CHINA - Overinvestment Will Be Hard To Correct

The IMF on Overinvestment 12-28-12 Michael Pettis, Financial Sense

China’s investment rate is so high that even ignoring the tremendous evidence of misallocated investment, unless we can confidently propose that Beijing has uncovered a secret formula that allows it (and the tens of thousands of minor government officials and SOE heads who can unleash investment without much oversight) to identify high quality investment in a way that no other country in history has been able, there is likely to be a systematic tendency to wasted investment.

How much overinvestment?

One of the implications of the study is that households and SMEs have been forced to subsidize growth at a cost to them of well over 4% of GDP annually. My own back-of-the-envelope calculations suggest that the cost to households is actually 5-8% of GDP – perhaps because I also include the implicit subsidy to recapitalize the banks in the form of the excess spread between the lending and deposit rates – but certainly I agree with the IMF study that this has been a massive transfer to subsidize growth.

This subsidy also explains most of the collapse in the household share of GDP over the past twelve years. With household income only 50% of GDP, a transfer every year of 4% of GDP requires ferocious growth in household income for it just to keep pace with GDP, something it has never done until, possibly, this year.

The size of the transfer makes it very clear that without eliminating this subsidy – which basically means abandoning the growth model – it will be almost impossible to get the household and consumption shares of GDP to rise if China still hopes to maintain high GDP growth. The transfer of wealth from the household sector to maintain high levels of investment is simply too great, and this will be made all the more clear as the growth impact per unit of investment declines.

Another implication of the IMF study is that to get into line with other equivalent countries at this stage of its economic takeoff, China would have to reduce the investment share of GDP by at least ten percentage points and perhaps as much as twenty. Aside from pointing out that the sectors of the economy that have benefitted from such extraordinarily high investments are unlikely to celebrate such a finding, I have three comments. First, after many years in which China has invested far more than other countries at its stage of development, one could presumably argue that in order to get back to the “correct” ratio, investment should be lower than the peer group, not equal to the peer group. In that case investment has to drop by a lot more than ten percentage points.

After all if China’s deviation from the experience of other countries is meaningful, then after a few years of substantial deviation, it cannot be enough for China simply to return to the mean. It must come in lower than the mean for a few years so that on average the deviation is eliminated.

Second, even if China had kept investment at the “correct” level, as measured by the peer group, this would not imply that China has not overinvested. I haven’t been able to dig deeply into the comparison countries, but the study does list them, and a very quick glance suggests that many of these countries, after years of very high investment, themselves experienced deep crises or “lost decades”.

This implies to me that these countries themselves overinvested, and so even if Chinese investment levels were not much higher than that of the peer group (and it was mainly in the past decade that Chinese investment rose to much higher levels than that of the peer group, and not in the 1990s, exactly as we have been suggesting using more qualitative measures), this could nonetheless be worrying. China would still have a difficult adjustment for the same reasons that many if not most of the peer group countries also had difficult adjustments.

The average number driven by the peer group sample, in other words, is not in itself an “optimal” level of investment. It might already be too high. That Chinese investment levels have been so much higher than theirs is all the more worrying.

How much would growth have to slow?

My third point is more technical. If Chinese investment levels are much higher than optimal (assuming the peer group average is indeed optimal), of course the best solution for China is immediately to reduce investment until it reaches the right level. The longer investment rates are too high, the greater the impact of losses that have eventually to be amortized, and the worse off China is likely to be.

But it will be very hard for China to bring investment down as a share of GDP by ten full percentage points very quickly. Let us assume instead that China has five years to bring investment levels down to the “correct” level, and let us assume further that the “correct” level is indeed ten percentage points below where it is today. Both assumptions are, I think, dangerous because I am not convinced that an investment level of 40% of GDP is the “correct” level for China going forward (I think it must be much lower) and I don’t think China has five years to make the necessary adjustment without running a serious risk of a financial crisis.

But let us ignore both objections and give China five years to bring investment down to 40% of GDP from its current level of 50%. Chinese investment must grow at a much lower rate than GDP for this to happen. How much lower? The arithmetic is simple. It depends on what we assume GDP growth will be over the next five years, but investment has to grow by roughly 4.5 percentage points or more below the GDP growth rate for this condition to be met.

If Chinese GDP grows at 7%, in other words, Chinese investment must grow at 2.3%.  If China grows at 5%, investment must grow at 0.4%. And if China grows at 3%, which is much closer to my ten-year view, investment growth must actually contract by 1.5%. Only in this way will investment drop by ten percentage points as a share of GDP in the next five years.

The conclusion should be obvious, but to many analysts, especially on the sell side, it probably needs nonetheless to be spelled out. Any meaningful rebalancing in China’s extraordinary rate of overinvestment is only consistent with a very sharp reduction in the growth rate of investment, and perhaps even a contraction in investment growth.

In fact I think over the next few years China will indeed undergo a sharp contraction in investment growth, but my point here is simply to suggest that even under the most optimistic of scenarios it will be very hard to keep investment growth high. Either Beijing moves quickly to bring investment growth down sharply, or overinvestment will contribute to further financial fragility leading, ultimately, to the point where credit cannot expand quickly enough and investment will collapse anyway.

This is just arithmetic. The extent of Chinese overinvestment – even if we assume that it has not already caused significant fragility in the banking system and enormous hidden losses yet to be amortized – requires a very sharp contraction just to get back to a “normal” which, in the past, was anyway associated with difficult economic adjustments. It is hard to imagine how such a sharp contraction in investment will itself not lead to a sharp drop in GDP growth, and the IMF paper recognizes this:

To the extent that elevated levels of investment during the post-crisis period in China were somehow abnormal and necessitated by the sharp external slowdown, the challenge now is how to return to a more “normal” level of investment without compromising growth and macroeconomic stability.

JAPAN - Central Bank Asset Ratio versusu Yen Devaluation

Presenting Abe's 'Super-Secret' Devaluation Plan - Double-Down 12-28-12 Zero Hedge

Much has been made of newly appointed uber-easer Abe's plans to weaken the JPY by any means possible. Since the global financial crisis began in early 2008, USDJPY has tracked remarkably closely with the ratio of Federal Reserve assets to Bank of Japan assets - as the currency wars escalated. Assuming the Fed proceeds with its planned QE3/4 $1tn expansion, then BoJ assets would need to expand by around JPY100tn to meet this target. The current BoJ holdings of JGBs just crossed JPY100tn - so this new printing is double the current holdings and considerably more than double the planned JPY44tn purchases for the year. Good luck with that given the expected JGB issuance this year is only around JPY44tn and good luck persuading anyone that the BoJ is not directly funding the government in the ultimate reacharound. As the Fed monetizes 1 year of Treasury issuance so the BoJ has to monetize over 2 years of JGB issuance - sustainable?

The current collapse in USDJPY to 86 has actually recoupled with the
ratio at around 0.0184x (Fed 2.92tn / BoJ 157.833tn). This implies the market is priced for around JPY56tn of JPY printing already (25% more than planned); but, given the USDJPY
target of 90 that has been implicitly discussed, this would mean the ratio of
Fed/BoJ would need to drop to 0.0165x.

The recent drop in USDJPY has recoupled with the current Fed/BoJ ratio once again...

but given the Fed's grand QE3/4 plan, the BoJ will have to be very aggressive to weaken the JPY - obviously - though monetizing double the planned JGB issuance this year seems like a stretch for even Abe (if he hopes to maintain any semblance of market confidence).

Chart: Bloomberg

MONETARY - Growing Risk Free Collateral Crisis

The Fed is Playing a Very Dangerous Game 12-28-12 Gains, Pains & Capital

"the search for collateral will drive yields lower… until the bond markets truly begin to spin out of control. In the meantime, the US Fed is playing a very dangerous game by purchasing as many Treasuries as it is. But that game can last much longer than anticipated."

The US Fed is committed to keeping interest rates low for the simple fact that if interest rates were to rise then the payments on the debt would send the US into an EU-syle debt crisis along with the commensurate intense austerity measures being implemented.

Unfortunately for the Fed, the bond markets may indeed force this in spite of the Fed’s efforts.

Weimar Germany, like most historic episodes of hyperinflation, occurred when Germany’s Central Bank began monetizing its debts. This worked until the country lost credibility in the international bond markets at which point the Central Bank was forced to monetize everything resulting in a currency collapse and one of the worst episodes of hyperinflation in history.

The US has been moving increasingly down this path which each new QE program. The two reasons the US has not yet entered an inflationary death spiral are:

1. The fact that the US continues to maintain its credibility in the bond markets (at least compared to Europe and Japan).
2. Large financial institutions’ needs for high-grade sovereign bond collateral.

Regarding #1, the US has never defaulted on its debt. Compared to Germany (another safe haven), which has defaulted on its debts twice in the last 100 years, the US remains one of the most credible governments in the world, regardless of how bad the country’s finances are becoming (for now at least).

