Wednesday, November 17, 2010

John von Neumann: Playing for Keeps

It should be noted that children at play are not playing about; their games should be seen as their most serious-minded activity.   Michel de Montaigne

According to Lewis Straus, one of the original five Atomic Energy Commissioners, when John von Neumann, eminent mathematician and co-author of Theory of Games and Economic Behavior (available at, lay dying of cancer in 1956-7, “gathered round his bedside, and attentive to his last words of advice and wisdom, were the Secretary of Defense and his deputies, the Secretaries of the Army, Navy and Air Force, and all the military Chiefs of Staff.” That’s quite a bit of attention being paid to one man and I can’t think of another person since who has been held in such high regard by the US’ Military Industrial Complex’s power elite. 

Ironically enough, he earned this high regard from such serious people, in part, by preaching that life was (heuristically) a game.  The irony fades when one discovers that Johnny, as he was universally (according to the biographies I’ve read) known, thought of both poker and nuclear deterrence as different forms of similar games.  Moreover, the sense of “game” to which von Neumann referred was consistent with the opening quote- a serious endeavor to which good players bring their full attention.  Life lived as a game, in my view, is life lived aware, with a focus on constant improvement, or as Socrates put it, a life examined.

Reading von Neumann's analysis of the complexities involved in trying to model economic behavior- the theory behind the symbols- was, for me, a window into the mental process of a true genius.  The process, for me, was the "meat", far more mentally nourishing than the "conclusions" which might be construed by some as useful economic strategies.

But, I digress.  Onward to the perspective. 

For von Neumann (leaning on the work of Austrian Economists) the quantum of modern economics was an exchange, or in game-speak, a move.  The sum of all such moves, and their effects on production, distribution, etc. comprise the game we call economics.  In that sense, von Neumann’s sale of the book was a move, and a pretty good one at that.

Importantly, within that perspective, there are no disinterested umpires, although some players do “double duty” just as a poker player will, from time to time, both deal and play.  Such “double duty” demands extra scrutiny from the other players whether the game is poker or international finance.  If you wish to assume simple selection of a player as Treasury Secretary or dealer guarantees righteousness, I want to deal a few hands of poker to you and your friends.

There are a few other “sacred-cow-slaying” passages of the book which caught my attention.

 Beware of Omniscient EconomistsFirst let us be aware that there exists at present no universal system of economic theory and that, if one should ever be developed, it will very probably not be during our lifetime. The reason for this is simply that economics is far too difficult a science to permit its construction rapidly, especially in view of the very limited knowledge and imperfect description of the facts with which economists are dealing. Only those who fail to appreciate this condition are likely to attempt the construction of universal systems.

On the Ideal of Free Competition: The classical definitions of free competition all involve further postulates besides the greatness of that number.   E.g., it is clear that if certain great groups of participants will for any reason whatsoever act together, then the great number of participants may not become effective;  the decisive exchanges may take place directly between large "coalitions," few in number, and not between individuals, many in number, acting independently. Our subsequent discussion of "games of strategy" will show that the role and size of "coalitions" is decisive throughout the entire subject.

The Futility of “Maximizing Utility”: A particularly striking expression of the popular misunderstanding about this pseudo-maximum problem is the famous statement according to which the purpose of social effort is the "greatest possible good for the greatest possible number." A guiding principle cannot be formulated by the requirement of maximizing two (or more) functions at once. Such a principle, taken literally, is self-contradictory, (in general one function will have no maximum where the other function has one.) It is no better than saying, e.g., that a firm should obtain maximum prices at maximum turnover, or a maximum revenue at minimum outlay. If some order of importance of these principles or some weighted average is meant, this should be stated. However, in the situation of the participants in a social economy nothing of that sort is intended, but all maxima are desired at once by various parties.  (see also: Fed mandate of maximum employment with minimal inflation)

Finally (for this essay, I think the book is well worth a read, no summary of mine would suffice) von Neumann raises the issue of economics as a non-zero-sum game, i.e. a game in which the sum of all payments equals the sum of all losses.  As we’ve been slaying sacred cows, let me join the fray.

The apparently widespread assumption of perpetually rising GDP can be thought of as the apparently equally widespread assumption of non-zero-sum games always increasing the pot of winnings.  I think this is a dangerous assumption.  “Moves” by big players, “double duty” players, and coalitions, and their effects on others’ moves can increase as well as decrease the pot of winnings.  To wit, it seems likely to me that continued social distribution of losses and privatized winnings (bank coalition bail-outs being a case in point) will (and, in my view, has already) decrease the pot of winnings.

In all games, cooperation is key, especially in games like economics, that are played for keeps.

Wednesday, November 10, 2010

US Bonds: Waiting for the First Rat

US 10yr Notes have had a tough few days with yields rising some 15bp.  Irish Bond traders might be wondering, if a few days yield rise of 15bp can be described as “tough” what word would one choose to describe government debt trading in Ireland lately.  Yields on Irish 10yr government debt rose by more than 60bp today, making the total yield gain since May more than 400bp.  I think “crisis” seems most apt.

What’s the difference between Irish Debt and US Debt trading besides currency denomination?  That is, why are Irish yields rising dramatically and US yields not?  After all, both nations have a large stock of government debt, a not insignificant portion of which was necessitated by bail-outs of highly leveraged banks and are running substantial continued deficits (admittedly the expected Irish deficit is roughly 3 times the US relative to GDP).  Why are Irish yields so sensitive to news of additional deficits while US yields remain stable?

The French refer to this conundrum as the “exorbitant privilege” of the US.  If Ireland were to announce a policy of Irish Central Bank monetization of the next 9 months of debt issues, Irish Debt would, I suspect, crash more severely than it has.  Yet, this is just what the Fed announced last week.  It’s good, it seems, to issue the world’s reserve currency.

Press coverage of Irish debt trading speaks of investors demanding ever-higher yields as risk compensation given Ireland’s fiscal woes, while the fear in the US is just the opposite, i.e. of another asset bubble being created, despite, it seems, the US’ fiscal woes. 

Perhaps the answer to the query, “what’s the difference between Irish and US debt trading?” is simply time.

At some point in all markets, the metaphoric rats leave the sinking ship.  In the Irish 10yr, it seems 6% was the yield of no return.  Leveraged owners of the debt started to flee (sell) while Ireland’s financial needs grew (due to, if for no other reason, higher borrowing costs) and debt sales begat more debt sales. 

To repeat, at some point in all markets, the metaphoric rats leave the sinking ship, even, I believe, US debt markets. 

Of course, when the feasting has been very good for a long time and when a rat might fear repercussions from leaving early, a wise rat might wait until other rats left safely before leaving himself.  A wise bond trading rat might watch US yields and flee when they rose above some level, say 4% in the US 10yr.  An even wiser rat, having decided the meal was not to his liking (or so I understand the debt rating downgrade from a Chinese rating agency), might sell while the selling was good, say while the ship’s owner (the US) was buying.

