Better than war

By Julian Delasantellis

In Funny Girl, William Wyler's 1968 film version of the Broadway stage musical, Fanny Brice (Barbara Streisand) , laments her role in life as the girl who gets the finer things only when others are through with them:

Stuff in our apartment came from father's store
Even things I'm wearing someone wore before
It's no wonder that I feel abused
I never get a thing that ain't been used
I'm wearing second hand hats
Second hand clothes
That's why they call me
Second hand Rose.

Even Jake, the plumber, he's a man I adore
Had the nerve to tell me he's been married before!

One wonders if, when China picks the United States up off the

bargain basement floor, whether they will be similarly self pitying, or will they know a good deal when they see it better than poor Fanny?

You can feel it; it's that moment just before the credits are set to roll on that long, sad saga that is the US auto industry. Chrysler fell into bankruptcy on April 30, GM on Monday. When next we see Chrysler it will be only as a digestive of the Italian automaker FIAT. GM, Alfred Sloan's once proud amalgamation designed to provide price and lifestyle points all along the value spectrum for the entirety of the huge American market, will be mutilated and shorn down to a company consisting of basically just two operating entities - Chevrolet and Cadillac.

Press reports are speculating that the new company may be brought back to the stock market in 18 months or so, but with US auto sales currently running at about a 9.3 million unit annual sales rate, down 45% from their highs in 2000, sales will have to recover quite a bit, perhaps all the way back to the teens, before Wall Street will be willing to take another look at an industry whose failures have just wiped out every single penny the Street had put in it for, in the case of GM's up to yesterday tenure of a member of the Dow Jones Industrial Average, the last 83 years.

The key operating concept of bankruptcy, of course, is that an individual, company, or even a nation, lacks the funds to pay back the debts it has incurred. Putting the whole matter in the hands of the bankruptcy court judge does not generate one extra penny for the debtholders; it just provides a framework and structure by which what few assets the company has can be somewhat equitably distributed among the large pool of creditors that the company owes money to.

If the ultimate intention is not to liquidate the enterprise but to keep it functioning in some manner after emerging from bankruptcy court, the asset sales must necessarily be more constrained, since the cuts can't be so deep as to strip the company of operating assets and equipment needed to produce its product. For GM, with over US$173 billion of debt, owed to everybody from holders of its bonds to those who delivered stationary and pencils to its accountants, against just over $82 billion in assets, the challenge involved in keeping GM around will be substantial.

It now appears that the bankruptcy court framework to be utilized with GM will be similar to that used with other large corporate bankruptcies (GM will be the fourth-largest bankruptcy in US corporate history, behind last September's Lehman Brothers filing, WorldCom in 2002, and Enron in 2001) - a so called debt-to-equity swap.

In this, the bondholders are going to be forced to exchange the debt owed by the company for equity shares in the new company - shares that, for a while at least, will have almost no value. According to press reports, the deal has the biggest bondholders exchanging $27.2 billion in GM debt for between a 10% and 25% equity share of the company.

At Friday's GM total market capitalization of $457 million, the bondholders are exchanging their billions of dollars of debt for no more than $120 million. Reports of the final deal have the United Autoworkers Union (UAW) and US government taking the remaining equity shares, the UAW taking an ownership stake in return for giving up its previously negotiated health and retiree benefits, the government taking a 60% majority ownership in return for the $60 billion in TARP and other aid provided to the company since last December.

If you followed my writings on developments in the mortgage markets, you may recognize what's going on here. This whole debt/equity swap process is not much more than a very sophisticated mortgage "cramdown", where debtholders find that they are being given an ultimatum to accept less than they are rightfully due and desire in the hopes that this will preclude the possibility of getting absolutely nothing.

In relation to mortgages, cramdown referred to ultimately rejected proposals that would have given judges in bankruptcy court the right to alter mortgage repayment terms so that the guy maybe a few thousand dollars down on his mortgage might get a chance to get his head above water rather than automatically and inevitably face foreclosure. (See A break from the bankrupt norm, Asia Times Online, May 7, 2009.)

