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2011 September 11 Sunday
Defense Of Bondholders Holding Back Economic Recovery

John Hussman argues governments are making a mistake by defending bondholders rather than allowing losses would cut the debt overhang that is weighing down economies. Agreed.

The global economy is at a crossroad that demands a decision - whom will our leaders defend? One choice is to defend bondholders - existing owners of mismanaged banks, unserviceable peripheral European debt, and lenders who misallocated capital by reaching for yield and fees by making mortgage loans to anyone with a pulse. Defending bondholders will require forced austerity in government spending of already depressed economies, continued monetary distortions, and the use of public funds to recapitalize poor stewards of capital. It will do nothing for job creation, foreclosure reduction, or economic recovery.

So far the banks that hold large amounts of sovereign debt are being defended against losses by their governments. The European lending to Greece, Ireland, and other heavily indebted countries has as one of its major aims the prevention of the bankruptcy of northern European banks that hold large amounts of PIIGS debt. Too much debt. What do to? Create more debt to fund the interest payments on the existing debt. It is a pyramid scheme that will collapse eventually with far more pain.

Hussman thinks the bondholders can afford the losses. I'm more skeptical. I think bondholders need to take major losses. But we need an agreed structure that allows the losses without causing a financial panic.

The alternative is to defend the public by focusing on the reduction of unserviceable debt burdens by restructuring mortgages and peripheral sovereign debt, recognizing that most financial institutions have more than enough shareholder capital and debt to their own bondholders to absorb losses without hurting customers or counterparties - but also recognizing that properly restructuring debt will wipe out many existing holders of mismanaged financials and will require a transfer of ownership and recapitalization by better stewards. That alternative also requires fiscal policy that couples the willingness to accept larger deficits in the near term with significant changes in the trajectory of long-term spending.

The problem is even bigger than the current mainstream projections show because of Peak Oil. Therefore even if bank and sovereign bondholders take big haircuts we aren't going to return to the old economic growth trend. At beset economic growth will be low or negative. More debt will go bad as a result. Future tax revenues will be lower as demands on governments rise from the unemployed and retired. Debt haircuts will just make conditions less bad than they otherwise would be.

As an example of the excessive bias toward protecting bondholders at the expense of everyone else look at the disagreement between the European Central Bank and the Irish government over whether bondholders of senior unsecured unguaranteed debt should get repaid after 2 major Irish banks failed. When companies fail bond holders take losses. So why should bond holders get bailed out by the Irish taxpayers for the failure of these banks? Answer: Other European banks would benefit from the taxpayer bail-out.

EUROPEAN CENTRAL Bank chief Jean-Claude Trichet has ruled out supporting Minister for Finance Michael Noonan in his push to avoid repaying some of the debt owed by Anglo Irish Bank and Irish Nationwide Building Society.

JP Morgan analysts think making Anglo Irish Bank debt holders whole is unnecessary and unwise.

In addition, the nature of Anglo Irish Bank as a run-off institution and clearly not having the same importance as a Pillar banks, would most likely have facilitated some type of burden sharing outcome with nominal contagion impact. We also note a willingness of domestic policymakers to implement burden-sharing on the institution. However, despite all these perfectly valid reasons we note that opposition of the ECB to the burden sharing outcome will most likely imply that the senior debt will mature at par, with the ECB most likely having concerns with the impact that broader contagion might have on its outstanding exposures to the European banking sector. In the event that Anglo Irish debt is not burden shared then we would take this as a very strong indicator of the lack of willingness to inflict losses on the senior unsecured debt of European banks under the current regime.

I find this push by the ECB outrageous. Western governments have been captured by the banking industry and its bond holders. Bond holders should take losses when companies fail. The total amount of debt should go down due to losses on the debt. Otherwise private debt gets converted into public debt and the needed shrinkage of the total debt burden does not happen. The political machinations to try to prevent Greek default have make the crisis there far worse. To lesser degrees the same is happening in most other Western countries including the United States.

By Randall Parker    2011 September 11 10:11 AM Entry Permalink | Comments (6)
2011 May 15 Sunday
Hernando de Soto: The Destruction of Economic Facts

Noted Peruvian economist Hernando de Soto argues in a Businessweek piece that the financial markets went so awry because there is no longer enough publicly available knowledge about financial firms to enable the markets to operate efficiently.

To prevent the breakdown of industrial and commercial progress, hundreds of creative reformers concluded that the world needed a shared set of facts. Knowledge had to be gathered, organized, standardized, recorded, continually updated, and easily accessible—so that all players in the world's widening markets could, in the words of France's free-banking champion Charles Coquelin, "pick up the thousands of filaments that businesses are creating between themselves."

The result was the invention of the first massive "public memory systems" to record and classify—in rule-bound, certified, and publicly accessible registries, titles, balance sheets, and statements of account—all the relevant knowledge available, whether intangible (stocks, commercial paper, deeds, ledgers, contracts, patents, companies, and promissory notes), or tangible (land, buildings, boats, machines, etc.). Knowing who owned and owed, and fixing that information in public records, made it possible for investors to infer value, take risks, and track results. The final product was a revolutionary form of knowledge: "economic facts."

