Monday, January 26, 2009

The Case for Gold - AKA, It's the End of the World as We Know It

These days, I think it's wise to read up on the Great Depression and the history of the Fed.

I'm currently in the middle of Murray Rothbard's "The Mystery of Banking". It addresses a lot of what we are facing now. It had been out of print for a few decades, but a 2nd edition was recently published. It's also available for free online in pdf format.

Below is a great clip from the book on the time lag for inflationary and/or deflationary expectations to set in.

However, before you get to that, I've included a link below to the St. Louis Fed's website. The link is to the Monetary Base of the United States (i.e., the amount of "money" we have that excludes the creation of money from fractional reserve banking and the like). Click it now before going on as it is a must see.

As I've been saying, it took the Fed about 100 years (through August) to get to where it was, it's taken about five months to do it all over again (more than double the monetary base). Remarkable.

What's amazing is that if you look at the "Observations" data below the graph, the pace of money printing is not slowing whatsoever. The argument for doing this is that GDP = Money Supply * Velocity ("Velocity" being a plug which loosely represents the some balance of demand for or supply of money) and since Velocity has obviously fallen off a cliff, if you offset that by increasing the Money Supply....well, you can do the math. Call me Skeptical as to the efficacy of this "cure".

Here is the long cut and paste from pages 68-74 of the "Mystery of Banking" (it references a handful of supply/demand graphs, but I think the point is made in the text in any case):
During the 1920s, Ludwig von Mises outlined a typical inflation process from his analysis of the catastrophic hyperinflation in Germany in 1923—the first runaway inflation in a modern, industrialized country. The German inflation had begun during World War I, when the Germans, like most of the warring nations, inflated their money supply to pay for the war effort, and found themselves forced to go off the gold standard and to make their paper currency irredeemable. The money supply in the warring countries would double or triple. But in what Mises saw to be Phase I of a typical inflation, prices did not rise nearly proportionately to the money supply. If M in a country triples, why would prices go up by much less? Because of the psychology of the average German, who thought to himself as follows: “I know that prices are much higher now than they were in the good old days before 1914. But that’s because of wartime, and because all goods are scarce due to diversion of resources to the war effort. When the war is over, things will get back to normal, and prices will fall back to 1914 levels.” In other words, the German public originally had strong deflationary expectations. Much of the new money was therefore added to cash balances and the Germans’ demand for money rose. In short, while M increased a great deal, the demand for money also rose and thereby offset some of the inflationary impact on prices. This process can be seen in Figure 5.3.

In Phase I of inflation, the government pumps a great deal of new money into the system, so that M increases sharply to M′. Ordinarily, prices would have risen greatly (or PPM fallen sharply) from 0A to 0C. But deflationary expectations by the public have intervened and have increased the demand for money from D to D′, so that prices will rise and PPM falls much less substantially, from 0A to 0B.

Unfortunately, the relatively small price rise often acts as heady wine to government. Suddenly, the government officials see a new Santa Claus, a cornucopia, a magic elixir. They can increase the money supply to a fare-thee-well, finance their deficits and subsidize favored political groups with cheap credit, and prices will rise only by a little bit!

It is human nature that when you see something work well, you do more of it. If, in its ceaseless quest for revenue, government sees a seemingly harmless method of raising funds without causing much inflation, it will grab on to it. It will continue to pump new money into the system, and, given a high or increasing demand for money, prices, at first, might rise by only a little.

But let the process continue for a length of time, and the public’s response will gradually, but inevitably, change. In Germany, after the war was over, prices still kept rising; and then the postwar years went by, and inflation continued in force. Slowly, but surely, the public began to realize: “We have been waiting for a return to the good old days and a fall of prices back to 1914. But prices have been steadily increasing. So it looks as if there will be no return to the good old days. Prices will not fall; in fact, they will probably keep going up.” As this psychology takes hold, the public’s thinking in Phase I changes into that of Phase II: “Prices will keep going up, instead of going down. Therefore, I know in my heart that prices will be higher next year.” The public’s deflationary expectations have been superseded by inflationary ones. Rather than hold on to its money to wait for price declines, the public will spend its money faster, will draw down cash balances to make purchases ahead of price increases. In Phase II of inflation, instead of a rising demand for money moderating price increases, a falling demand for money will intensify the inflation (Figure 5.4).

