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China’s Resource Buys

by rziemba
February 20, 2009

Note: This post is by Rachel Ziemba of RGE Monitor (where this first appeared) thanks again to Brad for letting me fill in while he’s on vacation.

note: I’ve made a slight update to the discussion on the price Russia will pay for its loan.

China development bank must be busy…. Over the last few weeks, loans worth over $50 billion have been confirmed with the oil companies of Russia, Brazil and the Australian mining company Rio Tinto, all of which have found themselves with financing issues in light of the collapse in commodity prices and credit crunch. While $50 billion is a relatively small in terms of China’s foreign exchange liquidity, this is a significant investment on China’s part in the resource sector, and shows that it is trying to get higher returns on its capital – while coming to the rescue of those who cannot tap the still relatively frozen international capital markets. And given some of the dire predictions for energy sector investment (including warnings from the IEA) might avoid a severe drop off in investment, allowing some of these countries and China to get more bang for the buck as global deflationary trends lower costs.  Most significantly, it increases the share of oil supplies that are pre-contracted, perhaps a desire from both China and its suppliers to have a somewhat more predictable price environment for at least some of its supplies. And given the financing needs, China may be able to push for lower prices.

Leaving aside Rio Tinto, to which I’ll return in a bit, these indicate an increase in long-term oil supply deals between customers and producers both of which are state-backed enterprises, bankrolled by the government backed development bank. It thus increases the role of governments and may trigger greater concerns if not from the recipient countries then from others. It further reinforces the increased role of government and quasi-government influence in the energy and resource sectors as state-backed resource companies have an increasing role in the energy sector in terms of production and supplies. Several of these companies have some private funding but ultimately governments have a key influence on decisions, backstopping decisions.

Russia and Brazil will repay China’s loans in oil. In the case of Russia, estimates from uob kay hian suggest that given an interest rate of 6%, Chinese companies are getting access to supplies at approx $22/ barrel.  This seems low, even at today’s prices given the long-term oil prices that most of these companies assume.  Other estimates seem to suggest that that the price is closer to $70 a barrel, which presumably is the notional value of the loan. But much will depend on the interest rate which is apparently between 5-5.5% according to other sources and pegged to libor, which leaves Russia vulnerable to further libor volatility.  Update: Based on a helpful commentator, it seems that the loan will buy access to oil but not oil itself, with the price being obtained monthly from Argus and Platts quotes.

China has already had oil supply deals with Venezuela and Japan signed a 5 year 120,000 barrel a day deal with Abu Dhabi’s ADNOC these deals are somewhat larger. Russia has promised the equivalent of 300,000 barrels per day or almost as much as china imports from its largest supplier, Saudi Arabia.

Speaking of Saudi Arabia, Hu Jintao just visited the kingdom and left with contracts to build the train to Mecca, an extension of a natural gas joint venture, another joint effort on two refineries, in which Chinese companies will provide assistance but will not own a stake. The natural gas cooperation is of particular interest to both countries. Saudi Arabia (and most of its neighbors except Qatar) are short on natural gas and in recent years the fuel has attracted more exploration activity than oil given its role in power generation and as a feedstock in petrochemical production, a key growth industry aiming at the Asian market. Most of Saudi Arabia’s natural gas is found with oil, making it more difficult to exploit. In fact, Jadwa notes that natural gas demand might actually restrain further and sustained oil production cuts.  In Saudi Arabia, Chinese companies already operate much of the construction in Saudi Arabia and China is the largest source of imports for Saudi Arabia. However, Aramco remains relatively flush despite the Saudi spending increases and revenue declines, raising capital in recent years to fund its expansion.

But the Russian oil companies and Petrobras clearly need funds.

Russian oil companies, like Russian banks, borrowed heavily abroad when credit was cheap. In the case of the oil companies,  the Russian tax structure, especially export taxes limited profits with the government itself taking most of the revenues above $25/barrel. Oil and Gas companies went cap in hand to the government some months ago asking for funds to maintain their investment plans and refinance their debt. Russia’s oil companies had previously insisted that maintaining production required well over $70 a barrel oil.

