The United Kingdom of Massive Debt

Perhaps it is unpatriotic of me to ask, but are France’s shrill politicians right? Is the United Kingdom the weak link?

From the Guardian:

The entente is no longer so cordiale. As the big credit rating firms assess whether to strip France of its prized AAA status, Bank of France chief Christian Noyer this week produced a long list of reasons why he believes the agencies should turn their fire on Britain before his own country.

France’s finance minister François Baroin put things even more bluntly: “We’d rather be French than British in economic terms.”

But is the outlook across the Channel really better than in Britain? Taking Noyer’s reasons to downgrade Britain – it “has more deficits, as much debt, more inflation, less growth than us” – he is certainly right on some counts.

Britain’s deficit will stand at 7% of GDP next year, while France’s will be 4.6%, according to International Monetary Fund forecasts. But Britain’s net debt is put at 76.9% of GDP in 2012 and France’s at 83.5%. UK inflation has been way above the government-set target of 2% this year and the IMF forecasts it will be 2.4% in 2012. In France the rate is expected to be 1.4%.

On growth, neither country can claim a stellar performance. France’s economy grew 0.4% in the third quarter and Britain’s 0.5%. Nor has either a particularly rosy outlook. In Britain the economy is expected to grow by 1.6% in 2012. But in the near term there is a 1-in-3 chance of a recession, according to the independent Office for Budget Responsibility. In France, the IMF predicts slightly slower 2012 growth of 1.4%. But in the near term France’s national statistics office predicts a technical, albeit short, recession.

There is one significant factor everyone is overlooking.

Total debt:

From Zero Hedge:

While we sympathize with England, and are stunned by the immature petulant response from France and its head banker Christian Noyer to the threat of an imminent S&P downgrade of its overblown AAA rating, the truth is that France is actually 100% correct in telling the world to shift its attention from France and to Britain.

France should quietly and happily accept a downgrade, because the worst that could happen would be a few big French banks collapsing, and that’s it. If, on the other hand, the UK becomes the center of attention then this island, which far more so than the US is the true center of the global banking ponzi scheme, will suddenly find itself at the mercy of the market.

And why is the debt so high? Well, the superficial answer is that the UK is a “world financial centre”. The deeper answer is that the UK allows unlimited re-hypothecation of assets. Re-hypothecation is when a bank or broker re-uses collateral posted by clients, such as hedge funds, to back the broker’s own trades and borrowings. The practice of re-hypothecation runs into the trillions of dollars and is perfectly legal. It is justified by brokers on the basis that it is a capital efficient way of financing their operations. In the US brokers can re-hypothecate assets up to 140% of their book value.

In the UK, there is absolutely no statutory limit on the amount that can be re-hypothecated. Brokers are free to re-hypothecate all and even more than the assets deposited by clients. That is the kind of thing that creates huge interlinked webs of debt. And much of Britain’s huge debt load — particularly in the financial industry — is one giant web of endless re-hypothecation. Even firms (e.g. hedge funds) that do not internally re-hypothecate collateral are at risk, because their assets may have been re-hypothecated by a broker, or they may be owed money by a firm that re-hypothecates to high heaven. The problem here is the systemic fragility.

Simply, the UK financial sector has been attracting a lot of global capital because some British regulations are extremely lax. While it is pleasing to see the Vickers report, that recommends a British Glass-Steagall separation of investment and retail banking, becoming government policy, and while such a system might have insulated the real economy from the madness of unlimited re-hypothecation, the damage is already done. The debt already exists, and some day that debt web will have to be unwound.

Now Britain does have one clear advantage in over France. It can print its own money to recapitalise banks. But with inflation already prohibitively high, any such action is risky. If short sellers turn their fire on Britain, we could be in for a bumpy ride to hell and back.

UPDATE: Readers wanting to understand the true extent of economic degradation in some parts of the UK ought look no further than a recent post

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Motherfucking Global

How times have changed for Jon Corzine.

Just a couple of months ago he looked like the prime candidate to take over Tim “No Chance of a Downgrade” Geithner’s poisoned chalice at the US Treasury.

Now he looks like he’s heading to jail for stealing money from clients.

Probably the most sage coverage of this saga comes from Roger Lowenstein writing for Bloomberg:

Thirteen years ago, when the hedge fund Long-Term Capital Management was desperately negotiating with Wall Street banks for a bailout, Jon Corzine, the chief executive officer of Goldman Sachs Group Inc. (GS), called John Meriwether, LTCM’s founder, and read him the riot act. Wall Street would invest, Corzine said, but “JM” would have to accept more controls, including strict supervision over his firm’s trading limits.

