Tuesday, March 31, 2009

G20 Fizzle

There has been some talk about a "new world order" in the G20 meeting going on now, specifically around the replacement of the dollar as the worlds reserve currency with a new global currency. One wonders what there is for sale this world currency could buy; what there would be that backs its value other than fiat currencies themselves. Anyways, from what I've been reading it does not sound like these talks have progressed very far, and unlikely will by meetings end. Otherwise there is empty chatter around the current global downturn, and some welcome discussions of anti-protectionism, that unlikely will make much difference.

With talk of a new world order, gold has been doing okay. The dollar I anticipate will recover after the meeting closes.

Monday, March 30, 2009

Automaker Bailout Denied

After dipping in the bailout well once already, to the tune of around $20B from the first round of TARP money, the automakers GM and Chrysler have been back for more to stay afloat, which has been denied by the Obama administration until more corporate restructing has taken place. As a consequence, the CEO of General Motors has resigned.

Today Obama reassured us that the auto industry would not "vanish," and there is no reason it should, if there are entrepreneurs who will buy the bankrupted factories and resume auto production more profitably.

Hopefully, what is being said today about the auto industry will be applied later to banks and their subsidiaries. I'm looking at you AIG and Citigroup.

Sunday, March 29, 2009

Predictions: The Good, the Bad, and the Ugly

March 16, 2008 stands in history as the all-time low for the U.S. Dollar Index. Two weeks later, one year ago today, I started the Ca$h Bull.

I started it amid fears that the dollar was facing imminent collapse, and in danger of being replaced as the world reserve currency by the Euro, or even the Yuan. This blog was begun on the premise that the value of currency should be viewed by its purchasing power of goods and services in its native economy rather than as a contest against other currencies on the global market—and that cash, especially the dollar, would emerge strongly as the world-wide credit bubble resolves in a recessionary economic contraction.

Some anniversary facts and statistics: with all the posts (not including this one) cut and pasted into a word file with a 12 point font, the document is 104 pages long. Sadly, neither “The Ca$h Bull” nor “The Cash Bull” flags this site on a Google search. But “the Cash-Inventory Equivalency” comes up on the first page, and “The Desire Coefficient” comes up #1.

So I’d like to thank those who patronize this blog, especially you East.Bay.Miser, your responses do make a difference. Today I’m going to start allowing anonymous posting to make it easier for people to comment. I’m also modifying the tags system to be in line with its proper use, rather than as keywords which I originally thought. The new tags should be up in a day or two.

Though I try to focus on financial analysis here and avoid making predictions, sometimes they slip out. So, for fun, here is a rundown of how I did—divided into the good, the bad, and the ugly.

The Good:

