Tuesday, October 29, 2013 - Happy Birthday

Happy Birthday

by Sinclair Noe

DOW + 111 = 15680
SPX + 9 = 1771
NAS + 12 = 3952
10 YR YLD - .01 = 2.50%
OIL - .95 = 97.73
GOLD – 8.90 = 1345.30
SILV + .01 = 22.62

The internet is 44 years old today. Happy Birthday. Oct. 29, 1969, that was when the very first message moved between the first two computers connected on the new network designed to link the numerous computer science projects funded by the government. 

On that day 44 years ago, an operator at Professor Leonard Kleinrock's lab in UCLA's Boelter Hall began tapping out the word "LOGIN" and sending it to a sister computer at SRI, a government contractor, in Menlo Park. He got as far as "LO" before the SRI unit crashed. Later that day the bug was fixed and the message completed. Within a year, ARPAnet linked 10 computers across the country.

The first email message using the "@" symbol in its address went out in 1971;  the TPC/IP protocol was developed in 1974; Tim Berners-Lee implemented the world wide web in 1989 and that is the version that we access through our browsers. So, you could make the claim the internet, as we know it and use it, is just 25 years old.

The internet was a government project, built with your tax money, because private companies, such as AT&T and IBM, didn't see enough profit in the idea. That's what government is supposed to do, take on important jobs shunned by the private sector.

The network was the brainchild of Robert Taylor, then chief of the information technology office at the Defense Department's Advanced Research Projects Agency (ARPA), who demanded that the computer research projects he was funding around the country learn to talk to one another. In 1966 he secured a $1-million appropriation for the design and construction of a network that would be known at first as the ARPAnet, but its role as the Internet's parent is undisputed. Taylor later moved to the Xerox Palo Alto Research Center and oversaw the invention of the personal computer.

Today also marks the 84^th anniversary of Black Tuesday, when the Dow Industrial Average lost 11.7% just one day after Black Monday. These two Black trading days, which destroyed nearly a quarter of the Dow's value in less than 48 hours, mark a sharp break between the Roaring '20s and the onset of the Great Depression. Some $30 billion in market value was destroyed in these two days -- an amount equal to more than 30% of U.S. GDP -- and at this point in the Great Crash, the Dow had already lost 40% of its value since peaking at 381 points in early September.

The most surprising thing about Black Tuesday, to those of us with the benefit of hindsight, is that the national mood was overwhelmingly positive. Toward the end of the day, wrote the Los Angeles Times, "There was a wave of optimistic feeling among the brokers. Old traders 'felt it in their bones' that the worst was over." Journalists, financiers, and politicians from across the country stridently championed an imminent return to prosperity. The Associated Press and The New York Times  gathered many notable statements in Black Tuesday's aftermath, and to these seasoned professionals, Wall Street's future was so bright that everyone would soon need to wear shades:

The Kansas City Star wrote: "Now that the inevitable deflation has come, business conditions remain essentially sound ... the way is prepared for a further advance in industry."

"The sagging of the stocks has not destroyed a single factory, wiped out a single farm or city lot or real estate development... all those things are still there," claimed New York News.

"The stock market crash is the result of many forces, most of them transitory, and all of them combined incapable of upsetting the firm base of prosperity," wrote the Baltimore Sun.

"The country is in reality no poorer than it was before the boom set in," claimed the Des Moines Register. "We may look forward confidently to a much saner and much safer financial winter than promised a few weeks ago."

The Davenport Times wrote, "The nation is economically sound. Now, not a month ago, is the time to be bullish on America."

Black Tuesday was also remembered for it's frenzied trading volume of more than 16 million shares. Nowadays, we have personal computers and the internet and high frequency traders that can move 16 million shares faster than I can say 16 million shares.

Today, the Federal Reserve FOMC is meeting. Tomorrow the FOMC will wrap up their 2-day session and publish a statement on their thoughts for monetary policy. They will basically maintain the status quo. We better hope so anyway; they haven't communicated any significant policy shift; the markets abhor surprises from the Federal Reserve. Still, we wait for the fat lady to sing because you never know what can happen in the bottom of the 9^th inning with 2 outs.

