Fed Says “Don’t Worry, Be Happy”

 ”The last duty of a central banker is to tell the public the truth.”   Alan Blinder, Fed Vice Chairman

 We are sure that if Professor Blinder had known what was coming down the tracks, that he would never have made the foregoing comment on the national airwaves in 1994.

 Last Friday the Fed finally released a document describing the methodology behind it’s the long awaited stress tests (called Supervisory Capital Assessment Program (SCAP)). As you know we have been calling for this triage to be imposed even before the September meltdown of Lehman and AIG (see our previous posts) According to the Fed document the process began in February and focused on banks with assets over $100 billion dollars. According to the Fed there are 19 firms in this group that collectively holds two-thirds of the assets and more than one-half of the loans in the U.S. banking system. Taken together this group supports a very significant portion of the credit intermediation done by the US banking sector.

Full results of how each bank fared are expected to be released by the Fed on Monday, May 4. The SCAP report can be found at:

http://www.federalreserve.gov/newsevents/press/bcreg/20090424a.htm

 However the initial pages of the report make ominous reading for anyone who is hoping for transparency, and more importantly, solutions, to come out of this process. The first sentence of the report states “Most U.S. banking organizations currently have capital levels well in excess of the amounts required to be well capitalized.” In reading further it did not get any better or more objective, thus significantly heightening our concerns that this exercise is designed to be a whitewash rather than a fact-finding process aimed at measuring the scale and depth of the problem such that appropriate remedies might be devised and implemented.

 The SCAP document goes on to state:  “The SCAP is a forward-looking exercise designed to estimate losses, revenues, and reserve needs for Bank Holding Companies (BHCs) in 2009 and 2010 under two macroeconomic scenarios, including one that is more adverse than expected. Should the assessment indicate the need for a BHC to raise capital or improve the quality of its capital to better withstand losses that could occur under more stressful-than-expected conditions, supervisors will expect that firm to augment its capital to create a buffer.”

Tested firms were asked to estimate potential losses on loans, securities trading positions, off-balance sheet commitments and contingent liabilities over a two-year time horizon. Firms trading over $100 billion in assets were also asked to estimate additional possible trading-related market losses and counterparty credit losses under the adverse scenario based on the market shocks experienced in late 2008. These submissions were then analyzed by supervisors from the Federal Reserve Board, the 12 regional Federal Reserve Banks, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency.

Anyone remotely familiar with the various contortions banks in the US have been going through in order to continue to project a “patina of solvency” to the market, knows that the banking system in the US is insolvent at a macro level. This is why Fed Borrowings have remained at historically unprecedented levels since the latter part of calendar 2007. The relaxation in the FASB 157 rule; a lax attitude by FDIC inspectors and it seems a continued unwillingness on the part of the Fed and the Treasury to admit to the true scale of the problems, add up to the reality that a Giant Bamboozle is Underway.

 Furthermore, with the Federal Government borrowing all the dough on God’s green earth, thus effectively “crowding out” all but the most creditworthy borrowers, it is not clear how Zombie Banks might be expected to raise capital on economic terms and in sufficient quantities from skittish investors.

 The answer to this is found in the nature of the stress tests themselves. The following table compares the “Stress Test” data to the worst recorded previous down cycles:

 On the surface, although the process looks legitimate and thorough, the reality is that the “Stress Tests” are anything but. In comparing the stress data to previous down-cycles one finds that the scenarios tested were not stress scenarios at all. In fact, the recently released GDP numbers show that the US economy is already contracting faster on an annualized basis than in the “More Adverse” scenario. Similarly the Bureau of Labor Statistics has already published unemployment numbers that exceed 13%. The SCAP does not even explicitly incorporate issuer default forecasts in its analysis. This seems strange in the context of a comprehensive risk assessment of lending institutions. We could go on with further criticisms of the process but it would belabor the point.

 What this means is that the magnitude of the continued vulnerability of the banking system to economic weakness will not be revealed; the deposit-making and investing public will not know which banks are in real trouble and no transparent and credible plan to find and apply a solution will ever be found as a consequence of this exercise.

 The whole point of the SCAP it seems has been to obscure the problem and prevent anyone from finding out how bad things really are. Most likely this is because there is significant confusion and debate within the Fed and Treasury and the Administration on the best way forward. These institutions appear to be making things up as they go along.

 Despite our assessment, it is not clear that come Monday the SCAP report will announce a clean bill of health for all 19 Banks. That may have been determined to be too much for the market to swallow. More likely is that some of them will be shown to be at risk, but that on balance the system will be given a “Pass”.

 This amounts to a very risky bet that the economy will improve sufficiently and within a short enough timespan in order to re-float the many sunken US banks that so far no one is admitting to the existence of.

 What this means for investors is that traditional areas of activity – stocks , bonds and real estate – will remain danger zones despite the recent stabilization and/or uptick in prices. The apparent manipulation of this process also suggests that the current positive price action very likely constitutes a Bear Market Rally that should be avoided unless one intends to trade from the long side with tight protective sell orders and the intention of bailing before the music stops yet again.

 In coming months we would not be surprised to see forward thinking investors contemplate entry into markets that are un-correlated with stocks, bonds, and real estate, and to diversify out of US Dollars – buying up commodities, precious metals and other instruments. Despite what US Representative Barney Frank has recently said about America’s largest foreign investor (”They are bluffing!!”), China is already leading the charge away from the Greenback.

  ”The Fed was forced to improvise in the Bear Stearns, Lehman and AIG episodes. These improvised actions have had mixed success”   St. Louis Fed President James Bullard

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Eyes Only!!! – President’s Report ahead of the G20 – IMF Financial Sector Stability Assessment

1^st April 2011

His Excellency
Mr. Xie Xuren
Managing Director
International Monetary Fund
700 19th Street, N.W.
Washington, DC 20431

Dear Mr. Xie;

Using this opportunity I would like to express my gratitude to the International Monetary Fund (IMF) for its continued support of the United States’ economic reforms, including the ongoing IMF-sponsored Staff Monitored Program (SMP). We are currently taking the necessary measures to address the problems associated with the episode of misreporting and risk management failure that was exposed in 2007, and to remove the institutional weaknesses that led to it. The field work for the special audit of the Federal Reserve Board has been completed and the draft report was made available to Dr Gideon Gono, the Special Advisor to the Federal Reserve Board System, in late December. We also made three repayments to the IMF, and expect to make the remaining sixty-nine payments as scheduled.

It is heartening that macroeconomic developments through end-September of last year were positive, despite recent difficulties which include the domestic civil disobedience and disorder that occurred in the aftermath of the recent re-basing of the US Dollar to the US Peseta standard; the unfortunate nuclear incident in the Middle East and the subsequent repatriation of US military personnel and forfeiture of materiel from every offshore base and operational area outside of the Continental USA (see below for revisions to National boundaries), and the significant escalation in the prices of imported electricity and fossil fuels imposed by Hydro Quebec, Ontario Power Generation and certain other energy companies in Canada.

