MasterFeeds: December 2011

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December 31, 2011

We Hold This Truth To Be Self-Evident: You Can't Solve A Debt Problem With More Debt

We Hold This Truth To Be Self-Evident: You Can't Solve A Debt Problem With More Debt

Flat Earth
"Whoever cannot seek the unforeseen sees nothing for the known way is an impasse."
― Heraclitus, Fragments

Which path will we take? If we could only grow our way out of our sovereign debt problems. But growing debt creates even more problems if not dealt with, making it even more difficult to deal with; yet getting the debt and deficit under control brings its own form of pain.

As I keep pointing out, there are no easy choices left. Some countries must choose between difficult and very bad, and others are faced with either disaster or calamity. Greece simply gets to choose what it wants to be the cause of a depression. Long and slow or fast and deep? Choose wisely.

It's that time of year when we start thinking about what the next may hold for us. I am reading and thinking a great deal about my annual forecast issue next week, taking some time off from my usual Friday missive; so this week we look at what I think is one of the best pieces of analysis I have read in the past few months. It is from a private letter for the Boston Consulting Group, and Dan Stelter graciously allowed me to let my friends read it.

Follow this thinking carefully and then think through their outline of what a country would have to do to leave the euro, which starts at the subhead entitled "What if… ?". Then ask yourself what do you need to do. The short answer from me is that you need to consider more what you already own rather than what you should buy.

At the end of the letter is a link to an in-depth review of what scenarios businesses should be considering, but it will also work for individual investors. Now, let me turn it over to Dan and David.

Collateral Damage

What Next? Where Next?

What to Expect and How to Prepare


David Rhodes and Daniel Stelter

January 2012

This paper covers some familiar ground in order to remind readers of the interplay among the most important economic developments, considers the scenarios for which companies should prepare, and suggests some steps that prudent companies may wish to consider. For those readers who are well acquainted with the economic scenarios described, we suggest that you start reading at "What Should Companies Do to Prepare?" beginning on page 13, below.

The economic travails of much of the West are reaching a decisive stage as the year ends. In 2008, we predicted sluggish recovery and a long period of low growth for the West in a two-speed world. This picture does not now properly reflect the downside risks. The policy of "kicking the can down the road" is failing, as the intensifying crisis in the euro zone and the failure of the G20 summit in late October clearly demonstrate. As to December's European summit, we describe its impact later in this paper.

Such extreme uncertainty is challenging for companies trying to prepare their budgets for next year—or, more fundamentally, trying to plot their strategic course. It helps to have a clear understanding of what may happen and why it may happen. So before we address the question of which scenarios to expect and how to prepare, let us remind ourselves about the root of the problem: the West is drowning in debt.

A World with Too Much Debt

Total debt-to-GDP levels in the 18 core countries of the Organisation for Economic Co-operation and Development (OECD) rose from 160 percent in 1980 to 321 percent in 2010. Disaggregated and adjusted for inflation, these numbers mean that the debt of nonfinancial corporations increased by 300 percent, the debt of governments increased by 425 percent, and the debt of private households increased by 600 percent. But the costs of the West's aging populations are hidden in the official reporting. If we included the mounting costs of providing for the elderly, the debt level of most governments would be significantly higher. (See Exhibit 1.)

Add to this sobering picture the fact that the financial system is running at unprecedented leverage levels, and we can draw only one conclusion: the 30-year credit boom has run its course. The debt problem simply has to be addressed. There are four approaches to dealing with too much debt: saving and paying back, growing faster, debt restructuring and write-offs, and creating inflation.

Saving and Paying Back. Could the West simply start saving and paying back its debt? If too many debtors pursued this path at the same time, the ensuing reduction in consumption would lead to lower growth, higher unemployment, and correspondingly less income, making it more difficult for other debtors to save and pay back. This phenomenon, described by Irving Fisher in 1933 in The Debt-Deflation Theory of Great Depressions, can result in a deep and long recession, combined with falling prices (deflation). This is amplified when governments simultaneously pursue austerity policies—such as we see today in many European countries and will see in the U.S. beginning in 2012. A reduction in government spending by 1 percent of GDP leads to a reduction in consumption (within two years) of 0.75 percent and a reduction in economic growth of 0.62 percent. Saving (or, more correctly, deleveraging) will reduce growth, potentially trigger recession, and drive higher debt-to-GDP ratios—not lower debt levels. Indeed, during the early years of the Great Depression, President Hoover—convinced that a balanced federal budget was crucial to restoring business confidence—cut government spending and raised taxes. In the face of a crashing economy, this only served to reduce consumer demand.

