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U.S. Treasury Bond Market Crash Not Stocks the Big Story of 2010


Let’s pretend the US is a company.

For starters, this company has a massive debt problem. The official number is $12 trillion and counting, which is roughly the equivalent of one year’s annual production. On the surface, that’s not TOO bad.
However, if you treat the US’s balance sheet according to Generally Accepted Accounting Principles (GAAP) you have to also consider future liabilities in the form of Social Security and Medicare, which puts total debt at $65 trillion: an amount equal to 5 years’ worth of production: a REAL issue.

A debt load of this size requires massive sales and cash flow to service it. However, the problem is that the company’s primary sales segment (tax receipts) is plummeting. Indeed, individual income tax receipts are down nearly 30% from last year (a year that the economy was already falling off a cliff). Similarly, corporate tax receipts are negative.
Now, the company has just gotten a new CEO (the old one left after racking up this massive debt load). However, rather than trimming the fat from the company, he’s decided to INCREASE its operating costs/ annual spend. So the company is now having to issue MORE debt (roughly $150 billion a month) at the same time that it is trying to roll some of its OLD debt over.

This MIGHT work if the company’s current debt holders (foreign governments, especially China and Japan), weren’t already beginning to doubt that they’d ever get their money back.

Indeed, a few weeks ago, the Treasury Department released its Treasury International Capital Data for October: the numbers showing foreign interest in new debt issuance. The following is a BIG deal:

Net foreign acquisition of long-term securities, taking into account adjustments, is estimated to have been $8.3 billion (Graham’s note: we’ve issued nearly $2 TRILLION in debt this year).
LINK HERE

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Sprott – Is it all just a Ponzi scheme?

This is the most important article of the year, I hope everyone reads it. The issues occurring here are what will shape all the markets for 2010.

We have known that games were being played in the bond market and I’ve speculated that there was more “Quantitative Easing” going on than was admitted. They have placed their fingers on identifying the shell/ Ponzi schemes that are being played. (ht Maize Pays)


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Credit Card Delinquencies, Chargeoffs Rise Again; Bank of America Has Credit Card Headaches

Given there has been a financial recovery of sorts, but no recovery at all on main street, it should not be surprising to see Credit-Card Delinquencies Rise Again.

The rate of charge-offs on U.S. credit cards rose more than a half-percentage point in November, snapping a two-month run of drops from an all-time high in August, and delinquencies rose for the fourth consecutive month, Moody’s Investors Service said.

Charge-offs, which are those loans a credit-card company doesn’t think it will be able to collect, were 10.6% for November, compared with 10% in October. The ratings firm also said the delinquency rate, which gives a glimpse of issuers’ potential losses and how much they may need to set aside in reserves, rose to 6.2% in November.

Bank of America Now Choking on Growth at any Cost Policy

Please consider New Chief at Bank of America Seeks Credit-Card Fix

When Bank of America Corp.’s new chief executive takes over next week, one of the first problems he will face is one he’s already been grappling with—the bank’s credit-card business.

“We gave a lot of cards out to our customers,” Mr. Moynihan said in a Nov. 5 speech. “We were giving them to too many people.” He discussed a “repositioning” of the business that would rely less on borrowing and more on card transactions, while acknowledging that the business won’t be as big or as profitable as it used to be.

Bank of America is the second-largest U.S. card issuer, after J.P. Morgan Chase & Co., and the card division accounts for 23% of BofA’s revenue through the first nine months of 2009. Yet cards also lost $4.5 billion during that same period, making it the worst-performing Bank of America business line. It also had a default rate higher than other major rivals, at 13%.

The current problems have their root in Bank of America’s push to become No. 1 in the card business. In 2006, it purchased MBNA Corp., one of the nation’s biggest credit card issuers, for $35 billion, hoping to combine the card company’s marketing and underwriting skills with its own massive branch network.

But in its pursuit of market share, Bank of America made poor underwriting decisions and the banking crisis of the last two years exposed many of those flaws. While trying to become the nation’s No. 1 small-business lender it offered unsecured credit lines of up to $100,000 to start-ups, some in business for only one day. Bank of America’s small-business default rate hit 17.5% in the third quarter of 2009.

Another misstep for Bank of America, said FBR Capital Markets analyst Paul Miller, was that it took too long to cut credit lines as customers went delinquent. BofA “always took a more optimistic view of the economy,” he said.

