ES -- DX/CL -- isee -- cboe put/call -- specialist/public short ratio -- trinq -- trin -- aaii bull ratio -- abx -- cmbx -- cdx -- vxo p&f -- SPX volatility curve -- VIX:VXO skew -- commodity screen -- cot -- conference board

Tuesday, March 31, 2009


the hancock building: CMBS barometer

much was made of the cut-rate auction of boston's john hancock building this week. asia times' david goldman at inner workings demonstrates that this is in fact good news for the banks as holders of triple-a tranches of both commercial and (with some implication) residential mortgage-backed securities.

This example is consistent with the 50% recovery rate on foreclosure in most residential real estate markets. There are entire tracts that will be left for the junkies, to be sure, but for the most part, the California market is clearing quite nicely at levels sufficient to avoid impairment on the AAA-rated tranches of subprime and Alt-A loans. If valuations hold at around these levels, the position of the banks should be quite survivable.

In a nutshell, securitization “worked.” It created an awful mess in some respects, but it did help buttress the banks against losses, while hedge fund and private equity investors died like flies.

creditsights some time ago asserted that, given expected loss severities averaging around 35%, subprime defaults in a typical securitization pool would have to rise to 30% to begin impairing a standard triple-a subprime bond. with apologies to goldman, we have to be very close to or beyond that already in california, where average price declines are in the area of 40%, likely more for subprime properties. (in some cases, much more.) add in the costs of foreclosure, and loss severity must be well in excess of 50% even as subprime foreclosure rates exceed 25%.

nevertheless, indexes on view at markit indicate a fair value of less than 30 cents for triple-a subprime. at this point, cash flow impairment can't be anything like that bad. this is a good example of the hows and whys behind what may well be the refusal of the banks to unload what would be, in the eyes of warren buffett, their most profitable assets from current market marks into any government-sponsored liquidation.

of course this doesn't do much to defang tavakoli's assertion that securitizations were designed to lose money for unsophisticated buyers -- the originating banks kept the super-senior stuff that goldman thinks is unimpaired only to foist massive losses onto others.

more importantly, however, it doesn't address the primary concern -- price declines and foreclosure rates appear nowhere near peaked. so triple-a subprime bonds aren't as severely damaged as marks would imply at this moment. will they be in a year's time? two years? it's a wide open question, given manifest uncertainty regarding government fiscal willpower.

in any case, the lack of systemic balance sheet that is a major side effect of the collapse of shadow banking will keep this divergence between market prices and cash flow valuations (to the extent that a value can be ascertained) open. there is far more of this stuff for sale than capacity to buy it at virtually any price -- the money is gone. unless tim geithner's PPIP is a success on a scale stunning even to the most hopeful, that will remain true for the duration of the crisis -- indeed probably grow more and more true throughout.

UPDATE: zero hedge with a differing view on the hancock auction from morgan stanley, which analysis discounts the implied value of financing.

In a foreclosure auction today, the John Hancock Tower - a marquee building in Boston - traded at $660MM to Normandy Real Estate Partners. That same property was appraised for $1.3BN in 2006 and traded for $935MM in 2003. This is VERY negative for commercial real estate. At face, it looks like even top quality assets are down 50% from their peak, but that forgets the value of the financing that Normandy now gets to assume. There will still be a $640.5MM mortgage on the property at a rate of 5.6%.

What is the value of being able to get a 97% LTV loan at 5.6% these days? Let's say you can get a 60% LTV mortgage ($400MM) at 8%, and the other $240MM in mezz financing (which has no chance of getting done in this market) could hypothetically get done at 15%. That combination produces a weighted average financing cost of almost 11%. A 5.6% mortgage at 11% yield is about a 70 $px, which means the value of assuming the existing financing on the Hancock Tower is close to $190MM. The real clearing level for the top commercial property in Boston was only $470MM - down 65% from 2006 levels and down 50% from 2003 levels. If we assume 2008 NOI numbers are still accurate, this would be a 9.5% cap rate adjusted for the financing. Without adjusting for the value of financing, the purchase price of $660MM looks like a 6.7% cap rate and $383/sqft - rich, relative to 1540 Broadway (NY office vs Boston office) recently clearing at ~$400/sqft.

**The main takeaway: property values are down A LOT more than people think, especially when considering the implied value of financing. Caveat Emptor.**

so the truer parameter of goldman's above analysis should be a 35% recovery in foreclosure -- a loss severity of 65% -- not 50%. and this for the widely-acknowledged best property in boston.

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bank walkaways

quite possibly more prevalent than the mortgagor variety. the new york times:

Banks are quietly declining to take possession of properties at the end of the foreclosure process, most often because the cost of the ordeal — from legal fees to maintenance — exceeds the diminishing value of the real estate. ...

The problem seems most acute at the bottom of the market — houses that were inexpensive to begin with — and with investment properties, where investors and banks want speedy closure by writing off bad loans as losses.

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how you know interest rates are going to stay low, or how goldman sachs could blow sky high

zero hedge poses some interesting questions about goldman sachs and the $160tn (notional outstanding) interest rate swap market.

Has Goldman, in its pursuit to catch up with the imaginary PIMROCK decided to chew off a little more than its assets would allow? 1,056% more in fact? Or, alternatively, has the company bet a little too much in its bet that it can easily anticipate interest rate moves? As pointed out, over $160 trillion in Interest Rate contracts exist currently. What the credit crunch taught us is that the risk management of credit derivatives was woefully inadequate in a time when credit was flowing freely and the system was nice and liquid. After the bubble burst, certain entities (wink wink AIG) ended up having to commit capital to a sizable amount, more than half at times, of the total notional of derivatives the company had underwritten - a scenario previously never thought possible. And the massive reduction in global CDS notional outstanding over the past year and a half (from over $60 trillion to under $30 trillion today) has been a direct result of financial companies realizing they did not provision well enough for the "black swan" day, and thus rushing to unwind as much of these ticking time bombs as they could.

In the meantime, the interest rate black swan is growing. Do not misunderstand us: Zero Hedge has no idea what, if any, a black swan in Interest Rates may be. It is - by definition - an unexpected, unpredictable, outlier, aka fat-tail, event. Its prediction would immediately render it a grey swan at best, if not beige. However, instead of focusing so much on CDS as the financial system bogeyman, is it not time to look at some of these other derivative instruments that may soon plague the Basel I/II and whatever other risk consortia appear in the future. At $200 trillion in total derivatives, and $160+ trillion plus concentrated in Interest Rates, a fat tail event here, whether due to a paradigm shift in US monetary policy (that whole thing about Greenspan focusing on inflation instead of deflation now might raise a few eyebrows), or something totally different, even partial needs to satisfy these contracts will result in staggering and unmanageable repercussions to the global economy (tangentially, is it even physically possible to print $200 trillion in one year?)

Of course, as everything is smooth sailing in IR Swaps for now, I doubt anyone will even think about potential issues in this space... until it is too late.

the easy conclusion from this is that goldman sachs -- being the wall street house of the democratic party, with alumnus robert rubin aiding protoges larry summers and tim geithner in pulling levers of power in washington -- knows what the federal reserve is going to be doing over the next year in such totality that they don't mind wagering not only the firm but a large chunk of western civilization on the outcome, so certain are they of monster profits.

the harder conclusion is that -- just perhaps -- the united states government doesn't really control its interest rates under every conceivable scenario.

and who's on the other side of the trade, you ask, making fixed payments and receiving floating? here's some.

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house price declines still accelerating, continued again

returning to a theme -- calculated risk:

The Composite 10 is off 19.4% over the last year.

The Composite 20 is off 19.0% over the last year.

These are the worst year-over-year price declines for the Composite indices since the housing bubble burst started.

so far from a bottom, prices are still continuing to build momentum to the downside -- prices are falling faster now than ever. CR also notes that, though it is early returns, price declines are tracking the worse-case scenario once postulated by treasury for bank stress tests.

this was a case that looked a lot like consensus forecast when it was issued to me, and perhaps its even good news that house prices are no longer radically underperforming expectations. and one can at least imagine a slackening in the second derivative over the last few months. with inventories as a function of sales still near all-time highs but coming off peak in absolute levels, with new home starts having crashed almost completely, the seeds for an eventual base have at least been sown.

but i would also advise caution here. from richard koo's "the holy grail of macroeconomics" (2008), pp 152:

In 1996, the year before Hashimoto's fiscal reforms were launched, Japan recorded an economic growth rate of 4.4 percent, the highest among the G7 countries. Encouraged by this strong growth, asset strippers from New York rubbed shoulders with ethnic Chinese investors from Hong Kong in Tokyo hotels in late 1996 as they looked for real estate to buy. They came to Japan because land prices had fallen so fast that, relative to rents, properties had become attractive investments even by international standards. If the government had not scaled back its fiscal stimulus in 1997, the growth momentum from the previous year could have been maintained, and asset prices would likely have formed a bottom with the help of foreign investors.

Instead, fiscal consolidation torpedoed the economy, which proceeded to shrink for five consecutive quarters. This economic meltdown prevented foreign investors from carrying out due diligence, and drove them out of the country. (Due diligence involves verifying the profitability of a potential acquisition through careful estimates of future revenues and expenses. An economic collapse makes it impossible to forecast revenues, rendering due diligence, in turn, impossible.) Their departure, in turn, triggered a renewed slide in asset prices. Instead of stabilizing with the help of foreign investors in 1997, commercial real estate prices started falling again. From 1997 to 2003, commercial property prices plunged another 53 percent, further aggravating the balance-sheet problems of Japan's corporate sector.

This additional 53 percent drop in real estate prices was an unprecedented blow to the Japanese economy. Although property values in 1997 were down substantially from their peak, they were still no lower than in 1985, some six years before the bubble peaked. At that level, most Japanese companies could still absorb the losses and move forward, and for many firms, it was simply a case of paper profits disappearing or turning into small paper losses. But a further 53 percent decline from the levels of 1997 took real estate prices down to levels last seen in 1973. No company (aside from those that were debt-free) could escape serious balance-sheet damage in the wake of such a massive decline in values.

in other words, the first instances of significant positive carry on cash-flow-generating assets -- the precondition sought by paul mcculley as necessary to support house prices, though we remain far from it where i live -- were not enough to put in a bottom. john hempton has mentioned this phenomena in relation to japanese land during the bust as well, though perhaps without nailing down the explanation quite so clearly as koo, i think, has. with asset prices returning to valuations justified by discounted cash flow (DCF) analysis, further collapses of -- or temporary vacuums in the knowability of -- those cash flows can and will precipitate deep further corrections which serve to aggravate the nature of the depression and the imperative for balance sheet remediation. for the duration of a balance sheet recession, DCF will be highly dependent on fiscal stimulus emanating from the government.

if or when the dedication of elected officials -- who are as responsive to populist "common sense" concerns about government debt as they were oblivious to the actual creation of the massive private sector debt that was a necessary condition of this crisis and which the government must refinance onto its own balance sheet to prevent collapse -- to support economic activity by deficit spending equal to private sector debt repayments and savings falters, monetary aggregates and incomes and DCF and therefore especially levered asset prices will have room to fall much further than most anyone will now make mention of in the public record. such a failure of stamina, salutary examples of which accompany every debt deflation i am aware of, is almost certainly what sir john templeton had in mind when he famously forecast in 2003, well in advance of the hysteria and excess seen in 2005, 2006 and 2007:

Sir John also had a few words about debt -- a four-letter word that folks seem not to care about: "Emphasize in your magazine how big the debt is. . . . The total debt of America is now $31 trillion. That is three times the GNP of the U.S. That is unprecedented in a major nation. No nation has ever had such a big debt as America has, and it's bigger than it was at the peak of the stock market boom. Think of the dangers involved. Almost everyone has a home mortgage, and some are 89% of the value of the home (and yes, some are more). If home prices start down, there will be bankruptcies, and in bankruptcy, houses are sold at lower prices, pushing home prices down further." On that note, he has a word of advice: "After home prices go down to one-tenth of the highest price homeowners paid, then buy."