The banking and finance industry screamed like banshee divas getting bounced from a cheesy reality TV show over the prospect of mortgage cramdown, defeating the proposal in the US Senate, but GM's ability to sail through bankruptcy, cramming a deal down the bondholders' throats that they hate (of course, they'd rather have the money owed them - wouldn't you? ), retiring debt by giving shares of, to put it mildly, uncertain value, only once again proves an important, eternal truth of finance. If you owe a creditor $5,000, the creditor owns your soul, if you owe the creditor $5 billion, you own his.

Why stop with GM's $173 billion of debt? If debt/equity swaps are the magic trick that squares circles and makes everybody happy, might one work with the world's currently biggest debt problem - America's $11.3 trillion of government debt, now growing at close to $5 billion each and every day?

I frequently receive questions seeking my opinion as to how I think the entire economic and financial crisis will end. Assuming that you have not yet drunk from the "green shoots" Kool-Aid cup and so now believe that things are getting great even as the economy dies around you (the horrible Case/Shiller home price and loan origination numbers should disabuse most of those who seem to be smoking and toking the green shoots), you may be one of those who think that the US government and Federal Reserve are going to be printing money so fast so as to debase the economy and inflate the currency out of the real value of its huge debt.

With the Federal Reserve first pegging short-term US interest rates at zero, and then initiating a massive "quantitative easing" expansion of its balance sheet, the salvation-through-inflation crowd's argument is somewhat convincing. Still, with the "inflation vigilantes" on watch in the government debt market, the same force that has put over 100 points on the 10-year note yield in just two months, the market may he just a bit too clever to allow itself to be shafted so blatantly and obviously.

But it's not the hyperinflation/it'll take a billion dollars just to buy a loaf of artisan sourdough bulgur wheat bread scenario that I'm looking for. I'm looking for the greatest debt/equity swap of all time.

When the talk turns from how much debt to who owns the debt, everybody knows who we're talking about. China has earned a national treasure since assuming its role as America's factory floor, and the specific national treasure I'm talking about is what once was America's. Out of almost $2 trillion in total foreign exchange reserves, China, according to the most recent US Treasury data, holds over $760 billion in official US government securities; add in government agency bonds and corporates, and well over half of China's reserves are held in US dollar-denominated debt securities.

There is every indication that, what with the incredible fiscal profligacy forced on the Barack Obama administration by the financial crisis, the Chinese government enjoys this financial dependence on the US not one little bit. It's now a regular occurrence to have Chinese officials wag their fingers at America and scold it for its budgetary licentiousness, and the US Treasury's monthly Treasury International Capital report, the ledger as to who is taking money out of America and who is putting it back in, is showing China lightening up on both the maturity and duration of its US Treasury holdings, shifting to the shorter, safer, more liquid leg of the yield curve.

In response, the Obama administration has shifted its policy focus as well. Gone are the days early in the administration when China would be warned to stop keeping its currency, the yuan, too low. Now, the policy is much simpler. It consists of having US officials, such as US Treasury Secretary Timothy Geithner last weekend, make the trip to Beijing to prostrate themselves before the country's ruling communist plutocrats and beg them not to pull their money out of US assets, and, by extension, the US economy.

Obviously, with the twin risks of both currency and capital asset depreciation, China is starting to examine seriously the wisdom of holding so much of its hard-earned treasure in debt securities of a questionable currency paying coupon interest, in the case of the US 10-year note, of just under three-and-a-third percent per annum. Still, America desperately needs China's money. It is frightening just to think of the extent of financial deleveraging that would befall the US economy should a trillion dollars of Chinese assets be suddenly withdrawn from the current weakened American financial system.

Some might think that a limiting factor making a US debt/equity swap impossible is the basic fact that, of course, you can't buy and sell shares of the US government (US politicians - that's another story). If there's no shares, there's nothing you can swap your debt into - right?

Not really.

What has the last year taught us more than the fact that in contemporaneous mixed economies, private and public sectors are very flexible and diaphanous concepts? Since the current crisis began, and whenever it needed to, the public sector of America, as well as in many other previously assumed to be market governed economies, has intervened deeply and repeatedly in corporate affairs previously assumed to be wholly within the purview of the private markets.

