29 November 2007

M&S pyjamas' silver lining helps stop MRSA

Pyjamas that have been designed to protect hospital patients from the MRSA superbug have gone on sale in Marks & Spencer.

The £45 garment has silver thread woven into it, which tests show can reduce the spread of infections. The ongoing clinical trial's interim results are positive

M&S is selling the "Sleepsafe" pyjamas, below, at 100 stores as part of a trial.

Silver-laced nightwear has been tested in a handful of hospitals, but M&S has become the first retailer in Britain to stock the pyjamas.

They are only available for men at present and come in three colours - teal, navy and burgundy. A spokesman for M&S said: "They are produced using a fabric which has two per cent silver woven into it. Silver is know for its infection fighting properties and has previously been used by the military.

"The fabric that the pyjamas are made of has been clinically proven to reduce the risk of MRSA by killing bacteria that come into contact with the fabric. Clinical trials are currently ongoing and are three quarters of the way through. The interim results were positive."

Katherine Murphy, from the Patients' Association, said: "We welcome the fact these are going on sale, but it shows how desperate the public is."

Dr Mark Enright, a microbiologist at Imperial College London, said that the pyjamas would reduce the risk of a patient getting a skin infection that could infect a wound.

However, Tony Kitchen, of MRSA Support, said: "It sounds like a gimmick - it cannot be a super suit and probably doesn't make a jot of difference.

"The problem lies within the hospitals. They are dirty and it should not be up to the public to safeguard themselves, it's the ethos of the hospital that needs to change.

"We've had troops who manage in the Gulf but end up contracting diseases back in British hospitals. If it's possible to keep that clean in the desert why can't we do it in a hospital?"

Pam Milward, 73, who went into hospital in Redditch, Worcs, three years ago with a rash and ended up unconscious and paralysed for a month after contracting the superbug, said: "If they work then it's a good idea but at £45 they are very expensive for pyjamas."

spirals of death

Close observers of the US housing finance disaster in recent months will have noted a curious phenomenon. Companies such as Countrywide that were in late August regarded as rock solid have recently passed clearly into the danger zone while those like Fannie Mae and Freddie Mac that were regarded as potential market saviors have come under a cloud. In Britain Northern Rock, whose September bailout was said to be modest, involving little risk to the taxpayer has now turned into an immense 25 billion pound ($51 billion) potential black hole – real money even in the US economy let alone in the much smaller British one. This illustrates a deeply troubling quality of the largest downturns: the tendency for the free market to turn into a death spiral, in which even sound well-run institutions are engulfed.

Death spirals are fairly rare in financial history. The Wall Street Crash of 1929 was perhaps the most virulent example. After the first downturn, the market recovered for several months. Then the collapse of the Bank of the United States in December 1930, together with the further economic damage from the Smoot-Hawley Tariff caused a further collapse in confidence and activity that was concentrated in the banking sector, as relatively solid institutions followed the Bank of the United States into bankruptcy. The Federal Reserve failed to correct for the money supply contraction caused by the bank bankruptcies, leading the US economy further into the pit. The additional shove given by President Herbert Hoover’s 1932 tax increase was almost unnecessary; only the confidence brought by a new president (albeit with equally counterproductive economic policies) brought recovery from 1933. By the time the spiral was over, more than one fourth of the banks in the United States had gone bankrupt and the stock market had bottomed out at one tenth of its peak.

A second death spiral, with somewhat less dire economic consequences, occurred in Britain in 1973-74. Edward Heath’s government had removed the quantitative controls on bank lending in 1971, which resulted in an orgy of high risk lending against real estate, very similar to the recent episode in the US except that most of the loans were made against commercial real estate rather than housing. When the first major real estate lender, London and County Bank, collapsed in November 1973 another more conservative house, First National Finance (FNFC), was used as the epicenter of the “lifeboat” rescue organized by the Bank of England. However, the decline in confidence and real estate values quickly sucked FNFC into the maelstrom.

The lifeboat rescue fund grew larger and larger for more than a year as the stock market declined to record low levels, 70% below its 1972 high. Homebuilders such as Northern Developments, in no way involved in the original crash but dependent on bank lending, were dragged down. So were the two most important entrepreneurial finance houses, both internationally diversified and neither significantly involved in commercial real estate lending – Jessel Securities, founded by Oliver Jessel and Slater Walker, founded by Jim Slater.

Neither Jessel nor Slater had been aggressively run – indeed Jim Slater had begun de-leveraging a year before the crash, as he saw trouble coming – and no wrongdoing was proved against the head of either organization, yet by the end of 1975 both very substantial companies had gone bankrupt and neither founder played a significant further role in the British financial sector. This was a great pity: in losing Jessel and Slater Britain had lost not only their very able founders but the most aggressive entrepreneurial teams in the City of London, who might have been best able to compete against the foreign invasion when Britain deregulated the financial services sector in 1986.

The British experience of 1973-74 seems more like the current position in the United States. National policy is currently reasonably neutral, so far avoiding the twin dangers of protectionism and tax increases which caused the medium sized downturn of 1929-30 to turn into the Great Depression. The problem is concentrated in the property sector. However there are already worrying signs that the magic alchemy of modern finance, though such mechanisms as securitization vehicles whose funding falls apart and complex derivative securities that prove to be unsalable in a crisis, is causing the problem to metastasize. In the consumer sector, GMAC has reported problems with its automobile loan portfolio, while it appears that credit card debt quality is rapidly deteriorating. In the corporate loan sector, loans to aggressive leveraged buyouts have got in trouble, and loans to hedge funds and private equity funds have been sharply cut back. (The latter effect can be seen in the movement of the yen/dollar exchange rate from 120 to 108, as the hedge funds’ ”carry trade” positions have been de-leveraged.)

The “death spiral” characteristics of the current market are pretty clear. If Fed Chairman Ben Bernanke’s original estimate of subprime loan losses of $50-100 billion had been anywhere close to accurate, there would have been no problem. The market deals with difficulties of that size all the time, without significant effect on surrounding sectors. A few fringe operators go bankrupt, a few large houses show unexpected losses, and the overall market continues without a tremor. The collapse of the Amaranth hedge fund in September 2006 or that of Refco a year earlier were substantial events, causing losses to a number of those institutions’ business partners, but there was no question of any general market disturbance.

When the subprime problem first emerged in February, it appeared that it would also be limited. A number of subprime lenders, relatively insignificant institutions, were forced to shut down. However the general market appeared unaffected; its view appeared to be that the problem was localized and should have no effect on the real economy, nor even any great effect on the broader housing finance market.

August’s widening in Libor spreads, at which banks lend money to each other, should have told us that this problem would be different, and altogether more important. If leading banks were unable to assess each other’s credit quality for short term transactions then something much more serious was wrong than the collapse of a modest fringe sector of the housing finance market. The Fed’s chosen solution, dropping interest rates and pumping more money into the system, did not address the real problem and was thus useless, as it has since proved. It has only postponed the denouement for a few months and stored up further trouble with inflation.

Two factors are at play here. The first is sheer size. If as now appears likely the eventual losses in the home mortgage market do not total only $100 billion, but a figure much closer to $1 trillion, then the subprime debacle becomes something much more than a localized meltdown. $1 trillion of losses is 7% of US Gross Domestic Product. The market cannot absorb losses of that size without some major institutional bankruptcies or a lengthy recession. The closest equivalent problem is the savings and loan collapse of 1989-92; that caused a major housing downturn but only a minor recession. However its cost (mostly borne by the US taxpayer) of $176 billion was about 3% of 1990 US GDP, only half the size of the likely current losses on mortgage loans.

The second is lack of transparency, and the blow to confidence that comes from the dawning suspicion that a large portion of the derivatives and securitization mechanisms designed in the last quarter century are faulty. The unluckily timed implementation for years beginning after November 15 of FAS Rule 157, requiring banks to divide their assets into three levels according to their degree of marketability, has thrown an unwelcome spotlight on the problem. If Level 3 assets can be valued only by reference to an internal valuation model, and have been allowed to accrue value in banks’ financial statements for a decade or more (enabling hefty bonuses to their progenitors) then how do we know they are really worth anything close to what the model says, and how do we go about realizing them, in a market where confidence has vanished?

To ask those questions is to answer them. Since every incentive led bank mathematicians to devise models that maximized the reported value of the bank’s holdings, and since little or no market existed by which those values could be checked, it is likely that today those assets’ book values are highly overstated. Moreover, even in banks where the mathematicians and their bosses were scrupulously, even impossibly disinterested and intelligent, there still remains the problem that those assets are worth far less in a downturn, because their illiquidity makes them intrinsically unattractive in a market where liquidity has become once more important. Anyone who has attempted to sell venture capital positions in a bear market can attest to how rapidly and completely the value of such assets can disappear. It is thus perfectly possible that the true realizable value of “Level 3” holdings in a bear market is no more than 10% of their book value.

This immediately demonstrates the problem. Goldman Sachs, generally regarded as insulated from the subprime mortgage problem, has $72 billion of Level 3 assets; its capital is only $36 billion. If anything like 90% of the Level 3 assets’ value has to be written off, Goldman Sachs is insolvent. They do not have the option of acting like Nomura Securities did recently, selling everything possible and writing the remainder down to zero, because they would be without capital. Instead they are likely to be dragged kicking and screaming, quarter by quarter, to a gradual writedown and sale of their Level 3 assets, with their true position remaining undisclosed and obfuscated by meaninglessly optimistic statements by top management. Only the bonuses will survive, paid in cash and draining liquidity from the struggling company.

That’s what a death spiral looks like. The US survived the Great Depression, eventually, and Britain survived the 1973-74 debacle. However the market recovered only after it had plumbed depths previously thought impossible, at which even the soundest investments were trading far below their true value. After normality returned, the financial services landscape was very different, with many large and apparently solid houses having disappeared, a generation of participants reduced to driving taxis or selling apples and a generation of investors scarred by their losses and unwilling to return to the market. Emergency infusions of money, from the Fed or the taxpayers, generally do no good, only postponing the denouement and delaying the arrival of truly bargain price levels.

Such spirals of death represent the final definitive triumph of the bears.

Regulatory Debauchery

Dazzling World of Derivatives (2006, FT-Prentice Hall).

Earlier versions of some parts of this article have appeared in Business Standard (India), www.businessspectator.com and www.minyanville.com

Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. Debauching the regulatory apparatus is a step along the same road.

Current problems in credit markets are attributable, in part, to failures on the part of central banks and regulators. The response to the credit crisis also contains fundamental deficiencies.

The “Greenspan” Put

Central bankers fueled the liquidity bubble through excessive monetary growth and low interest rates. The “Greenspan Put” repeatedly bailed out banks and investors from poor decisions or irrational exuberance underwriting excessive risk taking. Asset price bubbles rolled merrily along; waves of risk mis-pricing moving through different markets. The current credit crisis has its origins in the Federal Reserve’s interest rate cuts of the early 2000s that helped engineer the housing bubble. This enabled the markets and economy to recover from the Internet bubble.

Bank regulators have presided over substantive changes in financial institution balance sheets and risks. The balance sheet of large banks and investment banks now hold high levels of risky and illiquid assets, such as private-equity investments, bridge loans, hedge funds investments, distressed debt and exotic derivatives. Derivative transactions with and loans to hedge funds through their prime broking operations are substantial. Assets and exposures in “arbitrage” conduit vehicles, structured investment vehicles (“SIVs”) and hedge funds outside regulated bank balance sheets have increased. A recent OECD analysis[i] shows that while major banks have increased capital and reduced reliance on short-term funding the risks have increased faster.

Regulators have been uncritically accepting of financial innovation. The benefit of dispersion of risk through the final system has become the accepted orthodoxy. The risks of a diffuse, opaque, globally inter-linked, highly leveraged financial system have largely been ignored. Belatedly, in its 2007 annual report, the Bank of International Settlements (“BIS”) admitted that “our understanding of economic processes may be even less today than it was in the past”.

