It was only ‘a’ great depression, after all…

…because it seems another one could well be around the corner. The World’s Most Prestigious Financial Body, they call it, and the Bank for International Settlements is down on global prospects. In their annual report, released yesterday – you might want to just go for the overview, though.

The report suggests quite a lot of things. It states that the global expansionary trend (around 4%) ought to continue, perhaps slowing with the US. It contains the understatement due any economics report worth anything at all (my favourite, “The impact of the downturn in the US housing market might not yet have been fully felt”). It is focussed more than anything – which is unfair of me for a start, for a report of this nature – on cheap credit, and something to which they refer as “increased risk appetitite,” which I would sooner call, say, “greed.” And here are where the parallels to the Great Depression enter the picture.

The Bank’s report is wary of a few things, in particular:

• The US’ Current Account Deficit, the financing for which, “…as well as private capital outflows from the United States, continued to be available at terms that seemed to factor in expectations of only a very moderate further depreciation of the dollar.” This is at the same time that the US’ reliance on capital imports (below) and the varied pressures potential placed on its interest rates (government borrowing among them) makes the US dollar quite vulnerable on the ForEx market. Meaning higher depreciation ought to be allowed for in those financing plans, for us to be assured those obligations can in fact be met.
• Continued gambling on risky debts, including the Frankendebt CDOs (I like that term), the consequence of hedge funds and private equity types chasing ever higher yields. This “appetite for risk” is one of the bigger links the Bank makes to the 1930s. Specifically, the murkiness of the banks awareness that they are generating components of bonded, on-sold securities is a disincentive for adequate protection against risk (the stopping of this, and squeezing of new home loans, is one of the effects, finally, of the hedge funds’ over-exposure to sub-prime mortgages).
• China’s utter lack of structure or order in its financial markets, even as it amasses trillion dollar reserves, is going in for Sovereign Wealth Funds, something the IMF is beginning to follow closely as well (not just China, but generally). The scale of firms losing money (40%) in China also prompts parallels to the bad-governance banking crises of Japan in the 1980s and SE Asia, 1997.
• The rate of leveraged buy-outs, and the debt:cash-flow ratios involved, a result of the race for high returns amongst private equity investors. The Bank’s suggestion is that this lasts only as long as cheap credit. I tend to feel it will last only until equity firms begin to proliferate and Private Equity runs out of things to buy and people to whom to sell them. I take the Bank’s point – with cheap enough credit, the cycle literally could just continue, with take-over bids and degrees of leveraging getting higher and higher (as would, incidentally, exposure to debt).

Of the capital importers, nobody comes near the US:

And of the exporters, China is streets ahead – which any reader of US newspapers would already know.

Although Japan is in the same league, more of its capital is exported to its neighbours (though not most, and that’s another problem for another time – Japan’s capital exports are not as high as their current account surplus – insufficient recycling of capital between Japan and Asia). The Bank recommends a few things, in response to these.

• Clearly some sort of control in China, before things get out of hand. Also some proper structural reform of their currency exchanges (related to the next point)
• Some fiscal restraint, particularly by the countries with big CADs. The chances of reducing global current account imbalances in an orderly way would also seem to be enhanced by more exchange rate flexibility, and by structural changes. Countries with current account deficits need to focus on the production of tradables, and those with surpluses on non-tradables. In this respect, neither the past strength of the housing sector in the United States nor the current strength of the export sector in Asia can be judged wholly welcome. That’s a big recommendation, when you line the modern economies up against their declining manufacturing sectors.
• Attack-levels of interest rates, to deal with the burgeoning levels of inflation we thought Bill Clinton and Alan Greenspan had defeated. This relates also to those CADs, and the plans for financing them.

The Bank is only suggesting, really, that there’s a 1930s-style depression in the offing if none of this is done. Many of these issues – cheap credit, over-exposure to under-considered risk, current account imbalances with bad forecasts for financing – were around at the time, and ignored (partly monetarism, partly because there hadn’t really been a depression before I suppose).

I’m obviously taking some degree of hell-bound pleasure in hedge funds and Private Equity over-extending their greed, but I would be surprised if a depression truly arose. I think the exposure of pension funds to instruments like CDOs is something managers of those funds need to address as quickly as they are still worth anything. Certainly inflation needs to be held down, but the Federal Reserve faces a bundle of obligations attached to its rates from now into the near future, so I don’t envy them that job. Meanwhile savings rates in the US are just atrocious, but their economy depends upon consumer spending – not a choice I’d want to have to make.

