The Market Ticker

Remember that "D" word I used?

You know, DEFLATION?

Well, as I noted, the way it comes is via tightening credit. To the point that the attempts to pump and bail out are simply gnats on an elephant's ass.

Its starting. A partial list from the last few days:

• The GSEs will no longer buy some paper they were willing to before (tightening CLTV requirements, especially in "bad" areas - that is, declining markets. Guess what - that'll be all 50 states soon)


• Mortgage insurers are in some cases doubling premiums for certain borrowers, and also tightening restrictions.


• First Marblehead gave up on securitizing some student loans that would have formerly gone to the market without question.


• Moody's put a bunch of SIVs on "credit watch" and basically said that this model was dead, strongly implying that they won't be cut - they'll be destroyed. That's hugely deflationary.


• Bush and Paulson's "bailout" plan for "subprime", if it is anything more than election-year posturing, will instantly decimate investor demand for mortgages that are non-agency paper (e.g. ARMs, Jumbos, etc.) As noted before there are so many stakeholders surrounding the issue of these securities that its not so simple as to say "oh it helps homeowners and prevents foreclosures." Specifically, the AAA-tranche holders could see their coupon cut which might actually be WORSE than the lower tranches going in the trashcan, especially if you can wind down the structure! Those who wrote some derivatives - a requirement for some to buy these securities - will get screwed even though they made the correct bets. Oh, and Congress is now trying to go even further.


• Moody's is now predicting a 30% house price decline. Take the value of all residential real estate and mutliply that one out. Make sure you're sitting down - that's real collateral impairment that hits real credit availability. Deflationary? Uh, yeah.


• Merrill Lynch's latest update is even more bearish, forecasting negative earnings not only for 4Q (duh!) but into 2008. Earnings power stock prices and credit growth in the commercial space.


• Ohio's AG is now potentially after not only the brokers in subprime deals but also the Wall Street investment banks. This is the "money shot" from this week guys; if indictments come out of this for racketeering (and this article strongly hints this may be where the investigation is headed!) it has the potential to actually sink one or more of these companies! Holy liquidity contraction Batman!

That's just in the last two days, and I'm sure I missed a few. The news items have been coming so fast and furious it would be impossible not to.

The Fed can't touch this and neither can the government, but you can bet they'll both try.

Next week we will get the schizoid master of them all, the Fed decision on 12/11. I am personally in the camp of either hold or cut 25 bips, depending on the EFF/FFR spread on Monday. There's a SLIGHT skew towards a 25 bips cut, but not much. In addition the slosh has been going up the last couple of months but hasn't unlocked the credit markets. The BOE cut and was "rewarded" with an opposing move in LIBOR that immediately took a big part of it back in the real world. This is the danger for The Fed - there comes a point where they lose control, and they got a stern warning from the BOE and LIBOR behavior this week.

Oh, and let's not forget the hot wage inflation print from last week. That's the sort of inflation The Fed REALLY fears, because its a genie that is very hard to stuff back in the bottle once it gets out. Still think we might get 50 bips eh? I don't think so!

As those with money go from "ok, I'll lend" to "no mas!" to "get ocularly penetrated!" the deflationary thesis gains legs, and they get longer and stronger.

Here's a quick technical look at the week ahead...

Challenger Layoffs up 15.9% this month.

Leading industries? Auto and energy, along, of course, with financials.

Housing-related layoffs fell? Yeah, right!

Consumer spending appears to have gone off a cliff. Been to the mall lately? Where's the crowd carrying shopping bags? You know, evidence of actual consumption?

I love the people who say "oh but traffic is up!" Well yes, we've trained our Pavlovian dogs well to salivate at the possibility of spending... but when the card is blackened....

ADP Employment report came in up 189,000?! Two and a half times the estimate?

WHAT?!

Friday is going to be really interesting now! Anticipation was that we'd get a horrible print and that would give The Fed plenty of room to cut rates.

