The Market Ticker

I have promised a treatise on the proper regulation of liquidity in the economy from a perspective of avoiding both speculative credit bubbles and deflationary credit collapses.

There have also been those who disagree with my definition of "money."  I will therefore remove that term entirely, since "money" connotes different things to different people and we'll go through the definitions again:

• Asset: An item that has value of some varying amount of stability.  Examples are a stand of trees, a stack of sawn and finished lumber, a bushel of corn, a house, a car, a CNC machine and a computer.
  
  
• Currency: An abstraction of a collection of assets, also of varying value against those assets.  Often used as a medium of exchange between parties who wish to exchange one asset for another, and sometimes used as an abstracted store of value.  Examples include federal reserve notes and quarter coins.  Some forms of currency are officially backed or mandated for certain uses, but not all.
  
  
• Credit: A further abstraction of currency, but generally fungible with currency in commerce.  When brought into existence backed by an asset, credit is "hard" or "secured"; when not, credit is "speculative" or "unsecured."  Credit always, in some form, requires payment of interest.
  
  
• Interest: The amount one pays for the use of credit, usually (but not always) denominated as a percentage.  The elements of interest are the risk of failure to pay, the risk of debasement of the unit credit is denominated in, the scarcity of credit and the demand for profit on the lending transaction.
  
  
• Liquidity: The amount of currency and credit in an economic system that is available for deployment (that is, is not committed to some other purpose) at any given point in time.

From this we can determine certain relationships:

• The greater the system liquidity the lower the rate of interest, all other things being equal.  That is, the more "free and uncommitted" currency and/or credit is available, the less will be charged for its use in recognition that credit follows the classic economic supply/demand curve.
  
  
• The greater the interest charged the less deployment of credit will take place, and the greater the preference to use credit for productive purposes.  As the cost of credit rises its use for speculative or consumptive purposes becomes less desirable compared to saving the funds required prior to their expenditure.  Likewise, the lower the cost of credit the more likely it will be used to pull forward demand (consume) or speculate.
  

It is generally-accepted that significant inflation or deflation are undesirable. 

During significant inflation goods become more expensive relative to incomes.  If there is sufficient labor pricing power to force coupling of these price increases back to wages, then a wage-price spiral ensues and can quickly get out of control, since labor is the predominant cost for most businesses.  If there is insufficient labor pricing power to force coupling of price increases then the standard of living degrades for the citizens, in severe cases sufficiently to force a material part of the population into abject poverty.

Significant deflationary events, on the other hand, bankrupt debtors as the real value of the currency used to pay their debts rises rapidly.  This can quickly overwhelm their ability to pay, even when that debt was acquired for legitimate productive purpose.  When these entities fail they discharge workers, forcing contraction of GDP which can in turn lead to further insolvencies as purchasing power declines in the population.  This too can become self-reinforcing and lead to significant economic dislocation.

It is often claimed that "hard money" is a natural check and balance on the tendency of fiat currency regimes to "run away" into an inflationary mess as a means of "printing" out of sovereign debt.  The alternative, however (hard money), has a many-hundred-year history of causing forced inflationary and deflationary spikes that are extremely harmful to the economic climate of any nation, as is shown by the following chart found on Wikipedia:

The inflationary and deflationary spikes are caused by the nature of "hard currency"; once dug out of the ground gold, for example, is not destroyed.  When innovations in productivity outrun the ability to provision new currency reserves deflation ensues as the mining rate cannot keep up - the resulting deflation causes business and personal bankruptcies.  This in turn causes a contraction in GDP but that cannot be balanced with a withdrawal of the currency base since it already exists!  The result is a punishing swing between severe bouts of inflation and deflation; this is unacceptable.

Yet the history of our fiat money regime as practiced to date, while perhaps "better" in terms of violence, certainly isn't in terms of bias, which is clearly inflationary, all the time.

Why?

Simple: Given the proclivity of "choice" the monetary authorities will always choose to try to paper over their friend's mistakes!  This requires inflation, not deflation.

