The Elusive Canadian Housing Bubble

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The machinations of the daily grind have left me a few days behind in getting the next posts in our series out to you.

Since you have dropped by, I offer a paper by Alexandre Pestov titled, "The Elusive Canadian Housing Bubble"... if you haven't already seen it elsewhere.

Canadian Housing Bubble ==================

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Sunday Funnies - March 21, 2010

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Alan Greenspan: The Fed Failed

Let's take a momentary break from our series for this must-read treatsie from Alan Greenspan.

I will post some concluding thoughts on this past week's series on Monday.

Today, however, check out this newly released paper from the former US Federal Reserve Chairman. In it, Greenspan discusses the causes of the financial crisis and the Fed’s failures leading up to it.

Greenspan is famous for his libertarian leanings and hands-off approach to Wall Street, but he now appears (finally) to be having some second thoughts.

Once celebrated as the “maestro” of economic policy, Greenspan has seen his reputation dim after failing to avert the credit bubble that nearly brought down the financial system. Now, in a 48-page paper that is by both analytical and apologetic, he is calling for a degree of greater banking regulation in several areas.

The report, which he presented Friday to the Brookings Institution, acknowledges his shortcomings in regulation and admits that, "regrettably, we did little to address the problem."

The former Fed chairman also acknowledged that the central bank failed to grasp the magnitude of the housing bubble but argued, as he has before, that its policy of low interest rates was not to blame. He stood by his conviction that little could be done to identify a bubble before it burst, much less to pop it.

“We had been lulled into a sense of complacency by the only modestly negative economic aftermaths of the stock market crash of 1987 and the dot-com boom,” Mr. Greenspan writes. “Given history, we believed that any declines in home prices would be gradual. Destabilizing debt problems were not perceived to arise under those conditions.”

Click here to see full document

To read the next part of our series, click here.

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Arghhhhhh........

This will be the fifth post in our series this week. On Monday I will post a summary and my conclusions/thoughts.

Post #1 can be read here. Post #2 here. Post #3 here. And Post #4 here.

China as Canada's economic saviour

It's stunning the number of people who believe that, regardless of the US sovereign debt position, Canada will be okay because our resource based economy will be in demand by the emerging economic behemoth of China.

It won't be.

China's foreign exchange reserves stood at the astonishing level of $2.4 trillion at the end of 2009. About $2 Trillion of that is in US Treasuries.

That's $2 Trillion dollars in IOU's from the United States. If the sovereign debt crisis leads the United States to default, just who do you think is out all of that money?

Notwithstanding this small fact, the current economic situation in China is not as rosy as you might think.

Yes, they have invested an astonishing amount of foreign reserves in American debt, but did you know that China's proposed annual budget for 2010 will produce a record deficit?

Now, granted, this deficit is just $154 billion, or 2.8% of China's gross domestic product. In contrast, the Congressional Budget Office projects the US budget deficit for fiscal 2010 at $1.3 trillion. That's equal to 9.2% of GDP.

But let's take a closer look at China's finances. The following data comes to us from Jim Jurbak's journal.

There's a good argument to be made that if you look at all the numbers, instead of just the ones the budget magicians want you to see, China has far more debt than meets the eye.

If you look only at the current position of China's national government, the country is in great shape. Not only is the current budget deficit at that tiny 2.8% of GDP, but the International Monetary Fund projects the country's accumulated gross debt at just 22% of 2010 GDP. US gross debt, by comparison, is projected at 94% of GDP in 2010. The lowest gross-debt-to-GDP figure for any of the Group of Seven developed economies is Canada's 79%.

But China has a history of taking debt off its books and burying it.

If we go back to the last time China cooked the national books big time, during the Asian currency crisis of 1997, we can get an idea of where its debt might be hidden now.

The currency crisis started in 1997 with the collapse of the Thai baht—and. Like dominoes, the currencies of Indonesia, South Korea, Malaysia, and the Philippines collapsed. In each case, the country had built up an export-led economy financed by foreign debt. When the hot money that had been flowing in reversed (and started flowing out), that sent currencies, stock markets, and economies into a nosedive.

China escaped the first stage of the crisis because the country's tightly controlled currency and stock markets, and its economy, had kept out hot money from overseas.

China had built its export-led economy on domestic bank loans instead. The majority of bank loans, then as now, went to state-owned companies — about 70% of the total.

Those loans were all that kept the doors open at many of China's biggest state-owned companies. It's estimated that about 75% of China's 100,000 largest state-owned companies lost money and needed bank loans to continue operating.

That became a problem when, in the aftermath of the currency crisis, China's exports fell. That sent revenue plunging at state-owned companies that were already losing money. Suddenly, China's banks were sitting on billions and billions of debts that anybody who'd taken Bookkeeping 1 in high school could tell were never going to be paid.

This was especially a problem for China's biggest banks, all of which had ambitions to raise more capital — and their international profile — by going public in Hong Kong and New York. But no bank could go public with this much bad debt on its books.

So what did China do? They buried the bad debt.

The Beijing government created special-purpose asset management companies for the four largest state-owned banks, the Industrial and Commercial Bank of China, the Agricultural Bank of China, the Bank of China, and China Construction Bank.

These asset management companies — China Cinda, China Huarong, China Orient, and China Great Wall — would ultimately wind up buying $287 billion in bad loans from state-owned banks. The majority of those purchases were at book value.

So how did the asset management companies pay for the purchase of that $287 billion in bad loans? They certainly didn't pay cash. Instead, they issued bonds to the banks in exchange for the bad loans. The bonds, of course, were backed by the promise that the asset management companies would gradually sell off or collect on the bad loans in time to redeem the bonds. And in the meantime, they'd pay the banks interest on those bonds.

Neat, huh? In one sweat move, the state-owned banks got $287 billion in bad loans off their books and turned deadbeat loans that would never pay off into streams of income from these bonds. To read more on this neat bit of financial engineering, check out this research paper.

