Tuesday, August 14, 2007

Carlo Ponzi - Fed Chairman, and the current crisis

Central banks around the world have been injecting funds into markets in response to an undesired and unwelcome spike in short-term rates suggested that demand for reserves was outstripping supply. The following is a rundown of the totals and excerpts from any statements issued Friday by the regulators. WSJ

Federal Reserve
Thursday: $24 billion
Friday: $38 billion (tranches of $19 billion, $16 billion and $3 billion)

European Central Bank
Thursday: €94.84 billion ($130 billion)
Friday: €61.05 billion ($83.56 billion)

The Bank of Canada
Friday: 1.64 billion Canadian dollars ($1.55 billion).

Bank of Japan
Friday: one trillion yen ($8.39 billion)

Swiss National Bank
Friday: two to three billion Swiss francs ($1.68-$2.51 billion) [estimate]

The Reserve Bank of Australia
Friday: 4.95 billion Australian dollars (US$4.18 billion)

The Monetary Authority of Singapore

Friday: 1.5 billion Singapore dollars (US$986.1 million)


FRANKFURT/SINGAPORE (Reuters) - Central banks in the world's leading economies pumped money for a third day into the financial system on Monday, but in smaller amounts as investor nerves steadied over the dangers of a credit squeeze.

The European Central Bank lent out an extra 47.67 billion euros ($65.29 billion) in overnight funds, its smallest amount since lending rates shot up last Thursday on fears European banks faced huge exposure to risky U.S. mortgage debt. The ECB noted that markets were beginning to return to normal.

While the Atlantic Hurricane season has been slow (so far) it appears that a whale of a storm just hit the financial markets. You know things are grim when the sedate FT prints articles that seem more at home on a blog. Jeremy Grant's Learn from fall of ancient Rome, official warns US reads like something I would write. Of course crisis periods usually evoke crisis warnings and we are experiencing a crisis, aren't we?

We don't need no st-ee-nking crisis

Judged solely by the actions of the world's Central Banks a credit crisis seems obvious. Yet, having been around the financial block for a few decades I'm a bit confused. Crises ain't what they used to be.

I was an economic consultant out in SE Asia during the 97-98 crisis and remember it well. By the time the Fed decided to act, in September of 98, most Asian equity indices had lost at least half of their value, and many, much more. For instance, Singapore's Straits Times Index had fallen from Jan-97's 2216.8 to 826.93 by Sept of 98.

In the US, the Dow Jones Index had fallen from a spring 98 peak of just over 9000 to around 7500 when the Fed eased in September of that year- roughly a 17% decline.

Meanwhile Russia was defaulting on its foreign debt and Brazil was on the brink.

Now that's a crisis.

The current crisis, at least judging by equity indices, seems much more tame.

Asian equity indices have fallen, but only by 10% or so from early year peaks. European equity indices have fallen by similar amounts of 10% or so. The Dow Jones Index is down about 850 pts from it's peak of 14K or just over 6%. That's 1/3 of the 98 equity decline that got the Fed into action a decade ago. And I am unaware of any Russian style sovereign debt defaults this go round.

If the current crisis is, judging by equity indices, orders of magnitude less severe, than what's the deal? What makes this a crisis?

The wrath of the Derivative's God

The most glaring difference between the 98 crisis and the current period is the growth of derivatives in general and credit derivatives in particular.

According to the OCC, the total notional value of derivatives for US banks in Q2 1998 was US$28T, of which interest rate derivatives totalled some US$20T and credit derivatives totalled some US$129B.

As of Q1 2007, the total notional value of derivatives for US banks was US$144T (a quadrupling over 10 years), of which interest rate derivatives totalled some US$119T (6 times the 98 amount) and credit derivatives totalled some US$10T (an almost 10 fold increase over the decade).

Another difference is the concentration of exposure into fewer banks. In 1998 derivatives exposure was spread across 8 big banks, while currently (again according to the OCC report) Commercial bank derivatives activity is heavily concentrated in the three largest dealers, which hold 89%of all contracts.

Back when I was trying to explain derivatives to Asian Central Bankers I used to tell them to think of derivatives as leverage- more derivatives equals more leverage. So in the 10 years since that last crisis, leverage has increased dramatically AND been concentrated into fewer and fewer hands.

Increased leverage means that it takes less unanticipated price action to create a crisis. A decade ago, equity indices could fall 20-30% before Central Bankers warned of a crisis while now a mere 10% move evokes the same warning.

Increased concentration of exposure into fewer and fewer institutions also decreases the amount of unanticipated move necessary before alarm bells ring. A tremendous amount of leverage concentrated into three institutions, which, as an aside, was just the type of situation Glass-Steagle and the other post depression financial regulations were trying to avoid, is a recipe for disaster- when one goes the market goes with it. Good thing those regulations were repealed.

In other words, increased leverage and concentration makes our financial institutions much less resilient to unanticipated shocks. As any leveraged futures trader who has been burned can tell you, the more leverage you use, the better speculator you need to be, or as we will discover, the better placed your friends need to be

What if Robert Rubin had founded LTCM?

