Wednesday, March 5, 2008

Debt Rattle, March 5 2008

Updated 4.40 pm

Ilargi: The news is here: trading was halted earlier for the announcement, but it turns out Ambac shares rose on emptiness: there is no deal worthy of that term. This one will hurt, badly.

Ambac's Subprime Solution
Ambac Financial Group disappointed Wall Street on Wednesday, announcing it would raise $1.5 billion in the public securities markets to shore up its capital.

Investors had been primed by press reports to expect a bank bailout of the bond insurer, whose triple-A ratings are threatened. Instead it is turning to the financial market, including, it seems, its own long-suffering shareholders, for cash to bolster its balance sheet after an ill-fated expansion into providing insurance for mortgage-related securities.

Ambac Financial Group shares slumped 11.9%, or $1.28, to $9.44, after it filed for two separate securities offerings with the U.S. Securities and Exchange Commission. Shareholders have seen the value of their stock drop 89.1% over the past year. Which makes this statement from Chairman Michael Callen incongruous: "In this offering, we are targeting our core investor base, the long-term holders of our stock, who have been loyal to Ambac."

If they like the stock, they are welcome to buy $1 billion more, in a public offering meant to increase Ambac Assurance’s capital position. Ambac also announced a complex $500 million offering of equity units, a bond-like security that requires holders to purchase shares in May 2011.

Only $100 million of the money raised will stay with Ambac Financial Group, to be used to pay principal and interest on its debt, operating and other expenses, and to pay dividends on its stock. The rest will to subsidiary Ambac Assurance, to support its credit rating.

U.S. Stocks Fall as Ambac Files for $1.5 Billion Cash Infusion
U.S. stocks fell, erasing earlier gains, on speculation that Ambac Financial Group Inc.'s plan to raise $1.5 billion won't be enough to salvage the bond insurer. Bank of America Corp. and JPMorgan Chase & Co. led financial shares to their fifth straight drop. Ambac slumped the most since Feb. 12 after trading in its shares was resumed.

The Ambac plan has "too many blanks and unanswered questions," said Daniel McMahon, head of equity trading at Oppenheimer & Co. in New York. "The market never should have rallied on this news in the first place." The S&P 500 dropped 3.53 points, or 0.3 percent, to 1,323.22 at 1:50 p.m. in New York, after earlier rallying as much as 1.3 percent when the New York Stock Exchange halted Ambac trading for news.

Earlier gains were spurred by a smaller-than-forecast decline in service industries. Ambac Financial, which is facing a crippling credit-rating downgrade, slumped $1.50, or 14 percent, to $9.22. The sale will be split into $1 billion of shares and $500 million of equity units, New York-based Ambac said. The offerings will be managed by Credit Suisse Group, Citigroup Inc., Bank of America Corp. and UBS AG, Ambac said in a filing.

Ambac shares have dropped 89 percent in the past year as it seeks to prevent a downgrade of its AAA rating following record losses on subprime guarantees. The loss of Ambac's top rating would exacerbate losses on $556 billion of municipal and asset- backed securities insured by the company, forcing some investors to sell the debt and others to reduce their holdings.

CNN: Great Depression Coming

Note: The video may require you to have a Shockwave player installed. You can download one here. Apologies for any inconvenience.

Ilargi: As could be expected, there’s tons more cheer in the markets today. But let’s start off with an underlying, and still poorly understood, source of confusion: the difference between high commodity prices and inflation.

Life in a world of sky-high commodities
Even as commodity prices come off their recent highs, the hand wringing continues. Acccompanied by some attempts to profit - UBS has launched the first index designed to allow investors to profit from rising food inflation, including high-quality winter red wheat, soyameal, soy oil, orange juice and lean hogs.

On the angst side, soaring commoditiy prices, rising headliine inflation and weakening economic growth: for those whose memories stretch back to the 1970s, this combination brings painful memories, says Martin Wolf in the FT. The gap that has opened up between headline inflation and the “core” rate, which strips out energy and food prices, is of particular concern. Commodities are behind this gap. But says Wolf:
A rise in the relative prices of commodities may reflect inflationary pressures. It may also cause inflation. But it is not itself inflation….. What we are seeing then is a global shift in relative prices, with commodities, particularly energy, becoming much more expensive, relative to manufactures.
Strength of demand in emerging economies, notably China, does not entirely explain the rise. There have been the mandates to produce biofuels at work for some agricultural commodities and supply constraints such as bad harvests.

Speculation, adds Wolf, seems not to be that important. If it were, inventories would be soaring. But they are not. The primary question is: what a big rise in relative prices of commodities does, or should, mean for the proper conduct of monetary policy.
If central banks are confident that commodity prices will now stop rising, or even fall, they should slash rates in response to any prospects of serious economic weakness. But, given the continued rapid growth of emerging economies, they cannot be sure of that. Worse, core inflation itself seems already to be drifting upwards.

My guess is that the right policy lies between the Fed’s one of doing everything possible to eliminate downside risks and the European Central Bank’s one of masterly inactivity. Yet we do not know. The reason for that is clear: for the first time in a quarter of a century, the background for monetary policy has become difficult. But of one thing I am certain: responsible central banks would not risk a return to the 1970s.

Fears of a commodity crash grow
India faces a mountain of surplus sugar. Brazil has ramped up cane production in a burst of expansion. It is now exporting record amounts of sugar, even after diverting half its harvest into ethanol for cars. By any definition, there is a global glut. Yet this has not stopped sugar futures jumping 40pc since December, reaching 14.18 cents a pound on the March 2008 contract. Sugar has been swept up with the whole gamut of commodities - grains, metals, oil and gas - in a fevered surge of investment in futures contracts, regardless of the real demand from daily users. Wheat has risen 112pc in four months.

The sugar syndrome is the starkest evidence to date that the raw materials boom is getting ahead of itself. A variant of the pattern is emerging in industrial metals, crowned by an explosive "short squeeze" in copper last month. Arguably, even crude oil futures have decoupled from the real market.
The benchmark CRB commodity index has risen 15pc so far this year, eclipsing moves in the 1970s. It is the most spectacular new year rally in half a century. It is taken for granted that China will continue gobbling up the world's resources with a limitless appetite, the world faces an inflationary fire and that the dollar will slide further. However, these assumptions are less certain than they look.

"The strength of base metals is absolutely bewildering given that the US is falling into recession," said Stephen Briggs, a metals analyst at Société Générale. "America matters. There is economic contagion in Europe and it is spreading to emerging markets as well, yet people don't seem to care. They are taking no notice of the economic fundamentals, or they're betting that supply will continue to fall short even if demand slows. This is dangerous. Base metals are highly cyclical. Sentiment can change overnight," he said.

The "culprit" is the new breed of commodity index funds. Each week over the last two months, between $5bn and $10bn of fresh money has been pouring into the Goldman Sachs Commodity Index, the Dow Jones-AIG Commodity Index, and other funds, according to a UBS study. Together, the indexes now hold $200bn.

"Some commodities have leapt into the stratosphere over the last year: they've been pushed higher than the fundamentals merit," said John Reade, head of the UBS metals team. The buyers are typically big institutions such as Calpers (the California retirement fund), or the Dutch pension funds. "This is passive long-only investment, so it is not really a bubble. It would be a much bigger problem if it was leveraged speculation," Mr Reade said.
Crude oil has surged to $104 a barrel, yet US gasoline inventories are at the highest level in 14 years. Oil stocks have been rising for the last seven weeks, even though we are at the top of the winter season when inventories normally fall. The tsunami of pension money is beginning to distort the market for energy futures.

