Metamorphosis

Let's spin this globe and take a look at things from a slightly different angle. If we could inventory the entire planet, every real, solid, tradable item we came across would belong to someone. Someone somewhere, or a group of someones would have bragging rights to each and every thing on this planet.

Each one of these items that is the least bit tradable would have some sort of value attached to it. Of course some things are not tradable. For example, a mountain in the United States that has been designated by the collective as public land is not a tradable property. Neither is Antarctica.

But those things to which property ownership rights can be transferred must have a value of some sort. And this value is a numerical representation of their relative usefulness or desirability to humanity when compared to everything else. Of course, less tradable items, like the Kremlin or the White House, need not have a calculable value in any real sense.

Equity versus Debt

Equity is the value of a person's interest in a piece of property in excess of all other claims against that property. If you financed your home you probably pay a little principle and a lot of interest each month on your loan. The principle portion of your payment generally gets added to your equity position in your home.

In the modern world you can obtain bragging rights to a piece of property in a number of ways. But that doesn't necessarily mean you own it. If you purchase something for cash then you have full equity in that item, and no one else has a claim against it. Or you can also obtain bragging rights by borrowing, leasing or financing that same item. This is different than paying cash because it delivers to you the use of that item, but not the full ownership.

Now some items that we find in our planetary inventory are productive equipment items. These are things that if used properly can increase the amount of wealth in the world. A giant crane, for example, can be used to build new structures that can then be valued and traded relative to everything else in the world.

With nearly 7 billion people in the world today, the various tasks of production have been divided to the extreme. For example, you will be hard pressed to find a man operating a crane, who also owns that crane, and also owns the project he is working on as well as the land underneath it. If such a man exists, then it is surely a very small project in his own backyard.

So cranes are generally loaned, leased or financed to those who want to build, by those who want to own (productive capital). And the return to the owner of the crane is a function of the value of the use of the crane. Not the appreciation in the tradable value of the crane itself. Can you see the difference? If someone owns a full equity position in a piece of productive capital, he does so in order to earn a return, a yield based on the value of the USE of that capital. He does not count on the value of the crane increasing in the future so that he can sell it for a profit. There is a big difference! Think about this.

Ponzi Value


Let's imagine I personally paid cash for my home. It was not my best investment as it turns out. But at least I have a full equity position in it. (Let's ignore the separate issue of property taxes to the collective for the sake of this discussion).

My next door neighbor, on the other hand, financed his home. Earlier this year he realized that his equity position had gone very negative and he walked away. Today, 9 months later, his home still sits empty.

But here is my question: Who actually owns that home next door? And what do they actually own? What value (relative to the rest of the real world) do they actually hold? And how does that true value they own compare to the numerical value they believe they own, the one that is printed on their monthly portfolio statement?

The answers to these questions are not as clear as they might seem, at least not the answers I am seeking. We could simply walk down to the county recorder's office and pull the title to that property. It would give us a name, perhaps two names, and a value number. But even the bank's name on that title does not represent a full equity position in the house.

If we were to look at the bank's balance sheet we would see that house (now that my neighbor has left) listed in the asset column and a corresponding number in the liability column (the remainder of the loan my neighbor abandoned). The two numbers will probably cancel each other out. Perhaps it says $400,000 next to the house in the asset column, and -$400,000 in the liability column, for a net position of zero. The problem is that the house can only sell for $250,000 in today's market. This makes the bank's true net position a negative number, -$150,000. And that is only AFTER the bank sells the house. In the meantime, there are costs associated with holding the title, which the bank currently must pay. So who owns the house next door?

For the answer I am looking for we need to play things out the way they should have played out and drill down to who would end up with a full equity position on that house next door. I am also interested in what would be the true relative value of that equity position and how that number compares to this person's or group of people's perception of the value they hold today. Who is it? What do they think they have? And what do they really have?

Drill Down

If the bank was left to its own devices it would have to reconcile its assets and liabilities which would leave that bank insolvent with a negative net worth. So the bank is obviously not the true owner (with bragging rights) of the house next door. What about the bank's managers? Nope, they will be out of a job after liquidation of this insolvent bank. What about the bank's stockholders? These are the real owners of the bank. Nope. As it turns out, they own nothing but a really big negative number. In other words, they own a very real debt that must be paid! Funny how this bank stock traded at hugely positive numbers for the last two years while what was really traded was ownership of a debt!

