Big Ben Panics and Gold Responds

In Globally Contained Liquidity Crunch I pointed out that the Fed was providing temporary loans (as repos) not capital to the markets. While true I missed something. What I missed involves the collateral the Fed is willing to take for those short term loans.

Mr. Practical was right there with The Fed's Path.

It has now become obvious to me the path of the Fed. No, Mr. Bernanke is not going to be tough on markets. He is not going to give the medicine that is needed. He has chosen his path, the seeds of which were planted in his November 2002 speech about monetization (dropping dollars from helicopters).

The Fed today injected $65 bln of repos, extending credit to banks to shore up their liquidity needs. Normally the Fed only accepts treasuries as collateral. But the banks no longer have enough treasuries, or they don't want to sell their "safe" assets in exchange for credit. But they do have lots of risky assets like CDOs that everyone wants to get rid of. The Fed bent over and today announced they will take those "off their hands".

....

This is alchemy finance in its truest form. All it will do is stave off the inevitable and make it worse when it happens.

Read that last sentence again. This is the same mistake Japan made.

Credit Addicts On Withdrawal
Central Bankers worldwide have now all panicked in unison. And the stock markets are not even down 10% from the recent highs. The DOW is still up on the year. This means they central bankers are really spooked. And this sure as hell is not an inflation scare.

Kevin Depew on Minyanville was talking about Credit Addiction in points 1 thru 5 of "Five Things". Let's take a look at point #4: Like All Enablers, They "Didn't Know".

* As recently as Tuesday the FOMC warned of the continuing risks of inflation.
* The European Central Bank, in its monthly report noted in Number 3 actually said its monetary policy is still "on the accommodative side."
* Yes, that's the same report that was released a day after the ECB injected a record amount of liquidity into the banking system.
* A day after the Bank of Japan, which maintains it has successfully defeated its bout with deflation, pumped 1 trillion yen into the money market in coordination with the U.S. and European central banks.
* So what's next? The same thing that happens whenever any junkie reaches the end of the ability to expand his or her addiction.
* A deflationary cutback.
* What does it mean for a junkie to enter a period of "deflationary cutback"?
* Well, consider for a moment how an addiction begins. Ordinary, normal people in the early stages of addiction are typically able to service both their habit and their outside obligations - family, work, etc.
* In the final stages of addiction, all those obligations - to family, to work, to friends - are sacrificed in order to service the addition.
* If the addiction is to credit/debt, then everything must be sacrificed to service that debt. The ability to expand the addiction has concluded.
* We know what happens next: enabling (and the negative consequences) or (real) intervention (kick the habit).
* Neither are pretty, which is what makes the choice between the two so hard.
* Until the end, even among friends and family, the path of least resistance is to enable the addict.

The Credit High Has Worn Off
Bloomberg is reporting Central Banks Add Cash to Avert Crisis of Confidence.

The Federal Reserve, in a second day of action in concert with the European Central Bank, provided $38 billion of reserves and pledged further funds "as necessary," in a statement unprecedented since the aftermath of the Sept. 11, 2001, attacks. The European Central Bank loaned 61.05 billion euros ($83.6 billion) after injecting a record amount yesterday.

In the U.S., the federal funds rate opened at 6 percent, the highest in six years. The rate, which normally fluctuates around the Fed's target, fell to 5 percent after the New York Fed bought assets including mortgage-backed securities in three operations over a six-hour period. The $38 billion was the highest amount of temporary funds since Sept. 12, 2001.

Today, the Fed said in an unscheduled statement that it will add money to the system as needed to steer the federal funds rate "close to" the 5.25 percent target. Officials also noted that direct loans through the Fed's discount window are available "as always."

Countrywide Financial Corp., the biggest U.S. mortgage lender, today said it faces "unprecedented disruptions" that may hurt profit. Countrywide won't be able to sell as many of its loans as expected because investor demand has dried up, the Calabasas, California-based company said. NIBC Bank NV in the Netherlands posted losses from U.S. credit investments.

Credit Crack
Countrywide is hooked on "credit crack". They continuously need more of it. I talked about Countrywide (CFC) last week. The overnight gyrations of CFC (gapping down to $24.76 and recovering all the way back up to $28.08 before settling at $27.86 down about 2.8% perhaps tells a story. If so what is that story? Is the Fed accepting mortgage backed garbage from CFC as collateral?

Gold Responds
Gold was up on Friday, perhaps in response to Bernanke's three repo actions accepting mortgage assets that no one else wants as collateral. Then again perhaps gold was responding to something else (which is why one must be cautious about such casual correlations). Nonetheless the 24 hour chart from Kitco was interesting.

click to enlarge

The above chart is thanks to Kitco and is a snapshot taken 16:41 EST on Friday August 10. Whether or not gold was acting the way it did because of Bernanke's panic is hard to say. What's easier to say is that is how we should expect gold to behave if the Fed is willing to take toxic waste as collateral for temporary loans.

But enabling addicts (which is what the Fed is doing) is morally wrong. See High Rate CDs and other Moral Hazards for more on that topic.

And the thing about addiction is that over time it takes stronger and stronger doses to achieve the same high. In 1980 it took $1 in debt to add $1 to the GDP. Today it takes closer to $7 or $8 in debt to add $1 to GDP and that of course presumes one believes today's GDP figures.

The problem with such addiction is that stronger and stronger doses eventually kills the patient. This is where we are today. Some junkies (consumers) have finally realized this on their own accord, most far too late to do any good, as debt has already hollowed out their livelihood just as heroin would have done. Some dealers (banks and brokerage houses) have belatedly realized the same thing and have stopped extending credit to credit junkies. A violent withdrawal is now underway. An enabling Fed is attempting to halt this "credit withdrawal" but as Succo suggests, the Fed is fighting a losing battle.

