Time to Pay the Piper

By Mr Practical  APR 02, 2008 10:15 AM

Manufactured rallies can't stop deflation.

 


I'd use the phrase "The Big One" to refer to what people will call this period in the future. This is where it all changed.

After years of credit inflation caused by excessively easy credit produced by central banks, around mid-2007 the major world economies, led by the U.S., finally began experiencing trouble in carrying all that debt. Debt levels in the U.S. reached six times their usual amount relative to economic production. As the credit began to deflate, liquidity driving asset prices quickly dried up. We're now seeing those same central banks desperately attempting to reflate credit, only to see that borrowers are no longer in shape to borrow and lenders are no longer in shape to lend.

In fact, we've reached the point where banks and dealers in the financial system are forced to suck at the teat of the central bank credit machine in order to survive. Banks literally have no capital to support their declining asset values: the harder they suck at the teat, thus devaluing the dollar more and more, the more the collateral value declines. But even the teat isn't enough. Dealers and banks are having to raise longer term capital at egregious rates, thus diluting future earnings even more, and this despite record low treasury rates. Lehman (LEH) raised about $4 billion through a preferred stock offering at 8.5%. This may seem low relative to Citigroup (C) raising money at 13%, but in reality it is fairly comparable because the preferred is not tax deductible.

Yesterday some very large European dealers wrote off vast sums of debt. There will be more to come. But the market took it as the last write-down, just as it has in the past, and a vicious short covering rally ensued with the help of government hands behind the scenes. Desperation is everywhere. But don’t confuse a short covering rally in a bear market with a bottom in a bull market correction: the news will continue to get worse and the manufactured rallies will be fewer and fewer as deflation takes hold.

In all my years I have not seen anything like this. My overly conservative bent used to be commonplace, back in a time when investments produced cash and people invested accordingly. People used to evaluate a business on what it actually produced, not where it could pretend to mark its assets as a form of return.

Banks and dealers have produced one thing over the past several years: various forms of loans in paper form. When banks value a loan there are two primary variables: default rates and interest rates. Default rates estimate the probability of getting your money back; interest rates how much you get paid for taking that risk. Banks and dealers made gobs of loans valuing them way too high because they underestimated default rates and over-estimated the interest rates they'd receive (the bank gave full value to the paper assuming the borrower would successfully be able to pay higher rates when the lower teaser rate converted to a higher fixed rate). So all this paper was carried on the books at a high price: The banks showed profits by marking up the value of the paper.

That brings us to our paradox. Now we know that those variables were fallacious: higher default rates and lower interest rate assumptions are forcing those banks to write-down the value of those loans. But they still haven’t written down the paper to where realistic default and interest rate assumptions lie. Real buyers are now assuming realistic assumptions where banks still aren't. If banks assume higher interest rates so they get more cash over the life of the loan, they must then assume higher default rates for those go up when interest rates, the cost of a loan, goes up.

So there's no place the banks can go except to write-down more the value of the enormous debt they are carrying on the books. Those buying financial stocks now say the loans have been written down enough. The problem with this logic is that if they are right about default rates they are wrong about how much banks will earn off the loans.

Even if those loans are near correct valuations for now, the stifling of the great credit machine will (has) caused a recession. The consumer's in no shape to borrow and with the decline in the value of the dollar that need is rising not falling. As the recession takes hold the value of the loans will fall again (higher default rates) and the deflation cycle will continue until vast amounts of debt is written off.

This story's not about three 400-point rallies in the Dow over the last month or so. This is a much bigger story: one that will unfold over the next few years. Traders will get chewed up in market volatility, we will be fed new saving regulations by government bureaucrats, and the media will mis-inform us all along the way.

I have always believed that Minyanville is not about catching the next few hundred point rally; with this volatility there are no odds in trying to predict it. With this volatility being short stocks is very risky and making money that way will be left to only a very few traders. I believe Minyanville is one of the few venues where the truth is discussed with no hidden agenda. That's going to be very valuable over the next few years.

Higher stock prices aren't less risk: They're more. With treasury rates so low it's obvious that a good amount of people are seeking lower risk while central banks want them to seek higher. You have to decide for yourself where we are and all I can do is present some real facts for you to make that decision.

The best advice I can give is the same. Stay out of debt, try to save money (even though the government is making it nearly impossible to do so) and keep risk low.

No positions in stocks mentioned.

The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

Copyright 2011 Minyanville Media, Inc. All Rights Reserved.