“Credit is the air that financial markets breathe, and when the air is poisoned, there’s no place to hide.” – Charles R. Morris

With the help of the Fed, the hissing from the big bubble is not done.  There are no Black Mondays with housing prices, when prices fall 23 percent in a day.  They occur much more slowly than stock prices.  But not subtley.  So wrote Paul Krugman on August 8, 20005.  His book published earlier this year deals with economic times in the Great Depression, and how they relate today.  No wonder he won the Nobel Prize in Economics this year.

On December 22, 2008, Paul Krugman wrote in the New York Times that whatever the new administration does, “we are in for months, perhaps even a year, of economic hell. After that, things should get better, as President Obama’s stimulus plan ― O.K., I’m told that the politically correct term is now “economic recovery plan” ― begins to gain traction. Late next year the economy should begin to stabilize, and I’m fairly optimistic about 2010.” 

When he was asked his thoughts on the prospect that gasoline could go over $4 a gallon this summer, George W. Bush, Jr., responded, “I hadn’t heard that!”   At the White House press conference, on Feb. 28, 2008, he also denied the country was headed into a recession.  Economists now say that recession began in December 2007. 

Looking for wisdom.  It was always out there.  In Charles Kindleberger’s book, Manias, Panics, and Crashes.  I am reading it now. 

One of the New York Times 100 notable books of 2008 is the book, The Trillion Dollar Meltdown: Easy Money, High Rollers and the Great Credit Crash, by Charles R. Morris. 

Morris is author, attorney, former banker, and software company executive.  He puts the readers through the factors which created “the greatest credit bubble in history.”  His book had been published before St. Patrick’s Day, long before talk of activating the Large Hadron Collider machine on September 10, 2008.  I was suspicious about the LHC and its affect on Wall Street.  I lived next door to Calvin Coolidge’s secretary in 1969.  Miss Braddock felt that landing someone on the moon was gonna set off the ocean tides. 

From the Bloomberg News last week.  “You’re up to $1 trillion now and this is still going to run for some time,” said Charles R. Morris, whose book “The Trillion Dollar Meltdown” was published in March. In September 2007, “the first back-of-the-envelope calculation I did came up with $1.1 trillion and this was using really low-default estimates.”

Mr. Morris writes in his book: “The sad truth…is that [the] subprime [mortgage market] is just the ‘first big boulder’ in an avalanche of asset write-downs that will rattle on through much of 2008.  An overhaul of subprime-like assets, at least as large, is sitting in corporate debt, commercial mortgages, credit cards, and other portfolios.  Even municipal bonds may be at risk.  Loss estimates of $400 billion to $500 billion barely get your halfway there…When large wobbly objects tumble, they go very fast…I lay out…the likely course of write-downs and defaults on the whole asset gamut–residential mortgages, commercial mortgages, high-yield bonds, leverage loans, credit cards, and the complete bond structure that sits atop them.  It comes out to about $1 trillion.” 

I do not think that the financial meltdown of 2008 was a temporary dislocation.  William Hughes wrote a book review of “The Trillion Dollar Meltdown” in March 2008.  He included in his review the coming conflict in fiscal policy in a recession, involving lower wages to keep US Government bonds more attractive than stocks, the ugliest of ugly conflicts of interest by the US Fed.  He predicted the bailout put together by Ben Bernanke and Henry Paulson 6 months before it was raised.  “We will see money overflowing everywhere. We will see more money directed towards speculation again. We will see more price inflation. The only big question in my mind is whether higher wages will be tolerated. They call them ‘Secondary Inflation Effects’ which are halted, thus enforcing the destruction of the Middle Class. Lower wages permit the long-term interest rate to stay suppressed.”

If there is something fundamentally wrong with the US economy, then spending more will not fix it.  A physician listens to subjective complaints and then goes in search of objective data.  What do the findings show?  Because getting the right diagnosis means finding the right treatment plan.  These symptoms include massive debt and overspending, both individually and collectively.  By people.  By companies.  By municipalities.  Drinking, smoking, carrying on.  All the excess.  Of high income concentration.  The contagion of too much debt in the neighborhood.  The subprime collapse was just another symptom of little regulation over time, with a loss of transparency.  Too much reliance on money from overseas.  China was booming based upon the appetities of the American consumer.  So foreigners have joined the feast because of all of the US debt. The United States continues importing more than it exports.  The “customer” was lost amidst all of this.  That customer who was always right.  Customers once got attention, whereas consumers got no real attention.  Many feel there was not  enough tax revenue to maintain what we had, in the way of roads.  Despite the reckless government spending.   

