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Welcome to the World of Deflation

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The question is, what comes next?

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"Welcome back my friends to the show that never ends
We're so glad you could attend
Come inside! Come inside!
There behind a glass is a real blade of grass
be careful as you pass.
Move along! Move along!
Cold and misty morning, I heard a warning borne in the air
About an age of power where no one had an hour to spare,
Where the seeds have withered, silent children shivered, in the cold
Now their faces captured in the lenses of the jackals for gold."

- Karn Evil 9, Emerson, Lake and Palmer, from the album Brain Salad Surgery

Deflation hasn't been seen in this country since the 1930s, so there may be some who are unfamiliar with it. What is "Deflation"? Below is a definition from Investopedia:

Deflation: A general decline in prices, often caused by a reduction in the supply of money or credit. Deflation can be caused also by a decrease in government, personal or investment spending. The opposite of inflation, deflation has the side effect of increased unemployment since there is a lower level of demand in the economy, which can lead to an economic depression. Minyanville's Why Wall Street Will Never Be the Same

Deflation is a topic that has been well covered in Minyanville, from contributors such as Todd Harrison (Mar 18, "Climbing the Wall of Depression"), Kevin Depew, who back in December 2007 made it one of his Five Themes for 2008, and Mike "Mish" Shedlock, (Jan. 18, 2008 "Deflation American Style"). And now, without question, my biggest fear since the Credit Crisis began - the absurd levels of debt on every front, the creation of esoteric instruments based on bad debt - has been what would happen once the crisis unfolds; deflation. I sense it is now upon us.

According to their website, the Federal Reserve's four main goals are:

  1. Conducting the nation's monetary policy by influencing money and credit conditions in the economy in pursuit of full employment and stable prices.
  2. Supervising and regulating banking institutions to ensure the safety and soundness of the nation's banking and financial system and to protect the credit rights of consumers.
  3. Maintaining the stability of the financial system and containing systemic risk that may arise in financial markets.
  4. Providing certain financial services to the U.S. government, to the public, to financial institutions, and to foreign official institutions, including playing a major role in operating the nation's payments systems.

According to the European Central Banks website, their primary goal:

  1. The primary objective of the ECB's monetary policy is to maintain price stability. The ECB aims at inflation rates of below, but close to, 2% over the medium term.

So there we have it. The Fed and ECB's goals are basically to ensure a safe system with price stability. Nowhere in either of the Central Bank statements does it say that a goal should be to avoid price and asset erosion.

This is my greatest fear of all and one that is playing out in real time. In sum, I believe that deflation is either already upon us or is right around the corner. And from my perch, deflation is a far worse outcome than inflation in that inflation can be contained while deflation is not easily contained. Just ask the Japanese.

Where is Deflation rearing its Ugly Head?

Where is deflation rearing its ugly head? Well, pretty much everywhere. Every place I turn, whether it be money supply, real estate prices, equity prices, debt prices, loan creation, commodity prices (except gold), consumer confidence, I see deflation.

When you think about it, it is not terribly difficult to understand how we got into this mess. Too much debt, notably low quality debt was created at every level; Government, consumer, corporate, etc. Then, this debt was levered up at the suggestion of the SEC and then carved up into esoteric investments that were scattered about the globe in an insidious manner.

We are simply now living through the painful unwind of debt creation, that is to say we are living through debt destruction, which is just a nasty version of deflation.

Note the chart below that no matter how hard the Fed and ECB try to pump money into our fragile financial system, the rate of growth of 'reconstituted M3' (courtesy of www.nowandfutures.com) is decelerating sharply. This is at a time when the system is starving for liquidity. Banks, brokers and consumers are in dire need of liquidity to solve their levered mess. But just as you can 'lead a horse to water but can't make him drink', you can try to force liquidity into the banking system, but you cannot force banks to lend.

In order for banks to lend, they must first have solid balance sheets and be able to finance their operations at a rate low enough so that they can then lend at a profit. When we consider why lending has come to a near stand-still, we must realize why this is so. In my opinion, the majority of financial institutions have been virtually shut out of the financial markets as confidence levels have shrunken to near zero.

When I wrote my piece entitled Dead Banks Walking?, I wrote that there was a 'recipe' for bank failures. This is not an exercise in chest-beating, but many of the names I mentioned are now gone (Fannie Mae (FNM), Freddie Mac (FRE), Washington Mutual (WM), American International Group (AIG), Lehman Brothers) and surely there are many more to follow.

If I had to re-write that piece today, sadly, I could likely come up with north of 25 public companies in the financial space alone that have the recipe for failure. The recipe as I see it is that your balance sheet is impaired from poor loans and ownership of esoteric securities that are constantly re-priced lower which results in write-downs/write-offs. This places you in a position that you either need an equity infusion or need to raise capital in the public or private markets, which in theory, sounds great-all the way until you find out that the current cost of capital is so high that it is un-economic to do so.

For instance, Wachovia (WB), a behemoth with nearly $1/2 trillion of deposits found itself in a rather precarious situation. Their 2 year debt was trading in the 45% yield to maturity area, their 'hybrid' preferred securities that were issued in February 2008 at 100 (fixed-to-floating rate perpetual preferred stock) at 22 cents on the dollar or 38% yield and their 8% preferred shares that were issued just last December at $25 per share trade at $6 or a 28% yield.

Wachovia likely needed upwards of $20 billion of capital just to remain solvent, but how does one raise $20 billion at 25-45% and expect to make money? Clearly a rhetorical question if there ever was one-you don't.

The problem, of course, is that Wachovia isn't alone in this sinking boat. National City (NCC), KeyCorp (KEY), Firth Third (FITB), Regions Financial (RF), Morgan Stanley (MS), Sovereign (SOV), and many others are in the same boat.

So if you are one of these unfortunate institutions, what do you do if you cannot get access to capital?

You either:

a) Fail or are forced into the hands of a stronger institution like WaMu was given to JP Morgan on Friday
b) Shrink your balance sheet,
c) Sell common equity to a vulture investor, forever diluting your existing shareholders or
d) Declare bankruptcy

No matter which you choose, all options are deflationary in nature.

More problematic is that it is not just present at Wachovia and is not confined to the US. It is a global problem and one that won't go away very easily. No matter how much money the Treasury, Fed, ECB and Congress throw at the Crisis, the Crisis ends up winning. Simply put, the Crisis is bigger than the system itself.

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Position in FITB, FITB options.

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.

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