"Pimco's Gross Calls for US to Spend Trillions to Save the Economy
The financial services industry is full cry in its demands for taxpayers to save its hide. From Bloomberg:
Yves here. Brad Setser, who follows international funds flows generally and China in particular, sees no such risk on this front, at least this year. Indeed, some think China may pick up its purchase to lower the RMB, although that runs the considerable risk of retaliation from the US and other advanced economies.
The real risk is the supply side, not the demand side, and higher spending merely makes the funding gap greater, albeit with a bit of a lag.
Recognizing that, China is moving to shorter maturity Treasuries, seeking to reduce its exposure to inflation, which erodes the value of longer dated bonds far more than short ones.Back to the article:
Yves here. He's right on the latter point, although that's like saying a heart attack is a significant event. Buying Treasuries is a desperate move by the Fed that will work for a while, but I cannot seeing it do more than stave off the inevitåble for a little while. How will the markets react to the specter of a burgeoning Treasury balance sheet, with its purchases in a loss position on any kind of "real" mark to market basis (an unmanipulated market price on the bonds would be considerably lower). The 30 year bond has fallen from a peak of 142 to its current level. That's a nearly 20% loss in less than a quarter.
And how will the markets react with the realization that the Fed is insolvent? This isn't lunatic fringe thinking; Willem Buiter (a respected and generally left-leaning economist), who has advocated that the US engage in less rather than more deficit spending, has discussed the risk to central bank solvency of absorbtion of private sector losses. In a recent, more urgent, post, he contends the US is on its way to default (either explicit, or far more likely, implicit, via inflation) unless in contains its level of spending:
Now my German buddies remind me that in the German hyperinflation, government bonds were the last asset type to tank. Even in 1923, they traded at a yield of 6% before collapsing. So even in the face of rampant actual or expected inflation, the authorities can hold seemingly inexorable forces at bay longer than one might expect.
And Bloomberg gives us the real reason behind Gross'appeal:
Pimco is structurally long bonds, so declining interest rates are in his favor. But more immediately, unless he went long very short maturities, he is probably sitting on losses on his December bet, and without Fed intervention soon, he is unlikely to get whole on those purchases."
Bill Gross, co-chief investment officer of Pacific Investment Management Co., said the U.S. may slump into a “mini depression” unless policy makers spend trillions of dollars to spur growth.
“This economy needs support from the government, a check from the government in the trillions,....There is a potential catastrophe if the U.S. government continues to focus on billions of dollars."...
Pimco won a Federal Reserve contract in December as one of the four managers of a $500 billion program to purchase mortgage-backed securities. The company was also one of the managers selected to run the Commercial Paper Funding Facility in October.
The Fed will have to step in and buy Treasuries, Gross said, to keep long-term interest rates low as the U.S. increases its debt sales to finance a growing budget deficit and stimulus programs...
Speculation has risen that China, which holds $681.9 billion of Treasuries as the single largest investor in U.S. debt, may stop or slow the purchases of U.S. debt as its own economic growth slows...
Yves here. Brad Setser, who follows international funds flows generally and China in particular, sees no such risk on this front, at least this year. Indeed, some think China may pick up its purchase to lower the RMB, although that runs the considerable risk of retaliation from the US and other advanced economies.
The real risk is the supply side, not the demand side, and higher spending merely makes the funding gap greater, albeit with a bit of a lag.
Recognizing that, China is moving to shorter maturity Treasuries, seeking to reduce its exposure to inflation, which erodes the value of longer dated bonds far more than short ones.Back to the article:
“To the extent that the Chinese and others do not have the necessary funds, someone has to buy them,” Gross said. “It is incumbent upon the Fed to step in. If they do, that will be a significant day in the bond market and the credit markets.”
Yves here. He's right on the latter point, although that's like saying a heart attack is a significant event. Buying Treasuries is a desperate move by the Fed that will work for a while, but I cannot seeing it do more than stave off the inevitåble for a little while. How will the markets react to the specter of a burgeoning Treasury balance sheet, with its purchases in a loss position on any kind of "real" mark to market basis (an unmanipulated market price on the bonds would be considerably lower). The 30 year bond has fallen from a peak of 142 to its current level. That's a nearly 20% loss in less than a quarter.
And how will the markets react with the realization that the Fed is insolvent? This isn't lunatic fringe thinking; Willem Buiter (a respected and generally left-leaning economist), who has advocated that the US engage in less rather than more deficit spending, has discussed the risk to central bank solvency of absorbtion of private sector losses. In a recent, more urgent, post, he contends the US is on its way to default (either explicit, or far more likely, implicit, via inflation) unless in contains its level of spending:
There will, before long (my best guess is between 2 and 5 years from now) be a global dumping of US dollar assets, including US government assets. Old habits die hard. The US dollar and US Treasury Bills and Bonds are still viewed as a safe haven by many. But learning takes place. The notion that the US Federal government will be able to generate the primary surpluses required to service its debt without selling much of it to the Fed on a permanent basis, or that the nation as a whole will be able to generate the primary surpluses to service the negative net foreign investment position without the benefit of ‘dark matter’ or ‘American alpha’ is not credible....
The US Federal government has taken on massive additional contingent liabilities through its bail out/underwriting of the US financial system (and possibly other bits of the US economic system that are too politically connected to fail). Together will the foreseeable increase in actual Federal government liabilities because of vastly increased future Federal deficits, this implies the need for a future private to public sector resource transfer that is most unlikely to be politically feasible without recourse to inflation. The only alternative is default on the Federal debt. There is little doubt, in my view, that the Federal authorities will choose the inflation and currency depreciation route over the default route.
If I can figure this out, so can anyone in the US or abroad who follows recent economic developments. The dawning of the realisation will lead to the dumping of the assets....
