Banking follies in the eurozone

By Claus Vistesen, on January 18th, 2012

Edward Hugh has a brilliant analysis of recent events in the eurozone and especially how banks are leveraging the liquidity provided by the ECB to “cleanse” their balance sheet of bad assets and essentially exchanging these for freshly minted euro deposits at the ECB. I think we should be very clear what is going on here; this is essentially a covert recapitalisation of the European banking system and the ECB is in every sense of the word acting as a lender of last resort.

Here is the relevant part;

Another area where the transfer of liquidity doesn’t show up as a change in aggregate excess liquidity is when banks offload their wholesale liabilities to other EuroArea banks and refund via the ECB. Here again, if they do it smartly, they can even earn a bit of “quasi carry” in the process, by buying back their debt at well below face value from those who are anxious to exit the periphery, and then refinancing at the ECB without writing down the underlying asset. This could be termed a liability “write down”, and again the procedure earns the bank a nice bit of income which can subsequently be used to help the recapitalisation process.

Take the Portuguese Bank BPI (the country’s fourth largest), which is making public tender offers to buy back its debt. If all concerned tender their bonds to BPI, BPI will pay something short of  €1.5bn cash to investors. Mortgages which were previously sitting in one of their SPVs will return to their balance sheet, and ECB money will now be on the other side financing them allowing significant profits (and capital) to be reported. In this particular tender the smallest discount is 35% and the largest is 65%. Investors may initially balk at the offer, since they will nurse a heavy loss (equal, naturally, to BPI´s profit) but ultimately they will probably be only too happy to be able to walk away from Portugal, and  with some cash in their pocket to boot.

Iberian banks were already aware of  the benefits of this kind of restructuring during the 2009-2010 liquidity wave, and went about quietly repurchasing their bonds (bank capital, securitizations, senior bonds) on a selective and private basis at a discount. Much of their reported profits in those years in fact came from either the ECB carry trade or this kind of  transaction.  So when we read that another Portuguese bank – Banco Espirito Santo – has just had €1 billion of debt guaranteed by the Portuguese state (a sovereign which can’t itself go to the markets) it isn’t hard to imagine that the process going on in the background is something similar to that seen in the BPI case, and that the debt is being guaranteed so it can  go over to the ECB to be posted as collateral.

The National Bank of Greece has been doing something similar. They recently offered to buy back some €1.5 billion in covered bonds and preferred securities,offering 70% of face value for the covered bonds and 45% for the preferred hybrids. As the bank itself says, “The purpose of the offers is to generate core Tier 1 capital for the group and to strengthen the quality of its capital base….The offers would generate a gain for the group.”

And Italian banks would seem to be doing something similar, since they issued around €40 billion in government backed bonds specifically to take to the ECB. The bonds are held by the banks themselves and stay on their books to maturity, their only purpose being to provide collateral for use at the ECB. In fact Italian banks took something like €116 billion from the LTRO, or almost 25% of the total. Perhaps this is why Unicredit CEO Federico Ghizzoni and other European top bankers met ECB officials in Frankfurt back in November, to discuss new rules for collateral.

In Spain securitised mortgages sitting on the balance sheets of the bank-ownedFondos de Titulizacion de Activos could also be recycled in this way (here’s a complete list, although note that these Funds are regulated by Spain’s CNMV and not the Bank of Spain, which is why their presence is relatively unknown and people are able to accurately say that the central bank has been very strict on SIVs, since they weren’t their responsibility).

That something like this may be happening, with the ECB “buying into” public and private  Euro Periphery debt  while investors are discretely getting out is suggested by this report in Bloomberg:

The euro is losing the relationship with riskier assets that underpinned the currency in 2011 as the deepening sovereign debt crisis reduces the creditworthiness of even the biggest economies in the region. The 17-nation currency has fallen 8.7 percent against the dollar since October, while the Standard & Poor’s 500 Index has gained 3.4 percent, and the correlation between the two dropped to 58 percent from a record 91 percent in November, according to data compiled by Bloomberg. The euro had moved almost in lockstep with investments linked to growth, including stocks and the Australian dollar, since January 2011.

This decoupling is taking place as European Central Bank President Mario Draghi cuts interest rates and promises banks unlimited cash for three years to rein in soaring borrowing costs for governments… Strategists also anticipate more losses as the US economy improves while the euro zone shrinks, driving international investors away from the region’s assets.

So if the first two objectives were to help the struggling sovereigns, and enable the commercial banks to refinance their debt, then to some extent these objectives have been met. But what about the third objective, moving credit on the periphery to get the real economy moving again? Well, here the ECB’s measures are likely to have far less effect, and indeed what effect they do have may be in some way a mixed blessing, since the banks seem far more worried about demonstrating they have an adequate level of core capital than they are about participating in solutions to real economy problems.

While I would, in general, be hesitant in taking anything from Zero Hedge at full face value I think the following story on Unicredit adds flavor to this by providing further evidence on the points Edward mentions above.

The story is clearly speculative but gets backing from Edward’s accout above. The following seems to be a part of the general process which in itself is, in my view, absolutely mad.

Banks in weak countries have been issuing debt, getting a government guarantee, and then posting them as collateral at the ECB. There are examples of this for Greek banks for sure, but my understanding is it has also been occurring in Portugal and Ireland. It is the only way banks in Greece (and the other countries) can raise money.

The article then goes on to make this more alarming point (but really does not have evidence to back it up) that it appears that about €40 billion of the first LTRO was done by Italian banks (Unicredit?) that issued bonds to themselves and got a government guarantee, and then posted this asset as collateral for liquidity through the LTRO.

So, here is how I understand it.

Unicredit issues a 3m bill and gets a government guarantee so that whoever chooses to buy this bill knows that it will be backed by the sovereign (after all, this is still better than the bank even if the two are joined by the hip). The only problem is that it is being issued to itself with a permanent guarantee from the government.

From an accounting perspective this must be close to illegal in any meaningfully lawful jurisdiction, but I defer to experts here of course. The issue here is not then that the sovereign is guaranteeing a liability of a bank, we have seen this plenty of times and it is indeed the only way that some financials can issue debt, but rather that the bond never gets marketed to third party buyers.

It is absolutely astonishing that this 3m bill is then being posted as collateral at the ECB. But you must understand that it has to be posted as such as far as I can see since you can’t hold your own liabilities.  So, the banks posts a bond issued to itself and posts it at the ECB and get freshly minted fresh euros credited to its bank account at the ECB. After the process, Unicredit still has the bond as a liability but instead of the same bond on the asset side (which is impossible) it has a deposit asset with the ECB.

If this is true, and the ECB is agreeing to this I must admit that it amounts to a serious bout of banking follies in the European banking industry.



