Zero Cost Carries

Interest rates as a pricing mechanism in the economy go much deeper than the superficial assessments of mortgage loan rates or what one earns on deposit. Arguably one of the most significant jobs of interest rates as a pricing mechanism is the “cost of carry”.

This in plain language means how much it would cost to buy any item for resale at a future date. A simplified example may help. Say a store buys a product for resale at $100 with the aim of selling it within one month. Now let us state that interests rates at that time was 12%. That would translate into an interest rate of 1% for one month. So the store owner would have a cost of carry of $1.

The store owner paid $1 to carry the stock for one month. Say in this example that the store owner would have expected to make a net profit of $10 on the sale before paying for the cost of carry. That would imply that the store owner’s cost of carry would have calculated as 10% of the net profit. The importance of cost of carry is yet but partially explained.

What happens should the product not sell as expected in one month and the store owner is only able to achieve the sale after 12 months? Cost of carry now amounts to $12 and has wiped out the entire expected net profit and some. Accountants developed a measure to manage cost of carry in a stock turnover ratio. The manager would ensure that the total stock turns over as fast as possible to keep cost of carry as low as possible. The store owner would be encouraged to purge slow moving unwanted stocks from inventory through the cost of carry mechanism. A desirable and economically efficient behaviour trait operating on autopilot without outside intervention.

The principles of cost of carry translate directly into financial markets and financial speculation. Interest rates are not the only component in cost of carry but have always been an important component, that is before the advent of the zero bound interest rate policies of central banks.

Say you want to speculate on a rising oil price. Calculating the cost of carry on your position follows this economic and accounting logic. You borrow the cash required to make the purchase. Buy the oil and store it. Cost of carry will be the interest paid on the loan and the cost of storage for the period from when you entered into the transaction until you chose to exit. That’s the basics. Why should it be significant?

Cost of carry cascades through the economic fabric in millions of ways. A real estate owner for profit would purchase a commercial or industrial property and the expected profit would be the rental incomes, less cost of carry, less operating expenses. A speculator in shares would expect a profit equal to the difference between the buying and selling prices, plus dividends, less cost of carry. Interfere with this mechanism and it impacts as wide as supply and demand variables of property. Too low interest rate and access to easy credit would drive up demand and prices in no time for example. That is the birthplace of property bubbles (and all other asset inflations also known as asset bubbles).

The whole economic cosmos of derivatives is priced on a cost of carry basis. Forward cover on foreign exchange (say $/Yen) is based on the perfect hedge of borrowing the dollars and purchasing yen at inception. Invest the yen for the period. Cost of carry for the period would be the dollar loan cost less the yen income, both interest rate denominated. Thus the forward price of Yen would be the spot (today’s price) plus the cost of carry, which may be positive or negative. A neat little cross border trick performed by interest rates in this pricing mechanism. Mess with the interest rates in one or both sovereign economies and the exchange rate pricing mechanism get similarly messed up.

Interest rates are an invisible spider’s web influencing every price of every type of good or service produced in the economy. No matter where you touch it, it reverberates throughout the whole structure. Interest rates would regulate the allocation of scarce savings, and yes savings are always scarce without huge quantities of debt facilitating liquidity provision from the central banks. This job of allocation by interest rates when interest rates are free form manipulation or outright control is performed as a delicate harmonious melody throughout the economy in that invisible spider’s web. The dynamic takes cognisance of economic merit right down to the smallest individual transaction maintaining an intricate economic balance which in turn contributes to the harmony of all other pricing mechanisms.

Just try and imagine the corps of central bankers required to perform the same functions previously performed by interest rates without the interfering central bankers. It is not only probable but guaranteed that these delicate operations will no longer take place. At first the interest rates just gets distorted. The distortion in interest rates distorts all other pricing mechanisms and influences the choices and behaviour of economic participants. The previous dynamic harmony is lost.