As recent events show the risk transfer is largely cosmetic. In excess of $300 billion of risk in the form of Asset backed Commercial paper (“ABS CP”) - short term IOUs secured against high grade (AAA/AA rated) securities including CDOs (“Collateralised Debt Obligations”) – has returned to bank balance sheets as ABS CP investors have gone on a buyer’s strike.

Financial institutions have already incurred losses of over US$ 50 billion. A substantial volume of assets is likely to return onto bank balance sheets as off-balance sheet structures and hedge funds are forced to sell. For examples, HSBC has announced that it will bring around US$ 45 billion of assets from two SIVs de facto back on balance sheet. The total amount that will be re-intermediated by banks may be in the range of US$ 1 to 2 trillion. Weaker banks have been forced to forage down the back of the sofa for any loose change to add to their dwindling liquidity to meet these commitments. This has led to sharp rises in inter-bank lending and borrowing rates as well as general shortage of funds, especially for riskier borrowers.

Mean reversion

Central banks have reverted to type in dealing with the crisis. There is no difference between a run on a bank and shutdown of access to funding from the capital markets. US mortgage lenders have faced old-fashioned runs. Northern Rock found itself requiring central bank support (in excess of £20 billion (US$ 40 billion)) as it was unable to raise required funding in money markets. The Chancellor of the UK Exchequer was forced to effectively guarantee the UK system of bank deposits to restore confidence Central banks, including the Fed and European Central Bank (“ECB”), have pumped money into the system in an effort to ease the liquidity crunch.

In further regulatory debauchery, the Fed recently allowed banks to pledge ABS CP as well as highly rated asset-backed securities, corporate bonds and mortgage-backed instruments as collateral for funding at the discount window. Funding has been extended from overnight to 30 days. Other central banks have followed suit.

Traditionally, only government securities are eligible for discounting. A fundamental principal of the discount window is that it is designed to provide short-term liquidity against instruments of unimpeachable credit quality. The regulatory spin is that this is “temporary” “in the light of market conditions” and “recognises innovation in the market”.

There are profound practical and policy issues in this development. What price will the central banks attribute to these riskier securities? What is the level of the advance that the central bank will offer and how will this be adjusted as market values of the underlying collateral changes? There are unconfirmed suggestions that the central banks are placing a value of 85% on AAA CDO securities. Given that there is significant uncertainty about the value of the security and even how they should be valued, the entry into this debate by central banks is curious.

There is also the question what happens if the bank cannot redeem the borrowing at the end of the 30 days and the value of the securities is below the level of the amount advance. This is precisely the problem confronting lenders who have lent against these securities. Central banks appear to have entered the field of prime broking, perhaps tempted by the profitability. In widening the eligible assets, central banks are effectively underwriting the credit risk and the liquidity of the financial system with public money.

The moves have also done little to ease liquidity or credit market concerns. Following the cut in the discount rate, four major US banks used the discount window: “to encourage its use by other financial institutions”. They did not need cash. It was a sign of strength. In the words of financial historian, Charles Geisst, it was : “like someone from the Upper East Side being seen in .. Wal-Mart”.

In other cases of “déjà vu all over again”, there have been suggestions that Fannie Mae and Ginnie Mae step in to buy mortgages to support liquidity as they have done in past crisis. The two institutions have assets and guarantees of almost US$4.0 trillion supported by stockholders’ equity of around US$60 billion. Both entities have also reported recent losses and have been forced to raise capital. The scope for liquidity creation by this route is likely to be difficult.

Socialism for Wall Street

In good times, financial markets embrace Capitalism. In bad times, financial markets re-discover Socialism. Currently, the US Federal Reserve is engaged in a dangerous strategy to look after its Wall Street friends.

The Fed has cut the fed funds and discount rates. The markets cheered the Fed decision to cut rates in September and then again in October. “This is manna. I am blown away. These guys get it I could hug these guys. This is what we wanted.” Jim Cramer, CNBC's markets pundit, was at the forefront of the cheerleading. Since the Fed's interest rate cuts, equity markets have reached records levels and the junk debt has recovered modestly.

Relief has been short lived. In recent weeks, the differential between inter-bank rates and the central bank targeted rates has widened to levels not seen since August. This points to further potential cuts in both rates by the end of the year. Lower cuts are inconsistent with above target inflation levels resulting from high oil prices, higher food prices, increasing cost pressures in emerging economies such as China and the potential inflationary effect of a weaker US dollar.

The US central bank’s strategy is clear. The current credit problems require a substantial reduction in the level of borrowings and leverage in the global financial system. Asset prices ramped up by excessive debt need to adjust. The adjustment can take place via a “crash”. This would be de-stabilizing and would wreak further havoc on already weakened banks. Alternatively, the de-leveraging and price adjustment can be achieved by creating inflation through loose monetary policy. If asset prices remain at current levels, higher inflation allows values to fall in real terms. Higher inflation also reduces the value of the borrowings that must be paid back allowing the required reduction in leverage.

Between January 1960 and December 1974, the Dow Jones Industrial Average was substantially unchanged. This is despite significant periodic rallies during the “go-go years”. If inflation averaged 5% pa, then the value of the market (ignoring dividends) lost around half (50%) of its value in real (inflation adjusted) terms.

The Fed strategy also assists affected banks. The large writedowns in risky assets and the expected re-intermediation of assets means that some banks need large infusions of capital. Given recent performance and subdued profit outlook, it would be difficult for them to raise this capital at acceptable prices.

Lower short-term interest rates allow banks to borrow cheaply. The money can be used to purchase government bonds that provide higher returns than the cost of borrowing. This generates profits for the bank without the banks having to hold capital against their assets (banks generally are not required to hold capital against government securities). The profits help re-capitalize the bank. An added benefit is that the US government can fund its deficit by selling its debt to the banks. This would be handy if foreign demand for US Treasuries decreases in response to the weaker dollar.

In the 1980s, US manufacturers looked to Japan as the source of ideas to improve efficiency. Remember “Just-in-Time” manufacturing, “zero defect” etc. Now, it seems US regulators are borrowing ideas from their Japanese colleagues. The Bank of Japan used the same strategy to re-capitalize the loss making Japanese banks after the collapse of the “bubble economy” in 1989.

Higher inflation expectations are already evident in higher gold prices, the steeper US yield curve (long term rates are higher than short-term rates) and the weaker US dollar. Foreign investors, especially large sovereign investment funds, are switching from financial assets (bonds) to “real” assets (companies with real businesses) reflecting higher inflationary expectations.

The strategy is dangerous. Inflation can lead to a significant transfer of wealth from investors to borrowers. Inflation once embedded in the economy distorts economic activity such as investment and savings. The experience of the late 1970s and early 1980s highlights the difficulties in recapturing the inflation beast once uncaged. Paul Volcker, then Chairman of the Federal Reserve, bravely increased interest rates to stratospheric levels to squeeze inflation out of the financial system.

The strategy may also not work. The cuts in rates do not appear to have had the desired effect in improving market liquidity conditions. Default risk concerns continue to inhibit lending and other routine financial transactions. Lower rates may set off further bubbles – for example, in equities and emerging markets. Asset prices may fall sharply anyway. In fairness to Dr. Bernanke, he has limited policy alternatives available.

Central bankers have stated that “errant” banks and investors will not be “bailed out”. Actual actions suggest otherwise. Banks have played their “nuclear” option well. The specter of “systemic risk” – whether real or not - is one a central banker cannot ignore. The banks continue to privatize gains and socialize losses.

These moves have attracted remarkably little scrutiny or comment. Central banks are effectively underwriting the credit risk and the liquidity of the financial system with public money but without any transparent political debate. Socialism for Wall Street prevails, once again.

Central banks and regulators bear a serious responsibility for safeguarding the functioning and integrity of financial systems. At the moment they are being exposed like the Wizard of Oz – old desperate men (they are mainly men) behind the curtain running from one lever to another in a desperate attempt to maintain illusions.

© 2007 Satyajit Das All Rights reserved.

[1] See Adrian Blundell-Wignall (2007) An Overview of Hedge Funds and Structured Products: Issues in Leverage and Risk; OECD

28 November 2007

Google Plans to Develop Cheaper Solar, Wind Power

By Ari Levy

Nov. 27 (Bloomberg) -- Google Inc., whose corporate motto is ``don't be evil,'' created a research group to develop cheaper renewable energy sources, focusing on solar, wind and other alternative forms of power.

Google, the owner of the most-used Internet search engine, said today that it's hiring engineers and energy experts to lead a process that may cost hundreds of millions of dollars.

The project, called Renewable Energy Cheaper Than Coal, is meant first to help Google cut its energy costs and then to offer customers cheaper power. It follows initiatives this year to maximize the efficiency of its data centers, which account for most of the energy Google consumes.

``We're a large consumer of energy due to our data centers, so we're a natural customer,'' Larry Page, Google's co-founder, said in an interview. ``We see opportunities to make significant investments that generate positive returns.''

Investors might worry about the company's ``long-term focus'' and questioned whether the project was a good fit for the company, said Jordan Rohan, an analyst at RBC Capital Markets in New York. Mountain View, California-based Google makes 99 percent of its revenue selling advertising.

`What the Heck?'

``What the heck are they doing? It boggles the mind,'' said Rohan, who advises buying Google shares. ``The company is blessed with the best business model on the Internet. This makes me worry about Google's priorities.''

Google rose $7.57 to $673.57 at 4 p.m. New York time in Nasdaq Stock Market trading. The shares have gained 46 percent this year.

Through internal development and investments in other companies, Google expects to generate revenue in the alternative- energy market. Its philanthropic arm, Google.org, will make grants to companies, laboratories and universities working on related projects, the company said in a statement.

The goal is to create a gigawatt of renewable energy, enough to power a city the size of San Francisco for less than it would cost using coal, in ``years, not in decades,'' Page said. Coal accounts for more than 50 percent of all U.S. power and is one of the biggest sources of carbon emissions.

A typical data center consumes 300 megawatts to 400 megawatts of energy, according to Sandeep Aggarwal, an analyst at Oppenheimer & Co. in San Francisco. Google probably has 10 to 15 data centers, he said. One gigawatt equals 1,000 megawatts.

Large Consumer

``If Google is consuming between 3,000 to 5,000 megawatts of energy, they might be one of the largest consumers of energy,'' said Agarwal, who recommends buying the shares, which he doesn't own. ``If they can figure out how to save money in their energy consumption, this sounds like a positive to me.''

Google is already working with Pasadena, California-based ESolar Inc., a solar-power company, and Alameda, California-based Makani Power Inc., a developer of wind energy.

``Climate change is a very important reason for this announcement but it's not the only reason,'' Google co-founder Sergey Brin said today on a conference call. ``There's a lot of demand'' for cheaper energy, he said.

The company plans to hire 20 to 30 people over the next year for the project, Bill Weihl, the head of Google's environmental programs, said on the call. In June, Google and five partners including Microsoft Corp. started the Climate Savers Computing Initiative, a plan to save electricity in personal computers.

To contact the reporter on this story: Ari Levy in San Francisco at levy5@bloomberg.net .

25 November 2007

Panic of 2008

RHINEBECK, N.Y., Nov. 19 (UPI) -- A financial crisis will likely send the U.S. dollar into a free fall of as much as 90 percent and gold soaring to $2,000 an ounce, a trends researcher said.

"We are going to see economic times the likes of which no living person has seen," Trends Research Institute Director Gerald Celente said, forecasting a "Panic of 2008."

"The bigger they are, the harder they'll fall," he said in an interview with New York's Hudson Valley Business Journal.

Celente -- who forecast the subprime mortgage financial crisis and the dollar's decline a year ago and gold's current rise in May -- told the newspaper the subprime mortgage meltdown was just the first "small, high-risk segment of the market" to collapse.

Derivative dealers, hedge funds, buyout firms and other market players will also unravel, he said.

Massive corporate losses, such as those recently posted by Citigroup Inc. and General Motors Corp., will also be fairly common "for some time to come," he said.

He said he would not "be surprised if giants tumble to their deaths," Celente said.

