Wednesday, October 29, 2008

A dam burst and helicopter drop all at once?

As I've recently been noting, the Treasury is sitting on a pile of cash- we might, recalling Fed Chairman Bernanke's idea of a "helicopter drop" of money, consider this one huge payload.

At 4PM today (when the Treasury posts its daily statement) I found that the helicopter has begun to drop its payload. $115B of TARP money was distributed, which leaves $593B left to drop.

Coincidentally, the Fed decided to drop its key rates by 50 basis points, bringing the Funds rate down to 1%.

Additionally, the Fed announced: Today, the Federal Reserve, the Banco Central do Brasil, the Banco de Mexico, the Bank of Korea, and the Monetary Authority of Singapore are announcing the establishment of temporary reciprocal currency arrangements (swap lines). These facilities, like those already established with other central banks, are designed to help improve liquidity conditions in global financial markets and to mitigate the spread of difficulties in obtaining U.S. dollar funding in fundamentally sound and well managed economies.

Of late, many financial commentators have noticed the wide spread between the Fed Funds rate and Libor rates. It seemed as if there was a dam keeping liquidity in the US and not allowing it to reach emerging markets starving for US$s.

With this Fed creation of new swap lines, that dam may be about to burst.

To recap, the Treasury has begun the release of 5% of GDP in financial sector recapitalization and direct credit market support, coupled with substantial declines in the Fed Funds rates, even more substantial increases in the monetary base and new Fed swap lines to emerging markets.

Now that's financial shock and awe!

or, if you prefer, a Tsunami allegory:

When a tsunami is unleashed, right before the waves start to hit, the water recedes dramatically and then begins to flood in....wave after wave.

Was the most recent substantial withdrawal of credit (and coincident decline in equity and commodity markets) the water receding before the Tsunami hits?

The least risky deal in the world?

Imagine, if you will, a corporation- a very large corporation, mind you, that was earnestly seeking investments in the fixed income markets.

This corporation currently has a total debt load of 4 times annual revenue, which is roughly 60%financed through sale of mainly short term paper, and roughly 40% financed through internal pension and related programs.

This corporation has almost never produced a profit and, in the last year alone, increased its debt load by 40% of revenue, again, mainly through sales of short term paper.

For the past few decades, this corporation has consistently worked to reduce its borrowing costs, thus reducing profits for investors. Meanwhile, the currency in which interest income is paid (that's right, this corporation controls the value of the currency in which its loans are repaid) has fallen substantially against most goods and services, often more than erasing the ever lower interest payments. Over the past few years, loans to said corporation have produced negative returns.

Would you loan money to such a corporation?

If not, do you own any US Treasury Bonds, Bills or Notes? If you do, you are loaning money to that corporation.

To be fair, there are, to my mind, good reasons (for some) to loan money to this corporation- patriotism, fear of collapse, etc.- but those reasons have very little to do with profit seeking.

Are Philosoper Kings rare or the norm?

Until philosophers are kings, or the kings and princes of this world have the spirit and power of philosophy, and political greatness and wisdom meet in one, and those commoner natures who pursue either to the exclusion of the other are compelled to stand aside, cities will never have rest from their evils, — nor the human race, as I believe, — and then only will this our State have a possibility of life and behold the light of day. Plato's Republic

During a recent phone conversation with my friend, Stephen Plant, I opined, in reference to the curious unwillingness of the US Treasury to put the (now $714B ) already raised "bail-out" funds to work, that the party in power might be waiting to put the funds to work until after the election, perhaps to avoid a collapse of the US$.

There are, of course, many other potential reasons behind this policy choice. Perhaps (from a less skeptical perspective) simple operational difficulties of implementing such a large and complex task are slowing them down. Perhaps (with a greater degree of skepticism) they were waiting to "paint the tape" (i.e. drive the Dow higher) in the last week before the election. As with all public policy choices, its a combination of desires that tends to explain best.

I base my (more skeptical) speculations on my study of history both of politics in general and the current administration in specific. Rarely, it seems to me, and, as the opening quote above suggests, to Plato as well, are nations led by truly altruistic experts. Much more common are those who skillfully disguise their self-aggrandizing policies in the clothes of altruism or, are not expert at all.

