Credit Default Swaps on US Government Debt
Joe El Rady

Seriously, I couldn’t even make this stuff up if I tried: some commentators and investors seem to think that a real danger exists that the US government might default on its debt obligations. Their response: short treasuries by purchasing Credit Default Swaps on them. Ok, memo to these commentators: first, the US can print money; second, the US maintains significant taxing capacity—if you don’t believe me, simply compare average and marginal tax rates in the US to those of other industrialized countries. Finally, I would like to remind the proponents of this strategy that the buyer of a CDS accepts counterparty risk: the risk that the seller of the CDS will default before or at the same time as the borrower of the underlying debt. In such a situation, the buyer loses the seller’s protection against default by the borrower. I can’t imagine a scenario in which a treasury defaults and a CDS pays off. Let’s be honest, who sold you the CDS? Goldman? Morgan? You honestly think those firms would be around to pay your CDS in the case of a government default?

Continued...

A Word on Financial Bubbles and How They Burst
Joe El Rady

As the Financial Instability Hypothesis states, speculative investment bubbles are endogenous to financial markets. In prosperous times, a speculative euphoria develops due to increasing asset values. This encourages increasing amounts of speculation using borrowed money, which, in turn, results in debt levels that exceed serviceability by the investors’/borrowers’ revenues. When investors/borrowers lose the ability to service the spiraling debt they have incurred in order to finance their speculative investments, they rush to sell. As more and more investors face this same situation, the selloff grows larger and larger. Due to both the ballooning supply, which severely outpaces demand, and the similarly dire cash flow position faced by a large number of the market’s participants (they all need to sell), bids tremendously undercut asks, leading to precipitous collapse in market clearing asset prices and a sudden evaporation of market liquidity. This shapes a virtual death-spiral as losses on levered assets decimate equity and coerce the increasingly rapid sale of assets to reduce liabilities. The fire sale itself forces an increasingly intense devaluation of assets. The resulting devaluation of assets accelerates the need for asset sales, which accelerates the decline of asset prices, which, of course, decelerates the extinguishment of the matching liabilities, leaving large amounts of un-payable leverage in the market. The cycle continues, causing losses to beget losses and so on… The resulting liquidity crisis forces banks and lenders to tighten credit availability, even to borrowers that can afford loans. This type of financial crisis proves damaging enough without the magnification effects of structured credit instruments and portfolios that can turn a storm into a hurricane, the disaster that occurred during the financial crisis of 2008. More on that in a later post…

Continued...

Inflation Will Remain Low in the Short Term
Joe El Rady

Skiddish investors and laypeople have begun ringing inflation alarms all over the place. Every family member I know—even my grandmother—has been asking me about it. Let me be very clear, inflation is not a short term concern. Inflation will remain low for quite a while. Inflation is, however, a long term concern. The reasons for this are beyond the scope of this post; and, in future posts, I will delineate both the reasons for the lack of concern in the short term and for the concern in the long term. For now, I will only write, and I will expand on this also in other posts, that inflation is not a concern right now because quite frankly, the US economy still sucks. As for the long term, when economic growth returns, the concern regarding inflation stems from the very real possibility that the Fed may find it difficult to drain and/or offset the massive increase in bank reserves created by rescue responses to the recent instability in credit markets. More on this in future posts…

Continued...

Dollar Pain Will Continue This Week
Joe El Rady

Tomorrow’s Fed announcement, which I predict will leave interest rates unchanged, should comfort Dollar bears and reinforce their position.The current mix of bad domestic news regarding growth (as the Fed should state tomorrow: impeded economic growth due to curtailed bank lending) and better international news regarding financial stabilization and economic growth, will continue to encourage investors to forego the safety of Dollar and Yen denominated assets for higher-yielding ones.

The Dollar has fallen to a one-year low against the Euro and weakened versus the Yen on speculation the global economic recovery is gathering strength, encouraging investors to buy higher-yielding assets. The demand for dollars had temporarily inflated due to the flight to safety induced by the global financial meltdown. Good news, however, comprises bad news for the Dollar as stabilization reduces its safe-haven demand.

Nevertheless, some reflux may occur. Specifically, what started as a fundamental strategy may, as usual, devolve to a momentum induced and self-reinforcing bubble causing an oversold market for Dollars (some even think the Dollar has already crossed the oversold line). Furthermore, the dollar remains the global reserve currency, and as such, will rise on any hint of instability in global financial markets.

Continued...

Fed Will Not Raise Interest Rates at Tomorrow’s Meeting
Joe El Rady

The Federal Open Market Committee will likely argue that tight bank credit continues to impede economic growth and necessitate a continuation of the current low interest rate environment. Lending contracted for the past several weeks due to both unhealthy bank balance sheets and the Fed’s response to them (ordering banks to raise more capital and toughen lending standards).

Continued...