Rogoff, Reinhart, and minding your "D'oh"s and "Duh"s

"D'oh!" according to the Oxford English Dictionary (really!) is self--and-past-referential (think "eureka" with a self-deprecating slant) while "duh" refers, insultingly, to others without any sense of time.  In the words of Matt Groening, "so, you might say 'D'oh!' when you've been stupid, and 'Duh!' when you think someone else is being stupid, but then duh!, everyone knows that, right?"

Timing, as the saying goes, is everything.  In Carmen Reinhart's and Kenneth Rogoff's experience timing is the difference between enjoying bestselling author status and wearing a (metaphoric) dunce cap.  Examining centuries of history and most major trading nations of earth, This Time Is Different, their impressively researched, financial perspective on financial crises won them great fame, credibility and, I assume, money.    Based on the same data and premise- too much debt is bad- their paper,  "Growth in a Time of Debt", merely narrowed its focus to the public sector.   Their timing, and tone, with the benefit of hindsight, couldn't have been worse. 

Why?    

It's as simple as the difference between "D'oh" and "duh" and an interesting mental habit known as confirmation bias.

As evidenced by the wild who, how and why speculations following the Boston Marathon bombing, people's search for meaning in the face of disaster often leads inside rather than out.  Upset when the unthinkable becomes real, the threatened mind redoubles its efforts confirming other assumed aspects of "reality."  Those fearful of radical Islam before the bombing weren't surprised when first a Saudi National, and then Chechen immigrants were labelled suspects.  Their bias confirmed, no further questions needed to be asked.

This mental habit has its virtues. Imagine feeling the need to thoroughly examine a table's stability before putting a coffee mug down?  or a road's stability before driving?  A quick biased glance usually suffices for most.  Expertise in a field depends, in part, on informed bias.  An experienced auto mechanic (at least back when human diagnostics were the norm) usually narrowed down problems after a few questions, glances and a listen (whether they used this information to save you money is another matter entirely).

Sometimes, however, even well-informed bias misses warning signs hindsight, informed by consequence, can't ignore.  Homer Simpson's famous "D'oh!" got laughs because we've all been there.

For Reinhart and Rogoff, however, the crisis of 2008 wasn't a "D'oh" but a "duh" event.  Their bias wasn't a revelation occasioned by the crisis, its roots, as I'll soon explain, are much older than that.  The revelation was that others, influential others, didn't share their bias and maybe they could change that.

Years before This Time is Different was conceived Mr. Rogoff revealed his bias in a letter to Joseph Stiglitz just dripping with "duh": You seem to believe that if a distressed government issues more currency, its citizens will suddenly think it more valuable. You seem to believe that when investors are no longer willing to hold a government's debt, all that needs to be done is to increase the supply and it will sell like hot cakes. We at the IMF—no, make that we on the Planet Earth—have considerable experience suggesting otherwise. We earthlings have found that when a country in fiscal distress tries to escape by printing more money, inflation rises, often uncontrollably. Uncontrolled inflation strangles growth, hurting the entire populace but, especially the indigent. The laws of economics may be different in your part of the gamma quadrant, but around here we find that when an almost bankrupt government fails to credibly constrain the time profile of its fiscal deficits, things generally get worse instead of better.
 
Ouch!

In book form, their bias won them fame and fortune by eliciting "Doh"s.  Unlike the letter excerpt above with its reference to different laws in your part of the gamma quadrant, their book modestly hoped to give future policy makers and investors a bit more pause. 

That same bias, in the follow-up paper more closely resembled the letter in tone than the book.  In Congressional testimony, Carmen Reinhart wasn't sharing their bias to give pause, but to form policy.  Stripped of some nuance, and thus more actionable (politicians dream of such one-handed economists) correlation became dissent quashing causation. 

A unilateral causal pattern from growth to debt, however, does not accord with the evidence. Public debt surges are associated with a higher incidence of debt crises. In the current context, even a cursory reading of the recent turmoil in Greece and other European countries can be importantly traced to the adverse impacts of high levels of government debt (or potentially guaranteed debt) on county risk and economic outcomes.

There is scant evidence to suggest that high debt has little impact on growth.