For the private sector and government to reduce debt simultaneously would require running a trade surplus. So long as surplus countries (China, Japan, and Germany) pursue export-led growth, it will be impossible for debtor countries to deleverage. Martin Wolf put it trenchantly in the Financial Times: "The Earth cannot, after all, hope to run current account surpluses with the people of Mars." The lack of international cooperation to rebalance trade flows is a key reason for continued economic difficulties.

Saving and paying back cannot work for 41 percent of the world economy at the same time. The emerging markets would have to import significantly more, which is unlikely to happen.

Growing Faster. The best option for improving woeful debt-to-GDP ratios is to grow GDP fast. Historically, this has rarely been achieved, although it can be done—for example, in the U.K. after the Napoleonic Wars and in Indonesia after the 1997/1998 Asia crisis (although Indonesian debt levels were nowhere near contemporary highs in the West). Attacking today's debt mountain would require reforming labor markets or investing more in capital stock. Neither is happening.

Politicians are unwilling to interfere in labor markets given today's elevated levels of unemployment. Moreover, empirical evidence shows that the initial impact of such reforms is negative, as job insecurity breeds lower consumption.

Companies can afford to invest significantly more, as they are highly profitable. The share of U.S. corporate profits in relation to U.S. GDP is at an all-time high of 13 percent (as are cash holdings), yet corporate real net investment (that is, investment less depreciation) in capital stock in the third quarter of 2011 was back to 1975 levels. But companies are reluctant to invest while demand is sluggish, while existing capacities are sufficient, and while the outlook for the world economy remains highly uncertain.

The aging of Western societies will be a further drag on economic growth. By 2020, the workforce in Western Europe will shrink 2.4 percent, with that of Germany shrinking 4.2 percent.

The inability to grow out of the problem is bad news for debtors. Look at Italy, for example: Italian government debt is 120 percent of GDP. The current interest rate for new issues of ten-year bonds is 7 percent—up from 4.7 percent in April 2011. If Italy had to pay 6 percent interest on its outstanding debt, such a high rate would materially increase the primary surplus (that is, the current account surplus before interest expense) that Italy would need to run in order to stabilize its debt level. If we assume that Italy's economy grows at a nominal rate of 2 percent per year, the government would need to run a primary surplus of 4.8 percent of GDP (calculated as 6 percent interest incurred on its debt minus 2 percent nominal growth multiplied by 120 percent debt to GDP) just to stabilize debt-to-GDP levels; the latest forecasts show only a 0.5 percent surplus for 2011. Any effort to increase the primary surplus through austerity and tax increases runs the risk of creating a downward spiral. When investors start doubting the ability of the debtor to serve its obligations, interest rates rise even further, leading to a vicious circle of austerity, lower growth, and rising interest rates.

Debt in itself makes it more difficult to grow out of debt. Studies by Carmen Reinhardt and Kenneth Rogoff and the Bank for International Settlements show that once government debt reaches 90 percent of GDP, the real rate of economic growth is reduced. This also applies to the debt of nonfinancial corporations and private households. Exhibit 2 shows the current debt level of key economies by sector. In all countries, the debt level of at least one sector is beyond the critical mark. Somewhat perversely, only in Greece are the two private sectors below the threshold. And only in Germany and Italy (in addition to Greece) do private households have a debt level below 70 percent of GDP.

[Note: For those not familiar, the flags represent the US, Japan, Germany, France, Britain, Portugal, Italy, Ireland, Greece, and Spain, in order. – JM.]