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Unsegregated Allocated

By Bron Suchecki, on December 23rd, 2011
Following on from this post from 2009 where I identified five types of storage (Segregated Allocated, Unsegregated Allocated, Unsegregated Physical Backed, Unallocated Fully Hedged, Unallocated Unhedged), we now have confirmation that “Allocated” metal at a bullion bank is unsegregated from this interview with Kyle Bass (42 minute mark) where he talks about bars being all over the place when they did an audit.

The unsegregated nature of bullion bank allocated is why Bob Pisani picked up the wrong bar in his visit to the GLD vault as part of a HSBC promo.

This unsegregated storage is not necessarily a problem and would not make a difference in any bankruptcy of a custodian as the key “segregation” is the specific bar numbers and weights in the client name. Whether bars belonging to two different clients sit together on the same pallet or are on separate pallets separated by air, I cannot see making a difference.



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How to Make Money in a 'Fugly' Stock Market: Bob Moriarty

By The Gold Report, on December 8th, 2011

Bob Moriarty Despite the “fugly” future that Bob Moriarty, founder of 321gold.com, talks about in this exclusive interview with The Gold Report, he’s downright bullish on the U.S. dollar for the time being. He says it’s not only a safe haven but “the best investment to be in for the last six months.” As for equities, Moriarty makes it clear that he takes no pleasure in watching a company lose 25% of its value in a week when there is nothing wrong with the company. At the same time, he’s alert to bargains. Any time you have the opportunity to buy cash at a discount, he advises, “throw money at it.”

The Gold Report: Since the last time we chatted in July, Bob, a lot has happened. Congress raised the debt ceiling, as you predicted.

Bob Moriarty: Right.

TGR:Then the Super Committee failed to produce an agreement so we can look forward to the automatic debt reduction of $2.2 trillion.

BM: The Super Committee was totally illegal and unconstitutional in the first place and it was totally ineffective. They couldn’t reduce spending by $1.5 trillion over a 10-year period. Give me a break.

TGR: Okay. Moving on. . .Unemployment remains at about 9%.

BM: You say 9%? I don’t think so. How about 23%?

TGR: The list goes on. Occupy Wall Street protests have sprouted up all over the country. And of course, Newt Gingrich is the leading Republican candidate.

BM: That anyone could even consider Newt Gingrich for anything above the role of dog catcher is pretty terrifying.

TGR: There’s more. We’ve seen riots in Europe, with the epicenter in Greece. We’ve got a weak German bond market.

BM: Weak? It was a total failure; 39% coverage is a disaster. Germany is the bedrock of the EU, and if they can get bids for only 39% of bonds it’s over—over—for the EU.

TGR: The Italian bonds coming up should test that theory.

BM: Italian bonds are paying 8% or something like that. It can’t do it. The Greek two-year bond is paying 160%. The one-year bond is paying 270%. Greece has defaulted. Italy, Spain and France are going to default. It will be a series of cascading bank defaults. Dexia Bank failed a month ago. The banking system is under water. I’ve been saying that for years. It’s true.

TGR: So looking at this whole developing picture, from the crisis in Europe to the U.S. debt debacle, from stubborn unemployment, protests and riots to the upcoming presidential election—what do you make of all of this?

BM: The piece I wrote in early October captured it. I said things were about to get “fugly” and it’s time to head for the bunker.

TGR: In your Nov. 11 article, you stated specifically that you’d climb out on a limb and suggest that 2012 will go down in history as the year of bank failures. How do you see that scenario playing out?

BM: Okay. Here’s what’s important to understand and very few people understand this. If you start off with $1 million and loan it from one institution to another to another to another, you may have a net of $1 million. But if somebody defaults and that $1 million asset disappears, you get cascading defaults of every institution that had that $1 million asset. It’s really simple. The Greek default—and Greece has defaulted even though they won’t admit it—will cause a default in Spain and Italy, and that’s going to cause a default in France and that’s going to cause a default in the U.S.

TGR: And what happens when they default?

BM: The banks close. What can we do? We have more debt in the world than assets, so we have to write off the bad debt. Unfortunately, no government in the world is talking about that. The only people talking about it are Gerald Celente, Kyle Bass and me.

TGR: But bank foreclosure is more than writing off bad debt. That creates catastrophic. . .

BM: It’s a good thing if a business fails, because that means somebody who is efficient comes along and picks up the slack. We do not need to reward failure in the banking system. We need to reward success.

TGR: Could the banking system write off a portion of the debt?

BM: Nah, they are under water now. It’s a zombie banking system and has been since about the middle of September 2008. Just a while ago, at the end of November, the Federal Reserve disclosed $13 billion in profits to the banks from the trillions in loans they made back in 2008 that they’ve been lying about ever since. They were bailing out Barclays, Royal Bank of Scotland and lots of other banks that had nothing to do with the United States.

TGR: Is there a banking system that will survive these cascading defaults?

BM: The question should be: “Can you have a banking system that is sound and secure?” And the answer is yes. The Canadian banks are in a lot better shape than the U.S. banks. A sound, secure bank cannot have those zombie assets, such as the mortgages that we know people are not paying off. Half the mortgages in the United States are under water, with 25% in default. Those mortgages must be written off.

TGR: Couldn’t a component of the banking system—some of the regional banks in the U.S., particularly those that have written off some of those mortgages and are really more about loaning to local businesses and local communities—survive a banking system failure?

BM: The banking system in the United States is a network of giants and the regional banks really don’t exist anymore. I don’t have specific numbers but I think the big five banks probably represent 90% of the banking system. That leaves no fallback, really.

TGR: When the U.S. banks close, you’re in the Cayman, but what happens to the rest of us?

BM: Since Bretton Woods in 1944, governments have been spending money they don’t have and it’s time to pay the piper. A lot of people’s “assets”—Social Security, pensions, Medicare, Medicaid—will evaporate. They’ll disappear. We need to go back to a real world economy where people produce things of value. We need reasonable taxes. And we need a reasonably sized government that doesn’t spend beyond its means. This is true of individuals as well as governments.

TGR: How do people waiting in line for pensions, Social Security, Medicaid, etc. . .

BM: That money has to come from somewhere. Anything the government gives one group has to be taken from another group. The net is it costs you money to have the government provide healthcare, Medicare, Social Security. We would be far better off if the government didn’t provide these things. We didn’t have Social Security 100 years ago and people were fine. When I started working 40 years ago, people still had pensions from their employers. By and large they don’t have much of that anymore.

TGR: Unless they’re government employees.

BM: Yeah. Then you are going to get paid twice what the private sector is getting paid.

TGR: Your November article also said what you have been suggesting for months that cash is the best investment people can hold. In fact, you concluded with these words: “It’s time to stay in cash and head for the bunker.” As you mentioned before, “times are about to get fugly.”

BM: Right.

TGR: Do you include cash equivalents such as gold or precious metals under that “cash” umbrella?

