Saturday, September 27, 2008

The Debts of the Spenders: Lack of Trust Has Created A Nation Of Savers

For years academics and a few far sighted economists have railed against the lack of American savings.

Well, we finally got our wish. Just not in the way we expected.

In the past 4 weeks, the USA has gone from being a nation on credit to a nation of savers. BUT the impetus of this change is based on fear of the banking system collapsing.

This change is not just limited to individual depositors but has spread to institutions. Banks and companies are now hoarding cash, reluctant to lend it out except at the most exorbitant rates (see my prior article on the credit markets).

The impetus of this fear is the federal government's misguided actions at attempting to "solve" the financial crisis. Companies that fail are normally supposed to enter receivership or conservatorship. Their creditors are entitled to a fair hearing before a bankruptcy court to determine the allocation of assets. Different "tranches" or levels of creditors were relatively insulated from losses by the underlying common and preferred stock shareholders who would bear the brunt of the losses.

All of that has changed.

Now, the feds are literally making it up as they go along. Financial institutions are collapsing left and right with only the chosen few allowed to survive.

We now live in an environment of uncertainty.

Institutions were the first to withdraw funds. Now Main Street is panicking and extracting their 401k money from mutual funds. Even foreign investors have caught on and are cautiously taking their capital out of the US.

Thursday, September 25, 2008

The Debts of the Spenders: CDS Part II (Private Casino of the Rich and Infamous)

In case I didn't make clear in the last entry, CDS (credit default swaps) are the rich's private futures market.

Unlike regulated futures markets such as the CBOT or NYMEX where financial instruments are traded openly, CDS are traded in the OTC (Over the Counter) market. This means that there is no way to transparently view pricing mechanisms. It is difficult - but not impossible - to find the bid and ask price spreads.

In the NORMAL futures market, brokers act quickly to shut down losing trades. They do this by requiring customers to post more margin or liquidate existing accounts. There is a clear chain of responsibility in the futures exchanges - in the unlikely event customers are unable to meet their trading losses, their brokerage firms are responsible for meeting the losses. In the even more distant possibility of default by the wirehouses, the exchange itself is obligated to make the counterparties whole. Finally, both the brokers and exchanges possess billions of dollars worth of individual insurance.

There is NO such mechanism in the CDS market. In fact, until a few days ago the CDS market was not even regulated! Traders played in a gray realm of insurance, futures, and options compliance where the market was deemed "too big to fail".

Trading losses were bundled into mortgage packaged loans (CDOs or collateralized debt obligations) and sold to unwitting suckers like the NY Teachers Pension Fund or some village in Japan. When this private casino finally collapsed, Wall Street approached Main Street to ask taxpayers to pay for their gambling debts.

Monday, September 22, 2008

The Debts of the World: Credit Markets Explained

Most investors focus on the DOW, Nasdaq, and other stock indices. These are widely known metrics that attract the media spotlight.

Less well known however are the credit markets. Credit markets are the realm of the big players - the place where commercial paper and other short term loans - are traded between banks, insurance companies, and industrial giants. This is the "shadow banking system" where companies obtain financing for short term financing - w/terms as short as overnight. The bid and ask spreads in this lending system are opaque and are called "dark pools of liquidity" since there is little if any government oversight. And taking place front and center in the credit markets is the TED spread.

The TED spread is a measure of liquidity and shows the degree to which banks are willing to lend money to one another. The name comes from a combination of "T-Bill" (3 month US debt) and "Ed" (the ticker symbol for 3 month Eurodollar futures). The T-bill part is set by US bond markets while the Ed part is set by British bond markets. The British bond market is set by the LIBOR or London Inter Bank Offered Rate.

It is also an indicator of market perception of credit risk, as T-bills are considered risk free while the LIBOR rate reflects counterparty credit risk in lending between commercial banks. As the TED spread increases, the risk of default (also known as counterparty risk) is considered to be increasing, and investors will develop a preference for safer investments.

Spread sizes are denominated in basis points or percentage points. For ex: when the T-Bills are trading at 3.1% and Ed trading at 3.8%, the TED is said to be trading at .5% or 50 basis points.

During the past week, the TED spread rose dramatically as T-bill interest rates declined substantially while LIBOR rose. This huge gap was at one point close to 9%. It may not sound like a lot but consider that the TED spread is usually less than 1%.

The high spread was potentially lethal to banks and other financial institutions raised in an environment of cheap debt and poor capital w/lending ratios as high as 30:1. Case in point - Lehman Bros. had a 30:1 leveraged debt ratio and had to file bankruptcy last Monday.

Saturday, September 20, 2008

The Debts of the Spenders: CDS (Credit Default Swaps) Explained

Credit default swaps (CDS) are a credit derivative. Like other derivatives, CDS are bets on future outcomes. But instead of betting on the price of orange juice or coffee, a CDS contract is a bet between two parties on whether or not a company will default on its bonds (e.g. go bankrupt).

