The Deleveraging Spiral - Black Friday?
This might become a very interesting day in the financial markets.
New U.S. unemployment numbers will be announced at 8:30 ET. If they are worse than expected, everything might tank. That is, unless the Fed and the Plunge Protection Team step in.
All financial institutions and funds are now deleveraging, i.e. lowering their risk or cutting their losses.
A leveraging factor of 10 means an entity holds assets at a value of 100, but only has a capital of 10 and borrowed the other 90. If the assets of such an entity lose 10% of their value, the capital of the entity is 0. If they lose 20%, the capital of the entity is 0 and its lenders will have to take the rest of the losses.
As lenders do not like to lose money, they watch carefully and as soon as there is a threat of such a situation, they demand immediately repayment of a part of their loans, or more safe collateral for these loans. In finance speech - a margin call.
The entity receiving the margin call has to come up with new capital to bolster the collateral it can give to its lenders or make an emergency-sell of some of its already decreased assets to repay some of the loans and take the loss.
Yesterday Carlyle Capital, a listed hedge fund, received margin calls it could not satisfy. Practically it is bankrupt and its lenders, big banks like Citibank and UBS, will now have to take losses on the loans they made to CC too.
The fund was leveraged at a lunatic factor of 33 with assets of $22 billion and capital of $670 million. A fall in the value of its assets of just 3.3% wiped out all of its capital. But the assets even fell more (though we don't know how much yet) or were at least perceived to be worth less than 97% of their original value by the banks who lend to CC.
There is one really bothering issue in the CC story. The assets Carlyle Capital was holding were bonds issues by the Congress chartered Fannie Mae and Freddie Mac. These are first class rated bonds which, until a few days ago, were largely perceived to be backed by the U.S. government and as valueable as U.S. Treasuries. But as the Freddie Mac FAQ says:
Freddie Mac's obligations and securities do not constitute government debt and are not guaranteed by the Federal government.
The perceived government guarantee for Freddie and Fanny debt does not exist. The market value of their debt was 'faith based' and that faith has eroded.
Bloomberg headlines Agency Mortgage-Bond Spreads Rise; Markets 'Utterly Unhinged'
Yields on agency mortgage-backed securities rose to a new 22-year high relative to U.S. Treasuries as banks stepped up margin calls and concerns grew that the Federal Reserve may be unable to curb the credit slump.
...
"Everything is telling you the financial system is broken,'' Simon, whose Newport Beach, California-based unit of Allianz SE manages the world's largest bond fund, said in a telephone interview today." Everybody's in de-levering mode.''
Rising yields on a bond is an expression of its loss in value. So now Freddie and Fannie debt is perceived to have less value. This is quite bothering as Fannie and Freddie themselves are leveraged with a factor of about 30.
Their chartered business is to lend to homeowners (indirectly through brokers) and to issue debt bonds on the other side to get loans from investors. They only have $1 of capital for each $30 they borrow and lend to homeowners. As markets now value their debt at less than 97%, Fannie and Freddie are, in theory, bankrupt.
But these entities are 'too big to fail' and the government (taxpayer) will step in and add to their capital to lower their leveraging factor. The government will of course have to borrow the money itself. This will put further pressure on the dollar, increase long term interest rates and feed inflation through higher import prices.
With gas prices going to $5/gal more people will default on their mortgage, more of Freddie and Fannies mortgage holdings will go bad. Their bonds will lose further values. More bond holders will default. Their lenders will eventually default too. Citibank was one of the banks that lend billions to Carlyle Capital. If Citibank has to take more losses of this kind it will be bankrupt too. (It is also too big to fall and will likely be taken over by the government too.)
A deleveraging spiral is in full motion now. It feeds inflation and decreases the value of the dollar. It has not yet really hit the stock market, but it will when bank shares go down further and hedge funds will panic-sell their share holdings to meet margin calls on their debt.
Today may see the bad-news-trigger that marks the point where the 'faith crisis' hits the stock markets and these turn out to be 'unhinged' too.
Posted by b on March 7, 2008 at 07:28 AM | Permalink
So, if Bernanke cuts rates by 0.5% every couple of weeks, what will he do this summer, when the Fed rate will be at 0? He turns off the lights and leaves the building?
