Five Things You Need to Know: Debt Crisis vs. Liquidity Crisis
Kevin Depew's daily Five Things You Need to Know to stay ahead of the pack on Wall Street:
Some "Interesting" Datapoints... Debt Crisis vs. Liquidity Crisis... Why Now?... The Fed Should Have Been Right... What It All Means...
Some "Interesting" Datapoints
Here are some interesting datapoints that all these easy-credit-addled geeks clamoring for a Federal Funds rate cut - such as Pimco's Bill Gross - may not have noticed:
-
Since the Federal Reserve Open Market Committee began lowering interest rates on Sep. 18, 2007 the S&P 500 has declined more than 30%.
-
Over that same period, the PHLX Banking Index (BKX) is down 42%.
-
The PHLX Housing Index (HGX) is down 57%.
-
The PHLX Semiconductor Index (SOX)... Whoa, stop right there. What do semiconductors have to do with subprime mortgages or credit default swaps? ... is down 44%.
-
Since the first special Term Auction Lending Facility was created by the Federal Reserve and offered on December 17, 2007, the SPX is down 27%, the BKX down 28%, the HGX down 19% and the SOX...Whoa, again with the SOX, what does that have to do with the TAF? ... is down 32%.
-
Since the Term Securities Lending Facility was created by the Federal Reserve and offered on March 27, 2008, the SPX is down 20%, the BKX is down 20%, the HGX is down 20% and the SOX... No, it can't be!... is down 20%.
-
Since the Treasury Department's proposal on September 19 of the Troubled Asset Relief Program (TARP), separately, a new $50 billion program to insure investments and the termination of short selling on financial stocks, the SPX is down 16%, the BKX is down 22%, the HGX is down 21%. the SOX... Do NOT Say It!... is down 17%.
-
Since the passage of TARP on October 3, less than two trading days ago, the SPX is down 3.8%, the BKX is down 5.5%, the HGX is down 3.5%, and yes, the SOX is down 3.5%.
For those that have noticed these declines, the most frequently asked question, naturally, is, "Why aren't the Fed's and the Treasury's liquidity attempts working?"
It's a reasonable question, after all, central banks in both the U.S. and Europe have said without equivocation for more than a year now that they will provide "as much liquidity as the market needs" to "fix" the problem. So why has this liquidity not been enough to maintain and support asset prices? Because this is not a liquidity crisis, it's a debt crisis.
Debt Crisis vs. Liquidity Crisis
The difference is important, and grasping it can help us sort through a number of market actions that appear to be counterintuitive.
During a liquidity crisis, the issue is one of supplying money to those who, for whatever reason, have suddenly shortened their time preferences.
Suppose there is a rumor that a large bank has made a bad loan. Because banks lend out more money than they have on deposit - this is called a fractional reserve banking system - if everyone goes to the bank and demands their money at the same time, a liquidity crisis can occur because the simply bank does not have enough cash on hand to satisfy the demand from its depositors. The Federal Reserve will then step in and provide liquidity, allowing the depositor demands to be satisfied. If the rumor of the bad loan proves to be false, then the issue is one of temporary liquidity. Time preferences soon return to a more normalized state, depositors return, everyone feels better. But, if the rumor turns out to be true, it doesn't matter how much liquidity the Fed provides, the bank will go bankrupt.
Similarly, the issue today is not one of temporary liquidity, time preferences being shortened out of a temporary risk aversion. The issue is too much debt supported by too little real income. As a result, global time preferences are retreating, risk aversion is growing, and access to credit is diminishing.
The battle in financial markets over the past year has been between reflation and deflation. The reason reflation has not been winning is because the Federal Reserve is powerless to make bad debt good. The Fed can only provide liquidity, and then hope that liquidity spawns credit creation. The market is fighting this by taking that liquidity and using it to "deflate," or to pay down, debt.
Why Now?
Isn't this like 1991? Or 1997? Or 1998? Or 2001? Why now? In the past, liquidity crises did not turn into full-blown debt crises because banks were able to create new products that allowed debt to be repackaged and sold very quickly.
