Silent Scream

(editor's note - This blog entry was completed and posted on July 4. The entry date is showing as July 1, as the software uses the date on which the first draft was saved.)


Marc Faber was on Bloomberg TV today and he mentioned that the higher reported consumer inflation rates in Asia were a function of lower per capita GDP and a higher proportion of income spent on food and fuel - which are nearly the only prices that are rising aggressively. Common sense right? But of course that really made me start thinking - always a dangerous prospect.


Asia, Inc.

So Asia's consumer "basket" looks a lot different than that of the average American or Western European. But there are other differences as well. Many Asian nations are resource-poor, major importers of either food, raw materials or both and they depend upon exports of manufactured goods to pay for those imports. Now, let's look at the situation from a slightly different perspective. The industrial sectors of Asian economies look much like any diversified manufacturing enterprise.

Similar to our notional enterprise, these nations' factory sectors buy raw materials and energy. They employ people, paying wages in the process and sell a finished product to a customer. Substitute "import" for buy and "export" for sell and it's actually a pretty good analogy. A few differences, instead of profits, these entities collectively produce a surplus for the nation and they are also responsible for feeding and housing their workforce like an old-fashioned company town to the extent that the workforce doesn't grow its own food.So how do current conditions affect our metaphorical manufacturer? Inputs costs are rising fairly fast overall, with oil being a spectacular example though most increases are far more sedate and a fair number of industrial inputs are falling in price. Just as important, labor costs are rising. This is an obvious corollary to rising living standards and wage costs have been rising by double digits across much of Asia for years. At the same time, demand for many of their products has been weakening as their key markets (US, Europe, Japan) drop into a coordinated recession. So raising prices significantly isn't a solution as they would quickly suffer loss of market share. These factory economies are backed into a corner as surely as domestic manufacturers, with rising costs and falling demand. The Asian suppliers have the additional burden of rising labors costs on top of that. They can choose either lower revenues, lower profit margins (surplus) or some of both.

Now let's look at factors that introduce some added complexity to the model. Instead of cutting wages, nations also have the option to devalue their currency. This effectively reduces labor costs though not other inputs if they are imported. Lower "profits" can take the form of actual margin compression at the individual companies or smaller surpluses in the trade account. The factory sectors of Asia have an additional burden of the industrial surplus having to subsidize food imports - which of course are rising in price fairly quickly also.

What we see then are economies that likely will have to accept either smaller surpluses, lower corporate profits, lower wages, weaker currencies or some combination of the above.


Theory meets fact
Normally, high inflation rates tend to be associated with weakness against other currencies. Rapid declines in domestic purchasing power usually are accompanied by lower international purchasing power - again common sense. This is doubly true if the high-inflation economy does not raise interest rates to restrain demand. CPI equivalents have been high and rising across Asia for some time now, yet the currencies - like most others have been gaining vs. the dollar. To make matters worse, real interest rates in those countries are negative as well and have been for some time. Consumer prices are going up faster in most Asian economies than even the worst-case numbers here in the US - for instance John Williams at Shadow Government Statistics.

It has been odd to see such currencies rising against the dollar but there are several factors that have contributed. First was the differential in growth rates. Second was the perception of deep trouble in the US financial system combined with the impression of unstoppable rise for Asia. Third was the systemic imbalance of trade. Well, now we see that the extenuating factors are all at least beginning to falter. Growth rates are falling across Asia and we believe this is only the beginning of a very deep retrenchment there. The perception has shifted and the false impression that Asia would be immune to the problems of the US has been broken. The terms of trade are also starting to shift as fewer goods are sold to the US and other export markets. US trade deficit remains relatively flat with less of a gap with Asia being offset by higher oil prices.

In light of these factors, we are seeing high CPI and deeply negative real interest rates catching up with many Asian nations. Significant, and in some cases quite large currency reversals have taken place. One of the worst is India, where double-digit CPI, twin structural deficits and a severe slowdown are the story. With CPI pushing 12% and policy rates between 6.0% and 8.5% it's no wonder the Rupee recently reversed - down over 10% vs the dollar this year. Similar situations are brewing in Korea, the Philippines, Thailand, Malaysia and China, not to mention Vietnam. With the exception of still-hyped China, these currencies have lost 5-14% against the dollar from their recent highs. It's taken a while but normal economic relationships seem to be asserting themselves.

