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Generational Dynamics Web Log for 22-Apr-08
Investors back in full bubble mode, after concluding that the crisis is over

Web Log - April, 2008

Investors back in full bubble mode, after concluding that the crisis is over

However, the fundamentals haven't changed.

There's a great deal that's bizarre in today's global financial system, but it's hard to beat what happened on Friday.

Early in the morning the "Dow futures" were flat, indicating that the stock market would probably be flat when it opened at 9:30 am.

But at 6:30 am Citigroup announced really terrible earnings and additional writedowns of assets. The news was awful. So what happened? The Dow futures rose by 200 points, and the day with the market up almost 2%. It was truly astonishing.

One financial pundit after another said the same thing: The 'credit crunch' is over. The credit crisis is over. The assets writedowns are almost over.

The sudden and dramatic change that I wrote about last week is continuing.

There's a price/earnings ratio chart at the bottom of this web site's home page, and it gets updated automatically every Friday. Here's the April 18 version of the chart:

S&P 500 Price/Earnings ratio and S&P 500-stock Index as of 18-Apr-2008. <font face=Arial size=-2>(Source: MarketGauge ® by DataView, LLC)</font>

S&P 500 Price/Earnings ratio and S&P 500-stock Index as of 18-Apr-2008. (Source: MarketGauge ® by DataView, LLC)

As of last week, the p/e ratio index had suddenly spiked up to its highest value since 2005. That trend has continued for another week, as you can see from the region circled in red. The p/e ratio has spiked up further, to the highest value since 2004.

This is an absolutely incredible new trend. I'd say that it's "unbelievable," but so many "unbelievable" things have happened in the last two years, especially in the last six months, that "unbelievable" is the new norm.

Furthermore, this should really be big news. You'd think a sudden spike in p/e ratios to the highest value in four years would be worth a headline or two, but I've heard not a peep.

Each week I think that the craziness can't get any worse, but somehow it always does.

Betting the bank

I've written several times about Ben Bernanke and his Great Historic Experiment, and his belief that the 1930s Great Depression could have been avoided if the Fed had simply lowered interest rates sooner. I've written many times that this view doesn't make sense, but I won't go into that again here.

What has surprised me these last six months, since the credit crunch began in August, was how far the Fed was willing to go. The Fed seems to be willing to "bet the bank" that it can prevent a systemic financial crisis (what I would call a generational panic and crash).

On Monday, the Bank of England joined the club by announcing its own plan, similar to the Fed's.

There are now so many of these plans, offered by the Fed, the Bank of England and the European Central Bank (ECB), that it's almost impossible to keep all the details straight. But there's no need to understand the details because they all have the same major purpose: Allow financial institutions to continue to lie about the values of their assets.

What the credit bubble did is that it created tens of trillions of dollars of securities (CDOs or collateralized debt obligations), backed by mortgage-based securities, on the assumption that the housing bubble would continue forever. The math behind these CDOs was based on numerous false assumptions, as I explained in "A primer on financial engineering and structured finance." In addition, the same mindset that created the fraudulent CDOs also invented the hare-brained auction rate securities scheme, which has created in more trillions of dollars in worthless securities.

Financial institutions around the world have the worthless assets on their books, and various accounting rules have been forcing them them "write down" their values from their inflated nominal values to more realistic market values. This is a problem since many of them are worthless.

So, the banks, various agencies, and the government have been coming up with one scheme after another to allow banks to keep the phony inflated nominal values on their books. The first really major example was the Master-Liquidity Enhancement Conduit, or M-LEC, dreamed up last October. It was essentially a way for banks to commit fraud, sanctioned by the government.

These and other schemes have not prevented the forced writedown of many bank assets, now totalling something in the neighborhood of $500 billion.

Now, keeping in mind that some tens or hundreds of TRILLIONS of dollars of these phony securities were created in the credit bubble, it's pretty clear that the writedowns have a long way to go.

Even worse, there's a domino effect. When one institution is forced to write down its worthless assets, it has to sell off some of its "good" assets to meet reserve requirements, and that pushes down the the prices for the "good" assets, which can force another institution into panic selling.

This was the issue six weeks ago when Bear Stearns was on the verge of bankruptcy. The Fed arranged to save the company because it might have caused exactly this kind of chain reaction.

Since then the Fed and other central banks have decided to "bet the banks" that they can stop this chain reaction. They've set up programs whereby commercial banks, and now even investment banks, can trade in their "bad" assets for "good" assets from the Fed. They can turn in their CDOs, and get Treasury bills in return.

