"Today, The Music Stops..."

Authored by Simon Black via SovereignMan.com,

Today’s the day.

After months of preparing financial markets for this news, the Federal Reserve is widely expected to announce that it will finally begin shrinking its $4.5 trillion balance sheet.

I know, that probably sound reeeeally boring. A bunch of central bankers talking about their balance sheet.

But it’s phenomenally important. And I’ll explain why-

When the Global Financial Crisis started in 2008, the Federal Reserve (along with just about every central bank in the world) took the unprecedented step of conjuring trillions of dollars out of thin air.

In the Fed’s case, it was roughly $3.5 trillion, about 25% of the size of the entire US economy at the time.

That’s a lot of money.

And after nearly a decade of this free money policy, there is more money in the financial system than ever before.

Economists have a measure for money supply called “M2”. And M2 is at a record high — nearly $9 trillion higher than at the start of the 2008 crisis.

Now, one might expect that, over time, as the population and economy grow, the amount of money in the system would increase.

But even on a per-capita basis, and relative to the size of US GDP, there is more money in the system than there has ever been, at least in the history of modern central banking.

And that has consequences.

One of those consequences is that asset prices have exploded.

Stocks are at all-time highs. Bonds are at all-time highs. Many property markets are at all-time highs. Even the prices of alternative assets like private equity and artwork are at all-time highs.

But isn’t that a good thing?

Well, let’s look at stocks as an example.

As investors, we trade our hard-earned savings for shares of a [hopefully] successful, well-managed business.

That’s what stocks represent– ownership interests in businesses. So investors are ultimately buying a share of a company’s net assets, profits, and free cash flow.

Here’s where it gets interesting.

Let’s look at Exxon Mobil…

In 2006, the last full year before the Federal Reserve started any monetary shenanigans, Exxon reported $365 billion in revenue, profit (net income) of nearly $40 billion and free cash flow (i.e. the money that’s available to pay out to shareholders) of $33.8 billion.

At the time, the company had $6.6 billion in debt.

Ten years later, Exxon’s full-year 2016 revenue was $226 billion, net income was $7.8 billion, free cash flow was $5.9 billion and the company had an unbelievable debt level of $28.9 billion.

In other words, compared to its performance in 2006, Exxon’s 2016 revenue dropped nearly 40%, due to the decline in oil prices.

Plus its profits and free cash flow collapsed by more than 80%. And debt skyrocketed by over 4x.

So what do you think happened to the stock price over this period?

It must have gone down, right? I mean… if investors are essentially paying for a share of the business’ profits, and those profits are 80% less, then the share of the business should also decline.

Except — that’s not what happened. Exxon’s stock price at the end of 2006 was around $75. By the end of 2016 it was around $90, 20% higher.

And it’s not just Exxon. This same curiosity fits to many of the largest companies in the world.

General Electric reported $13.9 billion in free cash flow in 2006. Last year’s free cash flow was NEGATIVE.

Plus, the company’s book value, i.e. its ‘net worth’, plummeted from $122 billion in 2006 to $77 billion in 2016.

So investors’ share of the free cash flow is essentially worthless, while their share of the net assets has also fallen dramatically.

GE’s stock was actually down slightly in 2016 compared to 2006. But the minor stock decline is nothing compared to the train wreck in the company’s financial statements.

Between 2006 and 2016, McDonalds reported only a tiny increase in revenue. And in terms of bottom line, McDonalds 2016’s profit was about 30% higher than it was in 2006.

McDonalds’ debt soared from $8.4 billion to $25.8. And the company’s book value, according to its own financial statements, dropped from $15.8 billion to NEGATIVE $2 billion.

So over ten years, McDonald’s saw a 30% increase in profits, but took on so much debt that they wiped out shareholders’ book value.

And yet the company’s stock price has TRIPLED.

Coca Cola. IBM. Johnson & Johnson.

Company after company, we can see businesses that are performing marginally better (or in some cases WORSE). They’ve taken on FAR more debt than ever before.

Yet their stock prices are insanely higher.

How is that even possible? Why are investors paying more money for shares of a business that isn’t much better than before?

There’s really only one explanation: there’s way too much money in the system.

All that money the Fed printed over the years has created an enormous bubble, pushing up the prices of assets to record highs even though their fundamental values haven’t really improved.

As the Wall Street Journal reported yesterday, “Financial assets across developed economies are more overvalued than at any other time in recent centuries,” i.e. at least since 1800.

Investors are paying far more than ever for their investments, but receiving only marginally more value in return. And they’re actually excited about it.

This doesn’t make sense. We don’t get excited to pay more and receive less at the grocery store.

But when underperforming assets fetch top dollar, people feel like they’re wealthier. Crazy.

Today the Fed should formally announce that after nearly a decade, it’s going to start vacuuming up a lot of that money it printed in 2008.

Bottom line: they’re going to start cutting the lights and turning off the music.

And given the enormous impact that this policy had on asset prices, it would be foolish to think its reversal will be consequence-free.

Do you have a Plan B?

"They Dodged A Bullet": Why Insurer Stocks Are Soaring

After tumbling last week on concerns that between damage from Harvey and Irma, losses for the P&C space would be devastating, today the broader insurer space is breathing a sigh of relief after the Hurricane"s damage reportedly underwhelmed, especially following some especially dire observations over the weekend from the likes of Torsten Jeworrek, member of the board of the German reinsurance giant Munich Re, who on Sunday said that Hurricane Irma is proving to be a “major event” for Florida and the insurance industry.

As Reuters reported yesterday, Jeworrek and other insurance executives gathered in Monaco for an annual conference to haggle over reinsurance prices and strike underwriting deals. And even though Irma eventually skirted densely populated Miami, the Munich Re board member said that “Irma is still a major event for Florida and also a major event for the insurance industry.”  When asked by journalists, Jeworrek also hazarded a rough guess for the insured losses for the global industry of Hurricane Harvey: he said that losses were estimated at between $20 billion and $30 billion, which would put the storm on a scale of Sandy.

That number will likely prove to be overly optimistic, because as Goldman showed yesterday, many estimates of Harvey damages rose sharply during the first week after landfall; however, most have now settled in the $70-100bn range (Goldman itself assumes $85bn). While the uncertainty around these figures remains high, it seems clear that Harvey’s aftermath will be particularly severe. 

So with Harvey more or less quantified, the question then is what will Irma"s damage be? And it is here that some initial commentary from Credit Suisse explains (and may have sparked) a broad rally across the insurer sector.

In an overnight note from CS" Ryan Tunis, the Swiss bank analyst writes that even as Hurricane Irma barrels up Florida’s Gulf coast, "insured losses are now expected to be less than many feared with modeling agencies in general agreement of a sub $60b number."

As a result, Credit Suisse"s takeaway is that while Irma may be costly to reinsurer book values, the hurricane alone should not trigger the need for additional capital, and further expects tangible book value hits below 15% from Irma and Harvey combined. Of course, Tunis concedes that the capital raise conversation would likely be more pertinent should there be a "next catastrophe this year" or even another bad wind season in 2018. While projections for Hurricane Jose aren’t showing anywhere close to the amount of landfall risk that Irma had, but there are still a few projections of a potential threat to the US Northeast.

The key thing that saved insurers, however, and which resulted in lower insured losses is the last minute western shift in Irma’s FL path:

As destructive as Irma"s path continues to be, we think that the path up the west coast of Florida is better from an insured loss standpoint than projections from mid last week and even Friday that involved a more direct hit of Miami. As of 5pm today (Sunday), the storm seems to have weakened to a cat 2 as it has moved over Fort Myers, FL. AIR Worldwide estimates that there is $1 trillion of coastal exposure along west coast up to Tampa, 30% less than the $1.5 trillion of coastal exposure in the Miami Tri-County area. A west coast landfall should also bring more of the insured loss burden onto the personal lines companies. For a Miami-Dade hit, Lloyds industry losses assume 49% are from residential property and 49% from commercial property (rest auto and marine). For the Pinellas county (next to Tampa), residential property losses make up 70% of losses, while commercial property are 29% of losses.

Another question: how much flood is privately insured? According to Credit Suisse, it"s unclear at this point what portion of the damage will be caused by storm surge flooding versus wind, but Tunis believes that it"s a higher percentage than what the market was expecting on Friday.

"The private insurance industry should be far less exposed to flood damage than wind, especially on the commercial side where we understand that private flood insurance is either rarely offered or heavily sublimited, which we would think would be even more true in flood prone spots. The vulnerability to storm surge to Fort Myers, Tampa and St. Petersberg has also been very well understood by the cat modeling services (Karen Clark cited Tampa as #1 most vulnerable city to storm surge in 2005).

In this context, one of the debates in the coming weeks will center around how much of the homeowners flood damage is privately insured, especially since private flood insurance losses from Irma are likely to exceed that of Harvey.

