Tuesday, March 6, 2007

What Can The Fed Do Now?
...plus a post-script on recent losses

A while back I wrote that looser lending practices, most prominently reflected in the ready availability of sub-prime mortgages and shrinking bond risk premiums, negated the effects of the Fed's higher rates (the Greenspan "conundrum"). Not only were actual, real economy rates unusually low given the tightening monetary policy, they were historically low for even the riskiest of borrowers.

Financial "innovation" was coupled with the rapid rise of highly leveraged speculators hungry for yield pickups (hedge and private equity funds), their leverage financed by fee-driven investment banks using the yen, yuan and swiss franc carries. The Fed was easily trumped and bubbles formed in real estate, emerging and developed market stocks, commodities, structured products, LBO's. The US Government benefited also, selling Treasury bonds to foreign central banks at abnormally low rates, even as it cut taxes and engaged in costly wars.

This finance-driven global economy is now dependent on rising asset prices to sustain and service the mountain of debt it has itself created. Bubble prices, however, mean that incomes derived from assets (i.e. rents and dividends) do not suffice to amortize the debt properly and allow for a respectable profit margin. In simple words, the economy is hooked on rolling over existing debt and assuming even more debt to pay the interest owed - the very definition of a Ponzi scheme. The stubbornly negative US personal saving rate is a good overall macro indicator of this unsustainable borrow-spend-borrow condition.

When this global scheme collapses, Fed rate cuts won't have a positive effect. No matter how low the Fed goes, it will be credit-worthiness that will control loan availability, not interest rate cost - a bad credit simply won't be able to borrow as risk aversion comes back with a vengeance. The Fed will be pushing on a string, just as until recently it was pulling on a string un-attached to the "real" economy, dominated as it was by credit default swaps and ultra-loose lending practices. As the excesses reverse, effective real-life borrowing costs and conditions will become much tighter than nominal Fed policy would indicate - we will witness the Greenspan conundrum in reverse.

I do not expect this scenario to play out and conclude within just a few months. The correction of global excess is likely to last years and will affect assets, commodities and currencies everywhere. Many argue that this is a problem concerning only the US plus a few other over-indebted countries in the West and that the East will continue growing as before. I strongly disagree. The US accounts for 35-40% of the nominal GDP (non-PPP) of all other nations combined, so weakness in the US will have far reaching consequences, everywhere.

P.S. Another measure of recent losses

Analysts look at the decline in stock-market values to measure "money lost" in this latest episode of global market weakness (~$1.5 trillion). Here is an additional one, based on credit default spreads and the yen carry.
  1. I estimate that there are about $35 trillion worth of CDS outstanding now, split 70% investment grade - 30% high yield. As of last night credit spreads have widened roughly 10 bp in the first and 50 bp in the second, for a weighted "hit" of 22 bp. For the $35 trillion outstanding, this translates to $77 billion.
  2. As of June 2006 there were almost $6 trillion worth of yen FX forward swaps and currency swaps, probably nearer $7 trillion now. The yen has strengthened from 122.00 to 116.50, or 4.5%. For the $7 trillion in swaps, it translates to $315 billion.
Most importantly, the combined "hits" of near $400 billion on this, the non-equity and funding side of the business, have happened within just 3-4 days, meaning that margin calls and fund liquidation/withdrawal requests are just now making their way through the system. Naturally, not all of the $400 billion can be properly viewed as "losses" since these are swaps transferring risk between counterparties. However, a sudden $400 billion dollar move does not happen without massively hurting someone(s), added as they are to the $1.5 trillion stock-market drop . I believe we will soon see negative news coming out from some of the weaker and/or most aggressive speculative funds out there.

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