While it is true that abundant evidence of such policies in the past does not necessarily mean that the current Treasury policy falls into the same category, that same evidence at least suggests the current policy might so fall.

I would prefer to believe that the current policy is a result of altruistic expert views. However, I try not to let my preference get in the way of the evidence, or dismiss such speculation as a "conspiracy theory" - a term whose highly pejorative connotation in these United States seems a bit strange given that the nation was founded by conspiracy.

Treasury Watch

As of Oct. 27, 2008, The US Treasury's Total Operating Balance is: $714B

What are they waiting for?

Friday, October 24, 2008

What's going on at Treasury?

We need to get something done as quickly as possible. US Treasury Secretary Paulson, on 9/29/08 after the House rejected his initial proposal

If you happened to watch any TV news or read any print over the past few weeks, you will likely recall many public officials citing the urgent need to pass the rescue package as quickly as possible.

After some horse trading and a bit of grandstanding, the package was passed.

You'd figure, given the cries about the urgency of the bill, that once passed, funds would be raised and allocated quickly. I assumed the same.

If you assumed as I did, you would be (partly) wrong.

As I'm about to show you, funds were raised, but, as best I can tell, most haven't been spent.

The graph below depicts the US Treasury's Total Operating Cash Balance.

Yes, as of Oct. 23, the US Treasury is sitting on US$716B in cash. If I were a "Gordon Gecko"-type corporate raider, I'd think the US Treasury looks about ripe for a take-over. Drain the cash and let it go bust.

The head scratcher to me is....if it was so urgent to pass the bill, why not put the cash to work? Was the intent simply to soak up lots of short term liquidity and prop up the US$?

Notice I used "short term" for that has been the chosen financing option for this rapid and substantial expansion of the public debt.

As of end August 2008, total US Treasury Securities Outstanding was $9.646T, of which $5.479T was held by the public and the rest was "intragovernmental" (i.e. social security, Medicaid, etc.). Of the roughly $5.5T held by the public, $1.2T was in the form of bills.

As of end September 2008, total US Treasury Securities Outstanding was $10.025T (a 1 month increase of $379B), of which $5.809T (a 1 month increase of $330B) was held by the public. Of the roughly $5.8T held by the public, $1.5T was in the form of bills.

As of October 23, 2008, total US Treasury Securities Outstanding was $10.524T (a 23 day increase of $499B), of which $6.25T (a 23 day increase of $441B) was held by the public. Of the roughly $6.3T held by the public, $1.9T was in the form of bills.

In sum, since the end of August, the Treasury has increased the public debt by $878B, most of which was raised from the public ($771B) in the form of bills (roughly $680B). Its coffers are full, but funds are not (as best I can tell) flowing. Meanwhile, the average duration of US debt has become perilously short.

Do the guys in charge think of the US Treasury as a going concern? The way it appears to be run, I have my doubts.

A look at relative value

Saturday, October 18, 2008

An explanatory post

In hindsight, it might have been a defensive reaction to the Palin-led anti-intellectual nosedive of acceptable public discourse (who would'a thought one could nose-dive from the Bush-era level of discourse) at a time of obvious crisis- my reading tastes shifted some 10 days ago. Out went the recently written "how did we get here" expositions. In came the work of David Bohm and David Foster Wallace.

Overkill? Sure. But a balm to the mind all the same.

In a world where deliberation, planning and forethought have been deemed passé (from the Iraq War through the current economic crisis, policy makers have, in my view, reacted like drunk drivers- ignoring upcoming problems and then over-correcting, sometimes too late) filling my mind with prose that is complex, deliberate and well-planned has been a joy.

Revisiting Wallace's Infinite Jest has been equally joyful and tragic. The intensity of his prose reminds me of van Gogh's late work. The world must have been leaping at these minds all the time- like an Acid trip that never ended. I enjoy losing myself in both artists' work, and empathize with their reaction. Fortunately the spell is broken when I put the book down or turn away from the painting.

Yesterday, I got a break from home-schooling duties and I couldn't put the book down, thus the lack of contact, both via phone or blog.

Bohm's work, for practical purposes, has been most enlightening. His notion of an "implicate order" of reality-and-our-experience-thereof (for Bohm the distinctions are more artifacts of language than real) has implications for the more prosaic and pressing issues about which I opine.

