4 August 2008

The Saga of Humpty Dumpty

by John Needham, The Daniel Code Report | August 1, 2008

Humpty Dumpty sat on a wall; Humpty Dumpty had a great fall
All the King’s horses and all the King’s men; Couldn’t put Humpty together again.
As taught by my Burmese Nanny

The implications of Mother Goose’s nursery rhyme first printed in 1810 is that the great and good of the land (the horses naturally rank as the good) had no other priority than to repair Humpty and reinstate him on the wall. This longing to reject change and reinstate the perceived natural order, at least where that natural order means cosseting a generation with unparalleled spending power and access to liquidity, is the reason for the frenetic actions of central bankers and Treasury officials as they strive diligently to restore that which the people have come to demand as their right.

Humpty Dumpty in US

As the Treasury Secretary morphs from designating institutions with “too big to fail” status to demanding regulations where “institutions can be allowed to fail,” we see the urgent hand of executive government in that most dangerous of constitutional times, a time where half the Senate has changed and the balance are now vulnerable. For all three of the US decision making institutions to be aligned again is the greatest fear of incumbents, and so the inevitability of the law of pendulums (they go back and forth sport) must be debased, defeated, deferred or ultimately shoved into the national deficit for others to worry about many years hence.

In a crucial US election year the imperative of preventing reasonable consequences flowing from unreasonable policy and hence behavioral failures is excruciating, but so far US policy has had the mantle of respectability draped over its shoulders as governments world wide have elected the “lesser evil” policy, that of putting the egg back in its shell. Unfortunately for the egg scoopers, much has changed since Mother Goose tacitly endorsed the rescue efforts by the King’s men, not to mention the horses. Ludwig von Mises describes the endgame brought on by reckless expansion of credit:

"There is no means of avoiding the final collapse of a boom brought about by credit (debt) expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit (debt) expansion, or later as a final and total catastrophe of the currency system involved."

Humpty’s erstwhile rescuers are definitely in the “or later” camp. The desperation of the $300 billion US Housing Bill, totally unfunded, falls squarely into the “do something; anything” category, and will be just as effective as were the efforts of the King’s men in 1810. This from Reuters: A new fund, paid for with profits from the mortgage companies Fannie Mae and Freddie Mac, will help build affordable rental housing. The two companies will be allowed to buy pricier mortgages, up to $625,000, which would make stable loans available to buyers in expensive cities. The problem here is that these companies don’t actually have real profits. They have billions in unrealized losses. Quite how using a government bailout to increase the availability of top end mortgages, qualifies as helping struggling home owners has escaped me entirely. Must be an economists thing.

The President also was sensitive to complaints by fiscal conservatives, who object to the increase in the debt ceiling and the bailout for Fannie Mae and Freddie Mac shareholders. Some, but not all, were mollified by the bill's establishment of a regulator with stronger reins over the two companies and the new "consultative" role overseeing the companies for the Federal Reserve. The White House cast Bush's quiet signing of the bill as an act of expedience, not camouflage

In addition to the helpful components of the housing bill, The Center for Responsible Lending supports additional common-sense solutions, such as providing temporary deferment of foreclosures until housing markets stabilize. In this context “stabilize” means levitate. The inevitable conclusion that is being missed or simply ignored in this wave of Humpty restorations is that what we have seen in housing, auto loan and credit card debt, in the past 5 years in particular, is not normal. Bubbles are always an aberration that always lead to mean reversion in overblown markets


The current institutional belief is that the S&P can happily hold the range from 1250 to 1450. This belief is based on the assertion that half of the earnings in S&P companies are generated offshore and presumably are therefore immune from being degraded if US experiences several periods of below trend growth. Australia too has this belief with the variance that Down Under it is expressed as “China will save us”. It’s not going to happen folks. As the driver of the global economy US has in a decade swapped its industrial might for an outsourcing contract and ephemeral corporate profits, by arbitraging its back offices to developing countries. Last week Starbucks announced that it would close 60 of its 78 coffee shops in Australia. The Australian economy has yet to feel the ravages of the housing implosion and with mining enjoying a generational boom as Western Australia and Queensland tear large holes in the landscape to pour iron ore and coal into the insatiable maw of China, you cannot find a pessimist in the whole country. Yet Starbucks’ strategy is in tatters here.

Institutional trust that overseas earnings will support current stock price multiples is another egg on another wall. It too will fall.

