The End of Money

Getting to know the wild, Austrian-schoolish, Libertarian culture of goldbugs has been really interesting for me. We disagree on so many things but see the same crisis - an existential threat to the world's money system. Goldbugs make government deficits to be the first-order threat because of absolute size and inflationary primacy. I join those who make the collapse of credit institutions to be the first-order problem. Some goldbug share this latter view, Mish Shedlock notably among them. Although I'm not a goldbug, Shedlock's writings are part of the reason I am a so-called “deflationist”.

Clearly the “short dollars on imminent hyperinflation” trade has fallen apart. The yen is getting crushed. Paper gold has been acting oddly. I'm sorry, but I happen to be one of those people who think ETFs can overwhelm futures markets a bit. Thought so with oil this summer. Many knowledgeable people disagree. But the real value of gold is something reasonable people can debate. In fact, it's debated every day in London, New York, Sydney and Hong Kong. Right now, the consensus is: “not so valuable as we thought last week”.

What is not being debated properly is the value of our financial system. On the NewsHour Secretary Geithner pre-announced that nobody will fail the “stress test”:

“These banks now have very substantial amounts of capital relative to what you would have seen in the U.S. economy going into previous recessions.”

One problem with that assessment is collateral. In a sense, Bank of America (BAC) is a huge CDO. Citigroup (C) is a huge CDO. AIG is a huge CDO. CDOs are fine, unless you very badly misrepresent the “C” - and that's what's happened.

The conventional view makes this economic crisis to be a crisis of “beta” - a “fat-tails” crisis which will revert to the mean. I make it to be a crisis of “alpha” - a crisis of our financial system's intrinsic value and a crisis of collateral. The goldbug solution is simple – collateralize the system with gold. Goldbugs reason that if the problem is at the very core – the “fiat” or legal-accounting money system itself – then that system needs to be moved to solid collateral. I agree to this extent: If we don't deal with how our system is collateralized, we're finished.

[I even reluctantly and partially agree that gold could be part of the answer, but that's for another piece.]

Jim Cramer sees the collateral problem. His mortgage plan is about spreading a huge hit to term collateral value over a very long time. If you look at this interview with Robert Shiller and take a gander at the chart below which shows percentages of negative equity homeowners as house prices fall, you get an idea just how huge a hit we could be talking about.

click to enlarge

Despite all the talk about it, deleveraging probably has not happened in America. Collateralized leverage has likely skyrocketed. Fed Chairman Bernanke implicitly recognizes this. Markets were relieved to hear the Chairman didn't intend nationalization. An expert on providing liquidity, Bernanke now plans to create equity - balance sheet collateral, if you will. Preferred at first, “rolling” to common as loan collateral and quality deteriorate. The idea has balance sheet elegance and the more “we the people” find out management has screwed up their businesses, the more right we'd get to tell them what to do.

It's a great concept. The Diamond and Dybvig model of central banking says that in a crisis the government should trade immediate-term credit for long-term exposure. Big-government conservatism says in a crisis the government should intervene first with money (and guns), then take authority only as a last resort. It's wonkish and wonderful – an academic tour de force. So why am I hearing Jim Cramer in my mind's ear shouting “Bernanke's being an academic! It is no time to be an academic...!”?

It's because I'm not sure how cash helps these institutions. It didn't help AIG. The banks already have much more than enough cash. If they can't use what they have, how will more help? Banks need to get assets with longer-term value into their portfolios faster than their collateral is deteriorating (and risk is rising). Ben Bernanke apparently believe they can create or find those assets.

Those banks? With that management? In this economy? With their cost structure? Really?

I saw Dick Bove talking about how the banking system was very profitable. I nearly fell off my chair. $59 billion positive cash flow? So they can pay back the TARP in what, 10 years? 15? I got back on my chair and listened to his excellent point about franchise intangibles' being an important part of overall value. But has he read what Ken Lewis thinks are the most valuable parts of his franchise? The biggest, crookedest mortgage writer in history and a failed investment house? Those are the “stars”? When institutions issue thousands of “AAA” securities that turn out to be junk, their franchises suffer – badly and justly.

I've read the BAC bulls. I believe Geitner wants to bring in private investors. But these banks already have investors who are a big part of the problem. Bondholders represent a big portion of liabilities so, again, let's think of the banks as a bond – a huge, multi-maturity CDO. We know the collateralized leverage of this bond has soared and the credit quality has plummeted. The principal of many long-dated tranches has gotten killed, but the short-term tranches have been saved – so far.

