A New Bubble?

First blog entry in a heck of a long time. So I'd just like to start by catching up: Merry Christmas, Happy New Year, Happy Valentine's Day, and Happy Family Day.

It's been a rollercoaster since the last entry. The election of a new president, massive capital infusions, TARP, TARP II, TARP Classic, auto bailouts, the Porkulus bill, the Dow flirting with 7000, and the multi-trillion dollar Obama budget.

So where do we stand right now? Well, the credit markets are in better shape than they were a few months ago, but banks are still reducing lending or eliminating it all together. For instance, HSBC today announced that they will be eliminating its lending operations in the U.S., both in the personal and subprime segments. The major American banks are still hesitant to deploy their capital to borrowers who may not be able to pay them back. Think of it this way. I have $100 to lend. If I give that money to someone who wants to borrow - call him Ringo - I want to be fairly certain that I'll get most of my money back with interest. However, before I lend out $100 to Ringo, I want to know a few things about the him. I'd like to know about three key things: collateral, character, capacity. Collateral refers to the assets that can be sold if the customer defaults. Are the rings on Ringo's finger of sufficient quality and worth to me? Character refers to the borrower's desire to repay the loan as promised. This is probably based on my past experience with Ringo - did he repay me on time? Capacity is the ability to repay the loan. Can Ringo keep on touring and selling records to repay me?

In good times, maybe the answer to these three questions are positive. Today, however, there is serious concern about the collateral and capacity of borrowers. If all of a sudden Ringo can't repay me because his band broke up, he's out of a job, and has no income, then it makes little sense for me to lend him the $100. Similarly, it makes little sense for me to lend him $100 if the value of his rings - his only tangible asset in this universe - have no market value, or are worth a fraction of what they once were. Basically, people can't get access to money. It's a pretty big problem if you think about it. If you're a business, and you want to snag a loan with the hopes of making a positive NPV project that will create jobs, but the bank deems the venture to be too risky, all of a sudden, you're up a creek. Now you have trouble competing. It's in everyone's best interest to get lending going again.

So if lending is too risky for banks, and buying stocks is too risky for investors, where is all this money going? Under the mattress? Yes, some of it. The rest of it is going into Treasury bills, t-bills if you will. The good old "risk-free" asset issued by Uncle Sam. The yield on t-bills is virtually zero at this point. At points it has been negative - investors willingly taking a small, yet quantifiable loss, simply because this is favoured to losing your shirt in a riskier asset. For those of you who aren't aware, the yield of something like a t-bill moves opposite to the price. So when lots of people are bidding for t-bills, the price rises, the yield falls. When the yield is negative, that means you pay say $101 today to get $100 back in three months.

The widespread entrance into t-bills has created a bubble. However, with the government literally printing trillions of dollars, inflation is bound to rear its head. Yet, the massive increase in supply of t-bills has done little to dampen the demand or lower prices. Warren Buffett recently decried the creation of this bubble, and noted that investors have gone from underpricing risk to overpricing it. That means that people are now too concerned about risk, and are putting too high a premium on it. At what point does the bubble burst? When do China and Japan stop buying U.S. debt? When this happens, how much of a hit will the U.S. dollar take? Obviously these questions are impossible to answer, but the impact of the bursting of this bubble could deal another major body blow to a world economy that is already battered, bloodied and bruised.