We understand that though standard home policies do not include flood insurance, high net worth home policies are often inclusive of flood protection. Because of the high insured values of homes in FL (see Figure 1), there are more homes with high net worth home policies which could include private flood insurance.

Once the policyholder goes to the higher net insured value policy market – and we fear that many may in this case given high average property values of affected areas – we understand that policyholders have the option to purchase flood insurance. We have heard estimates that 50% of high net worth policy homes buy private flood insurance. Companies that may be exposed to this include AIG, CB, and Pure.

What about reinsurers? It is here that much of the hit will likely be, as Barclays warned two weeks ago:

[T]he reinsurers will be on the hook for the vast majority of privately insured losses. The most recent RMS report (Sunday afternoon) indicated that there is a 90% chance that the insured wind loss will be less than $60b which is down from the figure estimated Friday of 90% chance of sub $75b losses. That number does not include insured loss damage from flooding, the $10-15b of Irma damage in the Caribbean, business interruption losses in commercial insurance, or post event loss amplification issues such as demand surge. Offsetting this is our understanding that the Florida hurricane catastrophe fund (FHCF) may pay out around $15b of the total in a $40-60b loss scenario.

Putting these revised estimates in context, Credit Suisse writes that at this point, this does not appear to be a 1-in-100 Atlantic Hurricane event.

As a result, we are comfortable using company disclosed 1-in-100 year average loss disclosures as a worst case ceiling for individual company loss estimates. This number for the reinsurers (1-in-100 year US wind PMLs) appears to be 5-10% of tangible equity. If we assume 2-3% book value hits from Harvey, then this implies 7-13% hits to book value from both hurricanes. Reinsurers are believed to be relatively unscathed from Harvey, but one other incremental negative data point from this weekend was a new RMS estimate for Harvey losses which implies $18-25b of privately insured losses Harvey, which may be 30% higher than preliminary estimates perhaps leaving reinsurers more vulnerable.

What this means for insurers is basically good news, as today"s stock price reaction confirms:

As we have noted, net exposures should be relatively limited for PGR, ALL, TRV and HIG either through avoidance of Florida property or heavy reinsurance purchase, which is still the case. The path of the storm and expected storm surge does bring a higher level auto losses into play, though likely not at the scope of Harvey with plenty of advanced warning for all Florida residents and businesses. Katrina may be the best comparison at this point, which resulted in $2.8b of industry auto losses in today"s dollars and around $328mm for PGR. PGR reported $258.5mm ($328mm in today"s dollar) of personal auto from Katrina, Rita, and Wilma. ALL reported $283mm ($359mm in today"s dollars) of personal auto losses from Katrina, Rita, and Wilma. For ALL, the auto losses were about 8% of total Katrina losses. We note that PGR and ALL have 14%/10% market share of Florida auto physical damage (See Figure 4). PGR also has 16% of the commercial auto market in Florida.

* * *

Finally, adding fuel to the P&C surge was a similar analysis by Citi, according to which the cost of Hurricane Irma-related total estimated losses has been slashed to $50BN from $150BN.

"While the hurricane season is only half way through, so that number could increase but, for now, P&C insurers and reinsurers have dodged a bullet" Citi analyst James Naklicki wrote. As a result, Citi projects U.S. insured loses of $20 billion. Furthermore, citi also expects less selling pressure on reinsurers as the risk of capital raising eases, and remains overweight Travelers and Chubb; underweight Axis, RenRe and XL, while upgrading Axis Capital Holdings to Neutral from Sell.

End result: a surge in insurer stocks, more than undoing all of last week"s Irma-related losses.

China's Minsky Moment Is Imminent

Authored by Kevin Smith, Tavi Costa, and Nils Jensen via Crescat Capital,

Crescat Capital"s Q2 letter to investors shouold be retitled "everything you wanted to know about the looming bursting of the world"s biggest credit bubble... but were afraid to ask..." Don"t say we didn"t warn you...

History has proven that credit bubbles always burst. China by far is the biggest credit bubble in the world today. We layout the proof herein. There are many indicators signaling that the bursting of the China credit bubble is imminent, which we also enumerate. The bursting of the China credit bubble poses tremendous risk of global contagion because it coincides with record valuations for equities, real estate, and risky credit around the world.

The Bank for International Settlements (BIS) has identified an important warning signal to identify credit bubbles that are poised to trigger a banking crisis across different countries: Unsustainable credit growth relative to gross domestic product (GDP) in the household and (non-financial) corporate sector. Three large (G-20) countries are flashing warning signals today for impending banking crises based on such imbalances: China, Canada, and Australia.

The three credit bubbles shown in the chart above are connected. Canada and Australia export raw materials to China and have been part of China’s excessive housing and infrastructure expansion over the last two decades. In turn, these countries have been significant recipients of capital inflows from Chinese real estate speculators that have contributed to Canadian and Australian housing bubbles. In all three countries, domestic credit-to-GDP expansion financed by banks has created asset bubbles in self-reinforcing but unsustainable fashion.

Post the 2008 global financial crisis, the world’s central bankers have kept interest rates low and delivered just the right amount of quantitative easing in aggregate to levitate global debt, equity, and real estate valuations to the highest they have ever been relative to income. Across all sectors of the world economy: household, corporate, government, and financial, the world’s aggregate debt relative to its collective GDP (gross world product) is the highest it has ever been. Central banks have pumped up the valuation of equities too. The S&P 500 has a cyclically adjusted P/E of almost 30 versus a median of 16, exceeded only in 1929 and the 2000 tech bubble.

The US markets are also in a valuation bubble because US-owned financial assets have never been more richly valued relative to income as we show below. The picture is equally frothy if we include real estate, also at record valuations to income. China’s capital outflow spillover from its credit bubble has driven up real estate valuations around the world.

The unique aspect of the current global credit bubble is that China has emerged at its epicenter. Since 2008, China has created the world’s largest M2 money supply, the world’s largest and most grossly mismarked banking assets, the largest global trade with the rest of the world, the second-largest GDP, and the world’s largest credit-to-GDP imbalances.

Based on our studies of past financial crises, forecasting credit bubbles that are ready to burst with a high probability requires a combination of two key macro indicators that have been proven out across different countries and across time:

1. A high absolute level of debt to GDP relative to history


2. A high recent debt-to-GDP growth relative to long-term trend, what the BIS refers to as the “credit-to-GDP gap”. The credit-to-GDP gap flashes a warning signal of a potential banking crisis when credit growth rises more than 10% above its long-term trend.

The chart below shows thirteen countries with significant credit imbalances based on one or both measures. Note that at least ten of the countries have significant trade and capital flow links with China.

The first panel in the chart above shows seven countries including China that have historically high household and corporate debt compared to GDP, our first indicator.

The second panel shows the top-ten countries today with the highest credit-to-GDP gaps according the BIS, our second indicator.

Note that six of the credit-to-GDP gap countries are in Asia.

They include China and five related “Asian tiger” economies. Hong Kong has both the highest outright debt-to-GDP and the highest credit-to-GDP gap of all countries tracked by the BIS today. Hong Kong is not even technically its own country. It is part of China under a “one country, two systems” concept. One is Chile, the world’s largest copper producer and copper exporter to China. Four countries overlap on both indicators: Hong Kong, China, Canada, and Singapore.

What the chart above emphasizes is that not only is China in a credit bubble that is poised to burst, it is linked to many other countries through trade and capital flows that also have large credit imbalances making the China bubble even more significant. The nexus of China with these other credit bubbles is just one of the reasons that we believe China is ground zero for a pending financial crisis that will have global repercussions.

Using the “credit-to-GDP gap” to flag likely credit busts is based on the work of economist Hyman Minsky, an academic whose career focused on studying the causes of financial crises. Minsky’s models were posthumously credited with predicting the global financial crisis and adopted by the BIS. Minsky’s “financial-instability hypothesis” essentially postulates that long stretches of prosperity sow the seeds of the next financial crisis. A long stretch of prosperity was certainly the case with China over the last 25 years as shown in the chart below. China’s share of global GDP grew from less than 2% in the early 1990s to almost 15% today. China even accelerated its growth rate in the wake of the global financial crisis in 2008. Since then, China has been the largest GDP growth economy in the world accounting for 54% of global GDP growth.

The problem is that long stretches of prosperity tend to be delivered with increasingly speculative leverage and unproductive investment activity. The China growth story is not likely a miracle of communist government central planning; it’s a massive credit bubble, almost certainly the largest ever. China’s impressive growth has come overwhelmingly and almost exclusively from unsustainable credit expansion combined with extensive, largely unprofitable domestic infrastructure expansion. In the last two decades, China has seen the largest construction boom in any country ever. The construction boom can be seen in the chart below by looking at the portion of China’s GDP that has gone into fixed asset investment which has grown almost every year since 2000 from 23% of GDP to 87% of GDP in 2016.

