Hayman Capital's Kyle Bass Writes About The Cognitive Dissonance Of It All

Hayman Capital's Kyle Bass writes about "The Cognitive Dissonance of it All" - the fact that an increase in the unsustainable policies and economic structure of the past forty years that led to the recent financial crisis is being offered as the cure to the ills the very same policies caused. Sovereign defaults, debt accumulation, the Keynesian endpoint, Japan's coming X-Day, the future of the euro/EMU, fiat money, gold and other topics are all discussed.

Enjoy.

48881153 Kyle Bass Hayman Investor Letter February 2011[1]

Human Freedom Relies On Gold Redeemable Money

I think the title of this post is pretty close to a piece Congressman Howard Buffett wrote in the first half of the 20th century (yes, Warren Buffett's father - they have slightly different political leanings).

In any case, I felt it was an apt title to the below video from Charlie Rose where he discusses gold, inflation, "quantitative easing", and dollar debasement with a few folks including Greenlight Capital's David Einhorn (whom we are a big fan of), Jim Grant (again, we're huge fans), the Chairman of Barrick Gold and John Hathaway of Toqueville Asset Management. Enjoy.

Jim Grant - "gold is money."



HT: TB

"This Is True, The Plumber Is Clearly Smarter Than The Ben Bernanke"

I can't think of one thing that I disagree with in this. As an aside, I love when people use extraneous "the"s. Such as, "The Ben Bernank"[sic].



HT: O

St. Louis Fed President James Bullard On Deflation Risk

James Bullard, one of the Fed's few "inflation hawks" (which is a relative term when we're talking about people who's job it is to debase our currency, so being a hawk on the Fed really just means he's not as overwhelming an inflationist as some of his colleagues) is - out of left field - warning about deflation. Strangely, his argument is that the easy money language of the Fed "extended period of time", etc. is what is driving this. However, really what he's saying is that the interest rate isn't what matters at this point in a deflation cycle, that the Fed needs to be more forceful and adopt further quantitative easing. Interest rate movements simply incent borrowing and money creation whereas QE causes it explicitly.

Folks, QE2 is nearly upon us.

If you think Bernanke, an avowed currency debasor, isn't the puppetmaster coordinating this - even to the point of using one of his biggest inflation hawks to lead the debasement charge - then you are fooling yourself. By the way, Bullard is not just saying the fed needs further quantitative easing, he's saying they need to make an open-ended commitment to QE, they need to explicitly state their QE as part of ongoing policy, and that it should probably be a lot. Not QE2, but QEForever.

The first time around, the Fed simply did "a lot" but didn't make it open ended and explicit enough. Bullard says the Fed won't make the same mistake twice.

Folks, get your AU and AG now. We are entering crazy-land - these guys literally have no idea about the implications of what they are talking about.

BTW, they would not do this unless they were really, really worried about the state of the economy. I watch this and am legitimately frightened.



[HT: TD]

David Einhorn OpEd: NY Times - Easy Money, Hard Truths

TILB friends know that we have followed Greenlight Capital's David Einhorn for years. A year and a half ago, when he first began to publicly disclose his position in gold, we took note.

As we reported from yesterday's Ira Sohn Conference, Einhorn gave a presentation called "Good News for the Grandchildren" (implying that the debt crisis will manifest itself in our generation, not theirs). In today's NY Times, he basically provided them with a slightly modified version of the speech as an OpEd.

Here is the OpEd from the NY Times. Because it's basically the transcript of a speech he gave yesterday, we provide it below in its entirety. Please support the NY Times, one of TILB's favorite newspaper.

Op-Ed Contributor
NY times
Easy Money, Hard Truths
By DAVID EINHORN
Published: May 26, 2010

Before this recession it appeared that absent action, the government’s long-term commitments would become a problem in a few decades. I believe the government response to the recession has created budgetary stress sufficient to bring about the crisis much sooner. Our generation — not our grandchildren’s — will have to deal with the consequences.

According to the Bank for International Settlements, the United States’ structural deficit — the amount of our deficit adjusted for the economic cycle — has increased from 3.1 percent of gross domestic product in 2007 to 9.2 percent in 2010. This does not take into account the very large liabilities the government has taken on by socializing losses in the housing market. We have not seen the bills for bailing out Fannie Mae and Freddie Mac and even more so the Federal Housing Administration, which is issuing government-guaranteed loans to non-creditworthy borrowers on terms easier than anything offered during the housing bubble. Government accounting is done on a cash basis, so promises to pay in the future — whether Social Security benefits or loan guarantees — do not count in the budget until the money goes out the door.

A good percentage of the structural increase in the deficit is because last year’s “stimulus” was not stimulus in the traditional sense. Rather than a one-time injection of spending to replace a cyclical reduction in private demand, the vast majority of the stimulus has been a permanent increase in the base level of government spending — including spending on federal jobs. How different is the government today from what General Motors was a decade ago? Government employees are expensive and difficult to fire. Bloomberg News reported that from the last peak businesses have let go 8.5 million people, or 7.4 percent of the work force, while local governments have cut only 141,000 workers, or less than 1 percent.

Public sector jobs used to offer greater job security but lower pay. Not anymore. In 2008, according to the Cato Institute, the average federal civilian salary with benefits was $119,982, compared with $59,909 for the average private sector worker; the disparity has grown enormously over the last decade.

The question we need to ask is this: If we don’t change direction, how long can we travel down this path without having a crisis? The answer lies in two critical issues. First, how long will the capital markets continue to finance government borrowings that may be refinanced but never repaid on reasonable terms? And second, to what extent can obligations that are not financed through traditional fiscal means be satisfied through central bank monetization of debts — that is, by the printing of money?

The recent United States credit crisis was attributable in large measure to capital requirements and risk models that incorrectly assumed AAA-rated securities were exempt from default risk. We learned the hard way that when the market ignores credit risk, the behavior of borrowers and lenders becomes distorted.

It was once unthinkable that “risk-free” institutions could fail — so unthinkable that the chief executives of the companies that recently did fail probably didn’t realize when they crossed the line from highly creditworthy to eventually insolvent. Surely, had they seen the line, they would, to a man, have stopped on the solvent side.

Our government leaders are faced with the same risk today. At what level of government debt and future commitments does government default go from being unthinkable to inevitable, and how does our government think about that risk?

I recently posed this question to one of the president’s senior economic advisers. He answered that the government is different from financial institutions because it can print money, and statistically the United States is not as bad off as some other countries. For an investor, these responses do not inspire confidence.

He went on to say that the government needs to focus on jobs now, because without an economic recovery, the rest does not matter. It’s a valid point, but an insufficient excuse for holding off on addressing the long-term structural deficit. If we are going to spend more now, it is imperative that we lay out a credible plan to avoid falling into a debt trap. Even using the administration’s optimistic 10-year forecast, it is clear that we will have problematic deficits for the next decade, which ends just as our commitments to baby boomers accelerate.

Modern Keynesianism works great until it doesn’t. No one really knows where the line is. One obvious lesson from the economic crisis is that we should get rid of the official credit ratings that inspire false confidence and, worse, are pro-cyclical, aggravating slowdowns and inflating booms. Congress has a rare opportunity in the current regulatory reform effort to eliminate the rating system. For now, it does not appear interested in taking sufficiently aggressive action. The big banks and bond buyers have told Congress they want to continue the current system.

As William Gross, the managing director of the bond management company Pimco, put it in his last newsletter, “Firms such as Pimco with large credit staffs of their own can bypass, anticipate and front run all three [rating agencies], benefiting from their timidity and lack of common sense.”

Given how sophisticated bond buyers use the credit rating system to take advantage of more passive market participants, it is no wonder they stress the continued need to preserve the status quo.

It would be better to have each investor individually assess credit-seeking entities. Certainly, the creditworthiness of governments should not be determined by a couple of rating agency committees.

Consider this: When Treasury Secretary Timothy Geithner promises that the United States will never lose its AAA rating, he chooses to become dependent on the whims of the Standard & Poor’s ratings committee rather than the diverse views of the many participants in the capital markets. It is not hard to imagine a crisis where just as the Treasury secretary seeks buyers of government debt in the face of deteriorating market confidence, a rating agency issues an untimely downgrade, setting off a rush of sales by existing bondholders. This has been the experience of many troubled corporations, where downgrades served as the coup de grâce.

The current upset in the European sovereign debt market is a prequel to what might happen here. Banks can hold government debt with a so-called zero-risk weighting, which means zero capital requirements. As a result, European banks stocked up on Greek debt, and sold sovereign credit default swaps, and now need to be bailed out to avoid another banking crisis.

