Sunday, October 16, 2011

October, Wednesday 12, 2011

DOW + 102 = 11,518
SPX + 11 = 1,207
NAS +21 = 2,604
10 YR YLD + + 2.22%
OIL - .84 = 84.73
GOLD + 11.30 = 1675.50
SILVER  + .44 = 32.68
PLAT + 27.00 = 1555.00

Did you see them this morning? I did. I spotted one at the gas station. I stopped at the post office and saw a couple there. Stopped for a coffee and there were a couple of tables full of them. They’re easy to spot – their eyes have that glazed over look; their faces are scrunched in a desperate frustration; their hands shake and their fingers twitch; they talk but no one answers them. Yes, this is the horrible fate of Blackberry smart phone users – Research in Motion confirms there has been a service disruption – they claim the problem started in Europe, some switch that didn’t switch properly, there was a failure, and then like so many dominos falling, the European contagion spread to the United States.
Why does that sound so familiar?

European Commission President Jose Barroso called for a reinforcement of crisis-hit banks, the payout of a sixth loan to Greece and a faster start for a permanent rescue fund to master Europe's debt woes. Barroso urged a “coordinated approach” to deliver a “significantly higher capital ratio of highest quality capital” for banks, while offering government funds only as a last resort.
Slovak parties reached an agreement to approve Europe's enhanced bailout fund, paving the way for a repeat vote in the coming days after the pact failed to win support yesterday. Slovakia is the only country in the 17-member euro area left to approve the EFSF.
Earlier today, European Economic and Monetary Affairs Commissioner Olli Rehn said the region is moving toward a consensus on resolving the “calamity” of the debt crisis.
Notice he didn’t say they are going to resolve the debt crisis, just the “calamity” of the debt crisis. Greece is broke; it can’t pay its debt. Default is default. There is a very high probability that Greece will effectively default in the next week or two. The entire country is scheduled to strike on October 19th. Refinery strikes ahead of the general strike means that there are almost no supplies of fuel. Sanitation workers are already on strike; trash is piling up in the streets. The bankers may fancy themselves Masters of the Universe, but when the trash piles up and the rats come out and you can’t get enough gasoline to drive away – you quickly realize that the trash man is more vital than the hedge fund manager. Greece is a goner.  The only question is whether there will be calamity.
There is a G-20 Meeting scheduled this week in Paris. The U.S. says it will intensify the call for resolute action. Let me simplify this for you – FREE MONEY for the Banks – And of course, every time there is a promise or even a good rumor of FREE MONEY for the banks, Wall Street moves higher – even if Alcoa reports ugly earnings.
Now, let’s look at the real reason why all these central bankers and politicians are so scare of a calamity. The problem isn’t just a few billion dollars of Greek debt; the problem isn’t just the Greek bonds going into default.
They’re afraid of a good old-fashioned run on the banks. So they are requiring the banks to build up 9% in capital reserves, but late today the Financial Times reported the European banks are balking at recapitalizing at current levels. Surely this Rumor of the Day was intended to demonstrate that the European banks don’t need further capitalization; what it really indicates is that they CAN’T recapitalize. Nobody in their right mind would lend to an industry that continues to be locked out of short-term funding markets for the 4th month in a row. So that leaves two options: Option One – the banks liquidate what they can to recapitalize – they sell everything that’s not nailed down. Option Two: a run on the banks.
The threat isn’t just a potential run on the banks – The problem is bigger than that. If there are runs on banks that will, in turn, set off defaults in the derivatives markets, the CDS markets, where banks bet against countries, and each other for survival.
The notional value of the world's derivatives actually is estimated at more than $600 trillion to $1 quadrillion dollars – nobody knows for sure because the derivatives markets are largely unregulated and unaccounted for.  Notional value, of course, is the total value of a leveraged position's assets. This distinction is necessary because when you're talking about leveraged assets like options and derivatives, a little bit of money can control a disproportionately large position that may be as much as 5, 10, 30, or, in extreme cases, 100 times greater than investments that could be funded only in cash instruments. 

