Saturday, July 19, 2008

Wake Up Call: The End of Credit

People often ask me why I think this recession will become a depression when we've had many recessions in the 70 years since the Great Depression i.e. what's different this time? The fact is that nothing's different. What's different for a guy who has been living an unhealthy lifestyle for 30 years and eventually has a heart attack? The answer is nothing. Complex systems are often able to absorb substantial "adverse stimuli", but eventually they reach a critical tipping point that ends in disaster. Contrary to human optimism, the passage of time does not lessen the likelihood of an adverse event, it only increases the probability of an adverse event. When the tipping point occurs, it's not because of a "Black Swan Event", it's because of a "Dumb Swan Event".

In the case of our economy, the negative factor that's been building up all of this time isn't cholesterol, it's credit. Not to say that all forms of credit are bad, but just as with cholesterol, there is good credit and bad credit. In the case of our economy, our figurative "arteries" are clogged with "bad credit" also known as non-self-liquidating credit. This "nsl" credit refers to money borrowed to pay for consumption as opposed to self-liquidating credit which is is debt used to invest in productive assets (factories etc.). Borrowing for consumption imposes a negative burden (debt service) on future consumption, whereas productive investment creates a future source of income that (usually) more than offsets the cost of the debt service.

Non Amortizing debt
There is an even worse form of credit that the Government uses, which is non-amortizing credit. As opposed to a mortgage or even revolving credit, the Government's favourite debt instrument, Treasury bonds, does not require periodic payments on principal. Government bonds only require interest payments, so for example, on a thirty year bond our Government can defer paying back principal for the entire time to maturity (30 years). And when these "long bonds" do eventually expire, what does Government do? They of course issue a new long bond to pay off the old one and hence extend the time for repayment by another 30 years. Needless to say, this is an extremely handy way of shifting the repayment burden from one generation to the next. So, not only does Government run up obscene amounts of debt, they've even found a great way of paying the least amount possible in the current period against the debt. This is equivalent to an interest-only mortgage where you basically never pay off a dime against your house.

Why Now?
So then people ask me why do I think we are reaching this critical point now? I first came to realize that we were facing the first depression in 70 years when I observed the response of the Government and Federal Reserve to get us out of the last recession (2001-2002). In the end, the Fed had to lower interest rates from the 6% range all the way down to 1% in order to revive the economy. In addition, we had the massive fiscal stimulus caused by the war in Afghanistan and the war in Iraq AND the Bush tax cut. That for me was the wake up call. What that told me right there, is that monetary policy is losing its effectiveness. Fast forward 6 years to today and we've been borrowing steadily throughout this expansion and now we face yet another recession, this time much more leveraged thanks to all of the additional debt that's been incurred in the meantime. Add to that the recent evidence that the long-awaited "deleveraging" process is already well underway, to wit, the extreme turmoil and massive writedowns we've seen across the credit markets to date. And, as I wrote recently, (Fed Funds) rates are all the way back down to 2% and yet Fed policy is now trapped between the Scylla of inflation and Charybdis of bank failure.

Debt Addiction
The real story is how the hell did we get here? As I've indicated before, coming out of the 1970s, the U.S. was incurring structural fiscal and balance of trade deficits, indicating that the economy was no longer competitive. That's when the "neo" Supply Side Economics movement came along and convinced us that we could have our cake and eat it too, we just had to get used to taking on a little bit of debt. Or as Cheney put it "Reagan proved that deficits don't matter" (which makes as much sense as eating a Big Mac and declaring cholesterol doesn't matter). The other insidious element of SSE is the relentless drive for growth, because growth hides a lot of underlying problems - in the short-term. Stated GDP is never adjusted for debt levels which means that recent years' GDP is massively overstated relative to historic GDP.

The End of Credit
Our economy represents a 30 year bubble in credit. As the bubble expanded, our sponsors (China, Japan, Saudi Arabia) were more than willing to lend to us, in the belief they would be paid back with interest. More importantly, our current level of economic activity is predicated upon continued and growing access to credit. Credit is extended based on confidence in the likelihood of repayment. Once lenders' confidence is lost, it will go away for a long time and it will take with it the biggest part of our economy.

In short, it's wake up time folks. There are signs everywhere that we are at or near the all important "tipping point", you just have to be willing to look for them. Paraphrasing from Robert Prechter (EWI), it's better to be a year early, than an hour late when it comes to preparing for financial calamity. For those reading this near the time of writing, you must take steps to protect yourself, your family and your assets before it's too late.

Tuesday, July 15, 2008

Goodbye Fannie and Freddie, we hardly knew ye

The meltdown started late last spring with the implosion of a few lesser-known financial firms such as New Century Financial. Then in March of this year, once-venerable investment bank Bear Stearns basically evaporated overnight after 85 years of business and having weathered the Great Depression. The company was bought for $2/share by JP Morgan (w/Fed backing), after falling from $150/share in less than 9 months.

Moving on up, we are just now witnessing the nationalization of Fannie Mae (FNM) and Freddie Mac (FRE), the two companies chartered to provide liquidity to the U.S. mortgage market. Just this past Friday, the Federal Government stepped in and indicated they will "make good" on the implicit Government guarantee to backstop these companies financially.

I have no doubt that the Government will do whatever it takes to keep these companies from failing outright, because these companies now underwrite roughly half of the $12 trillion U.S. mortgage market. But to be sure, equity (stock) holders will be wiped out in the process and the cost to taxpayers could run north of a trillion dollars [unofficial guess]. Further to the point, in reaction to the news, U.S. Government bonds sold off sharply, based on genuine fear that through this action the U.S. Government may be at risk of losing it's AAA bond rating as a Sovereign borrower. As indicated here, major rating agencies were quick to clarify that a downgrade of the U.S. government, is not an immediate concern; however, the mere fact that a Sovereign downgrade is even on the table is beyond disturbing, and portends badly for the future. These bond rating agencies (Moody's/S&P) have been so incompetently behind the curve on their ratings relative to the market reality, that their reassurances basically have no value at this point.

