The mounting losses from mortgage papers forced financial institutions to raise capital. While capital inflows seem to be healthy the dangerous trend is developing.


Hi All! I want to share with you that I was cordially invited to start my own blog at Wall Street Examiner. You probably know this site very well as Russ Winter is contributing there as a blogger and Lee Adler is posting his excellent daily reviews for subscribers.

This is the location of my new blog, it’s titled “The yellow brick road” and I’m opening with a new installment of “Where is my recession?” serial.

Please share your feedback, do you like it, is it working well. I’ll continue to announce every post here for easy transition and I think I will keep this site for all posts that I will consider not applicable for WSE

At April 30 I’ve posted “Kiss this rally goodbye“. Well, I was wrong by 2 days and 18 points in the S&P. I’ve said that the peak will be 1404 at April 30 but now it looks like the real peak was fixed at 1422 at May 2 (both intradays). After yesterday 3.5% carnage in financial stocks they are tumbling by another 2% today. Financial sector is a leader in rallies and falls, so we won’t see that May 2nd 1422 level for months and, who knows, maybe years or even many years.

What happened? In this post 2 days ago (and the follow up discussion) I’ve suggested that Feds will have to make sacrifices in order to save the bond market. That had to do something nasty to scare the money out of stock market into bonds. My proposal was that the Feds will either suggest that they will allow Countrywide to fall or they will hint of possible rate hike.

Yes, they made a hint that the rate hike is possible, that worked very well – I was right. Second, the SEC declared that investment banks will now have to disclose the liquidity levels. That worked even better. The market is tanking exactly as Bernanke wants it to.

Yes, we know that Bernanke put exists for the bulls. Now we know that Bernanke call for the bears exists as well. Those who think that he will allow the stock market to rise at the expense of the treasury bonds are terribly mistaken. He will make all necessary sacrifices

I hear that the stimulus package just started in May and its effect will be felt over the next three months.

To this I will say c’mon guys, that stimulus package is already in the full force for the two full months. In early March we all knew how much it will be and when it will come (and if we qualify, unlike me, for example). Most people have credit cards and can pre-spend the check in advance.

That’s what they did, the just released data show that consumer credit in March rose $15 bln, well above expected and above $5 bln in January. I assume that most people are making the best efforts to manage their finances and if they increase debt in the face of obvious economic difficulties I assume they do it within the margin set by this check in the mail. So those who planned to spend the check are already doing so.

The second category of people are those who don’t have any credit lines left and can’t pre-spend the check. I assume that those people have horrible debt situation and whe they get the check it will go straight to pay the pile of bills. Those people will not spend much when they get this check.

And the third category of people are those who don’t plan to spend it at all. It will go to savings, to reduce debt, to pay for the college for the Fall and stuff like that.

Looking at all this I think I can estimate that about $60 bln of the $110 bln stimulus package will be spent and the rate of spending is set in March, i.e. about $15 bln/months. So the last dime will be spent during the 4th of July fireworks. The recession, which is interrupted by now, will resume in July. Plan accordingly.

Please read the fine post from immobilienblasen about price control in China. I want to dig a bit more into this topic.

Let start from the basics again. To simplify the things the world economy works as an entity that extracts natural resources from the Earth and process it into consumable goods. If you divide this entity into countries that are essentially sub-entities unified by some policy and other common properties of business units located in that country.

Each country has a particular competitive advantage in certain fields of processing natural resources and the logic of the world economy pushes those resources into this country. For example, Japan is very good in converting oil and silicon into flat panel televisions. So those countries who extract oil and silicon from Earth are sending them to Japan and then Japan sends those flat-panel TVs to the rest of the world. In case of Japan this advantage is in technology, patents and know-how.

In case of China the competitive advantage is the abundance of extremely cheap yet relatively qualified labor, concentrated along navigable rivers and backed up by business friendly government. There are many countries in the world with cheap labor but few of them are stable, qualified or accessible. The output from China is pretty much anything that is labor-intensive and can be easily outsourced from the West. Like plastic toys.

Now more about cheap labor. In the market economy there is a certain proportion between luxury, durable items and staples. For example, one day at ski resort will cost you the same as 10 bags of rice. The basket of consumable items will include the mix of staples and luxuries, both rice and ski resorts. The feedback loops between consumption of all those items creates this typical basket and the typical cost of labor in Western countries. Every kid in USA once in a while comes to Disneyland and this is a part of the basket.

