30 August 2007

too much confidence

Martin Hutchinson is the author of "Great Conservatives" (Academica Press, 2005) -- details can be found on the Web site www.greatconservatives.comT

he rapid rebound in the world’s stock markets following the Fed’s cut in its discount rate demonstrated again the central feature of the current market: investors have far too much confidence that all will turn out well, without major economic calamities or even market downturns. For their own wealth and that of the US and world economies, the quicker we can inject some healthy worry into their outlooks, the better.

The problem is: confidence sells. Indeed we need a fair amount of confidence in order to get through our day successfully. Psychologists have demonstrated that our natural state is to imagine ourselves more capable than we really are, imminently about to make the big breakthrough in our careers, able to forecast with more than usual accuracy which investments will do best for us. While it is notoriously the case that most institutional investors fail to beat the averages over the very long term, it is inescapably the fact that most private investors do even worse, buying high, selling low, being absurdly prone to following fashion and missing the performance of the stock averages by a substantial margin. The only thing that prevents us falling into terminal depression is that most of us are too lazy or poor at record-keeping to benchmark our performance properly against the indices.

The investment management and brokerage industries flourish through our optimism; that’s why most market commentary is relentlessly bullish. Of course, over the last 25 years relentlessly bullish market commentary has been right most of the time, with only the occasional regrettable lacuna in 1989-91 or 2000-02. Brokers, whose worst nightmare is the investor who sticks his money into an index fund and forgets about it, have made large fortunes over that period by convincing us that their bright new strategy is the one that will infallibly lead us to riches. Institutions themselves are not immune; otherwise the hedge fund and private equity fund industries, distinguished more for the size of their fees than for the superiority of their returns, would have no customers.

At the top of the cycle, of course, the perpetual optimists have credibility - also money. Ken Fisher, the broker whose perpetually bullish commentary infests the Internet, is a billionaire according to Forbes. In his new book, annoyingly advertised to me by e-mail, he claims investors believe three falsehoods: high price-earnings ratios make stocks risky, rising oil prices drive stocks down and big budget deficits are bad for the economy. I would argue that two out of three of those "incorrect" beliefs are bedrock principles of economic understanding and the third is true in most cases. However he’s a billionaire and I’m not, so let us pass on. As I said, optimism sells….

Confidence and salesmanship are particularly lucrative in the more high-tech portions of the financial market, where disclosure is limited and understanding even more so. Products such as securitization and derivatives have enabled deals to be done that would have been impossible in days when lenders knew their borrower the old-fashioned way.

The entire subprime mortgage market rested on this. In the days of savings banks lending directly to homeowners, the lending officer was responsible for the credit risk, so the WalMart cashier buying a $700,000 home didn’t get a mortgage. Today the people who have some chance of meeting the WalMart cashier, the mortgage broker and the loan origination officer, have no interest in anything beyond ringing up an extra fee. Meanwhile the originating company and its investment banks are mostly sales conduits, whose responsibility is diluted by the large number of loans in the packages they sell. The ultimate investors haven’t the faintest idea what they are buying, but buy it because it offers a high yield and their competitors are buying similar junk. With confidence, the wheels of commerce are well oiled and everybody is happy.

Now examine the situation when doubts emerge. The WalMart cashier may of course have no intention of making payments on the mortgage at all, in which case he has about 6 months free rental of a $700,000 house, plus the chance of a capital gain if the local real estate market is REALLY hot and he sells before they foreclose on him. The deadbeat’s situation thus stays the same whether or not confidence is good. However imagine the less extreme case, in which the WalMart cashier attempts to service the mortgage, perhaps making mortgage payments through the multiple credit cards he has acquired.

If confidence remains strong, the WalMart cashier has a good chance of selling the house at a profit. He also has an excellent chance of finding a friendly mortgage broker and appraiser, enabling him to refinance the mortgage for a larger amount, possibly at a lower interest rate (after all, having made some mortgage payments, he has graduated from "subprime," if not to prime then maybe to "Alt-A" status!) to pay off his credit cards. Either way, the mortgage gets repaid and everybody is happy.

Now suppose confidence has disappeared. In this case, the WalMart cashier defaults, because he can’t refinance or sell. The investor notices that the default rate on his mortgage bonds is increasing, so tries to sell the bonds. Quickly, the market price drops and investors for new mortgage bonds of that class disappear. Since new subprime mortgage loans are still being originated, everybody’s balance sheet quickly fills up, and the subprime mortgage market closes.

The same effect has become apparent in the leveraged buyout market. As with the subprime mortgage market, buyouts in the last year or so have been carried out for the corporate equivalent of $700,000 houses by the private equity fund equivalent of the WalMart cashier. A syndicate of banks would lend the fund the necessary purchase price, and syndicate the loans rapidly around the secondary loan and junk bond markets. While confidence remained, the private equity fund was able to report fictitious increasing values on its corporate holdings, audited by a major firm, naturally, and pay its principals 20% of the notional profit as "carry." (The principals then added public policy insult to financial chicanery injury by declaring this on their tax returns as a capital gain.) Only occasionally did the fund have to sell a company for something close to the appraised value, to keep confidence high and the game going.

Only when confidence lessens do these transactions cause difficulty; in this case, the loans cannot be sold off to the junk bond markets. Apparently $300 billion of LBO debt is now sitting on bank balance sheets, while banks that have committed to further transactions are desperately trying to wriggle out. Again, an initially modest decline in confidence has caused the market to close.

The same principle operates in the hedge fund arena, this time involving derivatives. Here, confidence and salesmanship allow the hedge funds to accumulate huge amounts of capital, then leverage themselves further from the banking community, pledging supposedly risk-free assets as "collateral." Their quantitative investment techniques work well provided there’s enough money behind them - they can force the market in the direction they need it to go. Borrowing yen at 2% and lending Australian or New Zealand dollars at maybe 6% or 7% is easy money while you can force the yen down and the Aussie dollar up, preventing any unpleasant losses on your currency mismatch. Derivatives trades allow the reality to be obscured and sometimes bring additional returns.

Once confidence ends, the markets move in the wrong direction on their own and even the weight of hedge fund money becomes insufficient to force them into submission. Complex derivative contracts, particularly those involving options, become illiquid and the models driving the investment strategy cease to work. Thus hedge funds using these strategies can suddenly report losses of 30%, 40% or even 100%.

Market action in the last ten days suggests there is still ample confidence in the system. Most participants are after all young and well paid (which itself tends to make them over-confident) and barely if at all remember the last significant credit market downturn, in 1989-90, let alone the last big one in 1973-75.The US stock market is off only about 5% from its peak, and is well up for the year. The yen carry trade appears to have resumed, with the yen showing weakness against the dollar. Countrywide, one of the biggest mortgage lenders, has been bailed out with an equity injection from Bank of America. BNP has figured out a way to price its subprime mortgage bond funds again.

This is not a good thing. The spread of securitization and derivatives has enabled more bad deals to be done, confidence to be raised to a higher and more irrational level and the asset bubble to be prolonged. By increasing the opacity of the market, these new techniques have weakened its ability to price risk appropriately.

Needless to say, when confidence finally disappears, the market outcome will be very bloody indeed. We have already seen this, in a blip in the inter-bank market similar to the darkest days of 1974, in which banks have been forced to pay more for simple overnight funding because counterparties did not trust what hideous losses might be hidden in their dealing rooms. This first time around, injections of cash from the Fed and the ECB prevented the panic from worsening. However panic will return, and at some point the world’s central banks will be unable to dampen it down. In the end, when all becomes opaque, all becomes uncertain and market confidence dies. Roll on that day, for ending the wave of overconfidence is a necessary corrective; the longer it is delayed, the more expensive the denouement will be.

At that point, market participants will doubtless wish that a healthy suspicion of new apparently painless ways of making money had been maintained throughout.

29 August 2007

Autumn Panics A Calendar Phenomenon

Calendar Research Inc.: Autumn Panics A Calendar Phenomenon: "The crash of the Hong Kong stock market in October 1997, with its obvious parallels to similar events in the U.S. in 1987 and 1929, once again raises the specter of October as a dark and ominous month for stocks. Is it merely a coincidence that these three crashes all occurred in October? Is there a timing pattern among autumn panics useful to market participants? This article expands upon the observation, originally contained in Chapter 1 of the author’s book, The Spiral Calendar1, outlining the correlation between the lunar calendar and the stock market panics of 1929 and 1987. This paper examines how the 1997 Hong Kong panic conforms to that earlier model, as well as examines the great autumn panics of the 19th century. Finally, a look at the peculiar international character of panics, and its implications for the possible causes of these panics."

Current Observations

Consider the following excerpt from Peter Eliades online "Current Observations":

We seldom use much newsletter space for the ideas of others, but the theories we are about to present fit together so well, we believe you will find them as interesting as we do. The two researchers are Steve Puetz (pronounced "pits") and Chris Carolan. Chris just won the 1998 Charles H. Dow Award for his original research and the complete article is offered on his website at http://www.calendarresearch.com . The research by Puetz was first noted in our October 10, 1995 newsletter. Here is what we wrote:

"Puetz attempted to discover if eclipses and market crashes were somehow connected. Without discussing our own opinion on the potential connection between astronomical configurations and market timing, let's simply relate to you the basic findings discussed by Puetz. He emphasized that he is not contending that full moons close to solar eclipses cause market crashes. But he does conclude that a full moon in general and a lunar (eclipse) full moon close to solar eclipses, in particular, seem to be the triggering device that allows for the rapid transformation of investor psychology from manic greed to paranoia. He asks what the odds are that eight of the greatest market crashes in history would accidentally fall within a time period of six days before to three days after a full moon that occurred within six weeks of a solar eclipse? His answer is that for all eight crashes to accidentally fall within the required intervals would be .23 raised to the eighth power less than one chance in 127,000."

