The Oil Drum: Europe

Jeff Rubin, Chief Economist at CIBC World Markets, in a recent report, is now saying that the current recession is caused by high oil prices. Defaulting mortgages are only a symptom of the high oil prices. We should be blaming the underlying cause--higher oil prices--rather than the symptom. These higher oil prices caused Japan and the Eurozone to enter into a recession even before the most recent financial problems hit. Higher oil prices started four of the last five world recessions; we shouldn't be too surprised if they started this one also.

In the US, as one door has closed on subprime lending, another has opened on credit card debt. Actually living within one's means doesn't always seem to be an option, for some due to poverty and for others due to greed. Either way, the debt hole Americans (and Canadians, and the British) are collectively digging themselves into is getting deeper by the day, and they start young.

As losses mount, the role of mortgage fraud, by both borrowers and lenders, and also potential securities fraud, is being revealed. The litigation is only just beginning, but be prepared for a storm of legal action and recriminations. The ratings agencies are looking vulnerable to European action as their ratings enabled the sale of bad loans to European institutions, under conditions of conflict of interest.

Signs of stress are spilling over from the world of high finance to the real economy, where trucking and shipping are feeling the slowdown. Meanwhile Canada (several months behind the US) is still seeing a booming housing market, but for how long?

An inflationary future is becoming conventional wisdom, but, as consensus takes time to develop, the stronger the consensus, the later it is in the trend. A consensus is a backward-looking phenomenon of little use - except as a general contrarian indicator - in detecting the inevitable discontinuities that can abruptly and painfully invalidate all one's assumptions.

We have lived through a long period of inflationary credit expansion, and regard it as normal, but credit expansion is a self-limiting condition. Credit bubbles are merely the rediscovery by a new generation of the powers of leverage (see for instance A Short History of Financial Euphoria by Galbraith, Manias, Panics and Crashes by Kindleberger or Financial Armageddon by Michael Panzner). Every credit bubble that ever existed has eventually deflated, and this one will be no different.

We have essentially already reached the limit of debt serviceability that brings an expansion to an end. We are already seeing the tightening of credit standards, the refusal of banks to lend to one another, the frozen commercial paper, the bank runs, the redefinition of what constitutes a store of value, the rejection of financial alchemy, the debt defaults that reduce the money supply, the falling prices in the housing market, the lack of confidence - which together unmistakably herald deflation. Central banks can do nothing more than paper over the cracks for a short time, at the cost of aggravating the eventual impact of deflation.

Time to Aim High?

I salute Wasik for pointing out the sham that the CPI is. However, it is because of the debasement of the dollar and distortions in the CPI that the Fed has practically forced risk down everyone's throat. But one must be cognizant of herding behavior that has nearly everyone thinking exactly like he is and the Fed wants. Aim high. Shoot for the moon. Do or die. You are losing money by saving. Buy assets. Only fools save. In the long term, stocks always go up.

The problem is that aiming high is synonymous with increasing risk. Up till now, risk taking has been rewarded. But what happens when everyone does the same thing? More to the point, what happens when everyone does the same thing for 20 years or longer? Eventually, risk gets so unappreciated that various asset classes go to the moon....

....Essentially, the same advice given for real estate (you cannot buy too much home, home prices always go up) is now being touted for stocks. There is an amazing belief in the Fed's ability right now to control the business cycle, as well as price stability. It's not warranted. At this stage of the cycle in a slowing economy, with rampant overcapacity, a tenuous job climate, and no real reason for businesses to expand, the odds are that aiming high is precisely the wrong thing to do.

This is a Finance Round-Up by ilargi. An Energy and Environment Round-Up will follow over the weekend.

Et tu, Canada?

There's a country just south of here that pretends to be the world's richest economy, but in reality seems headed for the Halliburdened poorhouse. Et tu, Canada? Depends on where you look.

