VIDEO – Texas Financial Market Roundtable 2012

The economic, financial and public policy issues associated with debt overload and bank runs is discussed by Dave Rosenberg, John Mauldin and Rich Yamarone. Professor Lew Spellman of the McCombs School of Business moderates.


If you enjoy this blog, please forward it to others who may be interested. Subscription to the monthly blog is free.  Links to forward and sign up are in the right hand column.

Preserving the Debt: The Helium Express

How much country debt is too much? This is an issue of relativity. In this case relativity depends on the income flows from which debt service can be paid. Whether the debt belongs to the consumer or the government, the combined burden must be serviced from a country’s income stream.

While there is some economic growth theory that addresses a sustainable stock of capital assets relative to income, there is no similar theoretical basis for indicating how much debt is too much relative to income. However, the two should be related, as they represent the two sides of the balance sheet when debt is used to finance the accumulation of capital assets. The linkage between debt and capital starts to break down when much of the existing debt was funded in order to consume rather than generate productive assets. As a result, debt for the purpose of consumption hangs more heavily on the balance sheet as it does not generate any future output or income to sustain the debt.

Lacking a theoretical answer, the question of how much debt is too much has only been answered on an empirical level. Reinhart and Rogoff address the effects of government debt and find that a debt-to-income ratio of 0.9 is the threshold for when economic growth begins to slow down. But this estimate doesn’t include consumer debt or state and local government debt, which for the U.S. is also well above accustomed levels.

This still leaves open the question of how do over-indebted countries re-establish stock-flow balance. While it takes long periods of time to accumulate debt at a faster clip than income — and its fun while it builds and generates income —the reverse occurs when the debt-to-income ratio is shrinking.

If individuals and governments seek to “do the right thing” and save in order to reduce indebtedness, progress in de-leveraging is agonizingly slow. This prescription, better known as austerity, can only be successful if the economy has other means of support from business investment growth and/or net export growth. This roughly parallels a literature entitled “expansionary austerity.” Yes, as you would guess, expansionary austerity is an oxymoron. There are precious few successfully sustained episodes of income growth in the face of austere deleveraging. For example, take a look below at how Greece is faring with austerity as a de-leveraging policy.

But if the re-establishment of stock/flow balance through expansionary austerity is not successful (and we wish Europe the best of luck), the market alternative is default. This is the swift and painful market response.  While the debtors are relieved of their debt burden all at once, the owners of the debt are similarly relieved all at once of their corresponding assets. That is to say, there is an instantaneous wealth meltdown, and all bad things follow that. We got a scary preview as we witnessed the Lehman Brothers financial meltdown in 2008 based only on mortgage debt meltdown.

Some of the defaulted debt is individually owned and hence it’s clear who has suffered a loss in that event. But the greater asset and wealth write-downs come from what most think are sacrosanct institutions, but they are not. Our private and public pensions, including Social Security (as its trust fund is 100% invested in U.S. Treasuries) will not pay out as promised. Nor will private insurance company annuities pay by contract terms. Our bank deposits and money market mutual shares will not pay 100 cents on the dollar — and don’t forget the impaired ability of endowments, charities and other trust funds to continue providing services in the face of their assets being written down. It seems safe to say that a developed country, particularly a democratically empowered government, will seek to avoid the correction to the debt-to-income imbalance, whether it is swift and painful or prolonged and agonizing. So, how do they preserve it?

Preservation of the imbalance is the road that we have embarked on. It requires that the asset/debt bubble be maintained indefinitely or until growth can be stimulated at a rate that outgrows debt accumulation. I call this the Helium Express, as it keeps the balloon floating in order to avoid the hard landing below. The intent is to keep balance sheets from imploding.

The Helium Express is occurring via super expansionary monetary policy the world over. It has become the policy of choice to keep the debt overload carrying cost affordable and hence sustainable as outlined in The Unintended Consequences of Saving the Sovereign.

Debt affordability and sustainability requires the Fed to pursue a goal of zero interest rates over the long haul in order to provide cheap and sustainable debt service that both the consumer and the government can afford.

In a very indirect way, this says that the Fed is seeking to maintain the right-hand side of the balance sheets of the big debtors, the consumers and the government. In doing so society’s balance sheet has an asset side as well and the two must balance. Hence, debt support is also generalized asset support. But how does that happen?

Well, there are many channels by which this works. Since the Fed implements the policy of affordable interest rates by purchasing Treasury debt at prices higher than market (to drive rates downward to historical lows), it also provides a capital gain to the seller of the bonds to the Fed. In turn that seller must now find a replacement asset with the proceeds of the sale to the Fed. As they look at a reinvestment in Treasuries they see yields so low that it doesn’t support conservative institutions investment income needs so another income-producing asset with higher yield must be found.

Hence conservative investors are forced into the “risk on” trade. They are seeking assets with investment income to support the income needs of the institution and must reach for greater default risk and volatility than their liking.

Another pressure to turn to the “risk on” trade exists when investors hold bonds with prices elevated higher than the redemption value by the Fed’s price support program. This provides the owner with an unrealized gain on their bond holdings and a smile on their face until they realize they are on the horns of a dilemma.

