The Daily Reckoning

Since we have little interest in joining the speculative party going on in the stock market at the moment – other than in the precious metals and “positive black swan” type of stocks we mentioned yesterday – the task of today’s Daily Reckoning is to prove why the coming collapse of the shadow banking system is not deflationary by inflationary and, among other things, bullish for gold.

If that’s not the sort of discussion that interests you, you might want to go take a powder or read a good book. These are murky waters we’re wading through. So we’ll do our best to clear them up for you. But it’s probably going to take two days. Today, we’ll look at the case against deflation. Tomorrow, we’ll look at what it means for Australia.

All good debates begin with a proper definition of terms. Rather than defining deflation in our own way, we’ll leave it up to one of its most consistent and articulate (and accurate) advocates, Robert Prechter. He’s written about it for years. But for a short course on what he’s predicting and why, check out this video.

In the video Prechter says, “The next big phase [in the cycle] is a credit implosion where people who are debtors are going to be scrambling for dollars to pay off their debts and the creditors are going to be dunning the debtors to pay them back….The scramble will be for dollars not for things.”

The investment outcome of Prechter’s scenario is bullish for the U.S. dollar and U.S. Treasury bills, where he says, “the chances of default are low.” Prechter’s argument is based on the idea – which we happen to believe – that the U.S. Federal Reserve is unable to prevent falling asset values. This would lead, by Prechter’s reckoning, to falling stock, commodity, and real estate values.

All of that seems right to us so far. The deflationary argument depends on the collapse of both the shadow AND the real (deposit taking) banking system. The shadow banking system is the murky world of credit, securitisation, and derivatives which currently supports and/or holds some $600 trillion in assets. Yes that’s trillion with a T.

Most of these are interest rate and credit derivatives. As we learned in the last two years, the big risk here is to institutions which owe and own these obligations amongst one another. In our view, the degree of interconnectedness among these obligations (they still aren’t unwound) still makes the entire global financial system vulnerable to a systemic shock and/or total collapse.

It nearly happened last time with Lehman and frankly not much has changed since. A good old interest rate spike that’s not in anyone’s model might be the sort of thing that precipitates the next crisis. After all, that’s the way these things generally begin.

You could make the argument that it shouldn’t really matter to the real economy if a bunch of global institutions find out they can’t settle their obligations to one another. Why not just forget the whole mess and start other? After all, most of these derivatives are just insurance policies of some sort. Can’t we just cancel the policy?

Probably not. These positions are held in conjunction with myriad leveraged bets on the direction of other asset prices. They are hedges. No one is going to walk away from them. But more importantly, the connection between the shadow banking system and the real banking system is much more substantial than you might first imagine.

So much of today’s funding, financing, and lending is done by the shadow banking system through securitisation and money markets and income and mortgage trusts. The real economy is tied to the shadow banking system in just the way that you are tied to your own shadow. And the real, deposit taking, depostior (taxpayer)-insured banking system is not much better off.

For example, my colleague Porter Stansberry reported today that in the U.S., 7.1% of commercial real estate loans are more than 90 days overdue. The FDIC reckons that over 700 U.S. regional and local banks are “danger” banks. The reason is that these banks own mostly commercial real estate. It’s their main asset. And unlike their money-centre big brothers on Wall Street, these banks aren’t going to be recapitalised or bailed out at taxpayer expense.

Students of the Great Depression will know that widespread bank failures led to a contraction in the money supply. Banks, more than the central bank, are the engine of money and credit growth in a fiat money system. Take away several hundred banks, and you get lenders not making loans. Money supply shrinks. Cash and Treasuries gain in value.

In fact, when you couple the wounded regional banks in the U.S., who are massively exposed to one dangerous asset class, with the potential collapse of the shadow banking system from another interest rate/liquidity/solvency shock, you begin to wonder how deflation is avoidable at all in the near future.

We have a laboured three-part answer. We’re going to lay it on you now. It begins with the destruction of the shadow banking system. It accelerates with the paralysis of the regular banking system. And it concludes with deliberate devaluation of the currency via monetary and fiscal policy to make up for a completely destroyed credit system.

It’s easier than it sounds.

Granted, it probably sounds absurd that you can have a $600 trillion wipe-out in the shadow banking system and have inflation. But there are two points to make here. First, it’s hardly believable that an institutional panic and bank run in the shadow banking system (what happened last time) would actually boost confidence by individuals and consumers in the overall banking system.

True, it might increase people’s preference for liquidity and cash. Stocks, real estate, and bonds would fall. But another swift collapse in the shadow banking system would be a hammer blow to already fragile confidence in our financial system, including the value of paper money itself.

But a more technical response is that as the shadow banking system is unable to finance economic activity and speculation, either that activity goes away (a Greater Depression) or someone else tries to fill the gap. We’ll assume for the moment the regular banks won’t do it. That leaves the government.

And in fact, that is what you had in the U.S. following the last crisis. You got an alphabet soup of Fed-backed programs to provide all sorts of credit…to students, to money markets, to car companies, to corporations. This list grows longer by the day. And what it means is that the only provider of credit in a post-shadow banking world is the public sector: the Fed and the Treasury.

Whether these are loan guarantees or outright loans or the purchase of securitised mortgages (Fannie and Freddie) it amounts to the same thing: a huge transfer and burden to the public sector balance sheet. Whether it’s monetisation or guarantees that add to Federal liabilities, both are dollar bearish. The transfer to the public sector then, results both in destruction of asset values and inflation in the currency.

But wait! You can’t have inflation if there’s no one to make loans and use the money multiplier to turn growth in the monetary base into new Federal Reserve Notes. That is, if the shadow banking system collapses, won’t this lead to the same no-risk paralysis with the big banks that has led to their holding trillions of dollars in excess reserves with Central Banks?

Why yes, it will. But this also argues for inflation. Here we’re going out on a limb. But what we’re arguing is that as the private sector is less able or willing to dole out credit into the economy, we’re entering a world where the government is going to bypass the middleman and do the job itself.

This happens in three ways. First, the government can buy securitised assets to fund non-bank lenders. The AOFM does this in Australia to support housing prices and non-bank lending to first home buyers. It’s done in the State at a much more comprehensive level. In effect, the entire American mortgage market has been nationalised with the government guaranteeing and buying trillions in mortgages.

This is the future. More nationalisation of key lending institutions. If the private sector won’t do it, the Feds will. But at great cost. Each new loan guarantee weakens the public balance sheet and the currency. Thus the retreat of the banks from credit creation hastens the day where fiscal and monetary policy are forced to be more transparently absurd and redistributive.

The second way in which the government becomes a lender is through extended unemployment benefits. The dole. In some States, it’s possible to receive 99 weeks of unemployment benefits. This doesn’t mean dole bludging has become a full time job. But it does mean that the structural changes to Western labour markets wreaked by globalisation are wage deflationary.

To us, this means a larger regular expenditure on the unemployed. The U.S. is headed the way of Europe, with higher structural unemployment. Whether it can afford to pay for this while fighting two wars, spending a $1 trillion expanding health care coverage, and preparing for an increase in entitlement payments…well you do the math.

The net result of the increased burden on the public sector in supporting private incomes is a weaker currency. It always comes back to that. And it’s true for the Euro, the Yen, and the Dollar. It’s true, in fact, for all paper money. This is why we believe the end of the super cycle in paper money is bullish for precious metals (not deflationary).

The third way in which the government bypasses the traditional banking sector to get money into the hot little hands of consumers has already been suggested by Ben Bernanke: via helicopter. And this really is the greatest argument against the deflationary theory.

In one sense, Bernanke was right. The Fed can create an infinite amount of digital dollars. It can expand its balance sheet infinitely too. It can buy assets directly. It can buy gold mines. It can probably create a market that securitises future consumer wages and pays you now for them. You literally mortgage your wage-earning future (or perhaps you get an early pay out on your social security).

