Friday, October 31, 2008

Big Investors Betting on Deflation


Mark Hulbert says that investors in U.S. treasury bonds are betting on deflation:

"The Treasury market [is huge] and its collective judgment cannot be dismissed lightly.

***

The bond market is betting that the [consumer price index] will average less than 1 percent annually over the next decade....Economists at the Cleveland Fed have devised an econometric model that estimates [how much treasury bonds are] skewed downward by . . . liquidity considerations. That model recently calculated this bias to be around 0.5 percentage point, suggesting that the true message of the bond market right now is that inflation would average around 1.4% year over the next decade.

***

The bond market is betting on deflation.

This puts into perspective the federal government's efforts in recent months to pour huge amounts of money into the financial arena. That would otherwise be quite inflationary.

But not if the forces of deflation are as large as the bond market is evidently assuming them to be.

And judging by the recent performance of both the bond and gold markets, it would appear as though deflation still has the upper hand."

There are good arguments for stagflation - instead of deflation.

But if the big boys are betting on deflation with their own money, that's important information.

Thursday, October 30, 2008

Law Professor: "We're Going To Have Casinos In Las Vegas Reconstituting Themselves As Bank Holding Companies and Applying for Government Loans"

An article by McClatchy includes two must-read quotes on the bailout:

"I could say I told you so," said Rep. Joe Barton, R-Texas, who helped lead a revolt against GOP leaders and sunk the $700 billion plan on its first pass. "It was so open-ended and we put so little accountability into it, they can basically do whatever they want to with the money."

***

John Coffee, a law professor at Columbia University in New York and adviser to Wall Street regulators, said the government missed an opportunity by taking equity stakes in banks without attaching requirements that they use the bailout funds for new loans to spur the economy.

"If we could do this all over again . . . you could have conditioned the loan (plan) on how the proceeds could be used," he said. "Some banks are still hoarding the money . . . and others simply are not interested in lending in areas where they classically lent, like construction lending, because they see a major recession coming. . . .

"Before this is over that we're going to have casinos in Las Vegas reconstituting themselves as bank holding companies" and applying for government loans, Coffee warned.

Wednesday, October 29, 2008

Credit-Default Swaps on US Treasuries Have Risen Nearly 40 Percent Since Bailout Law Signed; Now About the Same as on Mexican and Thai Government Debt

Bloomberg writes the following bombshell:

"Credit-default swaps on [U.S.] Treasuries have risen nearly 40 percent since TARP was signed into law Oct. 3, and are now about the same as Mexican and Thai government debt before the credit markets began to seize up in June 2007."
The article also states:

"Trading of credit-default swaps on government debt has increased since countries from the U.S. to Germany began pumping cash into their banks to prevent more failures, said Puneet Sharma, head of investment-grade credit strategy at Barclays Capital in London. The expenditures mean the 'probability of downgrade has increased,'' he said.

Investors are buying protection on countries to speculate on a deterioration of their credit quality and ratings as governments take on risky assets, even if they don't think there is a chance of default."

What do "probability of a downgrade" and "deterioration of ... credit quality and ratings" mean?

Well, credit rating agencies, such as Standard & Poor's and Moody's, assign credit ratings to countries, as well as companies.

A September 18 article in Bloomberg raised the possibility of a credit downgrade for the U.S.:

America's credit "profile is now weaker because contingent risks have become actual risks to the U.S. government,'' said John Chambers, managing director of sovereign ratings at Standard & Poor's in New York.

In fact, Standard & Poor's raised a possible downgrade of U.S. credit back in April. An article in Marketwatch explained:

The performance of government-sponsored enterprises like Fannie Mae could have a direct impact on the national economy and more importantly, the credit standing of the U.S., Standard & Poor's said Monday.

Fannie and Freddie, which enjoy implicit government guarantees, could cause the U.S. to lose its sterling triple-A rating if the government were forced to come to their rescue, the ratings agency said in a report.

"Even though...credit damage from GSEs is unlikely, the greater risk to the U.S. lies with them than with broker-dealers," S&P noted.

The demise of Bear Stearns Cos. - and the Federal Reserve's extraordinary efforts to alleviate strains at broker dealers - has captured the attention of market participants who feared that the financial system would seize up last month.

S&P, however, noted that while this credit crunch has caused financial markets to swoon, it hasn't threatened the standing of the nation's credit quality upon which U.S. Treasurys and the debt priced off this government debt depend.

But should a protracted recession cause Fannie and Freddie to buckle, S&P said, the U.S. rating would be in danger.

Of course, Fannie and Freddie did buckle and - in many ways - the health of the U.S. economy is much worse than it was in April, and the U.S. is spending literally trillions of dollars it doesn't have on corporate bailouts.

A 2005 article in Lew Rockwell called "Should the US Government’s Sovereign Credit Rating be Downgraded to Junk?" provides some details of how credit rating agencies assign credit ratings to countries:

When examined objectively, one could make the case that Uncle Sam’s sovereign credit rating should be downgraded – perhaps even to "junk." So where are the credit rating agencies? Are they going to miss this one just like Enron?

***

Both Moody’s Investors and Standard and Poor’s have granted the U.S. the highest sovereign credit rating possible (Aaa and AAA respectively). Most other countries are less fortunate and have lower credit ratings – which can affect such a country’s interest rates and access to the credit markets. The lower the credit rating, it is believed, the higher the chances are for a country to default on its sovereign debt obligations. Be aware S&P downgraded Japan’s sovereign credit rating to AA– on April 15, 2002 . . .
The article then analyzes the U.S. economy using 8 traditional credit-rating factors, and concludes that the U.S. has performed abyssmally in all 8:
Having gone through all eight variables, it should be obvious that both Moody’s and Standard & Poor’s have grossly overrated America’s sovereign debt – it doesn’t merit the top grade of AAA. In variables such as default history, inflation, external balance, external debt, and economic development, the U.S. should rate significantly lower than does Japan – and should rate worse in many variables as compared to a developing country such as Botswana.

So why hasn't America's credit rating been downgraded?

Well, a report by Moody's in September states:

"In superficially similar circumstances, the ratings of Japan and some Scandinavian countries were downgraded in the 1990s.

***

For reasons that take their roots into the large size and wealth of the economy and, ultimately, the US military power, the US government faces very little liquidity risk — its debt remains a safe heaven. There is a large market for even a significant increase in debt issuance."

So Japan and Scandinavia have wimpy militaries, so they got downgraded. But the U.S. has lots of bombs, so we don't?

In any event, as a quote from the Marketwatch article cited above hints, foreign governments themselves will likely demand a higher interest rate when loaning money to the U.S. because of its precarious situation:

"The federal government assumes that it can borrow whatever it wants from foreign lenders at low interest rates for as long as it wants,'' said David Walker, former comptroller of the U.S. Government Accountability Office who's now head of the Peter G. Peterson Foundation in New York. "That's an imprudent assumption."
Indeed, the International Monetary Fund - which oversees third-world economies - is so concerned about the solvency of the U.S. economy that it is conducting a complete audit of the whole US financial system. The results of that audit might be more honest than credit ratings by American companies, and may result in a reduced opinion of America's creditworthiness.

One way or the other, America's credit rating will be downgraded, which will only add to America's financial problems.

