Wednesday, December 31, 2008

Holiday Price Trends

After a bad retail year, the holiday season failed to turn things around, and sales were the worst in decades despite aggressive Christmas price cuts. General retail saw a downward trend even compared to previous months, and online sales saw year on year reductions of 3%. So, stores on the edge hoping for a seasonal reversal probably didn't get it. Recent bailout measures have shown no signs of invigorating the general economy, not this holiday season at least. Strong deflationary trends continue.

On housing, recent S&P/Case-Shiller data show year on year declines of 18% over 20 metropolitan areas, with Phoenix, Las Vegas, and San Francisco leading the way with price drops over 30%. Case-Shiller numbers continue to fall off a cliff with no sign of flattening yet.

Otherwise, the DJIA has been hovering in the mid-8000's for weeks now, which reflects a huge year on year loss from its 14000 peak in Oct '07. Foreign currencies and gold are a mixed bag and showing relative strength due to debasement of the dollar, still the dollar has advanced slightly over the year in these areas. I anticipate the U.S. dollar index will strengthen as other countries follow suit in debasing their currency. Gold remains to be seen.

Tuesday, December 23, 2008

TARP: the first $350B

Since it was passed, the first $350B of TARP money has now been spent—as of Friday when the last of it was used to bail out GM and Chrysler.

This article has a quick summary on how the TARP money was spent: $250B was used to recapitalize banks, $40B went to AIG, $20B to insure loses from the New York Fed in its latest bailout measures against a wide range of credit like student loans and credit cards, $20B went to CitiGroup, and then another $5B as a loan loss backstop to CitiGroup, and now $13.4B to the automakers.

The second $350B of TARP money needs Congressional approval and will probably be delayed until Obama takes office.

Money given to the banks is essentially preferred stock purchases from the Treasury Dept at a fixed return of 5%. So it’s an advance of capital of indefinite term which dilutes the value of existing shares. The remaining money was dolled out as loans.

Credit, this blog proposes, is temporary money. When it is paid back or defaulted on faster than it is lent, then money supply shrinks, and deflationary pressures on prices follow. These injections of capital function as credit: they may slow down price corrections, but they do nothing to reverse the course of the credit collapse.

Friday, December 19, 2008

You Will Inflate Dammit!

Over the last couple months the dollar has been shot, stabbed, strangled, and thrown into an icy stream. Thus, quite sensibly, investors are running away from the dollar to other currencies, and much of the advances made in the US dollar index since August has been wiped away. This is still a highly volatile state of affairs.

But yeah, the U.S. dollar is a horrible store of wealth at the moment. With overnight rates now at 0%, and $850B in newly minted bills (now up from $650B) ready to be shoveled into the economy, plenty of systematic effort has been made to devalue it.

Though the U.S. dollar index (USDX) is the usual way the value of the dollar is gauged, this blog posits that a better measure still is purchasing power in its resident economy. Generally, I keep my eye on stocks, houses, commodities, and gold. The coming weeks will tell if the Feds changes in monetary policy will affect the deflationary trends in these sectors.

Tuesday, December 16, 2008


Today the Fed announced it would drop overnight interest rates by 75 to 100 basis points to the 0% - 0.25% range. This is a record low for the Federal Funds Rate, and it cannot go any lower than this.

It is hoped that lending money for free will increase credit, lending, and general economic activity. We haven't seen that with the prior interest rate drops, and we won't see it with this one either. Lending already reached its terminal limit when interest rates were in the 1-2% range in 2003-4. I anticipate credit will continue to contract faster than base money is issued and so deflationary trends will continue.

With the Fed's money printing since September, such that bank reserved have expanded seven-fold, a ZIRP has been the economic reality for over a month. This makes it official.

Monday, December 15, 2008

Lost Money

There’s been a lot of talk about people losing money. Here, “lost money” will mean something different. If you lose $500 in Las Vegas, that’s not lost—the casino has it now. If you tried to flip a $500K house in Stockton and today you are lucky if you get $200K for it, that’s lost wealth, not lost money. Here lost money refers to cash outside the economic system that’s not available for spending; it’s “lost” to the economy, even if we know where it is.

Naturally, I’ve been following closely this latest expansion of base money by the Fed. A few days ago, what had been vertical growth since September has briefly flattened at exactly $1500B. Before, it had stabilized for over a two years around $850B; the rise to that level took years, so the latest 40% increase is very sudden and concerning. Put that in to a 10% fractional reserve system and that could inflate to another $6.5 trillion.

So far though, the U.S. dollar has been maintaining its trend of strength. Against stocks, commodities, real estate, and foreign currency it is much better off than it was a year ago. Though strengthening trends have leveled over the last month, it shows no sign no of remitting back to where it was. (UPDATE 5/20/10: it did over 2009, but today has rebounded and is showing strength again.)

Mish explained nicely with a series of charts from the Fed that the money printed isn’t going in to circulation. This money is on loan to banks, for them to lend out, but banks aren’t lending it out, so it’s just sitting in reserves. The reserve expansion of banks from $100B to $700B over nearly the same time course explains where most of where this money has gone.

So that’s what I mean by “lost money.” If one takes half the currency of an economy and puts it in coffee cans and buries it in the desert, prices will adjust to what money is left; they will fall to accommodate the reduced money supply. If the money is dug up and spent, as it redistributes throughout the economy, prices rise in response to the “new” money. Factoring in "lost money" simply says that prices adjust to what money is actually available for spending.

Wednesday, December 10, 2008

The Timing of Deflationary Downtrends

Austrian economics conceptualizes asset bubbles as being the result of credit expansion in fractional reserve systems. Once the forces fueling the expansion have exhausted themselves, it anticipates asset prices will drift back to “fundamentals” where costs of investments are justified by dividends and risk. Austrian economics explains the reason economic bubbles happen and their ultimate deflationary course (excepting cases of hyperinflationary events).

This post will examine two questions: how long and how high can these credit bubbles go, and once they reach their stall point, how long can inflated prices persist before they return to fundamentals.

Prior posts proposed the “cash-inventory equivalency” where the combined prices of all goods for sale in an economic system tend to self-adjust such that the sum exactly equals the money supply, which in a fractional reserve system is the sum of printed currency and credit. If money supply increases, then prices will follow; if credit and/or printed currency contracts then there is downward pressure on prices else velocity of sales slows and inventory starts to build. “Price disequilibrium theory” anticipates that if money supply grows through an unsustainable expansion of credit, then prices which were inflated as a consequence will be pressured downward once credit collapses.

If such is the case, then peak prices would be consistent with peak credit, assuming printed currency holds constant. Though printed currency is not holding constant at the moment, this discussion will consider the theoretical situation where it does. In hyperinflation, the entire economy collapses and would be in limbo until a new money supply is established. Settings of moderate printing could still be assessed with this model where money supply is the sum of printed currency and credit. But for simplicities’ sake, it will not be.

I have argued before that in our current system banks have nearly infinite capacity to lend, so the limits of credit expansion is not with banks but with borrowers. The limit of credit growth is when borrowers do not have the ability to repay loans anymore, so they can’t borrow anymore. This stands to reason. Unfortunately, it is wrong—otherwise this would all be mathematically straightforward. In the present crisis, credit was expanded beyond and oftentimes without regard to the likelihood of loans being repaid. Banks didn't seem to care. So the question becomes, how far can that go?

The farther this trend does go, the more corrective forces will start to resist further lending. Failure to repay loans will erode the capital base of banks. The political tolerability of bailouts will eventually wear thin as these loses start to mount. As the capital base of banks heads toward zero through failures of loan repayment, the terminal limits of credit expansion would be the willingness of banks to risk their corporate viability on loans which have little chance of being repaid. For each bank, risk appetite will be slightly different, but the general erosion of the capital base of multiple banks marks the endpoint of credit expansion.


