How To (Mostly) Save The Financial System

First, do nothing. Yes, that's right: no bailouts, no alphabet soup programs from the Fed, no emergency liquidity injections, no "initiatives". Nothing beyond the customary daily operations - and make sure everyone knows it, particularly Wall Streeters.

What good will this do, you say? A ton of good, I say. Because it will immediately force everyone to accept and deal with reality, instead of hoping for "solutions" from the Fed, Treasury or Congress. The credit crisis is too widespread and ultimately beyond their intervention capacities; it is becoming increasingly obvious that conditions are deteriorating despite their efforts. There is too much debt compared to the earned income necessary to service it properly, so a large portion of it will go bad no matter what they do.

Now, throw in resource depletion plus environmental degradation. Debt is a one-way bet on rising future activity; scarcity and climate change are already forcing us to rethink the outdated Permagrowth model and we will soon be forced to abandon it altogether. Therefore, it is better to liquidate excess debt quickly, instead of wasting precious resources attempting to keep it afloat. Referring to a post from last July: putting patches on threadbare tires may temporarily prolong the Bong Bus trip, but will result in a catastrophic accident later. Better to stop now and force all the dopeheads to change the tires.

But what about the innocents, those middle-class depositors and investors who may see their lifetime savings disappear in a generalized credit melt-down? Fortunately (well, un-fortunately) they don't have all that much to lose: the vast majority of Americans (latest data from 2004) had much less than $100,000 in financial assets, including bank deposits, securities, 401(k)'s (see chart below, click to enlarge). Current programs in force like FDIC and SIPC will more than adequately cover them.

Financial Assets by Percentile of Net Worth (Chart: FRB)

The efforts currently being undertaken by the authorities are not directed at them. They aim at helping the very top, where most financial wealth resides: those debt instruments (and their issuers) that are owed by the bottom 90% of the people, but owned by the top 10% of them. I am most definitely no sans-culotte, but even to me this smacks of "Let them eat cake".

Unfortunately, instead of acting in the best interests of the vast majority of the people, we have now embarked on a course that leads to the following statement:

The analyst, Prashant A. Bhatia of Citigroup, said in a research report Friday, “It’s tough to have a liquidity-driven meltdown when you’re being backed by government entities that have the ability to print money.”

In whose interest is it to make our currency the harlot of the "free world"? Not the 90%, that's for sure. But here's the rub: pretty soon it won't be in the interest of the 10%, either.

In the early stages of the Great Depression then Secretary of the Treasury Andrew Mellon made the mistake of advocating liquidation because that was the way previous boom-bust business cycles worked ("Liquidate labor, liquidate stocks, liquidate farmers"). Like most short-sighted generals, he assumed he was fighting the previous war. It is the same with Bernanke, Paulson and Co. : like the Polish generals of 1939 they are stubbornly throwing masses of cavalry against Guderian's Panzers.

It is a familiar pattern of incompetency: the Iraq and Afghan wars are wasting hundreds of billions of dollars and hundreds of thousands of lives to prolong the Oil Era. The Fed and Treasury are destroying the good faith and credit of the USA to prolong the Debt Era. We will all suffer for it.

Homes On Margin

Most people who buy a home by taking out a mortgage don't think of themselves as buying on margin. Yet, this is exactly what they are doing, and more so when they take out home equity loans, second mortgages, etc.

The chart below shows how fast mortgage amounts ballooned in recent years and, worse yet, that such debt is now over 52% of the gross value of all dwellings in the US - up from a mere 18.5% in 1950 and 31.5% in 1980 (click to enlarge). According to the Fed, at the end of 2007 US housing was worth $20.1 trillion and mortgage debt came to $10.5 trillion. Housing "margin" is getting bigger and bigger.

Data: Federal Reserve

Assuming that house prices drop 20% - a reasonable assumption given the recent performance of the Case-Shiller index (see below) - the debt-to-value ratio will jump to 65%, all other things equal.

If housing was treated like a leveraged stock portfolio, margin clerks would be getting ready for "calls". And you know what? Mortgage securitization and derivativization has done exactly that. In a few short years investment bankers and financial engineers managed to turn the most fundamentally conservative asset class into yet another "trading sardine", subject to bubbles and busts...

