The Path of Deleveraging: Quantitative Ease Please!

How about some help with the heavy lifting Uncle Sam?

I've been contemplating this piece for quite a while, but with so much focus on inflation and the weak dollar decimating consumer purchasing power lately, I've written more on why inflation was the wrong bugaboo to be afraid of. I am going to declare temporary victory on the inflation question, despite what the ECB may think. I'll address "the great confidence game" of whether the threat of U.S. debt default causes hyperinflation and a third-world-type currency crisis here in the U.S. when the time comes....and at some point it may, but I'm not currently in that camp though I know that many are.

Yesterday, Bill Gross of Pimco (aka The King of Bonds) put out an investment strategy piece which was viewed as significantly more negative than in the more recent past (it may have even helped in the 300 point+ rout in the stock market). Now Gross is known on the street for talking his book and for sometimes being early, as he was on the housing crisis. He suffered poor relative performance for a year due to his bearish economic bet, before blowing the doors off everyone else when he was proven right. In fact, this makes perfect sense, because he is driving an oil tanker, he has to be early, and since he controls so much money, when he wants to change his bets it may behoove him to talk his book up to help generate demand for the other side of his trade. In his piece Gross enumerates what happens in a delevering cycle (and I thank him for doing my piece for me, but much more succinctly).

1) Risk spreads, liquidity spreads, volatility, term premiums – they all go up.

3) The raising of sufficient capital now depends on the entrance of new balance sheets. Absent that, prices of almost all assets will go down.

Gross goes on to explain what these three points mean and in the process he reminds us of some things that we already know in our guts but may be prefer to ignore. These are my interpretations.

Throwing out the baby with the bathwater - When people get burned in one asset they often sell other assets that have not yet been decimated in order to meet margin calls or just raise cash.

Relative value trading - investments with yield that get cratered increase in yield, which makes yields on other stuff look kind of thin in a "risky environment" this leads to mark downs across related assets. The risky stuff gets hit much harder and the spreads between assets rise, but everything sees it's risk premium rise.

Insurance policy prices rise - this is where the volatility part comes in. Those who would sell you you an insurance policy that would put a floor under your losses get nervous about the extreme swings in value (mostly to the downside), euphemistically called volatility and they raise the price of insurance policies/hedges.

What's left that we can sell? - With a prohibitively high cost of hedging risk, people have to worry a lot more about whether they can sell an asset that declines in value, rather than whether they want to. This is liquidity risk. Assets that are more liquid go down less, than the more illiquid ones, but liquid assets get dragged down, too, because they can at least be sold.

Standing Back - If all of this "negative feedback" isn't bad enough, eventually those who are not over-levered and have capital to invest become risk averse because they keep trying to call a bottom too early and continually get their fingers burnt. Pimco admits to being too early buying certain assets, along with many other smart investors. This general risk aversion is what keeps fresh capital from coming in and helping stop the deleveraging feedback loop.

Gross finishes his letter by calling on the government to get involved before risk aversion really sets in for good. How would this work? Gross' prior August letter dedicated quite a bit of space to the problem of the fed cutting interest rates but costs of mortgages going straight up anyway and pressuring housing prices further. Noah and I have commented on the incredibly pernicious impacts of this many times in the last few months. Here is a chart from Pimco's August investment letter, showing the impact of the Fed's rate cuts on the cost of borrowing for home mortgages.

It is and has been obvious to all that the Fed is "pushing on a string."
Ben Bernanke is known for his work on Japan's lost decade and one of the strategies that Japan nearly had to enact, when they had held interest rates at zero for several years and still couldn't stop the deflation, called quantitative easing. This is when the government actually goes out and buys debt, boosting prices, providing liquidity and easing volatility (they have already done a half step towards this with the "loan facilities" provided to banks and the Street). Uncle Sam could effectively do the same thing by just helping consumers get mortgages more easily, thus cushioning the housing market so those with cash can and do come in to buy houses and all the securities associated with housing. Either way it's on the government's tab. My guess is that they will do both. The question is just what is the most efficient policy mix to stop the asset deflation and de-levering (margin call) cycle.

Gross includes an ominous warning to the Feds with the following chart:

This composite chart of U.S. housing prices, stocks and bonds, shows the significant negative wealth effect now underway due to the effects of deleveraging. he notes that this magnitude of combined decline has not happened since the Great Depression and that this is what separates this financial crisis from prior ones where markets were hit. Gross provides some levity in his letter with commentary about his fascination with Jim Cramer and the idea that there is always a bull market somewhere. However, he makes a sharp point that as of now, as evidenced by the commodity rollover, there is nowhere for investors to run.

Pimco's flagship fund, Pimco Total Return, has gotten $15 billion of new money year to date, according to today's Wall Street Journal. The recent commentary is signed Booyah Hank? as if addressed to Hank Paulson (no doubt treasury would have to print a bunch of money to back up the Fed's efforts at quantitative easing and would have to help convince the government to intervene in the housing market in a big way). Is Gross sending a message to the Feds? I'll buy, but only if you buy first? A lot of smart money along with FWFs, private equity players and hedge funds might be tempted to follow his lead if Uncle Sam steps up....there is of course the eventual bar tab. Like I said, more on "The Great Confidence Game" in a future post.

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