Now, for the second question of how long it takes for prices to return to fundamentals after the credit contraction begins. If the prices of investments rise above their fundamental values, and prices keep going up and up, then their worth as investments is driven by the expectation of continued capital gains. Once the credit peak is reached and begins its contraction, further capital gains ought to no longer be expected, and the investment value of an asset is only its ability to generate dividends, rents, or yields. If there is a great discrepancy between disequilibrium asset prices and their fundamental values, then once the peak is reached asset prices should descend immediately to their fundamentals. At this point no buyer should pay more than that. To do so would be “catching a falling knife.”

But the price correction won’t happen immediately; they are slow with losses and advancements, and occasional bear runs, cycling over and over around a downward trend line toward the eventual correction.

Another way to look at the question is to ask why the seller should lower their prices? Prices are a negotiation between the buyer’s desire for the good and the sellers want of money. As desire for over-inflated assets drops, and as sellers need the money—if they need the money—then prices begin to budge downward. If a seller has infinite resources an can hold out forever for a supposed turnaround, and they never need to “cash in” on a held property or investment asset, then prices could stay elevated forever, as velocity slows to a crawl.

If there is a holding cost to an investment—like interest payments on the money to purchase it, or property taxes, maintenance, and fire insurance—then pressure starts to mount on underperforming investments. If maintenance costs exceed rent for comparable properties, then the duration one can wait for the turnaround of property values is a function of economic capacitance, or duration one can weather negative cash flows through dipping in to savings or selling unneeded assets. Once economic capacitance is exhausted, the asset must be sold and the price it fetches reflects market value.

An economic system is composed of many micro-economies—of individuals, families, businesses small and large, non-profits, and government at all levels—and the economic capacitance of each will vary. In a disequilibrium contraction, prices move downward if a critical mass of asset holders are forced to sell at re-adjusted prices such that the market value is reset downward.

So, in price disequilibrium events, the upper limit of credit expansion is when the capital base of banks erodes through the non-repayment of loans. The maximum duration prices remain elevated after credit stalls is a function of the economic capacitance of those who hold the assets.

Saturday, December 6, 2008

Automaker Bailout

So, the news has been back and forth lately around the CEOs at the big 3 automakers saying at Congressional hearings they are "too big to fail," somewhat like CitiGroup did, and along with union representatives are requesting a bailout. The first round, they arrived in Washington in their private jets and asked for $25 million all told. They left empty-handed. This time, they drove there in their hybrid cars and requested $34 billion. It seems from reading about it they had a mixed and lukewarm reception, but an agreement has been reached between the White House and Congressional Democrats for $15 billion in loans.

I wrote my representative Nancy Pelosi, urging her to not use taxpayer money to support unprofitable corporations; rather, what is best for America would be to let the big 3 go under, so their production capacities could be sold to new firms that conduct their business better. I mean, at least the financial industry didn't off-shore Wall Street jobs... I don't think.

Actually, I see a plan starting to unfold: passing another bailout would be politically inexpedient at this point; so, Congress agrees to pass the unspent $350B of TARP bailout money, if the Bush adminstration agrees to give some of it to automakers.

UPDATE [12/11/08]: Though the $14B bailout proposal of the automaker passed in the House, today it was voted against in the Senate. Plan B mentioned in the above paragraph is still in play. [12/19/08] The Bush administration, citing concerns of a disorderly failure of automakers, will lend $13.4B to GM and Chrysler, coming from the first $350B of TARP bailout money. The second $350B still remains unapproved by Congress. Apparently this finishes up the first $350B of TARP funds. [12/29/08] For what it's worth, the Canadian government throws in another $4B to rescue the automakers, and the Treasury allows GMAC, which financed mortgage and auto loans, to be regarded as a bank, and adds another $6B to GMs bailout.

Thursday, December 4, 2008

World Rate Cuts

Today central banks of the world announced rate cuts in a move to offset the global liquidity crunch. Of note: The ECB cut by 75 bps to 2.25%, Bank of England cut by 100 bps to 2%; Australia by 100 bps to 4.25%; New Zealand by 150 bps to 5%, and Sweden by 175 bps to 2%. The coordinated move speaks to the widespread nature of the financial meltdown that began with the collapse of the subprime mortgage market and has extended to credit markets domestic and foreign. Today is a stepping stone that will likely conclude in a worldwide zero-interest-rate policy (ZIRP).

A half-point cut from the Fed to 0.5% is anticipated in their next meeting.

Monday, December 1, 2008

Bernanke’s State of the Economy Speech

Ben Bernanke gave a speech today before the Chamber of Commerce in Austin, Texas. It’s a bit dry but a good read. It paints a sober and sensible assessment of the financial crisis. He has given us some pretty misguided assessments in times past so this is a change.

The first section: “Federal Reserve Policies During the Crisis” is a recapitulation of major financial events since the collapse of Bear Stearns, and policy which has been formulated in reaction to them. It echoes most of the events reported on in this blog, telling things from the Fed’s perspective, and making some attempts to encapsulate the arguments pro and con to its actions. The only thing left out—that should have been included—is the recent expansion of base money supply.

The second section: “Economic Outlook” predicts the continuation of general economic downtrends at least for the short term, in housing, cars, and general retail, for example. In the long run, naturally he is optimistic about the U.S. economy. Around housing he specifically anticipates the “eventual stabilization in housing markets as the correction runs its course.” Finally, Ben has discovered the blogosphere!

The third and final section: “The Outlook for Policy” there were four points he spoke on: (1) Regarding the Federal Funds Rate that is now 1%, he admits the actual effective rate has been lower than that because Fannie Mae and Freddie Mac have been undercutting the Fed and lending their reserves overnight for less. Though he indicated the possibility they might go lower, at 1%, there isn’t much farther to go. (2) The Fed also offered the possibility to purchase GSE bonds, and Treasury Bonds to boost liquidity in the system. (3) The vast array of liquidity measures provided now can be broadened out and expanded further, he tells us—which would necessitate a expansion of the Fed’s balance sheet that would need to be contracted over time to prevent inflation. And (4) the Fed will continue to “preserve the viability” of failed financial institutions where it poses a systemic risk. He concludes by adding that foreign central banks are conducting similar extraordinary efforts. Again he leaves out the increase in base money by $650B (and counting).

Treasuries rallied on point (2) of the third section. Stocks fell sharply today.

Wednesday, November 26, 2008

Credit Expansion: Endgame

In a recent post where I revisited fractional reserve lending, I explained how as one goes below 10% reserves that small percentage changes result in drastic increases of the money supply. Additional capital can then be had through floating bonds, selling securities, and Federal Reserve bailouts. So we live in a system where people who have motive to borrow and means to pay back will find a loan—the limit is not with banks, but with borrowers.

Now, in recent times, in the latest mania, lending standards fell below even the ability to repay. The preponderance of stated income “liar” loans, negative amortization loans, option arm loans, and the general availability of mortgages over the Internet, seems evidence of that. Mortgages were originated with little discrimination figuring that house prices were only going to appreciate, so even defaults would be profitable. A nice theory.

Neither logic nor reality bears this out. House prices stalled in late 2005 or 2006 and began their descent about a year later. The timing varies by region, and I would argue the rate of correction depends on the economic capacitance of homeowners in the area.

In the end, credit expansion is limited by the ability to repay loans. If lending goes beyond that, defaults erode the capital base of banks. Money is created via credit when deposits are lent out, up to the reciprocal of the fractional reserve. That same money is undone when principle on the loan is paid back. Credit is a temporary increase in money supply that attenuates to zero over the life of the loan; though if rate of loan origination is stable then money supply holds constant.

