April - 2009 Economic Brief

Closing in on $13 trillion

In addition to the original goal of TARP, the U.S. government has loaned, invested, or committed $400 billion to nationalize the world's two largest mortgage companies ... $42 billion for the Big Three auto manufacturers ... $29 billion for Bear Stearns, $185 billion for AIG, and $350 billion for Citigroup ... $300 billion for the Federal Housing Administration Rescue Bill ... $87 billion to pay back JPMorgan Chase for bad Lehman Brothers' trades ... $200 billion in loans to banks under the Federal Reserve's Term Auction Facility (TAF) ... $50 billion to support short-term corporate IOUs held by money market mutual funds ... $500 billion to rescue various credit markets ... $620 billion in currency swaps for industrial nations ... $120 billion in swaps for emerging markets ... trillions to cover the FDIC's new, expanded bank deposit insurance, plus trillions more for other sweeping guarantees.

And it STILL wasn't enough

If it had been enough, the Fed would not have felt compelled this week to announce its plan to buy $300 billion in long-term Treasury bonds, an additional $750 billion in agency mortgage backed securities, plus $100 billion more in Fannie Mae and Freddie Mac paper.

Total tally of government funds committed to date: Closing in on $13 trillionBut, you say, what about the recent advance

The recent advance in the S&P 500 was the largest in the equity market since 1938. From its recent March 6th bottom to March 27th peak, the Dow had jumped a resounding 21 percent in just 20 short days. And the rally may still not be over.

Before I go on, let my just say:

Going forward, we expect to be hearing numerous parallels between this market and the 1930s, not all of them positive.

For example:
1) In America's First Great Depression, the financial collapses beginning in 1929 led to GDP declines of 8.6 percent in 1930, 6.4 percent in 1931 and 13 percent in 1932. The U.S. GDP is currently collapsing at the annual rate of 6.2%.

2) Market corrections can be measured by two parameters: time and price. The current decline of 69 weeks has taken the Dow down 50%. The pace happens to precisely equal the pace of the Dow’s decline in 1929-1930.

3) Moody’s Investors Service now predicts that corporate bond defaults will more than triple this year — and exceed the levels seen during the great depression!

4) Bloomberg just reported that the AVERAGE S&P company suffered a massive 58% plunge in earnings in the last three months of last year. Average earnings have plunged 61% year-over-year, much more than during the 1930s. In fact, the last time earnings declined more than 61% was 141 long years ago! It took 25 years for the Dow to recoup its 1929 high; 19 years after the Japanese bubble popped, and Japan's stock market is still making new lows.

5) Like this crisis, the Great Depression was essentially a debt implosion. But in 1929, total debts represented no more than 170% of GDP. This time around, U.S. consumers are buried under a far larger mountain of mortgage debt, auto loan debt, credit card debt and other consumer debts. Result: Total debts are now close to 350% of GDP – TWO TIMES MORE!

6) In the first 18 months of the 1929-32 bear market, there were many small and medium-sized bank failures. However, none were as massive or as dangerous as the giant failures we’ve experienced in the first 18 months of this giant bear market. This time around, the failures (or bailouts) of giants like Bear Stearns, Lehman Brothers, Fannie and Freddie, Washington Mutual, and Wachovia dwarf anything seen in 1929. And even these large failures will be trumped several times over by the impending demise of Citigroup and AIG.

7) In 1929, the United States was a creditor nation, with substantial foreign reserves. Today, the U.S. is the world’s largest debtor nation, dependent on foreign lenders to keep it afloat. That means that there’s a definite limit to how much longer the U.S. government can continue to borrow to bail out failing institutions.

8) In 1929, there were fewer giant banks. They controlled a smaller share of the total market. And they were generally stronger than the thousands of community banks around the country. Today, by contrast, the nation's high-roller megabanks dominate the market. In 1929, derivatives were virtually nonexistent. Not today! U.S. banks alone control $200.4 trillion; and it's precisely in this dangerous sector that the megabanks dominate the most.

Just two weeks ago, the S&P 500 Index slipped once again to a new bear market low, the lowest level since 1996 to be exact ... 12-years worth of stock market gains LOST in just 18 months! But then stocks turned on a dime and rallied dramatically, with the S&P 500 up nearly 10% in less than two-weeks.

So, what made this most recent advance and what does it really mean?

The Geithner's Plan

The Geithner's program is for a Public Private Partnership to take toxic assets off the books of the banks.

With this plan, Geithner is stating that the assets in question are only temporarily undervalued due to liquidity issues. He argues that these "firesale prices" are unfair and that the true value of the pool of mortgage backed derivatives is significantly greater than the 15-30 percent of current pricing. So, the government is planning to step in and provide the temporary liquidity needed to help the market find a fair price for these assets.

