Catalyst for Jawboning

Over the last several days, the Fed has trotted out multiple spokesmen to suggest there might not be another round of trash credit creation (quantitative easing). The Dallas Fed's Fisher came out on Tuesday and suggested the program should not be extended when it ends in June and that things may already have gone too far. Lockhart of Atlanta stated "it's a high bar" in response to questions about QE3. Minneapolis' Korcherlakota stated the economy would have to "worsen materially" to extend the bond market manipulation. Finally, Plosser of the Philadelphia Fed recommended not merely stopping or even reversing the bond buying but also raising interest rates.

The central bank should set a pace for selling its mortgage and Treasury holdings in conjunction with raising interest rates, Plosser said today in a speech in New York. He suggested selling $125 billion for every 0.25 percentage-point rise in the benchmark rate to almost eliminate $1.5 trillion in bank reserves.

So why is the Fed so concerned suddenly after abusing their authority in blatant fashion for more than two years? Clearly they don't care about inflation - having inflicted a tripling of oil prices, a doubling of most grains and even worse in some commodities upon the world. It would seem that they are concerned that people are catching on to what they are doing and starting to point the finger in the right direction. So now they need to very publicly posture as "inflation fighters" until people's attention wavers. And the spotlight is definitely turning their way. As the Financial Times reports:

The finger of blame is increasingly pointing toward central banks and the US Federal Reserve in particular. By printing money through quantitative easing, there are supposedly more dollars, yen and pounds chasing the same number of Beefy Crunch Burritos. Fed chairman Ben Bernanke actually was asked during a speaking engagement last month whether the central bank was culpable for the revolution in Egypt.

“I think it’s entirely unfair to attribute excess demand pressures in emerging markets to US monetary policy because emerging markets have all the tools they need to address excess demand in those countries,” said the clearly annoyed banker.

But an increasingly common view is that, with the very best intentions, he is at fault. Critics regularly cite the words of Milton Friedman, who said that “inflation is always and everywhere a monetary phenomenon”.

Essentially, the Bernak is standing over the body with a bloody knife in his hands and the lights have just turned on. He seems determined to brazen it out and has sent out his minions to talk about all of the wonderful things he's done and will do if we just leave him alone with his power. This is all an attempt to distract attention for the Fed's culpability in the destruction of purchasing power worldwide.

It is all about perception. That is why the Fed cares about inflation expectations, even while deliberately inflicting inflation on the economy. They can more effectively steal the value of your savings and income if you don't know what is going on. That job becomes much harder when the population starts to adjust their thinking and behavior to account for the destructive acts of the Fed. It is so important to prevent that change in thought and deed that Paul Volcker once raised short-term interest rates above 15% to prevent it.

With the spotlight now focused firmly on the Fed, this weeks' jawboning is just the first act of their attempt to change the subject. If that doesn't work, they might actually be forced to DO something. In particular they will need to act to stymie commodity speculation - which is the portion of the iceberg that everyone can see, as it affects the daily life of nearly everyone. While they are also likely to attempt to prop up the stock market, it will be tough to do both at the same time since commodity producers and related firms have been a key driver of the new equity bubble.

With private lending in the US essentially dead, the government is the sole source of credit growth right now. If the debt limit interferes with further bubble finance at the same time as the Fed is forced to try and look responsible, the speculative markets could be in for a rough ride indeed.

The Permanent Bailout

Milton Friedman once said that "Nothing is so permanent as a temporary government program." The central banks, as rogue private bodies exercising governmental powers a proving that axiom true yet again. The Federal Reserve claimed yesterday that we are in a recovery but none of their emergency programs can be rolled back.

... the Committee decided today to continue expanding its holdings of securities as announced in November. In particular, the Committee is maintaining its existing policy of reinvesting principal payments from its securities holdings and intends to purchase $600 billion of longer-term Treasury securities by the end of the second quarter of 2011.

Meanwhile, over in Europe, there is growing recognition that the bailouts have failed and that the money isn't going to be paid back. Instead of actually admitting anything of the sort, the ECB is now talking about effectively making the loans permanent. Sure, they SAY it's going to be a 30 year loan instead of 3 years but if Ireland and Greece can't pay the money back now and continue to run deficits, what makes anyone think they'll be in a better position to pay it back later?

The question sort of answers itself. The bailouts are throwing good money after bad as every one of these banks is so far underwater they can't even see the surface from here. Without honest accounting, we have no idea just how deep that hole is but it certainly looks like a bottomless pit from here. It's been stunningly clear for a while now that so much bad debt needed to be purged from the system but the central and TBTF banks have made every effort to PREVENT such a purge.

(Wall) Street Corner Hustle
The latest brainstorm from the ECB is exactly the same sort of shell game. Greece and Ireland can't pay the money back and they know it. Instead of acknowledging reality, we'll just convert it into a long-term "loan" so they don't have to pay it back within the term and maybe even the lifetime of the people making the decisions. It can't be paid back and it won't be paid back but maybe they can keep up the lies for a little while longer.

This is simply more Extend and Pretend so that they can keep trying to fool people into impoverishing themselves by overspending and taking on too much debt to keep up the illusion. That is the meaning of "prosperity" in a keynesian ponzi economy. You use inflation to convince people to eat their seed corn, making them feel better - for a little while. This is why central bankers place so much emphasis on "confidence" - in practical terms that measures the willingness of the population to deplete their capital and eat their seed corn due to the inflationary deception of the central banks.

The UDB gave us the biggest illusion of false prosperity the world has ever seen. The bankers are now trying to cover their tracks and delay the inevitable hoping you'll forget their complicity. But the best simple summation can be found from the creators of South Park:

The Law

Here at Financial Jenga we have hoped, even prayed for the law to be enforced for the last couple of years. Yet the fraud has raged unchecked and if anything grown worse. Banks have mass filed false affidavits to fraudulently seize houses through the foreclosure process and then said "oopps, we made a technical paperwork error" when caught. At first they got away with it. They HAVE seized houses through this procedure when there was no mortgage and no lien at all.

The Fed has gone and done things far beyond the scope of authority given to it by Congress - like using our money to prop up the investment banks and the stock fraud they are running. They are given the power to buy exactly two thing - bonds carrying the full guarantee of the US government and short-term loans for planting of crops. Buying junk bonds containing mortgages violates both the letter and the spirit of their charter. Buying stocks is so far beyond their legal powers that someone should be in prison and probably a lot of someones.