Expect to see frequent use of Bohm's focus on context in upcoming arguments.

Thursday, October 16, 2008

The only thing we have to fear is.... ourselves...the consequences of our past actions

At his first inaugural address in 1933, Franklin Delano Roosevelt famously opined, let me assert my firm belief that the only thing we have to fear is fear itself -- nameless, unreasoning, unjustified terror which paralyzes needed efforts to convert retreat into advance. Admirers of FDR find solace in the view- unreasoning, unjustified terror was the cause of the national paralysis, and, by virtue thereof, reason would banish fear, and the paralysis would cease. Ironically, the national paralysis was ended by fear- fear of a global Axis victory, which finally put US manufacturing overcapacity to profitable use, almost a decade later.

Leaders today, as then, are pushing the same view.

President Bush avers, Over the past few days we have witnessed a startling drop in the stock market, much of it driven by uncertainty and fear.....This is an anxious time. But the American people can be confident in our economic future. We know what the problems are. We have the tools to fix them. And we're working swiftly to do so.

While Bush's articulation wasn't as elegant as FDR's the view is the same. Fear not. Be confident. We have the tools.

I'm reminded of a scene from Fast Times at Ridgemont High wherein, after crashing a car, Surfer Dude Spicoli, trying to calm his passenger's unreasoning fear of retribution, says, Relax, all right? My old man is a television repairman, he's got this ultimate set of tools. I can fix it.

See the video.

Neither the passenger in the car, people in the 30s or people today, who fear the future are, in my view, being unreasonable, or lack justification. Spicoli's lack of fear of the possible consequences of his joy ride is akin to the Bush administration's lack of fear of the possible consequences of their economic joy ride. Spicoli's "don't hassle it" retort reminds me of Dick Cheney's "deficits don't matter" retort.

Cars can crash. Deficits do matter. The previous lack of fear of consequences, once exposed as unreasoning, inspires an even greater fear- of the consequences we didn't fear before.

Money, like a car, is a tool. Used wisely they can facilitate commerce or transportation alternatively. Used recklessly, they can impede commerce or transportation, and, in extreme cases, cause injury and death.

Children, beginning to drive, often lack the fear of a crash their parents have learned. Parents of these children hope that the fear can be learned without too much pain. Fear serves a purpose. It keeps us from doing something stupid, like crashing a car or borrowing more than we can hope to repay.

Man, to quote Mr. Spicoli, has got this ultimate set of tools. Fear of their misuse seems to me a good thing, and a sound platform upon which to rebuild.

Wednesday, October 15, 2008

Uncle Sam's A.R.M.

As many home-owners have or are in the process of discovering, adjustable rate mortgage (A.R.M.s) payments can quickly become unmanageable when rates reset. As interest charges double or triple the wisdom of a long term fixed rate mortgage becomes clear.

Fortunately the wise men at the Treasury Department are well versed in such matters and didn't succumb to the temptation of "teaser" rates.



According to the US Treasury, as of June 2008 (thus not inclusive of the recent bail-outs and mortgage market nationalization), of the $2.72T in government debt owned by foreigners, $1.2T has a duration of under 2 years. In other words, interest rates on that $1.2T ($1.4T including interest payments) will be reset in the next 24 months.

Expanding the scope to include all US external debt, as of June 2008, of the $11.7T of debt owned by foreigners, $6.3T has a duration of under 2 years.

One of Hyman Minsky's claims to fame is his research on the transition from financial stability to fragility in a capitalist economy experiencing a bubble- the Financial Instability Hypothesis.

The Levy Institute, continuing Minsky's research, argues: The aim of these hypotheses is to show that the normal functioning of “a capitalist economy endogenously generates a financial structure which is susceptible to financial crises”because of the higher sensitivity of the economy to changes in income, cash commitments and asset prices. Thus, it is important to explain how the financial structure of the economy (or a sector) changes. This implies studying how it is affected by the prevailing convention regarding the appropriate balance-sheet and cash-flow structures, and by thedevelopments in the productive economy: both the expectation and actual sides of the economyaffect the financial structure of the economy.

