My Two Cents - "Three Inflection Points"

1/11/2007

What a week. What a week and it is only Friday. It is said that the further you get into a crisis, the more talk you’ll hear about how it really isn’t a crisis at all, but just a bunch of coincidences, happy endings and happenstance. Looking back, this week might be seen as something of an inflection point. A time when the paradigms and dynamics changed. A time when the things we knew would happen all along finally did. More importantly, it was a week when we faced the grim reality that we have indeed moved into the next stage of this crisis. This is the stage of the crisis that will begin to bring real pain to bear on the Middle Class and Main Street.

Ben finally gets with the program

Ben Bernanke finally showed his true colors this week, dropping the annoying reasonable person act and beginning the serious business of massaging the financial markets. If you thought the injections of liquidity seen last year were a lot, then you haven’t seen a lot. Yet. I am quite certain that by the time this all ends, that he will have printed enough dollars to potentially pay the $3 quadrillion figure asked for by a Baker, Louisiana resident in the wake of Hurricane Katrina. Maybe even more. It is for certain that the money he’s created so far has done almost nothing except maybe help the system mark time. We are certainly living in Rothbardian times in which ever-expanding amount of money and credit are needed to produce the same economic result.

The Yen becomes a ‘beneficiary’ of credit market losses

The Yen has been on the rise in recent months moving from a low of around 124 in mid June to 108.95 yesterday vs. the US Dollar. We must be careful, however, in determining what benefits and detriments are. In today’s fiat world, a rising currency is generally regarded as a bad thing. Bad for who is the more important question.

The Yen carry trade is possible because of two things: First, the Bank of Japan has no qualms about destroying its currency and will print as much fuel as is needed. Second, the interest rate on Yen borrowed in Japan is currently at .5% For comparison, rates in New Zealand are 8.25%, 6.75% in Australia, 5.5% in Great Britain, 4.25% in the US and 4% in the Eurozone. At these spreads it is easy to borrow money at ridiculously low rates in Japan and invest in more profitable investments and other currencies. The Yen carry trade has been provided much of the fuel for recent record runs in the DOW and S&P500 in the US.

The carry trade, once valued at $1.4 Trillion has been pared recently. Current estimates place the value of the CT at about 800-900 billion. There may be a rough patch for carry traders in the Japanese currency coming in 2008 as well as credit losses continue to hamper investment in higher-yielding currencies. The fear of the unknown at this point appears to be the driving force. Many institutions are estimating the Yen to appreciate to the 100 level in 2008, which will further constrict the carry trade. However, it should be noted that depending on policy decisions, other carry trade opportunities might emerge. Sub 1% US interest rates coupled with a weak dollar and a flight from perceived risk in the US markets could touch off a dollar carry trade. The biggest risk to this assessment is the fact that it is unlikely for rates here to persist at sub 1% levels for any length of time (if they get there at all).

Countrywide’s ninth-inning rescue

The banking system in the US now resembles a Rocky movie more than anything else; except for the end. The banking system here is on the ropes, being relentlessly pummeled by the consequences of prior poor decisions, the disregarding of risk and overall greed. It has gotten pick-me-ups from Singapore to the U.A.E. and still is teetering on the brink of collapse. The mess began almost a year ago with the failure of the intermediate lenders such as New Century Financial and a slew of others. The crisis deepened to larger originators over the summer and is now systemic in scope. The entire system is infected with the virus, and the worst part is that it is hard to tell who the sick ones are. It is the worst kind of crisis. Turn to the right place and you might get some temporary relief. Turn to the wrong place though and you get zapped. Keep in mind that all of this is going on during a period when the bonus dollars were spread thickly across Wall Street. I continue to find it amazing how companies that are pinched and frugal when it comes to dividends for shareholders can have so many dollars to hand out to executives in the form of bonuses. Also bear in mind the losses incurred in 2007. Congress could have done us all a favor before they went on their extended Christmas holiday this year by passing a moratorium on lavish bonuses for executives while stockholders languish and absorb the losses.

Think for a minute of the impact of an election-year bankruptcy of the country’s largest mortgage lender. Think of insolvent Freddie Mac and Fannie Mae. Think of all the inflation being poured onto this fire (which was fueled by inflation to begin with). Countrywide simply could not be allowed to fail in this environment. Failure was not an option. And in the eleventh hour, here comes Bank of America to the rescue with a $4 Billion stock buyout. This is the second time that BofA has stepped in to help the embattled mortgage lender. In August, BofA spent $2 Billion buying preferred securities that could subsequently be converted into stock at $18/share.

There is a good bit of evidence which points to the fact that Countrywide was but a few days from insolvency. This buyout may have come from BofA, but it reeks of Paulson, Paulson and more Paulson. Yes, the bailout is in full swing folks. Get ready and hold onto your wallets; 2008 is going to be an interesting year.

Andy Sutton holds a MBA with Honors in Economics from Moravian College and is a member of Omicron Delta Epsilon International Honor Society in Economics. This article and other information is located at http://www.my2centsonline.com Please feel free to distribute, copy or otherwise disseminate this information.