Regarding the collateral situation, as I’ve explained in recent issues (see the “C” Word) one of the most critical issues in the financial system is the shortage of high grade collateral to backstop the $700 trillion derivatives market.

With France and the ESM bailout fund recently losing their AAA status, there is already a scramble for high grade collateral in the system. The US, despite losing its AAA rated status is still consider high grade due to its having never defaulted on its debt. With that in mind, the Fed decision to take US Treasuries at a time when more and more countries are losing their AAA rated status means that even less high grade collateral will be in the system.

Indeed, as I’ve noted before, because so much of the US debt market is already held by government controlled entities, the Treasuries shortage is even worse than the below article indicates.

Clearinghouses, run by firms such as Chicago-based CME Group (CME) and London-based LCH.Clearnet Group, make traders provide collateral, including government bonds, that can be seized and easily converted into cash to cover defaults. Traders may need from $2 trillion to $4 trillion in extra collateral to meet the new requirements, according to Timothy Keaney, chief executive officer of BNY Mellon Asset Servicing.

The trouble is finding all that high-grade debt. The U.S. had $10.8 trillion in Treasuries outstanding at the end of August. Other countries, including Japan and European nations rated AAA or AA, had about $24 trillion of debt in the second quarter of 2011, according to an April report by the International Monetary Fund. Those government securities are already in heavy demand from central banks and investors.

The solution: At least seven banks plan to let customers swap lower-rated securities that don’t meet standards, in return for a loan of Treasuries or similar holdings that do qualify, a process dubbed “collateral transformation.” The maneuver allows investors who don’t have assets that meet a clearinghouse’s standards to pledge corporate bonds or mortgage-linked securities to a bank in exchange for a loan of Treasuries. The investor then posts the Treasuries—the transformed collateral—to the clearinghouse. The bank earns fees plus interest, and the investor is obliged at some point to return the Treasuries. In effect, the collateral is being rented…

JPMorgan Chase (JPM) and Bank of America (BAC) are already marketing their new collateral-transformation desks, executives at the companies say. Other banks confirmed they’re planning to offer the service too, including Bank of New York Mellon (BK), Barclays (BCS), Deutsche Bank (DB), and State Street (STT).

http://www.businessweek.com/articles/2012-09-20/a-shortage-of-bonds-to-back-derivatives-bets

Here’s the actual amount of Treasuries available to the banks:

Indeed, as the below article reveals, the search for high quality collateral is one of the primary items holding up the Treasury market. The Treasury’s latest information reveals that:

Foreign ownership of U.S. Treasury securities rose to a record level in October, a sign that overseas investors remain confident in U.S. debt despite a potential budget crisis.

Total foreign holdings of U.S. Treasurys rose to $5.48 trillion in October, the Treasury Department said Monday. That was up 0.1 percent from September. Still, the increase of $6 billion was the weakest since total holdings fell in December 2011.

China, the largest holder of U.S. government debt, increased its holdings slightly to $1.16 trillion. Japan, the second-largest holder, boosted its holdings by a smaller amount to $1.13 trillion. Brazil, the country with the third-largest holdings, increased its total to $255.2 billion.

http://hosted.ap.org/dynamic/stories/U/US_FOREIGN_HOLDINGS?SITE=AP&SECTION=HOME&TEMPLATE=DEFAULT&CTIME=2012-12-17-09-44-48

My point with all of this is that the search for collateral will drive yields lower… until the bond markets truly begin to spin out of control. In the meantime, the US Fed is playing a very dangerous game by purchasing as many Treasuries as it is. But that game can last much longer than anticipated.

How precisely these issues will finally play out is a mystery. But the consequences will be tremendous. And enormous fortunes will be made by those who get it right. The first key clues will be when Bunds and Treasuries begin to nose dive in a big way.

On that note, we’ve recently prepared a Free Special Report outlining how to prepare for this as well as the ongoing currency debasement that is pushing inflation higher. It’s called Protect Yourself From Inflation and it outlines how inflation has already developed in the financial system as well as which investments will profit from it most.

MONETARY - Cash on the Sidelines Soars

Savings Deposits Soar By Most Since Lehman And First Debt Ceiling Crisis 12-27-12 Zero Hedge

A month ago, we showed something disturbing: the weekly increase in savings deposits held at Commercial banks soared by a record $132 billion, more than the comparable surge during the Lehman Failure, the First Debt Ceiling Fiasco (not to be confused with the upcoming second one), and the First Greek Insolvency. And while there were certainly macro factors behind the move which usually indicates a spike in risk-aversion (and at least in the old days was accompanied by a plunge in stocks), a large reason for the surge was the unexpected rotation of some $70 billion in savings deposits at Thrift institutions leading to a combined increase in Savings accounts of some $60 billion. Moments ago the Fed released its weekly H.6 update where we find that while the relentless increase in savings accounts at commercial banks has continued, rising by another $70 billion in the past week, this time there was no offsetting drop in Savings deposits at Thrift Institutions, which also increased by $10.0 billion. The end result: an increase of $79.3 billion in total saving deposits at both commercial banks and thrifts, or an amount that is only the third largest weekly jump ever following the $102 billion surge following Lehman and the $92.4 billion rotation into savings following the first US debt ceiling debacle and US downgrade in August 2011.

In total, there has been an increase of $112 billion in deposits in savings accounts in the past month alone, roughly the same as the total non-M1 M2 momey stock in circulation.

Ironically, it was only yesterday that we demonstrated the relentless surge in bank deposits despite the ongoing contraction in total bank loans, and explained how it is possible that using repo and rehypothecation pathways, that banks are abusing the endless influx of deposits into banks and using this money merely as unregulated prop-trading funds, a la JPM's CIO. In other words the "money on the sidelines" now at all time record highs, is anything but, and is in fact about $2 trillion in dry powder to be used by the banks as they see fit.

But most importantly, we showed how even as those happy few who can still afford to save, are fooling themselves int believing that they are pulling money out of other assets and storing it in what they perceive to be electronic mattreses at their friendly neighborhood JPM, Wells or Citi branch, and thinking this money is safe and sound. Alas, nothing could be further from the truth.

Because by depositing money into banks, ordinary Americans (and companies) are merely providing even more dry powder for the banks to trade on a prop, discretionary basis, either as directly investable capital or as asset collateral, and by handing over their hard earned cash to the banks are assuring that the scramble to bid up any and all risk assets continues indefinitely.

Yes, dear saver: the reason why stocks continue to soar above any fundamentally-driven level, is because you just made that bank deposit.

It also means, that come the New Year, and the unlimited insurance of various deposits comes to an end, and when banks once again represent a counterparty danger to savers (where they will be merely a general unsecured claim over and above any FDIC insured limit, be it $250,000 or less), should said deposits be pulled out of banks (and according to the WSJ there is about $1.5 trillion in deposits that may be impacted), the net result of such capital reallocation would be far more disastrous to stock markets than anything the fiscal cliff and/or debt ceiling theater could possibly do as it would mean unwinding an ungodly amount of trades that have had$1.5 trillion as real assets, with subsequent repo and re-repo leverage applied to them.

Source: H.6, St Louis Fed

MONETARY MALPRACTICE -Complaints Against the Fed

INFOGRAPHIC: Uncovering The Federal Reserve 12-26-12 Liberty Crier

CLICK FOR LARGE GRAPHIC

In the early 20th century, a financial crisis led panicked citizens to withdraw all their money at once, damaging banks. By 1913, Congress responded with the Federal Reserve Act, creating 12 regional banks acting as a federal bank to deal in local and global affairs with both private banks and the federal government.

Is the Fed still doing its job today? What secrets are being kept from us and how are the Fed’s ations impacting our economy?

Some say the Fed was meant to create a balanced economy, while others argue its purpose was to inorganically manipulate free enterprise, rescusing banks that we’d be better off without.

- Overly secretive
- Should be fully audited
- Encourages bad, risky investments by softening the blow of bad decisions
- Causes economic bubbles
- Makes the pain of recessions worse by covering up and exasperating problems that the market would correct on its own
- Caters to banks and financial insiders
- Systematically allows the value of money to decrease as a result of inflation
- For 100 years before the Fed, money retained or gained value over time
- Discourages people from saving for the future
- Doesn’t hold government spending in check

- Needs level of secrecy in order to maintain independence from political pressures and make wise decisions
- Monitoring of the Fed could create uneccessary economic panic
- Keeps inflation stable
- Softens the blow of recessions and prevents depressions

- Savers and investors have lost money to the big financial institutions
- $400 bill in government losses
- TARP still owes taxpayers $118.5 billion
- Fed claims to have gotten paid back for loans, but secrecy remains an issue

The gold standard was a method of valuing money based on the price of gold, a real tangible object with value. The gold standard was eventually abandoned by the Fed.

