Monday, February 23, 2009

Deducing the true character of Obama from the Citigroup incident

The details of the Financial Rescue Plan has yet to come out. 
Aside from the potential mandatory convertible preferred injection into all banks that don't pass the stress test, there are rumblings about government swapping its TARP preferred in Citigroup into common equity stake. I thought it would be interesting to record a snapshot of my analysis of the situation before the details are out, particularly because I want to analyze the TARP preferred to common equity swap in isolation. Even though the new equity injection may be more important when they come out, the way the Obama administration proceed with the preferred to common swap would reveal to me the true character of Obama.

Financial matters are always obscure to the majority public and the nuances of financial deals/structures are always beyond the comprehension of the mass. This is why it was so easy for Paulson to get away with injecting capital into troubled banks at favorable terms to the banks. This is why there has been no public uproar over the tens of billions of wealth transfer from taxpayers into the AIG bondholders. No one in the mass media gets too hung up on the fact that AIG bondholders should have taken a hair cut given the massive losses, and would have if the government hasn't been giving the rounds of windfalls to the bondholders.

But that was the Bush administration. So far Obama has done no such thing. Unfortunately, he is about to start. And it doesn't smell like he won't take advantage of the public's ignorance over financial matters to unjustly enrich the financial oligarchs. No conspiracy theory is necessary here. But it has always been common sense for politicians to steal money from someone who wouldn't know that it's being stolen from him. The side that you rewarded will find a way to reward you down the way anyway.

One key development to watch is how things would work for Citigroup. A good analysis of the situation will have to start with assessing whether Citigroup has lost more than its current Tier 1 structures can cushion. If it is probable that another $100BN losses or more yet to surface, then the government must not inject any more capital yet. For anyone fluent in banks financial statements, you have to be delusional to believe that Citigroup really has $29BN tangible common equity left. That's 1.5% TCE ratio. The government is about to boost its TCE ratio to more "overcapitalized" level. Call it 5%. This can be achieved simply by converting all $70BN preferred into common equity. But at what valuation? How about at the tangible book value? That's certainly generous relative to today's market valuation to banks, but it wouldn't be the most egregious thing that's been done by the government so far. That would give the government a 45% stake in Citigroup.

But the government could and should own more. They could seize the bank, wipe out all Tier 1 structures (even their own $45BN preferred) and own 100% of the bank. Then they could sell it to another bank or private equity buyers. It would own 100% of the bank instead of 45%. If it turns out that Citigroup is more than another $100BN under the water that the Tier 1 cushion wasn't enough to protect the debt, then either approach would lead to a complete wipeout of the government's investments thus far. If Citigroup's losses are not beyond its Tier 1 can cushion, then why would the government chooses to own 45% stake rather than 100%? If the government chooses 45%, it has given a windfall to the other 55% shareholders, no matter it's a willful act or just unintended side effects. The other 55% shareholders would have been wiped out long ago if not for the serial government capital injections, insurance wrap and funding backstops. The government doesn't want to consolidate the $2 trillion debt on its balance sheet? It can take a 79.9% stake like they did in AIG. It's still better. Triggering CDS? CDS were triggered in FNM and FRE's conservatorships and it went ok. It is an urban myth that triggering CDS is a systemic risk. No. It is the impairment of bonds such as what happened in Wamu or Lehman that caused the tsunami. Why do the Citigroup shareholders and preferred investors get such a preferential treatment compared to those of AIG, FNM, FRE, BSC, WB, WM and LEH? I've heard a lot arguments. None of them makes sense. If somehow Citigroup has equity value left in the Tier 1 structures, then that 55% ownership stake would represent what's stolen from taxpayers.

Unfortunately Citigroup has probably, though not certainly, lost enough that its Tier 1 structures have been completely wiped out as well. Whether the loss beyond Tier 1 is another $20BN or $200BN, it has to be borne by someone. Obama will have to choose between the taxpayers and the Citigroup bondholders. He will choose to pass the burden to taxpayers, because it is the less risky choice. Bondholders in the capital markets can revolt but taxpayers can't. That is, until they are angry enough.

Monday, February 16, 2009

The gold trade

Enough people have been bullish on gold that I wanted to write something about it so as to help myself think about this trade. 

I'm on the deflation camp of the inflation vs. deflation debate. The case for gold in the event of inflation as a result of loose monetary policy is obvious. It is the argument that gold would appreciate even in the event of deflation that I'm not comfortable with. I would say it is conceivable or even plausible that gold can appreciate in an unstable deflationary environment. It is also fair to say that when the Fed prints money to counteract deflation, the psychological net effect would be to bolster people's confidence in gold as a store of value than other fiat currencies. But these arguments somehow just don't sit well with my intuitive brain. That gold would appreciate in a deflationary environment just doesn't stand on sound enough logic that for me to risk my money on. But what do I know? Hedge funds bought gold at $800 which are up almost 20% now and I didn't. So I can be justifying myself out of missing a good trade. But below are the reasons why I think not.

