The banks SHOULD collapse

Whether the US government will permit them to go under, or whether it will attempt to kick the can further into the future like it did in 2008, is the only real question. This is a very good article on The Atlantic addressing how the banks have changed their debt-drug of choice from Collateralized Debt Obligations to Collateralized Loan Obligations. To translate that into English, the U.S. banking system has replaced its fragile foundation of homeowner debt with corporate debt:

After the housing crisis, subprime CDOs naturally fell out of favor. Demand shifted to a similar—and similarly risky—instrument, one that even has a similar name: the CLO, or collateralized loan obligation. A CLO walks and talks like a CDO, but in place of loans made to home buyers are loans made to businesses—specifically, troubled businesses. CLOs bundle together so-called leveraged loans, the subprime mortgages of the corporate world. These are loans made to companies that have maxed out their borrowing and can no longer sell bonds directly to investors or qualify for a traditional bank loan. There are more than $1 trillion worth of leveraged loans currently outstanding. The majority are held in CLOs.

Just as easy mortgages fueled economic growth in the 2000s, cheap corporate debt has done so in the past decade, and many companies have binged on it.

I was part of the group that structured and sold CDOs and CLOs at Morgan Stanley in the 1990s. The two securities are remarkably alike. Like a CDO, a CLO has multiple layers, which are sold separately. The bottom layer is the riskiest, the top the safest. If just a few of the loans in a CLO default, the bottom layer will suffer a loss and the other layers will remain safe. If the defaults increase, the bottom layer will lose even more, and the pain will start to work its way up the layers. The top layer, however, remains protected: It loses money only after the lower layers have been wiped out.

Unless you work in finance, you probably haven’t heard of CLOs, but according to many estimates, the CLO market is bigger than the subprime-mortgage CDO market was in its heyday. The Bank for International Settlements, which helps central banks pursue financial stability, has estimated the overall size of the CDO market in 2007 at $640 billion; it estimated the overall size of the CLO market in 2018 at $750 billion. More than $130 billion worth of CLOs have been created since then, some even in recent months. Just as easy mortgages fueled economic growth in the 2000s, cheap corporate debt has done so in the past decade, and many companies have binged on it.

Despite their obvious resemblance to the villain of the last crash, CLOs have been praised by Federal Reserve Chair Jerome Powell and Treasury Secretary Steven Mnuchin for moving the risk of leveraged loans outside the banking system. Like former Fed Chair Alan Greenspan, who downplayed the risks posed by subprime mortgages, Powell and Mnuchin have downplayed any trouble CLOs could pose for banks, arguing that the risk is contained within the CLOs themselves.

These sanguine views are hard to square with reality. The Bank for International Settlements estimates that, across the globe, banks held at least $250 billion worth of CLOs at the end of 2018. Last July, one month after Powell declared in a press conference that “the risk isn’t in the banks,” two economists from the Federal Reserve reported that U.S. depository institutions and their holding companies owned more than $110 billion worth of CLOs issued out of the Cayman Islands alone. A more complete picture is hard to come by, in part because banks have been inconsistent about reporting their CLO holdings. The Financial Stability Board, which monitors the global financial system, warned in December that 14 percent of CLOs—more than $100 billion worth—are unaccounted for.

I have a checking account and a home mortgage with Wells Fargo; I decided to see how heavily invested my bank is in CLOs. I had to dig deep into the footnotes of the bank’s most recent annual report, all the way to page 144. Listed there are its “available for sale” accounts. These are investments a bank plans to sell at some point, though not necessarily right away. The list contains the categories of safe assets you might expect: U.S. Treasury bonds, municipal bonds, and so on. Nestled among them is an item called “collateralized loan and other obligations”—CLOs. I ran my finger across the page to see the total for these investments, investments that Powell and Mnuchin have asserted are “outside the banking system.”

The total is $29.7 billion. It is a massive number. And it is inside the bank.

You’ll note that I correctly predicted this year’s economic crash… although the financial aspect has yet to show up despite an economic contraction of nearly one-third. The CLO meltdown is how the economic crash is most likely to translate to the inevitable financial crash, whether it happens before or after the end of the calendar year.


Unprecedented

In case you don’t fully appreciate how fragile the global economy is, notice that the banks have rendered themselves almost entirely irrelevant now thanks to the tsunami of debt they have created:

The Bank of England indicated Thursday that it could cut interest rates below zero for the first time in its 326-year history as it tries to shore up a U.K. economic recovery that is facing the dual headwinds of the coronavirus and Brexit.

