For these investors, the preferred investment habitat tends to be a blend of income-generating fixed income and equity type investments that are thought to contain the potential for growth. Because gold, as an investment class, provides neither steady income nor systematic growth, it succeeds in only providing emotional discomfort for these investors.

Warren Buffet’s recent article in Fortune is a reflection of this sentiment. First on the list of asset categories to consider are bonds or, more generally, fixed income. His analysis is instructive.

From his point of view, over the relevant time frame of the 47 years he has been at the helm of Berkshire Hathaway, continuous rolling short term Treasuries bills would have averaged 5.7% annually. But if an investor paid income taxes at a rate averaging 25%, the return is reduced by 1.4 points. Buffet then goes on to point out that the return is then further reduced in real terms by the invisible inflation “tax” which would have devoured the remaining 4.3%. Hence rolling short-term Treasuries would have yielded nothing in real terms.

If one held long maturity Treasuries over this period — which included 30 years of general Treasury bond price appreciation — the investment outcome is questionable if you take into account the declining purchasing power of goods in U.S. dollar terms.  It is even worse when compared to a market basket of goods from around the world.

In Buffett’s terms, fixed-dollar investments have fallen a staggering 86% in real dollar value since 1965 during his tenure at Berkshire Hathaway. He points out that today it takes no less than $7 to buy what $1 did when he arrived in Omaha.

He concludes with the recommendation that fixed dollar income investments should come with warning labels advising you that they’re bad for your financial health.

What if contractual steady income doesn’t perform well? Asset categories outside the normal preferred habitat need to be examined. That’s where gold comes in, especially considering that for the first time in our monetary history the central bank has adopted positive inflation as a policy goal. Nonetheless, the institutional sale is a hard one, not just because it’s not been a member of the preferred habitat, but according to Buffet it has other fatal defects.

After conceding in a backhanded way that gold has performed well, with reference to its near $10 trillion in market capitalization, he argues that it doesn’t qualify to be in his preferred investment habitat because it doesn’t produce a growing revenue stream — and if it doesn’t grow, it doesn’t compound.

Rather, he states that his preference would be to employ his capital with growth commodities such as farmland or businesses that will continue to grow its bread-and-butter capacity that can be sold in real terms. That is to say, he rejects gold because it doesn’t produce gold sprouts. Gold is just inert, lying in neatly stacked bars in a subterranean vault. It has but limited use in electronics, jewelry, dentistry and few other applications.

Buffett then goes on to compare the rising price of the sprout-less gold to a Ponzi scheme, which depends upon finding a bigger fool to pay yet a higher price for the same subterranean inert matter. This is apparently proving easier to do by the day as the developed world continues to run outsized fiscal deficits and then compels its central banks to purchase its paper.

Instead, Buffett prefers investments such as Coca-Cola or See’s Candy, which have the ability to sell more candy in the future at the prevailing price level as a means to produce real growth.

That’s where I depart from the Sage of Omaha. While not arguing with the ability of See’s Candy to deliver and the American sweet tooth to be unaffected by the growing concerns for obesity, I believe he fails to see the new product that gold represents and its growing sales potential.

This is “the new calculus of gold.”

In a wealth-accumulating economy there is always demand for an ultimate store of value for wealth preservation. In finance terms, there is always a demand for some asset for which an investor takes no default risk, nor inflation risk, and can be obtained and sold on liquid markets.

For decades, U.S. Treasury debt took over from gold as the market’s preferred store of value. Treasury bonds mythically had no default risk and little inflation risk when central banks were not under pressure to be concerned about unemployment, lending to insolvent banks, or propping up the value of government debt. Moreover, U.S. dollar-denominated Treasuries served not only as the store of value but also sprouted interest payments.

But all that has changed, perhaps not forever but likely for the next four decades, as developed world democratic governments will be under pressure from their constituents to make good on the social contracts of social security and comprehensive health care to the bulging baby boomer population. And, if need be, they will recapture the central banks (by legislative changes if necessary) if they fail to support U.S. Treasury prices.

Given the debt and monetary growth ramifications of these pressures, investors will seek an alternative embodiment of a store of value other than fixed dollar denominated assets, especially sovereigns. With all other developed countries in similar straits and emerging market countries exposed to inflation generation from developed country central banks, their currencies and sovereigns also fail to qualify. Hence, gold has reemerged to play the role of the store of value, despite its sprout-less property. Sprouts are the icing on the cake but not the cake itself — and many gold admirers remember Mark Twain’s old saw: ‘I am more concerned with the return of my money than the return on my money.’

The New Calculus of Gold has much more to its story than merely the market-designated good for inflation and default protection, with or without sprouts.

We are at a historic point in time when both consumer and government debt have grown dramatically relative to income, which is our underlying economic problem (See Roadblocks to Recovery: An Interview with Dr. Lacy Hunt). In the great debt run-up of the last few decades, lenders or bond investors underwrote debt or loans based on either the borrower’s cash flow to service the debt or based on the borrower’s collateral, or both.

But debt has a maturity, and when the maturity is reached, borrowers seek to go back to the well and roll the debt over. From the easy lending days of the turn of the 21^st century, the value of what has traditionally been accepted by the lender as good collateral has declined in market value as well as market esteem. That includes residential houses and commercial real estate for mortgages, mortgages for mortgage-backed securities, and mortgage-backed securities for CDOs.  Even government securities and guarantees have been questioned especially from abroad when collateral value is set by the credit rating of the collateral. By that measure even U.S. Treasuries and government guarantees fail the test of good collateral given rating downgrades.

Hence, the great corollary of over indebtedness is the relative scarcity of good collateral to support the debt load outstanding. This imbalance of debt to collateral is impacting the ability of banks to make loans to their customers, for central banks to make loans to commercial banks, and for shadow banks to be funded by the overnight Repo market. Hence the growth of gold as a collateral asset to debt heavy markets is inevitably in the cards and is de facto occurring. Gold is stepping up to the plate as “good” collateral in a world of bad collateral.

As described in the accompanying news story (J.P. Morgan to Accept Gold as Collateral), gold is now being accepted (or more likely demanded) as collateral for bank loans, which increases the demand for gold. Furthermore the scarcity of collateral has spread to Europe, where debt is now being priced according to the value of its collateral, and clearing houses are accepting gold as collateral and for exchange settlement. Furthermore in this environment of collateral scarcity, clearing houses that service the shadow banking repo loan closures are closing loans despite the arrival of the collateral (prosaically called settlement fails) but it doesn’t stop the loan from being closed without any collateral, either good or bad and is now causing a regulatory backlash to tighten up actual collateral.

In addition to the demand for gold as collateral to back private debt, there are growing instances of commercial banks and central banks stocking up on gold as assets to meet the perception of depositors that banks or currencies are financially healthy. In this regard there is a shifting of foreign exchange reserves of world central banks away from foreign currency (dollars) into gold as shown in the Figure.

Most importantly, China, in its not so secret desire for the Yuan to be a world reserve currency, is accumulating domestically produced gold as it bans exportation, and at the same time it is shifting its foreign exchange reserves from currency into gold. If the Yuan has a chance to have reserve currency status it likely would require gold backing. A gold-backed Yuan would make a big dent in the U.S. market for the dollar and Treasuries as the world’s store of value asset. A gold-backed Yuan would be the equivalent of gold certificates in a warehouse and denominated in a currency that would be on the upswing and very desirable as compared to developed country sovereigns or currency. It might even be more appealing than gold certificates stored in a Swiss warehouse, denominated in a currency that is not allowed by its central bank to appreciate.

