Phisix: Throwing The Baby Out of the Water

``An optimist sees an opportunity in every calamity; a pessimist sees a calamity in every opportunity.”-Winston Churchill

The recent selloff in most of the global equity markets has led some doomsday proponents to pronounce the toxicity of the emerging asset class as evidence by a drop in global forex reserves. They believe that a paucity of liquidity compounded by a US recession would lead to collapsing asset classes or some form of a crisis in emerging markets.

Unfortunately we can’t be convinced by such deflationary recoupling scenario promoted by perma bears simply because such argument has been predicated on the “fallacy of composition” or the generalization of the whole when it is only true for some its parts.

For instance, in the case of Russia which had been used as an example, which we recently also posted in An Epitome of A Full Scale Bear Market:: Russia, the country’s problem has been mostly from the political imbroglio where it got into a military engagement with neighboring Georgia. A compounding factor had been the liquidity crunch and falling commodity prices.

We aren’t seeing the same dynamics here in the Philippines.

Emerging Markets Are Not The Same

As we have repeatedly been arguing, for the Philippines it has not been about the question of risks from a recession, overleverage, oversupply, overvaluation, excessive speculation, stifling new government regulations or taxes, war, or even insolvency as seen in the case of the US or other developed economies.

Nor is it in Brazil whose housing or property industry remains sizzling hot according to the Business.view of the Economist.

For the Philippines despite the announcement of several banks with exposures to the Lehman bankruptcy, we had been right to say that the potential loses from these ‘toxic’ US instruments had been inconsequential relative to the banking industry’s capitalization or assets.

This from the inquirer.net (highlight mine),

``Seven banks in the Philippines have a total of $386 million in exposure to bankrupt US investment banking giant Lehman Brothers, according to the central bank’s estimates, but the banking system is widely believed to be in a good position to withstand the world’s worst financial shake-out.

``Even assuming zero recovery of their exposure to Lehman, the fallout for the seven banks is not expected to exceed one percent of their total assets.

``According to estimates by the central bank, Bangko Sentral ng Pilipinas (BSP), obtained by the Philippine Daily Inquirer, the retail tycoon Henry Sy’s Banco de Oro Unibank has the biggest exposure to Lehman at $134 million, followed by state-owned Development Bank of the Philippines (DBP) at $90 million.

``The BSP data show Metropolitan Bank and Trust Co. (Metrobank) has an exposure of $71 million, Rizal Commercial Banking Corp. (RCBC) $40 million, Standard Chartered Bank’s Manila branch $26 million, Bank of Commerce $15 million, and United Coconut Planters Bank (UCPB) $10 million.

``As a percentage of total assets of the individual banks, the exposures are as low as 0.5 percent and as high as 1.7 percent, according to the estimates, which were discussed at a meeting of the BSP policymaking body, the Monetary Board, on Thursday.”

As we have pointed out the main risk from the external link would come from the extent of foreign selling of domestic assets on the account of today’s mostly US based ‘deleveraging’ process. While there could still be some exposures to ‘tainted’ US financial instruments that may implode in the future, our idea is that this is likely to be material to impact normal business operations of the local banking industry.

Moreover, if some of the estimates are correct that over 50% of portfolio flows to Asia has been redeemed (as pointed out last week) then we are most likely to have seen the worst of the depressed foreign sentiment which leaves us with sympathy selling.

Figure 5: PSE Net Foreign Selling

The Phisix suffered its second worst week of the year which lost 6.93% compared to the week that ended January 18^th which accounted for a 9.57% loss. But relative to the degree of foreign selling, (see figure 5 orange arrows) the amount has been less intense compared to the similar circumstances when the Phisix had been subjected to the same fate.

In fact, last Thursday, which likewise accounted for a 4% drop following a similar decline in the US markets, the Phisix saw significant reduction of foreign selling to the tune of only Php 256 million compared to the daily range of Php 500-950 million a day during the past 2 weeks. This leaves us to hypothesize that mostly momentum driven domestic retail investors “threw out the baby with the bath water” in panic!

Of course, we are not saying the Phisix is riskfree or immune. Any risk from the Phisix would likely come from the political spectrum, if not from inflation or higher food prices, which so far have begun to decline. Of course, the recent concerted central bank pumping of liquidity into the global markets may reverse this decline. But if the global equity asset classes manage to absorb these injections, then the increase in consumer inflation could likely be gradual.

Debating Keynesian Concepts

Besides, we don’t buy into the Keynesian connection that consumer spending drives the economy which leads to the myth that the wilting US consumers will automatically lead to a bust in the emerging markets. As Gerard Jackson of Brookesnews explains, ``consumer demand springs from production, meaning you cannot consume what has not been produced. Therefore when consumers demand goods they are in effect exchanging what they produced for the products of other consumers. This is why the classical school considered money to be a veil that concealed the process of production and exchange from the public eye.”