After unanimously deciding to maintain the bank’s main interest rate at the record low of 0.1{5274a41d3bd2aa3d5829764fe19e8a7ecbc79c108731aad5f1ff2d292e60e2b4}, the nine-member rate-setting Monetary Policy Committee said it had discussed its “policy toolkit, and the effectiveness of negative policy rates in particular.”

In minutes accompanying the decision, the rate-setters said a recent wave of virus infections has “the potential to weigh further on economic activity, albeit probably on a lesser scale than seen earlier in the year.”

Though the committee noted that recent economic data have been a “little stronger than expected” at its last meeting in early August, it said it is unclear what that says about the future “given the risks.”

One clear concern relates to whether Britain, like others in Europe, will reimpose broad restrictions on businesses and public life after the recent flare-up in virus infections across the region. Already social gatherings are being restricted and certain areas of the U.K. are seeing localized lockdowns.

The British economy suffered one of the deepest recessions in the world this year when many sectors were effectively mothballed to help contain the pandemic. Though it recouped some ground in the summer as lockdown restrictions were eased, the economy was still around 12{5274a41d3bd2aa3d5829764fe19e8a7ecbc79c108731aad5f1ff2d292e60e2b4} smaller at the end of July than it was in February, when the pandemic started in Europe.

Debt jubilee is the only way out. Debts that cannot be repaid will not be repaid. The key to the solution is to make sure that those who are responsible for this epic debacle are forced to bear the primary consequences and are prevented from attempting to recreate the situation.


Not your father’s Dow Jones

This sort of regular reshuffling is why there is no point tracking the Dow Jones Industrial Average, or any other stock market index, over time:

Exxon is being kicked out of the Dow Jones Industrial Average index, where it has had a place since 1928. The reason: the Dow needed to make space for other, more valuable companies – and Apple’s stock split, CBS News reports.

The change will be effective on August 31.

Exxon, which was the oldest member of the index for the last two years after Dow removed GE, has been one of the most valuable companies in the US and the world for decades. That is until Big Tech showed up and began changing the world, its stock reflecting this change by swelling market caps.

Energy, which featured solidly on the index and in people’s lives a few decades ago, is being booted out by technology – Exxon’s replacement on the DJIA is a software company, Salesforce.

It was the realization that stock market numbers simply were not what I had been taught they were that first set me upon the path of becoming a stock market contrarian. The annual turnover in the NASDAQ is often on the order of five percent, which renders comparisons from one year to the next, let alone to previous decades, entirely meaningless.

Bet at the casino if you like, so long as you understand that it is no more “investing” than playing the slots at Caesar’s Palace.


Genius vs Nobel Laureate

Never, ever, bet on the prize winners. Remember, Bob Dylan was awarded the Nobel Prize for LITERATURE without ever even WRITING A BOOK! In his paper entitled “The Appallingly Bad Neoclassical Economics of Climate Change”Steve Keen, arguably the greatest living economists, critiques the prize-winning work of the 2018 winner of the Fake Nobel in Economics, Steve Nordhaus

Read the whole thing if you’re economically inclined, but I anticipate that even non-economists will find his concluding section below to be both informative and amusing.

When I began this research, I expected that the main cause of Nordhaus’s extremely low predictions of damages from climate change would be the application of a very high discount rate (Nordhaus, 2007)11 to climate damages estimated by scientists (Hickel, 2018), and that a full critique of his work would require explaining why an equilibrium-based Neoclassical model like DICE12 was the wrong tool to analyse something as uncertain, dynamic and far-from-equilibrium as climate change (Blatt, 1979; DeCanio, 2003).13 Instead, I found that the computing adage ‘Garbage In, Garbage Out’
Figure 10. Kahn and Mohaddes’s linear extrapolation of the temperature: GDP relationship from 1960–2014 out till 2100 (Kahn et al., 2019, p. 6).

(GIGO) applied: it does not matter how good or how bad the actual model is, when it is fed ‘data’ like that concocted by Nordhaus and the like-minded Neoclassical economists who followed him. The numerical estimates to which they fitted their inappropriate models are, as shown here, utterly unrelated to the phenomenon of global warming. Even an appropriate model of the relationship between climate change and GDP would return garbage predictions if it were calibrated on ‘data’ like this.

This raises a key question: how did such transparently inadequate work get past academic referees?
Simplifying assumptions and the refereeing process: the poachers becomes the gatekeepers
One reason why this research agenda was not drowned at birth was the proclivity for Neoclassical economists to make assumptions on which their conclusions depend, and then dismiss any objections to them on the grounds that they are merely ‘simplifying assumptions’.

