Debt and Sweat

Ordinarily, when I sit down top blog, I know what I want to write.  That’s not true now.  Yes, I could do a few book reviews.  I have six books read, and ready to go, but given the volatility of the markets, I feel I have to say something about the current activity.

I am a strong believer that there are few free lunches.  If there are simple policies that will easily produce prosperity, they would likely have been done by now.

As I have commented before, what we are seeing now is a shift in debt from the banks to the government.  Banks get capital, the government gets debt, and the money for the debt comes from three places: taxpayers, foreign lenders (central banks, probably) and perhaps at some point, the Federal Reserve could buy it (whether they monetize it or not is another question).  As jck noted yesterday, this has led to a selloff in Treasuries.  (Interesting that it happened on a day when the cash markets were closed, but the futures markets were open.  The reaction of cash bond market today is similar to that which the futures market exprerienced yesterday.)

Which brings me to my first point.  Today, when the rally in the fixed income markets gets reported (the markets again, were closed yesterday, you will likely hear that spreads rallied sharply.  But watch for the discussion of yields and prices (if there is any).  It’s quite possible that yields rise from Friday to the close of business today.

Second point, today $250 billion of the $700 billion got used on nine big/critical banks.  Now, this may have been somewhat coercive to some of the nine banks; as was said at Bloomberg:

None of banks getting government money was given a choice about it, said one of the people familiar with the plans. All of the banks involved will have to submit to compensation restrictions, said the person.

The government will also guarantee the banks’ newly issued senior unsecured debt, making it easier for them to refinance their liabilities, the person said.

Possibly the following message was delivered, “Be a good boy and get in line.  This is good for the nation, and we won’t be around for a decade.  You want to be a survivor, right?  You want friendly regulators when we review the levels at which you are marking your illiquid assets?  We thought so.  Sign here.”  (No surprise that Goldman then applies for a NY State, rather than Federal bank charter.  State regulation, particularly when you are a local champion, is much more flexible.  Just ask AIG. ;) )

Though this leads to a short-term bounce in bank share prices, the long term effects are less clear, which brings me to my third point.  It’s one thing to bolster their balance sheets.  It is another to get them to lend, particularly in the bear phase of the credit cycle.  Also, as leverage comes down, and it will come down, so will profitability at the investment banks, and probably other banks as well.  Securitization will be less common, eliminating hidden leverage that allowed for less capital.

The same thing is going on in Europe, though they actually think about how they might pay for the bailouts.  In the UK, it pushes the national debt to GDP ratio to 100%.  As it gets closer to 150%, the international debt markets usually start to choke.  We have traded bank credit risk for national solvency risk at the margin.  Maybe that will be different here, if only government creditworthiness is perceived to be safe.  It is a “new era,” right? :(

I find it interesting that Barclays is refusing help.  Either the UK regulators aren’t so coercive as those in the US, or Barclays is not as levered as I thought.  Or, it could be hubris on the part of Barclays’ management team.

Even Japan is getting into the act, though these measures seem so weak that I wonder why they would bother.  The government and Bank of Japan stop selling bank shares, and allow companies to buy shares back more aggressively.  That may push share prices up in the short run, but it substitutes debt for equity, which shouldn’t have much of a long-term impact.

On the Central Banking Front

Now, with the seemingly limitless amount of US liquidity being to the short end of the US money markets, you would think that we would get a bigger move than we have gotten so far. This will take time, but watch the yield as well as the spread.  Also remember that LIBOR has become somewhat of a fiction at present.  There many quotes, but not so many loans to validate the quotes.

What is being done that is new?

  • TAF expanded to $900 billion.
  • New commerical paper program where the Fed backstops the A-1/P-1/F1 CP market, including ABCP.  Terms hereFAQ here.  This is big, and it is much easier to start such a program than to end it.  It is difficult to end any program where credit is granted on less than commercial terms.  My guess is that it will be extended past its April 30th, 2009 planned expiry date.
  • Swap agreements allowing unlimited dollar liquidity to foreign entities through agreements with their central banks.
  • The Fed can now pay interest on reserve balances held at the Fed, which allows them to increase their balance sheet significantly.  In one sense, they become the Fed funds market.

What is not new is the idea that all we have to do is restore confidence, and everything will be fine.  No, we have to delever, and the US Gowernment is included in the list of those that need to delever.  There is no national reform going on here, but merely a shifting of obligations from private to public hands.

For investors:

For those that are investors, the biggest bounces tend to occur during depressionary conditions.  I would not get overly excited about the rally yesterday.  As John Authers at the FT points out, given the extreme changes being made, there should have been a bounce.  The question is whether it will persist.  I was a net seller into the rally toward the end of the day.  I think we have more troubles ahead.  Two things to watch:

  • LIBOR, CP yields and the TED spread. (The short end)
  • Overall yields of medium-to-long Treasuries and other long-dated debt.  (The long end.)

