I Feel Like It's Already Happened.

I'm sure it's a personal projection of some kind - at least I should be. But it doesn't feel that way.

It feels as though someone has made a very important phone call - one of those ones where you feel like you're filled with ice water and you're shaking, but you sound normal. What came out of their mouths came out as something smart and strategic, but it was really a plaintive wail and a desperate plea. The person on the other end didn't hear it cry. They didn't make much of it - dispense with it quickly. They did think about it after they hung up, but they went back to work, then turned on the basketball game for a few minutes, had a glass of water and went to bed. In the morning there was just another full day.

But not on the other end. The night was easier than expected on that end. There was a feeling of relief, even a wry laugter. On that end they watched a good chunk of the basketball game and woke up feeling pretty good. Felt a little odd at breakfast, but had some orange juice - very refreshing. A few butterflies, but they headed in bright and early. Certainly a priority list today!

Meetings were fast and precise - they were professionals energized by the task of high-speed problem-solving. The situation was bad, but the rhythm was good. Then around 10 somebody freaked. Whether it was that woman who cried or that guy you knew was going to be a problem really blowing his stack - I mean losing control - it's hard to remember. Suddenly nothing was happening properly. The call and response was way off. The rhythm was broken and knuckles got very white.

Then an hour or so later - hard to tell - there was that weird feeling of suddenly not knowing what to do - having nothing to do, really. You couldn't call X until Y called back. The numbers were going to take at least two hours. The lawyers hadn't arrived yet.

You never knew what "it's over" was going to feel like - certainly you didn't imagine this. Then you realized that "over" meant having so much to do and no way to do it or get it done. "Over" meant that the many things you needed to do were now going to find you, instead of the other way around.

And then all of us found out.

The End Of Money

Getting to know the wild, Austrian-school, Libertarian culture of goldbugs has been really interesting for me. We disagree on so many things but see the same crisis - an existential threat to the world's money system. Goldbugs make government deficits to be the first-order threat because of absolute size and inflationary primacy. I join those who make the collapse of credit institutions to be the first-order problem. Some goldbug share this latter view, Mish Shedlock notably among them. Although I'm not a goldbug, Shedlock's writings are part of the reason I am a so-called “deflationist”.

Clearly the “short dollars on imminent hyperinflation” trade has fallen apart. The yen is getting crushed. Paper gold has been acting oddly. I'm sorry, but I happen to be one of those people who think ETFs can overwhelm futures markets a bit. Thought so with oil this summer. Many knowledgeable people disagree. But the real value of gold is something reasonable people can debate. In fact, it's debated every day in London, New York, Sydney and Hong Kong. Right now, the consensus is: “not so valuable as we thought last week”.

What is not being debated properly is the value of our financial system. On the NewsHour Secretary Geithner pre-announced that nobody will fail the “stress test”:

“These banks now have very substantial amounts of capital relative to what you would have seen in the U.S. economy going into previous recessions.”

The conventional view - Geithner's view - makes this economic crisis to be a crisis of “beta” - a “fat-tails” crisis which will revert to the mean. One problem with that assessment is collateral. In a sense, Bank of America is a huge CDO. CitiGroup is a huge CDO. AIG is a huge CDO. CDOs are fine, unless you very badly misrepresent the “C” - the collateral - and that's what's happened. So, I make it to be a crisis of “alpha” - a crisis of our financial system's intrinsic value and a crisis of collateral. The goldbug solution is simple – collateralize the system with gold. Goldbugs reason that if the problem is at the very core – the “fiat” or legal-accounting money system itself – then that system needs to be moved to solid collateral. I agree to this extent: If we don't deal with how our system is collateralized, we're finished

[I even reluctantly and partially agree that gold could be part of the answer, but that's for another piece.]

Jim Cramer sees the collateral problem. His mortgage plan is about spreading a huge hit to term collateral value over a very long time. If you look at this interview with Robert Shiller and take a gander at the chart below which shows percentages of negative equity homeowners as house prices fall, you get an idea just how huge a hit we could be talking about.