As Paul Romer observed, the standard justification for this is ‘Milton Friedman’s (1953) methodological assertion from unnamed authority that ‘the more significant the theory, the more unrealistic the assumptions’ (Romer, 2016, p. 5). Those who make this defence do not seem to have noted Fried-man’s footnote that ‘The converse of the proposition does not of course hold: assumptions that are unrealistic (in this sense) do not guarantee a significant theory’ (Friedman, 1953, p. 14).

A simplifying assumption is something which, if it is violated, makes only a small difference to your analysis. Musgrave points out that ‘Galileo’s assumption that air-resistance was negligible for the phenomena he investigated was a true statement about reality, and an important part of the explanation Galileo gave of those phenomena’ (Musgrave, 1990, p. 380). However, the kind of assumptions that Neoclassical economists frequently make, are ones where if the assumption is false, then the theory itself is invalidated (Keen, 2011, pp. 158–174).

This is clearly the case here with the core assumptions of Nordhaus and his Neoclassical colleagues. If activities that occur indoors are, in fact, subject to climate change; if the temperature to GDP relationships across space cannot be used as proxies for the impact of global warming on GDP, then their conclusions are completely false. Climate change will be at least one order of magnitude more damaging to the economy than their numbers imply – working solely from rejecting their spurious assumption that about 90{fb585635b9f6189e33442b25caac15ec2544d7054f182b4f92840c6cee65accd} of the economy will be unaffected by it. It could be far, far worse.

Unfortunately, referees who accept Friedman’s dictum that ‘a theory cannot be tested by the ‘realism’ of its ‘assumptions’’ (Friedman, 1953, p. 23) were unlikely to reject a paper because of its assumptions, especially if it otherwise made assumptions that Neoclassical economists accept.

Thus, Nordhaus’s initial sorties in this area received a free pass.

After this, a weakness of the refereeing process took over. As any published academic knows, once you are published in an area, journal editors will nominate you as a referee for that area. Thus, rather than peer review providing an independent check on the veracity of research, it can allow the enforcement of a hegemony. As one of the first of the very few Neoclassical economists to work on climate change, and the first to proffer empirical estimates of the damages to the economy from climate change, this put Nordhaus in the position to both frame the debate, and to play the role of gatekeeper. One can surmise that he relished this role, given not only his attacks on Forrester and the Limits to Growth (Meadows, Randers, et al., 1972; Nordhaus, 1973; Nordhaus et al., 1992), but also his attack on his fellow Neoclassical economist Nicholas Stern for using a low discount rate in The Stern Review (Nordhaus, 2007; Stern, 2007).

The product has been an undue degree of conformity in this community that even Tol acknowledged:

it is quite possible that the estimates are not independent, as there are only a relatively small number of studies, based on similar data, by authors who know each other well … although the number of researchers who published marginal damage cost estimates is larger than the number of researchers who published total impact estimates, it is still a reasonably small and close-knit community who may be subject to group-think, peer pressure, and self-censoring. (Tol, 2009, p. 37, 42–43)

Indeed.

Were climate change an effectively trivial area of public policy, then the appallingly bad work done by Neoclassical economists on climate change would not matter greatly. It could be treated, like the intentional Sokal hoax (Sokal, 2008), as merely a salutary tale about the foibles of the Academy.

But the impact of climate change upon the economy, human society, and the viability of the Earth’s biosphere in general, are matters of the greatest importance. That work this bad has been done, and been taken seriously, is therefore not merely an intellectual travesty like the Sokal hoax. If climate change does lead to the catastrophic outcomes that some scientists now openly con-template (Kulp & Strauss, 2019; Lenton et al., 2019; Lynas, 2020; Moses, 2020; Raymond et al., 2020; Wang et al., 2019; Xu et al., 2020; Yumashev et al., 2019), then these Neoclassical economists will be complicit in causing the greatest crisis, not merely in the history of capitalism, but potentially in the history of life on Earth.


Devil Mouse debt watch

Or is it death watch?

Based on Walt Disney’s balance sheet as of May 5, 2020, long-term debt is at $42.77 billion and current debt is at $12.68 billion, amounting to $55.45 billion in total debt. Adjusted for $14.34 billion in cash-equivalents, the company’s net debt is at $41.11 billion. Walt Disney has $206.29 billion in total assets, therefore making the debt-ratio 0.27.

The Q3 report as of June 27 has long-term debt at $54.2 billion and current debt at $10.22 billion, amounting to $64.42 billion in total debt. Adjusted for $23.12 billion in cash-equivalents, the net debt is $41.3 billion vs $207.65 billion in total assets.

