An Occasional Letter From The Collection Agency

EW count

2010-10-31T19:11:00.000Z

The Weekly Report 13 July 2008 (continued)

2008-07-13T16:40:00.003+01:00

The Weekly Report
13 July 2008
Welcome to the Weekly Report. Normally at An Occasional Letter From The Collection Agency we try to focus attention on the macro-economic near term effects using the Weekly Report, allowing the Occasional Letter to look further into the future by about 18-24 months. We have reached a stage now where it is becoming difficult to keep the various strands of my convoluted thoughts distinct and clear for the readers so, in keeping with one or two other writers it is time for a re-cap.

My first public post on a financial site was 21 months ago so the timing is right. Unfortunately for the readers of my eco-babble I cannot do a 6 month resume, so here it is, a 21 month review of my work. We start off with a quick update to last week and a quirky question and then into the meat of the review.

Last week I opened by saying even I was worried about my own bearishness, using my own thoughts to make me think about possible supports (highlighting LTCM levels as possibly the area to watch for banks and financials). I am still watching this level. If support doesn't hold we are on our way down to the 9300 area on the Dow, eventually.

I have very little to sell, my little website was set up using the Austrian School of Economics as a guideline, it ticks along at a minimal cost to members because I didn't incur any debt or debt servicing costs to set it up. The capital I use is from savings and is repaid by the small subscription I charge, it even makes a small profit which when saved over a period of time may allow me expand the facility. If all my subscribers left tomorrow I could close the site down and walk away without having incurred any loss and move on to something new.

Now apply that line of thought to every single company in the S&P500. Can you find a single company that would be able to follow the same path? If you can, let me know because it would be nice to find a well run, properly capitalised Large Cap to put on the "long" watch-list. Remember, no debt. That includes bond issuance. If you wanted to be really at the cutting edge of investment in the new era of capitalism that will rise from the ashes of this Monetarist / Keynesian credi t/ debt orientated fiasco, check out the Funds in your portfolio, any leverage being used? The expression that "cash is king" is going to become the"new" catchphrase in the near future.

It is here that I have to do a recap of my previous remarks and comments about the economy. Unlike many bloggers and writers who are looking at the next Quarter or the second half of '08 and recounting what they said in March, my view has to go back much further than that to see if what I wrote about last year or earlier is coming to fruition. It is the only way I can help readers understand how my poor befuddled brain works. Now I cannot re-create each article here but what I can do is give you a link and a couple of key words or a phrase with the date of the article.

Is this an ego trip, a boost to my already self enhanced view of my abilities? Not really, it's just a way of showing you my timespan, how my thought processes work, you will find the odd wrong call too. So here we go:

A First Sighting originally written in November 2006:

"A lack of cash, driven down by tighter, more expensive credit, a lack of liquidity that starts at the bottom and works its way higher up the food chain, until even those, referred to in whispered tones as daz boyz, see that the health of the US economy is going to require a donation of wealth from everyone. Even them.
Can you see what I have caught a first sighting of?
And out there, somewhere in Hedgeland, someone is finding it more and more difficult to sleep at night, thinking about all those CDO's sitting on the books. No one to lay it off to, a one way bet on liquidity."

Gone in Sixty Seconds originally written in June 2007:

"If you have debt you are bending over and picking up the soap.
Straightforward, no nonsense, in the prison block showers, soap collecting. Hopefully coffee has been spat at screens, wives/delicate husbands have been offended and stopped reading within 60 seconds. Because what I'm about to impart to you should make you feel this way. You, Joe Public, are about to be ridden into the oblivion. No one can save you, no one really cares. Big boyz, from companies like mine are going to take your possessions away. Faceless corporations are going to take your home away. All because you have debt."

The Second Sighting originally written in September 2007:

"This leads us back to a rather large problem. In fact its huge problem and its not being talked about out there in Media land. What happens to a tapped out consumer, loaded with debt, trying to roll a teaser/innovative (thanks AliG) mortgage if rates are going up? It's not going to happen, it's a train crash. Borrowers are already operating under tighter credit controls so the ability to re-fi is curtailed for many. Add in much higher rates and the situation becomes impossible. Banks are going to suffer from a curtailed income stream, as debt default rises, just as the teaser rates for the Banks' borrowings come to an end and reset much higher. Can you see the irony?
Banks are no better off than over stretched sub-prime mortgage borrowers. They need an income stream from lending to ensure they can pay the liabilities they owe to savers, savers that will demand higher yields. It's unsustainable and it's going to stop, soon.
Banks are hit with a double blow, as a lack of income leaves them either unable to service their own debt and default or forces them into repaying the debt using capital holdings or returns from assets sold in the markets. Either way, credit for business and consumers becomes impossible to provide. A massive contraction of activity is a given.
It's been noticeable of late to see the recession word crop up, even in the mainstream media. I think they are wrong. I think the future contains a scenario much worse than a recession.
So, my forewarned reader, will you be leaving your money in a "sub-prime" bank?"

What Do Paulson, Bernanke and Greenspan Have in Common? Originally written in October 2007:

I want to walk you through why I see deflation in the future.
At this point I have to make something clear, whilst the traditional view of deflation is less money in the economy, I do not see cash as the current driver of inflation/deflation. The mover is credit. Allowing an unfettered increase of credit to replace the traditional over printing of notes to sustain a bubble(s) or ponzi scheme (if banks have, as a % of loans, effectively no reserves, what else can the system be based on?) then a reduction in credit must be deflationary.

The importance of this cannot be under-estimated. Credit itself has/is being used as an asset to beget more credit. This explains the exponential rise in credit; it feeds on itself as credit notes become the asset to allow further credit to be lent out. By allowing credit to underwrite itself to form other types of credit the whole system becomes reliant on the confidence of lenders and borrowers having the means to eventually repay. If that confidence is put under pressure, the system stops. If confidence cannot be restored in a very short timescale (Central Bank / Tsy intervention) then the system begins to reverse, as credit is redeemed. The reversal will be at the same pace as the initial rise in credit growth. Although painful, the reversal would be orderly, as long as all the borrowers have the ability to repay. If that ability to repay is impaired then the redemption becomes disorderly.

Is Ben Bernanke Getting Undeserved Criticism? Originally written in November 2007:

"So is Mr Bernanke getting undeserved criticism? I think he is and I think I know why. There is a war on Wall St right now and it's viscous. There are interests that need protecting, accounts that need to be kept hidden and rescues that have to be carried out. All of this has to happen in conjunction with falling rates. If it doesn't happen quickly, with the full cooperation of the Regulators, Fed and USTsy, then whole ponzi scheme comes crashing down. Someone though isn't giving out enough covering fire. Mr Bernanke is keeping some of his powder dry by not telegraphing further rate cuts, in fact you could easily see a case for rate rises if some of the downside risks become too big to ignore.
Wall St doesn't like it. The last thing the Cabal expected was that they would have to use their own money to sort out their own mess.

Is Mr Bernanke getting bad press at the behest of Wall St?"

The Event Horizon For Credit originally written in November 2007:

"You can now see why, as a result of a flat to falling monetary base coupled with a contraction of credit, I see the risks of a deflationary recession as a very high probability. A depression is not as remote as many think.
Is this just a US-centric problem? Not according to Esteban Duarte and Steve Rothwell at Bloomberg, who unearthed this:"
Europe Suspends Mortgage Bond Trading Between Banks
Nov. 21 (Bloomberg) -- European banks agreed to suspend trading in the $2.8 trillion market for mortgage debt known as covered bonds to halt a slump that has closed the region's main source of financing for home lenders.
The European Covered Bond Council, an industry group that represents securities firms and borrowers, recommended banks withdraw from trades for the first time in its three-year history until Nov. 26. Banks are still obliged to provide prices to investors, according to the statement today.
Banks including Barclays Capital, HSBC Holdings Plc and UniCredit SpA took the step as investors shun bank debt on concern lenders face more mortgage-related losses than the $50 billion disclosed. Abbey National Plc, the U.K. lender owned by Banco Santander SA, became the third financial company to cancel a sale of covered bonds in a week as investors demanded banks pay the highest interest premiums on covered bonds in five years.
``We are in a deteriorating situation,'' Patrick Amat, chairman of the Brussels-based ECBC and chief financial officer of mortgage lender Credit Immobilier de France, said in a telephone interview. ``A single sale can be like a hot potato. If repeated, this can lead to an unacceptable spread widening and you end up with an absurd situation.''

"You can find more about Covered Bonds at: http://ecbc.hypo.org/Content/Default.asp - if you can spot the difference between a CB and the MBS, ABCP or ABX derivatives then you have a keen eye.
Oh, and yes, you read that correctly - that is a $2.8 Trillion lending market that has been closed. No wonder LIBOR has been climbing to new 2 month highs and above and reaching new all time high in spreads from the Fed Funds Rate.

You are probably realising that this weekends events are not a surprise to me. As you can see my eco-babble ratcheted up as my first blog came into existence, prior to the blog I published my thoughts on financial bulletin boards, I moved on as the spammers began to disrupt any possible conversation and a core demand grew for my thoughts. Now I know you want more, especially as it is free, so refresh that beverage and we will move forward into 2008. First though was my long term warning about the state of the Stock market, given to readers as a Christmas present in December 2007:

Edwin Coppock, Fed Fund Rates and The Dow

The next chart shows 2 things. The first is my dire attempt to display what I consider to be the best chart of the year. If only I was better at this graphics stuff eh? Ah well readers, you can't have everything..... The second is the chart itself. I have overlaid a chart of the Fed Fund Rates from 1986 to present with a monthly chart of the Dow from 1986 with its Coppock Indicator. It's clear to see the CI before 1996 did indeed lag and post '96 it's a much better tool. Although the CI is used to indicate a bull market on a rise through zero it can be seen that in either half of the chart CI did give a lower high before stocks broke lower (marked by faint red lines). What's more those lower highs were divergent when compared to the Dow which made higher highs:

So, what are the Coppock, Fed Fund Rates and the Dow trying to tell us now? Firstly a rider. Although Fed Fund Rates are falling, other rates, especially LIBOR are not. We should keep this in mind. Firstly, we have a falling CI, with a divergent lower high when compared to the Dow. The Dow itself is beginning to resemble the 1999/2000 top, without a lower low as yet. Fed Funds are dropping and if consensus (a warning in itself) is correct, FFR will be much lower next year.
With the CI acting in a much more timely fashion, the minimum we can expect is for a flat return on stocks whilst FFR has ongoing cuts and the downward direction of the CI is maintained. A lower low on the Dow would make the flat return scenario seem less likely and open up expectations of a larger fall in 2008.

A simple lesson that many refused to listen to is about Fed Funds Rates and stocks, simply put: in this era of credit driven expansion falling rate environments are not a good time to buy stocks and this years events keep that rule intact. On the 4th of January 2008 I issued a warning to subscribers to adjust their strategies as I thought the Fed would cut rates between FOMC meetings.

Are you thinking I may not be specific enough? Well I don't like to mention specific calls on individual shares, that's not really what I am about but this one had reached an important level:

Citigroup - Opportunity or Death Rattle? Originally published in January 2008:

"The current low is different, a sustained period of selling continues whilst the oversold condition persists. It is the opposite condition of continued buying whilst in an overbought condition as seen in 1999/2000. Unless a financial miracle occurs Citigroup is going lower, 1998 anyone? If my suspicions come to fruition then the price may well end up quoted in cents."

Now Citi was already in a well established downtrend but I wanted readers to note that the low on Citi in January was different that in the previous decade. As we have seen Citi has indeed hit the 1998 low. Whilst the mainstream financial media and some bloggers were saying it was a buying opportunity my Technical Analysis was saying something very different. Fundamental Analysis is not ignored either as we take a look at this:

Automobile Wreckage. It Isn't just Ford and GM

"We see the same deterioration in price and the widening of spread that has become so familiar in the CDO/MBS indexes. As with housing, the inability to create further derivative structures due to rising spreads (risk premium) will curtail the lenders ability to clear the balance sheets and facilitate further lending.
It isn't just the Markit.com index which is dropping. TRR (Total Rate of Return) CLOs are struggling too as Fitch Rating Agency has noted, downgrading 28 tranches and also placed an additional 37 tranches on Rating Watch Negative. Unsurprisingly TRR CLOs are a mixture of derivatives of loan portfolios that according to Fitch are now at risk for intensified spread/credit risks. Market values on the SMi U.S. 100 have fallen 6% since mid '07. Considering the type of asset and its potential lack of worth in a flooded market (unlike housing) I expect spreads to widen considerably.
It seems to me that a combination of tightening credit for the consumer, caused by the inability of lenders to clear balance sheets due to derivative markets pricing in higher risks which is stifling new issuance, will cause a real fall in spending on Autos. It should not be forgotten that other unsecured debt will have the same problems.

The possibility of widespread damage in the US domestic Auto industry beyond GM and Ford seems much greater today than at any other time."

What really worries me is the manipulation of Joe Public when it comes to investment and, more importantly, the truth about the scale of the impending collapse of the current form of capitalism. The next article was this:

AIG Get Caught By The Auditors originally written in February 2008:

"Support at the $50 seems bust and the threat is a monthly close below the '03 low. It's yet another chart that flags up the lows from 1998. I'm not saying it's a short (or a long) that's not my job. I just want you too see something that looks worse than me in the mornings.
By the way, be careful of who you listen to. This was one of the comments I saw on Bloomberg about the AIG drop:
"Investors eventually will look back at yesterday's announcement and conclude they overreacted, said David Katz, chief investment officer for New York-based Matrix Asset Advisors, who supports Sullivan (the CEO)." Must be a coincidence......

Then again we are at point in the markets were hope is being ladled out to the hungry and despondent. As I write this little snippet appears:

"U.S. Industry: Uber-investor Warren Buffett on tv making remarks about the monoline insurance industry, apparently has offered a reinsurance plan to those firms. Talk has boosted the recently ailing monolines and is said to be behind the solid bounce in US stock futures in recent trading. Provided by: Market News International"
I have some bad news for Mr. Buffett. This isn't the bottom even for the better quality debt. As I have maintained for some time contagion in the derivative bond market is deeper than anyone realises and it has spread beyond investment and traditional banks. AIG know that only too well.

We go on; I know you are getting the point but this NOT an exercise in boasting about my calls on the markets, economy and impaired businesses. This is to remind you that things are truly different this time, to jog your memory, that just because changes are made it doesn't make the problem go away.

By now I was producing the Weekly Report and this particular issue got a huge number of hits:
The Weekly Report 25 February 2008:

"Now, I am not going to give you advice on what to do about your cash on deposit and I don't want you to think I am being overly bearish but…….I have called this whole fiat credit collapse correctly from the beginning. No, I don't want a pat on the back. I just want to read the next line carefully.
If I had money in a US bank today, I would be worried. So worried I would withdraw the cash before new regulations are passed restricting account activity. I know it sounds alarmist but then the first warnings always do."

Did you know that this weekend all customer "on-line" and phone access to IndyMac has been suspended, with normal service due to re-start on Monday?

This from CNN Money:

"Customers with uninsured deposits will get at least half that money back, and they could get more back, depending on what the FDIC gets when it sells the bank, said FDIC Chairman Sheila Bair. IndyMac customers will have their funds transferred to a new entity - IndyMac Federal FSB - controlled by the FDIC. They will have uninterrupted customer service and access to their funds by ATM, debit cards and checks.
However, customers will have no access to online and phone banking services this weekend, according to the FDIC. Service will resume on Monday. Loan customers were advised to continue making loan payments as usual."

With the timing of the IndyMac announcement and the restrictions imposed, what chance does a customer have of protecting their assets? Of all the remarks I have ever made, the one quoted from the 25th February is the most important for individual investors and savers. At the time I wrote it a reader left a comment that my bearish pronouncements might ignite a "theatre fire" type rush for the exits. My longer term readers may well have smiled at this, they know I look far enough ahead to issue warnings before the show starts.

On the 3rd March in the Weekly Report I wrote this:

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".

Nuff said. We are now at the point in the present that my projections saw coming. I didn't see everything that was going to happen and a couple of calls are still waiting to happen but I don't think I did too badly.

But what of the future you say? Get another coffee and we will look forward to what I think maybe in store for us all.

How close is the Federal Reserve to a margin call? Well, anecdotal evidence is pointing to a need for the Fed to open the discount window to bailout Fannie and Freddie. In an article published on the 12th March, Pre-emptive Warning of a Major Banking Crisis I highlighted this snippet:

"Right now the Primary Dealers are purely a front, emperors without clothes. Ben Bernanke is literally behind the curtain, pulling the levers. The problem for the Bernanke is the lack of levers, the SOMA is a finite resource, which I estimate to have $600Bn (ish) of usable collateral available."

That was then, how much does the Fed have left in the System Open Market Account (SOMA) as of Friday? About $473Bn is the answer, not including any liability for Freddie and Fannie. Remember according to the Fed SOMA is there to provide:

"Collateral for U.S. currency in circulation and other reserve factors that show up as liabilities on the Federal Reserve System's balance sheet "

How much do the GSE's need to ensure correct capitalisation? I have seen figures between $40-80Bn, personally I suspect it will easily break through $100Bn. Of course if they can do this for Freddie and Fannie, what about Sallie Mae et al?

Of course the real risk is to the Banks, Brokers and Insurers. All that GSE debt is AAA rated, as good as cash, and is classed as Tier 1 type assets - or it was until this week.

The problem? This:

"GSE securities are booked as risk-free investments by banks owing to an "implicit guarantee" assumption attributed to the GSE's. This relief is theoretical and changes in regulation may affect this assumption."

If the markets decide that nationalisation is about to happen, the guarantee becomes mute. As we have seen before, once the process begins, Governments have a tendency to change the rules and the pricing of debt, specifically how much less the debt is worth after nationalisation compared to prior. It's the Governments haircut policy at work.

If you think this is far-fetched then have a chat with Merv King over at the Bank of England who made sure the restrictions below were included in the terms and conditions of the Special Liquidity Scheme, as quoted in the Weekly Report for the 27th April 2008:

"The main category of assets will be securities backed by residential mortgages. Securities backed by credit card debt will also be eligible. These assets will be high quality - rated as AAA. If the assets were to be down-rated, banks would need to replace them with AAA assets. The facility will not accept raw mortgages and none of the underlying assets can be derivative products. The Bank of England routinely accepts assets denominated in currencies other than sterling. It will not accept securities backed by US mortgages."

Merv was certainly sending a message back in the spring.

Either more reserves will have to raised to cover the loss of value to these Tier 1 assets or the banks may decide that marking to market is "difficult" and enact the recently passed legislation, moving the assets down to tier 2, or 3. Either way, the liability for banks will go up. Basel 2 once more comes to the fore.

Some are relying on the possibility that this:

" The Senate measure would create a new $300 billion government-backed foreclosure prevention program and strengthen oversight of Fannie Mae and Freddie Mac."CNN Money.

may help to bail-out the 2 GSE's. However, what if that $300Bn, if the Bill is passed, is used to form a "new" GSE? Risk free investment, I think not. Neither does the market, I hoped you all noticed that the Bank/Broker/Insurance firms got hammered on Friday too. How much liability are we talking about for the banks and brokers, well this snippet from Reuters gives you an idea:

"Trone in a research note estimates that JPMorgan Chase's total exposure -- holdings of GSE debt, mortgage-backed securities and counterparty risk -- is $87 billion, or 69 percent of its equity.
Citigroup has exposure of $51 billion, or 40 percent, while Goldman Sachs has the largest total exposure among investment banks at $14.2 billion, or 32 percent of equity.
In addition, GSE bonds and mortgage securities generate underwriting and trading business that have fueled Wall Street profits for years."

If you read the news release for Fannie Mae you would wonder what all the worry was about, except for this line:

"As we work through this tough housing market, we are maintaining a strong capital base, building reserves for our credit losses,"

Not expected credit losses, or projected credit losses but credit losses. The shoe has dropped and now we all know it.

Freddie Mac on the other hand took a slightly different approach, after the usual bluster, easily summed up as everything is okay, Freddie then went on to say this:

"Beyond that, there are a number of options to manage our capital position. The average rate of run-off on our retained portfolio is currently about $10 billion per month, and not replacing that run-off would free up approximately $250 million of capital per month. Over the course of a year, this would free up approximately $2.5 to $3 billion of additional capital if this run-off rate remains constant. We also could consider reducing our common stock dividend. Our current annual common stock dividend is approximately $650 million.
Currently, Freddie Mac's liquidity position remains strong. This is a result of the combination of two factors: access to the debt markets at attractive spreads and an unencumbered agency MBS portfolio of approximately $550 billion which could serve as collateral for short-term borrowings. "

If everything is fine, why spell out what you will do if need to raise capital? Add that liquidity is in fact reliant on further borrowings and we begin to see the same situation exists at the GSE's as we saw with the Mortgage Lenders last year. Remember Fannie has already raised over $14Bn in new capital since November 2007.

Who is left to lend to the GSE's? I don't see the Banks rushing in - do you? The answer is the Lender of Last Resort, the tax payer. What of the moral hazard that grows daily as the US Fed and Gov't commit more and more dollars to this expanding mess? I wrote a warning in the 25th May 2008 Weekly Report of the need to keep tight control:

"To avoid moral hazard arising, strict controls have to be placed upon the facilities that are created and the use of the assets supplied from those facilities. A failure to control the results of centralist intervention will encourage the very behaviour that caused the original problem.
Let me be blunt. There is no risk to the financial sector that is so great that could justify invoking a moral hazard. If a bunch of banks and investment houses collapsed under the strain of unserviceable debt or losses so great that creditors required compensation, so be it. The pain would be enormous and the recession deep but the US economy and importantly the US financial sector would re-emerge stronger, leaner and fitter than at any time since WW2.
As we know such an event will not be allowed to happen, the Fed and the US Gov't are working together to ensure that credit markets at least allow maturing debt to be rolled over, giving time to the banks and investment houses to rebuild their capital reserves. It is a 2 pronged attack, the Fed keeps the banks functioning and the US Gov't drops money directly onto consumers in an effort to encourage spending or re-finance mortgages that have become too burdensome. These measures have no time limit, they can be repeated and increased until the day occurs when banks tell the regulators "all is well".

The groundwork for an episode of moral hazard is laid out but not yet constructed as long as the facilities are controlled and the assets applied to the task at hand."

Construction has well and truly begun. What is ugly about this is the way it is being done. Bernanke set his stall and the policy of the Fed (along with the US Treasury) on a monetarist based set of solutions that I explained in this series of articles dubbed the Eggertsson theory.

To give you some idea of the attempt to increase inflationary expectations, read this excerpt from someone we have already quoted today:

"US HOUSING: Federal Deposit Insurance Corporation Chairman Sheila Bair outlined in an Op-Ed piece in today's Financial Times a proposal that would assist one million homeowners who are facing foreclosure. The plan proposes that Congress authorize the U.S. Treasury to use $50 billion to make loans to borrowers with unaffordable mortgages to pay down up to 20 percent of their principal. The repayment and financing costs for these Home Ownership Preservation (HOP) loans would be borne by mortgage investors and borrowers. This approach is scaleable, administratively simple, and will avoid unnecessary foreclosures to help stabilize mortgage and housing prices."

They should have signed up to the offer; the cost is now $300Bn.

And what of the future, are we going to continue to stagger from one financial implosion to another, constantly increasing liabilities in an effort to keep the system going? Without a doubt the Governments and Central Banks will attempt to follow this path, sacrificing your future to preserve the present for a corrupt, failed and illegitimate financial system based on a branch of economics discredited not once, or twice ('30s and '70s) but now for a third time.

Yet I see a different outcome, one that is reaching towards its final conclusion:

" 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."

In Starve The Rich To Feed The Poor I point toward the reasons why the Fed policy, Eggertsson theory, is going to fail. We live in a special period of human economic history as shown in these charts:

After the deflationary experiences of the '20s and '30s the Fed embarked on a strategy to eradicate deflation and to control inflation using interest rates.

Yet today we see Fed Fund Rates at 2% whilst price inflation, caused by the pass though effect of the rising costs in the production of goods, remain stubbornly high. The Fed isn't fighting inflation, it is fighting deflation as it attempts to divert the effects of the great credit crash and de-leveraging of the financial system. The Fed understands that current price inflation is the legacy of loose credit availability, the feed though effects of the massive expansion of credit used to escape the deflation scare in 2002.

Yet despite the Feds every move, credit is being wiped out as losses and de-leveraging reduce cash reserves and banks tighten their lending standards to the extent that many are avoiding the market.

The situation is a copy of that in '29-'32 and similar to '37. Banks are unwilling to lend and are doing all they can to raise capital, cash is king. Prices of goods and commodities are reaching levels that are causing buyers to stop and think, not just consumers but Governments too:

"BANGKOK (Thomson Financial) - Japan has turned down 60,000 tons of rice from Thailand after the asking price nearly doubled in the space of a month, the Thai Rice Exporters Association said Wednesday.
Chookiat Ophaswongse, president of the association, said Thailand on Tuesday offered the Japanese government 100 percent white rice at $1,300 per ton -- up from the $720 it paid in March.
"This time, Japan turned it down, saying that the price was too high for their budget," Chookiat said, adding that Japan did not want to be seen as a country pushing up global rice prices."

We will soon reach a point were staple goods and energy prices will not be driven by demand but by the availability of cash and credit. The re-centralisation of cash and credit toward the coffers of Banks and Governments - accomplished by the raising of taxes, higher costs, the deflation of housing as an asset, the lack of wage rises, the inability to obtain credit and higher interest rates (beyond the control of the Central Banks) are all deflationary forces for the consumer, removing cash at a faster rate than it can be replaced.

A consumer retrenchment of proportions never before seen approaches. The temporary relief of tax rebates for US consumers has passed; it was noticeable that the main beneficiary was Wal-Mart, not the specialist or high end part the retail sector. The rebate was spent on essential or near essential goods.

It will be the inability of consumers and business to buy assets or services that will force prices down as the suppliers seek to keep market share. Are there signs that the availability of credit is going negative coupled with a reluctance of banks to do business?

Credit is contracting along with borrowing. The banks are deleveraging and unwinding positions at an accelerating pace. Banks continue to keep credit standards high and discourage borrowing by charging higher rates, or in the UK by not passing on Central Bank base rate cuts.

When will we know the process is finished?

We have a way to go. At a rough guess, US Banks and Institutions need to unwind $200Bn of capital. At a leverage of say 10, that's $2Trillion of positions, minimum.

Is there any sign of relief for the stock markets in the near future? The following chart (Dow weekly) shows the Dow since 2004 along with an important moving average, traditional support and resistance and a proprietary indicator. The vertical red lines identify turn points as flagged by the indicator.

I have had to compress the chart but it does show the change from low to high volatility. The head and shoulders, with a downward sloping neckline is textbook. The yellow highlight shows the retest of the neckline that took place over the past 2 weeks. If that neckline holds then the target for the Dow is 9305 (the lower thick purple line) minimum. The neckline is my line in the sand, circa 11430.

The diagram below is the Armstrong Economic Confidence Model:

Is the attempt by Governments and Central Banks to avoid the fallout from the credit crash and the horrendous damage being caused to the global economy doomed to failure?

My thanks to you all if you managed to stay with me to the end of this article. I firmly believe that this is how eco-bloggers, writers, analysts and fund shills should recap their calls on the markets. I do not believe a 6 month timespan is an effective window for investors to base their investment decisions on. What happened in the past does influence the future, the present is just those events unfolding.

Choices made over 10 years ago have influenced current events, those that dismissed the writers back then who warned of the possible outcomes will never be called to account, the memory of the market participants is too short. Those who did warn of the eventual outcome will get no recognition, unless they are one of the handful who managed to survive the snide comments and muffled laughter sent their way over the past decade.

I have no doubt we are in a bear market, a bear that will devour ALL asset types and not be restricted to stocks. A 20% fall in stock markets does not signal the onset of a bear, that was just a figure used by fund managers et al to keep you long in the market so you could absorb 20% losses. If that Head and Shoulders plays out a 20% loss will seem like a lucky escape.

During the last bear in stocks the advice from the vast majority of "advisors" was to stay in the markets, for many that meant unrecoverable losses. The advice back in 1929-30 was the same, most people only sold after they had taken enormous losses on their portfolios. Has it changed with the advent of the internet, satellite TV and mobile phones? No, it hasn't. All that happens now is the bad advice is delivered quicker that previously.

Bear markets are viscous, dangerous periods designed to make everyone hurt, including bears. Some of the biggest rallies in stock markets happen in bear markets. I do not expect markets to go straight down, you only need to look at 1998-2003 to see why.

Protect yourself, use stops, use only spare capital, be able to carry on with life if you lose your pot and stand back from the market, take a wider, longer term view. Finally be very careful who you listen to and what you read. When the overall pot shrinks those who need your funds to survive will do and say almost anything to try and make your wallet lighter.

This will be the last full article to be freely available for some months. If you like the analysis then consider visiting www.caletters.com and sign up to the 14 day free trial.

The Weekly Report -23 June 2008

2008-06-22T17:02:00.002+01:00

The Weekly Report

22nd June 2008

This week I want to aim the article at those who normally do not frequent financial bulletin boards or sites. You, the reader, need to help me in this cause.

People who read financial BB's are already interested and to some extent (though not always) informed about how certain economic conditions occur and can hold a healthy debate about the cures for such ills.

However we are a small group of independent thinkers, we exist at the margins where we try and do our best to inform the public about the dangers and benefits of our financial system. How many of us have watched our family and friends adopt a fixed grin and a glazed expression as we try and explain the complicated world of money flows, interest rates, inflation, deflation etc? We all know the moment when they stopped listening; it was when they started looking over our shoulder to see if there is someone more interesting standing behind us to talk to.

This Weekly Report is for those who glaze over. The trouble is the target audience doesn't read my website or these financial boards. So this week I want you to do a little something for me, send this article to your friends, the ones that now know something is wrong but don't realise what the problem is. It will be available, in full, on my old blog here.

However, before I start the article proper I want to share a little something with you. In April I wrote a series of articles about G B Eggertsson and how his paper "An interpretation of The Deflation Bias and Committing to Being Irresponsible" was being used by the Federal Reserve as the plan to escape from the deflationary effects of the credit crash. Three of the articles were subscriber only but I have now enabled those articles to be read in full without subscription of any sort at An Occasional Letter From The Collection Agency.

That's it, the second to last mention of my site in this article, you have permission to cut and paste this article from here (see the acknowledgement at the end) if you wish to send on to your friends and relatives who you think need to know what is coming. Reproduction on other sites is allowed too. This article uses the US and to a greater extent the UK to describe the background. It is applicable to all countries that allow a fiat currency.

How did this happen?

You will have heard of the sub-prime defaults, that credit conditions have changed, that banks are struggling. All these things are the not the cause of the current problems but are the symptoms of a system that allowed itself to become a one way bet, a self reinforcing merry-go-round of increasing debt. Let me show you how it works and how it breaks.

Mankind has only ever truly created one thing, fiat currency. Fiat currency is cash, paper and coins that are only backed by confidence, for paper they are promises to pay the bearer, coins have an intrinsic worth depending on the metals used to make them.(Hence why coins have become smaller and lighter over the years, production costs need to be below the notional worth of the coin). Paper has practically no intrinsic worth, except to paper recyclers.

Mankind can produce as much paper and coins as it wishes and since it is all based on promises, these days you don't even need a note, you can electronically promise "cash" too. Think about a mortgage payment. It is paid by an electronic transfer of an amount out of your bank account to the mortgage lender. The "cash" was originally placed in your account to be able to make the mortgage payment by electronic transfer from the account of your employer or your interest bearing savings / investment account. No real paper was used, no bags of coin delivered. It all happened electronically.

You can see the temptation such a system offers. You can invent money, lend it to others who pay you interest and at the end of the term you get the principal back too. You do not need to have any collateral to make this happen, though we do have regulations for banks that say they must have a reserve amount that is a percentage of the amount of money they invent. As all money in a fiat system is invented and relies on confidence, it doesn't really matter if reserves really exist or not, except to fulfil regulatory requirements.

