Wednesday, March 26, 2008

Everyone wants their own Bear Stearns.

Now that JPMorgan Chase received an Easter present of Bear Stearns (gift-wrapped by Fed in a $30 billion MBS swap), everyone else is (naturally) envious.

I work not far from Bear Stearns main building, and today there is some kind of protest going on there, with people in yellow jackets picketing on the sidewalks. Turns out, it is a bunch of angry homeowners:

My interest rate is 12 percent and I can't refinance," Gail explained.

Gail is joining a dozen other homeowners from Connecticut who are protesting the federal bail out of Bear Strearns. The company went belly up and has added to the ongoing mortgage crisis.

"They need to help people out too, not just companies," said Gail.

This makes perfect sense to me. Everyone has equal rights, correct?
Wells Fargo CEO obviously agrees with me, too:

Wells Fargo CEO John Stumpf said the financial crisis is presenting the bank with more acquisition opportunities.

"I would not be averse to a Fed-assisted transaction," Stumpf said in a recent interview with the San Francisco Business Times. "Fixer-uppers don't bother us."
Note to Fed: if you are gonna give out any more free lunches, please tell us where to sign up in advance, so that we don't feel left out next time.

Saturday, March 22, 2008

Black Guy Asks Nation For Change.

Don't miss this funny Onion: Black Guy Asks Nation For Change.
But they don't even know what they have hit on!

A year from now, when a massive financial bailout has begun, come back and read this again.

Thursday, March 20, 2008

Fed: from exhausted to cornered.

Quite a bit ago I suggested that Fed was exhausted. I was almost wrong - Fed took some steroids, donned a bandit mask, and sacrificed half of its own balance sheet to open another facility to brokerages and to bail out Bear. This, as I already hinted yesterday, backfired and turned Fed from hunter to hunted. And today, the hunted was cornered.

The interest rates on 13-week Treasuries plunged today to 0.4%, going as low as 0.2% at some point during the day. There is no more room for rates to drop. Even worse, Fed is now being under investigation by Congress - which questions the legality of recent moves. This should make Bernanke think twice before trying more questionable experiments. And if you thought it couldn't get any worse than that, guess again: Krugman believes Fed is now incapable of controlling even its own Fed Funds rate!

At the same time TED spread widened yet again, back to its all time high. This, and the borderline insane flight to the safety of T-Bills, means only one thing: the credit market is screaming out loud "We don't trust anyone, and we think even the largest banks are about to go bankrupt!" Everyone is on his own now.

Market to Fed: check, check, and mate.

Interfluidity: Credit Crisis for Kindergarteners.

In one of my earlier posts I tried to explain the current credit crisis in a simplified, big-picture way. But I still had to use big words like 'credit' and 'money supply'. I even used an abbreviation like M3.

But can we explain the current economic problems in a language that even children can understand? Turns out we can.

Interfluidity blog presents: Credit Crisis for Kindergarteners.

Alice, Bob, and Sue have ten marbles between them. Whenever one kid wants another kid to take over a chore, she promises a marble in exchange. Alice doesn't like setting the table, so she promises Bob a marble if he will do it for her. Bob hates mowing the lawn, but Sue will do it for a marble. Sue doesn't like broccoli, but if she says pretty please and promises a marble, Bob will eat it off her plate when Mom isn't looking.

One day, the kids get together to brag about all the marbles they soon will have. It turns out that, between them, they are promised 40 marbles! Now that is pretty exciting. They've each promised to give away some marbles too, but they don't think about that, they can keep their promises later, after they've had time to play with what's coming. For now, each is eager to hold all the marbles they've been promised in their own hands, and to show off their collections to friends.

But then Alice, who is smart and foolish all at the same time, points out a curious fact. There are only 10 marbles! Sue says, "That cannot be. I have earned 20 marbles, and I have only promised to give away three! There must be 17 just for me."

But there are still only 10 marbles.

Suddenly, when Bob doesn't want to mow the lawn, no one will do it for him, even if he promises two marbles for the job. No one will eat Sue's broccoli for her, even though everyone knows she is promised the most marbles of anyone, because no one believes she will ever see those 17 marbles she is always going on about. In fact, dinnertime is mayhem. Spoons are placed where forks should be, and saucers used for dinner plates, because Alice really is hopeless in the kitchen. Mom is cross. Dad is cross. Everyone is cross. "But you promised," is heard over and over among the children, amidst lots of stomping and fighting. Until recently, theirs was such a happy home, but now the lawn is overgrown, broccoli rots on mismatched saucers, and no one trusts anyone at all. It's all a bit mysterious to Dad, who points out that nothing has changed, really, so why on Earth is everything falling apart?

Perhaps Mom and Dad will decide that the best thing to do is just buy some more marbles, so that all the children can make good on their promises. But that would mean giving Alice 19 marbles, because she was laziest and made the most promises she couldn't keep, and that hardly seems like a good lesson. Plus, marbles are expensive, and everyone in the family would have to skip lunch for a week to settle Alice's debt. Perhaps the children could get together and decide that an unmet promise should be worth only a quarter of a marble, so that everyone is able to keep their promises after all. But then Sue, the hardest working, would feel really ripped off, as she ends up with a much more modest collection of marbles than she had expected. Perhaps Bob, the strongest, will simply take all the marbles from Alice and Sue, and make it clear than none will be given in return, and that will be that. Or, perhaps Alice and Bob could do Sue's chores for a while in addition to their own, extinguishing one promise per chore. But that's an awful lot of work, what if they just don't want to, who's gonna force them? What if they'd have to be in servitude to Sue for years?

