1 December 2009

Liquidity vs. Solvency: Interview with Bob Eisenbeis and David Kotok

The current issue of Institutional Risk Analytics features an interview with Bob and David Kotok of Cumberland Advisors. To me it is a must read, literally packed with insightful analysis about the dismal situation as concerns our fiscal and monetary affairs.

In essence, “the wounded banking sector of the US is here for a very long time”. Twenty-four hundred plus banks are now rated "F" by the IRA Bank Monitor, which is a quarter of the whole industry. Something like half of the "F" banks are expected to fail. At the same time, it appears we have a situation wherein “Washington has largely destroyed confidence in the United States of America among global investors... “

“On the way back from Tokyo last week, I sat next to a guy who is running the agency desk at one of the largest primary dealers. He described to me the road show he was on to sell US agency paper to Asian financial institutions. We talked about this approach. He said very bluntly that the Asian banks are not buying it. He told me that "we have destroyed confidence and they do not trust us." My response to this was "do you blame them?"

The failed auction has not happened yet. It may not happen. But it would not surprise any of us if it eventually does happen. I expect a VAT to be introduced. I expect it to be introduced during the lame duck session of Congress in 2012.

The IRA: You think we can hold it off for that long?

(Whalen and company were on Bloomberg Radio with Josh Rosner on Tuesday when Josh leaned over during a break and predicted that the Obama Administration was preparing to impose a VAT on the US, using the supposed pressure from our aggrieved allies and global investors as the pretext. We later spoke to our friends in the conservative movement and it turns out that Brookings Institution has been working night and day on a study that will be the road map for implementing a VAT. This is to be a nation-wide sales tax on the American people to pay for the bank bailout. Apparently Bob Rubin and Larry Summers are the proponents of the VAT and they are planning to use the apparent pressure from our foreign creditors as the justification for a large, permanent increase in taxes. And David (of Cumberland Advisors), just described the failure of an auction of agency debt that could provide the pretext for just such a move.)

Liquidity vs. Solvency

The final Q3 2009 data from the FDIC is loaded into The IRA Bank Monitor and, as we reported several weeks ago with our preliminary results stress in the banking industry is up from Q2 2009 and by a significant margin.

The number of FDIC-insured bank units rated "F" rose from 2,256 at the end of June to 2,337 as of Q3 2009. Even with the heavily subsidized money center banks added back into the equation, the Stress Index results suggest that the US financial services sector is still sinking bow down under the weight of the highest loss rate experience in the post-WW II period.

Whereas 2008 was about fear, 2009 has been about buying time. But now dwindling cash positions inside some of the largest financial institutions and investors seem to suggest that 2010 will be about resolution, whether we like it or not.

This suggests that the economy will muddle along through next year and that the 2010 US mid-term elections could be problematic for all incumbents.
With the apparent default by the leading government-owned holding company in Dubai, investors have been reminded that solvency remains a core problem in the global economy despite ample official liquidity.

While the Fed and other central banks have thrown a great deal of fiat paper money at the solvency problem, many obligors still have piles of liabilities that were predicated on price levels and volumes in many markets that no longer pertain. Ponder why the government of China might publicly state that its banks need more capital and the next leg of the proverbial systemic risk stool may come into sharper focus.

"The bottom line is that the policies that we see including this new instrument and the other, what I call "wiz kid" ideas like the $1 trillion PPIP which is a fizzle, they do not create confidence. These polices inspire distrust and undermine confidence number two. And thirdly they are not solving basic issues with banks and markets that Bob has been describing in our comments over the past many months, chiefly the difference between solvency and liquidity. Some people in the Treasury do not understand the difference or they do not want to."


GEAB quote – As early as January 2009, LEAP/E2020 warned its subscribers of risks of Dubai collapse in 2009
Fourteen subjects lose momentum along the year 2009 - 1. Financial services, central economic activities: In 2009, as the collapse of Wall Street and the City will deepen (and that of financial centres of secondary importance, such as Singapore and Dubai), the demonstration will be completed that a national economy cannot be based on financial services. The only financial centers to survive will be those based on a sound real economy (that will save Hong-Kong) and representing only one component, among others, of a country’s economy. On the one hand, financial services are reducing even faster than the rest of the economy when a recession occurs due to a financial crisis (they are attacked on every front); and, on the other hand, since financial services are so easy to relocate at the time of Internet (a lot easier than industrial labor-forces), they cannot be the mainstay of anything durable in fact. In 2009, everything that depends on the vitality of these financial centers will sink into the crisis at an even faster pace than the rest of the economy.

But Minack says equities will not roll over until next year..as is sanguine on Dubai.

Finally, sovereign stress has jangled nerves. We're not convinced that what's happened in Dubai is, by itself, of broad consequence. The sums involved are, relative to the global financial losses seen in this cycle, small change. Neither Jonathan Garner, our EM equity strategist, nor Rashique Rahman, our EM credit strategist, sees an end to the rally in their asset classes. (See Jonathan Garner, China/Dubai Newsflow - China More Important and Rashique Rahman, Credit (Dis)location - The Market Will Recover, 27 November.)

However, policy makers' response to the Great Recession has been the Great Swap, and one of the things swapped was the tail risk: a year ago that was private balance sheet implosion; looking ahead, the tail risk is the sovereign equivalent. While Dubai was unexpected, the simple point is that we have seen concerns rising in a number of places, notably Japan and southern Europe.

These factors may sound good reason to call the end of the rally. We know the risks in over-finessing market timing, but on balance we think there's one more leg higher. Our sense is that the current setback has been exacerbated by year-end profit-taking and thinning market conditions. Our hunch is that investors will again see this as a buy the dip opportunity and that the New Year could start reasonably strong, particularly if investors anticipate a continuation of recovery and low rates.

Consequently, we're sticking to our view that stocks can make new rally highs over the next couple of months, although we have lower conviction than in the prior corrections. We are taking last week's events as serious warning. What we are starting to see is a hint of the forces - developed world growth threatening to roll over, and heightened concern about public sector finances - that we think will at some stage lead to a significant fall in developed-world risk assets in 2010.

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