Update                   “For where your treasure is, there will your heart be also.”—Matthew 6:21              September 21, 2008

I’d Like To Know Where You Got the Notion…That More “Liquidity” Can Arrest the Crisis in the Markets.  (Part 2 of a series) September 21, 2008

            Yes, we know we promised that the second of our “Notion” missives would be related to the commodities markets.  But events of this past week compel us to pre-empt that episode in favor of this one.

            As this past epic week closed, the mood on Wall Street had shifted from one of terror at the prospect of being destroyed by a financial Armageddon, to one of at least a guarded optimism.  Financial markets the world over breathed a sigh of relief as it was announced that the U.S. Treasury Department was beginning to craft a “Resolution Trust Corporation” –type entity of an as-yet undefined nature; but one which will (hopefully) make everything better in the end.  How it does so-and if it does- will be a matter for great debate.  For the most part, though, markets are willing (as always) to keep faith that the massive amounts of “liquidity” made available already to institutions of (now) most variety will save our civilization.

            We beg to disagree, because we disagree with the notion that this blind faith is based on.  Liquidity is not the problem-solvency is.  And the only way the federal government can put even a meaningful dent in that problem will be by driving the final nails into the coffin of this nation’s currency. 

HOW WE GOT INTO THIS MESS

            Thos of you who understand the nature and workings of our fractional-reserve monetary system knew that what we are facing now was inevitable (NOTE: If you are either unfamiliar or even merely “rusty” on how, for instance, estate, credit and – finally- derivatives bubbles, STOP here and FIRST read Chris’ Fall, 2004 version of “Understanding the Game” For some added insight and history, you should also check out his front page story, “Glass-Steagall-R.I.P.” from the November 1999 Issue of The National Investor, located on the website in the Essays & Articles section). 

            There, now you will have a far better grasp on our plight than your neighbor, banker or stockbroker.  You will most certainly have a better handle on things than the pundits on “Tout-T.V.”, and much more so than the two major candidates for president.  It would strike us as hysterically funny were it not in the end so sad and frightening that Senators Obama and McCain could so incredibly outdo one another several times a day recently with their ignorance and inanities.

            Simply put-and as the current occupant of the White House alluded to on Saturday- a “house of cards” built on essentially nothing of value had become, functionally, our banking and economic system.  Long since past the point in an essentially gutted real economy one of real industry, real wealth-creation, etc. at its core-of having those things of substance on which to build a financial structure, we have instead watched the financial markets build a skyscraper of cards on their own dubious “assets”.  This “creation” of hundreds of trillions of dollars over the last several years was needed, as we pointed out in “Understanding the Game”, to keep the system plowing forward.  Now, though, the jig is up; what Chris called “The Last Speculative Hurrah” has run its course. 

            This last hurrah brought us “assets”- a variety of exotic financial instruments that even some financial professionals could not accurately describe were they called on to do so-on which the unprecedented explosion of trading volumes, activities and notional values of other assets came to be based in the recent past.  These derivative contracts came from the practice, as Barron’s Randy Forsyth quipped a while back were, “…Wall Street slices and dices sows’ ears into silk purse investments.”  For instance-where so-called sub-prime mortgages are concerned-a banker would “slice and dice” components of those notes and join them to elements of other, higher-quality debt.  The result was that everything now was highly rated (thanks, by the way, to the oblivious credit rating agencies who were among the many enablers of this whole fiasco).  Thus, with plenty of liquidity out there in the hands of investors, there was huge and growing demand for all kinds of this dubious paper.  Things were going so well, in fact, that institutions started to use these very instruments as collateral on which to
1.) engage in their won “money creation”, and 2.) leverage these “assets” into multiple other ones in some of these same kinds of paper.

 FINANCIAL TIMES CARTOON

           Big Problem Number One came when due initially to the real estate market’s boom running out of gas-new paper was not being created in big enough volumes to feed the monster.  (As with the underlying fractional reserve system itself, this incredibly juiced-up version could only thrive with ever-more activity).  It was inevitable that, just as the millions of homeowners who are facing solvency issues have had to begin dealing with figuring out how to manage a now unmanageable “nut”, so too must financial firms now figure out how to start pulling their horns into stay afloat.