No one has shown much sign of really stopping the Fed yet but the Massachusetts Supreme Judicial Court landed a major blow for the law today by confirming a lower court ruling that nullified two foreclosures because they plaintiffs couldn't show they owned the property. In both cases, "robosigned" affidavits were introduced as proof of ownership and later shown to be without merit.

The state Supreme Judicial Court today upheld a judge’s decision saying two foreclosures were invalid because the banks didn’t prove they owned the mortgages, which he said were improperly transferred into two mortgage-backed trusts. As reported by Bloomberg:

“We agree with the judge that the plaintiffs, who were not the original mortgagees, failed to make the required showing that they were the holders of the mortgages at the time of foreclosure,” Justice Ralph D. Gants wrote.

While there have been many similar rulings across the country, this is the first such decision by a state supreme court. And since property law is still properly the jurisdiction of the states, this decision is final as far as Massachusetts is concerned. Hopefully they will follow up with prosecutions for the mass of fraud represented by those false affidavits.

And this entire financial crisis is bound up with a struggle to centralize political power in Washington. One of the key enablers of the late-bubble madness was the effective nullification of state lending regulations. This was done in 2004 when the Office of Comptroller of the Currency used federal preemption to overrule state laws against predatory lending. It was one of the worst moments of the Bush Administration:

The Office of the Comptroller of the Currency Feb. 21 published for comment a ruling that Georgia's predatory lending law, the Georgia Fair Lending Act (GFLA), is preempted for national banks.

At the same time, it issued two advisory letters to national banks to clarify its expectations for banks to avoid involvement with "predatory" lending practices.

So basically, the OCC's action wiped out state legal protections against predatory lending. And they substituted a finger wagging "don't do it" with a nudge and a wink to just go ahead. And of course the very worst mortgage paper was written over the next three years after the change. We have documented the results of those no-doc, alt-A and option ARM loans here from the very beginning. But those abusive mortgages would not have been possible without Washington stepping in to remove the legal shield that states provided their citizens.

The Shadow Knows

Today's topic is Shadow Inventory - the foreclosed or soon to be foreclosed properties that banks are stuck with and which are not listed for sale. As a result, they are not found in any formal listing of housing inventory when existing home sales are reported. This has been a problem for a long time, as we mentioned many months ago in Household De-formation.

The media's silence on this issue has been almost total. Probably because any reasonable discussion of the topic would severely undermine the illusion of stability they are trying to project. This weekend, the Wall Street Journal took a stab at estimating the damage. Their conclusion is that it would take 107 MONTHS to clear the shadow inventory at current sales rates. Obviously not a number that the bankers and their apologists in government and media are anxious to publicize.

Over the summer, banks appeared to be making some headway. The government’s mortgage-modification program helped some people get current on their payments, taking their homes out of the foreclosure pipeline. At the same time, homebuyer tax credits helped boost sales. Combined real and shadow inventory fell to 91 months of sales in May.

Lately, though, a new wave of defaults appears to be coming in, in part related to the high rate of failures on government modifications. As of September, some 1.9 million homeowners had missed one payment on their mortgages, up 14% from March. Meanwhile, home sales have slowed sharply with the end of government stimulus.

The government "assistance" was never going to help many people, much less actually succeed on a large scale. However, it was helpful for the banks - aiding them in concealing the collapse of their collateral for another year or so (i.e. another Bonus Cycle).

But the good news is that we can expect the housing market to start to recover - in another eight or nine years.

Bank Debt Spiral

The zero interest rate policy (ZIRP) will kill the banks. Falling interest rates help banks by increasing the value of their bond and loan portfolios. This is the well understood inverse relationship between discount rate and present value of a future sum. But you see keeping interest rates at zero does virtually nothing for the banks as rates cannot fall further. There is a short window where ZIRP is a positive but an "extended period" (in Fedspeak) is just slow death for the banks.

During that short period, the banks are still collecting on portfolios constructed when rates were higher but as those higher-yielding assets mature, there is nothing comparable to replace them. We hear constantly how banks can just borrow at zero and invest in Treasuries - pocketing the difference. That would be fine if yields on Treasury debt were not low and falling along with everything else. The other problem is that this simplistic formula assumes that banks' operating expenses are negligible. Both unstated assumptions fail any sort of reality check.

Back in the real world, T-bills yield virtually nothing. The 2-year note is now at 50 basis points as of today. The 5-year is at 1.43% and the 10-year at 2.68%. Assuming zero borrowing cost (which is overly generous), net interest is equal to gross interest. Large banks generally require a net interest spread of more than 2% to cover their expenses, so they will lose money even buying 5-year Treasuries. If they invest their entire portfolio in 10-year notes, they'll make about a 50 basis point spread on assets pre-tax. But the 10 years is a lot of risk in terms of time for rates to change and also a long time to tie up the money. And banks care BARELY eke out a profit by taking this extreme level of maturity risk. There is a reason why you never see loan portfolios with 10 year average maturities.

For those advocates who think banks can rebuild their balance sheets by buying Treasuries, you might ultimately be correct but there are so many things that can go wrong with that scenario. First consider the size of the hole in bank balance sheets. Recent activity at the FDIC suggests that many troubled banks are overstating the value of their assets by 30% or more - that is the average size of the hit when the FDIC takes them over. At a rebuild rate of 50 basis points annually (with a lot of risk) it would take a literal lifetime to repair the balance sheets via this strategy. It was much easier in the early 1990s when rates for the 10-year started at 9% and never went below 5.5%. There was plenty of room to generate capital gains on bank bond portfolios wit falling rates and still leave a reasonable current yield at the end. Anybody using that era as a template for bank recovery is going to be sorely disappointed. Does anybody still wonder why Japan is trapped despite 20 years of ZIRP?

All of this assumes that ZIRP is sustainable over decades and that the financial system is sufficiently stable to endure the pressure over the long term. Neither one is proven and the ability to fund the debt implied by ZIRP is particularly shaky. If it works, it will take 60 years As one one of our favorite bloggers Karl Denninger says "the math is never wrong."