Changes in financial regulations (along with a large amount of enabling computing power) enabled financial firms to create private markets with repos, credit default swaps, and other instruments that leave regulatory agencies (along with buyers and sellers of shares in financial firms) unable to figure out the financial condition of banks, insurance firms, and other financial firms.

Over the past 20 years, Americans and Europeans have quietly gone about destroying these facts. The very systems that could have provided markets and governments with the means to understand the global financial crisis—and to prevent another one—are being eroded. Governments have allowed shadow markets to develop and reach a size beyond comprehension. Mortgages have been granted and recorded with such inattention that homeowners and banks often don't know and can't prove who owns their homes. In a few short decades the West undercut 150 years of legal reforms that made the global economy possible.

While de Soto does not mention it, resource shortages and other factors are undermining the ability of governments, firms, and workers to grow their incomes enough to service their debts. The enormous house of cards built with debt instruments stands at risk of an even greater crisis than we saw in late 2008.

The financial problem posed by rising resource prices and limits to growth has been driven home to me as I read Chris Martenson's The Crash Course: The Unsustainable Future Of Our Economy, Energy, And Environment. Our system of debt assumes growth. Take away growth and the amount of unaffordable debt quickly scales up into the trillions of dollars.

Looking at the Congressional Budget Office Analysis Of The President's 2011 Budget a link to economic projections of the CBO shows the CBO is assuming 4.2% annual GDP growth for 2012-2014 and then 2.4% annual growth for 2015-2020. They expect this to yield a 31% real growth in the US economy. Well, what if that does not happen? What if commodity price spikes keep kicking the US economy (along with the other OECD developed countries) back into recession? The effect on debt service would (will?) be catastrophic. More people would demand stuff from government (e.g. people would retire earlier due to lack of jobs) and they would pay far less in taxes.

While greater transparency would help (e.g. to help people learn they need to start growing gardens and cancel vacations) if economic growth stops then no amount of transparency will help us avoid inflation as some of the developed country governments try to inflate away their unaffordable debts. The Western countries and Japan aren't the only ones heavily dependent on growth to manage their debts. China's increasingly debt-driven growth puts its economy at substantial risk of a huge correction. A depression there is not out of the question. So many houses of cards.

By Randall Parker    2011 May 15 04:59 PM Entry Permalink | Comments (2)
2009 December 26 Saturday
Government Laying Groundwork For Next Crisis

At The Automatic Earth Ilargi says the economic recovery is a mirage created by replacing private debts with public debts. That sounds about right.

Ilargi: Many people today feel happy and positive when they look at the stock markets, because they think these reflect the real economy, and since the markets are up, things must have changed for the better in the past year.

But they haven't, not below the surface. It's all veneer and no substance. What actually has happened is that -virtually- no debt has been paid off in our economies, in fact we’ve added trillions of dollars more in debt. What is different from a year ago is that a huge part of the old debt and all of the new debt has been transferred to the public, and away from private business, in particular financial institutions (and, to an extent, carmakers).

So it comes down to the fact that people feel happy for being deeper in debt, and quite a bit deeper. Being the humans we are, we focus on the short term gratification which can be found in the Dow and a whole slew of increasingly fabricated numbers and government reports, while we conveniently ignore the enormous increases in debts, both public and private, that we will have to pay off down the line.

Ilargi writes from the perspective of someone who believes Peak Oil is going to rip the guts out of the world economy. I pretty much share that perspective - though I'm less apocalyptic in my views. I expect industrial civilization to survive intact, albeit at considerably lower living standards.

A poor handling of the current financial crisis will make for a much more dysfunctional response to world oil production decline. Marc Faber sees government credit policy as giving drugs to drug addicts.

"If we agree that excessive credit and excessive leverage led to the crisis, then what the Federal Reserve is doing is giving a wrong medicine to the patient—they are giving the drug addicts more drug instead of sending them to rehabilitation, which is not good for the economy. So I think that the whole policy will eventually end in another disaster but we don’t know when and many things can happen in between."

The price of oil will run up again high enough to cause another recession. More debts will go bad. The US governments own total debt will spike up again in the next recession.

Julian Robertson sees high inflation, depression, or both.

“I ask anyone to give me an example of an economy beefed up by huge amounts of quantitative easing that did not inflate tremendously when or if the economy improved. I think what we’re doing now will either fail, or it will result in unbelievably high inflation – and tragically, maybe both. That would mean a depression and explosive inflation, which is frightening.”

Jim Rogers says governments are suppressing a needed natural process of bankruptcy.

"The way to solve this problem is to let people go bankrupt," Rogers said.

"Then you will hit bottom and then you start over. The people who are sound will take over the assets from the people who aren't sound and we will start over. This is the way the world has worked for a few thousand years."

Government misregulation of banks (and reckless lending by the US government's own Fannie Mae and Freddie Mac) resulted in the banks issuing huge amounts of bad debts that caused a huge bubble. We can't get out of that bubble without lots of liquidation of debts. Bush and Obama have tried to prevent some of the needed adjustment. This means that when oil prices run up again and cause another recession the financial institutions will still be awash with bad debts and the next recession will be even more painful.

