Sunday, March 30, 2014

Few People Really Understand The Economy

Few people really think about the economy to any great degree or even try to understand it. We who find the subject interesting and study it or are involved in seriously self directed investments often forget this fact. While they will tell you otherwise the average person only begins to care when they are directly effected or financially slapped in the face. To navigate the treacherous terrain of investing without a road-map or knowledge means you travel at your own peril. This does not mean that even a person totally ignorant of basic economics will not have an opinion.

The study of economics is often baffling and confusing. Many economic theories exist but many are full of holes and conundrums. Much of how people react to a policy may have to do with timing and perception instead of reality. Economics is full of loops that feed back upon themselves and unexpected pitfalls based on expectations. All this can become quite abstract. Economist predict events that never tend to unfold as expected or planned. Many of the "modern monetary theories" in use today have not been proven over time, but reflect an attitude that we can control  economic cycles better than in the past.

A vulnerability and  invisible burden is carried by the masses. Most people do not  have at their disposal many of the investment options those fully engaged in the markets have developed. The learning curve to investing is both long and hard even though we are often lead to believe shortcuts exist. Simply reading a book, taking an investment course, learning a new charting or technical system is no guarantee you will make money. Most investors only learn after a series of mistakes and errors how difficult this learning curve really is.

The lack of these investment options mean that many people are left unable to react if and when a trend dramatically shifts. This leaves the bulk of society extremely vulnerably when a shift does occur. We can add to this fact that we are often lulled into being far to complacent as to the real economic risk that surrounds us. An example of this is how people assume the bank will honor their credit-lines or they will be given access to their savings in the case of economic difficulty. In a crisis as everyone rushes to the exit it is silly to think you will be served in an orderly fashion or even fairly.

I contend that never before has mankind diverted such a large percentage of wealth into intangible products or goods and this is the primary reason that inflation has not raised its ugly head or become a major economic issue in recent years. Like many of those who study the economy I worry about the massive debt being accumulated by governments and the rate that central banks have expanded the money supply.  If money suddenly flows into tangible goods seeking a safe haven inflation could soar even as debts go unpaid and promises are left unfilled.

When will the next financial crisis hit and how deep will it be? That is a hard thing to predict or answer, just as difficult is speculating the form it will take. Many catalyst exist that could usher in such a scenario. One thing that complicates any decision is timing. Watershed events can occur at the blink of an eye or be spread out over weeks or even months. The basis of the economy we have today is unsustainable and because it has been able to exist for so long does not mean it can continue.  The fact the system muddles through does not guarantee that we will not suffer financial harm as individuals.

FOOTNOTE: I have already started to flesh out an article that expands on the scenario put forth in bold print. It will be interesting to see how well I can defend the theory. The article should appear in the next few days. Again, I encourage comments and urge you to explore the archives for any other articles that might interest you.

FOOTNOTE #2; The piece I promised  delves into how chaos and major disruption could result from such the current monetary policies, it can be found at the link below.

The Issue Of Sovereign Borders

The Movie Braveheart Marks Man's Effort To Be Free
The aim of this article is to visit some of the issues concerning self-control and how the world reacts when people go in search of what they see as "freedom". We must understand that being recognized as legitimate by other governments is one of the first hurdles newly formed groups face. After that consider operating and running a government is expensive and requires a bit of experience. This area of expertise is also a major stumbling block to long-term success. The leaders of change or a revolution often do not possess the skills to progress through this next level. Issues like corruption are not guaranteed to vanish with regime change.

In June of 2013, I wrote an article about Scotland and the issues involved in its leaving the UK. I pointed out that such an event in the not too distant future may affect the British currency when voters in Scotland will be given the choice of separating from the UK and opting for independence in a referendum. What an independent Scotland might do about a currency is still up in the air. Another issue is whether the newly formed independent country would depart "Scot free" or would inherit part of the massive national debt owed by the UK. To clarify, in our modern world setting up your own independent nation is a formidable and complicated endeavor.

Another problem or question I tried to highlight is that if the UK Government is agreeable to allowing Scotland to go their merry way will Wales and Northern Ireland be inspired to move towards independence? I also noted this might encourage similar movements in Catalonia, Belgium, Northern League in Italy, Basques, Cornish, and among the Poles. Lots of problems could develop. As you may know, Venice and the area around the city recently voted to separate from Italy.

