Heads you lose, tails you die....the Automatic Earth:
theautomaticearth.blogspot.com
VK: The persistent notion that there's only $1-2 trillion in losses remaining in the banking system, as some people conclude from what Roubini and others may have stated, is false; that would be peanuts. The Federal Reserve printed $1.55 trillion to buy up toxic MBS plus Treasury paper. But the problem has not been cured, in particular: most of the toxic debt still remains hidden through the application of shady accounting practices. There is no solution in sight in the current political paradigm.
Think about it this way: the US government has implicitly and explicitly guaranteed, loaned, subsidized and given away about $12.8 trillion to banks while these banks have only $10 trillion or so in real assets. Why is the government giving so much assistance, a sum far greater then all assets combined of the US banking system?
Simple really, the derivatives aka bets are far larger than global GDP, estimated to be between $500 trillion and $1,5 quadrillion. JP Morgan alone holds $90 trillion or so in derivatives while the entire US GDP per annum is no more than one-sixth of that, at $14-odd trillion.
So those bets have gone bad and gone wrong and they have been kept hidden in the broom cupboard thanks to creative fictional accounting practices, in level 3 assets on bank balance sheets, and in off balance sheet items.
The losses are real, the bets went bad, and Washington is attempting a show of CONfidence to prevent a systemic collapse. But when Mr. Market calls the government's bluff, and he will, then people will realize the US Government is the naked emperor, with no money to back up those guarantees for failed and long dead enterprises.
There are three things in life that man can't prevent - death, taxes and Mr. Market calling the bluff.
See, Mr. Market is a master illusionist, is he not? Evidence you say?!
First he creates a mini panic, a preview if you will, that has many people crying out, "head for the hills", "rapids ahead!", then he deftly creates a slope of hope, which we are on now for the moment, where all the suckers who ran for the hills and paddled away from the rapids and in the process lost a few trillion here and there, realize how 'naive' they were and start buying any risky asset in sight. Gotta recoup those losses they say!
This year Mr. Market has gotten quite a leg up in emerging markets, what with Brazil rising 80% and India up by 70%, the anti-USD play evolving into a dollar carry trade and giving rise to bubbleicious bubbles in Asia, gold, stocks, and with corporate bond yields declining all year long. Alas, Mr. Market never makes it too easy and has been giving people cause for worry. What is it with those pesky 10 Year bonds yielding 3.5%, can't they sniff the inflation ahead people ask, why are they priced so high? Also, why did the difference between the long end of the curve and short end of the curve reach new highs recently?
Mr. Market gives hints to those who see and those who listen. What goes up, must come down as the old cliché goes. Bill Bonner puts it best, "The extent of the correction is equal and opposite to the deception that preceded it." And my, what deception we had! A glorious age of mankind was dawning we were told, that of stable growth, the end of recessions, scientific economic theory and a gilded age of prosperity.
So Mr. Market gives us hints, hints not to listen to the fools, the ones that missed the crisis and are now predicting its early demise. The hints are obviously the rising USD over the last few days, the considerable fall in gold, the problems re-emanating across Dubai, Spain, Greece, Ireland etc. Looks like Mr. Market is saying that the flight to safety has begun and lord knows it will be grand. When those on the slope of hope get caught up at the greasy end, when they suddenly lose grip, with horror etched on their faces as they tumble away far down into the nether regions of the world.
So the USD will rise in value much to the shock of all. The economy is worsening and it's rising people will say? Maybe even double in value from present values, it seems likely given the amount of debt deflation occurring in the world. The dollar represents 65% of the world's money and as money gets scarcer, the USD will be the One eyed King of the blind and ill, oil will fall substantially, a return to 10 dollars per barrel or less is in the cards given how much demand is going to plummet next year, so forget about Sheikhs in Abu Dhabi bailing out their hapless cousins in Dubai. Gold must fall, eventually I see Gold returning to 600 or less, maybe kissing the DOW, the bottom will be in when the Dow/ Gold ratio reaches around 1.
Emerging markets will get battered hard, bitterly hard. They rose the fastest and they will fall the fastest. The wind will get sucked out of them much faster than the US because remember emerging markets are peripheries, the flight to safety will see them crumble as money rushes to the perceived safety of the core countries. Imagine a concentric circle crumbling from outside in.
