Thursday, October 02, 2008

Why a Depression Is Already Baked In

The coming Depression is baked in and cannot be repealed by a vote of the Senate or the bailout of distressed/insolvent banks. Along with the Depression will come drastically lower prices for all assets, which will reflect drastically lower sales and profits.

The main reason why the Depression is baked in is the global credit bubble is finally bursting. When credit dries up and becomes more expensive, there is less money being borrowed and spent. That is straightforward.

But as frequent contributor Harun I. explains, the credit bubble also fueled an accelerated flow of money through the system, i.e. velocity of money. This has been readily visible in the number of dollars which must be borrowed to create $1 of additional GDP. As the credit bubble expanded, it required more and more dollars to be loaned/borrowed to eke out a mere $1 of "growth" (GDP). In other words, more and more debt had to be created and taken on to maintain even anemic growth.

Now the credit bubble has burst, this growth of debt has reversed as lenders "deleverage" i.e. sell assets and pay down debt.

Here is Harun's commentary:

This plan will be an abject failure simply because it will not create velocity of money. Jobs will not be created, consumers will not have more income to spend and will not qualify to borrow.
Trillions in MBS and CDS are symptoms of a greater problem. These instruments weren't created just because of greed, they were created because they were needed to fuel an economic ideology (or perhaps reality) that needs exponentially greater inputs to grow.

Mish analogized this with the "Red Queen's Race". Once the curve is close to or at vertical it represents infinity, i.e., inputs of infinite amounts of money or debt expansion (credit money) is needed infinitely just to remain in place. Because it is an exponential progression is why every graph we see today dealing with debt growth has "hockey sticked". There is simply no way to save this type of system.

Everyone, including Paulson and Bernanke got caught thinking linearly and therefore are now shocked at the rapidity of the onrushing collapse. I have been arm waving and shouting about this for some time and will continue to do so until people "get it".

The link below is a primer on exponential growth. The chart is a basic example of exponential progression. If we think in terms of debt growth, the Y axis represent quantity and the X axis is time. As the curve progresses exponential increases in debt are needed over an exponentially condensing time period until the time frame is always now and inputs required are infinite. Obviously this leads to collapse from exhaustion.

Understanding Exponential Growth

Economically, it should now be clearly understood that when an economy's physical output is in serious decline or non-existent and the economy becomes almost totally dependent on the expansion of monetary aggregate for "growth", a systemic meltdown is inevitable.

Here is an appropriate analogy from the Daily Reckoning:

We don’t know what Professor Chris Martenson is a professor of. But he has done the world a favor with his description of what happens when things grow exponentially, rather than arithmetically.

Imagine you could make a football stadium watertight, he writes. Then, imagine that you put a magic drop of water in the center...a drop of water that doubles every minute...so that after six minutes or so, you’d have about enough water to fill a thimble. Now how long would it take before the stadium filled, he asks?

We’re not going to leave you in suspense. For the first 45 minutes, you can walk around the stadium and barely get your feet wet. But in the next 4 minutes the stadium fills and you drown.

Thank you, Harun. Next, correspondent Peter F. offers an example of how the bailout (TARP) would work in Crony Capitalism , i.e. the system the bailout was designed to benefit:

Peter F.
I've given a great deal of thought as to how the Troubled Asset Relief Program (TARP), a/k/a the "bank bailout" will achieve the goals of saving the banking system and "getting the economy moving again." I think I've figured it out. I've read the House Bill and could find nothing that would prohibit the occurence of my scenario. Maybe you can find where I'm wrong.
1. We start with TARP, which issues $100 in new, full faith and credit, U.S. Treasury bonds. The agency now has $100 cash.
2. ABC Bank has on its books a portfolio of troubled debt with a face amount of $100. The problem for ABC Bank is that it will only be able to collect $70 from the borrowers. The loss to ABC Bank will be the difference, $30.
3. The bank sells the troubled debt to TARP for $100 and the loss disappears. Instead of holding $100 in problem loans, the bank now has $100 cash.
4. TARP doesn't want to hold the problem loans so it sells the loans to a new vulture/scavenger fund which pays $50 for the troubled debt. TARP now has $50 in cash and $100 in bonds outstanding.
5. Where did the scavenger fund get the $50 to buy the loans from the government? Well who now has $100 in cash? ABC Bank. The scavenger fund borrowed the $50 from ABC Bank.
6. ABC Bank now has $50 left over from the sale to TARP. What does ABC Bank do with that money? It buys $50 in Treasury bonds.
Look at Step 4. TARP now has $50 in cash. We then restart the cycle at Step 2 only with half the amount of money involved in the transactions. After we repeat the cycle enough times until we reach the limit (no assets held by TARP) here is what we get:
Banks
Treasury Bonds: $100
Scavenger Loans: $100
Loss Avoided on $200 in Loans: $60

