Welcome to the Weekly Report. Buzz words abound in the mainstream and financial media and the habit is spreading to the bloggers and writers some of whom have an agenda showing. We look at what the Federal Reserve is really doing and why it will not work. A rash of so called "new" alphabet debt appears as the toxic poison spreads. It is time to search out those companies loaded with debt that need to roll it forward and we finish off with some charts that might help highlight some opportunities.
A quick reminder to all readers, I do not have a vested interest in any fund, portfolio or trading instrument. I am not advertising any such either. What you read are my thoughts, shaped by research, I do not recommend positions.
The latest buzzword I see cropping up in the media is "stagflation" - the mix of high inflation and low/no growth. It fits current market conditions in the US, UK and parts of the EU and therefore has been adopted as the outcome of the current economic turmoil by many analysts, writers and bloggers. Readers of the Occasional Letter From The Collection Agency are not surprised, not one little bit. Here is why:
"A recap of the scenario:
bubble, easy money, inflation in fiat money supply, inflation in commodities and hard assets, inflation, fear of inflation, rising rates, YC inverting, flattening, rising and inverting again, tightening, withdrawal of liquidity, corrections, crashes, talk of stagflation, FEAR, withdrawal of speculative funds, further corrections and crashes, demand collapse.......Deflation."
I first wrote this scenario over 5 years ago on a bulletin board. Not one letter of it has been changed since. It's not a linear list, for instance I wrote the long term play for rates and the Yield Curve for the whole scenario as one statement but the rest is pretty much a timeline although the boundaries, just like a real economy, overlap.
Do I need to point out where we are now? No, I didn't think so. I do not believe we are entering a period of stagflation. Just because the data now fits the buzzword requirements does not mean you should extrapolate the statistics and point to a future of stagflation. It isn't going to happen.
Do I hold an anti-gold stance if I do not see an inflationary or stagflationary outcome to the unfolding credit crash? No, not one little bit. I may well believe deflation is on the way but that doesn't stop gold being a useful store of current worth. A strategy that doesn't have to be overly complicated will keep the current fiat monetary value stored in gold even in a time of deflation. I am not going to tell you how to do it but I'm sure readers can work it out.
US Dollar - Gold - UST 10 year yield - UST 30 year yield
(Courtesy of Stockcharts.com)
Are the falling yields on 10 and 30 year USTsy bonds indicative of an expected inflationary outcome? Bond markets do not slavishly follow the Fed, the conundrum was not that far back in history. Why would the yield on an interest bearing derivative of a devaluing asset ($) be falling?
One last point on inflation. I worry sometimes that people's misconceptions about inflation can be skewed, even unintentionally, by a misplaced statement. Normally I wouldn't comment but on seeing a recent remark, I feel obliged.
"I have heard others maintain that rising commodity prices are merely a supply problem. However, tight supply is a function of the artificial demand created by inflation. If the government handed out million-dollar bills there would be a shortage of Ferrari's as everyone would want to buy one." Peter Schiff - Here Me Now - Believe Me Later
If the US government handed out million dollar bills to everyone there would be a complete collapse of the dollar, followed about 30 seconds later by the complete implosion of any dollar based debt, driving yields to unimaginable highs. The dollar price of a Ferrari would become so high that the zeros required after the number would stretch across the dealership window, let alone the windscreen of the Ferrari. Mick Phoenix - in the last paragraph.
Don't get me wrong, Peter has a deep insight into the economic world and I read and enjoy his stuff. It's just sometimes.....well, enough said.
The Federal Reserve has a real problem looming, caused by its own actions. The TAF project continues to roll on, supplying capital to maintain margin limits on investments made by the Banks/Brokers who formally used ABCP/CP. As I mentioned at the time of the TAF announcement it was possible that the TAF itself could become a focus of speculation.
