Wednesday, December 24, 2008

The Debts of the Spenders: Lehman Bros - The Road to Hyper Deflation

When Paulson let LEH go bankrupt I was very surprised. Didn't he realize that LEH was a critical counter-party to many OTC derivative trades? Didn't he know that LEH was a primary dealer intimately connected to the world banking system? Didn't he know that LEH had clients all over the world?

For whatever reason(s), Paulson made a move that led to hyper-deflation this fall and early winter. LEH's collapse wiped out dozens of counterparties - starting with AIG - that has since rippled around the world. The first few cracks were visible and easily contained (AIG and the shorting ban).

BUT, like throwing a stone at a glass window, the cracks spread in a spider web pattern and branched out into dozens, then scores, and now possibly hundreds of smaller branches throughout the global economy. Even those institutions and individuals not directly exposed to LEH's trades became affected. The massive amount of debt destruction was reflected in the record TED spread and impending collapse of the money markets back in October.

Emerging markets were also another victim, then commercial real estate, then commodities, and now retail.

Credit or debt (depending on your viewpoint) is THE lifeblood of the modern economy. Debt allows borrowers to leverage their returns. It grants the small business and average person the ability to achieve in years what took their ancestors generations to achieve - the attainment of wealth (or at least its trappings). Just look at student loans for example. For larger institutions, the returns were phenomenal. Several hundred or even thousand percent returns in months and even weeks were possible (at least on paper).

I am not repeating anything that most readers here already know. I think it's just necessary sometimes to take a step back and analyze the trees from the forest. We get caught up in day-day market movements instead of looking at the bigger picture.

And for the inflation watchers...don't worry, I haven't forgotten you. My next article is called, "Obama: The Road to Hyper-Inflation."

Tuesday, December 23, 2008

The Debts of the Spenders: Obama's Choices Pt 2

I am not dismissive of the inflation side here. What Bernanke and Paulson are trying to do is "controlled inflation", e.g. off balance sheet currency debasement. This has NEVER been done before in history. NEVER.

They are shoveling all the private sector junk onto the govt's balance sheet and then pushing it onto foreigners. That's why the conversion thesis remains 100% reliant on net foreign creditors like China and Japan continual purchase of Treasuries to keep monetary inflation bottled up behind institutional walls.

Bernanke and Paulson then think they will be able to "dole" or distribute the inflationary money supply through select govt relief programs - aka consumer stimulus, Detroit stimulus, commercial real estate (CRE ) stimulus, etc.

Whether or not their theory succeeds in the longer term is another issue altogether. However at the moment all the central banks in the world are cooperating w/the US.

As for inflation, it will first make its way known through depressed commodity supplies...namely food and energy (mostly oil).

Non-renewable commodities like oil are at depletion levels. If you believe in peak oil (as I do), then you know that when the crunch comes it will be violent and quick. Any type of accord that the US forges w/foreign creditors could collapse in the face of resource wars.

At this point, the US creditors are simply waiting for Bush to expire so they can negotiate w/the Obama team. The US will likely have to surrender some sort of sovereignty rights that it took for granted in the past. Maybe rights for foreigners to own land, invest in "strategic" businesses, etc. Similar to what the US banksters did when they journeyed to Japan in the 1990s to force open their corporate markets.

There will be nationalist backlashes but I believe Obama is a practical man and will compromise w/our foreign creditors. He has to. There is really no other alternative (unless he triggers a Treasury default and no one wants that).

Sunday, December 21, 2008

The Debts of The Spenders: Obama's 3 Choices

Which Is Most Likely?

A) Default on Federal Debt (Treasury market)

B) Restructure Debt (Bankruptcy/Bretton Woods 2)

C) Conversion

I will go through each option to explore the pros and cons.

A) Default - This is the apocalypse scenario favored by goldbugs.

Under a default scenario, the US federal government will default on its external debt obligations.

