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A Occasional letter From The Collection Agency

Incorporating the 27 July Weekly Report.

It has been a rather busy time for The Collection Agency, picking up assets in lieu of cash. Anyone need a badly treated, surplus to requirements, Bank customer desk or ten? I can do job lots.

We start off with an excerpt from The Bernanke Conundrum written on 8th May 08:

  • "You see, For Ben Bernanke the current situation isn't "news"

    Bernanke has already studied the conundrum. I quote from "Non-Monetary Effects of the Financial Crisis in the Propagation of the Great Depression" as used in "New Keynesian Economics"(Mankiw and Romer Ch 29):

    "An interesting aspect of the general financial crises - most clearly, of the bank failures-was their coincidence in timing with adverse developments in the macro-economy"

    "The present paper builds on the Friedman-Schwartz work by considering a third way in which the financial crises (in which we include debtor bankruptcies as well as failures of banks and other lenders) may have affected output" .".....because markets for financial claims are incomplete, intermediation between...borrowers and....lenders required nontrivial market making and information gathering".

    Bernanke then goes on to state that as the real costs of intermediation rose some borrowers found credit to be expensive and difficult to obtain. He then states:

    "The effect of this credit squeeze on aggregate demand helped convert the severe.....downturn of 1929-1930 into a protracted depression"

    Bernanke goes on to identify various problems from the '20s that made the 29-30 downturn, which included the expansion of debt and in 1930 the move by banks out of the loan markets into more liquid instruments. Indeed the 1932 National Industrial Conference Board survey of credit conditions reported that the shrinkage of commercial loans in 1931 and the first half of 1932 represented pressure from the banks on customers for repayment and refusal by banks to grant new loans. The worry is that the Fed Chairman saw no cure better than the one used in the '30s New Deal and the large scale intervention of the federal Govt:

    "home mortgage market...function....was largely due to the direct involvement of the federal government....establishing ...FSLIC...federally chartered savings and loans....government "readjusted" existing debts....and substituted for recalcitrant private institutions in the provision of direct credit. In 1934.....Home Owners' Loan Corporation made 71 percent of all mortgage loans extended"

    It looks to me that Bernanke has already instituted the measures he believes will help avoid a repeat of '29-'33 by delivering the medicine now rather than later. As we have seen earlier in this article, the medicine does not seem to be affecting the patient. Credit availability continues to contract due to the policies of banks. Ben Bernanke now finds himself in a situation where he has delivered all he can to no avail. Does he sit back and wait for a change in credit conditions to become apparent or is there more that he can do?

    Whatever he does, unless lending conditions change markedly and rapidly in this quarter, it will be ineffective. Bernanke will no longer have to refer to history to see a deflationary depression, he will be living it."

Well lending conditions certainly changed markedly and rapidly in this quarter and not the way Ben Bernanke would have wanted. Fannie and Freddie, set up in past decades to solve the same problems we face today are defunct, broke, ripe for a knock on the door from yours truly.

Bluntly, you cannot expect to borrow short to fund long and survive. We have seen all those who went out on mega-leverage with this business model either fold or become unable to fund current positions, igniting a de-leveraging frenzy as a desperate attempt was made to try and save some of the capital that was used to make the positions.

We are now living the very scenario Bernanke studied; yes I am saying we are at the beginning of a Depression the likes of which the World has never seen. Of course those readers who read the excerpt from The Bernanke Conundrum can see what is different this time.

In '29-'37 the Government stepped up to the plate when the private sector stopped lending and originating mortgages by creating FSLIC et al. Now we don't have that option, instead we have the prospect of watching the destruction of the descendants of that '30s bailout.

Bernanke also pinpointed the other great problem of that era:

  • "because markets for financial claims are incomplete, intermediation between...borrowers and....lenders required nontrivial market making and information gathering".

When dealing with financial claims, originated upon assets or other debt, based and priced purely on confidence you have a major problem. If no one quotes a price the market dies. That is the problem right now in the "innovative" derivatives world. When you or I trade futures, CFD's, options etc there is a counterparty position created to whatever we decide to do. If there is no counterparty, then the trade isn't completed.