Tuesday, October 28, 2008

Government Saying One Thing on Bailout, Doing Another

In an act of superficial political theater today, Bush told banks to "stop hoarding money".

However, Bush's Treasury Department is encouraging banks to use the bailout money to buy their competitors, and has pushed through an amendment to the tax laws which rewards mergers in the banking industry.

Moreover, Bush's government bucked tradition and insisted that it only take non-voting shares in banks it bails out, ensuring that it has no power to require them to lend out money.

The government is saying one thing, while doing the exact opposite.

The Government's Actions Are Making the Financial Crisis Worse

The government's previous actions lead to the current financial crisis. See this.

Moreover, the government's current actions are actually making things worse:

  • The "Central Banks' Central Bank" says that all of the "central bank intermediation may in some cases weaken banks’ incentives to resume their intermediation function".
  • The bailouts are causing HIGHER mortgage rates for consumers
  • The government's commercial paper buying spree is INCREASING the cost of borrowing
  • They also undermine consumer confidence. For example, consumer confidence is now at an "all-time low", due partly to "increasing uncertainty about the government’s rescue plan".
Ill-advised government actions regarding the economy are not a trivial matter. For example, economists at UCLA have concluded that some of FDR's policies extended the length of the Great Depression by 7 years.

The government's attempt to stop the inevitable deleveraging process will also backfire.

In Trying to Stop the Inevitable Deleveraging Process, the Government is Only Making It Worse

The financial system is undergoing a period of deleveraging that cannot be stopped. For example:

  • Barrons is running an editorial entitled "The Crash Must Come: Intervention can't stop the business cycle".
  • The Economist writes, "Once started, the process [of deleveraging] is hard to stop."
  • The Financial Times quotes the Bank of Tokyo-Mitsubishi in saying, "There seems little what the authorities can do to reverse the process of deleveraging that is taking place with financial institutions all contracting their balance sheets at the same time".
Ultimately, “all the king’s horses and king’s men” cannot prevent the de-leveraging of the financial system under way.

***

Like a giant forest fire the de-leveraging process cannot be extinguished. Thoughtful actions can create firebreaks that limit preventable damage to the economy and the international financial system until the fire burns itself out.
The process of deleveraging cannot be stopped, but the government is trying to stop it anyway. Instead of allowing an orderly deleveraging process, the government is actually trying to prop up the leverage.

For example, instead of requiring banks to deleverage, the government is reducing their cash reserve requirements so they can increase their leverage to loan money they don't have through fractional reserve banking. See also this.

And - even after Greenspan confessed that derivatives were dangerous (and see this) - the government refuses to rescind them or take any other real actions to contain the nuclear fallout from such "weapons of mass destruction". Instead, the government is trying to prop up the derivatives market by various means.

By trying to put out the raging deleveraging forest fire, the government is actually fanning its flames and making it more dangerous. And even in those areas where the government appeared to put out the fire, there are hot coals just beneath the surface that are already erupting back into flame (as just one example, inter-bank lending rates are back up).

Instead of clearing out the flammable debris which could ignite next, the government is letting it accumulate . . . a recipe for another financial crisis.

As with other aspects of the government's actions, the attempt to stop the inevitable deleveraging process is only making matters worse.

Monday, October 27, 2008

The IMF Can Print Money Like a Central Bank


In an article entitled "IMF may need to 'print money' as crisis spreads", the Telegraph reveals that the IMF has the power to create money just like the Federal Reserve:

"The nuclear option is to print money by issuing Special Drawing Rights, in effect acting as if it were the world's central bank. This was done briefly after the fall of the Soviet Union but has never been used as systematic tool of policy to head off a global financial crisis.

'The IMF can in theory create liquidity like a central bank,' said an informed source. 'There are a lot of ideas kicking around.'"

Inflation, Deflation or New Nation?

Smart people like PhD economist Krassimir Petrov argue that we will have stagflation - inflation plus stagnant growth.

Other smart people like PhD economist Nouriel Roubini argue that we will have deflation (and see this).

But the debate about whether we will have inflation or deflation may be overshadowed by the question of whether the whole playing field is going to shift.

Specifically, inflation and deflation are both things which occur relative to a certain currency. For Americans, this means asking whether dollars will buy more or less.*

But the G-20 meeting in mid-November could totally change things. The biggest creditor nations might demand that a new world reserve currency replace the dollar (they've hinted at this). Or they could demand that the U.S. dollar go back to the pre-Nixon gold peg agreed to under Bretton Woods (they've hinted at this, too).

If a new nation takes over the role - which the U.S. has held for 64 years - as issuer of the world reserve currency, this will fundamentally change the landscape on which the inflation versus deflation debate occurs. The dollar would fundamentally be changed and - with it - the risks of inflation or deflation.

Confidently forecasting inflation or deflationary before the G-20 meeting is like trying to use the team roster to forecast who will win the second half of a football game when a major earthquake has just tilted and uplifted part of the gridiron and ripped deep canyons in another part.


* The Austrian school of economics points out that inflation and deflation are really about the size of the money supply, and not prices. If a new currency replaces the dollar as reserve currency, that would still shift the debate onto entirely new territory.

Of course, the U.S. is, or may soon become, insolvent. This would also dramatically shift the debate.

Saturday, October 25, 2008

Senator Warns of Revolution


Senators don't normally use the word "Revolution".

As a central part of the government, Senators do not normally wish to stir up any images of major challenges to power or of guillotines.

So it is dramatic that Senator Dodd mentioned the "R" word with a New York Times reporter:

I caught up with Senator Dodd, and asked him what he was going to do if the loan situation didn’t improve. “All I can tell you is that we are going to have the bankers up here, probably in another couple of weeks and we are going to have a very blunt conversation,” he replied.

He continued: “If it turns out that they are hoarding, you’ll have a revolution on your hands. People will be so livid and furious that their tax money is going to line their pockets instead of doing the right thing. There will be hell to pay.”
That statement is especially interesting because the banks have admitted that they will continue hoarding cash for quite a while.

Even the New York Times Calls Paulson a Liar


Even the New York Times is calling Paulson a liar:

“First [Paulson’s Department of Treasury] says it has to have $700 billion to buy back toxic mortgage-backed securities. Then, as Mr. Paulson divulged to The Times this week, it turns out that even before the bill passed the House, he told his staff to start drawing up a plan for capital injections. Fearing Congress’s reaction, he didn’t tell the Hill about his change of heart.

Now, he’s shifted gears again, and is directing Treasury to use the money to force bank acquisitions. Sneaking in the tax break isn’t exactly confidence-inspiring, either.”
What tax breaks is the Times talking about? The article explains:
A new tax break [pushed by Treasury], worth billions to the banking industry, that has only one purpose: to encourage bank mergers. As a tax expert, Robert Willens, put it: “It couldn’t be clearer if they had taken out an ad.”

The "Magic" of Compound Interest

As long as I can remember, whenever someone talked about "the magic of compound interest", I have been skeptical.

It always seemed to me to be some kind of pyramid scheme.

Ellen Brown sums up the evidence that this is true:

All the king’s men cannot put the private banking system together again, for the simple reason that it is a Ponzi scheme that has reached its mathematical limits.