The world will groan and moan, for as yet we have not seen a real bust, whether it's the gravity defying Australian kangaroo economy which must contract sharply as China's epic credit fuelled hangover will eventually end leading to a bursting resource bubble there and in the overvalued Australian dollar or the bubbly Canadian house price boom whose vintage is decidedly toxic or those overpriced box-like hovels in England people call homes, their true value must eventually come out as Mr. Market believes in the truth and nothing is quite like the light of truth to reveal the ugly toxic glory of all credit cretins.
We will also learn that all those factories in China are worth zero, as well as those in Korea and Japan, as the buyers of their goods are fast becoming broke, unemployed and homeless and those who still have a roof over their head will find out that those houses are worth close to Zero and my how wages will fall due to the cascading effects of the deflationary spiral! It will certainly be a sight to behold. Though you may not see much in your wallet or your bank account.
Corporate bonds will get hammered and many companies will default as they simply can't pay back or up. This will grievously damage or end many too big to bailout entities and heaven help them as countries decide that saving banks isn't a particularly good idea if they have to commit national suicide in the process. Even the strongest companies are not worth the risk, as cash flow will all but dry up, much like quality entertainment on US television at present, as hardly any exists.
Let's watch cash flow drying up in greater detail for a moment; the banks you see have borrowed trillions upon trillions of dollars from the rest of the world and each other. Between today and 2012-2013 the banks need to refinance around $7 trillion at the least (that's what they're telling us, it could be much higher).
Now a basic rule of capitalism and thus banking is that you obviously want to make a profit, greed and the self are the key building blocks of our capitalist system. So banks borrow cheaply and make loans at a higher rate, the spread is how they make a profit. Now currently banks are not making many loans, in fact both European and American banks are decreasing the amount of loans they make while holding onto record reserves of cash.
What they are doing is borrowing at 0% from the FED and using that to buy Treasuries that pay around 3.5% and currently since the market is rallying they are using that to go long via speculative positions.
It sounds like a good deal but when you think about the fact that they have borrowed at a much higher rate then 3.5% and that they still hold trillions upon trillions of derivatives that require interest payments on the liabilities side of the balance sheet, and that they hold trillions in deteriorating commercial real estate loans, mortgages, businesses loans, corporate bonds etc. on the asset side, you can sniff out the trouble they are in!
Now because the vast majority of money supply is credit and that supply of credit has been declining, the amount of cash in the economy is declining and will decline further due to the unwillingness of banks to lend and the fear that borrowers have of going into more debt then they already are in. Obviously at some point the borrower realizes that swimming is fun but only if your head is above the water!
So income streams from mortgages, commercial loans, small and medium sized companies start declining as these companies lack substantial cash flow to meet their loan obligations. When the assets remain marked to myth for a longer period of time, the cash flow declines start having very real impacts. As cash flowing into the banking system declines, how can banks meet their trillions in obligations in the form of loans, bonds, deposit interest and the like? In short, they can't.
So if less income is coming in from the asset side of your business, the less likely you are to be able to pay your liabilities regardless of how high you 'book' your level 3 assets. And if ever level 3 assets are allowed to be marked to market, you'll find that the whole bada bing is worth zilch instantly; what I would call a bada boom.
So Mr. Market will start calling the banks when serious cash flow problems start emerging, in today's slope of hope rally, participants such as the banks and corporations have issued a record amount of bonds to stave off their cash flow problems and keep operations going as they can't get loans. Trying to solve a debt problem by adding more debt is just plain silly akin to 'curing' a tumorous cancer by providing the patient with adrenalin jabs to keep him alive while he writhes in agony for longer. The next deflationary wave down then hits when market participants realize how bad the real economy is due to:
1) The hidden psychological (herding) forces. A crisis of confidence.
2) Declining cash flows, cash that is vital in keeping the economy afloat.
We will see a flight to safety and a cascade down in the markets along with declines in wages, prices and an increasing debt burden as real interest rates skyrocket, provoking downturns in world trade and the whole globalization whopeedoo train!
When the proverbial smelly stuff hits the fan, the long end of the curve is an attractive place to be, the differential between the long and short ends looks far too large. 30 year bonds will shoot up in price and go substantially down in yields. I'm thinking that Mr. Market is hinting at a huge flight to safety. This could see 30 year yields at 1% or less, it all depends on Mr. Market of course, he alone is the giant amongst men.
