DummySpots.com

It is not the responsibility of the Federal Reserve–nor would it be appropriate–to protect lenders and investors from the consequences of their financial decisions. (from Ben Bernanke’s Aug. 31 speech)

The Chairman is exactly right, and I’d go a step further: It is also not the responsibility of the taxpayers to protect lenders or investors.

As I’ve mentioned, one of my core beliefs is that true adulthood and maturity are the result of learning to accept and deal with the consequences of our own decisions. More importantly, it’s learning to consider the consequences before we commit to a decision, not just whether “I want it.”

Giving others (our children, our spouses, entitlement recipients, Katrina victims, subprime borrowers, Citibank, Long Term Capital Management, the United States Congress) the freedom to make decisions without having to consider the consequences does nothing but induce a spiral of more and more irresponsible behavior.

It is our job, as parents, friends, citizens, fellow humans, to maintain the connection between Freedom and Responsibility. That’s how they become independent and self-sufficient, instead of mewling, manipulative exploiters unable to control themselves and always needing someone else to bail them out.

The Problem With Subprime Defaults: The Deflationary Shock

Unfortunately, the consequences materializing from the actions of irresponsible lenders and borrowers don’t affect just them. Otherwise the solution would be easy- let the bums feel the sting! Trouble is, that sting is like a firecracker under a butane tank, the butane tank which is our entire economy- and those consequences would snowball into something that seriously hurts all of us.

You see, due to the way our fiat money system works, debt is money. Banks create money by loaning their excess reserves (how much excess exists in the system at a given time is one way the Fed exerts its influence). These loaned dollars (someone’s debt) are in turn deposited by the recipient, and the bank gets to count that money on its balance sheet, and turn around and loan most of it back out, which is then re-deposited somewhere else, etc.

This multi-generational money creation machine (think biblical- “10 dollars begat 9 dollars which begat 8 dollars…”) is how a few billion dollars added to the system can balloon into many many billions of new dollars floating around our economy in search of a product to purchase (or a 3BR, 1.5BA w/ 2CG and WBFP).

Now the ugly flip side: It works the same way in reverse. Drain a few billion dollars out of the system, and it results in many many billions fewer dollars floating around, since the cornerstone of the pyramid has been removed.

Fewer dollars chasing the same products- that’s also known as deflation, and as it ripples through the economy it affects us all. A deflationary spiral occurs when such a ripple adversely affects other borrowers (deflation makes debt more expensive and harder to pay off with future earnings), and those borrowers begin to default, which removes more money (debt) from the system, which compounds the problem and makes the deflation worse, and on and on…

Eventually the system can contract so much that massive defaults begin to occur even in “prime” loans. If we get that far, we’re in another Great Depression.

How To Prevent The Losers From Triggering A Depression - Refinance

As with your kid who’s been arrested for getting caught smoking pot naked in the back seat of the Lexus with the preacher’s daughter… it’s a little too late to go back and say, “DON’T DO THAT, YOU IDIOT!”

What we’re faced with is a choice between the lesser of evils. To do nothing and “let the bums feel the sting” is to do great damage to our own financial future through the mechanism of debt-deflation.

To write hundreds of billions of dollars of taxpayer-funded checks to the banks and relieve the bums of their responsibility is even worse. As I described above, that would just encourage more of the same behavior, from the bums and from the banks.

As much as possible and although we hate it, we need to prevent the bums from defaulting, but we need them to continue to carry their debt and make payments on it. The answer? Some type of refinancing solution. In this scenario, the banks take a little hit, the taxpayers take a hit (the refinanced loans would doubtless involve some type of government backing, which means it would cost us… but significantly less than actually taking on the debt itself), the irresponsible bums keep their loans at a lower rate which (hopefully) they can make payments on. The debt-money stays in the system, and we have a much better chance of weathering the coming recession. Oh yeah, did I mention that?

I believe this is why Chairman Bernanke is encouraging banks and legislators to pursue a refinancing solution, as in his letter to the honorable Chuckey Schumer:

The federal banking regulators have encouraged banks and thrifts to work actively with troubled borrowers to modify loans or to refinance as needed to avoid default or foreclosure…

and

It might be worth considering at this juncture whether the private and public sectors, separately or in collaboration, could help the situation by developing a broader range of mortgage products which are appropriate for low-and moderate-income borrowers, including those seeking to refinance. Such products could be designed to avoid or mitigate the risk of payment shock and to be more transparent with respect to their terms.