BM: No, I mean cash. The best investment to be in for the last six months was cash, U.S. dollar cash. Even Gerald Celente had a six-figure account with MF Global and the money simply evaporated. Without cash, people who go to bed wealthy will wake up poor.

TGR: All the goldbugs say that will happen if you keep your money in fiat currencies too.

BM: That’s not necessarily true. At times, investing in fiat currencies is a good deal. If you were investing in U.S. dollars in March 2008, you would have been better off that fall than you would with any other single investment. Gold went from about $1,200/ounce (oz) to $700/oz, while silver went from $21/oz to $9/oz. The stock market crashed. The gold juniors crashed. Sometimes being in cash, U.S. dollars, is a good investment. It’s been a particularly good investment for the last three or four months.

TGR: Because your analogy goes back to 2008, when we had a severe crash, is it fair to extrapolate that you’re predicting another severe crash?

BM: We are going through a crash right now.

TGR: If that’s the case, why should anyone be in equities?

BM: You can’t ever invest 100% in anything. No one can guarantee the future. All you can do is hope you get it right 55% of the time. Cash, U.S. dollar cash, has been a good investment since this past April, and it’s still a good investment. Europe is about to blow up and the dollar is a safe haven. There is a lot of deleveraging going on. And, as in 2008, the U.S. dollar is a good place to be. And cash is better than having the money in T-bonds, with a negative interest rate.

TGR: You are expecting the banking system to collapse, and banks typically hold cash. What value is the cash if the banks fold?

BM: You can buy things with it.

TGR: So you’re saying people should physically hold their cash in their homes?

BM: I do. I have some money in the banks to pay bills, but mentally I have written off every cent in the bank. I accept the fact that I will go down to the bank one day and the ATM won’t work anymore and the bank will be closed. You can have cash sitting in the bank, too, but at the same time you have to understand the great danger with the banks. While I wouldn’t sit on a half million dollars in cash at home, if I had it in a bank I would be prepared. I think everybody should keep three to six months in liquid assets, and that certainly would involve cash and gold and silver. Cash and gold and silver will be very valuable when the banking system collapses.

TGR: If the banking system collapses, how long will it be before new banks emerge to take over the fundamental role of banking?

BM: It’s not “if” the banking system collapses; “when” would be more accurate. You simply cannot justify the banking system today. The sooner we get to whatever comes next, the better off we’ll be. My opinion is that all fiat currencies will crash, and when they do, we’ll go back to a gold standard.

TGR: How quickly can we develop a gold standard from the annihilated banking system?

BM: It depends on how big the riots are. Governments never act. They only react. If we have riots in every major city in the United States and hundreds or thousands of people a day are being killed, the government may actually take some action that would make sense. That would be to say, “We have a financial system that doesn’t work. We need to go to a financial system that does work.” Gold and silver work and they have worked for 5,000 years.

TGR: Do you see a situation where the government would start a national bank?

BM: God, I hope not. That would be adding fuel to the fire. I think that “unlimited stupidity” and “government” belong in the same sentence. But if the government started a national bank, that wouldn’t be unlimited stupidity―that would be infinite stupidity.

TGR: Earlier you made a point about having to be right only 55% of the time to move forward with a balanced portfolio. Let’s assume that an investor has some hard assets now, in safe havens, with some at home. At that point, does this investor turn to the market?

BM: Yes. I just bought 100,000 shares of a company that did a financing at $0.80 in April. It now has $0.46 per share in cash and its stock is selling at $0.23. If I can buy cash at $0.50 on the dollar, I’ll do it.

TGR: So you are looking for opportunities with a company’s value below its cash balance.

BM: Any time you can buy at a discount, that’s a good deal. If you can buy a dollar for $0.50, the upside is $0.50. We see this happening every 10 or 15 years. In the summer of 2001, a number of stocks that were selling for less than the cash they had on hand doubled or tripled or quadrupled when the market turned around. In September and October of 2008, something like 200 companies were selling for less than their cash on hand. A Russian silver company was selling for $0.20 on the dollar. You simply cannot get a more favorable environment than buying cash at a discount. Any time you have that opportunity, you should throw money at it.

TGR: So, what companies are you finding that have cash at a discount?

BM: People are going to have to look for them themselves. All the figures are available to everybody. I use Stockhouse and StockWatch and look at the ratios.

TGR: We’re hearing that capital is so hard to come by, yet we found at the San Francisco Hard Assets Investment Conference at the end of last month quite a number who were getting capital.

BM: Those deals had actually been set up for months. The last few weeks the financings literally just stopped. Everybody is in a total panic now. I watched stocks drop 25% and I have to tell you, it was pretty scary even though I was one of the guys forecasting it. When a company loses 25% of its value in a week and there is nothing wrong with the company, it’s scary. A lot of times I see things happening that scare me and I don’t want them to happen. I talk about them because I have an obligation to talk about them.

TGR: Could you talk about the kinds of companies that are actually building their value?

BM: In August 2008 the Philadelphia Gold and Silver Index, which is a measure of pure psychology, went to the lowest level it had ever been in history. Stocks were cheaper in August, September and October 2008 relative to gold than they had ever been. But gold was $700/oz. Silver was $9/oz. And they got clobbered. So it’s natural that big gold and silver shares got clobbered too.

Now, we have $1,700/oz gold and $32/oz silver, and stocks are cheaper today than in 2008. That is totally irrational. Those kinds of circumstances do not continue for very long. In 2008 platinum came down to the same price as gold. Platinum is $210/oz cheaper than gold today and that has never before occurred in my lifetime. I don’t think it’s occurred in history. That’s an example of something that would be a very good opportunity.

TGR: So if the juniors are on sale, are the majors also on sale?

BM: Yes.

TGR: How should investors begin looking at the whole plethora of mining companies to decide which ones really create the value?

BM: My priority would be junior production stories. You’ve got Timmins Gold Corp. (TMM:TSX.V; TMM:NYSE.A), Fortuna Silver Mines Inc. (FSM:NYSE; FVI:TSX; FVI:BLV), Endeavour Silver Corp. (EDR:TSX; EXK:NYSE; EJD:Fkft), First Majestic Silver Corp. (FR:TSX; AG:NYSE; FMV:Fkft; FRMSF:OTCQX), Great Panther Silver Ltd. (GPR:TSX; GPL:NYSE.A) and Rio Alto Mining Ltd. (RIO:TSX.V; RIO:BVL; RIOAF:OTCQX). There are dozens, dozens of good production stories. Nobody quite knows where the price of gold and silver will go, but anybody in production now is literally minting money. You would have to be profitable. You couldn’t possibly not be profitable.

TGR: You wrote about Meadow Bay Gold Corp. (MAY:TSX.V; MAYGF:OTCQX) back in October. Is that still an interesting story to you?