Let me show you the system in this simplified diagram:

At the basic level the system is that simple. As long as the costs and defaults are exceeded by the profit made from the interest received your reserves grow and enable higher levels of leverage. You can get very rich doing this.

However every so often in human history events make this simple idea break down. It doesn't matter what the event is but if it makes the costs higher that the interest received then the reserve shrinks. This stops the increasing levels of lending and in severe cases can cause lending levels to fall or even stop altogether.

This is what we call a credit crisis. They have happened before and caused the bankruptcy of many lenders. Those that survived such events usually did so because they refused to allow indiscriminate lending, they applied standards to borrowers, checking to see if they could repay loans and refused to leverage to the maximum potential.

If an economy is reliant on the ability to borrow to achieve purchasing power or increase productivity then a credit crisis has an enormous impact, stopping growth and commercial activity. This worries bankers who have no wish to join the list of "also ran" names of yesteryear. So they decided to try and protect their business model and move some, or all, of the risk to another sphere of the financial system. To do this they had to make such risk taking attractive to others by offering compensation.

Again, here is our simple model but with a basic level of protection added:

You can see what has happened; the original bank lending system now looks stronger as the risk is lowered at the expense of some of the interest income. But notice how the model now becomes acceptable to the Insurer who can use the new income to raise their own reserves. What was a very simple model has now, with one change, morphed into a multi-party system that can be continuously expanded as risk is offloaded to other parties.

So what can go wrong?

1. Interest income does not cover costs.
If the amount of interest charged is too low to cover costs, interest rates on variable products can be raised. If the product is fixed rate then either customers can be encouraged to take variable rates that can be reset higher (after a lower introductory offer) or the debt can be packaged together and sold on to another party at a discount.
2. The principal may not be repaid.
The bank will invoke its insurance policy to cover the losses if the principal worth is calculated to have dropped below a certain level previously agreed with the Insurer. The payout can then be added to the reserves to ensure the bank complies with regulations.
3. Regulations change.
If the governing body decides that banks need to hold a higher percentage of reserves compared to lending then capital must raised to boost the reserves (e.g. Basel 2). This can be achieved by borrowing, rights or bond issues or by reducing the amount of lending.

Any one of these circumstances alone would not cause bankruptcy. Even a half decent capitalised bank could survive 2 of these events running concurrently. However if banks (and the Insurers and other lenders) have stretched the leverage out to 20, 30 or 40 times reserve capital and all 3 of these circumstances arrive at the same time you then have a credit crisis.

Remember the financial system relies on confidence. If confidence in the survivability of the system or part of the system is impaired then the structure slows and stops. In an extreme crisis the system may well go into reverse. Sub-prime became the headline for the current crisis but it is just a manifestation of the events above all occurring at the same time:

In many ways the 3 events almost seem to have been perfectly timed to cause the maximum damage, with rates moving higher from 2004 to 2006, just as many sub prime, Alt A and jumbo mortgages began to reset from teaser rates to higher nominal rates. In 2007 and 2008 capital requirements and the accounting and pricing of assets changed as Basel 2, sponsored by the Bank of International Settlements (BIS) came into force.

Certainly anyone in an informed position could have seen that the situation was set to deteriorate rather than stabilise. Without doubt the effects of these events where under-estimated by those charged with ensuring the Financial and Monetary system remained fit for purpose.

How is the financial system made fit for purpose?

Let me say that the methods used to make the credit system work again will be the same as those employed previously. Right now the world worries about inflation. Inflation is simply too much cash and credit chasing too few goods. Any asset or commodity that is in short supply will attract funds, causing the price of that asset to go higher.

The traditional method to control inflation is to raise interest rates, causing cash to be saved as returns become attractive and restricting the use of credit as it becomes prohibitively expensive. However there is another method that can be used.

Think of cash/credit as an asset. If you want the price of an asset to rise you make it scarcer, you restrict the amount available. As cash becomes more valuable the amount needed to buy less scarce assets drops. A s we are talking about cash that means the price of commodities etc falls.

Are central banks restricting the flow of cash into the financial system? Here are the latest money supply M4 figures (£ billions) for the Bank of England (The Federal Reserve will follow the same path, in time):

Whilst the growth of M4 continues we can see a slowing in the growth rate. The amount of cash and credit available in sterling is slowing:

This slowing of issuance and availability makes sterling more valuable, especially if the interest rate is attractive (this is the overnight interbank rate for sterling from Jun 07):

Notice the falling interest rate coincides with the slowing of M4 growth? As sterling becomes "rarer" the rate of return required on investment falls. Sterling itself appreciates, requiring less compensation in the form of interest. If you look back at the M4 growth chart, you can see that the 3 month rate of growth has been lower than the 12 month rate for some time (the blip in March was the second round credit crunch effects liquidity "save"). If the 3 month ROG remains like this then growth of the amount of sterling will continue to contract over the medium (12-24 months) term.

This is an anti-inflationary move by the Bank of England, yet the rhetoric over recent days has been about inflation fears. The increased rhetoric is to counteract inflation expectations and the fear that a widespread demand for greater wage increases will take hold, as the Bank of England Governor, Mervyn King, alluded to in a speech last week:

"The immediate cause of the current pickup in inflation is increases in food and energy prices relative to other prices. They are caused by the pressure of demand on the supply of food and energy in the world as a whole. Part of that pressure may well reflect expansionary monetary policy in the world as a whole. But the rise in commodity prices cannot, by itself, generate sustained inflation in the United Kingdom unless we allow it to. We will not. So although inflation in the UK will rise in the short term, inflation will then fall back.
That means that the rate of increase of other prices and domestic costs, notably pay, must remain low. The MPC does not take that for granted. Surveys - including our own -indicate that expectations of inflation have risen, meaning that inflation is likely to have some tendency to persist. That is why, as I explained in my letter to the Chancellor, we believe that a slowdown in the economy this year, creating a margin of spare capacity, will be necessary to dampen price and wage pressures and ensure that we fulfill our remit by returning inflation to the target. And growth is now slowing quite sharply - broad money growth is falling, business surveys point to particularly weak output growth in the second quarter and growth is likely to remain subdued for the rest of the year."

Read that extract carefully, within it are terms couched for the ears of business and economists. The threat is that if inflation expectations lead to higher wage demands then interest rates will rise. However King then goes on to explain why he thinks the rising inflation expectations will be quashed:

"we believe that a slowdown in the economy this year, creating a margin of spare capacity, will be necessary to dampen price and wage pressures"

In other words the cutting of M4 growth rates is being carried out to deliberately slow economic growth. By restricting the availability of cash and credit the economy will slow to a recessionary level where business will create a "margin of spare capacity" also known as unemployment. As I mentioned earlier the methods used to make the credit system fit for purpose are and will continue to be the same as those used previously.

The result, for ordinary mortals, will be an increasing difficulty in finding work, a greater fear that current employment may be curtailed and a reluctance to ask for higher wages. Savings will grow as non-essential spending is curtailed during an uncertain period, further reducing the availability of sterling circulating in the economy. Interest rates will remain high relative to discretionary income until the Bank of England decides that the Financial and Credit systems are once again fit for purpose.

The recession that will occur over the next 12-18 months is being deliberately engineered. Any growth in M4 will be redirected from the public to the banks, allowing the banks to repair their depleted reserves. Once these reserves are rebuilt lending standards will be loosened, allowing credit expansion to begin again. By that time interest rates will have been lowered, making the use of credit attractive, encouraging consumption and investment and helping GDP to expand. Another cycle of boom will then be initiated.

Less than 12 months ago the phrase "financial innovation" was still given credence, the "end of boom and bust" was still uttered to justify an economic third way. Now both phrases are discredited (pun intended) and have turned to ashes in the mouths of those who uttered them.

I have outlined above the truth of the current situation, how the greed of lenders caused a fatal weakness in the financial system and how ordinary people will have to deal with the results. A recession will be deliberately engineered to slow growth and allow banks to recover. As throughout history those that suffer in economic hard times are not those who profited in the boom. The masses will bear the burden and wonder what they did wrong to be placed in such hard times.

This article is to inform the public that the only thing they did wrong was to believe the rhetoric, the jawboning that was fed to them during the boom. The current situation is about to get much worse, it will not be due to higher wage claims, lack of productivity or uncompetitive practices. It will be because the politicians and bankers follow an economic system that is inherently flawed.

Until the public become educated about the way in which they are used to allow banks and governments to recover from "busts" and change the way they are led, then the banks and governments will continue to operate in their own interest, regardless of what becomes of the people. That education will not occur at the behest of governments or through the increased transparency of banking procedures and methods. It is up to us to try and let the people know what is happening. So use this article, reproduce it on blogs and sites and send it to others. All I ask is the following line is included:

Copyright: M Phoenix 2008. An Occasional Letter From The Collection Agency. Use of this article is unrestricted other than the inclusion of this acknowledgement.

The Future Actions of The Federal Reserve And US Govt Are Known

2008-04-08T19:28:00.004+01:00

An Occasional Letter From The Collection Agency

Presents

An interpretation of The Deflation Bias and Committing to Being Irresponsible by G B Eggertsson

Introduction.

This is going to be a long letter. It will attempt to explain the rational behind the current and future US Federal Reserve intentions from the point of view of Central Bank thinking. Firstly, you will need a coffee, a comfortable chair and an open mind.

I am going to take you on a journey which will require many explanations. You will have to concentrate but you will be rewarded by gaining knowledge of what the Fed is doing, why its doing it and how it will affect the future.

I intend to make extensive use of Federal Reserve material and will be quoting extensively. Remember, the views and assumptions you see in this article are not necessarily in agreement with mine. This is an attempt to get inside the thinking of the Fed.

Background.

Without doubt the current methods being employed by the Fed are on a par with those seen in the 1930's. There is fear at the Fed felt specifically with Ben Bernanke that, through inaction or policy mistakes, another re-occurrence of a deflationary recession/depression is allowed to happen again. We remember Bernanke apologising for the mistakes in the 1930's and promising (Friedman) that they wouldn't allow it to happen again. It is my intention to show that this fear is the main driving force behind recent Fed actions and will shape the future path of monetary policy in the future.

The Federal Reserve Makes a Choice.

We can assume that Bernanke is fully aware of the risks and is shaping policy to ensure an outcome that will be neither a Japanese '90s or '30s America scenario. He has studied both periods extensively and probably feels he can chart a course through the hard times and ensure an equitable outcome.

To do this he will try to enact Fed mechanisms that allow counterbalancing forces to be released to combat any deflationary threat. We know that this is his course of action because of decisions already made and suggestions put forward.

Is Bernanke following a Keynesian or Friedman (monetarist) approach in the solution of the current problems? (Here we have to assume that Bernanke sees a problem, current use of new Fed Facilities would reinforce this view).

Although this sound a rather academic based question, it is central to understanding Bernanke's approach. From G B Eggertsson "The Deflation Bias and Committing to Being Irresponsible" the fundamental question is:

"Can the government lose control over the general price level so that no matter how much money it prints, it's actions have no effect on inflation or output? Economists have debated this question ever since Keynes' General Theory. Keynes answered yes, Friedman and the monetarists said no."

Remember, I do not intend to get into the rights and wrongs of Keynesian/Monetarist approaches here, I am attempting to uncover the path that Bernanke has chosen. If Bernanke was following a Keynesian approach then any attempt to improve liquidity would be doomed to fail:

As GB Eggertsson put it:

"Keynes argued that increasing the money supply has no effect at low nominal interest rates. This has been coined as the liquidity trap."

If Bernanke had been following a Keynesian solution then he would have believed that any increase in money supply would have been ineffective. Yet we see constant attempts to increase liquidity flows. It is clear then that the policies evolving to combat the threat of credit and liquidity contraction are monetarist based. This makes Bernanke’s apology the first signpost on his intended path.

Many attribute Bernanke with the nickname "Helicopter Ben" in reference to remarks he made in a speech about how to combat deflation. It is oft used by those who rail against inflation to paint Bernanke as an inflationist. However, this is misplaced. Bernanke was in fact quoting Friedman. What many don't realise is that there is an assumption the Friedman was invoking Keynes in this approach. This isn't true. Keynes did not believe such an approach could work with low nominal interest rates whereas Friedman believed that changes to both fiscal and monetary policy could allow government control of prices.

Therefore we cannot look at the actions of the Federal Reserve alone. Any action by the Fed would, according to monetarists, be futile without support from the Government. It also supposes that deflation is caused by a negative demand shock that the then current policies where unable to combat. Indeed the current circumstances in credit markets are seen as a Minsky Event, an unexpected shock to the financial system.

However, it would appear that the Fed and the Government were already enacting policies prior to the credit market dislocation last summer. What happened after the dislocation was not an attempt to stop the problem occurring but was the second required tranche of policy that could only be enacted when the problem surfaced.

Let me explain why, for the Fed and Government, there was no "Minsky Moment" but rather a progression of an already foreseen problem. To do this we need to look at why the Japanese Government and Bank of Japan failed to break out of a deflationary scenario. Again I quote from G B Eggertsson:

"The deflation bias is closely related, and in some sense, a formalization of, a common objection to Krugman's policy proposal for the BOJ. To battle deflation he suggested that the BOJ should announce an inflation target of 5% for 15 years. Responding to this proposal, Kunio Okina, director of the Institute for Monetary Studies at the BOJ, said in DJN (1999): "Because short-term interest rates are already at zero setting an inflation target of say 2% would not carry much credibility." Similar objections were raised by economists such as, e.g., Dominiguez (1998), Woodford (1999), and Svensson (2001)"

At face value the remarks above would seem to support the Keynesian approach, that at low nominal interest rates, Government deficit spending and quantative easing failed to ignite the inflation required to break out of a deflationary spiral.

Within the quote though is the important point of inflation expectations. It is here that the importance of Bernanke's discussion of a targeted inflation rate and subsequent Fed warnings about inflation expectations remaining anchored becomes central to the main thrust of policy direction.

As we have seen, since 2000 the US Government has run a deficit whilst enabling tax cuts and rebates. The Fed allowed looser lending standards and brought down interest rates, in response to a business led recession. Rather than attempt to hide any inflationary tendencies inherent in these policies, the Fed has become more vocal about inflation ranges with the rhetoric pointing to overshoots of the target range. Inflation expectations amongst business and consumers have, somewhat naturally, been kept high.

The Fed is often measured by its inflation fighting credentials. I believe this is misplaced. The Fed should be viewed as a credible deflation fighter. The Fed had to establish an inflation target, either implicit or within a range, to ensure that further inflation was to be expected in the future.

Why? It is all down to inflation expectations. Japan is unable to break out of its deflationary scenario because no one expects inflation to happen and therefore business, credit and the consumer act accordingly, ensuring demand is constantly put off to a later date. (Why buy today if it is cheaper to buy tomorrow).

Again, I quote from G B Eggertsson: (the Markov equilibrium is covered later in this letter)

The third key result of the paper is that in a Markov equilibrium the government can eliminate deflation by deficit spending. Deficit spending eliminates deflation for the following reason: If the government cuts taxes and increases nominal debt, and taxation is costly, inflation expectations increase (i.e., the private sector expects higher money supply in the future). Inflation expectations increase because higher nominal debt gives the government an incentive to inflate to reduce the real value of the debt. To eliminate deflation the government simply cuts taxes until the private sector expects inflation instead of deflation. At zero nominal interest rates higher inflation expectations reduce the real rate of return, and thereby raise aggregate demand and the price level. The two main assumptions underlying this result is that there is some cost of taxation which makes this policy credible and that (2) monetary and fiscal policies are coordinated.

Because of raised inflation expectations, deficit spending by the US Government has the same effect as dropping money from helicopters. It is expected that because assets have been introduced into the economy inflation must rise. (It is useful to have a few members of the Fed that are inflation hawks and vocal in warning about increased spending leading to inflationary pressures).

However, if such funding is directed straight into current money supply it will not increase prices. Again I have to quote from G B Eggertsson:

"Deficit spending has exactly the same effect as the government following Friedman's famous suggestion to "drop money from helicopters" to increase inflation. At zero nominal interest rates money and bonds are perfect substitutes. They are one and the same: A government issued piece of paper that carries no interest but has nominal value. It does not matter, therefore, if the government drops money from helicopters or issues government bonds. Friedman's proposal thus increases the price level through the same mechanism as deficit spending. Dropping money from helicopters, however, does not increase prices in a Markov equilibrium because it increases the current money supply. It creates inflation by increasing government debt which is defined as the sum of money and bonds. In a Markov equilibrium, it is government debt that determines the price level in a liquidity trap because it determines expectations about future money supply."

Dropping money from helicopters and cutting taxes are not the only options available and the following paragraph from Eggertsson may jog a few memories:

"The government, however, can increase its debt in several ways. Cutting taxes and dropping money from helicopters are only two examples. The government can also increase debt by printing money (or issuing nominal bonds) and buying private assets, such as stocks, or foreign exchange. Ina Markov equilibrium, these operations increase prices and output because they change the inflation incentive of the government by increasing government debt (money & bonds). Hence, when the short-term nominal interest rate is zero, open market operations in real assets and/or foreign exchange increase prices through the same mechanism as deficit spending in a Markov equilibrium."

As an aside, you can see why this paper is central to my article. It is clear that a copy of it sits on Bernanke's desk.

It is becoming clear that Fed and US Govt policy have been in lockstep for some time and that the groundwork for fending off a deflationary attack was laid out over 7 years ago. The actions we have seen since August '07 are not the beginning of the attempted fix but the second stage.

Since 2000:

The US Government has run an increasing deficit.

The Fed has allowed the movement of interest rates to compliment a notionally low interest rate environment. The withdrawal of M3 increased inflationary expectations.

The loosening of regulatory oversight allowed a wider use of debt and increased consumption.

Since mid 2007:

The US Government has explicitly talked of increasing govt debt through tax rebates and targeting relief at overburdened indebted homeowners through the expanded use of Govt Sponsored Enterprises.

The Fed cut interest rates aggressively below rates of inflation and introduced facilities to engender the outright purchase as well as the long and short term loans of cash and US Govt Bonds.

The US Treasury does not rule out making the new Fed facilities permanent.

I believe at this point I have made a good case that I have identified the policy and framework that the Federal Reserve and the US Govt are pursuing and that such policies are co-ordinated and have been in place for much longer than most suspect. It is the expectation that such actions are inflationary in nature that encourages spending and investment (Buy today because it will be more expensive tomorrow).

The Future

We now turn our attention to the future. At this point we have to examine something previously mentioned in our article, a Markov equilibrium. Again from Eggertsson:

I analyze equilibrium under two assumptions about policy formulation. Under the first assumption, which I call the commitment equilibrium, the government can commit to future policy in order to influence the equilibrium outcome by choosing future policy actions (at all different states of the world). Rational expectations require that these commitments are fulfilled in equilibrium. Under the second assumption, the government cannot commit to future policy. In this case the government maximizes social welfare under discretion in every period, disregarding any past policy actions, except insofar as they have affected the endogenous state of the economy at that date (defined more precisely below). Thus the government can only choose its current policy instruments, it cannot directly influence future government actions. This is what I call the Markov equilibrium.

Essentially policy is either forward looking and adaptive or it works only in the "here and now" and cannot innovate.

Clearly my reading of the current situation is that the Fed and US Govt is committed to a future policy in its actions and has displayed the ability to be adaptive. Therefore we shall take that path to find what future developments may await us.

Again we rely on Eggertsson to lay out the groundwork:

"deflation can be modelled as a credibility problem if the government is unable to commit to future policy and it's only instrument is open market operations. This....illustrates how the result changes if the government can use fiscal policy as an additional policy instrument. I first explore if deficit spending increases demand. When the government coordinates fiscal and monetary policies it can commit to future inflation and low nominal interest rate by cutting taxes and issuing nominal debt. I then use the result to interpret the effect of open market operations in a large spectrum of private assets, such as foreign exchange or stocks."

It is without doubt the most forward looking statement I have seen. Or is it? Again we must look at this from behind Bernanke's desk to truly appreciate what we are reading. The statement is forward looking because it has been adopted as policy. We are living with these actions right now and we know that they will exist for at least 6 months as has been made clear in statements from the Fed. Expectations of a continuing inflationary bias must be deeply entrenched in the psyche of anyone connected to asset markets.

Eggertsson continues:

"Friedman suggests that the government can always control the price level by increasing the money supply, even in a liquidity trap. According to Friedman's famous reductio ad absurdum argument, if the government wants to increase the price level it can simply "drop money from helicopters." Eventually this should increase the price level-liquidity trap or not. Bernanke (2000) revisits this proposal and suggests that Japanese government should make "money-financed transfers to domestic households-the real-life equivalent of that hoary thought experiment, the "helicopter drop" of newly printed money." This analysis supports Friedman and Bernanke's suggestions. The analysis suggests, however, that it is the increase in government liabilities (money & bonds), rather than the increase in the money supply that has this effect."

"Since money and bonds are equivalent in a liquidity trap dropping money from helicopters is exactly equivalent to issuing nominal bonds. If the treasury and the central bank coordinate policy the effect of dropping money from helicopters will have exactly the same effect as deficit spending. Thus this paper's model can be interpreted as establishing a "fiscal theory" of dropping money from helicopters. The model can also be extended to consider the effects of the government buying foreign exchange (or any other private assets).

It is often suggested that the central bank can depreciate the exchange rate and stimulate spending by buying foreign exchange (and similar arguments are sometimes raised about some other private assets and their corresponding price). Due to the interest rate parity (and similar asset pricing equations for other private assets), however, buying foreign exchange should have no effect on the exchange rate unless it changes expectations about future policy (since the interest rate parity says that the exchange rate should depend on current and expected interest rate differentials).

Will such operations have any effect on expectations about future policy? Open market operations in foreign exchange (or any other private asset) would lead to a corresponding increase in public debt defined as money plus government bonds. This gives the government an incentive to create inflation through exactly the same channel as I have explored in this paper and, therefore, leads to a corresponding depreciation in the nominal exchange rate hand-in-hand with the rise in inflation expectations. An advantage of buying private assets, as opposed to cutting taxes, is that it does not worsen the net fiscal position of the government. It only changes the inflation incentive of the government.

If Bernanke and Co keep with the blueprint (it would be difficult to see how they could deviate now without destroying carefully implanted expectations) we can expect to see continuous and expanding intervention in what was previously thought to be off limit areas.

Treasury bond issuance should rise and does not have to have a defining limit. Tax rebates will continue and grow, expanding beyond traditional areas. Use of current GSEs to expand government debt will be encouraged and may well lead to the formation of "Super GSE's" that could take on second lien loans on property, for example.

The Fed will expand its facilities, including more market participants and widening the range of assets that can be used, including stocks. The facilities will become permanent but will be allowed to run down in use as circumstances dictate. It will be imperative to remove any stigma associated with the use of such facilities, possibly by converting the facilities to a type of GSE, or more likely, a Fed Sponsored Enterprise.

Concerted and possibly international intervention in Forex markets should be given a high level of probability. This will allow a slow and orderly re-pricing lower of the dollar and a continued bias toward inflation.

A campaign of "anti-inflationary" bias will continue and be ramped up if necessary. Rates could be raised without affecting the fight against deflationary forces because expectations would require such a move. A constant attempt will be made to anticipate a move higher in growth.

Is the path hyperinflationary?

To be blunt, no. These are anti deflationary measures that will give the Fed credibility in fending off the dreaded scenario. The threat to the policies is an acceptance of deflationary expectations by private money and consumers.

Hyperinflation would be unable to form as an expectation as long as the Fed continues to display a hawkish approach to inflation. As we have seen the delivery of fiscal debt, in the form of "helicopter drops" would bypass the pricing mechanism. Expectations of hyper-inflation would be negated.

Conclusion. Is it working?

It is at this stage that I can happily say that it would be unfair for me to judge whether the policy is working or not. This because the whole scenario, the playing out of the policy, is to do with perception. The only way that it can be measured by individuals when attempting to answer the question is to screen what they see through this article (or G B E's Fiscal Theory). As the writer if I answer the question I might colour an individual's perception.

What I can say is that with the framework exposed and on public view we have the advantage of spotting potential failure of policy. The potential for failure is increased by discussion and the recognition of the long term policy objectives (avoiding deflation) if such discussion raises the expectation of deflation.

I should remind readers that this article is my interpretation of G B Eggertssons' work. I believe it is the blueprint being used by the Fed and US Govt. Therefore I claim no superior knowledge to Eggertsson, just an understanding and the ability to navigate.

What should be remembered is the title of G B Eggertsson's paper:

The Deflation Bias and Committing to Being Irresponsible

(Edit: The above link to the NY Fed stopped working, I have found another on line version at the IMF and linked to it. I have also downloaded a copy, just in case)

In other words the future actions of the Fed and US Govt may appear "wrong" unless we understand what they truly fear.

The Weekly Report - 6th April 2008

2008-04-06T15:48:00.002+01:00

The Weekly Report
5th April 2008
Welcome to the Weekly Report. This week, I stick my nose in where it ain't wanted. (again)We get down in the dirt about deflation and we look at some stocks and wonder why and I show you my long term indicators.

Now, I'm not one to boast, really I'm not. No one enjoys the likes of me stuffing "I told you so" remarks down reader's throats. There comes a time when it does become slightly unavoidable. Is it ego, a demand of recognition? Is it a desire to be kingpin, the ultra guru? Frankly my dear, I don't give a damn, as long as my readers get something that helps make life as an investor /trader easier then my attitude is "so what?"

What a week that was, Dow up, then down, up again…..stop! Hindsight - blah! This is the Collection Agency, we pride ourselves on looking forward, not back. Where do I look, how far forward? The Occasional Letter looks 6-18 months ahead, soon it'll be looking for some buy opportunities. The Weekly Report is more short-termism, with the aim of looking for opportunities in the next few weeks.

Speaking of readers it is time for an update. Now most of you know I'm a blogger, no fund to sell, no angle to push, I really don't care what you buy and sell. I'm not bothered. I'm googlable but I don't really exist beyond those that read me at some rather classy sites. Yes that was me being a creep.

Here is my world coverage over the past 2 months, remember, I'm an unknown, a blogger:

If it's green, someone visited. I know, I'm amazed too, my grammar is awful! Around 16000 people have read my stuff in the past 2 months. Some may scoff at such figures, I don't. I would like to thank you all, I had no idea my "stuff" was that readable. As much as I can be, I feel slightly humbled.

"Enough" I here you cry and being one not to spit in the face of a crowd, lets get on with it.

There has been a war of words between Gary North and Steve Saville about whether the Fed is inflating or deflating. I have absolutely no connection with either writer and have no interest in badmouthing either of them. I am sure both have a loyal following and I do know both make interesting points.

Here is my roadmap, unchanged these past 5+ years:

"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."

If you read that 5 years ago, you would have pegged me as a survivalist or a gold-bug. Now you can pick your appropriate position. How did I know such tremors were coming? Simple, I studied the very same things Ben Bernanke studied, he became a bald academic, I became a bald blogger. I am better looking though.

Back to the GN/SS spat. I looked on, an interested observer in all matters inflationary and deflationary and decided to strip the argument back to its core. From what I could see this was a difference between M1 and MZM as to which held the key to inflation/deflation signals. So I went to the Fed.

St Louis to be exact, mainly because I like Poole, his St L Fed site is excellent; I do hope his successor keeps the access to facts as open as Poole did. Its worth reading up on William Poole, he may well surprise you. I digress, again:

Charts:

This is a chart of MZM (green), M1(orange) and CPI(blue), using the base of 1982, as CPI was rebased in 1982/84 according to St L Fed statistics. Everything is based on the left side, pure figures. You know what's coming next:

Same chart with CPI based on the left axis and M1 and MZM on the right axis with the same baseline of 1982. Astute readers can know see why I stick my nose into uninvited areas. Is any measure of "M" a worthwhile measure of inflation trends?

Inflation is not purely a monetary phenomenon. We all know if you over-print cash notes you encourage a debasement and a monetary inflation. What isn't so understood (except by some and believe it or not, the Fed) is that in a fiat monetary system, reliance on growth using leverage for the expansion of credit, is the true driver of inflation/deflation.

It's simple and easily understood if you think of greed. It is also why a fractional GOLD backed currency won't work.

I have $10, I lend it to my bank as a "savings" deposit. The Bank uses the deposit as an asset, lending on that asset by a factor of 10 (leverage). The bank lends out $100 backed by the original asset. The Hedge Fund borrows (credit) $100 from the Bank and utilising margin (further leverage), raises positions in markets notionally worth $1000.

The economy is booming, thanks to my $10. I am a capitalist hero. One day I decide to take my $10 out of the Bank to spend on a battery powered radio, to alleviate my boredom whist mowing the lawn.

Does the Bank have to unwind the leveraged lending based on my $10? No, it can count upon other deposits, savings, to replace the capital base.

This is all well and good during the good times. What happens when all my neighbours decide they would rather own assets than leave cash on deposit? We know already, thanks to the 3 day collapse of Bear Stearns. Banks fear above all else a run, where depositors decide they would rather have their cash in hand than in the Bank. You can see why they fear such a run, mass withdrawals would force the unwinding of leverage, a call on the loans made. That means the Hedge Funds would have to unwind their positions, to enable repayment to the banks. You get the picture. Another angle would be to look at productive workers, paid for their labour and depositing wages into the Bank. If the Banks had a shortfall of received wages the same problem would occur, Banks would no longer have the fractional base to enable their lending. Less workers, less deposits.

What we are witnessing is not a shortfall in the ability of innovative structures to enable credit. What we are seeing is the beginning of the destruction of the fractional base of Banks. I could go on, mentioning the shortfall in expected corporate profits over the next quarter or 2 as judged by the S&P500. My astute and clever readers have already jumped ahead to that conclusion.

Back to the central question, is the Fed inflating or deflating? Amazingly, it is doing both, thanks to the newly introduced "Facilities":

Above is something I rustled up earlier in the week. To my eye, the Fed is inflating the amount of Treasuries available to both Banks and Primary Dealers and debasing their worth by swapping them for cheaper assets. On the other hand the Fed has been extremely active with the Permanent Open Market Operations, selling treasuries and absorbing cash from the markets. The Fed is walking along a very loose tightrope, where each step is producing vibrations that affect all market participants.

It would seem the Fed is set on a course to provide solvency to Banks and Primary Dealers, by lending assets that can be used to raise/roll borrowing from Banks who are only willing to lend on AAA assets. This is far beyond the ability of MZM and M1 to measure. Such slow moving indicators are unable to capture the true intentions of the Fed as it provides the replacement for the Commercial Paper markets.

Let us gaze upon the graphs for M1, M2 and MZM:

Where M1 has remained in a tight range for the past 11 Quarters, the sudden acceleration in M2 and MZM points to a reflation BEYOND cash.

M1 is defined as all coins and currency held by the public including travellers cheques, checking account balances, NOW accounts, ATS accounts and balances in credit unions.
M2 is defined as all of M1 plus savings and small time deposits, overnight repos at commercial banks, and non-institutional money market accounts.
MZM is defined as all of M2 minus time deposits but including money market funds.

Yes, we are back to the Fed and its Facilities again. M2 and MZM include overnight repos at commercial banks. Since the credit crisis burst open in the summer of '07, the Fed has made ample use of repos. Indeed when the crisis intensified in October '07 and again in January '08 the Fed enlarged the amounts and frequency of repo arrangements.

It is quite clear that M2 and MZM are reflecting this. M1 does not include such actions as those carried out by the Fed. Repos can only be viewed as credit, newly created by the exchange of assets. Cash itself is not printed, there is no need. All that happens is a bank can swap assets to increase the notional amount it holds in its reserve and meet reserve requirements. Only if the repo was made permanent, with assets remaining at the Fed, could the Bank issue currency.

It is at this point I agree with Gary North, consumers are not seeing a reflation in wages or income, actual cash in the economy has been remarkably stable over the past 3 years. If one considers the loss of spending power of each dollar, then without an increase in the amount of physical cash, consumers are already in a deflationary cycle as the amount of cash after liabilities is falling. An inflation of prices must never be confused with an inflation of monetary supply, consumers are suffering a deflationary lack of cash when compared to the requirements demanded by an increase in the PRICE of goods.