By Randall Parker    2009 December 26 06:53 PM Entry Permalink | Comments (19)
2009 November 25 Wednesday
Democrats Support Usury

The party of rich financiers defends usury.

WASHINGTON - Efforts in Congress to cap credit-card interest rates are faltering because of opposition from Democrats and a lack of specific support from the White House, despite growing consumer outrage over a rush by banks to impose rates as high as 30 percent.

Since the Democratic Party is clearly the party of Ivy League graduate financiers the less educated and lower status lower classes are going to have to take their complaints to the other political party which must be there to represent them. That's how it works in a 2 party system. One of the parties represents capital and the other represents labor. Surely both parties haven't been captured by rival upper class factions?

Let this be a lesson to the spendthrifts who voted for the Democrats in 2008. If you want to borrow lots of money and pay low interest rates before defaulting you are going to have to find another party to vote for.

By Randall Parker    2009 November 25 01:23 PM Entry Permalink | Comments (3)
2009 May 31 Sunday
Nouriel Roubini: Convert More Debt To Equity

Nouriel Roubini says we aren't converting enough debt into equity.

However, fiscal policy cannot resolve problems of credit, and it is not without cost. Over the next few years it's going to add about $9 trillion to the US public debt. Niall Ferguson said it's the end of the age of leverage. It's not really. There is not deleveraging. We have all the liabilities of the household sector, of the banks and financial institutions, of the corporate sectors; and now we've decided to socialize these bad debts and to put them on the balance sheet of the government. That's why the public debt is rising. Instead, when you have an excessive debt problem, you have to convert such debt into equity. That's what you do with corporate restructuring—it converts unsecured debt into equity. That's what you should do with the banks: induce the unsecured creditors to convert their claims into equity. You could do the same thing with the housing market. But we're not doing the debt-into-equity conversion. What we're doing is piling public debt on top of private debt to socialize the losses; and at some point the back of some governments' balance sheet is going to break, and if that happens, it's going to be a disaster. So we need fiscal stimulus in the short run, but we have to worry about the long-run fiscal sustainability, too.

I agree about the need to convert debt into equity. I also think piling on more government debt is a bad idea. Roubini also does not expect a rebound until next next year and he considers a double dip recession a possibility. That would bring down more banks as more mortgages defaulted. Check out a take on the total bad debt picture.

By Randall Parker    2009 May 31 11:39 PM Entry Permalink | Comments (3)
2009 April 25 Saturday
Credit Default Swaps To Force GM Bankruptcy Filing?

Some GM bond holders are insured and would be better off if GM files for bankruptcy. So credit default swaps may cause GM's bankruptcy filing.

Put it this way: Treasury wants to get about 90% of the bondholders to take the debt-for-equity exchange. So you only need about $2.8 billion worth of debt in the hands of people who also own the swaps and a few others who won't take the deal to hold things up.

There are some $2.7 billion worth of GM credit default swaps swimming around in the market, says Tim Backshall of Credit Derivatives Research.

The Obama Administration would like to screw the bond holders to the extent possible in order to give more GM stock to the UAW for their medical retirement benefits. But in bankruptcy will bond holders or union medical retirements benefits hold more weight in the eyes of a US federal judge? Anyone have a good understanding of that one?

By Randall Parker    2009 April 25 09:45 AM Entry Permalink | Comments (0)
2009 February 11 Wednesday
Steve Sailer: Enforce Bank Transparency

Steve Sailer's modest proposal to improve the investing and lending climate in America: force the banks to publish all their securities holdings on the web.

The other problem is something the government might possibly be able to help with. And that is that it's currently prudent to assume there is a high probability that any financial institution you might want to deal with could be broke because their books are black boxes, especially the mortgage-backed securities they own. So, you don't want to invest in them or lend them money because you don't understand their financial position. This uncertainty over the value of financial instruments linked to mortgages can make things even worse than they really are -- All we have to fear is fear itself, etc.

So, it's time for the government to open up the black boxes by requiring all parties to mortgages, mortgage-backed securities, and derivatives tied to mortgage-backed securities to post everything on line. Privacy be damned.

We taxpayers are on the hook to guarantee the deposits in all the banks. So I think this gives us the right to know how they are putting our money at risk. I also think this increased transparency would have salutary effects. Thinking about buying stock in Bank Of America or Wells Fargo? You have no idea how much trouble they are in because they hide too much. Rational stock analysis for these companies isn't possible that I can see. Some might be far better than others and deserving of much higher stock market values.

Also, I want the transparency because I want to know whether the US government is bailing out shareholders of failed banks. Which securities does the government buy from CitiBank versus from JP Morgan Chase versus Bank of America? What's the market price of the securities purchased from these banks?

By Randall Parker    2009 February 11 10:52 PM Entry Permalink | Comments (0)
2009 January 25 Sunday
Jeremy Grantham On Popping Financial Bubble

Accomplished money manager Jeremy Grantham muses on why top financial institutions failed to see the popping of the debt and real estate bubble.