But when a loan is defaulted, after the bank tries to recover what assets it can, what debt is left is a square hit to the capital base. If a dollar is deposited, and 90 cents is lent, and the loan defaults and only 50 cents is recovered through seized assets, then the bank is 40 cents in the hole on that dollar deposit. It will need to be compensated by successful loans elsewhere. The potential money supply hasn’t changed. Those 40 cents not recovered has been spent and redeposited elsewhere and is still in the banking system.

So if banks lend what borrowers cannot pay back, their capital base erodes. If this happens enough times, their solvency depends on government and taxpayer support. It will eventually become clear that the more the government subsidizes unsound lending practices, the less it will have for its infrastructure needs.

The limit of borrowing is where interest payments equal income minus subsistence expenditures. Credit expansion cannot go beyond that. If interest payments go beyond that, economic capacitance can hold for so long and then it requires a tax base willing to compensate the difference. Bailouts are unstable territory that only goes so far.

Tuesday, November 25, 2008

Is the Dollar Headed into the Toilet?

I've never said the inflationists are wrong about inflation. I do think the inflationists are wrong if they say the dollar is absolutely going to inflate; and likewise I'd say the deflationists are wrong if they are certain about their perspective. With inflationists, you do tend to see more unsubstantiated and absolute belief in their position than you do with deflationists. I've only said whether the dollar inflates or deflates is a policy decision, and that it is my belief those in power would rather see deflation. But I may be wrong or not have the whole picture.

The vertical expansion of base money supply is worrisome at this point; base money supply has nearly doubled since September after being flat for years. Not dividing cash investments into other stores of wealth such as gold would be ill-advised at this point unless the vertical trend flattens very soon.

That said, given that money supply in any fractional reserve system is the sum of printed currency and credit, and that fractional reserves set by the Fed are at 10% and have probably been whittled down over the last few years, then at least 90% of the total money supply would be credit. Now say there is a 20% contraction of credit, and printed money doubles: then overall money supply has still dropped by 8% since the 18% loss to general money supply through credit contraction is compensated by only a 10% increase in printed money. Similarly, if credit drops by 50%, then even tripling printed money would not be enough to compensate a system which has been "credited out."

As has been argued by me and others before, as money supply tightens, prices need to fall to compensate, and hence deflation, where a given dollar can buy more and more.

So where the value of the dollar goes from here is a guessing game, and only the federal regulators know the answer.

Night of the Living Bailouts

Just when you thought it was over...

The Fed has pledged another $800B today hoping to keep the credit monster alive. $600B will be used to purchase troubled mortgages from Fannie Mae and Freddie Mac. Of this, $500B would buy mortgage backed securities, and another $100B would buy debt directly; I take it, the Fed would become homeowners. I can understand them not going to Congress for this money because they just approved $700B for that exact thing last month, and then the Treasury Department went ahead and did something completely different.

On top of that $600B, another $200B will be available for the general credit industry, which includes car, student, small business, and credit card loans. Non-recourse loans would be provided to these agencies, with (supposedly) highly rated securitized debt as collateral; if banks default on them, the Fed cannot recoup the money. The Treasury department will throw in $20B of TARP money to back the Fed in the event of defaults.

Obama is speaking as well of a $500B stimulus package. Given the pace of financial events, I'll wait until he takes office and this is passed before commenting in more detail.

...Actually, probably nobody thought it was over. That $700B lasted all of a month before the economy is in hot water again.

We're talking tens of thousands of dollars from every taxpayer going to the private interests of highly unprofitable and misguided financial firms. Currently, the justification is that this is all just loans, and the Fed and Treasury Department anticipate it will be reimbursed. We'll have to see how long this fantasy lasts.

Monday, November 24, 2008

Credit Expansion 101—A Primer

Since credit is the last leg of economic capacitance, or nearly last, I’d like to revisit the creation of credit and its limitations before considering the timing of deflationary downturns.

Money supply is the sum of base money and credit. Credit is created from deposits through fractional reserve lending—which allows money to exist in two places at once: deposits are available to the depositor on demand, and at the same time all but the fractional reserve may be lent out. In this way, money has been created through lending. This is the first step in the expansion of money supply through credit.

If the fractional reserve rate is 20%, then 20 cents of every dollar must be kept in the bank while 80 cents can be lent out. Ultimately, through spending and re-depositing this 80 cents again and again through the fractional reserve system, that deposited dollar has been expanded five-fold. Every dollar lent can expand money supply by as much as $4 in a 20% fractional reserve system. Exactly how lending 80 cents of every deposited dollar expands money supply by a multiple of 5 was reviewed in this post, and links within explain it in more detail still. Similarly, lending 90 cents on the dollar, with 10% fractional reserves, expands money 10-fold, and lending 99 cents on the dollar expands money 100-fold, and as you go to 0% then money expansion points hyperbolically skyward to infinity. That is, assuming all money that can be lent out has been lent out.

So, with small changes in fractional reserves from 10% going toward the 0% range, we can get asymptotically huge increases in money supply so long as the banks desire to lend and borrowers want to borrow. If interest rates are suppressed by central banks, that will sweeten the pot. Money supply can easily be expanded to ones hearts content by reducing fractional reserve limits—until you run out of borrowers.

Capital that banks take in through the sales of commercial paper and securities vary from deposits in the sense there is no reserve, but it cannot exist in two places at once either, so no money creation can come of it. Same with TAFs and any other low-interest capital injections that banks get from the Fed. They allow additional lending from banks outside of the deposit base, but do not expand money supply.

If the Fed and the FDIC are willing to back deposits, which they are, fractional reserves can drop as necessary to allow money creation though credit to expand to the degree that society desires to borrow. The only limitation is what people are capable of borrowing. The next theory post will consider the limits of credit expansion from that perspective.

Sunday, November 23, 2008

TARP Money and Asset Guarantees for Citigroup

In a timely example of economic capacitance, Citigroup is crashing and burning. Over the last week, despite protests of adequate capitalization, it's stock values are in their final death throes. Admittedly, it probably would be an unwieldy FDIC seizure, so Citibank will be getting an additional $20B in TARP money in exchange for handing the Treasury Department preferred shares at 8%; and in addition Citigroup will pay them $8B for loan insurance on $300B it holds in troubled assets.

It was barely over a month ago that Citigroup was fighting with Wells Fargo over the right to buy Wachovia. How times change. Now, the terms of the FDIC seizure of Wachovia were so favorable for Citigroup that who knows, it might have allowed them to persist a little longer. But that wasn't to be. Their options have run out. Government bailouts I suppose are the last and final leg of economic capacitance.

Wednesday, November 19, 2008

Economic Capacitance

Of late, the flavor of financial news has shifted. Much less is there a focus on the shenanigans of Washington and Wall Street, and much more we see reports of job loses, downsizing, and lowered expectations in the retail and manufacturing sector. The collapse of Circuit City, and the pleas by the big three automakers for bailout money, are recent examples that come to mind.

This blog attends to the supply of base money and credit, trends in general prices, and the relationship between the three. The strife that comes of failing financial policy I’ll leave to other sources. But personal case examples I see have started to accumulate over the past month or two.

So, the subject brings up a concept I’d like to introduce: "economic capacitance." Capacitors I know from the physics of electrical circuits—where stores of electricity build between two parallel plates, such that when the energy supply is turned off the capacitor will discharge and continue to power the circuit until exhausted. Economic capacitance behaves similarly, and refers to stored wealth, like savings accounts. In coming posts I will use it to conceptualize the timing of deflationary downtrends.

Prices are, and should be, whatever the seller decides to charge. If underpriced, then inventory will fly off the shelves and be consumed or resold at a profit. If overpriced, inventory will move slowly and accumulate. To reduce prices of a given investment below what was paid, the asset holder must concede a loss. The other option is to cling to an unprofitable business or investment practice hoping for a turnaround.

