Green Shoots and the Carbon Markets

“Green Shoots” and the Carbon Market 17th August 2009 EUA’09: €14.50 Recommendation: Hedge by buying Puts The last few weeks have seen an increasing number of market experts and economists calling the end of the recession and the resumption of an economic growth pattern similar to previous cycles. These are, however, the same market commentators who failed to foresee the imploding credit markets in late 2007. The market reaction to these predictions is best reflected in a 50% rise in the S&P 500 from its March lows. It is our opinion that this rally is illogical and unsustainable. Consequently we are forecasting a huge market correction before the end of autumn; and view the recent gains merely as a sharp rally in a sustained bear market that will lead to further pressure on world economies and reduce demand for Carbon Emission Allowances. Below is a summary of the economic position we find ourselves in and our predictions. The market began this prodigious rally on the back of a number of banks producing profits substantially above analysts’ expectations. A large proportion of these profits arose from highly advantageous settlements resulting from the US government’s bailout of AIG’s outstanding credit default swap obligations and the April 2 rule change of FAS 157 which allowed banks to mark their assets above market value boosting intangible profits. According to an IMF report released in April, global credit losses amount to over $4.1 trillion but to date only $1 trillion of this amount has been recognised. Some banks still maintain high leverage and, if these losses are recognised, the majority of bank equity will be wiped out. Commercial real estate losses have only just started to become a problem and are estimated to be in excess of $3 trillion - of which only 25% has been written down by the financial sector to date.   Emerging markets, including China, recently reported increases in GDP growth; however, the majority of this can be attributed to huge government spending and easy credit policies –one of the main culprits for the global financial crisis. This is similar to giving a drunk a bottle of whisky to cure his alcoholism. China’s two main stock markets are up an incredible 75% and 95% on the back of the government’s stimulus package and are supported by huge amounts of non-performing loans. This is just another bubble waiting to implode. Recent data shows that Chinese exports have fallen by an enormous 23% highlighting the fragility of their export-led growth. The surge in China’s exports was largely driven by US consumption fuelled by the credit boom. How this consumption will be replaced given the precarious financial position of the US consumer and the large unemployment percentage remains a mystery. The S&P 500 price earnings (P/E) ratio recently exceeded 140, equating to more than three times its value at the peak of the world equity markets in 2000. Markets have been driven by banks trading the large pools of liquidity supplied by the Federal Reserve to stimulate the economy that was meant to be leant to struggling firms and individuals. With US unemployment approaching the 10% level, it is unlikely the consumer will reignite the US economy. Recently a staggering 64% of GDP was generated by consumption driven by credit card debt and cashing in on the value of their inflated home prices. House prices in the US need to fall by 30% to revert to their long time mean of three times the annual average salary. The recent dramatic decline in bond issuance by the US Treasury may indicate that the government has reached its limit for debt issuance. We expect this to lead to a rise in long term rates and ultimately raising mortgage rates, only exacerbating our view of a continued recession in the US and the rest of the world.   SOURCE: US Treasury Direct, “Debt To The Penny” Conclusion: Recently the Carbon Markets have been following the equity markets as a proxy for an anticipated improvement in global GDP. We believe that this is a serious error in judgement and advise our clients to consider some kind of hedging strategy to lock in the advances of the last few months. Option volatilities have been sliding over the last few months as illustrated below, thus option prices have been declining. We expect volatilities to reverse this trend as the equity markets reverse their gains. We therefore recommend the purchase of put options to December to lock in the recent gains.

The American Housing Crisis Explained

This is the most illuminating video that explains the current crisis facing America and ultimately the rest of the world. Well worth watching: www.tickerforum.org/cgi-ticker/akcs-www?post=38857