We believe this has been a centrally planned misallocation of capital into white elephant, unproductive fixed-asset infrastructure projects that on balance will likely not ever generate sufficient return on investment to justify their cost. The penalty will come from China’s future economic growth.

A recent study by University of Oxford, Saïd Business School published in the Oxford Review of Economic Policy finds that China’s low-quality infrastructure investments pose significant risks to the Chinese and the global economy. The study headed by Atif Ansar analyzed 95 large Chinese road and rail transport projects in China. The evidence suggested that for over half of the infrastructure investments in China made in the last three decades, the costs were larger than the benefits they generated, which means the projects destroyed economic value.

Dr. Ansar and his colleagues concluded that investing in unproductive projects results in a boom only while construction is ongoing. The boom turns to bust when forecasted benefits fail to materialize and the projects become a drag on the economy. Because of the large build-up of debt associated with past projects, they warn that there is a strong probability that China is headed for an infrastructure-led national financial and economic crisis that will likely also be a crisis for the international economy.

A study of our own shows similar findings. In the left-hand panel of the chart below, we show the aggregate free cash flow profitability of all listed Chinese non-financial companies. It has been persistently and cumulatively negative since 2001 while aggregate debt has skyrocketed. The data clearly show that the debt and infrastructure expansion economic model for China has had more costs than benefits over the last 16 years for the whole of Chinese public non-financial companies. Look at the aggregate cumulative free cash flow of the more fundamentally sound non-financial companies of the S&P 500 over the same period in the right-hand panel. Note the stark contrast.

The Chinese local government sector has piled up a similar amount of debt compared to China’s listed corporates in supporting China’s poor returning infrastructure projects.

Michal Pettis a professor of finance at Guanghua School of Management at Peking University in Beijing explains the problem with China’s economic model:

“In a market economy, investment must create enough additional productive capacity to justify the expenditure. If it doesn"t, it must be written down to its true economic value. This is why GDP is a reasonable proxy in a market economy for the value of goods and services produced. But in a command economy, investment can be driven by factors other than the need to increase productivity, such as boosting employment or local tax revenue. What"s more, loss-making investments can be carried for decades before they"re amortized, and insolvency can be ignored. This means that GDP growth can overstate value creation for decades.”

The insolvency problem has already been building up for decades in China. It can’t go on forever, because it has led to a massive credit bubble that is doomed to burst. When a country piles more and more credit onto a faulty underlying economic model, it becomes a Ponzi finance scheme that has no other possible outcome but to implode on itself.
According to Minsky, there are three possible credit regimes in an economy:

1. Hedge Financing. Households and firms rely on future cash flows to repay principal and interest on their borrowings.


2. Speculative Financing. Borrowers rely on cash flow but can afford to repay only interest.


3. Ponzi Financing. Cash flows neither cover principal nor interest. Debt can only be serviced with the addition of new borrowing.

In a Ponzi-financed economy, lenders lend more and borrowers borrow more based on the greater fool theory, the idea that asset prices will keep rising. It all works in upward spiraling, self-reinforcing fashion until it simply cannot go on any longer and then asset prices suddenly drop, to the surprise of the vast majority, and then there is a self-reinforcing unwinding of the bubble, a financial crisis. The onset of the crisis is marked by a grab for liquidity, freezing credit markets, and a collective rush for the exits. This is what has come to be known as the “Minsky moment”. The initial asset-price downturn is usually sharp, but it can also be protracted. The downward impact to future GDP growth can be especially prolonged after a credit bust as the experience of Japan’s lost two decades shows.

In our analysis, the Chinese economy today is a classic Ponzi finance regime as described by Minsky and has been so in an egregious way since 2008. At the center of China’s credit bubble is its massive and opaque financial sector. The China Banking Regulatory Commission reports that the Chinese banking system had USD 35 trillion in on-balance-sheet banking assets through the first quarter of 2017. This is an incredible more-than-fourfold bank-credit expansion since 2008 as we show in the chart below. As a result, based on the ratio of on-balance-sheet banking assets to GDP, China’s banking bubble today is more than three times larger than the US banking bubble prior to the global financial crisis!

Just as alarming as China’s on-balance-sheet banking assets are China’s shadow banking assets. The British newspaper, The Daily Telegraph, recently broke a story based on an apparent leak of the People’s Bank of China’s 2017 Annual Financial Stability Report completed in June. The PBOC report allegedly showed that off-balance sheet banking assets in China have risen to somewhere between USD 30 and 40 trillion recently. These figures have yet to be confirmed or denied because the actual PBOC report has apparently been concealed by the PBOC and the IMF. Including both on-balance sheet and shadow bank assets shown below, the Telegraph story claims that “Chinese banks have built up exposure to assets equal to 650% of GDP”. The amount of shadow banking assets in China had been more widely recognized before the PBOC report to be only USD 9 trillion. If the amount that China’s off-balance sheet banking assets have risen to even half as much as the Telegraph reported – see the chart below (about USD 37 trillion is what it shows) – China would have recently had a shadow-banking gap that is even more concerning than the credit-to-GDP gap flagged by the BIS.

The reason that China’s shadow bank asset growth is a concern is that these assets have long been regarded by credible analysts, bankers, and regulators as China’s least liquid and poorest quality loans. In many cases, these are non-performing loans once held on bank balance sheets that have been rolled over, taken off balance sheet, and newly funded through wealth management products (WMPs) and other shadow banking vehicles for the banks’ off-balance-sheet activities. WMPs are such big business that the Chinese tech juggernauts have gotten in on the game including Alibaba’s subsidiary, Ant Financial, Tencent, Bidu, and JD.com. In our analysis, these companies, wittingly or not, through their “fintech” businesses, have become a central part of China’s grand Ponzi financing scheme. They have built the platforms for Chinese depositors to easily buy WMPs on their smart phones and indeed Chinese depositors are doing just that. It makes sense that shadow credit is exploding. The problem is that the idea of funding China’s rapidly growing long-term, illiquid, and heavily non-performing assets with rapidly growing short-term, liquid liabilities, all facilitated by the banks and tech companies, and all kept off balance sheet, is a formula for a systemic banking crisis.

One of the reasons shadow banking assets have been exploding in the last several years is the moral hazard associated with them. There is an implicit assumption in China, but not an explicit guarantee, that the banks and ultimately the Chinese government will make good on shadow-bank deposits in the event of a financial crisis. The problem is that such a moral hazard is what will almost certainly guarantee the crisis.

Minsky said an extraordinary acceleration in credit would be needed just to maintain a constant growth rate during the late stages of a credit bubble, just before the bust. The idea of monitoring the credit-to-GDP gap, and why the Telegraph estimates for shadow banking growth would be a strong crisis warning signal even at half the amount, is that credit growth naturally accelerates as the “Minsky moment” is arriving in a Ponzi finance-style banking system. Therefore, if China really were on the last legs of its real GDP expansion, before the bust were to kick in, it would make perfect sense that it would need rapidly accelerating credit growth to eke out any sort of positive real GDP growth at all. In a Ponzi finance-styled economy, the scheme goes on until it goes bust because that is the model they have committed to. Only the bust can force a change.

Chinese leaders have likely been implicitly sanctioning the acceleration of credit growth this year in their shadow banking markets to keep growth going at all costs even while publicly admonishing it ahead of the 19th National Party Congress (NPC) in November. Over the past several weeks, we have been hearing over and over that the Chinese leaders will not let the bubble burst before the NPC in November. Such is the conventional wisdom on Wall Street today. The takeaway for us is that Wall Street is finally acknowledging that China is indeed in a massive credit bubble. Before, during, or after the NPC, the timing of the bursting of the Chinese currency and credit bubble is imminent in our view. We believe it is prudent to be positioned ahead of the NPC and ahead of everyone else who tries to scramble for the exits after it is too late. We want to be shepherds not sheep. Like in the Big Short, sure, there can be some short-term pain in being early, but it was the early players who stuck it out and had the foresight and strength of their conviction who ultimately reaped the big rewards for their investors. We believe being early is the way to reap the big rewards on the China bust. We believe the bust is coming soon.

The China credit bubble already started to burst in late 2015 and early 2016 and Crescat capitalized extremely well during this period as we showed in our last quarterly letter while markets and most other managers were down. We believe that is a foreshadowing what is still to come on a bigger scale. The China equity bubble already peaked in 2015 as can be seen in the four Chinese stock market indices in the chart below. The chart also shows based on the aggregate revenue fundamentals of all Chinese companies, which appear to be now in the third year of revenue recession, that China’s GDP has very likely has been overstated recently and that its economy is under much more stress than most global investors realize. In other words, the huge non-performing debt and loss-making company problem has likely only been getting worse as debt has been exploding recently.

