We Have a Debt to Discharge

There is a common error with contrarian investing.  It is not a question of identifying things that people believe that are wrong, but finding things that people rely on that are wrong.  Reliance is the critical component.  I don’t care about what people think if they don’t have any skin in the game.  When someone relies on a certain result happening (or not happening), then there will be series of behaviors that happen as what he believes in fails, from intensifying the bet in the early phases, to throwing in the towel in disgust at the end.

I’m going to take this idea and twist it a different way today.  One thing that the Democrats and Republicans (except Ron Paul) agree and rely on is that they know how to avoid a repeat of the Great Depression.  The textbook answer is:

• Easy Money
• Fiscal Stimulus
• Don’t Raise Trade Barriers

Ben Bernanke learned this as a young college student, and built it up in his Ph. D. dissertation.  He has the same moral certainty about this that George Bush, Jr. does about fighting terrorism.  And, I’m going suggest that Bernanke, and most of the political establishment (which hasn’t really changed in the last few days) are wrong.

What is a bubble?  My definition: A bubble is a self-reinforcing cycle where monies invested obtain a negative return in aggregate over the long haul.  It is characterized by significant borrowing at low rates to invest in already appreciated assets in order to profit from a momentum-driven market.  When cash flow is insufficient to pay the interest to finance the bubble, the bubble pops, and a self-reinforcing bear market ensues.  When that bear market encompasses most of the financial system, we call it a depression.

What is a depression?  A severe recession where the banks are impaired.  In an ordinary recession, lowering the Fed funds rate can stimulate the banks to lend.  Not so now; the banks are licking their wounds, and letting profits grow by financing at lower rates, and sucking in bailout cash to shore up their balance sheets against future real estate lending losses.

The Great Depression ended when the Debt to GDP ratio dropped below 150%.  When enough debts were extinguished by payoff or default, the system could once again be normal.  Virtually none of the efforts of FDR focused on eliminating debts; in my opinion, he lengthened and intensified the Depression by not encouraging the liquidation of bad debts.  And now we do the same thing.  We perpetuate the misallocation of resources by trying to keep house prices high, by bailing out institutions that should go through the bankruptcy process.  This fails to convert bad debts into equity in newly solvent businesses.

All the US government is doing is creating a bigger bubble.  What will happen when the Treasury auctions fail, or, stretch the yield curve so wide that there is panic.  We don’t want our financial institutions to fail, so we are willing to wager the creditworthiness of the nation in order to save them.  I don’t like that bet.  Many empires have died choking on debt.  Is the US to be next?

When I wrote articles opposing the bailout, I did so because I did not think it would work, and that one-off conservations/liquidations would be preferable, but not optimal.  Optimal to me would be using the bankruptcy code on a expedited basis, wiping out junior capital, and making senior capital take haircuts.

But in the present, we contemplate borrowing to bail out all manner of problems — bail out homeowners, automakers, banks, insurers, guarantors, etc.  The end to this phase will come when the creditors of the US write off their prior lending, and decide not to throw good money after bad.  I have no idea when that time will come, but the dreamy schemes of politicians aiming to solve every financial hurt will help to force such a time to happen.

Comments

[bluesmoke:]

It seems to me in times of uncertainty investors would seek refuge in something with real monetary value - like gold. But that hasn't been the case. Instead, the only way to win has been to short the market and put your paper winnings under the mattress!

2008 Nov 07 09:12 AM

[Alan von Al...:]

Excellent statement, David. Thank you.

2008 Nov 07 09:19 AM

[Smarty_Pants:]

"The end to this phase will come when the creditors of the US write off their prior lending, and decide not to throw good money after bad."


Truer words have never been spoken. Our eventual fate rests uneasily in the hands of our creditors, and the gub'mint's plan is to keep adding to the pile of debt they are carrying on our behalf.

When "the end" arrives, it will be most unpleasant.

2008 Nov 07 09:30 AM

[DVW:]

You got that right, slick!

The problem is we expect the government to do something, so they do. The only thing they can do is reinflate.

Best case is they can reinflate without hyperinflating. It's a fine line, that one! Gold and assets will do well here.