I’m most curious to watch US debt trading in the coming months as Treasury data on foreign inflows details the movement of the rats off the ship.  Once the other rats know that many are leaving the exodus will become a stampede (lots more leveraged longs in US debt markets than in Irish debt). 

Who knows, in the not too distant future the press might speak of US Bond investors demanding ever higher yields.  

Disclosure: No positions in US Treasuries (yet)

Tuesday, November 09, 2010

Do We Need Another World War?

Ask the average guy on the street if we need another world war and he might respond with, “We need another world war like I need a hole in the head.”   Yet, there are medical conditions which can be solved by holes in the head, such as cranial swelling, i.e. when your brain gets too big for your skull.

War, according to Carl von Clausewitz, is merely the continuation of politics by other means.  In other words, when talking fails to resolve an issue in need of resolution, military force will accomplish what persuasion couldn’t.

However, winning a war, which, in Clausewitz’ view, means achieving political goals via military means, is easier said than done.  As Machiavelli warned, It ought to be remembered that there is nothing more difficult to take in hand, more perilous to conduct, or more uncertain in its success, than to take the lead in the introduction of a new order of things. Because the innovator has for enemies all those who have done well under the old conditions, and lukewarm defenders in those who may do well under the new.

The end results of WWII are consistent with Machiavelli’s warning.  Nazi Germany, Japan and Italy started the war to, inter alia, create a new world order and they succeeded, in part.  At war’s end, a new world order was created, with the US on top.

Having proved its dominance on the battlefield (leaving aside, for this essay, the stunning success of the Russians against the Germans), and carrying the big stick in the form of Atomic Weapons, the US could talk softly, solving, for a time, international financial conundrums which had proven intractable within the context of the League of Nations.  From this perspective, the “success” of the UN, IMF and World Bank, in contrast to the “failure” of the League of Nations is more a function of US power exercised through the new international institutions than some new-found commitment to cooperation. 

Of course, US dominance of world politics was due not just to military might but to its substantial Gold holdings, undamaged by war capital infrastructure, domestic commodity resources, and sheer economic size.  It seems to me the more recent failures of international financial institutions is more a function of the US resource depletion, gold reserve and capital infrastructure exports, and rapid economic growth of China and other populous nations, than some new found weakness in those institutions. 

Defendants don’t fear the Judge who imposes sentence but the power of the state behind him. 

The last world war was, in a sense, a schoolyard brawl decisively won, and broadcast globally, by the strongest kid, who happened to have the richest parents.        

I ask the opening question from the above perspective.  Do we need another world war to breathe new life and power into current or new international financial institutions- solving problems currently deemed intractable?

Barring a new enlightened faith in the virtues of international cooperation by top policy makers, and given the pressing need to apportion financial losses accruing from, inter alia, unprofitable international investments, the answer may be yes. 

Fasten your seat belts.

Sunday, November 07, 2010

Are We There Yet?

With the US$ sinking and Gold setting new highs every few days those, like me, who have been waiting for the final collapse of the current $ based international financial system have one question on our minds- “are we there yet?”

“Not yet.  But we’re getting very close.”

This past week the US electorate, in a fit of justified pique over Democratic failure to fix the broken (at least from the perspective of the majority of US citizens) economy, put Republicans back in charge of the House of Representatives.  Big Finance must have viewed election results with glee.  Gridlock, as we Americans lovingly refer to government divided and thus incapable of passing radical legislation, means the Volcker Rules (or other meaningful financial reforms) have an even slimmer chance of becoming law. 

Coincidentally, the Federal Reserve announced plans to buy, during the next 9 months, $600B of long dated US Treasuries- a policy they refer to as “quantitative easing”.  I prefer “monetizing debt” to avoid confusion.   

While Big Finance in the US celebrated the return of Gridlock and the gift from the Fed, our foreign financiers most likely took a less sanguine view of the policy changes.  US banks will soon be free to take even bigger risks while the Fed actively drives the value of the US$- the ultimate “asset” our financiers are promised- ever lower. 

The wonderfully apt, in this case,  phrase, “thick face,” no doubt crossed many Chinese minds as they pondered US Treasury Secretary Geithner’s proposed current account targets to “accelerate global rebalancing” in the context of US debt monetization and ever more impotent regulation of the big banks who have led the world to the current impasse. 

To wit-  Cui Tiankai, a deputy foreign minister and one of China’s lead negotiators at the G20, said on Friday, “We believe a discussion about a current account target misses the whole point,” he added, in the first official comment by a senior Chinese official on the subject. “If you look at the global economy, there are many issues that merit more attention – for example, the question of quantitative easing.”
It seems to me a sign of the times that Mr. Geithner didn’t respond to current concerns over the declining $ as Nixon’s Treasury Secretary, John Connally once did, i.e. the US$ “is our currency, but your problem.”  The swagger of US policy makers evident in decades past is now shrouded in sophisticated euphemism- but the effects will be similar.

“But, are we there yet?”

“Not yet.”

There is, in my view, one last road sign before we reach our destination.  When the US Bond Market begins to “fight the Fed”- a strategy normally as wise as spitting into the wind- we will begin the end stage of our journey to a new system of international finance.  When US Bond prices fall despite Fed intervention (better yet, when bond prices fall on news of increased intervention) the excrement will be about to hit the fan in international finance. 

We must, however, be getting close.  I noticed the Fed established the Office of Financial Stability and Research this past Thursday.  Talk about closing the barn door after the horses have all escaped.

Tuesday, May 25, 2010

Bernanke and the Depression of Damocles

It's showtime for Ben Bernanke, Fed Chairman. The moment of truth, so skillfully postponed by months of swapping good money for toxic debt, is once again at hand.

He will either be the hero or a punch line in some future Fed Chairman's speech.

The first lesson--economic prosperity depends on financial stability--seems obvious, but this connection was not always well understood. After the stock market crash of 1929, many thought a financial and economic crisis was necessary--even desirable--to wring out speculative excesses that had built up in the 1920s. Remarkably, despite the fact that the Federal Reserve had been founded to mitigate financial panics, the central bank made essentially no effort to prevent the wave of bank failures that paralyzed the financial system at the start of 1930s. Indeed, the Treasury Secretary at the time, Andrew Mellon, believed in the tonic effects of weeding out weak banks and famously advised President Herbert Hoover, "Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate … It will purge the rottenness out of the system."

The Depression of Damocles hangs over his head while he deliberates long run strategies for managing the Fed's balance sheet- a hot topic at the Fed's meeting late last month.

The staff next gave a presentation on potential longer-run strategies for managing the SOMA. At previous meetings, Committee participants had expressed support for steps to reduce the size of the Federal Reserve's balance sheet over time and return the composition of the SOMA to only Treasury securities. The staff discussed the potential portfolio paths and macroeconomic consequences of a number of different strategies for accomplishing these objectives. To date, the Desk had been reinvesting the proceeds of all maturing Treasury securities in newly issued Treasury securities, but it had not been reinvesting principal and interest payments on maturing agency debt and agency MBS, nor had it been selling securities. One strategy considered in the staff presentation was a continuation of the current practice, which would normalize the balance sheet very gradually. In addition, the staff presented information on a number of other strategies that included sales of SOMA holdings of agency debt and MBS and under which the proceeds of maturing Treasury securities would not be reinvested; these strategies differed by the date and circumstances under which sales would be initiated, by the average pace of sales, and by the degree to which the timing and pace of such sales would be adjusted in response to financial and economic developments.

