It is too late to avoid a depression in the US now. If the steps taken today were taken 12 months ago, right after the collapse of Bear Sterns, there would have been some possibility of an eventual turnaround. But the authorities ignored all the signs of impending economic calamity, dismissed the gigantic and interconnected risk structures of the past era as a market mechanism, and when that mechanism attempted to correct itself, they did not allow it to liquidate the bankrupt sectors. And now, by sustaining the tumour, they ensure that the cancer will do long term damage.

The government and the Federal Reserve are trying to make the American people spend like they were doing in the past, but unlike the past, there’s no credit, no secure jobs, no appreciating asset markets to back their exhortations. In response, Americans are saving like they have not done for quite a while. The dream is that ghe government can make people spend by simply giving them money; a foolish proposition disproven by the decades-long slump of the Japanese economy, and the various stagflationary periods of different nations.

There are two types of economic boom. One is created by expanding money supply and government action. The other is caused by fundamental factors such as technological innovation, or the global spread of productivity-enhancing techniques and tools. The former only creates illusory periods of speculative inflation, and its consequences are destructive, not creative. The latter can also fuel speculative activity, but it’s impact is usually long-term, and positive for the society at large. Our pessimism for the next 5-10 years is due to the fact that there will be a lot more monetary expansion than productivity-driven growth during the period. And the consequences of that will be turmoil, conflict, poverty, and despair.

As the sole remedy, we would be much more optimistic if China could be made to unleash its potential in a healthy manner. But given the attitude of the government, and also the traditions of the China people, we have grave doubts about the credibility of the “China-saves-the-world” scenario.

Yes, the stock market is rallying right now. Commodity markets are also rallying, and even shipping rates have been rising for a while. But we ask the reader to keep our word in mind, and to come back here a while later to check if we have been right or not: these episodes in all these markets are but bouts of volatility, created by the disappearance of the many liquidity-generators. The up-up-up markets of the past were an aberrance, and now we’re back to a normal situation where volatility complicates trading decisions, and economic analyis.That the economy will be in a slump for many years to come is a certainty. How much money the governments will print in their futile endeavour to resurrect a dead banking system in a deflationary environment is uncertain. Consequently, it is not possible to know if the price of a barrel of oil will be 1 USD, 10 USD, 100 USD, or 1000 USD, but until real liquidation and consolidation reshape the global financial system, volatility will remain high, real GDP growth will be low, and ROI in general miserable. We’d willing to bet one million dollars on this conjecture.


Commercial mortgage delinquencies continued to rise in November, as would be expected. The highest-rated CMBS are right now paying about a massive 12 percentage points more than Treasuries, compared with with just 0.82 in January:

Commercial mortgage delinquencies rose in November and will climb as the economy slows and unemployment grows, according to Barclays Plc.

Payments more than 60 days late on commercial real estate loans that were bundled together and sold as bonds increased to 0.69 percent last month, compared with 0.57 percent in October and 0.51 percent in September, Barclays data show.

The “relative spike” in delinquent loans marks the “beginning of a sustained, upward trend,” Barclays analysts led by Aaron Bryson in New York said in a report yesterday. “We have repeatedly stressed that CMBS delinquencies are a lagging indicator of performance and tend to lag changes in employment by close to a year.”

Waning demand for the bonds, which are backed by pools of commercial mortgages, caused sales to slump to $12.2 billion this year, compared with a record $237 billion in 2007, according to JPMorgan Chase & Co. estimates.

Delinquent Retailers

Retailers are leading the rise in commercial mortgage delinquencies, according to Barclays. Late payments on retail space rose to 0.58 percent in November, compared with 0.43 percent in October, the data show.

 “The depth and length of this economic downturn looks to be materially worse than many investors initially expected and worse than that experienced during the last recession,” the analysts wrote in a Nov. 26 report.

Looser Underwriting

Underwriting standards on commercial real estate mortgages taken out between 2005 and 2007 were looser than those on loans in prior years, which will contribute to more delinquencies, the JPMorgan analysts said.

The impending default of two commercial mortgages sent spreads soaring to record highs last month. A $209 million loan to finance the Westin La Paloma Resort & Spa in Tucson, Arizona, and the Westin Hilton Head Island Resort & Spa in South Carolina, is near default after cancellations sapped revenue. In southern California, the owner of the Promenade Shops at Dos Lagos missed two payments on a $125 million loan.

The loans were among the largest in a $1.16 billion commercial mortgage debt offering sold by JPMorgan on April 30, Bloomberg data show.

Another hedge fund has frozen redemptions:

Fortress Investment Group LLC fell 25 percent to a record low after the private-equity and hedge-fund manager halted redemptions from its Drawbridge Global Macro fund, which had lost value this year.

Investors asked to withdraw $3.51 billion by year-end, including the $1.5 billion in redemption notices disclosed last month, the New York-based company said today in a filing with the U.S. Securities and Exchange Commission. Fortress spokeswoman Lilly Donohue declined to comment.

“The market essentially lost faith in Fortress as a franchise so that anything Fortress does is tainted by problems that it had in its private-equity portfolio,” said Jackson Turner, an analyst with Argus Research Co. in New York, who has a “sell” rating on the company.

More than 80 firms have liquidated funds, restricted redemptions or segregated assets following a stock-market decline and a credit freeze that started with a housing slump and rising defaults on U.S. subprime mortgages. Hedge funds have posted losses averaging 23 percent this year through Dec. 1, according to Chicago-based Hedge Fund Research Inc.’s HFRX Global Hedge Fund Index.

Fortress said in November its hedge-fund clients asked to pull more than $4.5 billion, or 25 percent of their money, as the company reported its first quarterly loss since going public. The Drawbridge fund had $8 billion as of Sept. 30, and the requested withdrawals amount to about 44 percent of the money pool, said Roger Smith, an analyst with Fox-Pitt Kelton Cochran Caronia Waller USA LLC in New York. Drawbridge lost 12 percent this year, he said.

The hedge-fund industry may shrink as much as 45 percent by the end of this month to $1.1 trillion from its peak of $1.9 trillion in June because of investor redemptions and market losses, Morgan Stanley analyst Huw van Steenis said in a Nov. 24 report.

Yields on speculative-grade bonds imply a default rate of 21 percent, which is higher than the record of the Great Depression. Moody’s forecasts the U.S. default rate to rise to 3.3 percent in October, to 4.9 percent in December 2008 and to 11.2 percent by November 2009. In other words, the US economy will face a period of consolidation and reorganisation, and the US economy of tomorrow will probably depend on exports and manufacturing to a far greater degree than the economy today does. In essence, we’re witnessing that much feared, and discussed, seldom understood unwinding of global imbalances: China is forced to shrink its export sector, as the US is forced to restrain its domestic spending habits. While in sum this is a healing process, the surgery is rather painful because the patient was a bit too late in seeking help for its illnesses:

The extra yield investors demand to own U.S. high-yield bonds was 19.19 percentage points on Dec. 1, according to Moody’s. Assuming a 20 percent recovery rate, the spread implies a default rate of 20.9 percent, John Lonski, chief economist at Moody’s Investors Service, said yesterday in a market commentary. That compares with a rate of 11 percent in January 2001, 12.1 percent in June 1991 and 15.4 percent in 1933.

