Saturday, September 20, 2008

What the real problem is

I need to write something where I am not responding to questions or debating, so I am here. To spend an hour writing something for the PB board as to have it gone in a matter of minutes under the senseless stuff that is quite often posted there is a waste of time for any well thought out post, correct or in error. I know my writing always contains some erroneous conclusion, but amidst the errors is a basic point that is true to the point you can write it in stone.

The first point is that there is nothing new under the sun. FDR started this emergency procedure and it has never stopped since March 4, 1933. The day it stops will be the day that the phrase, "this note is legal tender for all debts, pubic and private", quits showing up on our money. I am not going to write 12USC95a and 12USC95b on this page, as it only consumes time, but I would get a copy of it and read it every time something like this happens. Rubin used it to send $40 billion to Mexico. Not one peep out of Congress. The Fed posted what it was going to do in assisting money market funds and banks in keeping that system liquid, saying there was no debate and they were going to start immediately. What was posted on PB was the press release, but somewhere there was an actual order issued by the Secretary or the President that quoted 48 stat 1 as its authority or 12USC95a and 95b. This is war ladies and gentleman.

I will start out by saying that the net result of what the government is doing in the money markets and capital markets will add up to about nothing. For the most part, what they are doing is assisting in liquidation. This is pretty much all the government does other than finance hot checks and put the balances in some of our accounts. The money market emergency allows the movement of deposits from money market accounts to other accounts by providing temporary liquidity. It allows for banks to deal with their off balance sheet subsidiaries that violate rule 23A or 23B, which deal in size in relation to capital reserves. We are looking at another SIV model in the money market accounts, something that seems to elude a lot of people and little if any insurance, only commercial paper, which is generally very high quality.

FNM, FRE and AIG were taken over in order to keep assets and liabilities that permeate the entire world financial system from collapsing. It appears that they either should have done nothing and let the chips fall or they should have taken in LEH as well. I am not going to get into any of this other than to say that the system is already illiquid and that for the short term, the mistake would be to allow any of these operations with assets and liabilities this large to cease to function. The mistakes made in taking them in can be rectified, as the businesses can be operated and liquidated in some kind of orderly fashion instead of falling into chaos, as is the case for Lehman. We will never know if such action would stop a depression until we do it, but to let them fail in a world system that has so much debt would be certain deflation and depression. If this doesn't work, which I don't expect it to work to the point that it is declared an immediate success, then we will find out about it and speculation that it should be done might end. If it does work, it adds an important tool. On an individual basis, this might be a moral hazard, but company wide, it is definitely a total loss for most involved in ownership of these companies. In the case of FRE, FNM and AIG, the shareholders are left with a maximum of 20% of what comes out of this mess, which probably isn't going to be much. The government stands to lose big or profit big, but the losses that hit the system had these operations failed would have made the government losses that much bigger. They were all headed for bankruptcy by the end of September and the GSE's would have probably been operated at that time under a rule of emergency, as the entire financial system would have seized up.

Here is the problem as I see it and why it can't be solved. I asked last night where were the deposits coming out of all these socalled printing press actions? There aren't any because assets of the system are being bought to liquidate debt and accounts. The actions to support the money market accounts is nothing more than allowing for liquidation of balance sheet assets to move balances. There isn't going to be a 1 cent increase in the balances of the new accounts from the old accounts because the Fed provided the liquidity. There was a reduction of $169 billion in MM accounts last week according to statistics posted by Doug Nolands Credit bubble bulletin. There was no corresponding increase in m1 and m2 to reflect this. Maybe we are dealing with a lag. This isn't the long term problem though

