Friday, December 24, 2010

Eating Fair Traded, Shade Grown, Free-range, Crow

One unfortunate feature of being an economic gadfly is the the field of economics is fraught with prediction, most of it coming from the third bend in an economist's colon.  At the Institute For Economic Reality, the convocation of macro-economic realists strives not to source its predictions in the same manner.  Even so, reality often intrudes in the most obsene fashion for those of us trying to politely cajole the mildly curious out of the dark arts of economic superstition and down the marble colonnade to economic reality.  Even the IER's predictions did not take into account the serialized criminal actions by the financial elites in this country to prevent the collapse of the debt-fueled consumption binge of the last 20 years.

That's a fancy way of saying that we didn't think the FED and US Treasury would resort to freebasing several trillion dollars worth of economic crystal methamphetamine to keep the party going. 

The IER's predictions of an 80% (minimum) peak to trough decline in sexy, bicoastal residential real estate by the end of 2010 is a bust.

Yes, the IER was wrong.  You heard it here, first.  The homes of the vainglorious twits (the ones that drone on endlessly about how valuable their homes are and how they are special and immune from the macro economic forces that subjugate the rest of us) only collapsed 30-40%, which is 80% lower than where said twits thought they would be.

As one of my favorite hockey players, Grant Marshall, would say when the Dallas Stars would lose a hockey game, "They didn't beat us; we just ran out of time."  He was implying that the Stars were better, but didn't get enough time to demonstrate it.

The same is at work here.  2010 has come and gone, but the game isn't over.  The only part of "20 cents on the dollar by 2010" that isn't true is the time element.  Make no mistake - we are going to 20 cents as soon as the FED runs out of ammo, and they are running out of ammo.

There is no better time to gun the financial markets higher than in the low volume trading days surrounding Christmas.  Even with this, the debt markets are getting crushed, and equities aren't exactly rebounding like they should.  With the FED now holding in excess of a cool trillion in US debt, they are very, very sensitive to the value of that debt.  Some students of this phenomenon have predicted that the FEDERAL RESERVE is going to be frozen solid if the 10 year US Treasury hits 4.5%.  Absent some flood of money hitting the debt auctions over the next few months, we should be there by Spring 2011.

How would you like to sell a home in a market that doesn't have loans available at any price?  If the FED freezes up, we get to find out.

Just as any tweaker knows, once you start meth, you have to keep on it to get the same high, while at the same time, your brain's ability to manufacture its own "happy drug" is essentially detroyed.  That's the situation with the Treasury and the FED.  13% of GDP is borrowed money, and that gets us a 2% growth rate.  Think about that and what happens when the government can no longer borrow 40% of what it spends.

The economy is just reacting to government spending, rather than to a genuinely expanding manufacturing base.  The deficit spending is killing off the private economy because the risk/reward is distorted.

So, for the record, and so everyone on "Rain City Guide" and the detractors on "Seattle Bubble" can rub my face in it, "20 cents on the dollar by 2010" is dead. 

Recipies for crow are being accepted.  In the interest of the sensitivities of those living on the southern 7 miles of SR-305, the crows must be fair traded, shade grown, and free range.

Monday, December 13, 2010

The Printers Are Coming! The Printers Are Coming!

EX NIHILIO credit is the mechanism most of the pundits confuse with "printing." 

When you go to your community bank to get a loan for a new Subaru Outback AWD, complete with "Wag More, Bark Less" and "COEXIST" stickers, your banker is extending you credit.  The banker is loaning you money he borrowed from someone else at a lower rate (depositors).  You take the money you borrowed from American Marine Bank Columbia Bank and give it to the seller of the Subaru.

They deposit that money into Frontier Bank Union Bank, who loans out the money to someone wanting to send the next generation of debt zombies to a degree mill.  The degree mill deposits the money into Washington Mutual Chase-Manhattan, who lends it out to someone wanting to build an iJunk manufacturing plant in China to sell to Americans with a 17% unemployment rate being paid by the government not to look for a job.