For the consumer this is clearly unsustainable. Eventually the consumer will hoard resources and only use cash to pay for essentials. Regardless of the Fed pumping assets into Banks and Primary Brokers who use the largesse to fund their own borrowings, the consumer will find it extremely difficult to access credit. Without credit consumers will be unable to expand spending as reliance on increasing wages is obviously misplaced.

Here we have the roots (and they run deep) of a major deflationary period. I have opined before that I saw a two track America, one where consumers where crushed by deflationary forces whilst "International USA" continued to offer acceptable returns in exchange for it debt. That moment may well be playing out in front of us now.

Here is a chart of 2 inter-related phenomenon; Consumer Prices (blue) and Total Retail Sales (red):

Here is a classic example of prices rising when goods are in demand. If you look closely, you can see that retail sales lead CPI, dips in sales slows and at times reverses CPI.

An adage I have for this is it doesn't matter how high prices go if there is no demand for goods. The goods will either be re-priced lower to stimulate demand or the production of the goods is stopped if the venture becomes unprofitable. It is the lack of cash that causes (spending and therefore) sales to drop. How the amount of cash consumers own is decreased is important. If more cash is required to pay taxes or service debt then the expenditure is onerous on the consumer balance sheet, no asset is exchanged. If the consumer chooses to spend more money buying assets, then at least there is an asset owned. If however the asset is depreciating in value, including assets bought using debt then the net worth of the consumer suffers a double blow.

Housing is suffering from the same effect. Now we see it in retail sales. You can see why tax rebates have been lined up, it is an attempt to stave off a deflation in sales. If it works it will have a lagging inflationary affect on CPI.

The problem though is whether consumers will spend tax rebates or save them. If rebate cash is used to pay down debt or placed on deposit there will be no stimulation to sales. CPI will drop. Here is a close up of the same chart:

The tax rebate effect can only be temporary even if it does stimulate spending. Without an expansion of credit or an increase in wages sales will continue to drop. What are the chances of credit conditions changing in the medium term or wages increasing during a recession?

The interesting part of all this is if consumers do save the tax rebate then M1 will not increase as savings and small time deposits are calculated in M2/MZM. Thus savings could cause a display of supposedly inflationary tendencies in M2/MZM. M1 would only increase if the savings ( or the tax rebate itself) were used to buy goods or services.

The actions taken by the Fed and the US Treasury will either distort CPI or cause a misreading of inflation if M2/MZM are used. The latter would be a grave mistake as the consumer would not have increased their spending power. The increase in M2/MZM would be a combination of increased use of credit by banks and an increase in savings by consumers.

The following chart shows the relationship between Sales and Industrial Production for Durable Consumer Goods:

Sales and Production are linked, it shows that the compensation given to workers for their labour is used to buy products, amongst other uses. The correlation is particularly noticeable prior to 1991. However since 1991 an inequity between spending power and production has appeared. It is my contention that increased productivity was a function of the slowdown of compensation in real terms and spending was boosted by an increase in the use of credit allowing sales to continue to rise.

This is a form of mal-investment, were credit has replaced true efficiencies in production. Purchases were not made from savings (workers earnings) but from earnings of yet unrealised worker compensation with a forward CPI and risk premium added.

With the standards for credit now at much tighter levels seen since 1991 this mal-investment is beginning to bite. Although this has consequences for consumer spending power, the real problem will lie within Corporate balance sheets. Reduced income will make the servicing of corporate debt much more difficult as we have seen in the Financial Sector. "Liquidity injections" from overseas investors have high rates of interest and with income streams falling, increased productivity and the ability to service debt can only be achieved by lowering costs.

If a production system is reliant on the use of credit to expand and that facility is removed then the results of previous bouts of debt fuelled expansion cannot be carried forward and offset against expected future income. Either the debt is repaid or defaulted.

Can increased productivity re-light consumer spending? It would appear not:

And it's a tactic that's already been tried. Notice the increase in productivity in 2007 did not re-ignite sales. It's most likely that the 2007 increase was a function of cost savings, rather than expansion.

On a more practical front, how can an investor use such information to aid their strategy?

Avoid debt on company balance sheets. An investor should get into the habit of checking the ratio of company debt to income and reserves. If you can find a company selling essential products that carries no debt on its books you are on the right lines. If you can find a company that also has saved its profits and is only willing to expand using its savings you may have found a good opportunity.

We finish off with a look at some charts and wonder why investors are buying financial sector stock. Is the recent rebound in financials worth buying into or watching? I leave that decision up to you, I don't do recommendations but as you have read, my filter for acceptable buys would discount the sector. You may well have a different take on the situation, my only advice would be to do your research with extra diligence. I have no positions in shares in the following charts and will not take a position on them for some time.

Firstly my Dow Daily Chart, used for long medium length trends:

We are near the top of the sideways trading range(down arrow) that has been in force since January. For the first time in 4+ months we have a neutral reading, with 3 days of support at the pink, median line (up arrow). Whilst calling direction from here would be a bit silly, at least with a neutral scenario we can take cues from breaks of support/resistance from here.

Citi, I have removed the down channel as we have broken out. Citi is trying to break above the MA but might be forming a rising wedge:

Goldman is at the upper end of its down trend channel and finding resistance at the MA. Strong support at $163:

Gold, an update from last week. The down arrow shows the attempt last Monday to regain the MA which failed. Gold found support in the $885 area on a closing basis. This level now becomes important support for future moves. I would need to see a higher high and support from the MA before looking for upside:

That's it for this week.

The Weekly Report - 30th March 2008

2008-03-30T23:09:00.004+01:00

The Weekly Report

30th March 2008

Welcome to the Weekly Report. Click on the link for my update on Moral Hazard written for Livecharts earlier this week. Stress continues to increase across all markets, a fact that should make all investors stop and think about the root cause.

First up, we dig into the Flow of Funds Accounts of the United States for Q4 '07. Specifically I want to look at the growth of Domestic Non-Financial Debt:

Remember this is a growth chart, the amounts are still rising. Without using a chart, you can see a bell curve in household debt, State and Local Govt debt and Federal Debt. Inverse to this is Business debt. There are some disturbing patterns here that bode ill for the future.

The growth in household debt is slowing rapidly, almost halving since Q1 '06 to Q4 '07. I somehow doubt Q1 '08 will show an improvement. It is clear that for consumers the debt crisis did not begin in the summer of '07 but in Q3 '06. Anyone who tries to label the MBS credit crunch as a Minsky event, an unforeseen happening that surprised the Markets, didn't look deep enough. This disinflation in the growth of consumer debt is different than the expansion we saw during the last recession. There is no support coming for the economy from a continued and increasing expansion of consumer debt. This is a consumer led recession that has ramifications for the whole system of funding used by local and national government. Without an increasing flow of taxes raised through spending, Municipal, State and National funding will be increasingly reliant on raising debt through bond issuance.

Indeed the process had already started, as can be seen by the rise in Local/State and Federal Debt to cover the shortfall in funding. As we all know the Municipal Bond (MB) Market looks like the Somme in 1916, cratered and deadly to all participants.

The figures for Q3 and 4 '07 show the sudden difficulty in raising debt experienced and the acceleration of the problem. This makes sense if viewed from MB buyer's point of view. If the MBs are issued using future tax/income flows as the underlying asset it is no wonder that, after a quick glance at slowing consumer debt, the underlying asset is no longer seen as such a secure basis for borrowing. It is exactly the same calculation used when buyers deserted the lower (and now top) rated MBS tranches, a lack of confidence in the underlying asset to perform at its historical level of return.

Business lending looks solid at first glance but if we take a longer term view, a pattern becomes evident:

Notice the pattern? Business debt grows until hard times arrive. It is likely that falling rates (yields) become attractive and business debt is increased or rolled over on better terms. As I have shown before it is this short-sighted view that often becomes the undoing of Business. Whilst falling yields are attractive to borrowers they are the precursor of a contraction in economic performance. The Fed allows rates to drop for a reason; it is to attempt to stimulate economic growth. That stimulation is required as conditions weaken:

We can see this in practise above, as conditions shown by the ISM readings for manufacturing (red) and non-manufacturing (black) business are interest rate sensitive (effective Fed Fund Rates- blue). Rates climbing above 5% are not conducive to a healthy business environment. Even periods of stable rates above 5% do little to help business; it demonstrates that business planning is not aided by "stability" but by low, accommodating rates. As we can see, the Fed did not pursue a new paradigm this time around. Business conditions had to show marked deterioration before the Fed cut.

Here is the conundrum for the Fed. Previous accommodating drops in rates helped to re-invigorate business after deterioration, helping employment, expansion of credit and consumerism. This time the Fed faces a problem not seen since the depression (except in Japan 1990 - present).

Lowering rates is ineffective if Banks do not lend. It is clear that Banks either are not willing or are unable to extend credit facilities to all sectors of the economy, including to each other. The Fed has attempted to address this with a series of new measures, designed to alleviate the pressures on Bank capital reserves. Banks are grateful for this but will not take new positions in credit markets. The Fed support is being used to repair and rebuild bank balance sheets by deleveraging, using cheap Fed assets and funds to roll their own positions, whilst keeping income streams high on current lending. If the Banks decide its time to clear the decks of liabilities, this process could take much longer than most expect.

Without access to lower commercial rates, businesses could find themselves unable to use credit to roll over existing debt or to use new credit for "expansion". This would be comparable to the conditions seen in Japan in the last 2 decades.

How tight are current Bank credit conditions? Put it this way, if the Fed has to enact '30s legislation to save a broker and then set up a discount window for other Primary Brokers it is clear that Banks are unwilling to help out.

Here we see the massive drop in borrowing, except for two sectors:

Apologies if it is a bit small, here is the link to the Fed Fed Z. 1. Credit market borrowing in the Financial Sector is down from $2339.1Bn in Q3 to $1300.5Bn in Q4 '07. That's some disinflationary rate, 55.5% quarter on quarter! No wonder Banks and Primary Brokers were happy to take "liquidity injections" from SWF's and Middle/ Far East investors.

The only expansions of note were in Agency and GSE backed mortgage pool securities and Funding Corporations.

Conditions will not improve until Banks allow credit to expand. Clearly from the data above that hasn't happened into the end of '07. With the continuing use of the Fed and its expanding list of lending programmes, the "Bank of Last Resort" demonstrates that conditions continue to worsen. Until Bank lending standards are relaxed the consumer and business will remain mired with long term debt that requires servicing at rates well above those Banks are being charged by the Fed.

In effect a dollar based carry trade is in operation, with low rate debt borrowed from the Fed lent out at higher rates to all sectors of the US Economy. As we have seen in the past year the carry trade mechanism is reliant on confidence that the high rate income stream continues to flow allowing the servicing and pay down of the low yield debt.

If confidence in the income stream becomes threatened then in normal conditions the carry trade is unwound or more collateral is required to secure the short term (in this case, Fed) debt. This though is not a trade under normal conditions. The Fed can allow collateral levels to remain the same or even be relaxed even if conditions worsen.

The method being used to bailout the financial system is now open to public scrutiny. Banks and other lenders that are "vital" to the stability of the US Economy will be allowed to set their own rates on their lending whilst assured of a low burden of payment on their own borrowings.

Conditions are ripe for Banks to begin to encourage issuance of Corporate Bond debt. The following chart shows the Moody rates for AAA (purple) BAA (green) corporate bond yields and the Primary Credit Rate. I have had to join up a couple of gaps in the data, it is still worth showing:

Primary Credit Rate at the Discount Window (left axis) is now 300pb below AAA corporate yield and 440bp below BAA.

Here is a plan that may well be put into place by the Fed, Banks and now the Primary Brokers. The Fed continues to lend at very low rates to the financial sector. The Banks and PD's begin to roll their leveraged assets into a mix of corporate bonds and higher yielding treasuries using the income stream to payback the Fed and repair the balance sheets. To further enhance the domestic dollar carry trade, the Fed raises the Fed Fund Rates, citing inflationary pressures but keeps rates at the discount windows artificially low. It might not happen in the near future but there maybe a hint that others are considering this as a possibility:

(Chart from CLP Structured Finance)

It's too early to say "trend change" but it maybe worth watching yields to see if markets start to price in rate hikes.

Finally, two charts which are both at a critical juncture. First up is Dollar/Yen, a monthly chart. With the month close on Monday, it looks increasingly like the Dollar is in need of help. Will anyone hear the call?

Lastly, Gold Daily chart. Gold needs to rally rapidly from here to stop a test of support at $845 area.

That's it for this week.

Moral Hazard, Merrill Lynch, Goldman Sachs, Spiders and Margin requirements

2008-03-30T13:18:00.001+01:00

Moral Hazard, Merrill Lynch, Goldman Sachs, Spiders and Margin requirements

Now if that title doesn't cause Google bots to have a happy hour I don't know what will?

There is a lot of talk about moral hazard being assumed in the Markets, what with the intervention of the Fed with Bear Stearns, the Bank of England with Northern Rock and the Bundesbank with a whole host of German banks.

Some ask what is there to worry about, intervention is good, stopping further havoc in the markets and adds "stability". Let's have a look at a couple of definitions of moral hazard, back to basics:

From Global Business Today: Moral hazard. "Arises when people behave recklessly because they know they will be saved if things go wrong."

From Deardorff's Glossary of International Economics: Moral hazard. "The tendency of individuals, firms, and governments, once insured against some contingency, to behave so as to make that contingency more likely. A pervasive problem in the insurance industry, it also arises internationally when international financial institutions assist countries in financial trouble."

I had a good search through my books and on the internet and I could not find one definition of accepting moral hazard as a method to protect the financial system. In every case it either specified or implied a change in behaviour that would make the event that had caused moral hazard to be invoked more likely to occur.

The main keywords used were dishonesty, questionable integrity, a lack of incentive, more risk, danger, incompetence and temptation.

Just the kind of attributes you do not want associated with the Markets in their current state. Still, it has happened, intervention in "free" market mechanisms has occurred and we now have to accept it as a reality. To protect ourselves we need to know how does the acceptance of moral hazard cause an increase in the risk of the very event that was being avoided?

Here are the words of a Central Banker and a Treasury official. Both have been involved in creating a moral hazard in 2 different International markets.
First up is Mervyn King of the Bank of England. Having already bailed out and the acquiesced to the nationalisation of Northern Rock (in my view against his own better judgement) this is what he had to say to Parliament on Wednesday:

"So we are discussing with the banks how a longer-term resolution of the problem might be reached,
This would be based on two principles -- that the risk of losses on banks' lending remains with bank's shareholders and that the longer-term solution "should focus on the overhang of assets and not subsidise issues of new assets.

With reference to increased lending facilities by the B of E, he said "Such lending can be only a temporary measure but it can be a useful bridge to a longer-term solution."

Mr King has been reading his definitions too. I suspect he is very worried about moral hazard leading to its conclusion and is attempting to tell the markets that reliance on a lack of perceived risk is misplaced. However, until the UK governing politicians back him up it will be seen as jawboning.

Next is Hank Paulson, US Treasury Sec who is credited with being instrumental in the Fed sponsored buyout of Bear Stearns. He takes a very different view of how moral hazard should be viewed. After praising the Fed for its "creativity" he went on:

"It would be premature to jump to the conclusion that all broker-dealers or other potentially important financial firms in our system today should have permanent access to the Fed's liquidity facility,"
"The trade-off for this subsidized funding (for banks) is regulation tailored to protect the taxpayers from moral hazard this insurance creates."
"and the sooner we work through it, with a minimum of disorder, the sooner we will see home values stabilize, more buyers return to the housing market, and housing will again contribute to economic growth."

In Q&A after his speech he then said "financial institutions are critical to the economy and innovation precedes regulation."

No flat out refusals in this text, the use of the word "premature" in relation to permanent access to Fed liquidity implies the idea is on the table, encouraging increased risk taking. Think of it like this, you get a fallback position allowing you to take one great bet. If it fails then the Fed pick up the pieces and you walk away. If it works you join the Big Players League. If a whole sector tries it, no problem, the temporary arrangements will become permanent as to do otherwise would invoke the very problem trying to be avoided now.

Notice one other subtle difference between Mr King and Mr Paulson? It's the implied threat as to who gets hurt if the situation isn't allowed to run the course they have set out. Mr King points squarely to shareholders, there will be no offer to buy shares of busted banks. Not so from Mr Paulson, he threatens the public, by insinuating that if he and the Fed do not get their way, housing and the economy will suffer.

As for "innovation precedes regulation" Hank needs to look at some timings, repealed laws and the amount of lawyers it takes to change an SPV to an SIV. Threatening banks with regulation has the same effect as threatening a warmongering dictator with a major leaflet campaign.

Moving on to an interesting chart which could be titled "Dude - Where is my bear market?"

Here we have Merrill Lynch, Goldman Sachs and SP500 Spiders on a 1 year comparison chart (Bloomberg). You can see my dismay. My bear market hasn't really started yet. It could be easily said that the credit crisis fallout is restricted to the financial sector. SPY is down around 7% (approx) from last year. It's not exactly leaping off a cliff. Think of this chart as displaying positive divergence for the S&P. Will it last is another question, divergences have an unfortunate ability to correct, as well as pointing out a disequilibrium. I shall be watching MER very closely though, it is struggling to join in with the current rally.

Of course if the S&P is reflecting a measured worth of intervention, then it is probably correctly priced. The problem is if moral hazard reaches its conclusion and the attempts to avoid the problems are unsuccessful, then the S&P will have some "catch up" to do on the downside.

Finally, instead of the market snippets this week, I want to just tip you off about margin requirements. Some of you may already know that margin levels are being raised by a number of brokers. Here is why:

"As a result of the Margin requirement changes imposed by the Exchanges, we will be revising the margin requirements on the following Futures contracts":

10 Year US T-Notes Composite (Globex-CME/CBOT)

5 Year US T-Notes Composite(Globex-CME/CBOT)

30 Year US T-Notes Composite(Globex-CME/CBOT)

Euro FX/Swiss Franc(Globex-CME/CBOT)

Euro FX/Japanese Yen Cross Rate Future (Globex-CME/CBOT)

European Rapeseed (Euronext)

Corn (Euronext)

AEX Index (Euronext)

CAC 40 Index (Euronext)

In other words add to your capital or get closed out. The question is who is going to get squeezed, longs or shorts?

The Federal - Structured Investment Vehicle - Reserve LLC

2008-03-26T10:06:00.003Z

The Federal - Structured Investment Vehicle - Reserve LLC

Research Note and Outlook From The Collection Agency

So, in the end the Fed decided to copy Enron and become a Special Purpose Vehicle, more commonly known these days as a Structured Investment Vehicle. (SIV) The Fed has granted itself the ability to morph by expanding its short term lending and borrowing facilities to such an extent it is now the market.

The following is my take on what a research note would look like, if the Fed (FED) was a quoted, publicly traded company.

Lets recap how the Fed managed this amazing transformation from so-called Central Bank to an off balance sheet, Distressed Loan Hedge Fund.

It seems the transformation began with the appointment of a new CEO, a Mr Ben Bernanke who specialised in the history of distressed credit and loan periods, specifically the Great Depression and Japan. In hindsight the appointment by the Chairman, GW Bush, looks inspired, an astute move that showed a deep understanding of the problems that were to unfold. Indeed, it would not surprise me that after the Chairman leaves his current board position he becomes a target for the more discerning Hedge Funds.

The Chairman also appointed an old friend and ex-head of Goldman Sachs to the supporting role in PR and head of the Company's Debt Division, one Mr Hank Paulson. Hank had useful contacts throughout the Financial Sphere and acted as a conduit to Mr Bernanke. The chairman also slimmed down the Board of the Investment Vehicle, allowing decisions to be made in a more timely manner when problems occurred.

On appointment Mr Bernanke immediately set to work, using the premise of cost savings to cut back on the information the SIV gave to the public. With the loss of the M3 figures, off balance capital could be raised without alarming shareholders. He also began, in conjunction with Mr Paulson, a publicity campaign to make the under capitalised and debt burdened GSE's more attractive as investment conduits. This was no easy task, especially with the books being closely examined but as we shall see it was a necessary move to help shape the financial structure of the SIV.

Preparations continued to ferment a suitable environment that would allow FED SIV LLC to really ramp up its business strategy. Pressure had to be applied to raise interest rates that would allow stress to appear in the financial and economic systems. Firstly a sustained publicity campaign against inflation was launched with the hope that inflation expectations would grow, allowing acquiescence to the need to raise rates. This though was a smokescreen, designed to lead the crowd into the wrong trade. The second prong of this attack was already in play as FED compliance officials had, for some time, been pressurising Banks on lax loan standards, forcing a tightening of credit availability.

As the markets, the public, banks, dealers and hedge funds accepted the new conditions and set trades accordingly, the time was ripe for FED SIV LLC to take advantage of stresses in the system. What was important though was that FED ( Quote, Chart, News ) was not seen as the catalyst for the rapid changes that were to take place. It was a matter of waiting for a problem to arise and then, under the guise of assisting, make conditions such that lending dried up and debt became either unserviceable or untradeable. Thanks to the previous CEO, Mr Greenspan, the ability to mark debt derivatives to market had grown exponentially over the last few years. It would be difficult indeed to hide losses.

Then one summers day in 2007 the chance to profit came along. As credit had dried up and rumblings of difficulties at smaller bit part SIVs to roll Asset Backed Commercial Paper loans began to surface, interest rates broke away from FED fixed rate, reflecting an increased risk premium. As LIBOR rates rose, interbank lending slowed as capital was hoarded, causing credit lines and leverage facilities to be withdrawn. With markets betting on higher inflation and rates remaining high, FED stepped in and lowered rates at the discount window, hoping to pick up the demand not being serviced in traditional markets.

Although some business came their way, it seemed the financial system was trying to cope without the use of the new, innovative FED SIV. Then, as luck would have it, an investment house of some repute had to close down 2 hedge funds and recapitalise a third. Markets reacted by refusing to buy debt derivatives and banks demanded higher premiums on loans.

This was the opportunity FED had been looking for. It slashed the FED Fund Rates and expanded its lending facilities, using the System Temporary Open Market Operations (TOMO) in an aggressive move to replace funding, introducing longer term facilities on a rolling basis.

A new publicity campaign was started, playing down the stigma of borrowing from the FED SIV and encouraging its use. Hank Paulson began to talk up the dollar, in an attempt to forestall and foreign selling of dollar assets. Increasingly FED SIV began to talk down the risk of inflation and preferred to talk of a possible slowing economy. This subtle move balanced the bond vigilantes, who accepted that inflation was not the primary concern and bonds should start to price in an economic slowdown.

Although markets had become volatile and the failure of Mortgage Lenders and Hedge Funds continued, it appeared that FED had established a floor under the problems. The profits from increased lending began to grow.

The Stock Market took the situation in its stride, indeed in October '07 it made a new high. By now though talk of losses and discovery of toxic debt began to overwhelm bullish sentiment and stocks began to fall. It soon became apparent that problems had surfaced in Europe, where 2 FED subsidiaries, BOE Inc. ( Quote, Chart, News) and ECB Intl Ag, ( Quote, Chart, News ) started to make funds available to distressed traditional banks, indeed BOE Inc took one bank, Northern Rock, into its Distressed Business portfolio. With the dollar falling FED saw the new business in Europe as an excellent move and continued to push for overseas expansion.

By late November '07 it became apparent that some analysts had seen that the continuing FED rate cuts could have a damaging effect on the economy:

"Stephen Stanley, Chief Economist at RBS Greenwich Capital, says consumer conf might rebound like it did in 2005 but "the downside risks are very real. We continue to believe that the Fed would be well-served by holding off on any rate cuts in December and addressing market illiquidity head on by flooding the system with reserves."

Even some of the FED board had misgivings, at least in public:

Federal Reserve Bank of Philadelphia President and CEO Charles Plosser said today that because weaker economic growth is already expected in early 2008 and was considered when the Fed cut interest rates in October, he is not inclined to seek another cut unless growth is much weaker than expected.

"Arbitrarily lowering interest rates or providing liquidity to the market does not provide the answers the market seeks," he said. "Indeed, in some circumstances, lowering interest rates may prolong the painful process of price discovery."

It was clearly time for events to take another turn, so as not to undermine FED business strategy. LIBOR had reached new 6 ½ year highs showing the well prepared public, through a well rehearsed media that credit problems were resurfacing.

Indeed Commercial Paper rates began to rise again, even though FED rates were lower, as was the 3 Month T-Bill yield:

The inability to issue acceptable CP was threatening the ability of all borrowers to roll over their short term debt. Banks had become averse to lending:

(Charts by Colin Twiggs at Incredible Charts)

It was becoming clear that a second and more dangerous wave of credit destruction was approaching.

Fortunately CEO Bernanke had been waiting for such a crisis to unfold and had ensured that staff had drawn up a contingency plan. With the fortuitous failure of the Citi led attempt at setting up the "Super SIV" or M-LEC, FED were now in the driving seat.

By early December, Chairman Bush and PR guru Paulson began to outline a possible plan that involved renegotiating failing mortgages and made noises about mortgage forebearance. This helped to heighten the sense of fear in the market place, making the next move by FED to be seemingly natural. A new systemic threat had appeared, smaller SIV's began to fold and default in large numbers. As Moodys mentioned, the costs were climbing higher everyday:

"Moody's completed partial review of the SIV sector prompted by the continued market value declines of asset portfolios. Moody's confirmed, downgraded, or placed on review for possible downgrade, the ratings of 79 debt programmes (with a total nominal amount of approximately US$130 billion). This action affects 20 SIVs."

Then it happened, the Insurers or Monoliners as they became known, began to show serious signs of stress, as liabilities far outstripped capital reserves. Banks and Investment houses had no choice, either the SIV and Hedge fund liabilities were defaulted upon or they had to come back onto the balance sheet. This was the opportunity FED had been looking for, with a clear field it was time to roll out the new derivative innovation that had been carefully put together in the summer. With much fanfare FED announced the new strategy, involving its worldwide subsidiary companys.

Press Release

Release Date: December 12, 2007

For immediate release

Today, the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, and the Swiss National Bank are announcing measures designed to address elevated pressures in short-term funding markets.

Federal Reserve Actions

Actions taken by the Federal Reserve include the establishment of a temporary Term Auction Facility (approved by the Board of Governors of the Federal Reserve System) and the establishment of foreign exchange swap lines with the European Central Bank and the Swiss National Bank (approved by the Federal Open Market Committee).

Under the Term Auction Facility (TAF) program, the Federal Reserve will auction term funds to depository institutions against the wide variety of collateral that can be used to secure loans at the discount window. All depository institutions that are judged to be in generally sound financial condition by their local Reserve Bank and that are eligible to borrow under the primary credit discount window program will be eligible to participate in TAF auctions. All advances must be fully collateralized. By allowing the Federal Reserve to inject term funds through a broader range of counterparties and against a broader range of collateral than open market operations, this facility could help promote the efficient dissemination of liquidity when the unsecured interbank markets are under stress.

TAF was a great success, with demand outstripping supply. Profits from this venture should easily outstrip those from the more cumbersome and shorter term Repos under the TOMO System. TAF started out at $40Bn and was set to climb up to $100Bn as long as demand remained high. With Banks refusing to lend except on AA and above collateral, credit markets were still frozen. TAF allowed FED to fund short term loans on easier collateral terms, replacing the shortfall in Commercial Paper. FED had cornered the market.

FED SIV LLC was not about to sit back in the current climate. Opportunities in other areas were beginning to become apparent. CEO Bernanke's historical research had led him to believe that once problems of this nature became public knowledge the FED could be expected to continue its move to dominate US banking, with little or no opposition.

In January '08 FED moved quickly to offset the fallout from the SocGen failure in Europe, where lax French regulation had allowed a lone trader (not so alone as we subsequently discovered) to run up huge losses as he had bet against the FED business model. FED was delighted to put further pressure on Treasury Bond short players by cutting FED rate savagely. Stocks bounced and began to move upwards, soothing the nerves of the masses.

Damage had been done though, as a tightening of availability of Treasuries caused by a flight to safety further restricted borrowing, as by this stage Banks would only accept the highest grade collateral on loans.

FED was quick to seize on this new business opportunity as it held Treasury reserves in excess of $750Bn. More could always be supplied by the Company Debt Division, it just took a call to Hank.

Sure enough by early March '08 conditions were ripe for FED to enter the Collateral Swaps market, accepting low graded debt in exchange for AAA rated treasury debt. To enable this, FED SIV LLC created a new conduit known as the Term Securities Lending Facility. Here is the company press release:

Press Release

Release Date: March 11, 2008

For immediate release

Since the coordinated actions taken in December 2007, the G-10 central banks have continued to work together closely and to consult regularly on liquidity pressures in funding markets. Pressures in some of these markets have recently increased again. We all continue to work together and will take appropriate steps to address those liquidity pressures.

To that end, today the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, and the Swiss National Bank are announcing specific measures.

Federal Reserve Actions

The Federal Reserve announced today an expansion of its securities lending program. Under this new Term Securities Lending Facility (TSLF), the Federal Reserve will lend up to $200 billion of Treasury securities to primary dealers secured for a term of 28 days (rather than overnight, as in the existing program) by a pledge of other securities, including federal agency debt, federal agency residential-mortgage-backed securities (MBS), and non-agency AAA/Aaa-rated private-label residential MBS. The TSLF is intended to promote liquidity in the financing markets for Treasury and other collateral and thus to foster the functioning of financial markets more generally. As is the case with the current securities lending program, securities will be made available through an auction process. Auctions will be held on a weekly basis, beginning on March 27, 2008. The Federal Reserve will consult with primary dealers on technical design features of the TSLF.

In addition, the Federal Open Market Committee has authorized increases in its existing temporary reciprocal currency arrangements (swap lines) with the European Central Bank (ECB) and the Swiss National Bank (SNB). These arrangements will now provide dollars in amounts of up to $30 billion and $6 billion to the ECB and the SNB, respectively, representing increases of $10 billion and $2 billion. The FOMC extended the term of these swap lines through September 30, 2008.

The actions announced today supplement the measures announced by the Federal Reserve on Friday to boost the size of the Term Auction Facility to $100 billion and to undertake a series of term repurchase transactions that will cumulate to $100 billion.

FED was becoming not only the dominant force in US Banking but was achieving massive profits as lucrative trades in Distressed Debt added to the bottom line. With the ability to dump non-performing Distressed Debt and re-claim Treasuries the risk of default by a borrower was minimal.

By now though the problem of collateral degradation had spread beyond the banks and entered the Broker arena. A loss in confidence in the assets held at Bear Stearns caused a run that saw Bear collapse inside 3 days.

FED instituted an emergency board meeting and using company procedures not seen since the 1930's moved swiftly to make an asset grab. Acting through an old associate firm, JP Morgan, FED promised a credit line of $29Bn to secure Bear assets. It then set up a subsidiary Fund to control ex-Bear assets with Blackstone running day to day activities, as seen in this hasty press release:

"This action is being taken by the Federal Reserve, with the support of the Treasury Department, to bolster market liquidity and promote orderly market financing," the NY Fed said in a statement.

It will take control of a portfolio of assets valued at 30 bln usd as of March 14 pledged as security for 29 bln usd in term financing from the NY Fed at the 2.50 pct discount rate.

JP Morgan will bear the first 1 bln usd of any losses in the portfolio and any gains will accrue to the NY Fed. The Fed has hired BlackRock Financial Management to run the portfolio under guidelines established by the NY Fed "designed to minimize disruption to financial markets and maximize recovery value."

It looks like someone in the Press Dept used the old name of the Company, pressure to get this deal out must have been intense.

To ensure that FED would not have to go through such an unseemly rush when the next Institution fails it released details of its latest SIV conduit, the Primary Dealer Credit Facility:

Press Release

Federal Reserve Announces Establishment of Primary Dealer Credit Facility

March 16, 2008

The Federal Reserve has announced that the Federal Reserve Bank of New York has been granted the authority to establish a Primary Dealer Credit Facility (PDCF). This facility is intended to improve the ability of primary dealers to provide financing to participants in securitization markets and promote the orderly functioning of financial markets more generally.