Economic capacitance will refer to the ability of an economy— personal, government, business, or otherwise—to persist under adverse financial circumstances before collapsing in bankruptcy and foreclosure. It is the ability to withstand negative cash flows and relates to the amount of savings one has, assets one can sell, and the amount of credit they can borrow. It reflects the duration one can persevere with a negative cash flow.

There has been a tendency over the past few years to put a positive spin on one’s financial status—until overnight suddenly a business is bankrupt. It began with the fall of Enron, and we saw it with Bear Stearns, Fannie Mae, Freddie Mac, Lehman Brothers, AIG, Washington Mutual, and Wachovia. The factors that comprise economic capacitance are all private matters that nobody wants to share. Capacitance allows an unprofitable system to appear well until the point of total collapse.

Sunday, November 16, 2008

Opening of La Boheme

Today was the opening performance of Puccini's La Boheme at the San Francisco War Memorial Opera House. The opera was quite good and I highly recommend it.

Before the show, director David Gockley came on stage with an announcement that the turbulence in the rest of the economy is affecting the San Francisco Opera Company as well. He reassured us that certain standards would not be compromised, but advised the audience of uncertain times ahead in terms of its finances.

Now, this announcement must sound pretty strange to anyone going to operas there for the past few years. I was there at the performance of Madama Butterfly two years ago when he announced a $30 million gift, and since then even that was superceded by a $35 million donation. You would think that kind of money might last them a couple years. But at the performance today (I wish I had a written script of it) he mentioned problems with the "liquidity" of general funds, and access to capital. He sounded genuinely distressed, rather than the usual perfunctory plea for our donations. Nearly every opera I go to is full so ticket sales should not be a problem, which he confirmed was the case.

So what did they do with $65 million in donations... go out and try to flip houses in Sacramento? If that is the case, I say they can just burn opera scripts to stay warm. Or might certain endowments be (and none were mentioned by name) securities packages based on "mark-to-fantasy" (AKA mark-to-model) values that are really nearly worthless, such that the benefactors can write them off as charitable contributions?

Given how much press there was about the donations, hopefully more information on this matter will be revealed over time.

Friday, November 14, 2008

FDIC-Treasury Squabble

In an interesting display of interdeparmental politics, Sheila Blair who heads the FDIC has pushed forward with a proposal to use $24B of the $700B TARP bailout money to assist with mortgage loan modifications. This is 3% of money that was earmarked for Wall Street, and even that amount Paulson and the Bush administration is raising objections to.

It's becoming more obtrusively clear that the money was only intended to be a taxpayer bailout of the rich and powerful.

UPDATE [11/18/08]: This is almost a new post, but in questioning today by the House Financial Services Committee, Paulson reiterated that it was not his intention to use the $700B TARP bailout money to assist specifically with mortgages, and he does not plan to bail out the auto industry either. Interestingly, he added that he only intends to use $350B of it; the rest would be for the Obama administration. (Recall that $250B was allocated for the immediate use by the Treasury Department, then another $100B additional merely required approval from the President, then the last $350B require approval from Congress.) He added that it is his belief that the government would recoup the expenditure (having been used to purchase preferred stock in banks). If history bears this out then my opinion of him and the bailout would improve somewhat.

UPDATE [2/7/09]: ...but I guess not. This preferred stock has recently been valued at 60 cents on the dollar at purchase time, which adds up to $78B of tax money given to support failed businesses with excessive executive compensation. No surprises there—to my mind this has always been $700B down the drain regardless.

Wednesday, November 12, 2008

"Shifty" Paulson

The news today is reporting that Treasury Secretary Paulson is changing the way that the $700B bailout money is going to be spent. He has already done this once in a big way when he used his first $250B to buy preferred shares in banks rather than to accumulate troubled mortgages. In fact, I can't recall the man ever saying the same thing twice, so today's change of plans is hardly news and should have been anticipated. Today he is shifting away from mortgages entirely and hopes to direct the rest of the bailout money to credit cards, student loans, and other areas where the financial industry has been taking loses.

To my knowledge, the Treasury Department has not acquired a single troubled mortgage, which was the original intent of the bill. Banks are now starting to modify mortgages as they would under a free market without any government assistance, on the principle that getting less money from a loan modification is better than getting even lesser money from a foreclosure, in the setting of declining house values.

Actually, recalling my review of the legislation there was hardly a mention of mortgages, so the program is going as written, if perhaps not as advertised.

ADDENDUM [2/7/09]: For a nice review of bailout history and a blistering commentary on Paulson check this out.

Tuesday, November 11, 2008

China Stimulus

China has announced a $586B stimulus package. Though the number is quite high, since we are considering a communist nation, it doesn't particularly strike me as news, to the degree that the economy is funded by the public sector to begin with. Hopeless optimists see this as reason for a possible turnaround of a general downtrend in their manufacturing that had been explosive over the past few years, but was driven by credit and dependent on extreme global consumerism also driven by credit. Actually, it is an admission they have the same serious financial woes that are affecting other nations

Monday, November 10, 2008

Bailout Money at Work

American International Group (AIG), America's largest insurance company, has taken a prominent role in the bailout saga. First, it was taken under Federal conservatorship September 17th with an $85B advance for capital—with the intention that the profitable parts of the company would be sold off for as much and repaid to the Fed. Once the bailout money was received, the execs partied with expensive spas and hunting trips. Now AIG is back in the news needing even more bailout money, to the tune of $150B all told.

AIGs role in this was to sell Credit Default Obligations (CDOs), which allowed banks to sell off subprime mortgage backed securities to private investors, giving them more money to lend out, allowing for the ridiculous explosion of credit in the early half of this decade. When pools of mortgages are chopped up in to tranches and sold as securities, banks have to keep the riskiest "unrated" tranches for themselves—the ones that will go belly up first. They can avoid risk by getting CDOs (or bond insurance) on those tranches in case they default. This all is fine and dandy, until the insurance company is teetering on the verge of bankruptcy. Apparently, AIG was a major provider of CDOs.

CDOs are key. So long as banks can insure their unrated tranches as they sell off loans as securitized debt, they are no longer limited by fractional reserves as to the amount of credit they can create. Without CDOs, this credit explosion either could not have happened, or would not have happened to the degree that it did. Bailing out AIG is a more civil way of handing money to banks straight up.

Thursday, November 6, 2008

Coordinated European Cuts

I guess I'm back on, after a few days where financial events had slowed down I figure due to the election. Today the ECB dropped prime interest rates by 50 basis points to 3.25%; the Bank of England dropped their by a whopping 150 basis points to 3.00%; and the Swiss National Bank dropped rates by 50 basis points to 2.00%.

The European liquidity crisis is in full swing, and this is good news for the value of the dollar relative to these respective currencies (euro, pound, swiss franc). The euro appears to be having a particularly strong correction over the last couple months.

Wednesday, November 5, 2008

Congrats Obama!

Congratulations to our next President Barack Obama. Either candidate would have been a welcome replacement over the current administration—I believe the most fiscally self-defeating in our history. Unfortunately, both candidates supported handing a $700B blank check to the Treasury Department to bailout Wall Street. But Obama won over McCain with an attitude of hope, change, unity, and without the mudslinging campaigning that has come to dominate politics over the last few years.

Saturday, November 1, 2008

Red October

In October we see a chaotic whirlwind of financial news; though all of it though, we also see a fairly clear signal of the strength of the dollar, despite economic turmoil domestic and abroad.

We see the passage of the $700B bailout bill—followed almost immediately with a sudden plunge of the DJIA to the low 8000 range, with a struggling recovery in to the 9000s at month’s close. (Even in the low 9000s it is about 1000 points below the prior trend line dropping at 3000 points per year.) We see reason to wonder if those $700B are really going to trickle down to main street, as promised, since bad mortgages were not off-loaded from banks as planned, but rather big banks were forced to sell preferred stock to the Treasury Department, and plan to use the money mainly to acquire smaller, struggling banks. In other words, we see a huge move toward centralization of U.S. banks around the Fed and the Treasury Department.