In exchange for $25 billion over 20 years Russian oil companies, Rosneft and pipeline operator Transneft have agreed to supply China with around 300,000 barrels per day in oil and build a pipeline extension to China. The oil supplied would be equivalent to 8% of China’s daily oil imports (and 4% of daily oil demand).  FT’s Lex suggests that Rosneft’s $15bn share of the $25bn loan package will comfortably cover its $8.5bn debt maturing this year, 60% of which is owed to foreign banks half due in Q2 and allow it to make the investment increases to meet the needs of its supply deal with China. With its share of the funds, Transneft, the pipeline monopoly, will finance new pipeline spur to China which had been held up on price discussions as well as US$5.5–7.3bn capex in 2009, part of its future mid-term investments, including the US$3.6bn on the Baltic pipeline. Furthermore ING notes that the inflows associated with such a loan could relieve some of the pressure on Russia’s finances. Despite a very sharp contraction in imports (preliminary data suggest an almost 40% decline of imports from non-CIS countries in January) Russia’s current account surplus is likely to shift to deficit this quarter. Inflows from China could offset some of the growing financing gap depending on when it is delivered.

Brazil: CDB will loan Petrobras $10 billion helping the company continue its investment plan, especially relating to pre-salt oil and to aid in refinancing its outstanding debt. Details of the loan have not yet been released but will be finalized before a May visit to China by the Brazilian prime minister. Petrobras agreed to sell as much as 100,000 barrels of oil this year to Sinopec and increase it over time.     Petrobras is planning to invest well over  $100b over five years as it develops the pre-salt finds announced last year. The company has been seeking alternatives to international bank lending and bonds to finance its spending plan in the face of an international credit crunch. Petrobras already sells a some oil and products to China and signed a cooperation agreement with Sinochem in 2004 and CNPC in 2005

Petrobras has repeatedly stated that pre-salt production is still feasible even with a lower oil price. Yet, statements suggest the pace of development of pre-salt production could be slowed and that associated projects, such as plans to build two new refineries for export, could be put on hold. Collectively this means Petrobras is more reliant on its joint venture partners – Global Insight suggests that Petrobras may be able to keep diversifying its funding sources. But since Petrobras’ shares have come under such pressure, and financing terms at home and abroad are costly while the cost of hiring rigs  has not softened very much, Chinese funds could keep investment in the pre-salt area on course. Doing so supports the economic development and political goals of the Brazilian government.

In Australia, Chinalco, the Chinese largest state-owned company, financed by the China Development Bank, agreed to lend Rio Tinto $20b through a convertible bond to help it pay off its debts (it has $9b coming due in Oct2009 and $10b in 2010, mostly accrued during its purchase of Alcan). Chinalco will buy $7.2bn in convertible bonds, eventually increasing its stake in Rio from 9% to 18% and invest $12.3bn in strategic partnerships in Rio’s copper, aluminium and iron ore divisions. In exchange for providing capital as a very competitive rate Chinalco should get access to these prime assets for a key rate. The convertible bond structure was likely chosen to avoid restrictions on equity purchases.  Perhaps it is not a surprise that the Australian treasury is planning to change legislation to treat debt as equivalent to equity, possibly blocking the transaction.

Although Australia has been receiving an increased amount of investment from China with an estimated 10b in Australian dollars approved in 2008 (on top of an existing stock of A$6.2b according to Mark Thirwell.) Trade with China rose to 13% of Australia’s total. This is the first major test of of a new investment review process Australia introduced last year which clearly distinguishes between state and non-state investors meaning all state-backed investors are subject to increased review. Chinalco, a state-backed company will prompt significant scrutiny especially given the fears it will aquire the most profitable of Rio’s assets and increased bargaining power at price discussions. If regulators were concerned about the pricing power of a joint Rio Tinto/BHP Billiton, the Chinese funded Rio may also shake up the market. However unlike the oil deals, the investment in Rio is not explicitly linked to a supply deal with iron ore pricing still in progress.

For China, these investments seem to be a relatively efficient way to use its financial resources given the likely long-term appreciation of resource prices and uncertainty about financial assets. Like other cash-rich investors, it can set the terms and may provide the opportunity for its energy companies to really enter the global stage even if it may limit their intermediary role and tie them into their domestic political structure. It may also suggest that China can take advantage of the nascent reversal of resource nationalism that seems to be underway. When oil prices rise, so does the uncertainty of fiscal regimes in the sector and vice versa. For those receiving the funds, it provides a way to get cheaper loans than possible though other means. However in some cases, it may undermine the rights of existing shareholders – such concerns are more obvious in the case of Rio Tinto where existing shareholders may be disadvantaged when the new shares convert. Furthermore its joint interests as a shareholder and one of Rio’s largest customers may counteract

However, China may be getting access to supplies, but aside from some limited joint ventures, its companies are not getting access to reserves but to guaranteed end product. Over all,  the desire to lock up supplies may reflect a shift away from China’s policy of seeking out investment opportunities in a range of oil projects wherever they could be found, mostly in unstable states in Africa.  Erica Downs notes that the early go global efforts of China’s national oil companies left them with a range of investments in many countries a portfolio that was difficult to manage efficiently – now they may be trying to concentrate. There were other costs too.  Raghuram Rajan noted that buying stakes in opaque companies in poorly governed foreign countries might not be the best way to go. The security of a country’s ownership of oil assets in poorly governed foreign countries likely diminishes when the oil price rises. While China did not face nationalism pressures per se given their often minority stakes, events of recent years including attacks on Chinese workers in Nigeria have illuminated the economic costs of the production.