I ask myself, "Why is it that several dozen people saw this crisis coming for years?" I described it as being like watching a train wreck in very slow motion. It seemed so inevitable and so merciless, and yet the bosses of Merrill Lynch and Citi and even [U.S. Treasury Secretary] Hank Paulson and [Fed Chairman Ben] Bernanke -- none of them seemed to see it coming.

I have a theory that people who find themselves running major-league companies are real organization-management types who focus on what they are doing this quarter or this annual budget. They are somewhat impatient, and focused on the present. Seeing these things requires more people with a historical perspective who are more thoughtful and more right-brained -- but we end up with an army of left-brained immediate doers.

So it's more or less guaranteed that every time we get an outlying, obscure event that has never happened before in history, they are always going to miss it. And the three or four-dozen-odd characters screaming about it are always going to be ignored.

More than a few dozen people saw that the US economy was on an unsustainable path and in a housing bubble. See this debt bubble chart starting in 1915 that was published in 2004. Note that the big debt run-up as a percentage of GDP during the 1930s was because of the economic contraction. Whereas today we have a far larger debt as a percentage of GDP even before economic contraction.

Why do CEOs of big banks act in such irresponsible ways when something like a housing bubble is developing? I suspect part of the answer is they are aiming for short term profits and figure the bubble will last longer than it turns out to last. Some bubbles last a long time. The housing bubble is part of a debt bubble that started building in the early 1980s. Here is another graph on the long term trend in US debt. That's an unsustainable trend which has gone on for decades. A lot of people have made a lot of money betting that the trend wouldn't hit the wall and reverse while they held this or that stock or other investment.

Barack Obama uses rhetoric about sacrifice but so far our economy is running on the assumption that foreigners will continue to sacrifice consumption and buy our debt to allow us to live beyond our means. They will not continue to do so. When they stop that'll come on top of the bursting real estate bubble.

What he might have said was that the nations funding the majority of America's public debt -- most notably the Chinese, Japanese and the Saudis -- need to be prepared to sacrifice. They have to fund America's annual trillion-dollar deficits for the foreseeable future. These creditor nations, who already own trillions of dollars of U.S. government debt, are the only entities capable of underwriting the spending that Mr. Obama envisions and that U.S. citizens demand.

These nations, in other words, must never use the money to buy other assets or fund domestic spending initiatives for their own people. When the old Treasury bills mature, they can do nothing with the money except buy new ones. To do otherwise would implode the market for U.S. Treasurys (sending U.S. interest rates much higher) and start a run on the dollar. (If foreign central banks become net sellers of Treasurys, the demand for dollars needed to buy them would plummet.)

In sum, our creditors must give up all hope of accessing the principal, and may be compensated only by the paltry 2%-3% yield our bonds currently deliver.

As absurd as this may appear on the surface, it seems inconceivable to President Obama, or any respected economist for that matter, that our creditors may decline to sign on. Their confidence is derived from the fact that the arrangement has gone on for some time, and that our creditors would be unwilling to face the economic turbulence that would result from an interruption of the status quo.

We have multiple problems that could easily start feeding on each other in a vicious cycle. We have a dumbing and aging population. Those two demographic trends will cause huge problems even without a debt bubble. We also have overpriced real estate and lots of insolvent banks that are walking zombies. We also have an unsustainable trade deficit where we live beyond our means. This deficit keeps driving America ever more deeply in hock to the world. Plus, peak world oil production is on the horizon. Add all these things up and our current financial crisis might just be the opening chapter on far bigger problems.

Update: Back in November 2008 Arnold Kling opined on where our economic trends are taking us: the US government will strip assets from the productive.

My point is that sooner or later the U.S. government is going to have to get serious about stripping the assets of those of us who have tried to live within our means. Sooner or later, the profligate are going to take from the prudent, the grasshopper is going to confiscate the property of the ants.

If you've got wealth, you need to find a haven for it. You don't want to keep it in a banana republic for too long.

That this sounds correct is a very bitter pill indeed.

Update II: John Kemp thinks the US and UK are headed for a debt crisis.

From the 1970s onward, however, the economy has undergone two profound structural shifts. First, the economy as a whole has become much more indebted. Output rose eight times between 1975 and 2007. But the total volume of debt rose a staggering 20 times, more than twice as fast. The total debt-to-GDP ratio surged from 155 percent to 355 percent. Second, almost all this extra debt has come from the private sector. Take a look at Chart 2 ( Despite acres of newsprint devoted to the federal budget deficit over the last thirty years, public debt at all levels has risen only 11.5 times since 1975. This is slightly faster than the eight-fold increase in nominal GDP over the same period, but government debt has still only risen from 37 percent of GDP to 52 percent.

Instead, the real debt explosion has come from the private sector. Private debt outstanding has risen an enormous 22 times, three times faster than the economy as a whole, and fast enough to take the ratio of private debt to GDP from 117 percent to 303 percent in a little over thirty years.

Policymakers were complacent about the build-up of private sector debt because they naively thought that since companies are guided by market forces that the companies were competent to manage the debt.

