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Generational Dynamics Web Log for 19-Sep-2008
Government promises to buy bad debt to end the credit crisis

Web Log - September, 2008

Government promises to buy bad debt to end the credit crisis

Stock markets stage huge comeback as giddy investors pile in.

Exactly one year ago today, central bankers here and in Europe flooded the markets with liquidity, far in excess of what had been expected.

The results were spectacular. The credit crunch was brought to a halt. The markets had been falling, but now they shot up 2% in a single day. They kept on going on, reaching a new high on October 9.

Do you remember what that massive monetary loosening was, Dear Reader? The fed lowered the Fed Funds rate by a full point, when only point was expected. At the same time, the Bank of England guaranteed that depositors in the faltering Northern Rock Bank would be safe.

What was huge and massive a year ago now seems like a tiny baby step. Since then, Northern Rock Bank has been nationalized. Several American financial institutions have been rescued or nationalized as well -- many in just the last two weeks!


Market summary, 18-Sep-2008
Market summary, 18-Sep-2008

On Thursday, government officials took two major new actions:

The first announcement didn't cause much of a stock market rally at all. It was the second announcement that really caused the big rally.

Did you get that, Dear Reader? The infusion of $180 billion of new capital didn't have much effect, but the announcement that government officials were going to have a meeting caused a huge market rally. I've said this a million times, but it's worth saying again: What's happening on Wall Street has absolutely nothing to do with reality.

The growing asset writedown problem

The idea behind this new agency (the revival of the RTC) is that it would restore the banking system by buying up all the outstanding securities that had turned out to be worthless.

Does the US government have enough money to do that?

"Well of course it does," you might say. "The government can print all the money it wants."

Well, that has certain practical difficulties. A few days ago, we described how the Fed was almost out of money.

The Treasury Dept. could sell Treasury bills, or offer them in exchange for near-worthless mortgage-back securities, but how much are we talking about?

A new report published by Standard & Poors on Thursday (summarized on the FT Alpha site) says that things are getting worse.


Loss assumptions for mortgage-backed securities by year they were issued (2005-2007) <font face=Arial size=-2>(Source: S&P)</font>
Loss assumptions for mortgage-backed securities by year they were issued (2005-2007) (Source: S&P)

What's interesting about the above chart is that it shows that the loss assumptions are worse for securities issued in 2006 than for securities issued in 2005, and worst of all for securities issued in 2007.

I've pointed this sort of thing out many times on this web site, and it's very important. By 2006, and certainly by early 2007, it was obvious that the assumptions underlying the creation of these securities were fallacious. But instead of stopping the issuance of faulty securities, the investment banks issued MORE of them, with even MORE faulty terms. This is circumstantial evidence of massive fraud.

But now turning to Thursday's S&P report:

"Aiming the analysis at a wider range of MBS [mortgage-backed securities] that have lost value since summer 2007 expands the potential for write-downs to well over $500 billion. ...

The market is still searching for an equilibrium price on trillions of dollars of structured securities, in particular at the higher end of the ratings spectrum."

So according to S&P's report, there are trillions of dollars of more bad news to come.

The Federal government's budget deficit is twice as big as last year's deficit. The deficit was just under $300 billion for the first 9 months of the fiscal year, and raising that deficit by an additional trillion or two is not politically feasible.

The word "trillions" may be misleading because it leads you to think it might be just a few trillion. Keep in mind that there are $60 trillion dollars in credit default swaps outstanding, and there are $700 trillion of credit derivatives outstanding.

There is simply no possibility that the federal government will absorb all the losses endured by banks through worthless mortgage-back securities.

Jawboning

That's what makes Thursday's huge rally so remarkable. It was based on a meeting, a rumor, a plan, and an implied promise that can't possibly be fulfilled. But that's standard for investors, isn't it.

As I've said, it's really clear that no one has any idea what's going on or what's going to happen next. Look at all the historic events that have occurred in the last few days -- they were all unthinkable as of just a week or two ago.

Listening to pundits on Thursday, you hear statements like this: "This was more of the same, but it's a LOT more of the same. The Fed has to get ahead of the problem. By flooding this money into the banking system, and taking these steps, people will begin to regain confidence in the financial system again. This is the time to buy stocks -- there are a lot of bargains out there, at prices we haven't seen in years. A lot of people will be kicking themselves in a year or two for not buying now, when prices are so low."

These are commonly held views, and they're absolutely incredible. They say that fundamentals are completely irrelevant to the current crisis. The only thing that matters, according to this view, is "confidence," and that depends only on putting on a big circus in Washington, with lots of jawboning.

I started criticizing this "jawboning as policy" concept in 2004. It took me that long because I needed a very long time to realize that government official like Ben Bernanke could actually hold this moronic view.

