Tuesday, November 25, 2008

From QE and ZIRP to Bulldozer Paulson and Supranationalization

An FT Update... Painfull but Necessary

First, this short summary from the FT: "The world economy is suffering from a Keynesian shortage of demand. Worse, it is trapped in a dangerous downward spiral of falling asset prices, rising bankruptcies, foreclosures and unemployment feeding into more of the same, along with falling commodity and now goods prices. Since no country is exempt, international co-ordination is needed and made easier because of the obvious common interest. The rapidity of the current contraction also means that fiscal solutions, though helpful, are not timely enough and create obvious free rider problems.

That is why monetary policy should be the first line of action. But conventional monetary policy has gone almost as far as it can in the US and Japan. The failure of the European Central Bank and the Bank of England decisively to respond in October was very damaging, but that is now history*. Policy rates will fall further in December, but may make only a modest contribution to stabilising demand, given the further decline in bank balance sheets and rising levels of fear. It is therefore time for unorthodox policy, but one that is far better than Milton Friedman’s helicopter drops of money, because it is reversible."

Monetary Thoughts...More Pain

This is the call the US Fed is now making: Quantitative Easing. This is a new term that comes by way of the Japanese slow down of the 1990's. It means pumping money into the economy any way you can. In the case of Japan's use, it simply lead to a massive growth in the money supply. The Fed is trying to argue that in our case we are attempting to narrow credit spreads by providing liquidity in various asset markets (the Fed buying commercial paper, corporate loans, MBS', etc) and make investing a possibility again.

The Fed rate cuts are having little impact in creating new lending and investment, and the yield curve has become very steep as short rates are cut but long rates hold high. 30 year mortgages have been unchanged for the past year until Monday. The Fed thinks that by buying financial assets - providing liquidity and closing the bid/ask - they can have a real impact further out on the yield curve. The evidence of that plan's success is found in the immediate drop of 30 year mortgage rates due to the new TARP2, and the overall flattening of the yield curve.

The Fed balance sheet has expanded by over 100% to $1t in the past year. Resolving the credit spread problem and rebuilding investor confidence is key as the total amount of corporate financing required in the coming quarters is massive, from corporate loans to commercial real estate. And right now the only thing foreign investors want are US T's.

But the Fed has expanded their balance sheet mainly by printing money. Normally, they would need to raise money from the dent markets to sterilize, or offset, the money they are creating to support all of the programs. Through September and October they ran their supplemental financing program, raising $550b at the peak. That's compared to an expansion of the Fed balance sheet of $800b through the same period.

In theory this is good - we do want to fight deflation and we welcome inflation as a heavily indebted nation. But the Fed needs the money multiplier to stay high for that plan to work. And it has crashed as banks have shut down lending. While money supply is up, it's not having any impact without a strong multiplier. QE may offset some current deflationary risk, but longer term these measures could create other problems associated with growth in money supply - inflation and dollar devaluation, risks highlighted by the recent pull back in the dollar and big bounce in gold.

In tandem with a large fiscal stimulus, the argument is that through QE you can keep aggregate demand from falling further off a cliff and restore confidence through a narrowing of credit spreads and the resumption of investing. Any way you slice it, it still means a massive growth in money supply. It also will be a policy followed by the UK and Eurozone as they take their rates to zero.

The move to zero interest rate policy, or ZIRP, is the second to last tool in the monetarists tool kit. It is an attempt to stimulate an economy through borrowing; of course, if all the other countries do the same, then we don't get the same bang for the buck. But with zero percent rates and a massive growth in the money supply, the government offsets the deflationary impact of delevering. That, I think, is the current thinking at the Fed in the strategy to address the credit crisis.

Fiscal Thoughts... A bit More

At the Treasury, I don't think Paulson has a clear idea of what to do. He and congress are tied in political knots to avoid fiscal solutions that smack of favoritism, socialism, etc. Fist he made the TARP, a $700B fund for buying ailing MBS. Then he turned it into the TERP for buying preferred shares in banks and "bank like companies" to recapitalize the banking system. In reality these efforts of the Treasury are really quantitative easing efforts directed by the Fed.

