A Second Hand Conjecture

Admit it, you had to think for a second about whether this was serious or not didn’t you?

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Now that the NBER has decided to endorse my view that we went into recession last December which I first first claimed last January, I think my points about the efficacy of fiscal stimulus still apply.

As for spending already pledged to save us, the figures are growing at a rate that has even astounded someone as bearish and cynical as myself. Barry Ritholtz has given us a breakdown and a spreadsheet to track it:

I suspect given the continuing issues and a President intent on expanding the government balance sheet even more than our present one that that spreadsheet will get quite a bit larger. All that money to save a $13 trillion economy. What a mess.

Meanwhile the housing market continues to collapse, as the lights repeatedly seen at the end of a tunnel seem to really just be a series of oncoming trains. Lots of charts and analysis here and here.

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From the comments at Financial Times:

Nov. 13 (Bloomberg) — In a surprise move today, Whoopee Cushions Inc was approved bank holding company status by the Fed to enable the company access to the recently revised TURD scheme.

Imported far-eastern whoopee cushions have decimated the domestic industry over the past two decades, leaving former giants of the industry controlling a mere 0.1% of the domestic market. Some observers point to the poor reliability and high labor costs of domestic products as a defining factor in the industry’s demise, but it appears the government are prepared to spend now and ask questions later.

Chairman and CEO, Chuck Chuckles said “It is vital that the government recognises the role we play in the modern US economy. Whoopee Cushions Inc has been the backbone of US manufacturing for over 400 years and if we were to go under it would mean 100,000 people needing to learn new skills and find work in more productive industries. I think you will agree, that is something nobody wants to see happen”.

Finance Director Mr Magoo, 12, added “Whoopee! I’m off to structure some whoopee cushion backed securities to sell to the government at inflated prices”. At time of going to press it is not known whether the pun was intended.

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Yves Smith hits a theme I have been harping on, the Federal Reserve, and central banks in general, are making things worse in may ways by destroying the incentive for banks to lend or borrow from one another. She quotes James Bianco of Arbor Research:

The Fed’s massive and numerous liquidity facilities are making things worse. The problem is more than banks unwilling to lend to each other, they are also unwilling to borrow from each other. Banks can get all the funding they need (and then some) from their central bank so they do not need to seek a loan from another bank. I believe it has gotten so bad that they don’t even bother to make a decent market for inter-bank loans anymore. No reason to, they don’t need them anymore as central banks have replaced them.

I would suggest more subtle factors should also be emphasized besides how this distorts rates on loans. If banks do not need each other then they don’t communicate. Thus the hard work of investigating what counterparties real credit risk is goes undone. The market is shunting that off to governments. Furthermore, banks have no incentive to arrive at a believable accounting of their assets, they can wait and hope for a bailout rather than find a way or terms that other banks will accept.

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I am often asked about individual bank stocks, especially JP Morgan. Generally my answer is that Bank of America, JP Morgan and a few others look to be likely survivors, but how profitable they will be I am really unsure.

JP Morgan is a special discussion, because I point out a rather astonishing fact, they have a notional exposure to around 90 trillion in derivative contracts, or did last March (pdf.) 58 trillion of it swaps of some sort. Probably credit default swaps (CDS) are the majority. Which means…what? I don’t know, and frankly if anybody really does they aren’t telling me. In essence I am left telling people that I have to treat that as a “black box.” Not exactly confidence raising. Personally there are better ways to make money than hoping a company with 90 trillion in derivatives exposure has a handle on it in my book, but then again, I am admitting that I have no idea what I am talking about, and cannot find anyone else who does either.

Warren Buffet often speaks of defining a circle of competency when investing and staying inside it. It doesn’t matter how big the circle is, just knowing when you are inside it. Well, 90 trillion in derivatives exposure is outside of my circle of competency to assess.