Duh (ok, she didn't say that)

Another thing she didn't say was: In most instances, with enough pain and suffering, a determined debtor country can usually repay foreign creditors. The question most leaders face is where to draw the line. The decision is not always a completely rational one. Romanian dictator Nikolai Ceauşescu single-mindedly insisted on repaying, in the span of a few years, the debt of $ 9 billion owed by his poor nation to foreign banks during the 1980s debt crisis. Romanians were forced to live through cold winters with little or no heat, and factories were forced to cut back because of limited electricity.  
Reinhart, Carmen M.; Rogoff, Kenneth (2009-09-11). This Time Is Different


I copied the above from their book and am not surprised Reinhart didn't share it with Congress.  The story didn't fit what she was trying to sell.  In the event, Ceausecu's policy of austerity led not only to revolution, but his own execution.  That tale would have made for bad "optics" as they say in Washington.

 
Switching tone from "D'oh" to "duh" has its perils as explained here:  Duh is more derisive than doh. Perhaps because the word is associated with Homer Simpson, doh has a humorous quality about it. Duh is sometimes deployed with humorous intent, but more often for the purpose of mocking oneself or another. Put another way, saying duh in the wrong place at the wrong time could ignite a bar brawl. To my knowledge, no physical violence has ever been sparked by the word doh.

Dissenting economists, who'd previously been civil, dropped the gloves. Preferring to brawl in words and numbers rather than fists, the growing number of dissenters increased their scrutiny of the data.  Hell, it seems, hath no fury like an economist duh-ed.  Like Joe Wilson  fighting "stove-piped" data and the 16 words the dissenters' charges of cherry picked data, un-reproducible results, and excel coding errors started flying.  The damage, however, had been done.  Austerity in policy circles became a "duh".  I hope the bias doesn't lead to self-fulfillment.

In the event the US might have muddled through but for this, don't assume I'm laying the blame entirely on their, no doubt, well meaning shoulders.  To me, their bias was a catalyst which ignited another more commonly held bias.

Money not only matters, it matters a lot.

Hoping to give pause to austerity cheerleaders I'll offer a dissenting opinion (most likely to a chorus of "duhs" from the dissenting economists noted above).  It's not so much the size of the debt, it's what you do with it that matters.  Duration, source and relation of debt to current growth shouldn't be ignored but, in my view, the use of debt generated funds and the context of time and place are at least as important considerations.  While nothing is guaranteed in such matters, debt incurred to build hoped to be productive capital shouldn't incite as much worry as debt incurred to buy sports cars and vacation homes (or debt incurred to pay banks to hide the true level of debt).

What we in the US have been doing with debt sourced funds is a study for another time.  What we will do with it in the future is still unwritten.

Goldenfreude? how about Bankenfreude

Cheer if you will Goldbug bashers, but I suspect if Gold starts another swan dive, it won't be alone.  There may even come a time when you wish Gold would rise.

"Triumphalism," Paul Krugman opined in a 1997 New Republic article, "presents its own problems." Under the, dare I suggest, ironic headline, Superiority Complex, Mr. Krugman completed his thought: " though the "American model" has scored some important successes, it continues to fail in other respects, above all in generating an ever-increasing level of inequality. And we won't begin to address those failures if the national mood remains dominated by self-congratulation." He closed the article with sage advice for his readers: "The truth is that nothing in the experience of the last few years contradicts the idea that we could have a kinder, gentler economy that preserves the main virtue of the American system--high employment. All it would take is compassion. And a little less gloating."

Compassion, and a little less gloating might also help Mr. Krugman understand, rather than mock, Goldbugs- a label which, contra Krugman's caricature thereof, denotes a group exhibiting a very wide range of economic/investment views- while they are nursing their recently suffered monetary wounds. I imagine for every gold hoardin', gun totin', doomsday preppin' angry white male proclaiming the end of the world (they annoy me too),there's at least one confused, upset and perhaps unemployed person who's fed up with Wall Street's "head's I win, tails you lose" investment strategy, (or one, like myself, who believes structural reform-blocking rigidities in the developed world won't be overcome easily leaving only 2 eventual paths for excess liquidity, inflation or default). Those confused and unsettled Goldbugs, having witnessed a succession of bursting investment bubbles at home and more recently read about bank runs abroad might, not without justification, have decided to save in Gold, rather than a bank, or his mattress.

Mr. Krugman, alas, is not gloating alone over Goldbug's recent misfortunes. One clever soul coined the term Goldenfreude to describe his state of mind. Joe Weisenthal proclaims, EVERYONE Should Be Thrilled By The Gold Crash- a view echoed by Felix Salmon. Barry Ritholtz leavened his disdain for Goldbuggery with a sliver of compassion, I do not want to engage in Goldenfreude — the delight in gold bugs’ collective pain — but I am compelled to point out how basic flaws in their belief system has led them to this place where they are today. Gold, he avers, has no fundamentals and those who buy are engaging in the ultimate greater fool trade.