A Ponzi scheme is a form of pyramid scheme in which new investors must continually be sucked in at the bottom to support the investors at the top. In this case, new borrowers must continually be sucked in to support the creditors at the top. The Wall Street Ponzi scheme is built on "fractional reserve" lending, which allows banks to create "credit" (or "debt") with accounting entries. Banks are now allowed to lend from 10 to 30 times their "reserves," essentially counterfeiting the money they lend.

Over 97 percent of the U.S. money supply (M3) has been created by banks in this way. The problem is that banks create only the principal and not the interest necessary to pay back their loans.

Since bank lending is essentially the only source of new money in the system, someone somewhere must continually be taking out new loans just to create enough "money" (or "credit") to service the old loans composing the money supply.

This spiraling interest problem and the need to find new debtors has gone on for over 300 years -- ever since the founding of the Bank of England in 1694 – until the whole world has now become mired in debt to the bankers’ private money monopoly.

The parasite has finally run out of its food source. But the crisis is not in the economy itself, which is fundamentally sound – or would be with a proper credit system to oil the wheels of production. The crisis is in the banking system, which can no longer cover up the shell game it has played for three centuries with other people’s money.
The "magic" of compound interest - unfortunately - is not real. It is the Disney kind of magic . . . fun while it lasts, but gone as soon as you get back to the real world.

Note: I edited Brown's quote slightly for readability.

The Stunning Irony of the Financial Crisis


The financial crisis is full of irony.

For example, the loudmouth cheerleaders for free-market deregulation, such as Goldman Sachs CEO Henry Paulson, are now implementing socialism in America.

And the U.S. - which has long lectured third-world countries about the benefits of American-style neoliberal capitalism, is now a bankrupt debtor nation begging for loans from its creditors (including the countries we previously lectured).

But the biggest irony of all may involve America's depiction of Muslims and the "clash of civilizations" against the Middle East.

It turns out that the Muslims that the American neocons painted as barbarian, devil-worshippers who hated us because of our successful capitalist freedoms, may weather the financial storm a lot better than us, because they have avoided the most of the derivatives and other scams and - in some ways - practiced capitalism more faithfully than we have.

As an expert on Saudi-American relations writes:

Ironically, least affected by the crisis are Islamic banks.

They have largely been immune to the collapse because Islamic banking . . . forbids the buying and selling of a debt as well as usury. Additionally, [Islamic] banking laws forbid investing in any company with debts that exceed thirty percent.

"Islamic banking institutions have not failed per se as they deal in tangible assets and assume the risk" said Dr. Mohammed Ramady, Professor of Economics at King Fahd University of Petroleum & Minerals. "Although the Islamic banking sector is also part of the global economy, the impact of direct exposure to sub-prime asset investments has been low" he continued. ... Instead, said Dr. Ramady, oil surplus Arab nations are "reconsidering overseas investments in financial assets" and speeding up their own domestic projects.

Eight years ago, in May 2000, Saudi Islamic banker . . . Dr. Nayef bin Fawaaz ibn Sha'alan publicly gave a series of economic lectures in Gulf states.

***

He warned then that it was a certainty that the US economic system was on the verge of collapse because of its cumulative debts, ever-increasing deficit and the interest on that debt. "When the debts and deficits come due, they just issue new Treasury bonds to cover the old bonds due, with their interest and the new deficit too." The cycle cannot be stopped or the debt cancelled because the US would no longer be able to borrow. The consequence of relieving this cycle would be a total collapse of their economic system as opposed to the partial, albeit massive, crash of 2008.

"Islamic banking", said Dr. Al-Sha'alan, . . . has the best of capitalism - filtering out its negatives . . . ."

***

The whole exercise in democracy by force against Arab Muslim nations has almost bankrupted the US. The Cold War is over and the US has nothing to offer: no exports, no production, few natural resources, and no service sector economy.

The very markets that resisted US economic policies the most, having curbed foreign direct investments into America, are those who will fare best and come out ahead.

In other words, the Islamic barbarians may weather the storm much better than us because - in some ways - they practiced a form of true capitalism, buying and selling real things, while we abandoned Adam Smith's vision and turned America's economy into a rigged casino which collapsed under its own weight of manipulaton and greed.

Note: I know virtually nothing about Islamic banking, and am not promoting or endorsing it.

I am not a Muslim, and I despise fundamentalist Muslims as much as fundamentalists of any religion.

Finally, I do not support or criticize the leaders of any country in a vacuum based on religion or race. Instead, I look to their historical actions to see if they benefit or oppress people.

Friday, October 24, 2008

Disinfo Boys Strike Again?

A friend asked me to post this (click the title to go to link). For background, see this, this and this.

Paulson's Parallel Universe


In the real world, strong banks that made good decisions should thrive and weak banks which made dumb investments and lending decision should fail.

But in the parallel universe inhabited by Sec Treasury Paulson, the wealthiest banks as well as poor banks should all get bucket loads of money so consumers won't know which are weak and which are strong, but will keep on banking with the weak banks. As CNBC writes:

"Nine of the largest U.S. banks were essentially arm-twisted last week into signing on for the first $125 billion in capital infusions in an attempt to remove the stigma that participating banks need the funds to survive."

In the real world, banks aren't lending, and they've admitted that - no matter how much the government throws at them - they won't lend in the foreseeable future.

But in Paulson's parallel universe, the banks will be cheerfully handing out loans loans left and right to every mom and pop who politely ask:

"Our purpose is to increase confidence in our banks and increase the confidence of our banks, so that they will deploy, not hoard, their capital. And we expect them to do so, as increased confidence will lead to increased lending," Paulson said on Monday.
In Paulson's reality, everything is working out just fine. But in the real world where the rest of us live, the real problems aren't being addressed, and the bailouts are only making problems worse.

Bretton Woods II Could Mark Shift Away From American Dominance


You know that upcoming meeting of the G-7, dubbed "Bretton Woods II"?

Well, it turns out it will actually involve some 20 countries and regions, including those with emerging markets. As US News and World Report puts it:

"President Bush will meet not just with the traditional Group of Seven (G-7) cluster of industrialized countries but rather with the Group of 20. That larger forum brings in the major emerging-market nations. They include such rising powers and emerging economies as Brazil, India, China, Russia, South Africa, Mexico, and Turkey, among others."

Specifically, the G-20 includes:

1. Argentina

2. Australia

3. Brazil

4. Canada

5. China

6. France

7. Germany

8. India

9. Indonesia

10. Italy

11. Japan

12. Mexico

13. Russia

14. Saudi Arabia

15. South Africa

16. South Korea

17. Turkey

18. United Kingdom

19. United States

20. European Union

The G-7 is made up solely of Western countries and Japan (one of America's closest allies). On the other hand, the G-20 includes China, India, Russia and Brazil - countries that are not so closely aligned with America - as well as Saudi Arabia, one of America's largest creditors.

China and others have been making noises for a while about the need to shift away from a U.S. and dollar-centered financial system. For example, one of China's largest newspapers wrote today that the US has plundered global wealth by exploiting the dollar's dominance, and the world urgently needs other currencies to take its place.