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Mankind's optimistic bias runs so deep... (though that is a good thing overall). I have yet to see anyone venture to put real worst case housing scenarios out there (at least in the context of avoiding a global financial meltdown). Other than your insufficient stimulus example, reasons why US housing may surprise to below the historical price/earnings or price/rent ratio (most have been mentioned but quite gingerly and not all combined, or quantified):

1. General tendency of overshoot to the downside
2. Significant excess inventory of houses built
3. Return to more occupants per household
4. Research shows that birthrates fall in hard times, so some of Japan's demographic birth rate problem is likely the RESULT of their crisis. There's no reason that couldn't start in the US and elsewhere.

I know some can be mitigated by policy (low rates for #1, government demolition plans for #2) but it's still an ominous mix.

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When there is blood on the streets, buy property.

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You bring up a lot of good points about the housing market, especially that now may be a good time to evaluate how to jump into it. As a contrarian and advocate of maximum pessimism, John Templeton would likely advise to invest against the crowd.

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Monday, March 30, 2009


runs on insurance companies

this is something i noted was mentioned by rolfe winkler recently. now the risk is apparently materializing in some cases. clusterstock passes on david goldman of asia times.

Why would anyone hold an annuity from a life insurance company whose credit protection is trading at double-digit points up front? Annuity and whole life policies are at risk, and the blogs are starting to buzz about it. If customers rush to cash policies in, a number of insurers will be at serious risk.

Once again: the Treasury is pursuing the phantom of a bank-led economic recovery, when it should be fighting the risk of an insurer-led crash. If Americans think their insurance policies and annuities are at risk, it’s a different and much worse sort of crisis.

goldman earlier commented on the wrongness of the approach being taken by tim geithner and larry summers.

... They [Geithner and Summers] want the banks to lend more to the economy in order to stimulate economic recovery. This is perfectly ridiculous because no-one wants to borrow. Everyone with two synapses that fire in the same direction wants to pay down debt.

What Summers and Geithner haven’t absorbed is what a friend of mine who manages an enormous insurance portfolio worries about. The banks, he fears, have gotten themselves into such a hole that they will wear through their capital structure, starting with the preferred stock that Citigroup just proposed to turn into equity, and thence up the capital structure to subordinated debt and so forth. In the process, the necrosis in the bank capital structure will kill the insurance industry, just as AIG warned in a memo to Congress posted on the Financial Times website.

It’s not about getting a recovery going. That’s not going to happen, not if Martians land in flying saucers with a billion tons of gold to invest in bank capital. It’s about preventing something worse than we have now, namely screaming, bug-eyed, blood-in-the-streets, rape-the-crops-and-burn-the-women panic. ... The best we can get out of this is a zombie banking system, one that still pays its debts because it earns enough interest from the toxic assets left over from the last boom.

add goldman's asia times blog to the roll. this is really salient stuff, and he isn't shy to acknowledge the triumph of japanese fiscal policy in the 1990-2005 period as having avoided a catastrophic depression in japan. his diagnosis of what has happened in the real economy comports well with the conclusions i'm coming to, and he here presents it in the context of insurance.

For many families, a whole life insurance policy or an annuity is the financial shelter of last resort. An intimation that these might not be safe would have catastrophic effects on consumer behavior. The economy is in free fall because households are playing catchup with life-cycle savings. Rather than substitute capital gains on homes for ordinary savings, Americans are attempting to save as much as they can, which is to say that they are spending less, depressing economic activity. That prompts a secondary effect, or what economists call precautionary saving. Last year you started saving because you realized that your retirement wasn’t funded; this year you save even more because your job isn’t safe. That is how auto sales end up falling by half, and so forth.

There is yet a third-order effect that could take hold were the insurance companies’ viability to come into doubt, and that is the possibility that your savings aren’t safe. Not only do you not have a retirement plan, and not only do you not have enough in the cookie jar to tide you over if you lose your job, but the cookie jar itself might not be safe! In this event we will get full-tilt, uncontrollable panic, something America has not seen since the run on the banks when FDR was inaugurated.

That’s the sort of thing that academic tinkerers like Profs. Krugman and Roubini do not think about, and that is the government cannot let the capital securities of the banks evaporate.

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Japan managed to avoid a depression and suffered 20 years of sub par economic growth, and now is facing what looks like a depression far more severe than what they would have suffered had they not intervened so much. How can that be considered any sort of success? It seems more like a Pyrrhic Victory than something to be celebrated. They now have almost no fiscal flexibility, with gov debt to GDP likely to reach 200% in the near future.

We'll see how Japan ends up, but I believe it is too early to claim that their interventionist policies were a success. I would be inclined to call them an out and out disaster when depression part deux hits with full force over the next few years. I could be wrong, but I think they would be in much better shape today had they allowed a correction to happen, and the depression they are currently enduring will be much worse than it otherwise would have been.

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Any comments on FT's quote of Richard Katz on why comparisons with Japan may not be appropriate?

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dk, i'd say that what they're facing now is a different event -- something that actually aided them in getting out of the hole from 1990-2005 but has since remained their achilles heel: an export-oriented economy. there's little danger of the US becoming an export powerhouse for so long as we have the reserve currency.

but i do agree that japan's story isn't written yet. and if export revenues and profits helped their private sector recapitalize, and won't ours, it implies that our fiscal responsibility in demand management is going to be that much greater a burden for the united states.

but i don't think it very likely that their depression just beginning will really be insufferable for their public sector debt. firstly, their private sector is carrying the lowest level of debt-to-GDP seen since the 1950s. secondly, japanese interest rates are still extremely low, implying significant surplus funds in the system -- little loan demand relative to deposits. that implies a low-impact ability for the gov't to borrow further to tide over the demand shock. third, their banks are in perhaps the best condition of all major industrialized nations. fourth, household standards of living in japan have already corrected significantly over the last fifteen years.

so they may well be in a situation now near the end of the multiyear yen delevering with gov't balance sheet capacity remaining and a healthy financial system. as you say, only time will tell -- but i wouldn't be too sure that japan will emerge from the ashes of this depression in better forward-looking shape than most, even if their capacity remediation will be painful.

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rb, i can't offer a comprehensive critique of katz's argument, but -- while there's a lot to agree with -- some aspects of it strike me as strange prima facie.

the idea that there isn't a "real economy" problem in the united states presumes that we haven't undergone a massive misallocation of resources as a result of first the tech boom and then the housing boom. we in fact have, and with something like a third of the american economy linked to housing that is not a minor problem. that real economy distortion, once the bubble popped, has created the financial crisis.

while it is certainly true that sectors of the corporate sphere, as a result of the tech bust, already have trim balance sheets. but that is also to ignore the massive household balance sheet problem.

there are large parts of what katz says that make sense to me. he sees the major problem was loan demand, and notes the absolute need of fiscal stimulus:

There is a myth that Japan shows the uselessness of fiscal stimulus. Supposedly, Tokyo used massive stimulus and it accomplished nothing. The reality is that Japan applied fiscal stimulus is a very stop-go fashion. When Tokyo stepped on the fiscal gas, the Japanese economy did better. When it took its foot off the pedal or, worse yet, applied the brakes -- such as when it raised taxes in 1997 -- the economy faltered. Had Japan done nothing, it risked depression.

but katz also seems to believe that in the current case restoring the securitization market to function (by cutting out mark-to-market, recapitalizing banks, soaking up bad assets and restoring the regulatory oversight abandoned over the last several years) will solve the problem -- as would have a quicker remediation of NPLs in the japanese banking system. the presumption seems to be that, if banks clean up and get working again quickly, this is all much ado about nothing.

i would point him at this now-famous chart. i think we hit something like the zero hour bound and further debt growth is not an option. with the asset shock being felt by so many with shaky household balance sheets -- and here i think katz in figure 5 does a disservice in not examining the distribution of net worth as opposed to the aggregate -- debt reduction becomes the imperative.

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Good, thoughtful points. I have to agree with all of them. Japan's private sector certainly does have a nice stockpile of savings, I am just skeptical of whether that will be deployed or not. I think the Japanese people are more likely to take advantage of the strong yen (I think the Yen could go to 85/80) and buy assets abroad, which would spell trouble for the governments ability to fund itself should the crisis last longer than anticipated.

I guess it all depends on how long the current downturn last. I expect Japan's exports to be depressed for some time, and wouldn't be surprised to see the Japanese central bank print non stop to counter act the yen's rise. The current group of Japanese central bankers seems much less reticent to use the printing press than their predecessors were over the past two decades. But we shall see.

I agree with you that eventually, they will be in better shape, as they have already gone through much of the pain that is awaiting the US. I just think that the current downturn will be more severe and long-lasting, largely because they didn't allow their economy to properly adjust since their enormous property bubble in the 80's. Their banks equity base is/was (I believe the Japanese CB allowed some regulatory relief here) heavily in the highly depressed stock market, but on the whole, they are much healthier than most of their counterparts worldwide. Although from the rumblings I've read, it seems that Nomura has some indigestion from the Lehman acquisition, and if Asian economies collapse more than expected, not only Japanese banks, but also seemingly strong banks like HSBC (who has made some of the worst acquisitions out there and has a lot of Asian exposure), could come under fire. I'm not certain this situation is likely, but it seems a strong possibility to me, given the severity of the unwind I see coming.

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AIG as a laundering vehicle

a bomb dropped on zero hedge:

... in layman's terms:

AIG, knowing it would need to ask for much more capital from the Treasury imminently, decided to throw in the towel, and gifted major bank counter-parties with trades which were egregiously profitable to the banks, and even more egregiously money losing to the U.S. taxpayers, who had to dump more and more cash into AIG, without having the U.S. Treasury Secretary Tim Geithner disclose the real extent of this, for lack of a better word, fraudulent scam.

... What this all means is that the statements by major banks, i.e. JPM, Citi, and BofA, regarding abnormal profitability in January and February were true, however these profits were a) one-time in nature due to wholesale unwinds of AIG portfolios, b) entirely at the expense of AIG, and thus taxpayers, c) executed with Tim Geithner's (and thus the administration's) full knowledge and intent, d) were basically a transfer of money from taxpayers to banks (in yet another form) using AIG as an intermediary.

i don't think the postulation that AIG was being used by the government as a vehicle by which a recapitalization of the banks which are AIG's counterparties is new, but this letter from a trader working for one of the major banks does indeed give substance to the allegations by providing a framework. and that framework may be enough to get this story outside the realm of insider understanding and into the public zeitgeist -- to the probable chagrin of treasury secretary timothy geithner.

but the amount of money claimed to be involved, while substantial and of aid in raising capital, isn't enough to alter the economics of the banks significantly.

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No, it's not new. I've been saying this for months.

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yep, thanks to you and others, i think it's been a sort of open secret available to those who cared to look. now, however, it's starting to get into a wider audience -- last night on the way back from the office, it was part of the discussion on WGN radio.

perhaps we've already hit outrage fatigue and it will slip by unnoticed.