The notion of a consumer driven economy actually stems from monetary inflation which has a detrimental effect in shaping an economy’s capital structure, to quote Gerard Jackson anew, ``Monetary manipulation not only severely distorts a country’s capital structure by misdirecting production it can also lead to the currency being overvalued which in turn could induce some manufacturers to shift operations offshore when undistorted marketed conditions would have persuaded them to remain in the US”.

And if trade or current account balances signified of the symptom of inflationary monetary policies, then the Phisix hasn’t been in the same shape or conditions as the US enough to unjustly merit a “toxic” grade. Moreover, based on the account of real savings or savings from the actual stuff we produce, the Philippines with its large informal economy equates to a cash based society with minuscule leverage applied, meaning much of our economy has been based real output than from the influences of distortive monetary policies.

Besides, much of the angst from the past Asian financial crisis still lingers, as evidenced by the minimal exposure of the banking system to rubbish US papers and conservative lending schemes by the banking system.

Moreover, valuations in Asia ex-Japan have nearly fallen to its multi-year “floor levels” which may translate to a looming bottom, see figure 6.

Figure 6: Matthews Asia: Asia’s Valuations Near Extreme Lows

To quote Robert J. Horrocks, PhD of Matthews Asia, ``the “decoupling” term has done a disservice to the entire economic debate. It has given the impression that economies must sever their links, and has denied the possibility that countries might simply transform their relationships whilst remaining close. The failure then of the world to decouple has lead to an overemphasis on the short-term decline in earnings and the worry that Asia will follow the U.S. into recession. Valuations in Asia have collapsed from the overexcited levels of late last year to far more sober levels that capture little of the exciting prospects for Asian growth. As such, they provide a long-term investor with a decent margin of safety. Framing the argument properly, I believe, helps to see the opportunities more clearly.” (highlight mine)

Like Mr Robert J. Horrocks, we have often stated that the decoupling recoupling debate is nothing but an invalid abstraction detached from the reality of the globalization process. And that from a valuations viewpoint, Asia has reached extreme lows and apparently has become detached from the real economy.

So while there might be additional sympathy selling pressures arising from the impact of the US financial crisis, this could be seen as opportunities from the facets of margin of safety to accumulate than to join the bandwagon of running for cover. Because markets are emotionally driven over the short term, they can always overshoot to the upside or the downside.

Recommendation: A Tradeable Rally Ahead?

Finally, some indicators suggest that we could have likewise bottomed out over the interim and a tradeable rally could be in the offing.

One, the restrictions on short selling of 799 financial stocks in the US and also adopted in the UK has moved the equity markets in seismic proportions last Friday. This should translate to a strong open in the PSE at the start of the week. However the effects from restriction curbs tend to be short term.

Two, as pointed out in my recent blog, Fear Index Pointing To Tradeable Rally Ahead?, each time the VIX or Fear Index peaks at above 30 it is usually followed by a bearmarket rally. The VIX or fear index hit a record high last week signifying outsized fear.

Three, the Phisix is coming from an oversold level, which means there could be more room for more upside traction.

So far, the recent lows have held its ground, giving us a clue of the possible strength of the aforementioned support level. The longer the Phisix maintains such support level the stronger it becomes.

Fourth, massive injections of bridge financing by global central banks tend to induce a period of lull following the recent turbulence. In addition, the proposed resurrection of the Resolution Trust Company RTC type of rescue package will entail a huge cost to US taxpayers. Over the longer perspective, this could lead to some capital reallocation of Asian capital to within the region and,

Lastly, any forthcoming rally, which would probably coincide with the closing of the seasonally weak September, may strengthen our case for a yearend rally.

Inflation-Deflation Tug of War

Amidst the conservatorship of Fannie and Freddie, the rescue of Bear Stearns AIG and the bankruptcy filing of Lehman Brothers, credit markets continue to seize up on a global scale in manifestation of the rapid tightening credit conditions, aside from mounting loss recognition and forcible “deleveraging” liquidation as part of capital raising and shrinking of balance sheets by affected financial institutions which has resulted to the current downside volatility and staggering losses in global equity markets.

Courtesy of Danske Bank

A symptom of credit shortage can be found in the chart above courtesy of Danske Bank, one of the interbank rates used for stress testing (the Euribor-Overnight Indexed Swap). Importantly, the problems are obviously manifest in US Dollar denominated money markets, which of course, has been the epicenter of today’s crisis episode. Such dearth of “US dollars” available for credit have lent to the recent spike of the US dollar’s value which deflation proponents label as funneling to the “center”, aside from of course, the repatriation of US dollars to shore up foundering balance sheets of US financial institutions.

