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Sunday, December 21, 2008


it's official: paulson and bernanke are at sea in the storm of the century

lots of folks have noted the lack of a plan in the government response to the financial crisis. paulson did little in confirming the reality of the assumption.

but far worse than a lack of a plan is the general drift of the planless response -- which has been to attempt to support ridiculously high asset prices distorted by the massive credit bubble that has now irrevocably popped.

this crisis could have been attacked by nationalizing insolvent institutions, hiving off bad assets under government-recapitalized "bad banks", and returning delevered and scoured banks into the wild to lend responsibly with clean balance sheets. that would, however, have killed returns on investment for assetholders, shareholders and some bondholders as well -- and the overarching lesson that i would draw from the government response is that the government is the bitch of assetholders whose gilt capital lies at the corner of wall and broad, as a sensible and proven workout plan has been avoided in every instance. instead, we've repeatedly seen the only responses that might minimize short-run pain for asset holders -- transfering incredible credit risk to the government, recklessly daring foreign creditors to destroy the currency.

that this plan has failed to stem the rout of asset prices is testament to its futility -- after all, the destruction of credit is far easier and simpler than its construction, and the size of the collapsing bubble remains an order of magnitude larger than the government itself. the futility becomes inevitable particularly when government, cowed by assetholders, refuses to disintermediate them by nationalizing their holding companies, preferring instead to let large damaged banks hoard hundreds of billions in excess reserves.

but failure, rather than being admitted to be a necessary product of incorrect aims and philosophy, is spun as a matter of insufficient effort. and so the effort is taken to ever-more-ridiculous extremes. yves smith relays the latest and as yet most stupid effort -- the attempt to float hedge funds on the government balance sheet so long as they buy securitized consumer loans.

Hedge funds will be allowed to borrow from the Federal Reserve for the first time under a landmark $200bn programme intended to support consumer credit.

The Fed said on Friday it would offer low-cost three-year funding to any US company investing in securitised consumer loans under the Term Asset-backed Securities Loan Facility (TALF). This includes hedge funds, which have never been able to borrow from the US central bank before, although the Fed may not permit hedge funds to use offshore vehicles to conduct the transactions. ...

A senior official in the outgoing Bush administration told the Financial Times it could also be broadened to include new commercial and residential mortgage-backed securities.

The Fed thinks risk premiums or “spreads” for consumer loans are much higher than would be justified by likely default rates, even assuming a nasty recession.

It attributes this to a lack of buying interest in the secondary market where the loans are sold on to investors. By making loans to these investors on attractive terms it aims to increase market liquidity.

Making the scheme open to all US companies is a radical departure for the Fed, which normally supports financial market liquidity indirectly by ensuring banks have adequate liquidity to make loans to other investors.

However, the liquidity the Fed is providing to banks is not flowing through to financial markets, because banks are balance-sheet constrained and risk-averse. So it is channelling funds directly to investors.

The scheme is not designed specifically for hedge funds and a wide range of financial institutions are likely to participate.

Nonetheless, Fed officials hope that hedge funds will be among those investors that take advantage of the low-cost finance to drive down spreads.

The loans will be secured only against the securities and not the borrower. However, the Fed will lend slightly less than the value of the securities pledged as collateral. The Treasury has committed $20bn to cover potential losses.

Since the credit crisis erupted, hedge funds have complained that they cannot get the leverage they need to arbitrage away excessive spreads and meet high hurdle rates of return.

“Demand is there for leverage but not supply,” said Sylvan Chackman, head of global equity financing at Merrill Lynch.

In effect, the Fed will now take on the role of prime broker – the lead bank that lends to a hedge fund – for specific assets.

this is utter madness, with the fed now to act exactly as bear stearns and lehman brothers once did. the dollar now well and truly deserves, whether it happens or not, to die a disorderly and horrible death under the malfeasant mismanagement of paulson and bernanke. most unfortunately, such a collapse would destroy the savings of every hardworking and risk-averse american by rendering the purchasing power of his currency null.

