Federal Reserve Bank of Minneapolis: What Credit Crisis?

This financial crisis has painted a popular view that our economic and financial world seems careened towards perdition; largely underpinned by the blowup in the securitization markets and a freeze in the credit markets. And such is the reason why global governments have united to supposedly provide the intensive care treatment needed to avert a systemic meltdown.

Ironically, what the US Federal Reserve and the US Treasury have been saying runs counter to the insights of the Federal Reserve Bank of Minneapolis. The US government says the system is in danger which requires massive intervention while the Minneapolis implies that there is no systemic threat.

V.V. Chari, Lawrence Christiano, and Patrick J. Kehoe in a recent working paper “Myths about the Financial Crisis of 2008” (HT: Mike Moffatt About.com) disputes much of the woes aired by the experts and the financial press.

From Chari, Christiano and Kehoe,

``Clearly, the United States and the world economy are undergoing a major financial crisis. Interbank borrowing and lending rates have risen to unprecedented levels relative to U.S. Treasury Bills. Several major financial institutions have failed. These real problems have also been associated with four widely-held myths about the nature of the financial crisis and the associated spillovers to the rest of the economy. The financial press and policymakers have made four claims about the nature of the crisis.

1. Bank lending to non financial corporations and individuals has declined sharply.

2. Interbank lending is essentially nonexistent.

3. Commercial paper issuance by non.nancial corporations has declined sharply and rates have risen to unprecedented levels.

4. Banks play a large role in channeling funds from savers to borrowers.”

The Federal Reserve Bank of Minneapolis presents the following charts…

While volume transactions of commercial paper fell dramatically, the non financial market seems to remain buoyant.

Meanwhile 90 day commercial paper rates have zoomed.

Our comment:

On the surface it would appear there hasn’t been much of the dislocation in the credit markets. But if one takes into account the spikes of Interbank 5A, commercial and Industrial loans 3A, Bank Credit 1A and Loans and Leases 2A, they seem coincidental with the US Federal Actions. Perhaps much of the recent gains in these credit activities could have been influenced by Fed policies.

Another possible factor for a spike in the loans is that the compressed activities in the commercial paper market could have prompted corporations to tap their revolving credit lines instead. Or perhaps consumers have used more of the credit card to sustain consumption patterns.

Nonetheless, if the present crisis is viewed from the angle of the US Federal Reserve’s Balance Sheet, the change of its composition and its rapid expansion implies that the crisis isn’t a myth. Chart courtesy of by Federal Bank of Atlanta.

Such dissonance could imply of the concentration of risks in the US banking system to a few but large heavily affected institutions.

As Christopher Whalen (HT: Craig McCarty) of the Institutional Risk Analytics observes, ``Despite grim macro outlook for US economy, most smaller banks in the US are in good shape. While losses will rise for the banking industry as a whole, smaller banks up through large regional institutions have the capital to absorb losses and continue during business. Top five institutions are where the assets are concentrated and the loss rates will be higher as the credit cycle peaks in Q1-2 of 2009.”

Lastly if it is true that today's crisis is a myth then why the need for all these coordinated and intensive intervention? Perhaps to save Wall Street?

Another Grizzly Bear Transforms To A “Cautious Bull”: Jeremy Grantham of GMO

In his latest outlook Reaping the Whirlwind, one of my favorite and distinguished “perma” bear Mr. Jeremy Grantham (JG) of GMO, wrote some very important insights (all highlights mine/charts from Jeremy Grantham):

JG: ``Global profit margins, the second near certainty, are also declining rapidly, but have a long way to go. The estimates of future earnings that we have been sniggering at for a year are still inconceivably high. Why do they bother? To repeat our mantra: global profit margins were recently at record highs. Profit margins are the most provably mean reverting series in finance or economics. They will go back to normal. After big moves, they almost invariably overrun. With the current set of global misfortunes, they are very likely to overrun considerably this time.”

My interpretation:

The impact to the real economy of the imploding bubble and credit crunch has yet to filter into corporate profits. This means markets may overshoot to the downside as they will eventually reflect on the downscaling of profit expectations amid the unraveling recessionary environment.

JG: ``The real growth in the index has historically been only 1.8% per year for the S&P, but for technical reasons (low payout rates in particular) we have allowed for moderately more real growth in recent years. In the six years since October 2002, the trend line has risen to 975 (plus or minus a little – we are constantly fine-tuning a percent here or there). Needless to say, two weeks ago the market crashed through that level, producing Exhibit 1. So now all 28 burst bubbles are present and accounted for. Long live mean reversion!”

My interpretation:

Reversions to the Mean have always been a truism for markets. It has happened before (in 28 previous bubbles) and has reinforced its applicability again today. Serious investors have always to keep this in mind.

JG: ``Full disclosure requires that we add that, in our opinion, this is not as brilliant as it sounds, for markets have been more or less permanently overpriced since 1994 and have not been very cheap since 1982-83 and perhaps a few weeks in 1987. There is also a terrible caveat (isn’t there always?), and that is presented in Exhibit 3, which shows the three most important equity bubbles of the 20th Century: 1929, 1965, and Japan in 1989. You will notice that all three overcorrected around their price trends by more than 50%! In the interest of general happiness, we do not trot out these exhibits often and, until recently, they would have been seen as totally irrelevant and perhaps indecent. But, after all, it’s just history. Being optimistic like most humans, we draw the line at believing something so dire will happen this time.”

