Global Illness of Too Much Debt has Been Remedied by More Debt


A huge storm has blown through. Startled bystanders were caught by surprise. The damage was sudden and vicious. And then as quickly as it blew in, out it went and everything seemed to be back to normal. At least that was how the weather man described Saturday’s freak storm in Melbourne.

Your editor was semi-conscious over the Pacific ocean at the time, so he can’t vouch for reports. But our 30 hour trip back from Baltimore, via Chicago, L.A., and Sydney gave us time to think. Are we just being a paranoid nutcase about the global economy? Or is the position – gradually reduce your exposure to stocks and increase your tangible asset holdings – pretty sensible in a world with soaring debt and ambitious socialists?

You’ll find our answer in just a moment. In the markets, it’s pretty sunny out. While most of Australia idled its way through Labour Day yesterday, the ASX/200 crested through 4,800. It was a six-week high for the index. And then the news got better.

Newswires report that Royal Dutch Shell and PetroChina have offered $3.31 billion in cash and stock for coal-seam-gas player Arrow Energy (ASX:AOE). There’s some consolidation going on now in Queensland’s unconventional gas sector. So what should you do?

Nothing. The time to do some speculating was in November and December of 2008. That’s when our colleague Kris Sayce tipped two of the entrants in the CSG race in Queensland. As the projects were “de-risked” the share prices went up. We phoned up Kris down the hall this morning and it is long-since out of his LNG positions.

The point? You have to be a year or two ahead of these big ideas and risk looking like a fool to make the big money on them. There’s probably plenty of safe money to be made still. And if you are not a speculator or you don’t have money you can’t afford to lose, you shouldn’t be playing the small cap game at all.

But as we contended at a dinner in Baltimore last week, the best reason to be in equities at all right now is for the chance to make five or ten times your money. These are Taleb’s positive Black Swans, the low-probability, high-magnitude events that are actually good for your portfolio. Your much better off owning a portfolio of disruptive technologies or prospective ore bodies leveraged to higher commodity prices than blue chip stocks. Why?

The share market as a method for long-term, safe wealth-generation is a dead letter. That is, it ain’t gonna happen that way anymore. Stocks are up nearly 70% from their March 9 lows of last year. The reflation rally engineered by monetary and fiscal expansion in the last year has merely papered over some huge structural weaknesses in the global economy.

But more importantly, the share market is at risk now for a big fall as it was in the middle of 2007 when the Bear Stearns story broke. Since then the perimeter of global markets has gradually been overrun by the forces of wealth destruction. Investors retreat into a smaller and smaller circle of “healthy” institutions and currencies – which only heightens their risk to further asset write downs.

The basic problem is that the global illness of too much debt has been remedied by more debt, which is no remedy at all. France and Germany may bail out Greece. But who will bail out Europe? And who will bailout the United States when public debt could rise to be 716% of US GDP in the Congressional Budget Office’s alternative scenario (see page 20 for the figures).

Of course if you really think stocks are cheap now, your best bet would to be buy them and hold them. It’s worked before. But we wonder, given the demographic forces in the Western world, if there is simply going to be more sellers than buyers in the coming years as the boomers liquidate.

Granted, we’re arguing for a change to the prevailing conventional wisdom of the last 30 years. But hasn’t the last two years given you every indication that the world really is different now and that what worked for you before in investment markets may not work again?

Or if you prefer the argument in more concrete terms, have a look at what Karl Denninger has said about the systematic balance sheet fraud going on in the United States. Dennigner shows that the suspension of market-to-market rules for U.S. banks did not – surprise surprise – lead to any improvement in asset quality.

But it’s only at liquidation when the banks are taking over by the FDIC that the banks admit they’ve been carrying loan portfolios at much higher valuations than market prices would suggest. They only realise their losses when they are technically insolvent on their fictitious asset values. You wonder how many U.S. (or Australian) banks are doing the same thing.

Denninger reckons, based on the write-downs in assets on the firms seized by the FDIC, that total unrealised losses on bank loans could be between $1.5 and $3 trillion. Imagine what that would do to credit markets. And if the Fed tried to paper it over, imagine what that would (will) do to the dollar. Now imagine having the chance to buy gold at $1,124 an ounce.

Of course the underlying assumption to the recovery narrative has been that the bank collateral would always recover in value once the real estate market recovered. And that would happen with the passage of time, low interest rates, and short memories.

But in America at least, it’s nowhere close to happening. If anything, a second and destructive down leg is coming. This is why banks continue to hold large excess reserves at the Fed. They know they’re going to need it.

