Wednesday, April 22, 2009 on Geithner has a cover story on Tim Geithner which is decidedly negative.

Monday, April 20, 2009

Another ray of hope

Neil Barofsky seems to be taking his job seriously as TARP watchdog.

He seems to be warning about the same kind of abuses that I am worried about. That is good news for Americans.

But it is bad news for bank stocks and probably bad news for the markets. It means that the banks are going to have a harder time swindling their way out of trouble and so the question of how to save the banks is back on the table. Sorry, it won't be by defrauding hard working Americans. On to plan B or it is M by now.

Sunday, April 19, 2009

Strange NYTimes article

This New York Times article is certainly strange. Apparently the Obama administration is floating the idea that they have more ammo for recapitalizing the banks than everyone thinks.

Oh,really? What is the latest shennanegans? Well, remember that $350B in TARP money that Paulson put into the 8 largest banks. Well, that was preferred equity shares. That is sort of like a loan that never needs to be paid back (except on liquidation) where the company must pay a fixed dividend to these shareholders before paying the dividend to common shareholders. The yield (annual dividend over the price) was a measly 5%. What a great deal for the banks! But if times gets tight, it can stop paying both dividends without there being an event of default. The shares are non-cumulative so missed dividends never need to be paid back.

Because not paying the preferred dividend is not an act of default, this is considered equity not debt. Preferred equity is not counted any differently than common equity in the three capital ratios that are used by bank regulators although there are guidelines on how high the preferred portion can be - more than half is frowned upon.

These rules are well established in banking. Until now that is. Now the Fed wants to redefine what equity means. Now they want to pretend that all that matters is tangible common equity, bank regulation tradition be damned. So now you can increase the tangible common equity by converting the preferred equity to common equity. Presto, the banks have more capital!

Huh? This does not increase the total equity by one bit. It does nothing to change ASSETS-LIABILITIES which is the definition of equity. They have just shuffled the form of the equity. Really, they have just lowered the standard of acceptable capital levels and made it so that the banks fit the lowered standard.

While they are at it, maybe they can change the definition of liabilities as well. They can redefine it as all debts except those to the federal government. There you go again, instant improvements in capitalization! Just ignore those liabilities when calculating capital ratios.

Honestly, what a joke! Do they really think the market is going to buy this nonsense. The market knows what capital means and they know these banks ain't got it.

Saturday, April 18, 2009

Monday, April 13, 2009

China's bubble economy

While many people trumpet the strength of the growing Chinese economy, there are other signs that it is on the verge of collapse. Note the following Financial Times article .

Property prices in China are likely to halve over the next two years, a top government researcher has predicted in a powerful signal that the country’s economic downturn faces further challenges despite recent positive data.

The property market, along with exports, were leading drivers of the booming Chinese economy over the past decade and the slumps in both have taken a heavy toll.

Cao Jianhai, professor at the Chinese Academy of Social Sciences, a leading government think tank, said an apparent rebound in the property market was unsustainable over the medium term and being driven by a flood of liquidity and fraudulent activity rather than real demand.

He told the Financial Times he expected average urban residential property prices to fall by 40 to 50 per cent over the next two years from their levels at the end of 2008.

"being driven by a flood of liquidity and fraudulent activity". Hmm, why does that sound familiar? Ah, that's right. It sounds like our housing market in 2006.

Real estate agents in the residential property bellwether of Shanghai said the market seemed to have bottomed out as a result of government stimulus measures, falling prices and pent-up demand from owner-occupiers.

But Mr Cao said preliminary government investigations had turned up numerous examples of real estate developers using fake mortgages to offload apartments on to the books of state-run banks facing enormous pressure from Beijing to rapidly increase lending to boost the economy.

Does that sound like the basis of a sound economy? A sound housing market is one in which houses are affordable for the majority of the population. So how is that working out in China?

At a national level, average housing prices tripled between 2003 and the peak in mid-2008 and are now 10 to 12 times average income, which means 60 per cent of homebuyers’ monthly income must go to mortgage repayments, Mr Cao said.

Ok, I am pretty sure we all know how that story ends. Good luck China in your quest to prop up the world economy.