The only real restrictions on the Fed’s ability to create money are rising bond yields (market discipline on currency mismanagement) and political interference. On the first issue, the Fed has some covering fire. Global investors have to own something. And right now they prefer the dollar. Unless the Fed does something radical and reckless, it can expand its role in providing credit directly to the real economy without doing huge damage to the dollar…mostly because there are so few other good options.

Obviously we think gold is a good option. But for nations like China with trillions locked up in dollar-denominated assets, what options are there?

You could argue that the U.S. Congress and the President would not allow the wilful debasement of the currency via an expanded Fed role in direct lending. But we think just the opposite. Those ass-clowns will be begging for it.

When commercial real estate blows up regional banks, we predict you’ll see the President declare victory in Iraq and Afghanistan within months, bring the boys home, and cut defence spending by 30%. The money will pour into new lending and “jobs” programs to support the economy. Fiscal and monetary policy will work hand in glove to pump funny government money directly into the consumer economy. The only result there can be is hyperinflation.

So, it’s possible – likely even – that you’re going to see across the board falls in stocks, real estate, bonds, and commodities….AND inflation. Whether we got the proper sequence right, we’re not sure. But the combination of a shattered shadow banking system, a paralysed banking system, and a terrified government certainly do add up to massive inflation.

Tomorrow, is this just an American tragedy? Or is Australia at risk too? And quite obviously, what should you do?

Dan Denning
for The Daily Reckoning Australia

Similar Posts:

• Credit Markets Threaten Retail Banking, Bank Runs Next?
• Nationalised Banking System Will Come from Global Market Rout
• Bankers Take Money From the Government and Use it to Speculate
• The Single Best Trade for 2010
• World Economy Faces Hyperinflation or Deflation?

More articles from The Daily Reckoning….

By Karl Denninger, The Market Ticker

The idiocy coming from the EU reeks of desperation:

“For Greece, the problem is completely over,” said Prodi, who was also Italian prime minister, in an interview in Shanghai today. “I don’t see any other case now in Europe. I don’t think there is any reason to think the euro system will collapse or will suffer greatly because of Greece.”

Continuing…

Prodi, 70, who headed the European Commission from 1999 to 2004, will teach at the China Europe International Business School in Shanghai. He said budget deficits are “a general problem for almost all the wealthy countries.”

No, really?  You mean having the government be responsible for half of GDP is a problem, when everything that they actually obtain has to come, in the end, by taxing the citizens inside their borders?

The euro has weakened 5.8 percent against the dollar this year as concern Greece will struggle to finance its deficit eroded confidence in the European currency.

“Europe is more than happy,” said Prodi. “For the benefit of the European economy, the decrease of the value has been absolutely positive.”

Bah. 

As in the United States, European nations more-or-less index their entitlement programs to inflation.  And like the United States, they hold most of the costs of these programs off their balance sheet, where that indexing is not visible (directly) to markets, never mind that those are promises for tomorrow, not today.

It is here that the theories of all those so-called “economists” who claim that we “benefit” through currency devaluation by “inflating the debt away” have their thesis run head-on into a brick wall.

In the United States, for example, our “forward liability” for those entitlement programs is somewhere between $60-100 trillion, depending on who you ask.  The on-balance sheet public float of the debt is about $8 trillion.

So let’s assume we try to double that over the remainder of the decade (as the economists believe we both must and will) the only way to make that able to be carried is to devalue the currency through money-printing – “monetization”, if you will.

But doing so, because of the indexing in these entitlement programs, causes their forward costs to explode.

Let’s take an example and run the “forwards” on it.  We will assume that the “current” cost of a set of entitlement programs is $5 trillion, but it is to be delivered in 30 years.  If the forward implied inflation rate is 2%, as Bernanke claims is the “goal” (1-2% annually) then the 30-year forward implied cost of this program can be easily calculated since it is simply the compound growth rate over that time. In this case, that program has a “forward” (or “as delivered in 30 years”) cost of $9.06 trillion.

But now let’s assume we decide to “inflate away” the debt as “suggested” by the IMF (and on which point, I might add, Bernanke was grilled in his last testimony before Congress) by raising the inflation target to 5%.  That’s not all that bad, right?  It’s only three more percent!

Well, except for one small problem – that inflation rate drives the delivered cost of this entitlement from $9.06 trillion to $21.6 trillion, well more than a doubling, and what’s worse is that this additional cost totally destroys any “savings” in debt payment ability that would otherwise be generated by attempting to inflate away the “on balance sheet” debt amount.

In the case of the United States, of course, the forward cost is already $100 trillion.  Attempting to “inflate away” our $8 trillion (today) of public float, or the $17 trillion that the CBO says we’ll have by 2020, would cause that $100 trillion to explode upward.  Indeed, simply trying to get “a bit of relief” with a 5% inflation policy would more than double it, and an actual attempt to inflate it off over the course of ten years (which would require approximately a 7% inflation rate) would cause that $100 trillion forward liability to balloon to more than $300 trillion.

With that it should be obvious that any attempt to play “inflate it away” will simply never work.  It will and must cause the immediate detonation of all forward-promised social entitlement programs, and when you have placed half or more of the population at the time in a position of effective dependence on those programs attempting such a foolhardy path of action is guaranteed to lead to the total destitution of half or more of the populace.

Since it is an essential certainty that a population so-impoverished will inexorably rise in violent revolution there is a clear argument that can be made that any such suggestion or policy, whether made publicly or “in the dark of the House Cloak Room”, is in fact a violation of US Code, Title 18 Chapter 115 Sec2385, which provides in part:

Whoever knowingly or willfully advocates, abets, advises, or teaches the duty, necessity, desirability, or propriety of overthrowing or destroying the government of the United States or the government of any State, Territory, District or Possession thereof, or the government of any political subdivision therein, by force or violence, or by the assassination of any officer of any such government; or

 

Whoever, with intent to cause the overthrow or destruction of any such government, prints, publishes, edits, issues, circulates, sells, distributes, or publicly displays any written or printed matter advocating, advising, or teaching the duty, necessity, desirability, or propriety of overthrowing or destroying any government in the United States by force or violence, or attempts to do so; or

 

Whoever organizes or helps or attempts to organize any society, group, or assembly of persons who teach, advocate, or encourage the overthrow or destruction of any such government by force or violence; or becomes or is a member of, or affiliates with, any such society, group, or assembly of persons, knowing the purposes thereof—

 

Shall be fined under this title or imprisoned not more than twenty years, or both, and shall be ineligible for employment by the United States or any department or agency thereof, for the five years next following his conviction.

More articles from the Market Ticker….

As investors focus more and more on sovereign risk issues so gold stands to gain

Read more….

The Daily Reckoning

Since we have little interest in joining the speculative party going on in the stock market at the moment – other than in the precious metals and “positive black swan” type of stocks we mentioned yesterday – the task of today’s Daily Reckoning is to prove why the coming collapse of the shadow banking system is not deflationary by inflationary and, among other things, bullish for gold.

If that’s not the sort of discussion that interests you, you might want to go take a powder or read a good book. These are murky waters we’re wading through. So we’ll do our best to clear them up for you. But it’s probably going to take two days. Today, we’ll look at the case against deflation. Tomorrow, we’ll look at what it means for Australia.

All good debates begin with a proper definition of terms. Rather than defining deflation in our own way, we’ll leave it up to one of its most consistent and articulate (and accurate) advocates, Robert Prechter. He’s written about it for years. But for a short course on what he’s predicting and why, check out this video.

In the video Prechter says, “The next big phase [in the cycle] is a credit implosion where people who are debtors are going to be scrambling for dollars to pay off their debts and the creditors are going to be dunning the debtors to pay them back….The scramble will be for dollars not for things.”

The investment outcome of Prechter’s scenario is bullish for the U.S. dollar and U.S. Treasury bills, where he says, “the chances of default are low.” Prechter’s argument is based on the idea – which we happen to believe – that the U.S. Federal Reserve is unable to prevent falling asset values. This would lead, by Prechter’s reckoning, to falling stock, commodity, and real estate values.

