The Fed Is Chasing After The Wind
By Paul Lamont
April 30, 2008
Last month we stated: “we should expect rocket-launched (oh they’ve saved us) bear market rallies.” Since that time, the DJIA has had two separate blastoffs. That’s all it took for investors to forget about the massive deflation that is happening in U.S. neighborhoods. We view the rise of the last two months as a breather before more serious selling takes hold. Goldman Sachs agrees and is warning ‘delusional’ investors of a sell-off of “a further 15pc over the ‘near term.’” Warren Buffett has also recently stated “the recession will be more severe than most expect.” Meanwhile, the Fed is wondering why all of its extraordinary measures have not increased liquidity. We advise investors not to get swept up in the bullish hype of the recent upturn and follow the old Wall Street adage: “Sell in May and go away.”
“Panic, as a health officer, sweeping the garbage out of Wall Street”
Frank Bellew, New York Daily Graphic, September 29, 1873—American Social History Project.
Where Did All the Money Go?
At the bottom, investors will ask: Where did all the prosperity go? The answer is that it was merely credit: borrowed time, an illusion of confidence. What follows after panics has been similar throughout history. Money is hoarded by the banks and wealthy citizens. Credit disappears. Some folks are reduced to trading. Debt is seen as an evil trap. The new beginnings of a ‘thrifty’ trend are already surfacing.
Taxes – A Good Reason To Sell
During a bear market taxes rise. In 1932, top income rates were raised from 25 to 63 percent and the Estate Tax was doubled with the Revenue Act. And that was with a Republican in the White House! Three years later, the Wealth Tax Act was enacted raising the top income tax rate to 75%. Similarly, according to John Wallis in the “Depression of 1839 to 1843;” “In 1842…Americans in Indiana and Ohio were saddled with property tax rates eight times higher than in 1836. New York, Pennsylvania, Maryland, and Massachusetts all had state property taxes, where they had none in 1830.” We would therefore recommend investors to take advantage of relatively low tax rates to sell. Especially since David Walker, the U.S. Comptroller General, “a leading voice for fiscal responsibility,” has resigned in disgust.
“These Aren’t the Losses You Are Looking For…”
We have mentioned SIVs (structured investment vehicles) last September and VIEs (variable interest entities) in February. These special purpose entities (currently used by the largest financial institutions) were also employed by Enron. But Enron wasn’t the first. When researching the history of structured finance, we found that Andrew Fastow, the CFO of Enron, actually got his start at Continental Illinois. Continental Illinois Bank was the largest bank resolution (failure) conducted by the FDIC and Federal Reserve. At that time (1984), it was the seventh largest bank by deposits. According to A Financial History of Modern U.S. Corporate Scandals by Jerry Markham: “An article in the Financial Times of London that appeared before Fastow left the Continental Bank likened the bank’s cutting-edge structured finance products to characters in the Star Wars movies. That theme would carry over to Enron when Fastow joined the company.” Off-balance sheet entities at Enron were named JEDI and Chewco after Chewbacca. Chewco allowed Enron to keep $700 million in debt off Enron’s books. During our recent housing bubble, Wall Street Firms used similar entities to hold mortgages off-balance sheet. Now they will need more than Jedi mind tricks when they are forced to move the losses back on to the balance sheet. How big are these losses?
“Citigroup, which has incurred $22.1 billion in losses from the subprime crisis, has $320 billion in ``significant unconsolidated VIEs,'' according to a Feb. 22 filing by the New York-based bank…. The securities in the VIEs may be worth as little as 27 cents on the dollar once they're put back on balance sheets, according to David Hendler, an analyst at New York-based CreditSights.”
So Citigroup has $320B in VIEs with estimated losses of 73 cents on the dollar. This equals roughly $230B (they have already admitted to a ‘maximum exposure to loss’ of $152B) or roughly 5 times the reserves of the U.S. banking system. Bank reserves that would be sitting at the Federal Reserve, if they weren’t loaned out to support the system: negative $90B in non-borrowed reserves for anyone keeping up.
Yes, CEO Credibility is in Question
While some CEOs are quietly hiding losses, others are attempting something different. Mr. Immelt, GE’s CEO, “assured investors the company was on track to meet its profit targets.” A month later GE shocked Wall Street with a wide earning disappointment. Wachovia’s CEO Ken Thompson is also having questions raised about his credibility: “More recently, he said the bank's dividend of 64 cents a share wasn't in danger. On Monday, Thompson slashed it 41 percent.” Some might also point to Bear Stearns CEO Alan Schwartz’s CNBC appearance as another example of questionable CEO credibility.
Fed To Bear Stearns: We Are Here To Help
As we have continually stated: “Our bearish position is reinforced knowing so many central planning entities are hard at work.” We encourage folks to read the SEC filing on the occurrence of Bear Stearns events. Basically, after a downgrade in ALT-A mortgages that Bear Stearns held, insolvency rumors began on Wall Street. Hedge fund clients began withdrawing funds in an electronic run on the bank. What happened next is especially important: The Fed promised that they would lend to Bear Stearns through J.P. Morgan Chase on Friday morning, March 14th. The effect: Bear Stearns’ stock (chart shown below) fell 47% on Friday.
