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Guest Post: Some Thoughts On The Policy Bias Toward Inflation

Tyler Durden's picture




 

Submitted by JM

Some Thoughts on the Policy Bias Toward Inflation

Banks fear deflation.  They should:  sustained deflation will most likely kill the banks.  Also, since banks provide high-paying jobs to Federal Reserve types as kick-backs for well-aimed support while they are at the controls, the Federal Reserve fears it as well.  As long as they keep banks going, they will be well-taken care once they are no longer with the Federal Reserve.  Also, the only thing our current central banker in chief knows how to do to stimulate a basket-case is suppress nominal interest rates, or monetize debt. 

I don’t really care much about the inflation/deflation debate much anymore, because to me it is aside from the point.  What I care about is what the yield curve looks like because rates drive everything.  Not much to chase away the gloom in this, just a way to think about stuff. 


If you accept these curves, then a lender probably couldn’t care less about inflation either:  steep yield curve, very high inflation, hyperinflation (CPI up 50% a month), none of it matters.  This is because they can borrow at the short end of the yield curve lend farther out, and as a secured lender, they get recovery of the underlying asset in the event of default. The latter covenant is the most compelling reason in the world own banking stocks if (hyper) inflation is on your mind.

Consider that many risky ventures are financed with three to five year notes.  The borrower may receiver a longer term amortization schedule to pay down principle more, but the bulk of the note will end up as a balloon payment at the end which will need to be rolled.  In the very high inflation scenario, more cash flow will go into purchasing inputs, and if this input cost (programmer salaries, cost of fuel for travel) increase offsets the interest cost reduction, then a risky venture is worse off. 

Now consider a risky venture that faced a giant balloon payment that they can’t possibly pay out of cash flow.  A lender will offer refi terms based on market rates—rates that are expected to compensate for inflation.  The business now has lost most if not all benefit from inflation-adjusted interest costs.  It may be that the business prospects are so poor based on rising input costs and now interest burden that the terms will be adjusted for the risk, putting the business in a death-spiral.  What recourse does the lender have in the event that this risky venture cannot afford to refi or make the balloon payment when the note term expires?  The bank takes possession of the assets.  They most likely are not experts in the venture, so they have tow choices:   subsidize the venture for a while with better terms than the market requires just to keep it running, or they will have to sell the business whole or in parts to recover a fraction of their investment.  Either way they lose a chunk, but they do not lose everything. 

If a bank locks at least some funding needs in long term financing at a fixed rate, then banks will benefit from the erosion of this burden.  At the same time, their costs of inputs (mainly capital) will rise much less than most business lines simply because they borrow at fed funds or some interbank lending rate like it.  All they have to do is shorten their term risk.

If the yield curve ever did look like the hyperinflation scenario above, it is of course unsustainable and short lived.  But there will be little capital left after it is over.  Lenders will recover the real assets in the event of default, because there is no point in subsidizing a business that cannot possibly turn a profit.  Then they will liquidate the asset to the highest bidder.  Liquidation on a large scale will pretty much ensure that no business can turn a profit.  A sustained yield curve like the one shown above will reduce all activity to only short-term activities and ones that increasingly reduce to barter type transactions.  Nominal recovery may be higher, but there is not much they can do with the cash, other than move out of cash.       

 

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Wed, 06/15/2011 - 23:29 | 1373479 baby_BLYTHE
baby_BLYTHE's picture

QE3 cometh

Wed, 06/15/2011 - 23:37 | 1373492 Cliff Claven Cheers
Cliff Claven Cheers's picture

where are those titty pics?

Thu, 06/16/2011 - 07:40 | 1373838 snowball777
snowball777's picture

In your mom's super-8, sweet cheeks. Damn she's hairy. <shiver>

Wed, 06/15/2011 - 23:57 | 1373504 jaffi
jaffi's picture

Hey, new pic Blythe.  I see you grew your hair out.... Nice, I like it.  Sorry, I am a teddy bear when it comes to the ladies.

In either case, it is my belief that IF QE2 does end, then there will be a domestic rally on the dollar, that most are expecting a drop in yields (due to the rally), and that there will be a dip in commodities and equities.  While equities will get a big drop, this has a lot to do with the disparity between the dollar strength and commodity (PPI) dynamic.  We are in capital wasting territory, so even though commodities will dip, they will be far behind CPI.  The current problem facing domestic producers with regard to input and output prices will only increase, thus having downward pressure on non-farm wages (and, employment).  

I say that it would be prudent to buy the commodity dip, and stay out of equities altogether.  Yeah, you can hold some extra dollars for a time, but as soon as you hear QE3 out of the MSM, that's your cue.  I fully expect treasury yields to rise due to lack of demand, and that even the short-lived dollar rally cannot stop this; but, that is also why I think that the Fed will come in with QE3, that they will use increasing yields as their backdrop.  Happy trading......

Capital is going through the sluices faster than beer through an empty-belied drunk- this is not good.  Lots of capital-wasting in the good 'ol US of A.  

 

P.S.  Cliff, you're a prick.  

Thu, 06/16/2011 - 00:05 | 1373542 Cliff Claven Cheers
Cliff Claven Cheers's picture

Whatever dude, you sound like a real Wallstreet pro with all that giberish, but I doubt it since your are giving advice to non investors. So Fuck You Cock Suckker.  Sorry if if that is not P.C. but since you are gay I guess if is not so offensive.

Thu, 06/16/2011 - 02:49 | 1373668 jaffi
jaffi's picture

Nope, it has nothing to do with Wall Street "pro", or economic knowledge, and more to do with the fact that I am not an asshole.  I have this little thing called "class".  You may have forgotten it while your 8 year old mind was playing "sword fights" at the urinal with your friends while looking at a Playboy and pretending that you're not gay.  You know.... that thing?  You don't HIT the girls, rather you hit ON the girls.  Eh, forget it.  You'll never get the hang of it... You're too busy being a Wall Street "Pro".  

Oh, by the way, I would be remiss in my duties if I did not say, "welcome to Zero Hedge".  Now, go play in traffic fancy pants...

