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“Across the globe, investors have one thing in mind. How far will interest rates rise and is the great bull market in bonds finally over?” Lawrence MacDonald Henry Ford's missing punch bowl New York | The proverbial punch bowl has been spilled all over the floor. Not surprisingly, the departure of Janet Yellen as Chair of the Board of Governors of the Federal Reserve System is bad news in many quarters. The speculative policies that helped gun assets prices around the world are now ending – at least for now. An eight year bull market in bonds is also seemingly at a conclusion. Quantitative easing or “QE” went on for years longer than necessary, thus Yellen’s successor, Chairman Jerome Powell, must clean up a particularly large mess. Cleaning up other people’s messes is, of course, the key job requirement for being Fed Chairman and, particularly, President of the Federal Reserve Bank of New York. Names like Volcker and Corrigan return to front of mind, but the past three Fed chairs have not deigned to dirty their hands with mere banking . The mess cleaning task of the Fed is similar to the role played so wonderfully by Sally Hawkins and Octavia Spencer in The Shape of Water , our vote for the Oscar this year BTW. Besides conveying dying broker dealers and insurance companies into new hands, the merger of dying zombie banks with the living, and most important, preserving the Treasury’s access to the debt markets, the Fed is now tasked with cleaning up a mess in Washington. This last responsibility is about to become particularly difficult as we rocket into the future with a Republican Congress that refuses to raise revenue out of fear of losing the next election. Before Chair Yellen actually walked out the door, the Fed’s Supervision & Regulation function announced supposed sanctions against Wells Fargo & Co (WFC). The bank engaged in widespread acts of fraud against customers, apparently for years. The sanctions are an embarrassment and amount to a single gentle slap on the backside by the Fed. For starts, by telling a $2 trillion asset zombie bank and the largest loan servicer in the industry that they cannot get bigger, you are doing the CFO a favor. After all, it's about equity returns. The Fed has the power but not the will to act. For example, replace the CSUITE of WFC and force the bank to sell 50% of its assets. Then the Fed would be doing its job, as it would do without hesitation with a smaller institution. But by slamming dying zombies into healthy banks for fear of damaging confidence, the Fed created the governance problems at WFC. And the US central bank dares not challenge the bank monstrosities it has created over the years, in part because they are all primary dealers in US government bonds. None are more surprised about the market's turn of affairs than the inhabitants of Wall Street, both the perpetrators themselves and their loyal scribes in the world of financial journalism. The idea that markets for stocks, bonds and real estate might need to correct a bit after galloping along for five years at multiples of the official inflation statistics is a revelation to many -- but certainly not all. We still have “positive fundamentals,” you understand. Most of the senior pundits in the financial press have asked the right questions at one time or another, but as former Citigroup Chairman Chuck Prince lamented, on Wall Street you dance until the music stops. Or as they used to tell teary eyed fans at the end of his concerts, “Elvis has left the building.” No, Chair Yellen will not be playing an encore. And the timing of Chair Yellen’s departure is particularly unfortunate for the overbought and overheated financial markets. Washington has just done a reprise of sorts, repeating the market movements seen after the 2016 election. The yield on the 10-year bond is rising towards a five-year high, attracting cash from absurdly over-stretched equity markets. The chart below shows the 10-year Treasury bond and the S&P 500 Index. The arrow indicates the November election and subsequent discontinuity that included a surge in interest rates and stock prices. Was the post-election uptick in stock prices supported by “good fundamentals” or the proverbial animal spirits? Our friend and The IRA reader Dick Hardy down in Atlanta worries that the ratio of the 10-year Treasury bond and the SPX are nearing a worrying divergence. “Note the head and shoulders pattern developing, and note that if one draws a trend line off the 09 low and 14 low the trend has been broken. A break below 90 (the approximate head and shoulder neckline) would be an ominous sign. Might want to put this one on your watch list,” he writes. With most markets fully correlated, we may all be staring into the eye of a perfect storm in formation. First, Congress has just passed tax reductions that promise to greatly increase Treasury funding needs in the near term. Indeed, the position taken by Secretary Stephen Mnuchin and his predecessors about the US Treasury issuing primarily short-term debt seems to be evolving with each passing day. Look for those 10s and 30s to be reopened more frequently in coming months as the reality of Argentine style fiscal policy in Washington collides square on into a receding bond market and a weak dollar. Of particular interest is the decision by the Chinese government to reduce outflows of yuan and how this political shift will impact foreign asset prices. Press reports suggest that epitomes of leveraged growth such as HNA Group seem headed for default, although we still don’t know who actually owns the company! Speaking of AML violations, let's ponder the fact that global regulators and counterparties have no idea