From Green to Red – Is Credit Crunch 2.0 Imminent?

Satyajit Das is author of Traders, Guns and Money: Knowns and unknowns in the dazzling world of derivatives (August 2006) and Extreme Money: The Masters of the Universe and the Cult of Risk (August 2011)
~~~

In Crosstown Traffic, Jimi Hendrix sang: “can’t you see my signals turn from green to red / And with you I can see a traffic jam straight up ahead.” In global financial markets, the signals have changed from green to red. But rather than a simple traffic jam, a full scale credit crash may be ahead.

In financial markets, facts never matter until they do but there are worrying indications.


Fact 1 – The European debt crisis has taken a turn for the worse.

There is a serious risk that even the half-baked bailout plan announced on 21 July 2011 cannot be implemented.

The sticking point is a demand for collateral for the second bailout package. Finland demanded and got Euro 500 million in cash as security against their Euro 1,400 million share of the second bailout package. Hearing of the ill-advised side deal between Greece and Finland, Austria, the Netherlands and Slovakia also are now demanding collateral, arguing that their banks were less exposed to Greece than their counterparts in Germany and France entitling them to special treatment. At least, one German parliamentarian has also asked the logical question, why Germany is not receiving similar collateral.

Of course, Greece, which does not have two Euros to rub together, doesn’t have this collateral and would need to borrow it.

Compounding the problem is Greece’s fall in Gross Domestic Production (“GDP”) was worse than forecast, even before the latest austerity measures become effective. The Greek economy has shrunk by around 15% since the crisis began. 2-year borrowing costs for Greece are now over 40%, pawnbroker levels. The next installment of Greece’s first bailout package is due to be released as at end September. Some members of the International Monetary Fund (“IMF”) are already expressing deep misgivings about further assistance to Greece, in the light of the seeming inability of the country to meet its end of the bargain.

A disorderly unwind of the Greek debt problem cannot be ruled out. Ireland and Portugal remain in difficulty. Spain and Italy also remain embattled with only European Central Bank (“ECB”) purchases of their bonds keeping their interest rates down. Concern about the effect of these bailouts on France and Germany is also intensifying.

Concerns about US and Japanese government debt are also increasing.

Official forecasts show that America’s national debt will increase by $3.5 trillion from its existing $14.5 trillion over the next decade. These forecasts are unlikely to be met unless the political deadlock over the budget is overcome and economic growth recovers. Japan was downgraded to AA- and its longer-term economic prognosis continues to be poor.


Facts 2 – Problems with banks have re-emerged.

Banks globally, especially European banks, are seen as increasingly vulnerable to European debt problems. The total exposure of the global banking system to Greece, Ireland, Portugal, Spain and Italy is over $2 trillion. French and Germany banks have very large exposures.

If there are defaults, then these banks will need capital, most likely from their sovereigns. As they are increasingly themselves under pressure, their ability to support the banking system is unclear. The pressure is evident in the share prices of French banks; Societe Generale’s share price has fallen by nearly 50% in a relatively short period of time.

In the US, concerns about Bank of America (“BA”) have emerged, with analysts suggesting that the bank requires significant infusions of capital. The major concerns relate to BA’s investment in US mortgage originator Countrywide including continuing litigation losses, exposure to European banks, loans to commercial real estate and the quality of other assets, such as mortgage servicing rights and goodwill resulting from its acquisition of Merrill Lynch.

BA claims that its exposure of $17 billion to European sovereigns was hedged. As the world discovered in 2008, it wasn’t whether you were hedged but who you were hedged with and whether they were financially able to perform that was the issue.

BA shares have fallen by roughly 40% price over the past month, compared to a 15% decline in the S&P 500. The cost of credit insurance on BA risk has also increased sharply.

BA decision to issue $5 billion in preference shares to Warren Buffett’s Berkshire Hathaway, now confirmed as the market’s lender of last resort, at distressed prices was not a statement of strength but weakness. BA needs more capital in any case and Buffett is betting on both BA and if things go wrong that the US taxpayer will bail him out as they did with his investment in Goldman Sachs.

BA’s woes confirm that problems in the banking system exist globally, not only in Europe.


Fact 3 – Money markets are seizing up

Banks and financial institutions are finding it increasingly difficult to raise funds. Costs have risen sharply.

Spanish and Italian banks have limited access to international commercial funding. Like Greek, Irish and Portuguese banks, they are heavily reliant on funding from local investors and central banks, including the ECB.

American money market funds, which manage around $1.6 trillion, historically invested around 40-45% ($600-700 billion) with European financial institutions. Over the last few months, the money market funds have reduced their exposure to European entities, especially Spanish and Italian banks. The funds have also decreased the term of their loans to the European entities that they are willing deal with to as little as 7 days at a time, in an effort to limit risk.

European banks are having to pay higher interest rates, if they can attract funds. The problems are not confined to European financial institutions. Despite limited known direct exposure to European sovereigns and their relatively strong financial positions, Australian banks’ credit costs in international money markets have increased by more than 1.00% in less than 3 months.

As a result, non-financial institutions are finding finance less readily available and more expensive. Anecdotal evidence suggest that businesses are having difficulty financing normal commercial transactions, recalling the credit problems of late 2008/ early 2009.

Banks are increasingly following Tennessee Williams’ advice for survival: “We have to distrust each other. It is our only defense against betrayal.”

Fact 4 – The broader economic environment is deteriorating.

The global economic recovery is stalling. The risk of a recession or minimal growth is significant.

The favourable stock market reaction to the latest report of growth in orders for durable goods in America misses an essential point. At around $200 billion an month, it is still around 20% below its peak in 2007 and only at 2000 levels.

Germany and emerging market economies, like China and India, which have contributed the bulk of global growth since 2008, are showing signs of slowing. The effects of the excessive credit expansion in China and India are showing up in bank bad debts.

Then there are pernicious feedback loops. Tighter money market conditions feed into lower growth, increasing the problems of government finances. Falling tax revenues and rising expenditures push up budget deficits, requiring greater borrowing. Lower growth feeds into greater business failures that increase bank bad debts, feeding further tightening in lending conditions and the cost of finance.

The rapid and marked deterioration in economic and financial conditions means that the risk of a serious disruption is now significant.

If market seize up again, then “this time it will be different“. There might just not be enough money to bail out everyone and every country that may need rescuing.

Government policy options are severely restricted. Government support is restricted because of excessive debt levels and the reluctance of investors to finance indebted sovereigns. Interest rates in most developed countries are low or zero, restricting the ability to stimulate the economy by cutting borrowing cost. Unconventional monetary strategies – namely printing money or quantitative easing – have been tried with limited success. Further doses, while eagerly anticipated by market participants, may not be effective.

The global economy may muddle through, but a second credit crash is now distinctly possible. But the trigger and timing is unknown. As John Maynard Keynes remarked: “The expected never happens; it is the unexpected always.”

~~~

-Satyajit Das
August 27, 2011

http://www.ritholtz.com/blog/2011/08/from-green-to-red-–-is-credit-%20crunch-2-0-imminent/

And No Dialing Back

Nolan says it still looks crook!@

And No Dialing Back:

CNBC's Steve Liesman: "Mr. Secretary, how much concern do you have right now - how much pressure are you under right now to dial back on these programs. Dial back spending. Dial back - getting to the audience question right there that I think is critical and that is really indicative of how Americans feel: Get the government out of the private sector. How much pressure are you under right now?"

Treasury Secretary Geithner: "No one is going to be more eager than I am. You're just not going to care about that more than me. We do not want to be in any of these institutions a day longer than is necessary. And look at what we have already done. We already have $80bn of capital coming back into the Treasury. If you look at what I said today in my testimony on the hill, we've seen these emergency programs we put in place already be used at a tiny fraction of their scale in emergency. We designed these things so that they would not be used a day longer than necessary.

But we're going to be careful not to withdraw too soon. Again, the classic mistake countries make in crisis is that they put on the brakes too early and reignite the recession, ultimately at much greater fiscal cost and much greater damage to the economy. So that's the balance we've got to get right. And we are not now at the point - even though the challenge is shifting - we're a bit moving now from emergency to the harder challenge, frankly, of repair and recovery. That's going to change the mix of what we do. We're going to get out and walk these things back as soon as we are confident we can get out of this thing."

September 10 - Bloomberg (Jody Shenn): "'Credibly' privatizing Fannie Mae and Freddie Mac... may be too difficult given the precedent set by the Treasury Department's financial assistance, according to a Government Accountability Office analysis. 'The financial markets likely would continue to perceive that the federal government would provide substantial financial support to the enterprises, if privatized as largely intact entities, in a financial emergency,' the GAO said... 'Consequently, such privatized entities may continue to derive financial benefits, such as lowered borrowing costs, resulting from the markets' perceptions.' The Treasury today reiterated that the government intends to make recommendations on Fannie Mae and Freddie Mac next year... 'Any transition to a new structure would need to consider the enterprises' still-dominant position in housing finance and be implemented carefully (perhaps in phases) to ensure its success," the GAO said."

My interest is not in taking shots at today's policymakers. They have been faced with incredible challenges, and proceed now on a course they hope and believe is best for returning the country to sound footing. And while I disagree strongly with the current path of policymaking, it has been predictable. From a policymaking perspective, the greatest error came with the Greenspan/Bernanke Fed's failure to act to rein in systemic Credit excess, asset inflation, and financial Bubbles. Many belatedly recognized the Fed's failings, yet few today appreciate that the costs and risks of flawed analysis and theories only keeps mounting.

I retain keen interest in debunking the Fed's thesis - articulated most clearly by then Fed governor Bernanke - that central banks should avoid the business of popping Bubbles and instead focus on post-Bubble "mopping up" strategies. It was, after all, post-Russia/LTCM "mopping up" that fueled the tech Bubble, and then the post-Tech and 9/11 mopping fostered the Wall Street/mortgage finance Bubble. And the latest big mop up job sets the stage for perhaps the greatest Bubble all them all - the Global Government Finance Bubble.