Ironically, the Fed is not debating whether to "liquidate" à la Andrew Mellon, toxic debt purchased from the banking sector, but rather the pace of liquidation.

The modern Fed, if it tries to drain liquidity by liquidating toxic assets, may well, like its counterpart in the early 1930s bury the economy under a mountain of unpayable debt in order to maintain a "strong dollar", which, as an aside, has risen roughly 20% so far this year in Forex markets.

Let's return to Ben's jab at Andrew Mellon, The first lesson--economic prosperity depends on financial stability--seems obvious, but this connection was not always well understood. Whether this first lesson is currently well understood at the Fed remains to be seen.

While there are many aspects of financial stability, one key feature is sufficient income to service liabilities, a task which gets most difficult the higher the ratio of liabilities to income.

The graph below depicts total US financial liabilities (source Fed's Flow of Funds data) divided by US national income (source BEA).

As you can see, current trends do not engender a sense of US financial stability. Income needs to rise to avoid a Mellon-esque liquidation. Financial stability, in my view, does not flow from support to financial institutions, which but buys time, but from a financially stable real sector. Right now, the last thing the US real sector needs is less liquidity and a strong dollar.

The question, in my mind, is why the Fed tolerates a "strong dollar". Will the words of men like Bob Rubin- "a strong dollar is in the US national interest"- become Mr. Bernanke's ironic epithet?

In time, economic historians may realize the only interests served by a strong dollar in recent times are those of the TBTF banks, who get a "free ride" on the exorbitant privilege of the US$'s role as main global reserve. Bernanke, to avoid being the goat, needs to solve Triffin's Paradox as Alexander the Great solved the Gordian Knot, by cutting it in half- and choosing to support the domestic (real) economy.

The real economy in the US needs a weak dollar and inflation or it will not be able to service its debt. How one can think finance needed the Fed's shock and awe in 2008-09 but the real sector doesn't, and can instead service its debt with a long and gradual decline in unemployment, escapes me.  The US needs some inflationary shock and awe.

"But," you might be thinking," hasn't the US been inflating?"

Yes and no. While the monetary base has tripled over the past decade, growing even faster than in the 70s, when it doubled, broader money stock measures are not responding in kind- M2 has roughly doubled during the past decade while it more than tripled during the 70s. Credit, more and more over the years, is flowing to the financial markets, (and overseas- some $300B of US currency is in foreign hands source: BEA) bypassing the US real sector.

Debates over the pace of Fed credit draining via toxic debt liquidation is ample proof. US monetary policy has been hijacked by international financial concerns who don't want the value of their dollar holdings inflated away (but don't seem to realize current income without inflation only invites default). 

Bernanke needs to make a choice. Supporting the TBTF banks and the "strong dollar" as basis of global reserves got us into this mess. More of the same won't get us out of it.

Friday, May 21, 2010

THE Riddle Has Been Solved

Many readers will think that the last person whose opinion should be consulted on the issue of rating agency reform is a former rating agency employee. Maybe they’re right, but I did learn one thing from rating hundreds of complex securities. Contrary to what some may think, there are no easy solutions here. Unintended consequences are guaranteed. Gary Witt, former MD of Moody's Investor Services

What riddle?

Why is the industrialized world in the mess it's in?

Mr. Witt, writing at The Baseline Scenario answers this question, in my view, correctly.

We're in the mess we're in because there are no easy solutions. There haven't been easy solutions for quite a few decades as all of the "low hanging fruit" of industrialization currently being harvested in countries like China has long ago been harvested in the west.

Industrialization for economies is like adolescence for humans. It's a period of time when natural growth overpowers constraints that would hobble children or mature adults. There are easy solutions for adolescents and young adults but as we age our choices are more often an exercise in finding the lesser evil.

So it is, I believe, for US (and European and Japanese) economic policy makers. Shifting away from a financially centered economy will be painful. Wealth will be lost, interest rates will rise, and investment capital will become more scarce. We'll have to compete again, which tends to difficult for those who have grown accustomed to dominating.

"What evil," you might be wondering, "makes the above the better option?"

The alternative, in my view, is all of the above, but worse, and with less ownership. We won't be competing, we'll be sharecropping, as Warren Buffet once quipped.

In other words, I believe our economic woes are already built into the system. The expected growth in the New American Century, upon which dream, in part, credit was extended, didn't materialize.  Our choices now are between growing out of our dilemma- paying down debt with income(and lots of inflation)- or selling assets in lieu thereof.

Western Economies are, in a sense, middle-aged. There are no quick fixes available, just choices between accepting reality and having it forced on us.

Thursday, May 20, 2010

Imagine There's No Credit Market: Another Look At German Controls

Imagine there's no credit market
It's easy if your try
John Lennon (if he'd lived long enough)

[Money] is a machine for doing quickly and commodiously, what would be done, though less quickly and commodiously, without it: and like many other kinds of machinery, it only exerts a distinct and independent influence of its own when it gets out of order. J.S Mill

Centuries ago there were these things called markets. At the end of a harvest farmers would take their produce to a common area and (hopefully) exchange their goods for other goods or money. In some cities remnants of this history still exist, like civil war battle re-enactments. We call some of these "farmer's markets".

Over time, the word, "market" was applied to any process wherein people exchanged things, even if there was no designated place to meet and most of the exchanges were done by proxy. Thus we use phrases like "credit markets", for instance, which, unlike today's farmer's markets, don't exist. There is no common place to go when one has savings one wishes to lend to meet up with borrowers and haggle over terms.

If I told some friends the financial capital of the nation was allocated in Narnia, Middle Earth or Hades, they might think I needed some time in a rubber room. Yet I could tell the same people the financial capital of the nation is allocated in credit markets, and seem wise despite the fact that Narnia and credit markets are both simply mental constructs. They don't exist.

One of Ludwig von Mises' great contributions to Economics was his focus on human action as the quantum of economics. Aggregates (like GDP), averages (like median income), and credit markets (like the US bond market) are mental constructs, nothing more. When people talk about the US economy, for instance, they are talking about an idea, for such a thing does not exist.

We, humans, exist (sidestepping valid, but for our purposes, irrelevant philosophical issues). We live, breathe, eat, sleep and act, and in so doing, we change the world, which also exists, and are changed by it. This idea we call "an economy" is a construct we imagine to be composed of the actions of millions of people, making, working, buying, selling, and saving.

Confusion over this key point is rife. Politicians talk about saving the economy and speculators talk about freeing the markets, but neither exists to be saved or freed.  People all over the world think their investments are worth what a bunch of intermediaries say it is worth, instead of what it eventually returns.