The Panic of 2008 will lead to a lower U.S. standard of living, he said.

A result will be a drop in holiday spending a year from now, followed by a permanent end of the "retail holiday frenzy" that has driven the U.S. economy since the 1940s, he said.

24 November 2007

Bankers Gone Wild


“What were they smoking?” asks the cover of the current issue of Fortune magazine. Underneath the headline are photos of recently deposed Wall Street titans, captioned with the staggering sums they managed to lose.

The answer, of course, is that they were high on the usual drug greed. And they were encouraged to make socially destructive decisions by a system of executive compensation that should have been reformed after the Enron and WorldCom scandals, but wasn't.

In a direct sense, the carnage on Wall Street is all about the great housing slump.

This slump was both predictable and predicted. “These days,” I wrote in August 2005, “Americans make a living selling each other houses, paid for with money borrowed from the Chinese. Somehow, that doesn't seem like a sustainable lifestyle.” It wasn't.

But even as the danger signs multiplied, Wall Street piled into bonds backed by dubious home mortgages. Most of the bad investments now shaking the financial world seem to have been made in the final frenzy of the housing bubble, or even after the bubble began to deflate.

In fact, according to Fortune, Merrill Lynch made its biggest purchases of bad debt in the first half of this year after the subprime crisis had already become public knowledge.

Now the bill is coming due, and almost everyone that is, almost everyone except the people responsible is having to pay.

The losses suffered by shareholders in Merrill, Citigroup, Bear Stearns and so on are the least of it. Far more important in human terms are the hundreds of thousands if not millions of American families lured into mortgage deals they didn't understand, who now face sharp increases in their payments and, in many cases, the loss of their houses as their interest rates reset.

And then there's the collateral damage to the economy.

You still hear occasional claims that the subprime fiasco is no big deal. Even though the numbers keep getting bigger some observers are now talking about $400 billion in losses these losses are small compared with the total value of financial assets.

But bad housing investments are crippling financial institutions that play a crucial role in providing credit, by wiping out much of their capital. In a recent report, Goldman Sachs suggested that housing-related losses could force banks and other players to cut lending by as much as $2 trillion enough to trigger a nasty recession, if it happens quickly.

Beyond that, there's a pervasive loss of trust, which is like sand thrown in the gears of the financial system. The crisis of confidence is plainly visible in the market data: there's an almost unprecedented spread between the very low interest rates investors are willing to accept on U.S. government debt which is still considered safe and the much higher interest rates at which banks are willing to lend to each other.

How did things go so wrong?

Part of the answer is that people who should have been alert to the dangers, and taken precautionary measures, instead blithely assured Americans that everything was fine, and even encouraged them to take out risky mortgages. Yes, Alan Greenspan, that means you.

But another part of the answer lies in what hasn't happened to the men on that Fortune cover namely, they haven't been forced to give back any of the huge paychecks they received before the folly of their decisions became apparent.

Around 25 years ago, American business and the American political system bought into the idea that greed is good. Executives are lavishly rewarded if the companies they run seem successful: last year the chief executives of Merrill and Citigroup were paid $48 million and $25.6 million, respectively.

But if the success turns out to have been an illusion well, they still get to keep the money. Heads they win, tails we lose.

Not only is this grossly unfair, it encourages bad risk-taking, and sometimes fraud. If an executive can create the appearance of success, even for a couple of years, he will walk away immensely wealthy. Meanwhile, the subsequent revelation that appearances were deceiving is someone else's problem.

If all this sounds familiar, it should. The huge rewards executives receive if they can fake success are what led to the great corporate scandals of a few years back. There's no indication that any laws were broken this time but the public's trust was nonetheless betrayed, once again.

The point is that the subprime crisis and the credit crunch are, in an important sense, the result of our failure to effectively reform corporate governance after the last set of scandals.

John Edwards recently came out with a corporate reform plan, but it didn't receive a lot of attention. Corporate governance still isn't regarded as a major political issue. But it should be.

22 November 2007

Dark Horse of the Year: Ron Paul


GQ Men of the Year 2007

We've chosen presidential candidate Ron Paul as our Dark Horse of the Year—in GQ's December Men of the Year issue, on stands nationwide on November 27th. Here's why.

Washington sure seems like a town full of bullies sometimes. Along comes a 72-year-old physician from south Texas who weighs maybe 140 pounds with rocks in his pockets, whom most people, at the beginning of the year, couldn't have picked out of a two-person lineup, who took in barely enough first-quarter money to buy a fancy Italian car, who comes armed with ideas both misbegotten (Abolish the Fed!) and very much not (End this war! Stop indefinitely detaining human beings!), and what do the folks who run the Republican Party do?

They try to silence him. The head of the Michigan Republicans calls for his removal from the debates. Rudy Giuliani attacks him for—what else?—insufficient patriotism. To witness this is to understand the fear Ron Paul has instilled in the GOP.

He has tapped into his party's silent minority, one that won't abide torture, reckless spending, or endless war. And his supporters (and admittedly, there are some real conspiracy-minded moonbats among them) have rewarded Paul for his courageousness, to the tune of more than $5 million in campaign contributions in the third quarter—about the same as John McCain has raised.

It isn't a revolution, but Ron Paul's candidacy serves as a reminder that electoral politics needn't be a joyless march to a clothespin vote. It can be daring and kind of kooky, too. —Greg Veis

Citibank SIVs Hit Norway Townships

by Mike Shedlock

Several Norway townships are caught up in the international credit crisis.

Several small townships in northern Norway went along with a securities firm's advice and invested as much as NOK 4 billion in complicated American commercial paper sold by Citibank. They now risk losing it all.

The township politicians are both embarrassed and angry at the financial advisers who they now claim led them astray. "They think we're a bunch of small-town fools," one local mayor told newspaper Dagens Næringsliv.

Officials in four northern Norwegian townships (Narvik, Rana, Hemnes and Hattfjelldal) went along with an alleged recommendation by Terra Securities to invest a total of NOK 451 million in what they're now calling "high-risk structured products" offered by Citibank and sold for Citibank by Terra.

To boost returns, the Norwegian townships also borrowed NOK 3.5 billion to invest in Citibank's products, which later lost as much as 50 percent of their value because of the US credit crunch.

By now it should be clear that Asset Backed Commercial Paper ABCP problems are likely to turn up anywhere and everywhere.

Here is a small sampling:
Two Bear Stearns (BSC) Hedge Funds went to Zero
Two Hedge Funds in Australia liquidated
Money has been frozen in Canada including the Yukon
US and Canadian pension plans are affected
Two banks in Germany were bailed out by the ECB
Norway Townships borrowed money to invest in this mess
Citigroup (C) and Merrill Lynch (MER) both lost their CEOs over this mess
Hundreds of $billions in potential losses are still circulating

The latest news in the US is that SIV debts are hiding in scores of public school funds and close to a $billion in defaults losses had not even been disclosed as late as a week ago even though this mess has been brewing for six months. See SIV Debts A Disaster For Public School Funds for more on this story.

Very Expensive Lessons
Don't chase yield
Don't buy something you do not understand
There is no free lunch
Rating agencies opinions are essentially worthless because they are never timely enough and because their business model creates enormous credibility as well as conflict of interest issues
Don't trust Citigroup, Bear Stearns, Merrill Lynch or anyone else hawking debt

That last point is critical. Lack of trust will impact Citigroup, Bear Stearns, and Merrill Lynch's credibility, as well as their ability to raise capital for years to come. Trust once lost, is not easily restored.

Gold & Deflation/Inflation by Marc Faber

I am asked constantly how gold would perform in a deflationary collapse. With the propensity of the Fed and the ECB to flood the system with liquidity and to take "extraordinary measures" whenever problems arise, deflation is a remote possibility for the foreseeable future. So, before worrying about deflation, I would worry inflation accelerating strongly in the years to come - especially if the US economy stagnates. But let us assume that at some point in the future deflation follows. What then? In my opinion, deflation could only be triggered by one event: a total collapse of the existing global credit bubble. And the only event that I can think of that would trigger such a debt collapse would be a third world war. The failure of a large bank - say, Citigroup - wouldn't do the trick, because the Fed would immediately bail it out (unless Ron Paul is US President).

Now in a debt collapse, where would you rather have your money? In bank deposits, in CDs, in dubious commercial paper, in bonds, in money market funds - all of which would experience soaring default rates - or in physical gold, ideally in a safe deposit box? I think that, particularly in a debt collapse, physical gold would shine, as people the world over would become extremely concerned about, not the return on their money (interest), but the return of their money. This would be particularly true of Asian central banks, which now have less than 2% of their reserves in gold but hold massive quantities of all kind of debt securities.

Consequently, while I find the gold price to be currently somewhat overbought, I still think that gold will be one of the best investments over the next couple of years. In particular, I would expect demand for gold from individuals around the world to increase meaningfully - especially in Asia - at a time when production is unlikely to increase. I wish to add that I am not a "gold bug". I would much prefer to live in a world in which central banks' top priority was to safeguard paper money's purchasing power and its function as a "store of value". I would also much rather live in a world in which the US dollar was a strong currency, and where America was as free as it was in the 1960s, and the economic and financial imbalances weren't as extreme as they are today. As Steven Roach recently remarked, "no nation has ever devalued its way into prosperity". But the fact is, the time has come when we can no longer trust central banks. Therefore, each individual must be his own central bank and maintain adequate reserves for himself in the form of physical gold. The supply of paper money is potentially endless, whereas the supply of gold is very limited. (In fact, gold production from mines is declining.)

Marc Faber

excerpted from
The Gloom, Boom & Doom Report - Nov 2007

Central bankers grapple with dollar conundrum

Central bankers grapple with dollar conundrum

By Peter Garnham in London

Published: November 21 2007 02:00 | Last updated: November 21 2007 02:00

The sliding dollar has presented custodians of the world's massive foreign exchange reserves with a conundrum.

Countries such as China and those in the Gulf, which peg their currencies to the dollar, risk inflationary pressure that has the potential to trigger serious economic and social problems.

But any move to cut their links to the dollar could spark a run on the currency that would undermine the value of their reserves.

Global currency reserves have soared from $2,000bn in the second quarter of 2002 to $5,700bn (€3,885bn, £2,780bn) in the corresponding period this year, according to the International Monetary Fund.

Furthermore, two-thirds of the world's reserves are in the hands of six countries: China, Japan, Taiwan, South Korea, Russia and Singapore.

But China tops the league, with the latest official figures showing the value of its reserves at $1,443.6bn in July.

Many of China's trading partners argue that this stockpile - which grew at $40bn-$50bn a month in the first half of the year - has been caused by what they believe to be an undervalued renminbi.

Most analysts say that

the country's reserves have accumulated rapidly since July and that this explains the growing concern about the dollar expressed by Chinese officials.

Yesterday the dollar plunged to a record low of $1.4813 against the euro.

Beijing does not reveal the currency composition of its reserves. However, informed observers say the weightings of its various currencies roughly follow the latest figures from the IMF.

Central banks which have revealed the make-up of their reserves hold on average 64.7 per cent in dollars, 25.5 per cent in euros and the remainder in currencies such as sterling, yen and the Australian dollar.

China's concerns have been highlighted by Wen Jiabao, the premier, who said the country had never experienced such pressure over its reserves and that he was worried about how to preserve their value.

Hans Redeker, at BNP Paribas, says these comments are a clear indication that China wants to slow down the pace of increase of its reserves.

Primarily driven by food prices, China's rising rate of inflation currently stands at 6.5 per cent. Mr Redeker suggests that a rising renminbi is now favourable for the country as it will reduce import price pressure for food products.

"The undervalued renminbi supplied the globe with excess liquidity while the investment boom created demand for raw materials," he says. "This overvaluation [of raw materials] is now going to correct as China leads its currency closer to its fair value and tighter domestic conditions slow investment spending."

While an appreciation of the renminbi would slow China's accumulation of foreign exchange reserves, it would not address the problems caused by the weak dollar undermining their value.

Simon Derrick, at Bank of New York Mellon, says it is ironic that a large part of the reason for the dollar's fall can be attributed to central bank reserve managers.

