Friday, January 20, 2006

On the super-criticality of Financial WMDs

Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal. Warren Buffett

The War with Iran has begun in earnest, with Iran firing a precise strike into the heart of the West, the financial system. The headline announcing this radical change simply read, Iran said moving assets. The article explained that Iran was moving assets out of European Banks to shield them from possible UN sanctions but that is not the only effect which flows from this action.

One of the stated aims of Central Banking in particular and the Federal Reserves specifically is to fend off the spread of any panic induced bank runs. This is necessary, assuming, of course, you opt for a system of fractional reserves, because the inherent leverage of said system leaves it vulnerable to collapse in the event of withdrawals which exceed its reserves.

This vulnerability rises if the liquidation prices of the assets on the bank's balance sheets are
less than their "marked to market" value. That is, the effects of leverage, which has two faces, the inherent leverage of the fractional reserve system AND the leverage of the portfolio itself which is usually much higher, and market over-valuation are additive, hmmm, perhaps multiplicative is a better choice.

In the event of one bank's collapse, due to some combination of adverse market move and depostor withdrawal, depositors at other banks can become nervous and withdraw their funds, potentially sparking a chain reaction of financial default.

In a sense, you can think of a fractional reserve, or more generally, leveraged, bank as an unstable atom, and a highly leveraged bank exposed to over-valued markets as a highly unstable atom, for instance Uranium 233.

Both the Uranium and the highly leveraged bank have the potential to transform into a more stable state by releasing the energy that makes it unstable. Both the Uranium and the highly leveraged banks have the potential to ignite chain reactions, where such energy releases in one atom or bank creates instability in the next. In the case of Uranium, however, the medium through which such chain reactions occur is the proximate material universe while in the case of the financial system, the medium is the minds of men, which is why financial managers are always tempted to intervene in markets or otherwise obfuscate the facts.

In the patois of Nuclear Physics, criticality refers to a state where each nucleus that fissions induces on average one additional fission, i.e. it is self sustaining. This is the reaction used in Nuclear Reactors. Sub-criticality refers to a state where, while there are fissions they aren't inducing enough additional reactions to perpetuate the self sustaining energetic release.

This somewhat complex subject can sometimes be made easier to contemplate if instead of nuclear reactions you think of building a camp fire. Sub-criticality then refers to the state where you keep lighting matches and getting the kindling going but the fire keeps going out. Criticality then would refer to a nice camp fire that keeps you warm.

Super-criticality is the stuff of Nuclear Bombs. It refers to a state where there are more than enough fissions to keep the reaction going, indeed, the chain reactions grow exponentially over time. In our camp fire metaphor, your fire is supercritical when it ignites the tree under which you foolishly started it.

Getting back to the world of finance, it is the job of the Central Bankers to keep the inherently unstable leveraged institutions at sub-criticality. They perform this function by ensuring that the banks can survive a run by pooling reserves and directing them, at least in theory, where needed most.

To use Chairman Greenspan's favorite expression, pooled reserves are much more productive in that a much smaller quantity, relative to the amount that would be needed if each bank carried its own reserves, is needed to produce the desired effect - creating the impression of financial system solvency in the minds of depositers. Please note that I didn't write, be solvent, the aim here is to create the impression of, in fact, few banks could survive total depositor withdrawal.

The greater the systemic leverage the more difficult this job, of creating the impression of solvency, becomes as the effects of small price changes
on the financial sector's portfolios are greatly magnified, exposing the whole industry, in the event of a significantly adverse price change, to a loss of its entire reserve base. Let's go over that again to be clear, Central Banks pool reserves, making them more productive, at a cost, which rises with systemic leverage, of the implosion of the entire system.

Thus national asset markets under Central Banking become strategically important. A "crash" won't just impoverish speculators, it can cripple intermediation entirely for weeks, months or even years.

"But," you might be thinking, "don't all the banks mark their books to market. Surely the financial sector can liquidate at roughly its current value."

One of the experiences which led Warren Buffett to his view on derivatives was the unwinding of Gen Re Securities' derivatives book. He notes in his 2003 Letter to Shareholders:

When we began to liquidate Gen Re Securities in early 2002, it had 23,218 outstanding tickets with 884 counterparties (some having names I couldn't pronounce, much less creditworthiness I could evaluate). Since then, the unit’s managers have been skillful and diligent in unwinding positions. Yet, at yearend – nearly two years later – we still had 7,580 tickets outstanding with 453 counterparties. ......

The shrinking of this business has been costly. We’ve had pre-tax losses of $173 million in 2002 and $99 million in 2003. These losses, it should be noted, came from a portfolio of contracts that – in full compliance with GAAP – had been regularly marked-to-market with standard allowances for future credit-loss and administrative costs. Moreover, our liquidation has taken place both in a benign market – we’ve had no credit losses of significance – and in an orderly manner. This is just the opposite of what might be expected if a financial crisis forced a number of derivatives dealers to cease operations simultaneously.

This comports with my experience managing currency option portfolios for Chase Manhattan, unwinding derivative portfolios is an expensive affair, at the best of times. Thus you can see the trigger mechanism for the financial weapon of mass destruction right there, a financial crisis which forces a number of derivative (which might be better understood as EXTREMELY LEVERAGED) dealers to liquidate. Recalling yesterday's whimsical digression of euphemisms, we might wonder just what "financial crisis" means.

Well, the Asian Crisis occurred when international investors withdrew enough capital from asian markets to create financial super-criticality. So, to induce financial super criticality all one needs to do is withdraw enough funds, or sell enough Treasury Bonds or whatever, to force liquidations. The same can happen in any leveraged financial system, even that of the US.

I'm a bit spooked to consider the coincidence of Osama bin Laden warning of more attacks and Iran withdrawing funds. The intricate web of financial obligations mushroomed during the 90s based on the expectation of the whole world adopting western finance. The "Peace Dividend" in a sense, was wagered.

Yet, If enough key countries decide not to play, and by virtue of their oil reserves this means Iraq and Iran, the expectation on which this vast financial web is based becomes Soros' trend whose premise is false. It is the Achilles Heel of the west in general and the US, by virtue of its inability to self finance, in particular.

Hopefully this eventuality will be avoided. Although I am critical of US economic policy with regards to financial system leverage, specifically because it leaves the nation vulnerable to such attacks, I have no interest in being proved right in this way any more than one wants a friend, who happens to smoke despite your best efforts to get him to stop, to get cancer. If I was a politician I might argue something like, President Reagan told Mr. Gorbachev, Tear Down This Wall, and I tell Mr. Greenspan, Defuse the Bomb, Unwind this Portfolio. "Whew," you might be thinking, "don't quit your day job."

One final point if I may. It seems to me as if the only way that the US$ can continue as global reserve currency is if it brings all nations, especially oil exporting nations within its system. A Cold War style detante is no longer possible without significant financial disruption by virtue of the aforenoted massive expansion of leverage in the financial system, the bet on US$ global hegemony has been placed. It is an all or nothing, a binary proposition, which does not lend itself to hedging, the essence of derivatives valuation. I think this is going to be ugly either way.