Where Have We Seen This Movie Before?

The Aspiring Analyst Vol. 1 Iss. 11 theaspiringanalyst@gmail.com

It feels like dj vu when we see central banks enacting the same policies and measures they tried as recently as 2007 in order to prop up failing banks. Last time, it was because of toxic U.S. subprime mortgages. This time, it is toxic European government bonds. In a world awash with debt, throwing more liquidity at the problem isnt really going to help much. At the end of the day, write-downs and living within our means is still the best medicine; not some central banker scheme to promote animal spirits! While people are fixated with Europe, we would like to point out that China appears to be rolling over. Housing prices there are starting to collapse while companies kept on life-support (cheap credit) are going out of business. Although Chinese authorities have started loosening monetary policies once again, we think its best to avoid Chinese stocks until the dust settles. Bubbles tend to blow up in spectacular fashion, not deflate gradually. When have we seen a real soft-landing?

Jason Chen The Aspiring Analyst

Where Have We Seen This Movie Before? Erratum

The Aspiring Analyst Vol. 1 Iss. 11 theaspiringanalyst@gmail.com

For the first order of business this month, we would like to correct an erratum in last months letter where we misrepresented the per capita federal debt of Canada. The figure we previously quoted, $36,898.23 in per capital federal debt, is actually per capita public debt, which includes debts from Canadas provinces. Canadas federal debt is closer to $570 BB or $16,000 per capita. The rest of the analysis does not change, since it compares public debt in Canada vs. U.S. vs. Greece, etc. Canadians still have more debt. Sorry! Where Have We Seen That Movie Before? Would you believe me if I said the following paragraph1: Today, the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, and the Swiss National Bank are announcing measures designed to address elevated pressures in short-term funding markets... Came from the press release detailing the Federal Reserve and the global central banks coordinated liquidity actions on Wednesday November 30th? If you believed me, then you are wrong. The paragraph actually came from a press release in December 2007 when the global central banks first came together to alleviate stress in the short-term funding markets. Which is why we cannot understand investors enthusiasm for risky assets (global stock markets were bid up 4% in 1 day) on the back of November 30s coordinated measures. Central banks first started these coordinated liquidity measures in December 2007 and stock markets did not bottom until March 2009. Weve seen this movie before! Treating The Symptoms, Not The Cause The official reason why the Fed and other central banks decided to re-establish these swap lines was to ease strains in financial markets and thereby mitigate the effects of such strains on the supply of credit to households and businesses and so help foster economic activity. We speculate the more likely explanation is that a major European bank had been frozen out of inter-bank lending markets and would have failed had it not been able to borrow dollars from the central banks. But we likely wouldnt know whether our hypothesis was true or which bank it was until 3 years from now, just like how we recently found out that Morgan Stanley borrowed over $100 BB from the Fed2 at the height of the Great Recession (more than 10x its market capitalization). The problem we have today, in terms of short-term funding markets, is that many European banks are stuffed to the ears with European sovereign bonds that are now worth significantly less than what they

Federal Reserve, retrieved December 2, 2011: http://www.federalreserve.gov/newsevents/press/monetary/20071212a.htm 2 Reuters, retrieved December 2, 2011: http://blogs.reuters.com/felix-salmon/2011/11/28/chart-of-the-daymorgan-stanley-bailout-edition/

Where Have We Seen This Movie Before?

