Bernanke's Printing: Take II
A: By the way, I hope everyone enjoyed their Thanksgiving holiday and took some time out to offer prayer for the families of those killed & injured in the Mumbai terrorist attacks. Its times like these that we realize how precious life is, and what we should really be thankful for. I just want to follow up last weeks post on "Is Helicopter Ben 'Printing Money' or Not?", with the exact same chart of the St. Louis Fed's Adjusted Monetary Base. Its quite amazing to see this chart fly on a weekly basis. Only last week the y-o-y percentage change in the adjusted monetary base was about 33%. Well, upon last recheck the same metric surged to about 78%! Start the presses!!!
As the fed flushes money into the system via the front door, the question is how much is being destroyed through the back door? Is this pure expansion of the money supply (printing) or is it an illusion?
First, here is the chart of the % Change y-o-y of the St. Louis Fed Adjusted Monetary Base, this time the data only goes back to 1984, but still allows you to see the expansion:
Now, we must keep in mind the level of destruction in the shadow banking system as hundreds of billions of dollars worth of write-downs took place so far since the credit crisis began. The fed has been taking on risky assets as collateral for short term repos and for other credit lending facilities, trying to re-liquefy the credit markets. But banks seem to be still unwilling to lend like mad. Can you blame them?
The purpose of this is to understand that as the fed tries to pour water on a forest fire, there will eventually be a price to pay for this medicine! There are no free lunches and it seems to me at least that the fed is printing like crazy in an attempt to stop a deflationary spiral of asset prices. What will endgame bring? When I talk about endgame, I mean the final chapters of this story AFTER the economy is past the worst of the credit crisis, the rising unemployment, the GDP contractions, the manufacturing contractions, etc.. What will the price be that we have to pay in exchange for all this fiscal & monetary stimulus? If its inflation, where will it show up? Its just hard to see inflation re-emerge in housing prices as the credit markets will not revert back to the free-flowing days of 2002-2006! With regulation coming, securitization gone for now, and plenty of damage done, investor appetite for risky mortgage backed securities is likely never to reach the peak seen during the housing boom. And without this system of credit in place, I just don't see a new housing boom.
For now, its a race to debase and the fed's desire is for a weaker dollar; their fight is against deflation and the dollar swelling that comes with debt-deflation.
So, while deflation is king now and asset prices adjust, the question is will endgame bring inflation and if so, in what form? Housing? Stocks? Commodities? Precious Metals? Of these choices, I would have to say precious metals. I just don't see the new-age heavily regulated credit engine and the banks that lend off it, supporting another housing bubble anytime soon. Besides, after this housing deflation cycle, the asset won't be as 'sexy' as it was once perceived and in fact, a house will be viewed as an investment to save up for and live in; rather than a speculative asset that could be flipped for 50% profit in two years!
Posted by Aquarian
Sat Nov 29th, 2008 09:01 AM
Noah, you have written very intelligently on the market/credit crisis and asked good questions, speculating in a reasoned way as to what the effects of the gov purchase of toxic assets, bailout actions and Fed’s interest rate policies will be, what the endgame will be (deflation, inflation, stronger/weaker dollar and so forth), and where the economy and local RE market as a subset is going. I truly appreciate your honesty and efforts at trying to keep people ahead of the curve. Few if any other RE brokers in NY are doing anything like what you do. You do it well.
You and your readers may be interested in the work of DK Matai, who is a business consultant in London, but also has formed a forum for discussing in an open, honest Socratic manner the scope and magnitude of the problems, in not only the US, but in the world’s financial/banking structure. His is a heroic effort I think, worth at least an honest look. For those interested, below is a summary and overview of everything, the essence of the scale of the problem as of Nov 8th -- see The Eight Bubbles at http://www.mi2g.net/ under Latest News, Articles section.
There are at least eight bubbles in play worldwide and their approximate scale is as follows:
1. Subprime Mortgage linked Loans and other Assets (USD 1.5 trillion);
2. China, India, Eastern Europe and other Emerging Market Loans (USD 5 trillion);
3. Commodities (Commodity Derivatives at about USD 9 trillion);
4. Corporate bonds (USD 15 trillion);
5. Commercial (USD 25 trillion) and Residential property (USD 50 trillion);
6. Credit Cards Outstanding Debt (USD 2.5 trillion);
7. Currencies (Foreign Exchange Derivatives at about USD 56 trillion); and
8. Credit Default Swaps (USD 58 trillion) as a subset of all Derivatives (USD 1,144 Trillion).
The 1.144 Quadrillion derivatives market is further broken down (as quoted by the Bank for International Settlements in Basel, Switzerland):
1. Listed credit derivatives stood at USD 548 trillion;
2. The Over-The-Counter (OTC) derivatives stood in notional or face value at USD 596 trillion and included:
a. Interest Rate Derivatives at about USD 393+ trillion;
b. Credit Default Swaps at about USD 58+ trillion;
c. Foreign Exchange Derivatives at about USD 56+ trillion;
d. Commodity Derivatives at about USD 9 trillion;
e. Equity Linked Derivatives at about USD 8.5 trillion; and
f. Unallocated Derivatives at about USD 71+ trillion.
