Tuesday, December 30, 2008

Rationing Credit

Yes, the government has managed to force mortgage rates ever lower in their bid for 4.5% home loans. They'll get it there even if they have to destroy the entire financial system in the process.

To me, this is beyond farcical. Yes, we know that if the government puts its massive force behind something, it can will just about anything into existence. But there are always unintended consequences... these in a moment...

The big worry to me is that despite the government's best efforts, we have yet to see the follow through in actual mortgage origination. The same goes for corporate bonds... Yields have fallen sharply in the last 2 months, from over 9.5% to about 8% for Baa credits. But issuance has yet to follow suit.

The truth is that when the government sets a price for something artificially low, we shouldn't be surprised to see less of it. Unless the government itself is willing to lend the money in the mortgage market, there will never be enough capital to fund these loans.

We're headed towards a world where the "official" mortgage rate is 4.5%, but it will be close to impossible to get them. The richest people with the best credit scores will manage to refinance loans, but I am predicting now that the average person won't see the slightest benefit from this process. If anything, it might have the unintended consequence of inducing lots of Americans to seek refinancings, only to find a rude surprise when the appraisal comes. Just like we learned with the original TARP, sometimes ignorance is bliss.

Even if "appraisal shock" doesn't emerge as a major theme, what good is refinancing mortgages? It will only help the richest people who don't need help -- just like we see in the case of things like farm subsidies and public school, that's normally the way government works in this country.

How does letting the richest people refinance their mortgages prevent foreclosures for marginal borrowers? (Answer: it doesn't.) Who does benefit? (Answer: the banks, which are positively salivating at the prospect of earning fees from the whole process. In the early 1990s, Alan Greenspan deliberately caused a steep yield curve to help banks "rebuild their balance sheets." Some commentators elevated him to an Atlas-like stature for this policy, which put the country's monetary policy at the service of its lenders. This time cutting rates isn't doing much good, so the powers that be will find a way to help the banks make money somewhere -- anywhere. Never forget who the Ben Bernanke actually works for: the banks.)

We're headed to a situation where official mortgage rates are 4.5%, but no one can get them. It will be like buying gasoline by lottery in the 1970s, or going shopping in the Soviet Union, when the shelves were full of cheap merchandise that only existed on paper.

Whenever the government tries to overrule the basic laws of supply and demand, black markets develop. This is why I fear something much more sinister could emerge from these artificially low interest rates. I think it will be so hard to actually get the money that we'll see the rise of personal connections and politics play a role in getting a home loan. Given the President Elect's established ties to groups like ACORN, I fear the day when they gain control of the mortgage lending system.

It's disturbingly likely given the way things are playing out. First, we'll see some mortgage lending done at 4.5%, but only the richest peple will benefit. Then the media and Congress will express outrage (and somewhat rightly) that so many people are being "excluded"... After all, if the government's doing it, it should be for everyone. There will then be some kind of political pressure to extend loans to "minorities" etc. The next thing you know, groups like ACORN will be all over the mortgage market. Of course, it won't play out exactly like that... But the basic dynamics are there.

It's almost 2009. We are not learning capitalism, or seeing mistakes made for the first time. History teems with examples of politicians who tried to make the free market (ie, free people) do what was against their free will. Sometimes, such experiences end in violence. Often, they end in more poverty. But, they always end up as failures.

Monday, December 22, 2008

new thoughts for a new era

I have totally neglected this blog for various reasons, but feel the need to put some stuff in writing now...

First, I have been watching Larry Kudlow talk about how low gasoline prices will help the economy. This to me is unlikely because lower oil prices mean less money leaving our country in the form of trade, which means less money coming back in the form of capital-market flows. For the last 5-10 years our economy grew dependent on securitization as the spigot of credit for our economy. Evidence of this is massive in the data, which I don't have time to gather now... It's also apparent in the way the system broke down. We had a credit bubble because the underwriting and lending processes were separated... Fly-by-night mortgage brokers did the underwriting, and were essentially paid to manufacture mortgages, while Saudis, Chinese and Russians lent to us from the massive stockpiles of dollars they had accumulated selling us stuff.

Now that they're selling us less, they going to lend to us less.

People might say: great, Americans will now save. That's all well and good, and they have been saving largely by piling money into bank accounts. Twenty years ago, this would have been fine and dandy because banks actually lent money. Now, however, banks have simply become intermediaries between borrowers and the capital market. They have spent the last 5 years becoming less local and more massively corporate. While Meredith Whitney is brilliant, her recent recommendation that the country needs to go back to a local-banking model is economic suicide.

Now that securitization is moribund, banks have lost the ability to lend. This is why banks are sitting on vast piles of cash, uncapable of lending.

My expectation is that the Fed is going to keep spewing money into the economy, it's like putting gasoline into a diesel engine. Until securization returns, the economy is dead in the water.

This is remarkably similar to events in the 1920s and early 1930s... In 1925, for instance, Churchill (then Chancellor of the Exchequer) put Britain back on the gold standard, over the objections of John Maynard Keynes. The resulting deflation put the UK into the Great Depression five years before the rest of the world.

In the early 1930s, the Fed raised interest rates believing this would support lending in the economy. After all, that was the standard operating procedure during the gold-standard period in the 19th century. Even though the USA was still on the gold standard at that time, it was essentially dead because it had been abandoned by England, and almost every other country. Unlike Keynes, the Fed failed to recognize a new era had begun.

And in Germany about the same time, Heinrich Bruning tightened credit controls as the Great Depression began, following the belief that austerity would fix the economy. (This was apparently such a pervasive cultural value in the period that FDR actually ran on a small-government, budget-balancing ticket.) Bruning's policies proved even more disasterous in the long run than the Fed's, as history clearly showed. (Guess who soon succeeded him as Germany's leader?)

Just as balanced budgets and small government were the established beliefs in the early 1930s, allegedly Keynsian "stimulus" is the creed today. Just as most leaders failed to recognize the new economic realities of the post-WWI world, not a single policymaker today seems to understand how different the world is today from a few decades ago. (For more, read this posting.)

My contention is that we have entered a new world where established rules of monetary economics are breaking down. We had ample evidence of this in 2004-5 when the Fed's interest rate increases corresponded to an acceleration of mortgage lending. It was clear then that something wasn't working as it should. The rules never contemplated securization or the impact of unregulated borrowing mechanisms such as the yen carry trade.

The question is: will our policymakers ignore the new realities, just as Churchill, Bruning and the Fed of the 1930s did? So far, the answer appears to be yes.

My expectation is that credit will continue to contract and deflation will worsen. Home prices will keep falling, foreclosures will snap back in January and jobs will continue to disappear. The Fed's low interest rate policy will worsen the situation by harming repos and money-market funds, while doing nothing to spur lending. Securitization will remain close to non-existent and consumers will lose access to credit cards. State and local governments will run out of money and be forced to lay off workers, worsening the economic slump. (I am still not sure how anyone can be bullish on infrastructure stocks in this environment. If state and local governments can't afford to pay their workers, I'm not sure how they're going to pay for roads and asphalt.)

My recommendation remains the same: We need to stop thinking about the Fed funds rate and create a spectrum of spreads at which the government will buy various credit securities. (It should set the levels for different risk levels, and possibly nationalize the credit-ratings firms in the process.)

The evidence is overwhelming that capital markets have replaced banks as the source of credit in the economy. We can embrace this new reality -- this new market primacy -- or we can fight it. But we cannot change it.

No one doubts we're in a new era. It's time to starting thinking that way.

Friday, December 12, 2008

Detroit's Just End

The Senate just failed to "bail out" the U.S. auto industry. The real blame falls at the feet of the United Auto Workers who refused to accept pay cuts as part of the deal.

This is the just end for an industry that has enjoyed too much power in our country for far too long. Ever since the 1930s, the vast bulk of our public building and planning have revolved around the automobile. Cities were neglected and trillions of dollars in wealth were transferred from rich northern cities to poor areas across the Sunbelt in particular. This process not only contributed to urban blight and impoverishment during the 1970s and 1980s, it also caused Americans to become completely addicted to expensive, inefficient and irrational life styles. It made use voracious consumers of fuel, building materials and -- most importantly -- capital.

With their multiple vehicles, hunting lodges and high-income life styles, Michigan auto workers were perhaps the clearest example of this phenomenon. Furthermore, the culture of entitlement fostered by the union has, in many ways, spread throughout our country. For years, they won ever-rising salaries and benefits, even though many of them never went to college or did anything significant to upgrade their skills. They simply expected the money to be there, regardless of the competition, the quality of their vehicles or the financial strength of their company. They were even paid for not working.

This actually should come as no surprise. One of the great innovations of the auto industry was to pay workers high salaries to make them into a consuming class of customers. This basic economic paradigm, often called Fordism, dominated our society from the 1940s until -- roughly -- now. Of course, incomes have not done terribly well over the last decade or so, but the economy grew ever more dependent on the consumer.

