It's a BAC Attack!

Color from a dealer friend of mine:

This BAC secondary started as a reverse inquiry for a pfd exchange from four hedge funds. These funds owned the BAC 8 and 8.125s and had bought them in the 30s, by doing the exchange now with stock price higher they didnt have to wait and do the exchange with BAC later even at 90. BAC takes their exchange at whatever terms, call it 80 on pfd vs 300m in stock at $10 (those numbers are generalities, not specifics). This is new stock in conversion and dilutive like the C exchange. Now BAC takes their $10 bid for "multiple hundreds of millions of shares" and hits the street to raise money along side at those prices from their ATM offering which everyone assumes would be cleaned up as the street chatter goes. The book builds and they do clean up the ATM but they also are issuing new dilutive stock along side.

BAC closed 11.25, after market trading 10.62

We are now on Twitter

Click on InvestmentLB's follower button to get his thoughts in 140 characters or less, in real time. Tweet tweet.

Believe in Liberty, think for yourself, but listen to me.

The Chrysler Traveshammockery

It's been sold to America that Chrysler is of systemic importance. Countless articles have been written about the 40,000 direct job losses or the nearly 300,000 that would be lost systemwide due to job cuts that would occur as dealers, suppliers and suppliers' suppliers lay people off to adjust for lost business. These "facts" have been used as a justification for the Chrysler bailout; a sort of justification that has been used to mislead the public in virtually every bailout in government history (I make some minor exceptions during September of 2008). This is what is seen - the first order effect.

Like lambs to the slaughter, too numbed by all the horrifying governmental actions of the last year and the reasonable desire to believe in "hope" and "change", we have marched unquestioningly alongside our "leadership". However, common sense tells us that these job losses are an absolute sham. I honestly cannot believe that more folks haven't challenged this idiocy, though perhaps if the treatment of Chrysler's secured lenders is a guide, we are learning that challenging this Administration on the basis of legal rights or common sense put you on a fast train to publicity hell.

At The Investment Linebacker (TILB), we are willing to take the engineer's seat on that train: What is unseen are the jobs created and relative financial strength gained by Chrysler's competitors (esp. GM and Ford) if Chrysler had been allowed to perish naturally - the second order effect.

Chrysler, as an auto company, "creates" virtually no new demand. There are very few buyers that say to themselves, "gosh, I really don't need a new car, but I am so inspired by that Chrysler/Jeep/Dodge that I am going to go buy an extra car." As such, all Chrysler does is fulfill an existing demand for new cars. The evaporation of Chrysler would not at all eliminate that already existing demand nor would that demand lie fallow as some poor consumer demands a product that just cannot seem to be supplied. In fact, some other car company would certainly step into the breach and gladly fill that demand. This means that GM and Ford, two of Chrysler's most direct competitors would have been primary beneficiaries of a Chrysler liquidation. For those that don't know, GM and Chrysler themselves are struggling to remain solvent and would be strengthened by this market share opportunity - as would virtually all of Chrysler's competitors, making the entire industry more sound.

Jobs "lost" to Chrysler would have been jobs "created" (or retained that would otherwise go away) by other, stronger auto OEMs. GM, Ford and others would happily have purchased parts to make those incremental autos from suppliers, thus allowing those suppliers to "create" jobs that offset Chrysler suppliers' "losses". Those suppliers would have purchased inputs, materials, etc., etc. down the OEM foodchain. Back up the chain, GM, Ford and others would happily have employed people to assemble cars, trucks and SUVs for shipment to dealers. GM, Ford and other dealers would happily have sold those incremental cars on to end buyers at competitive prices, providing jobs at dealerships. The "loss" of jobs is quite clearly a sham as systemwide, there would not be jobs lost because there would not be a loss of aggregate demand or supply.

In fact, net, net jobs would have been retained and the employers providing those jobs would have been in a healthier position than they are today.

We can state with some certainty, the Chrysler bailout not only is a travesty to the perception of the soundness of contract law and the separation of private enterprise from unneeded public interference, it also weakens the overall automaker industry at precisely the moment they needed a boost. Conspiracy theorists might believe this is intentional as it increases the likelihood that the Administration (and the UAW) will control other domestic OEMs as well.

Since TILB is already engineering this train ride, we have nothing to lose: we will go ahead and note that in the long run, the OEMs that will suffer the most from this intervention are our higher cost-structure domestic OEMs - GM and Ford (see conspiracy theory above). At a moment when GM and Ford desperately need the breathing room afforded by absorbing some of Chrysler's 10% domestic market share, those already weak legends will in fact now be forced to compete with a government, UAW, and foreign (Fiat) owned competitor. A competitor with a questionable profit motive and a bankruptcy-assisted newly reduced cost structure. If AIG, FNM and FRE are any guide, Chrysler's prices will likely be so competitive that it will have the exact opposite impact on GM and Ford that would have occurred if nature had its way with Chrysler. Rather than gaining strength and breathing room, they will be increasingly impaired and short of financial oxygen. I suspect those two American Icons will find themselves stumbling hope-filled into the warm, loving, waiting, open embrace of the government.

Ironically (or perhaps not), this just finished playing out in the realm of life insurance as the government's ownership of AIG (and lack of profit motive in its insurance pricing) prevented a handful of already staggered competitors from raising prices and taking abandoned share in an effort to heal themselves. As such, they've just been welcomed into We The People's loving TARP program.

This whole affair absolutely and honestly saddens me.

The government's intervention makes a mockery of common sense and America.

It is a traveshammockery, but double the rage and minus the humor.

Our Misguided Drug Wars Enable Criminals to Expand Their Horizons

Really, the last sentence of the below AP article from the Washington Post is the only reason I care, "I think that what makes semi-submersibles a larger national security threat is: What else can they carry?"

This highlights yet another unintended consequence of our misguided drug wars: we're making criminals smarter and more sophisticated and that bad outcome has the potential to haunt us in ways that have nothing to do with narcotics. In a certain sense, by bloating profit margins through the criminalization of drugs (higher risk demands higher reward), we are actually paying these crime families to become increasingly sophisticated and dangerous. Their ongoing business viability means they must constantly adapt to changes in the way we combat drug-related crimes. This adaptation, paid for with fat profit margins rewarded in a concentrated fashion to the few, is a natural education seminar for all sorts of other illegal operations (be them smuggling or otherwise). Over time they've adapted by improving their means of communicating, their organizational structure, their ability to hide money, their military readiness (in a sense, they are a disbursed private army), their delivery methodology, their market testing and adaptation capabilities, and their technological sophistication, among others.

In exchange for all this, I'm not sure we've accomplished much of anything other than to make ourselves feel like we're doing something.

My younger brother believes, and I increasingly agree with him, that pot will be federally legalized under the Obama administration. His view is go long the US tobacco players to benefit (e.g., Altria) as they are the natural beneficiaries. That said, ironically, our criminalization of drugs (especially pot) has made it so that a large, broadly distributed number of people developed skills for personal growing and "small business" pot growing and logistics which may lead to large a number of unexpected competitors. Would be a fascinating business case study to watch play out in real time.

Anyway, here's the article.

US law fights submarine-like boats hauling cocaine
By FRANK BAJAK
The Associated Press
Sunday, April 5, 2009; 1:05 PM

BOGOTA -- It's a game played out regularly on the high seas off Colombia's Pacific coast: A U.S. Navy helicopter spots a vessel the size of a humpback whale gliding just beneath the water's surface.