As we saw first in Dubai and now in Greece, it appears that governments’ response to the failure of Lehman Brothers is to use any means necessary to avoid another Lehman-like event. This policy transfers risk from the weak to the strong — or at least the less weak — setting up the possibility of the crisis ultimately spreading from the “too small to fails,” like Greece, to “too big to bails,” like members of the Group of 7 industrialized nations.

We should have learned by now that each credit — no matter how unthinkable its failure would be — has risk and requires capital. Just as trivial capital charges encouraged lenders and borrowers to overdo it with AAA-rated collateral debt obligations, the same flawed structure in the government debt market encourages and therefore practically ensures a repeat of this behavior — leading to an even larger crisis.

I don’t believe a United States debt default is inevitable. On the other hand, I don’t see the political will to steer the country away from crisis. If we wait until the markets force action, as they have in Greece, we might find ourselves negotiating austerity programs with foreign creditors.

Some believe this could be avoided by printing money. Despite the promises by the Federal Reserve chairman, Ben Bernanke, not to print money or “monetize” the debt, when push comes to shove, there is a good chance the Fed will do so, at least to the point where significant inflation shows up even in government statistics.

That the recent round of money printing has not led to headline inflation may give central bankers the confidence that they can pursue this course without inflationary consequences. However, printing money can go only so far without creating inflation.

Government statistics are about the last place one should look to find inflation, as they are designed to not show much. Over the last 35 years the government has changed the way it calculates inflation several times. According to the Web site Shadow Government Statistics, using the pre-1980 method, the Consumer Price Index would be over 9 percent, compared with about 2 percent in the official statistics today.

While the truth probably lies somewhere in the middle, this doesn’t even take into account inflation we ignore by using a basket of goods that don’t match the real-world cost of living. (For example, health care costs are one-sixth of G.D.P. but only one-sixteenth of the price index, and rising income and payroll taxes do not count as inflation at all.)

Why does the government understate rising costs? Low official inflation benefits the government by reducing inflation-indexed payments, including Social Security. Lower official inflation means higher reported real G.D.P., higher reported real income and higher reported productivity.

Subdued reported inflation also enables the Fed to rationalize easy money. The Fed wants to have low interest rates to fight unemployment, which, in a new version of the trickle-down theory, it believes can be addressed through higher stock prices. The Fed hopes that by denying savers an adequate return in risk-free assets like savings deposits, it will force them to speculate in stocks and other “risky assets.” This speculation drives stock prices higher, which creates a “wealth effect” when the lucky speculators spend some of their gains on goods and services. The purchases increase aggregate demand and lead to job creation.

Easy money also aids the banks, helping them earn back their still unacknowledged losses. This has the perverse effect of discouraging banks from making new loans. If banks can lend to the government, with no capital charge and no perceived risk and earn an adequate spread, then they have little incentive to lend to small businesses or consumers. (For this reason, higher short-term rates could very well stimulate additional lending to the private sector.)

Easy money also helps the fiscal position of the government. Lower borrowing costs mean lower deficits. In effect, negative real interest rates are indirect debt monetization. Allowing borrowers, including the government, to get addicted to unsustainably low rates creates enormous solvency risks when rates eventually rise.

While one can debate where we are in the recovery, one thing is clear — the worst of the last crisis has passed. Nominal G.D.P. growth is running in the mid-single digits. The emergency has passed and yet the Fed continues with an emergency zero-interest rate policy. Perhaps easy money is still appropriate — but a zero-rate policy creates enormous distortions in incentives and increases the likelihood of a significant crisis later. It was not lost on the market that during this month’s sell-off, with rates around zero, there is no room for further cuts should the economy roll over.

EASY money has negative consequences in addition to the risk of inflation and devaluing the dollar. It can also feed asset bubbles. In recent years, we have gone from one bubble and bailout to the next. Each bailout has rewarded those who acted imprudently. This has encouraged additional risky behavior, feeding the creation of new, larger bubbles.

The Fed bailed out the equity markets after the crash of 1987, which fed a boom ending with the Mexican crisis and bailout. That Treasury-financed bailout started a bubble in emerging market debt, which ended with the Asian currency crisis and Russian default. The resulting organized rescue of Long-Term Capital Management’s counterparties spurred the Internet bubble. After that popped, the rescue led to the housing and credit bubble. The deflationary aspects of that bubble popping created a bubble in sovereign debt, despite the fiscal strains created by the bailouts. The Greek crisis may be the first sign of the sovereign debt bubble bursting.

Though we don’t know what’s going to happen next, the good news for our grandchildren is that we will have to face our own debts. If we realize that our own future is at risk, we might be more serious about changing course. If we don’t, Mr. Geithner and others might regret having never said never about America’s rating.

David Einhorn is the president of Greenlight Capital, a hedge fund, and the author of “Fooling Some of the People All of the Time.” Investment accounts managed by Greenlight may have a position (long or short) in the securities discussed in this article.

A version of this op-ed appeared in print on May 27, 2010, on page A35 of the New York edition

Inflation Nation - Prepare For The Coming Hyperinflationary Dollar Collapse

Dammit.

TILB has been trying to post less frequently and to have those infrequent posts avoid frustrating topics such as the destruction of our economic and social future. You can understand that.

I've established many times over that nobody cares, so why even keep banging the gong...particularly when it seems I'm banging it with my forehead instead of a mallet?

As an aside, friend of TILB and thief (before I invented it) of the phrase Tooth Fairy Economics Tom Woods makes several appearances in this video as do several other TILB mancrushes like Ron Paul, Peter Schiff, Mark Faber, and Uncle Jimmy Rogers.

This is the best video I've seen since Chris Martenson's Crash Course collection (someday I'll post about that video collection - if you haven't watched it yet, you must stop everything you're doing and spend a few hours watching immediately - link here).

I've been meaning to sit down and write more about the value of money, why price deflation is the natural course of the world (a good thing, btw!), and why not all GDP is created equal, but honestly, it's an emotional drain to reflect on and write about these ideas and it requires more of my head banging the gong. But I'll get to it, because while I'm sure nobody reads this, much less cares, I find the anguish and process of putting myself through it strangely beneficial.

In any case, watch this video and watch the Crash Course. As the great Cypress Hill has warned us so many times, "when the shit goes down, you better be ready...YOU BETTER BE READY!!" Indeed



PS: Please do me a favor and buy some actual, physical gold. It's for your own good.

The Anatomy Of A Failed T Bill Auction

So, the auction didn't actually "fail", per se. But this excellent Seeking Alpha piece breaks down a very strange Treasury Bill auction earlier this week. Very little buying from traditional sources forced primary dealers and - perhaps - The Fed to step into the breach. Here is an excellent breakdown on what was a very weak Bills auction yesterday.

We recommend clicking the above Seeking Alpha link and reading the article in its entirety, in order to understand how a Treasury auction works and what makes for a "strong" vs. a "weak" auction. What happened on February 23rd was unquestionably "weak", though to be fair, zero percent interest rates wouldn't drive me to bid either.

Here is a partial description from his article:

Now here’s where things get odd.

Of the competitive bids (meaning those bids coming from folks who care about yield), roughly 70% went to Primary Dealers (investors who HAVE to buy the debt and who usually turn around and try to sell it afterwards). To put this number into perspective here is the percentage of competitive purchases made by Primary Dealers in the last four 4-week Treasury issuances:


Date of 4-Week Treasury Auction
Primary Dealers as % of Competitive Buys

January 5 2010
42%

January 12 2010
70%

January 20 2010
60%

January 26 2010
67%

February 2 2010
51%

February 9 2010
51%

February 17 2010
61%

February 23 2010 (yesterday)
70%

You’ll note that during the stock market correction that took place during the end of January/beginning of February, Primary Dealers didn’t need to buy many Treasuries since investors were fleeing stocks and buying short-term Treasury debt as a safe haven.

You’ll also notice that yesterday’s auction featured MORE buys from Primary Dealers than almost any of those occurring in 2010. Remember, Primary Dealers HAVE to buy Treasuries. So to see them buying a high percentage of Treasuries at debt auctions means that few investors who can pick and choose what to buy are actually looking to buy US debt.

In plain terms, a debt auction that features a high percentage of competitive buys coming from Primary Dealers is BAD NEWS. It means investors generally aren’t buying US debt. It also means that foreign governments (those who have funded US debt auctions for decades) aren’t buying much anymore either.

So the fact we’ve have three short-term auctions in which more than two thirds of competitive buys came from Primary Dealers is worrisome to see the least.

Now here’s where it gets even worse.

Of the remaining competitive buys (about $8.86 billion), only 32% came from Direct Bidders or those who bought debt directly from the Treasury: orders that can easily be tracked. The other 68% ($5.9 billion) came from Indirect Bidders: folks who we cannot track.