IMF data reveal that, in the second quarter of 2002, the dollar represented 71 per cent of central bank holdings, while only 19.7 per cent was held in euros.

"All the available evidence indicates that the phenomenal growth in foreign exchange reserves over the past five years has been accompanied by a notable push to diversify away from the dollar and into the euro," he says. "This explains the rise of the euro."

Other analysts were less sure of the role played by central bank reserve diversification in the dollar's fall.

They say cyclical factors are the main driver behind the dollar's 40 per cent drop against the euro since 2002, arguing that the shift in reserve currency allocations needed to drive the dollar so far would be much greater than the shifts reported by the IMF.

Marc Chandler, at Brown Brothers Harriman, says central banks may well be diversifying new reserve accumulation away from the dollar, but China's recent comments do not mean they are diversifying existing holdings. "What incentive do they have to tip their hand, even if that is what they intend to do?" he asks.

In any case, Mr Chandler believes it is unlikely that the Peoples' Bank of China has turned from the traditional role of a central bank to become a currency speculator.

Global crash imminent, warns expert

Global crash imminent, warns expert
by Joel Bowman on Sunday, 18 November 2007

A sharp downward correction is due in the global markets as real estate, stocks and energy soar to record highs, warned a leading expert on the opening day at this year's Dubai International Financial Centre (DIFC) Week.

Even as emerging markets like China, India and Brazil careen ahead at voracious growth rates, the speculative "bubbles" arising in the markets could cause a major global recession, cautioned Robert Shiller, the Stanley B. Resor Professor of Economics at Yale University, at yesterday's event.

"Perhaps we have gotten a little too confident in the global economic growth," said Shiller. "The problem is high oil, stock and real estate prices. I believe that a substantial part is speculative bubble thinking. We have gotten too confident of the prices in these markets," he said.
Story continues below ↓

Oil prices, driven partly by demand from the rampant economic expansion of emerging markets, are flirting with all time record prices, even when adjusted for the devaluing of the U.S. dollar, in which oil is almost universally priced.

Housing too has been boosted to obscene highs on the back of the liquidity glut caused by low interest rates around the turn of the century and by speculative buying. Shiller pointed to the increase in long term home prices in the Netherlands, Norway and the U.S. to illustrate the precarious position the markets have been elevated to.

Now that the global credit crunch has all but dried up the lending and borrowing frenzy that fueled these price run-ups, the markets could face troubled times ahead.

"The unwinding of these markets is the most serious risk facing these markets today," Shiller said.

The confidence of consumers and investors has steadily eroded as they buckle under the pressure of these record high prices, according to measures taken by the Yale School of Management Stock Market Crash Confidence Index and its Market Valuation Confidence Index.

Shiller also pointed to the futures market, such as that of the CME in Chicago, which now predicts a major, ongoing decline over the coming four years.

DIFC Week runs until November 23 and features presentations from a host of economic leaders including Dr. Nasser Saidi, Larry Summers, Jeffery Sachs and Freakonomics author, Steven Levitt. View exclusive coverage at ArabianBusiness.com's Special Report .

21 November 2007

The Coming Crash

Message from John L. Petersen on the Coming Crash

November 19, 2007

It appears that the world in general and the United States in particular are on the edge of a major disruption in the global financial system. Here's the summary as we see it.

At a recent Board meeting of The Arlington Institute, Dr. David Martin, CEO of M*CAM and one of the members of the Board was asked for his assessment of the global financial situation in the coming months.

Here are my notes from his response:

I stand by my commentary in July of '06.

The next shoe to fall is consumer credit
Currently as reports came in on the 3rd quarter, foreclosures were up 470% this quarter alone. They will be up over 500% this coming quarter (4th). A foreclosure in our terms is when the bank has officially declared an account insolvent and tries to regain the asset (if it exists). The person who is foreclosed upon can no longer secure any traditional consumer credit. This in turn goes straight to the banks as no one will be able to get the store issued charge cards.

A minority of people pay off their consumer debt every month. When one considers the combination of consumer credit card debt and the compounded debt of “home equity” financing, we estimate that less than 20% of people actually carry no consumer credit from one month to the next. Many of the ones who don't pay off their carried consumer debt have at least one credit card at its limit and therefore lack credit capacity. Most have their paycheck directly covering bills and servicing the minimum balance due.

Therefore people who are foreclosed upon will not be able to obtain credit and since their paychecks will be maxed out, there will not be extra cash left over from the paycheck to service a new debt.

Next, everybody buys things at Christmas. As much as 40% of retail sales are done in the 4th quarter of the year – i.e. the retail miracle. The purchase decline in retail goods this fourth quarter will occur because many credit-only consumers will lack the credit capacity mentioned above. Frequently, people overcharge their limit and the banks (albeit a profit center for subprime credit users) levy a penalty by increasing interest rates and charging additional fees. In the 4th quarter of 2007, the amount of people overcharging their limits will be too many for the banks to handle. We do not have a system in place to deal with overcharge on that scale. A substantial number of this December's purchases will go into an overdraft on credit limits.

CDO – Collateral Debt Obligation – Consumer Credit

Consumer credit pooled debt investment instruments (a form of CDO) are originated and rated based on underlying historical credit behavior and a complex series of predictive models for repayment dynamics. CDOs have “strips” which are a combination of similar profile tranches within a larger investment product. Based on the market's appetite for risk, investment performance guarantees (or credit enhancements) are packaged with the credits. These credit guarantees are issued by insurance companies, reinsurance companies, and other specialty finance companies – many operating with extra-territorial jurisdiction rendering fiscal oversight more complicated.

These strips come in several categories:

* Investment grade
* Almost investment grade
* Junk and
* Why did we give them a credit card?

All of these grades are priced on historical default rates. The credit insurance companies (AIG, MBIA, Ambac, Financial Security Assurance, Channel Re, XL, Zurich Re and other reinsurers) have, from time to time, issued credit guarantees to the securities. Banks sell debt in the form of a Collateralized Debt Obligation (CDO).

Minor shifts in default actuarial activity (+/- 25 basis points) from normative behavior is absorbed within pricing of these financial guaranty contracts. However fundamental shifts (hundreds or thousands of basis points in one quarter) are not built into the model and result in credit enhancement insolvency on a major scale. When the insurer cannot pay based on its own liquidity impairment, the bank is left with catastrophic (an insurance term for excessive loss outside of expected) exposure.

If in a single quarter we have an increased foreclosure rate of 400% (or 4000 basis points) the insurance contracts simply cannot handle that kind of drastic shift as evidenced by the write offs in the third quarter. When we will follow the drastic third quarter with a loss of 500% in the fourth quarter, the trajectory becomes clear.

Neither the banking nor the insurance industry has a historical experience in dealing with this type of challenge and neither has the liquidity linked to these contracts to support system wide collapse.

Where was the announcement of this? There was no announcement.

However Hank Greenberg is resurfacing in AIG leadership even during an SEC investigation because without him, no one else can remember where the counterparty risks are. In order to save the insurance industry, shareholders have looked past alleged SEC violations as there is no one with Mr. Greenberg's awareness of the market and counterparty agreements who can hope to navigate the coming challenges. In the 4th quarter, the US will have another record foreclosure announcement. Once you're over 25% (25 basis point) foreclosure, all models are broken.

Under a consumer credit melt-down, Capital One and/or Wachovia are likely going to put a massive foreclosure liability to an insurance company and the insurance company will not have liquidity to cover the exposure.

This is the problem we got into when we issued credit card debt on top of secondary mortgages – (inflated the value of the home) and gave out credit based on faux equity that no one really had.

The reason why this problem is the second shoe to fall (subprime mortgage collapse was the first shoe) is because consumer credit has a different foreclosure frequency than traditional mortgage credit.

December is when the maturity of the giant buyout of the economy moves.

By December, you'll have a second round of charge offs based on consumer credit. The real big problem – when you foreclose on consumer credit, people stop buying things. When people stop buying things, we don't have a tertiary way to pump liquidity into the market. People won't have extra cash from their paychecks and won't have capacity on their cards.

Try this case study:

Go to the mall and stand in front of counter at Victoria Secret. Watch what happens when someone wants to pay with cash. The clerk won't know how to ring up cash. They will need a manager to come over to give change and unlock drawers. When you don't have capacity on those cards, you don't buy things. VISA credit cards actually denigrate using cash in their run-up-to-Christmas add campaign.

Next, go to any savings bank data set. If you were going to spend $1000 in cash this Christmas, can you do it? For the most part, the answer would be “no” because we have had a net negative spending for the last 5 years.

Therefore there will be depressed consumer spending this Christmas but what is spent, people will overcharge. This will take what used to be good investments in CDOs and will change the dynamic. If you used to be a person who paid their bills on time, you will now only pay half. If the credit companies are counting on the top two tranches to pay their card off in full and they don't, they won't have liquidity to cover the rest. The banks cannot afford the top tranch paying half.

The estimates are out. There will be at least $400B in the first round of charge offs in the CDO market.

We're not going to be done with the subprime mortgage when the CDOs fall. Therefore we will have an insolvency problem with the banks that are mentioned above.

This is the kiss of death of a privately held Federal Reserve. For the Federal Reserve to function, its stakeholder banks (like JP Morgan Chase) must remain viable and liquid. When one of them, or any major bank in the U.S. (like Bank of America, Citibank, Wells Fargo, Bank of New York, Washington Mutual, etc.) is impaired or ceases to exist, the architecture of the Fed's capacity to respond to systemic challenges is unsustainable.

If the banks have no money, they can't pump liquidity into the market. Taking half of a trillion dollars out of market in a single distressed write down becomes problematic. The US banking system does not have the liquidity to take the hit.

The actual solvency of the Federal Deposit Insurance Corporation is relatively indecipherable due to the fact that their treasury management processes (and the risks of their own investment strategies) are not uniformly disclosed with sufficient transparency. The FDIC was set up for isolated problems with a few bad banks but is NOT prepared to “insure” the system in an industry-wide crisis. The actual liquidity reserve of the “insurance” that Americans view as their safety net is 1/100th the actual exposure of outstanding deposits. The actual coverage ratio for the Bank Insurance Fund (BIF) fell below 1.25% in 2002, the same year that less stable credit practices were adopted by America's leading banks.

The funny part is that the Federal Government will be on holiday when all of this happens. There will be no one to put freeze actions and moratoria on actions. The only way you stop the cataclysm is to put together civil actions on deposit withdrawals.

As I discussed previously, the Chinese currency wild-card may become relevant far sooner than expected. An effort by China to convert its $1.4 trillion U.S. Treasury holdings into euros is not viable for many reasons – not the least of which is the European Central Bank's inability to absorb such an event. As China continues its rush away from supporting U.S. Treasuries and as Middle Eastern investors are buying them up in more diversified holdings, a new “currency exchange” is unfolding. Realizing that they cannot liquidate their holdings, it appears that the Chinese are currently using their U.S. Treasury holdings as collateral for euro denominated purchases and long term infrastructure transactions. In other words, they may be “liquidating” their holdings as collateral and, in so doing, effectively migrating to non-dollar value without ever having to officially dump their current Treasury holdings.

Therefore, collateralize the credit in dollars – especially if you're long in dollars. The lender/financier won't call the note because you have it structured in such a way to both allow it to perform and hold illiquid collateral that no one wants. This essentially inflates euros. Although you can't sell dollars, the whole purpose of collateral is that it is a second source of payment – collateral is there to down rate the risk of the loan. Secondary becomes irrelevant.

When February comes, the Chinese are going to do something as they will have to decide what the exposure is going to be with the treasury. As I see it they have to just dump the treasury. They only keep it because they can use it – they have 43% direct/indirect of US treasuries so they'll dump them on the market.

The US Congressional pressures to decouple the RMB will work, but not in the way we want. Our plan includes helping them hold on to the treasuries, it does not involve them not holding the dollar anymore. The US wanted the tether to be part of the float. This will cause disenfranchisement of the US electorate (during primary season). February is also when public (media) will realize we won't pull out of this.