Probable case is we wallow out a flat line for a long time until the debt is worked off. In that case, no asset class is predominant, not even gold.

Worst case is the beast continues to be hungry for liquidity and we see a Depression.

Like it or not the Fed has put a bottom in the deflation... for now. Can they maintain balance? We will see.

Watch the $USD and $CRB for trends going forward. To invest now you absolutely HAVE to know if we're inflating or deflating. Those two indicators will tell you without a doubt.

2008 Nov 07 09:38 AM

[bricki:]

Debt below 150% of GDP = end of depression because it happened ONE TIME before. Has anyone ever heard of correlation does not equal causation? Or cum hoc ergo propter hoc? Come on guys this is middle school stuff.

Really poor article.

2008 Nov 07 09:44 AM

[infp:]

The Wall Street bailout simply demonstrated the political power of Wall Street. Rather than allow all the investment banks to go bankrupt the elites or our country choose to transfer wealth from taxpayers to those banks. The populace was frightened into compliance with warnings of catastrophe if they failed to comply. If instead, we had allowed these investment banks to fail I believe that our financial system would have convulsed and regenerated itself quite quickly. There were many domestic and foreign financial institutions that could have stepped in to fill the void and we would have quickly eliminated huge amounts of bad debt. Unfortunately, we did not choose that option and the same financial elites that brought this crisis upon us are still in charge.

2008 Nov 07 09:56 AM

[SW Richmond:]

David,

Wow. Excellently written. I agree with all of it, and your assertions about certainty are well received here. I have argued repeatedly that there will be a massive attempt to reinflate for the simple reason that they believe it will work, and they will continue to believe that if it isn't working that's only because they're not trying hard enough yet. Bernanke simply goes down his tool list and keeps on inflating until it "works". I argue against it, and and write my congressmorons to not do it, but I know they're going to do it for the reasons you so aptly point out. It's their paradigm, their belief system. I wish I could say it in as few words as you have.

I concur also with your solution: bankruptcy. No more good money after bad. Good capital could be put to work starting recovery, but instead we are shoveling it into a bottomless pit.

Again, excellent and worth sharing with my friends.

2008 Nov 07 09:56 AM

[Broken:]

"Virtually none of the efforts of FDR focused on eliminating debts; in my opinion, he lengthened and intensified the Depression by not encouraging the liquidation of bad debts"

Actually, the economy grew by an average annual rate of 8% after hitting bottom in 1933. By 1935, the business community was clamoring for an elimination of FDR's programs since "the Depression was over". Many programs were cancelled (or nulified by the SCOTUS) and the economy slumped again. New programs were started up.

I disagree that "debt to GDP" was too high, since it was much lower than it has been in recent years. It depends on what you are including in that debt.

However, the biggest reason for the prolongation of the Depression was the extinction of foreign trade, which did not revive to pre-Depression levels until after WWII. Let that be a lesson to any with protectionist sentiments.

2008 Nov 07 10:07 AM

[Consider_this:]

Consider that all dollar bills are effectively "Federal Reserve Notes" backed by the full faith of the government.

From the above statement should be plenty clear that each dollar is effectively a unit of debt.

(This is a very little known and little publicized secret with our government. See landru.i-link-2.net/mo... )

Using that measure, trying to discharge debt or trying to default on them, effectively destroys money. It's also not the action anyone (in the system or in the know) wants the populace to behave.

In that context, trying to expect government to stop bailout, stop the inflation of more debt, is so fundamentally against what the government and the system has built that it'll be a futile effort.

I know this will be a shock to many who read my comment and the article I linked to, but this is the difficult truth.

We've been sold a bag all the way back when we adopted the fiat known as FRN, or the "dollar bill". We're all bagholders now.

It's not as simple as a plan to gradually get back to our feet and out of debt. This system is designed such that that's never possible. Trying to imagine or plan otherwise is futile. There's no gradual way out of this mess.

On the other hand, perhaps this bubble isn't big enough to destroy the system. if so, we've simply tested the system's limits, and we'll all collectively go on with debt-inflation after this intermission. Pretty soon, "Trillion" will be the new million.

As the Chinese always say, "May you live in interesting times."

