The Bottomless Money Pit

Over a week ago, Congress passed the $700 billion rescue package designed to unlock the credit markets. Because modern day politics is what it is, an additional $150 billion in relatively benign sweeteners was added to the package to secure approval. The increase in the FDIC’s guarantee to $250,000 from $100,000 was particularly well received.

Investors however were unimpressed and global equity markets continued to slide. Although Black Monday’s are becoming commonplace of late, yesterday the Dow Jones showed no favoritism and had its biggest one day percentage fall since the 1987 crash.

The main issue is that commercial banks around the world are hoarding cash. Trust has evaporated. When credit stops flowing, it does not take long for the effects to be felt on the real economy.

As it turns out, the Treasury and the world’s central banks were just warming up. This week, the Fed has announced another raft of new measures designed to unlock the credit markets and reverse the palpable fear evident in markets across the world.

Most importantly, the Fed has created another facility, this time to purchase commercial paper. The commercial paper market is a crucial source of funding for large companies all over the world. To manage cash flows, companies issue short term paper to pay wages, rents, suppliers etc. If this market grinds to a halt, as it has been, then the global economy is in big trouble. To ensure these companies still have access to short term funding, the Fed has now stepped in and will provide unlimited liquidity.

Not to be outdone, the UK government stepped up to the plate on Tuesday with a £400 billion rescue package for their banks to get the wheels of lending moving again. The plan equates to a partial nationalization of the sector and will see £50 billion made available in exchange for equity stakes. Also on offer will be £100 billion through the Bank of England’s special liquidity scheme, and a further £250 billion in the form of medium term debt guarantees.

Whilst a different tact adopted in each case, the objective of both America and the UK was the same, to defrost credit markets, and stabilize the financial system.

These moves, whilst significant, were still only part of the solution. Coordinated global easing has been missing to date, and Wednesday’s move by central banks around the world will in our view prove a defining punch. The Fed, Bank of England, European Central Bank, Swiss National Bank, Sweden’s Riksbank and the Canadian Central bank all lowered official interest rates by 50 basis points.

We believe this is just the first interest rate salvo. As we explain below, the financial markets are seizing up as investors scramble to the safety of cash. In response, central banks are increasing the opportunity cost of staying in cash by lowering the interest paid. Expect more to come.

The main issue is that commercial banks around the world are hoarding cash. Trust has evaporated and instead of credit flowing in the circular motion that characterizes capitalist economies, it is stagnant. When credit stops flowing, it does not take long for the effects to be felt on the real economy.

We are beginning to see this now with carmakers around the world experiencing plummeting sales. The vast majority of new cars are purchased with the help of credit, and the lack of credit is translating into a lack of demand for vehicles. This is just the most obvious example of how tight credit can impact the economy.

Banks are hoarding cash because liquidity is at a premium. When trust amongst lenders evaporates, the default option is to sit on cash. Lending between banking institutions only takes place at very high rates. The chart below shows the TED spread, the difference between three month LIBOR (London interbank offer rate) and Treasury yields, is at historic highs.

click to enlarge images

US and European banks in particular are woefully undercapitalized. Largely because of greed and regulatory laxness, these banks were allowed to grow their asset bases with minimal equity capital to support the growth. Debt was instead utilized to fund asset growth, hence leverage levels skyrocketed under the watchful eye of financial regulators.

Over the past few years, the hedge fund community has been a AAA banking customer, borrowing billions to finance their bets on mortgage assets, equities, commodities...you name it.

The chickens are now coming home to roost. All around the world, from investment banks to hedge funds to individuals, the deleveraging process is in full flight. To pay down debt, cash is needed. This process is causing a panic amongst non-leveraged investors too, and the rush for cash is on.

During more normal periods, when investors turn to cash, they deposit funds with their bank. But in reality, banks don’t have enough cash to satisfy the unprecedented demand for liquidity. So what do banks do? They go to their various lenders of last resort (the central banks) and post illiquid collateral (residential mortgages for example) in exchange for cash. This is what the newspaper reports refer to when they say that central banks are pumping liquidity into the market.