BM: It’s a really funny story. It totally screwed up its drill program. It was drilling for an epithermal vein system and hit a porphyry system. The significance of that is that porphyries are really big, so instead of having potentially 1–2 million ounces (Moz), literally overnight it went to having 3–4 Moz potential.

When I made that same comment about screwing up the drill program with Meadow Bay’s chief geologist, he laughed, because if you’re going to screw up by finding a much bigger deposit than you thought you had, that’s a really good deal.

TGR: You’d called it a no-lose drill program. Did you know it was going to come out the way it did?

BM: It had announced one hole—a porphyry hole. As soon as I knew it was porphyry I understood the future was bright indeed. That’s a really good company and it is doing a really good job.

TGR: Do you have a preference toward production of gold versus silver?

BM: Silver has attracted a lot of attention with people who simply don’t know what they are writing about. And they attract all the nutcases. You can make a lot more money shorting silver than you can going long silver because people get totally irrational. There is no shortage of silver. We are not about to run out of it. The ratio over 100 years has been 47:1—47 ounces of silver per ounce of gold. In a financial collapse, the ratio actually goes higher. I could see silver going to 100:1 before it goes 30:1. But, the primary factor in the price of anything is the cost of production. Silver costs $6–8/oz to produce, so $32/oz silver is pretty expensive.

TGR: So you would want to look at junior production companies that would still be profitable with silver at $10/oz?

BM: The silver companies would still be extraordinarily cheap even if silver went to $15/oz.

TGR: Do you have any other companies with no-lose drill programs or other nice surprises in store on your radar?

BM: Dozens of companies have done exceptionally well. I just came back from two weeks in Colombia, where virtually everything is a slam-dunk. Sunward Resources Ltd. (SWD:TSX.V) is going to be announcing really extraordinary results. It already has about 8.6 Moz. That’s an extraordinary amount of resources for a company only two years old.

TGR: If Sunward is still drilling, how big might that get?

BM: A lot bigger.

TGR: Double?

BM: Could be.

TGR: In what timeframe?

BM: Two years.

TGR: Any others you’d care to mention in Colombia?

BM: Colombia Crest Gold Corp. (CLB:TSX.V; EAT:Fkft), Red Eagle Mining Corp. (RD:TSX.V), B2Gold Corp. (BTO:TSX; BGLPF:OTCQX), Bellhaven Copper and Gold Inc. (BHV:TSX.V), Solvista Gold Corp. (SVV:TSX.V) and Continental Gold Ltd. (CNL:TSX). But, there are 36 listed companies in Columbia, and I don’t think you could go wrong investing there.

TGR: So Colombia as a region is a good play.

BM: It’s a phenomenal play.

TGR: You’re also big on Africa.

BM: I used to be, but Africa is getting really stupid. Tanzania’s come up with suggestions and changes to the mining laws. Ghana’s started getting greedy. In every business cycle when the cost of the commodities goes up countries start thinking, “You know, we hate to see these guys making all this money so we need to make sure it won’t happen.”

TGR: So Africa’s fallen out of favor.

BM: Australia, Peru and Argentina are also getting stupid.

TGR: Do you hold better hope for the U.S. on the mining front?

BM: The U.S. has some really wonderful properties in Arizona, Nevada, Idaho and Oregon. The western part of the country was wealthy due to mining and we are going to go back to that. I think the U.S. will split up into a series of five or six nation states. Florida has nothing in common with California and California has nothing in common with New York. But again, the U.S. as we know it might not exist a year from now.

Take a look at what I said a few years ago about riots in the United States. Occupy Wall Street started in September. It was a peaceful demonstration. There was no crime. There was no violence. The police started it by barricading young women behind the net and then spraying them in the face with pepper spray.

Occupy Wall Street hit a nerve in Americans and spread all over the country. When it got to Oakland, the police decided they needed to up the ante, so they started firing teargas grenades in the face of an Iraqi War veteran from 10 feet away. If I did that, I’d be in jail for attempted murder. Since a policeman did it, he got away with it. They beat another protester so severely with batons they put him in the hospital in critical condition with a damaged spleen. They have pepper-sprayed priests, 84-year-old women and pregnant women. And these are all peaceful protesters.

The key to understanding what is going on is the police continue to escalate the violence. The next thing will be something similar to Kent State, where they plant an agent provocateur who will fire a gun into the air and the police will take that as permission to start shooting protesters. When that happens, it will literally start a civil war—and it could happen any day.

TGR: That’s not like citizens of one state going against citizens of another state because they have fundamental differences.

BM: No, it would be a civil war of peaceful citizens against a violent, corrupt, out-of-control government. We have every bit of that now. The police are the ones doing the escalation, and sooner or later Americans will start defending themselves. If it had been my son or daughter who was shot in the face, I don’t know what my reaction would be. Those protestors all have parents and brothers and sisters and friends. I’m shocked at the willingness of police to escalate violence against people who are no threat to them at all. It could get really bloody really quickly.

TGR: Why do you think this is Occupy Wall Street and not Occupy Pennsylvania Avenue?

BM: The term should be AWA—Americans with an Attitude. I think that these protests are underway in 113 cities, so obviously a lot of Americans in a lot of locations are angry.

  • 23% of Americans are angry because they’re unemployed.
  • 46 million Americans are angry because they are on food stamps.
  • 50% of mortgage holders are angry because their mortgages are under water.

Everyone knows they have been raped by Wall Street and the government. The common theme is anger. We are angry at big business and we are angry at government.

Big business owns government. You have to go after big business. Barack Obama and this administration are totally controlled by external forces. They are controlled by Israel, Wall Street and the media. But we do not have an activist government that’s actually doing anything. It’s totally corrupt, bought and paid for. Everyone in Congress, with the exception of Ron Paul, has turned into a pimp.

TGR: That’s why congressional approval is as low as what―18%?

BM: 7%. The devil does better than that. Someone did a survey a week or so ago comparing Congress to Satan and Satan came up with an 8% approval rate.

Convinced that gold and silver were at their bottoms, and wanting to give others a foundation for investing in resource stocks, Bob and Barb Moriarty brought 321gold.com to the Internet 10 years ago, and later added 321energy.com to cover oil, natural gas, gasoline, coal, solar, wind and nuclear energy. Both sites feature articles, editorial opinions, pricing figures and updates on relevant current events. Before his Internet career, Moriarty was a Marine F-4B pilot and O-1C/G forward air controller with more than 820 missions in Vietnam. A captain at age 22, he was the youngest naval aviator in Vietnam and one of the war’s most highly decorated. He holds 14 international aviation records, and once flew an airplane through the Eiffel Tower’s pillars “just for fun.”



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Ian McAvity: Is Greed Good for Gold?

By The Gold Report, on December 1st, 2011

Amid a chorus of gold mining pundits yelling for investors to snap up cheap gold equities is Ian McAvity, a 50-year veteran of the markets, telling investors to wait. In this exclusive interview with The Gold Report, McAvity, who produces Deliberations on World Markets, explains why historical cycles lead him to believe the market is in for some new lows and what that means for the gold price and the juniors seeking out that shiny metal.

