Monday, January 12, 2009

The Progress So Far: Fed Completely Successful (so far) Bank Credit Crisis Over

The Crisis of 08 is still, form my perspective a classic Banking Crisis with the epicenter being the credit quality and ability to lend of the USA banks. The trigger was the large amount of non-agency scrutinized mortgages which triggered in an absolutely classic fashion a crash in bank credit.

So far this is the domain of the problem and one should not infer a moralistic viewpoint on spending or savings patterns of the USA or the worthiness of the USA market and capitalistic system beyond technical observations on how could the mortgage debacle triggered such a massive crash. All the other headlines such as AIG, autos, home prices, and employment are symptoms of the technical problem - a classic failure in the USA banking system.

There is a good chance, though I don't know yet if it is over 50% probability, that the fiscal remedies applied to fix a bank crisis and public policy fail, or are ill thought out. That certainly seems to be the case with the bizarre tax-centric fiscal stimulus Obama-Biden is proposing now. Then this technical issue of being a bank credit crisis could develop into a systemic crash as we had in the Great Depression. Given good policy and given this is a massive and powerful -still technical - problem, the recovery could be an extremely violent V shape full recovery in asset prices. Of course asset prices are now at levels with that in mind which is why the SPX has not made levels as we saw in the lows of 1933 and 1933. But if those levels develop the technical problem would have become systemic and then a V shape recovery would be very difficult. That development would have SPX trading with little liquidity with little daily volatility at around 200 to 300 and the large lurches down - jumps in vol parlance - would price to what appears to be an incredible 50 to 70 long term volatility and the VIX touching well over 150. That is basically a complete market failure and trading opportunity would be little and pain much.

In that state, to paraphrase Keynes, we are all dead - bull and bear alike. Jesse Livermore wrote the book on speculative trading and it should be kept in mind that he could not survive the depression and blew his brains out in the mens room of Delmonicos in 1940. We go to this state it is ridiculous to anticipate any trade opportunity. Dave Schulman was a great trader and survivor and partner to John Mulheren - he went through the 70s as an equity trader. I asked him about those times and he said the salary was the benefits and a place to hang out and after a few minutes in the morning everyone would settle down to play poker for the rest of the day. There was no trading. This is "only" the 1970s.

So all focus should be on keeping this a technical crisis and avoid at all costs a systemic failure.

Being a bank credit crisis what to watch as far as tracking progress and the maintaining of that progress to date.

Basically everything that can be done form a Friedman monetarist point of view has been done. Bernanke went to Congress with Paulson in September, warned our elected representatives what the score was and he was insulted and chastised with comments that one of the world's leading academic in depression economics would have thought inane and showing that Congress was a totally ineffective and unreliable avenue to meet this crisis. But for when summoned we never saw Bernanke again in front of Congress and then he faded quickly to Fed-speak, letting Paulson and his mini-me "Kash-and-Kari" to babble away and present a helter skelter policy answer.

Bernanke then steadily implemented the largest Central Bank operation since Bagehot wrote "Lombard Street" in the 1870s.

The progress of the Federal Reserve can be observed here: the H.4.1 "Factors Affecting Reserve Balances" which shows the following incredible "quantum physics" like developments. Compare the summation of the total liability of the Federal Reserve balance sheet (capital and A/L) on August 7 2008 versus the latest Jan 8 2009.

Capital and Assets and Liabilities Fed Res

August 7, 2008 $902,471,000,000

January 8, 2009 $2,141,053,000,000

First, as indicated by current money market relationships (which I give below) any Jim Grant or standard gold bug talk or USA falling apart like the USSR is obviously complete rubbish to anyone with even a moments thought on the above numbers. The August numbers were already at levels folks thought stressed and ready to crush the Fed with Maiden Lane on the balance sheet. Then looked what Bernanke did which resulted risk pricing leaving the market and basically a complete cure in money markets by taking almost the entire USA money market and putting it on the Federal Reserve balance sheet. At least to this level of stress all doubts or silly talk about demise of the USA should be laid to rest. And this "proof" is the core of any development of a bullish stance.

The spread between Fed Funds and LIBOR (rate banks led to each other) , and how it developed through the crisis and how it repaired contains most of the story, especially if the market expectations of this spread in the forward markets is looked at. In the following it is the spread as traded for the next 2 years:
The frightening data point is the 300 basis points reached in October which showed the market was pricing for a complete failure of the USA banking system resulting in either a nationalization or a bank holiday. Now the spread of 18 basis points (.0018%) indicates complete repair and confidence this Fed Reserve fix will be robust and last. Watch this spread before you start really betting on gold or other weak-USA trades.
Many in the market catch some of this change by watching the 2 year interest rate swap spread:
But this does not depict the dynamics occurring in the immediate short end and in Fed Funds.
As this bank credit crash was occurring, the most alarming pricing which actually did, for a few weeks lent credence to the most dire predictions of a depression and end of pax Americana was the risk premia in the risk-free curve. One way to observe it is ot look where the 3 months LIBOR rate is in Chicago 7 years in the future and subtract that rate from the same 8 years in the future:
This tracks from 12 to 20 basis points which can be an off the cuff risk premia measure showing the markets idea as to the risk of the Federal Reserve able to control inflation and deliver growth. I would certainly buy gold if this was seen to shoot up to 30 or 50 basis points. But the spread collapsed top where during the grimmest days of November, the absence of fiscal partnership to the monetary fix the Federal Reserve was providing indicated the development of systemic economic failure and the negative spread of -2 to -10 shows the market was starting to price for deflation 7 years plus forward. Think on that for a bit. But we are back form the brink and it looks like some normal expectations of risk has re-appeared.
So the technical issues have been pretty well all cleaned up as far as what happens with a bank crisis.
But to prevent this from becoming systemic, a fiscal stimulus policy has to be forthcoming which is in size equal to any jump increase in savings (which will be a drop in consumption as it occurs) along with offsetting the large drop in corporate investment (cap x) which will also be occurring. If the market starts to doubt the ability of the incoming administration to effect such a policy, the market will first discount secondary assets to bank credit - the SPX and credit spreads. But if Obama does not respond then - say with SPX making new lows - and rewrite the plan to provide adequate stimulus, then the containment shell the Fed Reserve will start to crack and if the above relationships return to October/November levels, don't buy gold but go buy arms, 2 years of dehydrated food, some good mountain bikes for you and your family, penicillin, and fish hooks (fishermen never starve).

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