Puerto Rico's Cash Crisis

"We are confident that we have the liquidity on hand to satisfy all liquidity needs until the end of the fiscal year," Treasury Secretary Melba Acosta Febo and GDB Chairman David Chafey said in a joint statement following the S&P downgrade.--Reuters

How long before Puerto Rico runs out of cash and defaults on its debt? The tea leaves suggest that the debacle will occur either this month or next.

One might well ask, what is PR's financial condition? PR's financial disclosure is poor and infrequent. The last comprehensive annual report was published nineteen months ago, in June 2012. The June 2013 report has not been published yet (shades of Enron). There was some spotty disclosure in October which did not include financial statements.

What an investor (or bond analyst) could really use at this point are: (1) a recent balance sheet; and (2) a monthly schedule of proforma cashflow for the balance of the year. In my experience with distressed credits, financial statements are commonly delayed or unreliable prior to default. Transparency takes a back seat when default looms.

According to a recent statement, the government intends to borrow soon: "the GDB and the Commonwealth of Puerto Rico have been in discussions with parties that have expressed an interest in arranging additional liquidity for the Commonwealth". If so, I would imagine that prospective "liquidity providers" would demand up-to-date financials and proforma cashflows.

Reuters published a very helpful story on PR's liquidity situation yesterday, which provides some indicative tidbits. There is the following paragraph:

The timing of S&P's downgrade, coming just 11 days after the agency announced a review, was unexpected. 'If we have enough information to take action, we have to release it; otherwise we're holding onto inside information,' S&P's Hitchcock said in an interview. 'We do have confidential information on GDB cash flows and liquidity, and, based on the information that we do have, we feel that we had to take action.'

In other words, S&P saw the numbers and had to act fast.

And then there is this:

The GDB is searching everywhere to increase liquidity. El Nuevo Día, the most widely read newspaper in Puerto Rico, reported that the GDB is asking for loans from Puerto Rico banks, trying to get refinancing and forbearance on outstanding loans and bonds from local creditors and trying to sell real estate holdings.

The above paragraphs would seem to contradict the government's happy talk about having adequate liquidity. So while we don't know precisely when PR will run out of cash, we do know that it is imminent, unless its current fundraising activities prove successful, which is unlikely given the recent rating downgrades. Whatever hopes PR had for raising funds have been severely complicated by the fact that it is no longer rated investment grade by either S&P or Moody's. That precludes most conventional municipal investors from buying--or even holding--PR debt.

The next step would be for the government to announce a "temporary" moratorium on debt repayment pending a review of its situation and conversations with creditors. Being unable to seek bankruptcy protection, the workout will be difficult and litigious. I can only imagine that the government has already retained a workout adviser such as Goldman or some other firm which is not a big creditor. It is as yet unclear to me in what venue such litigation will occur. It is also unclear to me whether PR enjoys complete sovereign immunity or is subject to court decisions made in San Juan or New York.

The government has scheduled an investor briefing for this coming Tuesday, which could include some useful financial disclosure. I would hope that there would be sufficient disclosure to be able to calculate PR's debt capacity, however exiguous. This would provide investors with a sense for the valuation of the commonwealth's bonds. My understanding is that the bonds are still trading at levels that suggest a substantial recovery rate. From what I can see, that is very optimistic. More on this later.

The Selloff Is Rational

Thesis: The selloff indicates that the economy is much weaker than the recent growth data would suggest, and that the data will have to catch up with reality.

The Dow is off by 1200 points or almost 8% since the beginning of this year, and is down 600 points in just the past week. The official explanation for the selloff is investor doubt about the growth outlook, as signalled by the December jobs report and the January ISM report. Which is strange, considering that the markets received very bullish news from the 3Q13 and 4Q13 growth numbers, which were both quite strong.

It would appear that the market is currently ignoring good news and focusing on bad news, whereas before Christmas it only noticed good news. Have the facts changed or has sentiment changed? I think sentiment is catching up with the facts.

