Yesterday the Fed and 5 other major central banks announced measures to shore up liquidity in the global banking system. In the past 6 months LIBOR OIS spreads, the TED spread, swap spreads and LIBOR had been rising steadily as money markets slowly seized up. Obviously the Fed felt that conditions had deteriorated to a level at which it had to act. The swap lines that the Fed would extend are due to expire Aug 2012. This has been extended a further 6 months to Feb 2013. So the announcement was regarding swap lines already in place and which are currently well under-utilized (about 2.5 billion USD) compared with the whole of 2008 and 2009 utilization (ranging between 100 – 600 billion USD). The cost of borrowing would also be reduced from OIS + 100 bps to OIS + 50 bps. This signals a possible reduction in the Fed primary discount rate from the current 75 bps. Absent such an adjustment, it would be cheaper for a European bank to borrow USD from the ECB than for a US bank to borrow at the Fed’s discount window. But that’s all academic. These swap lines are simply not being drawn down.

Since 2008, the knee jerk reaction has been for banks to sell down their loan books and to replace their balance sheets with sovereign debt. Why? Because sovereigns carry a zero risk weighting under Basel 2. Since corporates were at the same time shoring up their balance sheets just as sovereigns were bailing out private balance sheets by buying their toxic assets, risk was being transferred away from corporates to sovereigns just as banks were substituting away from corporates to sovereigns. A strong Tier 1 capital ratio has become a red flag lest the zero weighting was not due to cash and near cash assets. Now that banks are replete with sovereigns, very much eligible for repo with central banks, the cheaper source of funding has been to repo these assets at single digit basis points costs with the central banks and deposit the cash back with the same central banks for a thin but positive spread. Domestic banks, for example in the US, have to pay a small cost of insurance to the FDIC, pretty much destroying the arb spread, but foreign banks do not pay this cost. For them, it is entirely viable to repo their sovereign bonds and earn a spread on their reserves with the central bank.

So the Fed swap lines are currently not any where close to fully drawn and are not nearly as cheap as the repo market for which the banks have ample collateral. How interesting. At the same time, TED spreads and LIBOR OIS spreads have continued to widen even as equity markets have rallied. OK, so its been less than 24 hours and we are talking about the relative intelligence between fixed income and equity traders. No contest. My tendency is to go short the equity markets if the technicals even show a peep of weakness.

The cynic in me asks why the Fed is prepping the morphine when the patient is in a critical but stable condition.

The problems in Europe lie in plain sight. It is likely that the ECB will eventually print money to monetize European sovereign debt, albeit at the eleventh hour, on the eve of some pan European bank threatening not to open for business one winter’s morning. The debt problems in the US are also pretty evident. Every US Treasury is now a PIK.  India’s rupee has recently been sold down as public finances deteriorate. For real trouble one has to look at China.

The mild recovery in past couple of months in the US has come through exports of capital goods to the resource rich countries to its North and South who have in turn been feeding the building boom in China. This is at risk of coming to a quick end.

So far, with over 9% GDP growth and a slowdown in inflation, China seems to be heading for a soft landing. With official statistics hard to come by and methods of data collection and cleaning unclear, it is difficult to rely on hard numbers. Instead we turn to anecdotal evidence of a credit crunch in no small part engineered by the government itself.

The confluence of fiscal expansion through infrastructure investment, credit creation through off balance sheet vehicles akin to the SIV, as well as debt monetization in the West most notably the Fed, has created inflation in China. Headline numbers of just under 6% hide food price inflation numbers of nearly 12%, a price paid most by the poor and less by the rich. Asset price inflation further increases the rich poor divide as the cost of shelter has surged.

Inflation is a politically charged issue and so while the government fine tunes policy by reducing reserve requirements for selected commercial banks, a general easing is not viable.

As the government has restricted credit creation it has not only starved companies of access to mainstream credit, it has also created an informal and thus unpoliced shadow banking system of significant size. The SIV like LGFVs and trust companies which have been deployed in financing local government infrastructure projects number over 10,000 and are estimated to be over 2 trillion USD in size. Worryingly the senior liabilities are duration mismatched through short term retail products. Current estimates of bank exposure to the LGFVs exclude backstop facilities. Indeed information is sparse as to the existence and identity of a backstop lender. Ultimately of course it will be the central government.

Exports from China have slowed. In 2008 there was a sharp singular lurch in exports as trade finance was suddenly withdrawn as the international banking system went into temporary cardiac arrest. Exports subsequently resumed but by then a weakening USD and a higher savings rate in Western economies have capped China’s export growth.

A similar risk exists today. The slowdown in Europe and the tepid growth in the US, coupled with an increased savings rate must dampen demand for Chinese exports. However, this is a continuous and orderly process.

The European sovereign crisis is now impacting European banks’ ability to provide trade finance, an area where they typically dominate. A shortage of USD in the European banking system is leading European banks especially the French banks to cut down the size of their USD assets as funding in USD becomes more expensive. US banks are reported to be stepping in to this market but they remain similarly capital constrained. A credit crunch in trade finance is likely to take a heavy toll on an export driven economy like China and will be a drag on its foreign exchange reserves.

