Tuesday, September 15, 2009

Can the Market Stay Irrational Longer than the FED can Stay Solvent?

It was just a crazy night of football here in Massachusetts. After 3 and a half quarters of terrible defense and uninspired play the New England Patriots were down 11 points with 5 minutes to go. Faced with a huge upset loss and a loss in the division (important for tiebreaks) Tom Brady goes to the huddle and says "We are going to win this game." Now of course what would you expect him to say? Maybe not "We are done boys, lets knock off early" but seriously. Of course every quarterback would say the same thing, but Brady pulled it of in no small part to a huge blunder by the Buffalo Bills on fumbled kick off. While very exciting to watch, I came away feeling this years team will be a work in progress, not a well oiled machine. Still 15 games to improve. The Pats may need them all.

Can the Market Stay Irrational Longer than the FED can Stay Solvent?
Lost among all the 1 year anniversary musing about the fall of Lehman Brothers was this small snippet from an Ambrose Evans-Pritchard article for the Telegraph (several bloggers picked it up):
As of last week, the ABX index of sub-prime mortgage debt showed that AAA-rated securities from early 2007 were trading at 28 cents on the dollar – AA was at 4 cents, near all-time lows. No one can say that $2 trillion (£1.2 trillion) of sub-prime and Alt-A debt is still trading at panic levels, exaggerating losses. The dust has settled. What we can see is that creditors will never recoup their money.

So a year out from the alleged apex of the "panic" and this kind of mortgage debt is still selling (Who's buying? Look in Mirror for answer) at "distressed" prices.

Karl Denninger sums things up as:
More than a year later, it is clear: There was no panic; this was a JUSTIFIED level of trading and reflects the ugly reality - the investors in those bonds will NEVER get their money back.

So what does this all mean?

On a day when Ben Bernanke is calling the end of the recession, it may be a good exercise to look again at one of the most ardently held tenets by those in the FED and Treasury.

When the credit crisis really blew up, the government players were all very confident that the collapsing prices for mortgage backed paper were fantasy. They were out almost daily explaining that distressed prices were not reflective of real value, and that this liquidity crimp could be relaxed by central bank intervention and Treasury assistance for the banking sector.

It sounds pretty good, and heck, if that were the case you may (I said may) have even persuaded me to go along to help a short term crisis in the markets.

The problem is, and always was, that this mortgage paper is almost worthless. The values reported are very real. When you see mountains of foreclosures, and they are still rising, you know these securities are toast.

So it seems we are stuck at an impasse where the banks continue to hold this paper at almost full par value, and the FED even accepts this stuff as collateral for loans (maybe not the worst stuff, but plenty of the paper was taken. How much? Audit the FED to find out). Now if the assets are held to maturity, perhaps they will recoup some more value, but certainly no where near full price.

And this is the exact game that is on right now. Even a year out from the blow up, things are still looking bad. They will next year as well. I think 2013 will not look much better. Where do you stop? The banks have full backing of the FED and Treasury to hold off on recognizing losses on these assets. They are going to wait it out.

So while many are praising the efforts of all those involved in saving the entire world from collapse, understand they have not really saved anything. All that has been done was sweeping the issue under the rug in the hopes "rationality" came back to the markets. Maybe those values are indeed rational, and the government is irrational. With foreign interest in buying this kind of paper non existent, the FED will have to buy it all eventually. I am glad they are the "Buy and Hold" type.

Tornado Distraction
These pictures of Tornado's are a great distraction:
The astonishing twisters captured by storm-chasing photographer

Have a good night.


Dave in Denver said...

Hey dude. It's not just the assets underlying ABS Trusts that are collapsing in value - i.e. homes, credit card receivables, auto loan/lease receivables, it's that a lot of these trusts, like SIV's, CDO's etc are leveraged up as trusts AND they have CDS's "wrapped" around them.

So, you have a leveraged asset (i.e. a home w/a mortgage), you have a pool of leveraged assets thrown into leveraged trust, and then you have derivatives levering up the leverage. It's insane.

This is why companies like Bear, Lehman, AIG, Refco and Enron literally vaporize overnight.

Anonymous said...


It isn't going to be to much longer and that deflation monster is going to be chasing Bernanke down the street, It'll be interesting to see how long he has the cahones to keep playing this game as the dollar gets closer to 71.

From one of my favorites today:

It’s all a game of perception. An economy is a physical system, and in the long run it will react as such.

Recent history has seen economic growth stimulated by government(s) artificially lowering interest rates to get the consumer to borrow, which leads to companies building inventory, which leads to hiring, which leads to economic expansion.

This time around, the consumer is so levered that will not happen. The Fed itself has worried about this in papers as the “zero bound interest rate problem.”

This is a balance sheet contraction, a credit bust. You even hear the government saying it'll take years to recover. It'll take years for the consumer to delever (unwillingly).

I think most stock buyers know this, but aren't buying stocks because they think the economy will recover and profits will too.

I think a lot of people are buying stocks to 1. catch up with other buyers, and 2. because they're worried about “inflation".

I've written in detail why inflation (credit expansion) is unlikely: The fractional banking system is still broken, and so is the consumer. Without either or both, every dollar the Federal Reserve attempts to print just replaces a dollar destroyed by bad debt.

I estimate another $10 trillion to $20 trillion in debt/derivatives is still bad. The government is resurrecting PPIP to try to make that debt look better.

But again, an economy is a physical system.

When the market realizes that the Fed can't create inflation (a full monetization of the majority of debt; something that would make even Ben blink), it'll see that the S&P 500 is really trading at 20 times earnings that are not growing.

It'll realize that all we've done is actually increase the overall debt in the system with massive stimulus and spending.

It'll see the risk in stocks as extremely high.

Mr. Practacal


getyourselfconnected said...

when I think of the the instruments out there that exist only in a notional sense, my head hurts.

Thanks for that link. Mr. Practical is one of the absolute best and his writing s are must reads, though now they are infrequent.

Dave in Denver said...

GYC, I'm surprised you don't have "The Departed" on your movie list...

@kevin: watch this video series:


sedentary state said...

>that deflation monster is going to be chasing Bernanke down the street.

Sounds like a great premise for a video game.

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