The record demand for cash, and lack of supply, is leading central banks around the world to fulfill their role as lenders of last resort. Central banks have an inexhaustible supply of cash - it’s only paper after all - and so are supplying this huge demand at will.

In recent weeks, the US Federal Reserve's balance sheet has expanded massively. Since 11 September, Fed credit has skyrocketed from $888.2 billion to $1.388 trillion on 1 October. The Fed’s balance sheet expansion reflects commercial banks swapping illiquid assets for Federal Funds’ cash. The process of debt monetization is in full flight, as shown in the chart below.

But the hoped for impact of injecting cash into the financial system is not yet working. As James Grant commented in the most recent edition of Grant’s Interest Rate Observer:

By acquiring or monetising’, assets, the Fed creates liabilities, i.e., dollars. Every schoolboy knows that too many dollars chasing too few goods means inflation. Complications arise, however, when the dollars refuse to give chase but, gripped by fear, simply lie around in the vaults of the Fed. Today, there’s fear. But when courage returns tomorrow and hundreds of billions of green pieces of paper jump up to exert themselves in the channels of commerce, won’t the consumer price index jump up too?

Grant’s "tomorrow" is, in reality, an indeterminate time ahead, but we believe Grant is on the right track. In the meantime investors continue to suffer from asset deflation and outright panic in the equity markets. We have heard stories of mass investor redemptions causing fund managers to indiscriminately sell stock to raise cash. The VIX, a measure of equity market volatility and fear, is at record levels.

Hedge fund land is contracting sharply, and all the leveraged bets that were made on the weak US dollar/commodity price strength story are being unwound. As a result, commodity prices and producers are falling heavily.

We have received some criticism recently that our investment thesis of betting on long term inflationary conditions, to the benefit of gold and commodities in general, is wrong. Clearly in the short term we are wrong as the impact of global deleveraging savages the markets more than we would have thought possible.

But underlying our thesis is the view that we will see global policy stimulus to an extent never before witnessed. In order to elicit such a response, panic and fear of deflation is required. We are at this point now. The collapse of commodity prices is being viewed as evidence that the threat of inflation is receding and this will embolden policymakers to act.

Thursday’s coordinated interest rate cuts were just the first move. Expect to see more in the weeks ahead, including a state sponsored re-capitalization plan for the US banking system. Following on from Thursday’s rate cuts, Treasury Secretary Henry Paulson said:

It is the policy of the federal government to use all resources at its disposal to make our financial system stronger. We will use all of the tools we’ve been given to maximum effectiveness, including strengthening the capitalization of financial institutions of every size.

Bill Gross’ investment outlook, published earlier this week, had this to say on the issue of additional stimulus:

A systemic deleveraging likely requires a systemic solution, which moves beyond cyclical interest rate cuts, liquidity provisions, or even the purchase of subprime mortgage-backed bonds. We believe that the Federal Reserve must now act as a clearing house, guaranteeing that institutional transactions clear (and investors receive) their Big Macs at the second window. They must also take another bold step: outright purchases of commercial paper. They should also cut interest rates to 1%, because we are experiencing asset deflation, and the threat of headline inflation is long past.

The Big Mac reference was made earlier in Gross’ piece, which the Fed obviously read, as they created the commercial paper facility the following day.

This week’s edition of the influential Barron’s financial newspaper also calls for more to be done. The cover article begins:

The financial-market rescue package is a step in the right direction, but further steps are necessary to get credit flowing again.

And more is being done. As we have stated in the past, the current global financial and political structure is at huge risk if deflation becomes embedded. Authorities know this and are monetizing debt at a rapid rate. At this point in time, the debt monetization has gone unnoticed by a market gripped by fear.

Central banks can create money at will. They have a bottomless pit of paper money and a balance sheet that knows no boundaries. The vast debts currently clogging up the system will continue to be monetized and low to negative interest rates will inevitably entice the private sector to become a buyer of those assets.