While living in SE Asia during their late 90s crisis I witnessed first hand one of Gold's great virtues- when a nation's banking system, and almost always coincidentally, currency, comes under pressure Gold holds its value. The haircut recently forced on Cypriot savers was far less than that inflicted on Gold by the market. In other words, despite recent declines I'd rather be holding Gold in Cyprus than waiting in an ATM line to withdraw my daily allotment of currency.

America, the gloaters might retort, is not Cyprus. No, it isn't, and I (casting off one aspect of Krugman's Goldbug caricature) sincerely hope we don't find ourselves in their financial straits. My bet is that such can only be avoided by further monetization AND, in the absence of rapid real sector productivity gains which don't exacerbate income inequality induced domestic tensions (unlikely given right wing intransigence on welfare state expansion or a domestic Modest Proposal a la Swift), wage and price inflation.

"A ha," Krugman, beating his gloating compatriots to the punch, would likely argue, "you Goldbugs are always talking about runaway inflation. Didn't you read my recent article mocking your inflation worries thusly: "But the runaway inflation that was supposed to follow reckless money-printing — inflation that the usual suspects have been declaring imminent for four years and more — keeps not happening."

I agree, and the absence of broad based inflation given the stimulus in an environment of limited structural reform outside the developing world is my concern. I suspect if Mr. Krugman would stop gloating, it might be his too (more on this below).  If the recent decline in Gold signals, as many gleefully hope, a decline in inflation expectations, might the US, and, I suspect, other mature industrial economies (Europe and Japan) be drawing ever nearer to a stall in growth followed by a liquidity crunch?

Consider this potential catalyst for the Gold crash. "Macroeconomic stimulus," said a US Treasury FX Report chiding Japan for the recent, now reversed, Yen slide, "...cannot be a substitute for structural reform that raises productivity and trend growth." We'll return to structural reform momentarily after a look at market reaction. The Yen's rapid recovery following this report's release was coincident with the Gold crash- perhaps both price adjustments represent market belief that inflation games (currency debasement either externally or internally) won't be tolerated.  With austerity the rage in European policy circles (we aren't far behind in that regard, thanks to the Republicans), competitive devaluation verboten and Gold signalling, to the cheers of many, declining inflation expectations, I'd be surprised if yet another liquidity crunch isn't around the corner.

Factors Behind the Forecast:  Structural Rigidities and Over-Leveraged Finance

Despite recent record profits, the US financial system, still dependent on a few highly leveraged (how else to achieve such profits in a low interest rate environment) TBTF banks, is far from stable. Many mortgaged home-owners are still looking up at the zero-equity line. Those cheering the absence of inflation simply, it seems to me, because such makes Goldbugs look stupid, might want to consider that in a highly leveraged economy, the cascading defaults of deflation- the "it" Bernanke assured us wouldn't happen here- always loom in the background.

Cheer if you will Goldbug bashers, but I suspect if Gold takes another swan dive, it won't be alone. As we've seen over the past few days, Gold price declines are mirrored to various degrees by oil, other commodities, and equities. Declining prices, if such becomes the trend, will lead to higher unemployment and, amplified by the former, declining house prices and rising foreclosures. In the teeth of such an event, some might be yearning for the days when Gold was rising and inflation was assumed. I'll admit, such a scenario favors the dollars-saved-in-a-mattress strategy rather than Gold ownership but both tactics are anti-investments ridiculed by Goldbug bashers.

The elephant in the room for the Goldenfreuders is the lack of structural reform in the developed world- an omission perhaps due to a focus on high frequency and exclusion of low frequency economic factors. Structural reform, for those unfamiliar, refers to changes in the capital structure (factories, transport systems, education programs, agricultural methods, etc.) that hope to produce more for less. China's rapid economic growth over recent decades is, in large part, an effect of these reforms such as the shift, in 1978, from communal to industrial farming.

Significant structural reforms are often resisted.  Consider the resistance some individuals display when asked to eat less, drink and smoke less, and exercise more.  Note, "when asked."  Change is much easier (but not guaranteed) when it's wanted.  Consider, for example, the rapid adoption of computers and cell phones.  I doubt even severe coercion could have done half as much in twice the time.  Fortunately the benefits of these new technologies were readily apparent and despite some resistance by, e.g., book store owners to Amazon, those individual losses were smaller than the aggregate productivity gain.  Those productivity gains created an environment where jobs were plentiful, further easing stress caused by the destruction economic creation usually entails- agriculturalists rarely coexist harmoniously with hunter gatherers but they produce more food per acre meaning, if the latter adapt to the new system, both groups can survive.