 

Thu, 06/16/2011 - 00:00 | 1373543 Cliff Claven Cheers
Cliff Claven Cheers's picture

dupe, so fuck you twice.  Where are those titties?

Thu, 06/16/2011 - 07:43 | 1373841 snowball777
snowball777's picture

Hangin' off your chest you fat fuck. Buy a damn bra, hoser.

Thu, 06/16/2011 - 09:08 | 1374034 jaffi
jaffi's picture

"hoser".  Man, you been watching 'Strange Brew' lately?  Or, are you actually Canadian?  

Thu, 06/16/2011 - 03:01 | 1373700 jaffi
jaffi's picture

Eh, I get junked.  

However, I will say that come the first few weeks of July, the dollar is going to rally, CPI is going to go down, PPI is going to take a small dent, and yields will flatten and then rise, and equities are fucked (as if this hasn't already been happening), commodities will drop a little (but, not nearly as much as will be screamed from the megaphones of the press).  I have been saying it for about two months now, and just so long as QE3 doesn't come immediately after QE2 (i.e. there are a few weeks of "feeling around"), then that is the outlook.  If this is indeed what takes place, don't come crying to me that your longs trashed and your shorts fizzled; because that's just how I see it on the macro-level.  In the end, input prices of producers will continue to put pressure on output prices, thus wasting capital.  But, most of the MSM will be looking at CPI, not the comparative drops of CPI vs PPI, so they'll completely miss the increased costs of production.  And, of course, nobody is even noticing the disparity between GDP(E) and GDP(I), which only reinforces my argument.  

Happy trading...

Wed, 06/15/2011 - 23:38 | 1373489 RockyRacoon
RockyRacoon's picture

It's all about control.  And the Fed has lost what little bit it had.

Bernanke now preaching to Congress -- dogs and cats living together.

Wed, 06/15/2011 - 23:42 | 1373496 JW n FL
JW n FL's picture

was that you the other day that posted the Ghost Busters short?

 

NICE!

Thu, 06/16/2011 - 00:12 | 1373563 baby_BLYTHE
baby_BLYTHE's picture

agreed Rocky,

The FED would be singing no such tune if they were so confident their money printing had been a run-away success.

Now they are totally trapped. Not to QE3 means a Deflationary holocaust.

Initiating QE3 insures us double-digit inflation for at least the next 5-10 years.

total trap. Damned if they do, damned if they don't

Thu, 06/16/2011 - 00:16 | 1373564 Cliff Claven Cheers
Cliff Claven Cheers's picture

Where are those titty pics? Come on we know you have some.

Thu, 06/16/2011 - 01:47 | 1373650 Transformer
Transformer's picture

Hey, I like tits as much as the next guy.   But... hey....give it up.

Thu, 06/16/2011 - 01:52 | 1373653 vato poco
vato poco's picture

in the final analysis, you seen one, you've seen 'em both. still, that's never yet interfered with my fave human nature quote of all time - i just don't know who the hell said it. "History is littered with the corpses of men, who, pursued by certain death, stopped to watch a woman undress."

Thu, 06/16/2011 - 07:45 | 1373847 snowball777
Thu, 06/16/2011 - 08:05 | 1373885 Tater Salad
Tater Salad's picture

Blythe

"Initiating QE3 insures us double-digit inflation for at least the next 5-10 years."

Really?  And what about Japan, they've been printing for 20 years and no inflation.  There's something called velocity folks of which we have none, zero!  Hard to get inflation when dollars printed are just that, dollars printed.  Until this money makes it into the system i.e. the end user, we're not going to get inflation.  The aggs and industrial commodities are all bulled up by prop desks speculating on free money at the fed window.  This party will too come to and end and at that time, "deer in headlights" will have a new meaning as some will get decimated!  Lastly, your home isn't worth di** and you can't get a raise.  If you're going to talk inflation, you're going to need at least the aformentioned as part of several other metrics. 

QE3 is a coming, but sadly will be another failed experiment by the drunken monkeys.

 

Thu, 06/16/2011 - 08:09 | 1373886 Tater Salad
Tater Salad's picture

Blythe

"Initiating QE3 insures us double-digit inflation for at least the next 5-10 years."

Really?  And what about Japan, they've been printing for 20 years and no inflation.  There's something called velocity folks of which we have none, zero!  Hard to get inflation when dollars printed are just that, dollars printed.  Until this money makes it into the system i.e. the end user, we're not going to get inflation.  The aggs and industrial commodities are all bulled up by prop desks speculating on free money at the fed window.  This party will too come to and end and at that time, "deer in headlights" will have a new meaning as some will get decimated!  Lastly, your home isn't worth di** and you can't get a raise.  If you're going to talk inflation, you're going to need at least the aformentioned as part of several other metrics. 

QE3 is a coming, but sadly will be another failed experiment by the drunken monkeys.

 

Thu, 06/16/2011 - 09:06 | 1374018 jaffi
jaffi's picture

The primary difference is globally traded goods.  Yes, Japan printed up a storm to try to fight the correction, and it got them nowhere.  However, that started 20 years ago and continued up until this point.  When they were doing it they were dealing with trying to fight a domestic correction.  Today, the entire western world is attempting to do it in sync, and it is not going to turn out good for input prices (commodities, intermediate goods, and finished goods).  While everybody will be looking at CPI, they are entirely ignoring the fire that is getting ready to roar up the asses of producers.  Say hello to decreased incomes and wasted capital, because that is what is happening at this very moment.

Velocity is a keynesian dream, and is only pertinent to M1, M2 (i.e. depository money and money equivalents).  You are looking at bank money growth (velocity), but are ignoring the elephant in the room; that of MB and government spending.  Stop thinking like a banker and start thinking like an economist, and then you may get it.   

Thu, 06/16/2011 - 00:36 | 1373598 Michael Victory
Michael Victory's picture

+1 RockyRac

Wed, 06/15/2011 - 23:41 | 1373493 TruthInSunshine
TruthInSunshine's picture

Wow.

Where to begin.