Chinese equities still have much further down to go down in our strong opinion based on still-excessive valuations as we show further below. The banking crisis has not even happened yet in terms of losses being recognized through earnings charges and book value write-downs. Bad debt has been building up behind the scenes for two decades since the last banking recapitalization. Bank earnings are vastly overstated. By rolling over non-performing loans facilitated by new short-term credit, such as WMPs, banks have continued to report strong earnings and appear cheap. This is not much different than how US banks looked in 2007 before all hell broke loose. The difference is that Chinese banks are much bigger and likely much more insolvent.

If one wants to understand how big China’s overall financial sector bubble is today, relative to the overall China equity market, just look at the financial sector weight in the major Chinese and Hong Kong Indices: 36% of the Shanghai Composite; 43% of the CSI 300; 44% of the Hang Seng Index. Financials only make up 25% of the China MSCI Index because 28% of that one is crowded out by two tech stocks, Tencent and Alibaba, each priced at a frothy 11x EV/Sales. The indices in our table below that appear cheap on P/E are heavily overweighed in the highly leveraged financial sector. The E in the P/E of Chinese banks and other financials is simply not credible. Neither is the book value. Many global investors today are being fooled by this huge value trap. China’s technology–laden indices, Shenzhen and ChiNext, are also overvalued. Our table shows them with negative median free cash flow and massive P/Es. Chinese equities are overvalued across the board and offer excellent short opportunities today.

The Chinese currency is also highly overvalued and headed for a crisis as we explain further below. By shorting overvalued Chinese equities through US ETFs and ADRs, one also gets the bonus of the yuan currency short imbedded in the trade. By shorting ultra-frothy Chinese fintech stocks, including through US ADRs, one also gets exposure to China’s coming shadow banking meltdown.

The China currency and credit bubble has only gotten bigger since early 2016. The big credit bust is still ahead of us, in our strong opinion. The bust in some form will be triggered by bank runs from the masses of Chinese depositors when they learn that they are the ones holding the bag with respect to China’s insolvent banking system. We believe this is why the Chinese currency has already been under so much pressure already from capital outflows. It is pressure from the Chinese trying to get their money out of the banking system. The capital outflows to date have likely been less from the masses and more from wealthy Chinese elites who have seen the writing on the wall for some time already. Like money that fled the Soviet Union and Russia prior to and during its two big currency crises in the 1990s, that money is probably never coming back. The masses within China are the ones buying WMPs on their smartphones.

When the outflow pressure shifts from the elites to the masses of domestic bank and shadow-bank depositors, there is high risk of bank runs and social unrest. When this threat becomes all too real and begins to transpire, in our analysis, that is when Chinese authorities will be left with no other viable option than to resort to massive quantitative easing to bail-out and recapitalize their banks and re-stimulate their economy. That is when the insolvency problem in the Chinese banking system will have to be addressed, one way or another, and if China has true ambitions to transition from an emerging market to a developed economy, it will have to come clean on its NPLs. QE is therefore the only implicit guarantee that Chinese depositors should be relying on, but QE does not prevent a crisis; it will likely only coincide with the crisis.

So how much money will China have to print to recapitalize its banking system? Let’s be conservative and say that China’s non-performing loans are only half as bad as they were when it recapitalized its banks in the early 2000s. China ultimately confessed that 40% of its banking assets were non-performing loans that had built up in the wake of the 1997 Asian Financial Crisis. Let’s say it is only 20% today. It is probably more. Let’s also assume the most conservative estimates for shadow bank assets of USD 9 trillion. Along with USD 35 trillion of on-balance sheet assets (the Telegraph article says it is now $38 million), our conservative estimate equates to USD 8.8 trillion of loans in the Chinese banking system today that will effectively never be repaid and will need to be written off. Such an amount is equal to 84% of China’s GDP, more than enough to wipe out all the equity in its Chinese banking system twice over. If the banks were to write that debt down and recapitalize the banks with money printing, it would equate to 37% of its M2 money supply, all else equal a 37% currency devaluation. This is our best-case scenario for the inevitable devaluation of the China currency. It will likely be worse.

The 1997 Asian Currency Crisis provides several mid-case scenarios for what we should expect from the coming Chinese yuan devaluation. In the second half of 1997, four Asian Tigers came off extensive credit bubbles that had been building over a prolonged period including Thailand, South Korea, Malaysia, and Indonesia. In the bust, their currencies all declined between 47% and 85% within six months. Another mid-case comparable would be post-Soviet Russia where in Russian financial crisis of August of 1998, the ruble crashed 70% in one month. For the worst case scenario, the comparable is China’s former communist neighbor, the Soviet Union. The Soviet ruble was essentially a 100% wipeout, a zero though hyperinflation after the Soviet Union breakup the early 1990s.

One key signal that the China’s credit bubble is about to burst is housing prices in China’s Tier 1 and Tier 2 cities. Home prices in Tier 1 and Tier 2 cities reflect one of the biggest asset bubbles in China to go along with its massive credit expansion. Real estate prices have been soaring for many years led by Tier 1 cities such as Beijing and Shanghai. Rent yields in Beijing recently hit a new low of about 1.25% an insanely high price-to-rent multiple of 80 times. As part of China’s massive infrastructure buildout, there is an oversupply in housing. As shown in the chart below, price appreciation in Tier 1 cities has been decelerating for over a year. Prices may have turned negative in July in Beijing and Shanghai according to local sources. If true, this is just one of many sings that we have laid out herein that China’s Minsky moment is imminent.

Another new catalyst that is heating up right now is the possibility of President Trump imposing trade sanctions on China for “unfair trade practices” to punish them for not taking a tougher stance on North Korea also perhaps to fulfill a campaign promise.

Demographic trends are another key catalyst that point to clear bursting of the China bubble soon.

The idea here as shown in the chart above is that China’s working age population will peak next year.

The idea behind Minsky’s work is that it is the unsustainability of the credit bubble itself that is the catalyst for its implosion, but there are also many specific catalysts that have identified to justify our conviction that China bubble is going to burst soon. We have discussed many of them herein particularly related to China’s “credit gap”. In our last quarterly letter, we showed why Federal Reserve tightening credit late in the business/economic cycle is a significant catalyst to accelerate the bursting of the China bubble.

Here we enumerate the catalysts for the imminent bursting of the Chinese currency and credit bubble discussed herein and in our other work:

1. Fed credit tightening puts pressure on Chinese currency

2. China and Hong Kong is now flashing a banking crisis warning signal in BIS “credit-to-GDP gap” model

3. China’s connections to other countries also flashing warning signals of credit bubbles about to burst

4. Pressure from Chinese capital outflows

5. Threat of bank runs from Chinese masses

6. Housing prices on precipice of drop in China Tier 1 and Tier 2 cities from record price-to-rent levels and supply/demand imbalance

7. Ongoing poor and deteriorating fundamentals of China’s non-financial listed companies linked to unsustainable infrastructure investment binge

8. Dwindling, encumbered, and likely overstated foreign reserves

9. Imminent threat of US trade sanctions on China

10. Looming cresting of China’s workforce population

11. China credit bust already started to unfold in 2015, an early warning signal, but just a taste of what is to come, because the credit imbalances have only become more extreme

12. Widespread Wall Street complacency ahead of China NPC political elections in November

Bubble Update: Stocks Are Now at 1999 Bubble Levels (Guess What's Next)

Remember the 2007 Bubble?

Remember how everyone said that it really wasn’t that big of a bubble because stocks weren’t as expensive as they had been during the previous bubble (the Tech Bubble).

We all remember how that turned out: the bubble burst leading to the greatest financial crisis in 80 years.

Well, today’s bubble is WAY larger than that of 2007. And arguing that stocks are cheaper than they were during the Tech Bubble doesn’t hold water anymore either.

Below is a chart showing the S&P 500’s Price to Sales ratio (also called the P/S ratio). As you can see, based on this metric, the 2007 Bubble is a mere blip. We’re now in territory not seen since the 1999-2000 Bubble.

H/T Jeroen Blokland

Why does this matter?

Earnings, cash flow, and book value are all financial data points that can be massaged via a variety of gimmicks. As a result of this, valuing stocks based on Price to Earnings, Price to Cash Flow, and Price to Book Value can often lead to inaccurate valuations.

Sales on the other hand are all but impossible to gimmick. Either money came in the door, or it didn’t And, if a company is caught faking its sales numbers, someone is going to jail.

So the fact that stocks are now trading at a P/S ratio that matches the Tech Bubble (the single largest stock bubble in history) tells us that we’re truly trading at astronomical levels: levels associated with staggering levels of excess.

What does that mean for stocks?

We"re going to have the 3rd and worst crisis in 20 years.

A Crash is coming…

And smart investors will use it to make literal fortunes.

We offer a FREE investment report outlining when the market will collapse as well as what investments will pay out massive returns to investors when this happens. It"s called Stock Market Crash Survival Guide.