Interest Rate Policy Madness
It's fairly safe to say that Japan cutting rates to zero is probably a bad policy decision. But what about actions by the ECB or the Fed? Is anyone certain what to do? I agree with Ambrose Evans-Pritchard that the ECB is "trembling before a false inflation".

Anyone seeing inflation in either the US or EU simply does not know what inflation is.

However, we are in this mess because of central bank policies worldwide have purposely fostered inflation. Those policies "work" until they don't. We are now on the back side of a credit crunch unlike anything we have seen since the great depression.

And unlike 1930 there are far more variables such as global wage arbitrage, emerging markets, massive resource consumption India and China, global property bubbles, and peak oil. There is no way the Fed or the ECB can factor in all those variables, each of which changes dynamically every day. Furthermore neither US or EU policy can be set in a vacuum. What the US does may influence the correct course of action elsewhere. We're all related now.

The proper course of action may (or may not) be for the the ECB to cut. On the other hand, the US may (or may not) have already done everything that can possibly be done already (and then some). Canada is facing shrinking exports to the US but a jobless rate at a 33 year low. What's the right decision here? The answer might not be apparent until the Canadian property bubble busts for good.

It's time to face the facts: Central banks are guessing. In many cases it look like "panic guessing". However, the facts remain that the Fed, the ECB, and the Bank of Canada do not know where interest rates should be any more than they know what the price of orange juice should be. After all, it was the Fed slashing rates to 1% that created much of this mess. It is now widely understood, just how bad that decision was.

If the Fed proposed tomorrow to fix the price of orange juice, everyone would think they were mad. Ironically, the vast majority sees nothing wrong with price fixing interest rates, even though it is clearly proven the Fed has no idea what it is doing. Consecutive bubble blowing is proof. The sad thing in all of this is there is no need for guessing. We would not be in this mess if there was no Fed and there was no such thing as fractional reserve lending. Price fixing interest rates rates and currency manipulation got us into this mess, it will not get us out of it.

Double Bubble Trouble
The current recession has been set off by the simultaneous bursting of property and credit bubbles. The unwinding of these excesses is likely to exact a lasting toll on both homebuilders and American consumers. Those two economic sectors collectively peaked at 78 percent of gross domestic product, or fully six times the share of the sector that pushed the country into recession seven years ago.

For asset-dependent, bubble-prone economies, a cyclical recovery — even when assisted by aggressive monetary and fiscal accommodation — isn’t a given. Over the past six years, income-short consumers made up for the weak increases in their paychecks by extracting equity from the housing bubble through cut-rate borrowing that was subsidized by the credit bubble. That game is now over.

Washington policymakers may not be able to arrest this post-bubble downturn. Interest rate cuts are unlikely to halt the decline in nationwide home prices. Given the outsize imbalance between supply and demand for new homes, housing prices may need to fall an additional 20 percent to clear the market. Aggressive interest rate cuts have not done much to contain the lethal contagion spreading in credit and capital markets.

Now that their houses are worth less and loans are harder to come by, hard-pressed consumers are unlikely to be helped by lower interest rates. Japan’s experience demonstrates how difficult it may be for traditional policies to ignite recovery after a bubble. In the early 1990s, Japan’s property and stock market bubbles burst. That implosion was worsened by a banking crisis and excess corporate debt. Nearly 20 years later, Japan is still struggling.

There are eerie similarities between the United States now and Japan then. The Bank of Japan ran an excessively accommodative monetary policy for most of the 1980s. In the United States, the Federal Reserve did the same thing beginning in the late 1990s. In both cases, loose money fueled liquidity booms that led to major bubbles.

Stephen S. Roach is the chairman of Morgan Stanley Asia.

Focus Capital collapse adds to hedge fund fears
Focus Capital, a $1bn New York hedge fund, has been forced to liquidate its portfolio after missing margin calls from banks, it told investors -yesterday. The fund, which had produced strong returns by investing in Swiss mid-cap stocks since starting in 2005, is now expected to shut down after losing about 80 per cent of its value.

The collapse is the latest to hit leveraged hedge funds, following the failure of Peloton Partners' $2bn ABS fund last week, and comes as worries are rising that forced sales by hedge funds could drive down prices. Several other funds specialising in credit are close to crisis, according to investors and consultants, while a few smaller funds have had assets seized by banks or have required rescues by investors or allies.

In a letter to investors, the founders of Focus, Tim O'Brien and Philippe Bubb, said it had been hit by "violent short-selling by other market participants", which accelerated when rumours that it was in trouble circulated. Sharp drops in the value of its investments led its two main banks to force it to sell last Tuesday, according to the letter.

Europe vs the super-rich
The European Union will declare war today on Liechtenstein, Monaco, Andorra and Switzerland. Weary of losing billions of tax euros, the EU's 27-strong high command of economics and finance ministers, Ecofin, is meeting in Brussels to agree a strategy aimed at bringing the continent's tax havens under control.

Their weapon of choice will be a strengthened version of the EU's 2005 savings tax directive, which has proved pathetically easy for armies of accountants, lawyers and specialist tax planners to outflank.

Urged on by Peer Steinbruck, the German Finance Minister, the new directive will seek to close the loopholes. Mr Steinbruck says tax evasion costs Germany about €30bn (£23bn) a year in lost revenue; the UK loses a similar sum; the EU may lose €100bn (£77bn) in all.

The stakes are high. But tax experts remain sceptical about the prospects for this new offensive. Mike Warburton, senior tax partner at Grant Thornton accountants, commented yesterday that, while he and his firm condemned tax evasion, which is illegal, "tax avoidance is the second oldest profession in the world, and just as difficult to control. The tax havens will survive. There are stacks of money out there. If they close down the ones in Europe, the money will move to Dubai and Singapore".

Japan may move to support tumbling dollar
Pressure is building in Japan for official intervention to cap the surging yen before it triggers a sharp industrial slowdown and tips the country back into slump. The currency has appreciated by 19pc against the dollar to yen103 since July as Japanese investors retreat from global markets. Foreign hedge funds that borrowed at near zero-rates in Tokyo to chase higher yields abroad are scrambling to unwind "carry trade" positions, estimated at $1.4 trillion in its varied forms.

Fukoku Life, the giant life assurance company, said it planned to "pull out" of US bonds in preference for Japanese debt, a move underway across the Japanese corporate sector as the US yield advantage vanishes. "People are reconsidering the risks (in the US), and see the subprime problems as not being solved at all," said Yuuki Sakurai, the group's finance chief.

Yen strength has sent Tokyo's Nikkei stock index into nose-dive, falling 17pc this year. It tumbled 4.5pc yesterday to 12,992, led by Honda and the Seven Samurai leading exporters. "It's starting to look as if the markets may have to start factoring in a dollar worth 100 yen. This March could be very rough," said Jujiya Securities.

Businesses plot strategy to protect wealth funds
Sovereign wealth funds are teaming up with the private equity industry, business trade associations and major financial institutions to strategize a defense against the growing political scrutiny of the $3 trillion funds. Last week, about 30 lawyers and lobbyists — organized, according to one attendee, by a representative from private equity firm The Carlyle Group — conferred at JPMorgan’s New York offices to discuss their role in the growing political issue.

Congress, the Treasury Department, the International Monetary Fund and the European Union are questioning the government-backed investment funds that have made several high-profile investments in Western financial institutions in recent months. Two subcommittees of the House Financial Services Committee plan to hold a joint hearing Wednesday to discuss the role of foreign governments’ investments in the United States.

According to an attendee of last week’s New York meeting, most in the group rejected the idea of starting a trade association. Many in the group worried that a formalized association would project the wrong image. “I don’t think the funds think the answer to the problem is to look like OPEC or the Trilateral Commission or something coordinated and scary,” said another attendee. “I think the point is that they are going to work under the umbrellas of their government agencies or multilateral institutions.”

Ilargi: A $143.2 trillion drop. $135 trillion in interest rate futures alone. In ONE quarter. Think some of that might be moving into commodities?

Derivative Trades on Exchanges Fell Most in 14 Years
Derivative trading fell 21 percent to $539 trillion in the fourth quarter, the biggest drop in at least 14 years, as the freeze in money markets reduced the need to hedge risks, the Bank for International Settlements said.

Interest-rate futures, contracts designed to speculate on or hedge against moves in borrowing rates, led the fall in exchange- traded contracts with a 25 percent decrease to $405 trillion during the three months ended Dec. 31, the Basel, Switzerland- based BIS said today. The amounts are based on the notional amount underlying the contracts.

Trading declined as banks were hesitant to lend to each other as losses on securities linked to U.S. subprime mortgages mounted. The logjam pushed short-term interest rates to the highest in seven years, prompting central banks including the Federal Reserve and the Bank of England to coordinate efforts to restore confidence in money markets.

"The impairment of liquidity in term money markets may have been a factor dampening turnover in futures and options,'' BIS analysts Patrick McGuire, Goetz von Peter and Naohiko Baba wrote in the report.

Global bond sales by governments and companies fell 45 percent in the fourth quarter to a net $487 billion from a year earlier as credit markets slumped, the report said. Since 2000, year-on-year debt issuance increased by an average 20 percent, BIS data show.

Grim job market deals economy another blow
The weakening job market dealt another blow to the struggling economy on Wednesday, while more bad news emerged from the inflation front. U.S. private employment fell unexpectedly for the first time in nearly five years in February, according to a private report that does not bode well for the government's key U.S. payrolls release on Friday.

Economic optimists may take heart from separate report showing planned layoffs by U.S. companies fell in February, but even that data suggested that the housing-led economic slowdown was spreading to other sectors.

"The headline (ADP) number showed a decline of 23,000, which was the first decline in this series since the economy was coming out of the last recession so it is notable," said Joel Prakken, chairman of Macroeconomic Advisers in St. Louis, Missouri, a joint developer of the ADP report.

This left investors braced for Friday's monthly jobs data. Analysts expect that to show an increase of 25,000 in February non-farm payrolls but their estimates range widely from a drop of 110,000 to a rise of 100,000, according to a Reuters poll of economists.

"The ADB report has given us a heads up that the jobs report on Friday could be worse than expected. All the other jobs indicators are also consistent with a softening U.S. labor market, "said Shaun Osborne, chief currency strategist at TD Securities in Toronto.

Growing bankruptcy filings a grim omen
The consumer total rises 37% year over year. More is expected.

American consumers' bankruptcy filings jumped 15% in February from the previous month and a steeper rise is looming because of the sub-prime mortgage crisis, the American Bankruptcy Institute said Monday. Consumer bankruptcy filings in February totaled 76,120, up from 66,050 recorded in January, the nonpartisan research group said. The February number was 37% higher than in the same month a year ago, according to the institute.

"February's bankruptcy spike -- the highest single month since the 2005 [bankruptcy] law changes -- forecasts the start of more to come for the balance of 2008," said Samuel Gerdano, the institute's executive director. "It is probably too early to attribute the current trend to the mortgage crisis. But if it continues, as it is certainly expected to with adjustable-rate mortgages resetting, it could add to the bankruptcy rate," Gerdano said.

The institute is forecasting more than 1 million consumer bankruptcies in 2008, compared with about 800,000 in 2007, mostly the result of heavy household debt. But the 2008 estimate could go even higher "if this contagion affecting the home mortgage market continues," Gerdano said.

Last week, Senate Republicans blocked a Democratic-written bill that would change federal bankruptcy laws to curb rising home foreclosures. The legislation, which lawmakers said might be reconsidered in coming days, would let bankruptcy judges reduce mortgage amounts to reflect the current fair value of the home in Chapter 13 bankruptcy proceedings. The White House threatened to veto the bill, calling it too costly.

UK banks write off record £6.8bn in household debt
Britain's banks have been forced to write off a record chunk of household debt in the past year in the latest sign that families are struggling to keep up their repayments. Lenders from around the country wrote off some £6.8bn in individual debts last year, statistics from the Bank of England reveal. It is the biggest annual total since records began in 1993, more than doubling in the past five years.

The news coincides with figures from Nationwide showing house prices are now suffering their worst streak since 2000, after falling for a fourth month in February. With the credit crunch making it harder than ever for banks to seek funding in the City's money markets, they are clamping down on borrowers both by raising their mortgage rates and increasing the pressure on borrowers to pay back their debts.

Alan Clarke, UK economist at BNP Paribas, said: "This is certainly a sign that households are already struggling. The debt burden is high, and you would expect write offs to rise as a result. "But it's still early days and there's more bad news in the pipeline. We haven't yet seen arrears starting to bite, and if these numbers look bad now, they'll look even worse in a year's time. There are plenty more dead bodies out there."

Experts said the increase in write-offs could also be a consequence of the new insolvency arrangements which came into place a few years ago. The figures showed that banks classified a total of £2.1bn as bad debt in the final quarter of 2007, of which £1.6bn was consumer debt. Only a small fraction of this was mortgage debt, with the majority accounted for by credit card and other unsecured debts.

Credit Cards, Other Debt Are New Worry for Banks
U.S. regulators said they are watching credit cards and commercial construction loans for signs they may be the next trouble spots as strained financial markets constrain credit.The housing downturn, with its epicenter in the subprime mortgage market, remained atop the list of concerns. But banking regulators and Federal Reserve officials expressed concerns that credit risks may extend beyond mortgages.

Stocks fell as investors braced for more bank losses. Several financial stocks, including Citigroup, hit notable lows on Tuesday, while the S&P Financial index broke through its January low. Citi, the Dow's top decliner, hit a nine-year low. CNBC reported that Citigroup is now expected to cut more than 30,000 jobs in the next 18 months. Also, the head of Dubai International Capital said that Citigroup will need additional capital.

Merrill Lynch cut its earnings forecast for Citigroup, saying it now expects a first-quarter loss of $1.66 a share, compared with its earlier view of 55 cents a share, amid $15 billion in writedowns related to subprime mortgages, reported. Lehman Brothers and Freddie Mac also reached new intraday lows.

Bernanke's second-in-command, Donald Kohn, said at a Senate Banking Committee hearing that the Fed was also keeping a close eye on credit card, home equity and commercial real estate loans as banks cope with a widening range of credit risks.

Agency Mortgage-Backed Bond Spreads Reach Highest Since 1986
The extra yield that investors demand to own so-called agency mortgage-backed securities over 10-year U.S. Treasuries rose to the highest since 1986, boosting the cost of loans for homebuyers considered the least likely to default.

The difference in yields on the Bloomberg index for Fannie Mae's current-coupon, 30-year fixed-rate mortgage bonds and 10- year government notes widened about 1 basis point, to 204 basis points, or 70 basis points higher than Jan. 15. The spread helps determine the interest rate homeowners pay on new prime mortgages of $417,000 or less. A basis point is 0.01 percentage point.

Some owners have been selling the securities "to make room for the cheaper alternatives or to lighten up because they anticipated further unraveling" in the financial markets, UBS AG analysts led by Laurie Goodman wrote in a report yesterday. Agency mortgage securities were the "most liquid" bonds they could sell, the analysts wrote.

The spread for Fannie Mae's current-coupon securities over the average of yields on 5-year and 10-year Treasuries, a benchmark closer to their expected lives, was already the widest since 1986, according to Bloomberg data. That spread today rose to 258 basis points from 170 basis points on Jan. 15, the recent low. The similar spread for bonds backed by the U.S. government are also at the highest since the 1980s, at 225 basis points.

Agency mortgage-backed securities, an almost $4.5 trillion market, are guaranteed by government-chartered companies Fannie Mae and Freddie Mac or federal agency Ginnie Mae. Bloomberg current-coupon indexes represent the average of yields for the two groups of bonds with prices just above and below face value.

Corporate Bond Risk Rises on Speculation Bank Losses to Deepen
The cost of protecting U.S. corporate bonds from default reached a record as Federal Reserve Chairman Ben S. Bernanke warned that the housing slump may worsen and urged lenders to forgive more delinquent mortgages.

Credit-default swaps on the benchmark Markit CDX North America Investment Grade Index rose 1 basis point to 164.5 and earlier traded at a record 171, according to Deutsche Bank AG. Contracts on Citigroup Inc., the biggest U.S. bank by assets, also jumped to a record. Washington Mutual Inc., the largest savings and loan, and Countrywide Financial Corp. climbed the most in almost two months.

Bernanke's comments helped fuel speculation that $181 billion in bank writedowns and losses will deepen, causing more turmoil in credit markets. Citigroup, which has marked down assets by $19.9 billion and taken $2.5 billion in credit losses since the beginning of 2007, may have $15 billion of writedowns this quarter on mortgage-linked debt, Merrill Lynch & Co. analyst Guy Moszkowski said today in a note.

"The outlook for continued credit despair remains firmly entrenched for at least the near term, and there's no catalyst really to change that perception," said Peter Plaut, an analyst at New York-based hedge fund manager Sanno Point Capital Management. The CDX index has more than doubled this year and contracts tied to banks, mortgage lenders and securities firms have soared to records, or near records, as credit investors bet that losses sparked by the collapse of U.S. subprime mortgage securities will spread to other areas of the credit markets.

Ambac rescue plan eases concerns
Credit derivatives markets continued to rally on Wednesday after reports of progress on a rescue plan for Ambac, the bond insurer, cheered investors. Overnight CNBC said that Ambac was moving towards a deal on recapitalisation but had not yet reached an agreement.

Despite the news, concerns remain about the health of the bond insurers, especially after Ben Bernanke, chairman of the Federal Reserve, yesterday called on banks to forgive chunks of mortgage loans.

BNP Paribas said:
“With Fitch raising their loss estimate on subprime to the 21% to 26% range, and Bernanke clearly indicating that there is no near term bottom to housing, it is quite amazing how S&P and Moody’s continue to rate MBIA and Ambac as AAA entities.”

Auction-Rate Bond Failures Approach 70%, Show No Sign of Easing
Auction-rate bond failures show no sign of abating after investors abandoned the market for variable-rate municipal securities. Almost 70 percent of the periodic auctions in the $330 billion market failed this week as investment banks stopped buying the securities investors didn't want. Yields on the debt averaged 6.52 percent as of Feb. 28, up from 3.63 percent before demand evaporated in January.

States from New York to California and lawmakers including House Financial Services Committee Chairman Barney Frank are attempting to revive the market. Rising yields are pinching state and local governments just as a slowing economy and falling property values slash tax revenue by more than $6.6 billion, according to a report by the U.S. Conference of Mayors.

"Even if the auction-rate market survives, we're not going to see the kind of rates we're used to," said Roger Roux, chief financial officer at Rady Children's Hospital in San Diego, which spent an additional $940,000 on its auction bonds since rates reset as high as 15 percent last month.

There were 521 failed auctions in the market for the floating-rate securities yesterday, amounting to a rate of 66 percent, according to data compiled by Bloomberg from brokers at Wilmington Trust Corp., Bank of New York Mellon Corp., Deutsche Bank AG and Wells Fargo & Co. The rate of failures reached 87 percent on Feb. 14 and has since ranged from 61 percent to 69 percent, according to Bank of America Corp.

Ilargi: In a funny twist (and/or reversal?!) of fate, Canada’ no.1 business cheerleading paper National Post invites Roubini to explain why cheerdeading is not appropriate these days.

The coming financial pandemic
For months, economists have debated whether the United States is headed toward a recession. Today, there is no doubt. The severe liquidity and credit crunch from the subprime mortgage bust is now spreading to broader credit markets, $100 barrels of oil are squeezing consumers and unemployment continues to climb. And with the housing market melting down, empty-pocketed Americans can no longer use their homes as ATMs to fund their shopping sprees. It's time to face the truth: The U.S. economy is no longer merely battling a touch of the flu; it's now in the early stages of a painful and persistent bout of pneumonia.

Canada and other countries are watching anxiously, hoping they don't get sick, too. In recent years, the global economy has been unbalanced, with Americans spending more than they earn and the country running massive external deficits. When the subprime mortgage crisis first hit headlines last year, observers hoped that the rest of the world had enough growth momentum and domestic demand to gird itself from the U.S. slowdown. But making up for slowing U.S. demand will be difficult, if not impossible.

American consumers spend about $9-trillion a year. Compare that to Chinese consumers, who spend roughly $1-trillion a year, or Indian consumers, who spend only about $600-billion. Even in wealthy European and Japanese households, low income growth and insecurities about the global economy have caused consumers to save rather than spend. Meanwhile, countries such as China rely on exports to sustain their high economic growth. So there's little reason to believe that global buyers will pick up the slack of today's faltering American consumer, whose spending has already begun to drop.

Credit Agricole Swings to Loss On Write-Downs
French bank Credit Agricole SA Wednesday said write-downs related to the credit crisis caused a hefty net loss in the fourth quarter. The Paris-based bank said its fourth-quarter result plunged to a €857 million ($1.3 billion) loss from a €1.06 billion net profit in the year-earlier period. That figure is worse than analyst expectations of a loss of €480 million.

Agricole cited €3.3 billion in write-downs at its investment bank Calyon as the main driver for the quarterly loss. The figure is above the €2.5 billion in write-downs disclosed by the bank in December. Agricole's chief financial officer, Bertrand Badre, said the company took €700 million in additional write-downs in the fourth quarter to cover its exposure to bond insurers.

The bank, one of Europe's largest by assets, also poured cold water on takeover speculation involving scandal-plagued rival Societe Generale, saying "the group will make organic growth its priority and it is not considering any significant new acquisitions." Asked about the impact of SocGen's woes on Agricole's own strategy, Mr. Badre said only that the group "cannot remain indifferent to what happens in the domestic market," without being more specific.
Agricole owns France's largest retail bank network.

Fears grow for European houses prices
European property began to freeze over last year, with almost every European housing market taking a turn for the worse and prices tumbling fast in Ireland and Germany, new research shows. The majority of housing markets slowed sharply last year, according to the annual European housing review from the Royal Institution of Chartered Surveyors.

Cyprus and Iceland were the only countries to buck the trend, while prices in Poland soared for another year, as money earned by immigrants in the UK poured back into Eastern Europe. Experts warned that there would be worse to come this year and the next, with prices tumbling in the UK recently and expected to drop in Spain in coming months.

The property review, whose leaderboard has been dominated by Eastern European countries in recent years, saw Poland take top spot again, recording 28pc increases in property prices. Estonia, however, which topped the board two years ago, saw prices fall narrowly over the year, and RICS warned that similar scenes could soon be afoot in Poland.