The relative scale of the world's financial engine is as follows:
1. The entire GDP of the US is about USD 14 trillion.
2. The entire US money supply is also about USD 15 trillion.
3. The GDP of the entire world is USD 50 trillion. USD 1,144 trillion is 22 times the GDP of the whole world.
4. The real estate of the entire world is valued at about USD 75 trillion.
5. The world stock and bond markets are valued at about USD 100 trillion.
6. The big banks alone own about USD 140 trillion in derivatives.
7. The population of the whole planet is about 6 billion people. So the derivatives market alone represents about USD 190,000 per person on the planet.
Matia asks: assuming a 10% conservative default or decline in asset value, this could be a min. USD 100 trillion challenge on the base of a Quadrillion. What are the likely outcomes?
His answer in the form of questions/food for thought: “It would appear that there are four distinct global economic scenarios that may unfold towards the tail end of this year, 2009 and 2010”:
Scenario 1: Debt Deflation
Most product, service and asset prices keep falling and the vicious circle of deleveraging causes many businesses, factories and support sectors to shut down. This in turn causes rising and out of control unemployment and falling living standards quarter-in, quarter-out with a severe and ongoing headache for some governments to provide stimulus in the face of declining revenues. This is a similar scenario to the US in the 1930s post the 1929 Wall Street crash.
Scenario 2: Hyperinflation
Some governments print money to try to stave off a recession / depression and end up stoking large scale inflation in a similar way to the Weimar Republic in Germany around 1923 post the first world war's conclusion in 1919. Hyperinflation is the flip side of currency collapse, which then leads to multiple domestic and trans-national black swans.
Scenario 3: Quadrillion Play
The invisible one Quadrillion dollar derivatives equation underpinning the hundred trillion dollar plus debt pyramid manifest as "Eight Bubbles" (Ref: ATCA briefings) continues to experience trillion dollar black holes in which capital on the balance sheet vaporizes without warning, month-in month-out. Governments via central banks try to hyper inflate and levitate the system by pumping trillions of dollars of liquidity into the system. The net impact is manifest via two opposite north and south directional vectors -- hyperinflation and deflation. The two vectors collide continuously to create several vortices as the markets change direction nearly every day exhibiting high volatility. The consequence of being caught up in the resultant eddy currents of those vortices is that some asset classes levitate and give the impression of rising, albeit temporarily, and other asset classes fall or simply cease to exist as their underlying asset-base vaporizes within the gravitational pull of the nascent financial black holes.
Scenario 4: Muddle Through
Given that fiscal stimulus is one component of GDP over which there is direct policy control, the muddle through is another possible scenario. However, government spending is always far too slow and occurs at some point in the future so we can expect a lunge towards cutting taxes or offering tax holidays, which is the high velocity component. The massive public sector borrowing requirement may have an adverse impact by way of currency devaluation. There is some probability that the governments' massive stimulus packages and central banks' interventions, after a while of uncertainty in the minds of people, act as a partial, deferred offset to the ongoing global financial system deleverage. Then markets may revive, although some of the eight bubbles are only partially deflated. Life goes on in a new muddled way as new and larger bubbles are created. Politicians stop panicking and get re-elected and a new bigger set of bubbles prepare themselves for collapse a few years later, say, 2015 or 2020. This is similar to the scenario post the dotcom and 9/11 crashes in 2000-2001 and the muddle through which occurred until 2007 on the back of extremely low interest rates, credit card, car and housing loans and the other eight bubbles. There is, however, one caveat. Countries without reserve currencies -- of which there are really only two -- and in particular those with large financial sectors given the base of their GDP, can practically prime the pump only in a very limited way and in doing so risk moving from a banking crisis via a currency crisis on to sovereign default. That would mean expectations from fiscal stimulus are far too high, and not all countries would be able to muddle through.
