Debt and the Delusionals

By: John Mackenzie | Sun, May 8, 2005
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A favorite book of mine remains 'Debt and Delusion' by Peter Warburton, published in 1999, the book was quickly ushered out of print; but remains a classic 'Financial Reality Bites' read of a highest order.

Warburton picks up where Paul Volker's triumphant shock therapy had attained prestigious heights for reigning in the inflationary precipice faced by our Nation.

In 2000, Volker's reply when queried was telling:

INTERVIEWER: And did you or anybody quite expect how tough a time it would be with inflation at 20 percent?

PAUL VOLCKER: If you had told me in August of 1979 when I became chairman of the Federal Reserve Board that interest rates, the prime rate would get to 21.5 percent, I probably would have crawled into a hole and cried, I suppose. But then we lived through it.

Governments needed continue to expand well beyond their own financial means without suffering inflationary widespread consequences. At the time, additional inflation would have been resisted after President Carter's Secretary of the Treasury; G. William Miller ran the presses literally non-stop.

After Secretary Miller's foray, the Bond Market would resist inflation, insisting on higher rates of return. Volker had little choice as market driven interest rates forced the Central Bank to follow with rate increases of its own in order to contain an expanding Monetary Base.

Volker had two choices: total destruction of the Dollar through accelerating inflation or raise rates and raise them aggressively. This series of Rate Hikes was a likely contributing factor to President Carter loss in the 1980 election.

If Government were to ever again attempt to expand under an Inflationary ruse, a dilemma needed to be resolved: a change in the very nature of financing Government debt.

Deficits would need to be financed through bonds sold to private investors through existing Financial Markets. This would place the bonds in the hands of Investment funds, rather than on the books of commercial banks as would have been the case had they returned to the old style of monetization under the old regime.

Consider the explosive growth of this new diversionary tactic over the course of the closing of the Gold Window through 2002:

1971 = $1 Trillion

1994 = $ 23 Trillion

2002 = $ 43 trillion

In addition to the new issuance of Bonds to fund deficits, the Government saw fit to extend its tentacles through General Ledger 'Trust' surpluses which have been raided wholesale. 'Savings' within the Social Security 'Trust' are continually replaced with Government Debt. The 'Piggy Bank' is running dry as the amount swapped from the Social Security Trust Fund has exceeded $1.5 Trillion, with an additional 1.6 Trillion swapped for Government Bonds from other 'Trusts.' These 'swaps' continue to mask Government Deficit Spending.

Suggesting 'Budget Surpluses" even exist, as President Clinton did, is laughable.

Dilemma solved.

The Government Bond Issuances 'Tsunami' has washed ashore upon every Capital beachhead, yet interest rates have been driven to historic lows and remain decidedly negative in real terms. Real Rates are far lower now than in 1971 when we had to carry $1 trillion on the Governments Books and with the Personal Savings Rate on the decline it is apparent 'Savings' from outside the United Stated is carrying the burden.

Figure 001: Five - Personal Savings Rate; Percent SAAR

This exogenous Net Foreign Direct 'Investment' is tracking well above $2 Billion Dollars per day.

After Friday morning's farcical BLS statistics, I choose to spend the balance of the day reviewing the most recent Bank of International (BIS) Settlements Data on Derivatives.

Exchange Traded Derivatives now total $279 trillion

OTC derivatives now total $220 trillion

Combined we have reached one Billon Dollar shy of a Quadrillion Dollars, or $500 Trillion.

I managed to contact various members of the BIS, NY Fed, General Accounting Office (GAO) and several Committee Members from a prestigious think tank reviewing both Monetary & Fiscal Policies since 1993, the FER.

What I confirmed was illuminating.

There are appeared to be a consensus among several of those willing to express 'Value Judgments' beyond the typical bureaucratic statistical pabulum.

Primary concerns focused primarily upon two factors:

1. Derivatives do not themselves create 'Value.'

2. Over the Counter Derivatives should be 'Regulated'

In discussing Interest Rate Swaps I began to query the GAO's own statistics for underlying 'Fair Value' to notional amounts reported. By the GAO's own metrics these 'Values' or "Money at Risk' account for between 5 to 7% of the 'Notional Values' stated in the BIS report. Given a very high percentage of these instruments are 'Interest Rate Swaps' we can make some simple assumptions regarding the underlying 'Money at Risk.'