For the most part, policymakers have been comfortable with rising private debt levels. Officials have cited a wide range of reasons why the economy can safely operate with much higher levels of debt than before, including improvements in macroeconomic management that have muted the business cycle and led to lower inflation and interest rates. But there is a suspicion that tolerance for private rather than public sector debt simply reflected an ideological preference.

In the wake of the last year of financial failures and bail-outs this faith in the financial institutions seems, er, dated.

Mish Shedlock responds to John Kemp and argues the US government might not be able to inflate the private sector out of its debt trap.

Clearly GDP needs to rise or debt levels reduced to reach a sustainable path. Kemp argues "widespread bankruptcies are probably socially and politically unacceptable."

While I agree with that statement in theory, practice is another matter. I do not believe government has a realistic choice in an environment of global wage arbitrage, changing consumer attitudes towards debt, and demographics of boomer retirement.

Mish thinks we are going to repeat Japan's deflationary pattern of the 1990s with repeated recessions and little economic growth.

Can we keep having a huge debt-to-GDP ratio or has the damage to the lending institutions become so great that the debtors are going to have an increasingly hard time rolling over their debts?

By Randall Parker    2009 January 25 01:26 PM Entry Permalink | Comments (10)
2008 November 24 Monday
US Federal Government To Provide $7.76 Trillion In Funds

The debt guarantees, loans, preferred stock buys, and commercial paper purchases are really adding up. Get your mind around the enormity of what's happening in banking as a result of the financial crisis.

Nov. 24 (Bloomberg) -- The U.S. government is prepared to provide more than $7.76 trillion on behalf of American taxpayers after guaranteeing $306 billion of Citigroup Inc. debt yesterday. The pledges, amounting to half the value of everything produced in the nation last year, are intended to rescue the financial system after the credit markets seized up 15 months ago.

That's a staggering number. What I want to know: Can the Fed inflate the money supply far enough to turn the price deflation into an inflation?

You hear a lot about the US Treasury's TARP program. But the Federal Reseve has lent more than 3 times the amount of money the US Treasury has provided.

Wall Street analysts, congressional overseers and the media have parsed every detail of the Treasury Department's financial rescue program -- $250 billion and counting.

Largely outside public view, however, the Federal Reserve is lending far more than that amount -- $893 billion, roughly the equivalent of the annual economic output of Mexico -- to help a wide range of institutions weather the economic storm.

As of last week, the Fed's loans included $507 billion to banks, $50 billion to investment firms, $70 billion for money market mutual funds, and $266 billion to companies that use a form of short-term debt called commercial paper. It is considering a new program that would make billions more available to prop up consumer lending: auto loans, credit cards and the like.

The changes away from previous trends at the macroeconomic level are breathtaking. The mortgage-backed securities (MBS) market has collapsed. Any mortgage lending can only be done by financial institutions that have enough money on deposit to fund new mortgage loans.

But for now, the issuance of nonagency mortgage-backed securities (MBS) in America has plunged by 98% year-on-year to a monthly average of $0.82 billion in the past four months, down from a peak of $136 billion in June 2006. There has been no new issuance in commercial MBS since July. This collapse in securitization is intensely deflationary.

It is also true that under Chairman Ben Bernanke, the Federal Reserve balance sheet continues to expand at a frantic rate, as do commercial-bank total reserves in an effort to counter credit contraction. Thus, the Federal Reserve banks' total assets have increased by $1.28 trillion since early September to $2.19 trillion on Nov. 19. Likewise, the aggregate reserves of U.S. depository institutions have surged nearly 14-fold in the past two months to $653 billion in the week ended Nov. 19 from $47 billion at the beginning of September.

Housing prices were inflated and need to fall further until ratios of housing prices to incomes and other housing price indicators fall closer toward historical trend lines. The collapse of the MBS market helps to drive that needed correction.

In the face of a rapidly contracting economy and falling prices the new Presidential Administration is looking to do a big spend to prop up the economy.

Facing an increasingly ominous economic outlook, President-elect Barack Obama and other Democrats are rapidly ratcheting up plans for a massive fiscal stimulus program that could total as much as $700 billion over the next two years.

So far all the efforts to put Humpty Dumpty back together again are not working. Goldman Sachs expects the economy to start contracting at a 5% annual rate.

Last week, Goldman Sachs said it expects the economy to shrink even faster by the end of the year, at a 5 percent annualized rate. Meanwhile, the Dow Jones industrial average dropped 5.3 percent for the week; and the nation's largest bank, Citigroup, sought government assistance to avoid collapse.

Obama's economic stimulus probably isn't going to help. He'd do more good if he cut taxes in half and then the Fed bought up all the T-bills needed to finance the tax cut.

By Randall Parker    2008 November 24 09:41 PM Entry Permalink | Comments (5)
2008 November 13 Thursday
Hank Paulson On Imbalances As Economic Crisis Causes

US Treasury Secretary Hank Paulson discusses some ways to fix the financial system but also addresses imbalances that led to the crisis.