Humpty Dumpty Down Under

“Ironwood” aka Mike E from Australia wrote during the week to take issue with my statement that "The four major Australian/New Zealand banks have already received undisclosed billions in loans and quasi capital injections from the Australian Futures Fund." Mike attached an article from a prominent Australian newsletter writer that bestowed blessings on the Futures Fund for its ostensibly sensible behaviour and said “There is an element of public good in investing bank bills because, as the ABN Amro paper pointed out, interest rates on home loans would probably be higher if Australia's major banks had been forced to obtain more expensive funding offshore. The Future Fund took higher risks shifting its deposits from the risk free RBA (sic Reserve Bank of Australia) into bank bills. But in doing so it acted within the parameters of its directions from the parliament to take an acceptable but not excessive level of risk.” Mike adds “I do not believe that our Future Fund or Reserve Bank are involved in underhand dealings”

Whilst it would arguably have been better to have higher housing interest rates earlier and save some of the poor unfortunates from their own excesses, that is another issue best left for another day. The newsletter writer is a highly skilled financial journalist and commentator and comes across as a lovely guy, but he has approached the whole question of the Future Fund with the benign eye of a gentle observer.

I, on the other hand, am an aged Attorney who spent many years pursuing (and defending) rogues in suits in commercial litigation. I long ago lost faith in men in suits, particularly those who have their snouts in the public purse. I would add to this list women in suits. They are after all, well, women in suits. I prefer my variety in dresses but then again as my children so aptly remind me, I am not only old but old fashioned to boot. Nonetheless in the interests of fairly assessing the weight to be given to the self serving statements that issue from these worthies, let me put the other side of the case.
April 17 (Bloomberg) -- The Australian government's A$60 billion ($56 billion) Future Fund is among the least transparent in the world, the Australian Financial Review reported, citing a ranking of sovereign wealth funds. The Fund was ranked 9th among 10 sovereign pension savings businesses that failed to meet Washington-based Peterson Institute of International Economics' standards of governance.
AAP on Senate estimates committee-22 February 2008. David Neal, the fund's chief investment officer, said Australian share values had dropped about 15 per cent in recent months, knocking $600 million to $700 million off the value of its local share portfolio. He was unable to give an immediate accurate loss of the international equity portfolio because it was complicated by the currency element. Mr Neal said the fund also invested in global property trusts during two transactions in late October and early November. The property trusts break down to 50 per cent in US assets, 30 per cent European and 20 per cent Asian, Mr Neal said the US trusts were predominantly in commercial property, which was not as badly hit as the residential market following the collapse of the US sub-prime market.
SYDNEY, June 12 (Reuters) - Cash-strapped Australian banks are tapping the country's sovereign wealth fund to raise new finance as traditional sources of funding dry up in the ongoing global credit crisis. Australia and New Zealand Banking Group Ltd (ANZ) Australia's third-biggest lender by assets, has raised about A$500 million ($472 million) in term funding from the Future Fund, an industry source said on Thursday. "My understanding is that all Australian banks have done transactions with (the Future Fund). If you want debt in your portfolio, having some bank term debt is not a bad option, particularly given that you are getting more attractive spreads," said one industry source, who declined to be identified.
ABC News-The $51 billion in the Federal Government's Future Fund will be managed by a foreign bank with no base in Australia. Northern Trust will manage the Future Fund's money from its regional headquarters in Singapore using staff in Bangalore, India. That simple task will generate Northern Trust about $30 million in annual fees.
Wed Apr 23, 2008, April 23 (Reuters) - Australian sovereign wealth fund the Future Fund, which has A$60 billion ($57 billion) in assets, said on Wednesday it was eyeing private transactions and debt markets amid the current stock market turmoil. General Manager Paul Costello told a business lunch the fund was a cashed-up supplier of liquidity that was operating in a market currently short of providers of funds. Costello said the fund's private markets team was looking at infrastructure, private equity and real estate investments. Costello said debt strategies were also attractive in the current investment climate, and there were plenty of opportunities outside of the stock market.
Future Fund billions help banks ride credit storm The Age. July 14, 2008. The Federal Government's Future Fund and the Reserve Bank have quietly propped up the banks through the global financial turmoil of the past year, ABN-Amro economists have revealed. They say the two institutions provided a quarter of the massive growth in bank funding to fight off the global credit crunch.

On this evidence the Future Fund management comes off somewhere between naïve and plain stupid. Commercial real estate, debt strategies, inability to figure currency conversions for a Senate hearing, failing to meet international governance standards! Messrs Costello and Neal would do better to cut out the business lunches and do their homework. I get a peanut butter sandwich for lunch, if I’m lucky, but even this geriatric lawyer can figure currency conversions. It appears to me that these guys are acting more like a start up hedge fund than the conservator of the country’s vital budget surpluses. The thought that these tyros are “looking at infrastructure, private equity and real estate investments” is kinda scary. NAB has just demonstrated what happens when the country cousins try to play with the big boys.