The Non-Comparison

It seems quite popular in these days of crisis for certain commentators to compare struggling individual states within the USA to the troubled Eurozone PIIGS (Portugal, Ireland, Italy, Greece and Spain). ECB President and Apologist in Chief for the Euro Jean-Claude Trichet (and boy isn't that a bunch of Capitalized Words strung together) is a prime example. A couple of weeks ago in a speech about the Greek Financial Crisis his remarks were summarized by Business Week:

He [Trichet] also played down the importance of Greece's economy on the euro region, which he said represents less than 3 percent of the bloc's GDP, especially when compared with the size of a U.S. state such as California.

A number of news outlets and blogger have echoed these sentiments so it behooves us to examine the validity of the comparison. On the pure surface level, Trichet is correct: California had a GSP of $1,850 billion in 2008, whereas Greece's GDP was less than one fifth as large at $343 billion. So we can conclude that he in not lying outright but what of the implied statement that California's financial problems are more important to the US than Greece's are to the Eurozone and EU? For this analysis we will leave aside the issue of the rest of the PIIGS.

For perspective, let's start with raw numbers. The debt of the Greek government hit 300 billion Euros two months ago making headlines around the financial world. At current exchange rates, this is over $400 billion and is surely higher today. The total general fund debt of California is LESS THAN $85 billion as of January 1, 2010. So in absolute terms, the Greek Problem is nearly FIVE TIMES LARGER than California's. In terms proportional to the size of the respective economies, the disparity becomes even more striking.


Implications of Federalism
With a little thought, the reason for this disparity should be obvious. California's state government brings in tax revenue of just under 5.0% of GSP and plans to spend 5.5% of GSP in the FY 2010 budget. Greece taxed 32.2% of GDP and spent 43.0% of GDP in 2009 as estimated by the CIA World Factbook. The state government of California is not the top-level sovereign even within its own borders. Federal taxation and spending within California far exceeds the comparable activities driven by Sacramento. In terms of government impact on the economy, the key is at the Federal level, not the state. So in addition to California's government problems being a much smaller deal overall, the consequences of failure would also be less for the population than would be the case in Greece. We can safely conclude that Trichet's statement, while true at first blush was highly misleading in its implications. There is simply no comparison between the gravity of the current crisis in Greece and the looming one in California.

Having dealt with that nonsense, let's talk about the rest of the PIIGS. These are all similar, top-level sovereign situations. It would appear that Portual is next, with Spain not far behind from the trading activity in CDS and the rising risk premiums being demanded. Italy is not nearly as badly off and it may be unfair to lump them in with the rest of this group; the market appears to be taking note of that as well. And then, there is Ireland.


Celtic Hedge Fund
Ireland is in for a tough time. Their total external debt was 1,637 billion Euros (roughly $2.23 trillion) as of September 30, 2009 with an economy of $177 billion per the CIA. Irish banks alone account for 41% of the debt. Another way to express this is that their banks owe foreigners over 500% of the nation's annual GDP. Many financial institutions are counted in the "Other" category which is nearly as large in terms of foreign obligations. The largest components would be insurance companies and pension funds. In all, Ireland's financial sector probably owes nearly 1,000% of GDP to overseas entities. This is a time bomb comparable in design to Iceland but with many times the explosive power. This is another nation being run like a hedge fund but Ireland currently owes more than 30x as much as Iceland going into their meltdown.

None of this is to suggest that the US doesn't have truly huge problems. But let's not be distracted by specious comparisons involving the states. In the US, the fate of sovereign credit will be determined almost entirely by the actions of the Federal government and the market's reaction to them. In the Eurozone, that same process will be resolved in the national capitals and possibly also in Berlin. Barring a decision by Germany to bail out other members, individual European nations can and will choose austerity or default themselves.

An Elegant Solution

The heads of the global banking cartel are currently gathered for their annual meeting in Davos, Switzerland. They have received enormous subsidies and bailouts at the expense of taxpayers in many nations all around the world. Those nations that possess representative governments are now beginning to respond to the outrage of their citizens at this gross injustice. In Britain, this has taken the form of a proposal to tax financial transactions. In the US, President Obama recently proposed regulations to limit the risk-taking activities of banks and to force the "too big to fail" institutions to shrink. The bankers' response is a proposal to take regulatory power away from national governments according to a British Press outlet.

This of course would be precisely the WRONG action. National governments in representative systems are forced to respond to the concerns of their citizens. The bankers' proposal would push the power even further away from the people and vest it in unaccountable supra-national bureaucracies. Our response should be precisely the opposite - devolve regulatory power over the banks back from the Federal government back to the state level. This should be particularly true for commercial banking. First, power should be as close to the citizens as reasonably practical so that the exercise of government power will be as responsive as possible to the average citizen. Second, power should be decentralized so as to reduce the incentive to abuse it and to minimize the damage when such abuse does occur.

One very positive effect would be to create a framework that automatically penalizes large organizations. Giant banks constantly lobbied to reduce the role of the states in banking regulation in the name of "efficiency" starting in the 1970s. One of the chief claims advanced during that period was that US banks would be unable to compete with foreign (especially Japanese) banks without consolidation. That turned out to be correct as the US banks produced a bubble very comparable to the one that has led to a 20 year depression in Japan.

The collapse of the states' role led directly to the creation of corrupt TBTF mega-banks by reducing the cost of geographic consolidation, just as the weakening and then repeal of Glass-Steagall enabled the growth of financial conglomerates via acquisition across business lines. President Obama has called for limiting the ability of banks to take risk and also breaking up the TBTF banks. We agree and call upon the president to immediately re-implement Glass-Steagall in order to confirm the seriousness of his words via corresponding action. In addition, we call upon him to remove all federal roadblocks to state banking regulation.

The mega-banks object to state regulations because it would increase their cost of compliance. We agree that it would increase such costs and further state that such an outcome would be a GOOD thing. It would create an automatic systemic incentive not to expand. It would be far better for the banks to decide to break themselves up rather than to mandate such an outcome. The legal and regulatory environment can provide the proper incentives and then leave the implementation to the individual players when they find such actions to be in their self-interest. The explicit repudiation of the "too big to fail" doctrine should be sufficient as the only reason to create such behemoths was to become large enough to hold the US economy and financial system hostage. But it never hurts to create the right incentives - all that Washington DC needs to do is stop interfering with the states' ability to regulate.