I’ve also caught wind that the “Hope for Homeowners Act,” passed in August, is struggling if not failing. I’m not going to repeat the low numbers I’ve heard for revised mortgages under the legislation because they must be inaccurate.

In October we see a massive printing campaign of U.S. dollars, where since mid-September the base money supply has increased by half. This would be bad news to anybody with a savings account, were it not for much stronger deflationary forces in play. Even this huge injection of cash is small compared to the magnitude of credit loses. There seems to be a general demand for hard cash world-wide that the printing is a response to.

We see no end to liquidity measures from the Fed such that I’ve stopped adding it up. There is practically unlimited capacity for borrowing in the system, sponsored by the Fed, and the taxpayer. Such measures are having no effect other than possibly to be preventing total collapse. Just because one has a credit line doesn’t mean anyone is using it. We’ve reached a point where we cannot manage our credit problems anymore with more credit.

In October, we see significant declines of all investment classes against the U.S. dollar: stocks, commodities, real estate, foreign currency, metals, have all fallen in price. This is all far from over but the strength of the dollar at this point supports the underlying premise of this blog: that the value of cash is inversely proportional to credit in the system; in other words, as credit collapses, cash will strengthen.

A common sentiment when I started this blog—that the U.S. dollar is about to tank because our general economy is in trouble—has proven inaccurate.

Thursday, October 30, 2008

Dollar Swaps

Earlier this month, the Fed established $600B of swap lines with European banks, where the local currency could be exchanged for dollars. Yesterday, the Fed announced similar swap lines with Brazil, Mexico, Korea, and Singapore, at $30B each.

I understand that dollars are in scarce supply which causes problems with foreign banks paying their debt to U.S. banks. In essence, the swaps would appear to be an indirect way to further replenish the capital base of U.S. banks (by giving dollars to foreign banks who owe U.S. banks money), while the Fed ends up holding on to up to $700B in various foreign currences that could easily continue their decline.

I have a suspicion this is where all the newly minted currency since September is going.

Wednesday, October 29, 2008

Fed Cuts to 1%

In its ongoing effort to reinvigorate the economy, the Fed cut the overnight rate by 50 basis points to 1% today. Liquidity measures so far have done little to reverse the deflationary course for houses, stocks, commodities, and foreign currencies, though arguably it might be slowing the process down. Still, the Fed would be remiss not to exhaust its options, and so we fast approach the "tyranny of zero."

Tuesday, October 28, 2008

Carry Currencies

This post considers how the foreign carry trade affects cash value. To repeat, the carry trade is where a bank borrows money at low rates to invest in higher yielding loans; the foreign carry trade is where banks borrow money from a country with low interest rates, exchange it for a local currency where national interest rates are higher, and then lend that out.

Currencies which underwrite the carry trade will be referred to here as “carry currencies,” vs. “exchange currencies” which form the second leg of the transaction. To be a carry currency, interest rates must be suppressed by the monetary policy of their national central bank, such that it becomes an attractive source of capital for foreign investors. This is true of the yen since the early '90s and of the dollar since 2002.

Now, what we see in this credit meltdown is carry currencies strengthening, and exchange currencies falling off a cliff.

The strength of a carry currency would be similar to the strength of deposits in a credit crisis: e.g. savers are owed their deposits regardless of the performance of the loans they underwrite. Failed loans are a loss to the banks; but even uninsured deposits would only be threatened if the bank outright fails. Likewise, banks still owe back any foreign loans they take as capital regardless of the performance of their loan portfolio. So a carry currency is a safety bet, particularly if governments seem eager to bail out the banks.

During boom times deposits suffer because greater yields can be had elsewhere; and likewise anyone holding a carry currency would be better off converting that to an exchange currency and depositing it in a foreign bank at a higher interest rate.

A general problem for the exchange currency in this system is that if the carry nation is big enough, like the United States and Japan, then exchange nations like Europe would have a huge source of capital to over leverage themselves with risky loans. Whereas American banks had to go scrounging for commercial paper investors and securities buyers to expand their lending portfolio, the Europeans had two of the world’s largest economies to draw their capital from.

How the foreign carry trade plays out will be commented on as it unfolds.

Monday, October 27, 2008

The Foreign Carry Trade

The carry trade is simple in principle: borrow low and lend high. Pay depositors 3% on their savings so you can lend it out for mortgages at 7%. The 4% difference is profit for the banks. Internationally, it is a similar principle, and may explain some of the bizarre relationships now being seen in world currencies.

It goes something like this: If the Japanese central banks sets its lending rate at or close to 1% year after year, and if the European central bank sets it closer to 5%, and the two currencies stay fixed against one another, then wouldn’t it be sensible to borrow from a Japanese bank where loans are going to be cheaper, convert the yen to euros, lend out the euros at the higher interest rate, then when the loan is paid back in euros, convert those euros to yen, and pay back the Japanese bank?

That works, so long as (1) all currencies involved are readily available in a fluid market, and (2) everyone is paying back what they borrow, and (3) currencies are holding their relative value against one another and exchange costs aren't too high.

In a liquidity crisis, say the Japanese banks are holding on to yen because they are facing currency crises of their own, and don’t want to lend to foreign banks out of a general lack of trust in the creditworthiness of the system, then the yen becomes increasing scarce, and begins to skyrocket on foreign exchange markets in a scramble to make repayment obligations.

While Japan has operated in a system of suppressed interest rates for decades, for America this has been true as well for the better part of this decade, and the dollar has become a carry currency. In other words, American banks have lent to foreign banks in dollars, and the foreign banks converted those dollars to, say, euros, and then lent euros out at higher rates to whomever for whatever, and when paid back they converted euros to dollars and paid back U.S. banks. Now as dollars are becoming scarce, it’s value in foreign exchange markets is quickly rising, which may be behind the Federal Reserves recent printing campaign, and its pledge to supply foreign banks with all the dollars they ever need with their own currencies as collateral.

The simultaneous plummeting of most world currencies against the dollar, except the yen which is swinging but mostly rising, suggests we are in the beginning phases of a collapse of an overleveraged international carry system. Details will be commented on further as the process continues.

Friday, October 24, 2008

8,000 Territory

Earlier this month, right after I made the 10,000 call for the DJIA trend line, and right after the $700B bailout bill was passed, the DJIA plummeted right through the 9,000s, and this week was hovering in middle 8,000 range. I'm not anticipating much steam in any recovery in to the 9,000s again.

On the other hand, last week Warren Buffett made a bottom call, reportedly moving all of his personal holdings from Treasuries to the stock market, and advising everyone else to do the same. Many feel this decline still has a little ways to go. There would be no doubt in my mind there is a long way to go, were it not for the spectre of inflationary printing.

Thursday, October 23, 2008

$350 Billion Expansion of Base Money

The base money supply, according to this graph from the St. Louis Fed, had been holding steady at $850B for the better part of the last two years. Since September, it has shot up to $1200B—which is a whopping 40% increase in base money. Are we at the verge of the Wiemar Republic?

For now, the U.S. dollar is strengthening against: stocks, houses, nearly all commodies, the euro and nearly all world currencies except the yen, and now recently it is even strong against gold. Gold is trading strongly, it is just that it is priced in dollars, and the dollar is trading more strongly. The U.S. dollar seems to be in high demand worldwide. In short, we have both deflationary forces though the collapse of credit, and inflationary forces through printing in play.

My general investment strategy remains unchanged. With charts like we are seeing now I cannot advocate a cash position, but I still hold the belief that deflationary forces will outweigh inflationary ones as this drama unfolds.