Now very clever Chinese authorities came to a very clever idea (used in all Eastern European countries before) that they can subsidize the staples and change the proportion between various items. So the day at Disneyland (or ski resort) will cost not 10 bags of rice but 50 bags. So the typical consumption basket will include more rice and less Disney, overall supporting all the life necessities at cheaper price. The idea is that only a fraction of the country output is sufficient to be used for subsidies but overall it will make the labor artificially cheap and thus supporting the big trade surplus.

In the completely free market economy the China market would quickly adjust itself, the basket would be more expensive and include more luxury items and services, the price of labor would go up and the trade surplus shrink quickly. But this doesn’t happen.

So what is the conclusion? The world economy is in market equilibrium based on certain price of all goods. But the big player China is distorting the market mechanisms. First, they consume more natural resources than they would otherwise. Second, they produce more artificially cheap goods than they would otherwise. And this disproportion is widely based on subsidies that are coming from large trade surplus.

If anything in this artificial, non-market structure will start breaking the results may be disproportional the the cause because the market usually adjusts itself much better than any government structure. It looks to me like a big house of cards which is much more stable flat rather then tall

While the fabrics of the world financial system is too complicated for anyone to understand it is sometimes possible to track several bold moves that are likely to lead into equally bold consequences.

First of all is the continuous disruption of the world food economics. After I’ve tried to explain the sharp increase of food prices by simple supply and demand the collective finger was pointed toward my nose forcing me to accept that the apparent disruption of the world financial equilibrium is also likely to be the cause.

This is very similar to the gold run that we observed in the past few years. When the trust into dollar future was fading the first reaction of market participants was to hoard something precious to them, like gold. But in the past few weeks the world market discovered that there is something much more precious than gold, like food. If you saw the multitude of movies about wars you probably know that (at least in the movies) during the war a fine gold watch will buy you few cans of spam or a bag of flour. Not that gold is so cheap, but the food is so precious. When millions of people are losing any trust to their local currency (pegged to falling dollar) they resort to hoarding rice, which is relatively easy to store. One bag of rice is equivalent to one gold watch, when the time comes.

Now the second bold move. It’s the apparent shortfall of US tax collections comparing to soaring needs of this administration spending habits. The outstanding treasury debt is quickly approaching $10 trillion, and this is one of biggest Ponzi schemes in the world. This is the story we all know.

And the third bold move is the panic at Japanese bond market this night. Inflation finally reached Japan and the bonds started to fall so fast that the trading was suspended (those guys still don’t understand free markets). The elimination of ZIRP in Japan will lead into many redistributions in the word financial system. For example, I think the eventual introduction of the unified Asian currency may prompt China to sharply increase the purchase of Yens and reduce the purchase of dollars, and now is a good time to start doing so, because the interest rates in Japan will start moving closer to the rest of Asia.

Now the result of all this. Check the chart of the 10Y bond yield:

It clearly broke the trendline by a meaningful margin. The sharpness of the upward move will tell us the magnitude of the disaster. I think this is the most important event on US markets we need to watch now

I just want to put up the summary about the reasons behind rising food prices that I’ve got after reading and listening many educated opinions. I also want to deny the popular misconceptions that some people have. Of course this is just my opinion.

The main reasons I know are:

  1. Most important is the increased wealth around the globe. Wealthy people eat more meat and less grain, but it takes a lot of grain calories to raise cattle. Some people used to say that wealthy people consume pretty much the same amount of food as poor people. This is wrong. The amount of grain needed to produce one meat stake is enough to feed more than 50 people. Feeding grain to cattle produce major shortages
  2. Ethanol policies in US. We just burn food and we also burn a lot of fossil fuel to produce this food, this is very counter-productive and must be stopped
  3. Climate change. There is permanent (10 years) drought in Australia, for example. Ask Al Gore for details
  4. Free trade failure – many countries are restricting food exports in order to control domestic prices

The reasons that are often mentioned but are completely wrong:

  1. The falling dollar. This is wrong because food prices are rising all around the globe, without any relation to dollar or to any other currency
  2. This is a result of Bernanke lowering interest rates. Wrong, as mentioned above this is unrelated to dollar, hence unrelated to whatever Fed policies are
  3. The food prices are rising because of inflation. Wrong. This one is the most hard to get even for the best minds around, like Barry Ritholtz. Inflation is when the money supply and money velocity are growing faster than supply of goods and services, i.e. inflation is a monetary phenomena. There are countries that are experiencing strong inflation, there are countries where inflation is much lower, but the food prices are on the rise everywhere no matter what the inflation rate is. If you carefully examine the 4 reasons I listed in the first section they clearly show fundamentally increased demand and fundamentally decreased supply. I don’t see the inflation to be the part of this equation

We finally got to the point when Main St takes a hit from Wall St. As you recall I’ve mentioned few times that so far the collapse of commercial paper market was offset by the extension of lines of credit. Few minor bumps on this road are not important.

Now is the major bump. Just released H8 shows that banking credit contracted by $102 bln from last week and by $132 bln from the March peak. Now add here $16 bln two-week contraction of commercial paper. I always used to add those two numbers, so the total two-week credit contraction is $148 bln. You can add here a more modest bond issuance contraction that I reported here. The total outstanding short-term debt is $1,817+$9,433=$11,250 bln. The relative contraction is 1.3%.

I think this is a very big number. You can compare it with “stimulus package” passed earlier this year – they pretty much cancel each other. I think the effect will be almost immediate – we are in the earning season and one after another the corporate CEOs will tell us that they plan to cut spending. Of course they will be forced to cut spending if they are forced the reduce debt.

Maybe I should call all this the year of The Great Deleveraging?

The visual representation of current lenders risk tolerance (click):

Here you see the corporate highest and lowest investment grade, 30Y mortgage and 10Y treasury. Add here a separate chart of high yield bonds:

The top traded bonds from this index are from such companies as GMAC, GM, Ford, Freescale semiconductor, E-Trade, China 3C group, etc. The price to get a loan is about 3% above what it was same time last year. This rate implies the expected default rate of over 9%, the default rate for January is 1.09%.

I would say the debt market has no illusion about the prospects of this economy. Does the stock market discount the expectation that subprime corporations will start defaulting at the rate 9% per year?

Maybe the corporations think that this is a temporary phenomena and it’s better o hold on a bit and issue bonds later? Not at all, they are trying to lock into rates:

Corporate treasurers are increasing sales of long-term investment-grade bonds for the first time in a decade, a sign they’re betting U.S. borrowing costs will rise as the Federal Reserve slows the pace of interest-rate cuts.

What about the volume?

First-quarter investment-grade sales fell to $210 billion from a record $281 billion a year earlier. New issuance of speculative- grade, or junk, bonds plunged to $10.4 billion from $42 billion.

This is the real, main street credit crunch, which has nothing to do with subprime mortgages

Latest – Banks borrow 10.3 bln usd from discount window, largest since Sept. 2001. We all thought that $100 bln TAF would cover everything. I guess now they need $110. At the same time the outstanding banking credit just declined by $31 bln and commercial paper declined by another $5 bln. When banks are increasing lending and then run to discount window – this is bad. When banks contract lending and still run to discount window – this is panic. I hope that you are all aware that non-borrowed reserves of depository institutions stand at -$61 bln? Good.

The wise men from used to say:

Bull markets are climbing the wall of worry, bear markets slide the slope of hope

In the last couple of days I hear a lot of totally misplaced optimism from radio and TV. “Jobs are lagging indicator so bad jobs numbers mean we bottomed”. What this guy had for logic? “We are looking to buy early cycle leaders, like transports and basic materials because we are early in the next cycle”. Materials are late cycle leaders, not early. First you have to wait until late cycle leaders crash before you conclude that the cycle is restarting.

Look at the KRE – regional banking sector. This chart will bottom well before the economic cycle bottoms. Those banks are lending to main street business. Until you see the Street Corner Bank doing well it means matters will continue to get worse.

And those who claim that credit crunch is reaching the bottom are not bringing any arguments. I do. Wells Fargo is still lending mortgages with 0% down. Right now. Next week they will require to bring 3% down. In early 1990s when the last housing bubble popped nobody was lending unless you bring some serious downpayment. 5%, 10%, 20% – depending on conditions, but never 3%. Lets wait until we get there before we call the bottom.

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