Baseball91's Weblog

September 27, 2008


The revolution is here in the financial markets.  There was never a new paradigm.  In a crisis of debt the best action is to pay off debt completely.  That is how you win back a credit rating.  Those are the cardinal rules.  And the cardinal rule of savings might be the real solution.  You can no longer create wealth in this environment with leveraged borrowing.  Big money realizes that in a deflation, you need cash to keep going, to keep your business in operation.  In the new era of deflation accompanied by low interest rates, you want cash.  Hence the coming sell-off in stocks, to raise cash to support an income stream over time.

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 at 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 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 had 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-plus 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. And 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 he 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? What does leadership not understand? 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 diminished, 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 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?

The revolution is here in the financial markets. And no one knew what to do.

Charles Kindleberger, the MIT professor, leaned heavily on Minsky’s work. Kindleberger, the author of
Manias, Panics, and Crashes: A History of Financial Crises, wrote that cash generated by their assets no longer is sufficient to pay off the mountains of debt they took on to acquire them, which prompted lenders to call in their loans. “This is likely to lead to a collapse of asset values,” Mr. Minsky wrote. Forced to sell even their less-speculative positions to make good on their loans, markets spiral lower and create a severe demand for cash. It is all about cash.

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  1. This whole bail out is scary. If I ran my house like the government runs this country, I’be be bankrupt. Oh wait a minute….

    Comment by PHP Developer — September 28, 2008 @ 4:13 AM | Reply

  2. Comment by baseball91 — March 24, 2012 @ 2:31 AM | Reply

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