They are called credit because they are speculating on the price of credit (bond payments). They are called default because they are speculating on whether that company will default. And finally they are called swaps because ANY 3rd party (that is major US/UK bank or insurance company) can participate. Thus a company like AIG could sell CDS to Ford to protect Ford in the case of a default. But AIG could also sell CDS to ANYONE else. Only the big boys played this game since the premium payments were so high.

In a typical CDS, the “protection buyer” gets a large payoff from the “protection seller” if the company defaults within a certain period of time, while the “protection seller” collects periodic payments from the “protection buyer” for assuming the risk of default. Just like normal insurance companies, CDS sellers collected premiums or insurance payments on a regular basis - usually every 3 months.

Unlike normal insurance, "protection buyers" were not just limited to the underlying company. Noooo. Protection sellers were willing and able to sell CDS to ANYONE with the money as long as they met regulatory standards and had the cash.

A seller like AIG could sit back and collect $320,000 a year ($80k/every 3 months) in premiums just for selling “protection” on a risky BBB junk bond from a crap company like Ford. The premiums are “free” money – free until the bond actually goes into default, when AIG could be on the hook for $100 million in claims. Remember, just like insurance the seller only charges a miniscule percentage of the total insured amount. However, they are insuring astoundingly large amounts of money here - $100 million and up. This means that only big guys can play - who else can afford to pay $80k every 3 months w/no guarantee of payment? And to do so on a scale of dozens of different CDS contracts? Not even private millionaires have the cash to participate.

And there’s the catch: what if AIG doesn’t have the $100 million? What if 10 "protection buyers" had bought CDS from AIG and now demand a total of $1 billion? AIG is screwed and goes into bankruptcy; but both parties are claiming the derivative as an asset on their books, which they now have to write down.

Players who have “hedged their bets” by betting both ways cannot collect on their winning bets; and that means they cannot afford to pay their losing bets, causing other players to also default on their bets. The result is a chain reaction that kills every major bank/insurance company in the US/UK (CDS ONLY exist in the US/UK due to "free market" principles).

Oh here's the best part - CDS aren't available to the public. They are only traded between the big boys on their own private computer networks. That means, no one - except them - knows the true price until the whole house of cards collapses.

The Federal Reserve is literally owned by a cartel of 19 banks. These are the guys who get cheap interest loans from the Fed (this is called the Fed Funds rate) and then sell it to smaller banks at higher interest. This is the ONLY reason why the Fed/Treasury acted together. They had to protect their oligopoly over dollars.

The Debts of the Spenders: Negative Interest on Treasuries

Negative interest rates on treasuries mean the bond buyer is receiving less than what he originally paid for! While this may be a short term solution to fears about the economic system it is not a viable longer term solution. Who would want to buy an investment like that?

Eventually buyers would migrate out of the country towards more attractive foreign locales.

The Debts of the Spenders: Foreign Reaction To Bailouts

Look at Line 3

Thursday, September 18, 2008

The Debts of the Spenders: Return to Level 3 Accounting

Since some of you have been asking for Level 3 accounting, here is a short review:

Under FASB terminology, Level 1 means mark-to-market, where an asset's worth is based on a real price. Level 2 is mark-to- model, an estimate based on observable inputs and used when there aren't any quoted prices available. Level 3 values are based on “unobservable” inputs reflecting companies' “own assumptions” about the way assets would be priced.

Wednesday, September 17, 2008

The Debts of the World: Hyperinflation Meets Hyperdeflation

I admit I was wrong about gold and continued dollar strength this week. All of the classic history cases have gold rising solely due to hyper-inflation. Most of the gold bug web sites and other subscription channels repeat the hyperinflationary environments astheir textbook cases to go long gold.

I based most of my analysis on the Japanese deflation of the 1990s inthe wake of their market crash. During the 90s gold sold off a little and didn't rise much. This is because in Japan, the process was moreor less orderly and well managed by the government and big banks.

The USA is different. I assumed the Fed and Treasury would be able to manage things in much the same way as the Japanese and hold things off until after the election is finished. Instead, the debt monster has grown so huge that the efforts of the government and banks to gently unwind the beast have failed repeatedly. They know the trend is down and are trying to calm things in an orderly fashion but are losing power. Each time they intervene there is less and less effect. This is the law of diminishing returns.

The catalyst for gold's super rise today was the bailout of AIG latelast night. People got scared that the markets will fall faster and harder down the road. Also, treasuries have reached capitulation.Foreigners are beginning to exit the dollar and focus on protectingtheir own countries' economies.

Conclusion - We are in an environment of both hyperinflation and hyperdeflation. This is normally an impossible thing to achieve. However the USA's unique position as the biggest debtor in worldhistory living well beyond its means is responsible for the current market environment.

Wednesday, September 10, 2008

The Debts of the World: Deflation Part III

It's not just here in the US we have asset deflation.