3/29/09: “I am heavily invested in the U.S. dollar, and contrary to many opinions, I think now is a good buying opportunity for it.” (Truth be told I started working on the theory posts of this blog, up to "The Value of Money," a couple weeks beforehand.)
4/5/08: “So long as base money continues to hold about even, the fallout from the credit bubble will be deflationary as asset prices correct to their fundamentals.” Even with base money doubling we are still seeing a deflationary trend. This sentiment has been repeated many times so will be mentioned just this once here.
4/28/08: “Though they will almost certainly print some money, it will not be enough to stave off a deflationary recession.” They have and it hasn't.
5/14/08: “Americans have been lent more than they will be able to pay back, which will result in widespread defaults and foreclosures.” A straightforward statement now but very much denied back in the day.
6/28/08: “The last time we saw rates this low (2% overnight rate), we saw the rise of the housing bubble. Now, we see an economy holding on by its fingertips as this behemoth slides into a recession.”
8/5/08: “Prices are already dropping in the asset classes (i.e. stocks and houses) and I predict will continue to fall throughout the general economy under supply and demand forces as we progress further into the current economic downturn.” Today we see clear evidence of this downturn in commodities, retail, and manufacturing. Declining prices haven’t quite matched declining demand as of yet, but both are deflationary.
8/6/08: “Despite the stated intention of the legislation [The HOPE for Homeowners Act] to keep house prices unaffordable, my guess is the correction will continue unabated.”
8/7/08: Regarding rate drops by the ECB: “I think I am not alone in believing we can anticipate rate drops in coming meetings.”
8/9/08: “There will come a day where banks are unwilling to lend, and borrowers cannot or will not take on more debt regardless of how favorable are the terms.”
9/15/08: Regarding the fall of Lehman: “For the first time credit default swaps are being triggered, and soon the whole patency of the default swap market (in other words, bond insurance) will be tested.” Enter AIG bailouts the very next day.
11/10/08: “Bailing out AIG is a more civil way of handing money to banks straight up.” Common knowledge now that AIG was forced to disclose how it used the bailout money.
12/4/08: “Today is a stepping stone that will likely conclude in a worldwide zero-interest-rate policy (ZIRP).” The U.S. and U.K. are there, and the ECB not far behind.
12/16/08: Regarding ZIRP: “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.”
1/26/09: “future indicators show no end to budget cuts and profit downgrades.” There have been quite a few in the last couple months and more expected.
1/28/09: “Expect quantitative easing soon.” No shocker, but still a two-month heads up.
2/10/09: About Geithner and acquiring toxic assets from banks: “The fact he is calling for the use of private capital in all of this, for this ‘bad bank,’ which obviously isn't going to happen unless it is fully guaranteed, strikes me as almost a delay tactic.” This was a smirky remark but now the plan is for private acquisitions of toxic assets to be 90-95% government guaranteed.

The Bad:

4/30/08: “Today, the Fed eases the overnight rate to 2%, hopefully ending a striking series of sudden decreases throughout the past 8 months.” Oops. Not.
5/10/08: “I think the dollar will correct against foreign currencies eventually, but slowly” While the dollar is correcting against foreign currencies, slow isn’t the right word for it, unless you are willing to accept wild fluctuations around a downward trend line as meaning “slowly.”
9/7/08: “Clearly, banks have no reason to fear making unwise loans because they can anticipate a taxpayer bailout every time.” Not every time. In fact not enough times that they seem worried about it now.
9/15/08: “Not that I'm expecting $1.50 gasoline prices again…” I saw it once for around $1.90 in San Francisco, which is getting pretty close.
9/25/08: “This uptick on the base money supply is worrisome and if not a random artifact of the financial turmoil and indicative of a trend it could spell concerns for the value of the dollar.” If any Internet site reported on this shift in base money before me, I’d love to see the link. This files under “bad” because the dollar has continued to strengthen anyway.
10/1/08: “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.” I’ve already called this as wrong because things are going to get worse.
10/9/08: On the drop in the DJIA after the TARP passed: “This is a deep spike downward, but I anticipate there will be some recovery before proceeding with its steady downward course… there is plenty of steam left in this bust.” Eh… there wasn’t that much recovery, but the downward trendline since then has been steady.
12/6/08: “I see a plan starting to unfold… Congress agrees to pass the unspent $350B of TARP bailout money, if the Bush adminstration agrees to give some of it to automakers.” I must have put on my tinfoil hat that day. Automakers got their share of the first round of TARP money and, except for a $20B outlay to Bank of America, Obama got the full second half of it.

The Ugly:

9/11/08: Here’s what I predicted the bailout would be: “The federal government will buy troubled mortgages from banks, I imagine at near face value, floating Treasury Bonds as needed to pay for them—such that the Treasury Department holds the mortgage stinkers, bought for with bonds that will be paid off by the taxpayer over time. Banks now have the opportunity to become re-capitalized from recent losses and dump toxic mortgage securities all at once.” As it turned out, bailouts went every which way BUT that. Worse, I had this on “Selected Posts” for months. Even on 9/17/08 I made the comment: “My earlier prediction that the conservatorship of Fannie Mae and Freddie Mac was sufficient to cover the bailout fell squarely on its rear end less than a week later. You win some, you lose some.”
9/16/08: Regarding AIG: “Personally I cannot get excited about the downfall of an insurance company; they are the embodiment of the risk aversion seemingly inherent to American culture.” Oh, how much I had still to learn.
10/13/08: “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.” Mid-October was too early to make such a call, and with nationalization now looming under Geithner, I do find it troubling.
3/10/09: “Get dollars now and sell your stock while you still can.” Though in the long run I think you’ll be better off, this was a terrible statement to make right at the beginning of a bear run. It’s from a post written in the heat of the moment that probably never should have been uploaded and I have a good mind to delete it. I’ll be more careful from now on.