"The reality of post-summer market conditions offered a sharp wake-up call. Oversupply issues have arisen due to an overhang of unsold property and the swift shift made by foreign investors' from 'buy' to 'sell'," it said.

Euro bond spreads hit record as panic grips markets
Investors sold Italian and Greek debt yesterday in signs of near panic liquidation, driving bond spreads to the highest level since creation of the single currency.The yields on Italian 10-year government bonds reached 52 basis points above German Bunds, approaching levels that risk setting off a self-reinforcing spiral of investor flight. Spreads on Greek bonds also jumped to 52.

The wild moves on the euro-zone bond markets came as gold plummeted by $29 an ounce to $957 on automatic stop losses and forced selling by funds. Crude oil futures tumbled almost $3 a barrel in New York.
The Dow Jones index fell 226 points at one stage. Traders said the market was swept by rumours that a distressed hedge fund was being forced to sell profitable contracts to meet margin calls, triggering a cascade of sales in loosely correlated assets.

"We're in the middle of a big panic in the market," said David Keeble, a strategist at Calyon. "There are simply no buyers for anything with even slight risk on it." The grim mood caused a reflex flight to safety, boosting Bunds and refuge currencies such as the Swiss franc and the yen. Funds dumped bonds from the more vulnerable emerging markets and picked off the weakest members of the euro-zone.

"There are forced sellers out there having to liquidate assets," said Dominic Konstan at Credit Suisse. "There are also people out there who always felt EMU wouldn't work and this is bringing them out of the woodwork. The blowing up of the spread does not help sentiment and these things can become self-fulfilling.”

Mounting evidence that Italy is sliding into recession have raised fears of a ballooning fiscal deficit, putting the country’s debt trajectory on an unsustainable course. The collapse of Romano Prodi’s government has left Rome in limbo and raised doubts about the viability of economic reform.

The rating agencies have already downgraded Italian debt twice. A growing number of banks have advised clients to take “short” bets against Italian debt, including Goldman Sachs and BNP Paribas. Simon Derrick, currency strategist at Bank of New York Mellon, said flow of funds data show that foreign investors have suddenly liquidated half the Italian and Greek governments bonds accumulated over the last four years.

Soaring euro threatens European jobs exodus
A top aide to French President Nicolas Sarkozy fired a shot across the bows of the ECB yesterday, demanding that "monetary policy must remain within reasonable bounds". The comments are a clear hint that Paris may try to force a change of tack by invoking Maastricht Article 109, which gives EU politicians the power to dictate exchange policy. France has lacked allies for use of this so-called "nuclear option", but this may change now that a number of eurozone countries are in trouble.

Spreads between 10-year German government bonds and the equivalent debt across the eurozone's Latin bloc have jumped to the highest level since the launch of EMU, reaching 45 basis points for Greece, 43 for Italy, 36 for Greece. The spreads on Spanish bonds have ballooned to 28 from 4 last May, reflecting an abrupt change in perceptions as the property boom deflates and investors take a closer look at Spain's current account deficit, now a 10pc of GDP. "The widening spreads are telling us that these countries are going to be hit harder than core Europe in a downturn," said Simon Derrick, head of currency research at Bank of New York Mellon.

Hans Redeker, currrency chief at BNP Paribas, said foreigner investors had largely stopped buying euro-zone bonds, suggesting that the euro rally is now on its last legs. The inflow is mostly "hot money" speculation.
Mr Redeker said there may soon come a point when the ECB's ultra-hawkish turns negative for the euro, causing traders to look beyond instant yield and focus on the risk that monetary overkill could tip the bloc into a deep downturn. He warned that spreads on Italian and Spanish bonds may jump to 60 basis points.

"The European economy will weaken from the periphery to the centre. Countries where there is also a lot of exposure to the housing market, such as Spain and Ireland, may find themselves in a recessionary environment," he said. Germany is in a much better condition to weather any storm. It has gained 30pc in unit labour cost competitiveness against Italy and Spain since 1998 by screwing down wages, and 20pc against France.

Bernanke's Speech Lays Groundwork for Nationalization of Fannie Mae, Freddie Mac
"The government-sponsored enterprises (GSEs), Fannie Mae (FNM) and Freddie Mac (FRE), likewise could do a great deal to address the current problems in housing and the mortgage market," Bernanke said. "New capital-raising by the GSEs, together with congressional action to strengthen the supervision of these companies, would allow Fannie and Freddie to expand significantly the number of new mortgages that they securitize." 

That almost sounds like it would be a good thing.  In at least one sense, it would be a good thing, but only by default.  Bernanke concludes; "With few alternative mortgage channels available today, such action would be highly beneficial to the economy." That's certainly true, but only in a grimly ironic sense.  It's government-enabled expansion of Fannie Mae and Freddie Mac that led to a situation where there are "few alternative mortgage channels available today" in the first place. 

So Bernanke's ultimate conclusion is this:  "I urge the Congress and the GSEs to take the steps necessary to allow more potential homebuyers access to mortgage credit at reasonable terms. "  It takes either a massive degree of denial or a broad imagination to accept that sentence at face value.  What Bernanke is really urging is the full-scale nationalization of the GSE's.

We can continue to pretend that these companies are going to be just fine, but the reality is it is impossible to fit together the pieces - raising massive amounts of new capital in the face of a yet-to-peak-wave of mortgage resets and housing price declines while simultaneously expanding their mortgage securitizations - without taking what Bernanke calls "congressional action to strengthen the supervision of these companies" to mean,essentially, nationalization of the housing market. 

Fannie and Freddie stocks are down about 6% so far today.  Perhaps the reality is now setting in that nationalization doesn't benefit shareholders.

Our Run-In With Auction Rate Securities - And What It Taught Me About Markets
The most interesting class I took at Wharton where I got my MBA was called "speculative markets" and in that class I learned that markets include different classes of investors. There is the safe money, the hedgers, and the speculators. For example, when a company (like Yahoo) gets a takeover bid and the stock soars, the safe money generally leaves the stock, takes its gain, and the stock trades into the hands of speculators who are now taking the risk that the deal will in fact go through. They are a different kind of investor who is getting paid to take those kinds of risks.

The same thing has happened to the auction rate security market, at least temporarily. The safe money (at least, our safe money and I am sure many others' safe money) is gone from that market. And in its place are speculators who are willing to take the risk of illiquidity and even default (which is very low in the muni market) in return for getting tax free interest rates of 7% to 15% (which is the equivalent of 10-20% taxable).

What was my big takeaway from this whole affair? When risk is appropriately priced, there is a market for something. And in the case of auction rates, the risk is illiquidity and so you must focus on the penalty rates. When they are priced appropriately, the market works. When they are not, the market doesn't work. Thankfully the people who helped us construct our auction rate portfolio understood this. Now we do.

The $34 trillion problem
Twice I have asked Alan Greenspan what he considers the greatest threat to the U.S. economy, and both times he has answered immediately with a single word: Medicare. He isn't so worried about the trade deficit and the housing crash; he figures market forces will sort them out. But Medicare is something else - a multitrillion-dollar problem that's about to get dramatically worse, and one that nobody wants to talk about. You'd think that the greatest threat to America's economy would be Topic A for the presidential candidates. But it's actually a topic they hate to touch.

Especially now. An analysis of their speeches shows that last year Senators Hillary Clinton, John McCain, and Barack Obama would occasionally mention the Medicare mess. But recently, with the economy slowing and voters feeling insecure, all three candidates have turned more populist: Their economic talking points are about feel-good reassurances, not about facing hard realities.