So in a full liquidation of the bank's assets, who gets them? Well, the way it is supposed to work, the holders of bonds issued by the bank would be the ultimate recipients of the liquidation value of the bank. These are the people that loaned money to the bank. But in the case of commercial banks this seniority ladder is further complicated by an even more senior creditor, the depositor.

Now, in a full liquidation of all insolvent banks we would need to see all homes "owned" by the banks (REO's) go on the market until they were sold. We would see prices fall until they reached a level in which the entire market could be cleared and all debt positions change hands into equity positions.

A rough estimate of this scenario would mean an additional haircut of 50% from current housing price levels. So in the case of my next door neighbor, the empty house of debt would likely be filled with a full equity position (along with all others) at, say, $125,000 (50% of $250,000).

Moving from Debt into Equity Positions

So in the above scenario we have moved all property from a position of debt ownership to a full equity position that can be balanced against the rest of the real world. And in the process we have completely wiped out the original homeowner (who lost all perceived equity in his home), we wiped out the bank (which became insolvent and had to be liquidated), we wiped out all the banks stockholders (debt owners), and we, at best, gave the bondholders a 70% haircut on their savings. At worst (with an insolvent FDIC) we also wiped out all the bondholders and gave the depositors a haircut on their deposits!

Of course this didn't happen because of the FDIC, which is really just a fancy façade in front of a printing press. But if the FDIC was needed to make the depositors whole, then the bondholders were wiped out anyway.

This is the deflationary collapse scenario. This solution for changing debt into equity preserves the sanctity of the senior debt holder (only to the extent of the true value of the physical assets) and the numéraire (denominator) of the debt (the dollar). It keeps the dollar intact and, had it been allowed to play out, would have likely allowed the US Treasury to continue issuing bonds for another whole cycle. But this scenario was never meant to be. It wasn't even an option.

Some people have proposed a different way that debt positions could have been forced and crammed into equity positions had it been done early in the crisis. You see, the difference between debt and equity is that debt is denominated by the numéraire (the dollar), ranging from 0 to infinity, while equity is denominated in percentage terms of ownership, ranging from 0 to 100.

This is why the stock market is known as the equity market, and the bond market is the debt market. When you buy a stock, you are buying a percentage of ownership in that company. But when you buy a bond, you are buying a debt specifying a fixed payment denominated in dollars.

In the stock market you share in the profits or losses of the company, but you are theoretically isolated from the volatility of the numéraire. In the bond market you are theoretically isolated from the performance of the company or public entity, but you are exposed to the risk of total loss through a purely symbolic currency.

The way some say they could have forced debt positions into equity positions would have been to forcefully convert all debt (bonds) into percentage shares of the debtor. Then they would give enough shares to the debtor to match his initial starting capital (down payment). His initial equity position. This keeps the debtor in the game, which keeps the underlying asset valuable to a greater degree than in a massive liquidation of like-kind assets. (This would work similarly for underwater public companies and underwater homeowners alike).

Let's say the ultimate bond holders owned 75% of a $400,000 house upon loan creation and the homeowner put down a 25% down payment. Then the value fell by half. Now the entire asset is worth $200,000 and the debtor is in the hole for $100,000, while the bondholder is still showing a $300,000 "asset" on his books. Choice A; the debtor walks away and the house liquidates for $125,000 and the bond holder gets $125,000. Choice B; the homeowner gets 25% equity in $200,000 and stays... no liquidation! Now the bondholder has a real equity position of $25,000 or 20% more than under choice A! And the system becomes stable and sustainable once again because it is now based on equity, not debt!

There is a precedent for this type of non-usurious system in the Bible and other religious texts. [1] But alas, it would be too logical to do it the easy way. So instead we will do it the hard way. Since we didn't do it by force (forced equity), or allow it to happen within the system's "rules" (deflationary collapse), this highly unstable system will be forced to stabilize itself.