The PDCF will provide overnight funding to primary dealers in exchange for a specified range of collateral, including all collateral eligible for tri-party repurchase agreements arranged by the Federal Reserve Bank of New York, as well as all investment-grade corporate securities, municipal securities, mortgage-backed securities and asset-backed securities for which a price is available.

The PDCF will remain in operation for a minimum period of six months and may be extended as conditions warrant to foster the functioning of financial markets.

It is clear that with Chairman Bush, CEO Bernanke at the helm, excellently supported by Hank Paulson, head of the Debt Division, FED is well placed to take advantage of the Distressed Debt markets. Profitability seems assured and risk has been prudently cut.

With a business model designed to allow lending of assets and cash in exchange for illiquid and unwanted lower grade debt as collateral, FED has cornered short to medium term lending. Charging rates between 2-3%, coupled with guarantees of reverse swapation and income streams from various Managed Conduit Funds, FED dominates the market.

The Collection Agency rates FED as a Strong Buy.

Weekly Report 23 March 2008

2008-03-23T21:37:00.003Z

The Collection Agency - Weekly Report

23rd March 2008

Welcome to the Weekly Report. Firstly a big thank you for the interest in this article. From the reaction I have seen, it looks like I put into print what many were thinking. Enough hindsight, let us see what opportunities and risks face us in the coming week, or longer. We take a look at the Financials, looking for weakness and strength, wonder what the Dow has to say and have a look at gold and a few other commodities. We finish with an example of current living standards in the US, thanks to an email sent to me a couple of weeks ago.

Regardless of whether we consider the Fed/US Gov't (Fannie and Freddie especially) intervention into "free" markets as right or wrong, we have to be realistic and face the fact that it is happening. One of the worst mistakes you can make as an investor or trader is to fight the Fed. Their pockets go much deeper than ours and as I have said previously intervention begets more intervention. Are we facing a dramatic drop in the stock markets, the big one? Or will the Fed/US Gov't instil enough confidence to let stocks rally?

It's the big question and it is one you do not want to ask. So rather than stand on the rail tracks hoping the train will switch rails, lets see if we can highlight some possible trends. Keep in mind the following, regardless of what the media and shills will tell you, the macro-economic fundamentals are under stress, meaning more shocks are likely. In the shorter term leverage is being unwound on some positions whilst new positions are being created elsewhere. Volatility abounds, it may give us new opportunities but it can also severely damage your wealth. Use protection to stop contamination.

First up an old favourite (that may not last….) Dollar/Yen/Euro/Dow. I use this chart to spot changes in Forex flows over the medium term. Some of my longer suffering readers know I use $/Y to help identify carry trade flows in stocks and bonds. Whilst the carry trade continues this chart will be helpful.

In this version, Yen is shown as a baseline (hence 0%) and the dollar (pink), DJIA (red) and Euro (green) show their respective moves from Yen.

Click on image or here to visit the excellent Stockcharts.com interactive chart. You can change the baseline instrument by clicking the tabs at the top. Whose the daddy? The Yen, no doubt about it. Since June 07 even the almighty Euro has lost ground to the Yen, the damage to the dollar and dollar denominated Yen priced stocks is extraordinary. If you were a Japanese investor who bought stocks on the "dip" in August 07 you made a big mistake. If you sold Yen to buy dollar based assets, looking for the carry trade, you are crushed. Think of the charts you see pricing the Dow in gold, this is presenting the same scenario.

It gets worse, much worse. This next chart holds a warning about why policies that allow dollar devaluation will continue to damage fundamentals, we may be seeing an acceleration of foreign funds abandoning support for dollar assets.

Again thanks to Stockcharts.com. The two new lines are gold (turquoise) and the 10yr Treasury bond yield (pink) using Yen as the baseline. The one profitable carry trade, gold, has taken a big hit. Japanese/Yen borrowing investors must be wondering where they can get any return on the carry trade.

We are at a critical junction here, either direct Central Bank intervention stops Yen appreciation (remember Yen is up against just about everything) and restores stability or we could see a capitulation. With a lack of credit liquidity and therefore further leverage unavailable for Hedge Funds, Banks and Institutional Brokers, no wonder the Fed has spread its largesse this past week. If the carry trades in Financial Sector cannot add capital (margin calls) or double up, hoping for a reversal then they are stuffed, roasted alive.

So what will be the outcome? Let us look at this realistically, not at what should happen but at what the interventionist policy prone Central Banks are likely to do. We do not want to get caught on the wrong side of this.

As much as I would hate to see it on a macro-fundamental long term view because of the damage it will cause, I think Central Banks will intervene, they know of no other reaction. The only question open now, in my opinion, is the timing. Do the Central Bankers wait for the beginning of a capitulation move or do they move earlier to try and prevent it?

Looking at the timing the Fed took over Bear, they were deeply concerned about the Far East reaction (Greenspan was asked what would be the biggest change to his routine after he left the Fed, he replied "not having to check the Tokyo markets first thing in the morning") and ensured the plan was released before Far East markets sold off heavily (they bounced on the announcement). So we need to be prepared for an attempt to push the value of the Yen down, to re-invigorate the carry trade and stop Yen based losses. If such intervention does happen (I could be wrong, I have been before) the rally in stocks could be fast and large. As the Financials would benefit the most, I would expect them to rocket higher.

However, any such move may well be temporary. Remember, Banks, Institutions, Primary Dealers and through them Hedge Funds are surviving on the Feds willingness to lend. The Fed will want their money and assets back (with a profit, notice Fed lending is not free) and a rally could well be an opportune time to unwind positions, drawback leverage and withdraw credit facilities on repayment. Look for strong hands to sell into the weak hands who buy. Keep an eye on the financial media, if it starts telling investors that the good times are back, be wary.

Finally on the subject of Yen carry trades, I did a bit of digging, looking at $/Y and 3 month Treasury Bill yields. I went back to 1980 to encompass 4 recessions, mainly to see what effect recessions had on Fx rates and yields. I got more than I bargained for.

$/Y is in blue, 3 month T-Bill rate in red. Some important points show up here. Falling yields weaken the dollar, rising yields strengthen it. Since the double dip recession in the early '80s there is a strong correlation to this link and showing that yield moves lead FX changes. We can see the effects of Japanese Central Bank interventionist policies from 2001-05 as the dollar was propped by the Bank of Japan which mitigated but did not break the correlation.

Now we shouldn't map the future according to the past, we avoid it wherever possible but Central Banks tend to rely on the past to give them lessons for the future. Let there be no doubt, either the Fed has to raise rates to stop $/Y descending into the abyss or the Bank of Japan has to intervene and prop the dollar by selling Yen.

What are the chances of Ben "chopper" Bernanke raising rates in the next 6 months?

Intervention from the Bank of Japan becomes the last hope of the carry traders, without it all of the emergency actions taken by the Fed will come to naught. I may not like the Feds policies or direction but I do not think they are stupid. It seems to me that the Fed has laid the foundations for the Bank of Japan to build upon.

So how can we ensure that if/when intervention occurs we are not standing in front of the train?

You do not want to be caught in short positions on dollar based shares as a re-invigorated carry trade will home in on perceived Yen priced value. If the dollar climbs against the Euro be careful going long on speculator dominated commodity positions. Whilst in the big scheme of things such actions by Central Banks can only be temporary, remember timescales are relative. A temporary move by Central banks can last 1-2 years, sometimes longer. That is far too long to attempt to fight the trend as a trader.

Here is my long term trend chart of the Dow:

The trend is still down but we have an important attempt to hold the 2000 high as support. Note the retest of the moving average. It looks to me that over the next 2-3 weeks we may well get to find out if concerted, combined Central Bank intervention is to take place. You do not want to be on the wrong side of the move whichever way it goes from here.

Lets look at a few daily charts of financials both in the US and UK (The Bank of England, as reported by The Sunday Times, seems to have decided to use Fed style tactics to support Financial Institutions, although Merv King did say his remit did not stretch to "propping up the banks' profitability") remember, don't fight the trend.

Goldman Sachs:

Citigroup:

AIG:

BAC:

UK financials:

Barclays:

HBOS:

RBS:

There are other Financials worth watching too but I cannot discuss them.

Finally gold:

I have a position but it's a hedge and therefore unaffected by whichever direction gold chooses to go.

A couple of weeks ago a reader sent me his thoughts on the current economic climate along with his personal experience and situation in life. Normally I wouldn't do this but I think it may strike a chord with many readers.

M***, a US veteran living in Oregon, didn't rant or ask for anything, he just wanted to show his frustration at seeing old mistakes from the past repeated in the present. Notice that M*** is not a spendthrift, he is solvent and responsible:

"The day before yesterday I tanked my truck up to the tune of $79.50 (I already had a quarter tank) and used my debit card by mistake rather than my credit card, easy enough to do since both are WaMu MasterCards. So, realizing that, I had to go yesterday to the bank to make a cash advance on my credit card to deposit into checking to make sure I did not have an NSF fee of $32. Like so many other Americans today, this is just how fine a line I tread in daily living though my gross income is now over $51K and I am single with no dependants, and I do not work but am a disabled vet who also gets social security disability. Thank god I only have a total of $1*K in debt for my truck and credit card and nothing else.

Well, since banking today is more or less an exercise in futility, yesterday was no exception. The bank has new rules and I was not allowed to take a cash advance from credit for deposit into checking, I had to go to a payday loan shark for the money to avoid the NSF fee. So maddening when I get paid on Wednesday anyway.

Frankly, I wonder how much longer WaMu can stay in business, I doubt it will be allowed to fail entirely, but more like folded into another bank, or carved up and sold off piecemeal for pennies on the dollar. You know last year in the summer I went to them to ask about a veteran's home loan when I was thinking of buying a condo, they told me they no longer do those loans. Loans mind you that are backed by the VA. Also, when Wachovia took out two truck payments last summer in one month and messed me up, then refused to make a refund of the overpayment I went to WaMu to refinance my vehicle there, I was told that no longer do any form of auto financing, I went through State Farm instead.

I am a prisoner of this system though, as a recipient of two federal benefit payments per month, each requiring direct deposit, I may find one day that I cannot access my income at all. I already feel like I am on the border of what is referred to as working poor income levels, that is income adequate to stave off real poverty, but not enough to live well or even buy a house. I got by better two years ago on the VA income alone than I do now on combined VA and SSA incomes though both have had small COLA's since. I estimate that more than one third of my purchasing power has been lost to inflation in the last 35 months since I moved to ******.

It is my opinion that the rest of America will do what I am doing, cutting back all but the very most necessary spending, I eat little meat anymore, and never go to restaurants, I even get haircuts only about every three or four months and then I just have it buzzed off. I refuse to pay $25 for a haircut with tip, and if McDonalds wishes to grant themselves an 11% across the menu raise when I cannot do likewise then they will have just lost my business (I remember when a great steak dinner out was cheaper than a big mac meal is now, and it was not THAT long ago).

I think few Americans under the age of 40 can remember just how painful stagflation is, in my county on the ***** coast in the seventies the unemployment rate was 30%, I faced graduation in 1976 with no prospects for either work or college. I had no choice but the military. They never called it a depression, but for much of America that is just what it was.

So, I economize to the maximum extent I can and buy silver with what I can scrape up each month. It is not a lot of metal, but it is infinitely more than 90% of Americans who have laid nothing real aside for harder times. Mr. Bush and his NeoConmen have looted the nation and the piper is coming up the footpath to our collective doors, they may never call it a depression but no matter what name they offer it will come faster and crush more than any of your readers will ever understand.

Thanks for letting me vent and thanks for your great work, keep it coming.

M***"

Thank you M***.

A Reply to John Mauldin’s Outside The Box - Let’s Get Real About Bear

2008-03-19T15:27:00.002Z

An Occasional Letter From The Collection Agency

A Reply to John Mauldin’s Outside The Box - Let’s Get Real About Bear

I have been, and still am, a long time fan of John Mauldin (JM). I enjoy his take on the bigger picture, even if there are areas I disagree with, from time to time. Generally my disagreements are more to do with the severity of a particular problem or the benefits of a highlight. For instance, JM might allude to a recession but think that it will be mild and happen over a certain time scale, fitting his “muddle through” model. I would agree with the talk of recession but not necessarily the depth, timing or effect. You get the point.

However the JM article “Let’s Get Real About Bear” has somewhat shocked me at a fundamental level and it deserves a reply. Let me say this from the beginning, I do not intend to start a war of words or change JMs thinking. Neither approach is constructive or conducive to open discussion of a truly fundamental part of the US and Global economy. This not a good vs. bad scenario, I have little or no doubt that JM is a well read, intelligent, honest and thoroughly nice bloke. I am a trader/blogger that very few have heard of or know, using the internet to foster thought. (As an aside, I asked JM to have a look at my writings and consider maybe using an article in the OTB edition. The answer is within his Bear article. Sometimes trying to be a “platform start up” has its knock backs. So no hidden agendas and yes, I fully expect to be viewed as the “Darkside”. Ahh the fun of blogging.)

Here is a link to the JM article at Investor Insight. Please read it before going further. I am not going to discuss the 2 other articles appended to JMs writing.

JM is an investor/advisor who looks to get real returns beyond the effect of inflation. He operates in the free markets, looking for advantages that return above the “norm”. He searches for new, innovative technology that may become the “next big thing”. He is a capitalist, using the capitalist mechanism. He knows the risks and tries to avoid being on the wrong side or if that fails to mitigate the risk to his capital. I do the same as do most investors and traders. It is the way of the financial world. There are upsides and downsides, we know the risks and rewards, and the rules of the game are simple.

Unless, that is, you decide that the rules can be bent to accommodate failures, to mitigate the downside. Such an approach leads to tyranny, it destabilises the system causing feedback loops, encourages excessive risk taking and allowing that risk to be ignored and causes confidence in the financial structure to erode.

This is big picture stuff. It is not about 17000 jobs at Bear Stearns; it is not about a loss on share portfolios suffered by employees. Protecting a company and its share price is never a reason for intervention and the introduction of moral hazard.

Bear and its employees would not be in their current circumstances if they had obeyed the rules and understood the game.

Bear Stearns went bust because of a lack of confidence in its collateral used to finance its lending. Customers and Lenders walked away because the risk of staying was perceived as too great. It was the risk that Bear Stearns took using its business model and allowing exposure to be greater than its ability to pay. The Capitalist System did its job; it rooted out a bad business model and laid it low. If you took losses, I am genuinely sorry for you but you knew the risks. We all take a loss sometime. If it wiped you out then you did the same as BS, you allowed exposure to a risk to grow well beyond acceptable limits.

Does this sound harsh, a bit heavy-handed? It probably does but it isn’t me saying it, it’s the free market shouting loud as it does every trading day.

JPM have stepped in and offered $2 a share for BS. We have seen such action before, a fast move to grab assets perceived as cheap. It happens in the capitalist marketplace. The risk is transferred to JPM equity holders, JPM write-down $6Bn to acknowledge that risk. The trouble is the whole JPM move was not a function of the free market. Without The Federal Reserve accepting who knows what BS assets as collateral on a $30Bn loan this deal would not have taken place. Even worse JPM get rewarded by asset grabbing at an extremely cheap price. (I suspect we have not heard the last of that either).

JM contradicts himself within the article as he attempts to align the adoption of allowing a moral hazard to exist within the market. I quote:

“And I can understand the sentiment, as it appears that tax-payer money may have been used to bail out a big Wall Street bank that acted recklessly in the subprime mortgage markets. But that is not what has happened. This is not a bailout.”

But just a few lines later he is forced to acknowledge the underlying fear his readers have emailed him about:

“Yes, tax-payers may eventually have to cover a few billion here or there on the Bear action. But the time to worry about moral hazard was two years ago when the various authorities allowed institutions to make subprime loans to people with no jobs and no income and no means to repay and then sold them to institutions all over the world as AAA assets. And we can worry in the near future when we will need to do a complete re-write of the rules to prevent this from happening again.”

You cannot expect market participants to accept such reasoning unless you believe intervention is right and proper. If you do think that way then your perception of risk has to be misplaced.

So, it is more than possible that Tax-payers will face a bill for this bailout. The moral hazard, as the UK Govt discovered after Northern Rock is that if you “cover one bet, you cover them all”. The extension of liability and assumed enlargement of risk becomes burdensome and affects the fundamentals underlying the national economic base.

Today in the UK, there are rumours, denied by the BofE and the bank in question, that a Bank may or has a requirement for emergency funding. Regardless of the truth or otherwise, this has directly affected Sterling vs., of all things, the dollar:

The ellipses are the main points when rumour surfaced and re-surfaced. This is what acceptance of a moral hazard can do to a currency. I picked the $ as a comparison because it is weak, it shows the inherent weakness of Sterling under such circumstances. This is not a theory of mine, based around musings of economic facts and figures. This is market action telling us a story. Ignore the tale at your peril.

Should Bear have been allowed to go bust? Without doubt the answer is yes and to some extent JM agrees:

“If it was 2005, Bear would have been allowed to collapse, as the system back then could deal with it, as it did with REFCO. But it is not 2005. We are in a credit crisis, a perfect storm, which is of unprecedented proportions. If Bear had not been put into sounds hands and provided solvency and liquidity, the credit markets would simply have frozen this morning. As in ground to a halt. Hit the wall. The end of the world, impossible to fathom how to get out of it type of event.”

A very scary (and quite possible) scenario. JM is saying that current market conditions are not conducive to failure of a Financial Institution.

Well I’m sorry but these events happen because of the prevailing circumstances. Banks don’t go broke at the top of the cycle, failures occur when times are getting hard. It is the nature of the beast. To say the System cannot tolerate such an event is to deny the reality of capitalism. It encourages the acceptance of a safety net, a guarantee that regardless of the poor decisions and risk calculation taken there will be no failure.

This is truly a refutation of a capitalist, free market. No wonder CEOs take what seem to be enormous risk free assumptions about the future and the effects of their actions and decision upon the prospects of the company. They have nothing to fear. CEOs get their compensation, shareholders get a ride, and all is well. Until the cycle turns. The CEO has departed by then, either as part of a merger or retirement with an enormous compensation package. The shareholders are the weak hands, the strong hands sold at the top. Who cares what happens to the weak hands? Moral hazard isn’t just about tax payers.

JM quantifies what he thinks the damage to stock markets could be:

“The stock market would have crashed by 20% or more, maybe a lot more. It would have made Black Monday in 1987 look like a picnic. We would have seen tens of trillions of dollars wiped out in equity holdings all over the world.”

Again, I agree that losses of 20% or more could happen and still might. The reason it would have made Black Monday look like a picnic is because it was a picnic. In 1987 we didn’t have the massive expansion of innovative financial instruments, back then Futures and Options were complicated! If the free market decides it needs to provide a re-pricing then it should be allowed. After all, no one worries about the same mechanism working to the upside.

Would credit markets have closed, seizing up under the financial stresses? We don’t know. Let us assume that they would. So what? The weak debt would have been expunged, albeit on a massive scale. Would there be pain? Yes, massive amounts of pain would ripple through the global economy. Would it be the end of the world? No, it would not, prices would reset on the re-opening, risk would have been priced in - in full. Markets would continue to function, even if the players had changed or some disappeared. Eventually all this will happen and the outcome will be the same, we are living it right now. Delaying the inevitable whilst a transfer of liability occurs does nothing but risk the underlying fundamentals of the economy to further attacks and stress.

Does the acceptance of an enormous level of moral hazard have a justification? Again I quote JM:

“But for now, we need to bail the water out the boat and see if we can plug the leaks. Allowing the boat to sink is not an option. And get this. You are in the boat, whether you realize it or not. You and your friends and neighbors and families. Whether you are in Europe or in Asia, you would have been hurt by a failure to act by the Fed. Everything is connected in a globalized world. Without the actions taken by the Fed, the soft depression that many have thought would be the eventual outcome of the huge build-up of debt would in fact become a reality. And more quickly than you could imagine.

As I have repeatedly said, recessions are part of the business cycle. There is nothing we can do to prevent them. But depressions are caused by massive policy mistakes on the part of central banks and governments. And it would have been a massive failure indeed to let Bear collapse. I should note that this was not just a Fed action. Both President Bush and Secretary Paulson signed off on this.”

Quite simply (and JM touched upon this) intervention has exacerbated the conditions we live in. What was a normal business recession has been morphed into a possible depression. Not by capitalism or free markets but by centralist, socialistic interference.

Remember, last year when Bear closed down and re-capitalised the failed Hedge Funds? This was viewed as one of the problems that required action by the Fed. The intervention failed. All it achieved was a redistribution of risk to the Tax payer and JPM shareholders. The risk is not diminished; adding capital to a margin call does not make the position “safer” or profitable. It just risks more capital.

Trying to justify intervention by invoking fear may work at a human level but free markets ignore such reasoning’s. As far as the markets are concerned the game rules say you are responsible for your own risk management. If you fail to play the game well, you will lose or be given a disadvantage. Attempting to change the rules to favour one side breaks the game. The consequences of that are with us now.

JM defends his stance by pouring scorn on those who believe in free markets. It may also be the reason he didn’t like my writings. (This is fair enough, not every viewpoint that is contradictory to your own needs to be accepted).JM:

“I repeat, this was a good trade from almost any perspective, unless you are from the hair-shirt, cut-your-nose-off-to-spite-your-face camp of economics.”

I am a bear in the current climate, I have been a bull in the past and I trade both ways. In other words I am a realist, I may be bearish on macro-economic fundamentals but I can ride an uptrend when I see one. To use such an expression as JM has written to pooh-pooh those who believe in free markets shows a lack of argument. I have news for you all, regardless of your economic “bent”, unless you are prepared for events now you will all have your noses cut off.

Finally we look at the outcome of the current turmoil. Again JM is specific:

“It is precisely because the Fed is willing to take such actions that I am modestly optimistic that we will "only" go through a rather longish recession and slow recovery and not the soft depression that would happen otherwise.”

Does that qualify as “muddle through”? JM was looking for a muddle through scenario until very recently. I don’t think a longish recession and slow recovery qualifies. Muddle through to me was below average growth not contraction. There is no blame to attach here, it is just recognition that realism is useful and has a place in financial thinking. It is realistic to believe that if a moral hazard in the UK can affect the worth of that country’s currency, the same should be applied to any other government that accepts moral hazard can be introduced into the game rules. As we have already seen, intervention begets a further expansion of intervention.

JM makes a final point that the problem is so large and the effects on the “small guys” would be so great (i.e. small guys do not know about risk?) that a true re-pricing event would cause devastation. He also says that a lack of intervention caused the current turmoil. Other than a non-acceptance of capitalist free markets as a true reflection of worth, the blame appears to land at the door of the Government and the Fed. Boy they can’t win in this discussion.

Regulation is what JM is alluding too, or the lack of it. At what level though, the relaxation of credit lending standards? (Surely a bank decision). A lack of oversight in mortgages? (Greed from all parties overrode risk appraisal, including the consumer). A lack of transparency in credit markets? (Transparency is there, you just have to pay for it).

What exactly were the Fed and Govt agencies supposed to do? Regulate every transaction? Greed finds away around regulation, be it loopholes or flat out illegality. You can regulate for every function but it does not stop attempts to circumvent it.

If you want to correct an interventionist prone capitalist system then allow it to purge itself and reset the boundaries of its influence based on truth. If you want to get a rating on a debt package you wish to sell in the marketplace then tell the truth. Open the books, show the risk and accept the price that the market sets. You even save money on not paying a Ratings Agency.

Only this will restore confidence in the markets. If it means prices are lower (or higher for the good stuff) so be it. Its not the price that wipes you out, it’s the re-pricing when the truth comes out. Attempting to interfere and tinker will just cause greater imbalances and risks and lead to further opaqueness.

Maybe JM has forgotten how he worried about the costs of today being visited upon future generations. Intervention will ensure that such passing on of the debt will happen.

My thanks for your time if you have read this far, I appreciate it. Now, I may be inundated with emails after this article (or not!). Please don’t be offended if I fail to reply to them all. Please remember, I have written this letter not to ignite feelings but to open up an important debate. On Sunday I will be reading and enjoying JMs email, as usual.

The Weekly Report 16 March 2008

2008-03-16T18:45:00.002Z

The Collection Agency - Weekly Report

16th March 2008

Welcome to the Weekly Report. Events are moving at an accelerated pace requiring further Central Bank intervention as Hedge funds and Investment Banks are hit by ever tighter credit conditions and a run on deposits. I make no apology for using the past weeks events as the central theme for the coming week. Without doubt we have entered a new phase in both the financial and monetary spheres of the Global economy.

First up is US Tsy Sec Hank Paulson who had some rather strange advice for Financial Institutions. He warned that the largest US banks should raise extra capital beyond the $70Bn already accumulated in order to prevent the credit crisis from worsening. He went on:

"We are encouraging financial institutions to continue to strengthen balance sheets by raising capital and revisiting dividend policies ,…… We need those institutions to continue to lend and facilitate economic growth."

I have some bad news for anyone relying on Mr Paulson to come up with a solution to the credit crisis. The statement shows a complete lack of understanding of what is currently happening. This is not a crisis, this is a full blown, unfolding before our eyes, collapse in confidence in the fiat monetary system.

The complete lack of innovation by Banks, Hedge Funds, Financial Institutions, Central Banks et al in response to the beginning and current situation is staggering. What have we seen so far?

Consumers will get some legislation (passed eventually) it will be too little, too late to save them.

Financial Institutions get instant, on demand, no books read bailouts from the Fed. If you are not a Primary Dealer and not entitled to access the Discount Windows, don't worry, the Federal Reserve will funnel the money through a PD, it saves a lot of regulatory hassle. It helps if your party and counterparty risks are huge, then you get classified as "too big to fail" as the domino effect would destroy the current credit system.

Within Paulson's comment we see the lack of understanding of what Financial Institutions (Large Banks and Primary Dealers) are already doing in an attempt to stave off the biggest financial disaster in 100 years. They are already raising capital by calling in loans, regardless of risk. It doesn't matter if you are a Hedge Fund using borrowed leverage to deal in AAA rated Municipal bonds, the FIs are calling in the loan, raising margin requirements or asking for more and higher rated collateral on any borrowings. This is no surprise, anyone who watched what happened with Asset Backed Commercial Paper (ABCP) last year could see this coming. The Financial Institutions are not recouping capital to re-invigorate lending, they are just hoarding cash to ensure they can meet their own capital requirements and hunker down to survive the approaching disaster.

Credit markets have not seized up due to a lack of capital per se, they seized up due to a lack of confidence in the ability of collateral to keep its worth and the rising risk that any Insurance used might not pay out. The "buck" didn't stop here, it stopped everywhere.

A fiat monetary system, built on the use of credit as a driver for economic growth, is utterly reliant on confidence. If action is taken that undermines that confidence then the system stops working.

This is not a new phenomena, the evidence is already on display. The rise in commodities, i.e "stuff" is not a function of inflation. It is a rise in the lack of confidence of fiat money. When the dollar, the current world trading benchmark, is debased you place your capital into assets that have a tangible worth. They cannot be eroded or re-valued by the actions of a Central Bank, they are worth something to someone. The dollar does not have the same worth. It functions only because of the confidence placed in the assets that underpin it.

Devalue the assets and you devalue the dollar. The Fed has decided to swap US Treasuries for so-called AAA rated debt backed bonds, not placed on "watch" by the credit rating agencies, currently on the books of Primary Dealers. The risk of default on the debt has not been reduced, it has been transferred from private Financial Institutions to the US Government and the tax payers. All of the Feds actions are just to allow the current credit lending mechanisms to continue.

Devalue the assets, devalue the dollar. The cure to all these ills that Paulson refers to is an illusion. The FIs have bought time, swapping their collateral to the highest standard, allowing them roll their own borrowings whilst calling in monies and assets owed to them. It helps when you have to go begging to Sovereign Wealth Funds (SWF) to raise more cash. Don't expect an increase in dividend payments on your banking shares either, in fact don't expect dividends from a number of Financial Institutions for some time. Hank said it is okay not to pay out. It's the patriotic thing to do.

How much capital do Financial Institutions need to reclaim?

Here is the latest update, notice it does not include the increase in TAF. As I suspected, the TAF is being increased to keep total reserves stable.

We know the situation has deteriorated with TAF limits now pushed out to $100Bn. Doing a simple calculation, it would appear that the update to the chart above (if total reserves are to be maintained at around $43Bn) will show non borrowed reserves are now at or headed for net minus $57Bn (TAF minus total reserves). When we drop into The Slosh Report (highly recommended for Fed watchers) we see that the total amount lent out by the Fed is currently $60Bn of which $44.8Bn is collateralised by Mortgage Back Securities (MBS).
The Financial Institutions are in the hole to the Fed for between $101.8Bn up to a possible $117Bn. Obviously this does not include any borrowings made with other Central Banks, Institutions or SWFs.
Let us make an assumption that the "Fed capital" is required to shore up FI borrowing positions and that they will have to repay it some time in the future. We will use the lower figure of $101.8Bn and a leverage of 5, which is probably very generous. FIs have a minimum of $509Bn in positions reliant on continued Fed lending. If the FIs have (want?) to cover then they need to reclaim $509Bn from the financial system. To do that they stop lending, call in margin, make margin cover and leverage more onerous and close credit lines and facilities.
If the $509Bn is leveraged by a factor of 10 by the borrowers (Hedge Funds, Mutual Funds, Insts, Private Venture, Buy out vehicles, off balance sheet vehicles etc) then the drawdown on the financial economy to close out could amount to $5090Bn.
Any attempt to do this in a disorderly fashion would result in financial Armageddon. Thus we see the rationale behind the Feds actions. It is an attempt not to mitigate the pain but to drip feed it, a little at a time, so the markets only feel a series of pinches, not a right hook. The result however will be the same.
If I had any funds invested with Hedge Funds or leveraged accounts I would be looking for the door. It is more than feasible that the situation is worse than the current headlines.
I have been watching the actions and words coming from PIMCO, specifically Bill Gross and his call to reject the worries of moral hazard:

" And if Washington gets off its high "moral hazard" horse and moves to support housing prices, investors will return in a rush. PIMCO wants to sit at this more attractive return table - to provide an attractive return on your money (no matter what the asset class) as well as a return of your money. No Old Maids. No silicone AAA ratings. And ladies - no crotchety old bachelors either. The game, as well as the name of the game, is changing. It's no country for Old Maids anymore."(his emphasis)

At first glance its strange to see a bond maven calling for such a move, his job is to oversee investment to make returns on capital based on his projections for the future economy. Then I noticed this line in his March 2008 Investment Outlook letter:
"Old Maid now has a second life mimicking our financial markets, and at PIMCO we've played it frequently in our Investment Committee over the past several months. "Who's got the 'Old Maid'?" we ask over and over again - not to make us feel good that we don't - but to make sure we won't draw it when its holder tries to pass it on."
Mr Gross is saying, quite rightly, that his job is to avoid any potentially toxic assets leaking into his pond. Unfortunately sometimes a previously healthy asset already in the pool begins to decay, leaking toxins into the pond. In a small pond its easy to fish out the decaying matter, in a large lake, filled with cumbersome assets it can be much more difficult.
Has PIMCO found an Old Maid hidden in its hand?
Consider this, from Bloomberg :
"Ross, chairman of WL Ross & Co., and Gross, chief investment officer of Pacific Investment Management Co., said they jumped at the chance to buy $1 billion of municipals each. Their interest helped to drive last week's rally in fixed-rate debt. Investors remain concerned that a flood of new issues from borrowers refinancing auction-rate debt will overwhelm demand while hedge funds and banks pare their purchases, analysts at New York-based Citigroup Inc. said in a March 7 report."