Side note: Mayor Bloomberg could enter the race at this point, being the savior candidate (at least economically), but has $1B dollars in non-liquid money so he may not be able to enter.

March is when we realize that the dollar doesn't come back.

OPEC price with the whole fluctuation of oil futures presages the event. They are going to run the price of oil as high as they can get it on the dollar, while buying US treasuries from China with the money. When the dollar does collapse, they'll flip denominations. The wild card is long about March when the OPEC cuts spot oil off the dollar to the euro. One can look at the current oil price at close to $100/barrel and fail to see that, as this premium price is currently turning around and investing in a weakening dollar, the effective price (less the dollar investment hedge) is probably closer to $50/barrel than the spot price reflects.

Currency problems will change the game – they are financially structuring themselves to take the hit.

When we can't afford to buy oil commodities on a spot market – it compounds the problem however the consumer that Saudi Arabia ships to is liquid (China). In the US it is a big problem. There is still a market for oil; it just changes. When you come out of Straits of Hormuz, turn left.

RE: Key Paragraph Jacking Oil To Keep Up Dollar Demand... GrislyBear
NEW 11/20/2007 7:07:38 PM
OPEC price with the whole fluctuation of oil futures presages the event. They are going to run the price of oil as high as they can get it on the dollar, while buying US treasuries from China with the money. When the dollar does collapse, they'll flip denominations. The wild card is long about March when the OPEC cuts spot oil off the dollar to the euro. One can look at the current oil price at close to $100/barrel and fail to see that, as this premium price is currently turning around and investing in a weakening dollar, the effective price (less the dollar investment hedge) is probably closer to $50/barrel than the spot price reflects.

Several other analysts have made this point.

But since the USA consumes 25% of world oil, and less than 5% of world's population, the game can't go on much longer.
Specifically, at some point whether that be $150 or $200 oil, demand will crash and ironically, so will the USD price.

RE: Thanks, notsure smokey
NEW 11/20/2007 8:20:09 PM
"This is the kiss of death of a privately held Federal Reserve. For the Federal Reserve to function, its stakeholder banks (like JP Morgan Chase) must remain viable and liquid. When one of them, or any major bank in the U.S. (like Bank of America, Citibank, Wells Fargo, Bank of New York, Washington Mutual, etc.) is impaired or ceases to exist, the architecture of the Fed's capacity to respond to systemic challenges is unsustainable.
If the banks have no money, they can't pump liquidity into the market. Taking half of a trillion dollars out of market in a single distressed write down becomes problematic. The US banking system does not have the liquidity to take the hit. "


The Federal Reserve Banking system is based on collateralized debt. Before banks or other financial institutions can borrow from the system, they must offer something of equal value as collateral plus any added interest for the duration of the loan.

Ben Bernanke, in his "printing press" speech of 2002, either knowingly or unknowingly misspoke when he described the Fed's unlimited ability to provide liquidity to the markets.

The Fed injects liquidity into the financial system by buying certain assets like US treasuries. This process does not add any value to the system. It is the financial system which must use the injection of liquidity to add value through providing credit to entities which can then invest or speculate in appreciating assets.

As long as the financial/economic system is growing, banks and other financial entities will be able to use the credit issued by the Fed to grow their asset base by issuing their own credit to the expanding economy. They can then not only repay their loans from the Fed, but also buy US treasuries and other financial assets which can be used as collateral for future loans.

This mechanism works as long as appreciating assets in the system continue to expand the capacity for more debt. Financial bubbles of the recent past have been able to expand debt beyond its normal limits by hyperinflating the values of assets involved in the bubbles.

As long as these hyperinflating assets remained in the virtual reality of the financial markets like stocks, bonds and the derivatives thereof, they seemingly had infinite potential to appreciate.

But when the expansion of credit spread into the real economy through rising real estate prices, the asset appreciation began to be limited by the incomes of the real estate investors and speculators. This limitation of income then brought the expansion of credit to a dead-end through debt saturation.

The REAL economy brought the virtual expansion of financial assets to a screeching halt.

Without new assets with which to offer as collateral, the banks and large financial entities can no longer purchase the collateral necessary to expand their asset base through selling more credit. Therefore as the asset bubbles pop and defaults increase, the banks and their depositors are left holding the bag.

The Fed can lower interest rates down to zero, but without an expansion of the basis for collateral, the demand for credit will remain flat while the increasing defaults continue to destroy any possibility of credit expansion.

All talk of Weimar hyperinflation at this point is simply talk. The Federal Reserve banking system based on collateralized debt would have to be replaced with a nationalized banking system in order for a Weimar or Zimbabwe type hyperinflation of the monetary base to occur.

Of course, anything is possible.

Maybe Congress will forgo their upcoming paid holidays to abolish the Fed.

Ya think?

19 November 2007


LEAP/E2020 now estimates that at least one large US financial institution (bank, insurance, investment fund) will file for bankruptcy before February 2008, sparking off bankruptcies among a series of other financial institutions and banks in Europe (in the UK especially), in Asia and in various emerging countries. According to an expression by Blackstone president Tony James's (1), a financial « black hole » was formed after the US subprime crisis.

The triggering factors for a major financial institution to go bankrupt are now so powerful and warning clues so numerous that, according to our researchers, the probability that it happens within three month now reaches 100%. Probabilities are as high that the US authorities will try to introduce a reimbursement protection-net in order to avoid panic from spreading throughout the entire US financial system (2); but the size of the bankruptcy will immediately hit the most exposed financial institutions operating in the US and in the rest of the world. Countries whose financial operators are the most linked to US financial operators will be on the frontline: United Kingdom, Japan, China in particular (3).

There are four main triggering factors, according to our team:

1. Drastic drop in revenues for banks operating in the US
2. Slumping value of assets owned by these banks resulting from new US banking regulation (FASB regulation 157)
3. Increasing weakness of bond insurers
4. Economic recession in the US

These factors must of course be placed in the general context described by LEAP/E2020 since the beginning of 2006, i.e. a global systemic crisis, which only today is beginning to be grasped by the world's political, financial and economic leaders (4). The fact that over the past two years, the largest financial operators and central banks, the US Fed and the Bank of England in particular, were systematically late on the course of events, entails to believe that they will only become fully aware of the existence of a banking crisis once some major event has happened, once it is too late to efficiently prevent the system's contamination.

University of Michigan « Consumer Sentiment » (November 2007 included) – Source: Federal Reserve Bank of Saint Louis / LEAP/E2020
In the present public announcement of the GEAB N°19, LEAP/E2020 chose to present its anticipation of drastic drops in the revenues of banks operating in the US (Factor N°1).

Factor N° 1 - Drastic drop in revenues for banks operating in the US
As detailed in GEAB N°19, the coming into effect of the FASB 157 standard on November 15, 2007, will directly involve the financial statements of financial institutions operating in the US and expose them to the consequences of a loss in value of a large proportion of their assets, knowing that this part is increasing. Indeed the subprime crisis was nothing but a catalyst for a wider-ranging financial crisis today affecting all US financial assets (5). The CDOs altogether are now dragged into a general confidence crisis, and they represent a large part of bank assets since, in the past few years, large banks from lenders became investors and speculators, like hedge funds.

By the way, the latter represented for nearly a decade a growing source of revenue for large international banks. Everyone still has in the mind the huge fees that these hedge funds and investments funds paid to the banks in the framework of their various operations such as LBOs (Leverage Buy-Out), M&As (Merger and Acquisition) and other IPOs (Initial Public Offering). These not-so-remote-times (they ended last summer) now belong to the past.

Today, hedge funds are striving to avoid bankruptcy. Investment funds deepen their losses as they try to avoid being sucked into the “financial black hole” mentioned by Blackwater's CEO (cf Factor N°2, GEAB N°19).

Merger and Acquisition projects are at a standstill. For instance, in the technology sector (a privileged target of M&As), Wall Street saw the amount of transactions decrease from USD 99 billion in the third quarter of 2006 down to USD 52 billion in the third quarter of 2007 (i.e. a 50 percent drop), knowing that the credit crisis was only beginning in the third quarter of 2007. Yet the weakness of the US dollar provoked a frenzy of European LBOs in the US; indeed for the first time the Europeans bought as much as their North-American counterparts (6).

LBO freeze – Source Dealogic
Despite the fact that IPOs on Wall Street resisted quite well the Summer crisis, they are now postponed to unknown dates, when times are less gloomy. For instance, the number of IPOs for more than USD 1 billion fell from 8 per quarter (in the third quarter of 2006) to 2 (in this year's third quarter), knowing that this trends is strengthening as recently illustrated by RWE, this German energy supplier who decided to postpone its American Water division's public listing because of the credit crisis in the US (7); another example is provided by Rusal, the Russian aluminium giant who postponed to an unknown date its planned IPO, though it promised to count as this year's most important one and despite the fact that operating banks have already been designated (i.e. Morgan Stanley, JP. Morgan and Deutsche Bank) (8).

With regard to LBOs (these remarkable financial packages which make it possible to buy a company with the riches it potentially contains (9)), the market is practically closed. Moreover all transactions that were not frozen or cancelled end up in court, as illustrated by the emblematic case of SallieMae, the student loan company, and JC. Flowers (a very active investment fund with no website!) (10). In October, LBOs only represented 5 percent of all M&As, versus 31 percent in June 2007.

US banks' level of exposure to financial derivative risks – Source Contraryinvestor
All these tendencies point in the same direction: the loss of a significant source of revenues for banks operating in the US, that will soon combine with the consequences of the implementation of the FASB 157 standard on the one hand and with the CDO crisis on the other, meaning the loss in value of an important part of the same banks' assets.

Indeed in 2006, revenues drawn from their advisory and intermediary services in LBOs, M&As, etc… represented 27 percent of their total revenue, after experiencing the strongest progression recorded in the past seven years (seven years before, in 1999, i.e. on the even of the Internet bubble burst!). Moreover in 2006 already, these revenues had to compensate for losses induced by the first effects of the subprime crisis. In 2007, losses related to the mortgage market literally exploded compared to 2006, and everyone can see that all large financial transactions' advisory and intermediary services have now dried up (11).

No need to be visionary to conclude that these banks will experience between the end of this year and the beginning of next year a severe crisis capable of entailing losses that some of them will not be able to cope with. According to LEAP/E2020, all these clues are harbingers of a major banking crisis whose causes and consequences for investors and savers are retailed in the GEAB N°19.


(1)Tony James used this expression to describe the financial environment that led his capital investment company, one of Wall Street's wonders until a few weeks ago, to announce a USD-113 million loss (source Forbes, 11/12/2007). Blackstone's shares were listed on the stock market last year, simultaneously with a number of other mega-investment funds such as KKR or Fortress, for instance. By the way, last spring, our team warned that these Initial Public Offerings (IPOs) in fact aimed at pooling future losses rather than past profits. This is now confirmed.

(2)It is already the case with “Paulson's super-conduit” (cf. GEAB N°18).

(3)For more details on the level of exposure to US financial risks, see GEAB N°16, 17 and 18 in particular.

(4) This means that they are only beginning to understand the « systemic » nature of this crisis. Until now, they first refused to admit that there was a crisis, and then they treated it as one more episode of the usual economic and financial cycles.

(5) Source: Bloomberg, 11/13/2007

(6) Source: The451Group, 10/01/2007

(7) Source: YahooNews/Reuters, 11/14/2007

(8) Source: Financial Information Service, 09/21/2007

(9) As long as they manage to convince a sufficiently large amount of financial operators to lend them the corresponding sum.

16 November 2007

Six Positive Trading Behaviors

There is much more to good trading than merely eliminating bad habits. Here are six trading behaviors I find among many of the best traders I've had the pleasure to work with:

1) Fresh Ideas - I've yet to see a very successful trader utilize the common chart patterns and indicator functions on software (oscillators, trendline tools, etc.) as primary sources for trade ideas. Rather, they look at markets in fresh ways, interpreting shifts in supply and demand from the order book or from transacted volume; finding unique relationships among sectors and markets; uncovering historical trading patterns; etc. Looking at markets in creative ways helps provide them with a competitive edge.