Unfortunately such "papering over" ultimately leads to either a Weimar-style collapse or the utter destitution of huge percentage of the population, dependent only on whether wage-price coupling can occur.  As inflation is a "silent tax", so long as it does not happen too suddenly people tend to react much as a boiled frog - that is, they don't realize what's going on until they're cooked!

There are two competing issues - if you permit debt to rise faster than GDP over an extended period of time you will inevitably get a "runaway" condition and deflationary credit collapse.  This occurs because of the mathematical reality of exponential ("compound growth") functions and no amount of tampering can change it if these relationships are maintained.  The following chart demonstrates this phenomena:

But regulating liquidity and thereby preventing this outcome and what is otherwise a mathematically-certain outcome can be done through a ministerial process.  Let's go back to one of the charts I recently introduced - the Market Ticker Ponzi Finance Indicator:

This indicator is simply the arithmetic difference in growth rates between GDP and systemic credit outstanding.  If this indicator is positive then GDP is growing faster than (or shrinking slower than) credit in the system.  If it is negative the opposite is the case.

When the indicator is positive systemic stability in terms of debt coverage is improving, and likewise it is deteriorating when negative.

Since the goal of liquidity regulation is to maintain systemic balance in debt coverage the mandate to be provided as a matter of law to whatever entity regulates liquidity in the monetary system is simple: The Ponzi Finance Indicator must be slightly positive.

Implementation of this mandate is relatively simple, in that excursions beyond a modest negative value (e.g. -1%) denote severe monetary imbalances and produce asset bubbles.  The 1990s Asset bubble in Internet Stocks was produced by the severe imbalance in credit and GDP growth in the mid 1980s that The Fed refused to correct, and the Housing Bubble was produced by the continuation of that imbalance from the late 1990s forward.  The Fed's current policy, indeed, has spawned yet another asset bubble, this time in stocks which are trading at a completely preposterous 140 P/E ratio as of the end of September 2009, or roughly ten times the historical "fair" valuation.  While many will argue that this is an unfair computation given the negative earnings from last year the fact remains that these negative earnings were real; even on a "current" basis of the second quarter alone the P/E is 122.  This bubble, like all others, will burst with disastrous consequences.

The solution to this problem is to place system liquidity regulation under a ministerial regime that is respondent only to the Ponzi Finance indicator (and to further mandate that GDP be honestly reported, as distortions in GDP will of course lead to improper adjustments), both as a matter of law.  This will result in credit tightening on an automatic basis as long as credit growth is exceeding economic growth - that is, so long as market actors are using credit not for investment but rather to engage in ponzi-style consumption measured simply by the objective on-balance results of credit and output rates of change.

Such a change in policy measure will put a permanent stop to the policy of "bailing out" financial institutions through lowering interest rates at the precise time when they have engaged in Ponzi-style financial maneuvers, creating unsustainable credit.  It is precisely this cycle - the political demand to "cover bad bets" made through Ponzi-style financial manipulation, that ultimately, if left unchecked, leads to deflationary credit collapses or even destruction of a nation's currency.

Fiat currency can work, but to do so the liquidity supply must be constrained such that credit growth is never allowed to outpace GDP.  Simple sixth-grade mathematics prove this to be the case, and also prove that when this stricture is violated disaster will strike - we are left only to argue over how long we have before it occurs.

Those who argue otherwise, whether on the public or private stage, are committing fraud upon the public and must be held to account for their criminal acts.

Let's cut the crap here with the claims that the "FHA is making sound loans:"

The idea the FHA needs a rescue is “just plain wrong,” Stevens said in an Oct. 6 letter to the Wall Street Journal. That’s in part because the FHA’s accounting method mean its reserves are enough to cover more than 30 years of projected losses, assuming no revenue from new business, he said.

This is just plain pump-monkey nonsense.

FHA currently requires 3.5% down.  Remember that (contrary to the Realtard's assertions) all home purchases are instantly underwater by approximately 8% from their "purchase price" at closing, because typical Realtor commissions are 6% and closing costs, including title transfer, title insurance and doc stamps typically consume about 2% of the deal price.  A home that must be immediately resold thus instantly "consumes" about 8% of the purchase price, and this deficiency persists over time, rising market or not.