Use Today as a Selling Opportunity

As we approach the end of the first quarter who will find that a number of shares will be pushed higher by portfolio managers to boost their performance. What will be interesting is that no one will call foul and look for the rumour mongers when shares are pushed higher but just let one share (read HBOS) be manipulated down and it is the end of the world - Just the way of the world I am afraid. Both actions are illegal and fraudulent but only one is punishable. It really looks like the "Credit Default Swap" CDS market is about to blow up, the companies that have been writing these insurance premiums have no way of ever paying up should they be called to do so. FGIC has admitted that they don't have the required capital to justify their Insurer status and if taken to the logical conclusion means that they are no longer an Insurer - This means that there policies are worthless. The problem is that all the banks and I mean all are still using these policies to back up their balance sheet liabilities. The banks are all insolvent at present. This is something that ypu wont read in the financial press or hear from the pump monkeys on Bloomberg and CNBC> As this rally is definitely in its final stages I urge everyone to exit any exposure they have to equities, especially banking shares. The market is only some 12% off its peak and has a long way to go. I have revised my downside target on the FTSE to 4700 now. Sell - You have been warned

This rally is only a blip!!!

Since the Easter weekend the financial press and the pump monkeys on CNBC have been calling the bottom of the markets and an end to the credit crisis - their reason is that the banks are passed their worst all the bad news is reflected and the actions of the Fed will now stimulate the economy which will rebound in the second half of 2008. This cannot happen for the following reasons: 1) The USA will now enter a protracted phase of slow growth similar the path followed by the Japanese economy since 1987 - The Nikkei Index is still 75% below it's peak and interest rate have been at zero for decades, one thing in their favour was that they had extremely high rates of personal saving at the time - The American consumer is virtually bankrupt. The lower bank rates will not allow the consumer to take on more debt and continue to spend the country out of recession, the banks will not be in a position to lend at any rate, they will have to become more risk averse in the practices. 2) You cannot have a system where profits are privatised and losses are made good by the public - the bail out of Bear Stearn's has cost each citizen of America $300!!. House prices still have a long way to fall to revert to the mean, this will increase the default rate which will bring down the value of the toxic bonds that the banks and now the Federal Reserve own further exacerbating losses on Wall Street. This equates to higher PE's on the averages, which in spite of the bottom pickers claiming the market is cheap makes it extremely expensive. Meridith Whitney who has been spot on on calling the banks earnings has just lowered her earnings for the entire banking sector to a loss of 28 cents from a profit of 75 cents - You cant have a P without an E. 3) US consumer confidence is the lowest it has been since March 2003 and expectations are the worst since the oil crises of 1974 - Hardly an environment for shares to rally. 4) Commodity prices have probably peaked as the big hedge funds will need to unravel their speculative positions as margin call increase for all their positions - No more 32x leverage by the banks and trading houses. Some of my targets on the downside have been reached - my next post will be an update and predictions for the second quarter Watch this space

Who is this guy Margin who keeps calling me?

This is the most radical change and expansions of Fed powers and functions since the Great Depression: essentially the Fed now can lend unlimited amounts to non bank highly leveraged institutions that it does not regulate. The Fed is treating this run on the shadow financial system as a liquidity run but the Fed has no idea of whether such institutions are insolvent. As JPMorgan paid only about $200 million for Bear Stearns – and only after the Fed promised a $30 billlion loan – this was a clear case where this non bank financial institution was insolvent. The Fed has no idea of which other primary dealers may be insolvent as it does not supervise and regulate those primary dealers that are not banks. But it is treating this crisis – the most severe financial crisis in the US since the Great Depression – as if it was purely a liquidity crisis. By lending massive amounts to potentially insolvent institutions that it does not supervise or regulate and that may be insolvent the Fed is taking serious financial risks and seriously exacerbate moral hazard distortions. Here you have highly leveraged non bank financial institutions that made reckless investments and lending, had extremely poor risk management and altogether disregarded liquidity risks; some may be insolvent but now the Fed is providing them with a blank check for unlimited amounts. This is a most radical action and a signal of how severe the crisis of the banking system and non-bank shadow financial system is. This is the worst US financial crisis since the Great Depression and the Fed is treating it as if it was only a liquidity crisis. But this is not just a liquidity crisis; it is rather a credit and insolvency crisis. And it is not the job of the Fed to bail out insolvent non bank financial institutions. If a bail out should occur this is a fiscal policy action that should be decided by Congress after the relevant equity holders have been wiped out and senior management fired without golden parachutes and huge severance packages. Nouriel Roubini 17/3/2007