Despite all the talk about it, deleveraging probably has not happened in America. Collateralized leverage has likely skyrocketed. Fed Chairman Bernanke implicitly recognizes this. Markets were relieved to hear the Chairman didn't intend nationalization. An expert on providing liquidity, Bernanke now plans to create equity - balance sheet collateral, if you will. Preferred at first, “rolling” to common as loan collateral and quality deteriorate. The idea has balance sheet elegance and the more “we the people” find out management has screwed up their businesses, the more right we'd get to tell them what to do.

It's a great concept. The Diamond and Dybvig model of central banking says that in a crisis the government should trade immediate-term credit for long-term exposure. Big-government conservatism says in a crisis the government should intervene first with money (and guns), then take authority only as a last resort. It's wonkish and wonderful – an academic tour de force. So why am I hearing Jim Cramer in my mind's ear shouting “Bernanke's being an academic! It is no time to be an academic...!”?

It's because I'm not sure how cash helps these institutions. It didn't help AIG. The banks already have much more than enough cash. If they can't use what they have, how will more help? Banks need to get assets with longer-term value into their portfolios faster than their collateral is deteriorating (and risk is rising). Ben Bernanke apparently believe they can create or find those assets.

Those banks? With that management? In this economy? With their cost structure? Really?

I saw Dick Bove talking about how the banking system was very profitable. I nearly fell off my chair. $59 billion positive cash flow? So they can pay back the TARP in what, 10 years? 15? I got back on my chair and listened to his excellent point about franchise intangibles' being an important part of overall value. But has he read what Ken Lewis thinks are the most valuable parts of his franchise? The biggest, crookedest mortgage writer in history and a failed investment house? Those are the “stars”? When institutions issue thousands of “AAA” securities that turn out to be junk, their franchises suffer – badly and justly.

I've read the BAC bulls. I believe Geitner wants to bring in private investors. But these banks already have investors who are a big part of the problem. Bondholders represent a big portion of liabilities so, again, let's think of the banks as a bond – a huge, multi-maturity CDO. We know the collateralized leverage of this bond has soared and the credit quality has plummeted. The principal of many long-dated tranches has gotten killed, but the short-term tranches have been saved – so far.

Is the bond still paying the coupon? As Dick Bove points out, almost. But why do people focus on that? The structuring is destroyed and the collateral is crap. By taking the TARP money, Citigroup, AIG, BAC, etc. have declared an intention to pay the coupon out of the new, “free” government collateral. Unless the government intends to let banks and bondholders pretend the entire real estate bubble never happened, it won't be enough. To boot, I have very little faith the structuring of these CDOs will improve. When I look at BAC, I see a CDO that has gotten bigger, not better. And Citigroup? AIG?

The challenge is bad structure and bad collateral, which is why serious people are finally talking about capitalizing our financial system with full-faith-and-credit (FFC) instruments. I have no idea how it took so long. Laugh if you want, goldbugs, but it's a step forward. It's sure a lot more sensible than cash. It's not magic, but FFC bonds would immediately change institutions' capital profile. Of course the bondholders will still be pounding on the doors. Even if you don't think these bondholders are too big to fail, we certainly don't want them freaking out again, either. The stories are wild about the last time they freaked out, but the facts are bad enough.

I think we need to deal with the bondholders separately. But I don't know, maybe Bernanke, Geithner and the holdover crew (who missed the entire bubble in the first place) really do intend to re-collateralize the people who bought and sold all the bad debt. Why make people unhappy? Apparently, it wasn't the investors' fault. They were, after all, only professional financiers.

So how does “the end of money” come about? Option 1 is that the crew gets ahead of the process and creates hyperinflation. Yet, the dollar is a very, very big money system and “fortunately” the crew have shown no capacity to get ahead of the process. Option 2 is that as collateral collapses, they continually pay out slightly less than the deterioration. This is the Japanese “lost decade” prescription for deflation. And of course hidden costs can jump out and cause instability, as in the AIG catastrophe. This would also be deflationary. That's why I feel deflation is the more-likely outcome.

