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THE PRICE OF THE FIRST CIGARETTE
“The human race, to which so many of my readers belong, has been playing at children’s games from the beginning, and will probably do it till the end, which is a nuisance for the few people who grow up.” ~~ G. K. Chesterton, The Napoleon of Notting Hill (1904)
Every morning around 8:00, I exit the Standard Oil building in downtown Baltimore, walk to the edge of my block, insert 50 cents in the newspaper box, and I pull out one copy of the Baltimore Sun. Not the entire stack of freshly printed papers, mind you. Only one copy, just as most people in America do.
Unless you have fallen on hard, rock-bottom times and hope to make a few bucks by pilfering the entire stack of papers for black-market gains, then what purpose is served by grabbing more than one newspaper? Economists call this phenomenon the law of diminishing marginal utility. Simply put, the marginal utility (satisfaction) of a good or service decreases as the quantity of the good increases.
Said differently, the first sip of wine is always better than the last. The more we drink, the better we feel, and the better we feel, the more we drink. But consumption, like most things, comes at a price. For the fourth glass of wine, you pay with a headache. For spending more than you make, you pay with interest.
But the gods orchestrating the strings of modern finance offer us a short-term solution. They say Mr. Consumer can punt the headache. They convince his lesser half that his voracious consumption was driven in a moment of weakness. No worries ... you can pay us back next month.
But next month the neighbor bought a brand new Hummer. And now Sally cannot be seen in the ole ‘03 Suburban. So Mr. Consumer goes back to Mr. Banker to ask that he turn his head just one more time. “Sure,” he says. “Why not? The 2003 Chevy Suburban is so, well, 2003.” Mr. Consumer feels much better. Wife and banker are now both happy. The cycle continues until our hero wakes up to find himself burdened with debt. Then the banker comes in to claim his pound of flesh.
This is the game that caters to a new American generation – an entitled class of children playing children’s games. A generation weaned on bottle of instant gratification. They have been told to expect more for less. They have been assured that it is O.K. to spend more than you make because, in the end, the government will be there to brace your fall.
Unfortunately, mommy and daddy are broke. And so is Uncle Sam. But the American family keeps spending despite the fact that consumer savings rate for all of 2006 was negative 1%. The 2006 figure proudly surpassed (so to speak) the negative 0.4% savings rate in 2005. These two years produced the most reckless lack of savings since the negative 1.5% savings rate in 1933 during the Great Depression.
So while most Americans woefully stare at double-digit APRs as they cut another check for the minimum monthly payment, the debt continues to rise. It will not be long before the notion of keeping you are financial head above water will soon require more effort than signing one’s name on the back of yet another new credit card.
But wait a second. How did we get here to begin with, you ask? If the law of diminishing marginal utility states that the satisfaction of a good or service decreases as the quantity of the good increases, why do we keep consuming more than we could ever hope to utilize? I would venture to guess that he distance between economic theory and economic reality in most cases is somewhere between one and two feet. That is the approximate distance from your brain to your heart.
As Bill Bonner points out in his latest book Mobs, Messiahs, and Markets, “people’s convictions arise not from proofs supplied by the brain but prejudices amplified by the heart.” Most modern economic theory remains based on the premise that man is a rational being. Anyone who has spent more than five minutes on planet Earth knows that man is rarely a rational being. As Bonner explains, “Human beings are neither good nor bad, they’re merely subject to influence.”
The reason seems simple. People find comfort in knowing lots of other people have made the same choices. Human beings naturally gravitate towards the crowd. And “crowds cannot think. They can only feel and act.” So their behavior only seems rational in the fact that “everybody is doing it.” That was the rationale explained to me the first time someone offered me a cigarette.
You see, it is time to separate yourself from the masses. It is time to grow up. Find a good business and determine its intrinsic value. Then simply wait for the mob to overreact or under react to news, and buy the stock when the market prices the share for less than it is worth.
That is basically it. And for the record, I don’t smoke.Link here.
THE FALL 2007 RALLY
Asian stocks are to this market what tech stocks were to the mid-1990s.
Do not let this fall’s rally whiz right by you before you take a close look at stocks from Asia. The midsummer correction – at one point on August 16 the Morgan Stanley World Index was down 12.5% from its 2007 high – provided a great time to get into stocks on the other side of the dateline. If you do not own this region, now is the time to get in. When the rally resumes, Asia will lead. These stocks are to this market what tech stocks were to the mid-1990s.
What makes me so sure that we are in a correction, not a long-running decline? Four things. The first has to do with the shape of a bull market termination. The final peak does not arrive sharply. It tends to have a gentle upward slope, as the final but diminishing round of suckers is drawn in. And then the decline (usually) begins with a gentle slope, too (October 1987 was the exception proving the rule – over almost instantly), as some buyers continue to come in even after the bull market is over. The bull market leading up to the July 16 peak was too sudden and the plunge too sharp to presage a real bear market.
Second, bear markets do not start from old news. In this case the old news is that many subprime borrowers are going to default on their mortgages. While this misfortune is still unfolding, the basic facts have been out for a while. A fundamental rule of markets is that old news runs out of power. It takes new information to move stock prices.
Third, it usually takes a severe credit crunch to set a genuine bear market in motion. This credit crunch, at least for corporate borrowers, is not severe. You measure crunch by the spread in yields between junk bonds and Treasury bonds of like maturity. In 2000 that spread widened by three to four percentage points, a harbinger of both a broad tumble in stock prices and an economic contraction. In that case, moreover, the widening spread came atop rising Treasury interest rates. Weak corporate borrowers had two strikes against them. Contrast that with what is happening now. Junk spreads widened by only a percentage point before going back the other way, and much of the widening was from a fall in Treasury rates, hardly bearish. This is a phony credit crunch.
Fourth, the media always jump on a short-term correction but rarely wake up to a long-term bear market in its early phases. One form of this media attention is trotting out the perma-bears to deliver their “I told you so” speeches to the TV cameras, with scenes of the New York Stock Exchange running in the background. Generally speaking, the friendly interviewer conducting the show neglects to ask the bear when he first turned bearish and how much the market is up since then.
As with all corrections, a few months from now we will be wondering what the fuss was about. And Asian and Indian stocks will be much higher. Here are six I like ...Link here.
One reason for Wall Street’s recent frenzy is episodes of fear that credit will dry up and the leveraged buyouts that have energized the market will come to an end. The buyout game hinges on cheap, tax-deductible borrowings. No leverage, no buyouts. The LBO bunch normally has an appetite for debt that would shame a Sumo wrestler.
Well, the deal era is hardly over. Private equity financiers will find some way to get the capital they need. Deals, which generate the fat fees they so enjoy, are their oxygen. They are sitting on tens of billions of uninvested client dollars. I have never heard of a case where they returned the money to the customers.
And if they do hesitate, watch strategic buyers step in. That is Wall Street jargon for companies that buy other companies without any intention of flipping them. Corporate America still has lots of cash. The aftertax return on this cash is low compared with the earnings yield on purchased businesses..
Leveraged buying is good news for shareholders but bad news for bondholders. Maximizing shareholder value often minimizes bondholder value. If you own a corporate bond that does not have covenant protection against your company being purchased, whether by a private equity or a strategic buyer, the purchase is likely to pile on a mountain of debt, which reduces your interest coverage and the possibility of repayment.
It is quite possible for a strong business operation to be weak financially, if it is buried under an avalanche of debt. That is what happened to Spanish-language media empire Univision and hotel-casino operator Harrah’s Entertainment, to name just two. The bond buyer’s nightmare is waking up one morning to buyout news and seeing his nice A-rated corporate bond turned instantly into junk.
The way to protect yourself is to query your broker before you buy. Ask if the corporate bond has a “change of control” provision. This bond clause allows you to sell back your bond to the issuer, usually at a price of $1.01 on the dollar, in the event of a merger or corporate takeover.
A year ago Harrah’s bonds were investment grade (BBB-- rating) and stood a good chance of being upgraded. Then last September LBO firm Apollo Management said it would buy the company. My client accounts held Harrah’s bonds, specifically the Harrah’s Entertainment 5.375% due Dec. 15, 2013. Right after the Apollo news they dropped 10% in value. They had no put option for a change of control.
Contrast what happened at Equity Office Properties after the Blackstone Group announced its purchase of the REIT last November. All the bonds my clients held were redeemed. Equity Office, like most REITs, had sold its bonds with strong protections for the bondholders. Issuers do not make these promises out of generosity. They make them to keep their interest costs down.
What should individual investors do? Look at the fine print. Here are some bonds I like, all with change-of-control protection ...Link here.