Even more bizarre, only $5.9 billion in Indirect Bidder competitive buys were ACTUALLY OFFERED. So we had a 100% acceptance rate for Indirect Bidder competitive buys.

Let’s put this in perspective:

Date of 4-Week Treasury Auction
Indirect Bidder Acceptance Rate

January 5 2010
71%

January 12 2010
22%

January 20 2010
77%

January 26 2010
43%

February 2 2010
63%

February 9 2010
87%

February 17 2010
82%

February 23 2010 (yesterday)
100%

This means that the Treasury took up EVERY single cent of competitive bids coming from indirect buyers. Remember, indirect buyers are usually assumed to be foreign governments (even the Treasury website admits this).

If this was the case yesterday, then foreign governments barely bought much of anything in yesterday’s auction (only 19% of total debt issued). Moreover, it implies that Primary Dealers (those having to buy) had to gorge on the auction to make up for the fact that few if any foreign governments are interested in buying our debt anymore (including even short-term debt).

Or…

One could potentially argue that this indirect buying came from the Fed covertly buying under the guise of an indirect bidder (the Treasury recently changed the definition of what qualifies for an indirect bidder to make it more vague). It IS rather odd that every single cent of competitive bidding coming from indirect buyers was filled. It’s almost as if the indirect buyers knew precisely WHAT yield to accept… OR were simply trying to take up the slack in what was already a VERY weak auction.

I cannot tell you which of the above is true. Heck, neither of them could be and something completely different could be happening. But regardless, something very, VERY strange is going on in US debt auctions.

I wrote earlier this year that bonds, not stocks, would be the big story of 2010. We’re only into February and there are already some very unusual things happening on both the long (30 year) and the short (4 week) ends of the Treasury curve. And with the Fed’s Quantitative Easing Program scheduled to end in March, things are about to get a whole lot more interesting (barring of course an extension of the QE or QE 2.0).

Keep your eye on US Treasuries. Stocks, despite being so popular with investors are usually the LAST to get what’s coming down the pike. And investors just parked $30 billion for a month with Uncle Sam at virtually NO YIELD yesterday.

Put another way, someone(s) is/are willing to not make money just for the sake of insuring return OF capital (the US can always print money to return it) rather than any return ON capital.

[HT: TD]

The Final Countdown: Greek Sovereign Default

The aptly named band Europe brought us the epic music video and song "The Final Countdown" about 20 years too early (I mean, who cares about the countdown to the end of communism - let's talk about the PIIGS sovereign default).

As I read all these articles about Greece's impending doom, it's hard not to hear in the back of my head the implied complaint, "why won't they just lend us the money for free? This doesn't make any sense. Just lend us the money for free!"

[emphasis added and comments in brackets]

Europe Weighs Possibility of Debt Default in Greece
New York Times
By STEPHEN CASTLE and MATTHEW SALTMARSH

European leaders are quietly considering whether to come to the aid of their troubled neighbor Greece amid fears that the nation might default on its debts and unleash another round of financial crisis.

Only a month after Dubai was rescued by its neighboring emirate Abu Dhabi, Germany, France and other European powers are discussing whether Greece might need a bailout too.

After a decade of debt-fueled profligacy, Greece is confronting what amounts to a run on the bank. And, despite repeated assurances from Athens, the nation’s strained finances have put already jittery financial markets on edge. On Thursday, the worries stretched all the way to Wall Street, where the stock market sank 1.1 percent.

Some economists worry that Greece’s troubles could have deep and lasting repercussions for Europe. The crisis poses complex challenges for the euro, which Greece adopted in 2001. The currency sank to a six-month low against the dollar and yen on Thursday.[ironically, TILB thinks letting Greece go could be an incredibly strong event for the euro]

“Greece failing is not an option, and lots of people think that we will have to intervene at some stage,” said one European finance official, who was not permitted to speak publicly on the matter. “It doesn’t have to happen, and we hope it won’t, but it would be better than seeing a default.”

...

But doubts have intensified over the credibility of the drastic austerity measures put forward to try to get Greece’s budget under control, in spite of concerted efforts by the Greek government to calm the markets.

Investors worry that the crisis in Greece could touch off a domino effect across Southern Europe. Many are fleeing bond markets in Portugal, Spain and Italy out of concern the troubles might spread. [TILB - Collectively known as the PIIGS when Ireland is included]

The market’s judgment has been swift and brutal. On Thursday, the difference between the interest rates on Greek and German bonds — a measure of the risk investors perceive in the Greek debt — rose to nearly four full percentage points, its highest level since the euro was adopted.

Officials in Athens, Frankfurt and Brussels remained adamant that Greece was not at risk of being forced to abandon the euro. [TILB - of course not. Could you imagine if they said, "hey, we're thinking of going back to the Drachma so that we can print our way out of this debacle?" That would be amazing.]

As a condition of any aid package, the Greek government led by Mr. Papandreou would be asked to provide a more detailed program to bring the country’s deficit — currently equal to 12.7 percent of gross domestic product — under control. European Union rules call for a maximum of 3 percent. Officials insist that any bailout must not put into doubt the credibility of the euro.

Another condition of any aid would be further guarantees over the reliability of Greece’s economic data. Last year the newly elected government in Athens announced a sharp upward revision of its deficit figures, which have since been exposed as seriously flawed.

Next week, the European Commission is expected to propose greater powers for the European statistical agency, Eurostat, to audit the accounts of national governments. [TILB - watch Czech president Vaclav Klaus give this interview where he presciently assesses the fact that the EU and the Euro are forfeitures of sovereignity and freedom, then watch the slow leech of powers from the states to the centralized United States of Europe]

The latest moves reflect a continuing skepticism among euro-zone members over the practicality of the plans put forward so far by the Greek government. Athens wants to reduce the deficit to 3 percent of G.D.P. by 2012, an objective described as unrealistic by one European diplomat, also speaking on condition of anonymity. These plans are also to be assessed by the commission next week.

Greece’s budget deficit is four times the E.U. limit, while the country’s debt amounts to 113 percent of G.D.P. But officials insist that, because Greece is not one of the euro zone’s larger economies, the problems created by its grim public finances can be absorbed. The Greek economy represents about 2.5 percent of the euro area’s G.D.P. [TILB - Japan is over 200% sovereign debt to GDP and the US is a bit over 80%. Carmen Reinhardt and Kenneth Rogoff show that 90% is the threshold past which few survive, as well as 60% externally financed debt to GDP - this latter point has been Japan's saving grace, though that is likely over]

...

For Greece’s neighbors, there is the possibility of a domino effect, with investors subsequently moving on to test the resilience of another heavily indebted member of the euro area — possibly Italy, whose debt is also 113 percent of its gross domestic product.

...

One option, deemed unlikely, would be issuing a sovereign bond for the entire 16-nation euro area. That would probably require complex legal changes among members. [TILB - see prior Vaclav Klaus reference]

...

On Monday, Greece paid a hefty 6.22 percent rate to borrow money in the bond market, underscoring investors’ concern. [TILB - and it's much more expensive for them already, just five days later. If memory serves us well, they have a number of huge maturities in April/May that will be challenging to finance affordably without German backstop...]

In an interview this week, the Greek finance minister, George Papaconstantinou, acknowledged that the high rates were punitive but asked that investors keep faith. Greece needs to raise at least 53 billion euros this year, much of it this spring.

People think this is news?

As we've been saying for a year, just wait until Japan blows. It's situation is nearly twice as bad as Greece's. Despite having 40% of the U.S.'s GDP, it has as much debt. If its blended cost of funding goes up from 1.5% to a bit over 3%, 100% of its tax revenue will be absorbed by interest expense. We're talking about the second largest economy in the world and it literally has no other options than massively debasing its currency or defualting on its debt (or, more likely, both). That's what they get for following Bernanke's wicked advice.

The sooner Japan blows, the better for the U.S. - I suspect our only hope of not suffering the same fate is to witness Japan's meltdown after having followed a similar prescription.

And as to Europe, just wait until Greece's implosion lights up Italy, which is a very large economy. That is the real worry the EU is facing: do we let Italy go?

Which brings us full circle, to The Final Countdown...

U.S. Rail Data Crushingly Negative

[HT: Max Headroom and LB]

The weekly railroad traffic data collected by the Association of American Railroads (AAR) did not have a particularly difficult comp in January. You may recall that in January 2009, it seemed as if the world had stopped as retailers and suppliers were crushed by excess inventory that needed to be burned off. Those same businesses allegedly just stopped placing orders leading to the collapse in rail volumes during November and December of 2008 in the below graph. January 2009 was no better.
2010 - Jan 14 - AAR Data

So January 2010, even if still in the teeth of a recession, should at least have the benefit of not dealing with an excess inventory problem. It should have been better than January 2009.

