Thoughts without borders.

I have already explained the root cause of why we are in a financial crisis. I have explained why talking heads talking about this being a liquidity problem are speaking bunk. Now, I am going to explain why the current actions of governments around the world are making things far worse.

The last few weeks have been filled with government announcements that they will guarantee one form of debt, or another. They think they are helping, but in fact they are doing two things:

• They are destroying otherwise healthy parts of the world financial system.
• They are putting other governments in a position where they have no choice but to do the same thing.

Generally, big governments are considered a good credit risk. For example, people generally assume that if they lend to the US Government, they will be paid back. So, imagine an otherwise normally functioning market in today’s panicky times, in which various forms are debt are bought and sold. The government announces that they will be guaranteeing a particular form of debt.

At that point, rational market participators sit back and consider their options. They can continue trading in the debt they are used to, but these are tricky times, and the government guaranteed debt is safer.

So, they very quickly move their money in the guaranteed debt. Besides meaning that a government is now on the hook for much more debt than they thought, this also means that otherwise healthy debt is suddenly difficult to sell.

The government backstop stole buyers away from similar debt. At that point the market for that other debt is distressed, and previously healthy entities start teetering. In desperation, governments announce they will backstop the newly distressed market. This then causes money to be sucked out of some other market, and that market becomes distressed.

In the end, everything is distressed, and the government is backstopping everything.

But, governments don’t have infinite resources. At some point they either refuse to guarantee something, or they default on their own debt. And then, a much larger problem that they have created unravelles in a way out of anyone’s control.

(For one example of what I am talking about, have a look at what Mr Practical has to say at Minyanville.)

Please nip over at some point and have a look at my post about the root cause of the financial crisis. It will make this post make more sense.

I have already pointed out that the root of the problem is that many companies are functionally bankrupt because they are holding debt that has no value. They do not want to admit they are bankrupt. The powers that be are so afraid of a system collapse that they are not willing to force companies to come clean. I personally think that they are making a system collapse much likelier with their current actions. More on that in another post.

The current claim is that “the markets are frozen up and need more liquidity”. This is a load of bunk. What is actually going on is that a lot of people without enough money are trying to pretend they have money, and the Federal Reserve Bank (”The Fed”) is trying to help them do it. The Fed is doing this by making huge short term loans.

Here’s how it is done:

The Fed dumps a ton of money into the market, as loans. Companies take those loans, and try to pass the money around as fast as possible, to prove to any doubters that they aren’t bankrupt, and then give the money back to the Fed.

It’s a bit like a man with $1 that owes five people $20 each. He can borrow $9 for a day, and then rush around showing the $10 he now has to those people, and tell them that he has almost made back the money he needs to pay them back, and he’ll pay them back next week for sure.

If he’s lucky, he might be able to make a little money from that $10 and add it to what he has after he gives the $9 back.

Will it work?

Sure. For a while.

I’m tired of Doom and Gloom posts, and thought it was time to post something that makes me happy.

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In other posts, I have written long expositions of why we are in a financial crisis. I have decided to write several short posts on the subject as well.

The root of the problem is counterfeit money. I’m sure that’s a statement worthy of a double take for most people, but it is true.

In today’s world, there is not very much difference between debt/credit and money. If you write a check to someone saying your bank owes them $100, that’s pretty similar to giving them a $100 bill. Businesses buy and sell debt like they buy or sell anything else.

Now, a relatively easy way to make money is to convince someone that some debt is good, and sell them the debt. If you know the debt is bad, this is really a form of counterfeiting. For those interested, here’s another take on the problem.

An everyday example of counterfeiting debt is writing a bad check.

Now there are three forms of debt we care about:

• Debt that will be paid back, or good debt.
• Debt that is good debt now, but will go bad later.
• Debt that is bad now.

And they directly correspond to:

• Money.
• Counterfeit money that will magically become worthless in the future.
• Counterfeit money that people realise is counterfeit, and won’t accept.

The housing boom, mortgage backed securities, credit default swaps, etc. was all about making counterfeit money, whether it be intentional or unintentional. Mostly, it was in some grey area really close to “intentional”. Now, those same institutions dealing in this counterfeit money have been caught by their own creation.

That was the root of the problem.

The problem now is that lots of institutions are now holding counterfeit money that has turned bad, and they do not want to admit that they are bankrupt. Similarly, they are afraid to do business with other institutions, because they suspect those institutions have the same problem. They like to claim that they can’t sell their debt at the correct price, and that their “assets are illiquid”. That is not true, if they were willing to sell those assets for what they were worth, they would sell like hotcakes.

Any bailout attempt that does not force businesses to come clean about how much counterfeit money they hold is doomed to failure. Markets will be frozen until trust is restored, and trust will be restored when institutions are forced to come clean, and not a second sooner.

Authorities are trying to paper over the problem by providing “liquidity”; that is, lending money for short periods to those in trouble. This is a fool’s errand, as I will cover in another post.

