Friday, November 06, 2009

The Rising Fiscal Cost of Unemployment

Paraphrasing the old frat house saying about the party only getting started when something breaks- a financial crisis only truly gets going when the bond market starts to crash.

Sometimes a picture really is worth 1000 words.

click for bigger graph

The graph above depicts the 12 month moving average of the Federal Fiscal Deficit (in blue, left axis) and Non-Farm Payrolls (in red, right axis) since 1981. As you can see unemployment is becoming increasingly expensive.

When I first glanced at the data I was quite surprised. I wondered if the problem was more a function of expenditures, particularly War and Financial Bail-Out costs. While these play a significant part, the graph below shows that Federal Tax Receipts (in blue, left axis) are increasingly sensitive to changes in employment.

click for bigger graph

I'll be a very interested observer of the US Bond market in the coming months (who knows, things could get exciting today) to see if the normal "weak economy equals strong bond market" relationship doesn't shift into a "weak economy equals lower tax receipts, higher deficits, more bond supply and thus weaker bond market" relationship.

Paraphrasing the old frat house saying about the party only getting started when something breaks- a financial crisis only truly gets going when the bond market starts to crash.  After all it isn't much of a crisis if your lenders are willing to lend to you at lower rates then before the crisis, is it?

Full Disclosure: No position in US Bonds (but I'm thinking about it)

Wednesday, November 04, 2009

Feds Forget Bread Crumbs, Have No Exit Strategy

Early in the morning came the woman, and took the children out of their beds. Their bit of bread was given to them, but it was still smaller than the time before. On the way into the forest Hansel crumbled his in his pocket, and often threw a morsel on the ground until little by little, he had thrown all the crumbs on the path. Hansel & Gretel

This afternoon (thanks to the good fellows at Zero Hedge) I found my way to the Minutes of the Meeting of the Treasury Borrowing Advisory Committee Of the Securities Industry and Financial Markets Association.

After debate on other issues, The Committee then turned to a presentation by one of its members on the likely form of the Federal Reserve's exit strategy and the implications for the Treasury's borrowing program resulting from that strategy.

The presenting member began by noting the importance of the exit strategy for financial markets and fiscal authorities...A critical issue will be the impact on the riskier asset classes as market interest rates move away from zero.

The presenting member then looked at the likely sequence of the Federal Reserve's exit strategy. The member acknowledged that the central bank must address the uncertainty and fragility of the economic recovery and the dependence of the housing market on low rates. It was suggested that the most likely sequence would be the draining of excess reserves from the banking system, the cessation of the mortgage-backed securities purchase program, and only then raising the Fed funds target rate.

There you have it, drain excess reserves, stop buying mortgage back securities and then raise Fed Funds.

Easy, right?

Not so fast.

Several members at this point asked why draining reserves before ending the MBS program made sense. The presenting member noted that the program was already set to expire, and other measures, such as a revival of the Supplementary Financing Program, could be utilized by the Federal Reserve at the same time.

The presenting member then addressed the options for draining reserves from the banking system. The problem of excess reserves could persist through the end of 2011 with up to one trillion in excess reserves remaining after liquidity facilities and on balance sheet securities have rolled off. One approach, raising the Fed funds rate to increase the opportunity costs of banks using their reserves, carries the attendant problems of increasing interest rates too soon in the economic recovery. A second option, taking in term deposits, lacks a clear mechanism for rate setting and bank use. Selling assets may run into difficulties if the public appetite for debt at that time is sated, especially considering the impact on the housing market and the major role the Federal Reserve currently plays in the market.

According to the presenting member, these less than optimal solutions leaves the Federal Reserve the option of reverse repurchase agreements (reverse repos) as the most likely option although the potential of the mechanism for draining reserves is unclear. If it is to undertake these reverse repos, the selection of counterparty is important. Depending on how the program is designed, whether it is made to work with dealers or money market funds or to pursue a TALF model with banks as agents, there will be different impacts on the scope of the program, the ease with which it can be set up, and the term of the contracts. In all cases, the program will compete with other short-term investments and put upward pressure on Treasury bill rates according to the presenting member. Moreover, draining excess reserves may dampen the demand for Treasury securities by banks given that banks are investing in securities – particularly Treasuries - in the absence of loan demand.

Several members noted the graph discussing net fixed income supply in 2009 and 2010, and how issuance will ramp up dramatically in 2010. Federal Reserve purchases have taken an enormous amount of supply out of the market this past year across fixed income markets, but next year, financial markets should expect even greater issuance with no support. Such an outcome could pressure rates.

"Pressure rates," now there's an understatement. 

It looks to me as if the Feds didn't consider an exit strategy before embarking on their journey into the liquidity swamp called Quantitative Easing. There seems to me to be no viable exit strategy that won't have severe implications for the real economy. Given that we will be having elections in 2010, and again in 2012, the odds of the liquidity swamp getting drained any time soon, which would surely sour the mood on incumbents seems quite small.
Tightening, I suspect, will be done by the markets, and, under that scenario, those excess reserve might come in handy. At least then the Feds will then have someone else to try to blame.
Alternatively, this meeting could be just a show to buy time before the US$ starts to really sink.
No wonder Mr. Buffett wants to get rid of his cash.

Tuesday, November 03, 2009

Whistling past the Depression

Ben Bernanke – for it was he, of course – has found himself in an even more privileged position to learn such lessons. As chairman of the Fed, his record already deserves more plaudits than those prematurely heaped upon his predecessor. How lucky for us that a Great Depression buff was running the Fed when a second Great Crash came along! For this time the contractionary forces have not been intensified, in the name of sound money. Instead, an active monetary policy has pursued a strategy of easing credit restraints on the real economy, and the threat of inflation has been rightly dismissed as a purely notional danger under present circumstances. FT

The Fed, according to a scan of the financial news, is currently debating the timing and method of an "exit strategy" from the zero-interest-rate-policy (ZIRP), which, according to the above view, saved the US from a repeat of the Depression. This may well prove to be true, and if so, would be, in my view, an example of the myopia inducing effects of unproved assumptions.

The assumption, in this case, is the belief that a good deal of the pain of the Great Depression could have been avoided by policies enacted after the Crash of '29.

This was Milton Freidman's assumption and, judging by Mr. Bernanke's academic work and recent speeches, his as well. Depressions, they think, can be "cured".  Most people have not studied the Great Depression but in many cases seem more than willing to whistle past the the idea of a Depression- uneasily perhaps, but unwilling to change course while, knowingly or not, willing to put their faith in conclusions similar to those in the opening paragraph.

Conclusions drawn from a study of any historic event will necessarily be colored by prejudice. Open minded people, without an axe to grind, might quickly lose those prejudices that seem inconsistent with the facts and theoretical bent, if any, while the less open minded, for whatever reason, will come away with their main prejudices confirmed.

Perhaps because I've studied the Depression without hopes of being an economist with a future at the Fed or of writing any policy-effecting book on the topic (I'm lucky to get 1000 page views on this site) but rather as a husband and father who merely wishes to muddle through without calamity, my read of that (and the preceding) period in US history is that there is no "cure". Perhaps in the event that Plato's Philosopher-Kings ran the world, Depressions might be avoided- although this would involve a system of political economy very different from ours- but never cured.

The reasoning behind this view is as follows. Depressions, in contrast to the more common financial or inventory overheated recessions, are caused by many years of what Austrian Economists call mal-investment- investment, and by consequence, education and employment patterns predicated on a view of the future radically inconsistent with the economic conditions that actually unfold.

Depressions are not, in my view, caused by the financial crises that tend to precede them.  Rather the financial crisis is the moment when the mal-investment is first revealed to the unsuspecting, usually without changing too many minds.

In the case of the Great Depression of the 30s, the view upon which mal-investments were based was that there would always be willing and able consumers to buy whatever the US manufacturing machine was capable of producing at a profit to their costs. In the event, US manufacturers discovered they had grossly over-estimated the willingness and ability of the world's consumers to buy their goods. Had the emergence of World War II not provided insatiable consumers, and provided a crisis-induced mental reboot of the population, if you will, I suspect the 40s would have been far grimmer in economic terms than it proved to be.

In our current situation, the mal-investment is, in a sense, reversed. Instead of believing that consumers are infinitely willing and capable of buying their goods, the US believes that suppliers are infinitely willing to accept US$s in exchange for goods, regardless of US official policy towards their currency. Instead of people trained to work in factories, and an infrastructure geared to manufacturing, people are trained to work in Dilbert style cubicles, and our infrastructure is geared for an endless supply of cheap oil.

In both cases, strong lobbies resist change. Manufacturers had their thumb on government for much of the 20th Century, only to find their position usurped by Finance, which it still retains. Long standing beliefs as to the virtues of such influence will be slow to change, as will the beliefs of many people who, in my view, are educating and training themselves for a world that won't manifest.

