"I think we're going to experience a stagflation like we have never seen." ~ the Dude

The Lessons of Lehman...and Leeson
Unfortunately, there are some in the financial industry who are misreading this moment. Instead of learning the lessons of Lehman and the crisis from which we're still recovering, they're choosing to ignore those lessons. President Obama

I burst out laughing when I read the above line in the President's speech yesterday. "The lessons of Lehman!" I thought, "he's got to be joking." I have no doubt Big Finance took that lesson straight to heart.

Let's consider the meaning of the "lessons of Lehman." Given the context, I suspect the President wants Big Finance to see the demise of Lehman as an object lesson- as one might warn a friend trying to ride out a hurricane in New Orleans by reminding him to remember the lessons of Katrina. If this friend had just moved to New Orleans and was unfamiliar with Gulf Coast hurricanes, the "lessons of Katrina" reminder would likely be sufficient.

If, however, this friend owned a house in the French Quarter and had ridden out Katrina the reminder of the lessons thereof might evoke a chuckle and a quick retort, "Katrina taught me that the French Quarter is safe." "The lesson of Lehman," Big Finance CEOs might chuckle to themselves, "is to make sure we're too big to fail." Lehman's balance sheet wasn't big enough, thus failure was an option for them, but not for the biggest banks.

Or so they seem to think.

One of the reasons I didn't write much over the past few months (besides a general laziness and desire to enjoy the summer) was a strong feeling, whenever I looked at the data, of watching a horrible car crash in slow motion. Better, I thought, to avert my eyes.

Yesterday I spent a few hours filling up my spread sheets and catching up on policy speeches and decided the feeling that came over me wasn't as if I was watching a slow motion car crash. I feel now as if I'm a position clerk for Nick Leeson, the bane of Barings Bank, and everyone in the country works for them.

As is my wont, when a feeling like that hits me a quick Google search for "Nick Leeson" is just a few clicks away. Among the more familiar reports I was surprised to find a scholarly examination of the event from NYU's Stern School of Business, about which, more later.

In the movie, Rogue Trader, Nick Leeson explains the secret of his success in a sound bite Big Finance would love, "You keep doubling up, and sooner or later you're bound to win." In the event, Mr. Leeson found this not to be true as the losses on his long position in Nikkei futures (and related derivatives) exploded after the Kobe Earthquake sent the Japanese market plunging early in 1995.

The lesson of Leeson is that doubling up is no guarantee of success. Indeed, according to the NYU paper: Our interest in Mr. Leeson comes from the fact that doubling strategies are potentially dangerous from a systemic point of view. An important attribute of doubling strategies is that the inevitable and devastating loss is preceded by a period of high returns with low volatility. Conditional on the bad event not having happened (yet), the doubler’s investment performance appears to indicate significant investment skill. The doubler may then become too big to fail, both from the perspective of the investment firm and from the market regulators, so that the inevitable failure can have catastrophic effects, both for the firm and for the market. Among other things, this has important consequences for the effectiveness of Value at Risk-controls. Being able to track and take out these traders sooner, would limit possible systemic risks.

Of course, I'm not arguing that Big Finance is doubling up on a hidden (losing) long position in the Nikkei. Their losses are reasonably well known (if not well quantified) and, at least with respect to real estate, not about to turn into profits any time soon. This rogue is out in the open.

Like Leeson, Big Finance doesn't consider liquidation, which would realize the losses, an option. Like Leeson (whose book would make a great study in a Psych course), Big Finance would have us believe their motives are pure. I, however, find this view from the NYU paper interesting: That managers take additional risks to escape from a threatening situation is a well known theme in the field of managerial decision making. For example, Shapira (1997) and Kahneman and Tversky (1986, p. S258) show that people will take greater risks to escape losses than to secure gains. As a consequence, people's behavior tends to change in unexpected and unattractive ways when they are confronted with increasing losses. Thus in finance, where many occupations are high-wire acts, the fear of falling is constantly in the background and sometimes can lure people into disastrous activities. Individuals can become gripped by a frantic panic and may try to conceal these losses, or double up their bets like crazed gamblers trying to punt their way out of their mounting debts. This is the classic gambler’s fallacy.

There are, however, differences between the two.

Unlike Leeson, Big Finance has a supporter who agrees that liquidation isn't an option in the form of the Fed. If Nick had the Fed on his side he could have held on for a few more years (although current levels around 10K for the N225 suggest a loss orders of magnitude larger). The Fed (and Treasury) upon discovering the huge losses, not only provided liquidity to Big Finance, they provided capital support and relaxed accounting rules. As many others have covered (so I'll be brief) this support is unprecedented and ongoing. The "tide" of liquidity is high, as Warren Buffett might put it, and financial markets have responded (albeit with far less bang per buck).