Most of the Chinese oil production abroad was sold on global markets with the profits used to cross subsidize losses on domestic refining segments given fixed prices. In fact only about 10% of Chinese oil imports are supplied through the equity stakes that China has in oil projects abroad. Instead China imported oil from a range of countries in Africa which supplies 1/4th of China’s oil (especially Angola) and the middle east, which supplies 50% (mostly Saudi Arabia, Iran and to a lesser extent Oman.)

It also increases the amount of oil that is officially locked up for long-periods of time which will boost predictability for some producers and consumers even as it raises costs for others. Already the Asian market tends to have more long-term contracts than in other regions, because of the long transportation time and need of Asian countries for imported oil unlike other locations where the spot market is more developed. Longer term supply contracts may not only provide a more stable source of energy but may provide more opportunity for joint venture for somewhat lower costs, increasing the ability to plan given that most new production remains expensive by historical averages. Yet deferring investment in new resources would surely boost the price for all, including China.

Two more side notes (digressions) as this has been a big week in energy politics. Not only is a country like China trying to diversify their suppliers but some exporters are trying to diversify their customers. Russia trying to boost oil exports to china, it is trying to boost and diversify its natural gas exports to Asia by opening up a LNG plant on the east coast. The first cargos from Sakhalin-2 began to be loaded earlier this week. Most (65%) of the pre-contracted cargos are bound for Japan, which is the largest demander of LNG. Russian supplies may help to partly offset the decline in supplies from Indonesia which is consuming more at home. The rest of the LNG supplies are bound for other Asian countries, with a small amount going to a regassification plant in Mexico for the Latin American market. Given the obstacles in shipping, the reduction in distance and transport time, might reduce prices in Asian LNG market. However in both oil and gas, diversification of partners may divert supplies from existing customers, especially in Europe. Russia in particular is facing constraints in increasing supplies given relative under investment. Russian domestic natural gas exports have been on the decline for some years as domestic demand grew. While 2009 will likely prove a short reversal, the cheap power and gas prices will keep domestic demand high, meanwhile oil production is falling as fields mature.

Given that the focus of this note has been bilateral producer consumer deals, it seems apt to conclude with the energy ‘deal’ that President Obama and Prime Minister Harper announced yesterday. Details are still uncertain but the two countries have pledged to co-invest in technologies that will reduce the environmental impact of energy sources like coal and the bitumen harvested from Canada’s oil sands. In part it reflects the producer, Canada taking seriously the concerns of its largest customer – Canada is the largest supplier of energy to the U.S.. It takes the funds already allocated in the recent U.S. and Canadian fiscal packages to carbon sequestration and other clean energy investments (much more expansive in the US than in Canada). The economic incentives of finding cheaper, more efficient technology are clear. With California and other states moving ahead to seek cleaner fuels, the carbon footprint of the oil sands is a major burden. And given that the U.S. government now has a political consensus around a new climate change deal, as Annette Hester notes, it is in Canada’s interest to start making the changes that will make sure its supplies are not priced out of the carbon market which will eventually come.  the same goes for U.S. based refiners who were counting on Canadian refined crude. Given the regulatory changes relating to emissions, the high costs of production given that the swarm of producers into Alberta led to sky-rocketing prices (now reversing) oil sands projects have been frozen or deferred. This is a case where the government can create the incentives for the private sector to invest – and can best signal the direction of the developing new climate regime.  Given that the oil sands are often cited as one of several examples of more expensive supplies that will provide a price floor for oil production, it may be important development to watch.


  • Posted by Cedric Regula


    Some geologist lingo about where oil comes from:

    Ghawar occupies an anticline above a basement fault block dating to Carboniferous time, about 320 million years ago; Cretaceous tectonic activity, as the northeast margin of Africa began to impinge on southwest Asia, enhanced the structure. Reservoir rocks are Jurassic Arab-D limestones with exceptional porosity (as much as 35% of the rock in places), sourced from the Jurassic Hanifa formation, a marine shelf deposit of mud and lime with as much as 5% organic material (1% to 2% is considered good oil source rock). The seal is an evaporitic package of rocks including impermeable anhydrite.