As such FHA loans are all immediately in negative equity at closing.  If delinquency is running at 14% (which is 60 day+ only), or 22.9% (if you include 30 day lates) the fact remains that in order for the FHA to be "solvent" those problems must all occur after the loans go into positive equity status.

Now one can argue that with conservative loan-to-value ratios the FHA won't lose its shirt.   But even there the borrowers will unless the debt-to-income numbers are similarly conservative, and they are not, as I have previously documented.  Indeed, in that particular loan I documented which did in fact fund the FHA was unlikely to take a loss (LTV under 70%) yet the borrower's debt to income was fifty-three percent - and that's on gross income, meaning pre-tax.  The odds of that loan being sustainable and not resulting in the loss of the home for the borrower?  Almost zero.

So we have two problems here and yet the Realtor and FHA proponents don't want to talk about either.  The first is that for FHA-funded purchases the 3.5% down payment results in a LTV of 96.5%, rendering the property and loan instantly upside down by roughly 5% at closing.  Since the principal payments are near zero in all mortgages for the first few years a default in the first couple of years after origination will result in the FHA realizing an actual loss.  If prices continue to decline those losses will, as a percentage of loan value, become ridiculously large in a huge hurry.

In the second case, where refinances are taking place at reasonable LTVs (not the "streamline" refinances that are now authorized at up to 125%!) the FHA may not be exposed but the borrower sure is.

The FHA's claim that it is practicing "conservative" underwriting is both a bad joke and a flat lie.  Jeff Skilling went to prison for trying to run this sort of accounting at ENRON, yet we still have "government officials" doing the same thing at federal agencies.

Back end "debt to income" ratios (DTIs) must be cut back to no higher than 36%, and CLTVs post-closing must be limited to 95%.  For FHA loans this mandates a roughly 10% down payment, and refinances must be denied where post-closing, inclusive of all costs, the CLTV is over 90%.

If the government wants to provide "rescue" financing for underwater (or "about to reset/recast") homeowners then they must force the original originating and/or securitizing bank to accept the writedown of principal to where these CLTVs are achieved - even if it bankrupts them.

In a letter to The Senate Banking Committee today Representatives Grayson and Paul demanded of Senator Dodd that Bernanke's reconfirmation hearing be suspended until The Fed provides answers to several questions, specifically:

1. Information that Bloomberg reporter Mark Pittman has requested via a Freedom of Information Act Request on the Bear Stearns rescue and that the Federal Reserve is contesting in the courts and which Manhattan Chief U.S. District Judge Loretta Preska has ordered by turned over by the Federal Reserve.
   
   
2. Information that Rep. Grayson requested in February at a hearing and by follow-up letter on which institutions received the $1.2 trillion added to the Federal Reserve’s balance sheet, how much each institution received, and what was promised in return.
   
   
3. All Federal Reserve documents that went to Attorney General Andrew Cuomo’s office relating to the Bank of America/Merrill Lynch merger in which potentially illegal and coercive activity might have occurred, as well all Federal Reserve documents relating to the lawsuit pursued by Merrill Lynch shareholders in the US District court for the Southern District of New York.
   
   
4. Transcripts of all Open Market Meeting Minutes up to and including that of June, 2009, transcripts which are normally withheld from the public for five years.
   
   
5. Full disclosure of all terms and conditions of all off-balance sheet Fed transactions in the past three years.

I have been sharply critical of Representative Paul over the previous two years in The Ticker, mostly due to the fact that he has refused to display evidence that he "gets it", including questioning directed to Fed Chair Bernanke in multiple hearings since this crisis began.  "Hard money", his "all the time, every time" issue will no more solve the problems our nation faces than will wishing for The Easter Bunny or believing in Santa Claus.

But today I am forced to change my beliefs, at least in part.  I don't know if Representative Grayson turned a light on or if Representative Paul simply woke up over the last couple of months, but what I see here before me is a substantive and welcome change.

