naked capitalism

I must confess that I have found the events of the last few weeks mighty unsettling, for what they mean not just for the US and the world economy, but the possible implications for geopoltics and our own political processes. We are seeing big shifts along a lot of major fault lines.

I found this to be a bit of a pick-me-up. It is from an odd film of the 1970s, O Lucky Man, directed by Lindsay Anderson (of If fame) with Malcolm McDowell.

The movie uses the device of cutting away from action to the band, making it a Greek chorus that provides cynical observations about modern life in deceptively upbeat-sounding songs. But the theme song for the movie seems a good reminder right now:

Beaked whales: Sounding off BBC

The world’s 23 toughest math questions NetworkWorld

House limits constituent e-mails to prevent crash The Hill. In case your were wondering.

The Solution to Hunting’s Woes? Setting Sights on Women. Wall Street Journal. Is this sport, or cover for new fears about survival? Yes, you too can put food on your family. But cleaning a deer is bloody business….and I grew up in a family where if you didn’t plan to eat it, you didn’t shoot it.

When Wall Street Needs Money, Rules of Journalism No Longer Apply Dean Baker

A new reason to be bullish on America: It is (almost) Sweden Brad Setser

Mark-to-Market Quotes Calculated Risk

Real GDP likely fell in Q3 Jim Hamilton, Econbrowser

Wall Street backed bailout “yes” votes by 2-to-1 dollar margin Marketwatch. Patronage works.

Good day for democracy Joseph Stiglitz, Guardian. The good doctor spoke a bit too soon….

Antidote du jour:

Dunno about you, but I’ve had a rough week, and we are only two days into it, so here is a bonus Antidote:

Twin baby moose in sprinkler (video)

One of my hugely plugged in buddies has been warning that European banks are even more wobbly than US ones, and the ECB will wind up, like the Fed, cutting rates to as close to zero as it dares.

Some of his grim view is based on the fact that EU banks on average are much more highly geared than their US peers, and they were buyers of the dreckiest, end of credit cycle CDOs and structured credits.

But I wonder if he knew about this item too….(hat tip reader Richard)

The more information comes out, the more the financial industry looks like a house of cards. Is this the reason that the authorities have been reluctant to go in the direction of more transparency, despite the frequent calls for it? Particularly when more disclosure might reveal that they were asleep at the switch in the credit bubble?

Despite the hue and cry among the officialdom in favor of the bailout bill, the reading we have gotten from professional investors, some of them with very high level connections, and economists among our readership and personal network is strongly negative. Nevertheless, by making the bill a de facto ultimatum (“do this or we do nothing”) when there were other options for addressing the credit crisis, the Treasury assured a strongly negative market reaction when the bill looked to be in jeopardy (and in fact the Fed has pulled out the stops, but the popular media pay little heed). The specter of the stock market plunging has created panic, and the electorate is responding accordingly.

Sadly, the odds of getting a better bill were not high independent of the pushback. The House Republicans in most cases were opposed for ideological reasons, that the bill was too “socialistic” for their taste. The real issue is that the bill does little to nothing to address the acute aspects of the crisis, namely the seize up in the money, particularly the commercial paper, markers. There will be a brief psychological boost, then back to status quo ante.

From Bloomberg:

President George W. Bush and Senate leaders vowed today to revive a $700 billion financial rescue plan amid evidence voters and lawmakers regretted yesterday’s U.S. House vote to kill the bailout.

Senate Republican leader Mitch McConnell of Kentucky predicted lawmakers would wrap up work on the plan by the end of this week. A plunge in U.S. markets, partially erased today, makes it clear Congress must act, he said….

Voters flooded Capitol Hill offices today, decrying the defeat of the rescue package, a House Republican leadership aide said. Prior to yesterday’s tally, lawmakers said sentiment was running about 100-1 against the plan.

This message comes from a savvy reader/investor/economist, and is refreshingly succinct:

At this stage, I think the bailout complicates matters enormously, because the immediate problem is

1) Preventing further runs on banks and money market funds by extending deposit insurance & mmmf insurance

2) Reviving the interbank market by placing the Fed as counterparty and paying interest on loans

3) Keep working capital loans rolling over until solvency can be assessed and workout recaps can be facilitated.