". . .Puetz) used eight previous crashes in various markets from the Holland Tulip Mania in 1637 through the Tokyo crash in 1990. He noted that market crashes tend to be lumped near the full moons that are also lunar eclipses. In fact, he states, the greatest number of crashes start after the first full moon after a solar eclipse when that full moon is also a lunar eclipse . . Once the panic starts, Puetz notes, it generally lasts from two to four weeks. The tendency has been for the markets to peak a few days ahead of the full moon, move flat to slightly lower --waiting for the full moon to pass. Then on the day of the full moon or slightly after, the brunt of the crash hits the marketplace."

There's a solar eclipse on September 11th that will be preceded by a total lunar eclipse on August 28th. Furthermore, the full moon on July 30th occurs six weeks before the 9/11 solar eclipse. As indicated above, this means a stock market crash window will occur from July 24th to August 2nd.

This window should be expanded to a week before and after full moons according to a University of Michigan Business School study by Ilia Dichev and Troy Janes. This study examined 100 years of the stock market trends as they relate to the lunar phases. According to it, “Returns in the 15 days around New Moon dates are about double the returns in the 15 days around full moon dates. This pattern of returns is pervasive: We find it for all major U.S stock indexes over the past 100 years and for nearly all major stock indexes of 24 other countries over the last 30 years.”

Thus, from the week before to the week after the full moon on July 30th, there is the potential for a stock market crash. This potential seems much greater given the reversal from the 14000 mark in the DJIA and the Hindenburg Omen cluster.


Given that we are entering a window for a possible worldwide panic and global collapse of stock markets, it begs the question as to why?

If, indeed, a new large-scale decline in U.S. stock prices is getting underway, then what sort of events might erupt to upset investors' expectations?

Again, it could be that we are mainly dealing with an unraveling of the debt bubble that has been inflated by reckless government and Federal Reserve policies in recent years and decades. If so, then the stock market may now start anticipating a debt-deflation implosion in the economy that astute thinkers like Robert Prechter have been warning about for years.

Beyond the potential for a deflationary economic depression, however, what Prechter and other such long-wave theorists fail to recognize is that the social wave patterns they analyze do not necessarily unfold in a consequential manner, i.e., where a downturn in mood gives rise to the negative thinking and associated actions that beget greater upsets in collective confidence and reinforce given downtrends in collective mood. Rather, such historical wave patterns are synchronistic such that reversals and large-scale downtrends manifest as negative events collectively experienced as mass mood collapses. Accordingly, a reversal Dow 14,000 may be connected to negative historical shock(s) outside of financial markets and the economy. My concern remains for terrorism involving weapons of mass destruction and/or ultimately global nuclear war as I foresaw back in 1991.

28 August 2007

Mystery trader bets market will crash by a third

August 26, 2007
$4.5 billion options bet on catastrophe within four weeks

Anybody have a clue as to what these 'investors' are expecting?

The two sales are being referred to by market traders as "bin Laden trades" because only an event on the scale of 9-11 could make these short-sell options valuable.

There are 65,000 contracts @ $750.00 for the SPX 700 calls for open interest. That controls 6.5 million shares at $750 = $4.5 Billion. Not a single trade. But quite a bit of $$ on a contract that is 700 points away from current value. No one would buy that deep "in the money" calls. No reason to. So if they were sold looks like someone betting on massive dislocation. Lots of very strange option activity that I haven't seen before.

The entity or individual offering these sales can only make money if the market drops 30%-50% within the next four weeks. If the market does not drop, the entity or individual involved stands to lose over $1 billion just for engaging in these contracts!

Clearly, someone knows something big is going to happen BEFORE the options expire on Sept. 21.


The following theories are being discussed widely within the stock and options markets today regarding the enormous and very unusual activity reported above and two stories below. Those theories are:

1) A massive terrorist attack is going to take place before Sept. 21 to tank the markets, OR;

2) China, reeling over losing $10 Billion in bad loans to the sub-prime mortgage collapse presently taking place, is going to dump US currency and tank all of Capitalism with a Communist financial revolution. Either scenario is bad and the clock is ticking. The drop-dead date of these contracts is September 21. Whatever is going to happen MUST take place between now and then or the folks involved in these contracts will lose over $1 billion for having engaged in this activity.

"$1.78 Billion Bet that Stock Markets will crash by third week in September Anonymous Stock Trader Sells 10K Contracts on EVERY S&P/Y "Strike" Shorts Stocks "in the money" effectively selling all his SPY holdings for cash up front without pressuring the market downward.

This is an enormous and dangerous stock option activity. If it goes right, the guy makes about $2 Billion. If he's wrong, his out of pocket costs for buying these options will exceed $700 Million!!! The entity who sold these contracts can only make money if the stock market totally crashes by the third week in September.

Bear in mind that the last time anyone conducted such large and unusual stock option trades (like this one) was in the weeks before the attacks of September 11.

Back then, they bought huge numbers of PUTS on airline stocks in the same airlines whose planes were involved in the September 11 attacks.

Despite knowing who made these trades, the Securities and Exchange Commission NEVER revealed who made the unusual trades and no one was ever publicly identified as being responsible for the trades which made upwards of $50 million when the attacks happened.

The fact that this latest activity by a single entity gambles on a complete collapse of the entire market by the third week in September, seems to indicate someone knows something really huge is in the works and they intend to profit almost $2 Billion within the next four weeks from whatever happens! This is really worrisome."

Source: Ticker Forum

20 August 2007

Traders braced for another torrid week

By Ambrose Evans-Pritchard and Yvette Essen
Last Updated: 12:47am BST 20/08/2007

Switzerland's top banker has warned of massive losses from the unfolding credit crisis, describing the collapse in US lending standards as "unbelievable".

Comment: Bernard Connolly on the sub-prime crisis

All eyes will be on Tokyo today to learn if the US rate move helps restore confidence

Jean-Pierre Roth, president of the Swiss National Bank, said market turmoil was far from over as tremors from the sub-prime debacle continued to rock the world.

"We're certainly not at the end of the story. There are question marks surrounding the development of the American economy," he said. "Something unbelievable happened. People who had neither income nor capital got credit with very attractive conditions. Now reality is striking back," he said.

In Germany, the state bank SachsenLB admitted that it had received a €17.3bn bail-out after its investment arm Ormond Quai racked up huge losses on US sub-prime debt. It had previously denied holding direct exposure to sub-prime.

The revelation came as traders braced themselves for another turbulent week, with mounting expectations that central banks may soon cut rates to prevent market mayhem leading to an economic downturn.

While the surprise half-point cut in the US discount rate to 5.75pc last Friday helped settle markets and launch a relief rally on Wall Street and European bourses, investors remain wary until it becomes clearer who is holding the main losses on US mortgage debt.


Stockmarket historian David Schwartz warned investors not be fooled by signs of recovery. "The truth is no-one knows how serious the financial problem in the US is, nor how it will unfold. We do know central banks are scared out of their minds," he said.

The scale of last week's sell-off sent shock waves through almost every asset class. Hedge funds liquidated yen "carry trade" positions to meet margin calls, toppling dominoes across Asia, Latin America, and Eastern Europe.

All eyes will be on Tokyo this morning to learn whether the US rate move proves enough to restore confidence after the Nikkei index slid 5.4pc on Friday. The shares of Japanese exporters have crashed on profit fears following the yen surge.

Both Goldman Sachs and Lehman Brothers predict two cuts in the US federal funds rate to 4.75pc by the end of the year as falling house prices dampen spending. Michigan's consumer confidence index slumped to 83.3 in August, down from 90.4 in July.

Markets are pricing in a 34pc chance that the European Central Bank will have to start cutting rates before the end of the year after growth faltered in the second quarter. The French and Spanish property booms have both stalled.

Jean Claude-Trichet, the ECB's president, last week reaffirmed a likely quarter point rate rise to 4.25pc in September, despite the bank's emergency actions in previous days.

Michael Husdon replies

Dear Gunnar, August 19, 2007
Thank you for sending my Mr. Cook¹s article and your comments.
I¹m told that he is to be joining my team on behalf of Dennis Kucinich. So I
want to make clear how my ideas differ both from yours and his.
I realize that you are not going to agree with me Gunnar. I have
refrained from arguing with you in the past, because I don¹t want to get
into the situation that led both Randy Wray and Stephen Zarlenga to withdraw
from this list. The best thing is that we agree to disagree.
Here is where we disagree. I view ³the economy² as divided into
two sectors. The biggest sector as far as credit is concerned ­ over 99% ­
is the market for financial securities, mainly bonds, stocks and mortgage
loans and other packaged bank loans. Each day more than an entire year¹s GNP
passes through the New York Clearing House and the Chicago Mercantile
The small sector ­ using about 1% of credit ­ is the sector that
you and Mr. Cook focus on: the ³real² economy producing goods and services.
Given the disparity in sizes, most credit inflates asset prices.
In fact, since 1980 the U.S. economy has seen the most rapid inflation in
its history. But the inflation has been considered ³benign² and even ³good²
(Mr. Greenspan called it ³wealth creation²) because it increased the
purchasing power over living labor of property ­ real estate and financial
securities. The dead hand of the past increased its weight over the living.
You cite Cook¹s statement, ³But the peculiar thing is that
because the borrowed money pays for labor, commodities, rent, etc., it [He
means, ³its financing charges²] becomes part of the prices that are
eventually charged for goods and services.²
OR, the borrowed money ­ the great bulk of it ­ is used to bid
up prices for real estate (70% of U.S. and British bank loans are mortgage
loans), stocks (for LBO loans) and bonds (by flooding the economy with
credit to drive interest rates down, producing the greatest bond rally in
history as rates fell from 20% in 1980 to 5% in 2005).