Something might really happen at the G-20 meeting, scheduled to occur around November 15th. Especially since many of America's largest creditors will attend, it may truly mark a shift away from not only America's economic dominance but also its spendthrift behavior.

Giant Companies are Using YOUR Money to Buy Competitors

Giant companies are using YOUR money to buy their competitors.

For example, Bloomberg writes today:

PNC Financial Services Group Inc., Pennsylvania's biggest bank, plans to buy National City Corp. for about $5.2 billion in stock after receiving U.S. Treasury funds.

***

The $7.7 billion of Treasury funding, part of the government's $250 billion plan to recapitalize banks, "put this transaction on a very solid footing,'' PNC said.

Remember that the $250 billion is part of the $700 bailout which taxpayers are paying for.

This confirms CNBC's report that the feds were using the bailout to push bank mergers.

Update: Bloomberg posted a second article entitled "PNC's $5.2 Billion National City Purchase Is Takeover Template for Paulson" after I wrote this essay, which says:

PNC Financial Services Group Inc.'s taxpayer-backed $5.2 billion purchase of National City Corp. is a blueprint for regional bank takeovers pressed for by U.S. Treasury Secretary Henry Paulson, investors said.

Update 2: See also this New York Times article.

Hedge Fund Losses May Lead to New Derivatives Meltdown

Hedge funds are getting hammered. And the co-chief executive of Europe’s biggest hedge fund is warning that thousands of hedge funds are on the brink of failure.

This could lead to a derivatives nightmare.

Remember that the economic crisis was bad when home values dropped and the "subprime" loans started being defaulted on, but it really got bad when the collateralized debt obligations (CDOs) - which repackaged those loans - started plummeting in value. (CDOs were highly-leveraged, so a small drop in home prices resulted in large declines in the value of the CDOs; then, as the companies which held huge sums of CDOs started bleeding out, credit default swaps started being heavily bet against them, which drove up their price of doing business, which caused them to fail).

As Nouriel Roubini pointed out on October 15th:

Rating agencies [are] start[ing] to downgrade collateralized fund obligations (C.F.O.) which are the hedge fund equivalent of mortgage-backed securities: securities backed by hedge funds. Some have a 7-year lock-up period. While few in number, C.F.O.’s represent a broad swath of the $2 trillion industry.
CFOs are a "CDO-type vehicle that invests in hedge funds or private equity investments". Basically, if the value of the hedge fund increases, then the CFOs go up, and if they go down, they go down. Like CDOs, they are highly-leveraged derivatives, so that a small fall in the value of the hedge fund can lead to large losses in the CFO.

Because hedge funds are getting clobbered and many will go out of business, that creates a huge CFO derivatives exposure.

In addition, remember that hedge funds have a lot of derivatives exposure concerning other types as derivatives as well. As Roubini points out:
Hedge funds are among the net sellers of credit protection in the $54 trillion credit derivatives environment and might be called to perform on their obligations wrt Lehman, WaMu, Kaupthing, etc.
Therefore, if hedge funds go belly up, someone else will end up with their derivatives' liability.

See also this.

The Return of the Ice Age: Temporary Thaw in Inter-Bank Lending is Over

The one, much-trumpeted bright spot in the world economy was that inter-bank lending rates started to fall slightly.

Of course, banks lending to each other is not the same thing as banks lending to real people and the real businesses. They're not doing that, and won't any time soon. And the inter-bank lending rates may have been manipulated, so its hard to know whether the situation really eased or not.

However, manipulated or not, even the inter-bank lending rate is now rising again.

Any way you look at it, the much-hyped "thaw" in bank lending is over, and everything is freezing back up. Despite governments spending trillions upon trillions of dollars, we remain in an ice age of frozen lending.

Thursday, October 23, 2008

Gold May Do Well During the Later Stages of Deflation

Most people agree that gold does well during periods of inflation.

But what about during periods of deflation?

Leading economist Dr. Marc Faber wrote in October 2007 that gold will do well even in a deflation:

How would gold perform in a deflationary global recession? Initially gold could come under some pressure as well but once the realization sinks in how messy deflation would be for over-indebted countries and households, its price would likely soar.

Therefore, under both scenarios - stagflation or deflationary recession - gold, gold equities and other precious metals should continue to perform better than financial assets.

Faber's argument is supported by the following charts showing gold's performance as compared to the yen during Japan's "lost decade" of deflation:


Japan's deflation didn't definitively end until 2007 or 2008.

This provides some evidence that gold may tend to hold or increase its value at least in the later part of the deflationary period as compared with the relevant national currency.

Moreover, about half the time, gold has risen during recessions in the United States:

(The grey vertical bars show periods of recession; if your browser is cutting off the right edge of the chart, click here for full image; the chart gives gold prices in monthly averages).

Close examination shows that gold often falls during the beginning stages of a recession, then rises in the later stages of the recession.

Remember that gold is supposed to be a save haven investment during times of uncertainty and instability. Plain vanilla recessions are not really times of uncertainty or instability, so the tendency of gold to rise in deflations should hold more true than during recessions.

See also this.

Note 1: If you want to see my forecast as to future deflation and inflation trends, read this.

Note 2: Conventional wisdom is that gold goes down in a deflation.

Note 3: On the other hand, some people argue that gold did well during the Great Depression, proving that it will do well in all future deflations. However, the Great Depression is not an accurate test for how gold performs during a deflation because (1) the U.S. was on the gold standard then; and (2) the government arbitrarily set the price for gold as part of the gold confiscation program, so the price of gold was not a free market price. Ignore any analysis of how gold performed during the Great Depression that doesn't take these factors into account.

Note 4: It is possible that factors external to Japan drove up the price of gold against yen during Japan's lost years. Further analysis is needed.

Note 5: I am not an investment advisor and this should not be taken as investment advice.

Greenspan Admits Credit Default Swaps Have "Serious Problems"

Alan Greenspan praised credit default swaps in 2002. But today he admitted to Congress that there were “serious problems” with CDS.

Greenspan told Congress:

"Credit-default swaps, I think, have serious problems associated with them.

***

Excluding credit default swaps, derivatives markets are working well."

Derivatives are working well, other than the credit default swap market - which is bigger than the entire worldwide economy - and which was a major cause of the collapse of Bear Stearns, AIG, Lehman and the others?

That’s like saying “other than not being strong enough to handle ice bergs, the Titanic was a good ship”.

Or asking President Lincoln’s wife after he was assassinated while watching a play: “other than that, how did you like the play, Mrs. Lincoln?”

Forecast: 2 Years of Deflation, Followed by Raging Inflation


I'm calling 1 1/2 to 2 years of deflation, followed by raging inflation.

Deflation Now

Richard Berner of Morgan Stanley, said: “A global recession is now under way, and risks are still pointed to the downside for commodity prices and earnings.”

Nouriel Roubini writes: "There is a glut and excess capacity of goods while aggregate demand is falling soon enough we will start to worry about deflation, debt deflation, liquidity traps . . . ."

And an oxford professor of economics and expert on U.S. inflation thinks deflation is probably on the way.

As Dan Denning writes:
So far, it looks like the deleveraging of the global financial system is destroying wealth faster than central banks can create new credit to replace it. [My comment: it wasn't real money, only "cotton candy".]