That’s much more important at this stage.

The biggest problem with this bailout package it that it addresses the wrong problem with unspecified consequences.

It has be sold as protecting the people from the financial meltdown.

If it is posed as first the need to protect transaction deposits, and second to protect lending for current business operations and thus employment, then there are clear solutions that do not require a great deal of congressional for action.

The first problem is resolved by removing the deposits insurance cap and support for money market funds — now done.

The second is to restore interbank lending by introducing now the interest on gross reserves (Bernanke has already requested this) and unifying the discount and Funds rate to have the Fed become guarantor of the market.

To restore short term lending to business, restore real bills lending at the discount window, increase the insurance fund to allow FDIC to agressively resolve troubled insolvent banks, rather than fixing troubled assets

This should prevent the meltdown that Paulson is worried about.

Then the problem of the overall capitalisation of the system can be approached later, hopefully with a Swedish style rescue.

However, Doing Something is clearly taking precedence over Doing Something That Might Actually Work.

This doesn’t qualify as comic relief, but it is a tad freakish how well this clip works:

Hat tip Ben Bitroff

Markets continue to be roiled by the upset of the effort to pass the touted Paulson bailout bill. As of this writing, the FTSE and Dj Stoxx 50 are up slightly, but money markets took a beating, the reaction worsened by end-of-quarter factors. From Bloomberg:

The cost of borrowing in dollars overnight surged the most on record after the U.S. Congress rejected a $700 billion bank rescue plan, heightening concern more institutions will fail.

The London interbank offered rate, or Libor, that banks charge each other for such loans climbed 431 basis points to an all-time high of 6.88 percent today, the British Bankers’ Association said. The euro interbank offered rate, or Euribor, for one-month loans climbed to record 5.05 percent, the European Banking Federation said. The Libor-OIS spread, a gauge of the scarcity of cash, advanced to a record. Rates in Asia also rose.

“The money markets have completely broken down, with no trading taking place at all,” said Christoph Rieger, a fixed- income strategist at Dresdner Kleinwort in Frankfurt. “There is no market any more. Central banks are the only providers of cash to the market, no-one else is lending.”….

The two-month Libor rose to 5.13 percent today, also a record. Libor, set by 16 banks including Citigroup Inc. and UBS AG in a daily survey by the BBA, is used to calculate rates on $360 trillion of financial products worldwide, from home loans to credit derivatives.

Funding constraints are being exacerbated as companies try to settle trades and buttress balance sheets over the quarter- end, balking at lending for more than a day…..

Futures on the Chicago Board of Trade show a 66 percent chance the Fed will trim its 2 percent federal funds target rate by 50 basis points in October, surging from zero percent a month ago. The odds of a quarter-point reduction are 34 percent….

The Libor-OIS spread, the difference between the three- month dollar rate and the overnight indexed swap rate, widened to 246 basis points, showing cash scarcity is at a record.

The difference between what banks and the U.S. Treasury pay to borrow money for three months, the so-called TED spread, was at 338 basis points today after breaching 350 basis points for the first time yesterday. The spread was at 110 basis points a month ago.

As of this writing, Brent crude is at nearly $97 a barrel, gold is at $901 an ounce, and the yen is at 105 (weaker than yesterday’s 104). MacroMan provided more color:

With the end of the quarter and the three month date about to rollover into the new year, the dash for cash has generated substantial distortions, despite the recent central bank dollar swap announcements. First quote of the day for overnight dollars was 13.5%, and yesterday’s ICAP 3 month quote was 4.375%. The last time 3 month LIBOR was that high, Fed funds were 4.25%. The ruptures in the market can be seen in the chart below, which shows the 2-10 US government yield curve and the 2-30 US swap curve. Unsurprisingly, they are normally very highly correlated. However, recent front-end stress have driven a very significant wedge between government and swap curves

Quarter-end also brings about the usual mechanistic rebalancing flows from pension funds and other long-term real money investors. It appears that such flows are already going through in Europe, helping to generate a vicious intraday bounce in stocks. Well, it’s either that or the news of another Benelux bailout or an Irish government bank guarantee.

Or perhaps the market has decided that news which apparently ushered in a new Great Depression last night is actually pretty meaningless this morning. Macro Man and the chap next to him, both of whom are short stocks, have just been left shaking their heads this morning.