A Coast Guard ship dispatches an armed team to board the small, submarine-like craft in search of cocaine. Crew members wave and jump into the sea to be rescued, but not before they open flood valves and send the fiberglass hulk and its cargo into the deep.

Colombia has yet to make a single arrest in such scuttlings because the evidence sinks with the so-called semi-submersible.

A new U.S. law and proposed legislation in Colombia aim to thwart what has become South American traffickers' newest preferred means of getting multi-ton loads to Mexico and Central America.

Twelve people have been arrested under the Drug Trafficking Vessel Interdiction Act of 2008 since it went into effect in October. It outlaws such unregistered craft plying international waters "with the intent to evade detection." Crew members are subject to up to 15 years in prison.

"It's very likely a game-changer," said Jay Bergman, the U.S. Drug Enforcement Administration's regional director, based in Colombia. "You don't get a get-out-of-jail free card anymore."

The law faces legal challenges, though. The defendants have filed pretrial motions saying it violates due process and is an unconstitutional application of the so-called High Seas clause, which allows U.S. prosecution of felonies at sea.

The vessels, hand-crafted in coastal jungle camps from fiberglass and wood, have become the conveyance of choice for large loads, humping nearly a third of U.S.-bound cocaine northward through the Pacific, said Coast Guard Rear Adm. Joseph Nimmich, commander of the Joint Interagency Task Force-South based in Key West, Fla.

That's up from just 14 percent in 2007, according to the task force, which oversees interdiction south of the United States.

Colombian Navy chief Adm. Guillermo Barrera told a counterterrorism conference in Bogota last week that 23 semi-submersibles capable of carrying between 4 and 10 metric tons each have been seized in the past three years.

Though semi-submersibles aren't new to cocaine transport, a bigger, sleeker, more sophisticated variety that average about 60 feet (18 meters) in length began emerging three years ago. Earlier versions, christened "floating coffins," couldn't compete with fishing trawlers and speed boats known as "go-fasts" for maritime transport of drugs.

But drug agents started policing trawlers better, leading traffickers to new methods.

With just over a foot of above-water clearance and V-shaped prows designed to leave minimal wakes, semi-submersibles are nearly impossible for surface craft to detect visually or by radar outside a range of about 10,000 feet (3,000 meters.)

That accounts for their relatively high success rate.

They are propelled by 250 to 350 horsepower diesel engines and take about a week averaging 7 knots (8 mph) to reach Mexico's shores, Colombian and U.S. investigators said.

Fuel tanks carry about 3,000 gallons of diesel, so no refueling is needed on the 2,000-mile journey from Colombia north.

With cocaine in Mexico fetching $6,500 per kilo _ about triple the Colombian price, according to the U.S. Drug Enforcement Administration _ an average 7-metric-ton load yields $30 million.

Crews have no problem scuttling the vessels after off-loading their cargo, investigators say. The roughly $1 million spent on each craft is simply written off as the cost of doing business.

Though authorities caught 11 semi-subs last year in international waters off the Pacific _ with 7 tons of cocaine seized in one off Mexico in September _ they estimate from intelligence and interdiction that another 60 delivered their cargo, Nimmich said.

About the same amount will get through this year, predicts Adm. James Stavridis, the U.S. Southern Command chief. He told a mid-March U.S. Senate hearing they would have a potential cargo capacity of over 330 metric tons.

So far this year, crews sunk five semi-subs off Colombia's coast after being pursued by drug enforcers.

Two of the crews were arrested, plus a third one plucked out of the Pacific on Dec. 31 about 100 miles off Colombia. All are being tried in a Tampa, Fla., federal court, said Joseph Ruddy, the assistant U.S. attorney prosecuting them.

Semi-subs confiscated on land in Colombia since 2007 have given authorities a good glimpse into the state of the art.

In November, authorities arrested a man they consider the most ingenious semi-sub builder. Tammer Portocarrero, a rotund 45-year-old, used a shrimp boat fleet as cover, said Capt. Luis German Borrero, the navy chief in the Pacific port of Buenaventura at the time.

They seized two of his subs at a jungle shipyard in a remote estuary south of Buenaventura, Borrero said.

Portocarrero, whose extradition the United States has requested, allegedly began building vessels as early as mid-2007, as well as recruiting crews.

The made-to-order vessels have become increasingly sophisticated. Engines and exhaust systems are typically shielded to make their heat signatures nearly invisible to infrared sensors used by U.S. and allied aircraft trying to find them.

The cooling system of a semi-sub seized off Costa Rica in September piped engine exhaust through the hull and discharged it at ambient temperature, Nimmich said.

Unfortunately for crews, such design sophistication doesn't extend to their quarters.

"The conditions are terrible," Borrero said. "They don't have bathrooms. The beds are two mattresses draped over the fuel tanks, and the pilot can barely see through very small windows" in mini-cabin.

"The noise and heat must be something infernal," he added.

In a report provided to The Associated Press, Colombia's domestic intelligence agency said a four-person crew was sharing a payoff of about $50,000 per trip before the new U.S. law. Crews now demand about 25 percent more because of the higher risk of getting caught, U.S. law enforcement officials say.

GPS location devices and satellite phones are standard onboard equipment, and the technology is expected to advance.

Law enforcement officials say they already have unconfirmed reports of robotic semi-subs in action.

And with such vessels, Nimmich said, it's not drug smuggling that worries him, but a larger potential for peril:

"I think that what makes semi-submersibles a larger national security threat is: What else can they carry?"

How Much Delevering is Coming?

The below is from an email back and forth that a bunch of my family members were on sent March 2nd, 2009. After having read this article from Thursday March 26th's WSJ, I'm more confident than before that my numbers below are reasonable.

I organized the emails such that the earlier emails are at the top followed by a response and then my response to the response. Don't worry, my conclusion is everything's better. I mean, the stock market's up 25%, doesn't that constitute a new bull market? Happy days are here again - yippee!

I most recently discussed this topic last December here on The Investment Linebacker.

Lightly edited, the emails begin below:

Going back to [my cousin's] first email about thinking about all the system participants in aggregate, I've read slightly different numbers. Jeremy Grantham at GMO basically said that privately held assets in the US (stocks, resi real estate and comm. real estate) totaled to about $50 billion before the "crisis" began. I'll exclude government assets and liabilities for the moment. That Private Asset Base (as he phrased it) was supported by about $25 billion of private borrowings. If you assume the private asset base is now worth about $30 trillion (down 40%, which is probably right, but you can pick a different number if you want), assuming some further deterioration in housing and CRE prices, then the $30 trillion is now supported by $25 trillion of borrowings. This is an incredibly precarious position If we believe that the original 50% debt to equity ratio is the right one, then debt needs to decline by about $10 billion or three fourths of a year of GDP. That's the definition of pain. And that pain is going to be shouldered by the private market, barring further socialization of our private obligations. Even if socialized, it's still born by private individuals, but the burden is shared by people that did not actually borrow the money rather than merely by those that did borrow the money. Adding a new, substantial tax burden will further reduce the value of the assets - since the cash flow off them will be less - merely compounding the problem.