Defaults and bankruptcies are accelerating as financing options for high-yield companies dwindle amid the longest U.S. economic recession in at least 26 years. The U.S. default rate rose to 3.3 percent in October, according to Moody’s, which forecasts the rate to increase to 4.9 percent in December and 11.2 percent by November 2009.

“The default rate is going to start rising quickly, soon enough it’s going to be breaking above 10 percent,” Lonski said in an interview. “Lack of access to financial capital is a very big problem for high-yield bonds.”

Hawaiian Telcom Communications Inc., a provider of local and long-distance telephone service, and Pilgrim’s Pride Corp., the largest U.S. chicken producer, sought bankruptcy protection on Dec. 1, as they struggled with too much debt taken on before the credit crisis.

Trump Entertainment

Trump Entertainment Resorts Inc., the casino company founded by Donald Trump, had its ratings cut by Moody’s on Dec. 1 after announcing last week it would forgo a $53 million interest payment to conserve cash. Moody’s lowered its probability of default rating to Ca from Caa2 and its rating on the company’s senior secured notes due 2015 to Ca from Caa2, with a negative outlook, suggesting the company is more likely to default.

Three companies have sold $2.7 billion of high-yield bonds this quarter, compared with $30 billion in the same period a year ago, according to data compiled by Bloomberg. Leveraged loans arranged this year total $301 billion, down more than a third from last year, Bloomberg data show.

“There’s a lot of forced selling of high-yield bonds by hedge funds owing to the need to de-lever as well as by mutual funds in response to redemptions,” Lonski said. “You’re looking at a market where the sellers well outnumber the buyers and the reluctance on the part of buyers makes sense if only because a bottom for economic activity is not yet in sight.”

High-yield, high-risk bonds are rated below Baa3 by Moody’s and BBB- by Standard & Poor’s.

Today Mr. Bernanke enlightened us further on his solution to the credit crisis. What they will be doing, in essence, is selling Treasuries to the market in order to accumulate the funds with which the bailouts are financed, and after that, as yields fall to very low levels, buying the same Treasury bonds, and thereby injecting liquidity to the markets. Thus it sound circular? It does, and it is another of the Federal Reserve’s much publicized but eventually useless financial trickery.  

Why were the Treasuries sold? Because the government wanted to assume the role of the financial intermediary, as banks were unable to undertake their usual duties in that capacity. Since liquidity didn’t flow through private financial channels, the government sucked it out, and splashed it on bankrupt firms, by virtue of its AAA credit rating, and sovereign status. So what makes the Federal Reserve expect that throwing that same liquidity back into the market through Treasury buybacks will cause any changes? In fact, it’s a declaration of bankruptcy. The more he tries to reduce the rates on treasury bonds, the more liquidity will be sucked from markets, since more attractive government paper will necessarily cause other asset classes to present  even less value to investors. We’re back to square one:

“Although further reductions from the current federal funds rate target of 1 percent are certainly feasible, at this point the scope for using conventional interest-rate policies to support the economy is obviously limited,” Bernanke said in remarks to the Austin Chamber of Commerce.

One option for reviving the economy is for the Fed to buy “longer-term Treasury or agency securities on the open market in substantial quantities,” Bernanke said. “This approach might influence the yields on these securities, thus helping to spur aggregate demand.”

While Bernanke was “pretty aggressive on the possibility of the Fed using its balance sheet aggressively through Treasury purchases,” he wasn’t specific about the policy path because he probably didn’t want to preempt the discussion at the FOMC meeting in two weeks, said Sack, a former Fed economist.

The Fed will “continue to explore ways” to keep the market federal funds rate closer to policy makers’ target, after paying 1 percent interest on banks’ reserves failed to stabilize the rate, Bernanke said. The average daily rate has been below the central bank’s target every day since Oct. 10.

That’s because Fannie Mae and Freddie Mac, which are “large suppliers of funds,” aren’t eligible to get interest from the Fed and thus lend below the Fed’s target, Bernanke said.

Last week, the Fed announced two new programs aimed at unfreezing credit for homebuyers, consumers and small businesses. Those include a commitment to buy as much as $600 billion of debt issued or backed by government-chartered housing-finance companies and a $200 billion initiative to support consumer and small-business loans.

 ‘Sustainable Level’

The Fed’s balance sheet “will eventually have to be brought back to a more sustainable level,” Bernanke said. “However, that is an issue for the future; for now, the goal of policy must be to support financial markets and the economy.”

US manufacturing contracted in November at the steepest rate in 26 years. Chinese manufacturing PMI aso contracted.

The Institute for Supply Management’s factory index dropped to 36.2, below economists’ forecasts, and its gauge of raw- material costs plunged to the least in six decades, intensifying concern over deflation. The Tempe, Arizona-based group’s report came as factory indexes in China, the U.K., euro area, and Russia all fell to record lows.

 “This downturn in the global economy is probably more synchronized than we have ever seen,” said Jonathan Basile, an economist at Credit Suisse Holdings in New York. Policy makers should “open the flood gates” for more action, he said.

Construction Spending

A report from the Commerce Department also showed construction spending fell 1.2 percent in October, a bigger drop than forecast, as a slump in homebuilding spread to non- residential projects such as power plants, churches and highways.

China’s purchasing managers’ index fell to a seasonally adjusted 38.8 from 44.6 in October, the China Federation of Logistics and Purchasing reported today. An index covering the 15 nations sharing the euro dropped to 35.6, the lowest since Markit Economics began the poll in 1998.

VTB Bank Europe’s index covering Russia fell to 39.8, and the U.K.’s Chartered Institute of Purchasing and Supply’s factory index was at 34.4, the least since the survey began in January 1992.

New Orders, Production

The U.S. ISM’s purchasing managers’ gauge of new orders for factories decreased to 27.9, the lowest since 1980, from 32.2 the prior month. The production measure fell to 31.5 from 34.1.

The index of prices paid dropped to 25.5, the lowest level in six decades, from 37. That adds to concern that the U.S. economy may be at risk of deflation, a sustained decline in prices and wages caused by scarce credit. Deflation can worsen a recession by making debts harder to pay and countering the effect of interest-rate cuts.

Orders from overseas continue to weaken as economies abroad contract. ISM’s export gauge was unchanged at 41, the lowest reading since records began in 1988.

 ‘Difficult Years’

We are all expecting the year 2009 to be a very low year in terms of demand, not only in the United States, but globally,” Carlos Ghosn, chief executive officer of Nissan Motor Co., said in a Nov. 19 interview on Bloomberg Television. “We may be facing a couple of difficult years, with very low demand.”

In anti-climactic moment, NBER has declared a recession in the US:

The U.S. economy entered a recession a year ago this month, the panel that dates American business cycles said today, making this contraction already the longest since 1982.

The declaration was made by a committee of the National Bureau of Economic Research, a private, nonprofit group of economists based in Cambridge, Massachusetts. The last time the U.S. was in a recession was from March through November 2001, according to NBER.