Now this could be viewed as an attempt to capture some cheap assets with high yields. It could be viewed as an attempt to catch a falling knife. I don't think the reasoning behind such a move is either of these options. Mr Gross has no qualms about causing a moral hazard which in financial markets means intervention. I suspect the intervention, an attempt to restore confidence, has more to do with PIMCOs own position than it does with the Municipal Bond market.
A quick look at Allianz Global Investors site highlights PIMCO exposure to Municipal Bonds. The PIMCO California Intermediate Muni Bond Fund A (PCMBX) has total fund assets of $130.5m, PIMCO California Short Duration Municipal Income Fund A (PCDAX) $14.7m and PIMCO High Yield Municipal Bond Fund A (PYMAX) $167.5m.
However, the Fund that caught my attention was one that you might not expect to find, if your notion of PIMCO is as a safehaven:

PIMCO All Asset All Authority Fund A (PAUAX), total fund assets $772.3m, here is a description of the fund:
Portfolio Construction
"PIMCO All Asset All Authority Fund's portfolio invests in an expanded group of PIMCO mutual funds, rather than in individual securities, providing access to a variety of investments across both traditional and alternative asset classes. These underlying funds cover the full spectrum of traditional sectors of the stock and bond markets, as well as other asset classes, such as Treasury Inflation Protected Securities (TIPS), commodities, and real estate. Using a dynamic asset allocation strategy, as well as the potential use of leverage to attempt to enhance returns, the Fund's manager seeks to identify those asset classes and sectors that offer the most value at a particular point in the economic/market cycle. In keeping with PIMCO's dedication to risk management, the Fund contains internal guidelines to optimize risk controls, including:

No more than 50% invested in any single underlying PIMCO Fund.

No more than 20% invested in PIMCO StocksPLUS Short Strategy Fund.

No more than 50% invested in PIMCO Funds that track U.S. equity indexes.

No more than 331/3 % invested in PIMCO Funds that track non-U.S. equity indexes.

No more than 662/3 % invested in U.S. and non-U.S. equity funds combined.

No more than 75% invested in PIMCO Real Return Strategy Funds."

I have no doubt that Rob Arnott, the fund manager, is a sharp cookie and may well be rotating successfully between asset allocation models. What we don't know is the current composition of PIMCO mutual funds used within PAUAX and the amount of leverage currently employed. Maybe I am worrying too much, maybe things are fine and dandy at PIMCO. Then again, I have preserved a lot of capital by worrying.
That's it for this week, I have to finish this early today. Keep an eye on financials and Insurance (all types) as a measure of further market distress or intervention.

Pre-emptive warning of a major banking crisis

2008-03-12T20:06:00.000Z

An Occasional Letter From The Collection Agency

Presents a

Pre-emptive warning of a major banking crisis

When asked what represented the greatest challenge for a statesman, British Prime Minister Harold Macmillan responded in his typically languid fashion, "Events, my dear boy, events."

I wonder if any of the Fed Committee members recalled that quote during the video-conference held the day before the announcement of the "new" Term Securities Lending Facility (TSLF). It seems events are occurring at a faster pace than the Fed anticipated, causing more emergency plans to be put into operation.

One of the quirks of investing and trading is that news becomes old hat or familiar in a short space of time and actions that were seen as emergency responses become accepted after a few days or weeks. Not that surprising I suppose when the emergency is among the Banks and Institutions required to make the monetary system work.

After an increase in the size and frequency of repos, including the introduction of two 14 day rolling repos and discount rate cuts; the next crisis was met with the introduction of large cuts to the Fed Funds Rate and the introduction of Term Auction Facilities (TAF) and dollar lending facilities to other Central Banks. Then this week, after further rate cuts, the Fed enlarges the TAF, increases the dollar lending and introduces TSLF.

So here we are, 8 months since the sub-prime implosion morphed into a credit market crunch that ate Bank capital reserves at a phenomenal rate and the Fed launches another lifeboat from stricken USS Irresponsible Lender. Only this time there is no pretence of rescuing the passengers on the stricken liner, this lifeboat is exclusively for the Bankers, the crew of the USS Irresponsible Lender.

Let us first look at the new lifeboat, the TSLF. Here is the Fed statement on the matter:

"The Federal Reserve has announced that the Open Market Trading Desk ("Desk") will expand its securities lending program and initiate a Term Securities Lending Facility ("TSLF"). Under the TSLF, the Desk will lend up to $200 billion of Treasury securities held by the System Open Market Account to primary dealers secured for a term of 28 days by a pledge of other collateral. The Desk's current overnight Securities Lending operation will continue with no changes to program terms.

Weekly TSLF auctions will alternate collateral schedules resulting in a bi-weekly cycle for each pool of eligible collateral. In the first auction, the Desk will arrange an auction for a loan of Treasury securities against a pledge of all collateral currently eligible for repurchase transactions currently arranged by the Desk. In the second auction, the Desk will auction Treasury collateral for loan against a pledge of AAA/Aaa-rated private-label residential MBS not on review for downgrade, as well as collateral currently eligible for Desk repurchase transactions. Loans and collateral will be exchanged free of payment between securities accounts at the dealer's designated clearing bank. Loans will settle on a T+1 basis.

Each TSLF auction will be for a fixed amount announced ahead of the auctions. The first auction is scheduled for March 27, 2008, at 2:00 p.m. Eastern Time and results will be posted to the Federal Reserve Bank of New York shortly after the auction close.

The TSLF will be a single-price auction, where accepted dealer bids will be awarded at the same fee rate, which shall be the lowest fee rate at which bids were accepted. Dealers may submit two bids for the basket of eligible Treasury general collateral announced at each auction. At the TSLF auction, each dealer aggregate award and each individual bid will be limited to no more than 20 percent of the offering amount.

The Desk will consult with the primary dealers on technical design features of the TSLF in the coming days and specific auction details may be adjusted based on these conversations, experience in the initial auctions and market conditions." (My emphasis).

Primary dealers (PD) get treasuries in exchange for other types of bonds they cannot use due to current credit market conditions.

There is however another factor that was pretty much ignored in the most recent developments. The Fed introduced a series of Permanent Open Market Operations, selling treasuries to PDs. So far there have been 2 POMO's (double the number for the whole of 2007), the first for $10bn and the latest for $15Bn. These are cash transactions; the Fed received $25Bn in cash and gave out Treasuries from the System Open Market Account (SOMA).

There can be little doubt that the current crisis is centered on the PDs and is directly related to a lack of usable collateral to enable PD borrowing to take place. That is, no one is willing to lend if the collateral is not AAA government debt. The Fed is attempting to relight lending by swapping usable collateral (treasuries) for other AAA/Aaa debt that is not at risk of downgrade.

If the Fed allowed free market forces to operate then the PDs would have to buy treasuries from the market to possess the collateral required to borrow. This is clearly beyond their ability as the losses realized from selling low and buying high would obliterate their balance sheets. The Fed has decided to meet the Bankers margin call.

You may ask "why didn't the PDs just buy the treasuries from the Fed?" A fine question that deserves a simple, observational answer.

The Fed has conducted two 1 month TOMOs in recent days, lending out cash and taking mortgage backed collateral in exchange. The amount lent out is $30Bn. So to raise the cash to buy the treasuries from the POMO, the PDs borrowed from the TOMO. What does that tell us?

Quite simply the PDs have no cash reserves. They are bankrupt. When I mentioned in the recent Weekly Reports that the Fed had temporarily nationalized the Banks/Brokers, this is what I meant. The Fed is allowing PD assets to be moved off the balance sheet and into a new investment vehicle. The only difficulty is how do you make the make the words "Federal Reserve" and "Structured Investment Vehicles" into a new acronym?

Right now the PDs are purely a front, emperors without clothes. Ben Bernanke is literally behind the curtain, pulling the levers. The problem for the Bernanke is the lack of levers, the SOMA is a finite resource, which I estimate to have $600Bn (ish) of usable collateral available. After using that resource the Fed would either have to buy newly issued treasuries from the US Government or issue its own bonds. That would mean either the printing of new dollars to buy the treasuries or the invention of a new dollar derivative to use in the credit markets. Either choice has inherent risks to the dollars worth. Other new initiatives may well be viewed as panic moves, the goodwill of market participants may have been eroded to zero on this latest "boost" in the stock markets.

Why did stocks go up? Maybe the Hedge Funds stopped getting pressurized on their leverage and margin, allowing them to buy. If it is down to such a tenuous reason then the rally will last until the next squeeze on the lenders capital. Maybe I'm wrong, maybe it was just seen as a good buying opportunity by one and all.

None of these measures help Corporate America or the US public other than to allow the continuation of further debt accumulation, hence Bernanke floating ideas such as debt relief on mortgages. I await his solution for Corporate America with baited breath.

The yield curve tells a story that things are not different. Click on the image below to see what the yield curve did at the beginning of the decade through to the current day. Press animate on the lower menu to start.

With thanks to Stockcharts.com

Take a snapshot of the curve toward the '01'02 divide and compare it to current conditions. You can see how long it took after late'01 for stocks to eventually bottom. Remember, post 9/11 the Fed was extremely active, especially helping the Banking/Broker sector recover. Maybe it's NOT different this time, maybe the reality is that long end rates have gone as low as they will?

This is central to the future prosperity of the US. With the Fed pushing treasuries into the market place, prices are now more likely to fall, causing yields to rise. Fed rate cuts are only affecting the short (duration) end by steepening the curve, allowing a borrow short to lend long trade - just like the strategy used in the Commercial Paper markets prior to the credit crisis.

Whilst such a mechanism might help the Banks etc, it will force rates higher on loans, credit cards and mortgages. It will also require higher yields on corporate debt. Here is the rub, to recharge the reserves of the Banks; the money has to come from outside of the banking system. That means higher costs to the public and Corporate America. That means a domestic US deflation as the money supply is reduced.

For consumers that has already begun:

Even with rising CPI - including energy and food, the consumer is now spending less on a y-o-y basis.

For Corporate America you can see the problem:

Notice the beginnings of a move higher for both Aaa and Baa debt even after the new premium built in by the fall in treasury rates.

Thus we are left with 2 possibilities for events further ahead.

If the measures taken by the Fed are long term (and I cannot see how they can be viewed any other way for them to be effective) then rates will rise as treasuries flood into the market and the dollar suffers further devaluation. This will stifle new lending and causing an increase in default on current lending. It should not be forgotten that if paper, other than treasuries, is no longer acceptable collateral to facilitate lending then the credit markets will remain frozen for everyone other than those with treasury holdings.

The US (and World) financial system is reliant on credit to enable production, where borrowings are used to increase productivity returns beyond the capital borrowed and the cost of servicing the debt. It is when an expansion plan fails that debt has to be rolled over by Corporations.

Eventually the cost of the increasing burden of servicing debt coupled with a false measure of productivity meets an event, the inability to roll debt forward due to a lack of lenders. At this point the Corporation defaults. Corporations with strong cash reserves and low/no borrowing will survive, employing their savings (cash reserves) to expand productivity.

The consumer has already reached the event moment. The consumer's productivity is rewarded by wages. If however assets are bought using debt and the future payment of that debt is reliant on asset appreciation, then the risk of asset depreciation requires even higher productivity from the consumer or further lending to push out the timescale to allow the appreciation to occur.

If we discount the ability for many to borrow then the only recourse is to earn more and either service a higher percentage of the debt (increase payments) or save until the asset price is met. If consumers are in unproductive jobs then the expansion of wages is unlikely, indeed the risk will be a curtailment of employment. Both situations result in a deflation of the amount of money circulating an economy.

Both the consumer (public) and Corporations will survive albeit without some current participants. The debt will have been cleansed and true savings and investment will allow the purchase of assets and proper investment. The only downside is the loss of revenue for the Bank/Broker sector, whose survivors will return to more stringent and traditional methods of banking.

If the Fed plan fails and credit markets become even more chaotic then the disruption will spread to all sectors of the global economy.

How can the Fed plan fail? The risk is with the dollar. If the action taken by Bernanke is seen as a massive dilution of the strength of the dollar then it and its derivatives will all fall in price, regardless of any concerted cooperation by Central Banks.

If the markets believe the treasuries constantly introduced into the market are being used to shore up massive losing positions then the risk of default will increase. This will cause a fall in the price, placing the PDs with a further tranche of "sold low, buyback high" assets. With a lower pricing on dollar derivatives, the dollar will suffer the same fate as underlying loans have in MBS derivatives. The mechanism is the same.

With the Fed placing itself in a position were it holds lower worth assets than the treasuries it issued, the risk of a default by a PD becomes a risk to the Fed. In default the PD will have to hand over the treasuries used as collateral, leaving the Fed no better off than an SIV stuffed full of toxic debt that is unable to raise funds in commercial paper markets. The risk would be a loss of confidence with the Fed as an Institution.

The question posed is would the Fed allow treasuries lent out to PDs to be taken by creditors in the event of a default?

Weekly Report 9 March 2008

2008-03-09T22:59:00.001Z

The Collection Agency - Weekly Report

9th March 2008

Welcome to the Weekly Report. This week the Federal Reserve made its intentions clear and set a course into uncharted waters, taking the US citizen to the land of deflation. We look at the reaction in the fixed income markets, take a long term view of the Dow using 2 propriety indicators to help identify long term trends and wonder what Fitch has done to upset MBIA.

The Federal Reserve has decided to acknowledge that the Banking system is in total disarray and is now unable to meet its own obligations. Some of you may remember I referred to the banking cartel as being "sub-prime". I also pointed out a couple of weeks ago that the Banks no longer have any capital reserves that are usable. In other words all capital is now employed in current leveraged positions. Losses in those positions that result in margin calls, requiring more capital, are now being met by the Federal Reserve through repos (repurchase) and the TAF (Term Auction Facility). As the stock markets slid into further losses on Friday the Fed announced new measures to attempt to bolster the cash at hand for the banks.

Let me make one thing abundantly clear, this is NOT an attempt to save indebted US citizens, Funds, Hedge Funds or any other Capitalist Venture. This is a major bailout of the whole US fiat monetary system. It is designed to save the current banking structure of the USA and by indirect means support the world banking system. No country is immune (except Zimbabwe, whose currency might appreciate against the dollar) that uses a leveraged fiat monetary system.

Here is a prediction that might be seen as somewhat risky. By the end of 2009, I expect at least one trading currency in the world adopt a gold standard and regulate against leverage.

Back to the Federal Reserve and its new measures aimed at keeping leveraged trading in all markets possible and that all but officially announced it is now the Bank of Last Resort. There were 2 statements on Friday, the first concerns the TAF, the second related to the repo markets, covering both temporary and permanent operations. We had a warning that conditions are deteriorating as mentioned last week and now the Fed has been forced to take action.

The Fed announced that the TAF in March would be raised to $100Bn and continue to operate over at least the next 6 months. The Fed said that the action was to "address heightened liquidity pressures in term funding markets" and "to provide increased certainty to market participants" until market conditions improved sufficiently to allow the TAF to be discontinued. The Fed will accept Treasuries, Agency debt and Mortgage Backed Securities as they do in normal repo operations.

In conjunction with the increase in the TAF limit, normal temporary open market operations would also be increased in size, totalling up to $100Bn using 28 day repo agreements.

Both the TAF and the new 28 day repos could be increased in size "if conditions warrant". However the Fed then made it very clear, beyond the statements made above, that this increase of $140Bn (TAF was already at $60Bn) was to directly help bank balance sheets and not to increase monetary liquidity by also carrying out a permanent open market operation. The Fed trading desk announced it was selling $10Bn of US Treasury Bills to the markets "in order to maintain a level of reserves consistent with trading at rates around the operating objective for the overnight federal funds rate." The Fed trading desk also announced this little snippet:

"The Desk will continue to evaluate the need for the use of other tools to add flexibility to its open market operations. These may include further Treasury bill sales, reverse repurchase agreements, Treasury bill redemptions and changes in the sizes of conventional RP transactions"

We have conclusive proof that Fed is attempting to drain cash from the economy to support rates (and indirectly the $) whilst pumping funds directly into the balance sheets of the banks. Therefore the whole series of measures are not to deal with a liquidity issue but are to combat a breakdown in the capital reserves of the banks and a freezing/tightening/collapse of the credit markets.

US banks are being nationalized, temporarily, whilst they attempt to take cash away from all sectors of the economy, by either de-leveraging positions or calling in all debt owed to them on the flimsiest of excuses. Any non-performance in debt servicing by either Corporations or private citizens, for whatever reason, will result in immediate and swift foreclosure and an asset grab. I expect most credit lines to be withdrawn and limits imposed on the size of cash transfers and withdrawals in the very near future. All of these actions are to bolster bank reserves and the Fed itself believes this will take a minimum of 6 months. Some believe that is not enough. Kansas City Fed Pres. Hoenig called for the TAF to be made permanent.

It should be noted that if you use leverage or margin to trade markets, be prepared for that facility to be curtailed or withdrawn completely, forcing you to close your positions. Why would this occur? To enable further deleveraging and reallocation of capital and it's a very effective way of removing private investors from the markets. The Financial Institutions (FI) are in pain, they wouldn't like to have to move cash in the direction of private investors.

Am I being hysterical in my reaction to recent events? No I am not. The Fed and the FI's have yet to surprise me in their response to this self imposed crash; as conditions worsen I expect further draconian measures to be visited upon us.

For some, this is already happening in their everyday lives:

The green line shows CPI for all urban consumers minus energy, the red line is CPI for all items (both right scale). The argument that consumers are spending more on energy and less elsewhere is weak. What we do see is that rising CPI is not causing an increase in $ spending by consumers as seen by the blue line, showing retail and food services sales y.o.y (left scale). CPI is climbing higher but the amount spent is deflating year on year, as can be seen by the minus reading.

The price of goods may well be rising but the consumer isn't buying. I have said before, it doesn't matter how expensive an item is priced if no one buys it. Market forces will ensure that either prices fall to meet the reduced ability to spend or goods are no longer produced if that re-pricing makes it an unprofitable enterprise.

It should not be ignored that this deflationary effect is starting from a much lower base than the previous period covering the recession in the early 00's. The cushion of consumer spending power has been removed. Consumers are already suffering from a monetary deflation. I believe the cause is due to higher costs for servicing all debt and yet again the financial system will rebalance the capital reserve ratios at the expense of the US consumer.

There are possible signs that the credit market turmoil has spread to the Corporate Bond market. Whilst rates in Treasuries have been falling and have been followed down by the Fed Fund Rate, Corporate Bonds have maintained their yield levels from the beginning of 2007. Although the Corporate Bond yields have moved within a range there was a slight downward bias that occurred as Tsy's and the FFR fell, as you would expect in such an environment. Indeed even lower rated Corporate Bonds followed this pattern as can be seen in this chart:

The message I believe we see here is that the Corporate Bond Markets thought corporations would not be affected by the credit turmoil and that the requirement for a risk premium was purely down to the specific credit market problems. That is, there would be no spillover to the economy and therefore no requirement to price in a specific company risk premium.

I think that message has changed. Since the beginning of '08, even though the basis point gap to Tsy's (black line) and FFR (orange line) has grown, affording more risk premium, both top (blue) and junk (green) rated Corporate Bond yields have begun to rise. This dislocation can only mean that some in the corporate bond market now see possible or actual spillover effects that will affect the economy and company's on a widespread scale. Indeed, Moody's Seasoned Baa rated corporate yield is at new highs and has possibly broken out of the old well established range.

It is early days but with Aaa rated yields also moving higher this is a situation that must remain under close scrutiny.

This week we look at 2 propriety indicators that help identify longer term trends in stocks, specifically the Dow Industrials.
First up is the daily Dow chart going back to September 07 using a trend system that works equally well in bull or bear markets:

The Dow has broken and closed below support at 11928 as part of the move lower from late February. Unless the Dow rallies on Monday and moves above the 11928 ex-support then it would target a move to the January lows, circa 11640 and possibly a move to 11465. Only a close above 12145 trend support would have me looking for upside.

Here is the weekly Dow showing the long term trend. This chart is used to identify periods of weak and strong market performance. As of the close on Friday and for the first time in 5 years the Dow is now in a weak performance period. Only a move by the indicator above zero, combined with a recovery above the moving average would negate this.

This is my opinion only, I do not recommend any trading stance or investment decision is taken based upon this information. The information is purely supplied as a view to my thoughts and not to be taken as advice under any circumstances.

Finally we look at a rather strange decision taken by MBIA. It appears that MBIA has asked Fitch Rating Agency to stop rating its financial strength but to continue to rate the company's credit. It isn't known if it has made the same request to other Rating Agencies. MBIA had this to say:

"Fitch's ratings process differs in many significant respects from those of the other rating agencies, which affects how investors assess value……Fitch's coverage of the underlying credit quality of the transactions that MBIA insures is limited, and in turbulent times, the impact of this difference becomes significant, raising the risk of misinterpretation."

Could it be that Fitch's rating processes are more accurate and demanding than those of other rating company's? Has MBIA decided that it is easier to avoid meeting Fitch's rating qualification by just walking away? I expect further developments to appear about this as the week progresses.

Have a good week.

The Weekly Report - 3rd March 2008

2008-03-02T22:15:00.008Z

The Collection Agency - Weekly Report

3rd March 2008

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:

WASHINGTON (AP) - Shares of mortgage-finance companies Fannie Mae and Freddie Mac fell on Thursday after the Treasury Department denied rumors that the government would formally back the two companies and a report showed the foreclosures continued to soar.

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.

Did Mr Bernanke's Speech To Congress Mislead The People?

2008-02-27T21:33:00.001Z

Did Mr Bernanke's Speech To Congress Mislead The People?

Mr Bernanke went to congress to deliver the semi annual Monetary Policy Report today. For those of us who have the stomach to read the text of his speech it can offer some deeper insight into how the Fed is thinking.

Here is a link to the text: Bernanke speech

To help you along, I am going to reproduce some of it here and spell out what is required for the Fed Chairman wish-list to happen. Here is that first paragraph again:

"The U.S. economy has weakened considerably since last July, when the Federal Reserve Board submitted its previous Monetary Policy Report to the Congress. Substantial strains have emerged in financial markets here and abroad, and housing-related activity has continued to contract. Also, further increases in the prices of crude oil and some other commodities have eroded the real incomes of U.S. households and added to business costs. Overall economic activity held up reasonably well into the autumn despite these adverse developments, but it decelerated sharply in the fourth quarter. Moreover, the outlook for 2008 has become less favorable since last summer, and considerable downside risks to economic activity have emerged."

Now, I am going to be a little cheeky here. How many of you actually read the speech BB gave to congress? Yes, that one in the link above.

Well done if you did....but did you re-read the paragraph above too?

I wouldn't be surprised if it was only me. It's what I do, check things out, read the small print. The paragraph above is from the actual report, the very first paragraph of part 1.

Yes, you guessed it, I have no intention of seeking deeper insight today. I found something much darker to discuss.

Now please bear with me, here is the first paragraph BB actually delivered after his introduction:

"The economic situation has become distinctly less favorable since the time of our July report. Strains in financial markets, which first became evident late last summer, have persisted; and pressures on bank capital and the continued poor functioning of markets for securitized credit have led to tighter credit conditions for many households and businesses. The growth of real gross domestic product (GDP) held up well through the third quarter despite the financial turmoil, but it has since slowed sharply. Labor market conditions have similarly softened, as job creation has slowed and the unemployment rate--at 4.9 percent in January--has moved up somewhat."

Here is a list of words missing in BBs' first paragraph of his speech but are actually part of the first paragraph of the Monetary Policy Report to the Congress. I will show the phrase from the report first and then what BB actually said,

"The U.S. economy has weakened considerably since last July", replaced with "The economic situation has become distinctly less favorable since the time of our July report"

"Substantial strains have emerged in financial markets here and abroad" replaced with "Strains in financial markets, which first became evident late last summer"

"housing-related activity has continued to contract" replaced with "have led to tighter credit conditions for many households"

"but it decelerated sharply in the fourth quarter" replaced with "but it has since slowed sharply"

"Moreover, the outlook for 2008 has become less favorable since last summer, and considerable downside risks to economic activity have emerged." Replaced with a silence.

At first glance you may wonder why I think this is important? It looks roughly the same you might say. Well these are the days of market expectations, of political and economic spin and propaganda.

I will go further. These are the days of deceit and lies. Has Ben Bernanke sat in front of Congress and misled the People?

This is serious, this is an attempt to make the problems sound less urgent than the Federal Reserves' own report. Some areas of concern in the report are not present in the speech. Is this a deceit driven for political ends?

Shame should be heaped upon on the members of the committee on Financial Services at The US House of Representatives. They either knew of the deceit put before them or didn't even bother to read the actual report and therefore showed their ignorance. These so called representatives are nothing of the sort. Fifteen minutes of television coverage and a 2 minute close up are all they seek.

American citizens who read this article might want to think about the usefulness of such individuals.

This is shocking in the extreme. Every wire report I have seen carried BBs speech, not the actual report. Remember, this was the first paragraph, it sets the tone for the hearing, it gets the markets to react.

I am not going to go through the full texts here, it would take a much larger article. So, I'll leave you with the first part of the respective second paragraphs, again the actual report first and the speech second.

"The turmoil in financial markets that emerged last summer was triggered by a sharp increase in delinquencies and defaults on subprime mortgages. That increase substantially impaired the functioning of the secondary markets for subprime and non-traditional residential mortgages, which in turn contributed to a reduction in the availability of such mortgages to households."

"Many of the challenges now facing our economy stem from the continuing contraction of the U.S. housing market. In 2006, after a multiyear boom in residential construction and house prices, the housing market reversed course. Housing starts and sales of new homes are now less than half of their respective peaks, and house prices have flattened or declined in most areas. Changes in the availability of mortgage credit amplified the swings in the housing market."

You see what I mean? The report is realistic and identifies the areas of concern with clarity. The speech obscures the realism, using up tempo words such as boom. Where it is impossible to deny downside, the speech rewords the report to soften the meaning and context, "substantially impaired" becomes "changes in the availability of mortgage credit".

Ben Bernanke has wandered into the prison block showers and slipped it to the USA as it bent down to pick up the soap.

And he did it on Bloomberg.

No snippets today but for FTSE followers an update to RBS. Last week RBS denied rumours that it would seek funding. Today RBS confirmed it placed 50 million shares priced at 400p. The placing was rumoured to be with a Qatari Govt backed investment fund. How did the share react?

Right into the resistance pointed out last week at a premium to the placing. Spin indeed.

The Weekly Report 25th February 2008

2008-02-24T18:47:00.003Z

The Collection Agency - Weekly Report

25th February 2008

Welcome to the weekly report. The turmoil in credit markets continues and attention moves to CDS, the Federal Reserve gets worried about its credibility and the US markets get a boost 15 minutes from the end of Fridays close. We finish with a quick recap of some stocks we looked at last week and look around to see if anything else catches our eye.

Firstly an update to the continuing and widening collapse of the Municipal Bond prices as the failures in the auction rate bond (ARB) markets grow. Last week I mentioned 3 market makers who had stopped supporting ARB with their own capital to support prices. That list has grown, in addition to Citi, Goldman Sachs and Lehman Bros you can now add UBS, Morgan Stanley and Merrill Lynch. Without wanting to labour the point that's 6 of the biggest Investment Brokers / Banks that are effectively saying either the Muni bond market is toxic or they do not have the capital to support the Muni market. I firmly believe it is the latter.

I want to show you one chart that supports my assertion. It's from the Fed:

Colin Twiggs of Incredible Charts produced the chart, which saved me having to do it. You have seen this chart in my previously written articles. Clearly the situation has deteriorated at a rapid pace and is much more serious than the credit scare last August. US banks have no reserves; they are for all intents and purposes, broke. In fact they are beyond broke and as I suggested last year banks are now sub-prime. 150% of the reserves at depository institutions are borrowed. That can only mean one thing, the banks have "lost" 1.5 times their original non borrowed reserves. Not only have they lost what they had, they went on and lost half as much again. If you or I did that, we would be bankrupted and probably arrested for attempting to defraud the lender.

Notice the amount of total reserves (yellow line) is roughly equal and appears cyclical to the Federal Reserve TAF lending programme. The Fed is no longer the "lender of last resort" it has become the de-facto Bank of the USA.

I am amazed that so little attention has been paid to this state of affairs. The Northern Rock debacle, one overstretched bank in the UK, has had all the headlines, yet with the WHOLE banking industry in the US insolvent you hardly see it mentioned.

Now, I am not going to give you advice on what to do about your cash on deposit and I don't want you to think I am being overly bearish but…….I have called this whole fiat credit collapse correctly from the beginning. No, I don't want a pat on the back. I just want to read the next line carefully.

If I had money in a US bank today, I would be worried. So worried I would withdraw the cash before new regulations are passed restricting account activity. I know it sounds alarmist but then the first warnings always do.

This week saw talk of problems becoming apparent in the Credit Default Swap markets, a leveraged, counterparty insurance and re-insurance scheme designed to protect a buyer of debt against a default event using a third party who sells the protection.

For some of us, this is old news and signs of trouble have been around for sometime. Spreads on corporate debt have widened significantly of late. The Markit iTraxx Europe Index (yes Europe, you didn't think it was just the USA having problems did you?) composed of the prices of CDS for 125 investment graded companies saw spreads widen to 135 basis points, up from 91bp just 2 weeks ago. The higher the spread, the more perceived risk is seen in the markets. Get this, investors in this market are getting compensated for possible default rates up to 5.5 times higher than the highest recorded levels in the past 50 years.

Maybe I'm wrong to point out rising risk, maybe it's just over reaction and the spreads will fall back. Then again it is the market telling you about risk, not me.

The Federal Reserve seems to have a problem. It is becoming clear that even members of the committee are worried about the direction of Fed policy. The concern seems to be rooted in very economic soul of the committee members. Those that believe interest rates should go no lower or, indeed rise, are becoming more vocal. The latest to speak out was Dallas Fed President Richard Fisher. Although he has attracted a reputation for speaking "off message" thanks to the 8th innings remarks about interest rate rises, he has since then been a very clear and concise speaker. After voting against the latest cut in FFR (9-1) he has been explaining why he is worried.

Mr Fisher is no career economist, he is not from the Bernanke school. It may well explain why he feels strongly about the current situation. From the Dallas Morning News here is a quick run through his roots:

"Even more intriguing than Mr. Fisher's lonely vote at the Fed is the path this globe-trotter, self-made man and failed politician took to get there.
After his birth in Los Angeles to a father who had emigrated from Australia and a Norwegian mother who grew up in South Africa, Mr. Fisher moved with his parents to Mexico City, where he grew up speaking Spanish at school and playing on a youth baseball team coached by Norman Borlaug, the future Nobel Peace Prize winner.

Soon afterward, the family fell on hard times and moved back to the U.S., to Miami. Mr. Fisher, then about 11, remembers going with his mother to a pawn shop there, where she sold her engagement ring for cash to buy clothes for her children.

In another shift in fate, the boy won a scholarship to a private military academy.

Years later, after studying at England's Oxford University and collecting a degree from Harvard, as well as a Stanford University MBA, he would become a wealthy fund manager - moving between the financial world and government service in a career distinguished by intellectual curiosity and an independent streak."

I fully suspect Mr Fisher does not rely on computer models of the economy to get his "feel" for how things are going, unlike the Fed committee chairman. This guy has been there and done it, successfully too, unlike Greenspan.

Mr Fisher understands poverty, he lived it. He knows the effects it has and the struggles it causes. He is genuinely afraid of price inflation devaluing the money in peoples' pockets. Another snippet from the Dallas Morning News tells us all we need to know about Mr Fisher:

"There's a photo of Mr. Fisher with current Fed Chairman Ben Bernanke, and a portrait of former Fed Chairman Paul Volcker, one of Mr. Fisher's heroes."

Mr Fisher understands a simple rule, if you lower interest rates you ignite $ devaluation. Do this during a period of commodity bullishness and the basics become more expensive. It also raises what the Fed calls inflation expectations. Simply put that means if people perceive that prices are going to rise, they demand more money for their labour. True monetary inflation then follows. (NB, this is mainstream thinking, not mine - I see a different outcome.)

I suspect what is really worrying Mr Fisher is that despite repeated large cuts in the FFR, real interest rates for consumers, especially those hurting right now, have not fallen. Indeed the rates at Freddie and Fannie, for instance, have been rising of late. Why administer a medicine that has no effect on the illness?

His latest remarks in a speech at Fort Worth seem to be alluding to such:

'We're trying to bridge the gap, between what most people believe will be two quarters of 'anemia' in the economy, and prevent that turning into a recession, but not at the same time 'stir those dreadful embers of inflation.'