Economic growth was stronger than envisaged under the SMP. This was partly driven by a surge in overseas remittances from US migrant workers, which allowed the Treasury to accumulate net international reserves faster than programmed. We were able to achieve an overall fiscal deficit (excluding the externally financed Public Private Investment Program, PPIP), of 7.0 % of GDP, slightly lower than targeted, largely because of buoyant revenues. At the same time, concessional loan disbursements under the PPIP at end-year were faster than anticipated, though all disbursements were made under existing loan agreements and do not constitute additional borrowing under the definitions agreed with Fund Staff. As a result of these disbursements, we now project a higher amount of concessional external borrowing at end-December than programmed. In this context, the Congress, on October 28, 2010, approved a three year debt management strategy that sets a debt ceiling of 180 percent of GDP. We also tendered the audit of the state-owned car company GM/Chrysler and the state-owned electricity company AIG/Con Edison, and issued legislation establishing a supervision unit in the Department of the Treasury for regular monitoring of the financial operations of the 500 largest state-owned enterprises.

We are confident that we will achieve our SMP policy objectives for end-December 2012. In this context, we remain committed to the policies and targets I set out in my letter to you dated June 15, 2010.

It is of note that the external environment will continue to weigh on the United States’ macroeconomic outlook in 2011. The ongoing global slowdown, in particular in China, Europe and Japan will continue to dampen demand for US export goods and weigh on consumer sentiment. However, given significantly reduced direct linkages to global financial markets, we do not foresee any meaningful direct impact on The United States’ financial sector. All in all, we still aim to sustain the same growth level as in 2010, around 0.0% (measured gross of land and natural endowment sales and certain adjustments to our national borders – see below).

Social Benefit and National Security spending will be helped by the secession of Alaska, Oregon, Washington, Montana, North Dakota, and Upper New York State to join the Dominion of Canada and the re-districting of the southernmost 200 miles of each of California (to include all of Baja), Arizona, New Mexico, and Texas, into a buffer zone aimed at the containment of the drug cartels. At the same time, with global food, fuel and commodity prices soaring, we see inflation performance deteriorating throughout the year and the US Peseta depreciating in line with inflation differentials. As you know domestic CPI inflation in the United States remains stuck in the region of 12-15% while the inflation performance of our trading partners, most notably Canada and Europe remains anchored below 3%.

During the remainder of 2011, we expect to strengthen our net international reserves position somewhat faster than previously projected, and intend to save any revenue over-performance while maintaining strict expenditure control. This will be helped greatly by the anticipated revenues attached to the sale of the State of Hawaii to a consortium led by Club-Link Japan, Nike, and Tiger Woods Inc. Against that, it will take more time than initially thought to finalize the amendments to the new Federal Reserve Board Law and the new Commercial Banking Law. We have prepared a first draft of these amendments which go beyond the scope of the program, incorporating additional recommendations from the Financial Sector Stability Assessment (FSSA) report, and which we will now discuss with Fund Staff. We plan to submit these amendments to Congress by March 2012.

In this difficult global context, macroeconomic policies will be geared toward maintaining stability, while structural reforms will aim at raising the United States’ medium-term growth potential. The 2011 budget targets a modest overall fiscal deficit (excluding the PPIP) of 8.0 percent of GDP, allowing us to raise social spending by over 25 percent and undertake important investments in entitlements, roads, hospitals and other infrastructure. We do not see any scope for any reduction in the growth of net-debt in 2011 due to these important initiatives.

Negotiations with foreign creditors over Instruments and Guarantees issued by the Federal Reserve Board and Treasury are currently ongoing, and we are committed to settling all valid claims promptly while maximizing recoveries from domestic borrowers including the Federal Government. Our structural reform agenda for the remainder of 2011 will focus, inter alia, on: improving the deteriorated financial position and governance of the Federal Reserve Board, enhancing transparency and management at key state-owned enterprises, strengthening tax administration and public financial management, and creating an environment for financial sector re-development.

In line with our commitment to transparency of economic policies, we will continue publishing all SMP-related documents on the IMF’s website as well as the recent FSSA report. In addition, we will publish all key findings of the special audit of the Federal Reserve Board on the Federal Reserve Board’s website. Given the good progress we have made so far under the SMP and our firm commitment to successfully completing our 2011 program, we hope to begin discussions on a new program that could be supported by the Fund under the Poverty Reduction and Growth Facility in early 2012.

Your Excellency, please accept my assurances of my greatest attention to these matters of utmost importance,

Barack Hussein Obama

President of the United States

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The Politics of Denial meet the Economics of Hypocrisy

 “When the Blind lead the Blind, both will fall into the water”            Old  Chinese Proverb

Several months ago we referred to market psychology as being in a State of Denial as regards the Death of the Bull Market. This diagnosis can now usefully be extended to the New Administration and Congress. At every turn this Administration, similar to the last, is making decisions believing that somehow everything will turn out alright in the end – that the massive deficits will be financed overseas, that we in the West are not vulnerable to further financial disruption, that missteps now could never produce social dislocation, not to mention risk heightening geopolitical stress and the probability of conflict. In short, the intent of their public communications has been to assure the US electorate and those beyond its shores that life will go an as before.

Don’t Worry; Be Happy

 The actions and public pronouncements of the American Leadership however belie this unfounded optimism. Throughout the current crisis, and at each critical stage, US policy-making authorities have taken steps that are in violation of a basic rule of decision-making under uncertainty.

Specifically, at each of the recent major decision points the US Leadership has opted for alternatives and commitments that cannot be changed very easily, They have done so in place of pursuing more flexible, better advised policy options that are consistent with the substantial uncertainties that still swirl around our current predicament. In so doing they have constrained possible future courses of action, increased the risk of even worse problems occurring in the near future and made the World a more dangerous, as opposed to, a safer place.

Let us examine this hypothesis in somewhat more detail:

Son of TARP

Pity poor Secretary Geithner. His plan got panned. The reason for this is that it fell far short of the Scale and Detail needed to adequately combat the current problems.

The reality of the present situation is that we are in a Global Solvency Crisis. We are not in a Liquidity Crisis. There is ample liquidity, there just isn’t a whole lot of capital left. In the United States there is on the order of $3.0 to $3.5 Trillion of losses still unannounced and sitting in the financial system. This dwarfs the remaining $400 billion or so of financial institution equity that remains on balance sheets following the debacles of the last year. To be sure much of what is bring counted as equity would make even Andy Fastow blush. Take for example the $44 Billion of “deferred-tax assets”  that Citigroup is claiming as Tier 1 equity. This is an amount that represents accumulated losses that the bank hopes to use later to cut its tax bills. The number accounts for over half of Citigroup’s reported Tier I Capital, is more than three times what it was a year ago, and more than double the company’s $19 billion stock-market value.

