Courtesy of The Automatic Earth.
William Rittase Production line at Pioneer Parachute Co., Manchester, CT August 1942
The Financial Times started a series on shadow banking this week, which should be obligatory reading material for everyone who’d like a peek behind the veiled curtain that hides from scrutiny those things financial that would rather not be exposed to daylight, both in the west and – obviously by now – in Asia. Obligatory reading material doesn’t mean everything Financial Times journalists write should be taken for granted, they survey the terrain with the substantial bias that their employer thrives on. Still, that same employer has resources – in more ways than one – that few other sources possess.
Hedge Fund Chiefs And Former Bankers Enter The Shadows
In the six years since the financial crisis, the financial services world has seen all kinds of new institutions take over lending deals and clients that were once the domain of traditional banks. There has also been a parallel transformation: the mutation of bankers into shadow bankers, writes Patrick Jenkins in London. The bosses of many shadow banks – hedge funds, private equity and debt funds, tax-efficient “business development companies” and peer-to-peer lenders – seem increasingly to have been drawn from the upper ranks of the big traditional lenders.
Many bankers have become disillusioned with the old ways of doing things, demotivated by weak market conditions and shrinking ambitions, and frustrated by a mountain of new regulations. The freer world of shadow banking offers welcome liberation. It also presents an opportunity for those with experience in banking because they know where the business opportunities – and the regulatory loopholes – lie. But if the migration of bankers into shadow banking is a clear pattern in western markets, elsewhere it is harder to make such generalisations. Anecdotal evidence in China, one of the biggest – and most concerning – shadow banking markets, suggests a far more eclectic heritage at the helm of big non-bank lenders, a development that adds to the potential risks..
While shadow banking and dark pools and all of their siblings absolutely need to be erased from our own economies if we ever want to make them function in anything remotely resembling a ‘democratic normal’ again, in China the financial and – therefore – political powers lurking in the shadows are at least as dangerous, even if democracy is not the issue there. The reigning Communist Party and PBoC may have expanded their money supply far more than any other nation, including the US and Japan, who themselves have already gone totally insane, but the shadow banks have added much more to that, and the $25 trillion number touted could be a serious underestimation; we just have no way of knowing by how much.
A huge part of both the “official” increase of the money supply and the shadow part, which are far more tightly intertwined than anyone lets on, has been highly leveraged to boot. Over the past 10+ years, the Chinese economy has been a gambling parlor where no-one could lose no matter how crazy their bets became. Problem is, it did get too crazy; there’s so much leveraged debt hidden between local governments and 50 million empty apartments and ‘trust’ companies that not even a ‘normal’ desired low growth of 7% could keep things afloat.
As Beijing wants to enforce the rule that only its own Monopoly money is real, it digs its own downfall; it’s no longer feasible to take out of the economy those building blocks that belong in the shadows, because the entire edifice would crumble. It’s not feasible to leave them in place either, because a large majority of them are made of hot air only. That is Xi and Li’s conundrum in a nutshell. The Communist party saw themselves as architects at a great construction site, but they never bothered to properly check the quality of the bricks and cement that were used. They were far more preoccupied with reaching for the skies and the moon and the stars.
One example of China’s financial madness is of course the closed ports of Qingdao, where investigators and bankers scramble to get a clear(er) picture of which copper, aluminum, iron ore, steel or peanut oil stored inventory belongs to whom, after it was found that the same copper etc. was used as collateral for loans from more than one lender. Therefore, much of what’s stored in the warehouses belongs to several different “owners”, and there’s plenty that doesn’t exist at all except on paper. And there’s no way it’s only Qingdao, the practice became too widespread and too accepted and acceptable, and hence profitable not to have been used all over the country, and often with Communist Party involvement.
Well, that highly irritating loud screeching sound you hear is that of the margin call. Lenders come calling for their money back. And there is no money. What is left is iron ore inventories that have been used to get loans from 3-4-5-10 different lenders, and that just lost 44% of what value they had. Quite a few greedy entrepreneurs are at risk of having their kneecaps redesigned:
China Miners’ Loss Is BHP’s Gain as Iron Prices Slump 44%
Rio Tinto Group and BHP Billiton, two of the world’s biggest iron ore producers, are benefiting as falling iron ore prices pressure smaller rivals in China to shut down. The price of iron ore has plunged 44% from its February 2013 peak on the back of record output. That’s hurting mining companies in China where 20% to 30% of mines have closed, according to the China Metallurgical Mining Enterprise Association. The closures are helping Rio Tinto and BHP which, along with Vale, already control about two thirds of global seaborne supply from their low-cost mines. About $40 billion a year of iron ore is mined in China, the country that’s also the world’s biggest buyer of the steelmaking component.
“Many smaller mines in China have stopped production due to the falling prices,” said Sarah Wang, a Shanghai-based analyst with Masterlink Securities Corp. “It’s the right time for BHP and Rio to seize the opportunity to boost their market share.” BHP, the world’s biggest mining company, last month also flagged the closure of some Chinese ore mines. “Most of them are smaller ones, while the bigger ones are also starting to be affected,” Liu Xiaoliang, the association’s general secretary, said in an interview. “Almost 70% of the ore processing companies have also closed.”
You don’t want to be on the wrong side of any of these deals, least of all in China. It’s not good for your health, or your kneecaps, or digits. The Bloomberg headline that says a 44% price plunge is good for BHP or Rio Tinto needs a fair amount of salt, of course; they just lost a lot of money. And someone’s going to be selling a lot of these assets, at heavy losses, into the markets just to recuperate some cash.