Unfortunately the day of reckoning is imminent. Sometime in the next President's first term, Medicare Part A (hospital insurance) will go cash-flow-negative, and it's all downhill from there. Medicare provides a wide range of services and subsidies to more than 40 million old and disabled Americans. As the country ages, Medicare and Medicaid (for those of any age with low incomes) will devour growing chunks of U.S. economic output. So will Social Security, but its cut of GDP should stop increasing around 2030.

The federal budget has averaged about 18% of GDP over the past several decades. If that average holds and if the rules of our social insurance programs don't change, then by 2070, when today's kids are retiring, Medicare, Medicaid, and Social Security will consume the entire federal budget, with Medicare taking by far the largest share. No Army, no Navy, no Education Department - just those three programs.

But wait - the situation is actually much worse. Those estimates, reported in the latest Financial Report of the U.S. Government, assume that Medicare payments to doctors will be slashed drastically, by some 41% over the next nine years, as required by current law. It won't happen.

Canadians more loath to buy a home
Canadian consumers are turning more bearish on the housing market, with home buying intentions slipping to their lowest level in years, according to a poll released by Royal Bank of Canada Tuesday. Overall, the number of people across Canada who were “very likely” or “somewhat likely” to buy a home slipped by 5 percentage points to 23 per cent in January compared with last year, according to the poll conducted by Ipsos Reid.

The number of poll respondents who said they were “very likely” to buy dropped from 9 per cent last year to 7 per cent in 2008, the lowest level since the poll was started 15 years ago. “Considering the flurry of activity we've seen over the last few years, this year's results definitely signal a change,” said Catherine Adams, vice-president of home equity financing at Royal Bank. The number of Canadians intending to buy a home within the next two years dropped across the country except in Quebec, where it increased to 21 per cent from 19 per cent.

When asked whether they were “very likely” to buy, Atlantic Canadians were the least interested at just 5 per cent. Markets where the greatest number of poll participants said they were “very likely” to buy a home were led by the Greater Toronto Area at 10 per cent, and Saskatchewan and Manitoba at 9 per cent.

Japanese companies sharply curtail spending
Japanese businesses sharply reduced investment in new plant and equipment at the end of last year, the Finance Ministry said Wednesday, in another sign that the world's No.2 economy is slipping into recession.

Capital spending slid 7.7 percent in the fourth-quarter from a year earlier, almost four times more than expected. As a result, economists now expect growth in gross domestic product for the fourth quarter of 2007 to be revised down to 0.6 percent, from a previously reported 0.9 percent, a Reuters poll Wednesday of 21 economists showed, because of the weak capital expenditure figure.

And worse is likely to show up in data for early 2008, said Taro Saito, a senior economist at NLI Research Institute. "Even though October-December GDP will likely be revised down, we can say the economy was still firm then. But it has been slowing down since the beginning of this year," he said. Economists are forecasting a sharp slowdown in growth, and possibly a recession, in both the United States and Japan this year in the wake of the U.S. subprime housing crisis. European economists expect a slowdown on the Continent, but generally are not predicting a recession.

The news Wednesday came as the Bank of Japan began a two-day meeting, the last under Governor Toshihiko Fukui. Swaps contracts on the overnight call rate suggest investors anticipate a 50 percent chance that the central bank will cut rates by the end of the year, a sharp increase from a week ago, when the implied probability was 20 percent. The Bank of Japan policy board is widely expected to leave rates on hold this week, however.

Defaults on insured U.S. mortgages climb 31%
Defaults on privately insured U.S. mortgages rose 31% in January from the same period a year earlier, the 13th straight month showing an annual increase, an industry report Friday showed. Insured borrowers falling more than 60 days behind on payments rose to 68,950 last month from 52,528 a year earlier, according to the Washington-based Mortgage Insurance Companies of America. Defaults last fell in December 2006.

The worst housing slump in a quarter century has sent foreclosure rates soaring and saddled financial companies with at least $181 billion in asset write-downs and credit losses since the start of 2007, according to Bloomberg data. Mortgage insurers are scaling back coverage after a surge in claims pushed the top three firms into third-quarter losses.

"They were slow to hit the exit when they should have been running," William Ryan, an analyst with Portales Partners LLC in New York, said Friday. "Credit quality is going to continue to worsen, and the industry needs to raise capital if they want to continue to grow."

The total amount of insured mortgages also increased in January to more than $832 billion, rising about 24% from the same period a year earlier, according to the report.

Fed official: Economy trumps inflation
Despite the risk of inflation, further rate cuts may be appropriate and necessary amid a struggling economy, a Federal Reserve official said Monday. In a speech delivered to the National Association for Business Economics in Washington, the president of the Philadelphia Federal Reserve, Charles I. Plosser, said inflationary worries can be put aside in certain unique situations.

"There will inevitably be special circumstances or shocks that fall outside the scope of our economic models that will warrant monetary policy action," Plosser said. Plosser, a member of the key interest rate-setting Federal Open Market Committee, argued that the current economic downturn warrants further action to avoid falling into a recession.

"I believe we are in a situation where monetary policy cannot be made by focusing solely on inflation," Plosser said. "The current turmoil in financial markets has already had a significant impact on the economy and has the potential to continue to restrain economic growth going forward."

The bull market won’t come back
Stock returns may never be the same - at least for this generation of investors.

Although you won't find it listed on your calendar, we're approaching the anniversary of an epochal event. No, it has nothing to do with the NCAA basketball tournament. It's a different kind of March Madness: The end of the bull market that lasted for a generation and changed the way that Americans think about stocks.

When the greatest bull market in U.S. history started in the summer of 1982, only a relative handful of people owned stocks, which were cheap because they were considered highly risky. But by the time the Standard & Poor's 500 peaked in March 2000 amid a fully inflated stock bubble, the masses were in the market. Stocks were magical, a supposedly can't-miss way to pay for your kids' college, save for retirement, enrich employees by giving them options, and regrow hair. (Just kidding about the hair. Alas.)

Barring a miracle - or the creation of a New Math of the market variety - there's no way we'll ever see a bull market along the lines of what so many of us grew up with. During that enchanted period, the boring old S&P returned more than 19% a year. When you include compounding, your money more than doubled every four years. Pretty slick.
That was more than twice what stocks earned in the previous 56 years, when they returned about 9%. More than half of that was from dividends, which were almost triple their current level.

If this is a boomtown, then where is all the wealth?
[India] has an "ideal" demographic mix, with 60pc of its population under 30 and a brand-hungry middle class that is forecast to number 125m by 2025. It's churning out engineers and IT specialists, like nuts and bolts on a production line. And the film industry, Bollywood, is rivalling Hollywood. When launching Virgin Mobile there, Sir Richard Branson said: "The Indian market is growing like no other in the world."

As I left the Air India plane last Wednesday, I was keen to see this success in action. I had flown in from Dubai, which has transformed itself from desert sheikhdom to the Gulf's Las Vegas in 15 years. And though I knew that Delhi would be very different, I expected its metamorphosis to be no less remarkable.

I could not have been more wrong. The most astonishing thing about Delhi is just how little it has changed. Yes, there are a few more five-star hotels, some glitzy shopping malls and a greater number of foreign limousines, but the overwhelming impression is of a city that continues to choke on squalor. Rubbish is everywhere and rabies is endemic. Children as young as six or seven "panhandle" on street corners, while carrying tiny babies. Millions live close to the gutter. If this is boomtown, then these wretched people are the Boomtown Rats.

Humped cattle wander about freely, mingling with the clogged traffic. Motorised rickshaws are still there, so too are the Ambassador cars that look like relics from the 1950s. The Indian government is promising up to $450bn for improving the country's infrastructure. It will take every penny of that. Delhi airport - a shambles - is being refurbished, but is so far behind the curve, it's hard to see how it can ever catch up with the best of Asia, such as Hong Kong and Singapore.