as to the overship of HNA, the largest shareholder of Deutsche Bank AG . Reports that HNA and other Chinese investors may be forced by Communist Party leader Xi Jinping Beijing to lighten up on foreign real estate certainly provides food for thought. Will the forced assets sales by some of the more egregious examples of excessive leverage in China cause a general liquidation of the Yellen bubbles in stocks and bonds? As one New York real estate publication The Real Deal warned, "Brace yourself for a yard sale." The unwind of large bubbles does not necessarily happen quickly. The Great Crash of 1929 was actually the final crescendo of a period of financial boom and bust that began to end with the collapse of the FL real estate market in the mid-1920s. John Kenneth Galbraith, writing in his classic 1954 book “The Great Crash, 1929,” describes how parcels of land in Florida were divided into building lots and sold for a mere 10% down payment. In effect, Americans of the early 1920s were trading fractional options on FL real estate. Charles Ponzi, the great American fraudster and namesake of the financial pyramid scheme, was actively involved in selling parcels of land in Florida in the 1920s. He leveraged a steadily growing flow of investors until 1927, when the tide of new investors peaked and the FL property market began to crack. Sound familiar? Bitcoin is merely the modern day extension of the alluring logic of Charles Ponzi, albeit enabled by the Internet. The Great Crash of the stock markets in 1929 was not the final act, however, and would lead to the catastrophe of the banking crisis of 1933. As recalled in Ford Men: From Inspiration to Enterprise , a decidedly selfish Henry Ford helped to crater the US banking system by threatening to withdraw his cash from Detroit's banks. From early 1933, financial institutions from Chicago to New York closed for months and even years -- all thanks to Henry Ford’s enmity for his former business partner, Senator James Couzens, and most people generally. Scores of private banks and businesses failed in the forced deflation from early 1933 onward. When President Franklin Delano Roosevelt made his famous March 1933 inauguration day utterance about Americans having “nothing to fear but fear itself,” every bank in New York was closed. Millions of Americans were quite literally standing in the streets of major US cities. The terrible year 1933 was quite a bit worse than the crisis of 2008. Out of the experiences of the Great Depression and World War II, the Fed and Washington generally have evolved a progressive attitude towards “pump priming” consumer demand that has led us to the current juncture of zero rates and infinite duration. Most of the industrialized world, including China, is drowning in bad debt, but this fact goes unremarked. Several years ago, the big idea coming from Chair Yellen and her comrades on the Federal Open Market Committee and other global central banks was to lever up the economy with even more debt. This increase in global leverage included the purchase of trillions of dollars in stock funded with record amounts of corporate debt. Just to add some spice, the Yellen Fed purchased two trillion dollars worth of mortgage paper -- bonds that will sit on the Fed’s books for many years to come. Indeed, should we start to see mortgage agency bond issuance with 4 and even 5 percent coupons not so far down the road, the duration of the Fed’s MBS position will explode -- even as the nominal principal amount very slowly runs off. But at least holders of mortgage servicing rights (MSRs) can look forward to big positive marks in Q1 2018. The pressing question facing investors is whether interest rates will follow the pattern seen a year ago, when Treasury yields feel as the market retraced the increase in yields seen after the election of Donald Trump. The key market benchmark flirted with 2% yields in September last year. With each uptick in interest rates, the massive amounts of investor cash sitting on the sidelines returns, acting to counterbalance the market’s bearish tendencies. The difference between last year and 2018, however, is that now the Treasury is seeking to fund trillions of dollars in red ink to fund a badly advised peacetime pump priming effort. Don’t get us wrong. Structural tax reform is great. But the US badly needs to raise some revenue pronto or will run the risk of looking ridiculous to the entire world. The danger here stems not from the colorful occupant of 1600 Pennsylvania Avenue but from the fact that the larger building down the street that sits atop Capitol Hill appears to be empty -- of courage or even practical perspective. Market prognostications aside, the lack of political will among America’s leaders when it comes to matters of money is the biggest risk facing the world in 2018. #Yellen #PunchBowl #HenryFord #FordMen #duration