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g20 prospects poor

alan kohler of australia's business spectator analyzes the leaked draft statement to emerge from the g20 summit in london this week.

[T]he G20 diplomats have been working for weeks to draft a communiqué that is sufficiently short on detail for their bosses to safely sign.

It was published in the Financial Times last night, with a few blanks in the IMF section for the sums to be inserted, and brackets around their aspirations for the impact of the fiscal expansions produced so far on world growth (2 per cent increase in output) and employment (20 million jobs).

as one might have expected, short of this statement being scrapped the summit will be a massive failure for those expecting some real action. and that is a problem in the eyes of some, including george soros.

The forthcoming Group of 20 meeting is a make-or-break event. Unless it comes up with practical measures to support the less developed countries, which are even more vulnerable than the developed ones, markets are going to suffer another sinking spell just as they did last month when Tim Geithner, Treasury secretary, failed to produce practical measures to recapitalise the US banking system.

... Among other measures, both Europe and the US in effect guaranteed that no other important financial institution would be allowed to fail. ...

... As a result, capital fled from the periphery to the centre. The flight was abetted by national financial authorities at the centre who encouraged banks to repatriate their capital. In the periphery countries, currencies fell, interest rates rose and credit default swap rates soared. When history is written, it will be recorded that – in contrast to the Great Depression – protectionism first prevailed in finance rather than trade.

Institutions such as the International Monetary Fund face a novel task: to protect the periphery countries from a storm created in the developed world. ... [N]ow they must deal with the collapse of the private sector. If they fail to do so, the periphery economies will suffer even more than those at the centre ....

Yet profound attitudinal differences have surfaced, particularly between the US and Germany. The US has recognised that the collapse of credit in the private sector can be reversed only by using the credit of the state to the full. Germany, traumatised by the memory of hyperinflation in the 1920s, is reluctant to sow the seeds of future inflation by incurring too much debt. Both positions are firmly held. The controversy threatens to disrupt the meeting.

soros advocates the use of IMF special drawing rights (SDRs), lent from the center to the periphery, to finance the periphery through the crisis. if there is no consensus for doing so, soros fears that periphery collapses will quickly jeopardize the world economy. and this is very possible, given what is already happening.

the ft's wolfgang munchau elaborates on the slide in developed economies and therefore their banking systems, which is massive even without presumptions of an eastern european collapse.

Economists and policymakers who wonder how much it will take to recapitalise the banking sector are discovering that rescuing the banks is a much more dynamic exercise than they thought. Whatever you think it costs – and there have been widely different estimates – it is likely to end up costing you a lot more for that precise reason. The economy is trapped in a vicious circle where credit crunch and recession mutually reinforce each other.

ed harrison of credit writedowns reinforces that point highlighting the imminent difficulties of major western european lenders.

munchau's point is that policy efforts to date are simply insufficient, and by a wide margin. he hasn't any of the hope that soros might for the g20. ambrose evans-pritcahrd is likewise hammering on the need of a new consensus in london.

Do not be misled by apparent normality. Unemployment lags, and social devastation lags further – although it has already hit the Baltics and Ukraine. Do not compress the historical time sequence either. Life seemed normal in early 1931 when the press reported "green shoots" everywhere. Part Two of the Depression was the killer. Part Two is what we risk now if we botch it.

Yes, we have done better this time. We saved the credit system. Central banks have slashed rates to near zero in half the world economy. The heroic Bank of England has pioneered monetary stimulus a l'outrance, even if the ungrateful wretches of this island mock their own salvation. But we must move faster because world manufacturing is collapsing at three times the speed. The damage that occurred from late 1929 to early 1931 has been packed into six months. Japan's exports fell 49 per cent in January. Holland's CPB Institute says global trade shrank 41 per cent (annualised) from November to January. Industrial output has fallen heavily over the last year: by 31 per cent in Japan, 24 per cent in Spain, 19 per cent in Germany, 17 per cent in Brazil, 13 per cent in Russia and by 11 per cent in the UK and US. Almost all has occurred since September.

In any case, the European Central Bank (ECB) is still standing pat. It is partial to medieval leech-cures – and hamstrung by the lack of EU debt union. Now, if the G20 were to convey the world's wrath at Europe's monetary paralysis, we might get somewhere. But Gordon Brown has been sidetracked by fiscal flammery. We are past that stage. Only the printing presses can rescue us, and the ECB refuses to print. Tactically, Mr Brown erred gravely by promising "the biggest fiscal stimulus the world has ever seen". It is not his gift, and comes ill from a deadbeat state that cannot sell its own bonds.

i think it misunderstands the point of summits like this one to expect action. at best, summits are institutional reinforcers. moreover, i deeply disagree with evans-pritchard on the need and presumed efficacy of quantitative easing -- government fiscal commitments on the order of the rise in domestic savings and debt retirements are all that can work in an environment of collapsing loan demand to prevent a corresponding collapse in credit and monetary aggregates. there is going to be a contraction in demand regardless, as much excess demand was being called forward in time by a massive expansion in private debt. government cannot hope to finance a continuing expansion of debt, only a refinancing of existing debt onto the public balance sheet over time as the private sector moves to pay it down. but the need of that refinancing is absolute, and monetary policy cannot achieve it.

i do certainly agree however that, by being unable to convince germany and therefore the european union to move away from the restrictions of the maastricht treaty, later codified with a lovely bit of institutional irony in 'the stability and growth pact', the world will see the epicenter of the global collapse move to europe.

[L]ast week Brussels fired anathemae at Greece, Spain, France, Britain and Ireland, for breach of the 3 per cent deficit rule. We must retrench under Regulation 1466/97. Laugh not.

Germany's finance minister, Peer Steinbruck, is still digging in his heels against "crass Keynesianism". No matter that his economy will shrink 6-7 per cent this year. Germans must sweat it out: some more than others. Unemployment may reach five million in 2010. No doubt spending is a poor instrument, and we are all sick of bail-outs. But Mr Steinbruck might brush up on history. It was the deflation of 1930-1932 – not the hyperinflation of 1923 – that killed Weimar democracy. (Communists and Nazis won half the Reichstag seats in July 1932). The neo-Marxist Linke Party is already angling for 30 per cent in June's Thuringia poll.

You may agree with Mr Steinbruck. Fine. Capitol Hill does not. The most protectionist Congress since Bretton Woods is not going to acquiesce as precious US stimulus leaks abroad to the benefit of "free-riders". Patience will snap. "Buy American" is already US law.

The risk is that this G20 becomes the defining moment when a disgusted American political class – sorely provoked – turns its back on the open trading system. The US alone has the strategic depth to clear its own path, and might find eager partners in a "pro-growth bloc" – much as Britain led a reflation bloc behind Imperial Preference in the early 1930s. As the world's top exporters, Germany and China should take great care to restrain their body language this week.

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"i deeply disagree with evans-pritchard on the need and presumed efficacy of quantitative easing"

Do you consider QE to be worthless or actually damaging? I think it won't help fight deflation but that it can help keep nominal interest rates low...

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i don't have a powerful case for damaging, hbl -- but i wouldn't rule it out on correlation. to wit:

BoE began QE a few weeks ago. by putting a huge bid in on the gilt market, it is artificially inflating the price (to lower yields). after a couple weeks, HM treasury experiences its first failed gilt auction in many years.

is that a conincidence? some have said britain is simply asking the market to buy too much debt, but i'm not so certain that's true. i think the problem may be that QE had simply made gilts too dear, and treasury set the stopout yield too low. in other words, a market distortion created by QE may have resulted in a failed government debt auction.

but this is of course correlation, not firm causation. and britain is very definitely faced with massive foreign short-term debt rolls that could be very problematic. still, i wonder.

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I could see what you say being the explanation... However personally I think it more likely that we are in a peak period of investor panic that QE and other government stimulus will cause runaway inflation, and that once deflation asserts itself more firmly, that sovereign debt yields will become less volatile and settle somewhat at potentially lower yields. And QE does reduce the supply of assets on the market, which over time should be price supportive.

To me one of the most under-discussed dynamics to watch for though will be whether gold crashes if we experience a severe deflation, or whether enough people will be willing and able to keep holding it as "insurance" or "money" no matter what.

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gold would seem vulnerable to me, hbl, but i'm from the united states. there are other places in the world where an icelandic outcome is more easily envisioned -- including the UK -- and demand for metals in those societies could sustain or even drive up prices even in dollar terms.

walter rouleau used to say in growth fund guide that gold tended to outperform in periods of financial stress, either inflationary or deflationary. the psychology of uncertainty might be enough.

And QE does reduce the supply of assets on the market, which over time should be price supportive.

for a time, except that the market also has to anticipate that the gilts will be sold back into the market eventually to soak up excess reserves once loan demand starts to return. still, i'm with you on the call -- yields should continue to come down as loan demand stays low for longer than most expect now and banks get healthier.

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Agreed on the international gold demand factor, it may trump everything else.

Regarding selling back sovereign debt as loan demand returns... Have you read Steve Keen? If I understand correctly he thinks aggregate debt levels are too high for any recovery without eventual large scale debt repudiation, however unthinkable the concept is now. Shuffling debt between public and private balance sheets doesn't change its total burden on the economy. FYI, I consider Keen, Koo and Roubini as the top three public-facing economists regarding understanding this crisis.

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only a little bit on keen, hbl -- i should read more.

i do think (per koo) that fiscal stimulus should keep wholesale financial collapse at bay provided governments get on board with it in a more serious fashion. (not a given, of course.) in that scenario, economic acivity would stay high enough to the private sector to remediate over time, and post-remediation growth could begin from a much higher level. that should allow gov't to pay down debt with alacrity from there, a la britain post-1945. the return of loan demand would also allow for inflation to return, making possible an orchestrated 'soft default'.

but i also think this would clearly revise some things about our future government obligations that some of us take for granted now, such as medicare and SSA.

does keen speak to those points particularly?

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I agree that fiscal stimulus is important to keep collapse at bay, though there is a good chance as you say that governments will not understand the scale needed. But as Keen will point out, real GDP must fall, since debt levels must either stagnate or decline (much of recent growth has been at unsustainable ponzi levels predicated on forever rising asset prices), and debt growth has contributed around 20% of GDP per year to aggregate demand. (With "demand" in this case composed of both investment and spending demand combined).

I have not seen Keen go into too much detail on the shape of the future -- he focuses more on financial crises and how they develop and his predictions are rarer. But you may find something in his papers or posts. My guess is the big problem with the potential for the private sector to remediate over time is that:
(a) the existing debt will compete with new investments and crowd them out to some degree
(b) servicing the existing debt will be a huge drag on spending power (whether in the form of taxes, private mortgage payments, etc)

Hence the debt repudiation theme. After all Japan's debt-to-GDP has not gotten any smaller, when government is included, even after two decades.

The other way to look at resolution is massive transfer payments and a seismic shift in the gini coefficient to alter aggregate spending potential, but in essence that's roughly equivalent to debt repudiation.