The Gold Report: Ian, you have been involved in the markets for 50 years. How much of today’s market is a repeat of a cycle you’ve seen before and how much is unique?

Ian McAvity: Cyclical and secular trends haven’t really changed, but each one has slightly different characteristics. From 1982 to 2000, there was a powerful secular uptrend in the S&P 500. Since 2000, there’s been a secular bear trend, sideways or downtrend not dissimilar to 1966–1982 or 1932–1949 that may run through 2016 or 2018.

The big change has been the utter corruption of Wall Street and that nearly 80% of the trading on the New York Stock Exchange now is being done by high-velocity computers. When an investor puts in an order, it’s basically one computer versus another computer operating in nanoseconds. That’s why all of a sudden the volume is up or down 10 to 1 and you get a couple of hundred points added on or taken off the Dow in minutes. To me that’s a corruption of the process. “Ethics” and “Wall Street” are words you never use in the same sentence.

The trading mechanism is broken down. Leveraged exchange-traded funds (ETFs) are designed to consume the client’s capital in leveraging and rebalancing premiums. The high velocity traders literally get the opportunity to “front-run” public orders as the order flow to “the market” is available to them for a fee. It’s outrageous in the sense that they’ve legalized front running for those who pay up for the high-speed data feed. And then there’s the initial public offering (IPO) business. Anytime the public can get shares in an IPO, they don’t want it. If they can get some, it’s only because it’s not going to be that good a deal.

TGR: Is it the corruption of Wall Street or the development of Wall Street through technology?

IMcA: It’s the culture of greed coming out of the banking system. The Street always wanted to make money. That’s never gone away. But there was a time when good clients were actually respected by a firm. A firm wanted to do well for a good client because it wanted to keep the family assets in the firm. These days a client is considered to be a mark. The system is designed to convert the client’s capital into their fees and income as quickly as possible. The public is being chased out. There have been persistent outflows from domestic equity mutual funds since 2007. A lot of people justifiably don’t trust it.

TGR: Or perhaps the public just doesn’t have the tools and the speed to become an influential member of the market?

IMcA: Let me give you an example. The average daily turnover for one gold mining junior ETF is $100 million (M). Probably $80M is day trading where there is no net investment. To call moment-by-moment trading “investment” to me is a sacrilege. There’s no way that people are making a rational investment decision in that sense. I’d rather go to Vegas where they’ve got pretty girls serving you a drink while you gamble.

TGR: Aren’t day traders just playing nagainst each other? Someone bets it goes up. Someone else bets it goes down. They wait a very short period. Ultimately, it just evens out.

IMcA: In theory it works itself out, but it creates an illusion of growth that distorts trends because it injects volatility. The majority of the billions of dollars that are trading every day is intraday noise. All the computers scalping each other for as little as a tenth of a cent.

TGR: The market was up the other day in reaction to the debt plan that came out of Europe. Is this a real increase or just more intraday noise?

IMcA: One batch of traders shorted at the opening burst, but that afternoon it didn’t sell back. All the guys that shorted in the morning got their clocks cleaned and had to cover in the afternoon. That’s why there was a second rush into the close. That trading activity is symptomatic of what’s wrong with this market. Markets are being driven by headlines. Plus, the headlines are being misinterpreted most of the time. At first, it appeared that Europe had a perfect solution for everything. Then, by the end of the day, we were discovering that there were a lot of details missing and it was unclear how many parliaments have to approve the plan. Every day there’s a leak of some unsubstantiated “plan” and later it’s denied but the cheerleaders at CNBC seem to take every wiggle as gospel.

TGR: Is it driven by headlines or the 24/7 news cycle?

IMcA: I wish the news cycle was as slow as 24/7. When people are trading on one-minute and five-minute charts, a 24/7 news cycle can’t keep up with it. It’s not healthy to have this much liquidity. What it reflects is that the bailout of the banks has flooded the system with liquidity, but none of that is trickling down to Main Street or out into the real world. It’s just sloshing around in the financial markets. The velocity of trading reflects that the system is swimming in liquidity and nobody is feeling sufficiently brave to take any risk home overnight. We’ll churn the daylights out of it, but flatten the position before lunch or the close.

TGR: How does an individual investor operate in this environment?

IMcA: Basically hide. A number of people have told me that they’ve become day traders and I ask them how they’re doing and they say, “Well, I’m not quite there yet. I know I can make money doing it.” I tell them not to blow all of their capital while they try to learn. It’s an exploitable game for somebody that has the self-discipline. But it requires a degree of self-discipline that 90% of the people that try it will never acquire.

TGR: At The New Orleans Investment Conference where you spoke in late October, many speakers talked about how junior gold stocks are essentially on sale, inferring that this is the time to buy. Should investors run and hide from a corrupt and frothy market, or go out and buy?

IMcA: You’ve got to watch the inter-market relationships. The gold stocks have been very poor performers relative to the gold price. In the last 12 months, the junior gold stocks have been particularly bad even relative to the senior gold stocks. That is creating an undervalued situation. But undervalued doesn’t mean go out and buy it tomorrow morning. Yes, there was a marvelous October rally after five down months in the S&P. However, I believe that the S&P is going to go back down and at least probe the last lows, if not break them by year end or March. The junior gold mining shares will test their recent lows and then start to show relative performance where they’re not falling as much as the stock market. I’m watching for that type of relative strength and that’s when I would be looking to buy them. I wouldn’t be surprised if the gold price came back down to $1,650 an ounce (oz) as well.

I’m looking for a point where I want to buy, where for several months I was saying I wouldn’t even think about it. A lot of the excesses have been wound out, but the best buying opportunity still lies ahead. Year-end tax loss selling and a sharp down turn in the S&P where everyone is looking for a year-end rally could provide a great buying opportunity for the juniors soon.

TGR: You’re a technical analyst who relies on a lot of charts. What are you seeing in charts that make you believe that the S&P is going to pull back to its lows?

IMcA: I’m basing that on cyclical analysis within secular trends of the Dow Jones Industrial Average. I believe the top this year goes back to February as the cyclical top of the rebound off the 2009 lows, while the S&P made its actual peak in May. On a secular basis, I view this as the second half of the bear market that started in 2007. The first half of the financial bubble was undone from 2007 to 2009. The second half will run through 2012. There could also be a final low that may be as far out as 2016.

The undoing of the debt bubble over the last three decades is not a short-term affair. It’s going to take a long time to work off. The housing market has not seen its bottom. Job numbers are going to get worse. Everything that they are doing in Washington just says that they are looking for new ways to screw it up.

TGR: You’re expecting a double-dip recession.