They appear as free lunches at the time, but there are myriad financial and economic costs associated with government intrusions into the marketplace. Most are subtle and tend to remain quiescent for years. When (market pricing, resource allocation and economic impairment) distortions do eventually manifest into a crisis, policymaking will have a strong proclivity to treat misdiagnosed ills with only greater government manipulations and intrusions. And the greater the degree of intrusion into the markets, the greater the ongoing costs involved. Huge intrusions ensure open-ended government involvement and increasing governmental command over the economic system.

As much as I believe Secretary Giethner is speaking earnestly, there is no way at this point government influence in the marketplace can be meaningfully dialed back. The damage has been done - historic distortions to both the financial system and real economy. The damage began with the activist Greenspan Fed manipulating interest rates, promising market liquidity, and pandering to the leveraged speculators. The damage worsened as the government-sponsored enterprises came to dominate our nation's market for housing finance. And the damage turned unmanageable when the markets listened back in 2002 to Dr. Bernanke profess the virtues of helicopter money and whatever other unconventional measures the central bank might deem worthwhile.

Federal government finance (Treasuries, agency debt and GSE MBS) has expanded about $2.0 TN over the past year. I expect it to inflate another $2.0 TN over the coming twelve months. The private sector Credit apparatus is simply not up to the task of generating the necessary $2.5 TN (or so) of total system Credit expansion necessary to sustain the current economic structure. In this post-Wall Street Bubble environment, only government and government-related Credit retains sufficient "moneyness" in the marketplace. Systemic reflation today depends on a massive inflation of this government helicopter "money."

This week's GAO analysis on the GSE's was spot on and certainly applies to more than just the GSEs: "The financial markets likely would continue to perceive that the federal government would provide substantial financial support to the enterprises, if privatized as largely intact entities, in a financial emergency." Over five Trillion - and counting - of GSE securities are valued and traded in the marketplace as (money-like) government-backed obligations. Policymakers would not today risk the negative financial and economic ramifications from dialing back from Washington's explicit and implicit guarantees.

And as much as moral hazard and "too big to fail" are recognized as fundamental facets of the previous Bubble excess, our policymakers have nonetheless been compelled to expand only further toward backstopping the entire Credit system. Obviously, the GSE's were too big to really fail, while markets appreciate that policymakers now believe it was a mistake to allow Lehman to collapse. The markets - more than ever before - operate with the view that policymakers have no tolerance for a major financial institution failure.

When one contemplates the issue of "getting the government out of the private sector," these various market liquidity support programs being wound down are an insignificant issue. Fundamentally, for the economy to move toward sounder and sustainable footing would require at least a semblance of a market-based Credit pricing mechanism. Regrettably, the vast majority of system Credit today is "public." Government intrusion chiefly dictates the cost of finance and the allocation of financial and real resources. Furthermore, I would argue that the limited amount of private sector debt being issued these days is dependent upon the system-stabilizing effects of massive government debt issuance and spending.

As I have stressed repeatedly, in the neighborhood of $2.5 TN of non-financial Credit growth is required to stem systemic implosion - a massive Credit expansion with only our federal government up to the challenge. It is this fundamental facet of Bubble economies - a maladjusted economic structure sustained only through ongoing Credit excess - that prohibits Washington from extricating itself from very public "private sector" intrusions. Fixated on the notion of sustainable recovery, policymakers will not be dialing back from massive borrowing, spending, or market backstopping endeavors. And this gets to the core of the unquantifiable costs of failing to rein in Credit and asset Bubbles.

As I have written over the years, the entire notion of "mopping up" is as flawed as it is dangerous. Clearly, the notion of inflationism remains as seductive as it has throughout history. If, God forbid, deflation ever becomes a risk the central bank must aggressively raise the price level to preclude a downward spiral. We heard this dogma in the early nineties, heard it again earlier this decade, and have had it repeated too often over the past year.

And the more intense the necessity to reflate - the greater the government's evolving role throughout both the financial and economic systems. This is a fact of life, human nature and politics. And at the end of the day inflationism tends toward socialism. And there is only one way to reverse this course; it is anything but painless. The economy must be weaned off of Credit and financial excesses and government intrusions - and allowed to proceed through the arduous task of adjustment and rebalancing. Choosing instead a course of sustaining current financial and economic structures implies a huge and ever-expanding role for the government. There will be no dialing back.

Many hope the private-sector can again rise to the occasion. It is expected that as recovery gains a foothold private sector borrowing and lending will increase, tax receipts will rise, and the government enjoy the luxury of dialing back as the system normalizes. I don't expect this dynamic to work as it has traditionally because of the confluence of Bubble economy Credit requirements, acute private sector Credit system impairment, and the government's predominant influence on the recovery.

The dynamic today is one of a shallow recovery induced by a flood of government borrowing and spending and marketplace intrusions. Rampant financial speculation has reemerged, which leaves the marketplace increasingly vulnerable to any serious move to dial back. In a normal recovery, the system tends to gain strength and stability over time. Credit requirements are manageable, and speculative excesses have been largely wrung out of the system. In stark contrast, today's combination of huge Credit expansion and a highly speculative financial backdrop ensures only more acute systemic fragilities over time. And the distorted marketplace will simply not function well at even the notion of fiscal and monetary exit strategies.

Conceptually, somewhere along the line there reaches a tipping point where government intrusions are no longer stabilizing. They become invariably destabilizing, as the quantity of government monetary inflation becomes massive and uncontrollable. This is the nature of inflationism, although this dynamic is nowhere to be found in Keynesian doctrine. It is my view that this tipping point was reached some time back. It is with this analysis in mind that I fear the emerging Government Finance Bubble risks destroying the creditworthiness of our entire economy.


Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

http://www.prudentbear.com/index.php/creditbubblebulletinview?art_id=10271

The Stock Market and Monetary Disorder:

I’ll restate my thesis as concisely as I can (not my strong suit): The deeply maladjusted U.S. “Bubble” economy requires $2.5 Trillion or so of net new Credit creation to stem systemic (Credit and economic Bubbles) implosion. Only “government” (Treasury, agency debt, and GSE MBS) debt can, today, fill the gigantic void created with the bursting of the Wall Street/mortgage finance Bubble. The private sector Credit system is severely impaired, and there is as well the reality that the market largely lost trust (loss of “moneyness”) in Wall Street obligations (private-label MBS, CDOs, ABS, auction-rate securities, etc.). The $2.0 Trillion of U.S. “government” Credit creation coupled with the Trillion-plus expansion of Federal Reserve Credit over the past year has stabilized U.S. financial and economic systems.

The synchronized global expansion of government deficits, state obligations, and central bank Credit amounts to an historic government finance Bubble. Markets have thus far embraced the surge of debt issuance. This U.S. and global reflation will have decidedly different characteristics when contrasted to previous Fed and Wall Street-induced reflations.

First off all, the most robust inflationary biases are today domiciled in China, Asia and the emerging markets generally. The debased dollar has provided China and the “developing” world Credit systems unprecedented capacity to inflate (expand Credit/financial claims without fear of spurring a run on their currencies). Asian and emerging markets are outperforming, exacerbating speculative inflows. Things that the “developing” world need (energy/commodities) and want (gold, silver, sugar, etc.) should demonstrate increasingly strong inflationary pressures. Their overflow of dollars provides them, for now, the power to buy whatever they desire.

Here at home, the post-Wall Street Bubble financial landscape ensures the old days of the Fed slashing rates and almost instantaneously stoking mortgage Credit, home price inflation and consumption have run their course. Accordingly, the unfolding reflation will be of a different variety than those of the past – and, importantly, largely bypass U.S. housing. This sets the stage for a lackluster recovery in consumption and economic revival generally. Household sector headwinds will likely be exacerbated by higher-than-expected inflation (especially in energy and globally-traded commodities), higher taxes and rising interest rates.

There is a confluence of factors that expose the market to an upside surprised in yields. The bond market has been overly sanguine, emboldened by the prospect of the Bernanke Fed maintaining ultra-loose monetary policy indefinitely. Bond bulls have been further comforted by the deep structural issues overhanging both the U.S. financial system and economy. However, massive government Credit creation has, for now, put systemic issues on hold. Especially in Asia, unfettered Credit expansion creates the backdrop for a surprisingly speedy economic upsurge. The weak dollar plays a major reflationary role globally, while also raising the prospect for inflationary pressures here at home. Massive issuance, global economic resurgence, heightened inflation and a weak currency are offering increasingly tough competition to the bullish “forever loose policy” view.

Meanwhile, fixed income must gaze at the feverish equities market with disbelief – and rising trepidation. The bond market discerns incessant economic impairment, a historic debt overhang, 9.4% unemployment, and begrudging recovery. An intoxicated stock market ganders something altogether different, with the Morgan Stanley Retail Index up 61% y-t-d, the Morgan Stanley High Tech Index up 47%, the Morgan Stanley Cyclical Index up 52%, and the Broker/Dealers up 45%. The bond market has been content to laugh off the silly equities game. The chuckles may have ended today.

My secular bearish thesis rests upon a major assumption: The U.S. economy is sustained by $2.5 Trillion (or so) of new Credit. Only this amount will stem a downward spiral of asset prices, Credit, incomes, corporate cash flows and government finances. On the other hand, if forthcoming, the $2.5 Trillion of additional – chiefly government-directed and non-productive - Credit will foment problematic Monetary Disorder. In simplest terms, another bout of Credit inflation leads further down the path of unhinged market prices, destabilizing speculation, and unwieldy flows of finance.

The stock market has become illustrative of what we might experience in the way of Monetary Disorder. Speculation has returned with a vengeance, galloping blindly ahead of fledgling little greenish shoots. Those of the bullish persuasion contend that the marketplace is, as it should, simply discounting a rosy future. I would counter that problematic market dynamics have taken over, with prices increasingly disconnected from reality. In short, the market is in the midst of one major short squeeze.

There are myriad risks associated with the government’s unprecedented market interventions. Likely not well appreciated, policymaker actions have forced the destabilizing unwind of huge positions created to hedge against systemic risk (as well as to profit from bearish bets). This reversal of various bear positions has created enormous buying power, especially in the securities of companies (and sectors) most exposed to the Credit downturn. The reversal of bets in the Credit default swap (and bond) market has certainly played a role. Surging junk bond and stock prices have fed one another, as the highly leveraged and vulnerable companies provide phenomenal market returns. The markets are today throwing "money" at the weak and leveraged.