Almost whatever happens, the trading of chores, so crucial to the family's tidy lawns and pleasant dinners, will be curtailed for some time. Perhaps some trading will occur via exchange of actual marbles, but this will not be common, as even kids see the folly of giving rare glass to people known to welch on their promises. It makes more sense to horde.

A credit crisis arises when many more promises are made than can possibly be kept, and disputes emerge about how and to whom promises will be broken. It's less a matter of SIVs than ABCs.

Wednesday, March 19, 2008

Bear case still a crime unsolved.

When I first commented on the JPM / BSC deal I offered two interpretations of what happened.

The funny thing is, stunned financial commentators are still trying to choose between the two. Newspapers, blogosphere, market analysts, still cannot come to a single conclusion. Some, like Mish, think that the deal was an acknowledgment of Wall Street's insolvency; Mish even provided his own crude calculation of Bear's net worth and came up with $-30 billion. Others, like this analysis, assert that Bear has been set up by evil conspirators who wanted to take it over for nothing.

Whatever the explanation is, market as a whole seems to have chosen the robbery version. JPM's stock has been bid up to increase market capitalization by $10 billion. This is implicitly assigning 30$ per share value to Bear Sterns.

One might wonder why BSC stock itself is still trading at roughly 8$ per share, even though JPM will buy it for 2$. The answer is that BSC shareholders still need to vote 'yes/no' on the deal, and there are a lot of angry shareholders who did not like being robbed. In order to ensure that deal can go through, someone is buying up BSC shares to increase the voting power.

Who are these someones? The most innocent theory would be that it's Bear's bond holders, who need this buyout to happen or they lose everything (total bond value is on tens of billions). There are less innocent explanations too, but again, we will probably never know.

P.S. Maybe the only correction that I should make to my original analysis is that the theft seems to be not so much from Bear shareholders, but from the taxpayers. The $30 billion loan that JPM got from Fed to deal with surprises in BSC portfolio is not so much a loan but rather a purchase of Bear's MBS portfolio, since Fed assumed all risk. So it is more like a $10 billion gift from Fed (taxpayer) to JPM.

Tuesday, March 18, 2008

Another kind of Wile E. Coyote moment.

If you follow economic commentators you may have heard an expression "Wile E. Coyote moment", usually applied to US economy or dollar. This describes the coyote running off the cliff, and then running for a while before he realizes he is in the air and he must fall. Only then does he actually fall.

But I found a completely different kind of Wile E. Coyote moment that captures perfectly the plight of the Fed as it tries to calm the markets. Click the link and enjoy!

Charity with the biggest bang for your buck.

I am not usually big on making donations, partly because in most cases it frustrates me how insignificant any contribution I can spare is in comparison to the scale of the problem. For example, it makes me mad that for every 100 bucks I might give to an environment protection charity, someone out there would spend $100,000 or perhaps rather $100 million polluting the environment. So I feel I'd rather go tell all my friends about it so they could vote the bastards out and vote the more responsible ilk in.

But there is one organization that I feel very different about: The Smile Train. What they do is provide free surgery to children with cleft lip. What is great about it is that surgery only costs 250$, and every single surgery is equivalent to giving one person a gift of normal life, instead of life of perpetual mockery and isolation. It really does seem amazing that a measly sum of money could have such an enormous effect. Yet in developing countries there are many children whose parents cannot pay for this operation.

As Warren Buffett says: “A $250 surgery that can save a child’s life sounds like a pretty good investment to me.” And it is hard to argue with that.

Sunday, March 16, 2008

Fed confirms there is more than one cockroach.

Sunday night press release from Fed (have they slept at all in the last week??).

First, the Federal Reserve Board voted unanimously to authorize the Federal Reserve Bank of New York to create a lending facility to improve the ability of primary dealers to provide financing to participants in securitization markets. This facility will be available for business on Monday, March 17. It will be in place for at least six months and may be extended as conditions warrant. Credit extended to primary dealers under this facility may be collateralized by a broad range of investment-grade debt securities. The interest rate charged on such credit will be the same as the primary credit rate, or discount rate, at the Federal Reserve Bank of New York.

Second, the Federal Reserve Board unanimously approved a request by the Federal Reserve Bank of New York to decrease the primary credit rate from 3-1/2 percent to 3-1/4 percent, effective immediately. This step lowers the spread of the primary credit rate over the Federal Open Market Committee’s target federal funds rate to 1/4 percentage point. The Board also approved an increase in the maximum maturity of primary credit loans to 90 days from 30 days.

This one is easy to read. Like old saying goes, 'there is never only one cockroach'. With yet another never-before-seen facility Fed confirms that Bear Sterns was not the only Wall Street firm that is about to go belly up. This also makes it clear that those unnamed firms are unable to even wait a week for TSLF (which will allow them to temporarily off-load some of their mortgage-backed securities to Fed at inflated prices). Sheesh.

So, on one hand this will provide liquidity to these endangered firms. On the other hand, it screams nice and loud to the investors: 'time to panic now!' which removes liquidity from these endangered firms. I think I know who will win.