The Fed couldn’t force Bear Stearns’ customers and shareholders to stay. So the Fed admitted defeat and pulled its own support on Friday night:
“On Friday evening, Bear Stearns and JPMorgan Chase were informed by the New York Fed that the New York Fed-backed secured lending facility that had been entered into earlier that day would not be available on Monday morning. Also on Friday night, a government official advised Mr. Schwartz that a stabilizing transaction needed to be accomplished by the end of the weekend.”
The Lesson of Bear Stearns
The lender of last resort cannot support individual institutions. (Just like they can’t force bankers to lend or consumers to take on more debt.) The Fed is chasing after the wind when trying to fight the emotion of fear.
Margin Call At The Fed?
There is also precedent for a crisis that becomes too great even for the lender of last resort. In the Panic of 1825, the Bank of England itself came under suspicion. With its gold reserves dwindling to “under a million pounds” according to Edward Chancellor author of Devil Take the Hindmost, the Morning Chronicle warned:
“the Bank of England has to choose between its own insolvency, and the insolvency of these imprudent speculations, and as it is impossible, in the present state of things, for the Bank, with any regard to its own safety, to stretch out a friendly hand to them, the consequences may easily be foreseen.”
Chancellor concludes, “In other words the Bank of England was not in the position to act as the lender of last resort.” If the Federal Reserve continues to use more of its own balance sheet to support the mortgage market, look for this subject to be revisited.
Now That It’s Not ‘Contained,’ It’s Not Anything ‘Remotely Like’ the Great Depression
In our May Investment Flash: Derivatives Say Bernanke Will Be Wrong, we showed that derivative prices were forecasting a fall in mortgage values. We concluded: “Perhaps Chairman Bernanke does not expect it, but reports in the field, credit derivative indexes, and the Federal Reserve Bank’s own research economists are warning of further U.S. mortgage woes.” His conclusion that subprime mortgage problems were ‘contained’ proved to be incorrect. Now on April 11th, Mr. Bernanke stated that the “current experience is not anything ‘remotely like’ the Great Depression.” This as “John Dugan, who oversees about 1,700 national banks as comptroller of the currency, warns of a wave of bank failures”:
“More than a third of smaller community banks have made commercial property loans that exceed 300 per cent of their capital, the OCC says. By comparison, in 1987, when hundreds of banks failed amid a commercial property collapse, such banks had commercial property loans equal to 175 per cent of their capital.”
Lace Up the Nike’s And Get Ready To Run
If people are running to Sam’s Club to buy rice, what are people going to do when they start closing down a few hundred banks? As the Costco CFO put it; "We don't think there is a shortage, it is just increased shopping by customers who think there is." Unfortunately for Ben, there is always a shortage of cash in a fractional reserve system.
Food Prices – Time to Go Against the Trend Again
“Successful investing is anticipating the anticipations of others.”- John Maynard Keynes
Last September we stated: “Protectionism, environmental regulation, less migrant workers, energy costs, weather, Chinese growth, we don’t know what ‘reason’ will be attributed to agricultural price increases. But we expect food prices (and cotton!) to dramatically rise in 2008.” In February, we again highlighted our forecast for higher prices. The public is surely now feeling the effects at the supermarket. But as the U.N. discusses food shortage plans we will again go against the crowd. Remember crowds, governments, and U.N. bureaucrats are the last to recognize any trend. As you can see below, the Powershares DB Agriculture (a corn, wheat, soybean and sugar futures) Fund (DBA) topped out in March. (Notice the similarity to the Bear Stearns’ chart above.) We expect a sharp decline in food prices and commodity prices as we mentioned last month. So despite the recent hysteria, we expect food prices to fall. Unfortunately it will be due to a severe contraction of credit. (Without credit cards, how much can Americans buy?)
If there is a future problem for the farm industry it is too much debt. As this MSNBC article states:
“the agricultural economy bears a striking resemblance to that seen in the mid-1970s, when a seemingly insatiable demand for U.S. crops drove up land values and farmers took advantage of their soaring equity to increase debt. When federal policy changed and demand suddenly dropped, land values and farm income plunged, forcing thousands of farmers to sell out and leading to the failure of nearly 300 agricultural banks.”
While the agricultural industry has less debt than others, “from the beginning of 2003 to the end of 2008, total farm debt will have increased by about $52.8 billion, or more than 30 percent.” In the Great Depression, farm prices tumbled with the contraction of credit. Speculation in the futures market today is making it harder for farmers to hedge against a future decline in prices. Higher debt, falling prices are a recipe for disaster for farmers (just ask recent homebuyers).
Even The Curmudgeon Has Trouble Cashing Out
In Edward Chancellor’s description of the boom of the early 1820’s, Britain’s “national sense of well being was so great, according to the Annual Register, that ‘even the country gentleman, the most querulous of all classes…could no longer complain.’” Chancellor continues: “speculation flared up in commodities…the anticipation of exports to liberated countries provoked fears of raw material shortages.” Shortly after, a “torrent of distrust” enveloped credit markets, and fickle Fortune had left. In 1826, stocks were down 80%, while some “went unquoted.”
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