The resulting outperformance of fundamentally weak companies spurred short covering more generally, creating a dynamic whereby heavily shorted stocks became about the best performing sector in the equities market. This dynamic put significant pressure on so-called market neutral strategies that have proliferated over the past few years. The strategy of attempting to own the good companies and short bad ones is faltering, likely causing a flow out of these strategies - and a self-reinforcing unwind of positions. The “bad” stock soar and the “good” ones languish.

There’s nothing like a short squeeze panic to get the markets’ speculative juices flowing. Many will say all’s just fine and dandy – let the fun and games continue! My retort is that the stock market is indicative of the current dysfunctional financial backdrop. At the end of the day, the financial system must be capable of effectively allocating finance and real resources throughout the economy. I would argue that this is not possible for a system that congenitally misprices risk and distorts financial asset prices. Today’s stock market will inherently finance mainly speculative Bubbles and fragility. And the core systemic problem, the maladjusted "Bubble economy," well, the financial backdrop only worsens the situation.

I have great confidence that government finance Bubble dynamics ensure ongoing distortions in the markets’ pricing of risk and, as well, a continued misallocation of resources (financial and real). And it is increasingly clear that the stock market is embroiled in this problematic dynamic. But that is a dilemma for another day, as surging stocks fan optimism and risk embracement – not to mention forcing many into the stock market with both nostrils plugged. And speculative equities and Credit markets will spur increased economic output in the short-run.

Everything has been extraordinary; the boom, the bust, policymaker interventions, and now the bear market rally. I wish I could see some mechanism in the works that will help kick our system’s addiction to easy Credit and commence the inevitable process of economic adjustment and restructuring. Instead, I see confirmation everywhere that policy and market dynamics are working in concert to sustain the existing financial and economic structure. I have huge doubts it will work and no doubt about the risks of failure.


http://prudentbear.com/index.php/creditbubblebulletinview?art_id=10257

The Greatest Cost ~ damage to the underlying economic structure

An astute analyst posed the following question yesterday: “The current debate is centered on whether the Fed can take back the liquidity in time in order to prevent inflation. Suppose it can. Suppose they execute this perfectly. But if the Fed is able to flood the system with the liquidity (thus reducing the severity of the downturn) and take it back before it causes inflation, it seems there is a free lunch. We get something for nothing. So, assuming a perfectly executed game plan by the Fed, is there a cost? Do they keep rates low for a time, only to raise them a lot a year down the road – is that the cost? Or is there another cost?”

I’m short on time today, so I’ll attempt a brief response.

First of all, while it often appears otherwise, finance provides no free lunch. The mispricing of Credit and misperceptions of risk in the marketplace have deleterious effects, although their true impact may remain unexposed for years. Indeed, the more immediate (and always seductive) consequences of loosened financial conditions tend to be reduced risk premiums, higher asset prices, and a boost to economic “output”. Conventional analysis of monetary policymaking still focuses on “inflation” and “deflation” risks. I would strongly argue that our contemporary world has already validated the analysis that acute financial and economic fragility are major costs associated with market pricing distortions.

When the Federal Reserve collapsed interest rates following the bursting of the technology Bubble, the results seemed constructive. Stock and real estate prices inflated; a robust economic recovery ensued. There was at the time some recognition of the potential for real estate excesses. But this was seen as such a small price to pay in the fight against the scourge of deflation. It was not until 2007 that the nature of the true costs of a massive “reflation” began to come to light.

Many would today argue that it was simply a case of the Fed’s failure to take the punchbowl away in time. Such analysis misses a key facet of Bubble dynamics. Once the Mortgage Finance Bubble gained a foothold there was absolutely no way policymakers were going to be willing to risk bursting such a consequential Bubble.

I see ample support for my view that Bubble dynamics have taken root throughout government finance. This unprecedented inflation includes Federal Reserve Credit, Treasury borrowings, Agency debt, GSE MBS guarantees, FHA and FDIC insurance, massive pension and healthcare obligations, the myriad new market support programs, etc. This Government Finance Bubble is domestic as well as global. Amazingly, the scope of the unfolding Bubble dwarfs even the Mortgage Finance Bubble. And, importantly, it is reasonable to presume that the Federal Reserve will find itself in the familiar position of being trapped by the risk of bursting a historic Bubble.

So I see the probabilities as very low that the Fed will reverse course and impose tightened liquidity conditions upon the marketplace. Actually, reflationary pressures may force the Fed to increase its Treasury holdings in an effort to maintain artificially low interest rates. At the same time, I don’t see higher inflation as the greatest cost associated with this predicament. Much greater risk lies with the acute systemic fragility that I believe is inherent to major Bubbles. Similar to mortgage finance 2002-2007, the marketplace is significantly mispricing the cost - and failing to recognize the risks - of a massive inflation of government finance. And while every Bubble has its own dynamics and nuances, the unfolding Government Finance Bubble has even more precarious Ponzi Finance dynamics than the Mortgage Bubble.

The markets are on tract to accommodate two Trillion or so of Treasury issuance this year. This incredible amount of debt creation is in the range I would expect necessary to temporarily stabilize the U.S. (“services”) Bubble Economy. Importantly, this amount of new finance both plugs financial holes and works to stabilize inflated income levels. From yesterday’s income data, one can see that Personal Income was up 0.3% y-o-y to $12.04 TN. And while 0.3% is very meager growth, without massive government fiscal and monetary expansion (inflation) the economy would have suffered a destabilizing income contraction. Keep in mind that personal income has inflated 65% since 1998 and 33% from 2003.

I’ll try to explain my belief that dangerous Ponzi Finance Dynamics are in play with the current course of policymaking. First, I view panicked policymakers as seeing no alternative than to try to sustain the current (deeply maladjusted) economic structure. A more natural course of economic adjustment – from finance and consumption-driven Bubble Economy to a more balanced system – was going to be much too painful to endure. So a massive government inflation was commenced in desperation - with the grandiose objective of revitalizing securities markets, housing prices, and the overall U.S. economy. I just don’t see how this reflation goes much beyond stoking a susceptible artificial recovery.

First and foremost, with government finance now completely dominating the Credit system, I can’t even begin to contemplate how this process might nurture an effective allocation of financial and real resources. Indeed, I see today’s manifestations of Credit Bubble Dynamics as an extension of similar mispricing, misperceptions, and over-issuance that led to last autumn’s near financial collapse.

Admittedly, the massive extension of government Credit and obligations works wonders in stabilizing a devastatingly impaired system. Inflationism is always seductive; Trillions worth is absurdly seductive. Yet this extra layer of debt does little to affect change to the underlying economic structure. Actually, a strong case can be made that it only delays and sidetracks the necessary adjustment process. And, importantly, this enormous additional layer of system debt exacerbates system vulnerability.

At the end of the day, a system is made or lost on the soundness of its underlying economic structure. I posit that a sound economic structure is reliant upon only moderate Credit growth and risk intermediation. Our system requires massive Credit expansion and intensive risk intermediation. I would also posit that there are no benefits – only escalating costs – to throwing massive Credit inflation upon an unhealthy economic structure. And, returning to Ponzi Dynamics, one of the major costs to such inflationism is a massive expansion of non-productive Credit – obligations that are created without a corresponding increase in real economic wealth producing capacity. The debt can only be serviced by the creation of more debt obligations.

The danger is that markets too easily and for too long accommodate massive Credit expansion during the boom. Federal Reserve policies are fundamental to this dynamic. But at some point and out of the Fed’s control, as Wall Street learned, greed inevitably turns to fear and a reversal of speculative flows marks the onset of the bust. And it’s the massive inflation of non-productive Credit that ensures the unavoidable crisis of confidence. Can the underlying economic structure service the mounting debt load or, instead, is it the massively inflating debt load that is sustaining a vulnerable economy? And it is in this vein that I fear the Government Finance Bubble is on track to destroy the Creditworthiness of the entire economy. And this Ponzi Dynamic is The Greatest Cost to what I fear is a continuation of unsound policymaking.

http://www.prudentbear.com/index.php/creditbubblebulletinview?art_id=10221

Atlantic Monthly January 1930 "The Break in the Credit Chain"

The Break in the Credit Chain



Three paragraphs in an agreement too often signed without thought have played a devastating role in recent stock-market history. They relate to customer’s borrowings from his stockbroker, pleasantly referred to as ‘debit balances.’

The sum total of these debit balances furnished the flimsy scaffolding upon which stock quotations were lifted so far above rational investment values they could only fall on any change in speculative sentiment. And it is on account of them, and the lack of real it behind them, that the fall in stock prices, once commenced, was precipitate and could not be stopped until thousands of financial tragedies had occurred—tragedies affecting the life prospects of hundreds of thousands of individuals. These loans by brokers to their customers, made without regard to the customers’ credit rating and without pretense of credit investigation, form the weakest link in our credit structure.

On the stage, the Mortgage on the Old Homestead played a familiar part in the melodramas and tragedies of a former day. In the tragedies of real life to-day, the mortgage has been replaced by the much more highly efficient debit balance—efficient in its power to wipe out a man’s financial standing without affording him recourse to any of the protections and safeguards against hasty action which are thrown about the borrower on mortgage.

Moreover, formalities of law, evidenced by documents and red seals, have firmly planted in our minds the idea that the condition of being a mortgagor is not one to be entered into lightly. It is understood by a majority who mortgage their homes that interest and payments to reduce the principal of the mortgage must be calculated ahead and made a part of the family budget, along with life insurance, clothing, groceries, meat, fish, and music lessons. A mortgage is solemnly contracted and plans for its repayment out of income are made in family council, for it is understood that if the mortgage is not paid the home is in jeopardy.

Likewise, when a man wishes to borrow from a bank, although the lending of money is the bank’s largest source of profit, he will not find himself urged to borrow. In the well-conducted bank he will meet a counselor who will investigate the whole question of whether the loan is advisable, and if so, within what limits it should be kept, in order that it may be as happy a transaction in its termination as in its inception. In other words, the man’s credit is appraised and a loan is made proportionate to his credit standing.

