Sunday, May 11, 2008

Post-bubble-bubble-bubble time

Please don't miss today’s Debt Rattle, May 11 2008: It's a new game"

Ilargi: The inflation vs deflation discussion never seems to end. So here's yet another attempt at solving the errors that are constantly being injected. Trillions of dollars are gone through house price declines, imploding securities and dissolving derivatives, with much more to come (make that go). and we are supposed to enter an inflationary period? That is not possible, folks.

Inflation, when used as a term to describe rising prices in a particular segment of the economy, inevitably becomes a hollow term. These days, we can constantly read things like "food inflation" or "food price inflation". But there is no such thing. How do we know that? Well, there are several ways to figure this one out.

First, if you can call rising prices in one part of an economy "inflation", where does that stop? If for example food prices stay equal except for vegetables, do we have "vegetable inflation"? Perhaps the most obvious way to put this is to ridicule it. If prices for everything else remain the same, or even fall, but cookies get more expensive for some reason, are we seriously going to talk about "cookie inflation"? If not, there's no such thing as "food inflation" either.

Second, say we were to talk about inflation if for instance food prices go up, and food prices only. It's by no means impossible that prices for other items go down simultaneously. Using the terms this way, we would need to accept inflation and deflation happening at the same time. And that is ridiculous; the terms would have no meaning.

All this to say that rising prices by themselves cannot indicate inflation. Instead, it must be the other way around. You must have inflation first, defined as an increase in money supply and/or credit supply, and rising prices must come after. And it needs to be rising prices across the board, not just in one part of the economy.

In any other definition, the term "inflation" becomes nonsensical. A bad grain harvest turns into "grain inflation", peak oil leads to "oil inflation". And a strike in the cookie factory leads to cookie inflation. Yeah right. Let's stop doing that, why don't we?

Apart from all this linguistic theorizing, Steve Moyer's article below has a lot of other very valid points as well, that I think everybody needs to read. We are way past the maybe phase in all of this.

Real Estate and Credit Deflation: The Next Dozen Shoes to Drop
by Steve Moyer

"If the shoe fits, it's too expensive." ~ Adrienne Gusoff

I was offered a very nice position with Fisher Investments of Woodside, California last year and, although I passed on the opportunity, I truly respect their money management track record. At the same time, I have noticed from their website that they are comparing the current equity market with the set-up which existed in 1992; they see this as a brief cyclical downturn prior to a multi-year bull market run rather than an unfolding, post-triple-bubble economic downward spiral.

In fact, as I look through the site's archives, the Fisher research team (60 strong, and plenty bright) doesn't address post-bubble possibilities in any way, shape or form.

They have a major blind spot -- that being the collapse of real estate values and related securities in the U.S (and beyond) and the economic ramifications thereof. I guess they're too busy trying to figure out why the stock market isn't rallying enough based on attractive P/E ratios, favorable bond-to-earnings yields, low interest rates, wanton monetary policy and other irrelevant indicators. The answer is it's all being trumped by contagious real estate deflation.

This is no cyclical downturn, friends. This is post-bubble-bubble-bubble time in the U.S. (and now we've added deflating China and India stock bubbles to the mix). When the happy talkers on CNBC tell you about real estate or investment cycles "since World War II" or yammer on about "typical bear markets," just know that that's why bubbles inflate in the first place; few know (or want to know) anything about investment manias, credit implosions or deflationary depressions.

Few know that bubbles go bust with frightening consequences, or that housing bubble deflation is the most onerous one of them all (because far more people own houses than stocks). The "don't worry -- values will always go up!" crowd, emboldened by some sense that the Fed will surely "take care" of everything, will be the one turning bitter in the months and years ahead, while asset preservationists rule the roost.