UPDATE: ambrose evans-pritchard makes his best case for madness-as-sanity while recognizing the risk:

"The bond markets could go into free fall," said Marc Ostwald from Monument Securities.

"The Fed went into this all guns blazing just as the Neo-cons went into Iraq thinking it was a great idea to get rid of Saddam, without planning an exit strategy. As soon as we get the first uptick in inflation, the markets are going to turn and say this is what we feared would happen all along. Then what?" he said.

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"this is utter madness, with the fed now to act exactly as bear stearns and lehman brothers once did. the dollar now well and truly deserves, whether it happens or not, to die a disorderly and horrible death under the malfeasant mismanagement of paulson and bernanke."

OK, but now tell us what you really think!

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sorry, br -- rather losing my cool! -- but this is ridiculous. i work in the hedge fund world, and i can see no good reason any part of this business should be receiving government assistance. attempting to reinflate the dead and decomposing shadow banking system is as thoughtless and reactionary a "solution" to the problems this country faces as is imaginable. turning the fed into an investment bank, with $200bn today surely to be followed by much more after it has become the securitization market, is lunacy!

i am not one who necessarily believes that the morality of what has happened is cleanly delineated -- if pain can be spared the many by begrudgingly rewarding some who deserve otherwise, so be it. but this is insanity. what would success look like?

i'm left with two potential conclusions. one is that the fed really thinks the credit markets went awry not in 1996 or 2002 but in 2008, and that if we could get back to 2007 conditions all would be well. they have, after all, treated this more as a liquidity crisis than what it is from th estart. that would be testament to their delusional stupidity, something i do not wish to believe true of them.

the other is that they know otherwise, but are so craven in their fealty to assetholders that they are willing to risk the destruction of the government itself in an effort to preserve their privileges, even if the odds of success are not good or even significant. that, unfortunately, seems at least as likely.

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from perrone: gm, you know I love you, way back from the days of 1060 west, when it became clear you could think better than most. so it's as a pal that I hint to you -- cause I can listen to you from the outside while you, like all of us, can only listen to yourself from the inside -- that your fears about the currency have more to do with your primal terrors and passions than with your reasoned judgment. it's right here, when you write "most unfortunately, such a collapse would destroy the savings of every hardworking and risk-averse american by rendering the purchasing power of his currency null." I know you feel hard for justice, for equity, for decency, for fairness. so this is deeply pissing you off and scaring you, and that's understandable, and you're mostly dead-on as far as fingering the administration for bending over and contorting into every imaginable position for its pimps.

but I insist -- and many folks are having real trouble seeing this simply because it's so clear, so basic -- that the kind of currency collapse you evoke can only occur at the margins or outside the margins of an economic system, not at the center. that "horrible death" can befall the Hungarian or Zimbabwean coin, or even Germany's when it had just lost a world war and was pinned to the dirt under a mountain of war reparations. but it simply doesn't apply to the world's largest economy (especially in the absence of anything resembling a healthy competitor), it loses it's meaning. it becomes something else.

this DOES NOT mean that we won't end up monetarizing debt, that always happens, and does imply some real devaluation of the currency. but it kind of crawls along, people adjust as it goes, and the benefits it brings usually well outweigh its hardships.

is Bush's gang totally reprehensible, totally cynical, totally baldly in service of the cocksuckers who have brought the world economy to its knees and made a shitload of money doing so? god yes. are they totally fucked? oh hell yeah. is this going to mean a hellish amount of pain for at least half of all Americans and very probably more? yes. but it will soon become clear to everyone that years and years will pass before we even remember what inflation was.

again, I hug you, amigo.

