Three Bank Monty - Monday's Global Bank Failures

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

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The nationalization of the world's banking systems took a big step forward on Monday, with major bank failures happening in the U.S., England, and the European continent. In all cases, the respective governments are getting a piece of the action. While it is generally acknowledged that socializing anything will lead to inefficient operations, general dysfunctionality, and substandard practices, apparently the governments of a number of developed economies have decided that socialized banking is an important component of the solution to the current economic crisis. These are of course the same geniuses that created the government policies that allowed the current economic crisis to take place and then remained completely oblivious to them as they unfolded.

In the U.S., Wachovia now no longer exists. Only last week it was the fourth largest American bank. Over the weekend the FDIC 'facilitated' troubled financial giant Citigroup's purchase of Wachovia's banking operations. Wachovia's own demise can be traced back to its takeover of mortgage lender Golden West Financial in 2006. Citigroup is supposed to be absorbing $42 billion in Wachovia's losses, but this will not happen if the banking bailout plan passes because the bill states that the taxpayers pick up the tab in such circumstances. The FDIC is supposed to cover any remaining losses and in exchange for doing so will get $12 billion in preferred stock. Nevertheless, in a statement that seems to lack both truth and consistency, the FDIC said that the Wachovia bailout won't cost its deposit insurance fund anything. Even though Wachovia's stock fell to 91 cents in Monday's before the bell trading (under one dollar is the market's statement that a company is insolvent), the FDIC claimed the Wachovia did not fail. If you believe that, you are also likely to believe that a pile of manure is a mountain or roses. Wachovia is indeed the largest bank failure in U.S. history (at least for now).

While Wachovia was collapsing in the U.S., the Benelux countries (Belgium, Luxenbourg and the Netherlands) had to bailout Fortis NV with a $16.4 billion cash infusion. In return, the three governments will get a 49% stake in the bank. The demise of Fortis should be seen as a derivative implosion similar to that which brought down U.S. insurance giant AIG. Fortis has had to write down its credit default swaps (CDOs) by 78% so far and this essentially made it insolvent. As was the case for Wachovia, the downward spiral for Fortis was also caused by it taking over a financial company with a dicey lending book. Fortis was part of a three bank consortium that purchased ABN Ambro in October 2007 (long after the credit crisis was front page news). The lead bank in that consortium, Royal Bank of Scotland, is on New York Investing's likely to fail bank list and its stock was down 11% in early Monday trading.

England doesn't have to wait for a future bank failure however. The British government on Monday was forced to nationalize Bradford and Bingley, taking over its $91 billion mortgage operation. The Brits also paid Spain's Banc Santander $33 billion to 'facilitate' its purchase of Bradford and Bingley's savings business. Bradford and Bingley specialized in mortgages for rental properties and it was reported that there had been no income verification for at least 17% of its loans. This was the second bank nationalization in England, Northern Rock was the first, and followed the government arranged purchase of HBOS Plc by Lloyds TSB Group only nine days ago. It is quite obvious that it will not be the last either. Total mortgage lending in Great Britain has fallen 95% (yes 95%) in the previous month. A credit collapse of this magnitude makes the dislocations of the 1930s Great Depression pale in comparison.

NEXT: A Bridge Loan to Nowhere - The Wall Street Bailout Plan

Daryl Montgomery
Organizer, New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

The Inflation Versus Deflation Argument - Part 5

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

If the deflationists aren't really discussing consumer price inflation, what is it that they are really talking about? To figure this out, it is helpful to seperately analyze the two components of the deflationist argument, bank credit and money supply, since they operate in very different ways and combining them obfuscates the picture.

Since people don't take out a bank loan to buy a quart of milk or a tank of gas, but they do borrow to buy a house and financial instruments, there is a direct relationship between bank credit and asset prices. The effects of increases or decreases in bank credit are likely to show up relatively quickly in prices for real estate, bonds, and stocks. Only much lately are they likely to impact consumer prices and even then they will represent only one of many components (currency exchange rates being potentially far more important).

This proposed direct relationships between credit and asset prices and currency and consumer prices seems to be well supported by real world observations. In the late 1920s U.S. there was a massive increase in credit and strong bull markets in housing, stocks, and bonds, yet consumer prices were dropping. Even though the U.S. currency didn't float at the time, capital was flowing into the New York from around the world and if the value of the dollar had been market driven, it's exchange rate would have been rising. A similar picture exists for Japan in the 1980s, although there was an even more massive asset bubble and the Yen was experiencing a far more significant rise that the U.S. dollar would have had in the 1920s.

