sábado, octubre 19, 2013



Gold Fails To Obey Script

Oct, 18 2013, 18:53
In our interim update on gold a few days ago we wrote:
"It seems possible that news of a budget and/or debt ceiling deal could send gold prices even lower, but the likelihood of that happening is actually not as pronounced as it would have been if prices had risen during the current period of uncertainty.
Usually either the rumor is bought and the news are sold, or vice versa. Cases of 'sell the rumor and then sell the news as well' are generally fairly rare."
It should be remembered in this context that gold was supposed to follow a certain script in the context of the debt ceiling debate, written by Goldman Sachs analyst Jeffrey Currie and given the placet of analysts at virtually every mainstream bank:
"Once we get past this stalemate in Washington, precious metals are a slam dunk sell at that point," Currie said. "You have to argue that with significant recovery in the U.S., tapering of QE should put downward pressure on gold prices."
The markets rarely make things that easy, although one must of course keep in mind that the action over a few trading days cannot yet be called conclusive with regard to the medium term trend. In this particular case, shorts thought they had received an invitation to shoot fish in a barrel, but the market evidently decided otherwise.
(click to enlarge)
Gold, December contract daily - following a false breakdown, the contract shot higher upon the budget deal resolution.
As the above chart shows, while the especially smart bears who thought they could break gold below short term support by selling over $600 million notional on GLOBEX prior to regular COMEX trading hours had their clock cleaned, the bulls cannot yet claim a decisive victory either. Still, they have won an important battle. Here is a close-up of the action:
(click to enlarge)
December gold, 30 minute chart.
The biggest positive is in our view the "false break" highlighted above. Selling thousands of contracts in the "off hours" has this time not been enough to actually break support. When a market isn't going down when it "should," it often goes up instead. This is an excellent example for this rule. However, bullish traders require some follow-through buying at this juncture to produce a decisive trend change. There is strong lateral resistance in the 1340-1350 area, and it needs to be overcome to pronounce the trend truly changed.
Interestingly, as can be seen in the chart of 1 month GOFO (gold forward rate) by Societe Generale below, the gold forward rate has once again turned into negative territory in the London market. While this is not quite as significant as some people have asserted in light of extremely low LIBOR rates, it is still remarkable - moreover, negative GOFO rates alwaystend to provoke rallies in the gold price in the short term. There simply are no exceptions to this rule we know of.
Normally, gold is lent out in order to obtain collateralized dollar loans at a very low interest rate, as the lease rate paid on gold is deducted from LIBOR in these transactions. The situation actually reverses when GOFO is negative, as then whoever is on the other side of the trade actually paysfor obtaining the temporary use of gold. Why would anyone want to do that?
We believe the answer has to do with the fractionally reserved gold system involving unallocated gold accounts (i.e., irregular gold deposits). According to what must be considered quite credible estimates, the leverage employed can be as high as 100:1 - which is to say that unallocated gold accounts are backed by only a single ounce of gold per 100 ounces deposited.
The remainder of the deposits has been employed by bullion banks for their own business purposes - it is essentially fractional reserve banking, only it is using gold as the underlying currency. So what happens when delivery demands or demands to move gold from unallocated to allocated accounts exceed the amount of physical gold actually at hand? One way to satisfy such delivery demands in the short term is to borrow gold. So we suspect - although we cannot prove it - that this is why GOFO has turned negative.
(click to enlarge)
One-month GOFO turns into negative territory again.
We also like that Thursday's rally was greeted with incredulity all around. A friend sent us the following smattering of quotes from the mainstream financial press. We especially like the guys who just know that the "gold bull market is definitely over":
"The markets had anticipated a last-minute compromise of this kind," says a note from German investment bank and bullion dealers Commerzbank. "What is more, this also means that the scaling back of Fed bond purchases will be further postponed. A renewed sell-off of precious metals thus failed to materialize."
Issued before the debt-limit fix, "Resistance lies between 1301 and 1307," said Scotiabank's technical analysis Wednesday night, pointing to gold's 50% retracement of both its 2008-2011 uptrend and this year's June-August rally.
Longer-term, however, "Desire to buy gold as a hedge against the consequences of monetary policy has diminished," reckons Credit Suisse analyst Tom Kendall, who in February announced the "beginning of the end of the era of gold."
"When you've got other asset classes, equities in particular, doing so well, then it's hard to divert investments out of them and into something like gold, which is falling."
"A lot of gold," agrees Robin Bhar at Societe Generale, also speaking to Bloomberg today, "has been held for speculative purposes, investment and a store of value, and that's less of a reason going forward.
"If you sell your gold and put your money into equities, other fixed-income assets or real estate, you're going to show a return. The gold bull market is definitely over."
But "although the US has managed to avert a default," counters Nic Brown's commodity team at French investment and bullion bank Natixis, "it has clearly lost some credibility" with foreign creditors led by China. Not only did Washington's behavior annoy T-bond holders, says Natixis, "a concrete long term solution has once again failed to emerge."
(emphasis added)
And so it goes - we are going to keep these quotes for reminiscence purposes.
Gold Stocks
Yesterday the HUI gapped up above its 20-day moving average. We have become a bit wary of such gaps, but want to point out that the action so far looks quite similar to what happened in early July. Even today's pullback is reminiscent of the action following the gap up in July.
Whether the similarities will continue we cannot say, but we do like the fact that the index has done what it was expected to do in view of the wedge-like decline that preceded the recent rally.
(click to enlarge)
HUI daily - now we have an MACD buy signal as well, tentative though it may be.
Also worth noting is that in spite of gold's very strong rally, the HUI-gold ratio continued to improve somewhat:
(click to enlarge)
HUI-gold ratio still improving - and the recent move to new lows is beginning to look like a false breakdown as well.
So here we have another "false breakdown" in terms of the ratio of gold stocks to gold and obviously it would be quite encouraging if it manages to hold up.
As before, we cannot yet say whether a trend change is definitely in the bag. However, considering how absolutely dismal sentiment on gold is, considering the many similarities to the 2008 "retest" that could be observed recently (back then, gold was also declared "dead" by the mainstream) and given the fact that for a change, the gold market has not acted in the way that was widely expected, it continues to make sense to look for more signs of a trend change to emerge.
Ideally declines should continue to be kept in check by support at $1,275, while any rally that manages to exceed the $1,350 level on a closing basis and confirmed by the gold stock indexes can probably be interpreted as a sign that the short to medium term trend has finally reversed for good.