The nightmare is what if it is outside of JP Morgans circle? I suspect it is, and the massive exposure of two other banks as well (Citibank and Bank of America have approx. 38 trillion apiece.)

What makes me wonder about it today? Personally I have always felt that there was a good chance that JP Morgan was who was being saved when the Fed brokered the acquisition of Bear Stearns. Bear goes under and JP Morgan would have to come up with huge payments on CDS contracts. Also, I suspect that Bear was a counterparty for a large number of derivatives, which if Bear was insolvent might not have all been paid up. Or maybe not. Then I see this over at Barry Ritholtz’s:

“Lehman Brothers Holdings Inc.’s main lender and clearing agent, JPMorgan Chase & Co., caused the liquidity crisis that led to Lehman’s collapse, creditors said.

JPMorgan had more than $17 billion of Lehman’s cash and securities three days before the investment bank filed the biggest bankruptcy in history on Sept. 15, the creditors committee said in a filing Oct. 2 in bankruptcy court in Manhattan. Denying Lehman access to the assets on Sept. 12, the bank “froze” Lehman’s account, the creditors claimed.

JPMorgan, the biggest U.S. bank by deposits, financed Lehman’s brokerage operations with daily advances, while money market funds and other short-term lenders provided overnight loans, according to bankruptcy court documents. When JPMorgan shut Lehman off from funds, Lehman “suffered an immediate liquidity crisis that could have been averted by any number of events, none of which transpired,” according to the filing.

The creditors asked the judge in charge of the case to let them interview a witness and request relevant documents from JPMorgan and to pursue possible legal claims. U.S. Bankruptcy Judge James M. Peck is scheduled to hold a hearing Oct. 16 on that request, the creditors said.”

Hmmm, so Lehman may have been torpedoed by JP Morgan? Hardnosed but not weird, until this little tidbit in the update:

Ron Kirby notes: “I wrote about a very strange occurrence – the reporting of J.P. Morgan “transferring” 138 billion dollars to Lehman, after Lehman had already filed for Chapter 11 bankruptcy early last Monday morning…It is highly likely [or a certainty on my planet] that J.P. Morgan was INSOLVENT and was “BAILED OUT” last Monday, September 15, to the tune of 138 billion dollars. This would explain why the Fed and Treasury dictated that Lehman fail – to disguise or otherwise obfuscate the recapitalization of or illicit transfer of 138 billion to A MUCH SICKER, TEETERING ENTITY, J.P. Morgan Chase.”

The link is filled with some rather out there speculation (and I have no intention of confirming or discrediting it) but this is a very odd transaction. Immediately after sending Lehman 138 billion they received 138 billion from the Federal Reserve. What were they off loading? Meanwhile they allegedly cut off Lehman.

Back to Bear. Was allowing JPM to take over Bear and the Fed guaranteeing most of their debt a back door method of recapitalizing a banking behemoth? Are the acquisitions that JPM has been making under very favorable terms a sign of strength or weakness? Gifts from the Federal Reserve to recapitalize them? How much trouble is in that book of derivatives?

I have already pointed out the problems in Europe, problems which the failure of AIG would have exacerbated due to their massive involvement in the CDS market. Is it possible that JPM was also heavily exposed to a failure by AIG? With 90 Trillion in nominal exposure it is hard to imagine they were not. With that much exposure who could possibly be more of a candidate for the “too big to fail” label. Could the Fed be manipulating these events to save them without causing the kind of panic that Bear and the later victims have caused?

I don’t know, which is the real tragedy. Nobody knows what the exposure of anybody is, so we are all left guessing. The Federal Reserve, our government, the financial institutions themselves are all busy obscuring rather than bringing things to light. In order to avoid panic by showing us all how deep the problems are, they are busy spreading suspicion, distrust and panic by keeping everybody, including financial institutions they have to deal with, in the dark. The hope of generous terms from the government keeps banks from admitting what their books really look like, or to try and sell in an orderly manner what they have. Who needs to expose your books to potential lenders when the Federal Reserve will take a used car as collateral and at a lower rate.