2008 Nov 07 10:30 AM

[Mountain Fist:]

Excellent article David! I have to agree with you one hundred percent. No matter how based in reality, fact and intelligent reasoning an article on SA is there's always a couple of naysayers on here who just have to back up the failed policies of our gub'mint (as smarty_pants so aptly names them) and the Fed itself. Until we've been in a depression or recession for years, in fact usually not until it's over with and looked at from a historical perspective, many of these people will never admit we are/were in a depression or recession. How many people do you have to see suffering to admit reality? Or are you so removed from the real world that you don't get it. I think everyone that commented here is intelligent enough to grasp that correlation doesn't equal causation. Are you just trying to be insulting bricki?

bricki and Broken...It's not like this stuff is something new or made up. It's recorded history that's been going on thousands of years. While empires, systems of government, cultures throughout the ages have been different, it is the similarities we have to look at. The ecomomics of fiat dollars, debt, and powerful governments who think they can manipulate anything have not changed. It has never worked, and it never will. The Fed/gub'mint is killing the USA, and it is up to people who do get it, like Mr Merkel here, to be the voice of reason. It is patriotic and morally right for those who grasp the reality of our country's current fiasco to speak of it and to convince others of our friends, families and anyone who will listen of this.

2008 Nov 07 11:00 AM

[Mountain Fist:]

My apologies. Last line should read: It is patriotic and morally right for those who grasp the reality of our country's current fiasco to speak of it and to convince any of our friends, families, or others who will listen of this reality.

2008 Nov 07 11:05 AM

[Socialism c...:]

Right on, David!!! It's not just the financials that were a bubble -- they have "forced" the entire economy into credit-based living by the excessive taxation that we endure. Any unwinding has to be a return to living within our individual means...and we can't reach that ability and return to real growth based on non-credit spending until the government is radically downsized and spending within its means, and until We The People are allowed to retain most of what WE earn!! Anything else is fiscal insanity and we shouldn't wonder that bubbles continue to form -- the individual is continually faced with preemptive grabs of his earnings, and the use of the income tax and property taxes to fund things means that government readily fluctuates the amount taken -- generally to the up side...making it very difficult to have any semblance of stability or plannability in personal income. With a 66,000+ page federal tax code, is it any wonder that we can't model government revenue with any reliability?

The only sound answer is to abolish income taxes, and go to solely consumptive taxation. That along with a Balance Budget Amendment are *critical* to returning this nation to freedom, control of the government *by* the people, and fiscal sanity!!!

2008 Nov 07 12:20 PM

[Jason Rines...:]

Good article and the main salient point is debt to GDP. With dwindling cash, consumers and businesses can't pay debt. When WWII started and the US cranked up GDP towards defense spending to 75%, it created millions of jobs. Consumers and businesses displaced a bit for the war and these jobs, but then could afford to save and invest, paying off debts. Those jobs stuck, because WWII created innovation such as microwave, radar, computer, jet power etc etc. etc. Cranking up our GDP for energy independence is the solution to this catastrophe. Other critical things will happen on it's own as history has shown, such as voter revolutions and managment getting fired and replaced, bankruptcies and writing off some debt, etc. But that is a four year process give or take according to history and pain is the catalyst unfortunately for those processes to occur.

2008 Nov 07 02:14 PM

[X-15:]

-kinda reminds me of 'Apocalypse Now'! Slow drumbeats as the plot unfolds, inexorably, to a vastly stranger conclusion than you could have projected in the beginning.


Jim Rogers gave clarion call ..............

2008 Nov 08 12:34 AM

[CHASAM:]

Long term, Mr. Merkel may be right. (Note: I said may be). I wonder where we would be at present without some form of government intervention? Would the American people have stood for such a condition?
The "Apocalypse Now " is perhaps the answer to the former and social upheaval the latter. Are we, the American people, ready for this now? I doubt it.
Is it not better to attempt to survive the current situation, although that may entail the bailout of many of those responsible for our current dilemma, and then attempt to put in place measures that will prevent it's reoccurrence? I think so.
David; we all have skin in this game!

2008 Nov 08 09:37 AM

[CJ-49:]

Mr Merkel,
You seem a clever chap. Why isn't the Govt. employing you to help them sort out the problems they are facing?

