Chicago finances are even worse than I thought which is saying quite a bit because I have written about the sorry state of Chicago finances on numerous occasion.

Kristi Culpepper, a bond guru, has gone over Chicago’s annual financial report, bond documents, investor presentations, and CAFRs.  She has uncovered things the City of Chicago does not want anyone to understand.

For example, Culpepper reports Chicago general obligation bond deals have been used by the city as a means to avoid servicing short-term debt. Says Culpepper, “These bonds have received extraordinarily aggressive tax opinions . If the Internal Revenue Service ever gets around to scrutinizing them, your bonds probably won’t be tax exempt for long. Many of these uses of bond proceeds are not eligible for tax-exempt financing under the federal tax code.”

That is just the tip of the iceberg as to what Culpepper has discovered.

Who Is Kristi Culpepper?

Intrigued? You should be.

First let’s go over Culpepper’s background. Kristi Culpepper is a state government official with the Commonwealth of Kentucky. Among other things, she handles the structuring and sale of bonds for schools across the state. Previously, she worked for the Kentucky General Assembly analyzing state and local government bond issues and tracking the state’s capital construction programs. She has also worked at Merrill Lynch.

“Bond Girl”

Culpepper built up a huge following as “Bond Girl”. Bloomberg explains Twitter’s ‘Bond Girl’ Outs Herself as Kentucky Official.

Bond Girl, using the Twitter handle @munilass, had been posting commentary about state and city borrowing and issues beyond public finance since April 2011. Her sometimes-pointed posts attracted the attention of municipal-bond investors, bankers and analysts. Using her nom de Twitter, Culpepper sparred with other users, criticized public officials and vented about her life.

Culpepper “is regarded as an authority on capital projects and debt by the Legislative body,” according to a Kentucky Education Department website posted in November that announced her appointment. “She has worked with legislators, lobbyists, and attorneys to draft legislation and effect policy changes related to the state’s bonded indebtedness.”

Buyers and traders in the $3.7 trillion muni market had puzzled at the true identity of Bond Girl, Hector Negroni, co-founder of New York-based investing firm Fundamental Credit Opportunities, said in a telephone interview.

For any bond geek like myself, she’s fascinating, well-informed and entertaining,” Negroni said.

On Oct. 28, as Bond Girl, she wrote a 1,650-word blog post for the Financial Times’ Alphaville on a proposed debtor-in-possession financing for bankrupt Detroit.

Guest Post

I mention the above to prove Culpepper is highly regarded in the industry. She knows what she is talking about.  

The following guest post by Culpepper first appeared on Tumblr as How Chicago has used financial engineering to paper over its massive budget gap.

For those who want to follow Culpepper, her Twitter handle is @munilass.
I dispense with my usual blockquotes for ease in reading. What follows is a guest post by Kristi Culpepper.

Emphasis in Italics is Mine – My Comments and Recommendations follow Culpepper.

How Chicago Used Financial Engineering to Paper Over its Massive Budget Gap

Chicago made headlines at the end of February after Moody’s downgraded the city’s general obligation bond rating to Baa2. Moody’s has cut Chicago’s rating five notches in less than two years. This downgrade, however, placed the city’s credit below the termination triggers on some of its outstanding interest rate swaps. The city has been working to renegotiate the terms of those contracts with its counterparties.

If Chicago’s general obligation rating falls below investment grade, the city’s credit deterioration will become a self-fulfilling prophesy. The city risks nearly $400 million of swap termination payments and the acceleration of its $294 million of outstanding short-term debt.

Unsurprisingly, some of Chicago’s bonds are already trading at junk levels. Chicago CUSIPs are listed here.

That said, the rating agencies and most other market participants still appear to be light years away from understanding the true scope of Chicago’s financial problems. The city has a very — well, let’s just call it unconventional — approach to borrowing money and probably should not be considered investment grade.

Some Budget History

In order for you to follow my discussion of Chicago’s borrowing shenanigans, it is necessary to understand the fiscal machinery behind its bond issues. Please be patient with me here. This story will blow your mind shortly.

Chicago’s budget is divided into seven different fund classifications, but only three funds are relevant to our narrative: the Corporate Fund, Property Tax Fund, and Reserve Funds.

The Corporate Fund is Chicago’s general operating fund. This fund is used to pay for essential government services and activities (e.g. public safety and trash collection). Corporate Fund revenues are derived from a wide variety of sources, including: (1) local tax revenue from utility, transaction, transportation, recreation, and business taxes; (2) intergovernmental tax revenue, which represents the city’s share of the state’s sales and use taxes, income tax, and personal property replacement tax; and (3) non-tax revenue from fees, fines, asset sales, and leases.

Chicago’s property tax revenues do not go into its general operating fund. These revenues go into a Property Tax Fund, which is used to make debt service payments on the city’s general obligation bonds; make required employee pension contributions; and (to a minor extent) fund the library system. The fund also includes tax increment financing revenues that flow to projects in designated TIF districts.

The city used some of the proceeds from long-term leases of city assets to establish Reserve Funds. The Chicago Skyway reserve funds were established in 2005 in the amount of $975 million. The Metered Parking System reserve funds were established in 2009 in the amount of $1.15 billion. Of these funds, $475 million of the Skyway reserves were designated for budgetary uses. What remained was $500 million for the Skyway; $400 million for the Metered Parking System; and $326 million for a budget stabilization fund.

There has been a structural gap in Chicago’s Corporate Fund budget since at least 2003. Although most governments are required to balance their budgets on a cash flow basis each fiscal year, a structural budget gap can arise when recurring expenditures are greater than recurring revenues. Some of the city’s offering documents suggest that this gap is a legacy of the last economic downturn, but in reality the gap pre-dates the economic downturn by several years. The impact of economic downturns on tax collections tends to have a considerable lag anyway.

So, Chicago’s structural budget gap is a political, not economic, creature. Rather than cut expenditures to a level that could be supported by recurring revenues, the city mostly used non-recurring resources to fill the gap from one fiscal year to the next. This is not surprising. Most of Chicago’s Corporate Fund budget goes to salaries and benefits for its employees, and 90% of the city’s employees belong to around 40 different unions. Attempts to adjust expenditures tend to have well organized opposition.

Between fund transfers and drawing down its reserves, the city blew through its financial cushioning quickly. The $326 million budget stabilization fund was exhausted by 2010. From 2009 to 2011, the city used $320 million from the Metered Parking Reserves. The city’s budget gap was at its widest in the wake of the last economic downturn, at over $600 million.

Chicago’s Dysfunctional Debt Program

Now things start to get interesting. Transfers from reserves and other funds have not been the only means Chicago officials (across administrations) have devised to subsidize the city’s Corporate Fund. The city has effectively been using its general obligation bond offerings and interest rate derivatives to accomplish the same thing.

State and local governments typically use the proceeds from their bond offerings to construct or renovate public buildings and infrastructure. These are projects that have long useful lives and will benefit residents for generations.

Dating back to at least 2003, however, Chicago has been issuing long-term tax-exempt and taxable bonds to:

(1) Roll over short-term debt used as working capital;

(2) Pay for maintenance activities that would otherwise be paid from the Corporate Fund;

(3) Pay for judgments and settlements that would otherwise be paid from the Corporate Fund, including wage increases and retroactive pension contributions for its employees; and

(4) Provide discretionary funds to each of the city’s 50 aldermen to pay for activities in their own districts.

The magnitude of tax-exempt bond proceeds used for judgments and settlements over this period is staggering. The Chicago Tribune estimated it at approximately $400 million:

In 2002, for example, the city used tax-exempt bonds to pay an arbitration award involving the Fraternal Order of Police. Rank-and-file officers rejected a city contract offer in 2001, but an arbitrator ruled in favor of the city’s wage proposal a year later.

The deal included raises of 2 to 4 percent a year, to be applied retroactively. In bond documents, city officials deemed the back pay the city owed an extraordinary expense and paid $164 million of it with tax-exempt bonds.

The city ultimately will need to pay bondholders $280 million to cover the loan …

Bonds also ended up covering the $28 million a jury awarded to Joseph Regaldo in 1999. The jury found that, years earlier, a Chicago police officer had beaten him in the back of the head and neck with a blunt object, which ripped apart an artery and cut off the blood supply to his brain. The injuries left Regaldo unable to walk, talk or care for himself.

The judgment won’t be paid off until 2019 at the earliest; by then, the total cost will have grown to $53 million.

City officials eventually switched to paying judgments with taxable bonds, which are even more costly in the long run.

That is, until 2012:

About $54 million from a tax-exempt bond helped cover a legal judgment awarded to African-Americans who were denied a chance to become firefighters by a 1990s entrance exam that favored white applicants. An additional $8 million in tax-exempt bond money went to pay legal fees related to the case, records show.

By using bond money, the city created an irony for many of those awarded damages, as their future property taxes will help pay interest on the debt. In 2033, when the city starts paying down the $54 million, interest will have more than doubled the total cost.

Stop and let that sink in for a moment. That police brutality case? Wage increases negotiated with labor unions? Not just financed, but financed with long-term debt.

So why haven’t the city’s 50 aldermen protested the use of bond proceeds for these purposes? It probably has something to do with the “Aldermen’s Menu,” which allows the aldermen to use a portion of the proceeds from the city’s general obligation bond issues to pay for whatever they want for their district.

It is unclear (to me) whether the city tracks how the funds from the “Aldermen’s Menu” are spent, but in the aggregate they are not a negligible amount. From 2003 to 2012, these projects have ranged from $54.2 million to $102 million.

The use of bond proceeds to provide slush funds for policymakers has a historic analog in the revenue bonds Harrisburg issued for its incineratorproject as the city was on its path to insolvency. Pennsylvania law limits the amount of debt local governments can issue to finance projects that are not self-supporting. Substantially all of the bonds tied to the incinerator project were issued to provide working capital, although city officials were able to locate financial advisory firms that were willing to certify the opposite to state regulators.