How bad off are these institutions? We have no idea. We are left with our imagination and our nightmares.

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I have argued in the past that the Federal Reserve’s policies may be helping in some ways, but hurting in others. Way too much borrowing and lending is running through the Fed which is drying up lending between banks. It also reduces the need for banks to find reasons to communicate and trust each other, keeping the atmosphere of mistrust alive.

On a similar note one of Yves Smiths commenters left this comment, which is well worth pondering when thinking of the bailout plan being considered:

One of the most critical functions of the banking system is converting short-term deposits into longer-term loans for businesses. Much of the working capital market, for decades has come via money market funds (MM). Joe public or Joe CFO deposits money into a MM. That MM loans it to a bank (usually by buying paper, and usually at a medium duration) and then that bank loans it out to business for inventory, payroll or whatever. The MM has converted Joe’s demand deposit into a fixed-duration loan.

The problem we’re having is that people are fleeing commercial MM for treasury MM. Those are buying treasuries and thus converting the money to the desirable medium duration BUT that money is loaned to the Fed, and the Fed doesn’t make working capital loans. So the deposited money that had been made into working capital has been diverted into the Fed and lost to working capital.

The Fed is kind of trying to address this by loaning out money via various auction/discount windows. BUT, those loans have been overwhelmingly overnight – a particularly nasty demand deposit because it goes back so fast. For a bank to convert that to a 90-day loan it’s got to win 90 auctions in a row – a very risky deal with a crunch on. So the Fed undoes the duration conversion, and then some, converting the liquidity into a form that the banks can’t make into useful-duration loans.

Right now we have both commercial and treasury MMs. Deposits have shifted from commercial MMs to treasury MMs, and consequently we have less working capital (a commercial MM product) and better credit for the Fed (a treasury MM product). But, treasury MM rates are now very low and the gap between treasury and commercial fairly high, which creates an incentive for depositors to put money into commercial funds, producing some working capital.

When Paulson dumps out his 700 billion in treasuries it’s going to be at the short end. That will drive up rates for short-term treasuries. This will obviously draw even *more* deposits into the treasury MMs. That means even less in the commercial MMs and thus less working credit, the eventual commercial MM product. Hence Paulson’s billions remove working capital by competing for the deposits that could get used to make working capital loans. That 700 billion is going to go to fairly long-term mortgage securities. So Paulson’s billions divert credit from working capital to long-term mortgages – from where it’s most needed to where it’s most wasted.

Even if the giveaway adequately props up the banks, which I doubt, they still can’t make working capital loans, because the raw material they used (commercial MM deposits) will be desperately short.

I think it’s very telling that in two days of hearings and two weeks of discussion we have yet to see *any* detailed mechanism for how Paulson’s plan will increase the supply of, say, inventory loans. It’s not that every economist in the world is an idiot, it’s just not going to help. I think people have fallen into the fallacy that if it costs a lot it must be valuable. Paulson’s plan falls into the category of very expensive way to hurt ourselves.

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I do believe we should be doing something as a nation, through our government, to avoid the not insignificant chance of a total financial meltdown. I have seen several things proposed that I find interesting, and I will get into them and other longer term issues in coming days. I had hoped to address this all comprehensively, but time just isn’t allowing that, so let us do so piecemeal.

Today I would like to endorse one proposal that aligns exactly with my thoughts on this, which is we need to recapitalize banks in a more effective, less arbitrary manner while protecting taxpayers and homeowners as well.
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The Federal Reserve has for a long time eschewed increasing the money supply directly, and instead has manipulated credit to affect the economy and control inflation. This has led to three important things which are in my opinion at the root of this crisis.

