What do these two stories have in common?
October 30 ”“ UK Telegraph: ”œWages in China’s cities have risen by almost 20% since the start of the year, the government in Beijing said…adding to fears that the country’s economy is overheating and might export inflation round the world… Rising prices and inflation are putting pressure on the government to rein in the economy.”
October 30 ”“ Bloomberg: ”œAxon Financial Funding, a $9.5 billion structured investment vehicle or SIV, had its debt ratings cut by Standard & Poor’s after it sold assets at a loss. S&P cut its rating on the company’s debt by eight steps to BBB, two steps above high-risk, high-yield, from the top AAA investment-grade ranking.”
These stories exemplify two sides of the same economic phenomenon: extraordinary price movement in a short period of time. The only difference is that wage increases represent inflation in terms of real goods and services; the debt ratings cut represents deflation in paper assets.
We live in a strange world in which inflation and deflation are galloping rampantly about the globe, both at an increasing pace. Economists aren’t used to such a world, and their instinct is to choose one or the other as the true operating phenomenon, and in that case the default choice is almost always inflation because deflation is so rare.
Chinese philosophy posits the conflicting yet complementary forces of yin and yang, which is an appropriate analogy since China has been the source of both of these problems. China’s cut-rate manufacturing processes, relying on cheap labor, modest mechanization, and no governmental regulation, have hollowed out the manufacturing base of country after country (and not just Western, developed countries). After twenty years of unparalleled export growth, based also on an artificially weak currency, cost pressures are now building up rapidly in China. China began exporting deflation, then experienced domestic inflation, and is now switching to becoming an inflation exporter.
India has been equally culpable in this game, and I suppose we could also borrow from Hindu theology by referring to inflation as Brahma the creator, and deflation as Shiva the Destroyer. These two forces, ever competing with each other in the universe, are now let loose in the world. Inflation is winning so far, because at least under inflation some people are winners. Debtors get to repay their principal and interest with cheaper currency, and owners of real assets sit by as the value of these assets rises at a faster and faster pace.
So Brahma can accomplish some good, though obviously too much inflation at too rapid a pace can be dangerous. Investors around the world are now chasing after ”œthings” ”“ oil, wheat, gold, copper ”“ anything with tangible value that has some scarcity. One of the reasons tangible things are so valued is that Shiva is out destroying the intangible things like paper assets.
Take the interesting case of Merrill Lynch. In June it was sitting high on the world, the king of the mortgage securitization business. Four months later, Merrill Lynch has been forced to write down about $8 billion of assets, destroying 20% of its net worth and the equivalent of the past four quarters of its profits. Stan O’Neal has lost the chairmanship of Merrill Lynch, and analysts are openly discussing another $10 billion more of write-offs. Some are whispering about the possible collapse of the firm and forced merger with someone stronger.
What hath Shiva wrought? Deflation, certainly, and not just in the mortgage business. Banks, hedge funds, brokers, so-called Special Investment Vehicles (off-balance sheet repositories for bank assets) ”“ they’ve all woken up to an unprecedented and unexpected drop in the value of anything they own that cannot be readily sold. Due to the prevalence of the mark to market process ”“ so useful in the past 15 or so years in allowing the financial industry to declare profits and bonuses when paper instruments were going up in value – financial firms are now struggling to determine how truly deflated their assets are going to be.
Everyone says the banks have not ”œcome clean” about their problems. The truth is, banks don’t really know how bad their problems are. The picture changes from day to day. In August most financial markets had seized up and no one was making prices to each other. Things improved for a while but just this past week the same problems came back with a vengeance. Wednesday last week when the Fed lowered interest rates 25 basis points, it could not actually achieve this goal without injecting $41 billion into the banking system to force rates down. This was the second greatest liquidity injection by the Fed in the last ten years, the largest being right after the 9/11 attacks.
For Fed policy aficionados, the sight of the Fed pushing money into the interbank market to achieve an interest rate cut is extraordinary. It tells us that Fed Funds ”“ the purest and safest form of cash ”“ are another one of those ”œthings” that are now scarce and valued in a world that is highly skeptical of debt instruments. It also tells us that the market-setting level of overnight rates in the U.S. is higher than the Fed wishes it to be.