I'll be brief.

The only banks that fear deflation are those that control governments, which is the case with the relationship between almost all developed nations today and their 'central bank' masters.

The central banks can print as much fiat as they wish, to compensate for any and all "losses" that inflation theoretically could do to their holdings.

Banks that have to earn profits via the conventional banking model of borrowing money at a low rate from a central bank, and loaning that money out at a higher interest rate (the interest rate differential is their gross profit, essentially), have everything to fear from inflation, as it completely destroys their conventional and main method of making profits, during normal times in the economic cycle, wherein rising interest rates drown the value of their past loans extended, absent extraordinary subsidization from some external source.

Bank loans are bank 'assets,' while deposits are 'liabilities,' and all things being equal, inflation destroys any profit (and could put the bank deep in loss) that the conventional spread between money borrowed and loaned typically offers it.

So, aside from central banks, which can compensate for inflationary impact by printing more fiat, and too-big-to-fail entities, which enjoy de facto central bank status (literally; plus, look at all the revolving door nepotism as to hiring between central banks and too-big-to-fail banks) and all sorts of 'extras' in the form of guaranteed and risk free profit making avenues offered exclusively to them by central bank policies, inflation destroys lenders and rewards borrowers.

Wed, 06/15/2011 - 23:48 | 1373512 takeaction
takeaction's picture

Truth...help me understand something.....??  Wouldn't deflation in home prices just crush any banks that still have mortgages on their books?  Wouldn't (More)  deflation wipe out most equity that the banks originally originated  loans on?  And with the fractional reserve banking system leveraged so hard, wouldn't more deflation make the banks even more insolvent than they already are?  Appreciate the help.

Thu, 06/16/2011 - 00:03 | 1373534 TruthInSunshine
TruthInSunshine's picture

It's not deflation on home values that wipes out those banks that choose to carry (rather than sell at the time of closing) mortgage backed paper - it's the fact that the loans go bad since a greater % of the people who are indebted on the mortage quit paying on their loans.

Could the deflation lead to the non-payment? Sure. But it's far more likely that job losses and wage reductions affecting affordability of repayment will do that trick. To say that the deflation in home values will lead to job losses and wage reductions is a common misnomer, IMO, that many economists are perpetuating these days - the health of the job market governs home values; the value of homes DOES NOT GOVERN THE JOB MARKET.

Take a moment to think about the people still working, but who are underwater 20% to literally 75% on their home values, but are still making their mortgage payments because they are still working and still have that ability (although more and more who can do so are CHOOSING not to do so, but I digress).

All things being equal, deflation in general, and on home values, means that the bank is getting supercharged returns on the loan it extended to the homebuyer, assuming the loan performs and the bank receives repayment on the underlying note.

 

Thu, 06/16/2011 - 00:07 | 1373554 takeaction
takeaction's picture

I understand.....as long as the note is being paid all is good....but when a home owner just walks away...as many are doing, this is the deflationary nightmare (Which would escalate as deflation escalates). Not the actual carry of the paper.  Makes perfect sense.    Thanks

Thu, 06/16/2011 - 09:02 | 1374004 ibjamming
ibjamming's picture

That's what started the whole mess a couple of years back.  The price of gas shot up...that along with ARM resets, caused...forced...many to quit paying their mortgage (their BIGGEST expense) and the banks panicked.  All that debt the banks hold is dependent on people making their payments.  If the payments stop, the deleveraging starts.  The government stepped in and "made the payments" to the banks and started buying the bad mortgages.  Many held by foreign banks...hence why so much money from the bailouts went over seas.  That's where we are now...the government is keeping the banks solvent with taxpayer money because too many have stopped making their payments...and...home values are WAY down so they can't get anything back through foreclosure.  IMO of course.

Thu, 06/16/2011 - 00:08 | 1373558 jm
jm's picture

If input costs (salaries, material, balh, blah, blah) increases are greater than the reduction interest burden that inflation provides, then it doesn't help the borrower at all.  In fact, that they have to roll short-term notes, the interest burden reduction will be short-lived.

Unless of course you assume some kind of hyperinflation that makes roll a non-issue.  I don't place much credence to this possibility.

 

Thu, 06/16/2011 - 00:25 | 1373572 TruthInSunshine
TruthInSunshine's picture

It's my humble opinion that one of Bernanke's main goals was to flood as many banks with as much excess reserves as possible, while also extending extraordinary access to the discount window (offering de facto 0% loans), in an effort to keep as many of them from crashing as possible (I think about 900 have failed since 2008), during a time in which he knew their conventional means of generating income and making profits - via loaning money at higher rates than their borrowing costs - would completely break down.

And here we are, with banks that allegedly survived (so far), stuck with toxic balance sheets, full of shitty ass loans secured by eroding value assets, depending more and more on their excess reserve income and massive amounts of new fees (adding significant revenue to their top line) they are imposing on their customers, praying and hoping that here never comes the day that reverse repo operations really do take place, as that would mean a death sentence for another estimated 2500 banks (maybe more).

Anyone who tells me that banks are in anything other than extend and pretend mode, made possible by incredible intervention and excess reserves compliments of Bernanke & Geithner, along with incredibly lax regulation and fantasy-land valuation of assets (thanks to Congress), is really knee or thigh high in the Kool-Aid.

Similarly, given the unsettling trends of high inflation (real numbers), pathetic job growth (with the risk of actually printing negative numbers soon again - even by official and highly massaged measurements via the BLS), incredibly weak demand for loans and incredibly weak willingness/ability to make loans (unless its guaranteed/backstopped by the Fed or Treasury or subagencies of government), anemic retail and manufacturing data, etc., anyone who thinks Bernanke and our own beloved government haven't merely kicked the can at the expense of taxpayers and the organic economy and organic growth, for two long years, to the tune of at least 5 trillion in direct and incredibly inefficient spending (Stimulus, TARP, TALF, QE1 and QE2, etc.), and as much as 12 trillion considering what's yet to be paid back or what the government is still on the hook for in terms of guarantees on loans and toxic asset portfolios it contractually made, only complicating his dilemna and the nation's dilemna, should seriously reassess their level of intelligence or sources of information gathering.