The basic thesis behind taxes is that at virtually every mix of tax rates above a very low level, federal taxes end up fluctuating around 18.5% of GDP. An increase in taxes will cause a quick pop in tax receipts before the resulting drag on productivity brings it back down toward 18.5%. The same thing happens with tax cuts: in years one or two, tax receipts relative to GDP fall before the increased productivity in the economy accelerates capital through the system bringing tax receipts back up toward the 18.5% long term average.

Given that, from the government's perspective of maximizing receipts, tax policy needs to be geared not toward progressive, regressive or flat, but toward whatever solution drives sustainable, long-term growth in GDP since tax receipts will basically be 18.5% of that. We know for a fact that higher taxes reduce productivity, reduce positive private incentives, and manipulate behaviors in ugly ways. Lower taxes do the opposite. For some reason, even though cutting tax rates increases tax receipts over time, certain people get pissed about this fact even though the government's take is bigger because of it.

-TTB

My cousin's reply (he's a smart, great guy for anyone wondering):

I agree with the $50T and $25T numbers, they are within my $90T and $45T, the difference being assets and liabilities carried by other than private entities [referencing a prior email]. I think your 40% number may be a little brutal in the aggregate since it is off a base that includes cash and some safer investments.

Almost as brutal as the asset shrinkage though is the liability shrinkage. Of the $25T give or take $10-12T was in some kind of a securitization. If 25% of this naturally rolls over every year and there is no replacement than $2T or so is going to go away. There is no good way for this to happen.

I generally agree with your basic tax math but would look for other ways to help close the over all quality of life gap. That and other bad fiscal decisions and foreign policy mishaps by Republicans are what put me as the sole defender on this email chain of the esteemed [Uncle of TTB]. [This comment was referencing his bias toward left-leaning politics vs. my different tilt].

TTB's Cousin

My reply back that basically you can pick a less painful hit to the Private Asset Base, but it doesn't change the overall thesis that deleveraging is going to be enormous and painful because you cannot rationally pick a number high enough to avoid the problem. As I mentioned at the beginning of this post, I'm more and more convinced the 40% is reasonable.

I basically agree with my cousin that it would be nice to close the quality of life gap, but more important than the gap is the absolute level of quality of life. While the gap may be wider today than it was forty years ago (I have no idea), the absolute quality of life for everyone is much much higher. In any case, here's my reply:

Cash is a minor percentage of private assets in the US. Anyway, pick your number. -30%? I mean, the S&P’s down 55% from peak [today closer to -45%], so we have some cushion on the other asset side to play with. If it’s a 30% decline, then private assets are $35 Trillion and debt needs to decline by $7-8 Trillion which is a bit over half a year’s GDP. Point is, you can’t just wipe out 6-12 months of total economic activity in any way other than huge pain and we have barely started. All of this assumes that we do not over correct or land at a level of yet lower leverage.

The ideal is to absorb that pain over a big number of years, but it’s possible we eat it over call it a four year period which means GDP falls 10% a year for a couple of years before we’ve delevered merely to the leverage ratio we had at the beginning of this “crisis”. If we go to a more conservative position, which wouldn’t be shocking, the pain is worse.

During The Great Depression, nominal GDP declined 46% peak to trough. People don’t remember that fact, but just think about what that means for a minute. Lord willing that won’t happen again. But believe it or not, we have a lot more leverage relative to our asset base this time around, so I won’t say that it can’t happen, but I am hopeful it won't happen.

-TTB

Sorry for the sour posts, but I do not see any other way. The government can print money until the cows come home with a hope of supporting asset values, but the resulting inflation will likely end us in a worse place than if we just let the correction happen naturally.

-TTB

The TTB PA Hit a New High Today

Go team.

Tax the Hell out of these Bailout Thieves!

Before I get into why I support this tax, let me just state that Congress's behavior makes me sick. The fact that the government is trying to target specific kinds of employees for a tax is disgusting and, it seems to me, unconstitutional.

However, I'm still hopeful the most punitive version of this bill becomes law. Trap as many companies as possible and jack the tax as high as possible. I feel awful for writing that as the vast, vast majority of the people that received eligible bonuses don't deserve this punishment.

Nobody is more anti-tax than me, but the beauty of this is that it will have precisely the wrong outcome. It will serve to massively undermine the government's ability to convince companies to volunteer to receive bailout financing until things become drastic. This will cause a talent exodus from bailed out banks the likes of which the Pharoahs could hardly conceive. TARP money and other forms of bailout financing are increasingly going to serve as a scarlet letter and companies will avoid these capital injections until the last possible moment. This will improve the likelihood that capitalism's natural course will play out as it limits government's effectiveness.

Frankly, who on Earth will want to participate in the TALF or in the Public Private Investment Partnership? You just might find out after the fact that the government isn't so fond of your profiting with taxpayer support.

By the way, isn't the intellectually honest thing to do to make sure that these taxes also apply to all the income of government employees that make more than $250,000?

As a final aside, the dumbest aspect of this whole thing is that it only applies to bonus compensation. What? Why? What a crazy stupid incentive system that set-up creates.

The depth of the stupidity of our elected officials borders on the unfathomable.

Anyway, cheers to unintended consequences canceling out the intended consequences of prior governmental interference and thusly voiding their even worse unintended consequences.

Prediction: President Obama vetos this idiocy and he and most Senate Republicans end up on the same side of an issue for once. The problem for President Obama is it will only take a small minority of those Senate Republicans to override the veto and Chuck Grassley, who really bats more lefty than righty anyway, is clearly in favor of this. Should make for great theater.

-TTB

PS: Short NYC-metro area housing. No brainer. This is just going to add to the pummeling that market is already receiving.

The Bank "Not Too Much" Stress Test Plan

The following is an email I thumbed on my Blackberry while on an airplane to Asia (very light editing to clean up some Blackberry typos):

Reading the NY Times cover story on Citi and govenment mandated bank stress testing from today (Monday the 22nd) and in it the author talks about how banks' balance sheets will be stress tested by the Fed and Treasury under Geithner's plan. The testing will include scenarios that assess how banks would perform under a variety of "Depression-like [literally with a capital D] conditions, with unemployment surging to 10 or 12 percent [from 7.6 at last report], for example, or home prices dropping 20 percent further [officials said]".

At first blush, this seems like a good idea to me. We should want to know the answers to those implied questions.

However, the article goes on to say, "Fed officials emphasized that these hypothetical events were 'highly unlikely' to occur." The article actually goes on to call these "nightmarish economic conditions." Does anyone [reading this blog] think those conditions aren't reasonably likely?

Let me state unequivocally that 10%+ unemployment is not "highly unlikely". While it certainly may not occur, at best it is a "reasonably likely" scenario at this point. Also, home prices down another 20% also seems reasonably likely given that's about what it takes to return back to long run affordability averages (see Clay's email from Sunday). I'm not saying better than 50% odds but probably better than 25%, so certainly not "highly unlikely." Do policy makers really believe this and if so...

Nothing is certain, but these are anything but "highly unlikely" scenarios. They may not be "highly likely" either but frankly they should be in people's middle to slightly-worse-than-hoped-for case at this point.

Further, the article states the stresses will be an "or" scenario not an "and" scenario. For example, 10% unemployment OR housing prices declining a further 20%. However, if one of these happens I'd say it's "highly likely" both will happen. These stresses need to be applied under "and" scenarios. Obviously the outcome will be much worse under "and" scenarios, but that's the only sensible way to apply the stresses. They almost certainly will happen together so we need to assess their cumulative effects.