While the authorities can wipe out US debt in a single stroke the consequences are catastrophic. Looting and mass riots are the symptoms on the domestic front. Internationally the collapse of the dollar will mean even more widespread chaos in emerging markets and ripple effects among the remaining G7. The largest creditor nations will also face hyperinflation as their contractual debt claims would be wiped out. Nations that depend on US foreign aid in order to function will become suddenly isolated (Israel and Taiwan).

Winners: Agriculture, Energy, Guns, Canned Food, Gold (short term), US Taxpayer
Losers: Everything except the above

B) Debt Restructure (Bankruptcy) - Bretton Woods 2. An international consortium of G7 and powerful emerging market nations will form the parameters of a new world order.

A new currency would replace the dollar. This "New Dollar" would be backed by the full faith and credit of the new world order instead of the US government.

Treasury holders will lose most of their holdings although sovereign (international government) creditors would be given options, warrants, or some form of IOU that places them in a senior position to other debt holders. Institutional holders of Treasuries would be next in line. Finally the retail holders of Treasuries and state government debt would be wiped out. Make no mistake. This is an attempt to preserve the status quo but the price will be high.

Winners: US Govt, emerging markets, large foreign governments, agriculture, energy, corporate (FIXED INTEREST) bonds, non-Western Banking Cartel
Losers: Cash, inflation bugs, retail US govt debt holders (treasuries and munis), corporate CALLABLE (variable) bonds, US Taxpayer, Western Banking Cartel

C) Conversion: All existing US government obligations will be converted into EXTREMELY long term, low, fixed interest loans. Treasuries would be smoothed out to 50 and even 100 year maturities. The Federal Reserve would buy home mortgages outright from the banks and then offer the homeowner rates as low as 1-3%. This is basically a Japanese "Lost Decade" taken to extremes - global slowdown that will last 30-40 years minimally.

Note - This option is ONLY AVAILABLE TO THE US. There can be only one quantitative easing beast in the world and that is the US government. Other nations that try to emulate this model will be only partially successful.

The UK, EU nations, Japan, and maybe even China WILL try to copy the low interest, long term rates and be partially successful in doing so at the institutional level through DOLLAR DENOMINATED credit swaps run by the Fed or a new government agency.
But, they will still have to offer higher interest rates on their debt refinancing because there simply are not enough institutional or retail buyers to soak up all the new bond issuances.

Winners: US Fed govt, Western banking cartel, US State govts, US corporate bonds (fixed interest), agriculture, energy
Losers: Agency Debt holders, Corporate (variable) bonds, foreign govt bonds, commodity dependent emerging markets (Russia, OPEC, Latin American banana republics), smaller manufacturing based emerging markets (Vietnam, Taiwan, S. Korea), US Taxpayer

Conclusion: Out of the 3 options above, I believe US authorities are leaning towards #3 since it is the solution that best preserves the status quo. However, the conversion policy runs a VERY HIGH risk of triggering mass social unrest in less stable, foreign governments - particularly the commodity dependent emerging markets such as Russia, OPEC states, and virtually all of Latin America.

Saturday, December 20, 2008

The Debts of the Spenders: Are Callable Bonds The Heralds of The Next Storm?

The new threat is the callable bond.

Callable bonds are like options for the issuer. Issuers have the right - but not the obligation - to redeem the bond before maturity at the call price.

Callable bond holders are compensated for this uncertainty by getting paid a higher coupon (interest rate).

In options terms, the bond buyers are the option sellers. They get paid a premium to assume extra risk.

Callable bond issuers benefit because they bet on interest rates to fall at some time before maturity so they can refinance their debt at a cheaper rate. Similarly the bond holder benefits when interest rates fall and the bond's value rises. When the debt is redeemed it is done so at a premium to benefit the bond buyer. So, the bond buyer benefits 2x:

a) higher coupon and
b) higher premium.

The difference b/t options and bonds is that the bond buyers EXPECT the bond issuers to redeem at some point. There is an implied assumption that the bond seller will try to refinance the debt for the reason I just explained in the prior paragraph. It is expected and priced into the market.