If the Fed stops inflating the value of  Treasury bond in the market, the investor’s unrealized gain may never be realized if the Helium Express comes down to earth. Furthermore, even if the Fed’s price support is there for the long run — which is longer than the bond’s redemption date — the bond settles down to be worth only 100 cents on face value  at redemption time (which is normally a big relief). In this case it is a lost opportunity not to cash in on the Fed’s subsidy.

Now the pressure builds to sell Treasury bonds to the Fed and invest in a less inflated asset.

The risk-on investments could take many forms, and the channel by which the financial purchasing power spreads out is intricate. These risk-on pressures have sent purchasing power first to income-producing assets such as bonds up the rating scale, dividend paying stocks, and preferred stocks. Now with those assets more robustly priced, new flows are beginning to be deflected to the next reaches of risk — even to real estate, and even to rental homes.

One big change from a year ago, when QE2 was underway, is that the risk-on asset is no longer emerging nation equity or a Swiss bank deposit. The countries that experienced capital inflows as a result of similar pressures to take the Fed’s subsidy and run abroad are now off-bounds for investors, as those countries have reacted to burn the speculators who caused their currency to appreciate and reduce their trade competitiveness. So, the Fed subsidy is staying in the U.S., with perhaps some Euro bond market buying as an alternative where the ECB welcomes a market vote of confidence in its currency.

Additionally, once this risk-on process is underway, even if no one sees changes in fundamentals to warrant higher prices of, say, equities, there is the unquestioned Pavlovian response known as “Don’t fight the Fed”. In this case it is “Don’t fight the Fed to the 5th power,” as all major central banks are involved in the Helium Express.

Actually, what is being called the risk-on trade is actually risk-off in the sense that the Fed is not wanting the market to correct the debt/income imbalance via default or deleveraging, so it works to preserve the Helium Express.

It’s not your textbook economic expansion with Fed buying Treasuries that pumps up commercial banks. Instead the funds are moving through the shadow banking system to reach the far corners of the risk-on trade.

This ends up causing a great deal of hand wringing by asset value fundamentalists (especially as corporate profit have been declining), by those who do not take lightly the continued prospects for a contagious sovereign default, or by those who are fearful that no good comes of excess money except inflation.

Unless one of the financial traumatic events that is facing the world occurs — and don’t forget the potential for a middle east oil shut down — the Helium Express has the power to not just lift the risky financial prices but the economy as well, though it will take some heavy lifting. The Helium Express provides cheap financing to firms able to reach the public capital markets as well as a private wealth effect. The Fed is being only a little subtle in encouraging all to enjoy the balloon ride they are sustaining.

2012: Off to a Good Start; More to Come

In December, when my 2012 view became positive, I questioned whether I was misinterpreting the value of the LTRO and the Chinese reduction in their Bank Reserve Requirements, as I appeared to be alone in my assessment. Jim Cramer screamed the sky was falling and virtually no one, on any station, seemed to appreciate the two events. In my January 2nd newsletter I outlined the basis for my belief as we were significantly increasing our equity exposure. Since then, I am more convinced that this year will reward us.

I finally found support this weekend, from Jeremy Siegel (Wharton finance professor) who through his analysis of rolling 5-year periods and the market’s valuation, wrote that the Dow should end 2013 at 15,000 (2 out of 3 chance) or 17,000 (50/50 chance). Of course this was met on Monday be a barrage of talking heads who stated the kind of gibberish that one espouses when covering all possibilities, such as “I am long-term bullish, but the market seems overbought short-term”. Many others said that the 20% gain since the October lows is “too much, too fast”. These prognostications, though possible, are not based on anything but feelings. It brought back memories of 2009. In my March 2009 Forbes article I stated that it was time to get invested – we had TARP and a near $1Trillion stimulus being thrown around. As Professor Siegel has his naysayers, I had mine at the time. After just a few weeks the market had gained more than 20% off the March 9th bottom and the talking heads said the market had moved too fast and was setup for another test of the bottom. And then too, their statements were based on feelings rather than an intelligent assessment of the economics at hand.

As a point of illustration, look at the chart below. The red arrow shows you where the market was when it had realized the same gain from the March ’09 bottom as it has today from the October bottom. Feelings can leave a lot of money on the table. I am not saying the market will be a straight line up, but considering everything, I believe that Dow 17,000 by the end of 2013 may be the more likely of Professor Siegel’s scenarios.

Consider the following:

1. The S&P 500 was flat last year but average company earnings rose by 18%.
2. More than 70% of all S&P 500 companies have beaten earnings estimates for each of the last 10 quarters.
3. Based on expected 2012 earnings and a P/E of 14.6 (ten year average), the S&P would be 1560 at year end.
4. Ben Bernanke will do whatever he can to keep interest rates near zero for the next three years.
5. The ECB will add another €1 Trillion euros or more to the already €500 B in the LTRO at the end of this month – Europe’s QE.
6. China is on course to lower bank reserve requirements now that their inflation is within their parameters.
7. Greece will almost certainly receive their bailout once their austerity measures have become law.

The further infusion by the ECB, through its LTRO (Long-Term Refinancing Operation) will add a large measure of liquidity to the European banks, buffering the possibility of contagion (Italy’s 10-year Treasury yield is now below 5.6%), or even the removal of Greece from the euro.

