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My Reality


The Fed's balance sheet is not only massive, it is a mess with credit risk.

As more and more traders and investors view the recent rally through the eyes of technicals, we are closing in on the completion of the bear trap. Human beings are inductive: they see things and their preexisting views are reinforced by them. Rising prices beget rising prices until facts finally exact their toll. People assume others know what they're doing.

I came out of the airport terminal to grab a cab one night. The line was two hours long. The last person in line assumed the person in front of them knew what they were doing and resigned their fate with the rest. I decided to take a five minute walk to the next terminal, where I grabbed a cab immediately.

If people really did hard analysis on the current environment they would take a much different view. The Fed's balance sheet is not only irreparably massive, it is a mess with credit risk. When you hear people saying credit is improving, it can clearly be shown that the only areas of improvement are where the Fed has stepped in and become the market. The Fed has reduced transparency, not increased it.

Take any category where credit has improved and you will see that the Fed has taken and retains massive positions: Bank Credit Reserves increased over last year by $1.3 trillion, Agency Securities $70 billion, Mortgage Backed Securities $356 billion, Term Credit (LIBOR, the real headliner) $456 billion, Commercial Paper $238 billion (this market has shrunk dramatically so the Fed is basically the whole market), SWAPS (inter-dealer lending) $256 billion, and credit to AIG (AIG) $45 billion. These are the holes the Fed has stuck its finger in. If the Fed takes the finger out, the damn will bust.

Debt issued by the government is soaring while debt issued by corporations is crashing. Notice that this is the one hole that is probably too big for the Fed to stick its finger in to plug. Corporations, due to lower cash flows, cannot issue debt at high Baa rates (the highest since the early 1990s) because the cost of capital is too high.

This is why equity issuance, which lowers liquidity is soaring, while fixed income issuance is non-existent. Convertible bonds are a source of funds because the dilution necessary lowers the cost of capital; $600 billion of corporate debt has to be rolled over the next 15 months.

The point is that the Fed and the government have been able to shift psychology, convince people that things are "stabilizing", but they have done so at a high cost. The risk has increased dramatically. Who knows where the rally stops, if it does? But the marginal buyer is taking higher and higher risk. The economy and the markets are a physical system, which hasn't changed for the better. Sure, you can get a low rate mortgage now but you better be able to put 20% down. That is reality.

Maybe the Fed never takes their fingers out of the dike and just destroys the currency; a likely scenario. But then your stocks will go up but be worth nothing in dollars. But real lending will only start when real savers (private capital) sees real value at the right risk. That occurs at lower prices.
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