Of course, that still left the little issue of where the asset management companies were going to get the approximately $30 billion in annual interest they had promised to pay the state-owned banks. There was also the small matter of how they were going to pay off these bonds when they came due in ten years, especially since the cash recovery rate on these bad loans would run at just 20.3% in the first five years.

But who really cared? The Beijing government and the state-owned banks had kicked the problem ten years down the road. (A favorite tactic of politicians, Republicans, Democrats, and Communists alike, is to punt, so that today's problem becomes somebody else's problem in the future.) The bonds issued by the asset management companies didn't have an explicit government guarantee, but everybody assumed that at some future date the government would either pay up or punt again.

The ten-year punt of 1999 came to earth in 2009, and, lo and behold, there has been some more magic.

In some cases — China Huarong, for example — the asset management companies simply declared that they were done disposing of bad debts, that profits were soaring, and that they were seeking strategic partners in preparation for a public offering.

In others cases, the magic was more complex. In October 2009, for example, China Cinda said it had secured government approval for a restructuring plan that would create a company to dispose of the $30 billion in bad loans still on Cinda's books. The company said it would then look for strategic partners in preparation for a public offering.

Who in their right minds would be a strategic partner and investor in one of these asset management companies? Well, how about one of the original state-owned banks, China Construction Bank, that Cinda had bought the bad loans from in the first place. "The hardest thing," China Construction Bank chairman Guo Shuqing said in this October 17, 2009 interview, "is evaluation."

Really?

When the government runs the books, does all the accounting, and decides what assets to send where, I think evaluation would be very easy. Any wonder, then, that today's huge run-up in loans — and bad loans — by China's banks is making some critics nervous?

The bigger problem, though, isn't so much China's big banks, but the country's local governments.

By now, everyone knows that the country's banks went on a lending spree in 2009.

On top of official government stimulus spending of $585 billion, banks, encouraged by the government, doubled their lending in 2009 to $1.4 trillion from the previous year.

(Please remember when judging these figures that China's economy was an estimated $4.8 trillion in GDP in 2009, according to the CIA World Factbook. We banter around such large numbers that it's easy to have these figures gloss our eyes over. To appreciate the size and scope of China's debt consider that estimated US GDP was about three times larger, at $14.3 trillion. So China's 2009 bank lending of $1.4 trillion would be equal to lending of $4.2 trillion in the United States, and China's $585 billion government stimulus package would equal a $1.7 trillion US package, more than twice the $787 billion size of the US stimulus package of February 2009.)

China's banks hit the ground running even harder in 2010, lending out an additional $309 billion in January and February. If the banks had continued at that rate, they would have passed the official lending ceiling of $1.1 trillion by August.

So China's banking regulators, spooked by the increase in bank lending, tightened the reins. For 2010, they set a lending target 20% lower than 2009 lending levels.

They raised reserve requirements so banks would have less capital to lend. And they told banks to hit the capital markets to raise an estimated $90 billion through 2011.

It's not clear that those steps will be enough to balance the huge number of bad loans that China's banks made during the lending boom. But China's regulators have clearly learned a lot about how to address a bad loan problem in the banking system since the 1997 currency crisis.

But as the US Federal Reserve has so amply demonstrated over the past decade, regulators tend to gear up to fight the last war. That leaves them vulnerable to the next crisis precisely to the degree by which it differs from the last one.

China's new debt problem is the thousands of investment companies set up by local governments to borrow money from banks and then lend it to local companies.

By law, China's local governments can't borrow directly. But the incentives for local governments to set up investment companies were huge.

By making loans to local companies, local governments could produce thousands of jobs and drive up the value of local enterprises. And by funding commercial and residential construction, they could drive up the price of land. Those results were important to local officials who often profited personally, but they were also essential to the survival of local governments. By law, those units also aren't allowed to raise their own taxes for local expenditures. To meet local demands—and to fulfill the directives issued by Beijing—local governments are dependent on frequently inadequate revenue transfers from Beijing and what they can collect from such transactions as local real estate sales.

So how much did these investment companies borrow and then lend?

Local government investment companies had a total of $1.7 trillion in outstanding debt at the end of 2009, estimates Victor Shih, an economist at Northwestern University and the author of Factions and Finance in China. That's equal to about 35% of China's GDP in 2009.

In addition, banks have agreed to an additional $1.9 trillion in credit lines for local investment companies that the companies haven't yet drawn down, Shih says.

Together, the debt plus the credit lines come to $3.8 trillion. That's roughly equal to 75% of China's GDP.

None of this, Shih points out, is included in the IMF calculation of China's gross-debt-to-GDP figure of 22%. If it were, the number would be closer to 100%.

It means China's actual gross debt is almost the same as the United States.

Exactly how important is this number, tho?

It depends on how many of those loans at local investment companies will go bad.

Shih estimates that about 25% of current outstanding loans — totaling $439 billion — will go bad. (For comparison, remember that in the aftermath of the 1997 currency crisis, the newly established asset management companies swallowed $287 billion in bad loans.)

It also depends on how much of China's huge reserves and huge base of personal savings are available to offset the debt.

So far, I've been talking about gross debt. But China, like Japan, has a huge domestic pool of savings it can use to buy debt. Economists point out that Japan has carried what looks like a crippling gross-debt-to-GDP ratio for years — 188% in 2007, 197% in 2008, 219% (estimated) in 2009, and 227% (projected) in 2010 — without disaster, because the country funds its debt internally from savings.

China, the argument goes, could easily do the same, so what's the problem?

The problem for both China and Japan is that it's not clear exactly how much of their huge pools of domestic savings are actually available in the long run to buy debt.

Japan has a woefully underfunded retirement system, and it's by no means clear how the population of the world's most rapidly aging country is going to pay for retirement.

China has, for all intents and purposes, no public retirement system. As a result of its one-child policy, the country has also begun to age quickly, and by 2030, its population will be as old as that of the United States.