Cook continues:
³However, when the money goes back to the bank to cancel a
loan, that purchasing power disappears.²
It doesn¹t really disappear, of course. It is withdrawn from the
³real² production-and-consumption economy and added to the financial
sector¹s purchasing power. That sector uses its inflow of (re)payments to
lend out to buyers of real estate, stocks and bonds and entire companies to
further inflate asset prices.
As I¹m sure all of us on Gang8 know, banks don¹t lend to invest
in tangible capital formation. That is financed mainly out of retained
earnings. Neither James Watt, Henry Ford or industrialists in between could
borrow from banks to put their capital in place. Banks lend to against
assets already in place, or to finance the sale of goods already produced
and ordered, but not to create ³equity² investment in tangible means of
production. This is what warps the private-sector banking system today, and
I understand that this is Mr. Cook¹s criticism too. (Chris Cook might also
agree here.)

Mr. Cook concludes that ³The economy is thus a treadmill that
borrowers must constantly trudge along in order to have enough money for
I think it is a treadmill that becomes increasingly steep. The
debt repayment burden mounts up at compound interest.

You comment:
³In the circular-flow view of Entrepreneurial Production, newly
created credit/money/purchasing power enters the economy through the market
for Factor Services and exits the economy through the market for Final Goods
and Services.²
Again ³the economy² here is divided into two sectors. This is my
major point. Credit is NOT transformed ³into Final Goods and Services,² but
into asset-price inflation.
You ask, ³Why, then, does Cook assert that "this process
creates a chronic shortage of purchasing power²? My answer is that debt
service mounts up faster than the economic surplus, and ends up absorbing
it. Yours is, ³Because he defines "credit" as synonymous with the economy's
potential productive capacity and takes as given that actual mobilization of
Factor Services must fall short of that potential.² This sounds like the old
Social Credit idea.

You point out his citation that all definitions of credit ³ have
some connotation of the concept of ³value² Š²
I would rather say, ³Price.² Value in the sense the classical
political economists used the term reflects socially necessary costs of
production. Credit and other financing costs are external to the
production-and-consumption sector, being wrapped around it as I have shown
in the diagrams in my Kansas City and Harpers articles. These financial
charges are institutional, not technological. You focus on the ³real²
economy, as does Cook here ­ until he criticizes the fact that today¹s
banking credit is extended largely to finance predatory property

You then cite a sentence that seems to reflect both your views
in common: ³The idea of credit when viewed from a macroeconomic perspective
refers to the ability of an economy to produce goods and services of value
to the members of that community.²
My point is that credit been turned into its opposite ­
increasing the economic power and price of property over labor, as it takes
more and more wages to buy a home, more and more profits or rental income to
buy commercial real estate, or more and more labor income to buy a flow of
retirement income.
Cook writes: ³Without the credit-potential of a producing
economy, money has no meaning.² My point is that it HAS a meaning, but one
that takes the corrosive form of asset-price inflation. This becomes clear
when one looks at the buildup of interest-bearing debt at exponential rates
­ the ³miracle of compound interest.²
Cook points out that ³the ³real² credit of the U.S. economy was
much higher, because our economy is not running at anywhere near its full
To me, the answer is different. The volume of capital ­ and debt
­ far exceeds GNP. Hence, financialized asset prices are expanding much
larger than actual production. Credit is not extended to produce goods and
services, increase national income and GNP, but to buy assets and financial

You now quote from Cook¹s article, WHERE MONEY COMES FROM
I think he makes a good point when he writes that:
³Actually, an economy functions according to the principles
according to which it is designed and regulated. If it is designed to funnel
wealth into the hands of the monetary controllers, then that is what the
³market² and the ³invisible hand² will do. Š Unfortunately, we march today
to the tune of the monetary elite, so they are the ones who reap the profits
and the benefits. They are the ones on whom the ³invisible hand² lavishes
the wealth of the world.²
He continues:
³It is done through the process of bank-created credit. While
during the nineteenth century other forms of money circulated, such as large
quantities of coinage, silver certificates, and government-issued
greenbacks, almost all the money that exists today originates through a loan
by a financial institution to an individual or a business.²
He then proceeds: ³When a loan is made it is issued as a
liability on the bank¹s ledger. When it is repaid, the liability is
But in the interim, the bank receives interest ­ which tends to
accumulate exponentially to reflect the build up of loans. The
³administrative fee² he refers to as ³interest² is indeed an ³administered
price,² and hence a monopoly right ­ and as such, a form of economic rent.

Cook recognizes that ³Some credit is used by businesses or
individuals as investment in order to generate profits over and above the
amount they must repay to the bank with interest.²
Profits are not really the key these days. ³Capital gains² have
become the name of the game in today¹s ³Ponzi² stage of the business cycle,
to use Minsky¹s terminology.
Cook realizes this when he writes that ³Unfortunately, large
amounts of credit are used mainly for speculation, not for any benefit to
the producing economy. This includes securities bought on margin and
borrowing by hedge funds where the fund may make a profit even if the value
of its investments goes down. Bank-created credit in this case is little
more than chips in a casino.²
It actually is more than this. Credit bids up asset prices in
the ³large² finance-and-property sector that is wrapped around the ³real²
production-and-consumption economy. This is the major cause of economic
polarization in today¹s world.
This is why I find M3 an important measure, and why Stephen
Zarlenga has proposed the Monetary Transparency Act so that we are in a
better position to measure the extent to which the banking system is
contributing to asset-price inflation, loading down the economy with debt in
the process.

Cook makes an excellent point in arguing that ³individual
consumers should never have to borrow in the first place. And we never ask
ourselves why, with the abundance that is possible from modern science and
technology, should people have to borrow money at interest for the
necessities of life‹a house, a car, household expenses, an education, etc.
³Thus we realize that the financial system works against what
should be the real purpose of money, which is to serve as a ticket for the
purchase by people of articles they need to survive or otherwise desire to
utilize once the demand for survival has been met.²
Again, I¹m sympathetic to this, and also to his pointing out
something with which we all agree: ³money is being mis-defined as a
commodity. People who believe money is a commodity think it has value
in-and-of-itself.² Unfortunately, he defines money (and credit too?) as
³anything that a willing buyer and a willing seller agree to exchange for
something else.²
From ancient times, anyone could create credit simply by NOT
PAYING. Most debts in ancient Babylonia were arrears of payments for land
rent, consumption, taxes and fees (as the volume from our British Museum
conference edited by Marc Van De Mieroop and myself on ³Debt and Economic
Renewal in the Ancient Near East² has shown).
So to conclude, Cook gets confused by pointing that while ³the
2006 GDP of the United States was $12.98 trillion. But actually, the ³real²
credit of the U.S. economy was much higher, because our economy is not
running at anywhere near its full capacity.²
That¹s not the reason at all. The reason is that credit is used
to finance assets and financial securities, and as such, claims ON wealth
(as Soddy pointed out), not goods and services. Credit is extended NOT for
production, but for property rights and financial claims ON the economy. It
becomes a purely mathematical Ponzi scheme in the end. This is the stage in
which we find ourselves today.

Inasmuch as the right to create interest-bearing debt is the
right to a form of economic rent, I can agree that ³Therefore, credit can
and should be viewed as a communal endowment, a public phenomenon, a part of
what is called ³the commons,² even with the normal and natural fact of the
existence of private property. So the use of credit and its distribution
should be treated as a public utility, like water or electricity. Everyone
should have a right to its use, according to some rational, lawful, and
humane criteria of need or contribution to creating it. Š It is no
exaggeration to say that the existing system is one whereby the financial
elite has confiscated and privatized the most important public resource of
all, more important than water, land, electric power, etc.²
I wish his argument was that this resource has been distorted by
the fact that banks and the financial sector generally has a short-term
³extractive² outlook that has a disconnect with the production and
consumption sector, and actually works against it by inflating asset prices
rather than financing capital formation. His argument reads as if consumers
need more credit to help GNP be fully realized. Producers also need credit,
but instead, corporate raiders are granted credit to take over, downsize and
outsource the labor force, carve up the companies and avoid paying taxes in
the process.

Michael Hudson

19 August 2007

Henry Kaufman in WSJ on the credit crunch, liquidity, and hedge-quant funds

Henry Kaufman has a superb piece on the opinion page of the Wall Street Journal today, August 15, 2007, on the fundamental causes of the credit crunch. Behind the subscriber wall, here, but highly, highly recommended. Henry Kaufman, "Our Risky New Financial Markets," WSJ, August 15, 2007, opinion page.

The blurring of the distinction over time between "liquidity" and "credit availability" is crucial, as is his point about the limitations of the quantitative financial models. I must say, as a corporate finance professor, parts of this look remarkably similar to the problems of Long Term Capital a decade ago - the quant manager saying that there had been three successive days which the models predicted would occur only once every 10,000 years, the belief that the models had successfully hedged whereas the price movements in actual markets indicated otherwise ... combined with, as Kaufman points out, the emergence of financial institutions that are regarded as too big to be allowed to fail (and, a very striking point, his assertion that this very fact is part of what drives consolidation in the financial services industry - as the smaller players face the necessity of being part of an operation too big to fail) and the attendant moral hazard ... the risks are there to be seen.

If, of course, the market will not be allowed to operate, then moral hazard can only be avoided by more stringent regulation, which Kaufman is skeptical will come about.

Some excerpts:

The principal structural driver behind this and similar financial tribulations is the massive growth of financial markets, combined with a plethora of new credit instruments. By any measure, current financial activity -- new financing or secondary market trading volume -- dwarfs the past. The outstanding volume of nonfinancial debt now exceeds nominal GDP by $15 trillion, compared with $6 trillion a decade ago. Traditional credit instruments such as stocks, bonds and money-market obligations have been joined by a long and diverse roster of new obligations, many of them extraordinarily complicated. Along with the arcane tranches of mortgages that recently garnered attention are a myriad of financial derivatives, ranging from those traded on exchanges to tailor-made products for the over-the-counter market.