Thu, 06/16/2011 - 00:30 | 1373584 jm
jm's picture

The Fed can lower interest rates, but they can't control where the money goes. QE2 has it is going into basic commodities, and not into housing.  This is a disaster for banks.  They can handle defaults that they have provisioned for.  They can't handle the correlation in mortgage defaults seen in the 2008 crash.  They is why the Fed started credit easing.  I'm not sure what is happending right now.  RMBS and especially subprime may be weak right now because the Fed is unwinding some of this off their balance sheet.  Wish I knew for sure.

Also, inflation will do more for a bank with a poor balance sheet than anything else because they can borrow short and lend long.  deflation inverts the yield curve and they get caught positioned wrong.  It will kill them and they fear it. 

It is about rates.

 

Thu, 06/16/2011 - 00:47 | 1373609 TruthInSunshine
TruthInSunshine's picture

I think we need to agree that there is an ocean of divergence between what Bernanke & Geithner's intentions are with respect to garden variety banks, and those that were (and I would contend still are) considered too-big-to-fail.

It's my belief that Bernanke has pretty much shot his wad in helping the wide swath of conventional banks, so much so (due to incredibly nasty boomerang effects from his monetary policy) that he's not going to stop another die off in the small-community-regional bank sector, and will even allow some goliaths to go down, given the options he and the politicians are now looking at pre-2012.

Absent a dramatic global economic implosion, a major war, or some other globally systemic shock that takes risk way off (something the Bernank would actually probably welcome as it might make the Fed's position of buyer of last resort of tnotes easy to move out of), the Bernank has got to be weighing some means of sucking liquidity out of the system, especially since most would agree that a modest rise in interest rates really is not going to make or break the organic economy at this point, which is far more sensitive and responsive to employment trends (and ominously for Bernanke & Obama, inflation trends/expectations).

It's hugely ironic (to me at least) that deflation might be somewhat desirable for both Bernanke and Obama at this point, since we are in such a weird space, it is one of the few things that might stimulate consumption (turning conventional economic theory on its head), which is really what is desperately needed to produce a real rather than nominal boost to GDP and hiring (deflation is perversely even more desirable given the wage/benefit and consumer confidence stats).

I guess we'll see if Rickards is even close to the mark in that Bernanke will have much more purchasing power to buy significant amounts of tnotes post June 30th based on rolling over income from the Fed's existing balance sheet, rather than having to resort to new rounds of full fledged monetization (assuming that's even possible prior to anytime before November of 2012).

Thu, 06/16/2011 - 06:53 | 1373778 jm
jm's picture

Well, I can only conjecture here. 

But I agree on your first point... Ben knows where his future job/wealth is coming from when he is done at the Fed.  He will get a Wall Street job or consulting fees while an academic.  Conjecture:  it's not that he doesn't think he is helping Main Street.  He thinks he can help Main Street through Wall Street.  If a dealer fails, it will hurt Main street.

I agree that he is going to let commodities/equities plummet, but I also think that he can't afford to let the curve invert. So he won't.  

My point is that inflation benefits struggling banks.

 

Thu, 06/16/2011 - 00:37 | 1373600 takeaction
takeaction's picture

Sure appreciate your posts...thanks...you said..

"with banks that allegedly survived (so far), stuck with toxic balance sheets, full of shitty ass loans secured by eroding value assets,"

.

That is my entire thought about deflation tied to the Fractional Reserve Banking scam?  How can any bank that holds mortgage paper be solvent....especially if we are looking at another 30% or more possible asset devaluation? As deflation continues in assets and inflation happens in commodities, and wages are stagnant...we are so screwed!  Right? Looks like the images of Greece will be here soon.  Wow!  Again...if I am missing something...I appreciate the input.   Oh yeah...What is "BLS".  Remember I am learning. :)

Thu, 06/16/2011 - 02:44 | 1373615 TruthInSunshine
TruthInSunshine's picture

BLS = Bureau of Labor Statistics, which is the agency that tracks employment, inflation, etc.

Keep in mind the important and devastating trend that many here and elsewhere have observed, whereby most things people own or in normal times aspire to own that are typically financed by credit (borrowing money), along with wages, fixed income have all been ravaged by deflation, whereby necessities of day to day life that are less economically flexible (food, energy, medical goods/services) have been inflating (not to mention no relief in sight on income taxes, property taxes, permit fees, licensing fees, and other government taxation and tribute extraction).

There really has been a duality that is bi-flation. Bernanke is resorting to really cheap tricks (made possible by BLS cheap tricks) and severely underspeaking to the pervasiveness and perniciousness of 'real world' inflation.

Oh well, I believe Bernanke & The Fed wrecking crew have sounded the risk off alarm, and basically and blatantly told the inner sanctum that life support is being removed from equity markets for the time being, and we'll get fixed income yields rising, at least for the next 8 to 12 months, barring an absolute collapse of....everything.

It's going to be entertaining to see how Wall Street sell side analysts peddle/market equities now.

Cue the snake oil.

Thu, 06/16/2011 - 08:36 | 1373957 JFK.4PREZ
JFK.4PREZ's picture

We live in a global economy which creates global prices for assets (see commodities).  Why aren't wages? IMO wages in the US are just dropping from their stratospheric level to something that is more competitive on a global front.  It's going to happen one way or the other.  Our education isn't nearly as premier as it once was- actually it's falling into the shitter.  I can only see more job outsourcing in the future until a economic meltdown paralyzes international trade.  

Thanks truth for the comprehensive run-down.  

Thu, 06/16/2011 - 02:44 | 1373687 topcallingtroll
topcallingtroll's picture

inflation is not an unsettling trend.

 

It is the trend that saves us! 

At least now that a bad decision was made to socialize bank losses.