This very fitting quote from Bloomberg, ``“There’s a complete lack of faith in the markets,” said Jim O’Neill, chief economist at Goldman Sachs Group Inc. in London. “There’s a lot of cash hoarding and people losing trust in banks, so the central banks are acting to relieve that. This might not be the last time they have to act.”

Such activities characterize deflation.

So on one hand you’ve got market forces unraveling the malinvestment from the previous credit bubble, which left leaning ideologues describe as “market failure” (which has actually been more government induced-via monetary policy and special privileges; besides capitalism includes profits and losses and not only profits).

On the other hand, global governments fearing a collapse to outright deflation have worked double time to reflate the world markets.

First, by massive bailouts-despite the overextended balance sheets of the US Federal Reserve.

courtesy of the New York Times

According to the New York Times (highlight mine),

``The Fed’s balance sheet, moreover, is being stretched in ways that seemed unimaginable one year ago. As recently as last summer, the central bank’s entire vault of reserves — about $800 billion at the time — was in Treasury securities.

``By last week, the Fed’s holdings of unencumbered Treasuries had dwindled to just over $300 billion. Much of the rest of its assets were in the form of loans to banks and investment banks, which had pledged riskier securities as collateral.

``In a sign of how short the Fed’s available reserves had become, the Treasury Department sold tens of billions of dollars of special “supplementary” Treasury bills on Wednesday to provide the Fed with extra cash. The Treasury sold $40 billion of the new securities on Wednesday morning and will sell $60 billion more on Thursday. More money-raising is sure to follow.’

Harvard Professor and former IMF Chief Economist Kenneth Rogoff estimates that the US would need $1 trillion in rescue package (some say more).

And next, by the unprecedented concerted global central bank actions to provide humungous liquidity to the marketplace in order to hold down interest rates.

courtesy of the Wall Street Journal

This from the Wall Street Journal, ``The Fed boosted its currency-swap lines -- through which it gives foreign central banks access to U.S. dollars -- by $180 billion, to allow central banks to meet fierce dollar demand from commercial banks outside the U.S.

``The Fed added a record daily total of $105 billion in temporary reserves into U.S. money markets, while the European Central Bank injected an extra €25 billion ($35.88 billion) in one-day funds. The Bank of Japan injected the equivalent of $24 billion into the local yen money market, and the Bank of England offered an extra £25 billion ($45.54 billion) in short-term funds. Monetary authorities in Hong Kong, India and Australia also stepped in with cash injections.”

So global central banks are today creating a tsunami of “money from thin air” to keep afloat the global asset markets from their natural reaction to overleverage, oversupply, overspeculation and massive malinvestments.

Of course, treating insolvency with massive liquidity ain’t likely gonna solve the problem as this has not been the first time global central banks have injected liquidity ever since the credit bubble crisis surfaced last July of 2007.

And worst, it could lead to a next problem. The unintended consequences of generating the next bout of inflation.

Quoting CLSA’s Russell Napier (source fullermoney.com),

``Let's get to the bottom line. A deleveraging process is under way. It can happen against a background of bankruptcy, deflation, declining cash flows and bank bankruptcy or in a slower way against a background of inflation. Both reduce the debt burden, but one is socially jarring and led in the past to mass unemployment and arguably WWII. Democracies will choose the inflationary approach. This is not evident today, but it will be more evident soon enough as the BoJ, ECB, BoE and others realise that their current monetary policy is driving them not to slower growth and lower inflation but to deflationary calamity. Today, you can see the calamity of the deflationary disease but what will you see tomorrow, or the day after, if the monetary cure pours from the medicine jars of the global central banks? (emphasis mine)

Will The Proposed Ban of Short Sales Support Global Markets?

The US SEC is said to be contemplating to impose a temporary ban on short selling (CBS).

A ban on short selling is another form of price control. How? Because short selling to quote Gary Galles of Mises.org, “increases the number of people with an incentive to discover valuable information about firms' prospects, by providing an added mechanism to benefit from information that turns out to be negative. When someone's research or information leads them to negative conclusions about a firm, short selling allows them to communicate their less optimistic expectations to others and make a profit if they anticipate the direction the market will later come to agree with. That is, they profit only if they come to "correct" conclusions before others. In the process, they benefit others by revealing accurate information sooner than would otherwise be the case, reducing the mistakes people would have made from relying on the less accurate prices that would otherwise exist.” In short, a ban on short selling, attempts to inhibit price discovery.

It could be also seen as a form of “market manipulation” except that it is done by governments.

Of course, because curbing short selling means covering all existing short positions, the initial impact would be for the markets to soar. However, like in the recent example, where the US SEC banned short selling on 19 financial stocks last July 21^st,(but announced on July 16^th)…

Short term gain-long term woes

...the "soothing" effects proved to be temporary- for the Dow Jones Industrials, bank, financial and broker indices. Eventually market forces reasserted themselves by exposing the fallacies of camouflaging inherent weaknesses of why these stocks /market have been falling in the first place.