Finally, adding value to the money system is not a forlorn hope. It can happen. Actually, we know that it will happen - eventually. It's really just a question of how long we want it to take. Many smart people say the problem isn't so bad and I respect that. However, I humbly suggest that if large numbers of people refuse to admit they lost money in what might be the biggest bubble in human history, money as we know it will end – at least for a while.

When A Plan Is Not A Plan

Secretary Geithner's plan for bank recovery is not viable and - as described so far - not sound. However, its lack of detail is not only understandable but good. Implicit in this un-plan is the question: "How do we get private money back in the banks and the credit markets?" So long as Secretary Geithner keeps asking that question and allowing it to guide him, he will be okay as he goes through the process of realizing that we *can't* get private money into the markets because private money does not and cannot trust the banks.

The trouble is there is also another question looming: "How do we get money into the economy?" This is a separate and far more pressing question and if not handled carefully, it could lead to rash decisions made in panic, haste and with more money than anybody as ever imagined. A deflationary crisis gives governments LOTS of room to maneuver. They can create LOTS of money and fund LOTS of programs - and nothing will work quickly enough. This means the tendency to think things through starts to diminish and we have to fight that. 

And just to be clear, I believe the deflationary crisis cannot now be avoided if indeed it ever could have been. Everyone outside the government is acting exactly the way people act to create a deflationary disaster. Bankers (obviously), business leaders and even governors, mayors and county executives are doing exactly the wrong things and exactly the wrong time, as you would expect them to do. This is the initial stage of the deflation during which none of these people can see the collective result of his actions yet. Each institution looks to preserve itself without seeing that by doing the same thing at the same time they are bringing us all down. For example, by trying to "get ahead of the curve" and cut their costs with big initial layoffs, American businesses have assured that unemployment will rise above the level the financial system can withstand. 

The federal government is trying to get ahead of the curve in the other direction, pouring out money as fast as it can. The problem is that the government is pouring out money to, in effect, prevent things that have already happened. The government has to get to a place where it can pour out money on the economy that will exist 6-12 months from now, not the economy that exists today or two months ago. The problem is that it is very hard to tell the voters that in a very short time, there will be fewer banks to rescue and in a very short time, there may be no point trying to prop up the market for consumer debt such as credit cards. Careless, reckless, "never, never" planning by the consumer credit industry means that around 10-12% unemployment, the backbone companies in that industry will start to fold. At that time the the federal government will run into a huge question: "Who in the world can we even lend money to?"

Right-wing ideology has blinded people to the obvious answer. In any economic crisis, you first lend to institutions that have the legal authority of taxation - the power to compel people to pay the money back. You lend to the states, cities and counties. You demand the highest standards of accounting, demand reform and then give them the money. It's just the wise thing to do. Then you lend to the institutions that have the best *ability* to pay the money back and can create the most economic benefit. You also do as much direct aid to individuals as possible, keeping in mind this unifying principle: ultimately, you are lending money to the people to put the life of the nation back together and they must do that through the bedrock institutions and through their own creativity and sense of purpose. You must give the people the capacity to build. 

One of the great things that World War II did for America - in fact, the only great thing it did for anyone in the world - was that it gave the American people a task that was too huge for anyone to tell them how to do it. Everybody became an "entrepreneur" in the mission to beat the Axis, from the fellow with a rifle, to the lady with a riveter, to the folks with the slide rules, pencils and heads to scratch with them. The War made America realize that this was their fight - all of them. So we invested in soldiers who had only weeks before been unemployed young men nobody cared about. Business executives got off their high horses, popped the bubble reputation and asked "how can I help?". American women said: "give us the job" and this time, we gave it to them. 

In more ways than one, the War was a war against the Depression. It was a horrifying way to solve a bad problem - the worst possible solution. Hopefully, we can look at that war, look at what was good in our nation's reaction and re-create that without the horror.