13 Notes About Markets and More

Includes: FMCC, FNMA, FXE
by: David Merkel, CFA

1) A response to those commenting on my piece A Stylized View of the Global Economy: when I say stylized, it does not mean that every nation fits the paradigm, only that most do. My view is that the debt overages will have to be liquidated, and there is no possible policy that can avoid it except large scale inflation. Those looking for clever ways out of this bind will be disappointed by what I write. When nations are heavily indebted their options decline, particularly when they don’t control their own currency. For the US I say that we should have liquidated insolvent firms rather than bailing them out.

Also, read Falkenstein as he takes on the idea that stimulus spending works. I have little confidence that the linear reasoning behind stimulus spending yields long-term economic benefits.

2) One blogger who I have some respect for, but have not mentioned often, is Bruce Krasting. He writes some good things on US social insurance programs. His recent post Social Security at Mid-Year highlighted what should shock many: we have hit the tipping point on Social Security. From here on out it will be a drag on the federal budget. Expect Congress to remove it from the federal budget. It no longer aids the illusion of smaller deficits. (What a cleverly hidden illusion.)

As he commented at the end of his article:

SS is $2.5T of the $4.5T Intergovernmental account. I believe that this entire group is going cash flow negative. The IG account cost us ~$160 billion in interest last year, but some out there are pretending the IG account does not exist. An example of this is in the following link.

Sorry, U.S. Federal Debt Is NOT approaching 100% of GDP anytime soon.

This kind of thinking is not only lunacy; it is dangerous.

And I agree. There are only two ways to look at the balance sheet of the US. Look at explicit debt vs GDP, regardless of who is owed the debt. Or, look at total liabilities vs GDP. But never look at explicit debt not used to fund social insurance funds. It is meaningless. The total liabilities number tells the whole story.

3) Spain is in trouble. Their banks are borrowing a lot from the ECB, with no end in sight. Perhaps that leads them to push for stress testing across all European banks. Or, maybe things are so bad that the banks are identified with the sovereign credit, and both are tarnished.

4) Or consider the Eurozone as a whole: The system begs for debt relief, but the Euro and ECB are tough taskmasters. The Euro has been an excellent successor to the Deutschmark in terms of preserving purchasing power, but perhaps purchasing power needs to be sacrificed in order to relieve debtors. The ECB is steps away from monetizing the debts of its governments. Perhaps they could preserve the Eurozone by destroying the value of the Euro. Germany might not stand for it, but it has significant unfunded liability issues as well.

As with the US, unless there is a large inflation, debts will eventually have to be liquidated, whether through austerity or default. There is no other way. Austerity will have its costs, but unless debts are inflated away or defaulted, those are costs that must be paid.

5) Can pensions be cut? The typical answer is no, but what if a state pays less than what was promised in inflation-indexed terms? That is what is being tested. I think that eventually states and municipalities will be forced into bankruptcy because they can’t make employee benefit payments and still maintain minimal services to the populace.

6) Debtors prison. I have mixed feelings here, because I think that those that can’t pay should not be put there for long, if at all. Those that can pay but won’t, should go there. Regardless, this is a trend, and those who think they can walk away from debts should think twice before doing so. You may be setting yourself up for prison.

This is just another front in the war against those who can pay but won’t. More lenders are suing those who won’t pay, and going after their assets. My only surprise is that it has taken so long for this to happen.

7) Fannie and Freddie are a giant black hole. It astounds me that there is any respect given to two companies that have lost massive amounts of money since their inception. The US would have been better off without them, and will be better off with them in bankruptcy. The US should not promote single family housing as a goal, because it cannot create the conditions where marginal people can be capable of financing housing on their own.

So, when some suggest one last bailout, I say, let them fail. Cancel the common and preferred stocks, and fold the remainder into Ginnie Mae.

8) Occasionally, there are really dumb articles, like this one. The time for debt was November 2008 through March 2009, when I recommended investing in junk bonds. There is little reason to borrow now; valuations are relatively high, don’t take your life into your hands.

9) And, occasionally, smart articles, like this one. If you are in a volatile profession, reduce your risks by investing in high quality bonds. If you are in a safe profession, invest in stocks. When I went to work for a hedge fund, the first thing I did was pay off my mortgage, so that I could take more risk, without worrying about getting kicked out of my house.

10) Felix Zulauf has generally been a bearish guy, and so has done well over the past decade. But is he right now? Will stocks revisit their March 2009 lows? It is possible, but I lean against it. We would need a situation where most of the developed nations decided to aim for recession and stay there a while. I do not see that yet.

11) Is it is liquidity problem or an insolvency problem? If you have to ask, it is usually insolvency. Consider Richard Koo, and his thoughts on the matter.

12) Using the rubric of the “Tragedy of the Commons,” Kid Dynamite points out how it sets up the wrong incentives if we bail out profligate states and municipalities. As a part of my “new normal,” it is no surprise to me that this is happening. It should be happening, and will happen for at least the next five years.

13) Because of my employment agreement, I can’t tell you exactly what I know about the demise of Finacorp. But I can tell you that the article cited is wrong. Finacorp never carried an inventory of assets. It only crossed bonds between buyers and sellers. The failure of Finacorp occurred for far simpler reasons.