In other words, while the balance sheet doesn’t show the impact of Corona-chan on the organization yet, Disney is having to borrow a LOT of money in order to keep enough cash on hand to pay its bills. Keep in mind that less than two years ago, the Devil Mouse had $3 billion less total debt than it currently holds in cash.


No worries, it’s all fine

This relaxed response to the US economy hitting historical debt heights tends to remind me of Goldman Sachs telling everyone that the US economy was recession-proof in December, 2019:

Economists and deficit hawks have warned for decades that the United States was borrowing too much money. The federal debt was ballooning so fast, they said, that economic ruin was inevitable: Interest rates would skyrocket, taxes would rise and inflation would probably run wild.

The death spiral could be triggered once the debt surpassed the size of the U.S. economy — a turning point that was probably still years in the future.

It actually happened much sooner: sometime before the end of June.

The problem with debt crisises is that everything is always fine right up until the moment that it isn’t.


Corporations that can’t play by the rules

How can “gig economy” corporations expect to survive if they have to obey the laws? Obviously, they can’t, as Uber and Lyft flee California due to their inability to continue abusing their drivers:

After a California court’s preliminary injunction required Uber and Lyft to reclassify drivers as employees, both companies threatened to shut down their ride-hailing services, with the latter confirming the move.

Lyft will suspend its transportation activity in California at 11:59pm local time on Thursday, the company announced in a blog post. “This is not something we wanted to do, as we know millions of Californians depend on Lyft for daily, essential trips,” the company – valued in the billions of dollars – lamented.

“We’re personally reaching out to riders and drivers to share more about why this is happening, what you can do about it, and to provide some transportation alternatives,” it added.

The drastic move was prompted by a preliminary court decision last week that required Uber and Lyft to stop classifying their drivers as independent contractors.

If your business model is dependent upon breaking either the employment or the consumer laws, it isn’t a sustainable one, no matter how heavily Wall Street may be willing to invest in it.

Gig economy gigs lower the price of labor, which in the USA has remained flat since 1973. It is as deleterious as the doubling of the female workforce and the mass immigration that are the two primary contributors to the low price of labor that has rendered US society unstable and destroyed the middle class.

The important thing to remember is that consent does not define morality. The prostitute consents to sell her body, the debt-slave consents to sell his labor, and the defrauded consents to invest his money, yet we find these practices to be both morally wrong and illegal. California gets many things hopelessly wrong, but its strong legal protections for employees and consumers against the rapacious predators of the financial class is not one of them.

And if you think Uber is a fine capitalist corporation being abused by the socialists in the California legislature, I suggest you look up the documents related to Abadilla et al v. Uber Technologies, Inc. and you will rapidly learn otherwise. I don’t know much about Lyft, but Uber is an abusive, lawless, and hypocritical organization that mandated independent arbitrations for its drivers, then spent FIVE YEARS in a futile attempt to prevent more than 12,000 of those drivers from exercising their only remedy against the corporation’s mistreatment of them.

In fact, this decision to flee California is a consequence of the two corporations’ long-running attempts to avoid the arbitrations they mandated. Sound familiar?

In combatting these individual arbitration claims, the ride-share companies adopted several tactics including: 1) delay the arbitrations by not paying the arbitration initial filing fees, 2) challenging their opposing counsels’ qualifications, and 3) offering incentives for employees to drop their arbitration claims.

Don’t be surprised when Patreon suddenly announces an “unexpected” relocation to Utah.


Recession proof

Or maybe not. Remember how I pointed out that there was going to be a crash this year? Now consider what Goldman Sachs was saying at the end of December:

Just months after almost everyone on Wall Street worried that a recession was just around the corner, Goldman Sachs said a downturn is unlikely over the next several years.

In fact, the firm’s economists stopped just short of saying that the U.S. economy is recession-proof.

An analysis Goldman conducted of the current potential risks to growth show that they are mostly muted. The report found that the pillars of the “Great Moderation” that began in the 1980s — low levels of volatility marked by sustainable growth and muted inflation, interrupted only by the financial crisis more than a decade ago — are still standing.

Investors could be excused for getting a little nervous over such calls, as optimism also was heavy in late 2007, just as the economy was about to enter the worst of the financial crisis.

So much for those “mostly muted” risks to growth.


Deflationary inaction

Banks are flat-out refusing to provide business loans unless the government fully guarantees them so they aren’t subject to any risk. It’s interesting, though hardly surprising, to see that the loan guarantees are actually making loans harder to get.