Certainly, Central Banks of the G4 (USA, Great Britain, Europe, and Japan) have shown that it is now their dominant strategy to expand their balance sheets at any sign of trouble, so we can be fairly comfortable in knowing that we have a safety net should foreseen or unforeseen trouble arise. Great Britain has just this month, added another £50B to their quantitative easing program, taking its total to £325B while cutting their interest rate to 0.5%, the lowest in history.

With central banks everywhere adding to their money supplies, the sad reality is that the bankers who were enriched by the bad loans and the politicians with their billions each year in deficit spending (now for four years in excess of $1.3 Trillion/year here at home), will have citizens of the western world pay for their looting. The trillions of dollars, euros, pounds and other participating currencies will ultimately be paid through inflation. The decline in purchasing power and the increased cost of commodities will most adversely affect the poor, those on fixed incomes, and unsuspecting investors who rely on savings, CDs, and bond interest (especially those in bond funds). It is more important than ever to maintain a hard-asset bent to our portfolios. In addition to gold, copper, iron ore, oil, pipelines and companies with prime real estate holdings, we have been assessing a number of real estate limited partnerships which may be held in Fidelity accounts, to compliment our portfolios with assets with lower correlation to the stock market and offer excellent hedges to a devaluing dollar. More will follow on these shortly.

Last month I wrote about the benefits of a National Energy Policy based on natural gas. Natural gas emits 40% less CO2 than gasoline, and very little of any other pollutant. You might say it is so clean that you can burn it in your kitchen – try that with gasoline (No, not really). I did a little calculating and thought you might find this of interest. It takes 126 cubic feet of natural gas to equal the power of one gallon of gasoline or diesel. That means that one mcf of natural gas is equivalent to 8 gallons of gasoline. An mcf of natural gas cost about $4 delivered to your home and 8 gallons of gasoline costs $28 (assuming $3.50/gallon). If an mcf of nat. gas rose to $7.00 it would still cost you only 1/4 as much to drive each month.

If the typical driver is using $150/month of gasoline, he would save over $100. There are over 200 Million drivers in the U.S. If the average monthly savings is only $100, this would be a $20Billion/month stimulus to the economy. It would stimulate job growth and severely impact the ability of countries like Iran to wreak havoc since the price of oil would drop dramatically. The drop in the price of oil would also be a stimulus for those still using gasoline and other forms of oil, as well as all other countries who currently import oil. Natural gas vehicles are throughout the world – Austin and many other cities use them for their fleets, they are prevalent in Europe and Pakistan has almost 100% of its cars and trucks powered by natural gas. Pass it along.

The U.S. has over 100 years worth of natural gas and more is being found every day. We will begin exporting it early next year. I’d like to use it here, but we will at least be invested in the companies that will be producing and shipping it to buyers all over the world.

Happy Valentines Day,

Ph. 5 12.345.6789

2009 S. Capital of Texas Hwy. 2nd Floor
Austin, TX 78746

How Monetization Happens: Being at the Helm When the Ship Goes Down

The consequences of excess debt are now facing the leaders of Europe head on, and a monumental decision must be made whether explicitly or implicitly. Excess debt leads to a long chain of D words: Deleveraging in an attempt to retire debt results in a depressed economy and declining asset prices. The depressed economy breeds private debt defaults that in turn produce distressed banks. The chain then runs through depositor flight from the banks, producing a financial crisis and in turn a devaluation of the currency as capital flees. When foreign goods become more expensive there is a declining standard of living as import prices rise faster than wages. Then in an effort to stop the government debt trap, there is a default on promised entitlements under an austerity program leading to the swift defeat of the political leaders. But ultimately there is a sovereign restructuring or a default of the government debt. Most, if not all, the D words are visiting Europe at the moment and its leaders are falling by the wayside.

There is not a precise science that tells us when the debt trap begins the downward spiral that takes the ship down, but there are some rough guidelines. Reinhart and Rogoff (This Time is Different) have found to the extent one can generalize when a country’s debt-to-income ratio reaches the 90 percent level the ship of state begins to list and currently the OECD aggregate of 30-country gross debt-to-income ratio is 105 percent.

The sustainability of a country’s stock of debt is assessed by the market relative to the income flows that will be taxed in order to support the overhead cost of interest, even assuming an endless capability to rollover principal. The unraveling occurs when the financial markets lose confidence that the debt problem will be resolved successfully through income growth, austerity, or both and the refinanced debt carries the new higher market yield.

At that point, the overhead cost of the debt load is ever more depleting of the income stream that must be taxed to pay the higher interest carry. Now on a daily basis, there is a market panic attack if the market yield on Italian sovereigns rises above 7 percent. (Note the yield was close to 5 percent earlier this year so sovereign default is indeed being priced.)