It’s clear that the insuperable bulk of capital travels between China and the US – could a tanking US merely take China down with it? If China can safely diversify its reserves, limiting exposure to US treasury debt, the US might just bomb on its own. A colleague of mine expressed confidence that when the worst happens, the US will take the one course he seemed they were perfectly willing to take – not pay. And who’d make them? Hopefully, nobody. Because that would be worse.

Most days I’m with the crowd that says if the US can just make it past the tenure of George Bush, the next person is bound to be smart enough to fix things – deal with housing, deal with consumer debt, remember what a balance budget was, get rid of, yet again, 30-year bonds. Regulate, for Cliff’s sake, hedge funds and private equity.

It’s actually a long list. I accept though that this isn’t only kind-of-likely. Certainly the GOP, but honestly many others in Congress, seem to have found a way to reverse the old statistics rule. They display wisdom without knowledge, knowledge without information, and information without data. I wouldn’t trust them to fetch my mail in while I was on holiday.

Of all of this, for me, the sovereign wealth funds are the most random element. They push around phenomenal amounts of money, even by today’s standards, internationally by design, definitely preying upon other country’s attempts to use monetary policy for domestic macroeconomic purposes – without so much as a codified list of best practices. I think the three of them – sovereign wealth funds, hedge funds and private equity, are going to find themselves the topics of discussion at G8 and other meetings, soon enough. Hopefully before they generate real instability.

The bookends, finally, of the Bank’s report:

The favourable global economic performance seen in recent years extended into the period under review. Global growth was strong and there were even welcome signs of better balanced demand. The US economy slowed somewhat, largely due to a weaker housing sector, while domestic demand in Europe, Japan and a number of emerging market economies picked up. Although output in many countries seemed to be close to potential, and commodity prices rose still further, overall inflation pressures remained muted. In this environment, there was a moderate tightening of monetary policies in many countries, although overall monetary and financial conditions remained highly accommodative. In part this was due to real policy rates remaining rather low, with associated effects on long-term interest rates. But it was also due to an increased willingness of lenders to advance credit to high-risk borrowers with less onerous conditionality than in the past. While the credit cycle has peaked in the subprime mortgage market in the United States, the expansion has continued in most other areas. As a result, global asset prices either continued to rise or were maintained at unusually high levels. Moreover, financing for the US current account deficit, as well as private capital outflows from the United States, continued to be available at terms that seemed to factor in expectations of only a very moderate further depreciation of the dollar.
…
The consensus economic forecast expects the recent excellent global performance to continue. Yet at least four sets of concerns can be raised, even if our capacity to calculate both their likelihood and possible interdependence remains limited. First, a rise in global inflation pressures cannot be ruled out. Second, the current slowdown in the United States might prove more significant than expected and the global implications greater. Third, global current account imbalances, together with large and volatile capital flows, indicate an exposure to disruptive exchange rate changes with potential implications for financial markets as well as asset prices. And finally, with most asset markets already “priced to perfection”, any unwelcome shock might have unexpected consequences.

In the face of such uncertainties, formulating macroeconomic policy in a forward-looking way is not easy. Moreover, the difficulties are compounded by ongoing debate about the appropriate role for monetary and credit aggregates in conducting monetary policy, as well as the desirability of pre-emptive action in responding to procyclicality in the financial system. That said, against a backdrop of concern about both overall global inflation and evidence of increasing financing imbalances in many areas, tighter monitoring and financial conditions would seem called for. Similarly, more fiscal restraint could have welcome short- and medium-term implications. Evidently, countries with large current account deficits should be in the forefront of such tightening moves. The chances of reducing global current account imbalances in an orderly way would also seem to be enhanced by more exchange rate flexibility, and by structural changes. Countries with current account deficits need to focus on the production of tradables, and those with surpluses on non-tradables. In this respect, neither the past strength of the housing sector in the United States nor the current strength of the export sector in Asia can be judged wholly welcome.

Ripples spread in the sub-prime pond

As I said the other day, this has less to do with sub-prime lending or sub-prime mortgages than hedge funds who concoct bonds out of them and try to increase their yields. There’s lending, then there’s debt, then there’s investing in debt, which isn’t the same thing.

“Queen’s Walk fuels subprime concerns” is the story. Queen’s Walk is a fund founded by fund manager Cheyne Capital. I’m assuming without checking that it is named after the Queen’s Walk.

