Monday, June 30, 2008

Signs of the Economic Apocalypse, 6-30-08


Gold closed at 931.30 dollars an ounce Friday, up 3.1% from $903.70 for the week. The dollar closed at 0.6332 euros Friday, down 1.2% from 0.6408 at the close of the previous Friday. That put the euro at 1.5793 dollars compared to 1.5606 the week before. Gold in euros would be 589.69 euros an ounce, up 1.8% from 579.07 at the close of the previous week. Oil closed at 140.21 dollars a barrel Friday, up 3.9% from $134.90 for the week. Oil in euros would be 88.78 euros a barrel, up 2.7% from 86.44 at the close of the Friday before. The gold/oil ratio closed at 6.64 Friday, down 0.9% from 6.70 for the week. In U.S. stocks, the Dow closed at 11,346.51 Friday, down 4.4% from 11,842.69 at the close of the previous Friday. The NASDAQ closed at 2,315.63 Friday, down 3.9% from 2,406.09 at the close of the week before. In U.S. interest rates, the yield on the ten-year U.S. Treasury note closed at 3.97%, down 20 basis points from 4.17 for the week.

Since this was the last week of the second quarter, let’s look at the quarterly and year-to-date numbers. Gold fell 0.6% from 936.50 dollars an ounce for the quarter and rose 10.5% from 842.70 for the year. The dollar rose less than 0.1% from 0.6330 euros for the quarter and fell 7.3% from 0.6795 for the year. Gold in euros fell 0.5% from 592.80 an ounce for the quarter and rose 3.0% from 572.64 for the year. Oil rose 33.4% from 105.08 dollars a barrel for the quarter and 45.8% from 96.16 for the year. Oil in euros rose 33.5% from 66.51 euros a barrel for the quarter and 35.9% from 65.34 for the year. The gold/oil ratio fell 34.2% from 8.91 for the quarter and 31.9% from 8.76 for the year. In U.S. stocks, the Dow fell 7.6% from 12,216.40 for the quarter and 17.8% from 13,365.87 for the year. The NASDAQ rose 2.4% from 2,261.18 for the quarter and fell 15.5% from 2,674.46 for the year. In U.S. interest rates the yield on the ten-year U.S. T-note rose 53 basis points from 3.44% for the quarter and fell ten basis points from 4.07% for the year.

Here are some charts tracking changes back through 2005:

Another scary week with oil rising 4% in dollars and the Dow falling almost four and a half percent. As Nouriel Roubini points out, until recently it was possible for some to think that the worst of the financial crisis was past. Now few could say that.

The delusional complacency that the “worst is behind us” is rapidly melting away…and the risk of another run against systemically important broker dealers

Nouriel Roubini

Jun 27, 2008

After the collapse in mid-March of Bear Stearns and the ensuing bailout of Bear’s creditors and the extension of the Fed’s lender of last resort support to systemically important members of the “shadow banking system” (the non-bank broker dealers that are primary dealers) a sense of delusional complacency emerged in financial markets based on fairy tales such as “the worst is behind us”, the “recession will be short and shallow”, that “housing is bottoming out” or even that “we will avoid the recession”. This chorus of cheerleaders included policy makers that had missed the incoming financial tsunami for most of 2007, CEOs and senior financial sector folks who had lost hundreds of billions of dollars with their reckless lending, and investments and a bunch of self serving spin-masters talking non-stop their long books on CNBC and other financial media. This circus of “the worst is behind us” became a pathetic and louder chorus in the two months from mid-March till the end of May. This delusion was for a short couple of months supported by rising stock prices, reduction in credit spreads and interbank spread that, however, remained very high and indicated a persistent liquidity and credit crunch.

