Monday, July 30, 2012

Enquiring Minds Want to Know

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession  (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (, 2009)

The July 25, 2012, tribute to Barton Biggs received a large response. Biggs was obviously respected as well as loved. In the end, virtue is its own reward. Virtue is rarely rewarded in the world today; in fact, quite the opposite is true. It is refreshing to see such outpouring for a man who stuck to his guns and was also successful.

            Some correspondents wanted to know what James K. Glassman and Kevin Hassett, co-authors of Dow 36,000, are up to now. (For background, see Barton Biggs.) This cry poured in from near and far, including a message from J. Rogers in Singapore: "Where are they now? What do they say now?" In elaboration: "You should have exposed them further for the sake of all of us."

            Taking them one at a time:

            James K. Glassman wrote two books after Dow 36,000. In 2002, he wrote The Secret Code of the Superior Investor: How to Be a Long-Term Winner in a Short-Term World. According to the publisher's blurb, the book "focuses on the construction of a solid personal portfolio." Glassman offered a "Secret Code," in "uncertain and volatile times".

For devotees, the secret code probably caused less damage than Dow 36,000 since those who took Glassman's advice in 1999 had a lot less to lose by 2002.

Glassman writes a personal financial column for Kiplinger's Personal Finance. He was once president of the Atlantic, which explains why Dow 36,000 received such wide publicity in 1999. See below. (Who remembers Dow 40,000 and Dow 100,000?)

Glassman's financial planning advice in 2011 was dispensed in his third book Safety Net: The Strategy for De-risking Your Investments in a Time of Turbulence.

In his review of Glassman's newest contribution (for Reuters), John Wasik wrote that Glassman "made an effort to redeem himself with his latest book." The book was published in February 2011 - so, as a guess, was completed by the early fall of 2010. Glassman recommended that investors cut back on U.S. stocks, buy emerging market equities, buy U.S. Treasury bonds, and buy put options on stock markets for downside protection.

Glassman's prescription shows an ability to learn (this is rare among the cognoscenti and a genuine compliment to the man), but he refuses to come clean. Wasik quotes Glassman 2011 reflecting on Glassman 1999: "Yes, stocks bounced up and down but your job as an investor was to hang on and collect your reward for perseverance at the end. I advocated the same strategy of heavy and diversified U.S. equity holdings that most sensible advisors espoused - but with an extra dollop of optimism. And I was wrong."

Hanging on to "collect your reward" was not deemed necessary in 1999. Glassman had plenty of print media experience. He knows that most readers of an advice book cling to a catch-phrase (Stocks for the Long Run, 1994). Whatever warnings Glassman & Hassett published in their book, their preview of Dow 36,000 in the Wall Street Journal on March 17, 1999, was quite specific and sensationalist: "Our calculations show that with earnings growing in the long-term at the same rate as the gross domestic product, and Treasury bonds below 6%, a perfectly reasonable level for the Dow would be 36,000 - tomorrow, not 10 or 20 years from now."

Glassman has taken the same position - the Dow hitting 36,000 was a long-term calculation - when interviewed over the years. He spoke to Carlos Lozada in the March 8, 2009, issue of the Washington Post, who asked the bubble-blower: "What happened?" Glassman explained that he (and Hassett) made two points: "The more important was that for investors who could put their money away for the long term, stocks were a much better investment than bonds.... The second point was that based on our calculations, we believed that stocks would rise to roughly 36,000. We said in the book that it is impossible to predict how long it will take for the market to recognize that Dow 36,000 is perfectly reasonable...."

In addition to the Wall Street Journal preview, the Atlantic put Dow 36,000 on its September 1999 cover. This is a glaring example of when an idea has captured the major media, you know its time has passed. In the magazine of which Glassman was past-president, Glassman & Hassett wrote:

"Stocks were undervalued in the 1980s and early 1990s, and they are undervalued now. Stock prices could double, triple, or even quadruple tomorrow and still not be too high."

"Stocks are now, we believe, in the midst of a one-time-only rise to much higher ground - to the neighborhood of 36,000 for the Dow Jones Industrial Average."

