Tuesday, September 30, 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.

Er, most Americans now have a substantial part of their pension or 401(k) invested in stocks.

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.

Saturday, September 27, 2008

Shadow Banks, Shadow Government

Here at Financial Jenga, we don't often comment directly on politics - being much more inclined towards economics. We are also equally skeptical of both groupthink and conspiracy theories - which tend to be opposite sides of the same psychological coin. However, the sheer scale of the current crisis and many of the proposed solutions make this problem inherently political. It would also appear that many of the "fixes" being bandied about won't actually fix anything but WILL benefit certain politically-connected parties.

There is considerable evidence that the proposed $700 billion bailout of Wall Street will do little to fix the credit problems. One of the key arguements used by supporters is that banks don't have enough money to keep lending. This is simply a lie. The latest
Fed H.3 report shows that excess reserves in the banking system were $68.8 billion as of 9/24/08. This is 1400% above any other datapoint for the past year and more than 2000% higher than the average for that time. In other words, the Fed has FLOODED the banking system with borrowed money (the excess reserves) and the banks STILL won't lend.

In the real world, you cannot conduct fully-controlled experiments to validate an economic theory. But to the extent that it can be, we have already tested the thesis that giving banks more money will cause them to lend more and found it to be flawed. The most likely outcome of the bailout appears to be many banks saved at taxpayer expense but we get a credit crash and recession-depression anyway and Main Street has even less money to struggle through it since it will have been given away to Wall Street. Basically, it redistributes the losses for past transgressions from the guilty to the innocent and does little to help the future. We therefore oppose the bailout on both economic and moral grounds.

Hitting the Panic Button
According to various media reports, the supposed experts threatened Congress with all sorts of terrible repercussions if the bailout was not passed immediately and without strings. From their public statements, our representatives have been told that failure to do so would result in an immediate end of credit, a stock market crash, massive layoffs and likely a new Great Depression. As regular readers here know, many of these consequences ARE likely but they do NOT stem from the lack of a bailout for Wall Street. They are the DIRECT result of the orgy of foolish lending that preceeded the bailout request. Paulson and Bernanke are using their control of information and the ignorance of the politicians to run a bluff. We are being threatened with consequences that are likely to come in any event and the bailout won't change that.

In many ways, the financial authorities are taking active measures to make the crisis worse. The Fed has been withdrawing liquidity from the financial system for over a week. According to
the Slosh Report, system liquidity topped at $190 billion on 9/18 and fell to $110, $110, $90, $65, $63 and $59 billion on subsequent days. With the Fed deliberately cutting prior support, it's no wonder the short-term stress has become overwhelming. One result has been the largest bank failure in history (Washington Mutual) followed within days by a shotgun marriage to prevent an even larger one (Wachovia). The WaMu failure itself is quite interesting. The FDIC ALWAYS buries failed banks on a Friday, in order to give themselves time to sort the mess out over the weekend. We've gone back and checked and it's been true for many years. Yet the WaMu failure was announced on a Thursday, the day after the President unveiled the bailout proposal. The FDIC's timing on WaMu looks suspiciously like an attempt to rachet up the pressure on Congress - as does the Fed's withdrawal of liqidity support from the system.

In many ways this power-grab resembles the cynical use of religion in primitive societies. It is well documented that the priesthood in many cases studied the heavens with great care. One benefit would be the ability to predict solar eclipses - one of the most terrifying astronomical events to our ancestors. In some cases, the religious leaders used that terror to wring offerings, greater control and even political power from a frightened populace. The events in Washington today are quite similar but even worse. The crisis is already pre-determined. But the current financial leaders helped to create the disaster and now demand power to end it. In contrast the shamans and witch doctors were merely opportunists. The crisis centered in the Shadow Banks is now being used to create a Shadow Government.

Friday, September 19, 2008

Frederick the Great vs. Hank Paulson

This is total panic time. They're now firing off everything that they have after the first several attempts at an options expiration week stick save failed badly. Basically, the Treasury is guaranteeing virtually everything now with backstops for money market mutual funds and a new super SIV for bad assets. But as Fredrick the Great said: "He who defends everything, defends nothing!" This was a simple acknowledgement of military reality - concentrate on protecting the most important assets. Spreading yourself too thin invites defeat in detail and the destruction of your forces. Then the enemy can loot at leisure.

The government seemingly doesn't understand this but they will. There simply isn't the money to do everything and in their arrogance the Fed and Treasury have over-reached badly. By trying to save all of the bankrupt financial companies, they are weakening the defenses of the strategic key - Treasury debt. The bond market is already demanding 50 basis points more in interest than just days ago. Another way to look at it is that 10-year government bonds have lost 3.5% of their value in that time. The Treasury is the logistics depot from which the army defending every other target is being supplied. If it falls, the war is over and our enemies win.

One shot wonder, long-term consequences
The SEC, erstwhile market watchdog is barking up the wrong tree again. They sat on their hands and did nothing while the disaster built all around them and now they are attacking the group pointing out the problem, not the ones who caused it. In banning short-selling, they also increase the probability that there will be no bounce when the next decline occurs since short-covering is the one thing that has kept our stock market from collapsing like much of the rest of the world's.

