OIl's Great Fall: This Time, The Bailouts Will Be Harder

In a desperate move, Russia's central bank recently raised a key interest rate by 6.5% to 17%, propping up the ruble at least momentarily.  This was after the ruble had already lost about 50% of its value in the past few months.  Even if the ruble stabilizes, Russia verges on economic collapse. 

Venezuela was already hitting the skids when the price of oil began its big swoon.  Now, it will possibly default on its sovereign debt.  Other oil producing nations are hurting, too.  Some could survive by drawing down their financial reserves.  Others may not have adequate reserves on which to draw.

The impact of the oil price drops on major financial institutions and financial markets players is much more opaque.  When a key commodity like oil, and the currencies issued by its producers, belly flop as we have seen in the past few months, big losses are inevitable.  Some of these losses could be greatly magnified by the leveraging effect of derivatives.  A crucial question for regulators is where these losses are landing.  Surely there are losses on Wall Street and in the City of London.  But proportionately much greater losses may have been sustained by Russian and other European banks.  Dec. 31, 2014 will mark the close of financial reporting periods for many banks and other institutions. At that point, they will be required to disclose their financial conditions.  It wouldn't be surprising if the losses are big.  Talk of bailouts might follow.

It's one thing for the taxpayers of a nation to bail out the banks of their own nation.  They may be frustrated and outraged, and demand the punishment of bank executives and others.  But they have a strong interest in preserving their own financial system.  It's another thing when a foreign country wants a bailout, just after it sent its Special Forces surreptitiously into a neighboring country to seize territory by force, lied to the world about what it was doing, and then made aggressive moves against many other nations--especially those that border it and have historically been dominated by it.  The West has imposed sanctions on Russian banks.  It can't now bail them out.  It's attempting to force Russia out of Ukraine, using financial leverage as a key weapon.  It can't provide Russia with a financial bailout.

Venezuela has for years been seriously hostile toward the U.S., while getting cozy with Cuba.  Its current predicament is the result of spending way more than it was taking in.  A bailout for Venezuela has no chance of receiving Congressional approval, nor would American generosity do anything to ameliorate the key problem, profligacy by the Venezuelan government in order to win over voters.  The IMF would impose financial discipline on the Venezuelan government as a condition of any international bailout, something the current Venezuelan government surely wouldn't accept.

Free market advocates have railed for years about the bailouts made in the aftermath of the 2008 financial crisis, proclaiming that handouts to the wealthy and powerful would only foster moral hazard and encourage undue risk taking at the expense of taxpayers.  They may have their way in the wake of oil's great fall.  Some of the key players likely to need a bailout won't be getting them.  Chips will fall where they may, and we'll see how the markets operate in the absence of government intervention.  The results will be good for some, bad for others, and undoubtedly painful for many. 

A destabilized Venezuela will probably experience internal political change.  But a destabilizing Russia is much less predictable.  As long as Putin is in power, who knows what will happen?  And what is the potential for Putin to leave power?  Not much and it's not likely to happen in a gracious way.  Demagogues at risk of losing power sometimes turn to foreign adventurism to stay in control.  The farther oil prices drop, the harder these questions will become, and the more disturbing the potential answers. 

Regulatory Challenges of the Bond Market

The Great 2013 Bond Market Chain Saw Massacre has probably caused trillions of dollars of losses.  On May 1, 2013, the yield on the U.S. Treasury 10-year note went as low as 1.61%.  Since then, it has vaulted as high as 2.72% and most recently closed at 2.63%.  Such a jump in yields is, as kindergartners would put it, ginormous. 

The inverse math of the bond market would dictate that when yields jump this much this fast, the principal value of bonds will fall painfully and nasty losses will be incurred.  While precise numbers aren't readily available, losses in Treasuries may reach a trillion dollars.  And when you add in corporates, munis, junk bonds, and mortgage-backed securities, the losses could be multiple trillions.

