There Are No Simple Paths to Prosperity

by: David Merkel October 14, 2008    
David Merkel

David Merkel

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Ordinarily, when I sit down to blog, I know what I want to write.  That’s not true now.  Yes, I could do a few book reviews.  I have six books read, and ready to go, but given the volatility of the markets, I feel I have to say something about the current activity.

I am a strong believer that there are few free lunches.  If there are simple policies that will easily produce prosperity, they would likely have been done by now.

As I have commented before, what we are seeing now is a shift in debt from the banks to the government.  Banks get capital, the government gets debt, and the money for the debt comes from three places: taxpayers, foreign lenders (central banks, probably) and perhaps at some point, the Federal Reserve could buy it (whether they monetize it or not is another question).  As jck noted yesterday, this has led to a selloff in Treasuries.  (Interesting that it happened on a day when the cash markets were closed, but the futures markets were open.  The reaction of the cash bond market today is similar to that which the futures market experienced yesterday.)

Which brings me to my first point.  Today, when the rally in the fixed income markets gets reported (the markets, again, were closed yesterday), you will likely hear that spreads rallied sharply.  But watch for the discussion of yields and prices (if there is any).  It’s quite possible that yields rise from Friday to the close of business today.

Second point, today $250 billion of the $700 billion got used on nine big/critical banks.  Now, this may have been somewhat coercive to some of the nine banks; as was said at Bloomberg:

None of banks getting government money was given a choice about it, said one of the people familiar with the plans. All of the banks involved will have to submit to compensation restrictions, said the person.

The government will also guarantee the banks’ newly issued senior unsecured debt, making it easier for them to refinance their liabilities, the person said.

Possibly the following message was delivered, “Be a good boy and get in line.  This is good for the nation, and we won’t be around for a decade.  You want to be a survivor, right?  You want friendly regulators when we review the levels at which you are marking your illiquid assets?  We thought so.  Sign here.”  (No surprise that Goldman (GS) then applies for a NY State, rather than Federal bank charter.  State regulation, particularly when you are a local champion, is much more flexible.  Just ask AIG. )

Though this leads to a short-term bounce in bank share prices, the long term effects are less clear, which brings me to my third point.  It’s one thing to bolster their balance sheets.  It is another to get them to lend, particularly in the bear phase of the credit cycle.  Also, as leverage comes down, and it will come down, so will profitability at the investment banks, and probably other banks as well.  Securitization will be less common, eliminating hidden leverage that allowed for less capital.

The same thing is going on in Europe, though they actually think about how they might pay for the bailouts.  In the UK, it pushes the national debt to GDP ratio to 100%.  As it gets closer to 150%, the international debt markets usually start to choke.  We have traded bank credit risk for national solvency risk at the margin.  Maybe that will be different here, if only government creditworthiness is perceived to be safe.  It is a “new era,” right? 

I find it interesting that Barclays is refusing help.  Either the UK regulators aren’t so coercive as those in the US, or Barclays is not as levered as I thought.  Or, it could be hubris on the part of Barclays’ management team.

Even Japan is getting into the act, though these measures seem so weak that I wonder why they would bother.  The government and Bank of Japan stop selling bank shares, and allow companies to buy shares back more aggressively.  That may push share prices up in the short run, but it substitutes debt for equity, which shouldn’t have much of a long-term impact.

On the Central Banking Front

Now, with the seemingly limitless amount of US liquidity being to the short end of the US money markets, you would think that we would get a bigger move than we have gotten so far. This will take time, but watch the yield as well as the spread.  Also remember that LIBOR has become somewhat of a fiction at present.  There many quotes, but not so many loans to validate the quotes.

What is being done that is new?

  • TAF expanded to $900 billion.
  • New commerical paper program where the Fed backstops the A-1/P-1/F1 CP market, including ABCP.  Terms here.  FAQ here.  This is big, and it is much easier to start such a program than to end it.  It is difficult to end any program where credit is granted on less than commercial terms.  My guess is that it will be extended past its April 30th, 2009 planned expiry date.
  • Swap agreements allowing unlimited dollar liquidity to foreign entities through agreements with their central banks.
  • The Fed can now pay interest on reserve balances held at the Fed, which allows them to increase their balance sheet significantly.  In one sense, they become the Fed funds market.