My guess is the answer results in bad outcomes. I think it was BB&T that said a month or so ago (when measured unemployment was closer to 7.0%) that their modeling got ugly at unemployment of 8.0-8.5%. The next unemployment report will have us on the doorstep of 8% (if not over the threshold). Further, the shadow unemployment of reduced pay/shortened work weeks won't be reflected in the stats but is also impactful.

Food for thought.

The culprit in all this, I believe, is in the government's past "mandate" of high leverage. By having the Fed's support of low-reserve fractional reserve banking, it basically ensures that asset spreads (eg, lending margins) on bank owned assets would decline and leverage would increase to compensate. In order to maintain a reasonable ROE, you absolutely had to partake in the leverage orgy. This basically means that the government mandated both high leverage and low spread (risk both ways - high leverage and higher prices for assets funded with the leverage) that caused this crisis. While everyone from borrowers to lenders is to blame, the government (esp the Fed) deserve a double or triple dollop.

As an aside, everything I stated above is compounded by a foolhardy belief or semi-belief in the efficient market hypothesis - how else could someone possibly justify or dispassionately observe (as the Fed did) the massive leverage coursing through and ultimately building up in the system? You have to believe asset prices are fairly valued at all times to operate at 15x-20x levered (or more for investment banks). If a 5-6% general overestimation of asset values can lead to complete wipeout, how can you conceivably not think this is possible (much less likely) without a core belief in market value efficiency?

Don't be fooled by statements that this is a breakdown in free market behavior. Free markets are by definition imperfect and they generally structure and price to account for imperfection. Banks and insurers do not and did not operate in a free market (frankly nobody does given the government controls the printing press and thus manipulates demand signals by changing the pace and volume of printing as well as the accessibility of freshly minted dollars all the time). Banks and insurers are the most highly regulated and government manipulated private market in the U.S. outside of utilities. Free markets would NEVER allow the broad market of banks to lever like this because they'd be at constant risk of bankruptcy (much less lever more and more to fund increasingly risky assets). Rather than interbank lending supported by the Fed, banks would force settlement of assets received backed by other banks (eg, customer checks) which would immediately limit the pyramiding of leverage on bank equity.

Anyway, regardless of who deserves the aim of our damningly directed finger, we should at least demand that the "stress" test actually hypothesize a stressful AND unlikely set of scenarios. I only want to have my money on loan to an institution prepared to weather the highly unlikely not merely the somewhat unlikely.

If anyone identifies said institution, let me know. Your feedback is always welcome.

-TTB

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.

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.

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!

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.

-[TTB]

"The Perfect Storm" and other lame excuses

During the past few months, executives from virtually every kind of company - from autos, to tech equipment, to financials - have invoked the "we've been hit by a perfect storm" excuse as to why they are underperforming recently provided expectations. The beauty of the perfect storm excuse is that it deflects accountability.

No doubt, there is some truth to the fact that a confluence of factors have come together to negatively impact their business. The questions are "why is it a surprise" and "is this really as bad as it gets".

The confluence of factors often provided: deleveraging, consumer recession/demand collapse, lameduck presidency, housing collapse, stock market collapse, credit market collapse sure sounds like a perfect storm!

Other than the lameduck presidency, upon which I place virtually nil weighting for our present circumstance, these factors are all correlated. However, what our "blameless" business executives don't realize is that the perfect storm is not today, it was the boom times that were the perfect storm. Instead of calling it the Perfect Storm, I'm going to refer to it as the Suckers' Rally of 2004-2007.

Let's take a look at the Suckers' Rally, who is to blame, and why it was so damnable.

Congress is owed a huge dollop of blame, as is the Fed, borrowers, and all the usual sensationalist suspects. Everyone caused it. But especially the Fed. If we can agree that we went through a credit orgy, we have to point fingers most directly at the fathers of currency and credit: The Federal Reserve of the United States.

Let's step back and think about what it means to take on debt?

Debt is basically the process of taking from your future to spend or invest today. Conversely, saving is the process of taking from today to set aside for spending or investing in the future. That's what most people do not think about: debt is taking from your future. It ought to be a fairly attractive purchase or investment to entice you to take from your own future.

Our government encourages taking on debt in many, many more ways than savings, despite some nice things like 401-Ks and IRAs. One of its primary methods for encouraging borrowing is the tax deductibility of mortgage interest for individuals and the tax deductibility of all forms of interest for corporations (I first talked about this in a frighteningly prescient post in August of 2006). The Fed, through its Fed Funds and Discount rates also has provided a remarkably subsidized borrowing rate for much of the past two decades and has strongly encouraged banks to increase their leverage ratios until very recently.

In fact, while the Fed has increased the Fed Funds rate to something close to reasonable a couple of times, I cannot think of a time since the late 80s when the Fed has offered anything close to a punitive rate. You'd think, in order to offset some of the excesses that will obviously be created during times of cheap and easy money, it would need to occasionally offer a punitive rate. The Fed, however, seems quite one-sided in its price of money equation. This is obviously stupid as it basically is the equivalent of driving by only utilizing a balance of speeding and occasional short bursts of shifting to neutral before putting your foot back on the gas, but never using the brakes. Seems like just a matter of time before something gets out of hand. Most people would recognize that quickly.

Not our Fed, it seems.

These factors combined to create a huge increase in credit in the economy. As a percentage of GDP, credit nationally is about 360% and growing (page 13 in the presentation or this link), which is off the charts compared to history (at the peak of the Great Depression, largely because GDP declined by 46%, it reached 250% or so). Historically, 200% was high. Mind you, GDP is about $14 trillion per year (but shrinking). Therefore, every 100% decrease in credit as a percentage of GDP means contracting credit by $14 trillion dollars (or an entire year's economic output). Scary, but I digress.

Frankly, my personal belief is that the availability of inappropriately easy, unnaturally cheap credit is to blame for virtually every problem that ails us right now. The implication of this huge boom in readily available, subsidized credit was to create a spending orgy. We just took and took from our future to spend more and more in the here and now.

Businesses took these spending signals in exactly the way we should expect them to: they expanded capacity to meet the new "demand" not realizing that it was not sustainable demand. Rather, it was the future’s demand being brought forward to today – we can only take from the future for so long, so that type of “demand” is inherently limited in its ultimate scope and sustainability. That means that the capacity expansion of American business over the last decade was in response to a false signal: an unsustainable spending boom.

We saw this expansion in obvious areas like housing, but also in things like a huge boom in retail shopping outlets, an explosion in eating out (which is a more expensive way to deliver calories than cooking in), a huge boom in new car purchases, a huge boom in luxury goods "demand", a huge boom in leisure travel, etc., etc. Each of these booms leads down the supply chain to explosions of "demand" for inputs like steel (and thusly iron ore and coal), power, oil, timber, labor, etc., etc. Businesses sized up to serve this “demand”.

Just imagine what this means: Virtually everything in our society expanded to meet a demand that was inherently temporary. What a giant, giant period of malinvestment caused directly by the policies of our Federal Reserve and governmental leaders!! The frightening corollary to this is that because recent demand was taken from the future, the future's demand will now be "falsely" lower than it otherwise would have been, perhaps mistakenly sending the opposite signal. The implications for fallow capacity are scary.

In any case, I think there are a lot of fingers that ought to be pointed, but none more directly than at the Fed. Sadly, they’ve caused the problem yet we’ve also charged them with fixing the problem.