Richard Cordray and Mick Mulvaney New York | It’s a strange time in the housing market. Home price increases have been running above the posted inflation rate for more than five years, yet lending volumes are expected to fall again in 2018 for the third year in a row. The end of the Progressive Inquisition at the Consumer Finance Protection Bureau is in sight, yet the housing industry continues to reel from the massive increase in the cost of regulation, which has seen productivity in the world of mortgage finance cut by two thirds since 2012. News reports suggest that thousands of jobs could be lost in mortgage finance this year due to rising interest rates and falling lending volumes. This is primarily due to slack demand for mortgage refinancing as a result of rising long-term interest rates. Chart 1 below shows the 12-month average price change from CoreLogic for all US homes going back to the 1970s. Source: CoreLogic Note the upward surge in average home prices during 2012-2014, which was due to the work-out of distressed mortgages. Closing the gap between the deeply discounted value of foreclosed homes and normal sales accounted for a lot of the price gains reported during this period. The more subdued average home price action in many coastal markets since 2014, however, is still a multiple of the official inflation statistics coming from Washington. Despite policies from the Federal Housing Administration and Federal Open Market Committee meant to boost house finance, regulation and extremely tight secondary market terms are hurting profitability and employment in the mortgage industry. Most of the credit flowing from Washington is going to consumers buying larger homes rather than first time home buyers. Meanwhile, prices for mortgage servicing rights (MSRs) are still trading at a discount to the underlying collateral, as the FT’s John Dizard reports . Mortgage industry maven Rob Chrisman wrote recently of colleagues working “in a business where many are experiencing contracting volumes and contracting margins. Bank of the Ozarks of Little Rock will stop originating home loans for resale on the secondary market, a line of business that had ‘operated at essentially break-even’… Every company is taking a hard look at the continued high cost of originating loans, regardless of channel, and evaluating profitability. Watch for plenty of changes in 2018.” With Mel Watt, head of the Federal Housing Finance Administration, leaving office in less than a year, speculation about the chances for reform of the housing enterprises, particularly Fannie Mae and Freddie Mac, has grown. So much so, in fact, that somebody decided to leak a letter from Watt to members of the Senate Banking Committee regarding his views of GSE reform. “Watt said that once they are returned to the private sector, Fannie and Freddie would be the first two ‘secondary market entities’ able to issue government-guaranteed mortgaged backed securities as a common security that has a mandated rate of return set by a regulator,” American Banker reports . If, as Watt suggests, the idea is to have two “private” utilities with a government backstop for catastrophic risks, then that is what we have today. The two enterprises have government ownership with private capital standing in front in the form of risk sharing transactions. The key flaw in both Watt’s plan and the Senate proposal for GSE reform is the role assigned for private equity capital in the “privatized” Fannie Mae and Freddie Mac. If Congress wants to privatize the GSEs, then they should go right ahead. But please note that private mortgage companies are trading well below book value at present. You see, there is no utility in providing two more independent mortgage banks to an industry with profitability issues. If true privatization is the object of GSE reform, then the last thing the mortgage sector needs right now is Fannie Mae and Freddie Mac in drag, pretending to be private finance companies. All ties between the federal government and the GSEs must be severed to make “privatization” a reality. Instead of continuing the strange pretense of the “private” GSEs, better to simply liquidate the two enterprises and focus the distribution of all government housing subsidies on the FHA and Ginnie Mae, as suggested in several alternative plans floating around the House of Representatives. The US government through FHA would offer insurance on eligible loans held by any issuer without providing a backstop for the corporation. The private bank or non-bank would then sell the mortgage backed securities to investors, with either GNMA cover, private insurance or no insurance at all. As today, higher quality mortgages such as prime jumbos would not require any government insurance cover whatsoever, but the real opportunity is to privatize the 60% of the market now served by the GSEs. If you think of the mortgage market today, 25% of all mortgage loans are held by banks in portfolio with no cover, about 50% (mostly prime loans) are guaranteed by Fannie Mae and Freddie Mac, and the rest of the market (including below prime loans) are covered by the FHA and GNMA. Private investors could easily accept uninsured prime mortgage securities now covered by the GSEs and do so at a lower cost to consumers. Some three quarters of all loans today have FICO scores above 720, quality loans that private investors would readily accept. The pricing for Fannie Mae’s risk transfer deals calculated by Well Fargo suggests that virtually all of the default risk from GSE mortgage exposures could be underwritten by the private sector and at a cost that is a fraction of the guarantee fees charged today by the GSEs. Meanwhile, across town, acting Consumer Finance Protection Bureau director Mick Mulvaney also leaked a memo outlining how the agency will operate in future. The head of the Office of Management and Budget made clear that the bad old days of the CFPB extracting settlements from mortgage companies and banks is over. He wrote: "We are government employees. We don’t just work for the government, we work for the people. And that means everyone: those who use credit cards, and those who provide those cards; those who take loans, and those who make them; those who buy cars, and those who sell them. All of those people are part of what makes this country great. And all of them deserve to be treated fairly by their government. There is a reason that Lady Justice wears a blindfold and carries a balance, along with her sword." More significantly, Mulvaney confirmed that the CFPB will no longer regulate through enforcement