The logic of this financial instability hypothesis is that during a prosperous economicperiod, there are forces that progressively lead the economy from conservative financialpositions (hedge positions) to positions for which the articulation of cash flows is high andbalance sheets are illiquid and highly leveraged (Minsky 1986a, 210-211):

The logic of this theorem is twofold. First, within a financial structure that is dominated by hedgefinance, there will be a plentiful supply of short-term funds, so that short-term financing is“cheaper” than long-term financing. Accordingly, firms will be tempted to engage in speculativefinance. Second, over a period of good times, the financial markets will become less averse torisk. This leads to the proliferation of financing forms that involve closer coordination of cashflows out with cash flows in—that is, narrower safety margins and greater use of speculative andPonzi financing. (Minsky 1986b, 5)

In other words, Minsky, a proponent of financial regulation, argued that unregulated finance was prone to succumb to the temptation of lower short term rates. Debt duration would decrease and financial stability would be lost.

And so it has.

With the fiscal deficit expected to rise dramatically over the next 2 years, the US Treasury will not only need to finance that expansion, it will also need to roll-over the maturing short term debt.

Good luck.

In the event foreigners are reluctant to buy all this new paper, some horse trading might ensure. For instance, our creditors might be willing to extend additional finance if we agreed to changes in the international financial architecture, such as are being proposed now.

Tuesday, October 14, 2008

To vote or to weigh?

In the short term, the market is a voting machine. In the long term, it is a weighing machine. Warren Buffett

(Explanation: The father of value investing, Benjamin Graham, explained this concept by saying that in the short run, the market is like a voting machine–tallying up which firms are popular and unpopular. But in the long run, the market is like a weighing machine–assessing the substance of a company. The message is clear: What matters in the long run is a company’s actual underlying business performance and not the investing public’s fickle opinion about its prospects in the short run.)

Rome, it is said, was not built in a day. Crops do not emerge from seed and produce their fruit in a day either. Banks do not create profit in a day either, but only over time.

Time is the necessary ingredient which makes compound interest profitable. $100,000,000.00 invested in a 10% coupon bond is only worth $100,027,397.26 the next day. It will take 365 days for the value of the investment to grow to $110,000,000.




Apparently not.

In optimal conditions, it will be many years before the financial sector generates sufficient profits to repay recent government investments. Those optimal conditions include a wide spread between short rates and long rates such that banks can borrow short and lend long. The bigger the spread, the greater the profit.

But it will take time- many years of a wide spread.

Judging by recent action in the equity markets, and assuming no helping government intervention (an erroneous assumption, in my view), recent policy choices of partial nationalization and recapitalization are popular. The votes, as per the opening Buffett quote, have been cast.

Yet, the weighing remains to be concluded.

In the late 90s billions of $s were invested in Tech companies. Few, despite tremendous popularity for the entire industry, survived the eventual weighing. Ultimately, running a profitable business became more important than the ability to attract investments.

The banks have proven quite adept at attracting investments. Whether they can run a profitable business remains to be seen.

Friday, October 10, 2008

Even big guys have to take their losses

"Cut your losses and let your winners run," is a lesson every successful trader learns...the hard way. Trading, you see, is an implicit recognition of superiority- for only a quicker, smarter chap will be able to make money trading. Yet, that basic sense of superiority must be tempered by painful experience. The successful trader needs to grasp that he or she may be smarter than other traders but not the fundamentals themselves.

Fundamentals matter.

Even, eventually, for the biggest players.

Of late, the powers that be have been fighting the tape- trying to keep equity prices up, interest rates down, and precious metals down further. It is a Sisyphusian task.

In the US Bond market, foreign Central Banks, with help from the US Fed, have been trying to keep yields low. Unsurprisingly, at least to those of who for whom fundamentals matter, the credit markets have seized up. Private sector flows into Treasuries, as Brad Setser has long been noting, long ago dried up. The yield is wrong. If one wishes to attract private sector capital back into Treasuries, yields must rise.

Asian Central Banks and Sovereign Wealth Funds continue to manifest the faith evident in the run-up to the last crisis a decade ago- if we stop people from selling, the price won't fall. They, apparently, have yet to accept that prices are set in people's minds, and only manifest in the market. They also, apparently, haven't learned that key trading lesson, the first guy who dumps a declining market wins, even if the trade itself is a loser.

Better to lose a little than lose a lot, which is why cutting one's losses is vital.

