Agcapita UpdateApril 2010

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Contents

3 IstheFinancialCrisisOver–AreOurGovernmentsBankruptYet?

4 BailusOutwithPrintedMoneyandWe’llFundYourDeficit

5 DoubleDiponitsWay?WhatWilltheCentralBanksDo?

5 IsAnyoneGoingtobeAbletoPayfortheBoomers’Retirement?

6 MoralHazardandTheFallacyoftheSafeCanadianBankingSystem

7 InterestRatesVersusRollover–PickYourRisk

8 Surprise-AIGTooktheFedtotheCleaners

8 BankingSectorBacktoRecordProfits

9 By2012SurplusOilProductionCapacityCouldDisappear

9 OilDemandBackPast2007Peak

stag-then-flation…

WillRogersfamouslyquipped,“It is difficult to make predictions, especially about the future”.IgnoringMr.RogerssageadviceIwillattempttomakesomeeducatedguessesaboutthefutureanyway,albeitwiththeassistanceofsomeanalystsfarmoreprescientthanI.

TheevidencefromKennethRogoff’srecentresearchisthatinthethreeyearsfollowingafinancialcrisis,onaverage,cumulativefiscaldeficitsalmostdouble.Weseemtobewellalongthispathinthecurrentcrisis.

Rogoff’sresearchalsoshowsthathowthesedeficitsarefinancediscriticaltothequestionofwhetherinflationensues,whetheryouhaveaJapaneseoranArgentineanstylepost-crisisexperience.Ifthedeficitsarefundedfromexistingprivatesectorsavings(“belt-tightening”asRogoffdescribesit)theyaretypicallynotinflationary–e.g.Japan.Iftheyaremonetizedbythecentralbank(themoneyiscreated)theyareinflationary–e.g.Argentina.

Today,inonecorner,wehavethewholesaleliquidationofmal-investmentsthathaveaccumulatedinvirtuallyeverysegmentofthewesterneconomiesfromresidentialandcommercialrealestatedowntothemunicipalbondmarkets.Intheothercorner,wehavegovernmentsthatareactivelyresistingthiscleansingprocessasitthreatensthesolvencyofthepoliticallyinfluentialfinancialsector.

Theresultisthatviabailoutsandunprecedentedfiscaldeficitsprivatesectorcreditproblemsarebeingmovedontopublicsectorbalancesheets–balancesheetsthatarealreadyinprecariousconditionfrompastover-spendingandunfundedfutureliabilities.Bynationalizingprivatesectorlossesgovernmentsaroundtheglobeareseriouslycompoundingtheirexistingbudgetproblems.

AccordingtoresearchbySociétéGénéraleEUandUSnetliabilitiesadduptoaround$135trillion.That’sroughlyfourtimesthecapitalizationoftheworld’sequitymarketsandfortytimesthecostofthe2008financialcrisis.TheUSplanstoaccumulateanadditional$10trillionindeficitsoverthenextdecade.

Summary

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Theseenormousnumbersbegthequestionofhowourgovernmentsplantofilltheirfundinggaps?Ofcoursetheywillattempttoraisetaxes,butitseemsclearthattheyaregoingtoresorttoinflationaswell.Inflationismorepoliticallyexpedientastheapparentbenefitsareimmediatewhilethealltoorealcostsaredelayed.

ToborrowyetagainfromJensParssonandhisexcellentbook“DyingofMoney”:

“The government is free to incur any deficit and issue any amount of debt it may wish, so long as it is willing to draw purchasing power away from other borrowers and to tolerate the rise in interest rates which will result. The debt will create no inflation.

Government deficits and government debt thus are not inflationary if they stand alone, but they never stand alone. The creation of government debt is practically always accompanied by an increase of money. Competing against private borrowers for a static supply of credit capital, a large government debt issue would drive interest rates upward, and high interest rates are anathema to a government.