Now I want to challenge both Representatives Paul and Grayson, as well as the rest of the House and Senate, to consider the following points:

1. This is not a Recession.  It is a Depression.  All credit-led economic downturns are.  If you doubt that this is a Depression have a look at the article in The Detroit News today, chronicling a scene every bit as forlorn as was seen in the 1930s, every bit as poignant, and every bit as unnecessary.  It was asked:
   
   "This morning, I seen the curtain pulled back on the misery," he said. "People fighting over a line. People threatening to shoot each other. Is this what we've come to?"
   
   It is what we will come to nationally if we do not stop the stupidity here and now.
   
   Government created this Depression just as Government created the Depression of the 1930s by refusing to do its job of regulation.  75% of the people in the 1930s had jobs.  75% of people have jobs now.  If you truly believe that unemployment is 9.something percent, you're delusional.  If you believe it is the 16.x percent that is recorded in "U-6" you are likewise delusional as neither counts those who have given up trying to find work.  Take a trip to Detroit, Michigan.  It is not that different from any other major city today.  If your perspective is limited to the Beltway of Washington DC or the sheltered parts of America where it all appears ok you need to get out more often.  I have, I lived in the Detroit area in the 1970s and 1980s, and I have never - ever - seen anything like what happened at Cobo Hall as described in that article before today in America.  Anywhere.
   
   
2. This Depression was caused by the same thing all others in modern times have been: banks lending unsecured beyond excess reserves.  That is, banks lending in a speculative rather than secured manner. That is the primary sin. It is that simple. It has always been the primary sin that has led to this result, and it is the primary sin this time as well. This must end, now and forever, if we are to both stop this lunacy and prevent it from ever happening again.  Our regulators, our Congress, and so-called "economists" have spent more than two years waving their arms claiming that this or that "tweak" to the regulatory structure will prevent systemic risk and set things right.  They're either wrong or lying and the proof lies in mathematics, not political or philosophical dicta.  If you need an explanation, read "Sound Banking: A Capitalist Imperative."  Reality is that if you provide a business with a means to speculate with someone else's money (in this case, yours and mine through the credit of the sovereign) they will do so recklessly since the losses are not theirs.  You can only prevent this outcome by barring the practice.
   
   
3. We have compounded that sin by refusing to force banks to admit to their insolvencies, and there are in fact many, even a majority, that are insolvent.  They are not "mildly" or "slightly" insolvent either.  Just last week Warren Bank failed and was seized by the FDIC.  The loss to the deposit fund is estimated at $275 million out of an asset base of $538 million - that is, the bank was underwater by 51%.  But it is, in fact, much worse than that since "well-capitalized" according to the government requires a Tier 1 Leverage capital ratio of at least 5%.  To fail "adequately capitalized" you must have Tier 1 Leverage capital under 4%.  To put this in perspective this bank failed 12.75 times before being seized.  This is not an accident, it is willful, deliberate regulatory malfeasance or fraud on the part of examiners and institutions.  There is no other possible explanation.  This is also not an isolated incident; Colonial Bank was seized recently, a huge bank, and the assets were written down 39% - a nearly ten-fold failure before being seized.
   
   
4. The government cannot make up for the contraction in private credit.  All the government is doing is risking its own insolvency.  We cannot run trillion dollar+ deficits - Depression or no Depression.  We cannot continue to take bad debt onto the balance sheet of Treasury or The Fed and we cannot make unsound FHA (and now USDA!) real estate loans.  WE CANNOT LIE OUR WAY OUT OF THIS.  Despite the fact that Washington DC politicians are known for lying whenever their lips are moving, mathematics never lies and always catches up with you - without exception.
   
   
5. The Government's continued mendacity in this matter is leading to the destruction of the Dollar and, potentially, our economy and government funding mechanisms.  We now have an active "carry trade" going on using dollars as the funding currency - an unthinkable situation just a few months ago.  The credit system is functioning only in places where tens or even hundreds of billions in printed money are being used to "purchase" worthless (or nearly-so) loans.  Fannie, Freddie and now the FHA have become embroiled in a futile attempt to prop up residential property markets, which in turn has led banks to withhold foreclosure actions as a means of hiding losses.  This in turn has trapped millions of homeowners in underwater property, preventing them from moving to seek better employment opportunities and creating artificial shortages of housing in some MSAs as inventory is "locked up" by banks as a means to avoid recognition of losses that have already occurred.
   