Citigroup is not alone in this situation. The entire banking system in the US is effectively insolvent. This is why it makes more sense to conduct a comprehensive Stabilization and Triage operation as soon as possible instead of trying to ram piecemeal pieces of legislation through Congress that address in part but not in totality or in scale the various issues that need to be addressed and the way in which this must occur. The steps taken so far – borrowing vast amounts of money to prop up zombies; being unduly concerned about micro issues like executive pay and perks and making various pronouncements to the markets regarding the size and scale of the problems without disclosing the “how” of the bailout only serves to sap market confidence. Most importantly the recent announcement reflects a fundamental failure to understand that banks aren’t going to lend (and neither is anyone else except the Fed) as long as collateral values are falling and/or are still unknown.

Parenthetically, the Congressional Oversight Panel recently disclosed that assets bought by TARP are now worth $78 billion less than they paid for them. Not bad for a three month turn!!

The Stimulus Package

President Obama is on record as saying he will not run in 2012 if the package fails to deliver the intended benefits. His Staff better tell him to stop making these type of promises. Such rants are in fact best confined to election campaigns and later forgotten.

The Stimulus Package is anything but, but you would not know it, listening to the Obama-ites and the One himself. This past week ahead of his first Press Conference, President Obama lobbied hard for the Stimulus Bill. In fact, the numbers show he spent about 3½ minutes out of his 7 minute address talking about all of the roads and bridges that were going to be built.  From that one would have thought that about $350-400 Bn of the total package would be devoted to infrastructure renewal and other shovel-ready projects. No such luck.  The infrastructure spending total is around $30 Billion or less than 5% of the total vote contained in the Bill. The remaining monies are being largely spent on items that the Democrats hope will allow them to tighten their grip on power in the next mid term elections and some other initiatives that will not kick in for years.

However this only begs the question of why they are engaging in this spending in the first place. Every available shred of evidence from Weimar to Hoover to Latin America to Japan’s Lost Decade to Gideon Gono in Zimbabwe shows that you cannot spend your way out of this type of a predicament. Add to this the fact that the severity of this Depression is being made even worse by the Fed’s policy of holding interest rates at artificially low levels, which discourages savings – the exact opposite of what we have for some time being saying is needed.

One Trick Pony?

The scant weeks since the Inauguration have not been kind to the new President. The Stimulus Bill passed without any real bipartisan support. Several of his high ranking cabinet nominees have had to abandon their candidacy. President Obama has been given a rough ride in the foreign press, and received a public bollocking from President Ahmadinejad of Iran. And, although he still enjoys a high degree of public support, the President is down 20 points in the opinion polls,

Candidate Obama promised Change. President Obama gives is the same old spin in a different package.

Candidate Obama promised fiscal probity. America saw its debts double under George Bush. Under President Obama they are going up at a faster rate.

Candidate Obama promised bipartisanship. America gets to see partisan politics at their worst with President Obama leading the charge.

Candidate Obama promised fairness and transparency. America gets a President Obama who recently appeared to want the White House to have a say in the use of Census data and the redistricting of electoral boundaries.

We could go on. Suffice it to say that no one (except the Obama-ites) in the US is still in Campaign mode and we are hoping the President Obama is soon going to snap out of it too. Let us further hope that the new President is a fast learner, and that the first thing he now starts learning and doing is to get some substantive and workable policies in place. The World is waiting.

The Bottom Line

We are not the only pessimists. Many prominent politicians, economists and thinkers are joining the ranks of those that perceive the West to be in the midst of an unfolding crisis of vast proportions that is being fed by a sequence of serious policy failures.

Recently in Malaysia, IMF Managing Director Dominique Strauss-Kahn said the world’s advanced economies — the US, Western Europe and Japan — are already in depression, and that the IMF would slash its global growth forecasts further.

Jacques Attalli, the former inaugural Head of the EBRD stated recently “The major powers think that the crisis is only fleeting, and that we’ll soon return to the old order. No one really wants to undertake the profound changes necessary to resolve it. Although the world’s public debt should be cut, now it is only being increased.”

The result is that Foreign Investors who are being asked to foot the bill for all of these shenanigans in the United States are becoming increasingly impatient with the leadership there. We have revised our earlier expectation that the US might be able to run this game for a few years and now beleive that they are going to be tested much earlier. In the absence of immediate, substantive and effective policymaking it is highly questionable, due to the speed of the unfolding crisis and competition for limited investment funds, that  the US can play at this for much longer before foreign sources of capital dry up and it is forced to decide whether to bite the bullet and to then implement a set of appropriate policies or to keep rolling the dice.

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Oppenheimer Redux

 “We don’t know what to do. It’s really a throw-the-kitchen-sink-at-the-problem strategy”

 Kenneth Rogoff
former Chief Economist at the International Monetary Fund

We have been trawling through the usual year-end smorgasbord of predictions, prognostications and punditry. We have reviewed the usual plethora of numerical price targets, the sectors to watch out for and the hot stocks and so on but have come away from the table feeling a little empty.

Therefore we have to say “Thank You” to Professor Rogoff for his frank admission that the authorities have been fumbling in the dark for answers to the problems they ignored until it was too late.

In our view what most of these commentators are missing, (with the exception of Ken Rogoff and a few others) is the fact that the markets are still in fundamental disequilibrium. Nothing has been solved. The size, scale and prioritization of the financial policy issues that need to be dealt with is still far from being clearly reflected in the policy responses we have witnessed to date.

Significant, unprecedented risks to the system remain and we observe that whether the Western economies will emerge from this debacle relatively intact and soon; or, whether additional painful and extenuated maulings are in store is a Big Picture question that hinges on expectations regarding the level of US Treasury yields, the debt calendar, the dollar exchange rate and their combined effect on saving and spending decisions the world over. These critical factors will overwhelmingly drive investor expectations and activity in the months and quarters immediately ahead in all markets.

Buy Bonds for Paulson

Yields on US Treasuries have plummeted to historic lows. The 10 year Note currently pays a scant 2.25 %, a level that is below the rate of inflation, placing real investor returns in negative territory. Yields on T-bills are zero, meaning that Investors in those instruments are in effect financing the US Government at no cost to it and costing investors even greater negative returns in the process.

In September Hank Paulson announced the TARP aimed at averting catastrophe in the financial markets – price tag: USD 800 billion (USD 700 billion plus the add-ons and the pork). This, in combination with slowing tax revenues and new stimulus initiatives already in the works by the incoming Administration, will boost the US national debt by as much as USD 2.0 trillion in fiscal 2009 – an unprecedented increase in Treasury supply.