2008 Nov 08 12:17 PM

[GAMGLLC:]

Subject: 1973-1974 stock market crash...What will it take for a readjustment of property prices today? A Monte Comune?(Mountain of Debt) Public Debt in Early Renaissance Florence - the Monte (Mountain of Debt)... Is selling debt shares to reinflate the credit markets a solution?
Compiled by Peter Lundstedt 11/07/2008

Banking was highly developed in the 14th century. The Bardi and Peruzzi families built the largest, multinational, merchant-banking houses of the period before being swept under by the large defaults of Edward III of England in the 1340s.4 Banking reemerged as a powerful industry in the 15th century aided, among other factors, by the strong connection of the Florentine banks, in particular the Medici’s, with papacy finance.
In 1697, the Bank began “engrafting” government debt onto the bank’s capital, a practice that today would be called a debt-for-equity swap (Neal 1990, 51).3 This transformation of debt bearing a fixed rate of interest into equity was the key financial engineering of the time.

1973–1974 stock market crash
The 1973–1974 stock market crash was a stock market crash that lasted between January 1973 and December 1974. Affecting all the major stock markets in the world, particularly the United Kingdom,[1] it was one of the worst stock market downturns in modern history.[2] The crash came after the collapse of the Bretton Woods system over the previous two years, with the associated 'Nixon Shock' and United States dollar devaluation under the Smithsonian Agreement. It was compounded by the outbreak of the 1973 oil crisis in October of that year.



In the 694 days between 11 January 1973 and 6 December 1974, the New York Stock Exchange's Dow Jones Industrial Average benchmark lost over 45% of its value, making it the seventh-worst bear market in the history of the index.[2] 1972 had been a good year for the DJIA, with gains of 15% in the twelve months. 1973 had been expected to be even better, with Time magazine reporting, just 3 days before the crash began, that it was 'shaping up as a gilt-edged year'.[3] In the two years from 1972 to 1974, the American economy slowed from 7.2% real GDP growth to -2.1% contraction, while inflation (by CPI) jumped from 3.4% in 1972 to 12.3% in 1974.[1]



Worse was the effect in the United Kingdom, and particularly on the London Stock Exchange's FT 30, which lost 73% of its value during the crash.[4] From a position of 5.1% real GDP growth in 1972, the UK went into recession in 1974, with GDP falling by 1.1%.[1] At the time, the UK's property market was going through a major crisis, and a secondary banking crisis forced the Bank of England to bail out a number of lenders.[5] In the United Kingdom, the crash ended after the rent freeze was lifted on 19 December 1974, allowing a readjustment of property prices; over the following year, stock prices rose by 150%.[5] However, unlike in the United States, inflation continued to rise, to 25% in 1975, giving way to the era of stagflation.



All the main stock indexes of the future G7 bottomed out between September and December 1974, having lost at least 34% of their value in nominal terms, and 43% in real terms.[1] In all cases, the recovery was a slow process. Although West Germany's market was fastest to recover, returning to the original nominal level within eighteen months, even it did not return to the same real level until June 1985.[1] The United Kingdom didn't return to the same market level until May 1987 (only a few months before the Black Monday crash), whilst the United States didn't see the same level in real terms until August 1993: over twenty years after the 1973–4 crash began.[1]



en.wikipedia.org/wiki/...

Credit goes in part to Mr.JVHiesmenn for Monte idea.

[edit] References

1. ^ a b c d e f Davis, E. Philip (January 2003). "Comparing bear markets - 1973 and 2000". National Institute Economic Review 183 (1): pp. 78–89. doi:10.1177/0027950103... Retrieved on 2007-09-11.

2. ^ a b Woodard, Dustin. "1973 - 1974 Stock Market Crash". About.com. Retrieved on 2007-09-11.

3. ^ "A Gilt-Edged Year for the Stock Market", Time (8 January 1973). Retrieved on 2007-09-11.

4. ^ Dampier, Mark (6 May 2003). "Reading the stock market". BBC News. Retrieved on 2007-09-11.

5. ^ a b Ringshaw, Grant (1 February 2003). "Why we should fear a nasty 70s revival", Daily Telegraph. Retrieved on 2007-09-11.