***

[The trillions being spent on bailouts worldwide] small compared to the amount of value already destroyed in the residential real estate market and in the stock market. Twenty trillion has already been wiped off global shares. Property markets in the UK and the US are imploding.

So what we may have underestimated is how quickly this deleveraging and value destruction would spread to the commodity markets, which we thought would provide relative safety with the backing of tangible value. Resource stocks did not hold up for long at all. Why not?

On the one hand, it now looks like a lot of investors were buying commodities – and staying "long" of the trend – with borrowed money. Those investments have now been sold to raise cash and pay back loans.

Secondly, when it's a bear market in stocks, there aren't too many stocks that do well, full stop. Not even Gold Miners against the backdrop of gold bullion holding up well...or at least, not collapsing alongside everything else.
According to Bloomberg, people are not buying even though things are being sold at "Armageddon" prices.

Big investors are also hoarding cash. A report by JP Morgan shows:

"Markets are reflecting extreme levels of caution among investors. Institutional cash positions are close to their all-time highs."
Banks will keep on hoarding cash.

The Deutsche analysts don't see a bottom occurring until 2010. A recovery won’t occur until further beyond that: “unlikely in the foreseeable future”.

Inflation Later

But eventually, inflation will kick in. You've heard successful investors like Warren Buffet and Jim Rogers warn of inflation.

Well, the smart analysts I have been listening to are forecasting 1 1/2 to 2 years of deflation, followed by raging inflation.

Denning gives a possible scenario for how it is likely to play out:

If governments borrow to finance these various programs, they'll issue new bonds. Bonds soak up the available pool of global savings. To that extent, this new borrowing crowds out other ventures, which might otherwise have put the savings to a productive use. But financing the scheme with bonds is not, at least, right away, inflationary. Not in itself.

However, if governments can't find takers for the bonds they issue to finance these schemes, they will have to either raise taxes (not likely in a recession) or simply print the money.

And here's a hint. That's what they always do, from Argentina to Zimbabwe.

That is why we maintain the preferred response to huge debt levels is outright money-printing. Besides, simply making credit more available by lowering interest rates stops working after awhile (like when you can't lower rates any further...and become zero bound). How do you get available credit out of bank computers and into consumer wallets? It's not easy. Bankers are suddenly quite shy where they were once promiscuous.

***

Right now, all this government cash is simply shoring up bank balance sheets with more capital. But to really "get things going again" and "fight the recession", the money will have to get back into the real economy. And this is where we see the inflation coming. Not in asset prices for houses or shares. But in real goods. Why?

If the government engages in massive public works projects as a way of stimulating demand in the economy and keeping up growth, it's going to be resource intensive. In a way, this is just another kind of phony boom, but with the free-market varnish stripped off to reveal it as an ├╝ber-lending program by some kind of pan-governmental agreement worldwide.

***

Western governments are already suggesting a system where the world's top thirty banks will operate under the supervision of a government panel of some sort. You'll see more "super banks" and greater control of the levers of global banking too, plus a concerted program to flood the world with new fiat currency.
Of course, the deflationary phase could be shorter or longer, depending on what the government does.

And remember that we might very well get simultaneous inflation in some asset classes and deflation in others.

Caveat: I am not an investment advisor and this should not be taken as investment advice.

Greenspan and Cox Confess

Former Fed chair Alan Greenspan and SEC head Christopher Cox confessed their mistakes to Congress today.

By way of background, Greenspan was a one of the main supporters of derivatives since at least 1999 (and see this). He was one of the main cheerleaders for subprime loans. And of course, he pushed "easy credit" with low interest rates.

The SEC has advocated no government oversight and "voluntarily regulation" by the companies themselves.

But today, they confessed. As an article in Market Watch says:
Three current and former financial regulators told Congress Thursday that they made fateful mistakes that helped drive the global financial system to the brink of disaster, and urged Congress to fill the regulatory gaps.

"We have learned that voluntary regulation does not work," said Christopher Cox, chairman of the Securities and Exchange Commission, in testimony on Thursday at the House Oversight and Government Reform Committee. "It was a fateful mistake" that no one was given the authority "to regulate investment bank holding companies other than on a voluntary basis."

Former Federal Reserve Chairman Alan Greenspan . . . said, he and others are in "a state of shocked disbelief" that "counterparty surveillance" failed. He said he still doesn't fully understand what went wrong.

***
Greenspan said he favored strengthening the regulatory structure.
Bloomberg writes that Greenspan conceded to a "flaw" in his market ideology, and confessed his mistakes regarding derivatives:
Greenspan said he was "partially'' wrong in opposing regulation of derivatives and acknowledged that financial institutions didn't protect shareholders and investments as well as he expected.
Greenspan's admission might not sound very dramatic at first glance. But for a guy who is known for his cryptic mumblings and for rationalizating his own actions, this is his way of saying "we broke it, now someone's got to fix it".

Wednesday, October 22, 2008

The Fed’s Response to the Financial Crisis: More of the Hair of the Dog That Bit Ya

John Riley nails in a single paragraph what the government is doing wrong in responding to the economic crisis:

The Fed’s response to the financial crisis has been more of the hair of the dog that bit ya. Virtually everything the Fed is doing is increasing debt, not decreasing it. It seems that the Fed’s theory is to keep the drunk drinking to avoid the inevitable hangover. As we have said many times, the longer you put it off, the worse the hangover will be. And we are due for a whopper, thanks to the bartender, I mean the Fed’s irresponsible actions.
Riley has summarized in a few words what the Austrian school of economics, Ron Paul, and everyone else with a good head on their shoulders has been saying for a long time. The problem is that too much credit, artificially low interest rates and cheerleading for the binge by Greenspan and company led to massive malinvestments. The only way to get through the financial crisis is to tough it out until the hangover is really over.

Other people have used the image of heroin to make their point. For example, Financial analyst Puru Saxena compared the bailouts with "shots of heroin to fix the problem of an addict".

In the "Horse is Already Out of the Barn" Department

According to CNBC:

A group of Democratic senators asked the U.S. Treasury Department on Wednesday to set guidelines saying that banks receiving government capital injections should use the funds to restore their lending activities to levels prior to the credit crunch.

The senators said in a letter that Treasury officials should also issue guidelines or best practices that specify the type of lending allowed, encourage loan modifications, and provide more oversight of executive compensation.

"Although we are supportive of your efforts to restore stability to the financial system through direct capital injections into financial institutions, we are concerned that if the program is not implemented correctly, its effectiveness will be limited," the letter said.

***

"This plan will only be effective if these funds are used to increase lending by banks, and it is Treasury's obligation to ensure that," said Schumer, who chairs the Joint Economic Committee. "The last thing these banks should be doing is stuffing this money under the proverbial mattress."
Um, guys . . . you already approved the trillion dollar bailout, without insisting on giving the government any power to force the banks to lend, they aren't lending, and they won't lend until the financial crisis is over (see this).

We know that Treasury will not force the banks to loan money, and we can see through your political posturing.

The horse is already out of the barn. In fact, YOU opened the door and helped escort him out. Despite the fact that most Americans didn't want the bailout, and despite the millions of phone calls and letters we sent Congress saying "no".