Why We Left The Gold Standard

- Gives the government more flexibility for dealing with economic recessions
- Allows the government to spend more than it has on hand in case of emergencies

Benefits Of The Gold Standard

Holds government spending in check with upper limits
- Non-arbitrary
- A tangible, limited resource that sets real spending ceilings

What would things look like if the Fed had less influence?

- Interest rates would be higher
- People would save more and spend less
- Government would spend within its means
- People would spend within their means
- There would be decreased consumption
- People would invest more
- Stock values would track company value and efficiency more closely
- Government would shrink
- America would produce and manufacture more
- Trade deficits would shrink

- Boot Bernanke
- Get big bankers and corporate interests off the Fed boards
- Uphold higher lending standards
- Ensure the Fed doesn’t bend its own rules for personal interests
- Work for the whole economy and not just the banks
- Consider a return to the gold standard (removing the clout of monetary policy)

US DEBT - Credit Downgrade to A on 'Negative Watch"

Chinese Credit Ratings Agency Dagong Puts The US On Negative Watch 12-25-12 Dagon Credit

RISK - Global Risk Assessment

The Ultimate Global Risk Matrix - In Seven Dimensions 12-24-12 BBVA research (via True Economics blog)via ZH

Sometimes it takes 60 pages to describe where we have been this year; on other occasions it takes 28 pages to describe where we are going and why. However, BBVA (via Constantin Gurdgiev's True Economics) have managed to condense the state of risk in our global markets down to seven critical dimensions (and into one table). From Macro (GDP and inflation) to Fiscal, Liquidity, and Credit Growth, the following matrix is your must-have guide for this new-year's cocktail party circuit. You're welcome...

Click to Enlarge

JAPAN - Yen Plummets, JGB Go Ballistic

JPY Drops To 27-Month Low As Abe Front-Running Continues 12-26-12 Zero Hedge

Slowly but surely, USDJPY has moved back above 85.50 to its highest (weakest JPY) in 27 months as the threat promise of central bank intervention has once again created more front-running. With the market attempting to price in Abe's extravagance, we wonder just how much bang for the buck his 'actions' will create when words are not enough. Will Abe 2.0 be the same as OMT, QE3, and QE4 with the event actually constituting the 'top' or peak impact? Critically though, once Japan actually formalizes what it will do, which will be limited by how much rates can rise on bonds before all government revenue is used to fund cash interest, JPY will spike again, facilitated by the record short-interest (per CoT data). More curious is which Goldman alum will be appointed as the head of the BoJ once Shirakawa's term expires in March. As Bloomberg noted this morning, Japan’s Chief Cabinet Secretary Yoshihide Suga said, during a speech in Tokyo this morning, the "next BoJ Governor will be a person who shares Abe’s views."

USDJPY weakest in 27 months...

and the JGB curve is starting to look a little out of control...

Charts: Bloomberg

JAPAN - The Epicenter of the world's failed Monetary Policy Experiment

The Annotated Kyle Bass 'Short-Japan' Thesis 12-26-12 Zero Hedge

Bass's exact positioning is unknown but he has commented on using sovereign CDS and critically has not espoused a short Japanese equity position directly - preferring to focus on the debt problems.

With JPY bleeding lower once again overnight extending to 28-month lows against the USD (and the long-end of the JGB curve starting to show some signs of anxiety), it is perhaps timely to revisit Kyle Bass's five key reasons why Japan is the epicenter of the world's failed monetary policy experiment. In this excellent and much-requested summary 8-minute clip, Bass summarizes his Japan thesis and destroys several of the myths that talking-heads like to assign to the so-called widow-maker trade.

JPY/USD...(higher = weaker JPY)

The long-end of the Japanese yield curve is at near-record steeps...

(h/t InformedTrades)

JAPAN - USD/JPY Cross and YEN Carry Trade Revival

Every Major Yen-Moving Event In 2012 12-25-12 Morgan Stanley via ZH

Click to Enlarge

CENTRAL PLANNING - Political Polarization is now a Public Policy Tool

The Only 3 Charts Needed To Understand The Fiscal Cliff Resolution Process 12-27-12 Zero Hedge

Arguing semantics over cuts here, taxes there, we are close, etc. misses the entire premise of the entire political debacle that is now replaying in Washington. The simple fact of the matter is that our politicians will not cross the aisle, will not compromise, will not 'come together', will not 'rise above', will not 'think of the children' - until the market (that critical arbiter of everything that appears relevant to the elites) forces their hand. The following three charts should help clarify that for all market savants.

1. Political Polarization has never (NEVER!) been higher - and so expectations of any of these so-called men doing what is right is a joke...

2. Our Stock Market can do no wrong - thanks to Bernanke's (and Draghi's) visible hand, any concerns over downside scenarios are now so unambiguously removed from the distribution of policies that the supposedly efficient markets no longer reflect any discounting but merely the marginal veracity of the next flashing red headline (as we noted earlier).

3. Until Our Stock Market Sends The Message - just as with the debt ceiling debate, hope and belief and some level of "they'd never let us, would they?" phantasma remains in the US investors' psyche still - that is until the politicians cross the line. At that point, our markets recognize their role and reflexively react and enforce discipline and action in Washington

(note: we first showed this 2011 analog two months ago and were met with the usual derisive comments with regard - that could never happen again - seems like we are following a very similar path of hope and belief and now a little fear)

Unless and until we see a major correction in stocks, we highly doubt that any actual resolution will be announced - no matter what the spin or hope on every conference call and press conference.

Bonus Chart: it's not just Stocks that are following last year's Debt Ceiling debacle - VIX is following along very closely. The following chart shows the term-structure of VIX is moving exactly as it did last year - i.e. a higher point on the chart means the short-dated VIX is rising relative to medium-dated (and if it is >1, then short-dated VIX costs are greater than longer-dated) - clearly the current cliff debate is raising short-term risk concerns in a similar way...

CRISIS OF TRUST - The Dot.Com, Housing Bubbles and Financial Crisis' Post Traumatic Stress Syndorme (PTSS)

The Real Crisis: "People Have Lost Trust In The Government And The Market" 12-27-12

The death of the 'cult of equities' was a popular topic this year among both fringe blogs and the best-known institutional asset managers and sell-side strategists. As AP discusses in this excellent article, ordinary Americans - defying decades of investment history - are selling stocks for a fifth year in a row. It's the first time ordinary folks have sold during a sustained bull market since relevant records were first kept during World War II. The answer is both complex and simple but summed up best by a former stock analyst's comment that in order to buy stocks "You have to trust your government. You have to trust other governments. You have to trust Wall Street, and I don't trust any of these." With Fed policy trying to force investors back into stocks (at any cost), a former fund manager notes, presciently that, "When this policy fails, as it will, baby boomers will pay the cost in their 401(k)s." Are we the new 'Depression Babies'? We suspect so.

Investors, as you well know, are leaving the equity markets in droves...

Based on AP's calculations, individuals accounted for 40 percent to 50 percent of money going to U.S. stock ETFs in recent years.

If you assume 50 percent, individual investors have put $194 billion into U.S. stock ETFs since April 2007. But they've also pulled out much more from mutual funds - $580 billion. The difference is $386 billion, the amount individuals have pulled out of stock funds in all.

If you include the sale of stocks by individuals from brokerage accounts, which is not included in the fund data, the outflow could be much higher.

But why are investors not buying the propaganda this time and jumping in with both hands and feet...

"You have to trust your government. You have to trust other governments. You have to trust Wall Street," says Neitlich, 47. "And I don't trust any of these."

Defying decades of investment history, ordinary Americans are selling stocks for a fifth year in a row. The selling has not let up despite unprecedented measures by the Federal Reserve to persuade people to buy and the come-hither allure of a levitating market. Stock prices have doubled from March 2009, their low point during the Great Recession.

It's the first time ordinary folks have sold during a sustained bull market since relevant records were first kept during World War II, an examination by The Associated Press has found.

and...

"People don't trust the market anymore," says financial historian Charles Geisst of Manhattan College. He says a "crisis of confidence" similar to one after the Crash of 1929 will keep people away from stocks for a generation or more.

What is at the core of this mistrust or doubt?

People who think the market will snap back to normal are underestimating how much the Great Recession scared investors, says Ulrike Malmendier, an economist who has studied the effect of the Great Depression on attitudes toward stocks.

She says people are ignoring something called the "experience effect," or the tendency to place great weight on what you most recently went through in deciding how much financial risk to take, even if it runs counter to logic. Extrapolating from her research on "Depression Babies," the title of a 2010 paper (link below) she co-wrote, she says many young investors won't fully embrace stocks again for another two decades.

"The Great Recession will have a lasting impact beyond what a standard economic model would predict,"

But it's not just ordinary folks, its professional investors too...