Banks rarely, if ever, make loans to people with whose affairs they are not reasonably familiar. And even in the case of a well-known customer, if the loan exceeds what would normally be expected to satisfy the ordinary requirements of his business, the bank will call for a special investigation, perhaps an engineer’s or an auditor’s report, before making advances. And further, when a loan is made the bank will insist that a direct promise to pay a definite sum of money be signed by the borrower, so there can be no question in the borrower’s mind with regard to the amount and terms of his debt. This again is a sober business transaction, soberly entered into.

Not so with the debit balance and the agreement concerning it which is signed when an account is opened with a stock brokerage firm. A new customer enters the brokerage office with $25,000. He may or may not be known to a member of the firm. Perhaps he knows a ‘customers’ man’ who is eager to report a new customer and to swell his record of commissions earned for the firm. The customers’ man is delighted to see some real money. No question is raised even as to whether or not the money actually belongs to the customer. It may belong to his wife, his child, or, in a few unfortunate cases, to the bank where he is employed—situations that would come to light under credit investigation. But to the customers’ man it is too often sufficient that the money is present and that it is the material out of which margins are made.

The discussion proceeds at once as to what may be a ‘good buy.’ In ordinary times, this may involve discussion of earning ratios and dividend records, but in the last year or so generalities and golden future prospects have been substituted, because the earning ratios did not account for the current quotations. The customer’s own enthusiasm to participate in some of the ‘easy money’ which his friends have made and the youthful assurance of the customers’ man are enough to result in an order involving $50,000 or perhaps $75,000, of which from $25,000 to $50,000 must be borrowed by the customer. Is he asked to sign a note for $25,000 or $50,000, with a promise to repay it? Hardly, for in many cases the full realization of what he is doing would bring him part way back to his senses, and he would be unwilling to sign such a definite obligation. Commission business would suffer. Instead, ‘as a matter of mere form,’ the standard agreement relating to debit balances is presented for his signature.

Many who have suffered a tragic change of prospect as the result of having incurred a debit balance at their brokers’ may not even now remember just what it was that they signed that put them in such jeopardy. So it is well to print below the three paragraphs in the standard form of the agreement which has brought so much trouble upon so many people. No lawyers were present when this agreement was signed, no red seals attached; no drama had forewarned them of the seriousness of their act, when they affixed their names; nor had any disagreeable questions been raised as to their capacity to protect themselves against the full force of the third paragraph, in case of need. The three fatal paragraphs run in part as follows:

AGREEMENT OF........... Richard Roe

WITH
X, Y, Z & Company

In consideration of X, Y, Z & Company consenting to act as my brokers, and to carry for me securities on a debit balance, giving me credit service and/or affording me facilities for the transacting of business in securities, I hereby agree with them, as follows:

FIRST: [unimportant]

SECOND: I agree that X, Y, Z & Company may at any time, without prior notice to me, pledge any securities deposited by me with them, or purchased by them for me, or any part or portion of such securities, for the debit balance due thereon, or may pledge any or all of my said securities with other securities in a loan or loans for an amount greater than the debit balance due on my said securities…

THIRD: X, Y, Z & Company may, at any time, if my indebtedness or my obligations are not secured to their satisfaction, without notice or demand, sell at public or private sale, without advertising the securities or any portion thereof that they hold in my account…


How many have signed this agreement to their own and their family’s irreparable harm?

The debt they incur, represented by an ever-growing debit balance on their brokers’ books, has rarely any relation to their power to repay it. The hope of extricating themselves from debt, if in fact they fully realize that they are in debt, is founded upon the hope of selling the securities in their account upon a constantly rising stock market.

A stock market rising constantly at a rate greater than the steady growth of the country’s investable surplus is without precedent and presupposes an endless chain of optimists forever ready to incur greater and greater debit balances at their respective brokers’. It further presupposes an inexhaustible reservoir of credit available to the broker. It presupposes, in fact, a combination of circumstances which is obviously absurd.

It is now evident that a serious thing has happened in the lives of a large number of individuals through a dangerously unguarded use of credit. If it had happened to a relatively small proportion of the community, it might not call for more than passing thought. But it has happened to a substantial portion of the community, and its effects will be felt eventually by almost all who do business in this country and by many abroad. The normal flow of credit has been broken. The effectiveness of thousands of members of the community has been impaired.

Our civilization is based largely upon credit. Credit has become, in its various forms, the circulating medium of the country. It is the commodity in which banks deal. Through hundreds of years, banks have developed an experience enabling them in some measure to control the volume and to safeguard the quality of credit in use at any one time; to prevent it from being squandered and rendered valueless. They have learned that credit, to be a valid form of purchasing power, must be based on one of two things, either (1) upon the competence, character, and earning power of the borrower, or (2) upon documents representing genuinely self-liquidating transactions.

By self-liquidating transactions, we mean transactions which involve goods, services, or, in fact, securities which are in transit toward the ultimate consumer, user, or investor who will be able to pay for them in full without incurring a new debt.

The term ‘banker’ in its best sense implies a man who, through long training and experience in the affairs of men, has developed some degree of wisdom enabling him to form sound judgments with respect to the competence, character, and earning power of those to whom his bank is to extend credit, and to recognize the type of transaction which, under the conditions prevailing at the time a loan is made, will be genuinely self-liquidating. The community depends upon the fraternity of bankers to see to it that the credit of the community is not squandered, that it is sound in character and can be depended upon. And this is the function of the innumerable bankers who deal directly with the borrowing public. No Federal Reserve or other system can be devised to protect the quality of credit if the bankers throughout the country do not apply sound judgment in the making of each loan.

Broadly speaking, bankers have accepted this responsibility, but only as they have dealt directly with the final borrower. In the case of loans which they have made to brokers, secured by Stock Exchange collateral, they may have used some discretion in selecting the brokers to whom they were willing to loan. But the amount of the loan has been based almost entirely upon quotations on the Stock Exchange for the securities pledged. The final appraisal of the ultimate source of credit, namely, the power of the ultimate borrower to repay the loan, has been delegated in this class of transaction to the stockbroker. And it may be fairly said that hardly a brokerage office, if any, maintains a credit department.

Here we find a serious break in the credit chain; serious because of the enormous volume of brokers’ credit which is put in circulation, running to a peak, as it did in September 1929, of over eight and a half billion dollars. This is the amount reported by the New York Stock Exchange as having been borrowed by its members alone. It does not include loans made by banks or others to brokers not members of the New York Stock Exchange. But without further addition or estimate it is a staggering volume of credit to be allowed to grow under an established practice which provides no adequate deterrent to its reckless use, no systematic investigation of the ultimate borrower’s capacity to discharge his part of the total debt, and, in too many cases, no clear intimation to the ultimate borrower of the amount of his loan or of the serious nature of the obligation to pay which he has incurred.

The financial fallacy which underlies the creation of such a volume of loans and the manner in which they are created is evident to all who have made a study of the major influences which contribute to the creation of stock prices. There can be no doubt in the minds of those who have made such a study that the general level of stock quotations above a normal valuation is itself chiefly dependent upon the volume of brokers’ loans. Certainly it becomes almost wholly dependent upon this factor when stock prices have risen to a point where they are obviously far above any possible current investment values represented by the stocks.

How unwise it is to base a substantial portion of the nation’s credit upon the general level of stock prices, when those prices themselves are a function of the volume of the credit so granted, without introducing the credit standing of the ultimate borrower as a safeguard.

Out of the nation’s income, a certain part is available for investment in securities, and there is evidence to show that this amount increases from year to year in an orderly fashion along with the growth of industry and the consequent need of industry for additional capital. On this basis, new investment capital to buy outright the securities offered by corporations in providing for their growing corporate needs is available without the introduction of any abnormally large amount of credit. Some credit, indeed, is needed, as it is in any business involving distribution. But no gigantic credit burden would ever be created if the effort were only to coordinate the capital needs of corporations with the growing investing power of the community.

The greater part of stockbrokers’ loans to customers (in the form of debit balances) are made in the speculative hope that it will be possible for the customer to sell some of his securities to investors or to other speculators at a price higher than he paid for them. The hope is frequently justified in the early stages of a rising market, as more and more speculative buyers on credit are drawn in and the volume of loans to customers increases, while the general price level of stocks rises. Thus the appetite of the earlier speculators who have bought and sold out to later speculators is whetted by the profits they make, and they again enter, making larger commitments at a higher level. During the course of the process, some considerable volume of stock is distributed to bona fide investors; but to the extent that the investor pays more than what may be regarded as the normal investment value for these stocks, the investing power of the country is depleted more rapidly than it can be replaced. Consequently, toward the end of a long rise, both in brokers’ loans and in stock prices, there are few investors left capable of buying stocks outright and removing securities from the market. Only those are left as possible purchasers who must create new debt if they are to buy at all.

The sum total, then, of the debt against stocks is no longer self-liquidating, and the amount of debt owed by each individual borrower bears no relation to his competence, character, and earning power. The quality of a great volume of credit is then found to bear no relation to sound banking standards. It is based solely upon fictitious stock quotations, themselves the result of the abnormal volume of debt created. The credit structure breaks at its weakest link, and thousands who suddenly find that they are in debt beyond their means to repay are sold out.

It is all very well to say that the customers were foolish. As we suggested earlier, if only a small part of the population were affected, the matter might be passed over lightly. But when a system prevails which caters to the folly of too large a proportion of a population, a proportion so large that the destruction of its purchasing power is of concern to every business in the land, then it deserves serious attention.

Particularly is this true if stock quotations are to be used, not only as a basis of credit, but also as a basis upon which major financial transactions are undertaken. It will be well for the banking community, who are vitally interested in the maintenance of stable credit, thoroughly to investigate how valid stock quotations are, either as a basis of credit or as a basis for major intercorporate transactions. If they do this they will soon find that, under the present indiscriminate method of extending credit to brokers’ customers, such quotations are without validity, and the principal reason that they are without validity is that the credit upon which they finally rest has never been really appraised. It has not been based either (1) upon the competence, character, and earning power of the ultimate borrower, or (2) upon documents representing genuinely self-liquidating transactions.

The collapse of the stock market in 1907 was attributed in large part to an inelastic currency and banking system, which resulted in an inadequate volume of credit and a shortage of actual cash. The lesson learned inspired the formation of the Federal Reserve System, which cured these particular weaknesses.