My interpretation:

US markets today have fallen below trend line, but lessons of the past shows (see two charts above by Mr. Grantham) that there is that risk that markets can extend to the downside in as much as it has overreached to the upside. Don't forget markets are emotional than rational during major inflection points.

JG: ``On October 10th we can say that, with the S&P at 900, stocks are cheap in the U.S. and cheaper still overseas. We will therefore be steady buyers at these prices. Not necessarily rapid buyers, in fact probably not, but steady buyers. But we have no illusions. Timing is difficult and is apparently not usually our skill set, although we got desperately and atypically lucky moving rapidly to underweight in emerging equities three months ago. That aside, we play the numbers. And we recognize the real possibilities of severe and typical overruns. We also recognize that the current crisis comes with possibly unique dangers of a global meltdown. We recognize, in short, that we are very probably buying too soon. Caveat emptor.”

My interpretation:

US and global stocks have reached reasonable valuation or “cheap” levels. But since market timing is difficult, for Mr. Grantham, they will be gradual accumulators, in the understanding that markets could risk a downside overshoot.

JG: ``The global economy is likely to show the scars of this crisis for several years. In particular, the illusion of wealth created by over-inflated asset prices has been dramatically reduced and, though most of this effect is behind us, a substantial part of the housing decline in some European countries and the U.S. is still to occur. We were all spending and, in the case of the U.S., importing as if we were much richer than is in fact the case. Particularly here in the U.S., increasing household debt temporarily masked some of the pain from little or no increase in real hourly wages for 20 to 30 years. Household debt since 1982 has added over 1% a year to consumer spending. Unfortunately, this net benefit does not go on forever.”

My interpretation:

Following the bubble burst and the credit crunch, we transit o the next stage -the impact to the real economy.

The painful adjustment process will take time to heal which in the market’s vernacular translates to a cyclical shift into a “bottoming out” process.

JG: ``At under 1000 on the S&P 500, U.S. stocks are very reasonable buys for brave value managers willing to be early. The same applies to EAFE and emerging equities at October 10th prices, but even more so. History warns, though, that new lows are more likely than not. Fixed income has wide areas of very attractive, aberrant pricing. The dollar and the yen look okay for now, but the pound does not. Don’t worry at all about inflation. We can all save up our worries there for a couple of years from now and then really worry! Commodities may have big rallies, but the fundamentals of the next 18 months should wear them down to new two-year lows. As for us in asset allocation, we have made our choice: hesitant and careful buying at these prices and lower. Good luck with your decisions.”

My interpretation:

There are vast and select opportunities out there but an investor’s time horizon should extend to over 18 months, as bouts of volatility from the market clearing process will continue to surface intermittently until most of the required adjustments would have been attained.

Over the interim, inflation will not be much of a concern because of the deflationary impact from the ongoing debt destruction process.

Thank you, Mr. Grantham.

Thus, Mr. Grantham joins other contrarian former “bear” gurus as Warren Buffett and Dr. John Hussman to the cautious "bull" camp.

Gallup Polls: Filipinos Say US Election Matters, McCain Slightly Favored

Politicking is the lifeblood of Filipinos.

So even US elections are considered to be an important issue to Filipinos. That’s according to Gallup Polls.

From Gallup, ``The Philippines and the United States share strong historical ties and maintain close bilateral relations, which President Gloria Macapagal-Arroyo seeks to further expand. The United States has also traditionally been the Philippines' largest source of foreign investment and is one of its largest trade partners, so Filipinos have a vested interest in the next U.S. president's policy toward their country and their economic and diplomatic partners closer to home.” (highlight mine)

The latest survey shows nearly a majority of 49% of Filipinos considers the US elections as important, the rest are distributed as 27% no difference and 24% undecided.

And when considering the preference for the next US President, among all the countries surveyed by Gallup, “only Georgia and the Philippines” appear to support Republican Candidate Senator John McCain in a world overwhelmingly dominated by Democratic candidate Barack Obama supporters. It’s a nearly a 4-to-1 margin for Sen. Obama! (Wow Filipinos as contrarians, incredible!)

Here are latest Polls results …

Broken into regions, the National Capital Region (NCR) seems always the hotbed for the opposition even during local elections and is the only region in the Philippines where the pro-Obama preference has a clear edge.

The rest of the survey you can find in the Gallup article here.

As for my choice: None of the Above.

Hysteria That Goes Poof! Global Warming Turns Into Global Cooling

The number of climate change skeptics is said to be growing rapidly. That’s according to Lorne Gunter of the National Post.

Why?

“Because a funny thing is happening to global temperatures -- they're going down, not up,” says Mr. Gunter.

Further excerpts from the article.

“On the same day (Sept. 5) that areas of southern Brazil were recording one of their latest winter snowfalls ever and entering what turned out to be their coldest September in a century, Brazilian meteorologist Eugenio Hackbart explained that extreme cold or snowfall events in his country have always been tied to "a negative PDO" or Pacific Decadal Oscillation. Positive PDOs -- El Ninos -- produce above-average temperatures in South America while negative ones -- La Ninas -- produce below average ones.