We have entered an environment with elevated debt to collateral and elevated currency to goods, and gold is again demanded by market forces to enhance the value of debt paper and otherwise fiat currency.

What we are witnessing is a sea change in which market forces are driving a de facto return to the gold standard. All that is missing for this to be a de jure gold standard is some regulatory and legal recognition and one has been proposed. The Basel Committee for Bank Supervision, the maker of global capital requirements is studying making gold a bank capital Tier 1 asset.

This implies banks would be regulatory blessed to operate with less equity capital than is normally required of banks if they held more gold as an asset. Basically,  regulators would allow banks to be more leveraged, meaning the banks would not suffer as much equity dilution to recapitalize after sovereign and mortgage write downs. Not only would gold then be backstopping debt and currency but also be backstopping bank equity capital.  So the realm of gold is expanding to fill the void of other “money good” assets and elevating its demand.

The world has gravitated from one gold-backed paper currency to another before, and it likely is happening again. It would depend on whether investors in liquid, default-free, inflation-free paper prefer gold-backed Chinese Yuan to Swiss warehouse receipts or deposits from large international banks with large gold positions that operate with lots of leverage. This is a market choice that will determine the gold linked paper store of value, but the point is that all the paper contenders derive value from the gold backing, and thereby expands the demand for the shiny metal. This is the new calculus of gold. This state of affairs is likely to remain until developed world governments no longer reach for the unreachable and pressure their central banks to finance it.

If you enjoy this blog, please forward it to others who may be interested.

Moreover, we do not have an answer to the larger question of the sustainability of the Western social model of a government-funded retirement with medical care.

In the following guest blog, Dr. Wilfried Prewo points out that a decade ago, Germany was faced with a similar problem of sustaining the economy and delivering on the government’s social commitments.  As a result, she devised supply-side policies that have been very effective in meeting both goals. Today, Germany has the lowest unit labor cost despite also having the highest wages in Europe. As a result, she runs a trade surplus, has relatively low unemployment and a near balanced fiscal budget.  The U.S. has a lot to learn from these innovative supply-side policies.

Germany: Export Powerhouse Despite High Wages
by Dr. Wildfried Prewo

Just ten years ago, Germany was labelled the “sick man of Europe”. Following its remarkable post-WW II recovery, Germany became complacent in the three decades from 1970 to 2000. Its labor cost rose to the highest in the world, benefits became more and more generous, and the work-week was shortened to as low as 35 hours. Productivity growth slowed down, wage increases did not. Germany’s competitiveness as measured by unit labour cost (labour cost adjusted by productivity) slumped and threatened Germany’s export success despite otherwise superior engineering and product quality.

Over these three decades, Germany’s social model became less and less sustainable. With every recession during that period, unemployment ratcheted up and, in the following upswing, did not recede to the pre-recession level. With higher unemployment, payroll taxes had to be raised, thus exacerbating the labor cost situation and spinning a vicious cycle of higher unemployment and yet higher payroll taxes. In 2003, when Germany shrank by 0.2 percent, unemployment was 10.5 percent. But in 2005, with positive growth of 0.8, unemployment still stood at 11.7 percent. Then things changed.

By the time of the Lehman Brothers collapse, in September 2008, German unemployment had been brought down to 7.3 percent. Even more remarkable is the fact that, a year later, in 2009, when Germany’s GDP shrank by 4.7 percent in recession following the financial crisis, unemployment had hardly increased (7.9 percent in September 2009). Another September later, in 2010, when German GDP grew by 3.6 percent, unemployment was at 7.2 percent. Now, in February 2012, unemployment is at a seasonal 7.4 percent. If we were not overwhelmed by the debt crisis in Europe’s olive belt, prospects would be bright.

The improvement – or better, structural change – in Germany’s labor market was not achieved by axing wages and benefits. In 1997, German hourly compensation costs (wages plus benefits) in manufacturing were 29 percent higher than in the U.S., making Germany the world’s labor cost leader at that time. In 2009, Germany’s wages still were among the highest in the world, with only four small countries (Norway, Denmark, Belgium, Austria) having higher wages. But from 1997 to 2010, German labor cost had an annual average increase of 1.9 percent only, as compared with 3.2 percent in the U.S. Over the last decade, wages in Germany did not fully compensate for inflation. On top of that, German labor productivity did increase and restrained German unit labor cost to an increase of just 6% from 2000 to 2011. Contrast that with percentage increases of 19.9 in the U.S., 24.1 in the 27 EU countries overall, 32.5 in Italy, a major German competitor in machines and autos, or even 31.2 in Greece. (As an aside: This shows that the profligacy of countries like Greece and Italy was the cause of their debt crisis, and it shows what has to be corrected.)

The German labor cost mitigation was primarily not the work of government, but a joint and self-organized effort of companies and their employees. It was a sea change in labor relations as it replaced rigid work conditions and one-size-fits-all union wages by a myriad of flexible plans.

The change in labor relations began around 2003 and in small and medium sized companies with a lower degree of union influence. At that time, many of these companies, still reeling from the previous 2001/02 recession with its onerous cost of severance packages, were not profitable and strapped for money to invest in new equipment and material in a feeble recovery. The employees realized the dire situation and, in trying to preserve their own jobs, made significant concessions: Work rules were made more flexible, weekly hours were increased to 40 and beyond without extra pay; annual, in some cases even life-time work time budgets replaced rigid weekly hours; this allowed companies the flexibility to adjust weekly work hours to demand, say, anywhere from 25 to 45 hours as long as they stayed within the longer-term, annual time budget. Overtime compensation was scrapped. Even the regular wage for extra hours was not paid out in cash, but deposited in individual deferred compensation accounts which were to serve as rainy day funds.

By the beginning of the 2008 recession, these accounts were bloated and could then be depleted as companies sharply reduced their work hours during the recession. This preserved income levels, and German private consumption remained a robust pillar throughout the downturn. (As an automatic stabilizer, the German law compensating for “Kurzarbeit” had the same effect; under this government program, the wage reduction due to a recession-induced shorter work week is compensated by unemployment insurance at the unemployment benefit level, allowing a worker an effective take-home pay of around 90 percent of his previous wage, even if he is idled for a third of the week.)

In return, German companies guaranteed not to reduce their labor force except under exceptional circumstances, and they kept that promise. Companies also promised investment in German production facilities in order to allay labor fears that offshoring and outsourcing, a must-do in any globalized industry, would come at the cost of German employment.

German labor unions at first fought this bottom-up development as it reduced their influence and, of course, poked holes into their rigid and top-down, one-size-fits-all union contracts. But eventually, reason prevailed and the unions condoned these agreements by their rank and file members in the companies. Flexible union contracts that offer cafeteria-style provisions for individual companies’ circumstances are now standard.

With nominal unit labor cost remaining nearly flat over the last decade, German companies benefited from the strong decline in real unit labor cost. As a result, the profits of German companies, as a share of GDP, jumped from 14.8 percent in 2000 to 20.9 percent in 2008. German companies could invest and deleverage at the same time. When the 2008 recession hit them, they were in a financially robust state. By September 2011, they had more than erased the damage their balance sheets suffered during the recession.

