Extend & Pretend: Manufacturing a Minsky Melt-Up

A distracted and preoccupied amateur is no match for a determined, organized professional with a strategy. Though the collapse of the shadow banking system was a near fatal miscue for the global bankers, they have been quick to adjust their strategy. With an army of MBAs, quants and lobbyists they have reworked their strategy at the expense of the still comatose and shaken taxpayer.

It is the first anniversary since April 2nd when FASB 157 was suspended and with it the suspension of ‘mark-to market’ accounting. The US congress held a gun to the head of the Financial Accounting Standards Board a year ago. Congress left FASB no choice but to change their guidelines under the perception that it was a deferral, allowing time for the banks to adjust the toxic and devalued assets on their books. Where are we a year later with Mark-to Market still ‘on hold’ and Mark-to-Myth endorsed by the Federal Reserve Bank examiners? Frankly, the ‘happy face’ media doesn’t want to talk about it, so I will. As an investor, unlike politicians and the media, I must face reality or I will pay the ugly consequences.

In January’s EXTEND & PRETEND - An Accounting Driven Market Recovery, I outlined the accounting changes that had been implemented to ignite a market reversal and rally from the March 2009 low. These accounting changes ranged from the deferral of FASB 157 in March 2009, the Commercial Real Estate Loan Workout Policy in October 2009, the three cauldrons easing in November 2009, the deferral of FASB 166 and 167 in December 2009 and the System Wide Federal Bank Examiner Reinforcement Training in January 2010. The changes were executed in a controlled and almost militaristic operation. The market has reacted with a 58.4% retracement of the 2008 decline and a 70% increase from the lows in the DOW industrial, trumpeted eagerly by the nightly news. This was Stage I.

For an update of Stage I – see: Extend & Pretend-Stage I

STAGE II -- MANUFACTURING A MINSKY MELT-UP

My grandfather, who was proud to keep his farm during the depression, had an expression that I haven’t heard in a long time. He was fond of warning that: “Banks lend you an umbrella when it is sunny and then demand it back when it starts to rain!” It has been a long time since we have had a ‘rainy’ economy for any protracted period of time, but to this prairie farm boy the economic weather forecast doesn’t look that good.

We therefore need to remember some basics of banking. First, banks make money borrowing short and lending long. This strategy is inherently risky. This is why banking requires extensive regulatory laws and ever vigilant bank examiners. Neither are to be ‘tampered’ with, which our politicians now seem oblivious to.

Secondly, inflation and deflation are different for banks. The Consumer Price Index and how much food, energy, consumer staples etc have increased is not highly relevant to banks. Inflation or deflation to banks is about asset price increases or decreases. It is about whether their collateral positions are increasing or decreasing. I don’t mean to be too simplistic here since cost of money is critically important, but it serves to make the point that bank strategy is driven by their view of the direction of asset prices and whether their loans are covered, their capital ratio requirements are secure or what a new risk adjusted loan is worth to them. What does the chart below say about where banks view asset prices to be headed?

Banks win on asset inflation. Banks potentially lose on asset deflation. Rising asset prices:
1- Make Collateral more valuable or easier to secure for banks
2- Raise borrowing levels with which to finance higher priced asset prices which increase interest payments and fees.

If banks thought collateral values were headed lower, here is what they would do:

Banks need asset values to continue to climb. Now that the markets have reached ‘nose bleed’ levels and appear to be at the stage of looking for a consolidation, the banks need another strategy to ignite asset prices further. The banks must see higher asset prices to have any hope of achieving satisfactory Capital Ratios with the known amounts of bad and toxic debt still on their books. Is it any wonder banks are now making their profits primarily in their trading operations driving asset prices higher and with their Interest Swap where they are squeezing collateral call levels? (see: SULTANS OF SWAP: The Get Away!)

MANUFACTURING A MINKSY MELT –UP

If the banks wanted to get collateral values up, and manufacture a ‘Minsky Melt-Up' here is what some of their strategy elements would call for:

I am not saying that a successful Minsky Melt-Up will be achieved or in fact could be successfully manufactured. Frankly, I would be very skeptical if it weren’t for the fact that former Federal Reserve Chairman Alan Greenspan specifically said this could not happen (He also stated that market bubbles could not be identified by the Fed nor addressed with Monetary Policy (yeh right)). His views have typically been my contrarian indicator which has given me an investment edge over the years. Before reading Alan Greenspan’s ‘Greenspeak’, consider that we presently have unstable economic policies, risk premiums have been high and the Fed has successfully inflated a bubble in the Bond Market over the last 20 months through QE (Quantitative Easing).

