Macro Observations In The Context Of Newton's Third Law

Macro Observations In The Context Of Newton's Third Law
Posted by Tyler Durden at 10:22 PM

The one-two knockout punch from last week's quantitative easing by the Fed and today's massive implicit toxic asset offloading guarantee by the Treasury served a bitter dish to market doomsayers. Putting the fact aside that the two actions are essentially contradictory (30 years collapsed Monday after the ripfest last week), much was said today, and over the weekend, about Geithner's plan to present hedge funds with a once in a lifetime opportunity of a 12-to-1 upside/downside investment ratio. All else equal, this alone must be a manifest synthetic arbitrage opportunity somewhere, and indeed is, as reader Kushyama points out a peculiar inversion - via the PPIP, for the first time the cost of equity (the treasury's borrowing cost, although Felix Salmon has a few things to say about whether this should even be considered equity in the PPIP context) is lower than the cost of debt (the program funding at LIBOR + spread).

The nuances of the administration and treasury's actions over the past few days are vast and nuanced, and deserve a much more extensive post. The key takeaway is that the administration achieves many key short-term goals with the PPIP:

1) The marginal risk of overbidding on toxic assets' marks due to the program's leverage implies most eligible PPIP participants will get on board, and eliminates the need for price discovery so the administration can throw out the contemplated adjustments to MTM, in the process claiming it is all for transparency, potentially inciting another market rally.

2) Offloading the toxic assets from banks' balance sheets at current marks (although for full bait-and-switch transfer at least another $1 trillion tack-on to the PPIP will be needed), thus eliminating the daily chatter for major bank nationalization, relieving the bulk of the pressure on the market-leading financial sector.

3) Contrary to the administration's claims that it is not 'managing to markets in the short run [sic]' (today's quote of the day from Larry Summers), the immediate goal is precisely a market rally, driven by these very PPIP participants who can use the $900 billion taxpayer gift to buoy up the market, while at the same time taking massive mark ups on existing toxic portfolios of their own, and revive the long-side of the mutual and hedge fund industry, thereby soaking up so much of the 'sidelined cash' from institutional and high net worth clients with artificially inflated performance reports. The institutional cash inflows based on recent abnormally high returns, will yet again drive the market higher.

4) The FDIC's hair-raising problems can be swept under the rug, as the 'depositor insurer' takes on yet another implicit guarantor role, that of whole loan purchase backstopper. Despite the FDIC's DIF likely being at zero if not negative, the FDIC will now embed itself into the financial system to such an extent that the emerging vicious pentagram between taxpayers, depositors, bank holdings companies, toxic whole loans sellers and PPIP participants will make mutual assured destruction an inevitability if any one these defects, thus ensuring continuing cooperation regardless of real macroeconomic conditions.

While all these consequences seem wonderful in the short-term, Newton's third law applies here as it does everywhere else. The primary trade off will inevitably be the prompt realization, as CMBS and RMBS cash flows dwindle to a halt in 2-3 years, that the administration's optimism was unfounded. Instead of unjustified, rose-colored preaching, maybe someone in the administration can run a TREPP model on some of these toxic asset portfolios and see that based on current trends in DSCRs and recovery levels, the default tsunami in toxic assets is at most 3 years away. There is a reason why CMBS and RMBS are priced so low: the market is rational, it has a great facility in using an HP-12B and what it is seeing is the reason why market bids are where they are, somewhere in the neighborhood of 40-80% lower than where banks have these assets marked. The defaults will promptly eat up the non-recourse loans by the taxpayers as hedge funds trade out of these securities in advance of the crash.

End result: more and more and more printing of dollars. So much so that the M1-3 velocity will soon become unstoppable. That, combined with quantitative easing by our Eurozone friends (granted, some legislation has to be implemented first), and the hyperinflationary path is set, dooming our children to an economy reminiscent of the Weimar republic. But at least some banks don't get nationalized tomorrow, some other hedge funds make a ton of money that can be taxed next year once capital gains law is adjusted proving Obama's tax reform is a success, and the administration's fate is safe... at least for the current term.

But how about quantitative easing and stimulus benefits? That one is a doozy as well.

As all stops get pulled, it is not difficult to see mortgage rates dropping below 4.5%, which would imply an annual relief of $115 billion according to Merrill Lynch. Also beginning April 1, middle-income families will start seeing withholding taxes coming off their paychecks, which in ML's estimates, will result in a $35 billion boon, implying the monetary and fiscal policy tailwind will be a solid $150 billion. But... Newton's third law again... as people continue their thrifty ways, and savings rates approach 7%, this will drain $175 billion in spending, and from a static point of view, every percentage point rise in the savings rate is equivalent to the loss of 2.2 million jobs in terms of GDP impact. Add to that the expected actual 2.5 million in job losses (at least) through the end of 2009, adding another $125 billion in personal income costs. Lastly, ML estimates that the negative wealth effect will end up being a $400 billion drag on spending. All totalled, the economy faces $700 billion in headwinds, offsetting stimulus benefits to the tune of 5 to 1.

As for the $1.15 trillion in expansion in the Fed's balance sheet - well, that is a mere drop in the bucket considering that to revert to a historical mean private sector debt-to-GDP ratio (currently at 176%), another $8 trillion in household and business sector credit must be unwound.

And all this is happening in the context of household wealth, which is disappearing at a staggering pace: last at -$12.9 trillion, and currently at -$20 trillion through Q1. This is a 20% decline in household wealth since the peak in mid-2007, which is wealth destruction at a magnitude last seen during the Great Depression.

Buyer beware