Now, well...... wait - didn't the market basically price in 50 bips of cuts over the last week or so with that huge snapback rally? It sure did!

Now certainly, some of that was seasonal hiring (temporary) but what are we looking at here? Are we really going to get more liquidity injections and rate cuts into a market that appears to have no liquidity problems AND no immediate employment problems?

Uh, maybe not. And let's remember that the EFF is trading right at the FFT..... which would imply no movement in the Fed Funds target at all.

Productivity 3Q final +6.3%, Unit Labor Costs down 2% (both final)

You have to wonder where the market put the schizoid drugs. As soon as the ADP numbers sunk in the futures did a moon shot, up strongly, over 1% on all three major indices.

Uh, wait a second - last week we got a moonshot in the indices on the premise that the economy was weakening so The Fed would cut rates (even though The Fed doesn't set rates)

Now we get a strong employment print that suggests that The Fed has no reason to cut rates (again, although The Fed doesn't set rates) and the futures rally again.

And you wonder why I call equity investors "short bus" riders?

Anyway, at the end of the day there's no point in fighting the tape; clearly, the "pump monkeys" are more interested in mainlining some crack than looking at reality.

Oh, speaking of reality, 4Q and FY08 profit estimates continue to come down with the 4Q S&P500 numbers now approaching negative!

But but but....... it was all good, right? In October we rocketed to highs because there was no crunch, there was no problem, 3Q profits sucked but we'd have 11% in the 4th Quarter and double-digits into 2008.

Now profits don't matter either?

Guys and gals, a few things:

• Learn how the banking system and The Fed actually work. The Fed does not set interest rates. The Fed follows the cost of commercial credit.
• You buy stocks for earnings GROWTH. When you have profits DECLINING, it is just plain stupid to be buying stocks. You should be SELLING them.
• Oh, and don't be a polyanna. You can't have "a great market" because "The Fed will ride to the rescue and save the market", and then at the same time have a great market because "Jobs are great!"

This sort of irrational behavior was precisely what we saw towards the end of 1999 and into early 2000.

Oh, and back then you had Abbey Cohen pumping stocks too - just as she's magically reappeared in the last few days to..... pump stocks.

'Nuff said.

Oh, today Bush (and of course Hitlery) trot out plans to "Freeze ARMs for five years".

Do any of these politicians have a brain? Let's think about this one for a minute.

Abrogation of contracts cause the following, immediately:

1. Lawsuits. Lots of them. Illegal "taking", theft by conversion and on and on and on. That will go on for years.
2. The ARM mortgage has been officially taken out and shot. That will cause an instantaneous cratering of the housing market (beyond what's already happened!) in any place where house prices are beyond affordability limits for people on 30/fixed mortgages. That'd be, oh, most of the country.
3. Securitization? Ha! Oh yeah, I want to be long a securitized bond in this situation. Heh, just curious - how many billions worth of ARMs do Freddie and Fannie have on their books? Oh, I wonder what this does to the NIM on their book? AIEEEEEE!

Yeah. This ought to be cute. Wait until the market gets its ARMs around the implications of these schemes....

Here's the technical......

PS: No Tickers until Monday; gonna be doing family stuff.... enjoy!

No, not "Depression."

Deflation.

The name that must not be spoken, according to Ben Bernanke.

Is it inevitable?

Hmmmm..... Steve Liesman on CNBS was all but screaming for (another) 50 bips cut today.

Why?

The credit markets have all-but-locked up. And like a crack addict sniffing the carpet looking for the piece he dropped, the market is screaming for the drug it knows.

Will it matter?

No.

Should you expect that CNBS would ever explain how The Fed Funds Rate actually works? To explain that money is a commodity like any other, and that its cost is strictly defined by supply and demand? To explain that when you borrow $10,000 @ 6% interest, that clear logic (not to mention mathematics) says you must have $10,600 worth of money in the system - a $600 increase - a year for now - or there is no alternative but for you to default on the loan? That a quick stint with a financial calculator - or Quicken - will show that when the "borrowing" $100,000 to buy a house at 6% the money supply must rise to $216,000 over the next 30 years - more than double - for it to be possible for you to make the payments? Naw.