GOLD REGAINS ITS LUSTER
The long-term chart for gold is very interesting for a long-side trade. The Fed is pumping liquidity into the system and trying to put out the subprime brush fire with cheap money. This is clearly inflationary action from the Fed and may help to aggravate the global inflationary pressure that countries such as China are experiencing.
The Asian economies (ex Japan) are growing a massive industrial base, which is consuming the world’s commodity resources at a record pace and should continue to create inflationary pressures for the foreseeable future. This is a bullish environment for gold. Considering the inflationary backdrop and the bullish long-term technical formation for gold, we would recommend having some exposure to the group in the coming months.
The weekly chart for gold has formed a large bullish consolidation formation. This formation is a large ascending triangle, which is a continuation pattern and suggests that the next move in the metal will be to the upside. Once gold breaks out over $690, we would be looking for another leg higher, which should take gold out to a target at $820.
Gold stocks are lagging the broader market by a wide margin, as the consolidation in gold prices has these stocks stuck in neutral. The long-term charts in this group look bullish and should move out to the upside along with the commodity, but we would focus on the commodity itself and make the trade a pure play on gold without the complications of individual company fundamentals.
Traders can buy the SPDR Gold Shares ETF (GLD) as a pure play on the metal. A breakout over $69 in GLD would be an upside resolution to the large consolidation formation and suggests that gold is ready to resume the long-term uptrend.
Gold has two aspects to demand for the metal. The first is the monetary demand as an anti-inflation tool and a “store of value”. The second is pure commodity demand for the metal, mostly for jewelry. We would focus on the monetary aspects of the metal in the coming months. The falling dollar and rising-global-inflation picture may finally push gold out of the large consolidation pattern and give it some upside momentum.Link here.
WHEN MARKETS LOSE THEIR MIND
Free market economics is famously predicated on “market rationality”, the idea that each participant in the economy acts as a coolly reasoning “homo economicus” in purchase and investment decisions. [Ed: More accurate would be to say that free markets are assumed to weed out irrational behavior, so the actual participants are predominantly rational. To a point.] Yet as the disintegration of the 1995-2007 credit bubble continues it is becoming more and more obvious that in several areas economic decision-making during this period has been highly irrational. There are no complete solutions to this problem, but there are palliatives.
Subprime mortgages themselves exemplify irrational markets, yet the participants’ activities at each stage were economically in their own rational interest:
Each step of the process was rational (albeit operating on imperfect information), yet because incentives were hopelessly misaligned, the final result was an irrational market, in which loans that would not be repaid were securitized and sold to investors seeking an above-market return at below-market risk, a combination that in the long run ought not to exist without the application of extraordinary intelligence.
In the credit card business, equally likely to subside into a slough of defaults, the rationale was a little different. Here the subprime credit card consumer had no rational basis for believing that anything he bought with the card would become sufficiently valuable to pay off the card debt. Instead, the credit card business became a tribute to the power of advertising. By sending out credit card solicitations weekly to every deadbeat in the U.S., the card companies were able to persuade consumers that taking on too much debt was a perfectly natural means of acquiring the consumer goods or vacations they craved. Unsophisticated consumers are deluded into thinking that credit card debt is manageable, and that their income will increase sufficiently to service it. As with subprime mortgages, credit card lenders would not have been so aggressive if the assets had resided on their balance sheet, but through securitization they too could delude themselves that they were sloughing off the credit risks onto anonymous third parties.
The derivatives market was yet another area in which irrationality held full sway. Here the fault was excessive belief in mathematical models. It was attractive to traders and to operating management to pretend that markets were fully stochastic random walks – after all, Nobel prizes had been given for this assertion – and to assess Value at Risk on that basis, ignoring the reality that markets often behave in a highly non-random manner. By doing this, management could claim to investors that risk positions were in reality modest, while traders could bet the future of the institution on gambles that may go spectacularly wrong every few years, but in the meantime keep the investor capital and the bonuses flowing in.
When in mid-August Goldman Sachs announced that a “25 standard deviation event” had caused the value of its quantitative fund to drop 30%, the implication was that the subprime mortgage crisis had caused the market to behave in some wholly unexpected pathological manner, normally to be anticipated only two or three times in the history of the universe. In reality such “25 standard deviation events” happen two or three times a decade and are perfectly normal. The abnormality was in Goldman basing its reputation and its investors’ wealth on such obviously inadequate mathematical techniques.
On the funds management side, fiduciary investment in hedge funds and private equity funds is equally an example of market irrationality. Pension funds in particular have an exceptionally long time horizon, so investing in short-term oriented hedge funds was especially inappropriate. It was obvious also that private equity funds depend crucially on the availability of an active and receptive stock market for exit from their investment positions and so in no sense represent a “separate asset class” from conventional U.S. equities. While private equity fund and hedge fund sponsors have attempted to hide the reality of their funds’ mediocre returns, the truth has been apparent with a little digging for several years, which is why both types of funds market their returns on a “top quartile” basis, pretending as in Garrison Keillor’s Lake Wobegon that all funds are above average.
The reality is that only the remuneration of the sponsors is above average, far above that for managers of conventional equity funds, and rendered especially egregious by the practice of managers extracting their 20% “carry” before the investments have actually been sold, thus leaving the fund illiquid and the investors wholly dependent on exits that might never be achieved. There was nothing irrational in Wall Street selling these new funds. The irrationality lay in institutional investors buying them. Once it has become obvious what devastation has been wreaked on beneficiary pensions from these investments, it is likely that some of the more enthusiastic fiduciary participants will find themselves in class action court, if not in jail. The U.S. judicial system is these days particularly unforgiving of market failure, as Enron’s Jeffrey Skilling discovered.
Finally, there is the explosion in top management remuneration over the last two decades. It is folly to imagine that U.S. top management is many times better than in the 1980s, yet it is paid many times as much in real terms. The initial boost came from stock options, which management persuaded the accountants could reasonably be left off the income statement. Here both management and the accountants were acting rationally. The irrationality arose from the failure of the policing institutions such as the SEC to prevent such looting of shareholder wealth. More recently, management has been able to increase its remuneration by threatening the stockholders with defection to a private equity buyer. This has resulted in the breakup of a number of long established companies, almost certainly with highly deleterious consequences for the U.S. economy. Again, warped incentives produced behavior that was from a market point of view mindless.
From the above examples, it is clear that market madness derives from a number of causes, but primarily from misaligned incentives, excessive salesmanship and poor regulation. The decade of cheap money has exacerbated the problem. Behavior that would have been punished by bankruptcy before it became widespread has been allowed to spread throughout the world’s markets. The behavioral factors that sophisticated economists today recognize as important modifiers of the pure free market paradigm have become dominant, and have pushed the world economy a considerable distance from an optimal state.
The market will never be completely rational, and nor should we expect it to be. Equally, market irrationality has in the last decade enriched a lot of thoroughly unpleasant people at the expense of the economy as a whole. To cure the problem, government action is required only at the margins, tightening regulation on, for example, the marketing of credit cards to end the practice of unsolicited credit offers, so dangerous to the financially vulnerable and unsophisticated.
More important, money must be kept tight, in order that periods of irrational speculation do not extend themselves as they have done since 1995. It is likely that this will also involve a substantial shrinkage of the financial services industry, even if not to its 1970s size of approximately half its present proportion of the economy. The last decade has demonstrated that arcane areas of financial services are particularly vulnerable to rent-seeking sales operations, and the normal weeding out that occurs in downturns is impossible if bull markets are prolonged by a decade or more.
In many cases, if core participants had acted responsibly, market irrationality would not have occurred, but the overly-responsible get weeded out of the financial services business in a decade-long bull market. It is bull markets, not bear markets, that produce sharp increases in dishonesty and rent-seeking.
In the future, if after, say, 5 years the stock market is continuing to soar, the Fed should bring it back sharply to earth by a rise in short term interest rates. Former Fed Chairman Alan Greenspan should have done this when he spotted “irrational exuberance” in December 1996. It is to his everlasting disgrace that he did not. Only by such a grounding can the bubble operators be weeded out and rationality returned.
On days when the market drops, financial commentators are filled with gloom as they agonize over the possibility that the U.S. economy is headed into recession and the markets into freefall. Fear not. Market freefall and economic recession will sweep away the irrationalities of the last decade, and those uninvolved in scams will find their own wealth and share of the economy increasing comfortably.Link here.
CREDIT CRUNCH – THE NEW DIET SNACK FOR FINANCIAL MARKETS
New age financial theories are being exposed, and found wanting.
Inflection points in financial markets are difficult to identify. As Yogi Berra observed: “Making predictions is difficult, especially about the future.”