As we mentioned above, these economies are in the midst of a squeeze that will push down revenues and profits as well as the currency. Despite significant drops in many regional exchanges, fundamental deterioration can drive this process much further. The potential for a currency kicker on the downside simply makes these markets even more attractive as shorts. Loss of confidence could inspire capital flight, which would devastate both the local stock markets and the currencies. Again, with the exception of China, these nations probably won't have to worry about their currencies being too strong for much longer.

The stock markets and currencies of Asia's industrializing nations are screaming but few people seem to be listening. They were key beneficiaries of the UDB and it's demise will hurt them in direct as well as indirect ways. But that is a subject for another post.


Tea Leaves
So, why does the dollar index still look so weak? The index really isn't a good indicator of the strength of the dollar against the world since it is a trade-weighted index. Note that the Euro accounts for 57.6% of the weight, with both the Pound and the Yen also in double digits. The policies of the Fed have done nothing to help the dollar but at this point, the weakness is just as much a tribute to the ambitions of the EU and Germany's near-pathological fear of inflation as they are the result of incompetence at the Fed (though there is plenty of that). I have almost nothing good to say about the Federal Reserve but they only deserve half of the credit for the decline of the dollar index.

Why Bennie Can't Lend

Those of us from a certain age will recall a book about the failings of the education system called Why Johnnie Can't Read. Well, we're about to see the failings of the financial system exposed in similar fashion. The Fed has gone from "savior" that will "bail out the market" to talking tough on inflation and pointedly refusing to promise further rate cuts.

So when did this happen and why? The first thing to note about the Fed is they don't actually determine interest rates. They have the ability to set the Fed Funds target rate but then they have to go out and defend it in the marketplace - just like any other private entity seeking to set an arbitrary price. The strongest tool they have in this price-fixing scheme is the aura of omnipotence that they have acquired over the years so few other players are willing to take them on. A wise Fed chairman knows this and sets the target close to the market rate to avoid a test of wills that he might lose - along with his credibility in the process.

So let's look at the resources they have available to defend their chosen target rate. The Fed began 2007 with $277 billion in Treasury bills. As of the August 23 report, that number was unchanged but things began to move quickly thereafter. From the late summer of last year the Fed reduced its T-bill holdings by $76.7 billion by the March 6, 2008 report, which works out to about $12 billion per month. This was accomplished by bills maturing and not being rolled over as they usually would, which was sufficient to fund the TAF and discount window lending. Then things changed.

Storm Warning
In March, something really bad was brewing. We would later find out that Bear Stearns, a major investment bank was in the process of going under. Demand for Fed loans picked up dramatically and maturing T-bills no longer provided enough cash to fund the demand. So, for the first time since the crisis began, the Fed began to sell outstanding Treasury debt from their own inventory in order to supply the funds for the Primary Dealer Credit Facility (PDCF) which was introduced in early March:

3/7 - $10 billion sold
3/12 - $15 billion
3/17 - $18 billon
3/19 - $15 billion
3/25 - $12 billion
3/26 - $9 billion
total - $79 billion sold in 3 weeks

Of course, that is in addition to the normal process of runoff as bills mature. The numbers can be easily confirmed with a search of the NY Fed's permanent market operations. These actions pushed the 3-month bill's yield from under 1.0% to 1.4% in a short period. In addition, the Fed also began to sell off its longer-term Treasury obligations - $35 billion worth in 7 auctions through April 3rd. This pushed the yield on the 10-year (TNX) from 3.3% to 3.6% over that time. They sold another $30 billion in May, helping to push the yield on the TNX north of 4.0%. These actions account for the entire 12-month decline in longer-term treasuries. I'm virtually certain that the initial upward push in Treasury rates was welcomed as an "end to fear" and "return to normalcy" - also helping to push down risk spread by the simple expedient of increasing the base rate. I doubt that the second surge above 4% was quite so welcome and a repeat of that right now would be quite a major problem for the Fed.

