Thursday, November 22, 2012

Sovereign Debt, The New Subprime

I just watched this commencement speech by Michael Burry who was one of the speculators that made millions off of the subprime crisis.  The UCLA dork introducing him starts out by saying that Queen Elizabeth asked the London School of Economics why nobody predicted the 2008 financial crisis.  Then he goes on to say that  Burry was one of the few people who actually foresaw the crisis.  I am sure being a Professor in the Economics Department, the introducer desperately needs to believe that "no one saw the collapse coming",  however, unfortunately it's all complete bullshit of course, because everyone knew in the latter stages of that era that the housing boom was going to end very badly.  But like deer in headlights,  everyone essentially froze up and pretended that the unsustainable  would continue indefinitely.  Sound familiar?...

Here is what I wrote back in April 2008 about all of the obvious risks that were well known and publicized leading up to the Lehman event.  Entire blogs were dedicated to documenting the insanity of the housing crisis with all of its lurid shenanigans.  It was well known that they were giving loans to illegal immigrants.  And let's not forget that before Lehman, there was Bear Stearns, Fannie and Freddie and several subprime mortgage companies (e.g. New Century Financial) that had already been vapourized.  There were ample warning signs, yet still most people got caught in the 2008 market collapse.  What really made Burry a celebrity therefore, wasn't that he foresaw the collapse, it's that he made money off of it.  He along with several other speculators including the biggest one of all, John Paulson, made their fortunes by betting that American homeowners would get wiped out.  What a fucking accomplishment.  They went in and bought up subprime insurance contracts (CDS) that paid off when people lost their home and their life savings.  It's no different than buying life insurance on someone you think is about to die.  Insurance companies don't let you do it, due to the obvious moral hazard.  In the ultra-corrupt financial markets however, conflicts of interest and moral hazards are just commonly accepted as I wrote here. So it's honorary degrees all around.

The Obvious is not Obvious to the Idiocracy
The real lesson and key takeaway from that entire era is how risks can be acknowledged yet still essentially ignored, as if somehow they will automatically resolve themselves.  How is it that essentially the entire economics profession was blindsided (and financially impacted) by such a well documented slow motion train wreck?  Clearly, wishful thinking and willful ignorance played a role.  However, I believe that the main factor was in the sophisticated "alchemy" that is the hallmark of this entire financial bubble era.  All of the various derivatives, securitizations and other inherently risky and massively leveraged mechanisms of today, require widely accepted sophisticated theories that work in text books and fail catastrophically in the real world.  My point isn't to figure out why people felt compelled to shove their heads up their own ass, only to note that if they did it before, they will do it again.  We would be abject fools to believe the same people again when they ignore today's obvious risks, when clearly these self-nominated "experts" have a major blindspot for lethal yet obvious facts that don't somehow fit into their academic models.   More importantly, we don't need a PhD to realize that giving $750k loans to illegal immigrants making less than minimum wage is a bad idea.  This entire fallacy that we should be following the lead of over-educated morons with fancy degrees who have been proven to be clueless time and time again, is going to be the downfall of our civilization.

Sovereign Debt is the New Subprime
The key point is that we know from experience that the largest risks will be the most obvious ones.  And the largest most obvious risk we face now is sovereign debt.  After 2008, instead of reforming the financial system or making any major structural changes to Wall Street, every country basically just swept their private debts onto the public balance sheet - either explicitly, as in the case of Spain and Ireland or implicitly by running massive deficits and monetizing debt.  Here in the U.S. alone, over $8 trillion of combined fiscal and monetary stimulus has been applied since 2008, yet there are still infotainers who will tell us that the bailout made a profit.  Of course, like subprime back in 2007/2008, it's widely documented at this juncture that countries worldwide are struggling with massive debt loads that are growing inexorably larger, but everyone is still frozen from action.  Sound familiar?  One of the contributing factors for today's willful ignorance was the "bailouts" of 2008 themselves, which led to the ubiquitous assumption that changes had been made and problems had been solved.  But the overlooked reality is that the bailouts themselves just set the stage for an even more massive and lethal crash down the road.  This increased risk is due to the fact that they bailed out the lenders, but they left the borrowers still struggling under massive unsustainable debt loads.  Millions of Americans lost their homes and were bankrupted, while shareholders for Goldman Sachs were made whole by the bailout of AIG.  Then the Federal Reserve pumped trillions of dollars into the money supply to re-inflate the stock market and all other risk assets, while average Americans watched as their incomes declined for the last four years straight.  Clearly, the bailout was all just a snow job, because the structural risks have only been amplified in the meantime.  By bailing out the lenders v.s. the borrowers now borrowers worldwide are stuck with massive deflationary debts and stagnant or declining incomes.  How can all of these nations' taxpayers pay off massive public debts on top of their existing massive private debts.  In my last post I showed U.S. total debt at 350% of GDP while average incomes are now declining.  This is the most obvious and unsustainable fact of this era, yet it's completely ignored.  A one-sided bailout for lenders that only further burdens borrowers via increased public debt, is not a sustainable strategy.

The End of the World Only Comes Once And You Can't Make Any Money Off of It
There is one major difference between subprime and sovereign debt which is that Wall Street has not found a way to make money off of sovereign debt.  That only amplifies the ignorance factor, because instead of just oblivious academics and clueless journalists, you can now add preoccupied speculators who are more focused on picking a spot to buy Apple.

Steering the Titanic Through An Ice Field At Full Speed
The one cohort who are dialed in to this risk of course, are global Central Bankers who are the only reason a sovereign default has not already occurred.  The U.S., ECB, Canada, Japan, U.K. have all been monetizing debt to keep the credit markets operating.  These interventions also keep speculators at bay.  So the key question on the table at this juncture is how long can Central Banks continue to fund insolvent governments and overall how long can this paradigm last.  In Japan, debt monetizations have gone on there for close to twenty years, so that is the most common example cited for assuming that deficits still don't matter.  Then of course there is the hyperinflation camp who assume this will go on until the money supply gets so massive that it leads to out of control inflation.  I've already addressed that gold-sponsored fantasy multiple times.  This money is clearly not making its way into the real economy and the hands of consumers.  It's not intended for the middle class, it's intended for the Romney class only.  When I get a pack of Ben Franklins in the mail from Uncle Sam, then I will get worried about inflation.  Which gets us down to the key drivers that will lead us to the inevitable Minsky moment.  Despite their grandest efforts, Central Banks still only control a few trillion dollars across the entire capital asset markets, which are valued north of $200 trillion.  Think about that, they are trying to herd a pack of elephants using a border collie.  Sure it all works great when the elephants are orderly, but not so well in a stampede.  The same analogy applies in this situation - Central Banks are attempting to control $200 trillion of assets using marginal purchases of a very small segment of the entire credit markets.  As long as risk appetite is in the "risk on" mode, which it has been for most of four years straight, this strategy will work.  When risk appetite inevitably turns back to risk "off" mode - whether due to the deteriorating global economy, a geopolitical event, a credit default etc. etc. then the resulting stampede out of risk assets will overwhelm Central Banks' efforts to control the markets.  It's as simple as that.  However, unlike 2008, it's going to take a hell of a lot more people by surprise.