World War II, as earlier noted, provided a crisis that engendered a period when one could look at the world with fresh eyes. In the US families of farmers and laborers were able to dream of sending their children to college to become engineers, scientists, doctors and lawyers, or even to do this themselves.

I don't yet see such a catalysts for a mental reboot in the present period, although perhaps a US$ currency crisis might prove sufficient (and hopefully a war won't be necessary).

The thrust of my view is, to the extent I've correctly identified some of the causes of the Depression, the required mental changes in a good deal of the population, not to mention the manifestations thereof in education, training and investment will take years to unfold. If the US will no longer be able to set the terms of trade more or less unilaterally, we have a long way yet before our economy is ready to compete.  At a minimum the US population must accept that they will have to produce much more to enjoy the same standard of living, or deal with less.

In 2007, Fed Chairman Bernanke argued: Economic growth and prosperity are created primarily by what economists call "real" factors--the productivity of the workforce, the quantity and quality of the capital stock, the availability of land and natural resources, the state of technical knowledge, and the creativity and skills of entrepreneurs and managers. He then went on to highlight the crucial supporting role that financial factors play in the economy. I think he continues to place too much emphasis on the latter and not enough on the former in his views and the policies which emerge therefrom (on second thought he hasn't done a great job in getting finance to help the real sector either- leveraged bets on bond market capital appreciation doesn't seem like a cure for anything).

He, and many others may think they can whistle past a Depression as easily as they whistle past a graveyard, but in the case of a Depression, the Bogeyman is real.

Monday, November 02, 2009

Roubini Forgets the Riskiest Asset of All (the US$)

Since March there has been a massive rally in all sorts of risky assets – equities, oil, energy and commodity prices – a narrowing of high-yield and high-grade credit spreads, and an even bigger rally in emerging market asset classes (their stocks, bonds and currencies). At the same time, the dollar has weakened sharply , while government bond yields have gently increased but stayed low and stableNouriel Roubini

Mr. Roubini, whose views I usually find most enlightening, was one of the few prominent economists who forecast the financial crisis of 2008.  Recently, however, perhaps due to a 2005 forecast of an unraveling of Bretton Woods II and sharp decline in the US$ that didn't pan out (at least so far), Mr. Roubini, judging by the above argument, assumes that the US$ is "here to stay" at least in the medium term. 

I disagree (and think he and Mr. Setser should have stuck to their earlier views- sometimes such things take time).

In A Brief History of Time, Stephen Hawking relates the story below which is quite germane to a discussion of Mr. Roubini's view.
A well-known scientist (some say it was Bertrand Russell) once gave a public lecture on astronomy. He described how the earth orbits around the sun and how the sun, in turn, orbits around the center of a vast collection of stars called our galaxy. At the end of the lecture, a little old lady at the back of the room got up and said: "What you have told us is rubbish. The world is really a flat plate supported on the back of a giant tortoise." The scientist gave a superior smile before replying, "What is the tortoise standing on?" "You're very clever, young man, very clever", said the old lady. "But it's turtles all the way down!"

The question, on what belief(s) does your argument rest, gained increased importance ever since David Hume pulled the rug out from under those who assumed any "real-world" arguments were validly based on pure reason. Hume's argument, never refuted, at least to my knowledge, is that "always being followed by" is not the same as caused by. We might infer such, and certainly act on the view that what has happened in the past will happen again, but as we didn't make the rules of the universe, we don't really know. At best we can believe.

On what turtle does Mr. Roubini's view rest? It rests on the view that the US$ has intrinsic value. As he argues: First, the dollar cannot fall to zero and at some point it will stabilise; when that happens the cost of borrowing in dollars will suddenly become zero, rather than highly negative, and the riskiness of a reversal of dollar movements would induce many to cover their shorts.

I ask, why can't the value of the US$ fall to zero? From the long view of History, the odds of a currency of virtually no intrinsic value declining to that value is high, which might explain Voltaire's quote on paper money.

Perhaps, however, Mr. Roubini was speaking of the medium term, and using the value of the Japanese Yen as a "turtle" to support his argument. Alas, the US is not Japan. Despite their fiscal woes, Japan runs a current account surplus- last month's surplus came in at $13B. The world is not awash in Yen, on the contrary, Japan is awash in US$s, as are quite a few other nations- China comes to mind.

When the Yen was the carry trade vehicle of choice, the risk, which manifested from time to time, was of a sharp rally due to the lack of Yen in international markets. If Japan ran a current account deficit this risk would be much diminished. I suspect if Japan was running a C/A deficit when it opted for a zero-interest-rate-policy (ZIRP) the Yen would have quickly lost a good deal of its value.

The US has both a C/A deficit and a ZIRP. While I agree with Mr. Roubini that the US ZIRP is inspiring the mother of all carry trades, which can inspire sharp corrections, that risk is, in my view, more than offset by the mother of all long positions in the riskiest "asset" of all, the US$. The ZIRP makes holding US$s a losing proposition, as Mr. Roubini notes.

The turtle on which Mr. Roubini's view stands is the notion that the US$ is an asset, when, in my view, it is a liability. By statute there is no fixed exchange rate between the US$ and anything other than US$ debts.  Each time an adjustment arises such that there is a shortage of US$s, the Fed rides in to "add liquidity" because they are more interested in keeping the big banks afloat than the currency. Until that changes, the mother of all carry trades will, despite the odd setback, continue to grow.

Wednesday, October 28, 2009

Reflections on Soros' Reflexivity

I can state the core idea in two relatively simple propositions. One is that in situations that have thinking participants, the participants’ view of the world is always partial and distorted. That is the principle of fallibility. The other is that these distorted views can influence the situation to which they relate because false views lead to inappropriate actions. That is the principle of reflexivity. George Soros

The FT has most kindly provided excellent coverage of George Soros' recent CEU lectures on reflexivity and its relation to economics and finance. Both transcripts and video are available.

While reading his lectures I often found myself nodding in agreement. The man draws from an extremely eventful life with a gifted mind. If you opted to stop reading this blog now and "clicked" over to The Soros Lectures (instead of finishing my two cents worth now) you would only miss a small critique on his conclusions- a critique, however, which may have substantial ramifications.

For all his financial success, Mr. Soros strikes me as a man whose true calling was teaching. He has been pushing "his" Theory of Reflexivity for decades and remains somewhat baffled that it hasn't caught on. He suspects that the Financial Crisis of 2008 might be sufficiently negative feedback to inspire a broader examination of his theories in schools and use of his views in the formulation of public policy.

If I had a chance to offer Mr. Soros one sentence that might help him stop banging his head against the wall, it would be this: The safest general characterization of the European philosophical tradition is that it consists of a series of footnotes to Plato- Alfred North Whitehead.

2400 years ago in a culture that had reached a pinnacle of success in its area of the globe, but had suffered some defeats Plato watched the Athenian Democracy put his teacher, Socrates, to death. He spent the rest of his life exploring human thought individually and collectively in light of Socrates teachings and death as well as those successes and defeats.

He too drew on an extremely eventful life with a gifted mind and left his teachings for any who wished to read (albeit subject to the availability of books, which was a large issue, up until Guttenberg). Judging from his analogy of the cave, I don't think Plato would be surprised that few now "see" the value in his work. Nor, I suspect, would he be surprised by Soros' views, although he might find the term "reflexivity" (the quantum mechanical word is "entanglement") interesting as he wrote of the effects of the observer on the observed, and vice versa.

In other words, as Whitehead noted, the observer-observed problem has been an issue for thousands of years. Soros' views on reflexivity aren't new, but rather, as William James called his Philosophy of Pragmatism, a new name for old ways of thinking. This isn't in any way to diminish their importance. Many of the most important lessons in life are timeless. I'll bet there are quite a few speculators who wished they took to heart the Biblical teaching about 7 fat years and 7 leans years- an oldie but a goody.

What does strike me as somewhat new in reflexivity is the increased number of people observing the action, and acting on their observations, thus creating that which will then be observed- economic and financial self-awareness is on the rise. One additional effect of increasing wealth, not studied by the Greenspan Fed, is an increase in economic and financial reflexivity which reminds me Keynes ruminations on the topic, recently well described by John Cassidy at the New Yorker: He [Keynes] compared investing to newspaper competitions in which “the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view.” If you want to win such a contest, you’d better try to select the outcome on which others will converge, whatever your personal opinion might be. “It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest,” Keynes explained. “We have reached the third degree, where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.

It's quite a tangle, as Soros found himself: Reflexive feedback loops have not been rigorously analyzed and when I originally encountered them and tried to analyze them, I ran into various complications. The feedback loop is supposed to be a two-way connection between the participant’s views and the actual course of events. But what about a two-way connection between the participants’ views? And what about a solitary individual asking himself who he is and what he stands for and changing his behavior as a result of his reflections? In trying to resolve these difficulties I got so lost among the categories I created that one morning I couldn’t understand what I had written the night before.

The harder you try to get concrete answers based solely on these reflexive feedback loops the more complex the issue becomes- a Mobius strip with no beginning and no end..........

