Let's talk about risk, baby
Let's talk about you and me
Let's talk about all the good things
And the bad things that may be
Let's talk about risk
Let's talk about risk
Let's talk about risk
Let's talk about risk
paraphrased from Salt 'n' Pepa
We can guarantee cash benefits as far out and at whatever size you like, but we cannot guarantee their purchasing power. Alan Greenspan
One of the more perplexing developments, at least to old school thinking fellows like myself, in financial market participants' perception of risk is the view that bonds, at current rates of interest, particularly those issued by the US government, are less risky than Gold. I find the view perplexing in that it has very little basis in fact. As the Greenspan quote above alludes, there are no guarantees of purchasing power for the currency in which US bonds are currently (but not originally) denominated, US$. There is also no guarantee of the purchasing power of Gold, but unlike paper money, recalling Jefferson's adage about truth, this does not need the support of government.
Risk is defined as:
1. The possibility of suffering harm or loss; danger.
2. A factor, thing, element, or course involving uncertain danger; a hazard: "the usual risks of the desert: rattlesnakes, the heat, and lack of water" (Frank Clancy).
3.
a. The danger or probability of loss to an insurer.
b. The amount that an insurance company stands to lose.
4.
a. The variability of returns from an investment.
b. The chance of nonpayment of a debt.
5. One considered with respect to the possibility of loss: a poor risk.
The only variation of the definition that might lead one to the conclusion evidently held by the financial markets is 4-a, the variability of returns, and even then only when one restricts one's data set. It is true that Gold was a poor investment, unless you were a very nimble trader, in the late
70s and early 80s compared to US bonds. Double digit interest rates and new found stability for the purchasing power of the US$ from the mid 80s through the late 90s, but since lost, made US bonds a much better investment. But that was then.
In this century Gold has been a far less risky investment than US bonds according to variation 4-a not only because Gold has more than doubled, thus erasing the interest rate gain of bonds, but also because of the loss of purchasing power of the US$.
Moving beyond that one variation in the definition of risk, however, in the current context, it doesn't even seem to me to be a contest. Over the long term, and especially in extremis, Gold is, at least according to history, by far and away less risky than US bonds. Gold does not default, nor change the terms of repayment on the fly (Nixon closing the Gold window). It is what it is- a metal almost always acceptable in trade whose value, based on the thing itself, not the fiat of governments, throughout the past few millennia has always been relatively high.
Corporate, and by that term I mean to include governmental, religious and commercial variants, bonds have, throughout history, from time to time, defaulted. Bonds have their days in the sun, but as they draw their value from the power of the issuing institution, and not the intrinsic value of the thing itself, their value can go to zero, or as was the case with US bonds after Nixon closed the Gold window, can have their value eroded to mere cents on the dollar.
This is not to argue that there are never, or will never again be, periods of time when bonds prove to be better investments than Gold. I'm eagerly awaiting the time when governments need to compete for savings again. Rather, it is to argue that all bonds carry an inherent risk of non-performance that Gold does not. Gold transcends institutions of men. Faith in insitutions is always fleeting, albeit sometimes for quite long periods of time. It is this risk of non-performance, or minimally of failure to repay in kind that I feel to be missing from current calculations of risk.
US government bond advocates hang their hat, if you will, on the period from 1980 through 1999, but expanding their data set to include the preceding decade exposes their view as far less certain. For bonds to become an attractive investment for me interest rates would need to be much higher, like double digits. But even with the current yield curve at 5% the US mortgage market is near disintermediation. The US economy will, I fear, go through some difficult periods to get interest rates high enough to make US government Bonds worth the risk.
Of course, to agree with the view put forward here you have to be able to imagine that the US government will be unable to maintain the value of the US$. Despite the history of bonds in general, disclaimers from Fed Chairmen like Greenspan, and the dismal record of the Fed in maintaining the purchasing power of the US$, the US government is apparently considered, or at least inspires sufficient fear in prominent speakers to evoke statements to that effect, to be different than all other institutions in history.
US Bonds will be less risky than Gold as an investment in the current context if and only if the US government is truly different than all other institutions and retains the ability to do what Greenspan said it couldn't, maintain the purchasing power of the US$. Although I don't usually use Greenspan's views to support my own, in this case, I agree with him.
Some might question the wisdom of fighting conventional views in this matter. To those I would argue that history is filled with the downfall of previously considered indestructible institutions. The scheme of Carlo Ponzi, which immortalized, so far at least, his name in financial infamy, comes to mind.
It is worth noting that depositors at Ponzi's Security Exchange Company had always received on withdrawal, their promised 50% return in ninety days up until his public relations man reported that Security Exchange Company had never invested one cent in the depreciated European currencies from which he claimed his returns came. So long as investors kept depositing their cash with his company he was able to keep up with withdrawal demands.
People, even the well heeled, it seems, are susceptible to believing things that are too good to be true. Ponzi's scheme could, it seems to me, have gone on for many more years until it ran out of additional depositors. That is, the theoretical absurdity inherent in his scheme would only be exposed in fact when he reached the limit of everyone already being in the pool, so to write. Fortunately, the scheme was stopped before it reached that point.
Given that Greenspan's admission didn't lead people to question their faith in the US government's ability to produce returns for US bond investors, nor has the evidence over the first 6 years of this century, I wonder what it will take to shake their faith?
Barring the discovery of US Bond loving Central Banks on another planet, the US government will eventually run out of additional depositors and then we will see what is risky and what is not.
I met a traveller from an antique land,
who said--"Two vast and trunkless legs of stone
Stand in the desart....Near them, on the sand,
Half sunk a shattered visage lies, whose frown,
And wrinkled lip, and sneer of cold command,
Tell that its sculptor well those passions read
Which yet survive, stamped on these lifeless things,
The hand that mocked them, and the heart that fed;
And on the pedestal, these words appear:
My name is Ozymandias, King of Kings,
Look on my Works, ye Mighty, and despair!
Nothing beside remains. Round the decay
Of that colossal Wreck, boundless and bare
The lone and level sands stretch far away."
Ozymandius - Percy Bysshe Shelley
Friday, March 23, 2007
Thursday, March 15, 2007
Chimerica: can we "yada-yada" the imbalances?
George: Listen to this. Marcy comes up and she tells me her ex-boyfriend was over late last night, and "yada yada yada, I'm really tired today." You don't think she yada yada'd sex.
Elaine: (Raising hand) I've yada yada'd sex.
George: Really?
Elaine: Yeah. I met this lawyer, we went out to dinner, I had the lobster bisk, we went back to my place, yada yada yada, I never heard from him again.
Jerry: But you yada yada'd over the best part.
Elaine: No, I mentioned the bisk.
Seinfeld
One of the recent themes of historian Niall Ferguson's views, while not, in the limited sample I've managed to find, stated as such, is accepted economic convergence. He uses the term, Chimerica, a merger of China and America, to explain the view that international imbalances are not as troubling as they might appear, at least if we could see the world from his perspective.
From the LATimes: Yet there's another way to see these supposed imbalances: as no more worrying than the doubtless very large imbalances between, say, California and Arizona. Think of the United States and the People's Republic not as two countries but as one: Chimerica. It's quite a place: just 13% of the world's land surface but a quarter of its population and fully a third of its economic output. What's more, Chimerica has accounted for about 60% of global growth in the last five years.
The relationship isn't necessarily unbalanced; more like symbiotic. East Chimericans are savers; West Chimericans are spenders. East Chimericans do manufacturing; West Chimericans do services. East Chimericans export; West Chimericans import. East Chimericans pile up reserves; West Chimericans obligingly run deficits, producing the dollar-denominated bonds that the East Chimericans crave. As in all good marriages, the differences between the two halves are complementary.
As an upstate New Yorker I have some knowledge of these imbalances to which Mr. Ferguson refers- in my case that which exists between New York City, the main provider of state income tax funds, and Albany, New York's Capital, one of the main beneficiaries of these down state funds. To say that this imbalance is not troubling is to misread New York State political history. While dissension ebbs during periods of economic growth, its always comes to the fore when growth stalls, with the most recent significant example being the mid 70s financial problems in "The City" as we upstaters refer to the Big Apple. Intra-state tensions have been a feature of New York politics for much of the past two centuries.
Even the relationship he chose, that between California and its neighbors, is not nearly as "smooth" as he asserts. Two sources of tension spring to mind, electricity and water.
During California's electricity crisis of 2000-2001, tensions arose between electricity providers, Washington State and Oregon, and electricity users, California. A drought reduced hydro-electric power generation in the two northern states and their efforts to maintain water flow and thus power generation created domestic political problems.
Water itself is also an inter state problem out west. As Mark Twain once quipped on California's perennial problem, "Whisky's for drinking; water's for fighting over." California has for years been exceeding its Colorado River water allotment, set forth in the Colorado River Compact, which is now becoming a larger inter-state issue as populations in Arizona and New Mexico have climbed.
While I'm not arguing the states around the Colorado River are planning to call out their respective National Guardsmen and take Twain's view to heart, after all, most of the guardsmen are in Iraq, glossing over the tensions that exist, albeit below the national radar, will lead to confusion when larger mergers are envisioned.
As a student of History, Mr. Ferguson is well aware that the "religious" wars in Europe between Protestants in Northern Europe and Catholics in Southern Europe had an economic aspect, an imbalance, if you will. The schism of Western Christendom, which is in the process of attempted repair via EMU some 5 Centuries later, was caused, in part, by Rome's assumption that the merged "tribes" of Europe would stay that way while the Vatican and Southern European Bankers like the Medici kept draining the North of specie.
I may be in the minority but the current attempt to re-knit Europe into a whole via economic rather than religious means is not a done deal. Thus far, in my view, liquidity and strong global growth has papered over international differences on the continent. The true test of the union will come when credit conditions tighten and the fiscally responsible are dragged down with the fiscally irresponsible. It has only been 15 years since Italy was forced to exit the ERM due to their high debt and deficit to GDP ratio. Currently Italy's debt to GDP ratio of roughly 107% is still the highest in the Euro-zone.
Back within the United States again, the willingness to accept imbalances will be tested as Congress looks to bail out sub-prime borrowers. According to Bloomberg: Federal aid ``would come at a cost,'' said Douglas Duncan, chief economist at the Mortgage Bankers Association. ``It has to be paid for and the question is would the 34 percent of homeowners who have no mortgage be willing to pay taxes to support the bailout of people who traditionally have not managed credit well?''
If, as I imagine will prove to be the case, a bail out of this sort will be a tough sell, imagine how much more difficult it would be (is) to sell to East Chimerica, as Ferguson calls China, that they need to take a 50% "hair cut" on their reserves to help out their buddies in West Chimerica.
Bridging cultural differences and regional concerns has been the main impediment to the presumed great benefits of global cooperation. While I agree in theory that a global economic unit would be far more efficient than a number of autarkies, or self-sufficient economies, simply assuming that regional imbalances within an economic unit will not be troubling seems to fly in the face of history. Keeping those imbalances small or at least understandable, i.e. rational to the sensibilities of the time, has been the key to maintaining unity.
Sadly the great Achilles Heel of the de-regulated post Bretton Woods Economic System is the inability to correct imbalances of large economic units thus allowing them to grow unchecked. When the time comes to truly address the "Chimerican" imbalances, I'll bet that term will be about as popular as Mexifornia is to the Orange County crowd.
Fighting between the haves and have nots has been going on for a long time. "We are all Americans" speeches did not solve the class wars in the US during the late 19th and early 20th Centuries, addressing the imbalances did. As Mark Twain might have put it, we'll only be able to Tom Sawyer the East Chimericans for so long.