This seems to be an elegant solution.

Trembling Pillars of Fraud

Over the last two weeks we have seen a series of indications that some of the key elements supporting manipulation of market pricing mechanisms are beginning to tremble. We have seen equity prices rise despite the lack of any significant increase in profits. We have seen commodity prices spike without much increase in real demand. In our opinion the key institutions behind this mess are the major Wall Street (TARP) banks, government agencies and the Fed. They have all played a major role in creating credit inflation, with subsequent asset bubbles and debasement of our currency. But understand this: if you 'look through' each of those institutions you will find the US government backstopping each and every one of them. Each of those has come under increasing attack and as the supports have begun to shake, the fraudulent pricing they have promoted has also begun to unwind. As politics has supported bubble dynamics, so it can destroy them - live by the sword, die by the sword.


Fear and Loathing
First, Yahoo Finance reports that Wall Street's bonuses being paid out now will total $145 billion. That is greater than 1% of US annual GDP. In a normal year that number would be insane. After the disaster those same players inflicted on the US and global economy, that number is downright obscene. Bailouts were indefensible to start with and now you can add infuriating arrogance to the list of offenses. Public anger may be getting through to Congress and without siphoning off taxpayer money via the legislature, the rest of the Wall Street con game doesn't work. It has now gotten so bad that according to Dow Jones Newswire the TARP still exists only courtesy of a Senate filibuster by its supporters.

Fear of angry constituents has taken on a new urgency for our elected officials in the wake of a shocking Republican victory in the Massachusetts election for Senate. With citizens realizing that the Fed's actions have been a pure handout to Wall Street, the reconfirmation of Ben Bernanke as chairman is now very much in danger. Today, the NY Times reports that two additional senators abandoned him. With Geithner at Treasury already under serious scrutiny by Congress for his role in the bailout of Goldman via AIG and the subsequent attempt to hide the details, the two most prominent faces of bailout nation are both in danger of being forced out.


Friendly Fire
The biggest blow psychologically may be the rhetorical broadside from President Obama against the big banks that are a key leg of the credit inflation machine. His speech yesterday called for them to be cut down to size and shackled. This was a frontal attack on the concept of Too Big To Fail, with its implicit taxpayer guarantee for the stupid risks taken by big banks. The Obama Administration has given Wall Street nearly everything it wanted so the Street must now feel shocked that their tame politician has turned on them viciously. We have long felt that once the anger of the populace rose to sufficient levels, the political class would throw the financial elites under the bus in the interest of self-preservation.

Our government has betrayed our nation's citizens in many ways - from the TARP to the uncapping of taxpayer losses on Fannie and Freddie on Christmas Eve. The failure of those policies to make things better or even to stop them from getting worse is now obvious. The failure has become political kryptonite - so much so that Rep. Barney Frank is calling for Fannie Mae and Freddie Mack to be abolished. Frank has been one of their main defenders and cheerleaders for years if not decades. For him to even contemplate such a call tell us that taxpayer bailouts have become the political equivalent of Ebola.

Political support lies at the very foundation of attempts to revive the bubble by inflating credit and eroding the dollar. It is clear that this political support is evaporating before our very eyes and the state of the markets is beginning to reflect that. Suddenly the political foundation of Bailout Nation isn't looking too stable and the pillars resting on it are beginning to tremble violently.

Fractional Naked Shorting

Every dollar-denominated loan can be viewed functionally as a partial naked short position in FRNs (Federal Reserve Notes, 1.e. cash). The extent of the naked short is the inverse of the reserve ratio, so at 10% reserve, the position is written as 90% naked short. The entry is created where the bank shorts notional dollars into existence where none existed before. The Fed is a mechanism for supporting those naked shorts against margin calls that would otherwise happen in the real world - that's what a bank run really is, a margin call by lenders (depositors).

The continued existence of this naked shorting depends utterly on the willingness of the lenders to accept repayment in virtual instead of real dollars. Wire transfers, checks and book entries are all dollar substitutes, not actual dollars. An entire massive infrastructure has been erected to push people towards the conclusion that these are actually identical to FRNs. Banks will freely exchange your book entry with them for cash - until they can't anymore. The FDIC exists to guarantee that you will get cash for that book entry or other cash substitute. The Fed holds stocks of FRNs which it can exchange on a limited basis to commercial banks in danger of running out.

The scale of the pyramid scheme can be measured by the ratio of actual cash to virtual cash. Total cash in circulation (real cash) is $923 billion per the H.4.1 release dated December 10. The amount of virtual cash is the total credit outstanding, which is $52.6 TRILLION as of September 30 per the Z.1 release also dated December 10. In other words, each one dollar of cash is supporting nearly 57 dollars of credit. Through the mechanism of this gigantic naked short position, the value of the underlying security - the US dollar has been driven down to a huge extent. In fact, the short ratio can also be expressed as 98%. Not coincidentally, that is also the extent to which the US dollar's purchasing power has been reduced since the advent of the Federal Reserve.

This gives you some idea of the extent to which the value of the supply of dollars has been diluted by all of the substitutes that have been introduced into the system. If the dollar were a drug, it would be so heavily cut as to have no discernible effect. It also explains the desperation with which the financial world is attempting to save "the system" - by which they mean the machine that issues dollar substitutes and convinces you to accept them. There are sufficient dollars to cover less than 2% of domestic debt outstanding. That takes no account of the naked short positions of foreign banks. The bankers are short 57 dollars for each dollar that actually exists. You can well imagine what would happen if such a short position were to be squeezed to any significant extent.

One can justify banking to the extent than it increases productive capacity and therefore ultimately wealth. The increase in the pool of dollar substitutes will have minimal inflationary impact as that growth will be counter-balanced by an increase in the pool of goods those dollars can buy. This is a social good and one of the few philosophical reasons to support banking. Of course we are long past the point at which such banking was the norm, or even a large minority of credit activity.

Command and Control?

Much is made of the rebound in China's 2nd quarter GDP and the drivers certainly merit a closer look. We are going to focus on just one key metric today - credit. In an effort to reach escape velocity from the global collapse, China has ordered its banks to make lots of loans and the banks have complied. So just how much lending has occurred and what is the scale of the likely impact. Let's look at the numbers, shall we? Various sources have reported the lending numbers and this article from the Globe and Mail is typical:

Chinese banks lent 1.5 trillion yuan ($220-billion U.S.) in June, the central bank reported on its Web site Wednesday. That exceeded forecasts and was up from May's 665 billion yuan ($97-billion) in lending and April's 590 billion yuan ($86-billion).