A general sense is seemingly shared by many- when an aggregate measure (GDP) expressed in currency, mind you, not tons of steel, bushels of wheat, etc. of a non-existent construct (the US economy) rises, times are thought to be good. It seems to me, however, there is no time but our time, lived individually, not collectively. The economy to each of us is the sum of our actions conditioned by the sum of all others'.

I had the above points in mind while devising yesterday's model of a grain market with speculators. Instead of conceiving of it as a motion picture- a series of frames projected faster than the human eye samples, thus creating an illusion of continuous motion, or reality- I focused on the frames, which, in the case of markets, are transactions or exchanges.

I wrote that the model could be used for any exchange and as I've gotten some requests, here's the model applied to monetary exchanges, what we call credit markets.

As in our grain market model, there are producers, consumers and middle-men. Producers have money, consumers want money, and the middle-men bring the two together. The producers lend their money to consumers in hopes of future repayment plus some profit, what we call interest. As in our grain market model, profits are allocated based on individual transactions. Usually producers lend their money to middle-men who, in turn, lend it to consumers.

Let's imagine a farmer who had such a bumper crop he ended up with 2000 pieces of silver. Let's imagine a town administrator who wished to borrow 2000 pieces of silver to pay workers to build a bridge over a nearby river and thus increase tax revenue during the local market season. The administrator bets he can collect an extra 2100 pieces of silver during next year's harvest market.

In a small town, the administrator might visit the farmer and agree to borrow his silver and repay it next year plus 100 pieces in interest (not a bad deal as the taxes would be collected each year the bridge was still working). In a larger town, the farmer might bring his money to a bank, and the banker might lend it to the administrator and take, say, 30 pieces of silver for his trouble.

As in our grain market model, the middle-man/banker doesn't increase the total profit of the transaction, nor does he decrease the risk the bridge won't be completed and tax revenues won't be collected. If the administrator defaults on his obligation, the banker is still obliged to repay the farmer, from his own pocket, if need be, or he goes out of business (unless, of course, he's a TBTF banker who gets government to impose an additional tax on citizens to pay for his errors in judgment).

In the above model, the banker provides "liquidity" to the farmer, borrowing his money at a rate somewhat lower than he believes he can lend it to the administrator. Today, hordes of commercial paper and bond traders do exactly the same thing. Perversely, their liquidity providing actions, as they trade with each other waiting for a new producer with money to lend, or consumer, wanting to borrow it, has come to be called "credit markets" when real credit market action only occurs when new money is lent.

Thus, when people speak of "rescuing the credit markets" they really mean to say rescuing the liquidity providers who failed to assess lending risks so profoundly they can't make required payments. When people talk of German restrictions killing the credit markets, they really mean killing the middle-men (which may or may not have a deleterious effect on government borrowing).

German restrictions on certain types of equity and credit transactions are not aimed at reduced government borrowing. They are aimed at reducing the amount (and means of capture) of profit "earned" by middle-men in the transaction- profits, mind you, as per our model, in the case of government borrowing, come either as a result of the money's original owner getting less interest than a direct deal would generate, the government paying more interest (which only comes from higher tax revenues) than a direct deal would generate, or some combination thereof.

Like all markets, credit markets create nothing (which I suspect, is a big problem with naked CDS, from whence do the profits come in the event of default?), they merely distribute.  As per J.S. Mill, their purpose is increased efficiency of a task that would otherwise occur.

If all of the TBTF banks were put of business tomorrow by government decree, and forced to distribute whatever capital and deposits they could, there would still be people with money willing to lend, and borrowers willing to borrow (most likely at rates far higher than are apparent today).

Some might argue such would be the end of the credit markets, which, leaving aside debate over the termination of a figment of one's imagination, might not be such a bad thing.

Let's play along with John Lennon and imagine no market for government bonds. Let's imagine a government, like mine in the US, which, instead of announcing an auction of $113B in 2-year notes to be mediated by direct dealers (there's a neat contradiction in terms) simply lists its borrowing needs and potential terms on an internet site, which willing borrowers could view and perhaps post their desired terms. These days, an auction program could perform most of the same functions the direct dealers do- putting together sellers and buyers- at a small fraction of the

There are, of course, some things auction programs can't do, like sell toxic debt at low rates to unsuspecting people, but we might not really miss that.

Some eager bond traders would likely argue the above scenario would lead to more volatile interest rates. I agree. Prices of exchanges like the above would be much more responsive to current events. Countries like Greece would have gotten a much earlier warning of trouble ahead, which, in hindsight, seems a good thing.

In sum, liquidity providing actions of "credit market" middle-men has run amok. As per J.S. Mill, that credit markets are exerting a distinct and independent influence of their own means they are out of order. With increasing frequency, credit is mispriced or unwisely extended and liquidity, the raison d'être of these people, dries up when it is needed most. Yet the middle-men who fail in their tasks expect to be rescued from their failures, and given even more ways to profit from lending other people's money, while the pool of available savings shrinks.


p.s. In one sense I'm quite happy about all of the financial sector bail-outs governments have provided these credit-market middle-men. Before the bail-outs, one had to argue that finance was like a tax on monetary exchange, now this point is clear, finance is, in fact, a tax- and a growing one at that.

Wednesday, May 19, 2010

Merkel Does Mahathir and Martin Luther: Tilting the Market Table

In theory, free markets provide "just" prices or a level market table and thus allocate profits such that all market participants are willing to exchange goods freely. This is the basis of the division of labor in a free economy. In practice, speculators are finding they can tip the table as well as any government or church, thus inspiring an increasing unwillingness to play their game.

In 1998, Malaysian Prime Minister, Mahathir Mohammed imposed capital controls ostensibly to protect Malaysia from speculators like George Soros. Then as now (with respect to German controls, also ostensibly to ward off speculative attacks) the financial press was full of quotes proclaiming the foolishness of such actions. The Church of Free Capital is, apparently, a dogmatic church- nation-states, according to the creed, have no right to impede the flow of holy money, or alter the terms of trade.

The Church of Free Capital's creed states that prices set by market speculators (i.e. big finance) are, in a sense, divinely inspired, leading to the best outcome. That big finance has been taking home an increasing share of decreasing profits has not shaken faith in the creed among speculators, but it has angered capital providers in Germany sufficiently to provoke a protest and policy schism.

This isn't the first time Germany has protested the policies of a major Church. Interestingly, both protests, in a sense, included the imposition of capital controls.

Roughly five hundred years ago, a monk named Martin Luther sent a list of complaints- the 95 theses- to his Catholic superiors. His main complaint was about indulgences, whereby a Catholic could buy redemption from sin. "Why does the pope," Luther argued, "whose wealth today is greater than the wealth of the richest Crassus, build the basilica of St. Peter with the money of poor believers rather than with his own money?"

