This bailout that looks like that bailout

In August 1998, the Chinese government issued bonds to recapitliase the big four banks.
The PBC first lowered the statutory reserve requirement ratio for the banking sector as a
whole from 13 per cent to 9 per cent, the MoF then issued RMB 270 billion (USD 33
billion)7 in special government bonds. The big four state-owned banks used the liquidity
freed up by the lowering of the reserve ratio to purchase the bonds. The government then
injected all the bond proceeds as equity into the big four banks (Mo, 1999), with the
consequence that the capital base of the big four banks more than doubled. As the initial
sole owner of the big four banks, the MoF thus met the capital call from these banks and
explicitly burdened future taxpayers to fund a capital injection.

Ma, Guonan. Who Pays  China's Bank Restructuring Bill. pg 14, CEPII Working Paper. February, 2006. Available at: http://www.cepii.net/anglaisgraph/workpap/pdf/2006/wp06-04.pdf

Two drunks holding each other up, anyone?

Walter, Carl E.; Fraser J. T. Howie (2011-01-19). Red Capitalism: The Fragile Financial Foundation of China's Extraordinary Rise (Kindle Location 1069). John Wiley and Sons. Kindle Edition.

EDIT-1: For those of you who are missing the reference... Spain Weighs Injecting Debt Instead of Cash Into Bankia

Romney displays his complete ignorance about the global economy

I recently ran across a few headlines and news stories which claimed Romney had promised to stop borrowing from China. I had to read them a few times and then a few times again because, as I remembered, Romney claimed to know a little bit about economics and this was an egregiously incorrect statement, showing either a complete ignorance about the most basic aspects of the global economy, or a wish to exploit the fears of the Republican masses. Since I'd like to think he's not a total scum-bag, I'm going to assume it's the first.

The problem with this claim is that it claims that the US is dependent on the benevolence of Chinese creditors to fund its fiscal deficit. That's simply not true. Firstly, the accumulation of US obligations in Chinese balance sheets is a function of the Balance of Payments, not the US' fiscal balance. I'll quote Professor Michael Pettis here, as his explanation is more concise than mine,

...foreigners do not fund fiscal deficits. They fund current account deficits, and as an accounting requirement the size of the current account deficit is exactly equal to the net foreign funding. Capital account inflows must exactly match current account outflows.
...
The direction of causality can go either way. If investment in the US is so high, for example, that it is impossible for US savings to supply the full demand (as occurred during much of the 19th Century), then the US must import foreign capital to make up the shortfall.
...
Suppose foreign central banks have decided for domestic reasons (for example in order to generate domestic employment) to accumulate hoards of US government obligations and so run a trade surplus. This will cause a surge of net capital inflow into the US. In that case the US must run a current account deficit equal to the net inflow.

As is obvious to anyone following the developments of the global economy over the last 10 years, the obvious scenario is the latter. The US Treasury doesn't need China's money, China needs US Treasuries as a way to warehouse its FX reserves in order to maintain its current account surplus. In fact, China reducing its holdings of US Treasuries would be net stimulative to the American economy as the US trade deficit with China means that, along with knicknacks and iPods, the US is also importing Chinese unemployment.

Unless the US Treasury starts emitting dim sums (borrowing in CNY or CNH), the US is not borrowing from China. This is not subject to discussion.

Things EFSF Will Not Fix

Expecting a bunch of bureaucrats to fix a decade's worth of accumulated imbalances in a matter of months with some alphabet soup ain't gonna work. What will work? Peripheral countries deflating with respect to core. Not only will it work, but it is the only thing that will work. Pictures follow. Toodles!

Cumulative Inflation relative to Germany. (i.e. Germany CPI would be a flat line at zero)

Balance of Trade (Exports-Imports) for GIIPS

GIIPS Balance of Trade as a % of GDP

Balance of Trade for selected European economies

Balance of Trade for selected European economies as a % of GDP

On Economic Data and Time Scales

I was looking at the excellent Bonddad blog today, and came across the post, "Uh oh: YoY gasoline usage down 5%, worst since October 2008."A small piece is quoted below.

US Gasoline demand

Something's happening here, but what it is ain't exactly clear. The most obvious candidates are:

1. demand destruction. But if so, why is consumer spending, as measured by the Gallup daily survey, holding up so well?
2. energy efficiency. But have we really bought so many hybrid vehicles to make that big a difference?
3. the weather. OK, we did have a strange Nor'easter that pummeled the northern and western suburbs of the Megalopolis, but that was one day only.
4. random stuff just happens. Always a possibility, but this seems unlikely given at least three weeks in a row of awful YoY comparisons.

