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.
Showing posts with label cash. Show all posts
Showing posts with label cash. Show all posts
Thursday, 10 December 2009
Monday, 29 June 2009
Over Extended
We note with some amusement all of the talk about cash "on the sidelines" as if it's ready to pour into the stock market at the drop of a hat and take us to new highs. Nobody wants to admit that this is the cash that doesn't really exist. That fact was recognized by the market last year and earlier this year but has been obscured by a massive campaign of deception, propaganda and guarantees from Washington and Wall Street. Because the current mutant economic system depends on citizens digging themselves ever deeper into debt slavery, anything which causes them to save instead of borrow and spend is seen as the enemy and this includes the truth.
Much of the "cash" is in banks and money market mutual funds, both of which invest in debt that has become extremely dubious. The truth is that none of the "assets" (loans) that are backing the "cash" have gotten better and most have gotten significantly worse over the last 3-4 months. Credit card default rates now stand at a record high (again) for the fourth straight month. Auto loans are nearly as bad. 12% of all mortgages are now either in foreclosure, default or delinquent - but in any case they are not being paid. Commercial mortgages are quite bad now on the way to much worse and the State of California is so broke it is issuing IOUs instead of checks.
So what is going on here? The government-banker campaign has succeeded in getting one important group of people to dig themselves deeper into debt - speculators. If you look at the NYSE margin data, you will see that the ratio of margin debt to credit balances in margin accounts is at the highest it has been in a long time - 1.61. One can think of this as the ratio of margin actually used to unencumbered cash balances in those same accounts and so it measures the willingness of brokerage account holders to take on leverage as a percentage of their portfolios. The last time the ratio was this high was July 2007, just before the crisis began with the first round of emergency Fed intervention. Slightly lower levels were seen at the absolute top in October 2007 and again in September 2008, just before the largest leg of the stock market crash.
The latest data is from May and we await the June report with anticipation. The recent data show the speed with which a wildly speculative spirit has returned to stocks despite the small gains relative to the preceding decline. The fact that so many speculators have already leveraged up so heavily means that much of the fuel has already been burned off, leaving the market in a very vulnerable and over-extended position. These speculators have set themselves up for more crushing losses - note how much smaller both the margin and credit balances are than at any time in the recent past. Any significant decline at this point holds the potential to become self-sustaining as heavily leveraged positions become unsustainable in the face of the decline and subsequent margin call. In fact a cascade of margin calls could easily result.
Stocks are being bought but not by the cash on the sidelines. It appears that existing speculators margining themselves deeper into debt are the key driver of the bear market rally. The fact that they have used nearly all of their firepower and exposed themselves to potential forced selling is hardly bullish.
Much of the "cash" is in banks and money market mutual funds, both of which invest in debt that has become extremely dubious. The truth is that none of the "assets" (loans) that are backing the "cash" have gotten better and most have gotten significantly worse over the last 3-4 months. Credit card default rates now stand at a record high (again) for the fourth straight month. Auto loans are nearly as bad. 12% of all mortgages are now either in foreclosure, default or delinquent - but in any case they are not being paid. Commercial mortgages are quite bad now on the way to much worse and the State of California is so broke it is issuing IOUs instead of checks.
So what is going on here? The government-banker campaign has succeeded in getting one important group of people to dig themselves deeper into debt - speculators. If you look at the NYSE margin data, you will see that the ratio of margin debt to credit balances in margin accounts is at the highest it has been in a long time - 1.61. One can think of this as the ratio of margin actually used to unencumbered cash balances in those same accounts and so it measures the willingness of brokerage account holders to take on leverage as a percentage of their portfolios. The last time the ratio was this high was July 2007, just before the crisis began with the first round of emergency Fed intervention. Slightly lower levels were seen at the absolute top in October 2007 and again in September 2008, just before the largest leg of the stock market crash.
The latest data is from May and we await the June report with anticipation. The recent data show the speed with which a wildly speculative spirit has returned to stocks despite the small gains relative to the preceding decline. The fact that so many speculators have already leveraged up so heavily means that much of the fuel has already been burned off, leaving the market in a very vulnerable and over-extended position. These speculators have set themselves up for more crushing losses - note how much smaller both the margin and credit balances are than at any time in the recent past. Any significant decline at this point holds the potential to become self-sustaining as heavily leveraged positions become unsustainable in the face of the decline and subsequent margin call. In fact a cascade of margin calls could easily result.