A focus on the "placid surface" of global financial conditions, to borrow from Paul Volcker, to the exclusion of the actual economic conditions underneath recalls Korzybski's dictum, "the map is not the territory." Just because stock markets haven't crashed or other untoward financial developments haven't materialized does not mean that the "natives" aren't restless or that they are unconcerned about imbalances. I hope the current crop of Empire dreamers have something better up their sleeve than, "but the stock market didn't crash this time, why can't we globalize?"
Elaine: (Raising hand) I've yada yada'd sex.
George: Really?
Elaine: Yeah. I met this lawyer, we went out to dinner, I had the lobster bisk, we went back to my place, yada yada yada, I never heard from him again.
Jerry: But you yada yada'd over the best part.
Elaine: No, I mentioned the bisk.
Seinfeld
One of the recent themes of historian Niall Ferguson's views, while not, in the limited sample I've managed to find, stated as such, is accepted economic convergence. He uses the term, Chimerica, a merger of China and America, to explain the view that international imbalances are not as troubling as they might appear, at least if we could see the world from his perspective.
From the LATimes: Yet there's another way to see these supposed imbalances: as no more worrying than the doubtless very large imbalances between, say, California and Arizona. Think of the United States and the People's Republic not as two countries but as one: Chimerica. It's quite a place: just 13% of the world's land surface but a quarter of its population and fully a third of its economic output. What's more, Chimerica has accounted for about 60% of global growth in the last five years.
The relationship isn't necessarily unbalanced; more like symbiotic. East Chimericans are savers; West Chimericans are spenders. East Chimericans do manufacturing; West Chimericans do services. East Chimericans export; West Chimericans import. East Chimericans pile up reserves; West Chimericans obligingly run deficits, producing the dollar-denominated bonds that the East Chimericans crave. As in all good marriages, the differences between the two halves are complementary.
As an upstate New Yorker I have some knowledge of these imbalances to which Mr. Ferguson refers- in my case that which exists between New York City, the main provider of state income tax funds, and Albany, New York's Capital, one of the main beneficiaries of these down state funds. To say that this imbalance is not troubling is to misread New York State political history. While dissension ebbs during periods of economic growth, its always comes to the fore when growth stalls, with the most recent significant example being the mid 70s financial problems in "The City" as we upstaters refer to the Big Apple. Intra-state tensions have been a feature of New York politics for much of the past two centuries.
Even the relationship he chose, that between California and its neighbors, is not nearly as "smooth" as he asserts. Two sources of tension spring to mind, electricity and water.
During California's electricity crisis of 2000-2001, tensions arose between electricity providers, Washington State and Oregon, and electricity users, California. A drought reduced hydro-electric power generation in the two northern states and their efforts to maintain water flow and thus power generation created domestic political problems.
Water itself is also an inter state problem out west. As Mark Twain once quipped on California's perennial problem, "Whisky's for drinking; water's for fighting over." California has for years been exceeding its Colorado River water allotment, set forth in the Colorado River Compact, which is now becoming a larger inter-state issue as populations in Arizona and New Mexico have climbed.
While I'm not arguing the states around the Colorado River are planning to call out their respective National Guardsmen and take Twain's view to heart, after all, most of the guardsmen are in Iraq, glossing over the tensions that exist, albeit below the national radar, will lead to confusion when larger mergers are envisioned.
As a student of History, Mr. Ferguson is well aware that the "religious" wars in Europe between Protestants in Northern Europe and Catholics in Southern Europe had an economic aspect, an imbalance, if you will. The schism of Western Christendom, which is in the process of attempted repair via EMU some 5 Centuries later, was caused, in part, by Rome's assumption that the merged "tribes" of Europe would stay that way while the Vatican and Southern European Bankers like the Medici kept draining the North of specie.
I may be in the minority but the current attempt to re-knit Europe into a whole via economic rather than religious means is not a done deal. Thus far, in my view, liquidity and strong global growth has papered over international differences on the continent. The true test of the union will come when credit conditions tighten and the fiscally responsible are dragged down with the fiscally irresponsible. It has only been 15 years since Italy was forced to exit the ERM due to their high debt and deficit to GDP ratio. Currently Italy's debt to GDP ratio of roughly 107% is still the highest in the Euro-zone.
Back within the United States again, the willingness to accept imbalances will be tested as Congress looks to bail out sub-prime borrowers. According to Bloomberg: Federal aid ``would come at a cost,'' said Douglas Duncan, chief economist at the Mortgage Bankers Association. ``It has to be paid for and the question is would the 34 percent of homeowners who have no mortgage be willing to pay taxes to support the bailout of people who traditionally have not managed credit well?''
If, as I imagine will prove to be the case, a bail out of this sort will be a tough sell, imagine how much more difficult it would be (is) to sell to East Chimerica, as Ferguson calls China, that they need to take a 50% "hair cut" on their reserves to help out their buddies in West Chimerica.
Bridging cultural differences and regional concerns has been the main impediment to the presumed great benefits of global cooperation. While I agree in theory that a global economic unit would be far more efficient than a number of autarkies, or self-sufficient economies, simply assuming that regional imbalances within an economic unit will not be troubling seems to fly in the face of history. Keeping those imbalances small or at least understandable, i.e. rational to the sensibilities of the time, has been the key to maintaining unity.
Sadly the great Achilles Heel of the de-regulated post Bretton Woods Economic System is the inability to correct imbalances of large economic units thus allowing them to grow unchecked. When the time comes to truly address the "Chimerican" imbalances, I'll bet that term will be about as popular as Mexifornia is to the Orange County crowd.
Fighting between the haves and have nots has been going on for a long time. "We are all Americans" speeches did not solve the class wars in the US during the late 19th and early 20th Centuries, addressing the imbalances did. As Mark Twain might have put it, we'll only be able to Tom Sawyer the East Chimericans for so long.
A focus on the "placid surface" of global financial conditions, to borrow from Paul Volcker, to the exclusion of the actual economic conditions underneath recalls Korzybski's dictum, "the map is not the territory." Just because stock markets haven't crashed or other untoward financial developments haven't materialized does not mean that the "natives" aren't restless or that they are unconcerned about imbalances. I hope the current crop of Empire dreamers have something better up their sleeve than, "but the stock market didn't crash this time, why can't we globalize?"
Tuesday, March 13, 2007
The Wizards of VaR and "pilot error"
The company has also been honored for the way it does business, receiving the Ethics in America award from the Passkeys Foundation and Chapman University in 2004. “Over the years, we believe we have earned the reputation with our customers and our investors for delivering results without compromising our values; this is the cornerstone of our corporate culture,” notes Bob. “To articulate that culture, in 2005 we adopted a new brand identity, ‘A New Shade of Blue Chip,’ and created a strategy to help us live up to that brand. We are proud of our results, but just as proud of how those results are achieved.” New Century Financial Company History
NYSE's move [ to delist NEW ] came as New Century disclosed in an SEC filing today that the U.S. Attorney had initiated a criminal investigation into both the company's securities trading and accounting errors involving the company's allowance for losses from the repurchase of bad loans. New Century said it had received a grand jury subpoena and would cooperate. O.C. Register
According to Wikipedia, Pilot error is a term used to describe the cause of a crash of an airworthy aircraft where the pilot is considered to be principally or partially responsible. Pilot error can be defined as a mistake, oversight, lapse in judgement, or failure to exercise due diligence by an aircraft operator during the performance of his/her duties. In other words, the plane was working fine, us humans screwed up.
Despite fears of mechanization run amok, the financial world still relies on its pilots. Despite changes in tools (abacus, computer) and methods (cash, VaR) of calculation, people still have to input the records, ensure their accuracy and plan for the future. The most hi-tech tools and sophisticated methods (pun intended) will not mitigate the simple pilot error of being unprepared for eventualities.
I wonder how many at New Century Financial asked the question, once the Fed began raising interest rates in 2004, "How are we going to deal with the eventual slowdown in mortgage lending?"
I wonder how many times that question inspired a response to the effect that it wouldn't be a problem, that things were under control, and that all eventualities had been foreseen. In the event, as is all too often the case when money, lives and fortunes are involved, the real response was lie, deny, justify. Pilot error, sure, but show me a financial company without pilots.
And thus the ever efficient financial markets give another classic "crash and burn" picture. Like Enron, they did all they could to convince the external world that all was well, and, while buying some time, the eventual effect was to make the decline more spectacular and certain. Few things guarantee defeat more certainly than denying the possible.
Those who fear the mess to come from the VaR (Value at Risk) masked derivatives monster are in a similar position to those in New Century who worried about the eventual slowdown in mortgage lending. We are worried about eventualities, in New Century's case, interest rate hike inspire slowdowns in mortgage creation and in our case, unhedgeable (or mismanaged) price changes that lead first to individual bankruptcy and then, via ever more tightly woven financial links, a more general credit market breakdown.
While the Wizards of VaR, who turn The Wizard of Oz's trick on its head, using smoke and mirrors to make the awe-inspiring and terrible appear ordinary and manageable, (pay no attention to the trillions of $ of derivatives behind the curtain) would have you believe that by the magic of risk summation, millions of individual contracts between parties can be distilled into simple, hedgeable "deltas," I'd rather focus on those two words, pilot error.
Corporations, be they governmental, religious or commercial come and go. They are run by men and men err. Pilot error is here to stay and, as noted above, one obvious form of pilot error is to deny eventualities. So take your reassurances from the Wizards of VaR that there is far less risk than there seems to be with a grain of salt. If Toto, in the form of New Century Financial, fails to tear down the curtain there will be, I fear, more to come.
*********
The brass tacks crowd is likely wondering IS THIS IT? The problem is, I don't think anybody knows. How many other financial institutions are as unprepared for a housing recession, or any other untoward shift, as New Century, and as un-forthcoming?
My best guess is that, barring drastic changes, the world of finance can continue duct-taping the markets together for the time being. The myth, or so I see it, of safety in bonds and risk of real assets like precious metals, remains firmly entrenched judging by price action in Treasuries. When Bond prices begin to follow equity indices lower, which will likely coincide with a break in the recent correlation between precious metals and equity indicies, watch out.
NYSE's move [ to delist NEW ] came as New Century disclosed in an SEC filing today that the U.S. Attorney had initiated a criminal investigation into both the company's securities trading and accounting errors involving the company's allowance for losses from the repurchase of bad loans. New Century said it had received a grand jury subpoena and would cooperate. O.C. Register
According to Wikipedia, Pilot error is a term used to describe the cause of a crash of an airworthy aircraft where the pilot is considered to be principally or partially responsible. Pilot error can be defined as a mistake, oversight, lapse in judgement, or failure to exercise due diligence by an aircraft operator during the performance of his/her duties. In other words, the plane was working fine, us humans screwed up.
Despite fears of mechanization run amok, the financial world still relies on its pilots. Despite changes in tools (abacus, computer) and methods (cash, VaR) of calculation, people still have to input the records, ensure their accuracy and plan for the future. The most hi-tech tools and sophisticated methods (pun intended) will not mitigate the simple pilot error of being unprepared for eventualities.
I wonder how many at New Century Financial asked the question, once the Fed began raising interest rates in 2004, "How are we going to deal with the eventual slowdown in mortgage lending?"
I wonder how many times that question inspired a response to the effect that it wouldn't be a problem, that things were under control, and that all eventualities had been foreseen. In the event, as is all too often the case when money, lives and fortunes are involved, the real response was lie, deny, justify. Pilot error, sure, but show me a financial company without pilots.
