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David's Macro Blog

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Archive for April, 2009

Someone wrote a good summary of credit derivatives.
(Hat tip Eric Overfield for pointing this out)

At last, what we’ve all been waiting for, an understandable explanation of derivative markets.

Heidi is the proprietor of a bar in Detroit. In order to increase sales, she decides to allow her loyal customers – most of whom are unemployed alcoholics – to drink now but pay later. She keeps track of the drinks consumed on a ledger (thereby granting the customers loans).

Word gets around about Heidi’s drink now pay later marketing strategy and as a result, increasing numbers of customers flood into Heidi’s brand soon she has the largest sale volume for any bar in Detroit. By providing her customers’ freedom from immediate payment demands, Heidi gets no resistance when she substantially increases her prices for wine and beer, the most consumed beverages. Her sales volume increases massively.

A young and dynamic vice-president at the local bank recognizes these customer debts as valuable future assets and increases Heidi’s borrowing limit. He sees no reason for undue concern since he has the debts of the alcoholics as collateral. At the bank’s corporate headquarters, expert traders transform these customer loans into
DRINKBONDS, ALKIBONDS and PUKEBONDS. These securities are then traded on security markets worldwide.

Naive investors don’t really understand the securities being sold to them as AAA secured bonds are really the debts of unemployed alcoholics. Nevertheless, their prices continuously climb, and the securities become the top-selling items for some of the nation’s leading brokerage houses who collect enormous fees on their sales, pay extravagant bonuses to their sales force, and who in turn purchase exotic sports cars and multimillion dollar condominiums.

One day, although the bond prices are still climbing, a risk manager at the bank (subsequently fired due his negativity), decides that the time has come to demand payment on the debts incurred by the drinkers at Heidi’s bar.

Heidi demands payment from her alcoholic patrons, but being unemployed they cannot pay back their drinking debts. Therefore, Heidi cannot fulfill her loan obligations and claims bankruptcy. DRINKBOND and ALKIBOND drop in price by 90 %. PUKEBOND performs better, stabilizing in price after dropping by 80 %. The decreased bond asset value destroys the banks liquidity and prevents it from issuing new loans.

The suppliers of Heidi’s bar, having granted her generous payment extensions and having invested in the securities are faced with writing off her debt and losing over 80% on her bonds. Her wine supplier claims bankruptcy, her beer supplier is taken over by a competitor, who immediately closes the local plant and lays off 50 workers.

The bank and brokerage houses are saved by the Government following dramatic round-the-clock negotiations by leaders from both political parties. The funds required for this bailout are obtained by a tax levied on employed middle-class non-drinkers.

Finally an explanation I understand.

The following is from Mike Morgan’s blog (12/09/2008). I agree with many of his points.

If you still believe we are at or near the bottom, please consider a few of my Key Points to support the coming Depression:

1 – Housing prices are still falling.

2 – We are nowhere close to resolving the mortgage crisis, and millions of foreclosures are coming. In turn, this means lower housing prices and, in turn, more foreclosures.

3 – Wall Street and the Banking System has still not accepted the consequences of the toxic assets they built, sold, profited from . . . and now they are stuck with. All they have done is covered them up with a thin layer of Magic Dust (taxpayer bailout money).

4 – The housing ATM is closed. And with the closing of the housing ATM, consumers have less money to spend . . . and less money to pay their mortgages with, so there will be more foreclosures.

5 -If you map out the consequences for 1, 2, 3 and 4 you quickly see that less FFM “free-funny money” means less to spend and this means more job losses throughout the system, and this means much more pain to come.

6 – Worldwide we are seeing government responses with nonsensical bailouts and “spending” programs. The sad thing is, the spending programs are not directed at making us better, but just at how we can buy more toys and treats. In fact, governments are repeating the very same mistakes made in the 1930’s. By the way, these are only the big picture issues. I could give you a hundred reasons we are headed to very dark times, but all of it stems from the housing bubble that created the toxic asset crisis, and until we detox, the pain will get worse. This is no different than a drug addict. All we are doing now is feeding the drug addict and making matters worse . . . just like we did in the 1930’s. And just like a drug addict must go through a horrible physical detox, so must the world.

How bad is the current deflation?

It is so bad that every tool the Fed has to fight deflation, as listed by Ben Bernanke in 2002, has been used and still hasn’t stopped massive deflation.  Essentially the current economic and financial conditions where not even conceivable just a few years ago.

From Mish: Bernanke’s Deflation Preventing Scorecard

Bernanke’s Scorecard

Here is Bernanke’s roadmap, and a “point-by-point” list from that speech.

