Saturday, October 18, 2008
Pumping Dollars Into an Airplane with a Hole in the Side
Banks and other lenders have lost trillions of dollars recently (see this).
And, as we all know, they have severely reduced their extension of credit. As just one example, credit card lines will be reduced by some $2 trillion dollars in the next year or so .
Credit contraction is deflationary. Indeed, one of the two basic definitions of deflation is "A contraction in the volume of money and credit relative to available goods."
If the amount of money in circulation and available credit drops, then prices will eventually drop also.
In addition, banks are hoarding cash like never before. When cash is hoarded, it decreases the "velocity of money" - that is how quickly money changes hands. This also tends to lead to deflation and eventual prices drops.
If the economy is an airplane flying through the air, then deflation could be thought of as a decrease in cabin pressure.
The current economic crisis - with trillions of dollars in losses (an evaporation of available money), trillions of dollars less available credit, and hoarding of cash - is like a big gash in the side of the plane. For more evidence of deflation, see this.
The government's actions of lowering interst rates, sending people rebate checks, and throwing trillions of dollars at Wall Street is like someone trying to stabilize the cabin pressure in an airplane with a gash in the side by blowing air into the cabin.
If that person had a nuclear-powered blower, he might be able to re-inflate the cabin pressure in most parts of the cabin.
Are the government's actions powerful enough to stabilize the pressure? Will the government prevent deflation and push us into inflation?
Many people are sure we're headed into deflation. Others are just as sure we're headed into inflation.
But an expert says that its hard to predict which way it will go during periods of rapid change. Specifically, Oxford Economics professor John N. Muellbauer, an expert on U.S. inflation, said on October 10th:
The world is on the cusp of an inflation “turning point”, so the standard models are likely to go badly wrong.
***Too Much Here, Not Enough There
Forecasting inflation is notoriously difficult. . . . the speed of price changes tends to increase with big shocks. Most forecasting models used by central banks therefore put a large weight on recent inflation. This tracks inflation quite well except at turning points because the models miss key underlying influences.
***We are now on the cusp of the most significant tuning point for inflation in the last 20 years so that the many of the standard models are likely to go badly wrong.
Leading economist Dr. Marc Faber acknowledges that if the government takes enough action to fight inflation, it will cause some price increases. But, he points out that it is impossible for anyone - even the government - to predict which prices will increase.
For example, he notes that the government would like house and stock prices to increase, as that would help reinflate the economy (or at least give the middle class some sense of well-being in the short-run).
However, he said that it is possible that - instead - commodity or interest rate prices will increase, which will harm the consumer by causing higher food and energy prices and the cost of other essentials. As CNN writes: "Stock prices have plunged in recent weeks. So have oil prices. Most Americans probably see the former as terrible news and the latter as a ray of sunshine at a dark time." And as CNBC writes: "Home prices, much like stock prices, fundamentally affect people's sense of wealth".
When the government shoots its high-powered hose inside an airplane with a huge hole in its side, it will cause too much pressure in some parts of the cabin (unintentionally pushing some people out of the airplane) and not enough pressure in other parts.
We're in for a bumpy ride . . .
Friday, October 17, 2008
Inflation Or Deflation? BOTH
I have previously discussed the debate between inflation and deflation. There are good arguments on both sides.
But there are strong arguments that we will experience both inflation and deflation.
How is that possible?
Inflation does not occur simultaneously with the money supply is increased. There is always a lag time between printing more money and inflation.
So a lot of people believe we will get hit first with deflation, and then - after some lag time - inflation. Even Mike Shedlock - one of the leading forecasters of deflation - thinks there might be inflation coming down the road after a period of deflation.
Some Prices Will Go UP, Others DOWN
Some people think that some prices will go up at the same time that others go down.
For example, Dominic Frisby writes:
Are we going to see rising prices or falling prices? Of course, it depends on the asset class – and in what currency you are measuring.Adam Hamilton of Zeal LLC agrees:***
Falling prices in assets associated with debt - houses and financial stocks – and rising prices in things which you buy with cash – food, energy and some imported goods.
So we may very well experience both inflation and deflation.Anything typically financed by debt is likely to see its prices plunge dramatically, like houses and cars, as the ongoing Great Bear bust continues to destroy the gross excesses of debt via higher long rates. Conversely, anything not typically ‘paid for’ with debt, including groceries and general living expenses, is almost certain to rise in the coming years. We are staring down a brutal environment of widespread inflation marked by various sectors witnessing falling prices as debt leverage implodes.
Which Emerging Economies Are In Danger of Collapse?
Bloomberg has an interesting graph (courtesy of Danske Bank) showing the credit default swap risk of emerging economies:
On October 15th, Danske explained:
"The global credit crisis is now spreading to the most leveraged economies in the world. Iceland was the first economy to fall victim to the global credit crisis. However, it is not only Iceland that seems to be in need of a helping hand ....See also this.
***
Over the past month credit default swaps spiked in a number of Emerging Markets indicating a significant increase in worries over funding problems on the back of the intensified credit crisis. . . . In the graph [above] we show the 20 countries that have seen the strongest rise in CDS spreads over the past month.
***
It is striking that most of the countries in the “top 20” are countries that are either running large current account deficits . . . and/or countries that in recent years have had very strong credit growth."
Nouriel Roubini agrees that the countries with the most CDS bets being made against them - particularly those with large current account deficits - are in desperate shape, and may need emergency loans from the IMF to stay afloat.
See also this.
Central Bankers Think Credit Default Swaps are the Most Important Economic Indicator
Many of us talk alot about derivatives (see this) . You might think that we are too obsessed about the role of derivatives, including credit default swaps, in the economic crisis.