Ironwood then goes on to ask "Is there some Federal protection beyond the AU$20,000 per account holder which was recently announced? ” My response is that I haven’t parsed the terms of their client account protection but this is not an issue. Australia's big four banks are among only 20 AA rated commercial banks in the world. According to Standard & Poor's there are less than five commercial banks in the world with higher ratings.

The issue is that some of these guys are careless with the truth and “full disclosure” and “true and fair” accounts are not phrases that readily spring to mind regarding their recent conduct.

More Canaries

Last Friday astute FSO readers were aware of the first real mark to market of US CDOs when “News from Down Under” reported that National Australia Bank (NAB) had valued their senior tranche US CDOs at 10c in the dollar. I assumed that a dutiful audit clerk had finally suggested that facing reality was a good idea or was at least in keeping with the lofty ideals apparent in all Australian banks. My assumption was not only wrong but empirically flawed in ascribing such notions to they of the Janus mask (see FSO archives; Crash!). As the other shoe dropped on Tuesday, the story unrolled.

NAB were partners with US investment bank Merrill Lynch in this investment. This from Crikey.com:
The National Australia Bank's shock write-down of $830 million worth of collateralised debt obligations (CDOs) can now be explained. It was triggered by a move from struggling US investment bank Merrill Lynch to get rid of billions worth of CDOs in which the NAB was a co-investor. Merrill's took a decision to sell the CDOs at a written-down value and the NAB had no option but to follow suit. Its larger write-down than Merrill Lynch (90% vs. 78%) reflects its lower ranking of security. The NAB was involved in a parcel of what’s called "super-senior" CDOs with a face value of $19.9 billion. In effect Merrill's move to sell these holdings of CDOs to a distressed debt fund investor, forced the NAB to write-down the value of its holding in the CDOs.

It's that phrase in the above paragraph; "super senior ABS CDO" which reveals what happened. This sale was dated June 27. NAB was a 'senior' ranked investor in the CDOs and when a super-senior ranked investor decided to liquidate or sell the CDOs at a lower value, the other investors have no say in the matter and have to follow suit.

For Marius D to whom I promised an explanation of CDOs, I trust this assists. In truth I studied the structure of CDOs for some hours before admitting temporary defeat, but the short version is they are a manufactured security with the features that I have written about previously, the chief one being that all are different and so cannot be valued on a transparent basis. Perversely this is one of the features that has made them so attractive to institutions.

To add insult to injury NAB had been running an $800 million bond sale during the period that it was aware of the impending CDO write down but sadly omitted to mention the looming problem to investors who lapped up the road show and marketing blitz for the bond offer. NAB has since refunded hundreds of millions of dollars to irate investors who had bought into the bond sale in the days before the write down, according to reports today from UK Telegraph. More jolly good fun from your friendly bankers!

Gold, HUI and DX

US Dollar index had an unexpected burst of institutional support last Friday, and again on Thursday of this week, which continues to pressure Comex Gold, still holding up valiantly in the face of DX which is now rallying into the fifth month since its celebrated low on 17th March, foreshadowed and discussed in previous Financial Sense articles. At present Gold is holding within two standard deviations of its regression channel from the 05/02 low, but is decidedly on the bottom of that channel and is not being helped by weakness in the HUI Gold Bugs index

For the sharp eyed who noted the precise low in Gold at 893.30 on Wednesday, the red line at 893.1 is not a poorly drawn recognition of that turn but the Danielcode retracement level that has been on this chart for subscribers since a few days after the 07/15 swing high. For those who might wonder how often this occurs, the answer is almost all the time. The Daniel number sequence controls all markets by creating secret price levels that markets recognise but others do not see. I pray my subscribers indulgence for showing this chart, but there will be a new one with new numbers posted on Monday. Gold traders need to know these numbers.

Many traders and investors use D2 or derived data from HUI to verify signals in the primary Gold market. For those who are hoping for an early resumption of the tear away bull market, this indicator at least will be disappointing. HUI is stubbornly maintaining its sell signal on the monthly chart and tested its 2008 low on Wednesday. For Financial Sense readers I provide some free, and interesting Gold and HUI charts at the Danielcode website. They inject a degree of discipline and rigor to the weekly and monthly signals in both of these markets and are updated every Monday. You are most welcome to visit.

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