The "solution" to our unnatural explosion in credit that's being proposed? More credit! Our government has decided to replace all of the vanishing private sector borrowings (i.e., deleveraging) with public sector borrowings (i.e., levering up!).

I suppose the best analogy is taking a heroin addict to a meth clinic, but without any real supervision or understanding of the impact on the otherside.

A horrorshow of inflation seems like a virtually certainty to me, but only after a period of deleveraging caused deflation. Helicopter Ben has all but guaranteed a classic Helicopter Drop of cash. He is Charlie Munger's Man With a Hammer (to the man with a hammer, every problem looks like a nail). Deflation is Bernanke's nail. He has trained his entire life for this moment. I assure you he will not stop swinging his hammer until the nail's head has disappeared into the wood and the wood has a permanent hammer imprint pounded firmly into it.

Going back to the beginning of this post: why is it a surprise? and is this as bad as it gets?

The answer to the former is that while it's not a surprise to me, I think it is perfectly reasonable that most businesspeople were hoodwinked into believing false demand signals. The incentives for believing it are too powerful and the ability to recognize and dodge it is too rare.

As to the latter, I'm afraid not. We are not even remotely dealing with the root cause of this problem: too much leverage. Instead, we are adding new borrowed money to replace the bad borrowings of the past. The issue with these new borrowings (financed by We The People) is that the only credible way to pay them off will be the printing press. The problems that come with a massive inflation will be new and fun...

Boycott Over

Ever since Congress and our President approved the TARP legislation, I have been boycotting posting to my blog. It is dispicable and has turned into the unrestrained catch-all, bailout bill. So much bad policy and decision making has been enacted by our leaders since then that I cannot help but talk about it.

I hereby begin posting my rants again.

Congress grows a pair - staring into the abyss

Well, today was a day you only get to experience a few times in your life. Crazy. And you know what, I'm kind of proud of Congress. Seriously. If you've read my prior posts, you know that I've been against this "bailout" (read: subsidy) since the beginning. Before I get into my thoughts on the bailout, I think it is worth explicitly stating that the S&P 500 was down about 9% today on the Wachovia news and the spate of European financial failures (B&B, Fortis, and Hypo), with final capitulation after The House showed some balls and voted down this embarrassment.

That said, I never actually expected them to have the rocks to vote nay. I promise you, it was not easy to say "no". In this case, saying no legitimately means putting the global financial system at risk but doing so because it is what is best for the very long term health of the system.

Having seen a few movies with scenes of a heroin detox process depicted, this seems fairly analogous. As the druggie gets past the state where heroin is fun and into the stage where it is depressing and painful, he knows that his best option is to seek help. But seeking help sucks. He'll often almost get help several times just to succumb to his addiction in ever more painful ways. Going through a detox appears akin to a near death experience. And while it is clearly the better outcome in the long run, it always appears to be a horrifically painful fate in the nearer term. I think that is why so often it requires an external intervention. Someone generally forces the druggie into rehab. This normally happens after they hit a series of new personal lows and start stealing from friends and family to feed the habit.

Well, it's pretty obvious that the debt induced orgy we've been on for the past three decades is our drugs and alcohol. A little debt is like having a few beers: it's great as long as you have some self-control and don't feel like you can't live without a few beers or the number of beers you need to have in order to enjoy yourself is constantly growing. Before you know it, alcoholism manifests itself as a sort of gateway drug and you're a heroin addict. Well, that's how we got from real money buyers allowing their bond portfolios to be repo'd in order to generate a few extra bips to AIG writing CDS on CDO-squareds.

This is one of those cases where I think Congress was better lucky than smart. They voted this down for all the wrong reasons, but at least the conclusion (not that it is truly concluded) was the right one. They voted this down because in our bicameral system, our Founding Fathers decided the House would have to run for re-election every two years. If the bailout bill was up for vote this time last year, I suspect it passes. But with a national election only five weeks away and their constituents against the bailout by a ratio of something like 9:1, passing the bailout was career suicide and these guys have their own addiction that they can't seem to kick: power that comes with office. The reality is, I don't think these guys have any clue that they may have just set off a daisy chain of deleveraging that was already underway, but now has the potential to accelerate in an ugly fashion.

I suspect that the run on the money markets re-accelerates (mind you, it never stopped, which nobody is really talking about). Money market funds that are not purely invested in US Treasuries often serve as a short-term funding source to businesses via things like commercial paper (CP). CP is used by Main Street businesses to manage working capital sort of like a line of credit. The CP cycle allows them to keep very little cash on hand but do things like meet payroll, which is a somewhat lumpy cash event for most businesses. Obviously, as a few businesses miss payroll, folks aren't going to be happy. But frankly, for Main Street businesses, it is a temporary problem. CP is not their life-blood; it's merely a convenience.

For Wall Street businesses and many large'ish banks, CP is part of their lifeblood. It is a funding source that they explicitly rely on. As such, when Lehman went bust, as one of the larger issuers of CP, it actually caused a few money market funds - including the oldest and largest Reserve Fund, to break the buck. This led to lots of money market fund investors to actually look at what their funds were investing in and they freaked out! Other than Treasuries, these funds are often a veritable murderers row of borrowers: Lehman, Goldman, Morgan Stanley, Fannie, Freddie, B of A, Citi, BNP Paribas, ING, ANZ, UBS, off balance sheet vehicles like SIVs, etc., etc., ad nauseum.

When money market investors actually looked at that line-up of underlying investments and realized they'd indirectly lent their cash to the global financial system, everyone ran for the door at once. But the problem is money market funds are really the only natural buyers of CP assets and as all the non-Treasury money market funds shrank at the same time, there were no natural buyers for CP assets and therefore money market funds could not meet their redemptions. Thus money market funds had to freeze redeeming investors which caused an even greater freak-out than breaking the buck. This freezing of some money market funds led to investors in other money market funds to redeem before their fund was frozen as well, effectively leading to runs on all kinds of non-Treasury money market funds.

Most money market investors think of these funds as cash alternatives (my Schwab account, for instance, actually labels my investment in money market funds as "Cash"). Not being able to get your "cash" pisses people off and the redemptions start flying.

So, this self-feeding redemption frenzy actually served as a non-traditional run-on-the-bank. As banks that rely on CP have their old CP loans mature (every month or so), they cannot issue new CP to pay-off the maturing loans. It is just like having an abnormal number of depositors leave at the same time: it causes the bank's liability structure to explode. I imagine that the Federal Home Loan Bank system is overflowing with borrowing requests right now in order to offset the CP evaporation, thus putting the entire system on pins and needles. Further, as CP availability has declined, banks have looked to each other for daily borrowing and this increase in demand coupled with the seemingly endless line of failures has caused banks to become distrustful of each other, leading LIBOR (see the accompanying graph for overnight LIBOR - yowza), swaps, the TED spread, etc. to all blow out to record wides. This means that money has simultaneously become less available and more expensive, a painful combo for an already fragile banking system. As very short term borrowing costs rose, so did longer-term borrowing costs. Everything was widening out at the same time and since lenders didn't have a good sense as to where it would end, the desire to make loans was plummeting. Anyone that actually needed cash was looked at with great skepticism.