…Greenspan said “because the markets themselves are asymmetric: they melt down, but don’t melt up!” Mr. Greenspan argues:

(1) the ironic result of successful stabilization policies is a journey to excessively-thin risk premiums, and if
(2) history has not dealt kindly with the aftermath of protracted periods of low risk premiums, and if
(3) asset prices do not tend to melt up but do tend to melt down, then
(4) logic implies that the fattest fat-tailed secular risk to price stability is deflation, not inflation.
How so? If bubbles are the ironic externality of successful stabilization policies, then those policies can be successful only so long as there are asset classes that the central bank can inflate into a bubble. When there are no more free and clear assets to lever up, the game ends in a debt-deflation. As the great Hyman Minsky intoned, stability is ultimately destabilizing!  That is the logical consequence of too-successful inflation stabilization. Don’t call it a conundrum, but rather a dilemma, if the Fed were to set and achieve a too-narrow target zone for inflation. (2)

If according to Hyman Minsky, protracted periods of market stability leads to instability and a market meltdown, does this preclude therefore that protracted periods of market instability negate the possibility of a market melt-up (per Greenspan)? I intentionally phrased the logic for this argument in perfect ‘Greenspeak’ fashion so we can all remember exactly how we got ourselves into this global predicament in the first place.

CONCLUSION

This is a well executed strategy. It has been almost militaristic in its execution - all the elements from a solid communications program (i.e. CNBS hype), accounting and regulatory changes (FASB 157, 166, 167 deferrals et al ), government statistics (does anyone actually still believe the CPI, Labor Report or other government statistics any more?), and public’s sentiment through the controlled market perception barometer pumped at them every evening on how well the DOW Industrials are doing.  The US economic and financial situation has now reached a point where the potential crisis could be referred to by our government interventionists as a matter of national security. This is precisely why I am leaning towards a Minsky Melt-Up being successfully manufactured.

There is an old market saying: “Don’t fight the Fed!”  This market guideline has never been truer. In fact today it is more appropriate to say:

“It is impossible to fight central bank planning” To fight the central party planning (i.e. shorting an artificial market) exposes your wealth to being officially confiscated!

Sounds like something Karl Marx would have said?

FOR THE FULL VERSION OF THIS ARTICLE: EXTEND & PRETEND - Manufacturing a Minsky Melt-Up

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SOURCES:

(1) 03-06-10 All You Need To Know About Bank Balance-Sheet Fraud  The Market Ticker
(2) 08-03-06 Paul McCulley and Doug Noland Both Praise Hyman Minsky Economic Dreams
(3) 04-06-10 New NYSE Options Pricing Pyramid Promotes Derivative Driven Market Melt-Up  Zero Hedge
(4) 04-08-10 Home equity horror  Reuters

The last Extend & Pretend article:  EXTEND & PRETEND - Hitting the Maturity Wall!

Gordon T. Long

Tipping Points

Mr. Long is a former senior group executive with IBM & Motorola, a principle in a high tech public start-up and founder of a private venture capital fund. He is presently involved in private equity placements internationally along with proprietary trading involving the development & application of Chaos Theory and Mandelbrot Generator algorithms.

Gordon T Long is not a registered advisor and does not give investment advice. His comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. While he believes his statements to be true, they always depend on the reliability of his own credible sources. Of course, he recommends that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that, you are encouraged to confirm the facts on your own before making important investment commitments.

© Copyright 2010 Gordon T Long. The information herein was obtained from sources which Mr. Long believes reliable, but he does not guarantee its accuracy. None of the information, advertisements, website links, or any opinions expressed constitutes a solicitation of the purchase or sale of any securities or commodities. Please note that Mr. Long may already have invested or may from time to time invest in securities that are recommended or otherwise covered on this website. Mr. Long does not intend to disclose the extent of any current holdings or future transactions with respect to any particular security. You should consider this possibility before investing in any security based upon statements and information contained in any report, post, comment or recommendation you receive from him.