 Now, I don't want to pick on Hale Stewart, the author, or his commentators, but I need to point something out here because this is a narrative I have heard many times in the last 3 weeks. Reduction in gasoline demand is not due to increased fuel efficiency. I don't doubt the fleet is getting more efficient, but this narrative completely ignores appropriate time periods and this is something I see quite often in the blogosphere. A reduction in demand due to fuel efficiency will be measured in decades, not months. If there is changes in the monthly numbers, it is either a different factor or noise, but the effect of increased fuel efficiency will not be measurable in the weekly data. Why? Because, at current sales rates and assuming no net growth in fleet, it would take roughly 23 years to turn over the US automotive fleet.

Auto sales as % of fleet, estimated fleet growth and replacement rates

Instead, I suggest we look for a more common-sense narrative and look at hotel occupancy, since Americans love to drive and, since we're talking gasoline sales, we need not worry about trucking.

Hotel Occupancy rate, via Calculated Risk

Hmmmmm. Notice anything? Like hotel occupancy and gasoline demand both coinciding in their drops?

Let's use some more common sense here guys and realize that different things happen in different time scales and if you are not paying attention to that, you are lying to yourself and making worse decisions as a result.

xoxo,

GossipGirl

UPDATE-1: This is not a criticism of Hale! This is a a comment regarding the four commentators that attributed the drop to fuel efficiency. This is a narrative I have heard from many people in the last 3 weeks and it is WRONG.

Buy Home, Sell Gold?

Presented without comment.

Hypothetical payment of a median-price new home purchased using a conventional 30-year mortgage

Hypothetical payment of a median-price new home purchased using a conventional 30-year mortgage as a % of median household income

Median-price of a new home expressed in troy oz of gold.

Muni Madness

Via FRED, the Bond Buyer Index GO 20y to maturity, mixed quality) spread to treasuries (weekly)

I've made no secret that I have been a heavy buyer of long-term municipal credit risk, taxable and non (via Build America Bonds) with short in treasuries of similar maturity to isolate the spread, looking for compression. But, please, take a look at the big 2008 spike. At these levels DV01s are big, so that widening can be really painful. Do yourself a favor and watch your risk levels. While there's reasons (scroll down to TOB section if you must) why I, personally, don't expect a 2008-like event, I am ready for it. This goes double if you think you are going to boost your positive carry and grab extra return from a wide discount in CEFs, as illustrated below.

XBBNX is NAV of BBN

Discount / premium of MQT via CEF Connect

UPDATE-1: Going back to 1953 using the monthly 20y treasury series with the long-term average series for the gap (pretty good fit, actually)

Build America, Young Man!

This is one of my favorite trades right now because I don't have a clear picture of where other things will go. The trade is simple: Buy BBN, sell TLT. In other words, buy the discount and credit risk and hedge your duration. By my calculation, the discount at the time of this writing (intra-day) is around 10.5% and, in my opinion, spreads in the Muni and BAB spaces are relatively attractive, considering credit risk, if you're not exposed to duration. BBN is a closed-end fund that holds Build America Bonds (basically taxable munis) with high credit ratings (3.6%AAA, 69.4% AA, 35.1% A). About 57% of the bonds are callable in 5-10y, which explains why, even with leverage (~30%) the daily NAV moves of late seem small compared to treasuries. The trade carries positive (~3% including borrow). If you have size, selling the ultra bond instead of TLT is easier and cheaper, and it's what I prefer to use. The risk with this trade is that spreads and discounts can always widen. In Nov-Dec '08 30% discounts to NAV were common and Munis took a beating vs treasuries. If you 're not levered, you can sit it out and make faces at your account balance until the dust settles. If you use too much leverage, your friendly margin clerk will probably liquidate you. Size accordingly.

Disclosure: I am currently long BBN, short TLT and short Dec '11 CME Ultra T-Bond contracts for myself and my clients.

Please remember, this is not a recommendation to buy or sell any securities. The information presented here is believed to be accurate as of the time of this writing but, hey, everyone fucks up, even me. This post is simply meant to be an illustration of one of the strategies I use in client accounts.

XBBNX = BBN Net-asset value.