Here, in Phase II of the inflation, the money supply increases again, from M′ to M′′. But now the psychology of the public changes, from deflationary to inflationary expectations. And so, instead of prices rising (PPM falling) from 0B to 0D, the falling demand for money, from D′ to D′′, raises prices from 0D to 0E. Expectations, having caught up with the inflationary reality, now accelerate the inflation instead of moderating it.

There is no scientific way to predict at what point in any inflation expectations will reverse from deflationary to inflationary. The answer will differ from one country to another, and from one epoch to another, and will depend on many subtle cultural factors, such as trust in government, speed of communication, and many others. In Germany, this transition took four wartime years and one or two postwar years. In the United States, after World War II, it took about two decades for the message to slowly seep in that inflation was going to be a permanent fact of the American way of life [TTB note: culminating in the 1970s].

When expectations tip decisively over from deflationary, or steady, to inflationary, the economy enters a danger zone. The crucial question is how the government and its monetary authorities are going to react to the new situation. When prices are going up faster than the money supply, the people begin to experience a severe shortage of money, for they now face a shortage of cash balances relative to the much higher price levels. Total cash balances are no longer sufficient to carry transactions at the higher price. The people will then clamor for the government to issue more money to catch up to the higher price. If the government tightens its own belt and stops printing (or otherwise creating) new money, then inflationary expectations will eventually be reversed, and prices will fall once more—thus relieving the money shortage by lowering prices. But if government follows its own inherent inclination to counterfeit and appeases the clamor by printing more money so as to allow the public’s cash balances to “catch up” to prices, then the country is off to the races. Money and prices will follow each other upward in an ever-accelerating spiral, until finally prices “run away,” doing something like tripling every hour. Chaos ensues, for now the psychology of the public is not merely inflationary, but hyperinflationary, and Phase III’s runaway psychology is as follows: “The value of money is disappearing even as I sit here and contemplate it. I must get rid of money right away, and buy anything, it matters not what, so long as it isn’t money.” A frantic rush ensues to get rid of money at all costs and to buy anything else. In Germany, this was called a “flight into real values.” The demand for money falls precipitously almost to zero, and prices skyrocket upward virtually to infinity. The money collapses in a wild “crack-up boom.” In the German hyperinflation of 1923, workers were paid twice a day, and the housewife would stand at the factory gate and rush with wheelbarrows full of million mark notes to buy anything at all for money. Production fell, as people became more interested in speculating than in real production or in working for wages. Germans began to use foreign currencies or to barter in commodities. The once-proud mark collapsed.

The absurd and disastrous way in which the Reichsbank—the German Central Bank—met the crucial clamor for more money to spend immediately in the hyperinflation of the early 1920s is revealed in a notorious speech delivered by Rudolf Havenstein, the head of the Reichsbank, in August 1923. The Reichsbank was the sole source of paper money, and Havenstein made clear that the bank would meet its responsibilities by fulfilling the increased demand for paper money. Denominations of the notes would be multiplied, and the Reichsbank would stand ready to keep its printing presses open all night to fill the demand. As Havenstein put it:

"The wholly extraordinary depreciation of the mark has naturally created a rapidly increasing demand for additional currency, which the Reichsbank has not always been able fully to satisfy. A simplified production of notes of large denominations enabled us to bring ever greater amounts into circulation. But these enormous sums are barely adequate to cover the vastly increased demand for the means of payment, which has just recently attained an absolutely fantastic level, especially as a result of the extraordinary increases in wages and salaries.

"The running of the Reichsbank’s note-printing organization, which has become absolutely enormous, is making the most extreme demands on our personnel."

During the later months of 1923, the German mark suffered from an accelerating spiral of hyperinflation: the German government (Reichsbank) poured out ever-greater quantifies of paper money which the public got rid of as fast as possible. In July 1914, the German mark had been worth approximately 25 cents. By November 1923, the mark had depreciated so terrifyingly that it took 4.2 trillion marks to purchase one dollar (in contrast to 25.3 billion marks to the dollar only the month before).

