Taking Risks and Reaping Rewards

Another Sign of China's Collapse

Often times I hope I am wrong.

The FT reported that forest land that is to be preserved has been used as collateral in bank loans to build infrastructure by local governments. So if the loans go bad, they will have to sell the land to pay off the debt.

Since they are unlikely to be willing to part with large tracks of forest and other natural wonders, a bank bailout would be the natural option.

But why would the loans go bad?

Because no one is using the buildings that were built by their funds.

The FT reported that Chenggong is a new town near Kunming, one of the main cities in the south-west of China.

Construction started in 2003 and the results are now apparent in 13 immaculate local government buildings, each clad in marble tiles.

A high school boasts an impressive indoor swimming pool and several of the region's main universities have built large campuses.

Pristine high-rise apartment blocks stand in rows, their new windows glinting in the subtropical sun.

The one drawback: at the moment, Chenggong is almost completely empty. Its wide streets are all but bereft of traffic, a bank branch has no customers and leaves collect in the foyers of the municipal offices.

What's worse is that haven't stopped building or borrowing to do so. While China's GDP has grown substantially, the debt to GDP ratio has barely budged. The explanation of this is that the growth was from spending by state-owned financial institutions, not directly from the government. Loans last year more than doubled to nearly a third of GDP. 

Can you say unsustainable?

To put that in perspective it would be as if Bank of America Wells Fargo, etc. were state owned and they loaned out 33% of GDP, which would be almost $5,000,000,000,000.00 (trillion) if it were happening here. 

Investment that was once 25% of the Chinese economy is now more like 50%.That means that for every dollar (yuan) spent in China, 50 cents of it is by the government. Again in perspective, that would be $7,000,000,000,000.00 (trillion) in government spending if it were happening here.

China is trying to increase domestic consumption, reduce foreign demand, and reduce government spending, but it's a long and difficult process. One that we hope will go smoothly, but as I often say, hope is not an investment strategy.

Here's why it matters to you

When the highly likely burst of the China property bubble occurs, the repercussions won't stay inside their borders. It would easily drag the rest of the world into a double dip recession.

And we are pretty much out of economic bullets to shoot at another recession, so the next one will likely be worse than the last one.

Worse yet, China could be forced to quickly appreciate their currency which they have pegged to the dollar and is keeping our imported purchases of their goods at low prices, or they might dump the US government debt which they own plenty of. Either would send the dollar plummeting and the prices of imported goods skyrocketing.

And if that happened with no economic bullets left in our gun, well...let's just not go there before we have to.  

In conclusion, with no one living in an entire new city, it's hard to think that everything will be fine and this will all work itself out, but I sure hope I am wrong.

Another Iceberg in the Foggy Distance

The Capitan of the Titanic was asleep in his cabin when they hit the iceberg.

In today's dangerous waters, it's tough to get any sleep at all because of icebergs like this: High Yield Debt Refunding Requirements

A recent Moody's report says, "U.S. speculative-grade issuers face more than $800 billion in refunding requirements over the next five years, including $555 billion in bank credit facilities and $250 billion of bonds. About 995 of our 1,300 speculative-grade issuers have debt maturing over this period. The enormous amount of debt due over the next five years stems from a robust period of refinancing and leveraged buy-out activity prior to summer 2007."

The tidal wave of junk bond refinancing that will need to take place is concerning as the market may not be in a position to absorb such debt or have the risk appetite for it.

This comes as the Fed, as will other global banks, will very likely be increasing interest rates or may already have, so even if the debt can be rolled over, the price isn't certain at all.

But assuming someone will to lend them money at some price, this can impact the other debt markets and a crowding out could occur. This means other needy folks can't borrow the money they want or need. All of which slows the economy going forward.

More Yuck!

What this means to you

Right this minute, nothing. The debt has been rolled over and we are in another eye of the hurricane waiting for the next wall to see how hard it will hit us.

This is really just another lesson in looking out the foggy windshield and looking for things that might need to be avoided in the future.

Like icebergs of junk bonds.

Could China Collapse?

China announced that they are trying to slow the pace of lending.

That move, along with several others recently, is sending fear about a China collapse throughout the markets. 

It's pretty clear that China has been lending too much money as this chart shows:

The growth needs to be slowed, not only for the typical reason of inflation, but because China is producing a lot of goods, especially real estate, that it can't use efficiently. In fact, many buildings are just sitting empty.