Several [seasoned travellers] said to me they had never seen poverty like it - and did not want to again. When I mentioned this to an Indian businessman, who now works in Amsterdam, he smiled. "Well, if you think Delhi is bad, don't go to Bombay [no, he did not say Mumbai]. It is falling apart. And as for Calcutta, that is the worst of all." I spent only four days in Delhi - but that was enough. Given the extraordinary in-your-face disparities of wealth, it is not a particularly threatening city. It is, however, deeply discomfiting.


Anonymous said...

First started reading you guys over at TOD, and you`re doing a great job over here too, please keep it up!
Question for ilargi:

I understand that you see the current situation as being hugely deflationary, and i can see why. Obviously with available credit collapsing this is deflationary, loans being repaid or written off is deflationary, and with the banks able to lend out $9 for every deposit of $1 (via fractional reserve lending), every time somebody needs that $1 and withdraws it from their accounts another $9 of credit has to vanish, also deflationary.

The fed will see all these deflationary effects and print huge quantities of dollars to compensate? The dollar is fiat currency, and so there is no limit to how many they can print. Ah, but the Fed can`t just print money - all they can do is loan it, and if no one wants to borrow they are stuck? But hang on, they can make it worth your while to borrow, by offering the "loans" at such an attractive rate (low %interest or even 0% interest) you would be a fool not to borrow, as you could invest the money elsewhere at higher interest rates, thereby making money.

If they do this people will fall over themselves to borrow and invest in stocks or elsewhere and would this not counter all the deflationary effects (and lead to hyper inflation)?


Unknown said...

For those of us who aren't finance gurus. Can you explain the difference between inflation and prices going way up?

I see things the same as tennisball (I think). The feds will simply print whatever dollars are necessary to keep our bankrupt banks in business.

Ilargi said...

TB, Robert,

There is a limit to the amounts of money a central bank can print. And we will go way beyond that limit.

Besides, the Fed is doing the opposite of what people think they (will) do: it's withdrawing money supply, not adding it. See the graph by Lee Adler that I posted here.

Inflation is an increase in the money supply. Select prices can go up at any time, for instance through scarcity. That is not inflation.

I have argued that we just came out of high inflation: look at home prices. Only, people call higher home prices value increase, not inflation. In reality, it is.

Stoneleigh said...


As the Japanese discovered, 0% may not be low enough to make borrowing and lending attractive domestically - it's called the liquidity trap. Internationally though, their 0% did fuel a huge liquidity boom through the yen carry trade, which IMO is now on the verge of unwinding.

In a deflation, the nominal rate can go no lower than 0%, but the real rate (the nominal rate minus negative inflation) is what matters and that can still be very high. This is why debt becomes a millstone round your neck very quickly, while savers do very well (so long as they don't have their savings in a bank that fails).

In a deflationary environment, there is no interest rate that will make borrowing and lending an attractive prospect, and since this credit 'accident' will be global, there won't be foreign sources of cheap liquidity to tap.

Greyzone said...

Remember Focus Capital, a large US hedge fund, rapidly dumping assets to raise cash to meet collateral requirements or will face margin calls 2 days ago?

Well as of 3/5/08, Focus Capital has collapsed against margin calls.

Look at that, people. A $1 billion dollar hedge fund with 33% return in 2007 no longer exists. It's gone, instantly. And every investor in the fund just lost everything invested. That's gone too.

And the margin calls have just begun, folks. The pitcher is just warming up. This is just the top of the first inning and this game has a long way to go before its over. What's the Fed going to do, print $1 billion dollars and put it right back in the pockets of those who lost money? Who can borrow from the Fed? What collateral will they have with which to borrow?

It's over, people. They cannot hyperinflate out of this. The collateral does not exist and is vanishing as we debate. The only inflationary way out of this is to GIVE the money away and they are not allowed to do that. Further, what would happen if they did? The dollar would instantly collapse and no one would hold them.

It's over. It's completely over. Deflationary depression here we come.

Ilargi said...


I added the Focus story about the same time you wrote the comment. Yes, edge funds well be big stories. Since leverage is their middle name, a 10% margin call by lenders can kill them in days.

Peloton won an award for "best new fund" one month ago. Now they're gone.

Lots of rich investors will lose lots of money this way. This year.

Anonymous said...


Some things probably seem obvious to Ilargi and Stoneleigh, so their explanations are sometimes rather... brief.

Here is a try at explaining the difference between prices and inflation for Robert, by someone (me) who learned fairly recently and perhaps better understands what people need to understand.

Consider a country that in a given year creates 2% added value (i.e. growth) above the previous year. If during the same year, the money supply increases 2.5%, the excess above 2% is inflation.

Prices obviously reflect inflationary phenomena to some extent, but they are not themselves inflation. Some go up slightly, others a lot, e.g. food may go up faster than bicycles, but they are subject to many pressures and are in fact simply represent the cost of living, not inflation.

That is my understanding and I would be happy if someone could set me straight if it is not accurate.


Greyzone said...

That's close enough for a simple explanation, FB.

But I would further add that even if the economy did not grow and did not contract at all (remained a static size), price changes would still occur based upon scarcity. More scarce goods go up in price if the demand is there while less scarce goods go do.

So... even in a deflationary economy if the available oil supply shrinks prices can go up (for oil) even while the economy itself shrinks and prices for other things (houses) go down.

Price movements are sometimes indication of inflation, as you said. But price movements are also often indications of scarcity. Look at the street prices of the Wii video game system this Christmas! People were willing to pay 3-5 times the "list" price to get one. (Why? I don't know but I was simply observing the impact of high demand against low supply.)

Bigelow said...

Is not any increase in the money supply, regardless of change in a country’s domestic product, really inflation? More money would still buy a different amount of something than what the supply and demand would dictate.

Bigelow said...

"If the American people ever allow private banks to control the issue of their currency, first by inflation then by deflation, the banks and the corporations will grow up around them, will deprive the people of all property until their children wake up homeless on the continent their fathers conquered. The issuing power should be taken from the banks and restored to the people, to whom it properly belongs." --Jefferson

Greyzone said...

Strictly speaking, Bigelow, yes.

But imagine a world with a static (non-increasing) money supply and a steadily growing economy (more goods and services). In such an environment, deflation of prices is constant. As more goods and services (and people) are added, since money supply is finite, prices go down constantly. Note that this does NOT imply poverty unless you equate money directly with wealth. If you equate wealth with possession of things, then this means more and more people can become wealthier (own more things and have more services).

So the traditional response to that issue of constantly falling prices is to increase the money supply exactly as much as the economy increased. In that scenario prices may still change but only because of supply and demand. If supply and demand remain constant, despite growth in the economy, plus the money supply is as large as the economy, prices could (at least theoretically) stay constant.

This never works in practice because of changes in supply or changes in demand. Even fads, like the Wii video game system, change demand by raising it for the Wii but lowering it for something else.

Further, even the constant increase in money supply to match the growth of the economy masks an opportunity for the unscrupulous to enrich themselves at the expense of the hard working. With higher productivity and higher technology, prices should go down! That should be the fruit of our labor - easier life, yet it is not. We are the red queens running ever faster yet slowly falling behind, robbed by monetary inflation for the benefit of the few.

Stoneleigh said...

Sorry about the brief explanations FB. I had written a much longer one earlier, but my computer ate it, and I didn't have time to rewrite it until all the snow was dug out of my driveway and firewood for the week was safely stocked in the wood cabin. Several hours later, here we go again.

Inflation and deflation are monetary phenomena - an increase or a decrease, respectively, in the money supply relative to goods and services. Generally speaking, if the money supply is increasing prices will rise and if it is decreasing, prices will fall, all else being equal, but all else is not always equal.

Prices can fall during inflation (or during an inflation-mimicking credit expansion, such as we have just lived through, where a proliferation of IOUs temporarily function as money equivalents). For instance, global competition and international wage arbitrage kept prices for many manufactured goods (especially of the cheap plastic crap variety) falling during a period when the dollar lost approximately half its purchasing power (2000-2008). For prices to fall in nominal (non-inflation adjusted) terms under such circumstances, the fall in real (inflation adjusted) terms must be huge.

Conversely, prices can rise during deflation if scarcity reigns. In the case of oil or food, for instance, I would initially expect deflation to result in lower prices due to demand destruction (where demand is not what one wants but what one is ready, willing and able to pay for), with the caveat that the lower price may be less affordable then than the higher price is now due to money scarcity. However, the scale of the economic upheaval is likely to be so large that the knock-on effect on supply for essentials such as food and energy will probably be at least as large as that on demand. Energy projects will become uneconomic and far riskier, both economically and physically. Food distribution mechanisms may crumble.

As a far larger proportion of a far smaller money supply chases these dwindling essentials, their price is likely to rise (certainly in real terms and quite possibly even in nominal terms) against a backdrop of a collapsing money supply. A rise in nominal terms under such circumstances means that prices are actually going through the roof, likely pricing many, if not most, ordinary people out of the market entirely. This would have tragic consequences.

Anonymous said...

ilargi/Stoneleigh: where is the tip jar? I still have my Empire job for now, I must contribute to those who most usefully track what is really going on... Paypal? Small unmarked pieces of green paper (U.S., sorry) sent to a P.O. Box?

Anonymous said...

I think people tend to use "inflation" and "deflation" rather inconsistency. For example, I notice "deflationists" talking about deflation as a fall in the money supply, then having established this they go on to talk about falling commodity prices as if this automatically follows.
I also notice both camps talking as if the USA is the world. Hello, we have lots of floating currencies now. If you talk about a decrease in the money supply, WHOSE money supply are you discusing? It is quite possible for the US dollar money supply to decrease while WORLD money supply increases - for example the Chinese print lots of Yuan.
Or you could see the US money supply decrease, but the rest of the world could spurn the dollar to the point that it is worth a fraction of the current value, raising prices for commodities in US dollar terms.

Then of course there is the assumption that debt equals money, so as debt/credit evaporates the money supply decreases. Well maybe not. Maybe it was never money to start with - just fraud or wishful thinking. People acted as if they had money when they did not. If I write a check for a billion and some fool thinks I am good for it, does this increase the money supply?

Perhaps the money supply is now INCREASING, if you define it as paper greenbacks or treasury bills or numbers on the Fed ledger.

You can only say the money supply is decreasing if you include financial assets on bank balance sheets as money.

Personally, I would say it is decreasing from the top (of the pyramid) and increasing from the bottom. The more exotic financial instruments up in the clouds are evaporating with shocking speed, while the base of gold, greenbacks and T-bills is expanding.

The result of this is likely to be a fall in prices of financial assets and discretionary goods at the top of Maslow's hierachy of self-indulgence, and rising prices at the bottom, especially the things you absolutely can't live without - wheat, rice, water, oil, electricity.

Deflation at one end, Inflation at the other. Of course people focus just on the bit that suits them, or argue about what is happening to the "overall" money supply, which misses the picture completely, like the man with one foot in a bucket of boiling water and the other in a bucket of ice, who describes his situation, Greenspanlike, as "comfortable on average".

Of course money is a very confusing and nebulous subject. One might say that the money supply never actually increases at all in normal banking transactions - it is actually the velocity of money increasing. The same few dollars race around faster and faster creating the illusion that there is more of them. As they get double counted and triple counted etc they wizz around fast enough to make good all the promises that people have made.

When the crunch hits (that would be now) those wizzing bucks pause in the account of someone who is reluctant to let them go, and a score of promises cannot be filled, because the expected cashflow never eventuates.

This explains why the balance sheets start looking rather sick, write downs are made, asset values tumble. But does it follow that the price of essentials will drop too? Yes, to the extent that people are unwilling to part with dollars to purchase them. But the flow of money for essentials will not be as marked. It is here that people are last to cut back.

And some people - BRICS maybe - might not be cutting back at all.

goritsas said...

TenThousandMileMargin said...

I think people tend to use "inflation" and "deflation" rather inconsistency.

Not around here they don’t. Inflation is the net growth in the supply of money and credit. Deflation is the net decrease in the supply of money and credit. Why does this require endless repetition?. Prices change as a function of supply and demand. Thus, prices for some things may rise during deflation and prices for some things may fall during inflation. The point is prices are not the cause of inflation or deflation, changes in the net supply of money and credit are.

One might say that the money supply never actually increases at all …

But then one would be incorrect. Money supply increases or decreases as it’s printed and put into circulation or taken out of circulation and stored in government vaults or destroyed.

Credit increases or decreases as financial institutions issue loans or loans are paid off or written off.

The net difference between these two determines inflation or deflation. At this moment in time credit destruction far outpaces any money supply additions and thus we are in a clearly defined period of deflation. Then there is the relative contributions of money and credit. Money in the UK is around 3% of the total, the U.S. is lower, as I recall. It will take a printing effort of Herculean magnitude to print enough money to make any difference at all. There may not even be enough paper pulp to make such an effort possible.

As for the conversation being confined to the U.S., I think you need to review the past several days postings. This is not a U.S. specific problem in any way. In fact, the first victims were two German banks. The ECB is busy propping up Spanish banks, and more than likely other banks around the EU since they do all their propping in secret. The Fed is busy propping but the propping itself is more transparent. The collateral being used is as secret as the ECB so who really knows just how safe this propping up really is? The nationalisation of the UK’s Northern Rock is the just first of many banking debacles that will be taking place as more and more banks become more and more clearly insolvent.

Billion dollar write down announcements are the news du jour. Every time a bank or hedge fund writes off another billion here or another billion there we can see with absolute clarity deflation is in full swing.

What will happen to commodity prices, and prices in general, will be determined by two factors, supply and demand. In deflationary periods one would expect demand to fall and thus prices to fall. This may not be the case for some things like grains and energy. If grain or energy supplies are insufficient to meet demand then prices should be expected to rise even during deflation.

It is quite possible for the US dollar money supply to decrease while WORLD money supply increases …

In that case the value of the dollar will strengthen relative to the other currencies simply because there will be fewer dollars in circulation vs. more of those other currencies in circulation. You’ll be able to buy more shitty Chinese plastic because there’s a lot more Yuan in circulation, relative to the dollar. The point is, at least for the dollar in a U.S. deflation, is its purchasing power increases. What took five dollars a year ago may only require two dollars in two years time. If China expands its supply of money and credit thus enjoying a period of inflation, then Chinese exports are going to get cheaper in dollar terms. Especially if the U.S. economy is deflating.

If I write a check for a billion and some fool thinks I am good for it, does this increase the money supply?

It doesn’t increase the supply of money but it does increase the supply of credit if it’s funded by an overdraft (or other form of on demand credit facility) and it clears. If it doesn’t clear, then you’re a fraud merchant, will be found by the fool, and have the living shit kicked out of you. Oh yeah, and the debt will be written off, and the supply of credit will contract by $1 billion. Meanwhile you’ll be wondering if your knees will ever be useful again.