Good union, bad union.

A lot of discussion has been centered around excessive union demands that end up bankrupting various governments. Some have even declared all unions as evil. I think there can be a line drawn; some unions can be a useful tool of social equilibrium, while others may have no economic or social justification at all. I think private unions can be necessary to ensure that the profits are more fairly shared between the owners and the labour, but for this system to work, some conditions have to be met. Below I list those conditions and show how they often do not apply to public unions.

• Contract negotiation must happen with the employer. This ensures that unions will not be able to extort more than their labour is worth. At some point true business owner would prefer shutting his business down as an alternative to operating at a loss. Public unions, however, negotiate their contracts with other public workers in the government, while the true "business" owner - the taxpayer - is left out of the picture. This often allows public unions to negotiate conditions that could never be sustained in a profitable business.
• Business interests must be somewhat aligned with labour interests. The alignment does not have to be absolute. But if small private business goes bankrupt, workers normally suffer too. For public unions this is generally not so - public money comes in no matter what.
• Business must not be a monopoly. This is self-explanatory, I hope. The unwelcome effects of monopolies are well known in the Economic science. Healthy dose of competition ensures that labour  stays aware of its true market price. Public unions are often operated within a monopoly service, such as school system, and the costs are frequently hidden from both the taxpayers and the users of these services. The results, again, are a distortion of the market and salaries that would never be obtained in a competitive business.

 These three points are my case against many public unions, but not necessarily against private ones.

This is what a market driven by speculation looks like.

Below is a 6 month chart of  Canadian dollar compared to DOW.

Notice that the two are nearly perfectly correlated.  Some correlation is expected there, after all American companies are a large component of Canadian exports, but it should be nothing like 100%!

This correlation is consistent with the big market participants choosing these two assets to play in, so that when they buy or sell they always allocate their capital in the same proportions. They also choose when to buy or sell not based not on fundamental economic events, but on the access to money - or maybe even based on a whim.

This means that the prices in the markets are driven entirely by the speculation, and lost their relationship to fundamentals. Unless you have close ties to the circle of traders who are driving the market behavior, you have no business staying invested in stocks. However, if you are in that circle, you can trade virtually risk free. That may explain, for example, why Goldman Sachs had zero days with trading losses last year.

Why GDP in a service economy cannot grow, or productivity paradox explained.

In Economics, Productivity Paradox (why introduction of computers resulted in no productivity increase) still has no widely accepted explanation. Naturally, I must post my own here. I think this longish essay will be worth the read.

First, imagine an economy where over 50% of people are employed in food production; most of others are creating tools and houses; and "service sector" is an expression that nobody has heard. If you think this has nothing in common with the economies of today's developed countries, you are absolutely right. Yet this 19th century economy is exactly what people had to work with when most of the traditional economic theory was founded. In this economy, it is easy to calculate things. If total amount of money is M and total product is P, then worker's salary is typically (P/M)*V, where V is how much product that particular worker is responsible for. If you then add up all the salaries in the country, you get back something that is directly related to the total amount of physical goods produced. This is the GDP, measured in dollars, and it captures the country's output very well. Let's call this exhibit Economy #1.

Now fast forward to the day when technology advanced to the point where all fertile land can be managed by 2% of the population; all necessary clothing  can be made by another 2%; all required tools and houses can be built by another 6%; what about the other 90% who have nothing to do?

That's when the service economy is born, where most work is done not because it's needed, but simply in order to justify getting your fair share of food and other stuff. Most jobs pay based on how long they take to complete and not on their "usefulness", and it is therefore possible for a completely useless service (such as real estate brokerage) to be priced higher than somewhat useful ones (like lawn mowing and hair cutting). Producers of real goods have no choice but to go along with the program because otherwise they would not be able to sell anything to anyone (and would get lynched by an angry mob, to boot). In this economy, most of the product is intangible; and the total physical product P is a negligibly small part of the economy. In fact, the only thing produced by this economy is the time that people spend servicing each other. If total population is Y and total revolving money supply is M, then the average salary in this economy is going to be simply M/Y - because it's the only way to distribute food and shelter evenly. Notice how drastically different that is from our Economy #1. Even though some people (*cough* lawyers) will be better than others at marketing their time, the average is always going to be M/Y, and if you measure the GDP traditionally, by adding people's salaries, then total GDP is now completely decoupled from the actual physical product, and depends only on the money supply. In this economy it is practically impossible for the real output to grow, because the only significant product is people's time, and that is a fairly inflexible thing. And while you can "improve" GDP by creating more people or making them work more hours, it is impossible to change the productivity - because it will always be proportional to M/Y, no matter what happens to the total amount of tangible goods! And since we measure productivity in money, we will always get the same number back.