Sustainable Stability, Stable Sustainability

Say that ten times with your eyes closed! :)

Debt is inherently unstable. This is because debt can be destroyed instantly by non-payment, by default. "I'm not going to pay" or "I can't pay" simply destroys debt instruments held as a wealth reserve. In today's marketplace new debt is created extremely easily and casually. A new debt instrument is issued with the ease of a single signature, and then that debt is traded into the marketplace, marked to market as time passes and paper circulates.

Here is a news story that demonstrates the marked to market instability embedded in a fixed debt. Nakheel, the developer of palm tree-shaped islands off the coast of Dubai asked to have marked to market trading of its debt paper halted while it worked out the details of its default because the trading itself could affect the details yet to be worked out. [2]

DUBAI – Dubai's Nakheel asked for three of its listed Islamic bonds worth $5.25 billion to be suspended pending details of restructuring plans at its parent company, a move likely aimed at dampening speculation on the bonds.

The request briefly stalled but did not stop trading in the bonds, which are exchanged over the counter and not on the bourse, where the listing is regarded as a technicality.

The request also added to confusion that has reigned in the markets since the Dubai government last week said it would seek debt standstill agreements from creditors to Nakheel and Dubai World...

"Speculation on the bonds" means the marked to market trading of this "over the counter" debt instrument. Even the anticipation of a debt default can crash a system built on debt! And non-payment is not the only path to default.

If you are the world's largest engine of easy and casual debt creation and also the maker of the paper that denominates it, there is another way to default. And there is another kind of default the market can anticipate. Devaluation!

Another threat of extreme instability in a debt-based system is the chain reaction effect. Almost every entity that issues its own debt also holds the debt instruments of other entities as its reserves. So when one large entity defaults, the falling domino effect can be systemically catastrophic. And to complicate things even more, the methods of stemming systemically catastrophic consequences themselves have an even worse systemically catastrophic outcome; the collapse of the numéraire.

Debt is unstable because it is entered into (created) so lightly, and it is based on the assumption of a fixed future performance by an entity or individual. An assumption that is currently proving to be flawed during an economic contraction.


A system that is built upon equity positions is much more stable as equity agreements are entered into with much more gravity. If both parties share in the risks and rewards of future performance they will take everything more seriously. Also, equity agreements are based on the flexible assumption of variable future performance! A much more realistic assumption.

Finally, equity agreements by their very nature are more tied to the size of the real physical world than are debt agreements which are created at the drop of a hat.


This is why the global equity markets are about half the size of the debt (bond) markets. It is also why a virtual mountain of derivative "insurance policies" has grown around the debt markets like a terminal cancer while no such equivalent monstrosity strangles the equity markets. Credit default swaps and interest rate swaps are all a futile attempt to make an inherently unstable debt-based system stable and sustainable. There is no such need or incentive in an equity-based system.

In an equity-based system, any entity can still issue unlimited paper notes if it wants. Just like the US government does in its crazy debt-financed world. The difference is that the marketplace will price that paper against the real underlying property as it is issued. If a company doubles its issue of stock certificates to raise cash, then the price of each outstanding share will be cut in half. If a sovereign money-printer doubles his currency base to pay his cronies, then the value of each currency unit will be cut in half. But in today's debt world, a company can keep issuing more and more bonds until it ultimately collapses under the weight of its debt service. The same goes for countries.

Sustainability


Instability is the greatest burden the current system places on the real economy. It is what makes it unsustainable. As I read in a recent article:

Business is complicated enough without being inadvertently drawn into the [currency] exchange rate business...

Companies can hedge [this currency risk], to the tune of a notional value of roughly $600-trillion these days. But whereas larger companies, and those in developed countries, can rely on such hedging, companies in all the developing world cannot. [3]

So the instability of this debt-based system grows ever more dangerous as efforts are made to stabilize it. The growing mountain of derivatives is truly a house of cards capable of bringing down the whole system! How's that for stability and sustainability?

The question then becomes how will Mr. Market convert debt into equity and bring the system back to a state of sustainable stability and stable sustainability? Obviously our money masters have refused to go there willingly. Obviously our banks have refused to give up their debt positions. So what is next?