But even the mainstream press is now acknowledging that credit default swaps were largely responsible for bringing down AIG, Bear Stearns, WaMu and other mammoth corporations.
Moreover, according to Markit analyst Paul Davies:
"Most people might assume that central bankers would be watching libor rates, or spreads between libors and overnight interest rates as the main indicator as to the health of the system - they are not. These guys have recently become big devotees to the movements of the CDS markets."In other words, credit default swaps - not the interest that banks charge each other for inter-bank loans or other indicators - are the most important indicator that the world's central banks are now watching.
Snake Oil Derivatives Salesmen Bankrupting Schools
Do you think derivatives are some abstract thing which don't effect real people? Or that derivatives salesmen are just good folks who innocently sold bad products?
Well, as an article in Bloomberg points out, neither assumption is true:
"The U.S. Securities and Exchange Commission is investigating a Pennsylvania school district's derivative trades with JPMorgan Chase & Co. and Morgan Stanley that paid at least $8 million in fees to the banks and advisers.
***The SEC inquiry follows a Feb. 1 article by Bloomberg News showing that ... school districts across Pennsylvania were charged excessive fees by banks and financial advisers that sold them interest-rate swaps. The schools were routinely unaware of the fees they paid for the contracts, some of which have backfired amid the credit crisis.
***
The derivatives sold to school districts are known as interest-rate swaps, in which two parties agree to exchange periodic payments whose amounts are based on an underlying bond issue. The contracts are usually paired with municipal bonds whose interest rates are reset sometimes daily. The derivatives are designed to protect customers against the risk of higher interest rates, though they also can be used to speculate on movements in global lending rates.
***
The fees banks earn on the derivative transactions are rarely, if ever, disclosed, even by advisers school districts hire to render an opinion on whether the amounts are fair, the story found.
The contracts are typically awarded without competitive bidding and have left school districts exposed to soaring interest rates as the financial crisis causes banks and investors to hoard cash. Jefferson County, Alabama, has been pushed close to bankruptcy by its swap and bond deals, while elsewhere local governments have been slammed by high interest costs or fees to break derivative deals.
The Butler, Pennsylvania, school district, about 40 miles north of Pittsburgh, in August paid JPMorgan $5.2 million to escape from a derivative transaction that would have forced it to sell the type of debt being shunned by investors. Last month, the district sued JPMorgan and financial adviser Investment Management Advisory Group Inc. for allegedly conspiring to hide the fees the bank earned on that transaction and requested that the SEC investigate. The Erie, Pennsylvania, school district filed a similar suit.
***
At least five former JPMorgan municipal derivatives-unit employees are targets of that investigation, which centers on whether banks and advisers conspired to overcharge local governments, public records show. Some two dozen securities firms and advisers have also been subpoenaed in that investigation. No charges have been filed.
***
In the last week of September, the rate on $55 million of floating-rate bonds issued by [one Pennsylvania] school district in 2007 jumped to 8.5 percent compared with 1.9 percent at the beginning of the month. Two swaps with JPMorgan on the bonds added another 6.51 percent, making the district's total rate on the debt 15 percent. The overall rate has since declined to 9 percent.
***"The people who sold these came to us, not to assist us, but because they saw a way, with our money, to make money for themselves and we fell for it,'' said Stephen Antalics, 79. "Who's going to pick up the expense? It's going to come out of taxpayers' pockets. The people who created this will walk away Scot free.''
Thursday, October 16, 2008
Another Ticking Time Bomb: $71.2 Trillion Dollars in "Unallocated" Derivatives
According to the CIA Fact Book, the world economy was $54.62 (at official exchange rates) in 2007.
You've probably heard that the amount of credit default swaps (CDS) is greater than the world economy. This is confirmed by the Bank for International Settlements - the official organization which tracks derivatives - there were $57.9 trillion dollars worth of CDS as of December 2007 (Table 19).
But did you know that the amount of unallocated derivatives as of December 2007 was an additional $71.2 trillion dollars (Table 19)?
I'm not sure if anyone except the financial players themselves know what these unallocated derivatives are. But one thing is for sure: CDS and the unallocated derivatives have to be canceled or valued at a penny each, and regulated quickly.Credit Default Vultures Turn Focus on Main Street
Wall Street firms have been getting clobbered for months by credit default swaps - bets that the companies will fail. Indeed, that is a large part of why Bear Stearns, AIG, Lehman and other giant companies failed.
Now, the CDS vultures are turning their focus on Main Street.
As Markit analyst Paul Davies wrote yesterday:"Credit derivative markets turned their attention away from financial armageddon towards plain old recession on Wednesday morning, pushing up the costs of protection on the main indices for the first time this week."(Markit is the leading analyst of European derivatives).
And Markit analyst Gavan Nolan wrote today:
"A recessionary mood is setting in, with the number of widening credits [i.e. increasing bets that companies will fail] in the Markit iTraxx Europe index outnumbering tightening names by 5 to 1 . . . Supermarket chains - often thought of as defensive names - were among the worst performers. The move was indicative of the negative sentiment affecting the market. More illustrious companies, such as luxury goods firm LVMH, also widened sharply."In other words, the bet-makers think that the economic crisis has trickled down from Wall Street to Main Street, and are starting to wager real money that supermarkets and other Main Street businesses will fail. This, in turn, will make it more expensive for Main Street to do business, increasing the damage done by the financial crisis.
October 21st is Pay Day
October 10th was "D-Day", where D stands for "derivatives". That was the day that an auction for Lehman's $400 billion dollars worth of credit default swaps determined that sellers of swaps would have to pay out 91.375 cents on the dollar.
