13 September 2008

In A Crowded Theater, Never Yell ‘Fire'!

Wonder why so few of the regulators, officials, cabinet members, administration representatives, etc. are really candid about the true state of the financial system? With Paulson's experience in the investment world, he completely understands what is going on. Yet, as is the case with almost every official spokesperson, he tends to downplay the seriousness of what has happened and what is unfolding. Telling the whole truth now would be tantamount to yelling ‘fire' in a crowded theater. People would panic, there would be a stampede for the exits, and many would be trampled to pieces.

Unfortunately, the panic is almost certain to happen soon anyway, as the truth of the magnitude of these problems emerges in a general way. It is extremely important that none of us be lulled into thinking there is an easy solution to these troubles and that the current players are going to be able to solve them.

Has the storm really ended and is the worst behind? The answer is clearly NO. There is no way that this is over because the problem is simply too large to be dealt with in the way it has.

Since it was the real estate market that provided the liquidity to continue the bogus expansion that took place over the last several years, and since that activity was financed by mortgage schemes that are no longer available, what could possibly cause the economy to magically shrug off the continuing meltdown of trillions of dollars of valuation and assets? The unfortunate answer is: Nothing!

The main reason there is no easy solution for the current credit crisis is apparent from the table depicting the issuance of asset-backed securities. As you can see, liquidity, as would be expected in this environment, has contracted dramatically.

Whereas Collateralized Mortgage Obligations (CMO's) were the main source of mortgage availability for the last number of years for non-Agency-qualified borrowers, that game has now ended. And so there are very limited sources of financing that can be used by many caught in the trap of rising payments, falling prices and foreclosure. This insures that this perfect storm is still churning.

How Can We Be Sure The Next Phase Of This Is Imminent?

I have argued that the debt bubble would eventually exert an inexorable deflationary pull on the economy. It is my belief that the enormity of this debt bubble implosion virtually guarantees that it will overwhelm all of the efforts to stop the progression that is underway.

Prices are falling for many things now, not the least of which is real estate. If you look at a chart depicting the recent decline in (home) prices it is very hard to imagine where any fresh liquidity will come from in any sort of meaningful way. After all, if you were loaning money to someone to buy a home in this environment, and you couldn't be certain that prices would stop falling, wouldn't you be very careful in screening your borrowers? Wouldn't you insist on ironclad principles to protect you as best as possible? Of course you would---and so will mortgage companies and banks!

Three charts are depicted that clearly show a shift in the environment toward a burgeoning deflationary tilt. This has very serious implications for the economy because in a deflationary recession, most of the things that consumers have learned to do over the last few decades will have disastrous consequences. In a recessionary/deflationary environment, as many are now discovering, debt is a very heavy burden. Essentially, as time goes on and as prices for most things fall, debt becomes progressively more difficult to repay.

The rise in the dollar over the last month, is plainly telling us that the U.S. is already in a sharp contraction and that the rest of the world is moving in that direction very quickly. As I said, the implosion of the world-wide debt bubble (there are trillions of dollars of risk in over-the-counter derivatives held by some of the major financial institutions in the world) virtually assures us that these problems are not going away any time soon.

Money Is Not Getting To Where It Is Needed

One of the things consistent with a deflationary environment is that credit is not available to those who need it and the intended infusion of money into the system is ineffectual. The most recent depiction of the Velocity of Money shows how much economic growth results from a particular monetary aggregate increase.

There has been a very pronounced decline in the velocity of money especially related to MZM, or Money of Zero Maturity. This represents the so-called ‘hot' money (most liquid) and would measure some of the efforts by the Fed to try to stimulate growth. As is evident, their efforts are not having much success. In fact, monetary velocity (a ratio of GDP to money supply) has dropped sharply to multi-decade lows, which is telling us that consumers are holding on to their money and it is not circulating in the economy in a manner necessary to spark recovery.

With the current levels of debt, weak labor markets and all of the other problems that are out there right now, this is not a surprise. Debt in this country has become so large and so much a way of life, that only a sharp recession that wipes out the value of a lot of assets and results in massive debt repudiation will be enough to finally break the debt addiction. For most, it will not be pleasant. Observe the chart depicting consumer debt growth. You will see, consumer debt (not including mortgages) rising dramatically, especially since the real estate market peaked in 2005. In early 2006, you see how consumers have tapped into their last source of liquidity, namely consumer related debt and primarily credit card debt. This has terrible implications for most consumers because credit card debt is expensive!

However, in a developing recessionary environment, with weak labor markets, it will not be just the consumers who suffer from this excessive credit card debt. The
major banks and credit card issuers are soon to have a reality check similar to what has happened in the mortgage area. Massive defaults and write-offs related to credit cards and other consumer debt will soon occur.

If the natural economic laws of capitalism and free enterprise that have been subdued for so long, are finally allowed to operate, they will have a chance to efficiently, although painfully, correct the situation.

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