The dark side of this paradigm was debt. General Motors displaced Ford as the top automaker in the 1920s because it aggressively used financing to sell its cars. The dirty secret about our entire post-WWII society is that consumer debt grew a few percentage points faster than GDP almost every year. By the final end last year, debt was all that was driving the economy.

In many ways, GM is a microcasm for our entire country. GM was once a proud AAA rated company, with vast assets, enviable profit margins and a relatively small debt load. Everyone flocked to Detroit for jobs, making the UAW into a political force and a nexus of power and money. The organization bloated into a massive bureaucracy, with more committees, sub-committees and petty commissars than the Soviet Union. Factories sprawled across the Upper Midwest and pretty soon all of the brands were cannabalizing each others' sales.

Between all of its employees, executives and retirees, GM had many mouths to feed. Rather than downsize rationally, they chose to keep growing. The only problem is the Japanese had gotten really good and were now major competitors. The best way to move product and keep things going was to pay customers to buy their cars. Pretty soon, GM was offering 0% financing, or close to it, on their vehicles. Where did they get the money? They mortgaged their entire company.

Given their massive size, and helped by cheap oil in the late 1990s, they were able to keep squeezing more value out of their capital structure for about 25 years. Finally they are at the end of that road.

Now I listen to people talking about the USA. "We can afford a trillion dollars of stimulus," say some. "We have a better balance sheet than European countries," say others. While these statements are true, they reflect the basic problem with all credit-based investing: It's inherently backward looking and insufficiently aware of human culture and behavior. Credit investors only look at assets and liabilities. Unlike equity investors, they are seldom good at seeing where a company is going.

When I hear all of the loose talk about stimulus now, it reminds me a lot about the kind of thinking that ruled for decades at GM. "GM has plenty of money," said the union leaders. For decades, they were right. As a result, they developed a culture of waste and negligence. And, as a result of that, today the opposite is true. GM has almost no money.

The question is whether we will learn from Detroit. Profligate spending never made anyone richer. As Washington gets ready to hurl vast amounts of cash at the US economy in coming quarters, it's almost inevitable that decisions will be made as poorly as they were made in Detroit over the past years.

One last point about waste: Is there any reason why a 150-pound person needs to transport 2000 pounds of steel and fiberglass with them everywhere they go? Would you design a system where ordinary people are exposed to the legal liability of operating such a machine, and forced to pay for maintenance and insurance? Is it logical to borrow money to buy something that loses value the second you own it? Is there any reason why we must live at the end of suburban cul-de-sacs, in giant homes that consume even more energy than our vehicles? Is it healthy to spend several hours everyday in a vehicle, not exercising, earning money or learning new skills?

When you look at it from the big picture, none of it makes very much sense. The car culture is wasteful and, in the long run, unsustainable. But even more important, it draws on the worst in people rather than the best. It doesn't draw out the best in people, but the worst. It doesn't make us aspire to greatness, foster a better sense of community or more productivity. It's rooted in our crassest and most base tendencies.

Nothing embodies that more than the UAW, with its job bank and its calcified culture of entitlement.

When GM finally goes bankrupt, the blood will be on the union's hand. In the end, the truth always comes out.

Tuesday, December 9, 2008

Unintended Consequences

I have woefully neglected this blog. I want to get things going again with some quotes from interviews today on Bloomberg Radio and a story on Market Watch.

Mohamed El Arian, co-head of Pimco
What surprises you?
“The extent to which liquidations are still ongoing and more generally the deleveraging."
What do you want to buy in this environment?
“The sectors we envisage as under the umbrella of government action. You're looking at the mortgage market and the debt securities issued by the large banks. Those in our view offer the best risk adjusted returns."
Michael Darda, Chief Economist at MKM Partners
"This economy is (growing) far below potential.. That's probably going to be the case through the entirety of 2009."
“We looking at the fall of next year as the earliest the economy will bottom.”
Just for good measure, Darda added the unemployment may peak at a level "substantially higher" than his official forecast of 8.2%. He doesn't expect employment to show signs of improvement until 2010.

Roel Campos, Former SEC Commissioner & Obama Advisor

"We're looking for disclosure of positions, with a small delay, after a short sale is made."
Campos is seeking to have the next SEC chairman introduce new rules requiring short sellers to publicly disclose their positions in a manner that is similar to how equity investors are required to reveal their equity stakes.
(This according to MarketWatch.)

What it Means

These quotes illustrate points I have made earlier, but they are worth repeating.

First, as El-Arian says, the liquidation of fixed income assets remains a major problem. My contention has been that the entire credit market has entered an outright bear market. After years of complacency, it's swung in the opposite direction to utter paranoia and fear. People are more willing to earn 0% or slightly less in "risk-free" Treasury securities than investment-grade corporate bonds or mortgage-backed securities that are trading at such cheap levels that they're worth the risk.

My worst fear, as expressed in this blog entry, is that the overall credit market would enter a state of liquidation when everything gets sold. You might say "so, what, I don't own bonds ... I only own stocks." But stocks are equity securities that represent the "residual value" of a company. Once the creditors are paid back, shareholders get everything that's left.

That's great when asset prices are rising and credit is easy. Now that we're in a period of credit contraction, it will be increasingly difficult for companies and consumers to roll over debt. And, unlike stocks, debts come due. Companies have to pay back specific amounts of money at a certain point in time. If they can't borrow it again, they get liquidated or are forced to sell new shares. Both options are terrible for stock investors.

El-Arian's second comment is equally distressing. He says the best place to invest now is in areas guaranteed by the government. It should send a chill through anyone who believes in free-market capitalism that one of the great investors of our time doesn't want to buy any asset classes many people now claim are "cheap," such as mortgage-backed securities or investment-grade corporate bonds.

Both of these comments substantiate observations I have been making over the previous few months. Basically, we are in critical danger of the credit market bifurcating into a class of "touchable" and "untouchable" assets. Investors will gravitate solely to debt sponsored by the government and shun everything else. That will eviscerate seemingly healthy companies that need to refinance maturing debt, forcing them to sell assets, raise capital or seek bankruptcy protection in the midst of an already terrible environment.

This is a problem I raised personally with El-Erian colleague Paul McCulley as soon as the government said it would use the FDIC to insure financial-sector debt in October. At the time, McCulley agreed with my concern. El-Erian validated it today: “Every time the government intervenes in a certain sector, another sector gets destabilized because it hasn’t been included," he told Bloomberg.

In other words, we're looking at an environment where the only the government -- or its favored clients -- can borrow money. (Since the FDIC backstop has been put in place, lenders such as Citi, Bank of America and even KeyBank have utilized the it to issue tens of billions of dollars in debt. One might add it's terribly unfair that the companies that made the biggest mistakes now enjoy government guarantees, while those that "did nothing wrong" are forced into bankruptcy.)

Darda advances this point by saying the economy will expand below its potential growth rate. In other words, the private sector will contract, forcing the government to step in and employ people, factories and offices. (Factories and offices, after all, need to eat, too. Just like people, they have debts to pay.)

My concern is that as the private sector goes into cardiac arrest, people will increasingly look to the government as the ultimate consumer in the economy.

To sum it up, we're facing a situation where the government is the only party that can borrow. That means pretty soon, it will be the only party that can spend and hire. In other words, it will be an economy by the government, of the government and for the government. It won't take long before resources are misallocated and politics, rather than economic considerations, drive the decision-making process.

The Accidental Statist

If Americans wanted socialism, they would have elected Ralph Nader president. One of the great ironies of the current situation is that so-called conservatives in the Bush Administration and Bernanke Fed are clumsily nationalizing the entire financial system.

Where does this leave us going forward? The comments by Campos about disclosing short positions might seem innocuous enough. He wants to disclose short-selling positions. What's wrong with that?

1-It will be viewed as an attack on short sellers.

2-It won't accomplish anything except scaring people away from the market. There are many problems with the U.S. financial system, but short selling isn't one of them. A much better use his time might be to address how the SEC allowed such large amounts of financial instruments to be churned out like sausages over the last decade. First it was tech stocks, then it was off-label mortgage-backed securities and collateralized debt obligations.

3-It's a wholly political move. Short-sellers didn't cause the banks to fail, or make people default on their mortgages. Banks and regulators are responsible for that mess. Short-sellers were right about the industry's problems, and they shouldn't be punished for their perspicacity.

4-How will it work? Many traders sell a stock short and cover their position the same day. How do you account for them? What happens if they use other ways to bet against stocks, such as buying inverse ETFs that move in the opposite direction as share prices?

This kind of disclosure would do little more than drive more trading outside of the USA and undermine our financial system. Shooting the messenger is never a good idea. If short sellers are right or wrong, the market will reward or punish them. The SEC has dropped the ball for a long time in this country. There are many more productive places they can spend their time.

Thursday, November 20, 2008

Long-Term Stability, or Economy in Liquidation?

Maybe now the gravity of the economic situation is dawning on the more genteel classes such as Hank Paulson. It bothers me that they still don't understand what's really happening or how to stop it.

Quite simply, we need the government to start buying bonds right now: Investment grade, each with appropriate spreads. Perhaps something like +500bp for BBB and +250bp for AAA. We establish a few specfic points along the 5yr, 10yr parts of the curve.