2) Solid Execution - If they're buying, they're generally waiting for a pullback and taking advantage of weakness; if they're selling, they patiently wait for a bounce to get a good price. On average, they don't chase markets up or down, and they pick their price levels for entries and exits. They won't lift a market offer if they feel there's a reasonable opportunity to get filled on a bid.

3) Thoughtful Position Sizing - The successful traders aren't trying to hit home runs, and they don't double up after a losing period to try to make their money back. They trade smaller when they're not seeing things well, and they become more aggressive when they see odds in their favor. They take reasonable levels of risk in each position to guard against scenarios in which one large loss can wipe out days worth of profits.

4) Maximizing Profits - The good traders don't just come up with promising trade ideas; they have the conviction and fortitude to stick with those ideas. Many times, it's leaving good trades early--not accumulating bad trades--that leads to mediocre trading results. Because successful traders understand their market edge and have demonstrated it through real trading, they have the confidence to let trades ride to their objectives.

5) Controlling Risk - The really fine traders are quick to acknowledge when they're wrong, so that they can rapidly exit marginal trades and keep their powder dry for future opportunities. They have set amounts of money that they're willing to risk and lose per day, week, or month and they stick with those limits. This slows them down during periods of poor performance so that they don't accumulate losses unnecessarily and have time to review markets and figure things out afresh.

6) Self-Improvement - I'm continually impressed at how good traders sustain efforts to work on themselves--even when they're making money. They realize that they can always get better, and they readily set goals for themselves to guide their development. In a very real sense, each trading day becomes an opportunity for honing skills and developing oneself.

These six criteria, I believe, can form the basis for effective report cards. Traders can grade themselves in these six areas and, over time, establish where they're strongest and weakest. I find such self-appraisals very helpful for coaching; ultimately they provide goals for self-development and criteria for measuring progress over time. In no small measure, good trading boils down to three factors:

1) Having a demonstrated edge;

2) Having the skills needed to exploit that edge; and

3) Having the resilience to bounce back when the edge is no longer present.

It's the traders who have all three qualities that are most likely to make a long-term career out of the markets.

The big secret -- Rudd is the new Scullin --

(Don't tell the electorate, they will find out soon enough).
by James Cumes

There are intriguing similarities between the forthcoming Australian elections and those of 1929.
In 1929, the Scullin Labor Government won a landslide victory and took office just 2 days before the New York Stock-Exchange Crash of Black Thursday, 24 October ushered in the Great Depression of the 1930s.
Prime Minister Stanley Melbourne Bruce, after more than six years in office, lost not only government but his own seat in the House of Representatives.
Now we have a similar situation in that centre-right Prime Minister John Howard, after eleven years in office, looks like being swept away in a landslide by centre-left Labor led by Kevin Rudd. Though perhaps unlikely, it may be that Howard could even lose his seat in the House of Representatives.
However, what comes after is the most intriguing aspect. In 1929, no one, least of all James Scullin and his ministers, had any idea that the world was about to crash into the greatest economic depression the world had known. They had even less idea of how they should react to any such crisis. Intriguingly, two of the key issues which confronted them were irresponsible debt and industrial relations.
The same seems to be true of the prospective Rudd Government. He has proclaimed himself to be a “conservative economist.” He has spoken, during the campaign, mainly about interest rates and housing costs in conventional terms. He will amend industrial legislation to be more acceptable to workers. He says it all in the obvious expectation that the next few years – the next ten years perhaps – will be much the same as the last ten years under Howard.
There is not the slightest possibility that they will be.
We are about to go through the most tumultuous years – in economic, social, political and strategic terms – that we have ever known. The financial, banking and credit “system” will need to be reconstructed almost from scratch, globally as well as nationally. We will have to revise fundamentally our thinking about the means to maintain economic stability and growth, non-discriminatory international trade, stable exchange rates and international capital flows; indeed, the whole gamut of issues with which we were concerned in reconstructing the world economy after the Great Depression and the Second World War.
Can a Rudd Government survive attempts to achieve such a remodelling of so much? Does it have any idea how it will contribute to thinking about such re-modelling – and do so with the vital interests of Australia both short and long term in mind?
The Scullin Government was an abject failure. Despite Mungana, it was not corrupt or dishonest. It was well-intentioned; and it was in no sense extremist or revolutionary. On the contrary, its economic and financial policies were conservative. Though some of its members wanted more expansionist policies, it accepted a “Premiers’ Plan” so devastatingly conservative that it did more to create misery for the people of Australia than the Great Crash of the NYSE ever did.
Confused, defeated and despised by its left constituency as well as the right, it lasted until January 1932. The Labor Party split three ways. A Labor defector, Joe Lyons, formed the United Australia Party, became Prime Minister and staggered on until his death in 1939 – some months before the outbreak of war.
Labor did begin to show some signs of revival in the mid-thirties. Most conspicuously, Ben Chifley made some useful contributions to the Royal Commission on Money and Banking in 1936. By the time Labor regained office just weeks before Pearl Harbour in 1941, ideas that would remedy the ills of the 1930s were being drafted into policies by Labor and formed the basis of the domestic and international economic policies that the Curtin and Chifley Governments would implement with such success between 1945 and 1949.
For Curtin and Chifley, the revolution was well prepared and they succeeded. For later Labor Governments, the way was never sufficiently prepared. The Whitlam Government had no idea how to deal with the problems of the 1970s. The Hawke and Keating Governments thought they did know and, in the process, led us down a highly conservative, right-wing, Reagan/Thatcher road that now threatens to destroy global stability and Australia’s economic, political and strategic security in a highly toxic global environment.
Where does that leave us with a Rudd Government? Past governments have failed utterly to make us the “Tiger” we should have been in the world that followed the breakdown of post-war stability between 1969 and 1971. Instead, they have left us exposed to all the hazards that flow from “floating” exchange rates, massive global speculation, reckless deregulation, opportunistic privatisation and, most recently, the escapades of the financial adventurers, marauders and buccaneers who have flogged credit and other dubious derivatives, Structured Investment Vehicles (SIVs), Collateralised Debt Obligations (CDOs), hedge funds, private-equity deals and the rest around the world. These various financial “enterprises” have, inter alia, feasted on pension funds which, in turn, in our privatising mania, have fed on millions of pensioners whose future financial security is now gravely at risk.
There is nothing in what Rudd, his shadow ministers and advisers have said and indeed nothing in the pronouncements of academics, “experts” or anyone else, that suggests that the incoming government – whether it be Labor or Coalition – has the faintest idea of the nature, scope and magnitude of the problems that confront us or of the ways in which they may be resolved.
Unless the incoming government – let’s assume it will be a Rudd Government – is extremely lucky, the crash will become manifest in the next few weeks or latest by March 2008. The United States is almost certainly in recession already – concealed only by spurious official statistics – the dollar has fallen sharply and almost certainly will fall further and faster as the weeks go by. Household, corporation and public debt is monstrous, unprecedented and all those adjectives that we thought we would never have to use. Consumer and asset inflation is high. Credit is tight and getting tighter – largely because, in the casino world that the global economy has become, too many have already lost their shirts and far too many more fear that the shirt hangs far too loosely on their own back and on the backs of those who already do or might want to owe them money.
The financial crisis is already flowing to the rest of the American economy – and spreading, like a deadly plague, globally.
Central banks never were of much value. In recent years, they have created far more problems than they have solved. The Fed purports to manage the crisis; but its reduction of interest rates and its flooding of the banking system with funds serve little purpose except to give desperate, short-term hope in a financial “system” which is so inherently invalid that its collapse is several degrees more assured than we usually associate with the term “inevitable.”
Very little of this seems to be preoccupying anyone in Australia – at least among the campaigning parties or those advising them. Concern is expressed from time to time about the “sub-prime crisis” and the credit crunch. Very little is said about, for example, the carry trade which has been supporting the Australian dollar and conveniently neutralising a large part of Australia’s external deficit. Recently, the yen has been highly volatile and the carry trade has been unwinding and rewinding in harmony. We have not yet had the “Great Unwind” but, assuredly, it is not far down the road.
That leads us to the further point that we have, for the last two or three years in particular, been through one of the greatest commodity booms in history. This boom has affected a whole range of raw materials – as well as food for which, if, because of drought, we have not been able to sell in abundance, we should, in some compensation, have been able to get better prices.
From this, we might have imagined that we might be enjoying as splendid a surplus in our external trade as, let us say, Russia from the boom in oil. But that is not so.
It has not happened, largely because Australians have continued to consume vast quantities often of luxury goods, paid for by massive credit-card and mortgage debt based largely on false notions of expanding personal wealth.
The external deficit has shown some volatility but it is a reasonable prediction that, based on performance so far, the trend in future will show the deficit increasing rather than receding. The carry trade will then unwind, perhaps completely and there may be an easing – perhaps a grave easing – of commodity demand from China if their economy and, for example, India’s strike a rougher patch.
None of these developments is improbable nor is it improbable that they could occur together.
Australia is not prepared for any such eventuality. Past Australian policies have been based on about as many false premises as anyone can possibly poke a stick at.
Against this background, a Rudd Government is not remotely prepared to deal with the probable crises that might confront us; nor of course would a Howard Government have a clue as to what it might be best to do.
Either alternative would be faced with the outcome of nearly forty years of successive governments’ failure to make Australia one of the “Tiger” economies. Rudd now declares his determination to put a laptop in the lap of every young Australian. In itself, that objective is noble; but it is pathetic that only now a Labor campaigner for office should be advocating it as a sort of cure-all. He may be putting it forward when, before one laptop can be delivered under the program, the house of financial and economic cards that Labor and Liberal governments have built over the past three to four decades will be toppling around us. Many of us will be left with no job, no house, no adequate professional or trade education, no decent health service and, at the end of it all, no pension except one that has been heavily depreciated in the financial storms that our Governments have done so much to provoke.
A Rudd Government, if we get one, might last as long as Scullin’s did. That would take us perhaps to the beginning of 2010. Labor would probably split long before that. The Treasurer or some other minister might take a few Labor dissidents to form a government with Opposition members led perhaps by Peter Costello. Somehow, we might then stumble through a long, deep and terrible depression, to end around, let us say, 2017 in World War Three. Only the Almighty knows whether we might have any allies at all by then - and whether they might have any residual power even to secure themselves let alone prop up any allies.
With those prospects, Labor – and Kevin Rudd - might be well advised to disdain any offer of power to govern and so avoid going down in history as another well-meaning but feckless Scullin-type Government. Let Howard and his retinue take the blame and just opprobrium for a catastrophe to which they have contributed with such unbridled generosity.
It won’t happen of course. On the night of 24 November 2007, Labor, led by Rudd, will probably be declared the victor and they will confront their unenviable destiny. For Australia, it won’t be any worse than having Howard’s Coalition as the victor. Indeed, it might be rather better. However, whoever is the victor, I – as one who grew up in the last Great Depression – can only offer a prayer and express a hope. That hope is that we Australians may come through this new and even more terrible challenge, with the same spirit and fortitude that we did seventy years and more ago.

James Cumes
Author of “America’s Suicidal Statecraft: The Self-destruction of a Superpower”

15 November 2007

Merrill Taps Thain After Fink Demanded Full Tally

Merrill Lynch's decision to name John Thain as its new chief executive came after the firm's first choice, BlackRock CEO Larry Fink, demanded that Merrill make a full accounting of its subprime exposure, CNBC has learned.

Thain, who has been CEO of NYSE Euronext for nearly four years, will succeed Stanley O'Neal, who stepped down in late October after Merrill reported huge writedowns from subprime-related losses.

Merrill's selection of Thain was a surprise because the firm had recently indicated to Fink that the job was his if he wanted it. CNBC has learned that Fink said he would take the job but only if Merrill did a full accounting of its subprime exposure. At that point, Merrill, which owns 49% of BlackRock , moved in a different direction and decided to go with Thain instead.