In order to win authorization for bond issues that outright defied state law, Harrisburg’s later bond issues included a “Special Projects Fund” for city officials to play with. They bought things like artifacts for a Wild West Museum. In Pennsylvania. Don’t think too hard, there is no why.

See? Reading the Sources and Uses provisions in official statements can be fun. I know, this makes you want to invite me to your next dinner party.

Our story gets even more interesting when you look at how Chicago’s past general obligation bond offerings have been structured.

First, the city has undertaken several large, non-traditional refundings to push the maturities on debt that is coming due out into later years.

A traditional refunding is akin to how a homeowner refinances a mortgage loan. A new loan is used to prepay an old loan to achieve an interest cost savings. A “scoop and toss” refunding, which is what Chicago has done, involves additional interest cost — even in a ridiculously low interest rate environment — because the debt remains outstanding for a longer period of time.

The objective of these deals was to provide budget relief for the city’s general operating fund in the short term, even if the structure means escalating debt service payments in the long term. These restructurings artificially inflated the city’s debt capacity, so the city could continue to use property tax-supported bonds to take out the city’s working capital credit facilities, which allowed the city to avoid balancing its Corporate Fund budget.

Chicago is far from the only government to restructure debt for budget relief. Quite a few state and local governments engaged in similar transactions following the last recession. What makes Chicago unique is, again, the magnitude of this activity. According to the Chicago Tribune, “since 2000, the city has used $3.6 billion in bond money to refund old debt as principal payments came due. Of that amount, half will end up costing taxpayers in the long run.” For the sake of comparison, Chicago has around $7.2 billion of general obligation bonds outstanding.

Second, Chicago’s past few general obligation bond offerings have involved considerable amounts of capitalized interest.

Capitalized interest is typically associated with project finance, not general obligation bond issues. Project finance is a sector where loans finance revenue-producing facilities and infrastructure. The debt is supported by those revenues, not taxes as with general obligation bonds.

With capitalized interest, a bond issuer borrows more money than a project requires for construction in order to pay the interest on the bonds while the project is being built. The idea here is that the project will eventually generate revenues that can support debt service payments and the cost added by capitalizing interest.

From 2010 to 2014, Chicago’s general obligation bond deals included over $235 million of capitalized interest, simply as a means for the city to avoid servicing its debt in the short term.
If you are a bondholder, there are two things you should take away from this segment of our narrative.

First, if you hold the tax-exempt portion of these deals and the Internal Revenue Service ever gets around to scrutinizing them, your bonds probably won’t be tax exempt for long. Many of these uses of bond proceeds are not eligible for tax-exempt financing under the federal tax code. These bonds have received extraordinarily aggressive tax opinions — including, incidentally, from the same law firm that drafted Illinois’s swap legislation, which I will get to momentarily.

Second, Chicago taxpayers are on the hook for billions of dollars of long-term debt and have little of tangible value to show for it. There is a good chance that residents do not understand the nature of their government’s borrowing activities, since these were complex offerings. (Well, unless they read what I have written here…) As debt service payments increasingly compete with other political priorities for funding, this revelation might eventually erode the city’s willingness to pay.
These transactions should never have happened.

Chicago’s Interest Rate Derivatives Portfolio

Perhaps a third thing a bondholder should take away from our narrative is that to the extent Chicago is slapped with future termination payments on its interest rate derivatives, the security for your investment will be diluted. Since Chicago’s property tax revenues are also applied to pension contributions and the debt/derivatives of several other overlapping taxing districts, this is not an insignificant factor.

The State of Illinois authorized local governments to use interest rate derivatives in 2003. Here is a link to the legislation. The bill restricts the notional amount of a municipality’s interest rate derivatives to the outstanding debt the contracts will ostensibly hedge. Since the notional amount of a swap, etc. says nothing about an issuer’s risk exposure, this provision is pretty much worthless. And since the legislation was drafted by the financial industry, that probably wasn’t an accident.
The legislation allows the municipality to make payments due under the swap contract (which would include termination payments) from any source of revenue it has, including property taxes. This probably wasn’t an accident either.

Chicago used interest rate swaps on its 2003, 2005, 2007, and 2009 bond deals, apparently as part of a synthetic fixed rate strategy. (I explain the mechanics of synthetic fixed rate deals in this essay.) The city also recreationally experimented with more exotic contracts — swaptions and the like.
The associated bond offerings were multimodal. Multimodal bonds are bonds that can be converted to any of a number of interest rate modes at the option of the issuer. Bond documents allow the bonds to be remarketed daily, weekly, or monthly as variable rate tender option bonds, or in term or fixed rate modes. Like capitalized interest, this structure is typically used only in project finance. The multimodal structure allows long-term debt to function as both interim and permanent financing to accommodate the life cycle of a revenue-producing project.

Because the underlying debt is multimodal, Chicago never required interest rate derivatives to hedge its interest rate exposure. The city could have virtually any interest rate exposure it wanted as the bonds were remarketed. Why don’t all government issuers use this structure, you ask? Because most governments value predictable payments over trying to handicap interest rate trends and basis risk. That’s a function of being tethered to a budget.

As I noted at the beginning of this essay, Chicago is now almost $400 million out-of-the-money on its outstanding swaps. This only matters to the extent that the city’s credit ratings continue to sink toward termination triggers. Only one rating agency has to break these thresholds — so, even though S&P and Fitch still somehow believe Chicago is an A+/A- credit, Moody’s is the only rating agency that matters. If the city doesn’t get cut to junk and interest rates normalize, Chicago’s interest rate swap situation will eventually repair itself. The tipping point here either way is probably the outcome of the state/city’s pension litigation.

Chicago Public Schools — which already takes more property tax revenues from Cook County than the City of Chicago — has a swap/pension nightmare of its own to muddle through. Between the city and school system, area residents are at risk of making/financing $660 million of termination payments. The payments would compete with $28.3 billion of city and overlapping debt and billions of dollars of escalating pension contributions for funding. Basically, if you are in Chicago, your property is about to become more expensive.

From the outside, it looks like Chicago also used its interest rate swaps as a means of drumming up non-recurring resources to fill its budget gap in 2010 and 2011. If so, this is another example of the city’s willingness to trade long-term costs for avoiding politically inconvenient spending decisions.

The city made amendments to outstanding swap contracts by layering on forward-starting basis swaps. (This is something else Chicago has in common with Harrisburg.) These transactions changed the city’s net interest rate exposure on those deals from fixed to variable and introduced basis risk to the portfolio after they became effective in 2014. There was not an event that prompted these amendments and the city remains underwater on the deals. The city did receive a series of up-front payments, however. Judging from the swap confirmations from Deutsche Bank, PNC, and Wells Fargo, these payments amounted to around $25 million.

Could Chicago File for Chapter 9 Bankruptcy?

No. At least not right now. To be eligible to file for bankruptcy under Chapter 9, there must be a state law that specifically authorizes a municipality to do so. Illinois law does not currently permit municipalities to do so, except under a provision that relates to units of governments with populations under 25,000. Of course, Chicago would also have to meet the other eligibility criteria. The city does have a relatively large tax base.

That said, if state lawmakers wanted to give Chicago the ability to adjust its pension liabilities — its pensions have an aggregate funded ratio of 37% — amending a statute is a lot easier than amending the state constitution. Article 8, Section 5, of the Illinois Constitution says: “Membership in any pension or retirement system of the State, any unit of local government or school district, or any agency or instrumentality thereof, shall be an enforceable contractual relationship, the benefits of which shall not be diminished or impaired.”

Multiple federal bankruptcy judges have ruled that the federal bankruptcy code supersedes state constitutions, which theoretically provides a path for municipalities to adjust their pension commitments. The rulings have not been challenged in an appellate court, however, so there isn’t a bona fide legal precedent yet.

Illinois’s Constitution describes pension commitments as contractual in nature. For an obligation to be considered secured in bankruptcy, there has to be a property interest.

This logic also applies to the city’s general obligation debt though. For most of the city’s outstanding general obligation bonds, the city has pledged a specific property tax levy. Illinois is not one of the handful of states that provides general obligation debt a statutory lien. So it would seem, in my very non-legal opinion, that the bonds would be considered unsecured debt.

As I noted earlier, the city’s general obligation bond offerings have provided little of tangible value to taxpayers. If the city were authorized to file for bankruptcy and actually did so, there could potentially be political pressure to adjust general obligation debt before depriving pension beneficiaries their incomes.

It seems unlikely that the state or federal government would “Lehman” Chicago. It is the third largest city in the United States and a vital transportation hub. It seems reckless, however, to dismiss this possibility in its entirety over the medium term.

When you tally up the ways bond proceeds have been used to offset operating expenses, scoop and toss restructurings, capitalized interest, and swap modifications, the city’s cumulative Corporate Fund budget gap is much, much larger than the city’s disclosures imply. At some point, this manner of doing business will collapse.

END  Culpepper

There is much above to digest. Anyone investing in Chicago “Tax Exempt” bonds need beware.

Meanwhile, and in regards to Culpepper’s article, Yahoo! Fiance reports “The City of Chicago Mayor’s office did not respond to multiple calls and emails seeking comment on the matter.”

Politically and Financially Bankrupt

I have stated many times, my belief that Chicago is bankrupt; it’s just not officially recognized. Actually, Chicago is both politically and financially bankrupt.

The analysis from Culpepper confirms my belief. Her report provides many more details of what’s really behind Moody’s downgrade.

I wrote about the downgrade in Chicago’s Fiscal Freefall: Moody’s Cuts Chicago Credit Rating to Two Steps Above Junk; Snake Oil and Swaps; It’s All Junk Now.

