For the US, UK and Germany, a small window remains to raise long term debt. Take the UK for example. They need to issue 30 year debt in quantities sufficient to remove refinancing risk for the next 5 yrs, and then cut tax rates.

Usually in a distress refinancing, creditors want to see a plan of reorganization before they will agree to buy the new debt. The distractions from Southern Europe mean that the UK and Germany are being given the opportunity to refinance themselves even in the absence of a credible plan of reorganization. They should not look a gift horse in the mouth. They should refi now for the long haul and then use the time borrowed, for that is precisely and all that it is, and cut tax rates, reform the entire economic system, address moral hazard, sclerotic labour markets, anti-competitive policies, clean up the financial system and get the country back on its feet. Time is running out.

I’d like to understand the causality between lower MBS yields and unemployment. I’m sure there is a correlation, but I’m not sure that the dependence is so high.

 So if mortgage rates are low house prices will rise leading to lower lending standards, more mortgage lending, rising house prices, which lead to improved sentiment, better credit and the increased propensity to consume leading to an economic recovery. There are too many ifs, too many conditions which might not hold. We’ve had low mortgage rates for a while now, yet no significant rebound in house prices. The Case Shiller index is showing only nascent signs of improvement but this is probably a consequence of QE1.

For QE3 to work, house prices have to be rising independently of the MBS buying. Also, lower mortgage rates do not necessarily lead to more lending unless the securitization markets are open. (Unless of course the Fed intends to be the sole buyer of MBS.) Lower mortgage rates, absent securitization may drive banks to lend less as their returns from mortgage lending become less attractive relative to their cost of capital under Basel 3.

House prices have to rise at least until households face positive equity otherwise they will not be able to refinance under any mortgage rates. If they cannot refinance then they cannot take advantage of lower mortgage rates, which the Feds QE was supposed to produce.

There is also existing debt to be repaid. Any refinancing activity that improves household’s cash flows may not result in increased discretionary spending as household’s are likely to first pay down existing debt. This has to happen with or without QE and so is not an argument against QE, it just means that the impact of QE3 may take much longer than intended. US households need to save more and consume less, not the converse. I wonder if the Fed has this in mind. 

Demographics. What if the demand deficiency is a structural consequence of demographics? What if this generation is done with its big spending ways? 2007 coincided with the peak consumption age of the average Baby Boomer. Growth cannot come from unbridled consumption alone. And consumption certainly should not be financed out of debt; it should substantially be funded out of profits and cash flow. And what about exports? Unfortunately the world currently faces a synchronized slowdown and it simply isn’t possible for everyone to be a net exporter. Over the longer term, but not the long term, emerging markets’ demographics will mean that they will have to take on the mantle of consumer of the world. What does that imply for the US economy and other developed markets? Does the Japanese experience beckon? Does an ageing population lead to deflation and recession? (Not necessarily as Japan has different problems.) In the meantime a period of non-cooperation and self sufficiency appears to be emerging, as one would reasonably expect in a global recession. How long will this period of self sufficiency last? What are its consequences on the path of history.

Does QE increase or decrease the amount of debt? It seems a little bit strange that the proposed solutions to  a problem precipitated by excessive debt seem all to involve the creation of more debt. In a bankruptcy reorganization of debt is a necessary step but this comes with a credible business plan. Without fundamental changes to the cash flow generation plan, it is not possible to make an insolvent business solvent simply by shuffling the debt.

QE is a debt reorganization. It is silent about the cash flow generation model of the economy and the government. That part of the problem is equally if not more complicated. Being a macro debt reorg it does not address bottlenecks and agency issues at the micro level, but one could argue that it is sufficient, as a debt reorg.

A culture of entitlement hobbles the world. We want free medical care, free education, free everything, but we don’t want to pay the high taxes. Nothing is free but everyone wants it to be. People want others to pay for their stuff. Basically they are either don’t understand or don’t want to abide by their constraints and demand more than is available to them.

Our political systems ensure oppression by the majority, populism and cynicism. Where there is democracy, governments have not the strength of resolve to present to their people the hard truths. Where there is no democracy, governments simply trample on the will of the people. The democracies therefore hurtle towards disaster while the undemocratic profit handsomely at the expense of both the West and the haplessness of their own peoples.