Posted by: CluelessJoe | Mar 7, 2008 8:48:22 AM | 2
CJ,
I guess he will start paying people to take money off the Fed...
Posted by: ralphieboy | Mar 7, 2008 9:01:32 AM | 3
Our worthless government lies about everything b, you'll be shocked to hear. The U-6 unemployment number is far more accurate.
The popularly followed unemployment rate was 5.5% in July 2004, seasonally adjusted. That is known as U-3, one of six unemployment rates published by the BLS. The broadest U-6 measure was 9.5%, including discouraged and marginally attached workers.Up until the Clinton administration, a discouraged worker was one who was willing, able and ready to work but had given up looking because there were no jobs to be had. The Clinton administration dismissed to the non-reporting netherworld about five million discouraged workers who had been so categorized for more than a year. As of July 2004, the less-than-a-year discouraged workers total 504,000. Adding in the netherworld takes the unemployment rate up to about 12.5%.
The Clinton administration also reduced monthly household sampling from 60,000 to about 50,000, eliminating significant surveying in the inner cities. Despite claims of corrective statistical adjustments, reported unemployment among people of color declined sharply, and the piggybacked poverty survey showed a remarkable reversal in decades of worsening poverty trends.
Somehow, the Clinton administration successfully set into motion reestablishing the full 60,000 survey for the benefit of the current Bush administration's monthly household survey.
Here's a simplified version of b's post.
A seesaw with a house (image) on one end of variable size, representing dollar real estate value supporting debt (money creation) on the other end. The pivot point is not in the middle; it has been shifted way over toward the debt end so that the mortgage assets can support 10, 20 or 30 times its value in debt. Just for added fun lets put a big oxyacetylene flame under each end to add motivation for keeping the seesaw balanced.
All is fine as the total housing value keeps expanding and the workers on the other (debt) end gleefully add more money to balance it out; their glee even motivates them to further shift the pivot point in their favor when the govt isn't looking or can be paid not to look.
So as the debt workers siphon off more of the new money and less is available for new housing starts, the house image slows its growth to near zero. The debt workers should be worried but they now have mechanisms like derivatives designed to suck more money out of their wrinkled up source and all appears to be flush until the house image starts seriously shrinking.
That dazzling golden egg is disappearing. That homeowning payment source is running dry; most of that spouting cash generator stream has gone elsewhere, not to the wage earner with a monthly house payment. Our seesaw tilts precipitously as the short heavy debt end falls. People are bailing out on both ends.
Is there any way to fix this or do we need a new seesaw? Perhaps a fixed pivot point somewhere in the middle?
(This image is totally off the top of my head and not intended as criticism or disrespect for b's insightful original post. The seesaw is certainly incomplete and fraught with error.)
Posted by: rapt | Mar 7, 2008 9:55:34 AM | 5
@CL - 2 - Bernanke will use his helicopter and throw money out of the door.
In fact he is already doing that. Ínterest rates lower than inflation rate is already expensionary.
The fed has more tools. Next to interest rates it can lend money to banks. It already does this in huge amounts now and seems to take even the shabiest CDO as collateral.
But lowering the interest rate helps nothing in this situation. The U.S. must save more and spend less. It must let people get higher interest rates on their savings than the inflation rate. Who wants to save when you get less interest back than inflation eats up?
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BTW - a question too readers. When I write stuff like above I never knwo if it is written too simple or too nerdy. (The above is likely too easy?)
Is it a. understandable? b. of interest?
Some feedback is welcome.
b -
Brilliant post. Neither too simple or too nerdy. You sound a little like Billmon, I might even dare to say!
I lurk a lot, this is my first comment.
The insights of the regulars at this 'bar' are very worthwhile.
Posted by: foilhatgrrl | Mar 7, 2008 10:07:06 AM | 7
The perceived government guarantee for Freddie and Fanny debt does not exist. The market value of their debt was 'faith based' and that faith has eroded.
Does this sound familiar, the S&L scandal where various permutations of FLIC gave people the false idea that their savings were back by the Feds? Wasn't a Bush involved in that, theft, also?
It's great, b.
Thanks for this post as I am HUGELY interested and your writing on this topic always helps clarify what I have been reading elsewhere. I constantly marvel at the breadth and depth of your knowledge.