Currently US Federal Government funded debt stands at a shade under USD 11.0 trillion or a little over 70 percent of gross domestic product. Approximately 40 percent of this total is short term, meaning that it will mature in under one year. (Note that the short term debt includes not only current “on-the-run” Bills and cash management instruments but also significant quantities of seasoned Treasury Notes and Bonds which had original maturities of up to 30 years)

This means that in the next year the Federal Government will have to roll over about USD 4.3 Trillion of Debt on top of the estimated USD 2.0 Trillion of new financing.

Assuming that there are no more financial shocks, tax cuts or new spending initiatives, the debt managers at the Treasury have been tasked by their Fearless Leaders to find buyers for around USD 6,300,000,000,000 of US paper within the next twelve months. This is unparalleled by an extremely wide margin (and extremely inopportune for reasons discussed immediately below).
 
 
Care and Feeding of the Golden Goose

For years the US has typically enjoyed lower debt financing costs than other nations at every point on the yield curve. In addition, despite running high trade deficits the US was able to fund its fiscal and trade requirements effortlessly due to an “Entente Cordiale” between it and the countries with which it runs a trade deficit. The basic deal has been: We (the US) will buy your goods and in some cases provide a security guarantee and other multinational goodies (support for WTO membership and so on), and you (the surplus country) will buy our Treasury debt securities (and do us other favors). The ability of the US to cut these deals has relied not only on the fact that since 1971 the US Dollar has functioned as the World’s reserve currency, it is also because the US exercised (mostly) sober political leadership, has the World’s largest, most liquid and most (arguably) transparent capital markets, effective control of key multinational institutions and an overwhelming military capability.

Historically, the US could therefore borrow what it wanted at prices set by it regardless of the wisdom or efficacy of the economic policies it was following. In economic terms this meant that the supply schedule for imported funds into the US had zero slope, i.e. it is invariant with respect to the level of the USD, US interest rates or US funding demand.

As with any mechanism, this will work fine until it stops working.

This Postwar status quo ante has led most commentators and analysts to assume that this time around it will also be business as usual. These pundits maintain that because Japan ran large deficits in the 1990’s at negative real interest rates with no problem and no impact on the currency that it will be relatively simple for the US to achieve this feat. We beg to differ. Japan was able to do this because:

• Japan has a very large, persistent Trade Surplus. The US Trade Deficit is running at over 5% of GDP;
• Japan has a very large supply of domestic savings which soaked up all of the government debt supply through captive issuance channels (Kampo, Yucho and the domestic financial institutions). Short of printing money, the US is dependant on foreign investors to finance ongoing activity; and
• In terms of timing, Japan was alone in experiencing its own bubble and bust. The US is at the center of a Global Maelstrom which is laying claim to a chunk of everyone’s pot of savings.

To this we add that the recently rising USD and coincident low Treasury yields are a consequence of some very temporary factors in the marketplace.

•  The $700 Billion Lehman bankruptcy. Lehman had operations in dozens of countries. US Bankruptcy law requires that the bankruptcy trustees must consolidate the assets in the US or US controlled jurisdiction and in USD. Naturally this has boosted demand for USD in the short term;
• Repatriation of overseas assets by US private investors and institutions reacting to price declines and volatility in the US markets. (The flip side of this was the massive sell-off in many emerging and overseas markets in sympathy with the US.) This has also ramped spot demand for USD;
• The flight to quality by investors dumping toxic MBS and other structured paper;
• The parking of all of this cash in US Treasury Bills, Notes and Bonds sending their yields to historic lows;
• Parenthetically, the forced deleveraging has also hit other asset markets that were being propped up by large speculative positions held by banks, hedge funds and others that are now in liquidation because of the credit squeeze: Energy, Hard and Soft Commodities, Life Settlements, Corporate bonds, Municipal Bonds (You name it!)

What the current configuration of US Interest rates and currency values essentially means is that we are in a bubble which has arisen in part because of policy actions taken to combat the deflating sub-prime bubble. It is an aftershock, not an equilibrium state of affairs.

Pax Americana under Threat

In a fiat currency world it all comes down to confidence. And in a world where you are running a deficit profile of staggering proportions it all comes down to the confidence of foreign investors.

The “by-the-book” policy prescription for banking crises is for the Central Bank to raise rates, not to lower them. Higher interest rates are needed to ensure that foreign investors continue to supply credit to the debtor country. This policy move is typically supplemented by measures to shore up system liquidity using Central Bank support. Weak institutions are allowed to fail or are forcibly merged thus cleansing the system of the detritus and excess which led to the crisis in the first place.

The Fed and other Central Banks globally have done pretty much the exact opposite of this – they have cut rates and propped up most of the zombies. Foreign investors (Governments and Institutions) are now being asked to continue financing yawning US deficits at zero or negative real yields.

We submit that this state of affairs is fundamentally unstable, unsustainable and financially very risky.

Therefore, look for the following to occur in the coming months and quarters :

•  The US will be unable to achieve issuance levels of its debt in sufficient quantities along the yield curve to keep its Fixed/Floating exposure ratios within acceptable bounds. (The usually acceptable range of a Fixed/Floating mix is between 60/40 Fixed/Floating and 80/20 Fixed/Floating. The US is already at the outer bound of this range at 60/40. A higher proportion of floating issuance will mean even greater sensitivity of debt servicing costs to short term rates. For a wider discussion of Sovereign debt management go here on the Recovery Partners website)
• There will be failed Treasury Auctions. (Can’t believe it can happen in the US ? It already has, in the mid-90’s when I was a sovereign debt manager myself in an OECD country.)
• Interest Rates will rise along the Yield curve except where the Fed has most influence: one month and under. The yield curve will steepen considerably;
• The USD will sell off against the currencies of other countries whose financial policies are deemed to be more sensible or stable than those of the US; and, importantly, it will also depreciate in commodity terms; 
•  The US may decide to print money to “buy” its way out of the situation. Bernanke has already indicated that he will not hesitate to do this;
•  In the extreme the US may have to fund itself in currencies other than the USD because foreign investors go on “strike” until it cleans up its problems or provides them with a new “deal”. The key overseas debtholders here are China (25%), Japan (20%) and the UK (5%) who together own around 50% of US foreign held debt. (This latter development would be very serious and likely only occur after a period of significant geopolitical stress. If it did occur, the second order outcomes would likely include more geopolitical stress and unpredictability, probable domestic unrest and significantly increased incidences of adventurism by the usual cast of rogue states.)

“The ice age is coming, the sun is zooming in
Engines stop running, meltdown expected and the wheat is growing thin
A nuclear error, but I have no fear
London is calling – and I live by the river”

The Clash “London Calling” (emphasis added by Recovery Partners)

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Sell Everything !! (…or “Bernanke’s Blunder”)

First some figures.