We Are Giving Them Our Real Money to Make Up for Losses of Pseudo Money that Never Really Existed

In response to an essay about the government bailouts, I received the following comment:

"I posed a question to a few ‘experts’ asking where all this lost money had gone, or if it ever existed, but got no reply.

A couple of days later I heard the same question asked to a BBC radio business program. They went across the road from the BBC studio, to the London school of Economics to ask 2 of their senior lecturers this question.

Their answer? No, the lost money never really existed!

So now we are giving them OUR money to make up for the losses that only really existed as 1s and 0s in their computers. Unbelievable."
Is he right?

Yes.

As derivatives expert Satayjit Das puts it:
[A leading financial writer] coined the phrase "candy floss money" ["candy floss" is the British expression for "cotton candy"].

Financial technology spun available "real" money into an exaggerated bubble that, like its fairground equivalent, collapses ultimately. . . . The perceived abundance of liquidity was, in reality, merely an illusion created by high levels of debt and leverage as well as the structure of global capital flows.
The "lost" bank money which taxpayers are being forced to "replace" had no more substance than cotton candy.

Ratings Agencies "Sold Their Soul" . . . Joining Wall Street and the Government

A Congressional committee is holding a hearing today on the credit rating agencies and their role in the financial crisis.

Specifically, the big 3 ratings agencies - S&P, Moody's and Fitch - kept companies' credit ratings high for years after they should have been slashed due to inadequate capital, overstated assets, over-exposure to derivatives and other risky investments, and other chronic problems.

Indeed, emails show that the rating service employees knew they were acting fraudulently

Employees at Moody's Investors Service told executives that issuing dubious creditworthy ratings to mortgage-backed securities made it appear they were incompetent or "sold our soul to the devil for revenue,'' according to e-mails obtained by U.S. House investigators.

***

The Securities and Exchange Commission in a July report found the credit-rating companies improperly managed conflicts of interest and violated internal procedures in granting top rankings to mortgage bonds.

An e-mail that a S&P employee wrote to a co-worker in 2006, obtained by committee investigators, said, "Let's hope we are all wealthy and retired by the time this house of cards falters.''

As CNBC points out:

This instant message exchange between two unidentified Standard & Poor's officials about a mortgage-backed security deal ... :

Official #1: Btw (by the way) that deal is ridiculous.

Official #2: I know right...model def (definitely) does not capture half the risk.

Official #1: We should not be rating it.

Official #2: We rate every deal. It could be structured by cows and we would rate it.

A former executive of Moody's says conflicts of interest got in the way of rating agencies properly valuing mortgage backed securities.

Former Managing Director Jerome Fons, who worked at Moody's until August of 2007, says Moody's was focused on "maxmizing revenues," leading it to make the firm more "issuer friendly."

The credit rating agencies deserve the heat they are taking.

However, those agencies shouldn't be set up as the sole "fall guy".

Remember, the government de-regulated derivatives and many other important areas of finance (and see this), and failed to exercise any oversight.

And don't forget that:

"President George W. Bush has bestowed on his intelligence czar ... broad authority, in the name of national security, to excuse publicly traded companies from their usual accounting and securities-disclosure obligations."

(Business Week, May 23, 2006). Why isn't anyone investigating these questions:

How many times did [the] next intelligence czar nod and wink in this way? Which companies did they give a pass to? What "national security" crisis prompted them to exercise these extraordinary powers? And who in the White House and Congress ordered, signed off on, or who knew of, their actions?

CDS Report: Europe, Junk Bonds and Synthetic CDOs Getting Hammered

Central banks apparently watch credit default swaps as the single most important economic indicator. So I'll keep watching them also as a window into the real state of the economy.

Indicators for credit default swaps shows that several Europen countries, junk bonds, and synthetic CDOs are all getting hammered.

Europe

Several European countries are getting battered by CDS. Today's update from Markit shows that Ukraine, Hungary, Serbia and Turkey are in big trouble.

Junk Bonds

Low-grade investment bonds are also hammered (see this article from Bloomberg, and this from Alphaville).

There will be a lot of defaults on these bonds in the coming year, and many people who bought junk bonds (and some companies which issued CDS protection on them) are going to lose money.

Synthetic CDOs

Bloomberg has a very good article today on synthetic CDOs and credit default swaps. I'll quote it at some length, as it gives insight into the relation between CDS and synthetic CDOs:

Defaults and so-called "credit events,'' which can include government takeovers, force payment of the credit-default swaps packaged in the debt. This causes losses for investors or erodes capital.

"The same kind of shudders that went through the asset- backed CDO market will probably go through the corporate CDO market,'' said Sillis. "We'll see a pickup in default rates.''

Barclays Capital estimates that 70 percent of synthetic CDOs sold swaps on Lehman. Swaps on Kaupthing Bank hf, Landsbanki Islands hf and Glitnir Banki hf were included in 376 CDOs rated by S&P. The company ranks almost 3,000.

About 1,500 also sold protection on Washington Mutual, the bankrupt holding company of the biggest U.S. bank to fail, according to S&P. More than 1,200 made bets on both Fannie Mae and Freddie Mac, the New York-based rating company said.

The collapse of Lehman, WaMu and the Icelandic banks, as well as the U.S. government's seizure of the mortgage agencies, will have a "substantial'' impact on corporate CDO ratings, S&P said in a report Oct. 16.

The government in Reykjavik seized Kaupthing Bank, the country's largest lender, earlier this month. Assets and liabilities from Landsbanki Islands and Glitnir Banki were transferred to state-owned entities, triggering default swaps.

***

Investors may sell the CDOs back to the banks that structured them, which will unwind protection they wrote to hedge swap transactions, Barclays said. The chain of events will push up the price of default protection and company borrowing, according to Barclays.

Banks unwinding hedges helped double the cost since April of default insurance on the lowest-ranking equity portion of the benchmark Markit CDX North America Investment Grade Index, to 75 percent upfront and 5 percent a year. That equates to $7.5 million in advance plus $500,000 annually on $10 million of debt for five years.

***

Forecasts for ratings downgrades are "going to force a lot of activity'' in unwinding CDOs, said Rohan Douglas, former director of global credit derivatives research at Citigroup. '

Tuesday, October 21, 2008

International Swaps and Derivatives Association Says Lehman Payout Only $6-8 Billion Dollars

Its hard to believe, but I hope - for the sake of the economy - that it is true.

The Government Has Given Banks YOUR MONEY, and You Won't Get Anything For It


The government has given banks handfuls of YOUR MONEY and you won't get anything for it.

Don't believe me?

Let's recap:

  • And the government did not insist that the banks use the money to extend loan credit
So why has the government authorized trillions on our dime?

Well, the original version of the bailout would have helped mainly Paulson's old company, Goldman Sachs.

And according to one of the leading experts on monetary policy and economics, the government isn't "trying to save the banking system [but just] trying to save banks." Paulson trying to help out his buddies at Goldman Sachs and elsewhere?

Moreover, as the headline from a CNBC report reads today, "Feds Using Bailout to Push Bank Mergers". Hmmm. That would benefit Paulson's buddies, also, letting them use federal bailout money to take over their competitors.

I'm not saying for sure that all of the bailouts are solely for the purpose of helping out Paulson's buddies. What I am saying is that they won't help YOU.

