Money Sage (archive)

In working to form a judgment as to the probable extent, severity, and duration of the unfolding economic downturn, we consider a number of factors. There is one factor which serves as a confirmatory element in our assessment. This is the forecast of individual FED regional bank presidents and individual FED governors. These forecasts are, in a way, far more useful than the official FED pronunciamentos.

These latter are a group product, negotiated to take due account of a variety of viewpoints and different perceptions, and melded into a useless composite. Moreover, as we have noted in an earlier post, a well-known economist has compared the actual FOMC (Federal Open Market Committee) transcripts -- which faithfully record the verbatim proceedings of the FOMC meetings -- and the minutes, which are released shortly after the meetings. This economist -- a careful and reliable professional, we judge -- discovered that frequently the transcripts did not bear the remotest resemblance to the minutes. We leave it to you, dear reader, to figure out this, shall we say, "conundrum"?

We have read reams of "analysis" and heard innumerable warnings about the weakness of the American financial position vis-a-vis the profusion of creditors who have purchased our debt and who hold our I.O.U.s. In one sense, we have no problem with this analysis. The dire warnings about our relative weakness, about our vulnerability in depending upon foreigners to continue accumulating our currency and holding American assets, and the risk to the American economy should these foreigners decide to reduce their dollar denominated asset holdings all possess a considerable validity. What they gloss over, however, is a different facet of what is essentially a SYMBIOTIC RELATIONSHIP between America, the consumer, the borrower, the overleveraged, overindebted spender, and the more frugal, better energy-endowed, hungry foreign creditor countries. More specifically, current developments cast a spotlight upon a very real, if widely ignored, aspect of the economic balance of power between the United States, on the one hand, and its creditors, energy suppliers, and sources of cheap consumer items on the other. This aspect is: THE POWER OF THE WEAK. Yes, we are financially fragile. But we are also: TOO BIG TO FAIL. Our foreign creditors, foreign asset holders, foreign investors, foreign economies, foreign exporters DEPEND UPON US for their own prosperity.

Enough "flations" in there for you, folks?

To paraphrase what a late Vice-President of the United States once said in another, and very inappropriate context, "When you've seen one "flation" you've seen 'em all".

Or, maybe that isn't quite true? No, it's not. For the truth of the matter is there are "flations" and there are "flations," to coin a phrase.

The latest hullabaloo is over the reputed, multiple sightings of that dreaded enemy, "stagflation." This ungainly word describes an ugly economic condition, one characterized by economic "stagnation" (recession, really) accompanied by rising inflation. Yuk.

In a very general sense, we would regard the sovereign wealth funds' sizable cash infusions into our ailing banking system as one element in what we have termed "Bailout by Bits and Pieces." (See our essay under that title for more data). The substantial investments these funds have made -- and are continuing to make -- raise one interesting question. That question is: WHY?

Clearly, few of the super-savvy among American investors have acted on the repeated insistence in the financial media that bank stocks are a great buy, that this is where a lot of "smart money" is going, that these stocks possess the greatest rebound potential of them all. Insofar as we know, Berkshire Hathaway has NOT increased pre-existing stakes in any of the ailing bank stocks, apart from Wells Fargo, which is perhaps the least ailing of the lot. Nor have we heard any ringing announcements from the richest and savviest university endowment funds, or from other skilled, major institutional players in the American markets. At best, many of these non-participants are maintaining a stance of watchful waiting. What are they watching, and what are they waiting for? Oh, well, we bet you can guess.

We have always, always, considered ourselves to be mainstream thinkers. We have dismissed the "lunatic fringe" of the investment world as "the lunatic fringe." Now, we must admit, that we are becoming increasingly concerned that the "lunatic fringe" may not be so lunatic, after all.

Our confidence in "mainstream thinking" is being eroded by a combination of grotesquely incorrect mainstream forecasts, developments coming to light about bank and financial institution behavior which challenge credulity, and what has proven thus far to be a too little, too late response to an emerging financial iceberg on the part of the monetary and governmental policymakers.

We have NEVER been goldbugs, nor have we ever doubted the total reliability of the New Deal institutional and policy innovations which established a strong safety net for the banking and financial systems, and the overall economy. This despite the grievous policy errors of the central bank during the Great Depression.

Now, however, we are beginning to wonder.