He went on to mention that the fallout from the credit markets cannot happen without some pain and that pain cannot be removed by the Federal Reserve.

With Bernanke talking of a "consensus committee" my bet is that although only Fisher voted against a cut at the last meeting, many of the committee share his reservations on current Fed policy. As the last Fed minutes pointed out:

"When prospects for growth had improved, a reversal of a portion of the recent (rate)-easing actions, possibly even a rapid reversal, might be appropriate,"

That should be taken as a warning by anyone intending to borrow at current low rates. You do not want to be on the wrong side of a 1% rise in FFR.

A funny thing happened on the way to the market close on Friday. The markets took off with about 40 minutes of the session left, tagging on around 250 points.

The reason touted around appears to be this announcement:

"US BONDS/INSURANCE: CNBC is cited saying a bailout at bond insurer AMBAC may be reported Mon. or Tues; this news is aiding stocks."

I saw this happen, I was trading at the time and had closed out a long (I don't hold Index trades over weekends). The sell side of the Dow futures went away on holiday, resulting in trades on the buy side leap-frogging higher. A shame I didn't hang on a little longer but that's trading. It looks to me as though the market believes, or wants to believe the bail-out is good news. I have a couple of worries on that score.

Firstly, since when are bail-outs "good" news?

Secondly, another announcement on Friday hasn't been picked up on and it's much more important:

"NEW YORK (AP) - Moody's downgraded the financial strength rating of Channel Reinsurance Ltd., imperilling a pillar of credit safety for bond insurer MBIA Inc. Moody's cut its financial strength rating on Channel Re to "Aa3" from "Aaa." The new rating implies Channel Re's balance sheet is "high-grade," whereas the previous rating implied "maximum safety."

Channel Re was created in 2004 to provide "reinsurance" to MBIA, a bond insurer based in Armonk, N.Y. MBIA is Channel's only customer.

MBIA writes insurance policies that promise to repay bondholders when bond issuers default. MBIA, which insures $670 billion in debt, buys reinsurance for a little more than $70 billion of the bonds it insures.

Reinsurance essentially means buying an insurance policy to protect an insurance policy, or shifting some of the risk and some of the premiums to another insurer. Channel Re reinsures just under half of MBIA's ceded debt, implying the company guarantees more than $35 billion in bonds.

Moody's said Channel Re has "significant exposure" to risky mortgage investments. The company was too willing to accept risks from MBIA, Moody's said. Collateralized-debt obligations, or pools of different kinds of debt often layered with risky mortgage loans, constitute 12 percent of Channel's insured debt, Moody's said.

Moody's estimates Channel Re needs $1.3 billion in cash available to pay claims to maintain the top-notch rating. The company has access to $930 million, Moody's said.

When an insurer is downgraded, much of the debt the company insured is downgraded too because a bulwark protecting the debt from default is less sturdy. A downgrade of one of MBIA's reinsurers could leave MBIA itself more vulnerable to a downgrade.

Channel Re is owned by MBIA, RenaissanceRe Holdings Ltd., PartnerRe Ltd. and Koch Industries Inc."

Yes, notice that last line. MBIA is now suffering from the same threat of possible default on its insurance as the rest of the market is suffering from the possible default of MBIA but MBIA part owns the re-insurer! Oh the deliciousness of it all.

Short term the markets may well have gone up on the Ambac rumour. In the longer term disclosures like that from Moody's will kill it.

Finally an update to the companies we looked at last week.

BSC:

I have drawn in a tentative support line.

From this article at Livecharts "If it's February then it must be the bank sector reporting season" an update to some UK shares:

Barclays Daily:

As I suspected Barclays pleased the markets and broke out of the wedge. I am watching for a retest of the upper wedge line and a possible attempt to take out the January high.

HBOS continues to drift sideways within its wedge as does HSBC within its down channel.

Lloy Daily.

As I said in the original article, I was surprised LLoyds didn't look more bullish. It looks bullish now.

RBS Daily:

Possibly a rise on general sentiment, I did get the feeling last week that the market believed RBS rather than the analyst talk of raising new funds etc. It appears poised for a breakout but be warned it could just as easily reverse. Worth watching as results are announced this week.

FTSE Daily

As mentioned last week 6002 is resistance with 5861 as support. I have removed the upper triangle line, leaving the rising support line. I am watching for a move either through the mentioned resistance or support.

One last point, keep an eye on UBS. The FT reports that HSH Nordbank, a German bank that is the worlds biggest provider of shipping finance, has filed lawsuit on UBS claiming it was mis-sold CDO's to the tune of E500m - apparently "lost" in an SIV called North Street 4. If this suit gets legs many other Investment Bank CEOs might start sweating too.

Have a good week.

Edit:

In answer to Richards point, I found this chart (click on image for larger size):

What me, worry?

You can clearly see the current situation dwarfs even the near past events. 1987 and 2001 look like blips. As for the 30's - well I have always said that the impending credit collapse and its deflation will make that decade look "sweet" in comparison.

Whoever Heard Of A Risqué Virgin?

2008-02-21T12:30:00.002Z

Whoever Heard Of A Risqué Virgin?

It was that hour between the FTSE cash closing and FTSE futures closing and I was bored. I don’t trade that hour, it’s too illiquid and can cost you a days earnings if you aren’t careful. So I did what I normally do and checked my emails, deleting the adverts and out of date stuff - as you do.

Then suddenly there she was, just sitting amongst the junk At first I got no more than a coy look, a fleeting glance of the beauty that was inside. I couldn’t resist. Gently hovering the mouse I slowly, gently pressed the open button.

Inside I found so much more than I had hoped. Gone was that coy expression, replaced now by that knowing smile and provocative pose. Here is her picture:

So I did the only thing I could. I wandered over to her and asked “how good are your low risk bond and gilt assets”?

The reply astounded me. “Look here” she said.

Full listing of corporate bonds

Yes, this very day I had been offered a smile from “damaged goods”. I ran my eyes over the assets and began to feel a cold sweat break out on my upper lip. Did she not realize how much she was exposing? Or was it a further come on? I started counting, 1,2,3 4, ………25,26…….52, 53…...60. I estimate about 60 of the company bonds listed were either Insurance, Banks, Broker/banks, Re-insurers or Finance companies. Out of 100, a 60% exposure to the shakiest sectors in the markets where the potential for more shocks looms large.

No wonder she looked risqué. Now I’m not saying all these companies are going to fold but let’s face some facts here. Credit and credit markets have had a heart attack and the liquidity pump is stuttering, requiring Fed administer defibrillation via the TAF. Signs of the heart disease are spreading into the corporate bond market.

She saw my distress and wandered over, draped an arm over my shoulder and whispered these soothing words into my ear:

“We put the security of your capital first

One of the basic rules of investment is that risk and return go hand in hand. At Virgin Money we recognise that to customers investing in a fixed-interest fund, the security of your capital is as important as a steady return on your money.

Our investment approach aims to strike the right balance, by only investing your cash in top-rated corporate bonds with highly creditworthy and well-known companies from Europe and the UK, plus a range of government gilts, which are at the safest end of the spectrum for fixed interest investments.”

She opened her dainty purse and pulled out a snapshot of the family.

It was time to put this lady right. As attractive as her family was, it was time to show her a snapshot from my creaking wallet.

She recoiled in disgust - a sneer spreading across her face. I’m not surprised, it is an ugly shot. I hadn’t finished with her yet, it was time to make sure she understood I wasn’t interested. So I administered the coup de grace. Using one of her own corporate bond issuers to thrust home the blade:

“Morgan Stanley's interest rates strategist Jim Caron explains why seemingly high quality AAA assets are getting hit so hard currently. "Because leverage is not available and one cannot achieve the required returns on higher quality (tighter spread) product without massive amounts of leverage," Caron says. "No leverage, no trade!" The current crisis situation is now about liquidity and leverage not credit evaluations. "Remember, the financiers of risk and the wardens of fair value were levered fast money players whose lifelines were tied to cheap money and gobs of leverage," Caron says. Unleveraged, real money was pushed out of the way. But now, without leverage, this has all changed. Caron concludes, "the Fed needs to cut rates a lot and fast and keep rates lower for longer. The aim is to increase Net Interest Margins(NIM) significantly in order to reliquify banks (a.k.a. the new old liquidity/leverage providers). Inflation potential is soaring and the curves will steepen much further."

Turning on her heel, she goaded me about my performance and pulled out a picture that showed “I’d never match this”:

Laughing, she said she “enjoyed an average return of over 5.22% a year”

I turned my back on her and walked away.

She staggered away toward the deleted files bin, unable to comprehend the turn of events. I shouted after her “Risk in this market isn’t alleviated by a “pat” sales pitch. If you’re selling hot wares disguised as a “good thing” you better make sure the punter fully understands. Hey, if you want that kind of performance you could go to Northern Rock”

Market Snippets

FED REACT: ABN AMRO strategist Dustin Reid says FOMC minutes have "a clear bias unfolding whereby the Fed is more and more actively targeting the downside growth risks. This is going to have many in the market concerned about Fed credibility going forward - especially after this morning's higher than expected headline and core CPI numbers." (my emphasis)

US DATA: Jan CPI +0.4%, core +0.3% (unrounded +0.3106%), both higher than expected and bad for bonds. Apparel was +0.4% (NSA -2.1%), airfares +0.8%, drugs +0.7%, tobacco +1.1%, and hotels +1.1% -- most of which seem to be start-of-yr postings of higher book prices in non-necessities that might not hold. OER at +0.3% is worrisome as it marks a 3rd month of +0.3%. YOY CPI was +4.3% (highest since Sept '05) and YOY core was +2.5% (was also +2.5% in Feb-07, proving the point of bad seasonals).Food was +0.7% as poultry, fruits and veg soared. Energy was +0.7% as jumps in fuel oil and gasoline offset dips in electricity and nat gas.(my emphasis)

Weekly Report 18th February 2008

2008-02-18T16:20:00.004Z

The Collection Agency – Weekly Report

18th February 2008
Welcome to the weekly report. As another bond market fails due to a dearth of buyers and a lack of support from Market Makers, I want to have a look at the inner workings to see who is displaying signs of distress. Is the Municipal Bond market the right place for investment and have PIMCO and SIFMA unintentionally pointed out the pitfalls?

First up though is Bear Stearns whose shares and call options leapt up on Friday (15th).

An unconfirmed buyout rumour circulated the markets during Friday causing a 5.5% jump in Bears shares to $82.79 with 20 million shares traded, the highest volume since August last year. Call option volume was high too with more than 80,000 contracts traded. Someone made a killing on this rumour. The rumoured buyout price is around $98, with the offer supposedly in cash. However by digging a little deeper the possible real reason for the unconfirmed rumour becomes clearer.

According to Reuters via Bloomberg: “China's government-controlled Citic Securities Co., which agreed in October to pay $1 billion for a 6 percent stake in Bear, is renegotiating to get a 9.9 percent stake because of the decline in the company's shares since then, Reuters reported yesterday, citing two people with knowledge of the talks whom it didn't identify. Bear shares lost 33 percent of their value since the original Citic agreement through yesterday. Citic is still seeking to invest $1 billion in the company, Reuters reported.”

Without alluding to a conspiracy theory, the rumour does seem rather well timed. Let us say, just for arguments sake, someone is intent on ensuring that only 6% of Bear is up for sale. To achieve that target the share price would need to recover to the October level.

A look at the Bear chart for the past 6 months (Bloomberg) reveals some interesting points:

It has some nice support with volume in January and late September last year. For those that like gaps in price action we have gaps at approximately $90, $100, $112 and - yes you guessed it - at the high in October ’07. We may not fill all the gaps but I wouldn’t be surprised if 3 out of 4 did. As usual, I have no position in Bear and I am not recommending one be taken.

For those that read my Occasional Letters, the contagion in the credit markets comes as no surprise, indeed I have been writing about it for long enough that some may think its “old hat”. I hope so, it means I did my job well. This week saw a continuation of the breakdown in the Auction-Bond system, where Municipal Bonds are auctioned off by banks acting as market makers. The problem is simple buyers are not showing up, driving muni bond prices down and yields up. This is not a new event, it has happened before but previously the banks stepped in and provided support by buying using their own money.

Not anymore. The capital resources of major banks are no longer available to ensure the smooth running of the Municipal bond auctions. The money it seems is needed elsewhere. Don’t forget, these Muni bonds are not junk, they are highly rated with yields that reflected their status. We are not talking about banks being risk adverse (unless…..) this is about banks no longer having capital to support a safe market. Be warned.

If the Banks blame the auction failures on the downgrades of the Monoline Insurers, which is threatening the rating and safety of the muni bonds, think of the excuse as more of a propaganda tool.

Even in the failed auctions the yields on most bonds didn’t hit the headlined 20%. Most rose to the 5-6% area. You would have thought that should make easy profits for the market making banks if they picked up the muni’s at the lows. It would seem that the banks can’t even afford to bottom pick.

The fallout in the economy if this continues will be of great importance. Local Governments, Authorities, Hospitals, Schools etc will either have to pay greatly increased yields to bond buyers or buy the debt back. Either measure will cost those who have to pay taxes or fees. Yes, that you. Of course, the bond sellers could always default if the payment of the high yield becomes too much to bear. I suspect the calls for a full-scale bailout maybe louder and earlier than those made for the sub-prime crash.

As an aside, so far since the “credit crunch” arrived, the Commercial Paper, Asset Backed Commercial Paper, MBS, CDO, CDS, Covered Bonds (Europe) and LBO markets have all suffered dislocation or an actual closure or failure. Do not forget which Federal Reserve, Government, Treasury, Brokerage, CEOs or Analyst spokespersons told you this was a contained problem that would not spillover into the economy. Remember not to trust them again.

Let us spend a few minutes looking at which banks act as market makers in the Muni bond auctions. Of course, I am not saying that they maybe in trouble but it does worry me that they have no capacity left to help credit markets, or at least, they are no longer willing to make markets. Hands up those who think such a problem will remain contained to the Muni auctions? No hands…..You are all very bright…

Listed in no particular order are the banks associated with failed Muni bond auctions, with charts from Bloomberg:

Citigroup:

Goldman Sachs:

Lehman Brothers:

So far I have only seen reference to the above broker/bankers in relation to Auction failures and the lack of support. I suspect there are more.

You may well ask if there is a way that the troubles in the Muni bond market could be speculated upon? There is an instrument but I have reservations about it’s use.

Lehman Bros have an ETF (ITM) for municipal bond markets, however it is illiquid and thinly traded. It was first marketed in November last year, so data for the ETF is scarce. The timing of the introduction of ITM may just be a coincidence but I’m not so sure, it could be viewed as an attempt to increase liquidity, allowing Banks to expand hedging strategies.

ITM:

Finally I want to look at the dynamics of the municipal bond market. According to SIFMA:

“The municipal bond market is one of the world’s largest and most remarkable securities markets. Approximately $1.7 trillion worth of municipal bonds are currently in the hands of investors. There are more than 50,000 state and local entities which issue municipal securities, and 2 million separate bond issues outstanding.”

This is a large market to which many are exposed. Indeed it has a high number of private individual participation, either directly or through Funds. As SIFMA states:

“An estimated 5.1 million households own municipal bonds in some form—either through direct ownership of individual bonds or through investment in institutional portfolios, including mutual funds, unit investment trusts, and bank trust accounts, according to the most recent figures available from the Internal Revenue Service. Commercial banks and insurance companies are also major institutional holders of municipal bonds.”

Is there anything to worry over? Well frankly yes there is. Once again we have to remember that this market is reliant on high quality ratings given by the Rating Agencies to achieve it’s standing in the investment world. Whilst part of that rating is awarded on the credit quality of the bond issuer the larger emphasis is placed on the default protection granted by the Monoline Insurers.

Interestingly the low volatility of the Municipal Bond market is seen as a good point, not only by SIFMA but also by PIMCO. SIFMA like to point out that most individual investors buy and hold until bond maturity whilst PIMCO have this to say:

“Historically, returns on municipal bonds tend to be less volatile than those on other asset classes, from equities to long-term Treasuries…….One reason for the lower volatility: individuals are the main investors in the municipal bond market and in general do not actively trade the bonds. Retail investors tend to buy and hold muni bonds to maturity. This contrasts with many other fixed-income sectors where institutional investors dominate. Individuals comprise more than 70% of the municipal bond investor base. Property and casualty insurance companies are the next largest set of investors at around 14%. The remaining investors are banks and corporations.”

In other words, this is a market utterly dependent on the continued confidence of the private investor. Low volatility in a stable or rising market can be beneficial and would not be affected by illiquidity but that changes dramatically in a market panic.

Can this market continue to rely on private investor apathy? I doubt it and so do the banks.

We can see why the banks have withdrawn support. If yields continue to rise as a lack of buyers force bond prices down then the risk of a possible default event is heightened. Combine that with a complete lack of faith in the Monoline Insurers ability to cover such an event and the municipal bond market doesn’t look such a sure fire winner.

How will private investors react to a default event in the municipal bond market? Human nature being what it is coupled with an elevated awareness to credit and bond market disruptions will ensure an attempt at a mass exodus.

That is highly unlikely to be an orderly exit. PIMCO has this to say in the conclusion to “Municipal Bonds: A Unique Fixed Income Asset Class”:

“In addition to their tax-exempt status, muni bonds may offer several advantages, including: higher after-tax returns than many other taxable bonds, high credit quality, and relatively low volatility. While institutional investors dominate the investor base in most fixed income sectors, retail investors form the biggest investor base in the municipal bond market.”

At one time that probably sounded attractive to investors. A re-reading will have more than a few investors (and PIMCO?) looking nervously at their portfolios.

AIG Get Caught By The Auditors

2008-02-12T15:07:00.003Z

12th February 08

Boy you could here the squeals of pain all the way down Wall St. Getting caught by the auditors is the risk you take when you start playing with exotic instruments and “forget” to let the accountants know things may have changed. PricewaterhouseCoopers applied the pressure, uncovering “material weakness” in the way AIG accounted for it’s Credit Default Swaps.

The material weakness was to under-estimate the losses on CDS by 400%. AIG say the losses of $4.88Bn occured in October and November ‘07 on CDS sold to protect fixed income assets. Which, of course, means that January to March ’08 figures are not going to be any better taking into account the current turmoil in the bond and derivative markets.

AIG chart. Ugly. $35 looks possible.

This is a 10 year monthly chart with a 6 month moving average. Support at the $50 seems bust and the threat is a monthly close below the ’03 low. It’s yet another chart that flags up the lows from 1998. I’m not saying it’s a short (or a long) that’s not my job. I just want you too see something that looks worse than me in the mornings.

So what does a quarterly loss of $4.88Bn mean to AIG? In recent articles I have been informing readers that I believe banks will attempt to raise income to bolster their capital reserves. It would not be a step too far to say the same applies to Insurers. Yes, that is how bad it is out there in Financial Wonderland now, it’s no longer about profit, it’s about survival.
AIG had an income stream of around $14.93Bn in the last 12 months. If we assume that remains roughly the same AIG has the current and next quarter to sort out it’s derivative mess and stabilise its bond portfolio before its write downs out-strip income. Stripping out the “insurance” by writing off current CDS agreements might help the capital reserves ratio but will leave AIG exposed to bond market movement, increasing risk.

Another alternative is to raise more capital. The sale of preferred convertible bonds or interest bearing shares as seen in the recent bailouts of the investment banks is possible but would dilute shareholder value. Then again does AIG worry too much about that in the current circumstances.

There is a further measure AIG could take. As the 6th largest company in the world in ’07 (according to Forbes Global 2000) AIG has some interesting assets, not all of which are core business.

Amongst those assets are ILFC, an aircraft leasing company, 21st Century Insurance Company, American International Assurance, a near 10% holding in the Peoples Insurance Company of China, Stowe Mountain resort, the Bulgarian Telecom Company and Vivatel, a mobile network, AIG American General (insurance) which owns Matrix Direct Insurance Services and finally Ocean Finance a UK loans company specialising in mortgages and re-mortgages.

A sale of assets or a move by Fund Managers or Hedge Funds to force a release of “value” cannot be discounted. If that does happen, I wonder where AIG will be in the Forbes Global 2000?

By the way, be careful of who you listen to. This was one of the comments I saw on Bloomberg about the AIG drop:
“Investors eventually will look back at yesterday's announcement and conclude they overreacted, said David Katz, chief investment officer for New York-based Matrix Asset Advisors, who supports Sullivan (the CEO).” Must be a coincidence…….

Finally on AIG here is what the management had to say about risk in the 2006 annual report page 86 :

“AIG believes that strong risk management practices and a sound internal control environment are fundamental to its continued success and profitable growth. Failure to manage risk properly could expose AIG to significant losses, regulatory issues and a damaged reputation.

The major risks to which AIG is exposed include the following:

Insurance risk—the potential loss resulting from ultimate claims and expenses exceeding held reserves.

Credit risk—the potential loss arising from an obligor’s benefits inability or unwillingness to meet its obligations to AIG.

Market risk—the potential loss arising from adverse fluctuations in interest rates, foreign currencies, equity and commodity prices, and their levels of volatility.

Operational risk—the potential loss resulting from inadequate or failed internal processes, people, and systems, or from external events.

AIG senior management establishes the framework, principles and guidelines for risk management. The business executives are responsible for establishing and implementing risk management processes and responding to the individual needs and issues within their business, including risk concentrations within their business segments.”

At least we know who to blame.

It was noticeable that the UK markets didn’t ignore the AIG news. Insurers got a haircut along with some banks. Is the market trying to tell us something?

Back to the charts (Bloomberg) UK Insurers:

Aviva. Support at 500.

Legal and General. Support at circa 100 if current support fails.

Old Mutual. Support at 90.

Royal Sun. Support at 70 if current support fails.

Standard Life. Support at 100 if current support fails.

That’s what the market is saying to me, it may say something else to you.

Then again we are at point in the markets were hope is being ladled out to the hungry and despondent. As I write this little snippet appears:

“U.S. Industry: Uber-investor Warren Buffett on tv making remarks about the monoline insurance industry, apparently has offered a reinsurance plan to those firms. Talk has boosted the recently ailing monolines and is said to be behind the solid bounce in US stock futures in recent trading. Provided by: Market News International”

I have some bad news for Mr Buffett. This isn’t the bottom even for the better quality debt. As I have maintained for some time contagion in the derivative bond market is deeper than anyone realises and it has spread beyond investment and traditional banks. AIG know that only too well.

As a follow on to Automobile Wreckage. It Isn’t Just Ford and GM I see GM excelled themselves with a loss of $38.7Bn in ’07. That’s the largest ever loss for an Auto manufacturer. Well done.

Market Snippets

From MNI. The ICSC-UBS weekly chain store index shows +1.8% for week/week ended Feb. 9, and -0.7% yr/yr for the same week. ICSC said consumers are pulling back on spending.

Reaction to the offer from Mr Buffett isn’t that overwhelming as the details become known. Warren Buffett has reportedly offered to take on the municipal liabilities of MBIA, Ambac and FGIC -- about $800B of bonds. He noted that one company turned him down on the offer and that the other two have not yet responded.

RBC Cap Mkts TJ Marta says, "We remain doubtful about this deal. Buffett is obviously offering a "deal" that one of the companies could refuse. He is only offering to take on the "good" securities, or municipal bonds. This "offer" is much like that in the MLEC (Super-SIV), in which the bailout plan only bailed out securities that were salvageable anyway. “

Nice try though Mr Buffett.

The Collection Agency – Weekly Report

2008-02-10T19:18:00.001Z

The Collection Agency – Weekly Report

10th February 2008

Welcome to The Collection Agency Weekly Report, a new way to present my thoughts on the macro-economic outlook and the possible effects on financial markets. This first edition is a trial run of what hopefully will become a weekly event, seperate from but not replacing the Occasional Letter. At the end of the report is an email address, please feel free to send any constructive comments about this report. Now, on with the report.

Evidence from the US Federal Reserve shows lending standards have tightened appreciably in the past 3 months. Although this is lagging information it is of great importance as it shows the level of liquidity available to consumers and business. Whilst it can be risky to extrapolate a forward outlook from past data in this circumstance we see no current indicators that say conditions have reversed.

The Fed gathers opinions from the largest banks in each Federal Reserve District by asking them to complete a survey. The sample is selected from among the largest banks in each Federal Reserve District. In the table, large banks are defined as those with total domestic assets of $20 billion or more as of Sept. 30, 2007. The combined assets of the 33 large banks totaled $5.69 trillion, compared to $5.95 trillion for the entire panel of 56 banks, and $11.07 trillion for all domestically chartered, federally insured commercial banks.

As we are trying to look forward I want to concentrate on what the banks are doing in relation to the lending of credit to commercial and industrial (C&I) business and consumers.

Let’s look at C&I loan standards.

Standards for large and middle-market firms (annual sales of $50 million or more):

Standards for small firms (annual sales of less than $50 million):

Standards across the board tightened in the 4Q and especially in the smaller banks. With 25% of the banks surveyed tightening and no banks easing, qualifying for credit for businesses has become more difficult. It’s not just small business either as we can see above, the tightening of standards is universal. Banks are not tightening because of a recession risk per se. It would appear their actions are intended to discourage overall lending throughout the economy.

It could be said that banks are just more cautious in their use of capital but further evidence points to other measures that have been taken to discourage business borrowing. It also reveals the weakness of banks in the current climate.

Let us look at the terms and conditions banks require for making a loan. I will just use the data for large and middle market firms as the figures for small firms are comparable. Whilst the maximum size and maturity of credit lines and loans has tightened as would be expected with a squeeze on standards, we also see the following:

Costs of credit lines:

Spreads of loan rates over your bank's cost of funds (wider spreads=tightened, narrower spreads=eased):

Premiums charged on riskier loans:

There can be no doubt banks are raising costs, including spreads over their own funding (borrowing). This is not a move to protect against default in risky loans either, you can see that above as I have included premiums asked for riskier loans. Costs for loans not considered risky have also risen, even as prime rates have fallen.

The Fed began cutting its headline rate in September ’07, having cut the discount rate in August that year in response to the arrival of the credit squeeze in July. The banks received the survey in early January of ’08 and the returns were due by the 17th . That means the period reported on does not include the emergency inter-meeting cut and the further cut at the FOMC meeting in January. It does mean the Fed knew that lending standards had tightened considerably and this may well have been the reason for the Fed to dramatically cut its own Fed Fund Rates in an attempt to loosen conditions. It may well have realized that “baby step” reductions in the Fed Fund Rate were having little effect on bank rates beyond the published prime rate.

Has the Feds action had the desired result? At face value it may seem so as the prime rate that banks quote has dropped with the cuts in FFR. The differential has remained at 3% (Jun 06 PR – 8.25% / FFR - 5.25%, Feb 08 PR - 6% / FFR - 3%) but actual spreads above the PR have increased.

We already know that the sub-prime mortgage market has reduced to the point of almost being closed and that the standards for prime mortgage products have tightened. What though of the consumer credit card and loan market? Are stresses in bank capital resources showing here too?

As you can imagine the survey shows lending standards to have tightened with stricter criteria for fund amounts, credit scores and a widening of spreads for those that meet the requirements of a prime customer. The tightening for those with sub prime credit scores has been more severe.

Let’s see what the Fed survey shows:

The extent to which loans are granted to some customers that do not meet credit scoring thresholds (increased=eased, decreased=tightened):

Spreads of loan rates over your bank's cost of funds (wider spreads=tightened, narrower spreads=eased):

Banks are tightening and increasing costs to consumers even with a Fed easing policy in place.

Finally what does the Fed survey reveal about why banks feel they need to tighten lending and raise costs to borrowers? The Fed asked the banks the following questions:

“Assuming that economic activity progresses in line with consensus forecasts, what is your outlook for delinquencies and charge-offs on your bank's loans to businesses in 2008?”

Outlook for loan quality on C&I loans:

Outlook for loan quality on commercial real estate loans:

Outlook for loan quality on subprime residential mortgage loans:*

*For this question, 47 respondents answered “My bank does not originate this type of loan.”

In fact a similar picture exists for all type of loans at all levels of risk, deterioration in quality is expected by the majority of banks. Why do banks think this will happen? Again, the survey reveals the expected path banks see in the future when it asked for “possible reasons for tightening credit standards or loan terms”:

Deterioration in your bank's current or expected capital position:

Less favorable or more uncertain economic outlook:

Worsening of industry-specific problems:

Up until the survey was completed banks did not see deterioration in their capital as the main risk to loans, the concern was with the economic outlook and industry specific problems. Just under 25% of the banks in the survey did see a risk to their capital positions going forward. I expect that to have increased of late, with the threat to Bond (monoline) Insurers becoming greater by the day. For the purposes of this letter we will adopt the 25% as a conservative measure of what assets may be at risk.

The Fed survey has a summary of the assets of banks in the survey and for all domestically chartered, federally insured commercial banks:

“The sample is selected from among the largest banks in each Federal Reserve District. In the table, large banks are defined as those with total domestic assets of $20 billion or more as of Sept. 30, 2007. The combined assets of the 33 large banks totaled $5.69 trillion, compared to $5.95 trillion for the entire panel of 56 banks, and $11.07 trillion for all domestically chartered, federally insured commercial banks.”

Again, let’s be conservative and use only the assets of the banks within the survey, namely $5.95 trillion for the 56 banks used (although only 53 banks answered the question). 9 banks said their capital position was important, of which 7 were large banks. Using the 7 large banks only and again being conservative, let’s assume that only these 7 will have problems, i.e. are going to default and the malaise doesn’t spread to other banks. A minimum of $140Bn worth of assets are at risk. More realistically I suspect that figure should be doubled. It should also be noted that other banks may have deterioration in their capital position but when the survey was answered did not consider it to be important. That answer may well change in the coming months.

Banks are in a weak position and face a double whammy. Not only are capital positions under threat but the usual remedies of hoarding cash by restricting lending and raising the cost to borrowers may not be enough to cover the liabilities. Further downgrades of financial derivatives, bonds, junk bonds and falling stock prices will be a blow from which some may not recover.

Finally the survey reveals the one factor that most worries banks as shown by their answer to the following question:

”How significant do you anticipate the following potential obstacles to be for your bank to undertake the loss-mitigating strategies”

Borrowers are less motivated to retain possession of property:

We are already seeing stories in the media about people walking away from overpriced assets, many of whom are not in foreclosure. It looks to me that banks expect this pattern of behaviour to grow. I doubt it has been built into the risk models used when packaging and rating CDO, MBS etc.

How has the change in the banks attitude affected the consumer? We have already seen the slowdown in housing sales accelerate and be joined by the drop in car sales. Have smaller purchases been cut too? The following is typical of how retail spending is being reported:

From ICSC: "January sales grew by 0.5 percent on a year-over-year comparison for the same month of 2007 on a comparable store basis for U.S. chain stores. The softening of retail spending was across the board especially for luxury and department stores sales, which have dropped significantly from last year, weakening the overall sales gain for January. Wholesale clubs, the only category showing considerable growth (+6.3%) demonstrates that consumers are being conservative in their spending. Editor's note: 1.5 percent of the 6.3 percent growth rate for wholesale clubs can be attributed to gasoline sales."

It’s not just consumers that are retrenching as the latest jobs report shows:

(AP) –“Nervous employers cut 17,000 jobs in January -- the first such reduction in more than four years and a fresh sign that the economy is in danger of stalling. The Labor Department's report, released Friday, also showed that the unemployment rate dipped slightly to 4.9 percent, from 5 percent, as the civilian labor force shrank slightly.”

Joel Naroff, president of Naroff Economics Advisors had this to say:

“The mind-set of businesses people is one of some fear and uncertainty about the economy's direction, he said.”They are thinking if there is some capital spending I should postpone for a while, I should do that. If there is some hiring I don't necessarily need to do right now, I can put that off for a few months to see what happens," Naroff said. "The problem with that thinking is that more economic weakness or a recession can become somewhat of a self-fulfilling prophesy."