I can't believe the teeter-totter has not yet toppled. How much longer can the denial keep going? When is the big crash coming?
Here come the helicopters: Federal Reserve Announces Bigger Auctions to Banks to Help Ease the Credit Crisis
The Federal Reserve said Friday it is taking bigger steps to ease the nation's credit crisis, including increasing the amount of money it will auction to banks this month to $100 billion.The Federal Reserve said it will raise its planned March 10 and March 24 auctions to $50 billion each, up from the $30 billion limits it had previously announced. The auctions serve as short-term loans to get banks the cash they need to keep lending to their customers.
Fed officials said in a statement they planned to continue the auctions for at least six months, and would move to even larger auction amounts if needed.
B,
Your posts have been great!
I'm happy with both simple and nerdy comments. Sometimes I have trouble with the nerdy but a challenge is when real learning occurs.
Sorry I have been too busy to comment lately.
Posted by: Rick | Mar 7, 2008 10:23:53 AM | 11
b
Great post...Simple enough for me to understand and links for the more intelligent to deep-dive is they so desire.
Posted by: SimplyLurking | Mar 7, 2008 10:45:32 AM | 12
Undestandable and interesting.
I wonder if Billmon has been able not to hang himself at seeing the complete clusterfuck US economy has become. Or he's just shadenfreuding in his home sipping fine whiskey.
B - 6: Well, throwing money out of the door, expansionary policies and the like, we're speaking of the perfect recipe for continued inflation if not hyperinflation, aren't we? Can they be that retarded?
Posted by: CluelessJoe | Mar 7, 2008 10:58:06 AM | 13
@Clueless - 13 - we're speaking of the perfect recipe for continued inflation if not hyperinflation, aren't we? Can they be that retarded?
Yes and yes. They are in panic-mode and see a systemic financial crisis coming. They try to inflate it away which only will make it bigger.
As I have written before - the money the Fed pumps towards the banks will NOT be used to lend back out to hedgies or people who want mortgages. The banks with the cash will use it to repair their balance sheets - i.e. make profits so they can restock their capital base. Which markets will they use to make these profits - commodities.
Below a song I have stolen from a comment at Calculated Risk
probert writes:
Capital keeps falling on my head
And I simply redirect it to my fav-o-rate
Hard commodi-ty
Oil keeps on rising and
Financials keep on falling...
Capital keeps falling on my head
I'm telling bernanke man to stop it right a-way
Stop issu-ing-debt
People keep on panicking
They don't know what's the matter...
Re 9: my Q: How much longer can the denial keep going? When is the big crash coming?
a commenter at Elaine's seems to have an answer:
Now after 8 years the USA has another election. Bernanke is doing his damdest to keep the repuclicans in office. Interest rates will be lowered several more times this year, right up to election week. If this allows the republicans to retain office, the interest rates will stay low; if the dems win or Ron Paul wins, a strong dollar will suddenly be the FED mandate. Interest rates will sky, and all the crap that awaits will be unleashed at once.
Does this sound about right, b? Others?
This is a very good post, b. Clear enough for those of us without an economic background to follow and insightful enough for those with one to take the time to read. I'm always glad to read your thoughts and your links about the economy.
It is an area I ignored for years as seemingly arcane and somewhat boring, but I learned from a contract stint at Freddie Mac about 10 years ago (reading system code to produce a user manual) that I was no dumber and at least a bit more responsible than the average manager at a major financial institution (a scary thought). They really will game the system to benefit themselves at the expense of the rest of us. We, the general population, ignore this stuff at our peril. We need to educate ourselves about economics so we can evaluate who will better manage our economies; statements like "tax cuts generate additional revenue" and "deficits don't matter" might then immediately disqualify someone from being anywhere near our economic life.
I appreciate and sometimes marvel at the time and effort you put into each post you do. As over 1.28 mil page views attest, a lot of other people do as well.
Posted by: lg | Mar 7, 2008 12:36:28 PM | 17
Great post b, it is all very interesting how in some elliptical way (as in #link 16) this pervasive logic has infiltrated everything the administration does. Trying to pad out the economic situation until the next election cycle is not so different than what they are doing in Iraq, with paying off the insurgency to create the illusion things are getting better - at the cost of them becoming much, much worse later, but presumably under a democratic administration. Ya' gotta give em credit in belief though, they'd rather crash and burn everything in sight - than doing the
"socially or economically responsible" thing. Guess they're afraid it might work.