And thus the ever efficient financial markets give another classic "crash and burn" picture. Like Enron, they did all they could to convince the external world that all was well, and, while buying some time, the eventual effect was to make the decline more spectacular and certain. Few things guarantee defeat more certainly than denying the possible.
Those who fear the mess to come from the VaR (Value at Risk) masked derivatives monster are in a similar position to those in New Century who worried about the eventual slowdown in mortgage lending. We are worried about eventualities, in New Century's case, interest rate hike inspire slowdowns in mortgage creation and in our case, unhedgeable (or mismanaged) price changes that lead first to individual bankruptcy and then, via ever more tightly woven financial links, a more general credit market breakdown.
While the Wizards of VaR, who turn The Wizard of Oz's trick on its head, using smoke and mirrors to make the awe-inspiring and terrible appear ordinary and manageable, (pay no attention to the trillions of $ of derivatives behind the curtain) would have you believe that by the magic of risk summation, millions of individual contracts between parties can be distilled into simple, hedgeable "deltas," I'd rather focus on those two words, pilot error.
Corporations, be they governmental, religious or commercial come and go. They are run by men and men err. Pilot error is here to stay and, as noted above, one obvious form of pilot error is to deny eventualities. So take your reassurances from the Wizards of VaR that there is far less risk than there seems to be with a grain of salt. If Toto, in the form of New Century Financial, fails to tear down the curtain there will be, I fear, more to come.
*********
The brass tacks crowd is likely wondering IS THIS IT? The problem is, I don't think anybody knows. How many other financial institutions are as unprepared for a housing recession, or any other untoward shift, as New Century, and as un-forthcoming?
My best guess is that, barring drastic changes, the world of finance can continue duct-taping the markets together for the time being. The myth, or so I see it, of safety in bonds and risk of real assets like precious metals, remains firmly entrenched judging by price action in Treasuries. When Bond prices begin to follow equity indices lower, which will likely coincide with a break in the recent correlation between precious metals and equity indicies, watch out.
Monday, March 12, 2007
Hedgeability: The premise that is false
Find the trend whose premise is false and bet against it. - George Soros
Last week brought news of the death of Jean Baudrillard, or not as the case may be, whose rather esoteric works were highlighted in the film, The Matrix. While I didn't agree with his pessimism (see Bumming out with Baudrillard) I too have stared into the abyss of incoherence- the fear that there is no truth, and it left me as shaken as a character in an H.P. Lovecraft tale shouting Cthulhu at the top of his lungs. During periods of mass mania, if you are one of those stubborn souls who refuses to toe the party line, it can seem as if the truth does not matter.
But the truth does matter, or so I believe. One can swallow the party line that, for example, the economy is doing well only so long as one has enough food to eat. The old economic adage that it is a recession when your neighbor loses his job but a depression when you do still holds true.
And one needs to believe there is a truth, and that it matters, i.e. that it will force people to change behavior, if one is to make use of Soros' trading maxim above.
In response to a few comments on Too big to bail (out) today's musings will focus on how a supposedly well hedged portfolio, i.e. with minimal VaR (value-at-risk), can become a huge liability.
Back when I was an FX-Options dealer I would begin my day by getting the volatility "runs," the current volatility prices for at-the-money straddles- straddles being a equal amount of puts and calls with the same expiration and strike. I would then enter that data in our risk-analysis computer along with any overnight trades and then publish a few reports. The two key reports were with respect to time (theta) and underlying instrument price (gamma).
A typical gamma report for a portfolio long front month options might look something like:
GBP price Delta P/L
1.9500 2.2M +50.0K
1.9250 1.0M +17.5K
1.9000 0.0M 0.0
1.8750 -1.0M +17.5K
1.8500 -2.2M +50.0K
What the table means is that as spot GBP rises the portfolio becomes longer GBP and as it falls it becomes shorter. If getting longer as spot rises and shorter as spot falls seems too good to be true, it is. The catch is that good gamma, as the above is known in the trade, comes at a cost of time decay.
A typical theta, or time decay, report of the same portfolio might look something like:
Date Delta P/L
March 11, 2007 0.0M 0.0
March 12, 2007 0.0M -8.0K
March 13, 2007 0.0M -16.0K
March 14, 2007 0.0M -25.0K
March 15, 2007 0.0M -33.5K
March 18, 2007 0.0M -60.0K
That is, each day the portfolio loses about 8K and these losses will increase over time until expiration.
While there are many different strategies one can employ which might produce a similar report, thus leading to the conclusion that not all VaR neutral reports are equal, I've assumed an at-the-money straddle whose notional value might be 15M GBP per leg, i.e. a 15M GBP put and a 15M GBP call. Assuming nothing else in the portfolio (an assumption very rarely seen in the major trading house wherein one usually finds thousands of options of $100Bs of notional worth with wildly varying strikes and expirations along with spot and forward hedges) the true value-at-risk is the cost of the options.
If the portfolio had instead sold the options in question the true risk would be equivalent to a 15M GBP spot position mitigated by the receipt of the cost of the options. In that case the risk reports above would have their signs flipped- the portfolio would be getting shorter as spot rose, and vice versa (known as bad gamma) and would be earning money each day in the event spot remained the same (positive time decay.)
Let's assume, as is general practice in the industry, that the portfolio will be hedged in a sense, automatically. That is, each time, for instance, the delta reaches 1.0M GBP (one could choose a different amount), it would be "hedged" by entering a spot (or forward) trade of equal amount. In our example, the portfolio would then become a mix of both options and spot (or forward) deals.
This hedging would be done assuming that one or the other leg would be exercised which brings us to the first big risk options portfolios encounter, counter-party risk. In our initial example of a long options position, with spot rising, the portfolio would be short GBPs against the expected purchase at the strike price on exercise. If that counter-party defaults, as New Financial has apparently done, but not, I believe, in the FX options market, then the portfolio is just short GBPs sold at lower levels. That is, what seemed well hedged wasn't.
Thus you can hopefully see how LTCM's billions of $ of defaults were a major problem. Dealers who had bought options from or sold options to LTCM had hedged assuming LTCM would hold up their end of the deal. They assumed that all dealing institutions would exist in perpetuity, a rather silly assumption given the intermittent failure of financial institutions over the decades. Often though, counter-party risk is a secondary effect of a primary cause, a hedging failure.
The false premise, in my view, standing at the heart of our dilemma is the assumption of constant hedgeability. Option models, like Black-Scholes or their variants which we used to produce the hypothetical reports above, and which are used to produce reports throughout the financial universe, are based on this assumption of continuous pricing.
But what happens if markets don't exhibit continuous pricing? Let's assume we were managing the short side of the portfolio above and GBP gapped up from 1.900 to 2.000 in a few moments, say because Britain decided to join the ERM, as happened in October 1990. In that case, as they delicately put it on Wall St., you're screwed. In a few brief moments following an announced economic policy change, your nicely hedged portfolio becomes a disaster- you're now short 15M GBP from 10 cents lower (leading to a current loss of US$1.5M, far more than you collected in premium) in a rapidly rising market.
Perhaps you can now see how the Nobel Prize winning economists who founded LTCM, whose members included Myron Scholes of Black-Scholes fame, got blind-sided when emerging market debt prices became very volatile in the summer of 1998, a period which included Russia's default of sovereign debt. Markets which had seemed liquid enough to hedge suddenly became very illiquid. Prices were changing by large amounts (not exhibiting continuous pricing) and few wanted to take the other side of the trades, like buying Russian debt which was about to default, LTCM needed to make to stay hedged.
Thus the tremors of fear that emanated from financial centers around the world when China's market dropped 9% in a day and particularly when "calculation problems" caused an apparently instantaneous 200 point drop in the Dow. If you had been using the Dow Jones Index as spot price to "automatically" hedge, you didn't. (to be fair, from what I understand most equity hedging strategies used the relevant futures which were unaffected).
In other words, when markets gap up or down substantially the premise of continuous pricing upon which option pricing models are based is proved false. Moreover, as the LTCM case makes clear, even if you are well hedged and not directly involved in the volatile markets, exposure to other institutions who are involved can still get you. Thus the term, contagion.
Given that markets have, from time to time, exhibited just such discontinuous pricing (imagine a Wahhabi inspired coup in Saudi Arabia) many times in the past, basing a risk model which will serve as VaR calculator for portfolios which carry notional amounts (in our case above the notional amounts total 30M GBP) of many multiples of global GDP seems downright silly.
To be fair to Fischer Black and Myron Scholes, I'll bet that if they were told their theoretical musings would become the cornerstone of modern day portfolios they would likely have thought differently. So long as dynamic hedging flows (we referred to them above as automatic hedges) remained small relative to real trade flows, their assumptions, while not perfect, were, in a sense, workable. As these dynamic hedging and other speculative flows have grown, now swamping real trade flows, the flaws in the assumptions are laid bare.
Thus the ever increasing need for governments to engage in "market smoothing operations." Of course, market smoothing doesn't change the underlying fundamentals that gave rise to the discontinuities, they merely, if they work, foster the illusion of an "efficient market," and in so doing, lead more and more to join the party- thus begging the un-smooth-able.
Ultimately, I fear, we will regret the growth of the derivatives monster from manageable to unmanageable size. Political coups, abrupt decisions to not accept this or that currency and even economic warfare will, as they have in the past, appear. Certain financial institutions will get caught and their contagion effect will shake the whole house. We will, I fear, test whether these derivative dealing institutions have become Too Big to Bail (out).
p.s. many thanks to those who linked to this blog and brought thousands of new readers, although I hope one new reader so directed, the US Treasury's Executive Office of Asset Forfeiture, is just interested in my musings and not my house. (lol, I hope)
Last week brought news of the death of Jean Baudrillard, or not as the case may be, whose rather esoteric works were highlighted in the film, The Matrix. While I didn't agree with his pessimism (see Bumming out with Baudrillard) I too have stared into the abyss of incoherence- the fear that there is no truth, and it left me as shaken as a character in an H.P. Lovecraft tale shouting Cthulhu at the top of his lungs. During periods of mass mania, if you are one of those stubborn souls who refuses to toe the party line, it can seem as if the truth does not matter.
But the truth does matter, or so I believe. One can swallow the party line that, for example, the economy is doing well only so long as one has enough food to eat. The old economic adage that it is a recession when your neighbor loses his job but a depression when you do still holds true.
And one needs to believe there is a truth, and that it matters, i.e. that it will force people to change behavior, if one is to make use of Soros' trading maxim above.
In response to a few comments on Too big to bail (out) today's musings will focus on how a supposedly well hedged portfolio, i.e. with minimal VaR (value-at-risk), can become a huge liability.
Back when I was an FX-Options dealer I would begin my day by getting the volatility "runs," the current volatility prices for at-the-money straddles- straddles being a equal amount of puts and calls with the same expiration and strike. I would then enter that data in our risk-analysis computer along with any overnight trades and then publish a few reports. The two key reports were with respect to time (theta) and underlying instrument price (gamma).
A typical gamma report for a portfolio long front month options might look something like:
GBP price Delta P/L
1.9500 2.2M +50.0K
1.9250 1.0M +17.5K
1.9000 0.0M 0.0
1.8750 -1.0M +17.5K
1.8500 -2.2M +50.0K
What the table means is that as spot GBP rises the portfolio becomes longer GBP and as it falls it becomes shorter. If getting longer as spot rises and shorter as spot falls seems too good to be true, it is. The catch is that good gamma, as the above is known in the trade, comes at a cost of time decay.