The acronyms most of us had never heard of at this time last year - SIV's, ABCP, CDO's, RMBS's - were the result of more than a decade of financial engineering that allowed debt creation to expand, and bank profits to increase, thus masking weakness in the overall economy's ability to create enough growth to support this debt.
The process became self-reinforcing. The economy needed more debt to function, the banks needed to package and sell more debt to make money, investors needed to invest in more debt to increase returns, and so the game of musical chairs continued... until one small segment, one tiny fraction of the overall debt picture, subprime mortgage lending, failed.
The Fed Should Have Been Right
In March of 2006, the Federal Reserve and other government officials were repeatedly asserting that subprime mortgages were not a threat. In a sense, they should have been right. Subprime mortgages are/were a very small sliver of the overall mortgage pie. The Fed was correct in asserting that a healthy financial system should be able to support the total collapse of subprime mortgage lending with barely a hiccup. The Fed was incorrect in assuming our financial system was healthy.
The battle between bulls and bears last year at this time was over the following question: did loose underwriting standards and excessive credit creation in the subprime residential mortgage market exist in a vacuum?
Bulls believed that it did and, consequently, that loose underwriting standards and excessive credit creation were isolated to that small segment of the market. Therefore, according to that thesis, overall credit conditions were too tight and higher-quality segments of the market were being unfairly punished.
However, many of us believed that the subprime segment was simply a weaker version of the larger credit market paradigm - that loose underwriting standards and excessive credit creation was the norm across all market segments, not just subprime - and that was/is just the first inning of these credit issues.
What It All Means
One aspect of a debt crisis, as opposed to a liquidity crisis, is that a debt crisis reduces access to credit, and so we begin to see credit availability for even productive areas of the economy dry up; Salle Mae (SLM) cutting back on lending to students due to a combination of credit market turmoil and changes to federal law, for instance, American Express (AXP) cutting back business loans, commercial paper market becoming more fearful and even locking up, and on, and on, and on.
What must be remembered about what I have characterized as "the inevitable failure of the Bailout Bill" is what that failure means. It is not a "failure" in the absolute or idealogical sense; that ANY proposal or government intervention must be viewed as a failure. It is a failure in the sense that it will not return this broken economy to "normal" as so many are hoping.
After two full decades of credit expansion, having finally reached the point where debt is abhorrent, the new reality will be a more NORMALIZED credit market, not a return to the grossly abnormal market many of us have come to view as typical.
Think about it this way; it is not "normal" to be able to walk into virtually any retail store in the country and within 10 minutes be able to access $2,000 in credit by simply showing a drivers' license. It is not "normal" to buy a home with zero money down. This is not "normal" behavior. Adjusting to the new reality of normalcy will be a painful process.
On the one hand, Federal Reserve officials, Federal Government officials, many Wall Street executives and salespeople, believe it is "necessary for our economic security" to return to that place of easy credit. I disagree with that. I believe the American people disagree with that. And so the disagreement over the Bailout Bill, though pegged in the Mainstream Media as a war between battling economic classes, might really be a much deeper and more significant faceoff; a battle for the economic soul of this country.
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 2009 Minyanville Media, Inc. All Rights Reserved.
"...a battle for the economic soul of this country."
A hammer shot if there ever was one--my light bulb just lit up.
Thanks, Dale
Income for 80% of Americans has been going down or at best flat for the last 10 years (for some even longer) now that the housing atm in dead reality is hitting hard, the shop till ya drop set is done over. Until owning housing costs reaches a normal range, about 3X income or we get wages for the majority of Americans to go up drastically and that is not likely to happen soon as the corporations and banksters have successfully gutted almost all of the industry that created the middle class their is no way the economy can improve and reinflating the bubble if at all processable would just put the accounting off for a very short time this time,
hang on to your hats as wall street has trashed the worlds economy and it will be a long time before a recovery
and for the idiot advocating a massive war be very careful what you wish for the last 2 world wars didn't hit home this time would see things different I fear as our wonderful leaders have ensured that we are hated more than the Nazis were on the world stage
I hear from friends that HELOC loans are not available. Private Mortgage Insurance for those putting less than 10% down, likewise.
