Below is a great post by David Kotok and a related comment from Bond Girl on munis, Michael Lewis and his latest Vanity Fair ARTICLE Whitney critique. The original post is here https://self-evident.org/?p=931  Thanks to David Kotok & Bond Girl for reprint permiso. As I told Joe Mysak at Bloomberg earlier today, I still think that there is a medium term default threat for CA, IL and NY, in that order, but so long as the banks keep paying the advances on foreclosed homes, the problem will be kept at bay.  Meredith Whitney should buy David Kotok lunch and spend some time listening IMHO.  -- Chris

Michael Lewis’ latest piece in Vanity Fair, “California and Bust,” begins with a lengthy defense of Meredith Whitney’s prediction that there would be a wave of defaults in the municipal bond market. I was not planning on writing a response to his article – frankly, defending Whitney’s call at this point is very much like defending Harold Camping’s prophesy on May 22nd, after even the most gullible people have realized that they euthanized their pets for nothing. Who really cares about the intransigent believers that remain, for whom a forceful narrative has always been more relevant than facts?

Whitney’s call for “50 to 100 sizeable defaults” totaling “hundreds of billions of dollars” has not even come close to materializing. According to Richard Lehmann’s Distressed Debt Securities Newsletter, there have been $1.18 billion of municipal defaults through September 22, 2011, compared with $3.61 billion for 2010. In an earlier post, Default and Bankruptcy in the Municipal Bond Market, I suggested that conduit debt for healthcare and housing would continue to be the largest source of municipal defaults this year. In fact, healthcare credits have accounted for 39% of this year’s monetary defaults. The single largest monetary default was a housing project. The Clare at Water Tower in Chicago, a retirement facility that was financed in 2005 with $229 million of bonds, failed to make an installment payment to cure a shortage in its debt service reserve fund, which was a default event that triggered a mandatory tender on $125 million of floating-rate bonds. This meant the trustee had to make a draw on the credit facility that supported the debt. Lehmann has noted that defaults on Florida dirt bonds (which are secured by special assessments on real property) have been the “single biggest [on-going] default event in the history of the municipal market,” with 77% of bonds issued since 2003 having defaulted. (That figure includes bonds that have tapped debt service reserve funds.)

Even more to the point, all but one of these defaults have been on revenue bonds. The only monetary default on the general obligation debt of a municipality this year involved the city of Brighton, Alabama (population 2,945). According to Bloomberg, the city (which is located just outside of Birmingham) lost 19% of its residents from 2000 to 2010. It missed a $22,783 interest and $35,000 principal payment on its $1.2 million of GO warrants. While I am sure this event is tragic for someone, it hardly represents the Armageddon that Whitney predicted.

For much of the first half of the article, Lewis seems to be trying to support Whitney’s argument that states do “a poor job of providing information about their finances to the public,” and that “the scary thing about state treasurers … is that they don’t know the financial situation of their own municipalities.”

Lewis decides to test her assertion, at least as it pertains to California, which is the state Whitney says is in the worst position. Of course, Lewis does not interview Bill Lockyer, who is the state’s treasurer, but Arnold Schwarzenegger, the former governor. His rambling interview with Schwarzenegger, which takes place while the two ride bicycles along the beach, mostly covers the governor’s improbable ascent to political leadership and struggles while in office. Lewis leaves his audience with the impression that the state’s political leadership lacked a nuanced appreciation of the state’s financial management, and that the administration was pretty much winging it. Schwarzenegger likewise confessed to being clueless about local governments in the state: “I’m not into the local stuff … I was born for the world.” Um, okay…

I have the feeling that if Lewis had interviewed Lockyer instead of Schwarzenegger, he would have come away with a very different understanding of state and local finance and a very different view of public officials. But Lewis would not have had to interview anyone to see that Whitney was wrong about the level of financial information that the state government provides its residents and potential investors – he could have just visited Lockyer’s website. On the website, Lewis would have found: a summary of the enacted budget; agency-level detail of the enacted budget; the Legislative Analyst’s Office’s analysis of the enacted budget; the latest monthly General Fund cash receipts and disbursements; a discussion of trends in cash receipts and disbursements; the state’s annual debt affordability report; the latest report on outstanding and authorized state bonds; a searchable database for state and local debt; California state and local government debt issuance data; the California Debt and Investment Advisory Commission’s monthly newsletter; or any of a myriad other publications related to the financial condition of the state and its political subdivisions. Of course, Lewis could also review the state’s financial statements for the last decade at the controller’s website. While state policymakers have spent considerable time debating spending issues, I think it would be difficult to argue that financial trouble catches officials off guard. And while disclosure can and should always be improved, is this not a commendable effort at transparency? How would Lewis’ audience view state officials’ awareness of state and local financial affairs differently if he had mentioned that this information is publicly available and not a mystery as Whitney suggests? (Note: I do not own or work with California bonds.)

What about the monthly seminars the state hosts to educate local government officials on bond math, derivatives, and similar topics? Lewis could have also attended one of the financial management-related conferences the state hosts for issuers, market participants, and the media each year. (They are excellent and informative events.)

TO BCC LIST:   Forwarding this excellent comment about Munis and the Vanity Fair article.  It was written by bondgirl@self-evident.org.    Bondgirl advised in email that she/he desires to remain anonymous.  In our view that is a shame since the piece is so well researched and written and deserves wider readership but will not obtain it as long as the writer weeks to hide behind anonymity.  BTW, we have no way to know if “Bondgirl” is a girl or a boy.    D 

Bondgirl wrote:

“As I was reading Lewis’ defense of Whitney’s arguments, it struck me that he probably did not read Whitney’s Tragedy of the Commons report (as I have). If he had, it probably would have occurred to him that she mostly used data and analysis provided by organizations like the National Association of State Budget Officers (which publishes reports explaining the logistics of states’ individual budget processes and comparing state budget actions) and the Pew Center on the States (to name only a couple). She doesn’t really do any of her own analysis at all – her work reads like an incredibly verbose high school student’s book report. The only remarkable thing about Whitney’s research is that she somehow convinced her clients to pay $100,000 for information that was easily a Google search away (plus a considerable amount of political bloviating). He also would have known that her opinions about local governments were not based on any specific analysis of local credits. She said there would be hundreds of billions of dollars’ worth of defaults in a sector of the municipal market that she had not even studied. And Lewis seriously wishes to defend this kind of reckless and irresponsible behavior?

Lewis makes two other undeveloped arguments in support of Whitney. The first is that her claims have been misrepresented. It seems fairly silly to say that her words have been misrepresented when they have been captured on video and repeated ad nauseam over the past twelve months. And much has been made of how Whitney conflates what she calls “defaults on social contracts” and what most rational people would consider a default, which is a failure to observe terms of the bond contract or a failure to make timely principal and interest payments. (That is not misrepresenting her views, but providing a legitimate criticism of her sense of what constitutes a credit event.) In interviews, Whitney has generally moved back and forth between the two as is convenient.

But “she was referring to the complacency of the rating agencies and investment advisers who say there is nothing to worry about,” Lewis offers. As I have already explained, until recently, the rating agencies inexplicably rated munis on a tougher scale than other kinds of credits, and most of the monetary defaults the market sees are on bonds that had junk ratings or were unrated when issued. Lewis would know this if he had actually researched credit events in the marketplace before writing his article.

Lewis’ other defense is that:

Whatever else she had done, Meredith Whitney had found the pressure point in American finance: the fear that American cities would not pay back the money they had borrowed. The market for municipal bonds, unlike the market for US government bonds, spooked easily. American cities and states were susceptible to the same cycle of doom that had forced Greece to seek help from the International Monetary Fund. All it took to create doubt and raise borrowing costs for states and cities was for a woman with no standing in the municipal-bond market to utter a few sentences on television.

Ah, yes, the inevitable analogy to Greece. I have explained in prior posts why this analogy makes no sense, and how state and local governments are not dependent on short-term market access in the same way the US government and European sovereigns are. When municipal rates increased, state and local governments simply stopped issuing bonds. The fact that they could do so and not have immediate, bailout-inducing debt crises communicates volumes about the financial strength of the credits in this market. Also, the highest the benchmark Bond Buyer 20-Bond GO index reached following Whitney’s 60 Minutes interview was 5.41% on January 20. What conclusions would Lewis’ audience have drawn from his article if he had compared that to yields on Greek bonds? I would also submit to you that the market will be less vulnerable to such hysteria going forward precisely because Whitney has been so embarrassingly incorrect. Trusting Whitney was an expensive lesson for dumb money. (It was a terrific opportunity for private wealth and more savvy investors, however.)

The truth is that Whitney’s 60 Minutes interview coincided with the expiration of the Build America Bond program, which had caused a glut of new issuance in the market and was already driving rates up. Major structural shifts were already underway in the market, and the BAB program had been the last support. Either accidentally or deliberately, Whitney made her call in the middle of a perfect storm for munis. And she was still wrong.

I do not have much to say about the remainder of Lewis’ piece except to express a general frustration with the way journalists seem to equate anecdotal evidence with genuine financial analysis in terms of credibility. Yes, Vallejo’s situation is a prime example of how political paralysis can morph into a vicious economic feedback loop and legal industry stimulus program. But presenting Vallejo as indicative of a trend is another matter. Did other governments make generous commitments during periods of economic prosperity? Sure, it is almost impossible for political officials not to do this kind of thing. But are other governments pushing themselves to the brink by not addressing this issue? Lewis’ audience wouldn’t know, because he did not interview the mayors of any of the two-thirds of the 296 California municipalities (as surveyed by the League of California Cities) that are in the process of renegotiating changes to their retiree benefits plans. I suspect if Lewis had, he would have discovered that other cities have internalized Vallejo’s situation.

I hope no one will read this and think that I believe the municipal bond market is without risks. This is not true. (The most likely source of a major disruption in the municipal bond market in the near future is the tax status of the bonds – not massive defaults – in my opinion. But that is a topic for another post.) The municipal bond market is a complicated market. Many investors I have spoken with fail to appreciate the differences between claims, that there are different sectors in the market, the difference between conduit and government bonds, etc. This is a market where the difference between issuers matters. People like Lewis and Whitney, who are trying to sell a canary-in-the-coal-mine version of the market, are doing investors a disservice. There are hundreds of municipal bond market professionals that understand these matters on a granular level, have more than a couple years’ acquaintance with the market, and have actually analyzed local government debt, but you are unlikely to read about them in Vanity Fair or see them interviewed on 60 Minutes offering a counterpoint to Whitney. Why is that?

As a postscript, someone should ask Whitney why she has not formally submitted an application to the Securities and Exchange Commission for NRSRO status. (Remember how she was going to create a rating agency?) The SEC would have to waive its requirement that ten large institutional investors pledge they have relied on Whitney’s credit analysis for three years. Is she having trouble convincing the SEC to do so, or was she not sincere about establishing a rating agency in the first place? Inquiring minds want to know.”

Thank you, Bondgirl for permission to share this missive.

David R Kotok

Chairman & Chief Investment Officer

Cumberland Advisors

One Sarasota Tower | 2 N. Tamiami Trail | Suite 303 | Sarasota, FL 34236

614 E. Landis Avenue | PO Box 663 | Vineland, NJ 08362-0663

(800.257.7013 x 320  | NJ fax: 856.794.9113 | FL fax: 941.554.4352

* david.kotok@cumber.com |Website: www.cumber.com

We noted, in September, that corporate bond downgrades were outpacing upgrades very notably and today we get the other side of that with Moody's noting that in Q3, Muni downgrades outweighed upgrades by the most since the financial crisis began. At 5.3 to 1, the third quarter of 2011 had the highest downgrade-to-upgrade ratio of any quarter for the U.S. public finance sector since the onset of the financial crisis in 2008. "A rapid deterioration in credit metrics led to a higher-than-average 14 multi-notch downgrades."

While the number of defaults (and size) has hardly been what Ms. Whitney expected, and the overall performance of Muni bonds has been strong - especially relative to corporates - the volumes of downgrades from S&P and Moody's is definitely 'unusual' from a cyclical perspective and we note the rather systemic decompression between General Purpose Revenue bonds vs high-quality G.O.s.

Moody's 'government' upgrade/downgrades over past few years from Bloomberg's RATT screen.

S&P's upgrade/downgrades over the past few years.

And from Moody's:

At 5.3 to 1, the third quarter of 2011 had the highest downgrade-to-upgrade ratio of any quarter for the U.S. public finance sector since the onset of the financial crisis in 2008, says Moody's Investors Service in its quarterly report on rating activity in the sector. The previous high of 4.6 to 1 was registered in the fourth quarter of 2010.

 

"Downgrades dominated rating revisions across all public finance sectors except for healthcare," said Assistant Vice President-Analyst Dan Steed, author of the report. "A rapid deterioration in credit metrics led to a higher-than-average 14 multi-notch downgrades."

 

The impact of deficit-cutting measures by the federal and state governments will be a key driver of rating changes across public finance sectors as the strains on core operating expenses and revenue sources of the last three years will likely persist over the next year, according to Moody's.

 

"This will be mostly due to economic stagnation, high unemployment, declining home values, and low consumer confidence," said Steed. "We expect downgrades to continue exceeding upgrades in upcoming quarters."

 

--State ratings: Downgrades outpaced upgrades by 10 to 1, as transit and highway revenue bonds accounted for 60% of the downgrades. We expect the trend to continue against a backdrop of federal budget cuts, and lackluster revenue growth exacerbated by increased reliance on personal income taxes.

 

--Local governments: At 9 to 1, the ratio of downgrades to upgrades significantly exceeded totals (3 to 1)of the prior quarter. Similar to the first half of 2011, school districts were challenged by declining property tax revenues, as well as reduced state funding. A total of 26 local government issuers were downgraded by multiple notches given the sharp deterioration in their financial metrics.

 

--Not-for-profit hospitals: Upgrades outpaced downgrades for only the second quarter in the last two years. We do not expect this positive trend to continue, especially for smaller-sized hospitals, given continued pressures on major revenue sources such as Medicare.

 

-- Higher education and other not-for-profits: Ongoing operating pressures and strained liquidity drove the elevated level of downgrades. Unlike the previous two quarters, there were no multi-notch downgrades of higher education or not-for-profit credits. Over the near term, the number of downgrades will likely continue to exceed upgrades due to operating challenges and strained liquidity.

 

--Infrastructure: The third quarter's single upgrade was significantly overshadowed by 18 downgrades. Downgrade activity might stabilize as operating conditions for infrastructure credits are likely to stabilize over the next year unless economic growth declines precipitously.

 

--Housing: Continued challenges in the housing and mortgage market led to another quarter in which downgrades exceeded upgrades by a material 3-to-1 margin. The outlook remains negative due to high delinquency and foreclosure rates, low reinvestment rates, and the deterioration of counterparty credit quality.

It is worth bearing in mind that if downgrades continue and Munis underperform then the MtM changes may well be enough to drive significant negative pro-cyclical behavior as the typical investor (in a similar way to Italy bond holders perhaps) is not used to seeing capital depreciation while they earn their modest yield. Perhaps that is the catalyst - further downgrades, fund outflows on price depreciation, and exaggerated liquidity dry ups - as opposed to simple fiscal concerns?

Charts: Bloomberg

When French bankers gorge on roasting PIIGS...

From the NY Times:

PARIS
— BNP Paribas, the largest French lender, announced a sharp decline in
third-quarter profit Thursday and said it was writing off 60 percent of
the value of all the Greek debt it holds, a belated acknowledgment that
the loans are largely unrecoverable.

The
bank, based in Paris, said it was setting aside about €2.1 billion, or
$2.9 billion, of the value of its Greek sovereign debt. It is writing
down about €116 million of exposure to Greek corporate bonds.

It's
but so much of an acknowledgement, the write downs are woefully
insufficient - alas, they do match the numbers being bandied about in
the pop media so I guess management says that's sufficient "can kicking"
material...

The
bank said it had also moved to address its exposure to embattled euro
zone government debt in the latest quarter, selling €1.9 billion of
Greek sovereign debt, €8.2 billion of Italian debt and €2.5 billion of
Spanish debt.

Yeah, but the question du jour (or should that
be "question du trimestre") is what is the P&L hit of those sales
(we all know they couldn't dump that trash without significant pain, and
how much of it (my guess, none) is illustrated in the Q3 numbers???

‘‘The
new Greek debt restructuring plan has adversely impacted this quarter’s
net income, which, otherwise, is in line with the performances of
previous quarters,’’ Baudouin Prot, the chief executive, said in a
statement.

But that "new" Greek restructuring plan was old
before it was even launched. Greece cannot last at 120% GDP under
extreme austerity measures. I know that, and they know it too. Back to
the drawing board, buddy!

Many
large banks went on to write down half or more of their exposure, and
when a new Greek aid deal was announced on Oct. 27, its call for a 50
percent ‘‘haircut’’ on the loans merely codified what a number of banks
had already put into practice.

On with the game playing.
First, there was no haircut needed. According to TPTB, there was no
insolvencies, there would absolutely NO haircuts, defaults or
insolvencies (see Greek Crisis Is Over, Region Safe”, Prodi Says – I say Liar, Liar, Pants on Fire!). Okay, we were just joking, there weill be some haircuts, but no more than 21% (see A Comparison of Our Greek Bond Restructuring Analysis to that of Argentina). Did we say 21%? We meant 50%, must've been something lost in the translation (see How Greece Killed Its Own Banks!).
We said 60%, don't you understand. That is what the banks are writing
in, even though the IMF (whom Reggie Middleton has proven to be wrong to
the optimistic side nearly 100% of the time during this crisis, see Lies, Damn Lies, and Sovereign Truths: Why the Euro is Destined to Collapse!) says the haircuts need to be 75%. You don't even want to know what Reggie says they should be!  

Attention
professional and institutional subscribers! I will rerun the BNP
numbers with the most up to date and realistic numbers and publish them
within 24 hours. I will be avaialble to discuss them in the private
forums, or if you wish through a Google+ video conference call if enough
of you are interested.

Click to expand...

From Forbes.com:

Many
outside of Europe ask why are government’s paying so much attention to
Greece, such a small economy in EU terms, instead of focusing on larger
problems, like Italy and Spain.  BNP Paribas’ third quarter earnings illustrate the case.

France’s
largest bank, BNP Paribas saw its profits drop 72% to euro 541 million,
after writing down an additional € 2.4 billion in Greek debt, 60% of
its total exposure. 

Contagion
is the name of the game in Europe, and that’s why BNP Paribas has been
trying to cut its exposure and beef up its core tier 1 capital ratio. 
BNP lowered its exposure to bailed out peripherals (Greece, Ireland, and
Portgual) by 37.9% through the third quarter to € 3.3 billion.

Still,
BNP holds those € 3.3 billion in debt from bailed out countries (€ 1.6
billion of it in Greek debt), half a billion in Spanish debt, and a
whopping € 12.2 billion in Italian debt.  While the bank managed to cut
its exposure to Italy almost by half from € 20.5 billion, the value of
its portfolio has taken the hit.

BNP
Paribas’ total assets under management fell 4.1% to € 851 billion, as a
reaction to the drastic fall in asset prices, the accelerated outflow
of assets, and losses on its fixed income portfolio.

Corporate
and investment banking (CIB) revenues tanked 39.8% to € 1.75 billion. 
It was a slaughtering at the CIB unit, with fixed income revenue down
33.4%, equities down 44%, and the financing business down 13.6%.

The bank remains leveraged 22.3 times and is struggling to lower its exposure to U.S. dollar funding... 

Through the third quarter, BNP Paribas lowered its U.S. dollar funding
needs by euro 20 billion, as it moves toward a 9% core tier 1 capital
ratio.

BNP’s
share price action is another illustration of the dire situation in
Europe.  Despite these brutal results, shares in BNP Paribas actually
rallied on Thursday, up more than 7%.  The stock is still down almost
40% over the trailing 12 months, compared with a 10% drop for JPMorgan Chase and nearly 30% for Citi.

The large French bank is a perfect example of the interconnections between European nations and the exposure to peripherals. 
A default by Greece would spark a domino effect, as BNP Paribas would
have to go from writing down 60% of their peripheral exposure to 100%. 
As credit spreads widen in Italy, Spain, and the other PIIGS, further
stress would be put on BNP Paribas’ balance sheet, possibly tipping it
into insolvency.

Hmmm... This article was dated 11/03/2011. 

BoomBustBlog
susbscribers were alerted to BNP Paribas woes as far back as May 2010.
We issued explicit and verbose warnings with valuation bands for BNP in
June of this year. I am not aware of ANYONE on the sell side warning of
BNP's woes. ANYONE!?!?!? Subscriptions, anybody? As you can see from the chart above, it has been a very profitable ride down on the short side. As excerpted from This Is Why BoomBustBlog Is THE Place To Go For Hard Hitting Research: BoomBust BNP Paribas?:

Bear Stearns/Lehman Deja vu?

Yesterday, in my post 'As The French Bank Runs....", I
queried of the sell side, "What the hell took you so long to come to
these rather astute observations, dude?" Well, in continuing my crusade
of truth against the potential insolvency of French banks, I reference
the WSJ article titlled "BNP Paribas Denies Funding Problem"

PARIS—BNP
Paribas SA on Tuesday denied it is facing a dollar-liquidity problem,
as reported in an opinion column in The Wall Street Journal. BNP Paribas
said it is fully able to obtain U.S. dollar funding in the "normal
course of business," either directly or through swaps. In a column
published in The Wall Street Journal Tuesday, Nicolas Lecaussin,
director of development at France's Institute for Economic and Fiscal
Research, cited an unidentified BNP executive saying the bank "can no
longer borrow dollars."

A Wall Street Journal
representative wasn't immediately available to comment. BNP Paribas said
its has abundant euro short-term funding and has a net dollar
short-term funding with maturity shorter than a year worth €60 billion.
The bank has €135 billion in "unencumbered assets after haircuts" that
are eligible to central banks. The bank also said it is using
foreign-exchange swaps to more than offset the recent reduction and
"shortening" of funding from U.S. money market funds. French banks, in
particular BNP Paribas and Société Générale SA, have been hurt by a
perception that they face difficulties in tapping short-term funding in
the U.S., as money-market funds cut their exposure to the banks amid
fears about potential contagion from the Greek and broader European
sovereign debt crisis. Shares of BNP Paribas were down 8.3% at €23.97
recently, the biggest loser on the Paris stock exchange, where the
benchmark index was down 1.8%. SocGen was down 3%."

Hey, Big Wall Street Bank Execs Always Tell the Truth When They're in Trouble, RIIIIGHT????

Here's more of Alan Schwartz lying on TV in March of 2008

Like I said above, it's not as if upper management of these Wall Street banks would ever mislead us, RIGHT????

Erin Callan, CFO of Lehman Brothers Lying giving an interview on TV in March andagain in June of 2008.

Even
if the big Wall Street banks would lie to us, we have expert analysts
at hot shot, white shoe firms such as Goldman Sachs, who of course not
only are "Doing God's Work" but also happen to be the smartest of the
smart and the "bestest" of the best, RIIIGHT!!!??? Below we have both
Erin from Lehman AND Goldman lyingon TV in a single screen shot. Ain't a picture worth a thousand words???

We even had the inscrutable Meredith Whitney say "To suggest that Lehman Brothers is going out of business is a real stretch!" (She OBVIOUSLY DOESN'T READ THE BOOMBUST) as well as Erin Callan, the CFO of this big Wall Street bank on TV lying interviewing again...

But
that damn blogger guy Reggie Middleton put his "put parade"short combo
on Lehman right about that time, and had all of these additional
negative things to say...

Lehman stock, rumors and anti-rumors that support the rumors Friday, March 28th, 2008

It appears that I should have dug deeper into Lehman! 

So, does BNP have a funding problem, or is it at risk of the same?

BoomBustBlog
subscribers know full well the answer to this question. I'm also going
to be unusually generous this morning being that our prime French bank
run candidate has approached my "crisis" scenario valuation band. So, as
to answer the question as to BNP, let's reference  Bank Run Liquidity Candidate Forensic Opinion - A full forensic note for professional and institutional subscribers, and otherwise known as BNP Paribas, First Thoughts...

The WSJ article excerpted above quotes BNP management as saying: "The bank has €135 billion in "unencumbered assets after haircuts" that are eligible to central banks."

OK, I'll bite. Excactly how did BNP get to this €135 billion figure? Was it by using Lehman math? Methinks so, as clearly delineated in my resarch report on the very first page:

The
following two pages of this report go on to reveal the games being
played to potentially come up with a figure such as the 135 billion
quoted above. Boys and girls, I fear those may be Lehman bucks! 

For
those not familiar with the banking book vs trading book markdown game,
I urge you to review this keynote presentation given in Amsterdam which
predicted this very scenario, and reference the blog post and research
of the same:

• a research note to subscribers,  The Inevitability of Another Bank Crisis,
• followed by blog posts on the same, see Is Another Banking Crisis Inevitable?, as excerpted...

But wait, there's more - much more!

This
document is 19 pages full of stuff that BNP management may have
forgotten to tell you, as well as valuation for both "crisis" and
bailout scenarios. What you have before is an anecdotal 5 pages. To put
this in perspective particularly since no on the sell side warned about
French bank risk before the fact, let's look at the chart as of the day
this research was released and I'll let you tell me if it was worth the
subscription...

Roughly 50% and falling as Vol and gamma explode! 

Just to add a sense of chronological depth to this post, let's revisit the timeline from yesterday's piece, "As The French Bank Runs....": 

Saturday, 23 July 2011 The Anatomy Of A European Bank Run: Look At The Banking Situation BEFORE The Run Occurs!: I detail how I see modern bank runs unfolding

image012

Thursday, 28 July 2011  The Mechanics Behind Setting Up A Potential European Bank Run Trade and European Bank Run Trading Supplement

I
identify specific bank run candidates and offer illustrative trade
setups to capture alpha from such an event. The options quoted were
unfortunately unavailable to American investors, and enjoyed a literal
explosion in gamma and implied volatility. Not to fear, fruits of those
juicy premiums were able to be tasted elsewhere as plain vanilla shorts
and even single stock futures threw off insane profits.

Wednesday, 03 August 2011 France, As Most Susceptble To Contagion, Will See Its Banks Suffer

In
case the hint was strong enough, I explicitly state that although the
sell side and the media are looking at Greece sparking Italy, it is
France and french banks in particular that risk bringing the
Franco-Italia make-believe capitalism session, aka the French leveraged
Italian sector of the Euro ponzi scheme down, on its head.

I then provide a deep dive of the French bank we feel is most at risk. Let it be known that every banked remotely referenced by this research has been halved (at a mininal) in share price! Most are down ~10% of more today, alone!

•  French Bank Run Forensic Thoughts - Retail Valuation Note - For retail subscribers
•  Bank Run Liquidity Candidate Forensic Opinion - A full forensic note for professional and institutional subscribers

I
also provided a very informative document for public consumption which
clearly detailed exactly how this French bank collapse thing is likely
to go down:  French Bank Run Forensic Thoughts - pubic preview for Blog - A freebie, to illustrate what all of you non-subscribers are missing!

So, What's the Next Shoe To Drop? Read on...

For
those who claim I may be Euro bashing, rest assured - I am not. Just a
week or two later, I released research on a big US bank that will quite
possibly catch Franco-Italiano Ponzi Collapse fever, with the pro
document containing all types of juicy details. This is the next big thing, for when (not if, but when) European banks blow up, it WILL affect us stateside! Subscribers,
be sure to be prepared. Puts are already quite costly, but there are
other methods if you haven't taken your positions when the research was
first released. For those who wish to subscribe, click here.

•  Contagion Forensic Review - Retail
•  Contagion Forensic Review - Professional

Other reading of interest...

1. The Anatomy of a Serial European Banking Collapse
2. Greece Reports: "Circular Reasoning Works Because Circular Reasoning Works" - Or - Here Comes That Default!!!
3. The French Banks Are The First To Accept a Voluntary Greek Restructuring
4. Over
   A Year After Being Dismissed As Sensationalist For Questioning the
   ECB's Continued Solvency After Sovereign Debt Buying Binge, Guess What!
5. Click, Clack, Click: The Sound of Falling Dominoes Behind The Door of the Eurocalypse!
6. LGD 100+: What's the Possibility of Certain European Banks Having a Loss Given Default Approaching 100%?
7. Eurocalypse
   Cometh! Principal Haircuts, Serial Bailouts, ECB Insolvent! Disruptive
   Sound Of Dominoes In Background Going "Click, Clack"! BoomBustBloggers
   Instructed To Line Up Bearish Positions Again!

BNP specific BoomBustBlog research and free public opinion...

Remember, back in the day, when a bankruptcy was simply called a bankruptcy? Naturally, this was well before ISDA came on the scene and footnoted the living feces out of everything by claiming that a bankruptcy is never a bankruptcy, as long as the creditors agree to 99.999% losses at gunpoint, with electrodes strapped to their testicles, submerged in a tank full of rabid piranhas, it they just sign a piece of paper (preferably in their own blood) saying the vaseline-free gang abuse was consensual. Well, now we learn that as the global insolvency wave finally moves to China, a bankruptcy is now called something even less scary: "deferred loan payments" (and also explains why suddenly Japan is going to have to bail China out and buy its bonds, because somehow when China fails, it is the turn of the country that started the whole deflationary collapse to step to the plate). After all, who in their right mind would want to scare the public that the entire world is now broke. Certainly not SWIFT. And certainly not that paragon of 8%+ annual growth, where no matter how many layers of lipstick are applied, the piggyness of it all is shining through ever more acutely. Because here are the facts, from China Daily, and they speaks for themselves: "China's biggest provincial borrowers are deferring payment on their loans just two months after the country's regulator said some local government companies would be allowed to do so....Hunan Provincial Expressway Construction Group is delaying payment on 3.11 billion yuan in interest, documents governing the securities show this month. Guangdong Provincial Communications Group Co, the second-largest debtor, is following suit. So are two others among the biggest 11 debtors, for a total of 30.16 billion yuan, according to bond prospectuses from 55 local authorities that have raised money in capital markets since the beginning of November." So not even two months in and companies are already becoming serial defaulters, pardon, "loan payment deferrers?" And China is supposed to bail out the world? Ironically, in a world in which can kicking is now an art form, China will show everyone just how it is done, by effectively upturning the capital structure and saying that paying interest is, well, optional. In the immortal words of the comrade from Georgia, "no coupon, no problem."

Our advice: go long Teva, which recently acquired Cephalon, and its wonderful drug Provigil, which is basically legalized cocaine, speed, meth and heroin all in one perfectly legal pill, as the newsflow, up until now only picking up with the idiot headlines out of Europe at 3 am Eastern is about to become one constant 24/7 flashing red rumor/disinformation mill. Also, next time someone wants to make THE drug cocktail of choice for the headline reacting speed trading junkie, please name it appropriately. Jeffrey will suffice.

More on China's piglipsticking:

As local governments delay payments for projects commissioned as part of the stimulus to ward off recession in 2009, less money is available for bank lending even as China is taking steps to inject more into the economy. The central bank has held interest rates at 6.56 percent since July to boost the economy, while the US Federal Reserve and the Bank of Japan have kept benchmark rates near zero since 2008.

 

"When companies start to roll over debt they're not retiring debt, and banks aren't retrieving their capital, so you're crowding out new lending," Patrick Chovanec, a professor at Tsinghua University in Beijing, said in a Dec 13 interview. "This is a problem that's going to start to bite next year."

 

Local governments had 10.7 trillion yuan in debt at the end of last year, 79 percent due to banks, according to the country's first audit released in June. So-called local financing vehicles that meet collateral requirements can have a one-time extension on their loans, Zhou Mubing, vice-chairman of the China Banking Regulatory Commission, said at a conference on Oct 24 organized by the Internet portal Sina.com.cn, according to a transcript of his comments on the website.

 

Guangdong Provincial Communications Group, Hunan Provincial Expressway Construction Group, Gansu Provincial Highway Aviation Tourism Investment Group Co and Sichuan Railway Investment Group Co owe more than 200 billion yuan to banks, the data show. They plan to defer 34.4 billion yuan in interest payments, according to their bond prospectuses.

Yes, that's a lot, and it's going to get much worse. But not if you listen to Beijing Bob: yes, even communist countries have a department of propaganda:

Lei Wanming, Gansu Highway's deputy Communist Party secretary, said the company's interest payment deferrals do not raise any concerns. "Our company can pay our interest and our principal payments with no problem," he said in a Dec 5 interview. "You can't just consider this issue by looking at a bond prospectus."