In contrast, the U.S. in the 2000s was a period of declining currency values, the dollar peaked in 2002 and lost more than a third of its value by 2008. Bank credit expansion during this period led to massive bubbles in real estate and related debt instruments, with the S&P testing its 2000 bubble high in late 2007. When bank credit began its severe retraction, prices for real estate, non-government bonds, and stocks had significant drops. Consumer prices on the other hand accelerated higher. One major reason was the rising price in commodities. Since commodities are priced in dollars, they will go up if the U.S. dollar goes down.

The other component of the deflationist argument, money supply, has an obvious lagged effect on consumer prices. Changes can show up many years later. An examination of a money supply chart from the 1970s illustrates this quite clearly. M3 growth peaked in 1971, yet U.S. consumer price inflation didn't have an intermediate term peak until 1974 and the final high wasn't reached until 1980. The large rise in M3 in 2008 isn't likely to have its full impact on consumer inflation until some time in the 2010s.

Since deflation inevitably follows serious inflation, the deflationists at some point will be correct that there will be deflation in the United States. Worrying about deflation now though is like closing your windows and turning up your heat in May because you are worried about a cold winter coming.

For notes related to this talk, please see, 'Inflation vs Deflation Argument' at:http://investing.meetup.com/21/Files

Daryl Montgomery
Organizer, New York Investing meetup
http://investing.meetup.com/21

For more about us, please see our web site: http://investing.meetup.com/21

The Inflation Versus Deflation Argument - Part 4

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

While it is true that the U.S. experienced consumer price deflation in the 1930s and Japan did so in the 1990s and both experienced sharp drops in bank credit, there are few if any other similarities to the current situation in the United States in 2008. The situation in the 1930s U.S. and 1990s Japan is also a bit more nuanced that the deflationists would have you believe. In the late 1920s, the U.S. did see a big rise in money supply and credit, just as occurred in the U.S. in the early 2000s. According to the deflationists, this should have resulted in rising U.S. consumer prices at some point. It did not. Prices actually fell between 1926 and 1929. A similar thing happened in Japan in 1986. While consumer price deflation did appear in Japan after its banking system literally fell apart, it didn't show up consistently until 1999, nine years after the Japanese asset bubble began to burst. Based on these observations, the relationship between consumer prices and money supply and credit seem to be rather tenuous at best.

The deflations in the 1930s U.S. and 1990s Japan did have an important element in common that does not exist today - dropping commodity prices. As early as the spring of 1929, farm commodities in the U.S. experienced a sharp drop. All commodities declined in the crash month of October and then they crashed themselves in the spring of 1930 . While commodity prices didn't crash in the 1990s, they were weak throughout the decade. Oil reached its price low of just over $10 a barrel in 1998. Ten years later it would be almost 15 times higher. Not only were commodities not declining in the 2000s, but they were experiencing major price increases resulting in significant inflation in the U.S. and most of the world. The commodity picture in the 2000s was just the opposite of the early 1930s U.S. and 1990s Japan.

The import/export and deficit picture has no similarity to the contemporary U.S. either. In the late 1920s, the U.S. had a massive trade surplus and was the biggest creditor nation in the world. Its boom had been built on exports as was the case for Japan in the later twentieth century. Drops in exports damaged both economies. On the other hand, the U.S. in the 2000s was the biggest debtor nation in the world having both a massive trade deficit and government debt, which required heavy borrowing and had inflationary implications. Japan in the 1980s was similar to the U.S. in the 1920s and both were very dissimilar to the U.S. in the 2000s.

Currency also plays a different role in all three scenarios. The U.S. was on the gold standard until 1933 and even after that the currency didn't float. The Japanese yen traded relatively flat during the 1990s. In neither case, did currency have a significant deflationary or inflationary effect, in contrast to the U.S. in 2008 where currency played an inflationary role. The U.S. dollar dropped to all time lows in late 2007 because of the Federal Reserves easy money policy. Since the U.S. imported much more than it exported, this raised import prices and had a bigger inflationary impact than it would have had otherwise.

NEXT: The Inflation Versus the Deflation Argument - Part 5

For notes related to this talk, please see, 'Inflation vs Deflation Argument' at:
http://investing.meetup.com/21/Files

Daryl Montgomery
Organizer, New York Investing meetup
http://investing.meetup.com/21

For more about us, please see our web site: http://investing.meetup.com/21