A typical theta, or time decay, report of the same portfolio might look something like:
Date Delta P/L
March 11, 2007 0.0M 0.0
March 12, 2007 0.0M -8.0K
March 13, 2007 0.0M -16.0K
March 14, 2007 0.0M -25.0K
March 15, 2007 0.0M -33.5K
March 18, 2007 0.0M -60.0K
That is, each day the portfolio loses about 8K and these losses will increase over time until expiration.
While there are many different strategies one can employ which might produce a similar report, thus leading to the conclusion that not all VaR neutral reports are equal, I've assumed an at-the-money straddle whose notional value might be 15M GBP per leg, i.e. a 15M GBP put and a 15M GBP call. Assuming nothing else in the portfolio (an assumption very rarely seen in the major trading house wherein one usually finds thousands of options of $100Bs of notional worth with wildly varying strikes and expirations along with spot and forward hedges) the true value-at-risk is the cost of the options.
If the portfolio had instead sold the options in question the true risk would be equivalent to a 15M GBP spot position mitigated by the receipt of the cost of the options. In that case the risk reports above would have their signs flipped- the portfolio would be getting shorter as spot rose, and vice versa (known as bad gamma) and would be earning money each day in the event spot remained the same (positive time decay.)
Let's assume, as is general practice in the industry, that the portfolio will be hedged in a sense, automatically. That is, each time, for instance, the delta reaches 1.0M GBP (one could choose a different amount), it would be "hedged" by entering a spot (or forward) trade of equal amount. In our example, the portfolio would then become a mix of both options and spot (or forward) deals.
This hedging would be done assuming that one or the other leg would be exercised which brings us to the first big risk options portfolios encounter, counter-party risk. In our initial example of a long options position, with spot rising, the portfolio would be short GBPs against the expected purchase at the strike price on exercise. If that counter-party defaults, as New Financial has apparently done, but not, I believe, in the FX options market, then the portfolio is just short GBPs sold at lower levels. That is, what seemed well hedged wasn't.
Thus you can hopefully see how LTCM's billions of $ of defaults were a major problem. Dealers who had bought options from or sold options to LTCM had hedged assuming LTCM would hold up their end of the deal. They assumed that all dealing institutions would exist in perpetuity, a rather silly assumption given the intermittent failure of financial institutions over the decades. Often though, counter-party risk is a secondary effect of a primary cause, a hedging failure.
The false premise, in my view, standing at the heart of our dilemma is the assumption of constant hedgeability. Option models, like Black-Scholes or their variants which we used to produce the hypothetical reports above, and which are used to produce reports throughout the financial universe, are based on this assumption of continuous pricing.
But what happens if markets don't exhibit continuous pricing? Let's assume we were managing the short side of the portfolio above and GBP gapped up from 1.900 to 2.000 in a few moments, say because Britain decided to join the ERM, as happened in October 1990. In that case, as they delicately put it on Wall St., you're screwed. In a few brief moments following an announced economic policy change, your nicely hedged portfolio becomes a disaster- you're now short 15M GBP from 10 cents lower (leading to a current loss of US$1.5M, far more than you collected in premium) in a rapidly rising market.
Perhaps you can now see how the Nobel Prize winning economists who founded LTCM, whose members included Myron Scholes of Black-Scholes fame, got blind-sided when emerging market debt prices became very volatile in the summer of 1998, a period which included Russia's default of sovereign debt. Markets which had seemed liquid enough to hedge suddenly became very illiquid. Prices were changing by large amounts (not exhibiting continuous pricing) and few wanted to take the other side of the trades, like buying Russian debt which was about to default, LTCM needed to make to stay hedged.
Thus the tremors of fear that emanated from financial centers around the world when China's market dropped 9% in a day and particularly when "calculation problems" caused an apparently instantaneous 200 point drop in the Dow. If you had been using the Dow Jones Index as spot price to "automatically" hedge, you didn't. (to be fair, from what I understand most equity hedging strategies used the relevant futures which were unaffected).
In other words, when markets gap up or down substantially the premise of continuous pricing upon which option pricing models are based is proved false. Moreover, as the LTCM case makes clear, even if you are well hedged and not directly involved in the volatile markets, exposure to other institutions who are involved can still get you. Thus the term, contagion.
Given that markets have, from time to time, exhibited just such discontinuous pricing (imagine a Wahhabi inspired coup in Saudi Arabia) many times in the past, basing a risk model which will serve as VaR calculator for portfolios which carry notional amounts (in our case above the notional amounts total 30M GBP) of many multiples of global GDP seems downright silly.
To be fair to Fischer Black and Myron Scholes, I'll bet that if they were told their theoretical musings would become the cornerstone of modern day portfolios they would likely have thought differently. So long as dynamic hedging flows (we referred to them above as automatic hedges) remained small relative to real trade flows, their assumptions, while not perfect, were, in a sense, workable. As these dynamic hedging and other speculative flows have grown, now swamping real trade flows, the flaws in the assumptions are laid bare.
Thus the ever increasing need for governments to engage in "market smoothing operations." Of course, market smoothing doesn't change the underlying fundamentals that gave rise to the discontinuities, they merely, if they work, foster the illusion of an "efficient market," and in so doing, lead more and more to join the party- thus begging the un-smooth-able.
Ultimately, I fear, we will regret the growth of the derivatives monster from manageable to unmanageable size. Political coups, abrupt decisions to not accept this or that currency and even economic warfare will, as they have in the past, appear. Certain financial institutions will get caught and their contagion effect will shake the whole house. We will, I fear, test whether these derivative dealing institutions have become Too Big to Bail (out).
p.s. many thanks to those who linked to this blog and brought thousands of new readers, although I hope one new reader so directed, the US Treasury's Executive Office of Asset Forfeiture, is just interested in my musings and not my house. (lol, I hope)
Friday, March 09, 2007
Too big to bail (out): a case of Humpty Dumpty Finance
The circuit is now complete. Darth Vader
I've only been alive for a shade over 4 decades but I feel as if my past life as a Wall St. trader occurred in a different era.
No, I'm not referring to the change in technology although I do remember having to share a computer at Chase Manhattan, watching Telerate pages on little green screens and the days before Reuters dealer when voice brokers were charging $10-25 per million $ on spot FX, which allowed them to keep me and my co-workers in the industry fat, drunk and happy. Ah, the memories of those Friday morning hangovers and then the calls from the brokers who financed them asking me to do 20 "switches" sometimes totaling $200Mil, or $2K in bro, thus returning the favor. Switches, for the uninitiated, are back to back deals to allow two parties who didn't have credit with each other to complete a trade with my bank as intermediary. As Chase usually had great credit we could deal with everyone.
But Chase didn't always have great credit, although it now seems that such a thing could never come to pass, and it is the conception of credit and the relation of the government to leading financial institutions to which I refer when I write of a different era.
According to Bloomberg: Moody's announced new guidelines for bank credit ratings last month that consider financial strength along with any support companies may get from government and financial institutions if they get into serious trouble. Such backing might be offered if regulators conclude the effects of a failure would be catastrophic for the nation's economy, a concept rooted in banks' financial woes in the 1980s.
Fortunately, as noted above, I remember those halcyon days of yore, the 80s, when banks could have financial woes.
What exactly caused those financial woes, you might be asking? The same thing that always caused them, too much leverage. That's not what you meant? Ah, you mean what was the catalyst that exposed the overleveraged balance sheets? Funny you should ask. It was the mortgage industry, in the form of the Savings and Loans.
You might recall that period in our history if you are around my age or older, and if so, you might remember when (February 1989, don't worry I had to look it up, I'm not that much of a geek) George Bush the Elder proclaimed the creation of a program to fix the S&L crisis with taxpayer money- a program that, with the help of Congress, became the Financial Institutions Reform, Recovery and Enforcement Act of 1989. You might also remember that up until that point, the fall out from the banking problem was considered to be mostly contained, wink, wink, nudge, nudge Hank Paulson.
You might also, if you are old enough, recall the introduction of the phrase, "too big to fail," into the financial lexicon. I don't have access to lexis-nexis but I did a search on the NYTimes archives and the first instance of the phrase in "the newspaper of record" occurred in mid-1987. The author of the article, Thomas Olson, then President of The Independent Bankers Association of America (I guess this institution doesn't have much longer to live), argued that the US did not need "superbanks." I guess his view was not echoed by others.
The notion of "too big to fail" became a serious topic of discussion during the latter half of 1990 when major US banking shares took a swan dive. To give one example, Citibank, whose share price had just surpassed its 9/87 peak in July of 90 lost more than 50% and tested the 10/87 lows by 9/90. Major US banks were considered so un-creditworthy at that time that I needed to get banks to do switches for me at Chase because our credit was "no good," particularly with the Japanese banks.
After watching Drexel Burnham Lambert go bust that year (which taught me just how nasty unwinding options portfolios can be and that was back when a US$100M position was considered "big") I guess the powers that be decided that certain financial institutions could indeed be too big to fail. By late 1991, Citibank's share price has recouped all its losses.
Meanwhile, in 1991, Salomon Brothers, 12% of whose company stock was purchased by Warren Buffett's Berkshire Hathaway in 1987, got caught submitting false bids in Treasury auctions. After raising the ire of then NY Fed Chief, Gerald Corrigan (details of which can be found here), the US Treasury announced that Salomon would no longer be able to participate in Treasury auctions. This threat from Treasury led Salomon to up the stakes, and threaten bankruptcy.
The Most Important Day: The Treasury spokesman then got Secretary of the Treasury Nicholas Brady, at that moment visiting Saratoga Springs, N.Y., for the horseraces, to call Buffett. The two men had been friendly acquaintances over the years but could hardly have imagined they would be facing off on this Sunday morning. His voice cracking with emotion and strain, Buffett made his case, telling the Secretary that Salomon could not cope with the Treasury ban and that it was bringing in bankruptcy experts to prepare for a possible filing. Buffett stressed Salomon's gargantuan size and the worldwide nature of its business. He predicted that a Salomon bankruptcy would be calamitous, having domino effects that would reach worldwide and play havoc with a financial system that subsists on the idea of prompt payments.
Doomsday scenarios are not easy to get across. Responding, Brady was friendly and empathetic but inclined to think this talk of bankruptcy and financial meltdowns was far-fetched. He could not imagine Buffett refusing to take the job or failing in its execution. Brady was also highly aware of where things stood: The announcement had gone out, and reversing it would be an enormous problem.
But to Buffett's enormous relief, Brady did not cut off the dialogue. Instead, he went off to make some calls and then kept getting back to Buffett. In one of the stranger details of the day, Buffett talked on Salomon phones that had been programmed not to ring but instead flashed a tiny green light when someone was calling. For longer than he cares to remember, Buffett stared at the telephone, waiting for the Secretary of the Treasury to create light. With each call, Buffett tried to make Brady realize the seriousness of the situation and his sense that they were rocketing along on a train that had to be stopped--but that could be, once everybody realized that this was an accident that mustn't be allowed to happen. At one point in the Brady conversations, all of Buffett's anguish and sense of futility got jammed into a single sentence: "Nick, this is the most important day of my life." Brady said, "Don't worry, Warren, we'll get through this." But that didn't mean at all that he had changed his opinions.
It took Corrigan's entrance into the telephone calls in the afternoon to make a difference. This was the man who told Buffett to prepare for "any eventuality" and defined his term by endorsing the ban. But Corrigan now listened hard and seemed to assign credence to Buffett's talk of bankruptcy and of his personal plans to leave were a filing to come. Said Corrigan to Brady and another regulator on the phone with them: "We better talk among ourselves." Buffett went back into the boardroom and waited with the other directors. Six floors below, over 100 reporters and photographers, this author among them, were gathering for the 2:30 press conference. Directly outside the boardroom, some of the managing directors that Buffett had interviewed on Saturday were milling around, summoned because one of their number was to be named operating head of Salomon.