The money is cycled from China back into US Treasury bonds to keep Americans buying stuff they don't need, that they can't afford, with money they don't have.  The US taxpayer pays interest on that debt so China can buy weapons to kill the children of the debt zombies graduating from American degree mills with PhDs in Ethnic/Gender studies.

That's how "normal" banking works.  That same money deposited in American Marine Bank Columbia Bank is claimed by many different entities, which is called "velocity."  The greater the velocity, the greater the money supply.  As long as there is GDP underpinning all those people claiming the same dollar, we don't get inflation.

The FED has that ability, but also has the ability to generate credit out of thin air (ex nihilio).  Most people who know only enough to get them a talk show on cable or AM radio confuse this with "printing" money.  Sure, it looks, smells, walks, talks, and tastes like money printing, but it is not.

Here is how it works.

The US Treasury, under the steady hand of Turbo Tax Timmy Geithner, needs $100,000,000 in cash printed up for buying nudie scanners for TSA.  Timmy is the exchequer for the United States government, and he goes to the same place you would go to get some Benjis for a wild weekend in Vegas - the bank.  His checking account is at the FEDERAL RESERVE.  Timmy calls Ben Bernanke and orders up his money, but Ben doesn't do the printing - the US Treasury does. 

Ben waives his magic wand and "presto" there is $100,000,000 credit issued to the United States Treasury that appears as an asset to the Treasury and a liability to the FED.  So far, the books for that transaction are kinda balanced.  We can clearly see where the $100,000,000 came from and where it is now.  Timmy issues Ben a Treasury Bond worth $100,000,000, shown as an asset to the FED and a liability to the Treasury.

For those playing the home edition, we have:

Ben has an asset (Timmy's T Bond) worth $100,000,000 and a liability of the same (ex nihilio credit entry).
Ben's books are balanced.  The FED is worth no more today than it was last week.

Timmy has an asset worth $100,000,000 (Ben's credit that he may convert to a million C-notes if he wants via the US Bureau of Engraving), as well as a $100,000,000 liability (the IOU that he gave Ben).  The US Treasury is worth no more today than it was a week ago.

So far, so good?

There is, however, $100,000,000 more money in circulation today than we had last week.  GDP isn't up $100,000,000 in the same time frame, so we have some inflation.  Circulation/GDP has gone up.

The gold bugs, AM/cable talk show hosts, and Ron Paul all have a grand mal, foam at the mouth, and bloviate endlessly about the FED "printing" our way to eternal fiscal damnation.

Here is what they are missing.

The US Treasury, through its 110,000 thugs called IRS Agents, scurry about the private economy shaking people down to part with their money and giving them nothing in return, other than the courtesy of not dragging them out of their house and shooting them.

Money is being taken out of the economy after GDP is produced, which is deflationary.

That money goes to the Treasury and back to the FEDERAL RESERVE to extinguish the T Bond.  Once Timmy pays Ben the $100,000,000, the T Bond is put in the round file, the ex nihilio credit entry is erased, and $100,000,000 worth of GDP is now circulating in the economy and chasing the extra $100,000,000 that Timmy put in there.  The money that appeared out of the ether, now disappears into the ether.

The FED's books are clear and balanced.
The Treasury's books are clear and balanced.
The private economy has $100,000,000 of extra money in it covering $100,000,000 worth of new GDP, which all other things being equal, means the dollar is the same it was before we began this little exercise.

Where is the "print?"

The problem comes when the FED generates SO MUCH ex nihilio credit that it can't drain it due to the sheer size of the credit entry.  If the credit doesn't actually produce anything, but just goes to bail out other bad debt, the economy can't "grow" its way out of the mess.  That pretty much sums up what we have been doing.  The IER does admit that the potential for a de facto "print" to take place, but that would only happen in the complete collapse of both the underlying economy and the dollar itself.  When that happens, it's August 24, 410 AD all over again, and the Second Dark Age is upon us.

