Monday, April 14, 2008
$7 Billion for Wachovia
More capital infusion into the banking system. This time for Wachovia, from selling new issues of common and preferred stock. Today's $7 billion follows another $8 billion from January. This may relate to their questionable $24 billion purchase of Golden West in 2006, an Oakland-based mortgage lender. This sort of news underscores solvency problems, which is bad for banks and bad for lending, but I anticipate is good for cash.
Thursday, April 10, 2008
Power, Inflation, and the “Reset Button”
Proverbs 22:7: "The rich rule over the poor, and the borrower is servant to the lender."
Inflation is the natural enemy of cash. Hyperinflation is a nuclear strike on your bank account; though it is unlikely to happen, those long on cash ought to be wary. In any case, it will be a necessary concept when it comes to discussing the middle ground.
If as Mises says, at the end of a credit bubble, policy makers must choose either deflation or hyperinflation, the latter would be hitting the reset button on the economy. The system would have to start again from scratch by recreating a money supply that has value. All existing debt is effectively erased by hyperinflation. So… who wouldn't want to hit the reset button on the economy?
Those who benefit from the “reset button” would be people heavily in debt, like with large monthly mortgage payments. The government is heavily in debt too, so does it want to hyperinflate? No. The “government” is not a thinking entity with no motivation of its own and so does not care or is even cognizant of the amount of debt it owes. Rather, the “government” is a system of many politicians that decide on laws and how tax dollars are spent. So would the body of politicians want to hit the reset button on the economy ever?
One cannot speak for all politicians, and every politician has complex motives that drive him or her. They need to keep their electorate pleased, as well as keeping their contributors happy. That is just the reality of politics, the game that every one must play. Thus, we live in a mixed democracy/plutocracy (each at odds with the other), where the wealthy and powerful have a disproportionately greater say over political affairs than the common voting citizen.
Say 51% of the electorate has a toxic mortgage, and want to pay it off easily with hyperinflated currency and hold title to their house almost free. Does that mean the government will start printing away since it benefits a democratic majority? Probably not.
In terms of whom our financial regulators see fit to benefit, not everyone is created equal. In a recent example, we see the Fed has overstepped its authority to bail out Bear Stearns bond holders. Conversely, we see no concern they have for Bear Stearns share holders whose stock values plummeted from about $30 to $2 as a result of Fed action (it settled at $10). In essence, we have an example of the Fed using its regulatory power to benefit debt (bond) holders over asset (stock) holders. The key for us outsiders is to guess who or what it is the Fed will be treating preferentially with their regulatory measures, and invest accordingly.
But say the reset button is hit. Say the Fed rev’s up the printing presses full power. Treasuries are zero’d out. Mortgages are zero’d out. Superbowl bets that haven’t been paid up yet—those are zero’d out. Those who owed more money than they possess are happy—they are now richer, having no money, rather than debt. Those who have lent out money would be displeased, since they have lost what was owed to them. For every dollar borrowed—by government, businesses, or individuals—there is a bond holder somewhere expecting to be paid back.
Now, of the two, of borrowers or lenders, who would it be that contributes to politicians campaigns? Who would have the most say over the direction regulators take?
Inflation is the natural enemy of cash. Hyperinflation is a nuclear strike on your bank account; though it is unlikely to happen, those long on cash ought to be wary. In any case, it will be a necessary concept when it comes to discussing the middle ground.
If as Mises says, at the end of a credit bubble, policy makers must choose either deflation or hyperinflation, the latter would be hitting the reset button on the economy. The system would have to start again from scratch by recreating a money supply that has value. All existing debt is effectively erased by hyperinflation. So… who wouldn't want to hit the reset button on the economy?
Those who benefit from the “reset button” would be people heavily in debt, like with large monthly mortgage payments. The government is heavily in debt too, so does it want to hyperinflate? No. The “government” is not a thinking entity with no motivation of its own and so does not care or is even cognizant of the amount of debt it owes. Rather, the “government” is a system of many politicians that decide on laws and how tax dollars are spent. So would the body of politicians want to hit the reset button on the economy ever?