1973–1974 stock market crash


Here is the S&P 500 Nov 73 to Nov 74 and then the S&P 500 Nov 07 to Nov 08… At the time, the UK's property market was going through a major crisis, and a secondary banking crisis forced the Bank of England to bail out a number of lenders. In the United Kingdom, the crash ended after the rent freeze was lifted on 19 December 1974, allowing a readjustment of property prices. Sound familiar? What will it take for a readjustment of property prices today? Reverse Auctions for U.S. Treasury? A Monte Comune? See below.







Then here is the S&P 500 Oct 74 to Oct 75







finance.yahoo.com/echa...=^xoi;range=19731106,2...


Here is the Dow Jones Industrial Average Nov 73 to Nov 74 and then Dow Jones Industrial Average Nov 07 to Nov 08




Then here is the Dow Jones Industrial Average Nov 74 to Nov 75





finance.yahoo.com/echa...=^dji;range=19741101,1...


Reverse Auctions for U.S. Treasury
by: David Merkel November 06, 2008

How would one implement what Dr. Jeff suggests? As a bond manager, I was pretty good at price discovery. I would convene a committee of large holders of the illiquid instruments and ask them what are the largest classes of homogeneous structured securities that no longer have markets now. Once they agree on the classes (probably the AAA portions of the senior-sub structured ABS, RMBS and CMBS deals), the agent for the Treasury picks a subset of the largest deals, and announces how much of each security (say 10% of each tranche) they will offer to buy.
Market participants are then invited to submit binding offers to sell any amount of the securities up to the maximum. The Treasury’s agent could require a minimum amount of bids in order for an auction to be valid (say 2-3x the purchase amount).

One tweak I would put in would be to award the bonds to the winning bidders at the price offered by the bidder with the highest bid not receiving bonds. I used this successfully for years in bond auctions, and though it makes the trader shake his head initially, when I would say, “I’m offering protection against regret in advance, besides, I want aggressive bids.” they would say, “Okay, I get it.”

After the auctions, there would be benchmark prices, yields, and spreads for a wide number of securities, and then the modelers would apply those prices to the mezzanine and maybe the subordinate tranches, which are too small to hold auctions for.

Similar securities might find trading levels as well, but if not, the Treasury could run another set of auctions, and repeat as necessary. Given the most of the securities auctioned are AAA, at worst, the Fed might have an interest in the short-to-intermediate AAA paper.

If the Treasury followed a procedure like this, it could unjam the securitized fixed income markets, and do so at prices where the taxpayer bears modest losses at best. I am not as optimistic as Bill Gross or Warren Buffett on this matter. The point of the auction is to get the sellers to compete against each other, not compete with the government’s agent.

Now, price discovery is a two-edged sword. FInding the market clearing price will make the markets start moving again, but it also might prove that some financial institutions are inverted (negative net worth), if not insolvent (can’t get enough cash to pay all immediate claims). If we are willing to stomach the possible insolvencies that this will reveal, then I am game for Dr. Jeff’s proposal.

And, maybe this will show the need for RTC II, successor to the old Resolution Trust Company. Bad financial institutions need to be conserved/liquidated, so that leverage can be reduced in the financial system of the U.S.

So, let something like this be tried, but be ready for adverse consequences if the pricing turns out to be worse than anticipated.

seekingalpha.com/artic...


Public Debt in Early Renaissance Florence: Lorenzo Ridolfi on the Monte Comune (Mountain of Debt)
Renaissance Quarterly, Spring, 2005 by Willam Caferro
Lawrin Armstrong. Usury and Public Debt in Early Renaissance Florence: Lorenzo Ridolfi on the Monte Comune.
According to a Florentine official in the early fifteenth century, the monte was "the heart of this body we call city." It tied up an enormous amount of the capital of citizens, forging thereby links between private and public interest. Nevertheless, the fund was the subject of much dispute, particularly among theologians who questioned the right of creditors to receive interest and to speculate in the secondary market in debt shares that soon developed. Lorenzo Ridolfi (1362-1443), a lawyer and member of the political elite who strongly supported the monte and equated it with the "public good."