Turning back to John Wasik's review of Safety Net, he thought Glassman's 2011 advice should have been rendered in 1999. Reuter's essayist concludes: "Is it time to absolve Glassman for his irrational exuberance more than a decade ago?" Wasik answers with wise counsel: "[A] lot can be forgiven, although nothing is forgotten."

Wasik's advice should be applied to all the failed phonies who told us subprime mortgage problems were contained. These are the same central bankers, economists, strategists, and monopolists of editorial pages who are oblivious today yet still design policy and control its public discussion.

Currently, Glassman is the executive director of the George W. Bush Institute, "an action-oriented organization focused on independent, non-partisan solutions to America's most pressing public policy problems." One of the most pressing problems is the unaccountability and elevation within the old-boys-and-girls-club that has sewn such mistrust among the public. Glassman graduated from Sidwell Friends School then marched forth with the avant-garde Harvard class of 1969 (summa cum laude), where he edited the Crimson.

            Kevin Hassett (Swarthmore; U Penn, Ph.D., economics; Assistant Professor, Columbia University Graduate School of Business 1989-1993; Senior Economist, Federal Reserve Board of Governors 1995-1997; American Enterprise Institute, 1997-to-present; currently, Bloomberg columnist) made one more stab at the investment advice business with a 2002 book: Bubbleology: The New Science of Stock Market Winners and Losers. From the publisher's blurb: "There are only two types of stocks: those safe from bubbles and those that are not. This is a fact of investing many discovered as they saw their fabulous gains whittled away by the extreme calamity of the Internet sector."

            From this, one gathers Hassett was shell-shocked into a schizophrenic, Good vs. Evil investment approach. In any case, that was 10 years ago. He has since co-authored two policy books with Glenn Hubbard, which should offer Hassett a good shot at a high position in a Romney presidency (see "Limited Hope"). Make what you will of that. 

Wednesday, July 25, 2012

Barton Biggs

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession  (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (, 2009)

Barton Biggs (1932-2012) will be remembered by most of us for the words he wrote as strategist at Morgan Stanley. He worked at the firm for 30-odd years. He did not waver in his dismissal of Internet bubble promoters. At the same time, Morgan Stanley deserves credit since it did not fire Barton Biggs, Byron Wien, or Stephen Roach during that period when most Wall Street firms replaced nourishment with treacle.

Two events come to mind.

In the summer of 1999, Barton Biggs debated James K. Glassman. This was the high summer - or, at least, the final summer - of the Internet bubble. It was obviously ridiculous but there was still time to get rich quick. To quote myself: "During the first four months of 1999, the average first-day percentage gains on IPOs were 271% (in January), 145% (February), 146% (March) and (119%) in April. More to the point is the lack of any operating record on the part of these enterprises. They were often no more than lavish compensation schemes for the promoters. Many of the companies had never earned a cent; quite often, they had never sold a thing; and not infrequently, they had neither a product to sell nor intended to develop a business.

"The book that captured the national idiom was Dow 36,000, by James K. Glassman and Kevin Hassett. They posted a preview on the editorial page of the Wall Street Journal on March 17, 1999: "Our calculations show that with earnings growing in the long-term at the same rate as the gross domestic product, and Treasury bonds below 6%, a perfectly reasonable level for the Dow would be 36,000 - tomorrow, not 10 or 20 years from now."

            The debate between Biggs and Glassman is a classic example of people believing what they want to believe while ignoring the proverbial elephant in the room. Of course, in 2012, the obvious catastrophic consequences of central banking's destruction of the world's currencies as well as stock, bond, and commodities markets are not up for discussion.

Barton Biggs was considered a nuisance or maybe senile by the stock touts, since he was "perennially bearish." The phrase seemed attached to his name. He was always "the perennially bearish Barton Biggs." Glassman argued the Internet was the most important invention of the twentieth century. Biggs probably thought Glassman was an idiot, but was more diplomatic. Biggs made some obvious comments: air conditioning was more important - Atlanta and Singapore would be small towns without it. The audience voted. Glassman won: 80 to 2. Biggs' received a vote from his wife. Biggs later wrote that Glassman and Hassett "should be ashamed of themselves." Both were scholars who "were arguing [what] was patently ridiculous."