Tuesday, October 21, 2008


Yet another bailout instrument from the Fed is announced today—the Money Market Investor Funding Facility—offering $540B for struggling money market funds now tight on capital. The word is they are having problems honoring withdrawals in a timely way due to difficulties redeeming commercial paper in the current financial environment.

Friday, October 17, 2008

Fed Printing

This uptick in base money supply is no longer dismissible as an artifact or a random miscalculation, and seems to be trending skyward.

For the past year the Fed has been trying to save markets by enhancing liquidity. As this economic machine has reached credit exhaustion where liquidity measures have little further effect, now the Fed is turning to printing to unfreeze the economy. If they print enough, the U.S. dollar collapses. This is not a safe market for anyone or anything.

The solution to the current market freeze is to lower prices. There is only one alternative: to inflate the dollar.

German Bailout

In a situation closely paralleling the U.S. $700 billion bailout, the Germans today passed a similar plan for $675 billion (480 billion euros). Other European nations are likely to soon follow suit. The European recession which had been lagging the U.S. situation by a few months has now just about fully caught up.

Wednesday, October 15, 2008

So Who's Fault is This?

Now that we are playing the blame game—and fingers are pointing at Wall Street—who really brought all this on? Greedy Wall Street types were just acting according to their nature when presented with the opportunity. This doesn't wholly absolve them, but their actions were predictable given the circumstances. Who gave them this opportunity? Without the 1-2% overnight rate set by the Greenspan Fed from early 2002 to late 2004, the mad scramble for credit that resulted in the mortgage bubble would unlikely have ever started. Securitized loans and structured investment vehicles (SIVs) arose en masse to take advantage of the situation, pouring in to the system ever increasing cheap credit relative to savings and GNP—and thus price disequilibrium.

Real estate and stock prices returning to their equilibrium values should be welcome. Those whose financial security depends on disequilibrium prices are the same ones demanding taxpayer bailouts.

Monday, October 13, 2008

Bank Announcements

There were a lot of announcements by banks today. The Treasury Department made some announcements how it plans to begin the bailout, which is pretty much in accord with what the bill states. European leaders announced an aggregate $2.3 trillion rescue package for the banks, where each country pledged a certain amount to its own banking system. The actual money has yet to be appropriated. Bernanke pledged as many U.S. dollars as foreign banks want. I'm not wholly sure of the significance of this but will keep eyes peeled for financial analysis of its relevance. Market traders were not disheartened by the news today.

UPDATE: it seems the Treasury Department is moving away from the idea of exchanging toxic securities for Treasury bonds, and toward purchasing preferred stock in banks. Both hand taxpayer money to the banks who created this mess; however the preferred stock might hold value better than securities. The whole idea of "free market" in the financial industry is such a laughable notion by now that I don't find nationalization of the banks particularly troubling. So who knows... this change of policy still fits to the letter if maybe not quite the spirit of the $700 bailout bill.

Otherwise there is a mystery brewing as to why U.S. dollars are in such urgent demand in Europe.

Market Amplitudes

After a week of huge downswings, today the DJIA lept 936 points, or 11%, which was the biggest point gain and percentage gain in its history, and other markets followed suit. What this means is the amplitudes of the sinusoidal variances are growing. This is not a sign of market health.

Friday, October 10, 2008

Price Disequilibrium Theory

Classically, prices are driven by supply and demand. The Austrian School of economics adds the influence of money supply, as defined by the sum of printed currency and credit. This post will consider the influence of all these factors on price stability and instability.

The present theory of pricing begins with the assumption that the sum of all prices for all goods, services, investments, and anything for sale in an economic system is exactly equal to the money supply. This assumption does not require that all sellers conspire to price their wares such that the sum total equals the supply of printed currency and credit. Rather, the system resolves itself spontaneously: if prices are set above the relative demand for the item, then velocity of sales will slow such that inventory builds and prices are forced downward to clear the excess supply.

Explaining it in mathematical terms, we start with the identity that money supply (M) equals inventory (I). This position was defended earlier in the post "The Cash-Inventory Equivalency." Inventory then can be broken down to the sum of all classes things for sale, with a desire coefficent (d), and numerical supply for each category of goods. The fraction of money supply that goes for each subcategory (x) is d(x)*M. This would be divided by the number of goods in each subcategory to calculate the price per item: or d(x)*M/I(x). This is the equilibrium price for the item so long as demand, money supply, and inventory remain constant.

Now sellers are free to set prices at whatever they choose, but if they price it above this equilibrium point then unsold inventory will start to accumulate.

If money supply were only printed currency, then if money supply were inflated by printing bills, then equilibrium prices will adjust upward to reflect the increased money supply. A printing campaign could wreak havoc on bonds, deposits, and other kinds of savings, but the active elements of the economy simply adjust to the inflationary pressures by raising wages and prices.

Now, let us examine how prices may be pulled from an equilibrium state through the injection of credit. Consider the truism that money supply is the sum of printed currency plus credit. If banks start lending out their deposits, but those deposits are still fully available for withdrawal, then by definition there is a fractional reserve banking system. If regulators or legislation dictate that fractional reserves must be kept at 10%, then if $1000 is deposited in a bank, then money supply is increased by 9 times the deposit. The bank, who must keep in reserves 10%, or $100 of the deposit, can still lend $900. After the $900 is borrowed and spent and redeposited in another account, then 90% of that, or $810, can be lent again, and so on, until that $1000 expands the money supply by $9000.

So in a 10% fractional reserve system, assuming banks hold on to all deposits, the money supply is expanded 10-fold through lending, and price equilibrium adjusts to the reality of fractional reserves.

The problem with fractional reserve lending is that it leverages money, and any kind of leverage increases sensitivity to economic downturns. What might otherwise be a small downturn becomes a financial catastrophe if one is over-leveraged. Economic stability in a fractional reserve system requires a government willing to bail out banks in these sorts of events. However, when things are going smoothly, fractional reserve banking does not cause price disequilibrium. It merely expands the money supply by the reciprocal of the fractional reserve.

However, when cranks are pulled and buttons pushed on the financial machine such that credit is piled in to the system in an unsustainable manner, beyond the level of the deposit base plus fractional reserve credit, to the point where the system cannot borrow any more regardless of how available the credit is or how favorable the interest rates are, we have the essence of price disequilibrium. Here, money supply is inflated by unsustainable levels of credit, where prices break from equilibrium to readjust to the expanded availability of credit. Predictably, this increase in the money supply is only temporary, and as the credit expansion is paid back or defaulted on, and the burden of paying back loans is such that now credit cannot be lent to match the peak rate or even the baseline fractional reserve rate, then prices of goods, services, and asset investments must fall to a new equilibrium that reflects the contracted money supply.

This post defines price disequilibrium and its general underlying mechanism. Further posts will consider the limits and timing of price shifts and the related phenomenon of speculative runs on commodity and asset investments.

Thursday, October 9, 2008

Sinusoidal Variances about the Trend Line

Today is the one-year anniversary of the DJIA closing at its highest point ever, at 14,163. It had gone higher than that—the 52 week high is 14,279.96 in midday trading. As of this writing, it is a full 5000 points off from peak, struggling in the low 9000 range. 8000 territory is just a hiccup away.

There have been wild fluctuations of peaks and troughs on this downward pathway, and there is always plenty of financial analysis why it is up one day and down the next. Try as I might to resist, on occasion I succumb to correlating an up or downshift with a current event.

What matters, though, is the trend line. The market, being an imperfect tool for knowing the trend line precisely, will predictably cycle around it in a sine-wave fashion, with day traders knowing this and going long and short to play off of these inevitable rhythms.