In the short run, the market is a voting machine but in the long run, it is a weighing machine. - Ben Graham

This brings me to an Alexandrian moment before the Gordian Knot. Let's cut the complexity. If one is an investor, which I define as one who acts on the long view, the more Benjamin Graham's weighing machine comes into play. Reflexivity is more a function of action on the short view when Graham's voting machine is in play.

In my view, public policy should not make use of Soros' ideas, which are most suited for his Hedge Fund work, but rather should focus on the long view. That short run fluctuations threaten the system is to me more a sign that leveraged speculation has run amok. There's too much voting, which increasingly drives finance into the political TV talking heads frame of mind-which is as endless as that Mobius strip- and not enough weighing, due, in large part, to increased opportunities to leverage, as Soros noted.

One trend whose premise is false is that increased leverage has made the world's financial system more stable. Leverage tends to increase the importance of short term price fluctuations, and gets people increasingly involved in the endless feedback loop.  The amplitude of the boom-bust cycle increases when leverage is increased.  If financial market stability is a goal of public policy, reducing the amount of leverage seems a wise first step.

Sunday, October 25, 2009

Propaganda "Gets" Everyone, Mr. Geithner, even you

I myself was to experience how easily one is taken in by a lying and censored press and radio in a totalitarian state. Though unlike most Germans I had daily access to foreign newspapers, especially those of London, Paris and Zurich, which arrived the day after publication, and though I listened regularly to the BBC and other foreign broadcasts, my job necessitated the spending of many hours a day in combing the German press, checking the German radio, conferring with Nazi officials and going to party meetings. It was surprising and sometimes consternating to find that notwithstanding the opportunities I had to learn the facts and despite one's inherent distrust of what one learned from Nazi sources, a steady diet over the years of falsifications and distortions made a certain impression on one's mind and often misled it. No one who has not lived for years in a totalitarian land can possibly conceive how difficult it is to escape the dread consequences of a regime's calculated and incessant propaganda. Often in a German home or office or sometimes in a casual conversation with a stranger in a restaurant, a beer hall, a cafe, I would meet with the most outlandish assertions from seemingly educated and intelligent persons. It was obvious that they were parroting some piece of nonsense they had heard on the radio or read in the newspapers. Sometimes one was tempted to say as much, but on such occasions one was met with such a stare of incredulity, such a shock of silence, as if one had blasphemed the Almighty, that one realized how useless it was even to try to make contact with a mind which had become warped and for whom the facts of life had become what Hitler and Goebbels, with their cynical disregard for truth, said they wereWilliam Shirer: The Rise and Fall of the Third Reich

In a recent interview US Treasury Secretary displayed- presumably the reason he was chosen for the job- the ability to hew to the party line. I wonder if he has considered the costs associated with that strategy.

As the opening quote attests, even when one might know "the truth," the effect of habitual repetition of propaganda is to accept that which is repeated and echoed publically, even when it conflicts. Goebbels view on the importance of repetition, which has an analog in education, springs to mind.

While in private Mr. Geithner might attest to believing different things, in public he sticks to the script- he repeats it, perhaps often enough that like Mr. Shirer, he comes to believe it.  Mr. Geithner promotes the view that the US$ is the final solution of currencies, and other such nonsense.

To wit, in the interview Mr. Geithner is asked:

Question: World Bank President Robert Zoellick recently said that the U.S. should not take for granted the dollar's preeminence. Would you expect, at some point, that the dollar will not be the world reserve currency?

Geithner: I wouldn't. But I think the dollar's role in the system requires us to do everything possible to keep inflation low and make sure we're getting our fiscal house in order.

This seems to me a silly statement. The question of the length of US$'s preeminent role is one of time. Eventually the US$ will be replaced and those who think otherwise, apparently like Mr. Geithner, exhibit ahistoric beliefs.

Of course, the propaganda continues:

Question: Here we are at Dow 10,000, and JPMorgan (JPM) and Goldman Sachs (GS) are once again reporting great numbers and paying record bonuses. And yet 10% of the country is unemployed. Some people out there are saying: "Did we get snookered again? Have we learned anything?"

Geithner: We're not going to let this financial system go back to where it was, and we're not going to let the practices reemerge that caused this crisis. That's very, very important, and the financial community has a huge interest in a more stable framework with better protections for the industry. The best-run firms were disadvantaged by the worst-run.

The financial system, contra Mr. Geithner's statement, is already back where it was. Financial sector profits aren't flowing from borrowing short and lending long, but leveraged bets on US rates staying low, else they would not be nearly so substantial.

The last sentence in his response was particularly expressive of the propaganda flowing from Big Finance- their errors were a function, not of incompetence, but the spill-over effects of "worse-run" firms. Speculative Capitalism, at least as I understand it, is all about correctly forecasting the financial future. If the supposedly best-run firms didn't bet on the liquidity draining knock-on effects of those duped by financial over-shoot (or worse, got duped themselves) they don't qualify as best-run. Unless you happen to be Mr. Geithner whose goal is, to quote George Bush the Younger, to catapult the propaganda.

The men who truly fix the financial system will not be spouting such nonsense.

Friday, October 23, 2009

It's Not The Size Of The Banks, Comrade Bernanke, It's...

Mr. Bernanke, speaking at a Federal Reserve Bank of Boston meeting Friday on Cape Cod, said [in response to question about "too big to fail"] he would prefer “a more subtle approach without losing the economic benefit of multi-function, international (financial) firms." WSJ

The players are laying their cards on the table at the Big Casino debates over regulation. On one side of the table we have Paul Volcker, and Alan Greenspan, Mervyn King et alios, who think that banks should be broken up (although with some difference between them on how that might be done). On the other side of the table we have current Fed Chairman (who obviously knows whom he speaks for ) Ben Bernanke who thinks that Bigger is still Better when it comes to banking.

To wit, in that Friday speech, Mr. Bernanke argued: First, recent experience confirms the value of supervision of financial holding companies--especially the largest, most complex, and systemically critical institutions--on a consolidated basis, supplementing the supervision that takes place at the level of the holding company's subsidiaries.

Leaving aside the rather obvious (to anyone but Big Bank CEOs and Ben Bernanke, it seems) point that recent experience only proves that that the value of supervision of financial holding companies was roughly nil, let's examine his argument more fully.

He continues: Second, our supervisory approach should better reflect our mission, as a central bank, to promote financial stability. The extraordinary pressure on financial firms last fall underscored how profoundly interconnected firms and markets are in our complex, global financial system. Thus, any effort to address systemic risks will require a more systemwide, or macroprudential, approach to the supervision of systemically critical firms. More generally, supervisors must go beyond their traditional focus on individual firms and markets to try to identify possible channels of financial contagion and other risks to the system as a whole.

A ha. In other words, Big Banks mean Big Regulations. According to Comrade Bernanke, it's the job of the Fed (or another even Bigger Brother) to to promote financial stability, whatever that might mean.

The thin edge of the wedge has pretty much split the log of Capitalism here. The Fed's job, at least before Humphrey Hawkins slid into obscurity, is to maintain price stability and foster as full an employment situation as is consistent with the first directive. Financial stability, under that head, is only important to the extent it impairs one of those directives.

If "Financial Stability" of Comrade Bernanke refers to the casino-derivative markets never being short of liquidity, that is a fool's dream- Big Finance will keep leveraging until they ex(im)plode. It also strikes me as anti-Capitalist. Bankruptcies, liquidity shortages, defaults and currency crises are part of the game- a self-correcting game if failure is allowed to extract its price.

Paul Volcker's "middle of the road" approach, echoed by Mervyn King, to "financial stability" is to separate the casino (he, being more genteel used, speculative) elements of finance from the utility elements. In other words, instead of "financial stability" we should aim for "commercial stability" and retain the "survival of the fittest" aspect of capitalism in the big stakes arena.

In that way, Comrade Bernanke might even get his way, although I suspect the virtues of economies of scale to which he refers are offset by the vices of complacency that flow from lack of competition. As olive branch perhaps we can separate the commercial banking departments of the Big 5 from the speculative elements and roll them into one or two big firms with some Banking Czar, like Comrade Bernanke, in charge. Not that I'll be banking there, I'm going to stick with my local bank.  Then we can see if the proprietary traders at the big banks are really worth the bucks without risking the commerical financial system in the process.

The problem, to which I alluded in the title, is not the size of the banks. It's Big Finance's use of key commercial banking aspects to shield them from speculative losses that would have sent any other not protected firm into bankruptcy. Even LTCM got wound down.  Trading is supposed to be about managing risk (at least if the intent is to allocate capital wisely), and if you can't go bust, there isn't much of that.

Of course, mine is but a lone opinion from the woods of Upstate NY. I'm eager to see how the battle progresses, assuming the debate doesn't become moot due to another crisis.

Wednesday, October 21, 2009

Will "Executive Pay" be the Lever to Break-Up the Big Banks?