Said otherwise, all is good, and China's 'relatively fast' growth is still on the agenda:

National leaders set a goal of "relatively fast" economic growth for 2012 at a major conference in Beijing that ended on Dec 14, according to the Xinhua News Agency. The global outlook "remains very grim", Xinhua cited the leaders as saying.

What is most ironic is that Meredith Whitney will be right... just wrong about the country.

The extra yield required to hold Hunan Provincial Expressway's 900 million yuan in 2012 bonds has increased to 308 basis points from 151 basis points on June 21, when they were issued. That compares with a current spread of 11 basis points on Shenzhen's five-year direct municipal bonds. 

 

Yields on local government financing company bonds will remain high next year as selling debt becomes a main channel for raising funds, China International Capital Corp analysts led by the fixed-income analyst Xu Xiaoqing wrote in a Dec 16 research note. Most of the bonds are sold at yields of 8 percent, or 144 basis points more than the benchmark bank lending rate, according to the report. Five-year top-rated corporate bonds yield 4.98 percent, according to Chinabond, the nation's bond clearing house.

 

"Although the China Banking Regulatory Commission has recently eased loan restrictions to help liquidity, recent supply has been increasing, causing the secondary market to pay attention to systemic risks," they wrote. "The credit quality of recent financing vehicle bonds continues to get weaker."

For those who refuse to swallow China's lies, there is one way around it:

Five-year credit-default swaps insuring against default on China's sovereign debt rose 3.2 basis points recently to 149.66 basis points, according to data provider CMA...

As more and more scratch their heads, the math is clearly not your friend:

Even after the reduction in interest payments, Gansu Provincial Highway said that interest and principal payments in 2011 will amount to 3.33 billion yuan, more than its 2010 cash flow of 3.04 billion yuan, according to bond-marketing materials.

 

"This prospectus is telling us that banks can expect to only receive roughly half of what would have been expected in interest payments," Charlene Chu, a Beijing-based banking analyst with Fitch Ratings, said of the Gansu disclosure.

And as for what happens when an entire continent is stuck fighting simple math and failing, we refer you all to the case study that is Europe.

So as we all prepare for what is set to be, without doubt, a relentless barrage of headlines, lies, innunedo, rumors, media counterrumors, more lies, propaganda, from Europe, the US and now Asia, here, again, is Jeffrey.

Via Pete Tchir of TF Market Advisors,

Stock futures are up sharply after another week of unprecedented volatility. Although last week was relatively tame, only 13 times in the last 60 years has the S&P 500 had a down 1% day during the week between Christmas and New Year's.  We managed one of those days last week.  We also had a 1% positive day.  Futures are strong and looks like stocks will open above 1272 (where they closed on Jan. 3, 2011).

Not only does volatility remain elevated, the stories are about the same. We have some new acronyms to contend with, but ultimately the European Debt Crisis (it is both a bank and sovereign crisis) and the strength of the US economy and China's ability to manage its slowdown are the primary stories. Issues in the Mid-East remain on the fringe but threaten to elevate to something more serious with Iran flexing its muscles more and more.

So what to do?  Prepare for more headlines, more risk reversals, and more pain.

There are a few "consensus" trades that particularly scare me.  It is almost impossible to find anyone positive on European stocks or US Financials. Finding someone positive on European Financials is impossible.  Back on December 15th we started to believe that going long Europe vs short the US made sense.  Too much "decoupling" had already been priced in.  I think that trade continues to make sense.

My belief that the LTRO does reduce funding and liquidity pressure on banks could provide some support for those stocks.  I don't believe in the "carry" trade hype of LTRO but do think that between last month's LTRO and the one coming up, the liquidity concerns will diminish.  The fact that the banks are all depositing money at the ECB shows that they don't intend to use it to source new assets, but will use it to deal with debt redemptions.  This is a benefit and given how many people seem pessimistic about the banks longer term (myself included), it might be enough to spark a rally.  More surprising, to me, has been the willingness of governments to support the banks without forcing shareholders dilution. 

Governments seem willing to help banks fund and are not acquiring equity stakes (certainly not at a significant discount).  That surprises me, as I expected governments to try and actually get some value for their citizens, but it looks like they have bought into the argument (made by banks) that bank share prices equate to banks' willingness to lend.  That argument is flawed, but if the governments are willing to help the banks without charging for it, then they could continue to perform well. 

I expect JPM will have a very strong quarter. They come out on January 13th.  They had a relatively small gain due to their own credit spread widening ("DVA") in the 3rd quarter, and at the time, seemed to be conservative about releasing reserves.  I expect they will increase reserve releases to more than offset any DVA give back.  C is the next big bank to come out, but not until January 17th, so strong JPM earnings could be enough to whet investors' appetites further.  Once BAC and MS are done reporting on the 19th and 20th the shine will be off the financials.  BAC seems to be a mess and is hard to guess what will happen, but MS is likely to have a weak quarter.  They settled with MBIA this quarter, booking a big loss.  Their 5 year CDS went from 161 at the end of June, to 490 at the end of September, but is back to 415 at year end.  That should result in some significant DVA losses.  Since the CEO was so happy to take the gains back in October (as opposed to JPM which seemed almost embarrassed to book those sorts of profits), I can only hope he bought back a lot of cheap debt to lock in some of the gains.  Obviously in this headline driven world, anything can change in a moment's notice, but these points are worth considering as the year starts.

More broadly, the view seems to be that we will start the year modestly or even weak, only to rebound later in the year.  I have trouble believing that since I think Europe is not close to being resolved, that our own economy is only doing okay at best, and that China is in worse shape than the data shows.  So, if the consensus is wrong, it is that we will start more weakly than most investors believe and that we will not bounce and in fact will do even worse in the second part of the year.  That would suit my views, but wouldn't cause me enough pain.  The pain trade might be a much much much stronger start to the year.  Enough strength to make all the shorts cut and for all the underweight bulls to fully load up, only to be followed by a disastrous sell-off.  I think a move like that would cause the most pain and damage to market participants, and seems far enough away from the consensus, that although I don't really believe it could happen, it is worth thinking about.

How could such a strong rally be ignited?  Nothing is fixed, but there is such overwhelming bearishness in regards to European Stocks and all financials, that there might just be enough tinder there to ignite something.  The spark might be a continued shift by policy makers to focus on Small Enough To Manipulate ("SETM") Markets.  Clearly, pretending that they could solve Italian debt problems in the secondary market didn't work. It is just too big.  Now they are focusing on the "auctions" rather than the secondary markets.  Each auction is relatively small and relatively easy to manipulate.  Coerce some banks to participate, push some EU money at it, let dealers whisper to hedge funds how "cheap" the issue is and how much demand there is, and "voila" you have a successful auction.  Convince market data sources to reference the bonds you want them to as "benchmarks" and manipulate those.  FX rates might be hard to manipulate, but take a market like basis swaps, and manipulate the heck out of them.  Flood them with central bank money, convince banks not to play in them, and "voila" you have created another benchmark that tells a positive story.  Why are Spanish yields so much lower than Italian yields?  The one explanation that makes sense, is that the market is so much smaller, it has been easier to manipulate.  I think we will see more targeted efforts to make the markets seem healthier than they are.  They won't be that convincing, but with continued high volatility and a complete lack of liquidity they may well work for brief periods.

Credit ETF's and CDS Indices

HYG and JNK have both done well.  Although they offer a decent "spread" in this environment, the duration is low, and the convexity is fairly bad, and they are both trading well above NAV.  On HYG we are neutral, and actually prefer JNK right now because it is trading at less of a discount, and the weaker portfolio would outperform if we get a grab for yield in the underlying bonds.  HY17 actually seems a better long.  It looks relatively cheap and still has a lot of "decompression" trade shorts.  It also has some bad shorts from other markets, so am slightly more interested in being long HY17 vs either of the ETF's.

LQD is also only marginally appealing.  It is trading a bit rich to NAV and has too much rate/duration risk for my tastes.  On the other hand, I could see the financial component rallying significantly here.  On a "hedged" basis (short some treasuries against it), LQD is more appealing.  Spread compression seems more likely than outright yield performance given where treasuries are.   IG17 at 119 isn't particularly appealing.  I don't mind it, but it seems like far more IG17 shorts have been taken off than HY17 shorts.  I also believe there is a decent amount of long Main, short IG out there, on the "decoupling" theory, and that too could come under some early pressure, creating a bid for IG17.

TLT (or the other treasury ETF's).  Is this the year to finally be short? With QE and Twist and the Fed in general supporting the curve, it is hard to be short, but this asset class probably has more muzzled bears than any other credit asset out there.  After being wrong 5 years in a row (or so), most of the treasury bears seem very silent, but they are still out there, waiting for the opportunity to jump on the bandwagon.

MUB and BABS should continue to do well.  On a treasury hedged basis these are our favorite credit ETF right now.  They survived last year and look reasonably cheap.  We have started to see stories pointing out how wrong Meredith Whitney was, which could help demand as retail investors decide they won't be open to ridicule at a cocktail party if they say they are long munis.  MCDX is just too thin and not diversified enough for me to focus on at these levels.

For a fling, some longer dated (lowest price possible) Italian bonds might be worth a shot, and buying some Greek debt may be worth a short.  Italy is a bet that any degree of stabilization sees a temporary bounce in their bonds, and Greek bonds seem cheap enough to own some and see how the negotiations play out.  If banks really do agree to a 75% haircut, any bonds that didn't participate should do better.  If there is a "hard" default, and that drags in bonds held by the ECB and pension funds, then the pressure to offer a recovery of closer to 50 would be higher, and the bonds could do well.  Picking some with a coupon due in January might not be bad as you aren't paying 100% for the coupon and it seems unlikely any resolution to the Greek debt default/restructuring/haircut/comedy occurs before the end of January.

In his latest letter, Bill Gross, obviously for his own reasons, essentially channels Zero Hedge, and repeats everything we have been saying over the past 3 years. We'll take that as a compliment. Next thing you know he will convert the TRF into a gold-only physical fund in anticipation of the wrong-end of the "fat tail" hitting reality head on at full speed, and sending the entire house of centrally planned cards crashing down.

From PIMCO

Toward The Paranormal

 

1. Durations and average maturities should be at their maximum permissible limits. Even if reflation is successful it will only be because the Fed and other central banks keep policy rates low for an “extended period of time.” Financial repression depends on negative real yields and until inflation moves higher for a period of at least several years, central banks will hibernate at the zero bound
2. The bulk of sovereign bond holdings should be in the U.S. as long as Euroland credit implosion is possible investors should gravitate to the “cleanest dirty shirt” sovereigns with the least encumbered balance sheets. Anything short of a 5-year maturity however yields relatively nothing and provides minimal rolldown. Focus on 5–9 year Treasury maturities to guard against inflation which create opportunities to take advantage of rolldown capital gains.
3. Long Treasury maturities should be held in TIPS form.  If inflation really is coming, then an investor will want assets that offer inflation-protection.
4. Corporate credit purchases should be in higher-rated   A and AA paper. Senior as opposed to subordinated holdings in finance/bank debt should be considered as well. Haircuts ahead?
5. U.S. municipals represent an opportunity from the stand point of valuation. Their yields of 5–6% are near historically high ratios to Treasuries. They do, however, entail risk – not only volatility but occasional default risk. This is not a Meredith Whitney echo but simply a recognition that you usually get what you pay for in this world and nothing comes for free. Be selective and avoid states/municipalities with pension and funding problems.
6. Continue to avoid Venus fly trap peripheral Euroland paper. Italian bonds at 7% for instance are enticing but have trap door possibilities that could see further “price” defaults in 2012.

Stocks and Commodities:

1. Stocks yield more than bonds and will tend to do better in anything but a delevering fat left tail. That, however, is what worries us. Equity allocations, therefore should favor higher yielding companies in sectors with relatively stable cash flows: Electric utilities (yes they appear overbought), big pharma and multinationals should head your shopping list.
2. Commodities could go either way depending on the tails but scarcity and geopolitical considerations (Iran) favor a positive tilt. Gold at $1550 seems pricey but it has upward legs if QEs continue.

Currencies:

1. The dollar is king with a left-tailed delevering scenario – pauper in a right-tailed global reflationary expansion.

If anyone is tired of the daily European soap opera with surrealistic tragicomic overtones, they can simply shift their gaze to the 8th largest economy in the world: the insolvent state of California, whose controller just told legislators has just over a month worth of cash left. From the Sacramento Bee: "California will run out of cash by early March if the state does not take swift action to find $3.3 billion through payment delays and borrowing, according to a letter state Controller John Chiang sent to state lawmakers today. The announcement is surprising since lawmakers previously believed the state had enough cash to last through the fiscal year that ends in June." ....uh, oops? But sure, fix the problem of excess debt by more "borrowing" why not. As for the math: "But Chiang said additional cash management solutions are needed because state tax revenues are $2.6 billion less than what Gov. Jerry Brown and state lawmakers assumed in their optimistic budget last year. Meanwhile, Chiang said, the state is spending $2.6 billion more than state leaders planned on." Quick, someone come up with a plan that involves subsidies and tariffs on China, or something else that deflects from what the source of the problem really is. Because the last thing that anyone in America would want to bring up is this thing called "responsibility" for their actions, or, as in now becoming the default case, the lack thereof. And why do that, when time spent so much more productively scapegoating this, and blaming that for one's own massive errors of judgment.

From the Bee:

The Assembly budget committee is considering a bill today that would enable $865 million of borrowing from existing state accounts, Senate Bill 95. Chiang, after consultation with the Department of Finance and state Treasurer Bill Lockyer, is also seeking about $2.4 billion in delayed payments to universities, counties and Medi-Cal, as well as additional borrowing from outside investors.

 

Absent these actions, the state would fall below its prudent $2.5 billion cash cushion on Feb. 29, Chiang estimated. On March 8, the state would actually end up $730 million in the red. The state would be below the safe cash cushion for several weeks ending April 13, save for several days at the end of March.

 

With such actions, Chiang believes the state would not have to use IOUs or delay tax refunds, maneuvers that have been relied upon in previous years. But Chiang also said that "more cash solutions may be required if our revenues continue to erode or if disbursements significantly exceed estimates."

So 3 years after Lehman filed for bankruptcy, everyone in the world continues to be terminally insolvent, but because everyone is in the same boat, everyone pretends not to notice and the best thing is just to blame Meredith Whitney for telling it like it is, if not getting the timing quite right? But at least the Fed isn't about to print up a tsunami of dollar-equivalent ones and zeros.

Warning: Wonkish

When you stick your neck out and make prognostications about the future, sometimes you're going to be wrong. I’m certainly no exception. But when it comes to really big misses, I think Meredith Whitney’s call for a monster blow-out of the Municipal Bond market is on top of the list.

Meredith is a smart lady. That being the case, it’s worth looking into why she was so wrong. A report this weekend from the Bond Buyer provides a partial answer:

A 32% ($138B) YoY decline is a very big relative change. The drop in long-term financing was not offset by increases in short-term debt; that category fell by 7.4% ($5B).

The drop in total borrowings is almost exclusively a result of the 46% ($129B) in the “New Money” category. The drop in New Money debt issuance is a consequence of hundreds of cities and states collectively saying:

We’re in a pinch on revenues. Let’s not spend any money we don’t have to for the time being. We’re going to have put off the construction of the new (Sewer plant, overpass, water treatment facility, school, whatever). The last thing we want to do is go to the Muni market and borrow any more.

As a result of many individual decisions to defer infrastructure projects, the Munis have kicked the can down road. They have eliminated the current and future expenses related to these projects. With that, they have stabilized the trajectory of their debt growth and improved short-term cash liquidity (by having less ST debt). In the process, they have created a shortage of muni bonds (relative to expectations) in the market.

Thus, all may appear well in muni land. A successful re-balancing has taken place, for the time being. If the munis can continue to push off infrastructure projects, they will not suffer the fate that Ms. Whitney feared they might.

I said that the munis had “kicked the can down the road”. In this case, it’s quite a different form of can kicking. When the Federal government raises the debt ceiling, we all say, “They kicked the can”. But the munis are doing (pretty much) the exact opposite, so Can Kicking would appear to be an improper/unfair description of what is happening with Munis. I think it's still valid, deferring infrastructure investments is another form of kicking.

Like most Kicking efforts, it will end badly sooner or later.

I’m looking at a potential example as I write. One of NYC’s reservoirs is about a half mile away. A $60mm NYC/NYS funded construction plan was shelved a month ago. Could this become one of those examples where Kicking goes badly? Consider this daisy-chain.

The Croton Reservoir is part of a chain of reservoirs that provide water for NYC. It’s large (22 miles), but it’s small in comparisons to the big man-made lakes further upstate. Croton is important because it connects directly to those upstate reservoirs via an underground tunnel. That tunnel goes north, and then west. It is 1,000 feet deep where it meets the Hudson River.

A bit of physics. The upstate reservoirs are 1,000 feet above the sea and the tunnel is 1,000 below. The tunnel is (was) large enough to drive a truck through so the water pressure at the lowest part of the tunnel is enormous. What might you expect from a 75 year old tunnel under that much pressure? A leak? Sure.


 

This is one hell of a leak. As much as 35 million gallons a day was the estimate seven years ago. There is evidence that rate has since accelerated. That comes to  13 billion gallons a year, which is sufficient for 250,000 average Americans. Think Orlando, Madison, Winston-Salem or Reno. Each of these cities uses about as much water as NYC is leaking. In China, this much water would meet the needs of 1.7mm people, In Bangladesh it would be sufficient for 3mm. It's enough to fill 650,000 in-ground swimming pools. That’s a leak.

It gets worse. The leak was first detected in 1988. Therefore something like 15 million swimming pools worth of drinkable water have been pissed into the ocean. It’s so bad that areas on either side of the tunnel have sinkholes. People have been forced to move. Properties have been condemned. And the sinkholes keep getting bigger.

There are already dozens of lawsuits on this. They are after the State and the City who own and maintain the reservoirs. The judges have all sided against the City and State, and there have been promises to fix the damn leak for years. A few years ago, a formal plan was put together.

This is no small engineering matter. A new tunnel will be built that connects the old tunnel before and after the break. Once completed, the old tunnel will be cemented closed. The diversion tunnel will be ½ mile long. Recall that this is 1,000 below sea level, any construction/mining this deep is both difficult and dangerous (the bends). Those normal risks are, however, trumped by risks that the nearby existing tunnel breaches during construction of the diversion tunnel. The water pressure in the tunnel is sufficient to crush a submarine.

The only option is to stop the flow of water in the tunnel from the source, and then pump out what is left. The supply of water would be cut for about a year while the diversion tunnel is completed. This takes us back to the Croton Reservoir and the cancelled construction at this location. The plan was to raise the spillway by four feet. This change would have added a permanent storage to the NYC system of 11B gallons (11 days of consumption). It was intended that this expansion of storage would be completed before the leaking water tunnel is closed. It would have provided an additional level of comfort on available water for the City. Not any longer.

NYC’s has numerous sources of water. The Croton reservoir system could be eliminated for a period of time without a real shortage. However, that would not be true if the tunnel was closed for an extended period, particularly if there was a drought in the northeast.

I wouldn’t be surprised if the cut off in supply were much longer than the one-year projection. The North East has been blessed/cursed with above average rainfall for years due to the long running La Nina, but rainfall is impossible to predict. Could we be in a full-blown El Nino (dry in the NE) when the construction starts? Maybe. If so, NYC will regret not having upgraded the storage capacity at the Croton system.

I don’t want to leave the impression that NYC is headed for trouble. The possibility of a hard landing is small. But there are risks, and those risks are increased as a result of the cancellation of the Croton project. Caswell Hollowy, the NYC commissioner on the tunnel repair project said in 2010:

“You want to know how long the water is going to be off so you know where the supplemental water is going to come from. It’s absolutely critical to get it right.” 

When Hollowy said this, the plan to upgrade the Croton system was still on.  Now it is has been shelved (Budget concerns were the reasons cited). It's now more "critical" to get that timing right. I'm laying 4 to 1 they don't.

The Bond Buyer reported a drop of $129B in New Money bonds. If you consider the $60mm Croton project as being representative, about 2,200 projects got cancelled last year. With that big a number, it is just a matter of time before something falls through the cracks (literally) and economic consequences follow.

Will NYC or some other city have water supply problems?


 

Will some municipality have a breakdown in its water treatment capacity that results in huge sewage leaks?

Will a bridge collapse that restricts important commerce?


 

Will there be a blow-out of the electrical grid due to underinvestment?

The answers to these questions (and more) is that infrastructure breakdowns will occur. If we don’t invest, the  resulting “leaks” will come back and bite us in the ass.

So far, the munis have reacted to their changed financial circumstances and have avoided the fate that Whitney saw coming. If they (collectively) continue doing what they did in 2011, they will probably avoid a financial crisis. But that doesn’t preclude problems sometime soon. Some big “things” are going to break. When they do, large communities will be affected. In the end, Whitney might be right that some munis will run into trouble. If that trouble is the consequence of a significant infrastructure failure, Meredith Whitney will be right, for the wrong reasons.


 

Notes:

*I’m sorry this went on and on. I just love big construction projects.

*Why did the tunnel under the Hudson fail? It went through a section of limestone. The water from the reservoir is filled with acid rain. The acidic water dissolves limestone. The original tunnel designers had no clue what acid rain was, so the limestone section was not sealed during construction.

*The 138B drop in New Money is equal to 0.9% of total GDP. This lack of borrowing was a drag on total output. Another good example of Debt = Growth.

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By www.thetrader.se

Ft.com
Bo Xilai, the maverick Chinese politician who until recently was a frontrunner for promotion to the top decision-making body of the ruling Communist party, has been dismissed as party secretary of Chongqing municipality. Mr Bo has been replaced by Zhang Dejiang, a North Korean-trained economist and vice-premier, according to the official Xinhua news agency and sources close to the Chinese leadership. http://www.ft.com/intl/cms/s/0/94e2d35e-6e46-11e1-baa5-00144feab49a.html#axzz1pA65f3WX

Iran’s oil production has fallen to a 10-year low and could drop to levels last seen during the Iran-Iraq war in the 1980s as sanctions over its nuclear programme disrupt an industry already suffering from years of underinvestment.  The country’s crude production fell by 50,000 barrels a day to 3.38m b/d in February, according to the International Energy Agency. The last time it was that low was in late 2002, IEA statistics show.http://www.ft.com/intl/cms/s/0/50079b60-6df7-11e1-b98d-00144feab49a.html#axzz1pA65f3WX

President Barack Obama warned Iran on Wednesday that the window of opportunity for a diplomatic solution to the stand-off over its nuclear programme was “shrinking” and that Tehran should meet its “international obligations” to come clean over its activities. At a press conference with David Cameron, the UK prime minister, at the White House, Mr Obama said both the US and UK “are determined to prevent Iran from acquiring a nuclear weapon”.http://www.ft.com/intl/cms/s/0/ab456f7e-6df8-11e1-b98d-00144feab49a.html#axzz1pA65f3WX

Wsj.com
Asian stock markets were mixed Thursday as concerns that China would retain property-market curbs this year unsettled investors, while the U.S. dollar continued to rise broadly and Japanese exporters’ shares extended recent gains boosted by a weaker yen. Japan’s Nikkei Stock Average was recently up 1%, around an eight-month high, and South Korea’s Kospi Composite was a bare 0.1% higher. But India’s Sensex was down 0.3%, Hong Kong’s Hang Seng Index was 0.2% lower and China’s Shanghai Composite Index was down 0.3%. Australia’s S&P/ASX 200 finished with a loss of 0.2%. Dow Jones Industrial Average futures were 15 points up in electronic trading.http://online.wsj.com/article/SB10001424052702304459804577282271913670152.html?mod=WSJEUROPE_hpp_LEFTTopWhatNews

South Korea and the U.S. on Thursday will eliminate duties on thousands of goods as they implement a free-trade agreement that took one year to negotiate and an additional four years of political battling to complete. The deal is the largest trade pact, by value of traded goods, the U.S. has completed since the North American Free Trade Agreement with Canada and Mexico in the mid-1990s. But it is likely to have a far larger effect on South Korea than on the U.S. Trade plays a greater role in the South Korean economy and import tariffs have been kept high to protect its rapid ascent from poverty in the 1960s to affluence today. About 80% of the existing tariffs between the two countries will be eliminated Thursday. The agreement calls for 95% of tariffs to be wiped out within five years. http://online.wsj.com/article/SB10001424052702303863404577280851482718334.html?mod=WSJASIA_hpp_LEFTTopWhatNews

India is poised to overtake Japan as Asia’s No. 2 vehicle market by 2016, and sales gains in China will remain strong this decade, according to new estimates. Despite recent concerns about slower economic growth, China is on track to hit sales of 30.68 million vehicles by 2020, up 74% from 17.66 million last year, according to IHS Automotive. China overtook the U.S. in 2009 to become thehttp://online.wsj.com/article/SB10001424052702303863404577281040033926770.html?mod=WSJEUROPE_hpp_LEFTTopWhatNews

The number of unemployed Britons rose again in the three months to January while average wages fell to their lowest level in 18 months adding pressure to already squeezed household incomes, official data showed Wednesday. The Office for National Statistics said its internationally comparable measure of unemployment rose by 28,000 in the three months to January to total 2.67 million. The unemployment rate remained at 8.4%—the highest reading since 1995, while youth unemployment hit a 20-year high. Wednesday’s data showed that public sector employment fell by 37,000 in the fourth quarter of 2011, and by 270,000 on an annual basis—the second-largest decline since records began in 1999—although the government will likely take some reassurance from a 45,000 increase in private-sector employment in the final quarter of 2011.http://online.wsj.com/article/SB10001424052702304692804577280921738263682.html?mod=WSJEUROPE_hpp_LEFTTopWhatNews

The euro-zone countries Wednesday signed off on Greece’s second bailout program, ending a protracted and dramatic negotiating process that started last July. Their hope is that the €130 billion (roughly $169 billion) package—funded mostly by euro-zone countries and the International Monetary Fund—will be enough to keep Greece funded until 2014-15. But talk of a third Greek bailout has already begun, even as the ink is still drying on the second package. A report by European Union experts, seen Tuesday by The Wall Street Journal, highlighted the risks to structural-reform implementation and predicted stagnation, at best, for 2013. Greece is in its fifth consecutive year of recession.http://online.wsj.com/article/SB10001424052702304692804577281053193863424.html?mod=WSJEurope_hpp_LEFTTopStories

The break that had long eluded the political career of 57-year-old French Socialist François Hollande finally surfaced with a text message in the wee hours of May 15 last year. His girlfriend, 47-year-old journalist Valérie Trierweiler, read it and nudged Mr. Hollande awake: Dominique Strauss-Kahn—then-chief of the International Monetary Fund—had been arrested by police in New York on suspicion of sexual assault. “François did not grill me for more details about the arrest,” Ms. Trierweiler said. “He was already thinking of his next move.”http://online.wsj.com/article/SB10001424052970203833004577251702049350724.html?mod=WSJEurope_hpp_LEFTTopStories

Federal regulators are cracking down on an obscure but booming market for trading shares in companies before they go public. The Securities and Exchange Commission brought charges against two money managers, alleging they misled and overcharged investors on funds formed to buy shares of Facebook Inc., Twitter Inc. and other social-media companies.  A so-called secondary market in these companies’ private shares has grown rapidly as more investors seek to buy into the companies before their initial public offerings, hoping to profit later from a “pop” in the stock price after the IPO.http://online.wsj.com/article/SB10001424052702304692804577281844105719500.html?mod=WSJEurope_hpp_LEFTTopStories

Reuters.com
Gold regained some strength on Thursday after a drop in the previous session attracted bargain hunters, but a strong dollar and fading expectations of more monetary easing in the United States made the metal vulnerable to more selling. Spot gold added $4.69 an ounce to $1,646.79 an ounce by 0339 GMT. Gold extended losses and fell more than 2 percent on Wednesday — a day after the Federal Reserve offered no clues on further easing. “Sentiment is of course very bad, I can say. After slipping below $1,650, it may go down further to $1,600,” said Ronald Leung, director of Lee Cheong Gold Dealers in Hong Kong, adding that a rebound will be capped at $1,675 to $1,680. http://www.reuters.com/article/2012/03/15/us-markets-precious-idUSTRE82403220120315

Fitch Ratings revised down its outlook on Britain’s AAA rating to negative on Wednesday, warning the nation could lose its top-notch status in the next couple of years if the government eases back on its debt cutting stance. The Fitch action, which comes just a week before British finance minister George Osborne presents his annual budget to parliament and follows a similar move by Moody’s just a month ago, is likely to dampen calls for the government to loosen its fiscal stance. “This is a salutary reminder as to why Britain needs to deal with the enormous debts and deficit that we inherited, why we have got to stick to those plans,” said British Treasury minister Danny Alexander. http://www.reuters.com/article/2012/03/14/us-ratings-fitch-idUSBRE82D1H620120314

President Barack Obama and British Prime Minister David Cameron discussed the possibility of releasing emergency oil reserves during a meeting on Wednesday, two sources familiar with the talks said, the first sign that Obama is starting to test global support for an effort to knock back near-record fuel prices. Obama raised the issue during a broad bilateral meeting at the White House, according to a UK official with knowledge of the discussion. Asked about the talks, a senior Obama administration official said: “No agreement was reached. We will continue to work together to address energy security and oil price issues.” http://www.reuters.com/article/2012/03/15/us-obama-energy-spr-idUSBRE82E00P20120315

Bloomberg.com
India‘s central bank left interest rates unchanged for a third consecutive meeting after inflation accelerated and as it awaits steps to curb the fiscal deficit in the budget tomorrow. TheReserve Bank of India kept the repurchase rate at 8.5 percent, it said in a statement in Mumbai today. The outcome was predicted by 19 of 22 economists in a Bloo mberg News survey, with three forecasting a quarter-point reduction.  India joins nations from Indonesia to South Koreain holding borrowing costs this month, juggling price pressures with the need to prevent a deeper growth slowdown as investment falls and Europe‘s debt crisis hurts exports. The central bank has signaled rate cuts to counter the weakest expansion in almost three years depend on a sustained easing in inflation and moves to curb the largest budget gap among BRIC economies. http://www.bloomberg.com/news/2012-03-15/india-holds-rate-for-third-meeting-before-budget-as-prices-rise.html

Apple Inc. (AAPL), getting a boost from anticipation of the new iPad, rose to a record today and may climb 19 percent to $700, according to analysts who raised their price targets for the stock.  At least four analysts, including Katy Huberty at Morgan Stanley in New York, have increased price targets to $700 or higher in the past two weeks. Apple, based in Cupertino, California, rose 3.8 percent to $589.58 at the close in New York and has gained 46 percent this year. http://www.bloomberg.com/news/2012-03-14/apple-may-climb-above-700-as-new-ipad-sales-begin-analysts-say.html

Singapore companies are accelerating their push to expand overseas as tighter curbs on housing and reduced dependence on foreign workers lower growth prospects for the economy.  Hiring sentiments have softened amid an uncertain economic outlook and layoffs rose last quarter, the city-state’s government said today. Singapore Airlines Ltd. (SIA) said it’s offering pilots unpaid leave to cut costs as profit fell for five straight quarters, while lender DBS Group Holdings Ltd. plans to boost its China workforce after earnings there doubled in 2011 and it seeks to reduce reliance on its home market.http://www.bloomberg.com/news/2012-03-15/singapore-companies-seek-overseas-growth-as-economy-slows.html

Obama administration officials say they are worried India may run afoul of a new U.S. law restricting payments for Iranian oil, forcing the White House to impose sanctions on one of its most important allies in Asia. So far this year, India is failing to cut back its purchases of Iranian oil, which may force President Barack Obama to impose penalties as early as June 28, according to several U.S. officials who spoke on condition of anonymity because of the sensitivity of the issue. http://www.bloomberg.com/news/2012-03-15/u-s-may-sanction-india-over-level-of-iran-oil-imports.html

Cnbc.com
It’s no big surprise that most U.S. banks made it through the recent stress tests, according to analyst Meredith Whitney, who told CNBC the stocks are still oversold and better buys than their smaller competitors.  With the exception of a few large institutions with balance sheet and earnings problems, the founder of the Meredith Whitney Advisory Group said the banks should be trading around book value. Her comments came a day after the Federal Reserve announced that 15 of the top 19 American banks met capital levels that would allow them to survive a Depression-level economic crisis.http://www.cnbc.com/id/46737336

Dailyfinance.com
Oil prices hovered below $106 a barrel Thursday in Asia amid trader concerns that growing U.S. crude supplies reflect weak demand. Benchmark oil for April delivery was up 24 cents to $105.67 in electronic trading on the New York Mercantile Exchange. The contract fell $1.28 to settle at $105.43 per barrel in New York on Wednesday. Brent crude for April delivery was down 29 cents at $124.68 per barrel in London. The April contract expires later today.http://www.dailyfinance.com/article/oil-hovers-below-106-as-us-crude/1652052/

