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October 29, 2004

Chinese Proverbs
by Rob Kirby

[The New World Order]

Well, dear reader, in my never ending quest to stay ahead of the curve, I have decided to really get out front for a change and learn a little Chinese. Methinks this is something we all should be doing or will all be doing a lot more of, like it or not, in the days, months and years to follow. Some of you out there might think I've taken this a little too far and want to accuse me of opportunistic 'brown nosing'. I say to you, opportunistic admittedly yes, but if you are going to call 'it' anything, yellow nosing is likely more appropriate. Remember, dear reader, we live in a society which pays great homage to and idolizes wealth [you're fired] and power [who ever signs the checks] - so in that sense all I'm doing is jockeying for a good spot at the front of the line. Figuring that we might be able to 'come up the curve together', so to speak, I've been considerate enough [which I hope you all notice] to provide you with English sub-titles for all headers and titles in this article. So please pay attention and take good notes, as the next piece I write may very well be entirely in Chinese.

[Yesterday's News]

I read an article in our beloved 'main stream' financial free press the other day that said, "The Chinese Are Coming". The notion that the 'free press' had this [belatedly] to say made me wonder about a couple of things. The first thing that came to my mind was the term free, bought and paid for, corporate press? The second thing was why were they reporting this as news and why now? Now I don't know about you, dear reader, but where I come from folks are brought up being taught that nothing is 'free'. In fact, where I come from, folks were more often than not reared by penny-wise hard working types who believed in a hard days work for a good days pay. I ask you, dear reader, what has happened to that principle we were all raised on? Look at the debt - at the consumer level, budgetary and in terms of balance [more likely imbalance] of trade? Americans are clearly preoccupied with consuming foreign goods they cannot afford.

Well dear reader, the minute after I saw that headline, the why now part finally struck me. If the mainstream press was finally reporting something - it was probably yesterday's news. This headline [giving the false appearance that the story was 'fresh' and late breaking] was referencing an article on the Chinese purchase of Noranda, Inc., one of Canada's soon to be former industrial giants in the extractive natural resources sector of the economy. If you've been to your local Wal-Mart [China-Mart] at any point over the past few years, dear reader, you've most likely figured it out long before now, the Chinese are in fact already here. I had the occasion to visit a Wal-Mart [China-Mart] location recently with my young nephew - he's a happy go lucky inquisitive grade 2 student who likes to handle the merchandise. We had been in the store for about 20 minutes when out of the blue he looked up and asked me, "Why is everything made in China?" You know, I didn't give him a very good answer - not even by Greenspan standards.

The strangest thing of all, if you take a minute and scrutinize your local Wal-Mart [China-Mart] shelves, is that China has preoccupied itself with producing not only vast amounts of things Americans cannot afford, but so very many things that Americans really don't need! [A great deal of it Lava Light Junque!]

[The Real News]

The real news, as I see it dear reader, is perhaps not all that 'new' to any of you. The good stuff in life, be it news or anything of value for that matter, tends to be rare and relatively hard to find - so you usually have to look for it. With that in mind, I generally spend a whole lot of my time perusing news sources frequented by contrarians. What I have found, by and large, reading up on the beliefs espoused by these mostly independent, free minded thinkers gives me a sense of dejá vu all over again. By that, I mean they sound a heck of a lot like the voices of reason I remember from my parents and up bringing. Things like abhorrent debt are generally frowned upon and producing something that is of value or has some socially redeeming raison d'être is generally viewed as being 'good' - conjures up images of a romantic trip back in time.

After a recent read of mine, Freddie Mac: $5 Billion in Fraud and Counting - by Mr. Chris Sanders; I was struck with his lucid take on the GSEs and their entrenched positions as leviathans of the financial seas. As Mr. Sanders so aptly points out,

"When you consider that the GSEs collectively have balance sheets worth more than $2 trillion, or more than 20% of GDP, any politician contemplating letting them fail is likely to think hard and twice before allowing it to happen."

So it appears that the GSEs dominant and imposing positions in the American economy will be defended out of political necessity - but I ask, how vigorously, at what cost and what are the implications?