Although the Fed is aware of the problems it is also becoming clear that reducing the FFR is having only a limited effect. Banks will not be able to loosen their own standards until capital reserves are deemed sufficient and bad debt has been cleansed by a recovery in prices or being written off.

Until this happens credit availability will continue to contract for all sectors of the US economy. A lack of credit coupled with a demand to pay off existing debt will have dire consequences for any possible expansion of the manufacturing sector, small businesses and the self employed. Most at risk are those parts of the service and manufacturing sector that are reliant on discretionary consumer spending.

One last chart that shows an interesting development when comparing Dow Industrials and Morgan Stanley’s Consumer and Cyclical Indices. Unlike 1999/2000 when the Cyclical and Consumer Indices gave an early warning of impending recession, this time no warning was forthcoming.

Without wanting to sound too obvious it would appear that the root cause to the current situation is very different to that which led to the recession at the beginning of the decade. Then a slowing of consumer spending and capital investment by companies led to a drop in productivity and rising unemployment. These conditions were alleviated by reducing the cost of borrowing and relaxing standards to all time lows, re-inflating the economy.

This time is indeed different. As banks fight to survive an attack on their capital reserves they have withdrawn liquidity by reducing the amount of credit and raising its price to help bolster income flows.

Until their reserves are once again capable of covering both the Basel 2 requirements and are able to absorb losses from the bad debt on the balance sheets, credit conditions will remain tight.

I hope you enjoyed reading this report. As I mentioned this is a trial run of a new format and I would be interested in constructive remarks about its layout and content. Send an email to mickp@livecharts.co.uk.

Automobile Wreckage. It Isn’t Just Ford and GM - An Occasional Letter From The Collection Agency

2008-02-03T13:29:00.000Z

Automobile Wreckage. It Isn’t Just Ford and GM

Contained, they said. No spillover from the financial collapse, they said. The consumer is resilient and will continue spending, they said. Who are “they” you ask? The politicians, bankers, Fed speakers, analysts, brokers, economists and talking heads on the financial and - of late - mainstream media. All out there telling you its going to be okay, that the sweet life will roll on for just about everyone.

Why do they do this, why do they want you to believe that life will always be sweet? Simple. You have to continue to spend rather than save to keep the circle of money and credit viable. If confidence evaporates then spending stops as consumers begin to act in a discretionary manner, hoarding cash to buffer against the possible “unexpected” hard times. You can see the political advantages that accrue if you can say the hard times are due to an unexpected event. You don’t get the blame and the public accept the medicine required to alleviate the situation.

Everyone is focused on housing. All well and good but, without sounding dismissive, it’s built into the scenario now. We know foreclosures are rising and will more than likely will continue to rise. We know what effect that had on the pricing and rating of CDOs and MBS and the effect that had on CDS. The losses may well continue to rise, by huge amounts but…..we know. The focus has been upon the contained area, the Colosseum in which the blood would be spilt. We have been diverted from watching events elsewhere, beyond the blood sodden sand of the Circus Maxed-outus.

Not anymore. No we have definitive proof that it isn’t just housing that is suffering the blows of the Gladius. After the promises come the facts. That second largest purchase, the automobile, is entering the arena and it’s already wounded from previous contests.

Enough of my similes. Lets look at the automobile industry in the US.

Friday saw the release of the sales figures for the US domestic automobile market. Ugly would be a kind description. I want to use the January y-o-y figures to show just how hideous the economy is becoming. It’s not just domestic manufacturing that’s suffering. Importers (i.e. Japan and the Far East) are selling less in the US marketplace.

Firstly let’s look at the raw January y-o-y figures:

Ford Motor Co. reported Friday its U.S. light vehicle sales fell 3.9% in January.

In January, GM North America produced sales fell 5% in January.

American Honda Motor Co. Friday said its sales in January fell 2.3%.

Toyota Motor Sales U.S.A. Inc. said Friday its U.S. sales fell 2.3% in January.

Nissan Motor Co.'s Nissan North America Inc. division reported total sales in January fell 7.3%.

Porsche Cars North America Inc. said Friday its January U.S. sales fell 13%.

Kia Motors America on Friday reported January U.S. sales of 21,355 units, down 5.2%.

American Suzuki Motor Corp. said Friday its U.S. auto sales fell 13% in January.

Hyundai Motor America said January sales fell 23%.

Mercedes-Benz USA said Friday its U.S. sales rose 7.1% in January.

Mazda North American Operations said Friday sales in January rose 10.2%.

The last 2, Mercedes and Mazda, look healthy but both rises are on relatively small volumes as we shall see. Similarly Porsche and Suzuki figures are on small volume too. All the large volume producers lost sales volume. I am not overly interested in truck v car v SUV sales. I am looking at volume not choice.

Total sales for January vs January ‘07 were:

Ford - 159,355 down from 165,877

GM - 297,000 down from 313,000

Honda - 98,511 down from 100,790

Toyota - 171,849 down from 175,850

Nissan - 76,605 down from 82,644

Hyundai - 21,452 down from 27,721

Kia - 21,355 down from 22,465*

(*Approx)

According to AutoData Corp, overall car sales fell last month to a seasonally-adjusted annual rate of 15.2 million vehicles. That’s the weakest pace since the ending of heavy discounts at dealerships in late 2005.

Without doubt sales of the second biggest purchase made by the US consumer have plummeted y-o-y. If the US consumer is now withdrawing from big ticket purchases (including Porsches) then not only will manufacturing head into a deeper recession but the service industry will also see a reduction in income. Discretionary spending, reliant for so long on the continued use of credit, is grinding to a halt.

Let’s have a look at some possible opportunities. I remind readers, I am not recommending any positions in any instruments. All I wish to do is point out the possible areas that may be affected.

Here is the DJ US Auto Index from Bigcharts:

You can see the components here , with the DJ Automobiles& Parts Titans 30 Index here

Let’s look at some individual stocks:

Simply put, they are all at or near resistance. The reaction to this resistance will be most revealing.

Did consumers suddenly decide that in mid 2007 they were not going to buy a new vehicle? Indeed they did as we can see from the falling car sales but was this new choice forced upon them?

Most consumers use credit to buy vehicles, many rolling forward outstanding vehicle loans into the new loan taken out. As can be seen in the charts above, that rolling of credit appears to have
stopped and it's reflected in the share prices of the Auto makers. Indeed the charts are highly responsive to the tightening of credit in August, the attempted talk down of the threat into October and then the second bout of credit being squeezed.

With the tightening credit conditions generally the Auto sector is vulnerable to a further deterioration in sales volume and will experience the latest development in the Housing sector - consumers walking away from debt.

Watch the Dealerships, will we see people driving onto the forecourt, parking up, returning the keys to the office and then walking to the bus stop? I think we will and sooner than most think. That Fed/Treasury/Congress/Presidential handout might just be enough to buy a second (third?) hand car, for cash.

This has ramifications beyond consumer spending. Just as with housing, loans made on vehicle purchases (and credit cards) were repackaged and sold on as derivatives, namely CLOs.

Here is the derivative published by Markit.com showing the price and spread on the front contract:

We see the same deterioration in price and the widening of spread that has become so familiar in the CDO/MBS indexes. As with housing, the inability to create further derivative structures due to rising spreads (risk premium) will curtail the lenders ability to clear the balance sheets and facilitate further lending.

It isn't just the Markit.com index which is dropping. TRR (Total Rate of Return) CLOs are struggling too as Fitch Rating Agency have noted, downgrading 28 tranches and also placed an additional 37 tranches on Rating Watch Negative. Unsurprisingly TRR CLOs are a mixture of derivatives of loan portfolios that according to Fitch are now at risk for intensified spread/credit risks. Market values on the SMi U.S. 100 have fallen 6% since mid '07. Considering the type of asset and its potential lack of worth in a flooded market (unlike housing) I expect spreads to widen considerably.

It seems to me that a combination of tightening credit for the consumer, caused by the inability of lenders to clear balance sheets due to derivative markets pricing in higher risks which is stifling new issuance, will cause a real fall in spending on Autos. It should not be forgotten that other unsecured debt will have the same problems.

The possibility of widespread damage in the US domestic Auto industry beyond GM and Ford seems much greater today than at any other time.

Citigroup – Opportunity or Death Rattle?

2008-01-27T19:45:00.001Z

Citigroup – Opportunity or Death Rattle?

It’s not very often you will find me focusing on one share but something rather important has happened to Citigroup [C]. Firstly let me explain I am not, most assuredly not, recommending any position in Citi. I don’t “do” recommendations and as most of you who read my articles know, I prefer to look for the longer term effects. Think of this article more along the lines of a follow up to A beginners Guide To Credit Default Swaps and CDS, An Example in Real Time.

Citigroup is in serious trouble. It’s not the first time Citi has been threatened but it may be the last. Too many risks have been taken without adequate protection or examination. Whilst previous episodes of credit collapse were eventually seen off, with a little outside investment help, this time the problem may be just too big. If Citigroup does start waving a white flag, the repercussions will be enormous.

I am going to rule out a takeover/buyout similar to the Bank of America / Countrywide deal. That deal was not, in my opinion, about a grab for cheap assets. I believe BoA had too much invested in Countrywide to allow it to file for bankruptcy. I also suspect BoA may also have been exposed to large counterparty agreements that would have cost much more than BoA have paid to absorb Countrywide. Essentially BoA have covered their own position.

Citigroup will not get such kind treatment. Instead of it being “too big to fail” I think it may be “too opaque to sell”. Firstly, here is a chart of Citi, it is telling us what the market thinks:

It's a weekly chart going back to 1997. I have circled the 4 important lows: 1998, 2002 x 2 and current. Citi is now valued at the 2002 low price, including any inflation or $ devaluation effects. This is one ugly share to own if you are not a US based owner. Notice the subtle difference between the current low and the previous 3. Previously Citi spiked down into its low and then rebounded rapidly.

The current low is different, a sustained period of selling continues whilst the oversold condition persists. It is the opposite condition of continued buying whilst in an overbought condition as seen in 1999/2000. Unless a financial miracle occurs Citigroup is going lower, 1998 anyone? If my suspicions come to fruition then the price may well end up quoted in cents.

Can I relate fundamentals to the chart view? Yes I can. Even with the announcement of the capital injections, staff layoffs and the dividend cut:

“Citigroup reported a fourth-quarter loss of $9.83 billion, or $1.99 a share, which included $18.1 billion in subprime-related writedowns, and a $4.1 billion increase in consumer-related credit costs. Citi also said it would sell $14.5 billion in convertible preferred securities, including $12.5 billion to private investors. Citi also said it would cut its quarterly dividend by 41% to 32 cents a share from 54 cents a share.”

So to offset $22.2bn credit losses in the 4^th Q , Citi called on profits of $12.43Bn from its other activities to post a headline loss of $9.83Bn. What does this tell us? Simply put the losses on the credit side of the business are not yet over. Either more are expected or have yet to be calculated or fully acknowledged. Why else would Citi require a further capital infusion of $14.5Bn in convertible securities that pay interest at junk status, job cuts and slashing the dividend?

Combine the above with the warning that delinquencies are rising on its $200Bn+ home loan portfolio and that credit card and auto loans are increasingly going bad. We can see the problems are not over.

It gets worse. The SIV problem has come home to roost. With the destruction of M-LEC ( Mr Paulson mentioned it once, saying it was good that it wasn’t needed! ) all the toxic paper has to come onto the balance sheet. I suspect it’s still being examined and most of the losses are not yet in the open. Further, Citi has yet to come clean about its derivative positions. We still do not know what counterparty risk Citi is liable for. Did Citi carry out proper risk analysis on any CDS it wrote or was counterparty too?

Even worse, we still do not know who is liable if Citi has a default or credit event. Like subprime, the Citi situation is not going to be isolated. Contamination from toxic paper is guaranteed.

What can ensure the spread? This:

NEW YORK (Thomson Financial) - Standard & Poor's lowered Citigroup Inc.'s long-term counterparty credit rating to AA- from AA, and on Citibank N.A. to AA from AA+, citing the financial services company's "severe losses." The outlooks for the ratings are negative. The short-term counterparty credit ratings of A-1+ were affirmed.

"Our downgrade also takes into consideration that Citigroup's performance could be rocky in 2008 amid prospects for a continued difficult operating environment for U.S. banks," said S&P credit analyst Tanya Azarchs. "More writedowns of mortgage-related securities cannot be ruled out."

Observant readers of “Credit Default Swaps – An Example In Real Time” will remember the implications for being placed on a negative outlook.

Oh yes, I nearly forgot. The opportunity with Citi lies with its bonds. If it has a credit default event that triggers payouts on CDS, bonds have to be delivered before payment is made. I would not be surprised if there was a large shortage of bonds in such circumstances, thus raising the price.

Maybe the opportunity arises as the death rattle begins?

Be Prepared - A Note From The Collection Agency

2008-01-04T19:19:00.000Z

A happy New Year to one and all.

I want to send you a quick note with a warning of possible Federal Reserve action with regard to Federal Fund Rates.

Today saw an openly acknowledged meeting of the Presidents Working Group on Financial Markets and a follow on meeting with Pres Bush, attended by Mr Bernanke. Although the wires presented it as this:

"White House has confirmed Fed Chairman Ben Bernanke will be in the 1pm ET meeting update to Pres. Bush from the Working Grp. on Fincl. Mkts; that meeting is not about discussing possible stimulus programs." (my emphasis)

With the likes of Goldman Sachs being quoted as follows:

"US ECON: It's official, Goldman says they expect a 50bps rate cut by the fed AT or BEFORE the Jan 30 FOMC. But, they say an intermeeting cut would "probably require a major downside surprise in consumer spending within the next ten days." (MNI)

I believe the Fed may cut rates as early as Monday, before the markets open. They will probably cut by 0.25% with a further 0.25% at the scheduled Fed meeting.

These are dangerous times, the quickening pace of the slowdown in the economy is a surprise to the Fed et al. Ensure your strategy is adjusted accordingly.

A Christmas Special - An Occasional Letter From The Collection Agency

2007-12-21T12:30:00.001Z

A Beginners Guide To Credit Default Swaps

We hear and see the alphabet of the derivatives world thrown around with gay abandon, like so much confetti at the Brides third (and definitely for the last time, she insists) wedding. Often the word "bond" is thrown into the mix, just to spice up the play, not unlike the bridesmaids, who at 2 and 0 for successful marital bliss, scrum down for the prize of catching that bouquet one more time to hope for a third attempt.

For some people though the world of derivatives is not a wedding made in heaven. So for those readers lets take a condensed walk through what is a Credit Default Swap. (CDS)

What is a CDS?

First and foremost a CDS is not a bond. It is a derivative based on a bond or basket of bonds as the underlying asset. (think CFD and Shares). The CDS is used to transfer credit risk to another party and because its a derivative the original underlying asset is kept by the owner. The bond paper stays in the vault and on the balance sheets.

How does it work?

An agreement is drawn up by 2 parties where the first is seeking to buy protection against a credit event that would adversely affect the underlying asset (lets say bond from now on) and the second party who is willing to sell that protection. Just like insurance, the buyer has to pay a premium to the seller, whilst the seller has to cover losses in case of an event. Again, like insurance, those events that could qualify for a payout are drawn up in the agreement.

What is a credit event?

As mentioned above its a list of circumstances, agreed by both parties, that would invoke a loss to the protection buyer. That loss of course is on the bond, held in the vaults, that was issued by a third party, the bond originator. An event could include debt restructuring whilst in administration or, in the US under bankruptcy laws, insolvency, debt default, failure to service the debt, non payment or even a change in credit rating of the bond.

Why are CDS used?

As well as straight forward insurance on the bond, the CDS can also be used reduce exposure to an adverse turn in credit market conditions, to enhance performance of a basket of bonds or to trade on events that may happen to bonds that the buyer of protection doesn't own. Of course for every buyer there has to be a seller of protection who will want a premium that reflects the risk of insurance. This also opens up the possibility of arbitrage trades and allow the trading of differing spreads and ratings on bonds.

What are the risks?

Like all trading the most apparent risk is over-exposure to a particular event for the protection sellers and not enough coverage for the bonds held (partial hedge) for the buyer. Other risks include a lack of research on the bond issuer where the risk is not reflected in the bond rating, including a reliance on mathematical models that do not reflect the probability of an event accurately. Another risk to the protection buyer is his exposure to the possible bankruptcy of the protection seller, leading to a default in cover.

What happens if the bond issuer defaults or goes bankrupt?

As long as the event is covered in the agreement the protection seller has to pay the amount agreed to the protection buyer, who has to deliver the bonds covered. In an orderly market or a market where cover of the bonds is equal to the amount of bonds that exist then the transaction is straightforward. However if the cover purchased exceeds the amount of bonds that were issued then the protection buyer will either have to buy more bonds or pay cash to the market value of the outstanding bonds for delivery to the protection seller. This is what happened with Delphi in the US last year and why the bond prices rose after Delphi sought protection under bankruptcy.

The original idea of Credit Default Swaps was sound. A two way contract taken out to cover a third party liability. The complications arise when the CDS is used in ways that have not been stress tested in theoretical or actual market conditions. With that test now upon us it is a good thing that as many people as possible understand what may or may not occur.

Although not a comprehensive and in-depth brief, I hope the above has helped with the understanding of CDS.

Market Snippets

As quoted:

2008 AFP Business Outlook Survey finds: financial professionals do not expect a recession in 2008 but do predict a slowing in the economy - with GDP growth projected at a median of 2.5%. The worst of the credit crisis is not over (66%) but most corporations expect to weather the storm with little impact. 64% of financial professionals expect the growth rate in inflation to increase slightly over recent trends and 59% believe that interest rates will continue to drop during 2008.

From Challenger: "Ongoing troubles in the housing market threaten to greatly weaken the 2008 job market, according to Challenger outlook, which not only foresees a significant slowdown in job creation but warns that next year could see an increase in job-cut announcements. If that occurs, it would mark just the second rise in annual job cuts since 2001. Outlook noted concerns about the economy triggered by the housing downturn and the subsequent collapse in the credit markets are already causing employers to postpone expansion plans and delay hiring."

Economist Chris Low at FTN says NAHB index is stuck at a record low 19 for a third month. "Housing starts have recently fallen to levels not seen since the early 1990s, which has resulted in almost a year of falling new home inventories. The high-water-mark was 570k in August 2006. Inventories have since fallen to 520k. Still, there's a long way to go before it's a seller's market again. At the end of the last cycle, inventories fell to 320k."

Credit Default Swaps – An Example In Real Time

In that almost mystical way in which co-incidence happens, a real time occurrence of the risks I outlined in A Beginners Guide To Credit Default Swaps has appeared. With excellent timing S&P downgraded the rating of ACA Capital Holdings Inc to CCC or, as it is known, junk. Whilst not a happy occurrence, it does give us the chance to walk through the consequences.

ACA Capital Holdings Inc. provides financial guaranty insurance on municipal obligations, asset-backed and corporate financings, bank certificates of deposit and surety risks through its insurance subsidiary, according to Bloomberg. The downgrading of ACA means that the insurance given to municipal bonds and derivatives is also downgraded, effectively downgrading the assets themselves. This has consequences to those who bought the protection from ACA.

It works like this. ACA are in trouble, big trouble. They look unlikely to survive the credit crunch and with liabilities already higher than assets, any call made on the insurance they issued will cause a default. That default means the assets insured by the protection buyers become fully exposed to the market and therefore become riskier to hold. As with any risky asset, the price falls / yields rise because potential buyers of the assets would need a higher risk premium.

The fall in asset prices is also reflected in the same assets held by other institutions and banks and downward pressure on the asset type as a whole appears. This causes the risk exposure on the holding company to increase, putting its ratings under review, normally with a negative bias. Some Institutions have to sell any asset of derivative they hold if it falls below a certain grade or price, increasing selling pressure and lowering prices. Buyers meanwhile lower their offers in a falling market.

As can be seen above, the effect of a single default can have widespread and very damaging consequences, not just to derivative and asset prices but to the gradings of the banks and institutions that hold such paper.

In fact the risk was so great that as it appeared inevitable that ACA would be downgraded to junk, Merrill Lynch and Bear Stearns tried to launch a rescue package to postpone the event. S&P went ahead anyway.

You will notice in the diagram I have used CIBC, Canadian Imperial Bank of Commerce , as an example. For a very good reason too. Within hours of the downgrade of ACA, CIBC announced that it " believes there is a reasonably high probability that it will incur a large charge in its financial results for the first quarter''. The fifth largest bank in Canada said that ACA insured about $3.5Bn of US subprime investments.

Unfortunately, S&P didn't just look at ACA, they also placed AAA rated Financial Guaranty Insurance Co. on negative credit watch meaning there is a 1 in 2 chance of a rating downgrade in the next 13 weeks.

They also placed Ambac, MBIA and XL Capital Assurance on a negative outlook. This means the chances of a downgrade in the next 24 months is 1 in 3.

The importance of this move cannot be understated. If ML and BS felt threatened enough to attempt a rescue on ACA then everyone should take note. The fallout has only just begun. The tipping point may well be in the municipal bond markets. Municipal bonds gain the same rating as the Insurer who sells protection (a CDS on a MB) and that rating is oft transferred to the local government too.

If the rating on the Insurer is downgraded, so is the rating on the CDS, MB and the local government. Not only will yields rise on current issues but with the local government also "downgraded" future debt issues by them will have to be at a higher yield. This would require higher taxes and lower spending to service the higher debt payments.

In an economy already showing signs of stress, further burdens on the consumer and businesses would guarantee a recession.

Market Snippets

Morgan Stanley is the latest bank to receive a cash infusion from a foreign investor. MS said Wednesday it sold part of the company to China Investment Corp., for $5 billion to raise capital after taking $9.4 billion in writedowns on mortgage-related investments. In October, Bear Stearns Cos. agreed to a $1 billion cross-investment from Citic Securities Co.of China, while Citigroup received a $7.5 billion infusion from Abu Dhabi government last month.

Richmond Fed Pres Lacker in a speech in North Carolina, said "I am uncomfortable with the inflation picture" as November core PCE prices will accelerate; he added GDP is to be 'very weak' for several monthss before improving. He also said that financial markets will find ways to work through their problems and tighter credit may restrict spending, but if oil prices stay high monetary policy will be more difficult.

Edit. Here is a copy of an article I wrote for Livecharts about the Term Auction Facility:

Term Auction Facility

December 13, 2007

With credit markets extremely tight due to the continuing unavailability of short term commercial paper (CP), The Federal Reserve, The Bank of Japan, The Bank of England, The European Central Bank, The Bank of Canada and The Swiss National Bank have decided to experiment with the monetary system.Let me say straight away, the risk involved in this new venture is high, not only to the whole credit based monetary system but to the Central Banks themselves. That said, if it succeeds then the pressures in the credit markets should be lifted, allowing conditions to become conducive to further lending. The stakes are very high indeed.

So what exactly is the TAF designed to do? There appear to be 2 functions.

The first is to allow dollar swaps from the Federal Reserve to the other Central Banks to help alleviate dollar based liquidity problems outside the US.

The second function is more complicated, co-ordinated and risker.

As the CP market froze and then contracted, due to the lack of confidence Banks had in each other and other Institutions to repay (or service) the short term debt, the Central Banks offered funds through discount windows of one form or another, usually at rates higher than base but lower than commercial rates. After the Northern Rock debacle, borrowing from such avenues was not thought to be a wise move.

Time however, is against those who had borrowed using CP. As maturity dates approach it has become apparent that the CP market has not recovered to its pre-summer liquidity, indeed the CP market appears to be closed to new issuance. The short term loans used to purchase longer term assets or to fuel carry trades (selling low yield currency to buy high yield other denominated assets) will have to be repaid. This has now come to a climax as year end rolling of positions has been placed under threat or become non-viable.This was not part of the original plan when the lending had been entered into. Indeed, like Northern Rock the plan was to keep rolling the short term debt into new short term loans allowing the long term positions to continue.
With the facility withdrawn the plan became unstuck and the repayment of the loans would require sale of the assets bought. If the assets had appreciated then the position could be unwound without a capital loss. On the other hand if the asset had dropped in price then the amount owed would have to be made up using the Bank or Institution own reserves. As most of the borrowing had been used to bolster leverage (margin) then losses would be amplified, threatening their solvency. This also amplified the lack of lending, as Banks etc hoarded their reserves.

Back in September The Federal Reserve drew up the TAF as an answer to a US-centric problem. The idea was not implemented as it appeared credit markets were stabilizing. However that stabilization was fleeting and as conditions worsened the TAF plan was dusted off and put forward to other Central Banks as a solution.

That solution is to replace the traditional CP market, allowing the Central Banks to replace the previous participants. This is a full test of the Lender of Last Resort Theory where Governments or their Agencies are allowed to interfere in a capitalist structure.

At first glance the plan seems workable. There are however weaknesses which could become exposed, leading to further problems.

Firstly, the action must be co-ordinated between all participants, including the Bank of Japan, who appear not to be part of the TAF but are required to allow currency markets to flow freely. As much of the carry trade is funded by the Yen they are an integral part of the system. This could lead to political pressures building if the Yen is strengthened, hurting the Japanese export dominated economy.

Secondly, previous attempted international multi-agency intervention has not done well in financial markets. The attempts to keep Wiemar Germany afloat and the ERM regulated spring to mind as these efforts resulted in conditions that either worsened the problem or allowed speculation to destroy a framework. The risk to TAF would be the latter, where speculation in forex markets could endanger stability. More likely though is a stress test of the carry trade. It appears that the forex markets have already identified which assets are at risk, albeit not intentionally. When the TAF announcement was made gains in emerging market currencies and carry trade favourites, such as the NZD, AUD, TRY, BRL MEX and GBP were seen in expectation of continued risk taking in carry trades.

If the Central Bank intervention is to allow either an orderly unwinding of Emerging Market carry trades or a continuation of general carry trade conditions then speculative attack on TAF is a real possibility, not unlike Soros Vs Sterling. Shorting Emerging Markets, thus pressuring assets lower would force those in the carry trade to liquidate (costing capital reserves) or to approach TAF for higher borrowing, pressuring forex levels. Systemic risk would increase, either through a viscous circle of liquidations forcing prices of assets lower (along with other sellers heading for the exits) or a destabilization of forex levels requiring Central Bank intervention in interest rate markets.

On the plus side TAF has some flexibility, when initial lending operations were announced it was made clear that others could follow as required. TAF does not seem to have a lifespan either, possibly removing the bottleneck of the year end / Jan 08 roll over requirements. Of greater importance are the amounts of funding available, which should be enormous and the lack of a penalty rate on the interest charged. This should make TAF a much more attractive alternative than the higher interest rate required at discount window facilities..

Although the risks to TAF are high, the risks to the reputation of Central Banks are even higher. If this experiment fails then confidence in the system as a whole would collapse. Central Banks themselves are in danger of becoming victims, whose role and function could be radically altered or even removed in the event of failure.

An experiment of this nature has never been seen before and its unclear as to what the outcome will be. What is known is that stock markets hate uncertainty and that may well drive market direction into 2008 and beyond.

Edwin Coppock, Fed Fund Rates and The Dow.

2007-12-16T22:04:00.002Z

Aha there you are readers, I couldn't see you, hidden behind all that steam rising from the cups of mulled wine. A warm welcome to the last letter for 2007 - did I hear cheers and whoops of delight? Well its to be expected I suppose, I have been a rather grizzly writer over the past 2 years and I know you would prefer to see a more positive outlook.

However, a positive outlook requires positive action to happen now that will help further ahead on the economic road. Alas, I am not seeing too much that gives me cause for hope.

I hope you found time to visit http://www.livecharts.co.uk/livewire/ and read the articles posted. As well as shorter articles covering topical subjects by myself you will find articles written by others too. Its well worth a visit.

As you know I try to peer into the future and divine what the economic outlook has in store for us. Readers had been well briefed about the credit crunch or as I see it the outright deflation of credit and it effects on the economy. Whilst I don't like to keep repeating the same theme, credit deflation is with us and will be around for some time to come. In this letter though I want to look at what the outcome of the current economic situation may do to stocks. I only rarely look at stock markets and try to see where they may be heading, not because I don't think its important but because there are plenty of other writers and systems out there who do just that, I prefer not to join a crowded play.

Edwin Coppock developed an indicator that helped to spot bull markets. Its a slow moving indicator and is usually late although, since 1996, it has become somewhat more timely. I think there is a very good reason for that. In 1995/6 Alan Greenspan changed his rate setting methodology, instead of following gold, he broke the link, allowing a period of steady rates in a more relaxed credit regime - enabled by the virtual abolishment of Bank reserve requirements.

The chart below shows that relationship and where it decoupled (with thanks to itulip.com and Aaron Krowne, the chart is part of a great article) :

We can clearly see that he was attempting to rein in credit growth as he warned about "irrational exuberance" by keeping Fed Funds higher. As we now know the relaxation of reserve requirements had a much greater effect than he envisaged, probably due to his inability to see what the outcome of allowing unfettered credit creation and leverage would do, even with a Fed on an inflation fighting stance. Thus was born the beginning of the stock market surge in a newly revitalised Bull market, the building blocks for the housing boom and the acceleration of the credit derivative creation and application. I suspect the increase in the use of leverage and margin made the Coppock Indicator (CI) more sensitive to market conditions.

In decades to come, 1995/6 will be seen as a pivotal event, the enabling of what was to come. It was after this event that the CI became much more timely in showing Bull market conditions. Although the CI is a Bull indicator it can, if used carefully and by applying the new gold/Fed Funds relationship supply us with a longer term view of what may happen.

The next chart shows 2 things. The first is my dire attempt to display what I consider to be the best chart of the year. If only I was better at this graphics stuff eh? Ah well readers, you can't have everything..... The second is the chart itself. I have overlaid a chart of the Fed Fund Rates from 1986 to present with a monthly chart of the Dow from 1986 with its CI. Its clear to see the CI before 1996 did indeed lag and post '96 its a much better tool. Although the CI is used to indicate a bull market on a rise through zero it can be seen that in either half of the chart CI did give a lower high before stocks broke lower (marked by faint red lines). Whats more those lower highs were divergent when compared to the Dow which made higher highs.

Now before you run off and short every stock in the markets, remember, the CI wasn't designed for this use and the timescales involved increase the need for caution. Think of this more as a warning of a possible change of longer term trend, after all that's what I look for.

Lets look a little more at the CI before I discuss the Fed Funds Rate. Its use as a bull market indicator seems valid to me, it crossed up through the zero line twice, in late 1988 and 2003. By any count, that's not a bad indicator. Going long on those 2 dates would have been very profitable. When the day comes and the CI crosses zero to the upside again, I will be happy to look for good value long positions. Two other zero line crosses also appear, both to the downside. here is were I think the CI has changed. Notice the turn down in early 1988 would have to be judged as a failed signal, the Dow didn't retrace lower. In 2001 though the down signal was very useful especially when combined with the retest of the zero line and the turn back down. I suspect the difference between the the 2 signals was the way Fed Fund Rates were applied at the time.

The FFR in the late '80s was rising in an effort to control inflation (aha gold!) and even with the crash of '87 when rates dropped slightly, overall FFR continued to climb. As did stocks. There can be little argument that in modern times, rising FFR and rising stocks are not uncommon. For the long term, buying stocks when FFR is raised from a low is no bad thing. It also shows us that buying stocks when FFR is falling from a peak is a bad idea and since 1996, buying stocks with falling FFR and a divergence in the Dow/CI is not clever at all. Its noticeable too that if the CI is falling, even with FFR rising, stocks tend to tread water, a warning that conditions are not ripe for major stock gains. Its seen in the Dow returns in 1994, 1997-8, 2000 and 2004-5.

So, what are the Coppock, Fed Fund Rates and the Dow trying to tell us now? Firstly a rider. Although Fed Fund Rates are falling, other rates, especially LIBOR are not. We should keep this in mind. Firstly, we have a falling CI, with a divergent lower high when compared to the Dow. The Dow itself is beginning to resemble the 1999/2000 top, without a lower low as yet. Fed Funds are dropping and if consensus (a warning in itself) is correct, FFR will be much lower next year.