“Dr. Hackbart also pointed out that periods of solar inactivity known as "solar minimums" magnify cold spells on his continent. So, given that August was the first month since 1913 in which no sunspot activity was recorded -- none -- and during which solar winds were at a 50-year low, he was not surprised that Brazilians were suffering (for them) a brutal cold snap. "This is no coincidence," he said as he scoffed at the notion that manmade carbon emissions had more impact than the sun and oceans on global climate…

“Don Easterbrook, a geologist at Western Washington University, says, "It's practically a slam dunk that we are in for about 30 years of global cooling," as the sun enters a particularly inactive phase. His examination of warming and cooling trends over the past four centuries shows an "almost exact correlation" between climate fluctuations and solar energy received on Earth, while showing almost "no correlation at all with CO2."

If Mr. Gunter's assertions are correct, then could we be bidding goodbye to the ‘Green’ fanaticism?

Warren Buffett Declares A BUY!

Last Friday, in an opinion column at the New York Times, the world’s most successful stock investor declared that it is OPEN season for buying stocks…

Here are some excerpts (All highlights mine)…

``So ... I’ve been buying American stocks. This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.

``Why?

``A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.

``"Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.

“A little history here: During the Depression, the Dow hit its low, 41, on July 8, 1932. Economic conditions, though, kept deteriorating until Franklin D. Roosevelt took office in March 1933. By that time, the market had already advanced 30 percent. Or think back to the early days of World War II, when things were going badly for the United States in Europe and the Pacific. The market hit bottom in April 1942, well before Allied fortunes turned. Again, in the early 1980s, the time to buy stocks was when inflation raged and the economy was in the tank. In short, bad news is an investor’s best friend. It lets you buy a slice of America’s future at a marked-down price.

My interpretation of Mr. Buffett’s message:

1) too much fear have dominated the marketplace, this could be indicative of a near bottom or the near end of the bear market cycle,

2) valuations have turned inexpensive hence have become attractive for value investors like Mr. Buffett

3) market always operate in cycles. After a recession comes a recovery; it is time to look forward.

4) it’s difficult to second guess the market’s short term moves, so it is best to position today as the windows opportunities are widely open. Mr. Buffett offers a great analogy “So if you wait for the robins, spring will be over.”

Turning to Mr. Buffett again,

``Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.

``Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later. In waiting for the comfort of good news, they are ignoring Wayne Gretzky’s advice: “I skate to where the puck is going to be, not to where it has been.”

My interpretation:

1. Holding into Cash is likely a losing proposition as government actions today will prove inflationary in the future or our currency’s purchasing power will certainly dissipate or buy less of goods or services.

2. Bonds will be the next shoe to fall.

3. Stock market investments will outperform bonds and cash.

My additional comment..

For some of the “doomsayers” this seemingly “patriotic” call from Mr. Buffett would possibly be interpreted with political color, since it goes against their depression outlook, in the same way they have earlier fervently rebuked Mr. Buffett for his Goldman Sachs bailout.

For his JP Morgan-like act, they have denigrated him as a “political or celebrity endorser” and benefiting from assurances of Mr. Bernanke or Mr. Paulson, which some claim makes his flagship Berkshire’s investment in Goldman Sachs deal as “riskless” and guaranteed by US taxpayers.

We find such criticism similar to those whom earlier accused Mr. Buffett of having lost touch when he deliberately missed out the technology boom. In the same way, Mr. Buffett rode over the heydays of 2003-2007 in apparent anticipation of a bust in the derivatives market which he direly warned of as the Financial Weapons of Mass Destruction in 2003. Even former Fed Chair Alan Greenspan debated Mr. Buffett’s censure of derivatives. Apparently, all of them including Mr. Greenspan proved to be wrong.

Yes, past performance may not imply the same results, and Mr. Buffett could be wrong but our money is on him.

Nonetheless here are some other points to consider:

First of all it is true that at Age 77, Mr. Buffett doesn’t need the money. But this doesn’t mean he would squander all the years of extraordinary gains by unduly taking on risky positions today.

Since 1967 Berkshire Hathaway’s annual return has been at a magnificent 24.73% in 2008 (allfinancialmatters.com). At the end of 2007 Berkshire had amassed an astounding cash reserve of US $44.3 billion and this has been reduced to $31.2 billion by midyear 2008 on latest buying binge (Business Standard- Bloomberg)

Two, Mr. Buffett’s “Be fearful when everybody is greedy and greedy when everybody is fearful” has been a longstanding guiding principle in practice. It doesn’t take much to realize that Mr. Buffett’s secret has not been “Greek” sounding quant models or algorithms but plain emotional intelligence, understanding of market cycles and practical valuation assessment.

To quote Dr. John Hussman, ``At present, the most probable source of long-term returns is the willingness to provide liquidity (holding out willing bids at depressed prices in a panicked market), risk-bearing (taking on the market risk being liquidated by fearful or distressed sellers), and information (through the proper assessment of value). In my view, Buffett's willingness (and our own) to accept market risk here does all three.” (highlight mine)

Three, it would be wrong to assume that Mr. Buffett’s bet comes with nothing but himself at stake. Aside from money, he has his reputation at stake. His Berkshire Hathaway’s annual stockholder’s meeting is the “Woodstock of Capitalism” which draws about 20,000 shareholders and followers. I may not be an Omaha attendee but have surely followed his actions. Count me in as one of his fans when it comes to investment principles (but not in the realm of politics)

Fourth, Mr. Buffett’s investments has network externality effects which means the companies he acquire as part of his flagship’s portfolio tend to get impacted by his decisions. This means any decisions with negative effect will harm, aside from shareholders, the other stakeholders as management of every companies and corresponding subsidiaries and their respective employees, customers, suppliers, US and other governments for taxes reasons etc.... Hence his wide reach of people involved within his organization signifies as a personal responsibility.