All of that seems right to us so far. The deflationary argument depends on the collapse of both the shadow AND the real (deposit taking) banking system. The shadow banking system is the murky world of credit, securitisation, and derivatives which currently supports and/or holds some $600 trillion in assets. Yes that’s trillion with a T.

Most of these are interest rate and credit derivatives. As we learned in the last two years, the big risk here is to institutions which owe and own these obligations amongst one another. In our view, the degree of interconnectedness among these obligations (they still aren’t unwound) still makes the entire global financial system vulnerable to a systemic shock and/or total collapse.

It nearly happened last time with Lehman and frankly not much has changed since. A good old interest rate spike that’s not in anyone’s model might be the sort of thing that precipitates the next crisis. After all, that’s the way these things generally begin.

You could make the argument that it shouldn’t really matter to the real economy if a bunch of global institutions find out they can’t settle their obligations to one another. Why not just forget the whole mess and start other? After all, most of these derivatives are just insurance policies of some sort. Can’t we just cancel the policy?

Probably not. These positions are held in conjunction with myriad leveraged bets on the direction of other asset prices. They are hedges. No one is going to walk away from them. But more importantly, the connection between the shadow banking system and the real banking system is much more substantial than you might first imagine.

So much of today’s funding, financing, and lending is done by the shadow banking system through securitisation and money markets and income and mortgage trusts. The real economy is tied to the shadow banking system in just the way that you are tied to your own shadow. And the real, deposit taking, depostior (taxpayer)-insured banking system is not much better off.

For example, my colleague Porter Stansberry reported today that in the U.S., 7.1% of commercial real estate loans are more than 90 days overdue. The FDIC reckons that over 700 U.S. regional and local banks are “danger” banks. The reason is that these banks own mostly commercial real estate. It’s their main asset. And unlike their money-centre big brothers on Wall Street, these banks aren’t going to be recapitalised or bailed out at taxpayer expense.

Students of the Great Depression will know that widespread bank failures led to a contraction in the money supply. Banks, more than the central bank, are the engine of money and credit growth in a fiat money system. Take away several hundred banks, and you get lenders not making loans. Money supply shrinks. Cash and Treasuries gain in value.

In fact, when you couple the wounded regional banks in the U.S., who are massively exposed to one dangerous asset class, with the potential collapse of the shadow banking system from another interest rate/liquidity/solvency shock, you begin to wonder how deflation is avoidable at all in the near future.

We have a laboured three-part answer. We’re going to lay it on you now. It begins with the destruction of the shadow banking system. It accelerates with the paralysis of the regular banking system. And it concludes with deliberate devaluation of the currency via monetary and fiscal policy to make up for a completely destroyed credit system.

It’s easier than it sounds.

Granted, it probably sounds absurd that you can have a $600 trillion wipe-out in the shadow banking system and have inflation. But there are two points to make here. First, it’s hardly believable that an institutional panic and bank run in the shadow banking system (what happened last time) would actually boost confidence by individuals and consumers in the overall banking system.

True, it might increase people’s preference for liquidity and cash. Stocks, real estate, and bonds would fall. But another swift collapse in the shadow banking system would be a hammer blow to already fragile confidence in our financial system, including the value of paper money itself.

But a more technical response is that as the shadow banking system is unable to finance economic activity and speculation, either that activity goes away (a Greater Depression) or someone else tries to fill the gap. We’ll assume for the moment the regular banks won’t do it. That leaves the government.

And in fact, that is what you had in the U.S. following the last crisis. You got an alphabet soup of Fed-backed programs to provide all sorts of credit…to students, to money markets, to car companies, to corporations. This list grows longer by the day. And what it means is that the only provider of credit in a post-shadow banking world is the public sector: the Fed and the Treasury.

Whether these are loan guarantees or outright loans or the purchase of securitised mortgages (Fannie and Freddie) it amounts to the same thing: a huge transfer and burden to the public sector balance sheet. Whether it’s monetisation or guarantees that add to Federal liabilities, both are dollar bearish. The transfer to the public sector then, results both in destruction of asset values and inflation in the currency.

But wait! You can’t have inflation if there’s no one to make loans and use the money multiplier to turn growth in the monetary base into new Federal Reserve Notes. That is, if the shadow banking system collapses, won’t this lead to the same no-risk paralysis with the big banks that has led to their holding trillions of dollars in excess reserves with Central Banks?

Why yes, it will. But this also argues for inflation. Here we’re going out on a limb. But what we’re arguing is that as the private sector is less able or willing to dole out credit into the economy, we’re entering a world where the government is going to bypass the middleman and do the job itself.

This happens in three ways. First, the government can buy securitised assets to fund non-bank lenders. The AOFM does this in Australia to support housing prices and non-bank lending to first home buyers. It’s done in the State at a much more comprehensive level. In effect, the entire American mortgage market has been nationalised with the government guaranteeing and buying trillions in mortgages.

This is the future. More nationalisation of key lending institutions. If the private sector won’t do it, the Feds will. But at great cost. Each new loan guarantee weakens the public balance sheet and the currency. Thus the retreat of the banks from credit creation hastens the day where fiscal and monetary policy are forced to be more transparently absurd and redistributive.

The second way in which the government becomes a lender is through extended unemployment benefits. The dole. In some States, it’s possible to receive 99 weeks of unemployment benefits. This doesn’t mean dole bludging has become a full time job. But it does mean that the structural changes to Western labour markets wreaked by globalisation are wage deflationary.

To us, this means a larger regular expenditure on the unemployed. The U.S. is headed the way of Europe, with higher structural unemployment. Whether it can afford to pay for this while fighting two wars, spending a $1 trillion expanding health care coverage, and preparing for an increase in entitlement payments…well you do the math.

The net result of the increased burden on the public sector in supporting private incomes is a weaker currency. It always comes back to that. And it’s true for the Euro, the Yen, and the Dollar. It’s true, in fact, for all paper money. This is why we believe the end of the super cycle in paper money is bullish for precious metals (not deflationary).

The third way in which the government bypasses the traditional banking sector to get money into the hot little hands of consumers has already been suggested by Ben Bernanke: via helicopter. And this really is the greatest argument against the deflationary theory.

In one sense, Bernanke was right. The Fed can create an infinite amount of digital dollars. It can expand its balance sheet infinitely too. It can buy assets directly. It can buy gold mines. It can probably create a market that securitises future consumer wages and pays you now for them. You literally mortgage your wage-earning future (or perhaps you get an early pay out on your social security).

The only real restrictions on the Fed’s ability to create money are rising bond yields (market discipline on currency mismanagement) and political interference. On the first issue, the Fed has some covering fire. Global investors have to own something. And right now they prefer the dollar. Unless the Fed does something radical and reckless, it can expand its role in providing credit directly to the real economy without doing huge damage to the dollar…mostly because there are so few other good options.

Obviously we think gold is a good option. But for nations like China with trillions locked up in dollar-denominated assets, what options are there?

You could argue that the U.S. Congress and the President would not allow the wilful debasement of the currency via an expanded Fed role in direct lending. But we think just the opposite. Those ass-clowns will be begging for it.

When commercial real estate blows up regional banks, we predict you’ll see the President declare victory in Iraq and Afghanistan within months, bring the boys home, and cut defence spending by 30%. The money will pour into new lending and “jobs” programs to support the economy. Fiscal and monetary policy will work hand in glove to pump funny government money directly into the consumer economy. The only result there can be is hyperinflation.

So, it’s possible – likely even – that you’re going to see across the board falls in stocks, real estate, bonds, and commodities….AND inflation. Whether we got the proper sequence right, we’re not sure. But the combination of a shattered shadow banking system, a paralysed banking system, and a terrified government certainly do add up to massive inflation.

Tomorrow, is this just an American tragedy? Or is Australia at risk too? And quite obviously, what should you do?