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i don't doubt, perrone, that it is made more difficult by centrality. and i take a probability of a serious devaluation of the dollar as far more likely than burning deutschemarks in the woodstove -- particularly in the next few years, while the credit bubble unwind overwhelms. i agree with you that deflation is likely near-term.

but consider:

one way to view what is happening is an imbalance of production and consumption. this is most obvious between china and the united states, but operates on other levels as well. taking that example:

china produces more than it consumes. we consume more than we produce. the resolution of the current account imbalance is what this crisis is really about; it can be accomplished by i) china reducing production and increasing consumption; or ii) america reducing consumption and increasing production. the vehicle for inducing that change is currency exchange rate.

an economically normal adjustment would involve the renminbi rising vis-a-vis the dollar; this would make american exports more profitable, chinese exports less profitable. china would be forced to increase domestic consumption, including of some american goods, to absorb their excess capacity. america would be forced to reduce consumption as purchasing power declines, but with plenty of room made for domestic production to increase in the absence of effective foreign competition. facilitating this transition should be the job of government.

but it won't be frictionless. it means reduced standards of living on both sides in the transition as both economies reorient.

and this is why, so far, china is refusing to allow its currency to appreciate -- is in fact now talking about depreciating it vis-a-vis the dollar. this is an attempt to maintain a large current account surplus and protect its exporters and stave off civil unrest; it shifts the contraction of excess capacity onto america.

this is likely to produce countermeasures -- including a greater measure of quantitative easing than would otherwise have been needed. this dynamic, feeding on itself, could quickly devolve into a game of global competitive devaluations -- feeding something very much like a hyperinflation in a game of hot potato involving global excess manufacturing capacity.

it will also likely begin an explicit trade war, with the attendant decline in international trade -- so i do agree that deflation remains a difficult reality. but i wouldn't dismiss the prospect of a serious monetary inflation whose signs would become much more apparent following the waning of the credit deflation some time from now.

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on that nascent trade war -- the telegraph. the united states may be about to attack the global depression with an analogue of "imperial preference" -- but will it be as effective in a world where surplus nations are not bound to the gold standard the way america stubbornly was until 1933?

in those days, the deficit pound bloc was allowed to shunt off the lion's share of the adjustment onto the surplus countries, deeply aggravating the american collapse in production as the hoover administration stuck to gold convertibility.

i doubt china will make that mistake, though certainly it will suffer for its excess capacity.

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from perrone: ah, but China is making EXACTLY that mistake, by failing (refusing) to let it's currency appreciate. I would argue that in a global depression -- and we're in one, brother -- the kind of structure that produces a huge current account surplus is, somewhat ironically, a significantly more onerous burden than that which produced the gaping current account deficit. why? because the inevitable adjustment is far more traumatic for the surplus country(ies), really, particularly is the context of the competitive devaluations/beggars trade war you astutely convey. the best way for China to mitigate its dislocation and trauma would be to allow it's currency to appreciate, thus spurring natural and salutary rebalancing.

reduced standards of living, that's one thing. yeah, that's implied, and will happen. "serious monetary inflation" may happen, eventually. if/when it does my guess is it will be welcomed and celebrated -- with basically good reason.

the horrible death of the dollar in a blazing hyperinflation bonfire, on the other hand, I just can't find any plausible way to work it into the story. I'm open to narratives I've missed, and would be fascinated to hear them.

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GM, I work in the hedge fund business as well. For the record, I agree with you.

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the best way for China to mitigate its dislocation and trauma would be to allow its currency to appreciate, thus spurring natural and salutary rebalancing.

i agree with this, perrone, because i am an american -- but will china?

the big "mistake" the united states made, by which it unwittingly accepted a disproportionate share of the contraction in excess capacity until 1934, was to stick to the gold standard as others depreciated in 1931. using, the dollar appreciated versus the pound and the swedish kronor by nearly 40% in 1932, by 60% vs the yen, and these countries emerged from the depression relatively unscathed [ie delGDP > (-8%)]. france, on the other hand, did not devalue until 1937 and each saw something like a (-15%) contraction in GDP. germany never devalued (following the great inflation of 1924) -- indeed the reichsmark was the strongest currency of the era -- and suffered nearly as much as the united states (and much more, of course, if you count the 1933 election results).