Thus Bernanke, Geithner and even President Obama are engaged in a bit of cautious back-slapping.

This back slapping reminds me of another scene in Rogue Trader: 1994 is coming to a close and Leeson is long Nikkei futures and short Nikkei calls. The price is shown in big numbers, dominating the screen. He cheers and congratulates his team as as the Nikkei keeps rising and closes on its high.

In the NYU paper on the event the authors write: Leeson first sold options on the Nikkei index in October 1992, but his activity in this market really started in the second half of 1993. The value of the option portfolio fluctuated wildly over time, but it had mostly been positive. The highest value was reached by the end of December 1994, when the total value of the options was approximately US$178 million. Mainly due to the Kobe Earthquake, this reversed to a loss of approximately US$108 million by the end of February 1995 (SR App. 3K, p.179)

Given that he wasn't unwinding his risk into the rally, the cheers and back-slapping in December 1994 proved a bit premature. I'm pretty sure if he tried to unwind his position the market would have reversed.

Given that Big Finance isn't unwinding its balance sheet (I know that position can't be unwound without serious market damage) in the current environment, I suspect Bernanke's victory laps and Obama's reassurances may also prove premature, if, as I suspect, the transfer of "toxic" debt to the Fed proves as successful as similar operations in Japan. The reason for this, I surmise, is that such transfers merely buy time, which, when the losses are a large percentage of GDP, is only useful if one can grow out of the problem (which would require rapid growth) or if underlying conditions which created the loss, reverse.

These "underlying conditions" are the crux of the issue. When positions sizes are small enough for a given market, managers can play (and win) under the greater fool theory. The illusion of demand can be created long enough to sell out (or vice versa). However, when positions grow such that they cannot be dumped, the greater fool theory is disproved- you are the greatest fool. This doesn't necessarily guarantee a loss. It does, however, bring finance back to its beginning- the bets must prove out in the real sector.

Thus my concern.

Leeson bet the ranch on Japan returning to its go-go days. But Japan was an aging population with high wealth concentration in the aftermath of a bubble- a perfect recipe for risk aversion. Fortunately, Japan could self-finance and until recently seemed reasonably content to be a mature economy.

Big Finance, in a far more profound sense, has bet the ranch (our ranch) on the US returning to its go-go days. But the US (somewhat obscured by looser immigration standards) is an aging population with high wealth concentration. From whence will come the next productivity enhancing investments that (importantly) can operate within the existing capital structure (since liquidation is off the table). The computer and related communication boom was a perfect way to extend the life of the post WWII infrastructure, but those productivity effects are in the past.

Unfortunately, unlike Japan, we cannot self-finance. We need those capital markets flowing, however inspired.

Thus we took a page from the BoJ playbook and adopted a ZIRP (the world's reserve currency managers opt for a zero interest rate policy....amazing), and the effects are manifesting. Cheap $ finance is already working its magic in the commodity and equity markets. Gold is trading at $1000 as the US$ nears all time lows.

We're inflating all right, but the US real sector will be last in line to catch those flows- the conduits are broken. In the 90s above trend employment growth came, as noted, from the Tech boom, albeit with income gains that were far lower than in previous post WWII expansions. During this century there was no above trend employment growth and income is lower. The real estate wealth effect kept people happy on the margin but that is over too. Once a critical mass of the population is underwater on their mortgages real estate inflation will lag, not lead, more general inflation- an effect we would have experienced in the 90s but for the Tech Boom.

As a comic aside, we are like a team of old baseball players who just got purchased by Steinbrenner and don't want to be replaced by newer younger guys.

I think we're going to experience a stagflation like we have never seen.

But first, we will see a Leeson-esque collapse, first of the US$, and then, when they try to tighten to save it, of large chunks of Big Finance.

Sudden and swift.

I could, of course, be wrong.

Have a nice day.

http://dharmajoint.blogspot.com/2009/09/lessons-of-lehmanand-leeson.html

StrangeCapitalist, or how I learned to stop worrying and love Zombies

Reprising the dude's work which addresses why a nations dreams and goals must exist apart from its means. Money is mere means and in a perfect world finance would be boring and invisible and apparent only in the enabled ends...
Making money can no more be the authentic central goal of capitalism than the search for pleasure can be the goal of life. The pursuit of pleasure for its own sake is ultimately self defeating because the real purpose of pleasure is to modulate action....

During his campaign for President in 1980, George Bush famously dubbed Ronald Reagan's platform "voodoo economics." He must have been on the right track for in its wake we now see the mythic creations of voodoo doctors walking among us- Zombies.

We have Zombie Banks, Zombie Corporations, a Zombie currency and, if I may go so far, Zombie Economics.