The Box
We have now seen that the Fed can move longer-term interest rates if it has the resources and is willing to suffer the consequences of those actions - just like any other private bank or bond market player. We also note that there have been no open market sales of Treasuries since late May and the accompanying spike in the 10-year rate - critical since standard fixed rate mortgages are priced off of that rate. Even without selling pressure from the Fed, the TNX is still hanging out right around 4.0%. The rise above 4.3% must have scared the Fed to death since they reversed their rhetoric and even obliquely threatened to raise the Fed Funds target. Another half-point rise in mortgage rates would be likely to finish off a housing market already on life support and Bernanke doesn't want that on his record.

The state of the bond market leaves the Fed unable to sell any of its longer-dated Treasuries without severely damaging consequences. Yet long-dated securities are essentially all they have left - Treasury notes (2-10 years) and bonds (30 years) equal $412.4 billion. That compares to only $21.7 billion of the original $277 billion worth of T-bills. This is all that the Fed can really use without inflicting damage on the bond market that will be somewhere between severe and completely counter-productive.

June 19 H.4.1 report

This is the box that Bernanke is in. He can declare a cut in the target rate but he has no ammo to defend it. $21 billion is nothing and trying to defend a lower target and failing would be the worst possible outcome. The market may eventually give the Fed room to cut another quarter point but economic conditions will have to deteriorate further before that happens. Worse yet, the market appears to know that. The one tool that can still be used is the Term Securities Lending Facility (TSLF) but the Fed is growing more reluctant to lend out its remaining hoard of high-quality Treasuries in return for toxic waste from the banks and brokers.

As we have pointed out before, the Fed has always had the ability to hide problems temporarily by papering over the cracks. In this case, they lent a lot of money to the commercial and investment banks so they would be able to hold assets instead of selling and recognizing the losses. If confidence and credit growth return quickly, this can reduce the pain. However, they do not have the ability to actually solve problems in the credit market and papering things over only makes things worse if the problem does not go away on its own. That is happening now as banks that should have sold before are now going to be forced to sell at lower prices and bigger losses. By trying to avoid a "fire sale" the Fed merely created a bigger one with a bit of a delay.

That is where we are now. The Fed has failed. The Great Oz has been exposed a just a man behind the curtain. Prepare for severe credit deflation and falling asset prices in markets that traditionally use leverage to purchase or hold positions.

More Credit Deflation

It is critically important to understand the decline in overall credit levels in order see just how powerful the emerging deflationary trend is. One of my favorite analysts is Doug Noland of Prudent Bear. His Credit Bubble Bulletin is an indispensable tool for anyone hoping to fully understand what is happening. From his latest edition:

Total Commercial Paper increased $1.1bn to $1.753 TN. CP has declined $471bn over the past 46 weeks. Asset-backed CP fell another $5.0bn last week (46-wk drop of $447bn) to $748bn. Over the past year, total CP has contracted $390bn, or 18.2%, with ABCP down $412bn, or 35.5%.

So there is a hole roughly $400 billion wide of destroyed credit in the shadow banking system of SIVs and other off-balance sheet entities. That would be pretty tough to fill. And in the immortal words of Ronco "But wait, there's more!" Bloomberg reported yesterday that CDO defaults since October now total 200, with a face value of $220 billion. Given the performance of the ABX and CMBX indexes, it seems safe to value the defaulted CDOs at 50% of face value or less. So add at least $110 billion to that already deep hole of vanishing commercial paper. This is all on top of whatever enormous losses emerge in the official banking sector.

So what new credit is being created to counteract all of this credit destruction? No help from the official banking sector, including the Fed. Back to our friend Doug Noland:

Bank Credit dropped $24.8bn to $9.339 TN (week of 6/18). Bank Credit has now expanded only $126bn y-t-d, or 2.9% annualized.
Fed Credit has increased $1.1bn y-t-d and $27bn y-o-y (3.2%).

There is very little ability to create new shadow credit now that the inherent riskiness of these absurdly complex vehicles has been exposed. A lot of investors are learning the hard way that if you can't understand it, you shouldn't buy it - a lesson that goes all the way back to the Mississippi Company and South Sea Bubbles of the early 18th century. The entire panoply of complex derivative securities is being revealed for the severely under capitalized pyramid scheme that it always was: SIVs, conduits, auction-rate securities, CDOs, CDS, asset-backed commercial paper and more.

