion of paper and in the process wrote the check that covered the massive deficits that are occurring? These folks don’t get the fact that the entire credit curve is a measure of manipulation? Maybe they should start reading the Blogs.

To me, there is no evidence to support the MMT assumption that deficits drive interest rates lower. It's coincidental that the Fed is driving interest rates to zero while deficits are exploding. The “orthodox economists” have this one right. The MMT’ers are looking at the facts and drawing the wrong conclusion.

MMT is a 4-legged stool. One of the legs is wobbly (I would say missing). If you sit on it, you’ll fall.

*****************************

Saving the Taxpayers

The IRS issued the state of California a private letter ruling. They allowed Cali to re-market $132mm of 2010 BABs bonds. This wasn’t supposed to happen. Congress has let the BABs legislation lapse. But no one can argue with the IRS, so the bonds will be sold in the near future.

This is a, “no big deal”. But there was one aspect that gets me to comment. Tom Dresslar, a spokesman for Cali Treasurer Bill Lockyer had this to say about the IRS decision: (Bond Buyer link)

“The best part is that we are going to be able to save taxpayers money.”

Well, good old Tom is right. It will save the “taxpayers” money. The question is which taxpayers? The ones in Cali will pay less. But the taxpayers at the federal level will have to foot the bill. Uncle Sam will pay 35% of the interest on the re-marketed bonds.

The business of subsidizing Muni debt issuance with tax breaks or subsidies (BABs) has to end. The rallying point for this should be Dresslar’s words. I can’t think of better proof that the system is screwed up.

Enlightened Self Interest

Over the past few months my thinking on what global leaders should be doing in the face of the rapidly growing problems has morphed in an entirely different direction. For some time now I’ve been banging on the table that interference with market forces in an attempt to kick a can down the road are the worst kind of policies. My concern has been that the costs of this interference will ultimately be greater than the cost of letting chips fall where they may.

My revised thinking is driven by one factor. "What’s in my best interest?", is what it's come to. Enlightened self-interest is all that matters to me. To hell with everyone else.

To that end, I want to make a strong recommendation that a financial market tax be implemented in the US and Europe. What I want to see is a plan along the following lines:

Fee for stocks and options = ½%. (This would be applied to both the buy and sell side so that the cost of a “print” would be 1%)


Fee for all other transactions = .005% (FX, bonds, CDS, Swaps, Futures and all other derivative transactions.

Dean Baker, from CEPR, is strongly behind this type of thinking. It doesn’t matter that Dean has never been close to a financial market in his life. He actually thinks that transaction taxes could raise $100b++ a year (for ever). Dean does admit that there may be some consequence to this. He is aware that a proposal along these lines would destroy liquidity across all markets. He thinks this is not important at all. His thinking:

The small fees the EU is considering charging would only raise transactions costs and liquidity back to levels seen in the early to mid nineties.

Well, that’s what I’m looking for. Let’s dial back the markets so that the level of liquidity is back to the “early” nineties. That would be perfect for me. I don’t care that people who actually know what they’re talking about have to say about this. For example, Ken Rogoff, former chief economist at the IMF, (a guy who’s opinion I normally respect). His thinking on a transaction tax:

The tax would significantly reduce market liquidity with "no obvious decline in volatility" and "increase the cost of capital, ultimately lowering investment."

Let me explain my thinking. Upfront, I want to address the criticism I’m going to get. I’m a 10 percenter. I wanna be a 5 percenter. I don’t give a damn about anyone else in the system other than myself. I have financial resources. I have investment skills and experience that the vast majority of small investors don’t have. My goal is to make a pile of money off of those folks that don’t have what I have. Fairness and economic consequence is of no concern to me. I just want to get richer.

If we do get a Fin Tax that has some teeth, it will destroy liquidity. The vast amount of intra-day trading of equities is not able to generate a net 1% cost of transacting. The typical profit targets are far less than 1%. A transaction tax would wipe out the HFT crowd. That group accounts for as much as 70% daily turnover. Take out the rest of the day traders and jobbers and we would get turnover down to about 20% of what it is today. That would put guys like me in the catbird seat.