            But at least with homeowners, there is an underlying asset with some value; even if it’s not what a home was selling for in that neighborhood two or three years ago.  Big Problem Number Two for shaky Wall Street and Main Street financial firms is that much of their asset books and, in some cases, their collateral for their debts and investments have no value!

            John Gapper in Thursday’s issue of the Financial Times spoke of this incredible fact-unthinkable still, we surmise, to the average American-where the giant insurer A.I.G. is concerned.  If you’ve followed the saga, you know that Treasury Secretary Hank Paulson had been pretty well against coming to the company’s aid.  Much of Wall Street seemed almost stunned by the prospect that our nation’s largest insurance company could be in trouble…after all, aren’t they an insurance company?  Aren’t they safe; at least, safer than a hedge fund?

            Little did we know, though, that just as the energy company named Enron turned itself into a hedge fund a few years back-A.I.G. had done the same.  As Gapper wrote, “having examined the heart of darkness-A.I.G.’s $60 billion book of derivatives written on other derivatives based on bad residential mortgages-his resolve crumbled.  Lord only know where this leaves us, since only He knows what a credit default swap (CDS) on a collateralized debt obligation (CDO) is worth”.

            Paulson didn’t take the time to worry about how much of that $60 billion in notional value was legit.  He made sure every penny and then some was loaned to the company to keep it going; a loan based on your children’s and grandchildren’s future earning and tax paying abilities (or so you might think).  This movie, though, will have innumerable sequels; will-can-Paulson come to everyone’s rescue?

            Late this past week, CNBC’s Steve Leesman bluntly summed up this whole debacle-one, which has only just begun-in one of the best lines we’ve heard in a while.  He and a few others on a panel were debating how seemingly ineffective the Federal Reserve’s $180 billion liquidity injections over the previous night had been.  Leesman pointed out that liquidity had been “evaporating” from the commercial paper market as fast as the Fed had been pumping money into the system.  Getting around to our main point in all this, he went on to address the real problem; not only of leverage, but in what was being leveraged.  “We’ve been talking about this 30:1 ratio,” he said, in discussing the lunacy of many financial firms having been able to borrow 30 times their assets to invest in both real and (too often) imaginary “assets” comprised of “Lord knows what”.

            “The (real) problem is,” Leesman concluded, “there is no ‘l’”. 

MOVE OVER “HELICOPTER BEN” – HERE COMES “C-5 HANK!”

When you consider that there are tens of trillions of dollars of dubious assets characterized as “l’s” on the books of hundreds-if not thousands-of financial firms, you begin to appreciate the magnitude of this now rapidly evolving implosion.  Those “financial weapons of mass destruction” that Warren Buffett warned derivatives could become are now detonation.

            A rather stunning and revealing thing to ponder on in trying to understand the enormity of the implosion that is underway is just how quickly the Federal Reserve has been rendered impotent.  By most tallies, as much as two-thirds of the Fed’s own assets are already gone or loaned out as the central bank-in conjuction with others around the world-has tried to keep the system liquid.  It has had some success at this; but cannot do what needs to be done: make banks, hedge funds, insurers and others solvent.

            Now, “Helicopter Ben” is being pushed to second fiddle by “C-5 Hank”.  Yes, the central bank has great powers; but it has essentially dropped most of its ammunition on the markets.  Now, the more powerful (but, to markets, the relatively more distasteful) tools of the federal government itself must be called on to , though whatever fiscal measures are needed, try to stop more bombs from going off.

            The first step in this will be the eventual “RTC-type” institution that is set up to help financial firms offload “distressed assets”.  The price tag being mentioned so far this weekend is $700 billion (legislation being crafted as you’re reading this will include a related rise in the current statutory debt ceiling of $10.6 trillion).  That figure will wholly inadequate to cover the tens of trillions that will be evaporating from balance sheets in the coming months.