10/30/08: “I have a suspicion this [foreign banks] is where all the newly minted currency since September is going [to pay off loans to U.S. banks].” An interesting, if slightly paranoid, idea. Fed data shows clearly that the newly minted money is now sitting in U.S. Bank reserves. But might the Fed have given it to foreign banks first, in exchange for foreign currency, to pay off their carry debt to U.S. banks?

Saturday, March 28, 2009

Sign Twirler Sighting

I have seen YouTube videos of sign twirlers for real estate in California's central valley for at least a couple years now. Today, for the first time, I eyeballed one in the city limits of San Francisco, at the corner of 7th Ave and Lawton as I was riding my bike. Though San Francisco is finally starting to have some major price corrections in real estate, hopefully this is an early indicator the real action is about to begin.

Monday, March 23, 2009

The Legacy Loans and Securties Program

Obama's plan to purchase $1T in toxic securities, after being leaked over the weekend, was formally announced today.

Initially, the program will use the last of the remaining $75-100B (of an initial $700B) in troubled asset relief program (TARP) money for the purchase of these toxic assets. So far it has mainly gone to purchase preferred shares in banks, automakers, and AIG; and then to help fund Obama's mortgage renegotiation attempt.

To review bailout efforts so far:
*JP Morgan acquired Bear Stearns with the assistance of $44B in backing from the Treasury Department. This is more a bailout of Bear Stearns bondholders than the general economy, but one wonders who those bondholders were. Goldman Sachs maybe?
*Untold trillions of cheap credit, in a litany of lending facilities coming from the Fed, have been offered to lenders of all sizes and colors to boost liquidity in the system. How much actually has been lent through these facilities I believe is unknown despite attempts from Bloomberg and Fox News to sue for that data under the Freedom of Information Act.
*Three mortgage revision programs have been offered, the first two being complete failures, in other words resulting in not a single loan modification, and the most recent one I've heard has not generated much activity as of yet, but it's still new.
*Fannie Mae and Freddie Mac were seized and taken under Federal conservatorship, rendering the tax base liable to their bondholders, not unlike Bear Stearns.
*AIG got $85B from the Fed even before TARP money became involved, and went into Federal receivership.
*We have the TARP at $700B, which has had a range of uses but mostly went to provide extra capital to Wall Street. I believe AIG is the single biggest recipient at nearly $100B, which has mostly gone to pay off loses to banks.
*There was a doubling of base money from around $850B to as high as $1780B, from September 2008 to January 2009. Suspiciously, the amount of money in banks reserves has adjusted by almost exactly the same trend, suggesting the money isn't doing much.
*Obama's stimulus, at just under $800B, appears mostly headed to state and infrastructure spending, since state taxes are now suffering in particular with declining property values.
*Aside from dropping prime interest rates to 0%, the Fed has just announced over $1T worth of quantitative easing.

Since bailouts began the stock market has fallen by 50%, and real estate by nearly that in the more sensitive bubble areas.

The funding of this new "legacy" program still seems up in the air but as I said there is now still up to $100B in TARP money left for its intended use of taking toxic mortgages off banks balance sheets.

The program supports the private purchase of toxic loans and securities. Its intention seems to be to let the market determine their value, through a competitive bidding process between private investors. But one might easily doubt how truly competitive the bidding will be with the government offering guarantees for most of the investment, or imagine what shenanigans could easily be undertaken to jack up the bidding.