Dan Denning
for The Daily Reckoning Australia

Similar Posts:

• Credit Markets Threaten Retail Banking, Bank Runs Next?
• Nationalised Banking System Will Come from Global Market Rout
• Bankers Take Money From the Government and Use it to Speculate
• The Single Best Trade for 2010
• World Economy Faces Hyperinflation or Deflation?

More articles from The Daily Reckoning….

Zero Hedge

Former Bridgewater-ite (which we hear is not doing that hot lately) Rick Bookstaber, who was recently appointed at the SEC in some risk management capacity, comes out with a truly amusing rant on why gold is in a bubble, and, not just that, but that “we all know gold is in a bubble.” Ignore the fact that all multi-billionaire hedge fund managers have been loading up, all relevant and semi-relevant pundits have been claiming that gold is gradually becoming the one alternative to fiat debasement which has recently become a global phenomenon, and ignore that even with the dollar going up, gold has defended its 1,100 an ounce price quite successfully. Bookstaber compiles vivid imagery upon even more vivid imagery, and goes as far as comparing the quest for gold with the pursuit of hookers “Even if a guy is just after sex, he at least has the decency to act like there is some substance behind his interest. But with gold, no one seems even to
care about giving a justification, other than “gold has been a store of
value throughout 5,000 years of monetary history”. No one? Dear Mr. Bookstaber, feel free to peruse the following thoughts by Eric Sprott, Dylan Grice, Hugh Hendry, David Rosenberg, Fred Hickey, Jim Grant, David Einhorn and last but not least, Goldman Sachs, on some contrarian opinions to your prevailing dogma. And speaking of unconflicted advance warning vis-a-vis ponzi bubbles, where was your current employer cautioning the general population about the dot com bubble? Or the housing/credit bubble? Or the Madoff ponzi? Or the current Great Currency Deflation Bubble? Perhaps you can expend your time and energy on the real source of soon-to-be unparalleled wealth loss instead of focusing on the fringe “tin foil”-hatted gold community which nobody takes seriously anyway (except India of course which just incidentally bought 200 tons of gold north of $1,000).

From the SEC-member’s blog:

The Gold Bubble

This represents my personal opinion, not the views of the SEC or its staff.

I am not going to spend time here talking about how the price of
gold is off-the-wall, that it is not just a bubble in the making, but a
bubble waiting to burst. I don’t want to waste your time on that
point.We all know it is a bubble.

George Soros has said “The ultimate asset bubble is gold”. Many of
the top asset managers, such as Tudor and Paulson, are piling on; Paul
Tudor Jones recently said gold “has its time and place, and now is that
time.” The banks are echoing this view with their research. Goldman has
a research piece that looks for gold to approach $1,400 in the next
year. The more ebullient Charles Morris of HSBC has said, “I absolutely
believe it’s heading into a bubble, but that’s why you buy it. ” He,
along with a number of other professional and otherwise rational
managers, looks for gold to move as high as $5,000 an ounce.

More interesting than this almost universal agreement is what that agreement tells us about the dynamics of the market.

The Naked Bubble

Usually the markets have the
courtesy of giving cover for bubbles. We adorn the bubbles with some
justification. Even if a guy is just after sex, he at least has the
decency to act like there is some substance behind his interest. For
the Internet bubble, it was that fundamental analysis based on the
brick and mortar world did not bear relevance in the New Paradigm. For
the Nikkei bubble, it was that the crazy P/E ratios were not
considering one subtlety or another in the Japanese accounting system.

But with gold, no one seems even
to care about giving a justification, other than “gold has been a store
of value throughout 5,000 years of monetary history”. Which is fine as
far as it goes, but that doesn’t say anything about what the price of
that store of value should be.

Pump and Dump

Given that “hedge fund” and “highly secretive” are usually said in
the same breath, don’t you get suspicious when so many of the top
managers are so vocally out there about their gold investments? And
when their positions are structured in a way that make them open to
view? Paulson and Soros have huge positions in gold ETFs. We know that,
because if you buy ETFs, they show up in your 13-F filing. Granted,
with an equity investment you can’t help putting that information out
into the market, but with an asset there are plenty of ways to take the
position without signaling it.

That they are taking a highly
visible route to their positions suggests the game that is being played
is one of leading the herd. The 13-F reports positions with a big lag,
so no one will notice if they quietly slip out the side door while the
party is still hopping. And how about when the view is backed up by
none other than Goldman Sachs? Will they let everyone know when they
think it has gone too far before they get out. Or before they go short?
Maybe they already have.

Herds, crowds, mobs, and the Top Ten

And yet, we follow the herd, as we have countless times in the
past. Herding is a timeless and universal market behavior, but one that
seems less than rational. It is broader than markets; think of the Top
Ten phenomenon. We feel better if a lot of other people think that our
favorite artist or actor is The Best. We like a song better if we know
a lot of other people are liking it as well. Thus our love affair with
lists. Magazines featuring the Ten Sexiest, the Five Best, the 100
Whatever are all best sellers, even if the list is the product of a
story meeting between an editor and five reporters.

Herding can be explained as an
artifact of what was rational behavior in earlier times, when we were
running around as hunter gatherers. Back then, mob and herding behavior
made sense. Mob behavior if attacking a competitive group or killing a
large animal; herding behavior if protecting against predators or
uprooting to a new location. Whatever it was that got started, you
could be pretty sure there was safety in having a crowd on hand to
finish it.

The very notion of mobs and herds evokes a certain spontaneity. But
with the gold bubble, we are moving on to a concept of herding by
appointment. Everyone seems to be happy in agreeing that this is a
bubble, and we are all going to participate in this bubble in a
rational, genteel way. We have all decided that this is going to be a
number one hit, a Top Ten. Though we might want to ask who is leading
this herd, because my bet is they will be stepping aside and cheering
us over the cliff.

More articles from Zero Hedge….

Zero Hedge

The meeting between the Greek Minister Of Prime Scapegoating and the US Secretary of Treasury Defrauding (“I used TurboTax”) has ended “satisfactorily”: idiotic lunacy, which we are now convinced has mutated and gone airborne, has spread and now Geithner is very likely infected. According to preliminary reports president Obama may be contagious as well. G-Pap is quoted by Market News as saying that “President Barack Obama gave a positive response to the European efforts to combat some aspects of market speculation that could destabilize markets and the euro.” Seriously, is this just some sick, perverted scheme to make going long the dollar (short the euro) illegal? Can we just make it so much easier and simply hand Benny and the Inkjets the constitution to use as 1-ply Treasury Paper one of these days?

Some memorable quotes from Papandreou, who had he spent half the time fixing his busted budget as chasing after windmills and CDS trade tickets, Greece would have a budget surplus several time greater than its GDP, and not resort to hiring CB Richard Ellis to sell Mykonos.

“The European Union is stepping up to its responsibilities to deal with this issue, and I think that is a very important signal around the world because what is saying is that Europe is united on this cause, there is solidarity, and it will not allow speculators to play around with the stability of the eurozone and the currency.

It is very important to stabilize international markets to not allow the crises that may occur, such as the one that occurred in Greece, be used to create wider destabilization either of the eurozone or of the world financial system.

I found a very positive response by President and certainly this will be an issue that will be high on the agenda at the next G20 meeting.”

Furthermore,  Papandreou said German President Angela Merkel and French President Nicolas Sarkozy have joined him in taking the initiative to fight against such speculation. As for describing his meeting with Geithner, Papa said he had a good meeting in which he discussed specifics on the possible anti-speculation measures.

And since this is a world tour, and some concertgoers always get stuck in the nosebleeds, G-Pap, said, for the n millionth time, that Greece was not begging (or any variation thereof) for financial aid, and that all signs to the contrary have been planted by rogue and vile speculators.

More articles from Zero Hedge….

The Daily Reckoning

The reason you might have heard about my Securities and Exchange Commission (SEC) lawsuit is because I didn’t settle the case.

When most people are sued by the SEC, they do their best to put the matter behind them – as quickly and quietly as possible.