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debt growth has contributed around 20% of GDP per year to aggregate demand. (With "demand" in this case composed of both investment and spending demand combined).

important point this, and why no one should expect a no-contraction scenario no matter what is done.

still, i wouldn't think a) and b) are serious impediments. there's little to crowd out, which is why there's a crisis. and aggregate debt service should actually get much cheaper in moving to treasury rates at a time when those rates are approaching zero.

there's this trick in not inducing a run on the international debt and currency, a problem japan didn't have due to very high domestic savings pool and low foreign ownership of japanese assets. britain famously faced a series of runs in the depression that forced it to devalue, as did the united states, germany and others in 1931. (see krugman's chart.) this is a huge wild card, imo, and it could well be triggered by trying to float more debt than can be financed out of increased domestic savings -- to, say, bail out banks. (better to suspend mark-to-market, at least insofaras it applies to regulatory capital, and allow the banks to earn on net interest differential over time.)

maybe keen is talking about something along these lines? these countries did devalue by 40% or so in the end and that does basically constitute a partial default of the sovereign.

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Regarding currencies, for some reason, at least so far, surprise rapid declines in the dollar still seem improbable to me in the context of much of the world's problems being as bad or worse. (I suppose intentional devaluation is a risk, but with some currencies pegged and retaliation by others assured...?) Or if a currency/debt run does happen my sense is it would be in the context of a much larger problem (global war, complete financial meltdown, etc).

The only explicit example I think I remember Keen giving regarding debt repudiation was mortgage principle reductions (I don't remember if he went as far as to say elimination). Also though I think it's obvious, to be clear my responses above did extrapolate beyond what I understand of Keen's opinions.

Speaking of meltdown, I guess George Soros isn't one of those who just proclaimed the bottom was in! Chilling stuff.

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Friday, March 27, 2009


was there ever really any difference?

i'm inclined to call this a belated realization on the part of many who, for some cloudy reason, expected the united states to be exceptional in some way in how it manages its affairs under duress and who now face the disturbing entreats of reality. glenn greenwald at salon highlights first the disaffected commentary of former salomon and IMF hand desmond lachman in the washington post and then the atlantic article penned by former IMF chief economist simon johnson, also of baseline scenario, which follows on some of his earlier recent writing.

i would be the last to deny that the united states in reality falls far short of both its stated ideals and the narcissistic image held by many of its citizens under the malleable catchall abstraction of nationalist fantasia, 'patriotism'. (though i would certainly differentiate qualitatively between the concepts of patriotism and jingoism which so many seem unable to separate.) what strikes me odd is that any large fraction of sensible folks would think otherwise -- to the point of having their disaffections become a focal point of their interpretation of the crisis.

to be sure, without high ideals there is no hope of worthy achievement -- relativist cynicism, however useful, isn't a recognized quality of leadership. but it is simply the peculiar zeitgeist of nationalism that encourages people of all walks to conflate those ideals with a nation, and then by unfortunate extension a government. i think anyone might have seen that economic crisis would not result first in the improvement of the lot of the common man vis-a-vis his overseers in a declining age characterized by a power elite that has for some time now most efficiently described as predatory.

the real question, it seems to me, is whether the predatory dominant minority now ensconced within a dessicated parochial state which toynbee rightly labeled as the singular "menace to civilization" can see the threat to its own existence presented by further rapine. thusfar, i see absolutely no reason to believe so. but hope springs eternal.

the mechanics of a slow resolution are available. and the method is even friendly to the maintenance of some vested interests. but first we must put aside the desire to expend precious government balance sheet capacity in a foolish, shortsighted and predatory attempt to restore the array of now-crippled financial intermediaries to what would appear to be not only immediate solvency but immediate profitability by sacrificing demand management.

even if the united states were to win the international sovereign fundraising game, that is sure to be the surplus savings of some other nation in desperate need of those funds at home whose resulting economic weakness will in this globalized world likely wash up on our shores. our financial institutions in the main have, with forbearance and time, the means to recapitalize themselves out of income. more than a few will genuinely require restructuring and some even assistance; the vast majority won't, provided demand is supported. moreover, should demand not be supported, the declines in money supply, deposits, incomes and cash flows will serve to deal damage to banks that would more than undo all efforts of a misguided government.

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well written

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how treasury really works

yes, that is a chicken with its head cut off. h/t calculated risk. i posted the still to make it easier to savor all the possible options available to secretary geithner.

One vote for telethon. it's an appropriate metaphor for the gas bags on the nightly news. And at least someone can finally say to the country: "put up or shut up".

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the telethon would be cool. i wonder what "b celebraty" we could find to host the thing for the next 50 year?

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Thursday, March 26, 2009


commenting at option armageddon

rolfe winkler presents a decidedly different view than what i've settled on at his excellent blog option ARMageddon. i've recently left a (too long) string of comments here and here.

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Great stuff, gm. The Koo link is outstanding.

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Hi gm-

I'm glad to see you diverging more clearly away from the mainstream treasury bear camp... (As should be obvious by now I've always been skeptical of the treasury bear position, given the lessons of history with respect to this kind of crisis).

I think one of the key points people miss with the standard "these deficits are too big to be financed" claims is just how large the scale is of existing assets that are imploding or being absorbed by the government, leaving a big asset-demand "hole" that treasuries can sort of fill (with complications, of course).

Also there is so much ideological hatred of government that can blur thinking. The situation boils down to an investment choice between an entity with the lowest default risk (almost certainly zero for the US, given that it always has the option to print its own currency) and a sea of options (corporates, municipals, etc) with substantially higher default risk in the context of a debt deflation. It may be a rocky road to get there, but in this type of crisis that has no easy solutions, it's my belief that people will increasingly gravitate to "safe" investments. As to long duration versus short duration choices... I believe hunger for yield will over time push people longer out onto the curve even if there are some intermittent fearful flights to the shorter durations.

RolfeWinkler said "...start coming to the conclusion that the only possible outcomes are default or monetization...".

Regarding monetization -- if you believe like Steve Keen and others that the market leads the credit creation/reduction process, monetization is very unlikely to be successful at creating inflation before devleveraging is complete.

Regarding default -- it seems to me that either the belief path that the US will default or the belief path that the US will not can be a self-fulfilling prophecy, and I suspect the latter path will win out given the scarcity of good alternative safe havens. This could mean treasury yields are pushed low enough to be serviceable from tax receipts, even if government debt rises enormously (see Japan, 180% of GDP and low yields). For some reason the treasury bears seem to focus on the former potential self-fulfilling dynamic while ignoring the latter one. It probably has to do with being under the illusion of a "return to normal" in all areas except government debt levels.

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reading koo's book was frankly a revelation, rb, hbl. a stroll through the accumulating data makes plain that we are facing what he describes (though of course with the wrinkles that accompany every differing specific situation). his analysis and framework is, moreover, so compelling that i don't hesitate to say his work on depressions will rank with keynes if not obviate it. it's the roadmap.

this crisis has in many respects been the exemplary death of old-line monetarism -- no one will ever sensibly take friedman at face value again. and i have to agree with this sentiment:

there is so much ideological hatred of government that can blur thinking.

i'm a conservative fellow by nature, but to my mind i see shades of the cartoonish ideological stubbornness of the elites and those who would reflexively support them in the 1920s. (though i should be clear -- i'm not at all talking about rolfe winkler specifically.) conditioning oneself to vomit at the thought of government is neither a philosophy nor an understanding -- it is an escapist fantasy. at the risk of oversimplifying the panoply of risks we face, there are right ways and wrong ways to deal with balance sheet recessions. excluding the use of the government balance sheet in some fashion is, i think obviously, one of the wrong ways.

however -- i do think one can overdo it. japan had massive domestic household savings pool to draw down and a huge export market to draw income from. these were invaluable aids. while i do think financial assets will continue to be sold off to pay down debt and seek the liquidity and safety of treasuries (directly or though banks), there will be no exporting our way out. (of course, that has now become a terrible mixed blessing for japan -- perhaps better for us that we are in no position to seek such 'favorable' imbalances.)

the upshot, though, was never having to go into the international markets to sell JGBs. there is a danger here, however, that government spending -- being too interested in bailing out banks and other financial intermediaries -- will end up trying to sell much more treasury debt than increases in domestic cash flows to banks (savings, debt paydowns) will permit. particularly as banks are the beneficiaries of fat spreads and unmoveable government financing, they ought be allowed to earn their solvency back a la the latam crisis aftermath 1982-95. government balance sheet must be directed at demand management, or the whole house of cards can yet collapse.

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As Koo mentions on slide 20 of the presentation, there is yet the possibility of a dollar collapse due to over-aggressive monetary action. It seems a bit of a roll of a dice though isn't it -- how do you know that fiscal actions were optimal in balancing govt spending with demand for treasuries and did not result in an irreversible loss of faith in the currency? What if a concurrent peak oil scenario is a catalyst for the same? Retail investors like me can now invest in a whole range of commodities.

You seem to point towards a similar collapse scenario yet here too.

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technical trading tool

modified advance-decline statistics from dr. steenbarger.



domestic savings rate jumping

via ft alphaville:

US retail investors poured close to $250bn (€184bn) into bank accounts in the first months of this year, sharply accelerating a flight to safety as they continued to flee volatile stock markets. Bank savings deposits rose by $246bn to a record $4,343bn in the nine weeks to March 9, according to data from the Federal Reserve. This is more than the whole of 2008, in which savings deposits rose by $229bn. ...

It is not clear where all the deposits came from but in the first two months of the year, investors pulled $20bn from stock mutual funds — almost half the total $43bn redeemed during the whole of 2008 — as they appeared to lose confidence in stock markets, according to data from Financial Research Corporation. During the first nine weeks of the year, investors pulled a small amount — $15bn — from savings accounts with a period of notice, in an apparent indication they were reluctant to lock up cash for even short periods of time.

US net flows into savings have gone into only two places — bank savings and US Treasuries, according to Charles Biderman, chief executive of TrimTabs, a research group. Both asset classes, he noted, offer extremely low yields with a high degree of safety. “During an economy where equity prices are down about 50 per cent and home prices down about 30 per cent or so, is there any question as to why money is flowing only into the safest bets?”, he told the FT.

this is testimony to households dumping assets in favor of cash and savings. given further the shocking decline in loans to households now underway mentioned earlier this week -- if the contraction was (-$70bn) in 3q08, imagine what must be going on in 4q08 and 1q09 -- the increase in savings actually understates the cash flowing into the banks significantly. the data aren't in yet, but banks have probably received well in excess of $400bn, perhaps as much as $500bn in cash in the last nine weeks from the private sector.

my first observation is that $200bn in fiscal stimulus spending in 2009 will be a minor offset to such a collapse in demand. this is going to be a very difficult year for american GDP. (UPDATE: though, as brad setser cites the IMF, a rise in government deficit ex-bailouts of 4.8% of GDP is more comprehensive a measure and implies new demand replacement spending on the order of $650bn -- an amount obviously better than $200bn but a far cry from what is headed into savings alone, much less debt repayment, at current rates.)

secondly, the united states treasury is slotted to auction on the order of $2000bn in debt in 2009. if this rate of cash flow into the banks and treasuries were sustained for all of the year, the result would be between $2300bn to $2900bn flowing into bank coffers. with private loan demand vanishing, there's little wonder that demand for treasuries is so high that yields remain near post-war lows in spite of collapsing crossborder flows.

the question, thirdly, is whether such flows will remain sufficient to take up the schedule. one has to think that the dramatic flight out of assets sparked by the lehman collapse -- while it was picking up steam even in the first nine weeks of this year -- is not going to be consistent. however, i would not underestimate the potential for it to be durable, even if at lower average levels. with american households now in balance sheet repair mode, a steady stream of asset divestiture is likely part of our new reality.

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prepare for UK freefall

shoddy implementation of quantitative easing leads to weak gilt auction leads to weakened prime minister leads to political concession to wrongheaded populist opposition leads to curbing of the only support of the british domestic economy? all of a sudden, it seems possible.