A Sign of the Coming Apocalypse will be when I walk into a department store in December and they are *not* offering me 10% off to open a credit card with them.
What this means in a macroeconomic sense is that any arguments over the effect of government policies regarding taxes, balanced budgets, and / or regulation has to be viewed in the context of debt creation taking place outside of government at a radical pace.
If we import more than we produce for export we have a trade deficit which is debt.
If we send productivity and jobs over seas for a cheaper price, we also forsake the opportunity to fund our own social costs such as medical care, self defense, social security, research and development, job training be it educational, trade school, or on the job training. Those social costs are then transfered primarily to the Federal Government
causing an increase in the national debt.
The debt crisis will be over when we have a shrinking budget deficit and a positive trade balance and a productivity based economy. Problem is, that to paraphrase a famous person , to get there we have to be here.
I honestly don't see how we can become a productivity based economy, with out dismantling the system, defaulting on the public debt, writing off the private debt, and living in cardboard boxes for years to come.
Let's change this before any taxpayer money is spent. Mandate full disclosure now. That will not cure the patient immediately, but it will identify the rot and let it be handled by the market. Many companies will go bankrupt, yes. But many, many more will go bankrupt as the market tears apart any company that depends on credit. And how many companies depend on credit?
Not a fan of TARP. Just watching in amazement.
So, if bank X posts it's ownership of CDO 123456-A - what have you learned ? imho, you propose a simple solution - for an incredibly convoluted issue.
Is this (debt unwind, real estate unwind) the last fleecing (bubbles) of the baby boomers before they retire?
I'm not so sure.
After this is all done, the great commodity run of oil , etc. and inflation is probably coming. My rogue waves #2(oil), and #3 (huge debt, $50 Trillion in benefits to baby boomers), will hit our ship (in a few years, maybe less).
Ending up with money (worth something) to retire on has never seemed more difficult (if you are not in the top 1%).
Fortunately, we have Minyanville to the rescue!
With that in mind, may I suggest another fundamental which you may or may not agree with?
Just as it is not "normal" to be able to get $2k of credit with a driver's license or a house with no money down, it is also not "normal" for healthy, capable adults to retire.
The generations before the 1930's did not expect that 60+ would involve golf courses, puttering around the house, and hanging out with the grandkids. They expected it involved grinding poverty unless they saved properly and/or could get their kids to take care of them.
Our current ideas of retirement come from watching the WWII generation, who, because they averaged a large number of children, where able to use SSN and pensions to maintain a middle class lifestyle.
The truth is, though, that an economy can only support a limited number of non-productive consumers. As productivity increases, the number can go up, but it is not endless. Within my lifetime, there will be 2 workers supporting every 1 SS retiree. In other words, each worker must kick in about $6K in SSN taxes *alone* in order for the system to work.
Part of the reason we must feel this pain and readjustment is because a functional economy will be not be able to support the baby boomer retirement. I hear that many boomers are planning to extend their work years and, ironically, we will all be better off for that.
You are being generous when you give the mainstream media any credit for portraying this bailout debate as a war among economic classes. That's about all they said that was remotely correct.
The mainstream media has never been more impotent. I thought that maybe we'd reached the migration phase of the denial-migration-panic continuum, but the majority of this nation, and certainly the mainstream media, is still in complete denial that there is a huge problem. That problem is simply too much government.
The growth of big government is the real economy killer this time. Big government rewards too many unproductive citizens for producing nothing but crime and more dependence on government. Big government is the vicious bubble that is going to crash and burn very soon.
California bailout? Let that motherf'r burn. Burn motherf'r, burn.
Wait! or was it: "Crisis could prolong economic pain"?
Maybe he said the later but was really thinking the former
Thnx Kev for a great article. The path that led us here is well lit. Your 5 things will be forwarded to many friends.