This would solve the biggest problem of all right now: Liquidity in the markets. Banks would sell you bonds with the quasi-understanding they would be willing to buy them back. This constant buying and selling is what it means to "make a market."

Now that the banks have less capital, they are willing to take on smaller amounts of "inventory" (bonds). That means that if you want to sell your bonds, they'll just knock a couple of points off the price. Now people are facing losses and scared to buy anything else. The system dries up. By itself, that doesn't matter much because these bonds are all paying interest. The problem is that when people aren't buying bonds, companies cannot sell bonds.

Selling bonds is just about the most important thing that happens in the US economy. Corporate debt was traditionally relegated to the nerdy backwards of the financial world, far from the rock-star status of the equity guys. They would take all the glory for the big mergers, especially when they involved large amounts of debt. The bond offering that made the whole thing possible would barely get a moment's notice, even though hundreds of people put thousands of hours of work into making it happen.

Like the plumbing or the electricity, we counted on it to work. When banks wanted to lend more to people and didn't have the deposits, they packaged up loans and sold them to the yield-starved investors in the bond market.

The dirty secret is that our economy has grown increasingly dependent on an opaque capital market system that's only partially controlled by our regulations. Household debt grew at a 10-12% range almost every quarter from Q4 2002 to Q2 2006. This was driven by mortgage lending, which in turn was driven by huge demand for mortgage-backed securities.

Banks held smaller and smaller proportions of the loans on their balance sheets and the system became increasingly dependent on the bond market for its funding.

Bonds are traded in an unregulated global market where central banks and foriegners channel large amounts of money based upon their own need to invest funds. They didn't think about or care whether borrowers needed the money. They had smooth-talking American mortgage brokers speaking for them, and the credit rating agencies said it all just fine.

The lesson is that foreign capital can have a huge impact on the economy. In our country's case, we experienced that capital flows in two ways that helped to cause this credit crisis.

1-Outright buying. Foreign purchases rose from $15bln a month in late 2001 to $47bln a month in May 2007. (I am using the 12-month moving average from here.) This money resulted from our trade deficit with countries like China, was pumped in to all kinds of debt and consumer spending. When the bubble really started in early 2005, this recycled overseas trade money was injected an extra $25bln a month into the US economy, equivalent to about one month of Wal-Mart's total revenue. By 2007, foriegner capital was financing two full months of Wal-Mart revenue. (I am think Wal-Mart revenue is an important number that should be tracked as an economic indicator.)

Since May of last year, foriegn buying has been drying up. In August and September it turned negative. I suspect when we get the October data it will be especially bad. Instead of pumping an extra month or two at Wal-Mart, the foriegners are selling their bonds and are sucking liquidity out of the system. If they become net sellers, we're facing an utterly different economy.

2-Yen-carry trade investing. This is the little secret no one wants to talk about. Hedge funds and other investors essentially borrowed in yen at something like 0.5% and bought all kinds of other stuff yielding 6%. For years, the yen cooperated and thousands of investors put trillions of dollars into assets trying to milk out a few extra basis points.

Now it's going the wrong way, and the yen is rallying. That makes people's debts bigger, so they sell everything they own like stocks and mortgage backed securities.

The yen was like a huge, unregulated bank. It provided funds at a certain cost. Unlike a bank, it had no regulation and no guiding hand to make sure the money was invested wisely. These loans were all structured in ways so that the banks would get paid back even if the assets were liquidated. With the complicity of Japanese banks and officials in both countries, we have developed a shadow banking system that no one talks about. Bernanke's on the hill, and little mention of it. Paulson would never dream to discuss it. The hedge funds in congress, and the word yen isn't even uttered. This was another source of leverage that injected trillions of dollars of credit into the economy.

Both of these things did a great job injecting money into the economy for a long time. Now they are broken. We cannot simply turn our back on this market now that it has become our system. We need to keep it alive. That's why the government should buy these securities now. Alexander Hamilton consolidated the debts of the many states to instill a sense of confidence.

This time, instead of taking over the debts, let's buy them as investments. The simple truth is that many of these things are structured in ways that will pay off. Right now billions of dollars of these things are getting dumped on the market. That's making it impossible for people to buy new bonds, which is going to decimate companies' profitability. (That hasn't even been felt yet for real.)

We need the government to buy the bonds and create a new soveriegn wealth fund to help pay for social security and medicare. It would allow us to turn a grave national challenge into a new strength. This is what FDR did in the 1930s, and it's how we need to think now. We have to stop being so wed to the textbook and look at the new reality before us.

I might sound crazy to say the Fed is ignoring the problem, but the numbers do not lie. See the charts in this posting to see the links between foreign capital and home prices. The link between the yen and the recent liquidation is also undeniable. The two charts below show the dollar falling against the yen (the yen is rising as the chart goes down) and the stock market falling at the same time. It's the opposite of what happened between early 2005 and mid-2007.

Our economy became dependent on these two artificial sources of money. Bernanke thought he was reducing liquidity by raising Fed funds, but he ignored the $35bln or so of monthly inflows (about equal to Honeywell's 2007 revenue) that were gushing pouring over the top of the dam.

Now this money is being pulled out, and again we ignore it. If we don't end this insanity soon, a lot of the economy will turn very sour. Credit holds together an economy as cartilige binds a body. It's the place where suppliers and customers meet each other -- will suppliers now ask for payment every 30 days instead of 45? Are they getting squeezed by their peple as well. At the same time, banks will be less willing to extend more loans on the margin. This situation threatens to rip apart the binds of trust and confidence that exist across the economy. Credit starts in the capital market, and flows down from there. (While credit obviously started in agreements between individuals and not huge bond offerings. Customers' ability to pay can depend on their access to loans. These interpersonal relationships look up to the customer's access to money. If a supplier decides they have reason to doubt getting paid, it's their responsibility to demand immediate payment. This forces more things to get paid off at the same time, which is an anti-liquidity event.

Essentially, the market will become hegemonic. We now have a mass market for credit, or trust. It's called the bond market. As it gets trashed, a toxic venom will spread through the economy and significantly undermine business confidence. If the government doesn't step in and buy credit products soon, much of our private-sector economy faces outright liquidation.

Wednesday, November 19, 2008

Keeping GM Alive in Bankruptcy

The only valid argument I hear about "bailing out" GM is that a chapter 11 filing could make people afraid to buy the company's car, killing it as a business and preventing it from ever emerging intact. I researched this a little back in early 2006 as Ford and GM both descended deeper into junk.

Yes it's true the credit crunch has hurt GM, but let's not forget that their own excessive indebtedness is what now puts them in peril. Shares of Toyota, which happens to be a AAA credit, are down about 40% this year -- roughly the same as the entire stock market. GM, a CCC-rated concern, has fallen about 85% and is rapidly approaching penny-stock status. They're both facing the same terrible market. GM's problem is the debt load, which it accumulated paying for other people to buy cars and to pay employees from decades ago. Chapter 11 bankruptcy was designed to deal with a company in this position, keeping it intact for re-emergence.

Two ways to deal with GM:
1-The government will honor GM's warranty. If confidence is what they're looking for, how about the full faith and credit of the U.S. Treasury?

2-The government will provide, or arrange, the debtor-in-possession financing. This would be one of the largest DIPs ever, organized in the midst of the worst credit crisis in the post-WWII period. Leaving it to the banks, already capital constrained and risk-averse, would be like throwing a chicken to wolves.

Yes, a bankruptcy could destroy GM. But, it doesn't have to. With a rational plan and a sense of realism, we can make sure the company emerges stronger than before. They have made some real progress in cost cutting and quality. But there is simply too much debt and too much dead weight to remain alive in times like this. Going bankrupt is the normal thing for a company in their position to do. And, if the government is there to backstop the warranty, I can't see any reasonable argument against seeking Ch 11 protection.

This would be an intelligent way for the government to be active in saving GM.

(Dear me, now Andrew Ross Sorkin on Charlie Rose is saying exactly the same thing I have been about giving a government guarantee to GM.)

Companies in GM's position should go bankrupt. They put off their problems for too many years and got religion far to late in the game.

They should also talk out other deals. The government should push for things like an alliance with Google, ways to brainstorm better cars. Certain kinds of encouragement and moral/political support can pay great dividends. The real crisis we have in the US is a lack of pragmatic solutions. Our own enemy is our sense of inertia and what's not only possible, but profitable and worthwhile. Why isn't the government laying down a vision or providing direction? While many people lambast FDR as a socialist, he allowed Wall Street to fix itself in many ways. His plans were not just politically feasible -- they were socially pragmatic and truly useful. Things like the TVA and Hoover Dam had massive positive impacts on GDP for decades to come.

The key thing to remember about FDR was that he saw an economy glutted with over production and falling incomes. He knew that only by stimulating demand for stuff could all of this capacity be put back to work. He pushed things like housing and automobiles because they consumed lots of stuff. Rubber, steel, oil. The vision was laid during the Great Depression and served as the guiding principle for all US economic development until just a few months ago.

