Fin/Inv

Echoing some of the same sentiments that we’ve been preaching about on this site since our inception, the Wall Street Cheat Sheet has come up with this very interesting graphic to illustrate the debt problem facing Americans.

As Damian Hoffman so aptly put it; (LINK TO WALL STREET CHEAT SHEET)

This, my friends, is only the tip of the iceberg of what will unfold should we choose to kick the proverbial can farther down the road. As you can see in the infographic below, according to the US Treasury we are watching a debt Tsunami come ashore. If we have any pride or patriotism, we’ve got to start dealing with the crisis now before it wipes out generations of wealth:

The only part i disagree with is the last sentence.  In my view, generations of wealth have already been wiped out.  Its too late to deal with the debt crisis in an effective manner.  All that can be attempted now is to cushion the blow.  The United States has  left the printing presses on for far too long and indications are, it will keep trying to spend its way out of this mess and thus, continue kicking that can down the road like we mentioned the other night when I wrote about the Federal Reserve not knowing what else to do.

 

by Bruce Webb

Back in 2000 Alan Greenspan warned Congress about the potential disappearance of the long bond in the face of continuing surpluses. He probably knew at the time that he was just feeding the appetites of tax-cutters, and not say advocating for using those surpluses for something like Universal Single Payer, but he wasn't crazy, because to some extent the world is dependent on the existence of SOME amount of U.S. Treasuries just to keep the gears of the world economy going. For the time being the U.S. dollar is the biggest component of most other countries foreign exchange reserves and is also used to buy and sell many commodities, particularly crude oil.

So the question is How Low Can We Go? Where is the sweet spot in terms of the ratio of U.S. Debt Held by the Public and world GDP?

Now we know the answer in relation to Social Security, at least the statutory answer. The Trustees are mandated to target a Trust Fund ratio of 100 or one year of future cost at any given time. And since the annual cost of Social Security goes up every year due to changes in population and inflation the result is that even a perfectly balanced system will contribute that much more to total Public Debt (Intragovernmental Holdings combined with Debt Held by the Public) each year. For example you can say all we 'really' owe to Social Security is the amount of principal above a TF ratio of 100 plus the costs of servicing the remaining reserve, or $1.8 tn out of $2.5 trillion plus interest on the total.

And it would seem that the same applies to the world economy. How much of that $8.5 trillion are we actually on the hook for? Certainly we owe interest on the whole amount, but realistically how much on net will EVER get redeemed even under ideal economic conditions?

This is not a rhetorical question to which I will spring some nifty answer under the fold, this post doesn't have a 'read more'. Anyone care to kick this one around?

We're used to that line by now. Ross Perot—one of the more prominent people who got rich due to government contracts—used it, Carly Fiorina and Meg Whitman are using it (while desperately hoping you don't pay attention to how they ran Lucent/HP or eBay), and Aaron Sorkin even had Charles Grodin say it in Dave, if only to establish his Sensible Centrist cred.

So how are businesses running their debt-laden firms? Ask the WSJ and ye shall receive:

U.S. corporations have taken full advantage of low interest rates, going on a bond-issuing binge that has left them with tons of cash, which they appear to be holding largely as insurance against a new bout of financial turmoil, rather than spending on new hires. Nonfinancial companies were sitting on about $8.4 trillion in cash as of the end of March, or about 7% of all company assets, the highest level since 1963. Even before its [$1.5 billion at the bargain-basement interest rate of only 1%] bond issue, IBM had $12.3 billion in cash and short-term investments, which accounted for about 12% of all its assets.

The WSJ is, of course, worried about The Savers:

Meanwhile, though, savers are seeing some of the worst nominal returns in decades. As of June, the weighted average interest rate on deposits, money-market funds and other highly liquid investments stood at only 0.29%. Returns on riskier investments aren’t great, either: The average yield on near-junk bonds with maturities close to 30 years stood at about 5.9% this week.

As Brad DeLong said recently, in a slightly different context, "I share [the] belief that these numbers ought to be higher. But I also think that I don't have very good reasons to claim that I am right that they should be higher."

Neither does the market.

And it's not as if those companies were all saving during the Good Times. Indeed, they were arguably more poorly managed than the government. As Floyd Norris noted almost two years ago:

Over the last four years, since the buyback boom began, from the fourth quarter of 2004 through the third quarter of 2008, companies in the S&P500 showed:

Reported earnings: $2.42 trillion
Stock buybacks: $1.73 trillion
Dividends: $0.91 trillion

The net flows there is -$220B, give or take a billion. It's spending roughly $1.10 for every dollar you earn. And, to make matters worse, nearly twice as much was spent to make people go away (buybacks) than to reward loyalty (dividends).

If the government really were to be run like a successful business—the way the S&P500 are run, the way IBM is run—they would be borrowing long-term right now at that 2.82% 10-year or even than 4.00% 30-year rate.

If it's good enough for IBM, it should be good enough for the U.S. Government. The Mitt Romneys and Ross Perots have been telling us that for years; many we should listen?

In case you haven’t noticed, I have become slightly less “optimistic” about the prospects of a sustainable U.S. recovery. I used to think that the household deleveraging story was more of a decade-long project, and the economy would cycle throughout. But recent deficit hysteria has me worried; income growth might lapse.

What differentiates this recovery from every other cycle since 1929 is the lingering debt deflationary pressures. There is a very large overhang of U.S. household financial leverage that’s going down one of two ways: the easy way, through nominal income growth, or the hard way, by default. Unfortunately, the hard way is rearing its ugly head.

The chart above illustrates private-sector financial leverage (debt burden). Not a surprise; but, the real leverage problem is in the household sector, and to a much lesser degree, the non-financial business sector. Household debt burden is the ratio of the debt stock (generally mortgages outstanding plus consumer credit) to income flow (personal disposable income), while “de-leveraging” is reducing this debt burden.

Given that the burden has a numerator (debt stock) and a denominator (income), de-leveraging can occur through either variable. As such, I see three (general) de-leveraging scenarios (See an earlier McKinsey study on the consumer for a broader discussion):

1. If there is no income growth, then households must manually pay down debt at the cost of current consumption. The consumption decline drags the economy, and some default results.

2. If income growth is positive, then the degree to which households must pay down debt at the cost of current consumption will depend on the pace of income generation. This is the most macroeconomically-benign scenario.

3. If income growth is negative, i.e., deflation, then real debt burden rises. 30-yr mortgage payments, for example, are fixed in nominal terms and become more difficult to meet as income declines. In this case, widespread default is likely.

Of course, these are just three broad categories, but I believe that my point has been made. Clearly, choice 2. is optimal. However, evidence is pointing to a de-leveraging process that is more of the 1. and/or 3. type, especially as the federal stimulus effects run dry (although I have noted before that there is room for error in the measurement of the income data).

The chart illustrates annual growth of disposable personal income minus annual growth of disposable personal income less government transfer receipts (DPI – DPIexT). The variable DPIexT proxies the personal income growth currently generated by the private sector only. Note: this is a calculated number, based on the BEA’s monthly personal income report (Excel data here). The spread has never been wider, 2.1% Y/Y DPI growth over DPIexT growth in February, spanning every recession since 1980.

The government is propping up income (as it should be). Spanning February 2009 to February 2010, DPI averaged 1.2% Y/Y growth per month, while DPIexT averaged -1.1% Y/Y per month. Further, since the onset of the recession DPIexT fell an average 0.03% M/M (over the previous month), while DPI grew 0.18% M/M.

The economy has crossed the threshold and is expanding – phew! However, without a burst of export income, it’s going to take a lot more than 123,000 private payroll jobs per month to free the economy of its fiscal crutch. (I debated whether or not to use the term “crutch” when applying it to fiscal policy because fiscal policy is not a crutch; but the metaphor works.)

Households WILL drop leverage further; it’s just a matter of how smoothly.

Rebecca Wilder

"In the developed world we have huge debt to GDP, in terms of government debt to GDP and unfunded liabilities that will come due, and these unfunded liabilities are so huge that eventually these governments will all have to print money before they default."

Marc Faber is an international investor known for his uncanny predictions of the stock market and futures markets around the world. Dr. Doom also trades currencies and commodity futures like Gold and Oil.

"We went into this crisis with an unprecedented debt level and if you compare for instance with the Depression years...in the Depression years we did not have credit cards, and we did not have unfunded liabilities for Social Security, Medicare and Medicaid. These are all debts that will come due, that have to be payed by the Government. And eventually this will lead to sharply rising interest rates. In 10 years time I would estimate that between 30 and 50% of tax revenues will be spent on the interest payments of the government debt. And that will prove to be a huge trouble."

in CNBC

Marc Faber is an international investor known for his uncanny predictions of the stock market and futures markets around the world. Dr. Doom also trades currencies and commodity futures like Gold and Oil.

“Maximum within 10 years time more than 35% of tax revenues will have to be used to pay the interest on the government debt and then you are in trouble – because then there will be not enough money out of the budget to pay for other stuff. I’m convinced the US government will go bankrupt, but not tomorrow. And before they go bankrupt, they’ll print money, and then you get high inflation rates, you have a depression and eventually they’ll go to war.”

in rt.com

Marc Faber is an international investor known for his uncanny predictions of the stock market and futures markets around the world. Dr. Doom also trades currencies and commodity futures like Gold and Oil.

• Here comes Spain: Spanish banks start to unload property portfolios (WSJ) Some brilliant insight: "Accumulating properties also stopped a sharp drop in prices, avoiding the painful write-downs banks are required to book when the value of their assets falls." The FHA will not be reading this article
• How uou like your strong euro now Europe? After two years of crashing banking systems and economic recession, the euro zone enters 2010 with a full-blown debt crisis (WSJ)
• Treasuries set for worst year since 1978 as U.S. steps up sales (Bloomberg)
• First Brazil now Russia: Finance Minister Alexei Kudrin says Russian stocks "too expensive", nobody cares (Bloomberg). In the meantime Templeton's Mark Mobius, who after a 104% rise is still down relative to 2007 (56% decline in 2008) says "If you compare Russian valuations now with other major countries, it’s not overpriced. There are still opportunities there" One wonders who is pitching their book
• E-mails inside AIG reveal executives struggling with growing crisis (WaPo)
• Just in case you thought the "recovery" was for real, GMAC to demand $3-$4 billion more from the Obama endless bailout fund (Bloomberg)
• More debt supply on deck: $130 billion in Build America Bonds to be sold quickly as congress is set to change subsidy rules (Bloomberg)
• Geely bid for Volvo makes Goldman-backed boss disregard Toyota (Bloomberg)
• Paris plus Texas equals an American dream of striking oil in France (TimesOnline)
• Fidelity and Vanguard lead list of worst performing mutual funds of the decade (Bloomberg)
• Keeping the Yemen story on the front page: look for [WMDs/nukes/the great Kindle channel stuffer] to be found there soon to quite soon (Bloomberg, WaPo, NYT)

 

 

Two months ago Bloomberg's Jonathan Weil brought up the very relevant topic of fair value divergences on bank balance sheets courtesy of SFAS 107 and lax accounting firm standards (some more lax than others). Zero Hedge immediately followed up on this theme and presented a comparative analysis of various bank asset shortfalls, speculating that certain accounting firms are doing their best to do an Arthur Andersen redux for Generation Bailout. On October 15 we said: "Just what about the economic environment has given Citi auditors KPMG the flawed idea that the bank's loan can be easily offloaded with virtually no discount? And just how much managerial whispering has gone into this particular decision. If one assumes a comparable deterioration for the Citi loan book as for the other big 4 firms, and extrapolates the 2.8% getting worse by the average 1.5% decline, one would end up with a 4.2% Book-to-FV deterioration. On $602 billion of loan at Q2, this implies a major $25 billion haircut. Yet this much more realistic number is completely ignored courtesy of some very flexible interpretation of fair value accounting rules at KPMG. Maybe Citi and its accountants should take a hint from Regions Financial CEO Dowd Ritter who carries the FV of his $90.9 billion loan book value at a 25% discount." Today, finally, after a two month delay, these two articles seem to have finally made the inbox of the financial gurus at the Wall Street Journal, which, in an article named "Accounting for the bank's value gaps," says: "can investors count on consistency when it comes to bank accounting? As many banks struggle with piles of bad loans, it appears some auditors are being stricter than others when assessing their true value." Way to be on top of that ball WSJ/Mike Rapaport. Nonetheless, we are happy that this very critical topic, is finally starting to get the due and proper, if largely delayed and uncredited, attention it deserves.

Rapaport says:

Among the top-25 U.S.-owned commercial banks, those five Ernst and Deloitte clients accounted for five of the six biggest gaps between fair value and cost as of Sept. 30. The average gap among Ernst and Deloitte clients in the 25-bank group was about 6%; among clients of PriceWaterhouseCoopers and KPMG, it was about 2%.

Those differences can affect how investors view a bank's loan portfolio, and could have a concrete effect on regulatory capital in the future. The Financial Accounting Standards Board is considering changes in banks' accounting for loans and may require them to carry loans on the balance sheet at fair value instead of cost.

If that happened, the current fair-value declines could reduce shareholder equity and regulatory capital—in some cases, to levels regulators would find troublesome. At Regions, the $16.9 billion gap between its loans' fair value and carrying value would wipe out its $13 billion in Tier 1 capital using a fair-value balance-sheet standard. Huntington, Key and M&I would see Tier 1 capital slashed to low levels. SunTrust would see a major Tier 1 reduction also.

Rapaport even provides a fancy graphic, which is eerily reminiscent to the one posted on ZH 10 weeks ago.

WSJ:

ZH:

On the other hand you have Pimco (see prior post) claiming that investors can't go wrong by throwing their money at banks and their thoroughly mismarked balance sheets (and facing massive debt rollover risk: if rates really skyrocket as MS expects, we wish banks the best of luck as they face a maturity crunch. Has it occurred to anyone that banks are hording cash simply to be able to repay debt as it matures instead of refinancing? We will have quite a bit more to say on this topic very shortly). In the meantime, we lament the complete ignorance by the investing public of anything that is based on fundamentals (the government will bail them out after all), with only momentum and mass melt-up hysteria determining investing decisions.

True, the decade is not really over, but no one called 1930 the "last year of the 20's," and given the reflective mood that seems to grip all of Western society whenever a year ending in "9" draws to a close, well, we thought we'd better embrace the trend now so that when some idiot with a pair of glow-in-the-dark "2010" glasses with holes in the zeros for his eyes tries to convince us to watch Roy Scheider over and over again in a celebratory, all-day, marathon screening of "2010," well, we can say we gave at the blog.

Instead, and in conjunction with your many suggestions, we took the opportunity to go back over Zero Hedge's posts and see what moved you, with an eye towards getting a sense of what Zero Hedge wants to read.  The results were quite interesting.  We thought readers would find it engaging both as a sort of "year in review" post, and, perhaps, in finding old material missed the first time around (or before the discovery of Zero Hedge).

Though this is by no means a comprehensive list, and we have omitted a number of "big hit count" posts that may have repeated the subject matter of those listed here, or otherwise be dull (what weighty relevance could our T-Shirt post have?) the list below represents a good sampling of some of the most popular articles, reproduced here in (very rough) ascending order of popularity:

One thing we learned very quickly is that, as often as not, title is a strong determiner of post popularity on Zero Hedge. "Tiny Mauritius Tells US To Shove Its Dollar, Buys 2 Metric Tons Of Gold From IMF At $1,115 An Ounce" was one such.  The news that a small island was buying gold en masse hit all the hot buttons:  Gold.  Banana republics. The dollar as a reserve currency.  (The swimsuit picture might have helped too).

Obviously, the FDIC has been a frequent target of our curiosity.  Along with increasingly obvious signs of an impending nervous breakdown in Sheila Bair's on-camera appearance, the recent dip of the Insurance Fund into red ink prompted "FDIC Discloses Deposit Insurance Fund Is Now Negative," which, while unsurprising to those of us who have been watching for some time, was a good reminder that when you base insurance rates on something other than real actuarial data (like say, the impact those rates might have on a bank's bottom line) you get bankrupt insurance [companies|funds].  Of course, since the FDIC can "literally never run out of money," none of that really matters.  Right?

One thing leads to another, so it's not surprising that "Peter Costa: 'The US Government Will Be Totally Bankrupt In A Year And A Half'" ends up right next to Sheila in the popularity list.  Government spending is, of course, an important topic to Zero Hedge readers.  (Also, you seem to like videos from CNBC.  We aren't sure what to make of this).