Note that FT Alphaville last week had said that Bloomberg on stock futures:

U.S. stock futures rose, signaling the Standard & Poor’s 500 Index may rebound from yesterday’s 8.8 percent plunge, after lawmakers said they intend to salvage a $700 billion bank-rescue package.

JPMorgan Chase & Co., Citigroup Inc. and Goldman Sachs Group Inc. advanced more than 5 percent as Judd Gregg, the Senate Banking Committee’s ranking Republican, and Barack Obama, the Democratic presidential candidate, said a deal would eventually pass. Christopher Dodd, chairman of the banking committee, said senators may deal with the bill tomorrow…

S&P 500 futures expiring in December rallied 24.40 points, or 2.2 percent, to 1,143.20 at 7:08 a.m. in New York. Dow Jones Industrial Average futures gained 149, or 1.4 percent to 10,623. Nasdaq-100 Index futures added 0.7 percent to 1,523.25. European stocks rose, while Asian shares declined. Government bonds in the U.S. and Europe fell. The dollar climbed against the euro.

Conventional wisdom has been that Treasuries have been the yet another bubble as cash exited equities and other risky investments, first feeding a commodities spike, then seeking a better home in Treasuries.

But Merrill’s David Rosenberg, who was in a decided minority in seeing deflation as the likely outcome for the US (he has for some time forecast Fed funds at 1% by year end 2008), thinks that Treasuries will go even higher (which means lower yields) as debt deflation takes hold.

We have excerpted his discussion of the interest rate and housing price outlook from his September 29 report. He starts by showing that financial firms, consumers, and non-financial businesses are all shedding assets, which is deflationary.

From Rosenberg:

Barely halfway through the real estate deflation
The data we got yesterday were quite telling. New home sales sank to 460,000 units in August, a fresh 17-year low, and the inventory-to-sales ratio gapped up to 10.9 months’ supply (MS) from 10.3 MS in July. There is no chance that home prices stabilize until this ratio moves convincingly below 8 months. In fact, our models suggest that there is another 15-20% downside in average home prices and they are already down 20% from the peak. So, we are barely past the halfway mark in this real estate deflation.

Inventory backlog is proving intractable
As a sign of how difficult it has become for the builders to move product, the median length of time it is taking to make a sale from the time the unit is completed shot up to a record high of over 9 months from 5.7 months last year and the 4 months that typifies a normal market. Sales are down to 460,000 units and yet single-family starts, while down 35% from a year ago, are still running far ahead of demand at 630,000 units. This is why the unsold inventory backlog is proving so intractable this cycle – and this will exert ongoing downward pressure on residential real estate prices in most parts of the country.

We can’t grow our way out of this inventory overhang
We are not going to be able to ‘grow’ out way out of this acute inventory overhang via demand because the homeownership rate is still near historic highs of 68% – fully 4 percentage points above the norm. The homebuilders are going to have to work that much harder to work off the excess through a sharper cutback to housing starts, which are very likely to hit new post-WWII lows this cycle (and likely not priced into the HGX index).

Policymakers still underestimating the size of the problem
Tack on our view that the unemployment rate looks set to rise above 7%, the output gap to 4%; credit spreads at elevated levels, together with our expectation of continued house price deflation, and our estimate of the expected total losses going forward are close to $1.5 trillion or double the size of the TARP. So, the one problem we have with the TARP as it stands is the size – $700 billion. This tells us that even Bernanke and Paulson, who have been pounding the table to get this plan TARP legislated, continue to underestimate the total size of the problem. So, when you think about it, this entire credit collapse of the past 13 months has reflected one thing and one thing only, which is the unwinding of the greatest asset bubble in modern US history – residential real estate.

Still haven’t seen credit effects from consumer recession
We still haven’t seen the normal negative credit cycle that follows on the heels of a consumer recession. That is going to be the next leg of this story; it started this quarter, and likely to last well into 2009. In fact, when we look to the last consumer recession of the early 1990s and see what delinquency rates did for a range of mortgage and personal loan products, what it tells is that much like the real estate deflation story, we are at most 60% of the way though this down cycle in banking sector credit quality. Keep in mind that, based on our macro forecast, estimated total non-mortgage consumer and business losses are going to total roughly $300 billion in the coming year. That alone is more than double the entire loss posted during the S&L fiasco in the early 1990s.