In Indian mythology, we are in the Age of Kali – the last age. The world ends when Kali dances the dance of death. There are no such clear markers in markets. Recently, we came close. Jim Cramer, a CNBC pundit, launched a “We’re in Armageddon” tirade on air. Embattled Bear Stearns CFO Samuel Molinaro pleaded, “I’ve been out here for 22 years, and this is as bad as I’ve seen it in the fixed-income markets.” Kali had begun to shake her booty. The credit bubble was finally deflating.
In 2007, householders in “Cabbage-ville USA” (an English fund manager’s term) failed to make repayments triggering a global credit crisis. Markets ruminated about “a repricing of risk.” The faux “business as usual” calm masked the fact that the problems threaten to be the single largest credit crisis since the Savings and Loans collapse in the USA in the 1980s.
The early 2000s were a period of “too much” and “too little” – too much liquidity, too much leverage, too much complex financial engineering, too little return for risk, too little understanding of the risks. Steven Rattner (from hedge fund Quadrangle Group) summed it up in the pages of the Wall Street Journal: “No exaggeration is required to pronounce unequivocally that money is available today in quantities, at prices and on terms never before seen in the 100-plus years since U.S. financial markets reached full flower.” Traditional money fueled by loose monetary policy, excessive capital flows and now turbo-charged by “financial engineering” lies at the heart of the current credit crisis.
Candyfloss (cotton candy) – spun sugar – consists mostly of air. It is the quintessential experience of a visit to a fairground. New financial technology is “candyfloss” money – money spun out and expanded into ever larger servings. Derivatives, securitization and collateralized lending allow fundamental changes in credit markets and leverage.
Derivatives – highly leveraged bets on movements in prices of interest rates, currencies, shares and commodities – can be used to manage or create risk. Investors increasingly use derivatives to increase risk to earn higher returns. As at the end of 2006, derivative outstandings were around $485 trillion. In comparison, total global GDP is around $60 trillion. Derivative trading created additional liquidity and leverage.
Derivatives on credit instruments are a relatively recent innovation. A credit default swap (“CDS”) is credit insurance on a specific company. The buyer of protection (usually a bank who has lent money to the company) pays the seller of protection (usually an investor) a fee. In return, the seller of protection covers the bank buying protection against losses should the company go bankrupt. CDOs are steroid-fueled mortgage loan securitizations. A portfolio of loans, bonds or mortgages is assembled. Interest and principal from the underlying portfolio is used to make payments on the CDO securities issued to investors. In a CDS contract, unlike a loan or bond, the investor is not required to pay the full face value. With CDOs, the bank uses the dexterity of the Iron Chef to cut and dice the risk of the underlying loans. “Tranching” allows the creation of different CDO securities – equity, mezzanine and senior debt. Equity receives high returns and bears the most risk. If there are losses on the portfolio of loans then equity takes the first losses.
The structured credit market has supersized debt levels using techniques of staggering complexity, incomprehensible to all but a small group of practitioners. The market was so “like hot” that one professional confessed that even his headhunter had been recruited into a structured credit role at an investment bank.
Repurchase agreements or “repos” (secured lending against government securities) and margin loans (lending secured against stocks) are well established. Now, investors use repos to raise substantial amounts against any security or instrument, including distressed debt. Banks have also institutionalized the collateral game in a plethora of off-balance sheet structures – arbitrage or conduit vehicles, and structured investment vehicles (“SIVs”). The vehicles purchase high quality securities like AAA or AA rated CDOs and fund them with short-term borrowings (usually, commercial paper (CP) issued to money market funds). $1.2 trillion or 53% of the $2.2 trillion commercial paper in the U.S. market is now asset backed, around 50% by mortgages. When investors now buy assets, the dealers automatically ask: “would you like debt with that?”
The New Liquidity Factory, II
Banks traditionally wrote and funded their loans. In the new money game, banks “originate” loans, “warehouse” them on their balance sheet for a short time and then “distribute” them to investors using CDOs. Banks require less capital, as they do not hold the loan for its full term. The process encouraged declines in credit standards. The game relies on the ongoing liquidity of the market for securitised debt.
When the loans are sold, the bank effectively receives the difference between the interest on the loan and the return demanded by the investor “up front”. As loans are sold off, more loans must be written. Ever larger volumes are necessary to maintain profitability forcing banks to rely on brokers. In the new money game, banks increased loan volumes, reduced capital available to absorb risk and lowered the credit quality of their loans all at the same time.
Insurance companies, pension funds, asset managers, banks, and private clients are buyers of credit risk. Hedge funds moved into the credit markets in search of higher returns based on leveraged structured credit instruments. The high returns came with additional risks – a lack of liquidity and complexity of the securities. Buyers from Switzerland to Slovakia, Boston to Beijing bought up credit risk. The complexity and risk of structures was inversely related to the understanding of the investor being sold it.
In the new liquidity factory, investors did the borrowing. Hedge funds borrowed against investments. Traders borrowed cheap money (especially yen at zero interest rates) to fund high yielding assets in the famous carry trade. Financial engineering disguised leverage so that an investor’s balance sheet today does not tell you the amount of leverage being employed.
The new liquidity factory is self-perpetuating. If you bought assets with borrowings then as the asset went up in price you borrowed more money against it. In an accelerating spiral, asset prices rise as debt fuels demand for the asset. Higher prices decrease the returns forcing the investors to borrow more to increase returns. Bankers became adept at stripping money out of existing assets that had appreciated in price, such as homes. In the USA, UK and Australia – the fast debt nations – home equity borrowing funded a frantic debt addiction.
By the early 2000s, the new liquidity factory had created a money pyramid that had no parallel in history. This diagram sets out the money pile in modern markets. The tsunami of debt fueled price increases in financial assets – debt, equity, property, infrastructure. The current market volatility is not simply a correction in prices but this gigantic liquidity bubble unwinding.
A German banker recently accosted me: “Vhat does a poor American defaulting in Looneyville, West Virginia have to do vith me?” There were also defaults in Gravity Iowa, Mars Pennsylvania, Paris Texas, Venus Texas, Earth Texas, and Saturn Texas. Deregulation, abundant liquidity and rising house prices encouraged lenders to target less affluent borrowers with poor credit histories who have long been excluded from the American dream of home ownership. Subprime and Alt-A housing loans included “innovations”:
Around 2003-04, the housing market began to slow. Banks and brokers maintained volumes at the expense of still weaker standards. LVRs rose and documentation requirements collapsed. Demand for long-term high-yielding assets from investors fueled the securitization process that the subprime market relied upon. By 2007, the subprime market accounted for 20% of new mortgages and 10% of all mortgage debt.
Francois Rabelias, the French author, observed in the 16th Century, “debts and lies are generally mixed together.” NINJAs (“no income, no jobs or assets”) able to sign their name could buy a house without any money. In 2006, Casey Serin, a 24-year old Web designer bought seven houses in five months using $2.2 million in debt. He lied about his income on “no document” loans. He had no deposit. In 2007, three of his houses were repossessed. The others face foreclosure. Serin’s website – Iamfacingforeclosure.com – has become the symbol of the excesses of the sub-prime mortgage market.
Hedge funds used leverage to “enhance” returns on subprime debt. This diagram shows how a hedge fund uses $10 million to take the risk of the first $60 million of losses on a $850 million portfolio.
A gradual and sudden death.
The “Goldilocks” economy led one commentator in 1997 to assume that the business cycle had been abolished. Unfortunately, interest rates increased sharply in the U.S. Central banks tightened liquidity as inflation rose. U.S. house prices stalled and then fell. Delinquencies in subprime mortgages reached 15% and in some types of loans approached 30%. Defaults rose, at an uncomfortable 45º gradient.
In 2006, an asset based securities credit index had been introduced to provide some transparency to the opaque CDO and mortgage markets. The ABX.HE (ABS Home Equity) entailed five separate indexes (AAA, AA, A, BBB, BBB-) referencing similarly rated tranches of 20 securitization transactions. The BBB- 2006 index collapsed from around 100 to initially 60-70% of face value to its current level of around 30-40%.
Like engine oil, credit lubricates and keeps the financial motor running. The oil was leaking out rapidly. The engine was seizing up. Subprime mortgage lenders closed as business dried up. Investments in the riskier tranches of the securitized mortgage pools were worthless. Investors in the “safe”, higher rated AAA and AA, tranches had real problems. In a typical securitization, actual losses on the underlying mortgages pool would need to rise above 15-30% before they suffered losses. AAA tranches were quoted at between 80-90% of face value. AA and A were lower again.
If the investor ignored the current (mark-to-market) value then the investor was still unlikely to actually lose money. Lower ratings forced investors to sell as the securities did not comply with investment guidelines triggering losses. Hedge funds who borrowed against the securities faced margin calls as the values fell. The lenders tightened lending conditions reducing leverage and increasing the cost. The subprime problem was initially a “specific problem” and “contained”. It was neither. It spread quickly and efficiently. The word “contagion” appeared. By August 2007, credit markets had just about ceased to function.