In cases when reform calls for the destruction of wealthy industries with government ties, substantial legal changes, or labor downtime and re-education for a significant portion of the work-force (especially in the absence of a decently funded welfare state), resistance can effectively block what would likely be widespread productivity gains.  Pre WWII rail transport in continental Europe seems a case on point.  International disagreements over railway standards and routes (an example of structural reform-blocking rigidities) kept the continent from reaping the productivity gains a fully connected rail system promised- and delivered, after a devastating war cleared away both dissent and, sadly, large chunks of the old rail system.  Expanding on von Clausewitz for the modern world (which finds the more apt term, political-economy, too archaic) war is not just politics by other means but economics by other means- the worst means, in my view.

Structural reform-blocking rigidities are, in a sense, other words for productivity sapping rent seeking- e.g. from a bottom up perspective, Luddites breaking machinery or US autoworkers striking to avoid being replaced thereby, and from a top down perspective, trade barriers (tariffs) or de jure monopolies (Britain's BBC prior to 1955).  Profits and Investments in rent seeking industries, particularly when higher productivity methods are known and feasible, tend to be misdirected from entrepreneurial activity (why make a better or cheaper widget when it's cheaper to bribe a competition stifling official?).  Bribery doesn't seem to me a very economically productive activity although it obviously benefits some while irking others.

For an example of a structural rigidity overcome consider recent changes in US law which reduced regulations on where and how (think fracking) petroleum products can be extracted.  Fracking has changed N. Dakota from a deficit to a surplus state and driven unemployment to near zero.  Before you send me a nasty-gram, I'm not arguing such is an unalloyed good- insufficient profits are likely flowing to those who have been and certainly will be negatively affected (this is no environmentally neutral practice).  I'm merely pointing out the positive economic benefits thereof.

To digress for a moment, first with an apology to the economically literate for the rudimentary and likely (to some) unsatisfactory treatment of these issues and second with further explanation thereof: the ideological (and physical) battle between communism and capitalism over the past two centuries is the battle between productivity and people.  In my view, productivity is most effectively and durably enhanced at an imaginary "sweet spot" between radical laissez faire (think Ayn Rand) and communal ownership (Marx).  Transfer payments, whether private (charity) or public (government welfare) are, in my view, necessary to ensure social cooperation within the capitalist framework.  Domestic dissent is a sign that transfer payments are, whether as a result of insufficient funds or inefficient distribution, not performing their function.  Labor dissent in many developed economies (Occupy and austerity protests in America and Europe respectively) suggest to me a hopefully solvable but currently intractable transfer payment crisis.  The pendulum has swung too far right which isn't meant to obviate calls therefrom for greater transfer payment efficiency.

Cheers for the Gold crash sound to my ears like cheers for austerity in Europe and further dismantling of the welfare state in the US. If Japan needs inflation now, don't we as well? Perhaps we too should join the Euro? and give up our right to buy time with inflation?

I'll close with a look at another structural reform-blocking rigidity whose removal might justify a moment of schadenfreude. The phrase "Too Big To Fail" speaks to a de jure monopoly of sorts for those protected banks.  Potential competitors were blocked from taking over business which would have looked elsewhere for financial services absent government support.  Competition was stifled and the public debt increased.  I believe, but for delusional faith in the virtues of these institutions (more below), a less costly, competition enhancing solution could have emerged from the crisis of 2008 and resolving that rigidity would have eased tensions between labor and capital. 

Consider: Would current budget negotiations in the US be so contentious in the absence of the recent bail-out and additional debt incurred?

Returning to the delusion, TBTF banks remind me of Alchemists wasting labor and resources trying to turn lead into gold, or, more accurately, trying to squeeze more profit out of trade than trade generates.  Finance, at best, facilitates trade. In practice it records, analyses, calculates and communicates. What Amazon did to the local book merchant a similar company (or 5 or 20) can do even more effectively to finance.  Surely networked computing should decrease the cost of finance for the rest of the economy. 

On the bright side, the presence of rigidities suggests greater future productivity upon their resolution, although it would be tragic if such resolution comes via violence rather than diplomacy.  I believe a new cooperation enhancing agreement between labor and capital is possible.  Given the European example, I believe American energy efficiency can be increased.   As noted above, I believe American financial efficiency can be greatly enhanced through the dissolution of TBTF. 