When will Fitch and the S&P catch up? Perhaps after they see this article.

Chapter 9 Bankruptcy Test

My personal viewpoint on bankruptcy aside, it’s important to point out that Chapter 9 has a different insolvency test than corporate bankruptcy.

It is not a balance sheet test, but a cash flow test. Municipality has to be in a position where it cannot make near-term payments on obligations as they come due (like within six months). This is one of several eligibility criteria. So Chicago is not bankrupt by definition (yet) and has a huge tax base. The biggest risk to residents (now) is that they are in for an absolutely massive property tax hike to pay for debt and pensions,” says Culpepper.

Pension Liabilities

On March 2, I wrote Illinois Pension Plans 39% Funded; Taxpayers On the Hook for $105 Billion in Liabilities; It Will Get Worse!

That was my second article for the Illinois Policy Institute where I am now a senior fellow. Please give it a look as it contains a detailed look at horribly funded Illinois Pension Plans state-wide, not just Chicago.

World of Hurt Coming Up

When the equity and junk bond bubbles break (and they will – big time), Illinois and numerous cities in the state will be in a world of hurt.

It is imperative the Illinois legislature start addressing these issues right now. Of course, California and numerous other states will be affected as well.

Needed Legislation

I mentioned three things Illinois needs to do in my first post for the Illinois Policy Institute: Right-to-Work Sweeps Midwest, Heads for Passage in Wisconsin.

  1. Eliminate collective bargaining of public unions
  2. Pass Right-to-Work legislation
  3. Scrap prevailing-wage legislation

Cities, municipalities, and the state itself massively overpay for services because of the influence of public unions and onerous prevailing wages laws.  This needs to stop now.

Raising Taxes Not the Answer

Raising taxes is not the answer. Illinois taxpayer pockets are nowhere deep enough to fix massive budget and pension undefundings.

Unfortunately, the Illinois legislature does not see it that way. Check out the massive Proposed Tax Hikes.

The array of six tax hikes proposed by Illinois lawmakers this legislative session adds up to more than $100 billion over the next five years. That’s more than the state’s total projected general-fund spending in fiscal years 2016, 2017 and 2018 – combined.

And the tax-hike proposals don’t stop there.

Additional tax-hike proposals are being thrown around without any idea of how much they might raise. State Rep. Rita Mayfield, D-Waukegan, proposed a 3.75% tax on guns and gun parts. When asked how much revenue it would raise, she said she didn’t know but thought “if we can get a good million or so, I’ll take it.”

Never-Ending Tax Hikes

The big problem with raising taxes is it will never stop.

Progressives will ask for more and more and more, driving businesses and mobile individuals out of the state. Moreover, tax hikes forestall the ability of municipalities to declare chapter 9.

Bankruptcy Law and Pension Reform

Rather than burden taxpayers (and tax hikes will ultimately not work any better in Illinois than they did in Detroit), Illinois desperately needs legislation to …

  1. End defined benefit pension plans
  2. Allow municipalities to set their own benefits (benefits are now they are set at the state level as if the state knows what’s best for every municipality)
  3. Allow cities and municipalities to declare bankruptcy 

Frank Discussion Needed

As I wrote on March 3, Chicago’s Only Possible Salvation is Bankruptcy – a Name That Cannot be Spoken.

The Illinois legislature and the city of Chicago both need to admit the sorry state of affairs instead of opting for can-kicking exercises that make the inevitable day of reckoning worse.

So, instead of playing shell games with derivatives, general obligation bonds and interest rate swaps, and instead of using long-term financing to fund ongoing needs, how about a frank discussion of everything discussed above?

The legislature and the City of Chicago owe taxpayers an honest assessment. It’s a sad state of affairs that we have to get that assessment from a bond guru in Kentucky.

Unsurprisingly, Chicago city officials would not comment.

Mike “Mish” Shedlock


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Our Current Illusion Of Prosperity

On April 1, 2015, in , by Tyler Durden


Submitted by Frank Hollenbeck via The Mises Institute,

President Obama and Fed Chair Janet Yellen have been crowing about improving economic conditions in the US. Unemployment is down to 5.5 percent and growth in 2014 hit 2.2 percent.

Journalists and economists point to this improvement as proof that quantitative easing was effective.

Pile on More Debt

Unfortunately, this latest boom is artificial and has been built by adding debt on top of debt. Total household debt increased 2.5 percent in 2014 — the highest level since 2010. Mortgage loans increased 1.5 percent, student loans 6.6 percent while auto loans increased a hefty 9.6 percent. The improving auto sales are built mostly on a bubble of sub-prime borrowers. Auto sales have been brisk because of a surge in loans to individuals with credit scores below 620. Since 2010, such loans have increased over 100 percent and have gone from 20 percent of originations in 2009 to 27 percent in 2013. Yet, auto loans to individuals with strong credit scores, above 760, have barely budged over the last year.

Subprime consumer borrowing climbed $189 billion in the first eleven months of 2014. Excluding home mortgages, this accounted for 41 percent of total consumer lending. This is exactly the kind of lending that got us into trouble less than a decade ago, and for many consumers, this will only end in tears.

But we need to ask ourselves: is the current boom built on sound foundations? In other words, do we have sharp increases in productivity or real wage growth?

Productivity increased less than 1 percent on average in the last three years and real wages have flat lined or declined for decades. From mid-2007 to mid-2014, real wages declined 4.9 percent for workers with a high school degree, dropped 2.5 percent for workers with a college degree and rose just 0.2 percent for workers with an advanced degree.

Is the boom being built on broad base investment in plant and equipment? The current average age of working plants and equipment in the US is one of the oldest on record.

Meanwhile, it is now clear that the shale boom was an illusion of prosperity. Oil prices have dipped below $50 with some analysts calling for $20 oil by the end of the year. This is a drop from over $100 from last year. Many shale outfits need oil above $65 just to break even. Massive layoffs in the energy sector are now a certainty. Few realize that most of the gains in employment in the US since 2008 have been in shale states. Yet the carnage is not over. Induced by low interest, investment banks loaned over 1 trillion dollars to the energy industry. The impact on the financial sector is still to be felt.

There Has Not Been a True Home Price Correction

The same is true about current increases in housing prices and construction costs. Following the financial crisis of 2008, real estate prices should have dropped much more than they did relative to other prices. The new reality between supply and demand would have led to a price correction similar to the ones we see in oil prices today or to high-flying internet stocks after the dot-com bubble burst. Housing should then have remained in a slump possibly for a decade or more, until the overhang of empty residential and commercial real estate had been cleared off.

Today, housing is back, with price increases at bubble-era levels and construction activity is picking up. The improvement is being driven by professional investors stretching for yield in the buy-to-rent market and by historically low long-term mortgage rates of below 4 percent. Yet, the overhang of empty commercial properties from the previous boom has not disappeared. It has just been left in limbo, because of the “extend and pretend” strategy of banks made possible by the central bank’s massive printing over the last six years. The number of vacant units (table 7) in the US still stands at over 18 million units — a level reached back in 2008–2009. As of 2014, the number of units held off the market was still at a record level of over 7 million units.

Will Easy Money Fix Everything?

Current policy coming from the Fed seems to be geared to create a never-ending series of booms and busts, with the hope that the busts can be shortened with more debt and easy money.

Yet one major driver behind the financial crisis in 2008 was too much debt – much of which led to taxpayer-funded bailouts. In spite of this, the best the Fed can come up with now is to lower interest rates to boost demand to induce households and governments to borrow even more.

Interfering with interest rates, however, is by far the most damaging policy. The economy is not a car, and interest rates are not the gas pedal. Interest rates play a critical role in aligning output with society’s demand across time. Fiddling with them only creates an ever-growing misalignment between demand and supply across time requiring an ever larger and more painful adjustment.


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The Shanghai stock market is on a tear as the following charts show.

$SSEC Shanghai Stock Exchange Monthly

click on any chart for sharper image

$SSEC Shanghai Stock Exchange Weekly

Cannot Wait to Get In

Since July 2014, the index has gone from roughly 2066 to 3810. That is a rise of 84% in eight months. As with every major bull market participants just cannot wait to get in, and cannot get in enough when they do.

China Margin Debt Soars to 1 Trillion Yuan

Bloomberg reports Shanghai Traders Make Trillion-Yuan Stock Bet With Borrowed Cash.

Shanghai traders now have more than 1 trillion yuan ($161 billion) of borrowed cash riding on the world’s highest-flying stock market.

The outstanding balance of margin debt on the Shanghai Stock Exchange surpassed the trillion-yuan mark for the first time on Wednesday, a nearly fourfold jump from just 12 months ago. The city’s benchmark index has surged 86 percent during that time, more than any of the world’s major stock gauges.

While the extra buying power that comes from leverage has fueled the Shanghai Composite Index’s rally, it’s also sending equity volatility to five-year highs and may accelerate losses if a market reversal forces traders to sell. Margin debt has increased even after regulators suspended three of the nation’s biggest brokers from adding new accounts in January and said securities firms shouldn’t lend to investors with less than 500,000 yuan.

“It’s like a two-edged sword,” said Wu Kan, a money manager at Dragon Life Insurance Co. in Shanghai, which oversees about $3.3 billion. “When the market starts a correction or falls, it will increase the magnitude of declines.”

Chinese investors have been piling into the stock market after the central bank cut interest rates twice since November and authorities from the China Securities Regulatory Commission to central bank Governor Zhou Xiaochuan endorsed the flow of funds into equities. Traders have opened 2.8 million new stock accounts in just the past two weeks, almost on par with Chicago’s entire population.

For BNP Paribas SA economist Richard Iley, the surge in Chinese margin purchases is among signs of a bubble fueled by individual investors. More than two-thirds of new investors have never attended or graduated from high school, according to a survey by China’s Southwestern University of Finance and Economics.