Benny, The Naughty Easter Bunny

The size and frequency of the Fed's interventions are increasing with each passing day. I wonder how people can still call this a "free" market with a straight face. Let's call a spade for what it is: privatizing profits and socializing losses is crony capitalism, pure and simple.

Keeping with the spirit of the holidays, it's like the Easter Bunny lets a few chosen children eat all the good eggs, but feeds those tainted with salmonella to the children of a lesser God. Naughty bunny...

Naturally, the Fed's hoppity-hops injected shots of optimism to markets teetering on the edge of a nervous breakdown last week. Many speculators are apparently willing to go bottom fishing, projecting an economic rebound in six months. I think they are wrong; their optimism is just one more in a string of bad predictions that got progressively worse: robust growth, moderate growth, Goldilocks, slowdown, no recession, mild recession..

There are two main reasons for my negative prognosis, as far as timing of bottoms goes:

• The labor picture is still nowhere near as bad as it gets in even a typical recession. After 1950, recessions have resulted in year-over-year losses of 1.8 million jobs, on average. We are currently showing gains of 860.000 jobs versus the same month last year (see chart below, click to enlarge). If we are in a recession right now, we still have a long ways to go.
  

• Consumer spending accounts for three quarters of the economy. Despite real wages stagnating after 2000, households went on a shopping spree because they could borrow to their eyeballs, mostly against real estate equity.
  

Annual Change in Retail and Food Service Sales

With easy credit now turned off, growth in consumer spending must come from (a) more jobs (not in the cards, as we saw), or (b) significantly higher wages (not happening).

Conclusion: don't hold your breath waiting for an economic rebound. Oh, and I would stay off Benny's Easter eggs for now...

Blogger's Block and The Easter Bunny

For those asking "where are you?"... fear not - I am well (and thank you for your compliments) .

A combination of blogger's block and the Easter holidays have come together to produce a brief hiatus in the usually torrid pace of postings. I shall be back later today with more..

The Fed As Bank

The Federal Reserve may be a central bank with special rights and obligations, but in the end it, too, is a bank and has to be very careful who it lends to and what kind of collateral it accepts in exchange.

From a bank analyst perspective, during the last few months the Fed has become increasingly more lax in its lending practices. It is financing highly leveraged investment banks and brokers and accepting a wide range of illiquid securities as collateral, particularly MBSs.

Let's look at the Fed's consolidated balance sheet (click to enlarge):



As of March 12, 2008 the Fed had almost $900 billion in assets, of which $700 billion were in Treasury bills and notes and the rest in an assortment of repos, the TAF facility, etc. The most recently announced programs like the TSLF ($200 billion), the open-ended discount window facility for investment banks/brokers and the $30 billion loan to Morgan (i.e. Bear's toxic assets) are not shown yet.

When those hit the books in the next few weeks, the asset mix will change drastically. The Treasury holdings will go down and be replaced by an assortment of GSE and private label securities. The Fed's risk exposure will jump higher, and significantly so.

Like any other bank, the Fed does not have an unlimited amount of money to lend - all it has is about $700 billion in Treasurys that it can exchange for other, less marketable securities (and it has already announced programs for a big part of that). In contrast, US home mortgages alone amount to $10.5 trillion; if things keep unraveling, the Fed's balance sheet will prove very small for the role it has now chosen for itself.

As for the liability side, the Fed has issued about $800 billion of its own Federal Reserve Notes, i.e. dollars. Our currency is thus increasingly going to be backed by lower quality, riskier assets that no one else wishes to buy or lend against, instead of Treasurys. In effect, Mr. Bernanke is betting the farm on a quick real estate/mortgage turnaround and a very shallow recession. Worse still, instead of charging a higher interest rate for the loans made against the riskier collateral, the Fed keeps cutting rates.

And just how sound is Mr. Bernanke's "bet the farm" wager on a quick turnaround of the US real estate market? Judging from the following chart, not very sound at all. Unlike previous real estate boom cycles that lasted 2 to 4 years and peaked at 700-800.000 new homes sold per year, the one now busting lasted 13 years and peaked in 2005 at 1.300.000 units. There has been a lot of housing demand satisfied for many years to come and the downturn will not likely end soon.