So anyway, this is an announcement, no action yet, not much activity predicted for a month yet, and any number of surprises might still be waiting before it is carried out. Still, the DJIA responded optimistically this morning.

Thursday, March 19, 2009

Inflation, Deflation, and Quantitative Easing

Deflationists have had it easy for the past six months. Against real estate, stocks, commodities, and foreign currencies, the correction of the dollar has been robust from its all-time low a year ago. Even against old standards like gold and treasury bonds, it has held its own. As job losses and dire statistics mount, one wonders how much longer it will be before the prices of everyday goods suffer the deflationary squeeze. The only real threat to the dollar—the doubling of base money—has been nary a speed bump, and all this extra money now sitting idly in bank reserves is a laughable monument to the failure of policy makers to regulate the direction of the economy.

Yesterday, the fun came to a sudden end. Once again, fear and doubt have arisen around the fate of the dollar. The latest federal open market committee meeting voted in support of the purchase of $1.25T in bonds: $750B of mortgage backed securities, $300B of treasury bonds, and another $100B of GSE bonds from Fannie Mae and Freddie Mac. Quantitative easing has arrived.

When all is said and done, quantitative easing is a roundabout way for the Fed to issue loans straight from printing presses without fractional reserves or any deposit requirements. The Fed prints money to buy the $1.25T in securities listed above. That money enters the economy, and in exchange the Fed holds a legal obligation for that same amount to be paid back over the time the bond matures.

So quantitative easing is a variant of credit, which in and of itself offers no net threat to the value of the dollar. Credit is a temporary expansion of money that is undoes itself over the time the loan is paid back.

So, to the degree the bonds are good, any threat to the dollar is only temporary. However, if the Fed ends up with a mountain of toxic securities bought with newly printed money, defaults would be of no consequence to them. Unlike banks whose balance sheets suffer from defaults, the Fed loses nothing other than paper and printing ink. This would be pure cash expansion of the worst kind.

So—the market value of the securities the Fed is buying will determine how inflationary this process will be. If the Fed buys bonds at market value, then the economic correction will be slowed down but prices will still correct downward to fundamentals. If the Fed buys junk at full price, then Bernanke is dropping fresh money from helicopters—so grab your wheel barrow when it comes. The truth will lie somewhere in the middle.

Naturally, the dollar suffered with this news, and a small rally in stocks and other investments would not be surprising. But Japan has been doing this for years and the yen remains one of the stronger currencies. I’m not buying gold just yet.

Wednesday, March 18, 2009

Quantitative Easing

"Quantitative easing" is a term that has been tossed about blogs, mainstream media, and formal discussions of financial policy. For as long as I've been hearing the term, I've been waiting for a clear definition, and have been waiting now long enough I'm skeptical one exists. But I've seen it in enough contexts now that I will hazard a general introduction of it here.

When money supply needs to be increased to stimulate economic activity, the banking industry, which includes central banks, prefers to do it by credit, rather than printing. Printing devalues currency if it outpaces economic growth; credit is only a temporary debasement of currency that reverses as the loans are paid off. So, the way the banking industry stimulates credit is for the central bank to lower the interest rates such that credit is less costly to accept. That is the primary way credit is expanded, until prime interest rates are lowered all the way to zero.

The Bank of Japan was the first to lower interest rates to zero, many years ago. At the end of last year, the Fed did the same, and now the Bank of England has reached that point, and the European Central Bank is not far behind.

If overnight interest rates are at zero, and the economy is still sluggish and requires more stimulus (or so policy makers believe), then "quantitative easing" is the next step. Here, any bonds can be purchased by the central bank with newly minted cash. Typically it would be treasury bonds, but any bond will do. Bonds are wealth and cash is wealth; but bonds yield their wealth only over time—in buying them with cash, however, the wealth is available immediately right now. In quantitative easing, money over time is replaced with newly minted money here and now. The central banks now hold the bonds, and the cash released on to the economy through quantitative easing slowly reverses as the bond matures.