actions and that fines and penalties will only by imposed when there is actual harm to consumers . This changes the inquisitorial approach of former director Richard Cordray, who extracted billions in wrongful settlements from private banks and mortgage companies during his reign of terror. Cordray is now seeking the OH governorship with a war chest filled to overflowing with contributions from the trial bar. Mulvaney stated in his memo: “So, what does all of this mean, in terms of how we will operate at the Bureau? Simply put, we will be reviewing everything that we do, from investigations to lawsuits and everything in between. When it comes to enforcement, we will be focusing on quantifiable and unavoidable harm to the consumer. If we find that it exists, you can count on us to vigorously pursue the appropriate remedies. If it doesn’t, we won’t go looking for excuses to bring lawsuits…. On regulation, it seems that the people we regulate should have the right to know what the rules are before being charged with breaking them. This means more formal rulemaking on which financial institutions can rely, and less regulation by enforcement.” Under the tyranny of Richard Cordray at the CFPB, the cost of servicing a performing mortgage rose three fold in the US, one reason why many smaller independent mortgage banks have shut their doors. Larger firms are under pressure as well, which is why half of the top ten independent mortgage banks are in bankruptcy or for sale. It is fair to say that there will be a significant number of business closures and acquisitions in the mortgage sector during 2018. Even with the welcome regulatory changes in Washington, it will take years for the mortgage finance industry to recover to something like a reasonable cost structure. In the meantime, millions of Americans could lose their businesses and their jobs in 2018 – not primarily due to rising interest rates, but because of the abuse of power in Washington by ambitious progressives seeking higher office. While the changes at the CFPB are welcome in the mortgage finance sector, the fact remains that 2018 is going to be a very tough year. The entire mortgage banking and REIT sector has been selling off since the end of December, reflecting investor concerns about rising interest rates and a flat yield curve. Regulatory changes in Washington are welcome and long overdue, but for the mortgage finance industry, it is still the depths of winter. #RichardCordray #CFPB #FHFA #FHA #mortgage #MSR

New York | With the global punditry assembled in Davos this week, the topic of the dollar seems to have bubbled to the surface again. Down more that 10% from the December 2016 peak, the greenback has started to sag at just the time when Treasury deficits are climbing and the Fed is paring back its purchases of US government debt and agency mortgage bonds, as shown in Chart 1 below. With the 10-year Treasury back over 2.6% yield, gravity seems to have been restored to the global economy. The last peak of the trade weighted dollar was in mid-2002, after which the US currency slid steadily into the 2008 financial crisis. Did investors and government officials outside the US perceive the approaching contagion? You bet -- but especially in China, where the political leadership understands the process of “dollar recycling.” Simply stated, if China stops buying US Treasury debt or other dollar assets, the surging yuan strengthens even more. And even as President Trump starts a trade war with China, the yuan is already soaring against the dollar. Duh? Starting in 2008, the dollar climbed steadily even as interest rates and credit spreads remained suppressed. But from 2009 through 2011, the dollar actually gave back ground even as the Federal Reserve ramped up purchases of Treasury debt and mortgage securities via QE. By 2012, the flood of foreign capital pouring into US real estate and financial assets finally began to lift the dollar, which by 2014 began a sustained rise in value that finally peaked at the end of 2016, just after the election of Donald Trump. The peak in the dollar in December 2016 came after years when strong capital inflows helped to reflate the US equity and real estate markets, the latter both for commercial and residential properties. But as prices for US stocks and real estate reached absurd levels, foreign purchases began to decline. In particular, changes in US tax rules for foreign investors in real estate as well as political changes in nations such as China have caused the dollar to slump over the past year, as shown in Chart 2 below. Notice that the yuan/dollar exchange rate and the dollar/euro rate have both seen the value of the dollar deteriorate over the past year under the leadership of Donald Trump. Of course, some observers would blame the slump in the value of the dollar on President Trump, especially now that Treasury Secretary Steven Mnuchin is publicly lauding the benefits of a weaker dollar. In Davos, for example, Mnuchin said: “Obviously, a weaker dollar is good for us as it relates to trade and opportunities.” Secretary Mnuchin is said to think President Trump is an "idiot," but compared to what? In reality the factor which seems to govern the movement of the dollar is not the pronouncements of Mr. Mnuchin but rather mounting federal budget deficits. The US deficit fell to “only” $438 billion in 2015 and has been growing substantially ever since. With the just passed tax legislation thrown into the mix, US deficits are expected to surge to more than 5% of GDP annually. Chart 3 shows the US fiscal deficit vs the trade weighted dollar. It’s interesting to note that while President Trump and Secretary Mnuchin may think that they are driving the proverbial bus