Sadly it does not stop there. Every intervention breeds another intervention to sustain the distortion of the previous intervention. All interventions breed like germs on rotting flesh left outside in the sun and spread like a virus on a university open website. The interventions accumulate and compound and monetary policy interventions reach the pinnacle of absurdity when it attains that final resting place of the zero bound.

The central bank has effectively discontinued the base interest rate from the economic landscape. Of the spider’s web which were tattered and torn by interventions now only remains a few malfunctioning strands. Interconnecting harmony and relative rebalancing is but an abstract memory.

Then again why would it matter? Unfortunately it matters very much. Visualise an economic pickup truck with no intricate wiring. Nothing works and it is simply being pushed around by government and central bank officials. Having destroyed the fabric of pricing mechanisms are not without consequences. Those consequences are as varied and as complex to pin down as were the contribution of interest rates to the pricing mechanisms.

Cost of carry is but one component where consequences will manifest. Staying with the examples given we can see that inventory management has been compromised and dead stocks can be carried without cost, which will certainly diminish efficient management of stock levels; the oil speculator can double or triple his position and carry it for longer with an immediate consequence that the price of oil may rise for everyone else though the general tendency would be for oil prices to become unstable and subject to violent unpredictable adjustments; the most obvious consequence for real estate is similarly boom bust pricing cycles but a menacing economic rot in the encouragement to banks to roll and refinance bad debs while in reality becoming owners of the properties on a zero interest cost of carry is a less obvious outcome; perhaps the most devastation to pricing mechanisms are the consequences of a zero cost of carry on derivative markets distorting macro pricing of exchange rates between currencies, hedging and arbitrage in all commodities and financial securities across all forms of derivatives from the plain futures and options to the exotics. No pricing mechanism is spared the taint.

A very real example which carries influences from cost of carry on inventory, to finance, to derivatives and even sovereign currency pricing is copper. Thus we can observe the absurdity of huge stockpiling and rising prices concurrently in real time.








The global economy is now cursed with the affliction of the zero bound interest rate policy in all the major economies. Thus all micro and macro pricing mechanisms must function with the heavy hand of central bank bureaucrats allocating with bias, subject to vested interests and central government direction. They only allocate where they can see and how they desire in the absence of the delicate spider’s web of dynamic interest rate allocation on economic merit.

Adam Smith’s invisible hand of the market has been chopped off at the elbow.


Sarel Oberholster
BCom (Cum Laude), CAIB (SA)
31 January 2010


© Sarel Oberholster



Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .

Twin Peaks – Jumping in Mud

In this edition of Twin Peaks we continue to monitor the unfolding developments in the Global Financial Crises (yes it is still with us) and the developments of the post Dec 1989 crises in Japan as expressed in the Dow and the Nikkei. The thesis as has been discussed at length in previous Twin Peaks series, is that the USA and Japan are following similar monetary policies of excessive monetary stimulation which achieved an artificial market condition described as “the zero bound” where short term interest rates are stuck at zero or near zero for extended periods. The 1989 economic collapse in Japan initiated its drive towards the zero bound and the USA started its march towards the zero bound after the 2007 economic crises. Both economies have achieved the condition of being stuck in the zero bound but the USA is about 18 years behind Japan. The zero bound monetary policy combines with Quantitative Easing and fiscal policies of budget deficits to generate an explosion of public debt.

The present tale of the charts is one of divergence. The USA chose aggressive monetary and fiscal interventions while the Japanese took a more measured approach. It is the Bernanke theory that this difference is what will distinguish the USA from Japan, where the USA will recover to rapid economic growth as opposed to the Japanese experience of a low level deflationary depression stretching over two decades and entering its 3rd.

The aggressive policies of the USA are showing up in the charts. That does not mean that the Bernanke theory is proven, it simply means that the markets reacted in predictable fashion to the very aggressive government policies. Government and central bank interventions are not self sustaining and must be repeated in ever growing tranches to simply maintain a stimulation effect. The next stimulation will need to be even greater than the previous two but it may not be as visible due to the adverse political consequences attached to the previous spectacles.