As readers know, I have been talking bearish since mid-December. I discounted the strong 3Q13 growth number and pointed to the weak December jobs number. I have no explanation for the 4Q13 growth number aside from the fact that it is inconsistent with my bearish outlook, and that the market agrees with me.

Although we have conflicting data points about the current rate of economic growth, there is nothing ambiguous about the current rate of money growth: slow and getting slower. The markets are unable to fight the Fed, and the Fed is the villain in this story.

Money growth has been declining for 18 months, from above 10% in the first half of 2012 to below 6% today, a 40% drop. A big chunk of that drop occurred in late-2013. Now, we know from Econ 101 that when both the money supply and velocity are declining, nominal growth must decline. And nominal growth has declined--until the last two quarters, which is why they look fishy to me.

From the monetarist perspective, the independent variable in the economy is M2 growth. M2 growth has declined to a dangerously low level, particularly given the ongoing decline in velocity, the transmission mechanism to the nominal economy. (Yes, I understand how V is calculated, but it is clearly declining.) We are in the midst of a low growth period as a direct result of Fed policy. (It is unacceptable for any central bank to argue that it can’t control the money supply, as Bernanke has explained to the Japanese and others on many occasions.)

Economics says that either the strong growth numbers are wrong, or else the weak money numbers are wrong. They are mutually incompatible. Being forced to decide between the bearish money data and the bullish economic data, I go with the stock market: I agree with the bearish money data.

Here is the Commerce Department’s reported real quarterly growth at seasonally-adjusted annual rates:

4Q12: 0.1%

1Q13: 1.1%

2Q13: 2.5%

3Q13: 4.1%

4Q13: 3.2%

There is certainly nothing bearish there.  But I don’t doubt the money data: when I look at the aggregates, they are all going in the same direction: M1, M2, M3 and M4. (The first two are from the St. Louis Fed, and the latter from the Center for Financial Stability). All of the aggregates show declining growth rates.

In my opinion, the selloff is rational and reflects a weak growth and earnings outlook. We will learn the answer as further growth-related data is dribbled out.

Conclusion: The selloff is rational and reflects weak growth. It won't reverse until the FOMC takes control of money growth.

Flirting With Recession

Investment Thesis: Treasury yields will fall further due to Fed tightening and sub-target inflation. Stocks will exhibit weakness until the decline in money growth is decisively reversed.

The Fed has been tightening for the past 18 months, since July of 2012. Money growth has declined from 10% in mid-2011 to 5% today. As a consequence, both inflation and nominal growth have also declined. Inflation has dropped from the targeted 2% to the current 1%, while nominal growth has declined from 5% to the current 3.4%. The economy has been slowing down in reaction to the Fed’s steady closing of the monetary spigot.

This slowdown has most recently manifested itself in the weak December jobs report, and will become visible in the 4Q13 growth numbers. (The strong 3Q13 growth numbers were a statistical anomaly; I expect the 4Q numbers to be much lower.) Until the slowdown is reversed by the Fed, the economy will flirt with recession. This will change the market’s psychology from “accelerating recovery” to “another slump”. The goldilocks scenario of continued recovery  will be discredited, which will be good for bond prices and bad for stock prices.

As readers of the FOMC’s emissions know, the Fed does not acknowledge that it has been tightening and insists that it has been providing “extraordinary monetary accommodation”. I don’t know why they say this when their own numbers say otherwise.

My opinion, as I’ve said before, is that the Fed has lost control of M2 and doesn’t want to admit it. Hence they only talk about what they can control, namely their own balance sheet. The fact that there is no observable relationship between the Fed’s balance sheet and the money supply is an embarrassing fact best left unmentioned. As QE had no impact, neither will the tapering of QE.