Despite the day-to-day financial craziness lately, the DJIA trend line over the past year has been very stable, falling constantly at a rate of—eyeballing the chart—just under 3000 points per year, with it bucking that trend only in the last few days in a serious downward shift. Crashes tend to start slow and accelerate in the middle—and then what happens at the end varies case by case, so it is possible we might be entering the accelerated middle phase.

So, I welcome financial commentators to explain why the trend line is dropping at a rate of almost 3000/year (with peak-to-trough being 2000 points higher than that). If they say it is because of the credit crisis, then I’d ask if there is any reason to believe the current trend will not continue for the next year. If they answer because the financial industry is getting a bailout, then I would say, lets get some popcorn, kick our feet up on the desk, and watch the action as it unfolds.

But I’ll try to avoid getting excited about short-term fluctuations, including this current one. This is a deep spike downward, but I anticipate there will be some recovery before proceeding with its steady downward course.

ADDENDUM: ...and what an anniversary this was, with an already bottomed-out DJIA dropping an additional 7% to 8579, mostly in late-day trading. Not long ago any bottom calls in the 8000s were considered radical, and there is plenty of steam left in this bust.

National Debt Passes $10 Trillion

Congress is wasting no time taking advantage of the new, recently passed, debt ceiling. And Treasury Bonds I hear have been selling like hotcakes at bargain interest rates.

In "a sign of the times" the Times Square national debt counter has run out of digits and cannot handle the newly-dinged $10 Trillion that taxpayers are now on the hook for. As a stop-gap, the dollar sign will be changed to a one. Almost more ominously, not one, but two digits will be added.

I would hope maybe we would think about... once this economic crisis settles... of taking away a couple digits.

Wednesday, October 8, 2008

IMF Predicts a Global Economic Downturn

All I gotta say is... isn't it a little late to be making this prediction? How about people make their forecasts before these things actually happen? Academically popular theories miserably failed to see this economic course of events. The Austrian School has predicted it for years and has been telling us exactly why.

Multinational Rate Cut

The central banks of the U.S. and Europe today dropped overnight lending rates by 50 basis points. For the Fed, that is now 1.5%—the first change since April, where it had been steady at 2%. ECB's new rate is 3.75%, Canada 2.5%, UK 4.5%, and Sweden 4.25%. China lowered its rate by .27%, and Japan, who has already been through the credit unwind, kept rates the same.

Given current deflationary pressures, this step is not surprising. Now whether it will help, or if these liquidity measures are just kicking a horse already dead from credit exhaustion, remains to be seen.

Tuesday, October 7, 2008

Fed to Buy Commercial Paper

Commercial paper refers to short-term bonds used by corporations for quick cash to cover temporary deficits. Typically it has a term of about a month with 3% interest, and historically has been regarded as "safe as cash."

Auction rate securities are one kind of commercial paper discussed before, which were floated by the financial industry, who cycled short-term bonds at low rates to fund long-term mortgages at higher rates. The failed auction-rate security system is now subsidized by TAFs, PDCFs, and TSLFs, arranged by the Fed and underwitten by the U.S. tax base.

Today, the Fed announced it would start to buy commercial paper from outside the financial industry. This market is drawing fewer investments from fund managers, and American businesses need it to operate. This was just an announcement; how much the Fed was willing to buy per business or aggregate was not disclosed.

Public Law 110-343 "bonuses"

It's like twenty bills in one! The Emergency Economic Stabilization Act came bundled with such an eclectic array of additional legistlation that it defies summary. Here are a few of the measures that were tied in to the bailout bill:

Most relevant would be increases of FDIC deposit limits from $100,000 to $250,000 until December, 2009.

Then there is a wide array of tax breaks for some very specific and localized interests, which is ironic considering what this bill could cost. Tax breaks for the use of alternative energy and plug-in hybrids stands out, and to those affected by recent hurricanes. Then there are tax cuts for "certain wooden arrows designed for use by children" and plenty of other focal beneficiaries of random tax cuts.

Approximately 20 million Americans will be protected from the Alternative Minimum Tax. It has never applied to me so I don't know much about it.

Insurance parity for mental health and substance abuse treatment services was thrown in; I suppose this isn't wholly unrelated since the government is funding a good chunk of those services now, perhaps it will permit a little "cost-shifting."

So, in conclusion, a lot of deals were made with a lot of congressmen to sugar coat the bill and get this bailout package through.

The Emergency Economic Stabilization Act of 2008

Last Friday Congress authorized a $700 bailout package in hopes to contain the overall economic turmoil from the meltdown of the financial industry, mainly centered around bad mortgage loans. A summary of the legislation is as follows:

The bill is divided in to three titles: The Troubled Assets Relief Program (TARP), Budget-Related Provisions, and Tax Provision. The core of economic rescue provisions is in the first title.

It authorizes the Secretary of the Treasury to purchase "troubled assets" from any financial institution, including the FDIC, and also from foreign financial authorities and central banks. It asks the Secretary to manage assets in a way that minimizes costs to the taxpayer, in terms of their purchase, holding, and sale. Purchase premiums should be in accordance with credit risk, and assets cannot be bought for more than their cost to the originating firm. For mortgages held by the Treasury Department it mandates they be managed in a way consistent with the Hope For Homeowners Act including reductions of loan principles and interest rates, and term extensions; as well as loan guarantees and credit enhancements to facilitate loan modifications. General limitations are advised for executive compensation and golden parachutes, and recovering bonuses and incentives from financial firms participating in the program. All transactions under the authority of this bill must be reported to Congress in a timely manner, and an oversight committee must be appointed.

$250 billion in funding is immediately available to the Treasury Department. An additional $100 billion can be authorized by the President, and an additional $350 billion can be authorized by Congress with fast tracking provisions.

The upper limit of federal debt is expanded to $11.3 trillion.

Monday, October 6, 2008

European Resistance

In the face of similar problems facing its financial sectors, including a credit freeze and banks on the edge suffering from mortgage loses, the Europeans are showing more restraint than the U.S. in bailout measures. Their solutions so far of deposit guarantees and bans on short selling are trivial compared to the hundreds of billions of dollars flowing out of Congress.

I don't think this is because Europeans support laissez-faire free market principles more than Americans do—rather, I think getting the member nations to agree on who-pays-what will be more of an obstacle than with Congress.

Further TAF Expansions

In an effort to boost liquidity in the system and reverse the ongoing and persistent credit freeze, the Fed is increasing TAFs again to $150 billion in 28-day cycles and $150 billion in $84 day cycles, which will bring TAFs to an even $300 billion.

Before today, to my knowledge there was $75 billion in 28-day cycles, and $75 billion in 84-day cycles. So today's action increased TAF funding by $150 billion. This action brings the Fed's cycling liquidity to $1160 billion both domestically and off shore, summing up all the citations I've found from news sources.

We'll see if this unfreezes markets. When a system is credited out, no amount of cheap liquidity is going to increase lending.

BoA Settles Countrywide's Loans

While talks about Bank of America acquiring Countrywide have been in consideration for awhile, it seems I missed the actual event, in July, for $4 billion. That one seems to have slipped under the radar. Its stock (BAC; the five year spread is probably the most informative) took a pounding in July but has recovered. Today, it sounds from this article that state attorney generals are pressuring a reluctant Bank of America to abide by the loan modification terms of the mortgage rescue bill passed in early August and to be enacted starting this month. Given the scope of the problem, the $8.6 billion price tag seems small. In related news, today BoA announced a 68% decline in profits from last year, and an issuance of 10 billion in common stock to firm up its balance sheet.

Saturday, October 4, 2008

10,000 Territory

Periodically I'll keep note of the correction of stock market values, and thought I better post the DJIA is trading squarely in the 10,000s—in a way that I don't think will be going back in to the 11k range for any sustainable duration any time soon—before it hits the 9000s.