Over the past few days, here on the Review, we've talked about the Fed andthe day when they will eventually begin to taper Quantitative Easing, and we've also talked about new rules from the Fed designed to have big banks hold more capital reserves to serve as a cushion in an emergency so we never have to bailout the banks again. Today, I'll explain how those ideas go together and the longer-term implications.

In the next 12 to 24 months, capital markets are going to struggle due to a shortage of government debt. That's right, not enough government debt. The problem of not having enough government bonds, notes, and bills might seem like a good problem because it assumes the government is balancing budgets and reducing deficits, but any significant reduction in the issuance of Treasury securities would directly impact lending and credit markets in the US and globally. Interest rates would rise, and capital markets would become distorted.

Before you scream out that I've lost my mind and there is no way our huge budget deficits will be tamed any time soon, especially with a dysfunctional government and politicians tripping over campaign donors to make a mess of everything, just consider: we thought massive deficits were incontrovertible and the budget impossible to balance. Then it happened under Clinton. Treasury issuance was greatly reduced as a result.

Long before budgets are balanced and deficits reduced, the soon-to-be vastly ratcheted-up demand for Treasury securities will be felt. The demand will come from banks, trading houses, and financial institutions of all stripes. What’s happening now is that regulatory changes are going to force banks and financial institutions to hold more Treasuries, a lot more Treasuries, and demand will accelerate over the next few quarters and couple of years.

New Basel rules will be implemented. New Dodd-Frank rules, those already written and the hundreds more that may get written, will eventually be implemented. And other regulators are imposing their own rules and requirements. The net result is that financial institutions are going to have to hold more and better capital and make themselves more liquid. They’ll do that by owning more “risk-free” Treasuries.

Ben Bernanke, chairman of the Federal Reserve, came out last Thursday with new liquidity requirements for banks and systemically important financial institutions. The “liquidity reserve ratio”will require institutions to hold high-quality liquid assets to cover anticipated total net cash outflows over a 30-day period.

What constitutes high quality assets? Treasuries. If you have to have liquid assets that aren’t going to fall off a cliff in a financial crisis that you can liquidate, meaning there have to be buyers, US Treasuries are it.

On top of filling liquidity requirements, Treasuries will be in huge demand as marginable collateral for credit default swaps, once the final language in Dodd-Frank is written and swaps are exchange-traded and trades are settled through clearinghouses that guarantee counterparty obligations. To do trades through a clearinghouse that’s taking on counterparty risk, margin has to be posted by traders. Collateral used for margin is only good if it can be quickly sold, especially in a multi-trillion dollar market where collapsing prices could implode global markets.

What constitutes high quality assets that are universally accepted as collateral? Treasuries.

The next best thing to Treasuries are agencies. Agency paper refers to debt instruments not issued by the US, but guaranteed either explicitly or implicitly by the US;such as debt issued by Fannie Mae and Freddie Mac. Those two giant Government Sponsored Enterprises (GSE) are the best example of issuers of agency paper.

And what are the politicians in Washington trying to do to Fannie and Freddie? Well, they're trying to kill them off. They are in Congress’ crosshairs right now. There are at least four proposed bills floating between the Senate and the House that all envision the disintegration of Fannie and Freddie. When that happens, assuming it will, there will be a lot less agency paper to be used as liquid collateral. The two GSEs, along with the Federal Home Loan Banks, have almost $7 trillion in debt outstanding that are considered safe assets. A dramatic reduction in agency paper will further increase the demand for Treasuries.

Eventually rising demand runs head on into reduced supply. It happened in the 1990's, and as a result of those two opposing dynamics happening, capital markets filled the void by manufacturing increasing amounts of guess what? AAA-rated mortgage-backed securities (MBS) and other then highly rated asset-backed securities (ABS). And yes, that's the kind of garbage that lead to lawsuits because there was garbage thrown into the pool. MBS and ABS aren't the same thing as Treasuries.

Are we headed down that path again? Probably.

Because the demand for Treasuries will result in institutions hoarding them, lending against less liquid collateral will cause interest rates to rise and credit conditions to tighten.

Quantitative easing has masked the problem so far. But, as QE is tapered out and if deficits are reduced while at the same time new regulations to make banks safer increases demand for Treasuries, we will face unforeseen capital markets dislocations and economic uncertainties.