Writes Harvard University vice provost for international affairs and a professor of Mexican and Latin American Politics and Economics, Jorge Dominguez, and Juan Enriquez, author of “The Untied States of America: Polarization, Fracturing, and Our Future”: 

“Austerity. Because we have been spending 5 to 7 percent more each year than we earn, a forced restructuring, triggered by a currency collapse, would have the same effect on wages and purchasing power that the housing collapse had on housing prices. All talk is of payments, supports, subsidies, incurring more debt, stimulus packages. The thesis seems to be: If only we spend more the party can go on. The thesis seems to true only if the financial meltdown is a temporary dislocation in housing and credit markets, a temporary mismatch. 

“Middle Easterners and Asians who save and invest bought dollars for decades, but some of this money is now fleeing. The dollar has dropped sharply. Gold has skyrocketed. In financial crises, huge pools of capital cross borders very quickly; a few can make a great deal of money shorting the country’s currency. The solution requires the country to begin to spend what it earns, reduce its mountainous debt, and address massive liabilities, restructure Social Security, pension deficits, military, and Medicare. No wonder politicians would rather spend more of your money now rather than address these problems.

William Hughes did a book review of Morris’ book.  “The massive financial chicanery, shady corporate insiders’ dealings, really stupid government policies, predatory lending practices, stockholders’ conning schemes, and the outright fantasies.  This is scary stuff!  What makes it even scarier is that one of the most culpable parties to this ongoing crash, President Bush, is in total denial.  And he’s going to be in office for another nine months!   Author Morris warns that to continue ‘to downplay and to conceal the current crisis will lead the country on a path to disaster.’”

Writes William Hughes, “Like a whirlwind, the crisis triggered by the housing crisis and mortgage debacle has extended to almost every phase of the landscape in US economic and financial life. And the rookies running the US Federal Reserve initially said the problem would be contained.  My claim made in late June 2007 was that it involved absolute contagion to the system, which is what we see vividly now.  Let’s review some high level stresses in several arenas, examine the response potentials, and check on the gold and US Dollar impact.  One should note, the gold and silver prices will soon demonstrate strong independence from the US dollar.  Just like in 2005, gold can rise even with some bounce in the buck.  Unlike 2005 though, the buck is likely not to make much in the way of advances.”

The story of 2009 will be foreign currencies.  Hughes predicted the weakness in foreign currency.  In the early part of 2008 as problems with banking, bonds, and now economies went global.  “In reaction to policy changes, primarily monetary and now fiscal, gold will react to an acceleration in monetary inflation after a long period of heavy money growth over 10% annually in many leading industrial nations.”

In March 2008, Hughes wrote, “The US Fed has been playing a dangerous secretive game. They denied the depth and power of the bond debacle in order to wait for Europe to feel the same problems.  The US Fed wanted to wait until Europe saw banking problems, economic slowdown, and bond losses.  Some degree of arrogance might have crept into their thinking that the US system was more resilient, more robust, and had stronger markets with greater safeguards installed.  All were untrue.  The US Fed figured they could cut interest rates faster later, only after Europe started to show signs of similar problems, joining them in the easing cycle.  Well, Europe took a few months more time to detect damaging signals, and their problems on the continent are much less imposing in their degree of destruction than what is seen in the Untied States.”

In March Hughes wrote, “The bigger reasons for the US Fed to fiddle and diddle, delaying and postponing, are more profound to the problems faced. They are two-fold.  Primarily, the US Fed is a private firm, with primary loyalty not to America but to owners who reside in London and Old Europe, with no desire to eat a trillion dollars or more in losses.  So their initial repurchase loans to member banks and other banks have been for high quality US Treasuries, not mortgage bonds, and certainly not collateralized debt obligations.  Up to the time when the Term Auction Facility opened shop last month, the US Fed only took US T-Bonds of various maturities. Since the Term Auction Facility began to lend against broader assets, they began to accept Fannie Mae & Freddie Mac bonds. Think their corporate bonds and mortgage backed (in)securities. Why would the US Fed take Fannie Mae & Freddie Mac bonds?  Because they eventually will be bailed out by the US Government.  Though they might not really be fully guaranteed, they will be at crunch time.