We made 1,000 copies to the general public.

Today is the last day this report will be made available to the public.

To pick up one of the last remaining copies…

CLICK HERE!

Best Regards

Graham Summers

Chief Market Strategist

Phoenix Capital Research

And The Best Performing Stocks In The World This Year Are...

Nigerian Banks!

"No Brainer" US bank stocks languish unchanged in 2017 and even the unstoppable FANG stocks are lagging badly behind Nigerian banks.

It appears all those emails from Nigerian princes are paying off?

Or, as Bloomberg notes, since the Nigerian central bank eased a dollar shortage by opening a currency-trading window for foreign investors in April, lenders in Africa’s biggest economy have soared.

The local banking index is up 35 percent this quarter, outstripping South Africa’s equivalent stock gauge and MSCI’s emerging-market financials index. Even after the jump, Guaranty Trust Bank is the sole Nigerian lender in the index to trade above its book value, while none of the six members of the South African index trade below that level.

Some Of The Funds Losing Billions In Puerto Rico's Historic Bankruptcy

In the aftermath of Puerto Rico"s historic bankruptcy, a clearer picture of losses accrued by U.S. mutual funds on their holdings of Puerto Rican debt is beginning to emerge: the WSJ has calculated the red ink at as much as $5.4 billion over the last five years on total holdings of $14.6 billion.  Wall Street"s paper of record lists the funds who have piled up losses, both realized and unrealized, on the trade. These include: Franklin Resources, Oppenheimer, Vanguard, Goldman Sachs Asset Management, Western, Lord, Abbett, AllianceBernstein and Dreyfus.

Of these, Franklin and Oppenheimer are the biggest losers, according to Morningstar data cited by the Journal. Oppenheimer has lost as much as $2.1 billion, and Franklin as much as $1.6 billion. That"s compared with AUMs of $230 billion and $741 billion, respectively.

Meanwhile, six other fund families managed by Vanguard, Goldman, Western Asset, Lord Abbett, AllianceBernstein Holding and Dreyfus have racked up between $100 million and $200 million in losses each.

Of course, in the grand scheme of the funds" AUMs, the losses so far are negligible, so before retail investors assume that Meredith Whitney"s prediction is finally coming true, resulting in another muni fund panic, it is worth recalling that all these funds have at least $100 billion each in muni-bond assets under management.  Furthermore, these investors are likely in better shape than some of their hedge fund colleagues as the damage done to mutual funds, and by extension the retirees and middle-class savers to which they cater, will be an important factor in the court-mandated restructuring of the island"s debt, which begins Wednesday with a hearing in San Juan.

As a reminder, earlier this month, the island"s governing body petitioned for - and its federal oversight board approved - its own version of bankruptcy protection under Title III of a rescue law passed by Congress late last year. 

The mutual funds will have a greater incentive to agitate for maximum recovery especially since they purchased debt closer to par values.  Mutual funds were the most heavily invested in Puerto Rican debt, tempted by attractive yields - 8% at the last issuance of GOs in 2014 - along with an exemption from federal taxes.

* * *

Meanwhile, Bloomberg reports that as the island"s restructuring progresses, creditors of Puerto Rico"s insolvent government development bank today agreed to accept losses by exchanging their bonds for new securities, moving the island another step toward restructuring its crushing debt load. Under the agreement, bondholders would exchange their debts at 55 percent, 60 percent or 75 percent of face value, depending on whether they elected to receive higher interest payments or the prospect of a greater recovery through debt with less legal claim to the bank’s cash, according to terms disclosed in a bond filing.

The deal comes less than two weeks after Puerto Rico initiated bankruptcy-like proceedings, giving it power to have debts dismissed in U.S. court if creditors don’t voluntarily agree to accept less than they’re owed. Puerto Rico has already reached a similar agreement with creditors of the government electric company and officials have said they intend to continue negotiating with investors.

"This agreement is an example that the government is regaining the credibility it had lost over the past few years,” Rossello said. “We are satisfied with this agreement.”

Debt could be issued for first-lien bonds at 55 percent of par with 7.5 percent coupons, or 60 percent of par with 5.5 percent coupons. Those electing for subordinate bonds would get 75 percent of par and coupons of 3.5 percent. New issuer will receive assets of GDB, with a book value of $5.3 billion.

Despite the enforced bondholder haircuts, the agreement would allow creditors to recoup more of their investment than current trading prices suggest. Government Development Bank bonds due in August traded Monday for an average of 24.3 cents on the dollar.

The negotiation has a long way to go: Governor Ricardo Rossello said at a press conference Monday that 45% of bondholders have so far consented to the restructuring. Under the federal emergency rescue law that allows for Puerto Rico to legally cut its debts, any voluntary agreement must be approved by a two-thirds vote of bondholders.

Today"s deal included the so-called ad hoc group, comprised mostly of hedge funds managed by Avenue Capital Management, Brigade Capital Management, Fir Tree Partners and Solus Alternative Asset Management, as well as local bondholders.

And speaking of hedge funds, as we documented previously, here"s a rundown of the other biggest losers, which include a handful of hedge funds and bond insurers - not to mention the Puerto Rican people, about half of whom live in poverty and will likely be forced to cope with cuts to basic services mandated by an austerity regime not unlike those seen across Europe.

• General Obligation bondholders include: Aurelius Capital Management, Autonomy Capital and Monarch Alternative Capital LP,


• Sales tax revenue-backed (Cofinas) bondholders: Scoggin Capital Management, GoldenTree Asset Management, Merced Capital, Tilden Park and Whitebox Advisors have held Cofinas.


• Bonds insurers: roughly $12 billion of the island’s $70 billion in outstanding debt is insured. It will be up to the bond insurers to fill the gap when interest and maturity payments are missed. Insurers backed a wide swath of bonds from Puerto Rico, complicating the island’s ability to prioritize payments. Among the companies with the biggest exposure to Puerto Rico debt include Ambac Financial Group, National Public Finance Guarantee Corporation, Assured Guaranty Ltd. and Financial Guaranty Insurance Company.

PR"s constitution requires the government to pay back GO bondholders in full, and the island has already offered a restructuring that favored GO bonds, over COFINAs, which are backed by tax revenue. However, other recent municipal bankruptcy cases have seen GO investors accept huge losses, according to data from Moody"s Investors Service.

• In Harrisburg, Pennsylvania, bondholders took a 25 cents on the dollar haircut


• In Stockton, California, the haircut was 50 percent.


• In Detroit, where pensioners suffered losses of about 18 percent, bondholders were slapped with a 75% haircut, taking home just 25 cents on the dollar.

Despite this, Moody"s rates PR"s GO and COFINA debt on equal footing, forecasting holders of both securities will recoup between 65 and 80 cents on the dollar, higher than the less than 35 cents expected for holders of debt from Puerto Rican agencies like the Government Development Bank.

With much left undecided, it"s pointless at this stage to anticipate how long this case may take, and what any final settlement might look like; nobody can say for sure whether the courts will find that they have the legal authority to issue a ruling. At some point, the Supreme Court may need to make a ruling.

Stock investors, for one, appear to be biding their time: While Detroit"s decision to file for bankruptcy back in 2013 shook markets, the Puerto Rican newsflow has barely registered outside of muniland.

Doug Casey Warns, The EU's Collapse Is Now "Imminent"

Authored by Nick Giambruno via InternationalMan.com,

On April 23, French voters could drive the entire European Union into its grave.

Doug Casey and I recently discussed this historic election—and why it matters to US investors.

Nick Giambruno: Doug, you predicted the fall of the European Union a few years ago. What has changed since then?

Doug Casey: Well, what"s changed is that the entire situation has gotten much worse. The inevitable has now become the imminent.

The European Union evolved, devolved actually, from basically a free trade pact among a few countries to a giant, dysfunctional, overreaching bureaucracy. Free trade is an excellent idea. However, you don"t need to legislate free trade; that’s almost a contradiction in terms. A free trade pact between different governments is unnecessary for free trade. An individual country interested in prosperity and freedom only needs to eliminate all import and export duties, and all import and export quotas. When a country has duties or quotas, it’s essentially putting itself under embargo, shooting its economy in the foot. Businesses should trade with whomever they want for their own advantage.

But that wasn"t the way the Europeans did it. The Eurocrats, instead, created a treaty the size of a New York telephone book, regulating everything. This is the problem with the European Union. They say it is about free trade, but really it’s about somebody’s arbitrary idea of “fair trade,” which amounts to regulating everything. In addition to its disastrous economic consequences, it creates misunderstandings and confusion in the mind of the average person. Brussels has become another layer of bureaucracy on top of all the national layers and local layers for the average European to deal with.

The European Union in Brussels is composed of a class of bureaucrats that are extremely well paid, have tremendous benefits, and have their own self-referencing little culture. They’re exactly the same kind of people that live within the Washington, D.C. beltway.