It is in the news because of a bit of a bath it took, recently. Having made EUR9.7m profit last year, it has now lost EUR67.7m this year, according to today’s announced results, having chased yields into risky debt, highly-leveraged lendings, sub-prime mortgages. You get the idea. Twelve percent of its holdings were sub-prime-mortgage-oriented US debt. The story doesn’t say how much UK debt it had invested in, however risky, but they wrote their assets down 50% in the quarter, selling it off quickly and getting the fund’s leverage ratio down from 28.6 x assets to 6.6 x assets.

If nothing else, this suggest writing on walls that I can’t see, but presumably someone at Cheyne Capital can? That’s a big loss, but it was also a big reduction in exposure, and they seem happy enough with the move.

Stuart Fiertz, a founder of Cheyne Capital said: “What is happening in New York is that people are seizing funds to make margin calls – but we are in a totally different position – we have €50m of cash on our balance sheet. We have derisked the company and repositioned us to go forward. The worst is over.”

Looks like the market agrees – it’s better to take a loss now if it gets you out of exposure to risky debts:

That’s a pretty small price-drop for that sort of a loss, I would think. Implications? The market doesn’t appear pleased with where these sectors are heading. I mean you know it’s bad when get-rich-quick schemes build themselves around something.

Across the US, Americans are gathering to learn how to invest in properties threatened with foreclosure.

One such seminar was held recently outside Washington, near Prince George’s County, Maryland, the cradle of America’s black middle class and an area hard hit by mortgage foreclosures as a wave of high-interest lending collided with falling property prices.

Several hundred African Americans gathered to listen to “Master Lloyd” and “Queen Vicki” Irvin tell them how to make “life-changing money” from investing in property.

The session was long on revivalist and motivational rhetoric – lots of talk about self-esteem, conquering fear and “giving back to the community”.
…
Internet sites also list properties in default and offer “how-to” guides on property short sales (deals where investors buy default properties from the lender at a deep discount and resell at a profit). Television adverts promise “win-win” schemes where families keep their homes, and investors get rich helping them. The TV series Flip this House shows how to generate equity from neglected homes.

Sydney: urban expansion or the Southerly Change? Your choice.

I’ve actually had this conversation a few times with my father, but wandering about in New York today reminded me of it. Specifically, places like PC Richards around the corner are still packed to the rafters with well-selling air-conditioners, but on days like today (bright, humidity increasing) restaurants run their air-conditioners with doors and windows open. Why? No idea. Sometimes it’s because the air-conditioning is set too high, but it can also be because patrons want (or owners think patrons want) fresh air, the sound of the street, who knows. It’s bloody idiotic, though. Would you turn your refrigerator up to maximum and then leave the door ajar? Of course not. And yet…

Air-conditioning isn’t the sole cause of the dying-out of the Southerly Change, but it’s a big one and it has other consequences, so the focus is on that.

First, background: the second law of thermodynamics states that, first, heat will not flow from a colder area to a hotter area, without energy used to make it so (heat would move from the hotter area to the colder area). So the second you get your house cooler than outside, you need to work to keep it that way, let alone make it colder still (e.g. you want 20 degrees indoors while it’s 35 degrees outdoors means more energy than keeping it 34 degrees, which still requires energy). Thus the air-conditioner, a cooling engine that must use energy to force this flow. In the process, it will generate heat of its own. So we have two things happening: the movement of heat from indoors to outdoors, and the generation of heat by the engine affecting that movement (through the creation of cold area using chemical reactions)

It is also the so-called entropy law, which says that entropy (chaos, disorder) will increase or remain the same. ‘Things’, naturally, do not order themselves when you leave them alone (weeded your garden, lately?). Putting an environment in order (i.e. stable cool air in a house) generates disorder (in this case more heat, outside).

That’s the physics, more or less, of how air-conditioners make urban enrvironments hotter – and this is irrespective of energy use/efficiency itself, which is a small part of this discussion. So by making your house cooler, you’re making the city you’re in hotter, exacerbating the need for you to make your house cooler. You’re currently shooting yourself in the foot with a Freon Gun. Soon you’ll be shooting yourself in the head.

Second. Sydney has a recurring phenomenon called the Southerly Change. This occurs during the Summer when winds shift from being hot Westerly and Nor’Westerly winds (which come from the desert, as you can see below):

And come instead from the South-Southeast, off the ocean (Sydney is on the East coast, towards the bottom. Green is arable/habitable land, brown/orange is …not. See why our population is so low?). For those of you meteorologically inclined, here’s an example progression:

That’s the southerly just off the map on the lower right.