This normally involves paying a large fine and essentially promising “not to do it again.” If you pay the fine, the chances are good most people will ignore the matter. You’re not required to admit any guilt. Thus, the damage to your reputation is largely mitigated and you can go on with your life. That’s why most people settle with the SEC when it comes to civil (noncriminal) lawsuits.

But I didn’t settle when they sued me.

Even when a settlement was offered to me for as little as $1 million, I refused it. Instead, I’ve faced a lengthy court battle that’s brought with it tremendous risks to my reputation and legal bills amounting to almost $3 million.

Why on Earth would I try to fight the “city hall” of the securities industry?

Because I’m eager for the facts of my case to come to the public’s attention. I know when the facts of my case are accurately known by the public, my subscribers will support my decision to fight the SEC. That’s why I’ve never tried to hide this matter from anyone.

Unfortunately, so far, almost none of the critical issues at stake in my fight have been accurately reported. Worse, people who have no idea what they’re talking about continue to assume my case is another example of a financial publisher acting scurrilously – front-running his subscribers or ripping people off by promoting penny stocks that he’s been paid to endorse.

And so… at the risk of upsetting the judges who have to date refused to believe a word I’ve said about the matter… I would like the opportunity to tell you, my subscribers, exactly why I’ve refused to settle my case. And why the matter is now pending before the U.S. Supreme Court.

I’d also like the opportunity to direct you to several reliable sources of information about the matter, such as The New York Times and The Wall Street Journal. Most of the things written about the case elsewhere are patently false and misleading.

For example, most people don’t know my battle with the SEC actually has nothing to do with stock trading or actual securities fraud.

The truth is, there isn’t any allegation that I ever owned the stock in question – and there never has been.

Nor is there any allegation I’ve done anything at all that’s directly related to the purchase or the sale of any security. I didn’t “front run” my recommendation. I wasn’t being paid by promoters to recommend a stock. These things have all been said about the case – even by a few fellow journalists. But in fact, I wasn’t even accused of doing them by the SEC.

So what is this case about, if it’s not about trading in securities?

My lawsuit with the SEC started as a fight over the First Amendment rights of a publisher – me. It has continued because I refused to settle or buckle under to the government. I maintain my writing was honest, materially correct, and is certainly protected by the First Amendment of the U.S. Constitution.

I claim a former unit of the Department of Energy – a unit that was sold to investors in 1996 and is now known as USEC – was withholding material information from the public. I believe it did so in order to reward certain investors, including its bankers, its corporate insiders, and members of the Department of Energy.

By revealing information about a major and long-pending agreement with USEC’s Russian supplier of uranium, I disrupted the opportunity insiders had to accumulate shares at lower prices. In short, I ruined the party by telling investors the agreement had been reached and would be announced in a few days.

Because USEC was trading at a very distressed price (half of book value) and was paying such a high dividend (yielding more than 8%), I believed the stock would soar once this long-pending agreement was made public. In my report, I explained why the agreement would turn USEC into a profitable company by lowering the company’s raw material costs dramatically. I predicted the stock would double on the news.

And that’s almost exactly what happened.

Based on what I’d learned from a company insider (the director of investor relations), I wrote the agreement would be announced at a major nuclear summit featuring presidents Bush and Putin on May 22, 2002. The insider explained the details of the summit to me in advance, long before they appeared in the newspaper and told me to “watch the stock on May 22.” And in fact, the long-awaited announcement came about a month later, on June 19, 2002. Keep in mind, this agreement had been pending for more than two years. And yet, somehow, I was able to pinpoint almost to the day when it would be announced to the public.

Did the stock soar? No, not exactly. It moved from around $8 to around $11. That’s roughly a 40% move in a few days. That’s not bad. More importantly though, following the new agreement with the Russian uranium supplier, the stock traded all the way up to nearly $20 over the following three years. In fact, by the time my case reached its first federal judge, investors who followed my advice would have made more than 150% on the investment, thanks to capital gains and big dividends. (The stock eventually went to $25 during the uranium bubble of 2007.)

Yes… that’s right. The SEC is suing me for a matter that involves a stock that went from under $8 to nearly $25. That’s more than a 200% gain. You’ve got to be kidding, right? Nope.

But why?

Here’s the heart of the matter.

I believe the company knew for certain its deal for cheap Russian uranium would receive the required final approval of both the U.S. and Russian governments at the summit. This approval was the only thing holding up the deal. With this knowledge in hand, it would have been easy for the company’s insiders and other senior officials in the Department of Energy to load up on the stock and profit once the news was announced to the public.

And I wasn’t the only analyst who was told when to expect the deal.

In the discovery process of our lawsuit, we found a notebook from USEC’s investment bank – Bank of America – where its analysts clearly indicated May 22 was the expected announcement date.

But instead of pursuing the possibility USEC’s managers and bankers were withholding this material information, the SEC decided to attack me. Keep this in mind: I didn’t use this information for my own personal gain. I didn’t buy the stock. Or even just tell my friends to buy the stock. No, instead I did my job. I published a report about what I’d learned and offered to sell my report to any (and all) interested investors.

I also sent a copy of my report (and the accompanying sales letter) to my source at USEC. He never asked me to change a single word of my report. He had my cell phone number. He had my office number. He had my e-mail address. If there was any legitimate problem with my report, all he had to do was ask for a correction. He never did. Not even to this day.

I did all of the things any reputable journalist would do. I checked my source’s facts. Sure enough, a presidential summit was approaching. Sure enough, there was a large pending contract. Sure enough, the new deal would change the economics of the company in a dramatically positive way. I sent a copy of my report to my source. And I offered it for sale to the public. If anyone wasn’t satisfied with the report, for any reason, I gave him his money back.

Even today, looking back at the matter through the lens of time and experience, I still think my USEC report was one of the great stories of my career and I’m proud of the report I wrote. Are there things I would have done differently? Yes. I would have made sure to have a recording of my interview.

You see, even though I never owned a share of the company, even though I had no incentive whatsoever to lie about the company, and even though third parties who have looked at the facts of the case (like The New York Times) agree my report on the matter was overwhelmingly correct… the SEC decided to come after me and not the people who were really defrauding the public.

Incredibly, the SEC sued me for securities fraud, saying I had lied about what my source told me and that selling my report about USEC was tantamount to brokering the stock. Specifically, the SEC claimed my source didn’t tell me to “watch the stock on May 22,” which was the only part of our conversation that I quoted.

Since I can’t prove what my source said, you might assume I must be lying. But if he didn’t explain the timing of the deal to me, how could I have known – within a month – exactly when the deal would close? The fact is, until our discussion, I didn’t know anything about the upcoming presidential summit. It wasn’t reported in The Wall Street Journal until about a week after our discussion.

But… just for the sake of the argument… what if you assume I knew about the summit from another source and I merely attributed it to the company in order to claim I really had “inside” information? Why then, even after I wrote the report and sent my source a copy, did he not demand a retraction?

And if the company knew my report was false, why didn’t it put out a press release denying it? The NYSE rules require companies to put out press releases anytime there’s a material misstatement in the press.

The fact of the matter is, my report was overwhelmingly correct. And my source couldn’t deny my report because he didn’t know whether or not I had a recording of our conversation (which took place over the phone).

When the SEC came calling later in 2002, I expected it would be going after the company for selective disclosure – a violation of SEC regulation FD. And sure enough, it wanted all of my personal records to make sure I wasn’t front-running the stock, etc. But then, instead of shifting its investigation to the company, it demanded to have the entire subscription list of not just my publishing company, but also of our parent company, Agora Inc.

It wasn’t going after USEC for withholding material information; it was going after us by intimidating our clients. And it didn’t ask for just the USEC report subscribers – it demanded every single name and address on our entire database, including my parent company’s database.

Rather than give in to this subpoena, we sued the SEC in federal court to protect our subscribers’ privacy. A well-established legal precedent protects a publisher’s subscriber lists. (What you decide to read is none of the government’s business.)