“The other reason the US Fed delayed in prescribing and delivering the needed monetary medicine again points to their private firm status. They wanted to have the US Government take the $1 trillion tab for bailouts, to put the kibosh on the US Dollar, not the private US Fed owners. They are no more a public benefactor than Wall Street. Both the US Fed and Wall Street firms are the quintessential parasites in the modern financial era.

“Finally, the US Government has proposed a measly $150 billion bailout proposal, the first of several.  My forecast has been firm, that the rescue packages will be numerous, greater in scope in succession, and each inadequate until a master Resolution Trust Platform is instituted. The price tag on the full blown rescue will be at least $2 trillion and possibly as much as $4 trillion. The US Government fiscal packages will include tax cuts for households, permanent installation of lower taxes for the wealthy and corporations, greater tax incentives for business investments and job hiring, items directed to the poor, and more.

“When the monetary stimulus takes root from lower interest rates and easier repurchases to assist the mortgage process, while at the same time the government fiscal stimulus packages spread out more broadly, we will see money overflowing everywhere. We will see more money directed towards speculation again. We will see more price inflation. The only big question in my mind is whether higher wages will be tolerated. They call them ‘Secondary Inflation Effects’ which are halted, thus enforcing the destruction of the middle class. Lower wages permit the long-term interest rate to stay suppressed. Lower wages ensure the recession necessary to keep US Government bonds more attractive than stocks, the ugliest of ugly conflicts of interest by the US Fed. The US Dollar takes heavy blows when the US Government stimulus package takes form as less an unknown. The gold price has risen since January, in part because of the foreseen combination of heavy US Fed monetary medicine and heavy US Government fiscal medicine working. It smells more inflation in all forms.  

“When prescription moves to application, gold will vault past $1000 per ounce easily. Also, silver will vault past $20 easily.  The major rub will be the effect on long-term US Treasury bond yields.  The solution requires more price inflation, asset inflation, wage inflation, and spillover, all of which contribute to rising long-term interest rates. Already, we see the rub in higher mortgage fixed rates, higher jumbo mortgage rates, higher corporate bond yield spreads, higher junk bond yield spreads, higher fixed rate swaps. My gut feeling is that Rookie Chairman Bernanke harbors quietly his biggest fear, that enacting a full blown rescue of the banking & bond & economic system will trigger a bear market in US Treasury Bonds. That would ensure a credit derivative meltdown an order of magnitude worse than just from Credit Default Swaps off mortgage bonds, and an order of magnitude more swift.”

So wrote William Hughes in March 2008.  

Alan Sloan wrote a piece in Fortune about market sentiment, without stating the obvious, that the fundamentals are unchanged.  The problem is debt.  You need cash.  You want cash. 

It was ten years ago in August that the Russian government ended up defaulting on $40 billion dollars in obligations. There was a “Minsky moment” with the Russian financial crisis at the time  when debt-heavy investors all rush to market with their assets at the same time, triggering de-valuation and ultimately a liquidity crisis.  

Hyman P. Minsky was an economics professor at Washington University.  Minsky believed there was an “inherent instability” in unchecked capitalism ay its core, which in turn led to “recurrent bubbles or stampedes or over-exuberance.”  He believed that finance was the bloodstream of the economy, and any poison entering it soon would pollute the whole system.  Instability was not an aberration in finance.  “He pretty much just harped on the fragility of the financial system and the economy.  It was the greatest curse because here was this guy harping on this thing nobody believed.  I had to labor under his tutelage, and I wasn’t sure I believed it either,” University of St. Thomas economics professor Mel Gray told a MinnPost reporter.  

The Minsky’s model of the credit cycle has five stages: displacement, boom, euphoria, profit taking, and panic.  George Magnus, senior economic adviser to UBS AG in London, is credited with coining the term the “Minsky moment,” describing the point at which credit supply starts to dry up even to sound borrowers and the central bank is obliged to intervene.  In August 2007, Magnus said, that moment arrived.  While equity markets have stabilized temporarily in anticipation of a Fed loosening, credit markets “remain deeply troubled,” he said.   