We were amused to no end on discovering that a CNBC video re-post was just below "CNBC Viewership Plunges 50% In October" on the popularity list.  To be fair, Zero Hedge has relentlessly hounded the bag of schnitzel that is CNBC on the ratings issue.  This particular post prompted an angry call from a fairly senior executive in CNBC's public relations arm to our never-complaining but often beleaguered (and uncompensated) Executive Vice President of Answering the Hot-line wherein the CNBC exec berated our hero for not calling him directly for comment before printing and accusing Zero Hedge of being a shill for the Fox network.  When asked if the figures discussed in the post were inaccurate CNBC exec reportedly paused before intoning: "Well, that's not the point, is it? You are comparing against our biggest ratings ever at the beginning of the crash!"  Yes.  And?

Huge selloffs often result in the dusting off of some version of "The 'Money On The Sidelines' Fallacy."  As a bit of silver lining lore, it is looking pretty tarnished.  That didn't stop our examination of it from being one of the top posts of the Summer.

A constant and early debate at Zero Hedge was the viability of a philosophy that included a wealth of Deep-dive analysis as a mainstay of our editorial strategy.  Would an audience entertain repeated and highly technical postings day after day and keep coming back for more?  Or would we drive away the interest if we did not dumb down the content.  As "deep-dive" goes, and begging the audiences pardon for the shameless self reference, my occasional pairings with Geoffrey Batt tend to peg the Zero Hedge complexity meter into the red with a combination of legal and financial wonkism.  "Is The Fed Facing Margin Calls From European Banks?" was no exception.  A hybridized subject matter including AIG, the circumventing of banking regulation, margin calls and backstopping by the Federal reserve combined to propel what was otherwise a highly technical post to one of the top 25 in Zero Hedge history, despite it being less than a month old.  Apparently, you Zero Hedge readers don't need "dumbing down" to remain interested.

It would be entirely impossible to catalogue a list of popular (or influential) posts at Zero Hedge without including "Is A Case Of Quant Trading Sabotage About To Destroy Goldman Sachs?" in a prominent spot.  Again, a combination of some classic Zero Hedge hot buttons (Goldman Sachs possibly influencing a young and impressionable U.S. Attorney, High Frequency Trading and the term "market manipulation") conspired to stress our servers.

Gold is a consistently popular theme at Zero Hedge so, in last month's runup, it wasn't hard to make some predictions a la "Is Gold Set To Hit $1,200 Within 24 Hours?"  Alas, we missed our call by 10 days.

Direct intervention in the equity markets by the Federal Reserve is a big "no-no."  But who cares when easy credit from the Fed can be used by primary dealers to go on a equity buying spree? We explored the answer to that question in "An Overview Of The Fed's Intervention In Equity Markets Via The Primary Dealer Credit Facility."  It was another highly technical (and yet highly popular) posting.  Kudos to you, oh, Zero Hedge reader of great complexity thirst.

We loves us some Janet Tavakoli.  So do you apparently, as the widespread interest in "Janet Tavakoli On Why Meltdown Risk Now Is Greater Than It Was In 2007" aptly demonstrated.  But then, who can fail to enjoy a firebrand like Tavakoli when she prompts the likes of Goldman Sachs to distraction?

One measure of Zero Hedge's success is the almost daunting stature of the many collaborators and guest posters our pages attract.  Articles with the likes of David Rosenberg as collaborators are, as one would suspect, intensely popular.  "The End Of The End Of The Recession" was no exception.

Need we insult you by explaining the popularity of "A Zero Hedge Petition: Break Debt Habit, Freeze The Debt Ceiling"?

It probably isn't a surprise that an article about phantom Treasury purchasers would be among Zero Hedge's top posts of all time.  That an article less than a week old would top many others with months of clicking under the belts already is, however, impressive.  Witness the massive click fest that was "Sprott Calls The Fed "A Ponzi Scheme" As Half A Trillion In Treasury Purchasers Are Unaccounted For".

The difference between real and nominal returns is oft ignored when the mainstream media engages in economic analysis based on equity prices.  Hence, our "DOW 10,000!!!! Oh Wait, Make That 7,537" got quite a lot of attention.  Never to be left out of the fun, the mainstream press has seemingly adopted the theme (10 weeks later).  We aren't holding our breath for attribution.

The Swiss Franc was redeemable in gold up until the year 2000.  Whatever else they are, the Swiss are stability obsessed.  Unsurprising, then, that "From Switzerland With No Love - Wegelin Bank Says Goodbye," a review of Wegelin's decision to abandon investment in the United States, drew so many Zero Hedge readers in.

As you might imagine, we hear a number of theories on why the Dollar is in a secular decline.  Still, our own analysis "Here Is Why The Dollar Is Now Effectively Worthless," used the apparently winning combination of QE and reserve analysis to wonder how anyone could ascribe a positive value to the fiat currency any longer.  Like it or not, you apparently enjoyed the discussion, as this post sailed effortlessly into our top ten of all time.

Closely behind was "Thousands Of Rusting Ship Hulls Are A Fitting Tribute To The Speculative Market Bubble," a bit of analysis that seems to have prompted a gaggle of writers worldwide to take a keen interest in satellite photos of idle shipping and GPS tracking sites for the world's mercantile fleet.  Of course, the obligatory flood of copy-cat analysis by more mainstream outlets followed hard upon.

My personal pick for best Zero Hedge post of all time "How The Federal Reserve Bailed Out The World" is also in the top five. I cannot imagine a forum in which this sort of analysis would ever find a public airing, or a place where readers could obtain a deeper understanding of the global interplay between central banks than is exemplified in this post.  Again, the fact that readers had a voracious appetite for the piece is a reminder than depth is not anathema to readership.

There is no way that, after a mere three days (and over the holidays no less),  "Brace For Impact: In 2010, Demand For US Fixed Income Has To Increase Elevenfold... Or Else" should be in the top four.  It is a deep, highly complex and analysis laden post.  True, there are colorful graphs, but even repeated readings by CNBC's color addled anchors could not explain the massive readership that hit this post on the afternoon of Christmas Day while the Christmas Ham (or non-denominational family dinner) was cooking in the other room.  Just, wow.

"Goldman Sachs Responds To Zero Hedge."  Yeah, so that was kind of popular.  Modest prevents us from further comment.

Arguments for the secrecy of the Federal Reserve, and pleadings for its continued independence, are always a big draw.  Still, we were surprised by the absolutely massive response to "Racketeering 101: Bailed Out Banks Threaten Systemic Collapse If Fed Discloses Information."  Massive enough, in fact, to make it the second most popular post on Zero Hedge.  Ever.

Number one "Shadowstats' John Williams: Prepare For The Hyperinflationary Great Depression" probably bears no further comment.

It has been a dauntingly popular year.  We look forward to the next one.  Join us? (Or die).

For some reason Zero Hedge is prone to take a great deal of heat (both directly radiated and reflected) whenever we opine on the (rather obvious to us) prospect that interest rates might actually (quelle surprise) rise in this environment.  Today, rather than engage in "we told you so" gloating, or endure the repetitive pleadings of commentators that this or that Treasury auction was really a success if you just look a little deeper at the figures, we'll just quote Bloomberg quoting other fixed income observers on today's auction of two years, in an article "ambiguously" titled "U.S. 2-Year Yields Highest Since October After $44 Billion Sale."

Treasury two-year note yields reached the highest levels since October as an investor class that includes foreign central banks bought the least of the debt in five months at today’s record-tying $44 billion auction.

 

Indirect bidders purchased 34.8 percent of the notes, the lowest amount since July, and below the average for the past 10 sales of 45 percent. Treasuries of all maturities have fallen 3.6 percent this year, according to Bank of America Merrill Lynch indexes. That would be the worst performance since at least 1978, when Merrill began collecting the data.

We aren't really sure how this will be spun into a "good thing,"™ but we are sure that someone will find a way.  Back to you, CNBC.

2010 will be a year of major transformations, punctuated by the following key escalating divergence: i) on one hand, the ongoing contraction of the US consumer will accelerate, because even as the stock market ramps ever higher (and on ever decreasing trade volume a 2,000 level on the S&P while completely incredulous, is attainable, but will benefit only a select few insiders who continue selling their stock at ridiculous valuations), household wealth will at best stagnate (as a reminder, an increase in interest rates "withdraws" much more household net worth, due to implied house price reduction, than any comparable boost to the S&P can offset), ii) on the other hand, China, which is faced with the ticking timebomb of continuing the status quo and hoping that US consumers can keep growing the global economy, or alternatively, looking inward at its own consumer class, and shifting away from its historical export-led model. The one unavoidable side effect of this prominent departure would be a renminbi appreciation, and a logical drop in the US currency, once the US-China peg if lifted (a theme opposed recently by SocGen's Albert Edwards, who sees the inverse as likely occurring). The main question for 2010 and beyond is whether this will be a gradual decline or a disorderly drop. And behind the scenes of all the bickering, jawboning and posturing, this is precisely what high level officials from both the US and China are currently negotiating. This will be one of the major themes that defines the next decade. Another phrase to describe this process is the gradual drift of US into a nation that is aware it is no longer the primary economic dynamo of global growth as China eagerly steps in to fill that spot.

Looking at the aftermath of the financial crisis, the two major consequences that will define US economic trends for an extended period of time, are the increasingly more frugal US consumer, whose savings rate is likely to increase gradually to the long-term low double digit average, and an ongoing outflow from equities into safer assets such as municipals, bonds and loans, as the maturing baby-boomers finds the volatility of the engineered equity market far too risky as they enter retirement age.

So with US consumption-led growth entering its twilight days, courtesy of assets that simply do not provide the kinds of returns that allowed for a savings-free lifestyle, what does this mean for Asia, and China in particular? Bank of America provides a good and succinct overview of the major historical themes that have defined Asian economics, and what the next decade will likely bring.

The essence of the Asian development strategy is to build manufacturing capacity for global demand. High savings rates allowed the needed investment in plants and infrastructure to be financed domestically. This strategy was pioneered by Japan in the 1950s and 60s, copied by the Asian “Tigers” (Hong Kong, Korea, Singapore, and Taiwan) in the 70s and 80s, and by a host of other Asian countries in the 80s and 90s. What changed the game was China’s adoption of the same strategy. Exports have increased nearly sixfold since China joined the World Trade Organization (WTO) in 2001. This had a profound impact on the global economy – but it had an even more profound impact on the China’s own economy and labor market. We estimate that 150 million Chinese workers joined the global labor force and began producing internationally traded goods. (As a contrast, the US labor force is 154 million people.)

The integration of China’s vast workforce into the global economy is what tipped the balance. The transfer of jobs and production from the US, where personal and corporate savings rates were low, to China, where savings rates were high, gave rise to huge imbalances. Within a few years after WTO entry, China’s current account surplus became the world’s largest, mirrored by an even larger US deficit.

Currency appreciation would have reduced wages, profits, and the flow of savings, but China was unwilling to allow market forces to play out. Thus, thePBoC (China’s central bank)  intervened in unprecedented amounts, and the vast flow of Chinese savings was channeled  abroad in the form of foreign exchange reserves – mostly short-duration government debt and bank deposits. Essentially, China was financing its own exports by purchasing short-term debt. The bulk ofthat found its way into US markets, keeping interest rates low and setting the stage for the housing bubble.

And herein lies the rub:

The financial crisis delivered a clear verdict, in our view, on the limits to the Asian growth model. It no longer makes sense to pursue double-digit growth by lending cheaply to the US consumer.

Yet change would require less reserve accumulation or – put another way – allowing the currency to appreciate against the US dollar, to which it is now effectively pegged. China needs to manage this “exit” carefully. Moving too fast risks a dollar crisis, with a disorderly drop in the US dollar and a spike in US bond yields. Moving too slow risks a boom-bust cycle in China, with capital inflows and strong monetary growth rates putting upward pressure on asset prices and inflation.

As noted earlier, the transitioning from the status quo, which worked for many years, but is now no longer relevant for the PBoC, will be likely even more critical than Bernanke's decision on when to finally begin raising rates. Because while the latter is mostly concerned with asset-price inflation (and stoking it every chance he gets), the Chinese decision will determine not only interest-rate policy for the US for decades to come, but will decide how soon the US should prepare to accept the consolation prize of first runner up in the global economic leader category. While on an absolute basis the US Economy is still a clear outlier, the rate of growth exhibited by China makes it a virtual guarantee that the days for US economic hegemony are numbered (even more so with GDP determination which is whatever the Central Committee says it is). The only open question is when will China decide it is finally time to shift away from the export-led growth model to one which prefers its own consumers as the source of growth. This transition will likely be of historical importance: just as the inception of the US vassal relationship with China lead to a historic and unprecedented boom in household net worth, doubling to $60 trillion in the span of a decade, so shall the unwind have a comparable impact to the downside.

It is merely this moment that Bernanke and the administration are doing all they can to prolong as much as possible. Alas it may be too late, as China seems to have finally realized that in the global prisoner's dilemma game, it has taken the constant US defections for far too long enough. And with the benefits of perpetuating the charade at this point outweighed by the detriments, 2010 could just be the year when China decides it has had enough.

For much more observations on the US-China relationship, and what lies in store for both the dollar and the renminbi, below is the most recent China FX roadmap analysis from BofA.

 

As everyone is engrossed by assorted groundless Christmas (and other ongoing bear market) rallies, and oblivious to the debt monsters hiding in both the closet and under the bed, Zero Hedge has decided it is about time to present the ugliest truth faced by our 'intellectual superiors' and their Wall Street henchman who succeeded in pulling off Goal #1 for 2009 - the biggest ever bonus season (forget record bonuses in 2010... in fact, scratch any bonuses next year if what is likely to transpire in the upcoming 12 months does in fact occur).

If someone asks you what happened in 2009, the answer is simple - two things. There was a huge credit and liquidity crunch, and then there was Quantitative Easing. The last is the Fed's equivalent of band-aiding a zombied and ponzied corpse, better known as the US economy. It worked for a while, but now the zombie is about to go back into critical, followed by comatose, and lastly, undead (and 401(k)-depleting) condition.

In 2009, total supply of all USD denominated fixed income, net of maturities, declined by $300 billion from $2.05 trillion to $1.75 trillion. This makes sense: the abovementioned crunches stopped the flow of credit from January until well into April, and generally firms were unwilling to demonstrate to the market how clothless they are by hitting the capital markets until well into Q2 if not Q3. What happened was a move so drastic by the Fed, that into November, the worst of the worst High Yield names were freely upsizing dividend recap deals (see CCU) - the very same greed and stupidity that brought us here. Luckily, so far securitization and CDOs have not made a dramatic entrance. They likely will, at which point it will be time to buy a one-way ticket for either our southern or northern neighbor, both of which, in the supremest of ironies, transact in a currency that will survive long after the dollar is dead and buried.

Back to the math... And here is the kicker. Accounting for securities purchased by the Fed, which effectively made the market in the Treasury, the agency and MBS arenas, but also served to "drain duration" from the broader US$ fixed income market, the stunning result is that net issuance in 2009 was only $200 billion. Take a second to digest that.

And while you are lamenting the death of private debt markets, here is precisely what the Fed, the Treasury, and all bank CEOs are doing all their best to keep hidden until they are safely on their private jets heading toward warmer climes: in 2010, the total estimated net issuance across all US$ denominated fixed income classes is expected to increase by 27%, from $1.75 trillion to $2.22 trillion. The culprit: Treasury issuance to keep funding an impossible budget. And, yes, we use the term impossible in its most technical sense. As everyone who has taken First Grade math knows, there is no way that the ludicrous deficit spending the US has embarked on makes any sense at all... none. But the administration can sure pretend it does, until everything falls apart and blaming everyone else for its fiscal imprudence is no longer an option.

Out of the $2.22 trillion in expected 2010 issuance, $200 billion will be absorbed by the Fed while QE continues through March. Then the US is on its own: $2.06 trillion will have to find non-Fed originating  demand. To sum up: $200 billion in 2009; $2.1 trillion in 2010. Good luck.

As we pointed, the number one reason why 2010 is set to be a truly "interesting" year is a result of the upcoming explosion in US Treasury issuance. Fiscal 2010 gross coupon issuance is expected to hit $2.55 trillion, a $700 billion increase from 2009, which in turn was  $1.1 trillion increase from 2008. For those of you needing a primer on the exponential function, click here. But wait, there is a light in the tunnel: in 2011, gross issuance is expected to decline... to $1.9 trillion.

And while things are hair-raising in "gross" country (not Bill...at least not yet), they are not much better in netville either. Net of maturities, 2010 coupon issuance will be about $1.8 trillion, a 45% increase from the $1.3 trillion in FY 2009 (and the paltry $255 billion in 2008).

Now everyone knows that the average maturity of the UST curve has become a big problem for Tim Geithner: nearly 40% of all marketable debt matures within a year (a percentage that has kept on growing). In fact, the Treasury provided guidance in its November 2009 refunding, in which it stated that it intends "to focus on increasing the average maturity" of its debt after relying heavily on Bill issuance in H2. Once again, we wish Tim the best of luck.

