BIS Snubs Greek Bonds

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Welcome back ASX/200 at 5,000. You look a bit winded. But the extra points look good on you. Who says a plus size resource boom isn’t as sexy as the housing market?

Yes, for the first time in 19 months the benchmark index for Australian stocks is breathing rarefied air. But the question today is whether this is just a base camp for the 6,000 level (a kind of false summit), or the actual summit itself of the post-reflation stock market high.

Commodities are certainly enjoying the view. Palladium made a two-year high at US$548/oz and gold was up. And to think that neither of those two precious metals are Dr. Alex Cowie’s favourite metal of 2010. That honour is reserved for platinum.

You would think with markets trudging higher, Joe Bloggs would be happy. But that was not the case yesterday when David Lowman, an executive for JP Morgan who was in Washington to testify in front of Congress, invited homeowners worried about getting foreclosed on to “come to me.” They did.

Not quite with pitchforks. But according to Reuters, “around 50 borrowers burst from the audience and presented Lowman with a 6-page document alleging his bank reneged on a pledge to help struggling homeowners.” Back on Wall Street, JP Morgan reported a 55% increase in first quarter profits on $3.3 billion in net income.

Anecdotal evidence, via ZeroHedge, is that U.S. homeowners (perhaps encouraged by the government and NOT discouraged by the banks) are simply not paying their mortgages. This boosts consumer spending. And the banks participate in the fiction by pretending the payments are being made and not marking the loans to market.

Not living in America anymore, it’s hard to say what’s really going in. But it sounds like the whole place has become a kind of Absurdistan where the government changes the rules of contract willy nilly and bank balance sheets can be whatever you want them to be, provided they are not accurate.

Hey while we’re thinking of it, good luck to Steve Keen and his crew on their way to Mt. Kosciuszko. We agree with Steve on the inevitable correction in house prices. But perhaps we both have underestimated the government’s determination in supporting prices. Still, it would be nice to get some fresh air today. The walk can’t be all that bad.

Uh oh. Just when you thought it was safe to jump back into Greece again, news comes that Greek borrowing costs have soared above 7% interest. AFP reports that, “Taxi drivers and lawyers have begun strikes against planned budget cuts.” Yet the important news here is that despite the assurances of loans from the EU, market investors are making the Greeks pay to borrow. Why?

Let’s turn the floor over to BIS Working Papers No 300, the future or public debt: prospects and implications, written last month Stephen Cecchetti, M S Mohanty, Fabrizio Zampolli. Hang on! Wake up! This is important.

“So far, at least, investors have continued to view government bonds as relatively safe,” the trio begins. “But bond traders are notoriously short-sighted, assuming they can get out before the storm hits: their time horizons are days or weeks, not years or decades.” This, by the way, could also be a symptom of fiddling with interest rates. It incentives short term financial calculations at the expense of long-term capital allocation.

“We take a longer and less benign view of current developments, arguing that the aftermath of the financial crisis is poised to bring a simmering fiscal problem in industrial economies to boiling point. In the face of rapidly ageing populations, for many countries the path of pre-crisis future revenues was insufficient to finance the promised expenditure.”

Australia, you might argue, would not fit into this dismal forecast for industrial economies. After all, Australia has rising real growth from its trade and commodity relationship with emerging markets in Asia. Even rising real interest rates won’t cripple the government ability to borrow internationally, provided it can service that debt with income from the commodity trade.

But what would happen if global investors started putting the question to governments more pointedly about how they intend to pay for future spending? “The question,” the three amigos write, “is when markets will put pressure on governments, not if.”

“When, in the absence of fiscal actions, will investors start demanding a much higher compensation for the risk of holding the increasingly large amounts of public debt that authorities are going to issue to finance their extravagant ways?”

If you’re a prudent investor, the answer to that is: now!

As we mentioned the other day, one way of explaining the new highs in the indexes is a rejection of government bonds in favour of stocks. Mind you, the conventional wisdom is that stocks are moving higher because investors are fleeing out of “safe assets” like bonds and back into “risk asset” like stocks or even emerging market bonds.

But with valuations already stretched, you shouldn’t be surprised to see stocks run out of momentum from here. What’s the old expression…sell in May and go away! But go where?

How about cash and tangible assets? This is what’s driving, at least partly, higher precious metals prices. And we’d venture to guess that more people now prefer actual ownership of those metals to paper claims on them. In fact, we aim to prove next week that there is a shortage of precious metals relative to paper claims on them next week.

For now, what should you expect? Well, unstable debt dynamics have a way of leading to unstable geopolitics too. You can never know what external event is going to trigger a loss of confidence by investors. But it will be a cold slap to the face when it comes.

But in the meantime, our editors here (Kris, Alex, and Murray) are using the higher index levels to lift their trailing stops and lock in profits on open positions that have benefitted from the rally that began last March. You can make money. But at this point, it looks a lot like speculation and very little like investing.

More on the BIS paper tomorrow…and on how to make it large in the second world.

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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Comments

  1. The Obama TARP programme has $50bn specificaly for mortgage foreclosure aid but is only getting a 1 in 10 success rate.

    http://money.cnn.com/2010/04/14/real_estate/COP_foreclosure_mitigation_report/index.htm

    Even when they are successfull it is only in the “now”, there is no guarantees that it isn’t going to fall to pieces as families and health and jobs that produce income to service the debt can fall apart over time.

    Denninger cites today
    quote
    Bank of America, the nation’s largest mortgage lender, ramped up its foreclosure activity in March, sending hundreds of letters warning delinquent borrowers in the region that it could sell their homes at auction in as little as three weeks, according to North County Times analysis of data from ForeclosureRadar.

    The bank said the increased activity was a natural consequence of borrowers running out of options.
    unquote

    But at least BOA are trying to get on top of their “extend and pretend” problem

    He has another of his “tickers” citing someone who thinks he can stick his head in the sand forever …

    quote
    The gloves came off entirely Tuesday in testimony before the House Committee on Financial Services. David Lowman, Dimon’s lieutenant and the CEO of Chase’s home lending, argued strongly against a cornerstone of the Obama Administration’s plan to help homeowners facing foreclosure.

    In his testimony (which can be read in its entirely in this pdf), Lowen sought to take the high ground in opposing the reduction of mortgage principal. “Like all loans, mortgage contracts are based on a promise to repay money borrowed,” he said. “If we re-write the mortgage contract retroactively to restore equity to any mortgage borrower because the value of his or her home declined, what responsible lender will take the equity risk of financing mortgages in the future? What responsible regulator would want lenders to take such risk?”

    unquote

    But as Denninger explains, any underwater mortgage not fixed by principal reduction goes underwater and that is 100% Chase’s problem. The borrower gets stuff all equity anyway and most are non recourse loans, so no deal and they walk ….. So Lowman is a dope.

    Reply
  2. “… and lawyers have begun strikes against planned budget cuts.”
    Wow! bring it on!

    Reply
  3. Sell in May and Go where? Well Italy is nice and they have been drowning in debt for years and an ageing population but somehow seem to muddle along. The food and wine is still superb, scenery is beautiful and people know how to enjoy life – bit like Argentina really.

    Reply

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