Debt Restructuring and Write-offs

We explored this option in our last paper (Back to Mesopotamia: The Looming Threat of Debt Restructuring, BCG Focus, September 2011). Assuming a combined sustainable debt level of 180 percent of GDP for private households, nonfinancial corporations, and governments, we estimated the debt overhang to be €6 trillion for the euro zone and $11 trillion for the U.S. We argued that (some) governments might be tempted to fund this through a one-time wealth tax of 20 to 30 percent on all financial assets.

The target level of 180 percent can be debated (and was debated by many readers of Back to Mesopotamia), but a level of 220 percent would still imply a debt restructuring of $4 trillion in the U.S. and €2.6 trillion in the euro zone, leading to a one-time wealth tax of 12 percent and 14 percent, respectively. Given the unpopularity of such a tax, we are likely to see less incendiary taxes imposed. This means that politicians must resort to the last option: inflation.

Inflation. Another option to reduce Western debt loads would be financial repression—a situation in which the nominal interest rate is below the nominal growth rate of the economy for a sustained period of time. After World War II, the U.S. and the U.K. successfully used inflation to reduce overall debt levels. In spite of today's low-interest-rate environment, we have the opposite situation: interest rates are higher than economic growth rates. As risk aversion in financial markets increases and a new recession in 2012 looms large, the problem could get even worse.

So the only way to achieve higher nominal growth will be to generate higher inflation. Aggressive monetary easing has barely moved the inflation needle in the U.S. and most of Europe, although the impact on U.K. inflation has been greater. Inflation is not being generated, because the expectation of inflation remains low and because there is still overcapacity and overindebtedness in the private and public sectors. Continued monetary easing could (and will) lead to a substantial monetary overhang that could, if the public loses trust in money, lead to an inflationary bubble. Some argue that inflation is unlikely because of the oversupply of labor and continued competition from new market entrants like China. Certainly we may see continued pressure on wages because of globalization, although the longer low growth persists in the West, the more likely it is that Western governments will resort to increased protectionism, leading to upward pressure on prices. Moreover, some observers believe that the inflation indicators do not give a true reading of the underlying rates of inflation.

It is also a matter of trust. Take, for example, the history of hyperinflation in Germany in the early 1920s. The German Reichsbank funded the government with newly printed money for several years without causing inflation. But once the public lost trust in money, people started to spend it fast. This led to higher demand and an inflationary spiral.Today the velocity of money in the U.S. is at an all-time low of 5.7. If the number of times a dollar circulates per year to make purchases returned to the long-term average of 17.7, price levels in the U.S. would rise by 294 percent over that period—unless the Federal Reserve simultaneously reduced its balance sheet by $1.8 trillion. Some inflation is probably attractive to those seeking to reduce debt levels. The problem is stopping the inflation genie once it has left the bottle.

There are no easy solutions to the debt problem. At best, we expect a sustained period of low growth in the West. Even this would require the following:

A coordinated effort to rebalance global trade flows, which would require the emerging markets, Germany, and Japan to import more, thereby allowing the debtor countries to earn the funds necessary to deleverage

Stabilizing the overstretched financial sector through recapitalization and slow de-risking and deleveraging—in contrast to today's new rules, which encourage banks to shrink their balance sheets rather than finance commercial activity (it is worth noting that the effect of monetary easing during a period when ultra-low interest rates are below the rate of inflation is essentially to provide additional support to the banking system through the provision of low-cost liquidity)

Reducing excessive debt levels, ideally through an orderly restructuring or higher inflation

Current policies fall short against all these criteria. The coordinated intervention of several global central banks on November 30 could be construed as a positive sign of global cooperation, given that the whole world fears the implications of a (disorderly) breakup of the euro zone. In reality, it was once again merely a case of pulling the only lever left—that of printing money—and so did not address the one fundamental problem facing the world economy. Even China's participation reflected its worries about its biggest export market (Europe) and the risk of another (possibly deep) recession more than a true willingness to support the West by rebalancing trade flows.

Any new recession, given growing and unsustainable debt levels, would increase the risk of short-term defaults and significantly increase the medium-term risk of higher inflation. Companies should therefore prepare for these scenarios. But they also need to consider how the situation in Europe could amplify the problem.