Why our generous best intentions to the US Treasury? Because unless the US consumer decides to forgo the purchase of the 4th sequential Kindle and buy some Treasuries (and not just any: 30 Year Bonds or bust), the presumption that the Bond printer will have the option of finding vast foreign appetite for its spewage is a very myopic one. We already know that China is a major question mark, and will aggressively be looking at pumping capital into its own economy instead of that of Uncle Sam's - at some point the return on investment in its own middle class will surpass that of funding the rapidly disappearing US middle class. That tipping point could be as soon as 2010.

As for Japan - the country has plunged into its n^th consecutive deflationary period. Whether or not the finance minister announces yet another affair with the Quantitative Easing whore on any given day, depends merely on what side of the bed he wakes up on. The country will have its hands full monetizing its own sovereign issuance, let alone ours.

Lastly, the UK - well, with the country set to have zero bankers left in a few months, we don't think the traditionally third largest purchaser of US debt will be doing much purchasing any time soon.

None of this is merely speculation: October TIC data confirmed these preliminary observations. It will only become more pronounced in upcoming months.

How about that great globalization dynamo: emerging markets? Alas, they have their hands full with issuing their own record amounts of both sovereign and corporate debt as well: in 2009 gross EM debt issuance reached an astounding $217 billion, $29 billion higher than the previous record in 2007. Gross EM issuance was particularly high in the last quarter at $73 billion, with October breaking the record for the largest ever monthly gross issuance of emerging market global bonds at $38 billion (January is traditionally the busiest month of the year.) With $81 billion, 2009 was notably a record year for sovereign bonds, while gross issuance of corporate bonds amounted to $136 billion, the second highest level after that of 2007 with $155 billion.

Bottom line: everyone has major problems at home, and is more focused on the supply than the demand side of the equation.

What options does this leave for the administration? Very few, and all of them are ugly. As we stated earlier on, the options for the Fed are threefold:

1. Announce a new iteration of Quantitative Easing. This will be met with major disapproval across all voting classes (at least those whose residential zip codes do not start with 10xxx or 068xx), creating major headaches for Obama and the democrats which are already struggling with collapsing polls.
2. Prepare for a major increase in interest rates. While on the surface this would be very welcome for a Fed that keeps hinting that deflation is the biggest concern for the economy, Bernanke's complete lack of preparation from a monetary standpoint (we are surprised the Fed's $200 million reverse repos have not made the late night comedy circuit yet) to a forced interest rate increase, would likely result in runaway inflation almost overnight. The result would be a huge blow to a still deteriorating economy.
3. Engineer a stock market collapse. Recently investors have, rightfully, realized there is no more risk in equities, not because the assets backing the stockholder equity are actually creating greater cash flow (as we demonstrated recently, that is not the case), but simply because taxpayers have involuntarily become safekeepers for the entire stock market, due to Bernanke's forced intervention in bond and equity markets. Yet the President's Working Group is fully aware that when the time comes to hitting the "reverse" button, it will do so. Will the resultant rush into safe assets be sufficient to generate the needed endogenous demand for Treasuries is unknown. It will likely be correlated to the size of the equity market drop.

If the Fed decides on option three, we fully believe a 30% drop (or greater) in equities is very probable as the new supply/demand regime in fixed income becomes apparent. We hope mainstream media takes the ideas presented here and processes them for broader consumption as indeed the Fed is caught in a very fragile dilemma, and the sooner its hand is pushed, the less disastrous the final outcome for investors. Then again, as Eric Sprott has been pointing out for quite some time, it could very well be that the US economy has become merely one huge Ponzi, and as such, its expansion or reduction on the margin is uncontrollable. We very well may have passed into the stage where blind growth is the only alternative to a complete collapse. We hope that is not the case.

Merry Christmas and Happy Holidays to all readers.

• Russia lowers key rate, kills carry trade.  Merry Christmas, foreigners.  ("In Soviet Russia, rates lower you") [bloomberg]
• Ethanol producers sue California to prevent low-carbon fuel restrictions. (Corn shortage forces greens to start to eating their own young?) [wall street journal]
• Latvia attempts to lower pension benefits to avoid fiscal meltdown. Courts: "Denied." Latvian PM: "We will just go bankrupt if we observe all legal norms" (Sufficiently satirical comeback fails me) [baltic reports]
• Increase in pension contribution requirement for NY Teachers causes rush to lock in old rates.  (Officials shocked, shocked to find that rational actors avoid taxes)  [wall street journal]
• Retailers extend Christmas hours to boost traffic. (Losing money for every open hour, but making it up on volume) [bloomberg]
• Dubai's Burj Dubai tower about to open as world's tallest building [in foreclosure?]  (Maybe.  Obama inspired transparency in government initiative forbids exact height disclosure)  [reuters]
• FinCEN proposes sharing bank data with foreign officials.  (KGB a/k/a "Goldman Sachs (Moscow)" to reopen economic espionage desk, install Rezident in Manhattan) [reuters]
• Japan's budget includes $484 billion deficit.  200% Debt:GDP just around the corner.  (Obama: "Only $484 billion?  You fail at fiat, Hatoyama.") [reuters]
• China revises energy per GDP unit use down to 5.2% 2007-2008. (Keynes resurrected! Taxpayer funded government stimulus double counts growth, single counts energy use) [financial times]

Tim Geithner and Ben Bernanke can both sleep well - the Great American Ponzi ("GAP") can continue for at least one more month, courtesy of Senate Democrats who all, with the exception of Evan Bayh, voted to raise the debt ceiling by $290 billion to $12.4 trillion. 59 Democrats all did their job in pretending that an exploding budget deficit is nothing to write home about, as there is this thing "called the printing press" yet with 60 votes needed America could have been on the verge of its first ever technical default. The savior: Republican George Voinovich of Ohio, who voted against party lines, and 39 other Republicans, and voted "for" unlimited printer cartridges.

From AP:

The Senate's rare Christmas Eve vote, 60-39, follows House passage last week and raises the debt ceiling by $290 billion. The vote split mainly down party lines, with Democrats voting to raise the limit and Republicans voting against doing so. There was one defection on each side, by senators whose seats will be on the ballot next year: GOP Sen. George Voinovich of Ohio and Democratic Sen. Evan Bayh of Indiana.

Obama must sign the measure into law to prevent a market-rattling, first-ever default on U.S. obligations. The government piled up a record $1.4 trillion deficit in 2009 to counter a meltdown in financial markets and help bring the nation out of its worst recession in seven decades.

With the exception of Voinovich, Republicans uniformly derided the bill, though they routinely supplied votes for eight previous increases totaling $5.4 trillion under President George W. Bush.

Voinovich, who is retiring, said he voted "yes" after Majority Leader Harry Reid agreed to consider amendments when the Senate takes up the matter again next month. Bayh told the Senate Budget Committee in November that he would oppose an increase in the limit unless Congress commits to a strict new debt-fighting plan.

Had this measure not gained the necessary 60 votes, the resultant market pandemonium would have been a sight to behold, as the ponzi would have been finally forced to unwind. Yet if Voinovich is replaced with a "money printing" hawk, and if Bayh remains steadfast in his opposition to spiraling out of control sovereign debt, the Democrats, and US CDS shorts, may well be out of luck on January 20, when the measure will be subject to a revote. If at that point the plan to expand the debt ceiling to the critical  $13+ trillion fails, the stock market rally will promptly hit the rewind button.

In the annals of bailout history, commitments don't get a lot more slippery than this.

U.A.E. Minister of Economy Sultan bin Saeed al-Mansouri said further federal government support for Dubai should be “studied” properly. “Each issue has to be studied in a proper manner, evaluated and based on that an answer will be provided at the federal level or the local level,” al-Mansouri told reporters in Abu Dhabi today when asked whether the federal government will extend more financial support to Dubai.

Well, at least the "case-by-case basis" statement made by Abu Dhabi earlier in the month is being applied consistently.  Less consistent, of course, have been Dubai's mercurial positions with respect to their creditor intentions.  There will be a standstill.  There won't.  Debt will default.  It won't.  Restructuring is out of the question.  It will be orderly.  The uninitiated might view this kind of committed commitment to the noncommittal as a sign of inexperience or confusion.  This would be to badly misunderstand the nature and of opacity in Dubai.  After all, this is the city that managed to run up a $7.5 billion accounts payable account with the likes of Mitsubishi Heavy Industries, with some of the past due amounts going back years even as foreign developers are forced to flee the jurisdiction rather than face prosecution by Dubai courts and jail time over defaults often brought on, ironically, by the government of Dubai's refusal to pay them.  How long might one expect developers to stay around pursuing their claims against the government in such circumstances, one wonders.  It will be seen that the surreal is most often the product of exacting design in Dubai.

This appearance of chaos would also, it seems, be the product of intelligent design. Most likely, and decidedly hidden behind the scenes, a delicate dance of brinkmanship is being played out between the forces of public panic, in the form of Dubai's ability to threaten very public and very messy defaults and the disclosures of actual financial condition that tend to accompany such things, thereby throttling the credit ratings of the entire region for some time to come, and increasingly scarce (and expensive) bailout capital, in the form of whatever lies behind the deeply opaque balance sheets of Abu Dabhi's sovereign wealth fund.

One can easily picture Dubai officials poised in the antechamber to the press briefing room and its microphone bristling podium, reaching for the door handle, looking over their shoulder at the cluster of increasingly worried looking Abu Dabhi officials.  "We'll do it.  The press is right there.  We'll freeze it all!"  Ok.  Ok.  Come back.  Sit down.  Let's reason this out together.  No need to be dramatic.  Crisis averted.  For now.  Bloomberg reports:

Dubai World will present a standstill offer to banks in early January as the state-owned company aims to restructure $22 billion of debt, said three bankers who attended a presentation on the matter yesterday.

Another day in the debt desert paradise.

The Los Angeles Times reports that the Governator is expected to appeal to Washington for some $8 billion in bailout funds, and is holding hostage CalWORKS, the mainstay of California's welfare program (and a long standing and favored catamite to the country's progressives) in the unlikely event he doesn't get it.  Arnie also seems poised to select this as an opportune time to re-open the question of drilling for oil off the Santa Barbara coast.

Of course, a number of other things are weighing on California's debt addled mind.  For instance, the impact of shiny new health care cost reductions on the states massive debt load.  Readers will be well aware of our view of the cost shell game being played with this legislation, but, we ask you, what is the point of hoisting $4 billion or so in expenses on California if the Federal government is going to have to send $8 billion right back into the state as a result?  Optics, of course.  Still we are fairly sure this will be an isolated incident as we cannot imagine that any other states are facing fiscal issues that would prevent them from easily paying for the cost savings the new health legislation will bless them with.

Of course, California doesn't seem to have expected federal legislation that would result in such a severe fiscal emasculation as is performed in the present bill and, given that Arnie was one of the few Republicans of any stripe to support the legislation, you can almost taste the sour sting of betrayal in the letter he wrote Nancy Pelosi yesterday:

Dear Madam Speaker,

 

As one of the few governors in the nation who attempted to pass comprehensive health care reform at the state level, I have great appreciation for the historic effort you are leading in Congress.  In fact, I am one of the only Republican elected officials in the country to publicly support the President’s health care reform efforts.

 

When asked for my support, I was assured that federal legislation would not increase costs to California or include new unfunded mandates. Unfortunately, under nearly every scenario we can predict, the federal health care reform legislation being debated would cost California’s General Fund an additional $3 billion to $4 billion annually. This crushing new burden will be added to a safety net that is already shredding under billions of dollars in unfunded federal mandates that we are struggling to meet. Medicaid is a partnership program between the federal government and the states. As the partner responsible for implementing this program, I am telling you that our Medicaid program is already at the breaking point, and if federal health care reform is passed without addressing the underlying faults in the system, health care reform will fail.

Sucker.

While we explore the fate of California, it is illuminating to notice the tired pattern of sovereign extortion in the form of the threat of imminent fiscal violence to favored (or even critical) government services.  Why is it that municipalities (or the Federal government for that matter) seem to uniformly respond to looming fiscal crises by announcing potential cuts in, for example, "...the In-Home Health Care Services program for the disabled and elderly poor," or police, emergency services, fire, and the department of motor vehicles?  Of course, we know the answer.

And so, California will, in all likelihood, get a large, steaming hunk of Federal extortion payments, making even more explicit the Federal Government's role as the lender of last resort for the abysmal failure of progressive (and expensive) municipal experiments in everything from welfare to green energy to hopelessly mathematically challenged defined benefit programs.  Given the total surrender of federalism and the wholesale abandonment of the republic, the clever Zero Hedge reader may consider adding to their municipal credit default swap pricing model a variable that captures expected gubernatorial expertise in fiscal extortion and lobbying.  We highly suspect that the last states to fail will be those who exhibit the highest levels of operational excellence in extracting liquidity from an increasingly sore Federal teat.  California seems to be off to a good start, but then their thirst for mother's milk is awfully daunting.

Much has been written about the Fed's Permanent Open Market Operations, or the technical name for Quantitative Easing's Bond Repurchase, aka Monetization, program. What has been largely left out is the true cost in the form of a call premium that the Fed has paid out due to what amounts to an early redemption of $300 billion in par securities. From a basic bond standpoint, the Fed's buybacks of Treasuries at market prices simply represent premium redemptions as a substantial amount of the bonds bought back had been issued (at par) when interest rates were materially higher. Therefore the differential from par to market has to be considered when evaluating the actual cost to US taxpayers, and by implication, early paydown benefit to bondholders. The surprising result: after $300 billion in par repurchases (or $295 billion ex-TIPS to be precise), a whopping $27 billion has been paid by the Fed over par to account for declining interest rates over the past three decades. As the actual price paid by the Fed is known only to the Fed itself, despite claims to transparency and openness, this is at best an exercise in extended bond math. Only when the Fed is truly audited will we get a full glimpse into just how much the Treasury portion of QE has truly cost US taxpayers in order to provide a quick and lucrative "out" to all those bondholders, especially the ones who purchased bonds at lofty interest levels (and thus very discounted prices) in the early to mid 80's. In sum, even though the Fed has purchased a nominal $300 billion in assorted government securities, its actual cash outlay has likely been in the $325 billion+ ballpark. Keep in mind this analysis excludes the roughly $1.4 trillion in MBS and Agencies that Bernanke is still actively gobbling up to prevent the housing market from collapsing. A comparable exercise performed in that part of the POMO market would likely yield even more distributing results.

On March 18th of 2009, the FOMC released a statement outlining the purchase of $300 Billion in U.S. Treasury securities. However, all reporting on these purchases were released in Par terminology, with no detail given regarding the market price of these securities. This brings up the question, what was the actual price paid for these securities? It would most certainly not be at par, so one must automatically assume that it was the market price. Unfortunately, without accurate reporting due to the Fed's unwillingness to disclose any actually relevant cashflows to the broader public, the exact amount spent on this program must be estimated. This further complicates the matter since the value depends on the rate of interest used for each security and few of these securities mature at the discrete intervals used in the construction of the yield curve.
 
First, let’s take a look at the facts:

Treasuries purchased:
Individual Securities: 143
Number of Transactions: 553
Total Par: $295,448,000,000
Weighted Average Coupon: 3.7213
Weighted Average Maturity (From 11/30/09): 6.02 years
 
Tips are irrelevant to this study, but the total par of 13 TIP Securities purchased is $4,552,000,000 or 1.52% of the total Par Purchase amount (combined, one gets the $300 billion par total for the Treasury portion of QE). The important item to note here is that after a large period of inflation, a small number of TIP securities were purchased at deflated prices.

Now for the Treasury Bonds/Notes, there are multiple methods to estimate the approximate rate of interest used, but for the sake of not overestimating the impact, the information being reported uses the higher of the two rates surrounding the actual maturity. For example, if a note matured 4 years, it is then bounded by 3 and 5 year rates for that particular day and thus the 5 year rate was utilized to estimate a purchase price. It must be noted then that the estimate being reported MUST be less than the actual price paid, by how much can not by determined unless the Federal Reserve decides to publish the actual values. To compensate for irregularities on the curve, valuations were then calculated using continuous formulas to provide for the most accurate values.

Upon completion of this study, multiple important questions became readily apparent. These will be outlined at the end. First, let us look at a security which was issued in 2009 that was subsequently purchased by the New York Fed.