A large government debt issue simply could not be marketed without a large increase in the money supply. Therefore the government creates not only the debt but also the money with which to buy it. In addition, large government deficit expenditure tends to accelerate the velocity of money because the government spends its money more rapidly than cautious private spenders do. This combination of increased quantity and velocity of money, not the deficits, does the job, both for economic stimulation and for monetary inflation.”Nowhereisanattemptatoneofthosetrickypredictions–willweseeinflationordeflationoverthenextdecade?Ibelieveyoucananswerthisquestionbyconsideringtheeffectofthefollowingfactors:

– GovernmentSpending&Deficits–increasing– Regulation–increasing– Taxes–increasing– MoneySupply–increasing

BasedonthesefactorsIbelievethatratherthanoutrightinflationordeflationwefacestagflationinthedevelopedworldasfurtherstateexpansionintotheeconomywillreducerealgrowthwhileacceleratingfiscaldeficitscombinedwithmoneysupplyexpansionswillleadtoinflation.Lowgrowth+highinflation=stagflation.

Therefore,ourinvestmentthesiscontinuestobetogainlong-termexposuretoinflationhedging,incomegeneratingassets,withdemonstratedlinkagestoemergingmarketgrowth–energyandagricultureremainourpreferredsectors.

Summary (continued)

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Agcapita Update (continued)

is the finanCial Crisis over – are our governments Bankrupt Yet?

Thosebelievingthefinancialcrisisisoverarewrong.Ithasmerelybeentransformedfromaprivatesectortoapublicsectorcrisis.DylanGrice,analystatSociétéGénérale,concludesthatdevelopedmarketgovernmentsareinsolventbyanyreasonabledefinition.Socgen’sestimatesofcapitalizednetstateliabilitiesareshowninChart1asthegreybars.

AccordingtoGrice“I don’t see how our governments can pay these liabilities. EU and US net liabilities add up to around $135tr alone. That’s four times

the capitalization of Datastream’s World equity index of about $36tr, and forty times the cost of the 2008 financial crisis. Our governments appear to be insolvent. They’re liquid, so they can stay afloat the way the Detroit auto companies did for years despite being insolvent. But unlike the Detroit auto companies, our governments’ debt doesn’t trade at distressed prices and as an effective option on finding an escape from impending bankruptcy. I think they should. Such liabilities have historically crippled governments (and economies, and companies, and anyone else for that matter). And although governments usually default via inflation, our governments are short real goods and services (e.g. earnings-linked pensions, health care), which they won’t be able to inflate away. This means there will ultimately be even more pressure to inflate away whatever they can.”Emphasismine

AsPeterBernholznotesinMonetaryRegimesandInflation,“there has never occurred a hyperinflation in history which was not caused by a huge deficit of the state.”ThecorrelationbetweeninflationandfiscaldeficitsisshownquiteclearlybyHussmanresearchsetoutinChart2.Obviously,weareinaperiodofunprecedenteddeficitspending–highestlevelsasapercentofGDPsinceWWIIandhighestinabsolutetermsinhistoryofmankind.Willinflationfollow?

Chart 1: are our governments solvent

Source:SGGlobalStrategy,OECD,FraserInstitute,Agcapita

750%

500%

250%

0%GermanySpainFranceItalyUKEUUSCanada

OfficialNetDebt,%GDPTotalnetliabilities(onandoffbalancesheet),%GDP

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Agcapita Update (continued)

Bail us out with printed moneY and we’ll fund Your defiCit

AtthetimewhenforeigngovernmentsareslowingdowntheirpurchasesofUStreasuriesUSbanksareincreasingtheirpurchases–puttingtheexcessreserveslenttothembytheFederalReserveintotreasuries,ratherthanprivatesectorloans(GluskinScheff’sDavidRosenbergestimatesthatbyFebruary$740bnofbankcredithadbeenwithdrawnfromthecommercialmarketsincethestartofthecrisis).Withzerocostmoneyandarelativelysteepyieldcurvethisisamassiveandprofitablecarrytradeandalarge,stealthsubsidytothebankingsector–borrowingfromthegovernmentshortandlendingtothegovernmentlong.