Conclusions
Whilst the fear is that we may be heading for Scenario 1 and the way to avoid it is via a benign form of Scenario 2 coupled with Scenario 4, it may be important to ask, what if, Scenario 2 has already happened and the Weimar Republic's printing of money is manifest in this broadband internet and high performance computing age, via the complex securities and instruments that private financial institutions created and sold between 1995 and 2007. This has been manifest via the invisible Quadrillion dollar derivatives equation and the associated hundred trillion dollar plus debt securitization pyramid. Banks and brokers were, in effect, printing their own proprietary issues of "money" via complex securities and as a result their supply of money grew to exceed by at least one order of magnitude the money printed by central banks. Central banks failed to recognize this phenomenon and continued to focus on monetary growth and money velocity utilizing old metrics rather than acknowledging the wider spectrum of public (central bank / government) and private money taken together. How could the central banks possibly fail to recognize this new phenomenon while securitization and derivatives, the tools of liquidity creation, were a central obsession of the financial industry? In fact, the central banks played along, humming the mantras of privatization and deregulation.
These quadrillion dollar worth private currencies -- paper assets -- have fuelled the globalization process, massive and unprecedented world GDP growth, mergers and acquisitions, and large scale industrial / infrastructure projects, until natural boundary conditions kicked in, ie, the earth ran out of raw materials and natural resources in sufficient quantities. Scenario 1 started as commodity prices -- food, fuel and raw materials -- went into hyper drive to trigger the catastrophic demand collapse we are now witnessing. Now what we may be heading towards is in fact Scenarios 3 or 4, which are post the Weimar Republic's hyperinflation manifest in most assets' pricing and Scenario 1, which is yet to play its full course. In a nutshell, "1923" already happened up until "2007", "1929" happened in 2008, and the 1930s equivalent is now unfolding. Given that the Great Unwind is happening near the speed of light because of the internet, mobile and satellite communications, as well as high performance computing, it is possible to move to Scenarios 3 or 4 and out of Scenario 1, much faster than was practicable before World War II.
In parallel, the central bankers would like us to believe that they have been and are still in charge because they can print fiat currency at will and set monetary policy at near zero rates if they like. This is governance by magic. What if they can no longer exercise sufficient control and have become co-dependent on the parallel printers of money -- manifest as paper assets -- which happen to be the private financial institutions? What if the central bankers and regulatory authorities are encumbered by what the private financial institutions have done during 1995 and 2007, during which time the policing of the global financial system was inadequate and cross-border arbitrage opportunities exploded? This may mean that we are still living within a myth that central bankers can resolve the mess in the real economy and actually they can't because the paper fuelling the real economy was not issued by them and large quantities of it resides off-balance sheet in a non-transparent way. Yet, the central banks have to mop up the ongoing toxic liabilities and black holes, which may or may not be possible ad infinitum given the unprecedented scale of this challenge. The quantum of asset price deflation underway post the collapse of the Weimar Republic type Quadrillion dollar paper asset bubble is so large that all the kings’ horses and all the kings’ men may not be able to put Humpty Dumpty together again. The power of central bankers may have been permanently eroded given that the centre of gravity has now shifted. It lies with the financial markets and their participators who transact the deflating quadrillion dollar plus paper asset equation of which fiat currency is a much smaller quantum.
His final question for readers to ponder: “Which scenarios do you think we are heading towards and in what sequence?” In my opinion it seems ultimately the currency obligations and debt instruments (that now have little or no value) the unregulated system has created are going to lead inevitably to a serious depression/collapse of some sort. I don't think any of us can yet get our minds around the true size and nature of the problem. We may be witnessing the Black Swan effect Nassim Nicholas Taleb wrote about.
Posted by Noah
Sat Nov 29th, 2008 05:25 PM
Thanks Acquarian!! Got family over, so Ill have to read through this and check that link out tomorrow.
Best
Posted by anon
Sat Nov 29th, 2008 05:50 PM
Derivatives are different from other assets in that they don't have any value of their own. So for every derivative that one entity is up money on, someone else is down - and usually marked to market, which means the losses and gains have effectively been realized. So it doesn't really make sense to talk in terms of 1.4 quadrillion dollars of derivatives "devaluing".
Posted by avUWS
Sun Nov 30th, 2008 09:47 AM
I think I agree with that last post. If the secondary derivative currency is the inflated Weimar currency, then perhaps its disappearance leaves all the finance types and securitized/ing institutions holdgin the bag while the regular economy continues to muddle along with non-securitized financing? Could it be that simple? Not htat it will be easy or quick. But is it that simple?
As someone with a small business, I can tell you that financing is still available for capital leases, term loans, etc. Standards have tightened in part because you practically didn't need to have a viable enterprise before in order to borrow. And they probably tightened more than they needed to. But perhaps that is what central banks can fix in the near term.
