The Obama Bounce is Yet to Come

The classic form of an economic depression sees the occurrence of major rallies. These "bear market rallies" tend to be huge, setting records for size-of-rally, and luring in those who are foolish enough to believe 'the worst is over.' Such rallies are easily observable in any graph of the Dow Jones (see this one as an example; source), and are impressive for their ability to both capture the painfully credulous, and extract from them their money.

In this depression there have not yet been any similar, massive rebounds in the stock market. A quick perusal of this chart will show this to be the case. The recent rally-ette is nothing like the scale of the first rebound of the 1929 Depression, so it is likely that the big first false-flag rebound of the 2007 Depression has yet to appear.

It is, of course, possible that the shape of this Depression will be different from historical ones. Past performance is no guarantee of future performance, in bad times as well as good. That said, we're fairly confident that such a big rally will occur at some point in the future. The reasoning behind our statement is fairly simple:

We're pretty certain that times are bad, and they will be getting a whole lot worse. Still, too many people are getting gloomy; far more than we would have expected. As a contrarian investor and cynic, we feel that, when people are being this gloomy, it is with their tongue firmly in their cheek. People say they expect horror and doom, doom, doom... but they're just waiting for the next big rally, so they can buy in just as "the bottom is in."

Simply put, we see a value trap. The average person now living does not know a person who was working for a living (i.e. to pay the rent, buy the food, support the family) in the 1929 Depression. Absolutely no one now living has any idea of just how bad a depression can actually get. People have, generally speaking, convinced themselves that the stock markets only go up; when 'up' is not happening, it is a road-bump. Eternal prosperity is a huge part of the American ethos, and everyone wants their share of that prosperity.

So, we feel confident in saying that things are going to go up, and in a big way. At some point in the future, for no particular reason, all the people sitting on the sidelines, wringing their hands and fretting profusely, will suddenly lose their inhibitions. They will feel rich again; their pockets will spring forth with great gobs of money to buy... anything! The stock markets will soar wildly, houses will be bought and sold, cars will zoom off the lots (perhaps on going-out-of-business clearance from the Big Three?), and life will seem to return to a generally-accepted normal. President Obama's approval rating will zip up to record levels, and he will be hailed as the hero who saved the consumer economy; it was the "Obama Bounce" that turned America around. So too will the rally be touted as the triumph of the consumer economy. Happy days are here again!

This will be the greatest disillusion of the 2007 Depression, when the rally inevitably fails. The reason the rally will crash is the same reason why the markets first crashed in October 2008: a crash happened. For whatever reason, people then, as they will in the future, simply got spooked and started selling to spooked buyers. It doesn't matter how, or why, these crashes occur. Rest assured, though, crashes will indeed happen, and no amount of wishful-thinking and lucky-rabbit-foot-stroking will stop them.

Peak Automobiles

CNN reports "Autos on U.S. roads set to fall." This is an unprecedented event. The automobile has been a defining aspect of American life. For most Americans, their first car is a right-of-passage. Likewise, most Americans consider their car indespensible.

The article suggests that the decline is mostly the abandonment of excess cars - moving from three cars in the drive to two. But it also hints at a decline of demand due to increasing unemployment.

Nowhere does the article suggest, as we do, that a permanent decline in incomes will produce a permanent decline in the need for autos. We don't think that view will ever make the mainstream. In the future, decline in auto use will mostly be reported as an increasing preference for urban life - or not at all.

In light of this development, bailing out U.S. automakers seems especially deranged. The industry already had excess capacity during the bubble years. Now it is even more questionable just how much manufacturing capability is needed. Certainly the U.S. Government is in no position to make this decision. Supposedly, that is what markets are for.

Oh wait, there is no market economy any more. If a big corporation with armies of lobbyists is losing money, the market can be swept aside, and Uncle Sam will pull out his teat.