Bear in the woods.
Two investors see a bear in the woods. One investor starts to run. “You can’t outrun a bear,” the other investor shouts. “I can outrun you!” responds the running investor. Investors and financial institutions now wanted to get their money out before the cash vanished. This diagram sets out how selling is exaggerated in a highly leveraged world.
The U.S. absorbs around 85% of total global capital flows. Asia and Europe were the world’s largest net suppliers of capital, followed by Russia and the Middle East. Cross border debt flows funded the U.S. government debt (up $400 billion) and a rapid expansion in U.S. private debt (up $1.3 trillion). Global money funded the U.S. debt binge and now global investors suffered losses.
Exposure started to show up in unlikely places via asset backed commercial paper money market funds. One institution disclosed that CDOs and subprime mortgages were classified as “cash and short term” on its balance sheet. Structured funding vehicles were unable to issue ABS-backed CP. They drew on standby funding arrangements. Banks refused to fund, arguing material changes in circumstances. Others had to forage down the back of the sofa for any loose change to add to their dwindling liquidity.
Reduced leverage and higher costs of funding affected hedge funds. Quantitative funds suffered large losses as forced selling and a (il)liquidity-driven market caused models to fail. Hedge fund investors, concerned about declines in returns and sharp falls in value, filed redemption requests that forced selling. Goldman Sachs was forced to step in to offer liquidity support to one of its funds.
Overheated equity markets fell despite strong corporate earnings and a growing economy on concerns about scarcer and more expensive debt. Stock values exaggerated by the possibility of debt-fuelled private equity bids fell sharply. Financial stocks fell as the losses, bailout costs and loss of future earnings was factored in. Investors regretted not taking Will Rogers admonition about worrying about return of your capital before return on your capital.
Market credit spreads and margins rose sharply. There was a flight to quality, to government securities and cash. Liquidity vaporized as fear about counterparty default meant that normal transactions between financial institutions became difficult. Risk lending dried up. AAA rated non-sub-prime mortgage-backed securities could not be placed.
There is no difference between a run on a bank and shutdown of access to funding from the capital markets. U.S. mortgage lenders faced old-fashioned runs. Central banks pumped money into the system. The Fed cut the discount rate. Four major U.S. banks used the discount window “to encourage its use by other financial institutions.” They did not need cash. It was a show of strength.
The problem was credit risk, not liquidity. Lack of information and diffusion of risk meant that no one was certain who had exposure to what or to whom. ECB governor Jean-Claude Trichet pleaded for everybody “to keep their composure.” It was reminiscent of Emperor Hirohito’s response to the bombing of Hiroshima: “The War situation has developed not necessarily to Japan’s advantage.”
Waiting for the other shoe to fall ...
The subprime losses had morphed into a fully-fledged “credit crunch”. Hedge funds faced substantial redemption requests especially from funds-of-funds in charge of allocating hot money in the coming months. Interest rates on large volumes of subprime mortgages were due to increase (by 3-4%) in 2008. The impact on delinquencies and losses were unknown.
The same model as subprime is used, worryingly, for leveraged funding in highly leveraged private equity, infrastructure and property financing. Banks underwrote the loans, warehoused them and then repackaged and distributed them to investors in the form of CDOs. Deterioration in credit standards was evident.
As of August 2007, $300 billion of leveraged finance loans made by banks is effectively “orphaned” – they cannot be sold off. One bank recently offered $1 billion to a client to walk away from an underwriting commitment where it stood to lose more if the transaction proceeded. Another bank, active until recently in making multi-billion dollar commitments to private equity transaction, told clients that “they were not in leveraged lending business any more.” It smacked of a day in the late 1980s when the then all powerful Japanese banks refused to participate in the leveraged financing of the United Airlines LBO ushering in the end of that era.
Keynes observed capital shifts “with the speed of the magic carpet ... disorganizing all steady business.” The real economy effects are slower to emerge and more difficult to measure. Higher credit costs and tighter credit standards will affect all business. The U.S. housing industry is badly affected with no immediate prospect of a quick recovery. Non-investment grade bond issuance over the last few years was concentrated in the weaker credit categories and is vulnerable to deterioration in economic conditions.
The fall in asset prices has “wealth” effects. U.S. consumption, based on borrowing against the inflated values of financial assets, drives the export driven economies of Asia, Eastern Europe and Latin America. Lower commodity prices already point to slower global growth. While Main Street was trying the assess the fallout, Wall Street was already issuing “pink slips” by the thousands as banks and mortgage lenders shed staff.
The market anxiously waited for “the other shoes to fall,” except it seemed the shoes were from Imelda Marcos’s collection.
Markets exaggerate the short-term impact and underestimate the long run impact of events. The new liquidity factories were based on the new age idea of “risk transfer”. The shell game requires three shells and a small, soft round ball, about the size of a pea. The pea is placed under one of the shells, then quickly the shells are shuffled around. Bets are taken from the audience on the location of the pea. It is a confidence trick used to perpetrate fraud. Through sleight of hand, the operator easily hides the pea, undetected by the victims. Risk transfer is the shell game of the credit markets – a short con, quick and easy to pull off.
Central banks believe that if banks sell off their risk then it is distributed widely, reducing the chance of a crash. Banks frequently do not sell off their real risks. For regulatory capital reasons, they sell off less risky loans. In a CDO, the bank typically takes all or a portion of the equity tranche. If there is a market disruption and the bank is unable to sell then the risk remains with the bank.
The risk may also return to the bank via the back door. Where it acts as a prime broker – executing trades, settling transactions and financing hedge funds – the bank lends to investors using the CDO securities created as collateral. If the value of the securities falls and the hedge fund is unable to post additional margin to cover the loss then the bank is exposed to the risk of the securities. The bank assumes that it can sell the securities it is holding to pay itself back. Banks provide “corporate credit cards” – standby lines of credit – to the conduit vehicles to cover funding shortfalls. If CP cannot be issued then the banks may be forced to lend against the assets that they have supposedly sold off.
Credit risk moves from a place where it was regulated and observable to a place where it is less regulated and more difficult to identify. Around 60% of all credit risk is transferred to highly leveraged hedge funds that may be inadequately capitalized to bear the risk.
Hedge fund trading strategies create risk concentrations as they hunt in packs taking bets on the same events. Hedge funds investors can withdraw funds at relatively short notice, typically, one to three months. The hedge fund’s borrowings are short term – one day. Short-term money finances long-term assets making them vulnerable to a credit crisis. Banks set up hedge funds and invest in them. When a hedge fund gets into trouble there is commercial and reputational pressure to support the fund bringing the risk back into the bank. Financial innovation may not decrease risk but increase risk significantly in complex ways.
Models behaving badly.
There are now more models in financial markets than on catwalks. Trading models tell you when and what to buy and sell. Pricing models value any conceivable security. Risk models tell you how much you may loss. Meta-models tell you which model to use.
Investors increasingly do not know what they are buying and what the security is worth. Traders say that the cost of what they sold is lower then what they paid for it (the price they paid is always lower than what the security is worth). Traders are smart and everyone else is stupid. Complex securities frequently do not trade at all so market prices are rarely available. Understanding and valuing structured securities requires a higher degree in a quantitative discipline, a super computer and a vivid imagination.
The current credit crisis is, in part, a case of model failure. In the U.S. mortgage market, automated credit assessments where information such as stated income or assets are not verified led to poor lending. HSBC trumpeted Household’s mortgage financing skills. Mention was made of hundreds of Ph.D.s skilled at cutting and dicing mortgage risk. In hindsight, HSBC would have been better served by old fashioned, common sense bankers who could eyeball clients and decide who was likely to pay you back.
Complex Monte Carlo models used to model and rate CDO securities performed badly. Trading models used by quantitative hedge funds malfunctioned as prices became driven by liquidity and market regimes shifted. Models used to set trading limits and set collateral levels significantly underestimated risk as volatility increased.
The risk of simplified, sometimes untested, models is not new. In 1987, portfolio insurance contributed to the crash. In 1998, LTCM’s trading and risk models failed. LTCM founder Robert Merton articulated the problems precisely. “At times we can lose sight of the ultimate purpose of the models when their mathematics become too interesting. The mathematics of models can be applied precisely, but the models are not at all precise in their application to the complex real world. Their accuracy as useful approximations to that world varies significantly across time and place. The models should be applied in practice only tentatively, with careful assessment of their limitations in each approximation.”
Asset values, profits and losses, risk calculations and collateral requirements all require the current market price of securities. Even staid accountants have embraced mark-to-market (“MTM”) as the basis for financial reporting. MTM assumes a market and a price. In volatile markets, liquidity becomes concentrated in government bonds, large well-know stocks, and listed derivatives. For anything that is not liquid, MTM means mark-to-model. The only price available is from the bank that sold the security to the investor in the first place, defying concepts of independence and objectivity.
As the 2007 credit crisis unfolded, there was no liquidity for structured securities. There was only one marketmaker – the person who sold it to you in the first place. In a dealing room during a crisis, the first rule is do not answer phone calls from clients. The second rule is say “wrong number” if you accidentally pick up the phone.
Inability to price or trade means that fund managers cannot establish current portfolio values or allow withdrawals of investor money. This forced funds to suspend withdrawals. Prime brokers could not establish the value of collateral. Where investors failed to make margin calls, the prime brokers could not sell the collateral securing their loans. They could not get back their money and were at risk of further falls in the value of securities.
Banks shared one objective – prevent the complex and illiquid securities being sold at a discount and pushing down prices in the market. If these securities actually traded then the lower market price would have to be used to calculate the mark-to-market value, increasing losses and margin calls on already cash strapped investors. Asset values, profit and loss calculations and risk computations were in the running for major awards in literary fiction.
One trader summed it up using Donald Rumsfeld’s immortal words: The known known was that there were losses in subprime mortgages and anything related. The known unknown was that everybody knew that they did not know the full extent of the problem. The unknown unknown was that there could be other problems that we did not know about yet.
Financial crises now are less the result of economic downturns, geopolitical events or natural disasters and more the result of the structure and activity in financial markets. Risk is now driven by the increasingly tight coupling of markets and the resulting complexity and interdependence.
Modern financial markets assume free flow of information and relative transparency. There was little or no knowledge of the extent of subprime losses, who was exposed and what were the links. Sometimes, investors themselves could not work out whether they had subprime exposure or not. An analyst assured me that Asian banks’ exposure to subprime losses was minimal. Within days, Chinese, Korean and Japanese banks announced large exposures to subprime. The stock markets wiped 30-50 times the potential losses off the share prices of the banks. The issue was that the banks did not know what they owned and what they could lose.
Diffusion of risk across the globe to unregulated investors subject to variable financial disclosure rule is inconsistent with transparency. Investors like hedge funds have steadfastly fought for increasing transparency and disclosure, except when it relates to their own activities.
Truth in labeling.
CDO ratings have been crucial to selling securities to investors. 30% and 50% of the revenue of the major rating agencies – Moody’s, Standard & Poor, Fitch – come from rating structured securities, including CDOs. Ratings are opinions of the likelihood of default of a particular security based on mathematical models, history and snake oil. Investors, some ignorant about how a rating is determined, ascribed magical properties to the alphabet soup of letters assigned to a security. Investors and bankers made assumptions about the stability of the rating. Rating was linked to pricing and used to set the amount of banks would lend against a particular security. Protected by expansive exclusion clauses, the agencies did not discourage these uses, instead promoted the wide use of ratings.
CDO rating anomalies abound. The number of defaults in the “BBB” class of CDO securities is not materially different from that on “BB” CDO securities. BBB is classified as investment grade while BB is not. Many investors can only purchase investment grade securities but in a CDO it seems the risks are the same. CDO security ratings also seem to be less stable than comparable rated corporate bonds. Likely reasons include model failure, input problems and a certain naivete in the application of these models to new markets.
There are uncomfortable similarities in the relationship between investment banks and rating agencies and that between auditors and the companies they audit. Investment banks pay the rating agencies to rate the CDO securities. Investment banks and rating agencies work closely in structuring the transactions. Rating agency staff cross over to the “dark side” to work for investment banks. CDO ratings pay more than rating conventional bonds.
John Kenneth Galbraith observed, “In central banking as in diplomacy, style, conservative tailoring, and an easy association with the affluent count greatly and results far much less.” Central bankers fueled the liquidity factories through excessive monetary growth and low interest rates. They championed financial innovation and “new age” finance theories. The risks of a diffuse, globally interlinked, highly leveraged financial system were ignored.
Regulators have presided over substantive changes in financial institution balance sheets and risks. The balance sheet of large banks and investment banks hold illiquid assets, such as private-equity investments, bridge loans, hedge fund investments, distressed debt and exotic derivatives. Derivative transactions with and loans to hedge funds through their prime broking operations have increased. Assets and exposures in “arbitrage” conduit vehicles and hedge funds outside regulated bank balance sheets have increased.
Banks also have increased trading risks, particularly in complex derivatives and structured investments. Constant Portion Portfolio Insurance (CPPI) products guarantee the return of capital to investors at a future date using a trading strategy similar to portfolio insurance. This requires continuously rebalancing of a portfolio of risky assets (usually shares and hedge fund investments) and cash. The trader is exposed to the risk of sharp changes in asset prices. It is unclear how these products and hedges will perform in volatile markets.
The Bank of International Settlements (BIS) in its 2007 annual report admitted that “our understanding of economic processes may be even less today than it was in the past.” Fundamental changes reshaping financial markets are needed. The temptation to seek a scapegoat (the brokers that sold subprime mortgages and rating agencies loom large) or a quick fix (lower interest rates) is ever present. The Fed has cut the discount rate. The Fed also clarified the rules – banks could pledge asset-backed commercial paper as collateral for funding at its discount window. Usually, only government securities are eligible. The Fed is effectively underwriting the credit risk and the liquidity of the financial system. It was arguably reverting to type, bailing out banks and investors from poor decisions or irrational exuberance underwriting excessive risk taking.
John Maynard Keynes knew the problem well: “The difficulty lies not so much in developing new ideas as in escaping from old ones.” But as John Kenneth Galbraith observed: “Faced with the choice between changing one’s mind and proving there is no need to do so, almost everyone gets busy on the proof.”
In Western societies, there is an increasing obesity problem, in part caused by poor diets that include fast food. A diet of cheap and excessive debt has created a bloated financial system. Crash diets rarely work. The solution requires will power, a sensible but reduced food intake, and exercise. In financial markets, the resolution requires regulatory will and an imposition of market disciplines on errant investors and banks. It also requires a sharp reduction in debt levels and addressing the problems of risk transfer, model risk, and market transparency.
I am not hopeful that the required reassessment will occur. The current credit crunch will be the new wonder diet snack for financial markets. It will have some short term effects but leave the root cause untreated. As Charles Kindleberger noted in the opening sentence of his classic study Maniacs, Panics and Crashs: “There is hardly a more conventional subject in economic literature than financial crises.”Link here.
In the early phase of a credit crunch, hope springs eternal.
When credit tremors started to appear in the subprime mortgage industry last spring, economists cited in the media quickly calmed the fearful by calling it an “isolated”, “contained”, and thus temporary credit disruption. On July 13, with the DJIA within 100 points of its peak and credit problems emerging on a world-wide basis, a Bloomberg news story said, “Lehman, Bank of America and Barclays Say the [Credit] Rout is Over.” It must be early [in the rout], because many large investment companies are treating damaged [credit sectors] as a great buying opportunity.
“It is not a signal automatically of a bad investment because they get a 7.25 percent yield, and the option to convert has a long term,” said Jefferson Harralson, an analyst at KBW, of the investment in Countrywide Financial by Bank of America. “They are supporting a company from bankruptcy that they have loans out to, and that benefit of the transaction doesn’t go away.” Whew, that must be a relief to B of A stockholders to learn that two (more) billion into Countrywide was not “automatically” a bad investment.
In the March 2007 issue of The Elliott Wave Financial Forecast we wrote this: There is one other frequently cited reason for forging ahead with ever greater amounts of debt. Many bulls say that there is way too much concern about credit for the debt bubble to actually break. As the pied piper of credit creation, Alan Greenspan, said in the midst of the initial subprime washout in early March, “People ask me what kind of shock I worry about, and I say, ‘If I worry about them and other people worry about them, they won’t happen.’” By this logic, the more worried they get, the safer people should feel. To the average contrarian, it probably makes sense.
But contrarianism has its limits, and one of the most valuable aspects of the Wave Principle is that it reveals where these limits are. In third waves and in C-waves within long-term A-B-C moves, the direction of events coincides with the direction of equity prices. The rising wave of anxiety over debt and default is not a “wall of worry.” It is a “wall of reality.” The current belief that it is otherwise is all part of Bob Prechter’s coined phrase for bear markets – the Slope of Hope.Link here.
In gold we trust.
United States currency notes carry the motto “In God We Trust”. Well, not anymore, we don’t. Put a letter “l” into the second word and you just may have a winner. With the global financial system basically dysfunctional, the issue for hard-working Asians is where to put their money. I would suggest looking at physical commodities such as gold and oil, if only the prices had not already jumped.