Bank of America Credit Chargeoffs vs. Allowances

Chart from the WSJ article above, I added the arrows.

Note that chargeoffs are increasing while provisions are collapsing. Also note that the chart only pertains to credit cards. What about residential real estate, home equity loans, commercial real estate, industrial loans, etc etc?

While some keep pretending there are excess reserves to be lent out, I scoff at the idea.

Assets at Banks whose ALLL exceeds their Nonperforming Loans

The above chart courtesy of the St. Louis Fed.

Because allowances for loan losses are a direct hit to earnings, and because allowances are at ridiculously low levels, bank earnings (and capitalization ratios) are wildly over-stated.

Excess Reserves? Please be serious.

For more on excess reserves please see Fictional Reserve Lending And The Myth Of Excess Reserves.

With unemployment at 10% and not headed significantly lower for years, and with allowances for loans and lease losses in the gutter, expect banks to be forced to raise more capital as credit card losses continue to mount.

Still more shareholder dilution via secondary offerings is on the way.

Mike “Mish” Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List


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Guest Post: The Federal Reserve Still Doesn't Know How To Get Rid Of Excess Liquidity


Submitted by James Bianco of Bianco Research

•    The Wall Street Journal – Fed Proposes Tool to Drain Extra Cash
The Federal Reserve on Monday proposed selling interest-bearing term deposits to banks, a move the U.S. central bank would make when it decides to drain some of the liquidity it pumped into the economy during the financial crisis. The new facility is intended to help ensure that the Fed can implement an exit strategy before a banking system awash with Fed money triggers inflation. Fed Chairman Ben Bernanke has described term deposits as “roughly analogous to the certificates of deposit that banks offer to their customers.” Under the plan, the Fed would issue the term deposits to banks, potentially at several maturities up to one year. That would encourage banks to park reserves at the Fed rather than lending them out, taking money out of the lending stream.The central bank said the proposal “has no implications for monetary policy decisions in the near term.” “The Federal Reserve has addressed the financial market turmoil of the past two years in part by greatly expanding its balance sheet and by supplying an unprecedented volume of reserves to the banking system,” it said. “Term deposits could be part of the Federal Reserve’s tool kit to drain reserves, if necessary, and thus support the implementation of monetary policy.” Michael Feroli, an economist at J.P. Morgan Chase, said “it’s another step forward in the exit-strategy infrastructure, but it’s been well flagged in advance, so it’s not a surprise.” When Fed officials decide to tighten credit, they would likely use the term-deposits program ahead of — or in conjunction with — adjusting their traditional policy lever, the target for the federal funds interest rate at which banks lend to each other overnight. The Fed also said Monday that its balance sheet rose slightly to $2.2 trillion in the week ending Dec. 23. The Fed’s total portfolio of loans and securities has more than doubled since the beginning of the financial crisis. As part of its efforts to fight the downturn, the central bank is buying $1.25 trillion in mortgage-backed securities, a program it says will end in March. The Fed now holds $910.43 billion in mortgage-backed securities, it said Monday.

•    Bloomberg.com – Fed Proposes Term-Deposit Program to Drain Reserves
The Federal Reserve today proposed a program to sell term deposits to banks to help mop up some of the $1 trillion in excess reserves in the U.S. banking system.  The plan, subject to a 30-day comment period, “has no implications for monetary policy decisions in the near term,” the central bank said in a statement released in Washington. Fed Chairman Ben S. Bernanke is preparing tools and strategies to shrink or neutralize the inflationary impact from the biggest monetary expansion in U.S. history. Central bankers are also conducting tests of reverse repurchase agreements and discussing the possibility of asset sales. Term deposits may help the central bank “assert operational control over the federal funds rate” once officials decide to lift the overnight bank lending rate from the current range of zero to 0.25 percent, said Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey. Excess cash “would be locked up” rather than put downward pressure on the federal funds rate, he said.The Fed won’t begin raising interest rates until the third quarter of 2010, according to the median estimate of 62 economists surveyed by Bloomberg News in the first week of December.

•    The Financial Times – Fed to offer term deposits to banks
The US Federal Reserve plans to offer term deposits to banks as part of its “exit strategy” from the exceptionally loose monetary policy used to fight the recession. In a consultation paper released on Monday the Fed said it planned to change its rules so that it could pay interest on money locked up at the central bank for a defined period. The Fed added that the well-flagged rule change – designed to allow it more influence over the $1,100bn in excess reserves held by banks – was part of “prudent planning. . . and has no implications for monetary policy decisions in the near term”. It is one of a number of measures that has been outlined over the past few months by Ben Bernanke, chairman of the Fed, as an option to drain liquidity from the financial system in a manner that protects the economic recovery while heading off the threat of inflation.