   
6. We cannot restore our economy to health until we force the bad debt out of the system.  We must stop trying to layer on more debt to pay interest on existing debt, and we must stop playing shell games with the bad debt that exists.  It is mathematically impossible for credit creation to continue at a rate exceeding growth in output on a continual basis.  The fraudulent granting of credit with no assets or capital behind it (#2 and #3) is why we are here.  The only path to a durable economic recovery is to stop doing that which led us into the mess in the first place.

Given these facts we have choices to make as a nation.

We can choose to continue that which has failed, or we can choose to reform the banking and financial system.  We can insist that the banking and financial system face the following regulatory changes:

• Mark all assets to the market, now and forevermore, on a nightly basis.  If this results in firms becoming insolvent, then so be it.  We need a banking system - we do not need the specific banks we have operating today.
  
  
• Pass a federal law mandating that receiving deposits or transacting business while insolvent is a felony, as is the case in several states.  Then enforce it.  Strictly.
  
  
• Define insolvency as the inability to pay all depositors at any point in time through ordinary business transactions.  This implements the requirement that banks lend unsecured only to the limit of their excess capital and never beyond.  Banks can lend to any degree they'd like provided they have capital or assets of at least the outstanding balance behind each loan.  If a bank wishes to lend to you on a credit card, it must hold one dollar of capital for each dollar you have outstanding on your charge plate.  If a bank wishes to write a 100% LTV home mortgage it may, but it must hold one dollar of capital for each dollar of loan balance beyond your home's recovery value - including resale expenses.  It is a bank's decision how close it wishes to operate to the line of insolvency and forced closure and it is also a bank's decision as to how much capital it wishes to raise; the less "cushion" it wishes to maintain the greater the risk that its shareholders and unsecured bondholders will lose everything through an unexpected drop in the market value of the assets behind their loans.  This removes all the nonsense and games about "leverage" and reduces it to one simple reality: you may not impugn the credit of the sovereign (The Federal Government) as a private enterprise.  Period.
  
  
• Force The Federal Reserve to disgorge all of its non-government-guaranteed paper.  The Federal Reserve Act (Section 14) clearly does not permit the purchase of any such obligation.  This is a monstrous problem as there could be hundreds of billions of dollars in losses embedded in that paper and it was acquired illegally.  Such a loss, if and when it detonates on their balance sheet, will have severe and perhaps catastrophic consequences for our government, our banking system and the dollar.  The entire essence of Mr. Paul's and Mr. Grayson's (very valid) complaint is that The Fed is preventing trash debt resolution by taking it onto its own balance sheet and refusing to disclose that it has done so and how it has valued those so-called "assets."  Disclosure is laudable but requiring The Federal Reserve to actually live within the strictures of The Federal Reserve Act should be the standard we demand.
  
  

These four steps end the credit crunch tomorrow and prevent it from ever returning.  They also end a number of large financial institutions tomorrow.  That's ok - there are literally 330 million capitalists in this nation, some of whom will want to start new banks, and there are also thousands of community banks and credit unions that can operate within these rules.

No, these steps will not bring back the "free credit" world of the 2000s.  That is gone forever whether we like it or not.  Credit will be available to worthy borrowers at a risk-adjusted interest rate that reasonably reflects the probability of default and inflation, plus a fair, demanded profit.  This is how credit should have been for the past 230 years of this nation's history, and how it can be going forward.

In addition The Federal Government must adjust its policies and operations, specifically:

• The government cannot spend more than it makes.  With the possible exception of a declared war, deficit spending is indefensible, especially when the deficit reaches 30, 40 or even 50% of the entire Federal operating budget.  If government wishes to increase spending then it must increase tax revenues.  This in turn requires that The Government take a long, cold, hard look at how we can couple tax revenues to growth.  I am a personal advocate of The Fair Tax because it aligns Federal Revenue with GDP and thus provides a powerful incentive for the government to act in a manner that promotes economic prosperity, but there are undoubtedly other means of accomplishing this central goal.
  
