 | | The Daily Reckoning | Thursday, July 15, 2010 |
- How "Statement 159" is blurring the lines this earnings season,
- China's uranium appetite booms while US states plummet into the red,
- Plus, Bill Bonner on the current state of the "go-nowhere" markets and the zoo-like nature of modern economics...
|  | | So Bad It's Good
| Statement 159 Helps Unhealthy Banks Book Healthy Earnings
| |  | | Eric Fry |
Reporting from Laguna Beach, California...
Straight from the "Only in America" file: Second quarter earnings were so bad...they were great!
Yes, dear readers, it's true, many of America's largest financial firms are producing such dismal operating results that their reported earnings might actually benefit.
Are you confused yet?
Here's how it works: A bizarre accounting rule that came into existence three years ago allows banks to book profits when the value of their own bonds falls. The tortured logic behind this nonsensical "Statement 159" accounting rule is that a bank could, theoretically, repurchase its bonds at a discount, thereby booking a "profit" between what it could have paid for the bonds and what the bank would have paid to retire its bonds at maturity. (An insightful story from Bloomberg News provides additional detail.)
This quirky little accounting gimmick produces something called a debt- valuation adjustment gain, or "DVA Gain." The more distressed a bond might be, the greater its drop in value and thus, the greater its "profit." Obviously, this logic is patently illogical. "Could have" or "would have" has nothing to do with reality. If a bank wishes to book a profit by buying back its bonds on the cheap, then the bank should actually buy back its bonds on the cheap - not receive credit for a transaction it does not conduct.
But America's accounting poobahs see it differently. Therefore, thanks to the "Statement 159" rule, many of America's unhealthiest financial institutions will post some relatively healthy earnings results for the second quarter.
Bank of America may record a $1 billion second-quarter gain from writing down its debts to their market value, according to Citigroup's banking analyst, Keith Horowitz. Morgan Stanley might also book a $1 billion DVA gain in the second quarter. That figure would represent about 60% of Morgan Stanley's pretax income for the quarter.
Horowitz estimates that the DVA gains for America's largest banks will contribute about one-fifth of their profits for the quarter. That's a big number, especially in the context of a 30% drop in reported profits for the quarter. In other words, if you subtract DVA gains from the profits Wall Street expects, the big banks' operating earnings would drop more than 40% from the second quarter.
Bank of America's earnings, for example, will likely drop about 40% from the first quarter - and 45% year-over-year - even with $1 billion in DVA gains! That's a pretty dire result for a bank that is supposed to be reaping the fruits of an economic recovery.
The reasons for the collapsing earnings are not hard to come by. For starters, the banks probably did not repeat their near-record trading profits from the first quarter. Additionally, the financial markets have not provided a friendly environment for either proprietary trading or investment banking.
"The Standard & Poor's 500 Index fell by 15 percent from a 19-month high in April," Bloomberg News reports, "curbing stock-trading revenue and prompting companies to cancel or postpone new share offerings and hold off on mergers and acquisitions that Wall Street bankers advise on to generate fees. US bond sales fell to $335.8 billion in the second quarter, down 37 percent from both the first quarter and the second quarter of 2009. It was the lowest amount since the fourth quarter of 2008.
"The weaker trading environment," Bloomberg News continues, "highlights how banks are suffering from lackluster demand for their basic products: loans to companies and consumers. Loans and leases held by US banks shrank for the sixth consecutive quarter to $6.88 trillion as of June 30, according to Federal Reserve data, which include an accounting change. Delinquencies on commercial real estate loans rose to 7.5 percent in May from 6.42 percent in March, according to Moody's Investors Service."
Hmmm... Seems like the recovery might still be on ice. |
| The Daily Reckoning Presents
| Uranium is Heating Up
| |  | | Byron King |
Uranium prices appear to be bottoming, as China buys major supplies from Cameco (NYSE:CCJ). On June 24, China agreed to buy more than 10,000 tons of uranium oxide - yellowcake - over 10 years from Cameco.
According to Thomas Neff, a physicist and uranium industry analyst at the Massachusetts Institute of Technology, China is buying unprecedented amounts of uranium. Based on public information, China may purchase about 5,000 metric tonnes of yellowcake this year. That's more than twice as much as China consumes.
Clearly, China is building up stockpiles for its long list of new reactors. According to the China Nuclear Energy Association, China plans to build at least 60 new reactors by 2020. The average 1,000- megawatt reactor costs about $3 billion. Loading a new reactor requires about 400 tonnes of uranium to start. Take 60 reactors, times 400 tonnes each. That's 24,000 tonnes of uranium (over 52 million pounds) - about all of the world's current output for one year.
New nuclear plants represent a game-changing aspect for future uranium demand and pricing. Even though the reactors may not come online for several years, the knowledge of hard future demand creates a solid floor for the uranium mining industry. Increased demand, just from China, could cause uranium prices to jump by about 32% next year, to about $55 per pound, according to RBC Capital Markets. And future speculative interest could drive prices to the $60-80 range - almost double the current price level.
