In an Undercollateralized World
By Frederick Sheehan
The world is undercollateralized. This is the single most important feature of the 2011 economy. Sixty years ago, if assets were worth less than loans, it was possible to work our way into the black. In 1950, 59% of U.S. corporate profits were from manufacturing; 9% were from finance. The roles of manufacturing and finance have reversed. Thus, we witness the desperate attempts to forestall what cannot be prevented. Yet, the world must deleverage. Banks must write off loans. Loans to bankrupt developers and companies must be called. Living standards must fall.
The authorities are doing all they can to prevent the necessary deleveraging. That is the context in which Michael A.J. Farrell, CEO of Annaly Capital Management (NLY- NYSE), spoke to investors during his company’s first quarter 2011 conference call:
"[T]he change that is happening in the financial markets is a chaotic mess. I believe the simultaneous execution of radical monetary policy, fiscal policy, and financial regulatory reform is introducing rather than reducing systemic risk in the global financial system by ignoring the simplest lesson of the scientific method. Rather than change one variable in a complex system and test the outcome, regulators and policymakers are changing virtually all of them at the same time: QRM [quantitative risk management], risk retention, the Volcker Rule, Basel III capital rules, derivatives clearing and related margin requirements. GSE reform. FAS 166 and 167. Zero-bound fed funds policy and QE2. Deficit financing, structural budgetary imbalances, and debt limit debate."
Where will this end? Michael Lewitt, proprietor of Harch Capital Management in Boca Raton, Florida, discussed the consequences of our leaders’ catastrophic policies in the May issue of his monthly letter, The Credit Strategist:
"Rather than confronting sources of volatility, policymakers have sought to smooth out volatility at all costs. Unfortunately, these costs are proving to be very high and will ultimately prove prohibitive. Pressures build inside complex systems until they can no longer be suppressed. When these pressures can no longer be contained, they tend to erupt with far greater violence than had they been allowed to adjust earlier.
Lewitt continued. Federal Reserve Chairman Greenspan and Bernanke "convinced investors the Fed would bail them out if the economy or markets got into serious trouble. As a result, investors engaged in increasingly reckless behavior…" The result: "Rather than saving the markets, Mr. Greenspan’s philosophy and approach guaranteed their failure." One of the consequences is "the build-up of unsustainable debt levels."
We are overleveraged, undercollateralized, and accentuating these unsustainable imbalances. Lewitt notes, "the Federal Reserve has accounted for 101 percent of the net Treasury bond issuance during the first four months of 2011." He goes on: "The U.S. government has been the largest purchaser of Treasuries, promulgating a Ponzi scheme of unprecedented scale."
The U.S. Treasury issues debt and QE2 buys it. Lewitt notes that 10-year Treasury yields have fallen from 3.59% on April, 11 2011, to 3.15% on May 6, 2011.
Since the Fed is the sole net buyer, the 10-year-yield is not a real interest rate. (It has not been a true market for years, but never more so than now.) This is also true of the zero-percent short-term yield, one of the trial balloons listed by Michael Farrell. Interest rates are integral to the pricing of assets. A country without an interest rate has a stock market with a price, but not a value.
The future-focused investor should estimate the value of stocks, commodities, and bonds as if interest rates were 5% higher. That day will come to pass: when assets seek the price of their true collateral. This is not widely appreciated. For instance, the recent dive in silver prices has been acclaimed as a bubble that popped. That might be true, if paper contracts were worth the value they purport to represent. There is not enough silver in the world to meet derivative claims – of ETFs, forward contracts, and so on. When this misrepresentation is widely recognized, physical silver will attract panic buying.
Silver is a fairly small market, so this may go unnoticed. That will be a shame for the majority since everyone holds a paper claim that is not worth the money it is written on. Dollar bills, still flowing forth from the Federal Reserve (more exactly: from the U.S. Treasury’s Bureau of Printing and Engraving), are losing value every minute. Treasury securities are undercollateralized: the Treasury spends $3 for every $2 it receives in tax payments.
What to do? One idea comes by way of footnote #8 in this month’s The Credit Strategist: "Readers interested in owning the Chinese currency can walk into the Bank of China in New York or Los Angeles and open a remnimbi-denominated account. While these accounts originally had limits on size, The Credit Strategist understands that these limits have now been lifted and meaningful amounts of money can be invested. These accounts are insured up to $250,000 by the FDIC (there must be some irony in that.)"
Frederick Sheehan writes a blog at www.aucontrarian.com
Awesome piece Ed. Thanks for sharing it
“Living standards must fall.”
Who’s? Without a pretty detailed specification it is safe to say it will be the poor who some seem to think live fabulously well in advanced economies.
This is just like the misanthropic environmentalist’s argument that the solution to environmental degradation is fewer people.
Which ones? Again the answer to this is inevitably the most vulnerable.