However,accordingtoDavidGoldmanthishastheeffectofbackingtheFederalReserveintoacorner “Most of this reflects use of the carry trade by foreign banks, or hedge funds, who are doing exactly what the American banks are doing: borrowing at 0.25% from central banks and lending it back to the US government at 1% or 2%, depending how far out the curve they go. The demand isn’t coming from the oil exporters, who appear to be net sellers. On a geographic basis, the main buyers are “United Kingdom” and the “Caribbean,” that is, banks and hedge funds.

Raise rates and the carry trade comes crashing down. And so does the Treasury market and the mortgage market and the US economy. The Fed is

Chart 2: us federal spending vs. Cpi

Source:Hussmanfunds

195119551959196319671971197519791983198719911995199920032007

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14

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10

8

6

4

2

0

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10

8

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0

FederalSpending(4yearGrowth)CPIInflation(RightScale)

Chart 3: CommerCial Bank holdings - us government seCurities vs CommerCial loans ($ Billions)

Source:FederalReserve

2000200120022003200420052006200720082009201020112012

$1,700

$1,600

$1,500

$1,400

$1,300

$1,200

$1,100

$1,000

$900

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BillionsofDollars

Gov’tSecurities

CommercialandIndustrialLoans

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Agcapita Update (continued)

stuck with loose money just as the Bank of Japan was during the 1990s, and for the same reasons.”

douBle dip on its waY? what will the Central Banks do?

TheConsumerMetricsInstituteconstructsanindexthattracksUSconsumptionbasedonactualtransactionsforarangeofmajordiscretionarypurchasessuchascars,houses,durablegoods,andvacations.The‘DailyGrowthIndex’haspredictedchangesinU.S.GDPreasonablywelltodateandrecentlybegantodeclinerapidlywhichmayindicatethatgrowthcouldbeabouttoslump–doubledipontheway?WillevenmoreQEfollow?

is anYone going to Be aBle to paY for the Boomers’ retirement?

Areboomersmerelymisinformedoraretheywillfullydeludingthemselveswhenitcomestotheirretirementprospects.

– ING’sminimumestimateoffundsrequiredforretirement-$675,000

– PersonalestimatesoffundsrequiredforretirementbyhouseholdincomearesetoutinChart5–46%ofpeoplesurveyedthoughtlessthan$499,000wasadequateand29%thoughtless$250,000wasadequate.

Chart 4: dailY growth vs. Bea QuarterlY gdp

Source:ConsumerMetricsInstitute

MarJunSepDecMarJunSepDecMarJunSepDecMarJunSepDecMar

8%

6%

4%

2%

0%

-2%

-4%

-6%

-8%

GDPQuarterlyChange

20062007200820092010

8%

6%

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0%

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MonthlyAvg.ofDailyGrowthIndex

GDP(Quarterly) ConsumerMetricsInstituteGrowthIndex

Growth

Contraction

Chart 5: estimated reQuired savings for retirement BY household inCome

Source:EmployeeBenefitResearchInstitute

Under$250,000

$250,000-$499,000

$500,000-$999,999

$1,000,000-1,499,000

$1,500,000ormore

Don’tknow/Don’tremember

29%

50%

27%

13%

17%14%

23%

16%

24%20%

26%

30%

8%5% 6%

13%

3%

4%6%

20%

13%3%

13%8%

AllWorkers Lessthan$35,000$35,000-74,999 $75,000orMore

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Agcapita Update (continued)

Clearlythemajorityofinvestorsmateriallyunderestimatewhattheywillneedtoretire.Theproblembecomesworseasevengiventheselowpersonalestimates,31%ofworkershavesavedNOTHINGforretirement.Whatthiswillmeanforpoorlyfundedboomersandgovernmentpensionplansoverthenexttwodecadesremainstobeseen-willtheboomersdemandthatthegovernmentmakeupthedifferenceregardlessoftheeconomiccosts?