And yet, despite the chaos and devastation, which wiped out the middle class, pensioners and fixed-income groups, and the emergence of a form of barter (often employing foreign currency as money), the mark continued to be used. How did Germany get out of its runaway inflation? Only when the government resolved to stop monetary inflation, and to take steps dramatic enough to convince the inflation-wracked German public that it was serious about it. The German government brought an end to the crackup boom by the “miracle of the Rentenmark.” The mark was scrapped, or rather, a new currency, the Rentenmark, was issued, valued at 1 trillion old marks, which were convertible into the new currency. The government pledged that the quantity of Rentenmarks issued would be strictly limited to a fixed amount (a pledge that was kept for some time), and the Reichsbank was prohibited from printing any further notes to finance the formerly enormous government deficit. Once these stern measures had been put into effect, the hyperinflation was brought to an end. The German economy rapidly recovered. Yet, it must be pointed out that the German economy did not escape a posthyperinflation recession, called a “stabilization crisis,” in which the swollen and unsound investments of the inflationary period were rapidly liquidated. No one complained bitterly; the lessons of the monstrous inflation were burned into everyone’s heart.

Only a clear and dramatic cessation of the spiraling expansion of the money supply can turn off the money tap and thereby reverse the accelerating inflationary expectations of the public. Only such a dramatic end to monetary inflation can induce the public to start holding cash balances once again.

Thus we see that price levels are determined by the supply and the demand for money, and that expansion of the money supply—a function solely of government—is the prime active force in inflation. [end cut and paste]

Scary times. All of this seems to add up to an argument for gold. I personally prefer the physical version to the ETF version, but the GLD ETF is better than nothing.

Tuesday, January 20, 2009

Obama or Nobama? The markets puke.

From an email I sent this past Sunday:

Larry Summers is directly at odds with two of TTB's predictions and surprises for 2009 (this problem isn't and can't be contained, though it could be shifted to a massive inflation and unemployment will near 10% in 09).

I still think I'll be right, though he has more influence on how unemployment is measured than I do and, of course, they can claim victory on containment at any time.

Dangerous word, "contain".

Last time a prominent administration official claimed containment, it didn't quite work out so well (both in the Spring of 07, otherwise known as the 3rd inning, if we calibrate to Jamie Dimon's call that Spring 2008 "75 or 80%" through the crisis: oops again!). However, if we calibrate to reality, which is that we're probably now in about the 5th inning, then we were really in the 1st inning when Bernanke and Paulson proclaimed the economic equivalent of Mission Accomplished. Ah, the bliss of no accountability!

See here for Sec. Paulson's boo boo:

See here for Helicopter Ben's boo boo:

Here's the language from the pertinent paragraph for Bernanke from March 07. Doh:

Although the turmoil in the subprime mortgage market has created severe financial problems for many individuals and families, the implications of these developments for the housing market as a whole are less clear. The ongoing tightening of lending standards, although an appropriate market response, will reduce somewhat the effective demand for housing, and foreclosed properties will add to the inventories of unsold homes. At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained. In particular, mortgages to prime borrowers and fixed-rate mortgages to all classes of borrowers continue to perform well, with low rates of delinquency.

Thursday, January 15, 2009

Bank of America: Pattern Recognition

Can't you just see exactly how the B of A situation is going to play out? I've been saying for three months, as BAC flopped around between $11 and $18 that $10 was the point of no return. All of the big financial institution failures had this same feature: if your stock crosses $10 the wrong way and doesn't bounce back, it basically loses a bid until somewhere in the $7s or $8s. Then, on the ensuing Friday, it loses a bid entirely and falls to $5-$6 or less. Then, by Sunday night ("before the Asian markets open" because heaven forbid Asia should have to worry about uncertainty in a random American company), the government announces a massive intervention. So, here's an email I sent around to friends this a.m. just after the open as BAC hit $9:

As an aside, my $10 BAC puts, which expire tomorrow, are up over 200% today. Sadly, not a huge position.

Can’t you just sense the playbook? B of A cracks the $10 and $9 barrier in the same day…a Thursday. We all know that when important financial institutions cross $10 (the wrong way) and then gap down, Sec. Paulson’s batphone rings. Friday things get really oogie; rumors abound. It falls to about $6. Over the weekend, people get really weirded out. Asia opens Sunday night, which is normally the deadline for dealing with this stuff, but the US is actually closed on Monday for MLKJr Day and reopens on the day of the inauguration of our first black president [noteworthy for coinciding with MLKJ Day]. Sundays are normally the day that this stuff is dealt with, but with Citi hitting new lows and B of A into the scary territory, there’s too much to deal with.

De facto nationalization of the banking system may not happen this weekend, but it’s coming. You can taste it. Buy gold.

So, apparently I'm not the only one that knows this is the playbook. Looks like B of A and the Feds are trying to preempt a weekend of worry, especially this weekend.