Many pundits have pontificated that Shanghai and Hong Kong have their own real estate bubble going on. 

The FT reported that former Morgan Stanley chief Asia economist Andy Xie said, "China's asset markets are a Ponzi scheme."

A ponzi scheme is scam where the scam artist uses money paid from new investors to pay off previous investors and they never really make any real profit. This works until there are no more new investors and then system collapses. 

Could this really be what's happening in China?

In addition to material from reasonably reliable sources, I was fortunate enough to have dinner with a good friend recently that just came back from three months in China.

In sharing his experience he made it clear not only was China going to have significant real estate problems, but also the people in China that are involved know it.

He felt their attitude is that they need to get as much as they can right now because they don't know how long the good times will last.

Further, he said the pace was at a furious dot-com like speed. Clearly not something that can continue.

While this is anecdotal evidence, there is no better way to understand what is going on than to talk to the people involved. 

Plus this is just another confirmation of the information that is already in circulation. 

Why this matters to you

China led the global markets out of the recent downturn by increasing spending faster than any other nation and creating demand that pushed all markets higher. 

The reversal of that would push most, if not all, markets lower and that's bad for everyone.

China is now a big part of the global economy. It will likely surpass Japan shortly to become number two behind the United States. (Assuming you don't add up all the countries in the EU).

They're so big and so integral that if they have a problem, then we have a problem.

And we don't need any more problems.

Just because the view of their past results, outstanding growth for over a decade, is clear in the rear view mirror, there is no guarantee that the road ahead won't have a few sharp turns in it. 

Keep both eyes pealed on the foggy windshield ahead.

Could China Collapse?

Yes.

Greek Tragedy Coming to a Theatre Near You

Global markets are focused on the situation in Greece and the need for Germany to step up and bail out the troubled nation.

Protesters will likely take to the streets if something doesn't get resolved this week as they need to borrow money by next week or go into default.

It's likely that either Germany by itself or with a nudge from the EU and ECB will take steps to avoid widespread panic. But that's not guaranteed and has never been done.

Anytime you are in uncharted waters, you can hit icebergs you didn't see coming.

The solution to Greek situation is financially simple, but politically almost impossible.

Simply increase taxes and decrease benefits to put their fiscal house in order.

To put it in personal financial terms, work more and spend less. (Not many politicians running on that platform are there?)

They have proposed raising the retirement age from 61 to 63, and predictably, the baklava hit the fan.

While the extension to 63 doesn't seem like a Greek Tragedy to us, it sure does to them.

Why this matters to you

California has the lowest debt rating of any State and both Moody's and Fitch rate it below Greece!

Note: California's economy is five to six times larger than Greece.

And California isn't the only state that is in this trouble.

Because Greece is a member of the European Union, they don't have their own currency. So they can't pay their bills by printing money like our Federal Government can or any other truly sovereign nation.

Greece is like California in this respect. They have to pay their bills by borrowing money or collecting taxes. When the lenders stop lending, the only option is to collect more taxes or go bankrupt.

But this won't happen to us. The federal government will save us.

Won't it?

Here's the rub.

For Germany, or the ECB for that matter, to agree to bail out Greece, they are going to have conditions and they are concerned that whatever is done for Greece will need to be done for Portugal, Spain, Ireland, Iceland and maybe more.

So the conditions will be harsh; increasing taxes, cutting programs, other measures to put their fiscal house in order.

Exactly what the protesters are against and what will increase the unrest.

For the US federal government to bail out California, a similar problem exists. They could help us, but then they would have to help many, if not all, the other states.

And the conditions of their help could be more harsh that Californian's would like because they need to stop every other state from asking for the same thing.

Governments are no different than individuals. If you can't pay your bills, your lifestyle has to change until you can.

Most Americans aren't paying attention to Greece or any of the problems "over there" but they should be.

It's a rehearsal of our own version of a Greek Tragedy that could be coming to theater near you.

 

 

Bill Gates is still learning. R U?

Bill Gates writes a blog.

Who knew? 

It's called the Gates Notes and he covers what he's thinking, learning and doing.

While it might be interesting to some to find out what he is doing to help with Malaria in Africa, education in America, or system development to deal with the next pandemic - I assure you he is doing stellar work in all those areas and more - what it more useful for most of us is insight into how he thinks and acts.