But this delusional complacency is now rapidly collapsing as financial markets are back to panic mode. Let’s detail how…

Those of us who had predicted this economics and financial mess (the worst housing bust since the Great Depression, the subprime and mortgage meltdown, the bust of the credit bubble, a nasty liquidity and credit crunch, high and rising oil prices, an ugly recession) well before (in the summer of 2006) 99% of the world had even heard the term “subprime” held to our sound and analytically grounded views that: this would be the housing was not bottoming out, that this would be the worst housing recession since the Great Depression and that home prices would eventually fall 30% plus, that millions of underwater households are at risk of walking away from their homes (“jingle mail”), that the we were in the eye of the financial storm (rather than past it) and this would be the worst U.S. financial crisis since the Great Depression, that credit losses would mount over time well above $1 trillion, that we would have a systemic banking and financial crisis with hundred of institutions going belly up, that the stock market would fall back into serious bear territory after another and last sucker’s rally, that the recession would be deep and protracted (12 to 18 months and U-shaped rather than V-shaped), that the Fed would stay on hold (or even cut rates further by year end) as the economic and financial crisis becomes more severe, that the world would not decouple – financially and/or economically – from the U.S. contraction, that the exchange rate policies of the BW2 countries (partially sterilized intervention creating easy monetary conditions and excessive credit growth) would lead first to asset bubbles and then to rising inflation as the needed real exchange rate appreciation would occur through a rise in prices if the nominal appreciation would be prevented, that BW2 would come under severe strain once this asset bubble would go bust and inflation rose.

Now the delusional complacency in markets is melting away or, better, going bust. With the 3% plus fall in US equity prices on Thursday stock prices are well below their bottoms of mid-march at the peak of the financial panic and back to level not seen since the fall of 2006. Also, credit spreads and interbank spreads are rising again towards their peak levels. Thus, the liquidity and credit crunch is significantly worsening. As argued in this forum the economic contraction would lead to a sharp rise in credit losses well beyond subprime: from subprime to near prime and prime, to commercial real estate, to credit cards, student loans and auto loans, to leveraged loans that financed reckless LBOs, to muni bonds, to further losses from the downgrade of monoline insurers, to industrial and commercial loans, to corporate bonds, to CDS losses.

In February this forum argued that credit losses would be at least $1 trillion. At that time that figure was derided as excessive but by now the IMF says losses will be $945 billion, Goldman Sachs estimates them at $1.1 trillion, George Magnus of UBS estimates them at $1 trillion and the hedge fund manager John Paulson (who made a fortune last year betting against subprime) is estimating them at $1.3 trilliion. Thus, it is now clear that $1 trillion is not a ceiling but rather a floor estimate for what those financial losses will be.

The deleveraging process for the financial system has barely started as most of the writedowns have been for subprime mortgages; the writedowns and/or provisioning for the additional losses have barely started. Thus, hundreds of banks in the U.S. are at risk of collapse. The typical small U.S. Bank (with assets less of $4 billion has 67% of its assets related to real estate; for large banks the figure is 48%. Thus, hundreds of small banks will go belly up as the typical local bank financed the housing, the commercial real estate, the retail boom, the office building of communities where housing is now going bust. Even large regional banks massively exposed to real estate in California, Arizona, Nevada, Florida and other states with a housing boom and now bust will go belly up.

And even large banks and broker dealers are now at risk. After the bailout of Bear Stearns’ creditor and the extension of lender of last resort liquidity support the tail risk of an immediate financial meltdown was reduced as that liquidity support stopped the run on the shadow banking system. Indeed in March we were an epsilon away from such meltdown as – without the Fed actions – you would have had a run not only on Bear but also on Lehman, JP Morgan, Merrill and most of the shadow banking system. This system of non-banks looked in most ways like banks (borrow short/liquid, leverage a lot and lend longer term and illiquid). So the risk of a bank-like run on non-bank (whose base of uninsured wholesale short term creditors/lenders is much more fickle and run trigger-happy – as the Bear episode showed - than the stable base of insured depositors of banks) became massive. Thus, the Fed made its most radical change of monetary policy since the Great Depression extending both lender of last resort support to non-bank systemically important broker dealers (via the PDCF) and becoming a market maker of last resort to banks and non-banks (via the TAF and the TSLF) to avoid a full scale sudden run on the shadow banking system and a sure meltdown of the financial system.

