The Price of Ponzi

Faking Bank
First let's be clear that prices for the majority of asset classes around the world are unsustainably high. This is an obvious corollary to the very inflated state of the global financial system and economy due to the excessive leverage that we have commented upon many times. It bears repeating that central banks (CBs) have little actual power, they merely serve as rallying points and fetish-totems for optimistic, true-believing speculators. The evidence is quite clear that CBs often fail to accomplish their goals, in recent cases despite extraordinary actions to "inspire confidence" - i.e. reignite speculation.

If the CBs were as powerful as most think, they could not possibly fail to accomplish their goals. Like voodoo, it is the BELIEF of the victim that causes the damage - a negative application of the well-documented placebo effect. While they have succeeded in restarting speculation to some extent in equities and commodities, they have utterly failed to do so in most of the securitization and especially the re-securitization markets. Other than the Fed itself, there is very little demand for MBS and ABS. CDOs have fallen flat on their face and can't get up. The investment bankers' efforts to re-securitize garbage and get it rated as AAA again have largely met with derision. Assets in the real economy are seeing no increase in demand at all to this point. Housing, commercial RE, private businesses, capital equipment and others are all in the doldrums with hardly any positives even in the second derivative.


Flee(t)ing Confidence
Take note of which asset classes are seeing speculation and which are not. It is only those that can be sold instantly with a mouse click that are getting any action - equities and commodities which trade as futures on an exchange. The exceptions are revealing. Iron ore, which requires long-term contracts instead of futures isn't going up and in fact is going down, with users essentially buying at spot by refusing to commit to L-T deals. Assets that are theoretically liquid but actually trade by appointment only are seeing little help. This would include the aforementioned MBS and ABS. Those that require a real commitment and have payback periods measured in years continue to crater. Basically, the only confidence at this time is the confidence of the daytrader.

Yet we now see speculation among economists that there could be a return to growth in the next four quarters and actually, it's hard to disagree that such a thing is technically possible. The key here is the massive amount of deficit spending by governments around the world. Official US Treasury estimates place the FY 2009 deficit at $1.8 trillion but $2 trillion is more likely. The DEFICIT will likely represent 14% of GDP this year. China is in a similar situation, with a "stimulus" package of nearly $600 billion in a $4.4 trillion dollar economy - which works out to just under 14% of GDP. Hmm, that number sounds familiar.

Large segments of both economies are ponzi schemes, though China's most vulnerable sectors are both larger and more leveraged relatively speaking. In the US, the most affected sector is finance; in China, construction and fixed investment. Consider for a moment that both governments are spending enormous sums of money they don't have - effectively borrowing it from the future to spend now. Once again hoping to ignite a chain reaction of speculation and a new bubble.

We actually expect a slight positive print in US GDP in early 2010, with a larger collapse to follow as soon as the government can no longer borrow cheaply. This is the inevitable result of spending twice your income (tax revenue) just to keep the current illusion alive. When the bond market cuts off this foolishness, the portion of the economy that is unsustainable without a bubble dies and all of the capital spent to keep it alive dies with it - a complete waste. Instead of a mere depression, we have a depression compounded with the destruction of capital that should have been preserved to start rebuilding afterwards.


Pricing Ponzi
If you think about it, both the US and China are expending one-seventh of their respective GDPs to support a lie. Another way to think of it is the rate of return the market (in the form of speculators) demands to continue to invest in the ponzi schemes. In effect, the government's best guess at the required RoR is 14%. Antal Fekete has written about the falling marginal productivity of debt. In other words, the debt-based ponzi scheme is becoming less and less effective. As a result the sponsor of the scheme (governments) are having to increase the amount pumped into the bubble to keep the speculators in and prevent a UNIVERSAL recognition of the failure that has already occurred. This is typical of late-stage ponzi schemes where a critical mass of investors become suspicious and demand their money. The sponsor has to come up with it somewhere and in this case they can conveniently pledge their citizens' future income (taxes) as collateral for more loans.