The EU was built upon a foundation of sand, doomed to failure from the very start. The idea was ill-fated because the Swedes and the Sicilians are as different from each other as the Poles and the Irish. There are linguistic, religious, and cultural differences, and big differences in the standard of living. Artificial political constructs never last. The EU is great for the “elites” in Brussels; not so much for the average citizen.

Meanwhile, there’s a centrifugal force even within these European countries. In Spain, the Basques and the Catalans want to split off, and in the UK, the Scots want to make the United Kingdom quite a bit less united. You"ve got to remember that before Garibaldi, Italy was scores of little dukedoms and principalities that all spoke their own variations of the Italian language. And the same was true in what’s now Germany before Bismarck in 1871.

In Italy 89% of the Venetians voted to separate a couple of years ago. The Italian South Tyrol region, where 70% of the people speak German, has a strong independence movement. There are movements in Corsica and a half dozen other departments in France. Even in Belgium, the home of the EU, the chances are excellent that Flanders will separate at some point.

The chances are better in the future that the remaining countries in Europe are going to fall apart as opposed to being compressed together artificially.

And from strictly a philosophical point of view, the ideal should not be one world government, which the “elite” would prefer, but about seven billion small individual governments. That would be much better from the point of view of freedom and prosperity.

Nick Giambruno: How does Brexit affect the future of the European Union?

Doug Casey: Well, it"s the beginning of the end. The inevitable has now become the imminent. Britain has always been perhaps the most different culture of all of those in the European Union. They entered reluctantly and late, and never seriously considered losing the pound for the euro.

You"re going to see other countries leaving the EU. The next one might be Italy. All of the Italian banks are truly and totally bankrupt at this point. Who"s going to kiss that and make it better? Is the rest of the European Union going to contribute hundreds of billions of dollars to make the average Italian depositor well again? I don"t think so. There"s an excellent chance that Italy is going to get rid of the euro and leave the EU.

If Marine Le Pen wins the elections, France will leave as well. That would be a smart move. She would also want to deport the migrants from Africa that are living in tent camps and cardboard boxes everywhere. Another good move. These people aren’t self-supporting, and are acting to destroy what’s left of French culture. Then again, Le Pen herself is no prize. She wants to continue the welfare state, and increase regulations and taxes. The French have zero good alternatives, at least if you care about either free minds or free markets. But that’s true everywhere in Europe. The very concept of liberty is dead in Europe.

Nick Giambruno: Why should Americans care about this?

Doug Casey: Well, just as the breakup of the Soviet Union had a good effect for both the world at large and for Americans, the breakup of the EU should be viewed in the same light. Freeing an economy anywhere increases prosperity and opportunity everywhere. And it sets a good example. So Americans ought to look forward to the breakup of the EU almost as much as the Europeans themselves. Unfortunately, most Americans are quite insular. And Europeans are so used to socialism that they have even less grasp of economics than Americans. But it’s going to happen anyway.

Nick Giambruno: What are the investment implications?

Doug Casey: Initially there"s going to be some chaos, and some inconvenience. Conventional investors don’t like wild markets, but turbulence is actually a good thing from the point of view of a speculator. It’s a question of your psychological attitude. Understanding psychology is as important as economics. They’re the two things that make the markets what they are. Volatility is actually your friend in the investment world.

People are naturally afraid of upsets. They"re afraid of any kind of crisis. This is natural. But it"s only during a crisis that you can get a real bargain. You have to look at the bright side and take a different attitude than most people have.

Nick Giambruno: If you position yourself on the right side of this thing, do you think you can profit from the collapse of the EU?

Doug Casey: Yes. Once the EU falls apart, there are going to be huge investment opportunities. People forget how cheap markets can become. I remember in the mid-1980s, there were three markets in the world in particular I was very interested in: Hong Kong, Belgium, and Spain. All three of those markets had similar characteristics. You could buy stocks in those markets for about half of book value, about three or four times earnings, and average dividend yields of their indices were 12–15%—individual stocks were sometimes much more—and of course since then, those dividends have gone way up. The stock prices have soared.

So I expect that that"s going to happen in the future. In one, several, many, or most of the world’s approximately 40 investable markets. Right now, however, we"re involved in a worldwide bubble in equities. It can go the opposite direction. People forget how cheap stocks can get.

I think we"re headed into very bad times. Chances are excellent you"re going to see tremendous bargains. People are chasing after stocks right now with 1% dividend yields and 30 times earnings, and they want to buy them. At some point in the future these stocks are going to be selling for three times earnings and they’re going to be yielding 5, maybe 10% in dividends. But at that point most people will be afraid to buy them. In fact, they won"t even want to know they exist at that point.

I’m not a believer in market timing. But, that said, I think it makes sense to hold fire when the market is anomalously high.

The chaos that’s building up right now in Europe can be a good thing—if you"re well positioned. You don"t want to go down with the sinking Titanic. You want to survive so you can get on the next boat taking you to a tropical paradise. But right now you"re entering the stormy North Atlantic.

*  *  *

There’s more turmoil ahead as French voters decide the EU’s fate on April 23—and it could be catastrophic for global currency and stock markets. We expect the fallout to be far worse than 2008. Most investors can’t handle that sort of chaos. But Doug Casey and his team know how to turn it into huge profits. They’re sharing need-to-know information about the coming global economic meltdown in this time-sensitive video. Click here to watch it now.

Trump And The Age Of Magical Thinking

Authored by Christopher Whalen via The Institutional Risk Analyst blog,

“Anyone taken as an individual is tolerably sensible and reasonable – as a member of a crowd, he at once becomes a blockhead.”

Friederich von Schiller, quoted by Bernard Baruch

The term "magical thinking" refers to how children believe that their thoughts have a direct effect on the rest of the world.  So last week we learned that the Trump Bump is not real. Lower taxes, increased spending, these were never really serious goals, but merely political talking points.

Charles Gasparino and Brian Schwartz of FoxBusiness also suggested that the proposed cut in corporate taxes would instead mutate into a repatriation scheme a la Argentina and Italy.  Corporate tax cuts are dead, but "a percentage of the money returning to the U.S. would be used to finance an infrastructure fund to build the roads and bridges that President Trump has recently been touting,” they report.

This is bad news for Wall Street, where lower corporate taxes have been a key underpinning for the recent exuberance.  As the Don mutates before our very eyes, his promise of big things and thus the outsized impact of same on financial markets will also change – and dramatically.

President Trump’s change of mind on corporate tax cuts certainly goes against the happy consensus view.  The move in the stock market from the latter part of last October to the beginning of March 2017 can only be described as a speculative episode, to paraphrase John Kenneth Galbraith. As he wrote in A Short History of Financial Euphoria:

“Regulation and more orthodox economic knowledge are not what protect the individual and the financial institution when euphoria drives up prices, and to the eventual crash and its sullen and painful aftermath. There is protection only in a clear perception of the characteristics common to these flights of what must conservatively be described as mass insanity.  Only then is the investor warned and saved.  There are, however, few matters on which such a warning is less welcomed.”

Indeed, while the raging bulls raised up Bank of America nearly 60% in four months and pushed the yield on the S&P 500 below 2%, the reality of the Trump Administration and its truly conventional nature was becoming apparent.  The big statements and big ideas are abandoned without remorse as the President seeks leverage, to paraphrase our friend Jim Rickards.

A key takeaway from earnings so far is that we have confirmation of a slow-down in lending and a related slowing of the economy.  Retail is also in a downward phase, although the stalwart optimists in the crowd believe that the numbers will improve later in the year.  And Chinese GDP beats expectations. 

The other obvious takeaway from earnings is that we’re pretty deep into the current credit cycle.  If anything, the Fed should be thinking about mild easing.  But instead Janet Yellen & Co are trying to “normalize” rates as the economy slows.

The chart below shows yield on the 10-year Treasury bond less the yield on the 2-year Treasury note.  Not only are interest rates falling rather than going up, but the yield curve is also flattening as the difference between long and short interest rates is squeezed.  This is not a bullish chart needless to say.

But even less encouraging is the juxtaposition of real GDP and the federal funds rate, an important chart that reorients your thinking about just where we are in relative economic terms and in particular the definition of “normal.”  The chart below shows these two relationships and suggests to us that getting short-term rates to 3% is going to be a near impossible task. 

We are waiting to hear from BAC this week to see just how our favorite zombie girl justifies those impressive forward estimates for revenue and earnings growth.  More than any of the top banks, BAC has reduced operating costs and positioned the bank for growth – this after years of bloody, slow-motion restructuring.  But rising interest rates will not help bank earnings, especially when interest rates are going down.

Readers of The IRA will recall that we took the view after 2008 that BAC should have put the parent holding company through a Ch 11 bankruptcy to accelerate the restructuring process.  But today, fact is, the bank’s selling, general and administrative expenses start with a “5” as in $54 billion rather than a “7” as in $72 billion in 2014.