We never seem to learn.

The issue here is about financial system “insolvency” in the US and a ban on short sales will be a quick fix which is likely to only prolong the agony.

Incredible Pictures: The World In A State of Panic!

September 17-18 should be a milestone of sorts as world markets freezes in panic.

This From Bloomberg,

``U.S. Treasury three-month bill rates dropped to the lowest since at least 1954 on concern that credit market losses will widen after the bankruptcy of Lehman Brothers Holdings Inc. and the federal takeover of American International Group Inc.

``Investors pushed the rate as low as 0.233 percent as the loss of confidence in credit markets deepened. Reserve Primary Fund, the oldest U.S. money-market fund, became the first in 14 years to expose investors to losses after writing off $785 million of debt issued by Lehman.

3 month US Treasury Bill

Everyone (public and private entities) seem to be scampering for the exit doors to the point of buying short term treasuries that almost yield nothing.

Yet, one sided trades like this are vulnerable to sudden sharp reversals.

London-Interbank Offered Rate - British Bankers Association Fixing for US Dollar.

Bank Lending in terms of Libor. Again from Bloomberg, ``Money-market rates jumped this week as lending between banks seized up. The London interbank offered rate, or Libor, that banks charge each for three-month loans rose the most since 1999, to 3.06 percent, the British Bankers' Association said.”TED Spread

Seen from spread of Treasuries relative to bank lending rates, another quote from Bloomberg, ``The difference between what the U.S. government and banks pay to borrow in dollars for three months, the so-called TED spread, widened to the most since the October 1987 stock-market crash as bill yields tumbled. The spread widened as much as 64 basis points to 283 basis points. It was as low as 75 basis points on May 27.” Awesome.

This credit seizure episode has now spilled over to Asia!

Again from Bloomberg,

``Credit-default swap indexes in Australia and Asia outside Japan traded at all-time highs after the cost to protect against a default by Morgan Stanley and Goldman Sachs Group Inc. rose to records in New York yesterday. Default swaps rise as perceptions of credit quality deteriorate…

``The Markit iTraxx Australia Series 9 credit-default swap index traded 40 basis points higher at a record 235 basis points today and was at 225 basis points at 12:15 in Sydney, JPMorgan Chase & Co. prices show…

``The Asian benchmark that tracks 50 investment-grade borrowers outside Japan jumped as much as 30 basis points to a record 240, ICAP Plc prices show. The Markit iTraxx Japan index increased 31 basis points to 200 according to prices from Morgan Stanley…

MSCI Asia Pacific Index

So it does not put a doubt that credit woes have likewise tainted other assets as Asian equities seen above.

The MSCI Asia Pacific Index have fallen to a three year low!

An Epitome of A Full Scale Bear Market:: Russia

Russia's financial market seems to exhibit what we might call a full scale bear market.

chart courtesy of Danske Bank

We previously featured part of this in our previous post " A Government Cardinal Sin That Results To A Bear Market? War!"

Collapsing equity and currency markets, soaring interest rates as funds flee, and declining currency reserves hallmark a true bear market. Major contributing variables: Russia's recent military activities in Georgia, falling oil/energy/commodity prices, global deleveraging and rising risk aversion.

Fear Index Pointing To Tradeable Rally Ahead?

Markets are being whacked globally in the aftermath of the combined troubles plaguing the US financial industry, particularly Lehman bankruptcy, Bank of America’s buyout of Merrill Lynch, aside from the capital raising and credit rating of insurer AIG.

There seems to be so much fear in today’s market climate.

One of the popular measure of Fear is the VIX index as defined by Wikipedia, ``VIX is the ticker symbol for the Chicago Board Options Exchange Volatility Index, a popular measure of the implied volatility of S&P 500 index options. Referred to by some as the fear index, it represents one measure of the market's expectation of volatility over the next 30 day period.”

During the past year each time the VIX spiked beyond 30, the markets tend to temporarily bottom and usher in some short term “rebound” as shown below…

The blue vertical lines point to the historical “peaking” activities of the VIX index.

The temporary bottoms which it coincides with have been followed by rallies as shown by the trend lines of the S&P and the Phisix. But the important point is that the scale of past rallies have differed, of which is a very important determinant of the viability of the trade proposition.

Bottom Line: Further selling pressures could translate to “short term trading windows” for the Phisix. At the risk end, these may seem like "catching falling knives"; but given a longer term perspective, opportunities seem to present itself as buying at fire sale levels.

Today's Phisix Carnage (4% Drop): More AIG Than Lehman?

First of all I don’t think today’s 4% massacre of the Phisix which was a vicious blue chip selling was mostly about Lehman.

 

I suspect this to be more of AIG-driven.