USAtoday.com
The U.S. current account deficit, which includes the trade balance of goods, services and investment flows, widened at the end of 2011 to the largest quarterly gap in three years. Widened by a slight decline in exports and stronger demand for foreign goods, the current accout trade deficit increased 15.3% to $124.1 billion in the 2011?s final three months. For the year, the current account deficit rose 0.6% to $473.4 billion, the biggest imbalance since 2008. A bigger trade deficit hampers economic growth since it means more goods and services are being imported while U.S. companies are making fewer sales overseas. Economists expect the deficit to keep rising in 2012. Europe’s debt crisis is likely to drag on U.S. exports, as is slower growth in Asia. And stronger growth in the United States should boost imports. http://www.usatoday.com/money/economy/trade/story/2012-03-14/current-account-deficit-2011/53524740/1

BBC.co.uk
Consumer prices in India rose more than expected in February, driven by a jump in fuel and power costs.  The wholesale price index (WPI), a key measure of consumer price inflation in the country, rose by 6.95% from a year earlier. Fuel prices have been rising globally amid fears over supply disruptions due to tensions in the Middle East. Analysts said fears of oil prices rising further may prompt the central bank to keep interest rates on hold.  “This figure is still a repressed number, because the complete pass-through of global oil prices has not happened,” said Rupa Rege Nitsure of Bank of Baroda. “If you take just the direct impact of global oil prices at current levels, then the headline inflation number could at least be 90-100 basis points higher.”http://www.bbc.co.uk/news/business-17363710

Zimbabwe’s government could “close” unless projected diamond revenues start to flow into the treasury, Finance Minister Tendai Biti has warned. He said the mines ministry had informed him that no diamond auctions had been held this year. Ministries in the unity government are split between President Robert Mugabe’s Zanu-PF and the MDC party. http://www.bbc.co.uk/news/world-africa-17369979

Telegraph.co.uk
Apple could account for more than 10pc of the America’s corporate cash pile by the end of the year, according to Moody’s, underlining the pressure the iPad maker is under to return money to shareholders. The Californian company is likely to see its cash reserve balloon to about $150bn (£96bn) this year unless it pays a dividend or embarks on a share buy-back programme, Moody’s predicted. Apple chief executive Tim Cook said last month that senior executives are in “active discussions” about what to do with its cash, which reached $97bn at the end of last year as consumers snapped up the latest iPhone and iPad. http://www.telegraph.co.uk/finance/newsbysector/mediatechnologyandtelecoms/9144204/Apple-to-account-for-10pc-of-US-cash-pile.html

More than 50 local authorities that held money with the failed Icelandic bank Glitnir are to be paid in full more than three years after the bank collapsed. The bank’s winding up committee announced it was to release €635m (£527.3m) to priority creditors on Friday. The cash will be paid into escrow accounts before being distributed to creditors – the majority of which are understood to be UK councils. When the Icelandic banks were nationalised in 2008, they held nearly £1bn on deposit for UK councils. Although some of the cash has been returned, this is the first time Glitnir has paid up. On Friday it is expected to take the first step towards paying 53 councils and public bodies €290m.http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/9144461/Icelandic-bank-Glitnir-to-repay-UK-councils.html

Smh.com.au
Greece’s Alpha Bank says it wants to scrap merger talks with Eurobank after last week’s huge sovereign debt write-down agreement between the government and private creditors. Shareholders would be asked at a general meeting to revoke a decision taken in November to approve the merger, Alpha said, adding that it had informed Eurobank of its decision. The decision came “following the conclusion of the exchange offer of bonds issued or guaranteed by the Hellenic Republic and its effects on the banking sector”, Alpha said.http://www.smh.com.au/business/world-business/greeces-alpha-bank-to-scrap-eurobank-merger-20120315-1v4ai.html#ixzz1pAC88w9z

Theglobeandmail.com
A successful bond auction by Italy on Wednesday cut the risk premium the country pays compared to Germany to issue 10-year debt and the head of the Italian debt management office said it could fall by much more by the end of the year. Investors have looked more favourably on Italian sovereign debt in recent weeks, impressed by a reform push by Prime Minister Mario Monti, in contrast to increasing concern about Mediterranean neighbour Spain, which is struggling to meet deficit pledges. http://www.theglobeandmail.com/report-on-business/international-news/european/italy-sees-growing-market-favour-after-strong-bond-sale/article2369340/

Graduates scouring the recruitment pages amid Portugal’s worst recession in memory are increasingly opting for the chance of a better life in the former colonies of Angola and Brazil. Portugal flourished as a global power with explorers like Vasco da Gama and Pedro Alvares Cabral building an empire that lasted for 600 years. Now, a new wave of adventurers is once again seeking work, and fortune, elsewhere. http://www.theglobeandmail.com/report-on-business/international-news/european/jobless-portuguese-flocking-to-former-colonies-of-brazil-angola/article2369282/

Sweden wants to think “outside the European box” after its heavy reliance on trade with the region was blamed for a sharp economic slowdown in the fourth quarter. Swedish trade minister Ewa Bjorling hopes to double exports by 2015 through measures that include pursuing export markets beyond the troubled European Union, such as Iraq, Africa and the BRIC countries (Brazil, Russia, India and China). “We can see that during the financial crisis and immediately after, those companies that have spread their eggs in different markets outside Europe managed to handle the crisis much better,” Dr. Bjorling said in an interview. “We believe we need to have other markets in combination with Europe.”http://www.theglobeandmail.com/report-on-business/international-news/global-exchange/globe-correspondents/financially-solid-sweden-feeling-pain-of-heavy-reliance-on-european-trade/article2368929/

Cs.com.cn
Premier Wen Jiabao said Wednesday that the 7.5 percent GDP growth target for 2012 is a result of the government’s proactive macro-control and can not be viewed as low. China’s GDP has reached 47 trillion yuan (7.46 trillion U.S. dollars). On this basis, the growth rate of 7.5 percent can not be counted as low, not to mention the economy would keep expanding at this pace, Wen told a press conference after the conclusion of the annual parliamentary session. Indeed, the Chinese economy faces slowing trend due to impacts from the European debt crisis and contracting overseas demands, Wen noted.http://www.cs.com.cn/english/ei/201203/t20120315_3281334.html

Premier Wen Jiabao said Wednesday that the country would not slacken its efforts in regulating housing prices, which he considered still “far from a reasonable level.” “If we develop the housing market blindly, a bubble will emerge in the housing sector. When the bubble bursts, not only the housing market will be affected, it will weigh on the entire Chinese economy,” said Wen at a press conference after the conclusion of China’s annual parliamentary session. The reasonable housing prices should match the people’s income, the construction cost, and the profit should be reasonable too, added Wen, calling for long-term, steady and sound development of China’s property market. The people’s housing demand is rigid and durative as China is a big country will 1.3 billion people, and in the stage of rapid industrialization and urbanization, according to Wen.http://www.cs.com.cn/english/ei/201203/t20120315_3281250.html

China will change three members of the central bank’s monetary policy committee, according to a circular released Wednesday by the State Council, or the Cabinet. The circular said the State Council has approved the appointment of Qian Yingyi, Chen Yulu and Song Guoqing as new members of the monetary policy committee of the People’s Bank of China. Qian is currently the dean of Tsinghua University’s School of Economics and Management. Chen is the president of the Renmin University of China, and Song is a professor of the National School of Development of Peking University.
Meanwhile, Zhou Qiren, Xia Bin and Li Daokui will no longer be members of the committee, the circular said.http://www.cs.com.cn/english/ei/201203/t20120315_3281247.html
Thehindu.com
Union Minister for Civil Aviation Ajit Singh has ruled out bailing out crisis-ridden Kingfisher Airlines and asserted that the Directorate-General of Civil Aviation (DGCA) would not make any compromise on passenger safety. Addressing a press conference after inaugurating India Aviation Show -2012 here on Wednesday, he said the DGCA, which was looking into the problems such as cancellation of flights and absenteeism by pilots, would submit its report in a day or two and the government would act based on the recommendations.

Economictimes.com
India continued to hold on to its position among the world’s top 10 manufacturers even as a slowdown has hit the sector during the second half of the ongoing fiscal. The latest United Nations Industrial Development Organisation ( UNIDO) report on Industrial Statistics shows that India along with otherBRICS (Brazil, India, China and South Africa) contributed around one fifth to the global manufacturing value added (MVA) during the quarter ended December 2011. India stood 9th in the overall rankings with a modest manufacturing growth rate of 4.1% during the quarter. Among other emerging economies, China’s manufacturing sector expanded at the highest pace at 13.1% while that of Brazil contracted by 1.9% during the quarter.http://economictimes.indiatimes.com/news/economy/indicators/india-ranked-9th-among-top-10-manufacturers/articleshow/12270665.cms
Yonhapnews.co.kr
Long-term foreign residents accounted for 1.97 percent of South Korea’s population in 2011, rising nearly 20 times from two decades earlier, a government report showed Thursday. The 2011 social index report compiled by Statistics Korea showed there were 982,461 foreigners who have been legally registered as long-term residents, compared with just 49,507 people tallied in 1990. Of the total, 231,000 were in the country on non-professional employment visas, with 68,000 enrolled in South Korean schools. Others were in the country after having acquired permanent residence status.http://english.yonhapnews.co.kr/business/2012/03/15/86/0502000000AEN20120315002200320F.HTML
Themoscowtimes.com
Gazprom is struggling to get a foothold in the Asian markets leading global economic growth. The company’s plan to supply liquefied natural gas to India from 2016, the year the United States is set to start gas exports, is faltering after buyers said they’re looking for cheaper fuel from North America. Last year, decade-long talks to supply pipeline gas to China foundered over price disagreements. “Gazprom has a major problem of having a fixed view on what the price of gas should be, irrespective of market conditions,” Jonathan Stern, chairman and senior research fellow at the Oxford Institute for Energy Studies, said by e-mail. “If this continues, it will create increasing problems for Russian gas exports.”http://www.themoscowtimes.com/business/article/indian-lng-market-a-challenge-to-gazprom/454702.html#ixzz1pAFEiWyl
Khaleejtimes.com
Investing in Indonesia’s mining sector has never been for the faint-hearted, but government proposals that could potentially disrupt Asia’s coal markets have raised the blood pressure of foreign investors. The government has outlined three policies which play well to its domestic audience but which have set alarm bells ringing, particularly in India, which hopes to meet much of its need for imported power-station coal from Indonesia. The proposed measures include introducing a benchmark price, which would determine spot and long-term contracts, as well as taxation and export duties.  Another policy calls for all miners in Indonesia to set aside a certain amount of output for the domestic market and there is a also a mooted requirement for foreign investors to divest 20 percent of their project to locals within five years of initial production and 51 percent within 10 years. http://www.khaleejtimes.com/biz/inside.asp?xfile=/data/internationalbusiness/2012/March/internationalbusiness_March47.xml&section=internationalbusiness

Meredith Whitney made her doomsday prediction. The nothing. Nothing. Then lots of glib muni expert pundits gloating because the Fed, the ECB, the BOJ, the BOE, the SNB, and of course, the central bank of Kenya, had managed to delay the inevitable by a year. Then some more nothing. Then suddenly Stockton, Mammoth Lakes, and now San Bernardino all file in the span of 2 weeks.

• SAN BERNARDINO, CALIFORNIA, WEIGHING CHAPTER 9 BANKRUPTCY - BBG
• SAN BERNARDINO COUNCIL TO DISCUSS ACTION, SPOKESWOMAN SAYS - BBG
• SAN BERNARDINO SPOKESWOMAN GWENDOLYN WATERS SPOKE IN INTERVIEW - BBG

There is a reason marginal events are oh so very important: because as Greece showed, and now one after another broke California municipalities are dropping like flies, one the precedent is there, the easiest thing to do is to just hit Print on that Chapter X petition. After all everyone else is doing it, and remember: he who files first, files best.

Because once the dominoes start, they don't stop. Stockton, Mammoth, San Bernardino and now legendary rap and LA riots nexus - the City of Compton. Fear not: the ESM, and the German population whose retirement age will have to be in the quadruple digit range to fund a broke world, has got this, too, covered. Also, only squares don't make fun of Meredith Whitney for saying municipal America is insolvent, so please do.

From Reuters:

The City of Compton, a city of 93,000 people located on the outskirts of Los Angeles, must decide by Sept. 1 whether to seek bankruptcy, according to its two most senior financial officials.

 

Such a move would see it join a growing number of deficit-hobbled California cities that have used the filing to restructure onerous debt loads.

 

Compton, which has an accumulated $43 million deficit and has depleted what had been a $22 million reserve, will run out of cash to make its payroll on Sept. 1 at its current cash consumption rate, city comptroller Steven Ajobiewe told the city council during a July 17 meeting.

 

"I have $3 million in the bank and $5 million in warrants due in the next 10 to 12 days," said city treasurer Doug Sanders. "By then, the council will have a decision to make: don't pay the bonds, default on them, or have a serious talk about bankruptcy."

 

The city council adjourned at 11 pm without discussing a potential bankruptcy filing.

 

Compton Mayor Eric J. Perrodin also said he brought unspecified charges of "waste, fraud and abuse of public monies" to California officials, and had met with auditors from both the state and Los Angeles County.

 

He told the city council that at one point in its past the city had overspent legally set limits on certain programs by $17 million but would not elaborate.

 

Neither the state nor county has started an audit or investigation, city officials said.

 

A bankruptcy filing would follow one by San Bernardino, which on July 9 became the third California city this year to seek restructuring of its liabilities. Earlier, Stockton and Mammoth Lakes also said they would file.

 

Compton's problems escalated on July 13 when credit rating agency Standard & Poor's said it may cut Compton's BB long-term and underlying ratings for its lease revenue bonds.

One thing is certain: once Compton is completely free of law enforcement (which as it happens is unaffordable by broke cities), the local population will be calm, cool and collected as long as it takes.

Just under two years ago, Meredith Whitney made a much maligned, if very vocal call, that hundreds of US municipalities will file for bankruptcy. She also put a timestamp on the call, which in retrospect was her downfall, because while she will ultimately proven 100% correct about the actual event, the fact that she was off temporally (making it seem like a trading call instead of a fundamental observation) merely had a dilutive impact of the statement. As a result she was initially taken seriously, causing a big hit to the muni market, only to be largely ignored subsequently even following several prominent California bankruptcies. This is all about to change as none other than Warren Buffett has slashed half of his entire municipal exposure, in what the WSJ has dubbed a "red flag" for the municipal-bond market. Perhaps another way of calling it is the second coming of Meredith Whitney's muni call, this time however from an institutionalized permabull.

In bad news for the bullish muni community, the Octogenarian of Omaha has terminated $8.25 billion worth of sold municipal insurance (or half of his total, the balance of which he is unable to terminate, or technically, novate, due to timing limitations), a move which the WSJ says "indicates that one of the world's savviest investors has doubts about the state of municipal finances. If so, the move could be a warning to investors who have purchased such debt. In canceling the contracts early, Mr. Buffett probably "doesn't want this exposure anymore and is getting out while he can," said Jeff Matthews, a hedge-fund manager who personally owns Berkshire shares."

In what is worse news for the bullish muni community, the fact that Buffett closed the position at substantial losses indicates that the once deified investor is willing to swallow his pride, and despite his massive balance sheet, refuses to wait out the expiration of the insurance, implying he sees not only major shockwaves ahead, but turbulence that is imminent (if only M-Dub had waited until now). What is worst, is that Buffett's bearish move comes at a very fragile time for the muni market: weeks after three consecutive bankruptcies shook California, and just as various other cities are contemplating strategies to impair bondholders (a la Greece and Belize) to avoid all out Chapter 9.

From the WSJ:

The insurance-like contracts, which required Berkshire to pay in the event of bond defaults, were originally purchased by Lehman Brothers Holdings Inc. in 2007, more than a year before the Wall Street firm filed for bankruptcy, the person said.

 

Details of the termination, with the Lehman Brothers estate, weren't disclosed. It isn't clear whether Berkshire's move will leave the company with a profit or loss on the wager. Mr. Buffett, Berkshire's 81-year-old chairman and chief executive, declined to comment.

Actually, assuming the following chart from the WSJ is correct, it is fairly safe to assume that Buffett will close out with a substantial loss. Having sold over $8 billion in insurance on what appears to be 10 year duration CDS at 20 bps, the fact that he is unwinding at a spread four times wider, at a massive DV01, means that there is no way the roll alone would have offset the blow out in spread. As a result it is fair to assume that hundreds of millions in P&L were lost as a result of this trade.

But while traders with huge balance sheets carry paper losses for weeks, months, and years (see JPM's whale) as there is no fear of margin calls, the fact that Buffett closed out of this position, well ahead of its maturity, on his own is grounds for major concern.

"There is a need for concern,'' said Bill Brandt, chairman of the Illinois Finance Authority and chief executive of Development Specialists Inc., which advises troubled cities and companies. "Many of these municipal leaders appear ready to sacrifice bondholders on the altar of the taxpayers rather than the other way around, which has historically been the case."

 

Bonds issued by cities generally haven't affected debt sold by states, but some states have seen credit-rating downgrades in the past five years due to budget problems or economic weakness.

 

In July 2007, Lehman bought default insurance from Berkshire on bonds from 14 states, including Texas, Florida, Illinois and California, according to a copy of an agreement between the two companies. Lehman paid $162 million to Berkshire, which agreed to pay Lehman if any of the states defaulted on their debt over 10 years. Berkshire essentially bet that total payouts, if any, would be less than the money it received upfront.

 

Some investors still see municipal bonds as attractive at the right price. Garey Fuqua, who heads distressed municipal-bond investments at Spring Mountain Capital, said he has been increasing the New York-based investment firm's cash position in anticipation of municipal-bond prices falling.

 

"We do believe there will be a selloff because of increased interest rates or because of widening of credit spreads," Mr. Fuqua said.

And while the termination itself is bad, it could be worse if Buffett had unwound his entire municipal stake. Luckily for what's left of the US muni market which continues to trade on a hope and a prayer even as local muni and state coffers run dry, Buffett will retain half of his exposure. Not because he wants to, but because he has to.

Berkshire still has swaps tied to roughly $8 billion in debt issued by hundreds of cities, states and municipalities. Those contracts can't be terminated before the underlying bonds mature between 2019 and 2054, according to the company. Berkshire also was paid upfront for providing this protection, which was purchased by other financial institutions.

Buffett is also quite aware that by selling half of his position, the resulting sell off as piggyback traders jump on the trade, will impair the balance of his positions. And still he has proceeded with the sale. All of which leads us to believe that not only did Buffett just join team Whitney, he has in fact doubled down.

While most "developed world" people have heard of Hong Kong and Macau, far fewer have heard of China's province of Guangdong, which is somewhat surprising. With over 100 million people, a GDP of nearly $1 trillion - the biggest of all Chinese provinces, this South China Sea adjacent territory is perhaps China's most important economic dynamo. One of the key cities of Guangdong is Dongguan, which as the map below shows is a stone's throw from Hong Kong, has a population of nearly 10 million, and has long been considered Guangdong's boomtown and one of China's richest cities.

One notable feature about Dongguan is that it is home to the New South China Mall, which is the world's largest. It also happens to be mostly empty ever since it opened in 2005. Which perhaps is a good segue into this story. Because while for the most part the city of Dongguan has been a story of prosperity, a wrinkle has appeared. According to the South China Morning Post, which cites researchers at Sun Yat-sen University, this city is now on the brink of bankruptcy.

Make that a big wrinkle.

The irony, of course, is that as always happens, while everyone has been expecting the muni collapse to take place in the good old US of A, it may be about to strike with a great vengeance and furious anger none other than that credit black hole, in which nobody really knows who owes what to whom, China.

How is it possible that a city which as the SCMP describes was once a backwater farm town until the late 1980s, and then as China boomed was transformed into one of the most important hi-tech manufacturing centres in the world, and about which an IBM vice-president famously said a mere 15-minute jam on the expressway there would be enough to cause worldwide fluctuations in computer prices, could be facing bankruptcy?

The answer is an absolutely fascinating story, one which for the first time exposes what could be the most sordid underbelly of the broken Chinese shadow credit system, and which demonstrates very vividly just what the hard Chinese landing will look like. It also explains precisely what the real creditor-debtor relationships are like in a country in which the banks are the equivalent of government entities, and which do little if any retail crediting in a time when the government is set on contracting the money supply at the wholesale, if not at the bank level (recall the now daily reverse repos conducted by the PBOC).

Most importantly it reveals the monetary dynamic "on the ground" - one which is vastly different than the one in the "western world."

The question is whether the story of Dongguan is an isolated one. Alas, just like there is never one cockroach, we are confident that many more such provinical centers are currently undergoing the same challenges, which if unresolved would lead to a tsunami of municipal, county and city level defaults, that would leave China in ashes.

Ironically, Meredith Whitney may have had the municipal default theme right. She was just envisioning the wrong continent...

From SMCP:

Boom city Dongguan faces bankruptcy

Dongguan's derelict factories and huge deficits send chilling warning to a China in slowdown

After three decades of spectacular growth, Guangdong's boom town of Dongguan is on the brink of bankruptcy.

Up to 60 per cent of its villages are running up deficits and will soon need a bailout from the township, researchers at Sun Yat-sen University have discovered.

It is a dramatic turn of fortune for Dongguan - one of the richest cities in China - and could foreshadow a wider fiscal crisis as the country's economy cools.

Local government debt hit 10.7 trillion yuan (HK$13.16 trillion) nationwide at the end of 2010, equivalent to about 27 per cent of gross domestic product. Credit rating service Moody's estimates the actual figure could be about 14.2 trillion yuan.

Bai Jingming, a senior researcher at the Ministry of Finance, estimated in 2009 the total debt of village authorities could total 10 per cent of the country's GDP, but there is no official data.

Bai said many village chiefs he interviewed had no idea how much debt they had. Yet their failings could bring serious political and financial instability at higher level government right down to the grass roots.

Experts have found Dongguan's village debt woes stem from two factors: a tightly-bound landlord economy, plunged into crisis by failing factories in the global downturn, and political pressure on local village chiefs to pay generous "dividends" to voters under the immature rural election system.

"The financial problems of the villages are much more serious than expected," said Shao Gongjun, the owner of a printing company who blogs on Dongguan's economy. Shao attributed much of the crisis to the local authorities' dependence on rental incomes.

A backwater farm town until the late 1980s, as China boomed Dongguan was transformed into one of the most important hi-tech manufacturing centres in the world.

An IBM vice-president famously said a mere 15-minute jam on the expressway there would be enough to cause worldwide fluctuations in computer prices.

As industry thrived, the population swelled from 1.8 million in the '80s to more than eight million. Most of the peasants cashed in and built matchbox homes on their land, letting the flats to migrant workers. Village authorities leased community land to factories and collected rent as their main source of income.

This worked perfectly until the recent downturn. Shao said many factories had either closed or moved out over the past five years to inland provinces with lower costs.

The number of Hong Kong-backed factories has dropped by 15 per cent since 2007. As factories and migrant workers left Dongguan, rents nosedived.

"I'm so worried that before long I will lose my tenants and the flats would be left deserted," said a 61-year-old woman surnamed Luo. She put together two million yuan from her life savings 10 years ago and with bank loans built a six-storey apartment building in Luowucun in Zhangmutou county. Her family occupied the first floor and let the rest out to migrant workers.

Luo used to collect about 15,000 yuan a month in rent - nearly 10 times what an average worker earned. But rents have dropped by a third since 2007.

The fall in rental values forced 60 per cent of the 584 villages in Dongguan into budget deficits, the study by Professor Lin Jiang of the finance and taxation department of Lingnan College at Sun Yat-Sen University found.

Lin's estimate is based on a study of 30 villages in relatively well-off counties, such as Tangxia, Houjie and Humen, in May.

The figure may not reflect the whole picture, but it gives a good snapshot of the problems authorities face.

"They are in deficit because their incomes are shrinking while their expenses are going up," Lin said.

This is an unexpected sideeffect of China's fledgling grass-roots democracy.

While competitive elections are still absent at almost all levels of government, Beijing has started to let villages choose their leader through universal suffrage. These elections have been getting increasingly competitive, and candidates often promise to pay generous "dividends" to villagers to attract votes.

"In some rare cases, the leader-elect promised to give each household 10,000 yuan per month," Lin said. The money would come from the village community "investment" - effectively, the rent they collected from factories.

Lately, village chiefs have found it difficult to fulfil such election pledges. But instead of reneging on their promises and sparking the anger of villagers, they turn to the rural credit co-operatives - the de facto local banks - for short-term loans at interest rates as high as 30 percentage points.

Banks are willing to lend, because they know that the township government would have to bail villages out if things go wrong.

"Some village leaders are now really worried that the bank may come to call in the loans," Lin said. "If the villages default, the burden would be transferred to the county or the township government."

The Dongguan government is in poor shape to handle a crisis. Its GDP growth slowed to 2.5 per cent in the first half of the year. The average growth in the past eight years was about 11 per cent.

Xu Jianghua, Dongguan's party secretary, urged villages last month to stop raising money to pay dividends. Few took heed.

Village chiefs may argue paying dividends are not the sole cause of their debt. They also have to pay for local fire and police services - even though these are supposed to be the local government's responsibility.

For years, the township government underinvested in such services, knowing they would be taken care of by the cashed-up village authorities.

Eddy Li, president of the Hong Kong Economic and Trade Association, said in some counties police would refuse to investigate a crime unless it involved more than 20,000 yuan.

Shao estimated Zhangmutou county authorities alone have accumulated a total of 1.6 billion yuan in debt. Annual revenue is only 600 million yuan.

Shao said the Dongguan government needs structural reform to end its reliance on rental income. He proposed the township give residency to migrant workers so they can contribute more to the local economy.

"Without a radical change in the social structure, the economic transformation will never succeed," he said.

And some pictures from the city that may soon be the first cockroach observed once the light was truly shone:

A row of empty shops that have been idle for more than nine months – a common sight in what was once a hi-tech heartland. Photo: May Tse

Commercialism came storming into rustic residential areas. Photo: May Tse

Boarded up shops in the suburbs of Zhangmutou. Photo: May Tse

Many roads but few cars in the once desirable district of Zhangmutou, a favourite with expats and retirees. Photo: May Tse

Absent some earth shaking event between now and November, Obama is going to win, the House will remain in the hands of the Republicans and the Senate will continue to be equally divided. The war between Reds and Blues will be just as bad as it was a year ago. The day after the election, the fight over the fiscal cliff will commence. I expect it will be ugly.

-I think there is zero probability that all of the issues now on the cliff will be pushed off to some future period. (Ultimate-can-kicking) Some of the cutbacks/tax increases that are now scheduled, will happen.

-I put the odds on falling off the cliff without any compromises at 40%. This scenario comes about if the Reps and Dems can’t agree on anything. If that is the case, we fall very hard on January 2. (No-can-kicking)

-Therefore, I see a 60% chance of a compromise that softens the consequences of the fiscal cliff, but does not eliminate it entirely. (Semi-can-kicking, but still kicking ourselves in the face)

If there is to be a compromise, it will be interesting to see who gets what, and who gives up what. It might play out with the following results:

I) The 2% reduction in FICA taxes is history. As of 1/1/13 every worker is getting hit with a 2% tax increase. This is a very regressive tax increase.

II) The Bush tax cuts for those making more than $250k are gone. This is a very Progressive tax increase.

III) The Bush tax cuts for those making less than $250k will be retained. This “centrist” compromises is the result of the "give" on #s I and II. Both sides will be able to claim that they did their best for “Middle Class Workers”.

IV) The Alternative Minimum Tax will be adjusted for inflation and will be fully phased in over a period of three years. This tax will hit 40m taxpayers (up from only 4m today). This is most definitely a middle class tax increase.

V) The capital gains tax rate is going to go up to at least 25%.

The result of I – V is that everyone who works, or has investment income is going to be paying more. No one will escape higher taxes.

Then there is the spending side of the ledger. The so-called, “sequestered” amounts. Here is where the real horse-trading will happen. Keep in mind that the timing of this critical argument debate will be in November and December. What else will be happening in those months that will influence the budget compromises? Talk of War.

It is almost certain that post the election, Iran is going to be front and center. Israel has promised to hold off on an attack of Iranian nuke facilities until after America votes. After November 6, the headlines will be about war. There will be big NATO/US Navy activity all over the Straits of Hormuz. This will shape the debate on military cutbacks.

With this as a backdrop, I don’t see the mandatory cuts for the military sticking. Most of the promised cutbacks will get eliminated, or pushed forward. Obama would welcome this, as it would allow him to trade more military spending for a deferral of the cuts in non-defense spending.

We will get a half loaf of spending cuts and increased taxes. The results will not significantly change the trajectory of the deficit, it will create an additional drag on the economy.

If all of the tax increases/spending cuts now pending are allowed to happen (we fall off the cliff) it will result in a drop in economic activity of at least 1.5%. It will bring about a recession that will last a minimum of six-months. The compromises that I outline above will still result in a contraction of economic activity. If we get (more or less) of what I see coming, then ¾% of annual GDP will be lost; for a long time.

What does a lousy ¾% mean? It means sub-stall speed. It means GDP will be well below 2% for 2013 and beyond. It could mean that growth falls below 1%. (Functional recession; unemployment up, tax receipts down)

++

There are two issues related to the "cliff" that are of interest to me. These are minor matters (in the scheme of things). They are Wall Street related. They go by the odd names of:

GARVEEs

&

BABs

Grant Anticipation Revenue Vehicle (GARVEE) bonds are tax free, issued by states and are backed by anticipated future revenues from D.C. for dedicated highway construction. The Fed backing (not a guarantee) makes these bonds trade rich relative to straight state debt.

The federal money to pay Garvee bondholders is at risk. Future payments from Washington are part of the sequestered amounts that will be on the negotiating table come November 7.

The rating agencies have been downgrading Garvees because of the risk of repayment. There is only $10B of Garvee bonds outstanding. I think this problem will be patched up (it's too small a matter to cause muni defaults). I also think that there will be no more Garvees issued. The fiscal cliff showed the flaw in the construction of these “bullet proof” bonds.

Build America Bonds are taxable state debt issues. This hybrid security was a child of the crisis of 2008. It died in 2010 after $180B of BABs were issued. Republicans hated BABs, Democrats (led by Tim Geithner) loved BABS.

There is an odd feature to BABs; they become callable if sequestration takes place:

BABs were issued in the terrible days of 2009/10. Recall that the likes of Meredith Whitney were calling for massive muni defaults back then. As a result, the $181b of BABS that were issued all had nice fat coupons on them. The States would love to call that paper at par; they could replace it with much cheaper debt today. The losers would be the bondholders. They would see their nice yielding bonds called away. No one cares about bondholders anymore, so BABS are dead.

Garvees and BABS are inventions of Wall Street. They are structured financial transactions that allow states to borrow more money by accessing different investor bases (tax vs tax exempt). In the end, Garvees and BABS will be throwaways in the horse trading. Their loss does not add up to much. However, if you are thinking that the solution to America’s economic problem is a major infrastructure build out, forget it.

A program big enough to create a few million jobs and modernize our roads, bridges, seaports and airports can’t be done with more federal borrowing. It has to come from the states. Shutting down BABs and Garvees is also saying “no” to that infrastructure plan.

The worst case outcome would be that there are no compromises; and we fall off a fifty-foot cliff, and die. The best case is that we fall off a twenty-five foot cliff, and only suffer a few broken bones and a concussion. Options that were once available to the country to dig out of an economic hole will have been lost. A long period of economic mediocrity is the most likely outcome.

• Obama Concessions Signal Potential Bipartisan Budget Deal (BBG)
• Cerberus to sell gunmaker after massacre (CNN)
• With New Offers, Fiscal-Cliff Talks Narrow (WSJ)
• Judge rejects Apple injunction bid vs. Samsung (Reuters)
• U.S. policy gridlock holding back economy? Maybe not (Reuters)
• President fears for Italy’s credibility (FT)
• Struggles Mount for Greeks as Economy Faces Winter (WSJ)
• Abe leans on BoJ in post-election meeting (FT)
• Bank of Japan to mull 2 percent inflation target as Abe turns up heat (Reuters)
• EU exit is ‘imaginable’, says Cameron (FT)
• Sweden cuts interest rates to 1% (FT)
• Mortgage Risk Under Fire in Nordics as Bubbles Fought (BBG)
• External risks impede China recovery, more easing seen (Reuters)
• China appoints new top official for export powerhouse Guangdong (Reuters)
• RBA Cites Softer Labor Market for Dec. 4 Interest Rate Cut (BBG)

Overnight Media Digest

WSJ

* Morgan Stanley agreed to pay $5 million to settle allegations that one of its highest-profile investment bankers tried to "improperly influence" research analysts days before Facebook Inc went public in May.