• Asset price inflation (at least initially) as opposed to broader price inflation.
• A massive increase in leverage (debt to magnify returns) throughout the financial system and our economy.
• A massive increase in the size of the financial sector relative to the rest of the economy. Since it is built on leverage, financial sector compensation has soared and led to concentration of wealth in financial hands.

The last fascinates me, as a sector which should be a relatively small part of the economy functioning as intermediaries has through leverage achieved profits (a redistribution of wealth from the rest of our citizenry) far from the size their intermediary function can possibly justify. These intermediaries for example accounted for about a third of the market capitalization of the S&P 500 before they crashed and burned. How do the intermediaries deserve a market cap that amounts to around half of those for whom they intermediate?

The answer is increased leverage. I’ll address this in more detail later, but the Federal Reserve has finally decided to expand the monetary base, which has consistently grown at a very slow, or non existent rate. From David Merkel:

Check out the very far left side of the graph and look at the vertical takeoff.

David fills us in on the details:

Look at the H.4.1 report.  We may have finally hit the panic phase of monetary policy, where the Fed increases the monetary base dramatically.  They are pumping the “high-powered” money into loans:

• $20 billion for Primary credit
• $80 billion for Primary dealer and other broker-dealer credit
• $70 billion for Asset-backed commercial paper money market mutual fund liquidity facility
• $40 billion for Other credit extensions
• $80 billion for Other Federal Reserve assets
• -$20 billion netting out other entries

Making it an increase of roughly $270 billion from last week’s average to Wednesday’s daily balance.  Astounding.

In general, the increases are not being pumped into the banks, but into specialized programs to add liquidity to the lending markets.  Now, I’ve written about this before, but it bears repeating.  What happens if the Fed takes losses on lending programs.  It reduces the seniorage profits that they pay to the Treasury, which means the Treasury has to tax or borrow that much more.  The Fed isn’t magic; it’s a quasi-extension of the US Government in a fiat currency environment.  It’s balance sheet is tied to the US Treasury.

Yves Smith at Naked Capitalism is correct.  The US is no longer a AAA credit, particularly if you measure in terms of future purchasing power of US dollars.  I’ve felt that for years, though, with all of the unfunded future promises that the US Government has made with Medicare, Social Security, etc.  The credit of the US Government hinges on foreign creditors (like OPEC and China) to keep it going.  What will they offer them? The national parks?

True, all true, but possibly if they are going to provide monetary stimulus this might be a better way than cutting rates, now and in the future.

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Today the Fed went to the Treasury and asked for a line of credit. You know, the lender of last resort has had to turn to our Treasury to protect their balance sheet.

Want to see something weird. Go here and look at the treasury market. In the bond world, a 1% move is huge. So check out what has happened in the US Treasury market. Especially the 13 week Treasury bill. It’s yield collapsed by over 97.67% today.

Astounding, truly astounding.

My father who invested (and very successfully) through the late sixties/early seventies nifty fifty era, the bear market of 72-74, the market low in 1981 and Black Monday in 1987 says this is the most incredible market in all of his experience. It certainly eclipses anything I have seen from 1980 forward.

Update: Courtesy of Eddie Elfenbein:

At one point today, the yield on the three-month Treasury bill (^IRX) hit 0.01%!!

One Freakin Bip!!

This means that the risk-free rate is now in direct competition with the underside of your mattress.

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FROM: Dr Ben Bernanke
Central Bank of United States of America
01-658-555-1234

TO: CEO
Lagos, Nigeria

Dear Friend:

I have been requested by the regional members Federal Reserve of the USA to contact you for assistance in resolving a matter. The Federal Reserve of the USA has recently concluded a large number of contracts for credit derivative investment vehicles “CDIV” in the Wall Street region of the USA. The contracts have immediately produced moneys equaling US$40,000,000. The Federal Reserve of the USA is desirous of CDIV in other parts of the world, however, because of certain regulations of the USA Government, it is unable to move these funds to another region.