when it comes to the value of the dollar, in fact the deteriorating fiscal situation for the US seems to be the key determinant. Indeed, the passage of the tax legislation at the end of 2017 makes us somewhat more cautious about our bullish view of the 10-year Treasury, which now seems headed lower in price and higher in yield under the weight of expectations regarding Treasury debt issuance. But while we may be less bullish on the 10-year Treasury bond, the curve flattening trade is still a very real scenario because of the Treasury’s huge debt issuance calendar. The fact that the Federal Open Market Committee is slowly allowing its portfolio to run off is an important factor in the analysis. We continue to think that the Fed is being overly optimistic as to how quickly the late-vintage MBS in the System portfolio will prepay. Let’s review the questionable actions of the FOMC under Chairs Ben Bernanke and Janet Yellen from 2008 to 2014: QE1 (December 2008-March 2010) : The FOMC started with $600 billion in “sterilized” purchases of MBS (funded with sales of Treasury debt), then increased to a further $750 billion in outright purchases of MBS funded with excess bank reserves. QE2 (December 2010-June 2011) : Fed purchased another $600 billion in longer dated Treasury paper funded with bank reserves, extended duration of System portfolio. Operation Twist (2011) : The FOMC sold short term Treasury paper and bought longer dated Treasury maturities, significantly extending the duration of the System portfolio. QE3 (September 2012-December 2013) : FOMC committed to buy $40 billion per month in MBS and purchased an additional $45 billion in Treasury debt funded with excess bank reserves. Since then, increased interest rates and falling prepayments have extended duration of System portfolio. The FOMC under Chairs Bernanke and Yellen did everything possible wrong in managing the System portfolio. Now the Fed is illiquid, trapped in a long duration position in a rising rate environment because they violated the cardinal rule of central bankers: stay short duration. As we've noted previously, the FOMC dares not sell any of the System portfolio out of fear of generating losses. So the Mnuchin Treasury is planning to fund its spending deficits with short-term debt issuance, but the runoff from the Fed’s MBS portfolio may, in fact, be so slow that the central bank will not be able to purchase much of the Treasury’s new debt. As the FOMC tries to rebalance the System portfolio back to 100% US government debt, it may take years longer than currently estimated by the Fed staff for the System MBS positions to actually runoff. This means that the full weight of Treasury issuance of short-term debt will hit the markets with no support from the Fed and at a time when the dollar is falling. So the good news is that the FOMC has ended its long, strange period of social engineering known as QE. The bad news is that the Republicans in Washington have just cut taxes and the resulting red ink could see the US dollar test post-WWII lows. Because of fears regarding future deficits, the 10-year Treasury bond may not rally appreciably. Yet there remains a dearth of long-dated Treasury paper available in the markets, in part due to purchases by the FOMC. The surprise for newly installed Fed Chairman Jerome Powell is that the short-end of the yield curve could surge above the Fed’s target for short-term interest rates once Treasury begins to seriously increase issuance to an expected deficit of 5% of GDP annually. By 2022, the annual US deficit could be a trillion dollars. And even with significantly higher short-term interest rates, the dollar may continue to fall under the weight of rising fiscal deficits and the falling credibility of the US government. Doug Bandow stated the situation nicely in The American Conservative last week: “The United States is effectively bankrupt, but that doesn’t matter to the GOP. Once evangelists of fiscal responsibility and scourges of deficit spending, Republicans today glory in spilling red ink. The national debt is now $20.6 trillion, greater than the annual GDP of about $19.5 trillion. Alas, with Republicans at the helm, deficits are set to continue racing upwards, apparently without end.” So two questions: First, will the surge in US fiscal deficits cause short-term interest rates to rise and the dollar to fall faster than currently expected? Second, what happens to the overheated prices for stocks and US real estate in such a scenario? Further reading: No good reason for banks to offer more government-backed mortgages American Banker January 23, 2018 https://www.americanbanker.com/opinion/no-good-reason-for-banks-to-offer-more-government-backed-mortgages #dollar #deficit #mnuchin #trump #FOMC #Yellen #Bernanke

“To exactly solve the problem of corruption, we must hit both flies and tigers” Xi Jinping New York | In December this past year, Chinese lender Citic Bancorp warned that the high-flying HNA Group was having trouble paying its considerable short-term debts. After building a $40 billion pile of investments around the world largely funded with debt, HNA seems to have reached the end of its ability to grow further, both in financial and political terms. Thus western investors and banks began 2018 wondering whether the Chinese government will come to the rescue. HNA symbolizes China’s schizophrenic approach to economic growth, an on again, off again roller coaster which reflects the changing political priorities of the country’s communist leaders. Whereas in 2016 China’s leaders allowed and even encouraged Chinese investments offshore, both by companies and individuals, since last summer the situation has changed. Paramount leader Xi Jinping is