Recalling a quote of Peter Parker in the movie series Spiderman, “With great power comes great responsibility.” Mr. Buffett commands great power (financial, even political clout), thus has great responsibility.

Remember, Berkshire now owns a diverse range of businesses including candy production; retail, home furnishings, encyclopedias, vacuum cleaners, jewelry sales; newspaper publishing; manufacture and distribution of uniforms; manufacture, import and distribution of footwear; as well as several regional electric and gas utilities. (wikipedia.org)

Fifth, to strike bargain deals in an environment of fear isn't inherently wrong. He appears to use his political clout to seize such once in a lifetime economic opportunities. Ultimately the markets will determine whether he is right or wrong; not you or not me.

Lastly, Mr. Buffett isn’t just talking. He has long been putting his money where his mouth is even before the New York Times Op-Ed letter.

The latest buys of Mr. Buffett (deal.com)

-NRG NV, a reinsurance unit from ING Groep NV, for about €300 million ($440 million) on Dec. 28, 2007

-3% stake in Swiss Re AG for about Sfr840 million ($1.2 billion) on Jan. 23, 2008

-132.4 million shares of Northfield, Ill.-based Kraft Foods Inc., representing an 8.6% stake of the company

-$4.5 billion purchase of Marmon Holdings Inc., the Pritzker family's collection of 125 companies, in March 2008

-$6.5 billion to help Mars Inc. buy Wm. Wrigley Jr. Co., giving him a stake in the combined confectionery business, in April 2008

-$3 billion to Dow Chemical Co.'s $15.4 billion takeover of Rohm and Haas Co. in July 2008

-$4.7 billion bid for Constellation Energy Group Inc., the largest U.S. power seller, Sept. 18

-An estimated $1 billion for 71.2% of Japanese toolmaker Tungaloy Corp. Sept. 22

-$5 billion investment in Goldman Sachs Group Inc. Sept. 23

To add a 10% stake in Hong Kong listed Chinese battery maker BYD recently acquired for $230 million by Berkshire subsidiary energy company MidAmerican Energy (Reuters).

We think with Mr. Buffett along the bullish camp, the bottom looks likely very close.

It’s a Banking Meltdown More Than A Stock Market Collapse!

``The argument that the government is somehow pumping new capital into the market is absurd. Government is actually borrowing the money from the capital markets that it is in turn injecting into the capital markets. There is no additional source of funding; there is only a diversion of funds from more-productive outlets to less-productive outlets, with government acting as the middleman.” -Scott A. Kjar, University of Dallas, Henry Hazlitt on the Bailout

It’s amusing how many people believe that today’s financial crisis is just a “headline” material. They carry this notion that the meltdown seen in the stock market are just confined to within the industry. They believe in media’s assertion that these are all about just banking related losses and perhaps a prospective recession. Yet, importantly governments will successfully come to the rescue. And that banking deposits will be safeguarded by sanctity of government guarantees. We hope that such smugness is correct and don’t turn out to be chimerical.

From our side, the current global stock market meltdown is like utilizing a thermometer to a gauge the body temperature of a patient. From which the mercury’s position indicates of the degree of normality or abnormality in the patient’s temperature than of its cause. Hence, the thermometer signifies as the medium and the mercury’s position the message. In the stock market we see the same message See Figure 1.

Figure 1: Mercury Indicator: Stock Market Meltdown or Banking System Meltdown?

The Performance chart from stockcharts.com shows that since the whole bubble bust cycle episode unraveled, the losses of world equity markets have been far less than the damage suffered by the housing and the entire swath of financial and banking sector.

True, everyone directly or indirectly involved in the financial sector seems to be afflicted. But some are suffering more than the others. This means that like the thermometer, the public’s attention have been on inordinately transfixed to the freefall in global equities but have glossed over the significance of the ongoing risk dynamics in the US financial sector.

From our point of view, the stock market “meltdown” has been a symptom of a deeper underlying disease: the risks of a US banking sector collapse. And this is not just about your typical banking losses, but a representation of the real risks of a total freeze of the entire global banking network system as we discussed in Has The Global Banking Stress Been a Manifestation of Declining Confidence In The Paper Money System?

As had been pointed out, the US dollar standard monetary system has been anchored upon a global banking system from which operates on a fractional reserve banking platform from where the entire global banking network revolves or interacts upon. In short, deposits, credit intermediaries, clearing and settlement, maturity transformation, asset markets etc… are all deeply interconnected.

Since the US dollar standard banking system has been at the core of our troubles, all the network of banking nodes connected to such intertwined system have likewise been bearing strains, see Figure 2 from the IMF.