Now my German buddies remind me that in the German hyperinflation, government bonds were the last asset type to tank. Even in 1923, they traded at a yield of 6% before collapsing. So even in the face of rampant actual or expected inflation, the authorities can hold seemingly inexorable forces at bay longer than one might expect.
And Bloomberg gives us the real reason behind Gross'appeal:
Gross, 64, increased his holdings of U.S. government debt, a category that includes agency securities, in December for the first time in a year, according to the company’s Web site.
Pimco is structurally long bonds, so declining interest rates are in his favor. But more immediately, unless he went long very short maturities, he is probably sitting on losses on his December bet, and without Fed intervention soon, he is unlikely to get whole on those purchases."
Now my view:
Posts
From the BBC on Sept.16,2008:
http://news.bbc.co.uk/2/hi/business/7615974.stm
"Well, for starters there is Merrill Lynch. US authorities and many bankers feared that after Lehman's demise the attention of investors and speculators would have moved to Merrill.
The bank hopes to find safety under the roof of banking giant Bank of America.
The biggest worry, though, is insurance giant AIG. The company is running out of cash to cover its losses and has asked the government for an emergency bridging loan, reportedly to the tune of $40bn.
If AIG is in trouble, it would directly affect millions of consumers and companies around the world. It would also hurt the whole financial system, because AIG is in the centre of a web of complex financial deals.
And compared with AIG, the crisis surrounding Lehman is small beer."
From my perspective, some people knew on the preceding Sunday that Merrill could collapse if Lehman did. In other words, some people knew that a Calling Run ( Debt-Deflation ) was possible.
On Sept. 24th, William Gross wrote this:
http://www.washingtonpost.com/wp-dyn/content/article/2008/09/23/AR2008092302322.html
"And so, instead of mild medication and rest, it became apparent that quadruple bypass surgery is necessary. The extreme measures are extended government guarantees and the formation of an RTC-like holding company housed within the Treasury. Critics call this a bailout of Wall Street; in fact, it is anything but. I estimate the average price of distressed mortgages that pass from "troubled financial institutions" to the Treasury at auction will be 65 cents on the dollar, representing a loss of one-third of the original purchase price to the seller, and a prospective yield of 10 to 15 percent to the Treasury. Financed at 3 to 4 percent via the sale of Treasury bonds, the Treasury will therefore be in a position to earn a positive carry or yield spread of at least 7 to 8 percent. Calls for appropriate oversight of this auction process are more than justified. There are disinterested firms, some not even based on Wall Street, with the expertise to evaluate these complicated pools of mortgages and other assets to assure taxpayers that their money is being wisely invested. My estimate of double-digit returns assumes lengthy ownership of the assets and is in turn dependent on the level of home foreclosures, but this program is, in fact, directed to prevent just that.
In effect, the Treasury will have the fate of the American taxpayer in its hands. The Resolution Trust Corp., created in the late 1980s to deal with the savings and loan crisis, dealt with previously purchased real estate, which was flushed into government hands with a "best efforts" future liquidation. Today, the purchase of junk mortgages, securitized credit card receivables and even student loans will be bought at prices significantly below "par" or cost, and prospectively at levels allowing for capital gains. This is a Wall Street-friendly package only to the extent that it frees up funds for future loans and economic growth. Politicians afraid of parallels to legislation that enabled the Iraq war are raising concerns about a rush to judgment, but the need for speed is clear. In this case, there really are weapons of mass destruction -- financial derivatives -- that threaten to destroy our system from within. Move quickly, Washington, with appropriate safeguards. "
Now, Gross, a bond guru, has just missed the Flight to Safety:
http://www.bloomberg.com/apps/news?pid=20601087&sid=asgkk4AucjU8
Dec. 10 (Bloomberg) -- Bill Gross, manager of the world’s biggest bond fund, says he regrets not buying Treasuries in what is shaping up to be the best year for U.S. government debt since 2000.
“If we had our druthers, if we went back 12 months and we had known then what we know now, it would have been all invested in Treasuries,” Pacific Investment Management Co.’s Gross said in a Bloomberg Television interview from Newport Beach, California. “The question going forward is ‘Is it the winner over the next 12 to 24 months?’ We don’t think so.”
How could William Gross have missed the Flight to Safety? He must have believed that interest rates would not go lower. Why?
I believe that Gross, knowing that a Calling Run was possible, did not believe that the government would ever do something like let Lehman fail. He believed that the government had implicitly guaranteed to intervene to stop such a possibility. He and everybody else. That was our system after all. Paulson didn't get that memo. He decided to see what would happen if you let one domino fall. Now he knows.
Why would William Gross want the government to invest in toxic assets that he had explicitly avoided? And, even more astounding, claim that it was value investing? How could he know where this run would lead and how low housing prices would go? He couldn't. But he could see that the only way to stop such a run was for the government to intervene massively. The problem was that his plan was a massive transfer of losses from the owners of toxic assets to the taxpayers. It is true that there is a theoretical possibility that we could make out as he said, but that was a wildly optimistic view at the time. But he was correct about the guarantees, only not about how that should be done.
I could be wrong about this, but all of his prescriptions involve keeping banks going and getting investors as good a deal as possible. Always at the expense of the taxpayers. That's his view of our government. I do not consider it free market. It runs with an insurance policy for big banks bought by lobbying.
If we follow his advice, we will be leaving the current system in place, with the strong possibility of business as usual, whatever the government does, in the near future. Consequently, we have to do exactly the opposite of what he's advising, and take over some banks, leaving the bankers and shareholders out in the cold.I am also not a fan of driving down interest rates as he wants, but that's a different story.
Don the libertarian Democrat