Without Greenspan's negative real interest rates after 2000, the cycle would have probably turned down (red line), avoiding the bubble of 2002-06. Based on this hypothesis, there have been almost 3 million "extra" homes sold (black line minus red line), creating a fundamental housing demand deficit that won't go away even if credit becomes cheap again.

Let's summarize: riskier borrowers, low quality collateral concentrated on real estate, questionable appraisals for market prices and "low, low rates". Is the Fed turning itself into a sub-prime lender? If I were a bank examiner, I would want to have a quiet word with Mr. Chairman about his lending practices.

And if I were a shareholder or creditor of the Federal Reserve Bank (remember what its liabilities are), I would be worried. As, indeed, so many already are - they are those who are exchanging their dollars for other currencies and commodities.

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Sir Arthur C. Clarke passed away today. He was 90 years old and his writings inspired millions, including this blogger.

RIP

Revisiting The CDS Menace

As readers of this blog know, I have written extensively about credit default swaps (CDS) and the risks involved. I explored several aspects, from the theoretical (CDS Factors in Equity Valuation, a four part series), to the more practical (CDS: Phantom Menace).

Today, I am revisiting the CDS subject because of a reader's comment to last Saturday's post. He/she said: "I am unwinding every ITM CDS* on Monday with all my counterparties". There is a ton of trouble brewing within that one simple, declarative sentence.

I assume the commenter is a CDS dealer/market maker, likely running a square book, i.e. not exposed to credit risk on a net basis. But he/she is exposed to counterparty risk and by unwinding positions he/she wants to minimize that as much as possible. After Bear Stearns' implosion, I totally understand and I bet dozens of other institutions are thinking along the same lines.

As with all insurance contracts, the ultimate risk in CDS is counterparty risk, i.e. when time comes to collect on the insurance (or the premiums, for that matter) the other side won't pay up. Since these derivative instruments trade 100% over the counter, there is no central clearer in between to guarantee payment. And this is where notional amounts come into the picture.

The conventional view on CDS is that enormous notional amounts should not concern us because they mostly cancel out between counterparties, greatly reducing the net market exposure. The Bank for International Settlements puts CDS notional amounts at $42 trillion, but with a gross market value of $721 billion (BIS data as of June 2007 - pdf). The International Swaps and Derivatives Association provides a slightly higher figure for notional amounts, at $45 trillion (ISDA data as of June 2007 -pdf).

But if one or more counterparties were to fail, they would set off a series of dominoes which could easily result in a daisy chain. Netting would then become a matter for the bankruptcy courts, taking years to resolve. Not exactly a favorable outcome when market volatility is measured in minutes.

One more aspect to explore is CDS pricing. Amounts outstanding exploded upwards during the last three years, i.e. when credit spreads were at historical lows. The chart below shows the notional amounts of CDS outstanding versus the yield spread between BAA corporate bonds and the 10-year treasury bond (click to enlarge).

CDS Amounts Outstanding and Corporate Yield Spreads (Data: ISDA, FRB)

We see that while credit spreads stayed at a low 150-170 bp, CDS amounts boomed from $8 trillion to $45 trillion. In other words, the vast majority of credit insurance was sold at very low prices. Credit spreads have now spiked to 350 bp and the CDX index for North American corporate CDS is at 185 bp, coming from a low in the 20's last June.

This means that marking all those CDS to market is currently resulting in very large valuation losses for those that sold the insurance. This further exacerbates the counterparty risk problem, particularly with those that made a habit of collecting such pennies in front of steamrollers, e.g. hedge funds. And this, even before credit events have begun in earnest, during what many are already describing as the worst crisis since WWII.

We may be in for very unpleasant surprises when those who sold insurance on the cheap are called upon to pay. Let me put it this way: if the large, professional credit monolines (MBIA, AMBAC, etc.) were not adequately reserved, what are the chances that Joe's Greasy Spoon and Hedge is?
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(*) ITM = in the money.

From Animal Farm To Animal House

In Orwell's Animal Farm all animals are equal - except that some are more equal than others. All in the spirit of law, order and the proper functioning of society, of course. Fittingly, the animals that have chosen this role by themselves and for themselves, are the pigs.