The market for asset backed paper hated this idea, and the value of residential and commercial mortgage backed paper on bank balance sheets plummeted, pointing to a new round of ugly write offs.Then he created TALF out of the TERF to help investors raise money to invest in the asset backed market - a market that accounted for a huge amount of past financing (cars, boats, general consumer finance, etc). And now, back to TARP, The Return: a new program for the ailing credit markets, that now includes the TALF idea.

TARP2, directly funded by the Fed includes $600b for buying MBS, like the original TARP plan had intended, plus another $200b to finance consumer and small business lending - a sort of fiscla stimulus package. The resurrection of the TARP looks like a good idea - along with TALF, it's the only program that really addresses the housing finance/price problems.

30 year mortgage rates dropped and CMBS/RMBS paper rallied on the news of TARP 2. Refinancings are on the way. This addresses the needs of those who are still solvent but getting hurt - those with good credit records and not too deep in debt, the ones we're all going to count on to keep the ship steady until the rest of us can get back in.

But back to TERP, puting capital into banks in the form of preferred shares is completely chicken shit. The write downs still-a-coming, and they are huge, come out of tangible common equity. Some estimates suggest we will need another $1t in capital to get the leverage in the US financial system back to manageable levels - that is leverage measured by the equity that takes a hit on write downs.

I thought for sure that we would have a fiscal stimulus policy by now, but it looks as though Bush will go out with the same oblivious nature of denial that he came in with. It may be that we get no major plan until February. That means an ugly 2-3 months in the US and UK/Euro economies. In the playbook of the Great Delevering, we have only made it half way through delevering the financials. We still need to delever the corporates and then the consumers. This is a 3-4 year process, with one year down. This fiscal spending is the only way to cushion the economy and lessen the impact of the process. The US is one year ahead of the UK and the Eurozone. Just keeping score.

(the official bailout tally: Troubled Asset Relief Program, or TARP, which became T Equity RP in Sept - $700b; Temporary Liquidity
Guarantee Program in Oct - $350b; other random and unspecified government guarantees for asset backed paper, commercial paper and FDIC - sky's the limit, but at least $5t; Commercial Paper Funding Facility in Oct - $1,300b; Money Market Investor Funding Facility in Oct - $540b; Term Asset-backed Securities Loan Facility, or TALF, in Nov - $200b; Government Sponsored Entities Purchase Program in Nov, or TARP2 - $600b. Bloomberg says the implicit total is now $9t; 1991 S&L Crisis - $230b)

Housing, Commercial RE, Gold, Cars, Citi, Goldman Schadenfreude, China Lies and Sovereign Nationalization

In the meantime, the housing market continues to deflate, with prices dropping in September and Q3 at accelerating rates. The various policies and plans mentioned above should begin to have an impact on housing, but I suspect we will need to have an even broader policy response: new tax support for homeowners, more efforts to write down and work out mortgages to keep people in their homes. In fact, if the Treasury just came out and formally admitted it will guarantee GSE's, I think the Dow would be up 800 points on that alone. Just make it clear, would ya?

Among the other balance sheet bombs we have been waiting to see detonate, Commercial RE is, if not the biggest, one of the more concentrated. With a slew of specialist funds and a lot of commercial bank backing, this bomb started detonating last week. Two CMBR programs were on the verge of default causing CDS's for the whole group to scream. I think it's fair to expect banks to start dealing with this problem in Q4/Q1 through more write offs.

The auto companies were thankfully denied their bailout for now and the board of GM has formally announced that bankruptcy is an option. I understand not wanting the big banks to go ch11, because the collateral damage will be huge. But if we don't force GM to reorg, then we really should be shot. It will say that the political process is still driving the boat and we are making a mess of our attempts to allow the economy to delever and recover. Ch11 is as big a part of capitalism as stock options.