That’s part of the story I’m sure you’ve never heard before: We sued the SEC first. And we did so to protect our subscribers, the overwhelming majority of whom never bought the USEC report in the first place.

I understand that you might reasonably wonder… How could any of this be true? I mean, wouldn’t you expect that as soon as the SEC knew I’d sent my source a copy of the report, the matter would be closed? Or don’t you think as soon as it knew I wasn’t trading the stock or front- running it, the SEC would have simply left me alone?

Even after reading all of this, undoubtedly, a lot of people must think I’m merely trying to muddy the waters because I’m guilty of front-running the stock… or lying to investors. Why else would the government waste its time on a newsletter writer?

I understand my story might be hard to believe – at first. The public generally has confidence in our government. It will be hard for some people to imagine the SEC would actually go after a journalist with the intent of putting him out of business simply because it didn’t like what he was writing about.

But my story isn’t unique.

At the same time the SEC was abusing its power by subjecting me to interrogations, subpoenas, and crushing legal bills – all in violation of the First Amendment – it was also going after many other legitimate market participants – including David Einhorn, the well-regarded hedge- fund manager (Greenlight Capital) for merely speaking about securities.

As with my case, the SEC came after Einhorn for speaking openly about abuses taking place at a Washington-based business (Allied Capital), a company that – like USEC – was heavily staffed with former government officials, including Joan Sweeney, the company’s chief operating officer, who was a former senior member of the SEC’s Division of Enforcement. Our stories are eerily similar…

THIS IS WHAT EINHORN WAS WARNING INVESTORS ABOUT, AS EARLY AS 2002. THE SEC RESPONDED BY INVESTINGATING EINHORN.

Rather than investigating Einhorn’s claim that Allied Capital was cooking its books by using fraudulent accounting, the SEC instead began investigating him, alleging securities fraud because of what he’d said about Allied Capital during a presentation at an investment conference that’s held to benefit charities.

After several years of threats and abuses (like having his phone records stolen), Einhorn was vindicated. The shares of Allied Capital collapsed as the company was revealed as fraudulent. But even today, Joan Sweeney is still with Allied Capital. The SEC has never been forced to fire any of the agents who abused their power during the investigation of David Einhorn.

To draw attention to the abuse he’d suffered, Einhorn decided to donate all of the money he made from shorting Allied Capital to charity, and he wrote an entire book about the situation called, Fooling Some of the People All of the Time.

Says Einhorm about his experience:

Allied isn’t the biggest, most egregious, or most audacious fraud I have seen. In a sense it is a garden-variety fraud – dishonest business dealings by dishonest management. So why all the fuss? The story I am telling is one that has been surprising and unexpected – even to me. I think it is important and needs to be told. This book reveals some serious problems in the regulatory landscape that I am in a unique place to discuss.

I care that the SEC and other regulators seem to have stopped enforcing laws against corporate malfeasance. I care that company officials can lie with impunity on public conference calls. And I have been appalled that the government officials overseeing the lending programs that Allied has defrauded are so indifferent and unwilling to act even when presented with clear evidence of abuse. The overall lack of law enforcement is startling…

If we are going to permit the retribution against the whistleblowers shown in this story – defamation, investigation, invasion of privacy and so forth – then we surrender public free speech. If we allow the people in this story to operate outside the law, then we nourish a corrupt business culture. Rather than turn a blind eye to the fraud I witnessed, I made a decision to stand up and speak out despite the consequences. I hope my story inspires regulators and government agencies to do the right thing.

I hope you’ll remember most people don’t do what I’ve done and what Einhorn did.

Most people don’t fight the SEC because they don’t want their names in the paper, they don’t want the stigma of being investigated by the government, etc.

Believe me, I can understand why. When the news of the SEC’s investigation of me leaked out, publishers around the world refused to do business with me. Potential employees refused to come to work with me. Companies refused to be interviewed by me. The lawsuit has made it vastly more difficult for me to simply stay in business. Even today, every time a potential subscriber stumbles across information about the lawsuit on the Internet (and much of it is completely untrue) he’s likely to cancel his subscription or simply decide not to renew.

And think about this… the more people who simply refuse to write about securities because of the threat of an SEC action or because they fear retaliation from the businesses they write about, the less high- quality information will be available to investors. The less information is available, the more bad actors will take advantage of investors.

Whether you realize it or not, the SEC isn’t trying to protect investors. If it were, Bernie Madoff would have never happened. The SEC knew all about Bernie Madoff – the SEC audited him regularly. Many people – including Barron’s – pointed their finger right at Madoff and revealed his fraud. Still, the SEC did nothing.

The SEC knew all about Enron and WorldCom and the conflicts at the investment banks during the Internet boom. The SEC knew all about GM’s debt load. It knew all about the problems with Fannie and Freddie. In fact, it was the SEC that approved the huge increase to investment banks’ leverage in 2004 – a move that directly led to the financial crisis of 2008.

But… maybe you still trust the SEC. And if you do and you want to believe Porter Stansberry is out to harm investors by publishing independent reports on public companies – that come with a money-back guarantee – there’s probably very little I can do to change your mind.

On the other hand, if you ask any securities industry professional who reads our newsletters, I have no doubt he will tell you our work is among the best you can buy anywhere and is far superior to nearly all of the research put out by the brokerage firms. I know this is true because thousands of professionals are our clients and I have hundreds, if not thousands, of testimonials from these readers.

The truth of this case is so simple to see. Just ask yourself two questions:

1. How can the SEC accuse Porter of intentionally lying when Porter sent his source his full report and the source never requested a retraction or a correction to any of Porter’s reporting?

2. Why would the SEC risk a constitutional battle with a bona fide journalist over a report even The New York Times says was basically correct? Why would the SEC want to shut down a business like Stansberry & Associates Investment Research – which offers refunds to any unsatisfied customers and whose analysts never trade in the securities they recommend?

Don’t you wonder why the SEC would target my business – which doesn’t manage money or broker stocks – while ignoring enormous ponzi schemes going on in the businesses it supposedly regulates?

I can’t prove it… but I don’t think the government likes it very much when I tell investors the truth about things like Fannie, Freddie, and General Motors. I don’t think the SEC wants the American people to know the truth about our financial markets – or the state of our government’s finances. And I think the government is afraid of what will happen when you find out the truth.

Whatever happens with my court case, I hope you’ll know I did, and have always done, my best to tell you the truth.

After all, unlike the government, the truth is my only weapon.

Regards,

Porter Stansberry
for The Daily Reckoning Australia

Similar Posts:

• Who Was the SEC Harassing Instead of Madoff?
• You Can Never Be Sure How Fabricated Income and Earnings Are These Days
• Rising in Defense of Goldman Sachs
• General Electric & Lift Capital Usher in Rough Start for ASX
• How the U.S. Dollar Came to be the World’s Reserve Currency

More articles from The Daily Reckoning….

Zero Hedge

Two months ago we first presented a very gloomy outlook on Japan by Dylan Grice, one of the more erudite skeptics currently out there. Dylan’s thesis was simple, and was subsequently taken up by a variety of other pundits to express comparable concerns about developed countries with burgeoning debt levels, namely that an aging population, now actively engaged in asset sales, will have less of an ability to participate in its traditional role of purchasing JGBs. Dylan takes this opportunity to rebuff critics, and to point out that no matter how the data is sliced, when adjusted for the ever so prevalent “recency bias”, and when confronted with a topic near and dear to Zero Hedge, namely record rolls of increasing shorter-duration debt, coupled with an open admission by the biggest holderof JGBs, the Government Pension Investment Fund has “zero money to invest”, the recently awakend bond vigilantes (with or without the evil CDS speculator cousins) will very soon migrate away from the Eurozone periphery and focus on where the material problems really are focused. Unfortunately no amount of postruing by Merkel or Sarkozy can do much to change the fact that the imminent funding crisis for the world’s 2nd 3rd largest economy is becoming all too real.