When that happens I'll suggest a new word- Bankenfreude- and might even indulge in some myself.  I'll swap my Gold for currency and put it back in the game.  Until then, I'll remain a Goldbug.

Full disclosure (if it wasn't obvious) I own gold.

When is a Non-Default a Default?

'When I use a word,' Humpty Dumpty said, in rather a scornful tone, 'it means just what I choose it to mean — neither more nor less.'

'The question is,' said Alice, 'whether you can make words mean so many different things.'

'The question is,' said Humpty Dumpty, 'which is to be master — that's all.'

The US Government, according to most press reports, has, by virtue of a last minute- a self-designated limit, it seems worth noting- deal, avoided default.  Amazingly, both the process and situation are even more confusingly convoluted than my opening sentence. 

Imagine a world in which the debtor determines whether or not he is in default.  In that world defaults would be rare events indeed.  Alas for the debtors, but fortunately for the solvent, our world doesn't work that way, no matter how things might appear. 

In our world, debtors don't determine default, creditors do. 

Here's what some important US Government creditors have recently been saying:

1) China: (Xinhua News) With its debt already almost equaling its gross domestic product, the United States, as a major anchor of the increasingly globalized world economy and the issuer of the dominant international reserve currency, needs to roll out more responsible and effective measures to balance its budget and restore the economic health of itself and the world.

2) Russia: (Reuters) They are living beyond their means and shifting a part of the weight of their problems to the world economy...They are living like parasites off the global economy and their monopoly of the dollar. - Russian Prime Minister Vladimir Putin

3) China: (RawStory) China's foreign exchange reserves will continue following the principle of diversified investment, enhancing risk management and minimising the negative impact of volatility in global financial markets," People's Bank of China governor Zhou Xiaochuan said in a statement.

"Large fluctuations and uncertainty in the US treasury bond market will affect the stability of international monetary and financial systems, which will hurt the global economic recovery."

Also on Wednesday, the Chinese ratings agency Dagong downgraded the United States for the second time since November, with a continuing negative outlook.

Meanwhile my preferred measure of US credit worthiness (and market in which nations of less military prowess might express their views more safely), the value of Gold in US$s continues to set new records.

With combined holdings on some $1.28T of US Treasuries, China and Russia are, unlike the US, in a position to declare the US in default, which brings us back to the big egg.  Humpty Dumpty's great fall might prove prophetic (and hopefully, beneficially cathartic) but it's his words that haunt me.

The question is, which is to be the master- that's all. 

Once words (like default, creditworthy, war, ally, etc.) lose their agreed upon, dictionary meanings, might is eventually used to make right.  The US Kabuki Play that was the debt ceiling debate has apparently failed to convince our militarily armed creditors we have jumped back from the abyss.  They seem to think our non-default still looks like a near default, and are taking action.  Will we continue our dance, putting off hard (but oh-so-necessary) decisions hoping to distract our creditors with drama, or will we make honest strides towards resolving our debt issues, which, first and foremost, must include growth policies (of the non-rent-seeking kind)? 

As an aside, the notion that our debt problems can be solved simply through broad spending cuts or tax increases is absurd to me (and likely to our creditors).  If the US economy does not resume growing fast the Washington crowd can crow about avoiding default all they want, but the rest of the world will know otherwise and act accordingly. 

If the Washington crowd chooses the former "more of the same" option, we might have to have a contest (a.k.a. War) to answer Humpty Dumpty's question- which is the master?

In hindsight, it might have been better to self-declare default and immediately start picking up the pieces instead of watching and waiting while the big egg teeters on the precipice.  After all, we know how the rhyme ends.

Luckily, capitalism doesn't require putting the pieces back together again.  Indeed, capitalism works best when the broken pieces are used to make newer, better things than a silly egg on a wall, destined to fall.

Full Disclosure: Long Gold

After Osama

Osama bin Laden, according to CNN, has been killed in a firefight with US forces in Pakistan and his body has been recovered.

Almost a decade ago, bin Laden, in hopes of, according to some reports, inspiring a jihad and bleeding US financial strength, inter alia, directed the attacks on the Twin Towers and Washington D.C.

Now, only his ghost remains.  The jihad he hoped to inspire has thus far been thankfully quashed, but the US has been bleeding financially for that decade.

What next?

