Links 10/30/08


  1. Independent Accountant

    I read Hamilton’s comment on deflation. They way I say it is: Bernanke will not repeat the Fed’s 1929-1933 mistakes, but those of the Reichbank from 1918-1923. With the monetary base increasing 35.56% in six weeks, I can’t make a credible case for deflation.

  2. Anonymous

    Indy Account…

    I agree. Jim Hamilton is among a long list of people that continue to believe that the Fed can ‘print it’s way out’ of a possible deflationary scenario. For every action there is an equal and opposite reaction.

    If the Fed continues to expand it’s windows and balance sheet they will eventually cause a disruption in the treasury issues markets. A bond market dislocation.

    Hyperinflation is very possible if they continue down their current path.

    At some point money will flee treasury issues and there are few places for it to flee to. How about commodities? Is the latest move up in commodities and dollar weakness due in part or whole to the latest Fed interest rate cut?

    Problem with Hamilton’s theory is that he assumes that smart money will continue to purchase treasury issues even if they are offering low interest rates and confidence erodes further in the AAA credit rating of the US.

    Certainly the Fed can cause hyperinflation but at a terrible cost.

  3. Don

    ““You don’t just suddenly lose $120 billion overnight,””

    A post on the NY Times by Mary Williams Walsh about how AIG is spending its money from you know who:

    “The American International Group is rapidly running through $123 billion in emergency lending provided by the Federal Reserve, raising questions about how a company claiming to be solvent in September could have developed such a big hole by October. Some analysts say at least part of the shortfall must have been there all along, hidden by irregular accounting.

    “You don’t just suddenly lose $120 billion overnight,” said Donn Vickrey of Gradient Analytics, an independent securities research firm in Scottsdale, Ariz.

    Mr. Vickrey says he believes A.I.G. must have already accumulated tens of billions of dollars worth of losses by mid-September, when it came close to collapse and received an $85 billion emergency line of credit by the Fed. That loan was later supplemented by a $38 billion lending facility.

    I wonder what irregular accounting is.

    “These accounting questions are of interest not only because taxpayers are footing the bill at A.I.G. but also because the post-mortems may point to a fundamental flaw in the Fed bailout: the money is buoying an insurer — and its trading partners — whose cash needs could easily exceed the existing government backstop if the housing sector continues to deteriorate.”

    See, this is not news. We knew that they didn’t know exactly how much they might lose. Now you know why people are coming up with plans left and right to avoid foreclosures. AIG anyone? Taxpayers anyone?

    “No information has been supplied yet about who these counterparties are, how much collateral they have received or what additional tripwires may require even more collateral if the housing market continues to slide.”

    See, this is important to know. If we would have known this figure at the beginning, we might have reconsidered whether to give this money or the terms.

    “For securities lending, an institution with a long time horizon makes extra money by lending out securities to shorter-term borrowers. The borrowers are often hedge funds setting up short trades, betting a stock’s price will fall. They typically give A.I.G. cash or cashlike instruments in return. Then, while A.I.G. waits for the borrowers to bring back the securities, it invests the money.

    In the last few months, borrowers came back for their money, and A.I.G. did not have enough to repay them because of market losses on its investments. Through the secondary lending facility, the insurer is now sending those investments to the Fed, and getting cash in turn to repay customers.”

    1) A short term borrower borrows money and gives AIG some collateral
    2) AIG invests this collateral
    3) Short term borrowers come for collateral
    4) Investments lose money, not enough to pay back collateral

    This problem is being addressed by the $38 billion. $18 billion of it has been used.

    “An estimated $13 billion of the money was needed to make good on investment accounts that A.I.G. typically offered to municipalities, called guaranteed investment contracts, or G.I.C.’s.

    When a local government issues a construction bond, for example, it places the proceeds in a guaranteed investment contract, from which it can draw the funds to pay contractors.
    After the insurer’s credit rating was downgraded in September, its G.I.C. customers had the right to pull out their proceeds immediately. Regulators say that A.I.G. had to come up with $13 billion, more than half of its total G.I.C. business. Rather than liquidate some investments at losses, it used that much of the Fed loan. “

    1) Money put in GIC
    2) AIG downgraded
    3) GIC’s cashed in

    $13 billion spent here

    “The biggest portion of the Fed loan is apparently being used as collateral for A.I.G.’s derivatives contracts, including credit-default swaps.

    The swap contracts are of great interest because they are at the heart of the insurer’s near collapse and even A.I.G. does not know how much could be needed to support them. They are essentially a type of insurance that protects investors against default of fixed-income securities. A.I.G. wrote this insurance on hundreds of billions of dollars’ worth of debt, much of it linked to mortgages.”

    1) AIG offers CDS’s to lenders in case of foreclosure
    2) A bunch of foreclosures occur
    3) AIG needs to pay insurance on foreclosures

    A continuing and indefinite process.

    “By fall, as the mortgage crisis began roiling financial institutions, internal and external auditors were questioning how A.I.G. was measuring its swaps. They suggested the portfolio was incurring losses. It was as if the company had insured beachfront property in a hurricane zone without charging high enough premiums.

    But A.I.G. executives, especially those in the swaps business, argued that any decline was theoretical because the hurricane had not hit. The underlying mortgage-related securities were still paying, they said, and there was no reason to think they would stop doing so.”

    Thank God they’re not with the National Weather service.

    “Through spring and summer, the company said it was still gathering information about the swaps and tucked references of widening losses into the footnotes of its financial statements: $11.4 billion at the end of 2007, $20.6 billion at the end of March, $26 billion at the end of June. The company stressed that the losses were theoretical: no cash had actually gone out the door.

    “If these aren’t cash losses, why are you having to put up collateral to the counterparties?” Mr. Vickrey asked in a recent interview. The fact that the insurer had to post collateral suggests that the counterparties thought A.I.G.’s swaps losses were greater than disclosed, he said. By midyear, the insurer had been forced to post collateral of $16.5 billion on the swaps.

    Though the company has not disclosed how much collateral it has posted since then, its $447 billion portfolio of credit-default swaps could require far more if the economy continues to weaken. More federal assistance would then essentially flow through A.I.G. to counterparties.
    “We may be better off in the long run letting the losses be realized and letting the people who took the risk bear the loss,” said Bill Bergman, senior equity analyst at the market research company Morningstar. “

    See, this $447 billion dollar figure bothers me. Can you say hurricane?

    The problems are:
    1) Securities lending ( Category 3 )
    2) GIC’s ( Category 3 )
    3) CDS’s ( Category 5 )

    On the Saffir-Simpson Scale.

    “Winds greater than 155 mph (135 kt or 249 km/hr). Storm surge generally greater than 18 ft above normal. Complete roof failure on many residences and industrial buildings. Some complete building failures with small utility buildings blown over or away. All shrubs, trees, and signs blown down. Complete destruction of mobile homes. Severe and extensive window and door damage. Low-lying escape routes are cut by rising water 3-5 hours before arrival of the center of the hurricane. Major damage to lower floors of all structures located less than 15 ft above sea level and within 500 yards of the shoreline. Massive evacuation of residential areas on low ground within 5-10 miles (8-16 km) of the shoreline may be required. Only 3 Category Five Hurricanes have made landfall in the United States since records began”

    Add Hurricane AIG to the list. I hope I’ve misunderstood this article.

    Don the libertarian Democrat

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  5. Mr Curious

    Seems to me that this massive Fed lending is simply filling in the holes in balance sheets that losses created. But, the money at some point, needs to be re-paid. Thats when inflation kicks in. Right now, Fed is trying to slow deflation which is caused by credit destruction(massive losses).

    As no one knows(or says) what AIG’s losses are, we need to know how much the Fed(taxpayer) is on the hook for. Is it $100 billion? 200? Unlimited?

    What annoys me, is no one is putting up a timeline showing how commodities have tanked since August, versus when LEH/AIg hit the wall. Could it be that these firms are responsible to some large degree in the commodity runup? And that the selling we have seen is them exiting purely speculative trades?

  6. bena gyerek

    i found the aig article very interesting.

    i imagine the heart of the cds problem is a difference in accounting culture between capital markets (protection buyers) and insurance (protection sellers). i think this may be more to blame than outright fraud on the part of aig.

    capital markets simply mark contracts to market daily based on current credit spreads and other market variables. unsurprisingly, this apprach now shows most of the contracts to be deep underwater for aig and the protection buyers are therefore demanding lots of cash collateral. i imagine the valuation of a lot of these contracts depend on some key variables (e.g. credit correlation, recovery rates) that are not easily observable in the market. i also expect that the capital markets protection buyers control these variables when calculating collateral payments by aig, so unsurprisingly they now assume e.g. much higher correlation on cdo’s (not an unreasonable assumption), which again means a much more negative mark to market for aig who would have “wrapped” (insured) the most senior tranches of these cdo’s.

    i don’t know a lot about how insurers typically account for insurance contracts, but i would imagine that it is pretty binary (i.e. either it has resulted in a claim or it hasn’t), and is based on an actuarial approach that by definition is very slow to adapt to changing market sentiment. if the underlying risks are unpredictable and rare (like hurricanes), this is a reasonable approach. this approach is comparable to the one adopted by banks in marking to market bilateral loans.

    no doubt aig and other insurers will be forced in time to adopt more rigid mark-to-market methodology (although this still leaves open questions about correlation, recovery and other opaque pricing assumptions), so they account for these derivatives in the same way their counterparts do. this will reveal big holes in a lot of insurers’ balance sheets, so don’t expect the government to push this in a hurry.

    on the other hand, a moratorium on collateral payments by aig sounds quite reasonable given that aig is effectively us government credit risk now.

  7. a

    For AIG I imagine a lot of that money is going to the IB who cannot be named, who probably stuffed it with the worst toxic sludge imaginable.

  8. Tortoise

    Whether we like the Fed or not, we better pay attention to the old maxim “Do not fight the Fed”. It is the most powerful institution, though it really has so little “official power”. The Fed is more powerful in matters economic than Congress. And yet, the Fed can be abolished tomorrow by an act of Congress! (This may help in understanding the comedy of manners every time the Fed chair appears in front of a congressional committee.)

    So, rest assured, the Fed can create inflation if they wants to. But will they? Yes, if this is the politically less painful road. The Fed chairman is a political animal.

  9. doc holiday

    This metaphor is about being on thin ice. Many people go about daily life without realizing how fragile their infrastructure is, and thus they come to depend on synthetic support and bridges that are suspended by structurally flawed mechanics that are not bound by solid supporting mechanisms. This is an age of defying gravity, where the desire to find meaning in the unseen is seen in the LHC and other attempts to connect invisible shit to incomprehensible illusions, which then become our collective future sources of stability and strength for those that never got it in the first place.

    In regard to this boring economic metaphor, everyone knows that this youngster has been kidnapped from its crèche, while the real Mom is out at some casino taking chances on some wild bet to get more shit than she has. The compounding cascade of instability she created for herself with her latest run of bad luck was all about simple greed and taking her eye off the ball, i.e, her kid. This little one may depend on the mutual benefit of exchange, but what honesty is there in a system that thrives on greed and complex transactions.

    People end up creating financial messes because they fail to take time to place things into perspective — and instead, everyone looks for short cuts and then they place their trust in the fate of lotto tickets and 401ks which are linked to some glossy marketing bullshit that glosses over the reality of risk and the fact that they just need your cash to sustain the on-going pyramid scams. If yah look around, the thin ice is still melting and IMHO, this is not the time to be looking for an anchor to pull you down!

    As we, The Irish know, your born in pain, live in fear and die alone. These are harsh times indeed and the bottom line is that when your on thin ice, you may want to think about what lies beneath and ponder on your ability to sink or swim … and don’t forget that message with being greedy, which was in The Perfect Storm — based on a true story:

    The Perfect Storm

    This sermon has been approved by Doc Holiday and The Church of The Sacred Thin Ice Swaps.

  10. Anonymous

    Concerning the European sovereign debt problem that Evans-Pritchard and others keep on writing about:

    I think I’ve understood it now. The key is, that the potential BUYERS of the most important part of this debt (Euro bonds issued by Euro governments) BELIEVE that the coming recession is going to be so severe that there is close ZERO threat of INFLATION. As a result, their key criterion is, can the issuing sovereign PRINT MONEY to cover its debt in a worst-case scenario? Obviously The Euro governments actually cannot do this because the ECB is entirely independent, while the US and the Japanese governments can do this.

    They believe that printing money will not cause inflation (which would be equivalent to a partial default on their bonds) as long as it is counteracted by the deflationary effects of the recession.

    This is the only way I can explain the strength of the dollar against the euro, given the fundamental health of the European economy taken as a whole as against the bloated US economy.

  11. Anonymous

    People who buy bonds don’t care if the money is printed or left under pillows by the Fed Fairy. All they care about is the purchasing power of the currency they get back. That is determined by the amount of wealth out there competing to buy the goods and services that a produced during a given time. So many trillions of wealth has been destroyed that there are far fewers dollars out there to buy things. So there is plenty of room for right now for money printing before prices are driven up.

    However, once the liquidity crunch is solved, stock prices will recover to normal levels. At that point the Fed will have to sop up the extra cash. I don’t know how they will do that.

  12. R. Rambler

    Why is Roubini, who has been right as rain on most everything, calling for deflation? Hamilton, I remember, called the housing situation “froth” rather than a “bubble” in 2005, fwiw. Not that he didn’t come around, but who has been more direct and reliable in his calls?

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