The underlying belief to all of this is that the credit boom has already gone bust and assets won’t fall any further. You see this fiction over and over in America with the ramshackle and largely failed attempts to modify mortgages with longer terms and lower interest rates. But the basic problem – the house just isn’t worth that much – is ignored.

Here we are, then, a year into the rally. The great central bank counterfeiters of the world have pumped up prices – presumably so those in the know can sell at a smaller loss, or in the case of the investment banks, at a substantial profit. But the real economy remains massively burdened by debt. For the rest of this week, we’ll look at why we think the end-game to all this will play out over months, and not years. And why it won’t be deflationary. Until then…

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.


  1. I bought another penny dreadful stock.. 1 million shares for $6000 dollars. An investment company that deals in Oil and Gas (Natural) Will see how this one pans out over time.

    March 9, 2010
  2. Mr Shoes, which one?

    Trade you.

    WDS got hammered for the 2nd time recently after overspruiking the revenue order book and near term potential (timing) of its UCG opportunities. It did have a preferred supplier status announced in 09 with Arrow. The Arrow-Shell deal might give them a lift after they clear the decks and if they hold the Arrow deal.

    I am talking my long book here … so beware (but I did buy on the dip and had my eyes open on UCG likely being on a long curve)

  3. Dan, said enough to get me worried, but not enough to understand if this is relevant to Australia, especially the timing.

  4. “why it won’t be deflationary” is a big bet and DD is in the habit of occasionally making a case against himself lately.

    If you need to bet against the USD you need to do your currency swaps redeemable in Euro or gold, but alternatively if you are the world’s reserve currency you get to be the instrument of destruction used against all the other currencies. China said today it isn’t looking to gold reserves for the very reasons I gave the other day (it isn’t in anyone’s interest to take down the USD)

    And guess which currency has the greatest access to leverage in a race to the bottom? Thats why when they go after the PIIGs and STUPIDS with CDS it will always track backwards to positions taken in USD by their leverage merchants.

    So in a race to the bottom USD leverage should win. And despite Denninger’s call being right in terms of the mark to fantasy FASB rules hit up by Barney Frank you can’t say that US/UK residential real estate prices aren’t still moving in the deflationary direction or that US/UK commercial real estate is anything but a slower motion move in the same direction. For inflation there usually needs to be lending and liquidity to consumers rather than to those with balance sheets that can’t be redeemed except by unfathomable further govt debt funded bailouts and printing. The stagflation requires commodities to move but they can’t break supply and demand fundamentals and if consumer liquidty is shrunken then demand is smashed. And commodities float on inventory mountains of expectation and leveraged bets that dwarf those same mountains, one blink and prices collapse.

    Only Rudd and Swan and Keny Henry and Stephens have done that effectively using the veneer of fiscal prudence to keep sovereign risk off the agenda while masking the CAD reality, elsewhere it hasn’t happened (largess hitting consumers in such amount that it has them spend more).

    Looking forward to reading the case for the banksters accessing the massive extra (than currently in motion) inflationary liquidity any time soon. Later I do grant DD winning this argument but there may be a long interim road of equity potential for stocks retaining income and access to funds.

    Anyway most here know I got long equities early-mid 08. I am concerned however about my limited opportunistic direct commodity plays in Mt Gibson and even Riversdale topping out.

    Let’s look forward to DD making his case because it would change my world if he could make it.

  5. Imperial Corporation


    Also for the medium to longer term play

    March 9, 2010
  6. Ta shoes will take a look. Any view on TAP?

  7. SV – what happens to the world is relevant to Australia. We haven’t “weathered” the storm without cost.

  8. Dan – I know that much. But inflation in US does not literally mean inflation in Oz. We could easily be a full year behind US in that respect.

  9. That could be quite right. It’s difficult to quantify how much our markets and economy is anchored to the fates of US / Europe / China / SE Asia. I think, though, that, as was said in the mainstream media, we’re different because our rules of banking and business are different/tighter. This holds weight when comparing us to the US. We might not be in for anything resembling the US scenario. We don’t have ARM loans, for example, and we have different bankruptcy and mortgage default laws. It’s not so easy to have a flash crisis.

    Thing is, though, Australia is important to the US militarily (actually it is important to NATO), and as I’ve said before, it’s easier to defend than invade, even now. So I am cautiously optimistic that we’ll come out reasonably well from any major human-generated catastrophe – at least outside of the big capitals.

    My thinking at the moment is that the world does not all sink as one into the mire, but that economy is about comparisons. If Australia does less poorly than elsewhere, then Australia did well. Yet, as ADR hints strongly, because Australia did not go through the illness and pain of the crisis, as have other nations, we may have missed the chance to restructure for the better and instead are left weaker.

