Tuesday, February 19, 2008

There's M&M's in my alphabet soup

Please note: the Debt Rattle for February 19 can be found below or via the sidebar link

Ilargi: This is the next one in our series of articles too long to fit in a Debt Rattle.

We get a bit deeper into the mystery of M3, MZM and Mprime. There's a lot of confusion about what goes on with the money supply and the Fed's 'helicoptering' role in it. Lee Adler lifts a revealing part of the veil.

After that, John Mauldin gives an explanation of the rumble in the bonds market that is excellent in its simplicity.

More alphabet soup coming soon.

OuttaControl, one of our regular readers, wrote about a Financial Sense podcast on Saturday, in which M3 was discussed with John Williams of ShadowStats. M3 is a money supply definition that the US government stopped publishing last year, and which many people claim rises through the roof, and does so because the Fed pumps out money like a crazy old woman does gossip. There are also people like Mish Shedlock and Lee Adler who state that these claims are untrue and way off mark.

The text below is from a comment thread which follows Adler’s latest (subscription) RadioFreeWallStreet podcast, in which he talks about Williams' claims.

Lee Adler on M3, MZM, TAF and Shadowstats.

Reader A:
[Here’s the link for] the financesense.com podcast (MP3) in which John Williams challenges the thesis that the government isn’t injecting loads of liquidity (referencing SOMA - he also addresses the non-borrowed reserves issue) falling back on his M3 numbers and the notion that the Fed can print and inflate, exceeding the threat of deflation.

I find his arguments questionable (especially as it pertains to this sense of the Fed printing). Any comments? Perhaps briefly addressed during the next podcast?

This is something I have addressed publicly before, so I will answer it here.

Broad measures of money supply, whether the unofficial M3, or the official MZM published by the St. Louis Fed were indeed exploding through the end of December. There was a very simple reason for that and it had nothing to do with Fed pumping because as illustrated here, the Fed was reducing the monetary base, i.e. its contribution to the money supply.

The rise in the broadest measures of money was directly correlated to the collapse of the Asset Backed Commercial Paper market. Whatever cash was liquidated there flowed directly into institutional money market funds which are included in the broadest measures of money. The relationship of the growth in broad money, institutional money funds, and the shrinkage of M3 was as close to dollar for dollar as you can get.

Reader B:
The opportunity for the Fed to indirectly buy US government debt seems lie a useful mechanism to reflate poor bank profits as the US government deficits expand quickly. Japan and early 1990s USA reimbursed bank losses by allowing banks to borrow short term money at 1% and lend to the treasury at 4%. So I’m not so sure about your conclusion this is an easy long term treasury price collapse coming. The banks have unlimited buying capacity for long treasuries and maybe the central bank has been holding back on money pumping in anticipation of this well anticipated fan-meets-excrement event.

That’s why I am watching the TNX long term chart so closely. Not sure about Russ’s characterization that this is a slam dunk. As I said in the podcast, the seeds have been planted. Now we get to see if the germinate, grow and blossom.

Reader C:
Great podcast. The disconnect between those such as yourselves following the unfolding debacle in the treasury markets and the fiscal deficits and the seemingly oblivious general public is nothing short than astonishing, beyond proper description. An appropriate metaphor would be listening to two firefighters commenting on a 2nd floor bedroom set ablaze and rapidly spreading all the while the occupants are downstairs watching TV in the living room, albeit starting to sniff smoke, choosing to ignore the matter and focus on TV.

Adler wrote: “The relationship of the growth in broad money, institutional money funds, and the shrinkage of M3 was as close to dollar for dollar as you can get.” Considering that everything else made perfect sense,..i.e. ABCP paper flowing into Inst MM (incl in M3) so then after just explaining that M3 is a measure of the broad money supply, don’t you mean “growth” of M3 was as close to dollar for dollar as you can get[?]”.

I don’t follow the private services that report on shadow M3, but I do look at MZM, which is showing the same thing as M3. The change in MZM is nearly dollar for dollar the change in institutional money funds. That in return closely tracks the decline in ABCP outstanding. Some of those funds also have apparently flowed directly into bank CDs and other non transaction deposits.

NOTE Ilargi: Good overviews of the different “definitions of money” can be found here: Making Sense of Money Supply Data and here: Is the U.S. printing money like mad? , where Mike Shedlock elaborates on his Mprime (M’), which I personally find a very valuable addition to the M&M soup.