Destroying economic value by perpetuating chronically loss-making operations was probably the main thing that did in the Soviet Union. Evidently nobody in Washington was paying attention at the time. Those who do not learn from history are condemned to repeat it.

Are Big Banks Committing Suicide?

We were chatting with a friend the other day, who holds a middling commercial loan from a major bank. He's a very good client of this major bank, and he has been with this bank for quite some time. He told us this bank was going to charge him a fee equal to about 5% of the value of his loan. Apparently, this 'fee' was do to an error on the bank's part, but they were going to charge him, anyway!

Another friend has held a line of credit from another major bank for over a decade. Just recently his interest rate on his card's balance was doubled to 20%. He, too, had been a good client, and always paid his bills on time.

Earlier we wrote about Citigroup backing mortgage cram-downs, and how we felt there was something fishy about the whole thing. Then we saw articles like this one from Bloomberg, or human-interest pieces like this from WiseBread.com... and we really started to wonder. Are these major banks actually queuing up on a roof, waiting for the opportune moment to jump to their death?

Lending is the bread and butter of these major banks. They are alienating their borrowers, but they can't make money without lending... so they must have something else up their sleeve. Personally, we think it's our beloved Synthetic CDOs. Bear with us for a moment, dear Reader.

With AIG, Fannie Mae, Freddie Mac and the Big Three on the government dole, their collapse has been pushed off into the future. That means the SCDOs won't be triggered by the deaths of those companies. However, SCDOs typically have money center banks as a default trigger on the trillions waiting offshore.

The management of these major banks know they can't kill the car companies... but they can destroy their own banks. Then, the SCDO dollars will flow bank into the United States. Where to, you wonder? Well, with the big banks presumably shut down, where else can the money go but into the pockets of the management? We would wager the managers have set up private investment vehicles which have taken the benefit of the SCDO payout off of the banks' books. Think of it as the ultimate golden parachute.

The Doom of Air Transport

One or both of two things is going to happen in the very near future: kerosene is going to become a lot more dear as light, sweet crude fades away to the specialty corner of refiners' crude oil menus; and most of the people now flying or sending cargo by air will become too poor to afford the luxury.

The implications of this are devastating for a huge chunk of the developed world's economy. Aside from the airline and airport industry, the pain will be felt most acutely in regions dependent on air tourism, and airplane building.

According to the Boeing company, air travel has been growing even faster than World GDP. When World GDP shrinks as we expect, air travel can be expected to shrink much, much faster as GDP shrinkage will likely be skewed towards OECD countries who are the primary users of air travel.

Losses can be expected to pervasive and vast. Airports themselves represent hundreds of billions (maybe trillions) of dollars of sunk capital. That capital supports a great quantity of municipal bonds, and the income of investors who depend on them. The collapse of air transport should prove quite a bit more economically disruptive than the failures the 2007 Depression to date, even including the likely end of the 'Big 3' auto makers.

Of course, it will all come as a 'surprise', and 'No one saw this coming,' will again be the refrain. We wish we could say, "You read it here first, folks," but people have been warning about the demise of air travel for decades. If these Cassandras had been listened to, the USA would still have a decent passenger rail system.

It's a good thing boats use the left-overs from refining oil...

Bailouts are the Ultimate Corruption

As we had suggested earlier in the month, a token bailout has been given to General Motors and Chrysler. $17.4 bullion may seem like a ton 'o cash, but its chump change for these sieve-like companies. The Big Three have hit the proverbial iceberg; it's only a matter of time until they go propellers-up. Unsurprisingly, six in ten Americans would prefer to see those propellers than have their tax-dollars go towards making more gas-sucking, barely-functional fashion excessories. And who could blame such sentiment?

Even more odious, in our opinion, is the use of TARP (i.e. taxpayer) money to fund bonuses on Wall Street. The complete hypocrisy of, say, AIG's Jay Wintrob getting $3 million in 'retention awards' is mind-numbing. We personally feel so disgusted that we look for the lynch mobs forming, hunting down Wall Street's finest and stringing them up in Central Park... but we instead see complacence. The American public seems content to whine vaguely about things, but do nothing to stop out-of-control lemon socialism.