And to adequately reform our system, we must make sure we fully understand the nature of the problem which will not be possible until we are confident it is behind us. Of course, it is already clear that we must address a number of significant issues, such as improving risk management practices, compensation practices, oversight of mortgage origination and the securitization process, credit rating agencies, OTC derivative market infrastructure and regulatory policies, practices and regimes in our respective countries. And we recognize that our financial institutions and our markets are global, but our regulatory regimes are national, so we will examine how best to improve cooperation and information sharing to foster global financial system stability.

Paulson says global imbalances caused the capital market distortions that led to our unfolding financial disaster.

But let us not forget one fundamental issue which lies at the heart of our problems. Over a period of years, persistent and growing global imbalances fueled a dramatic increase in capital flows, low interest rates, excessive risk taking and a global search for return. Those excesses cannot be attributed to any single nation. There is no doubt that low U.S. savings are a significant factor, but the lack of consumption and accumulation of reserves in Asia and oil-exporting countries and structural issues in Europe have also fed the imbalances.

But why did the US savings rate plummet? My take: Low US savings are in large part a result of high Asian savings. The mechanisms that Asian governments used to reduce domestic consumption and to accumulate US debt caused distortions in the US monetary system and economy. The Asians - especially China - effectively kept US consumer prices down by buying US debt and keeping their currencies weak against the US Dollar. The Federal Reserve was therefore able to pursue an overly expansionary monetary policy without the warning flag of consumer price inflation. Instead the excess expansion of the US monetary supply expressed itself in asset price inflation.

Paulson wants to address the global imbalances. But governments of some other nations might continue to resist US efforts to close the US trade deficit.

If we only address particular regulatory issues – as critical as they are – without addressing the global imbalances that fueled recent excesses, we will have missed an opportunity to dramatically improve the foundation for global markets and economic vitality going forward. The pressure from global imbalances will simply build up again until it finds another outlet.

I expect the pressures from the global imbalances to build up again because so far I hear little from the bulk of our elites that indicate they understand the importance of fixing the causes of the problem. In fact, the priority in Washington DC is to reflate the bubble as quickly as possible. They seek to curtail the short term pain and help people who can't afford the houses to keep those houses. Yet we need prices to fall from their bubble levels.

As long as the housing price-to-rent remains above historical norms and the ratio of housing prices to income remains above historical norms we haven't reached sustainable prices in the real estate market. We should not reflate housing prices when housing prices are clearly distorted by reckless and destructive lending practices.

By Randall Parker    2008 November 13 11:14 PM Entry Permalink | Comments (12)
2008 October 22 Wednesday
Credit Ratings Agencies Lowered Their Standards

Many causes contributed to the debt crisis. One of those causes: the credit ratings agencies became lax when rating securities.

Employees at Moody's Investors Service told executives that issuing dubious creditworthy ratings to mortgage-backed securities made it appear they were incompetent or ``sold our soul to the devil for revenue,'' according to e-mails obtained by U.S. House investigators.

The e-mail was one of several documents made public today at a hearing of the House Oversight and Government Reform Committee in Washington, which is reviewing the role played by Moody's, Standard & Poor's and Fitch Ratings in the global credit freeze.

Fitch, Moody's and Standard & Poors competed and the originators chose the ratings agency most likely to score their securities the highest. The result was a decline in standards by the ratings agencies.

Jerome Fons, a former managing director of credit policy at New York-based Moody's, told lawmakers that originators of structured securities ``typically chose the agency with the lowest standards, engendering a race to the bottom in terms of rating quality.''

These agencies deserve to fail at this point. But will they?

Within the ratings agencies they knew what was happening.

Moody's Chief Executive Raymond McDaniel told directors in October 2007 that Moody's was facing a dilemma in trying to maintain both market share and quality in the ratings paid for by issuers of the securities.

"The real problem is not that the market... underweights ratings quality but rather that in some sectors, it actually penalizes quality," he said, according to the documents. "It turns out that ratings quality has surprisingly few friends: issuers want high ratings, investors don't want ratings downgrades, short sighted bankers labor shortsightedly to game the ratings agencies."

McDaniel said analysts and managing directors are continually pitched by bankers, issuers and investors and sometimes "we drink the Kool-Aid."

The house of cards has fallen.

``Let's hope we are all wealthy and retired by the time this house of cards falters,'' one e-mail from an S&P employee said.

Are we just so far removed in time from the Great Depression that our whole society has forgotten old lessons learned and become reckless with debt?

By Randall Parker    2008 October 22 11:41 PM Entry Permalink | Comments (4)
2008 October 07 Tuesday
Fed To Buy Short Term Commercial Paper

The US Federal Reserve, in a very unusual move, will by the short term debt of the highest ranking companies. These companies are finding it very hard to sell their commercial paper to finance daily operations.

The Fed said it was creating a new entity to buy two types of short-term debt, known as three-month unsecured and asset-backed commercial paper, directly from eligible companies. It hopes to have the program up and running soon, Fed officials said.

Fed officials said they would buy as much of the debt as necessary to get the market functioning again but refused to say how much that might be. They noted that around $1.3 trillion worth of commercial paper would qualify.