In the US, the national accounts may lie about the effect of the problem by putting Social Security and Medicare off-budget on the argument that, since these programs have their own dedicated revenue streams, they don't count as part of the national debt.

But that lie aside, because the benefits of these programs are defined, it is possible to put a dollar figure on the government's future liabilities in this area (with all the uncertainty that comes with forecasting inflation, of course).

China isn't hiding any future liability for pensions or retiree health care off the books. The government hasn't promised future payments. In an accounting sense, then, there is no future liability that ought to be on the nation's books.

But that doesn't mean China won't have to consume some portion of its accumulated savings to pay for its post-65 population in 2030.

The country, either through the government or through private citizens, will have to cover the costs of old age, however it defines that cost.

And any savings it will use to pay for those costs really aren't available now to pay current debts.

I think the Chinese leadership is profoundly aware of the need today to not waste money that the country will need tomorrow.

That's one reason Beijing has taken steps recently to rein in local investment companies. On March 8, the Ministry of Finance announced plans to nullify all guarantees by local governments for loans taken out by their investment company vehicles. And the national government plans to sell $29 billion in bonds for local governments this year, giving those governments an alternative to setting up local investment companies.

But the big job — the reform of China's tax system so that local governments don't have to rely on real estate and stock market bubbles for funding — didn't make it on the to-do list announced by the National People's Congress this week and last.

I think you will find that as the United States founders under it's debt load, so will China. Particularly if the United States opts to default on any or all foreign treasury obligations or if the United States opts to monetize the debt.

The world is placing China, today, on the same lofty pedestal in which Japan was placed in the early 1980s.

The outcome will be the same.

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The question isn't what are we going to do... the question is what aren't we going to do!

This will be the fourth post in our series this week.

Post #1 can be read here. Post #2 can be read here. And Post #3 can be read here.

The North American Economy on life support

Western economies are witnessing a massive decline in new business and consumer borrowing. Consumers and businesses are being pressured to pay down outstanding debts plus widespread defaults and foreclosures forcing lenders to write off massive amounts of debts.

Credit is being sucked out of the consumer and corporate economy at a torrid pace while, conversely, huge amounts of credit are being grabbed by federal and local governments to finance their giant deficits.

The current economic recovery is being bought and paid for by government through stimulus programs. The idea is that once the economy recovers, the private sector will take over and the recovery will flourish.

The catch-22 is that new business and consumers can't get that credit, so the recovery won't take hold in a meaningful way.

Which is why a sovereign debt crisis — and future difficulties by governments to continue borrowing — is such a threat. If the U.S. economy is just limping along even with massive government support, what kind of paralysis will hit if the U.S. government cuts back that support to curtail out-of-control deficits?

One thing that is almost a given is that - unless forced to - liquidity and quantative easing will continue to be thrown at the system in an attempt to jump start the economy.

The bottom line is that with the massive supply of government bonds on the way, prices will be driven down and long-term interest rates up. Short of a miracle, there is little hope to avoid this outcome. Furthermore, as the federal deficit continues to grow out of control, the Great Credit Crunch is going to get even worse.

If credit remains scarce, the odds increase greatly for a long, multi-year recovery. If so there will probably be a violent double-dip recession beginning later this year.

With this as a backdrop, let's look at the current Canadian situation.

Canada

In Canada, the federal government responded to the crisis much as the USA and the UK did. Quantitative Easing and virtually 0% interest rates.

Have they learned nothing from the past decade?

Our own Bank of Canada Governor has alluded to the looming danger. On October 27th, 2009 Carney said that "we are awash in moral hazard. If left unchecked, this will distort private behavior and inflate public costs."

Moral hazard is an old bit of insurance jargon that describes how people misbehave when they think they are covered against risk.

And we are ‘awash in moral hazard’.

When the Bank of Canada cut interest rates to virtually zero and purposefully dumped cheap money into real estate; reckless buying and lending exploded over and above the bubble that blew up from 2001-2008.

CHMC reports show 57% of all real estate purchases in 2009 coming from first-time buyers (double the number from 2008) and all of those first time buyers are putting down the minimum 5% - meaning they are all utilizing CMHC’s bank-saving insurance.

And because CMHC - a federal government agency - backs all these high-risk mortgages with taxpayer dollars, all the risk for making these loans is removed from the banks. It enables Banks to lend to people who don't have money and little prospect of paying their loans off. It enables Banks to give these high risk borrowers the lowest mortgages rates available despite the fact they have the highest default risk.

Why? Because no risk accrues to the banks because of the CMHC insurance.

Eombine these government guarantees with Canada's supposed reputation as a 'fiscally prudent' country, and you have money flowing from around the world to help securitize these mortgages making money readily available to more Canadians for even more borrowing.

And just how deeply in debt are Canadians?

Jonathan Tonge has updated his excellent set of statistics on this issue on his blog. (Note from Tonge: The following graphs show the actual changes to outstanding credit [blue line]. They also show two other lines. Both make changes to the 1999 balance only [or 2002 in the case of household credit]. The inflation line shows what the credit would look like had the 1999 balance grown at the rate of inflation. The purpose of the disposable income line is to show how much debt would exist if the debt-to-disposable income ratio was maintained at the 1999 level - which even then was a historically high figure.)

Credit Card Balances - 1999-2010

Credit card balances are now up 458% in 11 years.

It doesn't take a rocket scientist to foresee a huge problem for Canadians as they try to sustain this debt level when the credit ceases to expand or more likely, contracts.

If Canada was going to have a resurgent ecnonomy with real wealth gains, then this would drive the debt to disposable income rate down. Real higher incomes provide savings and the ability to pay down debt.

As outlined above, this is looking highly unlikely.

The fact of the matter is that the current Canadian incomes and the economy are heavily inflated by debt.

Residential Mortgages

In 1999, outstanding residential mortgage debt was $399 billion. Eleven years later, it has expanded by 242% to $965 billion.

