Epic enough for me to post it here.
Fundamental State of Our Economy
A reader asked yesterday what would fundamentally trigger a P3 collapse and consequently lead the world into a global depression. The short and simple answers are massive defaults of existing debt and loss of market confidence. The Federal Reserve’s current policy of quantitative easing seeks to reflate our way out of these impending defaults. It doesn’t take much to see the twisted nature of this logic and that such foolhardy policies will only provide a temporary reprieve. The financial crisis the United States faces is 30 years in the making and the policies being pursued by the Federal Reserve provides only a short-term remedy to what is a very serious and debilitating ailment. For all economists, media pundits, Green Shooters and Bears-turned-Bulls who now hail the Federal Reserve for its successful efforts in steering our economy clear from the Second Great Depression, I ask two questions. What are the fundamental problems of this crisis? And, what have we done to address and resolve those fundamental issues?
As a former mortgage and CDO credit analyst on Wall Street, I was at the epicenter of this credit crisis and witnessed first-hand the monumental implosion in the debt market. Outsiders to this very day place the blame of this crisis on the unscrupulous mortgage industry that aggressively pushed mortgage products onto borrowers they knew couldn’t afford them. They believe these overextended borrowers defaulted on their loans on a massive scale and consequently drove us into a liquidity crisis. I strongly believe this view to be narrow and, in many respects, ignorant. Mortgage credit is a subset, albeit a large one, in the great game of leverage our country is fully engaged in. It may have been the first domino to fall, but it was in no way a stand alone piece.
The fundamental cause of this crisis is leverage and our country’s addiction to it. Consumers, corporations and our government have embraced easy credit for so long that leverage is at the very heart of American culture. Needless to say, but leverage is a double-edged sword. It has contributed to almost 30 years of nearly uninterrupted prosperity; our elevated successes and overconfidence in the idea that is America has blinded us to certain realities; runaway growth can not go on forever and debt must eventually be repaid. Correction and regulation of exuberance and overconfidence are necessary and crucial to maintain the long-term viability of our economic system.
Unfortunately, Alan Greenspan and Ben Bernanke do not share this view. The Maestro believed markets could charge ahead full throttle with only occasional and inconsequential rests so that markets don’t lose their momentum. This view was reflected by his eagerness to lower interest rates too soon and his notorious habit of keeping them low for too long. His Laissez-faire approach to reforms and regulation in the financial service sectors gave birth to many of the products that will lead to the destruction of our financial systems, such as Subprime and Alt-A mortgages, structured credit products, credit default swaps and other complex financial derivatives. Bernanke is no better than Greenspan. Under his leadership, the Federal Reserve made no real attempts to reform what is a deeply impaired and fractured financial system. Even to this very day, when our economy is in the throes of economic abyss, no new and meaningful regulations have been enacted to rein in on the credit markets, derivatives products and culture of Wall Street.
The current Federal Reserve does not believe the fundamental cause of our epic crisis is leverage. Rather, they believe the market failure we saw in 2007 and 2008 was due to a collapse in confidence and the lack of liquidity that ensued. In other words, Bernanke believes markets were on the brinks of complete collapsed because it did not have enough leverage! To better understand Bernanke misguided beliefs, one must first understand the framework in which he approached his doctorate’s thesis on the Great Depression. Bernanke examined the Great Depression through a comparative studies framework; that is, he analyzed different economies around the world and why some recovered sooner than others. As a former econometrics student myself, these types of studies are always tricky due to the presence of confounding variables. Of course, Bernanke uses confidence tests and other complex statistical methods to defend the validity of his conclusions. I am no Great Depression expert, but common sense tells me you can not solve a problem of leverage with more leverage. If I took out a credit card debt that I couldn’t pay off and kept rolling it over onto another credit card, I did not solve anything. I am merely delaying the day of reckoning and magnifying my indebtedness which will eventually lead to more, not less, problems.