912828KN9 – 5 year note, 1.875 Coupon
Issue date: April 30th, 2009
Maturity Date: April 30th, 2014
Average Price paid at Auction: 99.6917
Total Issuance: $35,000,000,000
Average Sale Price: 99.167
Amount Repurchased by POMO at PAR: $5,961,000,000
% of Total Issuance: 17.03%
Approx Sale Price: $5,942,621,462
Number of POMO transactions: 6
Approximate Market Price Paid (total):  $5,791,441,102
Approximated Gain: $169,558,897.75
Approx % Gain from Sale: 2.31%
Approx % Gain from Par: 2.84%
Issue Notification: http://www.treasurydirect.gov/instit/annceresult/press/preanre/2009/R_20090428_2.pdf
 

Well, that appears to have gone well. But unfortunately out of the 143 individual securities purchased a gain was registered (from Par) for 15 of these securities or a mere 10% of the total. The total gain from Par pricing would be $533 million or so. But that’s not what should concern you. What should concern you is the larger number of securities where we paid $28 billion in excess of par. Let’s take a look at the security which would have the largest gain over par, which was issued on August 15th, 1989.
 
912810ED6 – 20 year bond,
Coupon: 8.12
Issue date: August 15th, 1989
Maturity Date: August 15th, 2019
Total Issuance Size: 20,214,000,000
Amount Repurchased by POMO at PAR: $3,788,000,000
Percent of original issuance: 18.74%
Number of POMO transactions: 5
Approximate Market Price Paid (total):  $5,356,587,487
Approximated Gain: $1,568,587,486
Approx % Gain from Par: 41.41%
 
In fact, when you look at the distribution of these securities, the largest gains over par ALL come from bonds issued from the late 1970’s to the early 1990’s, when they were issued with larger coupons. The plot gets thicker however when you do a Google search for each of these securities. When you research 912810ED6 you find out that in fact THIS SECURITY WAS ALSO PURCHASED IN 2001 DURING THE EARLY DAYS OF THE MELTDOWN. http://www.treasuryhunt.gov/instit/annceresult/press/preanre/2001/ofbbr41901p2.pdf
This brings up a larger issue…. Are Market Crashes the result of liquidity problems or are market crashes ENGINEERED to help solve liquidity problems? In effect, is the debt cycle the ultimate cycle? This simple exercise demonstrates that the total cost of the $295.5 billion in Treasury Purchases (not including TIPS) hypothetically would have cost the American taxpayer $322.8 billion, or rather $27.4 billion in excess of stated. This amount to roughly $100 per US citizen. How many hungry, homeless people would that feed?

And just what is the comparable "call" premium that the government has paid the likes of PIMCO and China in purchasing their MBS and Agency securities at prices exponentially over fair value? That is another exercise that we are currently conducting, but we can tell you now, dear taxpayers, your tax dollars were put to good use to pad the pockets of Mr. Gross, and all those others (all of them) who were selling MBS at market prices directly to the Fed over the past year. And with Wellington and BlackRock being completely phased out as agents in the MBS POMO program, very soon there will be absolutely no information leakage as to just how far the Fed has perverted the true state of the mortgage backed market. Which in these days of rampant and wholly accepted and endorsed bubble recreation, is a "very good thing." As Dan Aykroyd pointed out so many years ago in Spies Like Us, "Chem men'she znaesh', tem luchshe." The Chairman wholeheartedly agrees.

Summary of QE Treasury purchases at market.

 

After a fashion, one has to feel sorry for the Congressional Budget Office.  Except not really.  Though the organization is supposed to be "non-partisan," it faces a dilemma that much resembles that of the Federal Reserve.  It is intended, by design, to occasionally throw itself in front of moving freight trains and, despite whatever manic political momentum has built into velocity and pure mass of pages, occasionally stop them cold in the face of intense pressure, public and private.  It has singularly failed in this mission since about 2001, and has, in the last few years, become merely a rubber stamp regularly gamed to extract its endorsement to flaunt in the satirical play that is the courting of public opinion.

Of course, to the advocates of a given piece of favored legislation, any CBO action that would appear to delay, defray or dismay the latest pet project of the day's political class looks partisan.  So if it is going to do the time anyhow, might not a CBO be tempted to engage in a bit of "jury nullification" on occasion?  After all, legislators think nothing at all of shamelessly and openly gaming the CBO to suit their purposes.  In fact, one might even go so far to say that the machinations that accompany the Patient Protection and Affordable Care Act have quite literally jumped the firebreak that once defined the limits of decorum and good taste with respect to the increasingly common practice of CBO gaming.  Just this month, the Congress of the United States has so substantially exceeded these already permissive bounds that a full rendering of the new and expansive contours of legislative limits, even if they faced the active resistance of the CBO in full force, are beyond alarming to contemplate.

Moreover, despite the fact that members of Congress are, in theory, duty bound to oppose legislation they have reason to believe unconstitutional, this author is unaware of even a single legislator that seems willing to stand on this principal when it happens to violate party lines.  While it may seem trivial to point out, this particular duty is enshrined directly in the Constitution itself...

The Senators and Representatives before mentioned, and the Members of the several State Legislatures, and all executive and judicial Officers, both of the United States and of the several States, shall be bound by Oath or Affirmation, to support this.1

...and codified in the United States Code to require the following oath of office of all incoming members of Congress:

I, [Scum Sucking Fraud], do solemnly swear (or affirm) that I will support and defend the Constitution of the United States against all enemies, foreign and domestic; that I will bear true faith and allegiance to the same; that I take this obligation freely, without any mental reservation or purpose of evasion; and that I will well and faithfully discharge the duties of the office on which I am about to enter. So help me God.”2

5 U.S.C. § 3333 requires members of Congress to sign an affidavit that they have taken the oath of office.  Penalties for violating the oath of office are, however, vague in the absence of an oath taker who actively "advocates the overthrow of our constitutional form of government...."3

Given all this theater, what actual duty, one wonders, actually extends to a Congressperson tempted to support a piece of legislation they have not had the time to skim, much less read on any level that would permit them to make even a vaguely educated assessment of the statute's potential constitutionality?

What if aides were to call to the attentions of this morally complex (and therefore fictitious) Congressperson, provisions of the legislation that are blatantly unconstitutional on their face?  What does it say about the (d)evolution of the meaning of this oath that evoking it in this context is more likely to provoke sad, knowing smiles, than expressions of shock?

Normally, such musings would be beyond the purview of Zero Hedge.  Given, however, the immense implications the Patient Protection and Affordable Care Act has on markets and the economy, as well as upcoming votes on the national debt ceiling (scheduled for December 24, in line with the Patient Protection and Affordable Care Act as it happens- merry christmas!) it certainly must also have implications for sovereign debt, the share prices of a number of publicly traded insurers with significant exposure to health care markets and equity markets generally.  It seems willfully blind not to speculate on the fate of legislation due to pass in the last moments of 2009.

Accordingly, Zero Hedge offers the following prediction:

Before 2014, when the major "reforms" of this sprawling mass of squirming regulatory orgasms are due to kick in, what remains of this legislation in the wake of court battles, nullification and outright overturns, will be a hollow shell of the bill's former, shining Byzantine glory.

The Congressional Budget Office

Try to imagine for a moment, an "independent agency" tasked with "scoring" legislation and calling itself "non-partisan."  It is fairly easy to see that even the slightest subjective authority in any sort of scoring would be immediately labeled "partisan" by a bill's proponents.  The only way to sustain the appearance of "neutrality" would be to enumerate a number of strict guidelines that defined quite carefully the nature of the test, the criteria of its grading and the presentation of its results.

These guidelines will be recognized today as the scoring rules binding the Congressional Budget Office.  Of course, bright line rules are quite open to gaming (just ask any financial regulator) but in order to maintain the appearance of "neutrality" the Congressional Budget Office cannot but be beset by rules.  The exceptional (for government) Congressional Budget Office Director's Blog contemplates thusly:

Scorekeeping rules were set forth by the Congress in the conference report for the Balanced Budget Act of 1997 and are updated occasionally upon agreement by the full group of “scorekeepers,” a group that consists of the House and Senate Committees on the Budget, the Congressional Budget Office, and the Office of Management and Budget. The purpose of these rules is to ensure consistent treatment of spending authority, appropriations, and outlays across programs and over time.

Uh, yeah so... no they aren't.

If this language sounds a bit stilted it is partly because, at least for an "independent agency," the CBO leadership is surprisingly beholden to the whims of political foible.  The Director of the Congressional Budget Office is jointly appointed by the Speaker of the House of Representatives and the President Pro Tempore of the Senate.  One might be tempted to think that a structure providing for a four year term and no term limits would provide Directors some insulation from the fickle sway of party politics.  In this case, one would need to be ignorant of the ability of either House of Congress to dismiss any CBO director by simple majority resolution.  It should surprise no one that there have been three CBO directors in the past six years.  (Six if one includes acting Directors).  Since the formation of the CBO in 1975 only two CBO directors (Alice M. Rivlin and Robert D. Reischauer) have served multiple terms, and none have managed that feat again since Reischauer left office in 1995.

Reischauer's departure actually bears some exploring.  Let us set the way-back-machine to, say, 1994.  Interestingly, the country (well some of it) was again gripped by the frantic, perhaps even manic urge to pass some form, any form, of socialized medicine.

The siren song that had frustrated even Theodore Roosevelt had captured the imagination (again) of an emboldened administration.  The job looked like such a shoe-in, in fact, that it apparently seemed safe to put the First Lady on the case instead of distracting the President from his busy schedule.  But, you know, Teddy never had to cope with the CBO, and PACs had learned from Ronald Reagan's first "Harry and Louise" ad recorded back in 1961 (a must hear for would be Reagan wonks- back then it was Operation Coffee Cup, instead of Tea Parties).

Given that this was the largest and most complex bill the CBO had ever analyzed, the office took the job quite seriously.  That meant delays.  Delays that irritated both Congress and the Administration.  Serious sand-after-sex-on-the-beach level irritation, in fact.  The New York Times breathlessly outlined the conflict, starting with:

There are moments in this final phase of the health care struggle when people yearn, just a little, for the old leap-of-faith days of policy-making. Before the Congressional Budget Office was tallying up the costs, the risks and the impact on the deficit of every good intention.

They wern't kidding.  Anyone bold enough to stand in front of a determined Congress with a "Stop" sign was asking for trouble.

Lawmakers look to the budget office as an arbiter in a terrifyingly complicated, fiercely partisan debate. But the C.B.O. has also become a target as the effort to pass a health care bill comes dangerously close to running out of time -- and as more and more of what is left is spent "waiting for C.B.O. estimates." Has the budget office become the latest institution to be overwhelmed by the health care struggle?

[...]

At that moment, Mr. Reischauer and his staff were responsible for analyzing three thick health care plans in the House and the principal Republican plan in the Senate. House Democratic leaders had just announced that they might have to put off debate and floor action on health care until after Labor Day -- a move that dismayed many advocates of health care restructuring -- because they had yet to receive the necessary estimates from the C.B.O.

The Times piece goes on to quote Reischauer on his worst fears:

I guess my worst nightmare would be that some poorly thought-out plan is passed, and the American people would greet that plan with tremendous dissatisfaction, and it's repealed two years from now.

That sounds strangely familiar.  And yet, this time, the CBO seems to be entirely absent in any paragraph containing the world "delay."  It's almost like they had their analysis almost ready.  2200 pages of reading and they issue scoring in days.  Nice work!  More on this later.

Back then, for her part, Hillary Clinton complained that President Franklin D. Roosevelt "didn't have to carry around actuarial tables and then have arguments with people on television."

Ah, yes!  How wonderful it must have been to wield the sort of unbridled power that FDR enjoyed.  Free of fiscal restraint (or transparency).  Unchecked blank checkbooks.  Back when men were men, high courts were filled with old men needful of forcible retirement and national budgets were annual leaps of faith.  I'm feeling nostalgic.  Aren't you?

In 1994 the CBO was having none of it.  In February of that year, Reischauer's CBO published "An Analysis of the Administration's Health Proposal."  (A quick glance at the cover page suggests a bit more flash was expected of the CBO 15 years ago).  Among other findings the report uses a section wonderfully entitled "How CBO's Estimates Compare with Those of the Administration" to state:

In its budget for fiscal year 1995, the Administration estimates that its health proposal would reduce the deficit by $38 billion in 2000 and by a cumulative total of $59 billion over the 1995-2000 period.  (The Administration has not provided estimates for later years.) In contrast, CBO estimates that the proposal would increase the deficit by $10 billion in 2000 and by a total of $74 billion over the six-year period. The two estimates are virtually the same in 1995 but differ by growing amounts after that year. CBO's estimate exceeds the Administration's by about $50 billion in 2000.

More interestingly, the report honed in on an obscure accounting area, the inclusion (or non-inclusion) of the "Health Alliances" in HillaryCare as Federal Budgetary items:

In administering the proposed program, regional alliances, corporate alliances, and state single-payer plans (if any) would operate primarily as agents of the federal government. Therefore, CBO believes that the financial transactions of the health alliances should be included in the federal government's accounts and that the premium payments should be shown as governmental receipts rather than as offsets to spending.

Anticipating the conflict this would no doubt fuel, the report added:

The President and the Congress should ultimately resolve the debate over the proposal's budgetary treatment through legislation.

We, perhaps naively, read this more like "You want those Alliances off budget? Well, what does your mother (Congress) say?"

Faced with the rather large delta between Administration figures and the CBO ($50 billion was once a lot of money, you know) and the corrosive effects of the Harry and Louise ads, Mom was, perhaps unsurprisingly, no longer particularly inclined to indulgence.

Watching the "shoe-in" melt away in front of their very eyes, the Clinton Administration was not amused.  Not... one... bit.

Reischauer, who had just been re-appointed on November 27, 19931 after Clinton took office (the second and the last CBO director ever to be reappointed for a second term), found himself unceremoniously ejected mid-term his reappointment scuttled in 1995.  Said the New York Times of the removal:

Although Mr. Reischauer was hired and paid by a Democratic-run Congress, only last year his budget office dealt a severe blow to the keystone of President Clinton's legislative program -- an overhaul of the health care system -- by concluding that it would cost the Government far more than the White House had estimated.

Reischauer might not recognize the restricted CBO of 2009.  A number of changes to the scoring rules were made in 1997, including modifications to the bodies and procedures required to change the rules.  Nor, we suspect, would CBO officials of that era have imagined the degree to which the agency's ability to check spending (or even expose it) has been mitigated.  Legislators are well prepared for the slings and arrows of outrageous fiscal CBO restraint today.  The already pliable "scorekeeping" rules are, it would seem, made to be bent, if not broken.

Generally, scorekeeping rules focus the CBO on the first decade of fiscal effects.  It is a bit of a departure for the CBO to cast its penetrating gaze beyond that veil.  Having done so with the present bill, the CBO has a bit of explaining to do to avoid the ire of its legislative masters:

Although CBO does not generally provide cost estimates beyond the 10-year budget projection period (2010 through 2019 currently), many Members have requested CBO analyses of the long-term impact of broad changes in the nation’s health care and health insurance systems. A detailed year-by-year projection, like those that CBO prepares for the 10-year budget window, would not be meaningful because the uncertainties involved are simply too great. CBO has therefore developed a rough outlook for the decade following the 10-year budget window.

One can almost feel the inner conflict paining the CBO here, as it explains the limitations of its highly structured calculations in vague pleadings carefully buried near the end of a section.  The CBO has become keenly aware of the need to provide proper sound-bytes for legislators to sell their project with during prime time, even while hedging its bets with closing sentences no reporter will copy-paste.  To wit:

Based on the longer-term extrapolation, CBO expects that inflation-adjusted Medicare spending per beneficiary would increase at an average annual rate of less than 2 percent during the next two decades under the legislation—about half of the roughly 4 percent annual growth rate of the past two decades. It is unclear whether such a reduction in the growth rate could be achieved, and if so, whether it would be accomplished through greater efficiencies in the delivery of health care or would reduce access to care or diminish the quality of care.

If this doesn't make somewhat obvious the CBO's anxiety, its reaction to a particular class of gaming, and the total acquiescence of those issues might illuminate the matter more directly.

Remember the off-budget Health Care Alliance conflict?  You didn't think it was gone, did you?  Back in May of 2009, the CBO literally wrote an instruction manual describing exactly would keep "Federal Mandates" off budget:

To the extent that firms or individuals would be purchasing insurance from the government or via some entities acting on behalf of the government, the cash flows to and from the government (or such entities) should appear in the budget. But the budgetary treatment of purchases of insurance from private companies is more complicated. At its root, the key consideration is whether the proposal would be making health insurance an essentially governmental program, tightly controlled by the federal government with little choice available to those who offer and buy health insurance—or whether the system would provide significant flexibility in terms of the types, prices, and number of private-sector sellers of insurance available to people.