Here is what Philly Fed head Plosser (an inflation hawk) said after the first 2 TAF had been carried out:
Plosser said early evidence suggests the first two 20 bln usd auctions were successful. Two more have been scheduled later this month. The key point, he said, is that "the TAF did not change the stance of monetary policy. The Fed actually withdrew funds through open market operations as it injected term liquidity through the TAF."
The problem is that no longer appears to be the case. I regularly review the Slosh Report - a great resource for checking Fed repo action. Its called the Slosh Report because it keeps a running total of the amount of Fed originated cash sloshing in the banking system. From the beginning of the year the total average sloshing ranged between $25 and $40Bn with the most common figure around the high 20's. So the assertion that the Fed were not giving out liquidity from 2 differing punchbowls seemed to be correct. The variance in the amount sloshing from repos is within the parameters of the past year and the amount has remained stable since July '07. The Fed has not been adding to liquidity via temporary repos since July, just maintain a level. The TAF injection reached $60Bn at the end of Jan '08 and has remained at that level.
So what has changed? At first glance I thought not much, until I realised the usual end of month rise in repos had started somewhat early. Normally the Fed raises liquidity about 3 days from the end of the month to facilitate the Banks/Brokers abilities to roll over positions, pay out cash etc without straining the banking system by causing an illiquidity event. February was different.
On the 14th Feb an extra $15Bn+ was added, way too early for this to be EOM business. Between the 14th and the 29th the amount sloshing rose to $61.75Bn. This does not include the TAF. All categories of collateral rose but the timing was interesting. On the 13th Agency rose significantly followed on the 14th by MBS and Treasury. Although agency has fallen back, Tsy stands at $24Bn and MBS at $28.675Bn.
In other words, within 2 weeks of the TAF reaching $60Bn (at the end of January) the banks required liquidity and didn't mind paying higher rates for it (agency and mbs backed loans are charged higher interest rates). From mid Feb to today the Fed supplied over $20Bn in new cash.
The Fed is now squarely faced with a moral hazard and a self induced attack upon it credibility as an inflation fighter.
I leave it to Fed Pres. Poole to sum up the problem from the concluding remarks he gave at the Panel Discussion on Balancing Financial Stability, Price Stability and Macroeconomic Stability: How Important Is Moral Hazard? On 29th Feb:
"I suspect that the origin of this panel topic was the view that a central bank response to market turmoil creates moral hazard. A generalized monetary policy response, in the form of the FOMC cutting the target federal funds rate, is completely unlike the effects of government flood insurance on homeowners. Flood insurance will compensate the homeowner, period. A monetary policy response may or may not occur at a time when a financial firm gets into trouble and may or may not be adequate to prevent a firm from failing.
Moreover, a financial firm cannot expect targeted aid for just the firms in trouble. An exception to this general statement is that, unfortunately, the GSEs probably can expect targeted aid. Thus, putting the GSEs aside because they might get assistance directly from Congress, expectation of a monetary policy response to financial turmoil is completely unlike the situation faced by the homeowner with underpriced flood insurance. Many homeowners do build houses in areas where they would not build if they were totally responsible for losses, or had to buy insurance in a competitive market. Financial firms, on the other hand, cannot expect aid if they build on the financial flood plain. And that is as it should be."
I cannot state this more forcibly. If the Fed decides to keep increasing repo sizes or if the Fed increases repos and keeps TAF at the same current level, a full blown run on the $ is certain. If the Fed raises TAF to accommodate (swap) the increase in repos, the result is the same.
The Fed must immediately reduce either the repos or the TAF amounts (or both) to retain any credibility of inflation fighting and to assure the markets that the US Bank of Last Resort is not allowing a bailout of financial firms at the expense of Corporate America and its citizens.
For those who think a run on the $ would be inflationary, think again. The pressures placed upon the financial system would be overpowering. It would collapse, within hours. A fiat system without access to credit would result in instant depression. It doesn't matter how "expensive" assets are if you cannot buy them. For instance, taking account of Fed Pres Poole remarks, the opportunity has arisen were speculators can start to look at shorting GSE's and the $.