The Universal Debt Bubble was a massive confidence scheme but the marks are now wise to the game. A whole new generation of "investors" with no memory of the current scandals will have to grow up before such a thing can be attempted again. We are witnessing the slow-motion collapse of the multi-trillion dollar shadow banking sector. With (commercial) bank credit also beginning to drop and Fed credit nearly stagnant, the supply of credit to support asset inflation is shrinking outright.

Expect more pain across all major asset classes that are typically purchased in highly leveraged transactions.

No Credit for You!

As the Universal Debt Bubble has begun to collapse under its own weight, various portions of the shadow banking sector have come under enormous pressure. These are the non-bank lenders that have magnified a credit bubble into the UDB. Starting last summer, the initial push shattered the most egregiously complex and levered structures - the CDOs. In the Fall of 2007, the conduits and SIVs joined the tankage - along with asset-backed commercial paper, their primary funding mechanism. The worst of the hedge funds have been closing their doors at an increasing rate.

Now we are beginning to see simpler securitized products being shunned as well. From Prudent Bear's Doug Noland:

Asset-Backed Securities (ABS) issuance slowed this week to $3.3bn. Year-to-date total US ABS issuance of $104bn (tallied by JPMorgan's Christopher Flanagan) is running at 27% of the comparable level from 2007. Home Equity ABS issuance of $303 million compares with 2007's $191bn. Year-to-date CDO issuance of $14bn compares to the year ago $217bn.

Over the past year, total CP has contracted $381bn, or 17.9%, with ABCP down $402bn, or 34.8%.

Credit Bubble Bulletin

As I read it, ABS (mostly credit card and auto loans) are down 73% from last year. Securitized home equity is down 99.8%. CDOs have fallen 93%. These were key shadow banking sectors that provided trillion during the last leg as the credit bubble mutated into the UDB. Because the structures were kept off the banks' balance sheets, they almost never had proper reserve structures. With leverage ratios of 30, 50 or even 100:1, the inherent risk was high. At 30:1, your valuation assumptions only have to be wrong by 3% for the whole thing to blow up - as they are now duly exploding.

Any hope that the Fed and other central banks had of keeping the asset bubble intact is fading along with the excess credit that has supported absurd asset prices for so long. The disappearance of the shadow banks is critical to the process of deflating the bubbles. At the same time as this illegitimate source of funding is drying up, the commercial banks are being forced to recognize large losses. Now the banks must lend within the restrictions of their required reserves and capital. At the same time, that capital is being wiped away by losses far faster than it can be replaced.

The math virtually guarantees that there will be a lot less credit available for the foreseeable future. Assets and goods that are dependent on the availability of credit are likely to see sharp further price declines.

A Child's Perspective

The UDB grew until it encompassed virtually all asset classes and nearly every nation around the world. Many markets and countries have now fallen off the former trend but the consequences are just starting. In covering something this large and complex, we tend to use a lot of statistical analysis here at Financial Jenga. But occasionally, a simpler perspective can be really helpful.

I occasionally play babysitter for my young nieces on weekdays and they sometimes overhear my phone conversations with friends and colleagues. Yesterday, they were here and overheard me ranting about the bankers' attempt to get even looser accounting treatment. Right afterwards, the 5 year old said: "Those must be really bad people if they lie so much."

She made me think a bit. We've always known that the only way to offset a bubble bursting is to inflate an even bigger bubble somewhere else. And most of us learned from our parents that if you lie, you'll just have to make up bigger lies to cover it up too. I'd just never made the connection before but a child did.

At the heart of every bubble is a lie, often multiple lies. At a minimum, there is extraordinary mis-valuation and mal-investment. But usually, it is much worse than that - deliberate fraud and orchestrated deception on a large scale. One of the earliest was the South Seas Bubble, which rested on visions of wealth from commerce with exotic countries when in fact there was little basis and certainly no profit from such activities. In much the same way, the tech bubble produced fantasies of fabulous profits from commerce using exotic technologies. Both visions were fed to credulous "investors" by a whole host of con men and by the belief that the herd must be stampeding to rich pastures.

Every bubble has its (many) victims and its villains. The best way to avoid them is to remember something else your parents probably told you: "If it sounds too good to be true, it probably is."

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.

Consumer Co-dependency

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

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

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

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

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

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

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