A Merrill spokesman told CNBC that "Merrill Lynch can confirm that Laurence Fink was not offered the job of CEO at Merrill Lynch."

Replacement for Thain

The NYSE will name Duncan Niederauer, the current chief operating officer, as Thain's replacement.

Merrill ousted CEO Stan O'Neal after posting an $8.4 billion write-down for the third quarter. The write-down resulted in a $2.3 billion loss, the largest quarterly loss in the company's 93-year history.

Thain has a blue-chip Wall Street resume, with credentials sharpened by running NYSE and his time as a former co-president at Goldman Sachs.

Thain took over the NYSE in January 2004 after longtime CEO Richard Grasso was forced to resign over his $188 million pay package. Thain sought to present a new image for the exchange and pushed through some major structural changes, including the move to electronic trading.

Thain had also been rumored to be a possible CEO candidate for Citigroup , whose chief executive Chuck Prince also stepped down following big subprime-related losses. No replacement for Prince has been named.

Created Global Exchange

Thain, who is credited with remaking the NYSE into the world's first truly global exchange, is no stranger to the investment world. He started out on the bond desk at Goldman Sachs and left the firm as its chief operating officer.

Many say he's also exactly what Merrill Lynch needs after last month's ouster of Stan O'Neal. The former CEO was not well liked by Merrill's army of some 16,000 brokers, and lost their confidence after the company recorded its biggest loss since being founded 93 years ago.

Merrill Lynch ratcheted up a $2.24 billion loss during the third quarter because of investments in subprime mortgages and other risky types of debt. It joined dozens of other major financial institutions who are getting squeezed as investors steer away from riskier securities, causing credit markets to tighten significantly.

There is also speculation by a number of analysts that Merrill may take a $3 billion fourth-quarter writedown. That would be besides the $7.9 billion charge taken last quarter. Merrill originally said it would write down only $4.5 billion because of the credit crisis.

Faces Daunting Task

Thain faces a daunting task of cleaning up those investments, and reviving morale at a firm badly bruised during the past few months. There has been speculation that a new CEO would be forced to turn around Merrill's fixed income division, a department that he once ran for Goldman in the 1990s.

Meanwhile, Fink may be a possible replacement for Prince, who left the helm of Citigroup less than a week after O'Neal stepped down from Merrill. Thain was also said to be considered to run the nation's biggest bank.

Prince was forced out of his job after Citi's profit fell 57 percent in the third quarter after it booked $6 billion in asset markdowns and other credit-related losses. The night Prince resigned, the company estimated it would need to write down another $8 billion to $11 billion in the fourth quarter.

Thain leaves behind a transformed exchange now locked in competition with rival Nasdaq Stock Market. His first task after taking over in 2004 was the acquisition of electronic trading platform Archipelago Holdings. It was the first step in bringing NYSE into the 21st century, which ultimately led to the creation of a mostly electronic market last year.

He also shepherded the NYSE's April acquisition of European rival Euronext, which operated bourse's in Paris, Amsterdam, Brussels and Lisbon.

The Associated Press contributed to this report.

© 2007 CNBC.com
URL: http

14 November 2007

A Minsky Moment

Monday, November 12, 2007

The U.S. Credit Crunch Of 2007

A Minsky Moment By Charles Whalen

Introduction On September 7, 2007, just after the U.S. Department of Labor released its monthly jobs report, a journalist at National Public Radio asked three economic analysts for a reaction. Their one-sentence responses were: "It's worse than anybody had anticipated"; "It's pretty disastrous"; and "I'm shocked" (Langfitt 2007). Before the report became available, the wide-spread view among economic forecasters was that it would show the U.S. economy gained about 100,000 jobs in August. Instead, there was no job growth for the first time in four years. In fact, there was a net loss of 4,000 jobs (U.S. Department of Labor 2007).

The forecasters were not done getting it wrong, however. After publication of the jobs data, a number of them predicted the news would bolster the U.S. stock market. Why? Because, they argued, the employment report practically guaranteed that the Federal Reserve (Fed) would cut interest rates on September 18. Instead, investor panic over the employment report caused the market, which had been volatile during most of the summer, to quickly lose about 2 percent on all major indices. The Fed did eventually cut rates as expected, but it took a number of reassuring comments by U.S. central bank governors on September 10 to calm Wall Street's fears. What is now clear is that most economists underestimated the widening economic impact of the credit crunch that has shaken U.S. financial markets since at least mid-July. A credit crunch is an economic condition in which loans and investment capital are difficult to obtain. In such a period, banks and other lenders become wary of issuing loans, so the price of borrowing rises, often to the point where deals simply do not get done. Financial economist Hyman P. Minsky (1919?1996) was the foremost expert on such crunches, and his ideas remain relevant to understanding the current situation.

This brief demonstrates that the U.S. credit crunch of 2007 can aptly be described as a "Minsky moment." It begins by taking a look at aspects of this crunch, then examines the notion of a Minsky moment, along with the main ideas informing Minsky's perspective on economic instability. At the heart of that viewpoint is what Minsky called the "financial instability hypothesis," which derives from an interpretation of John Maynard Keynes's work and underscores the value of an evolutionary and institutionally grounded alternative to conventional economics. The brief then returns to the 2007 credit crunch and identifies some of the key elements relevant to fleshing out a Minsky-oriented account of that event. The Credit Crunch of 2007

As early as March 2007, a smattering of analysts and journalists were warning that financial markets in the United States were on the verge of a credit crunch. By early August, business journalist Jim Jubak concluded that a crunch had finally arrived in the business sector, but not yet for consumers ( Jubak 2007). Then, in early September, a survey sponsored by a mortgage trade group provided evidence that households were feeling the crunch too: a third of home loans originated by mortgage brokers failed to close in August because brokers could not find investors to buy the loans (Zibel 2007).

In an effort to explain the current credit crunch with an illustration, Jubak described the situation in the market for loans that finance corporate buyouts. In the past, banks have been willing to lend to the buyout firms because the banks have been able to resell the loans to investors. The problem in July 2007, however, was that the market for new and existing buyout loans had shrunk rapidly. Indeed, "Investors with portfolios of existing loans discovered [in late July] that they couldn't sell their loans at any price. They were stuck owning loans that were losing big hunks of value by the hour. And they couldn't find an exit" ( Jubak 2007). Because other investors do not want to get caught in the same situation, buyout deals sit idle. According to the September 3 issue of BusinessWeek, "Banks now have a $300 billion backlog of deals" (Goldstein 2007, p. 34).

The buyout market is just one dimension of the credit crunch. Another dimension involves "commercial paper"-- promises to pay that a wide variety of companies issue to acquire short-term funding. By the end of August, the $1.2 trillion asset-backed commercial paper market, which often uses mortgages as collateral, was "freezing up," just like the market for buyout loans (ibid.).

Yet another dimension to the crunch involves the role of hedge funds, which are largely unregulated, operate with considerable secrecy, and are designed primarily for wealthy individuals. Such funds are among the institutions that have relied most heavily on issuing commercial paper in the past few years. As recently as the end of 2006, Wall Street banks lent liberally to such funds, and much of that borrowed money was used to invest in huge packages of mortgages. However, when it became increasingly clear that large numbers of homeowners could not repay their mortgage obligations, the cash flowing to hedge funds dried up, and fund managers found themselves sitting on enormous losses. In June 2007, for example, two hedge funds run by Bear Stearns were wiped out, for a total loss of $20 billion (Foley 2007). The Economics of Minsky

Throughout the summer of 2007, more and more financial-market observers warned of the arrival of a Minsky moment. In fact, "We are in the midst of [such a moment]," said Paul McCulley, a bond fund director at Pacific Investment Management Company, in mid-August. McCulley, whose remarks were quoted on the cover of the Wall Street Journal, should know about a Minsky moment: he coined the term during the 1998 Russian debt crisis (Lahart 2007).

McCulley may have originated the term, but George Magnus, senior economic advisor at UBS, a global investment bank and asset management firm, offers perhaps the most succinct explanation of it. According to Magnus, the stage is first set by "a prolonged period of rapid acceleration of debt" in which more traditional and benign borrowing is steadily replaced by borrowing that depends on new debt to repay existing loans. Then the "moment" occurs, "when lenders become increasingly cautious or restrictive, and when it isn't only overleveraged structures that encounter financing difficulties. At this juncture, the risks of systemic economic contraction and asset depreciation become all too vivid" (Magnus 2007, p. 7).

If left unchecked, the Minsky moment can become a "Minsky meltdown," a spreading decline in asset values capable of producing a recession (McCulley, quoted in Lahart 2007). Even without a meltdown, the jobs market can soften. The "natural response" of employers is to be more cautious about adding workers when financial conditions tighten (Langfitt 2007). The attention now being paid to Minsky raises the questions, Who was this economist, and what did he have to say about market economies and financial instability?

Hyman Minsky was born in Chicago in 1919 and studied at the University of Chicago and Harvard University. He earned tenure as an economics professor at the University of California, Berkeley, but later moved to Washington University in St. Louis. From 1991 until his death in 1996, he worked as a senior scholar at The Levy Economics Institute of Bard College. Minsky considered himself a Keynesian, which is not at all surprising since he served as a teaching assistant to Harvard's Alvin Hansen, who was sometimes called the leading disciple of Keynes in America. However, Minsky was not comfortable with the way Hansen and most in the economics profession interpreted Keynes.

Minsky believed there were two fundamentally distinct views of the workings of a market economy, one of which he associated with Adam Smith, the other, with Keynes. In the "Smithian" view, Minsky argued, the internal and inherent (endogenous) processes of markets generate an economic equilibrium (either a static equilibrium or a growth equilibrium). In the Keynesian view, however, Minsky maintained that endogenous economic forces breed financial and economic instability.

This leads to what Minsky interpreted as two very different views of business cycles. In the Smithian view, business cycles are the product of exogenous shocks--forces external to market processes. In fact, unanticipated public policy interventions are, from this vantage point, among the most commonly identified sources of cycles. Moreover, in a Smithian variant called "real business cycle theory," an economy is believed to be at full employment during all cycle stages.

According to what Minsky called the Keynesian view of business cycles, however, booms and busts are considered an inherent part of the system. In the Keynesian view, the ups and downs of the economy are a product of the internal dynamics of markets, and this instability is considered a genuine social problem, in part because cyclical downturns are seen to be associated with an increase in involuntary unemployment. In the 1950s and 1960s, much of the economics profession interpreted Keynes in a way that brought him into line with the Smithian view of markets. Minsky disagreed, and outlined an alternative interpretation in his 1975 book John Maynard Keynes (Minsky 1975). The book is a major American contribution to what these days is called post-Keynesian economics, a label that scholars like Minsky came to accept as a way of distinguishing themselves from economists who held on to the mainstream view of Keynes.

Minsky's reading of Keynes rests on Keynes's appreciation of the distinction between risk and uncertainty. A situation involving risk is one where probabilities can be assigned with confidence. A situation involving uncertainty is different--there are no precise probabilities to rely on. According to Keynes, in a situation characterized by uncertainty, our knowledge is based on a "flimsy foundation" and is "subject to sudden and violent changes" (Keynes 1937, pp. 214?15).

In Minsky's book on Keynes, the stress is on the central role that uncertainty plays in economic life. This is especially true in the accumulation of wealth, which is the aim of all capitalist investment activity. Minsky's emphasis is consistent with an article Keynes wrote summarizing his General Theory of Employment, Interest, and Money (1936), in which he states: "The whole object of the accumulation of wealth is to produce results, or potential results, at a comparatively distant, and sometimes at an indefinitely distant, date. Thus, the fact that our knowledge of the future is fluctuating, vague and uncertain renders wealth a peculiarly unsuitable subject for the methods of classical economic theory" (Keynes 1937, p. 213). In other words, investment depends heavily on conventional judgments and the existing state of opinion, but ultimately, investment sits on an insecure foundation.