The interesting thing about FDR was his background as a jerk-turned-polite-cripple. He knew what it took to make it through a day suffering, and he knew how to survive. He knew in his heart that grit trumped principles. He knew that sometimes the economy needs some hair off the dog that bit it. If technological progress and the achievement of wealth had caused progress, which now was slowing down, why not bring it back with new demand? Why not find a way to employ all these people and their factories?

We need to think that way now about our own economy and society. In the 1930s our problem was too much production and not enough income. During WWI, the US grew as a producer of grain and industrial products. This caused general price declines throughout the 1920s and much of society was already in something of a depression when the stock market crashed. (New urban professional classes -- the emerging white collar world -- did quite well and emerged as a new consumer class.)

FDR saw a country full of potential. Society as we knew it in the late 1920s wasn't producing the kind of demand and production that was needed to employ itself. We had advanced science and engineering skills, the most factories and wealth of any country in the world.

But FDR knew that many people we still stuck in 19th century conditions. He knew that giving them things would be politically popular, and that it would only make the country stronger in coming years. After all, without power from the TVA, there would have been no nuclear weapons lab in Oak Ridge, TN.

Using electrification, roads and dams, FDR found ways to employ all this human energy and productive capacity. His financial reforms included the 30 year mortgage, which would go on to encourage a whole new kind of investment and consumption.

Today, we face very different problems. Instead of underconsuming, we have been overconsuming over the last few decades. Debt has grown just a little faster than GDP almost every year since WWII, and consumers grew increasingly dependent on credit -- similar to any older culture. (It's interesting to look at their leveraging relative to that of GM.)

We also need some new social groups to solve the generation gap problem. If we as a people continue to trust the government for solutions, we'll wind up killing each other. We essentially need a national debate forum -- two generations of stakeholders. Babyboomers on one side, and their kids plus immigrants on the other side.

The problem is that we have a leadership steeped in old ideas. We need to start thinking about what can be done, instead of indignantly declaring what must be done. "Must" only exists in the mind of man -- and algorythmns.

(We've have too many people who have studied at too many schools for too long. Too many people read too many books and wrote too many algorythmns. They drank their own koolaid and missed the bigger picture. Instead of being like eagles, deftly swiping at the markets with precision and intelligence, they were like flees on a dog. They were really good at sucking blood -- in their case by borrowing huge amounts of money to make ordinary momentum trades. But they didn't realize that 10,000 other flees are on this dog and it won't live forever.)

One other thing we need to address right away: We need a soveriegn wealth fund. It can buy structured securities now at huge discounts and use the profits to support social security long-term. This way, even if some of these loans go bad, the problem will be dealt with through the structured entity and the government will almost certainly profit. It will also prevent the collapse of the market right now from paralyzing the entire economy. We need to get issuance flowing again in the capital markets or companies and consumers will be like fish in a tank that runs out of oxygen.

I estimate something like $1-2 trillion of "extra debt" came into existence during the credit bubble. This resulted from foreigners recycling trade dollars into the US, hedge funds borrowing in yen and by structured products like CDOs and SIVs. As each of these things unwind, hundreds of billions of securities are spewed out onto the market. This has caused huge dislocations and prevented new bonds from getting issued. That means banks can't originate mortgages and credit card companies must tighten terms on customers.

This is the credit crisis. It's a huge liquidation of term debt securities. We as a country have developed a new kind of economy that is less dependent on banks. This happened because it made things better for a lot of people. We need to keep those gains now and move on to the next level of our economic life, where perhaps capital markets provide a larger role of financial intermediation.

Like it or not, these issues, like the yen carry trade WILL come up again. Bernanke's refusal to see it won't make it go away.

Friday, November 14, 2008

Fiat Money's Unexpected Outcome

Many experiences with fiat -- or paper -- money have made people think it must inevitably lead to inflation. This is what happened in the U.S. during the War of Independence, Weimar Germany and Zimbabwe.

But a more complex truth is emerging: Fiat money can produce extreme DEFLATION rather than inflation. Why? The answer is relatively simple: Central banks don't just "print" money. Under the concept of "fractional reserves," banks lend more than they hold in deposits, which brings new money into existence.

In less sophisticated economic situations, such as 18th century USA or Germany immediately after a war and famine, governments printed money which drove up the price of everything from bread to cab fares. But in advanced economies like the USA today or Japan in the 1980s, this money was channeled into "responsible" purposes, like funding office buildings, houses, stocks, and, of course, mortgage-backed securities.

This drives prices of these specific things higher. Instead of having inflation in common consumer items, we get inflation in assets -- BUBBLES.

When these bubbles inevitably pop, it contaminates bank balance sheets and causes losses in capital markets. In the case of Japan, banks curtailed all lending. In the case of the USA, where financial markets have replaced banks, market participants liquidated positions in things like asset-backed securities. Both events have the same outcome: less lending, less credit, deleveraging, recession and deflation.

The key difference appears to be that in the case of Weimar Germany or Revolutionary America (or even the USA during WWII), the government literally printed the money to pay for day-to-day stuff. This caused inflation in food, wages and other goods. In contrast, in the modern financial-market economy, it causes asset appreciation.

The difference is in the degree of financial intermediation. If there's a bank or some other kind of lender, they provide funds for assets. Even when banks helped to finance people's vacations, in reality they were providing something like a second mortgage on an actual house, so they were actually financing an asset.

Another key aspect of this is the role of trade and foreign capital flows. This provided a base of capital in both Japan and the USA, which wasn't present in Weimar Germany etc.

I have more evidence about the extent of the yen carry trade. I am beginning to realize what a massive phenomenon this was. Only government could make a mess this big. In this case, it wasn't even our government -- it was Japan's.

Going forward the U.S. will lever up to "stimulate" the economy, we may wind up creating money that is spent on stuff, such as wages. The big question is whether that will produce true inflation.

Tuesday, November 11, 2008

The Panic of '08

I have been seeing more and more parallels between the current economic crisis and the "panics" of the 19th century. The main reason is international capital flows: For the first time since the Panic of 1907, a full 101 years ago, the movement of money in and out of the U.S. appears to have played a crucial role in the current economic situation. Even though we now have "fiat money," our system is showing aspects of the gold standard. Only now, it's not the presence of gold that matters, but the flows of money into the economy.

Before WWI, the U.S. was heavily dependent on British capital. London was an essential investor in most railroads and other major public works throughout the 19th century. Most of the economic crises of that period involved a disruption of that money, a lack of gold, or both:

The Panic of 1837 was partially caused by the Bank of England raising its interest rates to keep gold from flowing into the U.S. economy.

The Panic of 1857 was partially caused by British investors removing funds from U.S. banks after the failure of the Ohio Life Insurance & Trust Co. It was exacerbated when a ship carrying about 15 tons of gold sank off the NC coast.

The Panic of 1907 was the direct result of the collapse of the Knickerbocker Trust Co. But that bank failure was the final in a complex series of events, the most important of which was the Bank of England's raising its interest rate to 6% from 4%.

In each of these crises, events caused British investors to remove gold from the U.S. economy. Less gold meant less credit, which meant less economic growth. This is why countries used to raise interest rates to attract capital. In the old system, higher interest rates actually increased credit growth. (This was one of the reasons for the creation of the creation of a federal reserve of gold, a lender a last resort, that would support U.S. banks in case random events on the other side of the globe caused a withdrawal of gold.)

During WWI, the U.S. essentially paid off its debts, so was no longer dependent on foreign capital. All of the the following crises resulted from problems in the domestic economy, such as declines in production after wars or inflation.

Something different started happening in the late 1990s when foreigners started buying more and more U.S. credit products... essentially corporate bonds and various asset-backed securities (mortgage bonds). My other observation is that as the dollar appreciated against the yen, it provided a handy source of almost infinite cheap money that could be invested in higher-yielding assets. My contention is that by raising interest rates from 2004 to 2006, the Fed inadvertently stimulated credit growth by allowing market participants to engage in the "yen carry trade." (Rising U.S. rates made it easy to bet on the dollar versus the yen.)

Every dollar Ben Bernanke thought he was taking out of the economy, Goldman Sachs and all the other hedge fund shops rammed more dollars back in by borrowing in yen. This was like a huge giant free bank, and it was made possible by the Fed's rate hikes. Then there were SIVs and hedge funds that funded at Libor... Both essentially borrowed at short-term rates and invested in higher yielding assets such as asset-backed securities. As the Fed raised rates, borrowing costs rose for these market participants, causing them to seek every higher yielding assets to invest in. This had the perverse incentive of increasing risk appetite. Because they were short-term investors and not regulated as banks, they could essentially take almost any kind of credit risk. Raising rates on them didn't make them lend more parsimoniously -- it made them more reckless!

This reminds me of the situation in China, where their high interest rates caused "hot money" inflows. This increased the deposits in their banks, allowing more credit creation.

In our case, the money went into our capital markets, which thanks to securitization, had replaced banks and the ultimate providers of credit to the economy.

