Monday, March 23, 2009

Macro Observations In The Context Of Newton's Third Law

The one-two knockout punch from last week's quantitative easing by the Fed and today's massive implicit toxic asset offloading guarantee by the Treasury served a bitter dish to market doomsayers. Putting the fact aside that the two actions are essentially contradictory (30 years collapsed Monday after the ripfest last week), much was said today, and over the weekend, about Geithner's plan to present hedge funds with a once in a lifetime opportunity of a 12-to-1 upside/downside investment ratio. All else equal, this alone must be a manifest synthetic arbitrage opportunity somewhere, and indeed is, as reader Kushyama points out a peculiar inversion - via the PPIP, for the first time the cost of equity (the treasury's borrowing cost, although Felix Salmon has a few things to say about whether this should even be considered equity in the PPIP context) is lower than the cost of debt (the program funding at LIBOR + spread).

The nuances of the administration and treasury's actions over the past few days are vast and nuanced, and deserve a much more extensive post. The key takeaway is that the administration achieves many key short-term goals with the PPIP:

1) The marginal risk of overbidding on toxic assets' marks due to the program's leverage implies most eligible PPIP participants will get on board, and eliminates the need for price discovery so the administration can throw out the contemplated adjustments to MTM, in the process claiming it is all for transparency, potentially inciting another market rally.

2) Offloading the toxic assets from banks' balance sheets at current marks (although for full bait-and-switch transfer at least another $1 trillion tack-on to the PPIP will be needed), thus eliminating the daily chatter for major bank nationalization, relieving the bulk of the pressure on the market-leading financial sector.

3) Contrary to the administration's claims that it is not "managing to markets in the short run [sic]" (today's quote of the day from Larry Summers), the immediate goal is precisely a market rally, driven by these very PPIP participants who can use the $900 billion taxpayer gift to buoy up the market, while at the same time taking massive mark ups on existing toxic portfolios of their own, and revive the long-side of the mutual and hedge fund industry, thereby soaking up so much of the "sidelined cash" from institutional and high net worth clients with artificially inflated performance reports. The institutional cash inflows based on recent abnormally high returns, will yet again drive the market higher.

4) The FDIC's hair-raising problems can be swept under the rug, as the "depositor insurer" takes on yet another implicit guarantor role, that of whole loan purchase backstopper. Despite the FDIC's DIF likely being at zero if not negative, the FDIC will now embed itself into the financial system to such an extent that the emerging vicious pentagram between taxpayers, depositors, bank holdings companies, toxic whole loans sellers and PPIP participants will make mutual assured destruction an inevitability if any one these defects, thus ensuring continuing cooperation regardless of real macroeconomic conditions.

While all these consequences seem wonderful in the short-term, Newton's third law applies here as it does everywhere else. The primary trade off will inevitably be the prompt realization, as CMBS and RMBS cash flows dwindle to a halt in 2-3 years, that the administration's optimism was unfounded. Instead of unjustified, rose-colored preaching, maybe someone in the administration can run a TREPP model on some of these toxic asset portfolios and see that based on current trends in DSCRs and recovery levels, the default tsunami in toxic assets is at most 3 years away. There is a reason why CMBS and RMBS are priced so low: the market is rational, it has a great facility in using an HP-12B and what it is seeing is the reason why market bids are where they are, somewhere in the neighborhood of 40-80% lower than where banks have these assets marked. The defaults will promptly eat up the non-recourse loans by the taxpayers as hedge funds trade out of these securities in advance of the crash.

End result: more and more and more printing of dollars. So much so that the M1-3 velocity will soon become unstoppable. That, combined with quantitative easing by our Eurozone friends (granted, some legislation has to be implemented first), and the hyperinflationary path is set, dooming our children to an economy reminiscent of the Weimar republic. But at least some banks don't get nationalized tomorrow, some other hedge funds make a ton of money that can be taxed next year once capital gains law is adjusted proving Obama's tax reform is a success, and the administration's fate is safe... at least for the current term.

But how about quantitative easing and stimulus benefits? That one is a doozy as well.

As all stops get pulled, it is not difficult to see mortgage rates dropping below 4.5%, which would imply an annual relief of $115 billion according to Merrill Lynch. Also beginning April 1, middle-income families will start seeing withholding taxes coming off their paychecks, which in ML's estimates, will result in a $35 billion boon, implying the monetary and fiscal policy tailwind will be a solid $150 billion. But... Newton's third law again... as people continue their thrifty ways, and savings rates approach 7%, this will drain $175 billion in spending, and from a static point of view, every percentage point rise in the savings rate is equivalent to the loss of 2.2 million jobs in terms of GDP impact. Add to that the expected actual 2.5 million in job losses (at least) through the end of 2009, adding another $125 billion in personal income costs. Lastly, ML estimates that the negative wealth effect will end up being a $400 billion drag on spending. All totalled, the economy faces $700 billion in headwinds, offsetting stimulus benefits to the tune of 5 to 1.

