Posted on 03/10/2008 8:36:24 AM PDT by PHLSyndicate
There is almost too much news going on in the financial world to even begin to try to analyze and discuss these days. I was watching financial cable news this weekend on Fox, who are usually cheerleaders for the market, and the mood is extremely pessimistic. I was amazed. So rather than comment on the 10 ongoing crisis at the moment, I've been thinking about some specific terms that should be defined... words we will soon hear a lot in the future. What's a systemic margin call? What is a cascading cross-default and why should you care?
Margin Call
So, let's say you put up $10 billion as colatoral so you can borrow $85 billion in order to invest in $95 mortgage backed securities. You do this cuz in the future you think those investments will be worth $100 billion. Once it hits that point you sell for that price, pay your broker back the $85 you borrowed, you recover your $10 billion in collateral and you pocket that $5 billion spread as profit. That is how you leverage and that is how you go "long" in a market.
So, what happens if those investments go to $70 billion instead of $100 billion as you hoped? Well, your broker or bank will notice that and will demand you put up more collateral. Because, after all, if you were to sell at $70 billion, instead of $100 billion, you'd end up losing $25 billion, which is more that what you put up to begin with. Your credit worthiness is now being challenged. So, the bank issues a margin call and demands you put up more money, maybe another $10 billion. But you don't have the money. So you sell your assets. You may have to sell stock that you'd like to keep in order to support the margin call, thus driving down demand (and price) of the stock. But what if you don't own enough stock, or what if there is ZERO demand for the debt you are holding? Then you become insolvent and the monetary base shrinks.
Systemic Margin Call
JPMorgan has issued a warning about what it calls a "systemic margin call":
NEW YORK (Reuters) - Wall Street banks are facing a "systemic margin call" that may deplete banks of $325 billion of capital due to deteriorating subprime U.S. mortgages, JPMorgan Chase & Co, said in a report late on Friday.Yes, that Carlyle Group. Even the insiders are even in trouble. So what about all this? The risk is that one failure will lead to another, which leads to another, causing a general change in psychology where leveraged positions have to be unwound in order to raise capital to maintain solvency. Each liquidation leads to additional stock market losses and thus more margin calls and thus more liquidations -- this is what would be known as a "deflationary spiral."JPMorgan, which sent a default notice to Thornburg Mortgage Inc. after the lender missed a $28 million margin call, said more default notices and margin calls were likely. The Carlyle Group's mortgage fund also failed to meet $37 million in margin calls this week.
Cascading Cross-Defaults
Given Bernake's studies of the 1929-1933 financial crisis, he is aware of the risks and has been taking actions to prevent the above from happening. One mechanism has been the TAF, which allows banks to anonymously trade mortgage back security and US Treasuries for cash, in order to maintain reserve requirements. The Federal Reserve is essentially turning bad debt into money and nationalizing vast sums of private real estate in the process, thus inflating the currency in an effort to maintain the monetary base in the face of the feared downward spiral. Every attempt by a central bank to avoid a debt-induced credit collapse in the past has met with hyperinflation (which I personally would define as > 100% per year in inflation).
By inflating the money supply, this will provide enough liquidity to the system in order to avoid what is known as a "cascading cross-defaults." Its a situation where banks call in loans they've made to each other, or various other financial/corporate entities, and the borrower doesn't have the money. This, in turn, would cause another entity to not have needed cash flow and thus be put at risk of also defaulting on an obligation. In such a scenario, one bank after another would fall like a domino causing an even further collapse of markets and pretty much every asset class. What would this mean for you? It would all end with you coming back to your office to find out that two other co-workers also had ATM cards that didn't work. On the third day of such a scenario the nation would have a full understanding of what was happening and then, the American public would handle however they would handle it. It would probably involve angry crowds at banks and the National Guard. It wouldn't be pretty -- and it would be just the beginning of a nightmare.
The Panic of 2008
The Fed, given Bernake's understanding of the 1929-1933 panic in US markets is trying to address this and prevent the above scenario from happening. Without a sudden reversal in the markets or a solution to mounting credit worries or a change in psychology, I'd put the chances of the above scenario working itself out over the next 18 months at about 35% The way the Fed is acting is entirely consistent with a program one might be tempted to undertake to stop the panic and problems of the aforementioned scale.
Deflation Death Match & What Now?
Essentially, this a Death Match for the central bank. The last time the Fed dropped rates twice in 10 days was the Panic of 1914. That year the New York Stock Exchange ceased trading for four and a half months. Many forsee deflation as the great evil that lies ahead. Yes, that's what *should* happen if the system were allowed to correct intself, but I expect a large amount of governmental intervention, which would probably lead to an attempt to inflate our way out of the problem. Its possible they may find somehow a way to actually do that.
Given the speculation in commodities and panic buying of contracts in a manner that is inconsistent with demand, I sense smart money is quickly moving to tangible assets (like gold). If we have a sudden crash in prices of commodities, I'd interpret that to mean investors are liquidating anything they possibly can in order to meet obligations and the Fed's attempt to inflate is failing. Or, prices could keep precipitously rising as an early warning sign of pending monetary inflation brought on by the Fed's policies. We'll be looking at 10% monthly inflation in 12 months or half of all banks will be out of business. Or nothing will happen. Either way, we'll have a much better idea of where things are going soon enough.
>Sorry. I have a really, REALLY tough time swallowing >“financial wisdom”
For starters, this is not financial advice. I’m merely reporting a summary of what many others are saying.
I hate to sound like an apologist for this guy, but I have to repeat - he is not predicting where the economy will go. Rather, he is saying that if certain things happen, WE may predict what it is highly likely it means and come up with our own predictions.
He is not giving readers a fish. He is teaching them how to fish.
Regarding the typo. I read a lot of blogs from very intelligent men and women. I see embarrassingly obvious typos in most. I don't like it, but they have to reach a certain threshold before I feel comfortable using it to impugn the content of the article. Especially with words that may be spoken often enough but are not seen enough in print. I've seen it in my business with VERY intelligent people - even with spell checker at their fingertips they miss the squiggle's red line, often times because so many of the words in technical articles are correct but still do not pass spell check. A good one is "impactive". Word doesn't think it is spelled correctly and offers no alternative. I finally checked dictionary.com http://dictionary.reference.com/browse/IMPACTIVE before I just added it to the Word library.
He said “wisdom”, not “advice”.
I sincerely don’t understand the animosity being expressed over this article. I wouldn’t exactly say that what I wrote is entirely controversial. There used to be a time when conservatives cared about things like budgets, debt, inflation, and the soundness of money. I don’t get what happened. You may not care that a billionaire gets wiped out, but when you can’t get a car loan or a mortgage has a 15% interest rate on it, you certainly will. Contrary to popular belief, the business cycle has not be eliminated.
So to sum up, we will have either a panic or not, massive deflation or inflation, or maybe nothing. Thats the gist of the last paragraph.
I misspelled a word once, and correctly twice. So crucify me. I’m a computer programmer with an interest in current events and economic history, not an English teacher. Since the rest of you are obviously university professors of some sort, I’ll be sure to bring it up a notch next time.
>>He covered all the bases so he can’t be wrong. I got to respect that.<<
If commodities go one way, I think it means one thing. If they go another, then it means something else. I’m not going to pretend to be smarter than the stock market. And I’m not telling people how to invest. Its entirely possible that I’m not understanding the situation and, as many of you wish, everything is totally fine. If I told you I knew what would happen, I’d be lying. All I can do is look at history, see how things played out in similar situations, and try to draw conclusions from the past experience of others.
My observation is: on the whole, things are going pretty darned well, and have been for quite some time - ergo, people are getting bored and looking for some hobgoblin to get scared about. Impending TEOTWAWKI (The End Of The World As We Know It) is always a popular subject for the luxuriously comfortable.
The moment had come,Yes, there are viable concerns about national/world-scale budgets, debt, inflation, and money integrety. Between long-running assurances that these really are reasonable, not a problem, and maybe even necessary for a strong economy, vs. it's all so bad that nothing but a world-pounding econo-crash can solve them, there's not much to do but get yerself out of debt (totally), get ready for major SHTF, and let the world do what it may.
I swallowed my gum,
We knew there'd be blood on the sand pretty soon.
The crowd held its breath,
Hoping that death
Would brighten an otherwise dull afternoon.
- Tom Lehrer
We can live beside the ocean
Leave the fire behind
Swim out past the breakers
Watch the world die
- Everclear
>>All I can do is look at history, see how things played out in similar situations, and try to draw conclusions from the past experience of others.<<
Yup. The scary thing is that when you add in the variables unique to this particular scenario, it can look REALLY scary. And with every passing month the potential downside looks worse. It is already far worse than many “experts” were predicting just a year ago, and we have just started our downward fall from the apex. Nobody knows how far it will go, but we will all find out fairly soon (next two or three years).
And nobody is even taking into account the “non-economic” events that could happen to exacerbate the problem.
Oh yes! The economy is just fine.....nothing to see here.
Run on the banks? That is a joke. The average person is $20,000 in the hole. Are they all going to suddenly run down to the bank and pay it off? Maybe it’s $40,000. Whatever.
Actually, its already happening.
According to this NY Times author there is a bank run going on between banks, rather than individual depositors and banks.
"Soon afterward, however, a full-fledged financial panic began. Investors pulled hundreds of billions of dollars out of asset-backed commercial paper, a little-known but important market that has taken over a lot of the work banks used to do. This de facto bank run sent shock waves through the financial system."
The primary reason behind the emergency rate cuts and the TAF auctions, which seems to be a means to monetize mortgage debt, is to stave off a lack of lending between banks.
A bank in England recently underwent defacto nationalization in order to stop a bank run.
The real question is whether creditors will demand “pay up now”, or will realize that a reduced/interrupted payment plan is better than no payments at all. The latter works OK for them ... up to a point, where there’s enough debtors facing “pay now” that the creditor’s income stops.
But yes, kinda hard to have a run _on_ banks when most people don’t have anything there to speak of. I suppose the counterpoint is that there IS at least _something_ in most checking accounts, but if everyone pulls _that_ out at once, there still won’t be enough cash to satisfy the demanded withdraws. The average person may be $20-40K in the hole, but they still have an average of $2K in checking; there isn’t $200,000,000,000 cash sitting in ATMs and bank branches at any given moment.
Right, nowhere close. Usually, bank reserves around $40 billion.
The TAF auctions were set up for a few reasons, one of which was to help banks remain solvent, not just overnight as the Discount Rate does, but for longer periods of time. As a result, from $40 billion in reserves the banking system went to (negative) $15 billion since December. Every penny that is in a bank, reserved for withdraw, is borrowed from the Fed at this point.
This is completely unprecedented. From what anyone can tell, the Fed is accepting mortgage debt, and other iffy collateral, in exchange for monetary injections. They are taking assets, which are really worth anywhere from 0% to 70% of their book value at full value and inserting money into the system to keep the entire system solvent.
This graph illustrates the issue. And it doesn't tell the whole story since the number extends nearly to the bottom as the current non-borrowed reserves level is about (negative) $15 billion. Or you can look at it from the other side and say borrowed reserves are at $15 billion.
If the Fed hadn't been on top of things and intervened starting in December, as far as I can tell, the banking system went insolvent in January.
Wow. I read this paragraph in the article:
“Given the speculation in commodities and panic buying of contracts in a manner that is inconsistent with demand, I sense smart money is quickly moving to tangible assets (like gold). If we have a sudden crash in prices of commodities, I’d interpret that to mean investors are liquidating anything they possibly can in order to meet obligations and the Fed’s attempt to inflate is failing.”
And then this just an hour ago:
“Foreign mining stocks hit as metals prices fall”
If the government stayed out of things and responded by stabilizing the currency the result would likely be a sharp painful recession followed by a slow but steady recovery. When the Fed/government tries to steady things with wheels and levers it will likely convert that short deep recession into a real long-term depression as was the case in the 30s. That one didn’t really end until the 50s recovery and boom.
Were you around in the 70s? Don’t worry about runs on banks. Don’t know anybody with enough “savings” to run for.
"There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved."~~Ludwig von Mises
Yes, if the government tampers in any way whatsoever. If we just let the dipsh!t investors stew in their juices, then no.
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