Now that we've built this system, we're stuck with it. In the early 1930s, one of the causes of the Great Depression was the Fed trying to turn back the clock and restore the gold standard. That just caused deflation and economic misery. This time, our complete neglect of the term debt market is having a similar effect. This is why I urge the government to start buying corporate bonds and asset-backed securities as quickly as possible. It's the only way to get credit back into the economy. Unfortunately, they be like the Fed in 1931, which emulated the Bank of England's 1907 rate hike. By then the gold standard was broken. This was Keynes's great observation.

This time, we still don't have a gold standard, but we are going back to something like it. Until we recognize that and embrace it, this economic crisis will continue to worsen.


It's like being the father of a 15-year old girl. One day she comes home pregnant. You can kick her out of the house, resulting in a nasty estrangement and perhaps major problems for both young mother and child. Or, you can embrace her and the new grandchild as family and your own flesh and blood -- intended or not.

Given the last 20 years of deregulation, globalization and securitization, this sick economy is now like our own 15-year old pregnant daughter. We can recognize that banks are no longer the ultimate providers of credit and embrace a capital-markets based system as we would embrace a new grandchild, or we can turn our back and lose a valuable part of ourselves. That means the time is now to intervene and support the term debt market. As I explain in this posting, messing about with the CP market won't work. The government needs to buy corporate bonds and asset-backed securities, or watch the stock market fall another 50%. (I see the S&P500 at 480 by the end of next year.)

Times change, and we must move on. We already know that the Fed's overnight lending facilities, etc, are incapable of fixing this. There is no going back. This weird capital-markets based economy is our new family. We cannot change reality by ignoring it.

Sunday, November 9, 2008

The Ignorance of our Chattering Classes

I am just now watching Fareed Zakaria talking on ABC's This Week with George Stephanopoulos. I had my doubts about his knowledge before, but now he's demonstrated even further that he doesn't have a solid grasp of the facts.

He said Barack Obama will be able to spend plenty of money to stimulate the economy "because interest rates are very low."

He was half right... Yes, the federal government's borrowing costs are still near historic low levels, but it has come at the cost of companies, and to a smaller extent, state and local governments. Investors are fleeing all borrowers with any kind of risk. As their financing costs rise, they will have less money for capital expenditures and dividends. The average person might ask "so what", but it will mean less investment in the economy and fewer jobs.

What's happening right now is an unprecedented crisis in the credit market that threatens to destroy thousands of companies and eviscerate the value of trillions of dollars in assets.

The two charts below illustrate what's happening. The top one shows corporate borrowing costs in blue and government borrowing costs in red, steadily declining since the early 1980s. They diverged during recessions or times when companies like Enron and WorldCom went bust, but the two more or less tracked each other lower -- until the present. The cost of money for companies, i.e. employers, is up about 37% since May, while the government's 10yr rate is up only 2%. If a company has $500mln of bonds to refinance, it will now cost them an extra $13mln a year. If they pay workers an average $50,000, that's equivalent to 259 jobs.

Even more important than the job losses are the consequences. Companies are already facing a sharp falloff in demand, so these higher interest costs come at a terrible time. Profits will plunge and the overall value of businesses will decline. This means the stock prices will continue to fall, devastating the savings of families and state and local governments. We're going to wind up with no one other than the federal government able to borrow money, no one other than the federal government able to invest, no one other than the federal government able to hire. In other words, it will be an economy run by the federal government.

The second chart gives a longer term view of how much above the government's rate companies must pay. This is called "spread." The wider it goes, the worst off we all are. We're now looking at the widest levels since at least 1962, when the data set begins. Spreads usually peak late in a recession. The fact they are this high before the economy has even yet officially contracted, or before the inevitable wave of bankrupcties hits, is very ominous. What will this look like after GM goes bankrupt?

Sadly, we are demonstrating the normal human tendency to "fight the last war." The conventional wisdom during a recession is to spend large amounts of money to "stimulate" the economy. The government is expected to sell more than $900bln of bonds before the end of March. They're doing this at a time when savings have already been devastated by stock market declines and foreign investors will be less interested than ever before in loaning us money. Those hundreds of billions will come at the expense of the private sector. It's going to be a zero sum game between companies and the government. Who will win?

Thursday, October 30, 2008

Down the Drain

The Fed continues to flush its balance sheet down the toilette to support our ailing financial institutions. The chart above shows Treasuries as a % of total assets at the Fed. The Fed started as a "reserve" for gold, then held only Treasury debt. Now, its main assets are loans to the country's banks.

I am not sure what will happen if some of these loans go bad for the Fed. Would it do any harm for them to just print more money and say it never happened? I am not sure.

What I am sure of is that the Paulson/Bernanke team have turned our financial market into a scrabble-like crisscross of mixed incentives. Banks have made major mistakes and inflicted a disaster of leverage on this country, and now our first priority is to help them? Hank Paulson forces them to take large amounts of easy money, Ben Bernanke coddles them with commercial-paper facilities and Sheila Bair comforts them with debt guarrantees.

These are the same banks like Citigroup that ran huge SIVs, which rammed hundreds of billions of dollars of extra debt into our economy just so they could make money. These companies stood at the central of the financial whirlwind that has shaken our land and pushed us towards something you might call socialism. Why do they deserve any support right now?
We've given them public money with no strings attached, and even now cannot force them to extend credit. Taking a page from the Bush tax cuts, we're insuring their debt for the next 8 months, and then it just stops?

The next problem is that they have failed to understand what hurt the interbank market. Everyone just assumes there is something deeply wrong when Libor stays significantly above the "official" rate like Fed funds or t-bills. But they forget that Libor is linked to a credit, and very real market prices exist for that credit.

Amid the meltdown on September 17th, yields of all financial sector corporate bonds spiked about 100bp. At the same time, panicked buyers pushed 3-month Treasury yields near 0%. Financials had major credit risk, so there's no surprise their yields were higher. At the same time, riskless yields plunged. Unlike in previous downturns, the fate of banks and the Treasury diverged.

Instead of recognizing this obvious reality of the market, the authorities have taken several actions to force interest rate unnaturally lower. They are spending billions to help the commercial paper market and insuring bank liabilities.

The interesting thing is that financial sector CP rates didn't move considerably during this period. In fact, the overnight, 15 and 90 day rates FELL... That means more people were buying those notes than selling that day.

What did move? Long-term corporate bonds and Libor -- the products that trade in the capital market.

What didn't move? Commercial paper.

Between Sept. 10 and Oct. 1, non-Treasury money market funds lost $440bln of their funds, or about 19%, according to AMG Data Services. That's why Sept. 17 was such a key date.. It was right at the start of a big liquidation that dumped billions of dollars in short-dated financial paper to be dumped on the market.

Bank of America's 1.5-year notes (BAC 7.800 02/15/2010) fell 3 points on Sept. 16.

The next day, its 10yr notes (BAC 5.650 05/01/2018) fell about the same amount. (Stocks also sold off.)

Many short-term financial sector bonds are linked to Libor -- "floating rate notes." These FRNs would have fallen when the market was flooded with other short-term debt.

When they fell, their yields rose. Because their yields are linked to Libor, Libor also was forced higher.

That's why Libor (and the TED spread) rose the following 1-2 days. Lots of floating-rate debt was trading cheap, with higher yields. With the market setting a price, Libor had to rise:
Eurodollar deposits (London)" ,Maturity,"3-month" (source)
09/12/2008, 3.00
09/15/2008, 3.00
09/16/2008, 3.20
09/17/2008, 3.75
09/18/2008, 5.00
09/19/2008, 5.00
09/22/2008, 5.00

Once again, we find the problem in the capital markets, not within the banks. This is not a banking crisis.

While we're talking about things in the capital markets, it appears there will be many headwinds in the credit market. It is clear that any improvements will be met with huge amounts of corporate bond sales.

Once the rallying in spreads ends, it might be hard for the stock market to keep moving higher. Looking purely at the chart, I would doubt the S&P500 could break through 1000. But, the election will probably have a positive impact. If Obama wins decisively and makes good actions right away, people might get excited about the end of the Bush reign -- which represented 8 years of lousy stock markets.

Even if things go perfectly for Obama and stocks go on a rally, I think the S&P 500 won't be able to make it through 1,200.

Getting back to banks: Once again, the problem began in the bond market, and then spread to the banks. After all, banks have grown more dependent on the capital markets during the last 20 years, using structured vehicles and corporate debt sales to fund operations.
Foriegners have also gotten much more involved in the credit market:
Here, the blue line shows the percent of U.S. corporate bonds owned by overseas investors vs those owned by life insurance companies. It's important because overseas investors will make decisions based on their own interests. They all had a single reason to buy U.S. corporates, so they all did the same thing. It's likely that if something bad happens, they will ALL become sellers as well. Their decisions are all based on trade and inflation.

Once again, a potential danger is lurking in the in the credit market -- the capital market. This is where problems START.

This is why I support a system that would bypass the banks by having the government buy corporate bonds and asset-backed securities. This would allow credit to flow to the economy and take pressure off the banks to lend.