Productivity paradox is explained trivially once you understand that. If you add computers to an office that employs 100 people and it now takes 33 people to do the same job, it does not triple the salary of the original 100 workers, because remember, they are not producing anything, they are just trying to sell their time to justify getting the appropriate amount of food and physical goods. If their jobs suddenly paid better, more and more people would apply for them and drive the salary back to average. So what must happen then is 77 workers have to be laid off and go on to become personal trainers, dog walkers and so forth. Measuring the productivity of the original 100 workers will give you exactly the same number before and after - because we measure it in money. The elusive productivity growth is actually represented by more services becoming available - but we have no tools to measure that.

You might ask, why is reported GDP changing, if productivity must remain constant?
Since money supply M is always changing, governments adjust productivity by inflation. However, they don't use change in M as their inflation number (and it's impossible to measure it anyway). Instead, a basket of goods is used to approximately measure the change in money supply, and of course it's a very crude proxy. So all changes in GDP that we are observing are actually just mismeasurement of inflation.

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As a bonus, we can now explain another paradox. You may have heard that pumping money into economy increases GDP, but in traditional economic theory that shouldn't work. In Economy #1, so many people are producing food and tools because they are actually hard to produce in low-tech society, and there isn't enough for everyone. So pumping money into economy (i.e. giving people more money) instantly increases demand for food and tools, and that drives up inflation by the same amount as the money supply, so total GDP (adjusted by inflation) does not budge.

However, if you add money into economy #2, people have no incentive to spend it on food or cloth, since people are already eating more than they need, and have more clothes than they can wear. So instead they dump their new money into things like bigger houses, they bid up education and health services, they buy stocks. Many of those things will not be (fully) captured by the traditional basket-of-good inflation measures, and therefore the GDP number is going to swell up instead. But it's all just an illusion - simply a mismeasurement of inflation. And that is exactly what happened in the USA in 1995-2006 and it explains how it's possible for the standard of living do stagnate during a period of GDP "growth".

Happy Valentine's Day!

Sign of the times, from New York Times:

[...] on Yahoo, searches for “cheap engagement rings” are “off the charts” compared with a year ago, according to Vera Chan, a trend analyst for the company.Other searches that are up over last year include “cheap lingerie,” “free Valentine’s Day cards” and “homemade Valentine’s Day gifts.”

Cheap engagement rings sounds almost like an oxymoron. But I liked that part:

Personal jewelry is being replaced by personal poems.

Maybe that's good news. So on that happy note, happy Valentine's Day to everyone!

Projecting the severity of the recession from credit market spreads.

When I was reading about the Great Depression in US I was struck by the following observation: the GDP decline of 28% peak to trough, which took somewhere between 2 and 3 years, correlates very well to the total number of failed companies (30%) and the peak unemployment (25%). After thinking about this for a while, I believe this is not a mere coincidence. In a severe, quick economic contraction, it would make sense that the number of working people directly relates to the GDP, since productivity does not have time to change much. It is also reasonable that the percentage of failed mid-size companies reduces GDP by the same amount, although this requires that the additional contraction among the surviving companies is offset by increased government activity and small businesses started by newly unemployed.

So while the number of failed companies is not a precise predictor of the depth of a depression, it should give the right ballpark number. Since we can deduce company failure rates by their bond spreads, one can therefore estimate market-implied severity of a recession.

From Financial Times:

US investment-grade corporate bond prices, for example, imply a cumulative default rate of 36 per cent over five years, assuming a typical recovery of 40 cents in the dollar, according to analysts at Morgan Stanley. This is more than 7.5 times higher than the worst default rate in any previous five-year period.

5 year default rate is not horribly useful, since a lot can change in 5 years. So let's convert it to a more relevant metric of roughly 8-9% of defaults per year. I think we can safely assume that the rate at which new mid-size companies are created goes down to roughly 1% from the typical 2-4% in 'normal' years. This means that within the next 2 years (typical time-frame for the worst part of recession) we are looking at the number of investment grade companies in US to shrink by roughly 15%.

So the market is pretty pessimistic and investors seem to project a recession with GDP decline in the ballpark of 10-20%, which puts it squarely in the depression camp.