Thu, 06/16/2011 - 02:50 | 1373691 TruthInSunshine
TruthInSunshine's picture

Inflation in the price of goods needed to live (i.e. the more inflexible, the higher the inflation), coupled with stagnation or deflation in wages, retirement benefits and more flexible goods requiring access to credit to purchase (i.e. things not purchased often, but owned by many, such homes, requiring access to loans) = toxic, devasting brew that will destroy the big, meaty section of Americans, aka The Artists Formerly Known As the American Middle Class.

Thu, 06/16/2011 - 09:24 | 1374080 jaffi
jaffi's picture


"inflation is not an unsettling trend.  It is the trend that saves us!"

Saves who?  I don't know about you, but I am not a nationalist, and I can care less about national (bank) interests.  I am merely trying to make real gains, and I can care less about nominal numbers.  Sure, it looks nice when the "numbers" go up (hey, look at the pretty numbers), but that does not mean that there is a net increase in utility.  Fuck that, as long as my real (adjusted) gains are positive, that is what I am putting my money into.

If I wanted nationalism I would be listening to the Bernank and the Pres.  Sorry, they have failed me too many times for me to take them seriously.  While I would like to be a humanitarian and increase the quality of life of everybody, they aren't listening, and are instead watching 'Dancing with the Stars' and thinking life is gravy (just so long as the bureaucracy is in charge).  They don't get it.  

Wed, 06/15/2011 - 23:53 | 1373532 topcallingtroll
topcallingtroll's picture

Yeah this is a little bit odd, but perhaps he is discussing what happens at the extremes or with short term lending and securitized lending.

Fixed rate lenders love mild deflation. Fixed rate borrowers love mild to moderate inflation.

I remember parents of venezuelan friends bragging about fifty bucks monthly house payments when ten years later the house had wuadrupled in nominal value and would now rent for about four times as much also. I didnt understand how a bank that kept a mortgage portfolio could survive in those circumstances.

Thu, 06/16/2011 - 00:15 | 1373567 takeaction
takeaction's picture

"Inflation destroys lenders and rewards borrowers"....only if they are hedged...like myself...correct?  Somebody who can not hedge against inflation could care less and will lose no matter what right? 

For example...I just bought this big house that sold for $650,000 a few years ago and still would easily cost $500,000 to build for $250,000.  I took a mortgage out at 3.75% instead of paying cash.  The cash has been placed in inflationary hedges because I see the writing on the wall thanks to this site.  So...I am Physical Huge..and all of my retirement garbage is VXX (Awesome Today) and miners.  So in theory, borrowing $250,000 at that low of rate locked for 30 years....and placing those funds into PM's potentially could pay off the home with a Monster Box or 2??  Am I getting this right?  I am buying another property tomorrow...dirt cheap..(Rent will cover mortgage) ...same thing.  Using my credit to go into debt at less than 5%(Rental)...and just leverage myself to hell on dream deals using my capital to continue to buy "Monster boxes".  If I am missing something....please enlighten me.

Thu, 06/16/2011 - 02:42 | 1373619 topcallingtroll
topcallingtroll's picture

You have a highly leveraged undiversified real estate portfolio. This pays off big time if we have inflation, but could be extremely costly in a deflationary environment.  You don't need to hedge this against inflation.  It is your inflation hedge.

All of your other investments are long the inflation trade also.  If deflation occurred you would lose in all of your investments most likely.  You actually have a unidirectional bet on the inflation trade, a bunch of naked longs.  This is called a texas hedge as a joke.

There are several ways to hedge your highly leveraged real estate portfolio (your house) against deflation.

you could buy bonds with the  money.  If you can get better than a 3.75 percent return you are doing great.  Anything less than 3.75 percent yield you can consider an insurance payment to insure you against housing deflation.  A thirty year treasury bond portfolio would be an excellent hedge.

You could also buy puts on a reit portfolio that specializes in mortgage finance or a reit that specializes in housing construction, or if you want to get sophisticated have a quant friend analyze the reits for which reit has historically had the closest correlation to single family housing prices.   Roll over your puts until your house is paid off, but you can buy fewer and fewer as the outstanding value of your housing loan decreases.  This is money down the drain if there is no deflation, but just like insurance you hope to never use it.  This does not require a huge amount of capital like a thirty year bond portfolio. 

However the thirty year bond portfolio has a return greater than 3.75 percent so you are getting paid a small amount to carry insurance.  The true cost of using a thirty year bond as a hedge against a leveraged real estate investment is not bond interest rate minus the housing loan interest rate, but the opportunity cost of you incur by foregoing other investment opportunities because you bought the thirty year bond.  People who really think they can get a better return than a thirty year treasury held to maturity (matched to the maturity of your housing loan) would prefer to hedge with options which free up more cash, or buy the thirty year bond portfolio on margin possibly.

Most people don't want to get this obsessive about it, but you did ask for a hedge against your house.

 

Thu, 06/16/2011 - 00:03 | 1373547 Global Hunter
Global Hunter's picture

Inflation destroys lenders and rewards borrowers. 

One word, six syllables could never have been so true!

Thu, 06/16/2011 - 01:11 | 1373624 idoubtit
idoubtit's picture

There are two segments of society.  Those that live off the labour of others through the collection of interest.  And those that labour and produce.  Although inflation helps borrowers by repayment in dollars that are worth less, deflation hurts the lenders even more because it means the assets that own (loans) deflate in value as loans default.   Hence the panic in Europe and the bailout of the banks in the financial crisis.  Inflation does NOT destroy lenders because inflation means rising asset values and for anybody that has the ability to print/loan money, they are always ahead of the curve as they are making loans along the inflation curve.

Our economic system is designed to protect the money lenders at the cost of labourers.  The reluctance of bondholders and banks to take writedowns has been evident enough.  Deflation HELPS the worker in that the little money they have in their pocket goes further.

Just imagine if oil was at $40 and other commodities were half price.  Would that not make life better for most of us?  The problem is that the book of assets that money lenders hold halves in value and the people in power will not let that happen.  ie Greece.

But in the end, the banks will lose.  It is not the printing of money that is the power.  It is the ability to borrowers to repay with their labour that forms the basis of society.  There simply is not enough borrowing capacity left anymore to inflate anymore.  The Fed might be about to pump up commodity prices for a few months, but unless people borrow more, deflation will win.