I cannot think of a more incompetent bunch of nitwits minding the store, from Greenspan to Bernanke to Paulson to Cox. At least Paulson has $300 million in Goldman Sachs shares to fall back on. Anybody want to wager whether he is still holding those by the end of the year?
The government needs to fire these bumblers and pretenders and hire Toddo, Kev, Mr. Practical, Prof. Sedacca, and Mish ASAP to right the ship and set course for white shores.
For every dollar borrowed there is a dollar loaned. I see all the people spending beyond their means, but doesn't there have to be somewhere an equal amount of real wealth that is spending below its means?
I know that China and Japan have loaned the US Government about 1 trillion dollars. I'm sure Messrs. Buffet and Gates and the like are spending below their means.
Why would "too much debt" inevitably cause "worldwide economic collapse." Why doesn't it or can't it play out as a zero sum game with as many winners as losers?
I am trying to understand how through market behavior this will happen, and the world can go back to producing as many widgets as before. I guess the answer is it will be a very different collection of widgets enjoyed by a different set of people. The debtors who imagined they were rich will have to get real, and the people who have accumulated actual wealth will enjoy their prosperity.
You are insulting nitwits everywhere when you say that.
Bernanke did not say "downturn." That would be unthinkable.
He said:
"the outlook for economic growth has worsened and that the downside risks to growth have increased...â
"economic activity is likely to be subdued during the remainder of this year and into next year."
"In light of these developments, the Federal Reserve will need to consider whether the current stance of policy remains appropriate.â
Wait! Is that icing on that cake? Mmmmm...
To make things worse for Weds will be the all but to be expected negative housing report. Maybe its been priced into the markets; yea that's it.
The real questions still remain. Is there any relief in sight? The answer. No. After two years of false economic indicators hiding the real story were reading now there is not a positive sign in sight.
I dont know about you folks, but I cant wait to see the next BLM report.
But fear not, if you can mizer your money long enough, there will be some real coin out there to be made. Now you just need to figure out where to jack that mil from to make your fortune.
WR
A mil won't be enough because a loaf of bread will cost $100k.
It's called the fractional reserve system. Fed has $1 of paper in its vault (their reserve). It gives $1 each to 10 banks. Each bank takes the $1 and puts it in its vault (bank's reserves), then lends out $10 based on that $1. The Fed has the mint print some money or does some electronic entries and the money pool grows. When the loans get repaid to the banks, now they each have $12 ($1 in the vault, the $10 in principal they lent, and $1 in interest from the borrower). Now they lend out $120. Rinse repeat. So where's the real wealth backing the system if a large portion of loans default or get called? There is little if any.
And right now it gets even more interesting because the Fed really has nothing left on its balance sheet and the banks are no longer required to keep reserves.
So, it becomes a race to the bottom unless or until confidence is restored in the system on the ability to repay. But, right now, states and countries--California, Maine, New York, Iceland and the US, etc., etc., etc., are teetering on bankruptcy. This is why there is nothing to fear but fear itself. Because once the confidence is gone in this global massive confidence game, the ponzi scheme falls apart.
Which is why I ask for searchable, sortable, on the Internet data. The problem is complex enough that smart people will have to be paid to sort it all out, but with sufficient (tens of head-years) effort, we can and must figure out who is in deep fertilizer and who is still a good credit risk.
Assuming that anyone is.
Banking laws and regulations were relaxed by mostly left-leaning members of Congress who think that everybody should own a house or two - especially those who cannot afford it.
The Fed enabled the folly to continue by keeping interest rates rediculously low while the bubble inflated.
Wall Steet obviously pocketed a lot of bucks in the process.
But individuals applied for those mortgages they can't repay. Perhaps the Devil made them do it, too.
MY beef is paying for everybody else's foolishness - they should go to the Devil, methinks.
1. If you think anyone in your house of congress leans left, you really need to look at the wider world. The most "left-leaning members" I can think of would be unqualified right-wing conservatives in most other western democracies, and
2. I suspect the real motivation for both sides of the aisle was the realisation that there was a lot of money to be made if only they didn't have all these silly rules and limits. Lets face it, everyone (including members of Congress) know that the more money their already rich friends can make the bigger the contributions to PAC's, personal trust funds, etc. That, and many of the members (and their advisors) responsible for removing limits on financial action came from the financial industry and planned on returning eventually.