Credit collapse is secular and deflationary
So the way to think of this credit collapse is that it is secular in nature, not merely cyclical and also deflationary. Those who believe that we’ve managed, in one day, to switch from a deflationary to an inflationary backdrop because of additional government debt creation are not taking into account the offsetting credit contraction in the private sector, which comes from three sources: asset liquidation, debt repayment and increased savings. The Fed and Treasury are merely cushioning the massive deflationary forces in the financial system.

10-year Treasury note yield plunged during RTC experience
If you go back to that 1989-93 experience with RTC, we can tell you that the 10-year Treasury note yield during that prolonged debt deflation period plunged 400 basis points as the inflation rate was cut in half from over 5% to around 2-3/4%. Let’s also remember that even as we look back to the original RTC, and that too was a major intervention at the time, it took a full year for the equity market to bottom, two years for the economy to bottom, three years for the housing market to bottom, and four years for bond yields to bottom.

Money supply will increase but money velocity will not
We are getting asked repeatedly these days how it is that the government debt creation we are about to see is not going to be inflationary. After all, aren’t we going to see a boom in the money supply? Well, we’re sure that the money supply is going to increase, but at the same time, we are going to see the turnover rate of that money, or what is called money velocity, decline. This is exactly what happened in that 1989-93 period when the Fed massively reflated. Money velocity contracted 13% and this is the reason why the inflation rate was cut in half that cycle and bond yields rallied 400 basis points, though no doubt that downtrend in yields was punctuated by intermittent corrections – as we’ve seen take place in the Treasury market over the past week.

Bloomberg gives a recap of the some of the credit market reaction in Asia, which is that borrowing has become, not surprisingly, more costly. Rates moved up even in Japan, whose banks are virtually unaffected by the financial crisis (out of a total $1 trillion plus in subprime debt, only an estimated $8 billion went to Japan).

From Bloomberg:

Asian borrowing costs rose, with Japanese and Singapore money market rates reaching the highest in at least eight months, even as central banks pumped in cash to ease lending after U.S. lawmakers rejected a banking rescue.

Japan’s overnight call loan rate rose to 0.6 percent, the highest in more than six weeks, and the three-month interbank offered dollar rate in Singapore jumped 11 basis points, or 0.11 percentage point, to an eight-month high of 3.90 percent as banks hoarded cash. Australian funding costs surged by the most since July.

“Counterparty fear in the banking sector is at a new extreme,” said Greg Gibbs, director of currency strategy at ABN Amro Holdings Bank NV in Sydney. “Credit conditions are as tight as a drum. Unless this settles down, central banks would need to cut rates globally to bring funding costs down.”…

The three-month interbank offered rate in Hong Kong rose by the most in nearly a week to 3.664 percent. The difference between the rate Australian banks charge each other for three- month loans and the overnight indexed swap rate jumped 14 basis points to 98 points, close to a six-month high. The gap has averaged 45 basis points this year.

“This crisis is not driven by corporate defaults but by a systematic failure of the banks themselves,” said Anita Yadav, head of credit and hybrid research at UBS AG in Sydney. “It’s no longer about just paying higher borrowing costs, but also about being able to get the money from the market at all.”

Obama Runs Constructive Criticism Ad Against McCain The Onion

Obama winning over ‘Wal-Mart moms’ Financial Times

The methane time bomb Independent

Mission Creep Dispatch: Winslow Wheeler Mother Jones News. A departure from our usual programming. On global Pentagon strategy.

NYT Promotes Hysteria on Bailout Bill Dean Baker

How I learned to love the Fed Steve Waldman

The end-goal of any bailout or government takeover John Hempton

Why Have Things Gone So Wrong? Roger Ehrenberg

Congress votes against bailout plan – but CFAs not actually huge fans either AllAboutAlpha

You Can’t Rescue the Financial System If You Can’t Read a Balance Sheet John Hussman (hat tip Cash Mundy), Nice piece, explains in some detail the observation we have made, that the Paulson plan accomplishes zero unless Treasury overpays for dud assets. Also offers a better rescue option, a so-called “super bond”.