(UPDATE 5/19/10: To rephrase the above paragraph, if a private entity or government sells a bond, there is no net influx of money into the economy. Cash is shifted from the buyer to the seller of the bond, and then re-shifted back to the buyer with interest over time as the bond matures. Cash shifts hands but is neither created nor destroyed. But if the Fed prints money to buy a bond, then that newly printed money IS an expansion of the money supply, reversed over time as the bond is paid off to the Fed.)

So quantitative easing is like defibrillating a dying credit bubble with shocks of sudden cash infusions. It's okay in theory. Japan has been doing this now for some time with no apparent reversal of their economic fortune, nothing one can clearly point to, other than the possibility things might have been worse had they not done it. Though the Bank of England has trailed the Fed in arriving at zero interest rate policy, now just having reached it they are about to embark right away on 75B pounds of quantitative easing.

The Fed has not ruled out the possibility of it, but no specific statements have been released as of yet.

UPDATE: Now wasn't that written moments too soon. Today the Fed announced it will buy $1.2 trillion in securities. Details to follow in upcoming posts as the news of this settles.

Monday, March 16, 2009

Banks Reject TARP Money?

In an optimistic development, healthier banks of all sizes are upset by the obligations of accepting TARP money. Particularly offensive is the government changing the terms of the contact after the money has been borrowed and spent. After all, the only real precedent to such outrageous behavior would be the credit card industry, but anyway. Also, TARP bailouts have become an embarrassing liability to those banks which remain solvent. It seems they are under a lot of pressure from Federal authorities to make loans in a pessimistic lending environment.

I for one am glad to hear that the terms of accepting a taxpayer bailout are so noxious that banks are "threatening" to pay the money right back—Wells Fargo, Bank of America, Goldman Sachs, and JP Morgan are the some of the ones speaking up. I'm sure they much prefer the easy money indirectly handed to them via AIG. But if they do pay it back, and go on carrying out their business as any private industry should, then it's all good in my book, and I'm happy to forgive this lapse as part of the hysteria of the moment.

I ain't holdin' my breath.

UPDATE [3/23/09]: Come to think of it... Bank of America CEO Kenneth Lewis has been one of those protesting not to be needing the TARP money. However, Congress approved the second half of the TARP money, intended for the Obama Administration, a week before Obama actually took office, just so Bank of America could get an extra $20B. There were no other uses for it over that week, and Obama didn't use it for several weeks in to his administration.

Sunday, March 15, 2009

AIG Counterparty Disclosures

AIG has been in the limelight this Sunday, as it gets a double whammy in today's news. First, it is taking heat from the Obama administration for its $165 million in executive bonuses, no doubt headed straight to offshore accounts.

The administration is telling us they are powerless to do anything about the $165M bonuses to be dispensed this week. (UPDATE [3/16/08]: New York Attorney General Andrew Cuomo today threatened subpoenas around the details of the retention payments, and possible legal action. [3/17/09]: Political upset at AIG continues with some in congress threatening a 91% tax against bonus payments; except that many of the recipients are not U.S. Citizens. Personally, I say let them keep the $165M. The amount of widespread public outrage these few executives have generated against financial bailouts is worth its weight in gold—Madison Avenue couldn't have done this—and may in the long run save the taxpayers billions.)

The other story is that under increasing political pressure AIG has released counterparty payments (also credit default swaps) for the final months of 2008, which included domestic banks, foreign banks, and municipal funds (see Toxic Securities Insurance). It accounts for $75B of the initial $85B bailout money, but leaves nearly $100B of taxpayer liabilities still unaccounted for. If it trickles out in upcoming news I'll update this post accordingly.