It all boils down to what kind of deflation we're talking about.

In neo-classical economics, the Fed has a God-like control of money supply and on inflation. If we're in a mild deflation which the Fed has the wherewithal to break, then the result would be the Fed increasing money supply, causing gold to appreciate.  But if we're in a kind of deflationary spiral that the Fed is powerless, the outcome might be very different. In short, neo-classical economics fail to describe our current predicament.

In a debt-based money system, debt is money and money is debt. This point is so beautifully illustrated by Steve Keen. When debt to GDP ratio in the US is at 350%, money supply has been expanded massively beyond any sustainable level. This $50 trillion of debt-based money supply is beyond what the Fed can control through its $1 trillion money base. When the society as a whole wants to deleverage, it means money supply is poised to shrink, no matter what the Fed does. When money supply shrinks from such historic proportion, it is not going to be just a mild deflation that the Fed can reverse. What does this shrinking of money supply mean for gold prices in money terms? After all, gold is a good store of value because its supply does not increase arbitrarily like fiat money does. But what if the money supply is shrinking and gold's is not? When one economic quantity is shrinking while the other one is not, the one that is shrinking (money) is likely to rise in value versus the one that is not (gold). The deleveraging of the economy also means that people are scrambling to repay debt and repair their balance sheet. They would sell whatever assets they can sell for cash to pay down debt. If gold is what they have and what they can sell, so be it. Because you can only pay down debt with cash but not gold, cash will be more sought after than gold in a deleveraging world. 

Right now the market is not pricing in deflation, judging from the breakeven yields of TIPS and the strong performance of gold. But we will see if gold retains its value if deflation takes hold.

Friday, February 6, 2009

The yuan peg and the inevitable US deflation

Whether deflation or deflationary spiral will happen in the US is a big topic I've been pondering for months. I'm always inclined to agree with the deflationists because of the underlying picture I see in the economy. But some insights inspired by ndk's post have led me to the conviction that deflation is not only what MUST happen, but that this deflation will have to be deep. The price competitiveness of Chinese product and labor has given rise to massive US trade deficit with China. The peg has ensure that this cannot be corrected by currency moves. This massive trade deficit cannot be made even more massive because then too much claims on US wealth would be surrendered to China. Therefore a US unilateral inflation policy is not feasible. In fact as you will see in the elaboration below, only a deep US deflation would correct this imbalance and this is exactly what we will see.

What dawns on me is that US cannot stop its trade deficit with China because its economy over the years has become too uncompetitive against China. Blame the bloated health care system, the outdated transportation infrastructure, the corrupt and wasteful US federal government that continues to squander over 10% of the US GDP annually, and the crowding out of the useful indsutrial capital stock by years of overinvestments in housing capital or financial alchemy. For example, the wage gap between a US auto-workers and a Chinese auto-workers are just too staggering, while their productivity gap are surely not that. The only way out is for the US economy to deflate significantly against China (call it 20-30%). You can achieve that "real deflation" by either devaluing the currency against yuan or have a price level deflation. Problem is you can't devalue the USD against yuan without China's consent. That leaves you only with price level deflation as a choice. Also don't forget Chinese output productivity is improving rather rapidly by the year, which makes everything a moving target. Unfortunately the target is moving further and further away from US. There is a long way to go before China's competitiveness improvement gets tapped out. With every 10% increase in scale of China's manufacturing base, they gain in network effect and economy of scale. They also continue to invest their savings into infrastructure such as roads, rails, telecom and ports, etc, which further enhances their cost competitiveness versus other developing nations. Yes the supply of cheap migrant workers for coastal factories was almost exhausted in 2007, (the trend is reversing due to massive layoffs in coastal areas) there are still 800 million farmers in China. If more industrial bases can be built inland, one can argue that the labor in China is practically inexhaustible. A casual China observer from outside might dispute this point. Although I have my own good reasons to believe that it is true. (Maybe for another post?) Anyway, whether this is true or not shouldn't even affect the conclusion of this posting. 

Absent a stop of the massive US-China trade deficit. which ran at $256BN in 2007 and is essentially the same in 2008, China will own too much US assets in the not too distant future. The exponential rise of China's USD reserves has been scary and I wager that will continue, albeit not as exponentially.  Because China holds mostly debt instruments in the reserve portfolio and it will most likely continue to do so, it is better for US if US deflate the economy before China owns too much of US assets. Inflation won't solve the problem because it will only makes this problem worse by making Chinese goods priced even more competitively versus US's.