Policy needs to focus on the capital market rather than the banks.

And, it needs to think about the health of the economy, not the health of the banks. But then again, who owns the Fed, but the banks?

Interest rates cannot be low forever. It seems that stocks do best when interest rates decline. At some point they have to rise. We might as well increase them as soon as possible, unless we want to suffer Japan's fate.

Tuesday, October 28, 2008

leverage rules, the Libor disconnect

in june 2008, a total of 45bln of credit securities were issued in the USA

in sept, 18bln, a multiyear low, of debt was issued. this month it's to be even lower.

in the world of credit, debt needs to get refunded. if companies don't sell new debt, they cannot roll over bonds coming due. many large companies like ATT, Comcast, GE, etc, issue bonds to pay for long-term assets.

normally any quality company can simply issue new debt and no one in the stock market even knows it happened. when it's not available, the shareholders are first in line to pay for it. dividends will be at risk, etc. it's a completely new kind of risk that's going to face non-financial companies (so far, we've only worried about banks, etc... GM could be next to go...)

I have observed that if a bond falls 10%, the same company's stock will fall 20-30%.

I am sure some official economist/credit expert somewhere knows the exact level... what that means is, when a company's debt comes due, management HAS to find a way to pay that money back. if they don't, it's chapter 11.

what I fear is that many industrial companies and others operate with small amounts of cash and require bank lines for working capital, etc. this environment will be brutal, and companies will be forced to raise capital and accept much lower earnings multiples.

this economy benefitted from 25-30 years of falling interest rates. that allowed a continuous process of multiple expansion... that era is over. deleveraging is how it will end.


by becoming more reliant on the capital markets, the banks have added a new element of risk. they decided to become reliant on capital markets and to sell bonds. now that these bonds are blowing up, how can anyone expect the banks to deal with each other?

if a company's long-term debt is trading like junk, how can anyone expect it to operate as a steady, reliable bank? why would other banks ever want to deal with it?

then the Fed goes and drives short-term rates lower. using the period of "normal" spreads, a bank like BAC would issue 3yr floating rate debt at about 5-10bp more than Libor. at the time, libor was about 5.25-5.50.. that means the cost of their credit risk is about 5.5% ... more or less all of their bonds yielded this.

suddenly, the Fed cuts rates. now, Libor "should" go lower. with fed funds of 3%, libor "should" be about 3.20%. why?

the interbank market is being affected by credit risk in the capital market.

if you now see Bank of America's 5-10 year bonds yielding 7-10%, you might be willing to accept 5% for the overnight risk on the name. but why should you accept something like 3.2?

but that's what the Fed is asking you to do. "ben and ted's unexcellent adventure"

because Libor is set by the market, it is the instrument that reprices. it's like ben bernanke came along and said "you WILL agree to lend to washington mutual for 2.5%, because the FOMC says so."
and the market answers back "no you won't. I will just refuse to bid on loans until Libor reaches the correct level." and then ben bernanke says "oh yeah, I forgot about Libor."
Libor is now around 3.40, and that's after some declines. the Fed needs to accept that Libor is a rate set by the market. somehow people have used this market to express an opinion. this is why they markets exist, after all.

in 2002, fed funds was 1%. something like 10yr bonds by jpm or citi back then would have yielded something like 4.2-4.5% -- at the most. and libor then would have been about 1.30%.

so, the normal spread between 10yr yields and 3 month yiedls was about 300bp.

now the yield on those long-term bank bonds is 8-9%.... using the old logic from 2002, libor should be somewhere closer to 5-6%. and, in 2002, there wasn't a debt crisis, so if anything it should be higher now....

this is why I am starting to fear the government's solution of insuring bank debt. it won't end well. this is why the only answer is for the govt to buy long-term debt.. ABS and corporates.

Wednesday, October 22, 2008

how strong are U.S. institutions?

this is from a recent AFP article:

"I'm hoping it's not close," said Richard L. Hasen, a professor who specializes in election law at Loyola Law School in Los Angeles.
"I am certain there will be problems on election day."

I generally would avoid sensational things like this, especially when it's from a newswire trying address an edgy topic... but I have heard enough worries about this issue now in the media that it's worth worrying about...

essentially, I think many of the country's voting facilities remain in pre-2000 (bush v gore) conditions. what happens if we have a contested election that drags on for months amid this economic crisis?

I have been arguing that the U.S. judicial-political-economic system has come to a major crossroads. we have abused our own system for decades, twisting our own constitution to mean anything we want it to mean, ignoring problems like healthcare and social security. our political class has no ability to do necessary things -- they are like spoiled children and don't recognize necessary things. they do what they think will get them re-elected, and nothing else.

the things that moved our system along previously have all petered out. we are now drifting without rudder or appreciation of what's going to happen politically. our naive and childish tendencies to "trust in america" and "trust in democracy" can't help us now that we've wandered so far from our constitutional basis.

Tuesday, October 21, 2008

judging the government's solutions

my plan of buying corporate and asset-backed bonds would do a better job of fixing the financial market than our current approach. in the last 10 years, banks have become less important as lenders in our economy, and the "capital markets" have become a larger source of money. over that time, all kinds of loans -- home mortgages, credit card balances, mortgages on office buildings, car dealer inventories -- have been funded by selling bonds. they are packaged into trusts, which then issue debt in the capital market. this is the new way our economy funds itself, and there are many benefits despite some real problems. fortunately, my plan would call for an overhaul of the credit-rating agencies -- major enablers of the binge.

my plan would embrace the new capital-market dominated reality. instead of trying to fix the banks, which long embraced these trusts, I think policymakers should look to the structuring technology as the solution. that means restoring the market for asset-backed securities -- especially those tied to credit cards and home mortgages. bank balance sheets and deposit bases are now much less important the economy. and, banks are private companies with their own shareholders to answer to. giving them free money and free guarantees, and then expecting them to effectively deploy the capital into the economy is naive. what's the incentive, other than the scorn of hank paulson, who'll be out of office in a few months? why should any bank put that money to work now?

paulson's "TARP" (troubled asset relief program) wanted to simply buy up distressed assets. some of his logic made sense because right now, some securities are TRULY MISPRICED and have very low risks of default under even the worst situations... the problem is that the market is frozen and no one wants to be the first one to buy.

that's why we need the government as a buyer... if the Treasury were to decree that AAA asset-backed paper should have a spread of 50 basis points over Treasuries, it would trigger a massive rally in securities that are now trading at areas around +500bp-600bp. because their default risks are so low, these are real instances of the market "going too far." many of these bonds were purchased by entities such as structured investment vehicles (SIVs), which got the money by borrowing short term in the "commercial paper" market. but now the commerical-paper market is crashing the SIVs have to pay back their debts, forcing them to sell longer-term asset-backed securities ...

a liquidity drain this size will inevitably reverberate throughout the economy. between aug 8 2007 and feb. 6 2008, the asset-backed CP market shrank by $378bln, or some 2.7% of GDP.

the market then more or less stabilized, as asset-backed CP levels remained close to $800bln from december through late july. it then fell 9% over the next five weeks.... then lehman brothers magicallly collapsed. (while it's hard to draw actual lines of connection, when you're dealing with large leveraged bets like this, it doesn't really matter how things work because everything winds up interconnected anyway.)

with less liquidity from ABCP, there was less money available to buy longer-term asset-backed (structured) securities, so issuance plunged:with less demand for these kinds of asset-backed securities, it's harder for credit card companies to securitize account balances. that means tighter standards, smaller credit lines and higher interest rates ... even businesses that have no exposure to housing will encounter tighter conditions as vendors demand earlier payments, etc. it will mean less money for ordinary people and small businesses... in other words, the exact thing the government wants to prevent.

this is a classic financial contagion scenario, where weakness in one area harms other areas. but this time, the problem is occurring in the capital market much more than the interbank market. we mustn't forget that the first indications of the credit crisis were visible in the asset-backed commercial paper chart above... it started falling in August 2007... while stocks went on to make new highs, the die was cast. by the end of the year, the sp-500 began a sharp bear market... by march, bear stearns was gone...


this housing boom and bust cycle was created in that capital market. that's where we have to solve it.