After holders of Greek debt “voluntarily” accepted an arm-twisted 50-percent haircut, the market now believes that a sovereign default by a Western democracy is no longer a fairy tale. Furthermore, the default can’t be reliably hedged by CDS contracts, which proved to be voidable at the whim of the government, thus converting hedged risks into naked risks for the holders of distressed government debt. To make matters even dicier, the BIS regulators are backing away from continuing to award capital shields to the holders of sovereign debt, as explained in my last blog (The Dumpster for Toxic Euro Sovereign Debt). Also, the market has come to believe the world is without remaining Rich Uncles willing to rescue the Poor Uncles of Europe. All these factors cause investors to revert back to pricing sovereign debt based on risk fundamentals rather than government pledges of invincibility or confidence in financial insurance.

At this point, the remaining options to avoid reaching the tipping point to the D chain explained above are few, and the decisions to be made are momentous. The options are: submit to what the market is doing to you; take the lead and offer a debt restructure at a fractional payout; or run the printing presses to purchase enough sovereign debt necessary to contain the market yields. Halfway measures such as strengthening the EFSF no longer buys even a day’s worth of market forbearance.

It certainly must be crossing the minds of the Euro leaders that there are consequences for being at the helm when the ship goes down. The alternative is to orchestrate your own departure, which was cleverly done by Papandreou in Greece by calling for an austerity referendum. In Italy, Silvio Berlusconi’s departure was orchestrated quite literally, as reported by Reuters:

“Italians sang, danced and drank champagne in the streets to celebrate the resignation of scandal-plagued billionaire Silvio Berlusconi, and an impromptu orchestra near the presidential palace played the Hallelujah chorus from Handel’s Messiah”.

Not even in my most Machiavellian thoughts had I conceived of the possible value of being “scandal-plagued” as a means to a back-door retreat from an uncomfortable situation. Given its frequency among politicians it seems to be an undervalued asset in politics. But the strategy doesn’t seem to fit Ms. Merkel, so she is stuck at the helm of the ship of state and is looking for a life raft.

And the consequence of being at the helm when all the D words cascade is more chilling when one witnesses what has happened to the Icelandic captain when his country’s ship went down. Iceland’s ex-premier is facing a formal indictment charging him with criminal violations against the laws of ministerial responsibility and “serious malfeasance of his duties as prime minister in the face of major danger looming over Icelandic financial institutions and the state treasury.” (See: Ex-Premier Charged)

We have reached the point where government bluff, bluster and promises no longer control the markets, and criminal indictments for those at the helm are threatening. If it is not possible to orchestrate an early exit, it would seem the only remaining life raft is the printing press — but that would not be easy for a German government to do out in the open, given their Weimar inflation history, as shown in the chart to the right.

The monetization of government debt is undoubtedly being conceived of as only a bridge to buy time to form a tighter Euro fiscal union with strict budget discipline. Indeed, this is being counseled by Joseph Ackermann, who seems to be the influential behind-the-scenes advisor.

But to keep things together until then, the ECB is no doubt on the job, if not directly purchasing Italian and other sovereigns, but lending to others who will purchase the same. But running the printing press does not stop with the ECB. Once QEs start for whatever reason and a number of countries are engaged, the very act of one major central bank printing to save a government drives capital offshore to perceived safer ports from inflation and a declining economy. This in turn sets up another dynamic that is well underway as other countries are driven to become sellers of their own currency in order to prevent its appreciation and maintain export market share. Thus, using the printing press to save the Euro debt leads to a global money race of competitive devaluations.

Now there is a confrontation of expectations in the markets, a bi-modal distribution if you will, of those believing the deflationary forces of the D chain above will dominate and those believing, now with greater justification, that the monetary produced inflationary route will be the Euro outcome.

Expect some inconsistent pricing in the market by those being moved to bet on inflation hedges side by side with those willing to bet on deflation hedges. What must be most maddening to a deflation hawk is the asset of choice in that circumstance, long-term government bonds, are at the very heart of the credit problem and are not the solution to protecting one’s portfolio. Nor is it the solution to the inflation hawks either. So the questionable sovereigns go begging among private investors with only the central bank as a friend.

The Dumpster for Toxic Euro Sovereign Debt

Some might be wondering why the euro zone rescue focus turned to saving banks as opposed to saving governments.  The reasons are illuminating. Consider the following: When a government has a debt bulge, the debt must be held as someone else’s asset. The designated chump to hold a large portion of it has been the banking system, as its portfolio of assets is easily manipulated by bank regulators. This is how it works.

Banks are incented by regulators to hold “safe” assets as a way of making them less vulnerable to failure. But—and you’ve probably already guessed it—regulators designated euro government bonds and even subprime residential mortgage securities as the banking system’s “safe” assets. As a result, the banks load up with the safe asset, which has the effect of over-financing that sector of the economy. This sets banks up for a debt crash down the road when there is more debt than income available to service that category of debt.

To make the regulatory system more convoluted, the incentive for banks to finance the safe asset—even when it is manifestly clear that the safe asset is no longer safe—is the regulatory rule that allows banks to hold less bank capital (preferred and common stock) on the right hand side of their balance sheets. Since bank capital is depleted as a result of the 2008 subprime mortgage write offs, there is a greater need for regulatory capital today.  This has caused Europe’s banks to load up with toxic sovereigns with its  banks holding 25 percent of their assets in government bonds as compared to 10 percent in the U. S.