With a 16% estimate for 2017 earnings and 21% for 2018, its does not take a lot of imagination to see why BAC moved as far and as fast as it did, but that’s all over now as the song says. The promises by Donald Trump during  the 2016 election have been replaced by conventional thinking and even more conventional people to think them. 

Witness reports from Politico that President Trump is expected to nominate former Treasury undersecretary Randy Quarles as the Federal Reserve"s top bank regulator. Quarles is a big time members of the establishment, a veteran of the George W. Bush administration and is a managing partner at equity investment firm The Cynosure Group.   

“I don"t think the folks who voted for Trump thought they were voting for Randy Quarles, although I like the Dickensian name,” notes one DC insider.  “Quarles is a Bushie and could be weaker than Tarullo."

CompassPointLLC opines  politely that “Our sense is that Mr. Quarles will be viewed as a pragmatic deregulatory force.”  But Washington’s premier investment bank avers that “tax reform expectations in D.C. continue to temper. Our view remains that political and policy realities will slowly grind broad tax reform efforts into a narrower tax relief package with corporate rates of 25-28%.”

So the good news and the bad news rolled up together is that the Trump Revolution is over.  All of the talk of change, tax cuts and new policies is rapidly giving way to a very conventional Republican Administration populated by bankers from Goldman Sachs.  To get a good bearing on President Trump, think of the first term of President William McKinley combined with the latter years of Ulysses Grant.

For Wall Street, the end of the Trump Revolution portends a return to the October 2016 status quo ante, with all of the attendant difficulties and discomfiture.  We can’t say for sure that BAC will go all the way back to $16 per share, where it started its remarkable journey last October. But even at the $22 close on Thursday, BAC was still trading below book value, a remarkable, even magical commentary in these increasingly conventional times.

WARNING: U.S. Ponzi Retirement Market In Big Trouble As Withdrawals Now Exceed Contributions

By the SRSrocco Report,

The U.S. Retirement Market is in BIG TROUBLE as annual benefits paid out are now larger than total contributions.  Actually, the amount of net withdrawals were the highest in history.  When payouts become larger than contributions... then we have the making of the typical PONZI SCHEME.

Americans who have invested their hard-earned money into a 401K, had no idea that it was the Greatest Ponzi Scheme in history.  Unfortunately, when the markets crack, so will the value of the U.S. Retirement market.  On the other hand, Americans who were wise enough to purchase physical precious metals will protect their wealth as the U.S. Paper Retirement Market collapses.

According to the most recent data by the ICI - Investment Company Institute, the U.S. Retirement Market ballooned to a new record high of $25.3 trillion at the end of 2016:

As we can see, the U.S. Retirement Market has nearly doubled since the collapse of the Housing & Banking sectors in 2008.  Total value of the U.S. Retirement Market increased from a low of $13.9 trillion in 2008 to $25.3 trillion at the end of 2016.  It"s not quite double... but close enough.

Furthermore, the surge in U.S. Retirement assets from $19.7 trillion in 2012 to $22.6 trillion in 2013 was due to the Federal Reserve QE 3 policy (Quantitative Easing #3).  This was the year that the monetary stimulus was funneled into the Stock, Bond and Real Estate Market and away from the precious metals.  Thus, the precious metals suffered huge price declines in 2013.

As Americans continue to contribute into their "supposed" retirement plans, few realize that more funds are now heading out than going in.  This is not a good sign at all.  If we look at the most recent data from the Investment Company Institute, Americans contributed a total of $373.6 billion into their Private Sector DC Plans in 2014 versus total benefits paid out of $402.3 billion.  Which means, net contributions were a negative $28.7 billion... the highest on record:

The grey bars represent total contributions while the red line shows total benefits paid.  The net result is shown in the GREEN & RED bars at the lower part of the chart.  Green bars are positive net contributions, while the red bars are net withdrawals.  Unfortunately, the Investment Company Institute does not provide data for 2015 or 2016 yet.  It will be interesting to see if these net withdrawals continue to increase.  My gut tells me that they most likely have.

NOTE: The majority of the Private-Sector DC Plans were 401k"s, which accounted for roughly 98% of total contributions and 91% of total benefits paid.

So, why is the U.S. Retirement Market is BIG TROUBLE?  Well, if we look at the next chart, we find our answer:

The chart shows that the U.S. Retirement Market has increased right along with surge in total U.S. public debt.  Thus, the U.S. Retirement Market"s value is being propped up by debt.   As the U.S. debt exploded from $875 billion in 1980 to $20 trillion currently, the U.S. Retirement Market surged from $822 billion to $25.3 trillion during the same time period.  We must remember the following:

DEBT IS NOT AN ASSET.  Also, the true value is subtracting total debt from total assets

Thus, if we just applied simple math here, the U.S. Retirement market"s net value is approximately $5 trillion... 80% less than what it is currently.  And that $5 trillion figure is likely inflated.  I do realize I am making a very general calculation here, but DEBTS are not ASSETS.

I discussed this in my recent interview on the Hagmann Report, which I highly recommend watching if you haven"t already:

The reason the U.S. Retirement Market is a huge Ponzi Scheme is that it has stored "Digital IOU"s" rather than real physical wealth.  A typical stock price is based on "Net Present Value."  They take the future value of the company"s earnings and give it a price today.  Unfortunately, companies earnings are based on the burning energy in the future.   There lies the rub.

Back during the 1930"s, most stock prices were based on the BOOK VALUE.  Basically, what the value of the company was worth if all its assets were sold.  Today, a stock price is based on EARNINGS.  Earnings can and will implode when the markets crack due to massive debt and falling oil production.

However, the few Americans who were wise enough to purchase physical precious metals rather than put their money into the Greatest Ponzi Scheme in history, will be protect wealth while most paper assets disintegrate.

$100,000 Physical Gold Investment vs $100,000 Invested in 401K

If an American decided to purchase $100,000 in physical gold over the past 30 years, they would have a true physical asset that they can sell close to that $100,000 figure.  If an American had $100,000 in their 401K, they would have to pay a 10% penalty for early withdrawal.  While a 401K withdrawal is taxed as regular income compared to physical gold taxed at a maximum of 28% capital gains, at least you can hold onto nearly three-quarters of your wealth (likely much higher percentage).

That being said, once the market crash occurs, the value of most American"s retirement assets are going to implode.  I would not be surprised to see at least 50-75% collapse (or more) in the typical U.S. Retirement Account.  Thus, the $100,000 invested in a 401K could fall to a low of $25,000, while $100,000 invested in physical gold, could easily double to $200,000.

Actually, this is the likely outcome.  Mark my words.  A typical American who has invested $100,000 into a typical 401K will find that his or her retirement account will fall to one-tenth its value versus someone who purchased physical gold instead.  The coming collapse of the U.S. and Global Oil Industries, due to lower oil prices, will be the factor that destroys the U.S. Retirement Ponzi Scheme.  It is not a matter of IF, it is a matter of WHEN.

Please continue to check back at the SRSrocco Report as I will be providing updates on the continued disintegration of the U.S. and Global Oil Industry.  Paying attention to what is taking place in the Energy Industry will provide CLUES to the timing of the Market Collapse.

Lastly, if you haven"t checked out our new PRECIOUS METALS INVESTING section or our new LOWEST COST PRECIOUS METALS STORAGE page, I highly recommend you do.

Check back for new articles and updates at the SRSrocco Report.

Here’s Why Italy’s Banking Crisis Has Gone Off The Radar

Authored by Don Quijones, Spain & Mexico, editor at Wolf Street

Here’s Why Italy’s Banking Crisis Has Gone Off the Radar

For a country that is on the brink of a gargantuan public bailout of its toxic-loan riddled banking sector, or failing that, a full-blown financial crisis that could bring down the European financial system, things are eerily quiet in Italy these days. It’s almost as if the more serious the crisis gets, the less we hear about it — otherwise, investors and voters might get spooked. And elections are coming up.

But an article published in the financial section of Italian daily Il Sole lays out just how serious the situation has become. According to new research by Italian investment bank Mediobanca, 114 of the close to 500 banks in Italy have “Texas Ratios” of over 100%. The Texas Ratio, or TR, is calculated by dividing the total value of a bank’s non-performing loans by its tangible book value plus reserves — or as American money manager Steve Eisman put it, “all the bad stuff divided by the money you have to pay for all the bad stuff.”

If the TR is over 100%, the bank doesn’t have enough money “pay for all the bad stuff.” Hence, banks tend to fail when the ratio surpasses 100%. In Italy there are 114 of them. Of them, 24 have ratios of over 200%.