October 21st is "Pay Day", when those liabilities actually have to be paid by the counterparties to Lehman's CDS.
The Depository Trust and Clearing Corporation- one of the main companies which handles processing and payments of CDS - has estimated the total Lehman CDS payout at only $6 billion dollars.
However, a finance & banking analyst at RGE Monitor says that the real payout would, in fact, be much closer to $360 billion dollars, and certainly more than $200 billion dollars.
As leading economist and RGE Monitor writer Nouriel Roubini says:
"After AIG, monolines and hedge funds are likely to scramble to raise cash for Lehman settlement on October 21, while banks enjoy access to Fed liquidity. The notional payout is likely to amount to $360bn (91% of $400bn). AIG received $85bn + $37bn already to respond to immediate CDS margin calls after Lehman's default, 10 dealer banks opened a $70bn liquidity pool to accomodate novations of contracts with new counterparties--> hedge funds and monolines, insurers, SPV are likely to owe the remaining $50bn or so by October 21."
Bailouts Have Failed: Banks Are Still Hoarding Cash
Despite spending trillions of dollars on the bailout plans, banks are still hoarding cash.
Why?
Because:
- They have huge derivatives liability (especially on credit default swaps), and they are trying to build up enough of a nest egg to be able to pay off their derivatives debts
- They're stashing cash to try to ride out the financial crisis in general
- Some are even using the money to buy up rivals
The feds handed out all of the dough without keeping any control whatsoever to make sure the banks used the money to lend out to Main Street.
The feds' hope that the banks would use the money to lend out to Main Street is about as smart as handing over your wallet to a robber based upon the hope that he'll pay your bills with it.
Wednesday, October 15, 2008
Is China Shielded From Derivatives?
Conventional wisdom is that China is shielded from the derivatives hurricane battering the rest of the world. For example, an article in the Financial Times says (partly tongue-in-cheek):
Asia . . . shunned the easy profits promised by the peddlers of toxic derivative products and fancy collateralised debt obligations. Its banks eked out a respectable living through the sensible business of lending money, its manufacturers through the old-fashioned practice of making things.
Is this true?
Well, China has in fact allowed currency derivatives, gold futures, and other types of plain vanilla derivatives trades.
And China apparently has had problems with a unique type of derivative called an "accumulator", betting against an inverted Euro curve. Indeed, when the Euro curve inverted, people demanded that the Chinese banks pay out on the derivatives, and they have simply refused to do so. See this and this.
Chinese banks have also purchased credit default swaps in Lehman and other American companies. As China Stakes reported on September 20th:
"China’s banking authorities have been rocked by Wall Street's financial crisis and are worried about the risks facing Chinese banks and financial institutions. Analysts repeat that the crisis has perhaps only begun and may worsen.
***
According to Caijing Magazine, Chinese-funded banks hold assets worth dozens of billions of dollars related to Lehman . . . . These assets include direct-held bonds, loans to Lehman, and bond-related derivatives with Lehman . . . ."
So China is clearly not totally insulated from foreign derivatives.
However, China did largely avoid the repackaged mortgage derivatives known as CDOs.
Moreover, China passed derivatives regulations in 2004 which aim to "specify qualifications, standardize trading behaviour, contain trading risk and ensure financial safety". It is not clear whether or not such regulations were effective (or even enforced). But given that the U.S. has not regulated derivatives at all, this is better than nothing.
So the bottom line is that China does have some derivatives exposure, but probably less than Western countries. As one blogger puts it "state owned Chinese Banks . . . have far less exposure to derivatives" than Western banks.
Hedge Funds' Derivatives Exposure and Margin Calls Driving Stock Market Crash
Leading economist Nouriel Roubini explains in bullet-point form how hedge funds are driving the stock market collapse. Take careful note of how credit default swaps are a key factor in the stock market sell-off, and how another type of derivative - "collateralized fund obligations" - may be the next shoe to drop:
- Oct 15: Lehman Brothers Holdings Inc.'s hedge-fund clients may have to pay more collateral on $65 billion of assets frozen when the investment bank went bankrupt a month ago--> "If your bank fails, you still have to pay your mortgage." Moreover, hedge funds are among the net sellers of credit protection in the $54 trillion credit derivatives environment and might be called to perform on their obligations wrt Lehman, WaMu, Kaupthing, etc.
- Oct 1: There are dozens of hedge funds whose Lehman prime-brokerage accounts were frozen when the company filed for protection from creditors on Sept. 15. "One executive who used Lehman as a prime broker -- and who asked not to be named because his firm is private -- estimates that hedge funds had between $50 billion and $70 billion in Lehman prime-brokerage accounts." Moreover, hedge funds had pledged equity securities as collateral that Lehman then loaned to other investors under a practice known as rehypothecation - PWC says in that case "clients may cease to have any proprietary interest in them."
***
- Perfect Storm for Hedge Funds: Short-selling rules were altered in a flash, the implosion of brokerages reduces the possibility for borrowing money, they’re stuck with delevering, and to top it off, many are getting hit with redemptions as September comes to a close, marking the end of the year for many funds. (MarketBeat) Redemptions could lead to fire sales and vicious circle.
- FT Alphaville: Because so many firms hold similar positions, forced selling by one in response to redemptions can have ripple effects, forcing other funds to sell. More nimble hedge funds have sought to profit from the dynamic by taking short positions in securities known to be widely held by rivals --> HF adopt strategies to take advantage of competitors' unwinding positions
- NYT: In the month of July, hedge funds experienced nearly $12 billion in outflows. September 30 is the deadline when many funds are scheduled to accept withdrawal requests for the end of the year. To pay back investors, some funds may be forced to dump investments at a time when the markets are already shaky thus fuelling a vicious circle--> some hedge funds are reported to block withdrawals.