UPDATE [3/17/09]: This article from Fox Business is reporting $120B of the nearly $180B in U.S. taxpayer money has been accounted for, with Goldman Sachs being the largest beneficiary at $12B—and Societe Nationale (France), Deutch Bank (Germany), and Barclays (England) following right behind in the $11B range. There is still around $1.6T in credit default swap obligations—a number likely to rise as economic turmoil continues.

Hopefully these stories, taken together, indicate the AIG mess will be unraveling soon.

Thursday, March 12, 2009

Oh What Tangled Webs...

This is more of a crime story than financial news, but as a $65B scandal, it is too large to go entirely without mention. Today Bernie Madoff plead guilty to charges related to the fraudulent operation of an investment firm that lost its clients everything.

It has been described as a Ponzi scheme, but I doubt it started that way. I can see it starting off as a routine mutual fund that might have legitimately done well for awhile—I mean it would have been hard to go wrong for the past decade until Bear Stearns unfolded. But then it might have gotten tied up in some bad derivatives, and stumbled, and then rather admit to a loss or decline in performance, Madoff simply reported numbers that looked as good as ever, and when people withdrew money, he simply paid it from incoming deposits rather than investing it.

As poor performance and withdrawals consumed the wealth of the fund, all further withdrawals were paid with new investments—which works only so long as the rate of withdrawal is less than the rate of new investment, after which it is over, the money is long gone, and the situation is revealed for what it is.

So in all likelihood Madoff will spend the rest of his years in jail. There isn't much else to say here, other than a lesson to be had about trusting other people with your money.

Tuesday, March 10, 2009

Citigroup's Profit

Mostly I don't comment on stupid news, but this one takes the cake. Sometimes the news can rise to a level of idiocy that falls under the category of genius, and today we are hearing such a thing. Stock markets are rallying and the dollar is falling after Citigroup's CEO announced they turned a profit in the first quarter of 2009. This, after they received untold billions in bailout money, and their stock [C] has been trading around a dollar.

Get dollars now and sell your stock while you still can.

Monday, March 9, 2009

Dominoes and Housing

Since December, house prices across the nation have been following a near-vertical downward trajectory as the deflation mindset settles in, and data trickling in from February estimates price declines in California to be 40-50% off from peak. I suspect it will be at least a few months before prices begin to level out again, and after that a slow rate of price declines could persist for years. What we are seeing now is an abrupt return to fundamentals, and then a lowering of even fundamental prices as the severity of the economic downturn continues.

It was subprime resets that initially destabilized housing, though the real estate industry posited this would be contained to subprime. Though this isn't making the news anywhere near as much as subprime did, we are amid the Alt-A corrections now which extend to middle- and upper-end housing markets, which started at the end of 2008 and will last until 2011. Alt-A price resets will probably not be as dramatic as subprime though, since the Federal Reserve rate is at 0%, versus closer to 4-5% during the subprime resets.

Now, even if we weren't in a recession, and even if the Alt-A corrections weren't building steam, I'd like to spend a moment arguing against the containment of house prices from subprime to upper end.

Granted, people in the market for high-end housing probably would not settle for subprime areas. Those markets have no overlap. But, it is not either-or but a range of grays in between that connect in a domino fashion. People looking for a place in the Upper-Haight in SF would not be interested in Stockton, even if house prices there dropped 60% and prices in the Upper-Haight fell maybe 10%. But, someone in the market for a house in Tracy might consider Stockton instead, so declines in Stockton would put pressure on the Tracy market. As Tracy prices fall, people looking for a house in Livermore might take a hard look at Tracy, and as Livermore prices correct, they would attract attention from Pleasanton, and maybe even Hayward. The better parts of Hayward could attract some of the San Mateo market, and even the better parts of Oakland could capture the eye of parts of the San Francisco market.

And so, real estate corrections in subprime can spread to prime. On second thought, dominoes are probably not the best analogy; since a 50% price drop in Stockton, would not drive a 50% price drop in Tracy—but maybe 35%. Some of the price deflationary energy would be removed at each step, such that Stockton price changes may only have a miniscule effect on San Francisco.