Inflation is not with us yet, but it is on the horizon. In the meantime, deflation is exerting its influence and will continue to do so for some time. As we have mentioned, asset market deflation is occurring because of forced deleveraging, selling assets at any price to pay down debts and move into cash. After being mauled by the bear, investors will need some time to lick their wounds before moving back into the market.

Because of this, the notion that markets are rational is difficult to accept at this point in time. Fear and confusion reign one minute, only to be replaced with greed and confusion the next. Value is being ignored while volatility reigns supreme. Hence our entry into the banking sector with this week’s recommendation of Wells Fargo. We strongly recommend that readers take current company values’, as represented by share prices, with a large grain of salt.

At the end of the day, the stock market in the medium to long term will always be about value and valuation. In any meltdown, bear market or stock market crash, value always bounces back. This will be the case again, despite the fact that in the short term fundamentals have been thrown out the window.

Although such volatility is unnerving, given our long term views, we believe remaining invested is the best course of action. We believe further coordinated global stimulus is approaching, which should provide the impetus for oversold markets to stage a major rally into the end of the year. Although the bear market could endure for another 6 to 12 months, it is possible we have passed the most acute phase. But readers should anticipate that further bouts of volatility will occur periodically before the next upward cycle in equities begins.

Comments

[Jimmy Lathrop:]

Great article, great analysis. I do take issue with your correlation with the auto industry and credit. I would posit that demand destruction caused by the speculation in oil prices in this summer had more of an impact than the easy credit. Those with great credit, the prudent ones, are willing to pay in cash or hold off on a purchase. The marginal buyers who depend on credit are getting shut out, but automakers have been running on the fumes of marginal buyers for far too long.

2008 Oct 12 11:05 AM

[alajac:]

What the `bailout of the bastards` is trying to do is add layers to the top of an ice cream cake that is losing layers on the bottom faster than they can be added on top because the cake is sitting on a very hot oven. What is heating the oven is the ongoing destruction of credit. (In other words, the destruction of the additional debt-money that banks were able to create from making loans based upon new reserves originally created by these now-bad loans.) This ongoing `destruction of credit` is resulting from masses of people becoming unable to make their debt payments. When a few people run into trouble they can willfully be left by the bankers to die by the side of the road, no problem, but when the masses start defaulting, the bankers` cake melts. Rather than fight reality (as the bastard bailout is attempting to do), the first thing we need to do is to GET THE OVEN COOLED OFF. We need to get money into the hands of the people who need it and are going to spend it, not into the vaults of people who don`t need it and who can afford to save it. This is what the HOW TO FIX THE ECONOMY plan does `IN SPADES`. We could do the same thing using Federal Reserve money, except that would be fricking stupid, resulting in us owing trillions of dollars (plus interest) to the bankers for helping them out of the hole into which they put themselves. How long are we going to continue to be fricking stupid?

the short version of HOW TO FIX THE ECONOMY

- Create a modern and national equivalent of the most stable currency America ever had, Colonial Scrip (paper fiat currency, backed by nothing).

- Put it into circulation via $1000 monthly distributions to every legal US resident
(similar to what was done with the 2008 Economic Stimulus Rebate money). (Distributions for minors to be held in trust.)

- Replace the Federal Income Tax with a small debit tax on electronic transfers, equally applied to all including foundations, trusts, and churches (avoidable by use of cash or barter). Adjust as necessary to deter inflation. Use Fed dollar proceeds to reduce the national debt.

- End any and all other Government-sponsored Personal and Corporate subsidies, especially including any Federal Minimum Wage laws as well as FDIC and any other form of risk insurance. All risk needs to be personalized, not socialized.

2008 Oct 12 07:51 PM

[Moon Kil Woong:]

The SEC letting people hide even more losses and decide what value to give them will only make matters worse. Rather than more transparency, the US is engaging in Japanese style loss hiding. That's what happens when you pass a $700 billion bailout without regulation and accounting reform. You get the worst possible result. No real valuation means chaos. Trust me, I have $100 billion dollars lol. No wonder no one will loan $ to each other.

2008 Oct 12 11:55 PM