Too Big To Fail?

By: Bob Hoye | Fri, Jul 11, 2008
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The following is part of Pivotal Events that was published for our subscribers Thursday, July 10, 2008.

Signs Of The Times

Last Year:

"This is far and away the strongest global economy I've seen in my business lifetime."

-- US Treasury Secretary Hank Paulson, Fortune, July 12, 2007.

There have been similarly fantastic utterances in other aspects of policy -- mainly that the only way the health of the planet can be saved is through increased regulation and taxation. On this, one has to readily accept a new version of political science and to welcome another rationalization of wealth confiscation.

Where the tout has not been colourful it has been demagogic:

"American Indians say "Earth Mother Getting Angry About Global Warming"

-- Concord Monitor, June 20, 2007.

"Get rid of all those rotten politicians, who are nothing more than corporate toadies and we need to start treating [non-believers in global warming] as traitors."

This was Robert F. Kennedy Jr. addressing the Live Earth USA Concert.

The July 9, 2007 edition of also reported that Kennedy grew hoarse from shouting his message. The program included "primatologist", Jane Goodal, who provided a gentle greeting to the audience in "chimpanzee language".

Guess you had to be there.

On the same date, AFP News reported that Buenos Aries had experienced its first snowfall in 89 years.

On the bigger picture, the audacity and error of the control freaks is monumental and has not been seen in four hundred years. That was at the culmination of the last Tyrannical Century--the 1500s--when the establishment ran a massive experiment in currency depreciation and authoritarian government.

One of the major errors was in physics and the Vatican, in an incredible fit of ego and control, insisted that the solar system was revolving around the earth. In order to explain the movement of the planets required fantastically complicated models that defied the laws of physics. Of course, Galileo, in building upon a long thread of science had it right, but bureaucratic intransigence then included the death threat to deniers of official wisdom.

The intensity of the conflict between ambition and science peaked with as price inflation began in 1500 and blew out in the early 1600s.

The previous Tyrannical Century occurred as bureaucratic ambition and greed corrupted the Roman Republic into a sordid police state under the guidance of the "Genius of the Emperor". It ran for a hundred years before the experiment collapsed, and created the model for the next as well as our century of political tyranny. It can be said that Rome suffered endless "New-Deals" until its economy collapsed.

In our tedious example, price inflation started in 1895 and this boom could mark the end of the phenomenon. Obviously, the economy and credit markets are being "New-Dealed" to death. In the post-1929 crisis, policymakers demanded bigger agencies that would prevent such a financial outrage. That was the intention of the imposition of the Fed in 1913, the SEC in 1934, as well as a huge number of agencies confected by FDR's "brain trust". Now the control freaks are at it again -- and how long will it take to assemble a "super agency"? How long do major post-bubble contractions last? Probably not as long as it takes to create another bureaucratic monster, the Crash ended in 1932 -- the SEC was created in 1934.

How effective have the last "super agencies" been?

There are a number of parallels in comparing today's global warming movement and the notion of the earth-centered-solar system. Too many for this page, but the most corrupt occurred when the Church was selling indulgences whereby those who had the money were able to offset a lifestyle of sinning and purchase a place in heaven.

This time around, the dreadful experiment has run for around one hundred years and the corruption is blatant with the selling of carbon credits for immediate absolution of a sinful lifestyle.

Successful and long lasting priesthoods learned to make the settlement on the promise to deliver heaven in the hereafter, rather than upon demand.

Stock Markets

Two weeks ago we noted that banks and financials (BKX) had fallen a long way and could find a "resting" level. At 60 then, the slide continued to an extreme of 54 on Monday. A relief recovery might have run into August, but the initial rebound was a massive squeeze to 60. In rapid time this has replicated the rebound out of January, when the 50% retracement was accomplished in less than two weeks. Then the news about banking disasters, committed over the past few years, began to be reported and the sector collapsed to 54.

Now the consequences of years of disastrous banking habits at Frannie and Freddie are being discovered and, what's worse, being reported. The stock market is being hit by severe problems in the financial sector largely due to collapsing asset prices.

At the climax of the January panic, our outlook was that the rebound could run into late spring and become so good that the street would again celebrate the genius of central bankers. That happened, but said street is taking on some " not-the-textbooks" learning, and with that some healthy scepticism about the real abilities of policymakers.

In the meantime, traditional credit spreads have again become ugly. In the March crisis the high-yield got out to 670 bps, over treasuries, and in the general revival came in to 551 bps in early May. Now they are out to 658 bps, without any great panic--yet.

Reflecting halcyon days, it was last July that the head of Citigroup committed professional infamy with his: "As long as the music is playing you've got to get up and dance. We're still dancing."

And this brings us to the remedy for the subsequent credit contraction. It is simple--all that central planners need to do is to inspire all participants in the credit markets, lenders and borrowers, to get as reckless as they were two years ago.