moral hazard and the fallaCY of the safe Canadian Banking sYstem

AdvocatesoftheCanadianbankingsystemarguethatCanada’slackofbankfailuresistheresultofconservativeregulationcombinedwithconcentrationinthesector.YetdespiteanallegedlymorerestrictiveregulatoryenvironmentCanadianbankswereactuallymoreleveragedthanwell-runAmericancommercialbanks.Forexample,attheendof2008accordingtoresearchbyPeterBooneandSimonJohnson:

–JPMorganleverage-13times–JPMorganTier1capital-10.9%–RoyalBankofCanadaleverage-23times–RoyalBankofCanadaTier1capital-9%–WellsFargoleverage-11times–Canada’sfivelargestbanksaverageleverage-19

times

GiventhatCanadianbankswereatleastasleveragedandthinlycapitalizedasmanyoftheirbankruptneighborstothesouth,whatpreventedbankcollapsesinCanadaduringthecrisis?AccordingtoBooneandJohnson,guaranteesprovidedbytheCanadiangovernment.Over50%ofCanadianmortgagesareguaranteedbythegovernmentviatheCanadianMortgageandHousingCorporation(“CMHC”)withabelowmarketcost(statesubsidized)toinsureagainstdefault.TheUS,ofcourse,hadFannieMaeandFreddieMac,withpredictableresultsasthemoralhazardcreatedbytheimplicitfederalguaranteeleaddirectlytotheircatastrophicparticipationinthesub-primemortgagebubble.

Chart 6: workers who have saved something for retirement

1994199520002001200220032004200520062007200820092010

Source:EmployeeBenefitResearchInstitute

Respondent Respondentand/orSpouse

57% 58% 74% 65% 67% 68%

78%

69% 72% 71% 68% 69% 70%66%

72%75%

69%

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Agcapita Update (continued)

StateguaranteeshaveallowedCanadianbankstobecometheclassic“toobigtofail”organizationsandofcoursewehavegraphicevidencethat“toobigtofail”organizationsareoftenonauto-pilottofailurebasedonmoralhazard.Duringtheheightofthecrisis,theCEOofTorontoDominionopenlyacknowledgedtheCanadiangovernment“put”whenhetoldinvestors“Maybe not explicitly, but what are the chances that TD Bank is not going to be bailed out if it did something stupid?” Someexamplesof“toobigtofail,butfailedanyway”:

– Britain’slargestbank,theRoyalBankofScotland,grewitsbalancesheettoaround1.7timesBritishGDPbeforeitcollapsed.

– Ireland’sthreelargestbanks’grewtheircombinedbalancesheetstoaround2.5timesGDPbeforetheycollapsed.

CanCanadianbanksresistthetemptationtoignorecreditqualityinthepursuitofstatesubsidizedprofitsandscale?Ultimately,IbelieveCanadianbankswillberevealedtobetheriskmis-pricingmachinesthatvirtuallyallstatebackedfinancialorganizationsbecome.

interest rates versus rollover – piCk Your risk

Overthecomingmonthsof2010theUSTreasurymustrefinance$1.8trillioninmaturingdebt+interestpayments.“Concerns about the U.S. budget deficit are beginning to hurt the Treasury market”saidSteveRodosky,headofTreasuryandderivativestradingatbondgiantPacificInvestmentManagementCo.(“Pimco”).Pimco’sBillGrosssaidrecently“[US]

bonds have seen their best days”andisadvisinginvestorstobuythedebtofcountriessuchasGermanyandCanadathathavelowdeficitsandhigher-yieldingcorporatesecurities.TheneteffectofthisongoingshiftwillbetoincreaseUSinterestratesandthecostofservicingthegrowingstatedebt.

ToputtheUSproblemsintoperspective,lookattheinterestexpenseoftheFederalGovernment.In2009Federaldebtincreasedsignificantlybutatthesametimeinterestexpensewentdownbyapproximately15%.Incontrast,the2010interestexpenseappearstobesettogrowfrom$383billionto$434billion,a13%increase.