 

Look at today’s news from CBS,

 

``Friday, the firm said it was reviewing its operations and that "everything was on the table," suggesting it might sell assets to raise capital and avoid a crippling downgrade. Standard & Poor's said it might cut its rating if AIG didn't take steps to shore up its business.

 

``Aside from potential asset sales, AIG is also seeking to raise more than $10 billion in capital, the Journal said. AIG has already raised about $20 billion in 2008.

 

``AIG shares slumped a record 31% Friday on concern the world's largest insurer may be downgraded by ratings agencies, triggering billions of dollars in new capital needs.

 

``Standard & Poor's put AIG's ratings on CreditWatch with negative implications, suggesting the agency may downgrade the insurer in the future.

 

``"Additional market value losses will place some strain on the company's resources," Standard & Poor's credit analyst Rodney Clark said in a statement. "AIG's potential access to the capital market may be more restricted in the short term."

 

One, compared to Lehman, AIG has direct exposure to the Philippines, which means any emergency fund raising from the mother unit would most likely involve directing its offshore treasury units to sell its most liquid holdings elsewhere (including the Philippines).

 

Second it’s all about timing. The news says AIG’s declaration to “sell assets to raise capital” was announced Friday. The amount of foreign selling today (Php 840 million) was almost to the same degree from last Friday (Php 749 million). But today’s action reflected more of the urgency to exit which almost falls squarely with sentiment reflected in the news report.

 

Of course this is just a suspicion.

Why Doomsday Forecasting And Bad News Sells: Learning From the Black Hole Machine Experience

``You gain strength, courage, and confidence by every experience in which you really stop to look fear in the face. You are able to say to yourself, 'I have lived through this horror. I can take the next thing that comes along.' You must do the thing you think you cannot do." -- Eleanor Roosevelt (1884-1962) former First Lady of the US

Bad news does sell! It had been a fortuitous event to have seen it happen first hand. And it was not just bad news, but a sci-fi version horror story as well.

It was not to my expectation that such an article would command tremendous response when I posted at my blog in the late afternoon of September 9^th, about the next day launching of the world’s largest ever scientific experiment called the Large Hardon Collider (LHC).

“Doomsday” was the battlecry of some the critics, see Will Tomorrow Be Doomsday? “Black Hole” Machine Switches On., who vehemently argued that any glitch encountered from such experiment could lead to an insurmountable growth of man made “black hole” that would eventually “consume” the world; our real time Armageddon.

And I thought of sarcastically relating such theme to the financial world: Financial pundits promoting for a global meltdown/depression could have perhaps wrongly premised their theme-instead of selling for financial or economic reasons, selling should have been recommended as the best approach to monetize on everything we own to enjoy the last moments of our lives (that is if there would be any buyers at all).

Figure 1: sitemeter.com: BAD News/Horror Story Causes Readership Spike!

When I checked on my blog counter (sitemeter.com) on September 10^th, I was stunned by the number of hits (which had spiked by fourfold) registered mostly from the said article as shown in Figure 1.

It was enough proof that many people can be easily swayed by horror stories!

Why People Love Horror Stories or Bad News

Some scientific research shows that the attachment/addiction to horror movies are partially due biological reasons such as “anxiety disorders” which carries either a genetic component or influenced by the environment where the trauma from horror movies results to the “release of opiate enorphins” or the revving up “the body's sympathetic nervous system” (Swedish.org).

Others say that scary movies could represent our legacy of “tribal rite of passage.” Dr. Glenn Sparks of Perdue University quoted by medicine.net ``There's a motivation males have in our culture to master threatening situations," Sparks says. "It goes back to the initiation rites of our tribal ancestors, where the entrance to manhood was associated with hardship. We've lost that in modern society, and we may have found ways to replace it in our entertainment preferences". In other words, enduring hardships (from horror movies) implicitly signifies as kind of psychological “ego” booster.

For others, it’s all about our alternative emotional safety valve outlet or other means to ease our aggressive impulses. From MSN’s celebrated financial pundit Jim Jubak,

``Sigmund Freud, Carl Jung and Bruno Bettelheim all theorized that we read fairy tales about evil stepmothers, parental abandonment in dark woods and child-eating witches to help us express and then cope with our darkest fears.

``The psychological value of these tales, in this theory, lies in the formulaic, repeated return to archetypical fears in what the reader knows -- even a reader as young as my 6-year-old daughter -- is a fiction. It also helps that, unlike real-life horrors, these tales usually have happy endings.”

Or similarly, why does bad news sells?

It can be little bit of Schandefreude (finding delight on other’s misery) or the release or ease of one’s stress by knowing of the suffering of others or social sympathy (misery loves company?) or occasionally “bad news is better than no news” (sciencedirect.com).