This morning Bloomberg reported that the total amount of assistance provided by the US Federal Government has reached more than $7.4 Tn., or half the value of everything produced in the United States last year, to rescue the financial system since the credit markets seized up in the late summer of 2007.

According to data compiled by the Bloomberg news organisation, the unprecedented pledge of funds includes $2.8 Tn. already tapped by financial institutions in the biggest response to an economic emergency since the New Deal of the 1930s, This financial commitment dwarfs the only plan approved by lawmakers, the Treasury Department’s $700 Bn. Troubled Asset Relief Program. So far the Treasury has committed some $300 Bn. under the TARP,  and has indicated that it would hold off until the new Administration is sworn in. Recall that the TARP was sold a a panacea for the nation’s financial ills back in September. You know our views on this topic.

Last week Morgan Stanley reported that global losses from the sell-off of equities has now reached more than $30 trillion – or more than twice the size of US GDP. This number only encompasses losses on traded equities and does not include other various write-downs, write-offs and value adjustments. For example the estimated hit to value of the US housing stock adds another $5.0 Tn. to the blood running in the streets.

Despite the toll to date, financial and economic conditions continue to deteriorate further. The World Trade Organization warned last Wednesday that the financing of global commerce is “deteriorating” amid the financial crisis and the situation is likely to worsen over the coming months. “The market for trade finance has severely deteriorated over the last six months, and particularly since September,” WTO Director-General Pascal Lamy told ambassadors of the organisation’s 153 members following a meeting with trade experts and bankers. “The view expressed this morning by the trade finance practitioners is that the situation is likely to deteriorate further in the months to come,” Lamy said.

Citibank, one of the behemoths on our “Zombie” watch-list, has predictably gone to ground after months of denial, and over this past weekend, agreed to a Government bailout.

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Saddle Up and Ride!! We’re Headin’ fer Armageddon

Dateline Washington, DC, Columbus Day Weekend, IBRD/IMF Meetings

The markets were up sharply overnight and today on news that 15 European countries are taking moves to shore up stresses in their banking systems. However, volume was thin as it was a holiday Monday in parts of Asia and all of North America. This impressive relief rally belies significant unease in the investment markets and does nothing to dispel fears of the now generally acknowledged wider recession that is on the way and the fears that yet more stresses are in store.

How Times Change

In years past the IBRD/IMF meetings represented the “Gotta be There” Schmoozefest for A-List Investment Bankers, Lawyers, Fund Mangers and a variety of other hangers-on in the game of international finance. To say that this year’s affair was subdued would be a vast understatement. In fact at times it appeared that the host institutions and the various politicians in attendance would have welcomed news of a massive asteroid on a collision course with Earth or an outbreak of a new virulent flu bug as a welcome diversion from what is turning into a quagmire of thorny and seemingly intractable issues.

The non-party got going late last week when the Treasury announced that it was going to substantially rework the TARP Plan as it did not meet the requirements of the situation (See our last month’s post on this topic). The G20 communiqué then announced that officials endorsed the idea of a coordinated response to the financial crisis, but offered no specifics on what this coordination might entail. The proceedings really started to fall apart when the Managing Director of the IMF, former French Finance Minister Dominique Strauss-Kahn declared that, rapidly growing “…… solvency concerns about a number of the largest U.S.-based and European financial institutions have pushed the global financial system to the brink of systemic meltdown.” Our readers might well imagine how pumped up the audience was after that pronouncement.

As an interesting counterpoint, an ANIME (Japanese Cartoon) conference was being held in the hotel adjacent to mine coincident with the IBRD / IMF meetings. Wild wigs, brassy makeup and other getups were the order of the day. Taking a cue from this event, I was given to wonder whether any of the IBRD/IMF delegates were tempted to join the cartoon celebrations in place of the sombre proceedings taking place within the Perimeter.

And the Second Angel Blew his Trumpet

Sunday afternoon we learned that the lip service given to a coordinated a response among the G-7 and G-20 has resulted in European countries announcing plans to inject “billions of dollars into their banks.” This needs to be viewed in the context of UK Prime Minister Gordon Brown declaring that he plans to sue Iceland over the failure of its banking system and consequent impact on British depositors; while Russia is being looked to as a saviour by the Icelanders – ahead of the IMF – as it is bearing a possible EUR 4.0 Bn rescue loan package.

Rather than reinforcing confidence, the general lack of coordination up until last night’s announcement, the paucity of answers and surplus of buck-passing that appear to be the hallmarks of this year’s set of meetings, will likely significantly worsen the already very gloomy market sentiment, despite today’s uptick.

The bottom line is World Leaders, with the US at the forefront, seem to have squandered a major opportunity at these meetings to draw a line in the sand and calm market fears about the spread of the liquidity crisis and the seeming resistance of this credit virus to the policy tonics that have so far been applied .

As the realization that this crisis is far from over watch for the fear and loathing to spread:

• Banks have already tightened lending conditions significantly. Expect further credit rationing as opposed to price-driven activity. This means that some well-capitalized borrowers will likely fail. No one is immune. (Note to the Unbelievers: When Lehman went to ground its leverage ratio was 10.5:1 , Hugely conservative for an I-bank and much less than Goldman’s contemporaneous 22:1);
• Consequently, there will be a significant spike in corporate bankruptcies both as a result of the credit squeeze but also intimately related to the vast volumes of sub-investment grade debt issuance in the last 5 years.
• Global Stock Markets will remain weak and IPO activity will continue at a low ebb, sapping banks of fee and spread income and foreclosing deal entry and exit points for private equity funds and corporations.
• Expect a further strain on Government resources in the affected countries, with consequent implications for employment, profits, inflation and growth. In this connection it is worth noting that, on our count, the Fed has already blown its wad and exhausted its Balance Sheet. Thankfully, cooler heads are tempering the Treasury’s initial planned reliance on fixed income financings as a way out of the mortgage quagmire. In part this strategy would have caused a predictable spike in bond yields (no doubt a reason why the TARP is being reconsidered along the lines we first suggested). So watch for additional money creation…..and a more immediate reaction on global markets once they realize that the wheels were never even on the TARP or any other plan in the first place;
• The witch hunt is only starting. This week we saw Dick Fuld, the former CEO of Lehman Brothers, being grilled by the House Oversight and Government Reform Committee. At the close of the sessions, Committee Chairman Henry Waxman ominously stated “Mr. Fuld, You say you will be haunted by the collapse of your firm until the end of your days, but you don’t seem to think that you did anything wrong. And that is troubling to me! (sic)” Will they call Fuld back to the Hill and then on to a courtroom for a slow “perp roast”, to be aired on C-SPAN? Maybe, maybe not. But you should expect a slew of corporate executives in a number of countries, but particularly the US, to be indicted, tried, convicted and led to the gibbet before the dust settles on this debacle.