 “It is clearly not going to end in a few months,” Jeffrey Frankel, a member of the NBER committee and a professor at Harvard University, said in an interview. “We would be lucky to get done with it in the middle of next year.”

The loss of 1.2 million jobs so far this year was the biggest factor in determining the starting point of the U.S. recession, the NBER said. By that measure, the contraction probably deepened last month.

At 12 months, the current contraction is already the longest since the 16-month slump that ended in November 1982, and exceeds the postwar average of 10 months.

The contraction is the second under President George W. Bush’s watch, making him the first U.S. leader since Richard Nixon to preside over two recessions.

Summers, More Action

Lawrence Summers, President-elect Barack Obama’s pick for White House economic adviser, said the economy is getting worse and requires more legislative action.

“Recent economic evidence suggests that the pace of this downturn is accelerating,” Summers said in a statement. He said Obama wants to enact a recovery package “soon after taking office.”

The likely length of this downturn may cast doubt on economists’ view that the business cycle was moderating in recent decades.

“Everyone had thought long, deep recessions were a thing of the past,” Frankel said. “There was a lot of talk of the new economy.”

More than 80 hedge funds have liquidated, restricted redemptions or segregated assets during the credit crisis so far. The reader should remember that market-size contraction is the hallmark of this crisis. Another one did so today:

Tudor Investment Corp., the firm run by Paul Tudor Jones, temporarily suspended client redemptions from the $10 billion BVI Global Fund Ltd. as it plans to split the hedge fund into two.

Tudor is proposing to put hard-to-sell investments, mostly corporate bonds and loans from emerging markets, into a new fund called Legacy, Jones said in a Nov. 28 letter to investors. BVI Global, the flagship fund Tudor started in 1986, would focus on easier-to-trade stocks, bonds, commodities and currencies.

Investors asked to pull 14 percent of their money from BVI Global as it lost 5 percent this year through November, according to the letter. That compared with an 18 percent loss through October of the Multi-Strategy Index compiled by Hedge Fund Research Inc.

Tudor, which oversees $17 billion, is asking BVI Global investors to approve the plan to split the fund in the next two months. Clients would have their money allocated between BVI Global and Legacy based on the division of assets.

Legacy will account for about 29 percent of BVI’s assets as of March 31, 2009, according to the letter. It will include emerging-market corporate credit debt, which has “ceased to be tradable,” as well as investments in private equity and hedge funds.

Emerging-markets securities have fallen as commodity prices plunged and investors shunned riskier assets on concern the global economy is entering a recession. The MSCI Emerging Markets Index has dropped 58 percent this year.

Jones, 54, told clients in August that Jim Pallotta, head of equities, is leaving to start his own firm. Pallotta will keep the Raptor Global Fund that he runs out of Boston from January. The fund lost 16.5 percent this year through Nov. 19, according to investors.

Industry Contracts

The hedge-fund industry may shrink as much as 45 percent by the end of this month to $1.1 trillion from its peak of $1.9 trillion in June because of investor redemptions and market losses, Morgan Stanley analyst Huw van Steenis said in a Nov. 24 report.

Hedge funds have posted losses averaging 22 percent this year through Nov. 24, according to Chicago-based Hedge Fund Research’s HFRX Global Hedge Fund Index.

And another one:

Highbridge Capital Management LLC, the $20 billion investment firm run by Glenn Dubin and Henry Swieca, is limiting client withdrawal requests to avoid selling assets at distressed prices, according to a person familiar with the matter.

Investors who submit withdrawal requests to the $1.9 billion Asia Opportunities Fund this quarter will get half their money by the end of January. The fund, which lost 32 percent this year through October, will return the rest within 12 to 18 months.

Highbridge, based in New York, will segregate hard-to-sell assets and sell them off over time in the hope that prices recover and clients get more money back. Firms including Tudor Investment Corp. and GLG Partners Inc. have taken similar steps in the past month.

The fund gained 18.7 percent last year, 15.4 percent in 2006 and 6.88 percent in the previous year when it was started. JPMorgan Chase & Co., the largest U.S. bank by assets, bought a majority stake in New York-based Highbridge four years ago and increased its ownership to 78 percent in January.

Corporate bonds, CDS, libor, commodities, are all in crisis mode at the moment. But the situation is not the same as in September, the financial system is already wrecked, and all that the investor has to do is waiting. A general pessimistic bet on the economy is likely to pay well for the next six months, even if angels descend to the Earth to save us all.

The cost of protecting corporate bonds from default surged to records around the world as the prospect of U.S. automakers filing for bankruptcy protection fueled concern of more bank losses and a deeper recession.

“Markets are back in crisis mode,” said Agnes Kitzmueller, a Munich-based credit strategist at UniCredit SpA, Italy’s biggest bank. “There is fear in the market.”

General Motors Corp., Ford Motor Co. and Chrysler LLC executives left Washington empty handed yesterday after two days of pleading with lawmakers for a $25 billion bailout. Credit markets have “significant” liabilities to the automakers, raising the prospect of “continued writedowns,” BNP Paribas SA analysts told investors today.

Credit-default swaps on the Markit CDX North America Investment-Grade index jumped 23 basis points to an all-time high 270, according to broker Phoenix Partners Group at 11:15 a.m. in New York. The Markit iTraxx Crossover Index of 50 European companies with mostly high-yield credit ratings rose 37 basis points to 927, having earlier traded at 933.

Stocks slumped worldwide as a Conference Board report of leading economic indicators fell for the third time in four months, signaling a deepening recession. U.K. retail sales dropped for a second month in October as rising unemployment and the financial crisis dissuaded shoppers from spending.

Treasury yields declined to record lows, with two-year notes dropping below 1 percent for the first time, as investors shunned all but the safest assets.

Credit-default swaps on New York-based Citigroup Inc. rose 40 basis points to 405, Phoenix prices show. Contracts on Goldman Sachs Group Inc increased 65 basis points to 400 and Morgan Stanley rose 60 to 515.

“Anything’s possible in this market,” said Mark Bayley, a director of credit at ABN Amro Holding NV in Sydney. “You’re seeing sellers of risk and very few buyers. The sellers are becoming more stressed and willing to accept very wide spread levels for corporate bonds.”

Investors also shunned high-risk, high-yield loans, driving the Markit iTraxx LevX index of CDS on leveraged buyouts down to a record low of 78.5, BNP Paribas prices show. The current series of the index began trading at 99 on Sept. 29. The benchmark falls as credit risk rises.

The US Treasuries keep outperforming everything else. But this may not remain so forever, if the Fed decides to activate its most outlandish contingency plans, so to speak. I believe that the Federal Reserve is soon going to engage in the most unprecedent reflationary effort of any government at any time, and we’ll together see the results of the experiment. Three month treasuries are yielding 2 basis points, that is 2 hundredths of one percent, at the moment.

Treasury yields declined to record lows, with two-year notes dropping below 1 percent for the first time, as global stocks slumped and a deepening recession drove investors to the safest assets.