The fact that they feel the need to use this one-time guaranteed short-squeeze now ought to tell you everything you need to know when the cost is so high for so little gain in terms of time. This tells me that election politics are paramount here since there is at least a chance (maybe 50/50) to delay the crash by 6 weeks. There is little prospect that we make it 6 months. With so little difference, I'd prefer it occur before the election to guarantee an Obama presidency. Whichever party holds power over the next 4 years will be discredited for a generation (after Hoover and GD 1.0, the Republicans were unable to build sustainable majorities for two generations). Though I'm disgusted with both political parties, there is at least some chance that the Republicans will return to their Reaganite roots after a time in the wilderness. I have no hope at all where the Democrats are concerned. The fundamentals are positively horrific and much depends on sustaining the illusion of control. Short-sellers overwhelmingly profit from disparities between perception and reality - as such, they are always among the first to point out that the emperor has no clothes. Given the stakes, anyone who sees through the deception must be punished and silenced.

There isn't even enough tax money to cover the normal operations of our bloated government, much less this madness. But the bond market was willing to make up the difference as long as there was a high probability of repayment. But the checks that Paulson is writing with his mouth right now are guaranteed to bounce and some bond buyers are noticing. From a low beneath 3.30% this week, the yield on the 10-year Treasury bond has skyrocketed by 50 basis points. The fact that the bailout silliness has more than doubled that deficit doesn't help at all. Like any fool who continues to spend far beyond his means, the creditors will charge us more and more to borrow until insolvency.

The only solution is immediate cuts in government spending and the repudiation of all the backstops that have been proposed. Getting within shouting distance of a balanced budget is the only thing that can prevent an imminent spike in Treasury rates. The entire game depends on the willingness of foreign savers to fund the now gaping chasm of the Federal Deficit. If they balk, the whole structure is endangered. By taking on the toxic waste of the financial industry, all the US government has done is place itself at risk in the inevitable implosion. This is too large for any government or even all of them together to solve. Remember how Congress sent the GSEs out to save a drowning housing market and the "lifeguards" not only failed the rescue but also got pulled to the bottom right along with everybody else? That is precisely what is going to happen to the US government if they don't extricate themselves now. A blowout in borrowing costs was a precursor to the demise of Fannie and Freddie; we appear to be seeing a super slow-mo, reverse-angle replay with the Treasury right now.

One reason the US survived GD 1.0 without the political damage in the rest of the world (think Hitler, generals in Japan, Peron and petty dictators from Pilsudski to Metaxas) was the fact that the our government's finances never reached a state of existential crisis. The deficit (what there was of it) and government bonds were always sure to be paid back. That assurance is not present today and the government's actions are making ultimate repayment ever less likely. The Argentine example is particularly poignant. In the early 20th century, that country had a higher per capita income than the USA. After decades of socialist and corporatist policies under the Perons, they became the ongoing basket case and borderline Third World country they are today.

I hate to paraphrase anything from the Star Wars series but it is too apropos: This is how freedom dies - to thunderous applause.

Wednesday, September 17, 2008

The Fed is Broke

Three months ago we published Why Bennie Can't Lend, detailing the Fed's balance sheet and the limitations they were up against. We contended that they were out of cash and unable to sell their bond holdings without serious consequences. That is why their incremental actions have been limited to the TSLF, where they loan out the actual bonds rather than cash. Today, the Fed admitted that we were right all along by arranging for the US Treasury to raise more money for them so they can keep lending via the alphabet soup of liquidity facilities.

The Federal Reserve has announced a series of lending and liquidity initiatives during the past several quarters intended to address heightened liquidity pressures in the financial market, including enhancing its liquidity facilities this week. To manage the balance sheet impact of (ed. - ie. pay for) these efforts, the Federal Reserve has taken a number of actions, including redeeming and selling securities from the System Open Market Account portfolio.

The Treasury Department announced today the initiation of a temporary Supplementary Financing Program at the request of the Federal Reserve. The program will consist of a series of Treasury bills, apart from Treasury's current borrowing program,
which will provide cash for use in the Federal Reserve initiatives.

Basically, this is simply another holding action by the Fed to prevent the "fire sale" (actual price discovery) of assets held across many financial institutions. Yet the implications are profound. This would have been a perfect opportunity for the Fed to print money if it had any intention of actually doing so. Yet they did not, even under the extreme pressure of Lehman failing and AIG bailing. Instead they chose to stay within the framework of fractional-reserve banking and they BORROWED instead. If they were going to conjure money out of thin air, this would have been the time to do it and they demurred.

We believe that this is a shock to the market in a number of ways. It clearly demonstrates the limitations of the Fed's power when many market participants believe that power to be virtually unlimited. It shows that the Fed is no different than any commercial bank in this regard - they have to be able to borrow and lend to expand the money supply. They have the advantage of being able to turn to the Treasury in a pinch but they are trying to support asset prices (promoting asset inflation) and they need cash to do it. The Fed either won't or can't create that cash by decree.

Ironically, just as the weaknesses of the Fed's inflationary program are being made clear, the herd is stampeding back
into the inflation trades. This appears to be based on the assumption that today's Fed action is inflationary (true on a very small scale) and demonstrates some new power on their part (not true at all). What has been demonstrated is the INABILITY of the Fed to inflate asset prices without the willing cooperation of the market. With sentiment having turned, the best they can hope for at this point is to slow the crash in prices of risky debt used to fund credit expansion. This is a desperate rear-guard action by the Fed