Geithner's goes on to say that even though these assets were tragically mismarked as AAA, they actually represent a mixture within the standard junk category, and not all should be rated at the bottom. The market responded and is encouraged that companies with good reputations that specialize in evaluating bonds to purchase, such as PIMPCO, or is that PIMCO, will be involved in managing the portfolio of these assets and helping to price and sell them. S&P, Moodys and Fitch, the rating companies whose collusion caused the crisis in the first place, will not be involved.

It would not be an overstatement to assert that the economic future of the U.S. for the next generation or two depends on him being right. There are many details yet to be worked out, but the current market rally is a sign that a significant number of large players are betting that it will succeed. I hate to be pessimistic or seem unpatriotic, but I will be betting against The Plan. It is just a bit too heroic for my taste.

As the Wall Street adage reminds us, "Bear markets decline on a slope of hope." They tend to end in a period of hopelessness, not heroism. We are not there yet.
Specifically, the Fed said that it will ramp up its purchases of Fannie Mae and Freddie Mac Mortgage Backed Securities (MBS) from $500 billion to a whopping $1.25 TRILLION in the coming months. The Fed is also going to double its purchases of Fannie Mae, Freddie Mac, and Federal Home Loan Bank bonds to $200 billion from $100 billion.

And for the icing on the cake...

The Fed will buy as much as $300 billion in longer-term U.S. Treasury securities. It's going to focus on Treasuries with maturities between two and ten years, and make purchases two or three times a week.

I am sorry to say this, but this is Banana Republic-type stuff, Zimbabwe anyone? Printing money out of thin air at the central bank, only to turn around and buy debt securities issued by your Treasury, is the kind of practice you typically see in emerging market regimes.

We're essentially monetizing our country's debt and deliberately devaluing our country's currency. We're also screwing over our foreign creditors — a dangerous path to tread considering we're a net debtor nation that's trying to borrow tens of billions of dollars a month to fund our massive deficits.

The Treasury, Federal Reserve, FDIC, and Congress have now lent, spent, guaranteed, or committed roughly $13 trillion to bail out the financial industry and attack the credit crisis. One wonders whether the outright failure of AIG might have precipitated a necessary cleansing that would have been healthy in the long run for the global financial system.

Instead, we have zombie corporations and more importantly until the third quarter of last year, the banks' losses in derivatives were almost entirely confined to credit default swaps — bets on failing companies and sinking investments.
But credit default swaps are actually a much smaller sector, representing only 7.8 percent of the total derivatives market.

Credit quality is worsening... and I'm not talking about home mortgages or credit cards

In other words, forget about PRIVATE credit quality. SOVEREIGN credit quality is coming into question, that is a debt instrument guaranteed by a government. Just look at this chart...



Unfortunately, it's not a stock. This chart actually shows the cost of buying insurance against a U.S. government debt default in the Credit Default Swap (CDS) market.

And now, with new losses in interest rate derivatives, the disease has begun to infect a sector that encompasses a whopping 82 percent of the derivatives market.

And U.S. banks alone control $200.4 trillion.

In the 1930s, the banking crisis helped drive the economy into depression and the stock market into its worst decline of the century.

The same is happening today. Whether the nation's big banks are bailed out by the federal government or not, the fact remains that they're jacking up credit standards, squeezing off credit lines, and even shutting down major segments of their lending operations.

The problem is according to the OCC's Q4 2008 report, America's top five commercial banks control 96 percent of the industry's total derivatives, In other words, for every $100 dollar of derivatives, the big banks have $99.78 ... while the rest of the nation's 7,000-plus banking institutions control a meager 22 cents!

This is a massively dangerous concentration of risk.

The point is that large banks are exposed to the danger that, with exploding federal deficits and likely inflation to follow, interest rates will suddenly surge, delivering a whole new round of even bigger losses in the months ahead.
Worst of all, the five biggest banks are exposed to breathtaking default risk — the danger that their trading partners could fail to make good on their debts.
Specifically, at year-end 2008:
• Bank of America's total credit exposure to derivatives was 179 percent of its risk-based capital;

• Citibank's was 278 percent;

• JPMorgan Chase's, 382 percent; and

• HSBC America's, 550 percent.

What's excessive? The banking regulators won't tell us.

According to the OCC, Goldman Sachs' total credit exposure at year-end was 1,056 percent, or over ten times more than its capital.

Does this preclude sharp rallies? Absolutely not!

Don’t worry they have insurance, they have A.I.G.