Sydneysiders hang out for this. With days on end above 40 degrees Celsius, humidity and UV ratings through the roof, you bake in the Summer, and the Southerly is your respite. Even firefighters will bet their success on one. More importantly, though, the Southerly turns heating of Sydney into cooling of Sydney. Cool winds blow over water and concrete, highways, train lines, skyscrapers, and allow the city to cool down overnight. Here’s where urban expansion and air-conditioning come in.

I’m talking about the combined effects of several things:

• Air-conditioner ‘deepening’ has gone from 49% to 64% of households in Sydney
• More concrete (buildings, motorways, driveways, patios, you name it
• Fewer waterways (less surface area, less wetlands)
• Less natural vegetation (see point 2)

These mean more heat comes off Sydney than ever before. From that 2nd law of thermodynamics, heat doesn’t move from cold areas to hot areas. So as the Southerly Change approaches Sydney, it is a cold front that meets a hotter and hotter front. On normal days, it will divert, probably back East to the Ocean. Meaning

1. Sydney gets no Southerly Change
2. Sydney doesn’t cool down overnight, the way it should
3. Sydney starts each day hotter, as Sydney, like Tokyo and Singapore, comes to resemble an oven
4. People use their air-conditioners more, at higher settings, longer, earlier in the day, you name it
5. FOR I = 1 TO 4
   loop body
   NEXT I

This was – more or less – the conversation I had with my father, while I sat in my office in York and he stood on his front verandah waiting for an ever-later-to-arrive Southerly breeze to come through.

Addendum

The environmental consequences of this are plain enough. Sydney can’t cool down in Summer, Sydney dies (and Sydneysiders, too). On non-ordinary days, that diversion isn’t as benign as I make it sound, and Sydney has it’s ass handed to it by storms, which are getting worse.

The economic consequences are also significant, and bleed into the environmental, somewhat. Electricity supply needs to be able to meet the highest demand. So for Sydney, that means the middle of Summer when everyone has their air-conditioning on. And it needs to be able to accommodate spikes, like Sydney in the middle of Summer at 6pm when the air-conditioners all go on. Or something. We’re talking about ever larger infrastructure for Sydney to meet the energy use requirements of itself. This energy requirement is projected to grow by 20%, and the ecological footprint of Sydney grows with it (Australia is 3rd after the US and Canada in ecological footprint terms). This all means the price of energy has to go up.

At the moment our government(s) keep trying to absorb it – bigger plants, new plants, talk of nuclear power plants – which only encourages us. We’re using resources, one way or another, that could go towards other things, and we use more of those resources, the price to do so has to go up. And use those resources we will. As we use more air-conditioners, which are very energy-intensive. Which we will, because Sydney, like the entire South-East of the Continent, and like the rest of the Continent, is getting hotter and more dry, hence hotter still. Our government(s) try – and will continue to try – to change the efficiency standards, which is fine – but we’re talking about units that last a bloody long time, so the bulk of air-conditioning will never meet those standards. To give you some perspective:

Almost one kilowatt-hour of electricity out of every five consumed in the United States in a full year goes to cooling buildings. Much of the nation’s excess power-generating capacity, which sits idle until needed to satisfy quick spikes in demand, has had to be built because of air-conditioning.

The electricity used annually to air-condition America’s homes, stores, offices, factories, schools, churches, libraries, domed stadiums, hospitals, warehouses, prisons and other buildings (not including what’s used to cool manufacturing processes and military facilities) exceeds the entire electricity consumption of the world’s second and fourth most populous nations – India and Indonesia – combined.

We’re not likely to get that bad – there’s only 21 million of us, not 300 million, but you get an idea. At a time when we’re already at the limit of Sydney’s ability to provide power, further expansion, or increasing urban density, will not help.

This also, by the by, ignores completely the other environmental consequence: the carbon load of air-conditioners and the electricity generated for those air-conditioners. Some other time, maybe. I’m more worried about Sydney losing the Southerly Change more or less permanently, the consequences of which are far more immediate.

The slow bleed in housing continues

That line is from Ethan Harris, chief US economist at Lehman Brothers Holdings Inc. The story so far is the much less interesting “Home sales hit slowest pace in 4 years”. Honestly, how dull. Bloomberg’s other good line is the Housing Recession – very nice. Very apt.

Remember, this is sales of existing homes (little building industry flow-on, but a good marker for underlying strength in the economy).

Existing home sales tally the number of previously constructed homes, condominium and co-ops in which a sale closed during the month. Existing homes (also known as home resales) account for a larger share of the market than new homes and indicate housing market trends.