Most of all China needs to print good numbers in growth, inflation, employment and trade. Why? Because the financial strength of any country is highly dependent on the confidence that its creditors have in it. China’s debt to GDP ratio is hard to determine and various sources cite numbers from 17% to 160%. Opacity is the enemy of confidence.

The coming Chinese Lunar New Year will be especially important. Anecdotal evidence already points at unpaid wages and zombie companies. The residential rental markets have begun to show signs of weakness as foreign company reps have been repatriated amidst weak business growth. The Lunar New Year is when workers from the central regions return home from the industrial cities for their annual family reunion. The layoffs, if any, will occur then. Businesses will not want to bear repatriation charges, will not want irate ex employees picketing shop fronts and factories, and will count on laid-off employees not incurring travel expenses to the industrial cities to demonstrate or express their grievances.

In 2012 the National People’s Congress elects the next leader of the country so it can ill afford economic instability. While economic growth is important what is more important is inflation. And inflation in the rural areas is driven by food and agricultural products where inflation is running not at 5% but closer to 12%. Absent a credit fueled infrastructure binge, China may face low growth and high inflation (there is a word for that.) The politics of China are likely to push the government to be more vigilant on inflation than on growth.

Is the European banking system solvent? How many European banks are insolvent? If one marks to market the value of all the assets of each European bank, how many would remain solvent? The volatility of 5 year French government bonds is over 6%. The volatility of 5 year Italian government bonds is over 15%. The risk free treatment of sovereign bonds on bank balance sheets is no longer adequate. Any rational analysis of European bank balance sheets must conclude that the minimum capital requirements under Basel 3 would place most banks at the brink of insolvency if not beyond it. Money market liquidity has dried up and if not for the significant credit offered to the banks by the ECB, Libor OIS spreads would be far wider than they are today. But liquidity is only one issue. Solvency is a separate issue which Europe’s banks face today. It is not clear how much longer the current situation can continue. Europe needs to find several trillion Euro, estimates range from 1 to 5, and some wilder ones even more. A 2.5 trillion Euro estimate seems reasonable for a back of envelope calculation. It has to find this somehow, by borrowing it from someone, expropriating it from someone, or by printing it from thin air, but it needs to find this money now.

The ECB understands the scale of the problem and it is only a matter of time before they will be forced, hopefully before but more probably after a significant bank runs aground.

Debt monetization is not ideal and it looks as if the market has forced the ECB to do the wrong thing, by making it the right thing to do. If they do do it, the long term implications for fiscal restraint and price stability will be threatened. If they don’t do it, a number of banks will be forced into state ownership. But given the Eurozone’s unique structure, how will taxpayers pay for the nationalizations? Even these will be no more than sleight of hand until inflation, hopefully not of the hyper variety erodes the value of debt.

Banks trade on confidence and reputation, not financial strength. Put aside for the moment the complicated and confusing Basel rules and let’s apply some common sense. Put aside definitions of risk weighted assets and Tier 1 or Tier 2 capital. Look at a bank as a business. If you have 50 billion in equity and you have 2,000 billion in assets, you are basically levered 40 X. This is a mathematical fact. It says nothing about how safe or risky those assets are.  All it says is that if you make a loss of 2.5% on your assets, you will have lost entirely all of your equity.

Now, consider that Basel 3 would have banks raise their minimum Tier 1 capital ratios from the current 4% to 6% by 2015. Does that mean that it will take a 6% loss on the assets in order to cause insolvency? Well, not quite. This is because the ratio is expressed as a ratio of Risk Weighted Assets. The Risk Weighted Assets of a bank is a weighted average of the assets of held by a bank. The weights are prescribed by the Bank of International Settlements under Basel 2 and now Basel 3 and basically go as follows. Cash is weighted at zero since it has no risk. Government bonds are also weighted at zero since… OK, lets not stop here in despair but lets go on.  Mortgages can carry of weight of anywhere from 5% to 35%, loans to unrated corporates carry a 100% risk weight, loans to highly rated corporates and banks a 20% risk weight, AAA CDO’s 7%, and equity in hedge funds and private equity up to 400%. The reduction of risk to a single number should be a red flag. So much for our departure from reality. Now back to our common sense approach.

For a bank whose only asset is cash, what is the risk of loss? Well, none. So the zero risk weight makes sense. How about a 20% risk weight on highly rated corporates? It depends on the seniority of claim. If one was to estimate the risk of these loans by looking at the secondary loan or bond markets for similar credits, what would one find? A number between 5% and 10% seems reasonable. Basel 3 would require a bank to hold a 6% X 100% = 6% capital buffer against these assets. 6% lies in the interval lies within the interval, not above it, so there is a good chance that the capital will be inadequate to cover the risk of the asset.

How about hedge funds? Basel would require 6% X 400% = 24% capital on a hedge fund holding. This seems reasonable. Most hedge funds have low single digit volatility so a 24% buffer will likely be sufficient to cover the risk of investing in a hedge fund.