In short, there is no easy way out of this mess. There’s painful, and there’s more painful. Those are our choices, our consequences for allowing a system which rewards greed, immediate gratification and irresponsibility.

We got our buy signal, and we got long. In the previous post I’d said

I see Thursday 8/16/07 as a PRIME, and possibly the LAST, opportunity for a buy signal to emerge before we have to look away

and I also said

I will get long very aggressively on any good OGRe (Opening Gap Reversal) once it trades back into today’s range.

This OGRe wasn’t a pretty one, however. (For a more thorough discussion of how I view OGRes, see this post about Trading Opening Gap Reversals). We got our gap down, but then spent the day alternating between ecstasy and agony with those wide swings… until 3pm EST, that is. Then we got that outrageous “4 dollars straight up in 50 minutes on huge volume” rally right at the end:

The daily chart looks more like a nice clean OGRe since it doesn’t show those intraday vascillations:

Note that, per the Gospel According to Steve Nison (aka Japanese Candlestick Charting Techniques) it’s not a hammer since the lower shadow isn’t at least twice the length of the real body. However, the real body on this monster is $2.31 wide, and the lower shadow is another $2.79 below that, which is still jaw-dropping.

Long, But Not For Long

This trade, like most I’ve written about the last few months, is based on my current RSI(4) -based methodology. These trades typically last from a few days up to about three weeks, with the majority on the “few days” end. So this is still a quick little swing trade in my book, not a pronouncement that we’re headed back for all-time highs.

So Was This The Bottom?

I don’t think so. The macroeconomic factors haven’t resolved in the least. In fact, I’ve continually made fun of the talking heads’ using euphemistic language like “housing slowdown,” “slump” and the ubiquitous “soft landing” … we’re not even close to the last shoe dropping on the housing bubble (can we all agree on that term now?). I firmly believe there’s a Dragon in the Corner and that we’re about to enter the recession portended by the yield curve inversion starting in December 2005 (remember, the recession often takes 18-24 months to show up, but of course the choir has endlessly sang “This Time Is Different”).

Note the deflationary symptoms rapidly emerging: tight credit, reduced money velocity, and hey bugs… check your gold prices– who says gold goes up because people buy it when they’re scared? People are scared as hell right now, but gold is faltering because of the risk of big “D”. Oil’s down, too, thanks to the stronger dollar. And yes, I believe the Fed’s response will be to lower the target Funds Rate soon and start increasing money supply vigorously, but in this case, I’d agree that it’s about their only choice since we’re so far down the Rabbit Hole.

Also, I’ve extensively (exhaustively, painfully) backtested the RSI(4) method I currently use, and it’s told me something: in uptrends, it tends to cycle from the high 20s to the mid 80s, sometimes spiking into the 90s (i.e. skewed upwards overall). In downtrends, on the other hand, it tends to drift up into the 70s, then soar down into the low teens or even lower. The last few cycles, it’s been acting less and less like these are “pullback in an uptrend” swings, and more like full-fledged downtrend thrusts. I may be switching from buying drops to shorting rallies in the very near future.

So You’re Overtly Negative, But You’re Aggressively Long Right Now…

Precisely!

A Larry Kudlow piece today contained an analogy by one of the guests that was just perfect: He mentioned that Repos (aka Repurchase Agreements) are basically like the Fed acting as a pawn broker for the banks. And he’s exactly right. Here’s how it works…

Bubba Has A Liquidity Crisis

When one of my redneck buddies blows too much of his pay on beer and fried chicken, he sometimes runs a little short on cash for the routine stuff. You know, like rent and electricity. So he takes an asset, say the wife’s wedding ring, down to the pawn shop on Texas street, and the guy behind the counter gives him a few hundred bucks.

Bubba’s a good guy at heart, so he uses that cash to pay the rent or buy the groceries. Then when he gets his paycheck on Friday, he heads back down to the pawn shop and pays the broker the cash back, plus a little interest, of course, and brings honey’s ring back home. All is well, at least for the moment.

Banks Are Bubbas Too

What has been happening the last few weeks is that banks (redneck beer-bellies that they are) have been having trouble meeting their own financial obligations because no one wanted to pay the asking price on some assets they were trying to sell. What assets? Subprime mortgage paper- the notes that amount to I.O.U.’s from millions of our irresponsible neighbors who got into houses they couldn’t afford.

Well, if the Fed just stood by and let the banks look at their creditors (ironically enough, often that’s each other) with a big blank stare and a hangover, things would get really ugly really fast. Banks would begin to default on their obligations and the domino effect would crash the entire economy, possibly in a matter of days.