These bailouts, besides unwise and reckless, are the signs of corruption so deep and pervasive it makes our head spin. For example, Mr. Henry Paulson, Jr. is a former Goldman Sachs CEO. As Secretary of Treasury and manager of TARP, Mr. Paulson has given his former employer $10 billion of unregulated cash. If this isn't a conflict of interest, we don't know what is. Mr. Paulson also helped remove Goldman Sachs from the old net-capital rule; last we checked, before its recent, cynical move to become a bank, this allowed Goldman to leverage their assets-to-capital to around 30:1 - a speculative foray which taxpayers are now expected to clean up the mess from.

Therein is the rotten core of the affair: public money has been usurped. Money which could have gone towards any number of productive things -- which would have given real, measurable benefits -- instead are going towards rewarding those who created the mess in the first place.

These people -- the bankers, the auto CEOs, Mr. Paulson, et al. -- are so obscenely greedy we feel ill sharing the same nationality. Even though the entire world is in the 2007 Depression, they will still try to milk the system for every last dollar they can get. The callous disregard for the misery and suffering they are helping to create is staggering, but yet it is apparently greeted with cheers and accolades.

Enabling Destructive Economic Behaviour

Although we ourselves are not of the socialist persuasion, we agree with socialists that there are cases where government can actually provide useful services, and at a reasonable cost. So reasonable in fact, that the case for privatisation is not particularly compelling.

Unfortunately, at the national level, the USA seems incapable of delivering that sort of socialism (with the possible exception of the Post Office). Instead it engages in malignant lemon-socialism, where destructive enterprises are rewarded with life-prolonging capital infusions, or outright government ownership.

Take, for example, a number of large banks, Fannie, Freddie, and Wall Street firms. These outfits swindled the world's investors. All issues of criminal fraud aside, their activities were and continue to be enormously destructive economically.

Investors lost confidence in them. Any sane governing authority would simply shut them down. In any sort of free market economy, they would be done already. There are thousands of better run competitors out there to take up the slack. But yet, the Federal Government saw fit to step in and keep them going. Not because no one else was providing some useful service they are. In fact, they aren't producing any useful service at all. Quite the contrary.

Another example is the bailout of the 'Big Three' automobile manufacturers. As stated in a previous post, there are many good, sound business reasons for these companies to go out of business. It's not like there aren't lots of other companies which can make cars. If the USA has a glut of car making capacity, then a fair chunk of it needs to go away.

The core economic problem of the failed Soviet Union was that its central planners took valuable natural resources and turned them into useless waste. Ignoring issues of quality and desirability, they measured output strictly in tonnage. This was socialism at its worst.

Unfortunately, the USA is following in the footsteps of the Soviet Union. Its central planners are diverting ever larger portions of the nation's income into operations that produce little or no benefit. The litany is extensive, but includes bloated 'Defense' and 'Homeland Security', subsidies for airlines, automakers, banks, construction, insurance, mortgage companies, prisons, and real estate brokers.

Spending by Governments at all levels in the USA is about 40% of total national income. Also, about 50% of the population is dependent primarily on government for its income. This is a country fairly deep into some kind of socialism. Is it getting a good value for its commitment? Does the USA have enviable public education? a low rate of incarceration? free health care for all? a first-rate passenger rail system? The answer to these questions is a resounding "No!"

On top of that, Government in the USA is quite involved with the private sector. Does the USA have a healthy industrial base? a healthy balance of payments with the rest of the world? energy security? well-paid, content workers? No, again.

We are profiling a country at the verge of leaving the club of wealthy, advanced nations, if not heading for outright collapse. The response of the political leadership to the 2007 Depression is very telling: bailouts, handouts, and more pork. This will do nothing to make the nation more productive and increase its citizens' income. On the contrary, it will make the nation less productive and exacerbate the decline in income.