The $965 billion is the figure quoted most often by the media. But it's missing an important trend that has occurred over the past ten years. Canadians have been tapping into the their home equity to finance purchases and mortgages at extraordinarily low variable interest rate through Home Equity Lines of Credit...

Personal Lines of Credit

Home equity lines of credit have become a vertible piggy bank for Canadian consumers. They use them to finance everything from cars to furniture to home renovations, and of course, additional mortgages.

Between 1999-2010, lines of credit grew 820% to $205 billion.

The total credit binge

As a result of credit cards, lines of credit and residential mortgages, household credit has expanded from $669 billion in 2002 to $1.41 trillion in 2009. Despite a small reprieve for a couple months in early 2009, it has been growing by roughly ten billion per month. By the end of 2010, Canada's household debt-to-disposable income will be roughly 155% (currently 146%).

In Canada the stage is set for a collapse of massive proportions.

Flaherty and Harper insist that Canada is sitting the catbird seat and that the Canadian economy will recover even while our largest trading partner, the United States, founders.

Recall that these are the same Masters of the Universe who said the growing recession in the United States in early 2008 wouldn't impact Canada at all.

Meanwhile 1/3 of Canadians are struggling financially.

Ask yourself, what happens when interest rates double, and the cost of debt does as well? Other studies suggest that Canadians are wildly overly optimistic about their financial picture. Canadians feel that they'll retire comfortably but can't verbalize or explain how that will happen. What happens when they come face to face with the reality that they are retired and not prepared?

Everyone says the nation will ride the economic recovery of the Far East and China, and that everything will be alright because of our commodity and resource rich land.

Tomorrow we will take a closer look at that.

To read the next part, click here.

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Fry?... Fry?... Fry?...

This will be the third post in our series this week.

Post #1 can be read here. Post #2 can be read here.

Yesterday we ended by noting that governments in the western world had responded to the 2008 Financial Crisis by liquefying the system beyond any rational explanation, more than doubling the monetary base since the collapse of Lehman Brothers.

The debt obligations of the financial system have now been passed onto government.

For the United States this is no small issue, because it is being piled onto an already massive pile of debt.

Many people don’t understand how money is created. Most, mistakenly, think that the United States simply prints up some more cash as needed.

It doesn’t.

The US Federal Reserve Bank is a private institution owned and controlled by private banks. It is a private bank that enriches its private owners.

As for regular banks, they do not make loans only from money they have on deposit. Through what is called "fractional reserve banking," They loan well over ten times the amount they have on deposit.

So where does the money come from?

The Federal Reserve Bank buys $10,000 of US debts called Treasury Bills from the US. Where does the Fed get the money? The Fed creates it out of thin air. This is the first bit of magic. This is authorized by the Federal Reserve Act of 1913, and is a questionable delegation by Congress of its own power to "coin money and regulate the value thereof.” It is the ultimate in privatization.

The Fed then loans this $10,000 to a bank and requires the bank to pay the current federal funds rate as interest. This $10,000 becomes a "liability" of the bank, but the bank immediately loans this money to a borrower, but in double entry bookkeeping, this $10,000 loan becomes an "asset" of the bank from which the bank can make further loans. Here is where the second bit of magic occurs called "fractional reserve banking." The reserve is not gold or any other hard asset. The "reserve" is debt.

All debt of the US, all corporate debt, and all individual debt are owed to private banks. All money is debt. And the people of the United States pay interest on that debt.

So when the United States doubled the monetary base, they added massively to the pile of public debt.

And this debt pile faces an avalanche of looming additions.

In the United States, Social Security, which was in balance in year 2000, is now underfunded by $15 trillion dollars.

Total unfunded obligations of the US Government are now $104 trillion.

If we add the $6 trillion of outstanding Fannie Mae and Freddie Mac debt and the $14 trillion of outstanding national debt, we arrive at a total US government debt obligation of $124 trillion.

It’s a truly preposterous amount of money that will never be paid off in today’s dollars.

And how is the United States handling the management of this “debt”?

Anyone who has debt knows that you manage it by paying the interest and paying down the debt. At the end of the month you pay your bills and then take any left over cash, and you put it towards your debt.

The United States currently, at the end of the month, has more bills than income. There isn’t enough to pay the basic bills, let alone pay down the debt. It means at the end of each month, the United States has to ‘borrow’ even more money... and goes deeper in debt. We call this deficit financing.

And as Martin Weiss,PhD, tells us, this deficit financing is reaching a critical stage.

For those of you other there who think that the sovereign debt crisis is mostly behind us... that America’s federal deficit is turning into a non-issue... or that we can just go back to business as usual... you’d better consider the drama now unfolding in the hard numbers just released last week:

In February alone, the official U.S. federal deficit was a monstrous $221 billion, far greater than anything the US has ever experienced in history.

To put this into perspective, back in the 1980s, for example, President Reagan was plagued with the worst string of federal deficits ever recorded until that time. But with February’s deficit, Washington has managed to run up just as much red ink as it did in all of 1986, the single worst deficit year under Reagan.

Going back further, to the 1970s under President Nixon, there was also had a rash of deficit spending that sent chills up the spines of economists. But last month’s deficit of $221 billion was more than TRIPLE the sum total of ALL deficits during the six years under Nixon.

Ever since America’s Declaration of Independence, deficit spending has been a recurring theme in Washington that invariably returns with a vengeance, especially during wartime. But it took 169 long years and seven major wars — from 1776 to 1945 — to rack up a cumulative deficit that matches the gaping budget hole of just 28 short days in February.

This is an unprecedented level of borrowing. And to where does the government resort in order to finance these humongous deficits?

In just one week last month (ending 2/26), the U.S. Treasury issued...

• $32 billion in 7-year Treasury notes,
• $42 billion in 5-year notes,
• $44 billion in 2-year notes,
• $8 billion in 30-year TIPS bonds,
• $26 billion of 3-month bills,
• $28 billion of 6-month bills,
• $31 billion of 4-week bills, and
• $25 billion of cash management bills.