Should we get a transaction tax, I would anticipate a enormous ramp up in daily volatility. Intra day swings of 5% on the big indexes would be a common event. Individual stock names would be subject to even more violent swings. Small cap stocks would be the worst hit. There I’m anticipating daily swings in the 10% range. On days where there is company specific news that intra day swing could widen to 20%. Cha Ching for me!

On an annual basis I would expect very big swings. 30-40% change in the S%P index would be a normal event. Over all, the ramp up in volatility would be very bad for equity valuations. Today there is a great debate as to whether the S%P should trade at 13Xs earnings or should it be 15Xs? In my view a year after the implementation of a transaction tax the market would be wondering if the “proper” multiple is not 5 -10Xs earnings. That outcome would suit me just fine. I want to buy assets very cheap. That the suckers who believed in the “Buy and Hold” were puking after a 50% correction wouldn’t bother me at all. I want to own Dean Baker’s stocks at 50 cents on the dollar.

I want the IPO market to dry up. I want any company to pay through the nose for new equity money. I also want secondary stock issuance for big companies to fall apart. Today, the cost of a secondary is a temporary reduction in a stock’s price of 3-5%. I want that to widen to at least 10%. I’ll make a fortune that way.

Bonds have always been a specialty for me. I’m certain that spreads would widen by big amounts. I would just sit back and make a bundle. Some poor sap wants to sell $100k of an obscure Muni bond? Screw them. My bid will be 5% down from the last trade. I think that bond trading for off the run issues will just be a cash machine for me.

I’m pretty good at distressed investing. Given that just about everything would be distressed I would have a field day.

The financial sector of the US (and the globe) would see their earnings go out the window. This, coupled with the fact that the same sector represents about 30% of current GDP, there would have to be a depression. A big one. Once again, this would suit me just fine. I would buy real-estate at 25 cents on the dollar. Cash, and only cash, would talk in these conditions. There would be no mortgage market left.

The Fed would be printing money like mad in these conditions. Hyper inflation would follow. I’m as certain as I can be that I would be a big winner (versus everyone else) should that be the result.

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I’m half serious and half joking this morning. I’m looking at the TV and all of the OWS stuff that is happening around the world. This is gathering speed very quickly now. Anyone who thinks this is going to go away in a few days is just nuts.

One global response from the “Deciders” to the current protests could be a transaction tax. That would be “popular”. It might just be something that is done as a way of appeasing the crowds. Whatever one thought of the possibility of a transaction tax a month ago, those estimates have to go up today. The bigger the protests, the greater the probability that the tax is implemented.

A transaction tax would be like Prohibition. The Volstead Act just made crooks rich. It cost the government billions in lost revenue. The population came to hate it. It was bad policy that was adopted because of a visible protest movement of that time.

The left side of my brain is with Rogoff. A transaction tax would kill liquidity/capital formation. That would result in a huge spike in volatility. This, in turn, would result in broadly lower equity multiples. The connection between stocks and the economy is too tightly correlated. A very sharp downturn in the economy would have to follow. For these reasons I’m violently apposed to a transaction tax.

The right side of my brain says, “Bring it on”. I’m confident that I can survive and thrive in that environment. Fortunes were made in the 30’s. What may come will be no different.

I do want to be clear about this. The 99% have been pushing the transaction tax. They may get what they think they want. But in the end it will result in more pain for the 99’ers. The concentration of wealth in America will just get higher and higher up the ladder. A transaction tax that limits liquidity will not create jobs, it will end up costing the government net tax dollars. But guys like me will do just fine.

Be careful of what you wish for.

Social Security to Bernanke – “You’re Killing Us!”

Bernanke has said dozens of times that he wants to boost inflation in his effort to lift stocks. He’s succeeded in pushing up the cost of things over the past year. Everyone is paying a price. Social Security is no exception. As it turns out, Ben’s policies have been hitting SS in a number of negative ways. Ben is driving up the costs over at SS and at the same time he is killing their interest income.

We get inflation numbers for September next week. This is an important data point for some 55 million recipients of Social Security checks. On the assumption that there is no (little) change in the MoM numbers the CPI-W will come in at 223.4. This number is used to calculate the average for the fiscal 4th quarter. The result is then compared to the 2008 fiscal 4th Q. My numbers:

CPI-W 4th Q 2008 = 215.495

CPI-W 4th Q 2011 = 223.110

COLA increase for 2012 = ~3.5%

This is not good news at all for the folks at SSA. The COLA increase will add $25 billion onto the existing expense base for 2012. On top of that there will be the increase in the total number who receive monthly checks (SS is getting 10,000 new beneficiaries every day). In 2011 the new (minus dead) beneficiaries added $25b to the cost of running the program.