That these two companies have lost 90% of their equity value and now are on the verge of massive failure, can come as no surprise. One would be hard pressed to find two companies more leveraged to the Global Ponzi scheme than these two. Both companies were chartered to bring liquidity to the mortgage market by buying up mortgages from local banks, thus providing local banks with fresh cash to originate still more loans. The FNM/FRE portfolios were typically leveraged 30:1 (you read that right), meaning for every dollar of equity, these companies held $30 of debt. What this means is that only a 3% decrease in value in the portfolio wiped out all of the equity. In other words, these companies had become massive call options on the U.S. economy, that worked great when the economy and housing market were growing, but have now since "expired" - and "out of the money", I might add.

Lastly, and almost forgotten in the excitement over FNM/FRE, IndyMac went bankrupt last week and was taken over by the FDIC. This was the third largest bank failure in U.S. history - so far...

Thursday, July 10, 2008

(Bear) Market Update

Since I subtly indicated here last May, that the stock market was carving out a multi-year double-top, the market soon after topped out in October and has declined 20% from the top.
Below is the current updated view of the S&P 500:

Granted my market calls have been early, and cynics might say that's because I am overly zealous about anticipating the "end of the world". To which I say, mea culpa. In reality, I should really refrain from making time-based predictions, even though it's a lot of fun, especially when I am right. And in all fairness to me, who knew that Bernanke would have been so *creative* in attempting to keep the Global Ponzi Scheme alive. By all accounts, he has come up with some historically novel ways of handing tens of billions of dollars to big banks and brokerage houses to make sure they don't suffer from their own greed and stupidity. Regardless, the man from Oz has only postponed the inevitable and taken the Federal Reserve basically out of the picture. With the Fed Funds rate at a mere 2% and inflation running at the highest level in decades, the Fed really has neither the option to cut nor to raise interest rates - if they cut, then inflation will accelerate killing consumers; if they raise, then banks will fail. The next option that Bernanke has hinted he might take is to "buy" long-term U.S. government bonds aka. monetize the debt, which is tantamount to "printing money".
Regardless of my calls being early, the trajectory and velocity of the current stock market decline thoroughly validates my overall thesis. We are still very early in this overall market decline and with each step lower, more and more of my longer-term predictions will be validated.
As for the commodities market, oil is hanging in there valiantly (~$140/barrel as of today). Paradoxically, despite being a big believer in Peak Oil Reality, I think the next major move in oil will be to the downside. I base this on demand destruction from high prices, weak overall economic fundamentals and over-supply from speculators who took oil out of the markets and will be puking it back onto the markets as the decline accelerates. I am clearly not among the current cohort of deceivers trying to convince everyone that speculation plays no role in commodity prices. If you believe that, then there's this bridge over here...

Also to date, contrary to my predictions here and here, and despite the fact that this has been the most volatile market in years, the major options put sellers have seemingly not yet shit the proverbial brick. however, I suspect that this past two times that the VIX touched 30, these guys had some serious nicotine stains in their underwear. As for the full scale filling of drawers, in my opinion that event is only a matter of when, not if. After all, stupid is as stupid does, and selling puts into a decline is like selling house insurance when the house next door is already on fire.

Tuesday, July 1, 2008


We've desecrated the Blue Planet.

This one, unique, gorgeous gift from God - for all we know the only hospitable planet that exists in the universe or at least within say a hundred million light years - and we've done our level best to destroy it.

Vanishing species, desertification, polluted land, air and waterways, depleted ozone and unprecedented climate change.

We've taken billions of tons of hydrocarbons that took hundreds of millions of years to form underground and released it into the atmosphere in less than 100 years. And now like a bunch of stunned dunces we stand around asking ourselves "I wonder if that caused a problem". One plan that's been put forward to slow global warming, is to pump carbon back underground i.e. take atmospheric gas that was converted from dense liquid oil and pump the expanded gas back into the ground - BRILLIANT! Let's put Exxon and the Saudis to work on that plan...

We've created myriad religions that put us at the center of the universe and rationalize our pathetic existence because we do not have the capacity nor courage to understand how insignificant we are in the context of the universe. We study holy books full of gibberish written hundreds (thousands) of years ago by people who were even more ignorant and backward than we are (hardly seems possible), to give ourselves the short stories we need to put ourselves to bed each night. The books all say we own this planet, so we can do what we want with it. To "worship" or admire anything that's natural or to find God's beauty in anything that's natural is deemed "Pagan". After all, religion, like all businesses, hates competition. Nothing can compete with such a deceptively alluring and self-serving way of thinking - science can't, logic can't, commonsense - no chance. Somehow God appeared a few thousand years ago to part the Red Sea and punish the Egyptians, but since then no one has seen hide nor hair of him - even as half a billion children evaporated from the face of this earth in the last century alone. I guess he was on his lunch break. The Book also says the Hebrews were punished for worshipping a golden calf, to which I say our entire consumption-oriented way of life including the pseudo religions that tell us to embrace it - are all one giant golden calf - a false idol.

Then I ask myself, how can we expect the average person to ever care about this planet when we are so busy stuffing our own bodies full of fast/factory food toxic waste? Logic dictates that guys like Dick Cheney who eat beef at every meal and have had 5 heart attacks, aren't worried about the fact that yogourt containers aren't recyclable.

The one true God gave us the greatest gift - our home - and we threw it away. This is desecration of the highest order and it shows more than anything what we think of God...and I have no doubt before it's all said and done, God is going to show what he thinks of us.