Want to avoid on-budget treatment?  Simple:

1.  Don't require purchase from the government or "via some entities acting on behalf of the government."
2.  Keep the proposal from "making health insurance essentially a governmental program."
2a. To avoid triggering (2) above, keep insurer Medical Loss Ratio requirements in the law below 80 to 85 percent.

The "Medical Loss Ratios" in (2)(a) are effectively margin limits on insurers.  An 80% Medical Loss Ratio would imply that an insurer spends $0.80 per $1.00 of premiums to pay out customers' medical claims.  The remaining $0.20 would, one assumes, be the maximum the firm could dedicate to administrative costs, salaries, and anything else that doesn't end up in the claims bucket.  Effectively, this is a limit on profit margins.  This rather arbitrary ratio emerged in a suspiciously timely (December 13th) memo from the CBO which states:

Taking those differences into account, CBO has determined that setting minimum MLRs under the PPACA at 80 percent or lower for the individual and small-group markets or at 85 percent or lower for the large-group market would not cause CBO to consider transactions in those markets as part of the federal budget.  Apparently, if the Federal government dictates your permitted profits and administrative expenses, but keeps those requirements under a nice round number or two, all is right with the world.

Constructing a complex structure that muddles these two issues sufficiently will force the CBO to treat a wide swath of spending as "off budget" for the public relations press that will follow.  Does the CBO seem to have made matters suspiciously easy?  Well, after their rather brusque May 2009 report, it didn't seem so.  But this MLR issue has many people quite suspicious.  Take Michael Cannon, for instance:

The problem is that crafting the private-sector mandates such that they fall just a hair short of CBO's definition does not reduce those mandates' cost, nor does it make those mandates any less binding. But it dramatically reduces the apparent cost of the legislation.

[...]
 
The MLR memo is the smoking gun: it shows that this is what they've been doing with CBO all along.  Proposals that would result in a complete cost estimate are dropped.  Because we can't let the public see how much this thing really costs.

What impact does this sort of hair splitting have?  Cannon again:

It's the reason we're all talking about an $848 billion Reid bill, rather than a $2.1 trillion Reid bill.

 

If someone sold you a house, or a car, or a mutual fund this way, we would put them in jail.

Proponents of the bill, however, are not fearful of imprisonment.  They don't even seem fearful of voter retribution.  It almost seems as if they are sacrifice flying the legislation to advance Congressional baserunners that aren't even standing on deck yet.  Perhaps they believe that passing a bill that will struggle through the courts (poorly) for some time will force their opponents ("Republicans" we suppose?) to wear the forehead brand of the "party that killed healthcare reform in the courts."  Or, better, the "party that repealed healthcare reform."

Then again, once the bill is passed it is easy to just ignore the CBO.  In the end it is the Office of Management and Budget (hereinafter the "OMB") a Cabinet office (and therefore entirely beholden to the current Administration) that dictates the treatment of budgetary items after laws are passed.  The CBO numbers become meaningless quite quickly after signing.  Lost and forgotten.  Does anyone remember, for instance, SarbOx's numbers?

Now that we consider it, why is it that $100 billion in AIG payments, the result of gaming regulatory rules governing insurance and derivatives, causes near riotous outrage, while gaming the CBO to the tune of $1.2 trillion is met with "job well done"s before passing the issue quietly into the night?

Finally, there is the question of why, given the serious constitutional issues it faces, this bill is even being proposed.

We aren't sure one even has to delve into language in the bill that purports to make it unrepealable...

...it shall not be in order in the senate or the house of representatives to consider any bill, resolution, amendment, or conference report that would repeal or otherwise change this subsection.

...to wonder after its legality.  If legal, one wonders why the Senate didn't think of this years ago.

It is common to hear that, given the fact that many states mandate financial responsibility as a pre-requisite to driving an automobile, a Federal Mandate to purchase health insurance is as American as apple pie.  This is an awful and abusive analogy.

Setting aside for a moment what should be obvious distinctions between state power and federal power, the possession of a license to operate a motor vehicle is, like it or not, a privilege afforded by states to residents, not a right.  States do not, for example, require residents with no desire to drive to, nonetheless, acquire insurance.  Nor can States require of residents proof of insurance (or even a license) when residents confine themselves to private roads.  The scope of regulation is confined to public operation of a vehicle on public roads.  Use of public roads is a privilege.  Simply waking up in the morning, however, is not something governments ought to be able to regulate.

Interestingly, the law does not actually regulate an activity- a key component of the Commerce Clause authority which the bill, of necessity, must invoke.  Instead, it regulates an anti-activity.  The act of not buying health insurance.  It is easy to make light of this distinction.  It is also quite foolish.  This sort of "negative regulation" is incredibly dangerous.  Moreover, the law itself mandates that individuals enter into a required contractual relationship with a private company.  Even State automobile insurance requirements permit individuals to post a cash bond to meet their financial responsibility requirements (i.e. to self-insure).  No such exception exists in the present legislation.  In fact, given the price control and "community rating" aspects of the bill, it is entirely obvious that the statute would require many individuals (particularly healthy 20somethings like your humble author) to enter into overpriced insurance contracts to subsidize other citizens.

In short, Federal mandates of this kind not only have no precedent, they would seem to fly in the face of the most basic notions of freedom of contract.

We hope that you are shocked at the lengths Congress will go to to deceive the public with respect to every facet of this bill from cost to deficit impact, from tax burden to effect and efficacy (or lack thereof), and that you will recoil to see how they have gamed the system to pass a brutally complex mass of legislation that surely remains (and will remain) unread by the very barons of democracy who will vote on it in your name.

While we are at it, allow us to welcome to the new way.  This having worked famously, expect more of the same.

1. 1. Article VI.
2. 2. 5 U.S.C. § 3331.
3. 3. 18 USC § 1918.

Whatever your position on the Ackman v. Hovde catfight (even if your position is that it is actually the Heavyweight Championship) there is something to see in Pershing's defense of General Growth Properties valuation from the Hovde assault.  Bloomberg sets the stage:

Pershing Square, based in New York, owns a 25 percent economic interest in Chicago-based General Growth, including 7.5 percent of its shares. The balance of Pershing Square’s General Growth holdings is in derivatives known as swaps. General Growth filed the biggest real-estate bankruptcy in U.S. history in April after amassing $27 billion in debt during an acquisition spree.

The Pershing Square report is, of course, a response to the Hovde Capital Advisors report of December 14, 2009.  Zero Hedge commented on the release of that report as well.  Actually, that particular Zero Hedge post appears to have been the first public airing of the Hovde report in general.  Later releases on Seeking Alpha and the like seem, however, to have gotten more attention.

If nothing else, one might derive a certain sense of how clever (or un-clever) retail investors are(n't) based on the stock's (non)response to colorful PowerPoint presentations.

Attachment	Size
GGP122209.pdf	1.18 MB

by Rebecca Wilder
(crossposted with Newsneconomics)

This week the Federal Reserve reported the Q3 2009 Flow of Funds accounts. The headline indicators show household net worth improving and private debt burden falling.

The private sector - households and firms - is dropping leverage.

Update: This chart has been modified slightly - the leverage level data (highlighted in blue, red, and green) has been updated.
Either by default or by growing saving, the private sector is de-leveraging. According to the D.1 table, households and nonfinancial businesses dropped debt a further 2.6% q/q annualized, while financial sector debt fell another 9.3%. However, total debt (of the domestic nonfinancial sector) grew 2.8%, as the federal and state and local governments grew debt 20.1% and 5.1%, respectively.

Household wealth grew $2.7 billion trillion for a cumulative gain of $4.9 billion trillion since wealth hit a cyclical low in Q1 2009. To put this gain in perspective, household net-worth dropped $17.5 billion trillion from Q3 2007 to Q1 2009, 3.5 x the recent gain. Wealth to disposable income, a statistically significant factor of the personal saving rate, rests right around it long-term (1952-1007) average, 4.9.

The chart illustrates the wealth-effect as the ratio of net-worth to disposable income. The direct and adverse impact of the wealth loss on consumption probably peaked last quarter; however, the lagged effects are ongoing.

Notice that the ratio shifted discretely in the 1990's, not coincidentally when China's current account surplus took off.

Most likely, the wealth to personal income ratio has mean-reverted, and will not rise back to its 5.7 1997-2007 average. A necessary condition is that global portfolio flows rebalance - i.e., China saves less and the US saves more. However, this will not happen tomorrow - de-leveraging is a process that takes years. The increase in international saving (i.e., falling current account deficits) will take some time, and by definition includes the general government eventually dropping its debt burden. Not to mention the political rhetoric and growing trade barriers suggest that a long-term economic shift is a ways off.

Rebecca Wilder

• Eurostar may struggle to move passengers by Christmas (Bloomberg)
• Lithuania let CIA use secret prison for interrogation (Bloomberg)
• A rising euro poses a threat to parts of block (WSJ)
• FBI probes hacker attack on Citigroup (WSJ, AP)
• Dubai stock markets to merge amid debt woe (WSJ)
• Are S&P 500 growth projections realistic (Seeking Alpha)
• Did deregulation cause the crash (The Claremont Institute)
• UK economy remains in recession (BBC)
• S&P - Nikkei spread collapses; Nikkei at 3 month high (Bloomberg)
• WTO backs ruling to loosen China media imports (MarketWatch)
• Eight things for markets to watch out for in 2010 (Bloomberg)
• Storm on big weekend raises worries for banks (NYT)
• Socialism creeps in as America sleeps (Investors.com)

 

The rating agency that has gotten selling out down to an art, just downgraded Greece from A1 to A2, yet kept it two notches higher than where the country is now fairly rated by Fitch and S&P, thereby preventing the country from collapsing into a liquidity crisis. By taking this action, Moody's has once again proven its utter worthlessness, by pretending to be objective while at the same time keeping an artificially inflated rating high enough to prevent the unforeseen spillover effects from Greece's inability to use Treasury's as ECB collateral: the definitive first domino to fall in Europe, about which we wrote 3 days ago.

Full Moody's ridicule script:

Moody's downgrades Greece to A2 from A1

Moody's Investors Service has today downgraded Greece's government bond ratings to A2 from A1. Today's rating action concludes the review for possible downgrade initiated by Moody's on 29 October 2009. The outlook is negative.

 

This rating action does not affect the ratings of Greece's country ceilings for bonds and bank deposits, which remain Aaa (like the rest of the Eurozone).

 

"Greece's repositioned rating of A2 balances the Greek government's very limited short-term liquidity risks on the one hand, and its medium- to long-term solvency risks on the other," says Sarah Carlson, Moody's lead sovereign analyst for Greece. Moody's notes that the country's longer-term risks have only partly been offset by the government's announced policy response.

 

Moody's had initiated its review of Greece's A1 sovereign rating in response to mounting evidence that the government's long-term credit strength was eroding materially. In particular, the rating agency intended to assess the new government's policy intentions and its room for manoeuvre.

 

"Moody's believes that Greece is extremely unlikely to face short-term liquidity/refinancing problems unless the European Central Bank decides to take the unusual step of making the sovereign debt of a member state ineligible as collateral for bank repurchase operations -- a risk that we consider very remote," says Arnaud Marès, Senior Vice President in Moody's Sovereign Risk Group.

Well, you know what they say one must do with any piece of paper that has the words "Moody's believes" on it...

Moreover, as evidenced by other support operations within the EU, Moody's indicated that there are potentially other means to mobilize emergency liquidity funding should it be required -- but Moody's does not believe that this will be necessary.

And again. For those who need a refresh, flashback to 2007 and this pearl: "Moody's does not believe that housing will pose a significant risk." Oh really now...

Moody's also does not believe that the Greek government's difficulties represent a vital test for the future of the eurozone, but rather a repricing of relative risks that had been concealed by years of abundant global liquidity and somewhat above-potential growth.

That's three times Moody's has said believe. Quite appropriate, two days before Christmas (yes, had it been Easter the irony would be supreme).

"The Greek government's credit challenges are of a longer-term nature," explains Ms. Carlson. "They stem from a slow erosion in competitiveness and economic potential, which implies that the government's debt problem cannot be resolved by growth alone. They also result from chronically weak fiscal institutions, which cast a shadow over the government's ability to implement decisive fiscal retrenchment in order to restore debt sustainability."

 

Furthermore, the combination of a global post-crisis environment that is less favourable to Greek public finance dynamics (with increased risk discrimination and muted global demand) and an equally challenging domestic environment (with accelerating demographic pressure on public finances in coming years) will make any fiscal adjustment increasingly difficult and costly to postpone. However, Moody's continues to think that a migration of liabilities from the banks' balance sheets to that of the sovereign is unlikely.

 

Moody's acknowledges that last week's announcements by the Greek government clearly identify these weaknesses and pave the way for a lasting solution. However, the long-term credit standing of Greece will depend on the Greek population's acceptance of these measures and the government's vigorous implementation of them. "As neither of these can be taken for granted, and because these measures will also take time to bear fruit, Moody's has placed a negative outlook on the Greek government's new A2 rating," says Ms. Carlson.

 

At A2, Greece's bond rating compares with those of other high-income but highly indebted countries that do not face external payment vulnerabilities. However, the rating is positioned well below those of Belgium, Ireland or Italy (which are rated at Aa1-Aa2) to reflect Greece's poor track record in terms of real fiscal adjustment. Greece's rating also remains higher than Baa-rated Mexico, Brazil or Hungary, all of which have better or similar debt metrics but much lower income levels. These countries also do not benefit from the protection against external payment crises afforded by Greece's membership in the European Monetary Union.

 

Looking ahead, the question of whether the negative outlook will evolve into a stable outlook or into a further downgrade will depend on the Greek government's plan being followed through -- as demonstrated for instance by a sustained increase in tax revenues and/or the effectiveness in reining-in expenditure.

And if all else makes perfect sense, even if it is in bizaro world, but that last paragraph is simply a killer. What world do these "analysts" live on?

Moody's last rating action with respect to the government of Greece was on October 29, 2009, when its A1 long-term debt ratings were placed on review for possible downgrade.

Once again the direct hotline straight to the cheap hooker suite at 7 World Trade Center does not disappoint. Today Trichet, tomorrow whoever is the next in dire need of "condoming" the most recent iteration of extend and pretend (if you get syphilis after rating agency rape and nobody sees your nose fall off, did you ever get a case of rating agency syphilis?). How Buffett is still involved in this garbage enterprise is beyond us. At least with an army of disgruntled Deep Shahs running around Moody's offices, one can be certain that at least several hedge funds found a way to make some serious money out of this latest piece of "news" from Moody's.

With sovereign CDS (and risk) finally becoming a heated topic of debate, Moody's has compiled its 2009 Review and 2010 Theme Review for sovereigns. The report opens with some rather stark and reasonable observations: "2010 may prove to be a tumultuous year for sovereign debt issuers given the uncertainties surrounding the likely pace and intensity of fiscal and monetary 'exit strategies' as governments start to unwind quantitative easing programs. Indeed, the only certainty is that the exit strategies will be fraught with a good deal of execution risk. In our view, the key policy challenge facing advanced economies is therefore to time the exit perfectly: not too quickly or too soon so as to prevent choking off growth; and not too slowly or too late so as not to unsettle financial markets." In short: 2010 will be the year when the experiment of offloading all private sector risk on the public balance sheet ends. Whether the conclusion will be a happy or sad one, remains to be seen.

A summary of Moody's key themes:

As the global economic recovery attains a more solid footing, 2010 will at best see a "normalization"and at worst a severe tightening in government financing conditions. Long-term interest rates may increase more rapidly than expected because of an over-reaction to economic news, which we believe will be mildly positive overall. Moreover, the slow unwinding of "quantitative easing" will accelerate this credit repricing process.

The end of exceptionally low financing conditions will expose the true cost of the crisis on government debt affordability across the world.

Aaa governments will probably not have the luxury of waiting for the recovery to be secured before announcing and perhaps also implementing credible fiscal consolidation programs.

As most governments simply cannot afford another financial crisis, they will attempt to ring-fence their balance sheets from selected contingent liabilities. This could in some cases create disorderly market conditions.

EMU membership will protect some countries against liquidity risk but not against long-term insolvency risk.

Despite a slow process of global sovereign risk convergence – i.e. a narrowing of the ratings gap between rich and poorer G20 countries – BRIC countries are unlikely to replace the large Aaas’ role as anchors to the system any time soon.

The crisis has once again revealed the dangers of financial globalization for emerging markets – namely, the upside of the recurrence of asset price inflation after the downside of precipitous outflows of capital. However, the arsenal of policy levers has not expanded.

Below is a summary of who did how in terms of their Moody's rating in 2009. The worst performers: Latvia, Lithuania, Japan, Iceland, and... no, not the US or UK, despite skyrocketing deficits, but Fiji and Jamaica instead. Score one for the frontal lobotomy machine.