•    The Federal Reserve – Notice of proposed rulemaking; request for public comment.
The Board is requesting public comment on proposed amendments to Regulation D, Reserve Requirements of Depository Institutions, to authorize the establishment of term deposits. Term deposits are intended to facilitate the conduct of monetary policy by providing a tool for managing the aggregate quantity of reserve balances. Institutions eligible to receive earnings on their balances in accounts at Federal Reserve Banks (”eligible institutions”) could hold term deposits and receive earnings at a rate that would not exceed the general level of short-term interest rates. Term deposits would be separate and distinct from those maintained in an institution’s master account at a Reserve Bank (”master account”) as well as from those maintained in an excess balance account. Term deposits would not satisfy required reserve balances or contractual clearing balances and would not be available to clear payments or to cover daylight or overnight overdrafts. The proposal also would make minor amendments to the posting rules for intraday debits and credits to master accounts as set forth in the Board’s Policy on Payment System Risk to address transactions associated with term deposits.

Comment

We believe the proposal of this new tool signals the Federal Reserve is still flailing around trying to look busy so everyone is assured they have a plan.  The fact is they have no plan and are still throwing everything on the wall to see what sticks. From the November 4 FOMC minutes:

Participants expressed a range of views about how the Committee might use its various tools in combination to foster most effectively its dual objectives of maximum employment and price stability. As part of the Committee’s strategy for eventual exit from the period of extraordinary policy accommodation, several participants thought that asset sales could be a useful tool to reduce the size of the Federal Reserve’s balance sheet and lower the level of reserve balances, either prior to or concurrently with increasing the policy rate. In their view, such sales would help reinforce the effectiveness of paying interest on excess reserves as an instrument for firming policy at the appropriate time and would help quicken the restoration of a balance sheet composition in which Treasury securities were the predominant asset. Other p

articipants had reservations about asset sales–especially in advance of a decision to raise policy interest rates–and noted that such sales might elicit sharp increases in longer-term interest rates that could undermine attainment of the Committee’s goals. Furthermore, they believed that other reserve management tools such as reverse RPs and term deposits would likely be sufficient to implement an appropriate exit strategy and that assets could be allowed to run off over time, reflecting prepayments and the maturation of issues. Participants agreed to continue to evaluate various potential policy-implementation tools and the possible combinations and sequences in which they might be used. They also agreed that it would be important to develop communication approaches for clearly explaining to the public the use of these tools and the Committee’s exit strategy more broadly.

The Federal Reserve first hinted at term deposits almost two months ago, although exactly what they were talking about was left vague until now.

Remember that the Federal Reserve has to withdraw over a trillion dollars of excess liquidity.  The easiest way to do this is to sell hundreds of billions of MBS, Treasuries and agencies.   As the bold highlighted passage above implies, they are scared to death of doing this, so they propose complicated schemes to withdraw liquidity like reverse repos and now term deposits.

We have argued that these schemes will not work.  They cannot be done in the sizes necessary or enough to even matter.  The Federal Reserve could possibly drain tens of billions of dollars via these schemes, but collectively that will amount to a rounding error when the goal is to withdraw over a trillion in excess reserves.

The Federal Reserve does not want to admit defeat, so they continue pursuing these strategies that will not make a difference.  We believe they also do it to “look busy” as they are taking measurements and notes as to how to withdraw all the liquidity they have pumped in.  They think this will give the market comfort that someone is on the case and that inflation expectations will not get out of control.  The market is not buying this.  Inflation expectations, s measured by TIPS inflation breakeven rates, are going vertical.

Reinvestment Risk

As to term deposits, the Federal Reserve is proposing an illiquid short term instrument for banks to invest in.  Banks would buy these instruments and “lock up” the excess reserves they now have.  This would have the same effect as draining excess reverses.  The maturities of these instruments would be as long as one year.