- Attari/Ruckes: Redemption feature causes fundamental maturity mismatch with borrowing short term and lending/investing long-term and illiquid e.g. in leveraged loans--> when redemptions increase, hedge funds have no other choice than liquidate assets thus fuelling a negative spiral. Evidence from leveraged loan market shows that this is unravelling is underway.
- cont.: Rating agencies start to downgrade collateralized fund obligations (C.F.O.) which are the hedge fund equivalent of mortgage-backed securities: securities backed by hedge funds. Some have a 7-year lock-up period. While few in number, C.F.O.’s represent a broad swath of the $2 trillion industry.
- About 350 were liquidated in the first half of the year and if the trend continues, the number of closures would be up 24 percent this year from 2007.
- Seides (InvestorsInsight): Hedge funds are sellers of 32% of all CDS, insuring exposure of $14.5 trillion. Recent estimates indicate that the entire hedge fund market is approximately $2.5 trillion in net assets under management. Thus, hedge funds are bearing risk in excess of their ability to pay the piper if anything goes wrong--> risk might well land again with former investment banks and broker dealers.
- Roubini: “one cannot rule out that some systemically important hedge fund may get into trouble with systemic consequences.”
***
***
Fire or Ice: Are We Headed Towards Hyperinflation or Deflation?
The most important debate among economists, high-level investment advisors and financial experts is whether the U.S. economy will heat up or cool down - that is, whether it will go into runaway inflation or deflation.
"Hyperinflation" is runaway inflation. This is what Germany experienced in the 1920s's, where people had to literally pay barrels full of German marks to buy a loaf of bread.
Deflation is what the U.S. experienced in the Great Depression, where most people had no one had money to spend, hire employees, or do much of anything else.
If we're going into hyperinflation, then investments like gold - which tend to hold their value in inflation - are best. In this case, the government should stop printing money like its Monopoly money.
If instead, we're going into deflation, then cash or treasury bills hold their value the best. Because prices go down in a depression, each dollar is worth much more, and is a good thing to hold onto for investing purposes. In this case, the government should spend more to get things going.
The Argument for Hyperinflation
Whenever governments inject a lot of money into the system, it tends to cause inflation.Why?
Because there are more dollars chasing the same amount of goods and services, which increases demand while keeping supply the same, which encourages sellers to raise prices.
The government has been injecting trillions of dollars into the system with its series of bailouts and "loans". Indeed, a Bloomberg analyst says that the supposed $700 billion bailout alone could balloon to $5 trillion dollars. And there are many trillion dollars in numerous other bailouts, federal guarantees of Fannie and Freddie's liabilities, and "loans" to financial institutions through the Fed's Open Market operations.
Indeed, according to the Wall Street Journal:
"The U.S. central bank said Monday it would provide unlimited dollars to the European Central Bank, Bank of England and Swiss National Bank, allowing them to relieve pressure on commercial banks across their regions. "Do dollars given abroad cause inflation inside the U.S.? Yes - because some proportion of those dollars will be spent by Europeans to buy stocks, commodities, goods and services within the U.S.
No wonder billionaire investor Jim Rogers says we are facing an "inflationary holocaust".
Thomas Wagner argues that the U.S. will experience massive inflation when China finally decides to dump the U.S. as a prized customer, and spends all of its stashed dollars buying U.S. commodities.
Steve Randy Waldman argues that inflation will win out, because Americans will not put up with deflation.
Even Warren Buffet says:
The policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.And Peter Schiff, the manager of 1 billion in funds, argues in his bestselling book Crash Proof that Americans should get all of their investments outside the U.S. (and into Europe and Asia), because America will suffer hyperinflation.
The Argument for Deflation
On the other hand, a new report shows that US retail sales are plummeting more than expected.A second report shows that producer prices are falling.
A third report shows industrial production is plummeting (and see this).
A fourth report from the Federal Reserve also points to a slowdown. As summarized by MarketWatch:
A broad slowdown in economic activity was under way by the end of September, according to the latest report on economic activity released Wednesday by the Federal Reserve.Consumer spending was down in most regions. Factory activity was also slow.Even more worrisome was the downturn in "nonfinancial services," which has been the backbone of economic activity.Residential real-estate and construction activity weakened or remained low, according to the report, known as the Beige Book. Most districts also reported slower commercial real-estate activity.
***Labor-market conditions also deteriorated and wage pressures remained muted.
- At least 29 states are facing huge budget shortfalls, and many are begging the federal government for bailouts of loans. For example, California - one of the world's largest economies - is begging the feds for billions
- Local governments are also in trouble. For example, facing a huge hole in Chicago's current and upcoming budgets, Mayor Richard Daley announced on Tuesday a plan to partially shut down city government for six days
International trade and shipping is declining (for example, see this).
Banks are hoarding cash (instead of lending it out) to try to weather the financial crisis. Indeed, surging foreclosures may wipe out any reassurance to the banks caused by the Treasury's bailouts.
And Americans are spending much less and borrowing much less because of the economic crisis.
Agricultural commodities are falling off a cliff. And energy costs are declining.
Top officials from the Fed are warning of a deepening recession, leading economist Nouriel Roubini is calling a severe recession in the U.S., and the International Monetary Fund is forecasting U.S. and global recession. Indeed, even China is not immune.