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Wednesday, March 25, 2009


weak treasury auction

this is a bad day for government debt. following on the failed gilt auction in britain, bloomberg reports on a weak treasury auction in the united states.

Treasury notes fell for a fifth day after an auction of $34 billion in five-year notes drew a higher-than-forecast yield, spurring concern record sales of U.S. debt are overwhelming demand.

U.S. securities dropped even after the Federal Reserve today bought $7.5 billion of Treasury notes, its first targeted purchases of U.S. securities since the early 1960s. The five- year auction drew a yield of 1.849 percent.

“This caught a lot of people unaware,” said Bulent Baygun, head of interest-rate strategy in New York at BNP Paribas Securities Corp., one of the 16 primary dealers that are required to bid at Treasury auctions. “Prior to the auction the Fed conducted its purchases of Treasuries, which may have compressed interest rates below where they would have been otherwise.”

not the outcome the fed would have wished for the first day of quantitative easing. some of these difficulties could be tied to quantitative easing and the price distortions created thereby. some also could be the product of a growing relief rally in capital markets diminishing safe haven flows. some of it is good old fashioned warfare with the government.

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BoE, tories oppose fiscal stimulus

on the heels of a failed gilt auction of potentially historic consequence, bank of england governor mervyn king attacked prime minister gordon brown for the profligacy of his labor government. via rolfe winkler and the times:

The Governor of the Bank of England laid bare tensions between Gordon Brown and the Treasury yesterday by warning that Britain could not afford a second economic stimulus in the Budget.

Mervyn King threw caution to the wind as he sided with Alistair Darling and the CBI against Downing Street in raising strong doubts over any prospect of another round of “significant fiscal expansion” next month.

"we've got to start living within our means," says tory leader david cameron. you picked a fine time to start trying, mr. cameron.

this reinforces my deep and growing dismay that the political and monetary authorities in britain and elsewhere do not understand the nature of their problems. this is a balance sheet recession -- private incomes are being diverted from consumption to savings and debt repayment, private balance sheet are trimming debt and trying to replace lost equity following the greatest asset shock in eighty years. it is precisely now that government must use its balance sheet capacity to pull cash directed at banks out and spend it to prevent a demand collapse and far greater problems.

in other words, while the citizens of the western world finally set about living well within their means, if a ghastly depression is to be avoided then the government absolutely cannot.

what's worse, because the authorities still believe that the nature of their problem is not credit demand but credit supply -- that is, they incorrectly presume that people will borrow if only the banks would lend -- they are directing valuable and limited government balance sheet toward recapitalizing banks instead of supplementing demand.

this same dynamic is playing out almost identically in the united states. as winkler notes, the obama press conference last night was for a time dominated by concerns over government deficits and debt. while that concern is not utterly misguided, oppositional republican hysteria about the damage being wrought by govenrment indebtedness -- not the fiscal reality, but the abstracted concept -- is.

in truth, economic collapse will be the surefire product of NOT financing fiscal stimulus at least almost as large as the newfound propensity of american households and businesses to save and pay down debt. to the extent that governments borrow heavily to recapitalize banks that could recapitalize themselves with time and restructuring, i agree that borrowing is poor policy. but that does not lessen the high probability that the only bulwark between today and economic disaster is the government spending which can keep money supply at current levels even as the entire private sector deleverages en masse. should it not, past experience shows that the ensuing devastation of tax revenues will guarantee even larger deficits in spite of reduced spending.

mervyn king, england's tories and american republicans at a minimum have the problem precisely wrong (which is not to say that labor and the democrats have it right). they are as a result unwittingly recommending a 'greater depression' as a solution to the problem, rather than a problem in need of a solution. that they are further succeeding by some measure to frame the public debate in both countries regarding government deficits is heart-rending.

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The problem with your analysis is that "stimulus" isn't on the table right now --- what Barack Obama and the Democrats call "stimulus" is wealth transfer. There is no job creation in what he has done, other than government job creation. So a big, bloated, unaffordable government goes into mind-boggling more debt to become even bigger, more bloated, and incredibly unaffordable. Pardon the opposition parties for trying to stop that. Perhaps there would be less opposition to Obama's spending if he weren't shoveling money to his masters on Wall Street and his unproductive constituencies.

If Obama, or Gordon, were proposing spending on things that made sense, that would actually stimulate the economy, you might get a better result.

As it is, it seems as if you are only exposing your party bias.

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no party bias, steve - i am an equal opportunity disdainer of political parties. this isn't abortion or gun control or some other godforsaken moral abstraction. i just think the republicans are wrong on the mechanics of what is happening.

like it or not, and contra some political dispositions, government-dependent job creation is in fact job creation. the checks cash, the money gets spent. i prefer the more efficient private sector variety, and i have nothing against government spending its money on private businesses, but we are not going to be getting significant private sector expansion -- and i think it is essential to realize first that THINGS HAVE CHANGED. the private sector has many years of balance sheet repair ahead of it, when it will not be expanding at all and in many cases downsizing and paying off debt.

in such a situation, the private sector will be paying back loans, not taking them out. if that is allowed to happen without government stepping up to borrow deposits out of the banks, the result will be a collapse in money supply and widespread bankruptcies -- which is what happened to this country between 1929-33. moreover, the data clearly show that the resulting collapse in tax revenue creates even larger deficits than would have been seen as a result of government demand management.

this is important to note, and the data is quite clear form previous crises: the consequence of refusing to use government to maintain economic activity is NOT SMALLER deficits -- it is LARGER deficits. if you dislike government debt, paradoxically, you should encourage government to borrow and spend private savings now.

in this environment of balance sheet consolidation, only the government can realistically turn over the new cash flows into the banks to prevent a depression.

moreover, government should be able to do so with no serious threat to the currency PROVIDED that it does not continue to borrow out these new savings flows for purposes that are truly not economic -- such as injecting lots of capital into the banks. they don't need to. banks can slowly recapitalize by net interest differential over time if they are shown plenty of regulatory forbearance. as much was done in the aftermath of the latam crisis from 1982-95, and in japan from 1990-2005.

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I suspect the suspicion with government job creation is concern that the "stimulative" intent might mutate into "jobs for life for my constituents" that one associates with some of these boondogles (TVA, various toll roads).

It would be all well and good to blow a couple of billion to hire contractors to build a bridge who will then blow their cheques on goodies, which will be produced by workers in factories, and so on..

I think it may be an entirely different issue if in practice we end up blowing those billions hiring bureaucrats whose only product in to interfere in people's lives and businesses (those who still have businesses that is)

Or perhaps shooting money into the pockest of nonproductive groups who appear to have limitless time to petition government to spend money on their pet issues and could use that money to hire a some beltway bandits with the right connections to turn a one time stimulus cheque into a permanent line item on the budget with all the requisite staff.

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"like it or not, and contra some political dispositions, government-dependent job creation is in fact job creation."

But it is not wealth creation. It does not improve the factors of production. We have too many nonproductive people in this society, and all you propose is creating more --- with all the attendant and permanent costs --- benefits, retirement plans, etc. And when did we ever create a temporary government job?

This is foolishness. And, by the way, do you even know what the Republicans are proposing that you disdain so much? You won't find out listening to CNN or MSNBC. All you will hear are the same strawman arguments that the Obama propaganda machine spits out. The Republicans are not being given a hearing. Barney, Nancy, and Harry shut them down. There is no debate going on in this Congress, only corrupt power being wielded.

This government is not the solution.

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But it is not wealth creation.

i wouldn't dispute that, steve.

but the realization has to emerge that we've spent the last twenty years in this country not creating anything like the wealth most people thought we were. what we were doing -- with the complicity of both political parties -- was recklessly levering up the private sector -- much more so than the public, where the debt float remains well under 50% of GDP -- which gave the temporary appearance of wealth. now the bill has come due on that debt.

the result is a nascent balance sheet recession, and private sector growth is simply not an option from this point. i would direct you to richard koo's presentation. again, we would all prefer private sector growth and wealth creation. but the reality is that this will not happen until the private sector balance sheet is repaired, and that will be several years doing as it has to liquidate one of the most titanic debt bubbles in the history of man.

what we're really discussing is how to tide over that period of balance sheet repair between now and the beginning of the next great growth cycle.

we can have government do nothing and watch as money supply and economic activity crash until we get to the point where the private sector is too poor to divert income or savings to balance sheet repair -- which is the equilibrium approached (but never reached) in the 1929-33 -- and then try to start growing from the wreckage of that very low level.

or we can carefully use government balance sheet to manage demand in order to prevent an economic collapse -- as was done in the US, germany and elsewhere from 1933-45 on, as well as in japan from 1990-2005. this will keep income flowing to households and businesses, enabling them to largely pay down debt from income and savings rather than simply defaulting on it en masse. once the necessary deleveraging has been effected -- likely several years' time of low or no growth -- we can resume growth from a much higher level. this will have the advantage of generating a lot more tax revenue out of lower tax rates (because the absolute level of economic activity is much higher), allowing the economy to generate the revenues that push the government into long-awaited and very desirable surplus while reducing the load as a percentage of GDP.

you obviously from your comments view events through a thick partisan political lens, and that's fine. but i would say that, as damaging as 'keynesian' stimulus is in a healthy economy, so it is necessary to avoid disaster in a sick economy. inflexible political ideologies that forward the same prescriptions under all circumstances, regardless of which party they are identified with, are inevitably counterproductive at points -- and this, i fear, is that point for the deficit hawks in both parties.

if it helps me in your eyes, my mainstream news source is bloomberg. :) i don't watch any cable or network news -- don't see the point.

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I suspect the suspicion with government job creation is concern that the "stimulative" intent might mutate into "jobs for life for my constituents" that one associates with some of these boondogles (TVA, various toll roads).

in truth, anon, private sector balance sheet repair is likely to take a long time -- ten years? fifteen? we are looking, after all, at retiring private sector debt on the order of 200% of GDP. the channels of government spending are certainy likely to calcify. that doesn't relieve us of the obligation.

koo notes that it barely matters what it's spent on from a macro perspective -- the important part is that it is spent to prevent monetary aggregate and economic collapse. indeed, i think good spending is infrastructure repair -- does not add to problems of overproduction as it largely is replacement, but still necessary for continued long-term economic function. but, washington being what it is, i'm also certain both parties will be sure their patron's troughs are filled to overflowing.

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more from ed harrison on this point.

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british gilt auction failure

german bund auctions have regularly been failing to cover for some time. that has been excused, perhaps correctly, by the vagaries of the auction method used by the german government.

that rationale does not apply to the united kingdom, however, and the british today experienced their first failed gilt auction of the downturn. previous fails occured only in inflation-linked bonds; this is a different story, and perhaps the first failed auction on record for british gilts.

Investors bid for 1.63 billion pounds ($2.4 billion) of the 40-year securities, less than the 1.75 billion pounds of 4.25 percent notes slated for sale, the U.K. Debt Management Office said today in a statement from London.

“Basically it’s the first failed auction,” said John Wraith, head of sterling interest-rate strategy at RBC Capital Markets in London. “They didn’t receive enough to cover it all so the market has obviously sold off extremely heavily.”

The yield on the 10-year gilt jumped 10 basis points to 3.43 percent by 11:45 a.m. in London. The 4.5 percent security due March 2019 slipped 0.84, or 8.4 pounds per 1,000-pound face amount, to 109.02. The yield on the two-year note rose six basis points to 1.30 percent. Yields move inversely to bond prices.