Here's an article from the WSJ on the subject. Looks like the Batphone rang and the Feds mobilized. The issue is, they are using the so-called Citibank Plan, but Citi also hit fresh lows today (below $4/share).

By the way, I know everyone railed John Thain for asking for the bonus he was contractually promised (crazy bastard!), but isn't it clear at this point that he should have been paid pretty much everything that Merrill received north of $1/share. I mean, the ML shareholders should have felt lucky to get $1, because ZERO was the other alternative. He should be given a hero's welcome by Merrill shareholders. They should all keep a bust of him on their mantle. Yet somehow he's vilified! This is a crazy, mixed-up world.

Also, have to love that BAC's market cap is now less than it intially offered for Merrill and less than all of its government capital infusions added together (including the proposed $20 billion). Pretty strongly implies that the market cap of BAC would be ZERO if not for federal intervention. Go taxpayers!

Tuesday, January 13, 2009

Predictions/Surprises for 2009

I put these together in the week before the New Year. Every year for the last five, I make everyone at my business submit to me their top ten predictions or surprises for the coming year (they should basically be predictions that have an element of surprise/non-consensus to them). Here are mine for 2009 (slightly modified to remove some private details):

[TTB's] Top Ten Surprises / Predictions for 2009:

1) [My company] takes no meaningful new clients in 2009
2) At some point during the year, the S&P 500 is up 30% from the beginning value, but ends the year +/- 10% from the beginning value. Selling at that +30% point will feel very hard to do and excuses will abound as why we shouldn’t/why our issues are behind us. Alas, not selling will have been a mistake.
3) Housing prices cross the -30% peak to trough level (Case Shiller 20-city index). Commercial real estate becomes the watchword as housing price declines begin to slow toward the end of 2009.
4) Our recession borders on a depression as 2009 GDP is -5% or worse (which is on top of 2008’s negative print). Unemployment nears 10%. Unemployment would be worse but lots of companies enact pay-cuts, either explicitly or through reduced hours. The aggregate impact feels like unemployment of 11%+.
5) The U.S. budget deficit blows through $2 trillion in 2009. Socialism becomes a commonly talked about concept and people are increasingly comforted by our move toward it.
6) The credit crisis is not arrested. After having rolled through housing, it begins its attack on commercial and corporate in force. The default rate for HY approaches double digits but bank debt only makes it to mid single digits (5-7%), so far. As I predicted a few years ago, the default wave continues to roll through credit sub-classes. While it was initially in subprime, which had the nearest resets and the lowest quality borrowers and collateral, we see it move into Option ARMs as people begin to reach 115% of their initial balance due to minimum payments and some 3/1 and 4/1 ARMs from the more toxic vintages of 06 and 05 hit resets. New CRE (commercial real estate) financing is unavailable at attractive interest rates and cap rates climb near double digits. That said, the CRE default wave only begins to pick up modest steam in 09 as the 5/25 balloons from 2004 and early 2005 approach or cross through their reset periods. Covenant-lite LBO debt performs horribly, but due to a lack of covenants, the defaults are really a 2010 and beyond phenomenon. Because each of these huge credit asset sub-classes really have staggered aggregate maturities, the credit crisis has trouble getting past us (subprime 2007-08, option ARM 2008-09, jumbo prime 2009-10, CRE 2009-14, full covenant bank debt 2009-10, HY 2009-11, muni 2010-11, cov-lite bank debt 2010-12). All flavors of credit are obviously correlated as the companies and institutions that provide the loans are the same for all kinds of credit and this continues to drive availability of credit down and the price of and standards for credit up. This adjustment hurts many people.
7) We continue to muddle through a deflationary period as the credit contraction continues. By late 2009, inflation starts to replace deflation, initially making Ben Bernanke proud of the success of his famed “helicopter drop”. But inflation’s pace picks up uncomfortably quickly. By late 2009, deflation is the last thing on anyone’s mind (I may be off by a year on this one, but so be it)
8) The dollar ends the year below $.80 on the Yen
9) The US suffers its first major terrorist attack since 2001
10) Hedge funds, in aggregate, suffer redemptions that exceed 50% of their AUM during 2008 and 09 combined, forever changing the business model. Certain strategies will increasingly require private equity style lock-ups. Fees will come down. A big NY property REIT/institutional CRE owner stares into the abyss.

Happy New Year.