Antidote du jour:

Our reader and sometimes contributor Lune worked on the Hill and was so kind as to send us his take on the choices facing the Senate and House leadership on the bailout bill, His position on it is rather clear:

While many of you may be popping champagne bottles tonight in honor of the bailout plan that never was, we need to realize that this is only one step. The bailout is by no means dead. Having dealt with the legislative process before, here is my speculation about what may happen in the coming days, and the options that Congress has before it:

1) The House schedules a re-vote on the same bill.
Keep in mind that victory today was a very narrow one. The final vote was 228-205. That means a switch by 12 congresspeople would make all the difference. All the leadership has to do is put 12 Bridges to Nowhere-type earmarks buried in the fine print of some appropriations bill, and those 12 votes can magically appear. Or promising to give/withhold campaign funds or plum committee assignments. The list of carrots and sticks available to the leadership is endless. In many ways, the vote turning out the way it did had nothing to with the bill per se, but rather represents a colossal failure of the leadership’s whipping process. You don’t walk into a critical vote like this without knowing how many votes you have beforehand. Indeed, a report in The Hill suggest that Roy Blunt, the Republican whip, miscalculated the votes in his pocket by 10, which was a huge mistake and probably cost them the vote.

2) The House schedules a re-vote after some minor alterations.
The leadership is by no means out of options in the horse-trading that’s likely occurring now. Some of the congresspeople voted no not because they disagreed with the gist of the bill, but because their pet issue (e.g. foreclosure assistance, tax cuts, regulatory changes, etc. etc.) wasn’t included. Just like adding the meaningless bond insurance plan into the bill bought a few Republican votes, similar minor provisions can be added to convince a few more people.

3) The Senate votes first, and the House uses that to pressure members to fall in line.
While the Senate seems to have the votes for passage, all bets are off right now until they come to grips with the House defeat. Senators are now deciding whether they want to walk the plank for Wall Street and possibly lose their jobs for a bill that won’t pass anyway.

4) The process starts again, with new proposals and plans debated.
While this is perhaps the ideal situation, the likelihood of such an orderly debate will depend greatly on how the markets do in the next few days. If chaos continues to reign, the pressure will grow to pass something. This is where all those economists need to come together and come up with an alternate plan fast. While the University of Chicago writing a letter condemning the current plan was nice, it would have been better if they proposed an alternative. Remember that when a house is burning down, and someone proposes doing something, and another proposes doing nothing, chances are that something will win out, no matter how bad it is, simply because doing nothing is not an option.

Economists with ties to the Hill, or with journalists that could publicize such a plan, need to come together to propose a reasonable alternative. Throw enough academic credentials behind it, and they have a fighting chance of being more trustworthy than Bernanke and Paulson. We’ll see if the academic community which has been so vociferous in its criticisms can also make constructive proposals (It doesn’t have to have all the details in place, just remember 3 goals that can be reduced to soundbites for public consumption: save the financial system, punish Wall St., and cost less than $700 bil).

5) Congress is paralyzed and adjourns before passing anything.
This may not be as far-fetched as it sounds. Right now, many congresspeople are desperate to get home and campaign. Plenty of people are locked in tight elections, and every day they spend in Washington is one less day spent rounding up votes. The number one priority of most congresspeople is getting re-elected. If that means leaving DC and leaving the economy in a tailspin, so be it. This will likely depend on how badly the markets are doing, and how far off from getting enough votes the leadership perceives themselves to be.

6) The executive branch (Treasury and the Fed) finds new executive powers that allow them to substantially implement the bailout without Congressional approval.
This has happened plenty of times during this current Administration. No reason to suspect they’re going to stop now.

Those are the possible scenarios that I see possibly playing out in the next few days. The bottom line is that today’s defeat of the bailout was a tactical victory, not a strategic one. There are still plenty of ways that we can end up with a bad plan, and we need to remain vigilant.

Per Lune’s final point: there is plenty the Administration could do on a stop-gap basis. One correspondent pointed out that the Administration could use the Exchange Stablization Fund (admittedly, it might need to be beefed up) to stand behind certain types of dealer trades or other “market maker of the last resort” as Willem Buiter likes to put it, activities.