Leading financial institutions have grown rapidly as well. More importantly, they have evolved to become integrated, diversified, global enterprises that bear little resemblance to traditional commercial banks, investment banks or insurance companies. As these giants grow and dominate the market, they carry enormous potential for conflicts of interest -- they simultaneously act as investors of their own massive assets and as dealmakers and consultants on behalf of their clients. And their reach into the financial system is so broad and deep that no central bank is willing to allow the collapse of one of these leviathans. They are deemed "too big to fail."

These structural and institutional changes have, in turn, encouraged a new understanding among market participants of liquidity. In the decades that followed World War II, liquidity was by and large an asset-based concept. For business corporations, it meant the size of cash and very liquid assets, the maturity of receivables, the turnover of inventory, and the relationship of these assets to total liabilities. For households, liquidity primarily meant the maturity of financial assets being held for contingencies along with funds that reliably would be available later in life. In contrast, firms and households today often blur the distinction between liquidity and credit availability. When thinking about liquid assets, present and future, it is now commonplace to think in terms of access to liabilities.

This new mindset has been abetted by the tidal wave of securitization -- the conversion of nonmarketable assets into marketable assets -- that swept across the financial world in recent decades. This flood of marketable assets not only has eroded traditional concepts of liquidity, it has stimulated risk appetites and fostered a belief that credit usually is available at reasonable prices.

These two developments -- securitization and the seamless interconnectivity of markets -- have brought intricate quantitative risk modeling to the forefront of financial practices. Securitization generates market prices, while information technology offers the power to quantify pricing and risk relationships. Few recognize, however, that such modeling assumes constancy in market fundamentals. This is because modeling does not adequately account for underlying structural changes when attempting to calculate future risks and prices.

Nor can models take into account the impact of growing financial concentration in the making of markets and in the pricing of securities that are traded infrequently, or that have tailor-made attributes. And what about the risks to financial markets of a major military flare-up, the ravages of a pandemic flu, a terrorist attack that would immobilize computer networks, or even shifts in the broader monetary environment? Do the models quantify these and other profound risks in any meaningful way?

Then there is the question of asset pricing. An essential component of successful risk modeling is accurate pricing of the securities used in the analysis. Here, again, the strictly quantitative approach shows its weaknesses. Accurate pricing is a thorny challenge. In rapidly moving markets, the price of the last trade may be invalid for the next one. The price a dealer is prepared to quote may be no more than an indication of a potential trade. And the price quoted may be valid only for a small quantity of assets, not for the full amount in the investor's portfolio.

At the heart of the long-term underlying challenges that face the U.S. financial system is the question of how to enforce discipline. One way is to let competitive forces discipline market participants: The manager who performs well prospers, while those who do not fail. This is the central precept of free market economies. But this approach is compromised by the fact that advanced societies typically do not allow the process to follow through when it comes to very large financial institutions. The fear is that the failure of behemoth financial institutions will pose systemic risks both here and abroad.

Therefore, market discipline falls more heavily on smaller institutions, which in turn motivates them to merge into larger entities protected by the too-big-to-fail umbrella. This dynamic has driven financial concentration and will continue to do so for years to come. As financial concentration increases, it will undermine marketability, trading activity and effective allocation of financial resources. (Ital. added KA)

If competition is not allowed to enforce market discipline, the most viable alternative is increased supervision over financial institutions and markets. In today's markets, there is hardly a clarion call for such measures. On the contrary, the markets oppose it, and politicians voice little if any support. For their part, central bankers do not possess a clear vision of how to proceed toward more effective financial supervision. Their current, circumspect approach seems objectively technical, whereas greater intervention, they fear, would seem intrusive, subjective, even excessive.

What is missing today is a comprehensive framework that pulls together financial-market behavior and economic behavior. The study of economics and finance has become highly specialized and compartmentalized within the academic community. This is, of course, another reflection of the increasingly specialized demands of our complex civilization. Regrettably, today's economics and finance professions have produced no minds with the analytical reach of Adam Smith, John Maynard Keynes or Milton Friedman.

18 August 2007

The Next big threat!

The following is a post made to the SiliconInvestor Website: The Epic American Credit and Bond Bubble Laboratory, Msg # 85257. If credible, this could really get scary. Also, I have posted below a section from the Fixed Income Clearing Corporation's Mortgage-Backed Securities Division which highlights part of the problem associated with clearings, trade comparisons, confirmations, nettings and other risk management issues. As the poster said: "As ugly as the markets are, behind the scenes the situation is even uglier"

From: Gemlaoshi 8/17/2007 10:12:24 AM
26 Recommendations of 85289

As ugly as the markets are, the behind the scenes situation is even uglier.

As I have posted here before, my daughter is a financial risk consultant with the consulting arm of one of the top accounting firms. Yesterday she received a call to get to GS as quickly as possible...it seem the derivatives settlement process is in danger of coming unglued.

Since most of these are poorly documented private contracts with counterparties, there are $billions at stake where they don't know the counterparty or if the CP is even still in business. This has made it impossible to ascertain their existing positions because so many of the "sells" in the last couple of months have not been settled, but are in limbo.

The NY Fed has been warning of this situation for the past several months...it seems like it is here in real life. My daughter has been told to expect to be at GS through the end of the year...the mess is HUGE.

About The Mortgage-Backed Securities Division

The Mortgage-Backed Securities Division operates two primary business units that serve the MBS marketplace: clearing services, which include trade comparison, confirmation, netting and risk management and Electronic Pool Notification (EPN), which allows customers to transmit/retrieve MBS pool information in real-time utilizing standard message formats.

Stability: A Unique Securities Market

The MBS market bears unique characteristics that affect how trades are compared and settled, and how industry participants communicate with each other. Our services and systems are driven by such distinctive market fundamentals as:

- Long settlement periods -- The average time between an MBS trade and settlement date is far longer than that in the Government securities and equity markets -- 45 to 90 days compared to one and three days, respectively. This extended settlement process greatly increases participants' exposure to price fluctuations in the MBS market.

- High transaction values -- While the number of transactions completed in the MBS market is smaller than that in other markets, an average MBS trade is significantly larger in size -- typically $10 million in par value or more. This increases the potential financial exposure and requires a sophisticated and proactive risk management approach.

- Variance upon delivery -- A seller in the MBS market is permitted to deliver securities that vary by a certain percentage from the originally traded face value. This variance creates post-trading profit opportunities and requires sophisticated accounting systems to track settlement activity.


16 August 2007

Roubini on the problem

Here are two examples of how uncertainty and opacity has vastly increased in financial markets.

First, you take a bunch of shaky and risky subprime mortgages and repackage them into residential mortgage backed securities (RMBS); then you repackage these RMBS in different (equity, mezzanine, senior) tranches of cash CDOs that receive a misleading investment grade rating by the credit rating agencies; then you create synthetic CDOs out of the same underlying RMBS; then you create CDOs of CDOs (or squared CDOs) out of these CDOs; and then you create CDOs of CDOs of CDOs (or cubed CDOs) out of the same murky securities; then you stuff some of these RMBS and CDO tranches into SIV (structured investment vehicles) or into ABCP (Asset Backed Commercial Paper) or into money market funds. Then no wonder that eventually people panic and run - as they did yesterday – on an apparently “safe” money market fund such as Sentinel. That “toxic waste” of unpriceable and uncertain junk and zombie corpses is now emerging in the most unlikely places in the financial markets.

Second example: today any wealthy individual can take $1 million and go to a prime broker and leverage this amount three times; then the resulting $4 million ($1 equity and $3 debt) can be invested in a fund of funds that will in turn leverage these $4 millions three or four times and invest them in a hedge fund; then the hedge fund will take these funds and leverage them three or four times and buy some very junior tranche of a CDO that is itself levered nine or ten times. At the end of this credit chain, the initial $1 million of equity becomes a $100 million investment out of which $99 million is debt (leverage) and only $1 million is equity. So we got an overall leverage ratio of 100 to 1. Then, even a small 1% fall in the price of the final investment (CDO) wipes out the initial capital and creates a chain of margin calls that unravel this debt house of cards. This unraveling of a Minskian Ponzi credit scheme is exactly what is happening right now in financial markets.

So combine an opaque and unregulated global financial system where moderate levels of leverage by individual investors pile up into leverage ratios of 100 plus; and add to this toxic mix investments in the most uncertain, obscure, misrated, mispriced, complex, esoteric credit derivatives (CDOs of CDOs of CDOs and the entire other alphabet of credit instruments) that no investor can properly price; then you have created a financial monster that eventually leads to uncertainty, panic, market seizure, liquidity crunch, credit crunch, systemic risk and economic hard landing. The last two asset and credit bubbles in the US – the S&L real estate bubble and bust of the late 1980s and the tech stock bubble of the late 1990s – ended up in painful recessions. The latest credit and asset bubble was much bigger: housing, mortgages, credit, private equity and LBOs, credit derivatives, corporate re-leveraging. So, the current bust and de-leveraging of the financial system is likely to lead to another painful economic hard landing.