On the cost side, these changes in labor relations were the major reason for Germany’s V-shaped recovery from the recession. On the demand side, the recovery was fuelled, as early as in the spring of 2009, by strong export orders from China and other Asian countries that were not inflicted by the financial crisis. The German export mix of cars, machinery, chemicals, and other investment goods with a high engineering content and requiring a skilled labor force is exactly what is demanded by strongly growing emerging markets. While in 2000 only 1.6 percent of German exports went to China, that share had risen to 5.6 percent by 2010. For the major emerging markets, the BRIC countries together (Brazil, Russia, India, China), the increase was from a share of 3.9 to 10.4 percent. Germany is now exporting more to the BRICs than to the U.S., whose share of German exports declined from 10.3 to 6.8 percent in the decade. (In absolute numbers, German exports to the U.S. are not lower now than in 2000.) Another symbol for the rising importance of emerging markets is that, since 2010, Mercedes has been selling considerably more of its top-of-the-line cars, the S class, in China than in the United States.

Manufactured goods with cutting-edge technologies require good engineers and a highly skilled labor force. Many Western countries, including the U.S., have the first, a pool of good engineers, but what the U.S., France, the U.K., or Italy as major German competitors lack is a broad highly skilled labor force. Too often, the manufacturing workforces in American or British companies consist of workers who have been trained for brief periods and only for the specific skills at their work stations. In Germany, the typical worker has undergone a three-year vocational training program after leaving school. As a consequence, Germany has few unskilled workers, and the systematic training at the beginning of the career is a base for further training later on as will inevitably be required by technical change. Germany is not the only country offering such a system; Austria, Switzerland, or Denmark have similar systems. All of these are countries which are successful in exporting and which also pay high wages. Comparing wages among industrial countries is a comparison between apples and oranges if skill differences are not taken into account.

In foreign production facilities where nationwide training systems do not exist, German companies often engage in considerable in-house training efforts in order to be able to achieve the same product quality as in Germany. Although these isolated, single-company training efforts are less efficient than a nationwide system, they are a second-best solution and work. One example: Who would guess the name of the largest exporter of American made cars to outside the NAFTA region? It is a German company – BMW. I am convinced that American machinery or chemicals manufacturers could emulate the German export success if there were a similar training system.

Society also benefits from systematic youth training: In January 2012, unemployment among young people (age 15-24) stood at 16.0 percent in the U.S., 22.4 in the EU as a whole, 23.3 in France, 31.1 in Italy, and a staggering 49.9 in Spain. In Germany, the rate is only 7.8, and the situation is comparable for Austria or Switzerland. In the other countries, youth unemployment is roughly double the overall unemployment rate and a cause for social problems.

When contemplating economic policies for the United States, it might be worthwhile to consider systematic youth training. It will take more time than an election cycle to show its effect and it is not a quick fix, but quick fixes rarely lead to a sustainable resolution.

prewo@hannover.ihk.de

March 22, 2012

Wilfried Prewo is chief executive of the Hannover Chamber of Industry and Commerce in Hannover, Germany. He holds a Ph.D. in economics from Johns Hopkins University and has taught economics, early in his career, at the University of Texas at Austin.

The extent and implication of the U. S. debt overload. Neither monetary nor fiscal policy can solve the debt problem nor the profound side effects of excess debt.

Download .pdf
Welling at Weeden Interview

While there is some economic growth theory that addresses a sustainable stock of capital assets relative to income, there is no similar theoretical basis for indicating how much debt is too much relative to income. However, the two should be related, as they represent the two sides of the balance sheet when debt is used to finance the accumulation of capital assets. The linkage between debt and capital starts to break down when much of the existing debt was funded in order to consume rather than generate productive assets. As a result, debt for the purpose of consumption hangs more heavily on the balance sheet as it does not generate any future output or income to sustain the debt.

Lacking a theoretical answer, the question of how much debt is too much has only been answered on an empirical level. Reinhart and Rogoff address the effects of government debt and find that a debt-to-income ratio of 0.9 is the threshold for when economic growth begins to slow down. But this estimate doesn’t include consumer debt or state and local government debt, which for the U.S. is also well above accustomed levels.

This still leaves open the question of how do over-indebted countries re-establish stock-flow balance. While it takes long periods of time to accumulate debt at a faster clip than income — and its fun while it builds and generates income —the reverse occurs when the debt-to-income ratio is shrinking.

If individuals and governments seek to “do the right thing” and save in order to reduce indebtedness, progress in de-leveraging is agonizingly slow. This prescription, better known as austerity, can only be successful if the economy has other means of support from business investment growth and/or net export growth. This roughly parallels a literature entitled “expansionary austerity.” Yes, as you would guess, expansionary austerity is an oxymoron. There are precious few successfully sustained episodes of income growth in the face of austere deleveraging. For example, take a look below at how Greece is faring with austerity as a de-leveraging policy.

But if the re-establishment of stock/flow balance through expansionary austerity is not successful (and we wish Europe the best of luck), the market alternative is default. This is the swift and painful market response.  While the debtors are relieved of their debt burden all at once, the owners of the debt are similarly relieved all at once of their corresponding assets. That is to say, there is an instantaneous wealth meltdown, and all bad things follow that. We got a scary preview as we witnessed the Lehman Brothers financial meltdown in 2008 based only on mortgage debt meltdown.

Some of the defaulted debt is individually owned and hence it’s clear who has suffered a loss in that event. But the greater asset and wealth write-downs come from what most think are sacrosanct institutions, but they are not. Our private and public pensions, including Social Security (as its trust fund is 100% invested in U.S. Treasuries) will not pay out as promised. Nor will private insurance company annuities pay by contract terms. Our bank deposits and money market mutual shares will not pay 100 cents on the dollar — and don’t forget the impaired ability of endowments, charities and other trust funds to continue providing services in the face of their assets being written down. It seems safe to say that a developed country, particularly a democratically empowered government, will seek to avoid the correction to the debt-to-income imbalance, whether it is swift and painful or prolonged and agonizing. So, how do they preserve it?

Preservation of the imbalance is the road that we have embarked on. It requires that the asset/debt bubble be maintained indefinitely or until growth can be stimulated at a rate that outgrows debt accumulation. I call this the Helium Express, as it keeps the balloon floating in order to avoid the hard landing below. The intent is to keep balance sheets from imploding.

The Helium Express is occurring via super expansionary monetary policy the world over. It has become the policy of choice to keep the debt overload carrying cost affordable and hence sustainable as outlined in The Unintended Consequences of Saving the Sovereign.

Debt affordability and sustainability requires the Fed to pursue a goal of zero interest rates over the long haul in order to provide cheap and sustainable debt service that both the consumer and the government can afford.

In a very indirect way, this says that the Fed is seeking to maintain the right-hand side of the balance sheets of the big debtors, the consumers and the government. In doing so society’s balance sheet has an asset side as well and the two must balance. Hence, debt support is also generalized asset support. But how does that happen?

Well, there are many channels by which this works. Since the Fed implements the policy of affordable interest rates by purchasing Treasury debt at prices higher than market (to drive rates downward to historical lows), it also provides a capital gain to the seller of the bonds to the Fed. In turn that seller must now find a replacement asset with the proceeds of the sale to the Fed. As they look at a reinvestment in Treasuries they see yields so low that it doesn’t support conservative institutions investment income needs so another income-producing asset with higher yield must be found.