This was the state of the market two Wednesdays ago just prior to the Treasury's bailout announcement. At the same time as that announcement, the Fed set up a few programs that would allow money market funds to get liquidity and would guarantee the value of the funds. However, with yesterday's ballsy vote by the House, even with those guarantees, we are back to where we were which is to say we are Staring into the Abyss.

The Bailout:
Hammerin' Hank Paulson is a man I respect a ton. He's in an awful, awful position. The ultimate lose/lose. But I feel like he's been a bit misleading about one thing: The Hammer continues to state that the root cause of the problems in the financial sector are housing and the related illiquid securities (for our purposes, we'll just call those securities "ABS", which is a bit broad). That is false. Those are symptoms of the root cause. The root cause is two fold:
1) too much leverage;
2) bad underwriting.

That really is a toxic combination as the each of the factors magnifies the problems of the other one. So, in my mind, any bailout plan that does not address the real root cause is not what we need and is a distraction from the end goal.

The Treasury's plan, in fact, actually rewards the bad behavior. We are protecting companies from the reality of too much leverage by buying their poorly underwritten assets at premium prices. This is a subsidy, plain and simple. And it's dumb.

If we collectively decide that it is too societally expensive to allow massive failures and we want to instill some calm amongst depositors, then some plan is needed. Thus, if we are going to put We The People's capital at risk, we absolutely must attack the core problems and begin healing. The detox must happen. The problem clearly cannot be put off again, because we may just end up overdosing and killing ourselves (if we haven't already).

So, I'd propose an alternate plan that allows companies to fail from an equity holder and non-depositor lender standpoint:

First: credit ratings agencies will be forced to compete and the current government authorized oligopoly will be loosened with an agency to monitor existing/approve new ratings agencies. Ratings scoring will be standardized and apples to apples across asset classes. The issuer will continue to pay for ratings, but the ratings agencies will have to defer 20% of their revenue to an insurance pool with a five year vesting. In any given one, three or five year period that their aggregate forecasts vary from expected outcomes by more than two standard deviations, some amount of the deferrals are forfeit. In extreme cases, fines could be levied as well. Any forfeit revenue will go to support certain aspects of the regulatory regime. Executive compensation of approved ratings agencies will be subject to the same terms outlined below for bankn executives.

Second: banks have five years to take leverage to no more than 7:1 if the asset mix stays somewhere close to history. Leverage needs to be defined, but I might start by saying that it should be defined as delta adjusted notional exposure of long assets offset by 50% of the delta adjusted notional exposure of hedges. There will still be some risk-based element to the assets that are allowed to be owned. Leverage would be allowed to max at 9:1 if only super high quality assets were owned, as determined by the regulator/ratings agencies.

Third: FDIC expands its insurance level to $250,000 and heretofore, that level is indexed to inflation.

Fourth: during that five year period, any and all FDIC insured banks or thrifts that the pertinent regulator deems at serious risk would be subject to a similar takeover structure as AIG. The government will come in, provide a senior line of credit, cram down the entire capital structure below depositors, replace management if they ran the bank when the problems occurred, receive a massive warrant package, and set a time line for disposition via sale or IPO. These rules must be clearly stated so that depositors know they can depend on them and they must be consistently applied so that lenders and owners can operate in an environment that has some amount of predictability and standardization.

Fifth: During that initial five year period and beyond, for any FDIC insured institution (or insitution involved in the capital markets as a counterparty to an FDIC insured institution with more than $10 billion of notional counterparty exposure), employee compensation in excess of $2 million per year, set to inflation, would be deferred on an even four year vesting schedule (in year one you'd get $2 million, at the end of year two, you'd get 1/4 of the deferred comp, etc.). If the government has to implement an AIG-type plan, all deferred comp is forfeit and goes to the benefit of the FDIC's insurance fund. There is no employment vesting. So, the money is yours, free and clear, as long as your bank/institution does not fail (as defined by the AIG-type takeover) within four years of your last paycheck. This is not at all a limit on compensation, it is merely a recognition that if you are going to rely on a government subsidy for your operations, you need to be incented to behave in a way that minimizes long-term failure.

Sixth: Transparency to the public/depositors must improve somehow.

Finally, the government should immediately loosen ownership restrictions on private equity buyers taking stakes in banks, but force them to over-equitize initially.

In sum, we force leverage down, transparency up, accountability up, and thus underwriting standards up. This improves confidence and soundness and provides a base to begin to grow from again. From a legislator's perspective, it protects depositors (consitituents), punishes poor business decisions, improves incentives, protects tax-payers, and limits similar situations from re-emerging in the future.

What does this mean? I'll give the quick answer here. Regardless of whether my ideas or any other are implemented (including the Treasury bailout), we are going to witness the great deleveraging of our time. Thus, there will be a one-time, painful readjustment in values in order to reflect less available, more stringent, more expensive leverage.

Historically, an 80% Loan to Value ("LTV") loan on a house has been a reasonably safe loan. The buyer's 20% was enough skin in the game to keep him/her/them honest even if it turns out the house price was a bit high. Lenders rarely lost money. A big part of this was that houses were historically appreciating assets (unlike most cars, for example) and thus the lender's margin of safety was growing in two ways: 1) every month the borrower paid back some principal on the mortgage, improving the LTV; and 2) over time the value of the home increased, also improving the LTV.

However, everything seems to have suddenly changed. Borrowers' behavior is less predictable - they are willingly defaulting on their mortgages much more often (even those that had 20% down). Further, home prices are declining. Now, from an aggregate standpoint, that same 80% LTV mortgage seems substantially less attractive to the lender. Their margin for error seems to actually be shrinking rather than growing.

So, what will the rational lender do?
1) delever their balance sheet: in response to the volume of bad loans and the increasingly transitory nature of deposits, banks are going to delever in order to feel they can safely operate. Lenders and owners will require it. Reducing blow-up risk is key. So, fewer loans will be available in aggregate unless we capitalize a bunch of new banks or existing banks raise a ton of equity;
2) raise standards: You're going to make sure the people you loan to are highly unlikely to default - so credit quality will rise, which weeds out certain borrowers;
3) raise your price: You're going to charge wider spreads to your funding costs in order to compensate you for the higher risk you perceive that is associated. This has a depressing effect on asset prices as the cost of acquiring assets rises, all else being equal;
4) lend at lower LTVs: You're going to make borrowers put more of their own skin in the game which a) gives you more protection in case they default and in case asset values continue to decline; and b) makes the borrower less likely to default since he/she/they have more to lose. This will have the effect of weeding out borrowers who haven't saved up enough to be able to put up a bigger chunk of money.

Collectively, those four factors will have a depressive effect on any asset classes that have historically been acquired with borrowed money (LBO targets, real estate, etc.) in order to reflect less competition amongst buyers, to compensate the buyers for the increased cost of borrowing, and to generate attractive returns to the equity. This deleveraging spiral obviously has the ability to feed on itself until one day, it stops.

My guess is it will correct too far and at that point, the man with cash will be in an a once-in-a-lifetime position to profit. Buy assets when the provide reasonably attractive unlevered returns for the risk assumed. Levering those returns would just be gravy.

This is a time to sit and wait. Then when big opportunities come, and they will come if this volatility and deleveraging keeps up, swing hard.

-TTB

Wachovia goes down on the same day Congress grows a pair - welcome to the Dark Side

Hhheewwwwwww [sound of a long exhale].