Responding to the growing furor over the paychecks of executives at companies that received billions of dollars in the government’s financial rescue, the Obama administration will order the companies that received the most aid to deeply slash the compensation to their highest paid executives, an official involved in the decision said on Wednesday. CNBC

How, if one was a member of the Obama administration, would you go about breaking up the Big Banks? Would you try a frontal assault, or, would you first try to scare the top opposing generals to desert?

The Big Guns at the top US financial firms have been fighting to keep their operations as free from regulation as possible, perhaps because they fear such regulation would hurt profits and, by extension, and far more importantly, I suspect, their pay. I don't doubt that increasing capital requirements and limiting the speculative activities of Big Finance would hurt profits.

Yet, thus far at least, the political will to take on Big Finance directly has only come from across the pond- from BoE Governor Mervyn King.

Perhaps the Obama team is using a flanking maneuver. While public support for a break-up of the Big Banks is not strong, support for restrictions on pay for top earners in firms that received public funds is quite strong. It's a much easier sell.

If the Big Guns in Big Finance wouldn't be able to take home their ever increasing slice of the pie, why would they stay and fight against regulation? If executive compensation is capped they would, assuming they are as competent as they assert, be far better of joining some hedge fund which won't fall under those compensation restrictions.

If this is the lever the Obama team aims to use, it would be a clever political move. Yet, I fear for the precedent. I'm not in favor of the state having such a say in the internal operations of a private sector firm (admittedly, I'm not in favor of private sector firms getting the kind of bail-outs Big Finance received either). Perhaps this is one of those times when a greater good will be accomplished by somewhat unsavory means. If so, I suspect we will pay a price for this down the road.

Big Finance as Napoleon: Heading to its Waterloo

I cannot accept your canon that we are to judge Pope and King unlike other men, with a favourable presumption that they did no wrong. If there is any presumption it is the other way against holders of power, increasing as the power increases. Historic responsibility has to make up for the want of legal responsibility. Power tends to corrupt and absolute power corrupts absolutely. Great men are almost always bad men, even when they exercise influence and not authority: still more when you superadd the tendency or the certainty of corruption by authority. There is no worse heresy than that the office sanctifies the holder of it. Letter from Lord Acton to Bishop Creighton

To everything there is a season, and a time for every purpose under heaven, begins Turn, Turn, Turn by the Byrds. Within that perspective men play the parts assigned to them (sometimes poorly and sometimes exceptionally) towards some goal which may not, as Hegel, inter alios, assumed, by easy to divine.

Unifying and increasingly larger civilizations have been created by men like Cyrus, Alexander, Caesar, Mohammed, Charlemagne and Genghis Khan, to name a few. Whether this is for good or ill seems a matter of opinion but that these men played a large role in history is certain.

In more modern times, men like Washington and Napoleon played similar roles. The former managed to resist the temptations of power to which most men succumb, and thus helped create these United States. The latter could not resist temptation. He overplayed the given part, and ended his life in captivity.

From that perspective of purposeful history, Washington and Napoleon were asked, in a sense, to lead the effort to sweep away the Monarchical system which had run Western Civilization for centuries. Washington, perhaps due to his lack of skill as General compared to Napoleon, played his part well. His letters suggest an awareness of the role of Providence on his side and a sense that he was simply playing a role.

Napoleon, by contrast, called himself a liberator, and did free, for a time, Continental Europe from the old system and, I believe, helped plant the seed of liberation which eventually killed it. However, he, like most men who rise to positions of great power, succumbed to the temptation described by Lord Acton. He did not see that, as the Chinese might put it, the Mandate of Heaven was limited.

Big Finance, in a sense, played an important role in history as well. If you believe, as I do, that Capitalism, as classically understood, is a much better method of providing for man's material needs as compared to "rule from the top", whether by King or Committee, you might agree with the support Big Finance received from the late 70s through the end of the 20th Century. In this sense I agree, in part, with the views of Fukuyama's End of History. While I doubt the US model is an end, it seems a much better way station than the alternatives.

If the stock market crash of 1987 inspired a Mellon-esque liquidation would the Soviet Union have given way to the Russia we know today? If the Asian Crisis left those nations with the sense that their turn towards Western Capitalism was a mistake would China have continued its drive towards economic integration with the rest of the world?

Just as I can understand those who supported Napoleon early in his career, I can understand why many supported Big Finance when, from a purely economic standpoint, restraint seemed a wiser choice.

Napoleon, as we know, turned his back on the principles of the Revolution which gave him power and declared himself Emperor. Big Finance, in my view, turned its back on a key principle of Capitalism- a measure and procedure for failure- when they pushed the Financial Modernization Act of 1999 into law and used commercial deposits as assets to lever for speculation.

Since that time, Big Finance has successfully fought attempts to restrain its power. Like Napoleon in Russia, Big Finance suffered a terrible defeat in the arena of mortgage finance and credit default swaps. Also like Napoleon, Big Finance was not chastened by defeat, but rather emboldened. Like Napoleon, Big Finance pays no heed to old supporters' warnings. While Alan Greenspan doesn't strike me as a gifted economist, he has a proven knack for divining changing political winds. When he argues that banks which are too big to fail are too big, he seems to me to be sending a message that the political support Big Finance has long received is waning.

Big Finance, as I have been arguing, has as its greatest weapon the exorbitant privilege of unlimited US$ finance and presumed support of key politicians. They have bet heavily that this will continue.

Just today I find that Big Finance might have found its opponent- the counterpart to Napoleon's Wellington- in the person of the BoE's Mervyn King. Mr. King's declaration that Big Banks should be broken up sets the stage for Battle.

These words, from a recent speech by Mr. King are "fighting words": Whichever approach to the “too important to fail” problem is adopted, there is growing agreement that such financial institutions should, as I argued at the Mansion House in June, be made to plan for their own orderly wind down – to write their own will.

In support of this view he argues: To paraphrase a great wartime leader, never in the field of financial endeavour has so much money been owed by so few to so many. And, one might add, so far with little real reform.

It is hard to see how the existence of institutions that are “too important to fail” is consistent with their being in the private sector. Encouraging banks to take risks that result in large dividend and remuneration payouts when things go well, and losses for taxpayers when they don’t, distorts the allocation of resources and management of risk. That is what economists mean by “moral hazard”. The massive support extended to the banking sector around the world, while necessary to avert economic disaster, has created possibly the biggest moral hazard in history. The “too important to fail” problem is too important to ignore.......
In other industries we separate those functions that are utility in nature – and are regulated – from those that can safely be left to the discipline of the market. The second approach adapts those insights to the regulation of banking. At one end of the spectrum is the proposal for “narrow banks”, recently revived by John Kay, which would separate totally the provision of payments services from the creation of risky assets. In that way deposits are guaranteed. At the other is the proposal in the G30 report by Paul Volcker, former Chairman of the Federal Reserve, to separate proprietary trading from retail banking. The common element is the aim of restricting government guarantees to utility banking.

I wonder what carnage the upcoming battle will leave in its wake?  If Big Finance is broken up, will alternative investments like Gold become even more attractive?

Full Disclosure: Long Gold

Monday, October 19, 2009

Retiring to a Banana Republic, without leaving home

The figures, [NH Senator Judd] Gregg told [CNN's John] King, “mean we’re basically on the path to a banana-republic-type of financial situation in this country. And you just can’t do that. You can’t keep running these [federal] programs out [into the future] and not paying for them. And you can’t keep throwing debt on top of debt.” CNN

Retiring to a tropical paradise is a very common aspiration. Who knew all Americans of all income levels would get a chance to do so- if one considers a Banana Republic a tropical paradise.

What does Senator Gregg mean by the phrase "banana republic"? He is referring to the stereotype of a tropical country that borrows so much money it eventually finds its interest expense exceeds its receipts. Once that point is reached, no amount of primary (non-interest) budget restraint can fix the problem and default becomes the only option.

So long, however, as the US$, as currently defined, remains the world's reserve currency of choice the US cannot default in the classical sense. As Alan Greenspan noted a few years ago, We can guarantee cash benefits as far out and at whatever size you like, but we cannot guarantee their purchasing power.

Of course, the world has increasingly been looking to shift away from the US$ as world's reserve currency- the exorbitant privilege, to which Greenspan refers, is being revoked- thus the US may indeed risk a classical default.

That day, however, has not yet arrived, but it seems to be rapidly approaching. According to the FY2009 report, Federal Interest expenses came to $383B (admittedly higher than any annual deficit prior to 2004) which compares to receipts of $2,105B. On the surface, it seems the US has a lot of wriggle room.

Underneath the surface, however, the wriggle room is rapidly shrinking.

1) The interest charges on the rapidly growing stock of debt are at historically low levels. In the event the US$ needed to be supported by a substantial increase in interest rates (the, thus far, only sure fire method of putting a floor under a currency), particularly given the short duration of the debt stock, it wouldn't be long before interest charges alone exceeded the $1,000B level, assuming no increase in the debt.