Corzine, I wrote soon after, “understood the flaws” at LTCM better than anyone. The firm had no controls over risk limits, no accountability to anyone who wasn’t a trader.

Essentially, Corzine forgot the lessons of LTCM‘s failed arbitrageurs, and went the hyper-leveraged Martingale path. The trouble is that unless you predict accurately, this kind of activity is a quick and easy road to bankruptcy. Leveraged 50:1, a 2% drop in asset prices can be a wipeout, and end in insolvency.

There are two key points, and one key question to take away from this:

  1. The American banking system is susceptible to a Euro-collapse — MF Global went down betting on a Euro-stabilisation. The web of derivatives extends across the global financial system, creating ever-growing fragility.
  2. None of the lessons of AIG and Lehman have been learned — the bailouts and stimuli saved a broken system, and allowed it to continue to be broken.

And the question:

  1. What effects will MF Global’s removal from the web of debt have on the financial system as a whole?

The first point is obvious (although Morgan Stanley will keep denying it, and focus instead on how Groupon is worth at least $100 a share). The second point has been obvious for a long time.

The question is much murkier. Is MF Global too big to fail without sending financial systems into freefall (a la Lehman)?

The answer seems to be “probably not”.

From TIME:

So far, the problems at MF Global appear to not be spreading to other banks. While MF Global has $40 billion in assets, it only owed about $2 billion outright to other banks. What’s more, more than half of that debt is owed to J.P. Morgan, which is one of the strongest banks around. There are other banks that are owed $6.3 billion from loans MF Global took out to make its Euro debt bets. But those debts are backed by the bonds that MF bought, and if they end up being good as Corzine claimed, then those banks should get their money back, as well as the profits Corzine hoped to pocket for his firm. MF Global does not appear to have the same type of derivatives exposure to other banks that led to the demise of Bear Stearns and Lehman Brothers.

Nonetheless, we will see what we will see when we see it.

The Problem is Fragility

Mainstream opinion on economic conditions at present is a steaming shitheap of errors.

Deluge of hopium from ABC (sponsored by Citigroup, no joke):

Stocks closed higher on Thursday after European leaders agreed on a plan to avert a Greek default and the Commerce Department announced third-quarter gross domestic product grew 2.5 percent, boosted by higher consumer spending, allaying fears that the economy is slipping into another recession.

The Dow Jones industrial average increased about 2.9 percent to 12,209 and the tech-heavy Nasdaq increased about 3.3 percent to 2,784 at the end of the day. The S&P 500 had its biggest monthly rally since 1974, according to Bloomberg, increasing 3.4 percent to 1,285.

The GDP rate was in line with what economists were expecting. The 2.5 percent growth rate is almost triple the 0.9 percent pace of economic growth in the first half of this year, which has been far too slow to generate any job growth. Unemployment has remained stubbornly high at over 9 percent.

The thing is, high unemployment and low GDP growth (now — ahem — magically cured) are (and always were) secondary problems. They’re the things that hurt, sure — but they’re not the cause of the illness — they’re just symptoms The main problem is systemic fragility, and the failure to understand the economy from a systemic perspective, and understand the systemic risks. If the financial system (both global and national) is not resilient to shocks and the unexpected, the system will unravel under the slightest pressure. As I have repeatedly explained, the Western economic paradigm is a highly fragile for two reasons: over-dependence on foreign goods and resources controlled by hostile nations, and the pattern of interconnected financial debt that leaves the system open to collapse if just one significant player collapses:

Not only did the bailouts disable creative destruction (the engine of innovation and social progress), they also created so much debt that they have already damaged the ability of future generations to save, invest and innovate.

Worse, they did nothing to address the fundamental fragility of the system. All of that interconnected debt means the system is still fragile to a default cascade, which means that if the system is to be “saved” again, it will require more bailouts and more debt-acquisition, further eroding the ability of taxpayers to save and invest, as governments tax and inflate the currency to pay down the debt.

I expect future generations to look back on this episode as a bizarre aberration. America — surely the greatest producer and innovator in the history of human civilisation — forgot how markets work and the notion of creative destruction, forgot that an empire dependent on hostile partners (i.e. China and the Arab world) is hugely fragile, and then forgot the fact that America emerged as a superpower as a director result of its status as a great creditor and manufacturer, and that the old European empires lost their superpower status through loss of productivity and massive debt acquisition.

The beautiful thing about artificial abstract systems is that they can be remade at will, unlike ecosystems or organisms. It would be so easy — in principle — to rip up the global financial system and start again, because it’s all abstract. But there are too many vested interests — creditors want their pound of flesh, consumers and businesses want stability and fear change, and so establishment economists and thinkers will hunt ceaselessly for any kind of confirmation for the idea that the system is stabilising, that things are getting better, that things can go back to normal, that prosperity will return.

