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The Land of Credit


All this liquidity is driving nominal asset prices higher and higher. And ironically they must in order to keep the borrowing bubble bubbling.

Everything looks great, but somehow you get that uneasy feeling. When this happens it is always good to check your premises.

I think we can all agree that the markets, from stocks to bonds to art work, are riding on a sea of liquidity. So let's begin checking our premises.

First, liquidity can come from two sources: income or borrowing. Real disposable income has actually fallen over the last five years. It is no secret with a negative savings rate and gigantic trade deficit that U.S. consumers are borrowing to consume. A total credit to GDP of 3.6 times (the next highest was 2.9 in 1929 and has averaged maybe 1.5 times over the last decades) the lowest equity levels in homes ever, the highest percentage of disposable income going to service debt ever, government budget deficits of over $300 billion and a public debt figure approaching $9 trillion (not even counting the war costs of $500 billion so far not added in and forgetting about $45 trillion in unfunded liabilities from Medicare and Social Security) etc., all confirm this fact.

Few people really understand the ramifications of this or the process by which the bureaucrats in Washington accomplish the harm all this debt will eventually do by creating more of it.

A $1 billion REPO by the Fed doesn't seem like much until you check your premise. The Fed just did a $1.3 billion dollar coupon pass, which is like a permanent REPO. The Fed calls up JP Morgan (JPM) and purchases its bonds with credit, credit created from nothing. They just tell JP Morgan, "we owe you money."

JP Morgan now has funds (credit) it can lend out. But because of margin requirements it can lend out much more than $1.3 billion. In fact it lends out about twenty times that amount. So let's say they call up 20 regional banks and let them borrow $1 billion each. In turn, each regional bank then lends out $5 billion to various mortgage borrowers. These borrowers refinance their house and spend the extra cash while the equity in their home drops.

The original $1.3 billion of credit the Fed created yesterday will in a few days turn into $100 billion of money borrowed by consumers. In fact these numbers are born out by the Fed's activity over the last year. The Fed's balance sheet has grown by about $30 billion over that time, while total credit market instruments outstanding grew by $3.5 trillion.

But that is just traditional pyramiding. Today we have the derivatives markets where JP Morgan can take some of that credit and lever it 100 to one by underwriting derivatives (I don't mean to pick on JP Morgan, although it is by far the largest derivatives dealer in the world; others like AIG or other large Broker Dealers are doing the same). So of the $1.3 billion, let's say JP Morgan keeps $300 million and then sells options to customers. It uses that credit as capital to support the trade; the trade itself is $150 billion in notional contingent liabilities. The notional amount of derivatives over the same period of time has grown by a scary $88 trillion. Derivatives are lending on steroids.

All this liquidity is driving nominal asset prices higher and higher. And ironically they must in order to keep the borrowing bubble bubbling.

But risk is increasing exponentially and threatens our very country's solvency. The only reason things seem great is because other central banks around the world are willing to keep creating credit themselves and lending it to us. Todd calls this the elasticity of debt: how much debt will the market accept before it can't take anymore. I don't know the answer to that, but when it occurs there will be no escape.

We are really, really good at creating credit. Are we good at paying it back?
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