When trust breaks down across banks, investors have no option but to walk away from financial assets. This has already happened, as gold prices surged above $700 an ounce, and oil prices hit a new high for the year ($77 a barrel). The preference for commodities is bothersome for central banks, as high input prices make the task of cutting interest rates (as demanded by banks) less defensible.
More important, central banks in the U.S. and Europe have lost credibility with investors. They are no longer trying to prevent inflation, but appear more concerned with preserving the lot of bankers. This suggests greater value destruction for global investors, particularly for Asians investing in financial assets in Europe and North America.
Neither the U.S. dollar nor the euro has any credibility in this situation, which means that the average Asian saver has no option but to purchase gold as a store of value. Even as U.S. dollar bills proudly carry the motto “In God We Trust”, I think it's time for Asians to put their trust in gold instead.Link here.
THE ROOT OF FINANCIAL PANICS
Imagine for a moment the dark days of banking when banks had to redeem gold coin for the money substitutes they issued, which were either bank notes or deposit accounts. Folks were generally happy to keep their gold locked up in a safe place and found it more convenient to use the substitutes. Very importantly, most of them were also either stockholders of the bank or in debt to it, so they had little incentive to confront the bank for redemption. But this very fact enticed banks to create substitutes well beyond the amount of gold they held in their vaults, a practice considered normal and not the least fraudulent.
Occasionally, of course, someone would ask for their gold, and the bank on those occasions complied. The transaction produced no strife, and life went on. For the bank, life went on until hordes of people came in clamoring for the same thing. It is said the customers of the bank had panicked, driven by a fear their substitutes would not be honored. Their fear, of course, was well-founded, and the bank would either close down for good or ask the people to come back some other time, perhaps in a few years.
In the 19th Century there were five major financial crises or panics in which bank stampedes of this nature occurred: 1819, 1837, 1857, 1873, and 1893. In each case the panics were preceded by periods of spectacular growth in the money supply, through a combination of unbacked note issue and credit expansion. In some panics there was also a pronounced increase in specie, either gold or silver coin. The Panic of 1837, for example, was preceded by rapid growth in silver coin from Mexico, where Santa Ana’s government was financing its deficits with nearly-worthless copper coin, which drove gold and silver out of the country.
Some economists maintain that the tremendous increase of specie in U.S. banks was the primary cause of the monetary expansion preceding the Panic of 1837, but banks then were inflating at a rate of roughly 7 to 1, credit to reserve specie. Thus, the surge in U.S. banks’ silver coin deposits prior to 1837 only made the money growth worse in absolute terms, due to the money multiplier of fractional reserve banking.
While bank failures and unemployment are endemic to panics, some banks did quite well. Officially or informally, they were able to postpone redemption while remaining in business, meaning that while they no longer honored their obligation to pay note-holders or customers in gold or silver, they required their debtors to pay them at par in specie.
Panics happen when banks have inflated so much they lose public confidence. With whom does the fault lie – the bank’s note-holders and customers who panic and demand specie payment or the bank for committing a hoax? Here is how London South East Company defines a financial panic: “Financial Panic: A self-fulfilling prophecy. If people believe that the bank will be unable to pay, they will all attempt to withdraw their money. This in itself will ensure that the bank cannot pay, and it will go bankrupt.”
Their “definition” has some revealing features. First, it admits the bank is truly insolvent because it “cannot pay” all its depositors. But it also suggests that being insolvent is not bad as long as people do not panic and ask for their money. Should we look at banks as we might any other business that takes risks? Or are there important distinctions we need to make?
When people deposit gold in a bank, Murray Rothbard argues, the bank is not borrowing from them. It does not pledge to pay back gold at a certain date in the future. Instead, it pledges to pay the receipt in gold at any time, on demand. In short, the bank note or deposit is not an IOU, or debt. It is a warehouse receipt for other people’s property. Further, when a businessman borrows or lends money, he does not add to the money supply. The loaned funds are saved funds, part of the existing money supply being transferred from saver to borrower. Bank issues, on the other hand, artificially increase the money supply since pseudo-receipts are injected into the market.
Whether they agreed with this view or not, bankers continued to issue unbacked money substitutes. When they brought on the infamous panic of 100 years ago, big bankers and politicians accelerated their push for more control over money and banking and shackled the country with a central bank, the Federal Reserve System, in 1913. The new Fed would provide all the money a robust economy and an “active” government demanded without those embarrassing panics. Economic dips would be history; growth would be an upward slope only.
Well, not quite. For the first 19 years of its existence, the Fed still had to contend with the gold standard. Following a 1917 amendment to the original act, the Fed managed to centralize much of the gold stock of the commercial banks, making it more difficult for people to get their hands on what was rightfully theirs. It took the Great Depression and massive bank failures to eliminate gold domestically as a check on bank inflation. During the early years of the Depression, people were withdrawing gold from the banks, as they had every right to do, but politicians, including President Hoover, condemned them for “traitorous hoarding” and keeping banks from bringing about a recovery. Withdrawing gold reduced the money supply, which lowered prices. Politicians and their Ivy League advisors considered low prices the cause of the Depression. Roosevelt agreed and took the country off the gold standard soon after he took office in 1933.
With gold banished as money, the Fed had finally succeeded in preventing panics. What would be the point of a run if there was only fiat money in the vaults? If people insisted on holding cash, the Fed could simply instruct the Treasury to print whatever was necessary. Money had been removed from the people and placed in the care of politicians. And political money did not require the expense and labor of mining ore – just ink and the will to print. Strife was history, and life would go on.
But there was a catch. As Alan Greenspan noted in 2002, although the gold standard could hardly be portrayed as having produced a period of price tranquility, it was the case that the price level in 1929 was not much different, on net, from what it had been in 1800. But, in the two decades following the abandonment of the gold standard in 1933, the consumer price index in the U.S. nearly doubled. And, in the four decades after that, prices quintupled. Monetary policy, unleashed from the constraint of domestic gold convertibility, had allowed a persistent overissuance of money.
That kind of persistence created havoc in the 19th Century. What is it doing today? The Fed controls the money supply by controlling the reserves of its member banks. It controls reserves mostly by raising or lowering the federal funds target rate, which is usually close to the market rate banks charge one another for overnight loans. It can also control reserves through its discount window, which is the rate set by the Fed on funds it loans to members. Normally, the discount rate is a full percentage point above the federal funds target rate.
Since June 29, 2006 the target rate for federal funds has held steady at 5.25%, reflecting a modest tight-money policy the Fed has pursued to stem price inflation. Any change in the target rate is normally announced at the Fed’s monthly FOMC meeting rather than done on the fly. Among other things, monthly rate reviews give the impression that the economy is in the Fed’s steady hands. No need to panic. In fact, St. Louis Fed president and FOMC member Bill Poole stated publicly recently that he sees no need “to make a decision before the next [FOMC] meeting” on September 18.
For those addicted to Fed liquidity, that was the last thing they wanted to hear. Seeming to speak for all Fed dependents, stock trader Jim Cramer appeared on CNBC last month and went ballistic. “Bernanke needs to open the discount window!” he roared. “He has no idea how bad it is out there! He has no idea! He has no idea! ... And Bill Poole has no idea what it’s like out there! ... They’re nuts! They’re nuts! They know nothing! ... THE FED IS ASLEEP!”
Ten days after Cramer’s plea, the Fed announced a drop in the discount rate from 6.25% to 5.75%. Cramer barked, and Bernanke tossed him a bone. Then on August 22, five days after the rate drop, the Wall Street Journal had this to report: “The four biggest U.S. banks said they borrowed a total $2 billion from the Federal Reserve, falling in with the central bank's efforts to stanch turmoil in financial markets by encouraging borrowing from the Fed. It was unclear how much the move would calm tense credit markets ...”
“Tense credit markets”? Wasn’t the Fed supposed to be the cure for this sort of thing? “Jiggling its interest rate,” James Grant wrote, “the Fed can impose the appearance of stability today, but only at the cost of instability tomorrow. By the looks of things, tomorrow is upon us already.”
“Tomorrow” was upon Americans in 1929 when the 1920s expansionist policy of the New York Fed’s Ben Strong caught up with them. And the day after that “tomorrow”, a period of suffering began that lasted nearly two decades, counting the war. But does the Fed get blamed for inflating us into the crash? Except for the Austrians (PDF), no. Instead, it takes responsibility for failing to inflate us out of the depression. The cause of the crack-up is seen as the cure.
“Tomorrow” is upon us now, was upon us then, has been upon us throughout out history because banks have been inflating throughout theirs. Only when we put a stop to it will our financial tomorrow seem genuinely bright.Link here.
Financial crises of past have familiar ring today.