Dear Mr. Bush

An Open Letter To United States Lawmakers President Bush 1600 Pennsylvania Avenue Washington, DC 20015 Transmitted by Fax CC: Joint Economic Committee Members House Financial Services Committee Members Senate Banking Committee Members Hillary Rodham Clinton, Senator New York and Presidential Candidate Barack Obama, Senator Illinois and Presidential Candidate John McCain, Senator Arizona and Presidential Candidate Dear Mr. President: It is now clear that we face a nearly-unprecedented financial crisis in this nation. Since President Clinton signed the repeal of the last pieces of Glass-Steagall, our banking system has intentionally and willfully ignored both the letter and spirit of the law when it comes to regulatory requirements and just plain old fashioned good conduct. The stress imposed by the collapse of the subprime lending space has exposed the truth – banks and other institutions have employed Enron-style financing vehicles to keep liabilities hidden and assets unvalued by the market, literally inventing valuations as they go along. Ratings agencies, paid by the seller of securities, have admitted to using flawed computer models – specifically, the assumption that house prices would never decline – in their rating of these securities. The Federal Reserve has been complicit in this game of “Hide Waldo” by first issuing “23A Exemption Letters” starting in the spring of 2007, and now, through the use of the “TAF” facility, it is preventing the investing and depositing public from learning who is under stress and to what degree. What is clear from the market, however, is both that this stress is real and that it is dangerously close to a breaking point. The expansion of the TAF facility on March 7th, 2008 is rumored to have been prompted by a potential collapse of one or more major financial institutions. Other institutions, including Thornburg Mortgage, have disclosed that they are restating earnings for the December quarter and may have to file for bankruptcy protection. If December’s earnings are being restated, that means they were aware of – but did not disclose – the level of stress they were under when they originally filed those reports. The secondary mortgage market, six months into this mess, remains almost completely frozen. In addition, Hedge Funds and other unregulated entities have been met with increasingly stringent capital demands and margin calls, with the latest two to fall being Peloton and now, it appears, Carlyle. Peloton has collapsed outright while Carlyle has been suspended from the public exchanges in Europe. These margin calls, along with a lack of trust and the ability of the market to absorb forced sales, have caused spreads on Fannie and Freddie paper to rise to historic wide levels. Mr. Bernanke and The Fed have lowered the Fed Funds Target from 5.25% to 3% over the last few months and the “slosh”, or free funds available in the Fed Banking System, has nearly doubled over that time. Yet this additional liquidity has done nothing to address the problem and won’t because the issue is not one of inadequate liquidity; rather it is a desperate move to hide the fact that a significant number of financial institutions in our nation are, if forced to mark all their paper to the market and recognize their exposure to off balance sheet vehicles, insolvent. At the root of the matter, Mr. President, is a lack of trust caused by the intentional acts of these institutions, and lack of regulatory enforcement by both the Federal Reserve and other agencies such as the OTS and OCC. As a direct consequence, those who lend money have literally taken their ball and gone home, either parking their funds in the Treasury market (irrespective of the yield being under the rate of price inflation) or sending their money outside the United States entirely. The Fed’s attempt to manage this crisis by injecting liquidity has only forced the dollar lower, which feeds a perverse cycle of price inflation in our economy. Oil is over $100 precisely because the dollar has been debased by 18% in the last two years. But for this intentional debasement, oil would be under $80 right now. Instead, the dollar continues to decline, and all goods and services priced in other currencies continue to increase in price. The economic impact of these actions on American Families has been catastrophic. Food and energy price inflation has destroyed the purchasing power of those on fixed incomes and families just starting out, such as Senior Citizens and our legal immigrants. Real purchasing power of the American Family has declined for the last three years while, according to the Federal Reserve’s latest documents for the 4th quarter of 2007, so has Americans’ net worth. That outcome is due to the lack of trust, which is the root of the problem – banks and others simply do not know who is bankrupt and who is not, because nobody is able to get an honest look at these institutions’ financial condition! I have been writing since last April in my Blog at http://market-ticker.denninger.net about this matter, and have continued to chronicle on a near-daily basis the insanity that is being allowed to continue in our financial markets. This beast was created through intentionally making unsound loans in the belief that the risk could be sold off and therefore quantity was the only metric that mattered, while quality was immaterial. This in turn drove up the price of houses to unsustainable levels. More than 100 years of history tells us that the maximum sustainable home price is approximated by a median home in a given area selling for approximately three times the median income in that same area. Today, most markets have home prices that are well in excess of this figure with coastal areas frequently running in excess of five times incomes. Proposals floated by various parties that attempt to prevent the correction of home prices to historical means will not work. Such price levels cannot be sustained, and it does not matter whether this is politically palatable or not. This is a matter of mathematics, not politics. Home prices must be allowed, and in fact encouraged, to contract until they reach economic equilibrium with household incomes. Government must not interfere with this process! Today, on the 7th, we had printed the second consecutive negative jobs figure. Since this statistic has been kept, two consecutive negative prints have, 100% of the time, indicated that a recession has begun within the last two to three months. We are in a recession, and it is incumbent upon our public officials to admit to our economic situation. I, and those who have signed this letter, call upon you Mr. President, the members of the House and Senate Banking Committees, and the members of the Joint Economic Committee, to immediately act to