Anyway, there are multiple downward pressures on house prices now: more joblessness, more foreclosures (triggered by both job loss and mortgage resets), tighter lending standards, a deflationary psychology, and most importantly a badly needed correction to fundamentals.

Thursday, March 5, 2009

Global March to ZIRP

Today the European Central Bank dropped interest rates to 1.5%, and the Bank of England to 0.5%. These are record lows, and likely they'll follow in the Bank of Japan's and Fed's wake to zero interest rate policy. The dollar's exchange value responded favorably.

Wednesday, March 4, 2009

Toxic Securities Insurance

Last September, AIG approached the Fed for a $75B loan. Instead, they were given $85B. By November they had received $40B of TARP money, and with another $25B infusion they were up to $150B in bailout money all told. Yesterday, they received another $30B from the Fed, and for the first time ever we see Bernanke showing an edge of emotion about the mess. AIG gained additional notoriety for a nearly half-million dollar spa retreat right after its first bailout, and then a hunting trip in England because its executives were still under a lot of stress.

More and more, it appears an insurance company—AIG—is central to this credit bubble. Make no mistake; there still would have been a major bubble in real estate and probably stocks without AIG, merely with the Fed lowering interest rates to 1%. But it would not have lasted as long and not have gone as crazy as it did without the ability to insure debt. By securitizing loans and then insuring unrated tranches, banks had the opportunity to go ballistic.

By securitizing loans, banks can avoid most, but not all of the risk of the loan. I’ve argued recently that securitized loans remove credit from the money supply. A loan from a bank increases money supply by that which is not part of the fractional reserve—in other words, a $1000 loan must be backed by $100 in a 10% fractional reserve system, and the remaining $900 is pure monetary expansion. It is monetary expansion because that $900 exists in two places: both as a deposit for the depositor, and as a loan. Selling the loan as a security undoes this process, such that securitized debt is no different than any credit between two private, non-banking entities.

As long as banks can sell loans as securities, they can make the craziest loans they want to, and securities buyers bear the risk of loan defaults. As long as loans are removed from the balance sheets through sales of securities, banks are not limited by fractional reserves; as long as securities are a hot market, fractional reserves remain available for further lending. In selling securities, banks forego profit by interest (which goes to the investor) but still profit by fees, both in packaging the securities and handling the loans. Once a loan is securitized it is risk-free to the bank.

But there is a catch, and here is where AIG comes in. When securities are chopped up and sold, banks have to keep the riskiest tranches. Those tranches that go belly-up first, banks have to hold on to them, per regulations. That means they are holding on to a lot of toxic material waiting to go bad as lending standards completely collapsed around 2005 and 2006. So what they do is insure toxic debt with credit default obligations (CDOs). AIG was happy to sell this toxic debt insurance. If and when the debt goes bad, banks get the insurance money. There is no way to go wrong, right?

Then AIG can even sell those CDOs to private investors, as it did to Lehman Brothers and Bear Stearns hedge funds, removing AIG from the risk of a systemic collapse.

Okay, so bad loans went belly-up. Bear Stearns and Lehman ran out of money from paying of loan insurance to banks (and anyone else who wanted to insure the debt). Paying off what CDOs AIG couldn’t sell, now they’ve run out of money too, and with AIG in trouble, banks are under the pressure of a big pile of unrated tranches.

This is where the taxpayer comes in. And now you know the rest of the story.

The big boys have to fall. It’s the only solution. Keeping this kind of corporate malfeasance alive is wholly counterproductive. Contrary to fear mongering we hear lately, new banks will rise to replace the old.

Monday, March 2, 2009

On Fundamentals

Ah, memory lane. It’s been fun watching the DJIA lately. Each time there is a major drop it’s been fun reading how it hasn’t been this low in how many years, upon which I fondly recollect what I was doing back then. Of course, this is fun only because my wealth is stored in U.S. dollars. If my wealth were in stocks, or most other investments except Treasuries, gold, or yen, I imagine this sort of news must be pretty miserable.