Monday will be a long day...

JPMorgan gets a gift of Bear Sterns.

Only last Friday Bear Sterns has collapsed spectacularly. And two days after, rubble has been clumsily swept under the carpet.

As you can read in various news sources, JPM bought BSC for a laughable price of 2 dollars a share. I guess Bear had to be sold before Japanese stock market opened on Monday morning, hence the Sunday night press releases.

As I have previously mentioned, nothing scares Fed and Wall Street more than a full derivative unwind that an outright bankruptcy by Bear would trigger. Also, Bear is a major clearing house, and if they stopped processing transactions it would have paralyzing effect on the markets. So, you might be inclined to think that it is good news that BSC was sold, and said unwind was prevented.

But let's consider the actual deal. Just 6 months ago Bear was valued at $18 billion dollars, or 150$ per share. Even after it became obvious on Friday morning that Bear is no more, panicked investors valued it at 30$ a share on NYSE. On Saturday, Bear executives claimed that the book value of the company is actually 80$ per share (book value is total assets minus total liabilities, so in theory company should be worth at least that much).

But JPM buys them at 2$ a share.

You can only explain this in one of two ways, and neither one is pretty. Pick your poison:
a) Bear Sterns, the brightest, smartest, one of the most reliable investment banks on Wall Street, was in fact nothing but an empty shell. This should immediately ring an alarm bell in any investor's brain: if Bear was nothing but the smoke and mirrors, and was valued at $18 billions just a few months ago, what about the rest of the Wall Street? Doesn't this implicitly confirm the suspicion (that so many already voiced), that most of the big Wall Street firms are insolvent for all practical purposes?

b) One of the greatest robberies of our time just happened in broad daylight, with an enthusiastic prodding by the Federal authorities. At least $10 billion of wealth was stolen from Bear Sterns shareholders and transfered to JPMorgan Chase. In a clumsy attempt to prevent market seizure Fed has violated every rule of free markets. Whatever remained of trust that foreign (and domestic) investors might have had in fair and honest functioning of US markets has likely just disappeared this Sunday night.

The fact that Fed allowed this deal go through on such conditions shows just how scared they are of a complete and total market failure across the globe. Scared witless does not even begin to describe it.

And the last thing - I think this may turn out to be the very mis-step by the Fed that I was cautioning about.

Saturday, March 15, 2008

Look the other way!

So, more and more news are slowly coming out about Bear Sterns demise. Mostly it's the things you would expect, with Wall Street workers paralyzed with fear and uncertainty, Fed and other government officials running around with their hair on fire, etc.
Not interesting.
Looks like JPM is buying Bear after all - okay, saw that coming too. Fed must have offered some really sweet deal to JPM, maybe even full immunity to financial risks. Whatever.

Look the other way!
While Wall Street was getting a heart attack, I was intently watching the news for any sign of Chinese involvement. They are the guys with $1.6 trillion dollars. They can just make the whole thing go away. The crisis has been raging for 6 months now, yet Chinese did nothing!

If they are going to help at all, now is the time. And then I saw this piece:

Citic Securities Co., China's largest brokerage by market value, said the company ``can't guarantee'' that it will reach a final agreement on a proposed investment in Bear Stearns Cos.

This is it, folks. I guess China is not helping. The only conclusion I can draw from this is that China must have realized that this crisis may effectively eliminate USA as a super-power, and they are letting it burn.

Remember that China is practically the last big player who is still propping up our terminally ill dollar. If China goes from 'not helping' mode into 'let's nudge them closer to the edge' mode, the whole effing game is over. Instantly.

Be. Very. Scared.

Friday, March 14, 2008

Fed fights desperately to save Bear Sterns (BSC).

Last update 22:49 - scroll down.
10:30 AM: Boom! Man down! Or rather, a Bear... Just a few days ago I wrote that the next milestone would be a major bank failure, and here we have it. The news just broke that Fed is feeding discount window money to JPMorgan Chase so they could quickly provide emergency funding to BSC. The most ominous phrase in the press release was "JPM is working closely with BSC [...] on other alternatives for the company". Just imagine all those wonderful 'other alternatives'!

Twice in the last two weeks there were rumors that BSC cannot meet its liabilities, and today was the third... Like they say it, third time is a charm.

This is not small fish like Thornburg, and not even medium fish like Carlyle, this is Fed's cherished Primary Dealer!
Apparently, none of the usual rescue tools Fed keeps at hand for banks in trouble have worked in this case. Bear probably did not have enough collateral to post to borrow from discount window itself, and TSLF doesn't start for a week, so Fed is spoon-feeding them through JPM. Is it legal? Probably not. Is anyone likely to object at this point? Haha.

This is the end of Bear as we knew it. Investment Bank's main asset is credibility, and their credibility was just taken out the back door and shot. Their most likely fate? They will be bought out by JPM for pennies on the dollar.

I don't think anyone will let BSC declare bankruptcy officially, since they are a major counter-party to almost everyone dealing in derivatives, and if there is one thing Well Street and Fed are both scared witless off, it is a CDS monster.