Cut to US financial markets today. After years of swinish behavior more reminiscent of Animal House than anything else, the pigs are threatening to destroy the entire farm. As if it wasn't enough that they devoured all the "free market" food available and inundated the world with their excreta, they now wish to be put on the public trough. Truly, some businessmen believe they are more equal than others.

But do not blame the pigs; they are expected to act as swine nature dictates. The fault lies entirely with the farmers, those authorities entrusted by the people to oversee the farm because they supposedly knew better. While the pigs were rampaging and tearing the place apart, they were assuring us all that farms function best when animals are free to do as they please, guided solely by invisible hooves. No regulation, no oversight, no common sense. Oh yes, and pigs fly..

So what is to be done now? Two things:

(a) Let financial markets sort themselves out, but with rock solid backing for bank depositors, pension funds and public institutions. The public purse should not be used to bail out - directly or indirectly - speculators in hedge funds, private equity funds and the like. Those that live by the leverage sword can defend themselves or perish by credit destruction.

(b) Revamp public policy towards increasing earned income for working people.

In other words, the focus from now on should be on adding value by means of work and savings (capital formation), instead of inflating assets and borrowing.

Furthermore, we should realize that in a world already inhabited by close to 7 billion people and beset by resource depletion and environmental degradation, defending growth for growth's sake is a losing proposition. The wheels are already wobbling on the Permagrowth model; pumping harder on the accelerator is not going to make it go any faster and will likely result in a fatal crash.

Debt, and finance in general, should be left to re-size downwards to a level that better reflects the carrying capacity of our world. The Fed's current actions are shortsighted and "conservative" in the worst interpretation of the words: they are designed to artificially maintain debt at levels that myopically projects growth as far as the eye can see.

What level of resizing may be necessary? I hope not as much as at Bear Stearns, which got itself bought by Morgan at buzz-saw prices: $2 per share represents a 98% discount from its $84 book value. What scares me, though, is the statement by Morgan's CFO, who said the price reflected the risk the firm was taking, even though he was comfortable with the valuation of assets in Bear's books. It "...gives us the flexibility and margin of error that's appropriate given the speed at which the transaction came together", he said.

If it takes a 98% discount and the explicit guarantee of the Fed for a large portion of assets to buy one of the largest investment banks in the world, where should all other financial firms be trading at? ....Hello? Anyone? Is that a great big silence I hear, or the sound of credit imploding into a vacuum?

Beware Of Feds Bear-ing Gifts

With Bear Stearns having to be rescued by the Fed (i.e. the government), the credit crisis is entering the seriously ugly phase. And I say this now because we Street types exhibit sangfroid when a sub-prime family gets thrown out of its home ("they should have been more responsible in managing their debt"), but when the sheriff comes calling to our neighborhood "it's the market's fault". Come to think of it, I have never seen a mirror at a bank/broker/investment bank office - I wonder why..?

Anyway, prior to rescuing Bear Stearns yesterday, there were only two prior occasions when the Fed used the obscure provision about funding non-bank institutions through the Discount Window. As The Economist points out, the last time was in the 1960s - and before that in the 1930s. References and parallels to the Great Depression are getting all too frequent lately, it seems.

While the failure of one major-bracket investment bank to get funding on its own is bad enough, worse is yet to come. Broker/dealers are entirely dependent on ample short term loans and trading lines to carry their securities' inventory and to clear transactions. Any hint of trouble and counterparties pull their lines and customers pull their accounts. The end comes instantly, usually no more than a few hours: Sudden Debt, to coin a phrase*..

The trouble at Bear will now cause every firm to become even more cautious with counterparty risk, clamping down on credit lines to trading partners and customers. The immediate reaction is "Bear is history, who's next?". Unlike the isolated 1998 LTCM snafu - one bad apple threatening to contaminate many otherwise healthy apples - the current crisis is fundamentally more serious and widespread. We know that many healthy-looking apples are already wormy inside, but we don't know which ones. The result is less trust in "apples" overall, a major problem in an industry where trust is the cornerstone of daily business.

Bottom line: short-term market credit (aka margin) is going to get squeezed much harder in days and weeks to come, forcing the Fed into even more "gifts" of TAFs, TSLFs, etc. That's too bad: to use mythological parallels, Pandora has opened the box... or the Trojans have wheeled a certain horse into their city.