sábado, octubre 19, 2013


Terminal Phases

October 18, 2013 

Record highs for the S&P 500, the S&P 400 Midcaps, and small cap Russell 2000. Upon this week’s legislation to reopen the government and raise the debt ceiling, the President stated that there were “no winners.” Yet equities (and, more generally, financial asset) investors and speculators did just fine. This week saw the S&P500, the S&P 400 Mid-Cap Index and the small cap Russell 2000 all trade to record highs. The week’s 2.8% advance increased the small caps’ year-to-date gain to 31.3%. Google added about 140 points and $38.5bn of market cap this week (to $338bn) to reach an all-time high (up 43% y-t-d). The more speculative “beta” stocks continue to outperform. Chipotle rose 15% this week, increasing 2013 gains to 71%, and First Solar jumped 8.7% to boost y-t-d gains to 82%. The NASDAQ 100 (up 3.7% this week), Morgan Stanley High Tech Index (up 2.6%) and The Interactive Week Internet Index (3.4%) all traded to the highest levels since 2000. Treasury, MBS, and corporate debt prices were higher as well.

The QE-enhanced 2013 version of “how crazy do things get?” is outshining even the 1999 speculative melee. The (post-LTCM bailout) year 1999 saw the small cap Russell 2000 Index jump from 422 to 505 (19.7%). This year, it has already run from 849 to 1,114 (up 31.3%). The S&P400 Midcap Index jumped from 392 to 445 in 1999 (13.5%). With more than two months to go, so far it’s 1,020 to 1,290 for the midcaps (up 26.5%).

It was not only U.S. investors that were enriched from Washington dysfunction. Germany’s DAX equities index added 1.6% this week to a new all-time high (up 16.5% y-t-d). Italian stocks jumped 2.1% (up 18.4% y-t-d) and Spanish stocks surged 3.5% (up 22.5%), both to more than two-year highs. Australian stocks gained 1.7% (up 14.5% y-t-d). Despite major economic issues, India’s stock market jumped 1.7% this week to within a couple percent of new highs. Stocks jumped 4.2% in Brazil and 4.3% in Argentina. Indonesian stocks rallied 4.5%. Around the globe, most equities markets pushed higher. Fueled by huge ETF flows, total equity mutual fund inflows this past week jumped to a whopping $12.7bn (from AMG/Lipper).

On a weekly basis, I track global central bank International Reserve Assets (data from Bloomberg). This data provide a decent proxy for global financial flows, especially to the emerging markets (EM). From $6.63 TN back in April of 2009, International Reserves surged this week to a record $11.415 TN. Reserves have inflated 330% in ten years.

Reserve Assets showed atypically slow growth between May 10th ($11.124 TN) and September 20th ($11.174 TN), not coincidently a period a heightened EM instability. Courtesy of the Fed, BOJ, and Chinese, the “money” spigot was reopened. Though the data tends to be lumpy, it is worth noting that Reserves jumped $240bn over the past month. Indonesian 10-year yields have declined about 100bps since September 30th to 7.34%. Yields in Turkey are down about 130 bps from August highs to 8.70%. In general, EM markets have bounced back strongly from May/June tumult. The Fed’s taper deferral and China’s retreat from Credit tightening reversed the “hot money” EM exodus – for now.

China’s International Reserves jumped a notable $164bn during the third quarter to a record $3.660 TN (from $250 billion when Dr. Bernanke joined the Fed back in 2002). This compares to Q2 Reserve growth of $54bn. The People’s Bank of China this week stated that trade and capital-related inflows were again bolstering excess: “The pressure for monetary and credit expansion is still large.” Myriad data, including stronger-than-expected 7.8% Q3 growth, support the view of a meaningful pickup in Chinese activity. And while the consensus sees China’s recovery as fundamental to a bullish global backdrop, I’ll offer a contrary opinion.

My Macro Credit thesis holds – and there is ample fundamental support for – the view that we’re now five years into history’s greatest global Bubble. I have posited that China is deep into its “Terminal Phase” of Credit excess. With China’s 1.35 billion people and Trillions of unrestrained Credit expansion, I’ll argue China’s “Terminal Phase” is integral to the overall “Terminal Phase” of a most protracted and dangerous global Credit Bubble. In general, post-2008 global monetary inflation pushed EM to precarious “Terminal Phase” Bubble excess, leaving deep wounds of economic maladjustment and financial fragility.