“It is apparent to me that Washington’s attempt to bail out banks and brokers will do nothing but add to consumer debt, weaken the US dollar, and literally waste $700+ billion dollars which could have gone to more productive uses. Since the markets blew up in the summer of 2007, Paulson and Bernanke have tried one thing after another to stimulate lending and restore confidence but nothing has worked for more than a brief period.  For the past 14 months Paulson and Bernanke have thrown hundreds of billions of dollars of fed assets into the market, yet lenders still won’t lend.”                                                            – Alan Sloan in a piece in Fortune this week

The revolution is here.  The panic phrase.  Some $1.2 trillion in home equity was borrowed against from 2002 to 2007, says the public- policy group Demos in New York.   Those days are over.  The downward pressure is in place on housing.   Deflation was coming to a theater near you.  And not just in real estate. 

Market sentiment might be temporarily sustained but the fundamentals are unchanged.  The problem is debt. 

According to Richard Russell, “From what I see, the markets are telling us to prepare for hard times and a global spate of the worst deflation to be seen in generations. This is why gold has been sinking, this is why stocks have been falling – big money, sophisticated money, is cashing out, raising cash, preparing for world deflation.”

The fear is what has been presented as a credit problem, one on liquidity, essentially turns into one of solvency, solvency among homeowners, builders, mortgage providers and financial institutions.  My fear with infusion of money is the day if eventually arrives when the government that prints money stays solvent.  Germany in the 1920s. 

So why, with the “bailout,” a concentration on credit markets?  To build more?  If this was a revolution, why do we need more Burger Kings, more Lowes, more strip malls, and more new houses?   With the past credit binge in the last 20 years, there are too many strip malls and stores.  Why, especially in a recession?  In the new world order, it was all about paying off what you wanted to keep.  Expansions were followed by contractions. 

In a deflationary environment, people have an incentive to put off spending.  The profit motive is dimished, and the economy weakens.  Government has few tools to stop deflation. 

 (Posted on August 23, 2007 by Gwen Robinson)

The immediate focus is on short-term funding, financing flows and counterparty risk. This week, three-month US Treasury bills touched 2.99 per cent, compared with a yield of 5 per cent a month ago. Investors are avoiding securities collateralised against or invested in mortgages. This ‘Minsky moment’ is not yet over – interest rates in the US and perhaps elsewhere will come down sooner or later. The path ahead is littered with losses, lawsuits, and greater regulation.

But what about the economic consequences?, asks George Magnus.

In Magnus’s view, two main propositions define the outlook: “First, the flight from debt in this downswing may be as potent as the rush towards it on the upswing”. It is most likely, he warns, that the reduced availability of cheap credit is going to lead to a sharp reverse in US spending on goods and services and assets.

Second, “current credit cycle concerns are about solvency, not liquidity per se, as was the case in 1998, after which the world economy recovered quite promptly”. This time, the problem is about solvency among homeowners, builders, mortgage providers and financial institutions, he notes.

Added to these worries is an increase in the cost of capital, a cyclical switch from building up debt to rebuilding savings and probable declines in consumer and business confidence. It is hardly surprising , then, that Magnus’s conclusion is that all this suggests “the business cycle is going to get quite rough.”  (end of Gwen Robinson’s post from August 23rd, 2007)

That Minsky Moment has lingered on and on, since Ms. Robinson’s post. 

It was two weeks ago yesterday that Hank Paulson and Ben Benacke had convened a meeting on Wall Street at the close of the business weeks.  UBS economist Larry Hatheway pithily observed about that meeting in a note to clients yesterday: “Put differently, if a (quasi) private sector solution was in the offing this past weekend, then Secretary Paulson and New York Fed President Tim Geithner invited the wrong financiers on Saturday-Sunday.”  He invited the top executives from Lehman Brothers, Goldman Sachs, J P Morgan Chase, Citigroup, Morgan Stanley, and and other financial companies.  Larry Hatheway’s view was that the nature of the on-going de-leveraging, in which declining asset values, debt reduction and asset sales reinforce one another, called for additional intervention by government. Hadn’t that intervention come and failed over the last 12 months? 

No one knew what to do.    

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