Hence conservative investors are forced into the “risk on” trade. They are seeking assets with investment income to support the income needs of the institution and must reach for greater default risk and volatility than their liking.

Another pressure to turn to the “risk on” trade exists when investors hold bonds with prices elevated higher than the redemption value by the Fed’s price support program. This provides the owner with an unrealized gain on their bond holdings and a smile on their face until they realize they are on the horns of a dilemma.

If the Fed stops inflating the value of  Treasury bond in the market, the investor’s unrealized gain may never be realized if the Helium Express comes down to earth. Furthermore, even if the Fed’s price support is there for the long run — which is longer than the bond’s redemption date — the bond settles down to be worth only 100 cents on face value  at redemption time (which is normally a big relief). In this case it is a lost opportunity not to cash in on the Fed’s subsidy.

Now the pressure builds to sell Treasury bonds to the Fed and invest in a less inflated asset.

The risk-on investments could take many forms, and the channel by which the financial purchasing power spreads out is intricate. These risk-on pressures have sent purchasing power first to income-producing assets such as bonds up the rating scale, dividend paying stocks, and preferred stocks. Now with those assets more robustly priced, new flows are beginning to be deflected to the next reaches of risk — even to real estate, and even to rental homes.

One big change from a year ago, when QE2 was underway, is that the risk-on asset is no longer emerging nation equity or a Swiss bank deposit. The countries that experienced capital inflows as a result of similar pressures to take the Fed’s subsidy and run abroad are now off-bounds for investors, as those countries have reacted to burn the speculators who caused their currency to appreciate and reduce their trade competitiveness. So, the Fed subsidy is staying in the U.S., with perhaps some Euro bond market buying as an alternative where the ECB welcomes a market vote of confidence in its currency.

Additionally, once this risk-on process is underway, even if no one sees changes in fundamentals to warrant higher prices of, say, equities, there is the unquestioned Pavlovian response known as “Don’t fight the Fed”. In this case it is “Don’t fight the Fed to the 5^th power,” as all major central banks are involved in the Helium Express.

Actually, what is being called the risk-on trade is actually risk-off in the sense that the Fed is not wanting the market to correct the debt/income imbalance via default or deleveraging, so it works to preserve the Helium Express.

It’s not your textbook economic expansion with Fed buying Treasuries that pumps up commercial banks. Instead the funds are moving through the shadow banking system to reach the far corners of the risk-on trade.

This ends up causing a great deal of hand wringing by asset value fundamentalists (especially as corporate profit have been declining), by those who do not take lightly the continued prospects for a contagious sovereign default, or by those who are fearful that no good comes of excess money except inflation.

Unless one of the financial traumatic events that is facing the world occurs — and don’t forget the potential for a middle east oil shut down — the Helium Express has the power to not just lift the risky financial prices but the economy as well, though it will take some heavy lifting. The Helium Express provides cheap financing to firms able to reach the public capital markets as well as a private wealth effect. The Fed is being only a little subtle in encouraging all to enjoy the balloon ride they are sustaining.

In December, when my 2012 view became positive, I questioned whether I was misinterpreting the value of the LTRO and the Chinese reduction in their Bank Reserve Requirements, as I appeared to be alone in my assessment. Jim Cramer screamed the sky was falling and virtually no one, on any station, seemed to appreciate the two events. In my January 2nd newsletter I outlined the basis for my belief as we were significantly increasing our equity exposure. Since then, I am more convinced that this year will reward us.

I finally found support this weekend, from Jeremy Siegel (Wharton finance professor) who through his analysis of rolling 5-year periods and the market’s valuation, wrote that the Dow should end 2013 at 15,000 (2 out of 3 chance) or 17,000 (50/50 chance). Of course this was met on Monday be a barrage of talking heads who stated the kind of gibberish that one espouses when covering all possibilities, such as “I am long-term bullish, but the market seems overbought short-term”. Many others said that the 20% gain since the October lows is “too much, too fast”. These prognostications, though possible, are not based on anything but feelings. It brought back memories of 2009. In my March 2009 Forbes article I stated that it was time to get invested – we had TARP and a near $1Trillion stimulus being thrown around. As Professor Siegel has his naysayers, I had mine at the time. After just a few weeks the market had gained more than 20% off the March 9th bottom and the talking heads said the market had moved too fast and was setup for another test of the bottom. And then too, their statements were based on feelings rather than an intelligent assessment of the economics at hand.

As a point of illustration, look at the chart below. The red arrow shows you where the market was when it had realized the same gain from the March ’09 bottom as it has today from the October bottom. Feelings can leave a lot of money on the table. I am not saying the market will be a straight line up, but considering everything, I believe that Dow 17,000 by the end of 2013 may be the more likely of Professor Siegel’s scenarios.

Consider the following:

1. The S&P 500 was flat last year but average company earnings rose by 18%.
2. More than 70% of all S&P 500 companies have beaten earnings estimates for each of the last 10 quarters.
3. Based on expected 2012 earnings and a P/E of 14.6 (ten year average), the S&P would be 1560 at year end.
4. Ben Bernanke will do whatever he can to keep interest rates near zero for the next three years.
5. The ECB will add another €1 Trillion euros or more to the already €500 B in the LTRO at the end of this month – Europe’s QE.
6. China is on course to lower bank reserve requirements now that their inflation is within their parameters.
7. Greece will almost certainly receive their bailout once their austerity measures have become law.

The further infusion by the ECB, through its LTRO (Long-Term Refinancing Operation) will add a large measure of liquidity to the European banks, buffering the possibility of contagion (Italy’s 10-year Treasury yield is now below 5.6%), or even the removal of Greece from the euro.

Certainly, Central Banks of the G4 (USA, Great Britain, Europe, and Japan) have shown that it is now their dominant strategy to expand their balance sheets at any sign of trouble, so we can be fairly comfortable in knowing that we have a safety net should foreseen or unforeseen trouble arise. Great Britain has just this month, added another £50B to their quantitative easing program, taking its total to £325B while cutting their interest rate to 0.5%, the lowest in history.

With central banks everywhere adding to their money supplies, the sad reality is that the bankers who were enriched by the bad loans and the politicians with their billions each year in deficit spending (now for four years in excess of $1.3 Trillion/year here at home), will have citizens of the western world pay for their looting. The trillions of dollars, euros, pounds and other participating currencies will ultimately be paid through inflation. The decline in purchasing power and the increased cost of commodities will most adversely affect the poor, those on fixed incomes, and unsuspecting investors who rely on savings, CDs, and bond interest (especially those in bond funds). It is more important than ever to maintain a hard-asset bent to our portfolios. In addition to gold, copper, iron ore, oil, pipelines and companies with prime real estate holdings, we have been assessing a number of real estate limited partnerships which may be held in Fidelity accounts, to compliment our portfolios with assets with lower correlation to the stock market and offer excellent hedges to a devaluing dollar. More will follow on these shortly.

ENERGY:
Last month I wrote about the benefits of a National Energy Policy based on natural gas. Natural gas emits 40% less CO2 than gasoline, and very little of any other pollutant. You might say it is so clean that you can burn it in your kitchen – try that with gasoline (No, not really). I did a little calculating and thought you might find this of interest. It takes 126 cubic feet of natural gas to equal the power of one gallon of gasoline or diesel. That means that one mcf of natural gas is equivalent to 8 gallons of gasoline. An mcf of natural gas cost about $4 delivered to your home and 8 gallons of gasoline costs $28 (assuming $3.50/gallon). If an mcf of nat. gas rose to $7.00 it would still cost you only 1/4 as much to drive each month.