But alas. In fact, the first week of January is comping well below the worst average month in all of 2008 or 2009 (or any month for YEARS, for that matter). Green shoots?

From the AAR's weekly rail data release (emphasis added):

WASHINGTON, D.C. – Jan. 14, 2010 – The Association of American Railroads today reported that freight rail traffic is off to a slow start in 2010 with U.S. railroads originating 236,796 carloads for the week ending Jan. 9, 2010, down 12.4 percent compared with the same week in 2009 and down 28 percent from the same week in 2008. In order to offer a complete picture of the progress in rail traffic, AAR will now be reporting 2010 weekly rail traffic with year-over-year comparisons for both 2009 and 2008.

Helicopter Ben, your authotization to continue debasing has arrived. Continue your destructive ways freely.

Bread Is Money And Money Is Bread

"We have free markets."

This mantra is unquestioned around the world in the context of The United States of America. Nobody prevents you from buying the vast majority of products you desire and nobody prevents you from selling the vast majority of products. In broad terms, you can generally do what you wish with your money.

So, the mantra is true: we have free markets.

Or, perhaps before answering the question, we should allow our mind to churn a bit.

When asked by Congress and when giving speeches, Chairman Bernanke affirms his belief in the need for free markets. I am certain if you asked if he was in favor of price fixing, he would laugh at you and say, "of course not. The freer the better, (with certain 'protections')."

And yet, as chairman of the Federal Reserve, he is of course the world's largest price fixer. He controls the monopoly printing control of U.S. dollars and he controls the price and availability of these dollars. He controls who gets newly printed dollars and who does not. These dollars are backed only by the Full Faith and Credit of the United States, rather than by anything tangible. As such, these unbacked currencies are referred to as "fiat" money, as they are commanded into society be fiat, rather than choice.

Bernanke controls the price of dollars through Fed Funds rate implementations (and other similar tools) and he controls the availability in any number of manners, but suffice it to say a dollar's legal name is a Federal Reserve Note, so each dollar is theoretically a liability of the Fed and thus created always and everywhere by the Fed (banks sort of also create dollars through fractional reserve banking, but this is with the Fed's explicit blessing and under the Fed's control).

The price and supply of dollars is not set via market forces, it is set via the collective decision of a dozen or so bureaucrats sitting in the Washington, DC headquarters of the Federal Reserve.

In practice, the majority of those bureaucrats has never dissented from the opinion of the Fed Chairman, so Bernanke effectively dictates the price and supply of money with the advice of mandarins.

Luckily, money's not a very important instrument, so this seems like it shouldn't cause problems.

Everyone knows that is a ridiculous statement, but have you ever thought about what "money" is? I don't mean "dollars," I mean "money," in all its forms.

Money is simply a store of value, of man's productive output. When man innovates and produces above his cost of capital, money becomes more valuable because the same amount of money can now acquire more, different, and/or better things.

Money is exchangeable for goods and services and thus money represents some amount of claim on goods and services. As such, things like bread, milk and financial advice are all embodied in money. It is a fractional claim on everything.

Each transaction in life represents two sides of the same coin. While we generally think of a transaction as money buying bread, another way to think of it is of bread acquiring money. As such, bread is money and money is bread. They are claims on each other. In essence, every good and service is a claim on some amount of other goods and services and money is simply the trusted lubricant in the transaction.

This brings us back to Chairman Bernanke's seemingly benevolent dictatorship of the price and supply of money.

Because bread is money and money is bread, what is Bernanke actually controlling the price and supply of? Is he only price fixing dollars?

Obviously not. He is using an incredibly blunt (albeit convenient) mechanism - the dollar - to price fix everything in the economy.

If you've never thought of the nature of money before, this should scare the absolute shit out of you.

One guy is in charge of all of this?

Further, the Fed is a largely independent body of unelected officials with no meaningful transparency or accountability to We The People. We have handed the economic nuclear football to a bearded Princeton theoretician and told him it would be grand if he didn't use it, or at least use it responsibly.

This is truly insane.

It also means we live in anything but a free market. We live in a market that is manipulated at all times and in damnable ways. Not only are dollars not created and priced via natural supply/demand dynamics, they are a form of money that is manipulated and used to the benefit of certain special interests at the expense of everyone else in an opaque system.

Given this backdrop, in some sense it is almost amazing these United States have been as successful as they have.

I attribute the success we have had to a few things, not least of which is the reality that every country on Earth (that I am aware of) uses a similar or worse methodology for creating and pricing their imposed form of money, so the dollar has not served as a meaningful comparative disadvantage. In fact, its status as the global reserve currency - which is now waning - has been a substantial advantage as it imposed our price control structure onto many nations and global transactions and allowed us to export a good portion of our inflation.

We also have historically had greater freedom from governmental control in other aspects of life than most nations, giving us a further competitive advantage of more freedom, even if incomplete. That gap too is waning as certain other countries grow their freedom and we are actively and aggressively shrinking ours.

Importantly, we built our reputation as a nation of freedom during a time that predated the Federal Reserve and had a reasonably well enforced classical gold standard. We still lean on this reputation today.

The fact that other countries have been more evil than we have is not exactly the stand on which we should endeavor to hang our hat.

We should understand the long-term implications of what it means to live in a society that suffers from governmental imposed price fixing in every market. Some implications are as follows:
1) we suffer a drought relative to freedom that we should have;
2) we can know for a fact that our scarce resources are misallocated and scarce investment capital is maldirected as time and time again has shown the optimal system for directing resources and capital is a reliable price system;
3) the long-term governmental incentive to inflate the currency supply is overwhelming as this form of taxation is largely hidden from sight and fiat money allows it limitlessly. Monetary inflation thus leaves elected officials less accountable than if a more straightforward tax was required. This monetary system thus helps (in the short- to medium-term) the government finance things that are difficult to pay for with new taxes due to their unpopularity like war and freedom encroaching bureaucracy;
4) certain private industries and citizens benefit - these beneficiaries are in essence the early holders of newly printed dollars before they've cycled through the system and impacted prices (e.g., banks, bank borrowers, and wealthy investors) at the expense of holders that see the new money later in the process (e.g., fixed income retirees and middle class workers);
5) we risk our competitive advantage to countries that are willing to be more free than us. Increases in true freedom have everywhere and always improved the lot of the people (see modern day China, for example); and
6) someday we should expect that the build-up of problems caused by the system lead to the system's failure. What that entails is potentially awful. Historically massive wealth loss, poverty, political upheaval, class warfare and actual war are on the menu.

So, have we actually lived in a free market economy during the last few decades, waking every morning to an improving society?

No, we have not. The market will continue to fight against the current system until it breaks, as freedom once held cannot be suffocated, it can simply be constrained. Market freedom is a core freedom and it demands the right to carve its own path.

We now know that bread is money and money is bread - that money, is in fact a small part of everything that can be acquired. We know that as new money is brought into circulation, it dilutes the per unit (e.g., per dollar) claim we have on all goods and services. We know the perverse incentives of fiat money and the near certain direction that fiat money's supply will progress.

With those important pieces of information, you should perhaps ponder whether you prefer holding a money that is 38 years old (the fully unbacked dollar came into being in 1971, after the pseudo-gold backed dollar suffered its demise upon Nixon's command) or whether you prefer a form of money that has been freely selected by individuals in every geography on Earth in which it existed for the last 6,000 years.

Perhaps fiscal discipline will return and monetary discipline will follow. Perhaps government officials will choose to tax less and spend even less in the coming years, easing the pressure on the Fed to debase. Perhaps the Fed will see the folly of its ways and halt or reverse the printing press actions of the past year. Perhaps these things will all happen in the next two or three years before our debt gets past the point of no return.

Perhaps.

But I know my preference:

Gold.

[For more on the meaning of money, read Francisco D'Anconia's brilliant speech linked here]

David Rosenberg Calls For Gold $2600

To the moon.

Enjoy.

Gold Hits $1215/Ounce

And we're off to the races. Luckily the Fed thinks gold is a "side show," so it's no big deal. Somewhere Bernanke smiles, so don't worry.

To the moon...

Ben Bernanke Defends The Indefensible: The Fed

As we occasionally do with OpEd's intended for broad public distribution, we provide below the complete version of Bernanke's ridiculous defense of the Fed's ability to hide its actions from Congress and his table pounding support for the Fed's place as a regulator.

These ideas are of course ridiculous on their face, as the power to destroy our currency and thus our country should be watched closely (it should never be granted in the first place, but certainly we should have a right to understand what they are doing and who benefits). Further, The Fed has obviously been an abject failure as a regulator (a cursed job to begin with, admittedly).