  • Posted by gillies

    our story is mostly about the monkeys burning the trees.

    – first the trees in the form of timber. then in the form of ancient deposits of coal. (note that there was a threatened timber crisis, ‘peak timber’ if you like, and coal came to the rescue.) then the steam locomotive gave way to the internal combustion engine, and oil took the place of coal, in transport at least. but it is still the monkeys burning the trees . . . .

  • Posted by Twofish

    ReformerRay: The same thing we are doing today. Provide the banks with federal money but put limits on which bills they can pay in the interim.

    1) We are talking about several hundred billion dollars of money that has not been appropriated by Congress.

    2) You just can’t say, we will pay X but not Y without having huge consequences. Once you say that we will not pay Y, then people who are owed X will wonder about things.

    Trying to figure out what you will pay and what you won’t is a tricky thing that will take months. Ultimately, what you want to do is to set up a “good bank” with assets and liabilities that will be paid, and a “bad bank” with assets and liabilities that won’t. That’s actually what has been suggested for Citigroup, but there are two problems……

    ReformerRay: No more payoffs to credit default swaps or other deriatives that are part of the toxic assets. Only payoffs to firms or individuals who have put their money in the bank on a termporary basis and is legally entitled to the money.

    1) The problem here is that you can screw people over…… Once. Once you screw someone over financially, then it becomes difficult to go back to them and ask for money again.

    In order to figure out what assets can need to be paid and what assets can be dropped, you need either need the cooperation of people within the bank. The guy (or more accurately hundreds of guys) in charge of the database is not going to be that cooperative if he thinks he is going to fired the next day.

    2) The other problem (and I think people have only begun to realize this is a problem) is that if you screw hedge funds and private equity, they stop lending. With all this talk of nationalization and defaults, none of the people who manage money in hedge funds and private equity are interested in lending any new money.

    To get them to lend money, you have to provide government guarantees on any *new* loans, which may cause major problems in a few years.

    In finance there are no “do overs”, once you pull the trigger, what happens, happens which means that people are very slow to pull triggers.

    ReformerRay: There is a whale of a lot of difference between a Treasury Sectretary who has a clear sense of what needs to be done that will be supported by public opinion and a Treasury Secretary who is afraid to move because he will offend some interest group. Obama will decide this issue.

    Treasury Secretaries can’t think out loud. It may be that the Geither has decided that nationalization is unavoidable, but he isn’t (and shouldn’t) breathe a word of this before he actually does this.

    The second issue is that I strongly distrust people with a “clear sense of what needs to be done”. Things are moving so rapidly and we are learning things so quickly that anyone that “knows what needs to be done” is obviously incompetent. For example, the problem in which nationalization talk has been spooking people with money is only something that people figured out was happening last week, and all of this came to a head on Friday when the stock market tanked.

    Geither and his advisors are trying to figure out what to do right now, and we’ll know Monday.

    One reason people in the financial markets are a bit spooked is that everyone knows that the fact that there are Federal bank examiners crawling over the books of every major bank means that Geither is thinking of doing “something interesting.” The thing about “stress testing” is a cover for some ulterior motives.

    Geither (and everyone else in the industry) already knows who is in trouble and who isn’t, but by having people poring over the books of the banks, he will know exactly what liabilities are essential and which one’s aren’t.

  • Posted by Twofish

    ReformerRay: Do you prefer that taxpayers should pay for their mistakes?

    Depends. Which taxpayers? If the former CEO of Lehman Brothers gets a nice hefty tax bill in the mail, I’m not going to shed any tears.

    Part of the reason I don’t care if the “taxpayer” pays is that I don’t see my tax bill going up, unless I make a lot more money in which case I don’t care.

    One reason that I prefer to pay through taxes rather than by just putting in sanctions is that with taxes you have a lot of control over who ultimately pays. With non-tax sanctions it’s sometimes not obvious who is going to ultimately pay, and given the games that people can pay, it’s likely it will be someone you that shouldn’t be paying.

    This is actually one of the problems with taxes. It’s obvious who is paying.

    Talking about the “taxpayer” is a very clever rhetorical trick that Reagan thought up. There are some equally clever rhetorical tricks that you can think of to justify cleaning up the banking system. However, right now people are too focused at fixing the problems to think too much about marketing. Maybe that’s a good thing.

    ReformerRay: No more payoffs to credit default swaps or other deriatives that are part of the toxic assets.

    That’s possible, but if the government orders non-payment of CDS, then you have huge problems because the people who have collateral against those CDS’s will get to keep it, and then will immediately stop extending credit based on those CDS’s.