All of this points to deflation and potentially depression, as most people have less available money, which means fewer dollars chasing the same goods and services, which means falling prices.
Indeed, as CNN notes:
"The credit market crisis, combined with the recent stock market declines and the plunge in home values over the past two years, is setting off the deflationary alarm bells for economists.
Paul Kasriel, chief economist with Northern Trust in Chicago, said most bouts of deflation have started with sharp declines in assets such as stocks or homes. That has tended to lead to a loss of value of collateral for loans and ultimately, large losses by lenders and very tight credit.
***
This week, San Francisco Federal Reserve Bank President Janet Yellen broke a taboo among Fed officials when she said in a speech that the economy "appears to be in a recession."
But in the same speech, she was reluctant to use the word deflation, even though she danced around the concept. She said falling commodity prices, job losses and weak demand for products were likely to "push inflation down to, and possibly even below, rates ... consistent with price stability."
MoneyWatch's Dominic Frisby thinks the depressed mood indicates we'll experience deflation - at least for a while - even though governments are trying to inflate their way out of deflation.
Richard Russell, who has published Dow Theory Letters since 1958, believes that we are on the eve of world deflation:
“From what I see, the markets are telling us to prepare for hard times, and a global spate of the worst deflation to be seen in generations. This is why gold has been sinking, this is why stocks have been falling - big money, sophisticated money, is cashing out, raising cash, preparing for world deflation.”
URALSIB writes:
"Under normal circumstances, an increase in dollars would hike inflationary risks but these are not normal circumstances. The crisis on the world’s credit markets is rapidly slowing the circulation of dollars which will offset the effects of an increase in global money supply. At the same time, the looming recession in the developed world is pushing down prices for raw materials, goods and services and creating deflationary rather than inflationary pressures."Karl Deninger argues that deflation will win out because bankers profit more during deflationary environments. He thinks that Bernanke's talk about throwing money from a helicopter is just that - talk.
Oxford Economics professor John N. Muellbauer - an expert on U.S. inflation - wrote on October 10th:
The world is on the cusp of an inflation “turning point”, so the standard models are likely to go badly wrong. Recent research with better models suggests that the US inflation rate could become negative within the next 18 months.
No wonder people like Mike Shedlock of the popular website Global Economic Analysis, and investment advisor at Sitka Pacific Capital Management, argues that we are headed for deflation (Shedlock follows the Austrian school's definition of inflation and deflation; see this article by a former employee of the Federal Reserve Board of Governors and the Securities and Exchange Commission explaining the Austrian view of inflation and deflation).
Some people argue that we will get severe stagflation. In other words, high inflation and economic stagnation occuring simultaneously and remaining unchecked for a period of time.
Some believe we might experience conditions that makes America's bout with stagflation in the 1970's look like a walk in the park.
Indeed, some argue that we may experience a hyperinflationary depression, where the economy experiences both hyperinflation and depression. For example, economist and leading inflation expert John Williams argues:
"By the time hyperinflation kicks in, the economy already should be in depression, and the hyperinflation quickly should pull the economy into a great depression. Uncontained inflation is likely to bring normal commercial activity to a halt."Williams argues that - at least for a while - the entire monetary system will break down when this happens. Williams argues that, in the absence of a monetary system, people will turn to barter.
He makes the following specific recommendations:
With standard currency and electronic payment systems non-functional, commerce quickly would devolve into black markets for goods and services and a barter system.
Unlike Zimbabwe, the United States does not have widely available, for circulation, a back-up reserve currency for use in place of a highly-inflated domestic currency. The alternative here is in the traditional monetary precious metals. Gold and silver both are likely to retain real value and would be exchangeable for goods and services. Silver would help provide smaller change for less costly transactions.
Other items that would be highly barterable would include bottles of a good scotch or wine, or canned goods, for example. Similar items that have a long shelf life can be stocked in advance of the problem, and otherwise would be consumable if the terrible inflation never came. Separately, individuals, such as doctors and carpenters, who provide broadly useable services, would have a service to barter.
A note of caution was raised once by one of my old economics professors, who had spent part of his childhood living in a barter economy. He told a story of how his father had traded a shirt for a can of sardines. The father decided to open the can and eat the sardines, but he found the sardines had gone bad. Nonetheless, the canned sardines had taken on a monetary value.
Reserves of the Necessities of Life. Howard J. Ruff, who has been writing about these problems and issues since Nixon closed the Gold window, rightly argues that it will take some time for a barter system to be established, and suggests that individuals should build up a six-month store of goods to cover themselves and their families in the difficult times. Mr. Ruff covers this and many other excellent fundamentals in his new book How to Prosper During the Coming Bad Years in the 21st Century (see recommended further reading at the end of this report).
Financial Hedges. During these times, safety and liquidity remain key concerns for investments, as investors look to preserve their assets and wealth through what are going to be close to the most difficult of times.
In such a circumstance, gold and silver would be primary hedging tools that would retain real value and also be portable in the event of possible civil turmoil. Also, at some point, the failure of the world’s primary reserve currency will lead to the structuring of a new global currency system. I would not be surprised to find gold as part of the new system, structured in there in an effort to sell the system to the public.
Real estate also would provide a basic hedge, but it lacks the portability and liquidity of gold. Having some funds invested offshore — outside of the U.S. dollar — would be a plus in circumstances where the government might impose currency or capital controls.
While equities do provide something of an inflation hedge — revenues and profits get expressed in current dollars — they also reflect underlying economic and political fundamentals. I still look for U.S. stocks to take an ultimate 90% hit, peak-to-trough, net of inflation, during this period [Williams wrote this in April 2008]. Where all stocks are tied to a certain extent to the broad market — to the way investors are valuing equities — such a large hit on the broad market will tend to have a dampening effect on nearly all equity prices, irrespective of the quality of a given company or a given industry."
