Fed Credit: The Latest And Perhaps Next-To-Last Bubble

I can't claim to be the origin of the Fed Credit Bubble idea, because it occurred to me as I read a fantastic piece by one of my favorite analysts, Doug Noland of Prudent Bear.

We've just come out of a huge bubble that consisted of inflated real estate investment and speculative finance credit. The bubble burst and the market began to correct itself, menacing to take a lot of nations' economies with it.

The reaction of our economic leaders was and continues to be to try to maintain a minimum of stability by propping up the various players on the world financial stage as they began to totter, one by one: first the real estate sector with aid to Freddie Mac and Fannie Mae, then the banking sector by saving Bear Stearns and loans to other institutions, then the insurance sector by bailing out AIG, then the automobile sector with handouts to GM and Chrysler, more money and loans to the banking and real estate sectors, more to AIG, recently some more to auto supply companies, more to AIG, and now the credit card and other large ticket item credit sector--an endless list, it would seem.

The central banks of the world, to a varying degree, are performing their propping-up role as the ultimate insurance company, the lender of last resort; and the US Fed, given the universal role of the US dollar as reserve currency, is the one that will be the buck-stops-here Last Lender of All Last Resorts.

As Noland points out, however:

"Our federal government has set a course to issue Trillions of Treasury securities and guarantee multi-Trillions more of private-sector debt. The Federal Reserve has set its own course to balloon its liabilities as it acquires Trillions of securities. After witnessing the disastrous financial and economic distortions wrought from Trillions of Wall Street Credit inflation (securities issuance), [it is possible that] the Treasury and Federal Reserve have set a mutual course that will destroy their creditworthiness - just as Wall Street finance destroyed theirs."

He's saying that the Fed is going to create the Bubble of All Bubbles, right there in its own house.


[Thanks to Bouncehousesnow.com for the picture]

But just how much air can the US Fed balance sheet withstand, without bursting its own skin? The inflationist central banks are acting on the assumption that they can right the "market failure" (see PS below) through this "temporary" remedy, that the market cannot right itself alone, or at least not without disastrous consequences. But aren't they trying to add air to an already burst bubble?

Instead of curing the problem, they are acting contrary to the market's instinctive corrective hiatus and will end up distorting events even further. How can arbitrarily selective bailouts and the forced financing of government projects--projects that otherwise most likely would not have been financed--do anything except further distort the admittedly slow and cumbersome but essential market reevaluation process?

"[T]he seductive part of [the optimistic] view is that unprecedented policy measures may actually be able to somewhat rekindle an artificial boom – perhaps enough even to appear to stabilize the system. But seeming 'stabilization' will be in response to massive Washington stimulus and market intervention – and will be dependent upon ongoing massive government stimulus and intervention. It’s called a debt trap. The Great Hyman Minsky would view it as the ultimate 'Ponzi Finance.'”

Precisely. The ultimate Bubble, created by those who are supposed to help us avoid them altogether.

So how will the world react when this latest bubble bursts? At some point, investors looking to preserve the value of their wealth will realize that there is no investment denominated in an existing national currency that does the trick, and they'll turn to gold, always the last fat lady to sing before the curtain falls and reality sets back in. (By now, you've figured out that I'm somewhat of a gold bug.)

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PS: We have no market failure here. On the contrary, the market is functioning perfectly. It is waiting to discover the real price of toxic assets, if only the government and its allies would let it. Rather, it is the market players who have failed us, and more specifically those who would pretend to manage our monetary units. For more on the true source of the real estate and credit bubbles, find yourselves a copy of the March 16, 2009 Research Reports out of the American Institute for Economic Research (annual subscription), and read the piece by Walter M. Cadette entitled "Greenspan the Goat."

Another Behind-the-Scenes Wall Street Bailout

Most people don't know it, but the financial world almost stopped turning in 1998 when a huge hedge fund called LTCM (Long-Term Capital Management) "lost $4.6 billion in less than four months and became the most prominent example of the risk potential in the hedge fund industry," according to Wikipedia. ($4.6 billion in 1998 is the equivalent of $5.79 billion in today's dollars. Source)

Fearing devastating repercussions at the time, the Central Bank of New York got involved, and a "bail out" arrangement ensued whereby several large financial houses agreed to back the bad loans.

Where have I heard before that history always repeats itself? We now have a similar situation happening today, only the present-day LTCM is Bear Stearns. This time, we're talking about $3.2 billion at risk, guaranteed by Bear Stearns itself. The quasi-authoritarian intermediary this time is Blackstone, whose two principals are a former classmate of Bush at Yale and a former US secretary of commerce, the same Blackstone in which China just invested mucho dollars. (Aside: Has anyone investigated the potential conflict of interest with this kind of mixed-bedfellow deal? But I digress.)

So far, this is well within Bear Stearn's means, so panic hasn't started yet. But the jitters have begun in earnest, as players watch the other hedge funds that have highly leveraged portfolios as well. There may be a steady flow of money coming into the country even as the big players unwind their unbalanced dollar portfolios, but panic is a funny thing: it doesn't always listen to reason and won't always wait for a level-headed solution to an immediate sticky problem.


[Thanks to number-10.gov.uk for the image.]

The problem irking everyone is that the global financial markets now flow so easily from one country to another, and from one sector to another, and the sums are so huge, that any sign of instability could create a panic environment. The US deficit is supported by billions of investment from foreigners, and these investors have already begun to diversify away from the US dollar as it loses value on the international market. (It has gone from $1 = euro 1.20 to $1.00 = euro 0.74 over the last 6.5 years.)

Whether or not this situation is actually going to threaten America's financial stability is not a sure bet. There are those who deny that the LTCM matter was life-threatening, ironically among them the former chief of Bear Stearns himself. But there is a consensus that there exists an unsavory level of leveraged risk-taking at the present time.

I'm all for risk taking, assuming that it will be the risk-takers who pay the piper, and not the rest of us. Unfortunately, as I have explained in previous posts like this one, I believe the central banks are responsible for this situation and that we are all paying for it through diversion of real wealth to such lottery games, due to the uncertainty of the financial times we live in.

For more on these events, read this article at The Economist, this one by Michael Panzner at SeekingAlpha.com, and this one by Jody Shenn and Bradley Keoun at Bloomberg.

This is definitely something we all should be following closely.

Hedge Fund Woes Finally Hitting the Fan?

Peter Viles, blogger at the LA Times, writes today about the saber rattling going on among a few of the big bullies on Wall Street, most recently Bear Stearns, JP Morgan, Deutsche Bank, and Merrill Lynch. It seems that those risky subprime mortgage financing vehicles that were all the rage until 2006 are coming back to haunt the current owners.

This touches on a domain that central bankers have been jawboning about for months now, the credit derivative and securitization market imbalances that are becoming dangerously out of whack. They know--and Wall Street bankers must know (even if they don't act like it)--that there are factors at work in the global economy that have created huge waves of what the financial world calls "liquidity," or large holdings of spending and investing money, if you will.

You have only to follow the recent buzz around the newer Basel II accord to see that the international banking community is aware of the problem; however, just like hyper-gifted children, they sometimes have a hard time disciplining themselves. This lack of self-discipline is creating much central banker angst, because the central bankers are supposed to be supervising banking activity. If they fail to do so, their respective governments will either have to mop up the mess (i.e. bail somebody out) or take blame for the devastating consequences that are potentially very bad for the dollar (not that anyone seems to care anymore) and horrible for the US economy.

The nature of the factors behind this liquidity has provoked much speculation, but as yet there is no consensus. The US banking-overseer head honcho, Ben Bernanke, blames it on what he has called a "global savings glut" (as though there could exist an excess of savings). Personally, I suspect that the central bankers themselves are at least partially responsible, but I'm not so sure they would agree. (See this previous post in rebuttal to a couple of Fed researchers who tried to pass the buck.)

But whatever the cause, the fact is that trillions of dollars are currently roving the earth looking for a roost, and everywhere they have chosen to alight they have caused bubbles, to wit the 2000 dot.com event and more recently the 2002-2006 housing boom. Other more sustained and recent bubbles can be found in the current securitizations and derivatives markets, where high-rollers bet on the odds of certain financial events happening. (See my article at Prudentbear.com for a discussion of the process.) Until recently, much of this activity centered around the subprime mortgage market, which as we all know is now turning very sour.


[Thanks to ironicconsumer.com for the photo.]

Now, if these particular bubbles burst, they will smack the face of some pretty embarrassed Wall Street fellows who, up until now, have been riding pretty high, making trillions of high-roller subprime risk-taking profits. Who are these gamblers? The same hedge fund managers about whom Peter Viles blogs.

But it goes beyond a mere squabble among bankers. If these bubbles burst, the amount of money involved is so large that the mess could be substantial. This situation must have every central banker on the edge of his seat, wondering whether he will be able to juggle this new event, on top of the rest of the problems of the economy that they are supposed to manage. (See my earlier post for more.)

I wouldn't want to be in their shoes--and I certainly won't be buying hedge fund stock any time soon. (Yes, they're trying to pass the buck, too.)

The Second Wave of Subprime Victims

I've been complaining on behalf of those innocent borrowers, now foreclosed upon, whom the mortgage industry has chewed up and spit out as a result of the recent turmoil in the housing industry. My fury has always been directed at the "buck stops here" top of the line, which is the US Federal Reserve and the other central banks of this world who have been pumping damaging excess liquidity into the system, under the mistaken impression that they are "controlling" prices and employment. (More on that later when I attack Fed Governor Frederic S. Mishkin for some really stupid and conflicting statements.)

Now we have the second wave of victims: Those who bought the securities that funded the housing boom. (For a good explanation of the transactions behind the issuance of these securities, see my Prudent Bear article.)

Some of these buyers of bonds are ordinary Joes and Janes and pension managers who are now looking for a scapegoat. "It's those nasty big banks who put the bond packages together," they are yelling in unison, in the hopes that Congress will "do something about it." Everybody hates the Big Bad Banks. (See this Bloomberg article by Christine Richard.)

This crying-to-papa is a very dangerous trend. This is how Big Government pulls your heart strings and gets you to vote for more regulation of industry, which regulations actually are counterproductive. They eliminate competition by squashing the smaller players in any given industrial field and create monoliths like Bear Stearns, JP Morgan Chase, Credit Suisse and Morgan Stanley.


[Thanks to safaritaxidermy.co.za for the image.]

That said, most of the damage done in the subprime market was done by players who are outside of the Fed's jurisdiction. Please keep in mind that the banks and mortgage companies are just the jackals of this world doing what comes naturally: eating up the weak. The Big Bad Wolf in Sheep's Clothing is the Government itself through its collaborator, the Federal Reserve. It is they who proclaim to the world that they are in control of inflation (Mishkin uses the catchy erudite-economist-sounding phrase "nominal anchor." I'll address this speech soon.) It is they who say that this is not a housing bubble caused by their own loose monetary policy. (See my post back in September of 2006 when their researchers declared just that.) It is they who deny any and all responsibility for the damages now being suffered by the little people. And it is they who stand by and watch the massacre while continuing to deny their hand in it.

A pox on 'em.