Wednesday, July 23, 2008

Redefining Bad

A few postings ago I predicted that analysts and other market participants that gauge corporate results would switch from "better than expected" to "not as bad as expected", in their efforts to sugarcoat dismal performance. That's exactly what an article in the NY Times now makes clear:

For now, at least, some investors seem to have become so inured to the bad news that results that would have once been viewed as disastrous are now seen as good, or even great. The sober phrase often used on Wall Street to describe solid corporate results — “better than expected” — has been replaced by “not as bad as feared.”

Hiding behind this development is the expectation that "surely, things can't get any worse", which goes a long way to explain the various relief rallies going on in the financial sector. Unfortunately, this expression of hope is not founded on solid fundamental evidence but on irrationality (at worst), or uninformed mechanistic cyclical analysis (at best).

Two observations:
  1. I'll pay more attention when the attitude shifts to "it's bad and it's going to get much worse", i.e. when even the professionals reach the capitulation phase and abandon all hope. That won't be the point to jump in, mind you, but it will be a sign to stop fishing and get back to work(*).
  2. This is not a garden variety recession. It is not caused by cyclical excess inventory accumulation that can be reversed within a couple of quarters, but a most pernicious credit contraction. It's not only that banks are less willing to lend; it is borrowers that are retreating from debt because their incomes can no longer support the heavy burden accumulated over the past decade. Household debt as a percentage of personal income now stands at 115% versus 79% in 1998. This ultimately acts as a drag on consumption and won't go away quickly or painlessly.

(*) A famous market speculator once said: "There are times to be long, times to be short and times to go fishing".

Monday, July 14, 2008

The Ripples Are Getting VERY Big

The ripples in the financial crisis pond keep getting bigger and bigger. IndyMac was just taken over by the Feds and now the behemoths Fannie and Freddie are, too. Obviously, this is very bad news: hundreds of billions of taxpayer money will be needed. Like I said in the previous post, this is orders of magnitude bigger than all previous bailouts. These are no longer ripples but waves..

And what if it doesn't work out? What if, after an initial positive knee-jerk reaction, the market prudently decides to "give" (sell to) the Treasury as much stock in Fannie and Freddie as it has , while there is big buyer? What will the government do then? Double up and buy even more? Trying to put an artificial floor under stock prices is a fool's game and always ends up creating a bigger mess.

And the size of the two GSEs is so large that a BIG mess is all but guaranteed. The real danger here is that these actions ultimately lead to a cross-infection of the Treasury bond market. If this happens the wave will be a tsunami that will wipe the US off the global financial map.

I have reason to fear, too. This is the same band of incompetents that "managed" New Orleans into near oblivion.

Friday, July 11, 2008

Insolvency Dominoes

If Fannie and Freddie are at, or near, technical insolvency (combined assets worth less than debt) as ex-Fed member William Poole said yesterday, what are we to think of every other bank in the US?

Those two GSE's alone own or guarantee nearly $6 trillion in mortgages and have another $1.45 trillion of their own bonds outstanding, so ownership of their (nominally AAA) mortgage pools and other securities is definitely widespread amongst the US and global financial institutions. And let's not forget that central banks accept such AAA repo collateral willy-nilly, to finance banks and investment banks.

This being summer (numerous alternatives to writing and reading blogs) I have but a single question:

Can everyone see the dominoes?
Addendum, July 11

The NY Times has a story about the government considering a takeover of the two GSE's in the form of conservatorship. Well worth a read, it clearly spells out the serious problems facing such an undertaking. For example, such a move would not really solve anything because the market already assumes that Fannie and Freddie have the implied backing of the government.

There are no easy solutions here. Time has come to look for the hard ones, and take the bitter medicine as soon as possible. There is no way to sugar coat this pill - it's simply too big, orders of magnitude bigger than Bear Stearns/JP Morgan.

My opinion is to let those two behemoths wind down their business in a controlled fashion and to revert to a mortgage market backed by regular banks. Mortgage issuers would then not be able to pass the paper to Fannie and Freddie and would have to hold on to it themselves.