reasserting the government’s control over the economy. And perhaps the highest priority for China’s rulers is reining in the overheated financial sector symbolized by firms like HNA. Think of HNA Group as a Chinese version of Softbank, but with considerably less transparency and more debt leverage. The firm exploded onto the global financial scene several years ago, acquiring New Zealand’s largest financial services firm, and stakes in companies such as Hilton and Deutsche Bank. It ostentatiously hung its name on office buildings in major world financial centers. HNA created its own aircraft leasing company, Avolon, to compete with global banks in this lucrative financial market. Incredibly, it even acquired SkyBridge Capital from hedge fund manager Anthony Scaramucci before he briefly joined the Trump Administration last summer. The public face of HNA is Adam Tan, who is identified as chief executive officer and co-founder. The company’s ownership and corporate structure remains shrouded in mystery, however, causing investors increasing disquiet. To fuel its growth, HNA aggressively leveraged existing assets to fund the purchase of new ones, the Financial Times reported last summer, a process known in Chinese as “a snake swallowing an elephant”. Rating agency S&P has cut the company’s debt rating deep into junk territory, causing some analysts to predict that the firm will eventually default. There has been talk of asset sales to deleverage and pay down debt. But the key question is whether the founders of HNA, which started off as a regional airline, have lost the political support of China’s leaders. “There has been a lot of commentary focusing on the notion that China is deleveraging,” notes Leland Miller, CEO of China Beige Book . “China is not deleveraging right now, at least in terms of where it really counts, the corporate sector. What is happening is a crackdown on certain shadow products across the financial sector. The government is clamping down on instruments it thinks are running amok, such as wealth management products, trust products, negotiable certificates of deposits, and others.” Miller notes that he expects there to be some high profile defaults in China during the coming months. It is critical that Beijing sends the message that people can and will lose money when they invest blindly into the shadow banking system, he notes: “They have to eviscerate the idea that the Great Chinese Government Backstop continues to remain in place.” Many foreign investors and corporate managers find it convenient to believe that firms like HNA are private companies that are similar to their western counterparts, but in fact all businesses in China are ultimately subordinate to the Chinese Communist Party (CCP) and Xi Jinping. Last summer, Chinese regulators began restricting liquidity to acquisitive Chinese firms, Reuters reports, ordering a group of lenders to assess exposure to some of the more aggressive dealmakers, including HNA, the property-to-film conglomerate Dalian Wanda and Anbang Insurance Group. Foreigners also like to believe that the party will support companies such as HNA when they get into financial trouble, but in fact the decision of whether to bail out an insolvent bank or company is ultimately political. HNA’s roots are also political, as a June 2017 feature article in the Financial Times makes clear, but this could ultimately lead to the firm’s undoing. When Xi Jinping ascended to become the unquestioned leader of the CCP and co-equal with Mao last year, his coronation marked the conclusion of a “anti-corruption” campaign to systematically destroy any potential rivals in the party apparat . Insecurity drives Xi’s relentless focus on abolishing alternative sources of economic and political power. His father Xi Zhongxun was persecuted during the Cultural Revolution, and Xi was for many years shunned because he was deemed “not suitable” to be a member of the party. Now firmly in charge of both the CCP and the Chinese military and police, however, Xi now appears intent upon remaking China’s economy in his own image and deemphasizing foreign influence via increased party control over “private” companies. When Xi proposed his ‘Thought on Socialism with Chinese Characteristics for a New Era’ – the opening phrase of his report to the CCP congress last year, he was starting a process of economic and political reform that is ultimately designed to focus power into his hands indefinitely. And this new stage of the “reform” process will be focused on domestic firms such as HNA as well as foreign companies with roots in China. “The [anti-corruption] campaign was aimed at the public sector; it cleaned out a rotten bureaucracy and helped Xi to wrest power from China’s provincial barons and powerful figures in the military,” writes Qi Gua in The London Review of Books . “It looks as though the next five years will see it extend to the private sector, and the first task will be to bring the tech giants to heel.” He continues: “The government is now proposing to increase its stake in our big tech monsters, Alibaba, Tencent and Baidu. According to Bloomberg, it already has holdings in Tencent (0.8 per cent) and Alibaba (1.3), but wants to acquire another 1 per cent in each: an approach they’ll find hard to refuse, even though the objective is to penetrate the two companies and oversee every key decision they make. Mao called this steady infiltration ‘mixing the sand into the hardened soil’.” As Xi prepared to take control of the CCP, China began to tighten capital outflows in the second half of last year. This change in the official tolerance for foreign investments has slowed the hectic pace of deal-making by domestic companies looking to scoop up overseas