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.