Countries worldwide are experiencing the bursting of bubbles.

There are 3 types of international economies undergoing asset deflation - commodity based exporters, manufacturing based exporters, and mature economies. Commodity based exporters - United Arab Emirates, Iran, Venezuela, Russia, Brazil, Australia, Kuwait, Saudi Arabia.

Manufacturing based exporters - China, Vietnam, Taiwan, S. Korea, Mexico.

Mature economies - UK, Ireland, Japan

ALL of these countries have one thing in common - BIG real estate bubbles and in many cases big stock market bubbles too.

Many of these countries built too much too fast. Just look at China or the Middle East.

Who else builds 20 skyscrapers a month? A 7 star hotel in the desert?

China has even worse problems than we do - their stock market is ALSO deflating. The Shanghai index has been down for the past 3-4 months (look at FXP - Ultrashort China ETF for ex.).

I repeat, gold will NOT rise in value until the asset deflating is done. Until then, all these foreign countries are piling into Treasuries and buying more time for the US to do more bailouts. The full effects of hyperinflation will begin sometime next year.

Tuesday, September 9, 2008

The Debts of the World: Deflation Part II

Some of you asked for examples of deflation.

Well, here they are:

1) Deflation in housing (lower prices),
2) deflation in credit (stricter lending standards),
3) deflation in commodities (oil, gold, and corn were the most egregious offenders),
4) and now deflation in equities (DOW and S+P ran up to ridiculous levels).

Yes, the money supply is increasing, including M3.

This is going to lead to inflation...but we won't fully feel its effects for a while. Normally, gold should shoot up like a rocket.

However, the gold bugs forget one little detail - the unique position of the USA as the world's biggest economic engine.

Foreigners HAVE to keep buying dollars - either directly on the fx markets or through Treasuries and/or agency debt. They NEED our consumers fat and happy to run their factories and prime the oil pumps. They NEED to keep their currencies competitive for their exporters to be strong.

We WILL fully feel inflation's time; perhaps as early as late November. Until then, the Fed/Treasury is re-loading for another round of bailouts.

The Debts of the Spenders: If they Build It, They Won't Come

Commercial real estate has been speculating for years on an ever growing supply of credit among consumers. Few stopped to question whether that money would keep on coming.

Now the consumer is tapped out...exhausted from an inexhaustable supply of layoffs, rising fuel costs, and other cost of living adjustments. Now, they can't even make it to the malls in time for X-mas. Expect a brutal holiday earnings season for the REITs and their tenants.

The Debts of the World: How Deflation is Killing Gold and Strengthening the Dollar

Enough about the conspiracy theories on banks shorting gold.

While there's a kernel of truth to that, the real story is in deflation.

I'm watching the BOND markets - not precious metals -for the realstory. There was a HUGE rush to Treasuries today because of the Lehman implosion.

Poor economies in the OECD are leading to a rush to cash - and no currency is more "safe" than the dollar. The retail investor is not used to thinking of debt as money...but it is the de facto currency of the institutions. All Treasuries and government paper is merely the present value of future payments. This leads to deflation buying more time for the government agencies to bail out their friends on Wall Street.

Effectively, when deflation is strong it gives the Treasury more ammo
for another round of bailouts. The ultimate, long term effects will beVERY bad for the US economy...but Paulson and Bernanke will be long gone by then or on the other side.

Just look at Greenspan - he now works for the Paulson hedge fund (no relation to Hank Paulson), which actively shorts sub-prime debt.

Chalk it up to institutional inertia by central banks and long standing tradition by formerly poor developing nations. Gold will keep on going down until the next President pulls an FDR.
Until then, we might see another short term rise if there is another banking bailout -possiblyas early as this weekend (the traditional time to bail out banks).

Saturday, September 6, 2008

The Debts of the Spenders: The Real Cost of a Bailout

Fannie and Freddie are back in the news again with a bailout this weekend. It looks like the CBO figures given in mid-July were criminally low.

Thursday, September 4, 2008

The Debts of the Spenders: Questioning Government Statistics

Last week's GDP figures were more than suspicious, they were outrageously false.

Tuesday, September 2, 2008

The Debts of the Spenders: Why the Dollar is Rallying

The fundamentals have not changed. The US economy remains as weak as ever.

What has changed are geo-politics and economic weakness in Europe. Inmany respects, we are in a "Race to the Bottom" w/the Europeans to seewhose economy does worse. Wall St led the pack for the past fewmonths. Now, it is the Europeans' turn. In this perverse game,"victory" is measured by how much better one's economy is inincremental comparisons to its peers.
Interestingly enough, the recent Russian-Georgian war has created ashort term boost to the dollar. The recent strength in the USD is notUSD strength per se, but Euro weakness. The fear is that Europe willbe involved in a war with Russia, and energy will be involved. Russiasupplies 25% of the EU's energy needs and over 50% to many EasternEuropean states. The EU is Russia's largest trading partner.