Yields on two- and five-year notes and 30-year bonds dropped to the least since the Treasury began regular issuance of the securities. Ten-year note yields touched the lowest since 2003 after yesterday’s release of the minutes of last month’s Federal Reserve meeting showed policy makers expect the economy to contract through the middle of 2009 and more interest-rate cuts may be needed to counter deflation.

Investors turned to government debt as recessions in the U.S., Europe and Japan hurt corporate earnings and drove prices of shares, commodities and real estate lower. Stocks declined worldwide, with the MSCI World Index losing 2.4 percent.

Longer Maturities

The 30-year yield fell as much as 21 basis points to 3.70 percent, the lowest level since regular sales started in 1977. Yields on five-year notes declined to 1.93 percent, not seen since 1954, according to data compiled by Bloomberg and the Fed.

Treasury Bill Rates

Two-year notes returned 6.5 percent in 2008, compared with 7.5 percent last year, according to indexes compiled by Merrill Lynch & Co. The yield declined from 3.11 percent on June 13, the highest level this year.

Rates on three-month bills dropped to 0.02 percent. That equals the level reached after the collapse of Lehman Brothers Holdings Inc. on Sept. 17, the lowest since the start of World War II.

Fed officials lowered their economic-growth estimates to zero to 0.3 percent for 2008, from 1 percent to 1.6 percent previously, the median forecast of Fed governors and district- bank presidents showed. The predictions for GDP next year ranged from a contraction of 0.2 percent to growth of 1.1 percent. The jobless rate is projected to be 7.1 percent to 7.6 percent.

Derivatives contracts tied to the value of the yen have helped drive down 10- and 30-year interest-rate swap spreads as the Japanese currency rallies against the dollar, Ahrens said. The yen has gained 12 percent since September as investors purchase the currency to repay loans made in Japan in order to unwind investments in higher-yielding assets.

Paulson’s Decision

The price to exchange, or swap, floating for fixed-rate payments for 30 years fell below the yield on similar maturity Treasuries by the most ever as dealers hedged against risk related to derivatives, Ahrens said. The yield on the 30-year bond was as much as 51 basis points higher than the 30-year swap rate. The swap rate has remained below the long bond’s yield since Nov. 5.

The gap between 10-year swaps and the 10-year note yield reached as low as 6 basis points, the narrowest since at least 1988, when Bloomberg data began tracking the instruments.

Yields have hit record lows since Treasury Secretary Henry Paulson said on Nov. 12 he would abandon plans to use the Troubled Asset Relief Program to buy mortgage assets from banks. The London interbank offered rate has spiked 11 basis points in the three days after Paulson’s shift. Before Paulson’s announcement Libor, which banks charge each other for three- month loans in dollars had fallen for 23 straight days.

“Changing the terms of the TARP as suddenly as he did undermined investor confidence,” said Richard Schlanger.

Investors erased more than $33 trillion from global stock markets this year as the U.S., Europe and Japan slipped into recession.

Breakeven rates, which show the difference in yields between inflation-linked and nominal bonds, suggest traders are betting the U.S. economy may face deflation over the next two years. The two-year U.S. breakeven rate was minus 4.09 percentage points.

“You have the cloak of a declining inflationary environment,” said Tom Tucci, head of U.S. government bond trading in New York at RBC Capital Markets, the investment- banking arm of Canada’s biggest lender. “People are denying it, but we are mirroring the whole Japanese situation and if that’s the case interest rates are going to go a lot lower.”

Credit rating downgrades are going on, adding fuel to fire. Though of course, it’s the natural outcome of past’s complacency, and the rating agencies should not be blamed for downgrading these firms now, but for not having downgraded them before.

Macy’s Inc., the second-biggest U.S. department-store company, is headed into the holidays facing the possibility of losing its 11-year-old investment-grade rating.

Macy’s debt has started trading like a junk bond, a signal that ratings companies may demote the owner of Bloomingdale’s department stores to non-investment grade. That would increase the company’s cost of raising funds at a time when capital is increasingly difficult to come by and the retailer is preparing for about $1 billion in 2009 debt repayments.

“The last thing Macy’s needs at this point is a downgrade,” Pete Hastings, a fixed-income analyst with Morgan Keegan & Co. in Memphis, said today. “They’ve got enough trouble the way the economy is going, and this would just make things tougher for them.”

Junk Territory

The extra yield, or spread, that investors demand to own Macy’s 5.35 percent notes due 2012 instead of similar-maturity Treasuries was more than 15 percentage points yesterday, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

That was greater than the 13.2 percentage-point spread on non-investment-grade BB rated bonds, according to Merrill Lynch & Co. index data. The spread on J.C. Penney Co.’s similarly rated debt due 2023 was 765 basis points. A basis point is 0.01 percentage point.

Moody’s Investors Service said Oct. 15 that it had a “negative” outlook on Macy’s Baa3 rating — the lowest investment grade — meaning it was more inclined to downgrade the retailer. Standard & Poor’s Corp. did the same on Oct. 10. They may next put Macy’s on review for a downgrade, or simply cut ratings without the interim step.

`Not Ordinary Times’

“Ordinarily they wait until the holiday season is over to make changes to retailing ratings, but these are not ordinary times,” Carol Levenson, an analyst with Gimme Credit LLC in Chicago, said Oct. 15. “Given the agencies’ waning credibility in other areas, they may be quicker to pull the trigger on marginal names such as Macy’s than they would have been before the credit crisis.”

The company plans to pay off debt due next year with cash and may use its $2 billion credit facility, he said. It has borrowed $150 million, he said.

That plan may impair the retailer, Hastings said in a telephone interview.

“If they use cash on the balance sheet to reduce debt to keep the investment grade, they would have less flexibility to weather the downturn,” he said.

Sales at stores open at least a year may fall as much as 6 percent in the fourth quarter, after dropping in 10 of the last 11 quarters, Macy’s said.

A rating downgrade can depresses demand for bonds because some funds prohibit investing in junk. The rating increases borrowing costs by forcing the company to offer investors a higher interest rate to assume more risk.

Macy’s would be joining General Motors Corp. and a growing number of so-called fallen angels — former investment-grade companies. There were 40 as of Nov. 11, compared with 29 a year earlier, according to an S&P report. Fifty-seven more, including Macy’s, are at risk of being downgraded to speculative grade, S&P said.

Macy’s, which runs more than 850 stores, has $350 million of bonds coming due in April and about $600 million in July, according to data compiled by Bloomberg.

The retailer’s ratio of debt to earnings before interest, taxes, depreciation and amortization — a measure of earnings that the credit rating companies track — rose to 3.17 times in the third quarter, from 3.04 times a year earlier. Junk-rated Sears has a ratio of 1.82.

Will Citigroup survive this crisis? It depends entirely on the government. If the government shows hesitancy, they are doomed.

Citigroup Inc. fell as much as 25 percent in New York trading, after losing almost a quarter of its value yesterday, as concern intensified that the U.S. recession will generate losses and weaken demand for financial services.