I knew the game was rigged when I found out that the rules enacted (because of Enron) eliminating off balance sheet entities were not to be applied to banks and certain other financial institutions. Level 3 assets in SIV's are still the elephant in the room, and I think it might have diarrhea.
Cheers,
Colin.
A little research reveals how and who pushed for the relaxation and expansion into moderate and middle income levels.
Naturally upper income folks were able to move up by selling to the lower tiers.
There were many contributors to the problem. Everybody loves a bubble on the way up. I object to paying their return fare on the way down - regardless of their politics.
After World War II, apparently Japan had to reset their financial system back to zero, and completely start over. That may be the only thing that makes sense in the long run.
I believe the system is irrevocably broken, and has been for some time. We have a nature linked low energy living demonstration site in West Virginia <A HREF="http://entropypawsed.org">Entropy Pawsed</A>.
We seeks to find a way forward such that all children of future generations may live in a reasonable world.
Believe me. Nothing else will work. The discovery process WILL happen one way or another. Either chain the market with regulations or give it what it wants - the truth.
An alternate financial system anchored by the Fed doing commercial lending might take root and encapsulate the rot in zombie banks. Turn them into men's clubs. That is one way we could avoid the Japanese soution.
Imagine a huge subdivision of structures being built, funded by many banks. At one point when construction was in full swing, the lumber yard started sending over rotten wood that got by the inspectors. That wood was sent out to all the construction sites each day. Some structures got this wood in the foundation, some in the trim work, but all got some. The subdivision is finished and turned over to the banks which starts selling the structures. (These structures are CDO's and SIV's. The wood is the mortgage backed securities that went into those financial structures.)
No one knows there is rotten wood in the structures until one day a couple of them collapse. A big investigation takes place and the truth comes out. Everyone knows the structures were built with rotten wood. No one would buy and people even stopped visiting neighbors because no one knew where the next collapse might be.
Now what to do? People are sure that only a few of the structures have the rotten wood in the foundations or bearing walls. In most of the structures, the rotten wood was "cosmetic". But now no one will buy the structures because no one can tell which ones are dangerous and which are safe. Even if interest free loans are made available to buy those structures. Even if the government buys up some of the structures.
None of the owners that already bought want the structues inspected, because if the rot is bad, the structure goes way down in value - in fact the owners might lose everything. The banks don't want the structures inspected for the same reason - they risk catastrophic loss if it turns out that their inventory has a lot of rot in it.
So the city mandates building inspections. The inspectors go out to all the structures, crawl around everywhere, taking off sheetrock to thoroughly check. That all has to be patched and painted. The rot is found. Some houses are condemned and torn down. Others are repaired. It is expensive, and many owners whose houses were perfectly fine had to endure hardship. But in the end, everyone knew all the structures were safe. People moved in, and the neighborhood flourished.
That's what happens in the real world. That's why we have building inspectors. That's why the plans of all structures have to be filed with the building departments and fire departments â so in an emergency we know what is there. This does not bankrupt construction companies or building management companies. Profits are totally available.
Transparency. It's just a different way of doing business.
Pretty good analogy and for the most part I agree with the proposed solution.
However, there are two potential problems. First, I think there are probably a lot more houses with structural damage than you might imagine. Remember, they have been leveraged 30, 40 even 50 to one. In addition to that many of the houses aren't owned by a single entity but instead have been divided up among millions of 'investors' across the globe. This will complicate the 'condemnation' process.
Second, given human nature don't you think there will at least be an attempt to pay off the 'building inspectors' to fudge which 'houses' are actually 'structurally sound'? After all, for many people (aka institutions) this process will mean they end up 'homeless' (i.e. insolvent).
There are a lot of solutions to this crisis floating around that fail to take into account the greed, arrogance and deceit that got us into this mess.
Oh, what a tangled web we weave when first we practice to deceive.