It is impossible to calculate the precise cost but we can look at deficit and "stimulus" spending as a good first approximation of the price to keep the ponzi scheme rolling. If 14% of GDP can be spent and not even produce a single quarter of positive numbers then the decay is even larger and more advanced than we have previously postulated. As an example, the latest Personal Income Report from the BEA showed the scale of government attempts to manipulate the economy. Wages dropped sharply but personal income rose 1.4%. The money quotes:

Private wage and salary disbursements decreased $12.4 billion in May, compared with a decrease of $0.7 billion in April.

Personal current transfer receipts increased $162.6 billion in May, compared with an increase of $59.1 billion in April. The American Recovery and Reinvestment Act of 2009 provides for one-time payments of $250 to eligible individuals receiving social security, supplemental security income, veterans benefits, and railroad retirement benefits. These benefits boosted the level of personal current transfer receipts by $157.6 billions at an annual rate in May.

Once the long-end of the Treasury yield curve resumes its upward march, the financing will get more difficult. If short-term money ever becomes expensive for the US government then the deception is over. But for right now we may get further upticks in optimism as long as the government can continue to create doubt and obscure the real state of the economy. In the near term, it's all in the hands of the speculators and their mood swings and isn't that a sad commentary on the state of the world.

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.

Fed Deception Wears Thin

Two critical events in the last 24 hours:

1) AIG reports an enormous loss
This is very important since insurance is the largest financial sub-sector which does not have access to the Fed's discount window, which has been used to conceal the losses or the various swap programs designed maintain the fraud that some banks are not insolvent. Given that, an honest report from AIG gives us some insight into what the REAL situation looks like in the financial industry and it's not pretty. With the strains imposed on the Fed's balance sheet by their past actions there is essentially zero chance that the insurance industry as a whole will get access.

Yesterday's selloff was triggered by an SEC announcement that greater disclosure would be required in the balance sheets of investment banks. Financials dropped hard. Essentially anything that interferes with the ability of the banks to commit fraud is going to tank the sector since fraud is the only thing between some of them and bankruptcy. The follow through from AIG just reinforces this as the look behind the curtain revealed loses of nearly $8 billion this quarter and there's no end in sight. They will raise $12 billion in new capital and also (weirdly) raise the dividend. So they bought back stock when it was expensive a year or two ago. Now they're selling when it's cheap. Buy high, sell low is not a good way to make money. We saw this trend coming back in November and wrote about it in Tactical Nukes

"Liquidity" has been removed. LBOs of any real size are dead. Instead of buying back shares to reduce the supply, corporations are starting to issue more stock and increase supply just as demand is falling. It looks to me as if the even the tactical bull case has been nuked at this point. The strategic case is long-dead. What is the reason to still own stocks today?

Also they are raising cash but will increase the rate at which they burn it by paying out higher dividends. Hello? Earth to AIG, anybody home?

2) Citigroup to sell half a trillion dollars of assets
$500 billion - that is a big number. Just for perspective, that is twice as large as all of the Fed's uncommitted assets. Like I've said before, Citigroup is too big for the Fed to save and this at least shows that management is taking action to control the damage on their own. For that I applaud them.

The flip side is going to be truly problematic for the financial sector though. Most of the Fed's actions have been aimed at preventing everyone from finding out what these assets are really worth. They've loaned out a bunch of money specifically so that banks could hold the assets instead of selling them - thereby establishing a market price for them. This announcement from Citi indicates that the game of hide the garbage may be over finally. Since the asset base involved is so big, there is no entity on the planet with enough money to allow them to hold on indefinitely. Once market prices for the assets are established, balance sheets across the financial world will have to be adjusted to the new valuation levels. This should result in another big round of writeoffs and losses.

Smaller and more nimble players may choose to get out quickly, before this enormous wave of selling. The selling itself will drive down prices, especially when it occurs on this scale. Just as the buying induced by the credit bubble drove asset prices up. If I were a manager in the banking sector (which thankfully I am not), I would front-run the sale of Citigroup assets so as to get the best price NOW. Sometimes he who panics first, panics best.


My major concerns at this point are where to put my money to keep it safe. The Fed games have ensured that we have little information on which to base our analysis. JP Morgan and Bank of America seem to be the "designated survivors" in the banking sector. Lending directly to the Federal government via Treasuries and small community banks with very high lending standards seem like the only other viable options. I am hopeful the these latest revelations bring the equity indicies back to more rational levels so that we can avoid the severe crash that a sudden recognition event would cause.