Higher prices would be a relief for suffering uranium investors. Uranium prices have tumbled about 70% since peaking at $136 a pound in July 2007. Part of the tumble was due to increased output. According to data from Cameco, there were at least 27 new mines, in nine countries, coming on line in the past 10 years. This has added nearly 65 million pounds a year to global output.
The strong uranium market of 2006 and 2007 stimulated the development of new supply. But with current pricing in the $40 per pound range, the economics don't support new mines. It's certainly not enough to ensure adequate supply for future requirements.
According to the World Nuclear Association, China's demand for uranium may rise to 20,000 tons a year by 2020. That translates into more than a third of the 50,500 tons mined globally last year. The thing is, all of the world's current uranium output currently has a market, supplying the existing global demand for nuclear power.
Now we're going to see an explosion (no pun intended) of uranium demand from China, on top of the existing user base (plus other new demand from India and numerous other locales in the world).
Where will China obtain its future uranium? According to China National Nuclear Corp., it's exploring for the fuel in Niger, Namibia, Zimbabwe and Mongolia. Indeed, we're just beginning to see the initial stages of China going abroad to buy stakes in uranium mines, similar to what we're already seeing with China and oil.
Thus, don't be surprised to see uranium in shortage by the second half of this decade. Looking ahead, there's just not enough new production in the planning stages. The world needs new mines, but startup costs are much more expensive than 10 or 20 years ago.
Meanwhile, much of the world's uranium comes from mines that have been in operation for a long time. That, and decommissioned nuclear warheads from the Cold War days. But this latter source is nearing exhaustion.
Bottom line in all of this is that we're right at the bottom of the curve for uranium pricing. Going forward, we're watching as the new demand unfolds, to make uranium investments all that much more valuable.
Regards,
Byron King
for The Daily Reckoning | | | When the States Go Bankrupt
| |  | | Chris Mayer |
While the private economy has done a good job adjusting during the recession and paving the way for the growth we see now, we can't say the same holds true for the government. In fact, as fiscally irresponsible as the US government has been, the next big shoe to drop for the US may be the revealed insolvency of some of its big states.
Already, we hear the "B" word being tossed around. A San Diego County panel - faced with $2.2 billion in unfunded pension liabilities and $1.3 billion in unfunded health care liabilities - recommended, among a number of other possible actions, filing for bankruptcy. According to Grant's Interest Rate Observer, four major American cities (Miami, Detroit, Los Angeles and Harrisburg) have all hinted at the same this year.
The big states are even worse. The Economist reports on Illinois: "By 2018, Illinois will be paying $14 billion a year in benefits, equal to more than a third of the state's revenue, compared with $6.5 billion now."
Plugging those kinds of gaps means getting creative with new forms of skullduggery. For instance, the State of New York, with its $9 billion budget deficit, is looking at a proposal to borrow $6 billion from its state pension fund in order to make a $6 billion payment due to that same pension fund. Yeah, you read that right.
The trials of Illinois and New York are not isolated incidences, either. Grant's quotes from the Center on Budget and Policy Priorities: "At least 46 states face or have faced shortfalls for the upcoming fiscal year (FY 2011, which will begin on July 1 in most states). These come on top of the large shortfalls that 48 states faced in their current budgets (FY 2010)."
Yet incredibly - or maybe not - Moody's maintains that "the credit profile of the US state and local government is very strong." Huh? What are they looking at? That's ridiculous. Why anyone should take what these ratings agencies say seriously is beyond me.
In any event, what I see happening is a great big bailout from Uncle Sam, which itself is broke - bleeding astronomical deficits and in hock for record amounts.
In order to do that, the government will simply print what money it needs. We all know what happens then. The value of the dollar goes south.
To protect your wealth, stay with things, as opposed to paper, like bonds. Own hard assets, things like gold and oil. Own the stocks of companies growing fast enough to beat inflation. And don't be afraid to put your money outside of the US.
Regards,
Chris Mayer
for The Daily Reckoning
| Bill Bonner
| Stagnant Stock Prices Still Have Lower to
Go | |  | | Bill Bonner |
Reckoning from Paris, France...
Not much action in the markets yesterday. The Dow barely budged, but still ended the day in positive territory - the 7th day in a row of gains. Gold fell $6.
Investors beware!
Why? Because they are trapped. After 12 years without a real gain, they can't afford to miss a major rally. So, they're inclined to take chances. But is this rally worth betting on?
Nope. Not in our view.
Stocks have gone nowhere in 12 years. But it's not 'nowhere' that they need to go. They need to go down. They need to complete their historic rendezvous with the bottom.
Currently, the S&P trades at about 17 times earnings. You buy a share for a dollar. You get a company earning about 5 cents a year per share. But at a real bottom, a dollar's worth of stock ought to buy you 20 cents worth of earnings. At one point in the '30s, there were major companies selling at barely 3 times earnings...that is, a dollar's worth of stock earned 33 cents.
We have a long way to go. And it's not going to be much fun for those who are holding shares and hoping they will go up. Most likely the bottom won't come for a few years. And when it comes, people will be shocked, broke and disappointed.