Posted by: anna missed | Mar 7, 2008 12:52:23 PM | 18
@Hamburger - Does this sound about right, b?
It certainly was the hope of the Republicans to keep the walls of the Potemkin city (stock market) standing up until the Dems take over and have to clean up the mess and take the blame for it.
There were three mistakes they made:
1. Markets are hard to control when you don't believe in regulation. Unregulated markets behave in unpredictable ways. They thought they could control the markets without having the tools to control them.
2. The war costs. They did not see the costs of war and its effect on commodities and inflation.
(The war is in some fields of commodities a real problem. Two examples: 1. The emergency build of mine-resistant vehicles cleared the markets of certain special steel variaties. Prices for those varieties shoot up. Other steel prices followed. 2. Tires get used up in Iraq and the army bought all that was available. A friend of mine is working in a crane factory. They had new cranes standing around ready for delievery, but had no tires for those. Delievery delay for new tire orders for a reasonable price was two years.)
3. They thought they could control the Europeans
The European Central Bank has one monetary task. "Fight inflation."
The Fed has a monetary and a political task. "Fight inflation but keep the economy going." Under Republicans the second part was more important and interpreted as "keep our profits high at all costs".
While the Fed ignored inflation and fed a housing bubble festival, the ECB looked at inflation rates and kept interest rates higher.
Now came the emergency. The Fed wants to keep the markets going by lowering the interest rates. But it also has to keep up the dollar. So it hoped and prodded the ECB and the Bank of England to also lower rates. No say both of them. If you are afraid of a lower dollar you better rise your rates.
As the U.S. has no leverage it can use against an independent ECB, Bernanke is now between a rock and a hard place. He can save the stock-market by lowering the rates further, but that would kill the dollar and oil prices would go through the roof.
(There is also a personal story behind this of a very pissed Trichet who wasn't consulted when Bernanke made an unprecedented emergency drop of the Fed rate by 0.75% just because the European markets dropped a few percent that day. That day the ECB lost all respect for Bernanke.)
So three mistakes in the Republican plan:
- Hate for regulatory instruments
- Lack of spending disciplin due to the wars
- Lack of partner behaviour instead of bullying
All these mistakes are classic for Republicans. One could say they screwed up their plan by being themselves. Reagan was a bit smarter than Bush in this. He at least raised taxes 1 1/2 year before he left.
b,
As someone who worked at the Fed for 20 years, I thin you are right on the mark. Sometimes it IS all rather simple when you cut to heart of the matter.
As far as timing the collapse though, it's a whorehouse of cards but it's the only house in town. Most people with a sense of justice tend to analyze situations according to the rules and with a eye towards past events. If there's one thing we should see it's that these fuckers just make shit up and change the rules to suit their tastes. They are not going to go bankrupt or go to prison in a world that they created themselves.
Mozilo, O'Neal and Prince defend pay
tone deaf, absolutely tone deaf. look:
"In short, as our company did well, I did well," Countrywide's Mozilo said.Actually, your company was going bankrupt, on the schedule you determined.
Stanley O'Neal, who relinquished his title as chairman and CEO of Merrill Lynch & Co. in October after the company reported an $8 billion loss on subprime related investments, argued that his compensation was in line with the broader financial services industry and that his pay was determined as "the board saw fit."I believe that is the problem under critique.
O'Neal called reports that he collected about $161 million after he stepped down "inaccurate."Yes, I'm sure they are quite inaccurate. The truth in these cases is always more disgusting.
Posted by: citizen | Mar 7, 2008 1:23:16 PM | 21
Helpful post indeed. Aimed well, to my mind.
Now how about some failsafe ways [for an American] to 1) at least avoid the worst consequences of the dollar devaluation 2) make a profit. Just kidding. My investing acumen could be a negative indicator par excellence. That's why I pay a fee to some manager to handle my meagee retirement cache.
b,
your decryption of the language of business, such as this excellent post, reveals the truth of the phrase "voodoo economics"
thank you
Posted by: jcairo | Mar 7, 2008 1:58:33 PM | 23
Adding to my comment @19 -
point 3 - the ECB is not willing to follow the fed into hyperinflation
This just in: ECB economist says central banks must chart their own course
The chief economist at the European Central Bank said Friday that central banks were free to chart their own monetary polices, implying that the ECB was under no obligation to cut rates in line with the US Federal Reserve.I understand that Stark is carrying two messages here:
...