Figure 2: IMF’s GFSR: The Evolution of the US Banking System From Deposits to the Shadow Banking

According to the IMF’s Global Financial Stability Report (emphasis mine), ``Banks have been shifting away from deposits to less reliable market financing. “Core deposits” dominated U.S. banks’ liabilities in the past, but have been gradually replaced by other “managed liabilities”…At the same time, near-banks—which are entirely market financed—have grown sharply. This is related to the “originate-to-distribute” financing model that relies heavily on sound short-term market liquidity management. Euro area and U.K. banks also rely more on market financing than in the past, as in the United States. Similarly, the share of deposits by households (defined roughly the same as U.S. core deposits) has been gradually declining over time, while deposits held by nonfinancial corporations, other financial intermediaries, and nonresidents have steadily increased. In addition to these “managed deposits,” financing through repurchase agreements and issuance of debt securities, both in domestic and foreign markets, have expanded, indicating that European banks are also increasingly exposed to developments in money markets. At the same time, the share of household deposits for Japanese banks has been stable and even increasing over time. This may partly reflect the prolonged low interest environment since the late-1990s.”

In other words, from a depository based banking system the US has evolved into gradual dependency on “near banks” or what is known as the “shadow banking system” (we previously featured a schematic chart from the Bank of International Settlements The Shadow Banking System) which basically relies on short term financing or maturity transformation borrow short and lend or invest long.

Thus, when the collaterals backstopping the entire short term financing channels began to deteriorate, whose chain of events included the Lehman bankruptcy, this resulted to a collapse in the commercial paper market (forbes.com) and the “breaking the buck” in the money markets (edition.cnn.com) as banks refused to deal (borrow and lend) with each other on perceived “rollover risks”.

Consequently, major financial institutions dumped the banking channels and stampeded into US treasuries. This exodus or flight to safety set a record yield of .0203% for 3 months bills last September 17^th (Bloomberg), which we described last week as an “institutional run”. And these strains reverberated throughout the network of banks all over the world which raised credit spreads and resulted to a dearth of US dollars and lack of liquidity in the system as banks and companies hoarded cash. Thus as a result to the credit gridlock the liquidity crunch inspired the sharp selloffs.

So while the defensive mechanism for the global banking system has been designed against isolated instances of retail depositors run via a depositors insurance (e.g. FDIC, PDIC etc…), an institutional run has not been part of such contingencies.

Hence what you have been witnessing is an unprecedented monumental development which has a potential risk of a downside spiral.

To consider, the assets of Shadow Banking system was estimated at some $10 trillion dollars which is almost comparable to the assets of traditional banking system. According to a report from CBS Marketwatch (all highlights mine),

``By early 2007, conduits, structured investment vehicles and similar entities that borrowed in the commercial paper market and bought longer-term asset-backed securities, held roughly $2.2 trillion in assets, according to the Fed's Geithner.

``Another $2.5 trillion in assets were financed overnight in the so-called repo market, Geithner said.

``Geithner also highlighted big brokerage firms, saying that their combined balance sheets held $4 trillion in assets in early 2007.

``Hedge funds held another $1.8 trillion, bringing the total value of asset in the "non-bank" financial system to $10.5 trillion, he added.

``That dwarfed the total assets of the five largest banks in the U.S., which held just over $6 trillion at the time, Geithner noted. The traditional banking system as a whole held about $10 trillion, he said.”

So as hedge funds continue to shrink from redemptions, TrimTrabs estimates a record $43 billion in September-liquidity requirements, margin call positions, maintaining balance sheet leverage ratio or plain consternation could risks triggering more negative feedback loop of more forced liquidation.

Besides, risk of a deep and extended recession could imply larger corporate bankruptcies and larger defaults from corporate leveraged loans that could trigger credit events in the CDS market that could give rise to new bouts of forcible liquidations. All these could similarly shrink the capital base of existing banks, even under those buttressed by capital from the US treasury.

In addition, the risks of heavy damages in the asset markets could spread to the insurance and pension funds which risks reinforcing the downside spiral. In short, the shadow banking system poses enough risk to destabilize the entire US banking system.

Global Governments Throws The Kitchen Sink And the House

Governments have virtually thrown not just the proverbial kitchen sink but the entire house to deal with such outsized dilemma. The US government pledged to “deploy all of our tools” as the G7 counterparts have “committed to a global strategy”.

Specifically the US government will earmark some $250 billion for its “capital purchase program” to be infused as capital to the banking system in return for preferred shares of which 9 of the major banks have “agreed” or “coerced” to participate, a temporary guarantee by the FDIC on the “senior debt of all FDIC-insured institutions and their holding companies, as well as deposits in non-interest bearing deposit transaction accounts”, the broadening scope Commercial Paper Funding Facility (CPFF) program which will “fund purchases of commercial paper of 3 month maturity from high-quality issuers” (Federal Reserve) and unlimited swap lines or “Counterparties in these operations will be able to borrow any amount they wish against the appropriate collateral in each jurisdiction” with major central banks as the Bank of England (BoE), the European Central Bank (ECB), the Federal Reserve, the Bank of Japan, and the Swiss National Bank (SNB) as “necessary to provide sufficient liquidity in short-term funding markets”. (Federal Reserve)

Figure 3: Wall Street Journal: Europe’s Bailout Package

Of course, it’s no different with the European counterparts which have committed aggressively some €1.8 trillion (US $2.4 trillion)-AFP.

So overall, including the US Congress’ contribution of $850 billion plus the Federal Reserves liquidity infusion via US dollar swaps these should amount to over $3 trillion or over 5% of global GDP (2007) of $54.62 trillion based on official exchange rate-CIA.

Such astounding financial theater of operations reminds us of the D-Day 1944 Normandy Landings. Bernanke’s helicopters have not only been operating on round the clock sorties, but they are also flying all over the globe as the Fed has essentially outsourced its printing press functions to international Central banks!