As ndk articulated, which I agreed, China has enough firepower left to reign in inflation, both by hiking reserve ratio requirement again or sterilization. While the Chinese government is currently trying to ease credit to warm up the growth engine again, it doesn't imply that they would tolerate high inflation, should it resurface in the horizon again. If China doesn't let inflation happen, US cannot by itself engineered high inflation without worsening the trade deficit with China and hence jumpstarting the death spiral of liquidating the wealth of the nation. In fact, not only high inflation is impossible, even a meagre 2% US inflation is unsustainable. The chasm of relative competitiveness between US and China together with the RMB peg dictates that US has to deflate. This is perhaps the new impossible trinity. If a large economy pegs its currency against another large economy, the relative price competitiveness of labor and products cannot differ too much without one country handing over substantial wealth to the more competitive one over the long term. The gap here is staggering as well. This in history is without precedents and hence one cannot and should not be able to draw from empirical experience. We are in uncharted territory, yet again. (Remember in early 20th century, the competitiveness gap between US and Europe were nowhere as staggering, due to the lack of a massive US population)

However, one thing that ndk didn't mention is the possibility of a moderate RMB appreciation against USD. Yes the PBOC might not like to have 15% revaluation as this will make their balance sheet look insolvent. But they can easily manage a 5-10% annual revaluation against the USD, as they have done in the past. There are interest incomes from their fixed income portfolio apart from the cushion provided by Chinese government deposits. Central banks can't bankrupt as long as central government's fiscal power can backstop the losses incurred. In the US, the US Treasury put in a $400BN Supplmental Financing to the Fed's balance sheet, which can be forgiven if these AIG CDOs, Bear Stearns Maiden Lane and ABS papers turns out to be worthless. So we should not underestimate the magnitude of an RMB appreciation that PBOC can manage simply because it is bankrolled by the Chinese government's taxation power. 

In summary, my conclusion is CURRENTLY that US price deflation is inevitable, unless Chinese agree to tolerate high inflation or to revalue RMB massively against USD. The possibility of Chinese government tolerating high inflation is nil. The chance of some moderate RMB appreciation exists. Although China will not have the obligation or the incentives to do so. That is not a good position US is in. 

Another interesting thought experiment is as follows. If US tries to unilaterally devalue their currency by whatever means, whether it be helicopter or other crazy approaches (which are indeed feasible if the US government raise debt to fill the hole in the Fed's balance sheet), what would the USD be devalued against? It can't devalue against RMB unless China agrees. It can devalue against Euro, but then so would the RMB. Then the same problem occurs to Europe. Europe would run too unsustainable a trade deficit with China that too much European wealth will be owned by China. SAFE will have too much euros flowing in every year that it will also have to decide whether to cross them to USD or not. If they do, which they will, it will just move the USD back up against euro. Europe collectively will also want to intervene anyway to prevent euro from appreciating too much against USD and RMB. If you think it through, there isn't any way USD can be devalued against the world's major currencies. The only option is deep deflation.

The Genesis

I've been following the events unfolding in the world from the point of view of an investor. Even though I grew up as a bottom-up value investors focused on security selection, I have spent the better part of the last 2 years focused on big picture, i.e. being a macro-oriented investor. After reading ndk's excellent post on why US can't deflate unilaterally, I had what I believe to be an epiphany on what's going on in the world. I then went on and put my thoughts down on paper. The logical next step was to then create a blog, in case I have more of these thoughts in the future. Like it always is, this is not really meant to be a blog, but it serves me as a place to organize my evolution of thought process, and most importantly as a place to gather thoughts from the wisers in the blogosphere. Actually, strike the thought gathering part because it's not clear whether this blog will attract any postings from those of you reading to begin with. But I want to let you know that I welcome any exchanges and corrections from you out there.

Oh yeh, the name "Could Marx Be Right" is chosen not because I subscribe to Mr. Marx's ideology, (or anyone's ideology for that matter) but because I want to frame this blog as one that tries to challenge all conventional wisdom and encourage asking unthinkable questions. Is the fractional banking system a Ponzi scheme? Is it possible for the world economy to go into a 30-year Dark Age of Depression? Or is it possible for US to inflate like Zimbabwe and have Dow goes to 300 million points? Could Israel's military victory in 1967 sowed the very seeds for the demise of the Jewish race? Would the major European countries form a federal union with collective fiscal taxation power as a result of the financial crisis, thus paving the way for a true European Union?