Keep in mind that the entire Chinese economy was approximately 30 trillion yuan in 2008. Another way to look at things is that China's economic output is roughly 2.5 trillion yuan per month and in June bank lending was equal to 60% of that output. One might safely say that credit expansion on that scale might have some impact on the economy. Keep in mind, this does NOT include bond issuance by corporations, the government in Beijing or the provincial and local governments; but the amount is enormous even without them. For perspective, the Flow of Funds shows total non-financial debt added in the US economy during 2006, the last full year of the UDB was $2.41 trillion in a $13.4 trillion economy - so borrowing was 18% of GDP in an extreme environment. Maybe this was just an aberration of one month? After all April and May were much lower. Well, let's look further down in the article:

The latest figure would push total bank lending for the first half of the year to 7.3 trillion yuan (just under $1.1-trillion).

So monthly loans averaged over 1.2 trillion yuan and June was more typical than the prior months. Interestingly, CNBC reports that Beijing's minimum bank lending target for all of 2009 is 5 trillion yuan and the banks have already exceed that number by 46% in just six months. Having established that the lending spree is enormous, the other key question is how much of a change it represents. For that, we will take words straight from the horse's mouth - a PBOC press release:

At end-June, outstanding RMB loans reached RMB 37.74 trillion, up 34.44% year on year, accelerating by 15.71 percentage points year on year and by 3.83 percentage points month on month. In the first half of the year, RMB loans increased by RMB 7.37 trillion, up RMB 4.92 trillion year on year.

Total debt grew 34.4%, while lending TRIPLED from 2.45 trillion to 7.37 trillion yuan year over year. Are the mental alarms going off yet? Again we will refer to the Flow of Funds for perspective. During the peak of the US housing bubble, mortgage lending took 6 years to triple from the trough in 1995. Yet China has compressed the impact of a historic multi-year bubble into 12 months. There also has to be dramatic deterioration in credit quality. There is no realistic way to triple lending without severely compromising lending standards - as we saw so dramatically with liar loans, nothing down, NINJA lending and option ARMs. Does anyone doubt that something comparable or worse is happening in China now?

The game plan for China should be obvious by now. They are following the path of every other participant in the UDB with a vengeance. Tripling lending until it reaches nearly half of GDP for the first half is the real stimulus in China. By contrast the US Federal government borrowing 14% of GDP looks downright conservative. China is attempting to reinflate their bubble economy but even if they "succeed" the price will be hideous. The price of failure is nearly unthinkable.

Great Pyramid of Geezer

An update by Karl Denninger at Market Ticker today got the old synapses firing. Denninger points out that pension plans are in trouble and cites a Wall Street Journal article strongly suggesting accounting fraud in public pension plans. The WSJ says:

Based on their preferred accounting methods -- which discount future liabilities based on high but uncertain returns projected for investments -- these plans are underfunded nationally by around $310 billion.

The numbers are worse using market valuation methods (the methods private-sector plans must use), which discount benefit liabilities at lower interest rates to reflect the chance that the expected returns won't be realized.

Last year we warned about the same phenomenon in private sector pensions in Some Key Questions and The Limits of Optimism. In every case the culprit was the same - overly optimistic assumptions about investment returns allowed a financially deficient structure to be sold to key constituencies as safe and sound. The wild optimism that causes managers to overreach like this and causes others to believe their literally incredible assumptions are part and parcel of the Universal Debt Bubble (UDB). Only in such a manic environment can such outlandish claims be regarded as anything other than the fantasies they are in reality. Even worse, a bubble atmosphere makes those assumptions even more dangerous than normal by burdening assets with inflated starting values, making the required price appreciation even less likely than usual. But as long as such tales are believed, a small sliver of capital can be made to support grand promises in the future.

Unfortunately, the credulous public has been misled in any number of similar ways. Robert Prechter of Elliott Wave International recently described the process by which banks also shrank the capital supporting their balance sheets to a tiny fraction of what had previously been required and considered prudent:

In the early 1990s, the Federal Reserve Board under Chairman Alan Greenspan took a controversial step and removed banks’ reserve requirements almost entirely.

To do so, it first lowered to zero the reserve requirement on all accounts other than checking accounts. Then it let banks pretend that they have almost no checking account balances by allowing them to
“sweep” those deposits into various savings accounts and money market funds at the end of each business day... The net result is that banks today conveniently meet their nominally required reserves (currently about $45b.) with the cash in their vaults that they need to hold for everyday transactions anyway.

Sure or Insure
Yet the problems of inadequate capital hardly end there. Like pensions and banks, insurance is another area that succumbed to the ubiquitous optimism of the UDB. Insurance companies became so accustomed to capital appreciation well above the historic norm that they began to take them for granted. Many annuity policies and guaranteed investment contracts were written promising high fixed rates of return based on that experience. This has proven devastating for many insurers, who are now rushing to rewrite such contracts. This is a microcosm for the weak capital position of much of the industry as key asset classes for most life and casualty companies are stocks, bonds and real estate. Like every other leveraged institution out there, the insurers have taken a beating on those assets and their promises to deliver future benefits are increasingly in doubt. Which brings us to a similar structure with the biggest capital shortfall of all.


GovernMENTAL Institutions
For the most part, capital is literally a foreign concept in this sector. Few governments have significant reserves, much less any real capitalization. Except in regions where government-owned enterprises dominate the economy, the primary source of revenue for most institutions is taxes - on the private sector naturally. So instead of actual capital, governments have something even more volatile - a projected future revenue stream. As with every other sector we have examined so far, those projections about the future are subject to the psychological distortions that accompany large-scale financial manias. In an environment of historic extremes like the UDB, those distorted perceptions can easily become fatal. We see that today in the sad case of California - where the state is issuing IOUs because they are out of money. Having accustomed themselves to double-digit annual rises in tax revenue, Sacramento (and other state capitals) simply spent it all. Those projections and plans aren't working out so well anymore.

