Jesse's Café Américain

Today is an especially interesting day.

US equities, led by the financials, are getting absolutely hammered, the longer Treasury bonds are down, dollar and gold and oil are up. The dollar strength may be more of a sign of euro weakness.

Royal Bank of Scotland and State Street Bank seem to have shaken up the confidence of the Asian and Mideast investors, and pehaps the continental Europeans.

We'll know more as the week progresses.

Bloomberg
State Street Falls Most Since 1984 on Bond Losses
By Christopher Condon

Jan. 20 (Bloomberg) -- State Street Corp., the world’s largest money manager for institutions, fell the most since 1984 in New York trading after unrealized bond losses almost doubled and analysts said the company may have to raise capital.

Unrealized losses on State Street’s fixed-income investments rose to $6.3 billion at Dec. 31 from $3.3 billion at Sept. 30, the result of falling values throughout the credit markets, the company said today in a statement. State Street also incurred $528 million in costs to prop up money funds and write down the value of investments on its portfolio...

Unrealized losses on assets held in conduits increased to $3.6 billion from $2.2 billion. The filing also revealed that the company had purchased $2.5 billion securities from the stable-asset funds...

State Street said that the net asset value of another group of unregistered funds had fallen as low as 91 cents a share on Dec. 31. These funds, which invest cash collateral that State Street customers receive in return for lending out their securities, also seek to maintain a net asset value of $1 a share, though they are not required to do so.

The average value of these funds at Dec. 31 was 95.5 cents a share, State Street said in the filing, with a substantial portion of the decline occurring during the fourth quarter. Total assets in the affected funds have fallen to $113 billion on Dec. 31, from $178 billion a year earlier.

State Street has continued to sell and redeem shares of these funds at $1 a share, it said in the filing. The funds can wait until the securities mature and they receive full face value from the borrower, rather than selling the holdings in the market at a loss.

The Jan. 16 filing said that continuing to sell and redeem shares at $1 may prevent State Street from passing on the losses later to shareholders if the value of the securities in the fund don’t recover.

The company also set aside $200 million to cover losses stemming from indemnification obligations on $1 billion in repurchase agreements that State Street clients purchased from Lehman Brothers Holdings Inc. The investment bank filed for bankruptcy protection Sept. 15.

This is a rather important essay in that it nicely frames up the problem that we face, and the constraints on the remedies at our disposal.

We will be speaking more about that in the near term, but for now here is a framework by which to understand the boundaries, the 'lay of the land.'

The key point is that the debt to GDP ratio has become unsustainable. The way to correct this is to lower it to a level that is manageable and to work it down.

It will likely require a combination of inflation and debt reduction by bankruptcies and writedowns in order to restore the economy to something which can be used to achieve a balance.

Liquidationism is a trap because it reduces GDP and cripples the productive economy as it reduces debt. It is similar to poisoning a patient to treat an infection. It is favored only by those who believe that they can insulate themselves and profit by it.

Without serious systemic reforms, any remedies will not obtain traction, merely provide a new step function for a repetition of the cycle of debt expansion, as was done in the series of credit bubbles under Alan Greenspan and Bush-Clinton.

The impact will be felt around the globe because of the interconnectedness of the world economy and finance, but the heart of the problem is in the US and the UK.

Economic Times
US and UK on brink of debt disaster
20 Jan, 2009, 0419 hrs IST

LONDON: The United States and the United Kingdom stand on the brink of the largest debt crisis in history.

While both governments experiment with quantitative easing, bad banks to absorb non-performing loans, and state guarantees to restart bank lending, the only real way out is some combination of widespread corporate default, debt write-downs and inflation to reduce the burden of debt to more manageable levels. Everything else is window-dressing. (Quantitative easing, bad banks, and state guarantees are the instruments of inflation. The amount of inflation that the West can manage will greatly affect the amount of these more draconian measures - Jesse)

To understand the scale of the problem, and why it leaves so few options for policymakers, which shows the growth in the real economy (measured by nominal GDP) and the financial sector (measured by total credit market instruments outstanding) since 1952.

In 1952, the United States was emerging from the Second World War and the conflict in Korea with a strong economy, and fairly low debt, split between a relatively large government debt (amounting to 68 percent of GDP) and a relatively small private sector one (just 60 percent of GDP).

Over the next 23 years, the volume of debt increased, but the rise was broadly in line with growth in the rest of the economy, so the overall ratio of total debts to GDP changed little, from 128 percent in 1952 to 155 percent in 1975.

The only real change was in the composition. Private debts increased (7.8 times) more rapidly than public ones (1.5 times). As a result, there was a marked shift in the debt stock from public debt (just 37 percent of GDP in 1975) toward private sector obligations (117 percent). But this was not unusual. It should be seen as a return to more normal patterns of debt issuance after the wartime period in which the government commandeered resources for the war effort and rationed borrowing by the private sector.