The papers' front pages show Prime Minister Stephen Harper, knowing there's no opposition left to speak of, though he leads a minority Cabinet. Stephen, too stiff to even play golf, shuffling the greens with Tiger Woods for a photo-op. Then a broad media smile: an alleged record federal budget surplus ($13.8 billion). To top it off, the new King of Nadamaskakas magnanimously hints at tax cuts. Little detail: it's $35 per person per year, less than 10 cents per day. But it sounded good at first, right, tax cut? Bienvenue à la politique.

In the finance pages, a different take: lax laws have allowed trusts, funds and your pet parakeet to issue non-bank commercial paper (ABCP), to the tune of $40 billion (bank ABCP: $80 billion more). On August 16, the biggest gamblers tried hard to change this from short-to long term debt. Turns out, that won't fly: nobody can even figure out where it is or what it's worth. Caught in their own trap.

Québec's massive Caisse de Dépot pension fund holds $20 billion worth of it, a sizable chunk of their $240 billion portfolio, and that's just their domestic toilet paper. Our advice: Keep the day job. Till you're, like, 95. Your pension has been gambled away.

About that federal budget surplus: Canada's federal debt is $467 billion. Which, to our untrained eye, means the term "budget surplus" is the victim of acute and intense inflation. Harper actually said on TV that the surplus will be used to pay off the debt. On our untrained calculator, that would take, at the current rate, a negligible 33.8 years, or until 2041, providing no new debts are incurred, and inflation stops dead in its tracks. But we kid you not, at the moment of writing this, Harper's on TV, saying he does this for future generations.

To finish off this sunny newscast, while TD Bank raves about the tar profits, despite royalty reviews, Big Oil has launched the first lawsuit against Canada under NAFTA law. We'll see much more of that, soon, as in the Alberta royalty revision plans. Send your kids to law school.

(See also the Energy and Environment Round-Up for September 7th below.)

For all those who think that the world's central bankers have the developing credit crunch contained, look at the liquidity crisis in asset-backed commercial paper (ABCP), which is currently affecting Canada worst of all. ABCP is an impenetrable mish-mash of mortgages, credit card receivables, car loans and other miscellaneous debt that institutions were quite happy, until recently, to use as a convenient place to park short term cash. Within a month that has seen a severe attack of risk aversion, it has gone from safe to toxic, with the result that liquidity has dried up almost completely.

In Canada, banks are trying to put together a deal that converts $35 billion of non-bank short term paper, that could no longer be rolled over, into 5-year floating-rate notes, but the credit default swaps (which can be, and were, used as vehicles for naked speculation) are a huge problem. Does the deal remind anyone of the Argentine financial crisis - where short term bonds were converted to long term (and then later defaulted upon)?

Those who think the situation contained might also look to Europe at the increasing gap between base rates and three-month interbank lending rates (Libor). That gap is now at its widest for 20 years, reflecting uncertainty and distrust as to the risk exposure of other banks, and the hoarding of cash. Interbank lending is breaking down, despite the efforts of the ECB and the Fed to restore confidence.

Is there really nothing to worry about?

ABCP investors could lose half their money

The vast majority of about $35-billion of non-bank ABCP is backed by risky bets on credit default rates that are now so far underwater that investors could be looking at losses as high as 50 on the dollar, said Edward Devlin, Canadian portfolio manager for highly respected California-based bond fund manager Pacific Investment Management Co. LLC....

....Commercial-paper markets around the globe have been struggling with fallout from the subprime mortgage crisis in the United States, but the situation is worst in Canada.

"It's the one country where people couldn't get their money back," Mr. Devlin said. "There's a whole group of people who bought commercial paper [thinking it was liquid] and now they find they can't get their money back."

Trust tax linked to private equity buyouts

The income trust structure was a major impediment to private equity firms buying up pieces of Corporate Canada, the Finance Department was told one day before Ottawa slapped a crippling tax on the sector.