Thu, 06/16/2011 - 02:38 | 1373684 TruthInSunshine
TruthInSunshine's picture

Although inflation helps borrowers by repayment in dollars that are worth less, deflation hurts the lenders even more because it means the assets that own (loans) deflate in value as loans default

 

I won't rehash everything I wrote earlier, because being redundant is a buzzkill, but I do think you need to break down your analysis a bit more.

First, there's the central bank, and then there are conventional banks. The former essentially prints fiat and affects the monetary base, while the latter category of banks do not.

So, the central bank isn't really a 'bank,' at all, at least not in terms of how the term 'bank' is commonly defined or perceived. It's a mutant creation that is an organ of policy, and an organ of profitability for its member shareholders (in a very convoluted - by design - method).

The central bank cares not whether its holdings, over the short or intermediate term, are affected by inflation or deflation, in reality. It has no risk, nor do its shareholders. It is able to increase or decrease the pace of fiat printing at its discretion. It only holds (at least directly and openly) physical assets in extraordinary circumstances (it is a bailee for gold, not an owner).

However, conventional banks, of the non-investment variety (although that distinction has become blurred), derive their revenue generation from making loans and capturing the spread between cost of money borrowed and lent, and not from the appreciation in the value of assets held/owned (aside from loans). In other word, conventional banks are not investment funds, buying and selling real estate, equities, commodities or bonds. Some may come into ownership of such assets as a result of defaulting loans, but those assets are sold, and under ordinary circumstances, represent a miniscule fraction of assets at any given time.

Consequently, appreciation or depreciation of the value of such asset classes due to inflationary or deflationary trends in the value of such collateral thst securitized their loans made has little bearing on their operations, as there time exposure to any such assets they come into possession/ownership of is time limited, and there repossessing such assets due to defaults is infrequent - absent extraordinary crises. As a matter of fact, such banks that practice proper risk management will planned for unlikely events and diversified and minimized their exposure to such crises.

Now, if you are speaking as to investment banks, with trading desks, and asset divisions with ownership interests in those assets, on behalf of the institution and shareholders, depending as to what % those operations constitute revenue generation vs conventional lending practices, inflationary and deflationary cycles certainly have a more direct and fundamental relationship to their bottom line, which is one of the reasons the systemic crisis in 2008 led to bailouts, TBTF guarantees and rescue packages, and ongoing and extremely damaging (to the organic economy) monetary policies under Bernanke and Geithner/Paulson, as the banks designated TBTF did not practice proper risk management (whether accidentally or by design, knowing they would be 'saved' via Main Street/taxpayer involuntary wealth transfers, is for individuals to decide upon).

Wed, 06/15/2011 - 23:39 | 1373499 takeaction
takeaction's picture

If you understand Fractional Reserve Banking then you understand why deflation is the ultimate enemy...the banks are so leveraged they are wiped out very quickly.

http://en.wikipedia.org/wiki/Fractional-reserve_banking

 

The PTB will not (At least try) to allow deflation to happen.  Another 30% down in housing prettty much makes every bank insolvent....correct me if I am wrong?

This is why QE to infinity as Jim Sinclair says is a given.....we are so screwed.

Wed, 06/15/2011 - 23:48 | 1373522 Josh Randall
Josh Randall's picture

100% agree thats how it is supposed to work in principle, or if Banks had to mark to market their actual losses on Foreclosures and underwater assets on their balance sheets. Since they don't currently, nor plan to in the future thanks to EY, KPMG, et al, then they can string this out a little while longer.

Thu, 06/16/2011 - 00:02 | 1373544 takeaction
takeaction's picture

@ Josh......Thanks for helping me understand.  With unemployment so high, it is impossible to pull housing out of this rut...right?  I still see for sale signs EVERYWHERE around me.... (Portland, OR).  I just bought another $650,000 home for $250,000 @ 3.75%....7 months ago....and I thought maybe we hit bottom and the prices are STILL GOING DOWN!   Maybe I should of waited...oh well.  Hopefully my "Monster Stack" will pay it off....LOL.  I am still stacking brothers.  Back to the question.......with prices still falling, and all of these homes on SOMEONES balance sheet.....when does everything bottom or reprice, or banks close...or is it just a forever..."Never going to face it" thing?  Again...I am learning...and appreciate this site!

Thu, 06/16/2011 - 02:08 | 1373660 Transformer
Transformer's picture

As credit become more and more unavailable, the price of housing will fall to the cash level.  ie. what you can sell a house for cash.  As inflation and probably hyperinflation are pretty much starting now, we may not see much more down in housing prices, priced in dollars.  However, priced in gold or silver, housing prices may continue on down from here.  Housing may decline to the level of 500 ounces of silver or 40 ounces of gold for an average house, somewhere in that area, and of course the gold:silver ratio will have a lot to say about the actual numbers.

People ask all the time how high will gold or silver go?  It doesn't matter, because by the time it gets there, we won't be valuing things in dollars, stuff, including houses, will be valued in real money.

If we follow the usual chain of events extant in most hyperinflations of the past, houses and other assets that are relatively non liquid will decline in value to seemingly unheard of levels.  If you doubt this, just read some history about recent hyperinflations, like Argentina or Chile.  There is no magic in America.  We will have a normal hyperinflation and most of the things that have happened in past events will happen here.

 

Thu, 06/16/2011 - 02:24 | 1373670 takeaction
takeaction's picture

Thank you sir...being a new poster...long time reader to this site...I appreciate your comments to my sometimes naive questions.    Here is my question.....If I think we the United States is going to have Hyperinflation, (Dollar Crash, Loss of faith in the Bernank Currency) then am I wise to use my credit to tie up as many cheap properties as I can.  (Note: Each Property payment (Mortgage) will be covered by the rent).  And the balance of my capital after the 25% down payments required to tie up each rental property put into PM's.  So when PM';s go to the moon....I just hand the lenders a fist full of gold to pay off each property while maintaining the rents?   What am I missing.....?  Unless we have riots in the streets....like Greece.  All bets off.  Help me here.  What am I missing?