    Maybe that’s a good thing, maybe not, but it’s a chess game in which you just have to think about four moves ahead.

    Wiping out old losses, is relatively easy to do. The trouble is convincing people that got wiped out once before to start loaning again. One particular problem is that the only area that had serious problems with securitizations was subprime mortgages, but if you wipe out all securitizations because of subprime, then people won’t extend credit for auto loans, credit card debt, student loans, and small business loans.

    ReformerRay: The important factual question hanging beteen me and Twofish is the composition of the assets on the books of the big banks.

    They are liabilities, and not assets. Remember that banks live in a mirror universe.

    ReformerRay: If the assets are mostly deposits that can be called at the disgression of the owner and the Secretary of the Treasury cannot specify the uses to which the Federal money can be spent, then my idea will not work.

    They don’t have to be mostly deposits. Remember that banks are mostly illiquid. They only hold a small amount of cash. In any typical bank, the amount of demand deposits is far, far in excess of cash on hand. Also there are things other hand checking accounts. Callable loans. Collateral. Repurchase agreements.

    When someone signs a derivative agreement, they aren’t stupid. Usually there is some collateral that they force the bank to put up. So if the bank doesn’t pay the derivative, they get to keep the nice shiny Treasury bill that the bank deposited.

    Part of the reason that “cancel all agreements” just doesn’t work is that people thought of that, and put lots of traps and bombs that go off if an agreement gets cancelled. For example, your standard repurchase agreement. I buy a treasury bond from you, and agree to sell it back in a week. If something goes wrong and all agreements get canceled, I don’t care, since I have your bond.

    ReformerRay: They go trough Chapter 7, which results in disolving the company. That reality is why I suggested Chapter 7 as the template for a new bankruptcy law for banks and insurance companies in the current reality.

    Even with Chapter 7, you need massive amounts of financing to pay for the liquidation and the lawyers. You see all of the “going out of business” sales at Circuit City. Some bank has to finance that. Also Chapter 7 is not the end of the story. Even after a company goes totally out of business, someone is going to wind up with assets that can be useful.

    Bankruptcy laws rely very heavily on functioning banks, which is why you end up with a total mess if the banks aren’t functioning.

    ReformerRay: If the Treasury Secetary provides the banks will sufficient funds BEFORE the word leaks out and he can force the banks to sign an agreement as to the use they will make of these funds, then it would work.

    Lots of problems. If you have the money there is no need to play nice. You can have Treasury and FDIC call the CEO to his office and fire them. In fact if you are in this situation you *SHOULDN’T* play nice.

    If you are in a situation in which the CEO can threaten to destroy the world financial system, if they don’t get what the CEO wants, then you aren’t in a good position to force them to agree to anything.

    This sounds silly, but this is *exactly* what General Motors is doing.

    The other problem is that the Treasury Secretary can only spend the funds that Congress has allocated.

    There is clearly not enough money to shut down a megabank. It would take several hundred billion dollars in cash to cover deposits, and a typical megabank has tens of billions of dollars in overnight loans that have to be covered by start of business tomorrow. Treasury doesn’t have this cash, and Treasury can’t get this cash without making a big noise.

    This was a big problem with Fannie and Freddie. Treasury couldn’t shut down Fannie and Freddie until July when Congress passed some key bits of legislation. Once that happened, people knew that the game was up. However Fannie and Freddie got their funds through monthly auctions, and there is no easy way of taking money out of the two. Banks are way, way different.

  • Posted by Twofish

    ReformerRay: They would be taken over by other banks, in the normal practive of FDIC. Only the toxic assets would be segregated for special treatment.

    What other banks? If you try to solve the problem by having banks take over other banks, then eventually you run out of banks. The other problem is that once you have few banks, the ones that are left are “too big to fail.”

    We’ve already long reached that point….

    Who watches the watchmen? Who bails out those that do the bail outs?

  • Posted by ReformerRay

    Twofish is good at thinking up obstacles.
    Where was he when Paulson developed his scheme of buying toxic assets, a scheme that did not work? Where was he when Paulson followed the advice of Paul Krugman? Direct infusion of money into the banking system did not work either.

  • Posted by ReformerRay

    I am adding comments separately because I want to add correctly.

    The public is increasingly waking up to the point that the Federal government was explicitly excluded from any role in these contracts (by the Commodities Futures Modernization Act of 2000) AND THERE IS NO REASON TO BRING IN FEDERAL PARTICIPATION AT THIS POINT.

  • Posted by ReformerRay

    Any private firm, whether a bank or an insurance company, that has taken on obligations that they cannot fulfill should be disolved and their assets distributed among claimants.