December 29, 2011

Euro Slide Could Be Preview of a Troubled New Year - CNBC

European sovereigns have to finance EUR 150 billion in the first quarter, of which Italy needs EUR 50 billion. Add to that an additional EUR 800 billion needed to recapitalize the banks and you see why the euro is weak...

CNBC: Euro Slide Could Be Preview of a Troubled New Year

The euro's dramatic slide to the year's lows in light trading is a likely prelude to more weakening in the New Year and highlights the long haul ahead for the euro zone's debt crisis.

Full Story:

December 28, 2011

Carlyle in record $15bn return to investors

Not bad for a forgettable year for investments

Carlyle in record $15bn return to investors
Financial Times, 5:34pm Tuesday December 27th, 2011
By Henny Sender in New York
Investment group aggressively takes advantage of market window and raises value of assets under management to $104bn

Read the full article at:

December 26, 2011

Why So Many Market Pros Made Bad Calls This Year Article: Why So Many Market Pros Made Bad Calls This Year

When the history books are written, 2011 may go down as the year when political risk trumped economics, earnings and interest rates as the main force driving capital markets.

Full Story:

December 23, 2011

India: U.S. To Invest $1 Trillion In Infrastructure

What about spending that money in the US....

India: U.S. To Invest $1 Trillion In Infrastructure
Stratfor logo

India: U.S. To Invest $1 Trillion In Infrastructure

December 23, 2011

The United States will invest $1 trillion in infrastructure development in India, Indian Ambassador to the United States Nirupama Rao said, The Times of India reported Dec. 23. Rao said U.S. Secretary of Commerce John E. Bryson will lead a trade delegation to India by March 2012 to discuss the investment. Rao added that India and Washington's political engagement has strengthened significantly as well as their strategic understanding.

© Copyright 2011 Stratfor. All rights reserved.

December 13, 2011

Steve Cohen calls insider trading rules vague | Reuters

Exclusive: Steve Cohen calls insider trading rules "vague"
By Matthew Goldstein

NEW YORK | Tue Dec 13, 2011 2:06pm EST

(Reuters) - Hedge fund billionaire Steven A. Cohen in sworn testimony earlier this year called the rules on insider trading "very vague" and said sometimes it's a "judgment call" as to whether a tidbit about a public company is inside information.

The founder of SAC Capital Advisors LLC, one of the hedge fund industry's best-known firms, offered up his views on insider trading during two days of deposition testimony in February and April this year as part of a long-running civil lawsuit filed by Canadian insurer Fairfax Financial.

It's rare for Cohen to speak publicly and even rarer for him to share his views on something as controversial as insider trading. Cohen's insights are revealing not just because of his status as an industry titan, but because his $14 billion firm continues to draw attention in an ongoing investigation by U.S. authorities into insider trading.

In the deposition, an extended excerpt of which was obtained by Reuters, the 55-year-old trader says he often leans on his fund's lawyer to determine whether something constitutes inside information and admits to being not well-versed in SAC Capital's own internal compliance manual.

"The answer is when you're trading securities, it's a judgment call," said Cohen, during the deposition that spans more than 600 pages. "Whatever the compliance manual says, it probably doesn't take into account every - every potential situation."

The deposition was taken in connection with a lawsuit filed in 2006 by Fairfax, alleging SAC Capital, Kynikos and other traders took part in a so-called short conspiracy.

The lawsuit alleges the hedge funds bet against Fairfax shares and then spread negative stories about the company in hopes of driving down the stock price. Recently, SAC Capital won a motion to be dismissed from the insurer's lawsuit but Fairfax's claims of improper trading against other hedge funds and traders continues.

Reuters petitioned the court to obtain the transcript. SAC Capital and its lawyers had sought to keep the excerpts of Cohen's deposition sealed, arguing that the contents were trade secrets and information that would be useful to competitors.

A Cohen spokesman was not immediately available for comment.

In the deposition, Cohen acknowledges that in the aftermath of Galleon Group founder Raj Rajaratnam's arrest on insider trading charges in October 2009, his public relations firm suggested he begin reaching out to some reporters to burnish his image and "dispel" rumors of improper trading.

