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Monetary Orientation - Financing "Team Noklu"

Thursday, July 3, 2014

If you really want to enjoy your beer after a win, you really don't want 'Junior' here at first base...

And if you're in favor of economic growth - and new jobs - you don't want money going to 'Junior's' company.  You might as well buy stock in 'Team Noklu'*

Yep, here we go again.  Time to start banging your head on the desk.

This time I want to try and explain why all of this new money the Fed has created has not only not solved the underlying problem in our economy, but has mathematically guaranteed the next financial crisis will be even worse than the last.

Money and business is like nature and a vacuum.  Just as nature abhors a vacuum - something will eventually rush in to fill it - money in the economy has to go somewhere.  So the more money you inject into the economy in excess of what is needed for growth (e.g. 'inflation'), the greater the risk that money will be allocated to inefficient, risky uses - Team Noklu.

The last financial crisis should have taught us this.  The low interest rates which started after the 2000 real estate slump made an excess of money available to the real estate market.  Now there were only so many objectively qualified borrowers, so the 'bucket' of demand for mortgages to qualified borrowers was filled up long before all that excess money was lent out.  This left the banks in a quandary, with management and shareholders now at cross-purposes.  The shareholders would look at the balance sheet and see an excess of cash.

"Why isn't this excess cash being lent out to support our investment?" they would ask.

"We've already lent to all the qualified borrowers," would come as managements' reply.

"OK, that's nice," the shareholders would reply.  "But what, again, is all that excess cash doing for the share price of my investment?  There are people out there who would love to buy a house with it."

"But they don't qualify!"

"OK, so let's look at your lending standards."

Who do you think wins these arguments?  The shareholders, every time!  If management refuses to lend the money out, the shareholders will just fire them and replace them with new management who will.  And so more and more money was lent out to less and less qualified ('sub-prime') borrowers.  In many cases these were adjustable rate mortgages which started to reset to a higher rate.  The monthly payment increased beyond the ability of the homeowner to pay.  The mortgages started going into default, threatening the viability of the banks.

Former Treasury Secretary Tim Geithner writes about this in his recent book 'Stress Test'.  In this book, Geithner attempts to justify the way the federal government bailed out the banks.  He consistently characterizes the problem as one of 'capital deficiency' - meaning the banking system needed to be 'recapitalized'.

If you haven't started yet, this is where you bang your head on the desk.

It is very convenient to describe the problem this way.  It avoids having to come to terms with the truth about the last financial crisis.  The problem was not a lack of capital but an excess of bad debt - a result which was all but guaranteed by the excess of money in the economy.  The difference between these two ways of looking at things is important, but at the end of the day I don't want you to have to wear a helmet the next time you read my blog.

The lesson to be learned is that we will eventually end up right where we started back in 2008.  Just recently, the Obama administration actually started making noises about banks loosening lending standards to boost the housing market.  You can be forgiven for asking "are you kidding me?"

Nope.

Only this time it will be worse because it will not just be the housing market.  Junior up there at the top of this post - who wants to play first base on your team - runs a business and needs to raise some money.  But his business plan bears no resemblance to reality and his management team is - to use a word I hear from my kids these days - sketchy.  He wants to retain ownership of the company, so he doesn't issue shares of stock (otherwise known as 'going public').  Rather, he sells 'bonds'.

He is trying raise a million dollars, so he issues 100 bonds, each with a face value of $10,000.  But since his business plan is questionable and his management team is sketchy, the 'rating agencies' - who issue the corporate version of a credit score for these kinds of bonds - gives them a low rating.  They call them 'junk bonds'; which is just the corporate version of the 'sub-prime mortgage'.

But that's quite OK for banks these days.  You see, they now have the same problem they had in the early 2000's.  They are sitting on all this new money created by the Fed.  And the Fed is only paying 0.25% for them to keep this money on reserve.  The market for highly rated bonds isn't paying much better - the benchmark rate is about 2.5%  So the banks are 'reaching for yield'.  Junior and his sketchy team are living in a fantasy land, so the banks can charge him a higher interest rate, and are happy to do so.  Highly rated bond issues have already been fully subscribed and there is still money sitting around.

It has to go somewhere.  So it is going to finance Junior and Team Noklu.  And we'll go happily along as before because it also provides the illusion of economic growth.  And the illusion will eventually be exposed for the bubble that it is - after it pops and it is too late to actually get things right.

When will we ever learn?

I'll reprise the end of last week's post: In a couple years we will begin paying attention as candidates run for President.  While I am not much interested in endorsing candidates, I am very curious to hear what Senator Rand Paul has to say because he comes from the 'school' which believes we need to return to 'sound money'.  That 'school' has been out of favor with economic 'experts' for quite a while - until now.

Please, read and read a lot.  Start with Geithner's litany of excuses for bailing out the banks.  You'll see what it looks like when the Department of the Treasury had Junior at the helm of their team - without a clue about how the money supply set us up for all of these problems.  Then read Steve Forbes' new book Money: How the Destruction of the Dollar Threatens the Global Economy.  When you understand what an excess of money does to an economy, you will be ready to make an informed - and hugely important - decision when we vote in 2016.

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* Actually, I owe the name to a group of guys I used to play softball against here in the greater San Diego area.  One of them is a friend and I have always loved their team name.  We were the "Stat Driven Bastards."  (I didn't pick the name, pastor.  Honestly, I didn't!)

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