    Paulson and his buddies in the finance sector are pretending and maintaining that to allow a big bank to fail will cause other firms to fail and will take out the entire banking system. The last phase is important and it is not true. The only financial firms that will fail if AIG or Citigroup goes under are those firms that participated in buying and selling these toxic assets that brought on the current recession – depression.

    We can live without ANY international banking firms for a while, if that is necessary. Foreigners are not willing to trust U.S. financial firms anyhow, after being burned by the demise of Lehman Brothers. Lets get the destruction over with.

  • Posted by ReformerRay

    Nationalization is possible but it will be a mistake if it saddles the Federal government with the responsibility to make good on contracts that brought down the banks. I think Lindsay Graham wants that form of nationalization.

    Notionalization could be instituted with the provision that the Federal Government would take responsibility for all contracts other than those produced as a result of the Commidities Futures Modernization Act of 2000. Then it would be OK. The Federal government could sell the firms back to the private sector, after the toxic assets have been disolved.

  • Posted by ReformerRay

    There is clearly not enough money to shut down a megabank. It would take several hundred billion dollars in cash to cover deposits, and a typical megabank has tens of billions of dollars in overnight loans that have to be covered by start of business tomorrow. Treasury doesn’t have this cash, and Treasury can’t get this cash without making a big noise.

    Then the Treasury must make a big noise. It cannot be the case that the overnight liabilities exceed the ability of the Tresur y and the Federal Reserve Board to handle the matter. Ben came up with enough money to keep the short term overnight markets going at the scale of all banks. If he can handle all banks, there is no reason he cannot handle one bank.

  • Posted by ReformerRay

    My main point to Twofish is that the Federal govenment should NOT be in the business of covering all the deposits listed on the balance sheet of a mega bank.

    He cannot see the possibility that some of the deposits on the books of banks must be disavowed.

  • Posted by ReformerRay

    The bankruptcy of Lehman Brothers shows what I want to happen to ATG and Citigroup. Lehman was not a bank. So the toxic assets on their books were not transfer to another bank or any other entity. They were resolved by the Depository Trust Clearing Company. All the Credit Defaut Swaps to which they were a party were resolved by the exchange of 5.2 billion dollars among the parties. The private sector settled this among themselves. That is exactly what I want to see happen to AIG and Citibank.

  • Posted by ReformerRay

    I am going to call my proposal “The Lehman Brothers Solution” in honor of the business firm that showed the world how to eliminate toxic assets from the books of banks.

  • Posted by Twofish

    ReformerRay: Where was he when Paulson developed his scheme of buying toxic assets, a scheme that did not work?

    In a cubicle, doing my job…..

    Anyway hindsight is 20-20. Paulson’s proposal was a good idea in October, and at the time I was hoping that it would work. It was worth a try, but things have changed since then. The big thing that has changed is all of those bad employment numbers that started coming out in November.

    ReformerRay: Where was he when Paulson followed the advice of Paul Krugman? Direct infusion of money into the banking system did not work either.

    Work for what? The infusion in November kept the commercial paper market from falling apart. You are looking for a single magic bullet that solves all of the problems, and things just don’t work that way.

    Trying things that don’t work is not a bad thing. I’m not a fortune teller and neither is Paulson or Geither.

    ReformerRay: Any private firm, whether a bank or an insurance company, that has taken on obligations that they cannot fulfill should be disolved and their assets distributed among claimants.

    It almost never works that way. Even in Chapter 7 liquidations, the bankrupt entity is not “dissolved.” A bankrupt company is still a company. Also in many (and probably most) bankruptcies, the creditors don’t want the entity liquidated since they end up losing more money that way.

    ReformerRay: The only financial firms that will fail if AIG or Citigroup goes under are those firms that participated in buying and selling these toxic assets that brought on the current recession – depression.

    Which is basically everyone in the world either directly or indirectly.

    ReformerRay: It cannot be the case that the overnight liabilities exceed the ability of the Tresury and the Federal Reserve Board to handle the matter.

    Yes it can be….

    ReformerRay: Ben came up with enough money to keep the short term overnight markets going at the scale of all banks. If he can handle all banks, there is no reason he cannot handle one bank.

    He came up with $50 billion “good faith money” from a slush fund to back money market and commercial paper markets that are in the trillions. It works just like FDIC, which has $50 billion but backs deposits that are in the trillions.

    When people are in panic mode and in a bank run, you can stop it by walking up to the teller window and waving lots of money. Once people calm down and see they aren’t going to lose all their money immediately, they calm down.

    The thing about FDIC and Treasuries backing of commercial paper is that it isn’t nearly enough money to shut down a megabank. Everyone knows it, so that’s why people are pretty confident that a megabank just will not be shut down. Nationalized maybe. Shut down. No.

