Initially bulls clung to the “Things are well contained theory”. Let’s take a look as to how this theory escalated over time.
Containment Theory Escalation
- Problems are contained to subprime.
- Problems are contained to subprime and Alt-A.
- Problems are contained to residential housing.
- Problems spread to Canada, Norway, Europe, UK, Japan and anyplace else dumb enough to buy US asset backed commercial paper.
- Paulson creates Super SIV bailout proposal.
- Super SIV bailout proposal collapses.
- Containment spreads to corporate real estate.
- Realization containment theory failed.
The containment theory was followed by the “Fed Will Save The Day Theory”. Let’s take a glance at the progression of that theory.
Fed Will Save The Day Theory Escalation
- Fed does surprise discount rate cut.
- Fed cuts interest rates to 4.75 to 4.50 to 4.25
- Fed cuts interest rates in surprise move to 3.50
- Fed cuts interest rates again 8 days later to 3.0
- Fed will likely cut to 2.5% in March
Fed Will Save The Day Theory In Graphical Form
Click on chart for sharper image.
Chart courtesy of HSH Financial Publishers.
Interest rates are now back to April 2005 levels. If the Fed cuts another 50 basis points in March we will be back at January 2005 levels.
Fed Will Save the Day Actual Results
- US Service Sector in Recession – Eurozone is Fading Fast
- Banks Put Stranglehold On Credit
- US Homeowners Confound Predictions
- Jobs Contract as 2007 Job Growth Revised Away
- 60 Minutes Legitimizes Walking Away
- The Business of Walking Away Is Booming
The Decouple Theory
In conjunction with the Fed Theory we had the Decouple Theory. The idea behind the decouple theory is simple. It is a global extension to the “It’s Well Contained Theory”. The refinement hung on the misguided belief that problems will be contained to the United States. This theory was shattered in a Global Equity Selloff and a virtual lockup of bond markets in Europe and the UK.
The Sovereign Wealth Fund Theory
The other day in response to a reader query about sovereign wealth funds, I made this statement: “Those dollars will eventually come home to buy US assets. A piece of Pfizer, Citigroup, Goldman Sachs, Exxon Mobile. How exactly does that cause “inflation”? “
I am curious how this would NOT cause inflation? New stock market bubble; expansion of P/E multiples; 401k becoming 801k; CNBC/FOX having a party, declaring victory for American capitalism; banks’ balance sheets improve somewhat; US investors feel wealthier on their stock portfolios and begin spending; Wall Street is looking up and Manhattan condo market stabilizes. The Concoran Group runs a full-page add in New York Sun “We just saw proof that Manhattan real estate never goes down significantly for extended period of time”
Repatriation of huge amounts of foreign held dollars that will flow into US stocks will create a huge expansion of money and credit, i.e. a bubble, i.e. inflation, almost by definition.
What am I missing?
Let’s start with the “Manhattan real estate never goes down significantly for extended period of time” theory. Two years ago the same “proof” was offered about real estate in the US in general. Since then trillions of dollars of fake wealth have been wiped off the books, and Citigroup (C), Merrill Lynch (MER), Lehman Brothers (LEH), all needed capital to keep lending.
Did those capital infusions reignite lending? Look at point number two above under “Fed Fed Will Save The Day Actual Results” for your answer.
Did those capital infusions reignite the stock market? Pull up a chart of the stock market an take a look.
Is Citigroup lending after two bailouts?
Would it be lending if China Bought the whole freaking bank? (The deal would never be approved so we have to talk in theory).
The answers to the above questions are
If China bought all of Exxon Mobil (XOM) would that cause Citigroup or Bank of America (BAC) to want to lend?
No again. XOM is not in the housing business and Citigroup is too capital impaired.
Would it push XOM higher?
Perhaps initially but it would then settle back to market price quickly.
There is no reason for banks to lend and there would still be no reason for banks to regardless of what capital infusion pour in. We do not need any more strip malls, grocery stores, nail salons, pizza huts, houses or anything else.
And with jobs going into the toilet we actually need less of all of those.
This notion that sovereign wealth funds can bail out the US is potty. It falls flat for many reasons, but the biggest one is that it does not create any jobs.
People are walking away from houses for two reasons
- Some because they can afford them but don’t want them
- Others because they have to
Bernanke will not succeed at containing that sentiment change. The Fed can only exaggerate the current trend it cannot change the trend.
Points of Failure
- Banks are unable or unwilling to extend credit
- Consumers and businesses are unable or unwilling to borrow
We are seeing both sides of this equation now, unwillingness to lend and unwillingness to borrow.
Sovereign wealth funds do not change this picture. One reason is rampant overcapacity and the second reason is jobs. US consumers are cash strapped. Unemployment is raising dramatically and is poised to go way higher. The recession has just begun. Consumers out of money cannot spend. More houses will be turned over to banks. I am looking for $500 billion worth of capital impairments on residential and commercial real estate. I could be way off on the low side.
Even if sovereign wealth funds covered every penny of existing and future capital impairments, not a single job is created in the process! For that reason alone the sovereign wealth fund theory will fail. Any proposed bailout of the monolines will fail for the same reason. The party is over even though hope lingers on.
Mike “Mish” Shedlock
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