Stocks are being bought but not by the cash on the sidelines. It appears that existing speculators margining themselves deeper into debt are the key driver of the bear market rally. The fact that they have used nearly all of their firepower and exposed themselves to potential forced selling is hardly bullish.
Monday, 29 September 2008
The Limits of Optimism
The absurd actions of our financial authorities continue to impress with the sheer hubris and vast scale of their proposals - with today's bailout attempt being the latest and greatest of many attempts. Some of the government's contortions would be impressive even for Cirque du Soleil were they not such a blatant effort to distort the market. Our nation and the world at large seem to be living out the economic equivalent of a Kafka novel today. Yet even here we see the boundaries of government interference and the limits of (unjustified) optimism. As advocates of the free market and rule of law, we have been constantly appalled. A nominally Republican administration continually interferes with market forces and changes investment rules in the middle of the game. How did we come to such a sad pass?
Like many children, yours truly had a favorite word for much of his childhood - "Why?" Eventually, I stopped bothering Mother but never stopped asking the question. It is particularly pertinent now. How did we put ourselves in a position where using tax money to subsidize Wall Street's losses could even be considered? Well, the stock market is now considered key to the retirement of many Americans.
Why?
Er, most Americans now have a substantial part of their pension or 401(k) invested in stocks.
Why?
Well, the higher average rate of return on stocks allows us to say that retirement is fully funded with less up-front investment. This is especially important for corporate and government pension plans. For individuals it allows hope of the big score and a cushy retirement.
Did the pension managers decide that was a good idea, themselves?
Umm, not really. Remember, stocks are not bought - they are sold. Some smart salesmen on Wall Street started to push this in the late 1980s, just as the last people who lived through the Great Depression were retiring.
But what about the higher risk?
The salesmen could point to the superior long-term returns from equity, while glossing over the risk and the folks who remembered the risk in very visceral ways were gone. Even so, many pension managers objected but were overruled by their bosses who wanted to lay out less money for pensions so they could spend it elsewhere (government) or report higher earnings (corporate).
What about 401(k) plans?
The long bull market convinced many individuals that there was little risk in stocks. They certainly had produced high returns. Many people hitched their wagon the Wall Street.
Perpetual Motion Machine
With so much money from average Americans pouring in, stocks could hardly do anything else but rise. Eventually it became a self-fulfilling prophecy as money chased performance, while pushing the price up in turn. That reached its peak with the Tech Bubble, when completely worthless companies were valued in the billions. When that broke down, the Fed stepped in and created a new bubble - actually several bubbles, led by housing. The same self-reinforcing dynamic - as old as markets themselves played out again.
With so much money from the masses committed to the stock and housing markets, there is considerable support for ANY measure to bail out these markets and prop up asset prices. This is the end result of individuals and pension funds refusing to settle for the smaller but steady gains from lower-risk investments. Keep in mind that not long ago, most pension and endowment type funds invested almost exclusively in bonds. For the economic importance of this, let's examine the characteristics of each class of capital:
- Senior Debt (bonds or bank loans):
first in line for assets and cash
must be paid or the creditor can liquidate the borrower
reliant on total company cash reserves
- Junior Debt:
next in line but otherwise similar to Senior Debt
- Preferred Stock:
3rd in line for assets and cash
dividend can be suspended as stockholders CANNOT force liquidation
reliant on company cash flow
- Common Stock:
last in line for assets and cash
dividend has the least protection of any security
reliant on company profits
potential for speculative gains
Slouching towards Insolvency
Over time, asset allocations at all levels have become riskier, including pension funds. From an economic standpoint, investment results became more reliant on marginal financial activities. For example, bonds are tied to current and future corporate cash (reserves + cash flow), which tends to have a linear relationship with revenue. Preferred is reliant largely on cash flow. Common is tied to marginal profit and even to the growth rate of profit - the second and third derivatives of revenue. Investment results went from relying on the soundness of the companies, to their profitability and then to the growth rate of that profitability. Under these circumstances, it is no surprise that the emphasis shifted away from ensuring that companies remained sound and certain to survive and towards showing growth or even accelerating growth (a fourth derivative!) at almost any price.