Moody's ten core themes in more detail:

1. Aaa countries will probably not have the luxury of waiting for the recovery to be secured before announcing credible fiscal consolidation plans.
2. The “growth versus adjustment” debate is artificial: advanced economies will need as much adjustment as necessary, and as much growth as possible.
3. For countries operating at sharply lower output levels and with reduced growth potential, the debt equation will look increasingly complicated.
4. Most governments cannot afford another financial crisis. Attempting to ring-fence balance sheets from
   contingent liabilities will keep policy makers busy.
5. Very large public debt and low economic vitality will prompt unprecedented questions about how governments can discharge their obligations without changing the rules of the game.
6. EMU participation protects against liquidity risk but not against long-term insolvency.
7. The dangers of a rapid and debt-fuelled income convergence process will lead to renewed emphasis on total country debt.
8. Global sovereign risk convergence is at play, but only slowly.
9. While the crisis has confirmed the dangers of financial globalization for emerging markets, the arsenal of policy levers has not expanded.
10. Debt hang-hover will test social and political cohesiveness.

Full report for much more detail.

 

• GM is reportedly looking at "all offers" for Saab. (Apparently only unrealistic offers have been entertained hitherto). [dow jones]
• Dutch automaker Spyker: "Hey, we'll bid."  GM: "Anyone... anyone at all?  Bueller...?  Bueller...?" [marketwatch]
• China's Zhu Min: "The world does not have so much money to buy more US Treasuries." (Current account woes. Who knew?) [shanghi daily via drudge]
• Iranian troops lower flag and withdraw from Iraqi claimed oil well. (Iranian theft of U.S. egg nog shipment to troops suspected).  [reuters]
• In Russia, judo throws you.  (Do not fuck with judo black belt Putin.  Period.)  [reuters]
• Only ~$300 million to go.  (Unholy results of sinister Smurf-Azrael genetic hybrid experiments earn $27 million on first day).  [bloomberg]
• Brazil, environmentalists of convenience, cancel voluntary carbon auction due to lack of interest.  (Al Gore shocked into silence).  [mondo]
• NYSE US 100: Old and busted: food, fuel and fighters (ADM, HES, RTN).  New hotness: detroit, debt and, uh, debt. (F, MA, PNC).  [mondo]
• Reid game employs kino, negs, takeaways and, finally, outright prostitution to plow through last minute resistance and score with Ben Nelson (D-NE) [bloomberg]
• Fight in the Supreme Court may make legislative machinations look like romper room.  [later today on zero hedge]

There was a time when investment decisions had more to do with fundamentals than whether Bernanke would wake up tomorrow and decide it is time to stop the liquidity spigot (arguably, the only thing that matters these days). Indeed, if in the odd chance Bernanke is not reconfirmed by the Senate, the huge drop the market experienced last year when Congress refused to get Paulson's first TARP version to be shoved down its throat, will seem like a Sunday morning picnic.

In those long gone days when there was more to valuation than persistent bubble liquidity, investors used to look at arcana such as cash flow statement and balance sheets (and income statements as well, before the FASB decided to make a total mockery out of the joke that are "reported earnings").

One recent topic that Zero Hedge has discussed has been the increase in cash and cash equivalents on the balance sheet. We have highlighted how this increase in cash has been primarily a function of increasing debt and decreasing capital expenditures (both maintenance and growth), as companies have bunkered down while the recessionary storm rages.

Today, we analyze a broader set of metrics of the combined balance sheet of the 500 companies in the S&P 500 index. We have compiled key data on a quarterly basis for both the asset and liabilities side of the broadest cumulative balance sheet in the world.

The table below highlights all the data compiled via CapIQ:

Total assets have grown by 30% over the past 4 years, from $19 trillion to $24.6 trillion as of September 30, 2009. And while cash has exploded by 74% from $872 billion at the end of 2005 to $1.5 trillion most recently, as a percentage of total assets it has been relatively flat, rising from 4.6% to just 6.2%.

Ironically, goodwill growth has been substantial, accounting for nearly $400 billion of total asset expansion, from $1.2 trillion to $1.6 trillion. How to believe this "growth" in the face of one the roughest revaluation periods for corporate acquisitions is a different story. It is likely that many companies are far overdue for major goodwill writedowns, which lax accounting standards keep permitting to be indefinitely put off into the future.

On the liabilities side, there are no major surprises: debt has grown by nearly triple the amount that cash increased during the observed period. Debt grew by $1.8 trillion from $5 trillion to $6.8 trillion in the past four years. This is nearly 2.7x greater than the comparable increase in cash. This should be a major concern to all who claim that corporate deleveraging is ongoing, and that the corporate cash increase is sufficient to offset the debt increase.

Yet what likely is the most relevant observation is the disproportionate need to constantly lever up to extract ever declining cash out the asset base, as well as the broadly declining quality of S&P assets as measured by their actual cash generation capacity.

The graph below shows the material increase in both total and net leverage in the S&P as calculated by Total and Net Debt to EBITDA - the one metric that still has some credibility even as Earnings and EPS have been rendered practically meaningless courtesy of ever more toothless GAAP rules. Total leverage has increase from 4.6x to 5.8x in the last two years, and even factoring for the cash increase does not present a rosier picture: Net Leverage is up 20%, from 3.8x to 4.5x. In essence the entire S&P is one big High Yield credit, and would likely be rated in the B2/B area by the rating agencies (assuming these had any credibility). As such, the cost of debt of the combined S&P if it were a standalone company would be around 7.5-8.5%. That it is currently much lower due to the Fed's intervention in the interest rate market is an aberration: look for cost of debt (and, by implication, overall capital) to spike broadly over the next several years, as normalcy (hopefully) returns.

Lastly, an unpleasasnt picture emerges when analyzing the (adjusted) return on assets and equity (however with EBITDA instead of earnings in the numerator). Both the return on assets (EBITDA/total assets) and return on equity (EBITDA/Shareholders' Equity) has plunged, with the first dropping to 4.7% from a four year average of 5.8%, an 18.3% reduction, while ROE has dropped from a 4 year average of 29.2% to 24.1%: a comparable 17.4% plunge.

The preliminary conclusion is that companies are scrambling to beef up the asset side of their balance sheets even as debt continues to be a major threat. The problem, however, as this brief exercise has shown, is that incremental assets are of lesser and lesser quality (even assuming no major goodwill impairments in the future), and the actual cash they generate continues eroding. Absent a major secular breakthrough in economic efficiency, look for cash flow reduction trends to continue even as the S&P labors under ever increasing debt loads. And with the shadow banking and asset system still solidly dead, it appears that creating asset returns out of thin air will not be an option for the corporate world for a long time.

Source: CapitalIQ

A week ago we posed several questions to Goldman managing directors Lucas van Praag and David Viniar. Earlier today we received a broad response. We present it in its entirety for our readers. We will provide our counter-response shortly.

---

Dear Mr. Durden:

We read your comments about prop trading with interest.  I’ve addressed some of the points you raised, as well as the questions you directed to David Viniar and me.  The fact that I haven’t necessarily addressed all your points shouldn’t be construed as tacit acceptance of any of them.

1)      “Considering that Goldman must disclose a trading VaR, or value at risk on a quarterly basis, which over the past year has averaged over $200 million, one can back into actual prop capital and revenue”

Our VaR is primarily driven by client-related activity rather than proprietary activity.  Using VaR to “back into actual prop capital and revenue” would produce a meaningless result.

2)      “A month ago Zero Hedge presented a unique glance into Goldman’s prop trading activities courtesy of the 2008 tax filing of the Goldman Sachs Foundation”

Your premise wrong. There are tax and legal restrictions which prohibit the firm from trading on the Foundation’s behalf.

3)      “Goldman disclosed that it had $352.2 billion in fair value of principal trading instruments at September 30, 2009. How much of this is considered allocated to prop if this is in fact a distinct strategy from principal?”

The $352.2bn is the fair value of our trading assets, the vast majority of which consist of trading inventory we use to make markets for our clients.

4)      “Does the firm's FICC revenue line have absolutely no prop trading embedded within it? Goldman made $20 billion in FICC year to date: is none of this $20 billion due to capital at risk, or is it all due to wide bid//ask spreads? ”

We’ve said publicly that prop trading represents approximately 10% of this year’s reported net revenue.  Some of that revenue is reflected in the FICC line.

We generate the vast majority of our revenue in FICC by facilitating trading activity for our clients and nearly all our revenues in FICC are “due to capital at risk” (your phrase).  In periods  when capital withdraws from the market, bid-offer spreads tend to widen and we benefit to the extent that we are willing to commit capital and do so successfully. These activities necessarily involve risk taking.

Over the last 5 years, prop investing activities have represented about 12% of firmwide net revenues

5)      “What was the pro rata allocation to Goldman Sachs Foundation as a percentage of capital per each trading ticket in 2008? Does GSF have a dedicated trading silo within Goldman?”

As I said above, as required by law, the Goldman Sachs Foundation is managed separately. There are no “trading silos” dedicated to the Foundation’s activities

6)      “Why did the Goldman Sachs Foundation not participate in Goldman's prop CDS trades?”

See above. 

7)      “How much did Goldman's prop operations lose in 2008 trading Russell 1000 futures?”

The amount was de minimus.

8)      “How much did Goldman's prop operations lose trading all equity, credit and commodity products?”

Not disclosed

9)      “When will Goldman clearly and distinctly segregate on its income statement the prop trading profit and losses, if these are in fact unique from "principal" trading as defined, and attach an MD&A to all relevant disclosure?”

Our proprietary activity is small in the context of the firm’s overall revenues and risk exposures.

10)     “Goldman is insinuating is that the firm's prop trading really carries virtually no risk.”

We don’t think any trading activity is risk-free. Risk is risk, and our job is to make sure individual risks are appropriately sized.

11)     “How do you define market risk?”

We define it as the potential for change in the market value of our trading and investing positions.

12)      “Do you take fixed price positions?”

Please explain your question.

13)     “Are you exclusively a hedger or do you ‘optimize’ your assets?”

Please clarify what you mean.

14)     “Do you have a risk policy?”

Yes.  We think of risk management as being one of our core competencies and it remains integral to our success as a firm. 

Our management team is active in risk management discussions across the firm and open discussion on the subject are encouraged.  By the way, we think fair value accounting is a critically important aspect of risk management.  Another important tenet of our approach to risk management is the independence of control functions from the business units

We also use a variety of approaches to monitor risk.  In addition to VaR, we use multiple stressed-based methodologies, including jump-to-default analyses, to quantify tail risks. 

16) “How do you monitor trading/hedging limits?”

Virtually all of our equity and fixed Income businesses receive VaR based risk-limits, aged inventory limits and balance sheet limits. The limits are reviewed by senior management and Risk Committee on a regular basis.

17)  “Mr. David Viniar, who recently said that the firm doesn't benefit from any implicit government guarantee. Goldman, as presented here, benefits directly from $21 billion in FDIC (taxpayer)-insured bond issues. How does Mr. Viniar reconcile this particular fact with his spurious claim?”

We don’t believe that we have any form of guarantee, implicit or otherwise, from anyone and we certainly don’t manage our business as though we do.

We issued debt under the FDIC’s Temporary Loan Guarantee Program and, like every other bank that issued debt under the program, paid the FDIC a significant amount of money upfront for the guarantee. We also pay interest to the investors who bought the notes. We stopped issuing debt under the program in March. The notes are not callable.

In the context of the firm’s approximately $900 billion balance sheet and hundreds of billions of dollars of funding, we don’t think any informed investor would believe that FDIC insurance on a small portion of our funding represented a “guarantee” of the firm.

Regards / Lucas van Praag

More lucid insight from the brilliant mind of Don Coxe, who this month focuses on Ben Bernanke's one and only specialty: the soothing short-term affect on pre-terminal symptoms of addictive, and very deadly, financial heroin. 

On those who dispense heroing to soothe the symptoms, and on those who actually make things better.

If Ben the Heroin Hero stops the infusions in time, he will deserve to be mentioned in the same breath as Paul Volcker—a real hero….

Because he will have done the brave thing—at the risk of the loss of his job and of the Fed’s independence.

Already the Pelosi Congress is considering legislation that would (1) subject Fed monetary policies to review by the Congressional Budget Office, and (2) strip the Fed of its supervisory authority over financial institutions, handing that power to a new agency created by Congress—presumably in the image of its Creator. The same politicians who applauded so vigorously as Fannie and Freddie debased the lending requirements for mortgages and expanded their balance sheets so recklessly, now seek to apply that expertise to supervision of the entire banking system.

Last week, Volcker, the man who has done more than anyone in modern history to design and deliver sound regulation to international banking, told a London audience what he thought was good and what was bad about today’s banks.

Volcker said the “single most important contribution” they’ve made in the last 25 years was introducing ATMs. ATMs meet, he said, the test of being “useful.” Apart from that, he had nothing good to say about commercial banks that behaved as investment banks. He agreed with the head of Britain’s Financial Service Authority that such banks are “socially useless.” He said derivatives, such as credit swaps and collateralized debt obligations, had taken the economy “right to the brink of disaster.” He noted that the economy had grown faster during the 1960s when such instruments didn’t exist.

One shocked member of his fi nancial audience challenged his dismissal of modern finance, and the magisterial Volcker huffed, “You can innovate as much as you like, but do it within a structure that doesn’t put the whole economy at risk.” He reiterated his support of Soros’ view that “proprietary trading should be pushed out of investment banks to hedge funds where it belongs.”

On weapons of financial mass destruction:

Volcker is right. The collateralized debt obligations, collateralized mortgage-back securities, and other computer-spawned complexities and playthings were not the solutions to basic needs in the economy, but to unslaked greeds on Wall Street. Without them, banks would have had no choice but to continue to devote their capital and talents to meeting real needs from businesses and consumers, and there would have been no crisis, no crash, and no recession.

Bernanke would doubtless concur, although he doesn’t dare say so in public. He is engaged in a multi-trillion-dollar rescue operation to save the global economy from collapsing under the weight of toxic derivatives and bad trading bets.

When will he take the risk of stemming the heroin flow?

As the 1970s demonstrated, the longer central banks wait to scale back on above-trend money growth, the worse the ensuing infl ation—even when the economy slides back into recession. It would seem that the appropriate year-end advice for levered bettors on US stocks and corporate bonds is, “Enjoy yourself, it’s later than you think.”

Lots has been spent: yet it is seemingly never enough:

After previous deep recessions, the snapbacks were dramatic, as inventory liquidation turned to inventory accumulation, and layoffs turned to callbacks. Despite all those trillions spent and all that monetary stimulus, the US economy has moved only from the critical care ward to the ambulatory convalescent wing.

With winter coming on, Bernanke, Obama & Co. could soon be of the same view as the despairing Lady Macbeth: “Nought’s had; all’s spent.”

And how to invest in the face of an endless bubble:

In brief, as long as you don’t try to delude yourself that you’re a value investor when you’re buying the typical non-commodity and cyclical components of the S&P or the Russell 2000, you can console yourself in the knowledge that this particular bubble may not be ready to burst for some months.

However, the amount of Bernanke pumping needed to keep it afloat is increasing, which suggests even he can’t keep this bubble alive much longer if the real economy fails to take wing. Despite a huge upside breakout of the Monetary Base in the past two months, the S&P has moved up just a tad. Even that move is suspect, because it has been accompanied by a plunge in short sales of non-financial stocks, and lackluster volumes.

Today's must read

 

h/t Mike

As was pointed out yesterday, Morgan Stanley's massive Real Estate empire is starting to unravel building by building. With a building here, five buildings there, the shareholder pain, and the writedowns start accumulating. But it was not always makeshift tears and walking away from buidings when your equity is underwater. In those long ago days of 2005 it was hope and bubblemania. Which is why we dug up various Morgan Stanley Real Estate Fund documents and materials, exposing the firm's delirium just as the peak in the real estate bubble was about to set in.

First we highlight the International Fundraising document used by MSRE Fund V, as we try to trace back where it is that things got so horribly wrong for Morgan Stanely and for investors in this and its other funds.

Notable is the incentivisation structure, particularly the "acquisition fee" - a fixed fee in addition to the traditional management fee, as can be seen below, is to incentivize the group to do deals. Any deals - even really dumb deals. And the traditional approach by MS: use firm capital as an initial equity investment, then fundraise around this. At the time, MS had no problem closing on $4.2 billion of equity capital commitments. Morgan Stanley accounted for 10% of both the MSREF IV and V investor base. This money has mostly evaporated. Tough for the retail investors as well, who lost as much as MS did. And all the while MS rakes in the cash in the form of the management fee, the acquisition fee and the GP promote (of course, as long as things are going well. When they implode, like they have now, the firm can simply walk away).