I expect yields to rise, even if some spread relationships fall.  The added financing needed by the US government is large.  Let us see where Treasury buyers have interest.

There are elements of this that remind me of my The US Dollar and the Five Stages of Grieving piece. This is for two reasons: first, we are asking foreign entities to hold more dollar claims at a time when they are stuffed full of them.  Second, this phase of the credit crisis reminds me of the “bargaining” phase of the five stages of grieving.  We are past a long denial phase, and the anger continues, but now we bargain that these proposals will allow us to escape the pain that comes from delevering.

I’m skeptical, but I hope that I am wrong, lest we get to the fourth stage “depression,” before we finally reach “acceptance.”  As it is, I am looking for companies with blaance sheets strong enough to survive the worst.  That is my task for the next few days.


  • Albert says:

    As always, a very interesting post, David. If you’re having trouble with coming up with a topic, how about your thoughts on the recent turmoil in insurance stocks — I find your commentary there particularly insightful.


  • Estragon says:

    DM – “There is no national reform going on here, but merely a shifting of obligations from private to public hands

    I suspect this is the single most important point. There’s no reason to suspect public hands will be any less tempted by the (temporarily) virtuous cycle of credit and asset prices than private, and lots of reasons to suspect public hands will be even more so. Bubble 3.0?

  • tv says:

    This is one of your best pieces David.

  • Jim Rogers and Marc Faber have been discussing the last bubble to burst will be US Treasuries… we have been chatting on this idea…as well as the US dollar… What is your opinion on both…and more so..what can we do to protect ourselves…Please let us know..thanks

  • matt says:

    Mr. Merkel:

    I am under the impression that the current account deficit is expected to contract over the next 12 months. Doesn’t a large part of America’s financing come from surplus countries who are trying to control their currencies. What happens when their surpluses diminish? Will there be less demand for treasuries at a time when record amounts are being issued? Will the Federal Reserve have to fill in the blanks?


  • B Reilly says:

    With regards to Barclays and the UK not being as coercive:

    My understanding (by way of FT Alphaville) is that banks were told to get their capital up to the lower of 9%, and an amount that with stress-test derived impairments would still be above a 7%.
    For example, it looks like the RBS stress test showed a far greater potential for impairments, so have had to raise more capital than Barclays.

    What they weren’t told is that it must come from the government. They were told they could do it any way they wanted, but that the government was willing to purchase preference shares and under-write equity placements if they couldn’t get it from the private sector.

    This appears to me to be a far better solution than we’ve seen in the US. I still don’t understand why (apart from Paulson being ex-GS) the US government are getting a far lower rate of interest on their preference shares than Warren Buffett.

  • “I still don’t understand why (apart from Paulson being ex-GS) the US government are getting a far lower rate of interest on their preference shares than Warren Buffett.”

    Had the government asked for Warren Buffett-like terms, only the banks that really needed the capital would have taken it from the government; that would have defeated the purpose of the government’s plan, which was to recapitalize key banks without stigmatizing the ones that really need it.

  • UrbanDigs says:


    Great piece! I have been discussing the SHOR THE LONG END OF THE CURVE trade on for about 4-5 months now.

    I devoted an entire discussion to it yesterday at NOON, and only today found your article:

    3 reasons why the long end could see higher yields in coming years, poppiong the 20 yr secular bull market in treasuries:

    1) MASSIVE MASSIVE issuance
    2) If credit quality/worthiness of USA gets put into question by the world; forget a downgrade of our AAA rating, I refer to the tradable markets questioning the credit quality..Similar to how the markets downgraded the bond insurers in late 2007, about 6 months before the rating agencies ever officially downgraded them.
    3) If our foreign funders decide not to play ball or decide to sell, stop buying our treasuries!

    This story is not over!

  • B Reilly says:


    Set a higher required capital level and if they want to get it from the private sector I don’t see what the problem is? Surely the issue is that a) banks haven’t been admitting the problems and b) nobody in the private sector wants to put in serious amounts of capital.

  • UrbanDigs – this is the major story ignored by most of the financial press. Like all bubbles, the one in Treasury debt will persist until it becomes impossible for the US Treasury to continue to sell the debt in order to pay interest and principal on existing debt. At that point, nothing will work. Not sure what would serve as a hedge against that… we can short, but what will we get in return at settlement?

    Matt – the current account deficit should decrease, though the increase in financing for the bailout may swamp improvements from net exports.

    Albert, TV – thanks. Some pieces flow… this one mostly did, though I fell asleep in the middle of writing it. I’ll try to get out a post on insurance stocks soon.

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