But, as I noted above, this view is only learned through bitter experience. One has first to realize that one can lose, that publically perceived reality is not infinitely malleable. Recent market action is teaching the powers that be this bitter lesson.

I've been asked to toss out my 2 cents worth of opinion on possible solutions to the current mess. The following might not be worth 2 cents but here it is.

1) The US needs to accept that in the absence of private sector bond inflows, cutting interest rates only exacerbates pressure on the Fed, and other Central Banks. The US needs capital, and they will now have to actually compete for it, by paying the right price.

2) The Fed has recently thrown in the towel on its multi-year attempt to restrain the growth of high powered money. The Monetary Base is up 19.6% y/y and 17.6% q/q. I believe they should continue this action while rates rise to equilibrium. Once beyond equilibrium, the Fed can tighten as Volcker did in the early 80s.

3) The US needs to quickly shift gears on spending- redirecting military flows to infrastructure flows. The multiplier effects of the two wars have been negative. Oil is more expensive and capital is being consumed. The multiplier effects of improved, far less energy intensive infrastructure would be, in my view, very positive.

4) Fortunately, current conditions are very different from those of the Great Depression. Then the US was a major exporter- capacity was far in excess of domestic demand. Thus the disastrous impact of reduced international trade. A shift back towards current account balance would not involve, as it did in the 30s, massive lay-offs, but rather large scale hirings in, inter alia, manufacturing. As noted above, however, rebuilding infrastructure and bringing manufacturing back home will require capital, for which we will have to compete.

5) The US financial sector needs to be nationalized (the purist in me prefers a clearing of the decks, so to write, but that has a tendency to invite both nasty domestic political changes, and/or foreign invasions) and soon. Portfolios need to be marked to market in order to get capital moving again and this process is likely to be too difficult for current management to do and survive. During this week's Presidential Debate, Warren Buffett's name was suggested as a possible Treasury Secretary. I think, given the current crisis, his distaste for derivatives would be a much needed attitude in that post.

6) Most importantly, the US (and the financial world at large) needs to cut their losses. The experiment in fiat money has run its course, and failed. Gold should be embraced instead of demonized.

Wednesday, October 08, 2008

Losing the Mandate of Heaven

The Mandate of Heaven (天命 Pīnyīn: Tiānmìng) is a traditional Chinese philosophical concept concerning the legitimacy of rulers. Heaven would bless the authority of a just ruler, but would be displeased with a despotic ruler and would withdraw its mandate. The Mandate of Heaven would then transfer to those who would rule best.

The Mandate of Heaven had no time limitations, but instead depended on the just performance of the ruler. The Mandate does not require that a legitimate emperor be of noble birth, and in fact, dynasties were often founded by people of modest birth (such as the Han dynasty and Ming dynasty). The concept of the Mandate of Heaven was first used to support the rule of the kings of the Zhou Dynasty and later the Emperors of China. Wikipedia

Sometimes, as Lehman CEO Richard Fuld recently discovered, the Mandate of Heaven is removed suddenly.

Mr Fuld, who has been testifying on the financial crisis before the US House Oversight Committee, was attacked on a Sunday shortly after it was announced that the banking giant was bankrupt.

Following rumours that the incident had occurred, Vicki Ward, a US journalist, said "two very senior sources - one incredibly senior source" had confirmed it to her. "He went to the gym after ... Lehman was announced as going under," she told CNBC. "He was on a treadmill with a heart monitor on. Someone was in the corner, pumping iron and he walked over and he knocked him out cold.

"And frankly after having watched [Mr Fuld's testimony to the committee], I'd have done the same too."

"I thought he was shameless ... I thought it was appalling. He blamed everyone ... He blamed everybody but himself."

But one week earlier, I suspect that same person would have been quite eager to get Mr. Fuld a towel.

Andrew Mellon is NOT running for President

Liquidate labor, liquidate stocks, liquidate farmers. Andrew Mellon US Treasury Secretary 1921-1932

The opening exchange in last night's Presidential Debate demonstrated to me that Mellon's liquidationist views are not an option on offer.

QUESTION: With the economy on the downturn and retired and older citizens and workers losing their incomes, what's the fastest, most positive solution to bail these people out of the economic ruin?