Your assistance is requested as a non-USA citizen to assist the Federal Reserve of the USA, and also the investment bank community of Wall Street USA, in moving these funds out of USA. If the funds can be transferred to your name, in your Nigerian account, then you can forward the funds as directed by the Federal Reserve of USA. In exchange for your accommodating services, the Federal Reserve of USA would agree to allow you to retain 10%, or Nigerian $4 million of this amount.

However, to be a legitimate transferee of these moneys according to USA law, you must presently be a depositor of at least $100,000 in a USA bank which is regulated by the Central Bank of USA.

If it will be possible for you to assist us, we would be most grateful. We suggest that you meet with us in person in New York, NY USA, and that during your visit I introduce you to the representatives of the Wall Street USA, as well as with certain officials of the Central Bank of USA.

Please call me at your earliest convenience at 18-555-1234. Time is of the essence in this matter; very quickly the USA Government will realize that the Central Bank is maintaining this amount on deposit, and attempt to levy certain depository taxes on it.

Yours truly,

The Esteemed Arch-Chairman

Credit: Barry Ritholtz

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I’m sure it’s just me and my strange world, but I realized tonight I haven’t seen a $10 bill in several weeks. It seems in every cash exchange I’m getting back two fives in instances needing a ten. I suppose my mind had registered it subconsciously some time ago, but only became cognizant at a gas station earlier tonight. I had about $16 in change due and the clerk had to call out “we need more fives again!” to his manager to give me three of them. I looked through my wallet for a ten. Every Federal Reserve note in there except the scarce $10. Strange.

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From Slate

On tonights podcast at QandO, I called in at McQ’s request to discuss the economy. One of the things we discussed was the likelihood of our government continuing to bail out our financial institutions. For a number of reasons that will be problematic.

Of interest is how many institutions are likely to fail?

One way to look at that is to see what the market is implying. Weighted by assets, right now the market is pricing in about a 4% failure rate for just the next six months. That would be far above the S&L crisis’ peak, and over its full term it amounted to failures of 17% of total assets. The assets which would need to be absorbed….575 billion. How much capital would that require to absorb them….50 to 80 billion. There is only about half that available from other institutions to take them over. Of that, nearly half is in small institutions which will be of little help. As loans continue to go bad that capital is likely insufficient to cover their own losses.  This implies much more raising of capital, and who is going to give it to them? Most people who were willing have already ponied up. JP Morgan and the Fed already took on Bear Stearns. Whose balance sheet is available?

The losers in this? Taxpayers and bondholders. Having just taken on Fannie and Freddie, and guaranteed their bondholders, I assume bondholders will have to start taking hits. The lesson might be for bondholders, if you are going to fail, fail early and fail spectacularly!

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Cross posted at Risk and Return

You may remember the website we discussed back in January. Dale Franks just discovered their program, because they now are on Television. He asks the obvious question:

So, should the mortgage companies get off scott-free from facing the results of their poor business decisions when it comes to the loans—loans they shouldn’t have made in the first place?

From my comment there:

No, they shouldn’t. I don’t endorse walking away, but when you take out a loan, and offer collateral, it is assumed that one possible recourse is to give back the collateral. Since lenders don’t want that to happen, they are supposed to examine the worth of that collateral pretty carefully, and get some money down. That way it isn’t in the interest of the homeowner to “walk away” even if they don’t mind the damage to their credit.

The lenders didn’t do either, now people are returning the house when it is in their best interest. I don’t count on the benevolence of my bankers, I suggest they shouldn’t have counted on consumers to take it on the chin for their sake either. Nor do I want our government, or the Fed, to keep bailing them out, either directly or indirectly by helping people keep houses they cannot afford. Neither is likely to work anyway.

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The Fourth quarter GDP numbers came in this week, and then the Fed went ahead and cut rates further. That is 125 basis points in about a week.!

I have a roundup of news, related opinion and other reactions at Risk and Return.