Here is the full text of JPM's announcement to shareholders:

We announced this morning that in conjunction with the Federal Reserve Bank of
New York, JPMorgan has agreed to provide secured funding to Bear Stearns, as
necessary, for an initial period of up to 28 days. As part of our discussions
with the Fed, they have agreed to provide non-recourse, back-to-back financing
to us through the Discount Window. As a result, we do not believe this
transaction exposes our shareholders to any material risk. We are also in
discussions with the Fed and working closely with Bear Stearns on securing
permanent financing or other strategic alternatives.

This transaction speaks to the strength of JPMorgan and the advantage of maintaining a fortress balance sheet at a time when capital is at a premium. JPMorgan has a proud history of partnering with the Fed and other government entities to help during turbulent markets. We're pleased to work with the Fed to help Bear Stearns with its current liquidity concerns.

We will continue to update you as things progress.

UPDATE: 17:30PM:

I have a few more details now, and WSJ has also updated their article with more information. Apparently, the move by the Fed was (barely) legal - they used a little known provision in Federal Reserve Act. This provision was added during the Great Depression, which before now was the last time Fed had to prop up a failing banking system. However, as Business Week notes, provision or not, the move will be questioned by banking experts and politicians, and many consider it to be outside of Fed's mandate (you bet it is!). This is the first time in history that Fed stepped in and saved an investment bank.

Also, Bear was not eligible to borrow from discount window itself (not that it had collateral, anyway!) because it does not have commercial bank license. That's why Fed had to reach them through JPM. Bear is an investment bank and a brokerage. Again, this is a moot point because Bear is certainly out of any eligible collateral to borrow from Fed.

Another observation - note that JPM's letter to shareholders says that JPM is not taking on additional risk. If you wonder who is taking on additional risk, then I am sorry to disappoint - it's YOU. Unless you pay taxes abroad, that is. It is quite obvious that loan made to Bear cannot and won't be repaid. One has to wonder what kind of guarantee JPM received from the Fed...

On a final note, Bear Sterns was founded in 1923, survived several vicious crises and has never had a yearly loss until 2007. That's right, not even during the Great Depression. It was a glorious journey, and what a spectacular ending!

UPDATE: 19:08:
Professor Roubini weighs in with an angry I told you so! As the great prophet of this catastrophe, he deserves credit.

UPDATE: 19:45:
Bear Sterns makes a public statement during a conference call and acknowledges that it may not survive. While this may seem like non-news, it does bring up an interesting question: do they mean they will be bought out, as I suspect, or do they mean they will really be allowed to default? The problem with buying them out is that their liabilities far outstrip any value they have, so who in their right mind would pay a positive amount of money to buy them? The problem with letting them default is that it will trigger a derivative unwind that may bury the entire Wall Street alive. Another stalemate (or checkmate?) for the Fed to ponder over the weekend.

UPDATE: 22:49:
Wall Street Journal brings us this gem: It Is Tough to Value Bear, But It Had Better Sell Fast. It is good for a few laughs if you are a misanthropic type and like schadenfreude. Otherwise it's plain depressing. WSJ grimly tells us that the only asset BSC has that is likely to have any real value is their office building. I see this building every day, and it's a nice building, but it's exactly the kind of thing you would rather not own today. Although it may be convenient for JPMorgan, since it is just across the street from two of JPM's own towers.
Bear says it is frantically searching for a buyer and want to find one in a few days. This is understandable, because in a couple weeks no amount of Fed money may save them from default.
The problem is, nobody on Wall Street would buy them right now. Not only is everyone out of money, who would want to take on Bear's liabilities and its bag of MBS, ABS and all other toxic securities?
This is the ultimate nightmare scenario for the Fed. They will have to bring in politicians, and fast. Depending on what they do, this may the proverbial mis-step by the government that brings the whole house of cards down.

Thursday, March 13, 2008

Particle Physicist elected to Congress.

Maybe they do elect smart people sometimes! New congressman from Illinois is a former Particle Physicist Bill Foster who worked at Fermilab for a few years. Although I do not know Bill Foster personally, I have myself contributed many years of work to Fermilab. Fermilab recently ran into serious funding trouble so having a Congressman on its side will hopefully help.

Extreme uncertainty about the future.

There is a lot of speculation going on currently about the likely course of further events. While economists have generally agreed that economy has already entered the recession, there is still a big ongoing debate about 'what next'.

You will find plenty of experts out there who predict anything from mild and short recession, to mild and long, to severe and long depression, and almost any other imaginable type of recession. Some predict deflation, some inflation, some stagflation, and yes, every imaginable type of -flation has someone predicting it. Well, most of these folk are paid economists and have to earn their salary, so fine.

But if you are a 'normal' person trying to figure out what will come out of this historical market turmoil, understand one thing: nobody has a frigging idea about what is coming, and all predictions are just a wild guessing game. There just isn't a sensible way to estimate the future state of a very unstable system that is desperately searching for an equilibrium and is not finding it, where moves by just a few big financial players can have gigantic consequences. Everyone who dares to make a prediction in this environment is effectively betting that they can see inside the minds of all the market players involved and how said players will react to the events that, well, just never happened before.

So what are the uncertainties and who are these 'important players'?
1. Federal Reserve: Bernanke is playing with fire. Credit crunch is a strong deflationary force, and all his experimental measures are done in order to mount a strong inflationary force to oppose it. It is very hard to balance two very strong forces. By continually raising their bets and directly taking on big risks, Fed officials put themselves in a situation where if anything goes wrong with their plans, they will trigger hyper-inflation, effectively killing any trust in US financial system. While attempting to mitigate a big crisis, they risk creating an enormous one.