From Econoday,

The red line is the mortgage rate; the grey histogram is sales, the statistic of interest. Yep, it is steadily falling, even as lending rates perked back up a bit. Even as the Fed meets on Wednesday to discuss…things. Like how to describe their inflation (core inflation is down, but it’s down relative to a recent spike, and core inflation excludes food and energy prices – meaning core inflation isn’t likely to be the inflation the rest of us experience, anyway. Housing is terrible, but unemployment is pushing inflation’s luck). Even as financial market shenanigans potentially undermine existing sub-prime-mortgaged housing (beyond the pressure increasing rates already are applying) and narrow the pool of potential mortgagees by refocussing lenders on risk.

I’m pessimistic, I guess, is my point. Employment is okay, although unemployment may be rising. Investment was okay, although it’s hardly lighting fires under its own statistics. Fallout from the CDO-investing, yield-chasing hedge fund story shouldn’t extend far at all into actual firms’ investment and the expansion in manufacturing, although the effects of rates, housing and the value of the dollar should.

How much energy was wasted on this legislation?

If the Senate energy bill were a movie it would be called “The Good, the Bad and the Ugly.” That’s because the massive legislation, which passed 65 to 27 late Thursday, is a mix of historic action, missed opportunities and outright cowardice.

I do like the Washington Post’s turn of phrase. Yes the Senate muddled out its Energy Bill last week. A requirement that utilities use 15% renewable energy was dropped, and an amendment to establish a carbon registry (for later use in any system of carbon taxation or trading) was defeated. Boo. Some USD32bn in incentives for renewable energy developers was also dropped. Money for carbon sequestration studies is good, as is the mentioned defeat of adding money for coal-to-liquid “boondoggle”, as the Washington Post likes to call it. I would use worse words, but then I don’t like coal.

The ‘good’, meanwhile – and this is not peculiar to the Washington Post – is the increase in CAFE standards. Originally put together post-’73, they haven’t come very far at all in 34 years (they’re currently 27.5 mpg for cars. 20.7 mpg for light trucks), which is amusing when you consider that the coming oil crunch will be permanent, not 90 days. The new standards in the Senate version of the bill is 35 mpg for all vehicles by 2020.

I find this laughable, for the simple reason that anyone not producing cars making at least 50 mpg by 2020 will be out of business. And that’s assuming there even is a business for petro-vehicles in 2020. As it stands, and as I’ve mentioned previously, since 2005, the number of cars available in the US that reached 40 miles-per-gallon or more had fallen from 5 to only 2. In Europe meanwhile, the number of such cars available had increased from 86 to 113. The US is slow, but it isn’t mentally defective. This bizarre imbalance will not last. The Senate compromised to get this far, dropping a 4% p.a. improvement in CAFE standards after 2020. I don’t think it counts for much – I really do believe these are numbers the Auto industry will find itself having to meet long before then.

Oddly, Auto spokespeople objected to any new CAFE standards, as they have always done, insisting that the Auto industry is struggling, etc. (a), I fail to see why we should all pay an environmental, social, resoure, etc. cost for their industrial problems, and (b) I can’t imagine engine design and CAFE standards are the problem, surely. Bloody lobbyist parasites.

So, for me, I don’t think much at all happened in this legislation, for all the hand-wringing. Even Tom Friedman agrees, for God’s sake (that’s behind the stupid Times Select firewall).

On to this week, then, it is the turn of Congress to come up with an Energy Bill. So far it looks like theirs will have incentives, but far fewer (USD16bn-ish, and for users, more than research/innovation). It also looks like more compromises will occur.

Rifts within their ranks, however, are forcing House Democrats to postpone some tough issues until fall – a move that could complicate coming to terms with the Senate once an energy bill clears the House.

At the heart of the House struggle over energy policy is a standoff between Speaker Nancy Pelosi and Rep. John Dingell (D) of Michigan, a powerful committee chairman with long-standing ties to the auto industry.

He’s one of the people crying over the frailty of the Auto industry. I don’t mean to be unsympathetic, but like I said – CAFE standards just aren’t likely to be what kills them. Protecting Detroit from international competitiveness is hardly going to do them much good in the long-run, but then I reckon John Dingell isn’t planning on staying in Congress until 2020, so his priorities might not be my priorities.

The differences, of course, go to conference. Which I’ve never liked, but perhaps with the houses in Democratic hands it might be less insidious a force in modern legislating than it has been in recent years.

There isn’t much news yet of Congress’ progress, but that ought to change. The Oil Drum is worth watching, for ongoing discussion.