The "good news" is that the assets don't have to be written down any more, since they're on the Fed's balance sheet, rather than the bank's balance sheet. The bad news is that the Fed's balance sheet is being loaded up with worthless assets.

And now, thanks to Monday's announcement, the same thing will be happening with the Bank of England.

This cannot possibly work for long, as you can see just from the numbers. The Fed has about $1 trillion on its balance sheet, and the Bank of England has about $100 billion. That's a drop in the bucket compared to the hundreds of trillions of dollars in vulnerable credit derivatives that were created during the credit bubble. So all these actions can do is postpone the inevitable.

Negative Fed funds rate

I've had questions from readers and seen discussions about the fact that the Fed funds rate is now effectively negative.

That is, the Fed funds rate is supposed to be at 2.25%, but the Fed is unable to maintain that interest rate, and in fact this interest rate is now effectively negative.

A lot of people believe that negative interest rates are impossible. Actually, that's simply not true. There is no such restriction.

In this case, I don't know the details of what's going on, but I can provide a conceptual explanation. Treasury bills are issued by the Treasury Dept. to financial institutions. The Fed can purchase these Treasury bills from these financial institutions.

In "normal" times, the Fed can control interbank interest rates -- the amount of interest that one bank charges to lend money to another bank -- through the use of "open market operations," as I explained in my August article, "Bernanke's historic experiment takes center stage."

In essence, a bank can lend money to the Fed by purchasing a Treasury bill from the Fed. When the T-bill expires, the Fed has to buy it back, with interest. That's in "normal" times, when the Fed funds rate is positive.

But these days, the credit crunch is keeping banks from wanting to lend money to banks at all, or at anything but the very highest interest rates. And so the normal "open market operations" are not working at all. In fact, T-bills are becoming as scarce as hen's teeth, as financial institutions are forced to provide these instruments to fulfill some contract.

Now, if T-bills are scarce, then the price goes up, and if the price goes up high enough, then interest rates are effectively negative.

There are many parties involved in the buying and selling of T-bills, and I don't have a clear idea of how these various sales are carried out, and so the above is just a conceptual explanation. What all this shows is that the Fed's monetary policy doesn't have much effect these days, as it does in "normal" times.

The LIBOR controversy

Libor -- the London Interbank Offering Rate -- is an international bank to bank lending interest rates. Libor is determined each day by the British Bankers Association (BBA) by doing a daily survey of banks, asking them what interest rates they're charging each other.

A scandal broke out last week, when it was thought that banks were lying to the BBA about what interest rates they were paying. They were apparently understating the interest rates, in order to avoid embarrasment. If this was true, it would mean that the Libor rate was no longer credible.

On Wednesday of last week, the BBA announced that it would investigate whether banks were distorting the Libor rate, and would punish any offenders. As soon as that announcement was made, the Libor rate spiked up to new highs.

The Libor rate is used by many financial institutions to set other prices, including the interest rate for home mortgages. So an increase in the Libor rate is expected to have wide fallout.

Shanghai

Shanghai stock market index, for five years ending April 21, 2008 <font size=-2>(Source: MarketWatch)</font>

Shanghai stock market index, for five years ending April 21, 2008 (Source: MarketWatch)

I have to mention the continuing crash of the Shanghai stock market, as can be seen from this graph.

The Shanghai stock market has fallen 50% from its October high.

This is turning into a full-scale stock market crash, with devastating consequences for the Chinese economy. At the very least, it raises many concerns about what's going to happen to China once the Olympics games end in August. What I don't understand is why this stock market crash isn't a major international news story.

Another thing that's affecting China and other countries around the world is the never-ending surge in food prices. There are more and more food riots occurring around the world, as you can see for yourself by typing "food riots" into Google news. It's been obvious for years that food prices have been surging, and I've been writing about it since 2004. It's only in the last week or two that I've begun to see news coverage about the food price problem, but the world is still mostly oblivious to it, and its enormous dangers.

For investors, there's nothing to worry about. The credit crisis is over, asset writedowns are over, the stock market will start rising again without limit, and the world is a wonderful place.

I've estimated that the probability of a major financial crisis (generational stock market panic and crash) in any given week from now on is about 3%. The probability of a crisis some time in the next 52 weeks is 75%, according to this estimate. (22-Apr-08) Permanent Link
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