What is happening in Ukraine and the unrest in many areas of the world brings into focus the many conflicts that develop when a region decides to change governments often outside the recognized democratic system of voting. In some cases, even after an overwhelming vote such as in Crimea, the whole process is called into question. Unfortunately, the American civil war did not resolve the issue of succession forever and definitely was not a template for a solution that should be used in countries across the planet. Bottom-line many in politics are slow to give up control and this will not change.

What we are talking about comes down to governance and the right of people to choose under whose rule they want to live. Sometimes it is about one group of people forcing their will upon another. Ethnic pride, taxation, persecution, and sometimes simply the desire for more autonomy that lead the move towards independence. While smaller countries have some benefits they often muck up the works and result in expensive bureaucratic duplication. It is difficult for a small country to function in our modern world and meet all the legal benchmarks required by their larger brethren. Currency, passports and documentation, conflicts in laws with other countries, and many other problems quickly surface.

Borders are a creation of man and not visible to the birds flying above. Much bloodshed and many wars could be avoided if the issues of regime change or borders could be handled in a more rational and constructive way, but do not expect this to happen. Borders and political control is a problem that haunts man since before the written word. Recently President Obama and other officials have talked about the legal sanctity of sovereign borders, but in reality, this is an argument of convenience masking deeper issues. When it comes down to it we are just pawns in this sad power game. If you doubt this just ask some of the many people displaced from their homes in Syria.

 Footnote; As always your comments are welcome and encouraged. I also urge you to visit the archives for other articles or topics that might interest you.

Saturday, March 22, 2014

China Enters The Great Credit Trap

Much of the recent growth in China after 2008 came from a massive 6.6 trillion dollar stimulus program that expanded credit and poured massive amounts of money into the system. This money encouraged expansion and construction with little regard as to real demand or need. Like a plane on autopilot China continued in the direction it had been on. This grow or die mentality always included building more and expanding more. Now China finds itself in a credit trap. For years the people of China have had the habit of saving much of what they earn but the low interest rates paid at banks has not rewarded savers. With few investment options much of this money has drifted towards housing and driven housing prices sky high.

Four big state-owned commercial banks and other mainly state-controlled banks account for nearly all official lending in China and their customers tend to be state-owned firms. This has left little room for private banks and this means informal lending in China has grown rapidly in the past five years. Even local governments borrow from the shadow banking system. Shadow banking is a slightly sinister name for trusts, leasing and insurance companies and other non-bank financial institutions which perform banking functions without a banking license. No one really knows how big the shadow banking sector in China is because it is largely unregulated by the banking authority, but shadow loans are estimated to make up 20% of all loans.

Every country has unofficial lenders, but in China individuals, companies and even local governments who can not get loans from state-controlled banks have been on a borrowing binge from these unofficial sources. After several years of growing debt concern is rising the whole unstable pyramid is about to come crashing down bringing China and possibly the global economy with it. This is not just about writing off a few bad loans. The shadow banking sector is so large that concerns exist about contagion and a domino series of defaults that might rack the economy as savers lose money. In the case of any banking crisis this could have a massive impact on the economy, since debt is estimated to be more than 200% of GDP. The Chinese central bank has reported that 89% of households and 57% of firms have borrowed money from these groups.

Shadow bank loans can charge as much as 24-30% in interest and be for as short a period as just three to five days if someone really is in need of cash. One shadow banker confessed that he charged interest rates of up to 100% and lent on average 6m yuan per month, which is around one million US dollars. Many people see the shadow banking system as a channel to get money to solve business problems as it's efficient and quick even if the rate is much higher than the banks. It seems these shadow banks have been selling wealth management products (WMPs), which offer returns that far outstrip the official deposit interest rate of 3%. A big problem is these unregulated products are riskier and reminiscent of some of the horrifyingly complicated products sold in the US and Europe before the global financial crisis that started in 2007.

While governments can never get rid of the borrowing in society they can ban the very high-rate loans. One of China's most notorious shadow bankers is now in jail serving a life sentence but this does not help those who loaned this person money because of the high rates he paid. The "investors" become victims and often lose everything they have saved to retire on when a shadow bank goes bust. In some cases people lend money to someone like their boss to earn more interest than the meager rate offered by the bank. During the global financial crisis the central government launched a spending program, however, rather than provide funding for this it left getting financing for projects up to local governments. It now appears even local government has borrowed in the shadows

If this develops into a full scale banking crash, the issue will be if the government of China can afford to or is capable of rescuing the banks. If it is able to halt a collapse the cost to growth will be severe, if not then China would be in crisis and the global consequences would be dire. In some ways since every saver is affected in the world's most populous country, it could even have a bigger effect than the collapse of Lehman. In the past, economists thought what Beijing wants it usually gets because of its total control of  the credit tap. The double-whammy of credit defaults and a deteriorating trade position, point to a new reality for Beijing as the days of backstopping growth with ever more credit appear to be numbered.