IMcA: It will be called a double-dip only because they’ve engineered what appeared to be a recovery, but there hasn’t really been a recovery that restored many lost jobs or did much more than temporarily slow the pace of decline in the housing market. All of the money and the liquidity that they threw into the market tweaked a few of the numbers in the gross domestic product to create the appearance of a recovery, but barely a penny of it ever got to Main Street.

TGR: Main Street is starting to spend a bit more.

IMcA: That’s like saying there is a housing recovery because housing starts went up from 420,000 to 425,000. Housing starts used to be 1 million.

TGR: When will the economy get through this mess and start on a real recovery?

IMcA: It’s going to take several years. It might start to show some signs of recovery in 2013 or 2014, or perhaps as late as 2016.

If the S&P is below 1,258 on Dec. 31, 2011, it will be the first down pre-election year since 1939. Election years don’t have as bullish a record as pre-election years. But how much fun has this year been so far? The market’s going to find a bottom for bear market rally bounces. Ned Davis Research Group created a model that I’ve modified that projects a decline in the Dow to a prospective cyclical bottom between 8,200 and 8,400 in August or September 2012 if we experience only an “average” bear market. I fear that it could be a lot worse than “average” given the geopolitical uncertainties as a backdrop.

TGR: Wow, that’s a claim.

IMcA: It’s interesting to see a cyclical decline projected through an election year. It’s not unprecedented, but it’s quite unusual.

TGR: You said earlier that you expect the gold price to pull back again. Do you expect it to pull back below its 200-day moving average?

IMcA: No. The market has come back and tested the $1,600/oz level twice. The last bounce off the $1,600/oz level was pretty credible. I’d be surprised if $1,600/oz is broken now.

TGR: You don’t believe that gold is a bubble then?

IMcA: Whenever somebody talks about gold being in a bubble, I tell them to look at the credit and stock markets. If the gold price is at $1,900/oz, it’s 2.2 times the high in 1980. However, debt in the U.S. is 12 times its early 1980 level. The S&P is trading at 10 times its 1980 level. The credit market and the stock market are about five times ahead of the gold price. I don’t forecast that the gold price will reach five times its 1980 highs, but it might. If it gets there then you can start talking about a bubble.

TGR: Do you believe that gold will replace fiat currency?

IMcA: I don’t know that it will ever replace fiat currency. The leadership of the G13, China, Brazil, and India, are probably going to push the old world to go back to some sort of a central discipline, such as indexing to a basket of commodities. It’s too cumbersome in the modern world to return to a gold standard. But I can envision an international governing body being proposed to push for some discipline such as the Bretton Woods Agreement after World War Two.

TGR: What’s in the basket?

IMcA: Gold, silver, oil, copper and conventional food.

The problem is no central banker ever wants to surrender sovereignty to some other body. The U.S. government is always going to want to call all the shots. But the U.S. government isn’t what it once was. The rest of the world is increasingly going to communicate that message. At some stage, the world needs a globally accepted common denominator. China, Brazil, India and the G13 have nearly $7 trillion worth of the debt of the old world. There comes a point where the creditor will dictate the rules.

TGR: That’s how the U.S. got to the position it’s in.

IMcA: Exactly, exactly.

My biggest concern is increasing geopolitical risk for those that are exploring all over the world, the most recent example being the Argentinean government putting in a new set of rules. The same thing could happen in African countries. If the gold price gets much higher, the South African government will be talking about nationalizing. Too many of those countries will love you while you are bringing money in, but once cash flow begins to flow out, the politics of greed and envy takes over, typically under the guise of economic nationalism.

Politically stable jurisdictions are my preference. I am most attracted to seeking deposits in conventional mining districts in Canada or the U.S. where mining laws and practices are understood and respected. Even South Carolina is coming back again. I remember the previous go-around on it.

TGR: What happened then?

IMcA: It didn’t work out because the gold price went down, as best I recall.

TGR: Any other last thoughts you’d like to leave our readers?

IMcA: The big contrast with this gold cycle and that of the ’80s and ’90s is that we haven’t really seen a big discovery that excites the world. In that last cycle there were about a half-dozen companies built on new deposits that are already mined out and gone now. Names like Echo Bay, Hemlo, Amax Gold, FMC Gold, Pegasus and several others were launched and became the darlings of the last cycle, and they have already gone from the scene by the time gold got above $1,000/oz this time around.

At some stage somebody’s going to make a discovery that’s going to turn the lights on to get the speculative juices flowing, one good, exciting discovery in a prospective new camp. It looked like that might be taking place in the Yukon with the takeover of Underworld Resources Inc. (UNDWF:OTCQB). Will there be a sequel discovery up there? One solid drill hole can transform a junior explorer, but it does need to deliver follow-up success pretty quickly to build on it.

That’s the nature of the drilling beast and discovery cycles. Others will remind you what the odds are. It’s a very high-risk and capital intensive business. That’s why I’m more attracted to the companies that are in that process of creating value out of the ground as opposed to having the political experience of dealing with environmental permitting and other regulatory impediments to getting a new mine into production. My idea is if you can make a discovery then God bless you and let somebody else have those future political and bureaucratic joys for the right price.

TGR: Ian, thank you for your time.

Ian McAvity has been involved in the world of finance for more than 50 years as a banker, broker, independent advisor and consultant. He has produced his Deliberations on World Markets newsletter since 1972. He specializes in the technical analysis of international equity, foreign exchange and precious metals markets, and has been a featured speaker at investment conferences and technical analyst society gatherings in the U.S., Canada and Europe over the past 40 years.



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Caught out by Reality in Europe

By Claus Vistesen, on November 28th, 2011

The rumour mill is grinding particularly fast at the moment. Germany and France seem to be working on the famous nuclear solution, Spain plays tough on outsiders, the IMF is rumoured to be preparing an aid package for Italy not to mention Hungary and Austria (just like Belgium) has entered the rating agencies’ cross hair.

So, what to believe?

I don’t know, but it is interesting that Reuters are now reporting France and Germany to be in an agreement on a fast track move towards fiscal union as well as allowing the ECB to aid sovereigns more forcefully (i.e. unsterilised intervention).

I want to see this before I believe it. Germany is certainly sending conflicting signals. Yet, this may be because they are truly unsure how long they can play this game of chicken with the rest of Europe. Clearly, Merkel has a point in refusing to issue euro bonds and/or letting the ECB step in since the periphery needs to put their house in order or at least show a credible plan to balance the budget. This is essentially quid pro quo as Merkel knows that Germany needs to pay in the end.

But there is a rub. One issue is surely the fact that public finances across the eurozone are unsustainable but another is how these economies are going to achieve anything near the growth needed not to collapse (default) anyway.

We keep on coming back to two main points.

1) It was clear for all that pain was coming in the periphery already in 07/08 and that this would be a substantial period of negative growth/deleveraging consolidation.