Back then, the Renaissance Popes were rebuilding Rome. Men like Michelangelo, Bramante and Raphael were paid to work on St. Peter's Basilica (inter alia) with money raised, in part, from the sale of indulgences to northern Europeans. Germany, then as now, wanted to keep their money. Whether the current schism in capitalism becomes as widespread as the former schism in Christianity remains to be seen.

I, for one, think the Church of Free Capital is overcharging for its services about as much as the Vatican was then. To their credit, at least the Vatican left something for posterity. We'll have to wait and see if the Church of Free Capital leaves anything to posterity besides broken dreams.

Returning to Malaysia, by the time (15 months after the crisis hit Thailand) Mahathir imposed his controls in September 1998 (about which, more here, and here), the Ringgit had already lost about half its value vs. the US$. That is, most of the capital that could and wanted to flee the Asian crisis had already fled. Thus, I suspect, Mahathir imposed capital controls hoping to avoid "punitive" speculation, since he was about to put his second in command, Anwar Ibrahim, a favorite of Western Financiers, in jail.

One wonders, to the extent the analog holds, what surprises Germany has in store for the Free Capital faithful. Perhaps, alternatively, Germany is simply trying to ensure that profits made on any future EU bond issues remain in Europe, or at least accrue to EU bond holders.

I'm very interested in Germany's policy shift because it's the first time in decades a mature industrialized nation has protested the allocation of profits decreed by financial orthodoxy. At core, German bans of "naked" (held by those who don't own the securities) shorts, paraphrasing Ms. Merkel- perhaps unsurprisingly the daughter of a Lutheran Minister- stops people profiting from the destruction of their neighbor's house at cost of less liquidity in the restricted markets.

In a sense, the policy shift is akin to a theoretical banning of naked shorts, such as occurs in the futures markets, by grain speculators. In theory, grain speculators, by providing liquidity- more potential contract prices than would occur in a simple point of sale transaction- in grain markets, help producers (farmers) and consumers exchange goods more efficiently.

In practice, grain speculators charge producers and consumers a fee, in the form of speculative profits, to provide price liquidity. If the fee is small, producers and consumers will find that additional efforts, such as spending more time at market finding people willing to deal at their preferred price, cost more than the additional profits so produced. Additionally, speculators take on risks producers (who want high prices and thus fear a bumper crop) and consumers (who want low prices and thus fear a lean harvest) might wish to avoid. Importantly, speculation neither increases total profits nor decreases total risk, it merely distributes them differently.

For example, imagine a farmer who produces 5,000 bushels of wheat (one CBOT contract), a wheat speculator, and a bread maker willing to buy the wheat. Imagine the farmer's costs of production and transportation come to $3.50 per bushel while the bread maker can sell bread profitably so long as he can buy wheat below $5.25. Let's assume our speculator's costs come to $0.05 per bushel. Each bushel of wheat then provides a profit opportunity of $1.70.

Ideally, the farmer sells his wheat to the speculator for $4.20 and the speculator sells the wheat to the bread maker for $4.55. The farmer makes $0.70, the bread maker makes $0.70 and the speculator makes $0.30.

Sometimes, producers or consumers try to tilt the trading table their way. Farmers might get government to put a floor on prices, say at $5.00, and keep more of the available $1.70, which will eventually piss off the bakers. Bakers, alternatively, might get government to put a ceiling on prices, say at $3.75 and shift the profits their way, which will eventually piss off the farmers.

A third scenario, closer, I suspect, to the way things work now, might look something like this. Speculators, after getting government to bar farmers from speaking directly to bread makers, manipulate prices lower early in the growing season and scare farmers into selling their wheat at $3.75 and then manipulate prices higher late in the growing season forcing bread makers to pay $5.00. Under that scenario, the farmer and break maker split a $0.50 profit evenly while the speculator walks away with $1.20.

Over time, the third scenario leaves both farmers and bread makers short of capital and forces them to borrow from the speculator to make necessary capital improvements. Eventually, barring a revolution, the speculator owns both farm and bakery and has to manage disgruntled employees on both ends, which likely leads to both less wheat and inferior bread.

Hopefully, the above thought experiment explained some of the important work markets do in providing prices. When they work well, primary producers and secondary manufacturers both find it profitable to produce, and middle men are rewarded for managing the transaction risks. However, when the table is tilted too far in any participant's favor, the whole system, which requires willing cooperation from all for optimal results, risks deterioration.

The above model can be used to examine any market transaction, even government debt finance. German controls, in effect, reduce the share of profits (if any) of such borrowing going to middle men. We'll soon see if the service provided by those middle men was worth the cost.

500 years ago, the Germans defied orthodoxy and ushered in a revolution which moved the center of Europe from South to North. They are defying orthodoxy again, and I can't wait to see what happens next.

Tuesday, May 18, 2010

Brilliant Quants Beside Us and Their Perfect Quarter

In a sense, brilliance is like a fast computer with lots of memory, it can be used to manage a ponzi scheme like Madoff's without detection, or to devise a new drug to cure cancer. Brilliance is like atomic energy, it can either power the city or destroy it.

How it is aimed matters.

Imagine reading the news to discover a close friend was, in fact, a master-thief, serial-killer, or driving intellect behind schemes that would bankrupt whole nations.

This gut wrenching experience has lately manifested in millions of investors and politicians as it did in crime writer, Ann Rule, author of The Stranger Beside Me.

Ms. Rule, at Seattle's Suicide Hot Line, worked with a man she described as brilliant and handsome. His name was Ted Bundy (yes, that one). Despite an early, avid interest in crime-fighting, which led her to undergraduate minors in criminology and psychology, Ms. Rule failed to see the budding serial-killer in her co-worker.

Her positive impression was so strong that, even after multiple arrests (and escapes), she couldn't quite believe the man she knew was a killer. She describes the moment of revelation in an interview:

"To be absolutely sure about his guilt," Rule remembers, "I needed to see direct physical evidence, and there it was [the bite marks and dental comparison], no question. It made me sick to my stomach. I went down to the hall to the ladies' room and threw up. Yet he still maintained this suave, friendly look. It was a bad day for me."

To this day, the experience haunts her and she feels fortunate that there had never been a romantic attachment between her and Bundy. "I felt dumb, I felt fooled, and I thought that my perception, which I'd always counted on, was flawed. Ever since then, I've felt I can't really know anybody." But she wasn't the only one. "We had very rigid screening at the Crisis Clinic where we had worked together, to be sure we were well adjusted and could help people who called in. Bundy fooled everybody."

Bundy fooled everybody. So did Bernie Madoff. So did many other fund managers, financial quants (experts in financial mathematics) and, I'm sure many will soon discover, so did the CEOs of major banks.

But how?

Each of these people was "brilliant" (in their way). They read people like a genius reads books, quickly, yet thoroughly- providing the appropriate responses to create their desired self-image in the minds of those testing them, at schools, jobs, and in social situations. They looked like the image they wanted to create and people judged the book by its cover.

Brilliant, intelligent, smart. These words will keep popping up.

To wit, in a Harvard thesis, Anna Katherine Barnett-Hart asks, How could so many brilliant financial minds have misjudged, or worse, simply ignored, the true risks associated with CDOs?