Lest we forget the midgets amongst men, we shall honour them as well, currently Mr. Market has led resource currencies and commodities to heights far above where they should be and soon we shall find out that they are going to get hammered and hammered hard into the ground. As the Chinese crack stimulus fades and the sheer force of the contraction we are facing will wipe out all pricing support as demand will evaporates into the ether.
Obviously as we see an increasing loss of confidence, a bank run could ensue and definitely accelerate events rapidly! We could see a cascade event/ tipping point in the middle of next year or earlier as people lose confidence in the system. Once fear grips the population, I suspect Mr. Market will be looking forward to creating bank holidays and closures of the stock market. Banning those 'evil' short sellers and jawboning the slope of hope recovery, expect great oratory from President Obama next year and an attempt to take on more debt by Congress in attempt to 'recover' and 'stabilize'.
Did I mention Mr. Market loves practical jokes?
Now there's the old adage, All men are created equal but some more so then others. 'Tis the same with debt really. Not all debt is equal, some of it is more useful then other debt, for example private sector debt is more capital efficient then public sector debt though both are socially inefficient in the long run but that is a story for another day. A corporation is going to use debt more efficiently then a government is ever going to, as it has a profit motive to extract the most out of that borrowed dollar.
Now things get interesting, the time of creation of that debt is also very relevant. As credit forms 99% of the money supply and because money supply must always grow given the present monetary paradigm, it is obvious that credit/debt created 20 years ago carried more bang for the buck and that credit/debt created 60 years ago carried even more than that!
In the 1970's a car, good affordable housing, a nice university education etc cost far less then it does today and on much lower incomes as well.
So in the 70's and 80's a dollar borrowed was worth much more then it is today. You could buy more land, more house, more car, more education and more stock! Today a dollar won't do much as it has steadily devalued over time by a process we all know and love called inflation whereby your purchasing power as well as borrowing power declines over time.
Moreover, our economies have hit the big fearsome brick wall of diminishing returns. Today we have a situation where for every dollar that an individual or a company borrows, the system gets out maybe 10 cents or less of growth. In the 1950's, it is estimated that every dollar borrowed would generate 3 dollars of growth. That's a large part of the reason why all those trillions in bailouts, guarantees, subsidies, loans etc are having such negligible impact.
So we have trillions of borrowing and record spending to get a few paltry billions in 'growth'.
A debt saturated society is thus faced with two conundrums as time progresses.
1) The ability to service the debt plus interest declines steadily over time leading to cash flow problems.
2) The usefulness of that extra dollar of debt also steadily declines. Thus we are moving towards a point where for every dollar borrowed we have a contraction (I was going to use that ghastly word 'negative growth' but decided against it) due to debt saturation.
Hence, the marginal cost of taking on one more dollar of debt will become detrimental to society as a whole, as the marginal benefit of that one more dollar is negative. This is precisely how societies decline and as in our present debt based monetary system, the principal must be paid with interest by society as a whole in one form or the other.
This is either done through:
1) A deflationary depression where debt is defaulted upon and living standards plummet and millions are left broke and homeless - a societal disaster.
2) A hyperinflation that leads to the complete debasement of the currency and the utter failure of the monetary system - a societal disaster.
Some deflationistas focus on the mechanics that will make deflation the driving force initially and for the foreseeable future - constrained lending by banks, hoarding of cash, the inability of the Fed to keep pace with credit destruction and the unwillingness of foreigners to finance government deficits indefinitely as their balance sheets are constrained by declining export income (we're looking at China and Japan, the Gulf). When, but only when, an economy has become isolated enough can hyperinflation take place, and as a reaction to deflation. The American economy knows no such isolation, and can therefore not be hyperinflated at the moment. In five years, yes, but the world will be a whole different place by then.
By the way, actually paying back the debt is impossible in a system that requires constant debt creation just to keep even, remember the Red Queen in Alice of Wonderland? One has to run faster just to keep up.
So next year we look all set to see the beginning of shortages of goods and services in the western world, as companies go bust due to their target market having barely enough money to survive. Bank runs and heightened fear are highly possible, but always remember at the height of that fear, Mr. Market will once again create a slope of hope much like 2009, but much worse, because at the time it will look like a God-send, a "recovery is finally here" will be the cry across the land. Here the battered and the wounded will be given hope and motivation, only to be suckered into finding out they are yet again on a slope of hope.
The slope of hope that leads to the abyss. I hope one now appreciates and understands Ilargi's all time classic line, "Heads you lose, tails you die". |
