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Sunday, January 24, 2010

Denninger: Weekend Roundup

From Karl Denninger:

Was that a little pre-shock tremor last week?

Let's review.....

Kennedy's former Senate seat - in a state that is so blue that you'd swear everyone is choking to death when you cross the state line, went to a Republican. A thirty-point swing in the polls in literally less than a month away from Democrats. Despite what the pundits have said this was not simply about health care. It was about general disaffection with where the country has gone and is headed.

Since March of last year the banks and stock market generally have rallied hard. But.....

The economy has not in fact improved. There are millions more out of work today than there were in March of 2009. There is scant little improvement in freight traffic. Sales tax and income tax numbers are below where they were last year at this time. This, of course, makes perfect sense - the unemployed pay few taxes.

The plates have been kept in the air only due to two things: (1) People not paying their mortgages for literally a year or more (and thus spending that money generally) and (2) massive transfer payments amounts to $500 billion a year from the government to the people - money that they borrowed, not taxed and collected.

You'd think with people not paying their mortgages the banks would be losing enormous amounts of money and all go under. The big banks haven't, but only because in March they got permission to lie about their "asset quality." This is a short-term game and relies on the cash flow being sufficient to (temporarily) cover up the truth. But the asset quality deterioration continues and the truly ugly reality isn't even found in the first mortgages - it is in the fact that all the home equity lines out there behind an underwater first mortgage that defaults are worth zero. These loans are concentrated in the "big banks" - and yet they are all carrying this paper at values assuming they'll be able to collect it.

Best of luck, boys.

In other words, the stock market rally has been about not improving economic prospects but rather utter BS, lies and scams. Let's look at some basic statistics:

15 stocks in the S&P 500 have a P/E over 100. 23 have a P/E over 60. 37 have a P/E over 40. 65 have a P/E over 30 and 152 have a P/E over 20. 220 - nearly half - have a P/E over 13, the historical long-term average. The latter statistic is trotted out from time to time to claim that the market as a whole isn't overvalued, but 125 stocks in the S&P 500 have a negative P/E - that is one quarter of the S&P 500 has negative earnings.

In the NDX (Nasdaq 100) believe it or not there are 13 stocks with a P/E over 40. But 39 have a P/E over 20 and 21, or 21%, have negative earnings.

People say we should ignore the past and focus on "predicted" earnings. But how accurate is that? Did those predictions correctly foretell the plunge in 2008 and early 2009? Nope. So why would you use them today, when they have a proven record of being wrong?

So how in the hell has the market rallied to the degree it has?

Simple: The market is a read of "fear and greed", and as such as people perceived that thievery and scamming would continue to be profitable the market has reflected that expectation in price.

But things are changing. It has been reported that Wall Street bonuses will total some $145 billion. That's 1% of GDP - and is absolutely obscene. The people have figured out that this is really nothing more than Wall Street firms sucking the blood of the citizens, and while it would be ridiculous in a good year where everyone is flush with lots of spendable income coming on the back of a year where millions of Americans have lost their jobs, taxes are going up, cities and states are going bankrupt and the economy has been and is for crap it is the sort of thing that stirs thoughts of boiled rope, lampposts and resurrection of the guillotine among citizens.

The Senate went so far as to demand that the citizens bare their necks once again by filibustering a vote to end TARP immediately.

Democratic leadership opposed the amendment because they felt it would have handcuffed Treasury Secretary Timothy Geithner in his efforts to ensure the stability of the financial markets.

In other words, to make sure those $145 billion in bonuses could be paid - out of your pocket.

Of course this was just the last piece of idiocy. Fannie and Freddie had their losses transfered "in entirety" to the taxpayer on Christmas Eve - after the market closed and while nobody (they hoped) was watching.

The loss of the Massachusetts Senate seat may have rocked the foundation though. It sure led to President Obama deciding to roll out Paul Volcker and a proposal to end proprietary trading by banks - an abusive practice that has certainly played a big part of "heads I win ($145 billion), tails the taxpayer loses."

Is it enough?

Hell no.

Nor does it go to the core of the problem.

I know I keep hammering on this but its important - we cannot have a sound economy when the "earnings power" of Wall Street is entirely focused on stealing a kid's candy and sucking your blood - literally. Yet that's what it's been.

The entire premise of Wall Street (and banks generally) is to "expand credit." You hear it from Obama and you heard it from Reid yesterday in his begrudging "I might vote for Bernanke" claim:

Reid said that Bernanke "must redouble his efforts to ensure families can access the credit they need to buy or keep their home, send their children to college or start a small business."

There's the statement of the problem right "in your face."

Credit, folks, is just a fancy form of the old Wimpy character in the Popeye Cartoons: "I would gladly pay you Tuesday for a hamburger today."

The reason the market collapsed in the fall of 2008 and spring of 2009 is that the eating of hamburgers exceeded the ability to pay for them Tuesday.