Overall, bad news or horror stories easily connect to the base human emotions of fear or anxiety or insecurity. These psychological aspects represents as an easy way to sell information (or even TV programs -e.g. reality TV as Fear factor!).

What lessons can be learned?

Incidentally, my blog (inspired from kiddy blogs then) had been originally setup for archiving purposes (where I can retrieve or search back issues faster) and secondarily, for public consumption. Although I’ve got a relatively small readership base, I hardly thought of it as a business model until the ad sponsorships came (yes, now I am also open to write for company blogs who are in need of outsource writers). Furthermore, I am delighted to see a small but increasing trend of readerships.

Nonetheless, since we knew that bad news sells all along, and if I were to simply aim for more readership in order to expand on my business model, then I would have concentrated on drilling on the bad news theme. But again, since my primary goal is to be profitable in financial market space, I would commit to assiduously to work on to be as objective as possible.

Famed self improvement author Dale Carnegie once said, ``When dealing with people, remember you are not dealing with creatures of logic, but creatures of emotion." (highlight mine)

Emotions such as fear, insecurity and anxiety can be used as Core Buying Emotions (CBE) or from a marketing perspective, a purchase trigger mechanism that could move people into action.

For some, doomsday forecasting can be an attractive CBE platform to promote one’s business. Whether or not such theme could be real world applicable isn’t perhaps the main concern by such promoters, but the business or popularity that could be generated from adhering philosophically to such dire scenarios.

The Black Hole Machine Encounter and Possible Investment Themes

As for the LHC or the “black hole machine”, we are not science experts to agree to disagree with the argument of the risks of its operation. One thing we know is that if the dissenters are right there won’t be anyone left to argue against it since we’d all be gone.

However from the benefit side, the Large Hadron Collider is suppose to uncover the underlying structure of the universe; the Higgs boson “elementary particles cause matter to have mass”, validity of the Grand Unification Theory (are electromagnetism, strong nuclear force and weak nuclear force a single manifestation?), existence of the superstring theory (quantum gravity) and dark matter and dark energy [Yes I am glad to learn that if scientific observation is accurate, the latter two forces dominate the Universe, from the BBC, ``The latest astronomical observations suggest ordinary matter - such as the galaxies, gas, stars and planets - makes up just 4% of the Universe. The rest is dark matter (23%) and dark energy (73%)].

Not only that, the LHC project will allow us to “accelerate computing cycles” (sciam.com) for “safely storing and then processing huge amounts of data” (guardian) which should revolutionize the way we utilize the internet and vastly enhance the research capabilities in the world of science.

In short, from an investment perspective, the LHC could be the nexus or the springboard for the next generation technology BOOM and a great enhancer of the lives of our children and hopefully including us, if scientific discoveries arrive on time and at affordable costs.

Fannie And Freddie Bailout Designed To Save The US Dollar Standard System

``Over the past few years, the Agencies were central to the process that brought the emerging world’s savings to the US housing market. And governments were involved every step of the way. When the world’s central banks (and other big bond investors) decided that the implicit US government backing for the Agencies wasn’t enough, the US government had to make the backing explicit.”-Brad Setser, Council of Foreign Relations, So true …

 

It was a highly volatile market out there this week.

 

The initial salvo was wild cheering from global equity markets on the recent action by the US Treasury to take its Government Sponsored Enterprise (GSE)-Fannie Mae and Freddie Mac- into “convervatorship” (quasi-nationalization). However, the festiveness quickly dissipated when the realities of “a weakening global economy”, the ramifications from the credit event of the F&F takeover on the Credit Default Swap Market and concerns over the persistent deterioration of US financial conditions as manifested by the lackluster capital raising quandary by Lehman Bros, which until recently, was the 4^th largest investment bank in the US, sunk into the consciousness of global investors which resulted to a retreat from most of the earlier gains.

 

The conservatorship program includes the taking over of management control of Fannie and Freddie (F&F) by its regulator the Federal Housing Finance Agency (FHFA), where common and preferred stock would be diluted and not eliminated. The takeover now alters the corporate objective of the GSEs to “improving mortgage financing conditions” from “maximizing common shareholder returns”.

 

The program also includes capital injection into the GSEs by US Treasury and FHFA to maintain the positive net worth of these agencies in order to fulfill its financial obligations, where in exchange the US Treasury receives “senior” preferred equity shares and warrants aimed at securing solvency.

 

Aside, a new credit facility designed to secure liquidity concerns will be introduced to backstop F&F and Federal Home Loan Banks, and which is set to expire on December 2009. Lastly, a temporary program will also be put in place to acquire GSE Mortgages in order to secure market liquidity of mortgage securities also slated to expire on December of 2009.

 

For starters, Agency securities are one of the world’s most widely held securities by both private and the public sectors (Sovereign Wealth Funds and Central banks).

