The Underlying Credit Crisis's Recent Effect on Market Prices

Once again, Doug Noland at Prudent Bear has come up with an answer I was looking for.

In this post from August 8, he offers one explanation for our current strange market conjuncture.

Commodity prices for things like food, petroleum, and oil ran up to record levels up until about mid-July for reasons that are unclear, but that economists have described as resulting from a mixture of:

1. Increased worldwide demand along with supply problems; and/or

2. Speculation that the US dollar would collapse.

In mid-July, along came the Freddie and Fannie problems (see this post for an explanation of the origin of their predicament, and this one for the latest dire news).

Then Treasury Secretary Henry Paulson issued this press release regarding the Treasury's intention to bail out Freddie and Fannie should problems arise.

We also learned of the Treasury's intention to bail out the FDIC (the government entity that guarantees some of your deposits at the bank) in case of need. (See this TickerForum.org entry explaining the FDIC situation, which forum, by the way, proves that ordinary citizens are not as dumb as some would think.)

These two government announcements blow both hot and cold. On the one hand, they reassure Freddie and Fannie bond holders and FDIC insureds that their investments will not disappear. This should be good news for the economy and for the market, and therefore for future demand for commodities.

On the other hand, they scream to market players that the US Government officials are really worried about Freddie, Fannie, and the banks. So what should be good news for market players and for future demand for commodities turns into a bad omen for the economy and thus for those same commodity prices.

Meanwhile, the signs of a recession are already evident. (See this American Institute for Economic Research post for the stats.)

So it would make sense that commodity prices would start to reverse big-time, which in fact they did in mid-July.

But--and here's the odd part--the stock market took a simultaneous leap upward, as did the dollar, counterintuitive movements under the circumstances.

Does this mean that the coming recession is somehow calming stock market nerves and inflation hawk fears? Perhaps so, because it might cause "inflation" (read "CPI price increase") to disappear just as the Fed predicted; and it will therefore allow the Fed not to raise rates to curtail such "inflation" (read "CPI price increases"). Low Fed rates mean, in the minds of some market players, that money will be available and things will improve.

BUT: I can't believe that such recessionary momentum will avert real inflation as that term is used in academic economics (read "excess money and credit"--see this post for an explanation of this word's definition problem), even though it may put a brake on CPI price levels.

I believe that real inflation will increase because:

The Fed and Treasury are taking unprecedented measures to avoid catastrophe, i.e. they have once again succumbed to the temptation to use the printing press to pay the monetary system's way out of trouble. They will use Treasury funds to bail out Freddie, Fannie, the FDIC, and--through the Fed's newly seized lending powers--any major failing commercial banks and other financial institutions. And these operations will be carried out on an unprecedented scale.

Remember, real inflation means more dollars running around than is necessary in a balanced monetary system. It means that you will be paying too many dollars for a particular thing, no matter whether the actual price of that thing rises, or whether the price just stays the same when it should in fact be falling in a deflationary market.

This also means that gold prices expressed in dollars (and perhaps other commodity prices as well) will not tend to decrease in the long run, because gold is a hedge against real inflation.

Doug Noland puts my theory into more appropriate financialese in his article. He offers a plausible explanation of how the speculative community has functioned under these unusual circumstances.

I particularly liked these two ideas:

"[I]t is not the nature of dislocated markets to let fundamentals get in the way of price movement. Markets, after all, live on fear and greed."

He is referring here to speculative markets, the ones he credits with causing both the run-up in commodity prices and the recent crashing of same.

And this one:

"The unwind[ing] of bearish speculations and hedges would be a most problematic market development, unleashing a final bout of speculative excess and disorder that would set the stage for a major market crisis."

He is talking about the credit maladjustments that are taking place behind the scenes and that most of us never hear about. See this post for a description of these.

This should all play out by the end of this year. Hold onto your hats.

Freddie & Fannie: Off With Their Heads

Cato usually gets it right, and William Poole has done it again.

He tells the story of Freddie and Fannie like it is in this latest article appearing recently in the New York Times. His recommendation: Get rid of 'em.


[Thanks to VictorianWeb.org for the image.]

He's right: Freddie and Fannie have been government entities from the start, even though they were "privatized." The federal guarantee simply went underground for those years.

Just the other day, private investors of Freddie and Fannie "convinced" Congress to admit that the guarantee was valid and made them sign on the dotted line--with your and my "pen" (read "money"), of course.

So this is the denouement of my recent blog post. Therein, I described an example, among many, of government intervention run amuck, where good intentions have dire consequences--a frequent occurrence where government is involved.

In this case, Freddie and Fannie have, in essence, been nationalized.

Who said the US was not a socialist country?

Here's another viewpoint by Gerald P. O'Driscoll, Jr., also of Cato.

Odd Ducks Freddie and Fannie: Example No. 17 of Government Intervention Run Amuck

"...[T]he vast majority of mortgage securities sold in the last six months" were offered by Fannie Mae and Freddie Mac, semi-public enterprises that are neither ducks nor geese, human nor animal; i.e. neither totally public nor private corporate entities. (Source.)


[Image thanks to Patricia Piccinini, an Australian sculptress, through About.com]

The Legislature created them in the 1930s and 1970s in order to help people of modest means acquire their own home; but--and this is typical of government well-meaning ventures of this type--the latest mortgage crisis has revealed that many of the people who obtained loans over the last four or five years should never have passed through the financial screening process from a banking point of view.

Yet still the impractical goal holds the minds and wills of our legislators today:

"'I want these companies to help with affordable housing, to help low-income families get loans and to help clean up this subprime mess,' said Representative Barney Frank, a Massachusetts Democrat and the chairman of the House Financial Services Committee. 'Otherwise, why should they exist?'" (Source.)

Excellent question, especially when one realizes that Freddie and Fannie were two of the originators of "this subprime mess" (among others).

Both organisms get most of their funding from the public sale of shares, but the line to the government purse is in place, "just in case." This dual line of financing is at once their saving grace and their Achilles Heel, because management has to please two benefactors.

Unfortunately, however, there is a golden rule that says, “No one can serve two masters, because either he will hate one and love the other, or be loyal to one and despise the other." (Luke 16:13).

In trying to please both, Freddie and Fannie have take on a precarious amount of leverage (i.e. they have borrowed way over their credit limit). The market allowed them to do this because of their seeming immunity to the effects of negative market forces, which immunity springs from their position as semi-governmental agencies. The government allowed them to do this because of their above-mentioned goal.

Both companies are about to face a crisis based upon this double role they have been trying to play. They may surmount it; but to do so they may have to dip into our tax money if their regular private sources of capital dry up.

I would hate to be in their CEOs' shoes over the next few months.

Here are two easy-to-read links that will inform you of the situation:

This Wall Street Journal article from today's paper; and

This nice graphic from an earlier New York Times piece.

There's another golden rule that we the voting public may learn in due course: When governments intervene in the marketplace, unintended forces will evolve, and they often run amuck of even the best of intentions.

Fannie About To Fall on It?

[Thanks to Pyzam.com for the image.]

Both Fannie Mae and Freddie Mac are way over their head in potential debt at this point. The legislators have seen fit to burden them with saving the country from the bursting mortgage bubble (actually a monetary bubble in my opinion).

The problem is that we, the taxpayers, will be called upon to cushion that fall, because the only outcome of a falling Fannie would be for our government to take her over and foot us with the bill.

See this great graphic at the New York Times, linked through this informative article by Charles Duhigg, linked through this great blog post at Peter Viles's LA Land blog at the LA Times.

And like dominoes, Freddie Mac, Sallie Mae (student loans), and the Federal Housing Administration are not far behind; then who knows, maybe even the FDIC (Federal Deposit Insurance Corporation) and the PBGC (Pension Benefit Guarantee Corporation)--but whoa, let's not panic yet.

As econonomists say, it is always easier to spend money when it's not your own. Legislators are not immune to this economic rule.

Oh, So That's Where They're Getting the Mortgage Money

If you're like me, you've been wondering: Okay, if credit markets have seized up, where are these new mortgages and refinancing deals getting the money? Why isn't Countrywide going bankrupt? I know they've received a $2 billion infusion from Bank of America, but that can't be enough.

The answer is, it's coming indirectly from you and me. Our tax dollars have just become collateral behind newly created bonds that the government has made available to the likes of Countrywide.


[Thanks to solomonsrose.com for the image.]

When companies like Countrywide found in August that they could no longer continue their operations for lack of funds to borrow, the government got busy trying to find a way to unlock the situation, and they found one. The solution they hit upon is to open the wallets of the Federal Home Loan Banks and of two semi-government entities, Freddie Mac and Fannie Mae.

These banks and mortgage institutions are basically government-guaranteed semi-private companies that deal in mortgage loans. Heretofore reticent lenders believe that the government (i.e. your tax dollars) are behind these companies. This means that these entities will manage to sell bonds to these reticent lenders, whereas other market operators won't be able to. With the cash in hand from these bond sales, the government can offer hard-to-find money to the real estate lenders who need it, backed by your and my guarantee. Without this deal, Countrywide might be dead by now.

This brings us to the question of whether or not the government should be saving the hind end of those like Countrywide who made bad business decisions. Personally, I think not, because it creates what economists call "moral hazard." In other words, the government is acting on what we believe to be good intentions (saving the general economy), when in fact we all might be better off if they just let Countrywide (and numerous others) bite the bullet (perhaps the economy could withstand it, and even should withstand it).

But the government does not like to be in power when things go awry; so they fix it, get the credit for fixing it, and then allow a changing of the guard, so that the next government can take the blame for the more long-term fallout (potentially: inflation through excessive credit creation, the survival of unsavory business practices like the poor-quality lending that went on up until 2007 and the housing boom/bust, and a flight from the dollar).

The details are explained in my previous post, and in this article at Bloomberg by James Tyson and Jody Shenn.

Other problems can also arise from two different sources: First of all, the semi-governmental companies who are doing the lending were themselves already overextended before this new lending began. All of them have been readjusting their accounting and books to correct severe past mistakes, and are only recently back in the clear (or at least we believe they are).

Secondly, if the new loans default, the only remedy will be for the government to spend your tax dollars to cover the hole.

Opinions differ about the degree of risk involved; but personally, I hate it when someone promises to pay their debts with my money, don't you?