TARP against H1B.

It has been reported that Congress is working on an amendment to the stimulus bill that would prevent TARP recipients from filing H1B petitions (or make it much harder, in the current form). H1B term extensions may be affected as well.

Considering how many companies received TARP money already, and how many more are likely to receive government aid in the future, this may significantly cut into the number of H1B workers.

Hopefully this amendment won't get included. It would severely impact competitiveness of American companies at the time when they desperately need to improve it. It surely isn't going to result in higher employment among American workers, and it will delay any economic recovery.

From bad science department: environmental impact of walking.

I often lament the lack of common sense in many scientists. Today's exhibit is going to be about a crazy piece of research which was even enthusiastically discussed by Freakonomics blog in Be Green: Drive followed up by More Analysis of the Environmental Impact of Walking vs. Driving. The researchers tried to calculate the carbon footprint of walking 1.5 miles versus driving 1.5 miles. Depending on how bad your diet is, walking could generate more carbon. One author then even went as far as recommend driving instead as more environment friendly.

Let me make a few observation which firmly put all of that research into mad science department.

• Worrying about the carbon footprint of human metabolism is silly for two reasons. First, unless you want to consider killing humans, we cannot do much about metabolism itself. It continues even while we sleep. Second, this carbon footprint comes mostly from food production, so we should work on making food production cleaner, not stop walking around, as the paper seems to suggest.
• Among those who try to achieve a greener lifestyle, walking is not considered an alternative to driving. Environmentally friendly alternatives to driving are living closer to work, taking commuter trains and using bicycles (which are 3-5 times more efficient than walking).
• People need exercise to stay healthy. That's why people should take a walk instead of driving (that, and fresh air).
• Even if all of us walk all day long, we will only increase the pollution levels by a minuscule amount.

Better way to stimulate the economy.

Leaving aside my doubts about the fairness of the currently proposed stimulus packages, government could still justify executing them if they were effective in helping the economy. Here I will try to rationalize why they won't be, and propose a much more effective and ethical way to spend taxpayer money on economic improvement.

First let's recognize that recessions have both desired and undesired effects on the economy. Recessions happen when the rate at which non-viable businesses die temporarily exceeds the rate at which new business is created. The increase in the destruction rate can be set off by many different reasons, but remember that that rate is never zero even in the best of times, and this destruction is both necessary and healthy. The unhealthy (undesirable) effects are the self-reinforcing negative feedback loops that usually accompany recessions - and these effects are mostly psychological.

Consider this example. Let's suppose people think the country is in a recession. Naturally, they expect job cuts and start worrying about their own security. In a country like USA loss of a job is a pretty severe blow to most families - you lose medical insurance, and unemployment assistance is only available for a short time. Therefore, anyone worried about their job naturally restricts their spending and tries to save as much as possible to protect themselves. If half of the families in US try to cut their spending by just 5%, a lot of the industries that rely on discretionary and semi-discretionary income could see huge drops in revenues, up to 50%. This may happen even if the actual unemployment rate does not increase at all, purely due to the fear. Of course, as revenues fall, this fear of job loss becomes a self-fulfilling prophecy as businesses contract and lay off workers. From here on, this becomes a self-reinforcing feedback loop. And that is the part of a recession that is not justified by the economic fundamentals and is entirely undesirable. Businesses that are viable in normal times suddenly find themselves bankrupt, and so on.

The idea behind stimulus based on creating arbitrary government projects is to pick up the slack in spending that workers who are unemployed (or insecure) have caused, and thus help healthy businesses live through the downturn. This is where things get tricky, however. This spending-for-the-sake-of-spending stimulus idea was not bad in the 1930s, or even 1950s, when most of the income was spent on necessities like food, and not a whole lot of spending could be called fully discretionary. A lot of decrease came from the people who actually become unemployed, and therefore the negative feedback was weaker (since the purely psychological component was much smaller).

Today, the economy looks much different. With 70% of it being in the service sector, the discretionary spending is a very big fraction of total, and it is much easier for people to cut their expenses. This means that the psychological negative feedback is much stronger than that driven by pure financial fundamentals. The stimulus now is supposed to pick up the tab not only for those who are out of funds, but also for those who have money but decided to willingly withdraw from the excessive consumption. Trying to counter that consumer withdrawal with government spending is like pissing against the wind, or shoveling against an avalanche. You achieve little, and risk getting yourself in trouble.