X axis daily TLT change, Y axis BBN NAV change

Light Vehicle Sales and the NFP Report

I'm really dreading ADP/NFP week. It's my least-favorite week of the month. This month, I propose we all stop getting our collective panties in a bunch over a meaningless data-point that is subject to huge revisions and instead use a little common-sense and keep it simple.

You know what people are going to do when they get a job? Buy a car. Why do I think so? Because financing rates are low, deals are good, the fleet is old, and the sales have been depressed for three years. Don't believe me?

Red: SAAR Light-vehicle sales divided by the total population estimate
Green: Total non-farm private payroll divided by the total population estimate

Blue: SAAR Light-vehicle sales divided by the total population estimate (inverted scale)
Red: Civilian Unemployment Rate

The sewers I swim in

Boston sewer image from Liquid Assets

I've seen lots of arguments about why reducing the deficit right now would bring crisis to the economy. Most of them are very textbook Keynesian arguments arguing that at times of excess capacity, reducing deficit spending would just add headwinds to an already struggling economy. The other argument is that the US should take advantage of exceptionally low borrowing rates to invest in rapidly aging infrastructure and put Americans back to work using a sort of New Deal 2.0 scheme.

The first argument is a bird's eye solution to a ground-level problem. Yes, government spending would goose GDP, but is that spending creating wealth? Where is that "stimulus" going? Our goal, after all, is not to maximize GDP, but to maximize wealth. GDP is just a poor objective measure for a deeply subjective phenomenon and gaming our own framework won't help anyone, regardless of what numbers the BLS, BEA and FRB release over the upcoming months. And let's not forget that Washington has a very poor track record as an allocator of capital. I'm simply not comfortable leaving these decision up to the people that decided to try to reflate the bubble by pulling-forward demand, subsidizing toy arrows and foreign liquor and build useless airports. Just sayin'.

But does this mean we should address the crisis with full-throttle austerity? Not quite. As it was eloquently pointed out last Summer on interfluidity, austerity is stupid and deficits are dangerous. We can't make generalizations about debt, deficits or balanced budgets. Deficits and debt are neither good nor bad on their own. Leveraging up for wealth-creating projects is good, borrowing to throw money away shoveling sand from one pile to the other not so much. Washington is focusing on abstract goals like "putting real Americans to work." And one can't blame them because that's what people want, jobs. But "jobs" isn't something you can simply create from thin air, you can't just throw money at this problem and expect to fix it. "Jobs bills" and "improving America" are nebulous ideas, subject to interpretation without any objective way to measure success or failure, which is probably what Washington wants.

"Well, fine, but what do you suggest then?" you may be asking yourself. I just want to say one word to you. Just one word. Sewage. We've spent the better part of the last 10,000 years trying to secure sources of clean water and get rid of waste. Humanity has developed modern plumbing and sanitary sewers. We survived the Great Stink of 1858. We've battled epidemics of water-borne disease, droughts and floods.  I feel comfortable in making the broad statement that clean water is good and shitty water is bad. Therefore, one could expect that making something good out of something bad would be a positive thing, an improvement, a wealth-creating action. If you disagree, feel free to stop reading now.

All of which brings me back to our original topic, the deficit. We have swaths of unemployed persons and slack capacity in all aspects of construction, record-low financing rates, and an economy that uses fresh potable water faster than it replenishes it (including aquifer sources). Wouldn't it be great if we could put excess capacity to work creating an infrastructure that helps us achieve sustainability and conserve one of our most vital resources while financing it all at record-low rates? Well, we can, and it's called sewage treatment. It's the effective, efficient and inexpensive process of cleaning water.