2) But the question was always whether such pain could be administered from within the euro zone. We are steadily coming to the conclusion that this is not possible and Germany knows this. But the solution is not clear since jettisoning the euro would have grave implications for the EU too and therefore there is a very strong lock-in mechanism here which it is difficult to get out of.

Finally, there is always the risk that one or many of the Southern European economies will simply “get” enough and make some quick and devastating decisions. It is important to understand my point on this.

I am sure it would be catastrophic for Greece or another country to leave by their own accord and do a messy default, but at some point the rest of Europe and the market will simply corner whatever government that might be in place and they will start taking their own independent decisions.

I note that there are calls for the new government in Spain to play “hardball” with Germany. In this situation, Germany has a distinct interest in just letting the market squeeze the periphery, but of course the rest of the “core” is getting dragged down too and the whole banking system is now at risk of a major liquidity/solvency crisis. In this sense, I only agree conditionally with Felix Salmon:

El-Erian is very good at explaining the problem which needs solving:

“Europe must still stabilize its sovereign debt situation. But this is now far from sufficient. Policymakers must also move quickly to contain banking sector frailties, and do so using a more coherent approach to the trio of capital, asset quality and liquidity.”

It seems to me, though, that sequencing matters here. Liquidity is — always — more important than capital/solvency. Give an insolvent bank enough liquidity, and it can live indefinitely. Remove liquidity from a bank, and it dies immediately, no matter how solvent it might be or how high its capital ratios are. And as for asset quality, we’re pretty much talking a zero-sum game here: when the banks’ dubious assets are the sovereign’s liabilities, the real solution is inflation, not nationalization.

I agree that liquidity is a key issue at the moment in the euro zone banking system, but let us not kid ourselves. Europe has not had a functioning interbank market since 2008 and we are just now seeing the accumulated effect of this.

I just read a big and very detailed BC report on deleveraging among EZ banks and I am extremely concerned. It is clear to me that not only sovereigns are battling with solvency issues but so are many banks and the extent to which they are fighting it means that they will have to cut lending and asset growth substantially. As such, I am afraid that the problems in the euro zone are beginning to resemble a widespread solvency problem both amongst banks and sovereigns, a combination which, to boot, will feed off each other. Especially Eastern Europe are going to have big problems in 2012. They are going to see an almost complete stop of credit flows through the banking system due to parents cutting cross border lending.

I think  that we will see a wholesale and government driven process of bank nationalisations and restructuring in the next 6 months in the euro zone. I also think that most southern european economies are ultimately facing both public and private insolvency issues which will need balance sheet write-offs to get solved. It seems to me that, as so many times before, euro zone politicians are once again getting caught out by reality.



Leave a comment   Economic Theory   , , , , , ,  

Fraud

By Simon Grey, on November 23rd, 2011
Pay close attention to this chart:
This is a problem. As a libertarian, I generally view regulation as pointless, needlessly expensive, counterproductive, and anti-liberty. As such, I oppose a good portion of government interference in the economy. However, committing fraud is not simply a matter of failing to comply with ticky-tack regulation. Fundamentally, it is a violation of property rights. As shown by the chart above, the current vitriol directed at the banks is wholly deserved since every major bank in the united states has committed fraud (i.e. violated property rights) multiple times each.
Merriam-Webster defines fraud thusly:

deceit, trickery; specifically : intentional perversion of truth in order to induce another to part with something of value or to surrender a legal right.

In essence, fraud is attempting to lay claim to the property of another under false pretenses. If you are selling a house and offer $50,000 for it but only pay $25,000, then my attempt to claim your property is fraudulent because I lied about what I would give in exchange for your house. Your decision to sell your house to me was made in the belief that I would pay you $50,000 for it. If I take title of the house without following through on my promise, then I have essentially cheated you out of your house.

Now, if the government must exist, then it is reasonable to expect the government to defend and enforce property rights. This means that the government should prosecute murder, theft, rape, and other crimes wherein one violates another’s property rights. This should also include fraud.

Fraud may not be coercive in the manner that, say, theft is, but fraud is no different than theft in that one takes something that does not belong to one’s self, in violation of the terms of the exchange. As such, fraud is most definitely a crime the government should wholeheartedly prosecute.

All the major banks have committed massive amounts of fraud. Every last one of them. Sometimes this has consisted of foreclosing on homes that were not even collateral for any loan. Sometimes this has consisted of knowingly lying about the quality of financial instruments. There are a variety of ways in which fraud has been perpetrated by the major banks, and I refer you to The Market Ticker (run a search for “bank fraud’)for a much more comprehensive view on the matter. Essentially, the banks have stolen from a large number of people and therefore deserve to be prosecuted to the fullest extent of the law. They have violated the property rights of far too many people, and they need to be jailed.

The assertion that the banksters deserve jail is not predicated on the complaint that banks have ignored trivial regulations; it is predicated on the fact that they have stolen from people. As such, it is not “socialistic” or “anti-market” to demand the prosecution of banksters. In fact, it is just the opposite. It is pro-market to demand that the government prosecute fraud and thereby uphold property rights. The time has come to stop the looting and start the prosecuting.



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Whence Regulation?

By Simon Grey, on November 17th, 2011
Ever heard of Dwolla?

Dwolla was founded by 28-year-old Ben Milne; it’s an innovative online payment system that sidesteps credit cards completely.

Milne has no finance background, yet his little operation is moving between $30 and $50 million per month; it’s on track to move more than $350 million in the next year.

Unlike PayPal, Dwolla doesn’t take a percentage of the transaction. It only asks for $0.25 whether it’s moving $1 or $1,000.

Sounds like a good idea, right? What took it so long?

What did you do for the first two years when Dwolla wasn’t technically legal?

Well it was legal, we just couldn’t operate outside of Iowa. For the first two years we built out the platform. We did a sh*tload of testing on a small scale because legally we couldn’t launch Dwolla nationwide. We spent two years inside of Iowa fine-tuning Dwolla with the financial institutions, building out some of the initial models, and trying to figure out how to legally do what we do. [Emphasis added.]

How’d you find a legal loophole?

Moving money is an exceptionally regulated business. We’re in Iowa, which is sort of conservative — I don’t know if that helped us or hurt us, but in the long term I think it helped us. We figured to do this legally, we had two options: we could take in a tremendous amount of money and go out and get licenses, which is how most people do it. But we didn’t have access to that kind of capital here.

It’s easy to see why the government would, say, ban smoking: it isn’t beneficial to anyone, at least in terms of health. It’s more difficult to understand why the government would ban something like Dwolla, which doesn’t appear to have any downside. Well, except for its competitors (large banks, e.g.).

Some regulation is born out apparent concern for people. But some is born out of bribery. Specifically, big businesses support a host of anti-market legislation because it gives them a market advantage. Conservatives need to learn this, because big business is no one’s friend. As Adam Smith once observed, “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.” This usually means petitioning the government to set policies in place that hamper or prevent competition.