Stimulation decay sets in after a while unless, and this is what is hoped for, the spark provided by the government is sufficient to get the economy going. The jury is out on whether stimulation will be a gasoline and newspaper bonfire burning fast and bright for a while to sputter and die or not. Everything rides on that outcome.




(Click chart to enlarge.)

The peaks of the Nikkei and the Dow are matched in this chart and not rebalanced thereafter to allow for significant deviances. The peak of the 1929 Dow has been added just to spice up the test against depressionary conditions. The aggressive US intervention has now carried the Dow upwards beyond the levels of the Nikkei, for a similar period as unfolded. The positive divergence in itself is not compelling as the initial equally aggressive reactions to the 2007 crash caused a similar positive divergence then, which was resolved with a dramatic convergence and negative divergence between October 2007 and April 09. This chart does not show it but the long term bottom of the Nikkei since Dec 1989 is as recent as 10 March 2009 at 7054.98.

The decay in the stimulations is already showing up in the momentum inherent to the move from April 2009.

The Momentum chart hereunder needs some explanation in interpretation. It measures the relative change in the gap between the 50 day moving average and the 200 day moving average, counting backwards. A 180 degree flip-over (negative to positive) in data occurs when the 50 dma crosses over the 200 dma.

Here’s what the chart tells us. The momentum in the bear move down was failing for weeks before late March, early April 2009. The bear market momentum gave way to a negative momentum bear, i.e. a bull market momentum since early April 2009. The flip-over/crossover occurred just before the end of June 2009. Momentum still spiked unto mid July but since then bull momentum has been in decline. The “jumping in mud” period started in late October 2009 where the market is still in bullish trend but just can’t get going.

Presently we are still in the “jumping in mud” phase but the beginning of a downward trend is showing up in the negative momentum bull, i.e. the bull marked momentum is failing. We have not yet reached a point where we can make a call to say that the bull marked has failed. The historic indications are that a -1.5% to a -2% recording is required to indicate a high probability that a bear market move is underway. The highest recording was -0.7% on Dec 31st 2009. So for now it is simply “jumping in mud” time until momentum picks up in either direction.




(Click chart to enlarge.)

The here and now is where the bulls will believe in the Bernanke thesis that this time it will be different for we acted faster and with more aggression in our stimulations. The bears will continue to claim that the speed and extent of intervention will not alter the outcome of a deflationary depression only how we get there. They would further insist that the likely outcome of a too fast and too furious monetary response will harvest an even worse outcome of a hyperinflationary depression in an effort to escape the deflationary depression. Already gold, silver, copper and every other commodity are being stuffed in custody and warehouses discounting such excess. Another vote of no confidence in official policies and not a sign of economic recovery.

The Japanese economy in this phase was typified by warehousing growing bad and delinquent debt with central bank and central government support. Mortgage debt for instance was warehoused in the Jusen structures, with similarities to the Freddie Mac and Fannie Mae structures in the USA. Every stimulation, regulation and intervention was aimed at reviving the asset inflation pre 1989 and denying the accumulation of decay in the economy. The economic events forced Japan to disprove the Keynesian theories of sticky downwards salaries and wages when after endemic unemployment, salaries and wages stated falling. Asset inflations never revived and in fact continued to deflate as each stimulation and intervention to prevent that outcome failed. Minuscule rises in interest rates or in direct or indirect taxes dumped the economy right back into crash mode, stumbling through two decades of economic decline until government debt equalled national savings in this previously high net savings nation.

Perhaps this time the outcome of Zero Bound and Quantitative Easing monetary policies combined with budget deficits and excessive government debt will be different, but probably not.

May you trade with wisdom and reward in 2010.


Sarel Oberholster
BCom (Cum Laude), CAIB (SA)
6 January 2010

Ps. I will post a news flash update should the Momentum chart post a negative 1.5%.


© Sarel Oberholster


Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .

Sarel On the Edge with Max Keiser (Part 1)

Sarel On the Edge with Max Keiser (part 2)

Parking Space for Non Performing Loans

The real estate market will soon recover and this whole financial crisis will be just a bad memory. This was exactly the reasoning of the Japanese authorities when the real estate market collapsed in 1990. The very obvious solution was to ensure that the debt accumulated in funding the real estate bubble could be parked safely away from prying eyes while patiently waiting for the real estate market to recover and the real estate prices to grow back to the levels required to settle the loans. Sadly it turned out to be a twenty year wait but the non performing loans could not remain parked in the private sector for such an extended period. Parking space required grew each time the problem was moved and the taint of government with it.

The tale starts in 1970 when eight Jusens were established. Seven by major banks and financial sector players with shareholdings dispersed amongst the players for each Jusen to avoid subsidiary status. The eighth was founded by Agricultural Finance Cooperatives which were banks (also called deposit taking institutions at the time). The Deposit Taking Institution definition was telling as it defined the status of the entity as a bank or not and not the fact that an entity may be making loans. The purpose of the Jusens was to finance mortgage loans for the household sector but they were not to take deposits and would therefore not be banks. The shareholder banks would provide all the funding required.

The non-bank status allowed the Jusens to escape regulatory scrutiny with the full knowledge and blessing of the political regime and the BOJ. The Ministry of Finance (MOF) actively participated with a policy of profit padding reminiscent of a protective cocoon of naval attack craft around vulnerable aircraft carriers nicknamed the convoy system (gosoo sendan hooshiki) to promote cartels and safeguard banking profits from unacceptable competition (Rosenbluth&Thies, 2000). Also called a “survival of the weakest” policy (Milhaupt, 1999).

The basic Jusen setup was a very simple structure which made a mighty contribution to the real estate bubble in Japan.





The Shareholder Banks in turn were also receiving generous liquidity support from the BOJ and all the building blocks for a real estate bubble were in place. Soon other banks described as non-founder banks were also lending into the Jusens. The Jusens in turn did not restrict its mortgage lending only to households but expanded into the (at first) lucrative lending for property development. Globalisation, market liberalisation and internationalisation arrived in Japan in the 1980’s and together with epic loose monetary policy in the wake of the 1987 soon too be forgotten crash of the stock exchanges, accelerated lending growth into real estate to a fever pitch, with the Jusens out front. Dark tales are told of how even the Yakuza got involved in the real estate business in many ways including by providing jiageya (a land turner) who would clear the way for large real estate developments by for example “convincing” obstructive small land owners or tenants to cooperate.

The Nikkei peaked in Dec 1989, the real estate bubble popped and by late 1990 the Jusens were in trouble with non performing loans. The MOF inspected the Jusens for the first time ever in 1991 and concluded that almost 40% of the loans were non performing (Milhaupt, 1999). The response were predictably to underplay the problem as was shown later and to develop plans aimed at parking the problem out of the way while waiting for the real estate market to recover. The initial write off for the Jusens was around $5million. See the table of losses published by the DIC (Deposit Insurance Corporation of Japan) further down for the disclosed losses after a final restructuring effort in 1996 which closed the Jusens down.

The structurers of the Jusens never anticipated any failure and it transpired that clear allocation of losses when they arrived could not be done. Soon the previous partners in the joint ventures were arguing who should bear the losses and in which percentages. Some argued for loan ratios, other argued for control ratios and fingers were pointed at the MOF as responsible. The MOF was forced to intervene in the growing Jusen crisis. MOF involvement “stabilised” the volatile situation within the greater context of the Japanese financial crisis with hints of public support and implied guarantees but was ultimately based on the vain hope that the problem would resolve itself as soon as the economy had been reflated.

