An Occasional Letter From The Collection Agency

A recap of the scenario:

bubble, easy money, inflation in fiat money supply, inflation in commodities and hard assets, inflation, fear of inflation, rising rates, YC inverting, flattening, rising and inverting again, tightening, withdrawal of liquidity, corrections, crashes, talk of stagflation, FEAR, withdrawal of speculative funds, further corrections and crashes, demand collapse.......Deflation.

• "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."

The above quote is from The Bernanke Conundrum written on the 8th May 08 and has come to pass. We hear today that the US Treasury is monetizing the debt taken on by the Fed for the nationalization of AIG:

• "Sept. 17 (Bloomberg) -- The Treasury will sell more debt to enable the Federal Reserve to expand its balance sheet, a sign of the strains created by the biggest extension of central-bank credit to financial companies since the Great Depression. The program starts today with a $40 billion auction of 35- day bills, a day after the government agreed to take over American International Group Inc., the Treasury said in a statement in Washington. The proceeds will ``provide cash for use' by the Fed as it seeks to boost liquidity in credit markets struggling from $515 billion in writedowns and losses since the start of last year."

For some of us, AIG was just a matter of time, as I wrote in "AIG gets caught by the Auditors" back in February '08:

• "Boy you could here the squeals of pain all the way down Wall St. Getting caught by the auditors is the risk you take when you start playing with exotic instruments and "forget" to let the accountants know things may have changed. PricewaterhouseCoopers applied the pressure, uncovering "material weakness" in the way AIG accounted for it's Credit Default Swaps. The material weakness was to under-estimate the losses on CDS by 400%. AIG say the losses of $4.88Bn occurred in October and November '07 on CDS sold to protect fixed income assets. Which, of course, means that January to March '08 figures are not going to be any better taking into account the current turmoil in the bond and derivative markets."

With a little bit of luck maybe that article got some out of AIG stock or at least got them thinking about what the future might hold. The fall of AIG isn't just one company, it was a sum of many parts:

• "Amongst those assets are ILFC, an aircraft leasing company, 21st Century Insurance Company, American International Assurance, a near 10% holding in the Peoples Insurance Company of China, Stowe Mountain resort, the Bulgarian Telecom Company and Vivatel, a mobile network, AIG American General (insurance) which owns Matrix Direct Insurance Services and finally Ocean Finance a UK loans company specialising in mortgages and re-mortgages.

• A sale of assets or a move by Fund Managers or Hedge Funds to force a release of "value" cannot be discounted. If that does happen, I wonder where AIG will be in the Forbes Global 2000?

  By the way, be careful of who you listen to. This was one of the comments I saw on Bloomberg about the AIG drop:

  "Investors eventually will look back at yesterday's announcement and conclude they overreacted, said David Katz, chief investment officer for New York-based Matrix Asset Advisors, who supports Sullivan (the CEO)." Must be a coincidence........"

Of course I doubt Mr Katz will go onto Bloomberg and issue a groveling apology, he like many others will blame speculators and shorters for the demise. What piffle. Banks, insurers and mortgage companies are going down not because of short positions but because they screwed up. They got greedy, they got complacent, they ignored risk and most importantly they employed very stupid people who preferred to please their masters rather than tell the truth.

Capitalism is screwed, more precisely the US / Anglo Saxon model is screwed. That means we are all screwed too. In the space of just over a week the main drivers behind the credit boom have imploded, brokers have gone down and the biggest insurer of debt has folded softly into the arms of the Fed. I wrote Pre-emptive Warning of a Major Banking Crisis back in March '08 which concluded:

• "How can the Fed plan fail? The risk is with the dollar. If the action taken by Bernanke is seen as a massive dilution of the strength of the dollar then it and its derivatives will all fall in price, regardless of any concerted cooperation by Central Banks.

• If the markets believe the treasuries constantly introduced into the market are being used to shore up massive losing positions then the risk of default will increase. This will cause a fall in the price, placing the PDs (Primary Dealers) with a further tranche of "sold low, buyback high" assets. With a lower pricing on dollar derivatives, the dollar will suffer the same fate as underlying loans have in MBS derivatives. The mechanism is the same.

  With the Fed placing itself in a position were it holds lower worth assets than the treasuries it issued, the risk of a default by a PD becomes a risk to the Fed. In default the PD will have to hand over the treasuries used as collateral, leaving the Fed no better off than an SIV stuffed full of toxic debt that is unable to raise funds in commercial paper markets. The risk would be a loss of confidence with the Fed as an Institution."

You know the dollar has a problem when sterling can do this:

The moral hazard invoked by the Fed, US Treasury and Congress is beyond anything ever seen in the past 1000 years. The very structures of daily life, of daily subsistence have been placed in jeopardy to save the banking and brokerage fraternity.

A deep recession or depression would have carried out its duties by purging mal-investment and bad credit. It would have been painful and unpalatable but the financial system would have survived. No doubt it would have changed and the power structures controlling it would have moved but, it would have survived.

Most readers know I see a deflationary depression in our futures. Now I see something different becoming a possibility. What if the US produces large scale, short term Treasury debt on a rolling basis to fund the long term debt incurred by the multi bailouts?

Some are thinking it would be inflationary, monetizing debt by the use of credit. As we have seen in numerous examples issuing short term debt to fund long term borrowing is a mugs game, it has been the downfall of Fannie, Freddie, Northern Rock, HBOS, Bear Stearns, Merrill Lynch, Lehmans, AIG, Countrywide and so on.

What on earth makes that risky, flawed model any different for the US as a whole? The assets taken in exchange for this increased short term government debt are toxic, useless, untradeable and riddled with legal complexity. Why would anyone want to buy short term debt issued by the most debt riddled country in the world?

Its beginning to look like the "insurance" on debt is also about to disappear:

• "Sept. 17 (Bloomberg) -- Deutsche Bank AG is taking steps to slow credit-default swap trades that expose it to the risk of failure among Wall Street firms, according to three investors told of the policy.

• Germany's largest bank is requiring risk managers to approve trades where the company takes over an investor's contract with another dealer, said the people, who declined to be identified because they do business with Deutsche Bank. Signing off on so-called novations can take an hour, deterring investors from the trades with the Frankfurt-based institution, they said.

  Financial companies are seeking to limit exposure to competitors after New York-based Lehman Brothers Holdings Inc. went bankrupt and the government seized American International Group Inc., sparking concern that other dealers may fail. Credit-default swaps based on Goldman Sachs Group Inc. and Morgan Stanley surged to a record today."

You want my advice? Get out, we're screwed. A deflationary depression would be a good outcome at this stage.