Recently, we saw China’s first-ever onshore corporate default on a bond. This default ends the belief Chinese corporate debt comes with a de-facto government guarantee and may help by injecting risk into the pricing scheme of China's massive domestic bond market. Unfortunately, many people think introducing market pricing at this stage in China’s cycle comes a bit late to instill real discipline. Instead, prepare for an ugly unraveling, as this could open the floodgates on credit defaults. The reality is that much of China’s heavy industry faces dismal fundamentals of high leverage, overcapacity and falling prices. We already know that Beijing is enforcing capacity reduction that will have spillover effects. Chinese Premier Li Keqiang recently promised 27 million tons of high-polluting steel production will be taken out this year. As much as 130 million tons of capacity may be marked for closure by 2017. This is a significant part of China’s annual 750 million ton output.

Another hurdle Beijing faces in terms of keeping the credit taps flowing is that its days of ever-increasing trade surpluses could be over. The release of February’s trade figures showed China racked up an unexpected  $22.89 billion trade deficit in February after exports fell 18.1%. The question now is whether trade deficits will become the new normal. We already know China is facing constraints on production capacity from land, labor and pollution, as well as steadily rising costs that are displacing large chunks of low-end manufacturing. Many people worry the impact from a key reversal of years of trade surpluses and foreign-reserve accumulation could be far-reaching.

 China’s current-account surpluses have fueled its huge money-supply growth within a largely pegged currency over the years. As foreign exchange piled up, the People’s Bank of China continued to print more yuan. According to some estimates, China’s banking system has grown from $10 trillion to $24 trillion since 2008. Now the reverse may happen, if the yuan weakens, the central bank will effectively have to buy its own currency using foreign reserves to maintain its peg. This could mean the external trade position would now cause the central bank to shrink domestic money supply. Beijing will need to get used to the market forced deleveraging and slower growth. It is clear the economic efficiency of credit is beginning to collapse in China and the unwinding of China’s giant credit spree could be very painful.

  Footnote; Please feel free to explore the blog archives and as always you comments are encouraged. For more on China see any of the four post below,

Sunday, March 16, 2014

The Minimum Wage Will Go Up, Right Or Wrong!

While I'm strongly against raising the minimum wage because it will make America less competitive and slow job growth, I concede the debate is destined to continue until it is raised. I hereby state without a doubt, the minimum wage will go up! Polls show a majority of Americans support this idea. It is my feeling that many people believe the myth this will put more money into the consumers pocket and create economic growth. They fail to recognize it will also spark inflation while reducing opportunity. New twist and wrinkles are being added by the White House and supporters of this increase every week. Expanding the number of workers eligible for overtime pay is another attempt to push this along. Unfortunately much of the impact and pain will directly fall upon small business the real creator of jobs.

I contend the minimum wage is more of a philological benchmark then a tool for solving issues of inequality. While the idea is considered politically popular raising it without considering the negatives would be a mistake. Sadly, that is often the way Washington works. This issue has been framed in a way that makes saying no difficult. Does any politician standing for reelection want to do the right thing and say "no" to "giving poor downtrodden hard working" Americans a raise? This attitude is what got us in the bind we find ourselves in today. Apparently this trend is also still active in Europe and Britain. The reality is as long as people in other parts of the world will work for less we are shooting ourselves in the foot.

A recent article In the BBC announced that in the UK the National Minimum Wage will increase by 19p an hour to £6.50. The new rates will be implemented in October and will benefit a million workers. The UK Business Secretary said he had accepted the recommendation from the Low Pay Commission that the minimum wage should increase by 3%. The increase is higher than the consumer prices index (CPI) rate of inflation, at 1.9%. This means UK workers will be seeing the biggest cash increase in their take home pay since 2008.

What I found most interesting in the article, it went on to say the rate for workers between 18 and 20 years old wages will go up by 10p to £5.13 an hour, a 2% increase and the rate for those aged 16 and 17 will rise by 7p to £3.79, also a 2% rise. This staggered minimum wage attempts not to lock out the young from ever getting their foot in the door. Even more telling of this is that apprentices will earn an extra 5p an hour, taking their wages to at least £2.73. It appears the system in the UK at least makes an effort to keep the door open to younger and less skilled workers who seek real jobs.