If the typical driver is using $150/month of gasoline, he would save over $100. There are over 200 Million drivers in the U.S. If the average monthly savings is only $100, this would be a $20Billion/month stimulus to the economy. It would stimulate job growth and severely impact the ability of countries like Iran to wreak havoc since the price of oil would drop dramatically. The drop in the price of oil would also be a stimulus for those still using gasoline and other forms of oil, as well as all other countries who currently import oil. Natural gas vehicles are throughout the world – Austin and many other cities use them for their fleets, they are prevalent in Europe and Pakistan has almost 100% of its cars and trucks powered by natural gas. Pass it along.

The U.S. has over 100 years worth of natural gas and more is being found every day. We will begin exporting it early next year. I’d like to use it here, but we will at least be invested in the companies that will be producing and shipping it to buyers all over the world.

Happy Valentines Day,

Frank
Ph. 5 12.345.6789

2009 S. Capital of Texas Hwy. 2nd Floor
Austin, TX 78746

www.BeckCapitalMgmt.com
www.ProPlayerInvesting.com

It is becoming increasingly clear that developed-world countries will attempt to go down a path followed before by governments facing similar debt loads… and it’s not pretty. In this case it’s not a wartime debt rollover, but a combination of lofty promises made to provide a social net to a burgeoning population demographic. And this follows years of fiscal sloppiness both here and abroad derived from an attitude best expressed in the infamous and thoughtless words of Dick Cheney, “Debt doesn’t matter.”  Well, Dick, it does.

With the U.S. and many other sovereign’s debt levels reaching or exceeding the 100% ratio to GDP, governments are in a mad scramble to line up financial resources to keep the debt thing afloat.

Europe (Greece in particular) continues to be the poster child for the illusion that a government can keep itself going by leaning on its citizens and others to create bailout funds, or by changing the accounting, regulatory or legal rules, or by engaging in other funny–money schemes. Europe has just concluded the 16th summit of its leaders in less than two years to solve the Euro debt problem once and for all — and all they do is create more debt (the ESM permanent fund) to solve an over-indebtedness problem.

Some of these efforts have brought a temporary reprieve from financial meltdown, but they do not provide a meaningful adjustment process to regain prosperity or debt sustainability. Basically, the horse is out of the barn. There is now so much debt and so many additional scheduled debt commitments that austerity on the rest of the budget will not contain the debt problem.

It would almost be an amusing soap opera if we, the spectators in the audience of this high-theatre drama unfolding in the daily financial tabloids in both Europe and the U.S., could sit back and enjoy the comedy, but unfortunately the bottom line is the actors in the comedy will soon be passing the hat around the audience — at first for voluntary contributions and later for mandatory contributions to the cause.

Moreover, we the audience will ultimately need to ante up less in direct contributions (whatever form of taxes you care to name), but more so in the loss of our income base and market value of wealth. All of this begins with the redirection of scarce capital to finance governments at terms favorable to the debtor government. When that is not enough, next comes the systemic raiding of banks and private resources to finance government debt.

Given the lack of will by the government actors in this soap opera to stop the entitlement game made by previous irresponsible governments, it appears that we will soon be learning the ultimate cost of attempting to keep the entitlement promise. The promise will not be delivered, but we will go down trying.

The cost of trying is not calculated in terms of the present value of the unfunded entitlement liabilities or in the cost of escalating government debt service that we can directly measure. Rather, the cost will be in the more difficult to calculate income, output and wealth losses as a result of a country’s undersupplied and misdirected capital resources. In the environment of attempting to keep the faith in entitlements, income flows and job growth occur at a diminished rate. The economic engine is stuck in low gear when a higher priority is given to financing the sovereign rather than the private sector.

All of this goes by the name of financial repression, a term that has resurfaced in the economic-financial policy lexicon in the last months and is becoming chic in the financial policy press. It’s a term that I am familiar with in that my Ph.D. Chairman, Professor Edward S. Shaw, along with Professor Ron McKinnon of Stanford University, invented it as an explanation of why the Less Developed Countries were less developed for about five decades. Now we get to view it in living color as the nightly news shows us how it is being applied to and affecting the developed economies of the world.

The idea of financial repression presented to me as a graduate student didn’t resonate then, but it does now as I view it and its side effects. It sometimes takes a while for ideas to sink in, and because history is repeating, I get to watch it live the second time — or the third, or however many times it’s been around. What needs to be understood is that financial repression is the unintended consequence of government efforts to suck private capital resources at favorable terms into the financing of government debt. It could just as well be called economic repression because that is what results.

While the general objective for a debt-stressed government is to induce or coerce the buying of its debt, it also needs the buying to take place at a cost the government can afford — not just zero, but even below zero. This occurs when the real interest rate (the nominal rate paid less the inflation rate) is held in negative territory. The cost becomes negative in real terms when a positive inflation rate depreciates the bond’s real value to a greater extent than interest is paid to the holder of the debt.

To pull this off requires a cooperative central bank to create the negative real rates. It’s been quite amazing how the “independent” central banks — made independent to provide checks and balances to prevent reckless government spending sprees — have been co-opted to play an essential role in financial repression. They do so by providing a negative real interest rate for governments by both targeting simultaneously both near-zero nominal rates of interest on government debt and a positive inflation rate.

Given this perspective it should be little surprise that the Fed has recently extended its near-zero nominal interest rate forecast (target) through 2014 and talk of another round of QE is alive both here and in Europe on top of all the others that have occurred in the last three years. While this cheapens government finance at the expense of the holders of the government debt, it also provides disincentives to save and accumulate capital for private uses, hence our near-zero saving rate.

A government’s central bank is its first line of defense in maintaining its ability to pay entitlements. The second line of defense consists of the banks and financial institutions that are coerced to hold greater proportions of government debt in the name of rising liquidity and capital requirements — but with almost zero nominal rates earned on this sizable asset class, they pay virtually nothing for deposits. Hence the banking system and financial institutions in general are also offering negative interest rates on deposits and are in a state of shrinkage, allocating smaller and smaller proportions of their portfolios to the private sector.

We the people will be the third line of defense as the government crams its debt down the throat of the unsuspecting and the unwilling. This generally takes the form of voluntary programs for debt purchases, as the WWII-era poster above suggests. Later this will be accomplished through a mandatory program, with mandatory purchases in the form of swapping “risky” private assets in an IRA for “secure government debt” to finance a private retirement.  This has just occurred in Hungry and Poland, and that discussion has been launched in the U.S. and is contained in the Annual Report of the White House Task Force on the Middle Class (p. 27).

But what do depressing government bond yields do to non-government financial prices? As discussed in my previous post Liquidity and Asset Bubbles: How Long Will the Dam Hold, the lowest interest rates in U.S. history promote a carry trade that finances the purchase of higher quality debt and higher quality dividend-paying equities that investors hope will survive a sovereign meltdown. By extending the time period of its zero interest rate policy out to three years, the Fed reduces the funding risk of the carry trade and ramps it up further.

There is substantial financial buying power to be spread out: the Fed and the ECB’s liquidity transfusions of operation twist, on top of swap financed lending to euro banks, on top of LTRO, on top of another LTRO in the works, and ad hoc ECB direct sovereign purchases, and now with just plain old out-and-out QE3 rumored to be on its way. Furthermore, QEs are also in operation with the BofE and the BofJ and other central banks concerned that capital flight to their currency will undercut their terms of trade. Hence, there is global impetus for central bank buying and money issuance in large numbers as depicted in the accompanying figure.