What is not new is the idea that all we have to do is restore confidence, and everything will be fine.  No, we have to delever, and the US Government is included in the list of those that need to delever.  There is no national reform going on here, but merely a shifting of obligations from private to public hands.

For investors:

For those that are investors, the biggest bounces tend to occur during depressionary conditions.  I would not get overly excited about the rally yesterday.  As John Authers at the FT points out, given the extreme changes being made, there should have been a bounce.  The question is whether it will persist.  I was a net seller into the rally toward the end of the day.  I think we have more troubles ahead.  Two things to watch:

  • LIBOR, CP yields and the TED spread. (The short end)
  • Overall yields of medium-to-long Treasuries and other long-dated debt.  (The long end.)

I expect yields to rise, even if some spread relationships fall.  The added financing needed by the US government is large.  Let us see where Treasury buyers have interest.

There are elements of this that remind me of my The US Dollar and the Five Stages of Grieving piece. This is for two reasons: first, we are asking foreign entities to hold more dollar claims at a time when they are stuffed full of them.  Second, this phase of the credit crisis reminds me of the “bargaining” phase of the five stages of grieving.  We are past a long denial phase, and the anger continues, but now we bargain that these proposals will allow us to escape the pain that comes from delevering.

I’m skeptical, but I hope that I am wrong, lest we get to the fourth stage “depression,” before we finally reach “acceptance.”  As it is, I am looking for companies with balance sheets strong enough to survive the worst.  That is my task for the next few days.

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This article has 12 comments:

  •  
    Oct 14 12:41 PM
    Ah, good to find another 'five stages of grief' file; I collect those since they are often funny to read.

    I agree there are no simple paths to prosperity, after living so many years above the real standard it is almost impossible to debt deeper to prosparity...

    __________

    What the LIBOR stuff concerns; I heard today it fell a tiny tiny bit but I haven't checked the details yet. Beside this for interbank lending to set in it is far more important to obsere a shift in overnight lending to longer terms of debt.

    My guess is that it won't happen for some while, even with the government guarantees on bank lendings. Most interbank lending was to feed the strange creatures on the 'off balance' balances and most of those alphabet soup beasts are (almost) dead by now.

    __________

    TAF extension to 900 billion US$ to help at years end:
    For a long time I am looking for more proof that says that all accepted collateral is free from the 'mark to market' rule.
    This big extension is only a clue that there is indeed a proof.
    Reply | Link to Comment
  •  
    Oct 14 01:16 PM
    I have to say that I enjoy reading Merkel.

    Unfortunately, we live In the world of free lunches for the rich.
    Reply | Link to Comment
  •  
    Oct 14 01:41 PM
    The government is saving the banks as it's all they can do for without the banks we are finished.

    However, the trillions of $$$ it will take to save the banks will come from thin air.

    Here's what's happened and what I believe will happen.

    1. Inflation in hard commodities.

    2. Deflation of everything that was overvalued due to too much easy credit.

    3. Creating wealth from the thin air to save the banks.

    4. Rising inflation which will be the final blow to the American consumption economy.

    5. Worldwide economic recession/depression
    Reply | Link to Comment
  •  
    Oct 14 01:52 PM
    You mean Cramer, CNBC, CNN Money, The Today Show and Good Morning America have been lying to me all these years?

    Oh NO!
    Reply | Link to Comment
  •  
    Oct 14 02:23 PM
    To curbs in.

    It is not that they have been lying; CNN, CNBC etc don't understand their own stuff. Just like the management of AIG, as an insurance company you would think they understand insurance...

    But AIG went to the FEDs for 40 billion, 40 billion turned into 85 and now another 37.5 billion is added to the tag.

    When the Lehman credit insurance has to be paid, another unknown billions have to be added too. Very likely the management of AIG does not know how much; they do not understand their business.

    Same goes for the FED and the Treasury; the FED does not know how to handle a fiat money stystem because the models they use do not take into account the size of debt on the vaious sectors.

    If the FED does not understand her thing, how can we expect from the mass media to grasp what is going on?
    Reply | Link to Comment
  •  
    Oct 14 02:27 PM
    The simple path to prosperity is clearly established in the Constitution:

    Personal freedom
    Sound money
    Low taxes
    Limited government

    With this simple plan, generations of Americans worked hard and prospered until we were hijacked by the Fed in 1913.

