Tuesday, March 11, 2008

Fed to the rescue?

I think it is time we have a debate here instead of the Bear Board. The posts of the debate get lost too quickly. It appears there is a massive difference of opinion as to what is going on here and I am going to add my two cents worth as I usually do.

As most of you know, I am a deflation guy. It has been my supposition for a long time that the mechanism of lending would break down and the stuff would freeze up and assets and monetary support would start going bad. It is clear to me that has happened. Those that disagree with me are too interested in what the Fed is doing and what commodities are doing to see what is happening. It hasn't occurred to them that operations like Carlyle are folding like cheap metal chairs, but instead like to claim the Fed is throwing money in the streets, just printing it up and throwing it out there with nothing in exchange. We couldn't be further from the truth.

The world has run out of good credit. The United States has been the last resort since 1944, but the world cannot see that. The world has accepted dollars because they needed them to expand their own economies and they have little to do with price levels. The flow of dollars has to do with price levels and the world is addicted to them.

First to the commodities. They have been bulled for a long time and the world is now afraid to recycle their dollars for the paper Wall Street has been putting on them. The float on commodities, once you get past gold, are ridiculously thin. If the company Microsoft changes in value $1 per share, the value of it changes $10 billion. Before the price run up, you could buy almost 2 days supply of oil on the world market for $10 billion. If one was to put in a position to hoard on a permanent and rolling basis 2 days supply of oil, they could drive the price about as high as could be imagined. It would be kind of like pulling 30 minutes supply of oxygen out of a room for a complete day. Someone is going to have to leave the room. The surplus supply of grains and most other commodities is even thinner.

To illustrate, there was rumored to be a 600 million ounce supply of silver in the world. I know this to not be true because if there was, the market would have been out of it a decade ago, the first time someone wanted to corner it. The bulls claimed the shorts just sold more of it to keep the price down. This is absurd. There is nothing ever said that could be more absurd, as the longs were the ones that weren't in the market. All the contracts expired and all the longs had to do is demand delivery. It would have taken all of $3 billion to pick up the entire rumored supply of silver in the world. Of course, the real supply is probably 30 times that, but the bulls would never let you know there was a 30 year supply of silver out there. I should get some debate on this, but I will only say that if the 600 million ounce supply was correct, then the market should have been cornered years ago.

The point here is that it is probably easier to squeeze the world supply of commodities higher than it is to squeeze the world supply of Microsoft higher. The SWF's in Asia are without use for the dollars they previously recirculated through the credit markets here and are instead laying in a supply of commodities. Thus they are paying a price with dollars they sold manufactured good or oil for. Being we do have a shortage of grains, due to more people being able to eat better food, driving the price of these grains higher isn't hard to do.

This move in commodities is being viewed as inflation. But, people forget what inflation is, the creation of debt to buy what was on the market before someone else could buy it. The confusion isn't over inflation, but when the inflation happened. I venture we are watching another bubble, the last bubble. The easiest bubble of all to blow up and the most risky when it deflates. What caused it?

The same thing that has caused the banks problems, unmarketable securities. The banks funded all kinds of stuff they were basically creating for resale. This included mortgage backed securities, debt to take over corporations put together for firms like Blackstone, KKR, Carlyle and others that I won't or can't name. The habit was fund this debt, put the credit out there, usually through an asset backed commercial paper game and liquidate it out to the world. So much of it was CDO's backed by sub-prime mortgages that all of a sudden, they couldn't move it, as word got out this stuff was almost unidentifiable and that certain portions of these CDO's were literally worthless. Then the ABCP market froze and the banks had to create credit on assets they were now stuck with. This is like pulling yourself up by your own bootstraps, in that you can't be your own creditor. Banks don't have accounts, they have assets and liabilities. The liabilities are accounts, so they were using their net worth to acquire this stuff that was falling in value. This created a lack of funds in the system and excess credits outside the system, as the banks couldn't cancel the credit they had to create to fund this stuff they previously funded out of ABCP.

