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Sunday, December 16, 2007 10:54 AM

Rear View Mirror Hyperinflation

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The Wall Street Journal is talking about a Citi That Gets No Sleep.

Citigroup Inc. seems like it is caught in a never-ending game of whack-a-mole: The second the bank knocks down one problem, another pops up.

On Friday, Moody's Investors Service downgraded Citigroup's long-term ratings, saying it expects continued losses related to mortgages and other complex securities. The action came a day after Citigroup resolved longstanding questions about troubled off-balance-sheet vehicles it sponsors.

The downgrade shows that Chief Executive Vikram Pandit, who started his new position Tuesday, has little room to maneuver ... [Rest By Subscription]

With Paulson's Super-SIV bailout plan all but dead, Citigroup Moves to Consolidate Seven SIVs on Balance Sheet.
Citigroup Inc. will bail out its seven structured investment vehicles, bringing $49 billion of assets onto its balance sheet in the biggest move yet by a bank to rescue the failing funds.

"After considering a full range of funding options, this commitment is the best outcome for Citi and the SIVs" Pandit [Citi's new CEO] said in an e-mailed statement.
I happen to agree with Pandit. Postponing problems is not a solution. However, I think Citi reacted because it was forced to by the market, not because it wanted to.

Is this Capitulation?

The question at hand is whether or not this is capitulation. I think not and neither does Mr. Practical who says: Citigroup's Move A Sign of Deflation.
As Citigroup (C) brings its formally hidden, off balance sheet loans back onto its balance sheet, some analysts are heralding the bottom. This is the capitulation they have been looking for. The bad news is out and the stock is cheap. Buy on the news.

Unfortunately, I disagree. Citigroup bringing $58 bln of loans onto its balance sheet is due only to what we pointed out when the super fund was first proposed by Mr. Paulson: it won’t work. There is no one left dumb enough to finance this debt. It’s that simple.

So now Citigroup has even less capital to collateralize its loans. It will have less ability to re-activate lending activity in the future.

C’s move today is a sign of deflation: the recognition that the debt cannot be financed or sold to investors. The dollar is much stronger today against all currencies because of these deflationary pressures.
Is the Fed In Control?

I have long contended that the Fed is not in control. The Fed can only "suggest". Suggest is not control. The Fed can encourage borrowing but it cannot force it. the difference is crucial. Mr. Practical agrees. Please consider the following Minyan Mailbag: Deflation, The Fed and Control.
Mr. Practical,

As a gold bug, my ears always perk up when the potential for deflation is discussed. I agree with Profs. Succo and Pomboy that we've had several years of hyperinflation hidden in asset price inflation. I'm aware that gold does poorly in the beginning stages of deflation. That said, I don't believe that deflation can occur until the Fed really panics, runs its printing presses 24/7 and fails to inflate. In my opinion, deflation cannot occur until the Fed takes rates to 0 and fails. It's hard to imagine how the dollar would not collapse before deflation takes hold. It seems to me that talk of deflation is premature. Am I missing something?

Thanks kindly for your insights. Happy holidays to you and yours.

Best regards,
Minyan Dennis

Minyan Dennis,

Your statement assumes that in fact the Fed is "’in control’’ here which is manifestly is not. The idea that the Fed directly controls the creation and destruction of credit is termed the potent director's fallacy.

While the Fed certainly does intervene in the market for capital (by adjusting its cost) its effects are largely a function of the prevailing appetite for risk. ...

We have seen this writ large in tech in 2000, housing in 2005-2006, and credit securitization up until August 2007. But when those collective appetites go from risk seeking to risk averting, there is simply nothing the Fed (or administration) can do to stop the process of asset renormalization (which is a fancy term for write-downs).

In the US, the economist Nouriel Roubini has been steadfast in his assessment that an insolvency crisis (which is most definitely what we are facing here) cannot be cured with lower Fed Funds rates. I couldn’t agree more. What cures a deflation is marking down the previously high valued assets to their new (much lower) market-determined price. Certain ABX indices trade at 20 cents on the dollar – an 80% decline for assets that traded at nearly par early in 2007.

What the above suggests is that we are in a deflation now. The write downs you see by Citigroup (C), HSBC (HBC), Washington Mutual (WM) et. al plus the 30%+ decline in asset back commercial paper volume since August 1 is in fact a deflation of the most serious kind. What you have not yet seen en masse is this credit deflation rolling downhill into the regular economy – into CPI, into PPI, into wages. Having such a massive – unprecedented – destruction of credit that we have seen worldwide not make its way from the financial economy to the ‘regular’ economy would be unprecedented in any cycle in any country at anytime in the modern financial era.

Lastly, we must differentiate between a currency hyperinflation – which is what is going on now in Zimbabwe and what happened in Germany under the Weimar Republic – from a credit hyperinflation – which is what happened in the US prior to the great depression and in Japan from mid 1980s to 1991.

They are vastly different things for reasons both theoretical and practical. Suffice it to say that a credit deflation – which I think is taking place as I write - is the vastly more probable path after a credit hyperinflation than is another credit hyperinflation or a currency hyperinflation (which is what you are suggesting the Treasury would be doing if they started running the printing presses).


Thus, even if the Treasury (remember the Fed cannot print money – all they can do is create incentives for market participants to take more credit) were to print currency, the effect – immediate effect – would be a devastating increase in domestic interest rates which would exacerbate the very process of credit deflation they are trying to avoid.

Thus, you can see why I say that all roads lead to a devastating deflation in the US (and very likely the rest of the world, which has been equally drunk on credit this decade).

As for your query about the USD; ironically enough, a significant credit deflation increases the demand for (and value of) the USD against almost all goods and services (and other fiat currencies) precisely because a deflation is an attempt to ‘’get liquid’’ – in the form of short term treasuries (see the US yield curve for supportive evidence on this idea) and in the form of cash and cash equivalents. In a credit inflation (2001-2007) the value of the USD fell rapidly. In a credit deflation, the opposite should happen.

Thank you,
Mr. Practical
Mr. Practical and I are in basic agreement. The interesting thing to me is all the focus on the PPI and CPI this last week while ignoring the big picture.

The Fed is trying their best to act as if inflation is a concern. If inflation was a big concern 10 year treasuries would not be at 4.2% nor would LIBOR be 75 basis points above the Fed Funds Rate. Most of all, if inflation was a big concern the Fed would not be cutting rates at all, let alone playing the absurd games they have been playing with the Term Auction Facility (See Fed Knowingly Takes Suspect Collateral in TAF Program).

We can argue all day long about whether deflation is here or is coming, but this is what we know right now.
  • There has never been a hyperinflation in history where housing prices declined. If anyone can find such an occurrence outside a war zone, please email it to me.
  • Those who really believe hyperinflation is coming should buy California real estate.
  • The leverage in real estate is higher than you can get in gold. You can buy a house with 0% down or close to it. It's hard to buy gold on 0% down.
  • Credit contractions and falling real estate prices are associated with deflation, not inflation.
  • The ability and willingness of lenders to extend credit is rapidly sinking.
Except in the longest of timeframes, history shows gold is a better deflation hedge than an inflation hedge. The reason is simple: Gold is money. Money does well in deflation. Perhaps there is another big pullback first, perhaps not, but the hyperinflation argument for owning gold does not hold water looking ahead.

Credit hyperinflation has already taken place. Those seeking to find it need only look in the rear view mirror.

Mike "Mish" Shedlock
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