Williams wrote the above in April, but on October 16th he wrote: "Inflationary Recession Remains Intact and Intensifies", so he does not think that the bailouts and other government actions are helping to prevent an inflationary recession.
Personally, I hope and pray that Williams is wrong, but I have the gut feeling that he is right.
Of course, if the money system does collapse, we can use that as a window of opportunity to build a better world.
Listen to the following 2 debates between leading some leading proponents of inflation and deflation here and here.
Tuesday, October 14, 2008
Feds Give Hundreds of Billions to Banks, But Get Only NON-VOTING Shares in Return
Paulson's original bailout plan was so ill-conceived, and the markets reacted so poorly, that he had to copy the European model of buying shares in banks in return for injections of capital. As Kenneth S. Rogoff, a professor of economics at Harvard, said, “The Europeans not only provided a blueprint, but forced our hand”.
But the European governments get voting shares in return for bailing out their banks. With voting shares, the governments could force the banks to operate in the best interests of the country, make sure they loan to consumers and small business, and take other action necessary to get their economies back on their feet.
With voting rights, the European governments can also insist that the banks stop buying and selling risky derivatives, which are one of the root causes of the economic crisis.
In contrast, America's bank buy-out gives the government non-voting shares. In other words, the feds can say pretty please, but they have no voting power.
This flies in the face of U.S. history as well. As the Wall Street Journal notes:
"During the Depression, the Reconstruction Finance Corp. bought billions of dollars of preferred stock that came with voting rights. The government then barred banks from paying dividends until they had bought out the government's stakes. This time, the government stakes are nonvoting and the dividend restrictions are less onerous."
Without voting rights, the banks can keep on doing the same things that got them (and our economy) into trouble in the first place.
Update: As an article in Bloomberg entitled "Paulson Lacks Leverage to Compel Banks to Put New Cash to Work" puts it:
"The equity stakes the government is purchasing ... come with no guarantee that the investments will spur lending and unfreeze credit markets. Nor do they give the government board seats or any other leverage to demand that that the firms actually use the money to help the economy.
``The truth of the matter is, they can't put a gun to their head and say you have to lend this money,'' said Charles Horn, a former official at the Office of the Comptroller of the Currency, part of the Treasury Department, and now a partner at the Mayer Brown law firm in Washington.
Treasury officials acknowledge they can't force banks to get the taxpayer money into the hands of their customers. Instead, officials are betting that the government's investment will create conditions where banks have a greater incentive to earn profits from lending than to hoard money to shore up their balance sheets.
***
Subtle government pressure on banks may not make much difference . . . the U.S. won't take a major share of the banks they invest in. Also, the Treasury has said it won't seek voting rights when it buys stakes."
NSA Tapped 9/11 Hijackers' Phone Calls for 2 Years - Inside the U.S.
I've previously pointed out that the U.S. government heard the 9/11 plans from the hijackers' own mouth. Most of what I wrote about involved the NSA and other intelligence services tapping top Al Qaeda operatives' phone calls outside the U.S.
However, it turns out that the NSA was also tapping the hijackers' phone calls inside the U.S.
Specifically, hijackers Khalid al-Mihdhar and Nawaf al-Hazmi lived in San Diego, California, for 2 years before 9/11. Numerous phone calls between al-Mihdhar and Nawaf al-Hazmi in San Diego and a high-level Al Qaeda operations base in Yemen were made in those 2 years.
The NSA had been tapping and eavesdropping on all calls made from that Yemen phone for years. So NSA recorded all of these phone calls.
Indeed, the CIA knew as far back as 1999 that al-Mihdhar was coming to the U.S. Specifically, in 1999, CIA operatives tailing al-Mihdha in Kuala Lumpur, Malaysia, obtained a copy of his passport. It contained visas for both Malaysia and the U.S., so they knew it was likely he would go from Kuala Lumpur to America.
The above information comes from James Bamford, the Washington Investigative Producer for ABC's World News Tonight with Peter Jennings for almost a decade - where he won a number of journalism awards for his coverage national security issues - whose articles have appeared in dozens of publications, including cover stories for the New York Times Magazine, Washington Post Magazine, and the Los Angeles Times Magazine, and is the only author to write any books (he wrote 3) on the NSA.
Israel Companies Handle Sensitive U.S. Spying Data
You might take comfort in the assumption that - if the U.S. government is spying on Americans - at least patriotic Americans are handling our sensitive information.
However, at least two foreign companies play key roles in processing the information.
Specifically, an Israeli company called Narus processes all of the information tapped by AT &T (AT & T taps, and gives to the NSA, copies of all phone calls it processes), and an Israeli company called Verint processes information tapped by Verizon (Verizon also taps, and gives to the NSA, all of its calls).
Even worse, two top Verint executives have already pled guilty of fraud and various felonies. And the founder and CEO of Verint is on the run. He's literally a fugitive from justice hiding out in Namibia.
The above information comes from James Bamford, the Washington Investigative Producer for ABC's World News Tonight with Peter Jennings for almost a decade - where he won a number of journalism awards for his coverage national security issues - whose articles have appeared in dozens of publications, including cover stories for the New York Times Magazine, Washington Post Magazine, and the Los Angeles Times Magazine, and is the only author to write any books (he wrote 3) on the NSA.
Kids Decide Who Lives or Dies in Iraq
You probably assume that high-level military and intelligence officers decide who gets thrown into the Abu Ghraib prison to get tortured, and whose house gets bombed in Iraq.