These incentives to hold the designated safe asset allow greater bank leverage, which translates to a lower ratio of capital to assets. One might ask why banks are strong-armed by government to maintain bank capital. The objective reason is because bank capital in the form of bank equity serves as a protection for depositors when the bank’s assets depreciate because bank equity is in the first loss position in case of an asset write down. Bank capital is also important to governments because of their guarantee (whether explicit or implicit) to restore bank capital in the event the bank is unable to. Without bank equity, depositors lose when banks write off assets; when a bank goes down, its depositors lose their wealth, which causes them to vote in great numbers against the government in power.

Thus, incenting banks to hold “safe” assets systemically makes the system unsafe: it becomes more leveraged, with banks holding a concentration of assets made riskier. The “safe” designation led to decreased market discipline by governments issuing debt, which allowed them to sell too much of it at unsustainably low rates. The ultimate regulatory convolution is when over-financed sovereign defaults take the banks down—but the sovereign maintains the responsibility to save the bank depositors.

Hence, the essence of the great euro debt-saving operation is maintaining and expanding the buying capacity of stressed euro sovereign debt—but not just the previously issued debt but the new debt yet to come. Bank buying power is necessary for euro governments to maintain the market value of their existing bloated debt, which is especially critical at times when the existing debt reaches maturity and needs to be refinanced in the market. Just imagine the challenges of maintaining market values of the yet to be issued debt to cover baby boomer entitlement over the next few decades! This will require expanding the banks’ balance sheet, which is the convenient dumpster for government debt in excess of what the market will absorb.

The problem with maintaining the capacity of the dumpster is based on banks’ ability to recapitalize (sell equity) to meet regulatory minimums. Banks have few good options in that regard—if they did there would be no euro sovereign or bank crisis.

Private equity does not gravitate to banks that have more bad assets than the banks or the government stress tests will admit. Unwary investors take a fall when the truth about the bank’s asset quality comes to light or when governments decide that banks will “voluntarily” take 50 percent haircuts on their sovereign debt holdings.

Ironically, banks don’t want to be recapitalized because it dilutes existing stockholders’ interests and lowers the rate of return on capital. Instead they prefer a capital handout from the government, which has a growing need for “dumpster” capacity for increasing government toxic debt. Government recapitalization of banks usually takes the form of non-voting preferred stock so as not to water down the returns to the common stockholders.

In the U.S., the Toxic Asset Relief Program (TARP) was a government fiscal operation that provided banks with near-costless government bridge financing that didn’t significantly dilute their common stockholders. But in Europe, the government debt financed multi-country funding source, the European Financial Stability Facility (EFSF), is capable (when and if it is funded) of covering only a very small portion of sovereigns and banks bailouts. How to backstop both sovereign debt and the dumpster banks has been center stage now for about a year and a half without resolution.

Written between the lines of last week’s sparse announcement of the “final” solution is a very tentative plan that still needs the approval of the German Bundestag, the last remaining “Rich Uncle of Europe” willing to bailout anyone. If Germany should balk at directly funding other governments or banks themselves or disallow changes in the treaty that would enable the European Central Bank (ECB) to do the same, where would the bailout funding come from?

Rather than relying on direct ECB support, the answer may lie in indirect ECB support through a newly created “Special Purpose Vehicle” (SPV). This legal financial entity looks a little like a bank in that the vehicle funds are used to purchase the assets the euros want off the table, and it is funded by a combination of debt and equity sources with the ECB being a primary contributor.

To give the SPV credibility, the equity portion will be the scant remaining 235 billion euros left in the EFSF (if and when fully funded). Using the bank model of leveraging, the scant capital is projected to expand the balance sheet a multiple of 4 or 5 times if there are takers of the SPV’s debt. This would create a much larger dumpster capacity to purchase toxic sovereign debt that no one else wants and perhaps even bank equity that no one is lining up for just now.

Does this sound familiar? It is the same model employed by Citibank to hide subprime mortgages offshore in an SPV or Enron’s partnerships used for the same purpose. How the government learns financial cover-up tricks from the private sector!

With the equity claims in the SPV held by the EFSF, the question is who will purchase debt claims in the SPV to leverage up the new debt dumpster in order to achieve the hoped for 4 to 5 times expansion of the SPV capacity to purchase bailout assets? Officials are traveling to China and Japan this week and will entertain other private debt investors in the SPV and make it juicer with as yet unclear government guarantees on a portion of losses of the debt investor’s losses in the SPV debt.

Hence, the SPV has a decidedly bank model flavor to it—except it is not subject to regulation and its transparency will be even worse than banks. At this point I believe it would be a heroic success to con individuals to do what bank depositors have become unwilling to do: continue depositing at banks whose assets contain bad government debt and whose deposits are “guaranteed” by the same insolvent governments.

Why would one think that the market will more likely invest in SPV debt than a euro bank deposit whose depositors are fleeing the banks with their money. If the SPV is the same dangerously leveraged model as the banks, with the same assets and the same guarantor, can you expect a different result?