(As a side note, the greatest stock jockey of them all, Federal Reserve Chairman Alan Greenspan, even at this stage of constant media manipulation, sided with Biggs. On May 6, 1999, the reprobate had said: "I do not say we are in a new era, because I have experienced too many alleged new eras in my lifetime that have come and gone.... There was far greater justification to view the future with the unbridled optimism of a presumed new era a century ago.... In a very short number of years the world witnessed an astounding list of new creations: electric power and light, radios, phonographs, telephones, motion pictures, x-rays, and motor vehicles, just to begin the list.")

The former Marine Corps infantry officer (Biggs, that is) was already a remnant. It was put to me: "1994 seems to me now the year when Wall Street broke from its moorings. Brokerage firms were losing their older 'customer's men.' The senior ranks on Wall Street had included a lot of Marine Corps and Naval officers from World War II and the Korean War. They kept it simple. They put their customers first. Those role models were leaving and there was a vacuum. It was every man for himself and if you didn't like it you either left or were forced to leave." This is not a phenomenon isolated on Wall Street. Self-control has disappeared en masse. (For more about that annus horribilis, see  "Is it 1994 Again?" and "Sidelights to 1994."

In the April 11, 1994, issue of Barron's, Alan Abelson quoted from Barton Biggs' weekly letter to Morgan Stanley clients. Quoting Abelson (omitting ellipses): "In his latest epistle for Morgan Stanley, the incomparable Barton Biggs reflects on secular bear markets: "Secular Bear Markets Ain't No Fun." A secular bear market, in Barton's definition is a biggie - the major stock averages decline at least 40%. [Biggs counted seven secular bear markets in the twentieth century - FJS] He finds it 'unnerving' that all the secular bear markets came out of the clear-blue economic sky. In each and every case, he goes on, stocks were overvalued and greed was rampant.

"The one secular bear market of modern times came in 1973-1974. 'The Nifty-Fifty was decimated, with declines of 60% common and some wipeouts like Avon (135 to 18), Polaroid (70 to 6) and Corning Glass (61 to 13). The broadest measures of equities at the time - the Value Line Composite, which peaked in December 1968 - was down 75% six years later.'

"And then Barton remembers what that secular bear market was like. 'For me it was waking up every night in the spring of 1970 like clockwork at 3 a.m. in a cold sweat and agonizing the rest of the night over our portfolio. (I was a hedge fund manager then.) In the summer and fall of 1974 when the declines were endless day after day, you seriously wondered how you were going to support your family and where you could get a job outside of Wall Street. There were no answers. People you knew in the business - salesmen, money managers - just disappeared, and years later you heard they had moved to Indianapolis and were teaching seventh grade.'"

Glassman and Hassett thrive in an America without moorings. This illustrates a defining characteristic of our times. Dow 36,000 turned them into celebrities. It was published at the moment it would receive the greatest applause. The opportunists could not have been more wrong if they tried. The media noise for Dow 36,000 would turn them into greater celebrities.

They continued to promote themselves on the Wall Street Journal's op-ed page:

"Dow 36000? It's Still a Good Bet"

-Glassman and Hassett, Wall Street Journal, Headline of Op-ed, March 20, 2001

"Diversify, Diversify, Diversify"

-Glassman and Hassett, Wall Street Journal, Headline of Op-ed, January 18, 2002

"[Glassman and Hassett] maintain it isn't their fault that people now focus only on their optimistic title and not on the caveats.... 'If you didn't have a sensational conclusion that follows from reasonable steps, people wouldn't pay attention,' Mr. Hassett says....Mr. Glassman sounds less sure about the title. 'That's the only thing about the book I'd consider changing,' he says."

