It was the Margin Call from Hell...
"Markets in turmoil after a fund fails," is the headline in today's
International Herald Tribune.
The price of gold has breached the im****tant $1,000 level...and hit a
new world record. And black gold too - oil - hit $110. The demand for
gold coins is so strong that a local coin dealer says he is out of
stock on a number of items.
The dollar fell, meanwhile...down below 100 yen, for the first time
since 1995. The dollar index hit a new low of 71.94...and the euro
traded above $1.56.
It took investors a while to connect the dots, but now they seem to
have the picture: the Fed's big bank bailout will not really wipe out
losses...nor make Wall Street more profitable; what it will do is save
the big banks from going broke - if they're lucky - while destroying
the dollar.
"We're in the helicopter phase now," says Howard Simons, a strategist
at Bianco Research in Chicago. He's referring to Ben Bernanke's famous
remark...that he would drop money from helicopters, if necessary, in
order to avoid a deflationary meltdown. On Tuesday, Bernanke's
helicopters dropped $200 billion. By Thursday, the hedge funds were
still failing. What's worse, there are rumors that a big bank may be
in big trouble.
We take a moment to explain how it works. The banks have lent a lot of
money to hedge funds. The funds didn't hedge...they gambled. As a
result, many are now in trouble; they can't repay the money.
The banks send out margin calls - asking for more cash from the hedge
funds, but the funds don't have it. This week, for example, the
Carlyle Fund got the "Margin Call from Hell" from its bankers. The
banks wanted $97.5 million. That didn't seem like much a few months
ago, but now money is getting hard to come by. Carlyle bet $31 for
every single dollar it had in capital. With that kind of leverage, the
managers stood to score a fortune if the markets went their way. But
if prices went in the wrong direction, and the bets went bad, it
didn't take much bad news before the fund went broke.
So, Carlyle has gone belly up. It couldn't make its margin call. And
all over town, other fund managers are biting their nails...and
refusing to pick up the phone. The bankers are pacing the room too.
You know the old saying: when you owe the bank $100,000...you can't
sleep at night. But when you owe the bank $1,000,000, it's the banker
who can't sleep. Well, a lot of bankers are now sleepless in Manhattan
and London...wondering which of their clients will be able to
repay...and which won't. And the last thing the Fed wants is for some
large bank to make the headlines with news that it is broke. That's
what the Fed is for, after all. It's a banking cartel...designed to
protect the banks from their own stupid mistakes.
Of course, the big mistake the banks made was lending money to people
who lent money to people who lent money to people who couldn't pay it
back. The subprime mortgage lenders didn't worry, because they sold
their loans on to packagers who sold them on again - often ending up
in the ****tfolios of highly leveraged hedge funds, to whom the banks
had lent money. S&P now projects that the losses from subprime will
rise to $285 billion, up about $20 billion from their last estimate.
Our estimate is that the losses will top $1 trillion...and if you
throw in the collateral damage, lower house prices, the bill will rise
to more than $6 trillion.
Houses in Southern California lost 17.9% over the past 12 months. The
median price has sunk to $408,000. In the summer, the median price was
over $500,000.
As expected, by us, retail sales slumped last month. Unemployment rose
to a two and a half-year high. And America's CFOs think the country is
already in recession.
But today's big question is this: will the feds succeed?
First, there is the practical issue of how lending to impaired banks
in the middle of a credit crunch actually stimulates the real economy.
The presumption is that there are worthy projects - new factories,
business expansions, new technological developments, new employees to
be hired - just waiting for credit from the banks. Now, with their
balance sheets restored (they laid their subprime-infected credits off
on the Fed in return for Treasury bonds)...they'll be able to lend
again; that's the theory.
But what new factories? Who's hiring? What businesses are expanding?
The country is in a recession, for Pete's sake. Besides, in the late
stages of a credit bubble, few people borrow to actually expand the
economy. The borrowers, instead, are hedge funds and speculators -
just the people the banks are now afraid of. That's just the way a
credit cycle works. At first, the borrowers are solid...with sensible
plans for the money. Each dollar they borrow results, say, another 75
cents to the nation's GDP. But as the cycle goes on, the borrowers
become more and more reckless. Asset prices tend to move up quickly,
so the borrowers figure they can't lose...and the lenders figure they
have nothing to worry about because the collateral is becoming more
and more valuable. As credit quality declines, each additional dollar
borrowed adds less and less to the real economy. By the end, it may
take an extra $10 worth of credit to produce a single extra dollar of
GDP.
We take it as a given, at this stage, that more lending from the Fed
cannot actually improve the real economy. In fact, it makes it worse -
propping up failing companies, increasing speculation, misallocating
resources, and adding to debts that will have to be paid, one way or
another, by somebody or another, eventually. A better question is -
how much damage will the feds do to the real economy?
By Bill Bonner
The Daily Reckoning
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