Public pension funds have cut stocks from 71 percent of their holdings before the recession to 66 percent last year, breaking at least 40 years of generally rising stock allocations

as old 'lessons' or myths are dismissed...

And old assumptions about stocks are being tested. One investing gospel is that because stocks generally rise in price, companies don't need to raise their quarterly cash dividends much to attract buyers. But companies are increasing them lately.

Dividends in the S&P 500 rose 11 percent in the 12 months through September, and the number of companies choosing to raise them is the highest in at least 20 years, according to FactSet, a financial data provider. Stocks now throw off more cash in dividends than U.S. government bonds do in interest.

Many on Wall Street think this is an unnatural state that cannot last.

As it seems, for once, a positive lesson is being learned...

"People aren't looking to swing for the fences anymore," says Gary Goldstein, an executive recruiter on Wall Street, referring to the bankers and traders he helps get jobs. "They're getting less greedy."

The lack of greed is remarkable given how much official U.S. policy is designed to stoke it.

But the powers that be are not happy about it...

"Fed policy is trying to suck people into risky assets when they shouldn't be there," says Michael Harrington, 58, a former investment fund manager who says he is largely out of stocks. "When this policy fails, as it will, baby boomers will pay the cost in their 401(k)s."

So, what are 'smart' retail investors doing with their money?

Instead of using extra cash to buy stocks, he is buying houses near his home in Sarasota, Fla., and renting them. He says he prefers real estate because it's local and is something he can "control." He says stocks make up 12 percent his $800,000 investment portfolio, down from nearly 100 percent a few years ago.

After the dot-com crash, it seemed as if "things would turn around. Now, I don't know," Neitlich says. "The risks are bigger than before."

Source: AP

Depression Babies paper link: malmendier

CRISIS OF TRUST - The Tool of "Political Promises"

A Politician's Promise 12-27-12 James E. Miller of the Ludwig von Mises Institute of Canada via ZH

The true purpose of a political promise is as a tool to maintain dominance over the herd. As long as the masses are lead to believe that success is only enabled by the state, they will cast a ballot for anyone that will grow state power to they believe is their benefit. Individual achievement in the context of laboring and serving others is belittled as being a waste of time in comparison to the sacrifice of the public sector. Politicians will pay lip service to individualism but only to point out that success is impossible without central government dictation. That way, campaign promises hold more weight and legitimacy in the eyes of voters eager to stick it to their fellow man. They are means to keep the state machine running smoothly as humanity slowly digests itself through continued warfare and destroying any incentive to save and invest for the future.

The sure sign of a halfwit is someone who believes a politician’s promise. They can be observed at candidate rallies with their faces beaming and their hands grasping tightly to a cardboard sign. In bars and restaurants they speak endlessly on how their preferred dictator is smarter, kinder, and cuter than the rest. In doing so, they make up for a lack of drunkenness with exuberance over the prospect of being ruled over. This mix turns the political enthusiast into a package more bothersome than either the chastising puritan or the destitute drunk.

This heap of idiocy finds its source in the promises made by public officeholders. Instead of relying on intelligence and reason to make their case, all an aspiring politico has to do is declare before a mob what he can give it in exchange for their votes. Every election hinges upon the degree that he can manipulate the public into believing his sincerity. Electoral contests are won and lost by the biggest coalition of fools who chant slogans devoid of actual meaning and purpose.

With the recent reelection of Barack Obama, there is speculation abound on how far the soon-to-be anointed king will deliver on his promised agenda. His leftist base of support is expecting an aggressive launch of statist initiatives aimed at righting some undefined injustice. Many of Obama’s detractors seriously believe he will use the Oval Office to institute a kind of socialist hell. Both are wrong. Obama’s second term will be a continuation of the centralization and consolidation of the state that has been occurring since the ratification of the Constitution. The path has already been laid out by the ruling cadre of politicians, high level bureaucrats, military generals, CEOs of banks, and the heads of politically-favored corporations. Obama’s promise of a robust American economy will not come to fruition because that was never the goal. Like all presidencies before it, the Obama presidency is there to ensure the “right” people keep having their pocket’s filled.

Meanwhile, an increasing number of young adults are becoming disillusioned with their own future and income earning potential. Many have witnessed the success of their parents and are now questioning why they aren’t experiencing the same level of achievement. In other words, they make perfect targets for political sloganeering. Through pledges for good jobs, these unemployed will easily be whipped into a frenzy of support for whichever candidate promises them a decent, salaried job. Their role as dupes has already been enshrined by the political class.

The record of unkempt campaign promises may be staggering but it has so far failed to deter a significant portion of people from participating in the electoral process. Time and time again, voters are promised an end to war, poverty, sickness, unemployment, addiction, obesity, starvation, homelessness, mental illness, crime, and violence. And with every election, each problem is exacerbated through state policies. Left to its own devices, a free, market economy has a tendency to improve living standards for all. That’s precisely why economic freedom is never granted by the state. It would make every politician, government worker, and state contractor’s perceived worth vanish overnight.

There are two types of promises that originate from a politician’s breath. The first is a starry-eyed pledge that is practically unworkable. The second is an assurance that would constitute a threat if given by a private individual. When announced, these promises are sold as a cure-all for all of society’s ills. They hardly ever come into fruition but are referred back to only if they aid in another reelection campaign.

The science of politicking is quite simple: appeal to the lowest common denominator of human life. This, most often, is the dim yearning of folks who aspire to do no more than feed themselves day by day. As long as this primitive instinct can be appeased by promise, a career in the nation’s capital is virtually guaranteed. Finding an honest politician is like searching for a virgin in a whorehouse. If you happen to stumble across one, they are always eager to give away what little integrity they have left in return for power.

The goal of the ruling class is a full blown return to feudalism. This social decaying is emboldened by the circus known as democracy where the mob votes away its own humanity for a naïve feeling of comfort. The masses have been fooled by years of unrelenting propaganda that government is, as Leo Tolstoy called it, “the representation of the citizens in the collective capacity” rather than its true designation of “one set of men banded together to oppress another set of men.” They are assured by campaigners for public office of a life that requires minimal effort, little intellectual stimulation, and no prudence whatsoever. A pol who speaks of freedom and responsibility is quickly gutted and cast aside. The mass-mind prefers to grovel at the feet of those who promise them a first class ticket to the land of plenty. In return, they receive a pittance while the more industrious of political brownnosers retain enriching privileges.

That is the true purpose of a political promise. It is a tool to maintain dominance over the herd. As long as the masses are lead to believe that success is only enabled by the state, they will cast a ballot for anyone that will grow state power to they believe is their benefit. Individual achievement in the context of laboring and serving others is belittled as being a waste of time in comparison to the sacrifice of the public sector. Politicians will pay lip service to individualism but only to point out that success is impossible without central government dictation. That way, campaign promises hold more weight and legitimacy in the eyes of voters eager to stick it to their fellow man. They are means to keep the state machine running smoothly as humanity slowly digests itself through continued warfare and destroying any incentive to save and invest for the future.

Mark Twain once wrote,

To make a pledge of any kind is to declare war against nature; for a pledge is a chain that is always clanking and reminding the wearer of it that he is not a free man.

Under normal circumstances, breaking a promise is regarded as unbecoming for any man. That is why pledges are hardly made except in instances in which they can be followed through with quickly and earnestly. Only the truly dishonest will often make promises since their frequent use has made them into a cheap currency used to solicit favors. The political class is the greatest practitioner of this tradition. It’s become a running joke in Western culture how conniving politicians can be. The fact that so many make light of the pathetic reputation shows a disdain for honest character.  Even worse is that such a criminal gang is still respected by the greater public. This terrible truth ends up reflecting worse upon the latter than the former.

RISK - Global Derivative Collateral

1000x Systemic Leverage: $600 Trillion In Gross Derivatives "Backed" By $600 Billion In Collateral 12-24-12 IMF via ZH

There is much debate whether when it comes to the total notional size of outstanding derivatives, it is the gross notional that matters (roughly $600 trillion), or the amount which takes out biletaral netting and other offsetting positions (much lower). We explained previously how gross is irrelevant... until it is, i.e. until there is a breach in the counterparty chain and suddenly all net becomes gross (as in the case of the Lehman bankruptcy), such as during a financial crisis, i.e., the only time when gross derivative exposure becomes material (er, by definition). But a bigger question is what is the actual collateral backing this gargantuan market which is about 10 times greater than the world's combined GDP, because as the "derivative" name implies all this exposure is backed on some dedicated, real assets, somewhere. Luckily, the IMF recently released a discussion note titled "Shadow Banking: Economics and Policy" where quietly hidden in one of the appendices it answers precisely this critical question. The bottom line: $600 trillion in gross notional derivatives backed by a tiny $600 billion in real assets: a whopping 0.1% margin requirement! Surely nothing can possibly go wrong with this amount of unprecedented 1000x systemic leverage.