Citi, down for eight of the past nine trading days, declined 81 cents to a 13-year low of $5.59 on the New York Stock Exchange at 1:09 p.m. The stock, which fell as low as $4.76, slumped even after Saudi billionaire Prince Alwaleed bin Talal said he would boost his stake in the New York-based bank.

Chief Executive Officer Vikram Pandit said this week Citigroup will cut 52,000 jobs in the next year, double the target announced in October, as loan losses surge and the economy shrinks. JPMorgan Chase & Co., the largest U.S. bank, plans to fire about 10 percent of its investment-banking staff, or about 3,000 people, a person familiar with the bank said today. Its shares dropped $3.35, or 12 percent, to $25.12.

Citigroup has lost about $20 billion in the past four quarters as bad loans increased and demand for banking services declined. Analysts surveyed by Bloomberg expect a $673 million deficit for the fourth-quarter.

U.S. Aid

The world’s biggest finance companies have taken almost $1 trillion in writedowns and losses since the credit markets seized up last year. The U.S. has injected more than $200 billion into the top U.S. banks and insurance companies to shore up their finances, and analyst Paul Miller at FBR Capital Markets in Arlington, Virginia, said as much as $1 trillion may be needed.

Jobs, Cars

The U.S. unemployment rate rose to 6.5 percent in October, the highest since 1994, as companies slashed payrolls, the Labor Department said this month. Auto sales plunged 32 percent, manufacturing contracted at its fastest pace in 26 years and consumer confidence fell by the most on record during the month.

The irrational and disastrous expansion of the TARP is continuing. The latest is GMAC. It is obvious that if he could, Mr. Bernanke would save the entire wreck of the financial system of today, and perpetuate it to the next decade. Sadly for him, but fortunately for the US, I suspect that even he can’t save the reckless lenders of these years.

-GMAC LLC, the largest lender to General Motors Corp. car dealers, has applied for status as a bank holding company so it can get access to the Treasury’s $700 billion rescue fund for the financial industry.

The lender also began an exchange offer for $38 billion of notes issued by the company and its Residential Capital LLC home lending unit to reduce outstanding debt levels, Detroit-based GMAC said today in a statement.

GMAC joins money-losing commercial lender CIT Group Inc. in trying to shore up its finances to gain bank status. That may help GMAC quell doubts about its survival after home foreclosures pressured the mortgage unit and GM’s auto sales plummeted to the worst level since 1945. GMAC may also be able to obtain U.S. government guarantees on new debt as a bank.

“If you let this many people participate, the benefit gets so diluted you haven’t done a lot of good,” said Peter Sorrentino, a senior portfolio manager at Cincinnati-based Huntington Asset Advisors. “You can’t save everybody. That’s the hard call.”

Meanwhile the future of GM looks more ominous by the day. The issue is whether it can survive until the next handout under the Obama administration. It’s unclear to me, whether they can do so.

General Motors Corp., the largest U.S. automaker, probably has weeks rather than months left before it runs out of cash without federal aid, said Jerome York, an adviser to billionaire Kirk Kerkorian and former GM board member.

Chief Executive Officer Rick Wagoner “all but said” at congressional hearings in the past two days that GM can’t continue to operate until a new U.S. administration takes over in January, York said in a Bloomberg Television interview today.

GM, Ford Motor Co. and Chrysler LLC should develop a detailed plan for sustained operations and present it to Congress as a condition of receiving support, with “chains” rather than “strings” attached, York said.

U.S. lawmakers after hearing from Wagoner, Ford chief Alan Mulally and Chrysler CEO Robert Nardelli remain deadlocked on an auto-industry bailout. Democratic congressional leaders disagreed with Republicans and President George W. Bush’s administration over how to provide $25 billion in aid to the three companies, with just two days left in Congress’ lame-duck session.

Today the Fed had has released its senior loan officers survey, the ISM has its survey of manufacturers. (Both of these are rarely revised, and are more reliable than preliminary estimates on GDP etc.) General Motors has declared October to be the worst month since 1945. U.S. consumer confidence fell to the lowest level on record in October as stocks plunged and banks shut off credit. The Conference Board’s confidence index tumbled to 38, which is the lowest reading since monthly records began in 1967. Meanwhile the Treasury is expected to borrow $550 billion in the three months to Dec. 31, compared with the $142 billion predicted in July, after a $530 billion record in the July-September quarter.

I quote mostly from Bloomberg:

The ISM data has showed the weakest level for U.S. export orders in the two decades the ISM has kept the data, a sign of slowdowns in Europe and Asia. The reading for October was the lowest since September 1982.

October’s ISM reading corresponds to a 0.7 percent annualized drop in GDP and the export gauge dropped to 41, the lowest reading since records for this component began in 1988.

GM reported today that its sales of cars and light trucks tumbled 45 percent from a year earlier. Ford Motor Co. reported a 30 percent decline and Toyota Motor Corp. posted a 23 percent drop. Honda’s were down 25 percent, Nissan Motor’s slid 33 percent and Chrysler’s fell 35 percent.

“If you adjust for population growth, it’s the worst sales month in the post-World War II era” for the industry, said Mike DiGiovanni, GM’s chief sales analyst, on a conference call.

Industrywide U.S. auto sales fell for the 12th straight month in October, extending the longest slide in 17 years.

Goldman Sachs projected $400 billion in Treasury borrowing needs for the final three months of 2008, followed by $375 billion for the first quarter next year. Those estimates don’t, however, include borrowing for the Fed’s supplementary financing program, which has already borrowed $220 billion since Oct. 1, Goldman Sachs economists said in a research note.


Blue Mountain Capital Management LLC froze its largest hedge fund after clients asked to pull a “meaningful percentage” of their money even as it outperformed the industry average by almost 10-fold this year.

The $3.1 billion Blue Mountain Credit Alternatives Fund declined 2.4 percent through October, compared with the 19.6 percent loss by the HFRX Global Index compiled by Chicago- based Hedge Fund Research Inc. Withdrawals were suspended so Blue Mountain wouldn’t be forced to sell assets in falling credit markets, the firm said today in a letter to clients.

“This shows that nobody is immune from the huge investor outflows in the industry at the moment,” said Matt Simon, analyst at New York-based Tabb Group, a financial-services consulting company.

Investors fleeing the worst financial crisis since the Great Depression have forced firms such as Deephaven Capital Management LLC and RAB Capital Plc to halt redemptions. In most cases, the funds have underperformed competitors. The Deephaven Global Multistrategy Fund was down 15 percent this year through September and lost an additional 10 percent this month.

Several of Blue Mountain’s fund-of-funds shareholders were under “liquidity pressures” from their own clients, Blue Mountain Chief Executive Officer Andrew Feldstein said in the investor letter, a copy of which was obtained by Bloomberg News.

“We are not comfortable with this state of affairs,” Feldstein wrote. “If we were to unwind or sell positions to meet current redemptions, the severe liquidation costs would be borne inequitably by the remaining investors.”

A spokesman for Blue Mountain, which oversees $5.5 billion from offices in New York and London, declined to comment.