Stock market roller coaster. Real estate meltdown. Crisis of confidence. Stephen Mihm of Decatur has seen these financial messes before. “We are in untested waters right now in terms of the complexity of the financial instruments in play,” says Mihm, author of the just-published A Nation of Counterfeiters: Capitalists, Con Men, and the Making of the United States. “I’m not so concerned about what happens tomorrow, but, eventually, there’s a day of reckoning,” adds Mihm, who teaches American history at the University of Georgia. Here are his top five financial crises in U.S. history:
TIME TO LIQUIDATE EVERYTHING AND GET INTO CASH?
I know it is crazy. But I have written a draft for my next newsletter advising readers to liquidate all their positions and get into cash. If you think that is crazy or just stupid, you need not bother reading on. Otherwise ... read on.
I wanted to see if a letter telling people to sell everything now sounded panicky ... or reasonable ... or not really sensible/defensible once you go through all the risks, costs, and objections to doing so. It could also be epic stupidity. But I am still not sure. So I went to my white board and made a list of reasons for and against advising readers to liquidate their stock holdings and get into cash. Can you see something I missed? What do you think? Are there exceptions?
Reasons against liquidation:
Reasons for liquidation:
Have I worried myself into a frenzy? Are our readers as scared into indecision as I am? Well, truthfully, I am totally in cash anyway, with no debts. So I am not much worried at night. But it is the first time in my 10-year career I have been this worried.
During every other mini-crisis I felt like there was something worth buying, some other asset class negatively correlated to the “bad thing” I thought was coming. But if the credit bubble well and truly deflates, the best place to be is with your feet firmly planted on the ground and cash in your pocket (not in the bank, or in a money market fund, or Treasuries (which should get shellacked now that Bush has proposed the nationalization of the sub-prime market).
Here is the essential question I am asking: “If there is one thing you could do with your money right now to make it safer, what is it?” My best answer is to take $1,000 cash out of the ATM and stash it in my cigar box. If you are thinking the same thing, or have any thoughts that might talk me down from the financial ledge, please share them.Link here.
Thanks everyone for the feedback. Lots of interesting and good ideas. Also, I should apologize for not making something more clear: I am ALWAYS right about this stuff. Always. It is just that sometimes I am a year or two early on the call.
For example, I quit Penny Stock Fortunes with a circulation of 30,000 readers because I thought the tech market had topped out ... in 1998. Right call, two years early. In 2000, at Strategic Investment I recommended the preferred “B” shares of Freeport McMoran as a play on gold. The B shares would be redeemable at 1/10th the price of gold in 2002 – right before gold’s big move. Early again.
In 2003, I recommended the Oil Service Holders (OIH) as part of the post-Iraq war strategy. I reckoned they would go from $40 to challenge their all-time high of $95. It did reach $95 by 2005 ... and then kept going. (It is at $180 now ... Thank you Peak Oil!) In 2004, I called the top in the mortgage-lending bubble. I recommended long-term puts on HGX, the homebuilders index. It doubled from there. I was two years and several trillion dollars in subprime mortgages early on that one. And in November 2005 I moved to Australia to escape the decline and fall of the U.S. dollar.
What I am trying to say is that in making my “go to cash” call now ... it is possible you have about 18 months to get out before it is too late. But if you use 2005 as the actual date of my call (judging by the deeds not the words), they you have about 62 days, 4 hours, and 23 minutes ... You have been warned.
For the record, I AM presumptuous. And a coward. And a Nervous-Nelly. And many other things. But not complacent. So I did tell the Aussie readers of our edition of Outstanding Investments to liquidate all their U.S.-dollar denominated stocks. Many of these stocks were no longer useful because they had appreciated so much ... or because in Aussie dollar terms, they were not going up fast enough to compensate for the currency risk.
It was not a wholesale exodus out of stocks. We have quite a few open positions in Aussie stocks, most of which are in precious metals, energy, base metals, and mining services (companies whose earnings are not dependent on the U.S. consumer). But I think it is still worth considering if it is time to make a major strategic change in focus. If not now, when?
My question about the market risk is still the same, after all the replies to my query: if credit as an asset class is in a bear market, how will stocks go up from here? It was the biggest bubble of all time and the signs that it has been pricked are all around us. Yet some people claim the whole thing has been factored into stock prices and earnings? Balderdash!!
It is not like we have not seen what happens at the top before. It is just that we are choosing not to believe the end of the credit bubble will result in falling stock prices. But why shouldn’t it?
As the Nasdaq declined to 4,900, 4,800, 4,500 there were plenty of dip-buyers. Dipwads! Once the tech bubble burst, there was no going back. The Nasdaq fell 77% from its 3-9-2000 closing high of 5,041 to 1,114 on 10-9-2002. And today, seven years later, the Nasdaq is still nearly 50% below its 2000 high.
Asset classes that lead one bull market up rarely lead the next one up. Instead, they go into a generational bear market, like real estate in Japan. It takes a long time to wash the taste of a crash out of your mouth. How is today so different that a genuine bear market in credit does not mean much lower stock prices? Will the whole bubble in structured finance deflate without any impact in the real economy?
You could argue that there is real economic growth to this boom, and that this boom is global. That would give you some justification for buying stocks. But which stocks? And more importantly, should you be buying any stocks at all right now, when the bear market in credit appears to be getting ready for something spectacular, vicious, and completely unplanned?
Of course it is probably a mistake to talk about “the stock market” and then make decisions about single stocks. So the questions I put to myself are these:
The market may have been a little over-sold by the end of August. But the “big dump” was not that big and it was not that much of dump. A “bigger dump” will mean much steeper falls in financial stocks and anything that depends on the U.S. consumer. Granted, you may get a few ultra-blue-chips that have lots of cash and very little debt that become “lifeboat stocks”. But I think the deleveraging of the market means much lower U.S. stock prices.
There probably ARE some quality U.S. businesses with strong balance sheets that are worth owning. I would make a list of the top 10 of them and look to buy them at much lower prices. Lots of cash, little debt, and lots of tangible (visible) assets on the balance sheet.
And if I never got to buy them, I would not lose any sleep over it. That is because I think this is exactly the inflection point we have been writing to our readers about for years. It is finally here and we want to imagine that things will keep muddling through. Maybe they will for a bit. But ...Link here.
Part III – Encore
Friends, Agorans, contrarians ... lend me your imagination. Imagine you have been hired by a wealthy client to take him to the summit of some very high and technically challenging mountain he has always wanted to climb. You have been paid top dollar. Your client is genial, equipped with all the best gear, and seems reasonably fit ... for a 75-year old chain smoker from Ames, Iowa. He is also a complete novice at what he is about to attempt. But he has the money and you have the expertise, so you get acclimated at base camp and off you go.
Then, you notice a storm rolling in. It is not right upon you. But you know the weather around the place. You know it will get worse. You know, in fact, that if you get caught in the storm, your client will probably die. You might die too, although you are younger and healthier. But your client ... if he insists on hiking into the storm you know is coming ... he may not make it.
At that point, is it not your job to be a good guide, and REALLY earn your pay by altering from the planned course when you conclude that is what is called for? As my dad used to say, “The map is not the territory.” When the investment conditions have changed so much (if they have) is it not prudent to change direction? It is your job to tell him, “We might get lucky and make it. But the weather can change. It is unpredictable. But the odds are if we keep going, something very bad is going to happen. The probability of success is low and the magnitude of getting caught in the weather is ... well ... it’s as big as it gets.”
Anyway, before I belabor the metaphor, my point is that it is not a betrayal of your relationship with your client to say you think it is time to do something radical that was not part of the original plan. Most of the time you would never have to say that. Markets go up. You buy and hold stocks for the long haul ... blah blah blah.
It is the few times where something radical IS required that your reader really needs you. We give our readers radical ideas that are mostly bullish ... because the stock market has mostly gone up for the last 20 years. It has not required a radical departure from a conventional buy-and-hold strategy.
Even when those big ideas have been bearish, there was still some bullish silver lining ... something you could buy to hedge against the risk and calamity. It has been this way for most of the 10 years I have been doing this. All the good ideas have been stock tips. Now maybe the best idea is a “cash tip”.
Now, getting into cash is a pretty radical idea for a stock-focused newsletter. And it certainly is not a market-neutral position. It is a claim that in the bursting of a credit bubble and the deleveraging that ensues (fire sale selling) it is much better to be in cash. You will need that cash later. You cannot take advantage of a firesale if you are inside the warehouse when it burns down.
Yes ... I would make a list of energy stocks, stocks not correlated to the U.S. consumer, or balance sheets heavy on tangible assets and light on debt. I would check it twice. And then I would wait for this little rally to blow itself out and see what happens. In the meantime, I would turn my attention to a part of world where all the biggest growth in the real economy is going to be for the next 20 years. Places where corporate earnings will not be driven by debt.