That this move should even be seen as necessary illustrates just how serious the credit crisis has become. When highly rated corporations can't borrow money the fear in credit markets is very high.

Available credit for corporations is contracting rapidly. A continuation of this trend would cause a depression.

In the past month, the amount of money outstanding in commercial paper loans has fallen 11% to a seasonally adjusted $1.6 trillion on Oct. 1 from $1.82 trillion on Sept. 10.

The decline in available funding indicates only part of the market's problems, however. Investors have also become unwilling to buy longer-term paper - beyond a week or two - from even companies and financial institutions with top-flight credit ratings.

Big names like GE and AT&T are finding it difficult to borrow.

A virtual funding freeze has affected even top-rated companies such as General Electric, the conglomerate, and AT&T, the telecoms group. Mirrored in Europe, where traders said an unusually high proportion of deals were for overnight borrowing, the freeze has intensified fears about the impact of the credit crunch.

Interbank lending rates are at amazingly high levels as compared to US Treasury bills.

Financing costs are soaring as banks hoard cash after the credit crunch triggered by the U.S. subprime mortgage crisis a year ago. The three-month London interbank offered rate in dollars rose to 4.32 percent from 2.64 percent in March, while the equivalent rate for euros increased to a record 5.38 percent, from 4.74 percent six months ago.

You can watch these measures of risk in the banking system with the USD Libor rate and the TED spread.

The Fed's move lowered interest rates on commercial paper.

The Fed's drastic move had a nearly immediate impact: Yields on top-rated overnight U.S. commercial paper dropped 0.74 percentage points, to 2.94%, according to Bloomberg Financial Markets. And rates on three-month Treasury bills—the ultimate safe asset to which big investors, like money-market funds, have been flocking—rose above 1.0% on Tuesday for the first time in weeks.

Commodity price declines and contracting credit have some worried about deflation.

Prices are already falling in parts of the world economy. Home values dropped more than 10 percent in the U.K. and in the U.S. in the past year. Oil, copper and corn drove commodities toward their biggest weekly decline since at least 1956 on Oct. 3, with the Reuters/Jefferies CRB Index of 19 raw materials tumbling 10.4 percent. The Baltic Dry Index, a measure of commodity shipping costs, has dropped 75 percent since May.

``We are certainly more worried about deflation than inflation,'' says David Owen, chief European economist at Dresdner Kleinwort Group Ltd. in London. Central bankers need to ``get rates down and keep them there for quite some time,'' he says.

So many signs of rapid declines in demand point toward a deep systemic problem. I question the ability of governments to reflate.

Consumer credit is contracting. The contraction is mostly coming from non-credit card credit.

Consumer credit fell by $7.9 billion, the most since statistics began in 1943, to $2.58 trillion, the Fed said today in Washington. In July, credit rose by $5.2 billion, previously reported as a $4.6 billion gain. The Fed's report doesn't cover borrowing secured by real estate.

MasterCard reports a big decline in consumer spending. Some are trying to save in the face of fearful news. Others are spending less due to job losses.

MasterCard SpendingPulse, which measures national retail sales, said a steep drop-off in consumer spending sent its specialty retail sales index plunging 7.7 percent in September compared with last year. In August, the decline was only 4.1 percent compared with the period a year ago.

Gasoline demand in the United States has dropped 9.5% in a year as measured by MasterCard.

American motorists pumped an average of 8.625 million barrels per day in the week ended October 3, down 5 percent from the previous week, MasterCard said in its weekly SpendingPulse report.

Year-on-year, gasoline demand plunged 9.5 percent.

The debate about whether we can avoid a recession is over. Now the question shifts to how deep and how long a recession. The public is rightfully scared. It only makes sense that people and businesses will pull back and try to build up their cash stores.

By Randall Parker    2008 October 07 10:41 PM Entry Permalink | Comments (9)
2008 October 04 Saturday
More Credit Crunch News

The credit crunch is showing up in many ways. Even if mortgage money is available fewer are applying for it.

In yet another sign of the economic crisis, the Mortgage Bankers Association said Wednesday that mortgage applications plunged 23% last week.

Things are tanking across the board. Some people are skeptical about the severity of the crisis. I think they aren't paying close enough attention.

Not only are banks afraid to extend credit. People are increasingly fearful about taking on debt.

As long as the constant drumbeat of bad economic reports continues, consumers and businesses may not be so eager to borrow money anyway even if banks start extending more credit. Friday's dismal jobs report, showing that 159,000 people lost their livelihoods, did little to inspire people to spend.

"You tell me I can have the credit, but I don't want it," said Amiyatosh Purnanandam, assistant professor of finance at the University of Michigan. "If people are not going to buy cars whether they can get credit or not, it's not going to help the economy."

Credit card defaults are expected to soar.

“If history is any indicator, there should be an equivalent surge in credit-card charge-offs very soon,” he said. “We forecast first quarter credit-card charge-offs will be $18.6-billion (U.S.) and that the total 2009 charge-off bill will add up to $96-billion.”