I see more than coincidence in the recent actions of Central Banks and the news that Goldman Sachs' Global Equity Opportunities Fund just got a US$3B shot in the arm. Financial industry consolidation and the seeming revolving door between high level Wall St. executive positions (most notably Goldman Sachs, from whence came Hank Paulson) and the US Treasury should set collusion alarm bells ringing.

I wonder if the LTCM fiasco would have been resolved differently if one of their founders had taken the job as US Treasury Secretary. In the event, LTCM was liquidated, while Goldman Sachs' Global Equity Opportunities Fund will likely continue operations.

Carlo Ponzi, Fed Chairman

Most press stories explain the recent liquidity additions as a concerted attempt by the world’s central banks to restore confidence in the global financial system.

How does the financial industry lose confidence? by losing other people's money.

How can the financial industry maintain confidence? Let's go back to the early 20th century and inquire as to the actions of one Carlo Ponzi (thus the eponymous scheme) whose Securities Exchange Company advertised a 50% return in 90 days:

as news of the audit hit the street, the whiff of insecurity began to work its magic, creating a run on the Securities Exchange Company. But it seemed as though Carlo had an inexhaustible supply of cash: all of the investors who that lined up to withdraw their deposit each received their cash plus 50 percent.

And as the audit progressed, the auditors were stumped. The company kept meticulous records of all deposits and withdrawals. No one was being cheated, and no law had been broken. The only thing that they couldn't find was how the company made its fantastic profits. When asked, Carlo indignantly replied that that was a company secret.

Carlo Ponzi maintained confidence in his scam by ensuring that depositors were able to withdraw funds. That is, so long as he was able to survive the run on his bank, i.e. seemed to have an inexhaustible supply of cash, he could stay in business.

I assume that one use of Central Banker liquidity will be to ensure that Hedge Fund investors get their money back, i.e. that redemptions will be allowed. Nothing kills confidence more than finding out you can't get your money back, just ask California or Florida real estate flippers.

I guess it's good to be a high net worth individual these days, as opposed to an average Joe who took Greenspan's advice and took out an adjustable rate mortgage a few years back, eh.

But Carlo Ponzi did not have the deep pockets that our financiers have. Let's go back to the early 20th Century again:

The feds responded to this [ being told that investment methods were a secret- exactly what Hedge Funds say today] by placing a restraining order on the company, prohibiting it from accepting any further deposits while the investigation was proceeding. Carlo, glimpsing impending doom, hired the well-respected William McMaster to handle public relations until the investigation blew over. This move didn't turn out so well for our friend Carlo. Shortly after being hired, McMaster issued a statement to the press that the Securities Exchange Company had never--not even once--conducted a single foreign financial transaction.

Again, investors created a run on Carlo's company, and again, Carlo appeared to weather the storm, even serving coffee and donuts to depositors as they waited. But eventually the toll of the investigation and revelations took their course, and more and more investors showed up to withdraw their money, until eventually the money ran out. On August 9, 1920, Carlo's bank issued a statement that it could no longer honor checks from the Securities Exchange Company. Two days later, Carlo's criminal record was released to the public.

Back when Carlo was being forced to repay investors, a dollar was worth something- about 1/20th of an ounce of Gold. Carlo couldn't just print Ponzi money and give it out.

Now the banks can, in essence, do just that. When they are faced with the modern form of a bank run- hedge fund redemptions, Central Banks can just inject liquidity into the system (Ponzi money) and the problem is solved, sort of.

What price confidence

The effect of bail-outs like these, as opposed to the liquidation forced on poor Carlo Ponzi, is a devaluation of the currency, inflation.

Back in 1998 much of the inflation was masked by the dire straits faced by Russia and other emerging economies. Their need to acquire US$s to repay debt and build up sufficient reserves to avoid a repeat of the crisis acted to drain much of the added liquidity from the system.

The situation now could not be more different. If the problem of 98 was a lack of US$ reserves among emerging market nations, the problem now is too much. Moreover the people short of $s are not emerging market nations, but western hedge fund managers and those who supplied them the leverage, a few western banks.

Aside from location, another difference between the emerging market nations that were short US$s a decade ago and the hedge funds and money center banks short US$s now is productive capacity. Emerging market nations could (and did, the swing from emerging market current account deficits in 97-87 to surpluses now has been well documented) produce goods to earn $s and repay their debts, the hedge funds and banks will not.

In other words, the increased liquidity a decade ago tended to finance, inter alia, increased productive capacity. I doubt the same will follow this time round.

So, what price confidence? Inflation, and lots of it. Financial industry consolidation guarantees that liquidations will be few and far between and bail-outs, more and more common.

The limits of Arbitrage

Who knows, we might even reach the point where investors realize that an ounce of Gold in hand might just be worth quite a bit more than US$666 of Ponzi money invested in a hedge fund.

The reason being, one cannot guarantee, in a real sense, investments that are too good to be true, particularly investments that don't finance productive capacity. There's only so much real money to be made arbitraging, which is what a fund that doesn't invest in productive capacity does. Parasites that outgrow their hosts, kill them, and then die themselves.

When the universe of arbitragers was small, real positive returns were possible, but as that universe has grown at much faster rates than that of productive capacity, real returns are getting harder and harder to come by. The only thing Central Bankers can guarantee is currency, not value- a lesson which will become more and more obvious as the next few months pass.