“Leverage cannot rise forever,” Iley wrote in a report last month. “The more the stock of margin debt climbs, the greater the risk of a disorderly unwinding of leveraged positions once net redemptions begin to accelerate.”

Another Central Bank Sponsored Bubble

We all know how this will end.

  1. Stock market crash
  2. Statements from central banks that they had nothing to do with it
  3. Statements from analysts that “no one could see this coming”

The one thing we do not know is how big these bubbles get before they burst.

Mike “Mish” Shedlock


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Earlier today, McDonalds announced that it would become the latest company to raise hourly pay for 90,000 workers by more than 10% and add benefits such as paid vacation for its restaurant workers. Specifically, starting in July, MCD will pay at least $1 per hour more than the local legal minimum wage for employees at the roughly 1,500 restaurants it owns in the U.S. The increase will lift the average hourly rate for its U.S. restaurant employees to $9.90 on July 1 and more than $10 by the end of 2016, from $9.01 currently. Finally, McDonald’s also will enable workers after a year of employment to accrue up to five days of paid time-off annually.

With this announcement, McDonalds joins the following companies which have likewise raised minimum wages in recent months:

  • WalMart
  • Aetna
  • Gap
  • Ikea
  • Target
  • TJ Maxx

Surely this is great news for the workers of these above companies, as some of the massive wealth accrued by corporate shareholders may be finally trickling down to the lowliest of employees, right? As it turns out, the answer is far from clear.

As the following WSJ story released overnight, here is what happens when mega-corporations such as WalMart and McDonalds, whose specialty are commoditized products and services and have razor thin margins, yet which try to give an appearance of doing the right thing, raise minimum wages. They start flexing their muscles, and in the process trample all over the companies that comprise their own cost overhead: their suppliers and vendors.

Take the case of WalMart: the world’s biggest retailer “is increasing the pressure on suppliers to cut the cost of their products, in an effort to regain the mantle of low-price leader and turn around its sluggish U.S. sales.”

What WalMart is doing is borderline illegal: it is explicitly telling its vendors “this is what you will do with your excess cash.” Of course, we say borderline because WMT’s action is perfectly legal in the confines of the pure law. However, in the context of an economy that is sputtering, WMT’s vendors have no choice but to comply or risk losing what is certainly their largest revenue stream and risk bankruptcy.

The retailing behemoth says it has been telling suppliers to forgo investments in joint marketing with the retailer and plow the savings into lower prices instead. Makers of branded consumer products from diapers to yogurt typically earmark a portion of their budgets for marketing with Wal-Mart, spending on things like eye-catching product displays and online advertisements.


Wal-Mart has long had a reputation for pressing its suppliers to cut costs to help lower prices, but the retailer’s new leadership has embraced the concept with fresh vigor. Wal-Mart’s price advantage against its competitors has been eroded, and it has steadily been losing market share in the U.S. since the recession ended, while rivals including Kroger Co. and Costco Wholesale Corp. gained share, according to data from the consultancy Kantar Retail.


The new dictate on prices is creating tension with companies that supply the hundreds of thousands of products on Wal-Mart’s shelves.

The irony is that while WMT (or MCD or GAP or Target) boosts the living standards of its employees by the smallest of fractions, it cripples the cost and wage structure of the entire ecosystem of vendors that feed into it, and what takes place is a veritable avalanche effect where a few cent increase for the lowest paid megacorp employees results in a tidal wave of layoffs for said megacorp’s vendors.

The zeal on pricing is part of a push by new Chief Executive Doug McMillon and U.S. head Greg Foran to turn around Wal-Mart’s core domestic business, which booked $288 billion in sales in the year ended Jan. 31, 60% of the company’s total. While U.S. sales were up 3% last year, the growth was a scant 0.5% excluding newly opened stores, and the division’s profit fell.


Messrs. Foran and McMillon laid out the pricing message during a private meeting with suppliers in February. They want suppliers to operate with the same everyday low cost model that Wal-Mart employs from top to bottom.


“They kept pushing, ‘We’re going back to basics, it’s all about low pricing,’ ” said one supplier who attended the meeting.

And a quick lesson in corporate double speak: where the new CEO says:

“We want to get back to a point where we are playing offense with price because of the way we go to market,” Mr. McMillon said, according to a transcript. “Our pricing strategy is aimed at one objective, and that is building trust.”

… what he means is that “our strategy is to remind our vendors that we call all the shots and since we can’t cut prices any more, they will have to do it.

Messrs. Foran and McMillon laid out the pricing message during a private meeting with suppliers in February. They want suppliers to operate with the same everyday low cost model that Wal-Mart employs from top to bottom.


“They kept pushing, ‘We’re going back to basics, it’s all about low pricing,’ ” said one supplier who attended the meeting.

Which is another way of saying “deflation” in compensation, also synonymous for “lower wages for everyone else.” Because now that each of WalMart’s suppliers is forced by WMT management to cut their costs and to be “price competitive”, they will either reduce wages of its own workers or, comparably, force their own suppliers to reduce pricing, and so on, until ultimatly the entire economy is gripped in wage deflation.

Which also means that Obama, who has decided to join the Fed in micro-managing the economy by diktat, will have no choice but to issue more executive orders, to undo the aftermath of this previous short-sighted commands. Perhaps he will start be realizing that it is not minimum wage that he should be focusing on but maximum hours as explained before:

Although when faced with what now appears certain sliding wages across a deflating US economy, not even Obama will be able to come up with mutually offsetting executive orders fast enough to fix what is now a runaway train on a collision course.

In fact, the only winner here, once again, will be the banks who will continue to fabricate, spin and perpetuate the lie that the only thing that can fix the next wave of declining wages is, as always, QE – QE whose only intention and purpose is to steal from the poor and middle class and give to the 0.01%.


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Submitted by Ben Hunt via Salient Partners’ Epsilon Theory blog,


Do, or do not. There is no try.”

– Yoda, “Star Wars: Episode V – The Empire Strikes Back” (1980)




I see it all perfectly; there are two possible situations – one can either do this or that. My honest opinion and my friendly advice is this: do it or do not do it – you will regret both.
Soren Kierkegaard, “Either/Or: A Fragment of Life” (1843)

The only victories which leave no regret are those which are gained over ignorance.
Napoleon Bonaparte (1769 – 1821)

Maybe all one can do is hope to end up with the right regrets.
Arthur Miller, “The Ride Down Mt. Morgan” (1991)

Of all the words of mice and men, the saddest are, “It might have been.”
Kurt Vonnegut, “Cat’s Cradle” (1963)

One can’t reason away regret – it’s a bit like falling in love, falling to regret.
Graham Greene, “The Human Factor” (1978)

I bet there’s rich folks eatin’
In a fancy dining car.
They’re probably drinkin’ coffee
And smokin’ big cigars.
Well I know I had it comin’.
I know I can’t be free.
But those people keep-a-movin’
And that’s what tortures me.

– Johnny Cash, “Folsom Prison Blues” (1955)


Regrets…I’ve had a few.
But then again, too few to mention.

– Paul Anka, Frank Sinatra “My Way” (1969)






The Moving Finger writes; and, having writ,
Moves on: nor all thy Piety nor Wit
Shall lure it back to cancel half a Line,
Nor all thy Tears wash out a Word of it.

Omar Khayyam, “Rubaiyat” (1048 – 1141)

You can tell it any way you want but that’s the way it is. I should of done it and I didn’t. And some part of me has never quit wishin’ I could go back. And I can’t. I didn’t know you could steal your own life. And I didn’t know that it would bring you no more benefit than about anything else you might steal. I think I done the best with it I knew how but it still wasn’t mine. It never has been.”
Cormac McCarthy, “No Country for Old Men” (2005)


Yeah, right, well, great. So listen, so here’s the deal. This is what we should do. You should get off the train with me here in Vienna, and come check out the capital.




Come on. It’ll be fun. Come on.


What would we do?


Umm, I don’t know. All I know is I have to catch an Austrian Airlines flight tomorrow morning at 9:30 and I don’t really have enough money for a hotel, so I was just going to walk around, and it would be a lot more fun if you came with me. And if I turn out to be some kind of psycho, you know, you just get on the next train.
Alright, alright. Think of it like this: jump ahead, ten, twenty years, okay, and you’re married. Only your marriage doesn’t have that same energy that it used to have, y’know. You start to blame your husband. You start to think about all those guys you’ve met in your life and what might have happened if you’d picked up with one of them, right? Well, I’m one of those guys. That’s me, y’know, so think of this as time travel, from then, to now, to find out what you’re missing out on. See, what this really could be is a gigantic favor to both you and your future husband to find out that you’re not missing out on anything. I’m just as big a loser as he is, totally unmotivated, totally boring, and, uh, you made the right choice, and you’re really happy.


Let me get my bag.

Richard Linklater, “Before Sunrise” (1995)

For it falls out
That what we have we prize not to the worth
Whiles we enjoy it, but being lacked and lost,
Why, then we rack the value, then we find
The virtue that possession would not show us
While it was ours.

William Shakespeare, “Much Ado About Nothing” (1612)

When to the sessions of sweet silence thought
I summon up rememberence of things past,
I sigh the lack of many a thing I sought,
And with old woes new wail my dear time’s waste:

William Shakespeare, “Sonnet 30″ (1609)

No, I don’t have a gun.

– Nirvana, “Come As You Are” (1992)







I spend a lot of my time speaking with investors and financial advisors of all stripes and sizes, and here’s what I’m hearing, loud and clear. There’s a massive disconnect between advisors and investors today, and it’s reflected in both declining investment activity as well as a general fatigue with the advisor-investor conversation. I mean “advisor-investor conversation” in the broadest possible context, a context that should be recognizable to everyone reading this note. It’s the conversation of a financial advisor with an individual investor client. It’s the conversation of a consultant with an institutional investor client. It’s the conversation of a CIO with a Board of Directors. It’s the conversation of many of us with ourselves. The wariness and weariness associated with this conversation runs in both directions, by the way.