And from the associated commentary:

MSREF V lnternational ('MSREF V") has closed with $4.2Bn of capital commitments

• 76% increase in equity raised and 126% increase in the number of investors vs. MSREF lV lnternational ('MSREF lV")

Don't these investors now wish there was a minus sign ahead of that number...

• 16 of MSREF V 24 institutional (67%) investors participated in MSREF V
• 26% of institutional capital (c. $850MM) are new to the MSREF program

More thoughts along the same lines.

• Largest real estate focused fund raised to date

The bigger they are, the harder they fall. And the more bailout money they receive.

Below is a detailed breakdown of who lost lots of money with Morgan Stanley failed Real Estate ventures:

• MSREF V is more diversified in its investor base with double the High Net Worth investors and a large pool of government agency capital

Gee, and we wondered who the Fed keeps on bailing out with all those MBS purchases.

• At the time of closing, MSREF V lnternational had already closed or committed on 40 investments totaling $1.48n of equity

I.e., there are at least 35 other buildings from which MS is about to walk away from. And this is only for the 2005 vintage. This must be "quite favorable" for rental and capitalization rates.

Looking at the broader group of all MS Real Estate products, 2004 and 2005 were good years, generating $750 and $1.2 billion, respectively. Of course, that revenue is now gone, as is the equity. We do not anticipate seeing this presentation for 2008 and 2009.

Real estate was in fact such a huge cash cow for MS, that it was "the top producing industry sector for IBD" in 2005:

And just in case anyone was wondering which bank was impacted the most from the collapse in real estate, the following league table chart should put it all into perspective:

A key question investors have had is how much capital has the firm blown down the rabbit hole. The following table should provide a broad sense.

Yup. Well over $5 billion. And this excludes all of 2006 and 2007. What was Morgan Stanley's TARP bailout amount once again?

As for future implosions after the San Francisco debacle? The list below is a rough indication. Once we obtain a full list of what the firm invested in in 2006 and 2007 we will promptly provide it.

We will leave off part 1 of this overview, with the one thing that nobody ever reads until it is far too late: the Conflicts Of Interest. These may be of particular interest nowadays, as specualtors are left to pick up the pieces on what Morgan Stanley decides to simply walk away from.

Below is the entire risk factor section from the bank's Real Estate Special Situations Fund III (yes, a different one) from November 2005. Grab a coffee - it's a fun (and long) read.

POTENTIAL CONFLICTS OF INTEREST

GENERAL

Investors should be aware that there will be occasions when Morgan Stanley, the General Partner, their affiliates, directors, partners, trustees, managers, members, officers and employees (collectively, for purposes of this “Section VI: Potential Conflicts of Interest,” “Morgan Stanley”) encounter potential conflicts of interest in connection with Special Situations III. These conflicts may arise in part because, as a diversified financial services firm, Morgan Stanley engages in a broad spectrum of activities, including financial advisory services, merchant banking, lending, arranging securitizations and other financings, sponsoring and managing private investment funds, engaging in broker-dealer activities, conducting an asset management business and other activities, some of which may be conducted on behalf of clients. In the ordinary course of its investment banking business, Morgan Stanley engages in activities where Morgan Stanley’s interests or the interests of its investment banking clients may conflict with the interests of the SS III Limited Partners, notwithstanding Morgan Stanley’s participation as a Limited Partner of the Fund. By acquiring SS III Units, each SS III Limited Partner will be deemed to have acknowledged the existence of, and to have consented to, such actual and potential conflicts of interest between the proposed activities of Special Situations III and the business activities of Morgan Stanley, and to have waived any claim with respect to the existence of any such conflict of interest.

The Advisory Committee will consider and, on behalf of the Limited Partners (excluding the General Partner), approve or disapprove, to the extent required by applicable law, including Section 206(3) of the U.S. Advisers Act, principal transactions and certain other related party transactions.

The following discussion enumerates certain potential conflicts of interest which should be carefully evaluated before making an investment in Special Situations III.

CLIENT RELATIONSHIPS

Morgan Stanley has existing and potential relationships with a significant number of corporations, institutions and individuals. In providing services to its clients and Special Situations III, Morgan  Stanley may face conflicts of interest with respect to activities recommended to or performed for such clients, on the one hand, and Special Situations III, the SS III Limited Partners or the entities in which the Fund invests, on the other hand. In addition, these client relationships may present conflicts of interest in determining whether to offer certain investment opportunities to the Fund.

In acting as principal or in providing advisory and other services to its other clients, Morgan Stanley may engage in or recommend activities with respect to a particular matter that conflict with or are different from activities engaged in or recommended by the General Partner on behalf of the Fund.

REAL ESTATE AND INVESTMENT BANKING ACTIVITIES

Morgan Stanley is involved in a broad range of investment banking activities, as described under “— General” above. For example, Morgan Stanley often represents potential purchasers and sellers in real estate related transactions or parties in corporate transactions. Morgan Stanley will continue to accept such assignments after the establishment of Special Situations III. In these cases, such Morgan Stanley client relationships may result in the Fund not being able to pursue certain investment opportunities. Accordingly, no assurances can be given that all potentially suitable real estate investments will be offered to the Fund.

From time to time, Morgan Stanley’s investment banking professionals may introduce to the Fund a client that requires an equity investment to complete an acquisition transaction. If the Fund pursues the resulting equity investment, Morgan Stanley could have a conflict in its representation of the client over the price and terms of the Fund’s investment. Furthermore, the Fund will not generally purchase securities being underwritten by Morgan Stanley, thereby limiting the ability of the Fund to make such investments.

In addition, Morgan Stanley could provide real estate and investment banking services to  competitors of companies in which the Fund invests, in which case it will take appropriate steps to safeguard the confidential information of each client. Such activities may present Morgan Stanley with a conflict of interest vis-à-vis the companies in which the Fund invests and may also result in a conflict with respect to the allocation of investment banking resources to such companies.

From time to time, Morgan Stanley may come into possession of material, non-public information or other information that could limit the ability of the Fund to buy and sell investments. The Fund’s investment flexibility may be constrained as a consequence.

MORGAN STANLEY AS LENDER

Morgan Stanley engages in a variety of activities involving the origination, funding and purchase of loans relating to real estate through its Securitized Products Group (“SPG”). Situations may arise where the Fund is one of several bidders for an investment property and SPG or another Morgan Stanley affiliate is financing a bid of another bidder for the same property. SPG or another Morgan Stanley affiliate may hold a loan on a property and such loan may be repaid in connection with an equity investment by a client advised by Morgan Stanley or an affiliate (including the Fund). SPG or other Morgan Stanley affiliates may originate loans to facilitate the Fund’s investment in companies, or purchase existing loans to companies in which the Fund has invested until they can be securitized or resold. In these and other situations, the interests of SPG or the other relevant Morgan Stanley affiliate may conflict with those of the Fund. For example, the situation may arise where SPG is required to take action or make decisions with respect to loans relating to one or more companies in which the Fund has invested (such as renegotiating the terms of a loan, deciding whether to grant a consent or waiver with respect to such loan or taking action due to a default under such loan) that were originated by or pledged to SPG in the course of its business activities. These activities (such as loan origination or purchase) will be undertaken by Morgan Stanley in its own capacity, will not require the consent of the Fund or the SS III Limited Partners, and may conflict with the interests of the Fund. In any event, in connection with the foregoing activities, appropriate safeguards will be maintained to preserve the confidentiality of the  respective clients’ information.

THE FUND AS A POTENTIAL CREDITOR

The Fund may invest directly or indirectly in debt securities or obligations of other Morgan Stanley affiliates or clients, in which case potential conflicts of interest would arise insofar as the Fund would have an interest in structuring the financial and other terms (such as interest and  repayment terms, covenants and events of default) to be more restrictive than the Morgan Stanley affiliate or client, as equity owner, may desire. In addition, further conflicts could arise after the closing of the investment. For example, conflicts would arise if a company is unable to meet its  payment obligations or comply with covenants relating to securities held by the Fund. If additional funds are necessary as a result of financial or other difficulties, it may not be in the best interests of the Fund to provide such additional funds. If the obligor would lose its investment as a result of such difficulties, the General Partner may have a conflict of interest relative to the other Morgan Stanley affiliate in recommending actions that are in the best interest of the Fund.

BUYING AND SELLING ASSETS

The Fund may purchase assets from or sell assets to the General Partner and its affiliates (including other Morgan Stanley sponsored funds). These transactions generally will not require the approval of the SS III Limited Partners. Any such purchases and sales could involve conflicts of interest with respect to price and other terms applicable to the transactions.

The General Partner may, without the consent of the SS III Limited Partners, determine to have the Fund make (i) any investment relating to any transaction in which Morgan Stanley has entered into an agreement or an agreement in principle prior to the date of the initial Subscription Date or (ii) any investment which Morgan Stanley shall have purchased on the Fund’s behalf prior to such date. The Fund will acquire any such investment from Morgan Stanley at Morgan Stanley’s total cost (including all acquisition costs) plus interest thereon at 9% per annum.

FEES FOR SERVICES

It is contemplated that Morgan Stanley will normally seek to perform investment banking and other services for, and will expect to receive customary investment banking compensation from, the Fund, the entities in which the Fund invests or other parties in connection with transactions related to the Fund’s investments. Such compensation could include financial advisory fees or fees in connection with restructurings and mergers and acquisitions, as well as underwriting or placement fees, financing or commitment fees, proxy solicitation fees and brokerage fees. These fees will not be shared with Special Situations III or the SS III Limited Partners, will not reduce the Management Fees and Incentive Allocation payable by or on behalf of the Fund and the SS III Limited Partners, and may not be the result of arm’s-length negotiations.

In addition, from time to time, the General Partner may request that various Morgan Stanley business units, or entities in which Morgan Stanley business units have an economic interest, provide services to the Fund for customary compensation. Morgan Stanley may provide the Fund with certain data processing, legal or insurance purchasing or administrative services (but excluding accounting services) which would otherwise be performed for the Fund by third parties and, in such event, Morgan Stanley will be reimbursed by the Fund therefor.

INVESTMENTS BY MORGAN STANLEY AND OTHER MORGAN STANLEY FUNDS OR SEPARATE SCCOUNTS

Morgan Stanley Related Persons will not make principal investments in securities of any Applicable Real Estate Company that are acquired in privately negotiated transactions, subject to certain exceptions, without first offering them to Morgan Stanley Real Estate for allocation among its clients as described below. The exceptions include, among other things, investments in connection with the operation of Morgan Stanley’s other businesses; investments made in connection with any co-investment with a Morgan Stanley Real Estate client, provided that such investment is not on terms more favorable than those applicable to the Morgan Stanley Real Estate client; investments made in connection with certain underwriting, broker-dealer, real estate brokerage or capital market activities of Morgan Stanley; investments offered as compensation for advisory services; investments offered exclusively to Morgan Stanley; investments made in connection with originating, purchasing as agent or principal, trading, restructuring, repackaging or otherwise dealing in portfolios of mortgage loans (other than portfolios of nonperforming loans) relating to the real estate and debt capital markets operations of Morgan Stanley; investments in connection with the purchase of a portfolio of securities, investments made in connection with any  discretionary or managed client accounts in an immaterial amount as determined by the General Partner in its sole discretion, investments of not more than $10 million; and other investments that the General Partner determines in good faith, after disclosure to the Advisory Committee, not to be in competition with Morgan Stanley Real Estate’s clients.

The General Partner and its affiliates within Morgan Stanley Real Estate manage real estate assets on behalf of their clients and investors in their funds, which include a wide variety of corporations, partnerships and trusts, public and corporate pension funds, insurance companies, endowments, foundations, foreign institutions, and high net worth individuals. There may from time to time be individual assets that meet the investment parameters of both the Fund and one or more of such clients and investors. In addition, certain of such clients have or will have priority rights in respect of certain types of investments pursuant to the terms agreed upon with such clients or pursuant to applicable law, rule or regulation in the jurisdictions in which such clients are organized or operated, which may result in such investments being allocated exclusively to such clients and not to the Fund (except to the extent such clients do not exercise their rights). For example, transactions sourced internally by Morgan Stanley’s German-regulated investment funds platform (the “KAG Platform”) must be offered first to the KAG Platform, which currently only sponsors funds seeking core and core-plus returns. In addition, Morgan Stanley Real Estate Fund V International—T, L.P. and the sister partnerships that co-invest with it, and Morgan Stanley Real Estate Fund V U.S., L.P. and the sister partnerships that co-invest with it, and such programs’ respective successor funds will each be accorded priority over controlling investments in real estate-related opportunities that, at the time they are evaluated, are projected to achieve returns of an “opportunistic” nature, including minority investments if, in good faith, the fund ultimately intends to seek to acquire a control position.

After taking account of any priority rights of other funds or accounts, opportunities sourced by or presented to Morgan Stanley Real Estate are allocated to funds or other accounts that are clients of Morgan Stanley Real Estate in accordance with the Allocation Process to reduce potential conflicts of interest and to ensure that opportunities are allocated in a fair and equitable manner. The Allocation Process may change from time to time in the sole discretion of Morgan Stanley without notice to the investors but, subject to any priority rights described above, in no event will Morgan Stanley adopt an allocation process that does not allocate investment opportunities in a fair and equitable manner.

The Allocation Process is intended to ensure that all clients of Morgan Stanley Real Estate,  including the Fund, will have fair access to new real estate investment opportunities made available to such clients.

Each client of Morgan Stanley Real Estate, including the Fund, is assigned a portfolio manager who develops an annual plan detailing the client’s desired investment volume, transaction structure,  risk/return profile and, by property type, the desired physical characteristics, pricing, leasing risk and target markets.

The portfolio managers meet regularly to review current real estate investment opportunities which have been identified by or made available to Morgan Stanley Real Estate. Any portfolio manager may select from these new opportunities, for further consideration, those proposed transactions which may fit a particular client’s investment parameters. If, as a result of the meetings among portfolio managers, an investment is identified for the Fund that is also suitable for one or more of Morgan Stanley Real Estate’s other clients, an investment allocation committee (the “Allocation Committee”) will prioritize such investment among Morgan Stanley Real Estate’s clients. If an investment opportunity is suited for more than one client, the Allocation Committee will consider various factors to allocate opportunities among clients. If, after considering these factors, the Allocation Committee believes that the investment is suitable for more than one of Morgan Stanley Real Estate’s clients, the committee will generally allocate the opportunity pursuant to a rotation system, except that certain investment funds will be accorded priority rights as discussed above.

Factors considered by the Allocation Committee in prioritizing and allocating investment  opportunities include, but are not limited to: (i) the client’s investment parameters, including return objectives, size of transaction, geographic location, property type, and risk tolerance; (ii) discretionary or non-discretionary requirements of the seller or borrower; (iii) the ability of the client to meet the proposed transaction’s timing sensitivity or remain flexible in the face of anticipated changes; (iv) specific requests of the party offering the opportunities; (v) other diversification requirements, such as whether the transaction is complementary to the client’s existing portfolio; (vi) contractual, regulatory and other legal requirements, including preferences concerning investments of a particular type that may have been, or may in the future be, granted to one or more clients targeting that type of investment with the concurrence of other clients with similar investment objectives; and (vii) in the event the rotation system is required or deemed desirable by the committee, the aggregate dollar amount invested and number and timing of transactions previously closed on behalf of the client. The ultimate allocation decision is formally approved by the Allocation Committee, which will be empowered to take into account other considerations it deems appropriate to ensure a fair and equitable allocation of opportunities.

Under the Allocation Process, while Morgan Stanley Real Estate will have the discretion to allocate portions of investment opportunities to multiple funds or accounts, generally it is expected that they will be awarded to one fund or account in accordance with the Allocation Process. In  situations in which the capacity of a potential investment opportunity is limited and Morgan Stanley Real Estate determines that multiple funds or accounts, including the Fund, will make side-by-side investments, this may result in the Fund making a smaller investment than it would have absent such determination. Potential conflicts may arise in situations where the Fund and other Morgan Stanley Real Estate clients or Morgan Stanley affiliates make side-by-side investments. For example, because the Fund and such other clients or affiliates may have different investment objectives or strategies or because of other differences, Morgan Stanley Real Estate or Morgan Stanley may make different decisions on behalf of the Fund and such clients or affiliates as to the appropriate time or manner of exiting such investments, and such decisions made on behalf of the other clients or affiliates could adversely affect the value of the Fund's investment.