2. Foreign central banks: China, Japan, India, Russia, Brazil - those countries together hold several trillions of US Treasuries, many (most?) of them short-term T-bills. The reason is that they have been pegging their currencies to dollar, effectively supporting the dollar and financing US deficit. China alone is buying around $60 billion USD every month. If not for this support, dollar would have been much lower than even it's present all-time low mark. Now, these countries have much to lose if dollar tanks (they lose their savings) and therefore they will do everything they can to continue supporting the dollar. But they are not omnipotent - this intervention creates significant stress and dislocations in their economies, and at some point they may simply be unable to continue their support. They certainly know this, and they have been probably watching Bernanke's antics with great unease. They have already been watching their dollar-denominated savings depreciate by 20% a year for the last 4 years. If Bernanke mis-steps, they may well decide that dollar is toast no matter what, and they should save as much as they can right now. If dollar panic by foreign central banks happens, dollar will lose all its value faster than you will hear the news about it. Just ask the people who lived in Soviet Union in the early 90s about how such things go. Again, foreign governments will try to avoid this at all cost, but this thing may simply be bigger than what they can handle.

3. US Congress. If you want a testament to how economically retarded the members of Congress are, look no further that the latest idea by Johnny Isakson on how to 'save' the housing market. He suggests Congress gives $15000 dollars to anyone who buys a home. Of course, all this would do is push house prices $15000 higher... If I had to guess what the Congress' role in the coming events will be I would say it's to pass several measures to help the economy, each having a negative impact in reality. However, where things could get really dangerous is if anti-immigration and anti-outsourcing lobby can convince Congress that it's all fault of evil foreigners. If Congress tries to 'save' US economy by imposing tariffs and starting trade wars, that would be one of the surest ways to finish off both the US dollar and US economy. Also, in case of severe crises politicians tend to equate saving the economy with robbing their own citizens.

So, is there hope? Considering that Bernanke hasn't misstepped yet, I think there is a significant chance (maybe even higher than 50%) that he will be successful in moderating this unwind and preventing a chaotic cascade of defaults. The debt deflation will slowly continue, offset by Fed's gymnastics. Many companies will default, but over a longer time span. Banks will not be able to lend much but won't be allowed to fail either, in what Mish calls zombification of banks. For economy, it is equivalent to banks going bankrupt but being instantly nationalized. In this scenario, US is looking at a decade or more of zero to negative growth, but the upside is that unemployment rate could stay low and most people would get by without severe pain. In terms of economic damage this would be equivalent to experiencing another Great Depression (we can't avoid taking this damage anyway) but spread over a long period of time it would do only moderate harm to most people.

On the opposite end of hope, it is possible that Fed overshoots, or Congress overreacts, or something else happens that plunges US into a real depression with GDP contraction of over 10% in a single year. If everything goes as wrong as it can, the economy could contract by as much as 50%, the dollar could go the way of peso, and most people would lose their savings (not that Americans have much saved).

Fed action forcing hedge funds into default?

Just hit on this analysis over at Alphaville:

…it’s arguable that the banks’ seizure of Carlyle’s $20bn-odd in assets has actually been encouraged by the Fed’s mortgages-for-Treasuries offer. Because the Fed’s new lending emergency lending facility allows the banks to swap mortgage-backed debt for Treasury Bills in a way that Carlyle could not do.

So it would be rational for the banks to take Carlyle’s assets and exchange them for top-quality, liquid US government bonds, rather than leave loans in place to a business, Carlyle, whose assets remained highly illiquid.

If this is even remotely true...

What it means is banks are pushing margin calls and forcing hedge funds to bankrupt so that they could seize their assets and exchange them at full value to the Fed, rather then let hedge funds liquidate them at fire sale prices. Talk about unintended consequences and disorderly unwind. In the coming days we shall see how much truth there is to this suspicion.

As someone said: 'Fed tried to pull a rabbit out of the hat, but got a grizzly bear instead'.

More talk of Fed outright buying MBS from banks.

There seems to be more and more talk in the news about Fed potentially just outright buying MBS securities from banks. Some credible people say it's a must-do, while other respected people are calling the entire set of recent Fed experiments criminal. Brad Setser also has some thoughts on what other central banks have been doing and claims that Fed is much tamer than say People's Bank of China. All this talk might be a prelude to the upcoming action and trying to get a feeling for what the public reaction to such a step might be.

I don't really care much if this action would be legal or not, since I think Fed's recent behavior has been equivalent to shedding all pretense that it is a responsible entity independent of the government, like its mandate says. At this point they are likely prepared to do whatever it takes to prevent the big banks from collapsing.

Also, by accepting MBS as collateral, they already accepted the risk of owning these MBS securities in case of a primary dealer default. So, if they see a major bank collapse as imminent lest they do something, they may as well think they got nothing to lose.

