March 23, 2009

Fed and Treasury - Putting off Hard Choices with Easy Money (and Probable Chaos)



John P. Hussman, Ph.D.

All rights reserved and actively enforced.

Reprint Policy

Brief remark - from early reports regarding the toxic assets plan, it appears that the Treasury envisions allowing private investors to bid for toxic mortgage securities, but only to put up about 7% of the purchase price, with the TARP matching that amount - the remainder being "non-recourse" financing from the Fed and FDIC. This essentially implies that the government would grant bidders a put option against 86% of whatever price is bid. This is not only an invitation for rampant moral hazard, as it would allow the financing of largely speculative and inefficently priced bids with the public bearing the cost of losses, but of much greater concern, it is a likely recipe for the insolvency of the Federal Deposit Insurance Corporation, and represents a major end-run around Congress by unelected bureaucrats.

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Last week, the Federal Reserve announced its intention to purchase a trillion dollars worth of Treasury debt by creating the little pieces of paper in your pocket that have "Federal Reserve Note" inscribed at the top. In effect, the Fed intends to monetize the Treasury debt in an amount that exceeds the entire pre-2008 monetary base of the United States.

Apparently, the Fed believes that absorbing part of the massively expanding government debt and maybe lowering long-term rates by a fraction of a percentage point will increase the capacity and incentive of the markets to purchase risky and toxic debt. Bernanke evidently believes that the choice between a default-free investment and one that is entirely open to principal loss comes down to a few basis points in interest. Even now, the expansion of federal spending as a fraction of GDP has clear inflationary implications looking a few years out, so any expectation that long-term Treasury yields will fall in response to the Fed's buying must be coupled with the belief that investors will ignore those inflation risks.

There is no doubt that the Fed also intends for the extra trillion in base money to end up as bank reserves. But think about what this move implies in equilibrium. The largest purchasers of U.S. Treasury bonds at present are foreign central banks. So what the Fed is really doing is printing enough money to crater the exchange value of the U.S. dollar, while leaving foreigners with a trillion dollars of savings that they would otherwise have invested in Treasury bonds, which they will now use, not to buy our lousy, toxic assets, but to acquire our productive assets, and at a steep discount thanks to the currency depreciation. So yes, the extra trillion in dollar bills will ultimately end up as bank reserves (and currency in circulation), but only by encouraging Beijing to go on a shopping spree to acquire a claim on our future production. Ultimately, funding the bailout of lousy assets comes at the cost of debasing our currency and selling our good assets to foreigners.

Make no mistake - we are selling off our future and the future of our children to prevent the bondholders of U.S. financial corporations from taking losses. We are using public funds to protect the bondholders of some of the most mismanaged companies in the history of capitalism, instead of allowing them to take losses that should have been their own. All our policy makers have done to date has been to squander public funds to protect the full interests of corporate bondholders. Even Bear Stearns' bondholders can expect to get 100% of their money back, thanks to the generosity of Bernanke, Geithner and other bureaucrats eager to hand out the money of ordinary Americans.

Though I believe that the consequences (via credit default swaps and the like) are overstated of letting bondholders take a haircut, and will ultimately be no worse than having the public take the losses, the fact is that we don't even need the bonds of major financial institutions to go into default. What we do need to do is offer those bondholders a choice:

1) The U.S. government takes receivership of the financial institution, changes the management, wipes out the stockholders and a chunk of the bondholders claims entirely, continues the operation of the institution in receivership, eventually reissues the company to private ownership, and leaves the bondholders with the residual. This is not "nationalization," but receivership - a form of "pre-packaged bankruptcy" that protects the customers and allows the institution to continue to operate, followed by re-privatization. As I've previously noted, this would fully protect all of the customers and depositors at no probable expense to the public. Alternatively;

2) The bondholders voluntarily agree to move a portion of their claims lower down in the capital structure, swapping debt for equity (preferred or common), allowing the bank to have a larger cushion of Tier-1 capital, avoiding insolvency, and hopefully allowing the bank to recover by its own bootstraps, preferably assisted by debt restructuring on the borrower side (via property appreciation rights and the like). Similar debt/equity swaps would be an appropriate strategy toward failing U.S. automakers as well.

No confidence

This week, the Treasury is expected to take another shot at announcing a toxic assets plan, which regardless of short-term market response, is likely to be met with a terrific vote of no-confidence.

Why? Because the only point in buying up a toxic mortgage security is if you can restructure it, which requires that you buy up every tranche having a claim to the underlying mortgages. These mortgage securities are a lot like a stack of sponges. If you pour water down, the top tranches absorb it first, and then the next, and so on. Banks don't want to let go of the better pieces (the tranches that pay out first), and nobody wants to buy the bottom ones because there's simply no point unless you can restructure the mortgage obligations so that there's a probable return of capital.

As I've said before, the U.S. currently has a private debt to GDP ratio of about 3.5, which is nearly double the historical norm, at a time when the underlying collateral is being marked down easily by 20-30%. That implies total collateral losses of 70-100% of GDP; a figure that includes not only mortgage debt in the banking system, but consumer credit, corporate debt and so on. The holders are not just banks, but insurance companies, pension funds, foreign lenders, and others. Even so, there is no way to prevent huge, ongoing losses, because the cash flows off of these assets are not sufficient to service the debt. The only question is whether the bondholders appropriately bear those losses, or whether the public bears them inappropriately. A continued policy of protecting all of these bondholders would eventually require U.S. citizens to be put on the hook for something on the order of $10-14 trillion. We are nowhere near the end of this process.