Ridolfi's treatise, Tractatus de usuris (Treatise on Usury)--that is, the section that deals explicitly with the monte. The treatise was composed between 1402-04, during the grave fiscal crisis arising from the Milanese war, when the government relied heavily on loans and credit. There were social and economic inequalities inherent in Florentine society and the city was highly polarized. The monte--indeed the Florentine tax system in general--favored the wealthy over the poor. Ridolfi drew on the opinions of previous writers, most notably the Franciscan theologian Francesco da Empoli and the Florentine legal expert Lapo da Castiglionchio. Having found theological and legal precedent, Ridolfi then supported the monte and growing market in debt shares (a still more controversial subject) on the grounds of public utility. He equated the moral welfare of the citizenry with the welfare of the state. The state needed the love of its subjects, which could not be obtained by coercion. Interest payments thus became a sort of reward for contributions to the common good.

In this manner, Ridolfi greatly aided the Florentine elite in establishing a "positive identification" with the monte. This was the true meaning of Ridolfi's work--it provided a means by which a small governing elite achieved broader consent from the enfranchised, but non-dominant, elements of society. Ridolfi is situated within the tradition of Hans Baron's famous thesis on civic humanism, tracing the affinities between the latter and Ridolfi's emphasis on the common good and classical antiquity.

2008 Nov 08 12:45 PM

[Asbytec:]

While I may agree that Bernanke's actions might be wrong, injecting liquidity like a mad man, it does seem to get at the root of the problem for the moment. It's just that the "problem" is wrong. Our economy is skewed. It's a debt economy.

I believe he understands the money supply is winding down, so to prevent a crash landing, he's dropped our flaps and landing gear. Put your tray tables in the upright position and fasten your seat belts, cuz this baby is going down.

They wanted our tax bailout money for what? To unjam the credit markets and get back to business as usual? I agree, they should have been left to fail. There are many banks out there with no sub prime exposure who should be allowed to manage our money...and pay us interest for doing so. Not the other way around.

We seriously need jobs and a strong dollar, not more credit. Carburetor heat on, throttle to 1000 RPMs, 20 degrees flaps, nose up and hold 60 knots. Check wheels down, cleared to land.

2008 Nov 08 01:01 PM

[Did U Think...:]

"We're all bagholders now."
Not really. Some people who are buying physical gold and silver are not bagholders. You may not buy gold or silver at the best possible price (and thus dollar cost averaging is by far the best way to save using these money metals), but you will NEVER look in the bag and find it empty. It will always contain exactly as much gold and silver that you originally bought. I think this reality is lost on many people who are enamored with FRNs.


On Nov 07 10:30 AM Consider_this wrote:

> Consider that all dollar bills are effectively "Federal Reserve Notes"
> backed by the full faith of the government.
>
> From the above statement should be plenty clear that each dollar
> is effectively a unit of debt.
>
> (This is a very little known and little publicized secret with our
> government. See landru.i-link-2.net/mo... )
>
>
> Using that measure, trying to discharge debt or trying to default
> on them, effectively destroys money. It's also not the action anyone
> (in the system or in the know) wants the populace to behave.
>
> In that context, trying to expect government to stop bailout, stop
> the inflation of more debt, is so fundamentally against what the
> government and the system has built that it'll be a futile effort.
>
>
> I know this will be a shock to many who read my comment and the article
> I linked to, but this is the difficult truth.
>
> We've been sold a bag all the way back when we adopted the fiat known
> as FRN, or the "dollar bill". We're all bagholders now.
>
> It's not as simple as a plan to gradually get back to our feet and
> out of debt. This system is designed such that that's never possible.
> Trying to imagine or plan otherwise is futile. There's no gradual
> way out of this mess.
>
> On the other hand, perhaps this bubble isn't big enough to destroy
> the system. if so, we've simply tested the system's limits, and we'll
> all collectively go on with debt-inflation after this intermission.
> Pretty soon, "Trillion" will be the new million.
>
> As the Chinese always say, "May you live in interesting times."

2008 Nov 09 02:54 AM

[dc1:]

So, let me see if I got this right. YOU have all the answers...and are smarter than all the people standing on the podium, behind Obama, during the press conference. Thank You.

2008 Nov 09 10:48 AM