One cannot speak for all politicians, and every politician has complex motives that drive him or her. They need to keep their electorate pleased, as well as keeping their contributors happy. That is just the reality of politics, the game that every one must play. Thus, we live in a mixed democracy/plutocracy (each at odds with the other), where the wealthy and powerful have a disproportionately greater say over political affairs than the common voting citizen.
Say 51% of the electorate has a toxic mortgage, and want to pay it off easily with hyperinflated currency and hold title to their house almost free. Does that mean the government will start printing away since it benefits a democratic majority? Probably not.
In terms of whom our financial regulators see fit to benefit, not everyone is created equal. In a recent example, we see the Fed has overstepped its authority to bail out Bear Stearns bond holders. Conversely, we see no concern they have for Bear Stearns share holders whose stock values plummeted from about $30 to $2 as a result of Fed action (it settled at $10). In essence, we have an example of the Fed using its regulatory power to benefit debt (bond) holders over asset (stock) holders. The key for us outsiders is to guess who or what it is the Fed will be treating preferentially with their regulatory measures, and invest accordingly.
But say the reset button is hit. Say the Fed rev’s up the printing presses full power. Treasuries are zero’d out. Mortgages are zero’d out. Superbowl bets that haven’t been paid up yet—those are zero’d out. Those who owed more money than they possess are happy—they are now richer, having no money, rather than debt. Those who have lent out money would be displeased, since they have lost what was owed to them. For every dollar borrowed—by government, businesses, or individuals—there is a bond holder somewhere expecting to be paid back.
Now, of the two, of borrowers or lenders, who would it be that contributes to politicians campaigns? Who would have the most say over the direction regulators take?
Citigroup's $12 Billion
In an echo of recent news for Washington Mutual, Citigroup just received $12 Billion cash from a sale of loan assets. Sort of.
It sounds like a mortage backed security what they did, except this wasn't for subprime mortgages. It was a rather messy sale: loans were sold at 90 cents on the dollar, then Citigroup agreed to accept the first 20% of loses, should there be loses, AND Citigroup helped to finance the deal. That does not sound like a strong bargaining position. Nor is this the rabid securitized debt market of years past. On the other hand, $12 billion is a lot of money for what may be toxic waste.
It sounds like a mortage backed security what they did, except this wasn't for subprime mortgages. It was a rather messy sale: loans were sold at 90 cents on the dollar, then Citigroup agreed to accept the first 20% of loses, should there be loses, AND Citigroup helped to finance the deal. That does not sound like a strong bargaining position. Nor is this the rabid securitized debt market of years past. On the other hand, $12 billion is a lot of money for what may be toxic waste.
Tuesday, April 8, 2008
$7 Billion Cash for Washington Mutual
Though mainly, on this blog, I am developing a model that analyzes the value of cash, and arguing that the upcoming recession will more likely be deflationary than inflationary, there will be times for interjecting significant news stories. This latest one is a $7 billion infusion of capital into Washington Mutual, a Savings and Loan, and a major player in recent subprime mortgages. In part it illustrates concerns around fractional reserve lending (see post below).
Washington Mutual devalued existing shares in order to get the cash it needed to stay afloat. It was losing its capital base from subprime foreclosures. When it lends it can leverage its capital base by a factor of 9 (with 10% fractional reserves), but when a loan defaults, that full amount is deducted from its balance sheet (mitigated by what the bank can get from selling the house).
Though the extra cash is good news for Washington Mutual, and anyone who does business with them—it is good news only in that Washington Mutual is barely staying afloat as opposed to collapsing from bad loans. It is mixed bad news for shareholders—though their shares are declining and dividends evaporating, at least they aren’t becoming worthless. It is good news for those who paid the $7 billion—they are probably getting a good deal on a sizable piece of the bank.
Lately, this is what is considered “good news” in finances: not prosperity, but either hanging on by your fingertips, or buying troubled assets for cheap. This is a deflationary event, and if it recurs enough we face a deflationary recession.