Aside from a substantial increase in Prez. Obama's political capital, which might deflect the right wing's attempts to dismantle the welfare state, inter alia, (and thus indirectly shift market sentiment, to wit, increase negative sentiment on US bonds) direct effects on market psychology and prices (and eventually the underlying fundamentals), at first blush, include:

1) A temporary (duration dependent on, inter alia, announced US policy changes in the next few days) resurgence in $ assets, and consequent decline in Gold and Silver. A rise in US debt market prices. A decline in oil prices.

2) Increased speculation on oversea troop levels in Afghanistan- will they be brought home, will they be redeployed, will they remain the same?

3) Will the Islamic world, in the event troops remain in Afghanistan or are redeployed either in Iraq or Libya, come to the view that US peacemaking after Osama is colonialism in disguise?

4) Medium term, a status quo military presence in the Islamic world, with a significant cause célèbre removed, will not only continue to negatively impact the US budget, it may also increase Islamic resistance (thus further increasing the price of military action), and reduce foreign willingness to finance what may seem more like colonialism than peacekeeping.

The ball is in the Obama administration's court.  Like 9/11, this is a key pivot point.

Much has changed in the US over the past 10 years.  Will this opportunity to change course be grasped, as a similar opportunity was grasped in the aftermath of 9/11?  Will the story simply fade from media consciousness in a few days- signaling an opportunity squandered (or deftly avoided depending on perspective)? What, if any, will the new course be?

From a financial perspective, this seems to me a wonderful opportunity to begin to significantly reduce military expenditure without losing face at home.   US military adventures abroad since 9/11 brought forward the US budget's "day of reckoning" by many years.  Either the US buys some time by reducing such expenditure or the financial day of reckoning will continue to creep forward. 

Without the goal of bin Laden's capture as cloak of respectability, assuming military deployments continue unchanged, the financial day of reckoning might leap instead of creep forward as foreign demand for US debt and willingness to sell oil "cheaply" dries up further.

Ten years ago the world went to war.

What next?

Full Disclosure: Long Gold

S&P Downgrade: Be Afraid, Be Very Afraid

In boom times, credit rating agencies, like S&P, are thought to have the foresight of the Fates- figures of Greek (et al.) Mythology who spun, measured, and cut the threads of life.  As boom turns to bust, these credit rating agencies fall into the trap of spinning too much thread which is only measured and cut after credit death occurs. 

After getting caught looking in the rear view window a few too many times, our Fates of credit appear to be attempting an image rehab with Big Game- the long term credit rating of the United States.  Of course, as S&P is made up of real people, not mythical figures, they aren't as brave as Clotho, Lachesis and Atropos and thus are merely threatening to measure the life-span of US AAA credit (i.e. shifting the outlook to negative), rather than pronouncing a definite end.

For my money (and let's be clear, the debt under review is that upon which the $s in my pocket are valued) S&P's focus on the debt ceiling sideshow in Congress as catalyst for default is likely misguided.  Then again, I wouldn't be totally shocked to see the newbies in Congress force a default of a few bond payments just to make the Prez (who gets no more respect from me since his invasion of Libya) look bad and thus win more votes.  Yes it would be colossally stupid and therefore, not out of the question.  S&P puts the odds at 1 in 3.

Assuming Congress avoids the colossally stupid option and raises the debt ceiling, the "no risk of US default" views of Barry Ritholtz and Yves Smith et alios would seem to suffice.  The US issues the currency in which its debt is paid, in somewhat similar fashion to the Tech companies of the 90s.  So long as our foreign creditors continue buying US debt, default would be self inflicted.

If I was playing the role of the credit fate, Lachesis, who measures the thread, I wouldn't be watching the shenanigans in Congress but rather our creditors' perception of rising confusion and dissent in the US.  Our nation seems adrift in a self-inflicted sophisticated fog. 

We are promoters of freedom currently engaged in 3 colonial projects (Iraq, Afghanistan and now, Libya) which engenders great confusion.  We want control, but we don't want to be seen grabbing it coercively.  We are confused.  Colonies, as history attests, are difficult ventures when such policies are overt.  Covert colonialism seems to me a contradiction in terms.   

Congressional pissing matches over the debt ceiling are another sign of great confusion.  Those who cheer Tea Party "balance the budget" principles would, in the event the right flexes its muscles, discover the rapid reduction of government employment and spending in a highly leveraged economy creates most unpleasant effects. 

This isn't to argue against deficit reduction in general (I suspect terminating our covert colonial ventures and redirecting that labor force back home on infrastructure would go a long way towards solving many problems) just the method on offer.