Here is how Dylan himself summarizies his view:

The thesis I outlined back in January was that since Japanese households ? the biggest effective drivers of JGB demand ? are set to dis-save in coming years as they retire (left-hand chart below) there will soon be no one left to finance the government?s nosebleed deficits at current yields. Indeed, the chart below suggests households are already running down assets. And because the interest rates which might attract international investors will inevitably blow up the budget (debt service is already 35% of government revenues at existing yields) there is a very clear and present danger that the government reverts to the well-established historical precedent for cash-strapped governments of currency debasement.

The most common argument I received on why I was wrong to worry was along the lines that Japan has had rising debt ratios and huge deficits for many years now. Not only have yields fallen, but the economy has struggled with deflation, not inflation.

To me this feels like “?recency?” bias at work, which is a type of “?availability?” bias by which we overweight events we find easy to imagine relative to those we don?t. Japanese debt markets have been stable for such a long time it?s difficult to imagine anything different, so we don?t imagine anything different and predict that the future will look like the past. Now, Japan?s debt markets may well remain very stable in the future and I?m very open to the strong possibility that I?m barking up the wrong tree. But ?logic? like that outlined above is lazy indeed. It echoes Bernanke?s now infamous 2005 conclusion that nationwide housing collapse in the US wouldn?t happen because it hadn?t happened before. More thoughtful critics argued that I was ignoring the Japanese government?s significant financial assets. Taking this into account shows a net debt position of closer to 100% of GDP (chart below), considerably more manageable than the 200% gross debt-to-GDP ratio and more in line with other OECD economies such as Italy and Belgium (great!).

But I’?m not so convinced by this argument, or to be more accurate, I?m not so convinced the numbers underlying this argument are correct. For a start, around 40% of the assets recorded on the asset side of the Japanese government?s balance sheet don?t actually belong to the Japanese government. They belong to Social Security and therefore to the  Japanese public. That the vehicle which owns the assets happens to be publicly owned doesn?t change the fact that it is a very real liability owed to individuals who must be either paid or defaulted on. It doesn?t just cancel out.

And just in case you thought our concerns about central bank insolvency could be limited to the US, it should come as no surprise that Japan has very much the same issues when it comes to the asset side of its balance sheet.

And who on earth knows what the other assets are worth anyway? The central government, for example, has funded projects deemed “?socially useful?” and which private markets wouldn?t finance. These loans, made via direct ?investments? in public sector organisations (called Fiscal Investment and Loan Program [FILP] agencies), are recorded as assets on the government balance sheet worth around 10% of GDP. Yet we know from decades of banking problems and bank recapitalisations that even the loans that markets did finance soured pretty spectacularly, so one wouldn?t imagine the FILP agency loans to be of particularly high quality. Indeed, a few years ago two economists at the NBER reckoned that nearly half of the FILP agencies were insolvent. Maybe those assets are being provisioned for correctly on the government?s books, but ? and call me a cynic if you like ? I really doubt it.

But even if we assume those numbers are a fair reflection of asset value there is also the implicit assumption that the Japanese government can monetise them. But I don?t think they can. Shares and equity stakes are marked at around 20% of GDP, mainly reflecting Japan Post Bank – the “?jewel in the crown?” – with $2.5 trillion in deposits. But last year, plans for its long-awaited privatisation were shelved, apparently for fear that on a purely private sector calculus, many small and medium-sized companies wouldn?t qualify for the funding they need to stay afloat. Keeping it in public sector hands was the only way to ensure their life-support credit lines weren?t cut. Of course, I may just be being cynical again, but I note that Post Bank is also a huge buyer of JGBs and doubt it was just the SMEs life support the government was worried about?

Grice brings up a relevant counterpoint: is the demand calculus in Japan merely shifting away from traditional buyers of JGBs in favor of a just as yield “ravenous” corporate sector? Bear in mind this is much less of an issue for the US, where traditionally low household saving rates have meant at best a rotation out of one asset into another, and never a de facto new and/or persistent demand interest. After all we had the Chinese doing that for us, with the receipt of the cash of all those trinkets that Americans just had to have over the past 10 years. Regardless, when it comes to China

This leads nicely to the other argument worth thinking about, which runs like this: the household sector may well be retiring and less able to absorb new JGB issuance, but the corporate sector is expanding thanks to a vibrant export sector. Since corporate sector savings are as large as households? isn?t it reasonable to expect them to take over as the primary source for government funding? The honest truth is that I don?t know. Maybe, I guess. But my gut feeling is pretty definitively no. For one, the corporate sector doesn’t actually have as large a pool of savings as the household sector.

For another, the corporate sector ? even in Japan ? doesn?t have anywhere near the same propensity to hoard cash (see chart above). Open the papers today, for example, and you read about Astellas Pharma going hostile on OSI, where it thinks it can buy its way out of Japanese stagnation. When companies have money, they need to spend ? sorry “?invest?” ? it (occasionally they even need to return it to shareholders). Anyway, it looks unlikely to me that companies are going to take over from households in financing the government?s deficit.

So in summary, refutations of the funding crisis are still lacking (Grice welcomes all input on where he may be wrong). In the meantime, it appears that the facts are in his favor, especially when one considers that the two primary traditional sources of demand are fallling by the wayside.

So I still worry. Households are retiring and running down their wealth; non-financial corporates don?t hold as much cash. So the non-financial sector (i.e. households plus nonfinancial corporates) just isn?t going to be in a position to provide the financial sector with the deposits it needs to recycle into JGBs.

That leaves the foreign sector as the only candidate to fund the government?s ever increasing structural deficits and explains the increased frequency of JGB roadshows we?re seeing around the globe. But is it realistic to expect foreign investors to fund a likely insolvent government at 1.5% (if this week?s Greek financings are a fair gauge, investors want closer to 6% to fund insolvent governments)? Anyway, debt service already accounts for 35% of the Japanese budget! Any reasonable interest rate will expose Japan?s budget for the mess it is.

But why take my word for it? Why listen to the rantings of some supposed ?perma-bear?; a deranged strategist working on a cold rainy island on the other side of the Eurasian continent from Tokyo, and with no great insight into the workings the JGB market or much else for that matter? Well, you shouldn?t. But you might want to take Takahiro Kawase, head of Japan?’s $1.2tr Government Pension Investment Fund (GPIF) and the largest owner of JGBs on the planet, more seriously. He said last summer, “?The big change this year for us is that there is zero new money to invest, so we may need to be a seller in the market to meet the pension benefits … our bond allocations are overweight, so we may need to reduce those a bit to raise cash.” Not to worry, though, because he doesn?t think it will have much effect on the market. “… the sales are not expected to be big, as we can cover the shortfall from maturing bonds.”

Ah: maturing bonds – the dreaded roll problem. We have recently demonstrated the major concern that rolling near-term debt is for Europe (here and here), here is what it looks like for Japan – the total amounts to a whopping 45% of GDP!

It sure does look a little scary. More from Dylan:

How significant a problem is this? In last week?s FT, Gillian Tett pointed to the importance of debt maturity in assessing fiscal breathing space. UK debt maturity, at 14 years, is one of the longest, while the US, at 5 years, is one of the shortest. In Japan, based on the Bloomberg data on the front page chart, the number is around 6, and ¥213 trillion matures in 2010.

To spell that out: we are going into a year in which the government has ¥213 trillion of bonds to roll over (chart below), and the biggest holder of JGBs is openly admitting he has no new inflows of money. I suspect he?s not as confident as he?s making out that this won?t be a problem, and I suspect the Japanese authorities aren?t either. Otherwise, they wouldn?t be scrambling to arrange a new borrowing facility for the GPIF so that it doesn?t have to sell JGBs to fund its pension obligations.?