I own and operate a consulting company the end goal of which is to set up & provide loans through multiple funding channels to franchisees of large and small chains nationally. The chains I work with many of you will be familiar with —dominos, jersey mikes, massage envy, European wax center, the joint, club Pilates, jimmy johns, wingstop, Orangetheory, moes southwest.  And many others.  Point is I have BROAD spectrum national exposure to many industries

The banks I work with are SBA, conventional lenders who service smaller loans under 2mm and generally smaller operators of these franchise systems, and then larger banks who provide loans to larger operators from 2-50mm.  I’m short — 20+ banks across ALL spectrum of SME lending

I fund 400-500mm in loans per year through these banks. In February we were on pace to fund well over 500mm and potentially 750mm — growing exponentially year over year.  STIFF DRINK TIME.  Since April 1st we have funded 5mm total through only 2 banks.  Let’s dive in as to why.

SBA banks — they have lending limits to 5mm.  Congress has authorized them to go to 10mm in the CARES Act but they have ignored it.  This will become important later.   They currently have guarantees from the govt at 80{4e01b0bc4ab012654d0c5016d8cbf558644ab2e53259aa2c40b66b3b20e8967d} – pretty good right? DOESNT MATTER THEY STILL WONT LEND

In fact they are pushing the government to guarantee 90{4e01b0bc4ab012654d0c5016d8cbf558644ab2e53259aa2c40b66b3b20e8967d} of the loans (and likely on their way to 100{4e01b0bc4ab012654d0c5016d8cbf558644ab2e53259aa2c40b66b3b20e8967d} — see my prior posts on the de facto nationalizion of the banking system).  In short SBA has SHUT OFF BORROWERS waiting for more from Uncle Sam.

Current excuses ARE PLAYING BOTH SIDES (and this applies to all banking segments). A chain with increased sales since pandemic — no loan. “We want to wait to see if sales increases are sustainable” Doesn’t matter that sales are up.  They may not be “sustainable”

On the other side for businesses with sales down — “well we just aren’t comfortable sales will rebound and we have concerns over COVID”.   So sales up = no loan.  Sales down or flat = no loan.  Operator size IRRELEVANT.   Are some banks lending? Yes. This is 75-80{4e01b0bc4ab012654d0c5016d8cbf558644ab2e53259aa2c40b66b3b20e8967d} of SBA banks. They are also being EXTREMELY selective on industries they will do.  If you are an industry with “large public gatherings” you better pray to Santa Claus for money.

On to conventional banks.   Little known fact is that 50+{4e01b0bc4ab012654d0c5016d8cbf558644ab2e53259aa2c40b66b3b20e8967d} have LEFT THE FRANCHISE LENDING SPACE ENTIRELY.  Of the remaining 50{4e01b0bc4ab012654d0c5016d8cbf558644ab2e53259aa2c40b66b3b20e8967d} — 90{4e01b0bc4ab012654d0c5016d8cbf558644ab2e53259aa2c40b66b3b20e8967d} of those are not taking new clients.   And they are not lending to their existing clients generally.

This is just one of the many reasons that a debt-based economy is a very, very bad idea. It’s the exact opposite of antifragility.


Hea culpa

Paul Krugman admits that he may, perhaps, have been a little incorrect about that whole global economy thing, at least in the short term:

Concerns about adverse effects from globalization aren’t new. As U.S. income inequality began rising in the 1980s, many commentators were quick to link this new phenomenon to another new phenomenon: the rise of manufactured exports from newly industrializing economies.

Economists took these concerns seriously. Standard models of international trade say that trade can have large effects on income distribution: A famous 1941 paper showed how trading with a labor-abundant economy can reduce wages, even if national income grows.

And so during the 1990s, a number of economists, myself included, tried to figure out how much the changing trade landscape was contributing to rising inequality. They generally concluded that the effect was relatively modest and not the central factor in the widening income gap. So academic interest in the possible adverse effects of trade, while it never went away, waned.

In the past few years, however, worries about globalization have shot back to the top of the agenda, partly due to new research and partly due to the political shocks of Brexit and U.S. President Donald Trump. And as one of the people who helped shape the 1990s consensus — that the contribution of rising trade to rising inequality was real but modest — it seems appropriate for me to ask now what we missed.

There’s been a lot of this going around. Leading globalists such as Kissinger and Fukuyama have published learned tomes explaining why globalism has “unexpectedly” failed. Of course, it never occurs to them to admit that nationalist skeptics like me were correct all along, hence these revisionist self-critiques that are primarily intended to salvage the tattered remnants of their award-winning reputations.

In the meantime, I will patiently await my Quasi-Nobel Prize in Economics for creating the Labor Mobility proof of the impossibility of free trade.

And I will also fisk Krugman’s entire column on the Darkstream this weekend.