Grand total: $236 billion in government debt issued in a single week, the most in the history of the world.

This means that Uncle Sam borrowed new money — and replaced old debt — at the rate of $390,212 per second … $23.4 million per minute… and $1.4 billion per hour — around the clock!

It is a pace of debt issuance that simply cannot be sustained without disastrous consequences.

One of those consequences is going to be a dreadful crowding out of the private sector. As long as Uncle Sam is continuing to hog most of the available credit, it’s going to be increasingly difficult — sometimes nearly impossible — for most businesses and consumers to get their share of desperately needed funds.

Consider the fourth quarter of last year, for example. The Fed’s Flow of Funds report, just released on Thursday, tells the story...

Government borrowing was massive. The U.S. Treasury jumped into the credit markets and grabbed up new funds at an annual pace of $954.7 billion, while local and state governments raised $114.2 billion. Total government borrowing (after some reduction in gov’t agency bonds): $1,040.4 billion.

In contrast…

Most business borrowers were shoved out of the credit markets: Not only did they have a tough time getting new loans, they also cut down their EXISTING debts — either voluntarily or not — at the breakneck annual pace of $1,097.5 billion.

Millions of consumers were virtually ostracized from the credit market. They were forced to cut their existing mortgages at the annual rate of $365.1 billion and their consumer credit at the rate of $145.3 billion — a total annualized cutback of $510.4 billion.

Don’t underestimate the potential impact of this phenomenon on the economy and your investments.

Remember, We are not just witnessing a decline in new business and consumer borrowing — a trend that typically signals economic weakness. Rather, what we have here is a decline to ZERO on a net basis! Plus… massive pressure on consumers and businesses to actually PAY DOWN debts outstanding! Plus… widespread defaults and foreclosures forcing the lenders to WRITE OFF massive amounts of debts

It’s bad enough when you see credit flowing to consumers and corporations at a slower pace. But what’s happening now is far, far worse! Credit is actually being sucked OUT of the consumer and corporate economy at a torrid pace.

Huge amounts of credit being denied — or even taken away from — those who could fuel a recovery … at the same time, huge amounts of credit being grabbed by federal and local governments to finance their giant deficits.

That’s why everyone is saying the current economic recovery is being bought and paid for by Washington. Which is why a sovereign debt crisis — and future difficulties by governments to continue borrowing — is such a threat.

If the U.S. economy is just limping along now - with massive government support - imagine the paralysis that’s likely to occur if the government cuts back that support in order to curtail out-of-control deficits!

In Greece the day of reckoning has arrived. The bond market vigilantes are forcing the Greek government to deal with their deficit and bring things under control.

That day of reckoning is not too far off for the UK and then it will be the turn of the United States.

Tomorrow we will look at what that means, for both the economy in general and for Canadians in particular.

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Bueller?... Bueller?... Bueller?...

Today's post is a continuation of a theme started yesterday. If you missed it, start reading here.

The Financial Collapse of 2008

It was the Lehman Brothers bankruptcy on Sept. 15th, 2008 that set the financial collapse of 2008 into motion.

I’m not going to dwell on the whole subprime mortgage situation, instead the focus is on what many people fail to appreciate… the mayhem that took place during the following days in the US money markets.

The day after Lehman’s collapse, the Reserve Fund, one of the oldest and most high profile US money market funds, began to hemorrhage money as investors redeemed in panic.

Large institutional investors soon began pulling money out of other major US money market funds fearing heavy losses from Lehman Brothers debt.

Almost $173 billion was pulled from such funds over the next two days, threatening to collapse the entire US financial system.

Two weeks later, on Sept. 29th, investors sent the Dow Jones plummeting 778 points, representing the largest single-day loss in the history of the index.

In hindsight, it was somewhat of a delayed response, because the real damage had by then been averted by the Treasury’s blanket guarantees on all money market funds.

The main issue is that on Thursday, September 18th, the main people in power in the United States were convinced that the US financial system almost completely collapsed.

The details of that day remain frustratingly murky. The imminence of complete disorder appears to have scared Congress into action, but we can only piece the story together through random anecdotes that have been partially revealed through subsequent interviews.

In what has been dubbed ‘the Kanjorski meme’, Congressman Paul Kanjorski recounts a meeting that was held between Ben Bernanke, Henry Paulson and certain members of Congress where the conception of the "Troubled Asset Relief Program" (TARP) supposedly took place.

To stem the flow of money out of US-based money market funds, Paulson had to provide an almost instant guarantee on all money market funds held within the United States.

Kanjorski recounts, "If they had not done that, their estimation was that by 2pm that afternoon (September 18th), $5.5 trillion would have been drawn out of the money market system of the United States, [which] would have collapsed the entire economy of the United States, and within 24 hours the world economy would have collapsed."

Further details of these meetings have been provided by Senator James Inhofe, who recounted that Paulson had warned of martial law and civil unrest if the TARP bill failed.

Curiously, in his biographical recount, Paulson makes no mention of those warnings of martial law and civil unrest. But it was the threat of this dire consequence that reportedly played a huge part in Congress’ rash passing of the TARP approval.

The official record of the events of September 18th, 2008 comes from a research report issued by the Joint Economic Committee. The reports states, "On Thursday September 18, 2008, institutional money managers sought to redeem another $500 billion, but Secretary Paulson intervened directly with these managers to dissuade them from demanding redemptions. Nevertheless, investors still redeemed another $105 billion. If the federal government were not to act decisively to check this incipient panic, the results for the entire U.S. economy would be disastrous."

Between the official record and the statements by members of Congress and the Senate, we can piece together that lawmakers were threatened that an almost system-wide collapse of the world financial system was potentially hours away if they failed to act immediately by implementing the recommendations thrust in front of them.

The second fateful date of note was October 7, 2008, when the UK almost collapsed.