That is a great opportunity for the readers now. It is outside the dollar, in companies that serve all these new consumers in Asia with fresh lines of consumer credit or – egads! – actual savings in the bank! It is really an American investor’s last best chance to reduce his home bias before the credit bubble fully trashes the stock market ... and leads to Nanny State Finance under the next Clinton Administration.
Or I could be wrong and the collapse of the biggest bubble ever will have a negligible effect on U.S. stock values and corporate earnings. Or I could just be two years early. You can decide for yourselves.
Anyway, I know everyone is working really hard on good ideas. Just wanted to share my thought process for what it is worth ... and the belief that this is not just a fire drill this time ... but a real inferno.
This really could be your last chance to get out of the dollar and dollar-denominated assets before it is too late. Reckoning Day ... Empire of Debt ... Mobs ... it has been a steady progression. We should not be surprised we are there. And we need not do anything irrational now that we are ... but we should do what we can, whatever that is.Link here.
THE EFFECTS OF THE SUMMER MARKET SHOCK
“Greenspan blamed for double bubbles,” says a headline in the NY Post. At last ... finally ... they are on to the old humbug. Of course, Greenspan is not really responsible – at least, not alone – for today’s huge credit bubbles. As Ben Bernanke explained, there was a lot of money coming into the world financial system from other sources. The Asians, for example, seem to know how to make money but not how to spend it. Thus are they left with billions of dollars of savings. And when the price of oil rose from under $20 to over $70, it put a lot of money in the hands of oil producers. What could they do with all that extra money but put it into investments? And whose investments were better known, more liquid, and more universally accepted than those that were quoted in U.S. dollars?
Naturally and inevitably, people who earned dollars, or who had dollars, or owned dollar-based assets, or who printed up the dollar bills themselves, thought they were hot stuff. Everyone wanted what they had. Prices on Wall Street went up. Wall Street bonuses soared. Hustlers started up hedge funds, private equity funds, and funds of funds to grab some of the loose change.
All this money coming into the U.S. drove down interest rates. But it was not just the foreign savers who drove down U.S. rates, and it was not just the foreigners who were stuffing American capital markets with cash. After the mini-correction of 2001-2002, Alan Greenspan and George W. Bush panicked. Greenspan cut rates to “emergency” low levels – the lowest rates since the Great Depression – and the federal government jacked up spending while cutting taxes. The result was the biggest wad of new cash and credit ever to come into world capital markets.
What happened next? Boom ... Bubble ... now, Bust?
The price of oil has hit a new record high at $79.91. Meanwhile, the dollar has fallen to a new record low at $1.39 to the euro (EUR). Wheat hit a new record high of $9 a bushel – twice what it brought a year ago. And the commodity index registered a new high too. Gold, the ultimate measure of paper currency destruction, held steady despite estimates that the U.S. money supply has been growing at a fantastic 50% annual rate, following the market shock in the summer! So much new cash and credit ... so little real wealth!
Pity the poor American householder. Just a few months ago he had people lining up to lend him money. Now they are on the phone wanting it back! He had gotten used to refinancing. But now refinancing is tough, and more expensive. He goes to the grocery store and finds his bread and breakfast cereal have gone up in price. He gets his health care bill and finds it rising faster than his income. He drives into the gas station and is shocked by how much it costs to fill up his tank. He hears on the news that the government says inflation is under control, the federal budget is balanced, and all is well. But then he looks at his own cost of living and realizes that the feds’ numbers are nonsense. They merely left out two of his biggest expenses – food and fuel – and they cheated on the others.
And as for Bush Budget ... he is sure the feds are pulling a fast one there too. Look at the numbers more carefully, says Fortune Magazine, and you find a deficit of more than $400 billion. And then, he discovers that his adjustable rate mortgage is going to be reset. Get ready for a “deluge” of resets, says Reuters. So far, only about a third of the subprime ARMs of 2005 and 2006 have been reset. The crest of the wave is still ahead.
Home sales have already crashed, and forecasts are being revised downward every week. They are already at a 15-year low in Southern California. And now, the “housing slump is starting to pinch the economy,” says an item at San Francisco Gate. Shopping malls are feeling the pain, adds the New York Times.
And in Detroit, some 700 houses are to be auctioned off between September 21st and 23rd. These houses have been on the market for more than a year. The banks and mortgage lenders who own them are desperate to get them off the books. So this should be interesting. Finally, we are going to see houses marked to market. Some are expected to go for as little as $5,000.
Here in London, the Financial Times reports that property prices fell in August, for the first time in two years. Property bulls argue that Britain is a small island and that there is a shortage of housing. Yet, there are said to be about 850,000 empty properties in England alone ...Link here.
REQUIEM FOR AN ECONOMIST
Kurt Richebächer died two weeks ago at his home in Cannes, France, at 88 years old. R.I.P.
One of our greatest complaints is the way the modern world pays homage to its dead. When a good man finally has the mud tossed on his face, he is almost instantly forgotten. So little notice is taken, it hardly seems worth dying. Meanwhile, those who are widely mourned and greatly regretted usually do not deserve it. When Paris Hilton dies, for example, America will probably declare three days of national mourning and hang black crepe on the capitol.
Kurt Richebächer met his end with hardly an “ave” from anyone but friends and family. We pause to remember him here for both sentimental reasons and practical ones. On the sentimental side, we remember him as an old friend and fellow idealist. On the practical side he, and practically he alone, understood the worldwide economic boom for what it really is – a sham.
Kurt Richebächer was born at the wrong time, in the wrong place. He came into this life in the middle of WWI, on the losing side. He was a young man when another losing war got underway. He was one of the generation who were plucked up by the Wehrmacht in 1939, and lucky to still be alive by 1945. Kurt was lucky, in a way. He suffered a disabling accident while still in training. He spent the entire war in various military hospitals, unable to walk. The rest of his life he walked only with a cane. Doctors did not know exactly what was wrong with him. At one point German military officials threatened to prosecute him for malingering. Had Kurt’s father, a Nazi party member, not intervened, he might have been shot. Instead, in his hospital bed, he began to read economics.
The classical economics texts Kurt read made sense to him. They described not merely the world as it was, but the world as it ought to be. They emphasized discipline, hard work, and capital formation as the essential elements of wealth creation. And they warned against excess credit and inflation as if they were loose women and demon rum. Both were sure to lead to ruin.
The war over, Germany threw off the bad advice of its American overseers. The deutschemark was made a rock-hard currency. Germans clove to the old economics. The country prospered. And Kurt Richebächer rose to be chief economist for Dresdner Bank. But then, in the 1970s, classical economics – known as the Austrian School today – was going out of style, even in Germany. Economists in the U.S. and Britain found they could upgrade their trade. Instead of merely reminding people of the old, unyielding truths, they began offering new tricks and innovations. They promised not merely to explain how the world works, but to make it work better ... by taking the devil out of it and making it a more agreeable place. Using their new tools, econometrics and statistical analysis, they believed they could manage an economy, so as to achieve full employment and steady growth forever.
Kurt saw the new trends in his profession as dangerous. He regarded their proponents as quacks. “All this emphasis on statistics and calculations,” he said, “without a proper theory, it is all nonsense. And your economists seem to have no theory at all. They just think they can manipulate the system in order to get whatever outcome they want. They think economic growth comes from consumer spending and that they can control consumer spending by adjusting lending rates. It is unbelievable that anyone takes this seriously. It is capital formation that really matters. ... A rich society is not one where people consume. Just the opposite. It is not what is consumed that creates wealth; it is what is NOT consumed. Yet, all the Anglo-Saxons focus on motivating consumers to consume. And now they are consuming more than they make. I tell you, in 70 years of studying economics, I have never seen such nonsense.
“I have always thought it was the duty of each generation to leave the next one a little better off. That means, each generation has to consume less than it produces. It has to leave a little something extra. The problem, you see, is not an economic one. What we are doing to our children with this use of credit and debt is deeply immoral. It is wrong. It is wrong to burden the future with our mistakes, our conceits, our ambitions. This is what we are doing, and it is shameful.”
Kurt warned against the bubble in tech stocks in the late ‘90s. Then, he warned against the great bubble in housing. In September 2001, he wrote: “The new housing boom is another rapidly inflating asset bubble financed by the same loose money practices that fueled the stock market bubble.”
In one of his final letters, he concluded, “The recklessness of both borrowers and lenders has vastly exceeded our imagination.” He went on to predict “that the housing bubble – together with the bond and stock bubbles – will invariably implode in the foreseeable future, plunging the U.S. economy into a protracted, deep recession.”
Paul Volker once remarked that the challenge of modern central bankers “is to prove Kurt Richebächer wrong.” Instead, they are proving him right.Link here.
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