Here's what I wrote at that time (17-Sep-04) in Federal Reserve congratulates itself on jawboning policy:

"The Fed says it propelled the economy upward merely by promising to keep interest rates low.

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What's coming next: Understanding the deflationary spiral: Why are the dollar and the yen getting stronger, while the euro is getting weaker?... (27-Oct-2008)
Roubini: The situation is "sheer panic," as hundreds of hedge funds are going bust: Policy makers may need to close markets for one or two weeks.... (24-Oct-2008)
There's never before been a day like this on Wall Street.: Possible exception: One of the days just before or after the 1929 crash.... (11-Oct-2008)
Ben Bernanke's Great Historic Experiment is at the brink: Desperation sets in as credit markets continue to seize up.... (25-Sep-2008)
Government promises to buy bad debt to end the credit crisis: Stock markets stage huge comeback as giddy investors pile in.... (19-Sep-2008)
Web site readers express sadness, anxiety and anger: It's beginning to sink in.... (18-Sep-2008)
Another stunning and historic bailout: Fannie Mae and Freddie Mac: Giddy investors are popping the champagne corks.... (9-Sep-2008)
Long-term negative market trends asserting themselves strongly: Stock and commodities prices plummet as worldwide foreclosures and recessions worsen.... (5-Sep-2008)
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As commodities plummet worldwide, the meaning is unclear.: We speculate on some possibilities.... (11-Aug-2008)
Alan Greenspan calls this a "once in a century" liquidity crisis.: Says that the "big surprise" is the "impressive" American economy... (3-Aug-2008)
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Understanding deflation: Why there's less money in the world today than a month ago.: As the markets continue to fall, the Fed is increasingly in a big bind.... (10-Sep-07)
Bernanke's historic experiment takes center stage: An assessment of where we are and where we're going.... (27-Aug-07)
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The claims are based on a study led by Fed Governor Ben Bernanke. The study found that merely by making statements that interest rates would be kept low for a "considerable period," the Fed changed public expectations so much that the values of stocks increased from 2003 to 2004. The conclusion is that the Fed can continue to use verbal statements to affect the economy positively.

I cannot say how strongly I disagree with this conclusion. It presumes that stock prices are based totally on emotions, and not on fundamentals.

Maybe that does work once, for a few months, but could Bernanke and the others possibly believe this strategy could ever work again? The only reason it worked this time is because it's never been used before. If it's ever tried again, people will remember, and won't be fooled a second time. ...

What really bothers me about all this is that Fed governors actually seem to believe this stuff.

I listen to high-priced analysts on TV all the time, and for them there's never any bad news. When stocks go up it's good news because stocks are going up; when stocks go down, it's good news because prices are low and people can buy more stocks cheaply. If these analysts were more balanced in their appraisals I might find them more credible, but when it's good news all the time, my conclusion is that they're in a serious state of denial.

Bernanke's report leads me to conclude that the Fed governors are in denial too, if they really believe that they can continue to get away with using a jawboning policy.

As we've previously said, the fundamentals are clear that we're in a period of long-term deflation, and can expect prices to fall by 30% in the next few years. Jawboning might postpone (and indeed has postponed) that result, but the fundamentals will win out sooner or later."

In 2004 I was simply astonished, but today it infuriates me that our Fed Chairman could believe such blithering nonsense, and is basing his entire policy on it.

Thursday's announcements are just more of the same that we've been getting for years. Say the right thing, do the right dance, have the right ringmaster, and investors will "regain confidence," and start expanding the bubble again. The journalists eat it up, the analysts sagely agree. What a pathetic bunch of idiots running things.

The inflation vs deflation debate

There's still a lot of debate surrounding the question of whether we're headed for a deflationary spiral versus whether we're headed for hyperinflation.

Hopefully, those who still believe that we're headed for hyperinflation will be able to see for themselves in the next few days how impossible that is.

The Fed is now injecting $180 billion of new money into the banking system. That should cause enormous amounts of hyperinflation right there.

Instead, what you'll see is a continuing deflationary spiral.

The credit bubble created hundreds of trillions of dollars of new money. The credit bubble is leaking now, and those trillions of dollars are disappearing. The Fed is injecting $180 million, and that's a tiny, paltry, drop-in-the-bucket sum compared to the leaking of the credit bubble.

Panic selling

On Thursday afternoon at about 4:30, CNBC reported "an astounding headline" that total money market fund assets are down $169 billion in the last week. This is based on a a new report by the Investment Company Institute.

This adds to other anecdotal evidence that panic selling is increasing.

This has been happening on international markets as well. The worst hit is the Russian stock market, whose index has fall 60% in the past quarter. Panic selling has been so prevalent that Russian President Dmitry Medvedev has had to shut down the stock market for most of the week.

See "Panic selling may be close, as money market fund 'breaks the buck,'" for more information on the consequences of panic selling. (19-Sep-2008) Permanent Link
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