Thu, 06/16/2011 - 04:16 | 1373727 Transformer
Transformer's picture

Your scenario could concievably work for you.  It also seems that there might be a huge number of variables that could affect your plan.  For example, I could see rents going very low as unemployment might be unusually high thus reducing your income to pay mortgages.  Predicting the future is very hard.  If you have extensive resources and credit, I would suggest investing in PM's and then when the actual series of events unfolds, you would be in a position to take advantage of whatever happens.  If you want to use your good credit, I would buy PM's, although I know that it is hard to borrow money for that purpose.

Conceivably, inflation will reduce the actual payoff of loans made now.  Don't underestimate the elites though, in their clever ways to foil just such a plan as you have.  Perhaps confiscating gold or silver.  Perhaps tying existing loan balances to inflation--don't laugh, it was done in the French hyperinflation of the 1790's. 

Anything is possible, so I would not be anxious to invest so quickly.  Real Estate may not be what you want to invest in after the collapse.  RE values could languish for years, 10-20 or more before going up again, if ever.  My own personal opinion is to look at real estate as a place to live, or make income from its value as a rentable property, but not as an appreciation vehicle, like it was in the past.  Predicting rental returns on investment would seem very hard to do right now.

Thu, 06/16/2011 - 09:37 | 1374127 Calmyourself
Calmyourself's picture

Indexing debt to inflation will happen very quickly as an emergency measure probably by Executive order. We will not be paying off our homes with Au /Ag as it will be outlawed as an above board trade. This will al l take longer and be more painful than we can imagine as the assets are sucked dry to protect the elite. The MSM will keep the sheep docile enough for long enough. There is only one way this ends favorably for the majority ( middle class)..

Thu, 06/16/2011 - 14:15 | 1375233 akak
akak's picture

If the sociopathic financial and political powers-that-be EVER even try to index debt to inflation, as sheepish as the American population has become, I predict that that move would be the final straw on the camel's back, and mark the beginning of the revolution.

Thu, 06/16/2011 - 02:29 | 1373672 takeaction
takeaction's picture

Welcome to the Double post  sorry!

Thu, 06/16/2011 - 00:55 | 1373612 Libertarian777
Libertarian777's picture

you're absolutely correct.

 

It's funny how we call it 'fractional reserve banking' whereas it is in actuality FRAUD plain and simple.

 

When you put your money with the bank, you are putting YOUR money with the bank. However there was a Supreme Court ruling many decades ago that stated that it is no longe ryour money, it is the BANKS... and you only have a claim against the bank.

When the bank only holds fractional reserves it has instantaenously debased your money that you placed, in safe keeping, with them.

 

There should be strict distinctions between banking as a utility function (i.e. transaction processing) and banking for investing (which has higher risks). Glass-Steagall more or less put these restrictions in place. While I think there is a free market solution that doesn't require an act of Congress, until we can stop Congress from giving the banks the legal ability to use fractional reserve banking, a Glass-Steagal type act is necessary.

The government should allow any depositor who places his funds with a bank, whose funds are fractionally lent out without their consent, to sue the bank for fraud.

Bank deposits are suppose to be the very definition of 'on-demand'. Much like how paper money originated... 'on demand notes' for gold or silver. Now you can't even get your cash 'on-demand'. There are clearance periods.

Thu, 06/16/2011 - 01:14 | 1373626 takeaction
takeaction's picture

Yep...I agree 100%...especially with your last statement.  "Clearance periods".  It gets better than that.  My bank not only has a hold when funds are deposited....you are limited to $3000 per day withdrawal...period.  

Guess how much cash I keep in the "Bank"....F...them.  I keep just enough to abuse them on their free checking with interest, and "Online" bill pay. 

Wed, 06/15/2011 - 23:44 | 1373500 DoctorMad
DoctorMad's picture

 Either way they lose a chunk, but they do not lose everything. 

How big of a "chunk" do banks have to lose when they are levered 15-20x before those losses start to REALLY hurt?

Yes, banks end up owning something at the end of the day, but not nearly, not even close, no snowballs chance in hell do they have of being able to keep pace with inflation this way.

Banks, like the rest of us, will be FAR better off if we take our medicine the old fashion way and accept the (hyper) deflation. The idea that they'll be able to "keep up" with any hyperinflation is LOL.

 

Thu, 06/16/2011 - 07:54 | 1373864 jm
jm's picture

Banks are borrowers as much as creditors.  Inflation helps their balance sheet if it carries risk.

Thu, 06/16/2011 - 00:04 | 1373549 Vint Slugs
Vint Slugs's picture

Just curious.  Do you do anything here besides post links to youtube?

Thu, 06/16/2011 - 06:59 | 1373782 Monedas
Monedas's picture

It's a musical public service announcement !

Thu, 06/16/2011 - 07:05 | 1373787 Version 7
Version 7's picture

buzzsaw99, is that really your pic?

Wed, 06/15/2011 - 23:51 | 1373520 Global Hunter
Global Hunter's picture

little riot in Vancouver, small one right now...they are lightweights out there but keep in touch.

Wed, 06/15/2011 - 23:53 | 1373525 Global Hunter
Global Hunter's picture

http://www.cbc.ca/news/canada/british-columbia/story/2011/06/15/bc-stanl...

Summer of discontent. So glad I'm leaving the city for good next month, it can't come soon enough. 

Molitov Cocktails bitchez!!!

Thu, 06/16/2011 - 07:02 | 1373789 Monedas
Monedas's picture

Monedas does not considered riots to be resourceful behavior !

Wed, 06/15/2011 - 23:58 | 1373541 jwäges
jwäges's picture

The problem of purchasing banking stock in said Hyperinflationary scenario is one of timing. How does one time the entry and exit points, as most investors are traditionally horrible at this? What are the signals? How extreme is the risk? Why not just keep physical PM's for stability versus risky signal based etfs?