Being honest would mean taking the "BS" out of "CNBS", and actually reporting instead of pumping, and that's not allowed. It would require that people understand that the credit cycle is a natural part of fractional banking, and that it is absolutely impossible for the money supply to grow at the required rate forever without "resets".

The fix is to detox, which means forcing all the crap out in the open, pulling all "SIV" (or is that HIV?) "assets" back onto the balance sheet, and forcing all derivative and complex security contracts to trade on a public exchange with a published bid/ask, and then leave the business cycle alone so we get smaller "resets" instead of really huge ones when everything goes to hell all at once!

Do I expect we'll see that any time soon?

Oh, in 2010 or so, after the full impact of this debacle becomes apparent and the usual "after the fact" outrage comes to the fore in Congress, we'll likely get transparency.

And more meddling to try to void the business cycle.

Well, I guess one out of two is better than nothing, right?

Never mind that this is the same Congress who has taken in millions of dollars in campaign contributions from the same idiots on Wall Street who have been pulling all this crap - and put us in this box - in the first place.

Never mind that after Enron blew up there was wide agreement that off-balance-sheet vehicles were, in the general case, inappropriate. This of course is why every financial out there has been setting them up and going for maximum opacity, rather than maximum transparency.

Recessions are not evil things folks. Neither is the business cycle. Neither will be denied. Attempting to play games and prevent them from taking their natural course leads to very, very bad outcomes.

Recessions and the business cycle clean out the weak businesses. Those who are over-leveraged. Those who do not have a solid product or service at a fair price. Those who are taking advantage of distortions in the marketplace.

We may find that The Fed's "dual mandate" - including "sustainable employment" - is in fact foolish and wrong. That The Fed's only mandate should be to control inflation, and let the business cycle fall where it may.

Of course that is anathema to politicians who believe that there should be a chicken in every pot, a car in every driveway, and a house on everyone's "ownership" list - even if the reality of the situation is that nobody really owns either the house or car due to the crushing load of debt they are carrying on their shoulders that threatens to blow every disc in their spine.

Consequences of all this meddling?

Many and severe.

Maybe disastrous this time around.

Notice that The Fed keeps talking about being very, very concerned about "consumer softness"; that is, a contraction of credit usage.

Why? Well, go back and read yesterday's Ticker. Read it a few times if you need to.

"The Monster" - the debt service monster - is nipping at the heels of The Consumer, and is about to eat him! If the credit monster isn't fed, he devours the principal.

To feed him credit must continue to expand at a higher and higher rate, because he keeps getting bigger and bigger.

Never mind that there is a real tug-of-war in evidence through this entire mess. Congress, for example, is now after the Credit Card companies for raising interest rates not because you defaulted, but because your credit score declined, not to mention all the screaming about the "poor subprime borrowers."

Is this a bad thing or a good thing? Hmmmm... if the card industry is not allowed to raise rates, they will simply cap limits. If you can't make loans at rediculous rates and fees, with less-than-worthy borrowers you simply won't loan at all.

When the credit monster gets starved for dollars he chooses to eat you instead of interest payments!

This is what happens, ultimately, when you refuse to take your recessions and business cycles in the ordinary course of life. When you try to "machine" your way out of it. When you lie, cheat and steal.

Refusing to feed the monster means deflation - the "D" word that must not be spoken by central bankers.... for when he runs out of money (interest payments) he instead eats the principal (via defaults) and the system resets.

Never mind that Charles Ponzi set "the standard" for such "growth industries" many years ago, and we know how that one turned out.

Oh, ICSC came in -2.0%. Grinchmas? Some commentators brushed it off saying "oh no big deal." Yeah, ok. When you have projections of holiday sales that are allegedly going to run more than 8% above last year, a print like this can't be viewed as a positive thing.

Here's your technical!