Is the bond still paying the coupon? As Dick Bove points out – almost - but why do people focus on that? The structuring is destroyed and the collateral is crap. By taking the TARP money, Citigroup, AIG, BAC, etc. have declared an intention to pay the coupon out of the new, “free” government collateral. Unless the government intends to let banks and bondholders pretend the entire real estate bubble never happened, it won't be enough. To boot, I have very little faith the structuring of these CDOs will improve. When I look at BAC, I see a CDO that has gotten bigger, not better. And Citigroup? AIG?

The challenge is bad structure and bad collateral, which is why serious people are finally talking about capitalizing our financial system with full-faith-and-credit (FFC) instruments. I have no idea how it took so long. Laugh if you want, goldbugs, but it's a step forward. It's sure a lot more sensible than cash. It's not magic, but FFC bonds would immediately change institutions' capital profile. Of course the bondholders will still be pounding on the doors. Even if you don't think these bondholders are too big to fail, we certainly don't want them freaking out again, either. The stories are wild about the last time they freaked out, but the facts are bad enough.

I think we need to deal with the bondholders separately. But I don't know, maybe Bernanke, Geithner and the holdover crew (who missed the entire bubble in the first place) really do intend to re-collateralize the people who bought and sold all the bad debt. Why make people unhappy? Apparently, it wasn't the investors' fault. They were, after all, only professional financiers.

So how does “the end of money” come about? Option 1 is that the crew gets ahead of the process and creates hyperinflation. Yet, the dollar is a very, very big money system and “fortunately” the crew have shown no capacity to get ahead of the process. Option 2 is that as collateral collapses, they continually pay out slightly less than the deterioration. This is the Japanese “lost decade” prescription for deflation. And of course hidden costs can jump out and cause instability, as in the AIG catastrophe. This would also be deflationary. That's why I feel deflation is the more-likely outcome.

Finally, adding value to the money system is not a forlorn hope. It can happen. Actually, we know that it will happen - eventually. It's really just a question of how long we want it to take. Many smart people say the problem isn't so bad and I respect that. However, I humbly suggest that if large numbers of people refuse to admit they lost money in what might be the biggest bubble in human history, money as we know it will end – at least for a while.

Disclosure: No positions (too depressing).

Comments

[PainfullyAware:]

Exchange will not end - the barter system is fail safe.

Since many seem to believe that the Funny Money System serves as a good system; why not just create a "Catastrophe Shell Company", dump all the lame assets into it at taxpayer expense, and continue as things were. This is what is happening anyway, in a more convoluted way.

I do not agree with this plan nor with what is happening.

Based upon what I am seeing in the distressed real-estate market in dealing with the FDIC and The Banks - THE UNDERWRITING WAS CRIMINAL. Lending on land based upon finished value foolery is rampant. Stack the multiplier of the "Financial Engineering", based upon these assets, on top of this fact and the scope becomes almost unfathomable.

The Money Hole Is Enormous And Will Use Up All Our Resources To Fill It. We will have little to combat the domestic issues that are coming.

There comes a point where one must recognize the futility and cut the losses. This has not happened and may not ever.

The Wild Sums Of Money Being Spent By The Government Should Be Allocated To TEMPORARY Safety Net Programs Only, And Things Should Be Allowed To Play Out. Food, Shelter, and Education should be the main focus of these programs to weather the storm.

I call on all to get involved in politics of some kind. Remember the Constitution And Hold It In High Esteem. The Price To Good Men For Apathy In Public Affairs Is To Be Ruled By Evil Men.

Views Untested Are Worthless; Debate Is The Distillation Of Reality.

The Worst Is Yet To Come.

Feb 27 03:08 PM

[dlaw:]

Thanks for the comment - and all the capital letters.

Feb 27 03:19 PM

[Truefire:]

Why is hyperinflation not a possibility? All these new dollars will go somewhere. The hyperinflation will come from collapsed supply of consumer goods (the end result of the natural deflation processs at the end off a boom/bust cycle), with more currency units chasing fewer goods & services.

The governments are guaranteeing this will occur as they will be monetizing debt on a gargantuan scale & doling it out to the populace in welfare type largesse. No new loans have to be written, no currency flow through the broader economic system. It will be helicoptered right into the end users hand.

This doesn't even assume that their will be a US Treasury dump when the monetizing starts in earnest. If that happens then there will be a psunami of cash on the market directly into the end users hands.

Won't the currencies lose value as the debt is monetized? Hence more currency units will be needed to purchase goods & services. Deflation of non essential goods & services will rapidly accelerate & consumer staples will see hyperinflation as the majority will be able to afford little else.

I concur with the author, this WILL be the end of fiat currencies. History demands it.

Gold & Silver will reign supreme.