The fall in stock prices in 1920 and 1921 was attributed largely to the inflated inventories which had been accumulated during 1919, accompanied by a spectacular rise in commodity prices. Attention then was focused upon the use of credit in its relation to commodity prices and inventories. From this episode, business has learned a lesson, and in 1928 and 1929, as stock prices reached ever higher levels, great comfort was taken in the fact that corporate inventories were low, and that therefore there could be no danger in the situation.

Let us not forget the lessons learned from these two former experiences. But let us face the fact that, while in 1929 we had apparently no inflation in commodity prices, no accumulation of inventories, and, through the operation of the Federal Reserve System, abundant credit and currency, yet a fall in stock prices has occurred, exceeding in rapidity anything we have previously experienced. Let us focus our attention upon one of the causes, perhaps the principal cause of this unprecedented break: namely, a weak link in our credit structure—the fact that no proper credit investigations are made when stockbrokers make loans to their customers by means of the debit balance. These debit balances, to be a valid part of the security price structure which they support, should bear some relation to the borrower’s power to repay the debt, whether or not stock quotations move in the direction he hopes they will. Let us find the means of applying to this form of credit standards which have been tested through centuries of banking practice.

http://www.theatlantic.com/doc/193001/credit-chain

Capitalism's Greatest Vulnerability:~ Nolan

The great Hyman Minsky postulated that Capitalism was “flawed.” Over the years I’ve taken exception with this particular view, countering that Capitalism is more appropriately described as “vulnerable.” As part of this line of analysis, I have used the analogy of the human eye. We would not think of its delicate nature and susceptibility to injury as some “flaw” in our eye’s design. Instead, this inherent vulnerability is fundamental to the nature of this important organ’s functionality. We worry much less about our elbows, but they’re not going to do an adequate job detecting light and transmitting visual signals to our brains.

I have argued over the years that an extraordinary backdrop has beckoned for keen focus in order to protect our Capitalistic system from its inherent vulnerabilities - just as one would don sun glasses on a sunny beach or ski slope or insist upon tight-fitting safety goggles before entering a metal-working shop. One must first recognize inherent vulnerabilities and then take more aggressive preventative measures as necessary in response to riskier environments.

We, as a society, failed to take preventive action. Now, Capitalism as we have known it is under fierce attack from many directions and on various levels. At the same time, there is regrettably scant indication that we now possess any clearer understanding of the nature of Capitalism or its inherent vulnerabilities. We’re still entwined in Mistakes Beget Mistakes.

But there’s lots of blame being bandied about. Many pinpoint “Wall Street greed.” The securities firms, reckless traders, hedge funds, rank speculation and egregious leverage are viewed today as the major culprits. Executive pay and Wall Street bonuses are pilloried for fomenting dangerous excess. Others trumpet the failure of regulation and corporate governance. Some attribute the mess to the Asian propensity to save. There’s a more sensible case that flawed banking and Wall Street risk models played an integral role in the fateful Bubble. Many that participated in the bountiful upside of the speculative Bubble these days posit that the rating agencies were at fault for garnishing “AAA” ratings on Trillions of risky securities and debt instruments. And a very strong argument can be made that hundreds of Trillions of derivatives played a fundamental role in the near financial implosion. But how could it be that so many things went so wrong all at the same time?

I have over the years expressed disdain with the “free market ideologues” for their steadfast refusal to even contemplate the possibility that “Capitalism” could possess vulnerabilities of need of recognition and corrective action. Yet, economic history is replete with boom and bust cycles, along with a bevy of post-Bubble writings providing us fertile ground for cogent analysis of system vulnerabilities. Contemporaneous analysis during the Great Depression focused clearly on the acutely susceptible U.S. Credit system that emerged from “Roaring Twenties” lending and speculative excesses. During the forties, fifties and even into the early sixties there was some adroit analysis of the Credit system’s role in the boom and subsequent depression. This entire fruitful line of analysis was, however, stopped dead in its tracks with the emergence of a revisionist view of the twenties as the “Golden Age of Capitalism” needlessly terminated by post-crash policy blunders.

The Great Depression and today’s turmoil expose Capitalism’s vulnerabilities. And as easy (and accurate) as it would be for me to write that the problem lies first and foremost in the “Credit system,” I have come to believe that it is vital to dig deeper to get to the root of the problem: Capitalism’s Greatest Vulnerability lies with Risk Intermediation.

The essence of Capitalism is one of a predominantly private system of allocating resources based on market price signals. A private Credit mechanism is fundamental to financing the economic system in a manner that effectively allocates both financial and real resources. And we can stop right here and recognize potential pitfalls. First, Credit flows may be inadequate to finance sound investments or to sustain economic activity. Second, there may be too much Credit. I have for some time argued that Credit excess (“Credit inflation”) is the Bane of Capitalism. Credit excesses distort the various costs of finance throughout the system, while inflating asset prices and fostering distorted spending and investing patterns (among other effects). And, importantly, Credit inflation inherently fosters self-reinforcing Credit inflation through asset price, economic, and speculative Bubble dynamics. In short, “Credit excess begets Credit excess,” with its subtle but corrosive effect upon pricing mechanisms.

But how on earth does the always-existing nature of “Credit Begetting Credit” somehow morph into the history’s greatest Credit Bubble? One way: Unfettered Risk Intermediation.

I often referred to “Wall Street Alchemy” - the process of various methods of intermediation (Wall Street securitization structures, myriad Credit insurance and financial guarantees, liquidity arrangements, dynamic hedging, explicit and implicit government backing, etc.) transforming risky loans into coveted instruments perceived by the marketplace as safe and liquid (“money-like”). I have also theorized that a boom predominantly financed by, say, junk bonds would never run too far before the market loses its appetite for the inflating quantity of (conspicuously) risky debt. In contrast, our recent Credit Bubble was financed by endless Trillions of “AAA” debt instruments (GSE debt, MBS, ABS, CDOs, CP, “repos”, auction-rate securities, top-rated guaranteed muni debt, Treasuries, bank deposits and such) ran to unmatched excess.

Importantly, there was a direct relationship between our contemporary system’s capacity to intermediate Credit risk and the expanding scope of the Bubble. Over years, risk was in varying degrees distorted, camouflaged, or deceptively concealed to the point that it was no longer even possible to monitor, analyze or regulate it. Worse yet, the risk intermediation process was self-reinforcing instead of self-adjusting and correcting. Wall Street “alchemy” was the true source of this period’s “easy money.”

Our Credit system’s capacity to intermediate Trillions of mortgage and consumer debt into “money-like” instruments was instrumental in fueling real estate and asset Bubbles throughout. It was the capacity of Credit system intermediation to create Trillions of instruments (chiefly Treasuries, agency debt, MBS, and “Repos”) perceived as safe and liquid by our foreign trading partners that accommodated our massive current account deficits (and attendant domestic and international imbalances). It was contemporary risk intermediation at the heart of a historic mispricing of finance for, in particular, mortgages and U.S. international borrowings. And it was the potent interplay of contemporary risk intermediation and contemporary monetary management/central banking (i.e. “pegged” interest rates, liquidity assurances, and asymmetrical policy responses) that cultivated unprecedented financial sector and speculator leveraging.

Most historical analyses of busts (going back about 300 years to John Law!) focus on banking ineptness, negligence, excesses and nuances. Banks, creating “money-like” (i.e. deposit) liabilities in the process of intermediating loans, have historically been at the center of boom/bust cycles. Contemporary finance – with its focus on marketable debt instruments - took intermediation risk to a completely new danger level. For one, traditional bank capital and reserve requirements no longer provided any restraint on the quantity of Credit that could be extended and intermediated (in the “market” or “off balance sheet”). Furthermore, the marketable nature of these instruments (created in the intermediation process) cultivated speculative demand for leveraging higher-yielding securities (i.e. hedge funds buying collateralized debt obligations that had acquired private-label subprime MBS). Cheap finance literally flooded the riskiest sectors of the economy

All of this led to extreme systemic distortions in the pricing of risk - along with the attendant massive over-expansion of Credit and the economy-wide (and global) misallocation of real and financial resources. Buyers of intensively intermediated instruments (say “AAA” senior CDO tranches or auction-rate securities) in many cases could not have cared less with regard to the type of underlying loans being financed. Elsewhere, the buyer (leveraged speculator or trade partner) of agency securities could not have been less concerned with GSE balance sheet issues or California home prices. This entire process of contemporary (marketable instrument-based) intermediation developed an overwhelming propensity for financing asset-based loans instead of real economic wealth-producing investment (unlimited supplies of mortgages were viewed as a more appealing asset class than limited amounts of corporate loans). It is not only in hindsight that this process of risk intermediation should be viewed as central to system asset price distortions and economic maladjustment.

I am tempted to write “I am as tired writing about the previous Credit Bubble as readers are reading about it.” But I’m not tired. And this topic is not as much about rehashing the past as it is about providing a perspective as to why I believe the current course of policymaking will inevitably end in failure. Why? Because of the very complex and unresolved issue of Risk Intermediation.

Wall Street “finance” self-destructed in the process of intermediating Trillions of risky loans. It was the quantity of Credit and the nature of resulting spending patterns (resource allocation) that both doomed this endeavor and ensured a deeply maladjusted economic structure. This terribly flawed financial structure has morphed into a system where our government has stepped forward to supplant Wall Street as predominant risk intermediator. Basically, the Fed and Treasury are in the process of intermediating risk on a system-wide basis – to the tune of tens of Trillions – with little possibility of extricating themselves from this endeavor going forward.

This development may be welcomed by Wall Street and the markets - and it certainly goes a long way toward getting the Credit wheels rolling again. It would be expected to help spur some level of global economic “recovery.” I would argue, however, at the end of the day we will see that it has only exacerbated the problems of risk mispricing, Monetary Disorder, financial and real resource misallocation, and economic maladjustment.

