US Government Policy and Ben Bernanke

The US Gov't is replacing private balance sheets with its own. I am sure that this will soon include pension funds and state/municipal governments. That is fine when we have balance of payments surpluses, but we don't and haven't for about 50 years. The world's economic engine post-WWII was driven by a persistent and growing US current account deficit. Now that that finally seems unsustainable, what happens now? Can we collectively ease off of, and gently devalue, the USD as the world reserve currency or will that too fall off a cliff, as have all other asset markets and currencies of late?

It looks like this can only go in two divergent, but related paths. Each comes with a great deal of pain, but will likely lead to a change in world leadership from the US to someone else at some point in time. It doesn't seem at this point if anyone else is ready to pick up the mantle, which will likely keep this disequilibrium in place for that much longer.

Who knows what the ultimate destination is for the US and world economies but the policy road ahead seems somewhat clear. A book I recently read laid out the Bernanke recipe should the US economy be faced with a possibility of deflation. It was written by Ethan Harris, (presumably former) Chief US Economist for Lehman Brothers. While not that insightful overall, I thought the following list was thought provoking. Take a look at this list and lets review what has or hasn't occurred.

Step 1: push the funds rate to zero (getting there)

Step 2: drive down long-term Treasury interest rates by either promising to keep short rates low for a number of years or commit to make unlimited purchases of Treasury bonds until their interest rate falls. (just announced)

Step 3: push down interest rates on private securities by buying them up as well (announcment of buying Fan and Fred qualifies - wonder whats next?)

Step 4: intervene aggressively in the foreign exchange market to weaken the dollar and raise the price of imports (not yet)

Step 5: Have a coordinated easing of both monetary and fiscal policy, with, for example, a cut in taxes financed by issuing money so there is no increase in government debt ($500B+ stimulus plan likely paid by new money printing)

This list seems to be a cookbook from the Chef Ben Bernanke. Seems like he will do anything to cook up some inflation for us. While the talk now is of deflation, seems like printing up gobs of cash and placing it into the system should ultimately have inflationary effects. And my guess is that this new inflation will not be successfully transmitted into financial assets, due to the longer memories of market participants who may not be as interested in extreme credit growth.

Somali Pirates in Discussions to Acquire Citigroup

November 20 (Bloomberg) -- The Somali pirates, renegade Somalis known for hijacking ships for ransom in the Gulf of Aden, are negotiating a purchase of Citigroup.The pirates would buy Citigroup with new debt and their existing cash stockpiles, earned most recently from hijacking numerous ships, including most recently a $200 million Saudi Arabian oil tanker. The Somali pirates are offering up to $0.10 per share for Citigroup, pirate spokesman Sugule Ali said earlier today. The negotiations have entered the final stage, Ali said. ``You may not like our price, but we are not in the business of paying for things. Be happy we are in the mood to offer the shareholders anything," said Ali.

The pirates will finance part of the purchase by selling new Pirate Ransom Backed Securities. The PRBS's are backed by the cash flows from future ransom payments from hijackings in the Gulf of Aden. Moody's and S&P have already issued their top investment grade ratings for the PRBS's.Head pirate, Ubu Kalid Shandu, said "we need a bank so that we have a place to keep all of our ransom money. Thankfully, the dislocations in the capital markets has allowed us to purchase Citigroup at an attractive valuation and to take advantage of TARP capital to grow the business even faster."Shandu added, "We don't call ourselves pirates. We are coastguards and this will just allow us to guard our coasts better."

Why Bank Equity Infusions May Not Work

If banks can borrow at the Fed Funds rate today at 1.00% and buy 30 year Treasuries at 4.25%, why would they ever lend money? Wouldn't it seem like too much trouble to actually underwrite credit, administer draws, read reports, etc. when all they have to do is buy the Treasuries and wake up in 30 years? That is what happened in Japan. Now while banks may be somewhat worried that the Federal Government may inflate, what does it matter to the banks because they are only transacting in dollars anyway. If the rate on loans to businesses and consumers is significantly above the long term bond yield, then maybe we can break this potential logjam. It will be interesting to see it all play out. It certainly would imply downward pressure on long T-bond yields. But my guess is that the government may specifically place limits on the amount of Treasuries a bank can hold so as to reduce/eliminate this arbitrage opportunity.

Right now, it seems like banks are paying massive rates to garner bank deposits from consumers. While growing these bank deposits are largely a desire to grow a stable funding base, it may also be that banks anticipate higher rates on loans and maybe even long Treasuries in the future. These factors currently seem to be at odds and it is not at all clear how it plays out.

Pension Fund Bailout

I think there is a strong likelihood that there will be a significant government bailout of major pension funds across the country. If one thinks of the fact that the government is run by the Democrats, and the traditional Democrat constituencies consist of academics (university endowments), unions (corporate pension plans), teachers (CalSTRS, TIAA-CREF, etc), one envisions that the government will step in somehow to shore up these funds' balance sheets.

It would seem to me that the losses suffered by groups such as CalPERS which may be staring at a loss of upwards of 50%, will have significant troubles servicing their obligations to their pensioners. That is where the Federal Government will step in. So while the Government does have the ability to tax its people up the wazoo that will be viewed as a politically impossible solution over the next couple of years. I can't imagine they will fund that bailout through budget cuts, so that leaves more borrowing against the short end of the yield curve. There will be literally hundreds of pensions to bailout. The first amongst them all will be General Motors. That is a likely consequence of any bailout by the government.