That's not how it works.
It turns out that kids fresh out of high school decide. Specifically, young people with only sixty-three weeks of training in in standard Arabic at Monterey, California make these life-or-death calls. They have usually have no training in Iraqi dialects, and don't have any real-world experience.
After their stint at Monterey, they are transferred to Fort Gordon, Georgia, where they work for the NSA. In that capacity, they listen into phone calls between Iraqis, and decide who lives, who gets tortured, who dies:
"it’s these people here that are sitting in this windowless room in the state of Georgia, near Augusta, Georgia, that are listening to these conversations in Iraq, in Baghdad, and they’re making instantaneous decisions on whether somebody is telling the truth or not. So they’re writing out these—they’re doing these transcripts, and then they’re writing these little comments saying this person here, Ali, is saying he’s going to deliver a load of melons to his cousin Mohammed tomorrow. And then you have somebody making a decision: is he telling the truth, or isn’t he? Are these melons, or possibly could they be IEDs? And if a person says, 'You know, I don’t think he’s telling the truth,' there’s a good chance that that house could be blown up or that person could be put in Abu Ghraib, or whatever."
The above information comes from James Bamford, the Washington Investigative Producer for ABC's World News Tonight with Peter Jennings for almost a decade - where he won a number of journalism awards for his coverage national security issues - whose articles have appeared in dozens of publications, including cover stories for the New York Times Magazine, Washington Post Magazine, and the Los Angeles Times Magazine, and is the only author to write any books (he wrote 3) on the NSA.
Monday, October 13, 2008
Helicopter Gordon, Helicopter Nicolas and Helicopter Angela
Fed chairman Ben Bernanke is nicknamed "Helicopter Ben" because he said years ago he would drop money out of a helicopter to fight deflation. And the U.S. has spent trillions in the last couple of months to try to artificially stop deflation.
Now, the European Union is now spending $2.5 trillion dollars on their bailout as well, including hundreds of billions each by British prime minister Gordon Brown, German chancellor Angela Merkel, and French president Nicolas Sarkozy.
Helicopter Gordon, Helicopter Angela and Helicopter Nicolas have now joined Helicopter Ben in throwing money at the problem, instead of fixing the real problems with the world's economy, like derivatives.
The Economy: Good News and Bad News
The stock market has reacted favorably to the European and American emergency economic plans launched over the weekend, with its biggest 1-day rise ever.
But as everyone knows, the stock market doesn't give the real picture . . . it only provides a superficial snapshot of investor mood (and - perhaps - a shove from the PPT).
So what is really going on underneath the surface?
Good NewsBNP Paribas reports that the weekend efforts have lowered the inter-bank lending rate (LIBOR), the main indicator of a "liquidity crisis". As summarized by economist Nouriel Roubini:
Credit spreads start to ease:Moreover, the cost of credit default swap protection dropped for many European banks:
- O/N USD LIBOR: 246bp down from 463bp (17bp pre-crisis);
- TED spread (3m LIBOR-T-bill spread) slightly down to 456 from record 463 earlier on Oct 13 after Fed announces unlimited USD liquidity (17bp pre-crisis);
- 3M USD LIBOR-OIS slightly down to 359 from 364 (10bp pre-crisis);
- 3M EUR LIBOR-OIS narrows to 182bp from 207 (10bp pre-crisis)
This shows that the bet-makers are somewhat reassured by the weekend moves, and believe that the risk of failure of these banks has lessened somewhat (it is not clear how much the nationalization of the Royal Bank of Scotland and other institutions affected the credit default swap rates)."Royal Bank of Scotland and Halifax-Bank of Scotland were two of the biggest improvers in credit derivatives markets Monday morning even as shares in both tanked after the finalisation of the UK government plan to inject both groups with fresh capital.
The falling cost of protection for most leading banks and insurers in Europe helped the iTraxx investment grade index to rally sharply, taking 6.3 basis points of the spread to 131.8bp, according to data from markit Group. This mimicked the wave of relief that swept stock markets broadly in Europe, although the dilutive effect of the measures on RBS and HBoS shareholders saw their stocks pummelled.
However, RBS led the way in credit default swap markets with its cost of protection dropping about 44.5bp to about 144.2bp, according to Markit, which means it costs €144,200 annually to insure €10m worth of debt over five years. UBS was next, 31.3bp lower at 185bp, while HBoS followed 31.2bp tighter at 155.8bp."
Bad News
On the other hand, nothing has fundamentally changed concerning America's underlying economic problems.
This week, reports on retail sales figures, industrial production and housing starts will be released, and they will all be bad.
America is already deeply in debt and the various bailout schemes will increase our debt by two or more times.
America is losing its status as the world's reserve currency.
We have no real manufacturing base, haven't saved anything, haven't fixed the derivatives nightmare, and haven't decided to bite the bullet and go back to sound policy or sound money.
And forget the housing meltdown, there could be wholly-unrelated additional meltdowns on the horizon (see this for example).
Forecast
Because the fundamentals are getting worse, rather than better, my guess is that today's stock market rally is a several week long bear market bounce, and that there are more crashes ahead.
Investor euphoria over the flooding of money into the system by central banks will eventually give rise to disillusionment as the fact that you cannot patch a busted dam with water becomes clear.
Sunday, October 12, 2008
Europe to United States: You're On Your Own!
Bush begged the G-7 to help fix America's economic meltdown. Like a drowning man trying to hang onto the back of a good swimmer, he pleadingly said "We're all in this together."