* Apple Inc is in early discussions to integrate local data from Foursquare Labs Inc into its mapping application, according to people familiar with the talks, as the company continues to build an arsenal of local data to try to take on Google Inc.

* A U.S. judge denied Apple Inc's request to seek a ban on the sale of some Samsung Electronics Co Ltd's products in the U.S. market.

* General Electric Co is on the verge of agreeing to a deal to buy Italian aerospace group Avio SpA for as much as 3 billion euros ($3.95 billion), according to people familiar with the negotiations.

* Sprint Nextel Corp said it reached a $2.2 billion agreement to buy the half of Clearwire Corp it doesn't already own, forcing the wireless broadband operator's shareholders to choose between a deal that could save the struggling company and a price that is lower than many had expected.

* Elliot Management Corp offered to buy the remaining stake in Compuware Corp that the hedge fund doesn't already own in a deal that values the software company at roughly $2.4 billion.

* Spain's Banco Santander SA said it would fully take over its publicly traded affiliate Banco Español de Crédito SA or Banesto, in a deal that will result in the closure of about 700 branches and underscores the gathering pace of restructuring in the country's stricken banking sector.

* Boeing Co said it will raise its quarterly dividend by 10 percent and resume a $7 billion share-buyback program, providing a long-awaited disclosure of plans to redeploy cash back to shareholders.

* Chevron Corp has offered to pay $149 million to settle two civil lawsuits in Brazil related to an oil spill in late 2011, with final approval of the deal likely in January, Brazil's federal prosecutor's office said.

* Wal-Mart Stores Inc, the largest seller of guns and ammunition in the country, removed a website listing for a semiautomatic assault rifle similar to the gun used in the Newtown, Connecticut, school massacre.

* Edison International's wholesale-power unit, Edison Mission Energy, filed for Chapter 11 bankruptcy protection in an anticipated move that the parent company said would cost at least $1.5 billion.

* President Barack Obama backed away from his long-standing call for raising tax rates on households making more than $250,000 a year, a development that inches the White House and congressional Republicans closer to a budget deal.

* The mass shooting in Connecticut appears to be reshaping the politics of gun control, with several ardent supporters of gun rights in Congress calling for steps to toughen the nation's weapons laws.

FT

OUTLINE OF US FISCAL DEAL EMERGES

A deal to avert the U.S. fiscal cliff is at last emerging, with at least $1 trillion in new taxes, up to $1 trillion in fresh spending cuts and an increase in America's debt ceiling.

DOZENS TO BE IMPLICATED IN UBS LIBOR DEAL

About three dozen bankers and senior managers will be implicated in the alleged rigging of Libor interest rates when UBS settles with global regulators later this week.

G4S SET FOR WELFARE REFORM ROLE

G4S is set to win a role in implementing the government's contentious and complex changes to child benefit and the universal credit.

TESCO EDGES CLOSER TO NAMING UK CHIEF

Tesco is moving closer to appointing a UK chief executive, with Chris Bush, chief operating officer, emerging as the front-runner for the role.

BAUGUR CHIEF INDICTED IN ICELAND

The most prominent of Iceland's one-time corporate raiders has been indicted in the latest attempt to uncover alleged wrongdoing from its dramatic financial crisis.

QUESTIONS HANG OVER APPLE'S LONG-TERM GROWTH

Wall Street's debate over how to value Apple has intensified with the iPhone maker's stock skirting around the $500 mark on Monday.

MORGAN STANLEY FINED OVER FACEBOOK IPO

Morgan Stanley <MS.N > was fined $5 million by the Massachusetts securities regulator who said the company's investment bankers had "improper influence" on analysts.

SLIM SUFFERS 2 BLN EUROS PAPER LOSS ON EU FORAY

Carlos Slim, the world's richest man, has overseen a loss of close to 2 billion euros ($2.63 billion) on his foray this year into the European market.

NYT

* Massachusetts's top financial authority fined Morgan Stanley $5 million for violating securities laws, the first major regulatory action tied to Facebook Inc's initial public stock offering.

* Google Inc seems on its way to coming through a major antitrust investigation in the United States essentially unscathed. But the outlook is not as bright for Google here, as the European Union's top antitrust regulator prepares to meet with Eric Schmidt, Google's executive chairman.

* General Electric Co is expected to strike a deal to buy the Italian aerospace company Avio for $4 billion or more, in a bid to bolster its commercial jet engine business.

* Sprint Nextel Corp agreed to buy all of the wireless network operator Clearwire Corp, an important step for the cellphone service provider as it continues its big turnaround campaign.

* Banco Santander SA said it would absorb Banesto, its main domestic subsidiary and once one of Spain's leading banks, as part of a plan to cut 700 branches, or about 15 percent of its retail network.

* Instagram released an updated version of its privacy policy and terms of service, which include lengthy stipulations on how photographs uploaded by users may be used by Instagram and its parent company, Facebook Inc. The changes, which will go into effect Jan. 16, will not apply to pictures shared before that date.

* Wal-Mart de Mexico was an aggressive and creative corrupter, offering large payoffs to get what the law otherwise prohibited, an examination by The New York Times found. It used bribes to circumvent regulatory safeguards that protect Mexican citizens from unsafe construction.

* Lockheed Martin Corp expects to earn a profit in the high single digits under a new contract signed last week for the fifth batch of its radar-evading F-35 fighter planes, company officials said.

* The hedge fund Elliott Management Corp offered to buy Compuware Corp, a business software maker, for about $2.3 billion, repeating a tactic that prompted the sale of Novell in late 2010.

* Sun Life Financial Inc, Canada's third-largest life insurance company, announced a deal to sell its annuity and some life insurance businesses in the United States for $1.35 billion.

* President Obama delivered to Speaker John Boehner a new offer to resolve the pending fiscal crisis, a deal that would raise revenue by $1.2 trillion over the next decade but keep in place the Bush-era tax rates for any household with earnings below $400,000.

Canada

THE GLOBE AND MAIL

* Dozens of vulnerable women who disappeared from Vancouver's poverty-stricken, drug-ridden downtown eastside were victims of systemic police bias and blatant police failures, says a highly anticipated public inquiry report.

* Just days after a lone gunman's rampage through a Connecticut elementary school left 20 children and six adults dead, a Vancouver primary school imposed a four-hour lockdown Monday after being informed of threats made toward its students and staff.

Reports in the business section:

* Mark Carney will face a grilling from British members of Parliament over his political ambitions and leanings after revelations the next Bank of England governor was recently courted by liberals to run for leader and that he and his family holidayed at the party finance critic's seaside home in Nova Scotia.

* Inmet Mining Corp's shares rose more than 4 percent Monday as investors in the Toronto miner bet that an ardent suitor has not played its last card with its C$5.1-billion ($5.18 billion) hostile takeover bid.

* Sun Life Financial Inc is selling for $1.35 billion a risky American division that swings wildly between profits and losses in an effort to focus on growth in Canada and Asia.

* The government of Newfoundland and Labrador and Nova Scotia utility company Emera Inc are proceeding with development of the C$7.7 billion ($7.82 billion) Muskrat Falls hydroelectric project despite lingering cost and environmental concerns, Premier Kathy Dunderdale said late on Monday.

NATIONAL POST

* A pair of NASA spacecraft crashed into a mountain near the moon's north pole on Monday, bringing a deliberate end to a mission that peered into the lunar interior.

FINANCIAL POST

* North American markets diverged on Monday as the Toronto Stock Exchange moved lower on widespread weakness across major sectors while Wall Street got a boost on encouraging signs from talks to resolve the "fiscal cliff" stalemate in Washington.

China

CHINA SECURITIES JOURNAL

-- Zhou Xiaochuan, governor of the People's Bank of China, said China will encourage foreign funds to invest in China's stock exchanges and bond market.

-- Alcoholic beverage maker Wuliangye Yibin Co Ltd said its senior management has purchased 83,301 company shares to express confidence in its healthy development. The shares are worth around 2.2 million yuan ($352,800) at the current price.

SECURITIES TIMES

-- Inner Mongolia Yili Industrial Group Co Ltd said in a statement that it plans to invest 214 million New Zealand dollars ($180.71 million) in an infant milk formula project in New Zealand.

CHINA DAILY (www.chinadaily.com.cn)

-- The growing number of Chinese looking to move money abroad could damage employment and rural economies in their homeland, warns a new report. Wealthy Chinese are increasingly looking for opportunities to move capital abroad, according to the 2012 Annual Report on Chinese International Migration.

PEOPLE'S DAILY

-- China's domestic non-financial direct investment rose 25 percent in the first 11 months year-on-year, data from the Ministry of Commerce showed.

Fly On The Wall 7:00 AM Market Snapshot

ANALYST RESEARCH

Upgrades

Duke Energy (DUK) upgraded to Buy from Hold at Deutsche Bank
Goldman Sachs (GS) upgraded to Positive from Neutral at Susquehanna
Horizon Technology (HRZN) upgraded to Outperform from Market Perform at Wells Fargo
Spreadtrum (SPRD) upgraded to Neutral from Underperform at BofA/Merrill

Downgrades

Centene (CNC) downgraded to Hold from Buy at Jefferies
Covenant Transportation (CVTI) downgraded to Hold from Buy at BB&T
FirstEnergy (FE) downgraded to Hold from Buy at Deutsche Bank
LG Display (LPL) downgraded to Neutral from Buy at UBS
Owens & Minor (OMI) downgraded to Sell from Neutral at Goldman
Rush Enterprises (RUSHA) downgraded to Hold from Buy at BB&T
Woodward (WWD) downgraded to Neutral from Outperform at Credit Suisse

Initiations

Biogen (BIIB) initiated with a Hold at Canaccord
C&J Energy (CJES) initiated with a Buy at Goldman
Carbonite (CARB) initiated with a Market Perform at Northland Securities
Community Health (CYH) initiated with an Overweight at JPMorgan
Delek Logistics (DKL) initiated with an Outperform at Wells Fargo
Demandware (DWRE) initiated with a Hold at Stifel Nicolaus
HCA Holdings (HCA) initiated with an Overweight at JPMorgan
Health Management (HMA) initiated with a Neutral at JPMorgan
Joy Global (JOY) initiated with a Neutral at Citigroup
LifePoint Hospitals (LPNT) initiated with an Overweight at JPMorgan
LogMeln (LOGM) initiated with an Outperform at Northland Securities
Proofpoint (PFPT) initiated with an Outperform at Northland Securities
RPC, Inc. (RES) initiated with a Neutral at Goldman
Raymond James (RJF) initiated with a Buy at Citigroup
Sirius XM (SIRI) initiated with a Buy at Goldman
SolarWinds (SWI) initiated with a Market Perform at Northland Securities
Tenet Healthcare (THC) initiated with an Overweight at JPMorgan
Tesla (TSLA) initiated with a Neutral at JPMorgan
Unilife (UNIS) initiated with a Buy at Cantor
Universal Health (UHS) initiated with an Overweight at JPMorgan
Vanguard Health (VHS) initiated with a Neutral at JPMorgan

HOT STOCKS

Banking analyst Meredith Whitney upgraded shares of Citigroup (C), Bank of America (BAC) and Discover (DFS), CNBC reports
Icahn proposed American Railcar (ARII) acquire Greenbrier (GBX) for $20 per share
Boeing (BA) raised dividend 10%, resumed $3.6B share repurchase
Eli Lilly (LLY) announced new $1.5B share repurchase program
Allstate (ALL) announced new $1B share repurchase program
AIG (AIG) priced entire remaining stake of AIA Group
Liberty Global (LBTYA) opened voluntary and conditional cash offer for Telenet
Manhindra acquired Navistar's (NAV) stake in India joint ventures for $33M
Gulfport Energy (GPOR) announced proposed acquisition of additional Utica acreage
Fluor (FLR), Granite Construction (GVA) team to build Tappan Zee Bridge replacement in New York State
Solar Capital (SLRC) to acquire Crystal Financial
Vitamin Shoppe (VSI) to acquire Super Supplement for $50M

EARNINGS

Companies that beat consensus earnings expectations last night and today include: Sanderson Farms (SAFM), Biodel (BIOD), Stewart Enterprises (STEI), Diamond Foods (DMND)

Companies that missed consensus earnings expectations include:
Shuffle Master (SHFL)

NEWSPAPERS/WEBSITES

GE (GE) CEO Jeff Immelt said economic uncertainty in the fourth quarter has caused "an investment pause" that has crimped the company's sales, although he voiced optimism overall and forecast industrial revenue growth in 2013, the Wall Street Journal reports
A U.S. judge denied Apple’s (AAPL) request for a ban on the sale of some Samsung Electronics (SSNLF) products in the U.S. market, tempering Apple's sweeping win in a California court case this summer, the Wall Street Journal reports
Knight Capital Group's (KCG) board was split between two competing offers for the firm after a meeting where Getco Holding Company LLC and Virtu Financial LLC presented their sweetened bids to Knight's directors, sources say, Reuters reports
United Parcel Service (UPS) offered more concessions in a bid to gain EU regulatory approval for its $6.84B TNT Express (TNTEY) bid, sources say, Reuters reports
Global coal demand will likely increase by 2.6% a year to 6.17B metric tons of coal equivalent in the six years to 2017, driven by China’s economic expansion, according to the International Energy Agency, Bloomberg reports
Goldman Sachs (GS) and Bain Capital are set to defend before U.S. District Judge Edward Harrington in Boston what they call legitimate private-equity practices against investor claims that buyout firms and their bankers colluded to rig bids on takeovers, Bloomberg reports

SYNDICATE

Galena Biopharma (GALE) intends to offer common stock and warrants
Gulfport Energy (GPOR) commences offering of 9M shares of common stock
RAIT Financial (RAS) commences offering of 9M shares of common stock
The Bancorp (TBBK) commences offering of $50M of common stock

"As long as the music is playing, you've got to get up and dance. We're still dancing.”

Chuck Prince

CEO, Citigroup

Bloomberg News reports that Bank of America Corp. (BAC), the best performer in the Dow Jones Industrial Average for 2012, has more than doubled since the start of the year “as the company rebuilds capital and investor confidence.”

My friend Meredith Whitney just upgraded BAC to a “Buy,” a call that is a little late given the stock’s performance to date.  But at just 0.5x book value, to be fair to Meredith, you could argue that the bank is still undervalued.  And many people do in fact believe this.  If we accept the basic bull market thesis for BAC being touted by Whitney and others, what is a reasonable valuation for BAC?  

Let’s set some assumptions.  

First, if you believe the bull market thesis for BAC, you must assume that the bank is going to prevail in the massive litigation it faces with respect to legacy mortgage securities.  This is a considerable assumption, but Whitney and the rest of the Sell Side analyst community seem to already have taken this leap of faith.  For the sake of their clients, let’s hope they are right.  

BTW, watch some of the more critical bank analysts ask BAC and other TBTF banks about the adequacy of reserves for civil litigation and put back claims by Uncle Sam in the Q4 earnings calls this January.  

Second and more important even than the litigation is the question of business model. Earlier this week, BAC CEO Brian Moynihan said that he was satisfied with a high single digit market share in the US mortgage sector.   Wells Fargo (WFC) is close to 40%.  BAC at < 10% market share nationally is perhaps a more profound assumption than the question of the BAC mortgage litigation.  BAC was once the dominant player in mortgage lending, both directly and through third part originations (TPO).  To have this bank’s huge balance sheet at such a low level of deployment is bad for the real estate market and for future earnings.  

Thanks to Senator Elizabeth Warren (D-MA) and the ill-considered Dodd Frank legislation, the TPO market has virtually disappeared.  The lending capacity once represented by Countrywide, WaMu and Lehman Brothers is gone.  BAC is still purchasing some production from outside providers, but the volumes are miniscule compared with the pre-2007 period. Thus the question comes: When Street analysts are showing a positive revenue growth rate for BAC and its peers, from where precisely is this revenue going to come?

Because of Dodd-Frank, Basel III and the Robo-signing settlement, the largest US banks are being forced out of the mortgage market.  Earlier this week, I talked about this dynamic on CNBC’s “Fast Money.” Suffice to say that analysts who assume that BAC will double in 2013 may not understand the new drivers – or lack thereof -- of revenue and earnings in all of the TBTF banks.

That said, I think it may be reasonable for BAC and even much maligned Citigroup (C) to double in the next twelve months, but not because of revenue or earnings growth.  If BAC hits street estimates for revenue in 2013 (+3-4%), is this a sufficient driver to justify a double in the stock?  No, but a doubling of the dividend is a good enough reason for cash starved investors.  In a very real sense, the biggest driver for stocks like BAC or C is not internal revenue growth but the zero rate policy of the FOMC.

During 2012, the preferred stocks of names like BAC and C have appreciated more than 15 points in price.  Yields for preferred issuers like the TBTF banks and General Electric (GE) have fallen by almost two points.  Is this because the revenue growth or earnings of these names have been growing?  No, these metrics are flat to down.  The appreciation of these securities has been driven by the FOMC and the Fed’s ridiculous zero rate policy.  ZIRP does not create jobs nor is it helping bank revenue.  

"Reduced expenses for loan losses and rising noninterest income helped lift insured institutions’ earnings to $37.6 billion in third quarter 2012," notes the FDIC in the most recent Quarterly Banking Profile.  "Two out of every three insured institutions (67.8 percent) reported year-over-year NIM declines, as average asset yields declined faster than average funding costs." The fact that the TBTF banks are relying on fee income and line items like investment banking to hit revenue and earnings targets is very telling.  

So when you see Sell Side analysts like Meredith Whitney being so constructive on the TBTF banks, even with the poor operating performance, investors need to ask themselves a question.  Is the prospective appreciation of BAC and C the result of strong business fundamentals?  Or is the prospective appreciation of these stocks more a case of traumatized investors fleeing to the fantail of the Titanic to avoid the icy cold financial repression of zero interest rates?  Keep in mind that most of the improvement in earnings which seems to impress Whitney and other analysts has come as a result of expense reductions, mostly credit costs.  Efficiency ratios for the large banks are over 60%, of note. 

Even if you believe that BAC is going to escape the most horrific outcome in the mortgage litigation, the valuation target that is reasonable for this bank, C and the other TBTF institutions such as JPMorgan Chase (JPM) and WFC, is probably between 1 and 1.25x book value.  So yes, given that valuation framework, you can justify a doubling of BAC from current levels to say $20-25 per share.  But keep in mind that this stock was trading at $40 back in 2008 and over $50 in 2006 prior to the acquisition of Countrywide.   Are we likely to see BAC go to over 2x book value again?  Well, maybe, but not because of strong earnings or revenue growth rates.  

Should names like BAC or C manage to get above 1.25x book, it will be because of the Fed and ZIRP.  And as and when Fed interest rate policy changes, look out below.  As I noted on CNBC, without the benefit of a strong mortgage origination and securitization business, the TBTF banks are going to become far less volatile and far more boring.  Even the marginally higher capital levels of today, pre-Basel III, will imply lower asset and equity returns.  And this is not a bad thing.   

Yet investors are really not prepared mentally or emotionally for a market where the large banks are not delivering double digit revenue and earnings growth, whether organically or via M&A.  Most institutional investors, keep in mind, have no idea how the TBTF banks actually make money.  So when well-meaning Sell Side analysts predict wondrous stock price appreciation for the Zombie Dance Queens, the proverbial sheep on the Buy Side sing with joy -- and rush into the interest rate trap so lovingly constructed by Chairman Bernanke and the Fed.  Keep in mind that the corollary of ZIRP is massive interest rate and market risk on the books of all banks.  Think trillions of dollars in option adjusted duration risk.

Without the benefit of gain on sale from mortgage origination and securitization, it is difficult to construct a long term bull scenario for any US bank, large or small.  As and when the Fed normalizes interest rates, the business models of the TBTF banks are going to be far less exciting.  Mark-to-market losses on securities will wipe out stated earnings.  New and innovative ways of presenting “pro forma” earnings will appear on the scene.  The TBTF bank CEOs will rightly blame Washington.  

In this future banking market, names like C which currently trade on a 2 beta will have higher dividends, but relatively flat earnings and revenues.  Cost cutting, not growth, will fund these payouts to investors. Occasionally you will see big numbers from these names when the investment bankers have an especially good quarter.  But overall the TBTF banks are evolving into low growth utilities with nice dividends.  This is precisely the way banks used to be before President Bill Clinton’s “Great Leap Forward” in terms of housing and home ownership.   And, again, this is not a bad thing.  

But investors in the TBTF banks need to understand that the business model for this industry has changed.  The business model for banks is going to continue to evolve away from the high-beta, high volatility model of the 2000s to something that looks more like banking in the 1950s.  The action in terms of significant volume growth is in the non-bank sector.  Get used to it.  

www.rcwhalen.com

Submitted by Dave Collum via Peak Prosperity,

Background

I was just trying to figure it all out.

~ Michael Burry, hedge fund manager

Every December, I write a Year in Review that has now found a home at Chris Martenson’s website PeakProsperity.com.^1,2,3 What started as a simple summary intended for a couple dozen people morphed over time into a much more detailed account that accrued over 25,000 clicks last year.⁴ 'Year in Review' is a bit of a misnomer in that it is both a collage of what happened, plus a smattering of issues that are on my radar right now. As to why people care what an organic chemist thinks about investing, economics, monetary policy, and societal moods I can only offer a few thoughts.

For starters, in 33 years of investing with a decidedly undiversified portfolio, I had only one year in which my total wealth decreased in nominal dollars. For the 13 years beginning 01/01/00—the 13 toughest investing years of the new millennium!—I have been able to compound my personal wealth at an 11% annualized rate. This holds up well against the pros. I am also fairly good at distilling complexity down to simplicity and seem to be a congenital contrarian. I also have been a devout follower of Austrian business cycle theory—i.e., free market economics—since the late 1990s.⁴

Each review begins with a highly personalized analysis of my efforts to get through another year of investing followed by a more holistic overview of what is now a 33-year quest for a ramen-soup-free retirement. These details may be instructive for those interested in my approach to investing. The bulk of the review, however, describes thoughts and observations—the year’s events told as a narrative. The links are copious, albeit not comprehensive. Some are flagged with enthusiasm. Everything can be found here.⁵

I have tried to avoid themes covered amply in my previous reviews. There is no silver bullet, however, against global crises, credit bubbles, and feckless central bankers. Debt permeates all levels of society, demanding comment every year. Precious metals and natural resources are a personal favorite. This year was particularly distorted by the elections; I offer my opinions as to why. Sections on Baptists, Bankers, The Federal Reserve, and Bootleggers describe the players in Jack Bogle’s Battle for the Soul of Capitalism.⁶ Special attention is given to a financial crime diaspora fueled by globally overreaching monetary policies. Everything distills down to a relentlessly debated question: What is the role of government? I finish light with the year’s book list that shaped my thinking. I acknowledge individuals who have made pondering capitalism a blast through direct exchanges over the years. They brought wisdom; I brought the chips and dip. You already know who you are. And then there are those characters whose behavior is so erratic, sociopathic, criminal, or just plain inexplicable—you guys are central to the plot. I leapfrog Rome and Titanic metaphors and go straight to the Lusitania.

One last caveat: I subscribe to the Aristotelian notion that one can entertain ideas without necessarily endorsing them, often causing me to color way outside the lines. With trillions of dollars circumnavigating the globe daily, nefarious activities are not only possible but near certainties. If you are prone to denounce conspiracy theories and conspiracy theorists to avoid unpleasant thoughts, you should stop reading now. I’m sure there’s another Black Something sale at Walmart. If you are a bull, you should also bail out or buckle up. This is the bear case. I will remain a permabear until some catharsis knocks me off my stance and they find a cure for my market- and politics-induced PTSD.

As this review was being completed, Lauren Lyster and Demetri Kofinas recently uploaded a companion interview on the Year in Review I did with Capital Accounts on RT_America (to be aired on December 21st and posted on Youtube.)⁷ In this context I offer wisdom from the Master:

If there is ever a medium to display your ignorance, television is it.

~ Jon Stewart

Footnote superscripts appear extensively throughout this review. The actual footnotes and associated hyperlinks can be found here.

Contents

• Background
• Contents
• Investing
• Thinking About Capitalism
• Election Year
• Events
• Broken Markets
• Precious Metals
• Resources and Energy
• The Baptists
• The Bankers
• The Federal Reserve
• The Bootleggers
• Personal Debt
• Mortgage Debt
• Student Debt
• Municipal and State Debt
• Corporate Debt
• Sovereign Debt
• Pension Crisis
• Roth IRAs: A Bad Idea
• Europe
• Asia
• Government Corruption
• Civil Liberties and the Constitution
• Limits of Government
• Books
• Acknowledgements
• Links

Investing

The elevated prices of financial assets have already eaten the future.

~ John Hussman, CEO of Hussman Funds

With rebalancing achieved only by directing my savings, I have changed almost nothing consequentially in my portfolio year over year. The total portfolio as of 12/15/12 is as follows:

Precious Metals et al.: 52%

Energy: 15%

Cash Equiv (short-term): 30%

Other: 3%

Most asset classes lurched off the starting line in January like Lance Armstrong. My portfolio eventually settled down and spent most of the year snorkeling slightly up or slightly underwater. In a relatively rare instance, an overall return on investment (ROI) of 4% was beat handily by both the S&P 500 (13%) and Berkshire Hathaway (17%), although nearly the entire return of the S&P was p/e expansion.⁸ A majority of hedge funds struggled to beat the S&P this year as well.⁹

My precious metals are distributed in approximately three equal portions to the gold-silver holding company Central Fund of Canada (CEF), Fidelity’s precious metal fund (FSAGX), and physical metals (Figure 1). Gains in gold (17%) and silver (8%) were offset by a horrendously lagging performance for the second year in a row by the corresponding precious metal-based equities (-10%). The metal-equity divergence began in January 2011 and continues to baffle the hard-asset crowd (Figure 2). A plot of the ratio of the silver ETF (SLV) versus the world’s largest silver miner, Pan American Silver (PAAS), is striking (Figure 3). In May I emailed a dozen gurus for opinions about arbitraging (swapping) an SLV position for PAAS. Realizing that collectively these folks controlled billions of dollars, I felt I had to move on the idea pronto (my only portfolio change for the year). After a few weeks of an overwhelming sense of superiority, gyrations eventually left the arbitrage at about break-even. I’m guardedly optimistic about the precious-metal equities, but they have been widowmakers for two years.

Figure 1. Precious-metal-based indices (GLD in green, XAU in red, SLV in brown, and XAU in red) versus the S&P 500 (in blue) for 2012.

Figure 2. Relative performance of gold-based equities (XAU in red) vs. gold (GLD in blue).

Figure 3. SLV/PAAS ratio over three years.

A basket of Fidelity-based energy and materials funds afforded 2-16%. They are represented emblematically by the XLE spider (3%) and XNG Amex natural gas index (1%) in Figure 4. I am wildly bullish on natural gas for reasons discussed in detail two years ago.² Unfortunately, Fidelity’s natural gas fund (FSNGX) foisted upon me by Cornell got crushed in 2009 and subsequent years relative to its peers. Making the right calls is hard enough without that kind of headwind. New management as of 2010 seems to be finally tracking the XNG. I keep adding to an already chunky position. Friends deeply embedded in the energy complex suggest that the fracking glut will take 2-3 years to burn off. (It is also claimed that the derivatives traders are whacking out the price discovery; what else is new?)¹⁰ A global shift toward natural gas should reward patience.

Figure 4. Energy-based indices (XLE in red and XNG in green) versus the S&P 500 (in blue) for 2011.

Cash was in a U.S. Treasury-backed money-market bunker returning 0%. I had a $25K money market fund that failed to reach the IRS taxable threshold! I could care less what risky gangplank Bernanke wishes that I walk. Buying ten-year Treasurys returning <2%, with or without your finger quivering over the sell command, is a fool’s game: I’ll take the yield hit. The bond market will eventually become a killing field. Those who are pair trading—long bonds/short brains—will get their organs harvested. This seems like a near certainty.

The most disappointing part of the year was a personal savings equivalent of only 11% of my gross income compared with 29% last year and 20-30% in typical years. Unusual expenses in the form of a year of college education, a serious violin upgrade, and very large landscaping costs don’t excuse the fact that we chose lower savings over lower consumption. This troubles me deeply. Profound austerity is not a cause but an effect, something the Europeans may be just now figuring out.

To understand my lifetime returns, you must understand two unusual premises that have dominated my thoughts and actions. First, you must become wedded to an investment. Did I just say that? Yep. You’ve got to be a true believer to resist being shaken out of good investments or suckered into bad ones. Many say it’s never a bad time to take a profit. Total hooey. Those ten-baggers—the miracles of compounding—will never materialize if you bail after 20%. Just ask the Microsoft investors who exited in 1990 for a handsome profit.

My second premise is that you have to get it right only about once a decade. One of my favorite bloggers and an e-pal, Grant Williams, illustrated how daisy-chaining four secular bull markets—Gold, Nikkei, NASDAQ, and Gold—could have produced a virtual return of 640,000%—a 6400-bagger (Figure 5).¹¹ Admittedly, this kind of luck is only found in Narnia. Statistically, somebody might have done this, although not likely in such a Texas Hold’em all-in fashion.

Figure 5. Sequential investments in secular bull markets starting in 1970.¹¹

My variant of such a sequential trek via imbalanced portfolios changed in decadal rhythms as follows:

1980-88: exclusively bonds (100%)

1988-99: classic 60:40 equities:bonds

1999-2001: cash, precious metals, shorts (minor)

2001-2012: cash, precious metals, energy, tobacco (minor)

My total wealth accumulated through a combination of savings and investment as shown in Figure 6. (I redacted the dollar amounts along the y-axis.) Avoiding 1987 and 2000 equity crashes and capturing the bull market in precious metals proved fortuitous. You can see that 2008 was the only down year. Berkshire has dropped five years since 1991. A 13-year accumulation rate beginning 01/01/00 of 11% annualized compares favorably to an annualized return on the S&P of -0.03% and on Berkshire of 7%.

Figure 6. Total wealth accumulated (ex-housing) versus year of employment. Absolute dollar values have been omitted.

I also monitor overall progress by what I call a salary multiple, which is defined as the total accumulated investable wealth (excluding my house) divided by annual salary (line 22 of the 1099 form excluding capital gains). Over 33 years my salary (actually total income) rose twelve-fold, which I can fairly accurately dissect into a fourfold gain resulting from inflation and a threefold gain (relative to starting salaries of newly minted assistant professors) due to increasing sources of income and merit-based pay raises. My accumulated wealth normalized to the moving benchmark of a rising income is plotted versus time in Figure 7. The fluctuations visible in Figure 7 not apparent in Figure 6 result from income variations.

Figure 7. Total wealth accumulated measured as a multiple of annual salary versus years of investing.

To clarify the origins of a 13-year return of 11% per year I offer Figure 8. By plunging into the precious-metal and energy sector early and avoiding all other forms of investments (S&P in particular), I was able to capture the entire hard-asset bull market. According to Money magazine’s calculator,¹² I can spike the ball in the endzone and dance. They are wrong. My ultimate target—a valid target—is to accumulate 20 salary equivalents over the next 12 years (age 70). This will require an inflation-adjusted (real) annual growth of 4-5%. Some of that will come from savings. As you can tell by the Hussman quote and discussions below, however, such gains are not assured.

Figure 8. Plot of Central Fund of Canada (CEF; 1:1 gold:silver by value), XLE, and S&P.

Thinking About Capitalism

When the blind lead the blind get out of the way.

~ First grader

I realize that is what I do—I think about capitalism. It’s not deep stuff; more like taking a weed whacker to a hay field of information. This year, however, there was something askew—something corrupting the information flow. It was the presidential elections. This is a good starting point.

Election Year

No serious person would question the integrity of the Bureau of Labor Statistics. These numbers are put together by career employees.

~ Alan Krueger, White House Council of Economic Advisers

To a news and economic data junkie, presidential elections are profoundly distorting. The news feeds are inundated by election analyses that are mundane at best and nauseating on a bad day. It’s a variant of Gresham’s Law—bad information pushes out good. The pundits are either talking about the elections explicitly or couching potentially credible news stories in the context of the election. Terrorist attacks in Benghazi mutate into Obama’s Big Screw Up. The news feeds are further corrupted by billions of campaign dollars spent to deceive us. Frank Rich, award-winning New York Times journalist, estimates that George Bush had 120 “journalists” on payroll. They get overtime and hazard pay during elections. The shenanigans go deeper.

