With the collapse in the price of sub-prime mortgage backed securities and credit derivatives, the credit boom has moved into the crisis phase. This is the place in the cycle where it becomes clear to the market the investments made possible by unfunded credit were mal-investments and they are re-priced.
The initial response of the Fed and mainstream media was that the sub-prime crisis was small and would remain “contained” without spill-over into the rest of the financial system. An Austrian would have a reason to doubt this because the mortgage debt markets are so large, and because credit is so central to all economic calculation. It would be difficult to have a credit expansion in the mortgage markets that did not affect other credit markets, and economic calculation generally, which must always balance the value of present versus future goods.
Now as the crisis begins to affect banks, hedge funds, and equity markets, how will the political system respond? By allowing the corrective process to wring out the bad investments and return to a base for sustainable growth? Or by more inflation in an attempt to sustain current asset prices? The latter, it seems. The “government-sponsored” enterprises Fannie Mae and Freddie Mac were instrumental in creating the mortgage bubble in the first place, as Doug Noland explains in his weekly commentary. But as they were found several years ago to have engaged in questionable accounting practices and fraud, they have been increasingly reigned in by regulators and forced to stop adding to their portfolios of securities.
The Financial Times reports in Democrats Call for Action on Mortgage Crisis that powerful senators are calling for limitations on the GSEs be relaxed so that they may purchase a greater quantity of mortgage-backed securities from the banks and hedge funds that must sell them to meet margin calls. initial reports indicate that the GSEs will not be unleashed at this time.
Their status as “Government-Sponsored” means in effect that any profits they make accrue to their share holders (including their executives, who are well-compensated with stock), while losses are implicitly underwritten by the Fed’s unlimited ability to print money. They are in effect a minor branch of the Fed.
The financial media has reported over the past week of central banks “injecting” money into the system to prevent liquidation of securities.
- Financial Times: ECB in €95 Billion Move on Market Turmoil
- Reuters: Asian Central Banks Join Bid
to Calm Money Markets - Financial Times: Central bank’s aggressive move stuns European markets
- Bloomberg: Bank of Japan Boosts Funds in System to Ease Credit
- Financial TimesCentral Banks Extend Liquidity Provisions
Central banks face the choice of whether to allow the crisis to unfold, which would risk taking down major financial institutions, hedge funds, and millions of over-leveraged US home owners, as well as affecting the status of the dollar in unpredictable ways. Or will they try, as I have argued in several articles (The Fed’s Box Canyon, Bernankeism, End Game: Hyperinflation) to monetize their way out of it? This week’s actions suggest that the latter will be chosen.
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I read a financial column this morning (author is Berry, and the article is displayed in today’s prudentbear news features) that explained that the US Federal Reserve System has reversed its 62 billion dollar repo agreement of last week, thereby–for the fragile moment–sustaining its tight money policy. This policy has produced roughly 2% annual growth in the monetary base over the last 18 months, beginning with the inaugeration of Ben Benanke as Fed chairman. Since about the middle of 2004, Frank Shostak’s AMS has declined from an annualized growth rate of 8% to roughly 1% today.
I have the feeling that Ben Bernanke is, for as long as politcal forces allow, determined to deflate the rampant, nearly fevered, leveraged speculation that has characterised the artificial boom. If the Fed stays moderately tight for a few more months, we can look forward to a very downward sloping asset price curve.
I’m probably naive about this, but tight money–over whatever comparatively brief period it can be sustained–argues for a stronger dollar. A recession whacks stocks and risk-bonds in the USA AND abroad: Europe, Asia, and the rest of the developing world. So as foreign investment holders of dollar assets repatriate into their own currencies or buy Treasuries–the world’s premiere safe haven parking garage in a storm–American investment holders of declining foreign assets also repatriate into dollars and perhaps Treasuries. It’s not clear to me that this process would send the dollar a lot lower. Meanwhile, a recession will reduce the demand for imported goods by American businesses and consumers, thereby reducing demand for foreign currencies, thereby boosting the dollar.
I also read on prudentbear.com this morning an article that headlined 5.6% inflation in July (annualized, compared to July 2006.) If price inflation advances from polite to rude to ugly in China, my guess is the People’s Bank of China will restrain money supply growth, boosting interest rates and thereby ruining the big party in Asia. Serious tightening in China might be a year or 18 months down the road, but the day will come. When it does, perhaps we should worry about another leg down in US asset prices.
That might be the day to buy stocks in Singapore and Thailand–both commercial way stations likely to be enriched (even more) by Chinese enterprise and trading.
The reference to 5.6% inflation in my post above is to China, not the USA.
I am curious about all of the Yen/Dollar carry trades. A lot of people borrowed in Yen to lend(invest) in dollars. How is the unwinding of that going to play out? The dollar denominated assets fell in value (a la mortgage blow up) implies a shortfall of money needed to pay off the Yen loans.
Though, it is only paper losses now, I am sure people are having to make margin calls because of panicking counter parties. The selling to make up for these margin calls is driving the yen up over the dollar. However, yen rates are a quite paltry .5% so what exactly is going to happen in Japan as far as a credit crunch is concerned? I will think about it myself.
Will the central banks “monetize their way out” of the unfolding crisis? Of course they will. After all, as bad as things already are, mortgage resets through the end of the years are “only” in the $50+ billion range. But look at the first six month of 08:
January: $80 billion
February: $88 billion
March: $110 billion
April: $92 billion
May: $76 billion
June: $75 billion
A helicopter drop, you say? No, as Jim Puplava says, it’s be a squadron of B52s.


To Banker: unwinding the yen carry trade will boost the yen substantially against the dollar, and other currencies. Until recently, as you know, the yen fell slowly and consistently against the dollar and other currencies, as speculators borowed yen at low interest rates, sold those yen to get dollars or other currencies, and placed their speculative bets arund the globe. In summary, a large contingent of speculators around the world have been short the yen. This trend has been reinforced by harried Japanese savers, many of whom apparently deployed savings abroad where they could earn higher returns than in Japan, and profit from the falling yen.
As markets in the US and elsewhere fall, carry trade speculators are forced to sell losers and repay yen loans. As the yen rises, yen loans become bigger libailities. As you know, to accomplish this turnaround, they have to buy yen. En masse. As the yen rises, and asset prices abroad start to decline in a serious way, Japanese savers will repatriate their foreign investments, thereby reinforcing the yen’s upward bias.
The last bout of yen strength, brought about by unwinding and short covering of the yen around 200, boosted the yen a lot–perhaps 33% or so. A bet on the yen is a bet that the markets are headed seriously south.
To David White: The mortgage resets threaten major upheaval, which as you point out, will bring central bank money pumping, as surely as night follows day. The interesting and pertinent question for investors is: when will Bernanke cave in to political screeching for monetary inflation? My 50 cents is on somewhat later, rather than sooner, because the dollar is at risk. As we all know, a declining buck will discourage foreign holders of US debt, producing at some inenvitable juncture, higher interest rates and a crises. So perhaps Bernanke will use restraint in pumping up the monetary base, as he has done since his inaugeration 18 months ago, for as long as he dares.
Who would have thought that Helicopter Ben would be a big improvement, so far, at least, over Alan Greenspan? Not me.
The last bout of yen strength, brought about by unwinding and short covering of the yen around 200, boosted the yen a lot–perhaps 33% or so. A bet on the yen is a bet that the markets are headed seriously south.
200 should read 2000–the year of the last recession.
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