This should not have happened and indeed it is Bernanke's job to guarantee that it does not, as mandated in The Federal Reserve Act (Title 12, Chapter 3, Sub1, Sec225a:)

The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.

In other words, the Federal Reserve does not set interest rates. It is charged under the law with controlling credit growth such that all the hamburgers you eat today can be paid for Tuesday, on balance, so that production and thus the economy grows at a sustainable rate.

When The Fed violates this prescription, as it has for the last 30 years, you set the stage for a credit boom - and subsequent bust.

Yet to get the boom (and then bust) you need more.

See, unbridled credit growth isn't really under The Fed's control, at least not in the main. Sure, The Fed can irresponsibly grow credit aggregates entirely within the government sphere where there is no private market activity to stop it, but in the private markets this is not possible all on its own. That is, the Fed can stop the expansion of credit but it can't start the expansion; it has the ability only to place a cap on credit growth but not a floor.


Because in order to irresponsibly expand credit - that is, to grant credit to more and more people in larger and larger amounts, beyond that which is justified by actual economic expansion, someone has to get screwed.

That's an inescapable fact - growth of credit that is supportable by output is both reasonable and sound. Growth of credit beyond that rate can only occur if some of the people it is granted to can't pay. Given full disclosure of the quality of said credit it is unmarketable.

If you were to mandate that all lenders had to hold their loans on their balance sheets then lenders would be very unlikely to make an unsound loan, as they would have to eat it.

But securitization (and trading generally) of credit obligations (that is, debt instruments of all sorts) is not necessarily bad. Indeed, a debt (for the creditor) is an asset to the person who made the loan, so why shouldn't he or she be able to sell it like any other asset - a house, a car, a boat, a backhoe or a combine?

We recognize in the law that the sale of a car with known-bad brakes to someone without disclosing that fact is an act of fraud. It is illegal to do that, just as it is illegal to sell a car and intentionally lie about the number of miles it has been driven (by, for example, rolling back the odometer.) Such an act in business is widely recognized as fraudulent and exposes the person who does it to both civil lawsuits and criminal penalties.

This is where the fundamental disconnect between Wall Street (and the stock market over the last nine months) and reality on Main Street lies.

We have done nothing to dissuade fraud and lies in the credit markets - quite the contrary. We have further enabled those lies, and that is why the stock market has "recovered."

The dive during this last week - some 500 pts on the DOW and nearly 60 handles on the S&P - was not due to Mr. Brown's win, nor Obama's rant against the banks.

Rather, it happened because market participants are sensing a crack in the government's ability (but certainly not desire!) to keep the fraud going, to keep the lies from being exposed, and to keep the losses hidden where nobody can see or act on them.

That the truth will eventually come out, and the pyramid scheme that has "enabled" this unbridled credit growth to occur will ultimately collapse, is a certainty. We saw a piece of it in 2008 and 2009, but only a piece. By aborting the market's ability to price in that fraud and accurately represent earnings capacity as a function of actual economic activity as opposed to scams, obfuscation and lies we have done even more damage to our economic future.

President Obama owns all of that additional damage, as it all - every bit of it - happened on his watch. The possible embedding of $500 billion in structural deficits is a part of this - money we don't have and ultimately will not be able to borrow. The pressure from Geithner, Obama's employee, to demand "mark to fantasy" accounting, allowing banks to hold HELOCs and other loans at values assuming payment where such is very unlikely to occur. The pressure, temporarily sated, from the Wall Street banksters to take "just another drink" from your jugular vein, much like the vampires in Daybreakers, while those on the street are blithely unaware that in the "harvesting lab" all of their sources of blood are literally dying off.

There are many pundits who say that the sell-off this week was an "over-reaction" in that the big banks will find a way around Obama's plans, even if he manages to get them through Congress.

They're probably right on the latter, but like most who focus only on the immediate they're missing the forest for the trees.

Today's valuations in the market can only be sustained if you believe that credit can be expanded from today's approximately $53 trillion (total system-wide) to about $95 trillion over the next ten years. To believe this you must believe that either (1) there is more payment capacity for interest and principal in the economy than is being used - a preposterous notion when the entire collapse began due to people being unable to pay their debts or (2) that we can grow GDP by an average of 7% annually over the entire next decade without fail.

The last five decades of history says that #2 is flatly impossible.

If neither #1 or #2 can happen then what you saw this week is a warning, just as you saw warnings in the summer of 2006 and the early months of 2007. A sell-off triggered by a fleeting recognition that the values being expressed in the credit and stock markets do not reflect forward earnings capacity but rather the fact that Wimpy indeed cannot pay for his next hamburger come Tuesday.

We are only left to argue about when the market has night terrors of recognition and acts accordingly - not if.

Now go read the latest from John Galt's Shenandoah, as well.

And remember -- what credibility will the Fed and the FedGov bring to any rescue efforts in response to a new collapse?


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