I believe the efforts so far will largely fail because they inject money into the wrong place. instead of rewarding banks with cheap subsidized capital, we should use that money to revive the market for long-term bonds. in this new modern system, the CAPITAL MARKETS, NOT THE BANKS, ARE THE SOURCE OF LENDING. investors are already on the sidelines with plenty of cash. they are afraid to buy now and recognize losses, but if the government were to establish official prices, they would rush back to the market.

such a solution would get money more quickly to the parts of the economy that need it. instead, we're trying to cobble together some kind of solution based on precedents established in other countries. we're giving the money to banks, which are bleeding out of every limb, and ASKING THEM to pass it along. this seems like plain wishful thinking to me. maybe hank paulson is just too close to wall street to know any better.

pursuing a capital-markets solution such as mine will also guarantee taxpayer upside. after all, bonds are priced relative to Treasuries. if they just took the average spreads over the last 10-15 years, it would allow to buy AAA at about +50bp, AA at +80bp, etc.


this would put a lot of onus on the credit-rating agencies. after all, the government would use their ratings to determine borrowing costs across the entire economy. that would require a major overhaul of the industry. for years, moody's and S&P have existed in a nebulous, murky realm. they take a cut of all issuance, which makes them resemble the investment banks that manage debt offerings. but unlike the banks, they cannot easily be sued. that's because they have the legal standing of journalists... this places them in a very priviledged place... they profit from surging debt issuance, but can't get in trouble when something goes wrong. heads they win, tails you lose.

we need to fix this situation. the rating agencies were at the very center of the credit collapse. (they're already ensconced in regulatory regimes around world involving pensions, insurance, banking, etc.) we cannot allow them to just slip into the woodwork. that's another benefit of my capital-markets solution... it would necessarily cast moody's and S&P into the political spotlight, where they belong.

as for-profit organizations, they inevitably seek growth first and foremost. in their case, they found that growth in structured products:

it appears Moody's and S&P made much more money rating complex debt securities than old-fashioned stuff like plain vanilla corporates and soveriegns. furthermore, those same issuers had less debt to sell. so the rating agencies turned to the most obvious growth opportunity: structured debt, most of which was tied to consumers rather than companies or countries.

on Feb. 4, 2004, Moody's acknowledged that the traditional corporate business would slow, but then assured investors with these words:

We also expect good growth in consumer spending in 2004. As a result, we expect that revenue from rating asset-backed securitizations, together with moderate growth in the commercial mortgage securitization and credit derivatives segments of the business, will substantially offset an important decline in revenue from rating residential mortgage-backed securities as the very strong refinancing activity of the past two years declines. In the public finance ratings business we expect approximately 20% revenue decline in 2004, reflecting projected slowing of issuance related to both refinancings and "new money" borrowings.

now, I am not sure why they said residential mortgage backed securities would decline. I don't believe that happened. but, we do see that Moody's was viewing structured finance as a growth area, which it was.

here's something from Moody's 2002's 10-K annual report:

Operating income of $538.1 million in 2002 was up 35.0% from $398.5 million in 2001. Moody’s operating margin for 2002 was 52.6%, up from 50.0% in 2001. The strong operating income growth in 2002 principally reflected the Company’s high revenue growth without a proportional increase in expenses.

again in 2003, the magically language appears:

Moody’s operating margin for 2003 was 53.2% compared to 52.6% in 2002. The increase reflected the strong growth in revenue in the Moody’s Investors Service business without a proportional increase in expenses.

in essence, these guys' were bringing in more revenue, but their costs didn't go up. everything was pure margin... why? because they were the gatekeepers sitting a top hundreds of trillions in debt issuance, and took bigger cuts when a deal was structured. all they had to do was hire a few more analysts and put in a few more computers... peanuts compared with the amount of revenue coming in. (this phenomenon is called "operating leverage.".. unlike making physical products with raw-material costs, the rating agencies just collect revenue when bonds are sold. if strong demand allows issuance to increase from $100mln to $150mln, the agencies get 50% more money for doing 0% more work... that makes the commission on $50mln pure profit.

and, the rating agencies' fees were almost certainly higher on these newer products. (I should emphasize there is no really definitive way to PROVE this, but it's a reasonable assumption given the chart above showing that the company's profit margin expanded when its product mix turned in favor of structured products.... furhermore, in any environment when something is new, with high growth potential, margins are ALMOST ALWAYS wider than a sector like sovereign debt, which has existed for centuries.)

and, of course, Moody's and S&P don't disclose their fees publicly.

this collapse of overall issuance, led by structured products, has been accompanied by a collpase of the share prices at both moody's and S&P parent McGraw-Hill this year.

even Fitch Ratings discussed how the weak structured-product market at its rival S&P could hurt McGraw hill's credit profile (which happens to be a plain vanilla corporate issuer in its own right, and the owner of S&P):

Rating concerns include dramatic slowdown in structured finance rating fee revenues, and the declining issuance of commercial mortgage-backed securities (CMBS), collateralized debt obligations (CDOs) and residential mortgage-backed securities (RMBS).

finally, as public companies serving shareholders, Moody's and S&P have no incentive to look at the macro economic/financial picture. no one stopped and said: debt in the overall economy is growing too fast-- make it stop. they continued giving the nod to individual securities without any sort of concern for the bigger system. they remind me of careless fishermen who overexploit an area just to make money, only to destroy a population's long-term viability. these rating agencies have eaten at the trough of the american financial system long enough. while they can produce a million excuses for why they misrated subprime debt, they can offer no explanation for allowing our household sector to take on so much debt except "it wasn't our problem." in truth, it wasn't their problem ... their only responsibility is to make money for shareholders. this renders them incapable of thinking about the broader financial system.

if we're going to give Moody's and S&P such an important role in the economy, maybe we should expect something more from them. maybe their mission should be brought into line with the needs of the country.

it's clear the rating agencies were at the center of this mess... and it's also clear that the mess began as early as August 2007 when asset-backed commercial paper came unglued and longer-dated issuance collapsed. that is what killed the bid for credit and unleashed the cascade of price declines, which subsequently caused bank writedowns. the problem began in the capital market, and that's where it needs to be fixed.

Saturday, October 18, 2008

foreigner, don't go home

summary: after years of pumping cheap money into our economy, foreigner investors may exit our market. this could translate into a long-term drain of liquidity that will make it harder to borrow, and resemble a tax on business that increases the cost of capital.

last week, the Treasury Department reported that overseas investors sold more than $13bln of corporate bonds in the month of august. it was the second negative month in a row, and the third to show a precipitous drop off. after averaging more than $40bln a month in purchases during 2006 and 2007, foreigners are suddenly fleeing the US credit market.

this is not the sort of event americans are used to seeing. we are accustomed to being the world's preferred borrower -- the highest quality credit. for years, our debt grew faster than the rest of the economy, allowing us to spend a little more than we ought, and letting companies borrow a little more than they normally could ...

two conditions allowed us to live beyond our means like this for years. the scary thing is that both of them seem to have reversed, so conditions could get a lot worse.

the first thing that made foreigners into our willing lenders was the trade deficit:

the U.S. has helped other countries develop for years by eagerly buying every barbie doll, pair of sneakers, or barrell of oil they produce. by 2004, the U.S. trade deficit had climbed to more than 5% of GDP, compared with the 1.3%. between 2003 and 2007, sucked a net total $3.3 trillion from our economy.


as the clothes, fruits and consumer electronics flooded the U.S., foreigner economies built vast stockpiles of dollars...

these dollars wound up at banks and financial institutions around the world. these same countries had policies of promoting exports, so they naturally wanted those dollars to stay as strong as possible. they didn't want to SELL THEM to buy their own currencies. so if you have a few hundred billion dollars you need to invest safely, where do you go? THE U.S. BOND MARKET.

the bond market is a place where anyone can lend money. you can chose between municipalities, companies, governments, and, of course, people.

established bond investors are very cautious by nature, so they research investments thoroughly and don't take stupid risks. but, unlike a being a loan officer at a bank, bond investors don't have to pass tests and answer to state regulators (who make banks stay conservative). bond investors don't have to know their borrower, the borrower's income or finances. all you need to buy into this market is a couple of hundred million dollars.

until about 30 years ago, only major organizations with long-term assets and cashflows sold bonds: governments, railroads, utilities, etc. but then came securitization. it started with fannie mae and freddie mac.. the GSEs ... in 1975, they issued $9bln of debt, while traditional corporates sold $27bln... GSEs were only 33% the size of corporates ... three years later, GSEs had blown past corporates.. by 1982, they sold two twice the amount ...

the GSEs purchased mortgages and assembled them into pools, which then issued bonds. this kept money flowing to the banks, promoting the general post-WWII trend in favor of homeownership. using structured finance, they transformed millions of loans into homogenous financial products. it was all for a good cause, and most importantly, it proved to be quite safe.


then came salomon brothers, which created the first private-label mortgage pool in 1983. the technology worked and soon spread to credit cards and auto loans. importantly, it passed through the S&L crisis of the late 1980s unscathed -- validating the belief that it was possible to structure a bunch of small consumer-based assets into a predictable source of cash flows... it was a new homogenized product in the market where everyone was looking for yield... salomon had invented a new widget, and it spread.

in the late 1990s, companies like worldcom, qwest, bell atlantic, time warner, comcast, etc, were building out the information superhighways, issuing hundreds of billions of dollars in the process. general motors and utilities others joined as well...

in 1998, the trade deficit started to widen sharply .. right around the same time china joined the World Trade Organization....

as investment declined and americans responded to 9/11 and the recession with furious spending as houses and cars grew bigger and retailers across the nation "went upscale" ... factor in the rising cost of oil imports, and the U.S. was consumed $700bln+ more than it produced in 2005 and 2006... a trade deficit of 5.75% of GDP both years.

as I explained above, most of those dollars were then recycled back into U.S. bonds, including corporates and asset-backed securities.

we do not know which kinds of bonds foreigners buy. the treasury department combines corporates bonds and all asset-backed securities under the same group. (the bonds related to fannie mae and freddie mac are not counted.)


in general, foreigners will buy a broad smattering of everything that's coming to market. in the late 1990s, they surely bought all the bonds from GM and worldcom... by 2002, companies didn't need the money, and most capital expenditures were finished.

but this was the same time the trade gap exploded wider, and the foreigners had more money than ever to put to work.

issuers of asset-backed securities stepped in to fill the breach. they basked in the liquidity, spoiled like children as the market gobbled up deal after deal.

investors loved ABS because they yielded a nice 10-30bp more than corporate bonds with comparable credit ratings.

bankers loved ABS because they generated underwriting fees. I am not sure, but I would believe they charged a higher commission than would have been standard for corporate bonds. (I say this because ABS were a newer market with a shorter history of competition.)