Finance Goes To The Fed

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* Yes, hours. To provide an example, during the 1987 crash my then firm (a major bracket, too) asked that customer margin calls be satisfied immediately - as in "wire or bring a check to the cashier by 2 pm or you will be sold out". Fun, eh? When survival is at stake in the Street, noblesse never oblige.

Yesterday's News

Standard and Poor helped the stockmarket clutch some more straws yesterday by providing a bit of yesterday's news about sub-prime loans. That the market chose to interpret it as it did is indicative of how desperate speculators have become for anything that provides a respite from the incessant drumbeat of terrible economic releases. (It also shows that many of the shorts are still of the "weakish" money variety and scare easily - but this requires a whole other analysis).

The rating agency said that it now estimates sub-prime mortgage loan write-offs will reach $285 billion (up from $265 billion in their previous estimate), but that the end of such hits to bank balance sheets is pretty near.

Well, excuse the colloquialism but.. Duh! The credit contraction has moved well past its sub-prime mortgage starting point and is currently reaching a whole array of other credit instruments from commercial real estate and leveraged buy-out loans, to consumer receivables and credit default swaps. Anyone still discussing sub-primes as "news" might as well announce that "Kennedy Was Shot!!".

What I would like to hear from S&P, instead, is their estimate for everything else. But I'm not holding my breath. They, too, have a business to run and profits to make, so don't expect them to start bad-mouthing customers who can still pay rating fees. As always, such reports will come out only after the customers are clinically dead and fee-less.

By the way, if you view this state of affairs as a "conspiracy" I have to inform you that this is business as usual. The two main ratings agencies, have always shut the barn door after the cows were gone. It's safer that way - unless, of course, you happen to own the cows..

Update: Bear Stearns being funded by JP Morgan and the Fed (!!!) is truly horrible news. Makes lots of other players suspect, too and the credit clamps are tightening fast. Oh, and I wonder what the funding split is Fed/Morgan?..

Update #2: According to Reuters, Morgan is essentially a conduit that will take Bear's collateral and post it to the Fed's discount window. So the Fed is doing 100% of the funding. Oy vey...

History Rhymes in Slow Motion

The repeated attempts by the Fed to arrest the credit contraction and prevent equity markets from going into a tailspin look to me like a repeat of what happened in October 1929, albeit in extra-slow motion. As an avid student of market history (... "it rhymes"), I highly recommend the careful reading of Galbraith's The Great Crash of 1929.

Within it are described concerted attempts to forestall the inevitable. As the market swooned in late September and early October 1929, "great men" from Morgan and National City Bank were sent to walk the floor of the New York Stock Exchange. They made a grand show of providing money at the broker call-loan post (margin funds) and supporting a variety of blue chips like Steel and Radio with repeated buy orders.

Their actions cheered speculators, who ramped up prices sharply for a few days. But when conditions worsened once again, the "great men" had to give up in order to protect their own institutions.

This time the "action" is taking weeks rather than days to play out, because:

• The "great men" have been replaced by the Fed, which has more resources at its disposal and less inhibitions to using them. It has no shareholders or depositors to protect (except for millions of taxpayers, but that's too amorphous a group) and the man at the helm is stubbornly certain he is following the right course.
• Markets are far more diverse and complex today than the simple stocks, bonds and trusts of 1929. While the overall leverage may in fact be far greater today, there are also more dominoes at play, i.e. more products (e.g. derivatives) and more players (e.g. all sorts of funds). Starting as always with the "bad debt" domino, it takes more time now for the whole series of them to drop before the final "equity" domino is hit a decisive blow.
  
• After 25 years of successful Fed action that averted or contained financial crises, its abilities have become an article of faith with most speculators, investors and - most unfortunately - politicians. This past performance has created widespread complacency; time and again I hear the same adage from "sophisticated" market participants: "They won't let it get out of hand". The Greenspan put has morphed into the Bernanke put, even though conditions are far more dangerous now.

To summarize, events are proceeding more or less along the same path as 1929 but with more fits and starts. The experience is akin to watching a football game entirely in slow motion - it may take a while to get to the end, but the outcome won't likely be any different.