Corporate Finance

The Universal Debt Bubble (UDB) has enabled many activities that could never be sustained in anything resembling a normal environment. Perhaps nowhere is this more clear than in the field of corporate finance and the related debt and equity markets. Let's look at the borrowing side first.

Just as with housing, cheap credit was widely available in the corporate sector. Anybody could borrow and at much lower than normal interest rates too.

One of the most important effects is that it was almost impossible to default on a debt. Since there was almost always another lender lined up to make a loan, companies refinanced instead of going bankrupt. This was very similar to the way homeowners refinanced instead of facing foreclosure. The magnitude of the drop in defaults was astounding. A study by Moody's showed that over 32 years the lowest rated bonds (Caa, Ca and C) averaged 23.7% defaults each year.
http://www.moodysasia.com/SHPTContent.ashx?source=StaticContent/Free+Pages/MDCS/Asia/Corporate+Bond+Ratings+and+Rating+Process.pdf

With the UDB in effect, the default rates for those risky bonds has fallen to virtually nothing:
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"Issuers rated CCC or lower typically default at an average annual rate of 25 percent, as measured by Fitch. In 2006, the default rate for such issuers was 4.5 percent, the lowest in 20 years."
http://www.ibtimes.com/articles/20070111/junk-bonds.htm

With consequences seemingly abolished, borrowers lenders began to behave badly - just as they did in the mortgage market. More and more of the bond deals funded were in the lowest credit categories: the corporate equivalent of subprime. The structures were increasingly convoluted and risky. Toggle notes were issued, giving the debtor the right to pay interest either in cash or more bonds - reviving the disastrous pay in kind (PIK) structure from the 1980s. This also looks suspiciously like an option ARM or negative amortization loan. Covenant lite loans removed most of the traditional protections for the lender, echoing the no-doc, no verification trend in mortgages. The parallels are uncanny - just as they should be since they were caused by the same UDB forces.

Once all of this foolishness is gone, we should see things revert to their historical levels. If we see anything close to normal, junk bond losses will be substantial. There are many other resemblances and we may deal with them at a later time. But the next topic for discussion will be what companies did with all of the money they raised in the bond market.

Where to Start?

This is such an enormous subject, it's difficult to know where to begin. I'm going to start with the prevalence and destructiveness of excessive debt. The best illustration of that so far is in the housing market. The symptoms there are more obvious and advanced than elsewhere. So let's go to the stats.

According to the Federal Reserve mortgage lending grew from $153.8 bil in 1995 to $1,051.8 bil in 2005 - a mere 584% in 10 years.
http://www.federalreserve.gov/releases/z1/current/z1r-2.pdf

The results were amazingly predictable: housing prices rising rapidly, with a speculative frenzy at the end. It's axiomatic that bubbles can only last as long as there is more money coming in. I'll freely admit that I expected a top in housing in 2004 as the pool of qualified buyers was drained. The lenders fooled us by making further loans to unqualified buyers to keep things going for another 15-18 months. In the end, this has only made things worse naturally.

We are at the front end of the suffering now. It was easy to see it coming when new houses were adding 2% or more to the existing supply for years and the population was growing at half that rate or less. The Census Bureau confirms that the number of empty houses has never been higher. Until 1999, homeowner vacancy rates were almost never above 1.7%. That number has been 2.5% or higher for 4 straight quarters now - suggesting over 1 million empty and unneeded houses.
http://www.census.gov/hhes/www/housing/hvs/historic/histtab2.html

The consequences are popping up in the form of falling home sales and prices, rising delinquencies and foreclosures, with collapsing lenders following quickly behind them. For detailed coverage and discussion of all these trends, check http://thehousingbubbleblog.com/

Unfortunately, the madness of the lenders was not confined to housing - far from it. There was similar Crazy Eddie lending in commercial real estate, corporate lending, foreign government bonds and the various forms of consumer credit. I'll examine each of these separately but the bottom line is that these practices have erected a house of (credit) cards that now threatens to collapse - taking much that I hold dear with it.