CO-INVESTMENTS WITH MORGAN STANLEY AFFILIATES

If the General Partner determines that the Fund should commit to invest less than the amount offered to the Fund with respect to an investment opportunity or should decline an investment opportunity, the General Partner may present to any person (including Morgan Stanley affiliates or some or all of the Limited Partners, as determined by the General Partner in its sole discretion) all or any portion of such investment opportunity remaining after taking into account the investment, if any, by the Fund.

The Fund may also make investments in transactions that have already been structured and  committed to by another Morgan Stanley affiliate. There can be no assurance that the return on the Fund’s investments will be equivalent to or better than the returns obtained by the other affiliates participating in the transaction. Morgan Stanley has made and will make large capital investments in other funds, and therefore may have conflicting interests in connection with any joint investments. It is not expected that any independent evaluation of a proposed transaction will be available.

The decision to allocate a particular investment between the Fund and other Morgan Stanley affiliates may involve conflicts of interest. See “—Investments by Morgan Stanley and Other Morgan Stanley Funds or Separate Accounts” above. The Fund may also give co-investment opportunities to certain Limited Partners, including Limited Partners with which Morgan Stanley has significant relationships and not other Limited Partners, which could present certain conflicts of interest. Further potential conflicts of interest could arise after the Fund and other affiliates have made their respective investments, including where the investment objectives, expected exit timing or financial resources of the co-investing entities differ substantially from those of the Fund.

The Fund may partner with operating companies or other entities in which a Prior Fund or other Morgan Stanley affiliate holds an investment or with which the Prior Fund or Morgan Stanley has a significant business relationship. The terms and conditions (including fees) governing the Fund’s relationship with such entities may not be the result of arm’s-length negotiations.

ASSET MANAGEMENT

Morgan Stanley conducts a variety of asset management activities, including sponsoring investment funds registered and regulated under the U.S. Investment Company Act. Such activities also include managing assets of pension funds, which are subject to federal pension law and its regulations, real estate separate accounts for institutional clients and portfolios of publicly traded securities. These activities may present conflicts of interest if the Fund pursues an investment in or transaction involving a company or property in which an entity in which Morgan Stanley’s asset management clients or investment companies have previously invested, or a company or property in which an entity in which Morgan Stanley’s asset management clients or investment companies have previously invested has an interest. In certain situations, the Fund may be restricted or precluded from pursuing an investment with respect to any such company or property due to certain regulatory considerations, such as Section 17 of the U.S. Investment Company Act. In addition, in the course of making investments or otherwise engaging in  investment or asset management activities for itself or its affiliates (including without limitation Morgan Stanley managed funds or accounts), Morgan Stanley may on behalf of itself and/or any affiliates (including without limitation Special Situations III) agree not to compete with certain parties or not to make investments in certain geographical areas, or otherwise agree to certain covenants that may place significant restrictions on the investment or other activities of itself and its affiliates, including without limitation, Special Situations III.

PROMOTION OF THE FUND

Morgan Stanley’s sales personnel have interests in promoting sales of SS III Units. Their remuneration relating to sales of SS III Units may be greater than that of other products that they might offer on behalf of Morgan Stanley and, accordingly, Morgan Stanley’s sales personnel may have an incentive to sell SS III Units.

INVESTMENT IN MORGAN STANLEY MONEY MARKET FUNDS

To the extent permitted by applicable law, Special Situations III may make short term investments of excess cash in money market funds sponsored or managed by Morgan Stanley. In connection with any of these investments, Special Situations III will pay all fees pertaining to the investments and no portion of any fees otherwise payable to Special Situations III will be offset against fees payable in accordance with any of these investments (i.e., there could be “double fees” involved in making any of these investments). In these circumstances, as well as in all other circumstances in which Morgan Stanley receives any fees or other compensation in any form relating to the provision of services, no accounting or repayment to Special Situations III will be required.

INCENTIVE ALLOCATION

The General Partner’s Incentive Allocation may create an incentive for the General Partner to make more speculative investments on behalf of the Fund than it would otherwise make in the absence of such performance-based compensation. In addition, the method of calculating the Incentive Allocation may result in conflicts of interest between the General Partner and the SS III Limited Partners with respect to the management, disposition and valuation of investments. Since the Incentive Allocation is calculated on a basis that includes unrealized appreciation of the Fund's assets, such compensation may be greater than if it were based solely on realized gains and losses. There can be no assurance that the Fund’s valuation of a Fund investment will represent the value that will be realized by the Fund on the eventual disposition of such investment or that would, in fact, be realized upon immediate disposition of such investment on the date of its valuation. If the Fund overvalues an investment, the benefits to the General Partner, including higher fees and performance-based compensation, as well as to personnel of the General Partner who may be responsible for the part of the Fund’s valuation process, as members of the MSRESS III Team, to be performed by the General Partner, will be greater than if a lower value had been
used. See “Section V: Certain Risk Factors—Valuation of Fund Investments.”

MANAGEMENT OF THE FUND

The personnel of the General Partner or its affiliates will devote such time as the General Partner, in its sole discretion, deems necessary to carry out the operations of Special Situations III effectively. It is expected that the Morgan Stanley officers and employees responsible for managing the General Partner will continue to oversee the Prior Funds and other funds and separate accounts managed by MSRE.

Morgan Stanley’s activities in respect of such other funds and accounts may be competitive with the Fund's activities. In addition, conflicts of interest may arise in allocating time, services or functions of these officers and employees.

PROPRIETARY ACTIVITIES

Morgan Stanley is an active participant, as agent and principal, in the global real estate markets. Morgan Stanley may invest or trade in the equity, debt or other interests of companies in which the Fund invests without regard to the Fund’s investment objective. These activities may include, without limitation, acquiring positions that are based on the same or a different strategy than that of the Fund. For example, Fund investments in public companies may impact Morgan Stanley’s trading flexibility in those securities. In this regard, from time to time, Morgan Stanley may choose not to act as a financial advisor in particular situations, although requested to do so, in order not to circumscribe its trading flexibility. Morgan Stanley may similarly elect not to undertake certain activities on behalf of the Fund in order not to limit its trading flexibility. Morgan Stanley may retain any profits that it may make in these transactions.

ACTIVITIES OF MORGAN STANLEY EMPLOYEES

The General Partner, the Investment Committee and the MSRESS III Team will generally consist of Morgan Stanley Real Estate employees. Such personnel will be responsible for the senior  management, direction and daily operations of the Fund, and will spend such time on the business and operations of the Fund as deemed advisable by the General Partner in its sole discretion. However, such personnel will generally have other functions and responsibilities for Morgan Stanley Real Estate and Morgan Stanley, and therefore generally will not spend all or substantially all of their time on the business and operations of the Fund and the performance of the Fund may suffer as a result. From time to time and subject to Morgan Stanley’s internal policies and procedures, Special Situations III personnel may consult with personnel in other areas of Morgan Stanley. Such persons may receive information regarding the General Partner’s proposed investment activities of the Fund that is not generally available to the public. However, there will be no obligation on the part of such persons to make available for use by the Fund any information or strategies known to them or developed in connection with their own client, proprietary or other activities. In addition, Morgan Stanley will be under no obligation to make available any research or analysis prior to its public dissemination.

The General Partner’s employees are subject to Morgan Stanley’s Code of Ethics and Business Practices (the “Code of Ethics”) and internal policies which prohibit them from investing in the securities of any company whose securities are under consideration for investment or have been acquired by a client of the General Partner. The Code of Ethics requires all Morgan Stanley employees to understand and comply with the laws, regulations and internal policies applicable to them, encourages employees to ask questions of supervisors and internal counsel and requires employees to put client interests first and avoid the appearance of impropriety. Additionally, the Code of Ethics and other internal policies require employees of Special Situations III to carefully protect confidential information obtained in the course of the GeneralPartner’s business, to provide fair and truthful disclosure to the public and to maintain accurate books and records.

In addition to guidelines on business conduct, the Code of Ethics and other internal policies also contain a number of policies governing the securities trading activities of Special Situations III’s employees for their own accounts. Those policies generally require all affected Special Situations III employees to maintain their securities accounts at Morgan Stanley, and requires all personal securities transactions to be pre-cleared by senior business managers and Morgan Stanley’s Compliance Department. In addition, Morgan Stanley Real Estate’s Chief Compliance Officer or other senior business managers annually review each Special Situations III employee’s securities holdings and each quarter reviews a report of all Special Situations III employee trades for the preceding quarter. These reports are prepared to detect whether Special Situations III employees are improperly trading on client information or otherwise improperly benefiting themselves. Suspicious activity and violations of the Code of Ethics are dealt with seriously and promptly.

DIFFERENT INTERESTS AND TERMS RELATING TO LIMITED PARTNERS

The SS III Limited Partners are expected to include taxable and tax-exempt entities and may include persons or entities organized in various jurisdictions, including non-U.S. jurisdictions. Because of the diverse investor base, SS III Limited Partners may have conflicting investment, tax and other interests with respect to their investment in Special Situations III. Conflicting interests of Limited Partners may relate to or arise from, among other things, the nature of investments, the currency in which investments are denominated, the structuring of investments and the timing of disposition of investments. Such factors may result in different after-tax returns being realized by different SS III Limited Partners. Conflicts may arise in connection with decisions made by the General Partner that may be beneficial for one SS III Limited Partner but not for another SS III Limited Partner, particularly with respect to individual SS III Limited Partners’ tax situations. In selecting investments appropriate for the Fund and structuring such investments, the General Partner will consider the investment objectives of the Fund as a whole rather than the investment objectives or particular tax or regulatory situation of any individual SS III Limited Partner.

Notwithstanding anything herein to the contrary, the General Partner reserves the right, in its sole discretion, to reduce all or any portion of or modify in any way the Management Fee or Incentive Allocation applicable to any SS III Limited Partner (including without limitation Morgan Stanley Investors and Related Funds formed for the purpose of participation by Morgan Stanley Investors) as may be agreed to by the General Partner and such SS III Limited Partners, and the General Partner may unilaterally make appropriate amendments to or supplement the Partnership Agreements (including in connection with the creation of additional classes or series of SS III Units (including, without limitation, in connection with Currency Hedging)) if required to reflect any such arrangements. In addition, the General Partner may, in its sole discretion, determine to grant certain SS III Limited Partners additional rights, including membership on the Advisory Committee, rights relating to the conversion of SS III Class R Units as discussed in “Section II: Summary Terms and Conditions of the Fund—Class R Units” and the right to receive certain additional information with respect to Special Situations III or such investor’s SS III Units without notice to other SS III Limited Partners.

BUSINESS RELATIONSHIPS OF THE GENERAL PARTNER

Morgan Stanley and its affiliates and other Morgan Stanley managed funds and accounts have long-term relationships with a significant number of property managers, facilities managers, developers, institutions and corporations and their advisors. In determining whether the Fund should invest in a particular transaction and which service providers to use, if any, the General Partner will consider these relationships in its management of the Fund. There may be certain transactions that will not be undertaken on behalf of the Fund in view of such relationships.

BROKERAGE ACTIVITIES

The General Partner has discretion to determine, without consent of the SS III Limited Partners, the broker or dealer to be used (if any) and the commission rates to be paid in cases where a broker or dealer is used.

The Fund may engage in transactions in which Morgan Stanley acts as a broker for the Fund and for another person on the other side of the transaction. In any such event, Morgan Stanley may receive commissions from, and have a potentially conflicting division of loyalties and responsibilities regarding, both parties to such transactions. The commissions charged by Morgan Stanley for such transactions may not be the lowest commission rate available. However, the General Partner will endeavor in good faith to obtain best execution of brokerage transactions for the Fund, taking into account all relevant factors in the selection of a broker, including research and other products and services that benefit the Fund,  execution capability, commission rate, financial responsibility and responsiveness. Morgan Stanley may also act as agent for the Fund and other clients in selling publicly traded securities simultaneously. In such a situation, transactions may, but are not required to, be bundled and clients, including the Fund, will receive proceeds from sales based on average prices received, which may be lower than the price which could have been received had the Fund sold its securities separately from Morgan Stanley’s other clients.

COUNTERPARTY TRANSACTIONS WITH MORGAN STANLEY

The Fund may participate as a counterparty with or as a counterparty to Morgan Stanley or an entity formed by Morgan Stanley in connection with currency, hedging, derivatives (including but not limited to swaps, forwards and options of all types) and other transactions. In this regard, the Fund may establish a prime brokerage relationship with Morgan Stanley to facilitate and improve transaction execution with respect to trading by the Fund in the fixed income, currency, equity or other markets (including with respect to derivative transactions). Morgan Stanley may retain any commissions, remuneration, or other profits which may be made as a counterparty in these transactions. In connection with prime brokerage or lending arrangements involving the Fund, Morgan Stanley may require repayment of all or part of a loan at any time or from time to time and take other commercial steps in its own interests.

The Fund will review each of the foregoing transactions and take such other steps as it may deem necessary to ensure that the terms of transactions are fair and reasonable and, if the General  Partner approves, it will consent thereto. For instance, in these circumstances, the General Partner will consider, among other things, pricing (including applicable commissions and fees), the ability to implement Fund’s objectives (including the avoidance of communicating the Fund’s objectives to the market) and the ease and speed of execution.

By executing the Subscription Booklet, a Limited Partner consents to all the counterparty  transactions with Morgan Stanley.

VALUATION OF FUND INVESTMENTS

The General Partner currently expects that market quotations will not be available for a significant portion of the Fund's investments. Valuations of such investments will be made as part of a process involving the Valuation Committee, the MSRESS III Team and the Valuation Agent, as discussed in “Section II: Summary Terms and Conditions of the Fund—Valuation.” During such process, the Valuation Committee will review and consider valuation reports prepared by the MSRESS III Team and the Valuation Agent. The Valuation Agent serves at the discretion of, and may be replaced at any time by, the Valuation Committee, and the members of the Valuation Committee, although to greater or lesser extents not members of Morgan Stanley Real Estate, are employees of Morgan Stanley, and therefore both the Valuation Agent and the Valuation Committee may have potential conflicts of interest when reviewing the proposed valuations of the MSRESS III Team and the Valuation Agent, respectively. Although the Valuation Committee will select or approve the Valuation Agent in accordance with its fiduciary duties to the Fund, it may be incentivized to choose a valuation agent that it believes will provide the most favorable valuations or which agrees to the most favorable compensation arrangement, regardless of the expected quality of such valuation agent’s services. Moreover, there can be no assurance that the Fund’s valuation of a Fund investment will represent the value that will be realized by the Fund on the eventual disposition of such investment or that would, in fact, be realized upon immediate disposition of such investment on the date of its valuation. Since the Incentive Allocation is  calculated on a basis that includes unrealized appreciation of the Fund's assets, such  compensation may be based on values that reflect incremental appreciation in assets which is not realized upon disposition and, accordingly, such compensation may be greater than if it were based solely on realized gains and losses.

If the Fund overvalues an investment, the benefits to the General Partner, including higher fees and performance-based compensation, as well as to personnel of the General Partner who may be responsible for the part of the Fund’s valuation process, as members of the MSRESS III Team, to be performed by the General Partner, will be greater than if a lower value had been used.

CROSS-COLLATERALIZATION OF FUND INDEBTEDNESS

The Fund may enter into a commitment-based credit facility with a bank or syndicate of banks that is secured by the obligation of Limited Partners to fund subscription calls. The indebtedness incurred by the Fund may be secured by the Commitment Amounts of some of the Limited Partners and may be structured on a cross-collateralized basis. Notwithstanding the foregoing, certain investors in the Fund or certain Related Funds (including Morgan Stanley employees and Limited Partners that are subject to the fiduciary rules of ERISA or the Code) may, for regulatory, ERISA or other reasons, be unable to pledge their interests in the Fund or the Related Funds to secure the Fund’s indebtedness. If the indebtedness is structured in this manner, such investors in the Fund or the Related Funds which invest directly or indirectly in the Fund will benefit from the incurrence of the indebtedness even though their commitment amounts in respect of the Fund or the applicable Related Fund will not be pledged to secure such indebtedness.

VOTING RIGHTS

From time to time, companies in which the Fund has an investment may seek the approval or consent of their investors in connection with certain matters. In such a case, the General Partner has the right to vote in its discretion the interest in the entity held by the Fund, on behalf of the Fund. The General Partner will consider only those matters it considers appropriate in taking action with respect to the approval or consent and SS III Limited Partners will not receive prior notice thereof.

LEGAL COUNSEL

Fried Frank is representing the General Partner in connection with this offering and organization of Special Situations III. Fried Frank represents Morgan Stanley and its affiliates from time to time in a variety of different matters. It is not anticipated that, in connection with the organization or operation of the SS III Fund, the SS III Fund will engage counsel separate from counsel to the General Partner and other Morgan Stanley affiliates. Prospective investors should seek individual counsel if they so desire.