If reality reveals anything, we are already seeing the ramifications of Bernanke’s policies. America is currently monetizing its national debt because foreign lenders are increasingly weary of lending to us. Many of our trading partners have already voiced concern about the level of our national debt and the long-term viability of the Dollar as a reserve currency. If Bernanke’s intent was to buy time, I ask, what steps have we taken to reform our banking systems, restructure our securitization industry, alleviate impending foreclosures in both residential and commercial properties, address concerns about our increasingly unmanageable national debt, among countless other fundamental problems that still loom over our financial system? The short answer is nothing. Other than paying worthless lip service for some vague need for reforms, this Federal Reserve and this administration has done nothing because they do not believe the root cause of this mess is leverage.
Bernanke’s defenders would argue that markets have rallied over 50% since March and such confidence is indicative of his policies’ success. This could not be further from the truth. Markets have fallen so much from its highs in 2007 and anyone who has traded markets long enough know markets were technically overdue for a powerful countertrend rally. Bear markets are known for its violent rallies due to massive short covering and performance chasing by asset managers. The P2 rally we are currently experiencing is vigorous and particularly unique in that federal liquidity is being used to support and guide markets higher; consequently, the same liquidity has probably kept this countertrend rally afloat much longer than it would have otherwise lasted on its own. For anyone who finds this PPT theory hard to believe, I ask why? Regulators around the world have long maintained open policies to intervene in currency and debt markets when needed. Historically, regulators have had no need to manipulate the equity markets because there was no national interest in inflating stock prices.
Unfortunately, our financial crisis is quite dire and like very few in the past; we are in a credit recession, not an inventory recession. The ability of companies to refinance and effectively avert bankruptcy is dependent on their share prices. If equity prices were allowed to collapse, these companies would not be able to roll over their existing debts. A collapse in equities may also breach debt covenants for some companies that may lead to asset sales or liquidation. On the consumer side, everyday Americans view the stock market as a barometer of the direction of this country. It is no coincidence that, in general, consumer confidence rises when stock markets rally and vise versa. One of the goals of Bernanke’s liquidity plan is to help stabilize equity prices so that markets have the confidence to help companies, especially banks, in need of recapitalization. This is where liquidity does not resolve the underlying problems of our economy. Rather, it provides a temporary support, creates a false sense of confidence and, in our particular case, false sense of overconfidence that we have now overcome what some believe is a run-of-the-mill recession.
Bernanke’s supporters have also distorted the analytical framework in viewing our current crisis and, in doing so, fooled Americans into believing there were no alternatives to the current Federal Reserve policies. Americans are currently led to believe that had drastic steps not been taken by the Fed, American would be in a Second Great Depression at present. I do not dispute this line of thinking. But I ask, is a severe market correction of 30 years of nearly uninterrupted prosperity avoidable? Perhaps a Great Depression is inevitable and the framework should have been, what can our country do so that we don’t exacerbate and prolong a much needed correction? Economic corrections give markets pause to reflect and correct policies, systems and environment that have led to unsustainable conditions. They allow markets to ultimately flush out excesses so that our nation—our financial systems re-emerge healthier and stronger than before.
The Fed has chosen to avoid this period of reflection at all expenses. The Fed has chosen to avert not a depression, but a much needed and painful de-leveraging process. By bailing out financial institutions and providing endless backstops, the Fed has created a moral hazard environment that rewards companies that mismanaged risks. Such policies has effectively socialized the losses of banks and failed companies, in which America has limited upside participation. Why not nationalize these failed banks and re-IPO them when they are fixed? Let private investors who made foolish bets on these banks take their rightful shares of losses instead of taxpayers, therefore reducing the amount of liabilities our government would have to assume in a nationalization effort. When the economy truly recovers, tax payers would reap all the benefits from years of austerity through re-IPO proceeds and a reformed banking system, instead of the pittance we received from TARP warrants so far. This is merely one example of an alternative solution to fixing our financial institutions that our corrupt regulators and media do not want public discourse on because bankers and private investors ultimately lose in this proposal.
Nothing has fundamentally changed or improved in our economy. Bernanke’s policies merely refashion the crisis. In very blunt terms, Bernanke has transformed a very serious credit crisis into series of outsized Ponzi schemes. Like all Ponzi schemes, either a loss of confidence or defaults will lead to their ignoble demise.