    ReformerRay: My main point to Twofish is that the Federal govenment should NOT be in the business of covering all the deposits listed on the balance sheet of a mega bank. He cannot see the possibility that some of the deposits on the books of banks must be disavowed

    Really difficult to do, and probably too late.

    Once you’ve guaranteed some of the deposits, then you get sucked in and you end up having to guarantee more and more of the deposits until you end up guaranteeing everything. The Federal government *already* has ended up guaranteeing all checking accounts, all savings accounts, all money market accounts, all mortgages, and backstopping commercial paper.

    ReformerRay: The bankruptcy of Lehman Brothers shows what I want to happen to ATG and Citigroup.

    1) Not all of Lehman Brothers went bankrupt. Lehman’s North American operations stayed solvent and was purchased by Barclay’s.

    2) Lehman is still in business, and they are hiring in fact. It will be another two years before they can permanently shut down their doors.

    3) Lehman was small in comparison to Citigroup or AIG. It had about $250 billion in assets. Citigroup and AIG are both $1 trillion+ companies. Lehman’s mistake was that it was not “too big to fail.”

    4) Nothing Lehman Brothers had was federally insured.

    5) The day after LB collapsed, you had hedge funds and depositors showing up the door of all of the major banks demanding their cash, and if the Fed had done nothing, the whole system would have crashed then and there.

    ReformerRay: So the toxic assets on their books were not transfer to another bank or any other entity.

    Actually they were. It’s more accurate if you think of these things not as “toxic assets” but rather as “horse manure.” If you have tons of what you thought were gold bricks but turned to be “horse manure”, you are trouble if you borrowed money against it.

    However, once you go bankrupt, there will be lots of farmers willing to pay you for your horse manure since it is worth something to them, and right now what the people working at Lehman are doing is going through all of their tons of horse manure, and finding buyers.

    ReformerRay: They were resolved by the Depository Trust Clearing Company. All the Credit Defaut Swaps to which they were a party were resolved by the exchange of 5.2 billion dollars among the parties.

    That’s not what happened…..

    The trouble with this is that one of the parties turned out to be AIG, and they didn’t have the money to cover the CDS’s which they had written. At which point the Fed had to step in.

    ReformerRay: The private sector settled this among themselves.

    No they didn’t. The Fed had to pump in money through AIG. If they Fed hadn’t bought AIG, the whole thing would have collapsed, since AIG has the counterparty for a lot of the CDS. And then it turned out that money market funds had exposure to Lehman, and then the Fed had to cover those too.

    The really scary thing is that the weekend before all of this happened, no one knew that AIG had so much so much exposure to Lehman. This is why Geither is being so slow to do anything. He wants to make sure that he knows who owes what to whom before doing anything.

  • Posted by Twofish

    It’s likely that something dramatic is going to happen in the next few weeks. It’s probably going to happen in late March and early April after first quarter earnings are compiled and we have another round of unemployment numbers.

    It will also likely happen on Friday evening or Sunday evening NYC time.

  • Posted by Twofish

    Just a note as far as why I blog.

    I do not think that it good for democracy if the major decisions are made behind closed doors. Even if good decisions end up being made the public ends up being rather suspicious of who and how those decisions are made.

    The discussion with ReformerRay is the type of discussion that does tend to happen behind closed doors. (We’d like to do that, no that won’t work, well what if we do this, well maybe let’s try that.) The reason these discussions aren’t open is that bad things tend to happen when powerful people think out loud.

    I’m sure Geither has thought about the possibility of shutting down a megabank, and I’m also sure that there is a group of dozens of people in Treasury that have prepared or are in the process of preparing a whole series of memos on how to shut down a megabank and what the consequences are. Even if they don’t do it, they need to have a plan in place, and they also need a plan so that they can think through exactly how.

    However, if Geither thinks out loud in front of camera, he could end up destroying the system. Since I’m very low on the totem pole, I can think out loud, and I think I have a good idea of what is going through his mind, and so does anyone else that works in finance.

    The other thing is for transparency is that people really don’t see what bankers and government bureaucrats do, so people assume they do nothing except take money. A lot of the day of your banker or bureaucrat involves having these sorts of discussions to figure out exactly how to get something done, and going through the check list of everything that needs to get done involves lots and lots of people.

  • Posted by ReformerRay

    Twofish – I am sincere when I say I really do appreciate your contribution. You obviously know much more about the banking business than I do. I am what is called a “naive observer”.