The US Federal Government is arguably in even worse shape. Borrowing this year is likely to approximately equal tax income. No entity can spend twice its income for long and hope to survive. The remnant optimism of the UDB has settled in one of its last-ditch redoubts: faith in government. In addition to the spending spree, Washington has also embarked on a series of empty promises that would make a serial polygamist blush. Not content to merely guarantee deposits through the FDIC, the Feds now do the same for bank bonds through TLGP. Fannie and Freddie debt is backed thorough a de facto nationalization and money market mutual funds are guaranteed by the Federal Reserve. Many trillions of government "guarantees" are piled atop the roughly $1 trillion of deficit spending for this fiscal year. These promises are lighter than a feather but certainly worth their weight in gold. In other words there is no way Washington can deliver but they are hoping nobody notices and that the empty promises will inspire "confidence" in the economy. Like many other sectors, various levels of government are attempting to cover huge obligations with inadequate resources.

Frankly, it's sad that so many people fail to see the little man behind the curtain putting up the front that is the Great Oz. These large and varied institutions have stretched themselves far too thin and are praying for another bubble to bail them out again. The title of this missive refers to those who will bear the brunt of the damage from our return to reality - those who bought into the promises of these institutional pyramid schemes and don't have the time to recover financially. The frenzy of financial pyramid construction certainly put the Egyptians' little excursion in stonework to shame. In reality, the old truths would have served us well, but like every bubble generation in history, ours has convinced themselves that "this time it's different" when it never really is. Like those who have gone before, we will learn the hard way when two things we all learned as children would have prevented much of this mess:

• Never count your chickens before they hatch.
• Save for a rainy day.

It seems so simple and most of us will never forget. With the optimistic assumptions that undergirded the psychology of the UDB evaporating, any program sporting the words insurance or guarantee must be treated with great skepticism.

CP to FRB ICU ASAP!

The commercial paper market certainly appears to be critically wounded. The seasonally-adjusted amount of CP has fallen dramatically since mid-September. Per the Federal Reserve the declines over the last three weeks:

September 17: -$52.1 billion
September 24: - $61.0 billion
October 1: -$94.9 billion

Headlines emphasizing funding cutoffs to companies in the real economy, like Caterpillar and A&T are highly misleading. Non-financial CP took a single hit of $18 billion ($217 billion to $199 billion) two weeks ago and has hardly budged since. The REAL story is the collapse of CP issued by banks and other financial companies. Domestic financial paper is down by $93 billion ($590 billion to $497 billion); foreign financial paper fell $40 billion ($225 billion to $185 billion, down 20%!); asset-backed paper is off $55 billion ($780 billion to $725 billion).

We have seen record withdrawals from money market recently, which has led to falling demand for commercial paper - which is usually purchased by these funds. In order to stem the flight from MM funds and hide the losses in asset-backed CP, the Fed recently extended their alphabet soup yet again. The "Asset-backed commercial paper money market mutual fund liquidity facility" or ABCPM3FLC for short was instituted just two weeks ago. It's gone from zero to $152 billion in just days - $22 billion average last week, to $122 billion average this week, to $152 billion by 10/2/08. All data are from the Fed's H.4.1 release.

Panic Lending
Actions of this magnitude clearly indicate that a major crisis is unfolding behind the scenes. The freeze in interbank lending, the explosion of LIBOR loan rates, the collapse of financial commercial paper and counter-measures taken by CBs around the world indicate that the final act of the Universal Debt Bubble may be upon us. The UDB rested entirely on confidence - and badly misplaced confidence at that. It allowed credit to be extended to those who were manifestly NOT credit-worthy and the temporarily elevated economic activity created the illusion of prosperity.

All of that is going in reverse now and the politicos don't like it. Well, unfortunately this is all necessary to return to a stable economic structure after the bankers deliberately destabilized it. One of our first blog entries was Legions of the Damned - wherein we pointed out:

Over the last several weeks, there has been a collective recognition of the inherent riskiness of using illiquid, volatile and hard to value paper as collateral for lending. The lenders are requiring either much more (paper) or better (cash) collateral to secure the loans. The result is the global "Dash for Cash" that we've seen recently. Cash is King again and the scramble to come up with it resulted in huge spikes in overnight lending rates. The injection of $150 billion into the system was designed to bring the rates back down to the ECB and Fed targets of 5.25% and 4.0% respectively.

Had the CBs not acted, there would have been massive forced selling of the illiquid paper, demonstrating it to be nearly worthless. Now that would only formally recognize a situation that already exists in reality but as long as the banks can pretend that it's worth face value, they can continue to make loans and prop up consumption. This is a classic example of Gresham's Law - to oversimplify "Bad money drives out good money." When dodgy paper assets are treated nearly the same as cash, nobody is going to put up cash.

As we surmised well over a year ago, the repricing of risk is ongoing and the current crisis is simply the big brother of the one we experienced last summer. The clearest indication of risk recognition is the explosion of spreads. Once again, according to the Fed's Commercial Paper Report, yield differentials between high-quality (AA) and lower-quality (A2/P2) commercial paper have blown out enormously - from 80 basis points (0.80%) just a few weeks ago to over 400 bp today. Then there is the spread due to implied higher risk just for being a financial company. The spread on financial vs non-financial paper has widened from 30 bp to 160 bp in just weeks. A risk that Financial Jenga readers have known about for a long time is now confirmed by the market.

Globo-shock
Inability to borrow in the US money markets helps to explain the severe dollar starvation overseas. It is this problem that the Fed is trying to fix with the their massive dollar loans (mischaracterized as "swaps") to foreign CBs. Less than a week ago, the Fed announced a $330 billion expansion of these loans.

The results of the dollar starvation are manifest across Europe. Huge institutions like Dexia, Fortis and Bradford & Bingley have been fully or partially nationalized within the last few days. It does not help that the leverage ratios of European commercial banks are typically much higher than their American counterparts. Not only are the commercial paper markets closing to such banks but elevated LIBOR rates cut those same banks off from cheap dollar loans from other banks. The squeeze to dress up balance sheets to make them look good for the quarter-end reports undoubtedly contributed to it but the fact that pressures have not abated much yesterday and today indicates that much more than a seasonal problem is at work here.