Advisors continue to preach the faith of diversification, and investors continue to genuflect in its general direction. But the sermon isn’t connecting. Investors continue to express their nervousness with the market and dissatisfaction with their portfolio performance, and advisors continue to nod their heads and say they understand. It reminds me of Jason Headley’s brilliant short film, “It’s Not About the Nail”, with the advisor reprising Headley’s role. Yes, the advisor is listening. But most find it impossible to get past what they believe is the obvious answer to the obvious problem. Got a headache? Take the nail out of your head. Nervous about the market? Diversify your portfolio. But there are headaches and then there are headaches. There is nervousness and then there is nervousness. It’s not about the nail, and the sooner advisors realize this, the sooner they will find a way to reconnect with their clients. Even if it’s just a conversation with yourself.

Investors aren’t asking for diversification, which isn’t that surprising after 6 years of a bull market. Investors never ask for diversification after 6 years of a bull market. They only ask for it after the Fall, as a door-closing exercise when the horse has already left the burning barn. What’s surprising is that investors are asking for de-risking, similar in some respects to diversification but different in crucial ways. What’s surprising is that investors are asking for de-risking rather than re-risking, which is what you’d typically expect at this stage of such a powerful bull market.

Investors are asking for de-risking because this is the most mistrusted bull market in recorded history, a market that seemingly everyone wants to fade rather than press. Why? Because no one thinks this market is real. Everyone believes that it’s a by-product of outrageously extraordinary monetary policy actions rather than the by-product of fundamental economic growth and productivity, and what the Fed giveth … the Fed can taketh away. 

This is a big problem for the Fed, as their efforts to force greater risk-taking in markets through LSAP and QE (and thus more productive risk-taking, or at least inflation, in the real economy) have failed to take hold in investor hearts and minds. Yes, we’re fully invested, but only because we have to be. To paraphrase the old saying about beauty, risk-taking is only skin deep for today’s investor, but risk-aversion goes clear to the bone.

It’s also the root of our current advisor-investor malaise. De-risking a bull market is a very different animal than de-risking a bear market. And neither is the same as diversification.

Let’s take that second point first.

Here’s a simple representation of what diversification looks like, from a risk/reward perspective.

                              For illustrative purposes only.

The gold ball is whatever your portfolio looks like today from a historical risk/reward perspective, and the goal of diversification is to move your portfolio up and to the left of the risk/reward trade-off line that runs diagonally through the current portfolio position. Diversification is all about increasing the risk/reward balance, about getting more reward per unit of risk in your portfolio, and the goodness or poorness of your diversification effort is defined by how far you move your portfolio away from that diagonal line. In fact, as the graph below shows, each of the Good Diversification outcomes are equally good from a risk/reward balance perspective because they are equally distant from the original risk/reward balance line, and vice versa for the Poor Diversification outcomes.

                                  For illustrative purposes only.

Diversification does NOT mean getting more reward out of your portfolio per se, which means that some Poor Diversification changes to your portfolio will outperform some Good Diversification changes to your portfolio over time (albeit with a much bumpier ride).

                                  For illustrative purposes only.

It’s an absolute myth to say that any well-diversified portfolio will outperform all poorly diversified portfolios over time. But it’s an absolute truth to say that any well-diversified portfolio will outperform all poorly diversified portfolios over time on a risk-adjusted basis. If an investor is thinking predominantly in terms of risk and reward, then greater diversification is the slam-dunk portfolio recommendation. This is the central insight of Harry Markowitz and his modern portfolio theory contemporaries, and I’m sure I don’t need to belabor that for anyone reading this note.

The problem is that investors are not only risk/reward maximizers, they are also regret minimizers (see Epsilon Theory notes “Why Take a Chance” and “The Koan of Donald Rumsfeld” for more, or read anything by Daniel Kahneman). The meaning of “risk” must be understood as not only as the other side of the reward coin, but also as the co-pilot of behavioral regret. That’s a mixed metaphor, and it’s intentional. The human animal holds two very different meanings for risk in its brain simultaneously. One notion of risk, as part and parcel of expected investment returns and the path those returns are likely to take, is captured well by the concept of volatility and the toolkit of modern economic theory. The other, as part and parcel of the psychological utility associated with both realized and foregone investment returns, is captured well by the concepts of evolutionary biology and the toolkit of modern game theory.

The problem is that diversification can only be understood as an exercise in risk/reward maximization, has next to nothing to say about regret minimization, and thus fails to connect with investors who are consumed by concerns of regret minimization. This fundamental miscommunication is almost always present in any advisor-investor conversation, but it is particularly pernicious during periods of global debt deleveraging as we saw in the 1870’s, the 1930’s, and today. Why? Because the political consequences of that deleveraging create investment uncertainty in the technical, game theoretic sense, an uncertainty which is reflected in reduced investor confidence in the efficacy of fundamental market and macroeconomic factors to drive market outcomes. In other words, the rules of the investment game change when politicians attempt to maintain the status quo – i.e., their power – when caught in the hurricane of a global debt crisis. That’s what happened in the 1870’s. That’s what happened in the 1930’s. And it’s darn sure happening today. We all feel it. We all feel like we’ve entered some Brave New World where the old market moorings make little sense, and that’s what’s driving the acute anxiety expressed today by investors both large and small. Recommending old-school diversification techniques as a cure-all for this psychological pain isn’t necessarily wrong. It probably won’t do any harm. But it’s not doing anyone much good, either. It’s not about the nail.

On the other hand, the concept of de-risking has a lot of meaning within the context of regret minimization, which makes it a good framework for exploring a more psychologically satisfactory set of portfolio allocation recommendations. But to develop that framework, we need to ask what drives investment regret. And just as we talk about different notions of volatility-based portfolio constructions under different market regimes, so do we need to talk about different notions of regret-based portfolio constructions under different market regimes.

Okay, that last paragraph was a bit of a mouthful. Let me skip the academic-ese and get straight to the point. In a bear market, regret minimization is driven by existential concerns. In a bull market, regret minimization is driven by peer comparisons.

In a bear market your primary regret – the thing you must avoid at all costs – is ruin, and that provokes a very direct, very physical reaction. You can’t sleep. And that’s why Rule #1 of de-risking in a bear market is so simple: sell until you can sleep at night. Go to cash. Here’s what de-risking in a bear market looks like, as drawn in risk/reward space.

                                            For illustrative purposes only.

Again, the gold ball is whatever your portfolio looks like today from a historical risk/reward perspective. De-risking means moving your portfolio to the left, i.e. a lower degree of risk. The question is how much reward you are forced to sacrifice for that move to the left. Perfect De-Risking sacrifices zero performance. Good luck with that if you are reducing your gross exposure. Average De-Risking is typically accomplished by selling down your portfolio in a pro rata fashion across all of your holdings, and that’s a simple, effective strategy. Good De-Risking and Poor De-Risking are the result of active choices in selling down some portion of your portfolio more than another portion of your portfolio, or – if you don’t want to go to cash – replacing something in your portfolio that’s relatively volatile with something that’s relatively less volatile.

In a bull market, on the other hand, your primary regret is looking or feeling stupid, and that provokes a very conflicted, very psychological reaction. You want to de-risk because you don’t understand this market, and you’re scared of what will happen when the policy ground shifts. But you’re equally scared of being tagged with the worst possible insults you can suffer in our business: “you’re a panicker” … “you missed the greatest bull market of this or any other generation”. Again, maybe this is a conversation you’re having with yourself (frankly, that’s the most difficult and conflicted conversation most of us will ever have). And so you do nothing. You avoid making a decision, which means you also avoid the advisor-investor conversation. Ultimately everyone, advisor and investor alike, looks to blame someone else for their own feelings of unease. No one’s happy, even as the good times roll.

So what’s to be done? Is it possible to both de-risk a portfolio and satisfy the regret minimization calculus of a bull market?

Through the lens of regret minimization, here’s what de-risking in a bull market looks like, again as depicted in risk/reward space:

                                             For illustrative purposes only.

Essentially you’ve taken all of the bear market de-risking arrows and moved them 45 degrees clockwise. What would be Perfect De-Risking in a bear market is only perceived as average in a bull market, and many outcomes that would be considered Good Diversification in pure risk/reward terms are seen as Poor De-Risking. I submit that this latter condition, what I’ve marked with an asterisk in the graph above, is exactly what poisons so many advisor-investor conversations today. It’s a portfolio adjustment that’s up and to the left from the diagonal risk/reward balance line, so you’re getting better risk-adjusted returns and Good Diversification – but it’s utterly disappointing in a bull market as peer comparison regret minimization takes hold. It doesn’t even serve as a Good De-Risking outcome as it would in a bear market.

Now here’s the good news. There are diversification outcomes that overlap with the bull market Good De-Risking outcomes, as shown in the graph below. In fact, it’s ONLY diversification strategies that can get you into the bull market Good De-Risking area. That is, typical de-risking strategies look to cut exposure, not replace it with equivalent but uncorrelated exposure as diversification strategies do, and you’re highly unlikely to improve the reward profile of your portfolio (moving up vertically from the horizontal line going through the gold ball) by reducing gross exposure. The trick to satisfying investors in a bull market is to increase reward AND reduce volatility. I never said this was easy.

                                    For illustrative purposes only.

The question is … what diversification strategies can move your portfolio into this promised land? Also (as if this weren’t a challenging enough task already), what diversification strategies can work quickly enough to satisfy a de-risking calculus? Diversification can take a long time to prove itself, and that’s rarely acceptable to investors who are seeking the immediate portfolio impact of de-risking, whether it’s the bear market or bull market variety.