Our Capitalistic system has been severely injured. I don’t expect meaningful structural recovery until there is some semblance of restoration to our Credit system’s mechanism for the pricing and allocation finance. This, I believe, will require our system to wean itself both off of its dependence on enormous Credit expansion and away from Washington’s newfound role of chief system risk intermediator and allocator (the “Government Finance Bubble).

http://www.prudentbear.com/index.php/commentary/creditbubblebulletin

Mistakes Beget Greater Mistakes:~ Noland

March 18 - Bloomberg (Kathleen Hays and Dakin Campbell): "Bill Gross, co-chief investment officer of Pacific Investment Management Co., said the Federal Reserve's purchases of Treasuries and mortgage securities won't be enough to awaken the economy. 'We need more than that,' Gross said... The Fed's balance sheet 'will probably have to grow to about $5 trillion or $6 trillion,' he said."

"The problem with discretionary central banking is that it virtually ensures that policy mistakes will be followed by only greater mistakes." Here, I'm paraphrasing insight garnered from my study of central banking history. Naturally, debating the proper role of central bank interventions - in both the financial sector and real economy - becomes a much more passionate exercise following boom and bust cycles. The "Rules vs. Discretion" debate became especially heated during the Great Depression. It was understood at the time that our fledgling central bank had played an activist role in fueling and prolonging the twenties boom - that presaged The Great Unwind. Along the way, this critical analysis was killed and buried without a headstone.

I believe the Bernanke Fed committed a historic mistake this week - compounding ongoing errors made by the Activist Greenspan/Bernanke Federal Reserve for more than 20 years now. I find it rather incredible that Discretionary Activist Central Banking is not held accountable - and that it is, instead, viewed critical for the solution. Apparently, the inflation of Federal Reserve Credit to $2.0 TN was judged to have had too short of a half-life. So the Fed is now to balloon its liabilities to $3.0 TN, as it implements unprecedented market purchases of Treasuries, mortgage-backed securities, agency and corporate debt securities. And what if $3.0 TN doesn't go the trick? Well, why not the $5 or $6 TN Bill Gross is advocating? What's the holdup?

Washington fiscal and monetary policies are completely out of control. Apparently, the overarching objective has evolved to one of rejuvenating the securities and asset markets. I believe the principal objective should be to avoid bankrupting the country. It is also my view that our policymakers and pundits are operating from flawed analytical frameworks and are, thus, completely oblivious to the risks associated with the current course of policymaking.

Today's consensus view holds that inflation is the primary risk emanating from aggressive fiscal and monetary stimulation. It is believed that this risk is minimal in our newfound deflationary backdrop. Moreover, if inflation does at some point begin to rear its ugly head the Fed will simply extract "money" from the system and guide the economy back to "the promised land of price stability." Wording this flawed view somewhat differently, inflation is not an issue - and our astute central bankers are well-placed to deal with inflation if it ever unexpectedly does become a problem.

Our federal government has set a course to issue Trillions of Treasury securities and guarantee multi-Trillions more of private-sector debt. The Federal Reserve has set its own course to balloon its liabilities as it acquires Trillions of securities. After witnessing the disastrous financial and economic distortions wrought from Trillions of Wall Street Credit inflation (securities issuance), it is difficult for me to accept the shallowness of today's analysis. In reality, the paramount risk today has very little to do with prospective rates of consumer price inflation. Instead, the critical issue is whether the Treasury and Federal Reserve have set a mutual course that will destroy their creditworthiness - just as Wall Street finance destroyed theirs.

The counterargument would be that Treasury and Fed stimulus are short-term in nature - necessary to revive the private-sector Credit system, asset markets and the real economy. That, once the economy is revived, fiscal deficits and Fed Credit will recede. I will try to explain why I believe this is flawed and incredibly dangerous analysis.

First of all, for some time now global financial markets and economies have operated alongside an unrestrained and rudderless global monetary "system" (note: not much talk these days of "Bretton Woods II"). There is no gold standard - no dollar standard - no standards. I have in the past referred to "Global Wildcat Finance," and such language remains just as appropriate today. Finance has been created in tremendous overabundance - where the capacity for this "system" to expand finance/Credit in unlimited supplies has completely distorted the pricing for borrowings. As an example, while Total US Mortgage Credit growth jumped from $314bn in 1997 to about $1.4 TN by 2005, the cost of mortgage borrowings actually dropped. It didn't seem to matter to anyone that supply and demand dynamics no longer impacted the price of finance. Yet such a dysfunctional marketplace (spurred by unrestrained Credit expansion) was fundamental in accommodating Wall Street's self-destruction.

Today, the markets will lend to the Treasury for three months at 21 bps, 2 years at 84 bps and 30 years at 371 bps. I would argue that this is a prime example of a dysfunctional market's latest pricing distortion. As it did with the Mortgage Finance Bubble, the marketplace today readily accommodates the Government Finance Bubble. And while on the topic of mortgage finance, with the Fed's prodding borrowing costs are back below 5%. This cost of finance also grossly under-prices Credit and other risks.

I would argue that market pricing for government and mortgage finance remains highly distorted - a pricing system maligned by government intervention on top of layers of previous government interventions. These contortions become only more egregious, and I warn that our system will not actually commence its adjustment and repair period until some semblance of true market pricing returns to the marketplace. Yet policymaking has placed peddle to the metal in the exact opposite direction.

The real economy must shift away from a finance and "services" structure - the system of "trading financial claims for things" - to a more balanced system where predominantly "things are traded for other things." Such a transition is fundamental, as our system commences the unavoidable shift to an economy that operates on much less Credit of much greater quality. But for now, today's Washington-induced distorted marketplace fosters government and mortgage Credit expansion - an ongoing massive inflation of non-productive Credit. I would argue this is tantamount to a continuation of Bubble Dynamics that have for years misallocated financial and real resources. In short, today's flagrant market distortions will not spur the type of economic wealth creation necessary to service and extinguish previous debts - not to mention the Trillions and Trillions more in the pipeline.

Market confidence in the vast majority of private-sector Credit has been lost. The Bubble has burst, and the mania in "Wall Street finance" has run its course. The private sector's capacity to issue trusted ("money-like") liabilities has been greatly diminished. The hope is that Treasury stimulus and Federal Reserve monetization will resuscitate private Credit creation. The expectation is that confidence in these instruments will return. I would counter that once government interventions come to severely distort a marketplace it is a very arduous process to get the government out and private Credit back in (just look at the markets for mortgage and student loan finance!). This is a major, major issue.

The marketplace today wants to buy what the government has issued or guaranteed (explicitly and implicitly). Market operators also want to buy what our government is going to buy. In particular, the market absolutely adores Treasuries, agency MBS, and GSE debt. There is no chance such a system will effectively allocate resources. There is no prospect that such a financial structure will spur the necessary economic overhaul. None.

There is indeed great hope policymakers will succeed in preserving the current economic structure. On the back of massive stimulus and monetization, the expectation is that the financial system and asset prices will stabilize. The economy will be, it is anticipated, not far behind. And the seductive part of this view is that unprecedented policy measures may actually be able to somewhat rekindle an artificial boom - perhaps enough even to appear to stabilize the system. But seeming "stabilization" will be in response to massive Washington stimulus and market intervention - and will be dependent upon ongoing massive government stimulus and intervention. It's called a debt trap. The Great Hyman Minsky would view it as the ultimate "Ponzi Finance."

As I've argued on these pages, our highly inflated and distorted system requires $2.0 TN or so of Credit creation to hold implosion at bay. It is my belief that this will ONLY be possible with Trillion-plus annual growth in both Treasury debt and Federal Reserves liabilities. Private sector Credit creation simply will not bounce back sufficiently to play much of a role. Mortgage, consumer, and business Credit - in this post-Bubble environment - will not return to much of a force for getting total system Credit near this $2 TN bogey. In this post-Bubble backdrop, only government finance has a sufficient inflationary bias to get Trillion-plus issuance. But the day that policymakers try to extract themselves from massive stimulus and monetization will be the day they risk an erosion of confidence and a run on both government and private Credit instruments. Also as I've written, once the government printing press gets revved up it's very difficult to get it to slow down. This week currency markets finally took this threat seriously.

Link

Bank of England warns tensions in banking system at fever pitch

Investors have restrained the amount they are willing to lend, banks have grown reluctant to entrust their cash to each other and levels of stress in the system have hit new peaks, according to the Bank's Quarterly Bulletin.

The Bank's chief economist, Spencer Dale, warns in the report, published today, that: "Against the background of a significant and synchronised weakening in international economic activity, market conditions generally remained strained. In particular, bank funding markets became more difficult again reflecting renewed concerns about the scale of potential credit losses and write-downs facing banks."

The report lays bare the fears investors currently have about the creditworthiness of Britain's biggest banks. It reveals that a key measure of interbank health - the spread between the London Interbank Offered Rate (Libor) and expected interest rate levels had "started to widen again" while "contacts reported some increased reluctance to lend to banks beyond very short maturities."

The main worry haunting investors is the threat that banks could be nationalised and that financial institutions are harbouring "ongoing balance sheet constraints".

However, most worryingly, it warns that the credit default swap spread rates on large banks - a key measure of concerns about their possibly insolvency - picked up to their highest level since just before the collapse of Lehman.