The game of musical losses is now in progress.  Through short positions, derivatives contracts and other hedges, the losses are flowing through to wherever they will end up.  The challenge for regulators is to find out, and quickly, where that end will be.  What must be ascertained is whether the losses are spread out and landing in places where they can be absorbed without too much fuss.  Or whether the losses are concentrated somewhere and could have secondary and tertiary rippling effects (i.e., cause a run on one or a few major financial institution(s)).  Well within living memory (2008, to be exact), sharp losses in the mortgage markets triggered tsunamis in the financial markets that washed over Bear Stearns and Lehman Brothers, and threatened to wipe out AIG, Fannie Mae, Freddie Mac and Merrill Lynch.  Bailouts and regulator-encouraged acquisitions barely prevented an abrupt, loud, low-flow flush of the entire financial system.

Regulators should be proactively trying to pin down where the bond market losses will fall.  Complicating their task is the likelihood of speculators who used leverage to make derivatives bets on a fall in interest rates.  Since there is no prohibition on speculating with derivatives, as opposed to hedging, it is possible (and probable) that some players in the financial markets made such a bet.  That wouldn't be intrinsically different from the bet that John Paulson made in mortgages shortly before the mortgage crisis that sweetened his net worth by billions.  It's also not intrinsically different from the gold bets that John Paulson's gold fund has likely made, which reportedly has sustained losses in excess of 60% (ouch).  Any such speculative bets in the bond markets could exacerbate the game of musical losses, and make the regulators' tasks all the more difficult, since many of the speculators might be trading through entities chartered in off-shore locations that might frustrate U.S. government oversight.  But the Feds will have to do their best, because the alternative would be what happened in 2008, when they waited until things blew up and bailouts were just about the only option.

There's more.  The yield curve has been steepening during the last two months.  The short end remains squashed by the Fed's scorched earth policy on short term interest rates.  But the long end, as we noted above, has been rising meteorically.  This steepening makes attractive a type of carry trade.  It's possible to make a lot of money by borrowing short term and investing long term.  

Fed policy makes this carry trade all the more enticing.  The Fed's intent, as far as it can be discerned from the entrails currently visible, is to begin cutting down on bond purchases (i.e., QE) within months, but to keep short term rates at zero until unemployment reaches 6.5%.  Although employment has been rising, the unemployment rate has been static for several months.  While no one really knows when unemployment will reach 6.5%, it's not uncommon to read predictions of mid-2014 or so for that level to be acheived.  If so, the carry trade could be profitable for a while, especially if the Fed's reduction of bond purchases push long term yields even higher. 

To paraphrase P.T. Barnum, or Mark Twain, or somebody, there's a smarty pants who shows up in the financial markets every minute. Some--and perhaps many-- will surely indulge in this carry trade, most likely on a leveraged basis (because leverage boosts profits, assuming the trade works in your favor).  But if the unemployment rate unexpectedly drops quickly to 6.5%, the partakers of this carry trade might wonder if they aren't living in a septic tank. 

Either way, the regulators have to keep an eye out for the possibility of mounting risks from this sort of carry trade.  It could look like easy money to banks, hedge funds, insurance companies and other important players in the financial markets--after all, with the Federal Reserve at least momentarily anchoring their borrowing costs while pushing up their profits, the government is on their side.  But borrowing short to invest long is the E. coli that has poisoned many a would-be financial marvel.  Regulators need to be watchful not only for bond market losses from risks that have already materialized, but also for the growth of more risk from the changing landscape of the market.

Greece and Dubai: Are the Lights Dimming at the Creditors Ball?

Holders of sovereign debt are not having a very good week. Last weekend, beleaguered conglomerate Dubai World reportedly was thinking of asking creditors to accept a settlement of 60% of the face amount of their debt, or taking a debt for equity exchange. The Dubai stock market dropped away when this story ran, even though Dubai World denied making such a proposal and Dubai debt holders rejected the proposal that Dubai World denied making.

At the same time, the Greek government and EU authorities swapped proposals. The EU wanted the Greeks to put together a detailed program of fiscal reform and the Greeks wanted the EU to announce a detailed bailout package. Aside from issuing dueling press releases, both sides largely eschewed progress.

Neither the Dubai debt kabuki theater nor the EU-Greece Alphonse and Gaston routine disturbed stock markets. From Asia to Europe to North America, stocks rose today, with the Dow Jones Industrial Average increasing almost 170 points on an unexpectedly positive manufacturing report and a drop in the dollar, along with some favorable earnings reports. The stock markets' bounce is bad news for sovereign debt holders.