Before all this mess became public, what were the big financials doing with their profits? Well, they were buying back stock and paying huge bonuses. This capital position money was pretty much being put into accounts that became liabilities of the system. To understand banking, one must realize that the balance sheets of the banks reverse mirror the balance sheets of their customers. This is why my deposit is a debit on my account and a credit on theirs. That term used to drive me crazy. Their balance sheet has all their loans on one side of the sheet, the debit side and all their liabilities and owners equity on the other side. Now they have the new games, the SIV's and MM companies that are off balance sheet and most likely have no capital requirements. But that is another matter. The problem with this layout is the net worth of the banks. As you might see, their loan balances and other assets are generally stated to be higher than their deposit liabilities. The paradox here is that the deposits are the only thing in the system as a whole that can pay the liabilities, meaning the capital account or the owners equity if you prefer is an illusion. This works well as long as money circulates in general, but once the imbalance gets large, it no longer works. This is why the rich become poor or much less rich as well in a depression, as their bank balances are required to disappear in order for the system to heal itself.

All the actions I have seen so far have done nothing to change the balance between assets and liabilities in the financial system. The new proposal is to create a super fund, now $700 billion to buy mortgages in the system. What is this going to do? My guess is the government is going to have to sell bonds, which means that all the mone spent to buy the mortgages is going to go back to the government or fed to buy the bonds. The government is going to counterbalance its costs of funds with the income off these mortgages and maybe redeem the mortgages over time. I have heard they are going to pay fair market value for them, maybe sell them off and maybe let some of them pay off on their own. If the bulls are correct, the government will make out like a bandit if they pay something close to FMV for these assets and not just set up a fund to buy bad assets. They say the problem is liquidity. I say it is capital position.

Why is it capital position? As I brought up, this time around, the banks didn't keep their earnings, but instead used them to buy back stock and pay large bonuses to their employees. What does this do? It converts capital to bank liabilities. Not bank assets, but bank liabilities. How? It converts bank capital, the earnings left after operation into money that now exists in the accounts of those that sold the stock. This served to inflate the value of the stock market temporarily as did the leveraging of the balance sheet of banks into more credit. Thus, the net worth of the banks were converted from net worth to liabilities. Pretty amazing fact. Do the transaction if you don't believe me.

Now what kind of deal did the banks make in this matter? Well, I doubt one of them can sell stock at anywhere near what they bought it back for. Also, they are now caught short capital and any capital raised now reverses the transaction I mentioned in the previous paragraph, increasing net worth and decreasing liabilities. But, it also decreases the amount of deposits in the system to pay the assets on the bank balance sheet, something that few understand. The entire cash movement in banks is a reduction or increase of liabilities and a reduction or increase in owners equity and there isn't a cash account per se on the debit side of the account other than cash held as an asset, as in Federal Reserve cash or credit balances of the Federal reserve. The exchange of check is all done on the other side of the equation and against assets,but rarely against cash to a significant degree with the public.

So here is the real problem. If we start out with a bank that has lets say $1 billion and it represents the entire game of credit. If it earns a net 3% on its business after expenses, its net worth will be $2 billion at the end of 24 years. It will owe $1 billion and have $3 billion or it will owe $2 billion and have $2 billion. Thus it will now have assets, mostly loans and cash of $4 billion and liabilities of $2 billion. This could be more extreme in that it might have assets of $10 billion and liabilities of $8 billion and owners equity of $2 billion. This works well as long as the bank is still acquiring physical assets or collateral as part of its net worth and the balances it owes to customers is circulating around the community as medium of exchange.

But, what happens once the system becomes highly collateralized and the bank no longer can expand its assets and liabilities against existing assets? Well, it still might work as long as the balances are circulating, but in time something is going to happen. The bank is going to make a mistake in sector lending, thus lend too much against real estate or stocks or new business or inventory. Second is the mathematical equation that money won't circulate evenly and the liabilities of the banks will become concentrated in one group of hands and the assets will be claims against another group of people. Thus, in either case, what started out as a bank having $1 billion morphed into the bank having $2 billion and the people having a billion to pay back the banks $3 billion or whatever.