What I am really interested in, is if it is even theoretically possible for Fed to start just buying ABS crap outright without generating an inflation spike. The recent TAF and TSLF were not money injections, as Fed has sterilized the money inflow by removing some money from circulation. But they had to use treasuries from their own balance sheet to do that. Fed balance sheet is only $1 trillion dollars. Just recent events alone have put Fed on the hook for about 400 billion of MBS. So, in a few weeks Fed's balance sheet will not be 1000$ billion of Treasuries, but 400$ billion of MBS and 600$ billion of Treasuries. That already seems very dangerous, considering that losses on those MBS are almost certain to be around 50%, AAA rated or not.

So to me, it looks like Fed has almost reached its capacity to sterilize this intervention further. And considering that the size of mortgage market is over $10 trillion, their move is still just a fig leaf on the size of the problem. I do think any further move in this direction would be the equivalent of printing money in some form.

Also, consider this: right now Fed officially deals only with the primary dealers. But there are numerous hedge funds out there in deep trouble right now, holding not only MBS, but all kinds of depreciating stuff. Banks have loaned enormous amounts of money to these funds, and they cannot get it back. Just today Carlyle Capital and several other hedge funds announced that they stopped withdrawals and are likely liquidating. The key problem is the entire financial system is over-leveraged (too much debt), not just the banks. So if hedge funds cannot answer margin calls and repay their loans back to the banks, which is the stage which we have reached, then even removing MBS from banks will not help much.

Fed may have been moderately successful in delaying the big disorderly implosion so far, but that is all it's been doing so far - delaying. I guess Fed's goal is to make sure the unwind stays orderly, but not to prevent the debt unwind from happening. Whether it will reach the disorderly stage or not, remains to be seen - but Fed's odds are getting worse.

So my conclusion:
a) Fed can buy moderate amounts of MBS from the most troubled banks without generating immediate inflation, but it cannot buy enough to really save the banking system. If it does try to buy enough, hyper-inflation will be here.
b) Fed does not have any solution for the hedge fund problem. They appear to be on the verge of blowing up en masse, and I have not yet seen any ideas from policy makers on how to deal with that.

Wednesday, March 12, 2008

Crisis coverage continued: Washington Post's summary of events so far.

Stumbled upon this very nice summary of the events so far, with minimal amount of financial jargon, so that anyone can understand exactly what is going on. Covers the last few months.

TSLF: market is not impressed.

Stock markets have rallied yesterday on the news of TSLF but the real measure of stress in the financial system is TED spread (graph), which indicates how much risk investors see in lending to banks. The higher this spread, the more risks lenders perceive. And in response to an unprecedented and extreme move by the Fed, the TED spread... barely budged.

Maybe because of this stock market traded down today and dollar tanked over 1% (USD to EUR is down 6% this month alone). Treasuries gained back everything they lost yesterday, suggesting that flight to safety has not abated.

If market does not believe that this action by Fed will restore trust in the system, what else can Fed do? It can slash rates further, from 3% to 0%, but considering that they are already in the uncharted territory of experimental monetary tools, they do not believe this would help much. They will cut, sure, but it does not address solvency problem. Another thing they could do is just buy the tainted assets like ABS outright, taking on risk. But this step would be so far outside the Fed mandate, it would probably require Congress approval first. Even if they do that, it would most likely amount to money injection and trigger a surge of inflation, so it's a no-win move.

I think deep down inside Fed officials know that they deal with solvency crisis, not just a liquidity one. And monetary tools cannot cure insolvent institutions. The reason Fed was implementing all these extraordinary measures is that they are trying to at least alleviate liquidity problems for those businesses which are sound and solvent. But the snag is, the only way Fed can lend money to ordinary companies is through primary dealers - big banks. However, what market is telling the Fed right now, is that it is the primary dealers who are insolvent. Confirming the suspicion, the primary dealers do not have the capital to take on more risk and are not lending out money.

With insolvent middle man stuck between the source of money and the solvent but illiquid companies, the situation resembles a stalemate. Or maybe a checkmate.

The last and ultimate thing Fed could do is to invoke the right it has to lend freely to any individual or company in the emergency situation. This has never been done before, not even in the worst crises. Fed does not have either the manpower nor the expertise to make loans to arbitrary companies. Will they try it? I doubt it, but who knows.

One thing for sure, if you hear the news that Fed is now lending money directly to companies like General Motors, then you know it has given up on saving the banking industry.

Tuesday, March 11, 2008

Roubini: losses may reach $2.7 trillion.

Nouriel Roubini was the first among well-known and respected economists to ring the alarm about the approaching crisis. He predicted the housing bust well in advance, he was the first to make a recession call (which appears to be right, as well) and he was the first to try and estimate the potential losses for the financial system - at $1 trillion.

In his latest column he notes that by now mainstream economists have caught up to his estimates, again proving that he was right, and right before everyone else.

But as the situation has evolved, Roubini updated his forecast. He now says that $1 trillion is a lower bound on the losses, and losses can easily reach $2.7 trillion in more pessimistic scenarios. Note that $2.7 trillion is roughly 20% of the GDP of the United States.

I think the size of these numbers makes it clear that any attempt to bail out the banking system by the government can only result in hyper-inflation. Note that $1 trillion is roughly $8000 per each American household and taxpayers simply do not have this money to spare.

There are only two ways forward for the American economy now.
a) Several big banks and large fraction of all companies go bankrupt, US experiences an equivalent of the Great Depression, after which rebuilding of the economy can start.
b) Government tries to save the financial system at any cost, hyperinflation results, torpedoing the dollar and the US economy. Economy experiences a downturn that is more severe than the Great Depression, with economic damage on the scale of the damage Soviet countries experienced after the fall of communism. Note that this scenario implies severe political tension with the foreign creditors, therefore I consider it less likely.