So, Uncle Ben Bernanke straightens his “Cat Diesel Power” cap, spits some Skoal juice into his ever-present styrofoam cup, and steps up to the pawnshop counter to save the day.

So far, what we’ve described is your normal, everyday overnight repo operation. “Repo” is the nickname for Repurchase Agreements, which simply means the Fed maintains liquidity by loaning the banks cash with some asset as collateral, and the banks then repurchase those assets in the designated time (hence the name- overnight repo, 3-day repo, 14-day repo, etc). This is how Repos differ from other Open Market Operations where the Fed purchases treasuries to permanently add cash to the system… repos add cash temporarily, then take it back, just “keeping the wheels greased,” so to speak, no net long-term change in the overall money supply.

Sounds familiar, no? That’s exactly what the pawn broker does for Bubba. He enters into a repurchase agreement with him for the wife’s ring.

Good Money for Questionable Collateral

But here’s the crucial difference with the Fed’s recent actions: they have agreed to take the unwanted subprime paper as collateral on the repo loans. Typically they would be getting Treasury notes as collateral. Imagine the pawn broker giving Bubba the cash loan and taking as collateral Bubba’s used wristwatch, which was valuable once upon a time, but no one wants it now because Bubba’s been wearing it while he replaced timing chains and camshafts, and it’s all banged up.

The pawn broker would have to be pretty worried about Bubba’s financial state to take a risk like that, wouldn’t he?

The Federal Reserve is providing tens of billions of dollars in liquidity to keep the banking system functioning, and is accepting moldy subprime paper (aka Mortgage Backed Securities) as collateral without significantly discounting those securities (it wouldn’t be as big a deal if the Fed were loaning, say, 40 cents on the dollar for the value of these notes).

That tells you how worried Uncle Ben is about the banks and their liquidity problem. And that’s the real news.

On July 26 I wrote the following:

I think stocks are being sold, bonds are being bought and yields are dropping precipitously in anticipation of something we “average” people don’t see yet; some economic news which eliminates any possibility of the Fed raising interest rates (not that there is such a possibility right now anyway), and in fact points to the possibility of lowered rates. That would only happen as a way to increase liquidity in the face of some severe, “unexpected” developments.

Now we have the story that the illustrious James Cramer is pleading for a Fed “rescue”.

I’ve written repeatedly over the last couple of years about how our economy’s best hope was for growth strong enough that the Fed could comfortably raise interest rates back to, or even better, above historical norms in order to contain that growth and its accompanying inflation. A strengthening dollar which would give China room to revalue its yuan without crashing our economy or bond market. I felt, and feel even more so now, that such strong growth lies somewhere between highly unlikely and impossible.

I wrote that the alternative (tepid growth in spite of low interest rates- and mortgages still under 7%!- and in spite of an extremely weak dollar) would paint the Fed into a corner and leave them with no wiggle room to do anything but start lowering rates back towards zero to try and re-stimulate our irresponsible debt- and- spend binge, the cycle which has gotten us to this point in the first place. Lowering from here (the lofty 5.25% level!) would cause the dollar to go into a spiral. The Chinese and Japanese would have to buy massive quantities of U.S. Treasuries to try to keep their currencies cheap relative to ours. I believe the current figure is that China is now up to about 1.3 trillion dollars worth of… us. At what level do we start referring to them as “lord”? When their ownership exceeds our GDP (about 10 trillion right now)?

The hangover we’re just beginning to feel is a very intense one, built up starting with the Greenspan-Bush delay of the 2002 “recession- which- wasn’t” by flooding the economy with unprecedented liquidity, resulting in the explosive increase in prices (stocks, homes, etc) we’ve subsequently seen. Milton Friedman would be proud. Not.

It’s not unlike drinking a fifth of whiskey to avert the pain we brought on by sucking down a 12-pack yesterday. We have not averted the pain, we have simply delayed it… to be paid later, with interest. And what Cramer is calling for is the equivalent of yelling, “Bartender!“. The problem has developed over years, and will resolve over years. It’s why I laugh when I hear silliness like, “Do you think the housing slowdown is over?”… it’s not a slowdown, it’s a drastic reversion to the mean, and at best, we’re at the “end of the beginning,” with the fun part yet to come. This stuff takes time.

Let’s hope the Fed does not “rescue” the billionaire parasites until their bleeding begins to threaten the entire economy (admittedly, that won’t take too long). For the long-term good, let’s fess up, take a couple of aspirin, and get ready for our hangover.