The Bulletin says: "With a number of banks reporting large credit losses and write-downs for 2008 Q4, perceptions about bank counterparty risk appeared to pick up again. Consistent with that, premia on UK banks' credit default swaps rose, and approached levels reached in October 2008 when fears about system-wide failure were intense."

link

The real deal, more or less, is common sense

http://prudentinvestor.blogspot.com/2009/03/capitalism-socialism-and-democracy-and.html


SUNDAY, MARCH 15, 2009
Capitalism, Socialism and Democracy - and Common Sense
Monitoring financial and political news has become a very depressing task recently.
While the USA enjoyed a short fairy tale period between president Obama Barack's election and his inauguration, the staccato of catastrophic news has accelerated into a crescendo of crisis since January. Financial TV gushes with appearances of the global top brass, united in the goal to fend off the consequences of 22 years of highly expansive monetary policy, free market gospel and excessive leverage on public and private levels, but clueless how to achieve this.
Europe fares still worse. What looks like a nosedive in American economic activity evokes images of a freefall in the old world at close range.
Overindebted consumers, now also fearing the increasing possibility of losing their jobs and tightening the grip on wallets thinned by rising public service fees, overshadow the progress in the East.
China's exports hit a roadblock in January with no signs of an improvement and India has to sober up from a credit financed shopping spree, now that the demand for online personal valets is on a steep decline and endangers many a call centre.
Daily closures in the Western hospitality industry clearly mirror a new mindset of frugality among consumers.
Eastern Europe is the ticking time bomb in the backyard of the Eurozone. The region currently wakes up to the devastating effects of forex borrwoing to finance consumer goods. Now the local currencies languish close to their record lows.
Major forecasters offer no relief. The World Bank, the OECD and many other institutions expect the global economy to shrink for the first time in ages. Deutsche Bank recently warned that the German economy could shrink an unprecedented 5% this year. This may still be optimistic given the recent halving of German machinery orders.
"They" Don't Have a Clue
While first being overwhelmed by the fastest contraction in economic activity in recorded history, hanging on the lips of central bankers and politicians in order to get an idea about the future, I have rescinded from this time-wasting procedure for a simple reason. "They" don't have any clue how to handle the rapid disintegration of the world's financial fiat currency system.
Memorializing financial history the current crisis finds multiple precedents. All economic crises in the western hemisphere have rooted in excessive monetary expansion that is only possible under a fiat currency system.
One cannot blame politicians for their preference of a monetary system that allows to catch voters with perks and benefits that will have to be paid for by future generations. But how could I cast a vote for them when they ultimately hang on to economic theories that have never proven to work in the last 4 centuries??
It is a fact that the purchasing power of all unbacked fiat currencies has always been wiped out by inflation. Floating currencies don't float. They only sink at different speeds.
This leads to the ultimate crux in the enduring discussion how to mitigate and solve the crisis. This is not a problem of the acting persons but a problem of the domineering theories where the supremacy of fiat money does never get questioned in the first place.
The global big-wig elite comprised of central bankers, bankers and CEOs, finance ministers and other government members, clings on to a bizarre mix of empty free market phraseology that stands in deep contrast to recent nationalizations on both sides of the Atlantic, and Keynesian attempts to jumpstart the economy with new debts on top of those that have become unbearable already, leading to the current disastrous environment.
Plunging stock markets may be a good indicator that investors correctly mistrust public promises that those in charge have a plan other than to echo the fallacies of John Maynard Keynes, who preached anti-cyclical government intervention to revv up the economic engine. But they conveniently forget the other part of Keynes' model. Keynes also talked about government savings in the fat years in order to finance the deficit spending periods.
At the same time the government's share in the economy rests well above the 40% threshold, hardly a proof that capitalism has developed according to the slogans of promoters from all political camps.
Conservative and progressive political camps apply the old standard fare. Hypocritical calls from the right that demand to let markets work their way through this crisis of epochal proportions are nothing but empty words, given the string of nationalizations initiated by comrades Henry Paulson, Britain's Alistair Darling and Germany's Peer Steinbrueck, all with a strong conservative background.
Capitalism, Socialism Converge in Their Late Stages
Current events disclose a remarkable convergence of capitalism and socialism in their final stages. A privileged few cronies enjoy the perks of power and money while the other 95% have to come to terms with policies that are beneath contempt to the true interests of the average citizen/consumer.
It is not in my interest to prop up ailing banks with my future tax payments who steered themselves into unsustainable profit expectations by rejecting common sense for years.
Peer pressure adds to the systemic problem that no banker can forego profits made by all others. Going back to 2005 there were only a handful of bloggers, economists and market pundits who stood out by warning well ahead of August 2007 when irrational exuberance vanished overnight and the credit crunch set in.
Calming official voices have failed to inform the public correctly ever since.
ECB president Jean-Claude Trichet erred especially at the beginning of the crisis, spreading the wrong word that central banks are capable of ending the crisis. By now he concedes that the end may be far off.
Fed chairman Ben Bernanke did not perform better. Both his speeches and the FOMC's monetary policy of the past 18 months are undeniable proof that the Fed has been behind the curve since the onset of the crisis, fulfilling former Fed chairman Paul Volcker's predictions that US fiscal and monetary policy would be "too little, too late."
The short breath of relief in the aftermath of Obama Barack's electoral victory has meanwhile given way to a far more somber scenario. The president's daily live appearances may show his commitment to the American people, but they lack any guiding substance. Neither he nor treasury secretary Tim Geithner have offered more than vague promises to fix the system, unfortunately omitting anything that could be construed as an effective start to tackle the worst insolvency crisis in history. Do they have a plan, it has to be asked repeatedly until they come forward with an unambiguous policy that shows a willingness to save and distribute government money to those in need.
The situation in the final era of busting fiat currencies reminds me a bit of the system wars between a sleek Apple MacBook Pro and the failure-prone Windows software architecture. Although 90% of PCs are running Windows this does not make them better computers. Remember Microsoft CEO Steven Ballmer who wrote in an email last year that he would get a Mac were he not working for Microsoft!?
The same happens on capital markets. Although the history of fiat currencies is a stream of hyper inflation tales the gold standard does not even get discussed in top circles. This will be hard to overcome as the hopeless indebtedness of the first world can only be written off via hyper inflation or war.
Also do not forget that the world has alrady turned upside down. Now it is the former paupers financing the profligacy of the western money sultans who wrongly thought that creating more paper equals more wealth.
What Happened To Common Sense?
The failure to apply common sense in a world where external business consultants direct company fortunes with their one size fits all templates appears systematic. Over-specialization has elevated many consultants to their own level of incompetence.
Take the car industry for instance. German producers still bet heavily on HP monsters capable of 150 mph top speeds. That's maybe useful for 3 AM commutes between Frankfurt and Hamburg, but in the daily traffic jam choking all metropolitan areas worldwide I would rather prefer some sort of living room on 4 wheels.
The Wrong Dogma of Ever Expanding Credit
Monetary policy has the same shortcomings. Blind to any other model than the perma-failing fiat currency ideology central banks shy away from any thought other than the current - but probably outdated - dogma of ever expanding credit.
Continuous failings of the fiat money system in the past 3 centuries have been aggressively ignored by economists and those actually involved in the economic process. Apart from Hungarian Antal E. Fekete there are no scholars researching the virtues of a gold standard that held inflation close to zero for more than a century in the USA before the Federal Reserve was formed.
Central banks have certainly done an excellent job in demon(eti)zing mankind's oldest currencies: gold and silver.
I am always appalled that the majority of fund managers still doubt the virtues of the only asset that is not somebody else's obligation.
As the whole world is about to suffer dearly from a crisis that has its roots in the irresponsible easy money policy of central banks I begin to wonder why there are no calls for responsibility. Like 9/11, where not a single military was charged with the greatest blunder in American defense policy, all those responsible for the current economic mess have been sent home with a golden parachute after proving their incompetence in the field. This is morale hazard and socialism for the rich at its best.
Who Will Be Held to Account?
While stealing an apple in a grocery store can earn a hungry impoverished evictee a life sentence if it was the third apple he grabbed to fill his revolting stomach, Ponzi schemers like Bernie Madoff are treated with silk gloves. Bankrupting thousands of investors to the tune of $50 billion, Bernie was let to enjoy his luxury condo another 3 months. What an awkward reminder of the sad truth that you are a murderer when killing one while one advances to a statesman when having killed thousands. The same seems to apply for fund managers who bet their clients money on exotic derivatives. It can be safely assumed that Madoff is only the tip of the iceberg.
The breakdown of morale at the wealthiest levels came with the markets nosedive to its current lows: When the going gets tough, everybody runs for the cover of cash.
While the banking crisis in the Great Depression took ist victims, today's Wall Streeters can only be seen jumping out of windows with fat golden parachutes. So much about the self-esteem of the posterboys who had never tired to preach the virtues of performance optimization and risk-taking.
Those few changes made at the top executive level are only window dressing a yet unsolved problem: Out goes the guy who didn't see it coming, and in comes another guy who had not see the oncoming disintegration of American (or European) banking. Is this really the needed change? I highly doubt it.
Politicians Asleep at the Wheel
Our honorable representatives in national and supra-national parliaments are asleep at the wheel meanwhile. Their ears filled with SOS calls from the banking lobbies they are not shy to announce 14-digit bailout packages as if they had only to reach into the state's coffers.
This is not the case anymore. After 4 decades of Keynesian politics all Western countries find themselves at the top of international creditor lists, meaning they have only excelled in creating more public debts instead of obeying the basic rule of commerce: You cannot live on debts forever.
American and European politicians are in for a rude awakening any day soon. China has already publicly voiced its concerns about the solidity of US debt paper in light of an economy caving inward.
The enormous self-destructive dynamics of the current economic hurricane may bring rapid change. People were trampled to death when Wal-Mart offered cheap holiday packages. What will happen if there is a food shortage?
I do not fear that there will be not enough food. But the fact that foods goes through 20 transport stations, on average, until it lands on our table, leave enough risk factors for possible supply disruptions that a recession inevitably creates.
Politicians, now still willing to throw gazillions of fresh fiat money, will very soon have to come to terms with a broadly changed capital market. Close to a billion mostly indebted Western consumers are not exactly the kind of clientele the emerging nations in the eastern hemisphere would like to have. Confronted themselves by faltering economies due to plunging exports they are more likely to use their national savings for domestic stimuli instead of feeding a Western elite that was entirely wrong in its predictions about economic developments although deteriorating indicators had written it on the wall since at least 2005.
Western States Find Themselves in the Role of Beggars
10% unemployment in the USA and not much less in the EU, at least according to official figures, will not make raising capital any easier.
While Mr. Obama certainly radiates a strong commitment to change America's fate, it can nevertheless be denied that he is the biggest beggar in the world who has to come up with some $5 billion in new funds every day, 365 days a year, in order to keep the US in its ill-fated tracks where the military's role seems only to grow.
The situation is not much different in Europe. Starting with my home country Austria that turns out to become the biggest victim of the financial recolonization of the former Austro-Hungarian empire and will probably need IMF help at some later stage, faltering property bubbles in other European parts will only serve as a precursor to a wave of corporate and personal bankruptcies.
Investors have already shed quite some fat last year. According to venture capital group Blackstone, in 2008 $50 trillion or half of the world's savings, were eradicated by crashing stock markets. Or do you know anybody who still made a good bundle last year?
This will limit lending for governments too, when even the ultra-rich have downgraded to merely ultra-rich within a year.
A Struggle of 2 Ideologies That Have Both Failed
This leads me back to my headline. As we have now witnessed the complete and total failure of both Communism and Capitalims within 2 decades the question has to be allowed why politicians still stare at the same worn out pages of their PR cook books, offering only more of the same nonsense that has brought the global economy down to its knees in the first place.
The dispute whether state management or private management is the better option is so long meaningless as we are not able to improve the safeguards that effectively block opportunities to loot the system. As we see these days it often was not a problem that authorities did not know about possible felonies among fund managers and bankers, but that the whole regulation procedures were not enacted against the respective cronies profiting illegally from it. IMHO effective regulation can only be enacted with a focus on true transparency. Why not the Swedish model, where all public documents are indeed public and accessible online?
When taking a closer look at the EU, I notice alarming trends towards more secrecy of this supra-national body that intervenes in the daily lives of some 500 million Europeans. I cannot shed the impression that current political activity serves more the ruling powers who keep telling us they are proteting democracy for us while a slew of police state like legislative shows the opposite. Do they want to save democracy from their citizens who may think very differently than the elected representatives.
As long as there is cronyism and tightly knit elites both political models mainly serve their promoters but not the voters. It is time to think about a 3rd way that combines the motivating factors of capitalism with a social security net that is an expression of the development of our civilization. After all, we should be able to talk instead of wielding ever more sophisticated sticks and stones in countless wars around the world.
Labels: central banks, credit, crisis, ecb, europe, Fed, fiat money, usa