OBAMA: Well, Alan (ph), thank you very much for the question. I want to first, obviously, thank Belmont University, Tom, thank you, and to all of you who are participating tonight and those of you who sent e-mail questions in.

I think everybody knows now we are in the worst financial crisis since the Great Depression. And a lot of you I think are worried about your jobs, your pensions, your retirement accounts, your ability to send your child or your grandchild to college.

And I believe this is a final verdict on the failed economic policies of the last eight years, strongly promoted by President Bush and supported by Senator McCain, that essentially said that we should strip away regulations, consumer protections, let the market run wild, and prosperity would rain down on all of us.

It hasn't worked out that way. And so now we've got to take some decisive action.

OBAMA: Now, step one was a rescue package that was passed last week. We've got to make sure that works properly. And that means strong oversight, making sure that investors, taxpayers are getting their money back and treated as investors.

It means that we are cracking down on CEOs and making sure that they're not getting bonuses or golden parachutes as a consequence of this package. And, in fact, we just found out that AIG (NYSE:AIG) , a company that got a bailout, just a week after they got help went on a $400,000 junket.

And I'll tell you what, the Treasury should demand that money back and those executives should be fired. But that's only step one. The middle-class need a rescue package. And that means tax cuts for the middle-class.

It means help for homeowners so that they can stay in their homes. It means that we are helping state and local governments set up road projects and bridge projects that keep people in their jobs.

And then long-term we've got to fix our health care system, we've got to fix our energy system that is putting such an enormous burden on families. You need somebody working for you and you've got to have somebody in Washington who is thinking about the middle class and not just those who can afford to hire lobbyists.

BROKAW: Senator McCain?

MCCAIN: Well, thank you, Tom. Thank you, Belmont University. And Senator Obama, it's good to be with you at a town hall meeting.

And, Alan (ph), thank you for your question. You go to the heart of America's worries tonight. Americans are angry, they're upset, and they're a little fearful. It's our job to fix the problem.

Now, I have a plan to fix this problem and it has got to do with energy independence. We've got to stop sending $700 billion a year to countries that don't want us very -- like us very much. We have to keep Americans' taxes low. All Americans' taxes low. Let's not raise taxes on anybody today.

We obviously have to stop this spending spree that's going on in Washington. Do you know that we've laid a $10 trillion debt on these young Americans who are here with us tonight, $500 billion of it we owe to China? We've got to have a package of reforms and it has got to lead to reform prosperity and peace in the world. And I think that this problem has become so severe, as you know, that we're going to have to do something about home values.

You know that home values of retirees continues to decline and people are no longer able to afford their mortgage payments. As president of the United States, Alan, I would order the secretary of the treasury to immediately buy up the bad home loan mortgages in America and renegotiate at the new value of those homes -- at the diminished value of those homes and let people be able to make those -- be able to make those payments and stay in their homes.

Is it expensive? Yes. But we all know, my friends, until we stabilize home values in America, we're never going to start turning around and creating jobs and fixing our economy. And we've got to give some trust and confidence back to America.

I know how the do that, my friends. And it's my proposal, it's not Senator Obama's proposal, it's not President Bush's proposal. But I know how to get America working again, restore our economy and take care of working Americans. Thank you

Contra Mr. Mellon, these two candidates expressed a view that can perhaps be summed up thusly:

Inflate labor, inflate stocks, inflate farmers.

Monday, October 06, 2008

Who can dig a deeper hole?

I spent the past few days on an excavator, digging (and reburying) some stumps, setting up a pad for a new building and digging a hole for some stone steps.

But, it seems to me, and to the stock market, the powers that be can dig a much deeper hole than I.

Ben Bernanke applauds the recently approved bail-out: I applaud the action taken by the Congress. It demonstrates the government's commitment to do what it takes to support and strengthen our economy. The legislation is a critical step toward stabilizing our financial markets and ensuring an uninterrupted flow of credit to households and businesses.

The Federal Reserve will continue to work closely with the Treasury as it undertakes these new initiatives. We will continue to use all of the powers at our disposal to mitigate credit market disruptions and to foster a strong, vibrant economy.