Comment: There’s little need for comment on all these developments, except to note that the Treasury’s continued haphazard accumulation of government debt will make this crisis far worse eventually than what it is even now. There’s no reason to believe that in this environment of extreme volatility the interest rates on Treasury paper will remain this low forever. It may not happen today, nor in six months, but when it does happen, it will bankrupt the US government.

Today the GDP numbers for third quarter have been published, and they came at minus 0.3, defying expectations of a worse number. My own choice is generally to ignore most of these numbers, because they are subject to dramatic revisions, and basing one’s analysis on preliminary data is usually gambling. The contraction in the third quarter of 2000, for instance, was first. reported as a 2.7 percent gain.

A more significant development is the 3.1 percent contraction in private consumption, and although it’s worse than expected, there’s no surprise in the result, as it would contradict logic if the US consumer, whose profligacy always depended on borrowing, could continue his habits during this unprecedented period of credit tightening. What must be realised is that this is only the beginning of a phase that will last for at least another year in the mildest scenario, and the chain reaction will have consequences for not only the US economy, but the rest of the world too, in particular for exporters such as Japan and China, Singapore and others, who made the most of the irrational excesses of the American consumer.

At this stage there is very little merit in preaching the obvious to the pious. The bankruptcy of Lehman was an event similar to those of August 2007, when the collapse of several hedge funds, and the reesulting inability to price mortage related assets caused a general paradigm shift in how the market valued certain asset classes. The demise of Lehman should only be seen as a further escalation of this trend, in which impossibles become possible, causing panic among speculators. It is meaningless to speak of investors at this stage, as volatility compels us to redefine “long term” within the span of a few months. Until a number of bankruptcies brings clarity to the situation, very few serious actors will be willing to assume long term exposure to the markets, and this will only make life harder for the governments.

Much is made of the recent easing in overnight rates, and the slight softening of the tensions in unsecured interbank lending. But while the governments’ massive injections of liquidity, and cash grants in the form of share and asset purchases appear to have made some banks and others more willing to accept higher levels of risk in overnight lending, with the Libor-OIS spread at 253 bp, one can only speak of lessening tensions in relative terms, comparing the situation to the period before the Lehman event. Otherwise it is clear that there’s very little lending going on between banks, and financial actors continue to be fearful in their dealings with each other. This is confirmed by the continued contraction in lending to consumers and the real sector, with both consumer credit, and corporate borrowing becoming more anemic by the day.

Others tie their hopes to the TARP and the Fed’s mergency lending and swap facilities, but while the latter may be of some use in alleviating the severity of the crisis, the former, in my opinion, will only make the problems worse, as there appears to be an irrational assumption in many quarters that throwing money at insolvent institutions can jump-start lending, and thereby the economy.

But this is deeply flawed reasoning. As I have stated here many times before, what the financial sector needs, and in fact, in an indirect way, demands, is bankruptcies. It’s very easy to gain a general idea on the status of many banks in the US by examining the FDIC’s statistics, or easier still, by visiting the FED’s website. What we see in the former is that banks have no money to cover their bad loans, and that this is a general phenomenon. The cover ratio of non current loans on banks’ balance sheets is only 70 percent at this stage, which is by far the lowest on record, and the situation is almost certain to deteriorate further from here. And on the Federal Reserve’s website one can see that they have been lending more than 100 billion dollars to commercial banks for the last two weeks, and although a bit crude as a measure, this serves well to demonstrate the difficulty in obtaining funding from other channels.

And so, why is the TARP counter-productive? Because it is funding institutions that have only one use for the funds they receive: patching up their books, covering their losses, and sustaining themselves. But what is the purpose of a bank, from the point of view of the public? It is to expand credit to the real economy and consumers. If the numerous banks that the TARP and the Fed are funding cannot expand credit, and are using the funds which they receive only for continuing their existence, isn’t the TARP prolonging and perpetuating the crisis, by helping those institutions that cannot, will not, and should not survive in the first place? If the program succeeds, and the complete mess of a system that we have now survives, will the financial system be in a better form where it is led and directed by players who exist as parasites on government subsidies, and whose only purpose is continued existence through government help? With the balance sheets that they have, and the managements that have brought them to where they are, can the American financial system have any hope of recovery if it expects the recovery to be financed by credit from institutions which are, for all intents and purposes, bankrupt, and which only exist at the mercy of the FDIC, and the federal government?

The TARP is a mistake, but given the way that the government has been reacting to each crisis, it’s not a surprising mistake.

Naturally, the reader will expect me to propose my own solution after this negative assessment of the government’s plan. In my opinion, what the economy needs is a dismantling of today’s system: the failed and bankrupt actors of yesterday should be nationalised when this is unvoidable, but for the greatest part, the government should manage a controlled liquidation of all firms that are clearly inoperable, and insolvent. Under normal circulmstances, this would have been managed by the free market, but there’s too much risk, excessive political costs, and too much uncertainty that make this choice undesirable and impractical. We should never try to forgo the cathartic period of the free market system, but the process should be managed and gradual. If this is the case, we need an organisation similar to the TARP, but its explicit purpose should be the liquidation of the firms that it helps for a brief period. The government could seek authority from the Congress for this purpose, and given the loathing that many of these financial firms arouse everywhere nowadays, such powers would be much easier to obtain than legislation that would sustain them. If, however, the government continues to throw money at these firms, it will only have the impact of feedings cancerous cells, it will surely bring no benefit, and is likely to cause much harm in the longer run.

Tomorrow I hope to write about emerging markets. Fed has recently been lending them billions over swap channels, and this is a phenomenon that is likely to go for quite a while. I believe the next phase of this crisis will be experienced in its severest form by developing nations.

At the moment, there’s political instability in Malaysia, Pakistan, Japan, Russia, Ukraine, and Turkey. Mexico, Iceland, Turkey, Russia, and Pakistan were or are also facing runs on their currencies. Banco de Mexico sold $2.5 billion in the market yesterday and early today to stem a rout in the peso and said it would offer an additional $400 million when the peso weakens more than 2 percent in a day.

VIX today exceeded 60 for the first time as the DJIA fell to a five- year low below 9,000. as Treasury Secretary H. Paulson is weighing plans government to invest in banks as the next step in trying to resolve the credit crisis.

Libor for three-month loans rose to 4.75 percent, the highest level since Dec. 28. The Libor-OIS spread widened to a record. The overnight dollar rate fell to 5.09 percent, still 359 basis points more than the Fed’s 1.5 percent target rate. The three-month rate in euros held at a record high of 5.39 percent.

ECB offered banks as much cash as they need for six days at its benchmark rate of 3.75 percent, also loaned banks a record $100 billion in overnight dollar funds, allotting most of the cash at 5 percent, down from 9.5 percent yesterday.

“Libor rates are now more or less meaningless because everyone is just doing business with the European Central Bank,” said Jan Misch, a money-market trader at Landesbank Baden- Wuerttemberg, Germany’s biggest state-owned bank, via Bloomberg.

South Korea, Taiwan and Hong Kong cut interest rates today, after yesterday’s coordinated reductions. The U.K. government also pledged to spend 50 billion pounds ($87 billion) to stave off a collapse of the British banking system.

Money-market rates rose in Hong Kong, Singapore and Japan to the highest levels in at least nine months. Hong Kong’s three-month interbank offered rate jumped to 4.4 percent, a one- year high. Singapore’s comparable rate for dollar loans increased to 4.51 percent, the highest level since Jan. 8.

Overnight borrowing costs for companies dropped to the lowest in almost two weeks after yesterday’s rate cuts and the Fed committed to buying commercial paper.

Iceland seizes a bank

One of the earliest victims of this crisis was Iceland. Their troubles have been intensifying since the collapse of Bear Sterns in March of this year.


From Bloomberg:


Iceland‘s government seized control of Kaupthing Bank hf, the nation’s biggest bank, completing the takeover of a financial industry that collapsed under the weight of foreign debt.


Iceland is guaranteeing Kaupthing’s domestic deposits and helping manage the banks to provide a “functioning domestic banking system,” the country’s Financial Supervisory Authority said in a statement on its Web site today.


Glitnir Bank hf, Landsbanki Island hf and Kaupthing are unable to finance about $61 billion of debt, 12 times the size of the economy. Their collapse has affected 420,000 British and Dutch customers, and frozen assets held by universities, hospitals, councils and even London’s police force. The government is seeking a loan from Russia and may ask for aid from the International Monetary Fund to help guarantee deposits. 


All trading in Iceland’s equity markets is suspended until Oct. 13 due to “unusual market conditions,” the country’s exchange said today.


Currency Peg


Trading in the krona ground to a halt today after the central bank yesterday ditched an attempt to fix the exchange rate at 131 krona to the euro. Nordea Bank AB, the biggest Scandinavian lender, said the krona hadn’t been traded on the spot market today, while the last quoted price was 340 per euro, compared with 122 a month ago.


Assets at Iceland’s three biggest banks had grown five-fold since 2004 as the companies looked to expand beyond the confines of an island with a population of 320,000, half that of Las Vegas. Much of that growth was debt financed, helping send gross external debt to 9.55 trillion kronur at the end of the second quarter, equivalent to $276,622 for every person on the island.


U.K. taxpayers will probably face a bill of at least 2.4 billion pounds ($4.1 billion) to compensate about 300,000 U.K. holders of accounts at Icesave, a unit of Landsbanki, the Financial Times reported, citing unidentified U.K. officials.


`Severe Recession’


“The economy may well contract more than 10 percent between now and the end of this crisis,” said Lars Christensen, chief analyst at Danske Bank A/S in Copenhagen. “Inflation will jump to at least 50 percent to 75 percent in the coming months.”


To avert the collapse, Iceland will start talks with Russia on Tuesday to secure a loan of as much as 4 billion euros ($5.48 billion), Prime Minister Geir Haarde said late yesterday. He added that loans from the IMF and Russia “are not mutually exclusive,” though the government hadn’t, “at this point at least,” asked the IMF for a standby loan or an economic program.


Fitch Ratings Ltd. cut Iceland’s long-term foreign currency issuer default rating to BBB- from A-. The rating remains on negative watch, Fitch said.


Ukraine seizes a bank

Ukrainian lender Prominvestbank had its credit ratings cut three steps by Moody’s Investors Service after the country’s central bank seized control.

The National Bank of Ukraine appointed its deputy governor, Volodymyr Krotyuk, as the temporary head of Prominvestbank yesterday and imposed a moratorium on payments to creditors for six months.

Ukraine‘s government has the worst creditworthiness among Europe’s emerging markets, based on the cost of credit-default swaps. It joins Iceland, Germany, the U.K. and Belgium among a growing number of European countries taking control of banks.

Prominvestbank, Ukraine‘s sixth-largest lender, had 27.6 billion hryvnia ($5.1 billion) of assets as of Sept. 30, according to its Web site.

And RBS is loudly struggling with solvency issues.

FerroChina Says It Can’t Repay Loans

FerroChina Ltd., a Chinese steelmaker, said it is unable to repay loans totaling 706 million yuan ($104 million) because of the “current economic crisis,” and a further 4.52 billion yuan in loans and notes may also be at risk.

Production at FerroChina’s plants has been suspended and the mill is in talks with creditors and potential investors, the company said today in a statement to the Singapore Stock Exchange, without identifying companies.

The escalating credit crunch has toppled banks in the U.S. and Europe, frozen credit markets and slowed economic growth, curbing demand for China-made products. Steel prices and demand in China have been declining.

The company, which has a market value of S$436 million ($297 million), requested on Oct. 7 that its Singapore-listed shares be suspended from trade. The stock, which last traded at 54.5 Singapore cents, has slumped 70 percent this year.

“Due to the current economic crisis, the group is unable to repay part of its working capital loans aggregating approximately 706 million yuan which has become due and payable,” the statement said. “The management is seeking new equity and loan funding.”

Further loan facilities and notes of about 2.03 billion yuan and “some other working capital loans” totaling 2.49 billion yuan may potentially become due, it said.

Changshu Plants

FerroChina has plants in Changshu City and Changshu Riverside Industrial Park in Jiangsu province, according to today’s statement. The company produced 1.65 million metric tons of steel in 2007, according to Kelly Chia, an analyst at OCBC Investment Research Pte.

“It could be because some of its customers weren’t able to pay up, or the price of its products weren’t enough to fund its working capital,” Chia said by phone from Singapore.

FerroChina reported net profit more than tripled to 230.4 million yuan in the second quarter from a year earlier, according to a slides presentation from the company on Aug. 14.

“Given the weak capital market and poor economic conditions, there is no assurance that we can be successful” in the talks with potential investors and creditors, today’s statement said. The talks with would-be investors were announced in a company statement on Sept. 16.

“As a zinc-galvanizing steel sheet producer, the slowdown in building, manufacturing and home-appliance industries hurt the company’s sales,” JPMorgan Chase’s Qin said.

The Chinese price of hot-rolled coil, a benchmark product, has fallen 29 percent to 4,230 yuan a ton from a record 5,957 yuan on June 5, according to Beijing Antaike Information Development Co.

The Fed has decided to buy commercial paper from firms, in another attempt to deal with the complete shutdown in financial markets. This essentially means that it is financing the day-to-day running of the US economy, and it is a positive step, as long as it is conducive to eliminating a bit of the panic and fear in the markets, but it will not address the basic insolvency and leverage issues, and will not prevent bankruptcies. From the Fed:

“For release at 9:00 a.m. EDT

The Federal Reserve Board on Tuesday announced the creation of the Commercial Paper Funding Facility (CPFF), a facility that will complement the Federal Reserve’s existing credit facilities to help provide liquidity to term funding markets. The CPFF will provide a liquidity backstop to U.S. issuers of commercial paper through a special purpose vehicle (SPV) that will purchase three-month unsecured and asset-backed commercial paper directly from eligible issuers. The Federal Reserve will provide financing to the SPV under the CPFF and will be secured by all of the assets of the SPV and, in the case of commercial paper that is not asset-backed commercial paper, by the retention of up-front fees paid by the issuers or by other forms of security acceptable to the Federal Reserve in consultation with market participants. The Treasury believes this facility is necessary to prevent substantial disruptions to the financial markets and the economy and will make a special deposit at the Federal Reserve Bank of New York in support of this facility.