What we need are diversification strategies that can act quickly. More to the point, we need strategies that can react quickly, all while maintaining a full head of steam with their gross exposure to non-correlated or negatively-correlated return streams. This is at the heart of what I’ve been calling Adaptive Investing.

Epsilon Theory isn’t the right venue to make specific investment recommendations. But I’ll make three general points.

First, I’d suggest looking at strategies that can go short. If you’re de-risking a bull market, you need to make money when you’re right, not just lose less money. Losing less money pays off over the long haul, but the long haul is problematic from a regret-based perspective, which tends to be quite path-sensitive. Short positions are, by definition, negatively correlated to the thing that they’re short. They have a lot more oomph than the non-correlated or weakly-correlated exposures that are at the heart of most old-school diversification strategies, and that’s really powerful in this framework. Of course, you’ve got to be right about your shorts for this to work, which is why I’m suggesting a look at strategies that CAN go short as an adaptation to changing circumstances, not necessarily strategies that ARE short as a matter of habit or requirement.

Second, and relatedly, I’d suggest looking at trend-following strategies, which keep you in assets that are working and get you out of assets that aren’t (or better yet, allow you to go short the assets that aren’t working). Trend-following strategies are inherently behaviorally-based, which is near and dear to the Epsilon Theory heart, and more importantly they embody the profound agnosticism that I think is absolutely critical to maintain when uncertainty rules the day and fundamental “rules” change on political whim. Trend-following strategies are driven by the maxim that the market is always right, and that’s never been more true – or more difficult to remember – than here in the Golden Age of the Central Banker.

Third, these graphs of portfolio adjustments in risk/reward space are not hypothetical exercises. Take the historical risk/reward of your current portfolio, or some portion of that portfolio such as the real assets allocation, and just see what the impact of including one or more liquid alternative strategies would be over the past few years. Check out what the impact on your portfolio would be since the Fed and the ECB embarked on divergent monetary policy courses late last summer, creating an entirely different macroeconomic regime. Seriously, it’s not a difficult exercise, and I think you’ll be surprised at what, for example, a relatively small trend-following allocation can do to de-risk a portfolio while still preserving the regret-based logic of managing a portfolio in a bull market. For both advisors and investors, this is the time to engage in a conversation about de-risking and diversification, properly understood as creatures of regret minimization as well as risk/reward maximization, rather than to avoid the conversation. As the old saying goes, risk happens fast. Well … so does regret.  


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Last week we highlighted a Bloomberg chart which showed that more than a quarter of new investors in the “self-feeding, leverage-fueled domestic frenzy” that is China’s equity market have an elementary school level education or less. Bloomberg categorized nearly 6% of new Chinese stock investors as “illiterate.” If true, we imagine this doesn’t bode particularly well for a bubble that’s been inflated on the back of massive leverage (buying on margin accounts for a fifth of daily turnover and margin debt now sits at 1% of GDP). As a reminder, here’s the graphic: 


Now, thanks to the China Securities Depository and Clearing Co., we get a look at just how quickly the situation is escalating. Nearly 1.7 million new stock accounts were created last week…

…marking a 49% increase from the previous week…

…which itself represented a 58% increase from the week before…

Here’s more via Bloomberg:

To get a sense of the frenzy in China’s world-beating equity market, consider this: In a two-week span last month, the rally lured 2.8 million rookie stock pickers, almost the equivalent of Chicago’s entire population.


The number of new equity accounts surged to a record during the two weeks ended March 27, five times the average of the past year, data from China Securities Depository and Clearing Co. showed on Tuesday. About 4 million were opened in

March, enough for every person in Los Angeles. More than two-thirds of new investors have never attended or graduated from high school, according to a survey by China’s Southwestern University of Finance and Economics.


Signs of inexperienced investors’ growing influence on the $6.5 trillion market have already shown up in the outperformance of China’s equivalent of penny stocks and a jump in share-price volatility to the highest level in five years. While fresh capital may feed market momentum as the government steps up efforts to support economic growth, foreign money managers have been selling shares on concern the gains are overdone.


“A lot of speculative money has come into the market,” Michael Wang, a strategist at hedge fund Amiya Capital LLP, said by phone from London. The rally “is not fundamentally driven. It’s much more of a flow-driven phenomenon,” he said.

*  *  *

We certainly don’t see what could go wrong here. Last month alone, a new investor base the size of Los Angeles — many of whom may be only semi-literate — piled into Chinese equities which have nearly doubled in the space of 8 months on the back of margin debt that can now be measured as a percentage of GDP and volatility is at a 5-year high. Everything should be fine. 


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Submitted by Michael Snyder via The Economic Collapse blog,

When an economic crisis is coming, there are usually certain indicators that appear in advance.  For example, commodity prices usually start to plunge before a recession begins.  And as you can see from the Bloomberg Commodity Index which you can find right here, this has already been happening.  In addition, I have previously written about how the U.S. dollar went on a great run just before the financial collapse of 2008.  This is something that has also been happening over the past few months.  Some people would have you believe that nobody can anticipate the next great economic downturn and that to try to do so is just an exercise in “guesswork”.  But that is not the case at all.  We can look back over history and see patterns that keep repeating.  And a lot of the exact same patterns that happened just before previous stock market crashes are happening again right now.

For example, let’s talk about the price of oil.  There are only two times in history when the price of oil has fallen by more than 50 dollars in a six month time period.  One was just before the financial crisis in 2008, and the other has just happened…

Price Of Oil 2015

As a result of crashing oil prices, we are witnessing oil rigs shut down in the United States at a blistering pace.  In fact, almost half of all oil rigs in the U.S. have already shut down.  The following commentary and chart come from Wolf Richter

In the latest week, drillers idled another 41 oil rigs, according to Baker Hughes. Only 825 rigs were still active, down 48.7% from October. In the 23 weeks since, drillers have idled 784 oil rigs, the steepest, deepest cliff-dive in the history of the data:


Fracking Bust 2015

We are looking at a full-blown fracking bust, and this bust is already having a dramatic impact on the economies of states that are heavily dependent on the energy industry.

For example, just check out the disturbing number that just came out of Texas

The crash in oil prices is hammering the Texas economy.


The latest manufacturing outlook index from the Dallas Fed plunged again in March, to -17.4 from -11.2 in February, indicating deteriorating business conditions in the state.


But this pain is going to be felt far beyond Texas.  In recent years, Wall Street banks have made a massive amount of money packaging up energy industry loans, bonds, etc. and selling them off to investors.

If that sounds similar to the kind of behavior that preceded the subprime mortgage meltdown, that is because it is.

Now those loans, bonds, etc. are going bad as the fracking bust intensifies, and whoever is left holding all of this worthless paper at the end of the day is going to lose an extraordinary amount of money.  Here is more from Wolf Richter

It suited Wall Street just fine: according to Dealogic, banks extracted $31 billion in fees from the US oil and gas industry and its investors over the past five years by handling IPOs, spin-offs, “leveraged-loan” transactions, the sale of bonds and junk bonds, and M&A.


That’s $6 billion in fees per year! Over the last four years, these banks made over $4 billion in fees on just “leveraged loans.” These loans to over-indebted, junk-rated companies soared from about $40 billion in 2009 to $210 billion in 2014 before it came to a screeching halt.

For Wall Street it doesn’t matter what happens to these junk bonds and leveraged loans after they’ve been moved on to mutual funds where they can decompose sight-unseen. And it doesn’t matter to Wall Street what happens to leverage loans after they’ve been repackaged into highly rated Collateralized Loan Obligations that are then sold to others.

At the same time, we are also witnessing a slowdown in global trade.  This usually happens when economic conditions are about to turn sour, and that is why it is so alarming that the total volume of global trade in January was down 1.4 percent from December.  According to Tyler Durden of Zero Hedge, that was the largest drop since 2011…

Presenting the latest data from the CPB Netherlands Bureau for Economic Policy Analysis, according to which in January world trade by volume dropped by a whopping 1.4% from December: the biggest drop since 2011!

Global Trade Volume

We are seeing some troubling signs in the U.S. as well.

I shared the following chart in a previous article, but it bears repeating.  It comes from Charles Hugh Smith, and it shows that new orders for consumer goods are falling at a rate not seen since the last recession…

Charles Hugh-Smith New Orders

Well, what about the stock market?  It was up more than 200 points on Monday.  Isn’t that good news?

Yes, but the euphoria on Wall Street will not last for long.

When corporate earnings per share either start flattening out or start to decline, that is a huge red flag.  We saw this just prior to the stock market crash of 2008, and it is happening again right now.  The following commentary and chart come from Phoenix Capital Research

Take a look at the below chart showing current stock levels and changes in forward Earnings Per Share (EPS). Note, in particular how divergences between EPS and stocks tend to play out (hint look at 2007-2008).


Change In 12 Month EPS

We all know what came next.

And guess what?

According to CNBC, a lot of the “smart money” is pulling their money out of the stock market right now while the getting is good…

Recent market volatility has sent stock market investors rushing for the exits and into cash.


Outflows from equity-based funds in 2015 have reached their highest level since 2009, thanks to a seesaw market that has come under pressure from weak economic data, a stronger dollar and the the prospect of monetary tightening.


Funds that invest in stocks have seen $44 billion in outflows, or redemptions, year to date, according to Bank of America Merrill Lynch. Equity funds have seen outflows in five of the last six weeks, including $6.1 billion in just the last week.

It doesn’t matter if you are a millionaire “on paper” today.

What matters is if the money is going to be there when you really need it.

At the moment, a whole lot of people have been lulled into a false sense of complacency by the soaring stock market and by the bubble of false economic stability that we have been enjoying.

But under the surface, there is a whole lot of turmoil going on.

