Monetization

Italian bank holdings of Italian debt: €400 billion, an all time high. Oops.

Fingers of Instability

Frequent readers will recall that in the past, on several occasions, we expected that MBIA would rise due to two key catalysts: a massive short interest and the expectation that a BAC settlement would provide the company with much needed liquidity. That thesis played out earlier this year resulting in a stock price surge that also happened to be the company's 52 week high. However, now that we have moved away from the technicals and litigation catalysts, and looking purely at the fundamentals, it appears that MBIA has a new problem. One involving Zombies. These freshly-surfacing problems stem from a particular pair of Zombie CLO’s – Zombie-I and Zombie-II (along with Zombie-III, illiquid/black box middle-market CLO’s).  While information is  difficult to gather, we have heard that MBIA would be lucky to recover much more than $400 million from the underlying insured Zombie assets over the next three years, which would leave them with a nearly $600 million loss on their $1 billion of exposure which would materially and adversely impact the company's liquidity.  And as it may take them a while to liquidate assets in a sure-to-be contentious intercreditor fight – their very own World War Z – MBIA may well have to part with the vast majority of the $1 billion in cash, before gathering some of the potential recovery.

Back in April, in a desperate scramble to raise liquidity courtesy of a hail mary Goldman syndicated term loan, we penned "Confused By What Is Going On At JCP? Here's The Pro Forma Cap Table And The Cliff Notes", where in addition to the obvious - that this is merely buying a few months for the melting icecube company which with every passing day is closer to a Chapter 11 (or 7) bankruptcy filing - we also laid out that what Goldman was doing was merely positioning itself to be at the top of the company's capital structure with a super secured and overcollateralized credit facility, through what is effectively a pre-petition DIP...  As it turns out we only had to wait for five months before the same Goldman that raised the company's emergency liquidity term loan turned around and launched a vicious attack on the same company that paid it millions in dollars in underwriting fees. Specifically, what Goldman just did is write a report (perhaps one of the best bearish cross-asset investment theses we have seen to come out of the firm in a long time) in which it laid out, in a lucid and compelling manner, why JCP is doomed. The report is titled appropriately enough: "Initiate on JCP with Underperform: Looking for cash in the name"... and not finding it.

It would appear, as uncomfortable as it may be for the mainstream, that the Fed's Bullard has been reading Zero Hedge and realizes the error of his (and his academic friends') ways. In his speech today he noted: "Many of my friends in academia and in financial markets argue that changes in the pace of purchases should not have an important effect in financial markets (and hence would have no eventual effect on the real economy either). However, the empirical evidence from these two episodes provides striking confirmation that changes in the expected pace of purchases act just like conventional monetary policy." In other words, as we said when QE3 was announced, "it's the flow not the stock that matters" and implicitly - as Bullard confirms - tapering asset purchases has the same effect as hiking rates.

The Fed's failure yesterday to announce some sort of tapering of its QE program, despite the consensus of an overwhelming percentage of economists who expected action, once again reveals the degree to which mainstream analysts have overestimated the strength of our current economy. The Fed understands, as the market seems not to, that the current "recovery" could not survive without continuation of massive monetary stimulus. Mainstream economists have mistaken the symptoms of the Fed's monetary expansion, most notably rising stock and real estate prices, as signs of real and sustainable growth. But the current asset price bubbles have nothing to do with the real economy. To the contrary, they are setting up for a painful correction that will likely be worse than the one we experienced five years ago. Following this playbook, the Fed will likely maintain the pretense that tapering is a near term possibility and that it has a credible plan on the shelf to bring an end to QE. In reality the Fed is stalling for time and hoping that the economy will inexplicably roar back to life. Unfortunately, hope is not a strategy.

Japan’s core CPI (which excludes perishables) surged 0.7% y/y in July, but the upturn is largely due to higher prices for energy that reflect rising import prices due the yen’s weakness. Despite global exuberance at Abe's "progress", BNP notes that there are still no signs of price growth for rent and service prices, factors behind Japan’s protracted deflation. Crucially, BNP believes that Abenomics could lead to four possible medium-term outcomes: (1) Continued deflation (35% probability), (2) Financial repression (40%), (3) High inflation (15%), and(4) Happy end to deflation via revived trend growth (10%). Furthermore, even if this happy ending scenario were to unfold, that does not mean that structural problems, like the swelling public debt and insolvent social welfare, will be headed for resolution.

When people think failed or busted Treasury bond auction, they usually imagine something out of Brazil or Russia where the government was selling obligations and nobody showed up. Of course, in the US, courtesy of the Primary Dealer system and more importantly, of a multi-trillion shadow banking system, where bonds are cash equivalent following rehypothecation and pledging for cash-equivalents with virtually no haircut, there is no risk of an auction failing in the conventional sense, at least not until Bernanke finally manages to irrevocably erode the Dollar's reserve currency status. However, that does not mean that auction's can't "fail" in a purely technical sense. Which is exactly what happened during last week's sale of 3 month Bills, when due to a "glitch" in the system not only was a key Primary Dealer locked out of the auction, forcing the US Treasury to arbitrarily reassign allotment in the parallel 6 month auction, but leading to a wild intraday mispricing in the already collateral-scarce, short term bond market.