While the tail risk of such a meltdown has now been reduced the view that systemically important broker dealers - that have now access to the TSLF and the PDCF – now don’t risk a panic-triggered run on their liabilities is false; several of them can still collapse and not be rescued. The reasons are as follows: liquidity support by the Fed is warranted for illiquid but solvent institutions but not for insolvent ones; and the risks that some of the major broker dealers may face is not just of illiquidity but also insolvency (Lehman had as much exposure to toxic MBS, CDOs and other risky assets as Bear did). The Fed already tested the limits of legality (as argued by Volcker) in its bailout of Bear’s creditors.

Suppose that a run – triggered by concerns about illiquidity and solvency – occurs against a major broker dealer (say Lehman) would the Fed come to the rescue again? The answer is not sure: such broker dealer has access to the PDCF but sharply borrowing from this facility would signal that the institution may be bleeding liquidity and be in trouble; thus large access to the Fed facility may cause the run on the liabilities of such financial institutions to accelerate rather than ebb. The reason is as follows: if creditors of the broker dealers knew with certainty that the Fed liquidity tab is open and unlimited the existence of the facility would stop the run. But if there is any meaningful probability that the amount that the Fed would be willing to lend to an institutions using that facility is not unlimited and is not unconditional then use of the facility may accelerate the run – as those first in line would have access to the liquidity provided by the Fed lending to the broker dealer in trouble while those waiting may be stuck once the lending stops. This is akin to a currency crisis in a pegged exchange rate regime triggered by a run on the forex reserves of a central bank. Once the reserves are running down and investors expect that the central bank will run out of reserves the run accelerated and the collapse of the peg occurs faster.

So why the Fed would not provide unconditional and unlimited liquidity to a broker dealer in trouble and thus allow the run to occur? Several reasons: the Bear Stearns actions were borderline illegal; the Fed cannot keep on bailing out any major broker dealer in trouble; the Fed may be running out of Treasuries to swap for illiquid/toxic securities; the Fed is starting to face credit risks from swapping and holding toxic assets (the $29 billion given to Bear, the hundreds of billions swapped via the TAF and TSLF); the authorization for the PDCF expires in the fall; the Fed should not bail out – with risks to its own balance sheet institutions that may be insolvent on top of being illiquid.

Thus, the delusion that TSLF and PDCF implies that the risk of a run against systemically important broker dealers is now close to zero is just a delusion. If a run against Lehman or another broker dealer starts again and this broker dealer borrows $5 billion from the Fed and then $10 billion investors and creditors of this institutions – who need to decide whether to pull out or keep their credit lines – will ask themselves whether the Fed would allow this broker dealer to borrow $10 and then $15 and then $20 and then $25 and then $30 billion and then even more. Unless the Fed credibly commits to unconditional and unlimited lending the use of the facility by a broker dealer in trouble may accelerate rather than stop the run on its short term liabilities. Thus, the argument that - in a world where the Fed has extended its lender of last resort support to non-bank financial institutions – the risk of a run against these institutions is now close to zero is flawed.

Certainly the rising financial tsunami ahead as the economic contraction gets worse, the financial/credit losses mount, the credit and liquidity crunch gets worse will test both the ability and the political willingness of the Fed to further bail out major financial institutions that are in serious trouble. So the worst is well ahead of us – not behind us – for the real economy and financial markets.

Commenting on Roubini’s post, David Seaton puts the fear and the rise of oil prices in perspective:

Oil and the mother that bore him

David Seaton

Sunday, June 29, 2008

One of my oldest customers is an energy derivatives brokerage, for whom I provide selections of articles and commentary for their webpage.

Thus, for many years now, every week of the year except August, I have had to read dozens of articles about oil.

I don't consider myself in any way an expert on oil, but I read and have read a lot of experts. I have been following oil since when it was absurdly cheap till now, when it is frighteningly expensive.