I'm going to "spend" my ticker today talking about something that you're not taught in school, yet is critical to understanding where we are - and where we're headed in the markets.

That is the money and credit cycle.

Let us think for a moment about what money really is. Gold is often called "real money", with the implication that other things used as money aren't "real".

Yet money, in the simplest (and most correct) definition is simply "a medium of exchange."

Through the years feathers, bones, foodstuffs and jewels have been used as money.

But - how is money created? Clearly, money must be controlled somehow, right? Otherwise you could walk over to your closest copier and run some off for yourself..... as much as you'd like. That would anger people, don't you think?

The first thing to get your mind around is that money, credit and debt are all interchangeable. In the world of economists these are known as "fungible" - that is, interchangeable without limit.

Today, when you go to the store and swipe your debit card, you are actually spending credit.

Let's say you walk into a restaurant and eat lunch. At the instant you order, you are in debt for $10 - the cost of the lunch. When you pay with your debit card, you settle that debt by moving $10 worth of credit from your account at the bank to the account at the restaurant.

So far so good.

But - where did the $10 you spent come from?

It was created through credit - that is, debt!

Let's start with a world where there is no money but some people own land. With land I can grow a crop to feed my family, but I first must acquire some seeds. Joe down the street has seeds, but he does not have land. We would both like to eat.

Therefore, I issue a debt to Joe in exchange for some seeds; I create money! I give him a promise to pay him part of my crop if he will give me some seed. He does; what he holds in his hands is, in fact, money. I have created it out of thin air by putting myself in debt.

Now what's the problem with that? Well, what happens to Joe if there is a drought? He has given up his seeds, but there is no crop! He loses. That's called risk.

Because of this risk, he will charge me "interest". That is, he wants somewhat more than the value of his seeds to cover the chance that I will in fact produce nothing with them.

And from this - risk - we sow the seeds of what ultimately causes headaches for the monetary system.

Let's say that today you wish to buy a car. You go into a bank and get them to agree to issue you a loan to buy that car. Let's say the loan is for $20,000. You sign a contract promising to pay back the $20,000 plus a rate of interest, which is charged so that the bank is covered for the risk that you won't pay them, and the value of the car at that time might not be as much as you owe. The car is the "security" for the loan - if you fail to pay, they will come and repossess it.

You now have $20,000 in your pocket, and you purchase the car. (We'll get back to how the $20,000 came to be in a minute.)

If these were the only two transactions in the world, you would soon recognize a serious problem - there is only $20,000 in money in the world, but you owe more than $20,000! The interest you must pay means that you somehow must acquire more money than exists in the world over the life of that loan in order to pay it back.

There is only one solution to this problem - the amount of money in the world must increase.

So the government will just print some more, right? After all, the can do anything they want.

Uh, no. If the government were to do that then the value of all the money currently in existence would go down by the exact amount that they printed. You could pay your debt but the bank would be in serious trouble because the money they got paid back with would not be worth as much as the money they gave you!

So where did the money come from?

It was created by the bank because some people trusted THEIR wealth to the bank to "hold" it for them - that is, they deposited some funds with the bank, and through the system of fractional reserve banking, the bank was thus able to "create" a certain amount of credit for each dollar on deposit.

If that system was short-circuited by a "raw printing" of money by the government, this would result in everyone "upstream" of you being hosed!

This of course is not acceptable to anyone (except you!) - the bank and auto manufacturer, along with the bank's depositors, specifically, would shortly say "no way!" and remove their funds from that system, choosing instead to do something else with it.

While many people believe that raw printing of currency is how governments respond to the need for "more money" or "more liquidity", with the exception of dictatorships this simply doesn't happen.

Instead, more money is created not through direct inflation, but rather through the pledging of more assets - that is, the creation of more credit/debt!

If the government wants to spend more it issues more debt (Treasury Bills/Bonds) which are then sold into the market - with interest attached. Due to fractional reserve banking once those bonds are purchased the funds can then be lent out at a multiple of the money received.