To wit, Michael Lewis, in The Big Short, leavening his prose with sarcasm observes: There was a sense that these were brilliant men, men of force, not cruel, not harsh, but men who acted rather than waited. There was no time to wait, history did not permit that luxury; if we waited it would all be past us…. Things were going to be done and it was going to be great fun; the challenge awaited and these men did not doubt their capacity to answer that challenge…. We seemed about to enter an Olympian age in this country, brains and intellect harnessed to great force, the better to define a common good.

To wit, in The Quants, Scott Peterson notes: On Wall Street, they [the young math whizzes] were all known as "quants," traders and financial engineers who used brain-twisting math and superpowered computers to pluck billions in fleeting dollars out of the market. Instead of looking at individual companies and their performance, management and competitors, they use math formulas to make bets on which stocks were going up or down. By the early 2000s, such tech-savvy investors had come to dominate Wall Street, helped by theoretical breakthroughs in the application of mathematics to financial markets, advances that had earned their discoverers several shelves of Nobel Prizes.

Perhaps brilliance isn't all its cracked up to be.

In a sense, brilliance is like a fast computer with lots of memory, it can be used to manage a ponzi scheme like Madoff's without detection, or to devise a new drug to cure cancer. Brilliance is like atomic energy, it can either power the city or destroy it.

How it is aimed matters.

And invariably, brilliance aims itself, seeking its own self-interest.

Importantly, brilliance is not synonymous with omniscience or omnipotence. Knowing more than most is not knowing all. Brilliance used for deception inevitably fails. In the end, Bundy hadn't fooled everybody, nor had Madoff, nor will the quants and TBTF elite. Bite marks, missing funds and paper trails always catch up to brilliant deceivers, sadly after much damage has been done.

What are we mere mortals to do?

1) Remember that brilliant people are people. They suffer temptation, to lie, cheat, steal and (in some cases) kill, but unlike the average person, they aren't as constrained by a lack of ability. Temptation rises with ability and just as those with the gift of gab can baffle with words, those with the gift of numbers can baffle with math.

2) Remember that brilliant people live in the same world we all do. Tiger Woods, at his best, beats all other competitors, but he doesn't birdie every hole, and will post a bogie from time to time.

In other words, demystify brilliance, which admittedly is easier written than done. Things which are too good to be true, even when promised by brilliance, usually are. Financial speculation, at best, makes an economy more efficient, but does not create money from nothing.  Checks and balances necessary for mere mortals are even more- not less, as seems to be the American view about financial wizardry- necessary for brilliance.

To wit, the signs of Madoff's deceit were obvious to any who examined his record with a skeptical eye as this excerpt relates:

Michael Ocrant wrote a story in 2001 for MARHedge, which covers the hedge fund industry, about how some traders, money managers and financial consultants questioned Madoff's record of 72 winning months in a row. "When I spoke to them about something not being right … they were adamant — there's no way this could be real," says Ocrant, now at Institutional Investor. "There's no one in history with that kind of results."

72 winning months in a row. "There's no way this could be real. There's no one in history with that kind of results."

Hmmm, if 72 winning months in a row couldn't be real, what should we think when a financial institution (check that, 4 financial institutions) claims to profit from each and every day's trading over a full quarter?

Those guys must be brilliant, eh?

Wednesday, May 12, 2010

Oh to be Solvent When Labor Strikes Back

Labor is usually helpless against capital. The employer, perhaps, decides to shut up the shops; he ceases to make profits for a short time. There is no change in his habits, food, clothing, pleasures—no agonizing fear of want. Andrew Carnegie

Back when companies were far more solvent than today, labor's ability to strike was balanced by capital's ability to lock-out (i.e. close down operations). Call it an artifact of solvency.

These days, while labor is deemed to be on the ropes by many, it is capital which, by virtue of the increasing web of necessary payments to the financial sector which seems to me to be on the ropes. Capital can't lock labor out, it is beholden to finance (as finance is to itself) in much the same way men of Carnegie's day were beholden to capital. 

I'll be a most interested observer of the Greek strike. I wonder how many days it will be before the banks cry "no mas" and labor discovers it has newfound power.  It's all about sufficient reserves, and it's easier to stock-pile food for a week than it is to stock-pile sufficient payments to the financial sector in the event of a business shut-down.

Tuesday, May 11, 2010

Money-Theism, The Faith That Failed

Future historians may well find post-modern man's faith in the power of money as perplexing as Cortes and his men found the faith of MesoAmerica. It is, I believe this curious faith in money's power that allowed finance to become as protected a practice as any in Christianity. How else could three men who kept markets functioning be proclaimed as "saving the world"? Why else, but for this faith, would politics allow their preeminent position to be usurped by banking?

Dedicated to Dr. Chan whose questions sparked this line of thought.

Human sacrifice. To the modern (i.e. late 15th Century on) mind, the notion of ritual human sacrifice earning the favor of the Gods seems absurd. While Hernán Cortés and his men had few qualms about killing people to achieve earthly goals, they were horrified by the MesoAmerican penchant for the practice during the Mayan and Aztec conquests.

Yet, I'm sure the Mayans and Aztecs "believed" in the virtues of human sacrifice, with some literally believing Gods' favor would follow while others, taking a more practical perspective, assumed the practice scared neighboring tribes or conditioned the population's acceptance of the regime's power.

Today, no doubt, some purists still pray to the money God, while others are motivated by more practical concerns, like Big Bonuses. So it is with all man's faiths.

Alas, for the MesoAmericans, their appeased Gods did not defend them from Cortés and his minions (or Cortés won them over with his greater blood-lust). The Gods failed.

Post-modern man has his Gods too. He worships, inter alia, technology, democracy and, in particular, money. The money worship to which I refer has little to do with the desire therefore, but rather, the faith in money's power over nationalist warfare and thus as means to world peace.

Future historians may well find post-modern man's faith in the power of money as perplexing as Cortes and his men found the faith of MesoAmerica. It is, I believe this curious faith in money's power that allowed finance to become as protected a practice as any in Christianity. How else could three men who kept markets functioning be proclaimed as "saving the world"? Why else, but for this faith, would politics allow their preeminent position to be usurped by banking?

Pedantic Pause:
One wonders how long it will be before an elected official complains, "Will no one rid me of this troublesome banker?" and then does penance at the slain man's tomb. My sense; if it doesn't happen quickly, the odds of seeking penance are small. Alternatively, some Jack Cade type might gain power and take the advice of a friendly butcher, but direct his ire at bankers instead of lawyers.

Paraphrasing the bard: Is not this a lamentable thing, that of the body of an innocent tree should be made paper? that paper, being scribbled o'er, should undo a man?

One can trace the growing faith in the money God in both the continued trend of US decisions in favor of monetary globalization at the expense of sound domestic growth and the rush to implement European Monetary Union (EMU) before political harmonization. A common money (call it money-theism), it was believed, would end centuries of European and even world conflict. Remember the joy of the Neo-Cons (inter alios) as the Russian and Chinese economies "dollarized"?