I had the pleasure of conversing with Chris Sanders of sandersresearch.com recently and I asked him if he felt the explosion of off balance sheet financial derivatives, as it relates to the collateral pool supporting its growth, was reason for grave concern? Spoken like a politician, Mr. Sanders' response was,

"[it] depends on the market situation. In a climate of two way risk, that is to say that there is a two way market in swaps and there are buyers and sellers on both sides of the fixed floating exchange, it is perfectly credible that there could be a huge excess of outstanding contracts over the underlying "collateral" market that provides the fixed rate cash flow. The problem arises when everyone is the same way around, i.e. a large majority of players decide that rates are heading up. In that event, as we saw when LTCM went under, the swap market ceases to be a market at all. It simply can't cope because the aggregate balance sheet that needs to be hedged has no natural counterparty."

[Sly as a Fox]

Mr. Sanders went on to explain something else, which had perplexed as well as disgusted me, when I had empirically observed it earlier this year. I'm talking about Fed Chairman Alan Greenspan's sly as a fox suggestion that home owners consider borrowing variable rate mortgages instead of opting for fixed rates. Mr. Sanders postulated that Chairman Greenspan is well aware of the systemic risk posed by the GSEs and was attempting to use his moral suasion to encourage homeowners to become the surrogate 'natural' [I prefer unnatural] counterparty [read sacrificial lambs] to the GSEs and their need for floating rate cash flow.

Mr. Sanders was quick to point out that, if this indeed was Chairman Greenspan's true intention -and if successful, it would only have served to have bought time [one cycle] before the whole issue resurfaced again with an even weaker more susceptible consumer.

[The Truth Is Out]

So it seems to me that the Achilles heel of the entire financial system might very well be a pronounced or sustained 'back up' in interest rates. Come to think of it, we have not really had a sustained or pronounced back up in interest rates in the past few years. There have been times when it started to "look" like this might happen, what with real interest rates having been 'negative' for so long, but it never [so far] seems to completely materialize. There always seems to be a fundamental 'reason' why rates don't have to increase - like there's no inflation [cough], we have a strong dollar policy [cough again] and the price of gold remains low and stable [choke].

This point is succinctly driven home by another free minded, articulate 'thinker' - Warren Pollock, whose observations and work I find invaluable in getting a good handle on the obfuscation provided to us by the likes of John Snow [Treasury Secretary], Alan Greenspan and the good folks at the Federal Reserve. In an article, Interest Rate Increases Stress the Banking System, Pollock reasons that,

"on two occasions it is very clear that interest rate increases severely stressed the banking system. When the inter-bank settlement system temporarily fails to clear transactions banks are effectively "bouncing or kiting checks" to each other."

The first of these events occurred in the aftermath of 9-11. The second incident was market driven when long term bond rates spiked in the summer of 2003. Pollock points out, that in both cases, rates were 'managed downward' and the problem was temporarily solved. The final conclusive piece of evidence supporting Pollock's contention was when a market induced spike in interest rates occurred again this past spring [2004]. On each of these occasions the Fed has responded with opening the spigots of liquidity injecting massive amount of fresh cash into the system [as measured by M3]. The culprit behind the system's inability to adjust to the rate spikes is in Pollock's words "the settlement system having significant problems absorbing modest changes in interest rates." He goes on to reason that, "Interest rate sensitive derivatives and interest rate arbitrage plays are putting pressure on the continuity of the banking system." The upshot of all this, of course, is that interest rates have been arbitrarily held lower than they would otherwise have been. I suggest you enjoy it while it lasts.

Just because the price of gold and interest rate levels are stuck in the weeds so to speak, does not mean - to quote Sanders,

"that the operation of supply and demand in markets has been repealed. All it means is that the central banks and their associates in the finance ministries of the developed world and the economics faculties of the leading universities have become agents of deception.

Gold is still flowing to economies with positive net exports such as China and Japan, and to those with sufficient capital to be able to buy it. No amount of derivative issuance, secret Treasury underwriting of short positions, or even illegal activity can stop this. All it can do is stop taxpayers from seeing where their reserves have gone and are going."

[Foolish Gambler]

In short, I suspect that Chairman Greenspan's primary job nowadays has quite simply become one of micro managing both statistics and interest rate movements, trying to finesse a losing hand - to continue the hoax being perpetrated on a naive, self serving global investment community. With the U.S. government running record budget and current account [trade] deficits, primarily funded by China and Japan, how much longer can Alan Greenspan delay a 'normalization' of interest rates [the inevitable crash] when China and Japan hold all the cards. He might be well advised to learn how to bluff [] in Chinese.

[The End]

Rob Kirby
Kirby Analytics

Copyright © 2004 - 2006 Rob Kirby

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