If bond issuers do NOT redeem WHEN interest rates have fallen to new lows, they risk upsetting the bond markets and panicking bond holders (aka institutions).


The automatic assumption among the bond holders is that the bond issuer is at such risk that NO ONE wants to refinance their debt because of...

Potential Default.

So which sectors issue the most callable bonds?

Munis, commercial real estate, and European banks.

The Debts of The Spenders: Foreclosures Doubled Before Great Depression

Foreclosures started to double before the Great Depression.
The parallels are eerie.

Thursday, December 18, 2008

The Debts of the Spenders: Gold Update

I have gotten some mail from goldbugs who apparently hate my calls. They have also been flooding my mailbox with the COMEX gold short conspiracy theory.

The COMEX theory states that gold is basically being shorted on the commodities exchange by banks in a coordinated effort. I will not bother addressing the merits of such a case except to say that ALL commodity classes have fallen significantly. Oil, agriculture, and industrial metals have declined much more substantially than gold. Gold retains intrinsic value but the possibility of gold $5k/ounce remain remote.

Please readers you misunderstand me. I am not an enemy of gold or precious metals.

I have no position in gold. I am not shorting gold. Nor do I have a long position.
Gold rallies on 2 things: 1) FEAR and 2) INFLATION.

1) There remains a lot of fear in the market. Who knows where the next time bomb is?

2) Global govts continue to cut interest rates. Highly inflationary (for them).

I prefer to remain neutral and just watch gold. I believe that there are better inflation/fear plays out there - like agriculture. People need to eat food. They do not need to eat gold bars.

The Debts of the Spenders: Detroit Bailout And Treasuries

Detroit will NOT be bailed out. Instead there will be a negotiated bankruptcy.


Because of the Treasury ponzi scheme. EVERY single US financial print media - WSJ, Financial Times, Investor's Business Daily, Barron's, etc. - is against an auto bailout. At least in the UAW's, Michigan politicians', and auto corporations' proposed form of TARP funding.

A bailout will undermine the shadow banking system of Treasury swaps and TARP re-capitalization of the financials. The money would be going into the real economy - UAW, creditors, Detroit councilmens' districts, etc. - as opposed to staying w/in the digital boundaries of the Fed's playland.

Wednesday, December 17, 2008

The Debts Of The Spenders: Deflation Summarized

You have to understand 5 things here and then it becomes very simple from there.

1) Excess money creation led to this problem
2) Money creation is not just limited to govt actors
3) Pvt actors can create money too (no not counterfeiting) through loan syndications and tranche bundling.
4) These pvt debts were created on leverage and fantasy accounting
5) When loans and tranches become marked to 0 money is destroyed.

Since all this private supply of money is basically 0 or in limbo land then the mkt reacts accordingly. Hence deflation.

This is my biggest disagreement w/gold bugs who keep calling for hyperinflation. They say money creation is only possible from govt actors. NOT TRUE. The pvt sector was minting money at the ratios of over 90:1 (Lehman and Bear Sterns).

Who knows how much imaginary money and leverage there still out of there?

Why are the banks now leveraged 20:1? Why even 10:1?

Friday, December 12, 2008

The Debts Of The Spenders: Naked Treasury Shorts and Failures To Deliver Part 2

When I say the primary broker dealers are shorting treasuries I mean that they are delaying delivery on future obligations by witholding them in order to increase the intensity of the bidding.

Their actions result in de facto shorting.

Alternately, another way of looking at it is to see that these primary broker dealers are the same charity cases that accepted TARP money in the form of Treasuries. And those Treasuries are the ONLY thing holding up their balance sheets (which should be uniformly negative by now). Given such a situation, the primary dealers have a powerful incentive to hoard the Treasuries they have in order to meet investor scrutiny.

Imagine an auctioneer being assisted by helpful agents (The Fed) in the room bidding up the price amid a crowd of frantic rubes. The way the secondary market works is that the primary dealers get to buy govt paper at a discount and then sell it on the secondary (repo) market w/a slight markup for their services. That's the way it works in normal times.