When a debt crisis clobbers the stock market, governments have to step in. Recall how the mortgage crisis made nervous Nellies of stockholders in 2007 and 2008, forcing the federal government to take over Fannie Mae and Freddie Mac. Then, when the collapse of Lehman Brothers imperiled AIG and Merrill Lynch, the government bailed out AIG, paying its creditors 100 cents on the dollar, and persuaded (that's one way of putting it) Bank of America to purchase Merrill. When Congress initially rejected the TARP legislation in the fall of 2008, the stock market tanked, voters' 401(k) accounts nosedived, and outraged constituents berated Congress back to a second vote that heartily endorsed TARP.

But when the stock market holds up, governments have more latitude to step back and just say no to creditors. That throws the battle for repayment back into the more traditional arena of contention between debtor and creditor, with taxpayers on the sideline.

Since the 2008 government subsidized sale of Bear Stearns to J.P. Morgan Chase, this has been the best of all possible worlds for creditors. Whenever they could conjure up even a faint specter of systemic risk, stock markets panicked and governments paid them out, often at 100 cents on the dollar, no matter how reckless their loans had been. The more stocks dropped, the more leverage lenders had to put the squeeze on taxpayers. But when stocks hold steady or rise, the creditors' cries of wolf sound less compelling. If the stock markets correctly assess that these crises aren't systemic threats, the music will stop playing at creditors ball. As shocking as it may sound, bond holders may have to bear risk and losses.

To be sure, short term price movements in the stock market are often misguided, and the picture may be quite different by the end of this week or the beginning of next week. The European debt crisis doesn't appear to be in a hurry to let up; news stories of a time bomb outside J.P. Morgan Chase's Athens, Greece office indicate that someone's trying to instigate something. The Dubai situation hasn't materially improved since it first blew up last fall, which means that it's deteriorating. Debts fall due as time passes, and the more time that passes in Dubai with no progress, the closer we get to defaults. So taxpayers shouldn't breath easy yet. Lenders may yet find a way to pick their pockets.

The Nine Lives of the Dollar

With feline quickness, the dollar has again pulled out of its latest nosedive. Greeks came bearing gifts, in the form of a Euro bloc debt crisis, and investors worldwide suddenly found the greenback in their hearts. Two and a half months ago, the dollar was trading at more than $1.51 per Euro. Today, it closed below $1.38 per Euro. That's close to a 10% gain (approaching 50% on an annualized basis). We're not suggesting that you jump into the currency markets. But if you're an American, your passbook savings account just enjoyed a pop in Euro terms.

Late last year, many predicted the imminent transfer of the dollar to hospice care. These days, the dollar is dancing up a storm in swanky nightspots with an endless stream of partners. There's nothing like a good old fashioned financial crisis to put the pep back in the greenback's step.

The Chairman and governors of the Federal Reserve Board are probably sleeping better, as a strong dollar portends lower inflationary risk and widens their latitude to continue monetary accommodation. The administration is likely breathing more easily, since a strong dollar attracts capital to the mountains of Treasury securities that will have to be sold soon to finance the burgeoning federal deficit. Exporters are not pleased. But reality is that the government sector of the economy is more important these days than the private sector. Although that's a very big long term problem, no more than three or four people in America are focused on the long term, while the unemployed and everyone else are wondering about today, tomorrow and next week.

Wall Street is pleased, if only because the recent volatility of currencies and the stock market, and divergence in the bond markets (corporate debt is down, Treasuries are up), provide profit opportunities. Big money is made by the big banks when asset prices soar and swoop, and churn the stomachs of investors. Volatility creates trading opportunities for returns above long term market averages. In order to cash in on these trading opportunities, the big banks have to convince you, dear reader, to be a short term investor who trades in and out. That gives them commission income and market making profits. Fastidious, disciplined long term investors who know that .300 hitters hit a lot of singles and not so many home runs, and therefore don't trade a lot, are not ideal customers for the Street, even if they impudently become personally prosperous. (See http://blogger.uncleleosden.com/2009/11/techniques-for-retirement-saving.html.)