assets. The imponderable question for foreign investors, banks and companies with exposure to HNA is whether China’s leadership views the Hainan-based conglomerate as an ally or a threat. The same analysis must be done with respect to other Chinese companies with significant foreign participation. So long as China’s banks are willing to work with HNA to restructure its debt and sell off assets, then the company is likely to survive. But any such analysis must recognize that more than ever under Xi Jinping, it is the CCP representative that ultimately validates the decision by the bank’s management. If Xi Jinping finds the continued existence of HNA to support his political objectives, particularly the renewed focus on investment in China, then it is likely that China’s state-controlled banks will continue to be constructive when it comes to unwinding HNA’s massive pile of debt. If not, then HNA may be pushed into a forced restructuring that will mark a further confirmation that China’s leadership has changed the way in which views foreign investments by corporate “tigers.” This article was previously published in The National Interest and is reproduced with permission. Further reading: Cutting Through the Fed’s Orwellian Doublethink: Will the new chairman continue to say one thing and do another? The American Conservative January 12, 2018 #HNA #XiJinping #China #Creditrisk #CCP

Tyler Durden, "Fight Club" (1999) Punta del Este | Last week our comrade at Zero Hedge astutely noted that, in the October 2012 FOMC minutes , Fed governor and soon to be Chairman Jerome Powell opined that the Fed has a “short” position in volatility. Powell said: “[W]hen it is time for us to sell, or even to stop buying, the response could be quite strong; there is every reason to expect a strong response. So there are a couple of ways to look at it. It is about $1.2 trillion in sales; you take 60 months, you get about $20 billion a month. That is a very doable thing, it sounds like, in a market where the norm by the middle of next year is $80 billion a month. Another way to look at it, though, is that it’s not so much the sale, the duration; it’s also unloading our short volatility position.” Of course, none of the economistas who supposedly follow the Fed for a living actually noticed Governor Powell's honest comments about how unwinding a short position in volatility might impact the markets. As we noted at the end of last year (“ Banks and the Fed’s Duration Trap ”), the Fed’s open market purchases of securities or “QE” has taken trillions of dollars in bonds out of the market, effectively reducing the amount of securities or duration available to private investors. The Fed’s $4 trillion or so in Treasury securities and mortgage backed securities (MBS) is not hedged, thus the Fed is long duration and has capped volatility in the markets as a result. Securities trading volumes by banks are also lower as a consequence of QE, hurting bank earnings. Most large banks have guided down trading revenue for Q4 ’17. But when Powell said that the Fed would “sell” $20 billion per month, he actually misspoke. The Fed is not going to actually sell any securities. And is his comment about the Fed having a “short volatility” position correct? We think not. Mark Dow on Twitter noted: "Being long MBS you are implicitly short treasury volatility. This is what Powell meant. The tinfoil hat charlatans left it ambiguous so that their readers would infer all kinds of nefarious direct manipulation of the VIX." Volatility is commonly viewed as a statistical measure of the dispersion of returns for a given security or market index. Volatility can either be measured by using the standard deviation or variance between returns from that same security or a market index such as the S&P 500. But like measuring "liquidity," trying to quantify forward price movements of a security based upon past data is a fool's errand. Students of Dow theory know that the past tells you nothing about the future. Yet since the Fed has suppressed interest rates and credit spreads through purchases of Treasury debt and MBS, is the central bank really “short” volatility? No. The Fed is certainly long duration, which is why the Federal Open Market Committee will not actually be selling any securities from the portfolio. Instead, as we discussed with Bob Eisenbeis of Cumberland Advisors in December , the FOMC intends to merely end its reinvestment of cash when securities are redeemed. That’s it, no outright bond sales. So is the Fed short volatility? No, but that is the joke on all of us. Thanks to the Fed’s manipulation of the credit markets, we are all short-volatility. The mostly commonly discussed measure of volatility is the VIX contract traded on the Chicago Board Options Exchange (CBOE). Unlike measures of actual market volatility, the VIX is a popularity contest; the measure of expected future volatility which is generally calculated as 100 times the square root of the expected 30-day variance or value at risk (VaR) of the S&P 500’s rate of return. By holding down bond yields and, indirectly, compressing credit spreads, the FOMC has reduced actual volatility and, more important, also gradually reduced the market’s expectations for future movements in the prices of securities. Chart 1 below shows the VIX over the past five years along with the spread between the 10-year Treasury bond less the 2-year Treasury note. Observe that as the Fed prepares to end bond purchases, the VIX has reached all-time lows. Expectations, after all, are a lagging indicator. Former Fed Chairman Ben Bernanke has argued that the FOMC should not begin to shrink its balance sheet until short-term interest rates are well away from their effective “lower