I believe the initial cracks in the EM Bubble developed this spring. Market turbulence from May and June provoked further global monetary accommodation, which somewhat reshuffled the deck in the global liquidity chase. And I wouldn’t be surprised if history looks back at this period as a final manic speculative blow-off in U.S. and global equities.

Despite generally bullish sentiment, I continue to believe that China faces serious imminent issues. Chinese officials in early June moved belatedly to try to rein in runaway Credit excesses. Not surprisingly, an increasingly powerful Credit expansion and attendant asset Bubbles had been impervious to cautious attempts to restrain mortgage and local government borrowing. When they resorted to more aggressive actions in June, financial and economic fragilities forced officials to quickly retreat from tightening measures. And, again not surprisingly, Credit excess bounced right back as powerful as ever.

The value of China’s September residential apartment sales surged 34% from August to $113bn. Year-to-date sales are running up about 35% from 2012. After bouncing back strongly in August (almost doubling July), September’s total system Credit growth (“social financing”) was reported at a stronger-than-expected $230bn. This puts year-to-date “social financing” at about $2.25 TN, a pace almost 20% above a record 2012. Some reports have mortgage Credit growing at a rate about 50% faster than last year. Additionally, forecasts are calling for Q4 corporate bond issuance to jump to $135bn from Q3’s $40bn.

There are multiple facets of “Terminal Phase” Credit Bubble excess at play today in China. In asset-based lending Bubbles, the rapid growth in both transactions and prices combine for exponential growth in underlying mortgage Credit. It’s worth recalling that annual U.S. mortgage Credit growth increased annually from 1997’s $313bn to 2003’s $1.011 TN to 2006’s $1.410 TN. Importantly, along with the exponential rise in mortgage borrowing comes a corresponding spike in the riskiness of late-cycle lending booms. Indeed, and fundamental to Credit Bubble analysis, “Terminal Phase” excesses foster an unsustainable parabolic rise in Credit and economic risks. Systemic stability becomes a major concern anytime circumstances dictate that officials prolong the “Terminal Phase.”

The surge in risky Credit tends to have myriad distorting effects on financial and economic systems. On the financial side, increasingly creative/aggressive risk intermediation is required to transform progressively risky mortgage debt into more “money”-like instruments palatable to savers, speculators and institutional holders. In the U.S. and now in China, so called “shadow banking” came to play an instrumental role. Here in the U.S., 2006’s $1.0 TN of subprime CDOs (collateralized debt obligations) provided a key and fateful risk intermediation mechanism. In China’s historic “shadow bank” Bubble, there is huge ongoing growth in trust deposits and various “wealth management” vehicles. A rapidly expanding chasm - between the perceived safety of “money”-like deposits/savings vehicles and the mounting risks inherent in system Credit - is fundamental to “Terminal Phase” processes and fragilities.

There is another key “Terminal Phase” dynamic at work in the Chinese Bubble, as was (and remains) the case in the U.S and elsewhere. As late-cycle financial and economic Bubble risks grow exponentially, policymakers turn increasingly timid. Powerful Bubble Dynamics become impervious to policy “tinkering,” while officials come to see the environment as too risky to implement the type of stringent (pain-inflicting) tightening measures required to quash (now well-entrenched) inflationary biases and rein in increasingly destabilizing excess.

The above reference to “serious imminent issues” reflects my expectation that the Chinese are likely gearing up for another stab at restraining Credit Bubble excess. It’s reasonable to presume they won’t do anything that would cause serious disruption. Yet, from my perspective, if they are serious about disrupting an increasingly destabilizing Bubble, there is no way around major global ramifications. And with international securities markets turning more intensely overheated by the week, this creates a potentially volatile dynamic.

There were more rumblings out of Beijing this week. At this point, it’s difficult to gauge whether they are more frustrated with Congress or the Federal Reserve. One of these days they may even be willing to rein in their Credit system and let the global chips fall where they will. Perhaps even one of these days global policymakers may actually part ways in what has been to this point concerted efforts to reflate global economies and markets. Over time, when monetary inflation’s fog begins to break, those on the losing end of inflationary processes begin to see things a little more clearly.

The dollar was hit relatively hard this week. Newfound dollar weakness may prove an important market development – perhaps even a crucial inflection point. Many speculators were positioned bullish the dollar, expecting a safe haven bid in the midst of unfolding EM instability. Months back I posited that a huge bearish short position had accumulated betting against the Japanese yen. There are mixed opinions as to how much the yen short has been reversed. Things could turn more interesting if dollar weakness spurs a short-covering rally in the Japanese currency.

Above I noted the possibility of a somewhat “reshuffled deck” in the resurgent global financial Bubble. While the liquidity high tide has so far elevated most markets, I would be surprised by a sustained reemergence of a generalized EM Bubble. We’ll closely monitor for a destabilizing “periphery” and “core” dynamic, expecting finance to flood into the inflating “core” (i.e. China) at the expense of the fragile “periphery” (i.e. Brazil, India, Turkey?). And there has been another out of “periphery” (EM) and into “core” (Europe) dynamic at play over recent months. Euro strength has been further bolstered by Washington dysfunction and resulting dollar weakness. Strong financial flows have been positive for European stock and bond prices (Spain and Italy, in particular), although a euro at about 1.37 to the dollar is particularly unhelpful for export competitiveness in struggling Italian, Spanish, Portuguese and French economies. Might dollar weakness push the ECB to counter with more aggressive monetary stimulus?

It’s been only about three weeks, but the fourth quarter has already shown itself worthy of the history books. If the leveraged speculating community can hold gains through year-end, the ranks of billionaires will surely inflate further. No winners?

The fiscal deal in Washington

Worse than Europe, really

None of the deeper problems with American government was solved this week

IMAGINE you are in a taxi and the driver suddenly turns violently and speeds towards a wall, tyres screeching, only to stop at the very last moment, inches from the bricks—and cheerfully informs you that he wants to do the same to you in three months time. Would you be grateful that he has not killed you? Or would you wonder why you chose his cab in the first place?

That is the journey Congress has taken the American people on over the past few weeks (seearticle). The last-minute deal to raise America’s debt ceiling, avoid a default and reopen the government at least until mid-January, which was signed by the president on October 16th, is welcome only compared with the immediate alternative.

For a long time American politicians have poured scorn on their European peers for failing to deal with the euro crisis. This week Washington equalled Brussels on one measure of dysfunctionality and surpassed it by another. The way in which the Democrats and Republicans, having failed to reach any agreement, decided to “kick the can down the road”, was deeply European. The deal allows the government to stay open till January 15th and the debt ceiling to be raised until February 7th. Just as America’s economy seems to be recovering, with the promise of GDP growing by 2.7% in 2014, it could face another shutdown of the kind that has just sent consumer confidence to a nine-month low and knocked back growth in the fourth quarter by an estimated 0.6 percentage points.

The way in which the Americans have surpassed the Europeans is the unreality of their discussion. The Europeans at least talk vaguely about banking unions and other solutions to their mess. In America the immediate budget deficit—at 3.4% of GDP—is smaller than that of many European countries.

Indeed the danger is of too much tightening in the short term. But the country’s long-term fiscal problem is immense: it taxes like a small-government country but spends like a big-government one. Eventually demography—and the huge tribe of retiring baby-boomers who expect pensions and health care—will bankrupt the country. By the IMF’s calculation, if America is to reduce its debt to what it regards as a sensible level by 2030, allowing for all this age-related spending, it needs a “fiscal adjustment” of 11.7% of GDP—more than any other advanced country other than Japan. Yet the Republicans refuse to discuss tax rises, without which Barack Obama and the Democrats refuse to discuss cuts to entitlements: neither of those things had anything to do with the impasse of the past few weeks.

Aux armes, citoyens

And to what end? Politically, neither Mr Obama nor the Republicans has much to show for their combat: the president has not persuaded his rivals to get rid of the sequester, which continues to squeeze vital functions such as defence and research, while the Republicans have to keep paying for Obamacare, the health reforms they had hoped to kill in this process. It is the political equivalent of the Somme: great damage has been done, but barely any ground gained.

The bigger losers politically, though, are the Republicans. Their demand that the Democrats rescind the key parts of many of the laws that Mr Obama has passed over the past five years was the principal reason for a debacle that has embarrassed America. Americans have noticed: the proportion who view them favourably dropped to 28%, the lowest level for either party since Gallup started asking the question in 1992.

When the Republicans are a small government party, this newspaper has much sympathy for their views. As long as they remain the no-government one, it is not inclined to take a ride in their cab again.

The JPMorgan Problem Writ Large

Howard Davies

19 October 2013
PARIS – JPMorgan Chase has had a bad year. Not only has the bank just reported its first quarterly loss in more than a decade; it has also agreed to a tentative deal to pay $4 billion to settle claims that it misled the government-sponsored mortgage agencies Fannie Mae and Freddie Mac about the quality of billions of dollars of low-grade mortgages that it sold to them. Other big legal and regulatory costs loom. JPMorgan will bounce back, of course, but its travails have reopened the debate about what to do with banks that are “too big to fail.”
In the United States, policymakers chose to include the Volcker rule (named after former Federal Reserve Chairman Paul Volcker) in the Dodd-Frank Act, thereby restricting proprietary trading by commercial banks rather than reviving some form of the Glass-Steagall Act’s division of investment and retail banks. But Senators Elizabeth Warren and John McCain, a powerful duo, have returned to the fight. They argue that recent events have shown that JPMorgan is too big to be managed well, even by CEO Jamie Dimon, whose fiercest critics do not accuse him of incompetence.
Nonetheless, the Warren-McCain bill is unlikely to be enacted soon, if only because President Barack Obama’s administration is preoccupied with keeping the government open and paying its bills, while bipartisan agreement on what day of the week it is, let alone on further financial reform, cannot be guaranteed. But the question of what to do about huge, complex, and seemingly hard-to-control universal banks that benefit from implicit state support remains unresolved.
The “school solution,” agreed at the Financial Stability Board in Basel, is that global regulators should clearly identify systemically significant banks and impose tougher regulations on them, with more intensive supervision and higher capital ratios. That has been done.
Initially, 29 such banks were designated, together with a few insurers – none of which like the company that they are obliged to keep! There is a procedure for promotion and relegation, like in national football leagues, so the number fluctuates periodically. Banks on the list must keep higher reserves, and maintain more liquidity, reflecting their status as systemically important institutions. They must also prepare what are colloquially known as “living wills,” which explain how they would be wound down in a crisis – ideally without taxpayer support.
But, while all major countries are signed up to this approach, many of them think that more is needed. The US now has its Volcker rule (though disputes between banks and regulators about just how to define it continue). Elsewhere, more intrusive rules are being implemented, or are under consideration.
In the United Kingdom, the government created the Vickers Commission to recommend a solution. Its members proposed that universal banks be obliged to set up ring-fenced retail-banking subsidiaries with a much higher share of equity capital. Only the retail subsidiaries would be permitted to rely on the central bank for lender-of-last-resort support.
A version of the Vickers Commission’s recommendations, which is somewhat more flexible than its members proposed, is in a banking bill currently before Parliament. A number of MPs want to impose tighter restrictions, and it is difficult to find anyone who will speak up for the banks, so some form of the bill is likely to pass, and big British banks will have to divide their operations and their capital.
The UK has decided to take action before any Europe-wide solution is agreed. We British are still members of the European Union (at least for the time being), but sometimes our politicians forget that. Sometimes they simply lose patience with the difficulty of agreeing on changes in negotiations that involve 28 countries, which seems especially true of financial reform, given that many of these countries are not home to systemically important banks and probably never will be.
But EU institutions have not been entirely inactive. The European Commission asked an eminent-persons group, chaired by Erkki Liikanen, the head of the Finnish central bank, to examine this issue on a European scale.
The group’s report, published in October 2012, came to a similar conclusion as the Vickers Commission concerning the danger of brigading retail and investment banking activities in the same legal entity, and recommended separating the two. The proposal mirrors the UK plan – the investment-banking and trading arms, not the retail side, would be ring-fenced – but the end point would be quite similar.
But the European Banking Federation has dug in its heels, describing the recommendations as “completely unnecessary.” The European Commission asked for comments, and its formal position is that it is considering them along with the reports.
That consideration may take some time; indeed, it may never end. Germany’s government seems to have little appetite for breaking up Deutsche Bank, and the French have taken a leaf from the British book and implemented their own reform. The French plan looks more like a Gallic version of the Volcker rule than Vickers “à la française.” It is far less rigorous than the banks feared, given President François Hollande’s fiery rhetoric in his electoral campaign last year, in which he anathematized the financial sector as the true “enemy.”
So we now have a global plan, of sorts, supplemented by various home-grown solutions in the US, the UK, and France, with the possibility of a European plan that would also differ from the others. In testimony to the UK Parliament, Volcker gently observed that “Internationalizing some of the basic regulations [would make] a level playing field. It is obviously not ideal that the US has the Volcker rule and [the UK has] Vickers…”
He was surely right, but “too big to fail” is another area in which the initial post-crisis enthusiasm for global solutions has failed. The unfortunate result is an uneven playing field, with incentives for banks to relocate operations, whether geographically or in terms of legal entities. That is not the outcome that the G-20 – or anyone else – sought back in 2009.

sábado, octubre 19, 2013


American mortgage lending

Home sickness

Weak mortgage earnings are weighing on profits. That may be a good thing

AFTER the mortgage-refinancing binge comes the hangover. On October 11th Wells Fargo and JPMorgan Chase announced third-quarter earnings that were dented by a decline in their mortgage business. Similar news followed on October 15th from Citigroup and the following day from Bank of America. The rise in interest rates from historic lows in April, despite a recent hiatus, has ended a period when taking out a new home loan to pay off an old one was a riskless, lucrative step for borrowers and lenders alike.

The increase in rates is a direct response to the Federal Reserve’s signals that it may soon curtail its bond-buying scheme, which is intended to suppress long-term borrowing costs. A higher price for money is not just toxic to the mortgage-refinancing business, and thus bad for banks, it also hurts house prices. That would suggest that it hurts the economy as a whole as well. But a new paperby two professors at the Cox School of Business at Southern Methodist University and a third at the University of Pennsylvania’s Wharton Business School argues otherwise: that efforts to boost housing loans have impeded the flow of credit to more productive uses.

America has long taken steps to prop up housing construction and prices, including a tax deduction for mortgages, tax breaks for certain companies that hold property (real-estate investment trusts) and an implicit state subsidy for the entire industry via state-backed entities with access to cheap credit that buy mortgages (Fannie Mae and Freddie Mac). Since the financial crisis, this has been augmented by the Fed’s efforts to keep interest rates low in an attempt, among other things, to revive the housing market. As the paper notes, Ben Bernanke, the chairman of the Fed, said last year, “to the extent that home prices begin to rise, consumers will feel wealthier; they’ll feel more disposed to spend…that’s going to provide the demand that firms need in order to be willing to hire and to invest.”

In addition to this “wealth effect”, higher home prices can stoke the economy by providing owners with more valuable collateral to borrow against for other purchases; many entrepreneurs fund their businesses this way. Rising home values also make existing mortgages less risky. If higher prices lead to increased construction, they boost GDP directly.

The recent recovery in housing prices has carried with it all these virtues, and perhaps others as well. Banks talk up the idea that as the value of their clients’ assets rises, they have added incentive to deepen their relationship with them. As ties grow, banks have both more reason and more capacity to monitor credit quality. Wells Fargo came out of the crisis with the biggest mortgage operation among America’s banks, and has since become the country’s most valuable financial institution, in part because it has managed to persuade clients with mortgages to take up other offerings, such as personal and business accounts.
Writ large, this would suggest that greater mortgage lending leads to more abundant and efficient channelling of resources from banks to their clients, both corporate and personal, and thus to the economy as a whole. But the paper disputes this. It argues that a rise in property prices simply prompts banks to devote more resources to mortgages and less to other loans (see chart). It shows that as property lending rises, banks in strong housing markets lend less to businesses than banks elsewhere. Businesses, in turn, invest less, as they are unable to replace all their lost bank lending with other sources of financing. The impact is particularly strong for small and medium-sized businesses that rely on banks rather than capital markets for funding, and when the main sources of capital are small and medium-sized banks.

The implication is that the many policies that encourage lending for property investments do so at the expense of other, potentially more deserving borrowers. That would be a drag on the economy and perhaps also on banks’ future profits. But the paper also raises hope that the present, increasingly hostile climate for housing finance may have a hidden benefit: mitigating a damaging distortion in the system. 


Where there’s money, there’s risk

Events in America show that no asset is copper-bottomed

A GOVERNMENT with debt denominated in its own currency need never default, or so the theory goes. It can simply print more money to pay off the debt. In practice, however, countries do default on local-currency debt: six have done so in the past 15 years, including Jamaica, Russia and Ecuador. Before this week’s budget deal, markets had feared that America could join the list, if only in a technical sense.

From the point of view of a creditor, however, the ability of a government to print money is of little comfort if the result is higher inflation (for domestic investors) or currency depreciation (for foreign ones). Investors who bought Treasury bonds in 1946, when yields were around current levels, did not suffer a formal default. But over the following 35 years they lost money in real terms at a rate of 2% a year. The cumulative real loss was 91%. By that standard, Greek creditors, who recently suffered a 50% loss via default, were lucky.

Given this baleful history, the idea that sovereign debt is “risk-free” is puzzling. When it comes to the purchasing power of an investor’s money, what does it matter if the loss comes in the form of a formal default or erosion in real terms?

The answer to that conundrum may be that default happens suddenly, whereas inflation and depreciation are slower, giving investors more time to adjust by demanding higher interest rates to compensate for their losses. This is particularly true in the case of short-term debt, such as Treasury bills; inflation is unlikely to do serious damage to a portfolio in the course of a few months.

Twenty years ago there was much talk of “bond vigilantes” who would respond to irresponsible fiscal policies by forcing up the interest rates on government debt. With the bond vigilantes on the prowl, any short-term real loss suffered by investors would be recouped in the form of higher real rates as the government’s debt was refinanced.

But by buying bonds in the name of “quantitative easing”, central banks are influencing interest rates of all maturities these days. By holding down bond yields, the authorities are employing a policy some have dubbed “financial repression”, in which real returns on government debt are reduced. The idea is to make investors buy riskier assets, such as equities and corporate bonds. In effect, the bond vigilantes have been neutered.

One way of protecting the real value of investors’ bond holdings is to buy inflation-linked debt. The repayment value and interest payments on such bonds are normally tied to a well-known inflation index. But even these bonds may not be completely risk-free; it is possible to imagine that future governments may find ways to redefine the inflation measure for their own benefit. And foreign buyers of inflation-linked bonds are still at risk from currency depreciation.

Inflation-linked bonds are extremely attractive to pension funds, since they are a neat match for the funds’ liabilities. So such bonds are snapped up quickly and tend to trade on low real yields; sometimes, those yields are even negative. An asset is hardly risk-free if it guarantees a real loss.

The concept of a risk-free asset is quite useful in finance. For a start, it provides the base from which other assets can be priced. Corporate borrowers pay an interest premium over the risk-free rate; equities have offered a higher long-term return than government bonds to reflect their higher risk. But what is the true risk-free rate? Multinational companies can borrow at a lower rate of interest than some governments: compare Apple with Greece, for example. And although America is the world’s biggest economy, its government does not borrow at the cheapest rate on the planet: Japanese yields have been lower for many years and German long-term yields are now significantly below those of Treasuries.

Where America does have a substantial advantage is that it borrows in the world’s reserve currency—the dollar—and that its debt market is by far the most liquid. The result is that Treasury bills, in particular, play a vital role in the system as cash equivalents and as collateral for short-term loans and derivative contracts.

Treasury bills are seen as risk-free in this context in that they are instantly and universally acceptable to all participants in the system. They are the oil that lubricates the global machinery of finance. That was the real risk of the latest stand-off: not that America would not pay its bills, which it could easily afford to, but that the system would grind to a halt.

Are You Prepared for the Next Crash?

Saturday marks 26 years that the market suffered its worst one-day crash ever. Another crash of that magnitude is inevitable.