The one thing the financial industry does know is that it is very unfair to force them to write down assets by as much as 80%, just because they can’t sell them to anybody at the moment. But this valuation accounting process, so lucrative to the industry for two decades, cannot now be jettisoned. Financial firms now have a cadre of independent valuation experts who determine what things are worth. Some of them, like the market risk team with daily oversight of the revaluation process, or the firm’s internal auditors, are subject to management pressure but ultimately have a simple rejoinder for even the chairman if he challenges their price put on something ”“ ”œif you think I’m wrong, sell just one of these assets and we’ll all see what the portfolio is worth.”
And there’s the rub. Not only are there few buyers, but management wouldn’t dare sell an illiquid asset for 20 cents on the dollar, because the rest of the portfolio would then be written down to that amount. Unfortunately, that’s the current market price for securities consisting of sub-prime mortgages. Even Aaa rated commercial paper, which is supposed to be close in risk to U.S. Treasuries, is no longer carried at par, but is discounted to a price around 85 cents to the dollar. A financial institution like Axon Financial Funding, the firm that just experienced a ratings downgrade from Aaa to just above investment grade, is in the same way being marked down to the market value of its assets. It says a lot about the destructiveness of deflation that a Aaa rated company can fall overnight by eight grades (the usual ratings downgrade by Moody’s or Standard & Poor’s is one grade, and two grades is rare).
The independent experts who mark to market bank portfolios look at this Axon situation and no doubt tell their own management that it is time to put a more appropriate value on their investment and trading portfolios, before the ratings agencies force them to do it. The banks and Wall Street firms and hedge funds are all resisting these pressures for now, because they realize how much is at stake. If Merrill Lynch can lop off 20% of their capital in a wink of the eye, how secure is the other 80%? Each CEO is looking at their own highly-leveraged institution and wondering if they have enough capital to survive this crisis, and they know that every other CEO is wondering about their own institution as well. No wonder no one is lending to anybody else, and the Fed has to force down Fed Funds rates when they announced last week’s interest rate cut.
So we are enjoying housing deflation in the U.S., a steady devaluation of the dollar, and now wholesale destruction of investment and banking portfolios worldwide. Short term lending markets are shaky, the securitization process has been halted in its tracks, asset backed commercial paper no longer trades anywhere, and bank Structured Investment Vehicles are slowly being wound down. Banks which are looking poorly capitalized rather than well capitalized face the prospect of taking on additional assets totaling $1 trillion.
No one wins in a deflationary environment. Once credit becomes impossible to obtain, business contracts and recession (or something worse) follows. Debtors find it better to walk away from their debt rather than pay it back with scarce cash, and this only makes the downward spiral accelerate. While Brahma appears to be winning at the moment, enticing speculators and others to pour into commodities, metals, oil, and a few favored stocks, Shiva will win this battle in the long run. There comes a point in a deflationary environment where the average person has to begin selling ”œthings” in order to survive, or at least make payments on their debt.
Is this financial Armageddon? It’s as least as serious a financial crisis as has ever been seen in anyone’s lifetime. The vast credit creation, money making machine that has been Wall Street finance in the past two decades has been shut down. Other parts of the financial industry, like commercial paper and now overnight cash deposits, are being affected. Whereas in the past commercial banks could step up and lend money when Wall Street faltered, now the major commercial banks of the world are integrally part of Wall Street and haven’t the capital or even expertise to make loans and keep them on their balance sheet. All these players and all these markets are at the very center of the global economy, and their destruction will drive the economy down with them.
At the moment the only people who can create credit anymore are the Chinese, Russians, OPEC nations, and other countries that own ”œthings” or still have some manufacturing and servicing export ability. But they are being swamped by the rising prices of ”œthings”; both China and Russia now have price controls on hydrocarbon products (gas, diesel fuel, heating oil) in order to cushion the shock to their mostly-poor consumers. The inflection point for them ”“ the point when Shiva overwhelms Brahma ”“ will be the inevitable stock market crash in China, likely brought about by some shocking debt default that ”œno one could have predicted or expected.”
It will be then that the global economy will head into a long dark nuclear winter. In our new-found poverty we will all await the third Hindu manifestation of the divine, Vishnu ”“ the Restorer, the Maintainer. Rest assured, he will take his time to appear.