"Globalisation does not expand the need for international monetary cooperation beyond an open exchange of views and information," ECB economist Juergen Stark told a conference organised by the French central bank.
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The ECB held its main interest rates at 4.0 percent at a policy meeting on Thursday, with bank president Jean-Claude Trichet stressing that fighting inflation remained his priority.
...
[Stark] said that a "central bank should not mechanically follow other central banks' policy decisions."Stark added: "The best international architecture is one in which each central bank has a clear mandate to focus on domestic price stability ... each central bank is well advised to react to foreign developments only if these become relevant for domestic price stability."
1. Towards the Fed - "f*** you!"
2. Towards other (smaller) Central Banks - "you are free to tell the Fed "f*** you" and you should do so."
So if I were central banker of Singapur, Brazil, or even Japan I would understand this as a "free hand" to deny any favor to the Fed and a bit of hope that the ECB will cover my back when needed (which will be privately expressed and granted).
Lesson: With a strong currency comes (monitary) political weight.
On a related note: I read awhile back someone listing all the players in this game called big shitpile and noticed that alumni of Goldman Sachs are everywhere, including Sec. of the Treasury. A few days ago I read someone who was totaling up the known exposure of all the Wall Street banks and investment firms, the ones predominantly run by forementioned alumni. The firm with the least exposure? Goldman Sachs. Coincidence????
Posted by: mikefromtexas | Mar 7, 2008 7:55:36 PM | 26
b, this post is very much of interest to me, no question. And a wealth of information, as well as intelligent analysis, as always.
Re your # 24, Singapur, Brazil, others may play free hands. But Japan won't. BOJ will continue to be Fed's silent partner in the field. See here how they may have helped the Fed postpone this current crisis a full five years the last time around. Or rather, bury it in the system so that it could come back as a systemic crisis, I guess.
How Japan financed global reflation
(Don't let the goldbug link put you off. It was originally published here, now behind a subscription wall.)
One would do well to factor in BOJ as part of the Fed's arsenal, though I don't know enough economics to project how that may play out...
Posted by: Alamet | Mar 7, 2008 7:58:52 PM | 27
Great explanation. Speaking about explanations, I found this little slideshow (with stick-figures) helpful in explaning the subprime crisis.
lg,
I have the sneaking suspicion that economics is intentionally presented as much more arcane and strange then it is. Makes it easier to convince people to let the professionals handle it (and handle it they do, to their own profit).
Posted by: a swedish kind of death | Mar 7, 2008 8:44:35 PM | 28
A really great post, b. And excellent comments too.
To Alamet @27, I think part of the BOJ answer is that they are currently already charging only 0.5 percent interest rate. This after years of zero interest rate that fed a "carry trade" of borrowing cheap and investing in the U.S., Europe and elsewhere with better returns. In times like we're witnessing now, they can only help the U.S. Fed to a limited extent, I think, since they have so little room to reduce and there is a dramatic decrease in liquidity seeking out the carry trade. (Other commenters please correct me here if this is misguided, as it may well be.)
Question for B., Biklett, others who may understand the mysterious ways of the Fed, and specifically referencing comment #10 above: when the Fed decides to hold these "auctions", they are in essence just printing more money. Right? Especially when they have made clear they would take worthless or heavily devalued crap like mortgage-backed securities as collateral? So it is another way of inflating their way to stability, they hope? And if the "loans" are not repaid and the "collateral" is worthless, does the borrowing bank or institution pay any price, or is it just us hapless citizens who end up holding the bag?
Posted by: Maxcrat | Mar 7, 2008 8:53:53 PM | 29
U.S. Lost 63,000 Jobs in February; Unemployment Rate at 4.8%
The unemployment rate is a joke - sinking unemployment rate when more people go jobless.Notice that hourly earnings year over year are lees than the inflation rate. Real earnings are sinking.
Posted by: b | Mar 7, 2008 8:42:12 AM | 1