From the IMF:

Over-the-counter (OTC) derivatives markets straddle regulated systemically important financial institutions and the shadow banking world. Recent regulatory efforts focus on moving OTC derivatives contracts to central counterparties (CCPs). A CCP will be collecting collateral and netting bilateral positions. While CCPs do not have explicit taxpayer backing, they may be supported in times of stress. For example, the U.S. Dodd-Frank Act allows the Federal Reserve to lend to key financial market infrastructures during times of crises. Incentives to move OTC contracts could come from increasing bank capital charges on OTC positions that are not moved to CCP (BCBS, 2012).

The notional value of OTC contracts is about $600 trillion, but while much cited, that number overstates the still very sizable risks. A better estimate may be based on adding “in-the-money” (or gross positive value) and “out-of-the money” (or gross negative value) derivative positions (to obtain total exposures), further reduced by the “netting” of related positions. Once these are taken into account, the resulting exposures are currently about $3 trillion, down from $5 trillion (see table below; see also BIS, 2012, and Singh, 2010).

Another important metric is the under-collateralization of the OTC market. The Bank for International Settlements estimates that the volume of collateral supporting the OTC market is about $1.8 trillion, thus roughly only half of exposures. Assuming a collateral reuse rate between 2.5-3.0, the dedicated collateral is some $600 - $700 billion. Some counterparties (e.g., sovereigns, quasi-sovereigns, large pension funds and insurers, and AAA corporations) are often not required to post collateral. The remaining exposures will have to be collateralized when moved to CCP to avoid creating puts to the safety net. As such, there is likely to an increased demand for collateral worldwide.

And there it is: a world in which increasingly more sovereigns are insolvent, it is precisely these sovereigns (and other "AAA-rated" institutions) who are assumed to be so safe, they don't have to post any collateral to the virtually unlimited derivatives they are allowed to create out of thin air.

Is it any wonder why, then, in a world in which even the IMF says there is an increased demand for collateral, that banks are making a total mockery out of such preemptive attempts to safeguard the system, such as the Basel III proposal, whose deleveraging policies have been delayed from 2013 to 2014, and which will be delayed again and again, until, hopefully, everyone forgets all about them, and no financial crises ever again occur.

Because if and when they do, the entire world, which has now become one defacto AIG Financial Products subsidiary, and is spewing derivatives left and right, may have to scramble just a bit to procure some of this $599 trillion in actual collateral, once collateral chains start breaking, once "AAA-rated" counterparties (such as AIG had been days before its bailout) start falling, and once the question arises: just what is the true value of hard assets in a world in which the only value created by financial innovation is layering of derivatives upon derivatives, serving merely to prod banker bonuses to all time highs.

MONETARY MALRPRACTICE - False Indicators

Bah! Humbug And A Happy Hyperinflationary Christmas To All 12-23-12 Zero Hedge

There are, according to USA Today, 364 items that need to be purchased to create the ultimate gift basket from the epic holiday song "The 12 Days of Christmas". Based on PNC Wealth's Christmas Price index, the cost of this basket is $107,300 in 2012 (up 6.1% year-over-year). Since 2001, when the Fed embarked upon its uber-expansionary monetary policy experiments, the cost of Christmas has risen over 40% faster than the Government's prescribed CPI (and if we use a different cost-base, since 2006, the cost of Christmas has risen 46% per year on average). And on an even more Bah! Humbug note, there is the important economic question of the Deadweight Loss of Christmas - i.e. gift-giving means consumption choices are made by someone other than the final consumer, with potentially sub-optimal micro-economic effects such as a mismatch with the recipient's preferences. This wonderfully positive report finds that between 10% and 33% of the value of gifts 'given' is destroyed through this inefficiency (with cash - or gold - the least impacted?). Happy Holidays, everyone!

The Deadweight Loss Of Christmas - PDF here

Cost of 12 Days of Christmas in 2005/2006 - PDF here

KEYNESIAN ENDPOINT - Revenue Growth Rate Equals Interest Rate

Visualizing The Keynesian Endpoint 12-23-12 Addogram

We recently posted Kyle Bass’s keynote speech at the Americatalyst 2012 conference. One of the main threads running through his thesis is the “Keynesian Endpoint”; covering debt super-cycles, the Federal Reserve’s inability to move rates from 0% and the (unintuitive) interconnectedness of sovereign default and hyperinflation. By way of clarification to global Ponzi we discussed earlier, Addogram has created an excellent infographic plotting the development of these ideas and mechanisms from 1792 to the present day.

A BROKEN PONZI SCHEME - Actions Required - Boston Consulting Group

Ending the Era of Ponzi Finance January 2013 Boston Consulting Group

The developed world’s Ponzi scheme is caused by record-high levels of public and private debt. As Boston Consulting Group notes, it is exacerbated by huge unfunded liabilities that will be impossible to pay off owing to long-term changes in developed-world demographics. Addressing these challenges at any time would be difficult. To make matters even worse, however, BCG points out that they come at a moment when the developed world’s traditional model of economic growth appears to be broken. This is partly a consequence of the Ponzi scheme itself. The underlying issues cannot be ignored any longer. The developed world faces a day of reckoning. It is time to act. In this excellent layman's guide to the the real world, not only does BCG explain the Ponzi, but they lay out ten critical steps that developed economies must take to definitively end the era of Ponzi finance. Some are sacrifices required of various stakeholders. Others are new social investments, both public and private, that are needed in order to return to a sustainable growth path.

The paper starts with the Origins of the Ponzi Scheme we call modern economies, then goes on to discuss the Broken Growth Formula...

Then lays out ten steps to any solution for developed economies...

Via Boston Consulting Group:

1. Deal with the debt overhang - immediately. A precondition to addressing the fallout of the unsustainable policies of recent decades is a fast cleanup of the debt overhang. In previous papers, my colleagues and I have discussed the various options for doing so.35 Put simply, some combination of writeoffs and restructuring, austerity, higher taxes, and sizable inflation will be necessary.

2. Reduce unfunded liabilities. Once debt restructuring is under way and the broader public sees that wealthy owners of financial assets are contributing to the necessary cleanup, it should be easier for politicians to take another painful step: addressing openly and directly the trillions in unfunded liabilities that are weighing down budgets and balance sheets across the developed world. It will require a combination of several measures to bring these unfunded liabilities under control.

3. Increase the efficiency of government. Parallel to reductions in government spending on social-welfare benefits, another key to reducing government’s share of GDP and increasing economic growth is to make government itself more efficient. A smaller government sector does not necessarily mean a weaker government. By defining the right “rules of the road” for society and business, governments can set the tone and priorities for development in a more effective as well as a more efficient way.

4. Prepare for labor scarcity. Countries need to start now to prepare for the coming era of labor scarcity. Doing so will require a series of initiatives to reduce the decline of the workforce.

5. Develop smart immigration policy. Even if developed countries take all these steps, it will still not be enough to reverse demographic trends. Therefore, these countries also need to become far more open and attractive to immigrants.

6. Invest in education. Education has to play a significant role in the future growth potential of the developed economies. Quality education will be the decisive factor in protecting and increasing GDP per capita. It is also the foundation of social mobility and a precondition to fully utilizing the innovative capabilities and entrepreneurial talent of a society’s members. For both reasons, it needs to be another key target of social investment.

7. Reinvest in the asset base. For more than a decade, the developed economies have reduced investments in public infrastructure and productive assets. Given the importance of the quality of capital stock to productivity and economic growth, it is time to reverse this trend.

8. Increase raw-material efficiency. The age of cheap resources may have come to an end. Developed countries have to increase their efforts to decouple economic development from resource consumption.

9. Cooperate on a global basis. Competition among countries will become more intense in the years to come. All countries will try to increase their exports; all will try to attract the best-educated immigrants; and all will try to secure scarce resources, from water to oil to commodities. This increased competition will pay dividends in the form of new and innovative products. But even as they compete, the world’s countries must also cooperate. The problems of the developed economies can only be addressed in a cooperative way on a global scale. Otherwise, the world risks descending into a vicious circle of beggar-thy-neighbor economic policies leading to much lower growth and slower improvement of living conditions worldwide.

10. Launch the next Kondratiev wave. Last but not least, the developed world needs to prove Robert Gordon wrong. By investing in a growing and highly productive workforce and making it easier for engineers and technologists to innovate and for entrepreneurs to start new businesses, the developed economies need to unleash a new Kondratiev wave of global economic development.

and ends with ideas for Negotiating The Fallout...

Must Read!