Perhaps my brains are a bit rattled (occupational hazard of sitting on an excavator) but borrowing an extra 5% of GDP to buy bad debts from the banking sector with the aim of maintaining an uninterrupted flow of credit to households and business (which seems to be the cause of the bad debt problem) is likely to do little to support and strengthen our economy.

While digging, I was thinking about the speed of financial sector consolidation in recent weeks. At the current rate the Fed will soon be able to conduct policy on a 3-way conference call.

The virtue of consolidation- reduction of redundancies- depends on a tried and true business model. Why the financial sector believes consolidation makes sense currently, when the failure of their business model is becoming ever more apparent, is beyond my ability to fathom.

In times past, capitalist competition was viewed through the same lens as evolutionary competition- the fittest would survive. Industry consolidation could, under that head, be seen as a decrease in intra-species diversity which occurs when an organism becomes extremely well adapted to an environment.

So, I wonder, why is the financial sector aiming to decrease diversity when a culling of the financial herd is imminent? Are we breeding bigger dinosaurs just in time for the great extinction?

Wednesday, October 01, 2008

Just a flesh wound

BLACK KNIGHT: Have at you!
ARTHUR: You are indeed brave, Sir knight, but the fight is mine.
BLACK KNIGHT: Oh, had enough, eh?
ARTHUR: Look, you stupid bastard, you've got no arms left.
BLACK KNIGHT: Just a flesh wound.
Try Youtube if you haven't seen it.

The US financial sector reminds me of the Black Knight in Monty Python's Holy Grail, with "reality" in the role of King Arthur. The bail-out, retaining the metaphor, is akin to sewing the Black Knight's arms back on so he can fight (and lose) again.

It seems a bit odd for me to argue against the bail-out. I expected something of the sort, and base my continued long position in Gold on its effects. The more non-performing debt that gets shifted from the private to the public sector, freeing the private financial sector to continue what they have been doing, the weaker will the US$ become, thus driving the price of Gold higher.

Yet, I think the bail-out will merely delay the inevitable- a massive crash of the major financial firms (clearing the field for new players) or nationalization. The party is, it seems to me, over.

Sadly, the US financial sector, like the Black Knight, just can't admit it has lost. Unregulated finance conducted under the umbrella of presumed safety of a lender of last resort- the Fed- combined with golden parachutes for senior management regardless of performance, tends to self-immolation.

The checks and balances of finance that you, I, or any small business work within are non-operative on that level. The attitude of "get the stock price up as high as we can, any way we can, so we can get bonuses, and if we fail, no biggie, the Fed cleans up the mess and we parachute down in safety," is a poor mind-set for making the vitally important decisions of capital allocation in an economy. It also hasn't helped that a few foreign Central Banks have bet heavily on perpetuation of the system and are loathe to take the hit if it falls.

I have previously bemoaned the shift in markets from price discovery to price enforcement vehicles. Price discovery is difficult enough without a bunch of big players with (almost) unlimited access to capital driving (or maintaining) prices to (at) certain levels. It has become a Sisyphusian task, the perpetuation of which, is seems to me, risks losing some of the open markets' great benefits.

The problems in the credit markets, in my view, are not due to a lack of liquidity per se, but a lack of liquidity at the enforced prices. If the powers that be wished to improve liquidity they could let interest rates rise, as LIBOR does when lenders are skittish.

Please note, I wrote, "let interest rates rise," not "drive them higher." The widening spreads between T-Bills and Eurodollars and LIBOR and Treasuries are signs that the price of credit is too low. If the Fed stood aside, interest rates would jump, and credit would be rationed by price.

In the not so distant past, one sure way to improve demand for credit securities was to raise the interest rate. When the last real estate mess was being cleaned up in the US, the RTC Bonds needed to carry a hefty interest rate. When Germany reunified, Bund rates jumped without dissent from the BBK as they were aware that capital wouldn't be easily found at the then current rates.

Of course, a jump in interest rates would have disastrous effects on the financial behemoths (and the common man). Trillions of dollars of derivatives would be repriced in a flash, in an environment where hedging would be difficult if not impossible.

It is the financial sector's apparent inability to allow price to act as credit rationing mechanism which leads me to the view that it is already dead. If a Bank can't deal with rising rates, it isn't, it seems to me, much of a bank.

The bail-out is just a way to keep rates low for a bit longer. At least until the next refunding, that is.