What would Warren do?
John Mauldin
You have got to hand it to Warren Buffett. He does have a sense of humor. Buffett offered to take the tax-exempt insurance business from the various monoline firms (Ambac, MBIA, FGIC) at a lowball price, and leave them with all the toxic waste from the various structured vehicles they insured. This would mean the investment banks who are counting on that insurance to hold down their losses from the subprime garbage they have on their books would see any hopes of getting anything from the monoline firms reduced to zero.

Why would the investment banks let that happen? Surely they should step in and recapitalize the firms, which while expensive, would be less than the losses they would be forced to immediately take should the monolines fail. Why let Warren get what is a very profitable business which could eventually allow the banks to get their money back? I and a lot of people were scratching our heads, wondering "What was Warren thinking?" He is very savvy and shrewd, and even though he cultivates a down-home image, he is a world-class vulture capitalist (which by the way is a compliment in my book).

So why would he make an offer that is seemingly a non-starter? To be sure, if Buffett was allowed to take the tax-exempt business, the concern in that market would immediately vanish. It would be the equivalent of walking into a child's room in a crisis and saying, "Daddy's home. It's alright." But to understand what I think is really going on, we have to step back and examine the crisis (and that is almost too understated a term for it) in the normally boring world of tax-exempt bonds.

Last summer we were repeatedly told subprime problems would not spread to other markets. "The problems will be contained," proclaimed one authority after another. Now of course we know that this is not the case. The subprime contagion has spread to all sorts of markets far and wide. Small towns in Norway have lost money to subprime borrowers in the US.

The most recent development has been in a rather obscure market called the auction-rate note market. Auction-rate securities are an unusual type of long-term bond that behaves like a short-term bond. While the terms vary, let me quickly try and describe a typical bond, for those who are not familiar with them. A tax-exempt authority like a school district, hospital district, or municipality will issue a long-term bond, but within the covenants of the bond is the stipulation that it will be auctioned every 7 or 30 days. The issuer does this because it allows them to pay a lower overall rate.

Buyers are short-term money market funds and investors who are looking for a slightly higher yield than they can get in a money market fund. These bonds are auctioned by the usual suspects: Lehman, Citigroup, UBS, Merrill, and their kin. In essence, these banks make a market in the bonds. Let's say a buyer says to UBS, "I will buy Small City School District bonds if they will pay me 4% for the next 30 days." The bonds go to the person who is willing to take the lowest interest rate for any given period. At the end of 30 days, I can re-bid or tell UBS that I want them to take the bonds back. UBS will buy them back from me, and put them on the list to be sold to another bidder the next day.

Why would someone be willing to take a chance on the bonds of a school or hospital district they have no direct knowledge of? Because these various tax-exempt authorities buy insurance from the monoline insurance companies that will give them an investment-grade rating. An investor simply looks at the rating and makes a buy decision. That was all well and good when you could trust the ratings.

Now the creditworthiness of the monoline insurance companies is in serious doubt. Ambac, MBIA, GFIC and others have been downgraded by the rating agencies or are in imminent danger of having their ratings cut. And without their ratings, they have nothing to sell. A rating cut is essentially a death knell for the company. But it is also a potential crisis for those who have bought the insurance.

And now, these auctions are "failing." By that it is meant that there are not enough buyers to take all the paper. The investment banks are being forced to take back that paper, and they don't want it. Much of the auction market is shut down. Now, here is the unusual feature of most of these bonds. If for some reason the auction fails, the interest rate is automatically set higher, so that whoever is stuck with the bonds is compensated for the loss of liquidity. And often that rate is a severe blow to the issuer.

Take the Port Authority of New Jersey (PANJ). Their $100,000,000 auction-rate bond offering failed. Their interest rate went from about 4% to 20%! It is costing them an extra $300,000 a week. That is serious money. No one would seriously contend that the PANJ is a financial risk. But buyers simply do not want to take the risk for 4%. I suspect that the PANJ will quickly put together a $100 million offering and buy back the expensive bonds, but in the meantime they are paying higher rates than they could get from the local Tony Soprano over by the docks.

Good friend and bond maven John Woolway sent me a list of auction-rate bonds. Last week bonds from Puerto Rico, rated AAA, were paying 4.3%. Today the bid is 8.75%, and if the auction fails the rate goes to 12%! The taxpayers of Puerto Rico will have to pay that extra cost. Does anyone seriously think Puerto Rico is not creditworthy? But this is a market that is simply frozen. Buyers are on strike. There are bonds of many solid issuers that are bidding almost 10% and will reset to 15% if their auctions fail, up from 4-5% last week. Understand, less than 1% of tax-exempt bonds fail. These are good-quality tax-free credits we are talking about, yet the possible interest rate is higher than CCC junk bonds.