If you had all the money in the world, which he actually does, then what would you do with your time?

Let's see... Work on your golf game? Travel to far away lands? Have lunch on your private yacht while playing cribbage at $1 million a point? Go to glamorous events cloaked in charities to reduce the guilt from your gluttony? 

Maybe. 

What most people wouldn't do is study economics.

After all, once you have all the money you could ever need, haven't you actually conquered economics?

In a recent post in his blog, thegatesnotes.com, Bill Gates says that he has been learning from the Great Lectures from the Teaching Company. He started with the sciences; biology, geology, medicine. The moved to history and then economics. 

Why this matters to you

Learning isn't something you do in school and forget.

Some of us have forgotten that.

We live in a complicated world bulging with information. At no time in history has it been so easy to learn something new. But with all the opportunity available to us comes another problem. 

How do we choose what we spend our limited time on learning?

Do we learn software to do our taxes? Do we learn how to manage our investments? Do we learn new skills so we can progress in our job? Do we learn about our health, our wealth, or our military stealth? 

(Sorry, I couldn't find anything else that rhymed with wealth and health and the rhythm seemed to need three terms.)

The point is that time is limited, energy is limited, but the amount you are capable of learning is unlimited. 

Overwhelming choice often leads to no choice at all and a confused mind typically says no. 

So we blow it off, don't bother learning anything, and just keep doing what we are doing, hoping that things will work out. 

To overcome this, start slow with a topic you like, that is fairly simple, and are interested in. Then start learning more about it. No midterms. No cramming. Just learning. Scan the web, watch some pod casts, read a book.

There's something I bet most haven't done lately. READ a BOOK. 

Just narrow it down to one thing and start somewhere. 

Once in the habit of continually learning, it's highly likely your life will change - for the better. 

Try it and see.

If the richest guy in the world spends his time doing it, then shouldn't you give it  a try?

Would you lend money to Portugal?

Portugal's ability to borrow money stopped yesterday. They tried to sell bonds to raise money to pay its bills. There weren't enough buyers and they canceled the sale.

(I wonder if they actually cut up the national credit card in front of the heads of state or if they just take it away and give them the look of shame?)

This is bad, very bad.

Here's why:

Countries borrow money.

We know that the U.S. borrows money. We see it in the news all the time as national debt and the yearly deficit adding to that debt make top headlines.

And most people understand that there will be a point when all this debt comes due and those that have loaned the money will want the borrowers to pay it back. So how much is borrowed and how easily it can be paid back is important in determining if investors are willing to loan you money.

While continual borrowing hasn't been a problem for the US yet, it is a problem in many other countries right now. Portugal, Italy, Ireland, Greece, and Spain (PIIGS) have put themselves in to a situation where they need to borrow money to pay their bills, but fewer and fewer people are willing to lend to them.

Other countries like former Soviet Union nations share similar circumstances.

Lenders lend based on several factors not least of which is the ability to repay the loan. Repayment risk in the aforementioned countries is rising, and therefore so are interest rates. At some point, the risk isn't worth any reward and all the lenders simply stop lending.

This is what happed in Portugal.

The result of not being able to borrow to pay your bills is that you go bankrupt. While Portugal isn't quite there yet, clearly having a failed attempt at borrowing is a sign they are close.

Countries have gone bankrupt before and will continue to do so in the future. While never a good thing, if the country is small and somewhat isolated, like Zimbabwe, the impact on everyone else is small.

However, if the country isn't isolated, for example part of the European Union (EU), then the damage can spread, potentially like wild fire.

Another major issue with the EU is the separation of monetary and fiscal policy. When a nation joins the EU they give away the monetary function of that nation to the overall EU. They lose a bit of their sovereignty.

Now, just when they need to have control over their monetary policy, they are forced to go to outside organization that doesn't have only the interests of one nation at heart.

For Americans that would be like allowing the Federal Reserve functions to be carried out by someone other than Americans with the goal of doing what's best for everyone even at the expense of Americans. Americans wouldn't think of giving up that control.

The obvious solution is to raise taxes, cut spending, and painfully change the way the debtor nations operate. Equally obvious is the political turmoil that will cause and the strong desire of politicians to avoid it.

It's possible that many of the nations in trouble, if this continues to get worse, will want that control of monetary policy back and wonder why they gave it away in the first place. While it's still unlikely that the EU would break up, it's not beyond the realm of possibility.