Prime Minister Gordon Brown’s government plans to sell an unprecedented 146.4 billion pounds of debt this fiscal year as Europe’s second-largest economy grapples with its first recession since 1991. Demand hasn’t fallen short at a sale of regular U.K. government bonds since 1995.

The U.K. had two failed auctions in the past 10 years, the most recent in September 2002 when the Treasury received bids for 95 percent of the 900 million pounds of 30-year inflation- protected bonds offered, according to the DMO’s Web site. The other failure was in 1999, when it tried to sell 500 million pounds of inflation-protected bonds.

“The risk of uncovered auctions is a normal part of the process,” said Sarah Ellis, a spokeswoman for the DMO in London. “Today’s auction was at the riskiest part of the curve. An additional factor which may have deterred some bidders is the imminent end of the financial year.”

perhaps BoE will now try to execute quantitative easing with some greater competence. macro man:

... [I]n the UK, the impact of QE was dulled yesterday by a higher-than-expected inflation print (the joys of a weak currency!) and comments from Merv the Swerve. Less than three weeks into QE, and Merv was already talking about the possible need to hike rates aggressively at some point. He also suggested that the BOE might not deploy its fully allotted £150 billion of buybacks should the program prove effective. While there was nothing technically wrong with these comments, they were the wrong thing to say to a teetering Gilt market, and were received with all the pleasure of a swift kick to the groin from an iron-tipped boot. Like Treasuries, Gilts are now below the closing on the day of the QE announcement. ...

In its most basic form, monetary policy is meant to influence the behaviour of economic actors. Virtually nobody outside of a few banks transact at central bank policy rates. But central banks change those rates in an attempt to influence other, market-based rates which do have a meaningful economic impact-bond yields, mortgage rates, etc. In a very real sense, while central banks adjust the sign posts, financial markets do the real work in changing monetary policy by moving market rates.

And yet when it comes to QE, Macro Man is hearing things like "the SNB wants to shake out a few longs before intervening again." What possible purpose does it serve to "punish" the very people who are supposed to make the policy work? While the SNB may be throwing a bone to the ECB by declaring that they don't actually want a weaker currency, it seems pretty clear that they do. Yet by submarining the market's positions, the SNB is creating a situation wherein any further intervention could be met with selling from relieved longs, rather than the sort of coat-tailing that would put EUR/CHF back to where it was a few months ago. Similarly, one wonders why the Fed would introduce unnecessary volatility in the back end of the yield curve by misleading the market with its statement a week ago.

To be clear, Macro Man is not asking for a handout or a tip-off, nor does he require one to make money these days a la Bill Gross. But by the same token, central banks should realize that the market is their ally in QE, not their enemy. Clear, unswerving policy and a total public commitment to maintain it (even if you don't actually mean it) will render maximum effectiveness unto QE. Ambiguity and flip-flopping will put the relevant asset prices right back where they started, with the market further out of pocket, and the "nuclear option" exhausted and ineffective. Granted, that's been the inevitable outcome of all previous policy initiatives since the crisis started. But it would be a pity to see a shock and awful outcome for the last policy bullet in the gun.

britain is potentially running up against some very significant constraints to its fiscal policy construct.

in a balance sheet recession, private parties will be redirecting income and even savings to the retirement of debt and contraction of money supply as they repair their balance sheets. it falls to government to dredge those savings out of the banks and spend them via deficit-financed fiscal stimulus in an effort to manage aggregate demand and prevent the asset shock from propagating into a disastrous economic collapse. if the government sticks just to recycling the domestic cash being directed to banks, some contraction is inevitable to the extent that the good old days were characterized by foreign investment inflows and the importation of overseas capacity to fill excess demand. but just selling treasury debt in the amounts domestic savers can finance should be enough to forestall a heinous depression.

here, however, is where bank bailouts come in. these transfers are not stimulative spending, but rather essentially a straight debt swap from banks to government. they do require government debt to be increased -- as per the TARP, or the imminent losses to be shunted onto the FDIC by geithner's PPIP -- and in a closed economy that would mean less domestic savings available to fight demand destruction. meanwhile, the newly-repaired banks are basically powerless to promote spending as they have little loan demand to fill. the result would be an inability of government to fill the demand gap, resulting in more intense debt destruction and -- of course -- greater impairment for the banks to overcome.

countries like the united states and great britain are not, of course, closed economies. but they are more closed than they were a year ago as globalization is thrown for a loss, and it seems very likely that the slowdown of international flows will be persistent and even intensify. that will necessarily make it harder to sell government debt overseas. furthermore, in a competition between governments to sell their obligations, some will be losers -- and here britain may be one of them. faced with banking system losses that the sovereign cannot hope to backstop in full, it seems madness for the british government -- already subject to massive short-term foreign debt holdings vulnerable to roll risk -- to attempt to sell the kind of government debt it would take to continue to repair disaster banks like RBS, regardless of their systemic importance.

here quantitative easing, providing a potentially infinite sink for government bonds in exchange for newly created high-powered money, has thusfar stepped into the breach in britain, switzerland, the united states (beginning today) and elsewhere. central banks can grow their balance sheets by issuing cash to buy sovereign debt. the cash -- in an environment of low loan demand -- will preponderantly find its way to excess reserves, further ballooning the central bank.

i would have to think that the initiation by the BoE of quantitative easing just recently played a role here by overvaluing gilts, holding yields unnaturally low and creating an incentive to sell. some have forecast that QE could in some situations ruin the private bid and result in central banks owning most or all sovereign debt.

but this interplay of treasury and central bank is of course a manner of confidence game. while international confidence remains, loan demand is low, interest rates are near zero, credit creation is negative and inflation is only what fiscal stimulus allows, there is little chance of an inflationary runaway.

but should international confidence break and a run on the debt and currency of the sovereign be enjoined -- perhaps as a result of attempts to sell much more government debt than can be absorbed without massive concessions to the market -- there exists the potential for an icelandic outcome.

UPDATE: bloomberg's second update includes some even more harrowing quotes.

“This is a warning signal investors are sending to the government,” said Neil Mackinnon, chief economist at hedge fund ECU Group Plc in London, who helps manage about $1 billion in assets and is a former U.K. Treasury official. “Investors are giving the thumbs down to the gilt market.”

“This sinks Brown below the waterline,” said Bill Jones, professor of politics at Liverpool Hope University. Brown’s “whole strategy is based on borrowing and now he can’t get anyone to buy his gilts. This means the prospect of going cap in hand to the IMF hovers increasingly into view.”

the UK was previously bailed out by the IMF in 1976.

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Tuesday, March 24, 2009


PPIP bids and the geithner put

jim chanos on cnbc points up the intent of the geithner plan -- to lift the bid using very cheap finance.

chanos remains skeptical that banks will want to lower the offer to complete much in the way of deal flow, but steve waldman on interfluidity illustrates a conspiracy theory involving a quid pro quo between the bank-directed treasury and the PIMCOs and blackstones of the world which would, by virtue of ridiculous bids, seal the deal.

My guess is that behind the scenes, Geithner has arranged a kind of J.P. Morgan moment. ...

I think that Treasury has already lined up participants for the "Legacy Loans Public-Private Investment Fund" and persuaded them to offer prices so high that despite the put, investors will expect to take a major loss. My little conspiracy theory is that the Blackrocks and PIMCOs of the world, the asset managers who do well by "shaking hands with the government", will agree to take a hit on relatively small investments in order first to help make banks smell solvent, and then to compel and provide "good optics" for a maximal transfer from government to key financial institutions. ...

Why would PIMROCK go along with this? Because they feel it is their patriotic duty to work with the government for the good of the financial system, even if that involves accepting some sacrifices. And because they hold $100B in J.P. Citi of America bonds, and they've received assurances that if we can get the nation out of the financial pickle it's in, there will be no haircuts on those bonds. "Shaking hands with the government" means that nothing ever has to be put in writing.

i have to admit, with so many hypothetical games afloat, that i'm skeptical enough of the PPIP to consider the possibility of such things if bids come in anywhere close to bank marks.

but the reality is that you don't need to get anywhere near such conspiratorial fraudulence to posit inflated bids because the embedded put option of non-recourse finance will support unrealistic bids. nemo at self-evident illustrates how, over a series of deals of varying value, overbidding on price is a reasonable outcome that realizes a high probability of investor return and guaranteed losses for the provider of leverage, ie the FDIC.

So say a bank has 100 of these $100 loan pools. And just by way of example, suppose half of them are actually worth $100 and half of them are actually worth zero, and nobody knows which are which. (These numbers are made up but the principle is sound. Nobody knows what the assets are really worth because it depends on future events, like who actually defaults on their mortgages.)

Thus, on average the pools are worth $50 each and the true value of all 100 pools is $5000.

The FDIC provides 6:1 leverage to purchase each pool, and some investor (e.g., a private equity firm) takes them up on it, bidding $84 apiece. Between the FDIC leverage and the Treasury matching funds, the private equity firm thus offers $8400 for all 100 pools but only puts in $600 of its own money.

Half of the pools wind up worthless, so the investor loses $300 total on those. But the other half wind up worth $100 each for a $16 profit. $16 times 50 pools equals $800 total profit which is split 1:1 with the Treasury. So the investor gains $400 on these winning pools. A $400 gain plus a $300 loss equals a $100 net gain, so the investor risked $600 to make $100, a tidy 16.7% return.

The bank unloaded assets worth $5000 for $8400. So the private investor gained $100, the Treasury gained $100, and the bank gained $3400. Somebody must therefore have lost $3600…

…and that would be the FDIC, who was so foolish as to offer 6:1 leverage to purchase assets with a 50% chance of being worthless. But no worries. As long as the FDIC has more expertise in evaluating the risk of toxic assets than the entire private equity and banking worlds combined, there is no way they could be taken to the cleaners like this. What could possibly go wrong?

in spite of this, it might fail anyway -- a lot of risk capital is gone, for one, and geithner needs to move well north of a trillion dollars in impaired assets.

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Jeffrey Sachs has a similar analysis at

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yep -- here it is, ia, and thanks. it's a straight flogging of the FDIC. of all the institutions in washington they might want to consider not fucking up, i'd put the FDIC near the top of the list. apparently they feel otherwise.

the sad part is that this needn't be attempted. the senior noteholders can stay whole and the banks survive if they are given time and forbearance in a wide net interest differential environment. meanwhile aggregate demand can be managed by dredging excess domestic savings out of the banks in the form of government borrowing. it'll take time, but private sector balance sheet repair can be effected.

this sort of giveaway, however, is terribly dangerous. because you're going beyond managing demand by redirecting private savings through government to consumption, you need to either float debt internationally or accept a demand contraction. that means potential currency trouble.

and for what? not so the banks can be solvent -- they can get there in time anyway. no, so that the banks can be PROFITABLE, and quickly. it's perhaps the worst example yet of the avarice of a system that sees itself as beyond good and evil.

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and more from ray dalio of bridgewater.

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goldman sachs to return TARP infusion

in the new york times.

Goldman Sachs is planning to give back its TARP money soon. Very soon, actually — ideally within the next month, according to people involved in the process. That’s a much quicker timetable than the end-of-year goal previously set out by Lloyd C. Blankfein, Goldman Sachs’s chief executive. As taxpayers, we should be thrilled that Goldman is going to quickly pay back the $10 billion it was given last October, right?

Well, not so fast.