As it dipped below the 11,000s last July we saw bailout after bailout keeping things afloat. Ironically, the DJIA closed at a multi-year low yesterday after the mother-of-all-bailouts was passed. I don't see what they have left when it hits the 9000s—but I won't be surprised if they surprise me. I need to watch what I say... there is always the H-word.

Friday, October 3, 2008

$700 Billion Bailout Passes

Last Monday we saw the House make a laudible effort to represent their constituency responsibly and vote against a taxpayer bailout of Wall Street. It was a nice effort, but financial power asserted itself Wednesday with the Senate vote, and again today with the House vote where it passed by a sizeable majority of 263-171. It was signed by President Bush about an hour later. Some politically expedient amendments were added in the Senate version to give House members an excuse for changing their vote.

Now, if the farmer leaves foxes to guard the chicken coop, and all the chickens mysteriously "disappear," I question the wisdom of bailing out the farmer for being dumb enough to let foxes guard the chicken coop, but at the same time one doesn't want to let the farmer starve. I can see the need sometimes to bail out duped farmers. But what I cannot see is bailing out the foxes, which is exactly what this bill does.

It was suggested the House "caused" the Wall Street crash of 777 points last Monday by voting against the bill—however the DJIA downward trend line has been steady since its peak last October. It was also suggested that without the bailout, credit will freeze and government and private operations wouldn't be able to access necessary credit lines to make payroll—however the Fed had already injected an additional $630 billion liquidty in to the system last Monday.

So, I can understand the need to bail out retirement funds that are in jeopardy. But I cannot agree with bailing out the system that caused the problems in the first place. This bill bails out people and organizations that brought us this financial turmoil.

I will comment on details of the bill once the dust settles.

Fighting Over Wachovia's Carcass

The acquisition of Wachovia by Citigroup is not going as smoothly as planned. Today, Wachovia sold itself to Wells Fargo for $15 billion dollars. Citigroup wants to keep the deal arranged by the FDIC, where it acquired Wachovia's assets for $2.2 billion. Wachovia obviously thinks it is better off with the Wells Fargo deal than a government seizure. I'm pretty sure Wells Fargo is anticipating the passage of the $700 bailout bill by the House this afternoon, where Wachovia's bad mortage debt will be bailed out with taxpayer money. At this time, the matter is unsettled.

ADDENDUM [10/4/08]: And the winner is... the lawyers! Looks like who gets Wachovia is going will be taken to court. Since Wells Fargo is now subsidizing Wachovia, Citigroup just has to play a waiting game until that become unfeasable and the FDIC has to formally seize Wachovia. [10/6/08]: The FDIC is going to have to be more authoritative about its "seizures" from now on; the Citigroup injunction against the Wells-Wachovia sale was turned down in court. The Fed is urging the two banks to come to an agreement. [10/9/08]: Wells Fargo prevails. [1/1/09]: The purchase of Wachovia by Wells-Fargo was finalized today for $12.7B.

Wednesday, October 1, 2008

Bailout Bill Sails Through the Senate

The pleasant surprise last Monday—the defeat of the $700 billion Wall Street bailout by the House (205-228)—remitted to politics as usual today when the same piece of legislation was crafted by the Senate and found easy passage there (74-25). So it returns to the House shortly. Hopefully, representatives who voted against the bill before don't change their convictions.

September Postscript

What a month! Since September 1, the credit economy was revealed for what it is: without substance, a mirage in desert. Previous assurances by Paulson and Bernanke that the U.S. financial system is sound have proven to be horribly misguided if not complete lies. Bailouts are now measured in the hundreds of billions, and evidence of bailout fatigue was shown in the last house vote. On this blog, up to three posts per day were hurriedly written during breaks at work. There has been so much news, encapsulating it has been my focus lately, however it is not the intention of this blog to echo news reports but to advance a theory that the value of cash is distinct from the health of credit markets. Summaries of news events are intended to capture relevant data, either supporting or refuting the theory.

To summarize: as credit markets contract, which they have, and the inventory of the economic system remains about the same, then prices will have to fall to capture what cash in the system is left, unless money is printed to compensate for the loss of credit to the total money supply. Now, the value of cash remains at the mercy of those who operate the printing presses, however I have argued those in power will work to preserve the strength of the dollar for their own economic self interest.

The month of September offers evidence in favor of this position. It was a calamity for the credit industry, and both the public and the congress have shown resistance to extreme bailout measures. Through all of this, the U.S. dollar has held steady against general investment classes—notably real estate, stocks, oil, and the euro—and I think it may be fair at this point so say it has even advanced slightly. Concurrent with the dollar, treasury bonds and gold have traded strongly as well. September is not proof of the theory, but offers a little factual support.

Ideas presented on this blog are heavily rooted in the Austrian School, but differ in their overall attitude about the strength of cash. The Austrian School of economics (mostly situated in Atlanta, GA), has predicted the collapse of the credit economy for years. The Austrian School also predicts the final outcome of the recent credit expansion, where investments are justified by their dividends rather than the silly expectation of permanent capital gains. When all is said an done, the DJIA will be trading close to the 6000 range, and real estate will fall on the order of 50% from peak, assuming there is not a hyperinflationary event.

What the Austrian School was unable to conceptualize was how far this credit expansion would go, and when the collapse would occur. Further theoretical developments here will address these questions. But if October is anything like September, attention will stay on current financial events.

Monday, September 29, 2008

Thumbs Down on Rescue Legislation

Over the weekend congressional leaders and the White House had reported agreement on a plan involving a $700 bailout of Wall Street, proposed as a public need to keep the general economy afloat. I don't buy it, the people I've been speaking to who aren't bloggers don't buy it either, their general mood is one of anger about it, and 228 house members thought similarly enough that they turned down this initial draft of the bill. I feared that a bill where taxpayers reimburse the recent losses of the financial industry would be rubber stamped, which I am pleased has proven untrue. Naturally, this isn't over yet.

Another $630 Billion Injection from the Fed

One day I'm going to have to sit down and add it all up, but by the running tally, I have around $400 billion of cash injections so far by the Fed into the banking system, in the form of TAFs, PL... and TD..Fs...whatever alphabet soup they list it under. Today it looks like $630 can be added to whatever there was before.

There have been news reports of the LIBOR spread (London Inter-Bank Office Rate) rising, with is the market rate banks lend to one another for short term loans. Historically it is better form for banks to borrow from other banks rather than borrow from the Fed. Usually the LIBOR follows closely the Federal Funds Rate, but now it is taking off indicating banks are cash hoarding and distrustful of the creditworthiness of their fellows. Todays action is intended to unfreeze banks and keep credit liquidity flowing. Like previous bailout instruments from the Fed, it is basically releasing $630 billion in short-term cycling bonds where treasuries are exchanged for securitized debt.

This article gives some figures. Starting with this post of mine from July, we have: TAFs in 21-day cycles at $75 billion; TAFs in 84-day cycles of $25 billion; TLSFs in 28-day cycles of $200 billion; and PDCFs in overnight cycles of around $40 billion. Now, today, adding to that is an expansion of TAFs to $75 Billion in 84-day cycles; and $330 billion to foreign central banks (terms were unspecified in the article, but it's a cash swap of dollars for foreign currency). Pulling out the calculator I get $720 Billion; plus there would have been a pre-existing line of credit to foreign central banks of $290 before today, which totals $1010 billion the Fed has in short term bonds to boost liquidity in U.S. ($390 billion) and foreign ($620 billion) markets.

Please excuse any omissions or calculation errors; the exact details matter less than the point that over a trillion dollars exists in the system, backed by U.S. taxpayers, to keep the domestic and world credit economy on life support.

ADDENDUM [10/6/08]: I don't know how the AP article gets $225 billion for 84-day TAFs. It's $75 billion, and numbers were recalculated accordingly. Calculations will continue to be refined as data filters through the press.