My guess is that it will be the US Government via the Pension Benefit Guaranty Corporation will be the vehicle for these bailouts. But in the article below, it appears that that bailout will need a bailout too. How many dollars will be needed? The shortfall for underfunded liabilities in 2007 (not 2008) was $14 Billion. Imagine what happens once these fund suffer 50% losses? This number may be $50 Billion or more for 2008 alone. Smells like trouble.

http://news.illinois.edu/news/08/1015pensions.html

So who cares? Well the follow on effects of this are that private equitym, hedge funds, real estate, stocks, bonds, basically every conceivable asset class will lose willing investors that mainly consisted of these pension funds. Forced sales in the markets will continue in rapid succession. This will likely push many funds to go out of business.

As of right now, investors in illiquid assets effectively hold cheap/free out-of-the-money options on their properties, considering that their equity investments up front are significantly impaired. Once these options start getting expensive through required equity contributions to cover debt drawdowns, interest carry, and other costs, then suddenly investors will likely break because of a lack of availability of capital from pension funds which may have no liquid assets left to cover these additional commitments (heck, they may not even have the capital to cover their actual commitments).

Sounds like there will be much more forced sales and unwinding. Pension funds, endowments, insurance companies and the like will be continue to crater and losses will shift to government balance sheets.

Paulson Inspiring Confidence Again

I think history my look unkindly at the steps the Treasury Department has made in trying to stem the losses from this massive credit deflation we are suffering through right now. Basically changing Treasury strategy midstream from buying toxic assets to bank capital infusion, while appropriate and ultimately more effective, is probably not going to inspire confidence in the American people that the US Government has any idea it knows what it is doing. If nothing else, they had no contingency plans for this type of scenario. I guess it shouldn't come as too much of a surprise in any case given the number of times they said that both the economy and the financial system were strong.

China the Commodities Trader

Given China's massive influence on the world commodities markets, one has to wonder if they have hedged their future exposure through commodity forward contracts. Being the cynical person that I am, I would not at all be surprised if we learned the following over the course of the next year:

- China locked in significant commodities exposure in industrial metals prior to the announcement of their $580B stimulus package through shell companies that transferred this exposure to the Chinese government via its sovereign wealth fund
- China is slowly and furtively selling off US Treasuries in order to fund the purchase of these USD denominated commodities
- China has been purchasing precious metals in the market to hedge against USD value declines so that they are less exposed to the impact of their massive USD exposure
- Singapore has figured this out and is moving to get ahead of this trade

While I don't think China created this worldwide economic recession, they are probably taking advantage of it.

We're All Keynesian Now - or - What Nixon and Mao Talked About in 1972

China just announced plans to spend $586B over the next two years for internal infrastructure spending and other measures to get things moving. That is a very large amount given that the Chinese economy is $3.2B. If one believes that China's growth rate currently is "only" around 5% or so, down from the reported 8% target they just announced fro the 3rd quarter, then the Chinese Government clearly feels that they must do something to bridge this gap and keep confidence up. Clearly this stimulus will be meaningful to prop up the economy, as well as the current Communist regime.

One wonders whether this stimulus will be effective. Remember, the real issue in China is not pure, raw GDP growth but whether or not they can effectively grow their internal consumption market. Right now, they have a long way to go as consumer consumption is less than 40% of total GDP. The majority is internal investment and exports. One thing they can do, which I would imagine is in the works, is to use their surpluses to create good social safety nets available in most other developed economies (think, Social Security, Medicare), that currently do not exist. This would go a long way to help smooth the expected impacts of business cycles on consumers and spur spending.

While it can be argued that a major benefit of the Chinese people is their ability and willingness to sacrifice and save, this only goes so far. Think about Japan. They have shared many of the same cultural attributes as China but now appear to be in a deflationary spiral because they can't get people to spend more money and their demographics are so poor. China is kind of like Japan but only larger. Now that being said, they have much more runway ahead of them than Japan, which appears to be fully developed, for lack of a better phrase. There is still mass poverty in China and a strong secular shift from an agrarian to an urban society. That shift still has many years to play out.

So all that being said, can China overcome in the long-term those issues that have plagued Japan? That remains to be seen. This short-term stimulus may solve some problems for the Chinese government and economy today, but doesn't address those longer term issues discussed above.

Given that, one has to wonder if the Chinese government doesn't spend a lot more effort and money to foster an internal market and less time and energy looking to develop their export markets (via current account deficit supports). These things are not mutually exclusive but it would appear that if successful, the mix of GDP in China will shift from heavily export oriented to more internal investment and consumption. This reduced reliance on exports, tied into a reduced current account deficit, means less funds to prop up the US economy. That should force an even more rapid unwind of US consumer spending as there is no longer a group to support above-equilibrium consumer consumption.

That leads to a subject closer to my heart - the US Treasury market. The US Government just announced the re-issue of 3 year Treasuries. That reminds me a lot of the bridge financing that has plagued many sectors during this credit expansionary boom (including commercial real estate, which I am most familiar with). It is a reliance on a debt market that will hopefully allow the US government to roll over its debts when the come due. Sounds like playing with fire. If the market disappears (read above), then the US government will be paying massively high yields to repay these debts. Or of course, they will be forced to print massive amounts of money. Bad news either way.