Here is more from the Times Online.

China faces a surge of bad loans and speculative bubbles as the country’s banks open lending and flood the market with record levels of money supply, economists are warning

... The peril appears to lie in the speed and geographical spread of lending: the mostly state-owned banks, scattered throughout both economically weak and strong parts of the country, are duty-bound to follow Beijing’s orders to lend. Few analysts believe that the banks have the mechanisms or expertise to assess the quality of the borrowers.

In short, China has a command economy. It doesn't have a real banking system. The "banks" in China are just state owned entities who don't know how to say no to loans. Even if China keeps growing due to this forced lending, it will eventually end badly. It is classic boom bust ponzi lending. Since capital is being allocated by fiat rather than based on economic soundness, it will result in inefficiency and waste and ultimately economic stagnation. Another result will be excess supply which will export deflation to the rest of the world which the boom finally goes bust.

Sunday, April 12, 2009

William Black Interview

Great interview on PBS with former banking regulator William Black.

Get the word out and forward this around.

Thursday, April 9, 2009

Interesting fact about imports/exports.

China sends us manufactured goods and we send them pieces of paper. No, I am not talking about US dollars or Treasury bills. We literally send them pieces of paper. Recycled paper is the biggest US export by ocean going container.

The list of biggest exporters and importers is here . Basically China and other high-export countries send us ocean going containers full of high value goods like TVs, cars, furniture etc, the stuff that gets sold at Walmart (the biggest importer). We send these shipping containers back filled with recycled paper which basically has little value. The Chinese turn the paper into cardboard so they can send us more cardboard boxes full of high-value goods. Pretty depressing huh?

We export lots of other high-value goods such as software, financial services etc. But not much in the way of tangible goods sent by ocean going container. Paper is pretty heavy though so many containers go back empty when ships hit their weight limit. Next time you want to take a trip to China, bribe some seaman to let you bum a ride in one of their empties.

Corporate Earnings plunging

Here are the total quarterly operating earnings for the S&P 500 companies (annualized). This excludes non-operating write-downs. Actual "as-reported" GAAP earnings are worse. Quite a plunge! S&P estimates that earnings will rebound some in 2009. I have my doubts. The S&P 500 is currently (Feb 10, 2009) at 834. So if 2009 earnings come in around 55, and the S&P trades at 15 times that, we come up with 825 which is about the current price. If it comes in at 30 (basically where it is in Q4 2008), the S&P may drop to 450 using 15X earnings.

The S&P earnings for 2008 were $27.7 using the Q4 estimates with 85% of companies having reported. The S&P 500 is trading at 827 which puts the P/E ratio at 29.86 which is one of the highest ever. According to the trailing PE, stocks are not cheap. In fact, they are amazingly expensive. However, there is something wrong with that argument. It has to do with the way things are averaged. For example, if the average PE is 29, one might think that there must be roughly half of companies trading at more than 29 times trailing earnings. Well, lets look and see. In the Dow 30, there are three companies with negative earnings in 2008 (C, GM and AA). Ignoring these three, here are the five with the highest trailing PE ratio: JPM (18.1), KO (17.0), MCD (15.1), INTC (15.0), WMT (13.5). Hmm, this is a funny kind of average when the top 5 have a lower than average PE. What is going on?

Well, S&P calculates the total earnings of the 500 companies making up the average. Then it is calculates the total market value. The it divides both by the same number (about 8700, called the divisor, it doesn't matter really) to report the S&P stock market index value and also the "earnings". The idea is that people then know about what the average PE is. However, this is not the same as < P/E >. Rather it is more like < P > / < E>. The two are not equal. For example, lets suppose that one company (lets call it Citigroup) loses $1 Trillion next year and goes bankrupt but the other 499 companies make $1.2 Trillion. Together then have made a net $0.2 Trillion. Lets say the total market cap of the 500 companies is $10 trillion. That looks like a PE of 50. Wow, pretty expensive right? Well, not really. Citigroup's weighting for the S&P is currently 0.27%. So if C goes to zero it reduces the index by a 0.27%. But then it gets replaced in the index by some other company that is unlikely to lose $1 Trillion the following year. People owning the index say good riddance to Citigroup and move on. In reality, they own an index at 8.3 times earnings not 50. Stock holders have limited liability. If C goes to zero, it doesn't matter how many gazillions of dollars they lose. The stock holders are not on the hook for it. Stock's can't have negative value.