The equity price run up the last few months is fun while it lasts, but ultimately and fundamentally, if the government interest rate anchor for the financial markets is reduced to a rate that does not reflect its risk, and if further price distortions are introduced into the pricing of equity so that P/Es become transparently unsupportable by fundamentals (if anyone remembers what that is anymore), then expect to see investors seek to place their capital elsewhere.

If the government then attempts to head that off with capital outflow restrictions and more mandatory funneling of capital to the government’s cause, then we are into a full-fledged financial and economic repression. Europe is certainly much closer to that than the U.S., but if there is a buyers strike of government debt here (China has removed itself from accumulating Treasuries), it will eventually repress the economy here as well. We will be no different than the LDCs that self-inflicted decades of pain, as explained by professors Shaw and McKinnon, and history will indeed have repeated.

challenges in the markets for government securities as a result of continued strong borrowing amid a highly uncertain environment with growing concerns about the pace of recovery, surging borrowing costs, sovereign risk and contagion pressures.” The report projects that industrialized governments’ gross borrowing needs will exceed $10 trillion next year, and government deficits are estimated to be 6.6% of the income bases of those countries. Private saving is not likely to cover the growth of debt. This leaves a funding scarcity for plant and equipment as well as sustained economic growth — meaning you can finance governments or economic growth, but not both.

While those are the raw numbers of both rollover and additional bonds to be absorbed, the report fails to point out all the incentives for private parties to divest themselves of the same securities. The incentives to get out of the bond pool include: bank deleveraging (which results in the selling of government securities); the pending rating downgrades of Euro sovereigns and the questionable value of financial insurance on the Euro sovereign bonds due to counterpart risk.

If, these are not ample reasons for investor concern; there is more. The list should also include the risk of a devaluating Euro if capital flight occurs; or if a country were to pull out of the Euro zone, euro claims would then be denominated in some new home country currency that is bound to fall in value. If that is not enough to cause one to pause before investing in the $10 trillion to be offered this year, there is a possibility of a preemptive Euro zone sovereign default, and countries do not hand over their hard assets to a bankruptcy trustee to be distributed to bond holders as with a private bankruptcy.

Aside from these incentives to NOT be swimming in the government securities pool, China’s declining trade balance surplus will reduce its accumulation of developed-world government bonds. So the doctrine of “spend now and send to the bill to China” is grinding to a halt just when it is really needed.

Euro governments were expected to address this shakiness in government bonds at the recent summit  by agreeing to put themselves on a debt budget. However, when push came to shove, the summit revealed that the combined governments of the EU were unable to strengthen the fiscal responsibility provisions of the Maastricht Treaty. They settled on each individual country legislating debt controls. Since we have already seen the U.K. say, “Yes, BUT …” to fiscal responsibility, the precedent has been set for each country in turn to say, “Yes, BUT …” to protect their own sacred cows. So much for solidarity.

The summit also revealed that even in a crisis Germany would not spread its own fiscal largess to the common protection of other governments’ debt. Germany’s demur, while consistent with its genealogy, was no doubt influenced by the shock of a failed auction of German Bunds over Thanksgiving.

So where are we on the greatest fiscal weakness and threatened financial collapse since the Great Depression? There are no fiscal resources, no hidden piggybanks of stored-up reserves for a rainy day. Government rescues of other governments or their banks would need to be debt financed, which is the problem and hardly a solution. Hence, we are left with the one big option of monetization. Think of this as market support based solely on liquidity rather than solvency.

While direct monetization of Euro sovereigns is taking place at the rate of $20 billion per week (more than $1 trillion per year), most of the government bond support under the Euro treaty would need to be accomplished in an indirect way. Since the treaty inhibits the ECB from doing a Quantitative Ease and purchasing a large stated block of government debt, its support of sovereigns is via “unlimited” super-cheap three-year loans to banks, which can use the full face value of the government bonds as collateral. Think of the leverage, the incentives and the profitability for the banks. Purchase an underwater Greek bond in the secondary market, say at half of face and borrow the full face of the bond and profit from the wildly high spreads.

This two to one loan-to-value ratio is a carry trade that even hedge funds can be very envious of. In the first day of this new lending program, the banks borrowed $635 billion.  For the ECB as the lender, this was a balance sheet expansion that exceeded the Fed’s nine month QE2. However in the logic of no free lunch, the loan program supports bank solvency and in turn government bond prices which are the most immediate problems, but it shifts the financial system’s insolvency from commercial banks to the central bank and raises the question of will the market flee the Euro when this becomes understood.

While this is material support that can and has gone a long way to relieving Euro bank liquidity problems in the last two weeks, it still does not generate enough comfort for non-bank private wealth to continue funding the government bonds with its own capital rather than ECB easy money loans. Private wealth owners are still left unsure of whether the central bank government bond “put option” (willingness to support the price) will be in place.

To the private investors in Euro sovereign debt, the central banks being the buyer of last resort is not a strong enough commitment. They care more about financial protection of their asset. They want the central bank to establish a floor price, not just to protect their investment but also to insure that the borrowing government’s cost of money does not rise above the threshold of fiscal survivability. This means that central banks more than ever are in the financial price-fixing business to keep the non-bank private investors swimming in the pool of sovereign indebtedness. Setting the minimum price is better known as an interest rate “peg,” which is far better financial insurance than a CDS contract. It is financial insurance that investors do not need to pay for, and the central bank is a better counter party than some unidentified AIG in the making on the other end of a CDS contract.

This reminds one of the Fed’s great interest rate peg of WWII. Scarcely 90 days into the war, the Fed, seeing the slippage in government bond prices due to the market’s anticipation of being flooded with Treasuries to finance the war, stepped in to announce the Accord. This agreement in effect provided investors with a put option to protect the price of Treasuries for the long haul — defined simply as “the duration” (which lasted nine years). This encouraged the private buying of Treasuries in addition to the Fed’s buying.

The same is being asked of the ECB for the same purpose today. The ECB has implied it will do the same, but it can only offer hints, as the Treaty does not condone it. Critics say there is a lack of clarity in the ECB’s put option or price support that hinders Europe’s sovereign funding. This is true: third-party guaranteed debt is better than holding the paper without a guarantee.  Moreover, it is in the interest of the ECB to provide financial guarantees as any private funding shortfall of government debt must be covered by the ECB’s own balance sheet.

This raises a key issue: What are the market implications from a central bank interest rate peg? What is being described, for as long as it holds, is an asset bubble centered in the first instance on government debt. It’s not the garden-variety asset bubble of tulip mania or more recently of housing mania that gave rise to behavioral finance ideas of confidence in ever-rising values, but an ongoing departure of sovereigns pricing from some underwriting standards of fundamental value that one can read from an Excel spreadsheet. It’s not irrational exuberance or excessive speculation, but it’s an asset bubble nonetheless. The question is, what other asset prices are affected, and in what direction and for how long?