There have been numerous accusations of voter fraud. From my recollection, it was mostly the left accusing the right (the CEO of Diebold in particular). A window opened when the mischievous computer hackers, Anonymous, did a smash-and-grab on Stratfor’s server, obtaining over 5 million emails. Stratfor provides confidential intelligence services to large corporations and government agencies, including the U.S. Department of Homeland Security, U.S. Marines, and U.S. Defense Intelligence Agency. From 971 emails released to date (by Wikileaks), we find that Democrats stuffed the ballot boxes in Pennsylvania in 2008 that went unchallenged by McCain. Jesse Jackson shook down Obama for a six-digit payoff.¹³ Emails detailing the Bin Laden capture are worth a peek.

The most insidious election year distortion may be the tainting of economic data feeds that the marketplace relies on. Data coming from career statisticians in the federal government are always suspect. The inflation numbers, for example, are widely believed to be cooked beyond recognition using corrections recommended by the Boskin Commission.^14,15 This year, however, the data massaging morphed into an all-out rub ‘n’ tug to ensure a happy ending for the Democrats.

The data from the Bureau of Labor Statistics (BLS) are especially susceptible to corruption. The Birth-Death Model, for example, estimates new jobs being created that nobody can detect.¹⁶ Apparently, the absence of data demands that some get fabricated. These embryonic jobs have reached epidemic proportions—hundreds of thousands per month—oftentimes overwhelming the detectable jobs. Curiously, no administration ever fabricates undetectable job losses.

Another trick is a very simple iterative process for reporting statistics: Step 1—Announce inflated economic statistics as good news; Step 2—correct the inflated statistics at some later date to a very deflated number, hope nobody notices, and call it “old news anyway”; Step 3—Report new inflated numbers that are spectacular improvements relative to the recently deflated statistics. Rinse, lather, repeat.¹⁷

The fibbing gets serious during an election year. When pre-election unemployment numbers plummeted by 0.4%—a monumental drop—the response was immediate, visceral, and seemingly uncontestable disbelief. David Rosenberg expressed it well:

I don't believe in conspiracy theories, but I don't believe in today's jobs report either.

~ David Rosenberg, Gluskin Sheff and ex-Merrill Lynch

Well, Rosie, apparently you do believe in conspiracy theories. Within minutes of the report Jack Welch, no neophyte to creative bookkeeping, released his now-infamous Tweet:

Unbelievable jobs numbers...these Chicago guys will do anything... can't debate so change numbers.

~ Jack Welch, former CEO of General Electric

It was an election year, however, so the goofy employment numbers morphed into a hot-button issue. Right-wing pundits accused the Obama administration of cooking the books. Left-wing pundits fired back with the shrill accusation, “Conspiracy theorists!” Few remembered that the GOP accused the Democrats of cooking the same numbers back in 2003.¹⁸

The whole sordid affair took a strange turn when Zero Hedge noted an odd mathematical relationship between the two carefully measured employment statistics:

Measured employment numbers:

fully employed/partially employed = 873,000/582,000 = 1.5000…

Gosh. What are the odds that those numbers were actually measured? I would say about 2.000…%.¹⁹

Counting those who no longer receive unemployment benefits as no longer unemployed, an accounting gimmick that became chronic once the crisis began, by no means was invented by Team Obama. None of this is new. LBJ was rumored to send economic statistics back to the kitchen for more cooking. The U-6 unemployment numbers account for that mechanical engineer who is now a part-time “deposit bottle recycling engineer and firewood procurement officer.” U-6 is a more accurate measure of the employment stress and is staying persistently above 14%.²⁰

Election year pandering may contribute to a very odd stock cycle.^21,22 If you break the 20th and 21st century into 27 four-year fragments corresponding to the election cycle—2009-2012 being the most recent—and average the returns, you get what is called the Presidential Election Cycle (Figure 9). What causes this cycle? One cannot exclude the role of friendly central bankers (sado-monetarists) juicing the markets. Mitt Romney, when he promised to fire Bernanke, may have sealed his fate.

Figure 9. Four-year election stock cycle throughout the 20th century.²¹

Maybe the four-year cycle in Figure 9 is a statistical anomaly and, even if real, we may not have a clue why it occurs. Nevertheless, it suggests that “Sell in May and go away” has a longer wavelength variant: “Buy the midterm and sell the Presidential.” Urban legend or not, 2013 is looking dangerous.

Events

Dan, quit embarrassing yourself.

~ Caroline Baum of Bloomberg Tweeting to a money guru who claimed that Hurricane Sandy will be stimulative

Acts of God—force majeure—tantalize market watchers and sophists alike but seem to have little effect on even the intermediate term: Economies and markets just keep marching forward. Katrina took its toll and irreparably altered lives, but it primarily illustrated government doing a heckuva job. Hurricane Sandy also exacted revenge against the civilized world (and New Jersey). It may portend things to come, should global warming live up to its billing. There is no doubt that corporations will use Sandy as an excuse for anything and everything. Q4 and year-end reports will have more Sandy-derived debris (including kitchen sinks) than dumpsters along the Jersey shore. Sandy also ushered in like clockwork the absurd claims that Frédéric Bastiat was wrong and that smashing windows and destroying infrastructure is good for the economy. Sandy will increase the GDP, but that is not economic gain. Sandy will be a bump in the road for the nation at large.

As I write this paragraph, cremnophobia—fear of cliffs—is sweeping the land. I submit that base-jumping the Fiscal Cliff may be exciting but doubt it will be some proximate trigger that causes cascading failure. The move to substantially greater austerity seems inevitable and likely to be painfully protracted—think Japan. The Fiscal Cliff would be a fumble on our own ten-yard line. It is just one down in a very, very long game. Regardless of outcome, this will be a topic for my 2013 Year in Review.

Broken Markets

A strange game. The only winning move is to not play.

~ The W.O.P.R. computer on “Wargames”

Since Cro-Magnon Man began trading flint, furs, and women, there have been nefarious activities in the marketplace. Painting the tape—moving markets at the end of a quarter to dupe customers—is tolerated. The pop icon Jim Cramer spilled his guts describing how players of even modest means can push prices around.²³ I bet Jim would like a do-over on that video. Options expiration week is always exciting, as the options dealers purportedly move the equities to minimize payouts on the heavily leveraged options to maximize pain on the plebeians. Insider trading is a death sentence for a nobody, but is a misdemeanor for the big bankers. When caught, the going rate on the punishment of investment banks is a 3-5% surcharge on the profit from the illicit trade. One can only imagine how much it would cost us in punitive rebates if the criminal behavior caused a loss.

In general, however, blaming markets for your losses is a fool's game. Nonetheless, something has changed. The Federal Reserve—the Fed—has explicitly stated a vested interest in both the magnitude and direction that markets move, abandoning all willingness to let markets determine prices. These guys are playing God, taking full possession of our hopes and dreams. In analogy to global warming, their loose monetary policy jacks up prices with markedly increased volatility and enormous social costs. Kevin Phillips’ 2005 American Theocracy is a brilliant account of the demise of Western empires. He notes that the final death rattle is the financialization of the economy. When moving money becomes the primary economic activity, the end is near. Let’s look at some of the symptoms.

The high frequency traders (HFTs a.k.a. “algos” or cheetah traders) have really upped their game. The title of this section stems from Sal Arnuk’s and Joe Saluzzi’s book Broken Markets, which describes the seedy world of supercomputers skimming enormous profits. It is consensus that HFT’s are profitable for the trading platforms but of little merit otherwise. They gum up the system intentionally to garner advantage and dump millions of fake quotes to be cancelled within milliseconds.²⁴ None of this is legal, but all is tolerated. They are now trading for razor-thin profit margins of as little as $0.00001 skim per share but making it up on volume—dangerously large volume. One Berkshire Hathaway trade—a $120,000 per share stock—is rumored to have netted $10 total (0.8 cents per share).²⁵

The markets are now at great risk. We should not expect that profiteers benefit society. We can demand that they don’t bring the entire system to its knees. I got my ten seconds of fame in an article describing the consequences of the legendary Flash Crash on May 6th, 2010:²⁶

Wall Street is a crime syndicate, and I am not speaking metaphorically... The banking system is oligarchic and the political system has metastasized into state capitalism. The most important market in the world—the market in which lenders and borrowers meet to haggle over the cost of capital—is the most manipulated market in the world.

~ David Collum, WSJ

Flash crashes are now daily occurrences, as thoroughly documented by market research firm Nanex, and are not restricted to any one market. India tanked 15% in a few minutes.²⁷ The precious metals appear to be a favorite playground: “At 1:22 p.m. SLV was forced down by rapid-fire machine-generated quotes—more than 75,000 per second.”²⁸ Berkshire Hathaway—Berkshire Hathaway!—dropped from $120,000 a share to $1 for a few milliseconds.²⁹ Commodity Futures Trading Commission (CFTC) commissioner Bart Chilton says that the “third largest trader by volume at the Chicago Mercantile Exchange (CME) is one of these cheetah traders in Prague."³⁰ (Bart appears to be a supporter of clean markets, though I remain distrustful.) On August 1st, 150 stocks swung wildly. In a heavy dose of irony, the wildest—a 40% swing—was a company called Bunge.³¹ The monstrous oil market flash crashed when a 50-fold spike in trade volume hit the tape.³² Some fear a flash crash in the unimaginably large U.S. Treasury market.³³

Irony reached a fevered pitch when BATS Global Markets (BATS), the third largest trading platform behind NYSE and NASDAQ, listed their own IPO.³⁴ Their primary customers—the cheetah traders—drove the share price from $16 to 1 cent in 900 milliseconds, forcing the cancellation of the IPO. Knight Trading, while beta-testing their own HFT algo, released it to the wild. While the traders snarfed down celebratory mochaccinos, a pesky sign error caused the HFT algo to buy high-sell low for a very long 45 minutes.³⁵ One of the most respected trading firms in the business was shopping itself to potential buyers within 24 hours. The standard excuse for erratic market behavior—Disney-like “fat-fingered traders” hitting the wrong key on a trade—became comical alibis for deep-seated structural flaws in the markets.

We have a huge problem. Don’t take my word for it. Let’s listen to what some of the pros have to say:

All this trading creates nothing, creates no value, in fact, subtracts from value.

~ John Bogle, inventor of the index fund

Essentially, the for-profit exchanges are approving their own rule changes. The lunatics are now running the asylum.

~ Joe Saluzzi, cofounder of Themis Trading

 High-speed trading, if we may get our two cents in, is a dubious activity to label as a technological advance.

~ Alan Abelson, Former Editor of Barrons

Not all IPOs flash-crashed; some simply beat investors like rented mules using more traditional methods. I had an entertaining Twitter exchange with Sal Arnuk, cofounder of Themis Trading and coauthor of Broken Markets, on May 18th just hours before the now-infamous Facebook IPO:

David Collum:

@nanexllc@joesaluzzi@themisSal A Facebook flashcrash to $0.01 would be fun and educational for the whole family.

Sal Arnuk:

@DavidBCollum doubt that....prepping for weeks

The rest is history. Facebook didn’t flash crash, but weeks of prepping were inadequate. Facebook crashed the NASDAQ market for 17 very long seconds, which is a lifetime when measured in algo years.³⁶ The high-profile Facebook IPO—technically a secondary offering—managed to maximize Facebook’s capital by selling shares into the market near its all-time high. Underwriter Morgan Stanley took a beating (possibly billions) defending the opening price of $38 before watching it drop, eventually reaching the teens. Isn’t “defending shares” illegal? While Morgan Stanley was getting hammered, the other underwriters, Goldman Sachs and JP Morgan, were loaning shares into the market for shorting.³⁷ Despite a huge outcry from those hoping for an IPO opening day bounce, I found this all highly entertaining and a good lesson in risk management. Investors hoping for easy money discovered that IPO stands for “it’s probably overpriced.” Facebook also spawned a cottage industry of Mad Libs (Fraudbook, Faceplant, Farcebook…)

A lesser known IPO failure causing a stir was Ruckus (RKUS), dropping 20% on the opening and blaming it on Hurricane Sandy.³⁸ Splunk’s (SPLK) IPO was halted after it hovered at $32 and then plummeted to $17 on a 500-share trade.³⁹ They eventually dropped 30% in an orderly slide. IPOs from the not-so-distant past that continue to inflict pain include post-IPO losses for ZYNGA (-80%), Groupon (-90%), and Pandora (-60%). Investment-grade Beanie Babies and CPDOs sound good by comparison.

The markets are broken. It’s only a matter of time before the vernacular phrases FUBAR and SNAFU will reassert into our language. The Tacoma Narrows Bridge as a metaphor for instability has been around the web for years, but is well worth a peek.⁴⁰

Precious Metals

They (gold investors) want everybody to be so scared they run to a cave with gold. Caves might be a better investment than gold. At least they’re not producing new caves all the time.

~ Warren Buffett

Those elements here and abroad who are getting rich from the continued American inflation will oppose a return to sound money.

~ Howard Buffett

Let’s stay on the theme of broken markets as a transition into a discussion of precious metals. Bill Murphy and the folks at the Gold Antitrust Action Committee (GATA) obsess over powerful and dark forces. Declassified documents showing overt attempts to restrain the price of gold provide a few smoking guns.^41,42,43,44 The Hunt brothers grotesquely misjudged the silver market and willingness of bankers to trigger margin calls and drive them to bankruptcy.⁴⁵

By the early 2000s even novice market watchers could see that central bank selling into the open market could have price suppression as a motive. Chancellor of the Exchequer Gordon Brown participated in the most famous market timing fiasco by emptying much of Britain’s gold stash below $300 per ounce.⁴⁶ That got him promoted to Prime Minister.

Then there is the very strange phenomenon of central bank leasing of gold. I surmise that the idea was presented to the populace as a way to make money from the shiny yellow metal that just sits there in vaults. Why not lease it? The gold carry trade commenced, but lease rates are fractions of a percent per annum.⁴⁷ No profit motive there. Central bank leasing of gold to the large bullion banks—the Too Big to Fail group—at a fraction of a percent interest seems to serve two purposes: (1) provide essentially free capital to the banks, and (2) apply downward pressure on the gold price. Rumor has it they are going to stop publishing the leasing rates.

The game began to falter in 2001 when neither the announcement of British bullion sales nor the actual sales dropped the price, commencing a decade-long run in the metals. That is not to say the central banks have given up. Sudden and repeated margin hikes at the COMEX trapped the levered longs, and affiliated mob-like hits by insiders became commonplace. A rumored huge silver short position by JP Morgan-Chase (JPM) may lurk beneath the London Whale saga. JPM’s commodity guru, Blythe Masters, began denying the silver short as the whale story started to surface, claiming that JPM’s silver positions were simply hedges for their customers.⁴⁸ Why would silver bulls hedge their investments? Data from the Office of the Comptroller of the Currency brought to light by Rob Kirby eventually showed that JPM has a whopping $18 billion naked short position in silver,^49,50 corresponding to 50% of the estimated global above-ground silver supply.⁵¹ Is it any wonder that silver gets “monkey hammered” with some regularity by the invisible hand? Naked shorting on such a scale is both illegal and reckless.⁵² To the extent that JPM is at risk, taxpayers are at risk. CFTC Commissioner Bart Chilton unabashedly claims that big money with outsized short positions are moving the silver market, although he won’t name names yet and hasn’t done squat.⁵³ Let me help you out Bart: Start with JPM.

I am wildly bullish about the metals going forward. Gold and silver’s returns look like a normal year within a secular bull market [editor's note: this section was written by David  prior to this week's smackdown of the precious metals]. Precious metals investors waited with baited breath as a descending triangle starting in mid-2011—a classic chart pattern recognized in technical analysis (TA)—marched to judgement day (Figure 10). Folklore says when the highs and lows converge, the price will resolve boldly to the upside or downside. OK. That sounds really stupid, but that’s state-of-the-art TA. In any event, it seems like gold took the 50% probability route to the upside thanks to an auspicious goose from more quantitative easing (QEIII). But that’s just T&A (chart porn) for the gold bugs.

Figure 10. Descending triangle and “resolution.”

The future is unknowable, yet $85 billion per month of QE IV is most definitely bullish for tangible assets. Central bankers around the World are printing around the clock. Of course, the usual cast of top callers were braying about a top. Notable gold bears included Warren Buffett hammering gold in the Berkshire Hathaway annual report, quickly followed by a show of support from his poker buddy Bill Gates. Buffett wrote an article entitled “Why Stocks Beat Gold and Bonds” and then promptly bought a gold-mining company.⁵⁴ Charlie Munger again displayed his tin ear with a decidedly anti-Semitic quote about gold (not worthy of repeating, only criticizing). There are credible arguments against gold, some better than others. An optimist might believe that central bankers will begin to behave themselves…but only in the land of unicorns and Skittles rainbows. Some claim it is a crowded trade. Many argue that gold has been a horrible inflation hedge. To this I note that shovels and bulldozers both move dirt but are very different tools. Equities and gold have similarly differentiated roles as inflation hedges.

Secular (multi-year) bull markets are said to attract investors in three specific phases: (1) first arrivals are wing nuts and whack jobs and precede anybody in their right mind, (2) the smart money arrives once the bull offers evidence there is serious money to be made, and (3) retail investors—the rabble—show up in the final phase. Once group (2) sells to group (3) in what is euphemistically called “distribution,” the invisible hand of the market throws a toaster oven in the pool and the bodies start floating to the surface. This year was dominated by smart-money gold supporters with gravitas and serious bucks. Hedge fund managers supporting gold with dire warnings of monetary chaos included luminaries George Soros, John Paulson, David Einhorn, Jim Rogers, Ray Dalio, and Kyle Bass. Einhorn and Dalio both took special care to condemn Buffett’s gold bash.^51,52 Bill Gross, head of PIMCO with almost two trillion dollars under management, noted gold “will be higher than it is today and certainly a better investment than a bond or stock, which will probably return only 3% to 4% over the next 5 to 10 years.”⁵³ Bill has caught the fever. Billionaires Hugo Salinas Price and Eric Sprott are avid precious metal investors and devout believers in organized price suppression.

Central banks became net buyers starting in 2009 after years of selling and have been increasingly aggressive (Figure 11).⁵⁴ (I call central bankers both “smart money” and “feckless”; I’m still working on resolving that paradox.) Chinese and Korean central bankers have explicitly stated gold is the only safe asset.⁵⁵ Such reports are picking up in intensity. Other events seemed new to 2012. The International Monetary Fund (IMF) has flipped to net buyer.⁵⁶ South Korea, Paraguay, Turkey, Vietnam, and Russia all increased their gold holdings. Iran swaps oil for gold with China and Turkey.^57,58

Figure 11. Central bank gold purchases

What made this year so interesting was the part occurring below the surface. Gold may soon be designated a Tier 1 asset.⁵⁹ Banks are required to maintain minimum balances of Tier 1 assets to ensure the safety of the system. (They need to work on that.) When the next credit crisis arrives, rather than selling gold to raise Tier 1 assets, banks will be incented to buy gold. It is beginning to act like a currency. The ramifications are multifold.

For the first time, we are beginning to hear discussions of some form of gold standard. It would probably be a variant of the gold-exchange standard of the early 20th century. I would be satisfied if gold was simply allowed to compete for supremacy in the open market. The most important step would be to pass gold legal-tender laws, which are at various stages in a dozen states.⁶⁰ (This could elicit a states’-rights battle.) Rendering gold’s price change denominated in dollars as a non-taxable event would be the big move. Bernanke tried to take on the push for a gold standard in a series of lectures at George Washington University.⁶¹ I found his arguments unpersuasive, exactly what you would expect from a guy who believes that profound monetary injections and inflation are valid monetary tools. The gold standard seems like a distant possibility given the Republicans endorsed the idea in their platform; we know they lied—their lips moved. The counter argument stems from a survey showing 37 prominent economists all opposed a gold standard; 37 economists couldn’t possibly be right.⁶²

One could dismiss discussions of a gold standard if it were not for the second really interesting topic—global gold movements. Let’s be clear, this story is muddled. There are three variants of gold conspiracy theory that may (or may not) lay the foundations:

(1) Thesis 1: Gold exists in the vaults of the Fed and Fort Knox, but we don’t own it anymore. We are told that the gold possession is as simple as a forklift moving a pallet from one wall to the next within the same vaults. Doubts about ownership are exacerbated by the unwillingness of the authorities to independently audit the gold since the 1950s despite calls for it from Congress. This is odd by any standard.⁶³

(2) Thesis 2: The gold in the vaults is of a substandard quality. This idea is way out there but cannot be summarily dismissed. What does low quality actually mean? Supposedly we have delivered sub-standard gold on a number of occasions.⁶⁴ There were rumors years ago that the gold in the bank of England was reported to be “flaking,” leading one intrepid analyst to declare that it doesn’t matter “provided they don’t try to sell it.”⁶⁵ Oh, I just wet myself. As a chemist, I can assure you if it flakes it ain’t gold and that analyst-dude is a perma-doofus. Tungsten-impregnated gold surfacing in retail gold markets has fueled speculation that the central banks are hoarding tungsten.⁶⁶ The conspiracy theorist in me wonders if the occasional fake gold bar would be good for tamping down an incipient gold mania.

(3) Thesis 3: There is no gold.⁶⁷ The claim that the gold is missing holds a certain logic. If the Fed leased physical gold to the bullion banks and these banks sold it into the open market for beer money, then it’s gone.⁶⁸ It is very odd that the Fed pools the physical metal and the leased metal on a single line of their self-reported balance sheet (to save space, I guess).⁶⁹

The status of sovereign gold stashes is unclear. Here’s where it gets really interesting. Sovereign states are starting to repatriate their gold—they want to bring it home. It started in 2011 when our close friend and ally Hugo Chavez requested 100 tons returned to Venezuela, with a correlated spiking of the spot-price of gold and gold backwardation. (Backwardation is a grammatical abomination indicating that short-term demand for a commodity is high and commodity traders flunked English.) Demand began in earnest starting in the Netherlands and spreading to other postage-stamp-size countries Paraguay, Ecuador, Vietnam, Switzerland, and Germany.^70,71Germany? Germany may be growing weary of sharing a fiat currency with the PIIGS—Portugal, Italy, Ireland, Greece, and Spain (vide infra).

It seems like gold is coming out of the closet. My concern is that we will quickly move from fear of deflation to disquieting inflation culminating in uncontrolled inflation. If the dollar goes south fast, do you think investors will seek safe-haven in another fiat currency? Those who headed to Swiss Francs got their heads handed to them this year in an instantaneous 10% debasement.⁷² There must have been some forex traders doing laps around the drain that morning. I cannot rule out a run on fiat currencies—a collapse of the entire Bretton Woods currency system. Mitigating such tail risks would not be completely irrational. Am I saying that this time it’s different? No. I am saying our fiat currency will join the other fiat currencies as historical footnotes.⁷³ As the insane posters at Zero Hedge like to say about gold, BTFD (buy the dips).

Resources and Energy

I'd put my money on the sun and solar energy. What a source of power! I hope we don't have to wait until oil and coal run out before we tackle that.

~ Thomas Edison (1931)

Eventually the point is reached when all the energy and resources available to a society are required just to maintain its existing level of complexity.

~ Joseph Tainter, author of Collapse of Complex Societies

The resource sector provides me with a potential inflation hedge and represents a bet on a secular change in energy availability, all the while allowing me to pretend to be normal. In previous years I have endorsed Chris Martenson’s Crash Course with unbridled enthusiasm—a must see,⁷⁴ which emphasized the case for increasingly constrained oil production, and delineated my enthusiasm for natural gas equities.^1,2,3 Many of my views have not changed.

Investment giant Jeremy Grantham continues to actively warn of acute resource depletion. He submits that rapidly rising raw material prices are not a bubble but rather a civilization-altering paradigm shift.⁷⁵ Simply put, we are depleting everything. The CEO of Gulf Oil, in a decidedly ambiguous statement, noted that “oil consumption in the next seven years is not going to grow and could drop off as much as 15%."⁷⁶

Suggestions of constrained oil supply continue to work their way into the mainstream. Data shows Saudi production has remained remarkably constant. Many doubt they can ramp it or even sustain it. The former vice president of Saudi Aramco warns of unwarranted optimism that price hikes stem from “the reality that the oil sector has been pushed to the limit of its capabilities.”⁷⁷ There are claims that the Saudis will be net importers by 2030 but from whom?⁷⁸ David Greely of Goldman Sachs indicated that it is only a matter of time before “OPEC spare capacity become[s] effectively exhausted, requiring higher oil prices to restrain demand.”⁷⁹

Other Goldmanites suggest that “a disturbing pattern has emerged where each tentative recovery in the world economy sets off an oil price jump that, in turn, aborts the process… Oil has become an increasingly scarce commodity. A tight supply picture means that incremental increases in demand lead to an increase in prices, rather than ramping up production. The price of oil is in effect acting as an automatic stabilizer.”⁸⁰ A hyperbole-free interview of prominent oil economist James Hamilton sheds light on a world facing tighter supplies.⁸¹

A counter-argument to all these gloomy views came in a report via Bloomberg stating that the U.S. will pump “11.1 million barrels of oil a day in 2020 and 10.9 million in 2025.”⁸² This may be true, but anybody who projects oil production a dozen years from now to three significant figures has credibility issues. That did not stop viral dissemination across the Twittersphere.

Some suggest that natural gas will fuel our economy for hundreds of years. Others say the case is wildly overstated: Bakken wells lose 90% production within five years.⁸³ Still others focus on the environmental catastrophes and legal boondoggles affiliated with fracking. It seems clear that, come hell or high water, we are going to frack, and we are going to witness a secular shift to a natural-gas-dependent economy. It would be great if this works and does so without environmental calamity. I am agnostic on both. The equity valuations are tame, especially given the current razor-thin profit margins that are projected to expand.⁸⁴ I continue buying the equities betting that powering the globe will be profitable.

Fresh water and, by direct correlation, food face huge supply issues in China, the U.S., and emerging markets around the world. Staying close to home on this one, the Ogallala Aquifer under the Great Plains was reported to be down to one third of its original depth and is projected to “run dry in two to three decades given recent withdrawal rates.”⁸⁵ Atlanta is in a legal battle with Florida and Alabama over 20% of the flow from Lake Lanier.⁸⁶ No matter how you cut it, this is foreshadowing trouble ahead. I looked into water-sector investments a decade ago but couldn’t tease out opportunities.

The blogosphere has made the case for highly constrained rare-earth elements crucial to wind turbines and solar cells.⁸⁷ The bulls note that China controls 95% of the market and suggest that building alternative energy programs based on the rare earths will drive the price to the moon. I had dinner with the CEO of Chemetall, a major dealer in metals and metal catalysts. He assured me that rare earths are not rare, and that China has driven competitors out of the marketplace; higher prices will fix that when needed. I could detect no agenda in his answers.

The Baptists

The lapse of time during which a given event has not happened is…alleged as a reason why the event should never happen, even when the lapse of time is precisely the added condition which makes the event imminent.

~ George Eliot in Silas Marner

We were all worried about these issues in 1927, but you can only worry about things for so long.

~ Anonymous

Prior to any financial dislocations there are many who preach of the coming crisis. In 1924, Roger Babson warned of credit excesses that would lead to catastrophe. Charlie Merrill of Merrill Lynch fame sought psychiatric help due to his inexplicable bearish views; as legend goes, he and his psychiatrist emptied their investment accounts and dodged the carnage. The stock futures speculation in the 1920s was so obvious that Congress held hearings to discuss it well before the crash.⁸⁸ The crash and subsequent multi-decade global devastation arrived to the total shock of many. Town criers could be heard screaming of a coming tech crash in the late ‘90s by those who listened. We had congressional hearings on derivatives speculation wherein Brooksley Born methodically laid out the plotline for the coming storm in unregulated derivative markets.⁸⁹ I wrote a 2002 email describing the coming subprime crisis and banking collapse.^3,90 Prescient? Not really. I was simply parroting ideas scattered over the Internet. The few who played the housing bust with leverage get the limelight; countless thousands saw the housing excesses in the years leading up to 2007.

This year had its share of preachers of unassailable credibility telling us of more trouble to come. Are they farsighted or fooled? I haven’t a real clue. I can say, however, that their advice demands your attention.

Let’s begin with the most prolific of doomers, David Stockman, former Wall Street insider and Reagan budget genius. Stockman was omnipresent, telling anybody who would listen of a coming mayhem in the bond market and accompanying pension crisis, labeling our current economic status as “the end of a disastrous debt super cycle that has gone on for the last thirty or forty years.”^91,92,93

David places blame squarely on the Fed by suggesting “if we don't drive the Bernankes and the Dudleys and the Yellens and the rest of these lunatic money-printers out of the the Fed and get it under the control of people who have at least a modicum of sanity, we are just going to bury everybody deeper.” Somewhat paradoxically, he noted, “if the Fed doesn't keep printing, it's game over.”

John Hussman undermines the very foundations of monetary easing in one of the most cogent arguments that I have read.⁹⁴ He is a deep-value guy whose analyses have refreshingly long-time horizons and whose portfolios have been bludgeoned in the short term.

George Soros rattled Newsweek readers when he suggested the global credit retrenchment is “about as serious and difficult as I’ve experienced in my career…comparable in many ways to the 1930s. We are facing now a general retrenchment in the developed world, which threatens to put us in a decade of more stagnation, or worse. The best-case scenario is a deflationary environment. The worst-case scenario is a collapse of the financial system.”⁹⁵ He predicts a collapse of social order, suggesting that “it is about saving the world from a downward economic spiral." George is known for talking his book, but what position is he talking up? This is not a trick question...well maybe it is. (Answer: Gold. Lots and lots of gold.)

Bill Gross suggests that "a 30-50 year virtuous cycle of credit expansion which has produced outsized paranormal returns for financial assets—bonds, stocks, real estate and commodities alike—is now delevering because of excessive ‘risk’ and the ‘price’ of money at the zero-bound.”⁹⁶ He concludes that “we are witnessing the death of abundance and the borning of austerity, for what may be a long, long time." Detractors like to pick on Bill’s DOW 5000 call years ago. With inflation adjustment—accurate inflation adjustment—that decade-old call is approaching spot on.

Jim Rogers predicted that some of the Ivy League institutions would go bankrupt.⁹⁷ Harvard had a terrible credit seizure in 2007-09 due to their hedge-fund-like endowment, but Jim’s prediction was made in 2012. Jim doesn’t think we are done yet.

Nomura's Bob Janjuah is always good for brutal assessments.^98,99 Bob noted that "markets are so rigged by policy makers that I have no meaningful insights to offer.” Bob goes on to note in a later piece that “central bankers are intentionally mispricing the cost of capital, in an attempt to push the private sector to misallocate capital into consumption and into asset purchases at the wrong time and at the wrong price.” He blames Greenspan and Bernanke explicitly for tens of millions of American citizens who are “either homeless and/or on food stamps.” Bob can really turn a phrase. “Financial anarchy” is always good for a few chuckles. Say what you really think, Bob. The world’s central bankers are reserving their own special place in hell.

Ray Dalio, head of Bridgewater Associates—the largest hedge fund in the world—has been bearish for awhile and is becoming quite the gold bug. In January he noted that he was bearish “through 2028.”¹⁰⁰ In subsequent presentations, he seemed to change his tune by referring to our global state of affairs as a “beautiful deleveraging ,” which he defines as some sort of optimal inflation/deflation cross-dresser operating through a combination of defaults and debt monetization.¹⁰¹ I guess beauty is in the eyes of the beholder. One prominent market watcher—me—suspected that Ray had an eye on a Romney-cabinet-level appointment. We’ll never know.

Legendary investor Jeremy Grantham with $150 billion under management, Thomas Brightman of Research Affiliates, and Robert Gordon of NBER lit up the blogosphere late in the year with conclusions that global growth would drop to the 1% zone.^102,103,104 Their predicted durations—decades or more—were newsworthy. Grantham suggests that demographics and resource depletion will cause us to never regain our previous growth rates. He had previously amplified a notion first presented by Adam Smith in The Wealth of Nations by showing that a sustainable 3% compounded growth rate, rather than the “greatest invention of all time,” is total mathematical nonsense.¹⁰⁵ A cubic meter of physical wealth expanding at 3% over the Egyptian dynasty—admittedly a long time—would fill ten solar systems—a large volume.

Billionaire Richard Branson joins Grantham in predicting that capitalism is destroying the planet, focusing in particular on the perpetual growth model that will consume everything. The great story about Richard is that he is rumored to have tried to hit up Obama for some weed in a recent trip to the White House.¹⁰⁶ We don’t know if Obama’s “Choomwagon”¹⁰⁷ was in the shop.