Laura Nishikawa, Innovest's consumer finance analyst, said the credit card issuers that will be hurt least in the coming crunch will be those who had the “foresight” to improve their risk management performance during the bull market, even if they sacrificed some growth in the process.

Credit card companies are raising interest rates.

The survey revealed that 37% of banks have increased rates, compared to 24% in April and 10% in January. They may be raising rates to compensate for losses. Advanta saw an 83% decrease in earnings in its second quarter, due in large to provisions for credit charge-offs. Capital One's profits dropped 40% and American Express saw a 38% decrease. And while Bank of America's 41% dip in earnings beat estimates, the company incurred $2.75 billion in credit card losses 31% more than last year.

Think you are immune? Maybe. Even Silicon Valley is not immune to the credit crunch.

Yet nonstop economic gloom in other parts of the economy seems to have frayed the nerves of even the Valley’s most sublimely confident. Discussions of the economic crisis dominate conversations. Technology blogs offer prescriptions for riding out the crisis and intense debates over what percentage of start-ups are destined to fail.

According to a quarterly survey by Mark V. Cannice, director of the University of San Francisco Entrepreneurship Program, the confidence of venture capitalists has plummeted to the lowest level since the survey began in 2004.

“Everyone is worried about their budgets and everyone is worried about the economy,” said Jayant Kadambi, founder of Yume, a three-year-old online video advertising firm. “These are the conversations we have these days.”

The state government of California is having a hard time borrowing money.

"It is daunting that California, the eighth-largest economy in the world, cannot obtain financing in the normal course of its business to bridge our annual lag between expenditures and revenues," Gov. Arnold Schwarzenegger wrote in a letter to the state's congressional delegation in Washington.

California is swiftly running out of time to float $7 billion worth of short-term debt needed to pay workers and bills as early as next month, state Treasurer Bill Lockyer warned in his own letter.

Car dealers are having a hard time getting credit for borrowers. They are also having a harder time getting credit to buy cars to put on their lots.

Autos. Many analysts hoped that car sales would pick up from summer lows, now that gas prices have drifted back below the $4 threshold that spooked buyers. But sales in September were the weakest in 15 years—and the credit crunch is now the main culprit. "The scarcity of credit has forced sales into freefall," Credit Suisse analyst Chris Ceraso explained to investors. "Volatility and uncertainty on Wall Street [has] spread to Main Street, leaving consumers paralyzed."

Dealerships report that "subprime" borrowers with marginal credit ratings essentially can't get loans. Some "prime" borrowers are being shut out, too. At some dealers, loan approvals are down 50 percent. And most homeowners can forget about using a home equity loan to help finance a car—since home equity has been plunging, and those loans drying up, too.

Hundreds of car dealers are going out of business.

In a typical growth year, America loses 75 to 150 dealerships, so some contraction is normal even in the best of times, said Paul Taylor. an economist with the National Automobile Dealers Association. But this year, there could be 500 to 700 fewer auto dealerships by the end of the year, he said .

Nouriel Roubini thinks the Paulson plan is insufficient to stop a silent run on banks around the world.

On the webcast Roubini accepted that the Paulson plan was about to become law, but dismissed it as less than a sticking plaster. Roubini said the financial system would remain “literally at the point of systemic collapse”. He said that only by “doing something even more radical” than not only the Paulson plan, but all steps taken so far, could a global domino effect of failing banks be averted.

Roubini’s thesis is that there is now a “silent run” hitting the world’s banks. There may be no Northern Rock-like queues of retail depositors standing outside bank branches.

European banks were as reckless as US banks with how they ineptly tried to reduce risks.

We now know that it was French finance minister Christine Lagarde who begged Mr Paulson to save the US insurer AIG last week. AIG had written $300 billion in credit protection for European banks, admitting that it was for "regulatory capital relief rather than risk mitigation". In other words, it was underpinning a disguised extension of credit leverage. Its collapse would have set off a lending crunch across Europe as banking capital sank below water level.

Very overextended Brits are suddenly paying much more for loans.

Over the past decade, consumers in Britain have accumulated debts, including their mortgages, worth on average 180 per cent of their disposable income, the highest proportion of any country in the G7 club of rich nations. It adds up to a mountainous £1.44 trillion of personal debt - and economic experts have been warning for several years that it would end in tears.

Ever since the credit crisis struck Britain's banks a year ago, they have been pushing up the cost of loans, especially for riskier borrowers, such as those who want to borrow a large multiple of their salary, or a have a poor credit record.

The rapid drainage of credit out of the economy has intensified as one bank after another has collapsed or been rescued. The Halifax - whose owner ,HBOS, was swallowed up by Lloyds TSB in a government-brokered rescue three weeks ago - announced this weekend that it is withdrawing many of its mortgage deals from the market and ratcheting up the interest rates on others. The cost of other loans, from credit cards to the car deals on showroom forecourts, is rising, too. The days of cheap credit are over. At the same time, falling property prices are making homeowners feel poorer.

By Randall Parker    2008 October 04 09:55 PM Entry Permalink | Comments (0)
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