Northern Rock, Bear Stearns, AIG - the roster will surely not end with GM. The flip side of this is how we have learned that, for many government officials, their time in government service is somewhat comparable to a sideways transfer to the company's branch office in the public sector - still very much within the corporate megalith. Assuming they have direct deposits

of their paychecks and so don't actually see them, it's a wonder that anybody at Goldman Sachs ever knows whether they're working in house for the company or for the government from one week until another.

Better than war
By Julian Delasantellis

For a country such as China, steeled in a cynical dictatorship's view of government power as something that never needs to be mediated through arcanum such as tradition or constitutional rules, the artificial dichotomy between a private sector's equity and its public sector debt must seen hopelessly pedantic. Private stock markets are the government's since, when the markets prosper, so does the government. Therefore, the private markets seed the government with their functionaries, so it can continue to do so.

Two things must happen simultaneously for a China/US debt equity swap that would wrap up the entire financial crisis. Both have happened recently, but not together - that will be the trick.

With just about $11.5 trillion in total market capitalization on the



US NASDAQ and New York Stock Exchange bourses, China obviously just can't buy up the US stock exchanges with just its $2 trillion-plus of foreign exchange reserves. Still, converting just a portion of its Treasury security debt into equity could have an enormous impact on the US financial markets, particularly if accompanied with some measure of leveraged borrowing, such as a canny utilization of options. The trick is to buy when the Chinese dollars can have the most impact. The trick is to buy when things are cheap.

Anyone considering any type of investment in a financial product denominated in a currency not of his home country knows that there is an extra dimension to this investment analysis - the currency. A 5% rise in the investment does no good if the currency that the investment was denominated in declines 10% over the same period. Therefore, China would have to strike at the perfect moment - when both stock and currency prices are so cheap as to make the investment decisions virtually irresistible.

Are US stock prices now cheap? Well, they certainly were a lot cheaper back in early March, before the almost 35% green shoots stock market rally. Worse yet for a stocks-are-cheap argument is a look at corporate earnings, down almost three-quarters from last year, with stock prices at these levels down only almost a third. At 15, the price/earnings ratio of the S&P 500 is not grossly extended, as it was at the top in October, 2007, but it's still not in any way "cheap", especially for a China which got badly burned trying to deploy its financial reserves to save the world financial system in late 2007.

On the other side is the situation in the US dollar. Many observers had previously noticed the seeming anomaly of a US dollar stable to even rising in value in the midst of a US centered financial crisis.

Not anymore. We've just seen a sharp fall across the board in the US dollar during the previous three months, down 13% against the euro and the other currencies of the trade weighted dollar index, 7% against the yen.

So there's one way that the financial crisis could end. Both stocks and the US dollar could suffer such sharp falls that US equities, indeed, the entire US, becomes so cheap that China and the other wealthy sovereign wealth funds (SWF) come in and, like poor Second-Hand Rose, swoop up all the bargains.

US public opinion would rejoice at an injection of liquidity that finally goes a long way towards replacing what the collapse of structured finance took out of it. Certainly, the happy, carefree, consumption-sodden days of just a few years ago must soon be once again just there for the taking. The fact that the nation has just sold its birthright and is now renting what took its previous generations over a century to build and own, is of trivial consequence.

As Obama is learning to his misfortune, the attempt to transform the US economy from leverage/consumption to investment/export is a lot harder sell now, after the presidential campaign is over, when Americans learn that, like the kids in Asian schools, they have to actually pay attention in calculus class to do so.

There is another way that the crisis could end, that the extra liquidity the economy needs could be delivered to it, one not so benign as the above, assuming you think that selling America share by share to foreign powers is benign.

At its heart, the recent rise in government bond yields across the capitalist world is the markets' pushback from the government's recent assumption that it can appropriate a much larger percentage of a society's savings without any serious consequence.

As I wrote last January:

Across the seven continents and now almost 200 nations, one factor unites the human race, the fact that with the private sector finance-centric economic system that bestrode the world since the fall of the Berlin Wall now lying in tatters, the private spending that the system previously gleefully financed is evaporating. Governments are being called on to spend what the private sector won't and/or can't, and if the governments don't have the money, they're being called on to borrow it. That's all well and good - as long as the funds are available to be borrowed. (See In the shadow of unwanted bunds, Asia Times Online, January 14, 2009.)

