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.