Worse than our confusion, from the perspective of the single party Chinese, is the dissent, notably that from S&P.  While the Chinese ruling party has apparently learned to deal with US political kabuki, the notion of a US ratings agency downgrading its outlook on US debt must strike them as odd indeed.  Having invented paper money, the Chinese know it rests on faith- faith that is eroded by dissent, ergo their rigorous crackdowns on such. 

Eventually the Chinese, whose faith in US economic policy making was shaken during the debt crisis of 2008-09, will tire of the confused games in the US and force us to deal with them with real currency, not the funny money we call US Federal Reserve Notes.  Far worse for the US than default is enforced real currency dealings.  As with all sophisticated cultures, reality is a bitch.   

Will the US sell Manhattan?

Those who face insolvency, Mr. Schlarmann, a senior member of Germany's Christian Democrats, said, must sell everything they have to pay their creditors. Thus, he said, Greece, given its debt problems, should consider selling some of its uninhabited islands to cut its debt.

The headline in the Bild newspaper took the argument a bit further, "Sell your islands, you bankrupt Greeks - and the Acropolis too!"

I guess we might call this the Andrew Mellon approach to sovereign debt crises- liquidate, liquidate, liquidate, on a national scale. It's a strategy which, if Niall Ferguson's argument-which contains the wonderful line, US government debt is a safe haven the way Pearl Harbor was a safe haven in 1941- that the US, and other western nations, may soon follow Greece into crisis, proves prescient, might inspire calls for the US to sell some islands, like Manhattan.

Perhaps selling the island outright might be a bit much. Yet, while the Chinese Government isn't a fan of the Dalai Lama it might appreciate the Karmic touch of leasing Manhattan from the US for, say, 99 years. Imagine the road signs, "Now Entering New Hong Kong."

In a sense, assuming Wall St. and the NY Fed were included in the lease, it would be the ultimate "pump and dump"- temporarily stabilize the financial system, in large part with money from Asia, and then dump it, and the derivatives portfolios contained therein, on China. Why wait for the next financial crisis to go hat in hand to Asia. Let's sell Citibank at $4 instead of waiting for it to fall under a buck.

The world might even benefit from such an arrangement. Yesterday, Paul Volcker told the House Financial Services Committee that regulators, like the NY Fed, are unlikely to rein in excessive Wall St. speculation. If the Chinese get the NY Fed, and thus oversight of financial markets, their no-nonsense approach to dealing with corruption, which includes the death penalty, might help finance get back on the "straight and narrow." I'd love to see Lloyd Blankfein testify to the Chinese Communist Party.

A man can dream, can't he? And who knows what the future will bring. I doubt the Ottoman, Mughal and Manchu Empires could have imagined that the West would take over administration of their territories.

Fortunately, at least for Wall Streeters wary of Chinese justice, the German proposal fell on deaf ears. Yet, the seemingly intractable problem of many western governments' unsustainable debt levels remains.

Niall Ferguson argues that the problem is the welfare state- perhaps he should take on Keynes with a new book, The Economic Consequences of the Welfare State. I suspect, however, improper- to the extent such policies are seen as wise means of avoiding social unrest- welfare state funding is but a symptom of an apparently widely held view by many in both public and private sector positions of power that, in the words of Dick Cheney, deficits don't matter. 

War finance and Wall St. bail-outs played at least as large a part as welfare spending in US Federal Debt doubling since 2001.   Those bail-outs, in turn, were made necessary by Wall St.'s take on Cheney's wisdom, which they express as, too big to fail.

Contra Mr. Cheney, deficits, which add up to debt over time, do matter.  Contra Wall St., no insitution is too big to fail.  Both views are, in my view, effects of a broader issue.  There is no agreed upon method, barring adoption of island sales, for sovereign debt resolution. In decades past when nations retained currency sovereignty devaluation was always an option, and fear of devaluation kept investors on their toes. The more recent desire for supra-national currencies turns countries like Greece into states like California with very limited options.

If current trends continue, nations like Greece and states like California might simply be absorbed into larger bodies. Greece could become a special administrative region of the EU and California could become a district of the US Federal Government. Yet this would simply buy time, making the ultimate sovereign debt problem that much harder to resolve.

If the world is ever to reform global finance it will need, first and foremost, to agree upon a method of debt resolution applicable to all large institutions, public and private.   So long as those running large institutions feel there are no consequences to deficits, debt problems will continue to mount.  If we are going to use money to drive the world, we need to take it seriously.