Anyway, from The Washington Post.

The right reform for the Fed

By Ben Bernanke
Sunday, November 29, 2009

For many Americans, the financial crisis, and the recession it spawned, have been devastating -- jobs, homes, savings lost. Understandably, many people are calling for change. Yet change needs to be about creating a system that works better, not just differently. As a nation, our challenge is to design a system of financial oversight that will embody the lessons of the past two years and provide a robust framework for preventing future crises and the economic damage they cause.

These matters are complex, and Congress is still in the midst of considering how best to reform financial regulation. I am concerned, however, that a number of the legislative proposals being circulated would significantly reduce the capacity of the Federal Reserve to perform its core functions. Notably, some leading proposals in the Senate would strip the Fed of all its bank regulatory powers. And a House committee recently voted to repeal a 1978 provision that was intended to protect monetary policy from short-term political influence. These measures are very much out of step with the global consensus on the appropriate role of central banks, and they would seriously impair the prospects for economic and financial stability in the United States. The Fed played a major part in arresting the crisis, and we should be seeking to preserve, not degrade, the institution's ability to foster financial stability and to promote economic recovery without inflation.

The proposed measures are at least in part the product of public anger over the financial crisis and the government's response, particularly the rescues of some individual financial firms. The government's actions to avoid financial collapse last fall -- as distasteful and unfair as some undoubtedly were -- were unfortunately necessary to prevent a global economic catastrophe that could have rivaled the Great Depression in length and severity, with profound consequences for our economy and society. (I know something about this, having spent my career prior to public service studying these issues.) My colleagues at the Federal Reserve and I were determined not to allow that to happen.

Moreover, looking to the future, we strongly support measures -- including the development of a special bankruptcy regime for financial firms whose disorderly failure would threaten the integrity of the financial system -- to ensure that ad hoc interventions of the type we were forced to use last fall never happen again. Adopting such a resolution regime, together with tougher oversight of large, complex financial firms, would make clear that no institution is "too big to fail" -- while ensuring that the costs of failure are borne by owners, managers, creditors and the financial services industry, not by taxpayers.

The Federal Reserve, like other regulators around the world, did not do all that it could have to constrain excessive risk-taking in the financial sector in the period leading up to the crisis. We have extensively reviewed our performance and moved aggressively to fix the problems.

Working with other agencies, we have toughened our rules and oversight. We will be requiring banks to hold more capital and liquidity and to structure compensation packages in ways that limit excessive risk-taking. We are taking more explicit account of risks to the financial system as a whole.

We are also supplementing bank examination staffs with teams of economists, financial market specialists and other experts. This combination of expertise, a unique strength of the Fed, helped bring credibility and clarity to the "stress tests" of the banking system conducted in the spring. These tests were led by the Fed and marked a turning point in public confidence in the banking system.

There is a strong case for a continued role for the Federal Reserve in bank supervision. Because of our role in making monetary policy, the Fed brings unparalleled economic and financial expertise to its oversight of banks, as demonstrated by the success of the stress tests.

This expertise is essential for supervising highly complex financial firms and for analyzing the interactions among key firms and markets. Our supervision is also informed by the grass-roots perspective derived from the Fed's unique regional structure and our experience in supervising community banks. At the same time, our ability to make effective monetary policy and to promote financial stability depends vitally on the information, expertise and authorities we gain as bank supervisors, as demonstrated in episodes such as the 1987 stock market crash and the financial disruptions of Sept. 11, 2001, as well as by the crisis of the past two years.

Of course, the ultimate goal of all our efforts is to restore and sustain economic prosperity. To support economic growth, the Fed has cut interest rates aggressively and provided further stimulus through lending and asset-purchase programs. Our ability to take such actions without engendering sharp increases in inflation depends heavily on our credibility and independence from short-term political pressures. Many studies have shown that countries whose central banks make monetary policy independently of such political influence have better economic performance, including lower inflation and interest rates.

Independent does not mean unaccountable. In its making of monetary policy, the Fed is highly transparent, providing detailed minutes of policy meetings and regular testimony before Congress, among other information. Our financial statements are public and audited by an outside accounting firm; we publish our balance sheet weekly; and we provide monthly reports with extensive information on all the temporary lending facilities developed during the crisis. Congress, through the Government Accountability Office, can and does audit all parts of our operations except for the monetary policy deliberations and actions covered by the 1978 exemption. The general repeal of that exemption would serve only to increase the perceived influence of Congress on monetary policy decisions, which would undermine the confidence the public and the markets have in the Fed to act in the long-term economic interest of the nation.

We have come a long way in our battle against the financial and economic crisis, but there is a long way to go. Now more than ever, America needs a strong, nonpolitical and independent central bank with the tools to promote financial stability and to help steer our economy to recovery without inflation.

The writer is chairman of the Federal Reserve Board of Governors.

End The Fed.

Inflation Vs. Deflation: Peter Schiff Gives The Definitive Interview

Peter Schiff apparently agrees with The Singularity thesis. This is the best interview I've heard about the inflation/deflation argument.

Schiff comes out on the side of inflation. He notes that deflationists are right, but only if they price assets in gold which is what their set of comparable history is relative to. Gold can't be printed and so credit collapses and their natural outcomes should be measured against that benchmark, rather than fiat currency.

Schiff also addresses why the U.S. will not be "fortunate" enough to have the Japan outcome (as TILB has said several times, Japan is our upside case). The differences are stark and important: Japan was a creditor nation, Japan had huge government and private savings, Japan had a budget surplus, Japan was a net exporter, the rest of the world didn't slow down with Japan, Japan's underlying economic engine remained robust throughout the period, etc., etc.

Enjoy.

President Richard Nixon Ends The Bretton Woods Agreement

God bless YouTube - TILB had never seen this before.

To think that our non-existent respect for Nixon could go lower would have been a challenge, but listening to him help lay the groundwork for the dollar's destruction makes us sick to our core. The below is video of his infamous decision to end the dollar's convertibility. The talk resonates particularly powerfully today as the media celebrates Helicopter Ben's "stabilizating" debasement efforts.

Beware what you wish for.

The Singularity: A World Walking The Tight Rope Of Low Interest Rates

[What follows is a thought piece I spent two weeks writing and sent around to some colleagues on Sunday October 18th. It has been modified slightly to take some associate's names out. TILB believes the outcome of rising rates would be unusually horrible for risk assets and, frankly, our society in general.]

“Are you getting it? Armageddon it! Ooh, really getting it? Yes, Armageddon
it!”

- Def Leppard

We have spent a great deal of time reflecting on the lessons learned over the past two years. As I've contemplated those lessons and considered Hatch's recent point that after this recent risk-rally, it appears that market participants' behavior is seemingly unchanged, I began thinking about what we should do to prepare/adjust for the risks that remain in the world (assuming any do). I have many views about this but want to address one in particular.

Humans have a fairly well defined collective “nature” and we are all challenged to deal with our own tendencies within our nature. We have a tendency to self deceive – particularly in situations where we’ve already put ourselves out to the world as having taken a view. Among other things, we have a desire to be right, a desire to be liked, we anchor to the past – especially the recent past – and we act emotionally and generally as a herd. I suffer from all of these, especially self deception.

It's part of life.

Hopefully I have some advantage in dealing with my own tendencies simply by acknowledging them, being aware of them, and realizing that self-deception doesn’t help with my even greater desire to be right. When I frame something through those combined lenses, it helps me stop deceiving so that I can get on the side of “right”.

That’s me. But collectively it’s not possible for man to suppress its aggregate nature and so we muddle along doomed to commit the same mistakes over and over again. The mistakes may not be identical on the surface but they’re identical at their core. This reality was reinforced by Seth Klarman at a conference I saw him speak at back in 2004 or 2005 when he fielded the question (paraphrasing), "do you worry that with the rise of hedge funds and everyone looking for inefficiencies that you're not going to find fat pitches anymore; that the market has become more efficient?" with the following response, "I'm not worried that human nature has changed."

Exactly.

So what is it about human nature pre-2007 that led to the “crisis”. This doesn’t need to address the true “core” problems that I see of fiat money, fractional reserve banking, and unintended consequences of certain policy and regulatory actions. Instead, let’s look at the nature of the foundation those skewed incentives created and how those building blocks were set to crumble in the first place.

In summary, we had a lack of respect for risk, perhaps engrained from 25 years of a generally painless experience for capital (recency bias) where the speedbumps that were approached seemed to be flattened out by the all-seeing, all-knowing Federal Reserve. Howard Marks said that, "the fear of loss is to capitalism as fear of hell is to Catholicism." Collectively, our balance between fear and greed was eroded by this apparent government-gilded safety net and the scales tipped out of whack. This manifested itself in a variety of ways including too much leverage, too little diligence, too much faith in government, too much moral hazard, prices that appreciated too far above the associated intrinsic worth of the assets they represented, too much illiquidity, etc.