It was proclaimed to be The End of History.

You could almost hear the Neo-Cons chanting, Tolkein-fashion: One money to rule them all, one money to find them, one money to bring them all and in the darkness bind them.

History, a decade hence, might borrow a line from Mark Twain and suggest, "rumors of my demise have been greatly exaggerated."

Ironically, the Gods of Mount Olympus have demonstrated the weakness of money-theism. Greek dissatisfaction with EMU rules (20 years ago, Greek officials would have just let the Drachma slide) supports "economist" over "monetarist" visions of the power of money which emerged on the road to Euro.

In 1970, the Werner Report forged a compromise of sorts between these two groups debating the means to create EMU. As Matthias Kaelberer details:

The major policy clash was between the "monetarists" and the "economists". The "monetarists"- a position forcefully presented by France- argued in favor of quick progress on monetary cooperation, which would then serve as a tool to harmonize economic policies. The "economists"- reflecting the position of Germany- argued in favor of prior convergence of economic policies before moving to a monetary union.

His critique of the monetarist position (written in 1993) was prescient:

Had the monetarist position succeeded, it would have offered deficit and high-inflation countries a free ride: In a complete EMU, Germany would have either had to finance the balance of payments [BoP] of the deficit countries or it would have had to accept a higher inflation rate.

In the event, "monetarists" won the battle but "economists" won the war. The PIGS went on a free ride and Germany (and the rest of core Europe), to keep EMU, must either finance the PIGS' BoP deficits or accept higher inflation.

On a wider stage, the ongoing battle between China and the US over exchange rates is another sign that money-theism, the current theme of globalization, has failed. The virtues of unified money will have to wait unless and until national political system aims and means converge.  We might even discover the drive for monetary union ignites rather than extinguishes war, but I hope I'm wrong.

It is, I believe, the end of an era.

But, my psychologists/editors at Seeking Alpha (an inside joke) are probably saying, "Where's the beef? What action should our readers take?"

The days of banker-glorification will soon be behind us. Politicians will retake the high ground and bankers will no longer be protected from the technology revolution. How much do you pay in ATM fees each year? The division of national corporate profits will shift back in favor of the real sector. If I was still trading at a Hedge Fund, I'd be short all the big banks.

The intensifying battle between bankers and politicians will likely lead to increased sovereign funding problems. States, once again, will have to pay a fair price to borrow.

I wouldn't be surprised to see double digit western sovereign bond coupons in the not too distant future. (In other words, sell western sovereign bonds).

While the theme of globalization has been exposed as false, the virtues of increased trade (which should accrue at a faster pace, once cleared of banker-parasites) are clear. The world, in my view, is not yet ready for a common money, but begs a flexible international financial architecture. Specie, as the recent rallies in Gold and Silver demonstrate, is making a comeback and may yet be resurrected as a basis, in one manner or another, of the next system.

Full Disclosure: Long Gold and Silver
Time Disclosure: I'm no longer a "trader" but an "investor".  I think, when investing, in units of decades, not weeks, days or hours.  In other words, those looking for the next 10/32nds in bonds are in the wrong place.

Monday, May 10, 2010

Exodus: The Irony of Solvency Via Dilution Strategies

The question is whether an individual country that has mismanaged its affairs will precipitate an international financial crisis. Two myths have propagated the view that the question has an affirmative answer. One myth is that the individual country's loss of creditworthiness has a tequila effect. The supposed tequila effect is that other countries without the problems of the troubled country are unfairly tarnished as also subject to those problems. In this way, it is said, contagion spreads the crisis from its initial source to other innocent victims.

The second myth is that a bailout of the troubled country is essential. The rationale is again the idea of contagion. Failure to organize a bailout will create an international financial crisis by a domino effect. Rescuing the troubled country saves the rest of the world from unwarranted financial collapse. Anna Schwartz

Traders are like fishermen- they've got lots of stories about landing the big one. While I tend to use this blog more to share my stories of trades gone wrong- hoping, perhaps, others can learn vicariously from my (many) trading mistakes- today's story is of a trade that worked, and why the guiding theme might still be of use in the coming months.

Back in the first months of 2000, I, like Julian Robertson, couldn't believe my eyes as "Dot-Con" stock prices soared ever higher. The higher stock prices rose, the more dilute, debt ridden and unprofitable did the "Dot-Cons" become. Financial analysis of the internet "space" (perhaps referring to the quarterly report line meant for profits) concerned itself with demand, of issued securities, not of security issuers' products at a profitable price. The quantity and quality of "Dot-Con"- issued security supply was analyzed using the efficient market theory- market prices are rising, securities must be sound.

Willing to bet that such views wouldn't stand the test of time, I bought puts on a number of "Dot-Cons", usually without any problems. One day, in late February of 2000, I asked my broker for prices on EXDS (Exodus Communications) puts.

"My options guys think you're a fool to want to buy puts on this company. They have some call spread strategies that you'll like"

"Thank them for me, but I don't share their optimism on EXDS. Just get me those put prices."

Ten minutes later, he calls back.

"They really think you're making a mistake here, and don't want to sell you those puts."

"I think they're making a mistake here, one that might lead me to find another broker. Get me those prices."

Shortly thereafter, he calls back with the prices and we deal. Within two months, the stock price had dropped precipitously (I watched the April crash at Motown in Roppongi, Tokyo). I'd been buying puts on various internet stocks since late November 1999, in case you thought I was more prescient than the average bear.

Towards sumer's end in 2001 my broker called, informing me he was quitting to get a better job and we joked a bit about some of our dealings, including EXDS. Laughing, he tells me EXDS is trading at 50 cents. As our last trade together, I ask him to buy 100 shares of Exodus, and send me the certificate, which I framed.

The irony of the investment exodus from Exodus was just too rich to pass up. I plan on giving the framed certificate, along with a graph of the price, to my son as a warning.

"What magic lure did I use to land this big fish?," you might be wondering.

The "lure" I used to bag this fish comes from an apparently obscure (judging by the "dilute 'till ya' drop" rescue plans from both the Fed and ECB) view of securities' analysis which holds: 1) the present value of any security can be estimated by calculating the net present value of associated cash flow 2) other things equal, dilutive issuance of a security reduces its value by spreading that cash flow over a larger number of claims (unless, as was the case with EXDS, cash flow is negative, thus dilution actually increases per share value by dividing the loss among increased claims).

I think this same "lure" will help me bag even bigger fish, like Euro and the US$ securities. After all, both the Fed and ECB are adopting policies straight from the "Dot-Cons", hoping to dilute their way to solvency.

To be fair, they, like the "Dot-Cons" are actually buying time with the dilution. Ironically, they are likely to find, as the "Dot-Cons" did before them, the more time purchased in this way, the less one gets in the end. One good dilution deserves another, it seems.