so what we're asking china to do is pursue a path by which it attacks the economic sector it has built its national rise upon heretofore -- exports -- which is already going to be weakened in an effort to amplify its immediate economic pain. in effect, we're asking them to play the role of the united states in the great depression up until 1934, allowing their creditors to lessen their adjustment obligations while they decimate their core competency.

it strikes me that china is unlikely to do any such thing unless it is compelled to. china has been a command economy, particularly as regards the RMB. that won't go quietly.

i suspect instead it is going to have to be demonstrated to china exactly why they don't have a choice -- that continuing to peg to the dollar or even depreciate will bring only tariffs and competitive devaluation in a trade war is cannot win.

and the reason why they will have to be shown is that the united states, unlike britain in the depression, is a massive net debtor vis-a-vis china and others. it was never within the capacity of the united states in the 1930s to force a true currency crisis on sweden, japan or (far more importantly) britain's "imperial preference" sphere. but it IS well within china's ability to at least attempt such a currency attack.

if china is going to be told to take the brunt of the disaster, why would it not counter by threatening to destroy the united states altogether? its forex reserve pile is almost certainly viewed by some important people in china as its "nuclear option" insurance policy. it may perceive itself as having little to lose in exercizing the policy if it's being told to price itself out of american export markets anyway and take a (-30%) GDP hit -- one which the government would probably not survive and is acutely aware that it would not survive.

it looks to me like china has the ultimate beggar-thy-neighbor trump card in this hand -- dumping hundreds of billions of treasuries onto the market and sparking a run on the dollar (which is currently more overowned than ever before) may very well end both the 'treasury bubble' and the greenback.

can you fellas disassemble that argument and show me wrong? please do! i don't much like the implications....

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or, as a piece of private research i'm reading said:

"Weimar Germany suffered through its inflationary and deflationary crises ... because as a defeated debtor country it was not in command of its own financial destiny. ... The United States is not Weimar Germany, but ... [it] is, financially speaking, a vassal state. ... The various sovereign creditors are now in a contest of strength to determine who is senior in the capital structure, and what the real value of their claims shall be. ... So long as the creditors remain in partial control of the process, deflation wins out over inflation....

... but if the debtor becomes unruly, something worse than a debt-deflation is possible.

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There won't be a run on any part of the term structure, the Fed can just buy up everything China dumps. They're already doing it with agencies. Once they dump all those newly created dollars, that could very well constitute a run on the dollar. Bernanke probably wants a controlled, steady, dollar devaluation as he believes that the 40% devaluation during the Great Depression was instrumental in leading us out of it.

Since you're in the hedge fund business, you should read Clarium's latest quarterly thought piece, if you have access to it. It's all FX and China focused, makes some interesting points.

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thanks for the discussion, folks.

Once they dump all those newly created dollars, that could very well constitute a run on the dollar.

right, br -- monetizing on that scale risks a monster inflation once delevering slows (or reverses, lol). this is certainly one view of potential currency mismanagement. once such an inflation begins, is the fed really going to extricate itself immediately from its lending facilities, contract its balance sheet and risk plunging the still-weak economy back into deflationary depression? still, perrone is right -- this sort of inflation would probably be welcomed here in some measure, provided it isn't allowed to run away.

the more serious if remote inflationary view, though, has to be of competitive devaluations. it seems to me that the risk being run by bernanke is that the dollar might be made to break in a very disorderly way -- while the reward is supposed to be an orderly relative devaluation. staying on the reward side can only happen with china's complicity, it seems to me, and i'm not sure what the quid pro quo is. telling them that they have to suffer the brunt of a great depression and potentially a complete social collapse in order to eat excess demand and move off the export-growth model -- isn't that the end of the stick they get either way?

that weimar bit actually is in clarium's conclusion. :) have to admit i'm still digesting their argument, though, which is more sophisticated than mine. they don't seem to see competitive devaluations as a big near-term risk, though.