-"Dow 36,000 Gurus Hold to Their View Amid Downturn" Wall Street Journal, July 29, 2002

"When our book, Dow 36,000 was published in September, 1999, the Dow Jones Industrial Average stood at 10318. The Dow closed yesterday at 8736. What went wrong? Actually, nothing."

-Glassman and Hassett, Wall Street Journal, August 1, 2002

"[W]hile such signs of speculation are troubling, there is little solid evidence that a real estate bubble is puffing up."

                        - James K. Glassman, "Housing Bubble?," Capitalism Magazine, May 24, 2005

Glassman would later say 36,000 was a long-term prediction: See Wall Street Journal quote from March 17, 1999.

Glassman & Hassett went on to star at the American Enterprise Institute, a think tank in Washington. Glassman was Undersecretary of State for Public Diplomacy and Public Affairs for President George W. Bush. In this capacity Glassman led "the State Department's struggling efforts to improve the U.S.'s image abroad" particularly "in the Muslim World." Hassett was an economic adviser to John McCain in his 2008 presidential campaign.

The world is their oyster. The apathy and sense of defeat among the American people is aggravated by witnessing the unflagging success of those who have behaved the worst and the amoral behavior of the hallowed institutions that promote them. 

Friday, July 13, 2012

The Real LIBOR Scandal

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession  (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (, 2009)
            Whatever can be said for and against Barclays and Bob Diamond, the story is in danger of exhausting itself at the wrong link in the chain. It has sidelined BubbleTV's around-the-clock coverage of Facebook. Mark Zuckerberg's dog walker has been waiting in a studio sound booth for a week now.

            The populace has been so successfully coached and beaten to a pulp that the source of interest-rate price fixing is not mentioned. That source is the Federal Reserve.

            Upon its invention, the Fed had no such authority. In 1923, New York Federal Reserve President Benjamin Strong wrote a letter to friend, which says about all that needs to be said about the Federal Reserve's open market operations: "What I can't understand is the willingness of thoughtful, studious men who presumably have been brought up in the spirit of American institutions and should be imbued with their principles, proposing a scheme to Congress which in effect delegates avowedly and consciously this vast power for price fixing to a small group of men who, in an economic sense, might come to be regarded as nothing short of a super-government. It is undemocratic, absolutely contrary to the spirit of America institutions, and so dangerous in its possible ultimate developments that I cannot see the slightest merits for its proposal." [My underlining - FJS]

            It should be noted that Strong was a Morgan man (Bankers Trust). He headed the New York Fed upon its birth in 1914. It is also of note that "Fed policy" was run by Strong, not by the Chairman of the Federal Reserve System in Washington. Power moved to Washington in the 1930s.

(Today, this appearance of power in the capital may be more form than substance. The current chairman of the board of the New York Fed is a Morgan man, in fact, he is the Morgan man: J.P. Morgan Chairman and CEO Jamie Dimon. The board of directors of the Federal Reserve Bank of New York chooses its own president: currently William C. Dudley, formerly, chief economist of Goldman Sachs. Dudley was hired by then-New York Fed president Timothy Geithner in 2007 to run the Federal Reserve's open market operations (buying and selling Treasury securities through his primary dealer network), which still operate from 33 Liberty Street in Lower Manhattan. The neo-Florentine palazzo has been home to the New York Fed since its construction was completed in 1924. As president of the New York Fed, Dudley's top responsibility is to find buyers of Treasury securities to plug Treasury Secretary Timothy Geithner's $1-trillion-plus annual gap between revenues and spending.)  

Despite his Morgan interests, and his power, Benjamin Strong saw no good in the Federal Reserve setting market interest rates. This was soon to change. The New York Fed contorted interest rates in 1922, 1924, and in 1927. (The 1922 operation was benign. In the words of Lester Chandler, author of Benjamin Strong: Central Banker: The "prime motivation was to assure themselves [the Federal Reserve district banks] of enough earnings to cover expenses and dividend requirements.")

Strong's change of heart might be chalked up to "absolute power corrupts absolutely." Strong was human. Senator Elihu Root of New York attempted to kill the 1913 Federal Reserve Act. He understood its inevitable folly: "[W]ith the exhaustless reservoir of the government of the United States furnishing easy money, the sales increase, the businesses enlarge, more new enterprises are started, the spirit of optimism pervades the community. Bankers are not free of it. They are human...when credit exceeds the legitimate demands of the currency and the currency becomes suspected and gold leaves the is the United States that is discredited by the inflation of its demand obligations which it cannot pay."

The Morgan man at Banker's Trust helped Senator Root prepare that speech.

Strong's decision to drive down interest rates in 1927 had the greatest consequence. Adolph Miller, a member of the Federal Reserve Board at the time, testified before the Senate in 1931. He described the explosive nature of the Fed's open market operations: "In the year 1927, you will note the pronounced increases in these [Federal Reserve holdings of Government securities] in the second half of the year. Coupled with the purchases of acceptances, it was the greatest and boldest operation ever undertaken by the Federal Reserve System, and, in my judgment, resulted in one of the most costly errors committed by it or any other banking system in the last 75 years.... [T]he Federal Reserve [put] money into the markets, not because member banks asked for it by offering paper for rediscount, but in pursuance of a policy of our own which in effect said, 'We shall not wait to be asked to provide increased money through rediscounts; we will operate upon our own responsibility....'"

Miller, unlike the fashionable economists of the 1920s, including Irving Fisher and John Maynard Keynes, did not fall for the New Era: "That was a time of business recession. Business could not use and was not asking for increased money at that time. But the banks do not want to and in fact do not carry uninvited moneys or idle reserves. Here then, in 1927, came an accession to their reserves for which they had to find a use."

Barclays and Bob Diamond, not free of the spirit of optimism, acted as described in the speech written by Senator Elihu Root and soon-to-be head of the New York Fed, Benjamin Strong.

"One of the most costly errors committed by it or any other banking system in the last 75 years" led to the Great Depression, during which, even third-rate pupils of the period learned that over production of money through open market operations can in fact lead banks to "carry uninvited moneys or idle reserves."

It would be better if Mark Zuckerberg's dog walker were Federal Reserve chairman today.

Since Libor is the purported subject here, the nagging question shall be raised: Why is an interest rate set in London fundamental to the structure of mortgage rates on the North American continent? Recidivist homage to the United States' former sovereign? This seems to be one more practice that has gone on for so long that its dissonance is forgotten.

Having raised one, another nagging question: Should it be LIBOR or Libor?

Wednesday, July 11, 2012

How Long Will This Go On?

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession  (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (, 2009)

            The Tisch family's shipping venture (A Buyer's Market) jogged the memory. The August 26, 1985, issue of Grant's Interest Rate Observer, in which Jim Tisch discussed buying ships for less than 10% of the new construction price, included a mix of leveraged developments that appeared doomed. Some were. Some go on and on.

            The story under a page one headline: "Mortgages: A Federal Risk" suggested "it might be helpful to know the extent of the Treasury's exposure to mortgage values (and thus to the great postwar bull market in houses, which seems to be getting tired). Helpful, or not, the numbers are staggering." In 1984, the federal government guaranteed $386.7 billion of loans in 1984. The biggest component by far is mortgages. "The heart of the mortgage numbers [were] real estate loans that the federal government itself was on the hook for...." [For comparison: the coarse measurement for the size of the national economy - the GDP - rose from $4.2 trillion in 1985 to $15.1 trillion in 2011. - FJS]

            According to, the federal government spent $851 billion in 1984. During this final year of the first term of the Reagan Administration, the government received $666 billion in revenues, thus spending $185 billion beyond its receipts. It was in the same year the government added $386 billion in (mostly) real estate guarantees. There may be a mismatch of calendar and fiscal years here, but Moody's and S&P still had cause to downgrade the U.S. government's AAA-rating. How long could this go on?

            In the same issue, a recent circular from Kohlberg Kravis Roberts & Co. was discussed. The founding partners had participated in 13 buyouts between 1965 and 1976 that produced an estimated 63% annual return. KKR was formed in 1976, after which (to the time of this circular, announcing its fifth equity investment buyout fund) the annual rate-of-return had been 46.8%.