BCG Ending the Era of Ponzi Finance Jan 2013

STUDY - Market Analytics

A Record $2 Trillion In Deposits Over Loans - The Fed's Indirect Market Propping Pathway Exposed 12-26-12 Zero Hedge

Perhaps one of the most startling and telling charts of the New Normal, one which few talk about, is the soaring difference between bank loans - traditionally the source of growth for banks, at least in their Old Normal business model which did not envision all of them becoming glorified, Too Big To Fail hedge funds, ala the Goldman Sachs "Bank Holding Company" model; and deposits - traditionally the source of capital banks use to fund said loans. Historically, and logically, the relationship between the two time series has been virtually one to one. However, ever since the advent of actively managed Central Planning by the Fed, as a result of which Ben Bernanke dumped nearly $2 trillion in excess deposits on banks to facilitate their risk taking even more, the traditional correlation between loans and deposits has broken down. It is time to once again start talking about this chart as for the first time ever the difference between deposits and loans has hit a record $2 trillion! But that's just the beginning - the rabbit hole goes so much deeper...

There are many reasons why the deposit hoard has continued to rise in the past 4 years, and according to the latest H.8 statement just hit a record $9.173 trillion as of December 12. This compares to $7.259 trillion in the week after the Lehman collapse: an increase of $1.9 trillion.

One contributing factor to this surge in deposits is the collapse in the Commercial Paper market (driven in big part due to the ongoing lack of counterparty faith as well as the ongoing Fed intervention in every possible market which has the paradoxical impact of eliminating confidence in the system and the desire by corporations to be able to fund themselves at a moment's notice come hell or high water) coupled with the unlimited insurance of various deposits courtesy of the government's Transaction Account Guarantee (TAG) program, which however will expire in 5 days, and which has made deposits the preferred pathway of preserving liquidity "dry powder" for both corporations and individuals.

But perhaps the biggest driver of the surge in deposits is the Fed's own ongoing liquidity tsunami, which using various traditional and shadow conduits has injected nearly the entire $2 trillion amount into the banking system (as Excess Reserves, Reverse Repos, Deposits with Federal Reserve Banks, and Other Fed Liabilities which combined conveniently amount to just about $1.8 trillion), which then via reflexive shadow pathways, most notably repo, has translated into an actual excess of cash to the bank's balance sheet: perfectly fungible cash which can then be used for any generic purpose: such as prop trading under the guise of "hedging" as JPM so vividly demonstrated a few months back. More on this in a second.

While the source of the cash for record deposits - i.e., the ever so incorrectly classified "cash on the sidelines" is debatable (but not much), one thing is certain: the total issuance of loans since the Lehman collapse in September of 2008 has barely budged and has increased by a whopping... -120.6 billion! That's a negative.

Indeed, in the past 4+ years, bank loan issuance has declined from $7.27 trillion to $7.15 trillion! To keep up with the increase in deposits, at least based on the historical relationship between deposits and loans, this number would have to be $2 trillion higher today, or some $9.2 trillion - money that would be going to individuals, households, and small, medium and large businesses to fund expansion and growth (instead the gross debt issuance frenzy we have seen over the past 3 years is only to refinance existing debt and lower rates: i.e., not only zero, but negative net issuance).

At least we can put to rest any debate whether banks are willing, able or even interested to lend out money in an unprofitable Net Interest Margin environment, such as that the Fed has created currently courtesy of ZIRP and courtesy of constant fronrunning of the Fed's purchases on the long-end.

If that was all, we could end this post here and tell readers to make up their own mind about what is truly happening behind the scenes. But there is much more to discuss about this record excess of deposits over loans. And the "more" is something that was only recently discovered, courtesy of a massive blunder by none other than JPM's Jamie Dimon. It is important to expose the "more" as it is in stark contrast with the conventional thinking adopted by much of the mainstream media (and even us until some time in May of 2012).

The conventional, or wrong way of thinking about the excess funding used by banks is best exemplified by this following headline from a August 20 Bloomberg article titled, "Banks Use $1.77 Trillion to Double Treasury Purchases."

In it the BBG authors note, correctly, that there was an excess $1.77 trillion in deposits over loans: a number which has since risen to $2.019 trillion as this post observes. Where the article is dead wrong is in its explanation of what the banks use said money for. Because while banks may or may not have used the excess cash for Treasury purchases (recall that we first highlighted that Primary Dealers held a record $140 billion in net Treasurys as of the latest week), the reality is that US Treasury paper is most certainly not what the final use of proceeds is.

Recall that as we have been describing for the past 3 years, a primary driver of "growth" in the US market, if not economy, has been the ability to transform asset and liability exposure off the books using various shadow conduits. The primary such conduit is and has always been repo funding (and various other forms of limited and/or unlimited rehypothecation made so popular after the collapse of MF Global). What repo does is it allows banks to exchange their holdings of Security X (in this case trasury) in exchange for nearly par cash courtesy of some custodian bank - and when it comes to the US non tri-party repo market there are only two: State Street and Bank of New York.

The biggest benefit of Repo financing is that the bank can still hold the original pledged security on its books for Fed "supervision" purposes, even as it obtains fungible cash equivalents via repo, cash which it can then use for whatever downstream purposes it desires such as purchasing stocks. This is where it gets confusing, and certainly confused our friends at Bloomberg who arrived at the wrong conclusion in their analysis.

A good summary of what really happens under the hood when account for repo comes from Citi's brilliant head of credit, Matt King, and his legendary note from September 5, 2021 "Are The Brokers Broken?" (which should be required reading for everyone), where he described the scheme as follows:

Paragraph 15 of the accounting rule FAS 140 stipulates that the amount referred to on the balance sheet statement need only be “collateral pledged to counterparties which can be repledged to other counterparties”. A further portion of the financial instruments owned – which is in many cases substantial – is reported in the 10-Q footnotes of “collateral pledged to counterparties which cannot be repledged”. An example might be tri-party repo, where until recently some custodians could not cope with the administrative complications of rerepoing received collateral. Although the assets themselves have always featured on the balance sheet, the fact that this non-repledgeable portion too is funded on repo is less widely appreciated. The combined volume – once it is arrived at – comes close to 50% of all financial instruments owned.

And this is where everyone loses the plotline, because the reality is that virtually half the balance sheet of US brokers can be repoed back to custodians, in the process leading to double, triple, and x-ple counting a single asset serving as deliverable collateral, and using and reusing (if need be), the cash proceeds, net of a token haircut (or no haircut in the case of English rehypotecation transactions), every single time purchasing riskier assets to generate a return on a return on a return of the original investment. In short: the magic of off-balance sheet accounting which allows brokers to abuse their already TBTF status and lever any underlying asset to the helt and beyond.

Think of Shadow Banking as your own in house synthetic structured product, allowing virtually unlimited leverage.

"Pure Hogwash!" One may say. "These are ridiculous allegations with no base in reality." One may add. We thought so too until the JPM "whale trade" fiasco happened, and all the dirt of the synthetic deposit-funding repo pathways was exposed for all to see.

Presenting Exhibit A, which comes directly from page 24 of JP Morgan's June 13 Financial Results appendix, in which the firm laid out, for all to see, just how it is that the Firm generated over $5 billion in prop trading losses in its Chief Investment Office unit - a department which had previously been tasked with "hedging" trades but as it turned out, was nothing but a glorified, and blessed from the very top, internal hedge fund, one with $323 billion in Assets Under Management! To wit:

The chart above shows the snapshot - from the horse's mouth -of how a major "legacy" bank, one engaged in both deposits and lending, decided to use the "deposit to loan gap" which had swelled to $423 billion at just JPM (blue box in middle), and led to $323 billion in CIO "Available For Sale securities."

What happened next is well-known to all: JPM's Bruno Iksil, together with Ina Drew and the rest of the CIO group (all of whom have since been dismisses), decided to put on a massive bet amounting to over $100 billion in notional across the credit spectrum (the one place where a position of this size could be established without becoming the entire market, although by the time it imploded Bruno Iksil was the market in IG9 and various other indices and tranches). The loss was just as staggering, and amounts to what is one of the largest prop bets gone horribly wrong in history.

Now the JPM spin is well-known: the CIO was merely there to "hedge" exposure, as a direct prop bet would be illegal as per the Volcker Rule, not to mention the avalanche of lawsuits and the regulatory nightmare that would ensue if it became clear that the firm was risking what amount to deposit capital to fund massive, highly risky prop trading bets. Which, when one cuts out the noise, is precisely what JPM did of course, especially since the "hedge" trade blew up just as the market tumbled in the spring of 2012, a time when it should have otherwise hedged the balance of the firm's otherwise bullish posture. That it did not do this refutes the logic that this was a hedge, and confirms that what JPM was doing was nothing short of using an internal, heavily shielded hedge fund, which had $323 billion in collateral as investible equity, to trade away, knowing very well no regulator would dare touch JPM. This is further compounded by the fact, that as one of only two Tri-Party repo dealers in the market (and by far the greater of the two, the second one being the innocuous Bank of New York Mellon), JPM could run circles around both the entire market, and the Fed, if it so chose, courtesy of its monopoly position in the repo market.