Well, prosperity may return, at least for a few short years, before the mass of interconnected leverage crumbles back into the murk from which it came. And as credit contracts (as is inevitable in a fractional reserve system) employment will slump, GDP growth will stall, and anger will rise.

The danger is that next time, the gears and wheels of productivity that hold up the abstract falsehoods of finance and consumerism will fail. I am not really a fan of Ayn Rand, but the analogy of Atlas shrugging holds true — in this case, the workshops, mines, and factories of “poorer” exporters holding upon their shoulders the parasitic mass of the consumerist Western nations. It won’t be industrialists and capitalists shrugging — it will be shipyard workers, machine operators, truck drivers, coal miners and construction workers, squeezed and dispossessed. Why should wealthy Westerners live a lavish lifestyle subsidised by the blood sweat and productivity of poorer nations? Because America has nuclear weapons? Because it invades nations that threaten to trade oil in things other than dollars? That kind of belligerence is a house of cards — it works with Third World despots, but not with an angry, politically engaged and dispossessed mob. I see it in the Occupy protests — the police can beat and brutalise protestors, but belligerence doesn’t change anything — the protestors are a hydra, cut off a head and two grow back.

The economic elite of the 20th Century learned to appease their malcontents by continuously raising the standard of living, expanding property ownership, and bringing plenty of food to tables, and new consumer goods to homes around the globe. If the economic elite of the 21st Century cannot learn to do the same I fear the malcontents will unleash hell.

 

On Solyndra

A few days ago Solyndra, a Bay Area maker of industrial solar panels, announced plans to file for bankruptcy.

From the L.A. Times:

It wasn’t just a blow for the company’s 1,100 laid-off employees or the investors who have pumped millions into the venture. It called into question the Obama administration’s entire clean-energy stimulus program.

Two important questions are raised by Solyndra’s failure: Should the government be in the business of picking winners and losers by providing loan guarantees to risky energy ventures? And is Obama using stimulus funds to reward his political contributors?

Now — to be clear — this isn’t solely Obama’s problem. George W. Bush, Bill Clinton, and many other administrations both in America and overseas have had lots of troubles with crony capitalism. Obama is by no means the worst next to twenty years of subsidised Japanese zombification.

So just what is the problem with crony capitalism, and with Solyndra in particular? Personally, I am the biggest supporter of solar technology out there. In my view, transitioning to solar energy is potentially the best thing that could happen to the US economy for reasons of energy independence, minimising carbon emissions, long-term sustainability, decentralisation and so forth. So I have no problem with solar energy, and I have no problem with the government supporting research into solar energy. But I still think this was a bad investment. It wasn’t supporting basic research, only a manufacturing process that was unviable in the market.

When it comes to marketable products, only the people out in the economy know what they want, and what they want to spend their money on. That’s why when government tries to pick winners and losers, it very often gets it totally and stupendously wrong.

From NBC:

Solyndra was touted by the Obama administration as a prime example of how green technology could deliver jobs. The President visited the facility in May of last year and said  “it is just a testament to American ingenuity and dynamism and the fact that we continue to have the best universities in the world, the best technology in the world, and most importantly the best workers in the world. And you guys all represent that.”

And why wasn’t Solyndra a winner.

From BusinessWeek:

All told, Solyndra raised $1.1 billion from private sources. The extra federal support ended up having the well-intended but unfortunate effect of letting Solyndra ramp up manufacturing in a hurry, even as evidence was emerging that the company had badly misread the changing economics of the solar panel market. A few years ago, prices for the silicon wafers used in most flat solar panels were soaring. Solyndra proposed building an entirely different panel, using cylindrical tubes coated with thin films of copper-indium-gallium-selenide that would pick up light from any direction.

In funding documents, Solyndra insisted that its tubes would be far cheaper than the silicon alternative. No such luck. Silicon prices have plunged nearly 90 percent from their peak in 2008, making conventional panels the better bargains.

So the government backed the wrong player, whose business model wasn’t economically viable. For the system to work, economically viable ideas have to succeed, and unviable ones have to be allowed to fail, and with government favouritism in the market, that just doesn’t work. Now that doesn’t mean to say that I don’t believe in some government role. In my view, the role of government is to create a level playing field for a free market to exist. Supporting basic research is the right role for the government in solar, so that solar efficiencies can be increased to a level where solar can compete on a level playing field with coal and oil.

Let’s move away from Solyndra (which is really a very small example), and onto the main target: the global financial system.

From Bloomberg:

Would you give money to a compulsive gambler who refused to kick the habit? In essence, that’s what the world’s biggest banks are asking taxpayers to do.