In response to a request from one of our readers, I decided to make like a cobbler and throw out the next dozen shoes to drop as real estate and credit deflation take greater hold. I accept the challenge, and understand that these answers might have some bearing on a 2008-2009 investment decision or two. So here goes:

1. The Fed won't turn around rapidly developing and contagious "depression psychology."

Can't, isn't and won't. Picture Bernanke, Paulson and the other United States' Economic Dictators standing around an emptying toilet bowl, frantically using their bare hands to keep water from going down the drain. Such is the case of these Dictators vs. the awesome force that is real estate/credit deflation.

When home values are declining and banks are afraid to lend money (to borrowers AND to each other), it makes no difference what desperate "policymakers" do; Bernanke, Paulson and friends don't have the power to force people to borrow and banks to lend. The market does that. That confidence is waning, and it's not coming back until few think it ever will.

2. Nothing will stop real estate values from continuing their decline

They will continue to fall, from coast to coast, category to category, setting up an eventual "crash" when a global systemic event takes the entire market out at the knees. Just laugh in the face of those who say real estate is bottoming now or will bottom "later this year," in 2009 or any other time in the next five years (at least). Certainly there won't be a "bottom" until a meltdown of one sort or another comes to pass and until most conclude that buying real estate is a losing proposition. Anyone who says we've reached bottom in the meanwhile surely has something to sell you (probably real estate or stocks).

THERE IS ABSOLUTELY NOTHING TO SUGGEST THAT THINGS ARE IMPROVING IN THIS ARENA; IN FACT, as lenders get more skittish, financing gets tougher to find by the day and more cash down is required, THINGS ARE GETTING MARKEDLY WORSE. REAL ESTATE VALUES ARE IN FULL DECLINE, AND THERE IS A LONG WAY TO GO. It's the top of the second, not the bottom of the eighth.

Credit Suisse projects that by 2012, 12.7% of houses in the United States -- roughly 6.5 million homes or ONE IN EIGHT -- will have been foreclosed upon (I think it will eventually be worse than that). Regardless, that projection alone is enough to cause significant strain on the U.S. economy, and that strain will only lead to more asset deflation. Suffice to say post-bubble real estate deflation has a long way to go, my friends.

Property sales require a willing buyer, a motivated-enough seller and an agreeable lender and there aren't now -- nor will there be -- enough of these folks to go around for possibly a generation. Buyers, in particular, will become ever-harder to come by.

When "the government" starts bulldozing entire tracts of houses -- and they will at some point -- in an attempt to do SOMETHING about chronic and persistent housing oversupply and blight, we'll start talking about "the bottom." Until then, there is no bottom.

3. "I can't get financing."

Despite my protestations, a client recently decided to buy a $4 million property direct from an acquaintance of his; a property/price combination he thought was too good to pass up. Tellingly, no lender came close to offering him the loan he expected. They either weren't interested in the loan at all or wanted a lot more money down and a much higher interest rate, not to mention his first-born male child as collateral. Once he got a sense of what the new rules of the game were, he quickly decided to pass on the "great opportunity."

A few months from now there might be another buyer, and she'll need even more cash to make the deal. By then, she'll be familiar with the financing landscape and will want a correspondingly lower price. Lo and behold, and assuming the seller is motivated enough to reduce the price again, even fewer lenders will want to make the loan. And so on down the deflationary line. It's part of the process, and happening as we speak. Most buyers don't realize it until one lender after another says thanks, but no thanks.

Get used to the refrain. Each month will bring additional categories of loans lenders will no longer be willing to make. For example, financing for condominiums (except within mature, well-established projects) is already almost impossible to get, which is sure to knock condo values down another 30-40%.

The Fed may lower short-term rates, but as we're learning, that doesn't mean lenders will follow suit. Now that they're back to imputing risk, they want higher returns, and the only way to achieve that is to raise interest rates, no matter the Fed. Truth is, the Fed has little to do with market interest rates for real estate.

The Catch-22 is that as real estate deflation continues to unfold, those intelligent enough to have 10 or 20% down (or more) plus cash in the bank to back up the purchase won't be stupid enough to throw good money after bad via buying market real estate. Only complete dunderheads are buying now and the dunderhead contingent grows tinier by the day.

4. Banks will be under more pressure, and bank failures will follow.

When the stock market's countertrend rally is finished and the summer/fall dive in the market takes hold, the cover story will likely be centered around failing financial institutions -- large and small -- and the "We Don't Have Enough Fingers for the Dike!" Fed. As one leak is plugged, three more will appear, and market confidence will be shattered as all major asset classes fall in value at roughly the same time. Nothing like a major headline run on the bank (or several) to get Americans heading into full-on depression mode.

5. The "Wealth Effect" will morph into the "Broke Effect."

The U.S. economy boomed and the stock market benefited from artificial, Fed-induced 2003-2007 reflation, mostly because folks felt wealthy due to phony home value "increases." This meant boomtimes in real estate, a seemingly healthy economy, further expected value increases, little incentive to save and an American cultural rush to "borrow to buy things." Now that home equity is disappearing by the day, homeowners saddled with too much debt feel ever poorer, not wealthier, and they'll do what most people do when they feel broke: They'll watch every penny and say no to more debt.

6. Consumers will spend less with each passing month.

The downturn in retail sales will become increasingly pronounced and force scores of bankruptcies in the retail sector. Face it, cash-strapped Americans, getting clobbered each week by the high cost of food and gasoline, forced to buy things with money they don't have (I'm talking cash, not disappearing credit), and already saddled with too much debt, have no choice but to snap shut their pocketbooks.

More importantly, they're in the process of discovering that almost any discretionary purchase will cost them less next year. Discount retailers might weather the storm, but the more optional the purchase, the worse-off the retailer will be. Not only will retailers be unable to pass along rising costs to their customers, price cuts, discounts, coupons, giveaways, close-outs and going-out-of-business sales will become the only way to attract increasingly tight-fisted consumers in the United States.

Obviously, retailers who opened outlets from coast to coast to take advantage of the borrow-to-buy-things spending spree of 2003-2007 will not be able to withstand such a striking reversal of fortunes. Look for going-out-of-business sales, sudden store closures, an epidemic of empty storefronts and rashes of bankruptcies (including a few "headline" big box names). Shopping mall and shopping center values will quickly get clobbered.

7. The commercial real estate value decline will intensify.

The homebuilding index led the way downhill in 2005 and home values soon followed suit; the same is now true in the commercial real estate game. Values on the commercial side have held up fairly well through the 2nd half of 2007 but commercial and office REIT's are now getting hammered (there's your fair warning) and the commercial mortgage sector is in the process of joining the growing default party.

Seasoned real estate investors are increasingly willing to wait on the sidelines; they see the handwriting on the wall and are happy to look for better deals. They MAY buy, but only at risk-premium discounts (i.e., higher capitalization rates) and that means lower prices.

As real estate deflation takes further hold, no commercial real estate category will be spared. Current investors will have their own problems to deal with (rising vacancies, lack of fresh leasing interest and declining rents) and they'll lose interest in buying until THEY think the shakeout is complete (best guess: April of, oh, 2018).

Interestingly, apartment rents have increased solidly in 2007 and into 2008 as housing sales have come to a standstill and folks choose to rent (or have to), but that trend will reverse itself soon enough. The last time the U.S. experienced a deflationary depression, residential rents fell for 18 consecutive years. Expect the same or worse this time around.

The market has held up fairly well for residential income property, but it won't be immune to deflationary real estate forces. If you don't sell your residential income property given everything you know now, you'll have no one to blame but yourself as values decline and management headaches multiply. It's still a very good time to get out.

8. U.S. real estate deflation is now the world's real estate deflation.

To make matters worse, much of the rest of the Western world is now experiencing the same, steep housing price drop/credit crunch. Real estate deflation has arrived on a worldwide scale and the pressure on the global economy and banking will be too great to hold back the spreading deflationary forces. Central bankers cannot and will not control the outcome, try as they might to slow it down during the plague's early stages.