Please note: the case for why I believe the following is laid out thoroughly here, here, and then here.

Well, I think the financial crisis is about ready to really get started.

So far, every government response to the crisis has been to make it worse, along with taking on debt. Taking on debt during extreme deflation is a slow way to commit suicide.

The US Government will probably need to sell around 3 Trillion dollars of treasuries this fiscal year, because of all the debt the government has taken on trying to fix this.

That’s far more than has ever been attempted before, and they’re going to be trying to do it in a panicky environment where people don’t have cash to spare to buy treasuries.

When everyone figures out the numbers, all hell will break loose.

Europe is in a worse place than the USA. The chances are that the moment of truth will start in Europe, and drag down the USA with it.

If you are in stocks, get out NOW.

If you are thinking of buying something big or expensive, DON’T.

Don’t listen to anyone who claims that we have found the bottom for at least another year. In a year, I’ll probably say the same thing.

I don’t see any place to hide. Deflation kills everything but cash. Every government in the world is frantically doing its best to destroy cash, too, and their actions force other governments to join them in a race to the bottom or perish first.

The only way to fix this would be to force massive defaulting of debt. There is no way politicians are going to walk out onto the stage and announce procedures that will overnight kill 20% of companies out there and force millions into foreclosure, and guarantee 30% unemployment. The alternative is worse for all of us, but there is no upside for a politician for being known as the person who forced a hard crash to forestall a bigger crash that he claims was around the corner, and that he can’t prove will happen.

Wow. This is happening a lot quicker than I thought it would.

It seems that some UCLA professors have figured out why the Great Depression lasted 15 years.

And the answer iiiiss: “F.D.R!”

I am quite scared for the short term future of the USA. I look at the potential presidents we could end up with, and I am faced with either ignorance or mal-education, or both. Let’s hope the results below are rubbed in their faces before they decide to “fix” anything.

For more have a look at: http://newsroom.ucla.edu/portal/ucla/FDR-s-Policies-Prolonged-Depression-5409.aspx?RelNum=5409

It seems that banks are now so afraid that their counterparts are insolvent, that they are not accepting letters of credit from other banks. This is a bit like a bank refusing to cash a check because the check draws on the account of another bank.

This is bad, because letters of credit are used as part of shipping goods around the world and within countries.

When letters of credit start failing, goods stop moving. Imagine not being able to buy food at your local store because it is empty, and not being able to drive to another because the gas station is also empty.

That is the logical end point for what is happening now.

Let us hope that the desire to make money keeps enough credit going that everyday life is not too badly impacted.

For more information, see:

http://www.nakedcapitalism.com/2008/10/international-trade-seizing-up-due-to.html

Something I have not spoken about, because I considered it tangential to the root cause of the current problems with the financial system, is the role of Credit Default Swaps. Although the real problem is that people essentially counterfeited money, credit default swaps were sometimes used as part of this process.

A credit default swap is a bet on some outcome. It can be legitimately used as a form of insurance against a negative outcome. For example, it was possible to buy a credit default swap as insurance against a piece of debt defaulting. In other words, “I’ll pay you a premium now, and if that debt over there becomes bad, you pay me the money I would otherwise have lost”.

Unscrupulous dealers bought credit default swaps on risky debt, so that they might sell that debt to other people as “good” debt. Unscrupulous insurers sold the insurance on the debt, thinking that they would simply refuse to pay if too much debt went bad. Some honest insurers sold legitimate swaps, but they we not aware of how risky the debt was that they insured.

Regardless of how honest people were when the transactions were made, when enough debt defaults, it is simply not possible for the insurers to pay without going bankrupt. And, everyone insured everyone else. So, in the end, the swaps neatly tied together a large number of companies in a net that insured that if enough parts of the net went down, the rest of the net would be dragged down with them.

In the context of the current crisis, the real problem with credit default swaps is that they tie all the dominoes together in a non-obvious way. Dominoes no longer need to be next to each other for a collapse to spread through the system.

For more context and background, this article is pretty good: http://www.newsweek.com/id/161199

Continued from Part 2

So whatever happens, we’re going to hurt a lot?

Yes. It’s going to hurt. A deflationary crash would be quick, and extreme. People who watch too many Hollywood movies think this means blood in the streets, but it really just means a lot of hard working people will be on the streets trying to find a way to be productive. People who would rather cry to the government for help than work will be screaming blue murder and politicians will be trying to prove they can help by doing something. If they give in and do anything that forces the US Government to borrow, they could make things worse or just make the crash last longer.

An inflationary crash means that we’ll have many living-dead companies, and many people just on the edge of bankruptcy. House prices will still crash as it will be impossible to borrow money to buy them, and impossible to pay the interest on a mortgage if people do buy them. The government will constantly be borrowing more and more to try and make the problem go away. If it borrows too fast, the entire economy crashes as the US Government defaults on its debt. If it borrows at just the right rate, the inflationary crash lasts ten or twenty years.

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