14 August 2007

The liquidity crisis and the stagnating US trade deficit

The liquidity crisis and the stagnating US trade deficit (Aug. 12, 2007)
The global liquidity squeeze has turned into a global financial panic. It has started with the subprime mortgage woes in the US. Many of those subprime mortgage loans require no down-payment at all, and carry a very low introductory interest rates for the first few years, call the “teaser rate”. After the period of the teaser rate expires, the interest rates on those subprime mortgage loans will move in tandem with the prevailing short-term market interest rates. As the short-term interest rates have risen substantially, those subprime borrowers suddenly face an unbearable monthly interest payments after the expiration of the teaser rate period. Thus many subprime mortgage loans end up in delinquency and then in default. Since most of those subprime mortgage loans are packaged into mortgage backed securities, the defaults of subprime mortgage loans have thus damaged the values of those mortgage backed bonds. Due to the invention of complicated financial derivatives, the damage on the price of those mortgage backed bonds is further amplified. Those subprime mortgage backed bonds are held widely by financial institutions and hedge funds around the globe so many entities have run into trouble by holding related bonds and derivative instruments. However, this kind of woes are not limited to subprime mortgages. In the non-subprime category a substantial fraction of newly granted mortgage loans also are adjustable rate mortgages that carry very low teaser rates and with scant down-payments. At a very low interest environment financially sound people will borrow 30 year fixed rate mortgages to lock in very low interest rates. In the non-subprime category, only those with good income but financially stretched will borrow adjustable rate loans with a teaser rate even substantially lower than the already low rates of the fixed rate mortgages, apparently in the hope that future interest rate will stay low or the rising housing prices will bail them out. As those scenarios failed to develop, the default rate in the non-subprime sector is also rising. Then there are home equity loans that are also adjustable rate loans. The default rate of home equity loans is rising, too. Those non-subprime adjustable rate mortgages and home equity loans are also widely packaged into mortgage backed or real estate equity backed bonds. Thus the pains of mortgage woes are quickly spreading beyond the subprime region. At the same time of mortgage woes the liquidity in the markets of junk bonds that are issued mainly to finance the frenzy of takeover booms in the hands of private equity firms is also drying up. Though some are trying to play the word game and called the spread of the financial pain and the drying up of liquidity as “the reassessment of financial risks”, the reality of diminishing liquidity finally hit and the financial pains has turned into a global financial panic in the last two days, on Aug. 9 and 10 of 2007. In order to understand the true nature of this liquidity crisis we will discuss in this comment the origin of the liquidity squeeze, the future course that this crisis will likely to take, and how this crisis will affect the global economy.

The global liquidity is pumped up by the global trade imbalance, not by the total amount of global trades. The majority of the global trade imbalance is due to the runaway US trade deficits. Let us consider first the situation of USA. As the US runs trade deficits, US dollars are handed over to foreigners. Since US dollars are not legal tenders in foreign countries, those dollars related to the trade deficit (we will call them trade-deficit-dollars from here on) must flow back to the US markets, mainly via the Wall Street. A portion of those returned trade-deficit-dollars will purchase US based assets like stocks and real estates, but the majority of the trade-deficit-dollars will be lent out in the form of purchasing dollar denominated debt instruments, ranging from US treasury issues, mortgage backed instruments, corporate bonds and so on. As lending generates more lending, the trade-deficit-dollars balloons to a large amount of liquidity. In 2005, the US current account deficit, the broadest measure to gauge the trade situation, has topped 600 billion dollars. Thus we may expect that the total liquidity originated from trade-deficit-dollars has already reached tens of trillions of dollars. It is this liquidity glut that is supporting the US government spending, the local government spending, the consumer spending, the mortgage lending, the borrowing by private equity firms to finance their buyout frenzy, and the borrowing by hedge funds to engage in speculative activities. However, the US trade deficit has stagnated for more than a year, and thus the liquidity squeeze. We will look into the actual data to give supports to this argument in the following paragraphs.

The current account deficits are not adjusted for inflation, so we always consider the ratio of the current account deficit over the nominal GDP, expressed in percentages, as a proper measure to gauge the trade situation. This ratio is called trade-deficit-to-GDP ratio in short. The four quarter moving averages of this ratio are plotted as the blue curve in the graph at the right. Four quarter moving averages of the growth rate of real GDP are plotted as the green curve, and four quarter moving averages of the growth rate of real (means inflation adjusted) debt are plotted as the red curve in the graph respectively. Since the onset of the globalization process in the early part of 1980's, there have been three bursts of US trade deficits as can be seen as three sharp rises of the blue curve. The first burst of the trade deficit occurred in the period from 1983 to 1986, and the growth rate of real debt (the red curve) far exceeded the growth rate of real GDP (the green curve) in this period, creating the debt bubble of 1980's. It was this debt bubble that generated the real estate bubble of 1980's and induced frenzied merger and acquisitions by issuing junk bonds to finance such activities. The US trade deficit at that era were mainly due to the trade deficits with Japan. Thus in early 1985 major powers agreed to let Japanese Yen appreciate against US Dollar; Japanese Yen rose almost 100% in the succeeding years. This great devaluation of US Dollar took about 2 years to be translated into the stagnation of US trade deficit and then the decline. As can be seen from the blue curve of the trade-deficit-to-GDP ratio, it started to stagnate in 1986 and had turned to an explicit decline near the end of 1987. With this retreat of the US trade deficit, the red curve, the growth rate of the real debt, had turned down sharply from 1986, indicating the steep drop of the rate that liquidity was created. As the liquidity squeeze due to the slowing trade deficit advanced, the merger and acquisition activities came to an abrupt end, withdrawing an import support for the stock markets. As the ratio of trade-deficit-to-GDP started to turned down at the end of 1987, stock prices crashed and the growth rate of real GDP slowed substantially. The three curves tumbled together toward the nadir of 1991, until the growth rate of real GDP became negative and an official economic recession was declared. This series of events shows how the flows and ebbs of trade deficits induced the rise and the bust of the debt bubble, and how the fate of the debt bubble pushed around the growth of the real GDP.

As the ratio of trade-deficit-to-GDP fell to its nadir, US Dollar regain the power to rise against Japanese Yen. Thus the US trade deficit started to expand again from its nadir of 1991. However, the second burst of the US trade deficit needed to wait Japan's near zero interest rate policy that unleashed yen carry trades to push US Dollar sharply higher against Japanese Yen. During this second burst of US trade deficit, a debt bubble did not emerge. Instead the trade-deficit-dollars flew into stock markets and created a stock price bubble. The debacle of US Dollar in 1998 and 1999 caused US trade deficit to decline in 2000 as can be seen from the peak of the blue curve in 2000. As the ratio of trade-deficit-to-GDP came down, so was the growth rate of real GDP. The third burst of US trade deficit has started in 2002, though temporarily disrupted in 2003 by the SARS scare. By the time of this third, or the current burst of trade deficit, China has replaced Japan as the major contributor to the US trade deficit. The movement of Dollar vs. Yen becomes less a factor in dictating the movements of the US trade deficit. Chinese Yuan has been pegged to US Dollar until the middle of 2005, and is allowed to float up slowly since the middle of 2005. Thus the drop of dollar against other currencies except Chinese Yuan from 2002 has a much less effect on the US trade deficit than used to be. Only from the beginning of 2005 US trade deficit less energy has started to stagnate, but the overall trade deficit was kept rising through 2005 due to the rapid rise of the price of crude oil. Only when the oil price stagnated, the US trade deficit has ceased to rise, and the blue curve has peaked and started to fall in 2006. During this current burst of the trade deficit, a debt bubble developed as the substantially higher debt curve (the red one) than the growth rate of real GDP (the green curve) indicates. As the trade deficit starts to fall, the growth rate of debt, the red curve, is falling in tandem, indicating the rapid disappearance of the liquidity glut.

In order to guage the future course of the liquidity squeeze, we must first understand the direction of the US trade deficit. Considering the dominance of foreign made, especially Chinese made, consumer goods in the US market, the trade deficit of the consumer goods sector is probably near saturation. The trend in automobile sector is for Japanese brands to manufacture cars within USA and gradually replace American brands. This transition of power will not cause the trade deficit of the automobile sector to increase sharply. As liquidity bubble bursts, the Wall Street people that have profited mightily from the bubble will be poorer, and will buy less imported luxury cars, and thus the trend of deficit in the automobile sector is a stagnation at best. The capital goods sector is sensitive to the value of dollar. At the dawn of the globalization era, the US enjoyed a substantial trade surplus in this sector. After experiencing waves of runaway trade deficits, this surplus in the capital goods sector had turned into a deficit of 17 billion dollars a year by 2005. The falling dollar from 2002 is narrowing the deficit in this sector fast. As a whole the US trade deficit less energy will continue to stagnate unless unexpectedly US dollar strengthens against the currencies of its trading partners, including Chinese Yuan, by a substantial amount. Barring such an unlikely currency exchange rate movement, only hope for a rising US trade deficit is for the price of crude oil to jump sharply from here. If that happens, the blue curve will turn up again, the red curve will bottom out, the liquidity squeeze will ease, stock prices will rise, but the growth rate of real GDP will fall further due to heightened inflation rate. If the oil price does not come in to rescue, the ratio of trade-deficit-to-GDP will continue to fall, and the growth rate of debt (the red curve) and the growth rate of real GDP (the green curve) will follow the blue curve down in a measured pace. Thus the liquidity squeeze will continue for quite a while.

Some claim that if only FED lowers interest rates and replenish the lost liquidity, everything will be fine. Let us look into this theme in details. Greenspan FED took the radical action of lowering interest rates to the 1% level in 2003, and ignited the housing bubble that is now deflating painfully. US Dollar tumbled from the level of 115 Yen/Dollar toward the level of 100 Yen/Dollar. Japanese government stepped in and bought up more than 400 billion dollars to prevent US dollar to collapse below 100 Yen/Dollar. As Japanese Government's dollar buying spree ends, FED was forced to raise interest rate rapidly and steadily until the Federal Fund's rate reached 5.25% to prevent the demise of dollar. This steady rise of the short-term interest rate is now boomerang back to intensify the pain of the mortgage woes. If FED lowers short-term interest rates substantially to replenish the lost liquidity and to prevent the deflation of the debt bubble, Japanese Government probably needs to buy up nearly one trillion dollars this time to prevent a whole sale collapse of US dollar. Even if Japanese Government is able to perform such a feast again, FED will be forced to raise interest rate again after Japan's dollar buying spree ends in order to defend the dollar and to fight off the inevitable inflation in such a scenario, and thus the financial crisis will reemerge in a few years.

There are people who naively claim that a whole sale collapse of US Dollar will only inconvenience some American tourists in overseas, but will achieve the desirable effect of shrinking the US trade deficit in a few years without any pain. Such a shrinkage of the US trade deficit will apparently force the further shrinkage of the global liquidity and makes the situation worse, rather than ease the crisis. Then there is an immediate and enormous danger overlooked by those claims. The danger is due to the existence of “derivatives”. The derivatives we are talking about here are not those exchange traded put and call options nor the exchange traded futures contracts. They are off the market financial contracts granted among large financial institutions, life insurance companies, hedge funds and so on. Those derivatives carry fancy names like interest rate swap, currency swap, credit risk swap, barrier options, lookback options, chooser options, knock-in and knock-out options, forward or delayed start swap options, index-amortizing swaps and so on and so on in addition to the familiar names similar to the exchange traded options. Those derivatives make the hedging of long financial positions possible, and thus encourage various entities to hold financial positions far beyond their reasonable means; such positions are called leveraged holdings. The leveraged and vastly expanded holdings of various long positions then in turn further escalates the trading of derivatives. It is reported that the total amount of the exiting derivatives already exceeds 50 trillion dollars globally. The values of a substantial portion of those derivatives depend on the value of US dollar. When US dollar collapses, a sizable loss, like 10 trillion dollars will be incurred in a sector of the participants of the game of derivatives. Many losers in the game naturally have no means to sustain such an outsize loss and will inevitably go under. Derivatives are a zero sum game. If there are losers, there will always be the matching winners. However, as losers go bankrupt, the paper wins of the winners also disappear. Most of those winners are probably using the derivatives to hedge their highly leveraged holdings that will lose value as dollar plunges. Thus those so called winners must realize the full amount of loss in their over-extended holdings once their insurance derivatives evaporates, and will go under along side with the losers. The bankrupted losers and winners of the derivatives tied to the value of dollar probably are also playing the game of derivatives tied to interest rates. As they go down, interest rate related derivatives will also evaporate, and expose the holders of outsize interest rate instruments directly to the rapidly gyrating market force. In a very short time span the shock wave of collapsing dollar will spread and will bring down the whole derivative house of cards, along with the whole global financial system. If that kind of scenario unfolds, due to the sheer size of losses involved, the whole world's central banks, IMF and the world bank combined will be utterly powerless to combat such a whole sale disaster. The best we can hope is that FED will not succumb to the temptation of lowering interest rates in a haste, and not to test the jinni of Dollar and derivatives.

The best way to understand why the problem of liquidity is globally connected is to look at the case of China. Chinese economic growth is based on the rapidly growing influx of dollars. The major source of the influx is from its rapidly expanding trade surplus. In order to slow down the pace of the rise of Chinese Yuan vs. US Dollar Chinese Government must buy up those influx of dollars. In the process of dollar buying a matching amount of Chinese Yuan must be sold into the market. It is this huge amount of Yuan flooding the domestic market that powers the growth of China's economy. Currently China's trade surplus is expanding by taking away the share of export markets of other countries. However, as the US trade deficit continue to stagnate as discussed before, the growth of China's trade surplus will gradually come to a hold, and China's economic expansion will also slow down unless Europe will expand its trade deficit sharply to shoulder a portion of the role that the US trade deficit used to play.

Europe's economy has benefited from the dynamic rise of new EU members. The low labor costs of those developing EU member states boosted the manufacturing in EU as a whole. However, if EU let its trade deficit to expand rapidly and shoulder a portion of the burden to let China continue to expand, then their newly industrializing members will suffer. EU is also benefiting from the influx of oil money. Many oil producing countries do not want to deposit their oil money into USA due to political reasons, and choose Europe as the target to pour their money into. Thus European financial institutions become the conduit of oil money to be reinvested into USA. Those European financial institutions and hedge funds are exposed to the same financial risks as their US counter parts. Actually the financial panic of Aug. 9 has originated from Europe. If the derivative market collapse, European financial system that is tightly integrated into global system will also be destroyed just like their American cousins. It is difficult to envision that Europe can really serve as the economic locomotive to pull up the whole global economy if the US economy stumbles.

Japan's economy is in a peculiar shape. In the middle of 1990's when Japan has embarked for the policy of very low interest rate, their central bank, The Bank of Japan, was still tightly controlled by the bureaucrats of MOF (the Ministry of Finance). It was the idea of the mercantilistic MOF bureaucrats to use the very low interest rate to suppress the value of Yen so that Japan can sustain a sizable trade surplus. This policy has wiped out the interest income of Japanese consumers that are known to be heavy savors. With this blow, the consumer spending has withered and the deflation has set in. This more than a decade long hardship of Japanese consumers is still continuing today. As Japan's job situation worsens, Japan's economy can only grow by increasing exports, utilizing the idled labor resources. That is what is happening today in Japan. As the US trade deficit stagnates and the ratio of trade-deficit-to-GDP comes down further, Japanese economic growth will also vanish.

The claim of soothsayers that the US has nothing to fear since the global economy is strong is simply dubious at best. The safest course for FED to take is to adhere to its current interest rate target, and steadfastly defend this target. If needs arise, FED can continuously inject sufficient amount of liquidity into the financial market to prevent the Federal Funds rate to go above 5.25%. After a while the financial market will get used to the gradually shrinking liquidity bubble, and the panic stage will be over. As the liquidity bubble withers away, the US economic growth rate will come down further and the job market will become worse, but the ratio of trade-deficit-to-GDP will keep declining. As the ratio drops to a certain level, US Dollar will regain the power to bounce up without the artificial stimulus like yen carry trades. It is at that juncture FED will be able to lower interest rate gradually and jump start the economic growth again. Only after such a soft landing is accomplished, policy makers should seriously consider ways to address the means to prevent the reemergence of global trade imbalance and to rein in the run away leverage and the explosion of derivatives even at the cost of scaling back the irresponsible and ill-thought-of globalization process. Otherwise the financial crises will reoccur again and again until the big bang that destroys the global financial system as well as the global economy.

Marc Faber on the money


11 August 2007

Big liquidation triggers hedge-fund turmoil

Some compare upheaval to LTCM collapse; market-neutral funds are hit hard
By Alistair Barr, MarketWatch

SAN FRANCISCO (MarketWatch) -- The liquidation of a big hedge fund or investment-bank trading portfolio is wreaking havoc in some parts of the hedge-fund business, managers and investors said Thursday.
Black Mesa Capital, a hedge-fund firm that uses computer models to track down investment ideas, said that at least one large hedge fund or investment bank is liquidating "massive" trading portfolios, according to a letter the Santa Fe, N.M.-based firm sent to investors Wednesday.
'Clearly, something is amiss in the markets that few in our strategy, if anyone, have experienced before.'

— Letter to Black Mesa investors
The warning is causing disruptions and triggering big losses among other so-called market-neutral hedge funds, Black Mesa said in its letter, a copy of which was obtained Thursday by MarketWatch.
"Clearly, something is amiss in the markets that few in our strategy, if anyone, have experienced before," Black Mesa's managers, Dave DeMers and Jonathan Spring, wrote. DeMers declined to comment Thursday.
The firm's hedge fund, which has about $1.9 billion in long positions and $1.9 billion in short positions, was down roughly 7.5% this month through Aug. 7. Those losses could grow to as much as 10% for August so far, Black Mesa noted.
A $700 million hedge fund run by Goldman Sachs (GSGoldman Sachs Group, Inc

GS ) , the North American Equity Opportunities fund, has sold some of its positions recently after losses, a person familiar with the matter said on Thursday. Goldman's biggest hedge fund, the Global Alpha fund, has suffered losses and may also be selling positions, but the person stressed that this fund is not shutting down.
'Quant' quake
The Global Alpha fund, which manages $9 billion, is a so-called quantitative fund, using computer models to locate investment opportunities.
Such "quant" funds are popular among hedge-fund investors. Many use a market-neutral strategy, which aims to balance long positions with short trades, or bets against securities. Others are so-called statistical arbitrage funds, which analyze the historical relationships between related securities and trade when those relationships get out of whack.
Many players in this part of the hedge-fund business have similar positions and use lots of leverage, or borrowed money, to increase their bets. However, that magnifies even small losses. Some of these hedge funds also have relatively permissive redemption periods, allowing investors to take their money out every month, with 30 days' notice or less.
So if losses trigger investor redemptions, these funds may have to sell lots of their positions. That, in turn, puts more pressure on the historical relationship between related securities, handing more losses to other hedge funds in the space.
If such positions are sold by lots of managers at the same time, the most leveraged funds get hit the hardest, possibly forcing big liquidations of portfolios, which triggers a chain reaction.
Two hedge-fund investors who didn't want to be identified said the current turmoil is reminiscent of the 1998 collapse of Long-Term Capital Management.
That giant hedge fund had some arbitrage positions based on the historical relationship between related securities. It made bets on the relationship between the prices of government securities from around the world. When Russia defaulted and devalued its currency, the ruble, there was a flight to quality that caused the prices of U.S. Treasury securities to spike.
LTCM collapsed amid rapid market dislocation and had to be bailed out by several of the world's largest investment banks as part of a plan organized by the Federal Reserve.
On Wednesday, Black Mesa told investors that other market-neutral hedge funds had suffered losses of between 5% and 15% so far in August.
The Highbridge Statistical Market Neutral Fund, a $1.8 billion hedge fund run by the J.P Morgan Chase (JPMjp morgan chase & co com