Comments

[abelardo:]

I understand your shock at the allowance of high risk instruments as collateral for the Feds repo. It would seem like a great business to be in... give your worthless assets to the government in return for full face value.

However , isn't it true that this are just three day loans and that the collateral never is exchanged, i.e. the hapless banker is still stuck with them.

I hope I am not wrong.

Keep up your good writing.

abelardo

2007 Aug 13 07:13 AM

[Chris White:]

Drilling down through the derivatives, structured products, cdo's and whatever each is hedged against or swapped for down at the bottom of the heap will be found someone who took out a mortgage to buy a house. The security for his mortgage is the house. As they used to say "if you pay you stay, if you don't you won't".

Suppose, pre-Greenspan's interest rate reductions, the 'house' would have sold for around 250K. There will be an 80% first and some mix of down payment and second for the balance. After the rate decreases and the mania the price may have gone north of $700k. The owner has no equity in the property. His income is the same as the guy who bought it at 250K.

The housing market turned in the summer of 2005. By last summer it was clear that sales had collapsed nationally. By this summer as inventories move beyond 11 months worth of sales at current levels we now know we're in a buyer's strike. Buyer's are waiting for the excesses to be wrung out of the system.

That may get resolved by what might come next in housing when the "sellers' panic"."Let's do what we have to do to sell, never mind holding on for price."

Already the equity in the $750k house should have been marked down. When the sellers' panic begins the mark downs will head back to where these houses were priced before Greenspan started his thing.

With the buyer's strike and houses not selling it is not possible to know what the mortgages at the bottom of the heap are worth because there is no value for the asset securing the mortgage. They aren't worth anything because no one wants to be holding the asset when prices collapse. Anyone lending today is not only going to need a really qualified buyer, with real income and documentation to back it up, they will also want to build in protections against the sellers' panic which will set prices much, much lower.

This problem cannot be dealt with in the credit markets either by interest rate reductions or repos and fractional lending. That will produce digital Weimar inflation even while the properties securing the asset class and everything leveraged against it continues at zero. That's when the Fed goes into the business of property management and becomes the country's landlord. Somehow that doesn't seem like anymore of a solution than having the banks take over the properties.

Last time anything like this happened they had to wait for the 'holiday' that cleaned out the financial part of the mess, which included converting what they then called "balloon" notes into 30-yr self-amortizing paper. This gave banks an income stream and kept people in their properties. Nowadays you'd have to forget about all the fancy structured stuff, and just replace the computers its all on with new ones with clean hard drives. But people get attached to all the bits and bites they say are making money for their employers.

2007 Aug 13 09:10 AM

[Jim Glazen:]

Gold responds? Gold was flat last week even though the global central bankers added over $300 billion to reserves.

A more appropriate headline would be "Central Bankers Panic and Gold Does Nothing".

2007 Aug 13 09:11 AM

[insideoil:]

Tell me the Fed loans have to be repaid in the short term, and cannot just be rolled over indefinitely - please ! Does this also apply to the ECB - are these short term loans or liquidity injections for free ?
Why does American sub-prime get all the blame - surely each and every entity with a positive cash flow has been pumped up as investors compete and chase up the asset price leveraged by cheap credit (hedge funds ?)- perhaps with the knowledge of a Greenspan "put", that has now become Benanke free cash from helicopters. If risk and the real cost of money has been underpriced and hidden by skillful (and plain deceitfull) packaging of unpayable debt in "mark to model" scams, then we have a general asset bubble - not just housing in sub-prime in America. I hope we are talking jail time here - not just "oops" we made a very profitable - thank you- mistake !!

2007 Aug 14 01:29 AM

[Phil Anthropy:]

Logical analysis and considered reasoning have long been useless in the U.S. economic model. When their is credit restriction due to lack of liquidity, liquidity is forthcoming, from a variety of sources. When there is consumer purchasing slowdown, government deficit purchasing increases. Once the underlying engine is explained it all makes sense: find the most powerful financial organizations you can, and see what will benefit them the most; that is what will happen.

There is no subprime problem. Depending on state law, people who default on their loans may be in debt for the rest of their lives under the new bankruptcy laws, paying back far more than they ever borrowed, while the houses are reclaimed at a discount by lenders. If banks need credit to cover defaults or sinkholes to unload their worthless debt, they'll get them.

Therefore, the stock market will go up and interest rates will stay about the same (they can't go up, because the Fed has just bought a boatload of bond-like instruments, which would lose value; they can't go down, because the dollar would weaken). So it's business as usual, except that the middle class will have to work longer hours to earn the same quality of life. Who knew?

2007 Aug 14 03:09 AM

[insideoil:]

Leo - I was afraid that someone would answer just as you have. Everything one (ethically) stands for tells one not to be so cynical, but reality laid out as it has been this last week, stripped naked of its misleading perceptions or false hopes makes it difficult to come up with any other conclusion.
Under this understanding - what happens to asset inflation and living cost inflation ? Are you saying that living cost inflation has to kick in to cover the cost of the "free" money being dispensed so liberally, or that the gap will be covered by having to produce more to be paid the same or less than before i.e that higher productivity is the way that living cost inflation will be kept under control? With interest rates not changing much, is the assumption then that asset pricing will have a soft landing - i.e a gentle deflation, or a stage managed slow increase that the investor is still willing to stay in the market. I guess as you say - it is business as usual - but you know you are paying the price while being productive and working for a living. It seems to me that the flexibility to manage such a tightrope have been significantly reduced - so we should expect volatile times - no-brainer for that one.

2007 Aug 14 04:39 AM