But wait a minute........

Isn't there a limit to this?

Ah, now there's the rub.

THERE IS!

See, there are only so many assets available to pledge. While human industry creates more over time - that is, we get better productivity through innovation and technology - there is a natural limit to the pledging of assets.

What's worse, the growth of money required to be able to meet interest and principal demand is an ever-increasing function. The "power" of compound rates of return is the damnation of compound interest, and in this case, its working against the system as a whole.

When the limit is reached - that is, there are insufficient remaining owners of credit-worthy assets who will (or can!) pledge them in return for more credit (money) being issued to them the system will fail and reset.

This is what happened in the 1930s.

It should have happened after the Tech Wreck in 2000.

But it did not, because when the velocity of money slowed precipitously in the tech wreck and Greenspan followed that velocity down by cutting Fed Funds to 1%, he managed to entice homeowners into pledging their HOUSES as collateral for yet another round of "reflation" in credit!

So the "reset" was avoided - for a while.

But - you saw what happened.

House prices exploded upwards as credit standards were thrown out and anyone who had a pulse qualified for a huge mortgage. The house was thought of as "security", making the loan cheap.

Or was it?

What did the mortgage companies and banks that made these loans know?

Well, what do you think they knew? They sold those loans off into the marketplace, keeping only a little - or none - of the risk for themselves.

Why?

Because they know what likely lies ahead - a monetary system "reset"!

This "last phase" marks a desperate reach for one more group of "suckers."

It is this phase which precedes the reset as debt merchants realize that they are in fact granting credit (creating money) to people who do not really qualify for it and have a high risk of default. As a consequence they will do everything in their power to collect as much of the "spread" (interest) as they are able, but lay off as much of the risk of the "reset" (default) as they can.

"Securitization" can be an element of misleading people into funding debt that will never be repaid because it allows yet another cycle of "credit reflation" while the risk is laid off on those unwitting market participants.

While "securitization" has its place in the credit cycle, when regulation is intentionally ducked by the government or worse, lending limits such as the existing "23A" exemptions are used like heroin given to an addict, the depth of the "reset" to come is grossly enhanced and the number of individuals and organizations that take the pain from the default cycle to come is significantly increased.

Unfortunately the ever-growing interest payment monster is now running into the hard reality that we're just about out of pledgable assets to put behind more credit.

WE ARE NOW FACING A "RESET" IN THE SYSTEM!

What happens in a "reset"?

1. The rate of credit creation slows precipitously as the list of assets that can be pledged dwindles down.
2. The interest and principal payments due on existing debt get close to and ultimately exceed the amount of money in the system, as the rate of credit (money) creation slows.
3. Those who detect this while they still have money pay off their debts, (correctly) deducing that a "reset" is about to take place - and that cash (assets) will have value, while debt will be a millstone that will drag you underwater.
4. Those who are unable to pay off their debts will find that a contracting credit (money) supply leaves them with insufficient funds to pay their debts. Debt defaults at a rapidly increasing rate.
5. The creditors (who granted the credit) will repossess the assets pledged for the debt in lieu of payment, while the debtors are financially destroyed.
6. The destruction of outstanding credit via default shrinks the money supply further, and we go back to #1.

This continues until equilibrium is reestablished, and the cycle begins anew.

Does this sounds kinda like what's going on?

It should - because it is.

Housing loans are defaulting. This is not "contained" to subprime and cannot be. As these loans default at a rate far beyond what was originally envisioned they contract the total amount of money in the system. This then forces defaults in other classes of debt - credit cards, automobiles, and various sorts of commercial credit as the money in the system is insufficient to service the debt that is owed.

This cycle will continue until equilibrium is restored. The depths to which we must go before equilibrium is reached, and exactly when it will initiate, is not possible to know in advance, but that we absolutely are going to undergo this process is known with certainty!

Creditors will end up with all the assets that are pledged on debts that default. Debtors will end up broke.