            A logical question involves pricing of the “assets” the Treasury will take off the market’s hands (ones which, don’t laugh too hard now, it’s claiming it will be able to re-sell later “when market conditions improve”). You see, UNLIKE the task undertaken by the Resolution Trust Corporation a while ago, these “assets” in many cases only have value because at some point they were “marked-to-make-believe” on a financial company’s books.  As a guest on National Public Radio’s Marketplace show quipped this week, all the gurus who will be hired to look into these various companies’ balance sheets and figure out what the assets are worth will, first, have the same kind of problem Superman would have were he asked to describe the contents of a package encased in lead.  Next, of course, will be to determine how much if anything, is of value.

THE CONSEQUENCES: STAGFLATION IN SPADES

 IN THESE TIMES CARTOON --MAY 2008

Elsewhere, we have previously had a lot to say (and will again) on how morally bankrupt our financial structure is.  By rights, one such as Alan Greenspan who did more than any person alive to both create and push us into this disaster should suffer the consequences of being a primary contributor to the destruction of the security of millions of Americans.  Instead, as with Enron and other past “scandals”, many other will be indicted, jailed and ruined (as is already happening t o hundreds of mortgage brokers and related professionals); all for following the orders and encouragements of their superiors in our wonder-filled “vibrant” economy.

            The financial consequences for all of us will be a sinking economy, and soaring prices.  Americans have already been reminded of the stagflation of the 1970’s by their experiences of the last year or two.  Both the economic weakness and the rise in consumer price inflation will worsen even more now.

            As analyst David Roche pointed out in the Wall Street Journal a few days ago, it takes a 10-15% expansion of credit to grow the global economy by merely 3% in real terms.  What we have now, though, is a credit contraction.  Lenders of all kinds be they to banks, brokers, corporate America or Joe Six-pack are scared.  Even with the liquidity being added, they are NOT about to expand new credit issuance-the “oxygen” of our completely debt-fueled economy.  Instead, just as many Americans did earlier with their stimulus checks, they will instead use any liquidity to improve the sorry state of their balance sheets, pay down their debts, etc.  As credit continues to be both scarce and expensive for everyone the economic downturn will gather steam, unemployment will rise, defaults will grow, and this whole vicious cycle will continue to outrun even Paulson’s C-5 cargo planeloads of rained-down cash.

            Which brings us to the “flation” part of the stagflation equation.  In last year’s issue of Barron’s wherein the excellent weekly has its Roundtable of experts holding forth on what each sees for the coming year, Marc Faber (one of our personal favorites) made a comment that suddenly seems far more plausible now than it did then.

            “In my lifetime I will need a million dollars to buy a cup of coffee,” he said, perhaps presciently anticipating today’s headlines.

            Markets have in the past been willing to overlook, if not forgive; the Fed’s various monetary/banking interventions.  After all-at least until now-most of those relatively limited band-aids kept the skyscraper under construction even if, from time to time, at a slower pace.  Now, though, the Treasury itself is overtly and directly being forced into taking all manner of overpriced paper (or just plain garbage) onto the national books.  That this will be one of the final major events leading to the final act of the U.S. dollar is hardly in question; the real question is how quickly this shoe will now drop.

            We occasionally (well, OK-we regularly) “bash” the Tout-T.V. channel CNBC for its own antics, naivety and irresponsibility.  But to be fair and to give credit where it’s due, we’ll close with another of our favorite quips from the recent coverage of Wall Street. 

            Immediately following the bail-out of Fannie Mae and Freddie Mac, a panel (which that day included former Treasury Secretary John Snow) were wondering out loud if or when federal officials would “draw the line” at who might be rescued.  Soon, the conversation took on a note of sarcasm; the station’s Joe Kernan, for instance, asked how quickly requests from the airlines, auto makers and others for help would be answered.

            Finally, Rick Santelli suggested that the U.S. government would need to do something truly aggressive: that is, take by force if necessary the forests of Canada.

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