The eventual price was to lever up companies far beyond what was prudent in the quest for "growth." It didn't matter if the growth was real or not, it just had to look real for the shareholders. Companies undermined their own capital base with stock buybacks that juiced EPS growth while consuming cash flow and in some cases requiring additional indebtedness. We pointed to this problem nearly a year ago in Tactical Nukes. The paradoxical result was a slew of companies that were "growing" rapidly but could not survive a downturn. By placing so much reliance on marginal outcomes, the system became easy to game as small movements in revenue could drive huge changes in "growth" rates. Eventually, growth became THE foundation of many investment strategies, making those folks dependent on them willing to support increasing distortions of free markets for financial gain.
Those distortions have been a large part of the discussion here at Financial Jenga since the very beginning. The collapse of the illusion of growth and the economic distortions that supported it have revealed the true state of the underlying economy for all to see and it's not a pretty sight. Such are the ironic outcomes of the Universal Debt Bubble.
Like many children, yours truly had a favorite word for much of his childhood - "Why?" Eventually, I stopped bothering Mother but never stopped asking the question. It is particularly pertinent now. How did we put ourselves in a position where using tax money to subsidize Wall Street's losses could even be considered? Well, the stock market is now considered key to the retirement of many Americans.
Why?
Er, most Americans now have a substantial part of their pension or 401(k) invested in stocks.
Why?
Well, the higher average rate of return on stocks allows us to say that retirement is fully funded with less up-front investment. This is especially important for corporate and government pension plans. For individuals it allows hope of the big score and a cushy retirement.
Did the pension managers decide that was a good idea, themselves?
Umm, not really. Remember, stocks are not bought - they are sold. Some smart salesmen on Wall Street started to push this in the late 1980s, just as the last people who lived through the Great Depression were retiring.
But what about the higher risk?
The salesmen could point to the superior long-term returns from equity, while glossing over the risk and the folks who remembered the risk in very visceral ways were gone. Even so, many pension managers objected but were overruled by their bosses who wanted to lay out less money for pensions so they could spend it elsewhere (government) or report higher earnings (corporate).
What about 401(k) plans?
The long bull market convinced many individuals that there was little risk in stocks. They certainly had produced high returns. Many people hitched their wagon the Wall Street.
Perpetual Motion Machine
With so much money from average Americans pouring in, stocks could hardly do anything else but rise. Eventually it became a self-fulfilling prophecy as money chased performance, while pushing the price up in turn. That reached its peak with the Tech Bubble, when completely worthless companies were valued in the billions. When that broke down, the Fed stepped in and created a new bubble - actually several bubbles, led by housing. The same self-reinforcing dynamic - as old as markets themselves played out again.
With so much money from the masses committed to the stock and housing markets, there is considerable support for ANY measure to bail out these markets and prop up asset prices. This is the end result of individuals and pension funds refusing to settle for the smaller but steady gains from lower-risk investments. Keep in mind that not long ago, most pension and endowment type funds invested almost exclusively in bonds. For the economic importance of this, let's examine the characteristics of each class of capital:
- Senior Debt (bonds or bank loans):
first in line for assets and cash
must be paid or the creditor can liquidate the borrower
reliant on total company cash reserves
- Junior Debt:
next in line but otherwise similar to Senior Debt
- Preferred Stock:
3rd in line for assets and cash
dividend can be suspended as stockholders CANNOT force liquidation
reliant on company cash flow
- Common Stock:
last in line for assets and cash
dividend has the least protection of any security
reliant on company profits
potential for speculative gains
Slouching towards Insolvency
Over time, asset allocations at all levels have become riskier, including pension funds. From an economic standpoint, investment results became more reliant on marginal financial activities. For example, bonds are tied to current and future corporate cash (reserves + cash flow), which tends to have a linear relationship with revenue. Preferred is reliant largely on cash flow. Common is tied to marginal profit and even to the growth rate of profit - the second and third derivatives of revenue. Investment results went from relying on the soundness of the companies, to their profitability and then to the growth rate of that profitability. Under these circumstances, it is no surprise that the emphasis shifted away from ensuring that companies remained sound and certain to survive and towards showing growth or even accelerating growth (a fourth derivative!) at almost any price.