Ahead of a meeting of the Group of Seven industrialized nations’ finance ministers in Marseilles this week, bankers have been pushing for a giant bailout to put an end to Europe’s sovereign-debt troubles. To quote Deutsche Bank Chief Executive Officer Josef Ackermann: “Investors are not only asking themselves whether those responsible can summon the necessary willpower … but increasingly also whether enough time remains and whether they have the necessary resources available.”

Unfortunately, he’s right. As Bloomberg View has written, Europe’s leaders — particularly Germany’s Angela Merkel and France’s Nicolas Sarkozy — are running out of time to avert disaster. Their least bad option is to exchange the debts of struggling governments for jointly backed euro bonds and recapitalize banks. European banks have invested so heavily in the debt of Greece and other strapped governments, and have borrowed so much from U.S. institutions to do so, that the alternative would probably be the kind of systemic financial failure that could send the global economy back into a deep recession.

But the problem is the destructive and failed nature of the financial system itself. If government doesn’t allow banks that made bad decisions to be punished by the market, then the bailed-out zombie banks can rumble on for years, parasitising the taxpayer in the name of ever-greater bonuses for management, while failing to lend money, create new employment, or help the economy grow.

The global financial system isn’t working because there are fundamental structural problems with the global economy. These include over-leverage, the agency problem, trade deficits, failed economic planning, massive debt acquisition, Western over-reliance on foreign oil and goods, military overspending, systemic corruption, fragility and so forth. Stabilising the global financial system merely perpetuates these problems. The market shows that it needs to fail — preferably in a controlled way so that real people don’t get hurt — so that we can return to experimental capitalism, where sustainable ideas prosper, and unsustainable ideas don’t.

Warren Buffett & CreditAnstalt

Is Warren Buffett shooting himself in the head? There’s one issue (okay — a couple of issues) I have been silent on in the past few weeks. But on Bank of America, it’s time to break the silence — because the issue of bank failures and bailouts can have huge, violent ramifications. So let’s look at Bank of America’s credit default swap spreads:


The red dot is where we leaped to just before Warren Buffett — the so-called Oracle of Omaha —  piled $5 billion into less than 24 hours after an Archimedean bathtub epiphany. I hope he did his due diligence:

“The Investor acknowledges that it has had an opportunity to conduct such review and analysis of the business, assets, condition, operations and prospects of the Company and its subsidiaries, including an opportunity to ask such questions of management (for which it has received such answers) and to review such information maintained by the Company, in each case as the Investor considers sufficient for the purpose of making the Purchase. The Investor further acknowledges that it has had such an opportunity to consult with its own counsel, financial and tax advisers and other professional advisers as it believes is sufficient for purposes of the Purchase. For purposes of this Agreement, the term “Transaction Documents” refers collectively to this Agreement, the Warrant and the Registration Rights Agreement, in each case, as amended, modified or supplemented from time to time in accordance with their respective terms.”

Of course, if Warren Buffet wants to throw billions of dollars at an institution which may or may not be sitting on a powder-keg of bad debt, then that is his prerogative. The problems begin when said Oracle’s new investments tank, are declared “too big to fail”, and are propped-up by the taxpayer. And it just so happens that there is an historical precedent for this. From Seeking Alpha:

As a former NLO dividend watchlist stock, Bank of America (BAC) has fallen on hard times that in many respects were predestined. In a posting titled Financial Panic Chronicles dated May 9, 2009, we pointed out the similarities of the October 1929 forced merger between Austria’s number-two bank BodenKreditAnstalt with number-one ranked CreditAnastalt, and the forced mergers between Bank of America/Merrill Lynch, Wells Fargo/Wachovia, and J.P. Morgan/Bear Stearns in 2008.

Our point of making the comparison between distinctly different institutions in different eras was to show what the hazards might be when an ailing bank isn’t allowed to fail. It was only two years after the merger of BodenKreditAnstalt with CreditAnstalt that the remaining “super bank”, CreditAnstalt, collapsed which resulted in the worldwide banking crisis.

The failure of CreditAnstalt in 1931 did not arrive without a fight. F.M. Rothschild committed enormous amounts of money from 1930 to 1931 in an effort to use his name and financial largess to sway public opinion of the health of CreditAnstalt, not unlike Warren Buffett’s most recent investment in Bank of America. Buffett’s announcement that he’ll invest up to $5 billion may be a significant win for the Oracle of Omaha, and has temporarily boosted the share price of Bank of America by nearly 13%. However, even the biggest money interests cannot forestall the inevitable consequence of forced mergers if hobbled banking institutions.

The culmination for CreditAnstalt was nationalisation. Will it be the same for Bank of America?