The nationalization of US banks continues apace with a further TERP investment in Citi. The bank is insolvent but has so much counterparty exposure that its failure would be another LEH x 2. This is a reminder that the banking system is still levered to the tune of 30x tangible equity, on its way to 12x. Both BAC and WFC have similar ratios of tangible equity to assets as Citi. That means $1t in new capital and 2-3 more years of processing the write downs. I think it really does mean the full nationalization of the US banking system.

In fact, it is difficult to see a long term end to the deleveraging spiral we are in if banks don't change behaviour. They need to move away from the originate and sell business and back into the originate and hold business of decades past. The days of outsourcing the core credit analysis skills of banking to the ratings firms are over. Sack up boys, it's time to put the eye shades and suspenders back on and get to know your customers.

Meanwhile the BSD's at Goldman have been leveled. The top five guys have collectively lost $840mm in paper profits. In an interesting, quick and dirty analysis, the stock topped at $225, leverage had to be cut by 2/3, financing costs will be much higher and deal volume much lower in the future, while their hedge fund/PE business will likely rebound. So the stock goes to $75 on the leverage cut (2/3), while the other issues cancel each other out.

Talking about yesterday's BSD's, the Chinese economy looks to be falling apart. If the speculation is right about the level of decline in the US/UK/Eurozone in Q4, then factory utilization in China must be getting crushed. Margins were already thin due to the mass level of competition in Chinese factories, so mass layoffs must not be far behind.

The just announced China rate cuts and easing of bank reserve limits, plus the recently announced fiscal stimulus package attest to the government's concern. The Chinese government has also confirmed they will push consumer spending hard. Together, these changes put China's investment in US fixed income assets to test. In pursuit of big budget bailout projects, China reverses its stance from buyer of US$ assets to seller. That reverses the dollar flow cycle that has supported the US debt machine and the dollar itself.

The issues about a China slowdown, the need for a new consumer spending program and the social threats that leads to have been mentioned before. But how big does the correction need to be to force this kind of secular change? Once in a generation? Once in a century? Don't you think we're there? China has never been where it is now; they have no idea how to navigate major social change in the age of the internet and mobile phone, despite Cisco's help. The country is divided into urban and country, people own stocks and houses, and the country is part of the global economy. God help 'em if the west ever gets religion about the social and ecological damage done buying China made good. More melamine, sir?

The impact of the WW slowdown on Asia will be felt severely in Q4/Q1, with declining currencies and markets. The slowdown has had the expected impact on FX reserves of EM countries, especially commodity dependent ones: Russian reserves have dropped from $550b to $450b in the past three months. This is great for the US foreign policy efforts: less concern for the rogue states of 2007 - vens, Russians, Iranians - and Chinese influence.

Deflation is certainly in force and will be for the coming few quarters; the economy is in a massive slowdown, commodity prices are tumbling, consumer spending is crashing, housing prices/rent are in full retreat and global delevering is crushing asset prices across the board. The TIPS have been hammered and might be a good place to look; the policies described above are as inflationary as they can be in the long run and will ultimately lead to a recovery and the return of inflation.
In fact, the first stage of the great delevering is simply transfering the debt from the financial sector to the public sector; step two is rebuilding economic strength and allowing the consumer and corporations delever more slowly. So when we do recover, it will mean slow, debt burdened growth ahead.

But the size of the loses at this point are so huge, and the size of the federal guarantees and funding - approaching $9t (that's in addition to the $10t US debt) - are so massive, that you wonder how much more the system can handle before we ask questions about this fiat money system. At what level of M3 growth (which is hard to estimate these days) does gold get moving again? When does the dollar resume is decline? At what level of CDS spread for US debt? The announcement of the new TARP hit the dollar by 2% and jammed gold up by $75.