Given that Yellen does not wish to see the economy flirting with recession, I expect her to propose new policies to reverse the decline in money growth. These could include a money-growth target, a price-level target, or a reduction in the interest rate paid on excess reserves. She is very unlikely to do nothing, and she knows that her power will never be greater than it is on Day One. If she wants to be a success, she will have to act now.

Frankly, I don’t care what new policies the FOMC adopts. I’ve had it with new policy rabbits coming out of hats. All I care about is money growth, inflation and nominal growth. Theological discussions can go hang; it’s results that I’m looking for. I was disappointed in Bernanke’s failure, and I do not want to be disappointed again.

Investment Conclusion: Until current monetary trends are reversed by the Fed, bond yields will fall and stocks will be weak. Watch M2 growth and nominal growth. If they accelerate soon, all will be well. Otherwise, recession looms.

Puerto Rico On The Brink Of Default

Investment thesis:

The Commonwealth of Puerto Rico will default soon.

It looks like the Puerto Rico debt crisis is rapidly coming to a denouement. The FT has a nasty story about Puerto Rico’s debt situation in today’s paper. The picture it paints is very bleak. CPR is a classic case of an over-indebted government which needs to borrow to finance operating deficits and to refund maturing debt. The government has run out of time to fix its finances. It needs to borrow more money than it can raise.

Three indicators suggest that the end is nigh: (1) Moody’s is very likely to  downgrade CPR to junk status in the near future, judging by the tone of its research; (2) the market rumor is that CPR will soon announce a debt moratorium; and (3) CPR’s creditors are meeting with debt restructuring experts.

It is impossible for a credit to recover from such a triple-whammy, whether a moratorium is planned or not. The government says it has enough cash to stay alive for the rest of the year, and it is hoping to issue new debt. Both facts may be true, but I am reminded of Enron and Lehman: a point is reached at which the credit cannot regain market confidence, and events  take charge.

Moody’s reports that CPR’s cash position is dwindling, and that a downgrade would make things worse: “The commonwealth has swaps and financings that include collateral and acceleration provisions in the event of a one-notch downgrade by any of the three major credit rating agencies. We estimate that a one-notch downgrade could result in liquidity demands of approximately $1 billion.” In the context of CPR’s proforma cashflows, $1B is material.

CPR has between $60-$70B of debt, depending on what you count, plus another $40B in unfunded pension liabilities. Moody’s compares CPR’s debt ratios to the 50-state median, which indicates that CPR’s indebtedness is an order of magnitude greater than the typical state. Debt to GDP is 72% for CPR and 2% for the median state. Debt to government revenue is 260% versus 42% for the median state. Although CPR doesn’t pay federal taxes, Moody’s says that its debt burden is “high by all comparisons”.

CPR is an interesting case, because its constitution prohibits bankruptcy, it is ineligible for federal bankruptcy, and it is required to service debt before all other expenses. The CPR government claims that this means it can’t default, but it can and it will. A deus ex machina rescue by the US Treasury is extremely unlikely. I don’t think that Treasury has any such authority, and I don’t see the House GOP caucus agreeing to bailout legislation (a bad precedent--and CPR doesn’t pay federal taxes). What is more likely is that Congress will establish a restructuring authority to administer the workout.

Will a CPR default be a big deal, or will it be a snooze? My sense is that it will be a snooze because it really has no implications for other credits, so there should be little contagion. It should raise credit spreads for weak municipal credits, but that is no catastrophe.

CPR can be analogized to the bad credits in the eurozone, in the sense that it lacks its own central bank, can’t print its own money, and can’t service its debts. Like Cyprus and Greece, its creditors will have to be “bailed in”. I haven’t looked at CPR’s banking system, but they are full-fledged members of the FRB/FDIC complex, which should provide a safety net.

Investment conclusion:

A CPR default should not be contagious, but will startle the muni market.

Look Out! The Fed Is Doing Something Strange

Investment thesis:

Money growth has to a dangerously low level. Unless this is reversed in the next couple of months, it will show up in both growth and equity prices. Watch M2 growth.