Washington Mutual devalued existing shares in order to get the cash it needed to stay afloat. It was losing its capital base from subprime foreclosures. When it lends it can leverage its capital base by a factor of 9 (with 10% fractional reserves), but when a loan defaults, that full amount is deducted from its balance sheet (mitigated by what the bank can get from selling the house).
Though the extra cash is good news for Washington Mutual, and anyone who does business with them—it is good news only in that Washington Mutual is barely staying afloat as opposed to collapsing from bad loans. It is mixed bad news for shareholders—though their shares are declining and dividends evaporating, at least they aren’t becoming worthless. It is good news for those who paid the $7 billion—they are probably getting a good deal on a sizable piece of the bank.
Lately, this is what is considered “good news” in finances: not prosperity, but either hanging on by your fingertips, or buying troubled assets for cheap. This is a deflationary event, and if it recurs enough we face a deflationary recession.
Monetary Expansion and Fractional Reserves
Any increase of money supply is of concern to the cash investor, as it can cause inflation. In prior posts I mentioned the two factors that constitute money supply: cash and credit.
I also argued a recession would be typically deflationary if it corrects a credit expansion, since (1) after the event people would have to pay back what they borrowed, and that leaves less money for them to spend; (2) if loans do not originate as quickly as they are paid off, money supply diminishes through the contraction of credit; and furthermore (3) any defaulting on debt would shrink the capital base of banks, and therefore decrease the money supply created by fractional reserve banking.
Now, if you lend someone cash that you have, it doesn’t increase the money supply because the amount of cash in the system is still the same. But banks are allowed to lend out more than they have in deposits, through fractional reserves. If regulators say they need to have at least 10% in reserves, then with $1000 of your savings, the banking system can issue a series of loans up to $9,000. [Basically, the bank takes your $1000 and lends $900 ($100 must be kept in reserve), and when that is re-deposited in another account in another bank, $810 is lent (with $90 in reserve), then $729 ($81 in reserve), etc. which when all loans originating from the initial deposit are added together approaches 9k; with a thousand in reserves].
Mostly, this works out okay for banks. In effect, it can add up to nine times cash deposits to the money supply, which remits as debt is paid off. But if banks lose their capital through defaults, the fractional reserve credit lost will be nine times the capital write off, and money supply shrinks.
So, for every dollar deposited in a bank, that is $9 added to the availability of credit. For every dollar lost by the bank to defaults, that is $9 removed. Are fractional reserves a bad thing? There is some risk in the event of many defaults, but I don’t lose sleep over it. However, it will be relevant for points I raise later.
I also argued a recession would be typically deflationary if it corrects a credit expansion, since (1) after the event people would have to pay back what they borrowed, and that leaves less money for them to spend; (2) if loans do not originate as quickly as they are paid off, money supply diminishes through the contraction of credit; and furthermore (3) any defaulting on debt would shrink the capital base of banks, and therefore decrease the money supply created by fractional reserve banking.
Now, if you lend someone cash that you have, it doesn’t increase the money supply because the amount of cash in the system is still the same. But banks are allowed to lend out more than they have in deposits, through fractional reserves. If regulators say they need to have at least 10% in reserves, then with $1000 of your savings, the banking system can issue a series of loans up to $9,000. [Basically, the bank takes your $1000 and lends $900 ($100 must be kept in reserve), and when that is re-deposited in another account in another bank, $810 is lent (with $90 in reserve), then $729 ($81 in reserve), etc. which when all loans originating from the initial deposit are added together approaches 9k; with a thousand in reserves].
Mostly, this works out okay for banks. In effect, it can add up to nine times cash deposits to the money supply, which remits as debt is paid off. But if banks lose their capital through defaults, the fractional reserve credit lost will be nine times the capital write off, and money supply shrinks.
So, for every dollar deposited in a bank, that is $9 added to the availability of credit. For every dollar lost by the bank to defaults, that is $9 removed. Are fractional reserves a bad thing? There is some risk in the event of many defaults, but I don’t lose sleep over it. However, it will be relevant for points I raise later.