However in the world of financial innovation, counterparty isn't required, you draw up a contract with another trader and set some parameters. You pay an income stream to maintain the contract and the other trader pays out if a pre-determined default position is reached. The other trader decides whether or not to lay off some or all of the risk, there can be no implicit acceptance by the market or any other participants that this has been done. Unlike a traditional derivative market (i.e. exchange traded) there may well be no "winner".

Financial innovation is based upon the premise that risk is more evenly distributed and less likely to cause a choke point. Clearly the failure to price these obligations (like an exchange, not mark to market) has led to today's problems. Although some debt derivatives do now have a pricing structure, eg Markit.com it is still reliant on participant disclosure, without which the contract remains hidden. There is a very good reason to hide the details of these agreements. If you, as the "other trader" did not spread some risk to the rest of the market, you are fully exposed to a default event. If the position is disclosed others may decide to take advantage of triggering a default, causing the concentration of risk that was to be avoided.

During the good times, those heady days of massive leverage and cheap debt, where massive income streams could be gained for agreeing to cover some improbable event it must have felt too good to be true. Why bother laying off the risk of some event that the risk models said was a 1-10,000 year event?

The only time a credit contraction is not deflationary is when no leverage has been used. Without leverage, the money lent is spent and re-circulated in the economy, ending up (or passing through) the lenders books (or some other bank) as new income. The loan, if defaulted upon, has no direct impact on the amount of money in the system - it is still circulating but belongs to someone else.

However with leverage you are playing the margin game. If $1million is put up as the collateral to a $10million loan, the leverage is 9-1. You supply the 1 and the lender supplies the 9. All is well and good as long as you service the $9million debt and its value is unchanged. If you can borrow short term at low rates and lend the $10million long at high rates, it's a lovely day for all. You keep rolling the short term debt for as long as it takes for the long term loan to be serviced and paid off.

It's stunningly simple and very lucrative. Until it isn't.

If the collateral (cash, assets, derivatives it doesn't matter, its all created, borrowed - none of it has an intrinsic value, other than confidence) is suddenly viewed as being risky, then the value of the collateral is downgraded and becomes lower in value.

So what happened to the value that was removed? It disappeared, it doesn't get re-circulated and it doesn't re-appear on the borrowers books. It has gone unless the value of the asset (including "money") goes up. The lender sees (or instigates) the fall in value and demand more assets to make the value back up on the collateral so that it matches the original nominal worth of the borrowed amount.

Some might say that the devaluing of the asset resulted in a transfer of wealth from the borrower using leverage to the lender. This didn't happen because the collateral is used to secure a 9-1 proportion of the lent amount. In effect the $9million lent was also devalued; the requirement to add to the original collateral of the $1million was to cover the losses in the $9million. If the asset was devalued 10% then the $9million would lose $900k. The collateral is said to be worth only $100k as the losses are borne by the borrower, not the lender. To make the collateral back up the lender needs to add $900k to match the original amount, even though the lenders asset has dropped below $9million (to $8.1million) if the borrower wishes to maintain the position.

To maintain the original worth of the position, a deflation of $900k is required from the capital of the borrower. That capital cannot be recovered unless the asset used as collateral is valued higher. It is this drawdown of capital from the borrower that causes a deflation in available assets because of the leverage involved.

As I have said more than a few times it is not a lack of printing that causes a deflationary environment but the lack of circulation of cash (asset) through the economy. The hoarding of cash to increase capital is the same as the Fed removing banknotes and not replacing them or the raising of taxation without a commensurate increase in Govt spending.

You do not have to stop or reverse the printing presses to cause deflation and any student of the '29-'37 period should know this. The House market in a large part of the western world is a stunning example of this un-leveraging deflation.

House prices have collapsed because the funds used to extend mortgages to borrowers have been withdrawn. The reasons do not matter, capital is being withheld and the lending process has almost stopped. If you bought a house worth $10million and used a $1million deposit, you borrowed $9million. If the house is now only worth $9 million (asset write-down?) then if you sell you will lose $1million. That's $1million of your capital gone, disappeared, not re-circulating in the economy or reappearing on a banks book.

You have had a deflation of $1million, the bank received back the original $9million amount lent. If you faced a loss bigger than your deposit you either have to raise capital to pay more to the bank or the bank takes a loss on the $9million and if the asset is priced correctly on its books, suffers a deflation too.

Has Hank Paulson achieved what he set out to do when he left Goldman Sachs?

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