It is unclear if there will be a secondary market for these instruments, and if so, how liquid it will be.
Without a secondary market, buyers of these instruments face huge reinvestment risk.  The future course of short term interest rates is arguably to the most uncertain it has been in decades.  Will the Federal Reserve stay near zero until 2012 or will they be forced to raise rates in the first half of 2010?  Given all this uncertainty, who wants to lock up money in something that cannot be sold before maturity?  This is especially true given the Federal Reserve’s statement that the “maximum-allowable rate for each auction of term deposits would be no higher than the general level of short- term interest rates.”

The general level of short-term interest rates is set on known instruments that have generations of history and active secondary markets.  If the Federal Reserve wants to introduce a new, and wholly unknown instrument with an uncertain secondary market and offer no interest rate premium, then we cannot see how this will work beyond a token amount after some arm twisting to get them sold.  The Federal Reserve will have to offer a premium for uncertainty and illiquidy to make this fly in any major way, something they said they will not do.

Complicated Is Simple

The Federal Reserve owns 80% of AIG.  With each passing day it looks like the Federal Reserve is adopting AIG Financial Product’s business practices.  That is, when faced with a financial problem, they create complicated tools (like CDS).  When critics says these new products will not work, tell them they do not know what they are talking about and create even more complicated tools to dazzle everyone.  Once the tools are so complicated that no one understands them, you will be hailed as an expert with no peer.  You might even be named TIME’s Person of the Year.

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Hussman on Valuation; Stocks Higher? Bulls Dance On Edge Of Cliff

Inquiring minds are reading Clarity and Valuation by John Hussman.

Last week, the dividend yield on the S&P 500 dropped below 2%, versus a historical average closer to double that level. While part of the reason for the paucity of yield in the current market can be explained by the 20% plunge in dividend payouts over the past year, as financial companies have cut or halted dividends to conserve cash, the fact is that current payouts are not at all out of line with their historical relationship to revenues, and even a full recovery of the past year’s dividend cuts would still leave the yield at a paltry 2.5%. The October 1987 crash occurred from a yield of 2.65%, which was, at the time, the lowest yield observed in history, matched only by the 1972 peak prior to the brutal 1973-74 bear market.

Those two periods had a few other things in common. In the weeks immediately preceding the market downturn, stocks were overbought, had advanced significantly over prior weeks, bond yields were creeping higher, and investment advisory bearishness had dropped below 19%. All of those features should be familiar, because we observed them at the 1987 and 1972 peaks, and we observe them now.

On the basis of normalized profit margins, the average price/earnings ratio for the S&P 500, prior to 1995, was only about 13. Higher historical “norms” reflect the addition into that average of extremely high “recession P/Es,” based on dividing the S&P 500 by extremely low, but temporarily depressed earnings. For example, the P/E for the S&P 500 currently is 86, because earnings have been devastated, but it would be foolish to take that figure at face value, and equally foolish to work it into a historical “average” P/E. The pre-1995 norm of 13 for price-to-normalized earnings is important, because at present – and again, we are not using current depressed earnings, but properly normalized values – the S&P 500 P/E would currently be over 20. That’s higher than 1987 and 1972, and about even with 1929. Of course, valuations have been regularly higher in the period since the late 1990’s (and not surprisingly, subsequent returns, even after the recent advance, have been dismal overall, with the S&P 500 posting a negative total return for the past decade).

So overvalued, check. Overbought, check. Overbullish, check. Upward pressure on yields, check. Market internals? – certainly mixed, but not bad – and there’s the wild card.

It’s important to recognize that when I quote probabilities, I am generally using a form of Bayes’ Rule. So when I say, for example, that I estimate a probability of about 80% of fresh credit difficulties accompanied by a market plunge over the coming year, that figure is based on various combinations of historical evidence, and what has (and has not) happened afterward, and how often. As a side note, a “market plunge” in this context need not be a “crash.” In the context of a credit-driven crash and rebound (which is what I believe we’ve observed), a typical post-rebound correction would be about -28%, but even that would take stocks to less than 20% above the March lows.

From current valuations, durable market returns appear very unlikely. As I noted last week, whatever merit there might be in stocks is decidedly speculative. That doesn’t mean that the returns must be (or even over the very short term, are likely to be) negative. What it does mean is that whatever returns emerge are unlikely to be durably positive. Market gains from these levels will most probably be given back, possibly very abruptly.

Stocks Higher? New Bull Market?

New bull market for the new year? Famed bond investor El-Erian of Pimco says don’t bet on it.

Homes are selling at their fastest clip in nearly three years, the unemployment rate is falling and stocks are up 66 percent since their March lows — the best performance since the 1930s.