Moody's and S&P loved ABS because they generated much bigger fees. like investment banks, the credit-rating firms take a cut of issuance volume. they won't disclose their commissions, but moody's does report its revenue from structured products and corporates. combining this dealogic's data on annual debt issuance, I have calculated my own measure of their commissions... I found that that Moody's earned about 0.04% of all structured debt issued... compared with 0.02% for corporates... this was a cash cow.

credit card companies loved ABS because they allowed them to keep churning over more money and collecting fees and interest on the way.

mortgage brokers loved ABS because that's where they got their money. they grew increasingly reckless, and came to realize they could sell any kind loan to the market. they also got a percentage of issuance, like the credit rating agencies and the investment banks.

all of these groups benefitted from ABS and had a vested interest in churning more money through the system. then came a flood of foreign capital, and the mortgage-lending orgy was in full swing.


I have reached two important conclusions about this period:

1- the problems happened because the capital markets took over for the banks. loans were issued to people, not because they needed a house or were able to pay back. loans were issued because the money had to be invested.

the capital market was doing the job of the bank, but without any of its regulation or accountability. but everyone was getting rich, so it continued .

because the originators didn't hold the loan to maturity, there was no incentive make good loans.

the loans wound up on a trust, backing thousands of different bond offerings.

for credit quality, everyone essentially deferred to the moodys and S&P, which provided the necessary spectrum of ratings.

2- trade can concentrate huge amounts of money to financial assets, like mortgages. history provides many unhappy examples .... in the 1970s, where US banks channeled arab oil money to latin american governments... in the 1980s, japanese export earnings were recycled into tokyo real estate. both ended in bubbles and years of anguish.

so, imagine what would have happened if those $700bln+ had stayed in the USA in 2005-7. that money would have filtered through the economy in the form of wages and tax receipts. most of it would have been spent on normal consumption... only a small fraction of it would have wound up on the bond market (probably via some retirement fund)...

in contrast, when that money leaves the country and returns, almost half of it goes to the bond market. (in the 1985-2007 period, an average 44% of the trade deficit was invested in the "corporate bond" category.)

this was a big part of the credit bubble. by far not the only cause, but the single strongest single event that made the bubble inflate.

the economic problems originated in the capital market. unfortunately, few people of influence, whether reporters, economists or government officials, seem to appreciate this. they are trying to fix it by tinkering with overnight lending rates and emergency liquidity tools... these are all tools designed to deal with banks. no one at the Fed is talking about the sick bond market -- even though issuance has fallen off a cliff.

even if ben bernanke and hank paulson aren't paying attention, plenty of people seem to understand this. economists, investors and traders have told me that the government should be either guaranteeing or simply buying corporate bonds. one big ABS investor told me "people have no idea how large and important the asset-backed market is."

it started coming apart in august 2007 when SIVs unwound (they borrowed using short-term commercial paper and bought longer-term ABS). this dumped large amounts of ABS onto the market, which drifted about at discounted prices. this extra supply made it difficult for credit card companies and other lenders to securitize their assets. this caused a net reduction in the financial system's liquidity, which caused more problems -- each of which makes the situation worse ... the collapse of bear, lehman, AIG, etc. all of it started when the SIVs unwound in august 2007.

we're suffering from a sudden reduction of liquidity in the capital market. this has created a series of implosions. I fear it could cause a severe decline of credit in the entire economy, which could be much more devastating.

it could be like the great depression in one, big depressing way.

the common understanding now about the great depression was that the fed made things worse by raising interest rates and reducing money in the economy. they correctly observed that the fed was too worried about inflation. (it really didn't make any sense because commodity prices were plunging in the late 1920s...)

this year commentators such as paul mcculley at pimco invoked this memory to argue in favor of low interest rates.

I believe they were right in spirit, yet reach the wrong conclusion. the answer is not for the Fed to cut rates or provide easy money to banks. the answer is to fix the problem in the capital market: NO ONE IS BUYING BONDS. that is tightening the noose around our credit system. THE ENTIRE SYSTEM IS POTENTIALLY INSOLVENT if this contagion spreads.


NO ONE UNDERSTANDS HOW MUCH MONEY THIS COULD BE. at the end of june, foreign investors owned $2.86 trillion of corporate bonds -- exactly 25% of the market.

as late as 2005, life insurers were the largest holders of credit securities. but foriegn investors blew past and now exceed them by a full TRILLION DOLLARS.

and, as I pointed out at the top of this entry, these foreigners are already selling their trillions.

two things that made them buyers before now make them sellers.

1-fewer are dollars streaming in.

2-their currencies are now falling too fast, so they might sell dollars and dollar assets. after all, corporate bonds are now their top holdings, surpassing treasuries and stocks.

the scariest thing of all may be that the government plans to stimulate the economy and borrow to do it... that means trillions of dollars of brand new, safe treasuries will come to the market, at the same time foriegners are dumping their own trillions of corporate bonds...

this will be devastating for credit, and could cause companies throughout the entire economy to freeze up.

the government's inability to see how this chain of events could play out is frightening. this is why I think bernanke's Fed is actually a lot like it was back in the 1930s. it's like terminator 3... even if you think you can stop it, the catastophe is almost destined to happen. our efforts play right into it.

finally.. I had some other observations about what caused this bull market in credit...

1-years of declining interest rates. since the Fed defeated inflation in 1982, long-term rates steadily marched lower.

2-improving corporate profitability, bolstered by higher worker productivity...
in addition to technology, globalized supply chains drove productivity gains... in other words: cheaper sourcing ... especially after china joined the World Trade Organization in december 2001.

... and once you have a surge in international trade, you get:

3-globalized capital flows: as the rest of the world sold more goods and services to the US, they accumulated dollars. those dollars were recycled back into the US, creating a boomtime in U.S. financial history I call "the foreign bid for credit."

many things happened during the great foreign bid for credit:

1-US treasury supply fell as budget deficits narrowed. (this deprived foreigners of places to park dollars.)

from 1985-96, the US government borrowed an average $201bln a year.
from 1997-2001, we paid back an average $80bln a year.

in other words....
treasury bond supply declined sharply starting in 1996. at the same time, corporate america globalized supply chains, leaving more dollars in the hands of foreigners. these foreigners generally wanted the dollar to remain as strong as possible (because that's how they get paid). loath to sell their dollars, they bought dollar-denominated bonds.

but because there were so few Treasuries, they started buying US corporate debt. over time they grew accustomed to it.... by June of 1998, a new trend had emerged.

between June 1998 and may 2007 corporate bonds were the leading destination for overseas money 56% of the time, compared with 22% during the previous 20 years (1978-98) ... (there are 4 categories under which the Treasury reports foriegn purchases of U.S. long-term securities: Treasuries, Agency/GSE, Corporate bonds and Corporate Equities. "corporate bonds" include asset-backed securities linked to everything from mortgages, credit cards and auto loans.)

this buying reached a fever pitch at the height of the US credit bubble:

just to round it out, you can see US home prices rose along with the foreign capital flows, and started falling only earlier.

looking at these charts, it's clear what drove the housing bubble: a vast surge in foreign demand for "corporate bonds" .. this was the great foreign bid for credit. it was a market trend that seems to be ending... this is why I fear a potential bear market in credit .. the possible implications of such a bear market have not yet been fully grasped... everyone now assumes credit will just "get better" ... but can that happen with foreigners turning into net sellers?

I put "corporate bonds" in quotations because it comprised both normal corporate bonds, issued by telecom companies and utilities, and asset-backed securities, which are dominated by mortgage debt.

during the great foreign bid for credit, both kinds of issuers had their day...

normal companies like GM, worldcom, qwest, ford dominated until about 2001 as they built networks and funded long-term pension liabilities...

by 2002, they fell off the map as the enron-worldcom credit crunch hit...

... at the same time, all this foreign money was flowing in and tens of billions of dollars cascaded through the system each month... before long, every half-witted mortgage broker from miami to las vegas had learned how to stick out a bucket...

thanks to them.... between 1998 and sept 2007, debt of banks, financials and structured entities rose from 40% of GDP to 110% of GDP.

given that US stocks were tacitly subsidized by foreign quasi-official purchases, what does the removal of that capital do to our economy?