In January, it was Germany having trouble with its debt auctions; now it's America. Already, the rise in US 10-year interest rates is bleeding through to higher home mortgage rates; with real estate prices falling 20% a year even with historically low mortgage rates, raising mortgage rates now is a lot like throwing a drowning man an anchor chain designed to look like a life preserver.

If the private sector is proving a bit pokey in providing what the world's governments need in terms of funding, how can their minds be changed, how can their fingers be loosened from the clutch of their silk purses? Can anyone make them an offer they can't refuse?

One thing seems to always work: war. When a nation is faced with the need to re-arm and then to combat a foreign army, what was once seen as the simple tightfistedness of the rich quickly morphs into selfish treason. Wherever you stand on the effectiveness of US president Franklin Delano Roosevelt's 1930's-era New Deal, one thing is basically agreed by all. By the early 1940s, the re-militarization of America, both to meet its own and Allied war needs, ended the Great Depression and brought a significant wartime prosperity to America.

In a recent article in Foreign Policy magazine, Oxford/Harvard historian Niall Ferguson sets the stage for a possibly very violent upcoming era.

Economic volatility, has returned with a vengeance. US Federal Reserve Chairman Ben Bernanke's "Great Moderation" - the supposed decline of economic volatility that he hailed in a 2004 lecture - has been obliterated by a financial chain reaction, beginning in the US subprime mortgage market, spreading through the banking system, reaching into the "shadow" system of credit based on securitization, and now triggering collapses in asset prices and economic activity around the world. After nearly a decade of unprecedented growth, the global economy will almost certainly sputter along in 2009, though probably not as much as it did in the early 1930s because governments worldwide are frantically trying to repress this new depression. But no matter how low interest rates go or how high deficits rise, there will be a substantial increase in unemployment in most economies this year and a painful decline in incomes. Such economic pain nearly always has geopolitical consequences. Indeed, we can already see the first symptoms of the coming upheaval ... Economic volatility, plus ethnic disintegration, plus an empire in decline: That combination is about the most lethal in geopolitics. We now have all three."

Ferguson explores some sample conflict scenarios, including Gaza, Somalia, Darfur, Zimbabwe, even a possible collapse of the narco-regime that is Mexico. There are probably about a dozen more, and not all in the Third World, but, in the final analysis, the "where" of crisis is less important than the "why".

Maybe the US will face off against China over North Korea or the Taiwan Strait, or maybe it will be a US-Russian confrontation over Iran or Eastern European missile defense. Maybe it will be the US and Europe versus a BRIC (Brazil-Russia-India-China) alliance, as the team of young challengers seeks the title of world superpower from the fading and wheezing champions.

No matter. All that is required is that the flags start to fly and the bands play; the soldiers march straight and true, and calls arise to fully feed, clothe and arm them in such a way that honors their bravery and sacrifice. Military budgets are passed with huzzahs by huge parliamentary majorities, orders flow to the factories, and workers who yesterday had been in the dole queue wake to the bugle's call to find themselves in the line for ready-to-eat breakfasts. Who is on the other end of the rifle barrels is ultimately immaterial; after all, as in George Orwell's 1984, Oceania has always been at war with Eastasia, or maybe it's the other way around.

So, either with a national fire-sale, or with a fiery battlefield on some far-off foreign shore, the economic crisis will end. The future is certainly turning out differently than the dream of eternal, peaceful capitalist triumphalism embodied in Francis Fukuyama's 1992 book, The End of History and the Last Man.

Then again, if, as Verbal (Kevin Spacey) in the 1995 movie The Usual Suspects contended, "The greatest trick the Devil ever pulled was convincing the world he didn't exist"; perhaps ol' Scratch's second-greatest ruse was convincing the world that history didn't exist anymore either.

Julian Delasantellis is a management consultant, private investor and educator in international business in the US state of Washington. He can be reached at juliandelasantellis@yahoo.com.


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