The "dash for cash" is on. Despite the Fed lending as fast as it can, commercial credit is being drained from risky financial institutions faster than the Fed and other CBs can pump it in. Having seen Wachovia, WaMu and a half-dozen European banks fail in the last week, we see no near-term end to the pressures or the bank failures.

MBS Deep Freeze

According to various sources, the GSEs Fannie Mae and Freddie Mac have been buying somewhere between eighty and ninety percent of all mortgages recently. This has led to very rapid growth of their mortgage portfolios. Just a few weeks ago, this report appeared in Newsday:

Fannie Mae, the largest provider of funding for U.S. residential mortgages, on Wednesday said it grew its investment portfolio in June at the fastest annualized rate in nearly five years.

Fannie Mae's mortgage portfolio increased at a 22.8 percent annualized rate to $749.6 billion in June, from $736.9 billion in May, the Washington-based company said in a statement.

The government-sponsored enterprise (GSE) has been boosting growth in its investments since its regulator earlier this year began easing requirements on capital it must hold against the assets. Lawmakers consider such purchases by Fannie Mae and rival Freddie Mac as playing a key role in supporting the U.S. housing market that is going through a wrenching downturn.

What a difference a month makes. Buried deep inside a Bloomberg article today, we find this:

Freddie's portfolio expanded at a 9.8 percent annualized rate to $798.2 billion in July, the slowest since March. The holdings may shrink this month based on forward commitments, according to the company's monthly volume summary today. Fannie expanded to $758 billion, an annual rate of 14.4 percent, the smallest increase since April.

The declining demand from the federally chartered companies, the biggest buyers of home loan securities, is sending mortgage prices lower and causing home loan rates to increase.

``It's become pretty obvious that they're not going to be able to grow going forward,'' said Walt Schmidt, a mortgage-bond strategist at FTN Financial Capital Markets in Chicago. ``Without a capital raise, you're not going to see a major recovery in'' mortgage securities.

Growth went from north of 20%, to low double or high single digits, then possibly to NEGATIVE in just a few months. It is a tribute to the speed with which leveraged pyramid schemes fail once the confidence is gone. Since the massive growth of the GSE portfolios was unable to arrest the rapid fall in bloated housing prices, the removal of this prop and sidelining the buyer of last resort is likely to result in another down leg in prices and unit sales.

Although Treasury Secretary Paulson pushed the GSE bailout bill through Congress by saying he needed a bazooka so he wouldn't have to use it, the market appears to have called his bluff. The problem is that many commercial banks hold Fannie and Freddie preferred stock as part of their capital. Simply guaranteeing the debt does nothing for the preferred it would be wiped out in the re-organization - adding another hit to capital and more failed banks. Government purchases of preferred stock would be less bad for the banks but they would still be diluted and have less capital. Only purchasing common stock would leave the preferred (and bank capital) intact. But that would bail out the management and prevent a much, needed re-organization of the companies. More to the point, it would also be seen as a pure bailout and politically very damaging heading into a national election.

There has been very little reason for the credit inflation crowd to cheer lately and the rapid growth of the GSE portfolios was one of the few bright spots for them. This growth appears to be done as well. The Shadow Banks are now shattered banks as off balance sheet vehicles are unwound and hedge funds shut their doors. We should expect to see even more of the later in the near future. The WSJ reports that July was the worst month ever for the Morningstar 1000 hedge fund index at negative 3.07%.

Mayday

We turn to Europe in this commentary as important events are occurring there behind the scenes and Asia has gotten the lion's share of the attention recently. The mariner's distress call actually comes from French, where "m'aidez" simply means "help me." We thought that would be a particularly appropriate title as Europe's financial system is starting to show signs of severe distress. From the actions of the CBs over there, we can infer that the problems there may be significantly worse than here in the US. Current open market operations show that the ECB has 451 billion Euros (about $640 billion) outstanding. This dwarfs the Fed total of just over $300 billion - including all liquidity facilities. It's pretty clear that there are many European banks in deep, deep trouble.

Starving for Dollars
It is also becoming increasingly clear that the European financial system has a desperate shortage of dollars. Since much of the debt outstanding is denominated in dollars and many European banks have taken in dollar deposits as well, there is a need for them to transact in our currency that is not reciprocated. When the Fed and foreign CBs set up the currency swaps, there was some suggestion that the purpose was to give the Fed enough Euros to intervene in the currency markets. That really didn't make much sense as the Treasury and the Fed have conducted a sub rosa weak-dollar policy for years. The logical and obvious explanation is now coming to the fore - Europe is seriously short of dollars and if they were forced to go out into the market and buy dollars, our currency would strengthen too much for the planners at the Fed who have been attempting to devalue it.

The bid to cover ratios from recent auctions make the point quite forcefully. The last set of TAF auctions in the US produced ratios of 1.51 and 2.19 (for the initial 84-day facility). The comparable ECB auctions in Euros had a bid to cover of 1.58. But ECB dollar auctions were bid at 4.56 and 3.85. US banks' demand for dollars appears to be roughly equal to Eurozone banks' demand for Euros. But Eurozone demand for dollars is twice as great as either one. This trend is confirmed by the result of the Swiss dollar auctions. Those had bid to cover ratios of 2.90 and 4.90. Finally, note that the Fed is not auctioning off Euros or Swiss Francs to anxious American bankers.

In addition, the high-yield bond market in Europe is completely frozen. Not one junk issue of any size has come out of Europe this year or for quite a few months of 2007. Retail sales there are falling farther and faster than in the US and the housing bust there has barely begun. Granted that theoretically the ECB had more room to cut rates than the Fed but the strength of unions and the social program costs make a wage-price spiral much more likely in the Eurozone, which seems to be constraining the actions of the ECB.

The FDIC and You

Well friends it's time to talk about bank failures and wealth preservation. We have talked about insolvent banks on multiple occasions before but the threat of large banks failing is now imminent. Countrywide was saved from such a fate by Bank of America. Now IndyMac is right on the edge. They're not officially dead yet - only mostly dead but there's no Miracle Max in sight.

Their recent letter to stakeholders reads like a death certificate:

• regulators involved
• prohibited from getting brokered deposits
• can't sell stock (no buyers)
• asset sales would deplete capital (tacit admission of mis-valuation)
• ===> must stop making loans

The FDIC has been bulking up for months now, anticipating a wave of bank failures. So far it's been a few small banks but now it's the big boy's turn. So how secure are bank deposits and and how much can the insurance fund really cover? For now, it looks like the answers are pretty safe (as long as you're under the $100,000 limit) and a pretty good amount as they have $54.5 billion in the fund as of the March 31 report.