Metamorphosis


I found this great line in Topaz' Time Currency blog:

The first rule of Faith-based systems is that any and every thing must have a paper equivalent for "valuation" purposes ...in order to compare apples and apples.

This is a great quote on many levels. Today we use these paper equivalents not only for valuation purposes, but also as a way to "save the real thing for future use". The quote also shows the mind set of the system. Paper compares with paper as apples to apples. But can this really be true when comparing equity paper with debt paper and its cancerous tumor of derivatives? With global equity markets at around $35 trillion and global debt markets ($70T) plus their derivatives at more than a quadrillion?

If Mr. Market is going to bring things back in line with reality, how will this be accomplished given the disparity of value between debt and equity?

Remember earlier I said this:

In the stock market... you are theoretically isolated from the volatility of the numéraire. In the bond market you are theoretically isolated from the performance of the company or entity, but you are exposed to the risk of total loss through a purely symbolic currency.

The purely symbolic currency. This is how Mr. Market is going to bring the paper world back into balance... apples to apples. In one fell swoop a foundation for stability and sustainability will emerge through natural morphosis!

Deflation?

If today's deflationists are correct then the numéraire will remain strong or even grow stronger while the world runs from equity ownership of the physical world into the warm embrace of casual debt creation stabilized by its own Ponzi-like exponential growth pattern.

Think it through. We don't just muddle through from here. We either shift toward equity or debt. We are currently not in stasis.

Perhaps at some point the Fed would like to crash the equity markets in order to drive you into its warm (debt) embrace. As someone from London once said, wash, rinse, repeat. Right? Will this be enough to convince Mr. Market to give up on equity positions? Could a stunt like this be enough to convince a world full of realists, producers and savers to hand their claims on real property over to the paper pushers in exchange for a signature?

For those of you who can't already see the obvious answer, as Another once said, "time will prove all things."

What about Gold?

Gold is a little different. Yes, it is the ultimate equity position with assured future global liquidity. Yes it is the ultimate wealth reserve as a known timeless claim on anything you may need in the physical world of your future. But it is also a multi-generationally depressed numéraire of the value of the entire physical planet.

Yes, apples to apples. Paper to paper, physical to physical.

Let's try a simple word replacement in Topaz' quote:

The first rule of [physical equity]-based systems is that any and every thing must have a [physical numéraire] equivalent for "valuation" purposes ...in order to compare apples and apples.

I will leave you to do your own math on where the real value of physical gold will come to rest on the other side of morphosis. I have already presented my calculation in other posts.

The bottom line is that debt (credit) markets appear to work great in a seemingly perpetually-expanding economy, but they are completely unstable, unsustainable and deadly in a severe contraction.

An equity-based system is stable and sustainable and a debt-based system is not. Mr. Market knows this in the same way a million individual ants can find the same piece of meat a mile away. And for the record, I don't buy the idea that an evil cabal can stop the tide from coming in.

I leave you with this little ditty from Bloomberg last Friday...

Nov. 27 (Bloomberg) -- Wall Street’s system for determining payments on derivatives linked to the debt of defaulted companies is showing cracks less than a year after securities firms changed practices to avoid “Draconian” regulation.

Credit-default swaps tied to Thomson SA, the Paris-based owner of film processor Technicolor Inc., paid some holders 30 percent less than those with contracts expiring a day later. In Japan, owners of swaps on Aiful Corp. haven't been compensated, though one of its banks said the consumer lender skipped loan repayments. Dealers can't agree whether to reimburse investors in Mexican cement maker Cemex SAB’s debt swaps.

Disparities are arising in spite of practices adopted in April and July to standardize settlements and curb risk in a market that exacerbated the worst financial crisis since the 1930s by contributing to the downfall of American International Group Inc. Analysts at Bank of America-Merrill Lynch, Barclays Capital and UniCredit SpA say changes are needed as dealers examine how to interpret existing rules to maintain investor confidence.

“The first cracks are being shown in the protocols,” said Edmund Parker, head of derivatives at Chicago-based law firm Mayer Brown LLP in London.

The rules are being tested as the global default rate rises...

Sincerely,
FOFOA

[1] History of Usury Prohibition
[2] Nakheel asks for sukuk suspension
[3] As the world floats