* * *

So where does that leave us?

Well, instead of JPM's "deposit to loan gap" discussion, whose massive loss (but, but, hedging...) was the dominant topic on the airwaves for a large part of the summer of 2012, we have the US financial system's "deposits to loan gap" - amounting to some $2 trillion - to contend with. But the punchline is that whereas JPM's decided to express its prop risk using fixed income instruments, and certainly not to buy simple boring Treasurys as the Bloomberg article speculated earlier, nothing prevented JPM from simply bidding up other risky assets "as a hedge" such as stocks, or crude, or slamming silver, or doing anything else it was perfectly entitled to do using the repledging mechanics of the repo system. And since Jamie Dimon has not yet given a full P&L breakdown listing CUSIP by CUSIP just what instruments JPM depositors were funding - either directly or indirectly - nobody actually knows just what securities the CIO was long or short.

The question then becomes: just how are the remaining hundreds of depositor US banks expressing their own iteration of the JPM CIO "deposits over loans" problem? Are they all trading CDS in the IG or HY space? Are they using repo proceeds from TSY purchases to generate fungible cash? Or are they simply using the cash directly and using it to big up risk assets?

All these questions will remain unanswered as it is in both the banks' and, therefore, regulators' best interests to keep the accounting behind repo, pledging and hypothecation transactions as is - nebulous, complicated and even contradictory (especially when it comes to FAS 140 whose paragraph 15 (d) makes borrowed versus pledged transactions off balance sheet, while paragraph 94 makes them on balance sheet), as overhauling the reporting requirements would expose just how much double-, triple-, quadruple- and more dipping America's major money centers are engaged in when it comes to propping up the market: dirt that would put the result of any "Audit the Fed" outcome to shame.

And after all, why should the Fed dirty its hands when it can simply provide the banks with the cash resources to do what they need without it having to engage in what is certainly illegal based on any of its charters. Because while the Liberty 33 Plunge Protection Team may, on occasion, engage the Citadel trading desk to buy ES at times when nobody else will step up, it certainly will not have to do so all the time if it were to flood banks with $2 trillion (soon to be $3, then $4 trillion as QE4EVA drags on and on and on...) in perfectly fungible capital, which can be metamorphozed from innocuous Excess Reserves to perfectly tradeable cash using two or three simple shadow banking transformations.

In that regard, we have to thank Jamie Dimon and his firm for being the biggest beacon of light in 2012, because without the generous contribution of the JPM CIO desk, and its explanation of how the "deposit to loan gap" we would all still be in the dark, and just like Bloomberg, assume naively that all a bank does with excess trillions in deposits, is to buy boring old treasurys.

Instead, we now know the truth, and for that Jamie - you have our sincerest gratitude.

* * *

Finally, the indirect implication of all this is for all those demanding that the "money on the sidelines" leaves the sidelines and is once again used by companies. The problem is that said money is already used by banks as prop trading capital: likely all $2 trillion of it (and if re-hypothecated, more) - in other words, if instead of being used by banks to prop up corporate stocks and risk in general, companies revert to the old mentality of actually reinvesting in themselves - i.e, CapEx spending, hiring new people, even M&A and generally growth - the fungible cash used by banks as investing capital will be redeemed and result in commensurate sales of stocks. Which means that should said "sideline capital" ever be pulled back by the same companies who are now granting, unbeknownst to them, direct asset management duties of said cash by the US banks, then watch out below, at least in the S&P. Which, as the Fed has made all too clear, is the only thing that matters in the New Normal.

PATTERNS - Copper

Who's Smarter? Dr. Copper Or Mr. Market 12-24-12 Zero Hedge

Copper is often referred to as the PhD of commodities for, as JPMorgan's Ken Landon notes, "When companies ramp up production of various products, whether during or in anticipation of economic recovery, they demand more cooper." Gold, however, he adds, "is not sensitive at all to business-cycle demand. Its price is driven by the monetary environment." While Bloomberg's chart of the day prefers to take the short-term (last few weeks) view of the world to justify a bullish equity market call, we prefer to look at longer-term cycles and the message is extremely clear - manufacturers are anything but confident, are doing anything but buying copper in anticipation of demand, and despite gold's recent fluctuations it is anything but implying that the world's grand monetary policy experiment is slowing down. What we see from this chart is yet another clear fundamental divergence between Dr. Copper's take on the global economy and the US equity market's nominal recovery.

Chart: Bloomberg

STATISM - The Security-Surveillance Complex - A Poltical Tool for Coercian, Extortion & Control

Americans Are The Most Spied On People In World History 12-28-12 Washington Blogs via Ritholtz

STATISM - A Crumbling Social Contract

The Structural Endgame Of The Fiscal Cliff 12-26-12 Charles Hugh-Smith via Peak Prosperity

The political foundation of America is starkly unjust.  An entrenched financial Aristocracy buys the complicity of the bottom 50% and retirees with Federal transfers – a Tyranny of the Majority.  The 24.5% below the Aristocracy who pay most of the Federal taxes are dominated by this alliance. This may be legal, but is it just? Even more critically, is it sustainable?

The Status Quo rests on this Grand Political Bargain:

1. We in the Aristocracy will pay significant taxes as long as we control the levers of financial and political power.
2. We in the top 24% will pay the rest of the income taxes as long as we and our children can continue to live well and accumulate wealth.
3. We in the "middle class" will continue to work hard as long as we have hope of bettering our lifestyle and the lives of our children.
4. We in the bottom 50% and retirees agree not to threaten the top 0.5%'s power as long as we continue to get our government transfers and benefits.

This Grand Bargain is coming apart as the promises made to everyone cannot possibly be met.  Claims on welfare and disability programs are skyrocketing at the same time that the demographics of an aging populace are causing 10,000 people a day to enter Social Security and Medicare, the two costliest government programs.  Meanwhile, the upper middle class that pays most of the taxes has been slammed with lower income and a devastating drop in their housing-based net worth.

According to former Congress members Chris Cox and Bill Archer, writing in the Wall Street Journal:

Why $16 Trillion Only Hints at the True U.S. Debt

The actual liabilities of the federal government—including Social Security, Medicare, and federal employees' future retirement benefits—already exceed $86.8 trillion, or 550% of GDP. For the year ending Dec. 31, 2011, the annual accrued expense of Medicare and Social Security was $7 trillion.

That is roughly double the entire annual Federal budget.

They go on to note that “to collect enough tax revenue to avoid going deeper into debt would require over $8 trillion in tax collections annually.”  Expropriating the entire income of the top 25% of households that pay almost 90% of the tax and all corporate taxes would only bring in $6.7 trillion.

Clearly, the promises that have been made to 315 million Americans cannot be met, and the current strategies of financial repression (zero-interest rate policy, etc.) and massive fiscal deficits that subsidize favored cartels in defense, housing, education, and healthcare are unsustainable. The politically expedient “fixes” to the Fiscal Cliff (a slight increase in the tax rate on earned income above $250,000, etc.) will not fill the $86 trillion gap between what has been promised and what can be collected in taxes.

What few dare admit, much less state publicly, is that the Constitutional limits on the financial Aristocracy and the Tyranny of the Majority have failed.  This guarantees a future Constitutional crisis as each political class – the financial Aristocracy, the top 24% who pay most of the taxes, the dwindling middle class and the bottom 50% who depend on Federal transfers – will battle for control as the Status Quo collapses under the weight of its unsustainable promises.

THE CHAINS OF EMPLOYMENT INCOME

• There are roughly 127 million people who receive government transfers or benefits. 
• Sixty-one million recipients of Social Security and Medicare and
• 66 million people receiving welfare (SNAP food stamps, housing credits, Medicaid, etc.) 
• Since there are about 115 million full-time jobs in the U.S., this means there are 1.1 government dependents for every full-time worker in the U.S.
• There are 315 million Americans and roughly 142 million jobs. 
• About 38 million of these jobs are part-time that pay less than $10,000 annually. 
• Fifty million wage earners earn less than $15,000 a year, and 61 million earn less than $20,000 annually.)

The Federal government counts a person who is self-employed and earns $100 a year as "employed" and a person who works one hour a week as "employed."  As a result, the only meaningful metric is full-time employment.

• The top 25% who pay most of the taxes, roughly 30 million people, are a political minority compared to the 127 million people drawing direct payments/benefits from the Federal government and the 65+ million who pay essentially no income taxes (though they do pay the 7.65% Social Security/Medicare payroll tax).