Banks ADMIT They'll Keep on Hoarding Cash


Many people (including me) have been warning that the banks will keep hoarding cash no matter how much money the feds give them.

Now, even the banks themselves are admitting it.

As the New York Times writes in an article entitled "Banks Are Likely to Hold Tight to Bailout Money":

"Will lenders deploy their new-found capital quickly, as the Treasury hopes, and unlock the flow of credit through the economy? Or will they hoard the money to protect themselves?

John A. Thain, the chief executive of Merrill Lynch, said on Thursday that banks were unlikely to act swiftly. Executives at other banks privately expressed a similar view.

'We will have the opportunity to redeploy that,' Mr. Thain said of the new capital on a telephone call with analysts. 'But at least for the next quarter, it’s just going to be a cushion.'

***

Lenders have been pulling back on credit lines for businesses, mortgages, home equity loans and credit card offers, and analysts said that trend was unlikely to be reversed by the government’s money.

Roger Freeman, an analyst at Barclays Capital, which acquired parts of the now-bankrupt Lehman Brothers last month [said] 'My expectation is it’s quarters off, not months off, before you see that capital being put to work.' ”

And another Times article includes the following quote:

“It doesn’t matter how much Hank Paulson gives us,” said an influential senior official at a big bank that received money from the government, “no one is going to lend a nickel until the economy turns.” The official added: “Who are we going to lend money to?” before repeating an old saw about banking: “Only people who don’t need it.”

The banks are going to sit on the cash, not loan it out. So can everyone please stop saying that the bailouts were necessary to increase liquidity?

Monday, October 20, 2008

The Problem Was Never Liquidity, But Insolvency ... And We Should Let Insolvent Banks Fail


The problem was never really liquidity.

Says who?

Says Anna Schwartz, co-author of the leading book on the Great Depression, and someone who actually lived through it.

The Wall Street Journal ran an interview with Schwartz last weekend:

Most people now living have never seen a credit crunch like the one we are currently enduring. Ms. Schwartz, 92 years old [but still sharp as a tack], is one of the exceptions. She's not only old enough to remember the period from 1929 to 1933, she may know more about monetary history and banking than anyone alive. She co-authored, with Milton Friedman, "A Monetary History of the United States" (1963). It's the definitive account of how misguided monetary policy turned the stock-market crash of 1929 into the Great Depression.

***

Federal Reserve Chairman Ben Bernanke has called the 888-page "Monetary History" "the leading and most persuasive explanation of the worst economic disaster in American history." Ms. Schwartz thinks that our central bankers and our Treasury Department are getting it wrong again.

To understand why, one first has to understand the nature of the current "credit market disturbance," as Ms. Schwartz delicately calls it. We now hear almost every day that banks will not lend to each other, or will do so only at punitive interest rates. Credit spreads -- the difference between what it costs the government to borrow and what private-sector borrowers must pay -- are at historic highs.

This is not due to a lack of money available to lend, Ms. Schwartz says, but to a lack of faith in the ability of borrowers to repay their debts. "The Fed," she argues, "has gone about as if the problem is a shortage of liquidity. That is not the basic problem. The basic problem for the markets is that [uncertainty] that the balance sheets of financial firms are credible."

So even though the Fed has flooded the credit markets with cash, spreads haven't budged because banks don't know who is still solvent and who is not. This uncertainty, says Ms. Schwartz, is "the basic problem in the credit market. Lending freezes up when lenders are uncertain that would-be borrowers have the resources to repay them. So to assume that the whole problem is inadequate liquidity bypasses the real issue."

In the 1930s, as Ms. Schwartz and Mr. Friedman argued in "A Monetary History," the country and the Federal Reserve were faced with a liquidity crisis in the banking sector. As banks failed, depositors became alarmed that they'd lose their money if their bank, too, failed. So bank runs began, and these became self-reinforcing: "If the borrowers hadn't withdrawn cash, they [the banks] would have been in good shape. But the Fed just sat by and did nothing, so bank after bank failed. And that only motivated depositors to withdraw funds from banks that were not in distress," deepening the crisis and causing still more failures.

But "that's not what's going on in the market now," Ms. Schwartz says. Today, the banks have a problem on the asset side of their ledgers -- "all these exotic securities that the market does not know how to value."

"Why are they 'toxic'?" Ms. Schwartz asks. "They're toxic because you cannot sell them, you don't know what they're worth, your balance sheet is not credible and the whole market freezes up. We don't know whom to lend to because we don't know who is sound. So if you could get rid of them, that would be an improvement."

What are the "exotic", "toxic" instruments Schwartz is talking about?

Derivatives.

As former Secretary of Labor Robert Reich says:

Despite all the money going directly to the big banks, despite all the government guarantees and loans and special tax breaks, despite the shot-gun weddings and bank mergers, despite the willingness of the Treasury and the Fed to do almost whatever the banks have asked, the reality is that credit is not flowing.

Why? Because the underlying problem isn't a liquidity problem. As I've noted elsewhere, the problem is that lenders and investors don't trust they'll get their money back because no one trusts that the numbers that purport to value securities are anything but wishful thinking. The trouble, in a nutshell, is that the financial entrepreneurship of recent years -- the derivatives, credit default swaps, collateralized debt instruments, and so on -- has undermined all notion of true value.

Many of these fancy instruments became popular over recent years precisely because they circumvented financial regulations, especially rules on banks' capital adequacy. Big banks created all these off-balance-sheet vehicles because they allowed the big banks to carry less capital.

Banks and financial houses have indeed hidden their derivatives exposure off the balance sheets.

And remember, mortgages were repackaged into derivatives called collateralized debt obligations (or "CDO's") and sold to both big and regional banks and investment companies worldwide. The CDO's were highly-leveraged -- many times the amount of the actual loans. When the subprime loan crisis hit, the high leverage magnified the fallout, and huge sums of CDO derivatives became essentially worthless.

And remember, almost no one really understood derivatives:

"Not only [world's richest man] Warren Buffett, but Bond King Bill Gross, our Fed Chairman Ben Bernanke, the Treasury Secretary Henry Paulson and the rest of America's leaders can't 'figure out" the derivatives market.
According to Paul Volker, the former chairman of the Federal Reserve, the entire modern financial system is based upon derivatives, and the financial system today is entirely different from the traditional American or global financial system because derivatives - a relatively new concept - now underly the entire fabric of the financial system.

No one knows what their own derivatives assets and liabilities are, let alone anybody else's (which is why Lehman's credit default swaps have caused so much anxiety, as just one example). Every bank knows that - because of its derivatives exposure and their poor business practices - its derivatives exposure may be many times bigger than its assets. And every bank fears that the other guy's ledger might be even worse.

As one of the leading experts on derivatives puts it:

Uncertainty about the impact of financial distress of one entity [from derivatives] on all other market participants causes trading in the inter-bank market to freeze up further increasing volatility and potentially risk of failure of weaker firms.

So its not a liquidity problem. As Schwartz says, it is an insolvency problem. Or more accurately, a lack of trust that the other guy not going to go belly up because of his derivatives liabilities.

Note: Schwartz believes that the fed should let insolvent companies which made bad decisions fail, instead of artificially propping them up. She thinks that propping them up will only prolong the crisis.