Updated Oct. 18, 2013 6:47 p.m. ET
On this 26th anniversary of the 1987 stock-market crash, the worst one-day drop in U.S. history, it's worth asking whether such an event could happen again.
According to a number of researchers, the answer is yes. And that is a sobering thought indeed, since the Dow Jones Industrial Average fell 22.6% on Oct. 19, 1987. An equivalent drop today would take more than 3,400 points off the Dow in a single session.
The stock market recovered from the Black Monday crash within two years. But Xavier Gabaix, a finance professor at New York University, says that recoveries aren't always this rapid. In fact, he adds, the market on average following past crashes didn't completely recover after even 10 years.
To prevent a crash from completely derailing your investment strategy, you might need to reduce the portion of your portfolio invested in stocks—especially if you have less than a decade in which to recoup your losses or lack the nerves of steel required not to bail out of stocks after a crash.
Mr. Gabaix and fellow researchers have developed a theory that predicts, over long periods, how many daily price drops of various magnitudes will occur over long periods. For example, their theory forecasts that a 20% daily drop in the market will occur, on average, once every 100 years, a 15% plunge once every 50 years and a 10% drop once every 13 years. Mr. Gabaix says that the theory has been found to be quite accurate when tested against U.S. stock-market history back to the early part of the last century, as well as against the stock markets of Japan and Hong Kong.
The reason crashes are inevitable, Mr. Gabaix argues: Every market is dominated by its very largest investors. When they want to get out of stocks at the same time, which on occasion they will want to do, the market will plunge.
That means regulators are tilting at windmills in trying to prevent another crash. Structural changes such as circuit breakers and trading halts ultimately will fail, Mr. Gabaix argues, since large investors always can go elsewhere to sell. For example, they can turn to private electronic-transaction networks in the U.S., known as "dark pools," as well as to foreign markets.
Because crashes are both inevitable and unpredictable, you need to permanently insulate your portfolio against them, unless you have a very long investment horizon and the discipline to stick with your strategies even in the wake of a crash.
Unfortunately, cushions are rare during crashes. The average foreign stock lost just as much in October 1987 as did the U.S. market, for example; stocks of gold-mining companies did even worse. Gold bullion itself held its own during the 1987 crash, but its behavior during prior crashes was inconsistent.
One study, by Duke University finance professor Campbell Harvey and Claude Erb, a former commodities manager at TCW Group, found that in over a third of the cases in which the S&P 500 experienced a big drop, so did gold.
Though U.S. Treasurys did hold their own during the 1987 crash, it is difficult to imagine—given today's low interest-rates—that bonds will provide much insurance against a crash. And if interest rates rise, as they almost certainly will over the long term, bonds could prove to be expensive insurance indeed.
That leaves cash-like instruments, such as money-market funds, and short-term bonds as the primary options for conservative investors wanting to protect themselves against a crash.
The question is: How much should be allocated to these risk-reducing investments by investors nearing retirement, as well as by risk-averse investors of any age?
The Hulbert Financial Digest produced a list of advisers who lost less than half as much as the Dow during the 1987 crash and who, since then, have beaten the Dow. We then eliminated those whose good performance was due to building up cash right before the 1987 crash, since crashes are unpredictable and you can't count on sidestepping them in the future.
With the exception of one adviser who is always fully invested in stocks, the half-dozen advisers in this subset, out of the more than 200 in the Hulbert database, have allocated an average of close to 40% to cash and short-term bonds over the past 26 years.
That might seem like overkill, especially if you are young. But note that these conservative advisers have kept up with the market since 1987. Even if such an allocation causes you to trail the market, it could be a small price to pay for a strategy you can live with through thick and thin.
One place where some of these advisers invest their cash is the Vanguard Prime Money Market Fund, which holds cash-like investments and has an expense ratio of 0.16%, or $16 per $10,000 invested. The short-term bond fund that is most recommended by these advisers is the Vanguard Short-Term Investment Grade Fund, with a 0.2% expense ratio.
The one advisory service in my select group that has remained fully invested in stocks is Investment Quality Trends, edited by Kelley Wright. Its portfolio, consisting entirely of high-dividend-yielding blue chips, lost less than half as much as the market did in the 1987 crash. And over the 26 years since that crash, it has outperformed the Dow.
The three highest-yielding stocks on Mr. Wright's best-buy list are Baxter International, the drug and medical-device maker, whose dividend yield—the annual dividend payout as a percentage of stock price—is 3%; oil giant Chevron, yielding 3.3%; and fast-food retailer McDonald's, yielding 3.3%.
—Mark Hulbert is editor of the Hulbert Financial Digest, which is owned by MarketWatch/Dow Jones. Email: mark.hulbert@dowjones.com