Richard W. Fisher, President and CEO of the Federal Reserve Bank of Dallas Texas, was a buzzkill for the fluffers at the Fed, noting that there is “a frightful storm brewing in the form of un-tethered government debt.”¹⁰⁸ He says that he chose the phrase "frightful” to “deliberately avoid hyperbole.” Fisher suggests that the long-term fiscal situation of the federal government will be unimaginably more devastating to our economic prosperity than the subprime debacle and the recent debauching of credit markets that we are working so hard right now to correct.

2012 was a big year for taking the bear case to the Halls of Power. Jim Rickards, author of Currency Wars, presented his concerns about currency debasement to Congress.¹⁰⁹ James Grant and Robert Wenzel in speeches at the Federal Reserve both hammered the Fed for horrendous monetary policies that are destroying our currency and capitalist system.^110,111,112 Jim is a total genius, and he is very attention-worthy.^113,114,115

Legendary hedge fund manager and cherished confidant David Einhorn poked at the Fed with his “jelly donut” speech.¹¹⁶It was Silence of the Lambs at the Buttonwood Conference when he pointed out what they should have known: Artificially low interest rates drive up commodities and reduce income streams to a trickle, forcing consumers to save more and spend less.¹¹⁷ He throws in a little money multiplier logic and—voilà!—stimulus is totally negated.

Einhorn accuses the Fed of “offering some verbal sleight-of-hand worthy of a three-card Monte hustle.” David wonders out loud: “We have just spent 15 years learning that a policy of creating asset bubbles is a bad idea, so it is hard to imagine why the Fed wants to create another one.” I wonder out loud: How much did Fed policy have to degenerate to force the Einhorns of the world to focus on monetary theory rather than investing?

We had several bootleggers-turned-Baptists. The technical term is “tranny.” John Reed confessed his sins while CEO of Citibank, explaining how Citibank and Travelers, with the aid of a very friendly administration, destroyed the Glass-Steagall safeguards that had protected consumers from financial disaster since the ‘30s.¹¹⁸ Sandy Weill, the next CEO of Citigroup, shocked the world by suggesting that big banks “be broken up so that the taxpayer will never be at risk.” What’s gotten into these Citi-boys? Would it be too much to ask for a mea culpa from Robert Rubin? Yes.

William Cohan, former Wall Street investment banker and author of several best sellers including a comprehensive history of Goldman Sachs, pointed out the cracks in the seams—the omerta—at Goldman, flaws in the FINRA arbitration system, the mathematically nonsensical $100 million IRA of Mitt Romney, the SEC’s lack of oversight on nefarious activities at Citigroup, and a striking exposé of Robert Rubin’s deep-seated political power.^{119,120,121,122}

These guys are some of the sharpest knives in the drawer. They view the world through darker lenses than most. Whether they are right or not, you’ve been warned.

The Bankers

It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.

~ Henry Ford

The most newsworthy story about Goldman Sachs may be that they weren’t in the news that much. Of course, there were a few skirmishes. Disgruntled employee Greg Smith took his best shot at the Goldman Death Star, but both his interview and book proved toothless.¹²³ Smith told us that Goldman employees showed scorn as they ripped the faces off their clients called “Muppets.” Anybody who read Michael Lewis’s Liar’s Poker knows that clients are chum for the brokerages. Goldmanites had to run out the back door without putting their pants on when it was discovered that they were part-owner of a website focusing on the sex-trafficking of underaged girls.¹²⁴ It also was reported that many Goldman folks were tipping off Rajaratnam, although that story is now passé. Most importantly, however, JPM managed to knock Goldman below the fold.

Problems for JPM began in 2011. As noted in my 2011 summary, MF Global—a reincarnation of the formerly bankrupted and scandal-riddled Refco—had collapsed, segregated funds had been rehypothecated (rehypothecate = used repeatedly; see also, “stolen”), and the money was lost speculating at the track. Remaining funds (including stored gold bars, if they weren’t already rehypothecated) were quickly snarfed up by JPM under the arcane principle of law referred to as “finders keepers, losers weepers.” We finished 2011 knowing that Corzine was a weasel and in a world of trouble and serious money had “vaporized”—not to be confused with “stolen”—to use language from a planted story.¹²⁵ Vaporized money brings to mind the must-see South Park episode, “And It’s Gone.”¹²⁶ The authorities were handed a Madoff-quality scandal to finally prove they are the best regulators money can buy. Twitter hound Mark Melin was posting hourly updates on nefarious activities while legal beagle James Koutoulis was gearing up for a big class action suit.

Just as night follows day, 2012 brought us…crickets. Nothing but chirping crickets. The case was dropped. How the hell did this happen? The JPM legal team exploited the chaos and rushed MF Global into bankruptcy. Chris Whalen explains that bankruptcy gave JPM “first dibs” creditor status whereas a fraud charge would have diverted the funds to less worthy folks—the rightful owners.¹²⁷

To ensure the transition went smoothly, former FBI Director and political hack Louis Freeh was put in charge of overseeing this mess. Freeh promptly asked the bankruptcy court to allow payouts to MF global executives for the long hours spent cleaning up.¹²⁸ (I'd give them free room, three square meals, and snappy orange jump suits.) Freeh then diverted funds from clients to legal defense funds of MFG execs.¹²⁹ The other MFG trustee named Giddens—the other MFG trustee?—pressured litigants to release the banks of all liability to receive reimbursement, suggesting that (1) the money didn’t really vaporize, (2) stealing money and then giving it back when caught should not be a crime, and (3) extortion is legal if you are a trustee.¹³⁰ Within a week it was announced that the Rule of Law had been downgraded to a guideline.

As often used in comedies, we use an epilogue to track the fates of the major players. Jon Corzine bought himself a “Get Out of Jail Free” card by remaining a major fundraiser (a bundler, to be exact) for Team Obama.¹³¹ The Department of Justice (DOJ) stood ready to indict Corzine if he missed a payment. Immunity to Corzine’s consigliere would have revealed some serious dirt, but the DOJ declared there was no case and walked.¹³² Corzine is exiled in the Hamptons sans ankle bracelet on an OJ-esque quest for the lost funds and a new job as a hedge fund manager. Rumors that Corzine’s life insurers put his policy in a risk pool have not been confirmed. Team Obama got a second term in the White House, and nobody in the administration has been indicted for racketeering. The sordid story of MFG has been relegated to case studies in MBA ethics classes. (Evidence aside, they do have such courses.) The main character, Jamie Dimon, landed a leading role in the next scandal and was put on the shortlist for Secretary of the Treasury.

As the replacement regulators and DOJ were playing Pull My Finger, rumors among the blognoscenti surfaced of a big London-based commodity trader who was in trouble.¹³³ The trader was originally referred to as “The Caveman” but soon became “The London Whale.” Mike Mayo, one of the elite banking analysts, downgraded JPM a day or so before the story broke and later attributed the problem to “negative incentives and the revolving door” (corruption from the unholy alliance of banking-government).¹³⁴ Jamie Dimon initially claimed it was “a tempest in a teapot ,” but then JPM announced burgeoning losses in the billions. Eventually, even CNBC bought a ticket on the London Whale Watching Tour. Those guys are sleuths.

JPM was in very big trouble. (Just kidding; of course they weren’t.) Damage control was swift and effective. JPM liquidated an estimated >$25 billion of assets to both clean up the mess and book enough profits to guarantee that their reported earnings would show that this was not a BFD (big deal).¹³⁵ The London Whale, aka Bruno Iksil, was labeled a rogue trader, which is a technical term for a “rainmaker turned patsy.” With dripping irony, Bruno’s boss is named Achilles Macris.

Normally, the story would end there, but the Greatest Banker in the Universe—Jamie Dimon—faced a stark choice: Either claim that he screwed the pooch—uniquely so—or admit that the banking system is still hopelessly corrupted. The forthcoming mea culpas were slathered with gobs of sincerity. “We were total idiots. We can’t pour water out of a boot with the directions on the heel.” (paraphrased, of course) Jamie testified to Congress for no apparent reason, getting grilled by Congressman Tim Johnson who, because of a massive stroke in 2006, was not particularly threatening. Spencer Bachus, Chair of the Financial Services Committee, treated Dimon with kid gloves and let him testify not under oath because JPM is his second biggest donor. What’s appalling is that Bachus sold us down the river for a take of $119,000 over the congressman’s career.¹³⁶ That was money well spent. Supposedly, the entire Financial Services Committee cost a little over $800,000.¹³⁷ Peter Schweizer’s book, Throw Them All Out (vide infra) documents in lurid detail that congressmen and congresswomen are prostitutes, but cheaper. In an interview in Davos, Dimon was able to put the problems to rest, noting that “most of the bad actors are gone." You betcha.

Of course, other banks wanted a piece of the action. Barclays made a feeble grab for fame by taking the lead in the Libor scandal.¹³⁸ Libor, the London Interbank Offered Rate, is a compilation of self-reported lending rates that influence interest rates throughout the $500 trillion global credit markets.¹³⁹ Self reported? Whatever could go wrong? It turns out Barclays was cheesing the numbers. The retribution was swift and severe: Barclays was fined a whopping $200 million,¹⁴⁰ which cut into some of their profits on the scam. The British Banking Society, using language right out of Casablanca, said that they were “shocked.”¹⁴¹

Meanwhile, journalists around the globe, scrambling to figure out what Libor meant, spouted scholarly analysis like Milli Vanilli. It soon became evident, however, that all of the banks were fudging their numbers.¹⁴² The scandal was promptly downgraded three levels to an embarrassment when 2008-vintage articles by Mark Gilbert and Gillian Tett surfaced that described the rate rigging.^143,144 The Fed knew about it in 2008.¹⁴⁵ Liborgate could clog the courts for awhile as borrowers lawyer up hoping to identify damages.

The blogosphere thinks Liborgate is “huge.” I find the scandal oddly anticlimactic given that central banks around the globe openly rig rates on a daily basis. James Grant concurs with this minority view. It is galling, however, that the scandal seems to reach the highest levels of the banking cartel—the central banks. For me, it is profoundly disturbing that global capital has been fully sequestered from price discovery.

The British Banking Association was shocked again when Standard Chartered Bank got accused of illegally laundering $350 billion for Iran.¹⁴⁶ Rogue New York banking regulator Benjamin Lawsky filed his charges as the Justice Department was on the verge of declaring that Standard Chartered’s trades “complied with the law.”¹⁴⁷ Standard Chartered promptly entered settlement talks with everybody. A Deloitte partner involved with the scandal offed himself. For him, the scandal was a big deal.

The hits just kept coming. HSBC got charged with money laundering for terrorists, drug cartels, and organized crime syndicates. It seems that HSBC must have picked up BCCI’s clients after their scandal-induced collapse in the late ‘90s. This ‘affiliation’ with organized crime is silly: Banking is organized crime. Reuters reported that HSBC could be fined over $1.5 billion for money laundering and face criminal charges.¹⁴⁸ Of course they could, but they won’t.

US Bancorp got charged $55 million for scamming customers with overdraft fees by illegally maximizing the number of checks put into overdraft.¹⁴⁹ In a possible script for the MFG sequel, Cantor Fitzgerald was accused of “undersegregating” funds.¹⁵⁰ This is like “kind of pregnant.” The whole thing seems “sort of criminal.”

The more generic thieves and scoundrels returned with an encore when CEO of Peregrine Financial Group (PFG) stole rehypothecated customer funds for several years.¹⁵¹ The CEO of Attain Asset Management (AAM) captured the spirit of the outrage against PFG, noting “This time it’s personal.”¹⁵² PFG CEO Wasendorf attempted suicide, presumably hoping to front run the AAM CEO to (paraphrased) “put a cap in his ass.” Jeffries promptly began a Chapter 7 liquidation of PFG positions after a failed margin call. Once again, Chris Whalen explained the nuances.¹⁵³ Apparently, this time they did it right by sending PFG into receivership to the advantage of the customers; Reuters reported depositors got 30 cents on the dollar.¹⁵⁴ I imagine that debt subordination by big money folks somehow played a role.

Whistleblowers took a serious beating this year. FINRA, Wall Street’s self-policing arbitrators, managed to bankrupt a Morgan Stanley broker with a fine of $1.2 million after he accused Morgan Stanley of adding hidden fees to retirement accounts.¹⁵⁵ When the case was followed up, nearly half of the 18 hrs of tape, mandated to be saved, “disappeared.” The transcript of an anonymous whistleblower testifying to CFTC was a great read. The CFTC removed it from their website, but a copy was saved.¹⁵⁶ A lawsuit by Securities and Exchange Commission (SEC) whistleblower David Weber alleges that the SEC is involved in all sorts of nefarious activities, including specifically tracking potential whistleblowers.¹⁵⁷ David Einhorn also presents the SEC as profoundly corrupt in his book, Fooling Some of the People All of the Time.

We found out this year that Deutsche Bank had been accused by three independent whistleblowers of hiding $12 billion in losses to avoid a bailout during the bailouts (if that makes any sense).¹⁵⁸ This scandal is a dog’s breakfast: (1) the whistleblowers—one of them a risk officer—got fired within days of the complaint; and (2) the current SEC’s chief enforcement officer was in charge of the legal compliance at Deutsche Bank and was its general council during the cover up.

I have painted the banking industry with an ugly brush. I’m sure most bankers are good, honest people. If so, it’s time you guys start cleaning up your profession. When you find yourself saying, “Somebody should do something,” that somebody is you. If you stay silent, it’s just a Sandusky sequel.

The Federal Reserve

I simply do not understand most of the thinking that goes on here at the Fed, and I do not understand how this thinking can go on when in my view it smacks up against reality…Do you believe in supply and demand or not?...Let’s have one good meal here. Let’s make it a feast. Then I ask you, I plead with you, I beg you all, walk out of here with me, never to come back. It’s the moral and ethical thing to do. Nothing good goes on in this place. Let’s lock the doors and leave the building to the spiders, moths, and four-legged rats.

~ Robert Wenzel, in a speech at the NY Federal Reserve

Well that pretty much captured my sentiments. The Fed gets their pick of the litter coming out of PhD programs. They are a politically (in)dependent group with a dual mandate of supporting the banks and maximizing bank profits. The dozen or so members of the Federal Open Market Committee (FOMC), by virtue of arrogance and hubris, have become intellectually neutered and are now menaces to society. Why listen to an organic chemist—an academic, to boot? Let’s see what the pros have to say.

A first year investment banking associate knows more about credit creation than the entire FOMC combined…. Our colleagues at the Fed have consistently failed to understand the operations of financial markets and how credit operates in our society. This may surprise some of you, but it doesn't surprise me at all.

~ Chris Whalen, Founder of IRA Risk Analytics

I have to say the monetary policies of the U.S. will destroy the world.

~ Marc Faber, Elite Barrons Round Table Member

The little sliver of remaining hope was officially pronounced dead [with QEIII]….we are witnessing the greatest monetary fiasco ever.

~ Doug Noland, Federated Investors

The Chinese aren't loaning to us anymore. The Russians aren't loaning to us anymore. So who's giving us the trillion? And the answer is we're just making it up. The Federal Reserve is just taking it and saying, ‘Here, we're giving it.' It's just made up money, and this does not augur well for our economic future.

~ Mitt Romney, unemployed

When I read direct quotes and commentary about Bernanke's policy of driving up asset prices in general and equity prices in particular, I almost want to cry over the ludicrousness of this position. The Fed is pursuing the same road to ruin as it did between 2003-2007.

~ Albert Edwards, Societe Generale

Bernanke, and his MIT ilk, has made monetary policy into a laboratory for monetary theoreticians.

~ Kevin Warsh, former Federal Reserve governor

It’s the general global landscape where you have an incredible mispricing of risk that’s being delivered at the hands of academics at the central banks of the world.

~ Wellington Denahan-Norris, CEO of Annaly Capital

I am a little—maybe more than a little bit—worried about the future of central banking. We've constantly felt that there would be light at the end of the tunnel, and there'd be an opportunity to normalize but it’s not really happening so far.

~ James Bullard, President of Saint Louis Federal Reserve

Let’s briefly break away from 2012 condemnations and snag a quote from my favorite book on Austrian economics and the Great Depression:

The end result of what was probably the greatest price-stabilization experiment in history proved to be, simply, the greatest and worst depression.

~ Phillips et al. in Banking and the Business Cycle (1937)

Of course, the big news was the third wave of debt monetization referred to as QE IV, QEtc, QEInfinity, or Cash for Clunkers II. The Fed is jamming over $80 billion of high-powered money per month into the economy. Initial promises to monetize aggressively until 2015 have been extended to infinity and beyond. The Fed pretended it was sterilized—the long-term debt purchases were being offset by short-term debt sales. “Operation Twist” (QE II), however, recycles the short-term debt right back into long-term debt. Problem solved.

There is some room for debate as to why they are pushing monetary policy to the edge of the known universe. They tell us that it is to improve the economy and help the little guy by throwing savers under the bus with repressively low interest rates. Last I looked, the savers are the little guys. It has been estimated that if interest income as a percentage of total personal income had remained at its 2008 level, the total would now be an additional $1.5 trillion.¹⁵⁹

To achieve their goal of stabilizing the banks—not all the banks, just the really big ones—the Fed has completely dismissed any notion that the debt markets should be allowed to clear, which is Austrian-speak for establishing market-based pricing. James Grant calls it “waging war on the pricing mechanism.” The Fed does this via purchases of 60-80% of all the newly issued federal debt because our foreign creditors have gone on a buyers’ strike.¹⁶⁰ Without the Fed’s unprecedented interventions, bond prices would plummet (sponsored by Red Bull, no doubt), affiliated interest rates would spike, bond holders would get crushed, and the federal government would have to borrow at rates that would completely choke our already auto-asphyxiated federal budget. We’re now homing in on why the Fed is monetizing debt. (Note to readers: When you read an article stating some variant of “low rates show everything is rosey,” that person is an idiot.)

The irony here is that the Fed’s zero interest rate policy (ZIRP) is choking the savers, as noted by David Einhorn (vide supra). Similar cases have been made by Chris Whalen and others.¹⁶¹ William R. White, former Head of the Monetary and Economic Department at the Bank for International Settlements (BIS), wrote a must-read paper entitled, Ultra Easy Monetary Policy and the Law of Unintended Consequences.¹⁶² The Fed’s policies are Soviet-style stupidity and a short trek to financial perdition. Even worse, Daniel Kahnemann, Nobel Laureate and expert in behavioral psychology, would probably argue that the Fed’s decision making is no more accurate than “monkeys throwing darts.” Milton Friedman indirectly made a similar case against central planners in an interview with macroeconomist Phil Donohue.¹⁶³

The Bootleggers

Why does the New York Times hate the banks?

~ Jamie Dimon, CEO of JP Morgan

It’s not the New York Times, Mr. Dimon. It really isn’t. It’s the country that hates the banks these days.

~ Joe Nocera, New York Times

I have beaten on the bankers hard and will continue to do so until somebody can say their house is clean. I should, however, let these bootleggers and affiliates—the Baghdad Bobs of Finance—speak for themselves. As you read these quotes, ask yourself: Did they really say that? Really?

Low Fed rates didn’t fuel the housing bubble.

~ Alan Greenspan, former Chair of FOMC

This is the United States of America. That's what I remember. Guess what.... It's a free f***ing country.

~ Jamie Dimon, CEO of JPM

Hanging bankers won’t help…Public anger over the financial crisis is wrong.

~ Tony Blair, former Prime Minister of England

Large numbers of people who have ‘lost’ their house through foreclosure have actually realized a profit because they carried out refinancings earlier that gave them cash in excess of their cost. In these cases, the evicted homeowner was the winner, and the victim was the lender.

~ Warren Buffett, Berkshire Hathaway

The evidence that I’ve seen and that we’ve done within the Fed suggests that monetary policy did not play an important role in raising house prices during the upswing.

~ Ben Bernanke, Chair of FOMC

We economists…have reason to be proud of our analyses over the past five years. We understood where we were heading, because we knew where we had been.

~ Brad DeLong, economist at UC Berkeley

Quantitative easing isn’t being imposed on an unwitting populace by financiers and rentiers; it’s being undertaken, to the extent that it is, over howls of protest from the financial industry.

~ Paul Krugman, Princeton University and Nobel Laureate

The demonization of Wall Street and bankers is very much a function of the press and of Washington, and not much more broadly held.

~ John Thain, former CEO of Merrill Lynch

Wage and price controls distort markets…prices are prices…We’re not going to monetize US debt.

~ Ben Bernanke, FOMC

Thank the people of AIG for having the courage to do what they did.

~ Robert Benmosche, CEO of AIG

To claim that it’s effectively a gift you have to claim that the prices the Fed is paying are artificially high, or equivalently that interest rates are being pushed artificially low. And you do in fact see assertions to that effect all the time. But if you think about it for even a minute, that claim is truly bizarre.

~ Paul Krugman, Princeton

There is a German word, backpfeifengesicht, that reputedly translates to “a face badly in need of a fist.” It seems appropriate for some of these characters, which would generate some serious schadenfreude. For these gentlemen, however, I’ll let pop culture respond:

What you have just said is one of the most insanely idiotic things I have ever heard. At no point in your rambling, incoherent response were you even close to anything that could be considered a rational thought. Everyone in this room is now dumber for having listened to it. I award you no points, and may God have mercy on your soul.

~ The Principal in Billy Madison

Personal Debt

I spent all my money on women and wine, and the rest I wasted.

~ George Best, Irish soccer player

Debt permeates all levels of the global economy. In the U.S., debt is growing much faster than the GDP (Figure 12). A montage of over 50 charts showing all facets of debt is well worth a peek.¹⁶⁴ Authorities are convinced that more spending and more debt will be our salvation. Daniel Bell, a Marxist from the turn of the 20th century, took the other side of this bet, suggesting that the consumer would eventually consume themselves. Apparently, I’m a Marxist. In this section I would like to briefly discuss personal debt. (Special aspects of student and mortgage debt are cordoned off into their own sections.)

Figure 12. Accrued debt with annotations showing dollars of debt required per dollar of GDP (source link lost).

The so-called resilient consumer is getting squeezed from every direction. The income of the average family has dropped from $53,000 to $47,000 in only 5 years.¹⁶⁵ Deleveraging is evidenced by a dropping debt-to-income ratio in Figure 12, yet two thirds stem from defaulted mortgages.¹⁶⁶ The national savings rate has once dropped to zero from historical norms of 10%. Credit card debt is said to be the leading cause of suicide among adult males.¹⁶⁷ Trimtabs reports a 40% drop in net median family worth since 2007.¹⁶⁸

Should the average family of four earning $47,000 happen to rashly buy everybody iPhones, they just committed 4-5% of their gross income to phone service. I’m not sure even families earning $150,000 should spend that much on phone service. Television and children’s activities used to be largely free; now we pay. Internet, as amazing as it may be, is a necessary expense. Don’t think so? See how your kids do in school without it. Figure 13 shows the ratio of personal consumption versus compensation. That rise stems from a combination of decreased savings and increased debt.

Figure 13. Personal consumption versus compensation.¹⁶⁹

In 2010 I discussed an insidious and overlooked contribution to inflation—accelerated depreciation. It is still overlooked by the mainstream so I am going to take one more abbreviated whack at it. For example, in 2009 I broke a 40-year-old blender. The Boskin Commission¹⁴ would argue that its replacement is even cheaper than the price tag would indicate because it has more buttons. Government statisticians actually “hedonically” adjust the price down for improved quality. Alas, that really cheap blender died after only two years of dedicated service. Chintzy goods at affordable prices have trapped consumers in a vicious replacement cycle. If Boskin et al. had looked at the per year cost of the blender, they would have corrected for depreciation with a 20-fold price multiplier before comparing the relative prices of old and new. The net domestic product—the gross domestic product with depreciation included—is an antiquated concept that needs resurrection.¹⁷⁰ Meanwhile, the consumers are choking on their vomit trying to keep up with depreciation.

Mortgage Debt

There is not a menace in the world today like that of growing public indebtedness and mounting public expenditures.

~ Warren G. Harding, former President of the United States

Harding was considered to be one of the least competent presidents. Could have fooled me. Mortgage debt presents its own unique issues. We are slowly winding down the mortgage bubble that burst in 2007 through a combination of defaults and debt restructurings. To say, however, that a modest uptick in housing activity means that the problem is solved is ridiculous (Figure 14). Is housing recovering? Not really. Maybe sentiment has begun to change but only with the unprecedented force of a central bank behind it.

Figure 14. Home building employment (red) compared with home builder sentiment (blue).

There are still an estimated 11 million homeowners underwater on their mortgages, including more than a million people who have just bought in the past two years.¹⁷¹ Ill-advised efforts to bail them out—foreclosures clear the market—seem to have faltered. Special Inspector General of the TARP Neil Barofsky discovered Geithner never intended to aid homeowners, only to delay foreclosures for a year or two so that they could occur orderly. Writedowns are taxable income,¹⁷² which prevents homeowners from accepting them. Distressed real estate purchased by speculators appears to decrease the housing glut. Unfortunately, this shadow inventory still exists if the speculators intend to flip the houses for a quick capital gain. The market won’t clear until demographics and income growth clear it, both of which are going backwards.

There seems to be some resolution of the catastrophe caused by the Mortgage Electronic Registration System (MERS) in which the ownership of millions of houses are being thrown into legal purgatory by foreclosure. Bank of America supposedly offered to take a deed in lieu of foreclosure, presumably to get the deed legally.¹⁷³ Legally dubious foreclosures are clearing through the legal expedient of turning a blind eye. Efforts in California to use eminent domain to clear out problematic underwater mortgages are so egregious that I have deferred them to the section on Civil Liberties and the Constitution.

Student Debt

Bart: don’t make fun of grad students. They just made a terrible life choice.

~ Marge Simpson

You’re f*cked.

~ Robert Reich, former Secretary of Labor, to Class of 2012

Student loans have soared from $200 billion in 2000 to over $1 trillion today (Figure 15),¹⁷⁴ surpassing credit card debt. Some say there is a student loan bubble, but the Bush-era legislation ensuring that student debt cannot be discharged even in bankruptcy suggests there is no bursting mechanism. Nevertheless, something will give, because loan delinquencies are going parabolic.¹⁷⁵ The paradoxical effect of the full-recourse loans is that banks are happy to provide almost unlimited funding to a slice of society rich in ill-conceived ideas. This debt is also localized in the most financially vulnerable demographic slice during a severe economic downturn. It ain’t just the kids. An estimated $38 billion in student loans are owed by seniors 60 and older, probably stemming from desperate efforts to retool their careers as well as co-signed loans for children and grandchildren.¹⁷⁶

As if the debt burden was not enough, potential employers are checking credit reports. High student debt can render you unemployable.¹⁷⁷ Seems unfair. The average medical school graduate has $161,000 in student loans.¹⁷⁸ The ultimate irony is that those young doctors on the cusp of achieving the American Dream cannot afford a starter house. Ben Bernanke’s son is said to be $400,000 in the hole.¹⁷⁹ Bernanke is indeed the father of a gigantic credit bubble. Financial independence for twenty-somethings—a rite of passage only a few years back—has become increasingly out of reach.

Figure 15. Comparison of student loan growth and other consumer debt growth.¹⁸⁰

An entire generation has been set up for debt servitude. We are eating our young. The source of the problem is a complex and nuanced confluence of factors. The chronically profligate boomers, stressed by inflationary pressures and dazed by the equity and real estate downturn, are in no position to help their kids pay for college. The cost of a four-year college education has also soared, while earnings after college have stagnated (Figure 16).¹⁸¹ The number of 26-year-olds living with their parents has jumped almost 46 percent since 2007.¹⁸²

Figure 16. Plot comparing college costs and earnings in early adulthood.¹⁸³

What is causing the rapidly escalating college costs? As a professor of 33 years, I can offer a few thoughts and opinions.

            (1) College tuition—the cost of running a small city—may be the single best measure of inflation. The tuition growth squares well with the inflation numbers posted by John Williams of Shadowstats.com.

            (2) Rapidly growing federal and state mandates to universities escalate bureaucratic costs. You know all those extra positions you see in secondary schools that didn’t exist when we were kids? Universities have them too.

            (3) Universities are much more complex, interconnected organizations than they were 30-40 years ago.

            (4) The quest to attract the best possible students and faculty has produced something akin to an arms race among the schools, forcing up the costs of chasing the competition.

            (5) Universities are financial enterprises that can approach $1 billion annual operating costs and are managed largely by academics often lacking the requisite training. The Dean of Arts and Sciences at Cornell is a physicist—a smart guy by any measure. What prepared him to run a $100+ million enterprise?

            (6) Guaranteed payers—banks offering unlimited student loans in this instance—are always inflationary.

I have an aversion to debt jubilees, but I suspect we are heading for a federally sponsored bailout of borrowers and those who traffic in student loans. How do we prevent a repeat of this debt problem? First, a warning: Don’t buy into the increasingly common claims that college is a waste of money. Such blanket statements are counterfactual. One rich dude bribed 100 kids not to go to college.¹⁸⁴ Some will be fine but others are going to get hit by the cluster truck. There are, however, many circumstances in which a kid should not go to college.

Students must be good consumers. It’s not just a degree; it’s an education. This means choosing paths wisely and working hard. Not all majors or institutions are created equal; enough said. Debt is a bad idea if it is not self-extinguishing—paid off with the net gain in proceeds from the education. If the kids lack direction or need a break, parents need to let them take time off. You read that right— it's the parents, not the kids, who oppose the change. Save your money until it will be used wisely. For their part, schools need to focus on strengths and, in many cases, specialize. Paul Smith's College, a small college in the Adirondack Mountains, is a great example. They educated my older son. His profound success after an inauspicious secondary education stems from the school’s focus—only four, highly pragmatic, majors. What a great model!

How do we fund college educations going forward? I understand the origin of full-recourse loans but find non-dischargeable debt to be anathema to the American system. We’ve got to curb predatory lending; full recourse loans with interest rates and penalties akin to subprime debt is loan sharking. The libertarian in me says caveat emptor, yet this is a vulnerable demographic lacking fully developed frontal cortexes. The best idea may involve creditors purchasing a percentage of the students’ earnings after graduation for a fixed period (10% for ten years, by example). It’s a form of venture capitalism. I would gladly invest in a tranche of loans to MIT students promising a slice of their earnings—at the right price, of course. For those schools in which the bet is a bad one—the loans are too big, attrition is TOO high, or incomes after graduation are on average too low—the resulting market-determined high interest rates would force change or the institution would fail.

The idea of “no child left behind” would take a beating, but I don’t buy the notion that we need more college-educated adults. We need better-educated adults. Whether this means education in a four-year college or a trade school is highly student dependent. Father Guido Sarducci’s “Five Minute University” has an appeal.¹⁸⁵ Another very entertaining parody makes a case for Princeton.¹⁸⁶ I would also say beware of law schools. They can be great opportunities but can also be exceedingly expensive holding tanks for college graduates still lacking direction.¹⁸⁷

By the way, would somebody—anybody—start teaching courses in personal finance at the high school and collegiate levels? That void is what got us into this mess in the first place.

Municipal and State Debt

This is not a boating accident.

~ Richard Dreyfus in Jaws

The balance sheets of municipalities and states are a total mess. Forbes recently noted 11 states flagged for dangerous finances.¹⁸⁸ It’s not just the sand states that are in trouble. Syracuse, NY is considering a debt restructuring due to excessive expenditures and pension promises.¹⁹⁴ Reuters reported that outstanding bonds, unfunded pension commitments, and budget gaps exceed $4 trillion for the 50 states.¹⁹⁵ That’s approximately $40,000 per taxpayer in the country. Illinois is now $150 billion in the hole, yet the voters defeated legislation designed to stem rising pension costs.¹⁸⁹

California’s estimated annual deficit rose from $9 billion to a considerably larger $15 billion in a matter of months. California alone owes over $600 billion, with New York coming in a distant second at $300.1 billion.¹⁹⁰ These are self-inflicted wounds. Orange County paid lifeguards annualized salaries of $200K.¹⁹¹ Hermosa Beach meter maids racked up an astonishing $300K annual salaries.¹⁹² Stockton, San Bernardino, and Mammoth Lakes all filed for bankruptcy protection this summer.¹⁹³ San Bernardino City officials sped up the filing to preempt legal action by creditors. Under Chapter 9, all court cases and other legal actions are halted until the bankruptcy case is over.