2) The debt, however, is not projected to remain stable. Rather, it is projected (by some) to rise by $1,000B per year for the next 10 years. Given the current stock of Federal Public Debt of $7,530B, a $10,000B increase at 12.5% interest would lead to interest charges in excess of last year's receipts. Admittedly, receipts might rise as well over the decade, but we might also find that the 12.5% interest might be too low. Alternatively, especially if economic policy retains its multi-decade "trickle-down" approach of financial system support to pull the real economy behind, receipts might continue their current decline (FY2009 receipts were $400B less than those of FY2007). The higher unemployment becomes, the higher the deficit will be, particularly given the aging demographics of the US population.  Gotta love multi-variable analysis.

Of course, long before the classic banana republic type default point is reached, cleverer people than I would have run their spreadsheets (as I have) and stopped buying new debt (unless the price was right, a much higher interest rate). Budget constraints, thanks to the large and growing stock of external debt, would be imposed from without and the painful choices, long pushed into the future would need to be addressed.

The question is one of wriggle room. Currently, low interest charges create the illusion that the US can continue to run trillion $ deficits for years. Yet, the US$, as I argued in yesterday's The Fed vs. Gold, is no longer nearly as good as gold. In the not too distant future the Fed will need to defend the value of the $. This rise in interest rates will, other things equal, further hinder the real sector, and, far more ominously, as I argued in From Black-Scholes to Black Holes, push the big banks closer to insolvency.

The time is soon approaching for the government to prioritize its goals. It seems clear to me that the US cannot wage wars, honor its commitments to its population, and support the speculative elements in its financial system from default, all at the same time. Choices need to be made or Senator Gregg will be correct.

Full Disclosure: Long Gold and Silver

Sunday, October 18, 2009

The Fed vs. Gold

In August, 1971, the US began a unique experiment in modern finance- with, I must add, after a very bumpy start, astonishing success, until recently. This was an experiment in "fiat money." The trick was to make the US$, without any fixed exchange rate to Gold, a store of value that wouldn't drive people back into the yellow metal.

I've put together a few graphs, the first of which depicts the relative value of an investment in Gold and in Fed Funds (I also ran a few simulations with Bonds and found that the 10 year has an even better relative return, thanks to the timely reset in 1981, although even there Gold is beginning to outperform) assuming that the Gold was purchased when Nixon closed the Gold window and held for the duration of the simulation while the coincident Fed Funds investment was reinvested daily (I used average monthly rates, which should be close enough).

As you can see, despite the very bumpy start, US$s invested in Fed Funds became as "good as (the) Gold" purchased at the beginning of the experiment by 1998 or so.

The second graph examines the Volcker Fed era, with a much higher starting Gold price.

His policy of very high rates early and stubborn (according to Greider's Secret's of the Temple) refusal to ease, made the US$s earning Fed Funds a better investment than Gold.

The third graph examines the Greenspan era.

Surprisingly, to me at least, the Greenspan era also was a better time to own US$s earning Fed Funds than Gold (although how this was done is a matter of some debate (see GATA)). Certainly by 2000, Gold once again began to shine as the relative return this century is 2.16.

The final graph examines the Bernanke Fed era.

Under Chairman Bernanke, Gold has been a much better investment than US$s, invested anywhere in the curve. While the relative performance during his Chairmanship is not yet as poor as that under Arthur Burns, Nixon's man at the Fed, with US yields so low he just might catch up (or down as the case may be).

Ultimately, as Ben Graham taught; in the short run, the market is like a voting machine--tallying up which securities are popular and unpopular. But in the long run, the market is like a weighing machine.

Since 2000, the scale is tipping, increasingly, towards Gold.

Thursday, October 15, 2009

It's a Bad Time for Bad Money

What a bunch of wussies the current generation of uber-Capitalists have become. In search of capital to bet they bought the assets of commercial banking, in effect turning those deposits into a "trust" of yesteryear. Then, with a copy of Atlas Shrugged on their bookshelves they run to the government for a bail-out when their investments don't pan out, hiding behind the recently purchased, socially vital commercial banking departments they wouldn't have deigned to join when job hunting.

Come January in upstate NY, when the snow flies and temperatures drop below 0F, it's a bad time to drive without a shovel. Likewise, when the financial system of an economy misprices assets and liabilities, it's a bad time for bad money.

To the extent one believes, as I do, that men, from time to time, as Charles Mackay wrote, think and go mad in herds, especially with regard to money, it seems a wise idea to have some sort of monetary standard to attenuate the degree of inevitable error. The more out of whack the mispricing the more difficult the path of recovery will prove to be, and the more likely will the anti-money crowd find open ears. A few more years like the last one here in the US and the Marxists will start coming out of the woodwork. The greater the disconnect between the real and financial sectors of the economy, the louder will the anti-money/anti-finance crowd scream- with even those usually in favor of Capitalism crying foul.

To wit; Naked Capitalism recently ran a piece entitled, Does Banking Contribute to the Good of Society, which opens with:

Quelle horreur, some smart people are starting to question whether banking serves a redeeming social function.

Of course, in the abstract, it does. Banking (or more accurately, extending credit) is essential for commerce. But any essential support function, if it overpriced in relationship to its true value, becomes a drag on the productive economy. And our modern system is extracting a very large toll relative to its actual worth.

That article was sourced from one similarly titled in UK's Telegraph. It argues:

The whole of economic life is a mixture of creative and distributive activities. Some of what we "earn" derives from what is created out of nothing and adds to the total available for all to enjoy; but some of it merely takes what would otherwise be available to others and therefore comes at their expense.......

Much of what goes on in financial markets belongs right at the purely distributive end. The gains to one party reflect the losses to another, and the vast fees and charges racked up in the process end up being paid by Joe Public, since even if he is not directly involved in the deals, he is indirectly through the costs and charges that he pays for goods and services.

Even what the great investors do belongs at the distributive end of the spectrum.

On the same theme I found How the Servant Became a Predator: Finance’s Five Fatal Flaws, which begins:

The financial sector is a tool to help those that make real tools, not an end in itself. But five fatal flaws in the financial sector’s current structure have created a monster that drains the real economy, promotes fraud and corruption, threatens democracy, and causes recurrent, intensifying crises.

While I agree, in part, with many of the underlying views behind the articles, and, from time to time, have used radical rhetoric myself, it's during crisis phases that proper articulation is key. Radical anarchic/revolutionary rhetoric in the late 19th Century inflamed populations sufficiently to inspire a rash of assassinations, including William McKinley here in the US. I've personally witnessed successful and attempted revolutions in Indonesia and Jamaica respectively, and they're no picnic.  During crisis phases, the risk of throwing the baby out with the bathwater rises sharply.

Back to the articles. Finance doesn't have a socially redeeming function in the abstract, it puts savings to real use, when well functioning the investments provide wonderful benefits for many. That there are more people living on the planet than, according to my understanding of history and anthropology, at any other time, speaks to these benefits.

Finance, in my view, is not necessarily a "distributive" activity. George Westinghouse's investment in Tesla's alternating current generation powers the computer on which you read this essay, and the pump that brings water in to your house, and allows sewage removal- a key point now that winter sets in as outhouses are quite cold places.

Yet, these financial polemics have a point. Big Finance, currently, is a large drag on the public sector, and by extension, the public, due to, I believe, a conflation.

Sadly, it was the titans of finance who fomented the current confusion over the virtues of finance when restrictions separating investment from commercial banking were dropped. As I recently argued, echoing Paul Volcker: Instead of designating certain financial institutions as "too big to fail" the US, he [Volcker] argued, needs to separate the aspects of finance which are too important to fail- broadly, commercial banking functions- from the more speculative practices- hedge and private equity funds and, more generally, proprietary trading. finance (intentional small "f"), i.e. commercial banking is key. Finance, i.e. investment banking, has its benefits as well, but only, I believe, when it is willing to accept the rules of Capitalism full bore- survival of the fittest.

What a bunch of wussies the current generation of uber-Capitalists have become. In search of capital to bet they bought the assets of commercial banking, in effect turning those deposits into a "trust" of yesteryear. Then, with a copy of Atlas Shrugged on their bookshelves they run to the government for a bail-out when their investments don't pan out, hiding behind the recently purchased, socially vital commercial banking departments they wouldn't have deigned to join when job hunting.

I wonder if the currently in production sequel to Wall Street will have Gordon Gekko almost losing it all in derivatives and then getting bailed out by the Feds to retire in comfort.

But where, you might be wondering, do the monetary standards you noted come into play?

Thanks for the reboot, I sometimes go off on a rant.

I opened with the idea that monetary standards act sometimes as a policy tool itself but minimally as a measuring tool of sorts. If a specie standard is chosen the drain (or excessive gain) thereof sends a sign that policy needs to change. If some monetarist standard is chosen there will be limits on the amount of liquidity prudently considered available to "buy time." There are other standards one can use but all act as a limiting factor- an anchor to some sense of reality, or measure of the divergence between the real and imaginary.

