How much are they holding on to?

If you wondered why JP Morgan is so interested in refinancing mortgages to Americans, the above chart (provided by http://mrmortgage.ml-implode.com/) illustrates why. The chart illustrates the number of assets that each institution has on their books and the amount of equity they have to cover potential losses. In particular, Level 2 assets are those which are being priced based on a model. Level 3 assets have no bid in the market and their value is unknown. The amount of mark-to-model assets alone is so large, that if the reflation of the housing market fails, it will mean the remaining institutions will go the way of Washington Mutual, Bear Stearns and Lehman Brothers, and it will drag the United States into a deep depression that will make 1929 look like a little league baseball game. 10:1 leverage created the Great Depression. I can only imagine what 30:1 will do.

Dragging down the innocent

The Federal Reserve during the 2001 recession sent the wrong signal to the market by setting interest rates to an artificial 1%. In doing so, it told the market: “We see future growth and prosperity ahead. Please spend”. Businesses that had should have went bankrupt, continued to operate, and expanded operations based on their faith that the good times were ahead. Fast forward to 2008, businesses that should have failed in 2001 have collectively made the bankruptcy pool larger, resulting in more pain for the US Economy.

While subprime is a thoroughly discussed subject, the main focus should be on the derivatives that were created on top of the mortgages. Derivatives are off-table bets that have no regulation. In particular, the Credit Default Swap market by itself is a whopping $50 trillion. CDS’s are insurance policies on bonds in case the company that issues them goes bankrupt. It is a hedge to recover principal in case bankruptcy occurs. A company that issues a CDS accepts payment for providing the insurance, and is “in the money” as long as the company behind the bond does not go out of business. CDS’s were once viewed as highly profitable since the following assumptions were always believed to hold true:

1. liquidity was always available
2. housing prices would always go up.

As the subprime crisis reared its ugly head, the institutions holding onto this toxic paper realized the gravity of the situation when Bear Stearns was near collapse. JP Morgan issued a lot of the CDS behind Bear Stearn’s bonds, and therefore had to bail them out or risk going out of business.

The problem is far from over however, as a second wave of option-ARMs (and all related derivates) are set to deluge the banks with more losses. As a result, credit to all sectors of the economy has dried up because the banks have to save capital to account for these losses. The losses aren’t going to be realized over a 20, 10 or even 5 years: They are imminent. Lines of credit have been stopped even to reputable businesses:

McDonald’s Says Bank of America Won’t Boost Loans (Bloomberg link)

Store owners have exhausted financing used to pay for upgrades and equipment to make lattes and espressos, and Bank of America won’t provide more money as it works on the planned purchase of Merrill Lynch & Co., McDonald’s said in a memo that was obtained by Bloomberg News.

When one of the biggest banks in the United States cannot offer credit to one of the most successful fast-food chains, what does that say about that bank?

The Mother of All Margin Calls

Federal Reserve chairman Ben Bernanke’s response has been to follow his original thesis in a Federal Reserve Paper entitled “Deflation: Making Sure it Doesn’t Happen Here”. In his speech, he examines the causes of the deflation and the Federal Reserves methods of counteracting this monetary phenomena.

Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

In September of this year, Bernanke and Secretary of the Treasury Hank Paulson faced a looming problem. Banks and mortgage lenders were failing left and right, and they were in dire need of capital. But they could not provide liquidity to the banks because of the threat of inflation, the US Dollar falling in value, and rising commodity prices. To give themselves leeway to implement their policy, they engineered the failure of Lehman Brothers, which set off the payment clause in Credit Default Swaps written against Lehman bonds. Hedge funds and insurance companies behind Lehman CDS were now in a huge scramble for capital. As these funds were not well capitalized and over-leveraged, their only source of funds was to unwind their profitable trades, which was dominantly long commodities, short the US Dollar. Thus we had a mechanical reversal of the charts of commodities and the US Dollar. In short we had a gigantic margin call with forced selling of commodity contracts that sent markets scurrying for dollars to settle these trades. The panic spilled over into the overall market and led to selling of all equities.

Dangerous Games

Deflation is now the buzzword in the financial press given the recent plunges in stocks and commodities. The US consumer has reigned in their spending and is paying off debt now that the years of “prosperity” appear to be over. Wealth has “vanished” as strategies such as diversification and overseas investing have done little to nothing to protect investors from the current bear market. The fear of deflation has moved consumers and investors to hoard dollars and rush into the safety of treasuries and bonds, driving down benchmark rates.

Interest rates are heading to 0% in hopes of lending money to reflate the United States economy. Printing large amounts of money will cause a natural rise in the prices of everything we buy. Oil will soon be returning to its highs and we will never see $50 a barrel again. This has been my biggest fear that I have been chronicling. Hyperinflation is coming. You cannot hope to get out of a crisis by issuing more currency.  The nations with US dollar currency reserves know the jig is up and are making plans to secure resources in attempts to jump start their own economies.