The Fed is playing an incredibly dangerous game and I suspect it is about to be called after going "all in".
Am I alone in thinking this way? No.
The Bank for International Settlements (BIS) reports in its latest quarterly review released today that dollar lending between banks remains under strain and will stay that way for 2008. It reports that Financial Institutions are reliant on currency swaps to access dollar funding. The BIS compares the euro/dollar swap price distortions to the yen/dollar in the late '90's and although disruption (so far) is milder the cause then (Japanese banks found it difficult to raise foreign Fx in currency markets) is now reversed and it is US banks who need the alternate funding. This has to place further strains on the Y/$ carry trade amongst many other problems.
A so called new alphabet derivative showed up in the news/blogs this week. VIE or Variable Interest Entities are beginning to show signs of distress. Why I do I write "so called new"? Because prior to Enron the VIE was known as a SPV or Special Purpose Vehicle. I suppose we should react with surprise, shock and disbelief. We won't though, it's not like we didn't suspect that some old models had been dressed in new frocks and paraded in front of the ogling crowd of investors. The VIE is built the same way as the SIV and SPV, stuffed full of assets bought using issuance of short term commercial paper to raise the cash. To keep the game going you roll the CP over at maturity.
Well, you used to.
The CP would be backed by assets (the assets bought with the funds raised by the CP issuance most likely) and partially insured against default. With all the lenders now "risk adverse" and having stopped lending cash on CP issuance and the Bond Insurers of some of the CP seeming to be having one or two problems raising capital for themselves, coupled with their own re-insurer problems and 2 outcomes loom. Either the SPV VIE goes belly up and has to dump the assets or the VIE is taken back onto the books of the originators.
Goldman Sachs said recently it might have losses of over $11Bn from VIEs, Lehman has an exposure of at least $6.1Bn. Citigroup has an exposure, by it's own calculation, of $320Bn "in significant unconsolidated VIEs" according to a filing made in February. Merrill Lynch has an exposure to $22.6Bn, according to CreditSights.
"The securities in the VIEs may be worth as little as 27 cents on the dollar once they're put back on balance sheets" - David Hendler, an analyst at New York-based CreditSights. The estimate was based on the market price achieved for the recent $800m sale of bonds by E*Trade.
This is just the tip of the iceberg, you know its going to get ugly. I'm sure you all remember my warning from last week.
I was going to look in-depth at Bank of Montreal as a follow up to this article (scroll down to Credit Default Swaps - An Example In Real Time) written for www.Livecharts.co.uk . To be honest, just replace CIBC with BofM in the diagram and the picture remains the same, including the bond insurer. If you want some excellent background on BofM then I suggest Mish Shedlock as your first port of call, I found this and decided I could do no better.
(You will notice that one of the companies placed on negative outlook, mentioned in the CDS article, is XL Capital Assurance. I don't think it has long left in this world. It would be interesting to find out if any Broker/Bank owns a large chunk)
So, where do the possible opportunities exist? Just charts, no commentary. (click to enlarge)
AIG (hourly)
Bank of America (daily)
Citi (daily)
Goldman Sachs (daily)
Barclays (daily)
HSBC (daily)
All financials and all ugly at first glance. There are however important supports not too far below except for Bank of America. I suspect we get some bad news from BoA in the near future. HSBC has results this week.
Until next week, take care.
Update.....
Along with the $ index managing a 72.xx print we get this:
Also Thursday, the Mortgage Bankers Association said the proportion of all mortgages nationwide that fell into foreclosure hit a record high of 0.83 percent in the October-to-December quarter. Among subprime loans with adjustable rates, the percentage that were either late on payments or in foreclosure rose to more than 25 percent, up from 23.5 percent in the previous quarter.
Shares of both companies hit 52-week lows. Shares of Fannie Mae fell $1.97, or 8.1 percent, to $22.30 in midday trading while shares of Freddie Mac fell $1.56, or 7.2 percent, to $20.08.