The Deer Island Treatment Plant on the Boston Harbor provides primary and secondary treatment for the waste and storm water of the greater Boston area. It serves 43 communities, 2.5 million people and hundreds of thousands of businesses and it cost $3.8 billion to build. The entire MWRA had $176M of sewer-related operating expenses in FY2010 (pg 50). That works out to $70.40 per-person per-year. That figure includes not only the plant, but the entire sewer system as well as treatment of storm water and one of the most advanced plants in the country. DITP not only discharges water that is cleaner that the water it is being discharged into, but it efficiently decomposes organic waste using anaerobic digestion, reducing the volume of the sludge by 90% and using the resulting methane gas to help heat/power the plant. The dried, pelleted result of the digestion process is sold as Bay State Fertilizer (the heat naturally created by the digestion and drying process kills the harmful pathogens). So, for $70.40 per-person, per year, the MWRA cleans, on average, 360 million gallons of waste-water per-day and turns the organic water contained in it into energy and high-quality fertilizer, saving the city millions of dollars in sludge transportation and disposal fees, all while keeping the harbor clean. And while the $3.8 billion cost of construction may sound like a lot, consider that the plant had an initial 30-year expected life, meaning buying the plant on credit and amortizing it over 30 years (using the current 30y tsy rate of 4.12% as a proxy) would cost a only $7.36 per-person, per month. To put it all in perspective, including both amortization costs and operating costs, the cost per-thousand gallons of water treatment comes out to $1.48, or about the price of a medium-sized water bottle in a convenience store.

That's deficit spending I can get behind.

UPDATE-1: fixed an arithmetic oops and added reference to plant cost.
UPDATE-2: It was pointed out to me that the actual number of users serviced is 2.5 million, not 2 million. All numbers adjusted to reflect this. Link to source added as well.

Shut-up, CNBC: Carney on Muni bonds edition

Yesterday, Carney, when discussing risks to the Municipal markets said something I feel is inaccurate and deserves correction.

5. Information Cost is High. Muni issuers are not subject to the same disclosure requirements as corporate borrowers. The market is illiquid so pricing is opaque. The swaps market—the market for tradable credit protection—is thin and unreliable. This means that bond buyers may be taking on risks that they are not aware of. This is a recipe for panic once a triggering event occurs. 

First of all, CDS trading on a LOT of things is very thin. The municipal market is not a monolith, it is composed of thousands of issuers and so, yeah, swaps are probably pretty thin for many issuers. Just like bond and CDS mkts would be thin for most corporate issuers. Second of all, municipal market is dominated by retail, for obvious reasons. Joe Smith looking for safe tax-free bonds isn't exactly your average CDS trader.

Secondly, information is not that hard to come by if you know how to look and are not lazy. Anyone that's lending anyone money should do their homework, or at least pay an adviser or fund manager that has fiduciary duty to do it for them. MSRB is a wonderful resource, including a freely available trade history and, as Bond Girl has pointed out before, MSRB's EMMA allows you to find many issues' official disclosure documents.

Lastly, if you are the kind of investor that doesn't need an adviser or fund manager and is buying large amounts of municipal bonds, you can probably afford a subscription to The Bond Buyer and professional research from the rating agencies (ignore the rating and read the analyst's report).

6. Arbitrage Buying Leads to Bubbles. Much of the demand for muni bonds is not a function of credit analysis or a desire for exposure to the revenue streams of local governments. It is done for a technical, legal reason—to take advantage of the tax-free status of muni bond income. This creates an artificially high demand—a bubble—much like Basel accord capital requirements led banks to overinvest in mortgage bonds.

As Bond Girl wrote a few weeks ago, the last few years have seen some demand destruction, not only from a shift in investor's appetite for municipals relative to other securities, but by the departure of a number of leveraged actors that, through the use of short-term funding schemes created additional demand at the long ends of the curve. We're also seeing that "the muni market is transitioning from an interest rate space to a credit space." I can't go into it here, but you should really read Bond Girl's piece, it is excellently written and informative in a way no newspaper ever will be. But, getting back to my point, tax-free income doesn't necessarily increase demand.

Tax-free yield is attractive and investors are usually willing to take smaller yields for tax-free debt because it is still attractive in a taxable-equivalent basis. However, tax-free yields are only attractive to investors that benefit from preferential tax-treatment, limiting the universe of potential buyers--this is why the BAB program was introduced, to stabilize demand by introducing new participants. In my opinion, the tax-exempt yield of municipals actually hurts demand by restricting the universe of potential buyers. One only needs to look at the disparities between non-taxable TEY and BAB yields earlier in the year to see this at work.

The solution here, in my opinion, is for the federal government to refund issuers directly, like in the BAB program. Investors will receive higher yields that are equivalent on a taxable-equivalent basis and municipalities can offset the additional cost of debt service with refunds from the tax collectors paid for by the tax collected on the new, taxable issues. Otherwise, we risk a market where municipals can actually pay a premium, as they trade not only on their taxable-equivalent basis, but also on any extra risk or liquidity premium required by the restricted universe of buyers, increasing volatility and therefore the cost to issuers.