Instead, government should try to directly attack the purely psychological component of the negative feedback loop. How do you do that? By reducing the incentive to save for the rainy day.

People are worried that without the jobs, there would be no medical insurance and no food or housing for their families. Government could just give a blanket guarantee on these things and eliminate most of these worries entirely. It would have a lot more effect on the economy than direct government spending on random projects, like in Obama's plan. It would also cost a lot less.

To understand the scale of the numbers involved, remember that Obama's universal healthcare plan is supposed to cost additional 100$ billion a year. So if we took just the original TARP money we could eliminate all healthcare worries in the country for 4 years. Remember that Fed and the government already given guarantees worth over 10$ trillion dollars to the banking sector. Imagine how much less money would we need if we simply guaranteed food stamps and housing stamps for anyone who gets laid off? I bet that would do a lot more good than just doing something for the sake of spending money.

That would also be a more ethical way to use taxpayer funds, since no money would go to the private sector, and even government itself would get a very small windfall, since most of these social guarantees could be provided by existing agencies like Medicare without major increases in funding.

Why TARP #2 will still look like theft.

As Fed has become powerless (and all but irrelevant) in the recent months, the powers that be have been trying fiscal measures. The original TARP has now been recognized by most as a failure, mostly because the money pretty much went to line up the pockets of the bankers at virtually no upside for the taxpayer. See for example how Merrill Pay Was Down Only Slightly in 2008 From 2007 Levels. At the same time, most people don't realize how close the whole financial system was to a complete breakdown (as in, no ATMs, no credit cards working) in the October of 2008. It is quite likely that TARP has prevented that event. So even though the plan resembled theft much more than a rescue mission it did do some good.

Now we have Obama's proposed 825$ billion stimulus that is being debated in Congress; and on paper it looks better, since money seems to be intended to go to various 'productive' projects like education, infrastructure maintenance, etc.

I already wrote in the previous post about my distrust for any centrally planned initiatives, and about the dangers of fiscal recklessness, but for the moment I want to leave these aside and present you with a little piece from Bloomberg about how government projects actually work in practice: Hidden Bonuses Enrich U.S. Government Contractors. Here comes the choice cut:

...the government spent $368.4 billion on all contracts in 2008, and Republican Oklahoma Senator Tom Coburn estimates that about $100 billion of that was wasted.

US government actually managed to dwarf the numbers that caused recent outrage about Wall Street bonuses: 16$ billion in bonuses, compared to unknown trillions of taxpayer money spent on maintaining the financial system alive.

That is why I don't believe Obama's TARP will be more ethical than Paulson's. Money is still going to line up the pockets of the bureaucrats, just slightly different ones.

There is a way to effectively spend money for economy stabilization, but it is not what the corrupt politicians in Washington are doing. We could have much more bang for the buck spending this money where it really helps, but I probably should write a separate post about it.

On Krugman and Keynes and why fiscal stimilus will not make our economy better.

I don't want to say Krugman's post named The greatness of Keynes is outright wrong, but it is at least controversial, and I think Krugman should know better.

Krugman argues for massive fiscal intervention in the form of 'make work' programs. Here is the relevant part where Krugman responds to critics saying that market knows better:

That is, if the private sector wouldn’t have created a job on its own, that job shouldn’t have been created — whereas the real choice is between having workers doing something and being uselessly, destructively unemployed.

There are two problems with Krugman's logic. First, it isn't really Keynesian. Second, Keynes may have actually been wrong, too.

Let me address the second point first, because it is much more important. The key question is, why do we think it is more productive to put people to work doing something, rather than be unemployed? This may seem counter intuitive, but think about it this way. By asking government to step in and create projects just to get people employed, we are effectively moving to central planning as opposed to profit-motivated resource deployment. As so many governments throughout the history have demonstrated, central planning has a disturbing tendency to get things spectacularly wrong. So if you let government decide what to do, you run a big risk of wasting not only human resources, but also a lot of natural, financial and social resources. Whereas unemployed people represent only a temporary loss of human resource.

Remember that the main argument against central planning is not that it's bad itself (when the right decision are made by decision makers, central planning is actually very very effective) but because when it does direct things in wrong direction, the failures are monumental and absolutely disastrous for the society involved. So the argument for market-based decision making is that while it may not be perfectly efficient, at least it avoids the biggest screw-ups.