In my view this would be a blessing and go a long way in
eventually normalizing the real estate and mortgage markets.

Tuesday, July 8, 2008

First Rule Of Banking - Broken

"Only lend money to those who do not need it".

This seemingly senseless maxim has been banking's cardinal rule since time immemorial. Another way to put it is this: borrowing should only be undertaken to improve returns, not to cover basic needs. Optimally, then, borrowing should be a choice, not a necessity and bankers should act accordingly.

However, lending to those who do not need the money is a ho-hum business and not very profitable. Witness the sleepy, two-martini lunch era of banking that lasted until the late 1970's. A comfortable living to be sure, but nothing to set the world on fire - or to buy mega yachts with.

But look at what happened during the last decade: banks increasingly lent to those who really needed it. Households needed to borrow heavily to buy homes and/or to supplement their dwindling income. Portfolio managers were forced to expose themselves to ever increasing leverage via exotic structures (e.g. SIV's) in order to enhance their dwindling returns from conventional securities. Investors, even conservative ones like pension and endowment funds, were forced into hedge and private equity funds because politicians left them few alternatives in a world of rapidly deteriorating demographic and labor conditions.

Well, we know what happens when bankers get greedy, break the cardinal rule and lend money to those who need it - don't we? Just ask Shylock...

The pound of flesh, which I demand of him,
Is dearly bought; 'tis mine and I will have it.
If you deny me, fie upon your law!
There is no force in the decrees of Venice.
I stand for judgment: answer; shall I have it?

May I remind all readers (bankers included) that Shylock does not get his "pound of flesh" in the end..

Friday, July 4, 2008


On this Fourth of July let's pause to ponder a most basic foundation of democracy: Truth.

Unfortunately, these days economic truth is hidden behind a constellation of asterisks and footnotes, making it nearly impossible to distinguish fact from fiction. Perhaps data releases should be sung to the tune of "When You Wish Upon A Star" - complete with a picture of Pinocchio's growing nose..

Consider "core" CPI inflation for May: it came in at the astonishingly low level of 1.8% annualized. I don't know about your own level of product substitution as assumed by the Bureau of Labor Statistics, but I haven't switched from wearing shoes to wrapping my feet in old newspapers yet.

And how does one account for the discrepancy between CPI and PPI, which came in at 11% for finished goods? Not easy to do hedonic pricing on a ton of copper, eh?

Ah, well.. we can at least use the releases for starting today's barbecue. Enjoy the holiday.

Thursday, July 3, 2008

Hand-basket, Stage Two

Well, I'm back from sailing and, as a reader said in a comment, all "Hell" broke loose while I was away. Putting it another way, things kinda went to hell in a hand-basket, as the saying goes...

Is this a climactic event that signifies a major bottom? No, I don't think so. It looks to me that we are in the early stages of a long, drawn-out process of reshaping the economy to a more rational model, one where corporatism, finance and markets play a smaller role. The clearest sign can be seen in politics, where Sen. Obama is successfully articulating a common sense theme: America's economy should benefit the vast majority of the people instead of a few mega-rich.

Corollary: all wealth-concentration processes will be running on reverse for years, including the biggest and most notorious of them all, i.e. speculative finance (high leverage, senseless M&A activity, etc.).

The old model is still very popular abroad, particularly in China and Russia. Despite their communist background (what a sad joke), the most extravagant excess is now happening right there. During my trip I heard a yacht broker boasting of chartering a sailing yacht for $450,000 for just one week to Russians - a big yacht (over 120 ft.), but still...

That's it for today, the employment numbers will be coming out soon and will update afterwards.

Employment numbers update.

The new positive spin mantra following economic releases is "only slightly worse than expected". That's how today's bad employment figures were labelled by the mainstream press, used to support the view that the economy is "resilient". Notice the erosion in the MoT dialectic: we have gone from "better than expected" and "in line with expectations", to "only slightly worse". I bet "one-time negative adjustment" is next.