9. Yes, your area will be hit, too. It's just a matter of time.

Each passing month brings another state or two -- and more counties within each state -- afflicted by real estate and credit deflation. Here in the Bay Area, for instance, San Francisco, San Mateo, Palo Alto, Marin County and the Oakland and Berkeley Hills have held up reasonably well in terms of median price, while neighboring communities get pimp-slapped one after another. Alas, it's only a matter of time until the cancer spreads.

First off, the number of sales in less-impacted areas is down substantially (fewer stupid buyers willing to pay last year's prices). Second, instead of "discounting to sell," frustrated but well-heeled sellers just take those properties off the market while they "wait for things to rebound and prices to go back up;" so entrenched is their view that values will keep going up, with occasional pauses along the way. In this case, it'll be like waiting for Godot.

Years from now, those sellers will end up either selling at lower prices (when things are significantly worse), walking away when they find themselves hopelessly underwater, or sitting in rocking chairs, waxing nostalgic about the time their property was worth two, three or four times what it has become.

10. Stock markets around the globe will face ever-more downward pressure

Dragged down by real estate and banking woes in the United States and beyond. When the real estate pain becomes bad enough, those markets will crash, too.

Will a stock market crash cause a bigger real estate crash, or vice versa? The answer is yes.

It doesn't really matter which is the chicken and which is the egg. With credit and real estate markets collapsing worldwide, a woeful lack of consumer confidence, ever-greater effects on the consumer and the economy (not to mention employment), people will be in no mood to buy stocks.

There might be a countertrend rally or two yet to come, but the late-2007 "top" is in and the post-triple-bubble deflationary drift will be overwhelmingly down. When the majority of people realize that the global economy has no chance of turning itself around, the United States stock market will crash and world markets will follow, causing real estate and other asset values to ratchet down even further.

11. Local and state governments and school districts

Already under pressure, [they] will feel the crunch more each day, and deficits, layoffs and bankruptcies will follow. Declining property values + far fewer transactions = significantly less revenue for state and local governments. It will be interesting to watch overtaxed and cash-squeezed citizens battle state and municipal entities as politicians try to float more bonds and work to raise taxes and fees in order to offset huge reductions in revenue. Meanwhile, necessary layoffs and budget cuts in the public sector will just add to the post-bubble, deflationary pressure.

12. One bad thing leads to five others.

Falling home prices will affect confidence which will affect buying psychology which will affect home sales which will affect the economy which will affect employment which will affect creditworthiness which will affect availability of credit which will affect earnings which will affect stock values which will affect social mood which will affect employment which will affect consumer spending which will affect home prices which will affect confidence which will affect buying psychology which will affect home sales which will affect.....Ah, hell, you get the picture.

If your neighbors can't connect the dots by now, there's really not much hope for them. I'm just glad you're here, reading stuff like this, taking good care of the eggs in your basket. Risk is everywhere, and something inside of you is telling you to be alert to the possibility. You're in a very select group, and I applaud you for it.

NOTE: We'd like to hear about your recent real estate stories, experiences and anecdotes -- good or bad. We may feature some of them in upcoming columns. Feel free to send them to me at or log on to our website and post your comments for further discussion. Thanks.

Please take a moment to read the signature piece below, related to our real estate/credit deflation premise. Penned by Michael "Mish" Shedlock, this is the article I'll be sending from here on out when hyperinflationists write in to say "The Fed will never allow a deflationary depression!" As we've maintained from the beginning, the problem is much too big for the Fed to contain, and Mish's article reflects that. I couldn't agree more with his conclusions.

Ilargi: Here's the article that Stephen Moyer refers to. Dated April 22, 2008, it's but one of many that Mike Shedlock has written on deflation in the past handful of years. And he is right.

For those who still don't understand, after reading both pieces I posted here, why inflation is simply not possible, I suggest doing a search for "mish" and "deflation".

Deflation In A Fiat Regime?
I was asked by many to reply to a post by Doug Noland called Setting the Backdrop for Stage Two. Before reviewing Noland's post I would first like to comment on this statement made by Professor Lewis: " I have never been one to believe you can have a true deflation with a fiat currency."

Before we can begin any discussion, it is imperative to agree on the meaning of terms. I happen to believe in Austrian economics and the definition I use when I speak of inflation is a net increase in money supply and credit. Deflation is the opposite, a net decrease in money supply and credit. For more on those definitions as well as rationale for discarding seven other definitions, please see Inflation: What the heck is it?

Deflation In Japan

Assuming that there is agreement as to what inflation and deflation are, it is quite easy to refute the idea that deflation cannot occur in a fiat regime. Japan was in deflation for a decade.

However, some still argue that Japan never went through deflation. One basis for that argument is that "money supply" as measured by M1 or base money supply never contracted over a sustained period. The other argument is that prices as measured by the CPI never fell much. Those are flawed arguments (at least from an Austrian economist point of view) given the focus on consumer prices and money supply alone as opposed to money supply and credit.

Although Japan was rapidly printing money, a destruction of credit was happening at a far greater pace. There was an overall contraction of credit in Japan for close to 5 consecutive years. Property values plunged for 18 consecutive years. The stock market plunged from 40,000 to 7,000. Cash was hoarded and the velocity of money collapsed. Those are classic symptoms of deflation that a proper definition incorporating both money supply and credit would readily catch. Those looking at consumer prices or monetary injections by the bank of Japan were far off the mark.

Yes, there was deflation in Japan. Furthermore, if deflation can happen in Japan, then there is no reason why it cannot happen in the US as well.

Economist Paul Kasriel Weighs In

I discussed how a Japanese style deflation might occur in the US in an Interview with Paul Kasriel.

Mish: Would you say that consumer debt in the US as opposed to the lack of consumer debt in Japan increases the deflationary pressures on the US economy?

Kasriel: Yes, absolutely. The latest figures that I have show that banks' exposure to the mortgage market is at 62% of their total earnings assets, an all time high. If a prolonged housing bust ensues, banks could be in big trouble.

Mish: What if Bernanke cuts interest rates to 1 percent?

Kasriel: In a sustained housing bust that causes banks to take a big hit to their capital it simply will not matter. This is essentially what happened recently in Japan and also in the US during the great depression.

Mish: Can you elaborate?

Kasriel: Most people are not aware of actions the Fed took during the great depression. Bernanke claims that the Fed did not act strong enough during the great depression. This is simply not true. The Fed slashed interest rates and injected huge sums of base money but it did no good. More recently, Japan did the same thing. It also did no good. If default rates get high enough, banks will simply be unwilling to lend which will severely limit money and credit creation.

Mish: How does inflation start and end?

Kasriel: Inflation starts with expansion of money and credit.
Inflation ends when the central bank is no longer able or willing to extend credit and/or when consumers and businesses are no longer willing to borrow because further expansion and /or speculation no longer makes any economic sense.

Mish: So when does it all end?

Kasriel: That is extremely difficult to project. If the current housing recession were to turn into a housing depression, leading to massive mortgage defaults, it could end. Alternatively, if there were a run on the dollar in the foreign exchange market, price inflation could spike up and the Fed would have no choice but to raise interest rates aggressively. Given the record leverage in the U.S. economy, the rise in interest rates would prompt large scale bankruptcies. These are the two "checkmate" scenarios that come to mind.

Deflation Is Here Now

The interview with Kasriel was in December of 2006. On March 17,2008 in Now Presenting: Deflation! I stated "Deflation is here and it is now." A followup post was called Why Do Oil Prices Keep Rising? The key idea from the latter article is as follows:

A Weak Dollar Is Masking Deflation!

Right now what we have is deflation with a weak dollar. That weak dollar, in conjunction with peak oil, has caught nearly everyone off guard to the point they are screaming about oil prices and bond bubbles, while missing the far more important deflationary forces of foreclosures, bankruptcies, and massive writedowns in credit.

Setting the Backdrop for Stage Two

Week in and week out Noland writes a great column. Stage Two made "Best of the Web" on Dollar Collapse. I happen to agree with that "best of" designation because Noland took a viewpoint and argued it well. However, let's take a look on a point by point basis:

Noland: I hear pundits still referring to a “deflationary Credit collapse.” Well, the U.S. Credit system implosion was largely stopped in its tracks last month. The Fed bailed out Bear Stearns; opened wide its discount window to Wall Street; and implemented unprecedented liquidity facilities for the benefit of the marketplace overall. Central banks around the globe executed unparalleled concerted market liquidity operations.

Mish: Technically the Fed bailed out JP Morgan (JPM) not Bear Stearns (BSC). The Fed was very afraid of a derivatives cascade, and the Fed made JP Morgan whole on swaps it was holding on Bear Stearns. At $10 per share its pretty tough to argue Bear Stearns was bailed out. Employees darn near lost everything. However, Noland is correct that Central banks around the globe executed unparalleled concerted market liquidity operations. In that regard, Noland has the key idea correct.

Noland: Here at home, the GSEs’ regulator spoke publicly about Fannie and Freddie having the capacity to add $200 billion of mortgages to their balances sheets, with the possibility of increasing their guarantee business as much as $2 TN this year (certainly including “jumbo” mortgages).

Mish: In practice there is little market for Jumbos. Where there is a market, interest rates are sky high because of credit risk. Jumbo rates are currently 2 points higher than conforming loans, and even higher in distressed areas. Furthermore, jumbos often require a larger down payment to boot. Liquidity on jumbos is more imaginary than real according to my contacts. In addition to the problem in jumbos, there is practically no market for condos. I discussed this situation in Condo Credit Squeeze. That squeeze is going to cause a wave of bankruptcies at regional banks for reasons cited.

Noland: The Federal Home Loan Bank system was given the ok to continue aggressive liquidity injections and balloon its balance sheet in the process. And now (see “GSE Watch” above) we see that the Federal Housing Administration (with its new mandate and $729,550 loan limit) is likely to increase federal government mortgage insurance by as much as $200bn this year, while Washington’s Ginnie Mae is in the midst of a securitization boom.

Mish: It is likely to do no such thing. The reason is the $729,550 loan limit is temporary. And because it expires at the end of the year, and because Fannie (FNM) and Freddie (FRE) have provisions in distressed areas like California, few deals are getting done. Banks are unwilling to do deals because they do not want to get stuck holding paper they cannot sell to Fannie after the end of the year. I have discussed this situation with mortgage brokers and this upping the limit is more show than reality. Perhaps Congress will remove that temporary restriction but as of now, not much is happening. One final point about jumbos: Fannie Mae and Freddie Mac will not refinance loans that are underwater. That alone will put a halt to GSEs rapidly expanding balance sheets on account of jumbos.

Noland: It is, as well, worth noting that JPMorgan Chase expanded assets by $80.7bn during the first quarter (20.7% annualized) to $1.642 TN, with six-month growth of $163.3bn (22.1% annualized). Goldman Sachs expanded its balance sheets by $69.2bn during Q1 (24.7% annualized) to $1.189 TN, with half-year growth of $143.2bn (27.4%). Even Wells Fargo grew assets at an almost 14% pace this past quarter. And we know that Bank Credit overall has expanded at a 12.6% rate over the past 38 weeks. Meanwhile, GSE MBS issuance has been ramped up to a record pace. And let’s not forget the Credit intermediation function now being carried out by the money fund complex – with assets having increased an unprecedented $371bn y-t-d (41.3% annualized) and $900bn over the past 38 weeks (47.7% annualized). It is also worth noting the $184bn y-t-d increase (29% annualized) in foreign “custody” holdings held at the Fed. Sure, the Credit system remains under significant stress, with additional mortgage and corporate Credit deterioration in the offing. But, at least for now, policymakers have successfully stemmed systemic deleveraging. The Credit system is simply not in deflationary collapse mode.

Mish: Technically Noland is correct. However, I ask the question: at what pace did Wells Fargo (WFC), Citigroup (C) , JPMorgan (JPM) etc, expand credit if that credit was marked to market? Is bank credit marked to market expanding or contracting? I suggest it is contracting. One of the ways it is being masked is by hiding garbage in Level 3 assets that were Level 2 assets last quarter. Another way it is being masked is by pretending that the collateral the Fed is swapping with banks and brokerages is somewhere close to full value.

I am quite certain that marked to market credit is contracting. However, I cannot prove it. I talked about this in Night of the Living Fed. "Several people have asked me recently if I have been changing my tune on a Fed bailout. The answer is no. I long ago predicted the Fed would try all sorts of things to stop a deflation threat. But I also have also said, these measures would not work and indeed they haven't. What is happening is the Zombification of Banks, that is exactly what happened to Japan as well."

Zombification does not halt deflation, it prolongs it. That is the main point I believe Noland misses.

Noland: When the Fed and Washington radically altered the rules of U.S. finance last month, they placed in jeopardy huge positions that had been put in place to hedge against and profit from systemic crisis. With the end of “Stage one” arises a major short squeeze in the Credit, equities, and derivatives markets. And when it comes to contemplating the scope and ramifications of today’s “hedging” activities, we’re clearly in Uncharted Waters. It is not beyond reason that a disorderly unwind of “bearish” Credit market positions could incite a mini bout of liquidity, speculation, and Credit excess that exacerbates Global Monetary Instability - while Setting the Backdrop for Stage Two of the Crisis.

Mish: I certainly can agree with the idea of Global Monetary Instability and one reason is counterparty risk on credit default swaps..

Credit Default Swaps

Bloomberg is reporting Credit Swaps Top $62 Trillion in Rush to Hedge Losses.
Credit-default swaps worldwide expanded to cover $62.2 trillion of debt in 2007 as investors rushed to protect against losses triggered by the collapse of the U.S. subprime mortgage market. Contracts outstanding rose 37 percent in the second half of 2007 from $45.5 trillion in the first half, the New York-based International Swaps and Derivatives Association said today.

Using data from the Bank for International Settlements, ISDA estimated the gross market value of all outstanding derivatives contracts is about $9.8 trillion. That would be the amount owed to banks or investors if the contracts were liquidated. Subtracting off-setting payments owed between trading partners, that number would fall to about $2.3 trillion, the group said.
Postponed Is Not Prevented

I agree with Noland that an immediate deflationary collapse was prevented when the Fed bailed out JP Morgan. However, that does not negate the ongoing deterioration of bank balance sheets and a slow deflationary process, just like happened in Japan. Looking ahead, I do not believe the Fed will be able to engineer another huge bailout in swaps when the need arises, which it will.

Citigroup is coming to market with an 8 3/8% preferred. Merrill Lynch announced an 8 5/8% preferred. That capital is being raised for one reason only: They have to, over and over. Credit is rapidly being destroyed and Bernanke cannot prevent it.

Too Big To Bail

Professor Sedacca made some interesting comments in The Moral Hazard Club.
When you add up all the Level II assets by just the eight largest holders in the U.S: JP Morgan (JPM), Citibank (C), Bank of America (BAC), Merrill Lynch (MER), Goldman Sachs (GS), Bear, Morgan Stanley (MS) and Lehman Brothers (LEH), it comes to a staggering $5 trillion - nearly half the size of the economy. Level III assets are nearly $600 billion.

Is the Fed big enough to bail out all these assets? My best guess is probably not, and more firms will fail. If the loans and economy both don’t start performing, these failures will happen more quickly, which is why my firm continues to avoid credit risk. It's not hard to envision an acceleration of this process if the market starts to believe the special loan facilities and other funding processes artificially created to deal with this mess cease to work.

The Fed is slowly becoming the dumping ground for dealers and banks - members of the ‘Moral Hazard Club.’ It's is running out of capital, and quickly.

The problem assets (at least the ones we know about) are way too large for the Fed to completely absorb. It's waiting and hoping the economy and credit markets stabilize before it runs out of ammunition.
What Cannot Be Paid Back Will Default

Debt that cannot be paid back will be defaulted on. And if one believes like I do, that the above chart shows a situation that is too big to bail, then default it is. Although the Fed is willing to break the rules to the point of taking illegal actions (See Fed Uncertainty Principle Corollary Number Four) it would be a mistake to think the Fed would purposely cause hyperinflation.

The reason is simple: Hyperinflation would end the game and whatever power the Fed had. With that backdrop, there are huge constraints on the Fed. One of them is the US dollar. Another one is wages. It does no good to force home prices up if people are out of work and cannot pay the bills.

Besides, the Fed clearly cannot force home prices up. If they could, they would have done so already. Yes, the Fed can cheapen the dollar, but the Fed cannot force banks to lend or force companies to hire. Without jobs and without rising wages, the Fed can lower interest rates to 0% and it will not stop a destruction of credit.

Noland gives far too much credit to the Fed. Postponed Is Not Prevented. It took three lending facilities, interest rates at 2.25%, and a rescue of JP Morgan to stabilize the markets. The cost was zombification of banks. Bernanke will soon have to face option arms, increasing numbers of walk-aways, a commercial real estate implosion, rising unemployment, mounting global tensions, and European displeasure over the Euro.

What will Bernanke do for an encore? Some suggest the answer will be to print. On that score I actually agree. But where will the money go? Will zombified banks be willing to lend? To who? I will address the issue of printing in a followup post.

In the meantime I am sticking with my story right now. The Fed is clearly not printing, and marked to market destruction of capital and credit is happening at a stunning rate. That combination equals deflation regardless of what the price of commodities is.

The mad scramble by some corporations to raise capital, the scramble by others to play "hide and seek" with level 3 assets, and the scramble by virtually everyone to play swap-o-rama with the Fed supposedly just to prove the process works tells the real story. The real story is deflation.

Mike "Mish" Shedlock


Anonymous said...


So, would you describe the situation as "deflation with a weak dollar and rising oil prices"?

I'm happy to call the situation deflation as long as nobody argues that prices for food and energy will fall.

The reason being that they don't have deflation in China. Quite the opposite.

Anonymous said...

"All this to say that rising prices by themselves cannot indicate inflation."

Governments like to define inflation as rising prices. Doing so allows them to inflate the money supply without "inflation", if they can simultaneously keep prices down by crushing worker wages or, for that matter, making price increases disappear through hedonics.

"You must have inflation first, defined as an increase in money supply and/or credit supply, and rising prices must come after."

Inflation is not just an increase in the money supply, it is a net increase in the money supply relative to goods and services.

Rising commodity prices are actually deflationary. As you point out with your cookie argument, if the money supply stays constant while the price of some commodity increases, there will be less money available for other goods and services. Governments inevitably respond to this situation by expanding the money supply to counter the deflationary pressure of rising commodity prices, which leads eventually to overall inflation.

It is this dynamic (at least with energy prices) that can lead to stagflation. Note that stagflation is misleadingly named, as deflation is really the driving factor, with the government trying to expand the money supply to counter a deflationary spiral. The economy is only superficially stagnant. In real dollars it is contracting.

There is more than one thing that can cause prices to rise. Scarcity, whether real or caused by politics, can cause prices to rise even in a deflationary environment. When that happens, everything you need will get more expensive, while everything you don't need will get cheaper. I think we're seeing that today.

Because of all this, I don't find the argument between inflation & deflation to be all that useful. Commodity-driven prices increases are deflationary, which triggers an easy money response from governments. What plays out is a battle involving aspects of both inflation & deflation (though, as I said, I view it as deflation at the core, with an inflationary response). Staglfation confused economists when it happened in the '70s. It doesn't sound like they have any better handle on it today.