October 18, 2013

Corruption in Peru Aids Cutting of Rain Forest

PUCALLPA, Peru — Afraid the police would tip off suspects, Francisco Berrospi kept local officers in the dark when he headed into the rain forest as a prosecutor to investigate illegal logging. Sometimes it hardly seemed to matter, though.
Even when he managed to seize trucks, chain saws or illegally harvested trees, judges would often force him to give them back, he said. Bribes were so common, he said, that one anticorruption official openly encouraged him to take them.
“The power of the logging industry here is very strong,” Mr. Berrospi said. “The corruption is terrible.”
More than half of Peru is covered by dense forest, including a wide stretch of the Amazon basin, which spreads across South America. Its preservation is considered central to combating global warming and protecting the many species of plants and animals found only in the region.
In recent years, Peru has passed laws to crack down on illegal logging, as required by a 2007 free trade agreement with the United States. But large quantities of timber, including increasingly rare types like mahogany, continue to flow out, much of it ultimately heading to the United States for products like hardwood flooring and decking sold by American retailers.
The World Bank estimates that as much as 80 percent of Peru’s logging exports are harvested illegally, and officials say the wood typically gets shipped using doctored paperwork to make the trade appear legal.
It is a pattern seen in other parts of the world, including the far east of Russia, where environmentalists have documented the rampant illegal logging of oak and other kinds of wood bound for the United States and elsewhere.
By The University of British Columbia School of Journalism
Hardwood timber from Russia’s Far East is being illegally cut and shipped to China to feed huge consumer demand for cheap wood products globally.
In September, federal agents in Virginia served search warrants on Lumber Liquidators, a major American retailer, in what the company said was an investigation into its importation of wood flooring products.
The company has been accused by environmentalists of regularly buying from a Chinese supplier that traffics in illegally harvested Russian oak. Lumber Liquidators disputes the claims, saying that it carefully monitors the origins of its wood.
Here in Pucallpa, a city at the heart of Peru’s logging industry on a major tributary of the Amazon, the waterfront is dominated by huge sawmills piled high with thousands of massive logs. They are floated in from remote logging camps, pulled by small motorboats called peke pekes, while trucks stacked with logs and lumber jam the roads.
A military officer stationed here to patrol the Ucayali River said that he had largely stopped making checks of the riverborne loads of timber, though the checks are supposed to be mandatory. In the past, he said, he had repeatedly ordered loads of logs to be held because they lacked the required paperwork, only to learn that forestry officials would later release them, apparently after creating or rubber-stamping false documentation.
In some cases, he said, loads of mahogany, a valuable type of wood that has disappeared from all but the most remote areas, were given fake documentation identifying the wood as a different kind.
“It’s uncontrollable,” said the officer, who was not authorized to speak publicly. Referring to local forestry officials, he said, “The bosses give jobs to people they trust and then take a cut of the bribes they get.”
Mr. Berrospi, who worked as an environmental prosecutor until August, recited a bitter catalog of frustrations. The local authorities are paid off by loggers to create or approve false paperwork, he said. On one occasion, he said, he was offered about $5,000 to stop an investigation. He reported it to a local prosecutor who specialized in corruption cases, but said he was dismayed by the response.
“Listen, in one year here you’ll get enough to build yourself a house and buy a nice car,” he recalled the other prosecutor saying. “So take care of yourself.”
Lucila Pautrat, director of the Peruvian Society for Eco-development, an advocacy group, said that despite new laws and the mandate under the trade agreement with the United States, the government had failed to tackle deep-seated corruption.
“There is a lack of interest, a negligence on the part of the authorities to regulate the forestry sector,” she said. “And, meanwhile, the wood keeps going out.”
The pressure to extract rare hardwoods and other lumber from the Peruvian rain forest has grown in recent years, as neighboring Brazil stepped up efforts to limit illegal logging, Ms. Pautrat said. She compared the situation to the drug trade, where efforts to crack down on cocaine production in Colombia have been followed by a big increase here in Peru.
“The pressure here grows,” she said. “It’s like cocaine. There is a constant demand in the market.”
Peru’s wood exports to the United States increased this year to $20 million between January and July, up from $15 million in the same period in 2012, according to United States Department of Agriculture data.
American officials say that Peru has made progress fighting illegal logging, but the persistence of the problem led the Office of the United States Trade Representative in January to demand stronger measures from Peru, including the swift prosecution of government officials and others who violate environmental laws.
While the United States, Europe and Australia have banned imports of illegally harvested wood, such efforts are often undermined by corruption and a lack of enforcement, said Kate Horner, a director at the Environmental Investigation Agency, an advocacy group in Washington.
“International demand for cheap illegal products is a main driver of illegal logging around the world,” said Ms. Horner, whose group has pressed the United States to seek stronger restrictions in Peru and recently issued a report accusing Lumber Liquidators of selling flooring made from illegally harvested Russian oak.
Cindy L. Squires, executive director of the International Wood Products Association, an industry group in Virginia, said that it was possible to operate responsibly in Peru, but that it required special vigilance. “This is not the kind of trading you can do from your computer at home,” she said. “You need to get out there and see.”
Mr. Berrospi, a bespectacled 45-year-old who carried antivenom in the jungle in case of snakebite, said officials in the Peruvian capital, Lima, had little idea of the obstacles faced by the country’s approximately 80 environmental prosecutors. Most investigations, he said, required traveling to remote areas, but his office had no boat or helicopter to reach logging camps inaccessible by road. Even getting a pickup truck required special permission, and he said he often had to pay for gas from his own pocket.
But his greatest frustration came from judges, who repeatedly sided with loggers, he said. In one case, he seized logs that he charged were part of a group of about 70 illegally harvested trees. But he said a judge had quickly ordered them to be returned to the logger.
“Do you know what the judge told me?” he said. “She said, ‘How am I going to send a person to jail or put them on trial for 70 little logs if I can see thousands or millions of trees growing here?' ”
In late May, Mr. Berrospi traveled over nearly impassable roads to a logging camp, seizing two tractors and three trucks. But local agencies refused to help find a place to keep them, so he had to return the machinery, he said. Then, a few weeks after he started his investigation, he said, the local forestry authorities restored the logger’s suspended permit without consulting him.
In the end, Mr. Berrospi said, his work made him such a “a stone in their shoe” that “the only thing they could do was get rid of me.”
He was removed from his job in August in what Antonio Fernández Jerí, the head of the environmental prosecutor’s office in Lima, said was a reassigning of personnel for “internal reasons,” though he praised Mr. Berrospi’s aggressiveness, saying that he had done a good job and that there had been no accusations of wrongdoing against him.
One investigation that Mr. Berrospi left unfinished involved Saweto, a distant Ashaninka Indian village near the Brazilian border. Edwin Chota, a resident who tracked a large load of logs transported by river from the village, said the barriers to enforcing environmental laws seemed overwhelming.
“There is no law,” Mr. Chota said, during a visit to the sawmill that held the stacks of massive logs that he had followed from his village. “There’s no money to investigate. There’s only money to destroy.”