Money growth has been declining for the past two years, as has velocity. Given the quantity equation, we know that when both money growth and velocity decline, nominal growth declines arithmetically (MV = NGDP). The Fed has been tightening for two years, resulting in declining inflation and nominal growth. You are not going to see real growth accelerate as long as nominal growth is declining. Declining money growth and velocity forecast a negative growth surprise for either 4Q13 or 1Q14, or both. The revised 3Q13 growth number was a fluke.

What is even more alarming is that money growth has declined sharply during 4Q13, and is now running below 5%--the slowest rate of money growth since the crash itself.

What is going on? Why has the Fed been tightening for two years, and why has the it allowed inflation to undershoot the target by such a wide margin?

Here is what the FOMC says on the subject: “To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens.” (Minutes, 18 Dec. 2014)

In other words, the Fed denies that it has been tightening. Someone should buy the Fed a subscription to its own database: it could be quite eye-opening. In seriousness, the Fed must be aware of what I have just observed. But why won’t the FOMC publicly address the issue? Shouldn’t the “most transparent Fed in history” explain to Congress and the people why it is tightening when it says it is not?

Investment Conclusion:

Whether the Fed knows it or not, money growth is dangerously low and falling. No one is minding the store at the Eccles Building. This means that we are in for a negative growth surprise for 4Q13, and for the stock market. In this case, bad news is bad news.

The Post-Crash Deleveraging Process Is Over

Investment Thesis: The post-crash unresponsiveness of the economy to monetary and fiscal stimulus has been due to the deleveraging phase of the credit cycle. However, the data suggests that the post-crash deleveraging process is nearing completion. Going forward, this should make conventional monetary policies more effective, and lay the groundwork for an eventual pickup in nominal growth. This will provide the basis for higher corporate earnings and higher inflation. Stocks should benefit, while bond yields will rise.

Economists, such as Larry Summers, have been seeking an explanation for the weak recovery. The need for an explanation is pressing, since the economy has been surprisingly unresponsive to conventional monetary and fiscal stimulus.

Here is Summers on the subject: “We are now 10%  below where we thought the economy would be now in 2007. There's been close to no progress in regaining potential measured relative to the judgments made at the time in 2007.”

Many explanations have been offered to explain the weak recovery, of both a structural and cyclical nature. Economists generally rule out structural factors because they are unmeasurable: if a factor cannot be measured, then it can’t explain anything. “Obama’s anti-business policies” and “Republican obstructionism” are both unmeasurable, and thus useless as explanations.

The weakness of aggregate demand (AD) is generally considered a cyclical phenomenon, not a structural one, and AD should be responsive to macro policy. Keynesians say that the weakness of AD is a consequence of  inadequate fiscal stimulus, while monetarists point to inadequate monetary stimulus. Paul Krugman, on a lucid day, mentions both. But the economy has had massive inputs of both fiscal and monetary stimulus, and yet has remained far below potential for the past five years. The Keynesians need to explain why massive deficits didn’t do what they said they would, and the monetarists need to explain why massive bond purchases didn’t work either.

I have argued that, despite QE1, QE2 and QE3,  monetary stimulus has not been “massive”, as evidenced by sluggish M2 growth since the crash, which provides support for to the monetarist viewpoint. But I contend that the sluggishness of money growth is a symptom of a deeper phenomenon which explains the failure of the Fed’s efforts.

That deeper phenomenon is the credit cycle. Credit cycle theory was first proposed by Irving Fisher in 1933 and elaborated by Hyman Minsky in the 1970s. Modern proponents include Richard Koo of Nomura, and Steve Keen of the University of Western Sydney. According to credit cycle theory, inflection points in the credit cycle (i.e., Minsky Moments) force economic actors (including banks) to deleverage, and as long as the deleveraging process continues, the credit aggregates shrink and money growth is retarded. The bigger the debt overshoot, the longer the required repair period.

