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September 22, 2008

Misdirected Credit Runs Unabated
by Doug Noland

When I titled last week's piece "Too Big to Suffer a Loss" I had no real inkling of what the past week would have in store. Actually, I had presumed that the Treasury and Fed wouldn't allow Lehman to fail. Lehman Brothers, after all, was one of the major players in the precarious daisy chain of Wall Street risk intermediation. A failure by any key player in this realm would immediately have this historic Credit Crisis jumping the firebreak from the rugged terrain of mortgages and "risk assets" into the hallowed land of perceived safe and liquid contemporary "money." The consequences of such a lurid escalation were potentially so catastrophic that I believed Hank Paulson and Ben Bernanke were prepared to use the overwhelming force of fleets of aerial supertankers to ensure our "money" tinderbox was not set ablaze.

It now appears they didn't appreciate the ramifications for Lehman going under - how this would quickly ignite a run on the core of our monetary system. It wasn't long, however, before the horror of watching the entire system going up in flames prompted a mad scramble to conjure the equivalent of monetary firefighting "Shock and Awe". What an incredible week.

Yesterday the administration presented Congress a $700 billion plan to stem the Credit and, increasingly, economic crises. Wall Street and the Banking system have been rapidly burning through their entire "capital" buffer, as the risk intermediation community suffers enormous and unending losses. The bursting of the Credit Bubble is proving catastrophic for many that intermediated the risk between Trillions of risky loan assets funded by the issuance of Trillions of perceived safe and liquid money-like liabilities. For awhile, the global sovereign wealth funds, speculators, and some investors were content to step up and lead a recapitalization process. As time passed, however, this was increasingly recognized as a classic case of "throwing good 'money' after bad."

As losses escalated and sources of additional "capital" dried up, focus quickly turned to escalating losses being suffered by some gigantic and highly leveraged players (i.e. Lehman, Merrill, and AIG). At least in the case of Lehman, a run on their money market liabilities (especially "repos") had commenced. Bankruptcy by Lehman - with the extreme market uncertainty associated with unprecedented losses to bondholders, creditors and counterparties - immediately froze the Credit default swap marketplace. Dislocation in the CDS market was a deathblow for AIG and many hedge funds.

The Lehman Contagion quickly incited panic throughout the money fund complex, to-this-point a bulletproof sector that had, after a year of enormous growth, become an even more vital pillar to the sacred domain of contemporary "money." Exposure to Lehman forced the Primary Reserve Fund, a venerable money market operation, to mark down its portfolio 3%. Primary Reserve saw 60% of its fund (almost $40bn) redeemed in just two days, as trading in even the lost "liquid" short-term money market instruments seized up. A modern day electronic "run" on contemporary "money" had commenced; the system had reached the brink of collapse.

To stabilize the system at such a point required nothing less than unprecedented measures. The Treasury and Federal Reserve would have to become major "buyers of last resort" - both the providers of massive marketplace liquidity and the underwriter of massive Credit losses. With the monetary system breaking down, the federal government saw no alternative than to fill the void left by the impaired risk intermediators. Or, from a more theoretical perspective, our government would have to guarantee the "Moneyness of Credit" - assume the spiraling losses between the Trillions of risky system loans and the Trillions issued of perceived safe and liquid "money." No systemic federal guarantee, no more "Moneyness" - and an immediate end to the last bastions of Credit growth that have been sustaining the U.S. Bubble Economy.

So what's the problem with the government stepping up to guarantee "Moneyness"? How can it be inflationary, when Credit growth has slowed so dramatically, assets prices have come under such pressure, and confidence in the system has been so shaken? Well, I continue to believe that some overriding issues are today lost in the discussion; lost in all the pontificating; lost in the frenzy of panicked policymaking.

I am not surprised that our policymakers nationalized Fannie and Freddie. It was predictable that the Treasury and Fed were forced into wholesale bailouts and unprecedented liquidity operations. That Washington had to step up and guarantee money fund deposits is not all too surprising. Ditto with the upwards of $1 Trillion of Congressional authorizations, with policymakers bumbling through various measures in hopes of stabilizing the system. Over the years, we've been pretty cognizant of the extreme nature of excesses; the extent of system vulnerability; and the expensive bill that would come due with the arrival of the bust. But I want to be especially clear on one thing: I am shocked and incredibly alarmed that all these measures became necessary at such an early stage of financial and economic adjustment. After all, the Dow remains above 11,000 and GDP expanded 3.3% last quarter.

And this gets right to the heart of the matter - where the analytical rubber meets the road. A massive inflation of government obligations; a major government intrusion into all matters financial and economic; and an unprecedented circumvention of free market forces have been unleashed - but to what end? I believe it is a grave predicament that such a rampage of radical policymaking has been unleashed in order to maintain inflated asset markets and to sustain a Bubble Economy. Normally, such desperate measures would be employed only after a crash and in the midst of a major economic downturn - not in efforts specifically to forestall the unwind. Not only will such measures not work, I believe they will only exacerbate today's already extreme Global Monetary Disorder. They will definitely worsen the inevitable financial and economic dislocation.

I have over the past several years repeatedly taken issue with the revisionist view that had the Fed recapitalized the banking system after the '29 stock market crash the Great Depression would have been avoided. Some have suggested that $4bn from the Fed back then would have replenished lost banking system capital and stemmed economic collapse. But I believe passionately that this is deeply flawed and dangerous analysis. An injection of a relatively small $4bn would have mattered little. What might have worked - albeit only temporarily - would have been the creation of many tens of billions of new Credit required to arrest asset and debt market deflation and refuel the Bubble Economy. Importantly, however, at that point only continuous and massive Credit injections would have kept the system from commencing its inevitable lurch into a downward financial and economic spiral.

Importantly, market, asset and economic Bubbles are voracious Credit gluttons. I would argue that the system today continues to operate at grossly inflated - Bubble - levels. The upshot of years of Credit excess are grossly distorted asset prices, household incomes, corporate cash flows and spending, government receipts and expenditures, system investment and economy-wide spending and, especially, imports. So to generally stabilize today's maladjusted system will, as we are now witnessing, require massive government intervention. Enormous government-supported Credit growth will be necessary this year, next year, and the years after that. To be sure, a protracted and historic cycle of Misdirected Credit Runs Unabated.

Today's efforts to sustain the Bubble Economy create an untenable situation. Washington is now in the process of spending Trillions to bolster a failed financial structure, while focusing support on troubled mortgages, housing, and household spending. Regrettably, this is a classic case of throwing good 'money' after bad. Not yet understood by our policymakers, literally Trillions of new Credit will at some point be necessary to finance an epic restructuring of the U.S. economic system. Our economy will have no choice but to adjust to less household spending, major changes in the pattern of spending (i.e. less "upscale" and services), fewer imports, more exports, and less energy consumption. Moreover, our economy must adjust and adapt to being much less dependent on finance and Credit growth - which will require our "output" to be much more product-based as opposed to "services"-based. We'll be forced to trade goods for goods.

The current direction of Bubble-sustaining policymaking goes the wrong direction in almost all aspects. At some point, the markets will recognize this Bubble Predicament, setting the stage for a very problematic crisis of confidence for the dollar and our federal debt markets.

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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