With the CI acting in a much more timely fashion, the minimum we can expect is for a flat return on stocks whilst FFR has ongoing cuts and the downward direction of the CI is maintained. A lower low on the Dow would make the flat return scenario seem less likely and open up expectations of a larger fall in 2008.

I do have one caveat to the above forecast. As can be seen in the next chart (below) Asset Backed Commercial Paper is still plunging but we can also see the beginning of an upturn in financial and non-financial Commercial Paper (CP).

Is liquidity beginning to return to the higher quality end of the market? Its probably too early to tell and the move higher could be connected with year end liquidity but a trend has to start somewhere. If CP has stabilized and issuance is increasing then confidence may begin to creep back into the markets.

I have no doubt it is connected to this:Term Auction Facility.

Finally, an old friend has been speaking, I refer of course to Alan Greenspan. (with thanks to Sarah for highlighting the article) A quick reminder of what I see ahead:

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.

"In an interview on ABC's "This Week with George Stephanopoulos," Greenspan said low inflation was a major contributor to economic growth and prices must be held in check.

"We are beginning to get not stagflation, but the early symptoms of it," Greenspan said.

"Fundamentally, inflation must be suppressed," he added. "It's critically important that the Federal Reserve is allowed politically to do what it has to do to suppress the inflation rates that I see emerging, not immediately, but clearly over the intermediate and longer-term period."

That readers, is Alan Greenspan asking for rate rises. It makes sense if you think about what he did to the FFR / gold link. Remember, as the architect of this financial monster he has now to support it. As he sees it, rising rates and rising stocks go hand in hand. I still think he fails to see the effects that credit creation had in the making of bubbles. Even with a small increase in CP, credit is still being destroyed at a greater rate, confidence is still missing. I leave it to the reader to check where his remarks fit into the scenario.

The interview with Greenspan went on with this:

"Greenspan repeated his assessment that the probability of a U.S. recession had moved up toward 50 percent but noted that corporate America's debt levels were in good shape, which should help cushion the blow from tightening credit terms.

"The real story is, with the extraordinary credit problems we're confronting, why the probabilities (of recession) are not 60 percent or 70 percent," he said.

Maybe someone should remind him that only a few months ago, he thought the chances of recession were about 30%.

I hope you found this letter helpful and enjoyable. More importantly, I hope that you and your loved ones have a Christmas to remember for all the right reasons. Gifts and presents are nice but the warm glow from a smiling face is worth much more.

To read more visit “An Occasional Letter From The Collection Agency”.

To subscribe or comment, email mickp@livecharts.co.uk

An Occasional Letter From The Collection Agency In association with Live Charts UK.

All rights reserved, Copyright © 2006-2007 Mick P.

The Event Horizon For Credit - An Occasional Letter From The Collection Agency

2007-11-23T11:53:00.000Z

I was going to write a letter that pointed to evidence that supported the scenario that you see near the beginning of my occasional letters. I decided not to.

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.

The trouble was as I reached the half way point of the now defunct article, I realised it contained far, far too many quotes from various sources and not enough thought from the writer. So I deleted it. If you are reading this letter, you want my opinion not the regurgitated words of others.

The other thought (I am blessed in being able to have more than one thought a day) was the frequency of my recent writing. I have been writing more of late. Which made me think (see?) that if I am seeing more events then the pace of the scenario is increasing. Not only that, the scenario is not just a list of events, its interactive, events overlap and are intertwined.

Firstly, I want to show you a chart.

Call me a cynic but when I see conditions repeating themselves I tend to think the outcome will be the same. It looks to me that conditions are ripe for a recession. Closer examination of this chart though yields some very important information. Unless there is a major Fed policy change, I think the path to a major deflationary recession or even depression is looming.

Now, before you all jump to the conclusion that I am basing a very large assumption on 3 wiggly lines on a chart, I better show you how I think it will happen.

There is a wealth of information on this chart. Lets start with the St Louis Fed Monetary base, which is supposed to be superior to the traditional measure. Look at that uptrend, the monetary base has increased from circa $475bn to $850bn in 10 years, its nearly doubled. Looking closer though and the uptrend appears to have been broken, its still rising but the acceleration is much slower to the point where it looks to be leveling out from around early 2006.

Why is this important? Well lets read the words of The Fed or more specifically the following quote from A Reconstruction of the Federal Reserve Bank of St. Louis’ Adjusted Monetary Base and Reserves, written by Richard G. Anderson and Robert H. Rasche, with Jeffrey Loesel, July 2003 (revised August 5, 2003). Its a gripping read, honest.

"Recent analyses suggest two roles for the monetary base in policymaking.
The first focuses on the long-run implications of monetary base growth for the price level and inflation rate.

These authors argue that the truth of Milton Friedman’s proposition —“inflation is always and everywhere a monetary phenomenon”— does not depend on whether a monetary aggregate appears in the central bank’s policy reaction function. Rather, at least in the theoretical long-run when the effects of other shocks have played out, the inflation rate is determined by the growth rate of money because, absent such growth, the inflation could not continue.

It matters not at all in the long-run whether policymakers target interest rates or monetary aggregates for, so long as their actions permit the necessary increases in the central bank’s balance sheet, the inflation will follow. Hence, observations on the monetary base may be important evidence useful to analysts seeking to understand the ex post, if not ex ante, effects of central bank actions."

Well that makes sense, if the amount of money increases then so does inflation. I doubt anyone disagrees with that.

I disagree - and right about now, if you have been paying attention and scrolled back up to the chart, your doubts are increasing too. How can we have inflation both in monetary terms and in prices, which according to many commentators out there are understated, if the monetary base has barely moved since early 2006 when compared to previous years?

Glancing back at the chart again, this time looking at the Total Revolving Credit Outstanding and the Individual Consumer Loans From All Banks. Debt at a consumer level. TRCO has gone up in a similar fashion to the monetary base but diverges from this path in early 2006. As the monetary base leveled off, credit took up the slack, the same can be seen with ICLFAB. Let there be no doubt, the US consumer has used credit to replace the lack of growth in real cash, the consequence of a lack of paycheck rises coupled with a boom in asset prices, especially housing. Inflation is being caused by an expansion of credit which, when coupled with demand, is causing asset prices to rise.

This has ramifications beyond the simple visual warning of a recession highlighted on the chart by the 2 ellipses. As important as that warning is, it is minor when we examine the result of what will occur when the recession hits.

Lets look at what the consumer has to deal with. Credit has to be serviced, you pay back what you owe plus interest. You pay with money, earned by your labour. That reduces the amount of monetary base (cash) and therefore over a period of time - without the monetary base being inflated - the debt swallows an increasing amount of cash due to the continuing application of interest to the outstanding amount. If however interest rates rise whilst the monetary base does not then the burden increases to the point when payment becomes difficult or impossible. The consumer has 2 options, either default or arrange for a new debt payment plan, usually in the form of a new loan.

As we have seen happening over the past 5 years, the latter option has been the preferred choice of the consumer especially the use of refinance on property. Not anymore. The game has stopped as the asset prices and the confidence of the markets has fallen. Now the first option is becoming the new choice.

We can see the over-stretched consumer/debtor is becoming the next event horizon. Not only are financial markets having to deal with the continuing destruction of wealth caused by the current batch of defaulting consumers but now access to credit is becoming problematic for many. The next batch of defaulters will arrive at the tipping point into insolvency at a much quicker pace due to the inability to refinance but also with a higher debt burden.

Lenders, of whatever type, will have to raise capital reserves as debt gets downgraded as well as setting aside reserves to cover defaults. Add to this a raising of lending standards and credit doesn't just get squeezed, it stops.

The credit crunch can only get worse from here on in. As credit is withdrawn the effect it has had, as a substitute for a non-inflating monetary base, is lost. You can see in the first chart what happened when credit leveled off in 2001 but at least the monetary base was rising, cushioning the blow to spending power. Now we have a flat and if viewed over the past few months (below), a falling monetary base coupled with a flattening in consumer credit as shown in the Fed figures:

2007		Week ending
Sep	Oct	Oct 17	Oct 24	Oct 31	Nov 7
784.6	781.8	780.5	782.2	779.2	783.7

You can now see why, as a result of a flat to falling monetary base coupled with a contraction of credit, I see the risks of a deflationary recession as a very high probability. A depression is not as remote as many think.

Is this just a US-centric problem? Not according to Esteban Duarte and Steve Rothwell at Bloomberg, who unearthed this:

Europe Suspends Mortgage Bond Trading Between Banks

Nov. 21 (Bloomberg) -- European banks agreed to suspend trading in the $2.8 trillion market for mortgage debt known as covered bonds to halt a slump that has closed the region's main source of financing for home lenders.

The European Covered Bond Council, an industry group that represents securities firms and borrowers, recommended banks withdraw from trades for the first time in its three-year history until Nov. 26. Banks are still obliged to provide prices to investors, according to the statement today.

Banks including Barclays Capital, HSBC Holdings Plc and UniCredit SpA took the step as investors shun bank debt on concern lenders face more mortgage-related losses than the $50 billion disclosed. Abbey National Plc, the U.K. lender owned by Banco Santander SA, became the third financial company to cancel a sale of covered bonds in a week as investors demanded banks pay the highest interest premiums on covered bonds in five years.

``We are in a deteriorating situation,'' Patrick Amat, chairman of the Brussels-based ECBC and chief financial officer of mortgage lender Credit Immobilier de France, said in a telephone interview. ``A single sale can be like a hot potato. If repeated, this can lead to an unacceptable spread widening and you end up with an absurd situation.''

You can find more about Covered Bonds at: http://ecbc.hypo.org/Content/Default.asp
- if you can spot the difference between a CB and the MBS, ABCP or ABX derivatives then you have a keen eye.

Oh, and yes, you read that correctly - that is a $2.8 Trillion lending market that has been closed. No wonder LIBOR has been climbing to new 2 month highs and above and reaching new all time high in spreads from the Fed Funds Rate.

So far in this letter I have not mentioned the US dollar. Just about all those who see inflation in the future point at the falling dollar. All well and good but as I have written it doesn't matter one jot how expensive an asset is, if there is no money or credit to buy it.

We all know what happens to expensive items that nobody buys.

Which brings me to the problem I mentioned about a need for the Fed to change its policy.Below is an excerpt from the Fed FOMC minutes taken at the 30/31 Oct meeting:

"In their discussion of individual sectors of the economy, participants noted that the recent declines in housing activity—while substantial—had largely been anticipated. Nonetheless, the potential for significant further weakening in housing activity and home prices represented a downside risk to the economic outlook.

Most participants pointed to the deterioration in non-prime mortgage markets as well as higher interest rates and tighter credit standards for prime nonconforming mortgages as factors that had exacerbated the deterioration-ration in housing markets, and they noted that these developments could further limit the availability of mortgage credit and depress the demand for housing.

Some participants also pointed to downside risks to the housing market stemming from the large volume of substantial upward interest-rate resets that were likely on subprime mortgages in coming quarters, which could lead to a faster pace of foreclosures in the near term, thereby intensifying the downward pressure on house prices.

Participants generally agreed that the available data suggested that consumer spending had been well maintained over the past several months and that spillovers from the strains in the housing market had apparently been quite limited to date. Nevertheless, a number of participants cited notable declines in survey measures of consumer confidence since the onset of financial turbulence in mid-summer, along with sharply higher oil prices, declines in house prices, and tighter under-writing standards for home equity loans and some types of consumer loans, as factors likely to restrain con-sumer spending going forward.

Moreover, anecdotal reports by business contacts suggested a softening in retail sales in some regions of the country. Participants expressed a concern that larger than expected declines in house prices could further sap consumer confidence as well as net worth, causing a pullback in consumer spending.

All told, however, participants envisioned that the most likely scenario was for consumer spending to continue to advance at a moderate rate in coming quarters, supported by the generally strong labor market and further gains in real personal income."

Where is the focus of the Fed? Are they truly looking at price inflation, asset depreciation, spillover effects, consumer spending, unemployment and not quoted above, disruption in the financial markets and waiting to see what the effects are?

Because if they are then the focus is blurred and the current policy of "wait and see" as to which of the upside or downside risks wins out will place the Fed in a position not unlike that of the Bank of Japan in the early 90's.

The Fed has no easy choices. Rate cuts alone cannot repair the damage caused to a financial system were confidence has been replaced by fear. So far I see no signs of reflation and I am beginning to wonder if the Fed wants a lower benchmark in the economy before it initiates such actions. If they do it could be a most dangerous course to take in a system reliant on an inflationary bias.

The speed and size of the credit contraction is growing, as it should where credit was used to beget more credit. A Fed that is still bias toward an inflation fighting stance could greatly exacerbate the situation.

Does the Fed possess the agility and the correct policy to react in a timely fashion?

I hope you enjoyed the read, if you would like to see more, visit “An Occasional Letter From The Collection Agency”.

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An Occasional Letter From The Collection Agency In association with Live Charts UK.

Is Ben Bernanke Getting Undeserved Criticism?

2007-11-13T12:39:00.000Z

As the markets rock and roll from one event to another hopefully readers kept a close eye on the $/Yen rate that we discussed in the previous Letter. It certainly helped me, there is nothing like a bit of carry trade unwinding to help with market direction.

Okay, I'll put my trumpet back in its box and get on with writing something less egotistical.

A recap of the scenario:

Yes, its time to remind you of the path I expect to see for the global economy. I do mean global, this is not a US-centric problem and in my opinion, never has been. So, where are we along the path? What clues are out there to help us, what analysis can be looked at to help us peer forward through the swirling smoke billowing up from the burning bundles of derivative paper?

How about looking at the words of Mr Bernanke? Most readers have probably seen the recent video clips of his Q&A session with Ron Paul, how he sat there looking like he wished he was anywhere else, or so the commentary goes. Very little has been written about his testimony, yet it contains some useful insight. So why not use it, after all at least his agenda is a lot more transparent than the analysis coming from the Bank/Broker/Financial Cabal. Shall we?

Okay, below is the extract from the testimony that I am interested in. Its the section where Mr Bernanke spells out what he sees as the forthcoming economic scenario and the possible up/down side risks. I am going to insert numbers into the text as we go along and I'll tabulate my thoughts to his remarks after the statement.

Chairman Ben S. Bernanke

The economic outlook

Before the Joint Economic Committee, U.S. Congress November 8, 2007

"Overall, the Committee expected that the growth of economic activity would slow noticeably in the fourth quarter from its third-quarter rate. Growth was seen as remaining sluggish during the first part of next year, then strengthening as the effects of tighter credit and the housing correction began to wane. (1)

The Committee also saw downside risks to this projection: One such risk was that financial market conditions would fail to improve (2) or even worsen, causing credit conditions to become even more restrictive than expected. Another risk was that, in light of the problems in mortgage markets and the large inventories of unsold homes, house prices might weaken more than expected, which could further reduce consumers' willingness to spend (3) and increase investors' concerns about mortgage credit.

The Committee projected overall and core inflation to be in a range consistent with price stability next year. Supporting this view were modest improvements in core inflation over the course of the year, inflation expectations that appeared reasonably well anchored, and futures quotes suggesting that investors saw food and energy prices coming off their recent peaks next year. But the inflation outlook was also seen as subject to important upside risks. In particular, prices of crude oil and other commodities had increased sharply in recent weeks, and the foreign exchange value of the dollar had weakened. These factors were likely to increase overall inflation in the short run and, should inflation expectations become unmoored, had the potential to boost inflation in the longer run as well. (4)

Weighing its projections for growth and inflation, as well as the risks to those projections, the FOMC on October 31 reduced its target for the federal funds rate an additional 25 basis points, to 4-1/2 percent. In the Committee's judgment, the cumulative easing of policy over the past two months should help forestall some (5) of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and promote moderate growth over time. Nonetheless, the Committee recognized that risks remained to both of its statutory objectives of maximum employment and price stability. All told, it was the judgment of the FOMC that, after its action on October 31, the stance of monetary policy roughly balanced the upside risks to inflation and the downside risks to growth."(6)

(1) Hey thats not bad stuff Ben, I wonder if he will start a blog? Right, we have a lot to cover here so lets get started.

(2) This needs to be re-read, Mr B is being quite bearish on the prospects of the US economy for this Q and into next year in the first paragraph and then gives that scenario a further downside risk. The risk being that if conditions in financial markets fail to improve. In other words the current status quo is enough for The Fed to downgrade the outlook. Conditions do not have to worsen for the downgrade, if there is not a rapid and widespread change in credit market conditions starting right now, then the Fed will have been too bullish.

(3) This is a direct reference to a weakness in consumer spending. Mr B is shouting "spillover effects" from the rooftops. I know its couched in that particular phrasing used by The Fed but its not oblique. Mr B is worried about spending power, not sentiment. I suspect he already knows that sentiment is seriously damaged.

(4) This is a very clear analysis of the current situation and the effects the current rises in oil, commodities and the drop in the $ could have on long term inflation. He seems worried that inflation expectations are under threat of breaking free from The Feds intended direction. This is not the rhetoric of a man readying the market for a series of cuts. This is the noise made by a Fed that wants to raise. Is Mr B preparing the way for a "Volker Attack" on inflation?

(5) "Forestall some of the adverse etc, etc". Take that as a full on warning that The Fed is limited in what it can do to help the "broader economy". I suspect the reason why the US Tsy had to help set up the Super Sell to You SIV-Lite Bailout Vehicle (Lets call it Cellulite, its a perfect description) was because Mr B would not lower himself to bailout speculators and gamblers. Is this a "hidden" display of morals and ethics by Mr B?

(6) Very straightforward. The view expressed is guaranteed for one day only, 31st Oct 07. From then on all aspects are subject to change, without notice. Risks can go to the downside as well as the upside. Now, you tell me, how often do you read bloggers, analysts, journalists and any other talking head that doesn't do the same as Mr B, qualifying the outlook or opinion as "depending on future data"? Yep, just about every single one.

So is Mr Bernanke getting undeserved criticism? I think he is and I think I know why. There is a war on Wall St right now and its viscous. There are interests that need protecting, accounts that need to be kept hidden and rescues that have to be carried out. All of this has to happen in conjunction with falling rates . If it doesn't happen quickly, with the full cooperation of the Regulators, Fed and USTsy, then whole ponzi scheme comes crashing down. Someone though isn't giving out enough covering fire. Mr Bernanke is keeping some of his powder dry by not telegraphing further rate cuts, in fact you could easily see a case for rate rises if some of the downside risks become too big to ignore.

Wall St doesn't like it. The last thing the Cabal expected was that they would have to use their own money to sort out their own mess.

Is Mr Bernanke getting bad press at the behest of Wall St?

Finally, a few snippets that may help you decide if Ben is looking in the right direction.

UK: Tuesday Morning Market: Rising inflation dampens rate cut hopes.

US OUTLOOK: From Goldman: "Without a rapid pullback in oil prices,
year-over-year CPI inflation is likely to reach 4% by early 2008, and
PCE inflation should push past 3%."

US OUTLOOK: From UBS: reducing GDP forecasts through mid-year 2008 (1.2%
Q4 '07 and 1.4% 1H 2008) and lowering terminal Fed Funds target to 3.5%.

US DATA: Nov IBD/TIPP Economic Optimism Index takes a dive, falling
3.5 points, or 7.4%, to 43.8. The report said:

"Persistent negative reporting in the media along with
high-profile stories about large companies cutting jobs are helping to
reinforce American's negative view of the economy. Tangibles like high
fuel prices, rising retail prices and the mortgage crisis are also to
blame."

If Ben did a blog, would you read it? If you did read it, where on the eco-path do you think we are?

PS

I cannot enable comments on the blog, I don't know if its a template/software or user problem. If you want to comment on this letter, send me an email and I'll gather a few together and post them up. If your 30 day trial period is up, you will need a google email address to access the blog. Its the downside to getting a freebie but it only takes a few seconds. I do not work for Google.

Fed Speak

2007-10-31T18:48:00.000Z

Sorry all, I forgot to enable comments, I will post this for those that wish to add remarks.

Edit - or maybe not! There seems to be a glitch with the comments facility. I'll try and sort it asap.

The Federal Open Market Committee decided today to lower its target for the federal funds rate 25 basis points to 4-1/2 percent.

Economic growth was solid in the third quarter, and strains in the financial markets have eased somewhat on balance. However, the pace of economic expansion will likely slow in the near term, partly reflecting the intensification of the housing correction. Today's action, combined with the policy action taken in September, should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and promote moderate growth over time.

Readings on core inflation have improved modestly this year, but recent increases in energy and commodity prices, among other factors, may put renewed upward pressure on inflation. In this context, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.

The Committee judges that, after this action, the upside risks to inflation roughly balance the downside risks to growth. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Charles L. Evans; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; William Poole; Eric S. Rosengren; and Kevin M. Warsh. Voting against was Thomas Hoenig, who preferred no change in the federal funds rate at this meeting.

In a related action, the Board of Governors unanimously approved a 25-basis-point decrease in the discount rate to 5 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of New York, Richmond, Atlanta, Chicago, St. Louis, and San Francisco.

Does The Fed Need To Cut?

2007-10-30T10:30:00.001Z

This is a subscriber only letter. It will not be offered for publication elsewhere until after the event.

Firstly, a welcome to all the new readers and thank you to those who took time to offer feedback by email. You can, as a subscriber, comment on the blog by using the reply facility, if you wish. Remember, after the initial 30 day guest period, you will need a gmail account to access the blog, its quick and easy to do and its pretty good. I do not work for google......

Although my letter tends to be forward looking I do occasionally look at what I consider might be inflection points, a current event that may have a long term impact. As you can see from the title, I suspect The Fed meeting, ending tomorrow, has this possibility.

I am not a share tipster and rarely call direction on the markets unless I see a set up that could have the potential to damage wealth. I can see such a set up today.

Now is a good point to do a reality check. Is the US heading for hard times? Well, looking at some of the figures for Housing, Consumer Retail and Financials you can make a good case for impending recession. I wouldn't disagree with that. Trouble is, in the face of a lot of bad news, the stock markets are still getting bought.

In basic terms, someone sees value in holding US shares. We can't hide from that, in spite of what seems to be bearish fundamentals, lets not blind ourselves to the obvious. So who is buying?

Simply put its anyone who can take advantage of leverage and a depreciating Dollar. Yes, its the carry trade. Its not just the Japanese either (or Swiss) its also US Institutions who borrow (sell) yen, convert (buy) dollars to then buy $ denominated assets, hoping the yield difference and capital gains exceed the any devaluation, inflation and costs, boosting the profits by leveraging the deal. The leverage is important as it magnifies the profits. Its a huge one way gamble involving truly massive amounts of.......credit.

Right now its balanced, the carry trade is good. Its so good that even on an intraday basis moves in the Yen are matching moves in the Dow, especially last week.

I'm focusing on Yen/Dollar here and although the real elephant is the Euro I am ignoring it for a simple reason. It makes the charts look messy. I have a couple of charts (thanks to Stockcharts.com) to show what happens to the Dow when the $ and Y move:

You can see the relationship, Yen (blue) is inversely related to the Dow (red). The dollar (green) is in a downtrend and looks sickly. So yen down, Dow up, looks pretty good to me. Hang on a minute though, look at the recent action in October (the chart covers the past 200 days) yen up, Dow up. Okay, we can see the relationship worked at first, the Dow dipping as the Yen rose but since the 19th even though the Yen has remained at the recent high, the Dow has rallied. This is unusual.

Here is a chart from 2004/05 showing the same relationships:

Ahhhh, maybe the truism isn't as good as was thought? Or there is a message being screamed out, loud and clear. Those who looked at the green line are on the path to enlightenment. Its the $. Its that relative value between the $ and Y that makes it all work. The Dow can go up when the Y rises, as long as the $ keeps depreciating or holding a lower value.

Look at what happened to the Dow (sorry for the hindsight view here readers but sometimes history can teach lessons to those who listen) in 2004/5 when the $ appreciated against the Y. Now look at the current situation.

You can see why I called this an inflection point.

Lets get down to it. What can The Fed do tomorrow?

The Fed could raise rates, saying the turmoil in the credit markets has stabilised and inflation needs to be addressed. The $ would scream higher against the Y and the stock markets would swan dive.

The Fed could stay pat, saying inflation is okay and its ready to move if any deterioration in the data warrants. The priced in 0.25% cut would be unwound, stock markets would have a bad hair day or 5.

The Fed cuts by 0.25% saying conditions require a flexible approach. The cut is priced in and the wording of the statement will be taken as a sign more cuts are on the way. $ drops and the Dow has a 200 point move up.

The Fed cuts 0.5% saying conditions in the economy and the credit markets are cause for concern. After an initial spike and run higher, markets reverse as reality hits home or - the carry trade is reinvigorated and the Dow heads for 15k.

The Fed does have a problem though. Before the meeting is over, 3Q GDP will be out. If GDP is strong and the Price Index shows inflationary pressure stock markets might take fright as the expected 0.25% cut is endangered.

If you are positioned in the markets into tomorrow you may want to re-examine your risk level.

Do the Fed need to cut tomorrow? If they want to save the stock markets then yes a cut of 0.25% is essential. Although this is a short term fix (and is related to my last letter), longer term the Fed maybe about to commit a mistake that will haunt them for years to come.

What Do Paulson, Bernanke and Greenspan Have in Common?

2007-10-21T20:53:00.001+01:00

Firstly, before we get into this letter, a quick explanation of the new format. I have set up a blog to try an encourage building a membership and utilise an easier way to archive previous letters. It will make it easier for your comments to be posted and accessed too. I have enjoyed the feedback from various readers out there, I have received really good, thought provoking comments that deserve a wider viewing and this format should help.

Its free, as promised. Its a simple blog, so what I intend to do is send out an email to the members to let them know a new letter is available. To view it you need to create a Google email address after 30 days, it only takes a minute or so. The advantage of membership is that you will get to view the letter first, publishing it elsewhere will be delayed. I will also look to start publishing more frequently (alright, who groaned?)

Right lets get on with it.

What have Paulson, Bernanke and Greenspan got in common? Let me show you and then I want to write about what I think they are alluding to, ie what they see is coming but dare not utter, not yet anyway. I also want to walk you through the steps to deflation (that's a good title for an album) and why those steps are throwing up the current confusion of thought in the mainstream media.

Here are the comments that caught my eye this past week:

Paulson : "The housing decline is still unfolding and I view it as the most significant current risk to our economy," he said. "The longer housing prices remain stagnant or fall, the greater the penalty to our future economic growth."

"The ongoing housing correction is not ending as quickly as it might have appeared late last year," he said. "And now it looks like it will continue to adversely impact our economy, our capital markets, and many homeowners for some time yet."

Bernanke : who said "market uncertainty" in September led to the cut in federal funds rate by a 0.5%. Bernanke said the assessment of Fed governors and bank presidents was that market uncertainty was thought to be "unusually high."

Greenspan : the market does not appear to have priced in the risks posed by the ongoing housing slump.

As recently as 2 months ago these 3 individuals didn't agree with each other, Greenspan was talking of highish odds of a recession, Bernanke was waiting for more data and worrying about inflation and Paulson saw no signs of a spillover into the economy from the housing slump. Now we have a consensus, they all have something in common.

Its the markets. Be it either adverse impact, lack of pricing risk or unusually high uncertainty its all down to whats happening in the markets.

What does this tell us? Firstly, there is a real fear out there that the markets are getting out of control and that reality has yet to visit. Secondly, the watchkeepers/booksellers of the economy are no longer looking ahead, even if they say they are. This means trouble is brewing, big trouble.

It looks like Bernanke and Paulson are preparing the "Excuse Quotes " chapters for their eventual books. Since early this year we have been subjected to the official line that the fallout from sub-prime (now housing, an upgrade to include prime, Alt A and Jumbo loans) would not harm the economy, that there would be no spillover. Then we began to get the odd mention of minimal spillover but the problem was contained. All this talk was to keep confidence in the markets, be they stocks, bonds or derivatives.

Not anymore. Now we get warnings (Darling, the UK Chancellor, is also now warning of economic harm to the UK) that this will affect the US economy, because the scope, size and the timescale of the problem is much greater than previously imagined. Greenspan, whose remarks about a recession in the US made earlier this year were ignored, is now joined by the Fed and the US Tsy. We are still getting remarks that US growth is "strong" and will be "about trend". Yeah, like that's believable after the back tracking on the causation that could affect growth.

The actions of the Fed are also interesting. Contrary to what the media will tell you, the Fed is not pumping money into the economy. It did initiate a few new weekly rolling repos back in August that it is still allowing to be rolled but there has been no ongoing infusion of cash, the Fed has remained tight. You can check this out at the NY Fed site: http://www.ny.frb.org/
So we can see, debt (ABCP), lent out as an instrument to secure short term debt( electronic cash), the proceeds of which is used to lend as credit - has imploded.Banks are not exactly banging on the glass at the discount window either. It looks pretty obvious that after the setting up (if it happens, its not a done deal) of the Super SIV, the Banks and Institutions have been told to use their own cash to sort out the mess of the off sheet imbalances. It seems the US Tsy has adopted Enron accounting practises as acceptable, maybe Enron was just ahead of the curve in financial innovation?

So, why have such practises now been condoned? That's simple. The problem is so big, so interconnected with all forms of the derivative markets that the only way out is to park the toxic instruments into a dump. I suspect the dump will have a long history of leaks, drip feeding poisonous paper into the community.

I want to walk you through why I see deflation in the future.

At this point I have to make something clear, whilst the traditional view of deflation is less money in the economy, I do not see cash as the current driver of inflation/deflation. The mover is credit. Allowing an unfettered increase of credit to replace the traditional over printing of notes to sustain a bubble(s) or ponzi scheme (if banks have, as a % of loans, effectively no reserves, what else can the system be based on?) then a reduction in credit must be deflationary.

The importance of this cannot be under-estimated. Credit itself has/is being used as an asset to beget more credit. This explains the exponential rise in credit, it feeds on itself as credit notes become the asset to allow further credit to be lent out. By allowing credit to underwrite itself to form other types of credit the whole system becomes reliant on the confidence of lenders and borrowers having the means to eventually repay. If that confidence is put under pressure, the system stops. If confidence cannot be restored in a very short timescale (Central Bank / Tsy intervention) then the system begins to reverse, as credit is redeemed. The reversal will be at the same pace as the initial rise in credit growth. Although painful, the reversal would be orderly, as long as all the borrowers have the ability to repay. If that ability to repay is impaired then the redemption becomes disorderly. This is the stage we have reached today.

The Super SIV mooted by the Banks is the last gasp attempt to stop a disorderly destruction of credit. A disorderly destruction of credit will invoke deflation.

Now some readers will be looking at the price of commodities and scratching their heads, trying to resolve the high prices they see with a deflationary outlook. I sympathise, the confusion is understandable. The thought would be if the price of "stuff" is going up, surely the price of end products will rise too? That must be inflationary!

Well it would be inflationary if prices caused an increase in credit. Its the horse and cart. The cart (price inflation) is dragged along by the availability of the horse (credit) to work and to continue to work at an ever increasing amount of effort. If the horse has a heart attack, the cart stops. If the cart is loaded with debt and its on an uphill slope, it will roll backwards.

So if this simple writer can see this surely all those buyers of commodities can too? They can. They are not buying "stuff" as an inflation hedge. They are buying hard assets. Something that the destruction of credit cannot take away. Except for those who bought using leverage and margin of course.

I'll leave you with a simple chart from the St Louis Fed that says a lot.

As we can see Financial CP flat lined for most of the year and after a slight rise, dropped. It is struggling to reach the gain line. Financials are not putting their own cash into the market in any great amount. This shows fear and uncertainty. ABCP looks to be in a terminal decline.

ABCP (the assets being debt) lent out to secure electro-cash, which is used to finance long term borrowing by a third party - has collapsed.

The horse is dead. That rumbling noise you can hear is the cart careering downhill.

Archiving previous articles

2007-10-09T13:16:00.000+01:00

Just a quick note, the posts below are an archive of previously published letters with the earliest first and the latest letter at the bottom. The letters are connected by theme so any new readers will benefit from a quick (or not so quick) read through.

Hopefully thats the last time I have to do that.......