Goldman’s sudden urgency to return the money stems, in part, from the uproar over A.I.G.’s bonuses last week, and the criticism of Goldman over revelations that the firm had been the largest recipient of government money as a counterparty of bets placed with A.I.G. It’s also paying a hefty 5 percent interest payment to taxpayers for that money.

“It’s just impossible to run our business in this environment,” said one senior Goldman executive who insisted on not being quoted by name for fear of crossing the Treasury Department.

Of course, another factor in Goldman’s decision to return the money is that it can: the firm is known to be sitting on a balance sheet with about $100 billion of available cash, so a mere $10 billion should be no problem.

why is a bank holding $100bn in cash? because it doesn't have a good prospect for investing it for profit.

it is becoming increasingly apparent that some banks, while appreciating the liquidity facilities made available to them as bank holding companies, have no use for TARP funds or other forms of excess reserves.

It could create even more chaos in the financial system if some banks gave back the TARP money, only to howl soon after that they still needed it after all. “We see another $1.5 to $2 trillion of as yet unrecognized losses from U.S. assets still to hit global financial sector balance sheets and challenge its institutions,” said Daniel Alpert, a managing director of Westwood Capital.

“The near daily announcements over the past two weeks, by money-center banks and finance companies, that they are making money this year on an operating income basis, have become borderline irresponsible, relative to continued deterioration in value of the assets on their balance sheets and the continuing impact of a worsening recession,” he added.

loan loss reserves very likely do need bolstering in general, which is why the ratio of loss reserves to total loans is climbing as steeply as ever. but $10bn in TARP capital will make no difference to a bank sitting on $100bn in that respect.

moreover, if banks in general are shown regulatory forbearance on how the derivative portion of their portfolios are marked, chances are that even the more damaged banks will earn their way back to solvency in due course (though it will be several years). the government has shown no inclination to force the issue and nationalize.

but what i find interesting is that banks like GS, BAC, JPM, WFC and others who have claimed to want to return TARP capital cannot find a good use for the money. if loan and investment opportunities were rampant, i have little doubt that obstacles like bonus restrictions would be easily overcome with a bit of creative regulatory arbitrage.

it's not that the bonus payment issue is null. this is capital, after all, which they are paying a 5% coupon for. goldman raised some billions from warren buffett in the heat of the 2008 crash for which they are continuing to pay on the order of 17%. so the restrictions -- and the probability of more restrictions to come -- matter.

but the issue of rejected capital bears watching for other reasons. excess reserves are moving in lockstep with monetary base -- since the beginning of fed balance sheet expansion in september, monetary base less excess reserves has risen by about $70bn, meaning that of $800bn in monetary base expansion 91% has gone straight to excess reserves. i would expect more of the same out of quantitative easing. the liquidity crisis that sparked massive new borrowings from the fed by depository institutions has eased significantly -- down nearly 70% from the mid-october peak, with participation in the fed's alphabet soup declining. ominously, total loans and leases at commercial banks is declining steadily -- and now has been since topping in late march 2008 (with a one-time jump thanks to the reorganization of some large investment banks as bank holding companies in the midst of the crash). fixed private investment is declining rapidly. personal saving and likely net private saving -- GDP less consumption (including durables), government sending and net foreign investment -- are jumping. shockingly, household credit market debt outstanding recorded its first contracting quarter since the second world war, and is flat YoY through 3q2008. more volatile commercial and industrial loans have also turned down.

this is all in line with the onset of a balance sheet recession -- plentiful reserves, improving bank liquidity, lack of advantageous use for bank capital, contracting commercial and household loans.

UPDATE: calculated risk highlights the strong negative mortgage equity extraction -- households are paying down loans.

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Monday, March 23, 2009


M-LEC 3.0: legacy loan program

the revised public-private super-SIV has a name -- call it PPIP. however, via ft alphaville and alea, following on some earlier comments on the previously leaked details, one has to wonder if it has a purpose anything like what many have supposed.

This is a “pingouins sur la banquise” problem, only the truly starving for capital will jump.

alphaville notes a "blog war" is shaping up. one can add john hempton to the list backing alea against the interpretation of paul krugman et al. alea is adamant that the incentive to use government balance sheet to overpay is minimal because the equity tranche -- however little of it is actually that of the private party involved -- is in the first-loss position. there is some question, however, as to the potential purchase of credit protection from the bank to create a sort of scam not dissimilar to that outlined by zero hedge regarding TALF 2.0.

with apologies to krugman, yves smith, simon johnson and others -- i find alea's analysis compelling. wild overpayment, to paraphrase myself, is much less likely than a continued wide bid-ask spread and locked market as the private end of the public-private partnership defends itself against losses.

the hazard of a swap transaction on the side between the private party and the bank alea calls a "fraudulent scam", "implausible" though not impossible.

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All I see is a bunch of bankers and hedgies holding a 100% stake in a worthless pile of crap. Now having the opportunity to buy each others worthless crap for 5%.

If it is all the same crap and you sell your 100% owned pile to someone else holding a 100% stake in another worthless pile it is in the best interest of both of them to buy the others for 5% and have Uncle Sam eat 95% of both piles of shit.

So much for solving our problem.

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i don't see much 'solution' here either, inp. shifting losses to the taxpayer is one way to help recapitalize banks, to be sure -- but the pricing method here does not look terribly conducive to paying top dollar.

if private parties which join up with treasury and then borrow 6x from FDIC can somehow work a side deal that remunerates them for any loss their stake would suffer -- they yes, i see a way for private parties to collude with the banks to overpay with government leverage and then walk. i'd be more assured if treasury were to specify the impossibility of such a game.

short of that, however, i don't see why private parties would risk much on higher pricing.

treasury seems to want to think that the restriciton is in the liquidity of the market -- if they provide the necessary balance sheet to leverage private parties, the thinking must go, bids will then return.

but given the probable real impairment -- not mark-to-market, but real cash flow impairment -- in these securities thanks to the defaults in the underlying loans, and the need for sizeable real returns to the investors after purchase, i just don't see how high-price bidding comes from this plan excepting that sort of collusion.

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Sunday, March 22, 2009


gaming TALF 2.0

early examples of TALF have been dismal, but with the pending expansion of the facility to impaired and downgraded assets observant minds are turning over the many loopholes by which banks and hedge funds could game the TALF to transfer hundreds of billions in losses to the government at virtually no risk to themselves.

zero hedge has been among many others a TALF critic from inception, and has one of the more compelling illustrations -- literally -- i've yet seen.

As a result of the TALF's non-recourse nature, a hedge fund X can buy Bank X's [$100mm face value] MBS Portfolio which is marked on the bank's books at 80 cents on the dollar (but has a market price of 20 cents) for the marked price with a 3% equity check and TALF filling the balance. A day later, Bank X repurchases the portfolio from hedge fund X at the 20 cent market price, pays a $5 million fee for the "trouble" and waits for the portfolio to appreciate to 50 cents on the dollar by 2014. Hedge fund X takes a 75% loss on its nominal equity stake but more than makes up in transaction fees. The TALF portion takes a 75% loss with no recourse and no margin to fall back on.

As a result Bank X takes no writedown now, and in 5 years may book an equity profit of as much as $25 million (net of transaction fees paid to the Hedge Fund X), while Hedge Fund X books a profit of $3.2 million for one day's work...

Lastly the U.S. taxpayer loses $54.3 million on a $77.6 million TALF Investment, or 70% (net of 5 years of interest income).

nice work from the goldman sachs ciphers heading up treasury and the national economic council.

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After the AIG bonus brouhaha? They wouldn't dare. Public shame has its privileges, too.

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Saturday, March 21, 2009


risk capital is gone

yves smith reads a gillian tett piece in the financial times harshly, but her essential point is right -- the status quo ante is dead and will not be coming back. a lot of people, including the united states government, are still in denial of this basic fact and the resulting misperceptions are dangerously misleading.

important observations relayed by tett:

... [S]ome recent anecdotes are chilling. Last week, for example, a group of senior hedge fund players and chief investment officers gathered in Dublin – and collectively guessed that about 80 per cent of the risk capital that was sitting in the European system a year ago has disappeared....

What is even more dramatic – but less visible – is the disappearance of banks’ proprietary trading desks... traders in London say there is really only one bank in Europe which is even pretending to run an active prop desk now – namely Goldman Sachs. As a result, billions of dollars of risk-taking capital is believed to have quietly vanished.

That has had all manner of extraordinary consequences. Two years ago, a host of hedge funds and prop desks in London were building up their distressed debt-trading teams to take advantage of a future turn in the credit cycle. Logic might suggest such funds should be wildly busy right now, swooping in to buy distressed companies, or securities. Nothing could be further from the truth. As banks have slashed their risk-taking operations, they have also cut their distressed prop desks, and most have stopped making markets in distressed products. Hedge funds dealing with distressed assets have also folded, unable to raise funds.

As a result, there is a dire shortage of capital to organise – or fund – even “simple” restructurings of companies, distressed investment entities or anything else. Hence the gridlock on dealing with toxic assets.

But not just credit assets are being hit. As asset managers hunt for places to put their cash away from the carnage of the credit or property world, some have been tempted by the world of small-cap equities. But trading in small caps can only take place with market makers – and right now, banks are not just cutting prop desks but market making activity too. As a result, fund managers are sitting on their hands. “We would love to buy small caps but we just cannot tolerate the liquidity risk,” explains one large asset manager. “Almost any sector which needs marketmakers is half-dead.” Logic would suggest that eventually this pattern should change. After all, oodles of cash remain in the system. That cannot all stay in government bonds for ever, least of all in a world where the Fed is busy intervening in such a dramatic fashion to suppress yields.

in fact it can stay hidden and likely will. sidelined risk capital is a myth -- it has been destroyed in the great unwind. much of what is hiding in t-bills is not risk capital, and a lot of it won't be coming out of t-bills.

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son of super-SIV

calculated risk highlights leaked sketches of treasury secretary geithner's plan to sink bad assets into a bad bank.

The plan to be announced next week involves three separate approaches. In one, the Federal Deposit Insurance Corporation will set up special-purpose investment partnerships and lend about 85 percent of the money that those partnerships will need to buy up troubled assets that banks want to sell.

In the second, the Treasury will hire four or five investment management firms, matching the private money that each of the firms puts up on a dollar-for-dollar basis with government money.

In the third piece, the Treasury plans to expand lending through the Term Asset-Backed Secure Lending Facility, a joint venture with the Federal Reserve. ...

The remaining 15 percent will come from the government and the private investors. The Treasury would put up as much as 80 percent of that, while private investors would put up as little as 20 percent of the money ... Private investors, then, would be contributing as little as 3 percent of the equity, and the government as much as 97 percent.

the FDIC loans will be non-recourse for good measure! this is why the guys at fortress are calling the expansion of TALF and geithner's asset sink "the great liquidation". the treasury is about to wildly overpay for hundreds of billions in non-performing loans in a backdoor bailout of the entire shadow banking system.

this isn't an idea so much as a dumbing-down of hank paulson's M-LEC.

this is government balance sheet that we will shortly regret not having preserved for fiscal stimulus. geither and the obama administration still believe that, if the banks are repaired, they will be able to create money supply through credit expansion. they likely will not -- the private loan demand will not be there, forcing even healthy banks to sit on excess reserves.

but, having dredged rapidly growing private savings to recapitalize the banks, they will not be able to tap those savings for fiscal stimulus as money supply continues to contract -- which will leave treasury to try to sell debt to a vanishing overseas market, or leave the federal reserve to monetize the treasury's excess issuance in size far beyond the $300bn announced this last week (though at least the skyrocketing excess reserve pile on the fed balance sheet should finance those purchases).

this crisis is two years and two administrations old, and the government still is operating without any understanding of what is actually happening. this is incredibly bad news.