Legend tells us there are risks when Greeks come bearing gifts. A bailout for Greece is reportedly in the works. If so, the burden will fall mostly on Germany, the economic engine of the European Union. France will contribute a high five but not too much money. The Dutch will frown and dourly push a few Euros into the pot. The Germans will probably insist on stiff terms for Greek fiscal reform, and pretend not to hear sardonic asides about jack boots, Panzers, and aspirations for continental domination. The Euro bloc bailout will probably feel ragged, begrudged and fraught with political risk (such as rejection by the Greek government due to internal opposition). Other financially troubled nations in Europe may also look to Bonn for a bailout. The burdens of bailouts could slow down Europe's recovery, which might in turn hinder America's recovery. The dollar may yet again lose its shine.

Why the Stock Market is Crashing and How to Recapitalize the Banks

Today, the Dow Jones Industrial Average fell 7%. It's fallen for seven straight trading days now, for a total drop of 21%. This is a market crash. Wall Streeters would euphemistically would call it a "market break." But if it walks like a crash, squawks like a crash, and looks like a crash, we'd better face the fact that it is a crash.

Although there are many cross-currents in the market, there is an overriding reason for the crash. Our leaders in finance and government prepared us very poorly for this moment. For way too long, Wall Streeters demanded palliatives from the government that would make all the boos boos of the mortgage crisis go away. Government leaders, in turn, acted as if that was their intention. The Fed was creative and the Treasury Department was aggressive. Interest rates were lowered. New programs were devised and implemented. Federal loans became available to new classes of borrowers. Rarely, if ever, was anyone heard to suggest that a blissful fix, with no losses or pain to anyone, wouldn't be possible. We seemed to be in a world where six impossible things could be accomplished before breakfast, and the government could protect the values of all assets and investments.

Thus, when bailout after bailout produced only falling stock prices, newer and bigger bailouts, and an internationalization of the credit crunch, investor confidence was not simply shaken, but shattered. As stocks kept falling, some of those who were previously calm have joined in the selling, creating more sell pressure that further depressed stock prices and triggered more selling. There have been waves and waves of selling, because hope, so assiduously cultivated by corporate and government leaders intent on discouraging runs on the banks, is gone. No one knows how bad things will get and everyone simply wants out.

There is no way to predict when the market will bottom out. We're dealing with panic, and irrationality cannot be quantified. Nor can we predict when things will settle down. We can only know the fear and panic will eventually subside. They did before, in 1987 and in the 1970s, both times when the market fell sharply. They did in the 1930s, when the stock market fell 85% before taking the road to gradual recovering.

Let us remember, though, that the unwillingness of our corporate and government leaders to level with us about how bad things could get is much of the reason for today's panic. Of course, they were trying to maintain confidence, the key to all financial dealings. But unwarranted optimism will be eventually belied by the truth, and nothing undermines confidence as much as unexpected, unpleasant surprises. This market crash is what results when undue hope is allowed to triumph over knowledge of the truth.

Now, on to the truth. One can reasonably infer that the industrialized world's banking system is effectively insolvent. Maybe some institutions are individually strong, but the system as a whole is broke. Bank regulators haven't admitted this, but it's obvious from their conduct. Government officials worldwide are taking extreme measures to administer financial CPR, and every week comes with a new program or proposal. One of the most recent ideas is for the government to make direct investments in distressed banks. This nationalization of the banking system (let's not pretend that it's anything else) isn't a bad idea. For every dollar of capital invested in a bank, it can reasonably make ten dollars of loans. That ten for one ratio is a pretty good bang for the buck. Purchasing toxic assets (i.e., the heart of the $700 billion bailout program enacted by Congress), would probably free up less lending power for each federal dollar spent.

But federal investments in banks should come with a demand for housecleaning writeoffs of the toxic mortgage-related assets and derivatives that have been bedeviling the banks and tying up their capital. The most important reason for the credit crunch is that banks seeking to borrow from the private sector haven't been transparent enough about their balance sheets to inspire lender confidence. That's why the federal government has thrown a lot of liquidity at the financial system, with little tangible benefit. No one wants to lend, even if they have the money, when they can't discern the borrower's ability to repay the debt.