KKR goes on, with some successes and some failures. RJR Nabisco and TXU were among the firm's ill-chosen ventures. Even if investors should have looked elsewhere after 1985, the principals have prospered. Henry Kravis continues to accumulate assets (that is, his personal fortune) by not veering much from the same leveraged strategy described to potential investors in the 1985 memorandum. Of the targeted companies: "There should be a low debt-to-equity ratio, thereby permitting significant additional leverage in the new capital structure."

            One consequence of this strategy has been the leveraging of corporate balance sheets across industries, no matter the inclinations of corporate management. A company that preferred to manage its balance sheet conservatively (mostly equity with little debt) stood as much chance of escape as a slow-moving target in a schoolyard, dodge-ball game. If it did not wise up (a little equity and mostly debt), KKR and its brethren would be sure to notice.

Companies in cyclical and capital-intensive industries that had traditionally eschewed debt were now showered with investment banking offers (along with the investment banks' well-compensated, Nobel-winning academics) to layer their balance sheets with faddish debt offerings. The result is an international corporate structure that is not poised to weather a decline in asset values. It is often claimed that U.S. corporations are "cash rich." This is highly misleading, as any reporter would discover with ten minutes of investigation, yet the claim is good for averting the S&P 500 and for deflecting closer inspection of companies that are buying back their own shares. The latter is another officially sanctioned though little mentioned contrivance to skew asset prices upwards.

Fannie Mae was the topic of another article. The credit-worthiness of Fannie was compared to its relatively unknown sister, Sallie Mae. (The latter won by a landslide.) As for Fannie, its chairman's second quarter letter to shareholders was discussed. Quoting part of what was quoted: "charge offs...for loan losses increased from $19.4 million to $27.6 million in the second quarter. During the second quarter, charge-offs exceeded the rate at which we provided for losses. The primary cause of this significant increase is the growing number of properties that Fannie Mae is acquiring through foreclosure. The problem is concentrated in depressed housing markets like Houston and Southern Florida, though is not limited to these."

-David O. Maxwell CEO, FNMA - second quarter [1985, believe it or not - FJS] report to shareholders.

            Grant's commented: "To the investing world, the stocks and bonds of Fannie Mae might just as well be candy. Never mind the company's enormous leverage, its chronic losses or...its mounting credit problems."

            Well, then, why was Fannie so attractive? The editor of Grant's had an answer: "Almost nobody could believe that 'they' (the Treasury, the Fed, the Department of Housing and Urban Development) would ever allow the Federal National Mortgage Association to go the way...." The way it in fact did go - twenty-three years later.

For many, this is painful to read. Not the comeuppance in 2008, but Fannie's pretense over the previous decades. There were short sellers who knew, without any doubt, that Fannie was insolvent in 1998, in 2000, in 2002. They kept shorting Fannie. Post-modern accounting conventions and congressionally muzzled regulators impoverished portfolios at the same time Jim Johnston, Franklin Raines, and Angelo Mozilo got rich.

Whether or not Maxwell, Johnston, Raines, Mozilo, or Henry Kravis understood it, they, and much of the so-called one percent, were on the winning side of the restructuring of the American economy. Woe betide the college graduate of 1980 who pursued a career at a manufacturer or oil producer. For decades, an incremental $1.40 of debt produced $1.00 of additional GDP. By 1985, it took $4.00 of additional debt to produce $1.00 of economic growth. This defied the natural boundaries of a functioning economy. Surely, the game was up.

The investor who understood nature, history, and fundamental analytics did not foresee how far an economy could push the limits when it could print its own currency, painlessly. The U.S. dollar has, subsequently, had its up and downs, but foreign central banks willingly (or, maybe not so willingly) have absorbed trillions of dollar emanations by releasing trillions of their own currencies. How long can this go on?