Granted, many of the banks in question are small local or regional savings banks with tens or hundreds of millions of euros in assets. These are not systemically important institutions and can be resolved without causing disturbances to the broader system. But the list also includes many of Italy’s biggest banks which certainly are systemically important to Italy, some of which have Texas Ratios of over 200%. Top of the list, predictably, is Monte dei Paschi di Siena, with €169 billion in assets and a TR of 269%.

Next up is Veneto Banca, with €33 billion in assets and a TR of 239%. This is the bank that, together with Banco Popolare di Vicenza (assets: €39 billion, TR: 210%), was supposed to have been saved last year by an intervention from government-sponsored, privately funded bank bailout fund Atlante, but which now urgently requires more public funds. Their combined assets place them seventh on the list of Italy’s largest banks.

Some experts, including the U.S. bank hired last year to save MPS, JP Morgan Chase, have warned that Popolare di Vicenza and Veneto Banca will not be eligible for a bailout since they are not regarded as systemically important enough. This prompted investors to remove funds from the banks, further exacerbating their financial woes. According to sources in Rome, the two banks’ failure would send shock waves through the wider Italian financial industry.

There are other major Italian banks with Texas Ratios well in excess of 100%. They include:

• Banco Popolare (the offspring of a merger of Banco Popolare di Verona e Novara and Banca Popolare Italiana in 2017 and then a subsequent merger with Banca Popolare di Milano on 1 January 2017): €120 billion in assets; TR: 217%.


• UBI Banca: €117 billion in assets; TR: 117%


• Banca Nazionale del Lavoro: €77 billion in assets; TR: 113%


• Banco Popolare Dell’ Emilia Romagna: €61 billion in assets; TR: 140%


• Banca Carige: €30 billion in assets; TR: 165%


• Unipol Banca: €11 billion in assets; TR: 380%

In sum, almost all of Italy’s largest banking groups, with the exception of Unicredit, Intesa Sao Paolo and Mediobanca itself, have Texas Ratios well in excess of 100%.

But, as Eisman recently pointed out, the two largest banks, Unicredit and Intesa Sanpaolo, have TRs of over 90%. As long as the other banks continue to languish in their current zombified state, they will continue to drag down the two bigger banks. And if either Unicredit or Intesa begin to wobble, the bets are off.

To stay on the right side of the solvency threshold, Unicredit has already had to raise €13 billion of new capital this year and last week it took advantage of the ECB’s latest splurge of charitable lending (formally known as TLTRO II) to borrow €24 billion of free money. But as long as the financial health of the banks all around it continues to deteriorate, staying upright is going to be a tough order.

This is where things get complicated. In order to qualify for public assistance, banks must be solvent. Presumably, that would automatically disqualify any bank with a Texas Ratio of over 150%, which includes MPS, Banco Popolare, Popolare di Vicenza, Veneto Banca, Banca Carige and Unipol Banca. The bailout must also comply with current EU regulations including the Bank Recovery and Resolution Directive of Jan 1, 2016, which specifically mandates that before public funds are injected into a bank, shareholders and creditors must be bailed in for a minimum amount of 8% of total liabilities, as famously happened in the rescue of Cyprus’ banking system in 2013.

The Italian government knows that this approach could end up wiping out retail investors (otherwise known as voters) who were missold, in many cases fraudulently, subordinated bonds by cash-hungry banks in the wake of the last crisis, in turn wiping out the government’s votes. To avoid such an outcome, the government has proposed compensating those retail bondholders with public funds, just as the Spanish government did with the holders of preferente bonds. Which, of course, is in direct contravention of EU laws.

So far, the European Commission has stayed silent on the issue, presumably in the hope that the resolution of Italy’s financial sector can be held off until at least after the French elections in late April, if not the German elections in September. Then, if those elections go Brussels’ way, a continent-wide taxpayer funded bailout of banks’ NPLs can be unleashed, as already requested by ECB Vice President Vitor Constancio and European Banking Authority President Andrea Enria.

With no guarantee that Italy’s NPL-infested banks can hold out that long, it’s a dangerous waiting-and-hoping game. In the meantime, shhhhhhhh… By Don Quijones.

EU Taxpayers Brace As Deepening Banking Crisis Means Euro-TARP Looms

Authored by Don Quijones via WolfStreet.com, 

If the ECB scales back stimulus, banks face even greater risk of collapse. But now there’s a new solution

Events are moving so fast in Europe these days, it’s almost impossible to keep up. While much of the attention is being hogged by political developments, including the election in the Netherlands, Reuters published a report warning that the European banking sector may face even higher bad loan risks if the ECB begins to scale back its monetary stimulus programs, something it has already begun, albeit extremely tentatively.

The total stock of non-performing loans (NPL) in the EU is estimated at over €1 trillion, or 5.4% of total loans, a ratio three times higher than in other major regions of the world.

On a country-by-country basis, things look even scarier. Currently 10 (out of 28) EU countries have an NPL ratio above 10% (orders of magnitude higher than what is generally considered safe). And among Eurozone countries, where the ECB’s monetary policies have direct impact, there are these NPL stalwarts:

• Ireland: 15.8%


• Italy: 16.6%


• Portugal: 19.2%


• Slovenia: 19.7%


• Greece: 46.6%


• Cyprus: 49%

That bears repeating: in Greece and Cyprus, two of the Eurozone’s most bailed out economies, virtually half of all the bank loans are toxic.

Then there’s Italy, whose €350 billion of NPLs account for roughly a third of Europe’s entire bad debt stock. Italy’s government and financial sector have spent the last year and a half failing spectacularly to come up with a solution to the problem. The two “bad bank” funds they created to help clean up the banks’ toxic balance sheets, Atlante I and Atlante II, are the financial equivalent of bringing a butter knife to a machete fight. So underfunded are they, they even strugggled to hold aloft smaller, regional Italian banks like Veneto Banca and Popolare di Vicenza, which are now pleading for a bailout from Rome, which in turn is pleading for clemency from Brussels.

What little funds Atlante I and Atlante II have left are hemorrhaging value as the “assets” they’ve been used to buy up, invariably at prices that were way too high (often at over 40 cents on the euro), continue to deteriorate. The recent decision of Italy’s two biggest banks, Unicredit and Intesa Sao Paolo, to significantly write down their investment in Atlante is almost certain to discourage the private sector from pumping fresh funds into bailing out weaker banks.

Which means someone else must step in, and soon. And that someone is almost certain to be the European taxpayer.

In February ECB Vice President Vitor Constancio called for the creation of a whole new class of government-backed “bad banks” to help buy some of the €1 trillion of bad loans putrefying on bank balance sheets. Constancio’s idea bore a striking resemblance to a formal proposal put forward by the European Banking Authority (EBA) for the creation of a massive EU-wide bad bank that, in the words of EBA president Andrea Enria, would “make it much easier to achieve critical mass and to create a well functioning market for (impaired) assets.”

Here’s how it would work, according to Enria (emphasis added):

The banks would sell their non-performing loans to the asset management company at a price reflecting the real economic value of the loans, which is likely to be below the book value, but above the market price currently prevailing in illiquid markets. So the banks will likely have to take additional losses.

The asset manager would then have three years to sell those assets to private investors. There would be a guarantee from the member state of each bank transferring assets to the asset management company, underpinned by warrants on each bank’s equity. This would protect the asset management company from future losses if the final sale price is below the initial transfer price.

One of the biggest advantages of launching an EU-wide bad bank is that it would avoid the sort of public “resistance” that would occur if it was done at a national level, says Enria. Italian lenders would presumably be able to continuing pricing bad loans at or around 40 cents on the euro on average, even though their real value — i.e. the current value priced by the market — is often much lower. The difference between the market price, if any, and the price the banks end up receiving for their bad debt will be covered by Europe’s taxpayers.

If given the green light, the scheme would pave the way to the biggest one-off bail out of European banks in history. It would be Euro-TARP on angel dust, with even fewer checks and balances and much less likelihood of ever recovering taxpayer funds. According to a banker source cited by Reuters, while Germany has not yet endorsed the EBA plan, the EU documents describe the development of a secondary market for NPLs as a priority. According to Enria, the EBA hopes to finalize matters “at the European level” in the Spring.

The documents also include proposals for a wider “restructuring of banking sectors” as states address the NPLs problem. This “could lead to mergers among EU banks after they offload their bad loans,” a banking industry official said.

In other words, EU taxpayers would have to spend potentially hundreds of billions of euros saving yet more banks from the consequences of their own acts and bail out their bondholders and potentially their stockholders too, with funds desperately needed in other areas. Those banks, once saved and their balance sheets cleansed, would then be handed on a platter to much bigger banks. In return, taxpayers would end up with an even more concentrated, consolidated, interconnected financial system that is even more prone to abuse, corruption, and excess.

The ECB’s policy isn’t about creating inflation but about keeping a financial system and a currency union from collapsing upon each other. Read…  ECB Trapped in its Own “Doom Loop” as Inflation Surges