Boy, there have been bigger bad investments (TPG putting $7 billion into WaMu comes to mind) but seldom has one come cropper as quickly as Mitsubishi UFJ’s $9 billion interest in Morgan Stanley. The bank took a cool $500 million one-day loss.

From Bloomberg:

Mitsubishi UFJ Financial Group Inc. took a $506 million paper loss on its $9 billion investment in Morgan Stanley yesterday after the rejection of the U.S. financial rescue plan sent banking stocks tumbling.

As part of the deal, the Tokyo-based lender agreed to buy $3 billion of Morgan Stanley’s common stock for $25.25 a share. The second-largest U.S. securities firm plummeted 15 percent in New York Stock Exchange composite trading to close at $20.99.

The loss underscores the risks involved for Asian companies seeking bargains in the wreckage on Wall Street. Morgan Stanley, Citigroup Inc. and Merrill Lynch & Co. have tapped the region’s banks and sovereign wealth funds for money in the past year as falling U.S. home prices triggered the worst financial crisis since the Great Depression.

“It’s increasingly difficult to know what’s going to happen,” said Naoteru Teraoka, who helps oversee $21 billion at Chuo Mitsui Asset Management Co. in Tokyo. “The U.S. bailout plan was the big change we hadn’t had before, but that’s gone now, so things can only get worse.”

Krugman’s post is here, with an acknowledgment that we also possess nukes.

We’ve been on that theme a while. A few examples:

America: Banana Republic Watch May 6, 2007

End of Dollar Hegemony Coming? May 22, 2007

“We may just have started to feel the pain” March 6, 2008

A secondary theme:

Tthe US is in very much the same boat as Thailand and Indonesia in 1997, during the emerging markets crisis. And although the US arguably has a more diverse economy, the main things that differentiate us from them is the dollar’s reserve currency status (which means if we implode we do a great deal of collateral damage) and our nukes.

Selected sightings:

“Debt Reckoning: U.S. Receives a Margin Call” March 15, 2008

“Eight hundred years of financial folly” March 23, 2008

From Imperialists to Third World? May 30, 2008

It took no particular insight to see these warnings.

This report from Bloomberg:

Rates in the $7 trillion-a-day market for borrowing and lending securities show that the logjam in credit markets is approaching the level seen after the March collapse of Bears Stearns Cos.

Securities that can be borrowed at interest rates close to the Federal Reserve’s target rate for overnight loans between banks are called general collateral. Notes and bonds that are in the highest demand in the repurchase, or repo, agreement market are called “special” by traders because rates on loans secured by these securities are lower than the general collateral rate.

The CHART OF THE DAY shows the spread of the general collateral repo rate below the Fed’s target rate of 2 percent. The gap, which averaged 0.06 percentage point in the 10 years prior to August 2007, when subprime mortgage losses spread, is now 1.25 percentage points. A wider spread indicates a greater scarcity of Treasuries. The spread reached 2.05 percentage points on March 19 after the central bank engineered the takeover of Bear Stearns by JPMorgan Chase & Co.

“Clearly we are in a high-risk premium mode, just as we were in March,” said Piyush Goyal, an interest-rate derivatives strategist at Barclays Capital Inc. in New York. “Lack of investor confidence, exacerbated by quarter-end concerns, has tilted the repo markets in favor of the collateral owners.”

Aha, the last TAF auction was on the 22nd, the next isn’t for a week plus. Unless the Fed staggers the dates of the increase in the facility, we won’t see relief from it for a bit. I see no press release on the Fed’s website, despite the report on Bloomberg. Weird.

This is on top of the $330 billion increase in dollar swap lines we mentioned this morning.

From Bloomberg:

The Federal Reserve will pump an additional $630 billion into the global financial system, flooding banks with cash to alleviate the worst banking crisis since the Great Depression.

The Fed increased its existing currency swaps with foreign central banks by $330 billion to $620 billion to make more dollars available worldwide. The Term Auction Facility, the Fed’s emergency loan program, will expand by $300 billion to $450 billion. The European Central Bank, the Bank of England and the Bank of Japan are among the participating authorities….

“Today’s blast of term liquidity will settle the funding markets down, and allow trust to slowly be restored between borrowers and lenders,” said Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York. On the other hand, “the Fed’s balance sheet is about to explode.”