Just because the market is more trustworthy than the government doesn’t mean that businessmen are more trustworthy than politicians.



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Protest what?

By Christopher Briem, on October 20th, 2011

I have looked at this a lot, but never had a reason for posting about it.  So now I note Bram passed on the image that highlights the conundrum going on Downtown and elsewhere as folks struggle to figure out where to focus their anger. It reminded me of  what may be the ultimate financial infographic of all time. See below.

Not new, this has been floating around for quite some time at this point.  I believe this is the original source, but it is hard to tell given how much the image has been passed around.  This is the reverse engineering one couple did of what happened to a single mortgage as it went from the signing of their promissory note and down into the rabbit hole known as the financial markets.  I keep trying, and failing, to find George Bailey in there somewhere.  As much as the name and cartoons are far more accessible to the general public, this is a far more accurate representation of what is otherwise known as Toxie in other circumstances (I have no reason to think Dan and Teri are themselves anything other than good credit risks).

So let’s say you were angry over the foreclosure crisis.. where in this diagram is the center of gravity that you would vent your anger at?



Leave a comment   U.S. Economics   , , ,  

Sounds Good To Me

By Simon Grey, on October 17th, 2011
The OWSers finally have a good idea:

The social uprising — called “Bank Transfer Day” — encourages bank customers to take their cash out of big banks and put it in smaller banks and credit unions instead. The movement is ostensibly in response to aggressive fees institutions are rolling out to recover profits lost from new financial regulations, notably Bank of America’s (BAC – News) decision to stick debit card users with a $5 monthly fee and Wells Fargo’s (WFC – News) $3 test of the same.

Of course, one need not be a pot-smoking leftist to think that putting one’s money in a bank that doesn’t charge you usage fees is a good idea. And one need not view opening up a checking account with a cheaper bank as a way to show solidarity or prove one’s radicalism. Going to a cheaper bank is simply good business.

At any rate, if you’re going to bank, you may as well bank with an institution that hasn’t perpetrated massive fraud against its customers or the American people. To that end, I also recommend putting your money in a credit union; I’m very happy with mine. I haven’t gotten ripped off, and no one who works at my credit union has been arrested on fraud charges, nor is anyone calling for such a thing.

Better yet, transferring your money from one of the big banks to a local bank or credit union strikes me as a way to a) end the “too big to fail” nonsense once and for all and b) strike back at the criminals running the major banks. In the case of the former, taking your money elsewhere means that any future bailouts will ostensibly be used for fat cat traders who didn’t have enough foresight to cover their risks, since the “little people” with bank accounts will be elsewhere. In regards to the latter, it will considerably harder for the major banks to turn a non-fraudulent profit if they have no customers.

I’m with the OWSers on this.



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Should government put fresh equity capital into State Bank of India?

By Ajay Shah, on October 7th, 2011

The discussion about State Bank of India (SBI) has treated one proposition as a given: that it is the job of the Ministry of Finance to continually inject capital into SBI so as to enable the growth of the SBI balance sheet; that SBI has a legitimate claim upon fiscal resources at all times.

I’m not sure this is a good way to think about the business of banking. The first task of a bank should be to produce adequate retained earnings so as to support the desired growth. If a bank cannot produce retained earnings enough to grow, there is reason for thinking that it should not grow.

Let’s compare the performance of the best private bank (HDFC Bank) and a good PSU bank (Bank of Baroda) from this perspective.

Growth of the balance sheet and leverage

Let’s look at how the two banks have fared, from 1999-2000 onwards, on the core issues of balance sheet growth and leverage:

1999-2000 2010-11
Bank of Baroda
Total assets 58,623 358,397
Leverage 18.12 17.07
HDFC Bank
Total assets 11,731 277,429
Leverage 15.33 10.93

From 1999-2000 to 2010-11, there has been a sharply superior performance by HDFC Bank. At the start, it was a small bank – with a
balance sheet of just Rs.11,731 crore while BOB was roughly 5x bigger. By the end, HDFC Bank was at a balance sheet size of Rs.277,429 crore while BOB was at Rs.358,397 crore.

What is more, HDFC Bank did this while being more prudent: they deleveraged in this period: They went from a leverage ratio of 15.33 to a leverage ratio of 10.93. In contrast, BOB stayed at a much higher leverage (18.12 at the start and 17.07 at the end).

The bottom line: BOB grew net worth by 6.5 times and the balance sheet by 6.11 times. HDFC Bank grew net worth by 33.17 times
and the balance sheet by 23.65 times.

So how did the net worth grow?

In the naive intuition that’s being bandied about in the discussion about SBI, there would be an expectation that the expansion of net
worth would be obtained by asking shareholders (new or existing) for money. What happened in HDFC Bank and BOB was a bit different.

The hallmark of a healthy bank is the production of retained earnings which can be ploughed back into the business. HDFC Bank did
that: over this period, it brought 13.23% of total assets (summing across the 12 years) back into the business, so as to grow net worth. BOB did not do as well: it brought only 7.86% of total assets back into the business.

In addition, HDFC Bank raised 13.66% of total assets by bringing in fresh capital. BOB, in contrast, brought in only 2.11% of total assets into the business. You could criticise the Ministry of Finance for being niggardly in giving BOB equity capital.

A thought experiment: Strangle HDFC Bank of access to fresh equity

Suppose we replay these 12 years while allowing HDFC Bank to only grow through retained earnings. We cut off all growth of net worth through issuing fresh equity capital. Suppose we force it to deleverage as it has: from 15.33x in 1999-2000 to 10.93x in
2010-11. Where does this leave us?

The answer: In 2010-11, HDFC Bank would have had total assets of Rs.146,742 crore if this policy had been followed. It would still have obtained growth of 12.5x through this period.

This thought experiment, then, serves as a nice demonstration of what a healthy bank should be: it should make money, pay dividends, and plough back adequate retained earnings to support growth of the balance sheet.

Summary

A well run bank must put retained earnings back to work. If a bank is unable to fund its own growth by increasing net worth through
retained earnings, there is reason to be concerned about the health of the core business.

A steady flow of new capital from shareholders, in order to enable growth, is not that different from recapitalisation in response to bad assets.

Public money is precious. The Ministry of Finance would do well to be very, very stingy in doling out public money to PSUs. Each Rs.5000 crore that goes into a PSU comes at an opportunity cost of 1000 kilometres of NHAI highways which could have been built using that money.

If a PSU cannot grow its balance sheet, odds are the problem lies within: it needs to become a better run business and thus grow the
balance sheet using retained earnings. Such PSUs are precisely the ones who are the least deserving to gain fresh capital. If anything,
fresh capital should be directed into banks like HDFC Bank (as the private capital markets have), who are doing a great job of  producing retained earnings.



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