The US credit cycle experienced a Minsky Moment in the 2008-9 crash. Before the Minsky Moment, high financial leverage (especially in households, housing finance, banking and the securities industry) was acceptable. After the Moment, high leverage became diabolic as did all associated debt structures and obligors. The credit market shut down, forcing indebted actors to rapidly deleverage. 

The credit market had a major shock when Lehman defaulted, and has suffered from PTSD ever since. The deleveraging process took three years, from the end of 2007 to the end of 2010. Total credit did not begin to grow again until late 2010, and a number of sectors took much longer to complete the debt reduction process. Only now has the process finally ended, although the PTSD remains.

The debt market’s standards for acceptable leverage changed overnight after Lehman, instantly rendering uncreditworthy huge swaths of the economy including households, securities firms, finance companies, and banks. In order to regain market access, these actors had to unwind their pre-Crash debt accumulation in order to conform to new leverage standards, which has taken them a long time to accomplish. It took 15 years for the cycle to build up to the Minsky Moment, and it has taken five years to dig out from it. The credit cycle is at its root an artifact of psychology, and the recovery from a major shock does not happen quickly.

Market monetarists such as Scott Sumner discount credit cycle theory, on the argument that it is a derivative of monetary policy and can be overcome by competent monetary policy. I agree (I have to, since I believe the quantity theory), but I would argue that the credit cycle explains why the Fed’s “massive” stimulus policies have failed: the down-leg of the credit cycle creates huge headwinds for conventional policy. Only truly radical policies (e.g., helicopters) can combat the credit cycle, and they haven’t been tried.

How can we measure the credit cycle? The Fed’s “Flow of Funds” report provides data on credit stocks and flows for:

• Households
• Nonfinancial businesses
• Financial businesses
• State & local governments
• The federal government

Here’s a quick summary of  the 21st century credit cycle (all numbers are sectoral  liabilities):

Household Credit: $13T

Rapid (12%) growth before the crash, negative growth during the crash, now very low growth at 1%. No recovery yet: banks are not making mortgages.

Nonfinancial Business Credit: $9T

Rapid (13%) growth before the crash, mild contraction during the crash, now fully recovered to almost 10% growth. Business credit has had the strongest recovery. (The business credit cycle inflected in 2001.)

Financial Business Credit: $14T

Rapid growth (12%) before the crash, severe contraction during the crash (-13%), now flat at 0%. No recovery yet; the bleeding has just stopped. The PTSD remains strong, and regulation hasn’t helped.

State & Local Credit: $3T

Modest (6%) growth precrash, low growth during crash, negative growth since the crash. No prospects for recovery.

Federal Government Credit: $12T

Moderate growth precrash (5-10%), extremely rapid growth during the crash (35%), and now moderate growth again at 6%. Despite running big deficits during the crash, federal borrowing was insufficient to fully offset credit contraction by the private sector. (This supports the Keynesian argument that fiscal stimulus was too small.) The outlook for federal credit growth is not good; the declining deficit means that the pace of government borrowing will decline further, which will dampen overall credit growth.

Total Credit: $58T

This is the single most important data series in explaining the credit cycle. Total credit was growing at 10% before the crash, contracted modestly during the crash (despite big federal deficits), and has since “recovered” to an anemic 3% growth rate. Three percent growth is nowhere near full recovery; 8% growth would signal full recovery. The credit market is still a bit traumatized.

A crucial credit sector with respect to economic behavior is the financial sector, which is a provider of both credit and money, since money is a liability of the financial sector. The cyclical volatility of financial credit has been pronounced. Financial credit grew at an unsustainable 13% before the crash, contracted very severely, and has not yet recovered (zero growth). Total financial credit remains 18% below its 2008 peak. This explains a large part of what has happened since the crash. Hospitalized banks don’t lend freely.