The "market is in a state of shock" after the Fed's decision to postpone taper, noted Credit Agricole's David Keeble adding that "Fed credibility and its communication strategy are in tatters." This, as others have noted, will make it many times more difficult to manipulate yields lower in the future as the "Fed is moving to a new way of looking at asset purchases." As we explained in detail 15 months ago, Keeble notes the Fed appears to have clearly signaled that the degree of accomodation is not linked to size of the Fed balance sheet, but that the flow of Fed buying is "very important."

So, it's the flow, not the stock; and that means, as we noted here, that unless The Fed is actively engaged in monetization at every given moment, the impact from easing diminishes progressively; ultimately approaching zero and subsequently becoming negative.

For all complaints about painful, unprecedented (f)austerity, the PIIGS (even those with restructured debt such as Greece) sure have no problems raking up debt at a record pace. Over the weekend, Spanish Expansion reported that Spanish official debt (ignoring the contingent liabilities) just hit a new record. "The debt of the whole general government reached 942.8 billion euros in the second quarter, representing an increase of 17.1% compared to the same period last year. Debt to GDP of 92.2% exceeds the limit set by the government for 2013..." Moments ago, it was Italy's turn to show that with employment still plunging, the only thing rising in Europe is total debt. From Reuters, which cites a draft Treasury document it just obtained: "Italy's public debt will rise next year to a new record of 132.2 percent of output, up from a previous forecast of 129.0 percent."

Moments ago the Treasury reported its deficit for the month of August, which was $148 billion, slightly less than the $150 billion expected. More importantly, it was over 22% less than the deficit from August 2012 when it was $191 billion. And that, in a nutshell, is the main reason why the Fed has no choice but to taper. What the chart below shows is the cumulative deficit of the US for fiscal 2012 and 2013. What becomes immediately obvious is that with the total deficit Year to Date of $755.3 billion running 35% below the $1,165 billion from a year ago, the Fed has far less room to monetize gross issuance.

The theatrics this time around will certainly be spectacular, but the end result will be the same: after much yelling, screaming, posturing and crying, the US debt ceiling will once again be raised. The next question: what will be the new and improved debt ceiling, since $16.7 trillion in total debt was hit back in May? According to the Bipartisan Policy Center, the minimum required permitted debt at December 2014 will be an increase of $1.1 trillion, or $17.8 trillion in total, or about 105% of GDP assuming current growth rates and assuming no more upward revisions to GDP which magically add $600 billion out of thin air the total number.

There is a saying: if in doubt, ask an economist, and do the opposite.

There is also consensus among the people inhabiting the real world -the one that is found outside the ivory towers of the economics departments of all US and global Tier 1, 2 and 3 universities - that the only reason the world is currently in its sad, deplorable and deteriorating economic state (which however keeps making the rich richer), is precisely due to these same economists, whose tinkering and experimentation with DSGE models, differential equations, curved lines, and all such things all of which have no real world equivalent, and specifically due to economists like Greenspan and Bernanke. These two men, both of whom barely have seen the real world for what it is or held a real job outside of their academic outposts, who surround themselves with brownnosing sycophants and who do the bidding of Wall Street, are the primary reason for the current centrally-planned quagmire. Which is why we wonder: is the fact that some 313 economists (and counting) have signed a petition pushing for Janet Yellen (aka Freudian slip "he" if you are the president), and against Larry Summers, sufficient grounds to actually like the outspoken former Harvard head?

Current US Treasury issuance is relatively low due to sequestration and (at least temporarily) less US warmongering in the Middle East. That's about to change, of course, now that the US is getting ready to launch a Cruise missile attack on Syria (we’re already been arming and financing the opposition rebels, including groups directly linked to al-Qaeda for several years now). Bernanke and the Fed doves would like nothing better than another “controlled” war in the Mideast, because with war comes massive debt issuance, and with massive debt issuance comes the transmission mechanism (QE) for monetizing that debt and mainlining it onto the Wall Street banks' broken balance sheets. And yes, they’re still broken, and Ben is still bailing them out at the expense of the American middle class. Make no mistake, Jamie Dimon, Lloyd Blankfein, and every other complicit banker on the Street has no problem with this, or any other, war, regardless of whether such a conflict would destabilize the entire region and would almost assuredly pull Russia and China into the fray. The more the merrier, just keep letting that free QE monopoly money roll in from the 4X weekly Federal Reserve Permanent Open Market Operations (POMO’s).  And with the significant financing needs for a large war effort in the Middle East, say good-bye to “Taper.”