Reading the August 26, 1985, issue of Grant's (and forbearing a synopsis of Professor James C. Van Horne's July 1985 paper in The Journal of Finance about the financial "promoter [who] wishes to make a profit regardless of whether an idea has substance"), we are reviewing an important moment in history; 1984 to 1986 was a time when finance and business broke from the past.

For instance, banking was now a growth industry. The loan officer at a money-center bank was no longer so concerned that a borrower could extinguish a loan as long as the interest could be paid. Rolling over the loan at maturity was enough. Lending had become a volume business. As long as the loan book rose at a faster rate than defaults, profits and dividends could meet growth targets.

Fifteen years after the Bretton Woods gold standard ended, redemption of loans was no longer necessary, since the volume of dollar growth was no longer restricted by redemption into gold.

Fast money has made more money since. Capital-intensive, slow assets lost. They went the way of disco. Dollars were growing at a faster pace than aluminum. It's easier and more fun to hand out money than run a factory. The latter pays off too slowly for the portfolio manager judged by quarterly or annual performance. So, the rust belt moved to China.

The question before the house: Can the Powers Who Want It to Remain So support asset prices of largely under producing and redundant assets, around the world, with more, and necessarily much larger, emissions of currency for another 27 years? (The investment strategy, no matter the answer to that question, is to buy gold and silver. Central bankers can only imagine, as a response to weaker asset prices, the production of trillions upon trillions of dollars, euros, yen, pounds, and yuan.)

A clue might be gleaned from the answer to the following question, aimed at (though we know in advance he would claim immunity) European Central Bank President Mario Draghi: "We know that most European banks no longer deal with each other. We know, for instance, the lending market among European banks contracted by $637 billion in the fourth quarter of 2011. To settle overnight balances, commercial banks now use the European Central Bank as its counterparty. That is, commercial banks trust that the ECB will not go bust before tomorrow morning. Yet, the ECB seems intent on diluting the credit worthiness of its own balance sheet. The ECB gave 75% haircuts (discounts) to some of the loans that banks used as collateral in LTRO2. Since then, you have added categories of collateral that were previously verboten. What will happen on the day banks decide your balance sheet is in worse shape than the counterparties they already rejected?"

ECB President Draghi might offer a similar response to that proffered by the host of a conference put on by Data Resources Inc. on August 12, 1985:

QUESTION: "It seems to me that the U.S. has turned into a three-tier economy. We've got the farm sector - it is on its ass - and the manufacturing sector - it is on its ass - and the services sector which in reality is the financial services sector, which in a great measure is the business of distributing and trading around government debt. Where does all this lead?"

ANSWER: "Let's move on to the next topic."

            As a gander, the spoil sport at the Data Resources soiree underperformed over the next twenty-seven years. Those who moved onto the next topic - that is, many who do not recognize, even today, the insubstantial nature of the world's economy - have made a mint. The latter defines 99% of what goes by the label of Wall Street, since those who did not go with the flow found a new job. Do investment advisers and consultants have another 27 years before their investment strategies come a cropper? It would be improvident to dismiss the possibility, but it seems more likely that in a flash of recognition, sooner rather than later, legions of experts will, along with Mario Draghi, ask: "Where did all the money go?"

Monday, July 9, 2012

A Buyer's Market

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (, 2009)

"China should delay its bid to pass South Korea as the world's biggest shipbuilder to prevent a flood of new vessels extending industry-wide losses, said Clarkson Plc's Managing Director Martin Stopford. 'This sort of target really should be put aside for the time being,' he said in an interview Wednesday at a conference in Shanghai.
China has asked state banks to boost financing for new ships to prevent order cancellations, safeguard jobs and support a plan to pass South Korea in ship production by 2015. At the same time, the global container-ship fleet has as much as 20 percent excess capacity...."

--"China Shipyards Should Delay Bid to Pass Korea,
Business Asia, December 4, 2009

"Jiangsu, the dominant province in Chinese ship manufacturing, received 61.7 percent fewer orders for ships in the first five months than in the same period of 2011, due to a slump in the global shipping market, new official figures have indicated....The sluggish world market and excess of transportation capacity contributed to the drop in orders, according to the commission."