Saturday, April 5, 2008
Printing, Cash, and Credit
Cash is going to be worthless because the government is printing money like crazy. Just look at all the inflating prices each time we go to the supermarket, or pump gas.
Not! Such would be a misconception, one not uncommonly espoused in some form or another on the blogs. The rate of printing over the last few years has been less than historical patterns (meet FRED). So what gives? What accounts for huge increases in sales and prices of residential real estate, commercial real estate, and stocks?
That would reflect the monetary expansion from credit, which is distinct from currency. In other words, there can be a huge expansion of credit, without necessarily printing any currency, or the banking system can print a lot of cash without extending any credit. Either way, or in any combination, money is injected in to the system. Credit has greatly expanded over the past few years, while the creation of base money, as the FRED graph shows, has been decelerating.
Credit may feel a lot like money, in the beginning. It’s easy to confuse them. You can spend it like cash, and so people who borrow a lot are probably feeling pretty rich when they first get it. Over time, however, credit reveals itself to be very different. Once it is spent, it becomes a liability that you have to pay back. Very often sensible adults see the acquisition of credit as prosperity, rather than liability. Just look at Japan.
So, just because there has been a recent expansion of the money supply does not mean it came about by printing. It could have, and did, come from credit originated by fractional reserve lending.
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.
Not! Such would be a misconception, one not uncommonly espoused in some form or another on the blogs. The rate of printing over the last few years has been less than historical patterns (meet FRED). So what gives? What accounts for huge increases in sales and prices of residential real estate, commercial real estate, and stocks?
That would reflect the monetary expansion from credit, which is distinct from currency. In other words, there can be a huge expansion of credit, without necessarily printing any currency, or the banking system can print a lot of cash without extending any credit. Either way, or in any combination, money is injected in to the system. Credit has greatly expanded over the past few years, while the creation of base money, as the FRED graph shows, has been decelerating.
Credit may feel a lot like money, in the beginning. It’s easy to confuse them. You can spend it like cash, and so people who borrow a lot are probably feeling pretty rich when they first get it. Over time, however, credit reveals itself to be very different. Once it is spent, it becomes a liability that you have to pay back. Very often sensible adults see the acquisition of credit as prosperity, rather than liability. Just look at Japan.
So, just because there has been a recent expansion of the money supply does not mean it came about by printing. It could have, and did, come from credit originated by fractional reserve lending.
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.
Wednesday, April 2, 2008
Austrian Economics, Recessions, and the Dollar
If you are investing in cash itself, rather than assets or commodities, you are betting that price of the goods and services money can buy will decline in the future. The Austrian School of Economics explains this well.
The Austrian School is an economic theory that arose in Austria around the time of the Weimar Republic. Its best known writer is Ludwig von Mises, most known for his general work on economics, Human Action (1949). It is worth a read if your investments are mainly in dollars, or want a contrarian viewpoint for weathering the upcoming recession. With the rise of the Nazi’s, most Austrian-school economists moved to America, and its hub is now situated in Atlanta, Georgia. Generally, its focus is pro-free market and anti-regulation of any sort. Mises argued that any and all government regulation of the economy benefits one group of citizens at the expense of another, and so is unfair except for necessary government services. Whether necessary or not, it introduces economic inefficiencies into the system, through tax burdens. This is a point I plan to return to over the course of this blog.
The theory is useful for explaining credit bubbles, which have been recurrent in history since at least the beginning of central banking. (Consequently, Austrian economics is highly critical of central banking, advocating for a gold standard instead.) Reading histories on the subject e.g. Extraordinary Popular Delusions and the Madness of Crowds (1841) by Charles Mackay, they all repeat similar patterns.