    I remain unpersuaded, however. I spent a bit of time this morning on the website for the Federal Reserve Bank of St. Louis, reading their Timeline of Events. It summarizes all the important actions of governmental agencies each day that it happened for 2007, 2008, 2009.

    The tie-in between the Federal Government and the mega banks that used to be private is amazing. Drip, drip, drip – more federal money dropped on the people that created the problem. This website also has a very short summary of the three interrelated causes of the financial crisis that focuses on description rather than making a political point.

    More to come.

  • Posted by ReformerRay

    Also this morning I stumbled upon a website titled “Seeking Alpha”. A commentary by Christopher Whalen, Feb. 19, titled “Too big to Bail: Lehman Brothers is the model for Fixing the Zombie Banks”.

    Finally the issue I want to see discussed is out in the open.

    His perspective was interesting and much more detailed than mine. He should be jocking with Twofish rather than me. But the equally interesting thing was the 25 comments that followed his article. The followup discussion centered on bondholders, an issue I have neglected.

    Seems I can’t just concern myself the kinds of contracts that the Depository Trust & Clearing Corporation claimed to successfully resolve in their new release dated October 30, 2008. I don’t have any opinion about bondholders. My inclination is to say no to them as well as the kinds of contracts handled by DTCC.

    I have carried this discussion with Twofish as far as I can carry it. I remain convinced that the Federal Government must reverse course. Proping up Zombie banks is a temporary expedient. It will not solve the problem. The Lehman experience should be the template to examine. How the Lehman template should be modified is above my pay grade, as Obama famously said.

    I recommed to anyone interested in this question (which should be all U.S. citizens) that you read up on this matter, beginning with the Whalen post of Feb. 19, 2008, with the commentaries and the DTCC news release of Oct. 30, 2008 and the timeline of official actions provided by St. Louis Fed. Reserve Bank.

  • Posted by Nicholas Dahlheim

    Good to have seen you this weekend at church, Rachel. Wow, this is a great report on the ongoing developments in energy politics. I really respect your broad understanding of complex issues—- I follow finance closely, but I have nowhere near the same balanced and nuanced approach you have for these complicated energy issues.

    It looks as if these developments are really part of the longer-term trend whereby the world economy re-balances itself more firmly around the longer-term prospects for growth and sustained wealth creation in the Far East. Russia and China have already grown much closer since the establishment of the SCO, and Russian exports of oil to China in return for loans to Russian energy companies will further cement their economic dependency on each other—-Russia for credit, China for energy. With US bogged down in Afghanistan and Iraq and with the US still desperate to maintain its dominance in the resource-rich areas of Eurasia from the Persian Gulf to the Caspian Sea, these developments are quite negative for the future of US power in this critically important region. I still think of the book Dr. Zbigniew Brzezinski wrote in 1998 entitled The Grand Chessboard—in it, he argued that whichever global power controlled the resource-rich regions of Central Asia essentially would set themselves up for dominance in the 21st century world. The pieces on the chessboard are shifting rapidly—and a stung and wounded Russia is definitely moving into the arms of the Chinese desperate to extend credit in return for vital energy resources.


  • Posted by Nicholas Dahlheim

    By the way, some of the earlier talk about abiogenic oil and that oil is a renewable resource is just silly. I can tell you from a contact I have with PIRA Energy and from reading snippets of the latest IEA Report from 2008 (and the IEA has been overly bullish on oil supply projections for some time now) that the global oil production is likely to peak sometime between 2012-2020 at the latest. All of the oil projects coming online to make up for stagnation and decline in older fields are deep sea oil drilling as that which is occurring off the coast of Brazil or it is heavy tar sands oil like that going on in Alberta. Russia was having trouble increasing production even before the credit crunch, and who knows how much oil is really left in Saudi Arabia’s mega-giant field Ghawar. Africa still has some sizeable oil deposits, but not nearly enough to replace peaking production in places like Russia or the US’s own falling oil production. The Caspian Sea basin was thought to have huge reserves of oil to rival the Saudis and the Persian Gulf, but oil discoveries there have turned out to be rather unimpressive…

    Let’s just say for the sake of argument that oil was indeed a renewable resource—I sincerely doubt that oil is renewable on the time scales orientated towards the needs of the energy-hungry modern economy. Even with the drop in price and the drop in world demand caused by the global recession, the world still will demand more than 90 million barrels per day sometime early in the next decade. I don’t know of any giant oil gushers deep within the Earth that are producing oil on that scale…..


  • Posted by locococo

    Indian s quote of “They, with their shady dealings, were offering unfair competition to the nationalized banks” reminds me to bring your attention to not forgetting nationalizing the fed. It s a bargain.