Yet, depending on the rescue's goal, the purchased time might be sufficient. Anna Schwartz, in the paper quoted above, wondered about the goal of the 1995 Mexican bail-out:

For whose benefit was the Mexican rescue arranged? Is there any doubt that the loan package was designed to pay dollars to Americans and other nationals who invested in Tesobonos and Cetes and dollar-denominated loans to Mexican nonfinancial firms? Is that the reason emergency loans are needed? To eliminate risk from investment in high-yielding foreign assets?

The question seem just as valid today:

For whose benefit was the European rescue arranged? Is there any doubt that the loan package was designed to pay Euros to Americans and other nationals who loaned money to PIGS? Is that the reason emergency loans are needed? To eliminate risk from investment in high-yielding foreign assets?

Of course, risk is never eliminated by such actions, it is merely transferred. As noted above, however, when distributing a loss, dilution is a plus in that the per unit distribution declines. Perhaps this explains the Euro (and related market) rebound.

Alternatively, the rebound might simply be a case of Pavlov's Investors, who, like those of a decade ago, have been conditioned to buy every dilution. Of course, Pavlov's Dogs eventually stopped salivating when the food no longer followed the metronome.

My advice- don't be a dog.

I'm sure Big Financial firms are already planning their own exodus from these soon to be declining securities (and quite pleased about today's reaction), whether it's via a hedge, outright sales, or (more likely) by swapping their bad debt for sounder securities with the appropriate Central Bank (if such can then be found in sufficient quantity).  The only solvency saved by these bail-outs is that of those running for the exits.

Sometime in the not too distant future, the following will provide a template for another author to discuss an exodus from sovereign debt, instead of internet shares:

In March 2000 when Exodus Communications announced its fourth stock split in 14 months Internet companies couldn't print shares fast enough.

Mere announcements of splits were magic. Their power to propel stocks was equal to the incantations of analyst Merlins. In the poof of a press release, employee stock options soared in value, issues of new stock and convertible bonds commanded higher prices, and the ability to make acquisitions was amplified.

Stock splits became part of the Internet business model. During the period of its splitting frenzy, Exodus (nasdaq: EXDS - news - people ) issued $1.1 billion of convertible bonds and announced nine acquisitions totaling $2.5 billion.

Today, those splits are like a cherry bomb garnish in a cocktail of imploding business demand and crushing debt.

As Anna Schwartz put it: The way to ensure global financial stability is for each global financial institution to monitor and control risk in managing its own internal affairs.

What a novel idea.

Sunday, May 09, 2010

Derivatives of Mass Destruction: From "Fat Man" to "Fat Finger"

I know not with what weapons World War III will be fought, but World War IV will be fought with sticks and stones. Albert Einstein

Deputy National Security Adviser John Brennan said Sunday that the White House does not believe Thursday's Wall Street nosedive was the result of a cyberattack. The Hill

Had Mr. Einstein lived long enough he would not have been ignorant of WWIII's weapons- they are financial in nature, and, instead of "Fat Man" and "Little Boy", modern WMDs are called Credit Default Swaps (CDS) and are ignited by a "Fat Finger".

The need to hedge derivative portfolio "delta" (sometimes in amounts far exceeding the underlying security's total value and often "computer driven") makes financial markets very vulnerable to "Fat Finger" problems (or any multi-standard deviation price changes). It's a WMD (not confined to CDS, hedging is common to all derivatives) waiting for a trigger.

We need to dismantle these WMD, instead of focusing all effort on stamping out the next lit fuse

Unconvinced?  Think I'm (falsely) "shouting fire in a crowded theater"?

Read on.

In theory, CDS provide securities' owners a means to cheaply insure against their default. By paying a (or series of) small premium(s) (usually far smaller than the security's yield) the risk of default is swapped to the CDS seller.

In theory, as with all derivatives (in a former life I used to trade these things), sellers can instantaneously hedge (for instance, by selling the security issuer's stock, bond, or currency) the assumed risks, deriving (sellers hope) profit from the received premiums less any hedging costs.

In practice, (as I learned, painfully) trying to maintain hedges in fast markets (and I traded foreign exchange- a pretty liquid arena) can be impossible. Worse, as price deviation from last hedged position grows, the amounts to hedge grow as well. A .5% move in the underlying might call for a 10% hedge, while a 2% move might call for 35% and so on.

Adding insult to injury, all those hedges may have to be unwound if prices come back to "normal". Among traders, market chasing as described above is called hedging "bad gamma" (which is about as fun as having "bad karma").

In practice, CDS are not primarily used as insurance. They are, more often, purchased "naked", not to hedge against a default, but to bet on it, and perhaps, as you'll see, to actually accelerate it, particularly if one could, through naked purchases in greater amounts than existing underlying securities, force hedgers into selling over-drive.

I suspect events like last week's panic in equity markets will become far more frequent so long as CDS (in particular) use, and thus necessity of hedging thereof, continues to grow.

Warren Buffett, before a Galileo-like recantation and rebaptism in the church of TBTF finance, was a pioneer in recognizing derivatives as financial weapons of mass destruction. Like the nuclear weapons of WWII, modern WMD are examples of tremendous leverage- tiny amounts of fissile material or premium, respectively, explode with enormous yield, wrecking horrific damage.

Unlike atomic weapons, whose direct effects are limited to a blast and radiation radius, modern WMD, like CDS use high speed connectivity and computer driven hedging as transmission mechanisms. The "Fat Finger" ignites a "critical price deviation" forcing hedgers of naked CDS to (try to) sell what might be many multiples of available securities.

Thursday's market action might in the future be seen as the Trinity test of the financial Manhattan Project, broadcast live to anyone in the world with an internet connection.

Fortunately, just as atomic weapons require radioactive cores, so too do our CDS WMD. In the latter case, the underlying core (financial entity) must be highly leveraged. Instability, either at an atomic or financial level, is key to explosive yield. Trying to force default in an unleveraged, highly solvent financial entity would be about as fun as using carbon-12 instead of uranium-235 in an atomic bomb.

In other words, while real world WMD deterrence might require a missile shield, financial WMD deterrence might require a solvency shield. The more solvent, and less leveraged a company becomes, the less it needs to respond to the whims of the markets.  It can just go about its business.

Highly leveraged financial companies like Lehman and Bear Stearns were prime "fissile" material- so unstable they needed daily financial stabilization. Unfortunately, there seems to me to be far more financially unstable material laying around than fissile isotopes- Wall Street finance being far more effective than, say, Iranian centrifuges.

On the bright side, fears of "Fat Fingers" igniting naked CDS into financial WMD might someday be seen in the same light as plans for mutually assured destruction (MAD)- as signs of the need to dismantle armaments. Perhaps Homeland Security should audit the Fed, and dismantle the highly leveraged and unstable financial cores we've strategically placed around the nation.

Either that or people of the future might visit New York as they now visit Hiroshima and Nagasaki- looking at a plaque commemorating the destruction caused by a "Fat Finger" instead of a "Fat Man" or a "Little Boy".

Who knows, maybe in addition to Arms Control, Capital Control will be a national security matter.