I would compare myself to a Moroccan cleaning lady in Madrid's cathedral, I know the difference between a priest a sacristan and a bishop and a cardinal, between a choir boy and an alter boy, but at bottom what they are all doing and why remains a mystery to me and I never forget my granny's words, "Be careful Fatima, they may all seem very nice, but never forget, that when that little bell rings they eat human flesh!".

What have I learned?

First, this is a huge question, it is a perfect example of the blind men feeling their way around an elephant. There are so many factors involved in the price of Oil that chaos theory kicks in rapidly in any analysis. Nobody has the complete picture. In some ways I think even Jim Kunstler is too optimistic, romantic, really.

One thing I am sure of is that future archaeologists digging over our detritus will baptize us the "oil civilization". Our world revolves around oil, first for objective reasons, but then because of its power, magic enters into it too.

There is much argument as to if we are rapidly running out of oil or if there is plenty left. Most of these arguments are magic ones. There are so many sound and reliable experts on either side of the question that I am tempted to say that the "magic quotient" is having a disproportionate effect on the present crisis.

My feeling (this is a blog and not a report) is that what is in crisis at this moment is value itself.

Value is in some sense dissolving and those who hold value are frantically trying to put whatever value they possess somewhere safe. Like a drowning mother throwing her child to a stranger.

This is no longer really about making money, this is about not losing shirts. Oil being the center value of our civilization its paper value is soaring, just as the paper value of gold and wheat. This is not "speculation", this is panic.

With energy and food prices rising rapidly, average people feel the crisis in their gut.

Inflation and job losses keep consumers glum

Burton Friers

Jun 27, 1008

NEW YORK (Reuters) - Consumer confidence fell more than expected in June, hitting another 28-year low as surging prices and mounting job losses contributed to a bleak outlook, according to a survey released on Friday.

The Reuters/University of Michigan Surveys of Consumers said five-year inflation expectations remained steady at the peak of 3.4 percent reached in May, which was the highest in 13 years.

Federal Reserve officials have focused on long-term inflation expectations and the persistence of such pressures heightens their dilemma -- whether to fight price growth or support a weak economy in the grips of the worst housing slump since the Depression of the 1930s.

The Surveys of Consumers said the final June reading for its index of confidence fell to 56.4 from May's 59.8. The report said the pace of consumer spending is likely to sink at least through the start of 2009.

"Moreover, gas prices have risen to an all-time peak, food prices posted the largest increases in decades, home prices have fallen faster than any time since the Great Depression, and there has been widespread distress associated with foreclosures," the report added.

Also weighing on consumers, data earlier this month showed U.S. employers shed jobs for a fifth straight month in May and the unemployment rate jumped to 5.5 percent, its highest in more than 3-1/2 years.

Economists had expected a reading of 57.0, according to a Reuters poll. Their forecasts ranged from 55.9 to 60.0. The final June result is slightly below the preliminary figure of 56.7 released on June 13.

"Overall, no new information, only confirmation of prevailing weak sentiment," analysts at RBS Greenwich Capital said in a note to clients about the report.
Financial markets showed little immediate reaction to the report. Stocks were flat and the dollar was down against the yen . Government bonds were higher on the day…

Should we be so pessimistic? Maybe a change in perspective will help us. A couple of weeks ago we quoted Ran Prieur who said that we should think of “corporate rule” when we hear the term “the economy.” We should interpret “expansion” as a “contraction.” So if we hear that the economy is crashing, we can think that really the rule of psychopathic corporations is crashing.

We're programmed to think of dying as the ultimate worst thing, as the negation of living, when really it's a normal friendly part of living, and what's negating our living is our fear of dying or physical damage. Our culture whips this fear into an insane frenzy, not just to keep us enslaved, but because our culture is an evil mass consciousness, a vampire that cultivates and feeds on our emotional contractiveness.

