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?