The problem that won't go away is that the pitch by the central planners that risk had been eliminated prompted the greatest experiment in leverage in history. Actually this has been a multi-generational accumulation of reckless investment and central banking habits. The consequence, as we concluded last July was that "The credit markets are in the greatest train wreck in history."

It isn't over and it will become more concerning when spread-widening at the long end exceeds the distress of March. Also the collapse of Fann and Fred has moved some money-market quotes, with dealer commercial paper jumping from 265 bps on Thursday to 280 bps on Monday. If this move continues and encompasses Libor then the next phase of the "wreck" will be on.

The main strategy would be to use rallies as selling opportunities.

Interest Rates

The Long Bond has enjoyed a rally from 112 in mid June to 117. This, of course, was in response to hit to the stock markets. But, as we have noted as stocks were making new lows, the bond was not making new highs. The high was 122.81 reached on the stock panic into January.

However, that the bond is not making new highs could be indicating that disappearing liquidity is beginning to have its way with the bond, which is facing overhead resistance at 118.

Credit Spreads: As reviewed above, traditional corporate spreads followed the lead from May's collapse in sub-prime and have been widening. This has been expected to resume in May and become disastrous in the fall.

The Yield Curve: On the 10s to 2s there has been some steepening since 117 bps on June 12. Over the past week its been between 147 bps and 141 bps. A few beeps beyond 147 will extend the trend and as we shudder to think, steepening is one of the features of a post-bubble contraction.

The usual indication of credit concerns becoming acute is a sharp decline in treasury bill rates.

Traders are positioned for steepening and investors now have another opportunity to sell the long bond.

This Week's Disasters

Fannie and Freddie have become disasters of virtually Biblical (Old Testament) proportions. It should be understood that these government-sponsored enterprises (GSEs) were created to impose arbitrary ideas about what financial markets ought to be doing. Arbitrary is always dangerous as it will succumb to uncorrectable ambition, and this has been the case.

In just reviewing FNMA--it was established in 1938 as part of President Roosevelt's "New Deal", and its collapse is signalling the beginning of the end of that dreadful experiment in central planning.

It is ironical that recurring expansions and contractions prevailed during Roman times. Each of the latter inspired an increasingly ambitious bureaucracy that responded to contractions by providing below market rates of interest on loans to depressed agriculture. This included advising grape growers to haul out vines during wine surpluses. It was and still is knee-jerk central planning and is well-documented. Rome was "New-Dealed" to economic death and it took the culture of the welfare state with it.

The ambition of arbitrary force knows no limits and this, with another example of remarkable irony, shows up in some announcements made during the March panic.

The Office Of Federal Housing Enterprise Oversight (OFHEO) runs the game, and on March 19 issued the following:

"Announce a major initiative to increase liquidity to support the U. S. mortgage market."

"Achieved through existing capabilities oh Fannie and Freddie, combined with new initiatives should allow the GSEs to purchase or guarantee about $2 trillion in mortgages this year."

The OFHEO director added:

"Let me be clear--both companies have prudent cushions above OFHEO requirements and have increased their reserves. We believe they can play an even more positive role in providing the stability and liquidity the markets need right now."

The CEO at Fannie chimed in with:

"This progressive, sustainable plan will help restore liquidity in the market."

Clearly, these boasts were from participants who have yet to understand the implacable nature of great changes in the credit markets.

Since the halcyon days at the high of 68 in August, 2007, fortune has changed, and since the boastful days of March when the stock was at 35, the price has declined to 6.68. Markets are rapidly providing the practical adjudication of interventionist schemes that financiers and libertarian economists dispassionately provided during the 1930s. In so many words, Mr. Market and Mother Nature, along with Mr. Margin are providing the same adjudication--forcefully.

Instead of supplying liquidity, decades of reckless conduct by many lending institutions created the equivalent of an astronomical black hole that is sucking in "liquidity", which has been the euphemism for a huge credit expansion.

The notion that the GSEs are too big to fail will likely provide only brief comfort as the collapse in asset prices in today's conditions can render such opinion as futile -- the collapse in price and collateral happens too quickly. But the same knee jerk remedies or comforts are always offered in the volatility that marks the initial phase of a contraction. In the 1825 calamity a financial article observed: "All through this bustle and anxiety public confidence has [not] been shaken. The nation is, in its general state, flourishing almost beyond parallel."

We thought it reckless and naive when the Fed took on $28 billion of suspect instruments on the Bear Stearns disaster. Fannie and Freddie liabilities (mortgage-backed securities and other debt) amount to some $5 trillion. By way of perspective, U. S. funded debt amounts to $9.5 trillion, and the U. S. GDP number is $14 trillion.

Obviously the situation is impossible according to the doctrine of "super agencies", but it is real and under similar post-bubble conditions the contraction runs until the markets clear all unsupportable positions.

Although it provides no comfort, it is best to keep in mind "Credit is suspicion asleep."

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Bob Hoye

Author: Bob Hoye

Bob Hoye
Institutional Advisors

Bob Hoye

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