It is important to consider the earnings weighted by the same weighting used in the S&P index which is by market cap. These can be found here .
The top 45% of the index includes only two banks, JPM and WFC. If you wipe out the shareholders of JPM, C, BAC, GS and MS you have wiped out only 4.02% of the total index. That is just a bad day in the stock market these days. The S&P 500 companies have annual operating earnings of roughly $500B. These five banks could easily lose that much money in 2009 if they properly market down assets to market value.

So lets go back to the current situation and look at some numbers gathered from my Morningstar account. I screened for the largest 500 companies by market cap and trading on either the NYSE or NASDAQ which is a decent proxy for the S&P 500 companies. Then I can rank them by various quantities to get some statistics. Here are some results.

First the trailing 12 month PE ratios. The median is 10.0. The quartiles (25 and 75 percentiles) are 7.0 and 15.7. The median price-to-cash-flow is 7.3. The median forward PE is 10.3. So according to this, stocks are not particularly expensive. In fact those are below average valuations.

Of course, stocks could be expensive if earnings drop a lot and if analysts are wrong about next years earnings (almost certainly the case). For example the median price-to-book-value (P/B) is 1.9. The median return-on-equity is 18.7%. Both are pretty high still. For the major bear market bottoms of the 20th century (1920, 1932, 1949, 1974, 1982) the average P/B came down to roughly 0.5 almost four times lower than now. Profitability is still quite high. That is likely to change.

To see this, consider the ratio of corporate earnings to GDP. See chart here . This ratio should be mean reverting if capitalism is functioning properly. Excess profits should attract capital investment until the excess profits go away. This chart shows that the ratio peaked at 10% in 2007. The average value is about 6% with a low around 3%. It is probably best to assume that this ratio will drop to 3% before rebounding back to the mean of 6%. Looking at our chart above, we see that S&P 500 operating earnings peaked at about 90. So assuming constant GDP (a decent approximation), that means if the corporate earnings to GDP ratio goes to 3% before rebounding to 6%, the S&P 500 earnings will drop to 27 before rebounding to 54. The normalized earnings is probably close to this number, 54. The value of the S&P 500 is probably about 15 times this or 810 which is not far below today price of 827.

So stock are probably fairly valued. However it is still likely I think that they go lower. Usually after a period of over-valuation, there is a period of undervaluation. If earnings really hit 27 and the economy is really, really bad with unemployment over 10%, I would not be surprised for stocks to trade at 10 times normalized earnings or 540. If earnings drop to 27, that would be 20 times trailing earnings which might not appear cheap to people expecting the current conditions to continue indefinitely (which is human nature). That would still likely leave the average P/B above 1 which would well above previous bear market bottoms. Given the different nature of today's non-capital intensive, service oriented companies, that might make sense. If we have a depression, earnings could go lower still. Earnings were negative during the Great Depression. If we have something similar and earnings go negative, stocks will trade based on book value and if they fall to 0.5 book, that mean the S&P near 220. I don't see that happening but it is not outside of the realm of what has happened in the past.

####### Update ########
AIG is going to post a $60B loss for Q4 which is much worse than the $12B loss that analysts expected. This will bring done the Q4 number for the S&P by about $5.50. The trailing PE for the S&P is now about 36 which is the second highest ever. The only year that ended with a trailing PE this high was 2001 when it was 46.

######## Another update ###########
The Q4 is now done. I was right about AIG but underestimated other losses. The final tally for Q4 was -$23.25. Wow! S&P now estimates "as reported" earnings for the next three quarters. $7.32, $6.64, $7.46. Note that those three add up to only $21.42 so if they are right about these, the trailing 12-month earnings will be negative in Q3 2009.