Sovereigns? Here is where Basel falls down. Zero X anything = zero. Since government bonds carry no capital requirement, banks often use them in times of credit stress to operate a domestic government carry trade. Lending to the private sector is risky and capital intensive so banks take advantage of yield curves where usually the short end has been anchored low by an accommodative central bank, and lend to the government at longer durations instead. The capital required to do this trade is, well, zero. This when the volatility of Italian government bonds can be as much as 15%.

So you can do this trade in pretty much any size you like until the volatility or loss on the asset (a sovereign bond) turns out to be significantly more than zero, at which time risk managers and CFOs frantically explain to their CEOs that their bank is insolvent. These CEOs generally will not turn to their regulator until it is too late. They will instead try to find a solution, such as dumping the asset, which tends to crystallize losses and push asset prices even lower thus destroying more equity capital. Only when they are comfortably well into insolvent territory might a CEO turn to the regulator. The regulator is used to dealing with slow moving quantities such as inflation. When sovereign spreads start surging and banks’ solvency is in doubt, they tend to call the politicians. This is the only time the politician is made aware of the problem. While the regulator seeks direction and consultation with the government to stem a potentially damaging situation, the government will be considering the cultural, historical, social and political implications of the situation. Before long there will be dissent, opportunistic politicking, cynical self interest ending in sclerosis. Only at the edge of perdition will there be any action, and then not necessarily appropriate action.

As a simple fellow, I tend to look at how much assets a business has and how much equity it has. A bank reporting a 10% Tier 1 capital ratio means little to me because I don’t know what it means. If that same bank tells me it has 2 trillion in assets, and 50 billion in equity, I know that a 2.5% variation in the assets of this bank can either double my equity or reduce it to zero. Whatever the composition of the assets, this remains true.

By this count, Deutsche can take a 2.5% asset variation, Dexia 1.7%, BNP 4.2%, JP Morgan 8.3, HSBC 6.3%, and the Singapore banks some 10% – 11%. What this metric doesn’t say is what kind of assets these banks are holding

The beginnings of a proper recovery are emerging in the US driven by exports and the repatriation of manufacturing. This has not yet but will soon translate into jobs and wage growth which will revive investment and consumption. The government can help this along by lowering marginal tax rates and simplifying the tax code, but hopes of rational government are always and everywhere wishful thinking.

The risk to this recovery lies with China and the emerging markets which represent the USA’s export markets. US consumers remain cautious and as a result emerging market exporters remain disadvantaged. China’s economy still relies on investment and government expenditure on infrastructure to grow. There are signs that the extraordinary credit creation to finance this infrastructure investment may be leading to a bubble on the edge of bursting. Until or unless that happens it is business as usual. China builds, prints, the West like Germany and the US supply capital goods and technology.

Expect this to be a long term phenomenon with any credit crisis in China, hard landing or soft that it may precipitate, a temporary set back.

For equity investors this is merely a continuation of a trend which has lasted the last 2 years, of rising globalized companies with exposure outside the US and struggling domestic businesses.

The same theme is mirrored in the emerging markets with exporters to the developed world continuing to struggle while domestic businesses flourish.

The Euro is no longer a risk. The damage lies in plain sight. Any solution leaving Greece in the Euro is no solution and should be sold into. Italy is a different mess. It suffers more from a crisis of confidence than of real insolvency, although of course the solvency of a sovereign, unlike that for real businesses is almost entirely a matter of confidence. The European banks are likely collectively and individually insolvent but markets have lived on thinner myths before. Again there are rich pickings of European based or listed companies with Lat Am, Asian or MENA exposure.

The US and European equity strategies remain the same as for the last couple of years. The emerging market equity strategy needs some adjustment. Where previously in Asia it paid to be long domestics and short exporters, things are no matter that simple. Chinese banks are at high risk. Chinese domestic companies will face a dearth of credit. If as expected the government starts to ease policy on the back of inflation easing up, it may start a broad based rally. But these are more tactical positions. There is no clear long term position to take in China. Elsewhere in Asia, inflation remains persistent, although there may be some respite from the turmoil in Europe and the weak growth in the US. Don’t forget that the call on a recovery is a very early signal and current indicators remain weak. Resource rich countries in Latin America and the Antipodes will likely continue to benefit from China’s voracious appetite for resources. With its exports still weak China will continue to build. This could confound the technical risk-off view on currencies like AUD.

Until further notice a rational strategy for equities is to maintain a trading stance with the old position of being long developed world exporters and short domestics. The emerging market strategy will be highly tactical shorting consumer goods exporters. Shorting banks all over the world might make academic sense but the propensity for governments to ban shorting when their banks are decimated make this a risky trade.

Fixed income has to be traded tactically as well. Its no use shorting PIIGS debt any more. An unstable ECB policy and the uncertain fate of the EFSF make buying or shorting Euro debt highly risky. US treasuries will remain the market of choice for risk on risk off trading. The curve is likely to remain flat or flatten as the Fed executes Op Twist. But the credit quality of the US is not great and US treasuries have basically become PIKS so even this trade is a game of chicken.