Bank of England Governor, Mervyn King, describes the situation: "Two of our major banks which had had difficulty in obtaining funding could raise money only for one week then only for one day, and then on that Monday and Tuesday it was not possible even for those two banks really to be confident they could get to the end of the day."

This was the justification given for the Bank of England to provide secret loans of £61.6 billion to The Royal Bank of Scotland and HBOS to maintain solvency.

Amazingly, news of these loans was never revealed until November 24, 2009; more than one year later.

Recalling that fateful day, David Soanes, Managing Director of UBS Bank, and part of the group assembled to assist with the UK government’s crisis response, stated, "We only really knew by probably about seven o’clock at night (October 7, 2008), that we, that everyone was going to get through to the next day."

These revelations raise new questions about the true scope of bailouts undertaken by the major governments at the time.

Lord Myners, the UK Financial Services Secretary, alluded to similar covert banking operations conducted by the European Central Bank and the US Federal Reserve. We have no idea what he is referring to, but we would certainly be interested to learn more.

This type of activity by the leaders of our financial system certainly helps to explain why those two dates are not more ingrained in our collective memory – strong efforts were obviously made to hide their severity.

What happened in September and October 2008 had previously been considered completely impossible and totally unthinkable.

But... it happened.

Moving forward, the first thing you have to come to grips with is that you must never forget that the ‘unthinkable’ can happen again. Until now we have always been told that the lessons of 1929 and the Great Depression had resulted in changes to the financial system so that NEVER AGAIN could the financial system come close to totally collapsing.

Yet... a complete banking collapse almost did happened. And as unpleasant and incomprehensive as it is, it must be remembered that we almost went there.

So where does this leave us for the decade ahead?

Regardless of whether you agree with the rational of 'imminent demise' used to coerce lawmakers into action in September & October 2008; the reality is that the emergency measures undertaken have left us in tremendously bad fiscal shape.

Our governments responded by liquefying the system beyond any rational explanation. The monetary base has been more than doubled since the collapse of Lehman Brothers.

The debt obligations of the financial system have been passed onto the governments of the Western World, including the government of Canada.

Tomorrow we will examine what that means.

To read the next part, click here.

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Déjà Voodoo Economics, all Over Again. Anyone?... Anyone?....

It's funny. My posts on the sovereign debt crisis and gold have triggered a wave of emails on the economy, interest rates and real estate.

I enjoy reading the email. And I enjoy how my posts trigger some very passionate opinions. I simply don't have the time to answer all the emails, but rest assured... each and every one is read.

I see that there is a need to try and pull together some of my though lines and connect the dots on why I believe they are relevant. So this week I am going to try and do that. I hope you will find this week's posts worthwhile.

Last week Eric Sprott & David Franklin of Sprott Asset Management wrote an excellent article in their ‘Markets at a Glance’ newsletter. I am going to borrow from it to write several of this week’s posts. If you would like to see their actual newsletter click here.

The crisis of 2008 is over?

I have talked numerous times about how many of us really don’t understand the depth and breadth of the financial earthquake that struck the western world in 2008.

Many believe the worst has past.

I maintain that – far from being over – we are plunging headlong into the worst phase of the crisis. Rather than mitigating the fallout, our government has simply compounded the problem and is intensifying the looming repercussions.

You need to understand what happened, appreciate what is developing, and then make your own decisions on the validity of the danger we face.

Then you have to make your own decisions on how best to prepare for what is coming.

The genesis of our current situation

The seeds of the financial mess we are currently experiencing began in the mid-to-late nineties.

As we approached the year 2000, a widespread belief developed that new technology would rewrite economic rules. The euphoric years between 1995 and 2000 became known at the dot-com era. And that euphoria blew into a massive bubble on the technology-heavy NASDAQ Index.

Watching those developments caused Alan Greenspan to first utter his now famous “irrational exuberance” warning in December 1996.

Despite recognizing what was going on, it wasn’t until mid-1999 that the U.S. Federal Reserve actually acted. The Fed increased interest rates in an attempt to quell the overheated stock market. Six times between June 1999 and January 2000 interest rates were raised in an attempt to cool the overheated economy.

On March 10, 2000, the dot-com euphoria burst when the NASDAQ peaked at 5,132 (more than double its value from only a year before). The NASDAQ bubble was born out of over-enthusiasm for the prospects of new technology and the Federal Reserve correctly tried to cool the bubble down, however feebly, in the years before its peak.

And when it burst, the economy should have gone through a recessionary period to consolidate and restructure.

But the NASDAQ collapse compelled Alan Greenspan and the Federal Reserve to embark on the largest rate cuts in US history in an effort to soften the impact of what should have been a difficult recession.

In hindsight we now understand that this was a massive mistake.

Our collective inability to face the consequential economic pain of the dot-com market crash ultimately set the stage for the second bubble of the decade, this time in housing.

By setting out to ‘rescue’ the economy, the Federal Reserve lowered interest rates thirteen times between January 3, 2001 and June 25, 2003.

This ‘economic cushion’ allowed for increasingly easy access to credit on a worldwide scale. And it wasn’t long before the second bubble began to develop.

Call it the law of unintended consequences, but in trying to help the economy, Greenspan unleashed a sequence of events that set the stage for the 2008 financial crisis.

People accessed that easy credit to purchase real estate in euphoric waves. It was as if the basic economic rules were trying to be re-written once again, only this time as they pertained to real estate.

Buying a home was transformed from serving as a place to live... to one where a home became an ‘investment’.

Lower and lower interest rates pushed real estate values higher and higher. Home prices rose at an annualized rate of more than 11% from 2000 to the peak on July 31, 2006 - more than doubling in that time period.

Real Estate became an irrational path to wealth and the warning signs were everywhere. The Economist magazine noticed, stating on June 16, 2005, that "the worldwide rise in house prices is the biggest bubble in history."

Servicing the housing boom propelled the financial sector into the US economy’s central economic driver, generating up to 41% of all corporate profits and making it the fastest growing sector of the economy.