A.I.G. didn’t specialize in pooling subprime mortgages into securities. Instead, it sold credit-default swaps.

These exotic instruments acted as a form of insurance for the securities. In effect, A.I.G. was saying if, by some remote chance (ha!) those mortgage-backed securities suffered losses, the company would be on the hook for the losses. And because A.I.G. had that AAA rating, when it sprinkled its holy water over those mortgage-backed securities, (now called “toxic assets”; remember Geithner's remark when speaking of the banks bailout earlier, that the “toxic assets” were tragically mismarked as AAA.) suddenly they had AAA ratings too. Already A.I.G. is into tax payers for 180 billion that they can’t be on the hook for; that’s equivalent to nearly HALF the U.S. government’s entire budget deficit for all of 2008! So much for insurance being of any real value and so much for a deregulated market...

Sadly, AIG's CDS portfolio is just one of many: Citibank's portfolio has $2.9 trillion, almost a trillion more than AIG's at its peak. JPMorgan Chase has $9.2 trillion, or almost five times more than AIG. And globally, the Bank of International Settlements reports a total of $57.3 trillion in credit default swaps, more than 28 times larger than AIG's CDS portfolio.

By the way, speaking of AAA ratings, last month saw two publicly-traded companies lose their AAA credit ratings, General Electric and Berkshire Hathaway . That might not sound like a lot ... until you realize that there were only seven to start with!

A recent quote by Paul Volker, ex-Fed Chairman, certainly causes one to stop and think, he said "The fate of the world economy is now totally dependant on the growth of the US economy, which is dependant on the stock market, whose growth is dependant on about 50 stocks, half of which have never reported any earnings."

So what does all this mean?

The U.S. government is heavily in debt to the tune of roughly $13 trillion. The U.S. government is going to have to print up trillions of dollars worth of new money in an attempt to break out of this economic crisis. This is a desperate attempt to maintain the status quo. Over the past several decades, we have burdened future generations with massive liabilities. With what we have added in the last year, we have ensured that those debts are mathematically impossible to pay. The only “solution” is to print more and inflate away those debts.

Buffett's answer...

"The precise nature is anyone's guess, though one likely consequence is an onslaught of inflation."

Buffett told CNBC that the economy “can't turn around on a dime” and that those efforts could trigger higher inflation once demand rebounds. We are certainly doing things that could lead to a lot of inflation. In economics there is no free lunch.”

How will we pay this back?

We will certainly not default on our debt anytime soon. It’s likely that the government could simply inflate its way out of this mess, so essentially the biggest debt ever amassed could be paid back with almost worthless dollars printed to avoid deflation and keep us in a recession, the lesser of two evils.

The kicker is:

This means the excess supply of currency in circulation is going to lead to demand-pull inflation. Demand-pull inflation is described as too much money chasing too few goods.

Here is how and why...

The Fed cut interest rates to almost nothing in an attempt to head off the deflationary effects of falling house prices and weakening consumer demand. This “reflation” shows us that the Fed is no longer focused on fighting inflation; they are now completely focused on avoiding a depression.

We already know deflation is bad, so why is inflation bad too?

Well, inflation hurts people who have saved up a nest egg and those who live on a fixed-income. The same dollars buy less goods and services. So those who have saved are penalized as the dollar is destroyed. Also, wages never go up as fast as inflation, so working people can experience an increase in their cost of living, without the pay raise to go along with it. It’s important that you shield yourself from inflation to protect your wealth and buying power. Knowing this, today’s 30-year fixed rate mortgages at 4.89 % look really good... and what we are doing to our children and grandchildren is unconscionable.

Because of the inevitable surge in interest rates driven by massive government borrowing this will challenge most corporate bonds to a point where they could lose anywhere from half to 90 percent of their current market value. And let’s not forget Treasury bonds, OK?

Even Warren Buffet says, “When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s," he went on. "But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary."

Why do 30-year fixed rate mortgages at 4.89 % look really good...

Consider that the lowest annual average mortgage rate seen in the 20th and 21st centuries was 4.7 percent, set right after World War II. In other words, this is just about the cheapest that mortgage money has ever been.

What if foreign governments decide they don't want to loan us any more money by buying U.S. Treasury and other government-backed bonds?

And who buys most of our bonds? China and Japan

At the end of 2008, China owned $727.4 billion worth of U.S. Treasury bonds. And Japan was second, at $626 billion. But China has been — and continues to be — the most important lender to the U.S.