The larger questions about this crisis still remain. The IMF’s resources at around USD 200 billion are woefully short of the amounts needed to make a dent in the problem. In fact the IMF appears to be holding its resources in reserve for a kind of “reverse triage” in case any of the emerging economies run into trouble. The G7 and G20 do not appear to be equipped or inclined to solve these problems. Therefore, questions must legitimately be asked as to whether the IBRD, the IMF and other global institutions are effective or even relevant any more, and moreover, whether the economic policy-making machinery and risk management systems in all of the major economies, should be in line for a major overhaul.

Don’t get sucked into today’s rally. It is primarily a technical bounce that will fade once the markets realize the scale and number all of the risks and obstacles that lie ahead.

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Dateline Washington: Drunken Sailors on Spending Spree

Intrade has opened a new market on whether the proposed bill (”TARP”, an acronym for Troubled Asset Relief Program) to bail out financial firms will pass Congress by the end of the month. The contract trades as BAILOUT.APPROVE.SEP08. Open for the past couple of days, the market has already gained significant trading volumes, and an early verdict: the bill looks about as close to a sure thing as you can imagine (90% at the time of writing).

Why, is not hard to fathom: Now that the White House, and the Fed and Treasury are finally owning up to the scale of the issues that need to be dealt with, they are desperate to demonstrate that they are in control and have all of the answers. They have pulled out every stop, including , not surprisingly, the use of scare tactics to strong-arm legislators into swallowing the TARP package whole.

Whereas a few quarters ago there was no “problem” requiring intervention according to the Administration; now the problem is of such a magnitude that unless the TARP gets passed before the end of September the world as we know it will end.

Red Herrings such as the debate on executive compensation are being thrown about to divert attention from the fact that the proposal arguably represents the biggest usurpation of Congressional accountability, oversight and responsibility to the voters in the history of the Republic.

In our view a rescue plan must satisfy several basic criteria if it is to be successful and contribute to a lasting betterment of the situation:

• The Plan must recognize that the first step in any troubled asset remediation  – if one’s objective is to avoid bankruptcy and liquidation – is first and foremost, to Stabilize the situation and then to Triage the zombies.
• The Plan must conserve precious financial resources.
• The Plan must be transparent and allow for performance benchmarking and accountability.
• The Plan must recognize that the process of remediation will take a long time and that not all problems are presently fully in view.
• The Plan must offer a reasonable probability of success to the American public.

Sadly, the proposed TARP legislation falls short in all of these key respects. Looking at this by the numbers:

There is nothing in this plan that suggests a normal stabilization process to remediate bad assets will feature prominently in the process of buying out the cratered paper. There does not seem to be a triage process defined in the legislation. As a consequence some institutions requiring help may not get it and others may receive more assistance than they need. The proposal leaves the entire process open to bad decisions and misappropriation. Wall Street houses are already now lining up to offer their services in helping to administer various parts of the proposal – to earn fees from problems they or their friends helped to create.

In his remarks to Congressional leaders earlier this week, Paulson signalled that it was time to move away from a case-by-case approach to a taxpayer funded  “carpet bombing” of the problem. The proposal to undertake a bond-financed USD 700 Billion buyout of bad assets could be not more ill-advised, as it is open to fiduciary malfeasance and inefficiency, and it further and unnecessarily encumbers the Government Balance Sheet. Because it is far from clear that this is as big as it is going to get, the strategy furthers pushes the envelope on the country’s solvency and significantly heightens the risk that the eventual bailout will be financed by printing money.

The draft of the TARP reads in part: “Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.” It goes on further to state…..”The Secretary is authorized to take such actions as the Secretary deems necessary to carry out the authorities in this act without regard to any other provision of law regarding public contracts.” No wonder Congressional leaders are rightly up in arms, there is no accountability and no transparency.

There is a real risk that the proposed legislation will prove inadequate because it does not address the other areas of concern that could lead to additional problems for financial institutions, Main Street, and the economy generally. These include now-latent problems in commercial real estate, brewing issues in the derivatives markets, the growing risk of a sell-off in the bond markets, and  the impact of rising prices and a slowing economy on corporate profitability and creditworthiness.

As a consequence of the forgoing, the probability of the proposal as announced and being discussed as leading to a durable solution are extremely remote – whether or not some of the features of the plan are amended. It is flawed in its essence. The markets will not buy into this for very long.

A Different Proposal

Here we suggest a solution that starts off with the premise that Stabilization and Triage are key. In order to help ease the gridlock in the credit markets we propose that the Treasury extend a specific guarantee over the liabilities of all US Financial institutions that apply for inclusion in the remediation program. The guarantee would be secured by the equity of the companies and a priority claim on their assets in the event of default. To apply, financial companies need to have assets above a minimum threshold of materiality, own a threshold percentage bad assets out of total assets, and be participants in the interbank markets.

Inclusion in the remediation program will also require that each of these institutions provide an accurate accounting of its financial position and a register of all impaired and defaulted assets on their books to the Treasury; and that each senior officer and the board directors of such applicant institutions provide representations and warranties for the accuracy of those submissions that would be irrevocably secured by a high percentage of their personal assets.

This would be a one time “Get Out of Jail for Free” card for the zombie institutions and their managers.

This strategy also suggests that the holding action to supply adequate liquidity to the markets to keep the credit wheels turning is continued by the Fed and other global central banks. As banks begin to trade with each other in the interbank again – the US Institutions with the benefit the guarantee from the Treasury – the central bank sources of liquidity could be gradually scaled back. The stabilizing actions (and other tactics not herein discussed) will provide the necessary breathing room to properly assess the situation and run a triage exercise.

In this phase, and using the information supplied by the applicant institutions, the Government would conduct a parallel process to assess and value all of the cratered assets in order to evaluate the sick and dying institutions and measure the actual scale of the problem. Valuations should rightly feature a distinction between OLV (Orderly Liquidation Value) and FLV (Forced Liquidation Value) to determine the scale of the buyout funding.

The weaker institutions could then be merged off with stronger players and bad assets would be hived off into a Bad Bank Vehicle (in the Remediation stage of the process). At each stage Treasury managers of this exercise would report to Congress through a public mechanism. Funding would be doled out on an as needed basis and subject to strict oversight.

As such the legislation to deal with the issues needn’t be rammed through in one go. There could be separate, less overarching, legislation for the Stabilisation operation, and additional legislation to cover offer the Triage and Remediation stages of the plan. This would give Congress and the public time to properly consider the proposals.

Moreover, the immediate Operating and Balance Sheet impact of this proposal would do far more to bolster confidence, buoy the markets and the support value of the US dollar than the idea to appropriate USD 700 billion of bond finance for a quickie buyout. At a minimum, there would be no immediate need to raise this vast sum of money on top of already otherwise ballooning fiscal requirements.