The question to ask is, “What does this do for SS?” The answer is, "Nothing good". To make an assessment of what 2012 will look like it is necessary to make some assumptions on what will happen in the real economy, and most importantly, what will happen to total employment.

My base case for 2012 is a repeat of 2011. No recession, but anemic growth. Total payrolls will rise (in part due to an increasing population). The number of new jobs will average 100k a month. As a result SS payroll tax income will rise by $24 billion (same as 2010-2011). Note: My Base Case is actually fairly optimistic. We could easily have negative growth (and zero job growth) for a quarter or two next year.

My numbers for the 2012 cash components at SS:

Benefits: $769
R.R Interchange: $5b
Overhead: $7b
Total Out: $781

FICA: $685b
Tax on benefits: $24b
Total In: $709

Net negative cash flow: $72 billion

There is a non-cash component to SS income. They get interest (paid in paper) on their holdings of Special Issue bonds. The SS Trust Fund owns $2.6 Trillion of this script. The % that the TF earns on this hoard is substantially above the current market rates. But there are troubling signs on the interest income line as well.

My number for % at SS in 2012 is still a whopping $112b. But this number is now headed south. (See notes below)

With the % income, the net change at SS will be a 2012 surplus of a lousy +$40b. This is a very important number. It’s dangerously close to zero. I can’t predict what will happen beyond 2012. What will happen with payrolls, the economy, inflation and interest rates is by no means clear. One very possible outcome is that 2013 and 2014 will bring (more or less) what we have in 2011/12. AKA Stagflation.

Ladies and Gentleman that would be an unmitigated disaster. Should we have more years of stagflation, the net surpluses (includes % income) at SS would fall to zero in 2014 and be negative in 2015. Once that line is crossed, it rapidly collapses. It's nearly impossible to reverse.

The current Base Case assumption by SSA is for the TF to “top out” in 2025. The forecast is that the TF balance will continue to grow for another 12-14 years. The SSTF projection is that the Fund will exceed $4 Trillion before it begins to decline.

Should the economy continue as it is, we reach the “top out” in 2015. The TF balance will never exceed $3 trillion. In other words, a critical milestone for SS will come ten years early, and leave the TF short more than $1 trillion. The broad implications of this are hard to fathom. A major restructuring of SS would be required.

Notes:

(#1)
To my knowledge, I’m the only one talking about this kind of outcome. So I expect to get flack from the usual suspects that my numbers are not reliable. To that I would respond that my numbers are consistent with the SSTF’s own numbers. What I think is coming is worst-case outcome (stagflation), but one close to the parameters of what SS considers reasonable. These are the numbers for the key variables from SSA and the ones that I use:


Benefits
2011 SSTF annual report, High Cost scenario for 2012 Benefits = $769
Krasting Estimate: $769
Variance: $0

FICA Receipts
2011 SSTF annual report, High Cost scenario for 2012 FICA = $711b
Krasting Estimate: $685
Variance - $26B (-3.5%)

My outlook is worse than the SSTF High Cost estimate for revenues. I maintain that this is justified as SSTF has built in a much stronger economic recovery into their model than than I (and Bernanke) consider likely.

(#2)
ZIRP, QE the Twist (and other actions) will be with us for years to come. SS (like every other investor) will have to suffer with low yields on investments as a result. Over the next five-years a substantial portion of SS’s high yielding portfolio will run off. It will be reinvested at sub 2% returns. This is my argument for a rapidly declining net % number at SS. A look at the portfolio and what is maturing:

(#3)
For 2012 SS will run a cash deficit in 9 out of 12 months. SS will have to fund these cash shortfalls by selling a portion of the TF notes. Think of this as having money in a bank CD, but being forced to borrow from a CC to cover a monthly nut (a reverse Repo). As a result, net interest income gets hit.