Exhausted Fed.

Fed Chairman Ben Bernanke was an academic before and studied at length the issues of monetary policy in general and dedicated a lot of time to The Great Depression in particular. Krugman notes in his blog that during his research Bernanke came up with two non-traditional emergency tools that Fed could use, and that Fed has already started to use them. TAF was the first one and today's TSLF is the second.

What this implies (and Krugman doesn't quite say it, which is understandable considering who he is) is that not only is Fed out of its traditional ammo, but even all the emergency tools are used up.

I do not want to underestimate Bernanke, he may yet pull another rabbit out of the hat, but to me it looks like matters are now outside of the Federal Reserve's power to influence. Fed is reduced to sitting there and praying that TSLF works. If it doesn't, the only thing that can save the banks is a direct donation of money to the banking system from the Congress - but good luck doing that quickly enough. Or maybe Chinese could donate us some of their reserve money - but I doubt that too.

At some point we should face the fact that financial system is looking at around 1 trillion USD of losses - so how much money are we prepared to spend saving the banks? It may well be cheaper to just let the banks fail and instead spend some of that money on unemployment benefits to the resulting masses of laid off people. But again, that would involve Congress.

More panic from FED: TSLF.

After discount window did not work, Term Action Facility did not work, Fed today introduced Term Securities Lending Facility (TSLF). By now it sounds old to say that Fed has once again reached a new level of panic and is not hiding it. So let's get to the gist of this.

What's new about it is that Fed is now taking Mortgage-Backed Securities as collateral from banks - this is the toxic staff that nobody else in the market was buying. This also provides additional 200$ billion in liquidity to banks. For all practical purposes, what Fed is doing is temporarily emulating presence of buyers for MBS securities, with the caveat that banks still retain the risks associated with them.
The hope here is that while Fed buys some time for capital-impaired banks, panic subsides and investors start buying MBS securities again, saving the financial system from collapse. However, in my opinion, it is a false hope. In order to save the banking system, it is not sufficient that MBS securities start trading again. Banks need them to also trade at the prices that are close to the ones originally assigned to these securities. Otherwise banks will face huge writedowns that will wipe most of them out.
But no private party in their right mind would buy them at such prices, not with real estate tanking and US economy possibly being in a recession.

So my take on this is, Fed is only buying some time for banks, but not doing anything to fix the problem in the economy. As I have previously written, problem is that there is simply too much debt in the system compared to anything of real value, and the economy is choking under the debt load. Trying to shove more debt into the system, as TSLF does, only makes the economy look even more dysfunctional.

What stinks here, however, is if some of the banks go bankrupt in the meantime, Fed will be left holding billions of MBS on their books, for which Fed gave away money at face value. The losses on these will be ultimately borne by the taxpayers - folks like you and me. Which means the following: americans bought homes they could not afford, and are now defaulting on them in numbers, but despite accepting the bankruptcy hit and all the woes that come with it, they will still be paying for their abandoned homes. For a long time.

Sunday, March 9, 2008

YAICHS: Yet Another Income's Correlation to Happiness Study.

Worldwide, Residents of Richer Nations More Satisfied

The above links to a yet another study which explores possible connection between wealth and happiness - by comparing various countries. Like most studies, the statistical analysis is completely flawed and conclusions blatantly wrong - I will address this in a second. The reason I think it is worth seeing is because their entire study is cutely summarized in a single picture:

To anyone educated in statistics this will look like a plot showing strong correlation between variables. However, after looking closely at this plot for a minute or two, I reach a different conclusion. This plot, in fact, appears to be composed mostly of two distinct parts.
First part is countries where incomes are more or less zero. Not surprisingly, happiness is low there - people are dying in wars and starving. But even there, there is a large spread in reported happiness, for basically the same level of income. I would bet this is due to presence or absence of war in a respective country.
Second part of the plot is all the countries where incomes are non-zero, above 2000$ per year or so. There, the variations in reported happiness are so huge, any correlation is nearly meaningless. But if you look even closer, you will see that almost every country that is at the lower end of the happiness spectrum, regardless of income, is either a country where there is a war, social injustice, or despotic oppressive regime. So GDP per capita may look okay, but if a large fraction of population is either left to starve, or is being tortured and imprisoned, or lives in a war zone, you would expect happiness to decline.

So, as is so typical of social studies, the results are misunderstood in this one. And as usual, the pseudo-scientists forgot to estimate what the uncertainty is and what is the statistical significance of their conclusions (it is very small). While the study shows correlation of happiness and income, it doesn't interpret it correctly. To me, it looks like the study demonstrates that happiness is negatively affected when people's right to live is endangered, either through war, or economical or political persecution. That GDP is also correlated with personal freedom and peace, is a secondary affect here. Once someone has bread, warmth and freedom, all correlation between income and happiness almost disappears. The reason we see correlation in the plot is because countries where people are more equal, more free and more peaceful, are usually way more productive.

So what we have here is yet another 'scientific' study that made a classical mistake of confusing correlation with causation. The real cause of rising happiness is less threatening situation in a given country, which correlates with GDP per capita.

