Wednesday, June 09, 2010

Now you see it, now you don’t

Most economists’ long-term fear is that the federal government’s wild deficit spending and bailouts will lead to inflation. Right now, however, deflation seems to be the order of the day. Wholesale and retail prices are generally flat or declining as is personal income. House prices also seem set to drop some more. What’s puzzling about this is that the federal government has been flooding the economy with cash from several different hoses. Where’s it going?

A lot of the money is going into the TBTF banks where it is being stuffed under the mattress. Despite their rosy claims, these banks are still in precarious shape with lots of near-worthless financial junk on their balance sheets. Much of this paper is still listed at their pre-collapse valuations rather than what they are truly worth. This is often called “mark-to-fantasy” rather than standard practice of “mark-to-market.” That mattress money is there (and growing) for the day of reckoning when the fantasy has to end.

Case in point is this announcement today from tottering bond insurer Ambac. An agreement has been reached with owners of insurance it had issued on CDOs (collateralized debt obligations) of ABS (asset backed securities, presumably mostly mortgages) that have plummeted in value. The settlement amounts to $ 0.28 on the dollar for over $16 billion worth of CDOs. Thus, with the swipe of a few pens, $16,400,000,000 became $4,600,000,000. Now THAT’S deflation. Incidentally, it was just such insurance issued by AIG to the TBTF banks which was redeemed at $1.00 on the dollar thanks to the generosity of the US Treasury. Not all debt, insurance or banks are treated equally.

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