Market technicals, which are nothing more than quantitative representation and signals of market conditions, suggest current market climate is reminiscent of the trading environment observed prior to major market crashes. I, however, am not a technical purist that believes markets are primarily driven off technical indicators and Elliott Waves. I take a more complex view in that markets are reflexive. At times, market technicals and emotions drive trading actions and trends and, in other times, they are driven by real fundamentals. This reflexive nature can best be visualized as a shoe lace where at times, the right side (fundamentals) crosses over and is dominant over the left side (technicals/waves/emotions) and we observe the opposite in other periods.
Fundamentals do not currently support this rally. The rise in equities since March’s low has been driven by market technicals, overly optimistic expectations of improving fundamentals and outright manipulation. Technicals have already been suggesting we are near a top of this countertrend rally. However, technicals mean little when there is a powerful force manipulating markets to conform with its agenda. Our government will not give up so easily and, if anything, they have already proven they will resort to any and all creative devices to prevent a collapse in confidence. If they don’t use PPT to support the futures market, or issue upgrades of leadership stocks and sectors when markets appear ready to break, they fabricate economic data.
How often in this rally have we seen markets go berserk to the upside on terrible, yet better-than-expected, economic data? Only months after when everyone has forgotten about those numbers, our government stealthily revises them to the downside. Need I remind anyone GDP for Q1 2009 was revised down from -5.5% to -6.4%? That’s almost 1 full percentage point. Or what about Q4 2008 when GDP was reported at minus 3.8%, revised down to -6.1%, only to be revised down again to -6.3%? Does anyone see a pattern here? Understate the bad news so we rally off them. Months after market forgets, report the true numbers. Understate the new numbers but make sure they are better than the previous data point. Market rallies off better-than-expected data, with a little push in the futures of course! We see the same pattern in unemployment, claims number and other economic data. You would think market participants would have picked up on this duplicity, but that would be assuming too much about their collective wisdom.
With fundamentals and technicals no longer supporting this rally, this Ponzi scheme becomes a game of confidence. As long as investors believe a green shoot recovery is a quarter or two away, no one will sell and markets may continue to grind along. But as stated above, there are serious underlying problems with our global financial systems. I believe missed earnings and lower guidance in Q3 or Q4 may put a dent in consumer and investor confidence. Consumer spending makes up approximately 67% of the US economy. Short of cooking the books, how do companies expect to beat estimates and raise outlook when consumers are still facing job losses, wage cuts, underemployment and saving more than they have in the past 14 years? Why anyone expects us to blow out earnings in Q3 or Q4 is beyond my comprehension.
Another fundamental catalyst may be another country defaulting on its national debt. Although all the focus is on our national debt, I believe a default and subsequent currency crisis will not originate from the United States. UK’s credit outlook has already been downgraded by S&P; this is typically a prelude for a ratings downgrade on the sovereign debt. Such debt default or loss of confidence in a major industrial nation’s debt could lead to panic selling of risk assets and a rush back to traditional safe havens like the US Dollar and Treasuries.
If anything, our banking system is one of the biggest game of confidence in town, second only to our Treasury markets. I believe most of our banks are insolvent. A Goldman Sachs research report a few months ago estimates that banks are still carrying bad loans near par or assuming unrealistic haircuts. See chart below. The changes to accounting rules for valuing these securities have probably driven most of these values closer to par since this Goldman report back in March. Banks have to maintain this charade because even a markdown of 10% across the books would lead to their insolvencies given their leverage ratios.
No one knows for certain what fundamentally will trigger a collapse in confidence, but one thing is for sure; there is no shortage of highly levered problems waiting to explode. P3 will begin with some fundamental event that causes investors to doubt or lose confidence about an imminent recovery. Wave 3 of P3 is when markets finally realize we are deeply entrenched in a bear market. When Wave 3 of P3 begins, no amount of intervention by regulators will make up for missed expectations, lost hope and shattered dreams.
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