So exactly how much is a trillion dollars?

With China and Japan both holding about a trillion dollars of US debt (with total foreign debt of 9T) I wondered, what exactly is a trillion dollars? How much does it buy?
Since economic power is so often linked to military power, I decided to calculate just how much military equipment one can buy with a trillion USD. So I found a nice table which lists the total number of all crew-operated military vehicles in US and for each type of vehicle I found the latest model and used its production cost to generously approximate average cost of a vehicle in that category. I then summed up the numbers, and here is what I came up with for all the weapons of the United States:

# units unit cost, mln $ total cost, mln $
Tanks 8000 3 24000
Aircraft carrier 21 4500 94500
Cruiser 22 1000 22000
Destroyer 52 1000 52000
Frigate 30 1000 30000
Corvette 46 300 13800
Nuclear sub 72 2000 144000
Fighter Aircraft
3200 43 137600


I excluded traditional nuclear weapons here, because their cost is almost impossible to estimate correctly. Production cost is minimal and it is mostly the cost of installations, missiles and maintenance.

The conclusion is that a trillion dollar would basically buy the entire weaponry of the United States twice over.
Note also that the ballpark cost of the current financial crisis is already being estimated to be roughly 1 trillion dollars. Just to show how serious the crisis is - and it has only just started.

Saturday, March 8, 2008

JPMorgan: systemic crisis is underway.

So, the zero hour is here. They finally come out and say it how it is, systemic crisis is underway:

A systemic credit crunch is underway, driven primarily by bank writedowns for subprime mortgages," according to the report co-authored by analyst Christopher Flanagan. "We would characterize this situation as a systemic margin call.
It is no longer some blogger or professor, but none other than official JPMorgan Chase report... TAF seems not to be working. Next milestone would be a major bank failure. Let's just hope we will not see any heart failures.

Friday, March 7, 2008

Paul Krugman is scared.

It's official: Paul Krugman, who is widely considered the most celebrated economist of the present time, is scared. The entire financial system has never been closer to toppling since The Great Depression. Paul Krugman is asking "What should be done?" and cannot think of an answer. Why? Because there is no answer that doesn't involve lots and lots of economic pain. Consider the following chart (courtesy SGS):

It shows money supply growth rates. M3 is money including all the credit, M1 is basically just cash (i.e. bank accounts and the like).
The problem here is that total credit (M3) is expanding at almost 20%, and the cash supply (M1) is expanding at 2% at best. This was going on for many years. But you have to pay the interest on your credit (M3) from your cash(M1). You can buy a TV on credit card, but you pay credit card bill from your bank account (at least eventually). In other words, amount of interest you have to pay eats more and more of the cash available in the economy, up to the point where this cannot go on anymore (i.e. this whole thing breaks down when M3*InterestRate == M1). This is the classical failure of the fractional reserve banking.

What happened is lenders thought they were richer than they really were (because they thought all those loans they owned represented purchasing power; they didn't because there wasn't enough money in the economy to ever call those loans back and buy something).

Now the answer to the question "What can be done?" becomes obvious doesn't it? Lenders must acknowledge that they don't own as much as they thought. They can either work out deals with creditors by reducing principal etc (what Bernanke tried to suggest) or by forcing creditors to default (what actually happened in Great Depression and almost every other crisis). Since there is no mechanism in place for lenders to reduce principals and they would be opposed to working out such mechanism quickly enough, we probably cannot do anything at this point. just let the defaults cascade through the system and hope we can unravel them...

And in order to avoid this situation from occurring again and again, fractional reserve banking needs to be replaced by a sane system, where amount of credit would not be allowed to experience runaway unchecked growth. Here is what happened to our money supply over the years (courtesy Wikipedia):

Wednesday, March 5, 2008

Republicans not letting Democrats have a democratic vote.

Holding a fair democratic election is not an easy thing to achieve. But I have long suspected that the convoluted election process in USA is purposefully complex and full of little rules and exceptions here and there. After all, the harder it is to understand the process, the easier it is to manipulate by those in the know, so I get that.
I have a PhD myself and still it took me over an hour to understand how primaries work (even without all these niceties in rules). Only to realize that at the end of the day, 200 people in Washington (super-delegates) have about as much electoral power as 20 million "ordinary" people.
But has USA finally reached the point where the system is so ridiculous it stopped bearing any semblance to democracy? Here is the latest example which makes me inclined to think yes.

Clinton and Obama were close in primary race, with Obama having somewhat better momentum. A lot depended on Texas and Ohio primaries, where Obama win would seal his nomination and would let him start preparing to the actual presidential election. I believe odds were placed in his favor, too. Republican race was finished at that point, with McCain already having won his nomination.

Seems like a fairly innocent setup, but here is where all the little complexities arise: Ohio and Texas allow open primaries, i.e. anyone can come and vote, without registering with a party. And what happened is that a lot of republicans (who did not need to vote for McCain anymore) went to the democratic poll booth and voted as if they were democrats. They voted for the candidate who was behind (Clinton in this case) to make sure democrats continue to squabble, throw dirt at each other, and waste money, while McCain is gathering money and momentum.

So, what kind of election is that where a republican can come to a democratic primary and just mess with the results? What kind of vote is that where many people have incentive to vote for the 'bad' candidate, just to weaken the candidate they themselves consider 'strong'?