Those that are looking for the signs are going to see the next crisis approaching well in advance.

Those that are not are going to get absolutely blindsided by what is coming.

Don’t let that happen to you.


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Not an April Fool?



Source: Townhall


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The Committee To Destroy The World

On April 1, 2015, in , by Tyler Durden


From Michael Lewitt, author of The Credit Strategist

The Committee To Destroy The World

Last month, the world mourned the death of beloved actor Leonard Nimoy. Mr. Nimoy, of course, was renowned for his portrayal of the iconic character Mr. Spock on the 1960s television series Star Trek. One of the most memorable Star Trek inventions was the transporter that allowed human beings to be beamed through space and time like light and energy. Investors expecting central bankers to solve the world’s economic problems might as well believe that Janet Yellen is capable of beaming them straight into the Marriner S. Eccles Building in Washington, D.C. Their failure to acknowledge that the Fed is failing to generate sustainable economic growth while contributing to income inequality and crushing debt burdens is inexplicable. Central banks that purport to be promoting financial stability are actually undermining it – with the able assistance of regulators who have drained liquidity from the world’s most important markets.

Negative interest rates on $3 trillion of European debt are an obvious sign of policy failure, yet the policy elite stands mute. Actually that’s not correct – the cognoscenti is cheering on Mario Draghi as he destroys the European bond markets just as they celebrated Janet Yellen’s demolition of the Treasury market. Negative interest rates are not some curiosity; they represent a symptom of policy failure and a violation of the very tenets of capitalist economics. The same is true of persistent near-zero interest rates in the United States and Japan. Zero gravity renders it impossible for fiduciaries to generate positive returns for their clients, insurance companies to issue policies, and savers to entrust their money to banks. They are a byproduct of failed economic policies, not some clever device to defeat deflation and stimulate economic growth. They are mathematically doomed to fail regardless of what economists, who are merely failed monetary philosophers practicing a soft social science, purport to tell us. The fact that European and American central banks are following the path of Japan with virtually no objection represents one of the most profound intellectual failures in the history of economic policy history. While the global economy is facing a solvency problem linked to excessive debt accumulation, the world’s central banks are pursuing policies designed for a liquidity problem. That is like treating cancer with a Tylenol. The only solutions in this known universe for a solvency problem are inflation, currency devaluation or default. Maybe Spock has a different solution but he’s been beamed up to a better place and is no longer on call to save us. Since none of these real-world solutions are politically palatable – no leader on today’s world stage has the courage to propose them and would be voted out of office by selfish and short-sighted constituents if he/she did – central banks are left offering huge doses of debt since equity can’t be conjured out of thin air. But all of this debt is just exacerbating the solvency problem and failing to solve the liquidity problem, pushing global markets closer to the brink.

The global financial system no longer possesses the productive capacity to generate enough income to sustain current asset values. The markets refuse to acknowledge this reality, but they will. In a presentation to the Global Interdependence Center on March 23, 2015 in Paris, France, Christopher Whalen, Senior Managing Director and Head of Research at Kroll Bond Rating Agency, gave an unusually frank assessment of the current state of the global economy. Mr. Whalen, one of the best bank analysts on Wall Street, argued that global banks face trillions of bad off-balance sheet debts that must eventually be resolved (i.e. written off) and are dragging on economic growth. These debts include everything from loans by German banks to Greece to home equity loans in the U.S. for homes that are underwater on their first mortgage. Banks and governments refuse to restructure (i.e. write off) these bad debts because doing so would trigger capital losses for banks and governments. As Mr. Whalen explains, “the Fed and ECB have decided to address the issue of debt by slowly confiscating value from investors via negative rates, this because the fiscal authorities in the respective industrial nations cannot or will not address the problem directly.” But in addition to avoiding the bad debt problem, these policies are causing further economic damage by depressing growth and starving savers. Per Mr. Whalen: “ZIRP and QE as practiced by the Fed and ECB are not boosting, but instead depressing, private sector economic activity. By using bank reserves to acquire government and agency securities, the FOMC has actually been retarding private economic growth, even while pushing up the prices of financial assets around the world.” ZIRP has reduced the cost of funds for the $15 trillion U.S. banking system from roughly $500 billion to only $50 billion annually, depriving savers of $450 billion of annual interest income. Zero interest rates are deflationary and sluggish national income growth renders it impossible to validate and sustain the current level of inflated asset prices. This means that any movement away from these policies, as the Fed now appears to be preparing, portends lower asset prices.

Investors are continuing to cling for dear life to stocks and bonds trading at unsustainable valuations and denominated in deteriorating fiat currencies. While it may appear rational to do so in a world in which professional investors are judged based on their relative performance and would rather fail conventionally than succeed unconventionally, true fiduciaries should protect their clients now from the steamroller that is about to run them over. Central banks have destroyed bonds as instruments of prudent investment and forced fiduciaries to buy assets that are going to generate negative real returns. While Mr. Whalen speaks of the trillions of bad debts that are suffocating growth, even the trillions of nominally money-good debts have been placed at risk by the current policy regime. The only reason the system is not yet in crisis is that interest rates are artificially depressed. Low rates have reduced the cost of debt service to manageable levels but done nothing to improve the productive capacity of companies or economies. But time is running out; the U.S. and Europe may be emulating Japan, but they are not Japan. While low interest rates were intended to buy time for fiscal policy makers to implement pro-growth policies and raise incomes needed to service and retire rising debt burdens, nothing of the sort has occurred. As a result, the global economy’s capacity to service its existing debt as well as its future promises is reaching its limits.

This leaves currency devaluation, inflation or default as the only possible resolutions to the end of the Debt Supercycle that began 30 years ago. All three are similar in kind because they deprive lenders of repayment of their loans in constant dollars. But that is the nature of debt in human economies; debts are rarely repaid in full in real terms. Human economies pay it forward and time erodes the value of money. Einstein famously said, “The only reason for time is so that everything doesn’t happen at once.” The same is true about debt. Debt was created because everything in economies can’t happen at once; in order to sustain ourselves, some future wealth must be brought forward into the present. In order to do that, we create money that doesn’t yet exist in the form of debt. We then hope to earn that money in the future through our economic activities and eventually repay it. Hyman Minsky taught us that “[c]apitalism is unstable because it is a financial and accumulating system with yesterdays, todays, and tomorrows.” Debt seeks to bridge that instability through the form of contracts that ultimately rely on the good will of those who sign them. In that light, we can see the real tragedy of negative interest rates: they not only have the perverse effect of reversing the flow of time, but they demonstrate that borrowers are not acting with the good faith incentives normally associated with someone who needs money. Rather than paying forward, borrowers are paying backwards because they are effectively trying to return something they don’t want. Such an arrangement renders it impossible for an economy to grow. By destroying the temporal and moral structure of money, negative interest rates destroy the economy. When tomorrow cannot be paid, the current regime must fail. The only question to be determined is the form that failure will assume. This may sound like philosophy but it is cold, hard reality.


Beam Me Up, Janet!

Another enduring image of Mr. Spock was watching him play three-dimensional chess, a game that demonstrated both his superior intellect and his ability to see the complexities of the universe in ways far beyond the limited abilities of mere mortals. Rather than think in only two dimensions, Spock was able to think in three (or even more). This is something that investors must be able to do in a digitalized world, particularly when currencies start to move as dramatically as they have since last summer. As a citizen of the 23rd century, Mr. Spock was able to envision a digital world that we are only beginning to experience.

Today, we inhabit a world in which we are just beginning to deconstruct every conceivable kind of data into different combinations of 1s and 0s that can then be reconfigured and transmitted around the world in the blink of an eye. For example, Israeli cybersecurity company Cyactive, which was just acquired by PayPal, uses evolutionary biology algorithms in its cybersecurity business. Cyactive’s specific area of expertise is predicting malware before it hits a network based on the premise that malware behaves like a virus; it mutates as it spreads. Algorithms are a common digital language that can be applied across biological and non-biological systems. The possibilities are truly as limitless as the space explored by Spock and his fellow travelers.

In the financial world, every stock, bond, loan, currency, commodity or derivative can be broken down into its constituent digital parts. Financial technology reveals the underlying reality that all financial instruments are merely different expressions of the same underlying economic information. For example, currencies and interest rates are different versions of the same underlying phenomenon – the cost of money. And while economists have taught us to think about the difference between “real” and “nominal” returns primarily in terms of inflation effects, inflation is inextricably linked to currency movements that affect the cost of money. With interest rates at or near zero and traditional inflation measures suppressed, currencies have picked up the mantle from interest rates for the transmission of real returns on capital. “Real” returns are intended to measure the return on capital in constant currencies, which today means adjusting them primarily for changes in the value of fiat currencies. Investors are playing on a multi-dimensional chessboard where the pieces are being moved around by increasingly desperate central bankers. When the currencies in which investments are denominated experience historic levels of volatility (i.e. the euro has dropped by 20% against the dollar since last July), a new dimension enters the investment landscape. The unstable currency regime has created a highly unstable investment environment that is placing capital at risk.


The Cannibal Economy

While most investors choose to remain blissfully ignorant about the nominal value of their investments, the real value of what they own is deteriorating. One symptom of the continuing destruction of the economic base is the increasingly cannibalistic nature of economic activity in both the private and public sectors. Instead of investing in the future – or creating a future – public and private sector actors are borrowing from the future while devouring the present. Promises to pay future obligations in constant dollars are literally no longer worth the paper on which they are written because those promises of future payment are being actively debauched. Having mortgaged our future and limited our ability to engage in productive economic activity, public and private economic actors are now consuming themselves.