address this issue before we find ourselves in a fully-developed deflationary credit collapse – that is, a re-run of either Japan’s experience or worse, ours of the 1930s, both of which were caused, at their root, by the same abuses and lack of government oversight and regulation. In short, if we are to avoid the worst potential outcomes, it is imperative that the following actions be announced immediately as public policy by our Government and implemented without delay: · All securities and instruments traded and held for investment by regulated financial entities must have a CUSIP assigned and be traded on a public exchange or their value must be established by independent appraisal (in the case of a house or other real property.) All real property already has a tax appraisal available; properties carried by banks and other financial institutions must not be “marked” at values in excess of those appraisals, and appraisals must be updated whenever ownership changes hands, including via foreclosure actions. We must stop ‘mark to model’ and ‘mark to myth’; if you cannot obtain a bid for a thing, today, its value for today is zero! These marks must be taken nightly for tradable instruments and no less often than annually for real property. · Margin requirements must be enforced against all market participants. It is simply obscene that we have firms rated “AAA” who hold less than 1% of their exposure in actual capital. That is not “AAA” credit irrespective of what anyone tells you, and when the bond market is trading their debt at 70 cents on the dollar, the market is saying that this firm is rated “C” – or just above default – at best. In addition, the idea that a bank or hedge fund can write a credit default swap without having to prove capital adequacy for the duration and reserve commensurately is an outrage – these are forms of insurance and must be regulated as such. · All off-balance sheet vehicles must be banned and existing ones immediately brought back onto the balance sheet of the firm involved and disclosed in full. Enron collapsed in no small part because these off-balance-sheet vehicles allowed them to hide their exposure until it was literally too late to do anything about it. We cannot afford a repeat of the “Enron experience” on an even larger scale, one that threatens our banking system! · We must either get rid of the NRSRO label for ratings agencies, allowing free and open competition, or we must hold those certified agencies to their ratings. Hiding behind a free speech disclaimer while enjoying oligopoly protection is an outrage; either all are free to speak or there must be no protection. In addition, as BASEL sets reserve requirements for banks based solely upon ratings, the systemic risk of a “gamed” ratings system should be obvious. That the current environment has been systemically gamed for years is now obvious for all to see. This must be cleaned up immediately. · All credit instruments must be subject to “Regulation FD” disclosure requirements. It is outrageous that bond rating agencies are given details on the mortgages and other instruments inside “CDOs” that are not available in the prospectus to buyers. · Fraud must be aggressively prosecuted in all instances. There were many homeowners who lied on mortgage applications but there were also just as many financial institutions who literally made up data for their models when it was missing instead of rejecting the loans outright. The worst abuses were in the “stated income” or “liar” loans, but the problem is not limited to that area of the market. The FBI must go after not only homeowners who lied but also the banks that deceived by omission or commission the purchasers of these securities, and those who continue to deceive with improperly booked capitalized interest earnings on homes which have declined in value below their mortgage balance. · Fannie and Freddie’s capital adequacy must be investigated and stringently monitored. If either of these institutions were to collapse the results would be catastrophic. The Federal Government cannot bail them out as that would cause a rocket shot in treasury yields which in turn would greatly increase the cost of government borrowing – which we cannot afford given the national debt and current budget deficits. Therefore, it is critical that OFHEO be extraordinarily diligent to insure that this does not happen, and that Fannie and Freddie ONLY buy fully-documented loans with no more than a 36% back end ratio and no more than an 80% LTV. This is a material tightening from current guidelines but it must be put in place immediately as it represents the benchmark of sound mortgage lending for more than 100 years. I recognize that these changes would cause some institutions to fail immediately. Nonetheless, the consequence of not taking these actions will be far worse, and the probability of that outcome is extremely high. Mr. Thomas Hoenig, President of The Federal Reserve Bank of Kansas City, said during a speech on March 7th in Brazil (available at http://www.kc.frb.org/SpeechBio/HoenigPDF/HoenigBrazil3.7.08.pdf) the following: “I believe there may be merit in considering formal liquidity requirements, and perhaps loan-to-value ratios for banks and other financial institutions, especially the large institutions that provide liquidity and risk management products to other financial institutions and to financial markets. I also think that it is time that we extinguish some of the off-balance sheet fictions that have developed to excess in recent years.” “In conclusion, let me stress again my belief that the response to this crisis should be fundamental reform, not Band-Aids and tourniquets. “ “I believe a central bank must have the legal authority to require this information from the supervisory agency on terms set by the central bank. A voluntary exchange of this important information is no more likely to be effective in a financial context than it was in the U.S. intelligence community prior to 9/11.” This, of course, was not widely reported in our “mainstream media”, but Mr. Hoenig is correct on all points. These actions need to be taken right here and now. I call upon you to act today in order to prevent the economic catastrophe which looms over our nation due to the artifice and outright fraud of the last ten years. I look forward to a public response from all recipients of this letter, addressing the points herein and announcing policy initiatives immediately. Our capital and credit markets cannot wait for the election or for long cycles of public hearing and comment. We must act now or our credit markets will remain seized as market participants cannot be forced to either lend or borrow. Our nation is in grave economic danger and requires your immediate attention. Sincerely, Karl Denninger