Yields on the TF securities are set by a formula that has benefited SS for many years. We have been in a 20-year cyclical decline in interest rates. The SS formula takes an average of prior years long-term fixed rates (it excludes short-term rates in the calculation). As a result, the interest income at SS has been “smoothed” and artificially maintained at higher % rates. That said, time and the formula are catching up with the Fund. In 2007 the SSTF invested 15-year money at 5.0%. For 2009 it was 3.5%. In 2011 they only got 2.5%, half of what it was just 4 years ago.

There is a part to this that gives me a chuckle. In month where there is a shortfall the Fund must sell bonds. The discount rate used for these routine transactions is also set by the formula. As the formula excludes short-term rates the Repo rate is set at an artificially inflated level. In August the TF had a deficit of $8.4B. They reverse Repo’ed that at a cost of 2.25% for 4 months ($55mm in interest expense for just the August shortfall). This will add up and get bigger.

 

I love it. Every dirt bag bank in the country is borrowing money from the Fed at ¼%. At the same time the largest holder of USA government securities in the world is borrowing short-term at 8Xs that.

The Fed’s policies are hitting the Social Security Trust Fund two ways. Inflation costs are high and interest income is falling. At the same time, SS can’t finance its inter-month shortfalls at today’s zero interest rates. Three ways a loser.

Cash on the Side

I have an account with one of the well know WS names. The guy I work with calls this morning. He says:

“Across the entire‘Wealth Management’ side of our firm we have clients who are sitting on cash earning zero return. For that reason we think stocks have to move higher.”

The guy is right. I’m scared to step up and so are a lot of others. So I say back to him, “I’ll think about it.” I did, my thoughts:

The recommendation is to position for a year-end rally. That’s what’s supposed to happen. It happens every year. But all I see is uncertainty.

What’s the Best Case for the EU as far as the markets are concerned? The answer is that a deal in excess of $3 trillion is coming. This is what the market is currently looking for:

-A deal where there is a soft landing restructuring of Greek debt.

-A “solution”, where dozens of big banks will be infused with fresh government capital (a la the US TARP).

-The outcome will be the Socialization of the banking sector and the problematic public sector debts of the PIIGS. This massive transfer of debt/risk will be facilitated with a leveraged SPV.

-Numerous weaker financials will be absorbed by the State(s) (a la Dexia). The terms of those TBTF wind-downs will be market friendly. Equity holders will not be wiped out, Preferred and subordinated debt will benefit from a new State guaranty.

-Coupled with the above, there will be an IMF package to assist in the bailout to the tune of $400 billion.

That’s the Best Case? To me that is a disaster. If all this were to happen it would result in a near immediate downgrade of both France and Germany. The “guarantees” of the SPV guarantors would be devalued in a month.

If this is the way the world is going to go, it is a road fraught with risk. The EU would look like the USA with Fannie and Freddie. Trillions of dollars of debt and guarantees would be "off balance sheet". The losses would be born by Germany and France. I think there is a very real risk that a “positive” outcome in the EU will lead, in short order, to a broad based credit crunch in Europe. The solution to that problem will be for the ECB to print money and the Federal Reserve will have to (again) come to the rescue with a multi-trillion increase in dollar swap lines to the EU Central Banks. The "Big Bailout" is a very slippery slope in my opinion.

That is an outcome that I would rather ‘sell on the news’  then ‘buy on the rumor’.

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The Worst Case (as far as the market is concerned) is that the deep thinkers in the EU actually start listening to the voters in France and Germany. The result is that the “Grand Plan” to save the Euro experiment is a dud. An outcome under this scenario is a deal that is woefully inadequate to the task. A popgun approach. Any “successful” plan  must put the German taxpayers at risk. A plan that falls short of today’s very high expectations would be seen through by the markets in just a few hours.

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On the USA side of things, there seems to be a disconnect between the real economy and equities. Over the next six weeks we have a few hurdles to cross:

-Another Continuing Resolution is necessary to keep the government running. The date for this is November 18th.

-There MUST be a resolution of the Bi-Partisan deficit commission on $1.4 Trillion of deficit reduction. (November 30th)

-As of today, the outlook for any 2012 stimulus is up in the air. Failure to pass any legislation will result in a $120 billion middle class tax increase that would kick in January 1. (The reversal of the “one-year only” 2% FICA tax reduction.) We may end up with the “Jobs Bill” being very much a slice of bread when a few loaves are needed. Should that be the case, 2012 GDP estimates would fall to the 0-2% range.