--"Chinese Ship Orders Drop Drastically," Xinhua, July 2, 2012

The unwinding of the commercial shipbuilding market will appeal to a small group of investors. It can be viewed more broadly as representative of value investments to come. The characteristics apply to assets that were ordered and built with projections of ever-increasing demand. Or, as described in the objective of Chinese shipbuilding above, to achieve national greatness, buyers or no buyers.

Demand for new ships is notoriously unpredictable. Shipping companies and commodity producers order when the economy is blooming: trade percolates, more ships are needed. Deliveries are often made after the business cycle has peaked and trade is wilting. Freight rates are falling at the same time cargo capacity (new and usually larger ships) is delivered.

The world economy is slowing fast. Trouble in shipping is being exacerbated by mendicant banks. A most neglected problem (in public discussion) is the deceleration of collateral, the consequence of which is forcing banks to shed assets. Europe is the center of balance sheet downsizing, but hardly alone. The base of assets that U.S. banks are permitted to pledge as collateral has shrunk by around $5 trillion since 2008. European banks lent generously to Asian companies, but are now retreating.

The indefatigable Andy Lees (AML Macro Limited) wrote in his July 2, 2012, Morning Headlines: "
The contraction in European banks' balance sheets took another turn as Commerzbank announced it was to pull out of ship finance. It had been the world's 3rd largest maritime lender. Danish shipping association BIMCO said 'Ship owners stuck in a financial moment they cannot get out of are likely to get closer to a bankruptcy as yet another option in the traditional ship finance banking market is lost.' Lloyds and Soc Gen [Societe Generale] have already pulled out. About USD249bn is needed in new debt and equity in the coming 3 years to cover orders for new ships."

Commerzbank, Lloyds, and Societe Generale are in a fix. First, is the general encumbrance of European banks, not necessarily the three under discussion. National greatness in the Old World opens with government demands for banks to buy their nation's debt. This has been a losing proposition since the dawn of the Renaissance. Second, the quality of their pledged collateral is falling. Most European banks need to borrow from the ECB (European Central Bank), but can only do so by pledging eligible collateral. They are selling assets that would require additional collateral, or, simply selling assets to reduce exposures.

Dominoes fall: As Danish shipping association BIMCO warns, this pushes the ship owners closer to bankruptcy. The value of those assets declines. The ECB then demands more collateral to supplement current pledges. We will stop here. (The ECB is turning the quality of the collateral into a farce, but that should be addressed separately.)

It is not difficult to look at this dynamic and foresee falling prices around the world. Given the tentacles of central banks across asset classes, it is to Bernanke, King and Draghi investors look to forestall an avalanche. The central bankers are doing what they can to suspend the repricing of assets in a deleveraging world. The ECB collateral farce is one attempt. The Bank of England's announcement on July 5, 2012, that it will dump £50 billion into the British economy is another. Given the volume of assets in the world, this is pocket change, as is Bernanke's latest Twist. The Fed chairman must be chomping at the bit. He has a textbook opportunity (his textbook) to really test his acumen: $5 trillion at a minimum.

Redundant ships brought the Tisch family to mind (Loews Corp: L on the NYSE). Searching the archives, it was Jim Tisch who was interviewed in the August 26, 1985, issue of
Grant's Interest Rate Observer. Ships were the Old Maid. "Sunk" was the headline in Forbes. "Used Ship Prices Set to Fall," claimed the Financial Times. A ship owner was quoted: "You'll probably [make] some money, but there'll be a hell of a bloodbath in the meantime."

Jim Tisch was buying ships for $5.5 million each. They had cost $60 million to build and would cost the same to construct in 1985. These assets (so to speak) were idling in Norway and Scotland (after having been renamed after Loews' movie theatres:
Orpheum and Paradise, for instance).

The thinking was probably not much different than investing in movie theatres: how much do we need to fill them to make money? (They made plenty.) Today, the coincident problems of falling asset prices and depleted lending will empty ships, commercial real estate, and other structures of investors, renters, and the good word of