Thu, 06/16/2011 - 00:01 | 1373551 Yen Cross
Yen Cross's picture

  Go to your local grocery store. You can't buy input costs on the roots of staples.

 

    Mother Nature dictates that one!

Thu, 06/16/2011 - 00:04 | 1373557 wesa
wesa's picture

Stripped of their many esoteric investment activities all that banks do is to buy money and sell money.  They try to buy money (get deposits or central bank funds) at lower rates than then they sell (loan) the money at.  The article is correct in that a well-managed bank can survive in any inflation/deflation scenario.

The problem is that many banks are not well-managed and are far too greedy. 

There are many banks that are far removed from the world stage that will weather the current storm simply because of prudent management. They may never make headlines but they do a good job of serving their customers.      

Thu, 06/16/2011 - 00:30 | 1373582 CD
CD's picture

In case anyone interested has not yet seen it, Turd Ferguson has unveiled his new, swanky digs for all those who are inclined to believe QE switch has fused in the 'on' position - and those of us who just like shiny metal objects: TF Metals Report

Thu, 06/16/2011 - 00:33 | 1373590 Lionhead
Lionhead's picture

There's lots more at work here than meets one's eye. I urge all to read about the ESF, it's working, history & leadership. This is a story that deserves attention by all FED watchers & perhaps a feature on ZH. This story is sure to garner more attention as the sleeves of the US gov't unravel.

The videos will open your eyes to a world few know about. Enjoy your trip down the rabbit hole.

http://www.gata.org/node/10009

 

Thu, 06/16/2011 - 00:34 | 1373594 SoNH80
SoNH80's picture

Inflation is the health of the state, like war and paranoia.

Thu, 06/16/2011 - 00:47 | 1373604 OrdellRobbie
OrdellRobbie's picture

EUR just dropped 60 pips, any comments?

Thu, 06/16/2011 - 00:54 | 1373610 Yen Cross
Yen Cross's picture

 I shorted e/j last night   116.20. That's my comment.   Yen Cross.

Thu, 06/16/2011 - 02:23 | 1373666 Yen Cross
Yen Cross's picture

 Be well. Yen

   Awe that was sweet. I want some Tuna!

 

     The blue fins change color just like Dorado.

Thu, 06/16/2011 - 02:36 | 1373682 topcallingtroll
topcallingtroll's picture

I think that was a good call.

Thu, 06/16/2011 - 02:48 | 1373693 steveo
steveo's picture

DRTV pattern

Dog returneth to vomit pattern, to flush out the weak longs.

http://oahutrading.blogspot.com/2011/06/ol-bucky.html

Thu, 06/16/2011 - 00:50 | 1373607 OrdellRobbie
OrdellRobbie's picture

EUR now down 90 pips in 10 minutes

Thu, 06/16/2011 - 03:01 | 1373701 dcb
dcb's picture

I don't think the article does a good job explaining why deflation is hated by the banks, and at this time I can't explain it well either. But, yes that is the point of QE. the value of future money must never be more than the value of present money. and yes the real reason for Qe has nothing to do with the economy, but to keep banks afloat so we can extend and pretend. I also think another reason is since deflation would show how insolvent the banks are and how bad a job the fed did, the emporer won't want to show that he has no clothes and will do all he can to cover up his mistakes. that is also a big reason for QE.

 

A different central banker, one who wasn't at the helm when this crap went down, may be willing to fix things and show bernenke to be the screw up he is. But bernenke will never do it. the best way to cover his mistakes is to make sure there is inflation

Thu, 06/16/2011 - 03:01 | 1373702 dcb
dcb's picture

I don't think the article does a good job explaining why deflation is hated by the banks, and at this time I can't explain it well either. But, yes that is the point of QE. the value of future money must never be more than the value of present money. and yes the real reason for Qe has nothing to do with the economy, but to keep banks afloat so we can extend and pretend. I also think another reason is since deflation would show how insolvent the banks are and how bad a job the fed did, the emporer won't want to show that he has no clothes and will do all he can to cover up his mistakes. that is also a big reason for QE.


 


A different central banker, one who wasn't at the helm when this crap went down, may be willing to fix things and show bernenke to be the screw up he is. But bernenke will never do it. the best way to cover his mistakes is to make sure there is inflation

Thu, 06/16/2011 - 03:32 | 1373715 Dirtt
Dirtt's picture

JM:  NAILS

Thu, 06/16/2011 - 03:51 | 1373722 pitz
pitz's picture

Banks hate deflation?  The past 30 fucking years has been deflation, valuing paper money over real money such as gold and silver.

ISTM, deflation has benefitted banks enormously.  It is inflation that ultimately kills banks and kills real estate.  In extreme cases, ie: Weimar Germany, hyperinflation pushed real estate 'values' and the value of banks to zero, while legitimate industrial interests were highly valued.

Thu, 06/16/2011 - 06:25 | 1373771 Version 7
Version 7's picture

Governments hate deflation also - they can't tax it.

Thu, 06/16/2011 - 13:28 | 1375054 Rusty Shorts
Rusty Shorts's picture

Smoke is rolling out my ears, thanks for the links.

Thu, 06/16/2011 - 08:34 | 1373953 FranSix
FranSix's picture

No amount of money that you print will result in any inflation if the discount rate is below a certain level.  Because the Net Present Value of any business, which denominates its returns in currency values is negative, especially banks and financial institutions.  

All of your returns fall below inflation, and all of your efforts result in negative rates of return.  Its worse if you have to borrow any money.  The real result has been that lending went into overdrive and prices bid up far beyond inflation in some cases, but the possibility still hangs over the markets that this will all collapse, and no real return will have been made as a result.

The inverse to this rule would be the gold miners.  Gold miners outperform in terms of IRR when rates are at extreme lows, or into the negative.  Where at one time, they were talking in terms of percentages of IRR, now they talk in terms of multiples of IRR. (it depends on grade, of course.)

The discount rate today is below 0.05%.  (IRX)

 

Thu, 06/16/2011 - 12:18 | 1374801 jm
jm's picture

I understand some, but not all of this. Would you mind clarifying?

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