The Illusions of Government Guarantees

If only those unlimited injections of liquidity can translate to REAL capital.

The unfortunate part is that government guarantees depend on the hard currency that backs the system.

For instance, in the case of Iceland which basically guaranteed deposits of its financial system and nationalized its major banks, the lack of hard currency has precipitated a crisis (See our Iceland, the Next Zimbabwe? A “Riches To Rags” Tale?).

As the Icelandic government operated on a huge current account deficit in the face of a paucity of global liquidity, rising risk aversion, global bear markets, global deleveraging and the monumental debt incurred by its banking system, investors withdrew funding and sold the currency aground. Last October 9^th the Iceland Prime Minister even pleaded to the public to restrain from withdrawals (Reuters).

Now goods shortages have emerged and consumer price inflation has soared. If Iceland can’t obtain the sufficient funding from overseas lenders (IMF or Russia or etc.) soon enough, then it would have to resort to the printing press or our developed country equivalent of Zimbabwe.

In a varied strain, Pakistan’s economy and banking system has allegedly been suffering from “some” depositor’s run (thaindian.news) on rumors that the government might impose withdrawal restrictions. Global volatility has exposed Pakistan’s vulnerability to its heavy dependence on short term debt financing and huge current account deficits (see our Increasing Signs of Pakistan's Depression?). Pakistan is now seeking a bailout package from China.

In both examples, government guarantees won’t serve any good if governments can’t support such claims.

Think of it, government revenues basically derive from three channels: taxpayers, borrowing through debt issuance or the printing press.

Even if your government guarantees deposits or other loans, assets etc…, if taxpayer’s can’t pay up, or if the government can’t raise enough borrowings to fund its present expenditure or settle its liabilities seen via fiscal or current account, your government ends up using the printing press to meet its needs.

This means that in the assumption that your government remains functional under a banking system collapse, whatever money guaranteed by the government will surely have its purchasing power evaporated!

If for instance the Philippine government allows deposit guarantees to increase at P 500,000 per depositor (from the present Php 250,000-PDIC) and our doomsday scenario occurs, such an amount which can momentarily buy a second car will eventually (perhaps in just months) buy up only a bottle a beer! That is if government even allows you to withdraw your money. In Argentina’s case during its 1999-2001 crisis, particularly in December of 2001, the Argentine government restricted depositors from withdrawing money to only a specified amount (BBC).

To Austrian economics, such restriction is equivalent to “Confiscatory Deflation”, which according to Joseph Salerno in his Austrian Taxonomy of Deflation, ``There does exist an emphatically malign form of deflation that is coercively imposed by governments and their central banks and that violates property rights, distorts monetary calculation and undermines monetary exchange. It may even catapult an economy back to a primitive state of barter, if applied long and relentlessly enough. This form of deflation involves an outright confiscation of people’s cash balances by the political and bureaucratic elites…

``Confiscatory deflation is generally inflicted on the economy by the political authorities as a means of obstructing an ongoing bank credit deflation that threatens to liquidate an unsound financial system built on fractional-reserve banking. Its essence is an abrogation of bank depositors’ property titles to their cash stored in immediately redeemable checking and savings deposits.” (highlight mine).

Yet when government mandated money loses trust among its constituents people tend to find a substitute, as example see our previous, The Origin of Money and Today's Mackarel and Animal Farm Currencies.

So as shown above, government guarantees do not constitute as an outright safety net. These will all depend on government’s access of available financing at future costs.

Under the same line of thought, the idea that the US dollar as the international foreign currency reserve with unlimited lending capacity is another mirage.

The US economy has been supported by the financing of its current account deficits by foreign exchange surpluses of current account surplus countries mostly found in Asia and Gulf Cooperation Council (GCC). This vendor financing scheme effectively recycles money earned from exports of EM economies by buying into US financial papers to keep their currencies from appreciating.

Hence, the US economy’s ability to provide unlimited finance is moored upon the willingness of foreigners as China, Japan and GCCs to sustain the present system. Said differently, for as long as these financers continue to buy US financial claims, they automatically provide the wherewithal or the “quiet bailout” to the US government.

So China, Japan and others essentially determines the guarantee provisions the US extends to its financial institutions aside from the world’s faith on its printing presses.

Besides, guarantees in the banking system as we previously discussed represent as “beggar-thy-neighbor” policy which keeps at a disadvantage countries offering less amount of guarantees, like the Philippines, since the former tend to attract more capital or savings because of the higher amount of safety.

Hence, guarantees signify as subsidies to those who apply more and a tax to nations who apply less. Thus, the policy regime of surging guarantees on deposits by Europe and the US tend to put into the downside pressures to the Philippine Peso.

Yet, our discussions above are some examples of isolated banking crisis and not of a systemic banking collapse, a domino effect from a prolonged cardiac arrest of the US banking system, the ultimate recipe for a global depression, where guarantees will just be that- a political rhetoric.

US Banking Collapse: You Can Run, But You Can’t Hide; Revival of Bretton Woods?

We proposed last week that this could mark the beginning of the end of the current form of paper money system or even signify as a harbinger to a new paradigm shift from our present monetary system.

Perhaps European Central Bank’s Jean Trichet heard our whispers and began to talk about the revival of a modern version of a “Bretton Woods” (see Did ECB’s Trichet Fire The First Salvo For A Possible Overhaul Of The Global Monetary Standard? and Bretton Woods II: Bringing Back Gold To Our Financial Architecture?)