Inflation and a weaker dollar will erode the value of China's near $1 trillion loan to the U.S. not to mention China’s trade deficit of 266 billion and China knows it. In fact, the Chinese are already starting to move out of U.S. bonds as the mountain of debt shoots to the moon and the safety of U.S. obligations comes under attack. The Treasury will likely have to boost interest rates to get investors to buy its bonds which is why the bond market is primed for trouble and the reason for Buffet’s comments above.

What does it all mean?

It's Geithner and Bernanke's goal to stimulate the economy at all costs... they’re not going to raise rates until they are absolutely certain that they have gotten the economy going again. And it's Obama's goal to get interest rates down, too... to make mortgages more affordable. So, still lower rates could be coming in the short-tem; and a devalued dollar and inflation have already been set in motion for the long-term.

Right now, you know intuitively that a key factor which got us into trouble was too much debt. Yet the solution being offered is to encourage banks to lend more and people to borrow more. Go figure!

Remember the market tends to recover before the economy and the economy tends to recover before employment. When you see employment start improving, that is when you need to start worrying about inflation.

And that means the U.S. dollar is going to decline. Partly because Fed Chairman Bernanke knows we need a weaker dollar to help get us out of the mess we're in.
And partly because China — despite all the complaining that you're hearing from them about the sinking dollar — also wants a cheaper dollar.

You see, China needs a cheaper yuan just like the U.S. needs a cheaper dollar. With a cheaper currency, China can avoid deflation ... spark inflation ... and boost its exports. China and the U.S. get what they want: Cheaper currencies. Meanwhile, both countries' exports to the Euro region and other areas, like Canada and South America, get a huge boost.

It’s a strange world isn’t it.

Out of the blue:

Is this a government in denial? Yes, and desperate to maintain local as well as international aspirations with or without an economic foundation. We still have our 730 military bases in 160 foreign countries and we still spend more on military endeavors than the rest of the world combined. Could some of those resources be better used here at home? Remember,

a government of the people, by the people, for the people, shall not perish from the earth...

Today the federal budget accounts for nearly 30% of GDP - the most since WWII. Add in the highly regulated and highly subsidized health care industry and you've got the government in control of nearly half the economy. Now add in the banking system - which couldn't exist without the FDIC, which would already be insolvent without the backing of Congress. Now add in the insurance industry, which will surely collapse next. Now add in all the state governments' spending and employees.

Most Americans don't understand: The government is now running most of the economy, by a wide margin. And who keeps the government afloat? The Chinese. The United States is now dependent upon the Chinese to finance our consumption through ownership of U.S. Treasuries. And with an already fragile economy, the U.S. is put in a position of weakness relative to China. China realizes that if the U.S. Government continues to print money at the current pace, their holdings will decline in value due to a devaluation of the dollar. So if the Chinese won’t buy our bonds, we will just buy our own. That is a nice setup. We print the money, we need to borrow to finance our deficit, if no one is willing to lend us the money we will just lend it to ourselves. Sweet!

Think about that for a little while... Up until now, the so-called "Communist" Chinese, whose government makes up about 10% of China's GDP and who control the No. 1freest city in the world (Hong Kong), are now paying for the most government-controlled economy in the world - the so-called "land of the free."

P.S.
Notice, I haven't even mentioned the potential for mischief and instability coming out of the rest of the world -- enough black swans to blot out the sun.
And don't forget about a crisis that's killing 12 million people per year, including 10,000 children per day. Three billion people have been added to the planet just since 1970, but the per capita supply of fresh water is one-third lower today than it was then. In the United States — groundwater is being used up at a rate 25 percent faster than it is being replenished.

Note to readers:
One may wonder how it is that I accumulate such a mass of information, let alone have the time for this blog. First, it is purely self-interest as I too have to navigate these markets and since I am making the time to do the reading and discovery, why not share it with a larger audience, and so I do. Second, my sources are many and varied and what I do is take the best of the best, cut and paste, and string together a somewhat coherent thesis. In reference to my sources this month, they include in no particular order: Gregory Spear's Market Commentary, Automaticearth.com, The Motley Fool, DailyWealth Reader, The Daily Crux, Money and Markets, Louis Navellier, Investorsdailyedge.com, Moody’s, Bloomberg, The New York Times, The Associated Press, Financial Times, The Globe and Mail (Toronto), Financial Week, International Herald Tribune, Reuters, The Washington Post, InvestmentNews, CBS News, The Toronto Star, Forbes, Jim Kunstler, Rick Pendergraft, Business Week, The Wall Street Journal, Martin Weiss, Sharon Daniels, Dan Weil, BCA Research, Financial Post, Gulf News, Los Angeles Times, Larry Edelson, CNNMoney.com, Google.com, Mike Larson, CNBC, ETF Trends, and The Times (London).