In July 2005, Greenspan described certain real estate markets as "frothy" and recommended that the Federal Reserve rein in lending standards.

It was never done.

Again, in hindsight it’s very safe to argue that the Fed probably shouldn’t have lowered rates thirteen times between January 3, 2001 and June 25, 2003. It proved to be an extremely damaging policy.

Artificially low rates created a lending mania of enormous proportions which dragged consumers along for a debt-fueled buying orgy. It triggered a massive Ponzi scheme sustained by overleverage as the financial sector piled new mortgage financing schemes one atop one another

What happened next was more than just a market failure. It was a systemic meltdown. But it was a meltdown that happened so fast that it seems to have failed to burn into our collective memory.

Everyone remembers that we went into a severe recession in late 2008, but do they know the details of what actually transpired?

Tomorrow we will discuss the collapse of 2008.

Then, later this week, we will discuss how the stage is being set for a Canadian collapse of historic and massive proportions.

To read the next part, click here.

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Sunday Funnies - March 14, 2010

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(Click on image to enlarge)

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China and gold

I got a kick out of a story earlier this week from Reuters that reported that China had renewed its commitment to the U.S. Treasury market but said it would be wary of substantially boosting its gold holdings.

Uh-huh.

The headline to the story was "China says committed to U.S. debt, wary on gold", and it was the headline that caught everyone's attention.

"It is, in fact, impossible for gold to become a major investment channel for China's foreign exchange reserves. I have 1,000 tonnes now, and even if I doubled that holding, according to current prices, that would be about $30 billion," said Yi Gang, China's chief currency regulator.

The comment caused the price of gold bullion fell about $3 an ounce. The price has come down a further $25 an ounce as the week comes to a close. Analysts contribute most of the drop, however, to unwinding of speculative bets linked to Greece's debt woes rather than disappointment over Yi's remarks.

Does that mean that China isn't buying gold anymore?

As one of the world's largest holders of US Treasury bills - the general estimate is that China owns close to $1 trillion of US Treasury securities - Chinese leaders have become more vocal in expressing their concerns over the United States' fiscal discipline and in calling for an alternative international reserve currency.

Since the outset of 2009, Beijing has taken pains to diversify its monetary risks, which include signing multiple bilateral currency swaps, and pushing for the restructuring of international financial institutions.

And diversifying includes China's actions in gold. In 2009 China reportedly bought 454.1 tons of gold from its domestic market, which is equivalent to nearly 50% of the total purchases of 890 tons of gold made by the world's central banks last year.

Add to this reports from the Guangzhou Daily newspaper that reported in 2008 that China's central bank was considering raising its gold reserve by 4,000 metric tons from the then 600 tons to diversify its forex risks (China's gold reserves currently total 1,054 tonnes, meaning that China is still looking to acquire 3,000 tons to match that 2008 goal).

A China News report last year (2009) cited Ji Xiaonan, the chair of the supervisory board for state-owned companies, who said that "China's gold reserves should reach 6,000 tons in the next three to five years and perhaps 10,000 tons in eight to 10 years".

Do you still think China has lost interest in acquiring gold?

By way of reference, US gold reserves totaled 8,133.5 tons in September 2008, accounting for 76.5% of its total forex reserves. Japan's 765.2 tons accounted for 1.9% of its forex reserves.

The inscrutable Chinese are hardly likely to inform the world that they are on a gold buying spree for fear of sending the gold price through the roof before they can finished their acquisition plans.

And while China is the largest gold producer in the world, with more than 300 tons of gold produced annually and while it is true that they will consume all 300 tons locally, the reality is that this internal production won't come anywhere near achieving China's goals for the acquisition of gold... especially if that goal is 6,000 - 10,000 tons within 10 years.

China increased its gold reserves by 76% in six years (2003) to 1,054 tons in 2009.

That dramatic increase of 76% caught the world completely off guard as those huge gains were garnered under the world's radar screen. It wasn't until it was suddenly announced to the IMF at the beginning of 2009 that anyone realized what China was doing.

In 2007, China surpassed South Africa as the world's largest gold producer, and in 2009 they passed India as the world's largest consumer of gold.

In 2009 China bought nearly 50% of the total gold purchases by central banks in 2009.

The Chinese PR machine tells you that China is "committed to US Treasuries and wary of gold."

So after all this activity, after all these surreptitious moves, after all the hand-wringing over America's finances, after publically stating their goal and objectives regarding gold holdings; China would have you believe they aren't moving out of US Treasuries and are wary of gold.

You believe that, right?

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Economic Abyss

Came across some succinct snippets yesterday that perfectly summarize the looming economic crisis in America.

David Walker, the former comptroller general of the United States and CEO of the Peter G. Peterson Foundation, is the author of 'Comeback America'.

'Comeback America' is a book detailing Walker's belief that if significant fiscal reforms aren't immediately enacted in the United States, interest rates on the national debt will rise, and federal taxes could easily double from current levels by 2030.

You can read Walker's take on the USA's current financial woes and his explanation of how America got there at this link.

"We're on an imprudent and irresponsible path," Walker says. "We must start making tough choices, sooner rather than later, and before we pass a tipping point."

Walker, who led the U.S. Government Accountability Office for almost 10 years, says that despite the many current economic pressures that America faces — war, recession, bailout — their recent budget deficits may pale in comparison to the economic disaster that looms if we don't take action.

"What threatens our [country] is the structural deficits that will exist after we are out of the recession, after unemployment is down, after the wars are over, and after we get past the current crises," he says. "Structural deficits represent a fundamental imbalance between projected revenues and projected expenditures even when the economy is growing, even when the wars are over, even when unemployment is down. And in that circumstance, we face — because of known demographic trends — the retirement of the baby-boom generation primarily and rising health care cost — large, known and growing structural deficits that could swamp our ship of state."

Walker says that unless spending is controlled, the country will enter an "economic abyss."