The increased cost of interest is a serious blow to some smaller issuers. One hospital district would lose 25% of the operating profits that allow it to purchase new equipment and maintain their facilities. School districts could have to make very ugly choices about where to make cuts in their budgets.

So, what are they doing? They are calling every politician on their rolodexes complaining about the problem. Fix the problem NOW. This week. So, what does Governor Elliot Spitzer of New York do yesterday? He threatens the monoline companies, telling them they have three to five days to find sufficient capital or the state will step in and take charge. And the state does in effect have that authority, as the states are the regulatory authorities.

One concept being floated is to break the monolines up into two banks, a good bank and a bad bank. The good bank would get the very profitable tax-exempt insurance business, and the bad bank would get all the bad subprime and structured vehicle debt. Another is that the monolines raise enough capital to get through the crisis. Some suggest the government step in, as it did with Chrysler. But the negotiations for additional capital are going rather slowly, or so it seems to those sitting on the outside. (I am sure if you'r on the inside it seems like warp speed.) To get the US government to step in would take even more time. And as I said last week, the spearhead for solving the current credit crisis is fixing the monolines. Nothing is going to get resolved with the current credit crisis until their problems are fixed.

Which now makes Buffett's offer rather intriguing. Spitzer the very next day comes in and says you have 3-5 days to get something done. That may or may not be possible. The issues are exceedingly complex and the egos are huge. Careers are on the line. The "easy button" for the regulators is "Let Warren Do It." Problem solved. Of course, investment banks and other investors (pension plans, insurance companies, hedge funds, and mutual funds) are out tens of billions of dollars. But they can just go get some more capital from Abu Dhabi or China. Why should we worry about large investment banks, who basically created the problem?

Well, gentle reader, it is not that simple. UBS estimates that investment banks from around the world could have to write off yet another $203 billion in debt if the monolines fail, in addition to the $152 billion they have already written down. I am not so concerned about the stock prices of the investment banks taking a hit. That is just the cost of their greed. I am more concerned about the hit to the US and European economies. Those large investment banks are the source of loans to corporate America and Europe, and too much of the rest of the world. They finance our credit cards and auto loans. And when their capital base is impaired, it means that credit becomes harder to obtain. Interest rates go up. Deals don't get done.

I and my partners talk to people (mostly in hedge funds) in the credit markets a lot. I can tell you that the leveraged loan business is almost nonexistent. There has not been a new CLO created since May. SIVs are for all intents and purposes being shut down as fast as possible. Credit standards at banks are tightening and getting into territory that typically reflects recessionary conditions. The good news is that the monolines will not have to come up with 100% of the capital of a failed subprime CDO, for example, all at once. The original CDO would have a theoretical life of 30 years. So the monoline would have 30 years to pay out the interest and principle. With enough initial capital, they could buy enough time to survive. The key is getting enough in a tough credit environment, with the main potential investors already suffering from capital problems.

It looks like we will know in a few weeks. And maybe Buffett's offer goes from being a joke to being gold for his investors. It would be interesting to know if he had any idea that Spitzer was going to hold a gun to the monolines' collective heads. Or maybe he is just the beneficiary of good timing. We will see.

1 comment:

Anonymous said...

I'm skeptical of arguments about the money supply based on Fed actions alone. The Fed doesn't create most of them oney in existence. Private banks do.

Presumably, when it was just private banks, the Fed kept a pretty good handle on how much money was being created, and by whom, and could influence that with the interest rates it charged banks and reserve requirements (the latter being largely hypothetical, as I don't recall the Fed ever ajusting reserve requirements, only being complicit in most attempts to reduce or eliminate them).

However, after the repeal of Glass-Steagel the banks all became brokerages and the brokerages all became banks. It seems to me that with securitization of loans, SPVs & SIVs, and off-book British Crown Colony entities, the banks-cum-brokerages were able to move loans (i.e. money creation) off their books and into the darkness where even the Fed can't see it.

I think the Fed has totally lost control of the money supply, and only has a rough idea how much money is being created and by whom (q.v. the nearly quadrillion dollar derivative market). The Fed only knows that a lot was created, and I think that is why they've been trying to drain liquidity out of the system.

Anyway, I don't know if that makes economic sense or not. But the Fed had to see the ridiculous growth of the derivatives market and be concerned about it.