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It’s just a joke to think we are out of the woods with energy prices. Look at this chart of the real cost of crude for much of the country. This chart is telling me that $105 oil is the bottom of the range. It’s also telling me we are headed back up, not down, as Mr. Bernanke keeps telling us. (I discount NYMEX crude pricing as a measure of anything).

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There is a credit crunch that’s sneaking its way through the US  debt markets. The latest evidence is in Jumbo Prime loans. See Zero Hedge for details (link). It’s creeping into critical areas of finance. Consider these words and charts from UBS:

The high yield primary market was virtually shut this week, with no deals pricing in the fourth $0 volume week since the start of August.

Since August, weekly volume has averaged a meager $699 million, versus $6.7 billion per week during the same period in 2010

Secondary markets have continued to trade wider. This week, the Broad Market, B-rated, and CCC-rated high yield indices all touched 2011 wides (and their widest levels since 2009). The BB-rated Index, while having fared better than its lower rated peers, also touched a 2011 wide during the week, and its widest level since mid-2010

It's increasingly clear that a credit contraction is in the works. In part, that’s due to folks like me that look at high yield debt returns and see capital loss resulting from default and restructuring. High grade debt pays nothing. Why bother.

 

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There is no good news coming from China over the next few months. Period. Depending on how the currency issue with the USA is resolved, it could get ugly.




We shall see what the markets will bring. There is too much cash on the sidelines and cash has been made trash by Bernanke. My broker friend may be right that the broad tape has to move higher. But I don’t trust it. I’ll keep the money in the wallet for a bit longer.

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I go to Zuccotti Park

Sunday was beautiful in NYC. Indian summer. I went to the OWS protest. Some observations and some pictures.

Zuccotti park is where the action is contained. This is a miserable excuse for a park. It’s about the size of a football field. Not a blade of grass to be found. As you will see from the pics, this place is already jammed. The limited space may prove to be an issue for this demonstration. You can’t get more than a few thousand in this cramped area.

The park is sandwiched between Broadway and Church. It’s bounded by Liberty St (and some other street I forgot the name of). On one side is the Brown Brothers Harriman Building (talk about white spats).

On the other is the rapidly rising world trade building.

The cops have the place surrounded. But it was very clear that these policemen were not looking for trouble. Two blocks away, I found where the police had set up a command post. I suspect the guys with the helmets were resting over there.

Congressman Eric Cantor made a foolish remark over the weekend. He referred to the happenings in lower Manhattan as a “Mob Scene”. Cantor’s an ass. He has no clue what is going on. This was just a dumb sound bite. He will regret it.

There was no mob. There were no professional provocateurs. There was festive attitude. There was no anarchy. The following pictures are the scenes that I saw. Look at the people in the background; you will not see anything threatening at all.

There was some attempt to bring order. A library, medical area, kitchen, a media center, legal aid and even a store for “essentials”:

Some people were painting signs:

Others were just painting people:

Wherever you looked there were signs. Just a few of the many:

 

There was one sign that caught my eye. I’m willing to bet it has also caught they eye of the FBI.

I left the area thinking that this very small group of people couldn’t possibly make much of a difference. It’s a rag tag demonstration. More a party than a serious effort to change the financial system. But as I walked north I thought of a different time in history. One that I participated in. To me, there was a very similar feeling in Zuccotti Park in 2011 to what existed in San Francisco in 1967.

The 1967 Summer of Love was a period where social/political changes began. The allure of sex, drugs, and rock and roll were very powerful magnets for this 17 year old. I crossed the country and spent a few memorable months in San Francisco’s Haight Ashbury District.

I slept in a crash pad. I went to the Fillmore West and watched Jim Morrison of the Doors sing “Light My Fire” till the sun came up. And yes, there were drugs. And yes there was “Free Love” in the park. And yes, it was a hell of a party. And yes, there was not much relevance to the whole thing.

But three years later a million people marched on D.C. and it altered the outcome of a war. It also tore the country inside out. It would be a big mistake to dismiss what is going on in Zuccotti Park. Whatever is happening there, it's not going to go away. It’s going to get bigger.

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