The Aspiring Analyst Vol. 1 Iss. 11 theaspiringanalyst@gmail.com

originally paid for them. Compounding the problem is that many of these bonds were thought to be risk free, and hence the banks did not have to put capital against them. Therefore, we have dubious assets that will likely require a write-down and not enough capital to be written down. So Wednesdays coordinated central bank liquidity measures are trying to solve a solvency problem with liquidity; it is like giving a flu patient chicken soup sure, it feels good and may alleviate the symptoms, but the correct prescription is to inject capital into the European banking system, not unlike what the US Treasury did with American banks like Bank of America and Citigroup, and allow the European banks to write-off their sovereign debts to a market-clearing price. Just Say No Taking a step back, the wider problem in Europe is that a number of governments are on clearly unsustainable fiscal paths. For example, Greece is clearly insolvent. Trying to wiggle around the technical definition of a default3 by saying private-sector write-downs are voluntary does not escape the fact that even with the write-downs, Greece will still have debt to GDP way over 100%. Despite political rhetoric, it was not the speculators that have caused this debt to accumulate, it was profligate government spending programs; blaming speculators and forcing voluntary write-downs will only make matters worse. In fact, part of the reason why Italy is paying an eye-watering 7% interest on 10-year debt is because the voluntary Greek debt write-downs have broken the credit default swap market. Credit default swaps are like insurance contracts used to insure against the credit risk. But if the terms of the swap contracts cannot be enforced, investors who may otherwise have bought sovereign bonds and hedged the credit risk with CDSs may find it much easier to Just Say No to European debt altogether, even to the best credits like Germany, as shown by a recent failed auction4. Who loses in the end? Chinese Tiger Rolling Over...Dont Get Crushed! About half a year after we wrote about the 64 million empty apartments in China, we may finally be seeing the signs of the Chinese credit and housing bubble bursting. Over the past several weeks, we have seen increasingly disturbing news stories coming out of China, such as company bosses running away because they couldnt pay exorbitant underground interest rates5, home prices falling in most major Chinese cities6 and apartment buyers in Shanghai realizing for the first time in their lives that housing prices dont always go up7.

Bloomberg, retrieved December 2, 2011: http://www.bloomberg.com/news/2011-10-27/greek-accord-won-ttrigger-credit-default-swaps-isda-rules-say.html 4 Reuters, retrieved December 2, 2011: http://www.reuters.com/article/2011/11/23/us-markets-bonds-bundsidUSTRE7AM0Y920111123 5 Bloomberg, retrieved December 2, 2011: http://www.bloomberg.com/news/2011-11-06/china-credit-squeezeprompting-suicides-along-with-offer-to-sever-a-finger.html 6 Bloomberg, retrieved December 3, 2011: http://www.bloomberg.com/news/2011-11-18/china-home-prices-fallin-33-of-70-cities-in-worst-performance-this-year.html 7 Bloomberg, retrieved December 3, 2011: http://www.bloomberg.com/news/2011-11-29/shanghaied-homebuyers-turn-protesters-as-shattered-dreams-vex-government.html

Where Have We Seen This Movie Before?

The Aspiring Analyst Vol. 1 Iss. 11 theaspiringanalyst@gmail.com

Combined with a slowing export sector due to European debt concerns8, it is no wonder that Chinese policymakers decided to cut bank reserves in order to boost bank lending9. The question is whether these moves will be effective in steering the Chinese economy to a soft-landing? We think not, since bubbles tend to blow up in spectacular fashion, not deflate gradually. Foreign Reserves Is Not A Giant Chequebook Speaking of China, we find it hilarious and sad that European politicians and technocrats keep hoping for a Chinese white-knight to solve their fiscal problems. Yes, China has $3.2 Trillion in foreign exchange reserves. But no, those reserves cant really be used to bailout Europe. Chinas foreign reserves are not cash. Instead, it is comprised of assets, mostly treasury bonds of the United States, Japan, or European countries. To bailout Europe, China will have to sell some of these assets and invest the proceeds into Europe. But selling Italian bonds to buy Italian bonds isnt really going to help, is it? Or if China were to start selling U.S. treasuries in size, would that instead drive up the borrowing cost of the U.S., or destroy the value of Chinas remaining USD holdings? The most China can reasonably do is invest new reserves into the European rescue schemes. In 2010, Chinas foreign exchange reserves increased by $400 Billion. So let say China invests all of its 2011/2012 foreign exchange reserves in Europe, is that enough? No, not when Italy and Spain probably need bailouts measured in the trillions of dollars! And what of the U.S.? If China buys only European debt, who will buy U.S. debt?

Bloomberg, retrieved December 3, 2011: http://www.bloomberg.com/news/2011-12-01/china-s-manufacturingshrinks-for-first-time-since-2009-on-europe-impact.html 9 Bloomberg, retrieved December 3, 2011: http://www.bloomberg.com/news/2011-11-30/china-cuts-reserverequirement-for-banks-as-europe-crisis-threatens-growth.html

Where Have We Seen This Movie Before?

The Aspiring Analyst Vol. 1 Iss. 11 theaspiringanalyst@gmail.com

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