Since 2009, companies in the S&P 500 have spent more than $2 trillion repurchasing their own stock. These repurchases have accelerated as stock prices have risen, which means that corporations’ appetite to eat their own has increased as their stocks have grown more expensive. In 2014, members of the S&P 500 bought back $550 billion of their own stock, according to data compiled by S&P Dow Jones Indices. In contrast, investors in mutual funds and ETFs bought only $85 billion of equities last year. Companies announced another $104.3 billion in buybacks in February, the highest on record according to TrimTabs Investment Research. In many cases such as IBM and Herbalife, they borrowed a great deal of money at low Fed-subsidized rates to eat their own.

The private sector is merely mimicking what the public sector has adopted as its formal economic policy. Since 2009, the Federal Reserve has purchased $4 trillion of Treasuries and agency securities that are currently sitting on its $4.7 trillion balance sheet. The European Central Bank has launched a $1 trillion bond purchase program while the Bank of Japan has gone farther and is buying gobs of stock and ETFs (which strikes me as wildly insane). So governments are also devouring themselves. In the latest version of this phenomenon, the oil market, where supply is outrunning demand, is now consuming itself as massive amounts of product are being bought into storage at what are believed to be low prices. It remains to be seen just how low those prices will prove to be after the final costs of storage and carry are calculated.

Any society that eats its own is doomed to perish. I am unaware of any race of cannibals that has thrived in the history of mankind. Eventually they run out of victims.


The Fed and the U.S. Economy

Markets reacted with their usual irrational exuberance to what they interpreted as a dovish tone in the FOMC’s formal statement after its March 17-18 meeting as well as Janet Yellen’s remarks afterwards. Rather than dovish, however, I believe the Fed is extremely worried. As well it should be. The denizens of the Eccles Building have painted themselves – and the rest of the world – into a corner. The Fed finally acknowledged that the economy is weak and that it doesn’t expect it to strengthen quickly. This is something I have been warning about repeatedly. Neither an over-indebted U.S. economy nor an even more over-indebted global economy is in any position to reach so-called escape velocity. The only velocity that is increasing is the velocity of denial among Fed apologists and stock investors who are going to hit a brick wall at high speed in the not-too-distant future if they don’t snap out of it.

After maintaining for months that the economy was improving, the Fed finally acknowledged that it is not. It now expects economic output to expand by between 2.3% and 2.7% in 2015, a downgrade from its December 2014 estimate of 2.6% to 3.0%. Even more important, it lowered its estimate of the non-accelerating inflation rate of unemployment (the unemployment rate below which inflation rises, also known as NAIRU) to 5.0% to 5.2% from 5.2% to 5.5%. This suggests that the Fed sees much more slack in the economy than before. While some might see this downgrade as giving the Fed more time before it needs to raise rates, a Fed that is concerned about low inflation should read it as a signal to accelerate its timetable in order to infuse some inflation into the economy with higher interest rates. But we all know that isn’t going to happen. Instead, the Fed lowered its forecast for the Fed Funds rate by 50 basis points across the board (0.675% by year-end 2015; 1.875% year end 2016; and 3.125% year end 2017). The economy looks increasingly exhausted.

The Fed has been consistent in its failure to forecast the economy with any accuracy, which is as much a commentary on forecasting as on the Fed’s abilities. Based on this track record and its outlook, it is hardly surprising that Mrs. Yellen & Co. are reluctant to raise rates even in the face of rising risks to financial stability posed by interminable zero rates. Having explicitly targeted asset prices and the so-called “wealth effect” as its policy after the financial crisis, the Fed is terrified of what might happen when it reduces the massive subsidy it has provided to the economy (primarily the wealthy). The problem with this regime, however, is that targeting asset prices, particularly stock prices, is far beyond the Fed’s purview and leads to distorted markets, misallocated capital and dangerous long-term economic, social and political consequences. Why the denizens of the Eccles Building can’t figure that out is best explained by those who awarded them their advanced degrees.

With the exception of jobs numbers, the string of disappointing economic data has been unrelenting in 2015. In fact, it would be difficult to point to any positive economic data other than employment data over the last three months. The Bloomberg Economic Surprise Index is at its lowest level since March 2009 and the Citi Surprise Index was recently at its lowest level since 2011. While factors like the West Coast port strike and arctic conditions in the northeast are no doubt having some impact, there is obviously a problem when economic data is flirting with levels last seen at the depths of the recession and the financial crisis. As the March Chicago PMI report stated, “While part of this decline may be attributable to the cold weather snap and strike action at west coast ports, the continued weakness in March points to a wider slowdown in business conditions.” I may have been an outlier when warning about a growth scare last November (just as I remain an outlier regarding the meaning of low oil prices for the U.S. economy), but I would rather be an outlier and correct than part of the consensus and wrong. There is something seriously awry in the U.S. economy. There is no self-sustaining economic recovery occurring. Instead, there is simply an inexorable build-up of debt that can never be repaid and that is sapping growth. The incessant flow of negative economic data is not an aberration – it is the new normal.

On March 11, Bridgewater’s Ray Dalio warned the Fed that raising rates now risked a 1937-style stock market slump. Mr. Dalio is likely correct that higher rates will strengthen the dollar and contribute to deflationary pressures, but the Fed should not be worrying about the stock market. The policy of targeting asset prices that the Fed adopted after the financial crisis has been an abject failure. The so-called “wealth effect” that these policies were supposed to create only helped those who have wealth; it has damaged the 99% of those who don’t. Trillions of dollars of direct bond purchases plus trillions of dollars of further subsidies in the form of zero interest rates may have caused the stock market to triple since its March 2009 low, but they have left the U.S. deeply indebted and struggling to grow at 2%.

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Much more in the full letter: pdf.


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The first quarter was hot across the Eurozone. The euro has gotten purposefully crushed by the ECB’s currency war. QE, first promised then implemented, became all the rage. And stocks surged: the Stoxx Europe 600 was up 16%; Italy’s FTSE MIB index up 22%; and Germany’s DAX also up 22%, the sharpest quarterly gain since Q2 2003. Since January 2012, in a little over three years, the DAX has nearly doubled. Only Greece couldn’t get it together.

And bonds have soared to ludicrous levels, with yields turning negative on €2.2 trillion in Eurozone government debt, according to Societe Generale. German government debt is now sporting negative yields up to a 7.5-year maturity, while 10-year yield – at 0.14% as I’m writing this – is on its way to negative as well.

So on March 31, Hans-Jörg Vetter, CEO of Landesbank Baden-Württemberg in Germany, spoke at the bank’s annual press conference – and fired a warning shot across the bow of investors.

Publicly owned LBBW, a full-service and commercial bank, serves as the central bank for the savings banks in the states of Baden-Württemberg, Rhineland-Palatinate, und Saxony. With €266 billion in assets and over 11,000 employees, it is the largest such Landesbank in Germany. And it too was dutifully bailed out by taxpayers during the financial crisis.

And so the press conference had the usual feel-good fare.

“Over the past few years LBBW has gained a very good position to operate successfully on a sustained basis amid a difficult environment,” Vetter said in the bank’s press release. “On this basis we are aiming for targeted and risk-conscious growth in our core business areas,” he said. There was a slight improvement in pre-tax profit to €477 million in 2014, from €473 million a year earlier. And for this year, he expected a “moderate” increase in pre-tax profit. He talked about how solid the bank was, and he talked about opening new offices…. It was that sort of press conference.

But then, maybe he got off script. That’s when the mundane bank press conference, designed for the taxpayers who own the bank but don’t care and certainly wouldn’t pay attention to it, turned into something that the major German paper FAZ decided to report.

Banks, insurance companies and all kinds of funds were taking on huge risks to get through the zero- and negative-yield environment, Vetter said. Alas….

“Risk is no longer priced in,” he said. And these investors aren’t paid for the risks they’re taking. This applies to all asset classes, he said. The stock and the bond markets, he said, are now both seeing “the mother of all bubbles.”

This can’t go on forever. Or for very long. But he couldn’t see the future either and pin down a date, which is what everyone wants to know so that they can all get out in time. “I cannot tell you when it will rumble,” he said, “but eventually it will rumble again.”

By “again” he meant the sort of thing that had taken the bank down last time, the Financial Crisis. It had been triggered by horrendous risk-taking, where risks hadn’t been priced into all kinds of securities. When those securities – mortgage-backed securities, for example, that were hiding the inherent risks under a triple-A rating – blew up, banks toppled.

Yet the bailed-out bank would not again engage in such risky transactions and would rather endure lower returns, said Vetter, who was brought in as part of the bailout in 2009 to clean up the mess and put LBBW back on its feet.

He warned that it’s hard for banks to make money by lending due to the combination of low interest rates and the effects of competition. There are too many banks in Germany and Europe, he said. They’re all going after medium-sized businesses, and prices for financings have become “critically low,” he said.

At the same time, a whole new generation was growing up without the idea of earning interest on savings in the this zero-interest-rate or negative-interest-rate environment. Without that incentive of interest, they aren’t learning to save. And banks won’t be able to play their traditional role as an intermediary to plow those savings back into the economy as loans. So he warned, “I am afraid that we will become only gradually aware of the medium- and long-term consequences of this European debt financing.”

We’ve been saying this – “the mother of all bubbles” – for a while, though we may not have used this exact technical term. And we’ve long lambasted this zero-interest-rate and negative-interest-rate environment. But he isn’t just some wayward blogger. He runs a big state-owned bank with responsibilities to taxpayers, a bank that had already taken too many risks that hadn’t been priced in, and when those risks began to exact their pound of flesh during the Financial Crisis, the bank cratered.

Central banks have re-created that environment, and similar risks are building up. With terrible consequences that we will know only afterwards. But no top banker, and certainly not a top banker at a state-owned bank, has been allowed to say it publicly. It would be heresy against current central-bank dogma.

This “mother of all bubbles” is front and center in the startup scene, where “valuations” have reached a state of delirium. Read…  It’s Just a Question of Whose Capital Will Be Destroyed


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