So aside from the rapid aggressive policy response (bailouts, liquidity injections, nationalization, blanket guarantees), some European leaders have also raised the idea for a shift in the global financial architecture.

As the Reuters report indicates ``Italy's economy minister said a reform of the Bretton Woods institutions should also review trade, foreign exchange and capital markets and questioned whether the dollar should remain the reference currency under a new system.” (highlight mine) So it won’t be a far fetched idea for a movement among nations to address the need to reform the present monetary system.

Yet as the crisis continues to unfold, everything now seems to depend on how the global markets will respond to the massive stimulus applied and how it will measure up to remedy the apparent weakening of the foundations of the US banking system.

Nonetheless the threat remains real.

This means that should the US banking system collapse, there will probably be no escape for almost everyone dependent directly or indirectly on the global banking system, not even for those who aren’t invested in the stock market. While it is true that alternative sources for financing such as microfinancing and trade finance may be picking up on some of the slack, it won’t be enough for it to replace the rapidly mounting losses in the financial system that risks becoming a financial black hole.

We can only guess what implications of a global depression as an offshoot to the US banking collapse could be: pension, insurance, and other money market funds will perhaps evaporate, stock markets will close, a collapse in the international division of labor means each country will have to fend for themselves or dominant “protectionist” policies will prevail (hence some countries will experience hyperinflation and others will suffer from deflation), a run of the US dollar or the present paper money system, rising crime and security risks, civil wars, return of authoritarianism etc…

On the other hand, some sectors would be quite happy- the extreme left will glee with the resultant equality from a depression, as well as bureaucrats and political leadership who will benefit from more government spending. Outside these sectors, everyone will probably be equally poor!

Sorry for the gloom.

Conclusion

Thus, it is an arrant misguided fairy tale to suggest that today’s stock market meltdown is just seen for its “media feed”.

Today’s stock market meltdown is representative of the real risks of a US banking collapse. While I am not betting that this devastation is gonna happen, a US banking collapse would have deep adverse repercussions to our domestic and global banking system, aside from the global economy which practically means the ushering in of the great depression (version 2008) . Why would global central banks have earmarked over $3trillion of bailout money? Why would Bernanke’s Federal Reserve Helicopters be doing simultaneous missions globally to drop “helicopter money”?

So it is equally myopic to suggest that our banking system will be “immune” to such extreme risk scenario. If the issue is only about banking losses and some disruptions in the system then yes the Philippine banking system will escape with some bruises.

Nonetheless if the US banking industry does collapse, not even those out of the stock market will be spared unless their money is stashed under their pillowcase or buried underground.

That is if street muggers don’t figure them out.

Panics: Die of Exhaustion Or From Policy Overdose?

``Word to the wise - don't accept advice or analysis about this crisis from anyone who failed to anticipate it in the first place! The people warning about Depression now are the same reckless jackasses who told investors that stocks were cheap and “resilient” at the highs.”- John P. Hussman, Ph.D. Four Magic Words: "We Are Providing Capital"

Let me offer a non-sequitur argument: Because we could be destined for doom, we might as well bet on hope.

In other words, with so much of the prevailing gloom in the atmosphere this could, by in itself, possibly signify an end to the panic.

As Morgan Stanley’s Stephen Roach eloquently articulated in the International Herald Tribune (hightlight mine), ``The most important thing about financial panics is that they are all temporary. They either die of exhaustion or are overwhelmed by the heavy artillery of government policies.”

True enough, as we have always pointed out, doom or boom or market extremes have simply been accounted psychological phases of the market cycles.

Nevertheless, Mr. Roach uses the Professor Charles Kindleberger’s “revulsion stage” as a paragon for the possible panic endgame.

Professor Charles Kindleberger in Manias Panics, and Crashes A History of Financial Crisis identifies the phase as [p.15] ``Revulsion and discredit may go so far as to lead to panic (or as the Germans put it, Torschlusspanik, “door-shut-panic”) with people overcrowding to get through the door before it slams shut. The panic feeds on itself, as did speculation, until one or more of the three things happen: (1) prices fall so low that people are tempted to move back into less liquid assets: (2) trade is cut off by setting limits on price declines, shutting down exchanges or otherwise closing trading, or (3) a lender of last resort succeeds in convincing the market that money will be made available in sufficient volume to meet demand for cash.” (highlight mine)

While low prices and lender of last resort could likely be more pragmatic solutions, it is doubtful if the cutting of trades or closing exchanges will succeed in limiting the panic phase. As the recent examples of Indonesia and Russia manifested, temporary suspensions of bourse activities have not deterred the onslaught of a rampaging bear.

It would be more suitable for the markets to discover the price clearing levels required to set a floor than to applying stop gap solutions that only delays the imminent or worsens the scenario. Price controls rarely work especially over the long term and could lead to extreme volatility.

Nonetheless, with the successive coordinated barrage of heavy systemic stimulus by global central banks, possibly attempting to err on the side of a policy overkill, we might as well hope that 1) these efforts could somehow jumpstart parts of the global markets and or economies that have not been tainted by the US credit bubble dynamics or 2) that market levels could be low enough to attract distressed asset buyers which could provide the necessary support to the present levels.