In plain English, underlying the $279 Trillion in Exchange Traded Derivatives:

$13.95 - $19.53 Trillion is 'Money' at 'Risk' as 'Fair Value' underlying the Notional Amount.

Underlying the $220 Trillion in Over the Counter (OTC) Derivatives:

$11.00 - $15.40 Trillion is 'Money' at 'Risk' as 'Fair Value' underlying the Notional Amount.

Of the $499 Trillion in combined Derivatives, $24.95 - $34.93 Trillion is 'Money' at 'Risk' as 'Fair Value' underlying the TOTAL Notional Amount of $499 Trillion.

These figures are simply staggering. It is important to note that although Exchange Traded Derivatives are regulated, OTC derivatives are not and in fact many OTC derivatives can go unreported.

Essentially, the $220 Trillion figure in the BIS release does not account for non-reporting and is therefore low.

In my opinion, Derivatives represent nothing more than a wealth transfer mechanism, a shifting of risks associated with Credit expansion. If the scope and scale of underlying 'Fair Value, Money or Capital' at 'Risk,' one has to question who has the ability to structure such vehicles for transfer.

Securitization is the process of creating a marketable asset by assembling together a basket of smaller Financial Instruments. An extraordinary number of Financial Products have been so structured because doing so allowed the velocity of credit to increase.

For instance, through the sale of these baskets, no longer would a bank be limited in its ability to lend money and aggregate profits. A small bank would be able to originate a conforming loan to aggregation standards thereby allowing that loan to be combined with other similar loans in a product called a mortgage backed security.

These products have allowed US Debtors to leverage Asian savings. Problems being that savings must find a risk adjusted return on investment. The risk component of the equation was totally ignored. MBS, CDO, Reinsurance and other terms are used to describe these products.

The underlying risk assumptions of these products are flawed. The point of these products was to sell a product, a product reliant on an ever increasing 'Velocity of Credit.' As Credit contracts the flaws Monetary and Fiscal Policies become apparent within the Business Cycle.

Thus, the IMF continues to widely promote Structured Finance and Securitization to Financial intermediaries, Corporations and Governments to transfer risk with little regard for Financial Stability. At present we are witnessing the greatest transfer of 'Risk' in recorded History.

We are dealing with leveraged risk, amplified risk. The velocity of credit has grown to such levels that the monies involved eclipse the real physical and tangible economy. With the US at the nexus of the global financial economy profits rely entirely on structured finance. The Asians, namely Japan on the other hand, are the holding the bag.

The array of products is extremely broad based:

Retail Lending:

Residential real estate
Home equity loans
Reverse mortgages
Auto loans
Sub-prime auto loans
Student loans

Wholesale/commercial lending:

Commercial real estate
Franchise loans
Equipment leases
Asset backed commercial paper/trade receivables

Bank securitization:

Bank loans - CBOs/ CLOs
Credit cards
Collateralized debt obligations/ CDOs
Private equity/ Hedge fund investments
Non performing loans
Re-packaging and structured product CDOs
Aircraft leases and revenues

Industrial revenues:

Public utilities
Government revenues

Future flows:

Future flows (including Export receivables)
Whole Business revenues

Risk securitization:

Catastrophe Insurance risk Non catastrophe risk Alternative risk transfer
Weather risk
Credit risk securitization

Observe the enormous RMBS market for securitized Residential Real Estate.

GINNIE MAE, FANNIE MAE & FREDDIE MAC (Agency) Securitization of Residential Mortgages represent the greatest threat to our highly leveraged Capital Stock. The U.S. 'Wealth' is obtained as the sum of the domestic stock of Capital plus the International Investment Positions. The chart in Figure 001 illustrates the explosive growth in MBS activity in the United States.

Figure 001: RMBS Activity 1980 - 2004

The United States Current Account balance from 1971 - 1982 (The net flow of current transactions, including goods, services, and interest payments, between countries) as a share of U.S. GNP; averaged approximately zero.