In particular, Cohen talked about a December 2009 story in The New York Times on SAC Capital and a subsequent June 2010 profile of Cohen and his wife Alexandra in Vanity Fair.

"There are rumors and what we wanted to do was dispel any notion of that," he said.

When asked by a Fairfax lawyer what rumors he was referring to, Cohen responded: "The rumors you just stated, that people weren't sure how we conducted our business."

In the questioning, Cohen comes off as controlled and well-prepared to engage in a sometimes testy back-and-forth with Fairfax's lawyer, Michael Bowe, over the dividing line between what constitutes permissible and improper trading.

Cohen says the rules on what constitutes inside information are "very vague" and sometimes it can depend on whether the information will move a stock, hurt another trader or can be obtained through another source.

For instance, Cohen said if he got a tip that an analyst is going to downgrade a stock and his fund opts to buy the stock that is proper "because I'm on the other side of the trade."

Cohen said what is "material" in analyzing whether or not it is inside information often depends on the circumstances.

"You know, I mean, I can argue that someone else could think that a - being short in front of a sell recommendation is a non-event because it's not going to move the stock, and somebody else would think, you know, that's trading on material nonpublic information regardless if it moves the stock or not," said Cohen. "These are judgment calls."

The release of a redacted version of Cohen's deposition came about after Reuters went to court to seek access to it and other documents produced in the lawsuit filed by Fairfax in a New Jersey state court.

A copy of Cohen's full deposition was subpoenaed last year by the Securities and Exchange Commission, which was conducting its own investigation into Fairfax's allegation.

Last week Reuters reported that the SEC closed its investigation in the Fairfax case with regards to SAC Capital and James Chanos' Kynikos Associates. (

(Reported by Matthew Goldstein; editing by Claudia Parsons and Martin Howell)

Exclusive: Steve Cohen calls insider trading rules vague | Reuters

December 8, 2011

Forget Europe… Germany’s Got Its Own Problems to Deal With | ZeroHedge

Source: IMF data

Forget Europe… Germany’s Got Its Own Problems to Deal With

Phoenix Capital Research's picture

Every day that Germany continues to flirt with the idea of propping up Europe, is another day that the country gets closer to its own fiscal crisis.

The mainstream media believes that Germany is somehow the bastion of fiscal strength. However, even a cursory look at the facts disproves this.

For starters, German banks post some of the highest leverage rations in Europe: higher that Italy, higher than Ireland, even higher than Greece. In fact, German banks are actually sporting leverage EQUAL to that of Lehman Brothers when it went bust.

To make matters worse, Germany has yet to recapitalize its banks. Indeed, by the German Institute for Economic Research’s OWN admission, German banks need 147 billion Euros’ worth of new capital.

Mind you, this is just NEW capital demands. In addition to this, German banks need to roll over 40% of their total outstanding debt within the next 12 months.

This is at a time when the many European nations are relying on the ECB to insure they don’t have a failed bond auction (by the way Germany had a failed bond auction just a few weeks ago).

Suffice to say, the German banking system isn’t as rock solid as the mainstream consensus. The German government knows about this situation which is why it’s already preparing for the potential nationalization of Germany’s largest banks should things get messy.

Germany’s sovereign balance sheet isn’t a whole lot better either. Officially, Germany has a Debt to GDP ratio of 84%. However, according to Axel Weber, the most recent head of Germany’s Central Bank (he left April 2011), Germany is in fact sitting on a REAL Debt to GDP ratio of over 200%. This is Germany… with unfunded liabilities equal to over TWO times its current GDP.

What’s truly frightening about this is that Weber is most likely being conservative here. Jagadeesh Gokhale of the Cato Institute published a paper for EuroStat in 2009 claiming Germany’s unfunded liabilities were in fact closer to 418% (and that was two years ago).

This further goes with my primary view: Germany has its own problems to deal with. So the idea that Germany is somehow going to prop up the EU is not really realistic. After all, if Germany was indeed going to serve as the mega-European backstop, don’t you think it would already have done so?

The truth is this: the German constitution won’t permit the issuance of Euro bonds. And the German population/ social contract between German politicians and voters will not stand for money printing of any kind.