The actual “cost” would be limited to the government taking on a contingent liability relating to the solvency of companies that it knows it will rescue with certainty, but only after appropriate due diligence has been conducted and after the size of the problem at the various companies has been soberly determined. As the guarantee would only cover the “Loss Given Default” of the liabilities, the size of the contingent liability at this stage is probably in the range of USD200 billion at most, and would not need to be financed. This is vastly more financially efficient than the TARP.

The Reality

Whilst we believe that other solutions such as ours outlined above merit consideration and that this is no time to be making significant decisions under artificial pressure and with still limited information, we also agree with the market’s political assessment of the legislative situation as outlined above. The package will pass.

Therefore we believe that ultimately this will all end in more tears. In our view, the combination of bumbling and incompetence represented by the lurch into these financial difficulties, the constraints on future action imposed by previous rescue measures, and now the $700 Billion TARP “Bond Aid” response is setting the stage for even worse problems yet to come.

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Zombies on Life Support

Early this morning key global central banks poured an unprecedented USD180 Billion of temporary liquidity into the global banking system to keep the wheels from coming off. While this will not alleviate the fundamental solvency problems of many institutions, the added liquidity will forestall disaster for a time.

It was about a year ago that we began to make occasional reference to “zombie” financial institutions. [“Zombies” are institutions whose equity and debt is trading at levels that make the continued viability of their business models uneconomic (equity too cheap to issue in needed amounts to re-float the business and debt trading at yields that do not allow their asset portfolios to be financed at a positive spread). Unless they are rescued or re-financed by stronger institutions, insolvency is the unavoidable outcome.]

In regards to the list of thirteen “Notable Zombies” that we set out in our last blog entry on September 8th, so far two of the firms on that list have gone out of existence; and AIG  has now been nationalized backed by an initial USD 85 Bn. of public funds. Our long-held views that the GSE’s were insolvent has also been proven out.

There are more bailouts in the pipeline and what is of some concern is that by now it should be clear to everyone that the US authorities have no plan, no roadmap, out of this mess. Recall that a year ago Bernanke and Paulson were reassuring markets that there really wasn’t a crisis at all; six months ago they were touting the GSE’s as part of the solution to the sub-prime mortgage crisis; and as at last Friday, AIG was not going to fail, it was going to be rescued by private sector firms.

Please click here for an extremely useful representation of the value destruction that has occured in the year to date, courtesy of the New York Times.

Through all of this, Paulson has reverted to type as an investment banker, whipping and driving deals, arranging shotgun marriages, doling out dollops of public sector funding for zombies on the verge, and trying to jawbone markets higher, while ignoring the public policy and government finance dimensions and longer term impacts of what he and the rest of the current Administration are doing.

In fact that the practical outcome of the use of public funds so far is far from certain in part because the process of rehabilitating the failed institutions that have been rescued, but remain unstabilized is going to take a very long time. In addition, in a normal transaction environment it usually takes months and quarters of due diligence before a successful change of control can be valued and implemented. For these and other reasons, success is far from guaranteed if we stay on this risky path.

This, in particular view of the fact that there are perhaps hundreds of smaller institutions that are also now on the zombie list that will eventually fail. Will the arranged marriage approach work; does Wachovia/Morgan Stanley make sense; or will some or a large proportion of these deals come apart and/or end up costing significantly more than the markets are being told?

To us it is very worrying that other means of support and other more comprehensive remedial approaches are not being explored and implemented and why confidence boosting measures that include more stringent regulation and oversight of the financial services industry are not now being signalled as part of the eventual solution to the problem. For example, the imposition of leverage caps for financial services companies – including hedge funds; more stringent and transparent reporting requirements; the more stringent enforcement of existing securities laws, and the rollback of some of the anti-regulation signed into law by Clinton in 1999 should all be on the table for discussion. Unfortunately this thinking goes against the grain of the non-interventionist orthodoxy in DC – in this case to the longer term detriment of the country and the planet, we believe.

Even though they are not saying it, the current behaviour of the Treasury and Fed indicates that the Administration believes that the band-aid remedies are appropriate, that they represent durable solutions, and that life can go on as before.

We do not agree. Our belief is that the current course of action has used up valuable public sector financial resources and reduced future options and flexibility for dealing with what is going to be a very long drawn-out crisis. And, as we have seen over the past few days, contagion to other markets has become more than a possibility.

Apart from the irony of having the world’s largest free market economy nationalize some of its most sizable companies, the heavy reliance of the Government’s balance sheet is only a few more bailouts away from exhausting existing resources. The jousting by Obama and McCain regarding tax policy is painful to watch as it describes almost total ignorance of the fact that whoever becomes President, in the very near future he will be faced with an economy saddled with what will prove to be near-Trillion Dollar budget deficits, near-Trillion Dollar external deficits, and no fiscal room to manoeuvre.

In the end, this may leave only the printing press with Helicopter Ben on the button to inflate away the excesses………with all that that implies.

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How Does an Ant Eat an Elephant?*

The answer to this age old African proverb is:

“One bite at a time!!”

And so it has come to pass that the US Government has finally owned up to what many of us have known for several quarters if not years: Fannie and Freddie are bankrupt. (You can check the posts on our blog for our earlier views in this regard.) It appears to us that the timing of this move was heavily influenced by the growing realization within the US Government that these entities, if left to fend for themselves, would shortly face insurmountable refinancing problems stemming from the need to roll over massive maturing term borrowings over the next several months.

The stock market roared ahead in the wake of the nationalization of the two GSE’s, the relief rally sending the Dow Jones index up over 300 points. Unfortunately, it is not immediately apparent that the socialization of the losses associated with these organisations represents a great day either for free markets or democracy.

What has changed we ask? The Fannie, Freddie announcement merely enables a needed liquidation process to commence; it will not speed up the process or make it any less painless.

Several key question marks remain following the announcements on the weekend that include but are not limited to:

• The size of the liability assumed by the US Government in this latest fire drill. We will not know the scale of the meltdown at these two institutions for many months, and we are extremely sceptical that it will be limited to the figure of “only” USD 200 Bn. that is being bandied about;
• The willingness and ability of the Federal Government to assume the obligations of other bankrupted or severely impaired corporates. This resolve will be severely tested over the next few months and quarters because a growing jumble of zombie companies is piling up like broken forest timbers in the wake of a meteor strike. Notable names include:
  • AIG
  • CitiGroup
  • Fifth Third Bank
  • Ford/Ford Credit
  • General Motors/ GMAC
  • KeyCorp
  • Lehman Brothers
  • Merrill Lynch
  • National City
  • Regions Financial
  • United Airlines
  • Wachovia
  • Washington Mutual
  • Zions Bancorp

  Watch Out!!: the cumulative liabilities of these firms rival those of the GSE’s in size; 

• The effect of influences stemming from a worsening economy, a large external deficit that needs to be financed amid the threat of accelerating inflation, and a FED and Treasury that are rapidly running out of ammo to deal with the various problems that beset them;
• The growing risk of a sell-off in Treasuries sparked by heightened inflationary expectations that would bring more pain for mortgagees and borrowers carrying high debt loads.