French Philosopher Baudrillard (about whose views I've opined here) reflected on the NYC Billboard depicting the growth of the public debt: The disappearance of the referential universe is a brand new phenomenon. When one looks at the billboard on Broadway, with its flying figures, one has the impression that the debt takes off to reach the stratosphere.

In other words, by bad money I mean unreal money, anchorless money. There is, apparently, no accepted measure by which one might judge a currency as failed- Baudrillard's hyperreallity. In plain language our money has been so bad for so long many assume it to be normal.

Consider. The British Pound was the currency of choice for a good portion of international trade in the latter half of the 19th and early 20th Centuries. It cost a bit more than 4 Pounds to buy an ounce of Gold. Over time it lost its utility as both a medium of international trade and standard of value from WWI through the eventual loss of most of its colonies in the 60s. During this time the value of the Pound declined from that 4+ Pounds per oz. of Gold to 14.5 Pounds per oz.- roughly 72 pence off each pound.

Few in the 40s, 50s, and 60s would have argued that such a devaluation was not a disaster. The US$ has lost a similar amount vs. Gold in the past nine years and yet there is heated debate to the effect that the demise of the US$ is exaggerated.

Some, like the FT's Martin Wolf, in rather stark contrast to his usual astute views, argues that Gold's price is a dubious indicator of inflation risks: its previous peak [just north of $800] was in January 1980, just before inflation was crushed.

This argument strikes me as silly. Yes, Gold did fall from $800, settling during the almost 2 decades of relatively stable commodity prices from 1980 to 1999 at $350. But that $350 was a 10-fold increase from the Gold Standard rate of $35. In my view, Gold was a wonderful inflation barometer during the 70s, and, barring the overshoot inspired by the Iranian Revolution and Russian invasion of Afghanistan, inter alia, remained a good barometer during the 2 decades of price stability- and obviously since (or perhaps not so obviously).

If you prefer a monetarist perspective; the Greenspan Fed's decision, followed more vigorously by Bernanke's Fed, to allow the monetary base to expand by leaps and bounds every time investment banking got in trouble seems ominous, the warning signs are clear.

Pick a standard and the message is the same, the US$ as international medium of exchange and on the margin choice of international store of value, is not just dying, it is dead. But as John McCain once quipped about Greenspan, the authorities are simply doing a Weekend at Bernie's- propping up the corpse of the US$ and declaring everything fine.

If we had some monetary standard I believe the monetary authorities would long ago have decided that investment banking needs to be cut loose to sink or swim on its merits, which are not small, if the manager is competent (I don't see George Soros begging for hand-outs) instead of dragging the US medium of exchange into the toilet and risking social discord on a scale not seen in many decades.  Instead the disconnect between the real and financial economies will simply be allowed to widen further.

Imagine how angry the common man will be if the DJIA hits 15K with gas at $5 and unemployment at 20% (as so accurately measured by the BLS).  It seems to me time to choose between letting the big investment banks go bust or (if you happen to have some assets left) living in walled off communities, hoping a revolutionary spark won't ignite.  I wonder if some have forgotten that there are other reasons besides gaining wealth that economists began tracking economic growth, income equality and other such statistics- societies are not inherently stable, reason and wisdom do not always prevail. 

Do you know where the tipping point is?   

Russia and China are just now recovering from a few decades of the effects of throwing the baby out with the bathwater.  These things happen.

Yes, it's a bad time to have bad money.

Full Disclosure: I'm long Gold and Silver

Tuesday, October 13, 2009

Will Goldman Sachs "Do It Again"?

The key to the game is your capital reserves, If you haven't got enough, you can't piss in the tall weeds with the big dogs. Gordon Gekko

Sidney Weinberg must be rolling in his grave at the news that Goldman Sachs, according to press reports, intends to pay its employees bonuses totaling some $23B. Mr. Weinberg, if you're unfamiliar with the name, was the man who brought Goldman Sachs back from the brink of disaster after the Crash of '29. One key aspect of his management approach was capital retention. Like the mythical Mr. Gekko, Mr. Weinberg knew the key to the game.

Admittedly, the game has changed. The former partnership went public in 1999 and become a bank holding company last year. I wonder how many owners (direct or indirect) of GS are aware that their holdings help finance these big payouts. The shift to bank holding company and consequent access to the Fed's discount window also facilitates the shift from Weinberg's capital retention mode to the current capital distribution mode.

These days, Goldman Sachs (GS) is on top of the world. GS men like Mr. Rubin and Mr. Paulson became US Treasury Secretaries, and many others seems to find opportunities in the state effortlessly.

What a recovery for a firm that was almost brought to its knees in 1929.

Last weekend I flew to Chicago and read The Partnership: The Making of Goldman Sachs, which I highly recommend, if you can manage to stomach the all too frequent claims of absolute integrity wrapped around some very dodgy activities (like getting caught forcing Penn Central to buy back its commercial paper while it was selling same to the public right before the railroad went bankrupt in June, 1970).

From the Court Record of the Case of Welch's et. al (who got stuck with the bankrupt paper) vs. GS:

Question: Were you aware that on Feb. 5, 1970, Wilson [a GS partner in the CP division] asked Penn Central to buy back $10M of its commercial paper from the inventory position of Goldman Sachs?

Gus Levy [GS Managing Partner]: It was in the memorandum, so I knew about it.

Question: Was that nonpublic information?

Levy: That was definitely nonpublic information.

Question: Did you instruct disclosure of that fact?

Levy: I did not.

The above, however, is not the "meat" of what I sat down to convey today. By "do it again" I refer to the Goldman Sachs Trading Corporation, about which, Seeking Alpha opines here (GSTC), the disastrous failure of which required 30+ years of diligent effort from Mr. Weinberg et. al. to repair.

In the latter half of the 19th Century, Goldman, Sachs & Co. was a mercantile (commercial) paper finance company started by Marcus Goldman. His son, Henry, expanded into investment banking before siding with Germany in WWI which led to his resignation. He eventually relocated to Germany and ran into Hitler in the 1930s (in case you thought their senior partners never made bad calls- what a horror that must have been).

Henry Goldman was replaced, in a sense, by Waddill Catchings, who promised The Road to Plenty in 1928 with William Foster. Despite early trepidation about the bull market of the 1920s he "caught the bug" and decided to launch GSTC. The book relates a quote on this decision from Walter Sachs which may prove quite ironic (again) in a few years time, "All would have been well had the firm confined its activities to the type of business which had been done over the years."

Launched in 1928, GSTC jumped out of the gate rising from its IPO price of $104 to $226 quickly and an eventual high of $326. Although already owning 10%of the shares, and contracted to receive 20% of the trust's net income as manager, GSTC bought another $57M of its shares in the first few months. In a few short years GSTC would trade down to $1.75.

What sin did GSTC commit, and Walter Sachs notice? GSTC (and via the ownership thereof, GS) stopped being an intermediary and took a position. The "boring" choice of simply being a financial intermediary was not enough for GS in the final stages of the 1920s US equity bull, and, it seems to me, the equally "boring" choice of being simply a financial intermediary in the final stages of the US's bull market has been eschewed by current GS management.

There's an interesting anecdote from the book which highlights this choice:
[Fischer, of Black and Scholes fame, then an employee of GS] Black was quantitative to a fault. The rigor of his logic and his infallibility to be anything but entirely logical led him to state some positions that were so perfectly rational that they were really very irrational. For example, one day he stopped everyone's clock with his conclusion that Goldman Sachs should go short- ten million dollars worth short- in financial futures. "If we are intellectually honest with ourselves, we will go short futures by enough to fully hedge our exposures to the cash markets, instead of always being net long. That way, we will be operating the firm with zero net exposure to market risk."


 "For Fischer," [recalls Silfen] "it was completely rational." But that was the theory, and the pragmatists of Goldman Sachs-with less than one billion dollars in total capital- simply couldn't imagine establishing a "simple" short position that was ten times as large as the firm's total capital. For them, Black's idea might be academically valid, but it was so totally irrational that it was insane.

In the years since Mr. Black made his suggestion, GS' capital leverage has only grown. Long ago they decided to not simply be intermediaries, but to be players. You can't make big profits, as Mr. Catchings likely advised in the late 1920s, without exposure.

This time it isn't just stocks which seem to drive profits. GS, in particular relative to other BHCs, seems to make money when US liquidity is rising and US yields are falling- as I noted in From Black Scholes to Black Holes.  This is a bet on a continuation of the "exorbitant privilege"- the ability to force as many US$s down the rest of the world's financial throat as they wish- which one might construe as yet another Road to Plenty.   Someday in the not too distant future, former Nixon Treasury Secretary Connally's quip might prove false- we (and GS) might discover that our currency is, in fact, our problem.

