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.

No comments: