Red Sky At Morning, Congress Take Warning
Denninger sees red this morning -- who's gonna believe a populist agitator -- but maybe I'll just stock another bag of dried beans (http://market-ticker.denninger.net/archives/622-Fiscal-Cat-5-Hurricane-Warning.html):
You only think the Stock Market has been smashed. Just wait until you see what will come next. If you're playing "Buffett", following his claim (note: there is no penalty for lying on national television about what you're doing in your personal account) that he's buying here, there is a little ugly fact you need to be aware of.
That fact is treasury issuance.
See, to fund all this crap that Congress, Paulson and Bernanke have in the pipe (you know, the TARP, the newly-minted SIV that Ben announced this morning to buy commercial paper, etc) the treasury issue requirements will be north of three trillion dollars in this fiscal year. Oh, and that's before Obama wins (and he will) and promises another $1 trillion worth of new spending without a nickel's worth of ability to fund it. To put this in perspective the total amount of treasury securities owned by all foreigners at present is about $2.7 trillion. Only a few months into this we're already requiring a crazy "tail", which is the amount of "goose" that has to be paid in order to get people to take down that debt. Its running around 20 basis points right now, and there was one disastrous auction that ran 40. Historical norms are in the ~2-3 basis point area for off-the-run securities. Now why does all this esoterica matter, you ask? You've probably heard that the "IRX", or 13 week T-Bill, has come up in yield recently, and this is being touted as a clear sign that the credit markets are normalizing. Not quite. Price and yield move in opposite directions, and when you issue a lot of short-term supply, the price goes down (supply and demand, natch), while yield goes up.
[graph embedded in linked article]
In fact, kinda like "straight up." Impressive eh? But what's nasty here is that right now we're seeing a flight INTO longer-term bonds (the 10 in particular), which means the market is anticipating another stock panic, and with good reason. See, Treasury has only two options here:
1. If they issue all in the short end of the curve (as they're doing now) they flatten the banks, as the entire point of a bank is to borrow in the short-term market and lend in the long term. When you compress the yield curve you destroy their capacity to make money off their ordinary business model.
2. If they issue in the long end of the curve (e.g. 10s and 30s) then the long end will skyrocket in yield. Anyone remember 18% mortgages? They could reappear. This, of course, will destroy what's left of the housing and consumer credit markets.
Now sure, The Fed can start printing money like mad and buy all these Ts, making their balance sheet expand like a balloon - or a bubble. And Bernanke, yesterday in his testimony, claimed that this didn't constitute "printing money" or "inflating the money supply." He may be technically correct but in practice he's lying through his teeth, and unfortunately Congress is both too uninformed to call him on it and lacks the balls to stop him (which they can do through the threat of, if not actual, legislation.) His production of money in exchange for Treasuries is nothing more than a sham sterilization action. He thinks this will go unnoticed by the markets, because he's swapping a dollar for an "illiquid" asset. The problem is that this is only monetarily neutral if the asset is actually worth a dollar. If it is in fact worth 50 cents then he printed the other 50 cents, and devalued every other dollar in the world by the same amount. The claim, of course, is that these assets are in fact "money good" but illiquid. I call bullshit on that claim. An asset is worth only what an uncoerced buyer and seller will transact at. This is first-semester economics, and Bernanke, who claims a PhD, is fully aware of that fact. So he, like Treasury with their TARP, is effectively buying assets that are not worth what their face value indicates. In this case Bernanke gets around the inconvenient law that prohibits him from purchasing things (as opposed to "discounting a note", that is, lending) by setting up "private" SIVs run by JP Morgan/Chase (gee, Jamie Dimon, no conflict of interest there!) and then lending the funds to the SIV. But wait - wasn't this Paulson's original SIV plan back in 2007? It sure as hell was. It went exactly nowhere because the banks came to the conclusion that they were being robbed; there was in fact no value equal to the claimed face in the instruments, and that plan died on the vine as a consequence.
Now, suddenly, it reappears for ABCP (asset backed commercial paper) to "liquefy" the commercial paper and money markets. Horsecrap. Bernanke is doing what Paulson tried and failed at in the "free" (coerced by arm-twisting by Paulson) market through executive fiat, and he is printing money to fund it. Exactly how much money he is printing (as opposed to lending) depends on the precise amount of overpayment that is being induced through these so-called "loans", but that it is happening is not open to question. Why has this become necessary? Ben and Hank produced a dislocation in this section of the marketplace by favoring other debt instruments with federal guarantees, thereby forcing money out of these instruments. This in turn created major problems for money market funds who buy this paper as a routine matter of course in that when they needed to redeem deposits they suddenly found no buyers for the securities, as those people had fled to other instruments that Ben had guaranteed payment on! As each new facility is rolled out by Ben and Hank a new area of debt becomes backstopped by the government in some fashion, thereby forcing money out of other instruments and causing those instruments to become distressed! We are rapidly reaching the point where only The Fed and Treasury are providing any lending at all! This is insanely dangerous to economic and monetary stability; all market discipline has been removed and now we're seeing in the credit markets that which began in the equity markets with Bear Stearns. Ben and Hank are going to produce the bond market dislocation that I have been warning about since earlier this year if he is not stopped immediately. The base gambit is cute - force all this new Treasury issue out into the market before the election and Inauguration, when Hank is going to be replaced with someone who might not be nearly as charitable as Hank is to issuing Treasuries like a drunken sailor, and pray that the bond market tolerates his game long enough for the issue he needs to fund this abortion to clear into the marketplace. The ugly is that there was a small inversion in LIBOR a week or so ago. That's really bad, as LIBOR normally never inverts. As Ben has played his games of late the inversion disappeared from LIBOR but moved over into the intermediate area of the US Treasury Curve, where it is far more dangerous. China, Japan and Saudi Arabia should bring the curtain down on this farce right damn now, because Treasuries are rapidly becoming no more secure than ordinary corporate debt and the buyers sure as hell aren't being compensated for that risk. Treasury buyers are being robbed blind along with US investors who think they're "fleeing to safety." Nonsense; as I showed yesterday the problem is that additional debt issue no longer renders much (if any) of a positive return on GDP - no matter who issues the debt - public or private.
The ugly little secret in that graph, if you study it a bit more, is what happens when interest rates spike higher. Go back and look specifically at the period surrounding 1980, when we had sky-high inflation. Notice that we didn't get back to trendline until bond rates came down - way down - as we started having supply absorbed by Japan, China and Saudi Arabia in the 1990s and into this decade. There is a very real risk that this Treasury Issue could force GDP return on new debt below zero. If that happens then the stability of the monetary system disappears immediately and you will see instantaneous and very large fails in the Treasury marketplace. The consequence of this event would be catastrophic. Ben would have only two choices - print raw money, which would immediately collapse the Treasury marketplace, or get Treasury and Congress to immediately reduce issue and spending to sustainable levels. What would "sustainable levels" be? Given that issue is running $3 trillion year-on-year, this could result in an immediate and forced cut in all federal spending by fifty percent or more as the TARP and other program money will have been spent and cannot be recalled. Yes, you read that right. Now go look at the Federal Budget and you will find that you could eliminate all discretionary programs and all of the military and not get there. This means that in order to attain stability we would have to immediately gut Medicare and Social Security by about 50%, cut our military budget dramatically, perhaps by 25% or more, and eliminate essentially all discretionary spending - all farm subsidies, the Department of Education, Unemployment Assistance and more. Oh, and having done that, the long end of the curve would probably still spike to 10%, which means 13-14% mortgage rates. Cut the value of every house in America in half - again - from here. The equity markets sense this. Not one equity trader in 1,000 understands it, but they all intuitively get that something is very wrong with what has been done recently, and that what's coming is going to be very bad - perhaps ruinously bad, especially in the corporate sector where corporate debt issue is a necessity to fund operations, and not just in the short-term commercial paper markets. Running on free cash flow alone, most corporations would make 20% of what they make today - if that much. This, of course, collapses the "E" side of the balance sheet, which means that the "P" in P/E has to come down. Way down. Oh, and that assumes they can take down the debt without imploding, and many of these firms will not be able to do so. If you were wondering where I got my S&P 500 target of 500 - or perhaps worse - this is part of the computation. Its not all of it by any means, but it certainly is part of it. There is exactly one way to stop this idiocy, and that is for the bad debt that exists out there to be forced into default and thus cleared from the system. This will cause the debt to GDP level to come down. Clearing it back to the point where a 1:1 ratio or better exists between GDP and a dollar of debt may not be possible or reasonable, but if we don't stabilize this situation - and soon - we are running the risk of literally crossing the event horizon. Congress must act now. The fuse is about to go inside the box and once it does, you can't snip it any more. It may, in fact, already done so.
Specifically, Congress must: (#1) Force the immediate cessation and unwind of these "special facilities", including the so-called "money market" liquidity facilities. While its bad if money market funds break the buck and return only 98 cents, the fact remains that every one of these funds has a statement in the front of the prospectus that says "may lose value." If The Fed refuses to stop coddling its member banks and tampering with the credit markets then Congress must force this outcome via emergency legislation. We must stop forcing money in the debt markets out of various portions of the market and into the "guaranteed" ones by removing the guarantees, or we will wind up guaranteeing all of it - an impossible task, as there is some $53 trillion of private credit in the marketplace and we don't have the money! Bernanke is a trapped rat and his desperate actions are now threatening the sovereign debt of The United States. (#2) Force a full stop on the insane pace of Treasury Issue. We cannot allow a bond market dislocation. If one occurs we will suffer an economic depression. Not might - WILL. (#3) Repeal the EESA and force Fannie and Freddie's portfolios to unwind, effectively repealing the portion of the Housing Bill earlier this summer that dealt with them. If this bankrupts Fannie and Freddie and results in losses for the debt holders, so be it. (#4) Enact policies (both literally and by "jawbone") that force the bad debt in the system out - through bankruptcy if necessary, through pay down if possible. This sounds cruel and painful. It is painful but necessary; the key here is to prevent a bond market dislocation, especially in the Treasury Market. (#5) As part of #4, force housing prices down so that the median home price returns to 3x median income. This will produce a monstrous number of foreclosures but that is preferable to the alternative - an economic depression. Note that these people will not be homeless; there will be lots of empty houses to rent, and rental prices will collapse due to oversupply. In a couple of years these individuals will be able to repurchase either their home or a comparable one - with 20% down, 36% DTI and a 30 year fixed mortgage, as prices will return to levels where this will be possible. I understand this is politically difficult but it is necessary; a massive number of consumer bankruptcies sounds bad, but is in fact good, as clearing the bad debt from the system is necessary to prevent its collapse. (#6) If the bad debt defaults cause the collapse of the large money-center banks, then Congress should consider the creation of five or ten new banks with an initial capital infusion of $20 billion each, IPOing each immediately and attaching an onerous coupon (e.g. 10%) to the initial capital to strongly encourage its replacement with private capitalization. This will provide a base lending support of $2 trillion into the economy. However - until #1-5 are undertaken the economy cannot absorb this capacity and therefore it is of no value until that bad debt has been defaulted.
Everyone is screaming about "increasing credit growth" - including Nouriel Roubini this morning on CNBC. What Nouriel and the rest who are calling for this sort of "tonic" are missing is that you can't increase credit growth into the market until the existing bad debt has been defaulted as the GDP contribution from additional debt load is dangerously close to going negative, and as it approaches zero you get no economic benefit from doing so. Attempting to issue new credit (debt) into the market at this time is at best of no benefit and at worst counterproductive. If that ratio goes negative then you are forced to issue new credit (debt) just to cover interest payments, at which point you no longer can get out of the mess without what amounts to a monetary and economic system collapse.
Those in the media who are chuckling at the folks stockpiling beans and rice will be begging for some of that stash if our government doesn't cut this crap out - and soon. We may be literally days away from a second, far more serious credit and equity market dislocation, this time originating outside the United States. We cannot prevent this second dislocation from occurring but it is absolutely essential that the government "ring fence" Treasury debt before it occurs. Government debt must be protected at all costs or we will lose our ability to fund essential services including Social Security and Medicare. If Congress fails to act (given that Treasury and The Fed have demonstrated they will tie our sovereign debt to the commercial credit markets to the greatest extent possible) and this second dislocation occurs the probability of an economic Depression rises to 80% or more and the odds of the 2003 market lows holding into 2009 and beyond are essentially zero. As I see no evidence that Congress grasps the serious nature of this threat and has refused to listen to those of us that have gotten this right from the start, including Nouriel Roubini, myself, Anna Schwartz and hundreds of other commentators and economists, you must prepare for this outcome - and remember who's responsible if and when it occurs.
You only think the Stock Market has been smashed. Just wait until you see what will come next. If you're playing "Buffett", following his claim (note: there is no penalty for lying on national television about what you're doing in your personal account) that he's buying here, there is a little ugly fact you need to be aware of.
That fact is treasury issuance.
See, to fund all this crap that Congress, Paulson and Bernanke have in the pipe (you know, the TARP, the newly-minted SIV that Ben announced this morning to buy commercial paper, etc) the treasury issue requirements will be north of three trillion dollars in this fiscal year. Oh, and that's before Obama wins (and he will) and promises another $1 trillion worth of new spending without a nickel's worth of ability to fund it. To put this in perspective the total amount of treasury securities owned by all foreigners at present is about $2.7 trillion. Only a few months into this we're already requiring a crazy "tail", which is the amount of "goose" that has to be paid in order to get people to take down that debt. Its running around 20 basis points right now, and there was one disastrous auction that ran 40. Historical norms are in the ~2-3 basis point area for off-the-run securities. Now why does all this esoterica matter, you ask? You've probably heard that the "IRX", or 13 week T-Bill, has come up in yield recently, and this is being touted as a clear sign that the credit markets are normalizing. Not quite. Price and yield move in opposite directions, and when you issue a lot of short-term supply, the price goes down (supply and demand, natch), while yield goes up.
[graph embedded in linked article]
In fact, kinda like "straight up." Impressive eh? But what's nasty here is that right now we're seeing a flight INTO longer-term bonds (the 10 in particular), which means the market is anticipating another stock panic, and with good reason. See, Treasury has only two options here:
1. If they issue all in the short end of the curve (as they're doing now) they flatten the banks, as the entire point of a bank is to borrow in the short-term market and lend in the long term. When you compress the yield curve you destroy their capacity to make money off their ordinary business model.
2. If they issue in the long end of the curve (e.g. 10s and 30s) then the long end will skyrocket in yield. Anyone remember 18% mortgages? They could reappear. This, of course, will destroy what's left of the housing and consumer credit markets.
Now sure, The Fed can start printing money like mad and buy all these Ts, making their balance sheet expand like a balloon - or a bubble. And Bernanke, yesterday in his testimony, claimed that this didn't constitute "printing money" or "inflating the money supply." He may be technically correct but in practice he's lying through his teeth, and unfortunately Congress is both too uninformed to call him on it and lacks the balls to stop him (which they can do through the threat of, if not actual, legislation.) His production of money in exchange for Treasuries is nothing more than a sham sterilization action. He thinks this will go unnoticed by the markets, because he's swapping a dollar for an "illiquid" asset. The problem is that this is only monetarily neutral if the asset is actually worth a dollar. If it is in fact worth 50 cents then he printed the other 50 cents, and devalued every other dollar in the world by the same amount. The claim, of course, is that these assets are in fact "money good" but illiquid. I call bullshit on that claim. An asset is worth only what an uncoerced buyer and seller will transact at. This is first-semester economics, and Bernanke, who claims a PhD, is fully aware of that fact. So he, like Treasury with their TARP, is effectively buying assets that are not worth what their face value indicates. In this case Bernanke gets around the inconvenient law that prohibits him from purchasing things (as opposed to "discounting a note", that is, lending) by setting up "private" SIVs run by JP Morgan/Chase (gee, Jamie Dimon, no conflict of interest there!) and then lending the funds to the SIV. But wait - wasn't this Paulson's original SIV plan back in 2007? It sure as hell was. It went exactly nowhere because the banks came to the conclusion that they were being robbed; there was in fact no value equal to the claimed face in the instruments, and that plan died on the vine as a consequence.
Now, suddenly, it reappears for ABCP (asset backed commercial paper) to "liquefy" the commercial paper and money markets. Horsecrap. Bernanke is doing what Paulson tried and failed at in the "free" (coerced by arm-twisting by Paulson) market through executive fiat, and he is printing money to fund it. Exactly how much money he is printing (as opposed to lending) depends on the precise amount of overpayment that is being induced through these so-called "loans", but that it is happening is not open to question. Why has this become necessary? Ben and Hank produced a dislocation in this section of the marketplace by favoring other debt instruments with federal guarantees, thereby forcing money out of these instruments. This in turn created major problems for money market funds who buy this paper as a routine matter of course in that when they needed to redeem deposits they suddenly found no buyers for the securities, as those people had fled to other instruments that Ben had guaranteed payment on! As each new facility is rolled out by Ben and Hank a new area of debt becomes backstopped by the government in some fashion, thereby forcing money out of other instruments and causing those instruments to become distressed! We are rapidly reaching the point where only The Fed and Treasury are providing any lending at all! This is insanely dangerous to economic and monetary stability; all market discipline has been removed and now we're seeing in the credit markets that which began in the equity markets with Bear Stearns. Ben and Hank are going to produce the bond market dislocation that I have been warning about since earlier this year if he is not stopped immediately. The base gambit is cute - force all this new Treasury issue out into the market before the election and Inauguration, when Hank is going to be replaced with someone who might not be nearly as charitable as Hank is to issuing Treasuries like a drunken sailor, and pray that the bond market tolerates his game long enough for the issue he needs to fund this abortion to clear into the marketplace. The ugly is that there was a small inversion in LIBOR a week or so ago. That's really bad, as LIBOR normally never inverts. As Ben has played his games of late the inversion disappeared from LIBOR but moved over into the intermediate area of the US Treasury Curve, where it is far more dangerous. China, Japan and Saudi Arabia should bring the curtain down on this farce right damn now, because Treasuries are rapidly becoming no more secure than ordinary corporate debt and the buyers sure as hell aren't being compensated for that risk. Treasury buyers are being robbed blind along with US investors who think they're "fleeing to safety." Nonsense; as I showed yesterday the problem is that additional debt issue no longer renders much (if any) of a positive return on GDP - no matter who issues the debt - public or private.
The ugly little secret in that graph, if you study it a bit more, is what happens when interest rates spike higher. Go back and look specifically at the period surrounding 1980, when we had sky-high inflation. Notice that we didn't get back to trendline until bond rates came down - way down - as we started having supply absorbed by Japan, China and Saudi Arabia in the 1990s and into this decade. There is a very real risk that this Treasury Issue could force GDP return on new debt below zero. If that happens then the stability of the monetary system disappears immediately and you will see instantaneous and very large fails in the Treasury marketplace. The consequence of this event would be catastrophic. Ben would have only two choices - print raw money, which would immediately collapse the Treasury marketplace, or get Treasury and Congress to immediately reduce issue and spending to sustainable levels. What would "sustainable levels" be? Given that issue is running $3 trillion year-on-year, this could result in an immediate and forced cut in all federal spending by fifty percent or more as the TARP and other program money will have been spent and cannot be recalled. Yes, you read that right. Now go look at the Federal Budget and you will find that you could eliminate all discretionary programs and all of the military and not get there. This means that in order to attain stability we would have to immediately gut Medicare and Social Security by about 50%, cut our military budget dramatically, perhaps by 25% or more, and eliminate essentially all discretionary spending - all farm subsidies, the Department of Education, Unemployment Assistance and more. Oh, and having done that, the long end of the curve would probably still spike to 10%, which means 13-14% mortgage rates. Cut the value of every house in America in half - again - from here. The equity markets sense this. Not one equity trader in 1,000 understands it, but they all intuitively get that something is very wrong with what has been done recently, and that what's coming is going to be very bad - perhaps ruinously bad, especially in the corporate sector where corporate debt issue is a necessity to fund operations, and not just in the short-term commercial paper markets. Running on free cash flow alone, most corporations would make 20% of what they make today - if that much. This, of course, collapses the "E" side of the balance sheet, which means that the "P" in P/E has to come down. Way down. Oh, and that assumes they can take down the debt without imploding, and many of these firms will not be able to do so. If you were wondering where I got my S&P 500 target of 500 - or perhaps worse - this is part of the computation. Its not all of it by any means, but it certainly is part of it. There is exactly one way to stop this idiocy, and that is for the bad debt that exists out there to be forced into default and thus cleared from the system. This will cause the debt to GDP level to come down. Clearing it back to the point where a 1:1 ratio or better exists between GDP and a dollar of debt may not be possible or reasonable, but if we don't stabilize this situation - and soon - we are running the risk of literally crossing the event horizon. Congress must act now. The fuse is about to go inside the box and once it does, you can't snip it any more. It may, in fact, already done so.