CONSTITUTIONAL CRISIS - Inequality, Productivity Paradox and Concentrated Power & Wealth

More Cliffs Than Fiscal 12-26-12 Charles Hugh-Smith of OfTwoMinds blog

CRISIS OF TRUST - Rule of Law

The Lie that Prosecuting Bank Fraud Will Destabilize the Economy Is What Is REALLY Destroying the Economy 12-22-12 George Washington via ZH

The Departments of Justice and Treasury are pretending that criminally prosecuting criminal banksters will destabilize the economy.

The exact opposite is true.

Failing to prosecute criminal fraud has been destabilizing the economy since at least 2007 … and will cause huge crashes in the future.

After all, the main driver of economic growth is a strong rule of law.

Nobel prize winning economist Joseph Stiglitz says that we have to prosecute fraud or else the economy won’t recover:

The legal system is supposed to be the codification of our norms and beliefs, things that we need to make our system work. If the legal system is seen as exploitative, then confidence in our whole system starts eroding. And that’s really the problem that’s going on.

***

I think we ought to go do what we did in the S&L [crisis] and actually put many of these guys in prison. Absolutely. These are not just white-collar crimes or little accidents. There were victims. That’s the point. There were victims all over the world.

***

Economists focus on the whole notion of incentives. People have an incentive sometimes to behave badly, because they can make more money if they can cheat. If our economic system is going to work then we have to make sure that what they gain when they cheat is offset by a system of penalties.

Nobel prize winning economist George Akerlof has demonstrated that failure to punish white collar criminals – and instead bailing them out- creates incentives for more economic crimes and further destruction of the economy in the future.

Indeed, professor of law and economics (and chief S&L prosecutor) William Black notes that we’ve known of this dynamic for “hundreds of years”. And see this, this, this and this.

(Review of the data on accounting fraud confirms that fraud goes up as criminal prosecutions go down.)

The Director of the Securities and Exchange Commission’s enforcement division told Congress:

Recovery from the fallout of the financial crisis requires important efforts on various fronts, and vigorous enforcement is an essential component, as aggressive and even-handed enforcement will meet the public’s fair expectation that those whose violations of the law caused severe loss and hardship will be held accountable. And vigorous law enforcement efforts will help vindicate the principles that are fundamental to the fair and proper functioning of our markets: that no one should have an unjust advantage in our markets; that investors have a right to disclosure that complies with the federal securities laws; and that there is a level playing field for all investors.

Paul Zak (Professor of Economics and Department Chair, as well as the founding Director of the Center for Neuroeconomics Studies at Claremont Graduate University, Professor of Neurology at Loma Linda University Medical Center, and a senior researcher at UCLA) and Stephen Knack (a Lead Economist in the World Bank’s Research Department and Public Sector Governance Department) wrote a paper called Trust and Growth, showing that enforcing the rule of law – i.e. prosecuting white collar fraud – is necessary for a healthy economy.

One of the leading business schools in America – the Wharton School of Business – published an essay by a psychologist on the causes and solutions to the economic crisis. Wharton points out that restoring trust is the key to recovery, and that trust cannot be restored until wrongdoers are held accountable:

According to David M. Sachs, a training and supervision analyst at the Psychoanalytic Center of Philadelphia, the crisis today is not one of confidence, but one of trust. “Abusive financial practices were unchecked by personal moral controls that prohibit individual criminal behavior, as in the case of [Bernard] Madoff, and by complex financial manipulations, as in the case of AIG.” The public, expecting to be protected from such abuse, has suffered a trauma of loss similar to that after 9/11. “Normal expectations of what is safe and dependable were abruptly shattered,” Sachs noted. “As is typical of post-traumatic states, planning for the future could not be based on old assumptions about what is safe and what is dangerous. A radical reversal of how to be gratified occurred.”

People now feel more gratified saving money than spending it, Sachs suggested. They have trouble trusting promises from the government because they feel the government has let them down.

He framed his argument with a fictional patient named Betty Q. Public, a librarian with two teenage children and a husband, John, who had recently lost his job. “She felt betrayed because she and her husband had invested conservatively and were double-crossed by dishonest, greedy businessmen, and now she distrusted the government that had failed to protect them from corporate dishonesty. Not only that, but she had little trust in things turning around soon enough to enable her and her husband to accomplish their previous goals.

“By no means a sophisticated economist, she knew … that some people had become fantastically wealthy by misusing other people’s money — hers included,” Sachs said. “In short, John and Betty had done everything right and were being punished, while the dishonest people were going unpunished.”

Helping an individual recover from a traumatic experience provides a useful analogy for understanding how to help the economy recover from its own traumatic experience, Sachs pointed out. The public will need to “hold the perpetrators of the economic disaster responsible and take what actions they can to prevent them from harming the economy again.” In addition, the public will have to see proof that government and business leaders can behave responsibly before they will trust them again, he argued.

Note that Sachs urges “hold[ing] the perpetrators of the economic disaster responsible.” In other words, just “looking forward” and promising to do things differently isn’t enough.

Robert Shiller – one of the top housing experts in the United States – says that the mortgage fraud is a lot like the fraud which occurred during the Great Depression. As Fortune notes:

Shiller said the danger of foreclosuregate — the scandal in which it has come to light that the biggest banks have routinely mishandled homeownership documents, putting the legality of foreclosures and related sales in doubt — is a replay of the 1930s, when Americans lost faith that institutions such as business and government were dealing fairly.

Indeed, it is beyond dispute that bank fraud was one of the main causes of the Great Depression.

Economist James K. Galbraith wrote in the introduction to his father, John Kenneth Galbraith’s, definitive study of the Great Depression, The Great Crash, 1929:

The main relevance of The Great Crash, 1929 to the great crisis of 2008 is surely here. In both cases, the government knew what it should do. Both times, it declined to do it. In the summer of 1929 a few stern words from on high, a rise in the discount rate, a tough investigation into the pyramid schemes of the day, and the house of cards on Wall Street would have tumbled before its fall destroyed the whole economy.

In 2004, the FBI warned publicly of “an epidemic of mortgage fraud.” But the government did nothing, and less than nothing, delivering instead low interest rates, deregulation and clear signals that laws would not be enforced. The signals were not subtle: on one occasion the director of the Office of Thrift Supervision came to a conference with copies of the Federal Register and a chainsaw. There followed every manner of scheme to fleece the unsuspecting ….

This was fraud, perpetrated in the first instance by the government on the population, and by the rich on the poor.

***

The government that permits this to happen is complicit in a vast crime.

Galbraith also says:

There will have to be full-scale investigation and cleaning up of the residue of that, before you can have, I think, a return of confidence in the financial sector. And that’s a process which needs to get underway.

Galbraith recently said that “at the root of the crisis we find the largest financial swindle in world history”, where “counterfeit” mortgages were “laundered” by the banks.

As he has repeatedly noted, the economy will not recover until the perpetrators of the frauds which caused our current economic crisis are held accountable, so that trust can be restored. See this, this and this.

No wonder Galbraith has said economists should move into the background, and “criminologists to the forefront.”

The bottom line is that the government has it exactly backwards.   By failing to prosecute criminal fraud, the government  is destabilizing the economy … and ensuring future crashes.

Postscript:  Unfortunately, the government made it official policy not to prosecute fraud, even though criminal fraud is the main business model adopted by the giant banks.

Indeed, the government has done everything it can to cover up fraud, and has been actively encouraging criminal fraud and attacking those trying to blow the whistle.

On The Morality Of The Fed 12/21/12 The Baupost Group via ZH

"Finally, we must question the morality of Fed programs that trick people (as if they were Pavlov's dogs) into behaviors that are adverse to their own long-term best interest. What kind of government entity cajoles savers to spend, when years of under-saving and over-spending have left the consumer in terrible shape? What kind of entity tricks its citizens into paying higher and higher prices to buy stocks? What kind of entity drives the return on retiree's savings to zero for seven years (2008-2015 and counting) in order to rescue poorly managed banks? Not the kind that should play this large a role in the economy."

...

"An environment where financial crises are seen to be a regular part of the landscape is one where people might actually take more precautions. People would maintain a margin of safety in all their decisions, investment and otherwise, regulations would be well thought out and diligently enforced, and the unscrupulous and the incompetent would quickly fail and disappear from the scene. Modern day attempts to abolish failure only serve to ensure it, as moral hazard - the likelihood that people's behavior changes in response to artificial supports or guarantees - surges. Attempts to prevent or wish away future crises only make them more likely. Only by allowing, even welcoming, episodic failure do we have a chance of reducing the likelihood and magnitude of future financial crises."

STATISM - How Our Liberty in Undermined

The End Of The Line: An Interview With G. Edward Griffin 09-17-12 Casey Research via Alt-Market

Here is a very interesting video interview with the the writer of 'The Creature From Jekyll Island', the preeminent book on the corruption of the private Federal Reserve Bank. Griffin underlines the great threat to our economy and the American ideal of liberty that is looming over our country today.