The report contains further indications that they see the problem as serious and imminent. For instance, last March the fund held $3.7 billion in cash, going to $4.0 billion in December and $8.0 billion this March. Clearly they are raising cash in anticipation of something. There is a similar pattern to the provision for losses from negative last March to $95 million in December and $525 million the March. Interestingly, that last number is about 2.5x the estimated losses on ALL failed banks YTD.

$5.6 million - Douglass National

$214 million - ANB Financial

$2.3 million - First Integrity

ANB is almost the entire amount but was not shut down until May. The FDIC was already anticipating a lot more at the end of March. It will be fascinating to see what kind of provisions they made at the end of June. We should have that report in approximately 2 weeks. The banks that have failed so far have cost the FDIC about 10% of deposits to make the depositors whole. This suggests that the regulators were planning on banks with another $3 billion in deposits going bad as of 4 months ago but IndyMac alone is much larger than that.

So what kind of impact should we expect if the FDIC has to liquidate a large part of their portfolio to make good on their guarantees? Personally, we're expecting a bear steepening of the yield curve but have a look at the composition for yourself:

There is a big slug of bonds maturing in 2009 so if FDIC is forced to liquidate, the pressure should be strongest on the 2-year and shorter Treasury market. Given the amount of cash, it would take a significant failure to force them to liquidate much before the maturity dates but we want to start thinking about the possibility and the implications of such an event.

Consumer Co-dependency

It appears that the abused average American has finally had enough. Target reported that Christmas sales were very weak and lowered their revenue growth numbers for December quite a bit. Add in the margin pressure from discounting and earnings in that sector should be a mess. The problems seem to be widespread and for once, stocks actually seem to be reacting to obvious fundamental problems. This should really be no surprise at all but sadly, equities have ignored fundamentals for so long that it's a shock when reality intrudes on the feeding frenzy.

Here at Financial Jenga, we've been documenting the many pressures facing consumers for some time now. Housing and mortgage debt were covered in Where to Start? We wrote about the deteriorating employment situation and failure of government statistics to reflect it in Behind the Numbers. The collapse of personal savings and explosion of total household debt was the theme of First Principles. Why is anyone surprised that a consumer sector with no savings, huge debts and fewer jobs would decide that reducing spending the the right course? "When you're in a hole, quit digging" is just common sense.

Of course, common sense has been in short supply for years. Americans have been able to get away with all sorts of foolishness and the banks and other lenders have been their enablers. It is simply human nature to slip into wishful thinking that there really IS a free lunch out there somewhere. Mark Twain once described a banker as "a fellow who lends you his umbrella when the sun is shining and wants it back the minute it begins to rain." Former uber-banker and CEO of Citigroup, Chuck Prince pretty much confirmed Twain's characterization back in July when he said:

When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.

Apparently, Chuck has stopped dancing and wants his umbrella back - except that he's no longer CEO. The reason he's not CEO now is because he waited too long to grab the umbrella and it looks as if he was right that "things will be complicated."

Banks are always willing to lend when they think there's little risk. That doesn't mean they are right in their risk assessment. Consumers have proven willing to borrow as long as they think they can make the payments. They are often overconfident on that front. The confidence of both is being pressured by the weak job market. Banker's willingness to lend is also falling with the value of the loan collateral - especially housing. Consumer confidence faces additional challenges due to higher food and energy prices. They were both wrong to be confident because they confused cyclical and secular economic forces. They also failed to recognize that their own behavior was the cause of the spike in asset prices. They borrowed and lent money used to buy the assets and prices quite naturally rose. Then they all congratulated each other on how smart they all were to "get in on a rising market." Now the prices are falling and the debt will still be the same size.

Consumers have a co-dependent relationship with their bankers - who have enabled destructive behavior for years. It appears that both sides are ready to walk away now that the relationship serves the needs of neither side.

Reserves, Profits and Multiples

One of the key problems with valuation in the stock market today is the difficulty of determining actual profits are trying to compare the numbers that are reported to previous years where different standards were used. Many bulls have tried to tell me that I should buy because the S&P 500 is selling at a P/E of only 16x 2008 earnings. Well, there are a ton of problems with that statement so let's just cover the fatal flaws.

First, I don't know what 2008 earnings are going to be and neither do they. They are using a guess as the denominator to get that multiple. The number we do have is the historical reported numbers and based on that the multiple is 18x, significantly higher.

Second, 18x is very expensive and even 16x is far from cheap. 16x would be a normal peak multiple over the business cycle. 18x would be extreme territory normally. During the 20th century, the P/E for the S&P 500 has exceeded 18x on a sustained basis 3 times: the late 1920s, the mid 1960s and the late 1990s. Each of them was followed by epic bear markets. Not a good set of precedents.

Each of those periods also featured prolonged (multi-year) periods of high earnings growth. We had the same thing this time in 2004-05 but EPS growth has fallen from 18% to 0% while equity indexes make new highs. Dangerous? You bet! In the past stocks rolled over shortly after earnings growth started to slow down. This time they refuse to roll over even when the slowdown is about to go to negative growth.

Then there is the quality of the profits themselves. The financial sector and banks in particular are quite problematic. The NY Times has done excellent coverage on the severe depletion of loss reserves at the big banks.

Some investors seem to think that banks’ current share prices reflect whatever grim earnings news remains ahead for the sector. But anyone who thinks that we have hit bottom in the increasingly scary lending world is paying little mind to the remarkably low levels of reserves that the big banks have set aside for loan losses. Indeed, loss provisions as a percentage of total loans held for investment plummeted to a historic low in the second quarter of 2007, the most recent period for which comprehensive figures are available.

Yep, we're heading into a major default crisis and banks have the lowest reserves ever. That's not a problem or anything that the Fed and Treasury want us to worry about. But the weak reserves have allowed financials to over-report profits for the last several years. Time to correct that and the price will be weak profits and for some, losses instead for the forseeable future. And I'm supposed to be interested in paying extreme peak multiples for inflated financial sector profits? No thanks.