Rock star banking analyst Meredith Whitney predicted serious financial stresses for municipalities, yet she made the fateful mistake of predicting what and when.¹⁹⁶ The Mayans taught us that you never predict both. At year end, the criticisms have been mounting. With that said, Moody’s is looking to downgrade some California municipal bonds. Buffett picked up a pile of municipal bonds at deep discount during the crisis, presumably using inside knowledge of the Fed backstop that he helped design, only to dump a bunch of these bonds this year.¹⁹⁷ The muni bond story is just getting started.

Corporate Debt

In aggregate, US balance sheets are in very poor shape.

~ Andrew Smithers, CEO of Smithers and Co.

You may have heard recently that…U.S. companies…are sitting on growing piles of cash they are ready to invest in the economy. There's just one problem: It's a crock.

~ Brett Arends, MarketWatch

Andrew Smithers and Brett Arends are the only two guys I know who claim that corporate balance sheets are not in good shape.^198,199 Everybody else raves about the robust corporate balance sheets while focusing on only one side. Corporations are flush with cash and chock full of debt (Figure 17).²⁰⁰ They are hoarding cash, presumably in anticipation of more credit constraints. The DOW 30 has a net debt (debt minus cash) of $500 billion despite fortress balance sheets by a minority including Microsoft, Cisco, and, if you believe them, JPM. Only 7 of the DOW 30 have net positive cash positions. Pensions of large-cap companies are also significantly underfunded (vide infra). It is estimated that major corporations globally will be refinancing $45 trillion of debt over the next couple of years.²⁰¹ None of this suggests strong balance sheets, only generous credit lines.

Figure 17. Non-financial US corporate debt market (billions of dollars) (source: SIFMA).

Sovereign Debt

There are two ways to conquer and enslave a nation. One is by the sword…the other is by debt.

~ John Adams, former President of the United States

There’s always the Federal Government to bail us out, right? Maybe, but we’re in serious trouble. The U.S. debt doubled in only four years (19% annualized). A recent Treasury report indicates that in less than a year we added $2.1 trillion to the national debt. Although it is tempting to point fingers, a screw-up of this magnitude requires a bipartisan effort. The Federal debt and deficit inspired Egan-Jones to downgrade U.S. debt,²⁰² which then inspired the SEC to investigate them (Egan-Jones, that is).²⁰³ The spendthrifts declare that we had a financial malaise to deal with. I wonder if history will look favorably on a Keynesian experiment in which we injected $1 million of government stimulus for each newly created job.²⁰⁴

It is estimated that we are collecting only 60 cents of every dollar spent by the Federal government. This is not the beginning of the end of some debt frenzy. It is the end of the end. Who is buying all this debt? Funny you should ask. The Fed is buying 60-80% of it. How do we afford it? Oddly enough, the Fed controls the interest rate on federal debt. Uncle Sam has an unbelievably cushy line of credit thanks to Fed largesse. The whole Fiscal Cliff debate illustrates that austerity is too inconvenient to deal with right now. We can worry about tightening the belt later. But this secular bond bull market is very long in the tooth. At some point rates will rise just like night follows day. Each 1% rise in rates on $16 trillion dollar debt adds an additional $160 billion to our interest rate payments.

What if we just really suck it up? Seriously. What if we go to the extreme by dropping all discretionary spending? No more military, highways, education, parks, etc. and pay only the interest on the debt and other payments mandated by statute. We still fall short of a balanced budget.²⁰⁵

For those confused about the Clinton-era balanced budget, it was a hoax—we had gobs of off-balance-sheet expenses putting us in the red. The reported deficit is the innocuous part. If one looks at unfunded liabilities—promises made to the populace for which we haven’t a clue where the money will come from even after projected tax revenues are included—we are in huge trouble. Years ago, Kotlikoff, Burns, and Smetters estimated $44 trillion of unfunded liabilities. Kotlikoff is now estimating over $200 trillion—40 Krugmans! (1 Krugman = $5 trillion)²⁰⁶ That comes to an IOU of $2 million dollars per viable taxpayer. So let’s not trivialize this issue by suggesting that this will hurt our grandchildren. As far as I am concerned, they are on their own. This is gonna crush you and me.

Pension Crisis

Demography is like a glacier: It doesn't move fast, but it is very predictable...it's inexorable.

~ Neil Howe, author of The Fourth Turning

We have a massive, multi-dimensional pension problem. Let’s begin with a look at the personal pension plans most commonly associated with 401K plans and related IRAs. Optimistic retirement planners at Fidelity recommend socking away 8x annual income by retirement.²⁰⁷ That’s not enough. More conservative estimates reach as high as 20x or even 25x your annual salary in savings.²⁰⁸ Further problems stem from the bond market, which approximates 40% of all retirement portfolios.²⁰⁹ In the downturn, huge gains in principal mitigated the pain of the equity losses. The best-case scenario going forward is that rates stay low forever, resulting in miniscule cash flows and no loss in principal. The more likely scenario is that interest rates rise and prices drop causing significant losses in principal. There is no slack left. Reaching for yield buying sketchy forms of fixed income is likely to be a road to ruin. Bold assumptions of 7-8% annual returns on pension portfolios will require double digit equity gains. Buffett and anybody else actually paying attention, however, will tell you that dropping rates, not low rates, helps equities.²¹⁰ Only the legalize-marijuana crowd on CNBC believes rising rates will not hurt equity returns.

Let us look at what is nearly a best-case scenario, a family in the top 5th percentile—the 5 percenter. This family is defined as earning $154,000 and a net worth of $1.2 million,²¹¹ which, by coincidence, is about an 8-fold ratio of savings to annual earnings. A couple at the demographic heart of this 5 percenter also is likely to be a late stage boomer on the doorstep of retirement. Way to go, Fidelity! Using assumptions based on standard portfolio theory and grounded in legally mandated IRA withdrawal rates, the 5 percenter should withdraw only 4% to ensure the money lasts—$48,000 per year. This is a problem. I’ve got to imagine that a 5 percenter is going to find a 50th percentile cash flow in retirement austere. The average boomer with a net worth of $180,000 spinning off only $7,000 per year is within an error bar of living on Social Security. 40% of the boomers literally will have only Social Security.

What about all those folks with defined benefit plans? First, defined benefit plans are becoming anachronistic, having been abandoned years ago by companies unwilling to shoulder the risk. Nonetheless, 341 of the 500 large caps in the S&P have retained some semblance of a defined benefit plan.²¹² It is also estimated, however, that the pension plans in 97% of these companies are underfunded.²¹³ A paper by William R. White out of the Dallas Fed estimated that the 1,500 leading companies in the U.S. have a 30% pension deficit of $689 billion.¹⁶² Despite the Pension Protection Act passed in 2006 aimed at protecting workers against companies using pension pools as cookie jars to boost earnings, the crisis in 2007 and affiliated lobbying campaigns convinced law makers that such protections were too inconvenient.

The municipal and state pension problems are acute. The Illinois State Pension Fund is currently 40% underfunded; there is no obvious way out of their hole short of a Federal bailout. Some states are topping off their pension plans by borrowing money from…wait for it…their state pension plans! Read that last sentence again.²¹⁴ Fully funding the state pensions would cost >$30,000 per taxpayer.

There is no guarantee that the defined benefits plans will survive. Chapter 11 corporate debt restructurings and Chapter 7 liquidations will continue to chip away at this liability. The Chapter 7 liquidation of Hostess and ensuing Twinkie riots—at least I rioted—leaves some wondering what kind of union-management stalemate could drive a company into bankruptcy. The 2,500 workers lost it all. Chapter 9 bankruptcies for restructuring municipal debts and negating pension commitments, unheard of only several years ago, are likely to become well known.

Unimaginable ink has been spilled discussing and analyzing the coming Social Security crisis. It’s an off-balance-sheet Ponzi scheme. Social Security also will be increasingly important as the other support mechanisms fail. With cooked inflation numbers and affiliated inadequate inflation adjusted payouts, it’s easy to imagine seniors getting stiffed.

Roth IRA: A Bad Idea

Cost of living now outweighs benefits.

~ Headline from The Onion

Before leaving the world of pensions I’m gonna pick a fight with Roth IRAs. When the Roth IRA was first announced I had a unique—as in only-guy-on-the-planet unique—visceral response. The original IRA was very farsighted: Savers were allowed to compound wealth unfettered by taxes while the government deferred tax revenues to future generations. By contrast, the Roth IRA pulled tax revenues forward, leaving future generations to take a hike. Imagine the truly awesome demographic problems we would have if the Roth had been introduced in the 60s and the entire baby boom generation became entirely tax exempt. Was this an oversight? I don’t think so. The introduction of the Roth and the substantial revenues from regular-to-Roth rollovers coincided with the Clinton administration’s efforts to balance the on-balance-sheet Federal budget for the first time in decades.

That is my minor gripe. To set up my really big gripe we must first dispel a widely held misconception and a common oversight.

(1) In a regular IRA, the money is taxed at the end, whereas in a Roth IRA taxes are levied up front. If the two are taxed at the same rate—this is a critical provision—the outcome is identical. They are not just similar, it’s an identity. Break out your calculator if you must. There is no differential advantage offered by compounding in the Roth over the regular IRA. Simply put:

Any advantage of the Roth IRA relative to a regular IRA necessarily stems from a lower tax rate while working than in retirement. Period/full stop.

(2) The tax rates of the Roth and regular IRAs are fundamentally different:

Roth IRA: Front-end loaded taxes paid at the marginal tax rate (highest tax bracket).

Regular IRA: Back-end loaded taxes paid at the effective tax rate (integrated over all tax brackets).

The distinction of marginal versus effective tax rate is critical and seems to be lacking from most analyses. One can calculate marginal and effective rates for any income online.²¹⁵ Let’s return to the top-5-percentile family—the 5 percenter. If they had used a regular IRA, they would be paying a 7% effective tax rate incurred on their $48,000 per year withdrawal in retirement. They paid an approximate 32% marginal tax rate—the tax rate at the top bracket—to shelter a few thousand per year in a Roth IRA. The numbers simply do not work.

It is worse than that. Let us consider the lucky soul family—the extraordinarily rare couple—who actually accrued 25 annual salaries in their retirement account. For this family a 4% annual withdrawal will be equal to an annual salary while working, placing them in the same tax bracket (ignoring unknowable tax law changes). Even so, they paid 32% marginal tax on the Roth to avoid a 22% effective tax rate incurred by the regular IRA. The numbers still don’t work. I do not understand why the Roth is being sold so enthusiastically to the public.

Now ponder all those folks who rolled over a lump sum from a regular to a Roth IRA. They not only paid the marginal tax rate on the rollover but caused the marginal rate to spike to a higher level! It’s hard to imagine that will prove to be a smart move. Congress is considering moving all pension funds to what is effectively Roth IRA rules as part of their Fiscal Cliff negotiations.²¹⁶ You young guys are about to get hosed.

Europe

The ECB is going to buy bonds of bankrupt banks just so the banks can buy more bonds from bankrupt governments. Meanwhile, just to prop this up the ESM will borrow money from bankrupt governments to buy the very bonds of those bankrupt governments.

~ Kyle Bass, CEO of Hayman Capital

Watching Europe is like reading Waiting for Godot—it is unintelligible. This is unfortunate because these folks may determine my fate. The problems begin with the PIIGS—Portugal, Italy, Ireland, Greece, and Spain—suffering from insolvency. We were assured that the Maastricht Treaty and Haagen Dazs Accord that spawned the Euro explicitly forbade deficits and bailouts.²¹⁷ Well that was then and this is now. Christine Lagarde, head of the IMF, held a press conference literally flashing a big, black purse suggesting that it needs some serious money, and—Shazam!—a €700 billion bailout was in place before the weekend was over. Soon there were trillion-euro bailouts with fuzzy names such as Long-Term Refinancing Operation (LTRO), European Stabilization Mechanism (ESM), European Financial Stability Facility (EFSM), and Monetary Injection Liquidity Fund (MILF). Spiking interest rates of the PIIGS were driven down to levels that look like AAA-rated debt of Pfizer and General Electric. The European Commission (EC), International Monetary Fund (IMF), and European Central Bank (ECB)—the so-called Troika—are the enforcers. The banks get what the banks want.

A Greek exit—shortened to Grexit by Willem Buiter—would have created a fiscal crisis as well as an acronym crisis—PIIS. We endured an insane discussion about whether or not Greece should suffer austerity.²¹⁸ Versus what? Rich, prosperous, and productive? The only legitimate employment was hawking gyros to rioters. A photograph of the Greek Ministry of Finance showing total chaos went viral, becoming a metaphor for the nation.²¹⁹ Nobody got the memo: Austerity is not a choice; it’s a result. Any banker who lends to Greece will be the author of his own (and our) misfortunes. Iran stopped shipping oil to Greece. Just when Greece appeared to be plumbing the bottom, they suffered a locust attack—a real one.²²⁰ Greece is the smallest pawn on the chessboard and with little bargaining power. They were asked to sign a bailout agreement with deep-seated sovereignty issues, yet the document was written in a different language with an incomplete translation.²²¹ However, the Greek default could cost the banks trillions, and the Greeks know this.²²²

The bailouts are coming from Germany because everyone else is on the receiving end. Yet, with an economy 20% the size of the U.S. economy, the Germans are trying to prop up a gaggle of countries that are collectively bigger than the U.S. economy. Europe has $30 trillion unfunded pension liabilities. It’s not going to work. Discussions of why the Americans should bail out Europe—even more than the hundreds of billions of QE II that ended up in European banks—led to a classic Santelli-Liesman love-fest on CNBC.²²³ The banks get what the banks want.

Soon Spain began to slip into the abyss,²²⁴ something I had been waiting for since 2009. [3] Shockingly, Mariano Rajoy, Prime Minister of Spain, declared, “We support a rescue mechanism, the bigger the better."²²⁵ It was all part of a shakedown of the EU, and it seemed to work. Money began flowing into Spanish banks. (Bankia actually got a bailout before the bailouts officially began because they couldn’t wait.)²²⁶ Spain put a €2500 cap on cash transactions,²²⁷ which is emblematic of an end game. Meanwhile, Spain is bidding for the 2020 Olympics. They will be sponsored by Lowenbrau.²²⁸

Then came the Italians. Bill Gross noted that "Italian banks are now issuing state guaranteed paper to obtain funds from the European Central Bank (ECB) and then reinvesting the proceeds into Italian bonds, which is QE by any definition and near Ponzi by another." The oldest bank in the world, Banca Monte dei Paschi di Siena founded in 1472, got bailed out. I wonder how many times that has happened in the last 540 years.²²⁹ The wheels of justice in Italy were moving forward; they convicted scientists for failing to predict an earthquake.²³⁰ The guys who cause earthquakes are still on the lam.

What happened to the assurances of the Maastricht Treaty that no sovereigns would be bailed out? It seems simple enough to me. Politically disconnected sovereign states are strongly shackled together by a common currency and borderless multinational banks. Why would the politicians in the sovereign states agree to self-destructive austerity deals rather than giving them the Icelandic Salute—a default and the finger? That’s easy, too; the banks own the politicians, probably via Cayman Island subsidiaries. (In the olden days, it would have been the Swiss, but their money-laundering ways are at risk.²³¹) One of the many subplots is a mountain of credit default swaps that would break the banks if they were triggered.²³² No problem: The banks refuse to declare the credit event. The banks get what the banks want.

The LTRO is particularly insidious because it subordinates existing debt, inducing a bad case of transurphobia (fear of haircuts). The more LTRO money, the less capital remains backing the existing debt.²³³ Which legal body gets to make this decision? That’s what the Troika is for—democracy not included. These guys are undermining the debt markets in fundamental ways.

The 2012 Nobel Peace Prize was awarded to the European Union,²³⁴ rumored to be for “keeping their shit together” and for “displaying an unprecedented willingness to not start another world war.” The great part about this wave of absurd Nobel Peace Prizes is that, in theory, I could get one—a dollar and a dream.

A World Economic Forum (WEF) report says we must double global debt by 2020 (to $210 trillion) to keep the global economy growing.²³⁵ If that’s the price, shrinkage is sounding pretty rational. The killer phrase was that “most of the growth will come from the government segment.” That ain’t economic growth.

Let us not forget the troubles in the UK. Goldman announced that they were installing one of their boys (Mark Carney) as head of the Bank of England, prompting David Stockman to ask, “Is there any monetary post in the world not run by Goldman Sachs?”²³⁶ UK family debts are up by almost 50% in a year. That is serious slippage. The Bank of England cranked $140 billion into the system in one day—equivalent to 177% of the annual global gold production.²³⁷

The Brits et al. are eating a lot of "toast sandwiches," otherwise known as the "austerity sandwich"—two slices of bread wrapping a piece of toast (butter/salt optional).²³⁸ Irish taxpayers withheld property taxes in protest to the Troika. This smacks of a “peasant rebellion” claiming taxation without representation. With this history ringing in his ears, Sir Mervyn King, Governor of the Bank of England, noted, “I have deep sympathy with those who are totally unconnected with the origins of the financial crisis who suddenly find that the returns on their savings have reached negligible levels. These are consequences of the painful adjustment prompted by the financial crisis and the need to rebalance our economy.”²³⁹ We feel your pain too, Sir Mervyn. Can I offer you a toast sandwich?

The whole mess has been summarized and bulleted by countless bloggers. A few are worth reading.^240,241,242 Credit Swiss noted that “Portugal cannot rescue Greece, Spain cannot rescue Portugal, Italy cannot rescue Spain, France cannot rescue Italy, but Germany can rescue France.”²⁴³ Of course, in February Baghdad Ben Bernanke noted that "the ECB is well capitalized."

Asia

Asia is, by comparison, a relatively serene place. There was a seemingly ominous event when the Bank of Japan was said to be selling its bonds (JGBs) for the first time in years.²⁴⁴ This smelled like the beginning of a large deleveraging. Recent reports suggest that they are back to monetizing debt in a big way.²⁴⁵ Some bears such as Greg Weldon, Simon Johnson, and Kyle Bass view Japan as ground zero for financial carnage.^246,247,248 Japan has spent 20 years losing 80% on the Nikkei—the so-called “lost decade” to those who can’t count—and now the carnage begins in earnest? Losing all of their nuclear reactors also seems ominous; I am guessing they were not using them as backup sources.²⁴⁹ Demographically, their population will continue to age for decades. This is not a pretty picture.

There are others who think China will be the source of fireworks. On the bearish side, you have Jim Chanos placing some serious shorts in position.²⁵⁰ You must take this as a serious omen. The average bloke does not understand the thoroughness of analyses by guys like Chanos and Einhorn. (Chanos, for example, was way ahead of all of Hewlett Packard’s auditors in detecting an $8 billion screwup in their purchase of Autonomy.²⁵¹) Besides a bloated real estate market and terrible bank balance sheets, China is said to have a huge buildup of finished goods—channel stuffing—which will cause trouble at some point.²⁵² This is consistent with often-cited suggestions that the authorities are terrified of unemployment and accompanying social unrest. On the other side, Stephen Roach and Jim Rogers, both highly respected market watchers, are rather enthusiastic about China. Years ago Rogers predicted strife in China would come to a head, and that would be the time to buy. I am quite confident, however, that I have no prayer of understanding China either now or in retrospect.

The Baltic Dry Index²⁵³ is a widely followed indicator of global economic activity (Figure 18). As you can see, the global economy is looking a little green around the gills.²⁵⁴

Figure 18. Baltic Dry Index as an indicator of global economic well being.²⁵⁴

I leave this section with an aside that is too curious to ignore. We were told this year that Japan had unwisely dumped $138 billion into Lehman before the company’s collapse and were promptly reimbursed by the Fed.²⁵⁵ Makes you wonder about those two Japanese businessmen caught crossing the Italian border with $134 billion of Treasury bonds.²⁵⁶ The Treasury denounced them as fake, but the Italians thought they were real. Who could launder them? (Silly question: HSBC would gladly do so for a cut.)

Government Corruption

Geithner heard this information and looked the other way. Geithner and other regulators should be held accountable, they should be fired across the board. If they knew about an ongoing fraud, and they didn't do anything about it, they don't deserve to have their jobs. I hope we see people in handcuffs.

~ Neil Barofsky, Special Inspector General of TARP

What we’re showing here is that cronyism is now permeating our justice system.

~ Peter Schweizer, author of Throw Them All Out

2012 witnessed plenty of government corruption. It is my thesis that corruption within government is getting worse for three reasons: (1) government is a larger percentage of our peacetime GDP than in any other time in history, (2) thanks to the Supreme Court, unlimited funds flooding into election cycles drown out all other interests, and (3) profound financialization of the economy—movement of money for the sake of money—due to unprecedented Fed interventions and deficit Federal spending aggregates criminal elements and elicits criminal behavior. To put it simply, the crime syndicates all had IPOs. Almost without fail the punishments for white-collar crime—really substantial graft—are a small percentage of the booty obtained from the crime. Failures to investigate and prosecute men of wealth and power are emblematic of a kakistocracy—government by the most unprincipled.

Attorney General Eric Holder was up to his ears in dirt. Holder’s law firm defended Corzine against prosecution by Holder’s Department of Justice.²⁵⁷ The law firm won that battle. This was the same Eric Holder who was charged with contempt of Congress for not forking up information about the “Fast and Furious” Mexican arms deals.²⁵⁸ This was the putative sting in which Federal agents sold arms to Mexicans to track the arms but somehow forgot to include tracking devices. Congress also appears to have forgotten to follow up on the contempt charge. I asked Peter Dale Scott, a UC Berkeley octogenarian and multi-decade scholar on the politics of drug cartels, if he knew what the real story was behind Fast and Furious. He assured me that “there is something very wrong with the picture and the official explanation for it.” Oddly, the investigation into the arms deals was terminated by...you guessed it, the Obama Department of Justice.²⁵⁹ That would be Eric Holder.

The authorities continue to cauterize the wounds from the mortgage fiasco by out-of-court settlements with banks, allowing no admission of guilt, no criminal prosecutions, and cash settlements representing small fractions of the profits. (I get in more trouble for leaving the seat up.) We thought the authorities finally levied a severe fine on the banks and brokerages with a sizeable $25 billion settlement for fraudulent foreclosures, only to find that most of the money—all but a few billion dollars—came from the bailout money and even their own write-downs of losses on defaulted mortgages.²⁶⁰ Dean Baker notes that Obama gave bankers immunity from prosecution, and in return, bankers agree to accept government money to cut mortgage principle.²⁶¹ Everything but the reduction in mortgage principal came to pass.

Although this is not easily prosecuted corruption, the racketeering (RICO) laws seem appropriate. To clarify, I am recommending RICO laws be used on the government officials who participated. Even the document that represented the attorneys generals’ settlements with the banks was shown to be fraudulent.²⁶² The New York Times reported that money intended for homeowners in the fraud settlement, as little as it was, got diverted by the states into general operating funds.²⁶³

Walmart got caught bribing Mexican politicians to foster their business interests South of the Border.²⁶⁴ Somebody bribed the Mexicans? Shocking indeed. This does not happen in the U.S. because we have registered lobbyists. Those same lobbyists will ensure that Walmart’s transition to redemption is seamless.

The SEC, to evade a Freedom of Information Act (FOIA) suit, expunged data pertaining to Citigroup as part of their catch-and-release program.²⁶⁵ Citigroup is protected by the Rubin mafia. This is politics Geithner Style. It will be interesting to see where the starting lineup for Team Obama ends up after they finish their first term. The FOIA by Bloomberg showed how the revolving door totally commandeered the Dodd-Frank act to make sure it was banking-friendly.²⁶⁶ The average salary boost on passing through the government-Wall Street revolving door is estimated at 1400%.²⁶⁷ I’m sure that top dogs like Geithner will do considerably better. Don’t let the revolving door hit you guys in the butts.

Another proud moment for the Obama administration’s push for alternative funding energy: Electric car battery maker Ener1, which received more than $100 million in government handouts, has filed for bankruptcy protection.²⁶⁸ I’m beginning to suspect cronyism here! Peter Schweizer’s book Throw Them All Out (vide infra) documented in repulsive detail the shovel-ready cronyism that occurred during the financial crisis.

There were old-school politics going on when Mississippi Governor Haley Barbour left office. On his way out the door he pardoned a number of seedy characters, including eight men convicted of killing their wives or girlfriends.²⁶⁹ The Mississippi Supreme Court upheld the decision. In Mississippi, the Rule of Law is a bad joke, and True Blood is a documentary. We have, however, not plumbed the level of the Thai politicians. A Thai senator shot his secretary with a machine gun in a restaurant and got a $625 fine for it.²⁷⁰ Very Cheney-esque.

If you want some fun, find the Clinton pardons. The original list I saw had over 1,100 and was easily located. The list was laced with drug busts and bank frauds. I can only find partial lists now. Even so, the number who were in prison for drugs or some form of bank fraud is striking.²⁷¹ This would partially explain how Clinton left office burdened by onerous legal fees and now has an estimated net worth of $80 million.²⁷² That’s a lot of honoraria for rubber chicken dinners. Tony Blair also seems to have laundered serious money into shell companies.²⁷³

State Supreme Court judges run for office in 38 states. Jeffrey Toobin warns us that the lobbyists discovered them in the mid-90s and are diverting some of their resources.²⁷⁴ In 1990 candidates for state supreme courts only raised around $3 million…in the races to the high courts, candidates now raise more than $50 million.

The government sold $5 billion worth of AIG stock acquired during the bailouts. AIG bought $2 billion of it, presumably using money from government bailouts. AIG was shockingly profitable owing to $17 billion of tax credits (gifts by the taxpayer).²⁷⁵

Harvard had a publicly embarrassing cheating scandal in which over a hundred kids in one course were accused of plagiarizing. What course would warrant such bad behavior? Introduction to Congress.²⁷⁶ I’m sure the kids will do better in their Introduction to Ethics in their MBA programs.

Recall the must-see Miami Vice episode entitled, “Prodigal Son?”²⁷⁷ Tubbs and Crocket trace the drug money straight to a wrinkly old banker who explains that the drug money ensures payment of South American bank debt. I remember at the it time that made sense, and it seems haunting now. It is rumored that Mr. Burns in the Simpsons was modeled after the Miami Vice banker.

Civil Liberties and the Constitution

There is very grave danger that an announced need for increased security will be seized upon by those anxious to expand its meaning.

~ John F. Kennedy, former President of the United States

There may be a number of people who cannot be prosecuted for past crimes, in some cases because evidence may be tainted, but who nonetheless may pose a threat to the security of the United States.

~ Barack Obama, President of the United States

One of my favorite bloggers, Charles Hugh Smith, cogently summarized instances in which incarceration was used to protect democracy and civil liberties.²⁷⁸ How ironic. Doug Casey provided a haunting account of creeping fascism in Germany in the ‘30s and how it occurs incrementally.²⁷⁹ It is an easy case to make that we are in a battle to preserve civil liberties simply because every year is a battle to preserve civil liberties. Civil liberties are forfeited one at a time. The battle lines are being drawn. You should fight every fight, no matter how big or small.

There is an ongoing battle for ultimate control of the Internet. Legislation includes the Stop Online Piracy Act (SOPA), the Protect IP Act (PIPA), and the Anti-Counterfeiting Trade Agreement (ACTA).^280,281 Superficially they are designed to achieve the named goals. The notion is that pirating sites can be blocked if they are interfering with trade. Their reach, however, is far greater. An accusation alone is sufficient to block a web site prior to any clear evidence of guilt.²⁸² Authorities could shut down search engines Yahoo, Google, or Bing suspected of enabling these hooligans. SOPA got shelved after there was, ironically, a massive Internet-derived protest. The digital world has taken our lives by storm. The Internet is as profoundly democratic as Gutenberg’s printing press. Keep it wide-open at all costs. Efforts to control information flow will keep appearing like the proverbial camel nose under the tent. And here comes the next one on cue in 3…2…1…enter the Trans-Pacific Partnership (TPP)!²⁸³

The implications of armed drones are staggering. We are not the only country with drones; they are proliferating around the globe. We managed to survive thermonuclear risk for half a century, and yet we find ourselves racing toward a Skynet-like drone war of staggering magnitude. The skies will be littered with drones like aerial minefields. It is terrorism to those on the receiving end, causing blowback to be almost a certainty. Congress passed a law opening U.S. skies to unmanned drones.²⁸⁴ Companies are lining up to launch them—an estimated 30,000 drones within a few years²⁸⁵—forming a nouveau industrial-military complex. As a guy who finds automated speed-monitoring devices irritating and automated ticketing profoundly disturbing, the drones make me crazy. Even if unarmed, is this not Constitutionally prohibited unlawful search? What event will elicit armed variants to protect us from the bad guys? And if all that isn’t spooky enough, the drones are being engineered for autonomous (human-free) response.²⁸⁶

Digital monitoring of “crimes against traffic” frees up police for more hands-on police work. Petty arrests now justify strip searches. The Economist describes increasing predilections toward stop-and-frisk policies within the cities.²⁸⁷ Legal scholar Jonathan Turley estimates that over 700,000 unwarranted stop-and-frisk searches occur each year in NYC alone.²⁸⁸

Jonathan Turley also notes that the Administration claims the right to assassinate a U.S. citizen either here or abroad, and it would seem that we did such a thing.²⁸⁹ Of course, the target deserved it because he undermined America! The FBI has described extremists as those who “may refuse to pay taxes, defy government environmental regulations, and believe the United States went bankrupt by going off the gold standard."²⁹⁰ Y’all should be careful because you never know what is flying 50,000 feet right above your heads. Obama is the only Nobel Peace Prize winner with a kill list. God save the poor soul spotted by drones entering Manhattan with a Big Gulp. Mayor Bloomberg’s war on Big Soda could turn violent.

Sergey Aleynikov was arrested in 2009 for the most egregious of crimes—stealing software from Goldman Sachs. The Goldman Stasi are good at their jobs, getting him into custody within hours. In 2010, he was convicted and sentenced to 8 years in jail for this profitless crime despite the probation office’s recommendation of 2 years.²⁹¹ The system seemed to correct itself when the United States Court of Appeals threw the case out in 2012, ruling the source code was not a "stolen good.”²⁹² It was a pyrrhic victory for Aleynikov. They arrested him again using a different jurisdiction to avoid double jeopardy.

Joshua Dressler, a criminal law professor at Ohio State University said that “it was highly unlikely that the separate Federal and state prosecutions in the Aleynikov case would violate the Constitution.” I think they just did. At least now Sergey doesn’t have to start his car in fear.

The National Defense Authorization Act (NDAA) was enacted to protect us against terrorists.²⁹⁴ Of course it was. It provided government authority to incarcerate an American citizen indefinitely without access to legal defense or the courts. Protestors challenging the unlawful incarceration were (you got it) arrested.²⁹⁵ In September, a Federal judge ruled it was not even in the same zip code as the Constitution and put a permanent injunction to protect us.²⁹⁶ Here’s the really troubling part: It had been passed by a large majority in Congress and a 91:9 vote in the Senate, and signed by President Obama. When the outcry began in earnest, Obama assured us that his administration would never act recklessly. I beg to differ: Signing the bill was reckless. I’ll take it a step further: Signing the bill was treason. Read your job description, Mr. President. Watch for that part about upholding the Constitution. And by the way, Team Obama is fighting the injunction.²⁹⁷

There is little doubt that municipalities in the sand states would do almost anything to dig themselves out of the mortgage crisis. The brain trust in San Bernardino, with the legal help of one of my colleagues (Professor Robert Hockett) got the idea to use eminent domain to commandeer underwater mortgages—mortgages that exceed the value of the house.²⁹⁸ The idea is to pay “fair value” (red flag!), bundle them up (red flag!), and sell them to private investors (red flags!). There would be no shortage of cronies willing to buy up these bundles. The subplot might be that this is a veiled attempt to clean up the MERS boondoggle that is causing foreclosures to throw the title of houses into a legal vortex. As preposterous as this sounds, it’s probably Constitutional given the eminent domain case in Connecticut that some believe drove Sandra Day O’Conner to retire from the court.²⁹⁹ It may, however, be illegal in California.³⁰⁰

The Citizens United suit gave Super PACS their unlimited political power by allowing them to spend unlimited money on political campaigns provided they follow a few guidelines.³⁰¹ Journalist and civil servant Jim Hightower referred to the majority justices as "five traitors to the democratic ideal.” It is indeed odd that support for freedom of speech may have profoundly oppressed free speech. A banking Super PAC overtly promoted by American Banker is blood curdling in its goal to defeat any candidate that is not friendly to banks.³⁰² A suit to ban excessive donations in Montana got nuked.³⁰³ According to the Supreme Court, money is speech. As a corollary, if you don’t have money, you will lack a voice.