I suspect when the dust settles we'll discover that GS "did it again"- got leveraged in the wrong market at the wrong time. Hopefully, as occurred in the 1970s, the failure of GS won't be seen as tantamount to a failure of the US, because it isn't.  In the 1970s the US courts handed GS a string of defeats related to Penn Central and, to the best of my knowledge, never worried if the company would fail.  Ah, the good old days.

Wednesday, October 07, 2009

Brad DeLong, meet Kevin Phillips (on the stimulus debate)

Very few days pass here in upstate NY without me marveling at the internet. In addition to video-conferencing with the in-laws on the other side of the planet, and publishing my musings to inquiring minds around the world (whether they are inquiring if I've lost my marbles or something more salutatory, I don't know) I can read the lecture notes of Professors around the world (for how much longer will the Ivy covered halls, such as those at my alma mater, Cornell, be able to charge such a high price I won't hazard a guess).

John Taylor, of Taylor Rule fame and Brad Delong are two professors who, to my great delight, publish lecture notes and other insights into their teaching process.

Today, I find a most timely lecture from Mr. DeLong, about the virtues of stimulus. If I was a student in his class I would ask him if he had read Kevin Phillips' American Theocracy, as the economics therein is quite germane to the debate.

As I recently argued in Even Macro-Economics Suffers from Diminishing Returns, assuming that all economies are the same exposes one to potential error. To wit, Mr. Delong uses the BoE's simulative policies during the crisis of 1825 as model to critique the "liquidationist" policies of the Hoover administration in the 30s and argue for more forceful stimulus today.

With the benefit of hindsight, the extremely simulative policies of the BoE in 1825 were wise, not as a general proposition, but because the model of capital stock development was still in the early days of profitability. In early 19th Century Britain, coal was moved either by ship or by horse. Canals were under consideration as a means to reduce transport costs but the 1821 and 1823 passage of Railway Bills allowed the use of locomotive powered rail for goods and passengers. Markets got ahead of themselves, thus the crisis, but the profits were still out there to be generated. Stimulus under those conditions, was, as noted, quite wise and the multiplier effects, spectacular.

Would stimulus applied earlier in the 30s have been successful?  My sense is, perhaps not.  We were an export nation with few credit-worthy consumers.  It has been well said that WWII brought us out of the depression by putting the factories to use.  Blowing up lots of Europe and Asia created lots of new consumers and extending them credit kept the war machine humming in peace time during re-building.  Eisenhower's Interstate Highways extended the growth period...but this is all in the past.

Enter Kevin Phillips. Mr. Phillips compares America of the current day to Britain at the end of the coal era and Holland at the end of the "wind and water" era. In brief, he argues that over time the wildly profitable capital stock of a nation ends up in the hands of a small elite who are reluctant to allow innovation. Britain, in his view, was slow to jump on the oil bandwagon because their elite owned coal centered capital stock. We, he argues, will be slow to adopt newer, more efficient technologies because our elite own an oil centered capital stock.

I tend to agree with Mr. Phillips. Our capital stock is old, yet new technologies challenging the old ways, despite vast amounts of cash earning next to nothing, find it difficult to get off the ground. Stimulus which flows through the old conduits may, if it props up the current elite, do more harm than good. Sadly, stimulus which aims to create a new elite may not be passed.

Repeating my old mantra about stimulus debates, "it's the capital, stupid!"

Oops, Mr. Delong just kicked me out of class.  "Hey, don't tase me, Bro!"

p.s. sad thing is, I often read Mr. Delong's notes for just such capital stock outlines as I offered today on 1825 Britain- a subject about which he no doubt knows far more than I....ah the perils of pre-approving one's own conclusions (something I've done myself not infrequently- Human, all too Human as Mr. Nietzsche might say)

Tuesday, October 06, 2009

Who's Afraid of Naked Short-Selling?

The real significance of the naked short-selling issue isn’t so much the actual volume of the behavior, i.e. the concrete effect it has on the market and on individual companies — and that has been significant, don’t get me wrong — but the fact that the practice is absurdly widespread and takes place right under the noses of the regulators, and really nothing is ever done about it. Matt Taibbi

Naked short selling, or the sale of a security you don't already own, has been an issue of concern for corporations for many years. According to those affected, the practice allows traders to drive a stock price lower than it "should be" if the practice was restricted.

This is, no doubt, true. Beyond the equity markets, this activity has been common practice in the foreign exchange markets for decades, and has inspired similar complaints. Ex-Malaysian PM Mohammed Mahathir heaped scorn on George Soros and other speculators for attacks on Malaysia's Ringgit and other currencies during the Asia crisis. Before that Mr. Soros became infamous as the man who broke the Bank Of England, driving the GBP and ITL out of the European ERM bands.

While I see the point of those affected, and agree that naked short selling run amok could stifle corporate IPOs and young businesses- which might not be a bad thing at certain times- there is a way to avoid a good deal of the damage this type of trading can unleash. Keep your financial house in order.

On the national level, it seems worth noting that Soros didn't try to short the DEM or the CHF, he chose the GBP and ITL for a reason. Those currencies were mispriced within the ERM.

More to the point, due to the guarantee of the ERM (which aimed to keep bilateral exchange rates within a trading band) long before Mr. Soros decided to short the GBP, speculators had bought it at the bottom of its trading rage against the DEM to pocket the interest rate spread between Britain and Germany. Mr. Soros' sales may have upset the balance, but it was the weight of "free money" investors who got, justifiably, spooked and ran for the exits, which crashed the GBP.

In other words, if the price of the security is not too high- say, as a result, in the equity arena, of too much debt and too little profit- short sellers will likely not find your security a profitable sale. Yes, there is a lot of gray here and I don't doubt that currencies or securities that might eventually justify their price could fall prey to naked short-selling. However, a company with a strong balance sheet and highly profitable capital stock might enjoy a round of short selling, to buy back their own stock.

What I found most interesting about Mr. Taibbi's excellent reporting is the increased Congressional interest. As the big banks in the US increasingly realize that they, given their extremely leveraged position, are prime candidates for naked short selling they will be caught in something of a dilemma.  On the one hand, they either engage in the practice themselves (after all what is the bet in a credit default swap) or finance hedge funds who do, while on the other they will (much more slowly I imagine) see themselves as potential victims.  I'm probably only half joking when I suggest that naked short-selling will surely be outlawed when Goldman Sachs, as one of the last banks standing, finds its stock under attack.

Karma can be a b!tch.

Sunday, October 04, 2009

A Welcome and a Clarification

Welcome to the thousands of new readers from Zero-Hedge and Naked Capitalism (thanks for the links). As you might surmise from reading the archives I post in spurts. Sometimes, as has been the case lately, I post daily and then I take a break, recharge and rejoin the fray. I figure I provide good service for the price.

I've already received a few emails suggesting a contradiction in my last post on macro-economists as in, "aren't you taking a macro-economic view that we have too many macro-economists in the kitchen?"

Guilty as charged, the view is macro-economic. My point, however, is that there are, apparently, too few real-sector advisers to the President and it is the real sector that will (or won't) pull us out of the slump. Whether the government should directly finance the real sector is another issue- how would one know which investment to choose? the eternal question of finance, unless we're in the Ponzi phase. Regardless, so long as the flow of funds is directed at the big banks and they direct those funds into, mainly, other financial sector investments, the real sector is crowded out of the flows- an interesting conundrum as I suspect some real sector investments would generate real earnings far higher than the financial sector offers, but finding the good ones would require a bit of work, on the ground, not with a spread sheet.

Economic policy these days reminds me of the old Tech company CMGI- lots of great finance guys, no real experience in the field. I shorted CMGI in 2000, not because I didn't think they brought something to the table but because they were valued far higher than they should have been.

Even Macro-Economics Suffers From Diminishing Returns

Capital, by persons wholly unused to reflect on the subject, is supposed to be synonymous with money. To expose this misapprehension, would be to repeat what has been said in the introductory chapter. Money is no more synonymous with capital than it is with wealth. Money cannot in itself perform any part of the office of capital, since it can afford no assistance to production. To do this, it must be exchanged for other things; and anything, which is susceptible of being exchanged for other things, is capable of contributing to production in the same degree. What capital does for production, is to afford the shelter, protection, tools and materials which the work requires, and to feed and otherwise maintain the labourers during the process. These are the services which present labour requires from past, and from the produce of past, labour. Whatever things are destined for this use—destined to supply productive labour with these various prerequisites—are Capital. J. S. Mill
How many macro-economists does it take to create a profitable venture?


How many profitable ventures does it take to create a prosperous nation?

Quite a few, in a more or less continuous fashion.

I pose the above riddles not to suggest that macro-economists are worthless but to highlight the apparently ever increasing faith the state seems to place in the policies they recommend. Newspapers, TV broadcasts and web sites increasingly debate the need for stimulus and the forms it should take.

Those in favor of stimulus argue about the effectiveness of monetary vs. fiscal policies usually based on the expected multiplier effects (the change in GDP per unit of stimulus).