The majority of the traders in this market are institutions but remember that not all institutions are built equally. We have the primary dealers (This is the same group that I write about in my earlier article, "The Libor Cartel") and then everybody else (wealthy individuals, regional banks, credit unions, pension funds, foreign governments, state governments, charities, endowments, etc.).

Pay special attention to the regional banks. These banks are the same entities that are also feeding from the TARP trough but are STILL hemoraghing cash from: sour commercial real estate loans, sour residential mortgage loans, sour trade loans, sour CDS bets, etc. They also have an incentive to meet analyst expectations by stuffing their balance sheets w/Treasuries to offset the horrendous fiscal reality of their finances.

The best example was the fierce bidding in the 4 week paper where there was NEGATIVE interest rates earlier this week in intra-day trading.

So, why is this allowed to happen?

This arbitrage is allowed to happen because of the antiquated method of settlement.
The value and quantity of bonds traded and the value and quantity settled are not the
same because of the process known as “netting.” In netting trade obligations, the Fixed Income Clearing Corporation, or FICC, uses bonds due to a participant to offset bonds due from the same participant in the same security. In many cases, there is NO ACTUAL DELIVERY of the treasuries because in their infinite wisdom our regulators believe that this process simplifies final settlement.

The markets say otherwise. Instead it allows a group of greedy, well connected profiteers to plunder billions from institutions and accelerate the cash flow problems for the broader financial sector. It is impossible to know just how badly the secondary buyers have been cheated because propietary data identifying specific parties is hard to come by.

HOWEVER, the parlous status of state and local finances in the muni bond market reflects just how badly governments have been violated by the chosen few of Wall Street.

The promise to deliver in the secondary market is backed by very lax penalties. This is actually a gray legal area that some academics have drawn attention to in the past. The problems have only accelerated exponentially since that time.

Apparently, the Treasury and Fed believe this to be a small price to pay in their in their broader policy of quantitative easing and - gasp - dare I say it, re-capitalizing the banks at the expense of the taxpayers (again).


The Debts Of The Spenders: Naked Treasury Shorts And Failures To Deliver

There is an incredible amount of naked shorting of Treasuries.

You have to look at failures to deliver since they are the root of the problem. Until the Treasury implements a real "penalty" for treasury holders (aka primary dealers) that refuse to surrender their bonds in a timely manner then there will be no fix.

Paulson won't investigate the problem b/c he knows that the banks have been playing an arbitrage game against the slight fees and penalties they incur. In fact he and Bernanke are ENCOURAGING it as part of their quantitative easing policy.

To see why we must examine repos. A repo is essentially an unsecured "loan" or promise backed by nothing more than the primary dealer's "full faith and credit" to deliver the asset in a timely manner. (Sounds suspiciously like Uncle Sam? Where else did you think the big boys learned such irresponsible behavior from?)

To understand why the repo market is malfunctioning we have to examine the "I know it when I see it" test made famous by Justice Potter Stewart of the Supreme Court when he tried to explain "hard-core" pornography, or what is obscene, by saying, "I shall not today attempt further to define the kinds of material I understand to be embraced . . . [b]ut I know it when I see it . . . Jacobellis v. Ohio, 378 U.S. 184, 197 (1964).

In other words something funny is going on in Wall Street. But then again something funny is ALWAYS going on in Wall Street. The question we have to ask ourselves is "Exactly how does Wall St benefit from delayed deliveries of Treasuries?"

The repo market is suffering from a liquidity crunch w/all kinds of maturities - not just bills. In fact I am going so far as to say that many of the primary dealers would become de facto insolvent if they were to honor their obligations RIGHT NOW.

Even the new treasury auction schedules won't help for 3 and 7 year notes. It's the REPO market that matters and repo buyers want the paper that they are familiar and comfortable with - not something that has unknown liquidity.

The result is that most treasury funds have simply stopped accepting new clients. W/interest rates so low the fund managers are squeezed for fees and can't legally justify dipping into the investors' principal to pay themselves.