As for the $1.15 trillion in expansion in the Fed's balance sheet - well, that is a mere drop in the bucket considering that to revert to a historical mean private sector debt-to-GDP ratio (currently at 176%), another $8 trillion in household and business sector credit must be unwound.

And all this is happening in the context of household wealth, which is disappearing at a staggering pace: last at -$12.9 trillion, and currently at -$20 trillion through Q1. This is a 20% decline in household wealth since the peak in mid-2007, which is wealth destruction at a magnitude last seen during the Great Depression.

Buyer beware. Sphere: Related Content
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Anonymous said...

I have been reading your blog for a little while and appreciate the cogent analysis. I know that you have been reluctant to give specific advice (don't short Citibank being the exception), but after such a gloomy forecast, could you please give some thoughts on what the average investor/ saver can do to protect themselves? (I know gold is the popular hedge fund trade, but I have never been intellectually comfortable with the arguments made by the gold bugs).

coolcatice said...

FWIW, I recommend complaining about this latest Treasury give-away to Congress. Something like:
* * * * *

We are outraged at the latest Treasury Department plan. It effectively sets up hedge funds and other speculators to make bets on mortgage-backed bonds and gives them government guarantees. They keep the gains but any losses will fobbed off on the taxpayer!

This is a ridiculous risk of taxpayer funds to further enrich speculators, Goldman Sachs, JPMorgan and AIG.

In the end, it will have no effect on the root problem of over-priced and over-indebted houses. Only the free market will “fix” this problem.

If you worried about the anger over $165M in AIG bonuses, wait until the public figures out the hundreds of billions in giveaways that will emanate from this latest plan.

Please stop this plan!!!

Concerned Citizen
* * * * * *
Please write today. Like the political "machine" in old Chicago, we recommend you write early and often:



Nancy Pelosi:

Anonymous said...

Seems like your dire predictions for long term are based on increased "thriftyness of the US consumer". I am at a loss how without the administration initiatives the consumer would be spending MORE. What am I missing?

ts said...

I have to disagree with you on this one. Geithner (and Bernanke) haven't the slightest idea what "money" is, and so have no idea how to produce enough of it to cause inflation.

All you describe in this post is deflationary, from the declining flow of income (and therefore price) from ABS as defaults take over to the wholesale destruction of household (and business) wealth. An entire generation is looking at poverty in their elderly years as they have retired on their home equity and 401k to take care of them and now have just Social Security.

Certainly the Fed has nearly (at least now - perception is reality) infinite power to create reserves and the Treasury has nearly (at least for now - perception is reality here too) to create debt instruments to satisfy demand (which, not coincidentally, is increasingly coming from the Fed now, our foreign partners having smaller trade surpluses to recycle).

However, I don't see an outlet for these funds. Certainly not in housing. Prices are falling at a 20% annual rate. Home equity for purchasing has evaporated. People never saved in the first place so they don't have the cash. Lenders require 20% down now, or at least significant skin in the game. There's 13 months of inventory on the market, and that's with over half being foreclosure sales, which are dumped on the market and cause prices to fall further. Unemployment is 8.1% and rising. In California unemployment is 10.5% and rising.

This is not an environment conducive to inflation. Even if we had complete transparency so we could make all the banks, broker/dealers, insurance companies, hedge funds, and everyone else whole, who would borrow? Who CAN borrow in enough amounts to clear the market, particularly with rates artificially set 400-500 basis points lower than what would exist without intervention. We might create a giant monetary circle jerk, but we won't create inflation.

What outlet is there for these funds that results in the spending on consumer goods (particularly our overly-narrow definition of consumer goods called CPI) that would drive prices up? It doesn't happen in an economy where household debt alone is 150% of GDP and almost half of Americans are living paycheck to paycheck.

Certainly it can fuel a one day rally (or a month. Remember we've seen a lot of these since 2000). It can also fuel a hell of a lot of volatility, because what isn't getting taken out of circulation is going right into speculative activity, which seems to only end up feeding the same small group of people.

However, most of this money is either destroyed or neutralized as soon as it is created. It either covers the gaping craters in the required capital of financial companies, or goes to pay down household debts contracted ages ago.

Industrial capacity is at levels not seen since 1982. The Chinese have 20-40 million newly unemployed factory workers and would probably be ecstatic to dump cheap crap on the market for the next decade. Trade is becoming increasingly contentious, and with the drying up of trade comes the loss of the gains from trade.

We are creating a lot of "M", but it won't get "V'd". Bernanke is unwilling to let "P" adjust, so Q is adjusting accordingly.

Anonymous said...

Don't forget the pension plans. I believe I read that many pension funds use Mar 31 as their year end date. This little Geithner/Bernanke rally is very timely from that perspective. The 20% rally over the last few days will save some companies, municipalities, and states, the grief of having to plunk new billions into their underfunded pension programs. Quite a well timed play.

ts said...

As a response to commenter #1, there's actually a lot one can do.

Americans should have an emergency fund to tide them over during difficult times. Normally people should do this during the good times, but every little helps.