One thing is clear and that is once systematic imbalances do occur, the problem of debt increase moves from being shown in price inflation to asset inflation, as the balances that increase over time become concentrated in the hands of few who now spend their money to enhance returns rather than to buy Cadillacs. They leave these acts to the welfare queens and the general public, who continue spending and increasing their pile of cash assets. Thus the bank balance sheet becomes a picture of liabilities it owes to a group that is entirely different than the group in general that owes its assets. A prime example would be a guy that bought a nice real estate project with 20% down for $1 billion. This guy is rich, but the loan proceeds went into the accounts of a group of 25 partners who now have $40 million each to draw interest off of and bid for other assets. Most will look to buy some stock of some other rich guy who will maintain the cash in his account. The money might filter down, but it won't filter down to the guys it needs to filter down to and it probably won't make it back long term to the guy that just borrowed the $800 million. That guy is going depend on the little guys continuing to get cash to go shopping and once that don't occur, the bank is going to get the project back. The entire value of the project then becomes the availability of credit for the middle class guy to go shopping and the next rich guy to buy the project. If credit for either disappears, the bank becomes dependent on the previous sellers or their assigns to come back and buy the property, hopefully at a price of at least $800 million. In the procedure, the $200 million put up for the purchase appears to have disappeared, but in reality, it exists now as a bank liability to the previous sellers or their assigns as well. Thus we have entered a period where the assets can't support the liabilities and the liabilities can't support the assets and the net worth must be adjusted downward. (if this appears to be out of order, I added it later so the flow to the next paragraph is going to look a little jerky)

So lets see what is happening today? First of all, this thing operates in a loop. The Fed doesn't print money and give it out without acquiring interest bearing assets in return. So, the more the Fed puts out, the more it takes back in the form of interest, thus its activities are always a net drain over time. Second, the banks give up their good assets and the Fed is taking even less good assets, but lending less money against them if this is necessary. But, they aren't printing money, but temporarily liquidating the assets of the banking system to supply cash equivalents to settle the liabilities of the system. They are not making these loans to allow the banks to loan money, only to settle their balances between themselves created out of prior loan activity. An example is the money market mess that erupted this week out of the LEH bankruptcy and most likely has been brewing for 20 years. The Fed opened a special window to allow for liquidation of commercial paper to facilitate the relocation of these liabilities. Lets say the head organization is Chase. If Chase is faced with a run on its off balance sheet MM fund, it can face a liability of huge amounts that it can't liquidate in the current market. If all the money merely moved from Chase MM account to Chase bank, the bank could merely buy the assets of the MM fund with the deposits moved, a trade. But lets say that Chase MM account has $10 billion that moves to another bank. Chase has no way of moving that money save an around the block liquidation of commercial paper in an unstable market. There was $90 billion moved in one day, so you might grasp the problem. There wasn't any new money created here, only a facilitation of liquidation of high qualilty, short term paper. The balances remain the same, only the collateral rests with another bank. There is no more money to lend, as the liability exists and has not been extinguished. Only the holder of the collateral and how draws the interest on it has changed.

The FNM, FRE and AIG take overs are another game. That said, has the government done anything different than KKR did with AIG? The government has backstopped these crucial organizations, not monetized them. The corporate takeover boom of the past 5 years was much more inflationary and dangerous than these moves. Credit contraction and squeezes were the problems with these firms along with maybe insufficient capital to exist as financial intermediaries. This doesn't mean they had negative worth on the market though. In the case of AIG, it had one side that was a mess and the other side which was probably worth more than the bad side was negative. But, it had to operate as an ongoing financial entity and it wasn't going to operate as such under the current financial conditions. Thus it was not going to match its cost of doing business with its income. Neither were FNM and FRE and all of them were woven throughout the world financial system. The government didn't even write a check to buy these operations in the sense that KKR, Blackstone, Cerebus and the other raiders would have. The idea at which end the government was going to get the bill for these failures was really a choice of whether they wanted to go through the worldwide financial failure or not. I don't think there is going to be a choice, as the whole thing is going to deflate, but this buys time.