 

Morgan Stanley’s Stephen Jen has a great breakdown on these (highlight mine),

 

`` Total foreign holdings of long-term USD securities increased from US$7.8 trillion in 2006 to US$9.8 trillion in 2007, with US$1.3 trillion of this annual increase from increased foreign holdings of US long-term debt securities, including US Treasuries, agencies, agency ABS and corporate bonds.  Foreigners are dominant in some of these markets.  For example, some 57% of the marketable Treasury securities are held by foreign investors. 

 

``Foreign investors’ appetite for US agencies – both straight agency debt and agency-backed ABS (also called agency pass-throughs) – has risen sharply.  (Fannie Mae and Freddie Mac (F&F) are government-sponsored enterprises (GSEs) with two main activities.  First, they securitise mortgages by converting conforming mortgage loans into tradable mortgage-backed securities (MBS).  Second, they have an ‘investment portfolio’ business, whereby they issue AAA rated agency debt to finance the holding of MBS or other assets.  The latter is a ‘carry trade’, capitalising on the then-implicit government guarantee.  One key part of the policy discussion regarding F&F is whether their second activity is justified.)   Of close to US$7.5 trillion in outstanding US agency debt and agency-backed ABS, some US$1.54 trillion (according to Fed flow of funds data, June 2008) is held outside the US, with China, Japan and AXJ being the largest holders of these securities, with US$985 billion of this latter figure held by foreign central banks. (The share of total US long-term securities held by foreign investors has more than doubled since 1994 (from 7.9% of the US$16 trillion in securities back then to 18.8% of the US$49 trillion outstanding as of 2007).” 

 

We featured a chart on the composition of foreign holdings of the F&F in Inflation: Myths And Beneficiaries. Nonetheless, private ownership of Agency backed papers appears to have stagnated since 2005 while foreign public ownership has steadily increased as shown in Figure 2.

Figure 2: Northern Trust: Foreign Public-Private Exposure On F&F

 

In perspective, aside from foreign holdings GSE debt securities are likewise owned by US households and institutions or financial entities as commercial banks, savings banks, credit unions, pension funds, life insurance companies mutual funds, brokers, ABS issuers and REITs.

 

However, as % of total outstanding debt, in 2007 ownership of GSE debt in pecking order: foreigners comprise 19.92%, followed by commercial banks 13.87%, households 12.06%, mutual funds 7.67% and ABS 5.13% (Northern Trust).

 

So when US Secretary Paulson was asked of the US government’s takeover of F&F, his reply as quoted by the Washington Post,

 

``"The U.S. government had no choice," he said.

 

``Mr. Paulson, in an interview with CNBC on Monday, said foreign pressure was not the "major driver" of the takeover, but acknowledged that "there's no doubt that there's fragility in the capital markets."

 

``"These companies are so big, and they are owned by investors all around the world. You are obviously going to get concerns," Mr. Paulson said. "It was definitely concerning overseas, but there was concern in this country. I tell you, my phone is ringing the most from investors here." 

 

This means the US financial system have reached a near calamity. 

 

However many had been quick to lash at the “conservatorship” program as virtually a bailout of foreign owners of agency securities.

 

While this perception seems partly correct, I think most of these critics ignore the fact that these actions basically signify a remedial patchwork to the emerging cracks at the Fiat Paper Money “US Dollar” standard system. The massive current account imbalances a common feature in today’s world tends to amplify on the systemic flaws especially amidst today’s heightened volatility.

 

At present, countries with current account surpluses at one side of the ledger need to be offset by countries with current account deficits at the opposite side. As an example, deficits of the US have been more than sufficiently covered for by capital flows from mostly emerging markets paving way for the unorthodox pattern of “Poor countries Financing The Rich”.

 

Yes, while various politicians and experts from around the world have boisterously decried about “social inequality”, unknowing to most is that such inflationary “inequality” mechanism appears to be the imbedded on the US dollar standard platform. Think of it, while profits are privatized, losses are socialized! Wall Street’s politically connected gets rescued, while the masses pay for the mess created by the former. The failed F&F model was demonstrative of the Keynesian brand of capitalism and not of the laissez faire genre. (Please don’t associate the fiat paper money standard as epitomizing laissez faire or free markets too. Same with currency markets, interest rate markets or even oil markets! These markets are controlled heavily by governments notably on the supply side. As an aside, the “anarchy” in the Shadow Banking System wasn’t symptomatic of a free market mess, but one of going around banking regulations or taking advantage of “regulatory loopholes” in order to take on added leverage by assuming more risk to magnify returns by the establishment of off-balance sheet Structured Investment Vehicles (SIV). Going around loopholes do not signify free market paradigms).