I think back on 2006 and remember having conversations over and over where smart investment managers told us that “spreads were too narrow” in the credit world. In fact, despite our repeated asking, we could find almost nobody who would admit to buying at then prevailing prices. This lack of opportunity caused these managers to hold cash or, more often, drift out of their competency in credit analysis into other areas like public equities, LBOs, etc. We spent a little time trying to figure out who was actually buying these assets but frankly did not do a thorough job. What bothered me about this was that I felt like this was a consensus view and my strong preference is to be contrarian.

I have been noodling on the paradox of what it means for me to agree with the consensus - perhaps it is possible that a consensus view point can actually be contrarian? My conclusion is it can. When very large unnatural forces impact the market, an artificial, "unseen" consensus may be created that opposes the traditional "seen" consensus, allowing the seen consensus to actually be contrarian.

I refer to the unnatural forces creating the artificial, unseen consensus as "dumb money". It is dumb in the sense that is not invested with risk-adjusted return generation as its north star; it serves some master other than unfettered economics, be it regulatory or political. In that regard, it is mindless and dumb.

As I mentioned, the view that credit spreads were too tight was a consensus view. However, a thorough research job would have shown us that there was, in effect, an enormous regulatory bid. It was a bid from ABS in the form of CDOs, CMBS, CLOs, RMBS, etc. This was and remains purely a regulatory game where assets that do not have the most attractive properties from a regulatory capital standpoint (e.g., sub-prime no doc mortgages, 2nd lien small cap bank lending to an LBO company, BBB tranches of other ABS) are pooled and re-crafted to rate very well from a regulatory standpoint. Generally 75-85% of these pools of unattractive regulatory assets receive an attractive regulatory treatment (A rated or better) and the balance of the assets are held by unregulated owners that are willing to take low- or un-rated risk.

When you think about this, it is a fascinating reality: buyers had all kinds of incentives that had little to do with the quality or price of what they were buying and a lot to do with interference in markets by regulators and government that drove buyers toward assets for unnatural reasons. In essence, they were price insensitive and it led to unsustainable outcomes.

So we learned a lesson: Follow the Dumb Money. It leads you to the excess (and perhaps to opportunities for shorting).

So Where is the Dumb Money Today?
All of the above was a preamble to establish the case that human nature is fundamental, it causes recurring problems, and the problems are identifiable if we’re willing to hunt down the Dumb Money’s most recent activities. We saw in the recent credit bubble a regulatory Incentive Caused Bias that led buyers to overpay for high ratings and over-trust ratings agencies. Where is Dumb Money today?

It has bothered me for some time that the "seen" consensus view point seems to believe higher rates and more inflation are inevitable. It bothers me because I completely agree with it. I operate more comfortably in a contrarian circle and yet here I find myself rubbing shoulders with the masses. Perhaps it's simply another form of self-deception but I believe we are witnessing a volume of Dumb Money buying ("unseen" consensus) that registers near the right tail on an all time scale. And the Dumb Money ring master is us - the US taxpayer - via our body politic and our printing press operations at the Federal Reserve.

One of the causes of truly great inflations is that in the early stages of rapid money-printing, the price of a typical consumer's basket of goods doesn't immediately respond one for one with monetary creation. The economist Murray Rothbard was a student of past inflations. He refers to that phase of apparent central bank induced nirvana of rapid money-printing and stable prices as a "heady wine" for those operating the printing presses*. It reinforces the logic and encourages a continuation of the practice and, by the time the inevitable result is obvious, it is too late and often too politically difficult to cease, much less unwind. Today we have a Chairman of the Fed that has all but promised to continue debasing the currency by interfering with the Treasury and Agency markets ("quantitative easing" or QE) and is in the process of fulfilling a nearly $2 trillion execution of his QE thesis. Two. Trillion. And I doubt he'll be able to stop there.

Today, I believe the Dumb Money is in sovereign debt, specifically US Treasury Bonds.

Similar to when AAA CLO tranches were issued at par paying 20 bps over LIBOR, Ten Year U.S. Treasuries today are priced to yield 3.3% - not exactly a glorious return, even if inflation is subdued. A while back, Jim Grant coined the term “return free risk” to describe Treasuries at these levels. I believe that return free risk extends well beyond simple Treasury Bonds but before we get to that, let’s talk about why these are the home for today’s Dumb Money buyers.

In a world of global trade imbalances, a dollar-based reserve currency, deleveraging and defaults, Treasuries hold a special place. Combined with unusually favorable capital treatment at regulated institutions, the artificially steep yield curve created by the Fed has given banks a taxpayer gift to put a bid on longer bonds. Near term deflationary fears have a foot on the head of the short end. Foreign central banks – flush with IOUs from the Fed (“dollars” exported by our trade imbalance) – have to buy Treasuries or other dollar denominated assets every single day. Capital raised by banks must find a home and when those banks either lack quality borrowers or are uncomfortable lending precious capital out (or both) they buy Treasuries. Scared by the run on commercial paper last year, money market funds have shifted toward Treasuries. Capital market participants have shifted away from risk assets and toward Treasuries. Etc., etc., ad nauseum. Most importantly, the Fed itself has announced that it will purchase hundreds of billions of Treasuries and even more of Agencies (the sellers of which then take the newly printed dollars from the Fed and themselves buy Treasuries).

In summary, there are a slew of buyers for U.S. government issued debt (including, confusingly, the government itself) and in the current environment of fear of “risk” assets, “risk free” assets have caught a hell of a bid. Most of these buyers are buying for reasons that have nothing to do with absolute value. They are mindless, Dumb Money buyers.

While the inflationary 1970s taught investors that fixed income securities could be “certificates of confiscation”, Greenspan and Bernanke’s Great Moderation brought us a slightly different lesson: From Oct. 1, 1982 through Sept. 30, 2009 (which is three generations, in Wall Street measurements), the Merrill Lynch 7-10 Year U.S. Treasury Bond Index returned 10.0% p.a. Over the last 1, 5 and 10 year periods, it earned 8.0%, 5.7% p.a. and 6.8% p.a., respectively. Stocks as measured by the S&P 500 did not manage to differentiate themselves, besting bonds over the 28 year period by just over 1% per annum, but trailing massively over the 1, 5 and 10 year timeframes.

As such, we have generations of Wall Streeters that have grown to appreciate and believe in the risk free return of U.S. Treasury Bonds, adding stickiness to their bid and reinforcing the mantra of “risk free” (another recent mantra, “home prices never decline nationally”). We have trade partners that are addicted to American IOUs ("dollars"), we have banks and insurance companies that are junkies for any regulatorily blessed capital rebuilding efforts and are now riding the yield curve dragon hoping to catch that old high, we have scared Boomers trying to preserve their precious retirement, we have a Fed that is encouraging the buying of Treasuries and that has itself become the global marginal buyer of Treasuries and Agencies. For the time being, the freshly printed money that is funding the Fed's purchases has not multiplied and filtered out to society, at least on a scale that has frightened the average American. We are in Rothbard's "heady wine" phase and so the process continues. As the merry-go-round spins, non-value oriented buying pressure is unnaturally manipulating prices, keeping them artificially high and yields artificially low.

The Dumb Money is in U.S. Treasury Bonds. They provide virtually no return and a ton of risk. They are, indeed, return free risk.

But, by definition, either this buying cycle will end voluntarily or a special dose of inflation will take hold. And when either of those occurs, what happens to rates?

Unlike other asset classes, U.S. Treasury Bonds denominated in dollars hold a special place in the world. They are considered the global Risk Free Return and are the benchmark for virtually every other asset class on Earth. Even to this day, despite the debacle of the past few years, homebuyers make their purchase decisions not on the economic return a house can generate, but on monthly payment affordability. That affordability is directly tied to Treasury yields and thus, homeowners are effectively short rates (or long long-duration bonds). Commercial real estate, when cap rates are in the 6-8% range as they are today, are attractive only if Treasury yields stay low. Today's price to earnings multiples of 17x or 18x (vs. historical averages of 15x) are implicit bets on low rates, all else being equal. Discount rates and WACC calculations for most people actually embed the 10 Year U.S. Treasury Bond into their calculation. Yield curve junkies are betting on stable or flattening curve-structure. How would floating rate borrowers perform in a rising rate environment, many of whom are skirting bankruptcy now on the backs of a sub 1.0% LIBOR?