The Treasury market has fired an unmistakable warning shot over the FED's bow, as the FED is seemingly plowing ahead on its urgent mission of LIQUIDITY CREATION. This shot consists in the 50 basis point (bps) RISE in yields at the long end of the Treasury market over the past 23 calendar days.

Since hitting an intraday low yield of 3.28 on January 23rd, the 10-year Treasury yield has backed up to 3.78 on Friday. The benchmark 30-year Treasury bond yield has similarly backed up 50 basis points, from a low of 4.10 on January 23rd, to yesterday's close at 4.60.

There are 2 ways of viewing this development, we believe. The first is to regard it as a normal price correction (with bond prices moving inversely to interest rates, which is a mathematical certainty)within the framework of an ongoing bull market. In fact, the extent of the correction places it close to the outermost limits of a typical bull market correction, in our judgment.

The second is to view it as a signal of spiralling anxiety among long-term bond investors over the PERCEPTION that the FED may create too much liquidity in coming months.

Generally speaking, FED rate cuts are a huge plus for the stock market. Rising liquidity is the other side of the coin of rate cuts, and it is LIQUIDITY, above all else, which drives markets. As liquidity increases, it constitutes the fuel needed to power bull markets. When liquidity contracts, it has the opposite impact. Since it is liquidity which drives all great bull markets, and the absence of same which bursts bubbles and catalyzes bear markets, a normal response to a fundamental change in FED policy should have a profoundly bullish impact on the equity market. The FED, after all, is the primary source of liquidity. It is, in the final analysis, the creator, and the terminator of bull markets.

These initials will be familiar only to those who have devoted a good deal of time to studying the bull market of the 1920s.

O.P. and M.J. were brothers. Oris Praxton, and Mantis James, Van Sweringen. O.P. and M.J. were developing some property shortly after the First World War. A company which owned land they needed for their project refused to sell. The company was a railroad. The brothers thereupon hit upon the idea: they would buy the railroad. This they proceeded to do.

The Van Sweringen brothers were very astute individuals. Realizing that vast sums could be made by buying control of railroads via LEVERAGED METHODS, they proceeded to do just that, building up a vast holding company empire of railroads. They became two of the most prominent and ultra-successful market operators of the 1920s.

Of course, human nature being what it is, the Van Sweringens went too far. They became extremely overextended, dependent for the survival of their empire upon EVER-RISING STOCK PRICES.

Well, markets being what THEY ARE, prices stopped rising finally and turned down. You, dear reader, can guess what happened to the Van Sweringens. You can also guess what happened to the hundreds of thousands, indeed, millions, who attempted to follow the paths of speculation with leveraged funds they and others blazed.

This post is VERY, VERY PREMATURE. And that is putting it mildly. However, we thought it would be interesting to address this question, even though the current liquidation is still in its early stages.

First, let us consider how liquidations DO NOT END. They do not end when people are hopeful. They do not end when the authorities remain upbeat. They do not end when a large number of economists and assorted Wall Street gurus assert that we are not in, and will not enter a recession, in the face of overwhelming evidence to the contrary. Nor do they end when market gurus announce "a bottom is in," or, "the market has made an important bottom." Nor do they end when the central bank and the Administration, via their media conduits, are putting out the word that there is not much more that the FED can really do, that there is not much more that the government can do. Finally, they do NOT end when those in the seats of authority tell us that the "markets" will have to sort this out, and that this will take time.

Regrettably, the answer to this question we pose in the title is: Affirmative.

New landmines are now surfacing, with the probable consequence of WORSENING the CONTINUING DETERIORATION of the capital position of the banking system, the ability/willingness to lend, and the ability of increasingly hardpressed borrowers to roll over their loans, increase them, or improve the terms of borrowing.

Without repeating what we have said again and again, we wish to UNDERLINE that there is in effect a MUTUALLY REINFORCING DYNAMIC between the deepening bear market in real estate (which is now spreading to NEW sectors of the real estate market and the securitized loans this sector supports -- viz., COMMERCIAL real estate), the falling value and marketability of an INCREASINGLY BROAD SPECTRUM of real estate backed loans, the consequent deterioration in the liquidity/solvency of the banking system, AND the concomitantly DECLINING OF THE BANKS TO ROLL OVER existing customer loans, make new loans, or improve lending terms. This, in turn drives the generality of borrowers (i.e., homeowners, consumers, major property owners, businesses of all classes) into an endlessly deteriorating liquidity situation with ever-more serious threat of insolvency to an ever-growing number of borrowers/homeowners/consumers.