What makes it seem possible is the (intentionally) still hidden role of the ECB. Since Germany will veto ECB participation in direct investments in the underwater sovereign assets, the SPV is a multi-government owned and controlled camouflaged bank that provides the indirect route for the ECB to uplift purchasing power in the toxic European sovereign debt market by purchasing SPV debt with printing press money. This designated role for the SPV in conjunction with the ECB keeps Germany’s hands clean, so to speak.

The ECB printing press provides the leverage for the SPV to increase the capacity of the dumpster. The SPV is also not banned from purchasing bank equity to maintain bank dumpster capacity if banks are unable to be recapitalized by the market, which is likely.

While the plan is a little convoluted, it offers governments the deniability of engaging in what some would call throwing good money (the EFSF funds) after bad (the Greek debt). Since the ECB provides unlimited debt expansion capacity for both the SPV and banks, one wonders why the euro zone heads of state became so caught up with creating the SPV functioning in parallel with the banks. Perhaps it was merely their political sense that the combined governments had to do something. They do, after all, run for re-election, and committing government fiscal resources to banks is not a popular thing to do.

But if the plan works, it will provide added SPV dumpster capacity alongside banks’ increased dumpster capacity, with neither German financial support nor direct ECB support.

The implication of monetizing the financing capacity of the SPV is no different than directly monetizing banks or governments. It supports the ability to have an expanded capability to purchase assets, keep them out of view (do you really expect transparency?), stop the debt unwind, possibly revive the economy with yet more new money, create an asset bubble and have inflation as a side effect. All of which seems better than an instantaneous euro zone unwinding and a debt deflation. Such are the machinations of colluding desperate governments who want to do something that appears on the surface to be helpful. How else can you run for re-election?

Folks, I can’t make this up. What might seem puzzling was the stock market rally late last week, both in anticipation of and following the long-awaited announcement. I can only presume the market was celebrating the fact that banks and the economy were not being deposited in the dumpster immediately, and an indirect vehicle to bring the printing press to bear has been created to increase the sovereign debt holding capacity.

Instead of imminent falling dominos, it is dominos re-inflating.

Dominos: From Financial Crisis to Economic Crisis to Government Crisis

The dominos are falling. It’s the modern version of a 1930’s bank run. Since everything is bigger (the leverage) and faster (the computers) these days, so is the downfall in financial prices and institutions.

The lead domino is an asset class becoming untenable. This time around it’s the subprime sovereigns of Europe, whereas three short years ago it was subprime mortgages. Then, as now, it was thought to be a small problem (if we count only Greece) of almost the same magnitude: $400 billion in subprime mortgages that was thought to be contained or walled off. From there you should get the general idea, as the subprime story should be fresh in your minds.

Since the most conservative and regulated institutions hold large proportions of sovereign bonds in their portfolios, the default of the bonds becomes their balance sheet insolvency.  The next domino is the withdrawal of the funding from banks by those who lend to them on a short-term basis and suspect the banks’ solvency is compromised.

Since demand deposits, just as the name suggests, are payable on demand, they are the next domino. This funding source exits the banks because of the suspected insolvency. To replace the lost deposit funding, banks borrow overnight from other banks or from “repo” lenders on a collateralized basis. When these sources find lending to the suspect bank too risky, they stop lending and another domino falls.

This is the part when everyone says, “Oh, don’t worry; I’ll go to the central bank to replace the lost funding.” At this stage, the banks complain of “liquidity” drying up but in reality but what is driving their liquidity problem is the market sensing their insolvency problem.  The liquidity then flows until the central bank hits the wall and another domino falls. The central bank has constraints, and when the collateral offered is no longer investment-grade as the ECB Treaty requires, then the ECB hits the wall and another domino falls.

Then, borrowing from other central banks (like those of the U.S., U.K., Switzerland and Japan) kicks in as it did three weeks ago. Because the Fed has over-extended its balance sheet, it recently took a pass on net economic stimulus, opting to buy assets financed by selling other assets so as not to further expand its already stretched balance sheet. Hence our central bank as lender of last resort is constrained, it can’t help the economy and another big domino falls.

When these sources no longer provide the liquidity necessary to support the right hand side of bank balance sheets, the bank’s stockholders start to leave in the form of selling bank stock.  So the next domino falls. Then stockholders of the banks and other institutions around the world ask their management whether they lent to the hedge funds whose collateralized assets are falling in value. The answer is obviously yes; as we examine the worried look on the face of a very large celebrated hedge fund manager who is pondering what to sell next in order to pay off his leveraged loans and cash out his investors seeking liquidation of their stakes in the Paulson Funds.

So then hedge funds which are larger in aggregate than U.S. banks sell, sell, sell to pay off short-term funding as well as equity owners who want out. This compresses their balance sheets, and all kinds of assets unrelated to subprime sovereigns fall wickedly in price such as gold, and the equity and debt of successful emerging nations.

So another domino falls. This doesn’t diminish these assets’ long term worth, but it sure puts a dent into value believer’s portfolios for now.

The next dominos from there are just beginning to enter the public consciousness. Can this top-down shedding of assets and compressing balance sheets also take down the economy? Well, yes, as all financial institutions are seeking to liquidate assets to meet the demands of their funding sources. So the next businessman who walks into the bank asking to roll over his loan and add to the balance to finance some new opportunity is met with the news that the bank expects payment in full on or before the current loan’s term. This, too, is a big domino as the financial crisis takes down businesses and the economy.