Some, usually the most dogmatic proponents, argue from the view that multiplier effects are constant across time and economy- they find a period and economy which exhibits a multiplier effect proving their view and rest their case. Their opponents, in response, argue that the chosen period and economy is not representative and then suggest either a "better" model, or mitigating/accentuating factors no longer present which proves their view. All, not without cause (even the physical sciences require this assumption to be meaningful), presume some constancy over time within an economy- which is assumed to only change "on the margin."

Most of the time these assumptions of rough constancy are demonstrated in reality. Sometimes they are not.

Sometimes, even in the physical sciences, durability and constancy of effect are just apparent waiting for the next earthquake, volcano or rainstorm to demonstrate a "fat tail"- that is, behave in a manner not captured in a series of medium term observations.

The fundamentals of an economy are always in flux, most of the time, "on the margin" captures the pace well. Sometimes, changes in trade routes- European discoveries of sea routes around Africa to "the Indies" and the opening of the Suez Canal are two of many such- discoveries of raw materials- crude oil in Pennsylvania, Texas and the Middle East- and technological innovations- Bessemer process and the steam engine locomotive- can lead to very rapid change in both a positive and negative sense.

On the positive side, new routes, resources and technologies lead to improved growth, some of which is "stolen" from those areas which used to supply the old routes, resources or technologies- that is, the negative side.

Often the negative effects are initially masked by increased debt or mispriced assets- the residual self image noted in the film, The Matrix. The capital stock of the nation or area is assumed to be as profitable as it had been in the past, but the underlying conditions that engendered the profitability have shifted. The implicit point being that economic growth is ultimately based not on the efficiency of monetary or fiscal policy but on the profitability of the capital stock.

Sometimes the shifts in underlying conditions that lead to decreases in capital stock profitability are not so stark- rising productivity in other nations, relative declines in key resource production (namely, in the US's case, oil) and a variant of the resource curse that afflicts some oil producing nations, but in the US's case, it's US$s.

For decades the US has clung to a residual self-image as the only economic power-house in the world, aided by the world's willingness to accept US$s in trade for goods. The capital stock of the US was designed for a world in which oil was both cheap and available in the US and has been maintained based on the continued acceptance of US$s- a practice which will eventually end. In my view, we need to retool the stock to reflect these changing conditions.

Our problems, it seems to me, are not solvable by macro-economic stimulus, although the necessary changes can be either helped or hindered by such policies. Far more important for the US is the realization that things need to change. Capital needs to redeployed. The more money spent maintaining a financial super-structure which has obviously misallocated capital, the less money that will be available for this purpose.

Recalling Shakespeare's Caesar, we need to regain that "lean and hungry look." I have faith we can accomplish this task, but only if faith in macro-economics and finance is replaced by faith in engineering and civil design.

To paraphrase Bill Clinton, "it's the capital, stupid!"

Thursday, October 01, 2009

From Black Scholes to Black Holes (part 4- Finance)

Were a modern-day financial Rip Van Winkle to awake today having slumbered for the past 20 years, he would observe a capital market vastly different from the one he knew. Introduction: From Black Scholes to Black Holes

It's been 16 years since the above noted book-a collection of essays explainging how one models the risks associated with certain derivative securities- was published and the introductory statement is more true now than then. In 1992, the notional amount of interest rate derivative exposure in US banks was about 77% of GDP. The graph below shows the growth since.

I begin this 4th look at the US economy from a flow of funds perspective with derivatives to "cut to the chase." This isn't to diminish the still currently intractable problems of mortgage finance, but that topic has been ably covered by many others. Further, as hard as it may be to believe, the problems associated with mortgage finance pale in comparison to those associated with derivatives. Warren Buffett famously called these securities financial weapons of mass destruction, but I think he understated the problem. These securities are far worse- a Ponzi scheme even Carlo wouldn't have dreamed of. We can choose to fire a WMD, but these securities have taken on a life of their own and they will, in my view, drag everything financially tied to them into oblivion- into a black hole.

The intent of the book From Black Scholes to Black Holes, to cloak these securities in an aura of cool, is quite ironic in its, apparently unintended, prescience. Black Holes are singularities in Einstein's space-time continuum which swallow, for want of a better term, everything that comes near. They are the Charybdis-es of space. Derivatives are the Charybdis-es of finance. They are creating their own ever stronger gravitational field that has already swallowed 3 of the 8 major US players since 1998. The 5 banks which remain are increasingly linked together.

Last night, after perusing the derivatives data from the BIS and Office of the Comptroller of the Currency (OCC), I was wondering what the end game would be, happened to glance at my book shelf and the book title jumped out at me. "It's a Black Hole," I realized. In the end the remaining banks will merge into one and money, instead of light, would never be able to escape as the fallacy of netting benefits- the assumption that they are all similarly valued- is exposed.

In the OCC Report on Derivatives, the benefits of netting are explained: For a portfolio of contracts with a single counterparty where the bank has a legally enforceable bilateral netting agreement, contracts with negative values may be used to offset contracts with positive values. This process generates a “net” current credit exposure (NCCE)

I had some experience with this fallacy of netting when I was trading FX derivatives for Chase. When Drexel Burnham collapsed I had to "net out" - put on the opposite trade with the same counterparty- the exposure of my option portfolios with Drexel's. While this seems easy to describe there was a problem. They didn't value their options at the same values we did. In some cases I was short low delta (far out of the money) options I had marked to the (lower) at-the-money value. Who should take that revaluation loss? In other cases, I might have to net out a position I needed only to find that replacing it was far more expensive than our agreed upon price.

Fortunately, markets I was trading at that time were not excessively volatile, which would have made the procedure even more difficult. Even more fortunately, the notional amounts were orders of magnitude less than currently carried by US banks.

50 basis points (a fairly trivial change in an option value, or, if you prefer, an aggressive post Volcker Fed tightening) on $100M (roughly the size of trade back then) is $500K. 50 basis points on $7Tln (or 1/5th (5 banks left) of the notional exposure in interest rate derivatives with maturities between 1-5 years) is $35B (7 times the total net income for JPM in 2008).

Why has interest rate derivative exposure grown so much over the past few years? The search for profits in an ultra low interest rate environment seems, in part, a good answer as the graph below depicts.

The other answer is that, as I discovered, the easiest way to make money from a derivatives portfolio is to grow it. Increasing risk in the far dates that is mispriced in your favor can cover many sins as derivatives mature.

Warren Buffett describes the pain of going in reverse on (winding down) such portfolios: When Berkshire purchased General Re in 1998, we knew we could not get our minds around its book of 23,218 derivatives contracts, made with 884 counterparties (many of which we had never heard of). So we decided to close up shop. Though we were under no pressure and were operating in benign markets as we exited, it took us five years and more than $400 million in losses to largely complete the task. Upon leaving, our feelings about the business mirrored a line in a country song: “I liked you better before I got to know you so well.” General Re's derivatives exposure was orders of magnitude less than that of GS, C, or JPM.

The OCC seeks to assure us that they have things under control: While market or product concentrations are normally a concern for bank supervisors, there are three important mitigating factors with respect to derivatives activities. First, there are a number of other providers of derivatives products whose activity is not reflected in the data in this report. Second, because the highly specialized business of structuring, trading, and managing derivatives transactions requires sophisticated tools and expertise, derivatives activity is concentrated in those institutions that have the resources needed to be able to operate this business in a safe and sound manner. Third, the OCC and other supervisors have examiners on-site at the largest banks to continuously evaluate the credit, market, operation, reputation, and compliance risks of derivatives.

In addition to the assumed virtues of netting, the OCC seeks to calm you with VaR (value at risk analysis) analysis (about the shortcomings of which, more here). The average VaR in 2008 relative to 2008 net income according to 10K and 10Q SEC reports is roughly 3% for JPM, C, and BoA and higher for GS. In the event revenues from interest rate derivative trading for Q1 2009 was $9B. Those tails sure seem to be fatter than assumed. If you can make it, as all traders eventually learn, you can certainly lose it.

Perhaps now we can see why the Fed is being so tentative with talk of removing stimulus and raising rates. 50 basis points can wipe out a bank. Imagine if the Fed is faced with the situation of a full blown currency crisis- the Scylla near the Charybdis- and needs to lift the Fed Funds rate 200, 300 or 500 basis points swiftly- a policy response chosen by the Fed in the late 70s/early 80s and many other Central Banks since.

In that event, the black hole becomes operative and another type of derivative, the credit default swap starts sucking the financial life out of the remaining big banks.

Since Q3 2007, credit default derivatives have generated $28B in losses. As of Q2 2009 there were still some $13.44Tln in notional exposure or 95% of GDP. What happens if only 1 bank is left? even if that bank has successfully bet on the collapse of the other 4? Who pays?

From Black Scholes to Black Holes indeed. In my view, the sooner, the better. If Warren Buffet's experience is any guide, an implosion of the 5 biggest banks seems a better alternative to an attempt to wind down these portfolios.