We simply cannot make these bad investments whole unless we are willing to hand the next 10-20 years of U.S. private savings over to the bondholders who financed reckless lending. Those bondholders should, and ultimately must, take a portion of these losses, and debt obligations will have to be restructured. Wall Street has become a bunch of Tooter Turtles crying "Help, Mr. Wizard!" because it got so used to Greenspan bailing everybody out. But that constant attempt to avoid inevitable private market losses is what allowed this problem to become so noxious. It will continue to do so until we collectively scream loud enough for Congress to say on our behalf, "Enough."

The sideshow about bonuses at AIG simply underscores how little these bailouts have altered the fundamental behavior of people throwing around other people's money with nothing at risk themselves. The bondholders of poorly run financial companies should lose because they deserve to lose. The American public does not.

Speaking of "other people's money" and conflicts of interest, the first step toward better public policy is to bar the unelected bureaucrats conducting these bailouts from any future employment by companies that benefit from their actions. Call me cynical.

A comment on inflation

It bears repeating that ultimately, inflation is not driven by monetary expansion per se, but by growth of government spending, regardless of how it is financed. Inflation basically measures the percentage change in the ratio of two "marginal utilities": the marginal utility of real goods and services divided by the marginal utility (mostly for portfolio and transactions purposes) of government liabilities. Think ice cream cones - the first one has a very high marginal utility, but the second one you eat has a little less, and so on. So increased supply tends to depress marginal utility, while scarcity raises it.

Rapid expansion in government liabilities, whether in the form of money or Treasury debt, depresses their marginal utility in relation to that of goods and services, driving inflation higher. Frantic safe-haven demand for currency and Treasury debt, as we've seen lately, increases the marginal utility of government liabilities and clearly depresses inflation. Scarcity of goods and services in relation to their demand raises the marginal utility of goods and services relative to that of government liabilities and is therefore inflationary. A glut of goods and services in relation to their demand lowers the marginal utility of goods and services and is therefore deflationary.

The reason we're not seeing inflation here and now is that despite a near doubling in the monetary base, we've seen a buildup in goods inventories combined with a surge in safe-haven demand for government liabilities. So investors have absorbed the increased supply of government liabilities without a collapse in their marginal utility. This will not persist indefinitely, so unfortunately, any nascent economic recovery in the next couple of years will be against the headwinds of both Alt-A mortgage defaults (coming to your neighborhood in 2010), and inflationary pressures as soon as safe haven demand for Treasuries eases back even moderately.

Milton Friedman was mostly right about inflation - inflation may be a monetary phenomenon, but only because governments ultimately can't help but monetize huge amounts of spending (as the Fed is doing now). He was entirely right about fiscal discipline - "the burden of government is not measured by how much it taxes, but by how much it spends."

Market Climate

As of last week, the Market Climate for stocks was characterized by moderately, though not extraordinarily favorable valuations, and unfavorable market action. The Strategic Growth Fund remains tightly hedged here, and the day-to-day returns of the Fund continue to reflect the difference in performance between the stocks owned by the Fund and the indices we use to hedge.

The advance of the past couple of weeks has been very characteristic of the "fast, furious, prone-to-failure" advances that tend to clear oversold conditions. Unfortunately, these advances are hardly predictable, since the market can persist for some time in an oversold condition that simply becomes more deeply oversold. At present, there is only a moderate "investment" merit for accepting market risk here, and very little "speculative" merit given unfavorable market action that has also cleared the prior oversold condition.

That doesn't mean that stocks can't advance further, and it's impossible to rule out potential enthusiasm that the Treasury "public-private partnership" idea might engender. But the relentless failure to properly respond to this crisis has increased the probable duration of the economic downturn, deepened the likely extent of job losses and deleveraging, and has lowered the expected level of future profit margins, all which erode the fundamental value of U.S. companies. Meanwhile, with the market no longer deeply compressed, there is less pressure for a rebound on the basis of easing risk aversion.

In all, I view the general market's condition somewhat less favorably than when we first observed these levels last year. Too much has gone wrong in factors that will have persistent effects, and having consolidated the losses, prices are not nearly as compressed as they were then. It is very true that the market tends to bottom when the economic news is still poor, but the economic difficulties here are well outside the norm, and we should at least allow for valuation extremes that are similarly outside of the norm.

In bonds, the Market Climate last week was characterized by unfavorable yield levels and moderately favorable yield pressures. Treasury inflation protected securities, precious metals shares, and foreign currencies all advanced sharply following the Fed's announcement last week, which benefited the Strategic Total Return Fund. Note that the inflation compensation in TIPS accrues as an increment to face, not as a distribution, so it does not appear as a component to current yield. Income distributions of the Fund (as with all mutual funds) are also net of expenses. As a result, the income distributions of the Fund are not closely indicative of the coupon yields of the securities held by the Fund, and certainly not of the inflation compensation from the TIPS. The Fund remains largely invested in TIPS, with about 30% of assets allocated across precious metals shares, foreign currencies, and a modest exposure to utility shares.

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The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.

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Estimates of prospective return and risk for equities, bonds, and other financial markets are forward-looking statements based the analysis and reasonable beliefs of Hussman Strategic Advisors. They are not a guarantee of future performance, and are not indicative of the prospective returns of any of the Hussman Funds. Actual returns may differ substantially from the estimates provided. Estimates of prospective long-term returns for the S&P 500 reflect our standard valuation methodology, focusing on the relationship between current market prices and earnings, dividends and other fundamentals, adjusted for variability over the economic cycle (see for example Investment, Speculation, Valuation, and Tinker Bell, The Likely Range of Market Returns in the Coming Decade and Valuing the S&P 500 Using Forward Operating Earnings ).





