Thursday, November 20, 2008
Wednesday, November 19, 2008
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
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
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
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?