So… don’t bank on Germany coming to save the day. Indeed, even the option of Germany somehow taking over other EU nations budgetary controls is ridiculous as NO EU member would submit to that.

Read the rest of the post here: Forget Europe… Germany’s Got Its Own Problems to Deal With | ZeroHedge

December 7, 2011

Bloomberg News Responds to Bernanke Criticism - Bloomberg

Bloomberg News Responds to Bernanke Criticism

Federal Reserve Chairman Ben S. Bernanke said in a letter to four senior lawmakers today that recent news articles about the central bank’s emergency lending programs contained “egregious errors.”

While Bernanke’s letter and an accompanying four-page staff memo posted on the Fed’s website didn’t mention any news organizations by name, Bloomberg News has published a series of articles this year examining the bailout. The latest, “Secret Fed Loans Gave Banks $13 Billion Undisclosed to Congress,” appeared Nov. 28.

“Bloomberg stands by its reporting,” said Matthew Winkler, editor-in-chief of Bloomberg News.

Here is a point-by-point response to the Fed staff memo.

From Fed memo: “These articles have made repeated claims that the Federal Reserve conducted ‘secret’ lending that was not disclosed either to the public or the Congress. No lending program was ever kept secret from the Congress or the public. All of the programs were publicly announced when they were initiated, and information about all lending under the programs was publicly released -- both on a weekly basis through the Federal Reserve’s public balance sheet release and through detailed monthly reports to Congress, both of which were also posted on the Federal Reserve’s website.”

Response: Bloomberg’s Nov. 28 story about Fed lending reported that the central bank published regular reports on the scope of borrowings from the discount window and other emergency or temporary programs. The loans were described as “secret” because the amounts, names of borrowers, dates and, often, interest rates weren’t disclosed. The stories reported that the Fed’s rationale for keeping the loans secret was to prevent bank runs.

From Fed memo: “The Federal Reserve took great care to ensure that Congress was well-informed of the magnitude and manner of its lending.”

Response: Bloomberg’s story said Congress wasn’t fully apprised of the details of the Fed’s efforts. “We were aware emergency efforts were going on,” U.S. Representative Barney Frank, who served as chairman of the House Financial Services Committee, said in the Nov. 28 story. “We didn’t know the specifics.” Other members of Congress on both sides of the aisle also said they weren’t aware of the details.

See the rest of the Bloomberg article here: Bloomberg News Responds to Bernanke Criticism - Bloomberg

The text of the Fed Note is below:

Why did the Federal Reserve lend to banks and other financial institutions during the financial crisis?

Intense strains in financial markets during the financial crisis severely disrupted the flow of credit to U.S. households and businesses and led to a deep downturn in economic activity and a sharp increase in unemployment. Consistent with its statutory mandate to foster maximum employment and stable prices, the Federal Reserve established lending programs during the crisis to address the strains in financial markets, support the flow of credit to American families and firms, and foster economic recovery.

All of the Federal Reserve's lending programs were announced prior to implementation and the amounts of support provided were easily tracked in weekly and monthly reports on the Federal Reserve Board's website.

The Federal Reserve followed sound risk-management practices under all of its liquidity and credit programs. Credit provided under these programs was fully collateralized to protect the Fed--and ultimately the taxpayer--from loss. As verified by our independent auditors, the Federal Reserve did not incur any losses in connection with its lending programs. In fact, the Federal Reserve has generated very substantial net income since 2007 that has been remitted to the U.S. Treasury.

Most of the Fed's lending facilities were priced at a penalty over normal market rates so that borrowers had economic incentives to exit as market conditions normalized. Lending peaked at $1.5 trillion in December 2008.* All of the emergency support programs established during the crisis were closed to new lending in 2010. Detailed information on the support provided to individual firms under these programs is available on the Federal Reserve Board's website.

* Liquidity Facilities include: Term Auction credit; primary credit; secondary credit; seasonal credit; Primary Dealer Credit Facility; Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility; Term Asset-Backed Securities Loan Facility; Commercial Paper Funding Facility; and central bank liquidity swaps.

See the Bloomberg article here:
Bloomberg News Responds to Bernanke Criticism - Bloomberg

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