"The things that are growing the fastest are health care — which would be Medicare, Medicaid and other federal health care programs. Social Security is growing, but not as fast — but you also have to look at the fact that before we even entered the recession, we were spending more money than we took in," he says.

"There are three key points with regard to spending. Spending more money than you make on a reoccurring basis is irresponsible. Irresponsibly spending someone else's money is unethical; and if you're a fiduciary, a fiduciary breach. And irresponsibly spending someone else's money when they're too young to vote and not born yet is immoral. And all three of those things are going on right now, and they threaten America's future."

He is, of course, bang on.

The economic crisis is only just starting. The full depth and breadth of the financial earthquake of 2008 still isn't fully appeciated (or understood) by Americans or Canadians.

And it's not all that surprising. On October 29th, 1929 the world changed, but most wouldn't be fully aware of the depth and breadth of that change (or exactly what had happened) until the end of the 1930's and into the early 1940's.

It's going to be the same this time around too.

Postscript: Great Britain is considered the canary in the coalmine for United States debt. For a UK update, I would refer you to: UniCredit Bank Warns Of Plunge In Sterling And Gilts, As Britain Is Next Country "To Be Pummeled By Investors"

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Through the Looking Glass and What Bernanke Found There

Today I am reminded of the book 'Through the Looking-Glass, and What Alice Found There'. Written by Lewis Carroll in 1871, it is the sequel to Alice's Adventures in Wonderland (1865).

Although it makes no reference to the events in the earlier book, the themes and settings of 'Through the Looking-Glass' make it a kind of mirror image of Wonderland including opposites, time running backwards, and so on.

Kinda like the mirror image of rational finances we are currently seeing in the western world.

Reinforcing that imagery is the Monthly Treasury Statement released yesterday. As Tyler Durden of Zero Hedge asks, what's wrong with this picture?

The United States has completed another month in the red. In February, the budget deficit was $220.9 billion, after receipts of just $107.5 billion with vastly surpassed by outlays of $328.4 billion.

That, btw, is a record.

Yet the interest on the public debt was a mere $16.9 billion (page 13 of the MTS report). The reason, as Durden writes, is because in February the interest on public marketable debt (which as of Monday stood at $8.061 trillion) hit an all time low of 2.548%.

In a normal world, the more money you borrow, the greater the associated risk, and the greater the interest payments on this debt. How is it possible that unprecedented debt accumulation can result in ever declining interest rates?

It's a rhetorical question, of course.

We know the answer. The US Federal Reserve, through complete domination of the entire capital market courtesy of ZIRP and Quantitative Easing, have now turned market logic upside down by 180 degrees.

Can we assume that the Fed can forever keep rates on debt at record low levels?

The only way that will happen is if the United States engages in Quantitative Easing to Infinity. If that becomes the only course of action, at some point all that money will have to enter the money supply and - voila! - hyperinflation.

Now we already know that current US Fed chairman Bernanke insists he won't do that. He delivered a blunt warning on U.S. debt and outlined how the stage is set for a Greek-style debt tragedy in the United States if dramatic action isn't taken on the national debt because the Federal Reserve won't monetize the debt with QE to infinity.

Does it look like the politicians heeded Bernanke's warning? Do you see how the United States is racing towards a cliff's edge?

If Bernanke remains true to his word, then you can understand former US Fed chairman Alan Greenspan's concerns when he said that he keeps daily watch on the interest rate on 10-year Treasury notes and 30-year Treasury bonds and calls them the "critical Achilles' heel" of the US economy?

Those spreads are some point are going to spin wildly out of the control at a moment's notice as investors come to full grips with what is looming on the horizon.

The only reason we haven't encountered that scenario is because the QE hasn't ended yet and because no one believes Bernanke won't continue with the policy.

And who can blame them?

Ask youself, what happens if the Fed ends the practice of keeping rates on debt at record low levels?

Currently income from taxes in the United States are plunging. Despite platitudes to the contrary, the economy is not rebounding and incomes are not rising - they're falling. Thus income from taxes are plunging dramatically.

Meanwhile the expenditure side of the ledger has exploded, and not as a function of debt funding: the bulk of outlays have to do with entitlement programs (social security, medicare, etc).

As expenses rise and income falls, it can only mean one thing: more debt.

Recently the debt ceiling was raised to $14.3 trillion which is expected to be hit in less than a year. Observant readers will recall that the previous ceiling of $12.4 trillion was supposed to last the US until the end of March.

Not only was this number passed over a week ago, it is now (less than halfway into the month of March) at $12.5 trillion. Left as it was, the US have broken the debt ceiling far in advance of expectations.

[And remember. This is a debt CEILING... the level goverment won't allow debt to pass!!!]

Obviously this leads us to believe that the $14.3 trillion ceiling will likely have to be raised once again.

Bernanke said the stage is set for a Greek-style debt tragedy in the United States, and he isn't kidding. Consider...

• Just as recently as September 2007 the interest rate on marketable debt was nearly 5%. It plunged to 2.5% in a year. Even the mere mention of actual tightening will spring rates right back to 5%. What does that mean for actual outlays?
• If total debt hits $14.3 trillion it will mean the marketable debt will be about $10 trillion, and the incremental 250 bps of interest will mean about $250 billion of additional interest outlays a year, or half a trillion annually.
• That comes to about $42 billion a month in interest payments alone.
  

In January 2010, $42 billion dollars represents double the amount of all money collected by the United States in income taxes.

If interest rates are allowed to rise, it will decimate the United States of America.

The bottom line is that either Bernanke will be true to his word and the bond vigilantes will force America into the same brutal debt management as Greece or Bernanke is going to pull the United States permanently to the other side of the Looking Glass and give us quantitative easing to infinity.

Do the math and the conclusions are inescapable.

We are going to have either sky-high interest rates from sovereign debt problems or Bernanke will trigger significant inflation with QE to infinity.

What more do you need to know when discussing the future of real estate in Vancouver and Canada?

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