As of now, the collateral the FED is holding against the ex nihilio credit is more than sufficient to keep things afloat, provided a complete collapse of the value of US debt is avoided.  The FED, while telling us member banks were solvent and assets at the member banks were close to face value, only took those assets as collateral after a reduction of at least 80% off the face value.  This is not to be taken as an endorsement for current monetary policy or bail outs, but just as a reality check.  That which is not sustainable shall ultimately cease or fail, and our current trajectory through fiscal history certainly applies.  Eventually, the bad debt will be defaulted, the dollar will rise, prices will fall, interest rates will rise, and we will rebuild.  The IER seriously doubts that the current paradigm will last long enough to destroy our society.  The fate of our society rests in politics and the general approval of living beyond our means, and a population being set against itself for the deliberate destruction of Western Civ.

Those issues are beyond the scope of the Institute For Economic Reality.

Stay solvent,

Ernst Stavro Bloviator, Senior Fellow, IER

Sunday, December 12, 2010

Is QE 2 Really The Titanic?

As the vast and loyal readership of Clearcut Bainbridge already know, the Institute For Economic Reality has been a pretty good fade for calendar year 2010.  The IER predicted a rising US dollar and falling "everything else."  This wasn't lost on the senior fellow level of the IER, and I had a short, but prosaic posting where I would be eating large helpings of corvus brachyrhynchos.  The mighty US dollar was the Pee-Wee Herman of Venice Beach, and the equity, debt, and commodity markets were Rambo on a 'roid rage.  Capping off all that was the two weeks prior to The FED announcing yet another asinine program to prevent the price discovery of banking assets (Quantitative Easing 2.0, or QE2), I took an unfortunate spill body surfing and spent my fortnight's leave in Hawaii lying in bed with a shattered shoulder and bombed on pain meds.

Just as I was going to press with my "101 Ways To Eat Crow" article, I placed a call to the IER's Great Lakes Associate Fellow to see what she had to say, and she told me to stand down from admitting defeat and check out the European bond spreads in the more dysfunctional economies (that's everyone but Germany).  Apparently, after a few liters of Irish single malt, things get a little foggy on the concept of actually paying back money you borrow to live beyond your means.

Sure enough, Ben Bernanke's idiotic plan to thwart the normal restorative properties of a free market and credit based hard currency system has blown up in his face almost as fast as a dumb insurgent tinkering with a roadside bomb.  Stocks are mixed, but the bond market appears to be treating Ben the same way the American voters treated Nancy on November 2.  Everything in Bondville is getting sold, especially closed ended mutual funds (hattip to Karl Denninger of the "Market Ticker").

Ostensibly, the entire idea of Ben issuing credit to buy debt in the amount of $100B/mo for 6 months, is to keep Treasury rates from climbing and continuing the charade of deficit spending papering over the contracting economy.  He also needs to keep prices of assets held by member banks high, and his member banks hold a trainload of Treasury bonds.  If those sell off, there aren't any accounting games you can play with those, like you can on mortgage-backed-securities.

Ben either continues to buy everything, or Ben's buddies go BOOM.

The problem is for the past few weeks, Ben's bluff has been getting called.  Check out these graphs.
10 Year Treasury Yield
(click to enlarge)

This is the 10 YEAR US Treasury bond as viewed from a yield point of view.  This is one of the biggest things driving mortgage rates on Bainbridgeislanddreamhomes.  Ben and the Boys announced the second round of "QUANTITATIVE EASING" on the low tick of this chart.  Since then, the interest rates have gone straight up.  That's pretty cool, but the object of QE2 is to keep rates LOW by the FED creating credit ex nihilio and purchasing these securities.  Rates move inversely, by definition, from price.  It would seem that the overall demand for this kind of debt is drawing down.

That's not good.  Not good at all.  Granted, Ben isn't going on his buying spree for a few more weeks, but normally bond traders front-run large purchases by the FED to sell to Ben at higher prices.  The real test is when he actually starts buying.  If rates still go up, he's done.