The commercial paper market has been under considerable strain in recent weeks as money market mutual funds and other investors, themselves often facing liquidity pressures, have become increasingly reluctant to purchase commercial paper, especially at longer-dated maturities. As a result, the volume of outstanding commercial paper has shrunk, interest rates on longer-term commercial paper have increased significantly, and an increasingly high percentage of outstanding paper must now be refinanced each day. A large share of outstanding commercial paper is issued or sponsored by financial intermediaries, and their difficulties placing commercial paper have made it more difficult for those intermediaries to play their vital role in meeting the credit needs of businesses and households.

By eliminating much of the risk that eligible issuers will not be able to repay investors by rolling over their maturing commercial paper obligations, this facility should encourage investors to once again engage in term lending in the commercial paper market. Added investor demand should lower commercial paper rates from their current elevated levels and foster issuance of longer-term commercial paper. An improved commercial paper market will enhance the ability of financial intermediaries to accommodate the credit needs of businesses and households.”

How to avoid a depression?

September 16, 2008

Wilbur Ross has told CNBC yesterday that one thousand regional banks could fail. He’s basing his opinion on historical record in light of recent developments.


What does this mean for the Federal Budget? Morgan Stanley believes it is manageable. (See bottom of the page) 


The government is expected to create stimulus packages, take over bank failures, finance the restructuring of the GSE’s, bailout failed financial firms, pursue two wars in Iraq and Afghanistan, provide or maintain tax cuts, and keep spending in order to sustain economic activity in general; and each of those items is at least a hundred billion dollar item.


At the same time the government’s revenues are likely to shrink as more bankruptcies and higher unemployment will be a feature of the next few years.  


How will the government get out of this without monetising some of these problems? Can the US avoid higher inflation in the long term?


Liquidity and the money supply are seen to be the solution by the Federal Reserve, but neither the government nor the private sector have a solid financial position to provide that liquidity. This is a solvency problem, and the cash is in the pockets of exporters, the debt is in the US Treasury. And as the debtor was the creator, and originator of a vast part of global economic activity in the past years, if the world wants to avoid a general economic cataclysm, it will have to bailout the American economy, arguably by continuing to buy increasing amounts of treasuries and other government paper.


This is not unprecedented in history. When, after the first world war, Germany faced financial catastrophe, it was the US that organised the bailout of the German state, as it was realised that a complete collapse of that nation was threatening the health of the American and international economies. In today’s case the Chinese and others are sitting on trillions of dollars, which are likely to depreciate significantly, if, as expected, the US does decide to solve its problems through monetisation. More importantly, neither the Chinese economy, nor in fact any other economy in the world is sophisticated enough to create or absorb those enormous sums without creating financial instability: it was a mistake on the part of the Chinese to accumulate that much in reserves, now they must at least make use of them. If they don’t, the US will depreciate its currency in the middle of a global recession, creating more insecurity, more contraction, and no one knows where this would lead us. 


In the long run, as I said, in the absence of an international solution, I believe that political reasons will lead the Congress and the administration to choose the path of monetisation, that is, inflation as the cure-all for the private sector’s problems. This is even likelier under Obama, and just today Barney Frank has been urging the government to begin to buy debt and other assets in the market. Indeed there does not appear to be any other solution to this issue. So far I have not heard a single voice providing a solution to the issues facing the economy: usually the suggestion is to let the markets solve their own problems, but politically the costs of this are going to be enormous: certainly double digit unemployment, and thousands of bankruptcies will be the outcome. But more importantly, if panic is allowed to take hold, the feedback loop can create problems that are not imagined today.


The United States escaped from the depression of the thirties only through war: the needs of a war economy, coupled with the psychological stimulus of a warlike mentality, allowed the system to grow out of its pessimistic stupor and create economic dynamism. Why did the recovery take so long? Because the collapse in confidence and goodwill after a long and severe bottoming, instead of creating new momentum and optimism, perpetuates the negative attitudes of the previous contraction. People are likely to enter the market to pick bottoms many times over many months, even years, and eventually it will be confidence that suffers the greatest damage. No amount of financial loss can account for the damage that confidence will suffer in a long term financial collapse. And that phenomenon is one of the reasons of Japan’s decades long slump too.













Will Lehman be the last?

September 13, 2008

The media concentrates on the demise of Lehman, but whatever befalls this institution is not of great consequence anymore. It’s almost a certainty that all the major financial actors have already made their preparations for any contingencies that will arise from this issue, and apart from the usual sell-off or rally to occur on Monday, nobody should hold his breath about the decorations of Lehman Brothers’ shroud.

The real issue here is the aftermath of this event. The half-hearted measures of the government are unlikely to instill much confidence in the markets, nor is it realistic to expect the Fed or the Treasury to have any success in reducing this very large body of continuing losses. As long as fear and pessimism persist, people will keep speculating on who will be the next to fall, increasing risk spreads and premiums, and eventually creating more bank failures, more bankruptcies, more defaults, and so forth. There’s already speculation about the fate of Merril Lynch, and there’s no reason to think that Lehman will be the last to die among the large institutions. Indeed, as long as the rumour mill is turning, as long as there’s a scarcity of goodwill, and as people realise that solvency issues are behind today’s difficulties, it’s a certainty that other institutions will fall too.

Just like the happy bubbles of yesterday fed on themselves to create ever more euphoria, the negative bubbles of today and tomorrow have the power to feed on panic and fear and reach irrational sizes. The only way to stop this from occurring without ruining the global financial system is global action by the central banks of the world, arguably nationalization and dismantling of bankrupt institutions. Essentially, there’s a need to create a central pool among central banks and treasuries to deal with the contingencies that are arising day after day. Because if this is not done, fiscal constraints, and political problems will prevent the actualisation of the very radical measures that are needed: in essence, the dismantling of the failing institutions, and socialisation of their losses. Of course it’s very unpleasant to even discuss this prospect, but what must be understood is that the failure and self-destruction of the financial system will hurt every single nation and individual in the world. There’s no way to escape the consequences of the debt binge of the past decade. And that bubble was a universal phenomenon, it inflated everything, now it will deflate everything.

The worst that can be done right now is an attempt at perpetuating the crisis by refusing to recognise the paradigm shift that has happened. To try to goad the US consumer to spend like he did in the past by stuffing ever more money into his pockets is only a way of delaying the inevitable for a few months. The positive effect of the latest stimulus package apparently lasted for only two months, indeed a very disheartening outcome for those who were expecting this to sustain consumption as during the 2001 recession. Today, however, people know that the era of non-stop borrowing is over, and just a single glance at the foreclosed homes of neighbours is enough to make them reconsider their plans of spending as if they had printing presses in the living room.

The growth potential of the US is less than what it was during the last decade. This is a fact that everyone has to realise. But of course, before that, we must first do our best to prevent the recession from turning into a depression: most reasonable people would now probably admit the clear potential for such an outcome.