Most likely, too, US incomes are going down. Much of the economic gains made over the last 20 years were phony. They were based on buying things with money that hadn't been earned yet. There were not many people who could afford Americans' standard of living in 2007...not even the Americans themselves.
And of course, businesses and investors made their projections for future earnings based on the same delusions. They built houses counting on rising incomes. They built malls counting on rising spending. They made their own retirement plans based on bubble-era estimates.
"Poor Johnny," a friend reported the news on another friend. "He's broke. You know, Johnny... He's a developer in Florida. But what is it with those guys? They never take their money off the table. He had made a fortune. But he just kept leveraging up. You know, he'd use his apartment buildings as collateral to buy more apartment buildings. And towards the end he was buying some pretty expensive property near Miami, secured by his other property, which was valued according to some very optimistic appraisals.
"I told him he should retire. He was 62. He was on top of the world. What more did he want? Why take chances?
"Then, when the bottom fell out, the whole thing collapsed. The last thing I heard, he was looking for a job."
We've already seen the peak. What's ahead is the valley. For the next few years - maybe 5...maybe 15 - we can expect falling standards of living in the US...along with falling stock and real estate prices. Yesterday's news, for example, told us that 1 million people are expected to lose their homes to foreclosure this year.
If you wanted more proof that the economy is not recovering, here you are:
"Retail sales fall for second month," says Bloomberg.
Households are getting rid of debt. They're sprucing up their balance sheets by increasing their savings rates. More savings, less debt. We have no quarrel with this process. It's the market's way of correcting mistakes and putting things back in order.
But it's not without its little aches and pains. You'd expect retail sales to go down, for example.
If this were a recovery, on the other hand, you'd expect sales to be going up...to be recovering, that is. If the economy were retracing its bubble path, sales would go up and up. Instead, they're going down and down - which is why it's not a recovery. It's a Great Contraction.
How long will it last?
Until it is over.
And more thoughts...
"The whole thing is a sham," we said to Elizabeth yesterday. It was a holiday in France. So we walked up the street to the only café that was open and sat down at a sidewalk table.
"The entire economics profession turned into a bunch of scalawags almost a hundred years ago," we continued. "They created a phony image of an economy. It was a bit like taking a jungle and turning it into a zoo. Once they had the animals in cages, they could make them do what they wanted. They could pretend that they controlled the economy. They were really just zookeepers."
"What do you mean by that?" Elizabeth asked. "A jungle is a natural thing. But so is an economist. They were just doing what came naturally to them. So, what they produce...what they create...is still a product of 'nature,' no?"
"Well, yes, that's what makes it hard to understand. Everything is in some sense 'natural,' since everything is the product of natural forces. But some things are more natural than others. And some actions - although natural - produce outcomes that are undesirable. You can round up people and put them in concentration camps...and you can say that this is a 'natural' thing for people to do...since they demonstrably do it from time to time. But it's not very nice for the people who get rounded up.
"Likewise, it's not very nice when the economists put you in a cage.
"The people doing the rounding up say they are making a better world. In yesterday's paper, for example, Paul Krugman says the Fed should set higher inflation targets in order to keep people from saving money. He doesn't seem a bit concerned that higher inflation rates will steal peoples' savings. He says the threat of higher inflation will force them to borrow, invest and spend. At least, that's the idea. But you can only have an idea like that if you've already become a zookeeper.
"You say... 'I'm a great economist. I can make the animals eat ice cream. How? I'll take away their meat.' So you take away the meat. The animals begin eating ice cream. And then you say, 'See, I told you I was a great economist.'
"But the animals don't really want to eat ice cream. And it's probably not good for them. They get sick and their teeth rot.
"And now - in the real economy - people don't want to eat ice cream. I mean, they don't want to borrow and spend. They want to save. But Krugman wants the feds to force them to borrow and spend - just like they were animals in a cage - by threatening to debase their savings. Maybe the feds can do that. And then Krugman will think he's a genius. The effects on the phony, zoo-economy might appear to be good. People might try to get rid of their money. They might spend and invest. The GDP figures might move upward.
"But that doesn't mean people would be better off. They'd be worse off..."
*** "China can teach Argentina a lesson..." says a news report. China is about to invest $10 billion in Argentina's railroads. Obviously, if Argentina wanted railroads it could finance them itself. If it had any money, which it doesn't. So, the Chinese have come to the rescue. Argentina is a good source of raw materials and food. The railroads will make it easier for Argentina to bring its produce to market, and make it easier for the Chinese to haul it away.
According to the report on Breakingviews, Argentina will learn the value of long-term investment in its infrastructure.
But the gauchos weren't born yesterday. They know how to play investors. They bring them to Buenos Aires. They are fed fat Argentine beef. They are watered with rich malbec wine. They watch a tango show and a polo match. After a few days they are ready to open their checkbooks.
Then, the Argentines take the money...and later default on their obligations. China is probably going to learn a lesson, too.
Regards,
Bill Bonner,
for The Daily Reckoning |
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