    Reply | Link to Comment
  •  
    Oct 14 02:44 PM
    "Free lunches for the rich" assumes there are some. I think what they are eating is neither free nor lunch. Why blame the rich anyway? Look to George W Bush and more lies and wretched actions than can even be remembered. 50 percent of the electorate voted for him, the huge majority far from rich. A payback mentality belongs in The Third Reich.
    Reply | Link to Comment
  •  
    Oct 14 02:46 PM
    "the trillions of $$$ it will take to save the banks will come from thin air" True, the same thin air that trillions of dollars have vanished into.
    Reply | Link to Comment
  •  
    Oct 14 02:53 PM
    "I am a strong believer that there are few free lunches. If there are simple policies that will easily produce prosperity, they would likely have been done by now.

    As I have commented before, what we are seeing now is a shift in debt from the banks to the government. Banks get capital, the government gets debt, and the money for the debt comes from three places: taxpayers, foreign lenders (central banks, probably) and perhaps at some point, the Federal Reserve could buy it (whether they monetize it or not is another question)."


    Yes, well, partly.

    I hereby today start the "potato" analogy. We have eaten all the potatoes from the pantry, and we have eaten all the potatoes from the root cellar, and we have eaten all the potatoes from seed shed that we had intended to plant next Spring. There are no more potatoes.

    Paulson and Bernanke and Trichet et al are going to print potatoes which they will plant in the banks. Those of you who don't already know, can wait to see how well printed potatoes grow.

    Anyone who has any potatoes, I suggest they hide them.
    Reply | Link to Comment
  •  
    Oct 14 03:14 PM
    "first, we are asking foreign entities to hold more dollar claims at a time when they are stuffed full of them"

    Uh, no, they are begging for U.S. dollars and shunning their own currencies - please get your facts straight.

    "Second, this phase of the credit crisis reminds me of the “bargaining” phase of the five stages of grieving"

    Bargaining? With whom? I would argue that a 30% drop in the DOW in 10 days in October is DEPRESSION and DESPAIR, not "bargaining"...

    "We are past a long denial phase, and the anger continues, but now we bargain that these proposals will allow us to escape the pain that comes from delevering"

    So now we've backed up to the anger phase? I thought we were already in the "bargaining" stage. Please, if you're going to use a hackneyed 5-stages of grief mantra, at least try to get the stages in correct order. Also, who said anybody is going to "escape the pain"???? The govt proposals are aimed at getting the credit markets working again. Do you have a problem with that???????

    CONCLUSION - MERKEL, YOU ARE A HACK.
    Reply | Link to Comment
  •  
    Oct 14 04:00 PM
    "There are no simple paths to prosperity."

    Beg to differ. This is *exactly* where the Fed, Treasury...and the *entire* federal government are getting it wrong! They are re-greasing the wheels of the credit machine, instead of addressing the core issue. They have dual vested interests for not doing so.

    The surface issue is that the average American is tapped out...overleveraged. The *core* issue is that we ever got into credit-based living to begin with!! And where does the blame for that lie? Certainly to some degree in personal choices. But to a very large extent, it is due to middle America having a large "first hurdle"...the 30-40% chopped right off the top of their gross income for Federal taxes!! It is way, way too much. The founders would have revolted again *long* ago!! Economically, it means that we are stuck in credit cycles, rather than spending from truly discretionary income. The vested interests *want* to keep this going: a) government - because it needs to keep its power (vs. letting the people be more truly free!); b) banks - its how they make their money!

    Why do we assume we need a mortgage to buy a house? Do we even think back only a couple generations ago to when this WAS NOT THE CASE???

    America, it's time to take back what is OURS!! == a) our freedom, and b) our money -- which is a partial means to the former! We must DEMAND government be cut to the core -- back to where it was intended to be; and DEMAND our money back -- an end to the welfare, entitlement state!! It has not worked, and this utter failure of the big-tax, big-spend, credit-based economy is proof.

    There IS a simple path to prosperity: it's the same as it has always been -- free market economics with MINIMAL government...so that people have maximum incentive for their own productivity to reap rewards that THEY get to keep, rather than being federalized to be handed to the entitlement recipients down the street! If this message is not heard in Washington, I warn you...the water is warming up, and the tea will soon be ready!!!
    Reply | Link to Comment
  •  
    Oct 14 04:03 PM
    @debtacid: RIGHT ON, BRO!! That's what I'm talking about!!!
    Reply | Link to Comment
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