One other thing the FT published, by Harvard political economy professor Benjamin Friedman, needs a bit of our attention. I think the best way start off with is through Mike Mish Shedlock, who in a reaction to one of FT’s shadow articles speaks truth to nonsense:
The Financial Times states “The concern is that financing could disappear for the most leveraged and riskiest parts of the economy, from real estate developers to steel mills. China’s investment-reliant growth could come to an abrupt end.” That’s ridiculous. The concern ought to be that absurd lending to unprofitable, poorly-managed companies and State-Owned-Enterprises (SOEs), continues, not that it ends. The longer malinvestment foolishness continues, the bigger the ultimate crash.
Mish sets the tone, and the principle, in a clear and concise manner: cut the crap, let’s get this thing back on its feet. Most people, including FT writers, have come to see the central bank largesse as positive, or necessary, even inevitable. Mish has not, and neither have I. That largesse is the greatest scourge upon us, because it can ultimately lead to one outcome only: it will devastate, obliterate, the man in the street just to keep up appearances of a functioning economy, which in reality ceases to exist the very moment central banks start supporting failed banks and other institutions through asset purchases and other stimuli.
Benjamin Friedman is one of the fools who wish to argue Bernanke, Kuroda and Draghu are doing us a favor. He calls his article “The Perils Of Returning A Central Bank Balance Sheet To ‘Normal’”, but really that should have been “The Perils Of A Functioning Economy”, because that’s what winding down a central bank’s balance sheet would achieve.
This may be complicated by the fact that all central banks are stuck in the same destructive stimulus and too-big-to-fail patterns, but the outcome is crystal clear no matter what: they can’t continue their behavior forever, and the hopes for an escape velocity recovery are imaginary only at this point, see for instance today’s Bloomberg: US Housing Falters as Forecasters See Sales Dropping. The lesson from that, for Yellen and the man in the street alike, is that central banks cannot cure economies, they can only distort them and make them – much – worse. Friedman’s arguments are one dimensional, blinders firmly in place (but if everyone around you wears them, who notices?):
The Perils Of Returning A Central Bank Balance Sheet To ‘Normal’
With the US Federal Reserve on its way to bringing its bond-buying programme to an end, many are asking how to return the central bank’s balance sheet to “normal” – that is, to its pre-crisis size and composition. The same debate is under way at other central banks. Should they sell their bonds, or hold on to them until they mature? And if they are going to sell, which securities should go first? Yet there is another question that is equally important but seldom asked: is it sensible to return central banks’ balance sheets to “normal”? There are good reasons not to.
At the beginning of 2007, the Federal Reserve System’s assets totalled $880bn. Today, the balance sheet stands at $4.3tn, including $2.4tn of Treasuries and $1.7tn of mortgage-backed securities. The reason for buying these assets was not to reduce the federal funds rate, which had reached zero by late 2008, but to lower the interest rates at which loans are extended to people and businesses, stimulating demand. The evidence shows that these bond purchases indeed lowered long-term rates relative to short-term rates, and lowered rates on more-risky compared with less-risky obligations. A conservative estimate is that a $600bn bond purchase (the size of the Fed’s second round of bond buying) lowered long-term interest rates by about 25 basis points: not enormous, but a worthwhile contribution to the US economic recovery.
There is no such thing as “a worthwhile contribution to the US economic recovery”, because there is no such recovery. What people like Friedman see, because they like it that way, is not recovery, it’s the Fed buying all these assets solely in order to keep the economy from functioning, from getting rid of bad and dead elements. It’s the Fed hindering the economy from functioning, for the simple reason that it favors some of its components, i.e. banks et al, which should no longer be alive because they gambled and lost far too big.
The composition of the assets that the central bank buys matters too. Buying mortgage-backed securities narrowed the difference between the interest rate American homeowners paid on their mortgages and the rate at which the US government could borrow. This helped stop house prices from falling and spurred residential construction. Buying or selling bonds gives the Fed a way of influencing longer-term interest rates in general, and mortgage rates in particular. This lever will remain useful long after short-term rates begin to rise. But it will be out of reach if the central bank returns its balance sheet to its pre-crisis state.
Oh, boy, did Americans ever benefit from the Fed bailing out its favorites and paymasters. Low interest rates for loans on grossly overpriced homes, what more can a US citizen ask for?
… no increase in inflation has yet appeared in any economy that has pursued this course. That is because the central banks in question have made it advantageous for banks to redeposit the additional reserves instead of lending against them. This has prevented these asset purchases from triggering what might otherwise be an inflationary flood of credit.
That’s just another way of saying QE doesn’t benefit the real economy, isn’t it? That all the Fed and its purchases do is perpetuate the illusion of a functioning economy while in reality no such thing exists anymore.
For decades, it has been commonly understood that the central bank’s policy interest rate is the only independent instrument of monetary policy. We now see that there are two: the policy interest rate and asset purchases or sales. But the central bank cannot sell what it does not own. To keep this additional policy tool available, the Fed and other central banks should hold on to an ample supply of assets. They should not shrink their balance sheets to the pre-crisis size.
Yes, they should. Central banks should withdraw all stimulus and sell all assets purchased, and let the market decide what they are worth. That is the only way to get a functioning economy back on track. Sure, it’ll be painful, especially for the financial industry. But it will also be real. And we all need a hefty dose of reality, sooner rather than later. If only because it’s the sole way to an actual recovery. But a functioning economy indeed has perils, for those who hold assets that have not been marked to market. It’s ironic, but power in our societies today lies with who holds most of the bad assets. And as long as they can make the rest of us believe that these things have real value, that’s where power will stay. And that’s exactly why today more than ever we need a functioning economy, to turn that wrong around and make it right.