From the 1970s onward, however, the economy has undergone two profound structural shifts. First, the economy as a whole has become much more indebted. Output rose eight times between 1975 and 2007. But the total volume of debt rose a staggering 20 times, more than twice as fast. The total debt-to-GDP ratio surged from 155 percent to 355 percent.

Second, almost all this extra debt has come from the private sector. Despite acres of newsprint devoted to the federal budget deficit over the last thirty years, public debt at all levels has risen only 11.5 times since 1975. This is slightly faster than the eight-fold increase in nominal GDP over the same period, but government debt has still only risen from 37 percent of GDP to 52 percent.

Instead, the real debt explosion has come from the private sector. Private debt outstanding has risen an enormous 22 times, three times faster than the economy as a whole, and fast enough to take the ratio of private debt to GDP from 117 percent to 303 percent in a little over thirty years.

For the most part, policymakers have been comfortable with rising private debt levels. Officials have cited a wide range of reasons why the economy can safely operate with much higher levels of debt than before, including improvements in macroeconomic management that have muted the business cycle and led to lower inflation and interest rates. But there is a suspicion that tolerance for private rather than public sector debt simply reflected an ideological preference.

THE DEBT MOUNTAIN

The data makes clear the rise in private sector debt had become unsustainable. In the 1960s and 1970s, total debt was rising at roughly the same rate as nominal GDP. By 2000-2007, total debt was rising almost twice as fast as output, with the rapid issuance all coming from the private sector, as well as state and local governments.

This created a dangerous interdependence between GDP growth (which could only be sustained by massive borrowing and rapid increases in the volume of debt) and the debt stock (which could only be serviced if the economy continued its swift and uninterrupted expansion).

The resulting debt was only sustainable so long as economic conditions remained extremely favorable. The sheer volume of private-sector obligations the economy was carrying implied an increasing vulnerability to any shock that changed the terms on which financing was available, or altered the underlying GDP cash flows.

The proximate trigger of the debt crisis was the deterioration in lending standards and rise in default rates on subprime mortgage loans. But the widening divergence revealed in the charts suggests a crisis had become inevitable sooner or later. If not subprime lending, there would have been some other trigger.

WRONGHEADED POLICIES

The charts strongly suggest the necessary condition for resolving the debt crisis is a reduction in the outstanding volume of debt, an increase in nominal GDP, or some combination of the two, to reduce the debt-to-GDP ratio to a more sustainable level.

From this perspective, it is clear many of the existing policies being pursued in the United States and the United Kingdom will not resolve the crisis because they do not lower the debt ratio.

In particular, having governments buy distressed assets from the banks, or provide loan guarantees, is not an effective solution. It does not reduce the volume of debt, or force recognition of losses. It merely re-denominates private sector obligations to be met by households and firms as public ones to be met by the taxpayer.

This type of debt swap would make sense if the problem was liquidity rather than solvency. But in current circumstances, taxpayers are being asked to shoulder some or all of the cost of defaults, rather than provide a temporarily liquidity bridge.

In some ways, government is better placed to absorb losses than individual banks and investors, because it can spread them across a larger base of taxpayers. But in the current crisis, the volume of debts that potentially need to be refinanced is so large it will stretch even the tax and debt-raising resources of the state, and risks crowding out other spending.

Trying to cut debt by reducing consumption and investment, lowering wages, boosting saving and paying down debt out of current income is unlikely to be effective either. The resulting retrenchment would lead to sharp falls in both real output and the price level, depressing nominal GDP. Government retrenchment simply intensified the depression during the early 1930s. Private sector retrenchment and wage cuts will do the same in the 2000s.

BANKRUPTCY OR INFLATION

The solution must be some combination of policies to reduce the level of debt or raise nominal GDP. The simplest way to reduce debt is through bankruptcy, in which some or all of debts are deemed unrecoverable and are simply extinguished, ceasing to exist.

Bankruptcy would ensure the cost of resolving the debt crisis falls where it belongs. Investor portfolios and pension funds would take a severe but one-time hit. Healthy businesses would survive, minus the encumbrance of debt.

But widespread bankruptcies are probably socially and politically unacceptable. The alternative is some mechanism for refinancing debt on terms which are more favorable to borrowers (replacing short term debt at higher rates with longer-dated paper at lower ones).

The final option is to raise nominal GDP so it becomes easier to finance debt payments from augmented cashflow. But counter-cyclical policies to sustain GDP will not be enough. Governments in both the United States and the United Kingdom need to raise nominal GDP and debt-service capacity, not simply sustain it.

There is not much government can do to accelerate the real rate of growth. The remaining option is to tolerate, even encourage, a faster rate of inflation to improve debt-service capacity. Even more than debt nationalization, inflation is the ultimate way to spread the costs of debt workout across the widest possible section of the population.

The need to work down real debt and boost cash flow provides the motive, while the massive liquidity injections into the financial system provide the means. The stage is set for a long period of slow growth as debts are worked down and a rise in inflation in the medium term.