Gross National Product (GNP) is the total dollar value of all final goods and services produced for consumption in society during a particular time period. Its rise or fall measures economic activity based on the labor and production output within a country.

An important distinction needs to be observed between NGP & GDP.

Gross Domestic Product (GDP) measures output generated through production by labor and property which is physically located within the confines of a country.

Beginning in 1983, however, the United States experienced increasingly large current account deficits, which reached 3.4 percent of GNP in 1987, coincidentally, on October 19th, 1987 the stock market crashed. The DJIA closed down 22.6% for the day.

October of 1987 had been a highly volatile month, there were warning signs flashing that provided clues as to what was coming with both the Dollar and Bond Markets volatility.

After the 1987 'Crash' the trend toward larger deficits gradually reversed during the rest of the 1980's, and by 1991 the current account was approaching zero once again.

Beginning in 1993 the Current Account began to trend towards increasingly large Current Account Deficits, which grew to 4.4 percent in 2000 and presently stand at approximately 5.75% according to U.S. Federal Reserve Governor Ben S. Bernanke. This trend, as illustrated below in Figure 002 corresponds with a dramatic decline in Personal Savings.

The change in trend of the Current Account is a warning, pure and simple.

The United States consumes more of the world's output than it produces.

We import more goods than we export and in exchange for these imports, we provide our trading partners with financial claims against our own future output.

The United States Dollar's Seignorage restricts the prospects of Foreign Diversification.

It is important to understand the nature of how our Capital Stock was raided, inflated and used to offset the decline our Rate of Savings. Every component of our Capital Stock has been inflated to create the illusion of a "Wealth Effect." No where has this effect been more profound than in the accumulation of value in home equity.

The 'Wealth Effect' has had and continues to have a measurable effect on consumer behavior, the greatest cause / effect has occurred within Residential Real Estate.

The prior Asset Inflations of Capital Stock have failed. The Nasdaq / Dot Com / New Economy bubbles blew themselves to smithereens in short order. The Fed's willingness to continue perpetrating its 'Moral Hazards' finally extended to real Estate.

The Federal Reserve understands all to well the very nature of 'Credit Cycles' and there inherent risks, they opted for a furthering of the cycle expanding it to the most underutilized component of 'Personal Savings,' the American Home.

Figure 002: Personal Savings

The Federal Reserve has the above data represented in Figure 002 in real time and prepares well in advance of the Primary Trend Illustrated above. By mid 1992 Personal Savings began to diminish as the 'Financial Economy' began to take hold.

Clearly, the Residential Mortgage Market was the most egregious form of Asset Inflation and Securitization the Federal Reserve.

Monetary Policy was both good for the goose and its shareholder gander. It was a win / win for the Fed as they injected massive 'Financial Economic Activity' while the rest of the economy continued to be starved for Capital. Business did not accept the 'Greenspan Moral Hazard,' they began reducing Capital investments with Nominal interest Rates at historic lows.

Mortgage Purchase / Refinance under the Federal Reserves reprehensible and utterly irresponsible Monetary Policies simply boomed.

Evidently enough, the Residential Mortgage market is one of the most fraudulent applications of securitization, judging by the level of accumulated Agency Activity at Fannie Mae, Freddie Mac and Ginnie Mae, the risks are astronomical.

Figure 003: Real Estate Fixed investment

The Savings Rate is important as saving provide the Capital for Investment which expands Economy Activity, this should not be confused with the fictitious 'Wealth Effect.' We are presently observing the effects of this mal investment take hold in my opinion. The very nature of this Credit Cycle's scope and scale are far too massive to accurately project what a very real and approaching contraction will look like, other than to say it won't be pretty and will most likely resemble an environment of chaos and instability, both financially and socially.

As the pace of Securitization accelerates while Agencies attempt to transfer risks to the Retail Public, we need to keep a close eye upon the Financial Markets ability to digest this process.

Increasingly, it is fraught with peril for both Lenders and Borrowers, a potent combination.


 

Author: John Mackenzie

John Mackenzie

John Mackenzie manages private capital.

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