The government is not only fighting the last war, and not only failed to help solve the derivatives mess, it has made it worse. The government de-regulated derivatives (and see this) and failed to exercise any oversight in this area. In addition, the government may have allowed normal accounting principles to be totally suspended under the guise of "national security".

Is LIBOR Still Being Manipulated?

The London interbank offered rate ("LIBOR") is the rate at which banks offer to loan money to one another in London. As such, it is a key indicator of liquidity in the financial system. (LIBOR is also to determine rates on $360 trillion of financial products worldwide, from mortgages to company loans and derivatives).

The governments of the U.S. and Europe have been pumping trillion dollars into the system to increase liquidity. LIBOR has, in fact, been falling, which is a very good sign.

However, the question is whether LIBOR is being manipulated, or is falling on its own.

Of course, the fact that governments have been giving banks staggering sums of cash encourages the banks to loan some of that money to each other. That's not manipulation - its socialism. But that's not what this essay is about.

What I'm focusing on is actual fudging of the numbers.

As Bloomberg notes today:

The Bank for International Settlements said in March some lenders may have "manipulated'' rates to keep from appearing like they were in financial straits.
The Bank for International Settlements is called the "central bankers' central banker", and so its opinion carries great weight.

Bloomberg carried the following quotes in May:

"The Libor numbers that banks reported to the BBA [the British Bankers Association] were a lie,'' said Tim Bond, head of global asset allocation at Barclays Capital in London. "They had been all along. The BBA has been trying to investigate them . . . ."

***

"Since the credit crunch, it's something that appears to have been manipulated,'' said Hahn, a former managing director at Citigroup.

Indeed, the central banks are now watching credit default swaps more than LIBOR as an economic indicator of the health of the economy. Is this partially because they know LIBOR isn't reliable?

As the Wall Street Journal explained in April:

In a development that has implications for borrowers everywhere, from Russian oil producers to homeowners in Detroit, bankers and traders are expressing concerns that the London inter-bank offered rate, known as Libor, is becoming unreliable...

Some banks don't want to report the high rates they're paying for short-term loans because they don't want to tip off the market that they're desperate for cash. The Libor system depends on banks to tell the truth about their borrowing rates....

No specific evidence has emerged that banks have provided false information about borrowing rates, and it's possible that declines in lending volumes are making some Libor averages less reliable. But bankers and other market participants have quietly expressed concerns to the British Bankers' Association....

Questions about Libor were raised as far back as November... In a recent report, two economists at the Bank for International Settlements, a sort of central bank for central bankers, also expressed concerns that banks might report inaccurate rate quotes.....

In a recent research report on potential problems with Libor, Scott Peng, an interest-rate strategist at Citigroup Inc. in New York, wrote that "the long-term psychological and economic impacts this could have on the financial market are incalculable." Mr. Peng estimates that if banks provided accurate data about their borrowing costs, three-month Libor would be higher by as much as 0.3 percentage points....

***
In one sign of increasing concern about Libor, traders and banks are considering using other benchmarks to calculate interest rates, according to several traders. Among the candidates: rates set by central banks for loans, and rates on so-called repurchase agreements, under which borrowers provide banks with securities as collateral for short-term loans.

In a report published in March by the Bank for International Settlements, economists Jacob Gyntelberg and Philip Wooldridge raised concerns that banks might report incorrect rate information. The report said that banks might have an incentive to provide false rates to profit from derivatives transactions. The report said that although the practice of throwing out the lowest and highest groups of quotes is likely to curb manipulation, Libor rates can still "be manipulated if contributor banks collude or if a sufficient number change their behaviour."

If banks manipulated LIBOR earlier to downplay how much trouble they were in, could they be manipulating LIBOR now to try to pretend that things are getting better and the the global economy is recovering?

If consumers thought the economy was recovering, they might buy more and borrow more, which means more profits for the banks. Therefore, the banks may have a very strong motivation for manipulating LIBOR.

I hope that the fall in LIBOR is real, but given the history of manipulating, we can't passively accept it without question.

Sunday, October 19, 2008

Bubbles Are Bursting Worldwide

CNN writes:

"The credit market crisis, combined with the recent stock market declines and the plunge in home values over the past two years, is setting off the deflationary alarm bells for economists.

Paul Kasriel, chief economist with Northern Trust in Chicago, said most bouts of deflation have started with sharp declines in assets such as stocks or homes. That has tended to lead to a loss of value of collateral for loans and ultimately, large losses by lenders and very tight credit"

Remember that a housing bubble has burst not only in the U.S., but in France, Spain, Ireland and the United Kingdom, Eastern Europe, and many other regions. China is slowing down as well.

And stocks are down worldwide.

This may point towards global deflation.

The Economist writes:

"A global recession is almost certainly on the way . . . With commodity prices falling sharply ... and economies suffering, inflation risks are evaporating in the rich world. .... Deflation is an increasing risk."

The Telegraph provides impressions of the slow down spreading all around the world:

The commodity and emerging market booms are breaking in unison, leaving no more bubbles left to burst. Almost every corner of the world is now being drawn into the vortex of debt deflation.

The freight rates for Capesize vessels used to ship grains, coal, and iron ore have fallen 95pc to $11,600 since May, hence the bankruptcy of Odessa’s Industrial Carriers last week with a fleet of 52 vessels. Cargo deliveries dropped 15.2pc at the US Port of Long Beach last month, but that is a lagging indicator.

From what I have been able to find out, shipping is slowing as fast as it did in the grim months of late 1931. “The crisis is now in full swing across the entire world,” said Giulio Tremonti, Italy’s finance minister. “It is hitting the real economy, the productive forces of industry. It’s global, it’s total, and it’s everywhere,” he said.

Italy’s industrial output has fallen 11pc in the last year. Foreign orders have dropped 13pc. But we are all in much the same boat. Europe’s car sales fell 9pc in September (32pc in Spain). US housing starts fell to a 45-year low in September.

Last week, the International Monetary Fund had to rescue Hungary and Ukraine as contagion swept Eastern Europe ....

Russia’s foreign reserves have fallen by $67bn since August. Ural crude prices fell to $65 a barrel last week, below the budget solvency threshold of the now extravagant Russian state.

The new capitalists have to repay $47bn in foreign loans over the next two months. In Russia, oligarch fiefdoms built on leverage - Mikhail Fridman (Alfa), Oleg Deripaska (Basic Element), and Vladimir Lisin (Novolipetsk) - are lining up for state bail-outs from a $50bn rescue fund.

Brazil is free-fall as well. Sao Paolo’s Bovespa index is down a third in dollar terms in a month. Hopes that the BRIC quartet (Brazil, Russia, India, and China) would take over as the engine of world growth have proved yet another bubble delusion.

China says 53pc of the country’s 3,600 toy factories have gone bust this year. Economist Andy Xie says China is at imminent risk of its own crisis after allowing over-investment to run rampant, like Japan in the 1980s. “The end is near. They’ve been keeping this house of cards going for a long time with bank support,” he said.

Indeed, China's GDP has slowed from 12 percent to 9 percent, and the Financial Times writes that "Indicators hint China [is] on verge of slowdown", and may be in for a hard landing.