JPM ) unit Highbridge Capital, fell more than 5% this month through Aug. 8, according to the bank's Web site. The fund uses computer models to pick undervalued and overvalued securities and maintains roughly equal positions on both sides to iron out the effect of broad market fluctuations.
Hedge fund investors also highlighted other firms that use quantitative and market neutral strategies, but it's not clear whether these firms have suffered losses.
Barclays Global Investors, the money management arm of U.K. bank Barclays PLC (UK:BARC: news, chart, profile) , is one of the world's largest quantitative fund managers. The firm also runs market-neutral hedge funds.
It's not clear whether Barclays funds have suffered any losses recently. Spokesman Lance Berg declined to discuss performance or the strategy of the firm's hedge funds.
"At this time we are maintaining risk levels and feel that our portfolios are positioned appropriately," Berg said.
AQR Capital, Algert Coldiron Investors and Tykhe Capital were among other hedge fund firms mentioned by investors. Representatives at those firms didn't return calls seeking comment on Thursday.
The Wall Street Journal reported that Tykhe, run by former D.E. Shaw managers, has suffered losses of about 20% in August, and is moving quickly to trim its investment positions.
Similar to Amaranth
Black Mesa said it started reducing its leverage and selling positions to raise cash on Monday. As of Aug. 8, the firm said it had between 50% and 100% of its portfolio in cash and had brought leverage down to 0.5 to 0 times its assets, according to the letter.
The market disruptions began on July 25, when Black Mesa spotted signs of a major liquidation by another market participant. That continued through the week, handing the firm its biggest losing day ever, when it was down 3% on July 27.
The firm analyzed what caused its losses over that weekend and concluded that the behavior of the markets were similar to mid-September 2006, when giant hedge fund firm Amaranth Advisors liquidated its market-neutral equity portfolio to meet margin calls triggered by energy trading losses, Black Mesa explained.
'Me-too' liquidations
As August began the selling continued, the firm said in its letter.
"Either the original liquidators had just paused, and/or others had begun to liquidate their market-neutral books on Wednesday, August 1," DeMers and Spring wrote. "By Friday, August 3, there seemed to be no abatement in the liquidations and over the weekend, we confirmed with other market-neutral managers that they were suffering similar losses."
Black Mesa then began to wonder whether others in the market-neutral space, having learned of these liquidations and having lost money themselves, could start cutting leverage in their own portfolios too.
"There was (and is) the possibility that, as great as liquidations had been so far, that it was just the beginning of a spiral of me-too liquidations," DeMers and Spring wrote.
The two managers said they didn't know now long such dislocations could last, noting that it could be two days, two weeks, two months or even two quarters.
Black Mesa said there are now "enormous profit opportunities" but the firm said it remains on the sidelines until signs of liquidations in the market dissipate.
Alistair Barr is a reporter for MarketWatch in San Francisco.

9 August 2007

A letter to investors

Hayman Capital 2626 Cole Avenue, Suite 200
Dallas, TX 75204

July 30th, 2007

Dear Investors,

Over the past few months, we have seen the exacerbation of the Subprime problem accelerate at a precipitous pace. Wait a minute…I thought the Subprime problem was neatly contained in a nice little box of risk that the Fed had put it in? After many meetings and conversations with the various leaders of brokerage firms and asset managers, I don’t think the Subprime problem is as contained as many would like for you to believe. To understand the massive ripple effects of the Subprime problem, you have to look deeply into who owns the eventual risk and furthermore, how it will affect their behavior going forward.

The Greatest “Bait and Switch” of ALL TIME

I recently spent some time with a senior executive in the structured product marketing group (Collateralized Debt Obligations, Collateralized Loan Obligations, Etc.) of one of the largest brokerage firms in the world. I was in Roses, Spain attending a wedding for a good friend of mine who thought it would be an appropriate time to put the two of us together (given our shared interests in the structured credit markets). This individual proceeded to tell me how and why the Subprime Mezzanine CDO business existed. Subprime Mezzanine CDOs are 10-20X levered vehicles that contain only the BBB and BBB- tranches of Subprime debt. He told me that the “real money” (US insurance companies, pension funds, etc) accounts had stopped purchasing mezzanine tranches of US Subprime debt in late 2003 and that they needed a mechanism that could enable them to “mark up” these loans, package them opaquely, and EXPORT THE NEWLY PACKAGED RISK TO UNWITTING BUYERS IN ASIA AND CENTRAL EUROPE!!!! He told me with a straight face that these CDOs were the only way to get rid of the riskiest tranches of Subprime debt. Interestingly enough, these buyers (mainland Chinese Banks, the Chinese Government, Taiwanese banks, Korean banks, German banks, French banks, UK banks) possess the “excess” pools of liquidity around the globe. These pools are basically derived from two sources: 1) massive trade surpluses with the US in USD, 2) petrodollar recyclers. These two pools of excess capital are US dollar denominated and have had a virtually insatiable demand for US dollar denominated debt…until now. They have had orders on the various desks of Wall St. to buy any US debt rated “AAA” by the rating agencies in the US. How do BBB and BBB-tranches become AAA? Through the alchemy of Mezzanine-CDOs. With the help of the ratings agencies the Mezzanine CDO managers collect a series of BBB and BBB- tranches and repackage them with a cascading cash waterfall so that the top tiers are paid out first on all the tranches – thus allowing them to be rated AAA. Well, when you lever ONLY mezzanine tranches of Subprime RMBS 10-20X, POOF…you magically have 80% of the structure rated “AAA” by the ratings agencies, despite the underlying collateral being a collection of BBB and BBB- rated assets... This will go down as one of the biggest financial illusions the world has EVER seen. These institutions have these investments marked at PAR or 100 cents on the dollar for the most part. Now that the underlying collateral has begun to be downgraded, it is only a matter of time (weeks, days, or maybe just hours) before the ratings agencies (or what is left of them) downgrade the actual tranches of these various CDO structures. When they are downgraded, these foreign buyers will most likely have to sell them due to the fact that they are only permitted to own “super-senior” risk in the US. I predict that these tranches of mezzanine CDOs will fetch bids of around 10 cents on the dollar. The ensuing HORROR SHOW will be worth the price of admission and some popcorn. Consequently, when I hear people like Kudlow on CNBC tell their viewers that the Subprime problem is “contained”, I can hardly bear to watch.

The Moral Hazard of HOT Potatoes

The key reason the Subprime problem exists as it does today has to do with the wanton disassociation of risk inherent in the machine that churns out Subprime loans. Unlike the S&L crisis of the 1980s, the mortgage lenders of today aren’t taking their own balance sheet risk when underwriting loans. These brokers get paid for quantity REGARDLESS of quality. The balance sheet risk is transferred through three entities in less than 90 days from origination. The originator will originate ANYTHING he can sell to a whole loan buyer to pass the hot potato on. Whole loan buyers are simply the aggregators of loans at the Wall St. firms that aggregate, package, tranche, and sell as quickly as they possibly can to the clueless buyer. This transference of risk is the crux of the Subprime situation. Just think about it…if you were a 20-something making mortgage loans in California using someone else’s balance sheet and being paid per loan (with no lookback to performance of the loan), how many dubious loans would you underwrite?

Buyers are now BEWARE

During and after the rout these investors are about to shoulder, how excited do you think they are going to be to purchase the next “AAA” rated piece of structured finance paper?!!?!?!? These same investors and global pools of liquidity have been funding the Leveraged Buyout (LBO) boom by purchasing the debt that funds the Collateralized Loan Obligations (CLOs) which in turn, buy 60%+ of the LBO debt used to finance these transactions. I also recently spent some time with one of the largest CLO issuers in the world. They had just returned from Japan where they were marketing a new CLO in order to be one of the buyers for new LBO debt. Needless to say, their marketing efforts fell on deaf ears. They were told by the Japanese investors that they have lost confidence in the ratings agencies (you think?) and that in an election year there is too much uncertainty. They basically said, “No more.” If there is not a CLO bid from Asian and Central European banks, where do you think the $290 billion in announced LBOs will go to sell their debt? I actually have no idea how to answer that question myself. We have seen the bank-loan index drop from 100.5 to 90.5 in 5 short weeks, and a widening in investment grade as well as non investment grade credit. In the immediate absence of liquidity, there will be many casualties of levered funds and firms. There will be a “re-pricing” of risk on a global scale that will mean more credit funds being carried out the door feet first.

Latest Casualties

Just today, the latest firm to suffer the wrath of too much leverage and mis-priced risk was Sowood Capital. What is truly remarkable about this particular situation is the fact that Jeff Larson, the former manager of the $30 billion Harvard Endowment, is the principal Manager at this firm. Sowood was renowned as being a “best-in-class” fund. If the former manager of the Harvard endowment managed to lose 57% of his fund (more than $1.7 billion in losses) in just 30 days, how are the “other” credit funds out there doing? How are they calculating Value-at-Risk? This afternoon, brokerage firms were sending collateral calls to other funds positioned similarly to Sowood. They joined the ranks of the two Bear Stearns funds managed by Cioffi, Australia’s Basis Capital, Absolute Capital, and Macquarie Fortress Funds as well investments by Korea’s Woori Bank, and London’s Caliber Fund by liquidating and eventually returning what is left to investors. Not to mention the downfall of the poster child of the levered “positive carry” industry, United Capital Market’s Horizon Fund – managed by John Devaney, owner of the aptly titled 142ft yacht, the Postive Carry (which is incidentally now for sale, all enquiries can be directed to http://www.iyc.com/featured_yachts.cfm?mn=1).