I would like to think it’s over from there, but it is becoming increasingly clear that taking down wealth, taking down the economy, and shutting off business and employment opportunities can easily lead to revolutionary changes in government. This is a very big domino that has hit the streets in Europe and here as well. It will also lead to revolutionary changes in Europe’s governance and institutions. On this side of the pond, the Federal Reserve is likely to be taken to task for pumping up the asset bubble with easy money known as QE2. This could result in changes in the voting membership and control of the Open Market Committee that makes monetary policy decisions. The Fed could quite easily lose its cherished independence, which is perhaps the biggest domino of all.

Whether the financial meltdown goes into overdrive as in 2008 depends on whether systemically important (large) institutions are allowed to fail as with Lehman. That lesson is now clear and the intention is to not repeat that episode says Secretary Geithner. If the government doesn’t have the ability to recapitalize banks and the financial market can’t absorb the rush of additional asset sales from the liquidation of a Lehman sized institution, then the “too big to fails” will be left in suspended animation with an upside-down balance sheet (better known as zombie banking) and glossed over with cover-up accounting. Zombie banks liquidate bank assets slowly but make no loans. At least the liquidation is measured rather than instantaneous.

Of course, only knucklehead governments do not immediately replace fallen bank lenders with fresh entry into banking — a concept known as “good” and “bad” banking. But we have a knucklehead government that doesn’t permit bank entry, so viable banks to finance growing businesses are few and far between.

The financial implosion could end if the central bank really goes over- the-top and purchases stock, either common or preferred, in the commercial banks, restoring their solvency. Our government can’t afford to do this, given its fiscal limitations. There won’t be another TARP. Central bank financing was ultimately the key to making zombie banks in Japan whole again in 2003, after more than a decade of being zombies. We’ve done lots of over-the-top things with the printing press, but at least this one makes constructive sense and is likely the last silver bullet left in the Fed’s and the government’s arsenal. As for Europe, even if Greece is saved their banks need saving and their governments also can’t afford it.

What I have described is not an ordinary recession in which over-investment in some sector causes a lull in new investment and trickles down to slow the economy without taking down the financial system or blowing up the government’s balance sheet. This is, instead, a top down financial shrinkage that takes down institutions, wealth, market valuations, the economy, governments and governmental institutions. How far it goes in Europe and in the U.S. will be determined over the coming years. One thing for sure, this one will go into the history books. The only thing in question is will it be merely the history of prosperity and depression or will it also include the history of government evolution.

Turn Out the Lights, the Party’s Over

Invitation: Unchartered Waters Ahead:  I will be giving a McCombs Alumni Lecture/Discussion (open to the public) Wednesday, Sept. 14, starting at 7:30 p.m. at the AT&T Conference Center just off campus. The content will be the likelihood and effects of the three options the U.S. faces as a result of its sovereign debt: balance the budget (which implies default on entitlements), default on its debt, or monetize its debt. All are costly, but with different outcomes for financial markets, income and wealth.  Invitation link and RSVP


The Financial Times ( did a summary of a video I posted on regarding how QE2 elevated financial markets here and abroad and generated inflation but reduced real income in the U.S. It is food for thought on why QE3 is unlikely. FT Summary

In a recent video on TheSpellmanReport, Lacy Hunt indicated why he hung in there in the long term government bond market in spite of the inflation generating QE2: The WSJ recognizes Hoisington’s admirable investment performance.

Blog: Turn Out the Lights, the Party’s Over

“Turn out the light, the party’s over” was the hymn sung by former SMU and Dallas Cowboys quarterback “Dandy” Don Meredith in his role as color commentator over the first dozen years of Monday Night Football at the point of the game (often well before time had run out) when, in his opinion, the winner and loser had been decided.

Well, I’m humming it and can’t get it out of my mind as I witness the disintegration of the Euro sovereign rescue and the attempt to launch a fourth-quarter comeback. Despite the best efforts of Europe’s politicians and central bankers to preserve the Euro zone, the euro, and European sovereign financial integrity, their heroic efforts are being overwhelmed. Consider the following:

– International lenders suspended discussions with Greece on its next €8 billion tranche of bailout loans as Greece is unable to balance its budget, a precondition of the bailout loan.  The Greek austerity program is also producing negative GDP growth.

– This week Germany’s Federal Constitutional Court will deliver its ruling — awaited for over a year — on suits claiming Berlin is breaking German law and European treaties by contributing to multi-billion-euro bailouts of Greece, Ireland and Portugal.

– Chancellor Angela Merkel has denied that a popular German backlash against euro bailouts is the cause of her party’s sixth successive defeat in regional elections.

– The market has rendered its opinion on not just Greece’s inability to perform on its sovereign debt but also whether the third-party guarantee from the rest of Europe, the ECB and IMF will be forthcoming. Greece sovereign market yields speak volumes on the market’s opinion.

– Italy’s bonds now need rescuing, and the ECB is pulling back its market support and is “studying” it

– European (and U.S.) bank stock is plummeting into “option value,” reflecting investors’ beliefs that the party is over for them as well.