Specifically, Congress must: (#1) Force the immediate cessation and unwind of these "special facilities", including the so-called "money market" liquidity facilities. While its bad if money market funds break the buck and return only 98 cents, the fact remains that every one of these funds has a statement in the front of the prospectus that says "may lose value." If The Fed refuses to stop coddling its member banks and tampering with the credit markets then Congress must force this outcome via emergency legislation. We must stop forcing money in the debt markets out of various portions of the market and into the "guaranteed" ones by removing the guarantees, or we will wind up guaranteeing all of it - an impossible task, as there is some $53 trillion of private credit in the marketplace and we don't have the money! Bernanke is a trapped rat and his desperate actions are now threatening the sovereign debt of The United States. (#2) Force a full stop on the insane pace of Treasury Issue. We cannot allow a bond market dislocation. If one occurs we will suffer an economic depression. Not might - WILL. (#3) Repeal the EESA and force Fannie and Freddie's portfolios to unwind, effectively repealing the portion of the Housing Bill earlier this summer that dealt with them. If this bankrupts Fannie and Freddie and results in losses for the debt holders, so be it. (#4) Enact policies (both literally and by "jawbone") that force the bad debt in the system out - through bankruptcy if necessary, through pay down if possible. This sounds cruel and painful. It is painful but necessary; the key here is to prevent a bond market dislocation, especially in the Treasury Market. (#5) As part of #4, force housing prices down so that the median home price returns to 3x median income. This will produce a monstrous number of foreclosures but that is preferable to the alternative - an economic depression. Note that these people will not be homeless; there will be lots of empty houses to rent, and rental prices will collapse due to oversupply. In a couple of years these individuals will be able to repurchase either their home or a comparable one - with 20% down, 36% DTI and a 30 year fixed mortgage, as prices will return to levels where this will be possible. I understand this is politically difficult but it is necessary; a massive number of consumer bankruptcies sounds bad, but is in fact good, as clearing the bad debt from the system is necessary to prevent its collapse. (#6) If the bad debt defaults cause the collapse of the large money-center banks, then Congress should consider the creation of five or ten new banks with an initial capital infusion of $20 billion each, IPOing each immediately and attaching an onerous coupon (e.g. 10%) to the initial capital to strongly encourage its replacement with private capitalization. This will provide a base lending support of $2 trillion into the economy. However - until #1-5 are undertaken the economy cannot absorb this capacity and therefore it is of no value until that bad debt has been defaulted.
Everyone is screaming about "increasing credit growth" - including Nouriel Roubini this morning on CNBC. What Nouriel and the rest who are calling for this sort of "tonic" are missing is that you can't increase credit growth into the market until the existing bad debt has been defaulted as the GDP contribution from additional debt load is dangerously close to going negative, and as it approaches zero you get no economic benefit from doing so. Attempting to issue new credit (debt) into the market at this time is at best of no benefit and at worst counterproductive. If that ratio goes negative then you are forced to issue new credit (debt) just to cover interest payments, at which point you no longer can get out of the mess without what amounts to a monetary and economic system collapse.
Those in the media who are chuckling at the folks stockpiling beans and rice will be begging for some of that stash if our government doesn't cut this crap out - and soon. We may be literally days away from a second, far more serious credit and equity market dislocation, this time originating outside the United States. We cannot prevent this second dislocation from occurring but it is absolutely essential that the government "ring fence" Treasury debt before it occurs. Government debt must be protected at all costs or we will lose our ability to fund essential services including Social Security and Medicare. If Congress fails to act (given that Treasury and The Fed have demonstrated they will tie our sovereign debt to the commercial credit markets to the greatest extent possible) and this second dislocation occurs the probability of an economic Depression rises to 80% or more and the odds of the 2003 market lows holding into 2009 and beyond are essentially zero. As I see no evidence that Congress grasps the serious nature of this threat and has refused to listen to those of us that have gotten this right from the start, including Nouriel Roubini, myself, Anna Schwartz and hundreds of other commentators and economists, you must prepare for this outcome - and remember who's responsible if and when it occurs.