And then, just at 2:30, Jerome Powell, an Assistant Secretary of the Treasury, called Buffett to read a statement the Treasury was ready to go with. It was effectively half a loaf, or maybe two-thirds, saying that the ban on Salomon's bidding for its own account was lifted while the ban on bidding for customers' accounts remained. "Will that do?" asked Powell. "I think it will," answered Buffett. The board then raced through electing Buffett as interim chairman of Salomon Inc. and Deryck Maughan as a director and operating head of Salomon Brothers. Buffett found Maughan and said, "You're tapped," and the two went down to the press conference, entering at 2:45.
And thus too big to fail became policy.
It is now 16 years later, the thin edge of the wedge has done its thing and the circuit is now complete. The financial industry has been, in a sense, nationalized. Credit rating agencies, as already noted, will now simply assume government support for large financial institutions. Moreover, this support has apparently been assumed sufficient to offset any balance sheet imbalances these financial institutions might encounter.
It was with this assumption in mind that the "too big to bail (out)" title came to me. There are limits to the amount of support even the mighty US taxpayers can provide, especially given the expected financing problems created by US population demographics (think baby boom) with respect to US entitlement spending over the next few decades.
My initial concern over the assumption of sufficient support was with respect to derivatives. If the derivatives inspired collapse of LTCM was a problem how much more problematic would be a similarly inspired derivatives collapse at JPMorgan given their US$62.6T in exposure. According to the Office of the Comptroller of the Currency (page 22), this US$62.6T in derivatives exposure is funded by assets of only US$1.2T. While this exposure is spread out over different asset classes and may well be perfectly hedged now, it seems to me that a discontinuous, i.e. unhedgeable, 10-20% move in key markets might be sufficient to drain JPMorgan's assets. And who will fill in the gap, US taxpayers? Are we now willing to upend social harmony, or what little that remains, by breaking promises of social security and other "entitlements" in order to keep big banks that mismanaged their investment portfolios afloat? And all this, by the way, while the upper class has been enjoying its biggest tax breaks in decades. I reckon that will be tough sell.
But, while reading today's news, I find another concern. Hank Paulson would like China to remove the restriction on foreign ownership of China's banks. Given the now enshrined in stone "too big to fail" policy will US taxpayers be expected (and able) to support our domestic banks in the event their investments in China's financial institutions, who already have substantial bad debt problems, go bad?
This seems to me to be a case of one's eyes being bigger than one's stomach. China is not Thailand or Argentina. At current growth rates the Chinese economy will surpass that of the US within a few decades. How can the US taxpayer fill a funding gap created in an economy bigger, thus leading to larger imbalances, than its own? Methinks the US is about to learn the lesson Britain learned when it was overtaken by the US- the tail cannot always wag the dog.
If US financial institutions expect to be bailed out they have to ensure their imbalances stay small enough such that the US taxpayer can, and be willing to, foot the bill. The $150B bail out of the S&Ls in the late 80s caused a recession and cost George Bush the Elder a second term. I wonder what effects a $1T or even $5T bail out would cause, particularly in the event it was engendered by problems in China's domestic economy. Short of a military dictatorship, I can't imagine a bail out of that size for that reason passing through Congress. And even if it did, who would buy Treasury bonds under those conditions?
What if the problem arises due to a collapse of some intervention scheme? Will US taxpayers be expected to bail out a covert scheme to keep the price of Gold down? or oil? More to the point, could US taxpayers bail out such schemes? Again, in the event support was needed and could be obtained under these conditions, why would anyone want to buy US bonds?
While the big banks are likely enjoying their "too big to fail" status, investors might want to consider if they have already become "too big to bail (out)." If one is searching for a conclusion, that, if generally accepted, would send the precious metals to the moon, this seems to me to be it.
A children's rhyme comes to mind.
Humpty Dumpty sat on a wall.
Humpty Dumpty had a great fall.
All the king's horses and all the king's men
Couldn't put Humpty together again.
Got Gold!
I've only been alive for a shade over 4 decades but I feel as if my past life as a Wall St. trader occurred in a different era.
No, I'm not referring to the change in technology although I do remember having to share a computer at Chase Manhattan, watching Telerate pages on little green screens and the days before Reuters dealer when voice brokers were charging $10-25 per million $ on spot FX, which allowed them to keep me and my co-workers in the industry fat, drunk and happy. Ah, the memories of those Friday morning hangovers and then the calls from the brokers who financed them asking me to do 20 "switches" sometimes totaling $200Mil, or $2K in bro, thus returning the favor. Switches, for the uninitiated, are back to back deals to allow two parties who didn't have credit with each other to complete a trade with my bank as intermediary. As Chase usually had great credit we could deal with everyone.
But Chase didn't always have great credit, although it now seems that such a thing could never come to pass, and it is the conception of credit and the relation of the government to leading financial institutions to which I refer when I write of a different era.
According to Bloomberg: Moody's announced new guidelines for bank credit ratings last month that consider financial strength along with any support companies may get from government and financial institutions if they get into serious trouble. Such backing might be offered if regulators conclude the effects of a failure would be catastrophic for the nation's economy, a concept rooted in banks' financial woes in the 1980s.
Fortunately, as noted above, I remember those halcyon days of yore, the 80s, when banks could have financial woes.
What exactly caused those financial woes, you might be asking? The same thing that always caused them, too much leverage. That's not what you meant? Ah, you mean what was the catalyst that exposed the overleveraged balance sheets? Funny you should ask. It was the mortgage industry, in the form of the Savings and Loans.
You might recall that period in our history if you are around my age or older, and if so, you might remember when (February 1989, don't worry I had to look it up, I'm not that much of a geek) George Bush the Elder proclaimed the creation of a program to fix the S&L crisis with taxpayer money- a program that, with the help of Congress, became the Financial Institutions Reform, Recovery and Enforcement Act of 1989. You might also remember that up until that point, the fall out from the banking problem was considered to be mostly contained, wink, wink, nudge, nudge Hank Paulson.
You might also, if you are old enough, recall the introduction of the phrase, "too big to fail," into the financial lexicon. I don't have access to lexis-nexis but I did a search on the NYTimes archives and the first instance of the phrase in "the newspaper of record" occurred in mid-1987. The author of the article, Thomas Olson, then President of The Independent Bankers Association of America (I guess this institution doesn't have much longer to live), argued that the US did not need "superbanks." I guess his view was not echoed by others.
The notion of "too big to fail" became a serious topic of discussion during the latter half of 1990 when major US banking shares took a swan dive. To give one example, Citibank, whose share price had just surpassed its 9/87 peak in July of 90 lost more than 50% and tested the 10/87 lows by 9/90. Major US banks were considered so un-creditworthy at that time that I needed to get banks to do switches for me at Chase because our credit was "no good," particularly with the Japanese banks.
After watching Drexel Burnham Lambert go bust that year (which taught me just how nasty unwinding options portfolios can be and that was back when a US$100M position was considered "big") I guess the powers that be decided that certain financial institutions could indeed be too big to fail. By late 1991, Citibank's share price has recouped all its losses.
Meanwhile, in 1991, Salomon Brothers, 12% of whose company stock was purchased by Warren Buffett's Berkshire Hathaway in 1987, got caught submitting false bids in Treasury auctions. After raising the ire of then NY Fed Chief, Gerald Corrigan (details of which can be found here), the US Treasury announced that Salomon would no longer be able to participate in Treasury auctions. This threat from Treasury led Salomon to up the stakes, and threaten bankruptcy.
The Most Important Day: The Treasury spokesman then got Secretary of the Treasury Nicholas Brady, at that moment visiting Saratoga Springs, N.Y., for the horseraces, to call Buffett. The two men had been friendly acquaintances over the years but could hardly have imagined they would be facing off on this Sunday morning. His voice cracking with emotion and strain, Buffett made his case, telling the Secretary that Salomon could not cope with the Treasury ban and that it was bringing in bankruptcy experts to prepare for a possible filing. Buffett stressed Salomon's gargantuan size and the worldwide nature of its business. He predicted that a Salomon bankruptcy would be calamitous, having domino effects that would reach worldwide and play havoc with a financial system that subsists on the idea of prompt payments.
Doomsday scenarios are not easy to get across. Responding, Brady was friendly and empathetic but inclined to think this talk of bankruptcy and financial meltdowns was far-fetched. He could not imagine Buffett refusing to take the job or failing in its execution. Brady was also highly aware of where things stood: The announcement had gone out, and reversing it would be an enormous problem.
But to Buffett's enormous relief, Brady did not cut off the dialogue. Instead, he went off to make some calls and then kept getting back to Buffett. In one of the stranger details of the day, Buffett talked on Salomon phones that had been programmed not to ring but instead flashed a tiny green light when someone was calling. For longer than he cares to remember, Buffett stared at the telephone, waiting for the Secretary of the Treasury to create light. With each call, Buffett tried to make Brady realize the seriousness of the situation and his sense that they were rocketing along on a train that had to be stopped--but that could be, once everybody realized that this was an accident that mustn't be allowed to happen. At one point in the Brady conversations, all of Buffett's anguish and sense of futility got jammed into a single sentence: "Nick, this is the most important day of my life." Brady said, "Don't worry, Warren, we'll get through this." But that didn't mean at all that he had changed his opinions.
It took Corrigan's entrance into the telephone calls in the afternoon to make a difference. This was the man who told Buffett to prepare for "any eventuality" and defined his term by endorsing the ban. But Corrigan now listened hard and seemed to assign credence to Buffett's talk of bankruptcy and of his personal plans to leave were a filing to come. Said Corrigan to Brady and another regulator on the phone with them: "We better talk among ourselves." Buffett went back into the boardroom and waited with the other directors. Six floors below, over 100 reporters and photographers, this author among them, were gathering for the 2:30 press conference. Directly outside the boardroom, some of the managing directors that Buffett had interviewed on Saturday were milling around, summoned because one of their number was to be named operating head of Salomon.
And then, just at 2:30, Jerome Powell, an Assistant Secretary of the Treasury, called Buffett to read a statement the Treasury was ready to go with. It was effectively half a loaf, or maybe two-thirds, saying that the ban on Salomon's bidding for its own account was lifted while the ban on bidding for customers' accounts remained. "Will that do?" asked Powell. "I think it will," answered Buffett. The board then raced through electing Buffett as interim chairman of Salomon Inc. and Deryck Maughan as a director and operating head of Salomon Brothers. Buffett found Maughan and said, "You're tapped," and the two went down to the press conference, entering at 2:45.
And thus too big to fail became policy.
It is now 16 years later, the thin edge of the wedge has done its thing and the circuit is now complete. The financial industry has been, in a sense, nationalized. Credit rating agencies, as already noted, will now simply assume government support for large financial institutions. Moreover, this support has apparently been assumed sufficient to offset any balance sheet imbalances these financial institutions might encounter.
It was with this assumption in mind that the "too big to bail (out)" title came to me. There are limits to the amount of support even the mighty US taxpayers can provide, especially given the expected financing problems created by US population demographics (think baby boom) with respect to US entitlement spending over the next few decades.