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i want to re-emphasize, though -- we are going to get some serious and long deflationary impulse before any of this currency-related stuff shows up as rising prices, if it ever does. i have some sympathy for lee adler's view -- we're obviously seeing wage deflation and a huge spike in unemployment quick on the heels a massive debt delevering in the shadow banking system. this is so far from inflation that it's hard to think about anything having to do with the fed's exit strategy.

but there will come a time when that matters -- and expansions of loans to beleaguered speculators to gin up some securitization will aggravate those problems.

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from perrone: gm, I want to get back to you on this, with some clarification that might offer _some_ comfort -- but right now I´m away from home and it´s not as easy to find the time and place to sit down and write. stay tuned, I´ll find a chance soon, I think. happy holidays.

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from perrone: OK, I think there´s some confusion here about what the US´ big mistake really was back in the early 30s. my argument is that sticking to the gold standard wasn´t what did the damage -- the dollar was going to appreciate no matter what, because the US was the huge surplus country (and btw, gm, Britain and the rest _were_ big net debtors -- BIG net debtors), and while sticking to the gold standard sped that appreciation and increased the short-term shock who´s to say that was necessarily the worst alternative (you prefer 15 years of slow quicksand like 90s and 00s Japan?)?

no, the real mistake -- for the surplus-burdened US -- was sticking for too long to a futile, dead-end strategy of (trying to) propping up exports instead of drawing down reserves and redirecting them to full-throttle domestic fiscal stimulus. and THAT´S the same mistake China seems to be on the verge of making.

look, the export market´s enfeebled. it´s mostly gone, just like in the 30s, whether you (the US in the 30s, China now) like it or not, and whether you see it or not. your currency HAS to appreciate, because that´s the only way for a semblance of world balance to return, and without that semblance of balance the world economy won´t heal and start growing again. you HAVE to consume more now -- that´s the only way for you to get better. if you stick to an export subsidy/cheap currency tack you can only incite trade wars and hurt yourself more.

so maybe it´s clearer now why I contend a surplus is worse than a deficit when depression comes. a deficit country will be forced to increase production, which is definitely palatable, although you consume less. but the surplus country, well, there were two ways for the US to adjust in the 30s -- consume much more or drastically cut production. cutting production is more traumatic, and that´s what the US was forced to do, because its export strategy necessarily failed. once it turned to bolstering consumption, things improved. my prescription for China isn´t borne of an American-centric perspective, but of an historical one. I think.

how´s that?

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perrone, i totally agree. indeed, china's recent deliberate weakening of the renminbi is little more than mercantilist trade policy for the benefit of its oversized export sector. that's the opposite of the necessary currency adjustment, as you note.

but that the adjustment is necessary or even optimal from the global perspective does not mean china will acquiesce to it. i think instead it will continue to attempt to bolster its exports through competitive devaluation -- maintaining their dollar link or even weakening against the dollar -- for as long as possible, as the alternative may really be violent revolution in china.

the harder they try to boost their export sector by weakening their currency, the more of the contraction of excess capacity will be transferred to its deficit trading partners, ie the united states and europe. indeed, in the overall view, the degree of damage is likely increased by so doing.

this was spared europe in the 1930s by the american refusal (thanks ot the stubborn ideology of sound money) to devalue until 1933, pushing the collapse of excess capacity onto the US and making the great depression great here while much less so in britain and other early debasers.

i see what you're saying about the need of china to allow appreciation or a clearly undervalued currency -- and that perhaps that adjustment isn't really the hard way out after all but merely the necessity. i simply don't think china, unburdened by a hard currency, will be willing to go along with what is necessary -- particularly early on in the process. rather, it will try to manage its currency to its perceived national advantage, perhaps political existence.

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