What Keynes was arguing is that sometimes companies are unable to deploy X amount of resources to produce Y amount of value because Y is underpriced in the market due to liquidity concerns. In other words, that is unprofitable because Y < X due to liquidity concerns only. If liquidity adjustment is Z, and we assume that X < Y + Z, then theoretically government should step in and stimulate the economy, since government can be less worried about liquidity. While there is certainly truth in this, I still wouldn't immediately say it's a good idea to actually try this in practice. This essentially means that your government should be smart enough to figure out what the actual value of X and Z are, and then deploy resources correctly. That is very tricky thing in practice. Market may be saying that Z is large (large liquidity preference) or it may simply be saying that X is unreasonable (workers want salaries they cannot get) and government probably would never tell one from another. Free market eventually would. So while Keynes had the right ideas, falling back on central planning is not the answer.

I would also argue that our current financial crisis is, in fact, the result of central planners deciding that it's a good idea to force debt on people and companies by endlessly 'stimulating' them with cheap credit. Which brings me to my first point, that Krugman's solution is not exactly Keynesian either. Keynes (I think) argued that when times are good you should run a surplus so that when times are bad you could use it (and maybe some more) on stimulus. United States has only had surplus for 4 years out of the last 40. In fact, the last half century represented non-stop stimulation of USA economy, and the mandate has been used up. The fact that economy is contracting nonetheless shows that stimulation no longer works, and should not be tried. Instead, focus should be on brining transparency into the markets and preserving the trust into the rule of law and value of currency.

Understanding the recent dollar strength.

As American economy is breaking down like a 1986 Oldsmobile, some people are wondering why the dollar has been strengthening so much, and whether it is just a weakness in Euro, Yen, etc, that we see.

My opinion - it's real dollar strength, not just euro weakness. But it is very temporary.
Let me explain.

In the last 2 decades, money has been flowing into BRIC, lots of dollars, that were converted to local currencies. In order to keep their currencies down, BRIC started to buy dollars at an ever accelerated rate, now approaching 90$ billion per month.

Now enter financial crisis. As investors realize that their BRIC companies are going to turn into smoking craters and the notoriously corrupt 3rd world government may just confiscate all their money, investors pull out of emerging world.

So what we have is that suddenly many private investors flock back to the political stability of the dollar. At the same time, BRIC continues to buy dollars due to the force of sheer inertia (and they still have trade surplus).

What's important to realize is this whole process is temporary. Private flight cannot continue for too long, and will stop in a few months. Also, Foreign Central Banks can only buy dollars with money made from selling stuff to us. As soon as real consumer depression hits in US, that money flow will wither out and die and central banks will have no choice but to withdraw their dollar.

Now combine this with ever more reckless fiscal policy of US government, and we are setting ourselves up for the dollar crash of epic proportions, some number of months ahead. And by epic I mean, 50% drop within a span of 1 month would not be unrealistic.

When policy-makers speak in an empty forest, do they make a sound?

This weekend we had a very fine illustration of an important truth: every word said by politicians and journalists is a lie more likely than not.

By all looks, it should have been very important: after all, G-7 summit itself spoke of potential currency intervention, asserted that it would not tolerate a weak dollar, and French Finance Minister Christine Lagarde even went as far as to call this a "turning point" and a major policy change.

Look, if this really was a policy change, and a turning point of some significance, then this is the kind of stuff which makes currency rates jump by 10% or more in day.

But in fact, after the announcement, dollar has done nothing but continue its usual fluctuations around the all-time low. This, of course, means that when politicians - even of the highest level - speak, no one thinks it is worth listening anymore.

Of course, the press either cannot comprehend or doesn't want to admit that market fluctuations are just that - random fluctuations. So, as usual, the press makes itself look clinically insane by simultaneously asserting that Dollar rebounds after G7 meeting and Dollar remains on backfoot after G7 meeting. Both articles are from the same newspaper (Forbes) and are published within 25 minutes of each other.

This whole farce underscores that the real reason for the credit crunch and liquidity problems is that lies and deceit are now in every part of the financial system. The reason Fed has been and remains so impotent in fighting the credit crunch, despite its unprecedented, almost trillion-dollar sized intervention, is that Fed's actions do nothing to restore the trust and honesty in the system. In fact, Fed's intervention has done nothing but help the banks further hide the truth. And as a result, it is doing nothing but prolong the crisis.

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.

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.

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.

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.

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.

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.

UPDATE: 1:39PM:
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.

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).