I understand that Mr. Sheehan is trying to make an argument about how the financial markets have been mismanaged and it is one with which I agree in many ways. But most of humanity lives now in market based political economies. In such economies one must either have previously accumulated wealth or income to live in anything resembling freedom. If you have neither you become a ward of some state which treats you according to its parochial standard for indigents, some better, some worse.
To continue to insist that significant portions of the workforce remain idle, and significant capital stocks along with them, for the purpose of getting your asset valuations back in line nicely avoids the question of what those people will use to purchase food and housing, an obvious and direct consequence of such an insistence.
Eliminate the automatic stabilizers and abolish food stamps. These two simple steps will allow the Federal budget to balance according to the “intent” of lawmakers rather than to surge into increasing deficit as an “outcome” of austerity as has been the case since the New Deal implemented the automatic stabilizers of Social Security and unemployment insurance.
This modest proposal will cull the heard and balance the budget, it might even be good for the environment. It also looks psychotically inhumane. Finance is a sophisticated and powerful tool. Like all tools it is morally neutral. Our decisions as to how we use our tools provide them with what moral agency they have. In the current crisis the refusal of finance to look at the moral dimension of its operations will make it lethal.
WIth one in seven americans relying on food stamps and more if you were to cut automatic stabilisers. This would mean the starvation of millions of americans. Why not go the full way and have american death camps for all those that rely on state pensions or benefits? Will this revitalise the economy?
No for a number of reasons. Real estate prices will collapse as the demand would simply not be there. You will have millions of dead americans who would have occupied those homes. The costs of providing goods and services for those left would rise because the fixed costs would be covered by a lower number of users, be this cable TV or internet access. The same would apply for public services like police fire etc.
No because those that are left will be saving like never before to make sure that a slight mishap to avoid starvation and poverty. That would mean that those businesses that rely on discretionary spending would collapse unlerss of course they appealed to the very very rich.
Living standards are already collapsing throughout the western world. They are dropping by 4 to 5% per annum in the UK, except for the rich. They will reveal that the last thirty years economic miracle have been being a mirage all along, with debt and asset bubbles replacing proper wealth creation. Unfortunately we are still not returning to a world where that happens. The eurozone, US and UK are still trying to reflate that bubble. Why? because the very rich depend on that model. Without it their wealth will evaporate, and they are the ones who have funded the political parties.
“Living standards must fall.”
Who’s? Without a pretty detailed specification it is safe to say it will be the poor who some seem to think live fabulously well in advanced economies.
This is just like the misanthropic environmentalist’s argument that the solution to environmental degradation is fewer people.
Which ones? Again the answer to this is inevitably the most vulnerable.
I understand that Mr. Sheehan is trying to make an argument about how the financial markets have been mismanaged and it is one with which I agree in many ways. But most of humanity lives now in market based political economies. In such economies one must either have previously accumulated wealth or income to live in anything resembling freedom. If you have neither you become a ward of some state which treats you according to its parochial standard for indigents, some better, some worse.
To continue to insist that significant portions of the workforce remain idle, and significant capital stocks along with them, for the purpose of getting your asset valuations back in line nicely avoids the question of what those people will use to purchase food and housing, an obvious and direct consequence of such an insistence.
Eliminate the automatic stabilizers and abolish food stamps. These two simple steps will allow the Federal budget to balance according to the “intent” of lawmakers rather than to surge into increasing deficit as an “outcome” of austerity as has been the case since the New Deal implemented the automatic stabilizers of Social Security and unemployment insurance.
This modest proposal will cull the heard and balance the budget, it might even be good for the environment. It also looks psychotically inhumane. Finance is a sophisticated and powerful tool. Like all tools it is morally neutral. Our decisions as to how we use our tools provide them with what moral agency they have. In the current crisis the refusal of finance to look at the moral dimension of its operations will make it lethal.
WIth one in seven americans relying on food stamps and more if you were to cut automatic stabilisers. This would mean the starvation of millions of americans. Why not go the full way and have american death camps for all those that rely on state pensions or benefits? Will this revitalise the economy?
No for a number of reasons. Real estate prices will collapse as the demand would simply not be there. You will have millions of dead americans who would have occupied those homes. The costs of providing goods and services for those left would rise because the fixed costs would be covered by a lower number of users, be this cable TV or internet access. The same would apply for public services like police fire etc.
No because those that are left will be saving like never before to make sure that a slight mishap to avoid starvation and poverty. That would mean that those businesses that rely on discretionary spending would collapse unlerss of course they appealed to the very very rich.
Living standards are already collapsing throughout the western world. They are dropping by 4 to 5% per annum in the UK, except for the rich. They will reveal that the last thirty years economic miracle have been being a mirage all along, with debt and asset bubbles replacing proper wealth creation. Unfortunately we are still not returning to a world where that happens. The eurozone, US and UK are still trying to reflate that bubble. Why? because the very rich depend on that model. Without it their wealth will evaporate, and they are the ones who have funded the political parties.