This is where I am going to part company with those that think we are suddenly headed for hyperinflation in a system where lending to any significant degree has frozen up in the most important trade partner in the world. It is clear that this insolvency extends to Europe and the next banking system to implode is going to be Britain. To illustrate what I am saying here, I am going to put up what it seems the sky is falling inflationists believe and what I believe and understand about the banking system. These infusions are different than the past ones.

First of all, the banks are exchanging assets. The Fed is getting good assets. It appears that many of you want to dispute this and that the Fed is just printing money on junk. The Fed has a right to a margin call. http://www.frbdiscountwindow.org/required.cfm?hdrID=19&dtlID=42
There are other documents here, just surf the site and you will find them. What you will find is the Fed requires more collateral than they will loan funds and the stuff has to have a market value, even though the chart infers it doesn't. I don't think you are going to find them taking any level 3 assets and if they do, it will be on solid evidence they have value and I believe the LTV will be 80% of estimated value.

When a bank gives up its assets to the fed, What it gets is other assets called cash or something like cash. Cash don't pay any interest to start. Second, they now have non interest bearing assets to back their liabilities. This won't allow them to create a single dime of extra credit, only service their liabilities between them, their customers and other banks. I think we will find this problem is going to get worse unless the securities they are stuck with suddenly become marketable.

So, why isn't this inflationary? It isn't inflationary because it is to fund money already created, not allow for the creation of more money. This is the money they need to pay their bills for taking the SIV's on their books. It is the money they need to raise because their creation of deposits to fund their own stuff that exceeded their net worth was a fraud in a sense. You might look at http://www.federalreserve.gov/releases/h3/Current/
In this report you might note that there was an excess of $17.265 billion in borrowed reserves over reserves. It shows an excess reserve of $1.8 billion, but I highly doubt this is accurate. The Fed isn't reflecting the true financial position of the banks, which is probably better reflected by the $17.265 deficit in reserves on their books. For those that believe they are printing money here, you might examine the monetary base. Though the auctions have raised $60 billion, monetary base has changed all of $7 billion for the past year, less than 1%.

Why is this not raising the monetary base? Because these invented funds are already in the money supply. The banks can't fund their own liabilities is why they are borrowing the liquidity. This evidently hasn't registered to most of those out there, that the $60 billion or $200 billion or whatever amount you want to talk about has been out there for awhile. This is more like a grocery store going to the bank to get cash to cash more checks.

Here is the deal. Lets say the Fed buys everything out there? What do they have if they buy everything out there? They have all the collateral available to create good credit. The banks then have non interest bearing cash and they owe all the money in the banks to those that are their depositors. At this point, the system might as well shut down and go home because the casino is out of chips. The depositors would remove their cash, go form combines and buy the assets that were worth a damn back from the Fed. In the meantime, the banks would be out of business.

What is going on is clearly being misunderstood. We haven't seen the result of what is going on because the fundings of the SIV's are still floating around the system. This money is chasing commodities, but it is stuff that has already been funded. The system is going to keep getting tighter, as it has no capacity to create new credit. In a month, the Fed will probably roll this new liquidity in the system after asking the banks for their interest payments and reassessing the collateral. The system will have less money in it and the squeeze will start again. We are at the tip of the iceberg here.

At some point, we are going to see the effects of this on world trade. I think we are going to see oil consumption drop. The next shoe to drop is going to be a panic in the Asian markets, as the dollar gravy train is coming to an end. There is going to be a massive retrenchment in US consumer spending because there is going to be a retrenchment in consumer credit. The bottom end consumer is going to be left out of the game on a greater and greater basis. Who will you sell your used car to? How about the starter homes, financed previously by sub-prime? What about the junk credit cards? Hard to see how they lose money with their terms, but my guess is they will just go flat.

Lost in this shuffle is the capacity of the system to create new credit instruments. We can't refund the auction debt of municipalities and other entities. We can't fund anything but prime mortgages and that market is getting tough. The insurers are far from being out of the woods. The next bomb is right around the corner. Lower demand will lead to lower capital spending and lower demand for commodities.

I am making one assumption here, that the world isn't going to ditch the United States. I don't know who they can. It would be like taking first and second gear out of a 3 speed transmission. If you floorboard the car, you can get it moving maybe.

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