Hhheewwwwwwwwwwwwwwwwwwwww

Hhhhhhheeewwwwwwwwwwwwwwwwwwwwwwwwww

Wow. What to make of it all? These two topics (Wachovia and the bailout) deserve two distinct posts. This one is going to be Wachovia.

First off, I hate (love) to say it, but I was spot on again. Wachovia goes down. And, yes, this is a bank failure. Taking out the third or so largest bank in the United States for $1/share plus paying the government Twelve f'ing Billion dollars to insure you against losses in the event the losses on a pre-identified $312 billion portion of Wachovia's asset portfolio exceed $42 billion? That implies there could be another $54 billion of losses in that portfolio. Really? I mean, wow. Folks, that is a failure. Don't let anyone tell you otherwise. The FDIC doesn't tend to post non-failure bank mergers on their website. It's a failure. Period.

And why did it fail? Major credit agencies were poised to downgrade the Dubya Bee if it didn't raise capital ASAP. As I discussed the other day, private lenders had already implicitly downgraded Wachovia by taking their credit to junk-like spreads after the FDIC's actions around WaMu rightfully freaked them out. My post (linked above) from last Friday was prescient enough that I'll go ahead and quote the pertinent section right here:

In that first post of 2008, I said that the failure of WaMu would be more important than the failure of the GSEs. I believe that proved out today, though most people still don't realize it. When WaMu was seized by the FDIC then flipped to JP Morganington Mutual Chase Stearns & Co, it had at least one odd unintended consequence. It absolutely screwed senior creditors who certainly assumed that their loan was secured by the assets and liabilities of the bank operating companies as well as the HoldCo assets. Instead, the FDIC used its authority under a seizure to rip the assets from the bond holders and sell them to JPM. In fact, the FDIC turned a $1.9 billion profit on the flip!

If you happened to be a senior lender to the next-weakest large financial institution, like, say, Wachovia, it turns out that you may not have enjoyed witnessing your colleagues in the world of lending to banks getting publicly gutted by the Feds.

So, what happened today to Wachovia? Well, it wasn't good. Wachovia CDS spreads blew out. As noted in the link, a standard CDS contract is quoted as the cost over swaps of a five year senior obligation. Wachovia closed Thursday (just prior to the WaMu gutting) at about 695 bps over (no up front points). It closed Friday at 40 points up front and 500 bps running! Doh! So, if we assume swaps are about 3.5% today and we just evenly divide up the 40 up front points over five years (8%/year), we are looking at Wachovia's current senior funding costs at about 16.5% per annumn (3.5% + 5.0% + 8.0%). Ouch! Hopefully they don't need to tap the credit markets in the near future!

Also, this is a classic unintended consequence of the no new short selling rule: if you want to short WB, the SEC has pretty much forced you to use CDS. Idiot Cox.

Some how evil speculators and Wall Street derivatives traders will be blamed for "manipulating" Wachovia's CDS costs, but the reality is it simply reflects the new failure paradigm that the FDIC defined through its actions for large bank failures. Charging a higher cost to lend to financial institutions is absolutely the rational thing to do. As regulators continue to manipulate the natural order of things, the more frequently and painfully these unintended consequences will pop up.

Luckily for Wachovia, if they need to shore up their capital base, they can always just issue stock.

Or...maybe not. Wachovia's stock was down about 40% today to $9/share. Interestingly, if you look at the presentation JP Morganington Mutual Chase Stearns & Co. sent around last night on the WaMu acquisition, they break out bucket by bucket how they came up with the $31 billion write-off they took on WM's portfolio (page #15), they wrote off another $8.2 billion or about 13% of the remaining Option ARM portfolio. They also wrote-off another 17% of the HELOC & LOC portfolio in addition to other broad asset category write-offs. In total, JPM wrote down WaMu's asset portfolio by about 15%.

Those are enormous write-offs and, if apples to apples, would imply devestation for Wachovia. Even if Wachovia's asset base (page #4), which also has huge Option ARM ($125 billion) and HELOC/LOC ($58 billion) portfolios out of a total $477 billion asset base is of better quality than WaMu, it's only going to be modestly better and WaMu had been more aggressive in its write-offs than WB even before the JPM takeover. I first discussed WB's balance sheet issues vis a vie WM back on August 6th. Given a nearly half a trillion dollar asset portfolio, Wachovia's market cap is just over $20 billion, so the margin for error is unusually small.

Another unintended consequence of the JPM/WM deal is that if you are a potential acquiror of WB equity (in whole or part), what's the rush? The longer you wait, the more the situation develops, the lower the price seems to go, and the more desperate the Feds become for private sector help. The government's perspective surely is that a bank Wachovia's size cannot be allowed to "fail". Another issue is that Wachovia is so big, the government really cannot allow it to be swallowed by another large bank. So, that means it would be split up. By delivering WaMu on a silver platter to JPM, the FDIC has shown that it is more than happy to kill a bank prematurely if it facilitates an orderly transition. Of course, that "order" is real only if viewed in a vacuum. Each one of these government manipulations seems to spawn now uncertainties and unintended consequences.

Given the small market cap vs. the magnitude of the potential problem taken in conjunction with the cost of debt financing, Wachovia's clock is ticking. They will do one of the following, and soon: 1) prove everyone wrong and show their asset quality is such that it does not need to be marked down much more (btw, auditors will definitely look at the WM/JPM transaction for valuation comps); 2) sell itself; or 3) fail and be sold by the FDIC. Frankly, I don't think there are any other alternatives given the impracticality of raising the necessary financing.

A final unintended consequence of WaMu's failure being such an orderly failure (no depositors were hurt) is that the media, which had been fairly restrained in an attempt to help avoid causing a self-fulfilling fear-based run on a bank, now has some cover to start reporting negative bank news before it becomes overwhelmingly obvious. In fact, the media seems to have taken off the gloves and decided no holds are barred. This NY Times article on Wachovia is a case in point. This sort of article did not used to get published by the mainstream media.

So, as I said, WaMu's failure is s scary thing. Creditors and owners of weak banks everywhere are rightfully nervous

I hope your boots were strapped on, because we are knee deep in it now.

So, Wachovia "failed" because the government decided it could not allow the bank to really "fail", if that makes sense. The writing was on the wall: losses were mounting, equity was depressed to levels that limited a capital infusion, buyers had been trained by the FDIC and the markets to just wait and the price will keep declining, credit funding costs were massively non-economic, ratings agencies were about to drop the hammer, and the media was all over the story leading to a potential for a lack of confidence driven bank run. In all, the whole thing was totally foreseeable and, I suspect, an excellent deal for Citi assuming they have managed to deal with their own problems. I actually trust Vikram Pandit more than any of the major Wall Street CEOs (including Glorious Jamie Dimon and LaLaLaLaLloyd Blankfein). He was the most aggressive about raising fresh capital back when that was doable, he's not married to the company and its legacy problems, he was early in grasping that the problems the industry is facing are big, and he is well regarded for his focus on understanding risk and return. That said, so much of what is happening these days is outsripping expectations that it's certainly possible Citi has their own problems elsewhere, but my guess is Citi is fine (as an aside, Citi is the only bank that I own, though it's not a big position).