My initial concern over the assumption of sufficient support was with respect to derivatives. If the derivatives inspired collapse of LTCM was a problem how much more problematic would be a similarly inspired derivatives collapse at JPMorgan given their US$62.6T in exposure. According to the Office of the Comptroller of the Currency (page 22), this US$62.6T in derivatives exposure is funded by assets of only US$1.2T. While this exposure is spread out over different asset classes and may well be perfectly hedged now, it seems to me that a discontinuous, i.e. unhedgeable, 10-20% move in key markets might be sufficient to drain JPMorgan's assets. And who will fill in the gap, US taxpayers? Are we now willing to upend social harmony, or what little that remains, by breaking promises of social security and other "entitlements" in order to keep big banks that mismanaged their investment portfolios afloat? And all this, by the way, while the upper class has been enjoying its biggest tax breaks in decades. I reckon that will be tough sell.
But, while reading today's news, I find another concern. Hank Paulson would like China to remove the restriction on foreign ownership of China's banks. Given the now enshrined in stone "too big to fail" policy will US taxpayers be expected (and able) to support our domestic banks in the event their investments in China's financial institutions, who already have substantial bad debt problems, go bad?
This seems to me to be a case of one's eyes being bigger than one's stomach. China is not Thailand or Argentina. At current growth rates the Chinese economy will surpass that of the US within a few decades. How can the US taxpayer fill a funding gap created in an economy bigger, thus leading to larger imbalances, than its own? Methinks the US is about to learn the lesson Britain learned when it was overtaken by the US- the tail cannot always wag the dog.
If US financial institutions expect to be bailed out they have to ensure their imbalances stay small enough such that the US taxpayer can, and be willing to, foot the bill. The $150B bail out of the S&Ls in the late 80s caused a recession and cost George Bush the Elder a second term. I wonder what effects a $1T or even $5T bail out would cause, particularly in the event it was engendered by problems in China's domestic economy. Short of a military dictatorship, I can't imagine a bail out of that size for that reason passing through Congress. And even if it did, who would buy Treasury bonds under those conditions?
What if the problem arises due to a collapse of some intervention scheme? Will US taxpayers be expected to bail out a covert scheme to keep the price of Gold down? or oil? More to the point, could US taxpayers bail out such schemes? Again, in the event support was needed and could be obtained under these conditions, why would anyone want to buy US bonds?
While the big banks are likely enjoying their "too big to fail" status, investors might want to consider if they have already become "too big to bail (out)." If one is searching for a conclusion, that, if generally accepted, would send the precious metals to the moon, this seems to me to be it.
A children's rhyme comes to mind.
Humpty Dumpty sat on a wall.
Humpty Dumpty had a great fall.
All the king's horses and all the king's men
Couldn't put Humpty together again.
Got Gold!
Wednesday, March 07, 2007
Is the militaryindustrial complex bad for the military?
In the councils of government, we must guard against the acquisition of unwarranted influence, whether sought or unsought, by the militaryindustrial complex. The potential for the disastrous rise of misplaced power exists and will persist. President Eisenhower
In the speech from which the opening quote was taken I found this sentence which seems even more true now than in 1961 when it was delivered: Our military organization today bears little relation to that known by any of my predecessors in peacetime, or indeed by the fighting men of World War II or Korea.
The men who returned from W.W.II and Korea had benefits such as the GI bill of rights which legislation, according to this website, provided funding for some 7.8 million veterans' education expenses and 2.4 million veterans' home loans. Injured veterans returning from the War on Terror have to face Walter Reed, and the prospect of lying in one's urine.
What went wrong? How is it that the United States can spend hundreds of billions of $ on "defense," more than the rest of the world combined, but cannot provide care for its own?
In my view, one causal factor is the profit motive. That is, the militaryindustrial complex of which President Eisenhower warned has taken control of the flow of "defense" funds. Funds flow to those endeavors from which handsome profits can be made, and don't flow to others.
While there are many human endeavors which are assisted by people's drive for profit, there are others which are not. Child rearing is one which comes to mind. As a father I am well aware that raising children is unprofitable in a monetary sense (wildly profitable in a human sense). My son is unlikely to repay my wife and me for the time and money we have and will sink into his care and education. And I don't expect him to. My hope is that he will treat his children at least as well as I have treated him.
Creating newer and more lethal machines to kill people, like the creation of any new machine, is an endeavor which is assisted by people seeking profit. But caring for the human element in the military apparently is not. Billions of $s in profit will be reaped by those engaged in the creation of the new nuclear weapons. But there will be relatively little if any monetary profit reaped by those caring for our injured. Of course, a great deal of human profit could be reaped by providing adequate care for those who were prepared to make the ultimate sacrifice, and came home missing a limb or their sanity.
It seems to me extremely odd that China, whose military spending is roughly 1/10th of the United States, can maintain a standing army of some 2.25 million men while we cannot adequately maintain an armed forces of some 1.4 million. While I imagine the average Chinese soldier expects far less than the average American soldier, the 10 fold gap seems to me more than sufficient to overcome this difference in expectations.
Moreover, given the abysmal results from the most recent hi-tech, and hi-expense shock and awe campaigns, and the now apparent lack of boots on the ground necessary to complete the mission, perhaps it is time to consider shifting the flow of funds a bit, even if it means less profit for the militaryindustrial complex.
I wonder if President Eisenhower ever worried that one negative effect of the growth of the profit seeking military industrial complex would be the diminution of our ability to win wars? As Rome discovered to its dismay one cannot maintain the necessary human element of any military campaign on the cheap.
In the speech from which the opening quote was taken I found this sentence which seems even more true now than in 1961 when it was delivered: Our military organization today bears little relation to that known by any of my predecessors in peacetime, or indeed by the fighting men of World War II or Korea.
The men who returned from W.W.II and Korea had benefits such as the GI bill of rights which legislation, according to this website, provided funding for some 7.8 million veterans' education expenses and 2.4 million veterans' home loans. Injured veterans returning from the War on Terror have to face Walter Reed, and the prospect of lying in one's urine.
What went wrong? How is it that the United States can spend hundreds of billions of $ on "defense," more than the rest of the world combined, but cannot provide care for its own?
In my view, one causal factor is the profit motive. That is, the militaryindustrial complex of which President Eisenhower warned has taken control of the flow of "defense" funds. Funds flow to those endeavors from which handsome profits can be made, and don't flow to others.
While there are many human endeavors which are assisted by people's drive for profit, there are others which are not. Child rearing is one which comes to mind. As a father I am well aware that raising children is unprofitable in a monetary sense (wildly profitable in a human sense). My son is unlikely to repay my wife and me for the time and money we have and will sink into his care and education. And I don't expect him to. My hope is that he will treat his children at least as well as I have treated him.
Creating newer and more lethal machines to kill people, like the creation of any new machine, is an endeavor which is assisted by people seeking profit. But caring for the human element in the military apparently is not. Billions of $s in profit will be reaped by those engaged in the creation of the new nuclear weapons. But there will be relatively little if any monetary profit reaped by those caring for our injured. Of course, a great deal of human profit could be reaped by providing adequate care for those who were prepared to make the ultimate sacrifice, and came home missing a limb or their sanity.
It seems to me extremely odd that China, whose military spending is roughly 1/10th of the United States, can maintain a standing army of some 2.25 million men while we cannot adequately maintain an armed forces of some 1.4 million. While I imagine the average Chinese soldier expects far less than the average American soldier, the 10 fold gap seems to me more than sufficient to overcome this difference in expectations.
Moreover, given the abysmal results from the most recent hi-tech, and hi-expense shock and awe campaigns, and the now apparent lack of boots on the ground necessary to complete the mission, perhaps it is time to consider shifting the flow of funds a bit, even if it means less profit for the militaryindustrial complex.
I wonder if President Eisenhower ever worried that one negative effect of the growth of the profit seeking military industrial complex would be the diminution of our ability to win wars? As Rome discovered to its dismay one cannot maintain the necessary human element of any military campaign on the cheap.
Tuesday, March 06, 2007
Say it ain't so, Al
We are in the sixth year of a recovery; imbalances can emerge as a result. Ten-year recoveries have been part of a much broader global phenomenon. The historically normal business cycle is much shorter'' and is likely to be this time. Alan Greenspan
I guess you have to leave Financial Official-dom to divine that imbalances can occur during business expansions and that those imbalances might hamper further expansion.
Hank, The Hammer, Paulson, as he has not yet left Financial Official-dom thinks The global economy is more than sound: it's as strong as I've seen in my business lifetime. No flies (or imbalances) on you, eh Hank?
He went on to opine about problems in the mortgage market, Some of the credit issues are there, but they are largely contained. Isn't that what they said when the Titanic first started taking on water?
I'll pick a nit with Greenspan's view- the idea that imbalances CAN occur. Is he suggesting that the US economy was in balance when he left it? Or is he expecting imbalances to show up some time in the future?
One last nit to pick, I wonder to what much broader, global phenomenon is he referring- globalization, productivity or himself?
I guess you have to leave Financial Official-dom to divine that imbalances can occur during business expansions and that those imbalances might hamper further expansion.
Hank, The Hammer, Paulson, as he has not yet left Financial Official-dom thinks The global economy is more than sound: it's as strong as I've seen in my business lifetime. No flies (or imbalances) on you, eh Hank?
He went on to opine about problems in the mortgage market, Some of the credit issues are there, but they are largely contained. Isn't that what they said when the Titanic first started taking on water?
I'll pick a nit with Greenspan's view- the idea that imbalances CAN occur. Is he suggesting that the US economy was in balance when he left it? Or is he expecting imbalances to show up some time in the future?
One last nit to pick, I wonder to what much broader, global phenomenon is he referring- globalization, productivity or himself?
Sticky wages get stickier
When Michael Maynard's company announced it was moving overseas, the 53-year-old machine technician from Massachusetts quickly found a job at another firm. As the sole provider for his wife and two daughters, Maynard jumped at the new opportunity, even though he had to take a pay cut of nearly $8 an hour.
Then Maynard got lucky. He discovered that, unlike most Americans who lose their jobs, he qualified for a little-known federal program that pays up to $10,000 to certain workers dislocated by trade. In addition to his regular paycheck, he gets a government check for $117 a week, he said, a sum that "helps a lot."
Now, congressional leaders want to expand the program, known as wage insurance, with some arguing that it should be available to any worker who loses a job for almost any reason. The proposal is part of a broader effort to ease the anxieties of middle-class Americans who feel threatened by the globalization of business and a churning U.S. labor market that creates and destroys about 30 million jobs a year. Making up for lower pay
It looks like the labor market arbitrage of globalization just got a little more expensive, albeit tangentially as the costs will be distributed throughout the nation's tax base.
Who knows, maybe some clever soul will decide that it might actually be better to once again MAKE THINGS in America.
p.s. before I get any nasty comments from my Austrian friends, NO I'm not supporting this initiative. I'd much rather corporate heads take a voluntary interest in making the country of their residence a better place to live for all, which might take the form of not accepting pay that is 400 times their average worker's income. Income disparities such as we have in the US inevitably give rise to such reactions.
Then Maynard got lucky. He discovered that, unlike most Americans who lose their jobs, he qualified for a little-known federal program that pays up to $10,000 to certain workers dislocated by trade. In addition to his regular paycheck, he gets a government check for $117 a week, he said, a sum that "helps a lot."
Now, congressional leaders want to expand the program, known as wage insurance, with some arguing that it should be available to any worker who loses a job for almost any reason. The proposal is part of a broader effort to ease the anxieties of middle-class Americans who feel threatened by the globalization of business and a churning U.S. labor market that creates and destroys about 30 million jobs a year. Making up for lower pay
It looks like the labor market arbitrage of globalization just got a little more expensive, albeit tangentially as the costs will be distributed throughout the nation's tax base.