"Private equity firms generally find it difficult to compete against the income trust alternative, said an Oct. 30, 2006, memo sent to Bob Hamilton, senior assistant deputy minister of tax policy at the Finance Department.

The memo was obtained by The Globe and Mail under access to information law.

For anyone at Finance who knew the trust tax was imminent, one conclusion that's easily drawn from the memo is that taxing trusts out of existence would likely usher in even more private equity buyouts by Canadian and foreign investors, which is what happened.

What Price Victory? (scroll down)

It’s reasonable to assume that, as professionals operating within a government department nominally charged with understanding affairs of finance, the folks working for Flaherty would have some rudimentary understanding of the way key players in the private space—private equity, for example—operate.

That is private-equity firms find undervalued, cash-generating businesses, strip them down and load them up with debt. Interest expenses basically wipe out taxes owed. That’s the nutshell.

What was that about “tax leakage”?

Either the professionals have no clue about their business, or they engineered the destruction of the trust sector. Secretive, incompetent and stupid is no way to run a government.

Mortgage woes could be 'tip of the iceberg'

For some, the lesson learned is: "buyer beware." But a series of interviews with subprime borrowers, mortgage lenders, appraisers, current and former regulators, and the inspector general of the Department of Housing and Urban Development paints a different picture - of a widespread pattern of questionable lending practices and outright fraud that has already sparked a wave of criminal and civil actions against various players in the $10 trillion market for residential mortgages.

Questionable mortgage practices can take on many forms, but the fall into two broad categories:

• Predatory lending. In this case, complex mortgage terms and interest rate risks were not fully explained as required by federal law. The borrower is usually the victim.
• Mortgage fraud. In these cases, often carried out by sophisticated swindlers, the lender is typically the victim.

Billions at risk from wheat super-blight

An infection is coming, and almost no one has heard about it. This infection isn't going to give you flu, or TB. In fact, it isn't interested in you at all. It is after the wheat plants that feed more people than any other single food source on the planet. And because of cutbacks in international research, we aren't prepared. The famines that were banished by the advent of disease-resistant crops in the Green Revolution of the 1960s could return, Borlaug told New Scientist.

The disease is Ug99, a virulent strain of black stem rust fungus (Puccinia graminis), discovered in Uganda in 1999. Since the Green Revolution, farmers everywhere have grown wheat varieties that resist stem rust, but Ug99 has evolved to take advantage of those varieties, and almost no wheat crops anywhere are resistant to it....

....What's more, Ug99 will find agriculture has changed to its liking in the decades stem rust has been away. "Forty years ago most wheat wasn't irrigated and heavily fertilised," says Borlaug. Now, thanks to the Green Revolution he helped bring about, it is. That means modern wheat fields are a damper, denser thicket of stems, where dew can linger till noon - just right for fungus.

Another worry is that travel has exploded in the past 40 years. There have now been several documented cases of travellers carrying rust spores on their clothing. Some fear Ug99 will hitchhike as much as it flies - and its spread need not be innocent. New Scientist has learned that the US Department of Homeland Security met in March to discuss the possibility that someone could transport Ug99 deliberately.

LNG beats pipeline

Treating delta gas as an LNG opportunity is much more attractive than the Mackenzie pipeline option. Maybe the big giants behind the backers -- Exxon Mobil, Conoco Phillips, and Royal Dutch Shell -- fear upsetting their global petroleum, natural gas and LNG apple carts by allowing their Canadian subsidiaries to start playing for the first time outside their Canadian sand boxes. It may be an intolerable horror for these multi-nationals to see delta LNG "washing up" at global LNG terminals, and competing with their own non-Canadian LNG delivered to U.S. and overseas LNG-terminals. Or might marketing delta gas globally snatch away the currently dominant fuel, gas, from the ravenous appetites of oilsands gas-guzzlers, forcing them to consider fuel options other than gas, and risking further delays, because they are also primary holders of Alberta oilsands leases.