Yes, I know, you can't make a sensible PE based on a negative number for earnings. For example the PE is predicted to be 1875 in Q2 and -450 in Q3. Ok, ok, lets look past "as reported" earnings and look at operating earnings which ignore one time losses and non-cash write-downs. We will make pretend that those things don't matter. S&P makes operating earnings predictions in two different ways: top-down estimates, looking at the macro picture and predicting total earnings and also a bottom-up picture, adding up the total earnings predicted by analysts of each company.

Using the top-down estimates, the forward operating earnings PE is 25 in Q3 and 18 thereafter. Using bottom-up estimates it is 18 in Q3 and about 12 thereafter. So there is a huge difference. I am more inclined to believe the top-down estimates especially if we are going to agree to ignore the "one-time" losses which have a habit of repeating themselves. I think analysts are making the incorrect assumption that companies can cost-cut their way back to profitability. I don't think this will work when everyone is doing the same thing. It just results in higher unemployment and less demand.

Stocks don't look so cheap to me.

Wednesday, April 8, 2009


This article really nails it. It is one of the clearest explanation of what is going on, why it can't be stopped by traditional means and what we need to do to get out of it. In short, we are in a depression not a recession. The difference is that a depression is when people's collective action are self defeating. They all try to save, cut costs and avoid taking risk and this just results in economic collapse rather than the desired outcome of improved individual balance sheets.

The only solution is truly massive government intervention because only government can organize collective action. The trouble is that the Fed, US government as well as foreign governments have not yet come to this understanding. They are still resisting nationalizing the banks and undertaking massive fiscal stimulus. Yes, the Obama administration has passed a stimulus bill but this is not nearly enough. Nor are the stimulus packages from abroad large enough. It will also be necessary for all of the governments to coordinate this action. Government as well as the market in general is still convinced this is just a deep recession not a depression. The longer they deny this, the harder it will be to fix.

Tuesday, April 7, 2009

Sheila Bair to the rescue?

The NY Times has a story in which Shelia Bair, head of the FDIC, says that the FDIC does not expect to absorb any net losses from Geithner's new PPIP idea. This restores within me a small bit of hope that the banks are not going to defraud their way out trouble at the taxpayer's expense, or rather not as much as the markets seems to be expecting.

Lets analyze this a bit at the macro level. If the FDIC does not take a net loss and the investors do not take a net loss then then the banks have to take the loss as they should. It is as simple as that... well sort of.

What the FDIC can do is raise their insurance premiums to collect back any losses in the future directly from the banks. If it has a cash flow problem, it is possible that they can borrow money directly from the capital markets with an implicit government backing.

If you trust Sheila Bair (I have a warm place in my heart for her) this cannot be good news for the banks or Wall Street. It means that the FDIC is not going to guarantee any loans in which it is likely to get screwed. That is, it is not going to guarantee any toxic asset purchases unless the price is low enough for the FDIC to come out OK in the long run. This probably means, lower prices and less leverage. Lower leverage means the investor's larger down payment will provide a larger first-loss cushion if the FDIC has to take over the assets.

Still, I think the FDIC will take some nominal losses. But I think they intend for the banks to pay for these losses through future FDIC premiums. This means that banks will be less profitable in the future even in they can survive. So really this is just a way for banks to postpone taking losses. Japanese lost decade, here we come!

Sunday, April 5, 2009

Nice plot of total US credit market debt breakdown

Some comments:

The Great Depression was partially caused by the vicious deleveraging of corporations and household. This time corporations are somewhat better off but households are worse and financials are a basket case. Remember, our money supply is determined by debt. Debt is money. If debt contracts, so will the money supply and this will lead to deflation.

Friday, April 3, 2009

Let's sum up the Geithner plan quickly

Every trade is a zero sum game. There is a winner and a loser. One bets right and the other bets wrong even if it isn't clear immediately which is which. If there are three parties involved, it doesn't make a difference. The sum is still zero.

The pimps at Pimco are calling the Geithner plan a win-win-win plan. Everybody wins. The banks will make a profit, the hedge fund investors will make a profit and so will the taxpayer! Wow, that must be quite a plan to defy even logic itself.

The fact of the matter is that the banks are not dumb enough to lose money on this plan. The hedge funds are not dumb enough to lose money either. The only one dumb enough to lose money is the hapless taxpayer whose representative Tim Geithner is actually working for the other players.