1. Reduce nominal interest rate to zero. Check. That didn’t work…

2. Increase the number of dollars in circulation, or credibly threaten to do so. Check. That didn’t work…

3. Expand the scale of asset purchases or, possibly, expand the menu of assets it buys. Check & check. That didn’t work…

4. Make low-interest-rate loans to banks. Check. That didn’t work…

5. Cooperate with fiscal authorities to inject more money. Check. That didn’t work…

6. Lower rates further out along the Treasury term structure. Check. That didn’t work…

7. Commit to holding the overnight rate at zero for some specified period. Check. That didn’t work…

8. Begin announcing explicit ceilings for yields on longer-maturity Treasury debt (bonds maturing within the next two years); enforce interest-rate ceilings by committing to make unlimited purchases of securities at prices consistent with the targeted yields. Check, and check. That didn’t work…

9. If that proves insufficient, cap yields of Treasury securities at still longer maturities, say three to six years. Check (they’re buying out to 7 years right now.) That didn’t work…

10. Use its existing authority to operate in the markets for agency debt. Check (in fact, they “own” the agency debt market!) That didn’t work…

11. Influence yields on privately issued securities. (Note: the Fed used to be restricted in doing that, but not anymore.) Check. That didn’t work…

12. Offer fixed-term loans to banks at low or zero interest, with a wide range of private assets deemed eligible as collateral (…Well, I’m still waiting for them to accept bellybutton lint & Beanie Babies, but I’m sure my patience will be rewarded. Besides their “mark-to-maturity” offers will be more than enticing!) Anyway… Check. That didn’t work…

13. Buy foreign government debt (and although Ben didn’t specifically mention it, let’s not forget those dollar swaps with foreign nations.) Check. That didn’t work…

Jim Klinge, one of my favorite real estate brokers and blog authors, was featured on ABC’s Nightline and Good Morning America:

See video here: The Honest Broker

This is Huge.  National attention.  Even bigger than front page on the LA Times.

Honest advice, not hype, sells in the internet age of abundant information.

I got these funny stories forwarded to me in email.  Now I’ve got friends on both sides of the aisle, but don’t read this if you get offended easily.

Story #1

I recently asked my friend’s little girl what she wanted to be when she grows up. She said she wanted to be President some day. Both of her parents, liberal Democrats, were standing there, so I asked her, If you were President what would be the first thing you would do?

She replied, I’d give food and houses to all the homeless people. Her parents beamed.

Wow…what a worthy goal, I told her, but you don’t have to wait until you’re President to do that. You can come over to my house and mow the lawn, pull weeds, and sweep my driveway, and I’ll pay you $50. Then I’ll take you over to the grocery store where the homeless guy hangs out, and you can give him the $50 to use toward food and a new house.

She thought that over for a few seconds, then she looked me straight in the eye and asked, Why doesn’t the homeless guy come over and do the work, and you can just pay him the $50??

I said, Welcome to the Republican Party!

Her parents still aren’t speaking to me.

Story #2

A young woman was about to finish her first year of college. Like so many others her age she considered herself to be a very liberal Democrat and favored re-distribution of all wealth. She felt deeply ashamed that her father was a rather staunch Republican which she expressed openly.

One day she was challenging her father on his beliefs and his opposition to higher taxes on the rich and more welfare programs. In the middle of her heart-felt diatribe, based upon the lectures she had from her far-left professors at school, he stopped her and asked her point blank, how she was doing in school.

She answered that she had a 4.0 GPA, and let him know that it was tough to maintain. She had to study all the time, and never had time to go out and party like other people. She didn’t even have time for a boyfriend and didn’t really have many college friends because she spent her time studying. She was taking a difficult curriculum.

Her father listened and then asked, “How is your friend Mary.”

She replied, “Mary is barely getting by”, she continued, “all she has is barely a 2.0 GPA,” adding, “and all she takes are easy classes and she never studies.” But to explain further she continued emotionally, “But Mary is so very popular on campus, college for her is a blast, and she goes to all the parties all the time and very often doesn’t even show up for classes because she is too hung over.”

Her father then asked his daughter, “Why don’t you go to the Dean’s office and ask him to deduct a 1.0 off your 4.0 GPA and give it to your friend who only had a 2.0.” He continued, “That way you’ll both have a 3.0 GPA and certainly that would be a fair and equal distribution of GPA.”

The daughter – visibly shocked by the father’s suggestion – angrily fired back, “That wouldn’t be fair! I worked really hard for mine, I did without, and Mary has done little or nothing. She played while I worked hard!”

The father slowly smiled and said, “Welcome to the Republican Party.”