The economic reality and reason I consider this so important is that with so few Americans actually paid the minimum wage a higher wage moves the bar and blocks entry to low level jobs. It makes these jobs even more scarce and causes them to be eliminated or disappear. To some workers a salary may represent what they as a person are worth, but in many ways it reflects more on the value of our currency, what it will buy in society and whether a person should or needs to work. A major issue that many Americans and our government continues to ignore is how much the cost of living varies throughout the country.

The cost of a house in California or in a coastal city is far greater than the same house in the Midwest, often demand in certain locations reflects a geographical preference. This should be reflected more in government social programs and they should be skewed to encourage people to relocate to less expensive areas rather than feed money into local economies already showing high demand. Current payouts from these programs remove incentive for those receiving "generous" government payments to seek work in low cost areas because it is relatively easy to make ends meet. In many ways it is the government that has made it to easier to not work.

 Through its safety net of social programs and subsidies government has done unmeasurable long-term harm to the lower ranks of society by muddying barriers to the shrinking middle class. Inequality is not as much an issue between the poor and being middle class. The focus should be centered on how the elite have highjacked a majority of the pie. The fruit of our labor now flows to very few. Raising wages on the low end may make a few people feel better but when it come to addressing the crux of our problem it is like putting lip-stick on a pig as you take the animal to the butcher.

Monday, March 3, 2014

Losing it all with no hope of recovery!

On occasion we all run into a "know it all" a person that is sure they have all the answers and will have the right response to any situation. Currently I see anyone bullish on this market viewing any pullback as a buying opportunity and sure the market will continue to rise as such a person. Often the people following this mantra feel invincible. After a good run it is strong in the nature of the human animal to double-down. We tend to get careless at a market top and ignore when a market turns or begins to take large swings. 

Those of us who have had the misfortune of losing a lot of money fast will tell you we never saw it coming or that it got far worse than we envisioned in even our worse case scenario. Sure they talk about diversifying but often even this recipe is not guaranteed to protect you. Way back in 2008 when the meltdown was just starting I found myself on a cruise ship in Greece where one of my fellow passengers who had embarked on this strategy was withering in pain.

A recently retired teacher who had placed her life savings in three solid stocks that were thought to be safe was in total shock. The three stocks she had bought were Fannie Mae, insurance giant AIG, and Lehman Brother. all of these were considered very safe prior to the 2008 financial meltdown. This woman had taken advice she considered sound and financially conservative and stepped into a giant hole losing almost all her savings, needless to say she was devastated. Just remember this is a dangerous game and at risk is a lifetime of hard work,sacrifice, and savings.

In the fast paced world of today we have all witnessed value suddenly vanish. Many examples exist from Ponzi schemes like the one ran by infamous investor Bernie Madoff to stocks that rose then crashed like Enron. We should constantly keep in our mind that we might at any time become a victim of this ugly fate. We are often lulled into complacency that markets are regulated and precautions have been put in place to protest us but  let me make it crystal clear, once it happens it is to late.

Investing in the stock market is not as easy as many people think or we are lead to believe. The idea that you can buy anytime the market pulls back is flawed. This becomes increasingly risky when the market is at lofty levels and when someone uses margin or borrowed money to leverage their position. We should also consider that cyber crime is real and continues to grow, this can spill over and create problems. With many people invested in intangible assets that are based on paper and promises such as pension payouts they leave themselves vulnerable to losses.

Nothing is sadder then losing the love of your life with no hope of getting that person back. An analogy might be make with a older person losing their life's savings and fortune. Bad luck does happen. When someone is young they have the option to learn from their mistakes and they also have time. Time to start over. The elderly often do not have the option of returning to work or reentering the game. To lose it all with no hope of recovery is something we all face in life. This is when you pray for the good fortune that it will not happen to you.

Sunday, March 2, 2014

Derivatives A House Of Cards

Derivative bets are not a zero sum game and have far reaching consequences in the real world. Trying to regulate this complex market is easier said than done.  These are usually lengthy complex legally binding agreements that are very difficult to dissect and often reek with possible contagion. Derivatives fall into many categories from futures, options, credit default swaps, and any complex combinations of these. They can also be used to wager, bet, and spectate on a market move or direction. Regulation is difficult and spotty at best in that a derivative transaction in one country might be considered a simple spot trade in another.