Corporate civil rights seem to be in the news. An Occupy Wall Street (OWS) protestor carried a sign, "We will know corporations are people when Texas executes one." It seems clear that corporate civil liberties without civil responsibilities is a problem. It is not true, however, that this was a recent or rapid change. Organizations began to accrue Constitutional protections beginning with a case of Dartmouth College versus the State of New Hampshire in 1819. Ted Nace’s Gangs of America tracks through the Supreme Court decisions that incrementally granted civil liberties to corporations. Despite the hyperbolic title, it is a balanced, scholarly analysis.

Why are civil liberties eroding? One notion is that tension between the central planners and free market crowd led to a societal compromise in the 1930s. Capitalism was allowed to flourish, but with safeguards to keep communistic ideals in check. With the fall of the Berlin Wall and the Soviet Block, the proletariat (in the U.S., that is) had no alternative system to keep powerful individuals mindful of their needs. Glass Steagall fell in the late 90s, the banking cartels grew, and wealth disparity—financial apartheid—emerged.

Limits of Government

A sinking economy requires stimulus from two agents, the Federal Reserve and the government.

~ Rich Yamarone, Director of Argus Research

During the time of the Soviet Union the role of the state in economy was made absolute, which eventually led to the total non-competitiveness of the economy…I am sure no one would want history to repeat itself.

~ Vladimir Putin, communist

We have witnessed a seemingly endless battle for the Grand Compromise between those supporting central planning versus market forces. 18th century economist Edmund Burke warned of the role of intellectuals trafficking in snark and trumpeted the Law of Unintended Consequences. Burke also recognized the wealth disparity in 18th-century France and accurately predicted the murderous end result. 19th-century economist Alexi de Tocqueville described the genius of America as not the equality of outcome but rather equality in the eyes of the law. 20th-century economist Joseph Schumpeter also viewed intellectuals with disdain and capitalism not as flawed but fragile. Friedrich Hayek, famous for his opposition to John Maynard Keynes, supported the notion of social safety nets, just not so many and not so invasive. I think Hayek’s stroke of insight was recognizing significant analogies with Darwinian evolution to understand that complex systems arise and persist more by trial and error than by explicit human engineering. Hayek’s Fatal Conceit describes the folly of intellectuals thinking they are smart enough to mess with free markets, hoping to obtain only intended consequences. My reading of Keynes is that he was a profound interventionist—a knob twirler—and was also a radical socialist.

The Yamarone quote illustrates that we have degenerated to a society in which even the big money guys—supposedly the bright bulbs—think that government will solve our problems. While watching a Yale panel discussion on the economy, I was struck by the explicit endorsement of government solutions by the panelists.³⁰⁴ Apparently, we are all Keynesians now. I could buy into a variant of the Keynesian model in which government acts as a financially interested party, buying goods and services when they are cheap and pulling back when they are expensive. It would naturally be counter-cyclical. Unfortunately, there is no chance it will ever work that way. Paraphrasing my dad who was paraphrasing Milton Friedman, government does everything inefficiently, so don’t ask them to do more than you must. It’s not about the morality of what government does; it’s about the low quality and horrendous inefficiency.

Hernando De Soto warns that the U.S. is forfeiting a critical feature that distinguishes it from Third World countries—well-defined property rights. The MERS catastrophe that threw the title of millions of properties into question was an 80-car pile-up on a foggy freeway that will be corrected by legal fiat. By contrast, mutation of the banking system into a cartel, while by no means unprecedented, is a serious problem. Now that this gargantuan organism has control, there is no means to wrestle it back. When you can purchase a politician for $100,000, how can we expect real change? The Citizens United case that opened the political process to unlimited capital is profound because attempts to unring that bell are opposed by unlimited capital. The power of the banking trusts has gone beyond the failsafe point. The Fed—the One Ring that controls them all—is the key. It will be a long trek to the Crack of Doom.

Challenges to our civil liberties, overreach of eminent domain, domestic drone surveillance, and attempts by elected officials to knowingly subvert Constitutional rights all attest to the insidious Orwellian creep of government into our lives. It is not obvious to me that we can negotiate our way out of this one. Some problems do not have solutions if you define a solution as a fix with tolerable pain. I suspect that resolution will occur, but it will be something historic. We are in a barrel speeding down the Niagara River toward the Falls. This is not an episode of Batman or McGyver: all palatable solutions have passed. We will experience the Falls up front and personal. Those in power will claim they did their best when, in fact, they were the root cause. Bernanke, one of the reputed world’s experts on the Great Depression, never mentions loose monetary policy in the 1920s as the cause. It is a lie by omission; a profound one at that.

I close with a simple directive: Watch Ron Paul’s farewell speech to Congress.³⁰⁵ You owe it to yourself. He’s the one that got away. To paraphrase Marlon Brando, “He coulda been a contender.” If you’ve had enough of darkness, try this John Cleese seminar on creativity³⁰⁶—it’s brilliant—or this photo montage of history’s most epic photos.³⁰⁷ Soon I will be off like a prom dress, but first I wish to share the books that I read this year, and the all-important acknowledgements.

Books

Every year I summarize books that I read. I am a slow reader so I try to chose them carefully. I’ve overdosed on crisis books for over a decade (beginning with crisisforeshadowing books) but succumbed to the temptation a few more times. I also slipped back into pop psychology mode.

The Clash of Economic Ideas: The Great Policy Debates and Experiments of the Last Hundred Years by Lawrence H. White

White describes the debates that took place throughout the 20th century, pitting the free market advocates against the central planners. Although White shows his colors as a free marketeer, he does a beautiful job of letting the reader ponder the debate rather than force-feeding the conclusion. The book might not be wonky enough for the pros, but I found it to be very scholarly—a great book for a wide swath of macroeconomic enthusiasts. This is the stuff economists-in-training seem to miss in modern curricula. I took the plunge prompted by an Econtalk interview of the author.³⁰⁸

Broken Markets: How High Frequency Trading and Predatory Practices on Wall Street are Destroying Investor Confidence and Your Portfolio by Sal L. Arnuk and Joseph C. Saluzzi

I don’t really know Sal Arnuk but am a big fan of Joe Saluzzi, occasionally swapping barbs about the horrendous price discovery process in modern markets. Joe and Sal describe in detail how high frequency traders are eroding the foundations of the markets—not just equity markets—through their relentless game of high-frequency Whac-A-Mole. Although Sal’s and Joe’s knowledge of the markets and passion for change is uncontestable, their frustration at times overwhelms the prose. I recommend the book, but some enthusiasm for trading may be required to nudge this book into the five-star group.

Bull by the Horns: Fighting to Save Main Street from Wall Street and Wall Street from Itself by Sheila Bair

I wasn’t going to touch this book if it were not for a personal endorsement from Chris Whalen. Bair, Chair of the FDIC (Federal Deposit Insurance Corporation), describes the incredible turf wars and petty battles below the surface of the bailouts. I previously had sensed Sheila was one of the good guys; the book reinforced it. She describes Bernanke as generally well-meaning, Geithner as a relentlessly pro-Citigroup promoter and Rubin pawn (to the point of racketeering), and a host of others who clearly need severe beatings. It is an antidote to the highly lopsided Sorkin treatise, Too Big to Fail. Here is a Bair interview.³⁰⁹

Bailout: An Inside Account of How Washington Abandoned Main Street While Rescuing Wall Street by Neil Barofsky

Neil entered the crisis plotline as the young, feisty special investigator general to oversee the TARP bailout (SIG-TARP). From his presentation, he was green and naïve, unready for the thugs he would be dealing with. By example, he figured out relatively late in the game that the gaping holes in the bailouts used by the banks to siphon trillions from the Fed were left there by design, not by mistake. The big loser is Geithner, who comes across yet again as a despicable human being. I was disappointed not to get more insight into Elizabeth Warren’s role as Chair of the TARP oversight committee. Barofsky has done many interviews; an Econtalk variant is particularly thorough.³¹⁰

Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon by Gretchen Morgenson and Joshua Rosner

This is an excellent and detailed analysis of the financial crisis, deeply probing the mortgage industry’s role (more than simply explaining the basics found in all of the crisis books.) Some may find this old news that they would like to put behind them. My only caveat is that one should read this book or Nocera and McLean’s All the Devils Are Here, but not both.

The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White, and the Making of a New World Order by Benn Steil

Benn is a fellow at the Council on Foreign Relations (CFR) with what I would call an Austrian economic slant. The book will be released in March. In it, Steil describes a fascinating battle between Harry Dexter White and John Maynard Keynes before, at, and after the 1944 Bretton Woods Conference in which the future world currency regime was hammered out. We get deeply insider views of the events in a prose and presentation that I found gripping. Keynes’s role as a diplomat, unknown to many, may have been his most important single contribution. Heads up: Steve Hanke of the Cato Institute and Johns Hopkins University also has a book on the Bretton Woods Conference coming.

Throw Them All Out: How Politicians and Their Friends Get Rich Off Insider Stock Tips, Land Deals, and Cronyism That Would Send the Rest of us to Prison by Peter Schweizer

Many may know Schweizer from a 60 Minutes episode that revealed broadly based, scandalous insider trading by Congress that is legal for them. This is the book upon which the 60 Minutes episode was based. Schweizer tells horror story after horror story of graft that would get normal citizens sent to prison. What is appalling is how often they sell the taxpayer out by billions of dollars so that they can make a few hundred thousand dollars. Obama comes out looking particularly bad as the author describes how shovel-ready projects were really about massive kickbacks for campaign donors. It was not, however, a partisan hatchet job.

Thinking About Capitalism by Jerry Z. Muller and Modern Economic Issues by Robert Whaples

These two trimester-length audio books from The Teaching Company focus on basic principles of economics from a decidedly descriptive slant (as mandated by audio).³¹¹ It’s easy listening stuff that is appropriate for those trying to become comfortable with foundational principles. I liked them because they provide these principles in particularly clear and cogent prose. Never pay retail; they go on sale at 80% discount many times during the year.

The Clash of Generations: Saving Ourselves, Our Kids, and Our Economy by Laurence J. Kotlikoff and Scott Burns

This is a follow up to Kotlikoff’s The Coming Generational Storm describing the impending problems from off-balance sheet obligations. The authors, in conjunction with Kent Smetters, did the seminal studies on unfunded liabilities—promises that are unfunded even when projected tax revenues are subtracted. The authors now estimate them at over $200 trillion. I found the The Coming Generational Storm more appropriate for my needs. The clash of generations is part warning and part investment book for those who are not familiar with this issue. I think the authors manifest ‘doomsayer’s fatigue’—the need to be optimistic after years of seeing a dismal future. I am, nonetheless, a huge Kotlikoff fan.

Thinking, Fast and Slow by Daniel Kahnemann

Kahnemann is probably the most prominent contributor to behavioral economics, garnering him the Nobel Memorial Prize in Economics. He works with Nassim Taleb and appears to be Taleb’s mentor. Thinking Fast and Slow presents the constant battle between the instinctive thoughts and more decidedly cognitive reasoning, explaining how we make decisions and how they can go astray. It is more thoughtful than Gladwell’s Blink, sometimes demanding deeper thought.

How We Decide by Jonah Lehrer

Lehrer’s book came recommended via an Econtalk interview.³¹² It is yet another Blink-genre book looking into how humans make decisions. I love these books but this treatise is presented at a much lower level than Kahnemann’s and is remarkably similar to a book entitled Sway by Ori and Rom Brafman. Consumers of pop psychology should probably check out Ed Yong’s interview on Econtalk discussing the underlying flaws in this type of social science.³¹³

The Wisdom of Crowds by James Surowiecki

Surowiecki discusses how collections of people with limited individual insights, if acting truly independently, display collective "wisdom" and how that wisdom is lost when they start acting in a correlated fashion. There are many cute snippets describing the results that, at times, become a little too loosely connected. Aficionados of this genre will find it both fun but partially redundant to other works (Taleb; Kahnemann; Gladwell).

My Stroke of Insight: A Brain Scientist's Personal Journey by Jill Bolte Taylor

Jill, a Harvard neurophysiologist, wakes up one morning and finds herself having a stroke in the highly rational left brain. Her deductive reasoning goes on- and off-line, throttling her back and forth between euphoria and panic. The story describes the stroke and the long recovery in hysterically funny prose from an especially insightful perspective of a neurophysiologist. I found the audio book to be an excellent medium.

Steve Jobs by Walter Isaacson

In case you’ve been living under a rock, this fully sanctioned biography that was in no way edited by Steve or his family is simply the best biography I’ve ever read. You get a bird’s-eye view of the computer revolution from soup to nuts through the detailed stories and words of all of the key players. Steve was a unique personality with a unique ability to translate unimaginable compulsive behavior into profound success rather than total failure. My conclusion: Sell any shares of Apple Computer because it ain’t the same company without Steve.

Secrets: A Memoir of Vietnam and the Pentagon Papers by Daniel Ellsberg

Ellsberg describes the events leading up to, during, and following the release of the Pentagon Papers, the media-driven exposé of nefarious activities by a string of administrations. It is not really about the content of the papers. Presidents who lie to the American populace seem rather pedestrian in this era. It was interesting but only in the four-star category.

Human Prehistory and the First Civilizations by Professor Brian M. Fagan

I have listened to dozens of trimester-length courses provided by The Teaching Company as audio books.³¹⁴ With only one exception, they have been great. In this course, Fagan does a great job of following the lineage from the origins of humans starting about 8 million years ago through to the ancient (pre-historic) civilizations across all continents. It’s both informative and very easy listening. Reminder: Never pay retail for these books: they go on 80% sale routinely, bringing the price down to about $70.

Bonhoeffer: Pastor, Martyr, Prophet, Spy by Eric Metaxas

Bonhoeffer was a cleric and a spy in Nazi Germany who eventually gets executed for his role in a conspiracy to kill Hitler. (That is not a plot spoiler; the author tells you he died right up front.) The biography describes the church-state battle, which was very new to me. In my opinion, however, there was way too much church and not enough state. Despite over 500 bonkers reviews at Amazon I found it to be boring.

Acknowledgements

OK. This ain’t a book; it’s just a friggin’ blog. I’ve got to take this opportunity, however, to thank some folks who have generously shared their time and insights so as to make thinking about capitalism a special experience. You guys have made a difference. Chris Martenson brings gravitas to the debate on resource depletion and, in conjunction with Adam Taggart, graciously publishes my Reviews and invited me for my favorite interview.³¹⁵ Rick Sherlund of Goldman Sachs/Nomura and friend of 40 years inadvertently and unknowingly triggered a discontinuity in my perception of markets with the most innocuous of statements. Bloomberg reporters are especially accessible. I have exchanged hundreds of emails with Mark Gilbert, head of Bloomberg’s London Office, Caroline Baum, and many other colleagues. Dave Lewis, a former Louis Bacon protégé and scholar of a higher order I call a friend although we meet up only sporadically. I have had dozens of exchanges with an eclectic mix of characters ranging from Elizabeth Warren on the left and Lew Rockwell on the way right. Within that enormous chasm includes multiple and meaningful exchanges with Stephen Roach (Morgan Stanley), James Howard Kunstler, Art Cutten (Jesse’s Café Americain), Byron King (Agora), John Rubino, Bill Fleckenstein, Benn Steil (CFR), Gerard Minack (Morgan Stanley), Doug Noland (Federated Investors), Richard Daughty, Jack Crooks, Grant Williams, and Jim Rickards. I thank Richard Uhlig, former CEO of Morgan Stanley’s banking subsidiary, for giving a two-hour guest lecture on mortgage-backed securities in my honors chemistry class. (The kids loved it!) Meetings and conversations with economists Larry Kotlikoff and Steve Hanke are enormously appreciated. I have especially cherished numerous exchanges with David Einhorn, a truly unique individual and intellect, culminating in a meeting with David and subsequent breakfast with his parents. (Mom is quite the bear.) I was profoundly honored when David Weidner included me in a WSJ article on the flash crash and Demetri Kofinas and Lauren Lyster invited me to do an amazing interview on Capital Account.⁷ These experiences are special and wholly orthogonal to my exposure in chemistry. Lastly, Bruce Ganem rekindled my interest in markets, politics, and economics. Our colleagues will never forgive you.

David B. Collum

Betty R. Miller Professor of Chemistry and Chemical Biology

Cornell University

dbc6@cornell.edu

@DavidBCollum

Links

The superscripted links are found here.

Full pdf version of this epic review here.

• Global Currency Tensions Rise (WSJ) - in other words, when everyone eases "to infinity", nobody eases
• EU to give Spain, France more time to cut deficit (Reuters) - But not because their economies are not "recovering" fast enough, oh no.
• As we expected, Grupo Bimbo considering a bid for Hostess' snack cakes and bread brands (NY Post)
• Time for bus-control: Eleven children killed in latest Chinese bus crash (Reuters)
• Greece Should Write Off Billions of Overdue Taxes, Report Says (BBG) - not all taxes in perpetuity?
• India clamps down on gang-rape protests, PM appeals for calm (Reuters)
• But Meredith Whitney said... Push for Cheaper Credit Hits Wall (WSJ)
• For Greece, last major austerity package, says eurozone official (Kathimerini)...  "unless there is another one"
• Americans Miss $200 Billion Abandoning Stocks (BBG) ... and two flash crashes... and $15 trillion in artificial central bank props
• Goldman Sachs Takes Long View Over Payouts (FT)
• Cliff Would Strike Low Incomes Hard (WSJ)
• Afghan policewoman kills US police adviser (AP)
• Navy SEAL commander dead in Afghanistan in suspected suicide (Reuters)
• For Sale in Japan: Electronics Assets (WSJ)

Overnight Media Digest

WSJ

* A federal judge in New Orleans approved a $7.8 billion settlement between BP Plc and Gulf Coast businesses and residents over damages related to the 2010 offshore oil spill.

* Engineers at Motorola Mobility are hard at work on a sophisticated handset - known internally as the "X phone" - but the Google Inc unit is running into some obstacles in its effort to provide more potent competition for Apple Inc , said people familiar with the matter.

* Shanghai regulators gave Yum Brands Inc some shelter from criticism by China's state-run media of its food-safety practices, saying chicken sampled from the U.S. restaurant company's KFC arm complied with government limits on antibiotics.

* News Corp said the publishing company it plans to spin off incurred losses last fiscal year and in the most recent quarter.

* The court-appointed authorities liquidating various parts of MF Global Holdings Ltd agreed to settle long-running legal disputes, a three-way truce expected to help customers of the failed brokerage firm get their money back more quickly.

* Federal agencies are examining allegations that Regions Financial Corp improperly classified loans that went bad during the financial crisis, according to depositions filed as part of a civil lawsuit against the large southeastern U.S. bank.

* After spending the past two years increasing investments in Europe's high-end real-estate market, Norway's $682 billion oil fund is poised to hit the U.S. property market with deep pockets and an appetite for big-ticket deals.

* Congressional battle lines hardened Sunday over firearms restrictions, laying the foundation for what will likely be a fight over any proposed new gun laws

FT

BRITONS PREFER TO GIVE MONEY, NOT TIME

Britons are far more reluctant to give up their time to help deliver public services than their European and U.S. counterparts according to an FT/Harris poll, dealing a blow to David Cameron's "Big Society."

RIO TINTO LIFTS RIVERSDALE BID

Rio Tinto (RIO.AX) has stepped up its pursuit of Riversdale Mining RIV.AX with a new A$3.9 billion bid that would entail at least an extra $1 billion in group capital expenditure.

GOLDMAN SACHS TAKES LONG VIEW ON PAYOUTS

Goldman Sachs (GS.N) has adopted a new long-term bonus plan that lets the board award top officers based on their ability to meet long-term goals without encouraging risk-taking.

GE TO PUT ASIDE $500 MLN FOR RIVER CLEAN-UP

General Electric (GE.N) will set aside $500 million to pay for the cleanup of toxic chemicals from the bottom of the Hudson River.

LENDERS BACK CREST DEBT-SWAP APPROVAL

The majority of lenders to Crest Nicholson [CRTNC.UL] have voiced support for a proposal by U.S. fund Varde which would see the company push through its second debt-for-equity swap in three years.

Canada

THE GLOBE AND MAIL

* Police officers across Canada continue to grapple with Twitter users revealing the location of impaired driving checkstops, which ramp up during the holiday season.

* Liberal leadership contender Justin Trudeau told an Islamic conference Saturday that groups who attacked his decision to attend the gathering only work to divide Canadians.

Reports in the business section:

* The Canadian Federation of Independent Business wants both lower taxes and deficit reduction this holiday season. During a recent round of pre-budget consultations, the powerful business lobby urged Ottawa to stick to its current target of wiping out the deficit by 2016.

NATIONAL POST

* A Gangnam Style parody video set in Sunnybrook Hospital's maternity ward, featuring a series of jocular delivery room scenes, was pulled from the organization's official YouTube channel after being met with criticism from a women's rights group, which has since demanded a public apology from the hospital.

FINANCIAL POST

* SNC Lavalin Group Inc is demanding that all independent consultants it does business with complete an "ethics exam" by the end of the year or risk losing their contracts with the company.

* Canada has increased by C$50 billion ($50.27 billion) the amount of residential mortgages that it is willing to guarantee.

But this time the Canada Mortgage and Housing Corp , the biggest provider of mortgage default insurance, is not getting any. Instead, the additional backing is going only to private-sector players such as Genworth Canada, who will see their maximum raised to $300 billion from $250 billion

China

CHINA SECURITIES JOURNAL

--Charoen Pokphand Group said the funds used to purchase a stake in Ping An Insurance (Group) Co Of China Ltd are legitimate. Domestic media has reported that a part of the funds were borrowed from local commercial banks.

--Shanxi, a province of North China, started the country's first coking coal spot trading platform.

SHANGHAI SECURITIES NEWS

--Investment in the domestic sea water desalination industry could hit 20 billion yuan ($3.21 billion) during the 12th five-year plan period, with a capacity of 2.2 cubic metres of sea water a day.

CHINA DAILY

--Deep processing in the agriculture sector is becoming a hot spot for investment, as venture capital and private equity companies seek new outlets in the gloomy economy. During the last three quarters of this year, $214 million flowed into the agriculture sector from 37 venture capitalist and private equity funds, according to a report by ChinaVenture Group.

--A cold front has descended on many provincials capitals, with temperatures in some hitting well below -20 degrees Celsius. Parts of central and eastern areas are predicted to hit record lows, the National Meteorological Center said.

SHANGHAI DAILY

--Chicken from Shandong Liuhe Group, supplier to Yum Brands Inc's fast-food chain KFC, is still being sold in some supermarkets in Shanghai. The city's food and drug authorities said there had been no order so far to pull it from the shelves.

PEOPLE'S DAILY

--China should expand domestic demand, strengthen the change in the economic structure and take more steps in innovation to achieve healthy economic development and social harmony and stability, the paper said in a commentary.

Fly On The Wall 7:00 am Market Snapshot

ANALYST RESEARCH

CorEnergy (CORR) upgraded to Neutral from Underperform at BofA/Merrill
Fly Leasing (FLY) upgraded to Buy from Neutral at Citigroup
Pinnacle Entertainment (PNK) downgraded to Neutral from Positive at Susquehanna
General Motors (GM) reinstated with a Buy at Goldman
Yahoo! (YHOO) price target raised to $26 from $19 at Needham
News Corp. (NWSA) price target raised to $29 from $26 at Deutsche Bank
Validus (VR) hurricane losses well above expectations, says Deutsche Bank
Greenbrier (GBX) board right in rejecting Icahn's offer, says Jefferies

HOT STOCKS

GM (GM), Punch Metals, ZF reached agreement on Strasbourg operations
AT&T (T) reached tentative agreement with Communications Workers of America
United Technologies (UTX) to divest UTC Power unit
Zynga (ZNGA) indicated U.K. online gambling initiative may come in early 2013

EARNINGS

Companies that missed consensus earnings expectations include:
Robbins & Myers (RBN)

NEWSPAPERS/WEBSITES

Japan's struggling consumer-electronics companies (PC, SNE, SHCAY) are putting aside years of resistance to get serious about shedding nonessential assets and streamlining their  operations. But this may be hindered by what they are willing to sell and what potential buyers want, the Wall Street Journal reports
Now that Facebook (FB), Zynga (ZNGA) and Groupon (GRPN) have fizzled in their first year on the stock market, the hype over social, local and mobile  has subsided. For many of the still-private Web start-ups that rode the wave up, that now means grappling with the downside of the cycle, the Wall Street Journal reports
PSA Peugeot Citroen (PEUGY) has ruled out a merger with General Motors' (GM) Opel division as part of their alliance, Autogazette reported, citing a Peugeot manager, Reuters reports
The rivalry between Amazon.com (AMZN) and Google (GOOG) will escalate in 2013 as their areas of rivalry grow, from online advertising and retail to mobile gadgets and cloud computing, Reuters reports
Americans investors have missed out on nearly $200B of stock gains as they drained money from the market in the past four years, a result of the financial crisis, Bloomberg reports
Investors reduced bullish commodity bets to the lowest in almost six months as U.S. budget talks stalled, increasing concern that lawmakers’ failure to reach an agreement with push the U.S. economy back into a recession, Bloomberg reports

BARRON’S

Central Garden & Pet (CENT, CENTA) could be a play for patient investors
PNC Financial (PNC) undervalued, could increase 20% if p/e multiple rises
Capital One (COF) 360 to launch in February, will link to ShareBuilder
Expedia (EXPE), Microsoft (MSFT), EMC (EMC) and Terex (TEX) have profit momentum and present a good opportunity for investors to find growth in earnings

SYNDICATE

ACADIA (ACAD) files to sell 19.5M shares of common stock for holders
Gas Natural (EGAS) files to sell $50M of common stock
Sagent Pharmaceuticals (SGNT) files to sell up to 24.05M shares for holders

ACTIVIST/PASSIVE FILINGS

Carl Icahn lowers stake in Greenbrier (GBX) to 3.41% from 9.99%
Visium reports 6.2% passive stake in ACADIA (ACAD)

Latest from my friend David Kotok.  I think both he and Meredith Whitney are too bullish on the banks.  Fred Cannon at KBW is right.  Mortgage banking revenue for US banks peaked in Q3 2012.  And don't forget to read David's insightful comment, "The Real State of the Union." Happy Valentine's Day to all -- Chris

Meredith, Will You Be My Valentine?

David Kotok/Cumberland Advisors (www.cumber.com)

February 14, 2013

On Thursday, February 7, as I do most days, I watched Bloomberg Television’s Surveillance from an exercise bike while sipping my morning coffee.  Sara Eisen, Scarlet Fu, Tom Keene, and Mike McKee were interviewing Meredith Whitney.

First disclosure: Meredith Whitney and I have had our disagreements over municipal bonds and municipal bond strategies.  This was exacerbated by her infamous call on 60 Minutes, in December, 2010.

In the recent Bloomberg interview, Meredith sponsors the notion that the banking sector is improving and that the results will reflect in bank stocks. The case she makes for the sector is bullish. 

We completely agree with her on this issue. We think her recommendations and her arguments are sound. In the banking sector, she is our Valentine pundit.

Second disclosure: Cumberland has been overweight the banking sector and financials since this bull market started. We use only ETFs.  The ones we own represent regional banks, big banks, insurance companies, and small specialty types of financial institutions. Those ETFs as a group are overweight banking relative to the benchmark index. We are fully invested, according to our internal asset-allocation weighting models.  We believe these assets will attain much higher prices over time.

Meredith Whitney established herself in the banking sector with a famous call about Citigroup. We agreed with her call then, and we agree with her banking sector call now. While our job is not to make calls but to manage portfolios, we believe it is correct to praise where praise is due.  In the banking sector, Meredith has and does earn that praise.

One of the big issues that prompted our public disagreement with Whitney involved her call on municipal bonds. In that call she articulated a prediction that “hundreds of billions of dollars worth of defaults” would occur.  Furthermore, she expected that it would happen in 2012.  We disagreed.

Our view on Munis has several components.  First, some municipal bonds default every year.  Most of them are in the junk-credit category or are tied to specific projects. 

Second, we see no way that annual defaults could reach Meredith’s massive numbers.  This is especially true with the ongoing quantitative easing by the Federal Reserve.  Furthermore, municipal finance is slowly improving in credit quality in many jurisdictions due to the ongoing economic recovery. That recovery, underway since 2009, is proceeding at a slow but gradually increasing pace. 

Third, Meredith ignored the idiosyncratic nature of tax-exempt municipal securities. There are approximately ninety thousand issuers in the US, which fall under the governance of nearly that many state and local jurisdictions; and the claims upon them are equally various. You cannot paint the tax-free or taxable municipal bond sectors with a single broad brush. That just does not work. It did not work with her 60 Minutes prognostication, and it did not work for those investors who thought that they could buy insured bonds and that those bonds were all gilt-edged.  That is and was a fundamental flaw in certain bond funds.

In order to successfully invest, own, or lend your money to a municipality, or to otherwise place capital in the municipal bond sector, you must carefully research the credit and structure of the specific instrument. There is a vast difference between the nature of a general-obligation pledge versus a budget funded by an annual appropriation in a city in California.  There are very strongly monopolistic government franchises, such as the NJ Turnpike. Essential-service revenue bonds are available with tight liens and claims to secure the bond holders.  Many Munis are quite solid when it comes to credit.

In the February 7th Bloomberg interview, Meredith Whitney was asked specifically about her history with the municipal bond call. Readers can judge her response for themselves.   See her interview on www.Bloomberg.com:

http://www.bloomberg.com/video/meredith-whitney-on-banks-muni-bonds-s-p-... .

Her famous “100 billion dollar default” interview is here:  http://www.youtube.com/watch?v=hI-rIGyLri4 

Our view is that one must do the analysis on credit.  There are many opportunities in the municipal bond sector. Default on them is unlikely and default in a massive scale is also unlikely.

To Meredith and to all readers, we wish you a happy Valentine’s Day.

And now for something completely different.

Citi's Willem Buiter is best known for his exhaustive, often times fatalistic outlook on Europe (he will ultimately be right about the Grexit, and Spexit, and ultimately Dexit, the only problem is so will Meredith Whitney about the state of the US municipals - eventually). It appears there may have been a reason for his dour outlook on life: a sexy stalker as it turns out. A sexy, but very demented stalker.

Meet Heleen Mees. Helen, 44, a one-time NYU professor from the Netherlands, had once been in a relationship with the fellow Dutchman and current Citi economist (unclear how long said relationship with the married with children Buiter took place).

The relationship turned sour, however, and the couple split, at which point Mees proceeded to bombard Buiter with over 1,000 emails, between July 1, 2011 and Monday, which contained everything from photos of herself masturbating and images of other naked women, to threats, while at least one was a hyper-sexual come-on. “What can I do to make it right? Shall I lick your balls?”

Mees allegedly wrote in one email. “Shall we adopt a child?” she wrote in another.

In a third she said: “Hope your plane falls out of the sky.” Well, if Buiter was harboring Snowden in his carry on, this just may have happened.

NY Daily News has more:

 The pair were once lovers — but at some point, the romance apparently soured and Mees unleashed her wrath on her fellow Dutchman. A noted researcher and columnist who speaks five languages, Mees barraged Buiter with an avalanche of emails between July 1, 2011, and Monday.

 

In addition to sending him X-rated images of herself, she sent him a photo of dead birds on May 3.

 

Mees also targeted Buiter’s economist wife, Anne, and children, sending them unwanted messages as well, court papers say. Buiter demanded she stop, and still the loony stalker kept harassing him.

 

Even after Buiter sent Mees a cease-and-desist letter Feb. 27, she allegedly wouldn’t stop, sending the object of her twisted desire several hundred more emails. “Defendant’s actions have caused him severe annoyance and alarm, and fear for his physical safety of his wife and children,” the criminal complaint says.

 

Mees — who once founded a female-empowerment organization called Women on Top — was arrested at 11:45 p.m. Monday.

 

She was arraigned Tuesday on stalking, harassment and aggravated harassment charges. She was ordered held on $5,000 bail.

 

Mees’ Legal Aid lawyer, Vaneshka Hyacinthe, said her client “had a longstanding relationship” with Buiter and “the emails go in both directions.”

 

Manhattan Criminal Court Judge Robert Mandelbaum issued Mees an order of protection and demanded she stay away from Buiter and his family.

 

“Do not call them, do not go to their home, school, businesses, place of employment . . . no email, no text messages, instant messages, no phone calls, letters, fax or voice messages,” the judge said.

 

A doorman at her building in DUMBO, Brooklyn, described her as a generous tipper and frequent traveler who is always seen with her bike and laptop.

So now we know about Buiter's secret life. Now: our kingdom for a few hints from the NSA about the "racy" contents the daily email back and forth between Jan Hatzius and Bill Dudley...