The current 3% total credit growth and 0% financial credit growth explain the inability of conventional monetary policy to stimulate money growth, inflation and NGDP growth.  The Fed has the ability to control the money supply, inflation and nominal growth, no less than do the central banks of Venezuela, India, Egypt, Iran and Argentina (which have all succeeded in creating inflation). 

The failure of the Fed to get control of the money supply is explained by the headwinds resulting from the credit cycle, particularly the financial sector, as well as its unwillingness to adopt sufficiently radical policies despite lip-service to the contrary. The Fed has missed its statutory employment and inflation targets for the past five years. The Fed allowed the credit cycle to overwhelm its stimulus efforts (as it did in 1930-33).

The crash had nothing to do with the corporate sector, which had already suffered its own inflection in 2001. Business credit growth rebounded quickly, which has been a major bright spot for the economy. The business sector today is very healthy, despite low nominal growth.

Money growth depends in part on the demand for credit, and the cyclical decline in credit demand has resulted in the buildup of excess reserves at the Fed (instead of bank loans). The reasons are: (1) a lack of credit demand because borrowers are repairing their balance sheets; (2) a lack of credit supply because credit providers are repairing their own balance sheets, and (3) credit providers have have raised their lending standards. 

Credit has not been flowing to the economy at a pace anywhere near the pre-crash rate. In fact, it’s even worse than that: credit growth today is lower today than at any point between WW2 and the Crash. Currently growing at 3%, it had never before dipped below 4% even during the worst postwar recessions. This is a huge drag on both AD and money growth.

(Yes, credit growth data is nominal, but I think that nominal data is more explanatory today than real data. Low nominal growth is the problem in the current circumstance, and it should not be disguised by the use of adjusted data.)

As I said above, the Fed has full control over the money supply, inflation and nominal growth, if it chooses to exercise it. The Fed has the power to overcome the credit cycle, as as did the Bank of England in 1931, FDR in 1933, and the Bank of Japan most recently. But, by refusing to adopt radical expansionary policies, the Fed has allowed the credit cycle to negate its efforts. Ultimately, the fault lies with the Fed, and Bernanke knows it.

The Outlook for the Credit Cycle

There’s good news and bad news in the outlook for credit growth. The dominant sectors are households (mortgages) and the federal government (deficits). Each sector has about $13T of debt outstanding. The good news is that households have stopped deleveraging and have (almost) begun to borrow again. Over time, household debt should grow as lending standards are relaxed, but that will take more time.

The bad news is that the pace of federal borrowing has declined sharply and will decline further given the current budget outlook. Taxes have been raised and the Budget Control Act remains largely in place. The period of federal pump-priming is over, and the private sector is now on its own. (This annoys Krugman and worries Summers.)

As I observed earlier, the all-important financial sector has stopped shrinking, and may be poised to start to grow, although there are many forces at play. The financial sector remains badly shell-shocked, and the revival of animal spirits will take time.

There is a better-than-even chance that private sector credit growth will more than compensate for the withdrawal of big deficits, and there is very little chance that credit growth will turn negative, since all of the confidence indicators are positive. Going forward, the Fed will no longer have to contend with fighting a credit contraction, and may get some wind at its back.

Summers has expressed the concern that the US economy is only able to grow during credit bubbles. I would restate that as: the US economy is only able to grow during periods of credit growth--and this is only true in the absence of competent monetary policy. The credit cycle can be fought.

The post-crash deleveraging process has ended, and credit has started to grow again. Much will depend upon the re-opening of the mortgage market and the pace of fiscal contraction. Nonetheless, the economy is now in a position to better respond to conventional monetary policy tools, which should give the Fed a greater ability to stimulate money growth. It is now up to the FOMC to do its job.

Investment Conclusion: Stronger nominal growth will increase earnings and support higher equity valuations, while exerting downward pressure on bond prices. The up-leg of the credit cycle will accelerate, and could last quite a few years: the last one lasted 15 years. This is good news for both investment and employment.