– The Euro zone is likely back into a recession, and with the fiscal strains of government, how can there be bank rescues on top of country rescues on top of stimulus programs?

When the bond market, the stock market, the electorate, the economy and possibly the Supreme Court are against you, those collective powers add up to more than government’s collective will.

The implications are now being priced in markets. The flight to quality asset seems to be the Swiss franc and the Japanese Yen. Oh yes, the Yuan is also doing well as deposits accumulate in Hong Kong Banks, as seen in the graph.

There is trouble with the Yen and the Swiss Franc currency appreciation in that it is not welcomed by the respective countries and they actively seek to depress their currency’s value to preserve export market share. The only flight currency that can’t be flooded by a central bank is gold, and its climb continues.

The U.S. has likely caught a break in that the Euro distress might scare us straight while we still have time to do a mid-course correction. Thus, it is too early to “turn out the lights” on the U.S. We are in the third quarter and recovery is far from guaranteed, but it is more likely with the vivid lessons of Europe fresh in our minds.

A Return to the Grand Tetons: Perspective on the Economic Obstacles Ahead

Last month, I made a personal odyssey to the Grand Tetons Mountains and Jackson Hole, Wyoming. It’s the place where I discovered the American West while in college. It is a mountain rising abruptly from its flat surroundings (the Hole) to jagged peaks with glacial snow rising above the spring like flora in the valley where the buffalo still roam.

It is the most majestic natural setting in America and a place that attracts many for the stark beauty and perspective it gives of our own economic hurdles that lie ahead. It resonates with an urge to devise a plan to tackle the mountain. Short of that, one can devise a plan to go around or test the foothills or even huddle below through the winter freeze.

Every August since 1982, the Federal Reserve returns to the base of the mountain as it will do again this week to gain perspective and set the mountain-climbing agenda ahead. At the meeting last year, with worried looks obvious on the faces of the Fed aristocracy, the QE2 plan was hatched in response to an economy that was weighed down with a private debt load so unwieldy that it couldn’t make it up and over the mountain. The Fed decided to experiment with a new rocket launcher called QE2 — a kind of brute-force money propulsion machine that had never been tried before. It amounted to a $600 billion government bond purchase over nine months, which is the amount normally purchased over a 15 to 20-year period.

With great fanfare the QE2 plan was hatched to provide the lift to hurdle the mountain. Well, a year later, it turns out  that it provided only short-term benefits that quickly disappeared when QE2 ran its course less than 60 days ago (see: Lacy Hunt on the Morass of Debt). The stock market bubble heralded by Bernanke as its crowning achievement has settled below pre-QE2 levels, as has the GDP growth rate, which is just fractionally positive. Inflation rates such as 14 percent for imports and 7.5 percent for producer prices would likely cause the Fed to back off from another money experiment that didn’t turn out well.

A year later the same intractable growth and unemployment problems still exist, only worse with the elevated inflation rates. The Fed has come back to Jackson Hole to take the measure of the mountain once again. On top of the private debt load which prevents successfully scaling of the heights, the mountain must now be climbed bearing the dead weight of the growing burden of intractable public debt as well. Not only is the public debt intractable, but that fact crushes confidence in the future, which in turn crushes investment and consumer sentiment and, in turn, spending. To make matters worse, both the U.S. debt ceiling debacle and the recently concluded round of Euro debt discussions reveal the inability of governments either here or in Europe to devise a mountain-climbing strategy or a means to shed its debt or prevent further accumulation.

The governments of the U.S., with its marginal plan to shed the debt ballast over the next decade, and Europe, with no plan at all, have opted to camp in the valley, and we hope to survive the coming winter of austerity. True, they might send search parties to test the foothills for a competitiveness route out of here, a policy coordination route, or a jobs program, but those won’t do the heavy lifting necessary to scale or find a pass through or over the mountain.

Alas, with the Fed once again staring at the mountain, it is being urged to take out the money rocket launcher for another try to be called QE3. But it will most likely hold its remaining powder dry, as it might be forced to be the lender of last resort when its policy Sherpas, the commercial banks and other financial institutions recently beaten up by the stock market, begin hemorrhaging from a liquidity drain.  Indeed, the ECB has had to perform triage on the Euro Sherpas to the tune of nearly a half-trillion euros in loans to their banks, loans that would need to be repaid by the banks if the government bonds provided as collateral default. That would be an endgame of financial market crumbling from the bank’s sale of assets to repay depositors and others who foolishly supplied the banks with short-term funding (including U.S. money market funds).

I am no longer a believer in manifest destiny that we will necessarily hurdle the mountain with Lewis and Clark like resourcefulness (they passed just north of here) and make “cheap” stocks more valuable. I would keep my personal powder dry until the issue of the mountain is resolved and until then seek out the flight to quality assets that are thriving in this harsh and uncertain environment (see: Reserve Currency Sovereign Defaults and the Flight to Quality Asset).

So here we sit in the valley looking at the mountain and our thoughts drift to choosing new leaders to replace those who are devoid of policy or leadership skills and only excel at finger pointing. Fear is accumulating that we will be stuck in this valley of austerity for a very long time.  As the Russians are fond of saying, it will be a cold winter.