  10. Thanx for the pep talk Dan,

    I’ve been watching the market, employment figures, business confidence indicators, house prices…all going up, like nothing’s wrong…just like the old days again. The same behaviour that got us in trouble in the 1st place!

    It’s easy to forget (as I did) that it’s all based on helicopter Bernanke and his printing press in the US, and it’s flow on effects here!

    Question though, do you think think they’re positioning the US for a sovreign debt default to make the ‘Amero’ the only palatable option to North Americans?

  11. Hi Cameron. Yeah, I kind of suspect that the planners in the US see the chances for exploitation of the southern parts of the continent through forming an economic zone / EU kind of thing. Also they are half-purposefully losing the war against northward-creeping Hispanicism with their amnesties and porous borders. Have read the articles suggesting leaked memos and so on about it too – where there’s smoke there’s fire perhaps?

    Remember though Australia has tangible wealth and is useful, as also does the US (they can still blow everything up and they have a very fertile land). A game of monopoly is all in the mind, but the paper, the cards, the board and the little plastic houses are real and can be reused for another game.

  12. Regarding timing things, it’s my inclination to remember that Obama probably fancies himself as a candidate in 2012? Which makes Dan Denning’s thought that “the end-game to all this will play out over months, and not years” interesting.

  13. @Ross
    Tap Oil I think are fair priced at the moment. They have some good prospects and some JV’s in productive fields.. around $60 million cash too.
    small number of shares means around 40% of their share price is “cash” which may be attractive to a bigger fish… potential takeover target.

    Earnings, Cash Flow and sales are all about 1/3 of peak.. no debt.
    Good medium term prospects Has upside potential, A good exploration result would see massive increase in share value.
    Drilling rig booked for June this year, July/August could see a spike in value on good results.. a bad result should not dampen too much.

    I would rate them as a buy.. not a strong buy but worth having some in my portfolio..
    Might even buy 10000 of them…

    March 10, 2010
  14. Dan, we do have an equivalent of option ARM loans, it is called “using equity in your home” – for holidays, cars, renovations. See this excerpt from today’s SMH: “Older homeowners, enjoying rising values for their properties, have taken out loans to upgrades and extensions to improve them, pushing up their home prices higher.” So these homeowners take extra loans, with no intention of repaying them from their regular income and counting on gains in price. This is not that different from option ARM.

    We even have people living from revaluation-to-revaluation – paying effectively less than minimum.

  15. @SV

    “We even have people living from revaluation-to-revaluation – paying effectively less than minimum. ”

    My ex wife is a prime example.. she owes more on the home we bought together in 2000 than we originally paid for it.
    She has invested the “equity” in high quality assets as well like, a new car, new furniture, big screen tv and a couple of holidays….

    March 10, 2010
  16. Yeah noted that, Biker. Now we have the RBA spruiking housing prices as well. Just what doctor ordered.

  17. Ha, Ha… anything to keep the bears happy!~ :)

    (You know it’s their lead-in to an interest rate rise, don’t you?)

    Biker Pete
    March 10, 2010
  18. @BP
    “Comment by Biker Pete on 10 March 2010:

    As population grows, housing construction slows…

    Same article is in the sister paper here in Victoria… the

    2 interesting papargraphs out of the article though…

    “Obvious examples of this are the trend towards young adults staying in the parental home longer, and a rise in the number of people sharing accommodation.”

    Ownership for buyers under 35, however, had fallen over the past fifteen years, according to RBA data released in December.

    First is very common here in Melbourne and Sydney.. I am sure you have heard the reports about the little boy that was died here in Melbourne. Lived with his family in a house of according to reports from neighbours has as many as 13 adults living there at times.. 8 at the time of the boys death..
    Many of the Asian migrants to Melbourne share accomodation.

    As brought up by some one else in this forum.. alot of “kids” today are just waiting now until mummy and daddy die and they get to inherit “their share” of the family fortune without having to work for it…

    Another article worth a read…

    Economy is strong, immigration is high, demand for homes is robust yet applications have slumped…

    March 10, 2010
  19. SV, that’s a bit like ARM, I agree, but it needs to be quantified I guess, and even then I would think there is a bit of a different risk assessment going on with it.

  20. And the likely result?~

    “Mr Turner said the data were unlikely to alter the RBA’s thinking on interest rates.”

    So interest rates rise, fewer build, housing shortage deepens, prices rise, rents rise. We currently only accept one-year-leases (against our agents’ advice) but if interest rates are going to rise _four_ times per year, we’ll change our policy to six-monthly leases. No shortage of tenants seeking accommodation in WA. We’ll keep really exceptional tenants on one-year leases and won’t increase rents on those homes.

    The more things change…

    Biker Pete
    March 10, 2010

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