UPDATE: yves smith outlines just what a disaster of a "plan" this is.

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hyperinflation on Weimar scales is on the way thanks to Helicopter Ben!


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I've been calling him Zimbabwe Ben since July. Hop on board!

I call the latest "plan" MLEC 3.0. It's the same story: overpay for the assets and obfuscate the issue as to what you did.

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ia -- between you, me and the rest of the world -- we'll have to monitor the outcome. i think he would love to be zimbabawe ben; he's taking every such ridiculous action. but how can he create real inflation in an environment of broken banks and extremely slack loan demand? all his pumping and printing ends up as excess reserves.

i can see how money-center banks could be washed (at incredible taxpayer risk) by a combination of a trashed-up TALF, MLEC 3.0 and QE to finance it all. so let's give them that as a hypothetical.

who do these banks loan to?

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Friday, March 20, 2009


tepid TALF



not unexpected, but not looking too good. the collateral quality is sure to be loosened as it is truly amateur hour at the fed.

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galbraith on financial services

via mark thoma:

A brief reflection on this history [of the Great Depression] and present circumstances drives a plain conclusion: the full restoration of private credit will take a long time. It will follow, not precede, the restoration of sound private household finances. There is no way the project of resurrecting the economy by stuffing the banks with cash will work. Effective policy can only work the other way around.

That being so, what must now be done?

The first thing we need, in the wake of the recovery bill, is more recovery bills. ...

Second, we should offset the violent drop in the wealth of the elderly population as a whole. ...

Third, we will soon need a jobs program to put the unemployed to work quickly. ...

... [A] payroll tax holiday would help restore the purchasing power of working families, as well as make it easier for employers to keep them on the payroll. ...

Finally, there is the big problem: How to recapitalize the household sector? ... This cannot be made to happen over just three years, as we did in 1942–44. But we could manage it over, say, twenty years or a bit longer.

shades of richard koo, and reconfirming jamie galbraith's observational genius.

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"Most men love money and security more, and creation and construction less, as they get older."

J.M.K. "The Future", Essays in Persuasion (1931)

With the demographic tidal wave drawing closer, "the future" is now I guess...

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there's a lot more to write about america's demographic decline, anon, but at leat from what i've seen our ageing problems are not nearly so bad as those of, say, europe.

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Wednesday, March 18, 2009


clock ticking for geithner

clusterstock relays a time magazine report quoting sources within the fed and treasury that treasury secretary lied to congress regarding his awareness of AIG's retention bonuses.

UPDATE: geithner admits that he pressured senator dodd to lift a restriction on bonus payments inserted into the stimulus bill "on or before february 11".


LMAO. Geitner was an abortion of a choice by the new administration. The most important role that Obama had to fill and this is who he came up with. That's not "Change we can believe in", it's a HUGE MISTAKE. Time to show Timmy the door.

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ccd, i can't tell if he's a terrible mistake, or if he's been set up to fail by rahm and axelrod. how else to explain that he's the only senior staff in treasury two months after inauguration?...

oh. well. i guess you could explain it by saying treasury was not on the obama team's radar. they did, after all, have a complete staff for state ready to go which are now all in place.

or one could say that no one will take a treasury job because no one on wall street wants to step in front of a train called depression.

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quantitative easing is here

the FOMC release via calculated risk.

In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months. The Federal Reserve has launched the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses and anticipates that the range of eligible collateral for this facility is likely to be expanded to include other financial assets. The Committee will continue to carefully monitor the size and composition of the Federal Reserve's balance sheet in light of evolving financial and economic developments.

if foreign demand is off and domestic savings are inadequate, the alternatives are monetization or regurgitation from other capital markets.

UPDATE: john jansen.

UPDATE: karl denninger, earlier today previous to this announcement, on an underrated threat highlighted by a 7.35:1 bid-to-cover in the bank of england's purchasing of gilts this morning.

Back in January I posted a Ticker in which I made clear what was likely to happen if Bernanke actually attempted to do (as opposed to threatening) QE:

Bernanke bluffed and the bond market called it. He cannot monetize several trillion in new issue plus the entirety of the 10 and 30 year bonds out there to stop a bond market sell-off. In addition, the market no longer believes him, as evidenced by today's price action. A serious bond-market sell-off will ramp the cost of all credit, including mortgages and commercial loans. If he tries to monetize the result will be current bondholders tendering into his buying, forcing him to essentially "consume" the entire float. That stunt will cause the dollar to implode and we wind up exactly like Iceland. Overnight. Ben knows this; ergo, he is screaming like a petulant child while the market laughs at him just like the market forced Paulson to do what he said he wouldn't with Fannie and Freddie. Bernanke had better shut the hell up before he precipitates a bond market dislocation; traders can and will try to force him to make good on the threat.

Ding. The BOE now has seen exactly what happens when you promise as a government to overpay for something - everyone hits your bid immediately!

UPDATE: my comment at zero hedge:

i'll just stupidly wager that this does nothing.

the fed will inflate its balance sheet by adding t-bonds to the asset side and currency in circulation to the liability side.

the treasury will take the fed's dollars and spend them, which will fill some but not nearly enough of the output gap. the spent cash will quickly find its way to the banks either as loan repayments or deposits. banks will thereby deleverage and/or put deposits on reserve at the fed because there's barely a decent credit out there. so the fed will see reserve balances balloon yet further, enabling it to go out and fund some more alphabet soup or buy some more treasuries.

ergo -- big big fed -- deleveraging banks -- massive excess reserves -- continuing deflation.

the reaction in the ten-year today, though, is certainly not nothing.

UPDATE: amid analyst reaction comes this illustration of what the announcement means for the fed balance sheet. the following commentary from monument securities' mark ostwald:

a) This looks to be an attempt to achieve maximum impact by co-ordinating the Fed move with the Treasury’s (Geithner’s) toxic asset plan details.

b) For that they have sacrificed the stated intention at the last meeting to wait and see the impact of the TALF before opting for what is the last card they have to play.

c) As for Bernanke’s cherished principle of transparency, that has now clearly been thrown overboard, and by opting to enact this just days after
Bernanke expressed the view that the US economy would recover in 2010, Mr Bernanke’s credibility is shot to pieces.

d) Will it work? Well it lower Treasury yields significantly, it will also offer market makers to stuff the Fed with Treasury paper at inflated prices, as the BoE’s QE buybacks has done for the BoE. Given that swap spreads ballooned out immediately, and that TIPS breakvens spiked higher, the intention “to help improve conditions in private credit markets” looks to be very wishful thinking in the first instance.

Sadly Anglo Saxon policymakers are digging an ever deep hole, with no signs that the measures do anything more than stave off an even worse outcome, but lacking the leadership qualities and ideas that would offer hope that they are capable of leading us out of this crisis. Should Mr Geithner’s tox asset plan continue to rely on market pricing mechanism (these are not functioning) and private sector capital funding for it, then the auspices for a resolution of the current crisis are very, very poor.

bernanke's credibility may not be missed, now that the fed has fired its last bullet. i will be extremely interested to watch excess reserves in the coming months, as will everyone else. i suspect that a lot of TALF and QE will end up quickly stagnated to excess reserves with no stimulative effect, and that government fiscal measures will continue to be the only important ones even as interest rates approach and exceed all-time lows.

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I agree with your comments, but would add the caviat that "no effect" would be the best possible outcome for this strategy. Until now we have been saved by the perception that the dollar is one of the few safe havens left in the world. With this move we are completely blowing our cover. While the treasury and the fed are different extensions of the US government, do they think they can fool people that the treasury can sell debt obligations and the fed can buy them and this is a legitimate customer / supplier relationship? Unless all the rest of the governments do the same thing (which is not beyond the realm of possibility) creditors will view this as a shell game. Our only two options going forward are taking on debt which will cap our growth for possibly decades, or inflate to pay the debt down with cheaper and more plentiful dollars. This move is the tell that we are taking the second choice. This changes perception from "safe haven" to "almost anything is preferable to this!" Is there something I am missing here?

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c -- remember this from earlier in the week?

“China is worried that the U.S. may solve its problems by printing money, which will stoke inflation,” said Zhao Qingming, a Beijing-based analyst at China Construction Bank Corp., the country’s second-biggest lender. “If the U.S. can make sure this won’t happen, then China will continue to invest.”

lol -- i can't imagine this kind of decision gets made without placing a call to premier wen jiabao, but it's panic stations in the neoclassicists camp and they could be running wild.

that said, imho our best solution is for gov't to sustain demand while private sector repairs balance sheet -- borrow out of the banking system what private sector pays into it through savings and debt paydowns. the banks can recapitalize on earnings over time while this goes on. GDP need not collapse, and the dollar needn't be annihilated in some monetarist idiocy. slow growth for several years, but in the end you get a heavily indebted sovereign and a clean private sector. then and only then can uncle sam start to control expenditures.

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chicago condo disaster

via chicago public radio.


I'm reminded of building projects in third world countries where it can take 10-20 years to finish a building. That's where we will be if this banking mess isn't taken care of.

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i'll bet you, ccd, that many whole buildings are either demolished or converted to rental.

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foreign demand for t-bonds wanes

brad setser again.

What have foreign investors been buying? Short-term Treasury bills. In huge quantities. ... However, that surge in demand for bills now seems to be fading.

The fall off in total TIC flows in January reflected private bill sales. The official sector is still buying — $100 billion in bill purchases over the last 3 months of data only seems small relative to the post Lehman peak. But with global reserve growth slowing (even China doesn’t currently seem to be adding to its reserves), central banks won’t be as large a source of demand for Treasuries going forward as they have been in the past.

That means a fall off in central bank demand for Treasuries wouldn’t necessarily be a sign that central banks have lost confidence in the US Treasury market. It could equally be a sign that a lot of central banks no longer have any new funds to invest.

again, the contraction in global trade volumes is rapidly downsizing both export and import volumes, with the net effect of a smaller trade deficit for the united states and smaller surpluses (even moves to deficit) elsewhere. this should not be a surprise, nor should it be surprising if it continues.

And if — as seems likely — foreign demand for Treasuries fades long before the US fiscal deficit, the US Treasury will need to sell an awful lot of Treasuries to American investors. For the past several years I have argued that it was almost impossible to overstate the impact of central bank demand on the Treasury market.

That may no longer be the case going forward.

The world is changing. Global reserves aren’t growing. The echo from their past peak that we observe in the current Treasury data will fade.

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i asked it jokingly, the treasury took it seriously.

As it’s currently set up, the TALF may lend as much as $1 trillion to investors from hedge funds to pension funds and insurance companies to buy recently created securities backed by loans for car purchases, college education and real estate. Applications for its first loans are due tomorrow.

Broadening the TALF to include older, illiquid and lower- rated securities could allow the participants in the public- private investment funds to potentially repackage assets and sell them on to a wider group.

The TALF is supported with money from the $700 billion bank-rescue fund passed by Congress in October. The Bush administration originally set aside $20 billion to seed $200 billion in loans; Geithner has proposed raising the government contribution to $100 billion. The facility could need additional money to address so-called legacy assets.

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These guys are so full of it. I expected to see the Fed buy anything from banks at far in excess of its market value. Repoed cars, old television sets, you name it.

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ia, i have some old clothes i was going to take down to salvation army. think they'd take it in TALF if i apply as a BHC?

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