naked capitalism

Only the Financial Times’ John Dizard would say straight out that monetary authorities (and diesel) constitute a bigger threat to our collective security than America’s pet nemesis, Iran. I would not be surprised to find some readers in agreement.

Dizard dispatches Iran first. He starts with some colorful quotes, from Talleyrand (in French) and Lord Curzon, both saying that the Persians are lousy fighters.

I’d feel slightly more confident if Dizard cited sources more current than the nineteenth century. Nevertheless, he contends that while an attack on Iran is a manifestly bad idea, the Muslim nation would not succeed in interfering with oil shipments. He recommends shorting oil if war breaks out even as little as a month out.

That’s the cheeriest news I’ve heard in a while.

On the central bank front, however, the writer is adamant that the combination of policies that the Fed and its friends are pursuing now are contradictory and doomed to end badly unless they hold some in abeyance for a while:

It will take serious demand destruction in the jewellery market to bring [platinum] supply and demand into balance, absent a real world depression.

Um, does Dizard know anyone in the diamond district? Visit Ten West 47th Street. All through the 1990s, the booths, which are very expensive, were all taken. At least a third, maybe closer to half, are now empty. There’s been pretty serious contraction for at least the last six years. Third generation dealers have gone out of business, as have very serious estate jewelers I know, as in their clients included the Basses, Bronfmans and Mnuchins. If that level of buyer has backed away from the market, you can imagine what average folk have done.

Back to Dizard

Of course, one should never entirely discount the ability of central banks to engineer just that outcome. The victory of Spain over Germany on the football field has not, sadly, been duplicated in the European Central Bank, as we saw with last week’s policy rate hike. Soon, though, the increasingly obvious vulnerability of European banks may even prompt Trichet & Co to consider how nice it is to have solvent – or at least liquid – lenders.

To hear them talk, central bankers and regulators believe we can continue to have, at the same time, accelerating asset writedowns, stricter capital ratios, and flatter yield and credit curves. That is, without having the real economies shut down from lack of liquidity.

The only way the banks can reconstruct their balance sheets, or at least their cash flow statements, is from years of steep yield curves caused by artificially low policy rates. Is there an inflation risk to that? Yes, of course. But, given our inability to travel in time, there is no way to go back and undo what Alan Greenspan and the others did starting a decade ago.

Banks will need years of cash earnings from positive yield curves, along with accountants’ forbearance, to maintain, let alone expand, their economies.

So, since we are trying to find a few more or less sure things to bet on this unsettled week, I stick by my position that the risk of Federal Reserve policy rate increases is much less than is discounted by the markets. That has worked out in recent weeks and I think will continue.

The level of gloom on housing finance has now got to the point where banks are competing to come up with yet more dire worst-case scenarios for valuing mortgage paper. Interestingly, though, even those cases appear to show some value in certain housing-backed paper.

For example, Bank of America’s fixed-income group, using a “stress case” analysis based on a further 27 per cent decline in house prices over the next two years, found some value in non-US government agency-backed paper.

Given the rate of dumping and consequent low prices, the bank says, “AA rated bonds backed by seasoned collateral offer double-digit returns with no principal writedowns . . . while AA bonds backed by 2006/2007 alt-A collateral take massive writedowns, their adjusted yields are in excess of 40 per cent even in our most conservative [house price decline] scenario.”

Of course, even with those calculations you cannot give the things away. Think about it.

The last few paragraphs bear out the message of Mohamed El-Erian in an earlier post, that there will be great buys for those with iron constitutions. But even the seeming screaming bargain highlighted by BofA could (likely will) get cheaper. Investors also have to be willing and able to ride out volatility and intervening mark to market losses.