bound,” one the magical terms employed by economists to convey the impression to the public that they know what they are doing when it comes to financial markets. Yet as we and a growing number of investors seems to appreciate, the Fed cannot force up long term rates so long as it is sitting on $4 trillion worth of securities that it does not hedge. More, given that the Treasury intends to concentrate future debt issuance on short-term maturities, downward pressure on long-term bond yields is likely to intensify, as Eisenbeis observes in his most recent comment on the FOMC minutes . What the FOMC has done to the markets via QE is essentially reduce potential volatility by holding securities and not hedging these exposures. The European Central Bank and Bank of Japan (and all global; central banks) do the same by purchasing securities and not hedging against price movements. In normal times (whatever that is), central bank purchases were so small relative to the markets that actual volatility served as a good indicator of future risk. But today, in the induced coma known as QE, measures of volatility are suppressed along with bond yields. Thus ZH asks the obvious question: How does Powell feel about volatility today? Dan writes: “Maybe someone can ask Powell at the next FOMC press conference just where that stands today, and whether he is still as skeptical the Fed will succeed in unwinding its balance sheet, as he was in October 2012.” ZH also quotes Powell on the risks of ending QE: “My third concern—and others have touched on it as well—is the problems of exiting from a near $4 trillion balance sheet. We’ve got a set of principles from June 2011 and have done some work since then, but it just seems to me that we seem to be way too confident that exit can be managed smoothly. Markets can be much more dynamic than we appear to think.” Yes, markets can be dynamic when they are allowed to operate. The whole point of QE has been to prevent the normal operation of the financial markets. As we all know, the social engineers on the staff of the Federal Reserve Board in Washington have a huge God complex . The Fed’s gnomes think they can manipulate markets with no downside risks. But they also fear taking losses on the Fed’s portfolio for fear that it will awaken critics of the central bank in Congress. So while the Fed is certainly long duration, we dear friends are short volatility thanks to QE. Or as Grant’s Interest Rate Observer said so well: “The Fed is selling, you are buying.” As the Fed ends its reinvestment of cash when bonds redeem, volatility will return to the markets, spreads will widen and trading by private investors will rebound. A lot of market participants will get their eyeballs ripped out when the weight of option-adjusted duration shifts back to private investors. Can't wait. "What everyone is missing is that as the US Treasury and MBS holdings roll off, the duration of their overall holdings is hardly affected," notes industry veteran Alan Boyce, referring to the possible extension of the MBS. "It is the higher coupon MBS plus the 15 year paper that are going to prepay. The new Fannie Mae 3s are not going anywhere. On the US Treasury side, ZERO of the long bonds are going away, they will just slowly March down the yield curve over the next 30 years. Amazing but true, the FOMC's taper could result in longer aggregate effective duration of System holdings even though the footings shrink." The return of market function, however, will spell bad news for the Fed’s MBS portfolio, which will decline in price faster than the market thanks to the convexity of mortgage securities. But as Boyce notes, the portfolio will also extend in duration as prepayments slow. This is just one reason why we don’t expect Chairman Powell to have a lot to say about volatility in future utterances. Fed Chair Janet Yellen and the majority of the FOMC have created a trap for themselves and Powell get’s to clean up the mess. The FOMC cannot sell securities without creating losses for the System Open Market account, thus triggering criticism from the Republican majority in Congress. But they cannot hike short-term interest rates three more times in 2018 as currently planned without inverting the Treasury yield curve and provoking fears of a recession. In order to manage the normalization of interest rates, the Fed ought to be selling the bonds and MBS, TBAs and dollar swaps to force long-term yields higher and thereby maintain a relatively normal curve. Hell, the Fed could even buy some mortgage servicing rights or MSRs as a hedge against its MBS. But that would require imagination and courage. A flat curve will be bad for financials, which are already facing an earnings bloodbath in Q4 ’17 thanks to reduction in corporate tax rates (and a commensurate mark-down in the value of tax loss carry forwards). Lower trading volumes will likely also be a negative for bank earnings this quarter. And lending volumes in just about every bank asset class are also soft, begging the question as to when big bank equity valuations will reset. More important for Chairman Powell, a flat yield curve will demonstrate to the markets and Congress that the majority on the FOMC has not the slightest idea how their policy moves impact the real world of money and credit. Powell certainly seems to get the joke. His first challenge as Fed Chairman may be navigating the dangerous political mess created by Chairman Bernanke and Chair Yellen, who actually seem to think that the US bond market can endure several years of an inverted yield curve as we wait for the Fed’s portfolio to run off before the central bank completes the normalization of policy. #zerohedge #VIX #JeromePowell #Bernanke #Yellen #TylerDurden