Following the activities of the last few months and this weekend, what seems to be less questionable at this moment is the US Government’s chosen approach to dealing with the Credit Crunch. Five defining behavioural characteristics seem to be emerging:

1. Buy Time: delay action and deny the existence of problems until the bitter end;
2. Shield the Problems: internalize the risk on the FED’s or the US Government’s balance sheet;
3. Spend Other People’s Money: aggressively use the public purse to fund and paper over mistakes made in the private sector;
4. Jawbone with Style: with the aim of keeping the markets relatively orderly during what will be a very long process of unwinding the excesses, so that the FED and Treasury, and by connection, the USD, will continue to enjoy the confidence of domestic and overseas investors; and finally,
5. [Try and] Keep some Powder Dry.

One bite at a time…Hmmmm…..Sounds OK and it Might even be Doable (but not likely) …In that case maybe all we need to do is to keep watching the FED……

* We gratefully acknowledge and thank, Ray Williams, Managing Director, Derivatives, National Bank Financial for suggesting the use of the Proverb.

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A Story in Pictures

It is rather remarkable to note that every time we visit the Fed’s statistical database we increasingly encounter a “SERIES DISCONTINUED” notice in connection with the data that we have come to rely on to analyze the activities of the US Central Bank and the health of the economy (Our friend, Marvin the Paranoid Android, asks:”What are they trying to hide?”). The disappering data notwithstanding, some inferences are possible using the information they still deign to release. We are therefore pleased to be able to offer the following narrative based on recent information found on the Fed’s website .

In March we informed our clients and service providers about the unprecedented developments on the Fed’s Balance Sheet. Back then we were surprised to find that the level of Reserve Borrowing had risen to USD 100 BN, a level of borrowing suggestive of the “backdoor nationalization” of the US Banking System. We argued that the re-entry issues associated with this state of affairs may prove extremely problematic.This is because over the entire history of the Federal Reserve System, Discount Window borrowings were usually maintained at extremely low, frictional, levels – certainly never much more than USD 1-2 Billion from week to week, whether the economy was weakening or not (see Chart 1). Since our March report the level of net borrowing has skyrocketed further, into the area of 170 BN, indicating that the pace of increase in the markets’ reliance on the Fed displays no sign of slackening.

Chart 1

Clearly, banks are finding it increasingly difficult to find funding in the open market for vast chunks of their asset exposures. This however does not tell the entire picture. The borrowings reported on the Chart above only include discount window loans to depository institutions and not the dollops of financing that have been extended to broker/dealers and other zombie institutions unable to otherwise source liabilities for themselves.

The recent buybacks of Auction Rate Securities (aptly named ARS’s) by the dealers have likely also been underwritten through the backdoor by the Fed. On our estimates, the Fed has now encumbered more that 75-80% of its balance sheet with illiquid, and otherwise unfundable, loss-making paper. There is presently no exit in sight.

Loan Losses Popping

While this has been going on, other statistics published by the Fed show that loan losses have started to accumulate in the Banking System. Chart 2 below shows that net charge offs have doubled in the year to end March 2008. 

Based on recent projections of system wide losses of USD 1.5 to 2.0 TRN that have been made by the IMF, Goldman Sachs and other market analysts, we can expect reported  loan losses to climb sharply in coming quarters and to vastly exceed the previous peaks shown on Chart 2 by a factor of 2 to 4. This means we can expect aggregate charge offs to reach some 4 to 6 percent of system assets if the loss projections announced by various analysts as described above come to pass.

This level of loan losses will be unprecedented. At a minimum it suggest that Ken Rogoff’s recent comments about a small number of high profile financial players going to ground is a conservative view. It will likely be much worse, and many, many financial institution failures will occur.

Chart 2

Don’t Count on the Curve to Bail Anyone Out

In past crises the Fed lowered rates, the yield curve steepened and the financial sector re-liquified their balance sheets as the spreads between their asset yields and liability costs widened. This is clearly shown on Chart 3, particularly in the spread expansion shown in the periods immediately subsequent to the previous downturns in the early 1990’s and 2000’s. The income statement response was fast and predictable.

Chart 3

Unfortunately this is not happening this time around. Net spreads have continued plummeting amidst one of the most significant Fed easings in recent memory. In fact net spreads are at an all-time low and still falling, despite the easing. Due to the fact that median asset quality is declining, significant optimism is required to support a view that even a small recovery from these levels is possible within a reasonable timeframe.

We’re not in Kansas any more Toto!

Thus, it appears that the tonics and potions that the Fed has used in past crises, and the new elixirs brewed up earlier this year are not doing the trick. This means that the Fed is rapidly running out of bullets, and they have to be now betting that things are going to get a LOT better before they get ANY worse.

Our conclusion is that the Fed is in a hole and digging itself deeper.

Since the Fed’s rescue program appears not to be working, expect more jawboning from the US Policymakers. However, if their comments continue to be as ill-advised as Paulson’s varied mumblings as regards the viability of the GSE’s and Bernanke’s recent inflation outlook commentaries, then the markets may punish them by sharply lowering the credibility they attach to such guidance (When I was trading rates we called this the “BS Coeffiicient”; or otherwise, the inverse of credibility) .

Other things to watch for include:

• Banks are going to tighten lending conditions significantly. Expect credit rationing as opposed to price-driven activity.
• There will be a significant spike in corporate bankruptcies both as a result of the credit squeeze but also intimately related to the vast volumes of sub-investment grade debt issuance in the last 5 years.
• Stock Markets will remain weak and IPO activity will continue at a low ebb. M&A, Private Equity Investment and other speculative activities dependant on friendly markets and gullible investors with deep pockets will decline markedly.
• Growing financial stresses will cause numerous banks to go under. Expect consolidation and a further strain on Fed and US Government Agency resources. In this connection, it is worth noting that the recent Indy Mac bankruptcy alone consumed 10% of the reserves of the FDIC.
• Spreading Contagion. A crisis of confidence might break out leading to a chain reaction in global financial markets and an ultimate break in confidence in the US dollar. This confidence is not being helped by recent Russian military adventurism, other festering problems in Central Asia and North Korea, commodity price volatility, poor relative inflation performance and the seemingly insatiable requirement for foreign capital inflows needed by the US to keep its game afloat.

Returning to our initial premise, if we can draw these conclusions on the basis of what the US Government is still allowing the markets to see in the way of statistical information, then, we wonder, how much worse is the situation relative to what we have been told and are able to deduce; how much more problematic is it going to get; and are US Policymakers truly able to adequately cope with what is turning into a rapidly deteriorating mess of gargantuan proportions?

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