Is Grice right? Time will tell. When a new, countertrend idea emerges, it needs a critical mass to gain traction. Are we going to see “idea dinners” in which selling JGBs (or, gasp, buying Japan CDS) is discussed? Unlikely. Especially not with Goldman Sachs as organizer. Yet the facts speak for themselves. We are on the cusp of a secular shift between traditional supply and demand mechanics, both in Japan and everywhere else, as the prevailing population gets older. Of course, the ramifications of all these observations are just as critical for America as they are for Japan. As we have been discussing extensively in the past, the real crisis is not Greece, not the UK, and not even Japan so much (and as for China who knows – if real, unmanipulated Chinese debt/GDP is at almost 100% as some economists have claimed recently, it will get quite interesting), but in our own country, whose only generic fall back is “we print the dollar.” One critical, and as yet unanswered, question is just how long can this particular excuse be reapplied over and over.

More articles from Zero Hedge….

By Karl Denninger, The Market Ticker

… suddenly politicians “get religion” about making damn sure it has no bullets in it:

“We’re of the opinion that a quick implementation of actions in the area of CDS has to happen,” Merkel said. Citing “ongoing speculation against euro-region countries,” she called for the “fastest possible” implementation of new rules. Europe must “do everything to avoid unhealthy speculation,” said Juncker, who heads the euro-area finance ministers group.

Where ‘ya been Angie?

Oh, and you too Papandreou:

“Europe and America must say ‘enough is enough’ to those speculators who only place value on immediate returns, with utter disregard for the consequences on the larger economic system,” Papandreou said yesterday in a speech in Washington.

And, of course, Sarkozy.

Note that I’ve been calling for these things to be either exchange-traded with central counterparty “blinding” (on purpose) as is the case with the regulated option and futures markets or be torn up since The Ticker began publication.

Why?  Because it is my position and remains so that unless you have this sort of market these contracts are all a scam. 

They are a scam because:

1. The counterparty cannot pay in aggregate for the exposure they have on.  This, in turn, “allows” them to write these swaps at an uneconomic price, which means that in effect these are all “side letter” deals.  That is, they’re intended to cheat regulatory capital requirements as everyone involved knows there is no possibility of actual performance.  In these cases everyone involved should be rotting in prison – the buyer for purchasing a knowingly-bad “insurance policy” against an event that they know can’t pay off for the singular purpose of defrauding a government regulatory agency (and/or the shareholders!) and the seller for putting forward a contract they know they are incapable of performing on.

2. The entire purpose of off-exchange trading of these instruments is to severely-damage the purchasers of these swaps in the retail market by obscuring the essentials of the transaction, including the bid and offer from other participants.  This also has the effect of allowing collusion, either active or passive, among sellers – nearly all of which are big banks and financial institutions.  This collusion, by the way, either is or should be a felony violation of anti-trust laws.  Finally, concealment of the market’s opinion on price and activity allows outright bribery and other very-unlawful acts such as allegedly occurred in Jefferson County, Alabama.

The solution to this is simple, it’s elegant, and I’ve been railing about it since The Ticker began publication, but there’s no time like the present to re-state the demands and make sure they’re clearly communicated to everyone.

In short, we must make all of these derivatives, including interest rate, currency and credit swaps:

1. Trade on public exchanges where blinding of counterparties takes place.  This is exactly identical to what is done with the OCC for listed options and the CFTC for listed futures.  If I buy a PUT on a company I have no idea who sold that PUT in the market, and further, if I exercise a long PUT the person who originally sold it may not be the one who gets assigned – that’s handled by lottery among all who are short that contract.  This makes abuse of these contracts by the buyers, who then seek to destroy the sellers, extremely difficult as they have no idea who to target.

2. Have the exchange is the buyer for every seller and the seller for every buyer.  Since the transaction is effectively “blinded” from the counterparties the exchange is thus in the position where it must make certain that anyone who is short has the capital posted and held as margin to guarantee performance or the exchange will wind up insolvent.  The exchange has nothing to gain and everything to lose by allowing people to “game” collateral and margin requirements – thus, it doesn’t happen.  Further, as volatility rises the exchanges tend to increase margin requirements in order to protect themselves against sharp and unexpected moves – exactly what would be expected of a prudent counterparty.  In short this process makes the market “safe” for both buyers and sellers, and even in times of extreme stress such as the 1987 crash nobody has ever had a regulated futures or options contract fail to be honored.
3. Break up those “custom” contracts that are so esoteric that only a handful of people want to trade them into standardized contracts that a lot of people want to trade.  Let’s say that someone wants a custom derivative that is comprised of the price of oil and the price of John Deere’s stock.  Perhaps they’re a major farming interest that is concerned not only about the possibility of Deere failing (they have combine orders stacked up that would be VERY expensive to replicate on the spot market) but also the price of oil since they have to fuel those combines.  That’s a custom contract that almost nobody would want to trade, but it can be deconstructed into a PUT on John Deere and a short on the oil futures.  In essentially every case these “custom” contracts can be deconstructed into two or more things that lots of people will want to trade, which immediately destroys the argument for “custom” OTC contracts.

For those financial parties who “resist”, the solution is simple: either relent or those contracts which you refuse to migrate to such an exchange are torn up as void ab-initio as you have refused to demonstrate both ability and intent to perform.  They are thus not valid contracts – end of discussion.  If the buyer wishes they can (and should) go sue to seller for return of their premium, since they bought something that was sold under false pretense.

Congress must take this action now, and if it will not, then the executive must by whatever means are necessary – including executive order.  It’s all the better if Merkel, Sarcozy and others on the world stage have finally come to realize what I’ve been saying now for the last three years when this mess first began:

These over-the-counter derivatives are an outrageous-destabilizing force and, in many cases, are outright fraudulent instruments as the selling entity lacks the capacity to perform as agreed.

The essence of the AIG mess was that the company lacked the financial capacity to perform.  It really is that simple.  Knowingly entering into hundreds of billions of dollars of financial commitments without the ability to perform should be treated as a felonious act, but apparently we have no cops anywhere in the world interested in massive and outrageous acts of this sort, as I have yet to see hundreds of perp walks up and down Wall Street.

Well, if the next-best thing is to prevent it from ever happening in the future, I guess we’ll have to settle for that – even though it is, on balance, wholly-insufficient when one considers the damage that these people have caused to the global economy and financial system.

More articles from the Market Ticker….

Those who favor affirmative action for people with no discernible skills undoubtedly appreciate Dana Milbank’s page 2 column in the Washington Post. Today Mr. Milbank used his column to tell the world that he knows absolutely nothing about economics.

The theme of the piece was that in ten years the United States will be like Greece. He discusses the trip to the United States of Greek Prime Minister George Papandreou seeking support for his country during its current fiscal crisis and tells readers: “if current trends persist, an American president will be doing the same thing in about 10 years.”

The article goes on: “He or she will probably be in Beijing, asking for more favorable interest rates or pleading with the Chinese government to keep speculators from betting on an American default.”

Okay, now let’s imagine that Milbank had taken an econ class at some point. Suppose speculators were betting heavily against the dollar. The value of the dollar would be plummeting. If China still had its peg of the yuan to the dollar, then it would be spending trillions of dollars every year keeping its currency from rising. What would we be begging China about in this story?

Suppose China had broken its peg to the dollar so the big bad speculators had pushed the yuan from its current value of about 15 cents to 30 or 40 cents. Chinese goods now cost 2 or 3 times as much in the United States and our goods cost one half as much to people in China. What would we be begging China about in this story? (Our other trading partners would be in the same situation.)

Currency values correct trade imbalances. While U.S. productive capacity has taken a hit from the policies that Milbank and his Post colleagues favor (the high dollar and trade policies they have promoted), it still produces and exports an enormous amount of goods and services. If we ever faced a crisis like that facing Greece today, it would be at least as much a problem for the rest of the world as for the United States.

The reason that Greece faces such enormous difficulties is that it is part of the euro zone and therefore does not have a currency that can simply adjust in value. This basic point, which has been widely noted in the business press, apparently escaped Milbank’s attention.

–Dean Baker

Read more….