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Tuesday, December 8, 2009

the slow entropy of leverage in semi-controlled reverse

When debt is not in the model, more debt is not a problem, except to the actors in the real economy.  The upshot is the model is not very close to reality.  Thus the model says keep doing A when A does not work.  JM welcomes the world to Japan.
Some Asset Behavior when Government Resists the Natural Order of the Universe
via Zero Hedge
December 4, 2009

Reducing risk should be written on your dreidel because Japan is the history of the future. Not just for the United States: the whole world. There are market forces bigger than any government action in play now; and in fact, policy makers trying to save the world have cemented it. Some call it the “new normal”. I call it Japanification: the slow entropy of leverage in semi-controlled reverse. The alternative is to let it all go in one smoldering champagne supernova. But all the hyper money printing and WWII grade stimulus just falls in a financial black hole so strong that not one penny will ever escape. I’m surprised so many people disagree about Japanification. It’s been going on in the United States for nearly a decade. There are variations from country to country, but here’s what it means in broad brushstrokes.
  • Bursting of an equity bubble triggers an economic shock
  • Policymakers react by lowering interest rates to increase liquidity
  • Resulting credit bubble in RE and CRE bursts
  • Policymakers respond by printing and throwing money at the problem.
  • Financial system instability persists because money printing is reactive, not proactive
  • Bankruptcy of major banks trigger a financial meltdown
  • Turning major banks into undead zombies or outright nationalization
  • Resulting sovereign debt explosion
  • Policymakers respond by quantitative easing
  • Central bank balance sheet indicates debt bubble
  • (Forthcoming in Japan) Rising Treasury yields (in spite of deflation) pretty much
  • crush everything
  • (Forthcoming in Japan) Government firewalls off its own credit risk by cutting
  • spending and raising taxes
I didn’t say anything about economic growth. Real growth is possible, albeit with quick reverses into contraction. And I haven’t said anything about inflation. Japanification—from aging developed economy demographics to consumer debt reduction to drying up corporate free cash flow to banks not lending to lower tier credits at all to unemployment rises all over the globe—has no place for inflation. Inflation can only occur after bubbles stop popping. Governments are fighting deleveraging in various ways. For example, Ben Bernanke actually pays banks interest on their excess reserves, guaranteeing a deeper credit crunch. Sweden on the other hand actually charges banks via negative interest rates to park excess reserves1. As creative and decisive as Sweden is from a policy perspective, it really just shows absolute panic in the face of reality.

Printing money doesn’t halt asset deflation for long

Money-printing won’t halt deflation because printing enough money to actually reverse deleveraging is self-defeating. Printing money is a pure shot of inflationary Everclear. But the gains seen from an inflationary reduction in the downside to hold assets is more than offset by inflationary destruction of collateral needed to purchase the asset in the first place. The only cure for asset deflation (we’re really talking RE and CRE) is organic recovery in demand. For this, you need economic growth and employment. For an economy in a financial crisis and high unemployment, demand for real estate won’t recover until a severe enough drop in prices significantly reduces the downside risk of holding property. Artificial attempts to pump prices don’t work.

Deleveraging is a vicious cycle downward that crushes asset prices in almost periodic waves

Companies and people get hit when falling prices (labor compensation or revenue) make them unable to service their existing debt obligations and so force default or liquidation of assets. These defaults and liquidations reinforce deflation and credit contraction in ever greater waves. These contractions do not happen in a gradual fashion… they happen in sudden bursts of volatility. This volatility is the chiefly the domain of equities and some commodities. I have risk exposure myself. Remember that nimble timing and ample leverage sound easy, but are they not.

As for those who love gold: I understand you. Anybody that has held a gold coin in their hand feels the draw. Anybody who held GLD in 2008 knows how effortlessly poised she is in great crisis. It is with regret that I bash gold. Respectfully, I don’t think you understand gold, bugs. When things are at their worst, she is lively, wise, and beautiful. But things never remain in great crisis. Nearly every intensity eases into mediocrity. In times of mediocrity gold doesn’t give anything to the relationship. She’s only happy when it rains. Gold isn’t a good risk asset for those inclined to surf liquidity, either: pretty crappy wave
most of the time.

Deflation safety is not found in owning high priced things, rather in highly credible promises of future income

Why do you think PIMCO has so much U.S. paper and so little HY allocation? It’s because Bill understands deleveraging. He probably knows very well Japan’s decade+ performer, aka, Kimiko’s very special friend.

If you think that the bull market in U.S. Treasuries is at a top right now, well I really can’t blame you. I respectfully disagree in spite of the irresponsible issuance coming on deck, simply because conditions are really that bad in my view. Notice that yields were less than 1% for 10 year Japanese government bonds in spite of exploding debt/GDP ratios! Also, quantitative easing (money printing) didn’t drive yields down more… it only created an extended and what will ultimately be an unsustainable top. It is the crushing effect of insolvency further down the capital structure that bids govvie bond prices up. I submit that
Treasuries haven’t seen the top yet.

Expenses < = revenues ends Japanification

Governments are the final domino. Government finances deteriorate due to fiscal spending during the crisis and a decrease in tax revenues amid the economic downturn. There is no choice: governments must triage the basket-cases, rationally distribute the pain, and firewall off the essential financial structures that can be saved; or the market does same with a colder, more merciless precision.

Lao-tzu has an answer for Aristotle. Don’t defeat the irresistible object by being immovable against it: yield to it. All the Dao of heaven wants is for things to return to reality and exist within their means. Fighting what can’t be beaten only makes the end bloodier. My view is that the Fed will not win their battle to reverse deleveraging. This does not mean the world will look like a woodcut from Gallerie St. Etienne. Frankly, excepting Wall Street and the financial world, there’s not much loss for the U.S. Do what you can Ben. Nothing escapes the Dao.

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