What’s not to like?

Plenty, according to Mohamed El-Erian, chief executive of giant bond manager Pimco. The investor says the recovery may be gaining steam but is no different than a kid who eats too much candy at one of the birthday parties his 6-year-old daughter attends.

“We’re on a sugar high,” El-Erian says. “It feels good for a while but is unsustainable.”

His point: This burst of economic activity fed by government spending and near-zero interest rates will soon peter out.

As CEO at Newport Beach, Calif.-based Pimco, El-Erian, 51, oversees nearly $1 trillion in assets, more than the gross domestic product of most countries. So when he talks, people listen.

What he’s saying now:

–Stocks will drop 10 percent in the space of three or four weeks, bringing the Standard & Poor’s 500 index below 1,000 — though he’s not predicting when.

–The unemployment rate will be hovering above 8 percent a year from now.

El-Erian says people are fooling themselves if they think all the bullish data of late means a strong recovery is in the offing. So he’s buying Treasurys and selling riskier stuff.

His bet: Investors will get scared again and want U.S.-guaranteed debt so they know they’ll get repaid.

James Paulsen, chief strategist at Wells Capital Management in Minneapolis, with $355 billion under management, has been pounding the table for months to buy stocks. Just like in the early 1980s, the recovery will take the form of a “V,” he says. The reason: Companies have cut inventories and payrolls to the bone, so just a little revenue growth could translate into a bumper crop of profits.

El-Erian says many of the bulls don’t appreciate just how much the government props still under the economy are masking its weakness. Instead of focusing on the fundamentals today, he says, they’re looking to the past, expecting a quick economic rebound because that’s what’s happened before.

We’re trained to think the “farther you fall, the higher you’ll bounce back,” El-Erian says. “We’re hostage to the V.”

El-Erian says we’ve probably seen the worst of the crisis but consumers, and not just Washington, need to start spending again for the recovery to really take hold.

He doesn’t expect that to happen soon. Like in the Great Depression, Americans are saving more and borrowing less — a shift in attitudes toward family finances that Pimco thinks will last a generation.

That, plus the impact of more regulation and higher taxes, El-Erian says, will crimp growth for years to come.

El-Erian Is An Optimist

As I see it, El-Erian is an optimist. A year from now it is extremely unlikely the unemployment rate will approach 8%. Please note El-Erian is not calling for 8% unemployment, he is only saying it will be above 8%.

How much above 8% are we talking about? Arguably, the answer to that question is another question: How nuts will Congress get with more stimulus packages? Then again, the current stimulus package did not create any lasting jobs, so why would the next one?

It is pretty clear the bulk of the current stimulus efforts is behind us. We will see the results in 4th quarter GDP, with some additional but smaller effect in the 1st quarter 2010 GDP. What then?

Hussman’s viewpoint is very similar to mine. I think the bottom may be in, but returns going forward are unlikely to be very good, and a strong pullback is very likely.

Other possibilities include a scenario in which the market goes nowhere (say +-150 S&P points) in either direction, for
a number of years. There is also a 20% chance Congress and the administration totally wrecks the US dollar and stocks magically go flying.

I think the probabilities look something like this:

  • 20% chance of a durable rally
  • 20% chance the market meanders nowhere for as long as 5 years
  • 30% chance of of a hard 25-30% correction
  • 30% chance the bottom is not even in

Unlike Hussman, I have not done any statistical analysis of those estimates. Certainly his “estimate a probability of about 80% of fresh credit difficulties accompanied by a market plunge over the coming year” is reasonable enough.

Note that Hussman’s 80% probability of a plunge encompasses a plunge where the bottom holds and also where it doesn’t.

The key for me is that on average it does not pay to be fully invested here, regardless of what the stampede of bulls say. Bear in mind, the bulls were saying exactly the same thing as they are now right at the October 2007 high. I received taunts for several months for my market top call late summer of 2007, about 3% and 3 months early.

Is the top in now? No one knows, but that is not even the right question to be asking. A far better question to be asking is “Is the bottom in?” Even if it is, a major test coming of that bottom down the road is highly likely and that will gore a lot of overly complacent bulls along the way.

In 2007, Chuck Prince former CEO of Citigroup proclaimed “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”

Once again, bulls are dancing on a clifftop, oblivious to the fact that the next step might be right over the edge.

Mike “Mish” Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List



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