Derivatives Could Explode Like A Bomb!
The more and more I study derivatives it now appears the main goal of QE may have been to hold up the underlying value of assets that feed into and support the massive derivative market more than help the economy. QE has up to now stopped an implosion of derivatives and the resulting contagion and shock that would have spread throughout the financial system. According to the Office of the Comptroller of the Currency’s fourth quarter report for 2011, about 95% of the $230 trillion in US derivative exposure is held by four US financial institutions: JP Morgan Chase Bank, Bank of America, Citibank, and Goldman Sachs. The staggering size of this market is beyond science fiction or anything that can be comprehended.

Hopefully, much of the derivative exposure somehow nets out so that real exposure is far less than the hundreds of trillions of dollars on the books. Still, the situation is so worrying to the Federal Reserve that after announcing the third round of quantitative easing which included printing money to buy bonds (both US Treasuries and the banks’ bad assets) it also announced that it was doubling its QE 3 purchases. In other words, the entire economic policy of the United States has been dedicated to saving four banks that are too big to fail. Yes, the main purpose of QE is to keep the up prices to support the debt on which banks have loaned money.

Recently the top markets regulator in the EU, the European Securities and Markets Authority, asked the European Commission to clarify what a derivative is. There is no single commonly adopted definition of derivative or derivative contract in the European Union. This plays havoc with what and when reporting rules apply. It also highlights divisions in how national regulators view reporting rules for the $693 trillion over-the-counter derivatives market. Remember this is only part of a much larger market that includes hundreds of trillions of dollars in non-reported agreements and private contracts.

Everyone paying attention knows that the size of the derivatives market dwarfs the global economy. Paul Wilmott who holds a doctorate in applied mathematics from Oxford University has written several books on derivatives. Wilmott estimates the derivatives market at $1.2 quadrillion, to put that in perspective it is about 20 times the size of the world economy. The world’s annual gross domestic product is around 55 trillion dollars. The Bank of International Settlements regularly publishes tables showing the amounts of different types of derivatives but these categories are ambiguous making it hard to get a good handle on what’s really out there.

Many of these writers of derivative might be called "too clever by half" if they think they have successfully controlled the risk or removed the implications and problems a default would cause. This is because they make money in the process of structuring  and selling these agreements. A derivative is in many cases an insurance policy covered by collateral. Sadly those who buy and write derivatives often play fast and loose with the value of the collateral or flat out lie about it. This moves them from an insurance policy and into the area of high risk. To view a good video to learn more about what constitutes a derivative clink on the link below;

My point of unquantified risk is reinforced with the closing last week of  Mt. Gox, a major Bitcoin exchange in Japan. This bankruptcy has not only focused attention on the risk of digital currency, but it also rattled a still-newer market that regulators are just starting to monitor that of Bitcoin derivatives. The regulation of Bitcoin, let alone derivatives of it is unresolved in many parts of the world. Even as regulators and investors struggle to grasp Bitcoin’s many uses and where it fits into the complex world of currencies they are now confronted with the additional complexities of an emerging derivatives market where entrepreneurs say current rules don’t apply. How do you properly value and assess the risk of such transactions?

It is reported the top US derivatives regulator, the Commodity Futures Trading Commission has lawyers considering if and how to oversee derivatives linked to Bitcoin and other digital currencies. The agency has been preparing an internal memo that examines CFTC’s authority over digital currencies and how it might exercise those powers to regulate the markets. Over the last year, Bitcoin’s price rose from $20, peaked at $1,147 and dropped to as low as $534.71 on Feb. 25. Bitcoin investors who can hedge against the price falling would have less reason to dump the volatile currency in a panic, contributing further to stability.

The point of this article is to call attention to the insanity of derivatives as an instrument or tool to add stability to our financial system. By stacking risk upon risk and transferring it off to another party who may not be able to perform or is over-leveraged you do not increase stability. Derivatives do just that with the parties involved often not even understanding the terms and implications of what they have signed. To make things more complicated cross-border agreements blur regulations, legal jurisdictions, and laws. A collapse or default often results in years of legal wrangling and finger pointing rather than a swift payout or settlement.

This is why I refer to derivatives as a house of cards. When one party fails these agreements are often so highly leveraged the transfer of the obligation or debt can put massive pressure and strain directly upon another party. We must question the quality of many of these contracts and worry about the potential of them to turn toxic. Contagion from insuring a contract or acting as an agent in case of default can be devastating with the obligation shifting to another party rather than simply vanishing. My father often said, "squeeze all you want but you can't get blood out of a turnip." This will be the case with those on the hook for trillions of dollars when the silly but real derivatives market heads south. Again we are talking about paper and promises that can vanish rather than tangible and hard assets.

 Footnote; For more articles that may relate to this post see the posts below, comments are welcome and encouraged,