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."

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).

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.

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).

Why?

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.

http://ftalphaville.ft.com/blog/2008/12/18/50594/
of-deutsche-bonds-and-conspiracies/

The Debts of The Spenders: Foreclosures Doubled Before Great Depression

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

http://research.stlouisfed.org/publications/review/08/11/Wheelock.pdf

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.

Why?

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.