Wednesday, December 10, 2008

The Debts of the Spenders: 0% Interest Rates On Treasuries

What does it mean?

The government is refinancing. They sell the bonds at 0% and then can pay off longer term bonds at higher percents.

The gold and inflation bugs got it all wrong because they are effectively shorting the dollar, shorting Treasuries, and betting on inflation.


Deflation is here to stay for a bit longer.

The best time to short Treasuries is when interest rates approach 0% or go negative (depending on the term we are talking about) because there is literally no further room to go.

But in this kind of environment all you can do w/that trade is short term scalping. The longer term trade will be after the Fed cuts to .5%

I say after instead of before because we remain in a deflationary spiral for the short - medium term. Normally the rates would go back up. Especially w/all the money printing going on.

BUT, just look at the case of Japan for an ex of what didn't happen according to plan.

A lot of yen bond shorts got destroyed or made only marginal returns in the mid-90s to first part of the 21st century because the BOJ continues to keep rates below 1%.

Monday, December 8, 2008

The Debts Of The Spenders: Pension Funds Beg Congress To Suspend Billions

In contributions. US pension contribution laws require corporate America to contribute significantly to employee retirement funds. Unfortunately, these contributions amount to a fiscal burden that is too heavy for many to bear.

The companies are de facto shifting the burden of retirement and healthcare costs onto the balance sheet of first the state and then federal governments.

State governments will have to contend w/lost business tax revenues, lost tax credits offered to these businesses, Medicaid contributions. These drawbacks are IN ADDITION to the plunging property tax revenues that local governments traditionally base the bulk of their budgets on.

The Federal government will have to contend w/unemployment benefits costs, food stamp costs, Medicaid contributions, lost income tax revenues, and possibly pension benefit guarantee costs (through the Pension Benefit Guaranty Corporation or PBGC that extends coverage to defined benefit plans) at the very least.

Thursday, December 4, 2008

The Debts of the Lenders: Dubai Property Implosion

It is FINALLY happening.

Condo flippers walking away are the first sign of trouble. The worst part (for them) is that there is a HUGE glut of inventory just about to come online in the market. This reminds me of Florida in early 2007.

Unfortunately, the UAE government is likely to repeat the mistakes of global governments
elsewhere. All of their fancy economics and finance degrees only boil down to one thing: print more money. Or in this case, slash interest rates . . . for now anyway.

Dubai's property bubble is financed on the expectation of $100+/oil and built by the toil of horriblly paid and treated workers from Muslim South Asia (overwhelmingly Pakistan and Bangladesh). These foreigners are a prime recruiting target for Al Qaeda and other Muslim extremist groups.

After all, what further proof do the imams need to demonstrate of the way mainstream Muslim leaders have isolated themselves from the common man? These workers know firsthand the kind of world they are forever barred from entering b/c they were building it w/their own hands.

Of course the UAE elite will respond by cutting interest rates and taking other means of printing money to protect the wealthy speculators. For all their fancy econ and finance degrees that's the only thing govt ministers know how to do. This will invite food and energy inflation - 2 areas which disproportionately affect the poor. And when that happens Dubai will be sitting on a powder keg.

The Debts of the Spenders: Muni Bond Ratings Are Worthless

At best ratings agencies are pressured by politicians to give local governments higher grades so that they may qualify for cheaper refinancing. At worst there is blatant lying or obfuscation of the off balance sheet fiscal weakness of these governments. Why?

Because state governments are run on politically necessary but fiscally unviable promises to select voter groups. The same situation exists at the federal level but Treasuries remain protected by large global actors such as the entire Far East, Middle East, and even the US' own Treasury purchases.

In 1929, more than 98 percent of the largest U.S. cities were rated Aa or better, according to Ciccarone’s research, which cites a study of municipal bonds showing that 3,252 issues went into default at the peak of the economic contraction in 1935. Almost half the bonds in default were rated Aaa in 1929.

“We may be facing the same conditions today that we did in the 1930s, but they could be worse because of pension and other liabilities,” Ciccarone said. “We have some huge liabilities at the same time that real estate values are falling.”