Why would Ben be so obsessed with buying US government bonds at the short duration?  The reason is that he has been stuffing the Federal Reserve wholesalers (called Primary Dealers) with government debt all during these bailouts.  It's an easy way to get money via the taxpayer, and since they get to keep the money that is the difference between the rate they bought in for, and that of ex nihilio credit, why not?  What is the downside?

10 Year Treasury Price
(click to enlarge)
This is the downside.  This is how Ben sees the bond market.  Those of us in the Great Unwashed only see the bond market in terms of how much it costs to borrow money to buy goodies, baubles, and Bainbridgeislanddreamhomes.  Ben and the banking cartel see the bond market in terms of price, which is what you see to the right.

Pretty ugly, huh?

Someone had better plug that hole STAT! or we are going to have a full-on bond collapse which will seriously imperil the government's ability to function.  Remember, Barry, Harry, and Nan have been spending almost twice what they collect via the thuggish IRS, which means that the Tax Cheat-in Chief (Geithner) has to borrow almost half of all federal expenditures.

Ben has been stuffing the PDs with US Treasury debt and as long as the coupon pays enough to keep things liquid, it works.  It also works as long as the price of the debt is high enough to sell into the market to raise cash.  When the price of debt falls (yields rise), those PDs holding the debt can't sell because they will take a capital loss, and believe it or not, all that ex nihilio credit creation needs to be paid back, or The FED blows up.  The banks find themselves in the same predicament they had when they were holding tons and tons of worthless mortgage backed securities, that were backstopped by the never ending rising of residential real estate.


Ben has to keep the market price of US debt high enough to keep his wholesalers liquid, otherwise it's TARP:  The Sequel, which would go over about as well as a disabled Iraqi War veteran marching in the 2004 Grand Old Fourth parade.

The Yankee Lira has been marching around in circles, looking for direction, and the contest is between Ben driving the currency into the ground (collapse of demand), and the circulation drop as debt defaults and the economy delevers (collapse of supply).  I am still firmly in the latter camp, and believe most of the hype around the impending doom of the US dollar is a bunch of nonsense.

The dollar has been tanking because of a bad risk-reward environment brought on by the FED using ex nihilio credit to keep the price of asset classes high as return on investment shrinks.  This elevates risk against declining reward, which can only find relief in abandoning dollar denominated assets en masse.  Ben ends up as the buyer of last resort, rather than the lender of last resort.

In fact, if any of the vast readership is still investing "for the long haul," you need to know that the only thing you are investing in is getting out of your assets before The FED does.  If you think you can hit the exits before the guy that actually knows when to exit does, you are one brave and foolish man.  That is all you are doing - betting you can get out before Ben does.

Good luck with that.

Being short isn't much better.  You need to be able to meet margin with real money and you are fighting a man with the ability to generate ex nihilio credit.  The only thing you have going for you is that your money can outlast Ben's credit-from-heaven.  Yeah, right...

That being said, if those charts of interest rates don't turn soon, the shorts will clean up.

[EDIT:  In order for Ben to get yields down and prices of bonds up, he must be able to generate ex nihilio credit faster than it is being destroyed in the private sector.  Failing that, he must generate some form of financial panic to drive money out of certain asset classes and into short term US bonds.  Look at Aug-Nov 2008 to see what that looks like.  Stock prices would come apart to foment such buying in short term Treasuries.  Equities are at eye-popping multiples and margin compression, brought on by rising commodity prices via dollar selling, will also bring in multiples.]

As the bottom falls out of dollar denominated asset prices, the risk of holding them goes down, and the rate of return on those assets rises.  This brings risk/reward back into balance, and the dollar will rise rapidly.  This is essential for the formation of capital to start the new economic cycle, and hopefully it won't be us flipping assets back and forth to one another and calling that wealth production.

The IER has been a pretty good fade for 2010, and that realization is a swift kick to the crotch.  It took several trillion dollars borrowed from our children, but the FED and US taxpayer made a monkey out of the IER...

...for now.

This isn't over.  Nothing has been solved.  Couple that with a narcissistic disaster on the verge of a nervous breakdown in the White House, 2011 should be an E-Ticket ride.