OnSeptember30th2009theoutstandingdebtwas$12trilliondollarswithaneffectiveaverageinterestrateof3.2%.Ifshortratesreturntothemorenormal5%rangeandlongratesreturntothe7%rangeandtheTreasurycontinuesfinanceitsneedsattheshortendofthecurve(astrategythatreducesinterestratesbutexposestheUSgovernmenttoextremeamountsofrolloverrisk)theaveragecouponwouldlikelyrisetoabout5.5%whichwouldcreateaninterestexpenseofaround$780billionwithinterestpaymentsconsumingapproximately2/3rdsoftheUSFederalbudget.

GoingforwardthentheUSFederalgovernmentisfacedwithaseriousdilemma–keepinterestpaymentsfromcripplingthebudgetbyfundingfromtheshortendofthecurvebutthenexposingtheUStotherisksofacrediteventcausedbyshortdurationandtheneedtofrequentlyrollover(refinance)largepercentagesofitsdebt.

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Agcapita Update (continued)

surprise - aig took the fed to the Cleaners

ItappearsthatacharitableinterpretationofthetransferoftheCDObondportfoliofromAIGtotheFedisgovernmentincompetenceinthefaceofaperceivedemergency;thelesscharitableinterpretationisthatAIGtooktheFedtothecleaners.AccordingtoDavidMerkel:

– TheaverageratingonthebondsintheportfolioisB-,with61%ratedCCCorlower.BelowBBB,lossratesturnupwithsignificantly.FortheportfoliotobeB-ratedonaverage,with61%CCCandbelowrepresentsextremelypoorcreditquality.

– 73%ofthedealsinthebondsoriginatedbetween2005and2007,and96%between2004and2008.Arguablythe2003-2008periodrepresentstheworstperiodforlaxcreditstandards.

AccordingtoMerkel,itisextremelyunlikelythattheportfoliowilleverexceedthe$22billionfairmarketvalueascribedtoitbytheFed–i.e.thelossispermanent.

Banking seCtor BaCk to reCord profits

RecordlowU.S.interestratesareboostingtheprofitabilityofthefinancialsector,creatingthesamekindofimbalancesthatfueledthecredit

crisis,accordingtoJimReid,aDeutscheBankAGstrategistinLondon.Chart8tracksearningsoffinancecompaniesagainstearningsfornon-financecompanies.“It seems incredible that financials are now scaling their 2006/2007 heights again,”Reidwroteinaresearchnotepublishedyesterday.“The dramatic imbalances are re-occurring.”

Chart 8: us finanCe seCtor profits vs. gdp

Source:DeutscheBankAG

500

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100

01970s1980s1990s2000s

inbillions

FinancialindustryprofitsNon-financialindustryprofitsNominalU.S.grossdomesticproduct

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Agcapita Update (continued)

BY 2012 surplus oil produCtion CapaCitY Could disappear

AccordingtotheUnitedStatesJointForcesCommand(“USJFC”)annualreport“By 2012, surplus oil production capacity could entirely disappear, and as early as 2015, the shortfall in output could reach nearly 10 MBD.”Thereportpointstogrowingenergydemandinthedevelopingworld,citingasanexamplethehugepotentialforgrowthincarownershipinChina,whichcurrentlyhasonly40millionvehiclescomparedtothe250millionintheUSA.TheUSJFCpredictsthatthecomingoilsupplygapwill“at best... lead to periods of harsh economic adjustment”.

oil demand BaCk past 2007 peak

Economicgrowthinthedevelopingworld,andespeciallyChina,whichreportedfirstquartergrowthof11.9%,causedtheIEAtoupitsestimatefor2010oildemandtoarecordhighof86.6millionbarrels/day-marginallyhigherthan2007peakproductionlevelthatsawapeakoilpriceofUS$147/barrel.Ofcoursemuchhaschangedsince2007,Westerneconomiesarestillbarelyemergingfromrecessionandaresaddledwithmassivepublicdebt,sothegrowthestimatesignalsashiftinwhichthedevelopingeconomiesgrowevenwithoutarecoveryintheirkeyexportmarkets.

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