Paying off debts is good too. A $1 extra in a mortgage payment is equivalent on your balance sheet to $1 in a tax-free 5-6% bond for the next 30 years. There just aren't many investments that are going to perform better in the short term, and auto, credit card and student loan debts are even better.

Finally, the stock market is historically very cheap. I don't think we've hit bottom yet (the long term stock market cycles last 16-20 years, so that would mean a 1982-style bottom around 2016-2020). However, an investor that dollar cost averages in and thinks ahead the next 20-25 years should be buying with both hands. Even people near retirement can lower their average cost and wait for the next bull market to take them out in 2-4 years around 11K or so.

Anonymous said...

I'm compelled to mention this because there's a mis-conception about that is repeated in the excellent comment above. We (loan originators) still are able to get 600 fico-score borrowers mortgages with just 3.5% down (FHA). Large downpayments may be coming but they're not here yet.

And FHA can now do some pretty large loans ($365,000 in MN where the median is only about $190K). I don't have any problems getting people purchase loans, its the refinancing that has disappeared due to the equity losses.

James said...

Great. all we need is people up to their asses in mortgage debt.

The market went up because BAC and C the two POS banks that the morons at the fed and treaury cobbled together were getting wobbly therefore another late ad hoc attempt and proping them was made.

Anonymous said...

It maddens me to watch trillions of dollars of debt be accumulated in a matter 90 days in an probably fruitless effort to "goose" the economy.

It's apparent that Bernarke/Obama absolutely refuse to allow a shakeout of the dead weight on their watch and they want to re-inflate the bubble at ALL costs.

Politics at it's worst. Free market forces be damned.

ts said...

@Anonymous 12:20.

I'm glad you have buyers for those loans. Apparently Fannie and Freddie haven't learned their lesson yet. I doubt the true risk premium alone would cover the 3.5% rate for a 600 FICO score. But hey, it's someone else's problem now.

Trivia: Minneapolis home prices are down 18.4% YOY according to Case-Schiller. The non-foreclosures may need a year to season, and the foreclosures may need two, but even if the rate slows by half it wipes out 20% equity in two years. And people don't even need close to that? Nifty!

A while back I read in the NYT that lenders would pretty much have to throw FICO models out once the unemployment rate hits 8.5%. About 80-20 odds that happens around 8:30am EST on April 3rd.

I also read the PR piece on home sales about how 1/2 of buyers are first time buyers. I suppose if they were priced out of the market during the bubble, bought a foreclosure getting dumped at 10-15% below market, and haven't taken a six-figure hit to their net worth, they can step into the slaughterhouse along with the rest of us.

I also suspect that a lot of husbands with a foreclosure on their credit score are having their wife buy the house, and vice versa. We're probably importing a number of new buyers too. None of this makes me feel any more hopeful for the future. But hey, the Feds can look at all those tax credits they're giving out and sleep better for now.

ts said...

I should mention that I smell Plunge Protection Team behind today's move. They're still out there. Was there a big pop in the futures around 8am EST? Tyler is probably much more familiar with their MO, but I've read they hit the futures market when they show up to work in the morning.

Gentlemutt said...


Many thanks for the analysis, particularly on the variety of headwinds into which our intrepid leaders sail our economy.

Question: Is there a good comparison available of the aggregate headwinds/tailwinds to be faced if the administration played genuine hardball and quickly seized the banks, separated bad from good, and spun them out asap?

I for one am willing to presume, for the time being, that the new administration is 'holding its nose' and trying its best to maximize aggregate economic outcomes. What I don't understand is why they evidently believe that keeping the old financial plumbing in place is so necessary to fix up the whole house? It seems to me they are confusing the urgent matter of 'availability and prudent use of credit' with the maintenance of the old, broken, and too-often despicable plumbing that ruined the house by spilling excess credit through floors and ceilings.

So it occurs to ask whether you could whip up an alternative to the trenchant high-level analysis in your post, to reveal the aggregate headwinds/tailwinds that would accompany a manly and rapid wind-down of the old plumbing and old plumbers? Maybe that would relieve some of the 'cognitive capture' problem and help put a little real spine into these guys.

Anyway, thanks much. I loved listening in on the Treasury call yesterday, too.

Anonymous said...

Wait till the rest of the hedgies figure out how to restructure the toxic tranches as we have.

Making some of them 100% toxic and therefore destined to be backstopped and others 77%-92% profitable. This is the greatest possible outcome.

Long live the TALF! Geithner next stop will be the Chairman of the Fed, and rightfully so!

Advant Guard said...

"printing of dollars. So much so that the M1-3 velocity will soon become unstoppable."

Printing money increases the supply not the velocity. If you are going to use economic terminology, you should use them correctly.

Anonymous said...

negativity blogs are the next bubble to pop. they're all over the place. none of them called this on the way down and there is more than a good chance none of them will call the turnaround. Seller beware.

Anonymous said...

@ anonymous @ march 24 - 10:26.

Do you have any actual facts to back up your asserations?

Anonymous said...

anon @ 1242...all i know is, I'm not the only one

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