And what about the U.S. Federal Budget? The average maturity on the Treasury’s debt is 50 months or so, meaning that the bulk of our issued debt has a four and a quarter year maturity or less, reflecting the U.S. Treasury’s attempt to take advantage of the most attractive end of the yield curve. Despite lower average rates, for the fiscal year-to-date through August (a September FYE), interest expense for the Treasury was $367 billion, eating up 20% of receipts.

We have built an entire world around the foundation of low rates. This is the thread that ties. The Singularity. This is the risk that could cause every asset in our portfolio to get face-punched, as diversity vanishes into the ether and the singularity saddles up.

If debasement activities continue much longer, inflationary expectations will take hold and rates will rise. They must to offset the losses created by monetary inflation, otherwise lenders will not lend and the government will not be able to finance itself. So rates will rise. Perhaps by a lot.

Imagine yourself in a world where instead of a 2s/10s yield curve of 0.9%/3.3%, we were in a world of 3%/6% or 6%/10%. What does that world look like? I’ll take a crack:

- Corporate profits suffer as financing costs skyrocket and customers pull back;
- P/Es contract massively and stocks get re-rated downward;
- Spreads widen on credit securities and absolute rates obviously back-up, leading to a severe decline in the value of credit securities;
- Homeowners get obliterated;
- Corporate borrowers get obliterated;
- Commercial real estate gets obliterated;
- This leads to giant holes in bank balance sheets;
- The annual Federal deficit gaps wider by nearly two-thirds of $1 trillion on U.S. Treasury interest alone (5% of GDP). That incremental deficit is the size of the entire deficit we suffered under Bush2 when we already thought the deficit size was unsustainable. Interest expense alone could theoretically consume nearly half of all Federal tax receipts. How do you ever recover from that?

As such, the Federal Reserve faces a Faustian bargain with a choice between letting nature take its course and walking away (allowing the deflation and liquidation phase of the cycle that the market demands) or to monetize aggressively. What do you think the Fed will do in that scenario? Abandon the Treasury and allow her to default? Monetizing is the Occam’s Razor outcome, despite the problematic result of reinforcing the higher rate regime. Bernanke has said again and again that he will not late the “mistakes” of the past recur. He has already and will continue to use freshly printed money to fill the money supply vacuum left by damaged, deleveraging banks. The government may struggle to find enough buyers to take on the new supply of debt the deficit would demand, forcing Bernanke to either let the Treasury deal with its own problems or to monetize the debt.

He will monetize.

As dollar holders rationally begin to question the value of their currency and the sustainability of its purchasing power, commodity prices will rise to reflect a weak dollar and the velocity of money will accelerate as demand for money diminishes**. Interest rates will rip, financial assets will face valuation headwinds, levered entities that need to refinance, sell or deal with floating rate obligations will spiral toward bankruptcy. The singular thread that ties virtually all asset classes is low rates. We need to be prepared for the pain that will occur when higher rates aggressively yank that thread and unravel the world.

Worst of all, this is a self feeding cycle that will persist as long as deficits grow as a percentage of output or the government continues to monetize debt. If nobody steps in to break the cycle (e.g., Volker), at some point utter devastation results.

I will go out on a limb and state that if rates rise too much and the monetization cycle loses control, a number of non-investment risks that can be difficult to mitigate may arise. These include the erosion of the dollar’s reserve currency status, cessation of tax-exempt status for not-for-profits, overtly confiscatory behavior by governments, much higher tax rates, a challenged system of fractional reserve banking, and the potential for civil unrest. Some of these are unavoidable and difficult to mitigate. But we should try.

How Can We Prepare?
As we consider preparing for the more pure investment ramifications of this outcome, the vast majority of preparations should not be around profiting, but instead should be built around preservation of purchasing power and asset protection/defense. From a macro standpoint, printing new money shifts a portion of every existing dollar's purchasing power to the hands of the person holding the newly printed dollar (the government and banks). This means the government will likely steal more and more of society's purchasing power through this particularly unconstitutional tax. Simply treading water from a purchasing power standpoint will take yeoman's work because we'll be fighting this backdoor wealth confiscation headwind. What are some steps we can take?
- Aggressively shift our equity exposure into high quality, unlevered, low capex businesses. Businesses with global or purely foreign operations may be preferred
- Immediately diversify a meaningful portion to non-U.S. domiciled custody, outside the grasp of our government if true tail risk arises (the new country’s stability must be considered as well). This is low cost, super high value insurance for a magnitude 10 Earthquake on the Richter scale. Seems like a no-brainer.
- On the margin, move our asset allocation toward cash and move “cash” toward select commodities and select foreign currencies as our "new cash". Don't be tricked into believing that just because our "new cash" seems to move everyday relative to the dollar means they have a special risk. Prices constantly move relative to the dollar for everything which means the dollar intrinsically holds the same risk. It just so happens that oil is quoted in dollars rather than dollars being quoted in oil. But the fundamental relative risk is the same, particularly if the dollar’s reserve currency status dissipates. Within commodities, focus on fixed or diminishing resources such as precious metals and energy resources, (maybe agricultural land).
- Avoid all Treasuries and, if we must hold some, keep it all in TIPS even beyond implied inflation levels where we might normally sell (recognizing that we are reliant on the CPI calculation, which is dangerous).
- Prepare for a distressed cycle - huge opportunity.
- Short long-duration Treasuries, perhaps through long-dated, well out of the money puts. Do it in a size that moves the needle and is perhaps surprisingly far out of the money. Long-dated is key. The issue is they are expensive today.
- Short a basket of credit spreads that are too tight, perhaps some sovereigns too - the U.S. isn't the only country going down this road.
- Economic unions like the Euro bloc could be blasted apart as different countries desire massively different monetary and fiscal policy actions.
- Raise the cost of our money yet further - we should be increasingly selective with investing "new cash". The implication of this is that perhaps we need to prune our portfolio and exposure even further and build our new cash exposure.

Where Are We Now?
It is impossible to assess exactly where we are now and when this interest rate/inflation risk might manifest itself. We can’t know with certainty that rates will rise – Japan has defied this experience for twenty years (as an aside, Japan faces this risk as well, perhaps moreso). I have been saying for some time that I think Japan is the U.S.’s upside scenario. In any case, Japan has two advantages on us: 1) they began with a lower level of government debt as a percentage of GDP; and 2) they began with a much higher personal savings rate with which to internally finance newly issued debt (they also had a bigger bubble which meant the deflationary headwinds were bigger to begin with).

I think the U.S.’s peculiar situation is that, because we’ve acted much more aggressively faster, we have already begun to scare off the marginal central bank buyer. The Chinese have aggressively curtailed Treasury purchases. For instance, for the four months through July 2009, China only purchased $33.6 billion of Treasuries (and actually was a net seller during the months of June and July). The oil exporting nations have only added $3 billion to their aggregate $189 billion Treasury portfolios through July.

Stepping into their shoes has been the U.S. Federal Reserve. The left pocket (the U.S. Treasury) is issuing bonds and the right pocket (The U.S. Federal Reserve) is buying bonds with newly printed money. In March, the Fed authorized $300 billion of Treasury purchases, $200 billion of agency debt (Fan and Fred) and $1.25 trillion of agency MBS. In the last week of September alone, the Fed reported buying $5 billion of Treasuries, $3 billion of agency debt, and $39 billion of agency MBS. Its 29 week average for these purchases has been $35 billion per week. Since the late March authorization was put in place, the Fed has bought $291 billion of Treasuries (out of $300b authorized), $700 billion in MBS ($1.25T authorized), and $130 billion of agency debt ($200b authorized). This totals $1.1 trillion and the Treasury bond specific buying authorization is basically used up, though the agency capacity is still ample to last another several months. Of course, the Fed can expand its authority at any time.

The point is, we’ve had $1.1 trillion of money brought forth by the Fed and put into the world over the last six months. The run-rate of the Federal deficit is not shrinking – so how can the Fed stop? Who will step into their shoes?

Imagine what the world would look like if that $1.1 trillion did not exist today.

And so we watch.

But one thing we know is this rate of monetization cannot continue indefinitely without being hugely inflationary, which leads to rising rates. We also know that if the Fed were to suddenly stop, marginal buyers that can step into the Fed's shoes do not seem to exist at today's yields. So a cessation would also lead to rising rates. The Fed’s obvious hope is that they can restart the economy (despite worsening employment and default trends) so that someone can replace their buying or so that the government can cut spending / raise tax receipts and bring the deficit back to more manageable levels. They would then theoretically slowly but steadily unwind their QE, somehow without tipping the economy back into crisis mind you, and take the inflationary risk out of the room. I suppose anything is possible, but I am skeptical.