Here is how it works: during times of easy credit, investors will borrow cheap money (at artificially low interest rates) to invest in higher-paying asset-based investments. Thus asset prices will rise due to demand. Then people borrow more money to buy assets expecting profits through capital gains. In short order, speculation gets carried away, to the point where the speculative cost of assets is far, far higher than its value in generating dividends. Recent examples have been the Internet dot.com bubble and the housing bubble.
According to Austrian Economics, there are only two ways to resolve the recession that follows a credit bubble: deflation, or hyperinflation. There is no middle ground-- there is no “muddle through” with moderate inflation, which just delays the price correction that must follow. Deflation of asset prices will occur if the market is left alone. The only way to stop deflation would be to “hyperinflate,” which means printing currency to pay off bad debt and keep asset prices high. History has examples of both deflationary recessions (i.e. The Great Depression, or Japan 1990’s-current) and hyperinflationary recessions (i.e. Weimar Republic, or Zimbabwe).
Since printing money is easy enough, it is the decision of our politicians and regulators which route to take. If they do nothing, deflation will occur. Hyperinflation will occur by printing the amount of money necessary to offset the impending deflationary event. This makes investing in the dollar rather exciting during the collapse of a credit bubble. With deflation, the value of the dollar will increase and cash becomes a good investment. With hyperinflation, the value of cash goes to nothing and it is a horrible investment. Making the right guess as to which way our regulators will choose to go will be critical to making the right investment.
If you invest in the dollar, you are absolutely betting this recession will be deflationary, and not hyperinflationary, and not even inflationary “muddle through.”
The Austrian School is an economic theory that arose in Austria around the time of the Weimar Republic. Its best known writer is Ludwig von Mises, most known for his general work on economics, Human Action (1949). It is worth a read if your investments are mainly in dollars, or want a contrarian viewpoint for weathering the upcoming recession. With the rise of the Nazi’s, most Austrian-school economists moved to America, and its hub is now situated in Atlanta, Georgia. Generally, its focus is pro-free market and anti-regulation of any sort. Mises argued that any and all government regulation of the economy benefits one group of citizens at the expense of another, and so is unfair except for necessary government services. Whether necessary or not, it introduces economic inefficiencies into the system, through tax burdens. This is a point I plan to return to over the course of this blog.
The theory is useful for explaining credit bubbles, which have been recurrent in history since at least the beginning of central banking. (Consequently, Austrian economics is highly critical of central banking, advocating for a gold standard instead.) Reading histories on the subject e.g. Extraordinary Popular Delusions and the Madness of Crowds (1841) by Charles Mackay, they all repeat similar patterns.
Here is how it works: during times of easy credit, investors will borrow cheap money (at artificially low interest rates) to invest in higher-paying asset-based investments. Thus asset prices will rise due to demand. Then people borrow more money to buy assets expecting profits through capital gains. In short order, speculation gets carried away, to the point where the speculative cost of assets is far, far higher than its value in generating dividends. Recent examples have been the Internet dot.com bubble and the housing bubble.
According to Austrian Economics, there are only two ways to resolve the recession that follows a credit bubble: deflation, or hyperinflation. There is no middle ground-- there is no “muddle through” with moderate inflation, which just delays the price correction that must follow. Deflation of asset prices will occur if the market is left alone. The only way to stop deflation would be to “hyperinflate,” which means printing currency to pay off bad debt and keep asset prices high. History has examples of both deflationary recessions (i.e. The Great Depression, or Japan 1990’s-current) and hyperinflationary recessions (i.e. Weimar Republic, or Zimbabwe).
Since printing money is easy enough, it is the decision of our politicians and regulators which route to take. If they do nothing, deflation will occur. Hyperinflation will occur by printing the amount of money necessary to offset the impending deflationary event. This makes investing in the dollar rather exciting during the collapse of a credit bubble. With deflation, the value of the dollar will increase and cash becomes a good investment. With hyperinflation, the value of cash goes to nothing and it is a horrible investment. Making the right guess as to which way our regulators will choose to go will be critical to making the right investment.
If you invest in the dollar, you are absolutely betting this recession will be deflationary, and not hyperinflationary, and not even inflationary “muddle through.”
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