There is, of course, nothing new in this observation. Others have beaten me to the punch. Banks and other corporations which should be dead are still walking, ergo, they are Zombies- blindingly obvious. Yet, just as a miner skilled in deep extraction might buy a vein most think of as "played out" I'm going to deep mine this well used metaphor.

There are many aspects of Zombie lore, from the aforementioned voodoo doctors to the film genre inspired by George Romero's Night of the Living Dead. In Romero's Mythos, Zombies don't do the bidding of their voodoo masters. Instead, they shuffle around in search of the living- to eat. Further, the living bitten by a Zombie become Zombies themselves.

Combining the two mythic strands, Reagan's Voodoo Economics, which manifested in the mind of Dick Cheney as "deficits don't matter" created, by allowing debt levels to rise beyond that which which could easily be extinguished in a normal bankruptcy, the Zombie Banks and other corporations which don't serve their creators but instead feed, not on people, but capital, creating more Zombies in the process.

Unlike those in Romero's films, however, we are not trying to rid ourselves of these Zombies. We are incorporating them in our economic policies. Thus we have Zombie Economics.

In a recent round table discussion, George Soros opined: There are two features that I think deserve to be pointed out. One is that the financial system as we know it actually collapsed. After the bankruptcy of Lehman Brothers on September 15, the financial system really ceased to function. It had to be put on artificial life support.

The problem with the "artificial life support" of the financial system is that the voodoo doctors (government regulators) decided to play Frankenstein- a violation of the laws of capitalism as profound as re-animating dead flesh is to the laws of biology- instead of transplanting the dead banks' useful parts into living organisms.

In a sense, the problem begins at birth. To incorporate is to embody, or give substance to. Nature both incorporates the living and ensures that they die. Modern Man, however, at least the American variant thereof, seems loathe to allow its creations to follow suit.

The "creative destruction" aspect of Capitalism has been aptly described as an evolutionary process- the strong procreate and the weak are culled. Within a Capitalist framework, then, zombie corporations have as little place as zombie humans would in real life.

In Romero's films the living are eventually consumed by the zombies and if we are not careful the same could happen to us. Financially mediated trade has risen, flourished, and died many times in human history- e.g. Roman commerce gave way to Dark Age feudalism. I often wonder if the much more recent experience of Mao-ism (a taste, if you will, of feudalism) informs the Chinese perspective of the virtues of financially mediated trade. They seem amazed that we would flirt with such an outcome.

American leadership, reminiscent of Kubrick's Dr. Strangelove- perhaps Dr. StrangeCapitalist, or how I learned to stop worrying and love Zombies, would be more apt- now faces the daunting tasks of rewriting the rules of Capitalism and convincing our creditors that Zombies are normal. Most recently, Treasury Secretary Geithner visited China and assured them our Zombie currency (the US$) wouldn't consume the capital they create and store therein.

On the home front, Zombies are not just consuming capital, they are, in a sense, consuming Capitalism.

In an ironic twist worthy of Greek Tragedy, the supposed proponents of free markets who refuse to let bankrupt corporations die are engendering the very regulations they worked so hard to remove. They have forgotten one of the essential aspects of capitalism- free markets cut both ways. You are free to succeed AND free to fail.

Complaints over executive compensation, or even transportation weren't credible until those executives decided to turn their corporations into Zombies instead of letting them die. Bankruptcy and dismemberment are the check and balance of Capitalism. Without that check and balance we are left with Zombie Economics and, apparently ever-increasing regulations. The longer we allow Zombies to walk among us the more intrusive will state regulations become.

There is another, more mundane sense of the word Zombie which also seems to apply to the current situation- a person without an animating force, just going through habitual motions.

This last sense seems to aptly describe the US economy in in the 21st Century. While the Clinton years were not without problems, there was an animating force driving the economy beyond the desire to just "make money"- we were getting on the "information super-highway." Yes, it's a cliché, but it worked. Economic growth was, in a sense, a function of, inter alia, getting the country "wired." While the guys doing the "wiring" were getting rich in the process it, at least to me, seemed as if people were excited about more than just money- they had a dream of a wired world in their minds and they manifested it in the real world.

Could it be that Capitalism which aims solely to make money is indeed soul-less?

I believe so.

This isn't a knock on Capitalism, but rather a recognition that the system is a means to an end, not an end in itself. Policies that aim to re-invigorate growth by re-invigorating growth will likely fail. It seems to me that there needs to be a greater goal to engender durable economic growth, be it the desire to save ourselves from Nazi-ism, pave the country for our new cars or wire it up.

Let me try to explain this view from a different perspective. Finance, per se, creates nothing. Finance used in pursuit of a goal can be extremely helpful so long as the goal is not merely making money (at which point the financial system, as seems obvious, becomes parasitic). Finance, in a sense, is a Zombie requiring an animating force, be it the desire to "go green" (by retooling our transportation and energy production sectors), make America beautiful (by rebuilding infrastructure), or some other desire.