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Contra David Merkel, Amity Schlaes says a choice can be made, and Bernanke’s worry should be inflation.

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From The New York Times:

WASHINGTON (AP) — The Federal Reserve, confronted with a global stock sell-off fanned by increased fears of a recession, cut a key interest rate by three-quarters of a percentage point on Tuesday.

Quicker and larger than expected.  I am curious whether investors will, at the margin, consider this a move to celebrate or evidence that things will get much worse?

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World markets are not happy with the stimulus plan. My breakdown of the plans likely impact can be found here.

Share prices in Asia, Europe and the Americas all plunged by significant amounts; Wall Street only avoided joining the tumble because U.S. markets were closed Monday for Martin Luther King Day.

Markets in Europe reacted with London’s FTSE 100 Index down 5.5 percent at 5,578.20; the CAC-40 in Paris down 6.8 percent to 4,744.15; and Frankfurt’s DAX dropping 7.2 percent to 6,790.19.

In Japan, the benchmark Nikkei 225 index closed on 13,325.954 points, a slide of 3.9 percent and its biggest dip in two years. Shanghai’s Composite index fell 5.1 percent.

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 (cross posted at Risk and Return)

Ben Bernanke gives Congress and the President the green light to take steps to stimulate the economy along with a warning:
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Chris asked what he thought the Federal Reserve could have done differently. I gave him an answer, but there was more to be said. My full answer is here. Scroll around, there is a lot more on the what could have been done, what might be done, and the general risks which now surround our economy.

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Milton Friedman’s research partner, Anna Schwartz, goes after the federal reserve:

As rebukes go in the close-knit world of central banking, few hurt as much as the scathing indictment of US Federal Reserve policy by Professor Anna Schwartz.

The high priestess of US monetarism – a revered figure at the Fed – says the central bank is itself the chief cause of the credit bubble, and now seems stunned as the consequences of its own actions engulf the financial system. “The new group at the Fed is not equal to the problem that faces it,” she says, daring to utter a thought that fellow critics mostly utter sotto voce.

More thoughts from Anna and my musings on the Fed.

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The economy is slowing, and if we are not already in a recession (I think we probably are) the risks of one are certainly high. So should our politicians do something with fiscal policy? Alex Tabarrok says no :

Fourth, in their desperation to “do something” politicians will often do something foolish. If a spending increase or tax cut isn’t worthwhile on its own merits then it’s highly unlikely to be worthwhile once we add in the benefits of “stimulus.” Thus, it’s one thing to argue for extending unemployment benefits as a matter of welfare it’s quite another to think that an increase in unemployment benefits will so increase spending as to reduce unemployment! (The implicit view of Larry Summers.)

I admit to being dubious of legislation and federal government action being useful for short term economic swings. Here are the other quite compelling reasons why:

First, the money for any new spending or tax cuts has got to come from somewhere, right? Thus there is usually substantial crowding out of any stimulus.

Second, by the time the new spending or tax cut gets through the political process the economy has moved on and the stimulus is no longer relevant except by accident.

Third, there just isn’t that much discretionary spending to play with and even a large increase in spending, say tens of billions, is too small to make much of a difference in a 13 trillion dollar economy.

My emphasis above. I am always amused at the power people ascribe to what seems to be a large action, but in the context of the US economy and financial system is actually pretty paltry. That goes for most actions undertaken by the Federal Reserve as well. Finally, even for those amongst us, especially economists, who find those arguments less than compelling, we should all remember this:

Economists may call for “temporary,” “conditional,” and “targeted” stimulus but they won’t be the ones designing the plan. Spending increases and tax cuts are policies with long term consequences that we need to think about carefully.

My own view relates to the first reason I quoted. Spending and tax decisions should make sense in and of themselves, not because of some quixotic attempt to influence the short term course of the economy.

Update: McQ is dubious about the specific package being offered by the Democrats in Congress on far less general grounds as well.

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