Another fundamental element in Minsky's 1975 book is that investment is given a central role in understanding a nation's aggregate output and employment. This emphasis is also rooted in Keynes's summary of his General Theory, in which, while admitting that investment is not the only factor upon which aggregate output depends, he stresses that "it is usual in a complex system to regard as the causa causans that factor which is most prone to sudden and wide fluctuation" (Keynes 1937, p. 221). ADVERTISEMENT World Currency Booklet! With the advent of the Philadelphia Stock Exchange's new cash-settled world currency options and futures, trading in the world of foreign exchange has taken on a new dimension! Learn choice of markets and accounts, contract sizes, specifications, style, and more!

Financial Instability versus Market Efficiency

While Keynes clearly stated that he thought conventional economics was unsuitable for studying the accumulation of wealth, the dominant view in contemporary finance and financial economics is an extension of the approach Keynes rejected. A core concept of conventional finance, for example, is the "efficient market hypothesis." According to that hypothesis, even if individual decision makers get asset prices or portfolio values wrong, the market as a whole gets them right, which means that financial instruments are driven, by an invisible hand, to some set of prices that reflect the underlying or fundamental value of assets. As finance professor Hersh Shefrin writes, "Traditional finance assumes that when processing data, practitioners use statistical tools appropriately and correctly," by which he means that, as a group, investors, lenders, and other practitioners are not predisposed to overconfidence and other biases (Shefrin 2000, p. 4).

Instead of believing in the efficient market hypothesis, Minsky developed what he dubbed the financial instability hypothesis (FIH). According to Minsky's theory, the financial structure of a capitalist economy becomes more and more fragile over a period of prosperity. During the buildup, enterprises in highly profitable areas of the economy are rewarded handsomely for taking on increasing amounts of debt, and their success encourages similar behavior by others in the same sector (because nobody wants to be left behind due to underinvestment). Increased profits also fuel the tendency toward greater indebtedness, by easing lenders' worries that new loans might go unpaid (Minsky 1975).

In a series of articles that followed his 1975 book, and in a later book titled Stabilizing an Unstable Economy (1986), Minsky fleshed out aspects of the FIH that come to the fore during an expansion. One of these is evolution of the economy (or a sector of the economy) from what he called "hedge" finance to "speculative" finance, and then in the direction of "Ponzi" finance. In the so-called hedge case (which has nothing to do with hedge funds), borrowers are able to pay back interest and principal when a loan comes due; in the speculative case, they can pay back only the interest, and therefore must roll over the financing; and in the case of Ponzi finance, companies must borrow even more to make interest payments on their existing liabilities (Minsky 1982, pp. 22?23, 66?67, 105?06; Minsky 1986, pp. 206?13).

A second facet of the FIH that received increasing emphasis from Minsky over time is its attention to lending as an innovative, profit-driven business. In fact, in a 1992 essay, he wrote that bankers and other intermediaries in finance are "merchants of debt, who strive to innovate with regard to both the assets they acquire and the liabilities they market" (Minsky 1992b, p. 6). As will be discussed in more detail below, both the evolutionary tendency toward Ponzi finance and the financial sector's drive to innovate are easily connected to the recent situation in the U.S. home loan industry, which has seen a rash of mortgage innovations and a thrust toward more fragile financing by households, lending institutions, and purchasers of mortgagebacked securities.

The expansionary phase of the FIH leads, eventually, to the Minsky moment. Trouble surfaces when it becomes clear that a high-profile company (or a handful of companies) has become overextended and needs to sell assets in order to make its payments. Then, since the views of acceptable liability structures are subjective, the initial shortfall of cash and forced selling of assets "can lead to quick and wide revaluations of desired and acceptable financial structures." As Minsky writes, "Whereas experimentation with extending debt structures can go on for years and is a process of gradually testing the limits of the market, the revaluation of acceptable debt structures, when anything goes wrong, can be quite sudden" (Minsky 1982, p. 67). Without intervention in the form of collective action, usually by the central bank, the Minsky moment can engender a meltdown, involving asset values that plummet from forced selling and credit that dries up to the point where investment and output fall and unemployment rises sharply. This is why Minsky called his FIH "a theory of the impact of debt on [economic] system behavior" and "a model of a capitalist economy that does not rely upon exogenous shocks to generate business cycles" (Minsky 1992b, pp. 6, 8). Understanding the Crunch from Minsky's Perspective

This brief is not the place for a comprehensive application of Minsky's FIH to the 2007 credit crunch. Fleshing out and connecting all the details are beyond what can be accomplished and presented here. Moreover, the event is still ongoing as of this writing. Nevertheless, it is possible to identify some of the key elements that must play a role in a Minsky-oriented account of this crunch.

Start with the housing boom, which began around the year 2000. After the "dot-com" bubble burst at the dawn of the new millennium, real estate seemed the only safe bet to many Americans, especially since interest rates were unusually low. At the same time, lenders became more and more creative, and enticed new and increasingly less creditworthy home buyers into the market with exotic mortgages, such as "interest-only" loans and "option adjustable rate" mortgages (option ARMs). These loans involve low payments at the outset, but then are later reset in ways that cause the minimum payments to skyrocket. Banks do not have to report how many option ARMs they write, but the best estimates are that they accounted for less than 1 percent of all mortgages written in 2003, but close to 15 percent in 2006. In many U.S. communities, however, option ARMS accounted for around one of every three mortgages written in the past few years (Der Hovanesian 2006). Also add to the mix new players: unregulated mortgage brokers. In late 2006, brokers accounted for 80 percent of all mortgage originations--double their share from a decade earlier. Brokers do not hold the loan, and they do not have long-term relationships with borrowers: commissions are what motivate brokers. Many brokers pushed option ARMs hard because they were structured to be highly profitable for banks, which in turn offered the brokers high commissions on such loans.

This leads us to another piece of the puzzle: securitization of mortgages. In plain English, this means that bankers bundle dozens of mortgages together and sell the bundles to investment funds. Among the biggest purchasers of such structured packages have been hedge funds, which took advantage of their largely unregulated status and used these mortgage bundles as collateral for highly leveraged loans--often using the loans to buy still more mortgage bundles. According to BusinessWeek Banking Editor Mara Der Hovanesian (2006), the idea was that buyers of these bundles are pros at managing the risk. Minsky, however, would say that Der Hovanesian has put her finger on the source of an important part of the current problem: the mortgage bundles, financial derivatives (such as futures and options trading), and other investment tools widely used by these investment funds involve a lot more Keynesian uncertainty than probabilistic risk. This points to yet another element that plays a role in the current crunch: the credit rating agencies, such as Standard & Poor's. These agencies rate debt packages for the banks that sell them, and their ratings are supposed to be a guide to the likelihood of default. However, the rating agencies are paid by the issuers of the securities, not by investors, so they are always under pressure to give good ratings unless not doing so is absolutely unavoidable--offering less-than-favorable ratings can mean losing business to other rating agencies. And these agencies have made a great deal of money in commissions on such work since 2001 (Coggan 2007).

The contribution of credit rating agencies to the credit crunch, however, involves more than the conflict of interest among the agencies and those they rate. On September 1, 2007, Christopher Huhne--a member of the British Parliament and an economist who worked for a number of years at a rating agency--discussed the agencies and the credit crunch on the British Broadcasting Corporation's World Business Review. After acknowledging that conflicts of interest are a perennial problem, he shifted the focus in a Minskyan direction: "The real problem [is] that financial markets fall in love. They fall in love with new things, with innovations, and the [important] thing about new things is that it is very difficult to assess the real riskiness of them because you don't have a history by definition" (Huhne 2007).

There's also a matter of "garbage in, garbage out." Because the rating agencies do not verify the information provided by mortgage issuers, they base their ratings on the information they are given. That brings us back to the commission-driven mortgage brokers, who have often steered borrowers to high-cost and unfavorable loans (Morgenson 2007), and to home appraisers, who do not usually get steady business unless they confirm the home prices that realtors want to hear (Morici 2007).

When the aforementioned elements (which are not meant to be a comprehensive list of factors contributing to recent financial-market events) are mixed together, one needs only to hit "fast-forward" to arrive at the observed wave of defaults by homeowners, highly leveraged mortgage lenders, an holders of mortgage-backed securities. In other words, the eventual destination is the credit crunch or Minsky moment, which hit in midsummer of 2007. At that point, borrowing and lending--and the hiring of additional workers--became more cautious across the board.

This new cautiousness was partly due to panic, but it was also partly due to recognition of the fact that precarious borrowing had woven its way into the entire system--indeed, into the global financial system--and nobody really knew exactly where the greatest dangers were. For example, here is an excerpt from the Annual Report of the Bank for International Settlements, released in late June of 2007:

"Who now holds [the risks associated with the present era's new investment instruments]? The honest answer is that we do not know. Much of the risk is embodied in various forms of asset-backed securities of growing complexity and opacity. They have been purchased by a wide range of smaller banks, pension funds, insurance companies, hedge funds, other funds and even individuals, who have been encouraged to invest by the generally high ratings given to these instruments. Unfortunately, the ratings reflect only expected credit losses, and not the unusually high probability of tail events that could have large effects on market values (Bank for International Settlements 2007, p. 145)."

Today, these "large effects" are being felt on both Wall Street and Main Street. Industry estimates suggested in late April 2007, before Bear Stearns lost $20 billion on its own, that investors holding mortgage-backed bonds could lose $75 billion as a result of home loans given to people with poor credit. It has also been widely reported that more than two million holders of these so-called "subprime" mortgages could lose their homes to foreclosure (Pittman 2007). Indeed, U.S. mortgage foreclosure notices hit a record high in the second quarter of 2007--the third, record- setting quarterly high in a row (Associated Press 2007).

Despite the arrival of a Minsky moment, a meltdown is not likely to follow. On both sides of the Atlantic Ocean, central banks have stepped in as "lenders of last resort" to help maintain orderly conditions in financial markets and to prevent credit dislocations from adversely affecting the broader economy. Through action taken in August and September of 2007, for example, the Fed reduced the discount rate it charges banks, lowered the quality threshold on collateral used by banks to secure overnight borrowing, infused cash into the financial system, and engineered a decline in private sector interest rates by cutting the federal funds rate. Fed Chairman Ben Bernanke has also endorsed proposals for quick and temporary legislative action designed to protect some mortgage holders via government-backed enterprises, such as Fannie Mae and Freddie Mac (Thomson Financial 2007). All of these responses to the credit crunch are consistent with what Minsky would have advised, though he would also have stressed acting to preempt financial-market excesses by means of more rigorous bank supervision and tighter regulation of financial institutions (Minsky 1986, pp. 313?28).

Nevertheless, the housing difficulties at the root of much of the credit crunch are likely to continue for some time. Layoffs among lending institutions are expected to be up sharply in the next few months. The peak in the upward resetting of monthly payments for holders of option ARMs is also expected to come toward the end of the year; and the resets will continue throughout 2008 (Nutting and Godt 2007). Since there is already a glut of homes on the market, the construction industry will most likely remain in a severe slump, and home prices can be expected to continue to fall. ADVERTISEMENT Leverage on Energy Movement Get your free Guide on Sector Index Options from Think or Swim.

Conclusion: "I Told You So"

This brief demonstrates that the 2007 credit crunch can be understood as a Minsky moment. It should also be stressed, however, that pulling out Minsky's ideas only during a crisis, then letting them fall back into obscurity when the crisis fades, does a disservice to his contributions, and to us all. Regardless of whether one is a student or a scholar, a policymaker or a private citizen, Minsky's writings continue to speak to us in meaningful ways about the financial system and economic dynamics. Although Minsky's career ended in 1996, his ideas are still relevant. His scholarship challenges a belief in the inherent efficiency of markets. As a consequence, it also challenges a laissez-faire stance toward economic policy. His ideas draw attention to the value of evolutionary and institutionally focused thinking about the economy.

Having worked with Minsky on a daily basis at the Levy Institute, I know that he would not have been surprised at all by the 2007 credit crunch and its impact on the U.S. employment report. While the reaction of mainstream economists was "I'm shocked," Minsky would likely have just nodded, and the twinkle in his eyes would have gently said, "I told you so."