Further, it is quite possible that we actually suffer from continued deflation, which would seem to justify low nominal rates. The issue, of course, is that a) this is bad for risk assets in general in a society as levered as ours; and b) if we suffer continued deflation, the ensuing inflation will be even worse because it will provide Bernanke cover for even more aggressive debasement tactics. He's playing with fire in a dry forest, but he obviously believes nothing major will come of it.

When this heady wine phase passes and the hangover comes, I hope we are prepared. We have no excuse not to be. It is the most obvious risk in the world, but we have been numbed to it by three decades of apparent stability. The Dumb Money is trying as hard as it can to keep the music on and the party going. However, the more drinks we have, the less fun tomorrow morning will be.

It is time to prepare.

* Rothbard's more full quote is from his book The Mystery of Banking and it reads as follows: "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."

** "Demand for money declining" may seem non-intuitive, but what we are really saying is that people who sell things demand more money for the same good or service or, described from the inverse, that consumers will prefer goods and services that can be purchased today to the risk of holding dollars for more expensive goods and services tomorrow.

Has The Gold "Bubble" Peaked?

This guy can't give away a ounce gold Maple Leaf. We think there may be a ways to go yet before Ben's mad experiment has run its course.



[HT: Cam]

Jim Rogers Gives An Extended Interview To The F.T.

"At the moment, I'm terribly pessimistic for the foreseeable decade or two..."
- Jim Rogers

"...and I do expect a currency crisis or semi-crisis in the next year or two...If you were Icelandic, you'd know what a currency crisis was. Some currencies will just totally lose value. This time it may be the U.K., it may be the U.S."
- Jim Rogers

We cannot seem to find a simple way to embed the video, so here's a link to the interview.

Great stuff.

[HT: Max Headroom]

FDIC Contemplates Making Banks Prepay $36 Billion In insurance Premiums

Seriously?

Lajuan Williams-Dickerson, is this true? Can it be?

We are skeptics but even TILB never saw this coming.

According to this story, the FDIC is contemplating asking, nay, forcing its insureds (banks) to prepay three years worth of insurance premiums. When we posted last week about the rumors the FDIC might rob the rich banks to pay the poor banks, we thought "maybe one quarter's worth of fees". But three years?

Wow.

We can't even get our mind around the balls that Sheila Bair must have dangling. She must f'ing hate Tim Geithner. Pure hate. She apparently prefers further imperiling the entire banking system to asking him to provide the FDIC with fresh cash that he (the Treasury) is legally bound to provide.

And why?

Ego is almost certainly the answer.

As long time TILB readers know, the issue the FDIC is facing is multifold:

1. The Deposit Insurance Fund (DIF) is negative. It brings in maybe $200-250 million of "revenue" per week but losses have substantially exceeded that. Using the FDIC's own numbers, we put the DIF at negative $1 billion before Georgian Bank's failure this weekend ripped another $892 million (perhaps $670 million net of revenue) out of the FDIC's already negative coffers. Our estimate is that the FDIC's Deposit Insurance Fund now has worse than negative $1.5 billion in its equity position (unless the FDIC chooses to fraudulently manipulates its reserving, which now is clearly on the table - TILB is basically expecting it at this point);
   
2. Much of the negative position is caused by reserving, so while the FDIC is insolvent and would have been taken over our failed if it were not a socialized insurer to begin with, it actually has plenty of "assets" to deal with its losses for the coming year;
   
3. However, an enormous portion of those "assets" are not cash. In fact, the largest line item on the DIF's balance sheet - by far - is toxic mortgages and other toxic loans that the FDIC could not sell when it took over a given bank. TILB's estimate is this number is currently in the $30-35 billion range. And to date, they have basically refused to sell these "assets" so we can safely opine those loan values are rapidly deteriorating in value as the delinquencies accelerate and servicing is limited or non-existent.
   
   

As we noted last week, charging premium before it's actually due does not fix the solvency problem. Borrowing money does not plug a hole that is fundamentally and "equity" problem. The DIF will still be negative and thus the FDIC will still be functionally insolvent. However, it does temporarily solve the "cash" problem that the FDIC was facing.

With that "solution" comes several potentially ill outcomes, most importantly the FDIC would be sucking $36 billion of much needed capital out of the banking system all at once in order to shore up the same banking system (bend your noodle on that for a bit), ironically making strong banks much weaker while not helping weak banks. This effectively will raise the cost of funds for strong banks (Sheila may as well go kick Helicopter Ben straight in his tiny balls). This capital is needed by banks to protect their own balance sheets or, God Forbid, to make new loans. But alas...

Next, she's kicking the can down the road: Sheila Bair will not be running the FDIC when it comes time to pay the piper as she's already announced that she likely won't stand for reappointment. This is creating a shitstorm for her successor.

Three, think of what this is signalling as to the scope of pending bank failures. The FDIC needs an immediate $36 billion infusion? Using the FDIC's own numbers, we know that the in the third quarter alone (6/30 - 9/30) losses for insured banks have been $14.9 billion so far. Last week we estimated that the FDIC likely had less than $10 billion of that precious asset called "cash" remaining. How long will the $36 billion last? One year? Maybe 18 months of we're generous? And then what? Banks won't owe any new premium for another 18 - 24 months at that point. How many times can the FDIC tap already staggering banks for more money? We suspect we will find out.

The Citizen Guarantors of the FDIC - you and me - will inevitably have to step up to the plate on this. It is a function of when, not if at this point.

We have a lot more to say on this matter, but frankly it's probably best if we just let it play out before letting the steam come out of our ears.

Reflections On Jim Cramer's "They Have No IDEA" Rant

It is almost hard to believe that it's been over two years since Cramer famously went apeshit on CNBC during that August of 2007 warning flash, shortly after the Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Fund, its sister vehicle, and Sowood all blew up, seemingly out of left field.

Banks had not yet begun to fail. Cramer, believe it or not, even alluded to Bear and other investment banks facing the likelihood of failure. This was in the face of Bear's stock trading for over $100/share! Amazingly, despite his well founded concerns, the market would go on to achieve new highs in October.

Cramer, we're sure, calmed down and went back to his typical schlocky pump and dump self. But for one afternoon in that summer of warnings, Cramer had prescience. He showed insight, knowledge, and connections. He was everything that he ought to be. It was fleeting and despite being the laughing stock of Wall Street in the days that followed this rant, nobody is laughing now. Watch the clip and ask yourself, "how did such a moron nail it so hard?"

When you watch this, it almost makes you respect Cramer. If he would stop with his typical showmanship schlock and do more of this, people would respect him.

What follows is from the afternoon that immediately followed Bear Stearns' conference call when it attempted to defend itself publicly and tell everyone, "there's nothing to see here. Move along."

Also, huge unintentional comedy in Cramer just totally disregarding Erin Burnett and steamrolling her.

In Cramer's own words:
"I don't want to create fear; I like Bear Stearns very much, but I think that at this stage this is not a good call, they shouldn't have done it, and they should have just said 'you know what, we're doing well' and don't say another thing. Just don't say it because it does not...it does not inspire confidence...

"Alan Greenspan told everyone to take a teaser rate and then raised the rate seventeen times, and Bernanke is being an academic...he has no idea how bad it is out there! He has NO IDEA! HE HAS NO IDEA!! I have talked to the heads of almost every single one of these firms in the last seventy two hours and he has no idea what it's like out there! NONE! And Bill Poole has no idea what it's like out there! My people have been in this game for twenty five years!! And they are losing their jobs and these firms are going to go out of business and he's nuts, they're nuts! They know nothing!!!"

Erin, "Cramer...I, I..."

"I have not seen it like this since I went five bid for half a million shares of Citigroup and I got hit in 1990. This is a different kind of market and the Fed is asleep. [Erin tries to interrupt] Bill Poole is a shame. He's shameful. [Erin tries to interrupt] He ought to go and read the Accredited Home document...You can't get a darn loan unless you're rich like me."

Then Erin tries to calm Cramer down, telling Cramer that if the Fed enacts an emergency rate cut we'll have Armageddon.

Cramer, "no, we have Armageddon. I wouldn't try to cause that. We have...we have Armageddon. In the fixed income markets we have Armageddon. We haaaavvve Armageddon...

"This is crazy. I am sorry to be upset about it...call someone for heaven sake...I worked at Fixed Income at Goldman Sachs. This is not the time to be complacent. I mean darn, sometimes I wish I didn't know anybody so I could just sit here and say, 'you know what, just go buy some Washington Mutual and take that yield.' Unfortunately I know too many people and I'm too darn old...I've been around too long... And Bill Poole? Bill Poole. Bill Poole listen to me: there was a president by the name of Hoover. And no one thinks much of him now: The Great Engineer..."

Anyway, enjoy the trip down Memory Lane. The rant is hard to view through the lens of August 2007, but you have to try.