Posted by Aquarian
Mon Dec 1st, 2008 06:39 AM
Derivatives in many cases have become very complicated instruments whose value and associated risks vary with fluctuations in the value of several underlying instruments or indices they are pegged to. There are triggering conditions in most contracts that may or may not be met. They are as pointed out by several posters in theory side bets that form a zero sum game as far as the parties to an individual deal are concerned (and assuming that both sides are forever solvent to honor their commitments and meet the risk they assumed), but when a hurricane hits it clearly is not that simple.
For those interested, a good derivative risks primer can be found here: http://www.freerepublic.com/focus/f-news/2084907/posts
One of the root problems with derivatives is the assumptions made regarding risk probabilities, and that each contract represents an independent risk. In bull markets that's usually a fair assumption, but not in recession or depression. As an example, if a wildfire hits and hundreds of risks correlate across an industry, how does collecting $6 billion in fees (with little or none kept on reserve or required as margin) protect against a potential of $70 billion in losses. It doesn't.
We saw the affect in all of the recent examples of systemic failures involving Lehman, Morgan, Goldman and the other investment banks around the world; and AIG threatening the entire system too. Even clear back in 1998 LTCM's little $5 billion loss nearly brought down the world's banking system. That "domino effect" is now repeating many times over, straining the world's monetary, economic and political systems.
Here's another explanation (from http://www.webofdebt.com/articles/its_the_derivatives.php): Credit Default Swaps (CDS) are bets between two parties on whether or not a company will default on its bonds. In a typical default swap, the “protection buyer” gets a large payoff from the “protection seller” if the company defaults within a certain period of time, while the “protection seller” collects periodic payments from the “protection buyer” for assuming the risk of default. CDS thus resemble insurance policies, but there is no requirement to actually hold any assets to cover losses, so CDS are widely used just to increase profits by gambling on market changes. In one blogger’s example, a hedge fund could sit back and collect $320,000 a year in premiums just for selling “protection” on a risky BBB junk bond. The premiums are “free” money – free until the bond actually goes into default, when the hedge fund could be on the hook for up to $100 million in claims.
And there’s the catch: what if the hedge fund doesn’t have the $100 million? The fund’s corporate shell or limited partnership is put into bankruptcy; but both parties are claiming the derivative as an asset on their books, which they now have to write down. Players who have “hedged their bets” by betting both ways cannot collect on their winning bets; and that means they cannot afford to pay their losing bets, causing other players to also default on their bets.
The dominos go down in a cascade of cross-defaults that infects the whole banking industry and jeopardizes the global pyramid scheme. The potential for this sort of nuclear reaction was what prompted billionaire investor Warren Buffett to denounce the use of derivatives as they've evolved today as extremely dangerous."
In 2002 he wrote the following:
"I view derivatives as time bombs, both for the parties that deal in them and the economic system. Basically these instruments call for money to change hands at some future date, with the amount to be determined by one or more reference items, such as interest rates, stock prices, or currency values. For example, if you are either long or short an S&P 500 futures contract, you are a party to a very simple derivatives transaction, with your gain or loss derived from movements in the index. Derivatives contracts are of varying duration, running sometimes to 20 or more years, and their value is often tied to several variables.
Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counter-parties to them. But before a contract is settled, the counter-parties record profits and losses – often huge in amount – in their current earnings statements without so much as a penny changing hands. Reported earnings on derivatives are often wildly overstated. That’s because today’s earnings are in a significant way based on estimates whose inaccuracy may not be exposed for many years.
The errors usually reflect the human tendency to take an optimistic view of one’s commitments. But the parties to derivatives also have enormous incentives to cheat in accounting for them. Those who trade derivatives are usually paid, in whole or part, on “earnings” calculated by mark-to-market accounting. But often there is no real market, and “mark-to-model” is utilized. This substitution can bring on large-scale mischief. As a general rule, contracts involving multiple reference items and distant settlement dates increase the opportunities for counter-parties to use fanciful assumptions. The two parties to the contract might well use differing models allowing both to show substantial profits for many years. In extreme cases, mark-to-model degenerates into what I would call mark-to-myth.
I can assure you that the marking errors in the derivatives business have not been symmetrical. Almost invariably, they have favored either the trader who was eyeing a multi-million dollar bonus or the CEO who wanted to report impressive “earnings” (or both). The bonuses were paid, and the CEO profited from his options. Only much later did shareholders learn that the reported earnings were a sham.
Another problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counter-parties. Imagine then that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company. The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown."
It's all food for serious thought, I think.