By way of analogy, consider whether you could get a loan from a bank without telling the bank about your other debts and liabilities. Maybe a few years ago, you'd have gotten a liar loan with a teaser rate. But now, you couldn't hope to get a loan without spelling out your financial condition and circumstances to the nth degree. Many large banks are still trying to borrow in the interbank market without being candid about their potential losses from mortgage-related assets and derivatives. It should hardly be surprising that they get the brushoff.

Time to come clean. Clarity and transparency are crucial to inspiring lender confidence, and writeoffs are essential to cleaning up borrower balance sheets. The price of federal capital should be full disclosure of the toxicity in the recipient bank's balance sheet. Moreover, the values of the nasty assets should be written down to amounts determined through prudent and conservative application of the relevant accounting principles. No smiley-face interpretations of the mark-to-market rules should be allowed. This trip by the banks to the woodshed may reveal that they're actually insolvent. So be it. We know that anyway and no amount of relaxation of the accounting rules will fool investors into believing otherwise (banks and regulators only fool themselves if they think that changing the accounting rules now will mollify investors, who may be stupid but aren't that stupid).

Full disclosure and writedowns would likely increase the amount of federal capital needed. That's okay. We should use the process of taxpayer bailouts to cleanse the banking system and get it started on the road to health. Simply burying the losses while giving the banks some financial methadone won't solve the problem. It will simply delay the day of reckoning. And when that day of reckoning arrives, the panicky selling that will be seen in the stock markets will make these days seem like a walk in the park.

Protecting Yourself in a Time of Bailouts

After a week of failure, angst, bad press coverage, arm twisting, and pork barrel rolling, Congress finally passed the Bush Administration's $700 billion bank bailout bill. The President signed it into law in less than a New York minute. The stock market, which had swooned when the House rejected the bailout early in the week, got giddy while the voting was under way but then pouted when all was said and done, closing down 1.5%. It seems that the market doesn't think the bailout bill went far enough. Let's face it: $700 billion just isn't what it used to be.

If you've been trying to make heads or tails of the stock market in recent weeks, chances are you haven't had much luck. The Dow Jones Industrial Average has recently moved three digits a day almost every day. Antacid sales are about the only thing going up.

The problem is that your investments aren't just subject to market forces. They're now subject to political forces. Market forces are tough enough to predict. Political forces are, on good days, arbitrary, capricious, warped, perverted, unfair, rife with favoritism and cynical payoffs, and entirely unpredictable. In the last year, the Federal Reserve and Treasury Department have gone a long way toward socializing the financial services sector, and the downturn in the market perhaps reflects the long term prospects for such socialism. At the end of the trading day today, there were calls for more government bailouts. Not that the government call afford more, but there will probably be plenty of bailout talk from both parties that will further bedevil your personal finances.

Today's market action demonstrates that there are limits to what government bailouts can do for you. If there ever were a time to take responsibility for your finances, now is it. Ask what can you do for yourself. Here are some suggestions.

Cash. Cash is your new best friend. Save more, not only to cover personal expenses in case of a job loss, but also to let you dive into the stock market if prices reach a level you consider attractive. Make sure your cash is in federally insured bank accounts ($100,000 per account and $250,000 for an IRA; these levels may rise as a result of today's bailout bill), or in a money market fund that invests only in U.S. Treasury securities.

Creditworthiness. Be a good borrower and repay your debts on time. Build your credit rating. Good borrowers get advantageous rates these days. Bad borrowers are foreclosed on. Get your free annual credit report (at annualcreditreport.com) and read it carefully to make sure your credit history is accurate. See that mistakes are corrected.

Health Insurance. Health insurance is very important, especially when times are tough. Economic stress can increase health risks, and a major health problem can blow up your weakened finances in a big way. If you lose your job, continue your health benefits through your COBRA rights. Whatever you do, don't forego health insurance coverage.

Diversify your investments. With the unpredictability of political forces now bruising your investment portfolio, diversification of assets is probably a sounder strategy than ever. There's almost no way to know what direction the pork barrel will roll or when. If you don't already have a piece of the action, you will miss the handout. And, at least in the near term, government handouts may be more lucrative than market forces.