Today the DJIA, as you know, opened and closed in the 6000s, for the first time since May 1, 1997. Now, on October 1, 2008, I wrote: “When all is said an[sic] done, the DJIA will be trading close to the 6000 range, and real estate will fall on the order of 50% from peak.” Back then, the DJIA had been hovering around 11,000, and real estate had shown major corrections only in the more sensitive bubble areas; the most bearish professional economists were calling a bottom in the 8000’s. So, I’d like to announce at this point that I was wrong, and why.

What I meant to say was that the DJIA would bottom in the 6000s and house prices would fall by 50% only if there were no recession. Since we are in a severe economic downturn, prices are going to fall father than that.

My predictions were based on a return to fundamentals, in an otherwise healthy economy.

Prices on investments, including real estate, are based on either fundamental value or speculative value. Don’t even think of telling me about “mark to model” or “the value of home ownership;” those are for when you go whining to Congress for a bailout. Fundamental values reflect the price-to-earnings ratio of an investment class. If we take an investment that involves any sort of risk at all, like stocks, bonds, or real estate, the price-to-earnings ratio should generate interest that at least out-performs treasury bonds. The more risky the investment, the greater should be the yield.

For housing, fundamental values are definitively described on Patrick.net, with the conclusion being that monthly payments to own the house (principle, interest, taxes, and insurance) should be less than what it would cost to rent the same house.

If monthly payments are greater than equivalent rent, or if dividends are similar to or less than Treasury bond yields, then the investment is speculative, and disconnected from fundamentals. Buying into a speculative investment might be sensible if one is certain that prices will rise and will sell at the peak. But one should do so with the understanding that prices will, one day, return to fundamentals. Once prices stall, and the capital gains party stops, there is nothing to further support speculative prices, and they return from orbit. The problem with this latest bubble is that even the experts did not realize this simple fact, or did not acknowledge it—to say nothing of ordinary folk taking out mortgages or putting money in 401Ks.

So, if we weren’t in a recession, a DJIA around 6000 would have yielded investment-grade dividends, and house prices falling 50% from bubble peak would make buying cheaper than renting, over the long haul.

But with the economic contraction, profits are falling across the board, and there will be pressure for rents to fall as unemployment builds upon itself, and as falling prices and falling rents continue, as well a tight credit market in response to years of excess, then fundamentals will follow the downward course, and where prices of stocks and houses settle become anyone’s guess.

Sunday, March 1, 2009

Let the Big Boys Fall!

Citigroup and AIG are back for more bailout money.

The latest Citigroup bailout involves an odd exchange of the preferred stock, that Paulson bought with TARP money, for common stock. This at least waives the mandatory 5-8% dividend required from Paulson's cash infusion. It also means we move that much closer to Citigroup's nationalization—thrown into the same heap with Fannie Mae and Freddie Mac. The Treasury department will convert up to $25 million of preferred shares to common, but only up to the amount of money that Citigroup shareholders will do the same. Time will tell how this plays out.

AIG, well, they just happen to need another $30B. No doubt they'll need still more later.

If a successful business were to get hit by a random calamity, I could see the possible sense of bailing them out. I might not agree but at least I could digest the logic. But this is insane. The financial giants are failing because of poor decisions and poor corporate management including, but not limited to, ridiculously high executive salaries. They need to be chopped up, and any valuable assets they have can be sold to banks that have done well, who managed to responsibly navigate the financial recklessness over the last decade.

Our credit needs can just as well be met by a new generation of banks. Banks (and insurance companies) thrive perfectly well in a free market setting and should not require government subsidies. New ones will come forth to replace the old. Citigroup and AIG have demonstrably failed as corporations. All that keeps them alive now is lobbying efforts for congressmen to divert tax money toward their undeserved sustenance.

UPDATE [3/10/09]: in the face of an increasing sentiment that failed banks should be allow to fail, Bernanke defended that they would *not* be allowed to fail. This is, actually, a first step.