Why JP Morgan wants Detroit to Die

The Big Three automakers (Ford, General Motors, Chrysler) are begging for a bailout. Although we haven't seen the CEOs of the companies on bended knee, we assume their pleas are strident and whiney. Nevertheless, we are certain that a token bailout is being rammed through Congress as we clatter away at the keyboard. $15 billion may sound like a lot of money, but it's a drop in the bucket for these behemoths. They are hemorrhaging capital, disbursing money like Ebeneezer Scrooge doesn't.

Despite this, there is no way in Mordor that the Big Three will live to see Christmas 2009. The obvious reasons: they're unprofitable; they're not competitive, either domestically or globally; their cars are crappy, ugly, out-of-date energy hogs that cost too much and are difficult to repair. Please, don't get us started, it will make us rant loudly.

Like we said, however, those were the obvious reasons. But there is something else - a Sword of Damocles - hanging invisibly over Detroit as we type: synthetic collateralised debt obligations (SCDO), which are soon to become massive windfalls to big banks, like JP Morgan. These SCDOs are very complicated, so please bear with us as we use the Business Spectator to explain:

"A synthetic CDO is a collateralised debt obligation that is based on credit default swaps [CDS] rather than physical debt securities... Here’s how it works: a bank will set up a shelf company in Cayman Islands or somewhere with $2 of capital and shareholders other than the bank itself... That allows the so-called special purpose vehicle (SPV) to have “deniability”, as in “it’s nothing to do with us” – an idea the banks would have picked up from the Godfather movies.

The bank then creates a CDS between itself and the SPV. Usually credit default swaps reference a single third party, but for the purpose of the synthetic CDOs, they reference at least 100 companies.

The CDS contracts between the SPV can be $US500 million to $US1 billion, or sometimes more. They have a variety of twists and turns, but it usually goes something like this: if seven of the 100 reference entities default, the SPV has to pay the bank a third of the money; if eight default, it’s two-thirds; and if nine default, the whole amount is repayable...

Finally the SPV is taken along to Moody’s, Standard and Poor’s and Fitch’s and the ratings agencies sprinkle AAA magic dust upon it, and transform it from a pumpkin into a splendid coach.

The bank’s sales people then hit the road to sell this SPV to investors. It’s presented as the bank’s product, and the sales staff pretend that the bank is fully behind it, but of course it’s actually a $2 Cayman Islands company with one or two unknowing charities as shareholders.

It offers a highly-rated, investment-grade, fixed-interest product paying a 1 or 2 per cent premium. Those investors who bother to read the fine print will see that they will lose some or all of their money if seven, eight or nine of a long list of apparently strong global corporations go broke. In 2004-2006 it seemed money for jam. The companies listed would never go broke – it was unthinkable.

Here are some of the companies that are on all of the synthetic CDO reference lists: the three Icelandic banks, Lehman Brothers, Bear Stearns, Freddie Mac, Fannie Mae, American Insurance Group, Ambac, MBIA, Countrywide Financial, Countrywide Home Loans, PMI, General Motors, Ford and a pretty full retinue of US home builders." [emphasis added]

Please, read this article from the Business Spectator. It is an excellent discussion of the swindle that are SCDOs. It is an epic financial bomb with an uncertain fuse, but will certainly go off with the Big Three dead and buried. And that, dear Reader, is why JP Morgan wants Detroit to die. While JP Morgan may or may not have invented SCDOs, they are certainly at the top of the guest list at this reportedly $50 trillion jamboree (yes, dear Reader, that's trillion).

Put simply, there is an unbelievably huge pie out there, somewhere, and JP Morgan is getting hungry. A little thing like the Big Three, or any of the other companies on SCDOs lists, will not stand in the way of their slice.