Who knows, maybe some clever soul will decide that it might actually be better to once again MAKE THINGS in America.
p.s. before I get any nasty comments from my Austrian friends, NO I'm not supporting this initiative. I'd much rather corporate heads take a voluntary interest in making the country of their residence a better place to live for all, which might take the form of not accepting pay that is 400 times their average worker's income. Income disparities such as we have in the US inevitably give rise to such reactions.
Monday, March 05, 2007
Ben Bernanke, Super-Central Banker (we hope)
When I was a youth, in addition to stamps and coins I used to collect comic books. As my collection expanded from the Marvel Comics I loved like The Fantastic Four and The X-Men to the DC Comics like Batman and Superman I learned that initially Superman couldn't fly, he jumped, as in "able to leap tall buildings in a single bound." I guess the authors figured that people wouldn't believe a man could fly. But this habit of disdain for the implausible faded and eventually Superman began to fly.
Over the weekend I learned, yet again, that this disdain for the implausible no longer exists. Look, up in the sky. It's a bird, a plane. No it's Ben Bernanke, Super-Central Banker, able to leap the impossible in a single speech.
What am I writing about? I'm referring to Ben Bernanke's recent speech on Globalization and Monetary Policy, in which he raises the concerns of other (obviously un-super) Central Bankers that the Fed's ability, given the accepted policy of globally open capital markets, to control monetary conditions in the US has been lost, or at least, seriously impaired.
But, fear not ye lesser mortals, sayeth the Super-Central Banker, the fact that the dollar is a freely floating currency whose value is continuously determined in open, competitive markets means that the Fed retains its control over monetary conditions in the US.
Why is this important? Let me cede the floor to an obviously lesser Central Banker, swervyn Mervyn King, whom I had the pleasure of meeting a few times in the late 90s:
Perhaps the key difference between the world of Bretton Woods and the world today is the size and volatility of private capital flows. Then, as now, it was recognised that no system could ensure the compatibility of:
(i) Domestic monetary autonomy;
(ii) Stable exchange rates;
(iii) Free capital mobility.
This "impossible trinity" has been at the heart of the debate on the international monetary and financial system for many years. A sustainable system must sacrifice one of these three objectives.
In that case it's good that the things a Super-Central Bankers asserts as facts, like the freely floating, continuously determined in open, competitive markets value of the US$ are so just by virtue of him saying it. For if the US$ did not float freely but was, for instance, subject to intervention by other Central Bankers attempting to maintain stable exchange rates, then the US would not have domestic monetary autonomy.
Yes, it's a good thing that the Japanese, Chinese, and oil exporting Middle Eastern nations don't intervene to maintain stable exchange rates for if they did we might come to wonder about the claims of our resident Super-Central Banker.
But wait, didn't our main man and the most recent ex-Goldman director turned Treasury Secretary recently visit the Chinese to implore them to let the Yuan, which has risen a whopping 6.5% against the US$ in the past 5 years, float more freely? Were you aware that the average price of $/JPY in the 21st Century is 115.13? Did you know that the Saudi Riyal is, in practice, fixed to the US$ at 3.75 per (in theory it is fixed to the IMF's SDR.)
Hmm, I'm starting to get confused because it seems to me that the US$ exchange rate with three of our major trading partners is pretty stable. Either the impossible trinity is no longer impossible or our Super-Central Banker is, well, er, um, WRONG! The Fed, to the extent US$ exchange rates are stable, has lost a degree of domestic monetary autonomy.
What would it mean if the Fed lost domestic monetary autonomy? Why it would mean that, for instance, bonds yields would fall when they would, with more autonomy, rise. It would mean that, instead of being able to drain liquidity from the ever growing derivatives bubble, liquidity would continue to flow and the bubble would continue to inflate. It would mean that the unregulated capital markets are OUT OF CONTROL and headed for a meeting with reality.
Fortunately, we have lost our disdain for the implausible. Superman can fly, financial professionals would never let narrow self-interest interfere with their important social functions as intermediaries, and Super-Central Bankers can do the impossible.
I feel better already (gulp!).
Over the weekend I learned, yet again, that this disdain for the implausible no longer exists. Look, up in the sky. It's a bird, a plane. No it's Ben Bernanke, Super-Central Banker, able to leap the impossible in a single speech.
What am I writing about? I'm referring to Ben Bernanke's recent speech on Globalization and Monetary Policy, in which he raises the concerns of other (obviously un-super) Central Bankers that the Fed's ability, given the accepted policy of globally open capital markets, to control monetary conditions in the US has been lost, or at least, seriously impaired.
But, fear not ye lesser mortals, sayeth the Super-Central Banker, the fact that the dollar is a freely floating currency whose value is continuously determined in open, competitive markets means that the Fed retains its control over monetary conditions in the US.
Why is this important? Let me cede the floor to an obviously lesser Central Banker, swervyn Mervyn King, whom I had the pleasure of meeting a few times in the late 90s:
Perhaps the key difference between the world of Bretton Woods and the world today is the size and volatility of private capital flows. Then, as now, it was recognised that no system could ensure the compatibility of:
(i) Domestic monetary autonomy;
(ii) Stable exchange rates;
(iii) Free capital mobility.
This "impossible trinity" has been at the heart of the debate on the international monetary and financial system for many years. A sustainable system must sacrifice one of these three objectives.
In that case it's good that the things a Super-Central Bankers asserts as facts, like the freely floating, continuously determined in open, competitive markets value of the US$ are so just by virtue of him saying it. For if the US$ did not float freely but was, for instance, subject to intervention by other Central Bankers attempting to maintain stable exchange rates, then the US would not have domestic monetary autonomy.
Yes, it's a good thing that the Japanese, Chinese, and oil exporting Middle Eastern nations don't intervene to maintain stable exchange rates for if they did we might come to wonder about the claims of our resident Super-Central Banker.
But wait, didn't our main man and the most recent ex-Goldman director turned Treasury Secretary recently visit the Chinese to implore them to let the Yuan, which has risen a whopping 6.5% against the US$ in the past 5 years, float more freely? Were you aware that the average price of $/JPY in the 21st Century is 115.13? Did you know that the Saudi Riyal is, in practice, fixed to the US$ at 3.75 per (in theory it is fixed to the IMF's SDR.)
Hmm, I'm starting to get confused because it seems to me that the US$ exchange rate with three of our major trading partners is pretty stable. Either the impossible trinity is no longer impossible or our Super-Central Banker is, well, er, um, WRONG! The Fed, to the extent US$ exchange rates are stable, has lost a degree of domestic monetary autonomy.
What would it mean if the Fed lost domestic monetary autonomy? Why it would mean that, for instance, bonds yields would fall when they would, with more autonomy, rise. It would mean that, instead of being able to drain liquidity from the ever growing derivatives bubble, liquidity would continue to flow and the bubble would continue to inflate. It would mean that the unregulated capital markets are OUT OF CONTROL and headed for a meeting with reality.
Fortunately, we have lost our disdain for the implausible. Superman can fly, financial professionals would never let narrow self-interest interfere with their important social functions as intermediaries, and Super-Central Bankers can do the impossible.
I feel better already (gulp!).
Sunday, March 04, 2007
When "divide and conquer" fails
Divide and conquer fails when the parties one aims to divide find they have more in common with each other than with you. A. Burns
The two parties [Iran and Saudi Arabia] have agreed to stop any attempt aimed at spreading sectarian strife in the region. Prince Saud al-Faisal, Saudi foreign minister
The two parties [Iran and Saudi Arabia] have agreed to stop any attempt aimed at spreading sectarian strife in the region. Prince Saud al-Faisal, Saudi foreign minister
China's (missing) FX reserves: a case of pay me later?
Brad Setser's blog, which I highly recommend, has focussed on, inter alia, China's missing FX reserves. His take, that China's reserve growth is actually higher than reported, may not be entirely correct, to the extent that the following is true.
According to Asia Times: Although the exact amount of overdue accounts receivable overseas is not known, Han Jiaping, director of the credit-management department under the research institute of the Ministry of Commerce, estimated that China has about $100 billion of accounts receivable overseas and the figure is growing by $15 billion a year.
In other words, China's missing FX reserves may not be as much a function of undercounting as under collection. What is better than paying for goods with newly printed currency or bonds? Not paying at all.
While US$100B may not be the sum is used to be, it ain't chicken feed, and as an owner of chickens I know the difference.
I wonder if we are nearing the end game of China's willingness and ability to service America's consumer needs. At some point, the lack of payment for goods received leaves the goods providers unable to continue to provide.
Further, and perhaps more interesting for those of us long the precious metals, bringing the account current would mean a substantial increase, given that there is a multiplier effect yet to be applied to the unpaid $100B, in global liquidity yet to be seen.
Seems to me like a damned if you do, damned if you don't scenario.
How big a fuse does one need to ignite the derivatives Neutron Bomb? perhaps $100B will suffice. We will see.
According to Asia Times: Although the exact amount of overdue accounts receivable overseas is not known, Han Jiaping, director of the credit-management department under the research institute of the Ministry of Commerce, estimated that China has about $100 billion of accounts receivable overseas and the figure is growing by $15 billion a year.
In other words, China's missing FX reserves may not be as much a function of undercounting as under collection. What is better than paying for goods with newly printed currency or bonds? Not paying at all.
While US$100B may not be the sum is used to be, it ain't chicken feed, and as an owner of chickens I know the difference.
I wonder if we are nearing the end game of China's willingness and ability to service America's consumer needs. At some point, the lack of payment for goods received leaves the goods providers unable to continue to provide.
Further, and perhaps more interesting for those of us long the precious metals, bringing the account current would mean a substantial increase, given that there is a multiplier effect yet to be applied to the unpaid $100B, in global liquidity yet to be seen.
Seems to me like a damned if you do, damned if you don't scenario.
How big a fuse does one need to ignite the derivatives Neutron Bomb? perhaps $100B will suffice. We will see.
Friday, March 02, 2007
Dr. Realove learns to love the Great Unwind
In the Kubrick movie Dr. Stranglelove, the appropriately named title character explains how to love the bomb. I'd like to explain how one might come to love the Great Unwind, or as Bill Murphy calls it, the derivatives Neutron Bomb, by way of an analogy.
One of the aspects of dieting, at least in B.F. Skinner's view of how man works, that makes it difficult for the longer term obese to maintain is their conditioned love of the insulin rush and the feeling of fullness. While they don't like carrying around the extra weight, many just can't give up the desired sensation of a full belly.
Financially speaking, the powers that be cannot give up their love for "full," by which I mean, overpriced paper markets. Despite the fact that the Chinese market was up, even after the 9% decline, over 100% y/y there seemed to be a fear that any substantial decline in any context was bad. The vigor with which the Gold market was hit can be thought of, in our fat (or phat depending on one's hipness) analogy, can be imagined as a disdain for and campaign against healthy nutritious meals. Nope, no moderation allowed, if we think of Gold as money we just might have to think of money as limited.
Perhaps the adrenaline junkie's (and I have some familiarity with this affliction) need might be more appropriate as these junkies and the markets both like being "up." And just like an adrenaline junkie, the markets only exhibit risk averse behavior after experiencing pain and once the wounds begin to heal and the pain is forgotten, the need for a fix once again becomes too difficult to ignore.
But, as has been my wont of late, I'm stretching the metaphor beyond application so I'll get back on track.