The eventual price was to lever up companies far beyond what was prudent in the quest for "growth." It didn't matter if the growth was real or not, it just had to look real for the shareholders. Companies undermined their own capital base with stock buybacks that juiced EPS growth while consuming cash flow and in some cases requiring additional indebtedness. We pointed to this problem nearly a year ago in Tactical Nukes. The paradoxical result was a slew of companies that were "growing" rapidly but could not survive a downturn. By placing so much reliance on marginal outcomes, the system became easy to game as small movements in revenue could drive huge changes in "growth" rates. Eventually, growth became THE foundation of many investment strategies, making those folks dependent on them willing to support increasing distortions of free markets for financial gain.
Those distortions have been a large part of the discussion here at Financial Jenga since the very beginning. The collapse of the illusion of growth and the economic distortions that supported it have revealed the true state of the underlying economy for all to see and it's not a pretty sight. Such are the ironic outcomes of the Universal Debt Bubble.
Thursday, 9 August 2007
Legions of the Damned
In Leverage and Its Uses, we discussed the large and growing cohort of companies with shaky credit and bond ratings in the CCC to C range. Many of these firms are effectively bankrupt already, borrowing just to pay the interest on existing debt. Such a practice was only possible in the loose money conditions of the UDB (Universal Debt Bubble), which is now bursting with shocking speed. These companies form one one cohort within the Legions of the Damned.
Today's actions by the European Central Bank and the Federal Reserve cofirm that the real threat is DEFLATION - not inflation. Central Banks don't pump $150 billion dollars into the banking system because they are afraid of creating too much money.
Central banks move to counter liquidity crunch
Central banks no longer expand the money supply by literally printing currency. They create new money by expanding credit through the financial system - mostly the banks but with other financial institutions playing an increasingly important role. Quasi-banks like hedge funds and CDOs take in money (investments instead of deposits) and use it to fund the purchase of assets, while introducing additional credit in the form of leverage as part of the process. These hedge fund and CDO positions have been used as collateral for further loans, increasing total debt in the system to absurd levels.
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.
We are reverting from this state to more normal relative valuation. As part of that process, the value of cash - as measured by interest rates is rising. The CB action is intended to suppress this normal market mechanism and keep cheap credit flowing. Unfortunately for their plan, market participants have correctly diagnosed this as a last-ditch effort born of panic. The price of money (the interest rate) has risen dramatically in commercial paper, where the free market still largely determines prices.
Commercial Paper Yields Soar to Highest Since 2001
Which brings us back to the Legions of the Damned. The commercial paper market which is tightening up is part of the same bond market that has kept these companies on life support for several years. The same bond market that is refusing to fund risky mortgages and risky leveraged buyouts. The plug has been pulled and the life support is shutting down. Is anyone listening?
Today's actions by the European Central Bank and the Federal Reserve cofirm that the real threat is DEFLATION - not inflation. Central Banks don't pump $150 billion dollars into the banking system because they are afraid of creating too much money.
Central banks move to counter liquidity crunch
Central banks no longer expand the money supply by literally printing currency. They create new money by expanding credit through the financial system - mostly the banks but with other financial institutions playing an increasingly important role. Quasi-banks like hedge funds and CDOs take in money (investments instead of deposits) and use it to fund the purchase of assets, while introducing additional credit in the form of leverage as part of the process. These hedge fund and CDO positions have been used as collateral for further loans, increasing total debt in the system to absurd levels.
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.
We are reverting from this state to more normal relative valuation. As part of that process, the value of cash - as measured by interest rates is rising. The CB action is intended to suppress this normal market mechanism and keep cheap credit flowing. Unfortunately for their plan, market participants have correctly diagnosed this as a last-ditch effort born of panic. The price of money (the interest rate) has risen dramatically in commercial paper, where the free market still largely determines prices.
Commercial Paper Yields Soar to Highest Since 2001
Which brings us back to the Legions of the Damned. The commercial paper market which is tightening up is part of the same bond market that has kept these companies on life support for several years. The same bond market that is refusing to fund risky mortgages and risky leveraged buyouts. The plug has been pulled and the life support is shutting down. Is anyone listening?
Subscribe to:
Posts (Atom)