Scavenger Funds
Junk Loans: $200
Bank Loans: $100
Loss Reserve: - 60
Net Loans: $140
Equity: $40
Profit to Scavenger Funds: $40

Isn't high finance great? On $200 in bad loans the private sector profited $100 ($60 in bank loss avoidance, $40 in scavenger fund profits).

But only the Federal Reserve can create money out of thin air. Who took the $100 loss that allowed the banks and scavenger funds to profit by $100? Hint: here's the balance sheet for TARP:
Assets: $0
Bonds Outstanding $100

Now look into the mirror.

Thank you, Peter. I have to confess this stretches beyond my comprehension of accounting but certainly seems to make sense. The working /retired accountants among you may be able to provide additional insights/critiques.

Nonetheless, this example illustrates how the bailout will do virtually nothing but enrich the cronies who will be buying the distressed assets at fire-sale prices from the Treasury, and how the taxpayer will be stuck with either worthless assets (i.e. mortgages so worthless even the cronies don't want them) or worthless debt.

Next up: a sample chart of just one credit-dependent industry among many: home builders. I have featured Toll Brothers here last month, and disclosed that I own puts on TOL (i.e. a bet the stock will decline in the near future).

Please read the HUGE GIANT BIG FAT DISCLAIMER below: this is not investment advice but the opinions of one amateur chart-gazer.

Auto sales--another credit-dependent business--fell off a cliff in September. Why would anyone think sales of luxury homes (Toll's product) would hold up better than vehicles? What will the cancellation rate be in September for luxury homes which buyers signed up to purchase earlier in summer? 60%? Or perhaps 90%?

How many luxury new homes will be sold next year? How many new homes will Toll build when inventory is still climbing and credit, income and household assets are all disappearing like summer rain in the Mojave Desert?

But TOL has jumped from $16 to $26 recently on the fervent if fantasy-based dream that some sort of reinflation of the housing bubble is just around the corner. The chart reveals a huge wedge which will have to resolved up or down in a major way very shortly. Even as indicators like MACD and stochastics are in visible downtrends, market Bulls have kept TOL elevated at prices which scream "housing recovery starts in January 2009 and then booms!"

Given the dire straits of the U.S. economy, credit markets and the housing glut/ crash, it seems more likely that TOL will declare bankruptcy in 2009 than announce a major strengthening of sales (which aren't cancelled a few weeks later). If the economic and credit data actually start intruding on the fantasy so near and dear to the hearts of the Bulls who have bid TOL up to "economic expansion/housing is healthy" levels, then the wedge may be resolved with a rapid drop back to the $16 level, and then on down to either $2 or zero.

This is not the only company which has continued to float on a fantasy-cloud of hope and dreams for a huge recovery in the economy a few months down the road. Meanwhile all credible data (such as new car and truck sales and the ISM report) suggests the economy is sliding down an increasingly slippery slope, gaining speed every day. Why would anyone want to own a stock which has no earnings and no hope of earnings, plus faces a good chance of insolvency in the coming Depression? I really don't know.

Two articles recommended by frequent contributor U. Doran:

Roubini: Risk as high as ever of global meltdown
Doug Nolan's Credit Bubble Watch

Please go to www.oftwominds.com/blog.html to view the chart of TOL and to read a dozen great Reader Comments.

Thank you, Kevin L. ($25), for your extremely generous donation to this site. I am greatly honored by your ongoing support and readership.

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