Wednesday, December 3, 2008

The Debts of the Spenders: What Is Quantitative Easing?

This is a continuation of my earlier post on the Fed buying Treasuries.

You might hear the term "quantitative easing" being thrown around by media pundits (as if they have a clue what it really means). So, what does it mean?

Quantitative easing is a term used to describe the fiscal and monetary policies of central banks in a zero or near zero short term interest rate environment. It was first applied by Japan during the 1990s. After Japan's equity markets imploded in the late 1980s, the BOJ repeatedly cut interest rates to nearly 0 percent. When these actions failed to stop the tide of poor economic data from affecting the markets, the authorities started buying its own longer term debt and then the debt of its banks. Their intent was to encourage less spending and more consumption by the consumer sector. The results were disappointing to say the least.

The overall effect was to keep Japan's banks on life support. Critics derided Japan's financial sector as "zombie banks". Notable critics included Greenspan, Bernanke, and other luminaries from the US who flew to Japan and lectured their authorities on what bad boys they had been.

Well. Fast forward 8 or 9 years to the present. The hypocrisy is astounding.

We now have the Fed buying Treasuries from the Treasury. But the Fed has scaled operations up significantly. Instead of just buying government debt, they have also taken on mortgage backed loans, credit cards, student loans, auto financing, and other commercial paper junk that will never see the light of full (model) valuation again.

When will it stop? No one knows exactly but the government looks prepared to bail out the Detroit 3 automakers and their staggering legacy costs.

Moreover, the situation is worse than any comparisons to 1990s era Japan. The Japanese economy is overwhelmingly geared towards exports while the US economy is geared towards consumer consumption. A staggering 65-70% of US GDP derives from consumer spending...the vast majority of which was built on the credit bubble.

The Japanese consumer is also more responsible than his or her US counterpart. Nowhere else in history have people been able to buy 5 or 6 houses w/no money down and w/no job. Nowhere else in the world are people able to buy cars and then trade them 2 or 3 years later for a newer model. And nowhere else in the world are people able to buy tvs, computers, and furniture w/zero percent financing for 18 months and no payments for 2 years. The worst part is that this culture of profligacy is still continuing during the holiday season.

So, can the US borrow its way out of a deficit?

I don't know but there is over 3% left on 30 year Treasuries left to go! After that the government might get the bright idea of issuing 100 year notes or even perpetuals. Don't laugh. The UK is still paying off World War I war bonds or perpetual gilts. But who would be dumb enough to buy government paper that has 0 inflationary protection, is callable, and is thinly traded?

Even China can't be that dumb. . .

Monday, December 1, 2008

The Debts of the Spenders: The Fed Is the Greatest Treasury Bull

The Fed is empowered to buy and sell Treasuries. Taken by itself this is not unusual and in fact forms a normal part of its operations. However, the Fed is now engaged in record buying of Treasuries that goes well beyond its traditional mandate.

The effect of Bernanke being the main buyer at recent auctions has been a record push of T-bills and T-notes to nearly zero percent interest rates. The government's aim is to force people to look for alternative investment channels that can offer higher returns, e.g., equities and corporate bonds.

This strategy will work. . . at least in theory. Investors remain wary of equities for a good reason. The fundamentals have not changed and have in fact gotten a lot worse. Corporate bond markets are a little better but the yields in some areas are priced for armageddon - commercial real estate and property funds are offering (forward) dividends in the triple digits (percentage wise)! More conservative bonds are pushing the low double digits. So, does this mean that corporate bonds are now the next green pasture to attract the Treasury bulls?


Institutions have to be convinced first. Since bonds are denominated in increments of roughly $10k or more the debt markets remain the domain of the big boys. Unfortunately for the government, many institutions have conservative mandates that require them to invest in less risky asset classes. And that has meant US government paper. For now anyway. I would not be surprised to see fund managers with links to dubious (aka troubled) firms lobbying the SEC and other regulators to allow them to change their investing mandates in the near future.

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