  
• The government must not bail people out.  The essence of capitalism is that when you screw up you fail - and go bankrupt.  Only the hand of the market provides disincentives to bad decisions - either prospectively or, if not heeded, retrospectively by clearing the playing field for new entrants in the place of failed enterprises.  The US car companies are prime examples; "Cash for Clunkers" and the US Auto Bailouts have been dismal failures; the collapse in sales in September has made clear that Chrysler, for example, is almost certain to fail to survive more than another year, even when the billions given to Cerberus to "restructure."  That was pure money down the drain that accomplished nothing other than suspending Chrysler's death sentence for a few months to a year, yet it has blocked the acquisition of those facilities by a potential competitor as-yet unknown.  The economic damage done via these interventions is severe and irreversible.
  
  
• Government must enforce laws against fraud in all areas of the market evenly and swiftly.  Banks, as just one example, cannot be permitted to "re-order" transactions so as to generate the maximum in overdraft and other "junk" fees - a clearly unfair business practice.  The practice of pretending that loans are performing when they are not by shuffling paper around between subsidiaries must bring prosecutions, not forbearance.   When someone is cheated (for example by bogus "ratings" on securities or unlawful front-running in the markets) they need to be able to look to the government for help, rather than the bad actors taking cover behind willful regulatory blindness.

The rest of the world is passing judgment on our nation's willingness and even ability to rein in the rampant financial fraud and outrageous acts that led us to this precipice.  These nations are, quite realistically, looking to diversify away from the dollar for international transactions and as a reserve currency as they perceive that our government and business environment has become nothing more than a giant looting machine operated for the benefit of a handful of firms and people on Wall Street who have been and will be allowed to siphon off whatever they desire at everyone else's expense.

Firms and individuals worldwide were sold well over a trillion dollars of worthless securities by these bad actors.  Some of them, such as the Chinese and large foreign banks, appear to have received a "back door" bailout via unannounced and likely unlawful actions of The Fed, while others have been left to twist in the wind.

Lehman was permitted to co-mingle customer margin funds with their own operating capital, resulting in billions of dollars of customer wealth that should not have been at risk being tied up in the bankruptcy courts, possibly for years, with a very real risk that it will never be returned to its rightful owners.  At the same time The NY Fed may have have received their funds back immediately after the filing in violation of bankruptcy preference laws.

Our banking system is currently hiding hundreds of billions in defaulted mortgage loans "off book" via exotic and undisclosed financial shenanigans.  In the instances where these properties are being disposed of huge losses, often in excess of 50%, are being realized - yet this is not being recognized as the "mark" on similar securities held by other institutions as it should be.  This is presenting a false view of financial institution health, but more importantly it is severely constraining credit as consumers trapped in these homes where banks are refusing to proceed to foreclosure are unable to proceed to rebuild their credit while the banks are stuck with an "asset" they are refusing to sell at its market price, clogging up their credit origination capacity.  Worse, those institutions that are disposing of these "assets" have first put in place "loss-share" arrangements where the FDIC or Treasury is in fact "eating" 90 or 95% of the losses - meaning that the loss of value in these assets (houses) is being distributed as a tax to all Americans!  The banks that distributed these "profits" to shareholders and executives on the way up have managed to set up a "heads we win and keep it, tails you lose and eat it" circumstance - but only for them.  For the homeowner he's bankrupted by these shenanigans and those who refused to participate in the fraud get the tax bill.

We can choose to address these problems now or we can continue to march toward the abyss.  The loss of confidence in our government, in our regulatory agencies and indeed in our currency is on the brink of becoming disorderly.  Should that point be reached it will be too late to take remedial action and our nation will be forced to suffer the (well-deserved) consequences of our willful blindness to these outrageous acts of looting, all of which will come raining down on American consumer's heads.

We the people must insist on better and hold our lawmakers feet to the fire.  If the Washington DC politicians will not do their jobs then we must in turn insist that our state lawmakers do so - including, if necessary, by enforcement of our State 10th Amendment rights.