The Mask of Solvency

On reading the news of Goldman Sach's involvement in the Greek Government's heretofore successful plot to negatively obscure their fiscal position from the rest of the world (with the notable exception of Goldman Sachs, it seems worth noting) a vision sprang to mind. In it, a group of Greek Finance Officials are seated on one side of one of those over-long conference room tables found in the upper floors of modern office buildings facing two people from Goldman Sachs- Europe's Chief Institutional Derivatives Salesman and his mid 20s blond bombshell assistant.


After the obligatory pleasantries are completed the assistant distributes folders to the Greek Officials, bending over slightly in front of each man in the process. "As I was saying on the phone, Gentlemen," the GS salesman interjects, interrupting the not well concealed ogling, "we at Goldman Sachs can structure a portfolio of derivatives to hide your true fiscal position from both potential investors and the prying eyes of the European Central Government. We call it, 'The Mask of Solvency' portfolio."

Fade out.

What an interesting name, and notion; The Mask of Solvency- a means for the insolvent to appear to all but the most discerning observer as solvent as the best AAA credit, e.g. the US Government (irony intended).

The invented-but-still-possibly-accurate name of the GS ploy reminds me of a book on Psychopaths by Psychiatrist Hervey Cleckley, The Mask of Sanity. The depiction of Psychopathology seems to me a most useful prism through which to view current financial affairs.

To wit (from the book): It must be remembered that even the most severely and obviously disabled psychopath presents a technical appearance of sanity, often one of high intellectual capacities, and not infrequently succeeds in business or professional activities for short periods, sometimes for considerable periods.

More often than not, the typical psychopath will seem particularly agreeable and make a distinctly positive impression when he is first encountered. Alert and friendly in his attitude, he is easy to talk with and seems to have a good many genuine interests. There is nothing at all odd or queer about him, and in every respect he tends to embody the concept of a well-adjusted, happy person. Nor does he, on the other hand, seem to be artificially exerting himself like one who is covering up or who wants to sell you a bill of goods. He would seldom be confused with the professional backslapper or someone who is trying to ingratiate himself for a concealed purpose. Signs of affectation or excessive affability are not characteristic. He looks like the real thing. Very often indications of good sense and sound reasoning will emerge and one is likely to feel soon after meeting him that this normal and pleasant person is also one with high abilities. Psychometric tests also very frequently show him of superior intelligence. More than the average person, he is likely to seem free from social or emotional impediments, from the minor distortions, peculiarities, and awkwardnesses so common even among the successful.

The idea of a mask of solvency must have seemed like a stroke of genius to those whose masks of sanity had faded as far from conscious awareness as breathing. Successful arbitrageurs, after all, are well practiced in accepting the facsimile of a thing as the true thing itself. Thus, for most, the S&P 500 future is seen as identical to a portfolio of those 500 stocks, even though it only delivers (or takes) cash on settlement. As with the psychopath itself, only careful observation of behavior in all facets of life distinguishes the arbitraged facsimile from the true thing.

Usually, the distinguishing characteristics only manifest, i.e. the masks slips, as seems the case with Greek debt, when the damage has been done.

Or is damage done? Is there a difference in experience between merely the appearance of a thing, or quality, like solvency or sanity, and that thing or quality in truth?

It seems man has been pondering this question for Millennia, which is to write that it is a question each person apparently needs to answer for his or her self. In Plato's Republic Socrates asks if there is a difference between a man who appears Just but is not and a man who is truly Just. Athens too, it seems, had its share of Psychopaths in positions of influence inspiring such questions.

In our modern, financially centered system, Solvency, not Justice is the issue. Recasting Socrates' question, Is there a difference between a financial entity which appears solvent but is not, and one that is truly solvent? Would it not be better, as Socrates' listeners asked (about Justice) in the Republic, to enjoy the extra consumption afforded those who can mask their insolvency?

Socrates argued against such a view, while admitting that those so masked might reap temporary benefits. His reward for such truth-seeking views was death ordered by an Athenian Government which was in the process of devolution from the core of a great empire to a city with little sovereignty.

Whether the question has been answered accurately is up to everyone to individually decide.

One wonders if any of the Greek Finance Officials recalled Socrates' views when offered the Mask of Solvency. Regardless, I suspect Socrates' wisdom is now evident to them.

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)

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.

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 stable.  Nouriel 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.

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, i.e.at 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

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.

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.