Free Lunch


By Monish Chhabra ǀ 10th September 2014

Fear and greed are both in the bubble. The dichotomy is dead.

German 2-year bonds hit negative yield this month. The German government is being paid to borrow money. Deflation turns the world upside down.

At the same time, the European high-yield market is roaring. It has grown to match the size of US, from a quarter in 2007.

Retail cash holdings – an indicator of fear - in the US are now lowest since 1998-99.

Where has the cash gone from retail accounts?

Into US equities. Institutions are selling to the retail. Many other indicators like valuations, leverage, length of rally, sector rotations and trading volumes also suggest - extreme.

However ‘extreme’ is a range, where only the beginning is identifiable.

Take a look at the Dubai stock market – up 53% this year. Or Argentina up 43%.

Yet all these are mere footnotes to the real extreme - debt.

Global debt today is 3-times the global output. That ratio continues to worsen as the debt grows while the economies struggle.

Italy’s economy has now diminished to the size it was 14 years ago. Also for the first time in 55 years, Italy is in deflation. Not a lonely place though. Spain, Greece, Sweden and Portugal share the company.

Banco Espirito Santo, Portugal’s second largest bank collapsed this month. The burden of bad loans sank its stockholders and junior bondholders.

Another casualty of reckless lending was the African Bank.

Founded in 1999 by Leon Kirkinis in South Africa, it was the largest issuer of unsecured loans (no collateral) funded entirely through capital markets (no deposits). High rate loans were issued to sub-prime borrowers.

The bank minted money through the upswing in the economy. When defaults rose, the provisioning proved grossly inadequate. Last month, the bank failed. The stock and subordinated debt are now worthless.

Loan loss provisions based on the near-term experience – especially through the upswing of enormous credit expansion - is a ticking time-bomb.

Foreign bank loans into China are growing at almost 50% rate. Cross-border loans would become 15-20% of China’s GDP by the end of this year.

Analysts say – no risk. The central government has $4 trillion in reserves to cushion capital outflows. Or to protect the currency. Or to monetize internal bailouts. Or to finance local governments.

Take a look at the list of things $4 trillion is expected to protect against (end-2014 estimates):

    • $29 trillion of Chinese bank assets
      (equivalent to US, China & India GDP combined)

    • $6 trillion of shadow banking assets
      (equivalent to Germany & France GDP combined)

    • $2.6 trillion of foreign direct investments
      (equivalent to Brazil & Peru GDP combined)

    • $1.6 trillion of foreign bank loans
      (equivalent to Korea & Taiwan GDP combined)

    • $0.5 trillion of foreign portfolio investments
      (equivalent to Malaysia & Philippines combined)

    • $0.5 trillion of other foreign investments
      (equivalent to Thailand & Vietnam GDP combined)

    • Total $40 trillion
      (more than half of World GDP)

The bailout of any one part of the system is paid by another. The money has to come from somewhere. The force has to fall on something.

Taxpayers, investors and currency – those are the key shock absorbers.

Similar to China today, foreign lending into Japan surged during 1996-97, amid a slowdown in domestic bank lending. Private credit peaked in 1997 and by April that year, the Japanese financial sector was in full-blown crisis.

By the time the dust settled, everyone paid the price. Taxpayers funded bailouts were equivalent to 10-20% of the GDP. Shares of the major banks fell by 70%. The currency fell by a third.

Friends all invited
Along we dine
Blood red wine

Ends with a draw
Lucky name pays
Oh it's mine!

This write-up is for informational purpose only. It may contain inputs from other sources, but represents only the author’s views and opinions. It is not an offer or solicitation for any service or product. It should not be relied upon, used or construed as recommendation or advice. This report has been prepared in good faith. No representation is made as to the accuracy of the information it contains, nor any commitment to update it.