Through this correction and going all the way back to 2001, gold has been the best investment. Even in the last few weeks as it has corrected from $1000 to $800, it has outperformed equities and much of the bond market, and in non $ assets is has actually been a positive return. The outlook for gold is still positive, first as a hedge against the $, and second as the ultimate hedge against sovereign risk and fiat currency concerns. We may be at the end of the $ rally as the Eurozone and the UK have made clear their move towards ZIRP; what other surprises come out of those economies to cause more dollar strength?

This concern about absolute sovereign debt levels is a real concern for Iceland. They have now taken out loans of $10b, or the size of their entire GDP. GDP will drop by 10% in '09, and the economy will now have $19b in total debt to recap banks and deposits. Pensions are gone, taxes are going up and everyone will be fishing again. The country faces mass emigration and the obvious risk that they cant repay the debt.

How does this end? I would say, the Netherlands or the UK just absorb the country. Supranationalization. Switzerland is not far behind when you consider the leverage of their banks relative to the size of their economy. Who saves them? The US? The situation is so bad that these issues have to be considered. The CDS for UK bonds are trading at a higher premium than the CDS' of 10 UK companies. The UK has foreign bank liabilities of 3x its GDP, and a 380b pound currency mismatch between assets and liabilities and FX reserves of 1/10 that. Hence the pound weakness.

Guidance... Rally Continues?

The banks are finally getting some religion about the US outlook: Goldman says GDP will be down 5% annualized in Q4, the 10yr T will hit 2.75% in Q1'09, US earnings estimates are still way too high and unemployment will hit 9% in Q4'09. Their outlook for 2010 is for continued expansion of unemployment and tepid GDP growth into 2011-12. Does that foot with a Dow 8000? Not sure.

The outlook for a major spike in corporate high yield defaults hasn't changed, but prices suggest a 20%+ default rate and that would be even higher than the 1930's - and twice the level of the early 1990's and the early 2000's. High quality bond funds are beginning to look interesting; spreads are huge, the prices might reflect the coming carnage and the liquidity should recover first.

The latest notes on UST's call for a flattening of the the yield curve, with short rates at zero and long rates at 2.50-3%. This process lasts through Q1'09 as mortgage refinancings increase on lower rates and mortgage investors have to buy long dated T's to manage this early repayment. It's a process being supported heavily by the Fed and we should get closer to the normal spread of 150bps on the 3mo and 10yr notes; maybe not all the way, but maybe 250bps.

It's a cycle that puts heavy buying into the long end, lowers yields and further helps the US homeowner. This beneficial cycle will do battle with the massive debt funding needs of the US government: $500b done in Q3, $500b needed in Q4 and $400 needed in Q1'09. But for now, the charts for long term T's say full breakout, as ZIRP takes hold. Again, the TIPS are looking interesting.

The 10% rally in the Euro and UK markets on the UK fiscal stimulus package gives us some insight into the potential impact of a US fiscal stimulus package. Any hint that we might be able to soften the recession, lessen its length and reboot some level of aggregate demand will move the market. Both the Dow Industrials and the Transports both broke to new lows, but then bounced right back to end last week back in the low 8000's. The VIX served as a good trading measure as it hit 80 and made the buy signal, and CDS spreads hit a similar peak giving a solid concurring oversold signal.

My tendency is to stay long with SSO, as a wicked 50% bear market rally has yet to show up, but I'm still looking for the trigger that sucks in the last hopeful players. Certainly, PE's WW have dropped into the single digits and the bond sell off has been epic. Valuation and extreme bearishness still look good for a long position, but with the current volatility, I have little short term trading confidence.

Longer term, no change in outlook. We might not get the fiscal package until February and in the meantime, EPS numbers are going down hard from here. The coming cycle of corporate bankruptcy will remind everyone of the downsides to capitalism: equity holders get killed, companies relist and business continues. Equity actually does have the highest risk on the balance sheet. This will kill growth stock premiums and lift the importance of dividends. As a sign of this, dividend yields finally overtook UST 10yr yields for the first time in 50 years.


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