Because someone better loan Portugal and several other nations some money, look for the European Central Bank (ECB), headed by Jean-Claude Trichet, to announce a plan to help. But the extent to which other nations are willing to help at the expense of their own fragile situation isn't clear.

Depending on what is proposed, this could calm the markets or stir controversy and pit nations against each other with the ECB in the middle. Regardless, much like our own bailouts, the fix isn't always a smooth transition to good times and uncertainty will linger.

Uncertainty increases risk and that hurts rewards and market prices fall. That's why few investors will lend money to Portugal and why this could be very, very bad.

Got Your Attention Yet?

The FT reported that the Bank of England cut it's official interest rate to a 315 year low of 1.5%. In December, the US Fed cut it's target interest rate to historic lows between zero and 25 bps and the discount rate will drop to 50 bps, a level not seen since the 1940's.

As if it wasn't already obvious that the situation was historic, these moves provide ample evidence that we have never seen anything like this and are unlikely to see it again in our lifetimes.

Apparently, historic problems call for historic solutions.

What can we learn from this?

Psychology is an integral and crucial part of markets. The impact of an extra 25 bps is negligible, basically worthless. They didn't drop rates to historic lows by accident. They did it to make a statement, hopefully a bold one. If that extra 25 bps gets a headline because it's historic, the psychological impact can be very helpful by showing that they are doing major and significant things to turn the economic situation around, not just empty gestures like a $600 tax rebate check.

In doing this, the goal is for everyone to take notice that the Central Banks are on this and staying on this until things improve.

Will it work? The answer to that is highly related to we all answer this question:

Got your attention yet?

Just Scratching the Surface

There has been a political proposal of a tax holiday on gas this summer. On the surface, it's sounds good. We, as a nation, will be driving more this summer and, if the Government can give us some relief from high prices, many people would like a break from these price levels. But that assumes that no one has ever taken an econ course.

Unfortunately for the politicians a couple of people have.

If we scratch the surface to reveal what's below, we find that oil, and therefore gas, prices are set by supply and demand. It is traded on the open market globally so our demand is only a part, albeit a big part, of the total demand. Another part, for example, is China and the building of 1,000,000 miles of new roads (to grasp that think of it as 400 transcontinental highways from NY to LA) and moving from the bicycle to the car at an unbelievable pace. That means that global demand has and will continue to increase. At the same time, we haven't found any more major oil fields, certainly none that are easily accessible.

Basic economics shows that if supply is constrained, and demand increases, prices rise. (For example, there are only so many Ty Cobb rookie baseball cards and as card collecting became more popular, the price went up) This is what's happening with oil. The oil companies are making massive profits because they own the oil fields (baseball cards). Another example would be owning a gold mine and having the price of gold rise due to higher demand. The miners do the same work, produce the same amount, but they sell it for more money which increases profits. (That's also happening right now, but gold is best left for another day.)

Further, basic economics shows that if prices fall, demand increases. So if we remove a tax to artificially lower the price, demand will increase. When demand increases, if supplies stay constrained, prices rise. This sends prices back upward and turns the tax revenue into company profits. Will the demand-led price increase be more or less or equal to the tax price decrease? No one knows for sure as it is too dynamic and to complex to predict with any kind of certainty. However, the premise is all that matters. A tax holiday may not lower prices at all, but it will increase oil company profits - certainly not reduce them - and leave the country borrowing more money to offset the lost tax revenue or cutting the services funding by that revenue. So the tax holiday will add to oil company profits, our national debt, and potentially not save us a penny at the pump.

Any econ student would see this as a dumb idea. A econ student that cared about the environment would also see that it increases pollution. But again, that's best saved for another day. And what did the markets see? Nothing, that's what.

What can we learn from this?

If the politicians don't remember basic econ, or if even they never knew it to begin with, they have all the advisers around them they need to find out that this is a dumb idea. But the politics trumps that. On the surface, it just sounds so good they can't resist.

Obviously, politicians are not objective, unbiased, truth-tellers, which is why I consistently urge you to ignore them when the speak about economics or at least not accept what they are saying on the surface of it. The markets do, so should you.