To the extent that market yields are held lower than what the market would price on its own for a long period of time, and U.S. Treasury yields are indeed at all-time lows, these induced lower yields spill over to a generalized asset pricing bubble for assets associated with income streams. This is because a lower discounting rate of income streams makes the streams more valuable, so the distortion to fundamental value carries over to other asset classes as well. This is a reasonable interpretation of the price buoyancy of dividend-paying common stocks, preferred stock, apartment REITS, farmland, high-quality U.S. debt, pipelines, utilities, etc. And don’t forget the ramping up of the carry trade for similar assets when many central banks are aggressively pursuing expansion whether or not they are specifically targeting ZIRP (zero interest rate policy).

But which income streams will be most affected: fixed income or income streams with some upward inflationary response? If you believe that containing Euro fiscal deficits and deleveraging of finance will produce deflation, then high-quality fixed income is inflated by the bubble. If you think that the central bank’s spending power will ultimately generate inflation, then incomes producing real assets become most favored. With likely bimodal distribution of expectations on inflation/deflation, there are camps that support both.

As long as the government bond dam holds to keep liquidity in the Euro government bond market, those assets classes stand to benefit — but the bigger issue is, how long can the dam hold?  When the market wants out of Euro sovereigns, the liquidity that seeps out must be replaced by the central banks. That means the rate of expansion of the central bank’s balance sheet now accelerates to cover both a fraction of the new issuance of government bonds, but also the quantities of government bonds the private market is casting aside.

It is possible that emulating the Fed’s 1940s successful sovereign price support (pegging of interest rates) could give Euro governments years of financing survivability as it did for the U. S. and some hope that growth will kick in — but there are too many ways the dam can be overrun, despite all the bank incentives and government promises. In the meantime, it’s an ultimate test of whether debt prices can be maintained with liquidity alone, irrespective of the solvency of the underlying bonds. That is, can liquidity trump insolvency?

There is not a precise science that tells us when the debt trap begins the downward spiral that takes the ship down, but there are some rough guidelines. Reinhart and Rogoff (This Time is Different) have found to the extent one can generalize when a country’s debt-to-income ratio reaches the 90 percent level the ship of state begins to list and currently the OECD aggregate of 30-country gross debt-to-income ratio is 105 percent.

The sustainability of a country’s stock of debt is assessed by the market relative to the income flows that will be taxed in order to support the overhead cost of interest, even assuming an endless capability to rollover principal. The unraveling occurs when the financial markets lose confidence that the debt problem will be resolved successfully through income growth, austerity, or both and the refinanced debt carries the new higher market yield.

At that point, the overhead cost of the debt load is ever more depleting of the income stream that must be taxed to pay the higher interest carry. Now on a daily basis, there is a market panic attack if the market yield on Italian sovereigns rises above 7 percent. (Note the yield was close to 5 percent earlier this year so sovereign default is indeed being priced.)

After holders of Greek debt “voluntarily” accepted an arm-twisted 50-percent haircut, the market now believes that a sovereign default by a Western democracy is no longer a fairy tale. Furthermore, the default can’t be reliably hedged by CDS contracts, which proved to be voidable at the whim of the government, thus converting hedged risks into naked risks for the holders of distressed government debt. To make matters even dicier, the BIS regulators are backing away from continuing to award capital shields to the holders of sovereign debt, as explained in my last blog (The Dumpster for Toxic Euro Sovereign Debt). Also, the market has come to believe the world is without remaining Rich Uncles willing to rescue the Poor Uncles of Europe. All these factors cause investors to revert back to pricing sovereign debt based on risk fundamentals rather than government pledges of invincibility or confidence in financial insurance.

At this point, the remaining options to avoid reaching the tipping point to the D chain explained above are few, and the decisions to be made are momentous. The options are: submit to what the market is doing to you; take the lead and offer a debt restructure at a fractional payout; or run the printing presses to purchase enough sovereign debt necessary to contain the market yields. Halfway measures such as strengthening the EFSF no longer buys even a day’s worth of market forbearance.

It certainly must be crossing the minds of the Euro leaders that there are consequences for being at the helm when the ship goes down. The alternative is to orchestrate your own departure, which was cleverly done by Papandreou in Greece by calling for an austerity referendum. In Italy, Silvio Berlusconi’s departure was orchestrated quite literally, as reported by Reuters:

“Italians sang, danced and drank champagne in the streets to celebrate the resignation of scandal-plagued billionaire Silvio Berlusconi, and an impromptu orchestra near the presidential palace played the Hallelujah chorus from Handel’s Messiah”.

Not even in my most Machiavellian thoughts had I conceived of the possible value of being “scandal-plagued” as a means to a back-door retreat from an uncomfortable situation. Given its frequency among politicians it seems to be an undervalued asset in politics. But the strategy doesn’t seem to fit Ms. Merkel, so she is stuck at the helm of the ship of state and is looking for a life raft.

And the consequence of being at the helm when all the D words cascade is more chilling when one witnesses what has happened to the Icelandic captain when his country’s ship went down. Iceland’s ex-premier is facing a formal indictment charging him with criminal violations against the laws of ministerial responsibility and “serious malfeasance of his duties as prime minister in the face of major danger looming over Icelandic financial institutions and the state treasury.” (See: Ex-Premier Charged)

We have reached the point where government bluff, bluster and promises no longer control the markets, and criminal indictments for those at the helm are threatening. If it is not possible to orchestrate an early exit, it would seem the only remaining life raft is the printing press — but that would not be easy for a German government to do out in the open, given their Weimar inflation history, as shown in the chart to the right.

The monetization of government debt is undoubtedly being conceived of as only a bridge to buy time to form a tighter Euro fiscal union with strict budget discipline. Indeed, this is being counseled by Joseph Ackermann, who seems to be the influential behind-the-scenes advisor.

But to keep things together until then, the ECB is no doubt on the job, if not directly purchasing Italian and other sovereigns, but lending to others who will purchase the same. But running the printing press does not stop with the ECB. Once QEs start for whatever reason and a number of countries are engaged, the very act of one major central bank printing to save a government drives capital offshore to perceived safer ports from inflation and a declining economy. This in turn sets up another dynamic that is well underway as other countries are driven to become sellers of their own currency in order to prevent its appreciation and maintain export market share. Thus, using the printing press to save the Euro debt leads to a global money race of competitive devaluations.

Now there is a confrontation of expectations in the markets, a bi-modal distribution if you will, of those believing the deflationary forces of the D chain above will dominate and those believing, now with greater justification, that the monetary produced inflationary route will be the Euro outcome.

Expect some inconsistent pricing in the market by those being moved to bet on inflation hedges side by side with those willing to bet on deflation hedges. What must be most maddening to a deflation hawk is the asset of choice in that circumstance, long-term government bonds, are at the very heart of the credit problem and are not the solution to protecting one’s portfolio. Nor is it the solution to the inflation hawks either. So the questionable sovereigns go begging among private investors with only the central bank as a friend.

Banks are incented by regulators to hold “safe” assets as a way of making them less vulnerable to failure. But—and you’ve probably already guessed it—regulators designated euro government bonds and even subprime residential mortgage securities as the banking system’s “safe” assets. As a result, the banks load up with the safe asset, which has the effect of over-financing that sector of the economy. This sets banks up for a debt crash down the road when there is more debt than income available to service that category of debt.

To make the regulatory system more convoluted, the incentive for banks to finance the safe asset—even when it is manifestly clear that the safe asset is no longer safe—is the regulatory rule that allows banks to hold less bank capital (preferred and common stock) on the right hand side of their balance sheets. Since bank capital is depleted as a result of the 2008 subprime mortgage write offs, there is a greater need for regulatory capital today.  This has caused Europe’s banks to load up with toxic sovereigns with its  banks holding 25 percent of their assets in government bonds as compared to 10 percent in the U. S.