The temporary parking space provided for the non performing loans policy was so successful that Visiting Executive Professor Masaru Yoshitomi concluded in his lecture at the Wharton School, University of Pennsylvania published 17 April 1996, thus:

In conclusion, the recent performance and recovery of the real economy is decoupled and isolated from the banking “crisis” in Japan. Therefore if both the Government and the public correctly handle the Jusen liquidation and other banking problems through overhauling the current financial and regulatory system, the Japanese economy will launch on the new underlying growth path of 3 percent or so with better shape of both real and financial sectors. (The “jusen” debacle and Japanese Economy)

The parking space provided by the MOF supported by the BOJ’s ultra loose monetary policy with limitless liquidity provision and zero interest rates or near zero interest rates combined with the envisaged “overhauling of the current financial and regulatory system” failed to generate the 3 percent or so growth path for Japan. In fact, the by then around 75% non performing loan problem of the Jusens grew to an almost total conversion to non performing status. An attempt to raid the treasury to clean the Jusen slate met with fierce political resistance. The Founding Banks and the MOF were forced to thrash out a painful deal in 1997 to “permanently” deal with the Jusen nightmare. It was implemented by dividing up the non performing loans amongst the MOF and the Founding Banks with provisions for greater disclosure and transparency. Yet again the non performing loans were shifted from the previous parking space at the Jusens to the MOF, the Deposit Insurance Corporation (DIC) and the balance sheets of the Founding Banks on a 15 year envisaged repayment structure.

It did not take long to realise that the banks simply could not cope with the additional losses of non performing loans going bad and as early as March 1998 the MOF was obliged to inject capital into failing banks. Nine years into the Japanese Financial Crises having provided parking space for non performing loans for all that time and yet again the Japanese authorities faced another banking crisis. Rosenbluth & Thies (2000) describes it as follows:

“Between October 1998 and October 1999, Long-Term Credit Bank and Nippon Credit Bank were nationalized, five other major banks were declared insolvent (Nikkei 10/18/1999), and many others have merged with healthier institutions.” (The Electoral Foundations of Japan’s Banking Regulation)

The history of the Jusen problem after the parking space deal can be seen in the numbers published by the DIC in the RCC – Secondary Losses of Jusen Account table hereunder:


Source: Deposit Insurance Corporation, Japan

(Click on the table for a larger view)

It is clear, looking back upon the past twenty years of the Japanese Financial Crises that the ultimate parking space for most of the non performing loans were found on the balance sheet of the Japanese Government, those of the Jusen and of the banks alike. The policies of providing parking space to “stabilise” bubble excesses has mired the Japanese economy in a deflationary depression for two decades and saddled a younger generation of Japanese with a depressing Government Debt burden of a quantity that will haunt their economic life for more than a generation.

Only those afflicted with that special kind of blindness of them-who-do-not-wish-to-see would be able to look upon the policies of the FDIC, the FHA and its wards Freddie, Fannie and Ginnie together with the antics of the Fed to provide parking space for non performing loans will fail to see the parallel with the recent history of the Jusens. The not so blind will note how the taint of bailouts and stimulations festers in this still growing parking space and contemplate a future perhaps akin to the vehicles abandoned at the Dubai International Airport car parks. Those who watch the growing sovereign debt burdens may eye the IMF and the World Bank for parking space when the next sovereign debt default announces its arrival.

Sarel Oberholster
BCom (Cum Laude), CAIB (SA)
3 December 2009


References:

1. Rosenbluth & Thies, 2000 – The Electoral Foundations ofJapan’s Banking Regulation, Electronic copy at: http://ssrn.com/abstract=1158646
2. Milhaupt, 1999 - Japan’s Experience with Deposit Insurance and Failing Banks: Implications for Financial Regulatory Design?, Monetary and Economic Studies, Institute for Monetary and Economic Studies, Bank of Japan, August 1999, pp. 21–46.
3. Yoshitomi, 1996 - The “jusen” debacle and Japanese Economy, The Long-Term Credit Bank of Japan Research Institute.
4. Felson, 1998 - CLOSING THE BOOK ON JUSEN: AN ACCOUNT OF THE BAD LOAN CRISIS AND A NEW CHAPTER FOR SECURITIZATION IN JAPAN, DUKE LAW JOURNAL Vol. 47:567, pp 567-612.
5. Organized Crime Registry, 1996 - Who got Yakuza into our banking system?, http://orgcrime.tripod.com/yakuzabanking.htm



© Sarel Oberholster



Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .