1)? Picking up on some comments from last night’s post, why I am I not concerned about counterparty exposure?? Because Wall Street has always been very good at cutting off overleveraged clients in the past.? LTCM was an exception there, and only because Wall Street gave in to their request for secrecy.? Wall Street grabs collateral first, and then lets the client argue to get it back.? The investment banks require a significant margin, and when there is significant concern about getting paid, the lines get pulled.
The real worry here is that the investment banks don’t have good enough risk controls for each other.? Note that Bear’s crisis started when other banks stopped extending credit to Bear, and the fear fed on itself.
I liken the investment banks to long-tail commercial casualty insurers.? No one knows whether the reserves are right.? No one can.? Confidence is a necessary part of the game, which is made easier at lower levels of leverage.? But high leverage and opaqueness are a recipe for disaster when volatility rises.
2) Should you worry about Fed policy?? Yes.? The Fed is steering away from the Scylla of a compromised financial sector, and into the Charybdis of inflation.? As I will point out later, that is already having impacts on the rest of the world.? As for now, there are a few ill-informed writers who say that a negative TIPS yield on the short end is a reason not to buy TIPS.? That might be correct if inflation mean-reverts.? Given the short-term resource scarcity building in our world, I don’t think that is likely.
3) Should you worry about the US Government budget deficit?? A little — oh, and worry about the real deficit, one that puts the wars and other emergency appropriations on-budget, and takes out the excess cash flow from Social Security.? In a macro sense, for the nation as a whole, the impact isn’t that great… but it sends a message to foreign creditors who wonder what the value of the dollars will be when they get paid back.? When they see the Fed running an aggressive monetary policy in the face of rising inflation and a weak dollar, it makes their heads spin, as they contemplate the hard choices the weak dollar forces on them.
4) Could the falling dollar cause a crisis in China?? Maybe.? China is levered to US growth, which is slowing, and their export competitiveness versus the US declines as the dollar declines.? And what will they do with all of those dollar reserves?? Beats me.? After a certain point, additional reserves are useless — it is akin to lending more to an entity that you know is insolvent.? My guess is that the yuan will get revalued after the Olympics, and then the real slowdown will hit China.
5)? What of foreign food riots; are they a worry?? (More, and more.)? A little.? They are a canary in the coal mine.? They point to the short-term scarcity of total resources in our world, which only becomes obvious as a large part of the world tries to develop.? But, one practical thing that it implies is that energy and food prices will remain high for some time.? We are one global market at present, and energy and food prices are interlinked through the energy and fertilizer costs of farmers, and through stupid ideas like corn-based ethanol.
6) What of flat crude oil? production?? Yes, worry.? As I have said before, the government oil companies of OPEC countries control most of the supply, but they don’t always manage their resources as well as a capitalistic oil company.? Mexico, Venezuela, and Russia have declining production, to name a few.? The Saudis may not want to produce more, because they don’t know what to do with all the US dollar reserves that they have today.? Or maybe they can’t…
7) Worry about falling housing prices?? Yes.? The problems in the housing market stem from overbuilding.? There are too many houses chasing too few solvent borrowers.? This will eventually affect prime mortgages, because declines of 15-20% in housing prices mean that many prime loans would be underwater in a sale.? Remember, an underwater loan becomes a default after a negative life event — unemployment, death, disability, divorce, and uninsured disaster.
Before all of this is done, one of the major mortgage insurers should fail.? We aren’t there yet.
8 ) What of falling residential real estate prices in foreign countries? Yes, worry.? For Europe, it could lead to the end of the Euro, as countries needing looser monetary policies get tempted to abandon the Euro.? If the Euro’s existence becomes questioned, it will be a systemic risk to the world.
9) What of credit card delinquencies?? Yes, worry.? It shows that total financial stress on the consumer is high, particularly when added to the problems in mortgage and home equity loans.
10) Should you worry about bank solvency?? A little.? All of these previously described stresses have some bearing on the ability of the banking system to make good on their obligations.? Be aware that the FDIC was designed to handle sporadic losses, not systemic crises.? The odds of these problems affecting the depositary financials is still low, but the protective measures will not be capable of dealing with the worst case scenario, should it arise.
Perhaps I have more to worry about.? As I close up here, I haven’t mentioned the PBGC, Medicare, and a variety of other problems.? But, I have to call it a night, and symmetry with last night’s piece is worth a little to me.
Re #7: Triad Guaranty is considering going into run-off, so this condition may pan out.
I generally tend to agree with you, and our general outlook is similar, but I have to disagree with you on the TIPS. If you have to buy bonds, a negative yield is not a reason not to buy TIPS, but in my view it is a sign you shouldn’t be buying bonds at all if you can help it.
And since in the next two sentences, you suggest that resource scarcity is the reason you think inflation will not mean-revert, I would suggest that buying a basket of commodities instead would probably work better.
I do actually do own some munis right now, and I think you can make a case for them in a taxable account, at least in the short term.
Excellent post David
Related to the counterparty issue, is there any way for outsiders to know how much the BSC and JPM derivative positions might offset one another (either because they were direct counterparties or because they held the opposite sides of similar positions with third parties)? I realize that any offset may not fix the system-wide issues, but any way to tell how material it is for these two?
Hi David,
Hope things are going well.
Interesting comment about the Euro and various European real estate markets. Obviously we are a long ways away from countries leaving the Euro, and I would imagine that there would be tremendous political pressure exercised to keep the Euro zone together, e.g. by France on Spain.
As a thought experiment though, what are the implications if nations like Spain and Italy leave? I can imagine a flight to the USD, but that might also be very short-lived, as the remaining EUR nations would presumably have a higher level of commitment to fighting inflation, in the eyes of the market.
Interested in your opinion, or those of other readers.
Steve
1. David is far more comfortable with this risk than I am. I think that the extent of the credit bubble brings into question whether the brokers’ historical diligence in protecting the franchise is warranted in the current cycle. LTCM clearly displayed that when greed and overconfidence are combined, the brokers will over reach. Greenspan recently argued that the CDS “problem” was due to a lack of processing. While I think that is a laughable statement by a tragic figure (in the Greek sense), it does highlight that the big banks were manufacturing these things so rapidly that to believe that they have any real comprehension of their total risk exposure is a giant leap in my opinion.
5. I think the food problem is huge. I know from my circles, most people bitched and complained about higher energy costs over the past couple of years. However, the sense of indignation about inflation has exploded in recent months with the dramatic increase in food prices. The initial moves to protectionism by some countries highlights the real risk I see – the political reality of food shortages is protectionism plain and simple. Is it wise to believe that politicians will stick with a politically abstract concept such as “free trade” when there are food shortages in their countries? Once the protectionism fuse is lit, it can get out of hand.
Jim Rogers has spoken (as usual) eloquently about the likely long term demise of the Euro. I personally believe that the risk of some countries leaving is significant over the next few years – like Italy and Spain. I think it will be a global trend in the break down of the fiat monetary system. If we are in a Kondratieff up cycle in commodity prices, this would likely result in a return to hard money in some form as the fiat system breaks down.
A few thoughts of mine, David.
(2) It remains beyond me why anybody would want to invest in TIPs – ever. They are created by an entity that also creates the inflation that the TIPs are supposed to protect you from. On top of that, Said entity continually and deliberately understates the level of inflation. Forget about your investment beating inflation, how can one just break even with the crummy things? From my view, they’re a complete joke.
(3) With respect to the spinning heads of foreign investors, I assume you’re referring strictly to the private sectors because their respective central banks are all part of the G7/Tri-lateral Commission cabal that fomented the world-wide real estate mess. There are no spinning heads in that rotten little clique.