It obviously begs the question: who's next? There are several obvious small banks to medium-small banks/thrifts like Bank United and Downey that are toast. I shared this link in early September and if you look at what has failed so far, we've really only just begun to make a dent in the list. Titans like Wachovia and WaMu were not even on the list. Those are the kinds of banks I'm most curious about. It seems to me that Regions Financial, Nat City, and Sovereign are all at risk. They are big enough to have CDS, they are big enough to catch media attention, they all clearly have problem loan books, and they all have important depositor bases. If I'm a big depositor at any of those three, I can't figure out why I'm staying. I know that Linda Lou at Regions has been my banker for all of my adult life and she assures me that everything is fine, but I suspect if you go ask Beauregard the Banker across the street at B of A whether they have been getting an abnormal amount of inflows from new depositors, the answer is an emphatic yes. As a depositor (ie, "lender") at Regions, that scares me. I'm walking.

Finally, and I'll touch on this is a follow-up post about Congress growing a giant pair today and voting against the bailout, but the credit markets broadly and CP markets specifically are in shambles and that's going to have a really negative impact on a number of financial institutions, medium-large banks certainly included.

You should be nervous. Things are bad.

-TTB

Where to Begin?

Washington Mutual failed last night. It wasn't even a Friday. Given how much I look forward to checking the FDIC website every Friday evening, it's with a small tinge of disappointment that I note WaMu failed on Thursday September 25th. That said, it is with a great deal of self-congratulatory arrogance that in the same above linked post, I also noted that WaMu was "probably still six or eight weeks out" from failing. That post was dated August 2, 2008. That was just under eight weeks ago. I'm not sayin', I'm just sayin', that's all... I also have been predicting that the catalyst for WaMu's failure would not be a traditional run on the bank, but a slow motion run on the bank by large depositors who a) have more to lose; and b) on average are more market aware and thus would be the most likely people to withdraw their deposits. In the last two weeks or so, the media has reported that $17 billion in deposits walked from WaMu, driven largely by large depositors.

I first predicted WaMu's failure in this blog back in mid-July. I started talking about it privately a few months prior to that. In fact, you'll note that the WaMu failure post was actually my first blog posting of 2008. That overwhelming sense that WaMu/SnaFu was toast and that nobody was focusing on it is what actually opened the floodgates for my blogging. Since then, everything that I've expected to happen (and some) has occurred.

Now, onto news. Effectively, JPM paid $1.9 billion to the FDIC and took a $31 billion write down as the cost of the acquisition (basically, $34 billion). They expect the WaMu transaction to add $2.4 billion in earnings in 2009 and then grow in the out years. That implies that JPM was able to acquire WM at 14x run-rate earnings. I suspect that WM contributes much more than that to JPM's annual earnings over time.

In that first post of 2008, I said that the failure of WaMu would be more important than the failure of the GSEs. I believe that proved out today, though most people still don't realize it. When WaMu was seized by the FDIC then flipped to JP Morganington Mutual Chase Stearns & Co, it had at least one odd unintended consequence. It absolutely screwed senior creditors who certainly assumed that their loan was secured by the assets and liabilities of the bank operating companies as well as the HoldCo assets. Instead, the FDIC used its authority under a seizure to rip the assets from the bond holders and sell them to JPM. In fact, the FDIC turned a $1.9 billion profit on the flip!

If you happened to be a senior lender to the next-weakest large financial institution, like, say, Wachovia, it turns out that you may not have enjoyed witnessing your colleagues in the world of lending to banks getting publicly gutted by the Feds.

So, what happened today to Wachovia? Well, it wasn't good. Wachovia CDS spreads blew out. As noted in the link, a standard CDS contract is quoted as the cost over swaps of a five year senior obligation. Wachovia closed Thursday (just prior to the WaMu gutting) at about 695 bps over (no up front points). It closed Friday at 40 points up front and 500 bps running! Doh! So, if we assume swaps are about 3.5% today and we just evenly divide up the 40 up front points over five years (8%/year), we are looking at Wachovia's current senior funding costs at about 16.5% per annumn (3.5% + 5.0% + 8.0%). Ouch! Hopefully they don't need to tap the credit markets in the near future!

Also, this is a classic unintended consequence of the no new short selling rule: if you want to short WB, the SEC has pretty much forced you to use CDS. Idiot Cox.

Some how evil speculators and Wall Street derivatives traders will be blamed for "manipulating" Wachovia's CDS costs, but the reality is it simply reflects the new failure paradigm that the FDIC defined through its actions for large bank failures. Charging a higher cost to lend to financial institutions is absolutely the rational thing to do. As regulators continue to manipulate the natural order of things, the more frequently and painfully these unintended consequences will pop up.

Luckily for Wachovia, if they need to shore up their capital base, they can always just issue stock.

Or...maybe not. Wachovia's stock was down about 40% today to $9/share. Interestingly, if you look at the presentation JP Morganington Mutual Chase Stearns & Co. sent around last night on the WaMu acquisition, they break out bucket by bucket how they came up with the $31 billion write-off they took on WM's portfolio (page #15), they wrote off another $8.2 billion or about 13% of the remaining Option ARM portfolio. They also wrote-off another 17% of the HELOC & LOC portfolio in addition to other broad asset category write-offs. In total, JPM wrote down WaMu's asset portfolio by about 15%.

Those are enormous write-offs and, if apples to apples, would imply devestation for Wachovia. Even if Wachovia's asset base (page #4), which also has huge Option ARM ($125 billion) and HELOC/LOC ($58 billion) portfolios out of a total $477 billion asset base is of better quality than WaMu, it's only going to be modestly better and WaMu had been more aggressive in its write-offs than WB even before the JPM takeover. I first discussed WB's balance sheet issues vis a vie WM back on August 6th. Given a nearly half a trillion dollar asset portfolio, Wachovia's market cap is just over $20 billion, so the margin for error is unusually small.

Another unintended consequence of the JPM/WM deal is that if you are a potential acquiror of WB equity (in whole or part), what's the rush? The longer you wait, the more the situation develops, the lower the price seems to go, and the more desperate the Feds become for private sector help. The government's perspective surely is that a bank Wachovia's size cannot be allowed to "fail". Another issue is that Wachovia is so big, the government really cannot allow it to be swallowed by another large bank. So, that means it would be split up. By delivering WaMu on a silver platter to JPM, the FDIC has shown that it is more than happy to kill a bank prematurely if it facilitates an orderly transition. Of course, that "order" is real only if viewed in a vacuum. Each one of these government manipulations seems to spawn now uncertainties and unintended consequences.

Given the small market cap vs. the magnitude of the potential problem taken in conjunction with the cost of debt financing, Wachovia's clock is ticking. They will do one of the following, and soon: 1) prove everyone wrong and show their asset quality is such that it does not need to be marked down much more (btw, auditors will definitely look at the WM/JPM transaction for valuation comps); 2) sell itself; or 3) fail and be sold by the FDIC. Frankly, I don't think there are any other alternatives given the impracticality of raising the necessary financing.

A final unintended consequence of WaMu's failure being such an orderly failure (no depositors were hurt) is that the media, which had been fairly restrained in an attempt to help avoid causing a self-fulfilling fear-based run on a bank, now has some cover to start reporting negative bank news before it becomes overwhelmingly obvious. In fact, the media seems to have taken off the gloves and decided no holds are barred. This NY Times article on Wachovia is a case in point. This sort of article did not used to get published by the mainstream media.

So, as I said, WaMu's failure is s scary thing. Creditors and owners of weak banks everywhere are rightfully nervous

I hope your boots were strapped on, because we are knee deep in it now.

-TTB