Reflections from South Africa

I have just returned from a two week trip from the Southern tip of Africa and thought I would share some of my observations. This is my first visit in six months and I was amazed at how the mind set and attitude of the people I interacted with has dramatically changed in that time. Since then we have seen Jacob Zuma take over the leadership of the ANC and Eskom start to invoke their load shedding arrangements, the Rand has also weakened considerably even against a globally defective dollar, something which I must say I never predicted. I was extremely impressed by the developments at OR Tambo airport, the extent of the new facilities and the friendliness of the the immigration staff - this is a 100% improvement over the last visit and I sincerely hope this continues as this is the first glimpse of a foreign tourist. Unfortunately this is where it ended. My trip to the car rental area was a minefield of illegal taxi drivers offering to take me to Sandton, surely what is needed is a regulated taxi rand where a visitor can queue up like most International cities and have metered and regulated trip into the city center, no such luck. The aggression and lack of courtesy afforded other drivers is very pronounced, ten minutes of driving and the tension starts to creep through your veins, making up one place in a three lane highway by changing lanes six times is par for the course, taxis come at you from all directions even the emergency lanes. My biggest shock was however the negativity of my friends (of all races) who have all been extremely bullish on the Rainbow Nation since 1994. Everyone has a story of a violent crime, a rape a murder of someone close to them. The talk around the dinner table is no longer of how good the way of life in South Africa is and how can you possibly take the London climate and has moved to where did I think the best areas of the UK are to move to or should they consider the US or Australia. Why the sudden change in perception, I think the realisation that the infrastructure is no longer holding up and that 2010 World Cup may possibly no longer happen has a lot to do with it. The fact that it is also no longer cheap to live in South Africa is starting to impact a number of peoples decisions on leaving too, people where amazed to find out that food, clothing, electricity, water are a lot cheaper in the UK even at 15 to 1. I guess only time will tell whether South Africa just becomes another African statistic - I sincerely hope not.