 

Going back to the unorthodox pattern of “Poor countries Financing The Rich”, during the gold standard, current account imbalances had effectively been curtailed by the shifts in the gold reserves by nation states engaged in trade. This essentially accounted for as an automatic adjustment mechanism, which is absent today under the digitalized and unlimited printing capabilities of central banks to churn out money “from thin air”.

 

And as we noted above, current account imbalances today need to be offset. During the recent past, the nations with current account surpluses signified as subsidies to domestic export-oriented industries but came at the expense of domestic consumers, i.e. China, Asia and other emerging markets. On the other hand, current account deficit nations run subsidies on domestic consumers via expanding domestic debt (financed by current account surplus countries) at the expense of domestic production. From which the transmission mechanism had been mainly via currency pegs or dollar links.

 

The foreign buying of agency papers or US debts were meant to sustain mercantilists’ policies by frontloading currency and interest rate risks in order to keep the exchange rate undervalued and thus promote domestic export oriented industries in order to expand employment. Hence, the currency manipulation policies that led to the current account imbalances had primarily been meant as a tool to manage domestic political risks.

 

In other words, the US dollar standard system paved way for political imperatives over economic goals, see figure 3.

Figure 3: Asianbondsonline.com: China-US yield curve

 

What sense would it make for a current account surplus country as China to buy or load up on assets of a depreciating currency, thereby suffer from currency loss? What sense too for current account country as China to buy assets whose yield is less than what is offered domestically, thereby suffer from opportunity cost of low interest rate spreads (assuming holding bonds until maturity)? And this has been going on for years!

 

The same for deficit countries, domestic consumers had been financed to go into a debt driven asset buying binge which resulted to overleveraged driven massive speculation, again for political goal of sustaining finance driven economic booms, where the demand from domestic consumption boom has greased the industries of current account surplus countries as China and emerging countries.

 

The US dollar, functioning as the world’s de facto currency reserve currency, has fundamentally been used by the US government to freely load up on debt, given its special privilege to underwrite from its own currency, by selling almost unlimited financial claims to international investors to finance such speculative unsustainable booms.

 

And as the US real estate and financial boom has basically unraveled, all these seem to be in a transition.

 

Recently there had been some signs of reluctance of nations with current account surpluses to stack up into agency papers. Of course, the recent actions by the US Treasury may seem to have assuaged the concerns of repayment by buying more into US treasuries instead of agency papers.

 

So what can we see from all these?

 

One, current account surpluses nations or foreign central banks seem to have the tolerance bandwidth, given their accrued currency reserves, to suffer from the risks of currency and interest rate losses provided they get repaid for holding these securities until maturity. I guess the actions by the US treasury may have answered such “repayment” concerns.

 

Two, foreigners which have been formerly financing the US real estate securitization boom appears to be bailing out, if not help tacitly ‘nationalize’ the structurally beleaguered industries by buying into agency papers until recently.

 

It also reveals of the extent of overdependence or vulnerability of the US on relying on foreign financing. The risk seems such that if foreign central banks or state owned Sovereign Wealth Funds or affiliated institutions would deem to have accumulated more US dollar reserves than what they might think is required, and change their priorities by reducing finance exposure to the US, which can even lead to more volatility in the US. Political factors can also hold sway to the appetite of foreign financing of US deficits.

 

In addition, understanding its present predicament and limitations, the “capital short” US government seems to be working feverishly to attract or to intermediate for foreign capital participation into buying out its besieged financial institutions. Example, a syndicate led by UK’s 3^rd largest bank, Barclay’s along with a “club rescue” team of “Temasek of Singapore and China Development Bank, was reportedly have shown willingness to back a deal that would put Barclays in the top tier of financial institutions.” (timesonline.co.uk)

 

Three, it’s all about the increasing integration of geopolitics or the decreasing hegemony of the US, as seen in the “Poor financing the Rich” aside from “Autocratic and non-democratic states financing democratic countries”!

 

Some Poor but Autocratic/non democratic nations that have been a beneficiary to the ongoing wealth transfer appear to have accumulated enough political clout as to weigh on the internal political policymaking of the US. 

 

Remember this quote from Yu Yongding, a former adviser to China's central bank quoted last in our Will King Dollar Reign Amidst Global Deflation? ``If the U.S. government allows Fannie and Freddie to fail and international investors are not compensated adequately, the consequences will be catastrophic, if it is not the end of the world, it is the end of the current international financial system.” The recent political actions employed by the US government appeared to underscore such circumstances and Mr. Yu’s prayers seems to have been answered.

 

Or how about Russia’s recent military offensive against Georgia (as discussed in Toynbee’s Generational War Cycle: In Mindanao or In Georgia/South Ossetia?) which has practically left the US as a political nonparticipant to a besieged ally?

 

This only goes to show how the US looks to be losing its imperial edge over the global geopolitical economy and how the US dollar standard system appears to be in greater jeopardy.