Credit bubble bulletin ~ Big Numbers

February 24 – Bloomberg (Mark Pittman and Bob Ivry): “…the U.S. government has pledged more than $11.6 trillion on behalf of American taxpayers over the past 19 months, according to data compiled by Bloomberg. Changes from the previous table, published Feb. 9, include a $787 billion economic stimulus package. The Federal Reserve has new lending commitments totaling $1.8 trillion. It expanded the Term Asset-Backed Lending Facility, or TALF, by $800 billion to $1 trillion and announced a $1 trillion Public-Private Investment Fund to buy troubled assets from banks. The U.S. Treasury also added $200 billion to its support commitment for Fannie Mae and Freddie Mac…”


The Administration’s new budget projects an astounding $1.75 TN fiscal 2009 federal deficit - or about 12% of GDP. Federal outlays are expected to surge 32% this year to $3.94 TN. In nominal terms, the deficit is set to quadruple the previous all-time record. In percentage terms one has to return back to the war economy of the 1940s to find anything comparable.

Yesterday, Fannie Mae reported a fourth quarter loss of $25.2bn, bringing the company’s second-half 2008 shortfall to more than $50bn. Non-performing assets surged a stunning 87% during the quarter to $119.2bn, a three-fold increase in just 12 months. Having more than depleted its razor-thin capital base, Fannie requested $15.2bn of additional Treasury support (from the $200bn promised).

The FDIC announced yesterday a $26.2bn Q4 2008 loss for the banking system. The Office of Thrift Supervision reported that our nation’s Savings & Loans lost $3.0bn during the final quarter of the year, increasing 2008 losses to a record $13.4bn. General Motors announced a $9.6bn Q4 loss, increasing its annual loss to a staggering $30.9bn. Analysts are expecting even greater losses to be reported at AIG and Citigroup.

The dimensions of the reported deficits and losses are not easily digested; the scope of the today’s systemic problems not so easily comprehended. I’ll push ahead with efforts to use the Credit Bubble Framework as an analytical tool for making some sense of the historic nature of the unfolding bust.

Let’s try to place the various huge – and increasingly numbing – deficit/loss numbers (attendant with this bust) into coherent context. For such an endeavor it is imperative to first examine the preceding boom. This week, in particular, seems an appropriate time to summarize, in Credit terms, the incredible dimensions of the fateful inflationary Bubble.

From the Federal Reserve’s “flow of funds” report, we can see that Total System Credit (non-financial and financial) ended 1995 at $18.475 TN. By the end of 2007, this number had inflated to $49.882 TN, for growth of 170% in only 12 years. During this period, Household Debt swelled 184% to $8.959 TN; Non-farm Corporate Debt 130% to $3.832 TN; and State & Local Government borrowings 109% to $2.192 TN. Federal debt expanded “only” 41% to $5.122 TN. Rest of World holdings of U.S. assets inflated 365% to $16.048 TN. While significantly trailing Credit growth, GDP nonetheless bulged 87% during this period.

Over the past decade, the “optimists” often cited the federal government’s positive fiscal position as evidence of the health of the overall economy and soundness of our prosperity. It should be clear these days that the protracted boom's massive inflation of private-sector Credit had grossly inflated government receipts (among other things). Indeed, over the 12-year period Federal Receipts inflated 88% (to $2.651 TN) and State & Local receipts increased 92% (to $1.903bn). This crucial facet of the inflationary boom spurred federal and state & local spending growth of 80% and 93%, respectively.

State & Local governments will now attempt to maintain these inflated levels of expenditures, while the federal government will move aggressively to grossly inflate already inflated spending. The budget now calls for federal expenditures this year to approach $4.0 TN. This compares to spending of about $1.6 TN back in 1995. The federal deficit is projected to expand by a combined $3.0 TN during fiscal years ’09 and ’10. This would amount to a 60% increase in federal debt in only two years.

Today’s unparalleled expansion of federal debt and obligations is being dressed up as textbook “Keynesian.” It’s rather obvious that we are in dire need of some new books, curriculum and economic doctrine. But from a political perspective, the title is appropriate enough. From an analytical framework perspective such policymaking is more accurately labeled “inflationism” – a desperate attempt to prop inflated asset prices, incomes, business revenues, government receipts, and economic “output”. There have been many comparable sordid episodes throughout history, and I am not aware of any positive outcomes.

The Administration’s budget earmarks an additional $750 billion as a contingency for added financial sector bailouts. Fed data nicely illuminate the dimensions of the financial sector's problem. Between 1996 and 2007, Total Mortgage Debt expanded 220% to $10.061 TN. Total GSE Agency Securities (debt and MBS) tripled to $7.397 TN. The ABS market inflated 580% to $4.50 TN. Over this 12-year period, Bank Assets swelled 150% to $11.194 TN. Securities Broker/Dealer assets ballooned 440% to $3.10 TN. In 12 years, Total Financial Sector borrowings expanded 300% to $16.90 TN – in the process creating a Credit and liquidity junky out of U.S. asset markets and the real economy. Today, the deeply impaired financial sector is incapable of assuaging the system's bloated Credit needs.

For perspective, a little compare and contrast is in order. Total Mortgage Debt increased $188bn in 1995, compared to $1.437 TN growth in 2005, $1.410 TN in 2006, and $1.098 TN in 2007. Agency MBS increased $98bn in 1995, compared to $609bn growth last year. The ABS market grew $127bn in 1995, in contrast to the $725bn growth in 2005 and 2006’s $808bn. Bank Credit expanded $273bn in 1995, compared to 2007’s $788bn and 2008's $1.294 TN. Broker/Dealer assets expanded $113bn in 1995, a small fraction of 2007’s fateful $615bn growth.

This unprecedented Credit explosion inflated asset prices as well as incomes. Between 1996 and 2007 National Incomes inflated 90% to $12.271 TN. Compensation of Employees surged 86% to $7.812 TN. Bubble Impacts were even more dramatic with respect to the Household (including non-profits) Balance Sheet. In twelve short years, Household Sector Asset holdings inflated $43.685 TN, or 133%, to $76.549 TN. Despite Household Liabilities surging 185% to $14.379 TN, Household Net Worth (assets minus liabilities) inflated $34.360 TN, or 124%, to $62.170 TN. Importantly, this Massive Inflation of Perceived Financial Wealth over years glossly distorted the quantity and pattern of spending throughout the real economy.

This historic Credit-induced inflation of Household Incomes and Net Worth was at the core of deep structural maladjustment to the U.S. “Bubble” economy. The implosion of “Wall Street finance” (in particular the collapse of Broker/Dealer financing, private-label MBS and other ABS, and various methods of leveraging mortgage, corporate and other securities) marked the demise of various Bubbles, including ones in private-sector debt securities, residential and commercial real estate, equities, and Household Net Worth more generally. In the final analysis, the bust has left multi-Trillion dollar holes in various sector balance sheets. Moreover, Patterns of Spending throughout the economy have been forever altered. Year-after-year of reckless lending has quickly come home to roost in a Big way.

Our federal government has commenced the process of attempting to fill holes through the massive inflation of government Credit and obligations (by the Trillions). Depending on the reader’s perspective, I risk appearing either the master of the obvious or a rabid sensationalist. Yet the stakes associated with the current course of fiscal and monetary policy are absolutely momentous. And I am compelled to write that “if you’re not confused you don’t understand the nature of the problem.”

What are the ramifications and consequences associated with U.S. deficits approaching 12% of GDP? Over the short and intermediate terms? Will unprecedented fiscal and monetary measures stem financial sector implosion? Will Washington’s efforts work to bolster a faltering Bubble Economy, or will they instead only tend to delay unavoidable structural adjustment? Will the Treasury market continue to so easily accommodate reflationary efforts? How long will the dollar remain relatively stable in the face of massive growth in U.S. Non-Productive Credit? Will multi-Trillions of government debt and obligation expansion help to resuscitate private-sector Credit creation - or will it instead simply destroy the Creditworthiness of the entire economy?

Not uncharacteristically, I pose more questions than I have answers. But I do fear that we now face Trillion dollar deficits as far as the eye can see. I don’t expect “Keynesian” policies to have much success in reinvigorating busted asset markets. I’ll be surprised if private-sector Credit creation bounces back anytime soon. I fear policymaking will do more harm than good when it comes to needed economic restructuring. And my worst fears of policymaking (fiscal and monetary, democrat and republican, national and local) bankrupting the country are being anything but allayed. Similar to my belief that mortgage Credit growth should have been limited to, say, no more than 4 or 5% annually during the boom, there is today a very serious need to incorporate some reasonable limits on the expansion of federal debt and obligations.