Our contractiveness is the same thing as our "progress," our descent on engines of disconnection into an artificial hell of computer spreadsheets and tax laws, pavement and cars that turn the grass under your feet into a mile-a-minute green blur, science that turns your view of the sky into mathematical formulas in windowless rooms. But everything that contracts must expand…

I think the next time we expand, we're going to follow through. I suspect that humans are smarter now than ever -- that intelligence is the default human condition, and stupidity has to be manufactured, and our intelligence has been growing stronger and stronger, invisibly staying a step behind advances in stupidity-manufacturing techniques, the same way weeds and bacteria have been growing resistant to high-tech poisons. The controlling interests seem to be winning, but the lid's about to blow off, and when it does, those of us who don't die of starvation or disease will see a blossoming of human power like nothing in history.

Here's what I mean by "human power": Right now if you need a place to live, you can't just find a place and live there, no matter how responsible you are. Places are all "owned," and not by people but by contractive patterns using people, by banks and businesses and money-grasping habits of individuals. You have to apply to these alleged "owners," submit to degrading rituals, accept permission to occupy a place, not change it in any important way, and pay a huge monthly sum of money -- a billion rivers of money running from the poor to the rich. And the only thing you get in return, what you're actually tricked into demanding, is to have your power/responsibility reduced even further by depending on the "owners" to make necessary repairs.

When we get our power back, you'll just pick an appropriate place and live there, and build or maintain shelter that fits the skills of you or your group. And in the transition to this, we'll survive by sleeping on each other's couches, by filling up our houses and learning to live in the same space with other people again instead of buying satanic isolation. We'll turn our lawns into vegetable gardens and feed ourselves with our own hands instead of depending on money and supermarkets. Our alleged poverty will lead us to rebuild community and autonomy that were destroyed by our alleged wealth.

Of course a lot of people will get hurt when something so large falls, but do we really want corporate rule to continue? On the other hand, we shouldn’t just passively wait for the crash to happen. As Franklin Sanders put it, the way to rebuild an economy after it crashes is to rebuild it before it crashes.

If the system that has been in place for a generation is ending, then opposite trends may characterize the next phase. If the last 25 years has seen globalization and the increasing power of multinational corporations, all of which has been dependent of cheap oil and U.S. hegemony, than maybe we will see more localization of economic life. Higher energy and transportation costs and the collapse of the unipolar world of U.S. military predominance should reinforce that trend. Who knows, maybe the trend of increasing social isolation and stress can be reversed. Again, if we are not passive and begin to build newer, more humane and localized economic and social forms perhaps we can lessen the pain of the coming crisis.

David Seaton again:

Once I built a tower, now it's done...

Tuesday, June 24, 2008

"We are so made that we can sustain our existence only in group life. Love is the essence of humanity, love needs something to bestow itself upon; human beings must live together in order to live a life of mutual love." D. T. Suzuki

"I sincerely believe that if you think there's a solution, you're part of the problem. My motto: F*** Hope!" George Carlin

Between the two quotes above there is certainly some space and variance of tone, but they are by no means contradictory and Suzuki would have been the last person to deny George Carlin's Zen.

Carlin was certainly right when he saw "no solution" and "no hope". However, it is useful before even thinking about solutions, to identify the "problem".

In my opinion, the distance between the reality we experience in our daily lives and Suzuki's deceptively simple analysis of our species, (which could, in great part, apply to the troop of baboons in the picture), is humanity's "problem".

In fact the distance is so great that many might dismiss Suzuki's analysis as treacly and sentimental when he says, "we are so made that we can sustain our existence only in group life (...) human beings must live together in order to live a life of mutual love", which, in fact, applies as accurately to any isolated human being as it would to any isolated baboon. A social animal being a social animal.

Over millions of years, our species evolved, like our cousins the baboons, to roam the savannas of Africa in extended families, sharing whatever food we found and curling up together at night to keep warm. Over most of our history that was our life, only of late have we taken a sinister detour. That wandering togetherness is what our brains, inhabiting spirits and digestive tract are built for and look where we are now.

Over a relatively few millennia we have woven ourselves into hell.

Certainly, unless we can recreate the essence of our cooperative origins on a mass scale within our present technological development, there seems to be no solution in sight to this hell we have created.

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