Peace!

Feb 28 07:52 AM

[jeffc:]

Anyone care to counter this. Let's say the "entire" money supply, is composed of
1. Printing USD and buying US Treasury security (Bills/bonds). The majority of this is done electronically rather than printing physical dollars.
2. Manipulation of reserve ratios by banks to increase money supply
3. Derivatives market - which previously and may still dwarfs the real physical money supply
4. Mortage market (from fannie/freddie) that can create "credit"
5. Homeowners who could monetized/cash out their home equity.
6. Money market funds that effectively lend out money deposits
7. Other sources I can't think of
The current deflationary "deleveraging" (water leaking out of a bucket) brought on my the credit market collapse is a result of items 3, 4 and 5 imploding. Therefore inflating the money supply (printing USD either physically or electronically) by 1 will only serve to "inflate" the market (adding water into the bucket) to counter the deflationary deleveraging. The degree to which they get this right will be the degree to which delfation (net leaking), moderate inflation (net filling of bucket) or hyperinflation (spillage and overflow of the bucket) occurs.

And one more note I would like gold standard people to comment on. Note the FED only controls #1 and #2 so a full reserve banking model or a even gold standard backed dollar would help but not be sufficient because it does not address the other sources of money supply (3 to 6). It may fly in the face of austrian economics though more "control" is required for items 3 to 6.

This is my thinking to someone articulate otherwise.

Feb 28 12:11 PM

[prudentinve...:]

What the system needs, first and foremost, is confidence. Without legal accountability for those who made fraudulent profits, confidence cannot return. I am against witch-hunts, as they serve no uesful purpose, but we are supposedly a nation of laws, and it seems probable that securities laws were broken on a large scale in mortgage origination and CDO/MBS packaging and rating. Our legal system is the foundation of confidence in the markets, and its uniform, impartial application is essential to restoring confidence.

Feb 28 08:58 PM

[Mad Hedge F...:]

OP tf Panic buying of gold coins continues to overwhelm coins dealers around the world. According to the Financial Times, the US Mint sold 193,500 American eagles in the first seven weeks of this year, more than it sold in all of 2007 at prices 40% lower. Retail investors fleeing paper assets, like plummeting stocks and bonds, are paying 5% premiums over face values. The same phenomena is appearing in other countries were gold coins are available to the public. Does this have a toppy feel to it?

Feb 28 10:14 PM

[dlaw:]

Mad Hedge, I think this has very much a "toppy" feel.

If you look at the arguments for gold, there is no reason it should be going down. No reason it should go down in the foreseeable future. That is the stuff bubbles are made of - certainty.

Gold is going down. The federal government is doing all it can to inflate, but gold is going down. Down too much, the logic is destroyed and there may be panic selling. People paying $1000/oz for coins and certainty are not going to be happy at $700/oz.


On Feb 28 10:14 PM The Mad Hedge Fund Trader wrote:

> OP tf Panic buying of gold coins continues to overwhelm coins dealers
> around the world. According to the Financial Times, the US Mint sold
> 193,500 American eagles in the first seven weeks of this year, more
> than it sold in all of 2007 at prices 40% lower. Retail investors
> fleeing paper assets, like plummeting stocks and bonds, are paying
> 5% premiums over face values. The same phenomena is appearing in
> other countries were gold coins are available to the public. Does
> this have a toppy feel to it?

Mar 02 12:14 PM

[dlaw:]

Mad Hedge, I think this has very much a "toppy" feel.

If you look at the arguments for gold, there is no reason it should be going down. No reason it should go down in the foreseeable future. That is the stuff bubbles are made of - certainty.

Gold is going down. The federal government is doing all it can to inflate, but gold is going down. Down too much, the logic is destroyed and there may be panic selling. People paying $1000/oz for coins and certainty are not going to be happy at $700/oz.


On Feb 28 10:14 PM The Mad Hedge Fund Trader wrote:

> OP tf Panic buying of gold coins continues to overwhelm coins dealers
> around the world. According to the Financial Times, the US Mint sold
> 193,500 American eagles in the first seven weeks of this year, more
> than it sold in all of 2007 at prices 40% lower. Retail investors
> fleeing paper assets, like plummeting stocks and bonds, are paying
> 5% premiums over face values. The same phenomena is appearing in
> other countries were gold coins are available to the public. Does
> this have a toppy feel to it?

Mar 02 12:14 PM

[Safely Buy ...:]

Just happened to read this today...

dlaw said;

"Gold is going down. The federal government is doing all it can to inflate, but gold is going down."

Gold is not going down. It's been going up for 8 straight calendar years.

Mar 11 06:46 PM