For the inflationists, where is the capital? The financial system needs capital, not Fed funds injections to expand. They need fed funds injections to meet the liabilities and imbalances in the system, not to make new loans. What about the GSE's and AIG? AIG sold for roughly $100 a share in 2000. That means their top worth was well in excess of $200 billion. FRE sold for roughly $70 per share in December of 2004. This talllies to $45 billion. FNM brought $86.75 in January of 2001. With roughly 1 billion shares, that is $86 billion. So conservatively we are talking about 3 institutions that had a worth of well over $330 at their combined peaks and now the private side of these 3 are worth less than $12 billion, over $10 billion still accorded to AIG. I highly doubt that at this fire sale time that the enterprise liquidation value of AIG is going to come anywhere near $50 billion, which is what it would have to bring in order for the current price to hold true. Chances are that by the time it pays the government its financing fees, buys its way out of its derivative positions that the whole thing might produce $5 billion. AIG stock is a dead short, which is why shorting has been banned.

The brokers are another animal. The Government didn't take over any brokers because the brokers depend on keeping their large customers. What customers would stay with a broker should the company be taken over by the government? Well, I think we all know the answer to that, which means that there wouldn't be a enterprise value at all for these guys because their business was gone the day the government would have stepped in. AIG and the GSE's have a potential enterprise value and I suspect that the GSE's might be significantly undervalued in the current environment, but then again might not be worth anything. But, it appears that the government is going to have to cut these guys into what they sell the next time around the block, regardless of how much money they have to put in. I don't believe this is true of AIG, which is being propped by a loan in exchange for high interest and 80% of the equity. The LIBOR plus 8% is going to force time to be of essense in this matter and the assets will probably be moved at less than attractive to AIG prices. The good side of AIG is a Cadillac in a stable of Fords, while the bad side is the sludge at the bottom of the feedlot pit.

No one has explained to me where the capital is coming from? All these transactions involve giving up good assets for liquidity that is already owed. The best the Fed can do is keep the price of assets up by preventing the system from freezing up. The now $700 billion bailout involves selling mortgages that to this point are illiquid. If they are bad paper, they won't bring much, so the entity selling them is going to have to take a writedown. Maybe this will allow some writing up of assets as some of the poor value has to do more with the fact that there isn't a market for them, but it won't make the assets good nor will it allow for capital appreciation. This is basically allowing companies to move their assets to liquidate their liabilities. It will speed deflation rather than prevent it.

Lets say that they do put up $700 billion? How are they going to finance this? My guess is a swap of treasuries for the mortgages. That was how the RTC was handled, but this has a problem attached to it. The government is limited in how much they can pay for this crap and if it is indeed toxic waste, this will be very little. In fact, there is a lot of level 3 assets that I suspect fit this category that have been marked to some kind of fiction that may be bought here. If the market price is what many of us expect, there will no longer be a mark to model or some other kind of fiction to support the fiction on the balance sheet of GS, MS, BAC, MER and others. The problem for all these assets holders is the fiction will no longer be the fact. There will be more hell raised than can be spoken generally over the next century in the next year if they end up paying a massive subsidy to the failed financial system. So, the best the system can do is sell these assets in return for treasuries. This won't be rolled off the press cash and the treasury and these sellers now exposes themselves to an interest rate risk and to a need to move interest rates on the short term higher to protect the dollar.

My points are that buying the assets of the banking system don't do anything to remove the liabilities of the banking system. They can support the liabilities of the banking system, but they can't make the assets good because the assets are owed by an entirely different group of people. They can tax away the liabilies and give the money to the other side of the equation if they close Walmart and do away with the game over a period of years, but they can't make the assets good or keep the liabilities intact over time. The problem is that credit has expanded to maximum potential and now has to implode. Banning short selling, the government purchasing assets at FMV, the government buying treasuries, etc., none of this extinguishes the liabilities in the system or creates a dime of capital. The losses or the bill is now coming due.

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