One theme I was trying to describe with yesterday's Franken-derivatives essay was the notion that a derivatives collapse would be an unmitigated evil. I'm not arguing the actual collapse and immediate aftermath will be any more pleasant than the first few months of dieting is, but the ultimate effect is most desirable. Once the Great Unwind is past, as opposed to the many temporary pauses caused by financial market indigestion, only to begin anew, we will find that our markets work much more smoothly- the parasite will be brought back down to manageable, i.e. symbiotic size. One key feature will be the reduction in the ever increasing intermediation tax or "vig" levied by the financial market makers to keep their derivatives bubble inflated.
We need to stop taking lessons from Dr. Strangeloves, who wish us to love the derivative bubble and get back to a real love of a financial system that works well, by which I mean doesn't seek to create reality on its own but instead is content to be a model of what is. The virtues of a fairly priced market are roughly analogous to a truthful statement, which, as Thomas Jefferson famously opined, does not need the support of government. Neither should the market.
For now though I'll continue waiting for the Great Unwind, with precious metals in hand, not so much for the schadenfreude (although I admit there will be some of that), but for the eventual effect.
Just as a healthy eater learns to enjoy broccoli, and fruit for dessert while losing a taste for fat drenched meals, so too can financial market players and policy makers learn to enjoy stable markets and precious metals as stores of value while losing a taste for increased leverage. All it takes is alignment of the immediate mental associations with the ultimate effects, fit bodies and well functioning financial systems.
An unrelated afterthought on Kubrick: I'm a big fan of his films, and, after some reflection, especially enjoyed Eyes Wide Shut. I wonder if it was a touch of his ironic genius for Kubrick to cast Cruise and Kidman as the married leads. There was no need for them to act, they were living a life of Eyes Wide Shut, which is a metaphor with much wider application in our times or will be when the final act is revealed. I wonder if Kubrick foresaw the divorce. I'll bet he did.
One of the aspects of dieting, at least in B.F. Skinner's view of how man works, that makes it difficult for the longer term obese to maintain is their conditioned love of the insulin rush and the feeling of fullness. While they don't like carrying around the extra weight, many just can't give up the desired sensation of a full belly.
Financially speaking, the powers that be cannot give up their love for "full," by which I mean, overpriced paper markets. Despite the fact that the Chinese market was up, even after the 9% decline, over 100% y/y there seemed to be a fear that any substantial decline in any context was bad. The vigor with which the Gold market was hit can be thought of, in our fat (or phat depending on one's hipness) analogy, can be imagined as a disdain for and campaign against healthy nutritious meals. Nope, no moderation allowed, if we think of Gold as money we just might have to think of money as limited.
Perhaps the adrenaline junkie's (and I have some familiarity with this affliction) need might be more appropriate as these junkies and the markets both like being "up." And just like an adrenaline junkie, the markets only exhibit risk averse behavior after experiencing pain and once the wounds begin to heal and the pain is forgotten, the need for a fix once again becomes too difficult to ignore.
But, as has been my wont of late, I'm stretching the metaphor beyond application so I'll get back on track.
One theme I was trying to describe with yesterday's Franken-derivatives essay was the notion that a derivatives collapse would be an unmitigated evil. I'm not arguing the actual collapse and immediate aftermath will be any more pleasant than the first few months of dieting is, but the ultimate effect is most desirable. Once the Great Unwind is past, as opposed to the many temporary pauses caused by financial market indigestion, only to begin anew, we will find that our markets work much more smoothly- the parasite will be brought back down to manageable, i.e. symbiotic size. One key feature will be the reduction in the ever increasing intermediation tax or "vig" levied by the financial market makers to keep their derivatives bubble inflated.
We need to stop taking lessons from Dr. Strangeloves, who wish us to love the derivative bubble and get back to a real love of a financial system that works well, by which I mean doesn't seek to create reality on its own but instead is content to be a model of what is. The virtues of a fairly priced market are roughly analogous to a truthful statement, which, as Thomas Jefferson famously opined, does not need the support of government. Neither should the market.
For now though I'll continue waiting for the Great Unwind, with precious metals in hand, not so much for the schadenfreude (although I admit there will be some of that), but for the eventual effect.
Just as a healthy eater learns to enjoy broccoli, and fruit for dessert while losing a taste for fat drenched meals, so too can financial market players and policy makers learn to enjoy stable markets and precious metals as stores of value while losing a taste for increased leverage. All it takes is alignment of the immediate mental associations with the ultimate effects, fit bodies and well functioning financial systems.
An unrelated afterthought on Kubrick: I'm a big fan of his films, and, after some reflection, especially enjoyed Eyes Wide Shut. I wonder if it was a touch of his ironic genius for Kubrick to cast Cruise and Kidman as the married leads. There was no need for them to act, they were living a life of Eyes Wide Shut, which is a metaphor with much wider application in our times or will be when the final act is revealed. I wonder if Kubrick foresaw the divorce. I'll bet he did.
Thursday, March 01, 2007
Franken-derivative: It's alive!
written with tongue firmly clenched in cheek, sort of
Losing control of man's creations is one of the recurring themes in literature of all ages. From Frankenstein to the Terminator to the Matrix the fear that man will become a slave to his creations resonates with people, perhaps not unjustifiably.
When I consider the recent about face from ex-Fed Chairman Greenspan on the possibility but not probability of a recession in the US the notion that we have become, in a sense, slaves to the ever growing derivatives market, comes into shape in my mind. Is Greenspan afraid his comments (as opposed to his actions as Fed Chair) will spook the markets? It isn't as if his track record on these things, at least given his public statements, is particularly good.
More to the point, however, I've been thinking about the fearful way the news of an equity market correction was reported in the regular media. The tight linkage between China's stock market and that of the US was asserted as a given, and I even heard mention of the Yen carry trade and the, terribly negative, expected effects of its unwinding. It is as if the derivatives monster has taken on a life of its and warning us humans that it means business- it will wreak havoc on our world if we don't supply it with its food, liquidity, and the means to get more, open capital markets. Even investment bankers like the guys at Dresdner Kleinwort fear the wrath of this beast, which they have called the Great Unwind.
Some of the reasons cited for the 9% decline in the Chinese markets were fears that the government would try to reduce the leverage (raise margin requirements) used to trade stocks and/or restrict foreign participation in their market. Apparently a 5% decline in the Chinese markets a few weeks prior, which was also blamed on similar fears, was insufficient to get the attention of policy makers who were apparently trying to starve the beast. So, as many do in this age of mass media, the derivatives monster made sure it got on TV. Shocking events get the attention of the media, the media broadcast your message to the world; Donald Trump, eat your heart out.
I've stretched this metaphor to an extreme by speaking of it as if it was a sentient being, which it is not. Yet, if it isn't a sentient being why do so many apparently heed its pleas? Finance is but one of many industries necessary to modern life. If we can bleed the manufacturing economy in the US, why can we not bleed the financial economy? particularly when it forces us to live with a nagging fear of impending doom. The fear of the Pope excommunicating a nation which modern man now finds so silly has been replaced, it seems, by fear that the new priests of high finance will crash our markets or cut off our access to capital.
I agree with Warren Buffett, derivatives are financial weapons of mass destruction so why do we not disarm them? Why do we want to let this creation of ours continue to lead us to misdirect capital, wasting vast amounts of valuable human time in the process? Why would we want to let this creature continue to concentrate capital in fewer and fewer hands, which, in the past, has almost always given rise to class warfare?
How long will it be before some clever terrorist decides to put down his guns and bombs and opens up a hedge fund instead? Rather than suicide bombers we could get suicide portfolios. How many LTCM type blow ups would it take, given the carnage in the sub prime mortgage market, to cause the major markets to seize up? Death by disintermediation.
When Communist Russia began to collapse, justifiable fears arose over its nuclear weapons falling into the wrong hands. What if the leadership of a country with a large financial portfolio, and these have multiplied over the past decade, fell prey to a coup? Should we not also be concerned that in that event the derivatives monster instead of a nuclear holocaust, would be unleashed on the world?
But, it seems we have grown accustomed to the financial sword of Damocles hanging over our heads, perhaps like those who live near volcanoes and don't leave when the ground starts rumbling. Some cultures, for instance like those in Bali who worship the volcanoes, are considered backward because they try to propitiate their gods and thus avoid disaster. This week, when we heard the ground rumble, we too propitiated our gods, convincing ourselves that by so doing, we avoid disaster- but all the while we know it is coming.
Losing control of man's creations is one of the recurring themes in literature of all ages. From Frankenstein to the Terminator to the Matrix the fear that man will become a slave to his creations resonates with people, perhaps not unjustifiably.
When I consider the recent about face from ex-Fed Chairman Greenspan on the possibility but not probability of a recession in the US the notion that we have become, in a sense, slaves to the ever growing derivatives market, comes into shape in my mind. Is Greenspan afraid his comments (as opposed to his actions as Fed Chair) will spook the markets? It isn't as if his track record on these things, at least given his public statements, is particularly good.
More to the point, however, I've been thinking about the fearful way the news of an equity market correction was reported in the regular media. The tight linkage between China's stock market and that of the US was asserted as a given, and I even heard mention of the Yen carry trade and the, terribly negative, expected effects of its unwinding. It is as if the derivatives monster has taken on a life of its and warning us humans that it means business- it will wreak havoc on our world if we don't supply it with its food, liquidity, and the means to get more, open capital markets. Even investment bankers like the guys at Dresdner Kleinwort fear the wrath of this beast, which they have called the Great Unwind.
Some of the reasons cited for the 9% decline in the Chinese markets were fears that the government would try to reduce the leverage (raise margin requirements) used to trade stocks and/or restrict foreign participation in their market. Apparently a 5% decline in the Chinese markets a few weeks prior, which was also blamed on similar fears, was insufficient to get the attention of policy makers who were apparently trying to starve the beast. So, as many do in this age of mass media, the derivatives monster made sure it got on TV. Shocking events get the attention of the media, the media broadcast your message to the world; Donald Trump, eat your heart out.
I've stretched this metaphor to an extreme by speaking of it as if it was a sentient being, which it is not. Yet, if it isn't a sentient being why do so many apparently heed its pleas? Finance is but one of many industries necessary to modern life. If we can bleed the manufacturing economy in the US, why can we not bleed the financial economy? particularly when it forces us to live with a nagging fear of impending doom. The fear of the Pope excommunicating a nation which modern man now finds so silly has been replaced, it seems, by fear that the new priests of high finance will crash our markets or cut off our access to capital.
I agree with Warren Buffett, derivatives are financial weapons of mass destruction so why do we not disarm them? Why do we want to let this creation of ours continue to lead us to misdirect capital, wasting vast amounts of valuable human time in the process? Why would we want to let this creature continue to concentrate capital in fewer and fewer hands, which, in the past, has almost always given rise to class warfare?
How long will it be before some clever terrorist decides to put down his guns and bombs and opens up a hedge fund instead? Rather than suicide bombers we could get suicide portfolios. How many LTCM type blow ups would it take, given the carnage in the sub prime mortgage market, to cause the major markets to seize up? Death by disintermediation.
When Communist Russia began to collapse, justifiable fears arose over its nuclear weapons falling into the wrong hands. What if the leadership of a country with a large financial portfolio, and these have multiplied over the past decade, fell prey to a coup? Should we not also be concerned that in that event the derivatives monster instead of a nuclear holocaust, would be unleashed on the world?
But, it seems we have grown accustomed to the financial sword of Damocles hanging over our heads, perhaps like those who live near volcanoes and don't leave when the ground starts rumbling. Some cultures, for instance like those in Bali who worship the volcanoes, are considered backward because they try to propitiate their gods and thus avoid disaster. This week, when we heard the ground rumble, we too propitiated our gods, convincing ourselves that by so doing, we avoid disaster- but all the while we know it is coming.
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