The world's gross domestic product (GDP) is only about $65 trillion. So there is literally not enough money on the planet to backstop the banks trading these things if they run into trouble.
I don’t mean to frighten you – really its not that bad; the Bank of International Settlements estimates the net notional value of uncollateralized derivatives risks is between $2 trillion and $8 trillion, which is still a staggering amount of money but nowhere near a quadrillion. But still a couple of trillion here and a couple of trillion there and pretty soon you’re talking about real money. The kind of money that might panic investors in the event of a governmental default on debt, causing a run on several major European banks, which could cause undercapitalized banks to run out of money and declare bankruptcy, which would cause short-term borrowing costs to skyrocket and credit would freeze up; and then like so many dominoes falling, the European contagion could spread to the United States.
And, wait a minute – why does that sound so familiar?

What can be done to prevent the contagion from spreading to the United States? If a bank fails, the FDIC is able to protect retail depositors fully, while wiping out shareholders and imposing losses as appropriate on creditors; that seems to work for small and medium sized banks. But can such powers really be extended to cover the largest banks? 
Under the Dodd-Frank financial reform law, regulators could have the ability to take over and wind down private financial companies, as opposed to the bankruptcy process which we saw for Lehman Brothers, or the bailout process that we saw for AIG. So, would that stop the dominoes from falling in Europe and destroying US banks? Probably not. U.S. legislation can’t specify how assets and liabilities in other countries will be treated; this requires an intergovernmental agreement of some kind. No meaningful cross-border resolution framework is even in the cards. 

And then if the regulators do close down a bank, we’re back to the same “Too Big to Fail” Dilemma we faced in 2008; in large part because there has been no controls imposed and there is no accountability in the quadrillion-dollar derivatives market. The simple reality is that the global financial system has not become safer since September 2008
There is a decent chance that governments and regulators, and G-20 finance ministers will be able to control the calamity of default. Probably. Maybe. Wall Street believes it has the risks under control. That should make everyone nervous.

The Federal Reserve released minutes from the most recent meeting of the FOMC. The big story was that  a couple of the Fed officials thought it would be a good idea to start up QE3, Quantitative Easing Round 3, which would involve large scale purchases of assets by the Fed. They generally agreed that QE3 wouldn’t really give much juice to the economy, at least not enough to offset the inflationary risk. They decided to hold off for now but concluded that if deflation becomes a worry, they might resort to a third round of QE.. One official thought the Fed should try to do something about unemployment even if it resulted in inflation; that idea didn’t go far. There was “considerable uncertainty” that economic growth will pick up, but for now the Fed is in wait and see mode.
A new report from JP Morgan shows the share of strategic mortgage delinquencies among the total has risen to about 26 percent to 27 percent from 20 percent a year ago, As home prices drop it wipes out the equity of homeowners. Typically when when negative equity tops 25%, homeowners are more likely to make a conscious decision to default on the mortgage even if they remain current on other debt and even if they appear to have the means to continue paying the debt. . The report finds the more more sophisticated prime and Alt-A borrowers are significantly more likely to choose to go delinquent.
The share of strategic delinquencies among prime non-agency mortgages is now almost 40 percent, up from about 30 percent a year ago. For Alt-A loans, considered between prime and subprime in terms of expected defaults, the share is about 35 percent, up from about 30 percent. For subprime loans, the amount is about 25 percent, up from less than 20 percent. That’s right, prime mortgage holders are twice as likely to deliberately default compared to subprime borrowers. It appears the more sophisticated borrowers have learned the bankers credo – it’s not personal- it’s just business. Payback is a bitch.

Just a quick note on Occupy Wall Street protests:

Iran’ figurehead leader Ayatollah Ali Khamenei said on Iranian television today that the United States is engrossed in a crisis due to the increasing severity of the Occupy Wall Street movement, which has spread from a dozen demonstrators in Lower Manhattan to thousands of protesters from coast-to-coast (and even abroad) in only a few short weeks.  Khamenei said that the United States’ "corrupt foundation has been exposed to the American people” and that a revolt will continue to be waged.
"They (US government) may crack down on this movement but cannot uproot it," Khamenei said. "Ultimately, it will grow so that it will bring down the capitalist system and the West."
Khamenei added that "the world is at a historical turn” and that capitalism in the West will soon come to a close.

Today in the Arizona Republic, columnist Robert Robb wrote: “The protests consist mainly of people who believe that economic and social justice requires a form of economic organization other than capitalism. That may not lend itself to a five-point plan, but it’s an agenda nonetheless.”

I think there is a lot of misunderstanding about Occupy Wall Street. When your column sounds remarkably similar to the Ayatollah Khamenei, you might want to reconsider your information  and your position.

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