We need, it seems to me, a goal, a dream, or we're just going to keep shuffling around like a Zombie.

http://dharmajoint.blogspot.com/2009/06/zombie-economics.html

A dam burst and helicopter drop all at once?

As I've recently been noting, the Treasury is sitting on a pile of cash- we might, recalling Fed Chairman Bernanke's idea of a "helicopter drop" of money, consider this one huge payload.

At 4PM today (when the Treasury posts its daily statement) I found that the helicopter has begun to drop its payload. $115B of TARP money was distributed, which leaves $593B left to drop.

Coincidentally, the Fed decided to drop its key rates by 50 basis points, bringing the Funds rate down to 1%.

Additionally, the Fed announced: Today, the Federal Reserve, the Banco Central do Brasil, the Banco de Mexico, the Bank of Korea, and the Monetary Authority of Singapore are announcing the establishment of temporary reciprocal currency arrangements (swap lines). These facilities, like those already established with other central banks, are designed to help improve liquidity conditions in global financial markets and to mitigate the spread of difficulties in obtaining U.S. dollar funding in fundamentally sound and well managed economies.

Of late, many financial commentators have noticed the wide spread between the Fed Funds rate and Libor rates. It seemed as if there was a dam keeping liquidity in the US and not allowing it to reach emerging markets starving for US$s.

With this Fed creation of new swap lines, that dam may be about to burst.

To recap, the Treasury has begun the release of 5% of GDP in financial sector recapitalization and direct credit market support, coupled with substantial declines in the Fed Funds rates, even more substantial increases in the monetary base and new Fed swap lines to emerging markets.

Now that's financial shock and awe!

or, if you prefer, a Tsunami allegory:

When a tsunami is unleashed, right before the waves start to hit, the water recedes dramatically and then begins to flood in....wave after wave.

Was the most recent substantial withdrawal of credit (and coincident decline in equity and commodity markets) the water receding before the Tsunami hits?

Link

Uncle Sam's A.R.M.~ ......Dude, where's the Dharma?

As many home-owners have or are in the process of discovering, adjustable rate mortgage (A.R.M.s) payments can quickly become unmanageable when rates reset. As interest charges double or triple the wisdom of a long term fixed rate mortgage becomes clear.

Fortunately the wise men at the Treasury Department are well versed in such matters and didn't succumb to the temptation of "teaser" rates.

Right?

Wrong.

According to the US Treasury, as of June 2008 (thus not inclusive of the recent bail-outs and mortgage market nationalization), of the $2.72T in government debt owned by foreigners, $1.2T has a duration of under 2 years. In other words, interest rates on that $1.2T ($1.4T including interest payments) will be reset in the next 24 months.

Expanding the scope to include all US external debt, as of June 2008, of the $11.7T of debt owned by foreigners, $6.3T has a duration of under 2 years.

One of Hyman Minsky's claims to fame is his research on the transition from financial stability to fragility in a capitalist economy experiencing a bubble- the Financial Instability Hypothesis.

The Levy Institute, continuing Minsky's research, argues: The aim of these hypotheses is to show that the normal functioning of “a capitalist economy endogenously generates a financial structure which is susceptible to financial crises”because of the higher sensitivity of the economy to changes in income, cash commitments and asset prices. Thus, it is important to explain how the financial structure of the economy (or a sector) changes. This implies studying how it is affected by the prevailing convention regarding the appropriate balance-sheet and cash-flow structures, and by thedevelopments in the productive economy: both the expectation and actual sides of the economyaffect the financial structure of the economy.

The logic of this financial instability hypothesis is that during a prosperous economicperiod, there are forces that progressively lead the economy from conservative financialpositions (hedge positions) to positions for which the articulation of cash flows is high andbalance sheets are illiquid and highly leveraged (Minsky 1986a, 210-211):

The logic of this theorem is twofold. First, within a financial structure that is dominated by hedgefinance, there will be a plentiful supply of short-term funds, so that short-term financing is“cheaper” than long-term financing. Accordingly, firms will be tempted to engage in speculativefinance. Second, over a period of good times, the financial markets will become less averse torisk. This leads to the proliferation of financing forms that involve closer coordination of cashflows out with cash flows in—that is, narrower safety margins and greater use of speculative andPonzi financing. (Minsky 1986b, 5)

In other words, Minsky, a proponent of financial regulation, argued that unregulated finance was prone to succumb to the temptation of lower short term rates. Debt duration would decrease and financial stability would be lost.

And so it has.

With the fiscal deficit expected to rise dramatically over the next 2 years, the US Treasury will not only need to finance that expansion, it will also need to roll-over the maturing short term debt.

Good Luck.