These incentives to hold the designated safe asset allow greater bank leverage, which translates to a lower ratio of capital to assets. One might ask why banks are strong-armed by government to maintain bank capital. The objective reason is because bank capital in the form of bank equity serves as a protection for depositors when the bank’s assets depreciate because bank equity is in the first loss position in case of an asset write down. Bank capital is also important to governments because of their guarantee (whether explicit or implicit) to restore bank capital in the event the bank is unable to. Without bank equity, depositors lose when banks write off assets; when a bank goes down, its depositors lose their wealth, which causes them to vote in great numbers against the government in power.

Thus, incenting banks to hold “safe” assets systemically makes the system unsafe: it becomes more leveraged, with banks holding a concentration of assets made riskier. The “safe” designation led to decreased market discipline by governments issuing debt, which allowed them to sell too much of it at unsustainably low rates. The ultimate regulatory convolution is when over-financed sovereign defaults take the banks down—but the sovereign maintains the responsibility to save the bank depositors.

Hence, the essence of the great euro debt-saving operation is maintaining and expanding the buying capacity of stressed euro sovereign debt—but not just the previously issued debt but the new debt yet to come. Bank buying power is necessary for euro governments to maintain the market value of their existing bloated debt, which is especially critical at times when the existing debt reaches maturity and needs to be refinanced in the market. Just imagine the challenges of maintaining market values of the yet to be issued debt to cover baby boomer entitlement over the next few decades! This will require expanding the banks’ balance sheet, which is the convenient dumpster for government debt in excess of what the market will absorb.

The problem with maintaining the capacity of the dumpster is based on banks’ ability to recapitalize (sell equity) to meet regulatory minimums. Banks have few good options in that regard—if they did there would be no euro sovereign or bank crisis.

Private equity does not gravitate to banks that have more bad assets than the banks or the government stress tests will admit. Unwary investors take a fall when the truth about the bank’s asset quality comes to light or when governments decide that banks will “voluntarily” take 50 percent haircuts on their sovereign debt holdings.

Ironically, banks don’t want to be recapitalized because it dilutes existing stockholders’ interests and lowers the rate of return on capital. Instead they prefer a capital handout from the government, which has a growing need for “dumpster” capacity for increasing government toxic debt. Government recapitalization of banks usually takes the form of non-voting preferred stock so as not to water down the returns to the common stockholders.

In the U.S., the Toxic Asset Relief Program (TARP) was a government fiscal operation that provided banks with near-costless government bridge financing that didn’t significantly dilute their common stockholders. But in Europe, the government debt financed multi-country funding source, the European Financial Stability Facility (EFSF), is capable (when and if it is funded) of covering only a very small portion of sovereigns and banks bailouts. How to backstop both sovereign debt and the dumpster banks has been center stage now for about a year and a half without resolution.

Written between the lines of last week’s sparse announcement of the “final” solution is a very tentative plan that still needs the approval of the German Bundestag, the last remaining “Rich Uncle of Europe” willing to bailout anyone. If Germany should balk at directly funding other governments or banks themselves or disallow changes in the treaty that would enable the European Central Bank (ECB) to do the same, where would the bailout funding come from?

Rather than relying on direct ECB support, the answer may lie in indirect ECB support through a newly created “Special Purpose Vehicle” (SPV). This legal financial entity looks a little like a bank in that the vehicle funds are used to purchase the assets the euros want off the table, and it is funded by a combination of debt and equity sources with the ECB being a primary contributor.

To give the SPV credibility, the equity portion will be the scant remaining 235 billion euros left in the EFSF (if and when fully funded). Using the bank model of leveraging, the scant capital is projected to expand the balance sheet a multiple of 4 or 5 times if there are takers of the SPV’s debt. This would create a much larger dumpster capacity to purchase toxic sovereign debt that no one else wants and perhaps even bank equity that no one is lining up for just now.

Does this sound familiar? It is the same model employed by Citibank to hide subprime mortgages offshore in an SPV or Enron’s partnerships used for the same purpose. How the government learns financial cover-up tricks from the private sector!

With the equity claims in the SPV held by the EFSF, the question is who will purchase debt claims in the SPV to leverage up the new debt dumpster in order to achieve the hoped for 4 to 5 times expansion of the SPV capacity to purchase bailout assets? Officials are traveling to China and Japan this week and will entertain other private debt investors in the SPV and make it juicer with as yet unclear government guarantees on a portion of losses of the debt investor’s losses in the SPV debt.

Hence, the SPV has a decidedly bank model flavor to it—except it is not subject to regulation and its transparency will be even worse than banks. At this point I believe it would be a heroic success to con individuals to do what bank depositors have become unwilling to do: continue depositing at banks whose assets contain bad government debt and whose deposits are “guaranteed” by the same insolvent governments.

Why would one think that the market will more likely invest in SPV debt than a euro bank deposit whose depositors are fleeing the banks with their money. If the SPV is the same dangerously leveraged model as the banks, with the same assets and the same guarantor, can you expect a different result?

What makes it seem possible is the (intentionally) still hidden role of the ECB. Since Germany will veto ECB participation in direct investments in the underwater sovereign assets, the SPV is a multi-government owned and controlled camouflaged bank that provides the indirect route for the ECB to uplift purchasing power in the toxic European sovereign debt market by purchasing SPV debt with printing press money. This designated role for the SPV in conjunction with the ECB keeps Germany’s hands clean, so to speak.

The ECB printing press provides the leverage for the SPV to increase the capacity of the dumpster. The SPV is also not banned from purchasing bank equity to maintain bank dumpster capacity if banks are unable to be recapitalized by the market, which is likely.

While the plan is a little convoluted, it offers governments the deniability of engaging in what some would call throwing good money (the EFSF funds) after bad (the Greek debt). Since the ECB provides unlimited debt expansion capacity for both the SPV and banks, one wonders why the euro zone heads of state became so caught up with creating the SPV functioning in parallel with the banks. Perhaps it was merely their political sense that the combined governments had to do something. They do, after all, run for re-election, and committing government fiscal resources to banks is not a popular thing to do.

But if the plan works, it will provide added SPV dumpster capacity alongside banks’ increased dumpster capacity, with neither German financial support nor direct ECB support.

The implication of monetizing the financing capacity of the SPV is no different than directly monetizing banks or governments. It supports the ability to have an expanded capability to purchase assets, keep them out of view (do you really expect transparency?), stop the debt unwind, possibly revive the economy with yet more new money, create an asset bubble and have inflation as a side effect. All of which seems better than an instantaneous euro zone unwinding and a debt deflation. Such are the machinations of colluding desperate governments who want to do something that appears on the surface to be helpful. How else can you run for re-election?

Folks, I can’t make this up. What might seem puzzling was the stock market rally late last week, both in anticipation of and following the long-awaited announcement. I can only presume the market was celebrating the fact that banks and the economy were not being deposited in the dumpster immediately, and an indirect vehicle to bring the printing press to bear has been created to increase the sovereign debt holding capacity.

Instead of imminent falling dominos, it is dominos re-inflating.

]]> http://thespellmanreport.com/2011/10/28/frank-beck-on-investing-in-uncertain-times/feed/ 0