Capital Crisis

There is talk about monetizing the debt. Well, I think it is being seen right now that the debt is already monetized or have you guys figured this out yet? Thornburg along with the Peloton blow up are showing the cracks.

This is a worldwide phenomenon and its origin is probably the US and European banks. When I went to college, there was a distinct difference preached between money market and capital market assets. Banks really weren't supposed to hold capital market assets, which were meant more for insurance companies and pension funds. Banks were at best supposed to fund the origination and the funding be closed out by a sale to one of these organizations. This is clearly not the method used today.

The skeletons are coming out of the closet. First it was the New York banks. Next it seems to be the hedge funds which were playing the carry trade, leveraging a minimal amount of capital against borrowed funds in a carry trade against bank credit or Japanese bonds to finance a wide variety of what should be savings vehicles. This works as long as the value of the collateral holds up and the rates on the carry stay down. In the case of the Japanese bonds, we are now looking at an appreciation of 3 or 4 points as the yields have moved from the 1.7% range to the 1.35 range, being discount at that rate is almost 100% of interest change. So there is double stress here as the bonds go higher and so does the yen and the American paper collateral shrinks.

How are the banks recapitalized? The only way I know is to take what amounts to bank credit out of circulation and put it on the balance sheet of the bank as some kind of paid in capital. It has to come out of an account that way, meaning the money is actually drained from the system. Another way is to trade bonds to the bank in exchange of stock. In this case, it wouldn't shrink the money supply, but it would remove capital from outside the banking system to inside it.

It is all leveraged. In the case of the mortgage game, the mortgage is leveraged on both sides, one side 10 to 20 to 1 in a lot of cases in the form of financing the purchase of a house and on the other side, maybe 5 or 10 to 1 generally. It appears the Carlyle situation was leveraged 30 to 1, maybe even more, but this was probably a sweetheart bank deal rather than the norm.

In any case, these loans have to be liquidated or the bank is stuck with them further limiting lending and tying up bank capital. There will be no cash raised if they take these mortgages and if the public does step up and buy them unfinanced, the supply of cash in the system will fall.

So what if the Fed comes in and buys this stuff? All it would be doing is making deposits already created liquid. Remember, the bank don't have a money account in reality, only capital to service the money liabilities against them. The Fed does nothing more than keep this part of banking liquid. It is necessary for the banks to have capital to extend credit.

So, we have evolved into a system where finance has replaced capital and the system is lacking in capital. Theoretically the liabilities of the bank represent capital, but only in the sense that they can be converted to capital. They are the liabilities of the bank, which has to have the capital to make good on them. The true capital is the house financed, the inventory financed, the job of the credit card debtor, the undepreciated value of the automobile or the bank interest in financed debt.

Now for the shocker. We are in a position where the US is going to be forced to repatriate all this money around the world. The problem here is that for most countries, the dollar is the capital behind the issue of their own central bank credit. Most of these currencies have nothing to stand on with dollar backing. Can you own property outright in China? Russia? Not really. My best guess is these funds, once the situation stabilizes will come back and buy the mortgage debt. But this isn't going to stop the deflation. It will be the deflation, as the entire world is going to have to recapitalize. The leveraged community will be bankrupt by the time this is done. It is a delusion that to any great extent that hedge funds retain their place in financial matters. We will go back to the old days, maybe all the way back to gold for you guys looking for maximum pain and total bankruptcy.