Wednesday, August 11, 2010

Parasitic Ponzi Growth, Dysfunctional Credit Markets, Bank Nationalizations And Final Demand

A very short and refreshing wrap-up around the "big picture" today, that still makes macro investors awake at night.

I posted about the US growth revisions yesterday, and I also mentioned "Recovery in asset prices and financial ponzi growth do not require a lot of working hands". It is worth adding here a comment by Dean Baker on Final Demand and the Inventory Cycle, for a different quality in details. The readers, of course, do know that "final demand" has been pumped with steroids, also via banker bonuses ...

However, Steve Keen is out in streets with Minsky-an-style "Bank Profits a sign of economic sickness, not health" today. And this is the point about the macro view.

Governments have been doing everything to support and keep the banks alive, starting from steep yield curves via monetary policy and down to all kind of back-door recapitalization phantasms. To me it appears that the only thing that markets are bothering is whether the governments/regulators will force the banks to step-up with additional equity, nothing more, as one may deduct from anti-stressed market reaction to European stress tests.

As to stress-testing, one of great examples is Modelling Fannie Mae and Freddie Mac by John Hempton at Bronte Capital (it is worth studying the entire series of posts). With a following conclusion (my emphasis) from extensive modelling:

Pre-tax, pre-provision operating profits of Freddie Mac are running at over $15 billion. If the government were not demanding 10 percent on its preference shares the companies would be sufficiently well capitalised to repay their interest in 4 years. With the drag of having to pay the government $5 billion per annum it will take a bit over five years. Either way the operating profits of Freddie Mac are big enough to ensure the government gets its money back. If you do the same analysis for Fannie Mae its is even better. However Fannie has less aggressively marked private label securities to market so it has less chance of recoveries from their current marks. The consensus view that the GSEs are forever toast – and forever a drain on the US Government is very likely wrong.

But here we come to the causes of the dysfunctional credit markets, that are driven by debt maturity ... Average maturity of bank debt is (about) less than 3 years (see, for example, the chart below with US banking elephants), and this debt should be rolled-over for bank to remain liquid and also solvent, or they are forced to shrink their balance sheets. Debt maturity and roll-over risks is the only criteria for any stress-test in credit markets, all else is "gaming the game".

Click on chart to enlarge, courtesy of Nomura.

Instead of solving the issues around the bank liquidity and solvency, governments have not undertaken any serious steps to DO SO. Quite the opposite, they have decided to pay the not yet identified price of moral hazard and promote the "parasitic role as the financier of Ponzi schemes".

So far so good, but Michael Pettis, while discussing the Chinese consumption today, rounds it up very well with this paragraph, my emphasis:

The PBoC seems to be increasing its purchases of the yen, and that is causing the yen to rise. It is also causing very unwelcome weakness in the Japanese economy. Whenever people argue that the US wants and needs net Chinese investment in USG bonds, you should ask how that can possibly make sense when every country seems to be doing all it can to repel foreign capital inflows (or to increase their own net capital outflows, as in the case of China, Japan and Germany). The idea that the US or any other country “needs” foreign financing is total nonsense. Nearly every country in the world is trying to export capital and import demand. The world has no urgent need of capital. It needs consumption.
QE2 will bring consumption?

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