But nothing concrete came out of the G-7 meeting, as the European countries weren't willing to slit their own throats to help the U.S. Instead, right after the G-7 broke up, the European countries met in Paris and agreed to concrete proposals to protect Europe from the economic crisis.
In response, Paulson begged for a joint response:
"Appealing for global unity in a time of crisis, Treasury Secretary Henry Paulson said Sunday that isolationism and protectionism do not offer a way to contain the spreading damage."
Will Europe be able to save itself? Stay tuned for updates . . .
Saturday, October 11, 2008
The Next Derivatives Bloodbath: Insurance and Auto Makers
This essay is about future derivatives problems. But before we look to the future, let's recap what happened yesterday, to gain some perspective.
Post-Game Analysis on Lehman
As the Washington Post writes today about yesterday's auction of some $400 billion dollars in credit default swaps for Lehman:
'If we see defaults from the standpoint that protection sellers don't pay up, then we're going to have a huge problem in the market,' Telpner said. 'But we don't have any explicit evidence indicating that sellers ultimately are not going to be able to pay the amounts owed to buyers.'
And the Sunday Times writes today:
"The valuation leaves the insurers of the debt a bill of about $365 billion. It is not clear whether the insurers, which are required to settle the bill in the next two weeks, will be able to pay – a development that could further undermine increasingly stressed capital markets."Will the "insurers" of Lehman's CDS be able to pay up? The big bank insurers to the Lehman swaps have been hoarding cash, and so can presumably pay.
The bigger question is whether the hedge funds - such as Citadel - will be able to pay up or will go belly up. The next couple of weeks will tell.
But even if no companies are wiped out by their Lehman CDS obligations, it is clear that yesterday was, indeed, a traumatic day for the world economy. As today's Sunday Times article put it:
"Lehman’s corporate debt default promises to increase the stress across global credit markets. Sean Egan, of the Egan-Jones ratings agency, said: 'This is a killer. Lehman said a month ago that it was in terrific shape and now you can’t even get ten cents on the dollar for its debt.
'It underscores the deep structural flaws in our financial system, knocks confidence in the financial markets and raises the cost of capital. It also demonstrates that we are experiencing not only a crisis of confidence, but a crisis.'"
Next Up: Automakers
The next phase of the derivatives wipeout will hit insurance companies and auto makers.
Initially, Standard and Poor's is saying that GM and Ford may very well go bankrupt.
As of 2004, "GM was among the five companies most frequently included in credit-derivatives contracts in 2004, along with Ford Motor Co., France Telecom SA, DaimlerChrysler AG and Deutsche Telekom AG, Fitch said."
Indeed, according to Fitch's, as of 2004 and 2005, there were perhaps billions of dollars in GM credit default swaps traded per day. Fitch's noted that "GM CDS are the second most included named in synthetic collateralized debt obligations (CDOs), behind Ford, as disclosed in several Fitch analyses of the CDS market."
On October 3rd, Bloomberg wrote:
General Motors Corp. saw its credit default swaps rise to a record after the automaker said Sept. 19 it was going to draw down the remainder of a $4.5 billion revolving credit line to preserve cash because of the instability in the financial markets. Detroit-based GM, the largest U.S. carmaker, has lost almost $70 billion since 2004.As of June of this year, "The cost to insure GM's debt with credit default swaps rose to 33.5 percent upfront . . . plus annual payments of 500 basis points" and "Ford saw its credit default swap spread increased to 30.5 percent upfront, plus 500 basis points annually".
According to financial advisor Mike "Mish" Shedlock, there are appromixately one trillion dollars of credit default swaps for GM.
If GM goes bust, there would be huge credit default swap liability. While I have seen no estimates of the current amount of Ford CDS, it is probably also quite high, given that it was one of the most common CDS issued in 2004.
Insurance
The insurance companies are also getting hit hard by CDS.
The October 3rd Bloomberg article states:
"The cost to protect against default by Hartford, Prudential Financial Inc. and MetLife Inc. soared to records and shares fell yesterday on speculation that turmoil in financial markets may be spreading to insurance companies."As an article at Naked Capitalism explains:
First it was banks and securities firms, and now the focus of worry has widened to include insurance companies. Reader John referred us to a Reuters article that MetLife credit default swaps are now trading on an upfront basis, which means buyers of protection against the default of MetLife bonds must make an upfront payment as well as agreeing to periodic fees. Only companies seen as being in serious risk of failure trade on an upfront basis. Another story shows similar pricing of XL Capital CDS.Instead of being the end of the derivatives bloodbath, Lehman was probably just the beginning.
Concerns about MetLife became serious when the company announced it was writing down its investment portfolio and withdrew its 2008 earnings forecast.
From Reuters:Metlife Inc's credit default swaps on began trading on an upfront basis on Thursday, indicating perceptions that its credit quality is considered distressed.The second Reuters story:
The cost to insure Metlife's debt rose to around 10.5 percent the sum insured as an upfront sum, or $1.05 million to insure $10 million in debt for five years, in addition to annual premiums of 5 percent, according to Markit Intraday.
The swaps had closed on Wednesday at a spread of around 717 basis points, or $717,00 per year for five years to insure $10 million in debt, according to Markit.Credit default swaps on XL Capital Ltd [an insurance copmany] began trading on an upfront basis on Thursday, and its stock price plunged more than 37 percent.
The cost to insure XL's debt rose to around 12.5 percent the sum insured as an upfront sum, or $1.25 million to insure $10 million in debt for five years, in addition to annual premiums of 5 percent, according to Phoenix Partners Group....
The swaps had opened at a spread of around 750 basis points, or $750,00 per year for five years to insure $10 million in debt, according to Phoenix.
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