This is a natural cycle and cannot be prevented; it is an inherent and necessary function of any financial system which involves return for risk (commonly known as interest), and it is not possible to have a lending system that does not compensate for risk!

Whether you're on a gold standard or not is IMMATERIAL, whether there is a Federal Reserve is IMMATERIAL.

This is not taught in school, but it damn well should be.

WE ARE TALKING ABOUT BASIC MATHEMATICS HERE.

Mathematics is the only TRUE science AND IT DOES NOT LIE.

How do you deal with this as a PRUDENT individual?

Bluntly, you should avoid debt to the maximum extent possible, especially long-term debt, because it is not possible to predict exactly when a "reset" will occur - but that resets WILL happen is a mathematical certainty.

For most people, avoiding all debt is simply unreasonable. But when you start to live your life in such a fashion that you are financing your standard of living with long-term obligations you are at severe risk of being bankrupted outright when a "monetary reset" occurs - and odds are, there will be one at some point during each of our lifetimes.

Obviously, governments desire to prevent "resets", because they are terribly disruptive to the economy. They destroy those who have chosen to employ leverage in their financial lives, both corporate and personal, almost without exception. They contract GDP severely as the monetary velocity slows precipitously, and cause huge ramps in unemployment. In extreme cases they can lead to civil unrest or even radical changes in the form of government in a nation (e.g. the rise of Adolph Hitler), especially if the government mismanages the reset process or attempts to bail people out through "direct" monetary inflation.

By the way, before you believe that the government will simply "print money", should that be attempted (or some resemblance of it - e.g. government issues Ts, The Fed buys them and injects the money) the response in the market will be an instantaneous shutdown of private (and outside-US) buyers of debt, as the demand for yields will go parabolic to a degree that the government will be effectively priced out. Since the government needs debt market access to be able to continue to operate, this idea is a non-starter and the government knows it.

The sad reality is that each attempt to prevent a "reset" through meddling in the markets simply makes the ultimate event worse, as the amount of credit that must default to restore equilibrium ratchets higher with each new intervention.

We avoided the "Reset" in 2001/2003, but in doing so we insured that an even bigger one would occur.

Are we now in the beginning of the next "big" reset after the 1930s?

It is not possible to know until we are in the depths of it whether the snowball will gain enough momentum so that it smashes attempts at intervention. Once you can identify with certainty that a "reset" is underway it is too late to position yourself for it.

The risks of this event are now higher than they have been at any time in the previous 50 years.

To believe that we will avoid this event, you have to figure out where the next set of assets will come from that can be pledged for another cycle of credit relfation.

Without that new, unencumbered set of assets, the process of the monetary reset is assured.

Oh, in the news of the day Paulson outlined his "plan" to try to avert foreclosures. Two things:

1. It won't work. Basically everyone who is in trouble is in trouble because they were sold loans that the originators knew they couldn't afford. There is no fix for this; they are due to get a personal "reset." This scheme of giving money to anyone who has a pulse is how the credit expansion was played for "one more round" after 2000; that can't be fixed.
2. Trying to finance this with tax-free munis is a non-starter. Among other things, the coupon required to float those will be obscene, which will kill it right there (you can't loan for less than you pay.)

Oh by the way, Paulson knows about the Credit/Money Cycle. He's NOT stupid.

You won't hear him talk about it, because if was to do so he would be quickly backed into a corner where he'd be forced to either dissemble or admit that indeed, we are very likely facing that very "reset" that he claims he has a way to avoid.

Finally, we would have gotten a new Hindenburg except that the 10W Moving Average, if I'm reading the chart correctly, is falling (and this is one of the requirements); the New High/Low numbers were hideous today.

Oh, 4Q estimates from Thompson for the S&P 500? Now estimated at 1.2% - new update today.

Estimates were 11% just a few weeks ago.

Guess what happens when the street gets its arms around this? Uh, yeah. What's the P/E/G on the S&P 500 with profit growth of 1.2%? Insane, that's where - 10+!?!

Here's your technical!