I have recently discovered the insightful writings of someone with whom I have not had the pleasure to speak or meet in person. Howard Marks is the Chairman of Oaktree Capital Management and he recently sent a letter to his clients entitled, “It’s All Good”. Mr. Marks had a most astute observation with regard to the recent investing environment:

“…investors’ recurring acceptance that it’s different this time – or that cycles are no more – is exemplary of a willing suspension of disbelief that springs from glee over how well things are going (on the part of people who’re in the market) or rationalization of the reasons to throw off caution and get on board (from those who have been watching from the sidelines as prices moved higher and others made money). In this way, the bullish swing of the investment cycle tends to cause skepticism and risk tolerance to evaporate. Faith, credence and open-mindedness all tend to move up – at just the time skepticism, discrimination and circumspection become the qualities that are most needed.”

Credit Markets and Where we are today in Subprime

Last week, I spent some time in the “Inland Empire” of California on a diligence trip to survey the actual damage. As many of you already know, 55% of all Subprime loans were made in California and Florida. The inland empire of California can be described as the central valley that extends from the southern part of the state all the way to the northern part of the state at least 1-hour inland from the coast. Let me start by saying it is MUCH WORSE than even I thought it could be. I met with various mortgage lenders, originators, economists, and capital markets professionals. The overriding theme that I got from them was that “Everyone committed fraud and everyone is responsible for the problem”. They told me that they believe that 90% of all Subprime loans that were made contained some kind of fraud. Either borrowers lied about their incomes or mortgage brokers fudged numbers on the applications to make them pass muster with the needed ratios in order to get loans approved. They also said that of the borrower frauds, 50% of applicants overstated their income by MORE THAN 50%!!! As Kindleberger put so well in his book, Manias, Panics, and Crashes:

The implosion of an asset price bubble always leads to the discovery of frauds and swindles. The supply of corruption increases in a pro-cyclical way much like the supply of credit. Soon after a recession appears likely the loans to firms that were fueling their growth with credit declines as the lenders become more cautious about the indebtedness of individual borrowers and their total credit exposure. In the absence of more credit, the fraud sprouts from the woodwork like mushrooms in a soggy forest.

In California today, home prices are down between 25%-40% in the central valley. From San Bernadino to Stockton, home prices are in free-fall and their physical condition is actually worse than their price decline. The borrowers are locked out of the financing market and there is no logical buyer for these homes outside of the original borrower. The foreclosure wave will hit these neighborhoods like the Asian Tsunami. If you plug in 15% depreciation in housing prices and 50% loss severities into our Subprime model, the capital structure is wiped out all the way to the “AA” tranches.

In the Subprime Credit Strategies Funds, we continue to hold our initial positions and have not taken any profits yet. In Hayman, we are short credit in the US (both Subprime RMBS and corporate credit) and long non-US equities and debt. We are short US consumer based equities, preferreds, and debt. I think the world is going to begin to decouple from the US and realize that currency appreciation coupled with the globe’s best growth is an attractive alternative to fraudulent ratings, US dollar depreciation, and financial inventions used to export risk.


J. Kyle Bass
Managing Partner

7 August 2007

FT Alphaville » Blog Archive » Lombard Street Research - potential for “major stress” in US banking

FT Alphaville » Blog Archive » Lombard Street Research - potential for “major stress” in US banking: "Banks are profit-maximising institutions that are the originators of liquidity through the expansion of their balance sheets. Two factors restrain their ability to expand: the need to hold some cash and the capital/asset constraint. A central bank influences the supply of money though its hold on the banks via the cash requirement, as at the end of the day only it can physically print money if there is a run on the banks. Central banks provide the banking system with liquidity at the rate of interest that they set. However, in normal circumstances the capital/asset constraint plays a more important role in banks’ decision to lend. Bear in mind that for banks, as profit-maximising institutions, lending at any rate is better than not lending at all if they have the capital. Of course they have to factor in risk."

3 August 2007

U.S. Housing Is Among `Biggest Bubbles,'

By Chen Shiyin and Pimm Fox

Jim Rogers, chairman of Beeland Interests Inc. Aug. 3 (Bloomberg) -- The U.S. subprime-market rout that wiped out $2.1 trillion from global share values last week has ``got a long way to go,'' said Jim Rogers, a New York-based fund manager who predicted the start of the commodities rally in 1999.

This week's rebound in equity markets hasn't persuaded Rogers, 64, to pull out of bets that U.S. investment banks and homebuilders are heading for further declines.

``This was one of the biggest bubbles we've ever had in credit,'' Rogers, chairman of Beeland Interests Inc., said in an interview from Hong Kong. ``I have been and am still short the investment bankers in America. I'm also short homebuilders.''

The Morgan Stanley Capital International World Index plunged 5.3 percent last week, its worst weekly drop in five years, on concern defaults among subprime mortgages may be spilling over to other credit markets and hurting earnings and takeovers. Further losses may be in store even after the index, which tracks $32.6 trillion of stocks, advanced 0.7 percent this week.

``Given the stage of the credit cycle that we're in now, we would have to expect more negative news popping up,'' Beat Lenherr, who oversees $7 billion as chief investment officer for Asia at LGT Bank in Liechtenstein AG, said late yesterday in an interview in Singapore. ``The market sentiment is a bit nervous to the degree that every bad news is answered with selling.''

Worse to Come

The MSCI World Index today climbed 0.1 percent, its fourth gain this week, as investors speculated that better-than-forecast earnings will help offset the impact of mortgage losses.

Gains may be capped by further signs of turmoil among borrowers. Accredited Home Lenders Holding Co., the subprime mortgage company being acquired by Lone Star Funds, plunged 35 percent yesterday after saying it may go bankrupt.

American Home Mortgage Investment Corp. yesterday said it plans to halt operations, becoming the second-biggest residential lender to fail this year. The company's shares dropped 86 percent this week, cutting its value to $79 million, from $1.8 billion in December.

A measure of financial companies such as Countrywide Financial has dropped 3.7 percent so far this year, the only group to decline within the MSCI World Index.

``This is the only time in world history when people were able to buy houses with no money down and in fact, in some cases, the builders gave them money for a down payment,'' Rogers said. ``So this bubble is the worst we've had in housing and it's going to be the worst before its over cleaning it out.''

Buying China

China is a market that Rogers isn't selling even as share prices fall, he said. He's sold his other emerging market holdings as stock gains outstripped the prospect for earnings, Rogers added.

The CSI 300 Index last week jumped 8.4 percent. The index had gained 2.7 percent to a record as of 2 p.m. in Beijing, heading for its fourth weekly gain in a row. The benchmark has more than doubled this year and is the best performer among 89 stock indexes tracked by Bloomberg.

``China's the next great country in the world and we must learn about investing in China, because that's where fantastic fortunes are going to be made in the next century,'' Rogers said. ``I would be looking at China very carefully.''

2 August 2007

Gartman's trading rules..

Once a year, on the day after Thanksgiving, Dennis Gartman publishes his 20 Rules of Trading.

I thought the best use of your time today would be to share some of his rules with you. In Gartman's own words...

1. Never, ever, ever add to a losing position: To do so will eventually and absolutely lead to ruin. Remember Long Term Capital Management and its legion of Nobel laureates who broke this rule repeatedly and went into forced liquidation. Learn this lesson... well and early!

2. Capital comes in two varieties: Mental capital, and that which is in your account: Of the two, mental capital is the more important. Holding losing positions costs measurable sums of actual capital, but it costs immeasurable sums of mental capital.

3. The objective is not to buy low and sell high, but to buy high and to sell higher: We can never know what price is "low." Nor can we know what price is "high." Always remember that Nortel fell from $85/share to $2 and seemed "cheap" all times along the way.

4. "Markets can remain illogical longer than you or I can remain solvent," is a brilliant statement from our good friend, Dr. A. Gary Shilling. Illogic often reigns and markets are inefficient despite what the academics try to tell us.

5. Sell that which shows the greatest weakness, and buy that which shows the greatest strength: Metaphorically, when bearish, throw rocks into the wettest paper sack, for they break most readily. In bull markets, ride the strongest winds.

6. Think like a fundamentalist; trade like a technician: It is imperative that we understand the fundamentals driving a trade, and that we understand the market's technicals also. When we do, then, and only then, should we trade.

7. Understanding psychology is usually more important than understanding economics: Markets are driven by human beings making human errors... and also making super-human insights.

8. Be patient with winning trades; be enormously impatient with losing trades: Remember, it is quite possible to make large sums trading/investing if we are "right" only 30% of the time, as long as our losses are small and our profits are large.

9. The Hard Trade is the Right Trade: If it is easy to sell, don't; and if it is easy to buy, don't. Do the trade that is hard to do and that which the crowd finds objectionable. Peter Steidelmeyer taught us this 25 years ago and it holds truer now than then.

10. There is never one cockroach: Bad news begets bad news, which begets even worse news.

1 August 2007

Macquarie warns Fortress fund faces 25 percent losses - International Herald Tribune

Macquarie warns Fortress fund faces 25 percent losses - International Herald Tribune: "SYDNEY, Australia: Investors in Macquarie Bank Ltd.'s high-yield fund Fortress Investments Ltd. face losses of up to 25 percent because of volatility in global credit markets.

The average price of assets in the fund's portfolios fell 4 percent in June and maybe another 20 to 25 percent in July, director of Macquarie Fortress Investments, Peter Lucas, said late Tuesday in a statement.

Fortress is the third fund manager in Australia to flag serious problems and the latest sign that the fallout from the U.S. subprime mortgage sector is spreading wider. Australia has the largest hedge fund industry in Asia, according to the government, and Australian hedge funds have been some of the first to say that the global widening in yield spreads has cut deep into their value.

Fund watchers say that as niche funds heavily exposed to U.S. credit markets assess their value at the end of July, more may report significant falls in value."