Crying for Argentina

The NYT reported today that the economy minister of Argentina, Martín Lousteau, stepped down after less than five months on the job, apparently frustrated with the government response to rising inflation and a strike by farmers. The story reported that, "Before resigning late Thursday, Mr. Lousteau met with (President) Kirchner and presented her with a plan to stabilize the economy, urging her to adopt it to "avoid a serious crisis," the Argentine newspaper La Nación reported."

But the President doesn't want to admit there is inflation, especially when there was an election coming up, even though the government is using high subsidies to control prices on food and energy (increasing consumer spending) to grow the economy at a rate of 8% per year. Some officials that have left have criticized the "new" method of calculating inflation and said it was closer to 16-18% than the 8.8% officially reported.

(Hummmmmm...so we aren't the only ones under-reporting inflation?)

The report also said that, "Despite his title, Mr. Lousteau held little power to set the overall direction of Argentina's economy, which most analysts said was being controlled by the former president."

In the United States our "economy minister" is Ben Bernanke, the head of the federal reserve. Unlike Argentina, he is not holding "little power." Quite the opposite. He is the most powerful force in not only our economy, but the global economy. Our president has almost no power at all, as evidenced by the $600 checks he is sending out that will have basically no impact. This is why when Bernanke sneezes the markets say "Gesundheit", but totally ignore politicians, including the president.

Bernanke has power because he is appointed for 14 years and can't be reappointed. It would take a procedure akin to an impeachment to remove him. Lousteau doesn't even get in the meetings where they are discussing the situation.

What can we learn from this?

Politicians have an incentive, reelection, that provides a desire to have a booming economy leading up to the election. The easiest and surest way to do that is to create inflation. Of course, that is the worst thing that can be done to an economy in both the short and long run. So the incentives are misaligned.

Argentina's government is holding prices down by subsiding food and energy. That works great in the short run, but eventually prices have to adjust. That's when the fit hits the shan and things spiral downward out of control. Price subsidies almost always lead to huge problems in the long run, but as these politicians know, the work in the short run.

We avoid that for the most part by separating the Central Bank from the politicos, there is no incentive at the Fed to do anything other than their job of stable prices and maximum sustainable output and employment. This independence made Regan so mad, he tried to make the Fed Chair a cabinet position that serves at the pleasure of the president. That's what Argentina has and that's why they are in such a mess.

Separation of politics from the economy is crucial to stability.

We have it, they don't, and that's a major difference.

I Agree

In todays FT, Mohamed El-Erian wrote a commentary entitled, "Why this crisis is still far from finished." While he agrees that the unwinding of the previous leverage has stabilized institutions and the unprecedented actions by the Fed and others has returned liquidity, he says that the argument that we are done with this is premature.

He suggests that there is another phase to come. This phase is far more traditional as the financial dislocations move into a far more standard economic downturn. How can consumers keep spending in the face of all the bad economic news that has been, and will continue to be, coming out? If they stop spending, the economy will certainly slow, perhaps significantly.

But here's the problem: The traditional tools the Fed uses to step on the gas and spur the economy are inflationary and with the global inflation pressures, especially on raw materials, this policy will be counterproductive for their main goal of controlling inflation and maintaining stable prices.

I couldn't agree more.

What we can learn from this?

Mr. El-Erian and I agree a great deal and I will not only buy his upcoming book, but devour it immediately. It's a natural tendency to like and accept people that agree with us. I think Mr. El-Erian is brilliant and honest. Of course I do, as his thoughts and my thoughts are aligned. It gives me great psychological comfort to know that someone of Mr. El-Erian's stature agrees with me.

But reading his book is a mistake as I will probably agree with just about everything it says and will likely not find any new information. But why is this is a mistake? Because it will only serve to harden my own thoughts and give me psychological comfort that I am not alone. In short, it will feel good and give me a potentially false sense of security.

One can't learn much of anything from someone that agrees with them. Sure, additional information that wasn't known before may add some texture to an existing position, but that's little help. For the most part, reading, researching, and thinking about all those opinions that are different in order to see if opinions and positions need modification is required to actually "learn" something. To put it in scientific terms, you can't accept the null hypothesis, only reject it. Information that confirms it is useless. Information that disproves it is invaluable. This is true beyond the markets, but especially true when making financial decisions. There is a bounty of evidence that shows agreeing with the crowd in many situations will take you over the cliff with the other lemmings.

Look for contrary opinions and see if they have merit. It won't be more comfortable, but it will likely be more profitable.