While it likely true that the credit system in the US and parts of Europe have been severely impaired and will unlikely restore the Ponzi dynamics to its previous levels that has driven the massive buildup of such bubble, the most the US can afford is probably to buy enough time for the world economies to recover and pick up on its slack and hope that they can the recovery would be strong enough to lift the US out of the rut.

Divergences of Policy Approaches: Asia’s Market Oriented Response

One thing that has yet kept the world out of pangs of the 1930s global depression is that global economies have remained opened and that actions of policymakers have been constructively collaborative instead of protectionist.

Put differently, the world has been using most of its combined resources to deal with such a systemic problem. While such grand collaborative efforts may lead to the risks of huge inflation in the future, the scale of cooperation should likely diminish the menace of “deflationary meltdown”.

So while the US and Europe have closed ranks and concertedly used governments to assume the multifarious roles of “lenders of last resort”, “market makers of last resort”, “guarantors of last resort” or “investors of last resort” to shield its financial system from a downright collapse, Asia’s approach has been mostly “market-oriented”.

Some of the recent developments:

1) Taiwan removed foreign ownership restrictions or opened its doors to the global marketplace (Businessweek) encouraging overseas companies to list, aside from attracting potential foreign investors (particularly China’s resident investors) to participate in Taiwan’s financial markets.

2) Taiwan slashed estate and gift taxes from 50% to 10% (Taipei Times)

3) The Indian response: From the Economist ``On October 6th the Securities and Exchange Board of India removed its year-old restrictions on participatory notes (offshore derivative instruments that allow unregistered foreign investors to invest in Indian stockmarkets). The next day, external commercial borrowing rules were liberalised to include the mining, exploration and refining sectors in the definition of infrastructure. That raised the cap on overseas borrowing for companies in these sectors from US$50m to US$500m—although there may be little international money to borrow.” (highlight mine)

4) To cushion the effects of a global growth slowdown, China’s leaders are presently deliberating to allow its rural farmers to sell or trade state owned land rights and possibly also extending the tenure of land rights ownership from 30 to 70 years.

According to the New York Times, ``The new policy, which is being discussed this weekend by Communist Party leaders and could be announced within days, would be the biggest economic reform in many years and would mark another significant departure from the system of collective ownership and state control that China built after the 1949 revolution….Chinese leaders are alarmed by the prospect of a deep recession in leading export markets at a time when their own economy, after a long streak of double-digit growth, is slowing. Officials are eager to stoke new consumer activity at home, and one potentially enormous but barely tapped source of demand is the peasant population, which has been largely excluded from the raging growth in cities.”

So what could be the potential impact for such a major reforms to China’s rural population? See figure 4.Figure 4: Matthews Asia: China’s Rural and Urban Incomes

According to Matthews Asia, ``This reform is timely as a growing wealth disparity between China’s rich and poor is becoming a concern. China’s rural economy, despite representing over half of China’s population, has lagged behind urban economic development. The agriculture sector currently accounts for less than 12% of the nation’s GDP compared to 25% two decades ago. The top 10% of wealthy individuals command more than 40% of total private assets in the country. The impact of this reform is likely to benefit both the agricultural sector and rural areas by increasing agricultural investment and rural consumption. Enhanced rural standards of living should also help improve farm productivity and yields, important aspects for China to continue its self-sufficiency in grain production.” (highlight mine)

In other words, we shouldn’t underestimate the reforms undertaken by Asian governments out to achieve productivity advantages by tapping into market oriented policies while their western counterparts are presently burdened with restoring credit flows and in the future paying for the cost of such rescue missions.

Inflation As The Next Crisis?

So while the risks are real that the US banking sector could collapse and ripple to the world as global depression, the lessons from Professor Kindleberger shows that panics either exhaust itself to death or will likely get overwhelmed by an overdose of inflationary policies.

Basically all we have to watch for in the interim are the actions in the credit markets. So far we have seen some marginal signs of improvement, but not material enough to declare an outright recovery, see figure 5

Figure 5: Bloomberg: Overnight Libor (left), and TED spread (right)

Yes, markets almost always tend to overshoot, especially when driven to the extreme ends by psychology spasms, but ultimately credit flows are likely to determine the transitional shifts.

If credit markets do recover, market concerns will likely move from threats of a systemic meltdown brought about by “institutional or silent bank runs” to one of the economic impact emanating from the recent crisis.

Besides, the policymakers are likely to keep up with such aggressive pressures to reinflate the system and possibly engage the present crisis with a zero bound interest rate policy which basically adds more firepower to its various arsenals to combat deflation.

It isn’t that we agree to such today’s policy actions but it is what they have been doing and what they will probably do more under present operating conditions. This means that if they succeed in reinflating the system the next crisis would likely be oil at $200!

Figure 7: iTulip: Inflation Is The Menace

According to Eric Janzen of iTulip ``Since the international gold standard was abrogated by the US in 1971, ushering in the second era of floating exchange rates in 100 years – the last one ended badly as well – no deflation has occurred. Japan's experience with "deflation" would not show up on this graph because in no year since 1990 has deflation in Japan exceeded 2%.

“We continue to expect that the actions of central banks to halt deflation will, as usual, in the long run work too well.”

So hang on tight as the next few weeks will possibly determine if our doomsday emerges (and I thought they said that the scientific experiment of the Large Hardon Collider risks a true to life Armageddon) or if the impact from the inflationary overdrive of the collective powers of global central banks materializes.