The people need to wake up. In the West they need to realize that they cannot have their cake and eat it. The culture of entitlement must be forfeited. In order to get borrowing costs down, some level of austerity is necessary in the form of poorer social security, medical benefits, free services. Governments need to reduce marginal tax rates. This is a commercial reality. As purveyors of tax domicile, they need to cut prices and that price is the marginal income tax rate for individuals and corporates. It is a less contentious alternative to trade war. In order to balance their profit and loss and cash flow, the size of government needs to be reduced. This is not an ideological objective but a practical one.

Undemocratic countries will continue to attract and harbour illicit businesses and capital. This time of economic crisis and ill advised government policy has only exacerbated the exodus of capital away from regulatory scrutiny. Western democracies need to address this in two ways; first, by reducing the tax arbitrage by lowering taxes, and second by pursuing with extreme prejudice, illicit capital and its custodians. Poor economic management can be condoned but willful misconduct must face punitive and if need be destructive consequences. Capital needs to be out in the open if it is to do any good.

Capitalism needs to be restored from its current incarnation. Since the fall of communism, capitalism has become adulterated with myriad forms of moral hazard, adverse selection and agency inefficiencies. Addressing moral hazard is all important. Capitalism needs to be allowed to punish as well as reward. If not, excessive risk taking will always occur with the final bill being visited on the public balance sheet. This pushes up the tax bill and inflates government. As part of this effort, the role of central banks needs to be examined. Unilaterally setting interest rates distorts relative prices as much as the arbitrary purchase of US treasuries or agency mortgage backed securities. The very existence of a lender of last resort is anathema to capitalism. Airbags and seatbelts save lives but increase the incidence of accidents.

Its Friday and its been a long week…

• When risks are high one reasonably expects the risk free rate to be low.

• Buy when interest rates are high, sell when they are low.

• ‘Tis calmest before the storm. ‘Tis very calm. Corollary: risk is high when VIX is low.

• Markets are attached to fundamentals by psychology, a very elastic couple.

• When the pie shrinks, people are less happy to share. There is a point when economic considerations give way to strategic considerations.

• ‘You got to know when to hold ’em, know when to fold ’em’. Kenny Rogers, The Gambler.

• “My options are decreasing mostly rapidly.” Gordon Sumner, Seven Days.

• Money can buy almost anything, even and especially experience. But pay as you go, there is no need for a retainer.

• Often the way to an efficient portfolio is a short memory.

• Often the way to successful trading is a long memory.

Painkillers are addictive. People follow the path of least resistance. Principles are always compromised. The prudent are the few. And often made to pay.

When unconventional policy was deployed to rescue a global financial system in crisis in 2008, we went down a slippery slope from which we have not recovered.

This time is different in that we have financial tools at our disposal that we had not in previous financial crises. This time is still the same in that we are human and we will repeat ourselves, and there are certain immutable laws of economics.

The most remarkable thing about policy response in 2008 was its intention to avoid any and all pain, its aim to bail out every investor, institution, company and country. Was not the idea of capitalism that the free market punishes in equal measure that it rewards? Has the culture of entitlement pervaded the human psyche to the extent that we expect no one and never to lose? Have we uploaded the ‘cheat codes’ (to use PC game jargon) so that all may use them? It is well known that players who use ‘cheat codes’ simply cannot survive when these codes are withdrawn. And what if everyone uses ‘cheat codes’? If one person uses them, then there is an incentive for everyone to use them. The result is a simultaneously chaotic and boring game.

One cannot help but feel that capitalism has failed. And that its death knell was sounded by the death of communism, its great nemesis. Without communism as a foil, capitalism evolved in a cancerous and uncontrolled fashion, resulting in the perverse form that rules us today.

One cannot help but suspect that a new system will emerge to challenge capitalism as an economic philosophy. But economic philosophies are born out of necessity. It is hard to see how the world will wean itself off our morphine induced dream.

Debt is being created even as it is being repaid, a self evident observation were it not for that the crisis was born in excessive debt, and the solution to its precipitation seems to be the creation of more debt. As debt is repaid, nominal output must fall, all other things being held constant. This accounts for the economic weakness observed across the world. Central banks only available response to stoking economic growth has been to apply more debt in the hope of igniting self sustaining growth. So far it has obtained limited success. 

It is certainly possible that our debt creation has outpaced equilibrium growth rates ex debt to the extent that the mean reversion cannot be adequately compensated for by conventional policy, or unconventional policy for that matter. If so, then our prospects are to wait for time and the natural cycle of recovery to stabilize output growth, once it has reached its negative extremities, and have it mean revert to positive territory. Given the extent of the debt fueled overshoot, this could take a long time.

In the meantime central banks have decided to act. Their efforts are aimed at staving off any kind of default or slowdown. They intend that the market must punish no one. What they may achieve, is an event or phenomenon that punishes everyone. Without the guiding torch of principle, capitalism has been distorted to a form of socialism.

Every central bank which can is monetizing its sovereign’s debt, or expanding its balance sheet, or trying to debase its own currency. Mutual and universal success must be evidenced by invariance of relative prices. Failure is likely to produce discontinuous price actions, which are not addressed by current option pricing models.

In theory, no country need default in the debt denominated in its own currency. In theory, a government cannot be obliged to pay back its debt. It can be compelled to do so by martial force (Britain has an excellent track record in this regard. Call it foreclosure with extreme prejudice.)

The l
argest creditors of national debt are the respective central banks. This presents an interesting discussion as a country drifts towards insolvency. Certainly it is the intention of each central bank to engineer inflation at least to the extent it erodes the value of the stock of debt. In the case of a reorganization, however, it is not clear what the objectives of the central bank will be as regards the claim it holds. This has implications for other claim holders who will almost surely be in the minority. Will their interests be aligned? For almost all investors, this question is academic and far off. But as this point approaches, it could crowd out private demand for government bonds.

In the meantime, controlled and moderately high inflation appears to be the plan for debt management. The risk is that the inflation becomes less controlled than planned. With a money base as large as has been created by the central banks, any pick up in the velocity of money or the money multiplier, is quickly multiplied through this money base resulting in the potential for some very interesting inflation levels.

Finally Bernanke has tired of announcing successive bouts of quantitative easing, he’s just announced that the Fed will be buying assets until the labour market picks up.

Buying what? US treasuries don’t really need a lender of last resort; Basel 3 has made them the asset of last resort for all the private commercial banks, who incidentally have loaded up on over twice the amount they bought last year, and this just till August this year.

So what’s all this MBS buying all about? For commercial banks, creating a mortgage consumes capital. The capital efficient trade is for banks to keep buying US treasuries. So what gives? What’s the Fed up to?

The Fed is not buying non-agency MBS, arguably a better trade given that the market has dumped them with the bathwater. But profit is not the objective.

The Fed is hoping that supporting the housing market will restart the credit machine.

A rising housing market would reduce the proportion of homeowners with negative equity, providing them the opportunity to refinance.

Bank’s lending standards since the crisis has tightened up considerably. The Fed hopes that rising housing prices may loosen lending standards.

Rising housing values opens the avenue to HELOCs, once an important source of funding for discretionary consumption.

Perversely, lower mortgage rates discourage mortgage lending since cost of capital is fixed. Only a robust securitization market might encourage mortgage origination.

Also, banks will not loosen underwriting standards unless they are able to transfer the credit risk off their balance sheets. With the Case Shiller index turning just positive, the first time since the crisis in 2008, the Fed may be attempting a momentum trade by encouraging a stronger recovery in housing.

Its not entirely responsible to address a problem of excessive debt by creating more debt, but what can you do? They have to try something.

Since the US economy recovered in 3Q 2011 asset prices had stabilized until the Europeans and their half baked efforts to secure the Euro fell flat and China landed with a thump (and is still looking moribund.) Today, the global economies look to be in a synchronized slowdown. Policy makers the world over certainly think so. Every central bank has plans to print and every government who can afford it has plans to build.

While the real economy sags, asset prices have been buoyed by super-loose monetary policy. There is a chance that animal spirits may be invoked to rescue the world. However, the exit is as yet unclear. What exit? Why the unwinding of banking system balance sheets which now stand at 5-6 times multiples of what they used to be before 2008. If there’s a plan for reversing the balance sheet inflation that has so far been deployed to save the world, once the world has been saved, I’d like to hear it.

There’s just this little risk of inflation… QE, Debt Monetization and Hyperinflation Risk

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